Edgar Filing: POTOMAC BANCSHARES INC

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
______________

FORM 10-K

ANNUAL REPORT
PURSUANT TO SECTIONS 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

(Mark one)

XXX		ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		For the fiscal year ended December 31, 2007

		TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		For the transition period from __________ to __________

Commission File Number 0-24958

POTOMAC BANCSHARES, INC.
(Exact Name of Registrant as Specified in Its Charter)

West Virginia	55-0732247
(State or Other Jurisdiction of	(I.R.S. Employer
Incorporation or Organization)	Identification No.)

111 East Washington Street
PO Box 906, Charles Town WV	25414-0906
(Address of Principal Executive Offices)	(Zip Code)

Registrant's telephone number, including area code		304-725-8431

Securities registered pursuant to Section 12(b) of the Act:

		Name of Each Exchange
Title of Each Class		on Which Registered
NONE

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $1.00 Par Value
(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes ___ No XX

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes ___ No XX

Indicate by check mark whether the registrant: (l) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes XX No ___

Indicate by check mark if disclosure of delinquent filers in response to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ___

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer ___ Accelerated Filer ___ Non-Accelerated Filer ___ Smaller Reporting Company XX

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

Yes ___ No XX

State the aggregate market value of the voting and non-voting common equity held by nonaffiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $50,054,614 as of June 30, 2007

Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date.

3,405,500 as of March 3, 2008

DOCUMENTS INCORPORATED BY REFERENCE

The following lists the document that is incorporated by reference in the Form 10-K Annual Report, and the Parts and Items of the Form 10-K into which the document is incorporated.

		Part of the Form 10-K into Which
Document		__the Document is Incorporated__

Portions of Potomac Bancshares, Inc.’s Proxy Statement for		Part III, Items 10, 11, 12, 13 and 14
the 2008 Annual Meeting of Shareholders

Potomac Bancshares, Inc.
Annual Report on Form 10-K
For the Year Ended December 31, 2007

PART I

Item	1.	Business	4
Item	1A.	Risk Factors	11
Item	2.	Properties	13
Item	3.	Legal Proceedings	14
Item	4.	Submission of Matters to a Vote of Security Holders	14

PART II

Item	5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	14
Item	6.	Selected Financial Data	16
Item	7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
Item	8.	Financial Statements and Supplementary Data	30
Item	9.	Changes In and Disagreements with Accountants on Accounting and Financial Disclosure	58
Item	9A(T).	Controls and Procedures	58
Item	9B.	Other Information	58

PART III

Item	10.	Directors, Executive Officers and Corporate Governance	59
Item	11.	Executive Compensation	59
Item	12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	59
Item	13.	Certain Relationships and Related Transactions and Director Independence	59
Item	14.	Principal Accountant Fees and Services	60

PART IV

Item	15.	Exhibits and Financial Statement Schedules	60

FORWARD-LOOKING STATEMENTS

The Private Securities Litigation Reform Act of 1995 evidences Congress’ determination that the disclosure of forward-looking information is desirable for investors and encourages such disclosure by providing a safe harbor for forward-looking statements by corporate management. This Annual Report on Form 10-K, including the President’s letter and the Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements that involve risk and uncertainty. “Forward-looking statements” are easily identified by the use of words such as “could,” “anticipate,” “estimate,” “believe,” and similar words that refer to a future outlook. To comply with the terms of the safe harbor, the company notes that a variety of factors could cause the company’s actual results and experiences to differ materially from the anticipated results or other expectations expressed in the company’s forward-looking statements.

The risks and uncertainties that may affect the operations, performance, development and results of the company’s business include, but are not limited to, the growth of the economy, interest rate movements, the impact of competitive products, services and pricing, customer business requirements, Congressional legislation and similar matters as well as the occurrence of the events described in the “Risk Factors” section of this Form 10-K. We caution readers of this report not to place undue reliance on forward-looking statements which are subject to influence by the named risk factors and unanticipated future events. Actual results, accordingly, may differ materially from management expectations.

PART I

Item 1. Business.

History and Operations

The Board of Directors of Bank of Charles Town (the "bank") caused Potomac Bancshares, Inc. ("Potomac" or the “company”) to be formed on March 2, 1994, as a single-bank holding company. To date, Potomac's only activities have involved the acquisition of the bank. Potomac acquired all of the shares of the bank’s common stock on July 29, 1994.

Bank of Charles Town is a West Virginia state-chartered bank that formed and opened for business in 1871. The Federal Deposit Insurance Corporation insures the bank’s deposits. The bank engages in general banking business primarily in Jefferson County and Berkeley County, West Virginia. The bank also provides services to Washington County and Frederick County, Maryland and Loudoun County, Frederick County and Clarke County, Virginia. In 2005 the bank opened a loan production office in Winchester, Virginia. The main office is in Charles Town, West Virginia at 111 East Washington Street, with branch offices in

Harpers Ferry, West Virginia,
Kearneysville, West Virginia,
Martinsburg, West Virginia and
Hedgesville, West Virginia.

The bank provides individuals, businesses and local governments with a broad range of banking services. These services include

Commercial credit lines, equipment loans, and construction financing,
Real estate loans, secondary market and adjustable rate mortgages,
Retail loan products including home equity lines of credit,
Checking and savings accounts for businesses and individuals and
Certificates of deposit and individual retirement accounts.

Automated teller machines located at each of the five offices and Touchline 24, an interactive voice response system available at 1-304-728-2424, provide certain services to customers on a twenty-four hour basis. The bank initiated the formation of an ATM network with two banks in the community to provide customers of all three banks 17 ATM locations in the eastern panhandle of West Virginia. Bill paying and certain other banking services are available through the Internet. The trust and financial services department provides financial management, investment and trust services. BCT Investments provides financial management, investment and brokerage services.

Lending Activities. The bank offers a variety of loans for consumer and commercial purposes. The majority of these loans are secured.

Underwriting standards for all lending include

Sound credit analysis,
Proper documentation according to the bank's loan policy standards,
Avoidance of loan concentrations to a single industry or with a single class of collateral,
Diligent maintenance of past due and nonaccrual loans and
A risk grading system that assists us in managing deteriorating credits on a proactive basis.

The lending policies of the bank address the importance of a diversified portfolio and of a balance between maximum yield and minimum risk. It is the bank’s policy to avoid concentrations of loans such as loans to one industry, loans to one borrower or guarantor or loans secured by similar collateral.

The bank's loan policy designates particular loan-to-value limits for real estate loans in accordance with recommendations in Section 304 of the Federal Deposit Insurance Corporation Improvement Act of 1991. As stated in the loan policy, there may be certain lending situations not subject to these loan-to-value limits and from time to time senior management of the bank may permit exceptions to the established limits. Any exceptions are sufficiently documented.

Loans secured by real estate are made to individuals and businesses for

The purchase of raw land and land development,
Commercial, multi-family and other non-residential construction,
Purchase of improved property,
Purchase of owner occupied one to four family residential property,
Lines of credit and
Home equity loans.

Approximately 91.1% of the bank's loans are secured by real estate. These loans had an average delinquency rate of 1.12% and a loss rate of 0.10 % during 2007. The average delinquency rate and loss rate are based on comparisons to 2007 average total loans.

As of December 31, 2007, aggregate dollar amounts (in thousands) in loan categories secured by real estate are as follows:

· Construction and land development	$	55 042
· Secured by farmland		1 328
· Secured by 1-4 family residential		98 864
· Secured by multifamily residential		1 749
· Secured by nonfarm nonresidential		47 726

	$	204 709

Commercial loans not secured by real estate with an aggregate balance of $5.0 million at December 31, 2007 make up approximately 2.2% of the total loan portfolio. The bank’s loan policy for commercial loans including those commercial loans secured by real estate is to

Grant loans on a sound and collectible basis,
Invest the bank’s funds profitably for the benefit of shareholders and the protection of depositors and
Serve the legitimate credit needs of the community in which the bank is located.

Average delinquency and the loss rate for commercial loans not secured by real estate was less than 1% during 2007.

Retail loans to individuals for personal expenditures are approximately 6.6% of the bank's total loans at December 31, 2007. The aggregate balance of these loans was $14.7 million at December 31, 2007. The majority of these loans are installment loans with the remainder made as term loans.

There is some risk in every retail loan transaction. The bank accepts moderate levels of risk while minimizing retail loan losses through careful investigation into the character of each borrower, determining the source of repayment before closing each loan, collateralizing most loans, exercising care in documentation procedures, administering an aggressive retail loan collection program, and following the retail loan policies. Loans to individuals for personal expenditures had an average delinquency rate of 0.06 % and a loss rate of 0.04% in 2007 (based on comparisons to 2007 average total loans).

All other loans total $193 thousand (0.1% of total loans) at December 31, 2007. These loans had no delinquency rate and no average loss rate in 2007 compared to 2007 average total loans.

Investment Activities. The bank's investment policy governs its investment activities.

The policy states that excess daily funds are to be invested in federal funds sold and securities purchased under agreements to resell. The daily funds are used to cover deposit draw downs by customers, to fund loan commitments and to help maintain the bank's asset/liability mix.

According to the policy, funds in excess of those invested in federal funds sold and securities purchased under agreements to resell are to be invested in (1) U.S. Treasury bills, notes or bonds, (2) obligations of U.S. Government agencies or (3) obligations of the State of West Virginia and political subdivisions thereof with a rating of not less than AAA or fully insured bonds.

The policy governs various other factors including maturities, the closeness of purchase price to par, amounts that may be purchased and percentages of the various types of investments that may be held.

Deposit Activities. The bank offers noninterest-bearing and interest-bearing checking accounts and statement savings accounts. The bank offers automatically renewable certificates of deposit in various terms from 91 days to five years. Individual retirement accounts in the form of certificates of deposit are also available.

To open a deposit account, the depositor must meet the following requirements for low risk individuals:

Present a valid identification,
Have a social security number,
Must be a U.S. citizen or possess evidence of legal alien status, and
Must be at least 18 years of age or share an account with a person at least 18 years of age.

When depositors are considered medium or high risk (i.e. out-of-state driver’s license and/or resident), additional verification requirements apply. Management believes that the bank fully complies with the USA Patriot Act.

Competition

As of February 29, 2008, there were 67 bank holding companies (including multi-bank and one bank holding companies) operating in the State of West Virginia. These holding companies are headquartered in various West Virginia cities and control banks throughout the State of West Virginia, including banks that compete with the bank in its market area.

The bank's market area is generally defined as Jefferson County and Berkeley County, West Virginia. As of June 30, 2007, there were seven banks in Jefferson County with 17 banking offices. The total deposits of these commercial banks as of June 30, 2007 were $ 720 million, and the bank ranked number one in total deposits with $ 215 million or 29.77 % of the total deposits in the market at that time. The bank has two branch offices in Berkeley County at this time. Opening in July 2001 and June 2003, these branches have 3.62 % of the market share of deposits in Berkeley County where there are nine banks with 28 banking offices.

For most of the services that the bank performs, there is also competition from financial institutions other than commercial banks. For instance, credit unions, some insurance companies, and issuers of commercial paper and money market funds actively compete for funds and for various types of loans. In addition, personal and corporate trust and investment counseling services are offered by insurance companies, investment counseling firms and other business firms and individuals. Due to the geographic location of the bank's primary market area, the existence of larger financial institutions in Maryland, Virginia and Washington, D.C. influences the competition in the market area. Larger regional and national corporations continue to be increasingly visible in offering a broad range of financial services to all types of commercial and consumer customers. The principal competitive factors in the markets for deposits and loans are interest rates, either paid or charged. The chartering of numerous new banks in West Virginia and the opening of numerous federally chartered savings and loan associations has increased competition for the bank. The 1986 legislation passed by the West Virginia Legislature allowing statewide branch banking provided increased opportunities for the bank, but it also increased competition for the bank in its service area. With the beginning of reciprocal interstate banking in 1988, bank holding companies (such as Potomac Bancshares, Inc.) also face additional competition in efforts to acquire other subsidiaries throughout West Virginia.

In 1994, Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act. Under this Act, bank holding companies are permitted to acquire banks located in states other than the bank holding company’s home state without regard to whether the transaction is permitted under state law. Commencing on June 1, 1997, the Act allowed national banks and state banks with different home states to merge across state lines, unless the home state of a participating bank enacted legislation prior to May 31, 1997, that expressly prohibits interstate mergers. Additionally, the Act allows banks to branch across state lines, unless the state where the new branch will be located enacted legislation restricting or prohibiting de novo interstate branching on or before May 31, 1997. West Virginia adopted legislation, effective May 31, 1997, that allowed for interstate branch banking by merger across state lines and allowed for de novo branching and branching by purchase and assumption on a reciprocal basis with the home state of the bank in question. The effect of this legislation has been increased competition for West Virginia banks, including the bank.

Employees

Potomac currently has no employees.

As of February 29, 2007, the bank had 98 full-time employees and 17 part-time employees.

Supervision and Regulation

Introduction. Potomac is a bank holding company within the provisions of the Bank Holding Company Act of 1956, is registered as such, and is subject to supervision by the Board of Governors of the Federal Reserve System ("Board of Governors"). The Bank Holding Company Act requires Potomac to secure the prior approval of the Board of Governors before Potomac acquires ownership or control of more than five percent (5%) of the voting shares or substantially all of the assets of any institution, including another bank.

As a bank holding company, Potomac is required to file with the Board of Governors annual reports and such additional information as the Board of Governors may require pursuant to the Bank Holding Company Act. The Board of Governors may also make examinations of Potomac and its banking subsidiaries. Furthermore, under Section 106 of the 1970 Amendments to the Bank Holding Company Act and the regulations of the Board of Governors, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or any provision of credit, sale or lease of property or furnishing of services.

Potomac’s depository institution subsidiaries are subject to affiliate transaction restrictions under federal law that limit the transfer of funds by the subsidiary banks to their respective parents and any nonbanking subsidiaries, whether in the form of loans, extensions of credit, investments or asset purchases. Such transfers by any subsidiary bank to its parent corporation or any nonbanking subsidiary are limited in an amount to 10% of the institution's capital and surplus and, with respect to such parent and all such nonbanking subsidiaries, to an aggregate of 20% of any such institution's capital and surplus.

Potomac is required to register annually with the Commissioner of Banking of West Virginia ("Commissioner") and to pay a registration fee to the Commissioner based on the total amount of bank deposits in banks with respect to which it is a bank holding company. Although legislation allows the Commissioner to prescribe the registration fee, it limits the fee to ten dollars per million dollars of deposits rounded off to the nearest million dollars. Potomac is also subject to regulation and supervision by the Commissioner.

Potomac is required to secure the approval of the West Virginia Board of Banking before acquiring ownership or control of more than five percent of the voting shares or substantially all of the assets of any institution, including another bank. West Virginia banking law prohibits any West Virginia or non-West Virginia bank or bank holding company from acquiring shares of a bank if the acquisition would cause the combined deposits of all banks in the State of West Virginia, with respect to which it is a bank holding company, to exceed 25% of the total deposits of all depository institutions in the State of West Virginia.

Depository Institution Subsidiary. The bank is subject to FDIC deposit insurance assessments. As part of new regulations implementing The Federal Deposit Insurance Reform Act of 2005 (FDIRA), assessments for FDIC deposit insurance coverage are now assessed and collected in the quarter following the period of insurance. On June 29, 2007 the bank was billed for the coverage period of January 1 through March 31, 2007. This is the first time in a number of years that the bank has had premiums assessed for deposits. For the first three quarters of 2007 based on our Category I risk classification our assessment rate annualizes to 1.250 basis points or .000125 times the total deposit assessment base each quarter. This is the least risky classification and the lowest possible assessment. An additional facet of the new legislation was a one time assessment credit available to institutions in existence on December 31, 1996 that had paid a deposit insurance assessment prior to that date which has completely offset the deposit assessments for the bank for the coverage periods for the first three quarters of 2007 and will likely offset the deposit assessment for one additional quarter and one additional partial quarter. The FDIC set the Financing Corporation (FICO) Bank Insurance Fund (BIF) premium for the bank at the annual rate of 1.1140 basis points or .0000285 times the total deposits of the bank for the last invoice received dated December 28, 2007. This is a separate premium which is not tied to the bank's risk classification. It is possible that BIF insurance assessments will be changed, and it is also possible that there may be a special additional assessment. A large special assessment could have an adverse impact on Potomac’s results of operations.

Capital Requirements. The Federal Reserve Board has issued risk-based capital guidelines for bank holding companies, such as Potomac. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations, takes off-balance sheet exposures into explicit account in assessing capital adequacy, and minimizes disincentives to holding liquid, low-risk assets. Under the guidelines and related policies, bank holding companies must maintain capital sufficient to meet both a risk-based asset ratio test and leverage ratio test on a consolidated basis. The risk-based ratio is determined by allocating assets and specified off-balance sheet commitments into four weighted categories, with higher levels of capital being required for categories perceived as representing greater risk. The leverage ratio is determined by relating core capital (as described below) to total assets adjusted as specified in the guidelines. The bank is subject to substantially similar capital requirements adopted by applicable regulatory agencies.

Generally, under the applicable guidelines, the financial institution's capital is divided into two tiers. "Tier 1", or core capital, includes common equity, noncumulative perpetual preferred stock (excluding auction rate issues) and minority interests in equity accounts or consolidated subsidiaries, less goodwill. Bank holding companies, however, may include cumulative perpetual preferred stock in their Tier 1 capital, up to a limit of 25% of such Tier 1 capital. "Tier 2", or supplementary capital, includes, among other things, cumulative and limited-life preferred stock, hybrid capital instruments, mandatory convertible securities, qualifying subordinated debt, and the allowance for loan losses, subject to certain limitations, less required deductions. "Total capital" is the sum of Tier 1 and Tier 2 capital.

Financial institutions are required to maintain a risk-based ratio of 8%, of which 4% must be Tier 1 capital. The appropriate regulatory authority may set higher capital requirements when an institution's particular circumstances warrant.

Financial institutions that meet certain specified criteria, including excellent asset quality, high liquidity, low interest rate exposure and the highest regulatory rating, are required to maintain a minimum leverage ratio of 3%. Financial institutions not meeting these criteria are required to maintain a leverage ratio which exceeds 3% by a cushion of at least 100 to 200 basis points, and, therefore, the ratio of Tier 1 capital to total assets should not be less than 4%.

The guidelines also provide that financial institutions experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. Furthermore, the Federal Reserve Board's guidelines indicate that the Federal Reserve Board will continue to consider a "tangible Tier 1 leverage ratio" in evaluating proposals for expansion or new activities. The tangible Tier 1 leverage is the ratio of an institution's Tier 1 capital, less all intangibles, to total assets, less all intangibles.

Failure to meet applicable capital guidelines could subject the financial institution to a variety of enforcement remedies available to the federal regulatory authorities, including limitations on the ability to pay dividends, the issuance by the regulatory authority of a capital directive to increase capital and the termination of deposit insurance by the FDIC, as well as to the measures described in the "Federal Deposit Insurance Corporation Improvement Act of 1991" as applicable to undercapitalized institutions.

The Federal Reserve Board, as well as the FDIC, has adopted changes to their risk-based and leverage ratio requirements that require that all intangible assets, with certain exceptions, be deducted from Tier 1 capital. Under the Federal Reserve Board's rules, the only types of intangible assets that may be included in (i.e., not deducted from) a bank holding company's capital are readily marketable purchased mortgage servicing rights ("PMSRs") and purchased credit card relationships ("PCCRs"), provided that, in the aggregate, the total amount of PMSRs and PCCRs included in capital does not exceed 50% of Tier 1 capital. PCCRs are subject to a separate limit of 25% of Tier 1 capital. The amount of PMSRs and PCCRs that a bank holding company may include in its capital is limited to the lesser of (i) 90% of such assets' fair market value (as determined under the guidelines), or (ii) 100% of such assets' book value, each determined quarterly. Identifiable intangible assets (i.e., intangible assets other than goodwill) other than PMSRs and PCCRs, including core deposit intangibles, acquired on or before February 19, 1992 (the date the Federal Reserve Board issued its original proposal for public comment), generally will not be deducted from capital for supervisory purposes, although they will continue to be deducted for purposes of evaluating applications filed by bank holding companies.

As of December 31, 2007, Potomac had capital in excess of all applicable requirements as shown below:

	Actual		Required		Excess
	(in thousands)
Tier 1 capital:
Common stock	$	3,672
Surplus		3,771
Retained earnings		24,787
		32,230
Less cost of shares acquired for the treasury		2,701
Total tier 1 capital	$	29,529	$	9,081	$	20,448
Tier 2 capital:
Allowance for loan losses (1)		2,779

Total risk-based capital	$	32,308	$	18,161	$	14,147

Risk-weighted assets	$	227,013

Tier 1 capital	$	29,529	$	11,818	$	17,711

Average total assets	$	295,451

Capital ratios:
Tier 1 risk-based capital ratio		13.01%		4.00%		9.01%
Total risk-based capital ratio		14.23%		8.00%		6.23%
Tier 1 capital to average total assets (leverage)		9.99%		4.00%		5.99%

(1) Limited to 1.25% of gross risk-weighted assets.

Gramm-Leach-Bliley Act of 1999. On November 4, 1999, Congress adopted the Gramm-Leach-Bliley Act of 1999. This Act, also known as the Financial Modernization Law, repealed a number of federal limitations on the powers of banks and bank holding companies originally adopted in the 1930’s. Under the Act, banks, insurance companies, securities firms and other service providers may now affiliate. In addition to broadening the powers of banks, the Act created a new form of entity, called a financial holding company, which may engage in any activity that is financial in nature or incidental or complimentary to financial activities.

The Federal Reserve Board provides the principal regulatory supervision of financial services permitted under the Act. However, the Securities and Exchange Commission and state insurance and securities regulators also assume substantial supervisory powers and responsibilities.

The Act addresses a variety of other matters, including customer privacy issues. The obtaining of certain types of information by false or fraudulent pretenses is a crime. Banks and other financial institutions must notify their customers about their policies on sharing information with certain third parties. In some instances, customers may refuse to permit their information to be shared. The Act also requires disclosures of certain automatic teller machine fees and contains certain amendments to the federal Community Reinvestment Act.

Permitted Non-Banking Activities. Under the Gramm-Leach-Bliley Act, bank holding companies may become financial holding companies and engage in certain non-banking activities. Potomac has not yet filed to become a financial holding company and presently does not engage in, nor does it have any immediate plans to engage in, any such non-banking activities.

A notice of proposed non-banking activities must be furnished to the Federal Reserve and the Banking Board before Potomac engages in such activities, and an application must be made to the Federal Reserve and Banking Board concerning acquisitions by Potomac of corporations engaging in those activities. In addition, the Federal Reserve may, by order issued on a case-by-case basis, approve additional non-banking activities.

The Bank. The bank is a state-chartered bank that is not a member of the Federal Reserve System and is subject to regulation and supervision by the FDIC and the Commissioner.

Compliance with Environmental Laws. The costs and effects of compliance with federal, state and local environmental laws will not have a material effect or impact on Potomac or the bank.

International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001 (USA Patriot Act). The International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001 (the “Patriot Act”) was adopted in response to the September 11, 2001 terrorist attacks. The Patriot Act provides law enforcement with greater powers to investigate terrorism and prevent future terrorist acts. Among the broad-reaching provisions contained in the Patriot Act are several designed to deter terrorists’ ability to launder money in the United States and provide law enforcement with additional powers to investigate how terrorists and terrorist organizations are financed. The Patriot Act creates additional requirements for banks, which were already subject to similar regulations. The Patriot Act authorizes the Secretary of the Treasury to require financial institutions to take certain “special measures” when the Secretary suspects that certain transactions or accounts are related to money laundering. These special measures may be ordered when the Secretary suspects that a jurisdiction outside of the United States, a financial institution operating outside of the United States, a class of transactions involving a jurisdiction outside of the United States or certain types of accounts are of “primary money laundering concern.” The special measures include the following: (a) require financial institutions to keep records and report on the transactions or accounts at issue; (b) require financial institutions to obtain and retain information related to the beneficial ownership of any account opened or maintained by foreign persons; (c) require financial institutions to identify each customer who is permitted to use a payable-through or correspondent account and obtain certain information from each customer permitted to use the account; and (d) prohibit or impose conditions on the opening or maintaining of correspondent or payable-through accounts.

Sarbanes-Oxley Act of 2002. On July 30, 2002, the Senate and the House of Representatives of the United States enacted the Sarbanes-Oxley Act of 2002, a law that addresses, among other issues, corporate governance, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information.

Effective August 29, 2002, as directed by Section 302(a) of Sarbanes-Oxley, Potomac’s chief executive officer and chief financial officer are each required to certify that Potomac’s Quarterly and Annual Reports do not contain any untrue statement of a material fact. The rules have several requirements, including having these officers certify that: they are responsible for establishing, maintaining and regularly evaluating the effectiveness of Potomac’s internal controls; they have made certain disclosures to Potomac’s auditors and the audit committee of the Board of Directors about Potomac’s internal controls; and they have included information in Potomac’s Quarterly and Annual Reports about their evaluation and whether there have been significant changes in Potomac’s internal controls or in other factors that could significantly affect internal controls subsequent to the evaluation. Effective in 2008, Section 404 of Sarbanes-Oxley will become applicable to Potomac.

Available Information. The company files annual, quarterly and current reports, proxy statements and other information with the SEC. The company’s SEC filings are filed electronically and are available to the public through the Internet at the SEC’s website at http://www.sec.gov. In addition, any document filed by the company with the SEC can be read and copied at the SEC’s public reference facilities at 100 F Street, NE, Washington, DC 20549. Copies of documents can be obtained at prescribed rates by writing to the Public Reference Section of the SEC at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Copies of documents can also be obtained free of charge by any shareholder by writing to Gayle Marshall Johnson, Sr. Vice President and Chief Financial Officer, Potomac Bancshares, Inc., PO Box 906, Charles Town, WV 25414.

Item 1A. Risk Factors.

Due to Increased Competition, the Company May Not Be Able to Attract and Retain Banking Customers At Current Levels.

If, due to competition from competitors in the company’s market area of Jefferson and Berkeley Counties, West Virginia, the company is unable to attract new and retain current customers, loan and deposit growth could decrease causing the company’s results of operations and financial condition to be negatively impacted. The company faces competition from the following:

local, regional and national banks;
savings and loans;
internet banks;
credit unions;
insurance companies;
finance companies; and
brokerage firms serving the company’s market areas.

Because of the bank’s geographic location, the existence of larger financial institutions in Maryland, Virginia and Washington, DC influences the competition in the bank’s market area.

The Company’s Lending Limit May Prevent It from Making Large Loans.

In the future, the company may not be able to attract larger volume customers because the size of loans that the company can offer to potential customers is less than the size of the loans that many of the company’s larger competitors can offer. Accordingly, the company may lose customers seeking large loans to regional and national banks. We anticipate that our lending limit will continue to increase proportionately with the company’s growth in earnings; however, the company may not be able to successfully attract or maintain larger customers.

It should also be noted that the company may choose with its larger volume customers to “participate” or “syndicate” that portion of a loan that exceeds its legal lending limit. This may be done from time to time to retain that customer’s primary relationship within the bank.

Certain Loans That the Bank Makes Are Riskier than Loans for Real Estate Lending.

The bank makes loans that involve a greater degree of risk than loans involving residential real estate lending. Commercial business loans may involve greater risks than other types of lending although the bank’s commercial loans are generally real estate secured. Only a small portion of the bank’s commercial loans are secured by collateral other than real estate. Consumer loans may involve greater risk because adverse changes in borrowers’ incomes and employment after funding of the loans may impact their abilities to repay the loans.

The Company Is Subject to Interest Rate Risk.

Aside from credit risk, the most significant risk resulting from the company’s normal course of business, extending loans and accepting deposits, is interest rate risk. If market interest rate fluctuations cause the company’s cost of funds to increase faster than the yield of its interest-earning assets, then its net interest income will be reduced. The company’s results of operations depend to a large extent on the level of net interest income, which is the difference between income from interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings. Interest rates are highly sensitive to many factors that are beyond the company’s control, including general economic conditions and the policies of various governmental and regulatory authorities.

The Company May Not Be Able to Retain Key Members of Management.

The departure of one or more of the company’s officers or other key personnel could adversely affect the company’s operations and financial position. The company’s management makes most decisions that involve the company’s operations. The key personnel have all been with the company since 2001. They include Robert F. Baronner, Jr., David W. Irvin and Gayle Marshall Johnson.

An Economic Slowdown in the Company’s Market Area Could Hurt Our Business.

Because we focus our business in Jefferson and Berkeley Counties, West Virginia, an economic slowdown in these areas could hurt our business. An economic slowdown could have the following consequences:

Loan delinquencies may increase;
Problem assets and foreclosures may increase;
Demand for the products and services of the company may decline; and
Collateral (including real estate) for loans made by the company may decline in value, in turn reducing customers’ borrowing power and making existing loans less secure.

The housing market in Jefferson and Berkeley counties in West Virginia has shown a sharp decline. The results have included each of the situations described above. However, management has taken a proactive approach to marketing foreclosed and repossessed properties. The losses on resale of these properties have not been material to date.

The Company and the Bank are Extensively Regulated.

The operations of the company are subject to extensive regulation by federal, state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on them. Policies adopted or required by these governmental authorities can affect the company’s business operations and the availability, growth and distribution of the company’s investments, borrowings and deposits. Proposals to change the laws governing financial institutions are frequently raised in Congress and before bank regulatory authorities. Changes in applicable laws or policies could materially affect the company’s business, and the likelihood of any major changes in the future and their effects are impossible to determine.

The Company’s Allowance for Loan Losses May Not Be Sufficient.

In the future, the company could experience negative credit quality trends that could lead to a deterioration of asset quality. Such deterioration could require the company to incur loan charge-offs in the future and incur additional loan loss provision, both of which would have the effect of decreasing earnings. The company maintains an allowance for possible loan losses, which is a reserve established through a provision for possible loan losses charged to expense that represents management’s best estimate of probable losses that may be incurred within the existing portfolio of loans. Any increases in the allowance for possible loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on the company’s financial condition and results of operation.

Management is constantly monitoring credit quality and any changes that may be tied to current economic conditions. As a result of deteriorating economic conditions bank management has increased the allowance for loan losses. The increase is based on the review of existing loans and managements’ analysis of the credit quality of the existing loans. Management takes a conservative approach to the quality of loans in the portfolio and feels that the bank is adequately reserved for the current market and loan portfolio conditions.

A Shareholder May Have Difficulty Selling Shares.

Because a very limited public market exists for the holding company’s common stock, a shareholder may have difficulty selling his or her shares in the secondary market. We cannot predict when, if ever, we could meet the listing qualifications of the NASDAQ Stock Market’s National Market Tier or any exchange. We cannot assure you that there will be a more active public market for the shares in the near future.

Shares of the Company’s Common Stock Are Not FDIC Insured.

Neither the Federal Deposit Insurance Corporation nor any other governmental agency insures the shares of the company’s common stock. Therefore, the value of your shares in the company will be based on their market value and may decline.

Customers May Default on the Repayment of Loans.

The bank’s customers may default on the repayment of loans, which may negatively impact the company’s earnings due to loss of principal and interest income. Increased operating expenses may result from the allocation of management time and resources to the collection and work-out of these loans. Collection efforts may or may not be successful causing the company to write off these loans or repossess the collateral securing these loans which may or may not exceed the balance of these loans.

The Company’s Controls and Procedures May Fail or Be Circumvented.

Management regularly reviews and updates the company’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, no matter how well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the company’s business, results of operations and financial conditions.

Item 2. Properties.

Potomac currently has no property.

The bank owns the land and buildings of the main office and the branch office facilities in Harpers Ferry, Kearneysville, and Hedgesville. The bank owns the branch office facility in Martinsburg and the land that was leased through February 2008 was purchased by the bank on February 29, 2008 as previously planned. The bank also owns a lot at the corner of Route 340 and Washington Street in Bolivar that may be used for future expansion or may be sold.

The main office property is located at 111 East Washington Street, Charles Town, West Virginia. This property consists of two separate two story buildings located side by side with adjoining corridors. During 2000, the construction of the newer of these two buildings was completed. The first floor of the new building houses the Trust and Financial Services Division. The second floor of the new building houses certain administrative and loan offices. Both of these floors open into the older bank premises. The older building, constructed in 1967, was renovated at the same time the new building was constructed. The renovation includes all new lighting, new ceilings, new floor and wall coverings as well as some minor structural changes for more efficient operations. In July of 2006, the bank completed the purchase of a property adjacent to the main office for future expansion. In March 2008, construction should begin for an addition to the main office facilities and be completed in early 2009.

In October 2005 to provide additional office and storage areas, the bank leased space in Burr Industrial Park in Kearneysville, West Virginia. The leased space houses the Finance Department and provides record storage facilities for the bank.

The Harpers Ferry branch office is located at 1366 W. Washington Street, Bolivar, West Virginia. The office is a one story brick building constructed in 1975 and renovated in 2005. There is another building on this property that existed at the time of the bank's purchase. This separate building is rented to an outside party by the bank.

The branch facility at 5480 Charles Town Road, Kearneysville, West Virginia was erected in 1985. This one story brick building opened for business in April of 1985. During 1993, an addition was constructed, doubling the size of this facility. Renovation of these facilities was completed in 2006.

The branch facility at 119 Cowardly Lion Drive, Hedgesville, West Virginia was erected in 2003. This one story brick building opened for business in June of 2003.

The branch office at 9738 Tuscarora Pike in Martinsburg, West Virginia (which opened for business July 2001) is located in a building owned by the bank. The construction of the one story brick facility was started in 2004 and completed in January 2005. The amended lease for this property expired and the bank purchased the land on February 29, 2008.

The bank is leasing offices in Winchester, Virginia, to house a loan production office that opened in late 2005.

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

Item 3. Legal Proceedings.

Currently Potomac is involved in no legal proceedings.

The bank is involved in various legal proceedings arising in the normal course of business, and in the opinion of the bank, the ultimate resolution of these proceedings will not have a material effect on the financial position or operations of the bank.

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

Not Applicable.

PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

The following information reflects comparative per share data for the periods indicated for Potomac common stock for (a) trading values and (b) dividends. This information has been restated, where applicable, to reflect a 2% stock dividend declared on March 14, 2006 and a 100% stock dividend declared on February 8, 2005. As of March 3, 2008, there were approximately 1,100 shareholders.

Trading of Potomac Bancshares, Inc. common stock is not extensive and cannot be described as a public trading market. Potomac Bancshares, Inc. is on the OTC Bulletin Board Market. To gather information about Potomac in this market use Potomac’s symbol PTBS.OB. Scott and Stringfellow, Inc., Koonce Securities Inc. and Ferris, Baker Watts, Inc. are market makers for Potomac’s stock. Market makers are firms that maintain a firm bid and ask price for a given number of shares at a given point in time in a given security by standing ready to buy or sell at publicly quoted prices. Information about sales of Potomac’s stock is available on the Internet through many of the stock information services using Potomac’s symbol. Shares of Potomac common stock are occasionally bought and sold by private individuals, firms or corporations, and, in most instances, Potomac does not have knowledge of the purchase price or the terms of the purchase. The trading values for 2006 and 2007 are based on information available through the Internet. No attempt was made by Potomac to verify or determine the accuracy of the representations made to Potomac or gathered on the Internet.

		Price Range				Cash Dividends
		High		Low		Paid per Share
2006	First Quarter	$	17.25	$	16.50	$	.0900
	Second Quarter		17.25		15.05		.0925
	Third Quarter		16.85		15.35		.0950
	Fourth Quarter		16.00		15.40		.0975

2007	First Quarter	$	15.99	$	15.15	$	.1000
	Second Quarter		15.99		15.20		.1025
	Third Quarter		15.70		14.55		.1050
	Fourth Quarter		15.45		12.05		.1075

The primary source of funds for dividends paid by Potomac is the dividend income received from the bank. The bank's ability to pay dividends is subject to restrictions under federal and state law, and under certain cases, approval by the FDIC and the Commissioner could be required. Management of Potomac anticipates that the dividends paid by Potomac will likely be similar to those paid in the past, but dividends will only be paid when and as declared by the board of directors.

Performance Graph

The following graph compares the yearly percentage change in Potomac’s cumulative total shareholder return on common stock for the five-year period ending December 31, 2007, with the cumulative total return of the Bank Holding Companies Index (SIC Code 6712) and the Hemscott Index. Shareholders may obtain a copy of the index by calling Hemscott, Inc. at telephone number (301) 760-2609. There is no assurance that Potomac’s stock performance will continue in the future with the same or similar trends as depicted in the graph.

The graph shall not be deemed incorporated by reference by any general statement into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that Potomac specifically incorporates this graph by reference, and shall not otherwise be filed under such Acts.

COMPARE 5-YEAR CUMULATIVE TOTAL RETURN AMONG
POTOMAC BANCSHARES, INC., BANK HOLDING COMPANIES INDEX
AND HEMSCOTT INDEX

ASSUMES $100 WAS INVESTED ON JANUARY 1, 2003 AND ASSUMES DIVIDENDS WERE
REINVESTED THROUGH FISCAL YEAR ENDING DECEMBER 31, 2007

ISSUER PURCHASES OF EQUITY SECURITIES

			(c) Total Number
			of Shares
	(a) Total		Purchased as	(d) Maximum Number
	Number of	(b) Average	Part of Publicly	of Shares that May
	Shares	Price Paid	Announced	Yet be Purchased
Period	Purchased	Per Share	Programs	Under the Program
October 1 through October 31	NONE	--	--	105 478

November 1 through November 30	NONE	--	--	105 478

December 1 through December 31	4 500	12.50	266 191	100 978

On February 12, 2002, the company’s Board of Directors originally authorized the repurchase program. The program authorized the repurchase of up to 10% of the company’s stock over the next twelve months. The stock may be purchased in the open market and/or in privately negotiated transactions as management and the board of directors determine prudent. The program has been extended on annual basis.

Item 6. Selected Financial Data.

	2007		2006		2005		2004		2003
	(Dollars in Thousands Except Per Share Data)
Summary of Operations

Interest income	$	19 691	$	19 099	$	15 424	$	12 008	$	10 786
Interest expense		8 161		6 932		4 135		2 409		2 235
Net interest income		11 530		12 167		11 289		9 599		8 551
Provision for loan losses		678		331		330		289		147
Net interest income after provision
for loan losses		10 852		11 836		10 959		9 310		8 404
Noninterest income		4 364		3 766		3 185		3 158		2 844
Noninterest expense		9 688		9 261		8 460		7 668		7 142
Income before income taxes		5 528		6 341		5 684		4 800		4 106
Income tax expense		1 998		2 306		2 020		1 710		1 432

Net income	$	3 530	$	4 035	$	3 664	$	3 090	$	2 674

Per Share Data **

Net income, basic	$	1.03	$	1.17	$	1.06	$	.89	$	.75
Net income, diluted		1.03		1.16		1.05		.89		.75
Cash dividends declared		.42		.38		.33		.29		.26
Book value at period end		8.52		7.78		7.23		6.58		6.15
Weighted-average shares outstanding, basic		3 423 239		3 454 961		3 460 984		3 463 373		3 570 143
Weighted-average shares outstanding, diluted		3 430 764		3 467 918		3 477 538		3 465 895		3 570 143

Average Balance Sheet Summary

Assets	$	297 716	$	289 303	$	264 314	$	226 052	$	197 052
Loans		226 773		220 895		196 478		155 546		125 407
Securities		42 040		48 891		47 183		46 701		47 087
Deposits		254 908		243 833		217 307		190 153		163 328
Stockholders’ equity		28 207		26 632		23 822		22 045		21 274

Performance Ratios

Return on average assets		1.19%		1.39%		1.39%		1.37%		1.36%
Return on average equity		12.51%		15.15%		15.38%		14.02%		12.57%
Dividend payout ratio		40.78%		32.48%		31.13%		32.58%		34.67%

Capital Ratios

Leverage ratio		9.99%		9.34%		9.18%		9.45%		10.20%
Risk-based capital ratios
Tier 1 capital		13.01%		12.71%		12.68%		13.29%		14.67%
Total capital		14.23%		13.82%		13.76%		14.44%		15.89%

All figures have been restated to reflect a 2% stock dividend declared on March 14, 2006, a 100% stock dividend declared on February 8, 2005 and a 200% stock dividend declared on February 3, 2003.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

AVERAGE BALANCES, INCOME/EXPENSE AND AVERAGE YIELD/RATE

This schedule is a comparison of interest earning assets and interest-bearing liabilities showing average yields or rates derived from average balances and actual income and expenses. Income and rates on tax exempt loans and securities are computed on a tax equivalent basis using a federal tax rate of 34%. Loans placed on nonaccrual status are reflected in the balances.

	2007						2006						2005
	Average			Income/		Average	Average			Income/		Average	Average			Income/		Average
	Balances			Expense		Yield/Rate	Balances			Expense		Yield/Rate	Balances			Expense		Yield/Rate
	(in thousands)						(in thousands)						(in thousands)
ASSETS
Loans
Taxable	$	225 876		$	16 971	7.51%	$	219 795		$	16 641	7.57%	$	195 357		$	13 635	6.98%
Tax exempt		897			76	8.47%		1 100			107	9.73%		1 121			106	9.46%
Total loans		226 773			17 047	7.52%		220 895			16 748	7.58%		196 478			13 741	6.99%
Taxable securities		40 112			1 894	4.72%		47 333			2 095	4.42%		45 721			1 516	3.32%
Nontaxable securities		1 928			112	5.81%		1 558			87	5.58%		1 462			79	5.40%
Securities purchased under
agreements to resell and
federal funds sold		8 226			435	5.29%		1 331			65	4.88%		1 164			43	3.69%
Other earning assets		4 616			267	5.78%		3 609			170	4.71%		3 278			108	3.29%
Total earning assets		281 655		$	19 755	7.01%		274 726		$	19 165	6.98%		248 103		$	15 487	6.24%

Allowance for loan losses		(2 433	)					(2 218	)					(2 077	)
Cash and due from banks		5 140						5 356						7 704
Premises and equipment, net		6 342						6 353						5 975
Other assets		7 012						5 086						4 609
Total assets	$	297 716					$	289 303					$	264 314

LIABILITIES AND
STOCKHOLDERS’ EQUITY
Deposits
Savings and interest-
bearing demand deposits	$	119 142		$	2 713	2.28%	$	127 869		$	2 752	2.15%	$	119 998		$	1 333	1.11%
Time deposits		106 778			4 983	4.67%		84 082			3 431	4.08%		63 661			2 107	3.31%
Total interest-
bearing deposits		225 920			7 696	3.41%		211 951			6 183	2.92%		183 659			3 440	1.87%

Securities sold under agreements
to repurchase and federal
funds purchased		10 959			441	4.02%		13 846			564	4.07%		16 557			516	3.12%
Advances from FHLB		416			24	5.77%		3 463			185	5.34%		4 937			179	3.63%
Total interest
bearing liabilities		237 295		$	8 161	3.44%		229 260		$	6 932	3.02%		205 153		$	4 135	2.02%

Noninterest-bearing demand
deposits		28 988						31 881						33 648
Other liabilities		3 226						1 530						1 691
Stockholders’ equity		28 207						26 632						23 822
Total liabilities and
stockholders’ equity	$	297 716					$	289 303					$	264 314

Net interest income				$	11 594					$	12 233					$	11 352

Net interest spread						3.57%						3.96%						4.22%
Interest expense as a
percent of average earning assets						2.90%						2.52%						1.67%

Net interest margin						4.12%						4.45%						4.58%

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

CRITICAL ACCOUNTING POLICIES

GENERAL

The company’s financial statements are prepared in accordance with U. S. generally accepted accounting principles. The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. In addition, U. S. generally accepted accounting principles may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

ALLOWANCE FOR LOAN LOSSES

The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS 5, “Accounting for Contingencies,” which requires that estimated losses be accrued when they are probable of occurring and (ii) SFAS 114, “Accounting by Creditors for Impairment of a Loan,” which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as doubtful or substandard. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects that margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

GENERAL

Although earnings were not as robust as the past several years, our capital did increase and we paid continually increasing dividends. The review of the company results of operations and financial position over the past five years as shown in the Selected Consolidated Financial Data schedule shows 2007 has been a year of change. Management’s wishes to grow the company by increasing loans and deposits and increasing earnings on a regular basis did not completely come to fruition in 2007, although there was some growth in loans and deposits. Increasing capital also provides the basis for continued expansion of the company including the ability to keep pace with the technology of our ever changing world. Maintaining the technology advantage is one of the most costly yet most necessary goals of doing business after costs of real estate and human resources.

The continuing increase of regulation in the banking industry and the associated costs continue to be a major concern of management. The cost of initial compliance with Sarbanes-Oxley Act of 2002 has been spread out over several years now, with the delay of the bank’s complete implementation date to December 31, 2008. Compliance costs add additional pressure for management to find ways to increase income.

The major source of income for the company is interest income earned on loans and investments and, is, of course, dependent on market conditions, so in addition to increasing income in these areas, management has concentrated on finding additional types of noninterest income. During 2007 and more particularly at the end of 2007 rates decreased. The decrease in rates helps on the interest expense side but decreases income. The bank continues to derive a generous amount of income from the overdraft protection plan introduced about five years ago and although there has been some concern that future regulation may diminish earnings on this product, which would have an adverse affect on the earnings of the company, this has not materialized to date.

The company continues to benefit from tax exempt loan income, tax exempt income of bank owned life insurance policies and tax exempt municipal securities in the investment portfolio and, in fact, increased holdings of life insurance and securities in 2007. These items reduce the income tax expense for the company as well as produce income.

The company continues to seek ways to reduce expenses in addition to ways to increase income while benefiting from processes introduced in the past five years for that purpose including (1) utilization of personnel to full potential by growing the company as much as possible without increasing personnel, (2) continuing the reclassification of deposits to allow a lower balance requirement at the Federal Reserve allowing funds to be used for other purposes such as making loans, (3) increasing service charges as appropriate and (4) the outsourcing of official checks which has been a generous income producer as the bank earns interest on the outstanding balances of the official checks.

The bank has been monitoring its efficiency through the calculation of the efficiency ratio each month. This ratio is the comparison of the bank’s noninterest expenses (overhead) with net interest income plus noninterest income. A decrease in noninterest expenses or an increase in net interest income and/or noninterest income will cause the ratio to decrease. During 2007 the ratio fluctuated in both directions within a few percentage points. In the beginning of 2007 rates were up slightly due to increases in late 2006 by the Federal Reserve board. However, as economic conditions worsened the Federal Reserve reversed ground and began to decrease rates at the end of 2007. As a result of these changes our net interest income has decreased. Overhead costs increased due to expenses related to repossessed property and some inflation related increases.

Management is unaware of any trends, events or uncertainties that would have a material effect on liquidity, capital resources or operations. There are no current recommendations by regulatory authorities that, if they were to be implemented, would have a material effect on the company.

The following table sets forth selected quarterly results (with dollars in thousands) of the company for 2007 and 2006.

	2007									2006
	Three Months Ended									Three Months Ended
		Dec 31		Sept 30		June 30		Mar 31			Dec 31		Sept 30		June 30		Mar 31
Interest income		$	4 821	$	4 900	$	5 014	$	4 956		$	4 995	$	4 961	$	4 756	$	4 387
Interest expense			1 968		2 081		1 980		2 132			1 977		1 926		1 611		1 418
Net interest income			2 853		2 819		3 034		2 824			3 018		3 035		3 145		2 969
Provision for loan losses			578		100		- -		- -			152		104		75		- -
Net interest income after
provision for loan losses			2 275		2 719		3 034		2 824			2 866		2 931		3 070		2 969
Noninterest income			1 142		1 185		1 088		949			913		936		1 071		846
Noninterest expense			2 549		2 442		2 393		2 304			2 227		2 356		2 335		2 343
Income before income taxes			868		1 462		1 729		1 469			1 552		1 511		1 806		1 472
Income tax expense			324		524		626		524			610		542		620		534

Net income		$	544	$	938	$	1 103	$	945		$	942	$	969	$	1 186	$	938

Earnings per share, basic		$	.16	$	.27	$	.32	$	.28		$	.28	$	.28	$	.34	$	.27
Earnings per share, diluted		$	.16	$	.27	$	.32	$	.27		$	.27	$	.28	$	.34	$	.27

NET INTEREST INCOME

As expected, the economy continued to weaken during 2007. The effect was a decrease of 3% in the loan portfolio and a 5% decrease in net interest income during 2007 compared to 2006. Income on securities and other interest and dividends showed slight increases in 2007.

The loan portfolio grew 9% during 2006 as compared to 2005. Net interest income showed an 8% increase over the 2005 results. The growth in 2006 was mainly due to a period of increased interest rates that leveled off at year end.

Interest expense increased 18% in 2007 compared to 2006. This increase is significantly less than the 2005 to 2006 increase. The reasons for this include less borrowing by the bank and decreases in interest rates enacted by the Federal Reserve in the last quarter of 2007.

The last quarter of 2007 ended much like the same period in 2006. Economic indicators suggest the economy is continuing to weaken. All indications are that the Federal Reserve will continue to decrease rates throughout most of 2008. Management is optimistic that the low interest rates will entice some loan growth. In addition, cost of funds should continue to be reasonable as interest rates are expected to decrease and then gradually level off throughout 2008.

VOLUME AND RATE ANALYSIS

This schedule analyzes the change in net interest income attributable to changes in volume of the various portfolios and changes in interest rates. The change due to both rate and volume variances has been allocated between rate and volume based on the percentage relationship of such variances to each other.

	2007 Compared to 2006									2006 Compared to 2005
	(in thousands)									(in thousands)
	Change in									Change in
	Income/			Volume			Rate			Income/		Volume			Rate
	Expense			Effect			Effect			Expense		Effect			Effect
INTEREST INCOME
Taxable loans	$	330		$	462		$	(132	)	$	3 006	$	1 794		$	1 212
Tax exempt loans		(31	)		(18	)		(13	)		1		(2	)		3
Taxable securities		(201	)		(362	)		161			579		56			523
Nontaxable securities		25			21			4			8		5			3
Securities purchased under
agreements to resell
and federal funds sold		370			364			6			22		7			15
Other earning assets		97			53			44			62		12			50
TOTAL	$	590		$	520		$	70		$	3 678	$	1 872		$	1 806

INTEREST EXPENSE
Savings and interest-bearing
demand deposits	$	(39	)	$	(342	)	$	303		$	1 419	$	92		$	1 327
Time deposits		1 552			1 011			541			1 324		768			556
Securities sold under agreements
to repurchase and federal
funds purchased		(123	)		(116	)		(7	)		48		(57	)		105
Federal Home Loan Bank
advances		(161	)		(177	)		16			6		(11	)		17
TOTAL	$	1 229		$	376		$	853		$	2 797	$	792		$	2 005

NET INTEREST INCOME	$	(639	)	$	144		$	(783	)	$	881	$	1 080		$	(199	)

NONINTEREST INCOME AND EXPENSE

As in prior years, fees generated through the bank’s overdraft protection plan available for customers continue to be a major contributor to the bank’s noninterest income. These fees are included in the service charges on deposit accounts category which totaled $2.1 million in 2007, $1.7 million in 2006 and $1.6 million in 2005. Trust and financial services is the next largest contributor to the 2007 noninterest income figure. However, growth slowed to 1.3% in 2007 compared to 8.6% in 2006. Trust income was boosted in the past several years by the accrual of fees for settlement of two significantly large estates. These fees are totally accrued and the estates are closed. Estate settlement fees are one area of income that is not particularly consistent from year to year. The financial services area is also continuing to benefit from the growth of BCT Investments that offers brokerage and other financial services.

The growth of the bank customer base continues to have a positive affect on various components of noninterest income in addition to the overdraft protection plan mentioned above. It provides for increases in other service charges such as stop payments, sales of cashiers checks and money orders, wire transfer fees, debit, ATM and charge card transaction fees.

Fees on sales of loans in the secondary market are a source of noninterest income that varies with the market conditions. Our income from this source was $197 thousand in 2007, $117 thousand in 2006 and $187 thousand in 2005.

During the fourth quarter of 2005, the company’s net income was negatively affected by the one time sale of approximately $14 million in Federal agency securities that had an average coupon yield of 2.6%. The gross loss on this sale was $369 thousand with an after tax net income effect of $243 thousand. The proceeds of this sale were reinvested in Federal agency securities with an average coupon yield of 4.9% which going forward, has favorably impacted income. However, a number of securities purchased during this transaction had call features. With the lowering of interest rates in late 2007, these securities with the higher rates are being called so they can be reissued at lower rates. We anticipate lower income on our securities portfolio at least through most of 2008.

Salaries and employee benefits of $5.3 million are about 54% of the total noninterest expense for 2007. This percentage is similar to 2006 and 2005. Even though the bank has grown during the past few years, full utilization of personnel has allowed the bank to hold down salaries and benefit costs by holding down the increase in personnel. During 2008, salaries and employee benefits are expected to increase for the most part due to annual salary and wage increases, including merit increases, rather than any extensive increase in personnel and due to increased group health insurance expenses.

Expenses related to premises and furniture and equipment have remained relatively stable showing modest increases of between 3% and 4% in 2007 compared to 2006.

The other noninterest expense category is the total of approximately 60 separate expense accounts. None of the account balances in this category exceed 1% of gross income of the bank for any of the three years presented. Increases are due to the growth in the bank’s customer base and some inflationary increases.

INTEREST RATE SENSITIVITY

The table below shows the opportunities the company will have to reprice interest earning assets and interest-bearing liabilities as of December 31, 2007 (in thousands).

	Mature or Reprice
				After Three
				Months			After One Year
	Within			But Within			But Within		After
	Three Months			Twelve Months			Five Years		Five Years		Nonsensitive
Interest Earning Assets:
Loans	$	65 111		$	21 632		$	75 555	$	62 309	$	- -
Securities		1 000			9 502			27 228		1 842		- -
Securities purchased under
agreements to resell and
federal funds sold		5 120			- -			- -		- -		- -
Other earning assets		93			275			4 517		3 035		- -
Total	$	71 324		$	31 409		$	107 300	$	67 186	$	- -

Interest-Bearing Liabilities:
Time deposits
$100,000 and over	$	8 682		$	11 139		$	8 383	$	- -	$	- -
Other time deposits		18 663			32 502			26 707		- -		- -
Gold and Platinum accounts
(NOW accounts)		47 402			- -			- -		- -		33 616
Savings accounts		- -			- -			- -		- -		38 286
Securities sold under agreements to
repurchase and federal funds
purchased		12 537			- -			- -		- -		- -
Federal Home Loan Bank advances		105			107			- -		- -		- -
Total	$	87 389		$	43 748		$	35 090	$	- -	$	71 902

Rate Sensitivity Gap	$	(16 065	)	$	(12 339	)	$	72 210	$	67 186

Cumulative Gap	$	(16 065	)	$	(28 404	)	$	43 806	$	110 992

The matching of the maturities or repricing opportunities of interest earning assets and interest-bearing liabilities may be analyzed by examining the extent to which these assets and liabilities are interest rate sensitive and by monitoring an institution’s interest rate sensitivity gap. An asset or liability is interest rate sensitive within a specific time period if it will mature or reprice within that period. The interest rate sensitivity gap is the difference between the amount of interest earning assets that will mature or reprice within a specific time period and the amount of interest-bearing liabilities that will mature or reprice within the same time period.

A gap is considered negative when the amount of liabilities maturing or repricing in a specific period exceeds the amount of assets maturing or repricing in the same period. An even match between assets and liabilities in each time frame is the safest position especially in times of rapidly rising or declining rates. During other times, the even match is not as critical. The advantages or disadvantages of positive and negative gaps depend totally on the direction in which interest rates are moving. An asset sensitive institution’s net interest margin and net interest income generally will be impacted favorably by rising interest rates, while that of a liability sensitive institution generally will be impacted favorably by declining interest rates.

During the first twelve months shown in the schedule above, the company is liability sensitive, and after that time period the company is asset sensitive. During January, February and March of 2008, $16.1 million more liabilities may reprice or will mature than assets. During April through December of 2008, $12.3 million more liabilities may reprice or will mature than assets. The total effect for 2007 is that $28.4 million more liabilities may reprice or mature than assets. Over the year this is minimal sensitivity in comparison to the total of all assets and liabilities repricing and maturing. During the 2008 time period the company should be only slightly impacted by either rising or falling interest rates.

LOAN PORTFOLIO

Loans at December 31 (in thousands) for each of the five years in the period ended 2007.

	2007		2006		2005		2004		2003
Commercial, financial and agricultural	$	4 987	$	4 247	$	6 046	$	5 949	$	6 217
Mortgage loans on real estate:
Construction and land development		55 042		53 801		41 174		28 929		14 071
Secured by farm land		1 328		1 557		2 381		3 986		3 711
Secured by 1-4 family residential		98 864		103 983		98 408		79 800		62 693
Secured by multifamily residential		1 749		3 733		3 486		3 088		1 635
Secured by nonfarm nonresidential		47 726		46 367		43 019		39 671		33 317
Consumer loans		14 718		16 089		15 549		17 346		17 697
All other loans		193		292		372		236		717
	$	224 607	$	230 069	$	210 435	$	179 005	$	140 058

The continued decline in the housing market had a negative effect on the bank’s loan portfolio in 2007. Despite an optimistic outlook at the end of 2006, the housing market did not rally as many had predicted. For the first time in many years the loan portfolio decreased in value. The loan staff is expecting another challenging year in 2008. Economic indicators suggest that interest rates will continue to decline throughout 2008. The hope is that 2009 will bring a stronger economy and an upswing in the housing market.

There were no categories of loans that exceeded 10% of outstanding loans at December 31, 2007 that were not disclosed in the table above.

REMAINING MATURITIES (in thousands) OF SELECTED LOANS

	Commercial,
	Financial and		Real Estate-
At December 31, 2007	Agricultural		Construction
Loans maturing within one year	$	1 428	$	27 324
Variable rate loans due after one year		517		16 478
Fixed rate loans due after one year through five years		2 944		5 109
Fixed rate loans due after five years		98		6 131
Total maturities	$	4 987	$	55 042

ALLOWANCE FOR LOAN LOSSES

The table shown below is an analysis of the company’s allowance for loan losses. Historically, net charge-offs (loans charged off as uncollectible less any amounts recovered on these loans) for the company have been very low when compared with the size of the total loan portfolio. Management continually monitors the loan portfolio with procedures that allow for problem loans and potentially problem loans to be highlighted and watched. Based on experience, the loan policies and the current monitoring program, management believes the allowance for loan losses is adequate. Due to the policies and procedures in place, management has increased the allowance to cover the increased risks in the portfolio resulting from the current housing market conditions and the economic slowdown.

	2007		2006		2005		2004		2003
	(in thousands)
Balance at beginning of period	$	2 423	$	2 161	$	1 966	$	1 724	$	1 642
Charge-offs:
Commercial, financial and agricultural		14		- -		30		- -		- -
Real estate – construction		32		- -		- -		- -		- -
Real estate – mortgage		206		- -		- -		- -		- -
Consumer		252		207		218		202		191
Total charge-offs		504		207		248		202		191
Recoveries:
Commercial, financial and agricultural		30		- -		- -		- -		- -
Real estate – construction		- -		- -		- -		- -		- -
Real estate – mortgage		- -		- -		- -		- -		8
Consumer		152		138		113		155		118
Total recoveries		182		138		113		155		126
Net charge-offs		322		69		135		47		65
Additions charged to operations		678		331		330		289		147

Balance at end of period	$	2 779	$	2 423	$	2 161	$	1 966	$	1 724
Ratio of net charge-offs during the period
to average loans outstanding during
the period		0.14%		0.03%		0.07%		0.03%		0.05%

ALLOCATION OF ALLOWANCE FOR LOAN LOSSES

The following table shows an allocation of the allowance among loan categories based upon analysis of the loan portfolio’s composition, historical loan loss experience, and other factors, and the ratio of the related outstanding loan balances to total loans.

	2007				2006				2005				2004				2003
	Allowance		% Loans in		Allowance		% Loans in		Allowance		% Loans in		Allowance		% Loans in		Allowance		% Loans in
	(in		Category to		(in		Category to		(in		Category to		(in		Category to		(in		Category to
	thousands)		Total Loans		thousands)		Total Loans		thousands)		Total Loans		thousands)		Total Loans		thousands)		Total Loans
Commercial,
financial and
agricultural	$	35	2.22	%	$	71	1.85	%	$	94	2.87	%	$	81	3.32	%	$	62	4.44	%
Mortgage loans on
real estate:
Construction
and land
development		1 025	24.50	%		820	23.38	%		538	19.57	%		166	16.16	%		141	10.05	%
Secured by farm
land		9	.59	%		12	0.68	%		17	1.13	%		29	2.23	%		37	2.65	%
Secured by 1-4
family
residential		924	44.02	%		753	45.20	%		696	46.76	%		458	44.58	%		272	44.76	%
Secured by multi-
family
residential		13	.78	%		27	1.62	%		25	1.66	%		24	1.73	%		20	1.17	%
Secured by nonfarm
nonresidential		661	21.25	%		478	20.15	%		477	20.44	%		341	22.16	%		330	23.79	%
Consumer loans		111	6.55	%		248	6.99	%		261	7.39	%		591	9.69	%		536	12.63	%
All other loans		1	.09	%		1	0.13	%		2	.18	%		3	.13	%		6	.51	%
Unallocated		- -	- -			13	- -			51	- -			273	- -			320	- -

	$	2 779	100.00	%	$	2 423	100.00	%	$	2 161	100.00	%	$	1 966	100.00	%	$	1 724	100.00	%

RISK ELEMENTS IN THE LOAN PORTFOLIO

	2007		2006		2005		2004		2003
	(in thousands)
Nonaccrual loans	$	1 584	$	144	$	122	$	- -	$	251
Restructured loans		- -		- -		- -		- -		- -
Foreclosed properties		430		- -		- -		- -		- -
Total nonperforming assets	$	2 014	$	144	$	122	$	- -	$	251

Loans past due 90 days
accruing interest	$	21	$	- -	$	65	$	- -	$	153

Allowance for loan losses
to period end loans		1.24%		1.05%		1.03%		1.10%		1.23%

Nonperforming assets to
period end loans and
foreclosed properties		.89%		.06%		.06%		- -		.18%

Loans are placed on nonaccrual status when a loan is specifically determined to be impaired or when principal or interest is delinquent for 90 days or more. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received.

At December 31, 2007, other potential problem loans totaled $4.2 million. Loans are viewed as potential problem loans according to the ability of such borrowers to comply with current repayment terms. These loans are subject to constant management attention, and their status is reviewed on a regular basis.

SECURITIES PORTFOLIO

In accordance with Financial Accounting Standards Board Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” the company records securities being held to maturity at amortized cost and securities available for sale at fair value. The effect of unrealized gains and losses, net of tax effects, is recognized in stockholders’ equity.

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

	2007		Weighted		2006		Weighted		2005		Weighted
	Carrying Value		Average		Carrying Value		Average		Carrying Value		Average
	(in thousands)		Yield		(in thousands)		Yield		(in thousands)		Yield
Securities available for sale
Obligations of U.S. Government agencies:
Maturing within one year	$	10 501	4.38	%	$	14 169	4.05	%	$	15 435	3.82	%
Maturing after one year but
within five years		26 200	5.00	%		26 819	4.86	%		30 243	4.10	%
Municipal obligations:
Maturing within one year		- -	- -			170	2.53	%		- -	- -
Maturing after on year but
within five years		1 029	3.71	%		466	3.59	%		147	3.75	%
Maturing after five years		1 842	3.87	%		1 082	3.97	%		1 126	3.87	%
Total securities available for sale	$	39 572			$	42 706			$	46 951

DEPOSITS

Deposits increased .63% in 2007. Periodically we have continued to depend on alternative methods of funding. We have seen additional deposit growth through our Berkeley County branch offices and anticipate continued growth in those areas. We are a relatively new face in the Berkeley County neighborhood and Berkeley County residents are still learning about us and continue to respond in a positive manner. As of June 2006, the bank had 3.4% of the market share of deposits in Berkeley County and as of June 2007, we had approximately 3.6% of that market. Jefferson County deposit market share is at 30%. We have a total market share in both counties of approximately 14.5% at June 30, 2007.

Schedule of Average Deposits and Average Rates Paid

	Year Ended December 3
	(average balances in thousands)
	2007				2006				2005
	Average		Average		Average		Average		Average		Average
	Balance		Rate		Balance		Rate		Balance		Rate
Noninterest-bearing demand deposits	$	28 988			$	31 881			$	33 648

Interest-bearing demand deposits		83 916	2.41	%		95 146	2.30	%		93 563	1.27	%
Savings deposits		35 226	1.96	%		32 723	1.73	%		26 435	.56	%
Time deposits		106 778	4.67	%		84 082	4.08	%		63 661	3.31	%

Total interest-bearing deposits		225 920	3.41	%		211 951	2.92	%		183 659	1.87	%

Total deposits	$	254 908			$	243 832			$	217 307

At December 31, 2007 time deposits of $100 thousand or more were 11.13 % of total deposits compared with 8.98% at December 31, 2006. Maturities of time deposits of $100 thousand or more (in thousands) at December 31, 2007 are as follows:

Within three months	$	8 682
Over three through six months		6 079
Over six months through twelve months		5 060
Over twelve months		8 383

Total	$	28 204

ANALYSIS OF CAPITAL

The adequacy of the company’s capital is reviewed by management on an ongoing basis in terms of the size, composition, and quality of the company’s asset and liability levels, and consistency with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses.

The Federal Reserve, the Comptroller of the Currency and the Federal Deposit Insurance Corporation have adopted capital guidelines to supplement the existing definitions of capital for regulatory purposes and to establish minimum capital standards. Specifically, the guidelines categorize assets and off-balance sheet items into four risk-weighted categories. The minimum ratio of qualifying total capital to risk-weighted assets is 8.0%, of which at least 4.0% must be Tier 1 capital, composed of common equity, retained earnings and a limited amount of perpetual preferred stock, less certain goodwill items. The company had a ratio of total capital to risk-weighted assets of 14.23% and a ratio of Tier 1 capital to risk-weighted assets of 13.01% at December 31, 2007. These two ratios have increased due to the growth in capital. Both ratios exceed the capital requirements adopted by the federal regulatory agencies.

	(In thousands)
	2007		2006		2005
Tier 1 capital:
Common stock	$	3 672	$	3 672	$	3 600
Surplus		3 771		3 661		2 400
Retained earnings		24 787		22 677		21 158
		32 230		30 010		27 158
Less cost of shares acquired for the treasury		2 701		2 279		1 850

Total tier 1 capital	$	29 529	$	27 731	$	25 308
Tier 2 capital:
Allowance for loan losses (1)		2 779		2 423		2 161

Total risk-based capital	$	32 308	$	30 154	$	27 469

Risk-weighted assets	$	227 013	$	218 193	$	199 602

Capital ratios:
Tier 1 risk-based capital ratio		13.01%		12.71%		12.68%
Total risk-based capital ratio		14.23%		13.82%		13.76%
Leverage ratio		9.99%		9.34%		9.18%

(1)

Limited to 1.25% of gross risk-weighted assets.

LIQUIDITY

Liquidity represents an institution’s ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. This could also be termed the management of the cash flows of an organization. Liquid assets include cash and due from banks, interest-bearing deposits in financial institutions, securities purchased under agreements to resell, federal funds sold, securities available for sale, and loans and investments maturing within one year. The company’s liquidity during 2007 is detailed in the statement of cash flows included in the financial statements.

Operating Activities. The company’s net income usually provides cash from the bank’s operating activities. The net income figure is adjusted for certain noncash transactions such as depreciation expense that reduces net income but does not require a cash outlay. During 2007 net income as adjusted has used cash of $5.2 million. This is due to the loans held for sale to BlueRidge Bank (In Organization) that we have disbursed but will not sell for several months. Typically our loans held for sale turn around in three or four days. Interest income earned on loans and investment securities is the company’s major income source.

Investing Activities. Customer deposits and company borrowings provide the funds used to invest in loans and investment securities. In addition, the principal portion of loan payments, loan payoffs and maturity of investment securities provide cash flow. Purchases of bank premises and equipment are an investing activity. As mentioned in the deposit discussion above, we have taken advantage of our borrowing capabilities for additional funding since deposit growth is not always sufficient to cover our needs. The net amount of cash provided by investing activities in 2007 is $8.0 million.

Financing Activities. Customer deposits and company borrowings provide the financing for the investing activities as stated above. If the company has an excess of funds on any given day, the bank will sell these funds to make additional interest income to fund activities. Likewise, if the company has a shortage of funds on any given day it will purchase funds and pay interest for the use of these funds. Financing activities also include payment of dividends to shareholders, purchase of shares of the company’s common stock for the treasury and repayment of any borrowed or purchased funds. The net amount of cash provided by financing activities in 2007 is $1.4 million.

At December 31, 2007, cash and due from banks, interest-bearing deposits in financial institutions, securities purchased under agreements to resell, federal funds sold and loans and securities maturing within one year were $60.4 million.

Borrowing capabilities provide additional liquidity. The subsidiary bank maintains a federal funds line of $7 million with one financial institution and a federal funds line of $4 million with a second financial institution. The subsidiary bank is also a member of the Federal Home Loan Bank of Pittsburgh and has short and/or long-term borrowing capabilities of approximately $139 million. In June 2001, the subsidiary bank borrowed $2.5 million amortized over seven years from the Federal Home Loan Bank. The subsidiary bank has a Repo Plus account with the FHLB with a current credit line of $20 million that can be renewed on an annual basis.

Financial Instruments With Off-Balance-Sheet Risk. The company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. Those financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the company has in particular classes of financial instruments.

The company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.

A summary of the contract or notional amount of the company’s exposure to off-balance-sheet risk as of December 31, 2007 and 2006 is as follows (in thousands):

	2007		2006
Financial instruments whose contract
amounts represent credit risk:
Commitments to extend credit	$	53 389	$	60 683
Standby letters of credit		3 294		4 750

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the company upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties.

Unfunded commitments under commercial lines of credit are commitments for possible future extensions of credit to existing customers. The majority of these lines of credit is collateralized and usually contains a specified maturity date and may not be drawn upon to the extent to which the company is committed.

Standby letters of credit are conditional commitments issued by the company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The company generally holds collateral supporting those commitments if deemed necessary.

At December 31, 2007, the company had $603 thousand in rate lock commitments to originate mortgage loans.

Short-Term Borrowings. At December 31, 2007, short-term borrowings consist of securities sold under agreements to repurchase that are secured transactions with customers. These borrowings generally mature the day following the day sold. The total of short-term borrowings was $12.5 million on December 31, 2007 and $10.5 million on December 31, 2006. The short-term borrowings at December 31, 2006 were securities sold under agreements to repurchase that were secured transactions with customers and federal funds purchased.

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

	December 31
	2007		2006
Balance outstanding at year end	$	12 537	$	10 526
Maximum balance at any month-end during the year	$	13 430	$	24 979
Average balance for the year	$	10 966	$	16 497
Weighted average rate for the year		4.02%		4.26%
Weighted average rate at year end		4.02%		4.13%
Estimated fair value	$	12 537	$	10 526

Contractual Obligations. The table below presents the contractual obligations of the company as of December 31, 2007:

	Payments (in thousands) Due By Period
					Over 1		Over 3
			Less		Year		Years
			than 1		through		through
	Total		Year		3 Years		5 Years
Long-Term Debt Obligations	$	212	$	212	$	- -	$	- -

Lease Obligations for Real Estate	$	114	$	51	$	63	$	- -

Lease Obligations for Equipment	$	77	$	33	$	44	$	- -

Item 8. Financial Statements and Supplementary Data.

Report of Independent Registered Public Accounting Firm

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

We have audited the consolidated balance sheets of Potomac Bancshares, Inc. and Subsidiary as of December 31, 2007 and 2006, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for the years ended December 31, 2007, 2006 and 2005. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Potomac Bancshares, Inc. and Subsidiary as of December 31, 2007 and 2006, and the results of their operations and their cash flows for the years ended December 31, 2007, 2006 and 2005, in conformity with U.S. generally accepted accounting principles.

We were not engaged to examine management’s assertion about the effectiveness of Potomac Bancshares, Inc. and Subsidiary’s internal control over financial reporting as of December 31, 2007 included in the accompanying Management’s Report on Internal Control over Financial Reporting and, accordingly, we do not express an opinion thereon.

Winchester, Virginia
March 24, 2008

POTOMAC BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
December 31, 2007 and 2006
(in thousands, except share data)

	2007			2006
ASSETS

Cash and due from banks	$	5 938		$	6 214
Interest-bearing deposits in other financial institutions		93			367
Securities purchased under agreements to resell
and federal funds sold		5 120			345
Securities available for sale, at fair value		39 572			42 706
Loans held for sale		8 133			405
Loans, net of allowance for loan losses of $2,779
in 2007 and $2,423 in 2006		221 828			227 646
Premises and equipment, net		6 237			6 421
Other real estate owned		430			- -
Accrued interest receivable		1 366			1 431
Other assets		9 507			7 214

Total Assets	$	298 224		$	292 749


LIABILITIES AND STOCKHOLDERS’ EQUITY

LIABILITIES
Deposits
Noninterest-bearing	$	27 994		$	29 873
Interest-bearing		225 380			221 905
Total Deposits	$	253 374		$	251 778
Securities sold under agreements to repurchase and federal
funds purchased		12 537			10 526
Federal Home Loan Bank advances		212			620
Accrued interest payable		757			672
Other liabilities		2 329			2 436
Commitments and contingent liabilities		- -			- -
Total Liabilities	$	269 209		$	266 032

STOCKHOLDERS’ EQUITY
Common stock, $1 per share par value; 5,000,000 shares
authorized; 3,671,691 shares issued	$	3 672		$	3 672
Surplus		3 771			3 661
Undivided profits		24 787			22 677
Accumulated other comprehensive (loss)		(514	)		(1 014	)
	$	31 716		$	28 996
Less cost of shares acquired for the treasury, 2007,
266,191 shares; 2006, 238,108 shares		2 701			2 279
Total Stockholders’ Equity	$	29 015		$	26 717

Total Liabilities and Stockholders’ Equity	$	298 224		$	292 749

See Notes to Consolidated Financial Statements.

POTOMAC BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2007, 2006 and 2005
(in thousands, except per share data)

	2007		2006		2005
Interest and Dividend Income:
Interest and fees on loans	$	17 093	$	16 712	$	13 705
Interest on securities available for sale - taxable		1 894		2 095		1 516
Interest on securities available for sale - nontaxable		74		57		52
Interest on securities purchased under agreements
to resell and federal funds sold		435		65		43
Other interest and dividends		195		170		108
Total Interest and Dividend Income	$	19 691	$	19 099	$	15 424

Interest Expense:
Interest on deposits	$	7 696	$	6 183	$	3 440
Interest on securities sold under agreements to repurchase
and federal funds purchased		441		564		516
Federal Home Loan Bank advances		24		185		179
Total Interest Expense	$	8 161	$	6 932	$	4 135

Net Interest Income	$	11 530	$	12 167	$	11 289

Provision for Loan Losses		678		331		330

Net Interest Income after Provision
for Loan Losses	$	10 852	$	11 836	$	10 959

Noninterest Income:
Trust and financial services	$	1 085	$	1 071	$	986
Service charges on deposit accounts		2 102		1 724		1 582
Visa/MC Fees		453		364		274
Net gain on sale of loans		197		117		187
Gain (loss) on sale or call of securities available for sale		1		- -		(369	)
Other operating income		526		490		525
Total Noninterest Income	$	4 364	$	3 766	$	3 185

Noninterest Expenses:
Salaries and employee benefits	$	5 252	$	5 104	$	4 518
Net occupancy expense of premises		563		546		507
Furniture and equipment expenses		925		890		875
Advertising and marketing		246		297		281
ATM and check card expense		328		319		252
Other operating expenses		2 374		2 105		2 027
Total Noninterest Expenses	$	9 688	$	9 261	$	8 460
Income Before Income Tax Expense	$	5 528	$	6 341	$	5 684
Income Tax Expense		1 998		2 306		2 020

Net Income	$	3 530	$	4 035	$	3 664

Earnings Per Share, basic	$	1.03	$	1.17	$	1.06
Earnings Per Share, diluted	$	1.03	$	1.16	$	1.05

See Notes to Consolidated Financial Statements.

POTOMAC BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
Years Ended December 31, 2007, 2006 and 2005
(in thousands, except per share data)

												Accumulated
												Other
	Common					Undivided			Treasury			Comprehensive			Comprehensive
	Stock		Surplus			Profits			Stock			Income (Loss)			Income			Total
Balances, December 31, 2004	$	1 800	$	4 200		$	18 631		$	(1 850	)	$	(25	)				$	22 756

Comprehensive income
Net income – 2005		- -		- -			3 664			- -			- -		$	3 664			3 664
Other comprehensive (loss):
Unrealized holding (losses)
arising during the period
(net of tax, $255)		- -		- -			- -			- -			(495	)		(495	)		(495	)
Reclassification for losses
included in net income
(net of tax, $125)		- -		- -			- -			- -			244			244			244
Total other comprehensive (loss)																(251	)
Total comprehensive income															$	3 413
Stock split in the form of a
100% stock dividend		1 800		(1 800	)		- -			- -			- -						- -
Cash dividends – 2005
($.33 per share)		- -		- -			(1 137	)		- -			- -						(1 137	)
Balances, December 31, 2005	$	3 600	$	2 400		$	21 158		$	(1 850	)	$	(276	)				$	25 032

Comprehensive income
Net income – 2006		- -		- -			4 035			- -			- -		$	4 035			4 035
Other comprehensive income:
Unrealized holding gains
arising during the period
(net of tax, $63)		- -		- -			- -			- -			123			123			123
Total comprehensive income															$	4 158
Adjustment to initially apply
FASB Statement No. 158,
in regard to pension and
other postretirement
benefits (net of tax, $441)		- -		- -			- -			- -			(861	)					(861	)
2% stock dividend		72		1 149			(1 221	)		- -			- -						- -
Purchase of treasury shares:
27,093 shares		- -		- -			- -			(429	)		- -						(429	)
Stock-based compensation expense		- -		112			- -			- -			- -						112
Cash dividends – 2006
($.38 per share)		- -		- -			(1 295	)		- -			- -						(1 295	)
Balances, December 31, 2006	$	3 672	$	3 661		$	22 677		$	(2 279	)	$	(1 014	)				$	26 717

Comprehensive income
Net income – 2007		- -		- -			3 530			- -			- -		$	3 530			3 530
Other comprehensive income:
Unrealized holding gains
arising during the period
(net of tax, $159)		- -		- -			- -			- -			306			306			306
Change in benefit obligations
and plan assets for pension
and other postretirement
benefits (net of tax, $97)		- -		- -			- -			- -			194			194			194
Total other comprehensive income																500
Total comprehensive income															$	4 030
Purchase of treasury shares:
28,083 shares		- -		- -			- -			(422	)		- -						(422	)
Stock-based compensation expense		- -		110			- -			- -			- -						110
Cash dividends – 2007
($.42 per share)		- -		- -			(1 420	)		- -			- -						(1 420	)
Balances, December 31, 2007	$	3 672	$	3 771		$	24 787		$	(2 701	)	$	(514	)				$	29 015

See Notes to Consolidated Financial Statements.

POTOMAC BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2007, 2006 and 2005
(in thousands)

	2007			2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	3 530		$	4 035		$	3 664
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Provision for loan losses		678			331			330
Depreciation		568			582			578
Deferred tax (benefit)		(250	)		(190	)		(41	)
Discount accretion and premium
amortization on securities, net		(63	)		(131	)		69
(Gain) loss on sale or call of securities available for sale		(1	)		- -			369
Loss on sale of other real estate		15			- -			- -
Loss on disposal of premises and equipment		12			- -			- -
Loss on sale of repossessed assets		8			- -			- -
Stock-based compensation expense		110			112			- -
Proceeds from sale of loans		11 002			7 285			10 260
Origination of loans for sale		(18 730	)		(7 690	)		(10 112	)
Changes in assets and liabilities:
Decrease (increase) in accrued interest receivable		65			(279	)		(239	)
(Increase) in other assets		(2 220	)		(211	)		(1 123	)
Increase in accrued interest payable		85			341			151
Increase (decrease) increase in other liabilities		10			(391	)		420
Net cash (used in) provided by operating activities	$	(5 181	)	$	3 794		$	4 326

CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from maturity of securities available for sale	$	14 470		$	15 500		$	9 000
Proceeds from sale of securities available for sale		- -			- -			13 900
Proceeds from call of securities available for sale		10 035			2 500			- -
Purchases of securities available for sale		(20 842	)		(13 437	)		(23 331	)
Net decrease (increase) in loans		4 709			(19 703	)		(31 565	)
Purchases of premises and equipment		(384	)		(958	)		(836	)
Proceeds from sale of other real estate		61			- -			- -
Net cash provided by (used in) investing activities	$	8 049		$	(16 098	)	$	(32 832	)

CASH FLOWS FROM FINANCING ACTIVITIES
Net (decrease) in noninterest-bearing deposits	$	(1 879	)	$	(2 741	)	$	(1 622	)
Net increase in interest-bearing deposits		3 475			24 639			30 951
Net proceeds (repayment) of securities sold under agreements to
repurchase and federal funds purchased		2 011			(9 031	)		1 980
Net (repayment) of Federal Home Loan Bank advances		(408	)		(385	)		(5 365	)
Purchase of treasury shares		(422	)		(429	)		- -
Cash dividends		(1 420	)		(1 295	)		(1 137	)
Net cash provided by financing activities	$	1 357		$	10 758		$	24 807
Increase (decrease) in cash and cash equivalents	$	4 225		$	(1 546	)	$	(3 699	)

CASH AND CASH EQUIVALENTS
Beginning		6 926			8 472			12 171
Ending	$	11 151		$	6 926		$	8 472

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash payments for:
Interest	$	8 076		$	6 591		$	3 984
Income taxes	$	2 368		$	2 936		$	1 519

SUPPLEMENTAL DISCLOSURES OF NON-CASH
INVESTING AND FINANCING ACTIVITIES
Unrealized gain (loss) on securities available for sale	$	465		$	186		$	(381	)
Change in benefit obligations and plan assets for pension
and other postretirement benefits	$	291		$	(1 305	)	$	- -
Loans transferred to OREO	$	506		$	- -		$	- -

See Notes to Consolidated Financial Statements.

POTOMAC BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Nature of Banking Activities and Significant Accounting Policies

Potomac Bancshares, Inc. and Subsidiary (the company) grant commercial, financial, agricultural, residential and consumer loans to customers, primarily in Berkeley County and Jefferson County, West Virginia. The company’s market area also includes Washington County and Frederick County, Maryland and Frederick County, Loudoun County and Clarke County, Virginia. The loan portfolio is well diversified and loans generally are collateralized by assets of the customers. The loans are expected to be repaid from cash flows or proceeds from the sale of selected assets of the borrowers.

The accounting and reporting policies of the company conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. The following is a summary of the more significant policies.

Principles of Consolidation

The consolidated financial statements of Potomac Bancshares, Inc. and its wholly-owned subsidiary, Bank of Charles Town (the bank), include the accounts of both companies. All material intercompany balances and transactions have been eliminated in consolidation.

Interest-bearing Deposits in Financial Institutions

Interest-bearing deposits in financial institutions mature within one year and are carried at cost.

Securities

Debt securities that management has the positive intent and ability to hold to maturity are classified as “held to maturity” and recorded at amortized cost. Securities not classified as held to maturity, including equity securities with readily determinable fair values, are classified as “available for sale” and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income.

Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (l) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

Loans

The company grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is comprised of loans secured by real estate. The ability of the company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions of the company’s market area.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff, generally, are reported at their outstanding unpaid principal balances adjusted for the allowance for loan losses. Interest income is accrued on the unpaid principal balance.

The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.

All interest accrued but not collected for loans that are placed on nonaccrual or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

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

Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance is based on two basic principles of accounting: (1) SFAS No. 5, “Accounting for Contingencies,” which requires that losses be accrued when they are probable of occurring and are capable of estimation and (2) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as either doubtful or substandard. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects that margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

A loan is considered impaired when, based on current information and events, it is probable that the company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

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

Loans Held for Sale

Loans originated and intended for sale in the secondary market are carried at the lower of cost or market determined in the aggregate. The company does not retain mortgage servicing rights on loans held for sale.

In 2007, the bank entered into an agreement with BlueRidge Bank (In Organization) whereby Bank of Charles Town would fund loans for BlueRidge Bank (In Organization) until such time as BlueRidge Bank (In Organization) could get its charter. Upon receiving its charter, BlueRidge Bank (In Organization) will buy the loans from Bank of Charles Town. In the event that BlueRidge Bank (In Organization) exceeds its legal lending limit, Bank of Charles Town will fund additional loan amounts through participation agreements. Bank of Charles Town has funded $7.8 million in loans on behalf of BlueRidge Bank (In Organization) as of December 31, 2007.

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

Premises and Equipment

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

Maintenance and repairs of property and equipment are charged to operations and major improvements are capitalized. Upon retirement, sale or other disposition of property and equipment, the cost and accumulated depreciation are eliminated from the accounts and gain or loss is included in operations.

Other Real Estate

Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lower of the loan balance or the fair value net of estimated selling costs at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net expenses from foreclosed assets.

Employee Benefit Plans

The company sponsors the following employee benefit plans:

a noncontributory, defined benefit pension plan covering employees meeting certain age and service requirements,
a postretirement life insurance plan covering current and future retirees with 25 years of service over the age of 60,
a postretirement life insurance plan covering certain current retirees who met certain requirements that is not available for future retirees,
a health care plan for current retirees who met certain eligibility requirements that is not available for future retirees and
a 401(k) retirement savings plan available to all employees meeting certain age and service requirements. Under this plan the employer may make a discretionary matching contribution each plan year and may also make other discretionary contributions to the plan.

Stock Dividends

On March 14, 2006 the Board of Directors declared a 2% stock dividend. Shares increased from 3,600,000 to 3,671,691. On February 8, 2005 the Board of Directors declared a stock split in the form of a 100% stock dividend. Shares increased from 1,800,000 to 3,600,000.

Earnings Per Share

Basic earnings per share represent income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the company relate solely to outstanding stock options and are determined using the treasury method. All amounts have been retroactively restated for the stock dividends as described above.

Income Taxes

Deferred income tax assets and liabilities are determined using the balance sheet method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary difference between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.

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

Income Taxes (Continued)

When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying consolidated balance sheets along with any associated interest and penalties that would be payable to the taxing authorities upon examination. Interest and penalties associated with unrecognized tax benefits are classified as additional income taxes in the consolidated statements of income.

Cash and Cash Equivalents

For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, interest-bearing deposits in financial institutions, securities purchased under agreements to resell and federal funds sold. Generally, securities purchased under agreements to resell and federal funds sold are purchased and sold for one-day periods.

Trust Division

Securities and other property held by the Trust Division in a fiduciary or agency capacity are not assets of the company and are not included in the accompanying financial statements.

Use of Estimates

In preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and the valuation of foreclosed real estate and deferred tax assets.

Advertising

The company follows the policy of charging the costs of advertising to expense as incurred.

Comprehensive Income

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

Stock-Based Compensation Plan

The 2003 Stock Incentive Plan was approved by stockholders on May 13, 2003. This is the first stock incentive plan adopted by the company. Under the plan, the option price cannot be less than the fair market value of the stock on the date granted. An option’s maximum term is ten years from the date of grant. Options granted under the plan may be subject to a graded vesting schedule.

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

Stock-Based Compensation Plan (Continued)

The stockholders initially authorized up to 183,600 shares of common stock to be used in the granting of incentive options to employees and directors. These shares have been restated to reflect the 2% stock dividend declared March 14, 2006 and the 100% stock dividend declared February 8, 2005. On April 24, 2007 the shareholders authorized an additional 250,000 shares of common stock to be used in the granting of incentive options to employees and directors.

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123R, “Share-Based Payment” (SFAS 123R). SFAS 123R requires companies to recognize the cost of employee services received in exchange for awards of equity instruments, such as stock options and nonvested shares, based on the fair value of those awards at the date of grant and eliminates the choice to account for employee stock options under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25). The company adopted SFAS 123R effective January 1, 2006 using the modified prospective method and as such, results for prior periods have not been restated. Prior to January 1, 2006, no compensation expense was recognized for stock option grants as all such grants had an exercise price not less than fair market value on the date of grant.

The following illustrates the effect on net income and earnings per share if the company had applied the fair value method of SFAS 123R, prior to January 1, 2006:

	For the Year Ended
	December 31, 2005
	(dollars in thousands except
	per share amounts)
Net income, as reported		$	3 664
Less pro forma stock option compensation
expense, net of tax			(55	)
Pro forma net income		$	3 609

Earnings per share:
Basic – as reported		$	1.06
Basic – pro forma		$	1.04
Diluted – as reported		$	1.05
Diluted – pro forma		$	1.04

Stock option compensation expense is the estimated fair value of options granted amortized on a straight-line basis over the requisite service period for each separately vesting portion of the award. The weighted average estimated fair value of stock options granted in the twelve months ended December 31, 2007, 2006 and 2005 was $3.76, $3.88 and $2.91, respectively. Fair value is estimated using the Black-Scholes option-pricing model with the following assumptions for grants during 2007, 2006 and 2005: option term until exercise 10 years, expected volatility of 19.56%, 17.86% and 19.46%, risk-free interest rates of 4.66%, 4.43% and 4.26%, and expected dividend yields of 2.74%, 2.66% and 3.15%, respectively. Expected volatility is based on the historic volatility of the company’s stock price over the expected life of the options. We have determined that the expected term for options is their contractual life of 10 years. The risk-free interest rate is the U. S. Treasury zero-coupon issue with a remaining term equal to the expected term of the options granted. The dividend yield is estimated as the ratio of the company’s historical dividends paid per share of common stock to the stock price on the date of grant.

Reclassifications

Certain reclassifications have been made to prior period amounts to conform to the current year presentation.

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

Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements, but rather, provides enhanced guidance to other pronouncements that require or permit assets or liabilities to be measured at fair value. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those years. The FASB has approved a one-year deferral for the implementation of the statement for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. The company does not expect the implementation of SFAS 157 to have a material impact on its consolidated financial statements.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (SFAS 158). This statement requires employers to measure plan assets and obligations as of the balance sheet date. This requirement is effective for fiscal years ending after December 15, 2008. The other provisions of SFAS 158 were implemented by the company as of December 31, 2006. The company does not expect the implementation of the measurement date provisions of SFAS 158 to have a material impact on its consolidated financial statements.

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 159). This statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective of this statement is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The fair value option established by this statement permits all entities to choose to measure eligible items at fair value at specified election dates. A business entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option may be applied instrument by instrument and is irrevocable. SFAS 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007, with early adoption available in certain circumstances. The company does not expect the implementation of SFAS 159 to have a material impact on its consolidated financial statements.

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141(R), “Business Combinations” (SFAS 141(R)). The standard will significantly change the financial accounting and reporting of business combination transactions. SFAS 141(R) establishes principles for how an acquirer recognizes and measures the identifiable assets acquired, liabilities assumed, and any noncontrolling interest in the acquiree; recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS 141(R) is effective for acquisition dates on or after the beginning of an entity’s first year that begins after December 15, 2008. The company does not expect the implementation of SFAS 141(R) to have a material impact on its consolidated financial statements.

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an Amendment of ARB No. 51” (SFAS 160). The standard will significantly change the financial accounting and reporting of noncontrolling (or minority) interests in consolidated financial statements. SFAS 160 is effective as of the beginning of an entity’s first fiscal year that begins after December 15, 2008, with early adoption prohibited. The company does not expect the implementation of SFAS 160 to have a material impact on its consolidated financial statements.

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

Recent Accounting Pronouncements (Continued)

In September 2006, the Emerging Issues Task Force (EITF) issued EITF 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.” This consensus concludes that for a split-dollar life insurance arrangement within the scope of this issue, an employer should recognize a liability for future benefits in accordance with SFAS 106 (if, in substance, a postretirement benefit plan exists) or APB Opinion No. 12 (if the arrangement is, in substance, an individual deferred compensation contract) based on the substantive agreement with the employee. The consensus is effective for fiscal years beginning after December 15, 2007, with early application permitted. The company does not expect the implementation of EITF 06-4 to have a material impact on its consolidated financial statements.

In November 2006, the EITF issued “Accounting for Collateral Assignment Split-Dollar Life Insurance Arrangements” (EITF 06-10). In this issue, a consensus was reached that an employer should recognize a liability for the postretirement benefit related to a collateral assignment split-dollar life insurance arrangement in accordance with either SFAS 106 or APB Opinion No. 12, as appropriate, if the employer has agreed to maintain a life insurance policy during the employee's retirement or provide the employee with a death benefit based on the substantive agreement with the employee. A consensus also was reached that an employer should recognize and measure an asset based on the nature and substance of the collateral assignment split-dollar life insurance arrangement. The consensuses are effective for fiscal years beginning after December 15, 2007, including interim periods within those fiscal years, with early application permitted. The company does not expect the implementation of EITF 06-10 to have a material impact on its consolidated financial statements.

In February 2007, the FASB issued FSP No. FAS 158-1, “Conforming Amendments to the Illustrations in FASB Statements No. 87, No. 88 and No. 106 and to the Related Staff Implementation Guides.” This FSP provides conforming amendments to the illustrations in SFAS 87, 88, and 106 and to related staff implementation guides as a result of the issuance of SFAS 158. The conforming amendments made by this FSP are effective as of the effective dates of SFAS 158. The unaffected guidance that this FSP codifies into SFAS 87, 88, and 106 does not contain new requirements and therefore does not require a separate effective date or transition method. The company does not expect the implementation of FSP No. FAS 158-1 to have a material impact on its consolidated financial statements.

In November 2007, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 109, “Written Loan Commitments Recorded at Fair Value Through Earnings” (SAB 109). SAB 109 expresses the current view of the staff that the expected net future cash flows related to the associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. SEC registrants are expected to apply the views in Question 1 of SAB 109 on a prospective basis to derivative loan commitments issued or modified in fiscal quarters beginning after December 15, 2007. The company does not expect the implementation of SAB 109 to have a material impact on its consolidated financial statements.

In December 2007, the SEC issued Staff Accounting Bulletin No. 110, “Use of a Simplified Method in Developing Expected Term of Share Options” (SAB 110). SAB 110 expresses the current view of the staff that it will accept a company’s election to use the simplified method discussed in SAB 107 for estimating the expected term of “plain vanilla” share options regardless of whether the company has sufficient information to make more refined estimates. The staff noted that it understands that detailed information about employee exercise patterns may not be widely available by December 31, 2007. Accordingly, the staff will continue to accept, under certain circumstances, the use of the simplified method beyond December 31, 2007. The company does not expect the implementation of SAB 110 to have a material impact on its consolidated financial statements.

Note 2. Securities

There were no securities held to maturity as of December 31, 2007 and 2006.

The amortized cost and fair value of securities available for sale as of December 31, 2007 and 2006 (in thousands) are as follows:

	2007
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		(Losses)			Value
Obligations of U.S. Government agencies	$	36 471	$	246	$	(16	)	$	36 701
State and municipal obligations		2 868		5		(2	)		2 871
	$	39 339	$	251	$	(18	)	$	39 572

	2006
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		(Losses)			Value
Obligations of U.S. Government agencies	$	41 213	$	16	$	(242	)	$	40 987
State and municipal obligations		1 725		3		(9	)		1 719
	$	42 938	$	19	$	(251	)	$	42 706

The amortized cost and fair value of the securities available for sale as of December 31, 2007 (in thousands), by contractual maturity, are shown below:

	Amortized		Fair
	Cost		Value
Due in one year or less	$	10 490	$	10 501
Due after one year through five years		27 008		27 229
Due after five years		1 841		1 842
	$	39 339	$	39 572

There were no sales of securities available for sale during 2007 or 2006. Proceeds from sales of securities available for sale were $13.9 million during 2005. Gross losses of $369 thousand were realized on sales in 2005.

The primary purpose of the investment portfolio is to generate income and meet liquidity needs of the company through readily saleable financial instruments. The portfolio is made up of fixed rate bonds, whose prices move inversely with rates. At the end of any accounting period, the investment portfolio has unrealized gains and losses. The company monitors the portfolio which is subject to liquidity needs, market rate changes and credit risk changes to see if adjustments are needed. The primary concern in a loss situation is the credit quality of the business behind the instrument. The primary cause of impairments is the decline in the prices of the bonds as rates have risen. There are approximately 8 accounts in the consolidated portfolio that have losses at December 31, 2007. These securities have not suffered credit deterioration and the company has the ability and intent to hold these issues to maturity or recovery of value; therefore, the gross unrealized losses are considered temporary as of December 31, 2007.

Note 2. Securities (Continued)

The following table summarizes the fair value and gross unrealized losses for securities aggregated by investment category and length of time that individual securities have been in a continuous gross unrealized loss position as of December 31, 2007 and 2006 (in thousands).

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


	December 31, 2006
	Less than 12 months					More than 12 months					Total
			Gross					Gross					Gross
			Unrealized					Unrealized					Unrealized
	Fair Value		Losses			Fair Value		Losses			Fair Value		Losses
Obligations of U.S.
Government agencies	$	6 753	$	(11	)	$	20 733	$	(231	)	$	27 486	$	(242	)
State and municipal obligations		- -		- -			731		(9	)		731		(9	)
	$	6 753	$	(11	)	$	21 464	$	(240	)	$	28 217	$	(251	)

Securities with a carrying value of $25.6 million and $25.2 million at December 31, 2007 and 2006 were pledged to secure public funds and other balances as required by law.

Note 3. Loans and Related Party Transactions

The loan portfolio is composed of the following:

	December 31
	2007		2006
		(in thousands)
Mortgage loans on real estate:
Construction and land development	$	55 042	$	53 801
Secured by farm land		1 328		1 557
Secured by 1-4 family residential		98 864		103 983
Secured by multifamily residential		1 749		3 733
Secured by nonfarm nonresidential		47 726		46 367
Commercial loans (except those secured
by real estate)		4 987		4 247
Consumer loans		14 718		16 089
All other loans		193		292
Total loans	$	224 607	$	230 069
Less: allowance for loan losses		2 779		2 423
	$	221 828	$	227 646

At December 31, 2007 and 2006, overdraft demand deposits reclassified to loans totaled $193 thousand and $144 thousand, respectively.

Loans to directors and executive officers of the company or to their associates at December 31, 2007 and 2006 totaled $2.8 million and $3.3 million, respectively. Such loans were made on substantially the same terms as those prevailing for comparable transactions with similar risks. During 2007, total principal additions were $566 thousand and total principal payments were $1 million.

Note 4. Allowance for Loan Losses

The following is a summary of transactions in the allowance for loan losses for 2007, 2006 and 2005 (in thousands):

	2007			2006			2005
Balances at beginning of year	$	2 423		$	2 161		$	1 966
Provision charged to operating expense		678			331			330
Recoveries added to the allowance		182			138			113
Loan losses charged to the allowance		(504	)		(207	)		(248	)
Balances at end of year	$	2 779		$	2 423		$	2 161

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

	2007		2006
Impaired loans without a valuation allowance	$	3 157	$	- -
Impaired loans with a valuation allowance		2 656		- -

Total impaired loans	$	5 813	$	- -

Valuation allowance related to impaired loans	$	636	$	- -

Total loans past due ninety days or more and still accruing	$	21	$	- -

	2007		2006		2005
Average investment in impaired loans	$	1 163	$	- -	$	- -
Interest income recognized on impaired loans	$	48	$	- -	$	- -
Interest income recognized on a cash basis on impaired loans	$	- -	$	- -	$	- -

No additional funds are committed to be advanced in connection with impaired loans. Nonaccrual loans excluded from impaired loan disclosure under SFAS No. 114 at December 31, 2007 and 2006 totaled $517 thousand and $144 thousand, respectively. If interest had been accrued on these nonaccrual loans, such income would have approximated $3 thousand in 2007 and $14 thousand in 2006.

Note 5. Premises and Equipment, Net

Premises and equipment consists of the following:

	December 31
	2007		2006
		(in thousands)
Premises and improvements	$	6 614	$	6 537
Furniture and equipment		4 393		5 360
	$	11 007	$	11 897
Less accumulated depreciation		4 770		5 476
	$	6 237	$	6 421

Depreciation included in operating expense for 2007, 2006 and 2005 was $568 thousand, $582 thousand and $578 thousand, respectively.

Note 6. Deposits

The aggregate amount of time deposits with a balance of $100,000 or more was $28.2 million and $22.6 million at December 31, 2007 and 2006, respectively.

Note 6. Deposits (Continued)

At December 31, 2007, the scheduled maturities of all time deposits (in thousands) are as follows:

2008	$	70 985
2009		20 516
2010		7 957
2011		2 482
2012		4 136
	$	106 076

Brokered deposits (all in the form of certificates of deposit) totaled $3.4 million and $12.9 million at December 31, 2007 and 2006, respectively.

Deposits of the company’s directors, executive officers and associates totaled $104 thousand and $96 thousand at December 31, 2007 and 2006, respectively.

Note 7. Borrowings

Short-term borrowings may consist of securities sold under agreements to repurchase and federal funds purchased. At December 31, 2007, short-term borrowings totaled $12.5 million in securities sold under agreements to repurchase through secured transactions with customers. There were no federal funds purchased.

At December 31, 2006 short-term borrowings totaled $10.5 million which included $10.3 million in securities sold under agreements to repurchase through secured transactions with customers and $200 thousand in federal funds purchased.

In June 2001, the bank incurred fixed rate long term debt consisting of a Federal Home Loan Bank seven year loan with an original balance of $2.5 million and monthly payments of interest and principal with an interest rate of 5.51%. Total non-securities collateral available to secure loans with the Federal Home Loan Bank is $134 million. The remaining principal payments on the note are due during 2008 in the amount of $212 thousand.

The balance of this loan at December 31, 2006 was $620 thousand.

The company has unused lines of credit with the Federal Home Loan Bank and other financial institutions totaling approximately $150 million at December 31, 2007.

Note 8. Employee Benefit Plans

The company sponsors a 401(k) retirement savings plan available to all employees meeting certain age and service requirements. Employees become eligible to participate in the plan upon reaching age 21 and completing one year of service. Entry dates are January 1, April 1, July 1 and October 1. Employees can make a salary deferral election authorizing the employer to withhold up to the amount allowed by law each calendar year. The employer may make a discretionary matching contribution each plan year. The employer may also make other discretionary contributions to the plan. The company made 401(k) matching contributions of $92 thousand, $56 thousand and $50 thousand in 2007, 2006 and 2005, respectively.

The company sponsors a funded noncontributory, defined benefit pension plan covering full-time employees over 21 years of age upon completion of one year of service. Benefits are based on average compensation for the five consecutive full calendar years of service which produces the highest average.

The company sponsors an unfunded postretirement life insurance plan covering current and future retirees with 25 years of service over the age of 60 and an unfunded health care plan for current retirees that met certain eligibility requirements.

Note 8. Employee Benefit Plans (Continued)

The company has entered into contracts with four retirees where the company agrees to pay the participants’ beneficiaries $50,000 upon the participants’ death. The present value of this postretirement benefit has been accrued as of December 31, 2007 in the amount of $77 thousand. While these liabilities are unfunded, life insurance has been obtained by the company to help offset these payments.

Obligations and funded status:

	Pension Benefits						Postretirement Benefits
	2007			2006			2007			2006
	(in thousands)						(in thousands)
Change in benefit obligation:
Benefit obligation, beginning	$	6 148		$	5 490		$	515		$	517
Service cost		254			274			11			10
Interest cost		362			323			30			30
Actuarial (gain) loss		(144	)		271			- -			(20	)
Benefits paid		(246	)		(210	)		(20	)		(22	)
Benefit obligation, ending	$	6 374		$	6 148		$	536		$	515

Change in plan assets:
Fair value of plan assets, beginning	$	4 622		$	4 097		$	- -		$	- -
Actual return on plan assets		442			436			- -			- -
Employer contributions		485			299			20			22
Benefits paid		(246	)		(210	)		(20	)		(22	)
Fair value of plan assets, ending	$	5 303		$	4 622		$	- -		$	- -

Funded status at end of year	$	(1 071	)	$	(1 526	)	$	(536	)	$	(515	)

Accounts recognized on consolidated
balance sheet as:
Accrued benefit liabilities	$	(1 071	)	$	(1 526	)	$	(536	)	$	(515	)

Amounts recognized in accumulated other
comprehensive (loss) consist of:
Net loss (gain)	$	936		$	1 210		$	(47	)	$	(47	)
Transition liability		- -			- -			122			139
Deferred tax benefit		(318	)		(410	)		(26	)		(31	)
	$	618		$	800		$	49		$	61

The accumulated benefit obligation for the defined benefit pension plan was $5.9 million and $5.0 million at December 31, 2007 and 2006, respectively.

Note 8. Employee Benefit Plans (Continued)

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

	Pension Benefits									Postretirement Benefits
	2007			2006			2005			2007			2006			2005
	(in thousands)									(in thousands)
Components of net periodic benefit cost:
Service cost	$	254		$	274		$	226		$	11		$	10		$	7
Interest cost		362			323			314			30			30			30
Expected return on plan assets		(356	)		(331	)		(314	)		- -			- -			- -
Amortization of net obligation
(asset) at transition		- -			- -			(15	)		17			18			17
Recognized actuarial (gain) loss		40			35			27			- -			- -			(2	)
Net periodic benefit cost	$	300		$	301		$	238		$	58		$	58		$	52

Other changes in plan assets and benefit
obligations recognized in accumulated
other comprehensive income (loss):
Net loss (gain)	$	(274	)	$	1 210			N/A		$	- -		$	(47	)		N/A
Transition liability		- -			- -			N/A			(17	)		139			N/A
Deferred tax		91			(410	)		N/A			6			(31	)		N/A
Total recognized in other
comprehensive income (loss)	$	(183	)	$	800			N/A		$	(11	)	$	61			N/A
Total recognized in net periodic
benefit cost and other
comprehensive income (loss)	$	117		$	1 101			N/A		$	47		$	119			N/A

The estimated net loss and prior service cost for the defined benefit pension plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year approximates $40 thousand. The estimated unrecognized transition liability for the other defined benefit postretirement plans that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year is $17 thousand.

Assumptions

	Pension Benefits						Postretirement Benefits
	2007		2006		2005		2007		2006		2005
	(in thousands)						(in thousands)
Weighted-average assumptions used to
determine net periodic benefit cost:
Discount rate	6.00	%	6.00	%	6.50	%	6.00	%	6.00	%	6.50	%
Expected return on plan assets	7.50	%	8.00	%	8.50	%	- -		- -		- -
Rate of compensation increase	4.50	%	4.00	%	4.00	%	3.00	%	3.00	%	3.00	%

Weighted-average assumptions used to
determine benefit obligations:
Discount rate	6.00	%	6.00	%	6.50	%	6.00	%	6.00	%	6.00	%
Rate of compensation increase	4.50	%	4.00	%	4.00	%	3.00	%	3.00	%	3.00	%

Note 8. Employee Benefit Plans (Continued)

Long-Term Rate of Return

The plan sponsor selects the expected long-term rate-of-return-on-assets assumption in consultation with their investment advisors and actuary. This rate is intended to reflect the average rate of earnings expected to be earned on the funds invested or to be invested to provide plan benefits. Historical performance is reviewed, especially with respect to real rates of return (net of inflation), for the major asset classes held or anticipated to be held by the trust, and for the trust itself. Undue weight is not given to recent experience that may not continue over the measurement period, with higher significance placed on current forecasts of future long-term economic conditions.

Because assets are held in a qualified trust, anticipated returns are not reduced for taxes. Further, solely for this purpose, the plan is assumed to continue in force and not terminate during the period during which assets are invested. However, consideration is given to the potential impact of current and future investment policy, cash flow into and out of the trust, and expenses (both investment and non-investment) typically paid from plan assets (to the extent such expenses are not explicitly estimated within periodic cost).

Asset Allocation

The pension plan’s weighted-average asset allocations at October 31, 2007 and 2006 (the plan’s valuation date), by asset category are as follows:

	Plan Assets at October 31
	2007		2006
Asset Category
Equities	61	%	63	%
Fixed income/cash	39	%	37	%

Total	100	%	100	%

The trust fund is sufficiently diversified to maintain a reasonable level of risk without imprudently sacrificing return, with a targeted asset allocation of 60% equities and 40% fixed income/cash. The trust fund allocation is reviewed on a quarterly basis and rebalanced back to the original weighting if the actual weighting varies by at least 5% from the target allocation. The investment manager selects investment fund managers with demonstrated experience and expertise, and funds with demonstrated historical performance, for the implementation of the plan’s investment strategy. The investment manager will consider both actively and passively managed investment strategies and will allocate funds across the asset classes to develop an efficient investment structure.

It is the responsibility of the trustee to administer the investments of the trust within reasonable costs, being careful to avoid sacrificing quality. These costs include, but are not limited to, management and custodial fees, consulting fees, transaction costs and other administrative costs chargeable to the trust.

There is no company common stock included in the equity securities of the pension plan at December 31, 2007 and 2006.

Note 8. Employee Benefit Plans (Continued)

Cash Flow

The company expects to contribute $300 thousand to its pension plan in 2008 and $23 thousand to its postretirement plan in 2008.

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

	Pension Benefits			Other Benefits
		(in thousands)
2008		$	238		$	23
2009			253			26
2010			254			28
2011			249			30
2012			300			32
2013-2017			1 838			165

For measurement purposes, an 8.5% annual rate of increase in per capita health care costs of covered benefits was assumed for 2007, 2006 and 2005, with such annual rate of increase gradually declining to 5% in 2013.

Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A 1% change in assumed health care cost trend rates would have the following effects:

	1% Increase		1% Decrease
		(in thousands)
Effect on the health care component of the accumulated
postretirement benefit obligation	$	20	$	(21	)
Effect on total of service and interest cost components of
net periodic postretirement health care benefit cost		2		(2	)

Note 9. Weighted Average Number of Shares Outstanding and Earnings Per Share

The following shows the weighted average number of shares used in computing earnings per share and the effect on weighted average number of shares of diluted potential common stock. Potential diluted common stock had no effect on earnings per share available to stockholders.

	December 31, 2007			December 31, 2006			December 31, 2005
	Average	Per Share		Average	Per Share		Average	Per Share
	Shares	Amount		Shares	Amount		Shares	Amount
Basic earnings per share	3 423 239	$	1.03	3 454 961	$	1.17	3 460 984	$	1.06

Effect of dilutive securities:
Stock options	7 525			12 948			16 554

Diluted earnings per share	3 430 764	$	1.03	3 467 909	$	1.16	3 477 538	$	1.05

Shares outstanding have been restated to reflect the 2% stock dividend in 2006 and the 100% stock dividend in 2005.

Stock options for 120,534, 83,811 and 40,574 shares of common stock were not considered in computing diluted earnings per common share for 2007, 2006 and 2005, respectively, because they were antidilutive.

Note 10. Stock-Based Compensation

During 2003, the company adopted an incentive stock plan which allows key employees and directors to increase their personal financial interest in the company. This plan permits the issuance of incentive stock options and non-qualified stock options. The plan authorizes the issuance of up to 183,600 shares of common stock (shares have been restated to reflect the 2% stock dividend declared March 14, 2006 and the 100% stock dividend declared on February 8, 2005). In 2007 the shareholders authorized an additional 250,000 shares of common stock to be used in the granting of incentive options to employees and directors.

A summary of option activity under the plan as of December 31, 2007, and changes during the year then ended is presented below:

						Weighted-
				Weighted-		Average	Aggregate
				Average		Remaining	Intrinsic
				Exercise		Contractual	Value
Options	Shares			Price		Life in Years	(in thousands)
Outstanding at beginning of year		115 739		$	14.31
Granted		36 723			15.60
Exercised		- -			- -
Forfeited		(1 346	)		12.35
Outstanding at end of year		151 116		$	14.77	5		$	87
Exercisable at end of year		81 757		$	14.30	7		$	66

Weighted average fair value
of options granted	$	3.76

The aggregate intrinsic value of a stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had all option holders exercised their options on December 31, 2007. The amount changes based on changes in the market value of the company’s stock.

The exercise price of stock options granted under this plan, both incentive and non-qualified, cannot be less than the fair market value of the common stock on the date that the option is granted. The maximum term for an option granted under this plan is ten years and options granted may be subject to a vesting schedule. The non-qualified options granted are exercisable immediately. The incentive options granted are subject to a five year vesting period whereby the grantees are entitled to exercise one fifth of the options on the anniversary of the grant date over the next five years. The following table summarizes options outstanding at December 31, 2007:

	Options Outstanding					Options Exercisable
			Weighted
			Average	Weighted			Weighted
			Remaining	Average			Average
Exercise	Number		Contractual	Exercise	Number		Exercise
Price	Outstanding		Life (in years)	Price	Exercisable		Price
$ 11.28		30 582	6.0	$ 11.28		23 238	$ 11.28
14.00		40 574	7.0	14.00		25 397	14.00
17.25		43 237	8.0	17.25		20 879	17.25
15.60		36 723	9.0	15.60		12 243	15.60
		151 116				81 757

As of December 31, 2007 there was $178 thousand of total unrecognized compensation expense related to nonvested stock options, which will be recognized over the remaining requisite service period. The unrecognized compensation expense has a weighted average life of three years.

Note 11. Income Taxes

The company files income tax returns in the U. S. federal jurisdiction and the state of West Virginia. With few exceptions, the company is no longer subject to U. S. federal, state and local income tax examinations by tax authorities for years prior to 2004.

The company adopted the provisions of FIN 48, “Accounting for Uncertainty in Income Taxes”, on January 1, 2007 with no impact on the financial statements.

Net deferred tax assets consist of the following components as of December 31, 2007 and 2006:

	2007		2006
	(in thousands)
Deferred tax assets:
Reserve for loan losses	$	790	$	669
Accrued pension expense		438		519
Accrued postretirement benefits		208		175
Nonaccrual interest		17		5
Stock option expense		35		20
Home equity closing costs		72		61
Net loan origination fees		14		- -
OREO expense		11		- -
Securities available for sale		- -		79
	$	1 585	$	1 528
Deferred tax liabilities:
Net loan origination costs	$	- -	$	9
Depreciation		122		130
Securities available for sale		79		- -
	$	201	$	139

Net deferred tax assets	$	1 384	$	1 389

The provision for income taxes charged to operations for the years ended December 31, 2007, 2006 and 2005 consists of the following:

	2007			2006			2005
	(in thousands)
Current tax expense	$	2 248		$	2 496		$	2 061
Deferred tax expense (benefit)		(250	)		(190	)		(41	)
	$	1 998		$	2 306		$	2 020

The income tax provision differs from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the years ended December 31, 2007, 2006 and 2005 due to the following (in thousands):

	2007			2006			2005
Computed “expected” tax expense	$	1 880		$	2 156		$	1 933
Increase (decrease) in income taxes resulting from:
Tax exempt income		(107	)		(87	)		(86	)
State income taxes, net of federal income tax benefit		191			202			173
Other		34			35			- -
	$	1 998		$	2 306		$	2 020

Note 12. Commitments and Contingent Liabilities

In the normal course of business, there are outstanding, various commitments and contingent liabilities which are not reflected in the accompanying financial statements. The company does not anticipate losses as a result of these transactions. See Note 14 with respect to financial instruments with off-balance-sheet risk.

Note 12. Commitments and Contingent Liabilities (Continued)

The company has approximately $92 thousand in deposits in other financial institutions in excess of amounts insured by the Federal Deposit Insurance Corporation (FDIC) at December 31, 2007.

The company must maintain a reserve against its deposits in accordance with Regulation D of the Federal Reserve Act. For the final bi-weekly reporting periods which included December 31, 2007 and 2006, the aggregate amounts of daily average required balances were approximately $300 thousand for each time period.

Note 13. Retained Earnings

Transfers of funds from the banking subsidiary to the parent company in the form of loans, advances and cash dividends are restricted by federal and state regulatory authorities. As of December 31, 2007, the aggregate amount of unrestricted funds which could be transferred from the banking subsidiary to the parent company, without prior regulatory approval, totaled $6.3 million or 21.8% of the consolidated net assets.

Note 14. Financial Instruments With Off-Balance-Sheet Risk

The company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. Those financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the company has in particular classes of financial instruments.

A summary of the contract or notional amount of the company’s exposure to off-balance-sheet risk as of December 31, 2007 and 2006 (in thousands) is as follows:

	2007		2006
Financial instruments whose contract
amounts represent credit risk:
Commitments to extend credit	$	53 389	$	60 683
Standby letters of credit		3 294		4 750

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

At December 31, 2007, the company had rate lock commitments to originate mortgage loans amounting to $603 thousand and mortgage loans held for sale in the amount of $306 thousand. The company enters into corresponding mandatory commitments, on a best-efforts basis, to sell the loans. These commitments to sell loans are designed to eliminate the company’s exposure to fluctuations in interest rates in connection with rate lock commitments and loans held for sale.

Note 15. Fair Value of Financial Instruments and Interest Rate Risk

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Short-Term Investments

For those short-term instruments, the carrying amount is a reasonable estimate of fair value.

Securities

For securities held for investment purposes, fair values are based on quoted market prices or dealer quotes.

Loans

For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for other loans were estimated using discounted cash flow analyses, using interest rates currently being offered.

Loans Held for Sale

The carrying amount of loans held for sale approximates fair value.

Deposit Liabilities

The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.

Short-term Borrowings

The carrying amounts of borrowings under repurchase agreements and federal funds sold approximate fair value.

FHLB Advances

The fair values of the company’s FHLB advances are estimated using discounted cash flow analysis based on the company’s incremental borrowing rates for similar types of borrowing arrangements.

Accrued Interest

The carrying amounts of accrued interest approximate fair value.

Off-Balance Sheet Financial Instruments

The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date.

At December 31, 2007 and 2006, the fair value of loan commitments and standby-letters of credit was immaterial. Therefore, they have not been included in the following table.

Note 15. Fair Value of Financial Instruments and Interest Rate Risk (Continued)

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

	2007				2006
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
	(in thousands)				(in thousands)
Financial assets:
Cash	$	6 031	$	6 031	$	6 581	$	6 581
Securities purchased under
agreements to resell and
federal funds sold		5 120		5 120		345		345
Securities available for sale		39 572		39 572		42 706		42 706
Loans, net		221 828		223 920		227 646		226 928
Loans held for sale		8 133		8 133		405		405
Accrued interest receivable		1 366		1 366		1 431		1 431

Financial liabilities:
Deposits		253 374		253 430		251 778		251 823
Securities sold under
agreements to repurchase
and federal funds
purchased		12 537		12 537		10 526		10 526
FHLB advances		212		212		620		620
Accrued interest payable		757		757		672		672

The company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the company's financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the company's overall interest rate risk.

Note 16. Regulatory Matters

The company (on a consolidated basis) and the bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory – possibly additional discretionary – actions by regulators that, if undertaken, could have a direct material effect on the company’s and the bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the company and bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

Quantitative measures established by regulation to ensure capital adequacy require the company and the bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2007 and 2006, that the company and the bank meet all capital adequacy requirements to which they are subject.

Note 16. Regulatory Matters (Continued)

As of December 31, 2007, the most recent notification from the Federal Deposit Insurance Corporation categorized the bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution’s category.

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

							Minimum
							To Be Well
				Minimum			Capitalized Under
				Capital			Prompt Corrective
	Actual			Requirement			Action Provisions
	Amount		Ratio	Amount		Ratio	Amount		Ratio
	(in thousands)
As of December 31, 2007:
Total capital (to risk-weighted
assets):
Consolidated	$	32 308	14.23%	$	18 161	8.0%		N/A	N/A
Bank of Charles Town	$	31 814	14.04%	$	18 124	8.0%	$	22 656	10.0%
Tier 1 capital (to risk-weighted
assets):
Consolidated	$	29 529	13.01%	$	9 081	4.0%		N/A	N/A
Bank of Charles Town	$	29 035	12.82%	$	9 062	4.0%	$	13 593	6.0%
Tier 1 capital (to average
assets):
Consolidated	$	29 529	9.99%	$	11 818	4.0%		N/A	N/A
Bank of Charles Town	$	29 035	9.84%	$	11 799	4.0%	$	14 749	5.0%


As of December 31, 2006:
Total capital (to risk-weighted
assets):
Consolidated	$	30 154	13.82%	$	17 455	8.0%		N/A	N/A
Bank of Charles Town	$	29 695	13.64%	$	17 421	8.0%	$	21 776	10.0%
Tier 1 capital (to risk-weighted
assets):
Consolidated	$	27 731	12.71%	$	8 728	4.0%		N/A	N/A
Bank of Charles Town	$	27 272	12.52%	$	8 710	4.0%	$	13 066	6.0%
Tier 1 capital (to average
assets):
Consolidated	$	27 731	9.34%	$	11 882	4.0%		N/A	N/A
Bank of Charles Town	$	27 272	9.20%	$	11 863	4.0%	$	14 829	5.0%

Note 17. Parent Company Only Financial Statements

POTOMAC BANCSHARES, INC.
(Parent Company Only)
Balance Sheets
December 31, 2007 and 2006
(in thousands)

	2007			2006
ASSETS
Cash	$	36		$	25
Investment in subsidiary		28 521			26 258
Other assets		458			434

Total Assets	$	29 015		$	26 717

LIABILITIES AND STOCKHOLDERS’ EQUITY

LIABILITIES, other	$	- -		$	- -

STOCKHOLDERS’ EQUITY
Common stock	$	3 672		$	3 672
Surplus		3 771			3 661
Undivided profits		24 787			22 677
Accumulated other comprehensive (loss)		(514	)		(1 014	)
	$	31 716		$	28 996
Less cost of shares acquired for the treasury		2 701			2 279
Total Stockholders’ Equity	$	29 015		$	26 717

Total Liabilities and Stockholders’ Equity	$	29 015		$	26 717

POTOMAC BANCSHARES, INC.
(Parent Company Only)
Statements of Income
Years Ended December 31, 2007, 2006 and 2005
(in thousands)

	2007			2006			2005
Income
Dividends from subsidiary	$	1 942		$	1 905		$	1 487
Interest income		1			1			- -
Total Income	$	1 943		$	1 906		$	1 487

Expenses
Stock-based compensation expense	$	110		$	112		$	- -
Other professional fees		57			39			34
Other operating expenses		65			56			60
Total Expenses	$	232		$	207		$	94

Income before Income Tax (Benefit) and
Equity in Undistributed Income of Subsidiary	$	1 711		$	1 699		$	1 393

Income Tax (Benefit)		(56	)		(51	)		(31	)

Income before Equity in Undistributed
Income of Subsidiary	$	1 767		$	1 750		$	1 424

Equity in Undistributed Income of Subsidiary		1 763			2 285			2 240

Net Income	$	3 530		$	4 035		$	3 664

Note 17. Parent Company Only Financial Statements (Continued)

POTOMAC BANCSHARES, INC.
(Parent Company Only)
Statements of Cash Flows
Years Ended December 31, 2007, 2006 and 2005
(in thousands)

	2007			2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	3 530		$	4 035		$	3 664
Adjustments to reconcile net income to net cash
provided by operating activities:
Equity in undistributed (income) of
subsidiary		(1 763	)		(2 285	)		(2 240	)
Stock-based compensation expense		110			112			- -
(Increase) in other assets		(24	)		(153	)		(251	)
(Decrease) in other liabilities		- -			- -			(3	)

Net cash provided by operating activities	$	1 853		$	1 709		$	1 170

CASH FLOWS FROM FINANCING ACTIVITIES
Cash dividends	$	(1 420	)	$	(1 295	)	$	(1 137	)
Purchase of treasury shares		(422	)		(429	)		- -

Net cash (used in) financing activities	$	(1 842	)	$	(1 724	)	$	(1 137	)

Increase (decrease) in cash and cash
equivalents	$	11		$	(15	)	$	33

CASH AND CASH EQUIVALENTS
Beginning		25			40			7
Ending	$	36		$	25		$	40

Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure.

Not Applicable.

Item 9A(T). Controls and Procedures.

The company’s chief executive officer and chief financial officer, based on their evaluation as of the date of this report of the company’s disclosure controls and procedures (as defined in Rule 13(a)-14(e) of the Securities Exchange Act of 1934), have concluded that the company’s disclosure controls and procedures are adequate and effective for purposes of Rule 13(a)-14(c) and timely, alerting them to material information relating to the company required to be included in the company’s filings with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

This annual report does not include an attestation report of the company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the company to provide only management’s report in this annual report.

There were no significant changes in the company’s internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation.

Management’s Report on Internal Control Over Financial Reporting

To the Stockholders:

Management is responsible for the preparation and fair presentation of the financial statements included in this annual report. The financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and reflect management’s judgments and estimates concerning effects of events and transactions that are accounted for or disclosed.

Management is also responsible for establishing and maintaining adequate internal control over financial reporting. The company’s internal control over financial reporting includes those policies and procedures that pertain to the company’s ability to record, process, summarize and report reliable financial data. Management recognizes that there are inherent limitations in the effectiveness of any internal control over financial reporting, including the possibility of human error and the circumvention or overriding of internal control. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control over financial reporting may vary over time.

In order to ensure that the company’s internal control over financial reporting is effective, management regularly assesses such controls and did so most recently for its financial reporting as of December 31, 2007. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on this assessment, management has concluded that the internal control over financial reporting was effective as of December 31, 2007.

The Board of Directors, acting through its Audit Committee, is responsible for the oversight of the company’s accounting policies, financial reporting and internal control. The Audit Committee of the Board of Directors is comprised entirely of outside directors who are independent of management. The Audit Committee is responsible for the appointment and compensation of the independent registered public accounting firm and approves decisions regarding the appointment or removal of the company’s internal auditor. It meets periodically with management, the independent registered public accounting firm and the internal auditor to ensure that they are carrying out their responsibilities. The Audit Committee is also responsible for performing an oversight role by reviewing and monitoring the financial, accounting and auditing procedures of the company in addition to reviewing the company’s financial reports. The independent registered public accounting firm and the internal auditor have full and unlimited access to the Audit Committee, with or without management, to discuss the adequacy of internal control over financial reporting, and any other matter which they believe should be brought to the attention of the Audit Committee.

Item 9B. Other Information.

None.

PART III

Item 10. Directors and Executive Officers of the Registrant.

The information contained on pages 7-8 of the Proxy Statement dated March 31, 2008, for the April 22, 2008 Annual Meeting under the captions “Management Nominees to the Board of Potomac” and “Directors Continuing to Serve Unexpired Terms,” and page 15 under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference.

The Executive Officers are as follows:

Name	Position Since	Age	Principal Occupation
Robert F. Baronner, Jr.	President & CEO 2001	49	Employed by bank as of 1/1/01 as President and CEO.

David W. Irvin	Executive Vice President 2004	44	Employed at bank from 2001 to present as Commercial Loan Division Manager.

Gayle Marshall Johnson	Sr. Vice President & Chief Financial Officer 1994	58	Employed with the bank 1977-1985 and 1988-present; Vice President and Chief Financial Officer since 1990. Sr. Vice President since 2005.

Donald S. Smith	Vice President 1994	79	Employed at bank 1947 to 1991; President 1979 to 1991 (retired).

The bank has adopted a Code of Ethics that applies to all employees, including Potomac’s and the bank’s chief executive officer and chief financial officer and other senior officers. Additionally, there is a Code of Ethics for Senior Financial Officers which applies to Potomac’s and the bank’s chief executive officer and chief financial officer. These Codes of Ethics are attached to this document as Exhibits 14.1 and 14.2. If we make any substantive amendments to this code or grant any waiver from a provision of the code to our chief executive officer or chief financial officer, we will disclose the amendment or waiver in a report on Form 8-K.

Item 11. Executive Compensation.

The information contained on pages 10-13 of the Proxy Statement dated March 31, 2008, for the April 22, 2008 Annual Meeting under the captions “Executive Compensation,” “Employee Benefit Plans,” “Employment Agreement,” and “Compensation of Directors” is incorporated herein by reference.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

The information contained on pages 9-10 of the Proxy Statement dated March 31, 2008, for the April 22, 2008 Annual Meeting under the caption “Ownership of Securities by Nominees, Directors and Officers” is incorporated herein by reference.

Securities authorized for issuance under Potomac’s 2003 Stock Incentive Plan are listed below:

Number of securities

remaining available for

to be issued

Weighted-average

future issuance under

upon exercise of

exercise price of

equity compensation plans

outstanding options,

(excluding securities

Plan category

warrants and rights

reflected in column (a))

2003 Stock Incentive Plan

amended by shareholders

April 24, 2007

152,462

$14.62

281,138

Item 13. Certain Relationships and Related Transactions.

The information contained on page 14 of the Proxy Statement dated March 31, 2008, for the April 22, 2008 Annual Meeting under the caption “Certain Transactions with Directors, Officers and Their Associates” is incorporated herein by reference.

Item 14. Principal Accountant Fees and Services.

The information contained on pages 6-7 of the Proxy Statement dated March 31, 2008, for the April 22, 2008 Annual Meeting under the caption “Audit Committee Report” is incorporated herein by reference.

Item 15. Exhibits and Financial Statement Schedules.

(a) (1) Financial Statements. Reference is made to Part II, Item 8 of this Annual Report on Form 10-K.

(2) Financial Statement Schedules. These schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes.

(3) Exhibits. See below.

2.1 Agreement and Plan of Merger dated March 8, 1994, by and between Potomac Bancshares, Inc., and Bank of Charles Town filed with and incorporated by reference from the Registration on Form S-4 filed with the Securities and Exchange Commission on June 10, 1994, Registration No. 33-80092.

3.1 Articles of Incorporation of Potomac Bancshares, Inc. filed with and incorporated by reference from the Registration Statement on Form S-4 filed with the Securities and Exchange Commission on June 10, 1994, Registration No. 33-80092.

3.2 Amendments to Articles of Incorporation of Potomac Bancshares, Inc. adopted by shareholders on April 25, 1995 and filed with the West Virginia Secretary of State on May 23, 1995, and incorporated by reference from Potomac’s Form 10-KSB for the year ended December 31, 1995 and filed with the Securities and Exchange Commission, File No. 0-24958.

3.3 Amended and Restated Bylaws of Potomac Bancshares, Inc. adopted by shareholders April 25, 1995 and incorporated by reference from Potomac’s Form 10-KSB for the year ended December 31, 1995, and filed with the Securities and Exchange Commission, File No. 0-24958.

10.1 2003 Stock Incentive Plan adopted by the Potomac Board February 20, 2003 and approved by the Company’s shareholders on May 13, 2003, amended by the Company’s shareholders on April 24, 2007 and incorporated by reference from Potomac’s Form 10-K for the year ended December 31, 2006 and filed with the Securities and Exchange Commission, File No. 0-24958.

10.2 Employment Agreement of Mr. Robert F. Baronner, Jr., filed with and incorporated by reference from Form 10-KSB for the year ended December 31, 2001, and filed with the Securities and Exchange Commission, File No. 0-24958.

14.1 Code of Ethics (for all employees)*

14.2 Code of Ethics for Senior Financial Officers*

21 Subsidiaries of the Registrant*

23.1 Consent of Independent Accountants*

31.1 Rule 13a-15(e)/15d-15(e) Certification of Chief Executive Officer*

31.2 Rule 13a-15(e)/15d-15(e) Certification of Chief Financial Officer*

32.1 Section 1350 Certification of Chief Executive Officer*

32.2 Section 1350 Certification of Chief Financial Officer*

99.1 Proxy Statement for the 2008 Annual Meeting for Potomac, portions are incorporated by reference in Form 10-K Annual Report*

* Filed herewith.

SIGNATURES

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

POTOMAC BANCSHARES, INC.

By	/s/ Robert F. Baronner, Jr.	March 24, 2008
	Robert F. Baronner, Jr.
	President & Chief Executive Officer


By	/s/ Gayle Marshall Johnson	March 24, 2008
	Gayle Marshall Johnson
	Sr. Vice President & Chief Financial Officer

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

Signature & Title		Date

By	/s/ J. Scott Boyd	March 24, 2008
	J. Scott Boyd, Director

By	/s/ John P. Burns, Jr.	March 24, 2008
	John P. Burns, Jr., Director

By	/s/ Guy Gareth Chicchirichi	March 24, 2008
	Guy Gareth Chicchirichi, Director

By	/s/ Margaret Cogswell	March 24, 2008
	Margaret Cogswell, Director

By	/s/ William R. Harner	March 24, 2008
	William R. Harner, Director

By	/s/ Barbara H. Pichot	March 24, 2008
	Barbara H. Pichot, Director

By	/s/ John C. Skinner, Jr.	March 24, 2008
	John C. Skinner, Jr., Director

By	/s/ Donald S. Smith	March 24, 2008
	Donald S. Smith, Director

By	/s/ C. Larry Togans	March 24, 2008
	C. Larry Togans, Director