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POTOMAC BANCSHARES, INC. AND SUBSIDIARY
FORM 10-Q
March 31, 2012

INDEX

PART I.		FINANCIAL INFORMATION	PAGE
Item 1.		Financial Statements.
		Consolidated Balance Sheets as of March 31, 2012 (Unaudited) and December 31, 2011 (Audited)	3
		Consolidated Statements of Operations (Unaudited) for the Three Months Ended March 31, 2012 and 2011	4
		Consolidated Statements of Comprehensive Income (Unaudited) for the Three Months Ended
		March 31, 2012 and 2011	5
		Consolidated Statements of Changes in Stockholders’ Equity (Unaudited) for the Three Months Ended
		March 31, 2012 and 2011	6
		Consolidated Statements of Cash Flows (Unaudited) for the Three Months Ended March 31, 2012 and 2011	7
		Notes to Consolidated Financial Statements (Unaudited)	8 - 26
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations.	26 - 31
Item 4.		Controls and Procedures.	32
Part II.		OTHER INFORMATION
Item 1.		Legal Proceedings.	32
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds.	32
Item 4.		Mine Safety Disclosures.	32
Item 5.		Other Information.	32
Item 6.		Exhibits.	33
Signatures			34

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 Form 10-Q, including 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,” “confident,” 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, unemployment, pricing in the real estate market, interest rate movements, the impact of competitive products, services and pricing, customer business requirements, the current economic environment posing significant challenges and affecting our financial condition and results of operations, the possibility of future FDIC assessments, Congressional legislation and similar matters (including changes as a result of rules and regulations adopted under the Dodd-Frank Wall Street Reform and Consumer Protection Act). The downgrade of U.S. government securities by one of the credit rating agencies could have a material adverse effect on the company’s operations, earnings and financial condition. We caution readers of this report not to place undue reliance on forward-looking statements which are subject to influence by unanticipated future events. Actual results, accordingly, may differ materially from management expectations.

2

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

POTOMAC BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
($ in thousands, except per share data)
(Unaudited)

		March 31,				December 31,
		2012				2011
Assets:
Cash and due from banks		$	1 571			$	1 485
Interest-bearing deposits in other financial institutions			26 770				11 445
Federal funds sold			740				794
Securities available for sale, at fair value			39 201				42 331
Loans held for sale			672				198
Loans, net of allowance for loan losses of $4,401 and
$4,484, respectively			200 845				202 761
Premises and equipment, net			7 834				7 923
Other real estate owned, net of valuation allowance of
$2,023 and $2,197, respectively			6 782				6 393
Accrued interest receivable			819				832
Bank owned life insurance			6 990				6 932
Federal Home Loan Bank of Pittsburgh stock			789				808
Other assets			5 282				5 491
Total Assets		$	298 295			$	287 393
Liabilities and Stockholders’ Equity:
Liabilities:
Deposits
Noninterest-bearing		$	43 313			$	37 050
Interest-bearing			221 715				216 067
Total Deposits			265 028				253 117
Securities sold under agreements to repurchase			4 333				3 415
Federal Home Loan Bank advances			1 221				1 523
Accrued interest payable			168				204
Other liabilities			1 680				3 669
Total Liabilities		$	272 430			$	261 928
Stockholders’ Equity:
Common stock, $1 per share par value; 5,000,000 shares
authorized; 3,671,691 shares issued and outstanding		$	3 672			$	3 672
Surplus			3 944				3 943
Undivided profits			22 968				22 648
Accumulated other comprehensive (loss), net			(1 853	)			(1 932	)
		$	28 731			$	28 331
Less cost of shares acquired for the treasury, 281,513 shares			2 866				2 866
Total Stockholders’ Equity		$	25 865			$	25 465
Total Liabilities and Stockholders’ Equity		$	298 295			$	287 393

See Notes to Consolidated Financial Statements.

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POTOMAC BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
($ in thousands, except per share data)
(Unaudited)

See Notes to Consolidated Financial Statements.

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POTOMAC BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
($ in thousands)
(Unaudited)

		For the three months
		Ended March 31
		2012				2011
Net Income		$	320			$	257
Other comprehensive income, net of tax
Unrealized holding (losses) gains on securities,
net of tax of $22 and $61, respectively			(38	)			119
Deferred tax adjustment			117				- -
Other comprehensive income, net of tax			79				119
Comprehensive income		$	399			$	376

See Notes to Consolidated Financial Statements.

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POTOMAC BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
FOR THE THREE MONTHS ENDED MARCH 31, 2012 AND 2011
($ in thousands, except share and per share data)
(Unaudited)

																Accumulated
																Other
		Common						Undivided				Treasury				Comprehensive
		Stock			Surplus			Profits				Stock				(Loss)				Total
Balances, December 31, 2010		$	3 672		$	3 932		$	23 725			$	(2 866	)		$	(1 687	)		$	26 776
Net income			- -			- -			257				- -				- -				257
Other comprehensive income			- -			- -			- -				- -				119				119
Stock-based compensation expense			- -			4			- -				- -				- -				4
Cash dividends ($.01 per share)			- -			- -			(34	)			- -				- -				(34	)
Balances, March 31, 2011		$	3 672		$	3 936		$	23 948			$	(2 866	)		$	(1 568	)		$	27 122
Balances, December 31, 2011		$	3 672		$	3 943		$	22 648			$	(2 866	)		$	(1 932	)		$	25 465
Net income			- -			- -			320				- -				- -				320
Other comprehensive income			- -			- -			- -				- -				79				79
Stock-based compensation expense			- -			1			- -				- -				- -				1
Balances, March 31, 2012		$	3 672		$	3 944		$	22 968			$	(2 866	)		$	(1 853	)		$	25 865

See Notes to Consolidated Financial Statements.

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POTOMAC BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
($ in thousands)
(Unaudited)

		For the Three Months Ended
		March				March
		2012				2011
CASH FLOWS FROM OPERATING ACTIVITIES
Net income		$	320			$	257
Adjustments to reconcile net income to net cash (used in) provided by
operating activities:
Provision for loan losses			309				423
Depreciation			110				125
Discount accretion and premium amortization on securities, net			56				75
Write down of other real estate			142				- -
Loss on sale of other real estate			54				27
Stock compensation expense			1				4
Proceeds from sale of loans			626				314
Origination of loans for sale			(1 100	)			(238	)
Change in cash surrender value of
bank owned life insurance			(58	)			(57	)
Changes in assets and liabilities:
Decrease (increase) in accrued interest receivable			13				(52	)
Decrease in other assets			367				274
Decrease in accrued interest payable			(36	)			(1	)
Decrease in other liabilities			(1 989	)			(100	)
Net cash (used in) provided by operating activities		$	(1 185	)		$	1 051
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from maturity of securities available for sale		$	- -			$	2 000
Proceeds from call of securities available for sale			8 000				3 000
Purchase of securities available for sale			(4 986	)			(15 000	)
Net (increase) decrease in loans			(204	)			5 230
Purchases of premises and equipment			(21	)			(12	)
Proceeds from sale of other real estate			1 226				470
Net cash provided by (used in) investing activities		$	4 015			$	(4 312	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in noninterest-bearing deposits		$	6 263			$	246
Net increase in interest-bearing deposits			5 648				14 808
Net proceeds (repayment) of securities sold under agreements to repurchase			918				(367	)
Net repayment of Federal Home Loan Bank advances			(302	)			(296	)
Cash dividends			- -				(34	)
Net cash provided by financing activities		$	12 527			$	14 357
Increase in cash and cash equivalents		$	15 357			$	11 096
CASH AND CASH EQUIVALENTS
Beginning			13 724				12 905
Ending		$	29 081			$	24 001
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash payments for:
Interest		$	495			$	926
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING
AND FINANCING ACTIVITIES
Unrealized loss on securities available for sale		$	(60	)		$	(180	)
Loans transferred to other real estate owned		$	1 812			$	914
Loans made on sale of other real estate owned		$	419			$	20

See Notes to Consolidated Financial Statements.

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

1.	In the opinion of management, the accompanying financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position as of March 31, 2012 and December 31, 2011, and the results of operations and comprehensive income for the three months ended March 31, 2012 and 2011, and cash flows and statements of changes in stockholders’ equity for the three months ended March 31, 2012 and 2011. The statements should be read in conjunction with Notes to Consolidated Financial Statements included in the Potomac Bancshares, Inc. annual report for the year ended December 31, 2011. The results of operations for the three month period ended March 31, 2012 are not necessarily indicative of the results to be expected for the full year.
	The consolidated financial statements of Potomac Bancshares, Inc. (the “company”) and its wholly-owned subsidiary, Bank of Charles Town (the “bank”), include the accounts of both companies. All material inter-company balances and transactions have been eliminated in consolidation.
	Certain reclassifications have been made to prior period amounts to conform to the current year presentation.
	In preparing these financial statements, the company has evaluated events and transactions for potential recognition or disclosure through the date the financial statements were issued.
2.	Stock-Based Compensation
	The 2003 Stock Incentive Plan was approved by stockholders on May 13, 2003, which authorized up to 183,600 shares of common stock to be used in the granting of incentive options to employees and directors. On April 24, 2007, the stockholders approved an additional 250,000 shares of common stock to be used in the granting of incentive options to employees and directors. This is the first and only 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. Employee options granted under the plan are subject to a five year vesting schedule. Director options immediately vest.
	Incremental stock-based compensation expense recognized for the three month periods ending March 31, 2012 and 2011 was $1 thousand and $4 thousand, respectively.
	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. Fair value is estimated using the Black-Scholes option-pricing model. There were no options granted during the first quarter of 2012 and 2011.
	Stock option plan activity for the three months ended March 31, 2012 is summarized below:

									Weighted
									Average
						Weighted			Remaining
						Average			Contractual		Aggregate
						Exercise			Life		Intrinsic
			Shares			Price			(in years)		Value
	Options outstanding, January 1, 2012		119 908			$	14.76
	Granted		- -				- -
	Exercised		- -				- -
	Canceled or expired		(8 180	)			14.54
	Options outstanding, March 31, 2012		111 728				14.77		3		$	- -
	Options exercisable, March 31, 2012		111 728				14.77		3		$	- -

	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 March 31, 2012. The aggregate intrinsic values change based on changes in the market value of the company’s stock.
	As of March 31, 2012 there was $0 of total unrecognized compensation expense related to nonvested stock options.

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3.	Securities
	The amortized cost and fair value of securities available for sale as of March 31, 2012 and December 31, 2011 (in thousands) are as follows:

	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. There are five debt securities in the consolidated portfolio that has a loss at March 31, 2012. The primary cause of the temporary impairments in the company’s investments in debt securities was fluctuations in interest rates. Because the company intends to hold these investments in debt securities to maturity and it is more likely than not that the company will not be required to sell these investments before a recovery of unrealized losses, the company does not consider these investments to be other-than-temporarily impaired at March 31, 2012 and no impairment has been recognized.
	There are three equity security investments in the company’s portfolio with losses at March 31, 2012. The company considers these investments to be temporarily impaired at March 31, 2012 and is recognizing no impairment. These are community bank stock related holdings that the company has the ability and intent to hold until recovery.
	U.S. Government sponsored agencies include the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation debt securities with a fair value of $19.3 million as of March 31, 2012 and $25.3 million as of December 31, 2011.
	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 March 31, 2012 and December 31, 2011 (in thousands).

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3.	Securities (Continued)

	The company’s investment in Federal Home Loan Bank (FHLB) stock totaled $789 thousand at March 31, 2012. FHLB stock is generally viewed as a long-term investment and as a restricted investment security, which is carried at cost, because there is no market for the stock, other than the FHLBs or member institutions. Therefore, when evaluating FHLB stock for impairment, its value is based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. The company does not consider this investment to be other-than-temporarily impaired at March 31, 2012 and no impairment has been recognized. FHLB stock is shown as a separate line item on the balance sheet and is not a part of the available for sale securities portfolio.
	At March 31, 2012 and December 31, 2011, securities with carrying values of approximately $12.7 million and $12.8 million, respectively, were pledged to secure public deposits, securities sold under agreements to repurchase, other borrowings, and for other purposes as required or permitted by law.
4.	Loans
	The loan portfolio, stated at face amount, is composed of the following:

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4.	Loans (Continued)
	The FHLB of Pittsburgh has a blanket lien on all the company’s loans except those loans specifically pledged to the Federal Reserve and removed from the FHLB lien. Currently, the FHLB lien is securing an advance to the company in the amount of $1.2 million and letters of credit issued on behalf of a customer of the company in the amount of $11 million.
5.	Allowance for Loan Losses
	The following is a summary of transactions (in thousands) in the allowance for loan losses:

Allowance for Loan Losses – By Segment
March 31, 2012
(in thousands)

										Commercial																All
		Farmland				Commercial				Real Estate				Construction				Consumer				Residential				Other			Unallocated			Total
Beginning balance		$	17			$	156			$	882			$	506			$	84			$	2 839			$	- -		$	- -		$	4 484
Charge-offs			- -				- -				- -				(354	)			(54	)			(50	)			- -			- -			(458	)
Recoveries			- -				6				2				2				54				2				- -			- -			66
Provision			(1	)			(6	)			(44	)			325				(19	)			54				- -			- -			309
Ending balance		$	16			$	156			$	840			$	479			$	65			$	2 845			$	- -		$	- -		$	4 401
Individually evaluated
for impairment		$	- -			$	159			$	100			$	125			$	33			$	510			$	- -		$	- -		$	927
Collectively evaluated
for impairment			16				(3	)			740				354				32				2 335				- -			- -			3 474
		$	16			$	156			$	840			$	479			$	65			$	2 845			$	- -		$	- -		$	4 401
Financing receivables:
Ending balance		$	561			$	7 618			$	78 032			$	16 149			$	5 956			$	96 851			$	79		$	- -		$	205 246
Ending balance:
Individually evaluated
for impairment		$	- -			$	159			$	6 698			$	3 705			$	101			$	6 485			$	- -		$	- -		$	17 148
Collectively evaluated
for impairment			561				7 459				71 334				12 444				5 855				90 366			79				- -			188 098
Total		$	561			$	7 618			$	78 032			$	16 149			$	5 956			$	96 851			$	79		$	- -		$	205 246

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5.	Allowance for Loan Losses (Continued)

										Commercial																All
		Farmland				Commercial				Real Estate				Construction				Consumer				Residential				Other				Unallocated				Total
Beginning balance		$	166			$	239			$	859			$	2 022			$	20			$	1 691			$	1			$	14			$	5 012
Charge-offs			- -				(20	)			(653	)			(1 673	)			(172	)			(1 536	)			- -				- -				(4 054	)
Recoveries			- -				30				6				5				131				11				- -				- -				183
Provision			(149	)			(93	)			670				152				105				2 673				(1	)			(14	)			3 343
Ending balance		$	17			$	156			$	882			$	506			$	84			$	2 839			$	- -			$	- -			$	4 484
Individually evaluated
for impairment		$	- -			$	161			$	122			$	102			$	39			$	349			$	- -			$	- -			$	773
Collectively evaluated
for impairment			17				(5	)			760				404				45				2 490				- -				- -				3 711
		$	17			$	156			$	882			$	506			$	84			$	2 839			$	- -			$	- -			$	4 484
Financing receivables:
Ending balance		$	598			$	8 361			$	76 882			$	19 179			$	6 165			$	95 944			$	116			$	- -			$	207 245
Ending balance:
Individually evaluated
for impairment		$	- -			$	161			$	6 995			$	5 250			$	109			$	5 662			$	- -			$	- -			$	18 177
Collectively evaluated
for impairment			598				8 200				69 887				13 929				6 056				90 282				116				- -				189 068
Total		$	598			$	8 361			$	76 882			$	19 179			$	6 165			$	95 944			$	116			$	- -			$	207 245

Credit Quality Information – By Class
March 31, 2012
(in thousands)

	As a matter of practice, we do not risk rate consumer or residential mortgage loans. Any of these loans listed in the risk rating table above are associated with commercial loans that have been risk rated as per our policy. When a loan is designated as a loss, the loss portion is charged off, and if applicable the remaining balance classified as substandard.

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5.	Allowance for Loan Losses (Continued)

Credit Quality Information – By Class
December 31, 2011
(in thousands)

Credit Quality Information – By Class
December 31, 2011
(in thousands)

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5.	Allowance for Loan Losses (Continued)

With no related allowance:
											Average			Interest
		Unpaid			Recorded			Related			Recorded			Income
		Principal			Investment			Allowance			Investment			Recognized
Commercial – non real estate
Commercial and industrial		$	- -		$	- -		$	N/A		$	48		$	- -
Commercial real estate
Owner occupied			4 291			4 089			N/A			3 734			39
Non-owner occupied			584			582			N/A			233			9
Construction
Residential			110			110			N/A			584			1
Commercial			3 175			2 810			N/A			3 389			4
Real estate
Farmland			- -			- -			N/A			- -			- -
Residential
Revolving open end			285			285			N/A			217			5
1 to 4 family –first liens			516			438			N/A			1 096			3
1 to 4 family – junior liens			- -			- -			N/A			142			- -
5 or more family			- -			- -			N/A			- -			- -
Consumer
Titled vehicles			- -			- -			N/A			4			- -
Deposit accounts			- -			- -			N/A			- -			- -
All other consumer			- -			- -			N/A			- -			- -
All other			- -			- -			N/A			- -			- -
		$	8 961		$	8 314		$	N/A		$	9 447		$	61
With an allowance recorded:
											Average			Interest
		Unpaid			Recorded			Related			Recorded			Income
		Principal			Investment			Allowance			Investment			Recognized
Commercial – non real estate
Commercial and industrial		$	162		$	159		$	159		$	164		$	1
Commercial real estate
Owner occupied			2 042			2 027			100			4 177			30
Non-owner occupied			- -			- -			- -			162			- -
Construction
Residential			121			119			29			450			- -
Commercial			669			666			96			1 596			11
Real estate
Farmland			- -			- -			- -			- -			- -
Residential
Revolving open end			1 272			1 269			33			585			16
1 to 4 family – first liens			3 612			3 584			435			2 780			33
1 to 4 family – junior liens			915			909			42			480			18
5 or more family			- -			- -			- -			- -			- -
Consumer
Titled vehicles			- -			- -			- -			- -			- -
Deposit accounts			- -			- -			- -			- -			- -
All other consumer			102			101			33			57			2
All other			- -			- -			- -			- -			- -
		$	8 895		$	8 834		$	927		$	10 451		$	111
Totals:
Commercial – non real estate		$	162		$	159		$	159		$	212		$	1
Commercial real estate			6 917			6 698			100			8 306			78
Construction			4 075			3 705			125			6 019			16
Real estate –farmland			- -			- -			- -			- -			- -
Residential			6 600			6 485			510			5 300			75
Consumer			102			101			33			61			2
All other			- -			- -			- -			- -			- -
		$	17 856		$	17 148		$	927		$	19 898		$	172

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5.	Allowance for Loan Losses (Continued)

With no related allowance:
											Average			Interest
		Unpaid			Recorded			Related			Recorded			Income
		Principal			Investment			Allowance			Investment			Recognized
Commercial – non real estate
Commercial and industrial		$	- -		$	- -		$	N/A		$	67		$	- -
Commercial real estate
Owner occupied			4 622			4 440			N/A			3 752			217
Non-owner occupied			587			583			N/A			132			11
Construction
Residential			512			506			N/A			799			14
Commercial			4 106			3 976			N/A			3 353			168
Real estate
Farmland			- -			- -			N/A			- -			- -
Residential
Revolving open end			225			224			N/A			160			15
1 to 4 family –first liens			948			870			N/A			1 257			26
1 to 4 family – junior liens			- -			- -			N/A			177			- -
5 or more family			- -			- -			N/A			- -			- -
Consumer
Titled vehicles			- -			- -			N/A			- -			- -
Deposit accounts			- -			- -			N/A			- -			- -
All other consumer			- -			- -			N/A			4			- -
All other			- -			- -			N/A			- -			- -
		$	11 000		$	10 599		$	N/A		$	9 701		$	451
With an allowance recorded:
											Average			Interest
		Unpaid			Recorded			Related			Recorded			Income
		Principal			Investment			Allowance			Investment			Recognized
Commercial – non real estate
Commercial and industrial		$	163		$	161		$	161		$	187		$	8
Commercial real estate
Owner occupied			1 989			1 972			122			4 800			93
Non-owner occupied			- -			- -			- -			163			- -
Construction
Residential			- -			- -			- -			979			- -
Commercial			771			768			102			2 443			30
Real estate
Farmland			- -			- -			- -			108			- -
Residential
Revolving open end			1 277			1 274			31			331			65
1 to 4 family – first liens			2 550			2 540			299			2 342			102
1 to 4 family – junior liens			758			754			19			311			28
5 or more family			- -			- -			- -			- -			- -
Consumer
Titled vehicles			- -			- -			- -			- -			- -
Deposit accounts			- -			- -			- -			- -			- -
All other consumer			109			109			39			37			3
All other			- -			- -			- -			- -			- -
		$	7 617		$	7 578		$	773		$	11 701		$	329
Totals:
Commercial – non real estate		$	163		$	161		$	161		$	254		$	8
Commercial real estate			7 198			6 995			122			8 847			321
Construction			5 389			5 250			102			7 574			212
Real estate –farmland			- -			- -			- -			108			- -
Residential			5 758			5 662			349			4 578			236
Consumer			109			109			39			41			3
All other			- -			- -			- -			- -			- -
		$	18 617		$	18 177		$	773		$	21 402		$	780

15

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5.	Allowance for Loan Losses (Continued)

For the Three Months Ended
March 31, 2012

					Pre-			Post-
					Modification			Modification
			Number		Outstanding			Outstanding
			Of		Recorded			Recorded
			Contracts		Investment			Investment
	Troubled Debt Restructurings
	Commercial – non real estate
	Commercial and industrial		- -		$	- -		$	- -
	Commercial real estate
	Owner occupied		- -			- -			- -
	Non owner occupied		- -			- -			- -
	Construction
	Residential		- -			- -			- -
	Commercial		- -			- -			- -
	Real Estate
	Farmland		- -			- -			- -
	Residential
	Revolving open end 1 to 4 family		- -			- -			- -
	1 to 4 family – first liens		1			227			226
	1 to 4 family – junior liens		- -			- -			- -
	5 or more family		- -			- -			- -
	Consumer
	Titled vehicles		- -			- -			- -
	Deposit accounts		- -			- -			- -
	All other consumer		- -			- -			- -
	All other		- -			- -			- -
	Totals		1		$	227		$	226

For the Three Months
Ended March 31,2012

			Number		Outstanding
			Of		Recorded
			Contracts		Investment
	Troubled Debt Restructurings
	That Subsequently Defaulted
	Commercial – non real estate
	Commercial and industrial		- -		$	- -
	Commercial real estate
	Owner occupied		- -			- -
	Non owner occupied		- -			- -
	Construction
	Residential		- -			- -
	Commercial		- -			- -
	Real Estate
	Farmland		- -			- -
	Residential
	Revolving open end 1 to 4 family		- -			- -
	1 to 4 family – first liens		5			715
	1 to 4 family – junior liens		3			110
	5 or more family		- -			- -
	Consumer
	Titled vehicles		- -			- -
	Deposit accounts		- -			- -
	All other consumer		- -			- -
	All other		- -			- -
	Totals		8		$	825

	Total Troubled Debt Restructurings as of March 31, 2012 were $12.0 million.

16

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5.	Allowance for Loan Losses (Continued)

Nonaccrual and Past Due Loans – By Class
March 31, 2012
(in thousands)

																				90 Days
		30-59			60-89			90 Days												Past Due
		Days			Days			or more			Total						Total			Still			Non-
		Past Due			Past Due			Past Due			Past Due			Current			Loans			Accruing			Accrual
Commercial – non real estate
Commercial and industrial		$	79		$	- -		$	- -		$	79		$	7 539		$	7 618		$	- -		$	91
Commercial real estate
Owner occupied			224			- -			1 244			1 468			59 290			60 758			- -			1 333
Non owner occupied			- -			330			179			509			16 765			17 274			- -			179
Construction
Residential			- -			- -			- -			- -			2 306			2 306			- -			119
Commercial			480			231			2 216			2 927			10 916			13 843			- -			2 566
Real Estate
Farmland			- -			- -			- -			- -			561			561			- -			- -
Residential
Revolving open end			- -			- -			- -			- -			4 628			4 628			- -			16
1 to 4 family – first liens			301			217			522			1 040			80 929			81 969			- -			1 998
1 to 4 family – junior liens			167			172			- -			339			6 850			7 189			- -			- -
5 or more family			- -			- -			- -			- -			3 065			3 065			- -			- -
Consumer
Titled vehicles			5			- -			- -			5			2 483			2 488			- -			4
Deposit accounts			- -			- -			- -			- -			584			584			- -			- -
All other consumer			3			- -			2			5			2 879			2 884			- -			2
All other			- -			- -			- -			- -			79			79			- -			- -
Totals		$	1 259		$	950		$	4 163		$	6 372		$	198 874		$	205 246		$	- -		$	6 308
Percentage to Total Loans			.61%			0.46%			2.03%			3.10%			96.90%						0.00%			3.07%

Included in the 30 or more days past due loans are non-accrual loans in the amount of $4.9 million. The remaining $1.4 million are in current status.

Nonaccrual and Past Due Loans – By Class
December 31, 2011
(in thousands)

																				90 Days
		30-59			60-89			90 Days												Past Due
		Days			Days			or more			Total						Total			Still			Non-
		Past Due			Past Due			Past Due			Past Due			Current			Loans			Accruing			Accrual
Commercial – non real estate
Commercial and industrial		$	- -		$	6		$	- -		$	6		$	8 355		$	8 361		$	- -		$	93
Commercial real estate
Owner occupied			2 376			996			344			3 716			57 370			61 086			- -			1 339
Non owner occupied			- -			- -			179			179			15 617			15 796			- -			179
Construction
Residential			- -			- -			385			385			2 107			2 492			- -			506
Commercial			19			44			1 602			1 665			15 022			16 687			143			3 693
Real Estate
Farmland			- -			- -			- -			- -			598			598			- -			- -
Residential
Revolving open end			- -			- -			- -			- -			5 015			5 015			- -			17
1 to 4 family – first liens			1 386			139			360			1 885			78 426			80 311			61			1 408
1 to 4 family – junior liens			176			- -			- -			176			7 354			7 530			- -			- -
5 or more family			- -			- -			- -			- -			3 088			3 088			- -			- -
Consumer
Titled vehicles			1			15			- -			16			2 634			2 650			- -			5
Deposit accounts			- -			- -			- -			- -			617			617			- -			- -
All other consumer			8			4			3			15			2 883			2 898			- -			3
All other			- -			- -			- -			- -			116			116			- -			- -
Totals		$	3 966		$	1 204		$	2 873		$	8 043		$	199 202		$	207 245		$	204		$	7 243
Percentage to Total Loans			1.91%			0.58%			1.39%			3.88%			96.12%						.10%			3.49%

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5.	Allowance for Loan Losses (Continued)
	Included in the 30 or more days past due loans are non-accrual loans in the amount of $3.7 million. The remaining non-accrual loans of $3.5 million are in current status. The past due policy of the bank is to report all classes of loans past due in the following categories: 30 to 59 days past due (principal or interest) 60 to 89 days past due (principal or interest) 90 days or more past due (principal or interest) Nonaccrual status.

6.	Employee Benefit Plans
	Components of net periodic benefit cost for the pension and postretirement benefit plans are shown below:

			Pension Benefits								Other Postretirement Benefits
			Three Months Ended								Three Months Ended
			March 31,				March 31,				March 31,			March 31,
			2012				2011				2012			2011
			(in thousands)								(in thousands)
	Components of Net Periodic Benefit Cost
	Service cost		$	- -			$	- -			$	1		$	3
	Interest cost			102				100				3			9
	Expected return on plan assets			(119	)			(119	)			- -			- -
	Recognized net actuarial loss			- -				38				- -			- -
	Amortization of net obligation at transition			- -				- -				- -			5
	Amortization of prior service cost			- -				- -				- -			- -
	Amortization of net loss			53				- -				- -			- -
	Net periodic benefit cost		$	36			$	19			$	4		$	17

 

	Employer Contribution
	The company anticipates the 2012 contribution for the pension plan will approximate $2 million and has made this payment as of March 31, 2012. The company has made payments of $4 thousand for the other postretirement benefit plans for the first three months of 2012 and anticipates remaining payments for 2012 to total $13 thousand. The company’s defined benefit pension plan was frozen as of October 31, 2009. Benefits of all existing participants stopped accruing and no new participants could be admitted to the plan after that date. The company sponsors an unfunded postretirement life insurance plan covering certain retirees with 25 years of service who are over the age of 60 and an unfunded health care plan for certain retirees that met certain eligibility requirements. These plans are not available to future retirees.

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7.	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 March 31, 2012 and March 31, 2011 earnings per share.

 

	For the quarter ended March 31, 2012, stock options representing 111,728 average shares, and for the quarter ended March 31, 2011, stock options representing 120,974 average shares were not included in the calculation of earnings per share as their effect would have been anti-dilutive.
8.	Recent Accounting Pronouncements
	In April 2011, the FASB issued ASU 2011-03, “Transfers and Servicing (Topic 860) – Reconsideration of Effective Control for Repurchase Agreements.” The amendments in this ASU remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee and (2) the collateral maintenance implementation guidance related to that criterion. The amendments in this ASU are effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. The adoption of the new guidance did not have a material impact on the company’s consolidated financial statements.
	In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurement (Topic 820) – Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” This ASU is the result of joint efforts by the FASB and International Accounting Standards Board (IASB) to develop a single, converged fair value framework on how (not when) to measure fair value and what disclosures to provide about fair value measurements. The ASU is largely consistent with existing fair value measurement principles in U.S. GAAP (Topic 820), with many of the amendments made to eliminate unnecessary wording differences between U.S. GAAP and International Financial Reporting Standards (IFRS). The amendments are effective for interim and annual periods beginning after December 15, 2011 with prospective application. Early application is not permitted. The company has included the required disclosures in its consolidated financial statements.
	In June 2011, the FASB issued ASU 2011-05, “Comprehensive Income (Topic 220) – Presentation of Comprehensive Income.” The objective of this ASU is to improve the comparability, consistency and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income by eliminating the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amendments require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The single statement of comprehensive income should include the components of net income, a total for net income, the components of other comprehensive income, a total for other comprehensive income, and a total for comprehensive income. In the two-statement approach, the first statement should present total net income and its components followed consecutively by a second statement that should present all the components of other comprehensive income, a total for other comprehensive income, and a total for comprehensive income. The amendments do not change the items that must be reported in other comprehensive income, the option for an entity to present components of other comprehensive income either net of related tax effects or before related tax effects, or the calculation or reporting of earnings per share. The amendments in this ASU should be applied retrospectively. The amendments are effective for fiscal years and interim periods within those years beginning after December 15, 2011. Early adoption is permitted because compliance with the amendments is already permitted. The amendments do not require transition disclosures. The company has included the required disclosures in its consolidated financial statements.

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8.	Recent Accounting Pronouncements (continued)
	In December 2011, the FASB issued ASU 2011-11, “Balance Sheet (Topic 210) – Disclosures about Offsetting Assets and Liabilities.” This ASU requires entities to disclose both gross information and net information about both instruments and transactions eligible for offset in the balance sheet and instruments and transactions subject to an agreement similar to a master netting arrangement. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. The company does not expect the adoption of ASU 2011- 11 to have a material impact on its consolidated financial statements.
	In December 2011, the FASB issued ASU 2011-12, “Comprehensive Income (Topic 220) – Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” The amendments are being made to allow the Board time to re-deliberate whether to present on the face of the financial statements the effects of reclassifications out of accumulated other comprehensive income on the components of net income and other comprehensive income for all periods presented. While the Board is considering the operational concerns about the presentation requirements for reclassification adjustments and the needs of financial statement users for additional information about reclassification adjustments, entities should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect before ASU 2011-05. All other requirements in ASU 2011-05 are not affected by ASU 2011-12, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. Public entities should apply these requirements for fiscal years, and interim periods within those years, beginning after December 15, 2011. The company has included the required disclosures in its consolidated financial statements.
9.	Fair Value Measurements
	Determination of Fair Value
	The company uses fair value measurements to record fair value adjustments for certain assets and to determine fair value disclosures. In accordance with the Fair Value Measurements and Disclosures topic of FASB ASC, the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.
	The fair value guidance provides a consistent definition of fair value, which focuses on exit price in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.
	Fair Value Hierarchy
	In accordance with this guidance, the company groups its financial assets and financial liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.
	Level 1—Valuation is based on quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 1 assets and liabilities generally include debt and equity securities that are traded in an active exchange market. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.
	Level 2—Valuation is based on inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. The valuation may be based on quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.

20

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9.	Fair Value Measurements (Continued)
	Level 3—Valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which determination of fair value requires significant management judgment or estimation.
	A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
	The following methods and assumptions were used by the company in estimating fair value disclosures for financial instruments:
	Cash and Short-Term Investments
	The carrying amounts of cash and short-term instruments approximate fair values based on the short-term nature of the assets.
	Securities
	Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). Certain of the equity securities with inactive markets utilize Level 3 which may include judgment or estimation.
	Loans
	For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for other loans were estimated using discounted cash flow analyses, using interest rates currently being offered.
	Loans held for sale
	The fair value of loans held for sale is based on outstanding commitments from investors.
	FHLB Stock
	The carrying amounts of FHLB stock approximate fair value based on redemption provisions of the FHLB.
	Bank Owned Life Insurance (BOLI)
	The carrying amounts of BOLI approximate 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 fixed rate 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 purchased 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.

21

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9.	Fair Value Measurements (Continued)
	Accrued Interest
	The carrying amounts of accrued interest approximate fair value.
	Off-Balance Sheet Financial Instruments
	At March 31, 2012 and December 31, 2011, the fair value of loan commitments and standby-letters of credit was immaterial. Therefore, they have not been included in the following table.
	The carrying amounts and estimated fair values of the company’s financial instruments are as follows (in thousands):

						Fair Value Measurements at March 31, 2012 using
						Quoted Prices
						in Active			Significant
						Markets for			Other			Significant
						Identical			Observable			Unobservable
						Assets			Inputs			Inputs
			Carrying Value			Level 1			Level 2			Level 3			Balance
	Assets
	Cash and cash equivalents		$	29 081		$	29 081		$	-		$	-		$	29 081
	Securities available for sale			39 201			-			38 537			664			39 201
	Loans, net			200 845			-			197 710			5 593			203 303
	Loans held for sale			672			-			672			-			672
	FHLB Stock			789			-			789			-			789
	BOLI			6 990			-			6 990			-			6 990
	Accrued interest receivable			819			-			819			-			819
	Liabilities
	Deposits		$	265 028		$	-		$	266 209		$	-		$	266 209
	Securities sold under
	agreement to repurchase			4 333			-			4 333			-			4,333
	FHLB advances			1 221			-			1 228			-			1 228
	Accrued interest payable			168			-			168			-			168

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9.	Fair Value Measurements (Continued)

						Fair Value Measurements at December 31, 2011 using
						Quoted Prices
						in Active			Significant
						Markets for			Other			Significant
						Identical			Observable			Unobservable
						Assets			Inputs			Inputs
			Carrying Value			Level 1			Level 2			Level 3			Balance
	Assets
	Cash and cash equivalents		$	13 724		$	13 724		$	-		$	-		$	13 724
	Securities available for sale			42 331			-			41 687			644			42 331
	Loans, net			202 761			-			196 240			6 497			202 737
	Loans held for sale			198			-			198			-			198
	FHLB Stock			808			-			808			-			808
	BOLI			6 932			-			6 932			-			6 932
	Accrued interest receivable			832			-			832			-			832
	Liabilities
	Deposits		$	253 117		$	-		$	253 885		$	-		$	253 885
	Securities sold under
	agreement to repurchase			3 415			-			3 415			-			3 415
	FHLB advances			1 523			-			1 534			-			1 534
	Accrued interest payable			204			-			204			-			204

	Assets and Liabilities Measured at Fair Value on a Recurring Basis
	The following table presents the balances (in thousands) of financial assets measured at fair value on a recurring basis as of March 31, 2012 and December 31, 2011:

23

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9.	Fair Value Measurements (Continued)

Assets Measured at Fair Value on a Recurring Basis Using Significant Unobservable Inputs (Level 3) (in thousands)

		Quantitative information about Level 3 Fair Value Measurement for March 31, 2012
		Fair							Range
		Value			Valuation Technique(s)		Unobservable Input		(Weighted Average)
Asset
Available for sale equity securities
Financial services industry		$	664		Discounted Market Price		Lack of marketability		10% - 30% (20%)
					to approximate book value

 

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9.	Fair Value Measurements (Continued)
	Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
	Certain assets are measured at fair value on a nonrecurring basis in accordance with generally accepted accounting principles. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.
	The following describes the valuation techniques used by the company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:
	Loans held for sale: Loans held for sale are carried at the lower of cost or market value. These loans currently consist of one-to-four family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the company records any fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale during the periods ended March 31, 2012 and December 31, 2011. Gains and losses on the sale of loans are recorded within other operating income on the consolidated statements of operations.
	Impaired Loans: Loans are generally designated as impaired when, in the judgment of management based on current information and events, it is probable that some amounts due according to the contractual terms of the loan agreement may not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Fair value is measured based on the value of the collateral securing the loans. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the company using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, then the fair value is considered (Level 3). The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivable are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the consolidated statements of operations.
	Other Real Estate Owned: Certain assets such as other real estate owned (OREO) are measured at fair value less cost to sell. The value of real estate collateral is determined by internal evaluation or an appraisal outside of the company or a comparative market analysis (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, or property is in the process of being appraised then the fair value is considered Level 3.
	The following table summarizes the company’s financial assets that were measured at fair value (in thousands) on a nonrecurring basis as of March 31, 2012 and December 31, 2011.

							Carrying Value at March 31, 2012
							Quoted Prices
							In Active			Significant
							Markets for			Other			Significant
							Identical			Observable			Unobservable
				Balance as of			Assets			Input			Input
	Description			March 31, 2012			(Level 1)			(Level 2)			(Level 3)
	Assets
	Loans Held For Sale			$	672		$	- -		$	672		$	--
	Impaired loans with a
	valuation allowance				7 907			- -			2 314			5 593
	OREO				6 782			- -			6 381			401

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							Carrying Value at December 31, 2011
							Quoted Prices
							In Active			Significant
							Markets for			Other			Significant
							Identical			Observable			Unobservable
				Balance as of			Assets			Input			Input
	Description			December 31, 2011			(Level 1)			(Level 2)			(Level 3)
	Assets
	Loans Held For Sale			$	198		$	- -		$	198		$	- -
	Impaired loans with a
	valuation allowance				6 805			- -			308			6 497
	OREO				6 393			- -			4 365			2 028

		Quantitative information about Level 3 Fair Value Measurement for March 31, 2012
		Fair							Range
		Value (000s)			Valuation Technique(s)		Unobservable Input		(Weighted Average)
Asset
Impaired loans with a
Valuation allowance		$	5 593		Appraisal and income or		Market discount		0% - 100% (10%)
					market valuation
OREO			401		Appraisal, internal evaluation or		Market discount		0% - 5% (5%)
					market analysis

			Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
			($ in thousands)
			Impaired Loans				Other Real Estate Owned
	Beginning Balance January 1, 2012		$	6 497				2 028
	Transfers into Level 3			645				- -
	Transfers out of Level 3			(1 521	)			(1 223	)
	Realized and unrealized gains and (losses)
	included in earnings			25				(44	)
	Settlements			(53	)			(360	)
	Ending Balance March 31, 2012		$	5 593			$	401

Item 2. 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.

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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: (1) losses be accrued when they are probable of occurring and are capable of estimation and (2) losses be accrued based on the differences between the margin value of collateral and the loan balance. The allowance consists of specific and general components. The specific component relates to loans (other than consumer and residential mortgage loans) that are classified as 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 environmental factors such as economic, concentration and growth trends. The bank uses a twelve month rolling average period for use in calculating the historical loss factor. FINANCIAL OVERVIEW The first quarter of 2012 has provided positive results with net income of $320 thousand, up almost 25% over the same period in 2011. The bank has produced two consecutive quarters of income despite the challenging economic environment. There has been significant positive movement in the unemployment rate in our local market over the past twelve months. We are seeing loan growth in the residential real estate portfolio. In addition to those items outside management control, the actions taken in the past year are creating improvement in economic performance. Interest expense as a result of decreases in deposit rates, are a significant reason for our ability to produce a profit. Management has aggressively marketed our inventory of other real estate. However, the inventory is still higher than what we would prefer. Management is hopeful that sales of other real estate will continue at a moderate pace. Total assets have increased $10.9 million or 3.8% from the December 31, 2011 total of $287.4 million to $298.3 million at March 31, 2012. Net loans have decreased approximately $1.9 million from the December 31, 2011 total of $202.8 million to $200.9 million at March 31, 2012 due to the pay down of existing loans, loan charge-offs and the transfer of loans to OREO. Other real estate, net of valuation allowance, has increased $389 thousand. With the decrease in loans and increase in deposits excess funds have been invested in securities, and overnight funds at the Federal Reserve. Total deposits have increased $11.9 million or 4.7% at March 31, 2012 compared to December 31, 2011. Interest-bearing deposits have increased 2.6% during the first quarter of 2012, with non-interest bearing deposits increasing 16.9%. Other liabilities have decreased approximately $2 million dollars. The decrease is primarily due to a $2 million contribution to the pension plan. The Tier 1 capital to average assets ratio (leverage capital ratio) is 8.70% at March 31, 2012 compared to 8.56% at December 31, 2011. This capital ratio is within the regulatory guidelines for “well capitalized”.

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The following table is an analysis of the company’s allowance for loan losses with amounts shown in thousands. Management monitors the loan portfolio on a continual basis with procedures that allow for problem loans and potentially problem loans to be highlighted and watched. Written reports are prepared on a monthly basis for all loans including commercial loans graded below a certain level for management review and are reported to the Board of Directors on a quarterly basis. In addition, a subcommittee of the board of directors meets monthly to review all classified assets. Based on experience, these loan policies and the bank’s grading and review system, management believes the loan loss allowance is adequate.

Loans are placed on nonaccrual status when the loan officer or collections officer who is supervising a particular loan determines that it is no longer prudent for a loan to continue to accrue interest, the loan is to be placed on nonaccrual status.

Generally it is the policy of this bank to stop accruing interest when principal or interest is greater than 90 days past due based upon the loan’s contractual terms, unless the loan is well secured and in the process of collection. Furthermore, should the bank become aware of events which have occurred or are expected to occur which causes doubt as to the full collectability of principal or interest in the future, even though the loan is currently less than 90 days past due, the loan is considered for nonaccrual status.

In order to justify the continuation of the accrual of interest on a loan which is greater than 90 days past due, the loan must be well secured and in the process of collection. The majority of the current non-accrual loans as shown in the chart below are in the process of collection. Following is a table showing the risk elements in the loan portfolio with amounts in thousands.

	March 31,			December 31,			March 31,
	2012			2011			2011
Nonperforming Assets
Nonaccrual loans (1)	$	6 308		$	7 243		$	2 674
Foreclosed properties		6 782			6 393			6 980
Total nonperforming assets	$	13 090		$	13 636		$	9 654
Performing troubled debt restructures (2)	$	8 655		$	9 078		$	- -
Loans past due 90 days accruing interest	$	0		$	204		$	276
Allowance for loan losses to period end loans		2.14%			2.16%			2.28%
Nonperforming assets to period end loans and
foreclosed properties, net		6.17%			6.38%			4.40%
Performing troubled debt restructures to period end loans		4.22%			4.38%			- -%

(1) Currently there are 7 TDR’s in non-performing assets with a balance of $3.4 million.
(2) Within this amount is 1 TDR with a balance totaling $35 thousand 30 or more days past due.

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The details of the income statements for the three month period ended March 31, 2012 and 2011 are highlighted below.

Ø Year to date net income in 2012 is $320 thousand compared to net income of $257 thousand in 2011. The loan portfolio has decreased as the result of foreclosures and normal run off. Deposits have increased slightly. However, the increase in volume has been offset by significant decreases in rates paid on deposit accounts. Decline in property values have further affected the net income as other real estate write downs have been charged against income. In addition net losses on the sale of other real estate doubled in the first quarter of 2012 compared to net losses in the same period in 2011.

Ø Interest income has decreased to $2.9 million at March 31, 2012 from $3.2 million at March 31, 2011. The reduction is primarily due to a decrease of approximately $240 thousand in the loan portfolio. This coupled with historically low interest rates has created the slight reduction in interest income.

Ø Total interest expense has decreased 50.4% in 2012 compared to 2011. Interest on deposits has decreased 49.7% during the first quarter of 2012 when compared with the first quarter of 2011.

Ø Provision for loan loss has decreased 27% when compared to the March 31, 2011 quarter.

Ø Net interest margin at March 31, 2012 is 3.80%. This is an increase from the net interest margin of 3.56% at December 31, 2011 and 3.44% at March 31, 2011. During the first three months of 2012, the overall average rate on loans decreased to 5.36% at March 31, 2012 compared to 5.53% at December 31, 2011 and 5.64% for the quarter ending March 31, 2011. The overall average rate being paid on deposits decreased to .83% from 1.21% at December 31, 2011 and from 1.53% at March 31, 2011.

Noninterest income increased 6.5% for the three months ended March 31, 2012 compared to March 31, 2011 and decreased 18% for the three months ended March 31, 2012 compared to the three months ended December 31, 2011. Some significant income items are listed here.

Ø Trust income increased 11.3% when compared to the March 31, 2011 quarter and increased 13.36% when compared to the December 31, 2011 quarter. The increase, in both cases, are due to new customer volume as rates have remained relatively steady.

Ø Visa and MasterCard fees have increased 13.8% on a year to date basis compared to the same period in 2011. The increase is due to an overall increase in consumer spending and the likelihood that consumers continue to get more comfortable with using credit/debit cards versus cash.

Ø The primary cause of the decrease in non-interest income compared to the December quarter was the termination of an other post-retirement benefit plan in the fourth quarter of 2011.

Year to date total noninterest expense increased about 8.27% for the three months ended March 31, 2012 compared to the same period in 2011. The quarterly result was an increase of 4% over the December 31, 2011 quarter. Excluding expenses and losses related to foreclosed properties non-interest expense increased by 1.04% when compared to the March 31, 2011 quarter, and decreased 1.82% when compared to the December 31, 2011 quarter. Some details of the remaining accounts are listed below.

Ø Equipment expense increased 21% over the March 31, 2011 quarter. The increase is a combination of increases in expenses related to our banking software and the expense of new computers purchased.

Ø Computer services and online banking expense increased 52.2% over the first quarter 2011 results. The increase is due to increases in costs related to the bank’s core software and additional online banking expenses related to new resources provided to customers.

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Ø Loss on sale of other real estate increased 100% in the first quarter of 2012 as compared to the first quarter of 2011. The increase is primarily due to the housing market slump lowering values in our market area coupled with a moderate amount of foreclosed properties remaining in the market.

Ø The FDIC assessment expense has decreased 36% from the March 31, 2011 quarterly total. The decrease is due to the change in the base rate of the calculation. The rate is now calculated on average assets as opposed to total deposits.

Ø Other professional fees have increased 45.2% over the March 2011 quarter. The primary reason for the increase is one time professional fees related to the design of new materials explaining the changes in the deposit accounts and fees related to updating materials for the bank’s new “tag line”.

Ø Foreclosed property expense has increased 14.5% in 2012 compared to 2011. The increase in expense is due to new inventory being added to other real estate and ongoing costs of existing inventory not yet sold.

Ø Write down of other real estate has increased significantly during the first quarter of 2012 compared to both the December 31, 2011 and March 31, 2011 quarters. The increase is due to the continual drop in property values. The write downs were executed based on new appraisals.

Ø ATM and check card expenses have increased 31% in the first three months of 2012 compared to the same time period in 2011. The increase is due to a significant increase in the number of transactions as well as a slight increase in per transaction fees.

LIQUIDITY

Liquidity is a measure of the Bank’s ability to respond to sudden changes in funding needs or funding sources. Examples of sudden changes could involve a sudden increase in loan demand, a funding need, or it might involve a large decrease in deposited funds, a funding source. The role of cash management is to manage assets and liabilities so that the Bank can respond to such fluctuations in sources and uses of cash. Management spends much of its time assessing our liquidity position.

Management is informed of the liquidity information via reports and committee discussion. The President is provided a weekly “dashboard” report of our liquidity information. The Asset/Liability Committee reviews and discusses our liquidity position on a quarterly basis. The committee has set a benchmark minimum liquidity ratio of 15%.

Public funds are required to have collateral pledged against their balances above the FDIC insurance limits. Generally the bank has pledged securities or obtained letters of credit from the Federal Home Loan Bank of Pittsburgh to cover public funds. Two additional strategies to cover these funds are now being used. In the case of public funds in the form of CDs, the bank is utilizing the CDARS network to insure their funds. We are also using the Insured Cash Sweep (ICS) product to secure public funds. Both of the programs provide complete coverage through FDIC insurance. Most importantly, the securities that had been pledged against the public funds can be used as a source of cash if the need would arise. The securities are effectively converted from a non liquid asset to a liquid asset.

Liquid assets of the company include cash and due from banks, securities purchased under agreements to resell, federal funds sold, securities available for sale, and loans and investments maturing within one year. The company’s statement of cash flows details this liquidity since January 1, 2012.

     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 2012, the net income as adjusted has used cash of $1.2 million. Interest income earned on loans and investment securities is the company’s major income source.

     Investing Activities. Customer core deposits and company noncore funding 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. We have taken advantage of our noncore funding capabilities since deposit growth is not always sufficient. The net amount of cash provided by investing activities in 2012 is $4.0 million.

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     Financing Activities. Customer core deposits and company noncore funding 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 noncore funding. The net amount of cash provided by financing activities in 2012 is $12.5 million.

At March 31, 2012, 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 $47.2 million.

Noncore funding capabilities, including borrowing, provide additional liquidity. The subsidiary bank maintains a federal funds line with one financial institution and is a member of the Federal Home Loan Bank of Pittsburgh. In July 2009 the subsidiary bank secured a credit line with the Federal Reserve discount window. At March 31, 2012, the subsidiary bank has total credit available through these institutions of approximately $89.2 million.

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. All capital ratios are within the regulatory guidelines for a “well-capitalized” institution as noted below.

	March 31, 2012 (000’s)
							Minimum
							Capital
	Actual						Requirement
	Amount			Ratio			Amount					Ratio
Total capital to risk weighted assets	$	27 910		13.46%				$	16 583			8.00%
Tier 1 capital to risk weighted assets	$	25 297		12.20%				$	8 291			4.00%
Tier 1 capital to average assets	$	25 297		8.70%				$	11 625			4.00%
	December 31, 2011 (000’s)
							Minimum
							Capital
	Actual						Requirement
	Amount			Ratio			Amount					Ratio
Total capital to risk weighted assets	$	27 487		13.10%				$	16 782			8.00%
Tier 1 capital to risk weighted assets	$	24 842		11.84%				$	8 391			4.00%
Tier 1 capital to average assets	$	24 842		8.56%				$	11 602			4.00%

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Item 4. Controls and Procedures

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the date of this quarterly report. Based on that evaluation, our principal executive officer and principal financial officer have concluded that these controls and procedures are effective. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.

Disclosure controls and procedures are our controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

There are no material legal proceedings to which the Registrant or its subsidiary, directors or officers is a party or by which they, or any of them, are threatened. All legal proceedings presently pending or threatened against Potomac Bancshares, Inc. and its subsidiary involve routine litigation incidental to the business of the company or the subsidiary and are either not material in respect to the amount in controversy or fully covered by insurance.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

ISSUER PURCHASES OF EQUITY SECURITIES

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 at Potomac’s reorganization meeting.

Item 4. Mine Safety Disclosures.

     Not applicable.

Item 5. Other Information

	(b)		There have been no changes to the procedures by which security holders may recommend nominees to the registrant’s board of directors since the registrant last provided disclosure in response to Item 7(d)(2)(ii)(G) of Schedule 14A.

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Item 6. Exhibits

	31.1		Certification Under Exchange Act Rule 13a-14, Chief Executive Officer (and Section 302 of Sarbanes-Oxley Act of 2002)
	31.2		Certification Under Exchange Act Rule 13a-14, Chief Financial Officer (and Section 302 of Sarbanes-Oxley Act of 2002)
	32		Certification Pursuant to 18 U.S.C. Section 1350, Chief Executive Officer and Chief Financial Officer (pursuant to Section 906 of Sarbanes-Oxley Act of 2002)
	101.INS		XBRL Instance Document. **
	101.SCH		XBRL Taxonomy Extension Schema. **
	101.CAL		XBRL Taxonomy Extension Calculation Linkbase. **
	101.LAB		XBRL Taxonomy Extension Label Linkbase. **
	101.PRE		XBRL Taxonomy Extension Presentation Linkbase. **
	101.DEF		XBRL Taxonomy Definition Linkbase. **
	**		Furnished, not filed, herewith

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SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

		POTOMAC BANCSHARES, INC.
Date: May 15, 2012		/s/ Robert F. Baronner, Jr.
		Robert F. Baronner, Jr.
		President & CEO
Date: May 15, 2012		/s/ Dean Cognetti
		Dean Cognetti
		Sr. Vice President and Chief Financial Officer

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