Grayson Bankshares (GSON) 10-K 2010 FY Annual report

  Exhibit 13.1

2010 Annual Report

Table of Contents

Stockholder Information	1
Financial Highlights	2
Letter to Stockholders	3
Report of Independent Registered Public Accounting Firm	4
Consolidated Balance Sheets	5
Consolidated Statements of Income	6
Consolidated Statements of Changes in Stockholders’ Equity	7
Consolidated Statements of Cash Flows	8
Notes to Consolidated Financial Statements	9
Management’s Discussion and Analysis	37

Stockholder Information

Annual Meeting

The annual meeting of stockholders will be held at 1:00 p.m. on May 10, 2011, at The Grayson National Bank Conference Center, 558 East Main Street, Independence, Virginia, located in the Guynn Shopping Center.

Requests for Information

Requests for information should be directed to Mrs. Brenda C. Smith, Corporate Secretary, at The Grayson National Bank, Post Office Box 186, Independence, Virginia, 24348; telephone (276) 773-2811.

Independent Registered Public Accounting Firm	Stock Transfer Agent
Elliott Davis, LLC	Registrar and Transfer Company
Post Office Box 760	10 Commerce Drive
Galax, Virginia  24333	Cranford, NJ 07016

Federal Deposit Insurance Corporation

The Bank is a member of the FDIC.  This statement has not been reviewed, or confirmed for accuracy or relevance by the Federal Deposit Insurance Corporation.

Banking Offices
Main Office 113 West Main Street Independence, Virginia 24348 (276) 773-2811	Elk Creek Office 60 Comers Rock Road Elk Creek, Virginia 24326 (276) 655-4011
East Independence Office 802 East Main Street Independence, Virginia 24348 (276) 773-2811	Troutdale Office 101 Ripshin Road Troutdale, Virginia 24378 (276) 677-3722
Galax Office 209 West Grayson Street Galax, Virginia (276) 238-2411	Sparta Office 98 South Grayson Street Sparta, North Carolina 28675 (336) 372-2811
Carroll Office 8351 Carrollton Pike Galax, Virginia 24333 (276) 238-8112	Whitetop Office 16303 Highlands Parkway Whitetop, Virginia, 24292 (336) 372-2811
Hillsville Office 419 South Main Street Hillsville, Virginia 24343 (276) 728-2810	Wytheville Office 150 West Main Street Wytheville, Virginia 24382 (276) 228-6050

1

Financial Highlights1

	2010			2009			2008			2007			2006
Summary of Operations
Interest income	$	18,359		$	19,917		$	21,950		$	22,884		$	20,623
Interest expense		6,508			8,417			10,433			10,834			8,636
Net interest income		11,851			11,500			11,517			12,050			11,987
Provision for loan losses		2,510			1,491			1,200			465			520
Other income		2,962			2,243			459			1,973			1,673
Other expense		10,871			11,269			10,074			9,095			8,670
Income taxes		266			100			(52	)		1,296			1,323
Net income		1,166		$	883		$	754		$	3,167		$	3,147
Per Share Data
Net income	$	.68		$	.51		$	.44		$	1.84		$	1.83
Cash dividends declared		.40			.40			.86			.86			.90
Book value		17.69			17.77			16.88			17.62			16.47
Estimated market value2		14.50			17.00			24.00			29.00			30.00
Year-end Balance Sheet Summary
Loans, net	$	248,513		$	266,628		$	267,889		$	263,729		$	245,517
Investment securities		47,692			42,034			49,451			42,573			40,848
Total assets		368,217			369,602			368,197			361,486			333,604
Deposits		311,817			313,483			305,730			309,174			282,246
Stockholders’ equity		30,410			30,540			29,017			30,291			28,304
Selected Ratios
Return on average assets		0.32	%		0.24	%		0.21	%		0.93	%		1.01	%
Return on average equity		3.71	%		2.99	%		2.46	%		10.77	%		10.85	%
Average equity to average assets		8.52	%		8.01	%		8.40	%		8.67	%		9.33	%
1In thousands of dollars, except per share data.
2 Provided at the trade date nearest year end.

2

Dear Stockholder:

It is our pleasure to present our Annual Financial Report to you.

We ended the year with total assets of $368,217,088, resulting in a decrease of $1,384,833 or 0.37% from the previous year.  Our return on average assets was 0.32% and the return on average equity was 3.71% as compared to 0.24% and 2.99% for the previous year.  Net earnings were $1,165,861, compared to $882,719 for the previous year.  Our net loans decreased by $18,115,092 or 6.79% while deposits decreased by $1,666,358 or 0.53%.  The book value for our stock at year-end was $17.69 per share and dividends for the year totaled $0.40 per share.  Please refer to our financial highlights page and accompanying statements for additional information.

The banking industry continues to be challenged on many fronts.  While economic indicators are beginning to suggest improvement in certain parts of the nation, the same cannot be said for our immediate market area.  Our real estate market remains subdued and the unemployment rate in Grayson and Carroll Counties, as well as the city of Galax continued to increase in 2010.  The impact of this continued weakness in our local economy can be seen in the increasing levels of past due and nonperforming loans and foreclosed properties.  Demand for new loans is also negatively impacted as evidenced by the net decrease in loans mentioned above.  We expect this will continue to place negative pressure on earnings until conditions begin to improve in our direct market area.

Banks are also facing significant challenges on the regulatory front.  Last year, in response to the financial crisis, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).  This landmark legislation contains many provisions that will have a direct impact on our business including the creation of a new “Consumer Financial Protection Bureau” to write consumer-protection rules for banks and nonbank financial firms to ensure that consumers are protected from unfair, deceptive, or abusive practices.  While banks with less than $10 billion in assets will be exempt from direct examination by the CFPB, they will still have to comply with many of the regulations established by the CFPB.  I have seen one estimate from a banking trade organization suggesting that the various regulatory agencies may have to write as many as 5,000 pages of new regulations to implement all the provisions of Dodd-Frank.  As is typically the case, we anticipate compliance with these new regulations will be disproportionately burdensome on smaller institutions.  This increase in compliance costs will be in addition to the increased FDIC insurance premiums that have already been in place for the past two years.

Despite the challenges of a deep recession we are pleased by the fact that your bank has continued to generate positive earnings throughout the downturn.  Our capital position remains strong and our core earnings remain solid.  Our employees continue to work tirelessly to rise to the challenges at hand and I thank them again for their dedicated service to the bank, our shareholders, and most of all, our customers.

As always, we appreciate your support, welcome your comments and the opportunity to serve you.

Sincerely,

Jacky K. Anderson

President & CEO

3

Report of Independent Registered Public Accounting Firm

Board of Directors and Stockholders

Grayson Bankshares, Inc.

Independence, Virginia

We have audited the consolidated balance sheets of Grayson Bankshares, Inc. and subsidiary as of December 31, 2010 and 2009, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010.  These consolidated 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 consolidated financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting.  Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Grayson Bankshares, Inc. and subsidiary as of December 31, 2010 and 2009 and the results of its operations and its cash flows for each of the three years then ended, in conformity with U.S. generally accepted accounting principles.

Galax, Virginia

March 30, 2011

   

Consolidated Balance Sheets

December 31, 2010 and 2009

	2010			2009
Assets
Cash and due from banks	$	9,200,552		$	8,637,123
Interest-bearing deposits with banks		3,305,724			300,000
Federal funds sold		27,745,592			19,356,999
Investment securities available for sale		46,841,247			39,859,119
Investment securities held to maturity
(fair value approximately $888,013
in 2010, and $2,254,196 in 2009)		850,590			2,174,882
Restricted equity securities		1,617,300			1,783,700
Loans, net of allowance for loan losses of $4,542,420
in 2010 and $3,555,273 in 2009		248,512,958			266,628,050
Cash value of life insurance		8,433,596			8,098,134
Foreclosed assets		3,256,725			2,808,885
Property and equipment, net		10,575,133			11,133,834
Accrued interest receivable		2,131,943			2,626,164
Other assets		5,745,728			6,195,031
	$	368,217,088		$	369,601,921
Liabilities and Stockholders’ Equity
Liabilities
Deposits
Noninterest-bearing	$	42,487,778		$	44,924,699
Interest-bearing		269,329,080			268,558,517
Total deposits		311,816,858			313,483,216
Long-term debt		25,000,000			25,000,000
Accrued interest payable		311,647			382,653
Other liabilities		678,813			196,107
		337,807,318			339,061,976
Commitments and contingencies		-			-
Stockholders’ equity
Preferred stock, $25 par value; 500,000
shares authorized; none issued		-			-
Common stock, $1.25 par value; 2,000,000 shares
authorized; 1,718,968 shares issued
in 2010 and 2009, respectively		2,148,710			2,148,710
Surplus		521,625			521,625
Retained earnings		28,975,488			28,497,214
Accumulated other comprehensive income (loss)		(1,236,053	)		(627,604	)
		30,409,770			30,539,945
	$	368,217,088		$	369,601,921

See Notes to Consolidated Financial Statements

5

Consolidated Statements of Income

Years ended December 31, 2010, 2009 and 2008

	2010		2009		2008
Interest income
Loans and fees on loans	$	16,648,016	$	17,813,275	$	19,312,389
Interest-bearing deposits on banks		6,826		-		-
Federal funds sold		49,383		37,187		329,750
Investment securities:
Taxable		1,278,064		1,659,813		1,826,384
Exempt from federal income tax		376,613		406,745		481,031
		18,358,902		19,917,020		21,949,554
Interest expense
Deposits		5,450,236		7,271,248		9,381,827
Interest on borrowings		1,057,600		1,146,197		1,050,649
		6,507,836		8,417,445		10,432,476
Net interest income		11,851,066		11,499,575		11,517,078
Provision for loan losses		2,509,569		1,490,848		1,200,385
Net interest income after
provision for loan losses		9,341,497		10,008,727		10,316,693
Noninterest income
Service charges on deposit accounts		1,098,135		1,031,306		956,049
Other service charges and fees		586,739		537,972		489,264
Net realized gains (losses) on securities		574,231		220,089		(1,643,046	)
Mortgage loan origination fees		153,389		127,961		154,906
Increase in cash value of life insurance		335,461		323,242		346,940
Other income		213,657		2,275		155,396
		2,961,612		2,242,845		459,509
Noninterest expense
Salaries and employee benefits		6,280,437		6,553,441		6,084,825
Occupancy expense		485,097		494,863		376,815
Equipment expense		760,313		830,877		858,919
Foreclosure expense		104,413		175,408		56,083
Data processing expense		406,839		361,138		307,091
FDIC assessments		727,008		879,903		214,275
Other expense		2,106,621		1,972,922		2,175,537
		10,870,728		11,268,552		10,073,545
Income before income taxes		1,432,381		983,020		702,657
Income tax expense		266,520		100,301		(51,702	)
Net income	$	1,165,861	$	882,719	$	754,359
Basic earnings per share	$	0.68	$	0.51	$	0.44
Weighted average shares outstanding		1,718,968		1,718,968		1,718,968
Dividends declared per share	$	0.40	$	0.40	$	0.86

See Notes to Consolidated Financial Statements

6

Consolidated Statements of Changes in Stockholders’ Equity

Years ended December 31, 2010, 2009 and 2008

										Accumulated
										Other
	Common Stock						Retained			Comprehensive
	Shares		Amount		Surplus		Earnings			Income (Loss)			Total
Balance, December 31, 2007		1,718,968	$	2,148,710	$	521,625	$	29,026,036		$	(1,405,498	)	$	30,290,873
Comprehensive income
Net income		-		-		-		754,359			-			754,359
Net change in pension reserve,
net of income taxes of ($569,949)		-		-		-		-			(1,106,372	)		(1,106,372	)
Net change in unrealized
gain (loss) on investment
securities available for
sale, net of taxes of $(272,135)		-		-		-		-			(528,262	)		(528,262	)
Reclassification adjustment, net
of income taxes of $558,636		-		-		-		-			1,084,410			1,084,410
Total comprehensive income														204,135
Dividends paid
($.86 per share)		-		-		-		(1,478,313	)		-			(1,478,313	)
Balance, December 31, 2008		1,718,968	$	2,148,710	$	521,625	$	28,302,082		$	(1,955,722	)	$	29,016,695
Comprehensive income
Net income		-		-		-		882,719			-			882,719
Net change in pension reserve,
net of income taxes of $555,893		-		-		-		-			1,079,087			1,079,087
Net change in unrealized
gain (loss) on investment
securities available for
sale, net of taxes of $203,119		-		-		-		-			394,290			394,290
Reclassification adjustment, net
of income taxes of ($74,830)		-		-		-		-			(145,259	)		(145,259	)
Total comprehensive income														2,210,837
Dividends paid
($.40 per share)		-		-		-		(687,587	)		-			(687,587	)
Balance, December 31, 2009		1,718,968	$	2,148,710	$	521,625	$	28,497,214		$	(627,604	)	$	30,539,945
Comprehensive income
Net income		-		-		-		1,165,861			-			1,165,861
Net change in pension reserve,
net of income taxes of $(60,010)		-		-		-		-			(116,490	)		(116,490	)
Net change in unrealized
gain (loss) on investment
securities available for
sale, net of taxes of $(58,196)		-		-		-		-			(112,967	)		(112,967	)
Reclassification adjustment, net
of income taxes of ($195,239)		-		-		-		-			(378,992	)		(378,992	)
Total comprehensive income														557,412
Dividends paid
($.40 per share)		-		-		-		(687,587	)		-			(687,587	)
Balance, December 31, 2010		1,718,968	$	2,148,710	$	521,625	$	28,975,488		$	(1,236,053	)	$	30,409,770

See Notes to Consolidated Financial Statements

7

Consolidated Statements of Cash Flows

Years ended December 31, 2010, 2009 and 2008

	2010			2009			2008
Cash flows from operating activities
Net income	$	1,165,861		$	882,719		$	754,359
Adjustments to reconcile net income
to net cash (used in) provided by operations:
Depreciation and amortization		746,010			765,609			732,592
Provision for loan losses		2,509,569			1,490,848			1,200,385
Deferred income taxes		(294,356	)		527,516			(827,301	)
Net realized (gain) loss on securities		(574,231	)		(220,089	)		1,643,046
Accretion of discount on securities, net of
amortization of premiums		271,646			100,616			4,513
Deferred compensation		(28,643	)		23,245			21,960
Net realized (gain) loss on foreclosed assets		(1,733	)		46,602			(21,926	)
Life insurance proceeds		-			-			(119,902	)
Changes in assets and liabilities:
Cash value of life insurance		(335,462	)		(323,242	)		(346,940	)
Accrued income		494,221			498,376			(128,279	)
Other assets		880,602			(3,641,525	)		(93,839	)
Accrued interest payable		(71,006	)		(109,452	)		(44,288	)
Other liabilities		511,349			(1,150,108	)		(225,770	)
Net cash (used in) provided by operating activities		5,273,827			(1,108,885	)		2,548,610
Cash flows from investing activities
Net increase in interest-bearing deposits		(3,005,724	)		(300,000	)		-
Net (increase) decrease in federal funds sold		(8,388,593	)		(8,207,281	)		13,487,413
Activity in available for sale securities:
Purchases		(42,282,312	)		(14,703,042	)		(30,787,874	)
Sales		9,609,736			7,104,836			700,000
Maturities/Calls/Paydowns		25,205,298			15,116,660			21,275,677
Activity in held to maturity securities:
Sales		1,366,635			-			-
Maturities/Calls		-			395,000			-
(Purchases) sales of restricted equity securities		166,400			(51,950	)		(601,900	)
Net (increase) decrease in loans		14,947,523			(862,200	)		(8,094,622	)
Purchases of bank-owned life insurance		-			-			(2,000,000	)
Proceeds from life insurance contracts		-			-			290,803
Proceeds from the sale of foreclosed assets		211,893			436,168			256,926
Purchases of property and equipment, net of sales		(187,309	)		(784,410	)		(3,362,567	)
Net cash used in investing activities		(2,356,453	)		(1,856,219	)		(8,836,144	)
Cash flows from financing activities
Net increase (decrease) in deposits		(1,666,358	)		7,753,042			(3,443,520	)
Dividends paid		(687,587	)		(687,587	)		(1,478,313	)
Proceeds from long-term debt		-			-			10,000,000
Principal repayments on long-term debt		-			(5,000,000	)		-
Net cash (used in) provided by financing activities		(2,353,945	)		2,065,455			5,078,167
Net increase in cash and cash equivalents		563,429			(899,649	)		(1,209,367	)
Cash and due from banks, beginning		8,637,123			9,536,772			10,746,139
Cash and due from banks, ending	$	9,200,552		$	8,637,123		$	9,536,772
Supplemental disclosure of cash flow information
Interest paid	$	6,578,842		$	8,526,897		$	10,476,764
Taxes paid	$	450,000		$	212,422		$	643,880
Supplemental disclosure of noncash investing activities
Effect on equity of change in net unrealized gain	$	(491,959	)	$	249,031		$	556,148
Effect on equity of change in unfunded pension liability	$	(116,490	)	$	1,079,087		$	(1,106,372	)
Transfers of loans to foreclosed properties	$	658,000		$	632,389		$	2,734,266

See Notes to Consolidated Financial Statements

8

Notes to Consolidated Financial Statements

Note 1.  Organization and Summary of Significant Accounting Policies

Organization

Grayson Bankshares, Inc. (the Company) was incorporated as a Virginia corporation on February 3, 1992 to acquire the stock of The Grayson National Bank (the Bank).  The Bank was acquired by the Company on July 1, 1992.

The Grayson National Bank was organized under the laws of the United States in 1900 and currently serves Grayson County, Virginia and surrounding areas through ten banking offices.  As an FDIC insured, National Banking Association, the Bank is subject to regulation by the Comptroller of the Currency.  The Company is regulated by the Federal Reserve.

The accounting and reporting policies of the Company and the Bank follow generally accepted accounting principles and general practices within the financial services industry.  Following is a summary of the more significant policies.

Critical Accounting Policies

Management believes the policies with respect to the methodology for the determination of the allowance for loan losses, and asset impairment judgments involve a higher degree of complexity and require management to make difficult and subjective judgments which often require assumptions or estimates about highly uncertain matters.  Changes in these judgments, assumptions or estimates could cause reported results to differ materially.  These critical policies and their application are periodically reviewed with the Audit Committee and the Board of Directors.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and the Bank, which is wholly owned.  All significant, intercompany transactions and balances have been eliminated in consolidation.

Business Segments

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

Use of Estimates

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

Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans.  In connection with the determination of the allowances for loan and foreclosed real estate losses, management obtains independent appraisals for significant properties.

Substantially all of the Bank’s loan portfolio consists of loans in its market area.  Accordingly, the ultimate collectibility of a substantial portion of the Bank’s loan portfolio and the recovery of a substantial portion of the carrying amount of foreclosed real estate are susceptible to changes in local market conditions.  The regional economy is diverse, but influenced to an extent by the manufacturing and agricultural segments.

9

Notes to Consolidated Financial Statements

Note 1.  Organization and Summary of Significant Accounting Policies, continued

Use of Estimates, continued

While management uses available information to recognize loan and foreclosed real estate losses, future additions to the allowances may be necessary based on changes in local economic conditions.  In addition, regulatory agencies, as a part of their routine examination process, periodically review the Bank’s allowances for loan and foreclosed real estate losses.  Such agencies may require the Bank to recognize additions to the allowances based on their judgments about information available to them at the time of their examinations.  Because of these factors, it is reasonably possible that the allowances for loan and foreclosed real estate losses may change materially in the near term.

Cash and Due from Banks

For the purpose of presentation in the consolidated statements of cash flows, cash and cash equivalents are defined as those amounts included in the balance sheet caption “cash and due from banks.”

Trading Securities

The Company does not hold securities for short-term resale and therefore does not maintain a trading securities portfolio.

Securities Held to Maturity

Bonds, notes, and debentures for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity or to call dates.

Securities Available for Sale

Available for sale securities are reported at fair value and consist of bonds, notes, debentures, and certain equity securities not classified as trading securities or as held to maturity securities.

Unrealized holding gains and losses, net of tax, on available for sale securities are reported as a net amount in a separate component of stockholders’ equity.  Realized gains and losses on the sale of available for sale securities are determined using the specific-identification method.  Premiums and discounts are recognized in interest income using the interest method over the period to maturity or to call dates.

Declines in the fair value of individual held to maturity and available for sale securities below cost that are other than temporary are reflected as write-downs of the individual securities to fair value.  Related write-downs are included in earnings as realized losses.

Loans Receivable

Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal amount adjusted for any charge-offs and the allowance for loan losses.  The Bank only charges loan origination fees on term loans with an original maturity of one year or less.  Loan origination fees are therefore not capitalized due to the short-term nature of the related loans.  Loan origination costs are capitalized and recognized as an adjustment to yield over the life of the related loan.

Interest is accrued and credited to income based on the principal amount outstanding.  The accrual of interest on impaired loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due.  When interest accrual is discontinued, all unpaid accrued interest is reversed.  Interest income is subsequently recognized only to the extent cash payments are received.  Payments received are first applied to principal, and any remaining funds are then applied to interest.  When facts and circumstances indicate the borrower has regained the ability to meet the required payments, the loan is returned to accrual status.  Past due status of loans is determined based on contractual terms.

10

Notes to Consolidated Financial Statements

Note 1.  Organization and Summary of 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 uncollectability of a loan balance, or portion there of, is confirmed.  Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility 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 impaired.  For such loans that are 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-impaired 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 the 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 Bank 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 all 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 Bank does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement.

Property and Equipment

Land is carried at cost.  Bank premises, furniture and equipment are carried at cost, less accumulated depreciation and amortization computed principally by the straight-line method over the following estimated useful lives:

	Years
Buildings and improvements	10-40
Furniture and equipment	5-12

11

Notes to Consolidated Financial Statements

Note 1.  Organization and Summary of Significant Accounting Policies, continued

Foreclosed Assets

Real estate properties acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at fair value less anticipated cost to sell at the date of foreclosure, establishing a new cost basis.  After foreclosure, valuations are periodically performed by management and the real estate is 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 loss on foreclose expense.

Pension Plan

The Bank maintains a noncontributory defined benefit pension plan covering all employees who meet eligibility requirements.  To be eligible, an employee must be 21 years of age and have completed one year of service.  Plan benefits are based on final average compensation and years of service.  The funding policy is to contribute the maximum deductible for federal income tax purposes.

Transfers of Financial Assets

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

Income Taxes

Provision for income taxes is based on amounts reported in the statements of income (after exclusion of non-taxable income such as interest on state and municipal securities) and consists of taxes currently due plus deferred taxes on temporary differences in the recognition of income and expense for tax and financial statement purposes.  Deferred tax assets and liabilities are included in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled.  As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.

Deferred income tax expense results from changes in deferred tax assets and liabilities between periods.  Deferred tax assets are recognized if it is more likely than not, based on the technical merits, that the tax position will be realized or sustained upon examination.  The term more likely than not means a likelihood of more than 50 percent; the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any.  A tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that has a greater than 50 percent likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information.  The determination of whether or not a tax position has met the more-likely-than-not recognition threshold considers the facts, circumstances, and information available at the reporting date and is subject to management’s judgment.  Deferred tax assets are reduced by a valuation allowance if, based on the weight of evidence available, it is more likely than not that some portion or all of a deferred tax asset will not be realized.

Advertising Expense

The Company expenses advertising costs as they are incurred.  Advertising expense for the years presented is not material.

Basic Earnings per Share

Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding during the period, after giving retroactive effect to stock splits and dividends.

12

Notes to Consolidated Financial Statements

Note 1.  Organization and Summary of Significant Accounting Policies, continued

Diluted Earnings per Share

The computation of diluted earnings per share is similar to the computation of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive potential common shares had been issued.  The numerator is adjusted for any changes in income or loss that would result from the assumed conversion of those potential common shares.  For the years presented, the Company had no potentially dilutive securities outstanding and therefore, diluted earnings per share would be the same as basic earnings per share.

Comprehensive Income

Comprehensive income consists of net income and other comprehensive income.  Other comprehensive income includes unrealized gains on securities available for sale, and unrealized losses related to factors other than credit on debt securities, unrealized gains and losses on cash flows hedges, and changes in the funded status of the pension plan which are also recognized as separate components of equity.

Off-Balance Sheet Credit Related Financial Instruments

In the ordinary course of business, the Company has entered into commitments to extend credit, including commitments under line of credit arrangements, commercial letters of credit, and standby letters of credit.  Such financial instruments are recorded when they are funded.

Derivative Financial Instruments

The Company accounts, and reports for derivative instruments in accordance with applicable accounting standards.  These standards require that all derivatives be recognized as assets or liabilities in the balance sheet and measured at fair value.  The Company had no derivative instruments at December 31, 2010 and 2009.

Interest Rate Swap Agreements

For asset/liability management purposes, the Company uses interest rate swap agreements to hedge various exposures or to modify interest rate characteristics of various balance sheet accounts.  Such derivatives are used as part of the asset/liability management process and are linked to specific assets or liabilities, and have high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period.

The Company utilizes interest rate swap agreements to convert a portion of its variable-rate debt to fixed rate (cash flow hedge), and to convert a portion of its fixed-rate loans to a variable rate (fair value hedge).  Interest rate swaps are contracts in which a series of interest rate flows are exchanged over a prescribed period.  The notional amount on which the interest payments are based is not exchanged.

In accordance with accounting guidance, the gain or loss on all derivatives designated and qualifying as a fair value hedging instrument, as well as the offsetting gain or loss on the hedged item attributable to the risk being hedged, is recognized currently in earnings in the same accounting period.  The effective portion of the gain or loss on a derivative designated and qualifying as a cash flow hedging instrument is initially reported as a component of other comprehensive income and subsequently reclassified into earnings in the same period or periods during which the hedged transaction affects earnings.  The ineffective portion of the gain or loss on the derivative instrument, if any, is recognized currently in earnings.

13

Notes to Consolidated Financial Statements

Note 1.  Organization and Summary of Significant Accounting Policies, continued

Interest Rate Swap Agreements, continued

Interest rate derivative financial instruments receive hedge accounting treatment only if they are designated as a hedge and are expected to be, and are, effective in substantially reducing interest rate risk arising from the assets and liabilities identified as exposing the Company to risk.  Those derivative financial instruments that do not meet the hedging criteria discussed below would be classified as trading activities and would be recorded at fair value with changes in fair value recorded in income.  Derivative hedge contracts must meet specific effectiveness tests (i.e., over time the change in their fair values due to the designated hedge risk must be within 80 to 125 percent of the opposite change in the fair values of the hedged assets or liabilities).  Changes in fair value of the derivative financial instruments must be effective at offsetting changes in the fair value of the hedged items due to the designated hedge risk during the term of the hedge.  Further, if the underlying financial instrument differs from the hedged asset or liability, there must be a clear economic relationship between the prices of the two financial instruments.  If periodic assessment indicated derivatives no longer provide an effective hedge, the derivatives contracts would be closed out and settled or classified as a trading activity.

Beginning January 1, 2001, in accordance with accounting standards, hedges of variable-rate debt are accounted for as cash flow hedges, with changes in fair value recorded in derivative assets or liabilities and other comprehensive income.  The net settlement (upon close out or termination) that offsets changes in the value of the hedged debt is deferred and amortized into net interest income over the life of the hedged debt.  Hedges of fixed-rate loans are accounted for as fair value hedges, with changes in fair value recorded in derivative assets or liabilities and loan interest income.  The net settlement (upon close out or termination) that offsets changes in the value of the loans adjusts the basis of the loans and is deferred and amortized to loan interest income over the life of the loans.  The portion, if any, of the net settlement amount that did not offset changes in the value of the hedged asset or liability is recognized immediately in non-interest income.

Cash flow resulting from the derivative financial instruments that are accounted for as hedges of assets and liabilities are classified in the cash flow statement in the same category as the cash flows of the items being hedged.

Fair Value of Financial Instruments

Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in Note 11.  Fair value estimates involve uncertainties and matters of significant judgment.  Changes in assumptions or in market conditions could significantly affect the estimates.

Reclassification

Certain reclassifications have been made to the prior years’ financial statements to place them on a comparable basis with the current presentation. Net income and stockholders’ equity previously reported were not affected by these reclassifications.

Recent Accounting Pronouncements

In March 2010, guidance related to derivatives and hedging was amended to exempt embedded credit derivative features related to the transfer of credit risk from potential bifurcation and separate accounting.  Embedded features related to other types of risk and other embedded credit derivative features are not exempt from potential bifurcation and separate accounting.  The amendments were effective for the Company on July 1, 2010.  These amendments will have no impact on the financial statements.

In July 2010, the Receivables topic of the ASC was amended to require expanded disclosures related to a company’s allowance for credit losses and the credit quality of its financing receivables. The amendments will require the allowance disclosures to be provided on a disaggregated basis.  The Company is required to begin to comply with the disclosures in its financial statements for the year ended December 31, 2010.  Disclosures about Troubled Debt Restructurings (TDRs) required by the Update have been deferred by the Financial Accounting Standards Board (FASB) in an update issued in early 2011. The TDR disclosures are anticipated to be effective for periods ending after June 15, 2011.  See Note 5.

14

Notes to Consolidated Financial Statements

Note 1.  Organization and Summary of Significant Accounting Policies, continued

Recent Accounting Pronouncements, continued

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which significantly changes the regulation of financial institutions and the financial services industry.  The Dodd-Frank Act includes several provisions that will affect how community banks, thrifts, and small bank and thrift holding companies will be regulated in the future.  Among other things, these provisions abolish the Office of Thrift Supervision and transfer its functions to the other federal banking agencies, relax rules regarding interstate branching, allow financial institutions to pay interest on business checking accounts, change the scope of federal deposit insurance coverage, and impose new capital requirements on bank and thrift holding companies.  The Dodd-Frank Act also establishes the Bureau of Consumer Financial Protection as an independent entity within the Federal Reserve, which will be given the authority to promulgate consumer protection regulations applicable to all entities offering consumer financial services or products, including banks.  Additionally, the Dodd-Frank Act includes a series of provisions covering mortgage loan origination standards affecting originator compensation, minimum repayment standards, and pre-payments.  Management is actively reviewing the provisions of the Dodd-Frank Act and assessing its probable impact on our business, financial condition, and results of operations.

In August 2010, two updates were issued to amend various SEC rules and schedules pursuant to Release No. 33-9026: Technical Amendments to Rules, Forms, Schedules and Codification of Financial Reporting Policies and based on the issuance of SEC Staff Accounting Bulletin 112.  The amendments related primarily to business combinations and removed references to “minority interest” and added references to “controlling” and “noncontrolling interests(s)”.  The updates were effective upon issuance but had no impact on the Company’s financial statements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

Note 2.  Restrictions on Cash

To comply with banking regulations, the Bank is required to maintain certain average cash reserve balances.  The daily average cash reserve requirement was approximately $1,943,000 and $1,612,000 for the periods including December 31, 2010 and 2009, respectively.

Note 3.  Investment Securities

Debt and equity securities have been classified in the consolidated balance sheets according to management’s intent.  The carrying amount of securities and their approximate fair values at December 31 follow:

	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
2010
Available for sale:
U.S. Government agency securities	$	1,231,318	$	60,277	$	--	$	1,291,595
Government sponsored enterprises		23,848,397		151,337		530,368		23,469,366
Mortgage-backed securities		10,254,088		394,732		18,126		10,630,694
State and municipal securities		11,673,223		81,369		305,000		11,449,592
	$	47,007,026	$	687,715	$	853,494	$	46,841,247
Held to maturity:
State and municipal securities	$	850,590	$	37,423	$	-	$	888,013

15

Notes to Consolidated Financial Statements

Note 3.  Investment Securities, continued

2009
Available for sale:
U.S. Government agency securities	$	1,629,026	$	81,689	$	-	$	1,710,715
Government sponsored enterprises		13,067,890		38,375		204,195		12,902,070
Mortgage-backed securities		17,295,436		560,310		-		17,855,746
State and municipal securities		7,287,155		162,768		59,335		7,390,588
	$	39,279,507	$	843,142	$	263,530	$	39,859,119
Held to maturity:
State and municipal securities	$	2,174,882	$	86,889	$	7,575	$	2,254,196

During 2010, three municipal securities classified as held to maturity were sold.  The amortized cost of the securities totaled $1,366,635 and sales proceeds totaled $1,386,012, resulting in a net gain of $19,377.  The securities were sold based upon evidence of deterioration in the issuer’s creditworthiness. Each of these securities had lost underlying insurance protection resulting in a reduction in credit rating for one issue and loss of credit ratings on two issues.  There were no securities transferred between the available for sale and held to maturity portfolios or other sales of held to maturity securities during the periods presented.

Restricted equity securities were $1,617,300 and $1,783,700 at December 31, 2010 and 2009, respectively.  Restricted equity securities consist of investments in stock of the Federal Home Loan Bank of Atlanta (“FHLB”), Community Bankers Bank, Pacific Coast Bankers Bank, and the Federal Reserve Bank of Richmond, all of which are carried at cost.  All of these entities are upstream correspondents of the Bank.  The FHLB requires financial institutions to make equity investments in the FHLB in order to borrow money.  The Bank is required to hold that stock so long as it borrows from the FHLB.  The Federal Reserve requires Banks to purchase stock as a condition for membership in the Federal Reserve system.  The Bank’s stock in Community Bankers Bank and Pacific Coast Bankers Bank is restricted only in the fact that the stock may only be repurchased by the respective banks.

The following table details unrealized losses and related fair values in the Company’s held to maturity and available for sale investment securities portfolios.  This information is aggregated by the length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2010 and 2009.

	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
2010
Available for sale:
U.S. Government agency securities	$	-	$	-	$	-	$	-	$	-	$	-
Government sponsored enterprises		13,870,450		493,346		32,178		37,022		13,902,628		530,368
Mortgage-backed securities		2,801,081		18,126		-		-		2,801,081		18,126
State and municipal securities		5,902,003		305,000		-		-		5,902,003		305,000
Total securities available for sale	$	22,573,534	$	816,472	$	32,178	$	37,022	$	22,605,712	$	853,494
Held to maturity:
State and municipal securities	$	-	$	-	$	-	$	-	$	-	$	-

2009
Available for sale:
U.S. Government agency securities	$	-	$	-	$	-	$	-	$	-	$	-
Government sponsored enterprises		5,454,054		204,195		-		-		5,454,054		204,195
Mortgage-backed securities		-		-		-		-		-		-
State and municipal securities		1,006,692		8,439		708,900		50,896		1,715,592		59,335
Total securities available for sale	$	6,460,746	$	212,634	$	708,900	$	50,896	$	7,169,646	$	263,530
Held to maturity:
State and municipal securities	$	-	$	-	$	220,031	$	7,575	$	220,031	$	7,575

16

Notes to Consolidated Financial Statements

Note 3.  Investment Securities, continued

At December 31, 2010, debt securities with unrealized losses had depreciated 3.64% from their amortized cost basis.  Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation.  Consideration is given to the length of time and the extent to which the fair value has been less than cost, and the financial condition and near-term prospects of the issuer.  The relative significance of these and other factors will vary on a case by case basis.  In analyzing an issuer's financial condition, management considers whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, the results of reviews of the issuer's financial condition and the issuer's anticipated ability to pay the contractual cash flows of the investments. Since the Company intends to hold all of its investment securities until maturity, and it is more likely than not that the Company will not have to sell any of its investment securities before unrealized losses have been recovered, and the Company expects to recover the entire amount of the amortized cost basis of all its securities, none of the securities are deemed other than temporarily impaired at December 31, 2010. Management continues to monitor all of these securities with a high degree of scrutiny. There can be no assurance that the Company will not conclude in future periods that conditions existing at that time indicate some or all of these securities are other than temporarily impaired, which could require a charge to earnings in such periods.

Investment securities with amortized cost of approximately $17,636,109 and $15,278,151 at December 31, 2010 and 2009, respectively, were pledged as collateral on public deposits and for other purposes as required or permitted by law.  Gross realized gains and losses for the years ended December 31, 2010, 2009 and 2008 are as follows:

	2010			2009			2008
Realized gains	$	629,558		$	277,614		$	18,000
Realized losses		(55,327	)		(57,525	)		(1,661,046	)
	$	574,231		$	220,089		$	(1,643,046	)

The scheduled maturities of securities available for sale and securities held to maturity at December 31, 2010, were as follows:

	Available for Sale				Held to Maturity
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
Due in one year or less	$	11,227	$	11,340	$	-	$	-
Due after one year through five years		3,452,391		3,648,641		367,935		388,247
Due after five years through ten years		13,138,348		12,995,661		-		-
Due after ten years		30,405,060		30,185,605		482,655		499,766
	$	47,007,026	$	46,841,247	$	850,590	$	888,013

Maturities of mortgage backed securities are based on contractual amounts.  Actual maturity will vary as loans underlying the securities are prepaid.

17

Notes to Consolidated Financial Statements

Note 4.  Loans Receivable

The major components of loans in the consolidated balance sheets at December 31, 2010 and 2009 are as follows (in thousands):

	2010			2009
Commercial	$	14,001		$	16,696
Real estate:
Construction and land development		21,308			29,171
Residential, 1-4 families		124,749			126,511
Residential, 5 or more families		2,864			2,317
Farmland		33,225			34,346
Nonfarm, nonresidential		40,342			40,545
Agricultural		2,924			3,841
Consumer		11,942			13,547
Other		1,700			3,209
		253,055			270,183
Allowance for loan losses		(4,542	)		(3,555	)
	$	248,513		$	266,628

As of December 31, 2010 and 2009, substantially all of the Bank’s residential 1-4 family loans were pledged as collateral toward borrowings with the Federal Home Loan Bank.

Note 5.  Allowance for Loan Losses and Impaired Loans

Allowance for Loan Losses

The allowance for loan losses is maintained at a level believed to be sufficient to provide for estimated loan losses based on evaluating known and inherent risks in the loan portfolio. The allowance is provided based upon management's comprehensive analysis of the pertinent factors underlying the quality of the loan portfolio. These factors include changes in the amount and composition of the loan portfolio, delinquency levels, actual loss experience, current economic conditions, and detailed analysis of individual loans for which the full collectability may not be assured. The detailed analysis includes methods to estimate the fair value of loan collateral and the existence of potential alternative sources of repayment. The allowance consists of specific and general components. The specific component relates to loans that are deemed impaired. For such loans that are 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 recorded value of that loan. The general component covers the remaining loan portfolio not evaluated individually for impairment, and is based on historical loss experience adjusted for qualitative factors. The appropriateness of the allowance for loan losses on loans is estimated based upon these factors and trends identified by management at the time financial statements are prepared.

A provision for loan losses is charged against operations and is added to the allowance for loan losses based on quarterly comprehensive analyses of the loan portfolio. The allowance for loan losses is allocated to certain loan categories based on the relative risk characteristics, asset classifications and actual loss experience of the loan portfolio. While management has allocated the allowance for loan losses to various loan portfolio segments, the allowance is general in nature and is available for the loan portfolio in its entirety.

18

Notes to Consolidated Financial Statements

Note 5.  Allowance for Loan Losses and Impaired Loans, continued

An analysis of the allowance for loan losses as of December 31 follows:

	2010			2009			2008
Balance, beginning	$	3,555,273		$	3,359,946			2,757,745
Provision charged to expense		2,509,569			1,490,848			1,200,385
Recoveries of amounts charged off		180,898			32,952			239,857
Amounts charged off		(1,703,320	)		(1,328,473	)		(838,041	)
Balance, ending	$	4,542,420		$	3,555,273			3,359,946

The following table presents information on the loans evaluated individually for impairment and collectively evaluated for impairment in the allowance for loan losses as of December 31, 2010:

Allowance for Loan Losses and Recorded Investment in Loans

As of December 31, 2010

	Commercial & Agricultural		Commercial Mortgage		Construction & Development		Farmland		Residential		Consumer & Other		Total
Allowance for loan losses:
Ending balance	$	436,872	$	777,515	$	526,231	$	710,368	$	1,861,953	$	229,481	$	4,542,420
Ending balance: individually
evaluated for impairment	$	-	$	28,082	$	-	$	32,410	$	55,185	$	-	$	115,677
Ending balance: collectively
evaluated for impairment	$	436,872	$	749,433	$	526,231	$	677,958	$	1,806,768	$	229,481	$	4,426,743
Loans outstanding:
Ending balance	$	16,925,908	$	40,342,235	$	21,308,301	$	33,224,917	$	127,613,043	$	13,640,974	$	253,055,378
Ending balance: individually
evaluated for impairment	$	-	$	2,020,678	$	2,718,524	$	2,913,440	$	5,052,920	$	-	$	12,705,562
Ending balance: collectively
evaluated for impairment	$	16,925,908	$	38,321,557	$	18,589,777	$	30,311,477	$	122,560,123	$	13,640,974	$	240,349,816

Management closely monitors the quality of the loan portfolio and has established a loan review process designed to help grade the quality of the Bank’s loan portfolio.  The Bank’s loan ratings coincide with the "Substandard," "Doubtful" and "Loss" classifications used by federal regulators in their examination of financial institutions. Generally, an asset is considered Substandard if it is inadequately protected by the current net worth and paying capacity of the obligors and/or the collateral pledged. Substandard assets include those characterized by the distinct possibility that the insured financial institution will sustain some loss if the deficiencies are not corrected. Assets classified as Doubtful have all the weaknesses inherent in assets classified Substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, highly questionable and improbable. Assets classified as Loss are those considered uncollectible, and of such little value that its continuance on the books is not warranted.   Assets that do not currently expose the insured financial institutions to sufficient risk to warrant classification in one of the aforementioned categories but otherwise possess weaknesses are designated "Special Mention."   Management also maintains a listing of loans designated “Watch”. These loans represent borrowers with declining earnings, strained cash flow, increasing leverage and/or weakening market fundamentals that indicate above average risk.  As of December 31, 2010, the Bank had no loans graded “Doubtful” or “Loss” included in the balance of total loans outstanding.

19

Notes to Consolidated Financial Statements

Note 5.  Allowance for Loan Losses and Impaired Loans, continued

The following table lists the loan grades utilized by the Bank and the corresponding total of outstanding loans in each category as of December 31, 2010:

Credit Risk Profile by Internally Assigned Grades

As of December 31, 2010

	Loan Grades
					Special
	Pass		Watch		Mention		Substandard		Total
Real Estate Secured:
1-4 residential construction	$	694,877	$	-	$	-	$	115,238	$	810,115
Commercial construction		218,345		-		-		-		218,345
Loan development &
other land		13,090,447		1,734,074		545,952		4,909,368		20,279,841
Farmland		23,512,660		1,558,170		1,703,049		6,451,038		33,224,917
1-4 residential mortgage		102,301,105		1,049,301		200,489		8,715,499		112,266,394
Multifamily		2,863,816		-		-		-		2,863,816
Home equity and second
mortgage		12,111,438		121,792		-		249,603		12,482,833
Commercial mortgage		30,756,084		3,578,944		721,327		5,285,881		40,342,236
Non-Real Estate Secured:
Commercial & agricultural		15,444,342		301,909		-		856,636		16,602,887
Financial institutions		-		-		323,021		-		323,021
Civic organizations		471,939		-		-		-		471,939
Consumer-auto		4,447,086		-		-		86,576		4,533,662
Consumer-Other		8,536,033		2,123		-		97,216		8,635,372
Total	$	214,448,172	$	8,346,313	$	3,493,838	$	26,767,055	$	253,055,378

Loans may be placed in nonaccrual status when, in management’s opinion, the borrower may be unable to meet payments as they become due.  When interest accrual is discontinued, all unpaid accrued interest is reversed.  Interest income is subsequently recognized only to the extent cash payments are received.  Payments received are first applied to principal, and any remaining funds are then applied to interest.  Loans are removed from nonaccrual status when they are deemed a loss and charged to the allowance, transferred to foreclosed assets, or returned to accrual status based upon performance consistent with the original terms of the loan or a subsequent restructuring thereof.

20

Notes to Consolidated Financial Statements

Note 5.  Allowance for Loan Losses and Impaired Loans, continued

The following table presents an age analysis of nonaccrual and past due loans by category as of December 31, 2010:

Analysis of Past Due and Nonaccrual Loans

As of December 31, 2010

													90+ Days
					90 Days or								Past Due
	30-59 Days		60-89 Days		More Past		Total Past				Total		and Still		Nonaccrual
	Past Due		Past Due		Due		Due		Current		loans		Accruing		Loans
Real Estate Secured:
1-4 residential construction	$	-	$	115,238	$	-	$	115,238	$	694,877	$	810,115	$	-	$	-
Commercial construction		-		-		-		-		218,345		218,345		-		-
Loan development &
other land		431,277		27,641		2,841,698		3,300,616		16,979,225		20,279,841		51,809		2,901,203
Farmland		509,005		1,003,879		2,936,006		4,448,890		28,776,027		33,224,917		-		3,507,668
1-4 residential mortgage		4,632,469		2,300,063		2,936,006		12,861,512		99,404,882		112,266,394		724,270		6,047,300
Multifamily		-		-		-		-		2,863,816		2,863,816		-		-
Home equity and second
mortgage		165,669		63,459		244,616		473,744		12,009,089		12,482,833		56,704		188,900
Commercial mortgage		487,226		319,431		2,493,535		3,300,192		37,042,044		40,342,236		-		2,579,645
Non-Real Estate Secured:
Commercial & agricultural		249,260		272,044		432,584		953,888		15,648,999		16,602,887		-		432,584
Financial institutions		-		-		-		-		323,021		323,021		-		-
Civic organizations		-		-		-		-		471,939		471,939		-		-
Consumer-auto		150,589		44,017		78,536		273,142		4,260,520		4,533,662		65,413		13,124
Consumer-Other		223,490		23,340		72,216		319,046		8,316,326		8,635,372		37,779		39,437
Total	$	6,848,985	$	4,169,112	$	15,028,171	$	26,046,268	$	227,009,110	$	253,055,378	$	935,975	$	15,709,861

Impaired Loans

A loan is considered impaired when it is probable that the Bank will be unable to collect all contractual principal and interest payments due in accordance with the original or modified terms of the loan agreement. Smaller balance homogenous loans may be collectively evaluated for impairment. Impaired loans are measured based on the estimated fair value of the collateral less estimated cost to sell if the loan is considered collateral dependent.  Impaired loans not considered to be collateral dependent are measured based on the present value of expected future cash flows.  The valuation of real estate collateral is subjective in nature and may be adjusted in future periods because of changes in economic conditions. Management considers third-party appraisals, as well as independent fair market value assessments in determining the estimated fair value of particular properties. In addition, as certain of these third-party appraisals and independent fair market value assessments are only updated periodically, changes in the values of specific properties may have occurred subsequent to the most recent appraisals. Accordingly, the amounts of any such potential changes and any related adjustments are generally recorded at the time such information is received. When the measurement of the impaired loan is less than the recorded investment in the loan, impairment is recognized by creating or adjusting an allocation of the allowance for loan losses and uncollected accrued interest is reversed against interest income. If ultimate collection of principal is in doubt, all cash receipts on impaired loans are applied to reduce the principal balance.

As of December 31, 2010, the recorded investment in impaired loans totaled $12,896,777.  The average age of the third-party appraisal or independent assessment used to measure impairment on our collateral-dependent loans was 11 months.  The Bank’s current practice is to consider an appraisal or assessment to be current if it is less than 18 months old.  The total amount of collateral-dependent impaired loans at December 31, 2010 was $12,049,301, of these $7,153,100 were measured for impairment using appraisals aged less than 18 months.  The remaining $4,896,201 of collateral-dependent impaired loans was measured for impairment using existing appraisals discounted 15-20% for age and other pertinent factors.  As of December 31, 2010, $2,690,866 of the recorded investment in impaired loans did not require specific reserves because they had been written down to the fair value of collateral through a direct charge-off.

21

Notes to Consolidated Financial Statements

Note 5.  Allowance for Loan Losses and Impaired Loans, continued

Impaired Loans, continued

The categories of non-accrual loans and impaired loans overlap, although they are not coextensive. The Bank considers all circumstances regarding the loan and borrower on an individual basis when determining whether an impaired loan should be placed on non-accrual status, such as the financial strength of the borrower, the estimated collateral value, reasons for the delay, payment record, the amount past due and the number of days past due.

The following table is a summary of information related to impaired loans as of December 31, 2010:

Impaired Loans

As of December 31, 2010

			Unpaid
	Recorded		Principal		Related		Interest Income
	Investment (1)		Balance		Allowance		Recognized
With no related allowance recorded:
Land development & other land	$	2,786,092	$	2,718,524	$	-	$	93,528
Farmland		2,513,148		2,492,274		-		6,962
1-4 residential mortgage		3,836,798		3,770,194		-		650
Commercial mortgage		1,902,880		1,896,597		-		-
Subtotal		11,038,918		10,877,589		-		101,140
With an allowance recorded:
Farmland		424,224		421,166		32,410		-
1-4 residential mortgage		1,306,962		1,282,727		55,185		8,391
Commercial mortgage		126,673		124,082		28,082		-
Subtotal		1,857,859		1,827,975		115,677		8,391
Totals:
Land development & other land		2,786,092		2,718,524		-		93,528
Farmland		2,937,372		2,913,440		32,410		6,962
1-4 residential mortgage		5,143,760		5,052,921		55,185		9,041
Commercial mortgage		2,029,553		2,020,679		28,082		-
Total	$	12,896,777	$	12,705,564	$	115,677	$	109,531

  (1)     Recorded investment includes unpaid active principal outstanding, accrued interest, late charges and unearned deferred cost

The average annual recorded investment in impaired loans and interest income recognized on impaired loans for the years ended December 31, 2010, 2009 and 2008 (all approximate) are summarized below:

	2010		2009		2008
Average investment in impaired loans	$	11,875,155	$	10,356,198	$	6,170,150
Interest income recognized on impaired loans	$	203,843	$	424,635	$	398,537
Interest income recognized on a cash basis on impaired loans	$	204,468	$	430,623	$	399,794

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

22

Notes to Consolidated Financial Statements

Note 5.  Allowance for Loan Losses and Impaired Loans, continued

The following table is a summary of information related to loan modifications as of December 31, 2010:

Modifications

As of December 31, 2010

	2010
					Post-
			Pre-Modification		Modification
			Outstanding		Outstanding
	Number		Recorded		Recorded
	of Contracts		Investment (1)		Investment (1)
Troubled Debt Restructurings
1-4 residential mortgage		3	$	506,882	$	505,359
Commercial mortgage		1		1,450,551		1,262,787
Land development & other land		1		112,103		112,103
Farmland		1		350,000		350,000

	Number		Recorded
	of Contracts		Investment
Troubled Debt Restructurings
That Subsequently Defaulted
Troubled debt restructurings:
1-4 residential mortgage		1	$	100,054
Commercial mortgage		1	$	1,262,787

(1)      Recorded investment includes unpaid active principal outstanding, accrued interest, late charges and unearned deferred cost

Note 6.  Property and Equipment

Components of property and equipment and total accumulated depreciation at December 31, 2010 and 2009, are as follows:

	2010				2009
Land	$	2,287,922			$	2,267,922
Buildings and improvements		8,889,692				8,871,986
Furniture and equipment		5,806,327				5,656,724
		16,983,941				16,796,632
Less accumulated depreciation		(6,408,808	)	��		(5,662,798	)
	$	10,575,133			$	11,133,834

Depreciation expense for the years ended December 31, 2010, 2009, and 2008 amounted to $746,010, $765,609, and $732,592, respectively.

23

Notes to Consolidated Financial Statements

Note 7.  Cash Value of Life Insurance

The Bank is owner and beneficiary of life insurance policies on certain employees and directors.  Policy cash values totaled $8,433,596 and $8,098,134 at December 31, 2010 and 2009, respectively.

Note 8.  Deposits

The aggregate amount of time deposits in denominations of $100,000 or more at December 31, 2010 and 2009 was $72,604,243 and $81,007,742, respectively.  At December 31, 2010, the scheduled maturities of all time deposits are as follows:

Three months or less	$	38,675,818
Over three months through twelve months		88,083,039
Over one year through three years		30,873,935
Over three years		27,560,992
	$	185,193,784

Note 9.  Short-Term Debt

At December 31, 2010 and 2009 the Bank had no debt classified as short-term.

At December 31, 2010, the Bank had established unsecured lines of credit of approximately $4,000,000 with correspondent banks to provide additional liquidity if, and as needed.  In addition, the Bank has the ability to borrow up to $41,170,000 from the Federal Home Loan Bank, subject to the pledging of collateral.

Note 10.  Long-Term Debt

The Bank’s long-term debt consists of borrowings from the Federal Home Loan Bank of Atlanta (FHLB) and Deutsche Bank.  The Bank had two outstanding advances from the FHLB at December 31, 2010, which are secured by substantially all the Bank’s first mortgage one-to-four family residential loans.  The first is a $10,000,000 advance that matures on October 24, 2017.  Interest on the loan is fixed at 3.802% and the loan is callable quarterly by the FHLB.  The second is a $5,000,000 advance that matures on April 23, 2012.  Interest on the loan is fixed at 3.593% until maturity and the loan is non-callable by the FHLB.

The borrowing from Deutsche Bank is a $10,000,000 structured term repurchase agreement.  This loan matures on February 10, 2017 and is secured by investment securities with an amortized cost of $14,463,913 at December 31, 2010.  Interest on the loan is fixed at a rate of 4.82%.

Note 11.  Financial Instruments

The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:

Cash and due from banks and interest-bearing deposits with banks:  The carrying amounts reported in the balance sheet for cash and due from banks and interest-bearing deposits with banks approximate their fair values.

Federal funds sold:  Due to their short-term nature, the carrying value of federal funds sold approximate their fair value.

Securities:  Fair values for securities, excluding restricted equity securities, are based on quoted market prices, where available.  If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions.  The carrying values of restricted equity securities approximate fair values.

24

Notes to Consolidated Financial Statements

Note 11.  Financial Instruments, continued

Fair Value of Financial Instruments, continued

Loans receivable:  For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying amounts.  The fair values for other loans are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.  Loan fair value estimates include judgments regarding future expected loss experience and risk characteristics. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows.  The carrying amount of accrued interest receivable approximates its fair value.

Cash value of life insurance:  The carrying amount reported in the balance sheet approximates fair value as it represents the cash surrender value of the life insurance.

Deposit liabilities:  The fair values disclosed for demand and savings deposits are, by definition, equal to the amount payable on demand at the reporting date.  The fair values for certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits.  The carrying amount of accrued interest payable approximates fair value.

Long-term debt:  The fair value of long-term debt is estimated using a discounted cash flow calculation that applies interest rates currently available on similar instruments.

The estimated fair values of the Company’s financial instruments are as follows (dollars in thousands):

	December 31, 2010				December 31, 2009
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
Financial assets
Cash and due from banks	$	9,201	$	9,201	$	8,637	$	8,637
Interest bearing deposits with banks		3,306		3,306		300		300
Federal funds sold		27,746		27,746		19,357		19,357
Securities, available for sale		46,841		46,841		39,859		39,859
Securities, held to maturity		851		888		2,175		2,254
Restricted equity securities		1,617		1,617		1,784		1,784
Loans, net of allowance for loan losses		248,513		250,800		266,628		269,442
Cash value of life insurance		8,434		8,434		8,098		8,098
Accrued interest receivable		2,132		2,132		2,626		2,626
Financial liabilities
Deposits		311,817		314,484		313,483		315,789
Long-term debt		25,000		27,672		25,000		27,511
Accrued interest payable		312		312		383		383

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures.  Securities available for sale and derivatives are recorded at fair value on a recurring basis.  Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as loans and foreclosed assets.  These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

25

Notes to Consolidated Financial Statements

Note 11.  Financial Instruments, continued

Fair Value Hierarchy

In accordance with applicable accounting guidance, the Company groups assets and liabilities 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.  These levels are:

Level 1 – Valuation is based upon quoted prices for identical instruments traded in active markets.

Level 2 – Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3 – Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market.  These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability.  Valuation techniques may include the use of option pricing models, discounted cash flow models and similar techniques.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Investment Securities Available for Sale

Investment securities available for sale are recorded at fair value on a recurring basis.  Fair value measurement is based upon quoted prices, if available.  If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions.  Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds.  Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities.  Securities classified as Level 3 include asset-backed securities in less liquid markets.

Loans

The Company does not record loans at fair value on a recurring basis.  However, from time to time, a loan is considered impaired and an allowance for loan losses is established.  Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired.  If a loan is identified as individually impaired, management measures impairment in accordance with applicable accounting guidance.  The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows.  Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans.  At December 31, 2010, substantially all of the total impaired loans were evaluated based on the fair value of the collateral.  In accordance with accounting standards, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy.  When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2.  When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3.

26

Notes to Consolidated Financial Statements

Note 11.  Financial Instruments, continued

Foreclosed Assets

Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets.  Subsequently, foreclosed assets are carried at the lower of carrying value or fair value.  Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral.  When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2.  When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as nonrecurring Level 3.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

December 31, 2010	Total		Level 1		Level 2		Level 3
Investment securities available for sale	$	1,291,595	$	-	$	1,291,595	$	-
U.S. Government agency securities		23,469,366		-		23,469,366		-
Government sponsored enterprises		10,630,694		-		10,630,694		-
Mortgage-backed securities		11,449,592		-		11,449,592		-
State and municipal securities
Total investment securities
available for sale	$	46,841,247	$	-	$	46,841,247	$	-
Total assets at fair value	$	46,841,247	$	-	$	46,841,247	$	-
Total liabilities at fair value	$	-	$	-	$	-	$	-
December 31, 2009	Total		Level 1		Level 2		Level 3
Investment securities available for sale	$	1,710,715	$	-	$	1,710,715	$	-
U.S. Government agency securities		12,902,070		-	$	12,902,070		-
Government sponsored enterprises		17,855,746		-		17,855,746		-
Mortgage-backed securities		7,390,588		-		7,390,588		-
State and municipal securities
Total investment securities
available for sale		39,859,119		-		39,859,119		-
Total assets at fair value		39,859,119		-		39,859,119		-
Total liabilities at fair value	$	-	$	-	$	-	$	-

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

The Company may be required, from time to time, to measure certain assets and liabilities at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principals.  These include assets and liabilities that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period.  Assets and liabilities measured at fair value on a nonrecurring basis are included in the table below.

December 31, 2010	Total		Level 1		Level 2		Level 3
Loans	$	4,344,737	$	-	$	3,009,982	$	1,334,755
Foreclosed assets		834,000		-		108,000		726,000
Total assets at fair value	$	5,178,737	$	-	$	3,117,982	$	2,060,755
Total liabilities at fair value	$	-	$	-	$	-	$	-

-           

27

Notes to Consolidated Financial Statements

Note 11.  Financial Instruments, continued

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis, continued

December 31, 2009	Total		Level 1		Level 2		Level 3
Loans	$	1,365,89	$	-	$	637,004	$	728,892
Foreclosed assets		331,159		-		67,159		264,000
Total assets at fair value	$	1,697,055	$	-	$	704,163	$	992,892
Total liabilities at fair value	$	-	$	-	$	-	$	-

Note 12.  Employee Benefit Plan

The Bank has a qualified noncontributory defined benefit pension plan which covers substantially all of its employees.  The benefits are primarily based on years of service and earnings.

The following is a summary of the plan’s funded status as of December 31, 2010 and 2009, and September 30, 2008:

	2010			2009			2008
Change in benefit obligation
Benefit obligation at beginning of year	$	6,975,571		$	6,381,001		$	5,897,476
Service cost		411,842			391,075			489,473
Interest cost		417,033			381,477			459,871
Actuarial (gain) loss		519,072			(100,579	)		(516,495	)
Benefits paid		(296,061	)		(77,403	)		(4,240	)
Prior service cost due to amendment		-			-			54,916
Benefit obligation at end of year		8,027,457			6,975,571			6,381,001
Change in plan assets
Fair value of plan assets at beginning of year		8,278,463			4,499,654			5,216,202
Actual return on plan assets		960,831			1,856,212			(1,662,051	)
Employer contribution		772,933			2,000,000			949,743
Benefits paid		(296,061	)		(77,403	)		(4,240	)
Fair value of plan assets at end of year		9,716,166			8,278,463			4,499,654
Funded status at the end of the year	$	1,688,709		$	1,302,892		$	(1,881,347	)
Amounts recognized in the Balance Sheet
(Accrued) prepaid benefit cost	$	3,395,737		$	2,833,420		$	1,284,161
Unfunded pension benefit obligation		(1,707,028	)		(1,530,528	)		(3,165,508	)
Amount recognized in other liabilities	$	1,688,709		$	1,302,892		$	(1,881,347	)
Amounts recognized in accumulated comprehensive income
Net gain (loss)	$	(1,658,572	)	$	(1,478,842	)	$	(3,103,061	)
Unrecognized prior service costs		(48,456	)		(51,686	)		(62,466	)
Unrecognized net obligation at transition		-			-			19
Unfunded pension benefit obligation		(1,707,028	)		(1,530,528	)		(3,165,508	)
Deferred taxes		580,390			520,380			1,076,273
Amount recognized in accumulated comprehensive income	$	(1,126,638	)	$	(1,010,148	)	$	(2,089,235	)
(Accrued) Prepaid benefit detail
Benefit obligation	$	(8,027,457	)	$	(6,975,571	)	$	(6,381,001	)
Fair value of assets		9,716,166			8,278,463			4,499,654
Unrecognized net actuarial (gain) loss		1,658,572			1,478,842			3,103,061
Unrecognized net obligation at transition					-			(19	)
Unrecognized prior service cost		48,456			51,686			62,466
(Accrued) prepaid benefit cost	$	3,395,737		$	2,833,420		$	1,284,161

28

Notes to Consolidated Financial Statements

Note 12.  Employee Benefit Plan, continued

	2010			2009			2008
Components of net periodic benefit cost
Service cost	$	411,842		$	391,075		$	489,473
Interest cost		417,033			381,477			459,871
Expected return on plan assets		(660,285	)		(476,975	)		(553,045	)
Recognized net actuarial (gain) loss		38,796			144,403			64,660
Amortization		3,230			10,761			12,536
Net periodic benefit expense	$	210,616		$	450,741		$	473,495
Additional disclosure information
Accumulated benefit obligation	$	5,750,508		$	4,845,345		$	4,227,710
Vested benefit obligation	$	5,638,819		$	4,740,299		$	4,094,817
Discount rate used for net periodic pension cost		6.00	%		6.0	%		6.25	%
Discount rate used for disclosure		5.50	%		6.0	%		6.00	%
Expected return on plan assets		8.00	%		8.0	%		8.50	%
Rate of compensation increase		4.00	%		4.0	%		4.00	%
Average remaining service (years)		15			17			17

Using the same fair value hierarchy described in Note 11, the fair values of the Company’s pension plan assets, by asset category, are as follows:

December 31, 2009	Total			Level 1			Level 2		Level 3
Cash equivalents and short term investments	$	(3,489	)	$	(3,489	)	$	-	$	-
Mutual funds – equities		5,170,173			5,170,173			-		-
Mutual funds – fixed income		4,549,482			4,549,482			-		-
Total assets at fair value	$	9,716,166		$	9,716,166		$	-	$	-
December 31, 2009	Total			Level 1			Level 2		Level 3
Cash equivalents and short term investments	$	116,686		$	116,686		$	-	$	-
Mutual funds – equities		4,230,412			4,230,412			-		-
Mutual funds – fixed income		3,931,365			3,931,365			-		-
Total assets at fair value	$	8,278,463		$	8,278,463		$	-	$	-

Estimated Future Benefit Payments

		Pension
		Benefits
2011		$	65,442
2012			95,328
2013			99,075
2014			176,962
2015			199,382
	2016-2020		2,121,031
		$	2,757,220

29

Notes to Consolidated Financial Statements

Note 12.  Employee Benefit Plan, continued

Funding Policy

It is Bank policy to contribute the maximum tax-deductible amount each year as determined by the plan administrator.  Based on current information, it is anticipated the 2011 contribution will be approximately $1,021,577 and pension cost will be approximately $171,252.

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, and with concurrence from their auditors.  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 the 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 December 31, 2010 and 2009, by asset category are as follows:

	2010	2009
Mutual funds – fixed income	47%	48%
Mutual funds – equity	53%	51%
Cash and equivalents	0%	1%
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 50% fixed income and 50% equities.  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.

Note 13.  Deferred Compensation and Life Insurance

Deferred compensation plans have been adopted for certain executive officers and members of the Board of Directors for future compensation upon retirement.  Under plan provisions aggregate annual payments ranging from $2,662 to $37,200 are payable for ten years certain, generally beginning at age 65.  Reduced benefits apply in cases of early retirement or death prior to the benefit date, as defined.  Liability accrued for compensation deferred under the plan amounts to $506,160 and $534,803 at December 31, 2010 and 2009 respectively.  Expense charged against income was $41,343, $43,489 and $80,132 in 2010, 2009, and 2008, respectively.  Charges to income are based on changes in present value of future cash payments, discounted at 8%.

30

Notes to Consolidated Financial Statements

Note 14.  Income Taxes

Current and Deferred Income Tax Components

The components of income tax expense (substantially all Federal) are as follows:

	2010			2009			2008
Current	$	560,876		$	(487,480	)	$	777,174
Deferred		(294,356	)		587,781			(828,876	)
	$	266,520		$	100,301		$	(51,702	)

Rate Reconciliation

A reconciliation of income tax expense computed at the statutory federal income tax rate to income tax expense included in the statements of income follows:

	2010			2009			2008
Tax at statutory federal rate	$	487,010		$	334,227		$	238,903
Tax exempt interest income		(155,902	)		(164,588	)		(179,725	)
Tax exempt insurance income		(114,057	)		(109,902	)		(117,960
State income tax, net of federal benefit		15,711			-			14,799
Other		33,758			40,564			(7,719	)
	$	266,520		$	100,301		$	(51,702	)

Deferred Income Tax Analysis

The significant components of net deferred tax assets (all Federal) at December 31, 2010 and 2009 are summarized as follows:

	2010		2009
Deferred tax assets
Allowance for loan losses		1,270,511		1,000,919
Unearned credit life insurance		12,820		15,477
Deferred compensation		172,094		181,833
Investment impairment charge recorded directly to stockholders’
equity as a component of other comprehensive income		564,672		564,672
Minimum pension liability		580,390		520,380
Non-accrual interest income		629,810		416,247
Net unrealized losses on securities available for sale		56,365		-
Other		12,779		35,019
		3,299,441		2,734,547
Deferred tax liabilities
Deferred loan origination costs		213,588		208,876
Accrued pension costs		1,154,551		963,363
Depreciation recorded directly to stockholders’ equity		246,420		278,186
Net unrealized gains on securities available for sale		-		197,068
Accretion of discount on investment securities, net		3,176		13,147
		1,617,735		1,660,640
Net deferred tax asset	$	1,681,706	$	1,073,907

31

Notes to Consolidated Financial Statements

Note 14.  Income Taxes, continued

The Bank has analyzed the tax positions taken or expected to be taken in its tax returns and concluded it has no liability related to uncertain tax positions in accordance with applicable regulations.  Tax returns for the years of 2007, 2008, and 2009 remain subject to examination by both federal and state tax authorities.

Deferred tax assets or liabilities are initially recognized for differences between the financial statement carrying amount and the tax basis of asset and liabilities which will result in future deductible or taxable amounts and operating loss and tax credit carry-forwards.  A valuation allowance is then established, as applicable, to reduce the deferred tax asset to the level at which it is “more likely than not” that the tax benefits will be realized.  Sources of taxable income that may allow for the realization of tax benefits include (1) taxable income in the current year or prior years that is available through carry-back, (2) future taxable income that will result from the reversal of existing taxable temporary differences, and (3) taxable income generated by future operations.  There is no valuation allowance for deferred tax assets as of December 31, 2010 and 2009.  It is management’s belief that realization of the deferred tax asset is more likely than not.

Note 15.  Commitments and Contingencies

Litigation

In the normal course of business the Bank is involved in various legal proceedings.  After consultation with legal counsel, management believes that any liability resulting from such proceedings will not be material to the consolidated financial statements.

Financial Instruments with Off-Balance Sheet Risk

The Bank is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit and standby letters of credit.  These instruments involve, to varying degrees, credit risk in excess of the amount recognized in the consolidated balance sheets.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments.  The Bank uses the same credit policies in making commitments and conditional obligations as for on-balance sheet instruments.  A summary of the Bank’s commitments at December 31, 2010 and 2009 is as follows:

	2010		2009
Commitments to extend credit	$	13,652,036	$	20,117,133
Standby letters of credit		-		-
	$	13,652,036	$	20,117,133

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 Bank evaluates each customer’s creditworthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the party.  Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate and income-producing commercial properties.

32

Notes to Consolidated Financial Statements

Note 15.  Commitments and Contingencies, continued

Financial Instruments with Off-Balance Sheet Risk, continued

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party.  Those guarantees are primarily issued to support public and private borrowing arrangements.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies as specified above and is required in instances which the Bank deems necessary.

Concentrations of Credit Risk

Substantially all of the Bank’s loans, commitments to extend credit, and standby letters of credit have been granted to customers in the Bank’s market area and such customers are generally depositors of the Bank.  Investments in state and municipal securities involve governmental entities within and outside the Bank's market area.  The concentrations of credit by type of loan are set forth in Note 4.  The distribution of commitments to extend credit approximates the distribution of loans outstanding.  Standby letters of credit are granted primarily to commercial borrowers.  The Bank’s primary focus is toward small business and consumer transactions, and accordingly, it does not have a significant number of credits to any single borrower or group of related borrowers in excess of $1,000,000. The Bank has cash and cash equivalents on deposit with financial institutions which exceed federally insured limits.

Note 16.  Regulatory Restrictions

Dividends

The Company’s dividend payments are generally made from dividends received from the Bank.  Under applicable federal law, the Comptroller of the Currency restricts national bank total dividend payments in any calendar year to net profits of that year, as defined, combined with retained net profits for the two preceding years.  The Comptroller also has authority under the Financial Institutions Supervisory Act to prohibit a national bank from engaging in an unsafe or unsound practice in conducting its business.  It is possible, under certain circumstances, the Comptroller could assert that dividends or other payments would be an unsafe or unsound practice.

Intercompany Transactions

The Bank’s legal lending limit on loans to the Company is governed by Federal Reserve Act 23A, and differs from legal lending limits on loans to external customers.  Generally, a bank may lend up to 10% of its capital and surplus to its Parent, if the loan is secured.  If collateral is in the form of stocks, bonds, debentures or similar obligations, it must have a market value when the loan is made of at least 20% more than the amount of the loan, and if obligations of a state or political subdivision or agency thereof, it must have a market value of at least 10% more than the amount of the loan.  If such loans are secured by obligations of the United States or agencies thereof, or by notes, drafts, bills of exchange or bankers’ acceptances eligible for rediscount or purchase by a Federal Reserve Bank, requirements for collateral in excess of the loan amount do not apply.  Under this definition, the legal lending limit for the Bank on loans to the Company was approximately $3,523,000 at December 31, 2010. No 23A transactions were deemed to exist between the Company and the Bank at December 31, 2010.

Capital Requirements

The Company and the Bank are subject to various regulatory capital requirements administered by federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory (and possibly additional discretionary) actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices.  The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.  Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital to risk-weighted assets, and of Tier I capital to average assets, as all those terms are defined in the regulations.  Management believes, as of December 31, 2010 and 2009 that the Bank meets all capital adequacy requirements to which it is subject.

33

Notes to Consolidated Financial Statements

Note 16.  Regulatory Restrictions, continued

Capital Requirements

As of December 31, 2010, the most recent notification from the Office of the Comptroller of the Currency categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the following table.  There are no conditions or events since that notification that management believes have changed the institution’s category.  The Company’s and Bank’s actual capital amounts (in thousands) and ratios are also presented in the table.

											Minimum
											To Be Well
						Minimum					Capitalized Under
						Capital					Prompt Corrective
	Actual					Required					Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
December 31, 2010:
Total Capital
(to Risk-Weighted Assets)
Consolidated	$	34,727		14.0	%	$	19,863		8.0	%	$	24,828		10.0	%
Grayson National Bank	$	33,806		13.6	%	$	19,841		8.0	%	$	24,801		10.0	%
Tier I Capital
(to Risk-Weighted Assets)
Consolidated	$	31,609		12.7	%	$	9,931		4.0	%	$	14,897		6.0	%
Grayson National Bank	$	30,688		12.4	%	$	9,920		4.0	%	$	14,881		6.0	%
Tier I Capital
(to Average Assets)
Consolidated	$	31,609		8.5	%	$	14,823		4.0	%	$	18,529		5.0	%
Grayson National Bank	$	30,688		8.3	%	$	14,800		4.0	%	$	18,500		5.0	%
December 31, 2009:
Total Capital
(to Risk-Weighted Assets)
Consolidated	$	34,391		13.2	%	$	20,840		8.0	%	$	26,050		10.0	%
Grayson National Bank	$	33,317		12.8	%	$	20,811		8.0	%	$	26,014		10.0	%
Tier I Capital
(to Risk-Weighted Assets)
Consolidated	$	31,136		12.0	%	$	10,420		4.0	%	$	15,630		6.0	%
Grayson National Bank	$	30,062		11.6	%	$	10,405		4.0	%	$	15,608		6.0	%
Tier I Capital
(to Average Assets)
Consolidated	$	31,136		8.4	%	$	14,765		4.0	%	$	18,456		5.0	%
Grayson National Bank	$	30,062		8.2	%	$	14,724		4.0	%	$	18,405		5.0	%

34

Notes to Consolidated Financial Statements

Note 17.  Transactions with Related Parties

The Bank has entered into transactions with its directors, significant stockholders and their affiliates (related parties). Such transactions were made in the ordinary course of business on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in the opinion of management, involve more than normal credit risk or present other unfavorable features.

Aggregate 2010 and 2009 loan transactions with related parties were as follows:

	2010			2009
Balance, beginning	$	1,853,079		$	1,962,879
New loans		87,000			335,505
Repayments		(469,295	)		(445,305	)
Balance, ending	$	1,470,784		$	1,853,079

Note 18.  Subsequent Events

Management has evaluated events occurring subsequent to the balance sheet date through the date these financial statements were issued, determining no events require additional disclosure in these consolidated financial statements.

Note 19.  Parent Company Financial Information

Condensed financial information of Grayson Bankshares, Inc. is presented as follows:

Balance Sheets

December 31, 2010 and 2009

	2009			2008
Assets
Cash and due from banks	$	643,365		$	371,076
Securities available for sale		-			496,250
Investment in affiliate bank		29,489,198			29,468,094
Other assets		277,207			204,525
Total assets	$	30,409,770		$	30,539,945
Liabilities
Other liabilities	$	-		$	-
Stockholders’ equity
Common stock		2,148,710			2,148,710
Surplus		521,625			521,62525
Retained earnings		28,975,488			28,497,214
Accumulated other comprehensive income (loss)		(1,236,053	)		(627,604	)
Total stockholders’ equity		30,409,770			30,539,945
Total liabilities and stockholders’ equity	$	30,409,770		$	30,539,945

35

Notes to Consolidated Financial Statements

Note 19.  Parent Company Financial Information, continued

Statements of Income

for the years ended December 31, 2010, 2009 and 2008

	2009		2008		2008
Income
Dividends from affiliate bank	$	687,587	$	343,794	$	721,967
Interest on taxable securities		7,171		22,850		49,600
Other income		-		-		14,450
		694,758		366,644		786,017
Expenses
Management and professional fees		206,701		202,361		190,375
Other expenses		33,431		33,494		31,493
		240,132		235,855		221,868
Income before tax benefit and equity
in undistributed income of affiliate		454,626		130,789		564,149
Federal income tax benefit		79,207		72,422		53,318
Income before equity in undistributed
income of affiliate		533,833		203,211		617,467
Equity in undistributed income of affiliate		632,028		679,508		136,892
Net income	$	1,165,861	$	882,719	$	754,359

Statements of Cash Flows

For the years ended December 31, 2010, 2009, and 2008

	2009			2009			2008
Cash flows from operating activities
Net income	$	1,165,861		$	882,719		$	754,359
Adjustments to reconcile net income to net
cash provided by operating activities:
Equity in undistributed income of affiliate		(632,028	)		(679,508	)		(136,892	)
Net realized gains on securities		-			-			-
Net (increase) decrease in other assets		(73,957	)		58,318			(215,225	)
Net increase (decrease) in other liabilities		-			-			-
Net cash provided by operating activities		459,876			261,529			402,242
Cash flows from investing activities
Investment in affiliate bank		-			-			(1,300,000	)
Purchases of investment securities		-			(500,000	)		(1,000,000	)
Sales of investment securities		-			-			700,000
Maturities/calls of investment securities		500,000			500,000			1,050,000
Net cash provided (used) by investing activities		500,000						(550,000	)
Cash flows from financing activities
Dividends paid		(687,587	)		(687,587	)		(1,478,313	)
Net cash used by financing activities		(687,587	)		(687,587	)		(1,478,313	)
Net increase (decrease) in cash and due from banks		(272,289	)		(426,058	)		(1,626,071	)
Cash and cash equivalents, beginning		371,076			797,134			2,423,205
Cash and cash equivalents, ending	$	643,365		$	371,076		$	797,134

36

Management Discussion and Analysis

Management’s Discussion and Analysis of Operations

Overview

Management’s Discussion and Analysis is provided to assist in the understanding and evaluation of Grayson Bankshares, Inc.’s financial condition and its results of operations.  The following discussion should be read in conjunction with the Company’s consolidated financial statements.

Grayson Bankshares, Inc. (the Company) was incorporated as a Virginia corporation on February 3, 1992 to acquire the stock of The Grayson National Bank (the Bank).  The Bank was acquired by the Company on July 1, 1992.  The Grayson National Bank was founded in 1900 and currently serves Grayson County, Virginia and surrounding areas through ten banking offices located in the towns of Independence, Hillsville, and Wytheville, the localities of Elk Creek, Troutdale, and Whitetop, the City of Galax and Carroll County, Virginia, and the town of Sparta, North Carolina.

The Bank operates for the primary purpose of meeting the banking needs of individuals and small to medium sized businesses in the Bank’s service area, while developing personal, hometown associations with these customers.  The Bank offers a wide range of banking services including checking and savings accounts; commercial, installment, mortgage and personal loans; safe deposit boxes; and other associated services.  The Bank’s primary sources of revenue are interest income from its lending activities, and, to a lesser extent, from its investment portfolio.  The Bank also earns fees from lending and deposit activities.  The major expenses of the Bank are interest on deposit accounts and general and administrative expenses, such as salaries, occupancy and related expenses.

Grayson Bankshares, Inc. experienced net earnings of $1,165,861 for 2010 compared to $882,719 for 2009 and $754,359 for 2008.  Earnings in 2010 continued to be negatively impacted by increases in nonperforming assets and related loan loss provisions as well as the high level of regulatory assessments.  Dividends paid to stockholders amounted to $0.40 per share in 2010 and 2009.

The total assets of Grayson Bankshares, Inc. decreased to $368,217,088 from $369,601,921, representing a decrease of 0.37% for 2010.  Management did not seek to grow the Bank during 2010 due to continued weakness in loan demand combined with federal funds rates near zero percent.  Average equity to average assets indicates that the Company has a strong capital position with a ratio of 8.52% during 2010.

Forwarding Looking Statements

From time to time, the Company and its senior managers have made and will make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements may be contained in this report and in other documents that the Company files with the Securities and Exchange Commission. Such statements may also be made by the Company and its senior managers in oral or written presentations to analysts, investors, the media and others. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Also, forward-looking statements can generally be identified by words such as “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “seek,” “expect,” “intend,” “plan” and similar expressions.

Forward-looking statements provide management’s expectations or predictions of future conditions, events or results. They are not guarantees of future performance. By their nature, forward-looking statements are subject to risks and uncertainties. These statements speak only as of the date they are made. The Company does not undertake to update forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statements were made. There are a number of factors, many of which are beyond the Company’s control that could cause actual conditions, events or results to differ significantly from those described in the forward-looking statements. These factors, some of which are discussed elsewhere in this report, include:

37

Management Discussion and Analysis

• inflation, interest rate levels and market and monetary fluctuations;

• trade, monetary and fiscal policies and laws, including interest rate policies of the federal government;

• applicable laws and regulations and legislative or regulatory changes;

• the timely development and acceptance of new products and services of the Company;

• the willingness of customers to substitute competitors’ products and services for the Company’s products and services;

• the financial condition of the Company’s borrowers and lenders;

• the Company’s success in gaining regulatory approvals, when required;

• technological and management changes;

• growth and acquisition strategies;

• the Company’s critical accounting policies and the implementation of such policies;

• lower-than-expected revenue or cost savings or other issues in connection with mergers and acquisitions;

• changes in consumer spending and saving habits;

• the strength of the United States economy in general and the strength of the local economies in which the Company conducts its operations; and

• the Company’s success at managing the risks involved in the foregoing.

Critical Accounting Policies

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP).  The notes to the audited consolidated financial statements included in the Annual Report on Form 10-K for the year ended December 31, 2010 contain a summary of its significant accounting policies.  Management believes the Company’s policies with respect to the methodology for the determination of the allowance for loan losses, and asset impairment judgments, such as the recoverability of intangible assets and other-than-temporary impairment of investment securities, involve a higher degree of complexity and require management to make difficult and subjective judgments that often require assumptions or estimates about highly uncertain matters.  Accordingly, management considers the policies related to those areas as critical.

The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio.  The allowance is based on two basic principles of accounting: the first of which requires that losses be accrued when they are probable of occurring and estimable, and the second, 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 has three basic components:  (i) the formula allowance, (ii) the specific allowance, and (iii) the unallocated allowance.  Each of these components is determined based upon estimates that can and do change when the actual events occur.  The formula allowance uses a historical loss view as an indicator of future losses and, as a result, could differ from the loss incurred in the future.  However, since this history is updated with the most recent loss information, the errors that might otherwise occur are mitigated.  The specific allowance uses various techniques to arrive at an estimate of loss.  Historical loss information, expected cash flows and fair market value of collateral are used to estimate these losses.  The use of these values is inherently subjective and our actual losses could be greater or less that the estimates.  The unallocated allowance captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowance.

38

Management Discussion and Analysis

Table 1.  Net Interest Income and Average Balances (dollars in thousands)

	2010								2009								2008
				Interest								Interest								Interest
	Average			Income/		Yield/			Average			Income/		Yield/			Average			Income/		Yield/
	Balance			Expense		Cost			Balance			Expense		Cost			Balance			Expense		Cost
Interest earning assets:
Interest bearing deposits	$	1,814		$	7		0.38	%	$	38		$	-		0.21	%	$	-		$	-		0.00	%
Federal funds sold		23,011			49		0.22	%		17,205			37		0.22	%		15,013			330		2.20	%
Investment securities		44,459			1,655		3.72	%		47,174			2,067		4.38	%		49,686			2,308		4.64	%
Loans 1, 2		263,963			16,648		6.31	%		270,114			17,813		6.59	%		270,741			19,312		7.13	%
Total		333,247			18,359					334,531			19,917					335,440			21,950
Yield on average
interest-earning assets							5.51	%							5.95	%							6.54	%
Non interest-earning assets:
Cash and due from banks		9,560								9,342								9,764
Premises and equipment		10,896								11,259								9,730
Interest receivable and other		19,223								16,850								13,573
Allowance for loan losses		(3,865	)							(3,317	)							(2,770	)
Unrealized gain/(loss) on securities		1,002								379								(742	)
Total		36,816								34,513								29,555
Total assets	$	370,063							$	369,044							$	364,995
Interest-bearing liabilities:
Demand deposits	$	22,119			125		0.57	%	$	21,292			190		0.89	%	$	20,058			178		0.89	%
Savings deposits		49,453			565		1.14	%		40,925			543		1.33	%		36,723			501		1.36	%
Time deposits		196,530			4,760		2.42	%		204,150			6,538		3.20	%		208,369			8,703		4.18	%
Borrowings		25,000			1,058		4.23	%		27,164			1,146		4.22	%		24,833			1,051		4.23	%
Total		293,102			6,508					293,531			8,417					289,983			10,433
Cost on average
interest-bearing liabilities							2.22	%							2.87	%							3.60	%
Non interest-bearing													��
liabilities:
Demand deposits		44,492								43,813								42,769
Interest payable and other		1,076								2,139								1,579
Total		45,568								45,952								44,348
Total liabilities		338,670								339,483								334,331
Stockholder's equity:		31,393								29,561								30,664
Total liabilities and
stockholder's equity	$	370,063							$	369,044							$	364,995
Net interest income				$	11,851							$	11,500							$	11,517
Net yield on
interest-earning assets							3.56	%							3.44	%							3.43	%
1  Includes nonaccural loans
2  Interest income includes loan fees

39

Table 2.  Rate/Volume Variance Analysis (thousands)

	2010 Compared to 2009									2009 Compared to 2008
	Interest			Variance						Interest			Variance
	Income/			Attributable To						Income/			Attributable To
	Expense									Expense
	Variance			Rate			Volume			Variance			Rate			Volume
Interest-earning assets:
Interest bearing deposits	$	7		$	1		$	6		$	-		$	-		$	-
Federal funds sold		12			-			12			(293	)		(349	)		56
Investment securities		(412	)		(298	)		(114	)		(241	)		(126	)		(115	)
Loans		(1,165	)		(759	)		(406	)		(1,499	)		(1,454	)		(45	)
Total		(1,558	)		(1,056	)		(502	)		(2,033	)		(1,929	)		(104	)
Interest-bearing liabilities:
Demand deposits		(65	)		(72	)		7			12			-			12
Savings deposits		22			(84	)		106			42			(11	)		53
Time deposits		(1,778	)		(1,542	)		(236	)		(2,165	)		(1,993	)		(172	)
Borrowings		(88	)		3			(91	)		95			(2	)		97
Total		(1,909	)		(1,695	)		(214	)		(2,016	)		(2,006	)		(10	)
Net interest income	$	351		$	639		$	(288	)	$	(17	)	$	77		$	(94	)

(1)   The variance in interest attributed to both volume and rate has been allocated to variance attributed to volume and variance attributed to rate in proportion to the absolute value of the change in each.

(2)   Balances of nonaccrual loans have been included in average loan balances.

______________________________________________________________________________

Net Interest Income

Net interest income, the principal source of Company earnings, is the amount of income generated by earning assets (primarily loans and investment securities) less the interest expense incurred on interest-bearing liabilities (primarily deposits used to fund earning assets).  Table 1 summarizes the major components of net interest income for the past three years and also provides yields and average balances.

Total interest income in 2010 decreased by 7.83% to $18.36 million from $19.92 million in 2009 after a decrease from $21.95 million in 2008.  The decrease in total interest income in 2010 was due primarily to lower interest yields on loans and investment securities.  Loan yields decreased due to the increase in loans placed in nonaccrual status and to customers’ continued ability to refinance performing loans at lower rate levels.  Average yields on investment securities fell as declining treasury rates triggered increased levels of bond calls and principal prepayments.  Interest income was also negatively impacted by the decrease in average loans outstanding during 2010 as compared to 2009.  Declining interest rates led to a decrease in yield on average interest-earning assets of 59 basis points in 2009 as compared to 2008.  Total interest expense decreased by $1.91 million in 2010 and $2.02 million in 2009.  The decreases in 2010 and 2009 came as a result of lower interest rates combined with a decrease in average time deposits outstanding during the year.   The effects of changes in volumes and rates on net interest income in 2010 compared to 2009, and 2009 compared to 2008 are shown in Table 2.

40

Management Discussion and Analysis

The aforementioned factors led to similar decreases in interest income and interest expense in 2010.  The result was an increase in net interest income of $351,491 or 3.06% for 2010 as compared to 2009.  The net yield on interest-earning assets increased by 12 basis points to 3.56% in 2010 compared to 3.44% in 2009.

Provision for Credit Losses

The allowance for credit losses is established to provide for expected losses in the Bank’s loan portfolio.  Management determines the provision for credit losses required to maintain an allowance adequate to provide for probable losses.  Some of the factors considered in making this decision are the levels and collectibility of past due loans, volume of new loans, composition of the loan portfolio, and general economic outlook.

At the end of 2010, the loan loss reserve was $4,542,420 compared to $3,555,273 in 2009 and $3,359,946 in 2008.  The Bank’s allowance for loan losses, as a percentage of total loans, at the end of 2010 was 1.80%, compared to 1.32% in 2009, and 1.24% in 2008.  The increase in the loan loss reserve from 2009 to 2010 was due to current economic conditions,  recent increases in the level of charge-offs, and increases in past-due and non-performing loans.

Additional information is contained in Tables 12 and 13, and is discussed in Nonperforming and Problem Assets.

Other Income

Noninterest income consists of revenues generated from a broad range of financial services and activities.  The majority of noninterest income is traditionally a result of service charges on deposit accounts including charges for insufficient funds checks and fees charged for nondeposit services.  Noninterest income increased by $718,767, or 32.05%, to $2,961,612 in 2010 from $2,242,845 in 2009.  The increase was due primarily to gains on the sale of investment securities as well as a gain on the sale of the Bank’s investment in Triangle Capital Corporation, a small business investment company, which resulted in a nonrecurring gain of $213,499.  The increase in 2009 compared to 2008 was due to a loss on investment securities recorded in 2008.  During the quarter ended September 30, 2008, the Bank recorded an other-than-temporary impairment charge on FHLMC (Freddie Mac) preferred stock of $1,660,800.  The preferred stock, which was originally valued at $1,730,000, is now carried at a value of $69,200.  Neither the Company nor the Bank owns any other preferred or common equity investments in Fannie Mae or Freddie Mac.  The primary sources of noninterest income for the past three years are summarized in Table 3.

Table 3.  Sources of Noninterest Income (thousands)

	2010		2009		2008
Service charges on deposit accounts	$	1,098	$	1,031	$	956
Increase in cash value of life insurance		335		323		347
Mortgage origination fees		153		128		155
Insurance commissions		12		27		18
Safe deposit box rental		41		41		40
Gain (loss) on securities		574		220		(1,643	)
ATM income		381		318		281
Other income		368		155		306
Total noninterest income	$	2,962	$	2,243	$	460

41

Management Discussion and Analysis

Other Expense

The major components of noninterest expense for the past three years are illustrated at Table 4.

Total noninterest expense decreased by $397,824 or 3.53% in 2010 after increasing by $1,195,007 or 11.86% in 2009.  The decrease in 2010 was due mainly to decreases in personnel expense and FDIC/OCC assessments.  The decrease in personnel expense resulted primarily from a decrease in expense related to the Bank’s defined benefit pension plan of approximately $240 thousand.  The decrease in assessments was due to a “special assessment” of approximately $165 thousand that was levied in 2009 that did not recur in 2010.  The majority of the increase in noninterest expense in 2009 was the result of FDIC/OCC assessments which increased by $693,365 in 2009.  Based upon recent changes to the assessment formula and reductions to the insurance fund due to increased bank failures, management expects the increased assessment levels to continue.    Additional “special assessments” may be levied at the discretion of the FDIC.  The increase in personnel expense in 2009 was due primarily to the hiring of a chief commercial lender as well as additional staff for our Wytheville branch.

Table 4.  Sources of Noninterest Expense (thousands)

	2010		2009		2008
Salaries & wages	$	4,492	$	4,504	$	4,147
Employee benefits		1,788		2,049		1,938
Total personnel expense		6,280		6,553		6,085
Director fees		193		195		190
Occupancy expense		485		495		377
Computer charges		407		361		307
Other equipment expense		760		831		859
FDIC/OCC assessments		883		1,007		314
Insurance		85		84		84
Professional fees		195		162		144
Advertising		161		189		203
Postage and freight		140		158		199
Supplies		141		131		181
Franchise tax		193		225		207
Telephone		175		174		157
Travel, dues & meetings		104		119		151
ATM expense		202		162		160
Other expense		467		423		456
Total noninterest expense	$	10,871	$	11,269	$	10,074

The overhead efficiency ratio of noninterest expense to adjusted total revenue (net interest income plus noninterest income) was 73.39% in 2010, 82.00% in 2009, and 84.11% in 2008.

Income Taxes

Income tax expense is based on amounts reported in the statements of income (after adjustments for non-taxable income and non-deductible expenses) and consists of taxes currently due plus deferred taxes on temporary differences in the recognition of income and expense for tax and financial statement purposes.  The deferred tax assets and liabilities represent the future Federal income tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled.

42

Income Taxes, continued

Income tax expense (substantially all Federal) was $266,520 in 2010, $100,301 in 2009, and $(51,702) in 2008 resulting in effective tax rates of 18.6%, 10.2% and (7.4)% respectively.  The decrease in the effective tax rate for 2008 was due to the decrease in taxable income.

The Company’s deferred income tax benefits and liabilities result primarily from temporary differences (discussed above) in the provisions for credit losses, valuation reserves, non-accrual interest income, depreciation, deferred compensation, deferred income, pension expense and investment security discount accretion.

Net deferred tax benefits of $1,681,706 and $1,073,907 are included in other assets at December 31, 2010 and 2009 respectively.  At December 31, 2010, net deferred tax benefits included $56,365 of deferred tax assets applicable to unrealized gains on investment securities available for sale, and $580,390 of deferred tax assets applicable to unfunded projected pension benefit obligations.  Accordingly, these amounts were not charged to income but recorded directly to the related stockholders’ equity account.

Analysis of Financial Condition

Average earning assets decreased 0.38% from 2009 to 2010.  Total earning assets represented 90.05% of total average assets in 2010 and 90.65% in 2009.  The mix of average earning assets changed only slightly from 2009 to 2010 as loan demand remained weak for the year.

Table 5.  Average Asset Mix (dollars in thousands)

	2010						2009
	Average						Average
	Balance			%			Balance			%
Earning assets:
Loans	$	263,963			71.33	%	$	270,114			73.20	%
Investment securities		44,459			12.01	%		47,174			12.78	%
Federal funds sold		23,011			6.22	%		17,205			4.66	%
Deposits in other banks		1,814			0.49	%		38			0.01	%
Total earning assets		333,247			90.05	%		334,531			90.65	%
Nonearning assets:
Cash and due from banks		9,560			2.58	%		9,342			2.53	%
Premises and equipment		10,896			2.94	%		11,259			3.05	%
Other assets		19,223			5.20	%		16,850			4.57	%
Allowance for loan losses		(3,865	)		-1.04	%		(3,317	)		-0.90	%
Unrealized gain/(loss) on securities	$	1,002			0.27	%	$	379			0.10	%
Total nonearning assets	$	36,816			9.95	%	$	34,513			9.35	%
Total assets	$	370,063			100.00	%	$	369,044			100.00	%

Average loans for 2010 represented 71.33% of total average assets compared to 73.20% in 2009.  Average federal funds sold increased from 4.66% to 6.22% of total average assets while average investment securities decreased from 12.78% to 12.01% of total average assets over the same time period.   The balances of nonearning assets increased from 9.35% in 2009 to 9.95% in 2010.

43

Management Discussion and Analysis

Loans

Average loans totaled $264.0 million over the year ended December 31, 2010.  This represents a decrease of 2.28% from the average of $270.1 million for 2009.  Average loans decreased by 0.22% from 2008 to 2009.

The loan portfolio consists primarily of real estate and commercial loans.  These loans accounted for 93.45% of the total loan portfolio at December 31, 2010.  This is up from the 92.38% that the two categories maintained at December 31, 2009.  The amount of loans outstanding by type at December 31 of each of the past five years and the maturity distribution for variable and fixed rate loans as of December 31, 2010 are presented in Tables 6 & 7 respectively.

Table 6.  Loan Portfolio Summary (dollars in thousands)

	December 31, 2009					December 31, 2008					December 31, 2008
	Amount		%			Amount		%			Amount		%
Construction and development	$	21,308		8.42	%	$	29,171		10.80	%	$	30,398		11.21	%
Residential, 1-4 families		124,749		49.30	%		126,511		46.82	%		131,191		48.37	%
Residential, 5 or more families		2,864		1.13	%		2,317		0.86	%		2,132		0.78	%
Farm land		33,225		13.13	%		34,346		12.71	%		31,024		11.44	%
Nonfarm, nonresidential		40,342		15.94	%		40,545		15.01	%		41,323		15.23	%
Total real estate		222,488		87.92	%		232,890		86.20	%		236,068		87.03	%
Agricultural		2,924		1.16	%		3,841		1.42	%		3,758		1.39	%
Commercial		14,001		5.53	%		16,696		6.18	%		14,924		5.50	%
Consumer		11,942		4.72	%		13,547		5.01	%		14,357		5.29	%
Other		1,700		0.67	%		3,209		1.19	%		2,142		0.79	%
Total	$	253,055		100.00	%	$	270,183		100.00	%	$	271,249		100.00	%

	December 31, 2007					December 31, 2006
	Amount		%			Amount		%
Construction and development	$	33,017		12.39	%	$	30,725		12.37	%
Residential, 1-4 families		121,074		45.44	%		111,089		44.72	%
Residential, 5 or more families		1,638		0.61	%		1,572		0.63	%
Farm land		29,134		10.93	%		27,979		11.26	%
Nonfarm, nonresidential		42,237		15.85	%		39,350		15.84	%
Total real estate		227,100		85.22	%		210,715		84.82	%
Agricultural		3,445		1.29	%		3,774		1.52	%
Commercial		19,950		7.49	%		18,294		7.36	%
Consumer		14,330		5.38	%		14,106		5.68	%
Other		1,662		0.62	%		1,530		0.62	%
Total	$	266,487		100.00	%	$	248,419		100.00	%

44

Management Discussion and Analysis

Table 7.  Maturity Schedule of Loans (dollars in thousands), as of December 31, 2010

	Real		Agricultural		Consumer		Total
	Estate		and Commercial		and Other		Amount		%
Fixed rate loans:
Three months or less	$	9,603	$	1,005	$	2,237	$	12,845		5.07	%
Over three to twelve months		11,772		1,375		1,264		14,411		5.69	%
Over one year to five years		12,959		2,066		7,767		22,792		9.01	%
Over five years		28,638		1,138		913		30,689		12.13	%
Total fixed rate loans	$	62,972	$	5,584	$	12,181	$	80,737		31.90	%
Variable rate loans:
Three months or less	$	14,747	$	3,165	$	120	$	18,032		7.13	%
Over three to twelve months		18,926		4,805		270		24,001		9.48	%
Over one year to five years		5,422		3,068		334		8,824		3.49	%
Over five years		120,421		303		737		121,461		48.00	%
Total variable rate loans	$	159,516	$	11,341	$	1,461	$	172,318		68.10	%
Total loans:
Three months or less	$	24,350	$	4,170	$	2,357	$	30,877		12.20	%
Over three to twelve months		30,698		6,180		1,534		38,412		15.17	%
Over one year to five years		18,381		5,134		8,101		31,616		12.50	%
Over five years		149,059		1,441		1,650		152,150		60.13	%
Total loans	$	222,488	$	16,925	$	13,642	$	253,055		100.00	%

Interest rates charged on loans vary with the degree of risk, maturity and amount of the loan.  Competitive pressures, money market rates, availability of funds, and government regulations also influence interest rates.  On average, loans yielded 6.31% in 2010 compared to an average yield of 6.59% in 2009.

Investment Securities

The Bank uses its investment portfolio to provide liquidity for unexpected deposit decreases or loan generation, to meet the Bank’s interest rate sensitivity goals, and to generate income.

Management of the investment portfolio has always been conservative with the majority of investments taking the form of purchases of U.S. Treasury, U.S. Government Agencies, U.S. Government Sponsored Enterprises and State and Municipal bonds, as well as investment grade corporate bond issues.  Management views the investment portfolio as a source of income, and purchases securities with the intent of retaining them until maturity.  However, adjustments are necessary in the portfolio to provide an adequate source of liquidity which can be used to meet funding requirements for loan demand and deposit fluctuations and to control interest rate risk.  Therefore, from time to time, management may sell certain securities prior to their maturity.  Table 8 presents the investment portfolio at the end of 2010 by major types of investments and contractual maturity ranges.  Investment securities in Table 8 may have repricing or call options that are earlier than the contractual maturity date.  Yields on tax exempt obligations are not computed on a tax-equivalent basis in Table 8.

Total amortized cost of investment securities increased by approximately $6.4 million from December 31, 2009 to December 31, 2010.  The increase came as cash, generated from decreasing loan balances, was reinvested in investment securities and federal funds sold.  The average yield of the investment portfolio decreased to 3.72% for the year ended December 31, 2010 compared to 4.38% for 2009.

45

Management Discussion and Analysis

Table 8.  Investment Securities - Maturity/Yield Schedule (dollars in thousands)

	In One			After One			After Five			After			Book			Market		Book		Book
	Year or			Through			Through			Ten			Value			Value		Value		Value
	Less			Five Years			Ten Years			Years			12/31/10			12/31/10		12/31/09		12/31/08
Investment Securities:
U.S. Government agencies	$	-		$	568		$	-		$	663		$	1,231		$	1,291	$	1,629	$	2,386
Govt. sponsored enterprises		-			299			9,016			14,533			23,848			23,469		13,068		14,107
Mortgage-backed securities		11			2,585			2,019			5,639			10,254			10,631		17,295		20,739
State and municipal securities		343			368			2,103			9,710			12,524			12,338		9,462		12,016
Total	$	354		$	3,820		$	13,138		$	30,545		$	47,857		$	47,729	$	41,454	$	49,248
Weighted average yields:
U.S. Government agencies		0.00	%		3.81	%		0.00	%		4.68	%		4.28	%
Govt. sponsored enterprises		0.00	%		4.40	%		1.61	%		3.95	%		3.07	%
Mortgage-backed securities		5.14	%		4.78	%		3.44	%		4.11	%		4.15	%
State and municipal securities		4.59	%		4.86	%		3.71	%		3.64	%		3.71	%
Total		4.61	%		4.61	%		2.23	%		3.90	%		3.50	%

Deposits

The Bank relies on deposits generated in its market area to provide the majority of funds needed to support lending activities and for investments in liquid assets.  More specifically, core deposits (total deposits less certificates of deposit in denominations of $100,000 or more) are the primary funding source.  The Bank’s balance sheet growth is largely determined by the availability of deposits in its markets, the cost of attracting the deposits, and the prospects of profitably utilizing the available deposits by increasing the loan or investment portfolios.  Market conditions have resulted in depositors shopping for deposit rates more than in the past.  An increased customer awareness of interest rates adds to the importance of rate management.  The Bank’s management must continuously monitor market pricing, competitor’s rates, and the internal interest rate spreads to maintain the Bank’s growth and profitability.  The Bank attempts to structure rates so as to promote deposit and asset growth while at the same time increasing overall profitability of the Bank.

Average total deposits for the year ended December 31, 2010 amounted to $312.6 million, which was an increase of $2.4 million, or 0.78% over 2009.  Average core deposits totaled $250.0 million in 2010 representing a 2.88% increase over the $243.0 million in 2009.  The percentage of the Bank’s average deposits that are interest-bearing decreased from 85.9% in 2009 to 85.8% in 2010.  Average demand deposits, which earn no interest, increased 1.60% from $43.8 million in 2009 to $44.5 million in 2010.  Average deposits for the periods ended December 31, 20010, 2009, and 2008 are summarized in Table 9.

46

Management Discussion and Analysis

Table 9.  Deposit Mix (dollars in thousands)

	December 31, 2010								December 31, 2009
	Average		% of Total			Average			Average		% of Total			Average
	Balance		Deposits			Rate Paid			Balance		Deposits			Rate Paid
Interest-bearing deposits:
NOW Accounts	$	22,119		7.1	%		0.89	%	$	21,292		6.9	%		0.89	%
Money Market		15,934		5.1	%		1.53	%		11,202		3.6	%		1.53	%
Savings		33,519		10.7	%		1.25	%		29,723		9.6	%		1.25	%
Individual retirement accounts		43,470		13.9	%		4.44	%		40,068		12.9	%		4.44	%
Small denomination certificates		90,123		28.9	%		2.80	%		96,923		31.2	%		2.80	%
Large denomination certificates		62,937		20.1	%		3.05	%		67,159		21.7	%		3.05	%
Total interest-bearing deposits		268,102		85.8	%		2.73	%		266,367		85.9	%		2.73	%
Noninterest-bearing deposits		44,492		14.2	%		0.00	%		43,813		14.1	%		0.00	%
Total deposits	$	312,594		100.0	%		2.34	%	$	310,180		100.0	%		2.34	%

	December 31, 2008
	Average Balance		% of Total Deposits			Average Rate Paid
Interest-bearing deposits:
NOW Accounts	$	20,058		6.5	%		0.89	%
Money Market		8,096		2.6	%		1.75	%
Savings		28,627		9.3	%		1.25	%
Individual retirement accounts		35,463		11.5	%		4.75	%
Small denomination certificates		101,301		32.9	%		3.98	%
Large denomination certificates		71,605		23.3	%		4.17	%
Total interest-bearing deposits		265,150		86.1	%		3.54	%
Noninterest-bearing deposits		42,769		13.9	%		0.00	%
Total deposits	$	307,919		100.0	%		3.05	%

The average balance of certificates of deposit issued in denominations of $100,000 or more decreased by $4.2 million, or 6.3%, for the year ended December 31, 2010.  The strategy of management has been to support loan and investment growth with core deposits and not to aggressively solicit the more volatile, large denomination certificates of deposit.  Continued weakness in loan demand in 2010 prompted management to further reduce balances in certificates of deposit.  Table 10 provides maturity information relating to certificates of deposit of $100,000 or more at December 31, 2010.

Table 10.  Large Denomination Certificate of Deposit Maturities (thousands)

Analysis of certificates of deposit of $100,000 or more at December 31, 2010:
Remaining maturity of three months or less	$	13,567
Remaining maturity over three months through six months		13,992
Remaining maturity over six months through twelve months		17,402
Remaining maturity over twelve months		12,723
Total certificates of deposit of $100,000 or more	$	57,684

47

Management Discussion and Analysis

Equity

Stockholders’ equity amounted to $30.4 million at December 31, 2010, a 0.4% decrease from the 2009 year-end total of $30.5 million.  The decrease resulted from earnings of $1,165,861, less dividends paid of $687,587, and changes in pension reserves and unrealized depreciation of investment securities classified as available for sale totaling $608,449.  The Company paid dividends of $0.40, $0.40 and $0.86 per share in 2010, 2009, and 2008, respectively.

Regulatory guidelines relating to capital adequacy provide minimum risk-based ratios which assess capital adequacy while encompassing all credit risks, including those related to off-balance sheet activities.  Capital ratios under these guidelines are computed by weighing the relative risk of each asset category to derive risk-adjusted assets.  The risk-based capital guidelines require minimum ratios of core (Tier 1) capital (common stockholders’ equity) to risk-weighted assets of 4.0% and total regulatory capital (core capital plus allowance for loan losses up to 1.25% of risk-weighted assets) to risk-weighted assets of 8.0%.  As of December 31, 2010 the Bank has a ratio of Tier 1 capital to risk-weighted assets of 12.4% and a ratio of total capital to risk-weighted assets of 13.6%.

In addition, a minimum leverage ratio of Tier 1 capital to average total assets for the previous quarter is required by federal bank regulators, ranging from 3% to 5%, subject to the regulator’s evaluation of the Bank’s overall safety and soundness.  As of December 31, 2010, the Bank had a ratio of year-end Tier 1 capital to average total assets for the fourth quarter of 2010 of 8.3%.  Table 11 sets forth summary information with respect to the Bank’s capital ratios at December 31, 2010 and 2009.  All capital ratio levels indicate that the Bank is well capitalized.

Table 11.  Bank’s Year-end Risk-Based Capital (dollars in thousands)

	2010			2009
Tier 1 capital	$	30,688		$	30,062
Qualifying allowance for loan losses
(limited to 1.25% of risk-weighted assets)		3,118			3,255
Total regulatory capital	$	33,806		$	33,317
Total risk-weighted assets	$	248,009		$	260,135
Tier 1 capital as a percentage of
risk-weighted assets		12.4	%		11.6	%
Total regulatory capital as a percentage of
risk-weighted assets		13.6	%		12.8	%
Leverage ratio*		8.3	%		8.2	%
*Tier 1 capital divided by average total assets for
the quarter ended December 31 of each year.

Nonperforming and Problem Assets

Certain credit risks are inherent in making loans, particularly commercial and consumer loans.  Management prudently assesses these risks and attempts to manage them effectively.  The Bank attempts to use shorter-term loans and, although a portion of the loans have been made based upon the value of collateral, the underwriting decision is generally based on the cash flow of the borrower as the source of repayment rather than the value of the collateral.  The Bank also attempts to reduce repayment risk by adhering to internal credit policies and procedures.  These policies and procedures include officer and customer limits, periodic loan documentation review and follow up on exceptions to credit policies.

48

Management Discussion and Analysis

Nonperforming assets at December 31, 2010, 2009, 2008, 2007 and 2006 are analyzed in Table 12.

Table 12.  Nonperforming Assets (dollars in thousands)

	At December 31,
	2010			2009			2008			2007			2006
Nonperforming loans:
Nonaccrual loans	$	15,710		$	14,159		$	9,215		$	4,108		$	867
Restructured loans		505			-			1,497			469			480
Loans past due 90 days or more		936			1,163			1,593			518			733
Total nonperforming loans		17,151			15,322			12,305			5,095			2,080
Foreclosed assets		3,257			2,809			2,659			160			60
Total nonperforming assets	$	20,408		$	18,131		$	14,964		$	5,255		$	2,140
Total nonperforming loans as a
percentage to total loans		6.8	%		5.8	%		4.5	%		1.9	%		0.8	%
Total nonperforming assets as a
percentage to total assets		5.5	%		4.9	%		4.1	%		1.5	%		0.6	%

Total nonperforming loans were 6.8% and 5.8% of total outstanding loans as of December 31, 2010 and 2009, respectively.  The majority of the increase in nonaccrual loans from 2009 to 2010 came in the residential real estate category.  Residential real estate loans in nonaccrual status increased from $4.8 million at December 31, 2009 to $6.2 million at December 31, 2010, representing an increase of $1.4 million.  This follows a $3.0 million increase in this category from $1.8 million at December 31, 2008, to $4.8 million at December 31, 2009.  The increase in nonaccrual loans from 2007 to 2008 came as a result of placing approximately $3.7 million of commercial real estate/land development loans in nonaccrual status in the fourth quarter of 2008.  Loans are placed in nonaccrual status when, in management’s opinion, the borrower may be unable to meet payments as they become due.  When interest accrual is discontinued, all unpaid accrued interest is reversed.  Loans are removed from nonaccrual status when they are deemed a loss and charged to the allowance, transferred to foreclosed assets, or returned to accrual status based upon performance consistent with the original terms of the loan or a subsequent restructuring thereof.  Management’s ability to ultimately resolve these loans either with or without significant loss will be determined, to a great extent, by general economic and real estate market conditions.

The increase in foreclosed assets from 2007 to 2008 resulted primarily from the addition of one commercial real estate property which was still held by the Bank at December 31, 2010.  Based upon the most recent independent appraisal management believes this property will ultimately be disposed of without significant loss.  During 2010, eleven properties valued at approximately $658 thousand were transferred to foreclosed assets while sales of six foreclosed assets totaled approximately $210 thousand.  Sales of foreclosed assets in 2010 resulted in a net gain of $1,733.  More information on nonperforming assets can be found in Note 5 of the “Notes to Consolidated Financial Statements” found in the company’s 2010 Annual Report on Form 10-K.

As of December 31, 2010 we had loans with a current principal balance of $8.3 million on the watch list.  The watch list is a classification utilized by us when we have an initial concern about the financial health of a borrower.  We then gather current financial information about the borrower and evaluate our current risk in the credit.  After this review we will either move the loan to “substandard” status or move it back to its original risk rating.  Loans may be left on the “watch list” for a longer period of time if, in management’s opinion, there are risks that cannot be fully evaluated without the passage of time, and we want to review it on a more regular basis.  Loans on the watch list are not considered “potential problem loans” until they are determined by management to be classified as substandard.   Past due loans are often regarded as a precursor to further credit problems which would lead to future increases in nonaccrual loans or other real estate owned.  As of December 31, 2010 loans past due 30-89 days totaled $11.0 million compared to $5.8 million at December 31, 2009.

49

Management Discussion and Analysis

Certain types of loans, such as option ARM products, interest-only loans, subprime loans and loans with initial teaser rates, can have a greater risk of non-collection than other loans.  The Bank has not offered these types of loans in the past and does not offer them currently.  Junior-lien mortgages can also be considered higher risk loans.  Our junior-lien portfolio at December 31, 2010 totaled $6.4 million, or 2.52% of total loans.  Historical charge-off rates in this category have not varied significantly from other real estate secured loans.

The allowance for loan losses is maintained at a level adequate to absorb potential losses.  Some of the factors which management considers in determining the appropriate level of the allowance for loan losses are: past loss experience, an evaluation of the current loan portfolio, identified loan problems, the loan volume outstanding, the present and expected economic conditions in general, and in particular, how such conditions relate to the market area that the Bank serves.  Bank regulators also periodically review the Bank’s loans and other assets to assess their quality.  Loans deemed uncollectible are charged to the allowance.  Provisions for loan losses and recoveries on loans previously charged off are added to the allowance.

To quantify the specific elements of the allowance for loan losses, the Bank begins by establishing a specific reserve for loans that have been identified as being impaired.  This reserve is determined by comparing the principal balance of the loan with the net present value of the future anticipated cash flows or the fair market value of the related collateral.  If the value of the impaired loan is collateral dependent, then any excess in the recorded investment in the loan over the fair value of the collateral that is identified as uncollectible in the near term is charged off against the allowance for loan losses at that time.  The bank then reviews certain loans in the portfolio and assigns grades to loans which have been reviewed.  Loans which are adversely classified are given a specific allowance based on the historical loss experience of similar type loans in each adverse grade.  The remaining portfolio is segregated into loan pools consistent with regulatory guidelines.  An allocation is then made to the reserve for these loan pools based on the bank’s historical loss experience with further adjustments for external factors such as current loan volume and general economic conditions.  The allowance is allocated according to the amount deemed to be reasonably necessary to provide for the possibility of losses being incurred within the respective categories of loans, although the entire allowance is available to absorb any actual charge-offs that may occur.

The provision for loan losses, net charge-offs, and the resulting allowance for loan losses, are detailed in Table 13.  The allocation of the reserve for loan losses is detailed in Table 14.

Table 13.  Loan Losses

	2010			2009			2008			2007			2006
Allowance for loan losses, beginning	$	3,555,273		$	3,359,946		$	2,757,745		$	2,901,997		$	2,678,055
Provision for loan losses, added		2,509,569			1,490,848			1,200,385			465,143			520,000
Charge-offs:
Real estate		(1,187,258	)		(340,180	)		(124,503	)		(283,658	)		(45,330	)
Commercial and agricultural		(278,495	)		(670,331	)		(446,271	)		(236,571	)		(199,372	)
Consumer and other		(237,567	)		(317,962	)		(267,267	)		(179,836	)		(148,971	)
Recoveries:
Real estate		81,233			14,167			35,949			19,515			6,000
Commercial and agricultural		74,024			2,587			63,934			22,515			35,426
Consumer and other		25,641			16,198			139,974			48,640			56,189
Net charge-offs		(1,522,422	)		(1,295,521	)		(598,184	)		(609,395	)		(296,058	)
Allowance for loan losses, ending	$	4,542,420		$	3,555,273		$	3,359,946		$	2,757,745		$	2,901,997
Ratio of net charge-offs during the period
to average loans outstanding during the period		0.58	%		0.48	%		0.22	%		0.23	%		0.13	%

50

Management Discussion and Analysis

Table 14.  Allocation of the Reserve for Loan Losses (thousands)

	December 31, 2010					December 31, 2009					December 31, 2008
			% of					% of					% of
Balance at the end of the period			Loans to					Loans to					Loans to
applicable to:	Amount		Total Loans			Amount		Total Loans			Amount		Total Loans
Commercial and agricultural	$	437		6.69	%	$	614		7.60	%	$	565		6.89	%
Real estate - construction		526		8.42	%		96		10.80	%		119		11.21	%
Real estate - mortgage		3,350		79.50	%		2,626		75.40	%		2,450		75.82	%
Consumer and other		229		5.39	%		219		6.20	%		226		6.08	%
Total	$	4,542		100.00	%	$	3,555		100.00	%		3,360		100.00	%

	December 31, 2007					December 31, 2006
			% of					% of
Balance at the end of the period			Loans to					Loans to
applicable to:	Amount		Total Loans			Amount		Total Loans
Commercial and agricultural	$	594		8.78	%	$	1,193		8.88	%
Real estate - construction		253		12.39	%		-		12.37	%
Real estate - mortgage		1,665		72.83	%		791		72.45	%
Consumer and other		246		6.00	%		918		6.30	%
Total	$	2,758		100.00	%	$	2,902		100.00	%

Financial Instruments with Off-Balance Sheet Risk

The Bank is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit and standby letters of credit.  These instruments involve, to varying degrees, credit risk in excess of the amount recognized in the consolidated balance sheets.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments.  The Bank uses the same credit policies in making commitments and conditional obligations as for on-balance sheet instruments.  A summary of the Bank’s commitments at December 31, 2010 and 2009 is as follows:

	2010		2009
Commitments to extend credit	$	13,652,036	$	20,117,133
Standby letters of credit		-		-
	$	13,652,036	$	20,117,133

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 Bank evaluates each customer’s creditworthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the party.  Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate and income-producing commercial properties.

51

Management Discussion and Analysis

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party.  Those guarantees are primarily issued to support public and private borrowing arrangements.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies as specified above and is required in instances which the Bank deems necessary.

Quantitative and Qualitative Disclosure about Market Risk

The principal goals of the Bank’s asset and liability management strategy are the maintenance of adequate liquidity and the management of interest rate risk.  Liquidity is the ability to convert assets to cash to fund depositors’ withdrawals or borrowers’ loans without significant loss.  Interest rate risk management balances the effects of interest rate changes on assets that earn interest or liabilities on which interest is paid, to protect the Bank from wide fluctuations in its net interest income which could result from interest rate changes.

Management must insure that adequate funds are available at all times to meet the needs of its customers.  On the asset side of the balance sheet, maturing investments, loan payments, maturing loans, federal funds sold, and unpledged investment securities are principal sources of liquidity.  On the liability side of the balance sheet, liquidity sources include core deposits, the ability to increase large denomination certificates, federal fund lines from correspondent banks, borrowings from the Federal Home Loan Bank, as well as the ability to generate funds through the issuance of long-term debt and equity.

The liquidity ratio (the level of liquid assets divided by total deposits plus short-term liabilities) was 22.0% at December 31, 2010 compared to 16.7% at December 31, 2009.  The decrease came as total deposits increased while the level of liquid assets was relatively unchanged.  These ratios are considered to be adequate by management.

The Bank uses cash and federal funds sold to meet its daily funding needs.  If funding needs are met through holdings of excess cash and federal funds, then profits might be sacrificed as higher-yielding investments are foregone in the interest of liquidity.  Therefore management determines, based on such items as loan demand and deposit activity, an appropriate level of cash and federal funds and seeks to maintain that level.

The primary goals of the investment portfolio are liquidity management and maturity gap management.  As investment securities mature the proceeds are reinvested in federal funds sold if the federal funds level needs to be increased, otherwise the proceeds are reinvested in similar investment securities.  The majority of investment security transactions consist of replacing securities that have been called or matured.  The Bank keeps a significant portion of its investment portfolio in unpledged assets that are less than 60 months to maturity or next repricing date.  These investments are a preferred source of funds in that they can be disposed of in most interest rate environments without causing significant damage to that quarter’s profits.

Interest rate risk is the effect that changes in interest rates would have on interest income and interest expense as interest-sensitive assets and interest-sensitive liabilities either reprice or mature.  Management attempts to maintain the portfolios of interest-earning assets and interest-bearing liabilities with maturities or repricing opportunities at levels that will afford protection from erosion of net interest margin, to the extent practical, from changes in interest rates.  Table 15 shows the sensitivity of the Bank’s balance sheet on December 31, 2010.  This table reflects the sensitivity of the balance sheet as of that specific date and is not necessarily indicative of the position on other dates.  At December 31, 2010, the Bank appeared to be cumulatively asset-sensitive (interest-earning assets subject to interest rate changes exceeding interest-bearing liabilities subject to changes in interest rates).  However, in the one year window liabilities subject to change in interest rates exceed assets subject to interest rate changes (non asset-sensitive).

Matching sensitive positions alone does not ensure the Bank has no interest rate risk.  The repricing characteristics of assets are different from the repricing characteristics of funding sources.  Thus, net interest income can be impacted by changes in interest rates even if the repricing opportunities of assets and liabilities are perfectly matched.

52

Management Discussion and Analysis

Table 15.  Interest Rate Sensitivity (dollars in thousands)

	December 31, 2010
	Maturities/Repricing
	1 to 3			4 to 12			13 to 60			Over 60
	Months			Months			Months			Months			Total
Interest-Earning Assets:
Interest bearing deposits	$	3,306		$	-		$	-		$	-		$	3,306
Federal funds sold		27,746			-			-			-			27,746
Investments		2,513			6,681			21,431			17,233			47,858
Loans		90,693			39,178			76,964			46,220			253,055
Total	$	124,258		$	45,859		$	98,395		$	63,453		$	331,965
Interest-Bearing Liabilities:
NOW accounts	$	22,285		$	-		$	-		$	-		$	22,285
Money market		17,161			-			-			-			17,161
Savings		44,689			-			-			-			44,689
Time Deposits		38,676			88,083			58,435			-			185,194
Borrowings		10,000			-			5,000			10,000			25,000
Total	$	132,811		$	88,083		$	63,435		$	10,000		$	294,329
Interest sensitivity gap	$	(8,553	)	$	(42,224	)	$	34,960		$	53,453		$	37,636
Cumulative interest
sensitivity gap	$	(8,553	)	$	(50,777	)	$	(15,817	)	$	37,636		$	37,636
Ratio of sensitivity gap to
total earning assets		-2.6	%		-12.7	%		10.5	%		16.1	%		11.3	%
Cumulative ratio of sensitivity
gap to total earning assets		-2.6	%		-15.3	%		-4.8	%		11.3	%		11.3	%

The Company uses a number of tools to monitor its interest rate risk, including simulating net interest income under various scenarios, monitoring the present value change in equity under the same scenarios, and monitoring the difference or gap between rate sensitive assets and rate sensitive liabilities over various time periods (as displayed in Table 15).

The earnings simulation model forecasts annual net income under a variety of scenarios that incorporate changes in the absolute level of interest rates, changes in the shape of the yield curve, and changes in interest rate relationships.  Management evaluates the effect on net interest income and present value equity from gradual changes in rates of up to 300 basis points up or down over a 12-month period.  Table 16 presents the Bank’s twelve-month forecasts for changes in net income and market value of equity as of December 31, 2010.

53

Management Discussion and Analysis

Table 16.  Interest Rate Risk (dollars in thousands)

Rate Shocked Net Interest Income and Market Value of Equity
Rate Change		-300	bp		-200	bp		-100	bp		0	bp		+100	bp		+200	bp		+300	bp
Net Interest Income:
Net interest income	$	12,560		$	12,688		$	12,655		$	12,660		$	12,700		$	12,837		$	13,023
Change	$	(100	)	$	28		$	(5	)	$	-		$	40		$	177		$	363
Change percentage		-0.79	%		0.22	%		-0.04	%					0.32	%		1.40	%		2.87	%
Market Value of Equity	$	30,786		$	32,878		$	33,062		$	31,426		$	29,931		$	28,556		$	27,954

Impact of Inflation and Changing Prices

The consolidated financial statements and the accompanying notes presented elsewhere in this document have been prepared in accordance with generally accepted accounting principles which require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation.  Unlike most industrial companies, virtually all Company assets and liabilities are monetary in nature, therefore the impact of inflation is reflected primarily in the increased cost of operations.  As a result, interest rates have a greater impact on performance than do the effects of general levels of inflation.  Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.

Table 17.  Key Financial Ratios

	2010	2009	2008
Return on average assets	0.32%	0.24%	0.21%
Return on average equity	3.71%	2.99%	2.46%
Dividend payout ratio	58.98%	77.89%	195.97%
Average equity to average assets	8.52%	8.01%	8.40%

54

Management Discussion and Analysis

Market and Dividend Information Related to the Company’s Stock

The Company’s Common Stock is not listed for trading on a registered exchange.  The Company’s Common Stock is currently quoted on the OTC Bulletin Board under the symbol “GSON.”  The Common Stock began quotation on the OTC Bulletin Board on January 19, 2010.  Prior to that date, shares of the Company’s Common Stock were neither listed on any stock exchange nor quoted on any market and traded infrequently.  Shares of Common Stock were periodically sold in a limited number of privately negotiated transactions.  Based on information available to it (including trades through the OTC Bulletin Board), the Company believes that from January 1, 2009 to December 31, 2010, the selling price of shares of Common Stock ranged from $13.00 to $24.00.  There may, however, have been other transactions at other prices not known to the Company.

Market Price and Dividends

	Sales Price ($)
	High		Low		Dividends ($)
2009: 1st quarter 2nd quarter 3rd quarter 4th quarter		24.00 24.00 19.95 19.00		24.00 21.00 18.00 15.00		0.10 0.10 0.10 0.10
2010: 1st quarter 2nd quarter 3rd quarter 4th quarter		19.00 16.75 15.00 14.50		17.00 15.50 13.00 14.00		0.10 0.10 0.10 0.10

As of March 30, 2011, there were approximately 800 record holders of Common Stock.  There were no Company repurchases of the Common Stock during 2010 or 2009.

Dividend Policy

The Company historically has paid cash dividends on a quarterly basis. The final determination of the timing, amount and payment of dividends on the Common Stock is at the discretion of the Company’s Board of Directors and will depend upon the earnings of the Company and its subsidiary, the financial condition of the Company and other factors, including general economic conditions and applicable governmental regulations and policies as discussed in Item 1., “Business – Supervision and Regulation – Payment of Dividends,” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

The Company’s ability to distribute cash dividends will depend primarily on the ability of the Bank to pay dividends to it.  As a national bank, the Bank is subject to certain restrictions on our reserves and capital imposed by federal banking statutes and regulations.   Furthermore, under Virginia law, the Company may not declare or pay a cash dividend on its capital stock if it is insolvent or if the payment of the dividend would render it insolvent or unable to pay its obligations as they become due in the ordinary course of business.  For additional information on these limitations, see “Item 1.  Business – Government Supervision and Regulation – Payment of Dividends” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

55