Grayson Bankshares 10Q 2011 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

[X] Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2011

[ ] Transition Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the transition period from ____________ to _____________

Commission File Number: 0-30535

GRAYSON BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

Virginia (State or other jurisdiction of incorporation or organization)	54-1647596 (I.R.S. Employer Identification No.)
113 West Main Street Independence, Virginia (Address of principal executive offices)	24348 (Zip Code)

(276) 773-2811

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes R No £

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

Large accelerated filer £	Accelerated filer £
Non-accelerated filer £ (Do not check if smaller reporting company)	Smaller reporting company R

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes £ No R

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

1,718,968 shares of Common Stock, par value

$1.25 per share, outstanding as of November 14, 2011.

PART I	FINANCIAL INFORMATION

Item 1.	Financial Statements

	Consolidated Balance Sheets—September 30, 2011 (Unaudited)
	and December 31, 2010 (Audited)	3

	Unaudited Consolidated Statements of Income—Nine Months Ended
	September 30, 2011 and September 30, 2010	4

	Unaudited Consolidated Statements of Income—Three Months Ended
	September 30, 2011 and September 30, 2010	5

	Consolidated Statements of Changes in Stockholders’ Equity—Nine Months
	Ended September 30, 2011 (Unaudited) and Year Ended December 31, 2010 (Audited)	6

	Unaudited Consolidated Statements of Cash Flows—Nine Months Ended
	September 30, 2011 and September 30, 2010	7

	Notes to Consolidated Financial Statements	8

Item 2.	Management’s Discussion and Analysis of Financial Condition
	and Results of Operations	25

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	29

Item 4.	Controls and Procedures	30

PART II	OTHER INFORMATION

Item 1.	Legal Proceedings	31

Item 1A.	Risk Factors	31

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	31

Item 3.	Defaults Upon Senior Securities	31

Item 4.	Removed and Reserved	31

Item 5.	Other Information	31

Item 6.	Exhibits	31

Signatures		32

Part I. Financial Information

Item 1. Financial Statements

Grayson Bankshares, Inc. and Subsidiary

Consolidated Balance Sheets

September 30, 2011 and December 31, 2010

	September 30, 2011			December 31, 2010
	(Unaudited)			(Audited)

Assets

Cash and due from banks	$	9,972,384		$	9,200,552
Interest-bearing deposits with banks		3,311,485			3,305,724
Federal funds sold		38,984,006			27,745,592
Investment securities available for sale		47,446,688			46,841,247
Investment securities held to maturity (fair value approximately $902,917 at September 30, 2011, and $888,013 at December 31, 2010)		867,033			850,590
Restricted equity securities		1,473,700			1,617,300
Loans, net of allowance for loan losses of $5,118,461 at September 30, 2011 and $4,542,420 at December 31, 2010		221,386,220			248,512,958
Cash value of life insurance		8,676,596			8,433,596
Foreclosed assets		4,181,066			3,256,725
Property and equipment, net		10,990,158			10,575,133
Accrued interest receivable		1,841,864			2,131,943
Other assets		6,880,407			5,745,728
	$	356,011,607		$	368,217,088

Liabilities and Stockholders’ Equity

Liabilities
Deposits
Noninterest-bearing	$	47,813,032		$	42,487,778
Interest-bearing		257,319,788			269,329,080
Total deposits		305,132,820			311,816,858

Long-term debt		20,000,000			25,000,000
Accrued interest payable		590,753			311,647
Other liabilities		508,934			678,813
		326,232,507			337,807,318

Commitments and contingencies		-			-

Stockholders’ equity
Preferred stock, $25 par value; 500,000 shares authorized; none issued		-			-
Common stock, $25 par value; 500,000 shares authorized; 1,718,968 shares issued and outstanding in 2011 and 2010, respectively		2,148,710			2,148,710
Surplus		521,625			521,625
Retained earnings		27,329,844			28,975,488
Accumulated other comprehensive loss		(221,079	)		(1,236,053	)
		29,779,100			30,409,770

	$	356,011,607		$	368,217,088

Grayson Bankshares, Inc. and Subsidiary

Consolidated Statements of Income

For the Nine Months ended September 30, 2011 and 2010

	Nine Months Ended September 30,
	2011			2010
	(Unaudited)			(Unaudited)

Interest income
Loans and fees on loans	$	10,649,917		$	12,660,654
Interest-bearing deposits in banks		7,122			3,636
Federal funds sold		48,451			31,091
Investment securities:
Taxable		772,493			1,030,937
Exempt from federal income tax		329,251			273,191
		11,807,234			13,999,509

Interest expense
Deposits		2,955,627			4,240,737
Interest on borrowings		880,903			790,071
		3,836,530			5,030,808
Net interest income		7,970,704			8,968,701

Provision for loan losses		4,139,570			1,562,733
Net interest income after provision for loan losses		3,831,134			7,405,968

Noninterest income
Service charges on deposit accounts		831,813			798,554
Increase in cash value of life insurance		243,000			225,000
Net realized gains on securities		509,364			203,101
Gain on sale of cost-based investment		-			213,499
Other income		547,438			512,952
		2,131,615			1,953,106

Noninterest expense
Salaries and employee benefits		4,676,074			4,694,115
Occupancy expense		357,569			348,119
Equipment expense		485,947			584,234
Foreclosed asset expense, net		651,078			66,844
Other expense		2,318,828			2,413,873
		8,489,496			8,107,185
(Loss) income before income taxes		(2,526,747	)		1,251,889

Income tax (benefit) expense		(1,053,000	)		251,000
Net (loss) income	$	(1,473,747	)	$	1,000,889

Basic (loss) earnings per share	$	(0.86	)	$	0.58
Weighted average shares outstanding		1,718,968			1,718,968
Dividends declared per share	$	0.10		$	0.30

Grayson Bankshares, Inc. and Subsidiary

Consolidated Statements of Income

For the Three Months ended September 30, 2011 and 2010

	Three Months Ended September 30,
	2011			2010
	(Unaudited)			(Unaudited)

Interest income
Loans and fees on loans	$	3,373,000		$	4,184,684
Interest-bearing deposits in banks		2,181			3,307
Federal funds sold		14,912			11,132
Investment securities:
Taxable		252,099			348,850
Exempt from federal income tax		102,338			87,223
		3,744,530			4,635,196

Interest expense
Deposits		894,827			1,363,655
Interest on borrowings		357,083			266,251
		1,251,910			1,629,906
Net interest income		2,492,620			3,005,290

Provision for loan losses		1,506,071			712,974
Net interest income after provision for loan losses		986,549			2,292,316

Noninterest income
Service charges on deposit accounts		295,853			293,772
Increase in cash value of life insurance		81,000			75,000
Net realized gains on securities		244,351			170,134
Gain on sale of cost-based investment		-			213,499
Other income		188,487			198,771
		809,691			951,176

Noninterest expense
Salaries and employee benefits		1,581,710			1,539,286
Occupancy expense		122,991			103,345
Equipment expense		162,546			188,243
Foreclosed asset expense, net		427,177			42,567
Other expense		780,224			775,886
		3,074,648			2,649,327
(Loss) income before income taxes		(1,278,408	)		594,165

Income tax (benefit) expense		(497,000	)		146,000
Net (loss) income	$	(781,408	)	$	448,165

Basic (loss) earnings per share	$	(0.46	)	$	0.26
Weighted average shares outstanding		1,718,968			1,718,968
Dividends declared per share	$	0.00		$	0.10

Grayson Bankshares, Inc. and Subsidiary

Consolidated Statements of Changes in Stockholders’ Equity

For the Nine Months ended September 30, 2011(unaudited) and the Year ended December 31, 2010 (audited)

										Accumulated
										Other
	Common Stock						Retained			Comprehensive
	Shares		Amount		Surplus		Earnings			Income (Loss)			Total

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 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

Comprehensive income
Net loss		-		-		-		(1,473,747	)		-			(1,473,747	)
Net change in unrealized loss on investment securities available for sale, net of taxes of $696,049		-		-		-		-			1,351,154			1,351,154
Reclassification adjustment, net of income taxes of ($173,184)		-		-		-		-			(336,180	)		(336,180	)
Total comprehensive loss														(458,773	)

Dividends paid ($.10 per share)		-		-		-		(171,897	)		-			(171,897	)
Balance, September 30, 2011		1,718,968	$	2,148,710	$	521,625	$	27,329,844		$	(221,079	)	$	29,779,100

Grayson Bankshares, Inc. and Subsidiary

Consolidated Statements of Cash Flows

For the Nine Months ended September 30, 2011 and 2010

	Nine Months Ended September 30,
	2011			2010
	(Unaudited)			(Unaudited)

Cash flows from operating activities
Net (loss) income	$	(1,473,747	)	$	1,000,889
Adjustments to reconcile net (loss) income to net cash provided by operations:
Depreciation and amortization		558,000			571,500
Provision for loan losses		4,139,570			1,562,733
Deferred income taxes		46,000			(12,000	)
Net realized gains on securities		(509,364	)		(203,101	)
Accretion of discount on securities, net of amortization of premiums		287,061			163,351
Deferred compensation		(14,459	)		(21,246	)
Net realized loss (gain) on foreclosed assets		355,396			(1,733	)
Changes in assets and liabilities:
Cash value of life insurance		(243,000	)		(225,000	)
Accrued income		290,079			76,600
Other assets		(1,703,544	)		392,004
Accrued interest payable		279,106			427,198
Other liabilities		(155,420	)		410,485
Net cash provided by operating activities		1,855,678			4,141,680

Cash flows from investing activities
Purchases of available-for-sale investment securities		(20,931,815	)		(28,352,647	)
Sales of available-for-sale investment securities		13,488,596			4,041,712
Maturities/calls/paydowns of available-for-sale investment securities		8,581,477			22,460,240
Sales of restricted equity securities		143,600			111,900
Net decrease in loans		20,341,381			7,161,753
Proceeds from the sale of foreclosed assets		1,366,050			211,892
Purchases of property and equipment, net of sales		(973,025	)		(157,628	)
Net cash provided by investing activities		22,016,264			5,477,222

Cash flows from financing activities
Net (decrease) increase in deposits		(6,684,038	)		3,660,143
Net decrease in long-term debt		(5,000,000	)		-
Dividends paid		171,897	)		(515,690	)
Net cash (used in) provided by financing activities		(11,855,935	)		3,144,453
Net increase in cash and cash equivalents		12,016,007			12,763,355

Cash and cash equivalents, beginning		40,251,868			28,294,122
Cash and cash equivalents, ending	$	52,267,875		$	41,057,477

Supplemental disclosure of cash flow information
Interest paid	$	3,557,424		$	4,603,610
Taxes paid	$	43,000		$	100,000
Transfers of loans to foreclosed properties	$	2,645,787		$	458,000

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

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”) in a bank holding company reorganization. The Bank was acquired by the Company on July 1, 1992.

The 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 Board of Governors of the Federal Reserve System.

The consolidated financial statements as of September 30, 2011 and for the periods ended September 30, 2011 and 2010 included herein have been prepared by the Company without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the information furnished in the interim consolidated financial statements reflects all adjustments necessary to present fairly the Company’s consolidated financial position, results of operations, changes in stockholders’ equity and cash flows for such interim periods. Management believes that all interim period adjustments are of a normal recurring nature. These consolidated financial statements should be read in conjunction with the Company’s audited financial statements and the notes thereto as of December 31, 2010, included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010. The results of operations for the nine-month and three-month periods ended September 30, 2011 are not necessarily indicative of the results to be expected for the full year.

The accounting and reporting policies of the Company and the Bank follow generally accepted accounting principles and general practices within the financial services industry.

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.

Presentation of Cash Flows

For purposes of reporting cash flows, cash and cash equivalents includes cash and amounts due from banks (including cash items in process of collection), interest-bearing deposits with banks and Federal funds sold.

Recent Accounting Pronouncements

In July 2010, the Receivables topic of the Accounting Standards Codification (“ASC”) was amended by Accounting Standards Update (“ASU”) 2010-20 to require expanded disclosures related to a company’s allowance for credit losses and the credit quality of its financing receivables. The amendments require the allowance disclosures to be provided on a disaggregated basis. The Company is required to include these disclosures in their interim and annual financial statements. See Note 4.

Disclosures about Troubled Debt Restructurings (“TDRs”) required by ASU 2010-20 were deferred by the Financial Accounting Standards Board (“FASB”) in ASU 2011-01 issued in January 2011. In April 2011 the FASB issued ASU 2011-02 to assist creditors with their determination of when a restructuring is a TDR. The determination is based on whether the restructuring constitutes a concession and whether the debtor is experiencing financial difficulties as both events must be present.

Disclosures related to TDRs under ASU 2010-20 have been presented in Note 4.

In April 2011, the criteria used to determine effective control of transferred assets in the Transfers and Servicing topic of the ASC was amended by ASU 2011-03. The requirement for the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms and the collateral maintenance implementation guidance related to that criterion were removed from the assessment of effective control. The other criteria to assess effective control were not changed. The amendments are effective for the Company beginning January 1, 2012 but are not expected to have a material effect on the financial statements.

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 1. Organization and Summary of Significant Accounting Policies

Recent Accounting Pronouncements, continued

ASU 2011-04 was issued in May 2011 to amend the Fair Value Measurement topic of the ASC by clarifying the application of existing fair value measurement and disclosure requirements and by changing particular principles or requirements for measuring fair value or for disclosing information about fair value measurements. The amendments will be effective for the Company beginning January 1, 2012 but are not expected to have a material effect on the financial statements.

The Comprehensive Income topic of the ASC was amended in June 2011. The amendment eliminates the option to present other comprehensive income as a part of the statement of changes in stockholders’ equity. The amendment requires consecutive presentation of the statement of net income and other comprehensive income and requires an entity to present reclassification adjustments from other comprehensive income to net income on the face of the financial statements. The amendments will be applicable to the Company on January 1, 2012 and will be applied retrospectively.

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 $2,010,000 and $1,943,000 for the periods including September 30, 2011 and December 31, 2010, respectively.

Note 3. Investment Securities

Debt and equity securities have been classified in the consolidated balance sheets according to management’s intent. The amortized cost of securities and their approximate fair values at September 30, 2011 and December 31, 2010 follow:

	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
September 30, 2011:
Available for sale:
U.S. Government agency securities	$	3,037,582	$	85,154	$	-	$	3,122,736
Government sponsored enterprises		23,311,184		619,364		3,716		23,926,832
Mortgage-backed securities		9,519,700		289,869		63		9,809,506
State and municipal securities		10,206,162		391,529		10,077		10,587,614
	$	46,074,628	$	1,385,916	$	13,856	$	47,446,688
Held to maturity:
State and municipal securities	$	867,033	$	35,884	$	-	$	902,917

December 31, 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

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 3. Investment Securities, continued

There were no securities transferred between the available for sale and held to maturity portfolios during the nine-month period ended September 30, 2011 or the year ended December 31, 2010. 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 $1,473,700 at September 30, 2011 and $1,617,300 at December 31, 2010. 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 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 September 30, 2011 and December 31, 2010.

	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
September 30, 2011
Available for sale
Government sponsored enterprises	$	1,000,260	$	3,716	$	-	$	-	$	1,000,260	$	3,716
Mortgage-backed securities		1,534,842		63		-		-		1,534,842		63
State and municipal securities		1,019,500		10,077		-		-		1,019,500		10,077
Total securities available for sale	$	3,554,602	$	13,856	$	-	$	-	$	3,554,602	$	13,856

December 31, 2010
Available for sale:
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

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 September 30, 2011 or 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.

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 3. Investment Securities, continued

Investment securities with amortized cost of approximately $21,616,705 at September 30, 2011 and $17,636,109 at December 31, 2010, were pledged as collateral on public deposits and for other purposes as required or permitted by law. Gains and losses on the sale of investment securities are recorded on the trade date and are determined using the specific identification method. Gross realized gains and losses for the nine-month and three-month periods ended September 30, 2011 and 2010 are as follows:

	Nine-months ended Sep 30,						Three-months ended Sep 30,
	2011			2010			2011		2010

Realized gains	$	518,619		$	243,085		$	244,351		170,134
Realized losses		(9,255	)		(39,984	)		-		-
	$	509,364		$	203,101		$	244,351	$	170,134

The scheduled maturities of securities available for sale and securities held to maturity at September 30, 2011, were as follows:

	Available for Sale				Held to Maturity
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value

Due in one year or less	$	225,265	$	231,395	$	-	$	-
Due after one year through five years		464,659		489,657		381,368		395,624
Due after five years through ten years		10,564,054		10,773,815		-		-
Due after ten years		34,820,650		35,951,821		485,665		507,293
	$	46,074,628	$	47,446,688	$	867,033	$	902,917

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

Note 4. Allowance for Loan Losses and Impaired Loans

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.

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 4. Allowance for Loan Losses and Impaired Loans, continued

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.

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 September 30, 2011 and September 30, 2010:

Allowance for Loan Losses and Recorded Investment in Loans

	Commercial & Agricultural			Commercial Mortgage			Construction & Development			Farmland		Residential			Consumer & Other			Total

Allowance for loan losses

Balance, January 1, 2011	$	436,872		$	777,515		$	526,231		$	710,368	$	1,861,953		$	229,481		$	4,542,420
Charge-offs		(388,159	)		(335,001	)		(1,215,525	)		-		(1,491,681	)		(279,523	)		(3,709,889	)
Recoveries		66,612			688			6,000			-		11,924			61,136			146,360
Provision		335,745			379,875			1,282,714			30,227		1,850,627			260,382			4,139,570
Balance, September 30, 2011	$	451,070		$	823,077		$	599,420		$	740,595	$	2,232,823		$	271,476		$	5,118,461

Balance, January 1, 2010																			3,555,273
Provision charged to expense																			1,562,733
Recoveries of amounts charged off																			163,332
Amounts charged off																			(1,035,503	)
Balance, September 30, 2010																			4,245,835

September 30, 2011
Ending balance: individually
evaluated for impairment	$	34,554		$	79,708		$	-		$	192,500	$	123,374		$	-		$	430,136
Ending balance: collectively
evaluated for impairment	$	416,516		$	743,369		$	599,420		$	548,095	$	2,109,449		$	271,476		$	4,688,325

Loans outstanding:
Ending balance	$	12,612,438		$	37,724,813		$	18,404,677		$	34,101,375	$	112,477,763		$	11,183,615		$	226,504,681
Ending balance: individually
evaluated for impairment	$	300,696		$	3,879,586		$	4,489,406		$	6,141,851	$	4,922,128		$	-		$	19,733,667
Ending balance: collectively
evaluated for impairment	$	12,311,742		$	33,845,227		$	13,915,271		$	27,959,524	$	107,555,635		$	11,183,615		$	206,771,014

September 30, 2010
Allowance for loan losses:
Ending balance	$	379,977		$	637,216		$	638,711		$	680,804	$	1,699,464		$	209,663		$	4,245,835
Ending balance: individually
evaluated for impairment	$	-		$	-		$	92,000		$	-	$	10,195		$	-		$	102,195
Ending balance: collectively
evaluated for impairment	$	379,977		$	637,216		$	546,711		$	680,804	$	1,689,269		$	209,663		$	4,143,640

Loans outstanding:
Ending balance	$	17,649,009		$	41,002,284		$	25,732,629		$	33,611,152	$	128,671,284		$	15,025,041		$	261,691,399
Ending balance: individually
evaluated for impairment		-		$	1,778,505		$	3,485,369		$	1,902,985	$	4,475,472		$	-		$	11,642,331
Ending balance: collectively
evaluated for impairment	$	17,649,009		$	39,223,779		$	22,247,260		$	31,708,167	$	124,195,812		$	15,025,041		$	250,049,068

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 4. Allowance for Loan Losses and Impaired Loans, continued

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 September 30, 2011 and December 31, 2010, respectively, the Bank had no loans graded “Loss” included in the balance of total loans outstanding.

The following table lists the loan grades utilized by the Bank and the corresponding total of outstanding loans in each category as of September 30, 2011 and December 31, 2010:

Credit Risk Profile by Internally Assigned Grades

	Loan Grades
					Special
	Pass		Watch		Mention		Substandard		Doubtful		Total

September 30, 2011
Real Estate Secured:
1-4 residential construction	$	520,749	$	-	$	-	$	63,000	$	-	$	583,749
Commercial construction		260,379		-		111,000		-		-		371,379
Loan development & other land		10,734,459		486,948		405,856		5,822,286		-		17,449,549
Farmland		18,547,711		5,944,180		2,082,629		7,526,855		-		34,101,375
1-4 residential mortgage		81,194,472		958,985		3,447,529		9,007,537		-		94,608,523
Multifamily		2,084,184		713,749		-		-		-		2,797,933
Home equity and second mortgage		11,999,187		614,933		874,945		1,582,242		-		15,071,307
Commercial mortgage		27,311,221		2,467,904		1,482,118		6,463,570		-		37,724,813
Non-Real Estate Secured:
Commercial & agricultural		9,994,749		1,309,241		305,262		758,872		-		12,368,124
Financial institutions		-		-		244,314		-		-		244,314
Civic organizations		365,149		-		-		-		-		365,149
Consumer-auto		3,183,654		17,254		-		-		-		3,200,908
Consumer-Other		7,179,287		13,225		203,525		214,021		7,500		7,617,558
Total	$	173,375,201	$	12,526,419	$	9,157,178	$	31,438,383	$	7,500	$	226,504,681

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 4. Allowance for Loan Losses and Impaired Loans, continued

	Loan Grades
					Special
	Pass		Watch		Mention		Substandard		Doubtful		Total
December 31, 2010
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.

The following table presents an age analysis of nonaccrual and past due loans by category as of September 30, 2011 and December 31, 2010:

Analysis of Past Due and Nonaccrual Loans

													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
September 30, 2011
Real Estate Secured:
1-4 residential construction	$	85,000	$	-	$	63,000	$	148,000	$	435,749	$	583,749	$	-	$	63,000
Commercial construction		-		-		-		-		371,379		371,379		-		-
Loan development & other land		460,337		120,000		4,196,117		4,776,454		12,673,095		17,449,549		-		4,377,417
Farmland		917,384		35,000		3,664,031		4,616,415		29,484,960		34,101,375		46,129		5,957,177
1-4 residential mortgage		2,293,825		1,431,244		4,740,239		8,465,308		86,143,215		94,608,523		1,095,160		4,850,826
Multifamily		-		-		-		-		2,797,933		2,797,933		-		-
Home equity and second mortgage		318,008		153,931		624,457		1,096,396		13,974,911		15,071,307		114,462		587,615
Commercial mortgage		486,007		173,187		3,563,288		4,222,482		33,502,331		37,724,813		-		3,951,280
Non-Real Estate Secured:
Commercial & agricultural		396,656		83,173		106,866		586,695		11,781,429		12,368,124		-		475,735
Financial institutions		-		-		-		-		244,314		244,314		-		-
Civic organizations		-		-		-		-		365,149		365,149		-		-
Consumer-auto		148,228		47,583		47,733		243,544		2,957,364		3,200,908		21,693		26,040
Consumer-Other		128,259		47,426		104,133		279,818		7,337,740		7,617,558		31,450		73,975
Total	$	5,233,704	$	2,091,544	$	17,109,864	$	24,435,112	$	202,069,569	$	226,504,681	$	1,308,894	$	20,363,065

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 4. Allowance for Loan Losses and Impaired Loans, continued

													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
December 31, 2010
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		5,928,980		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 September 30, 2011 and December 31, 2010, respectively, the recorded investment in impaired loans totaled $19,733,667 and $12,705,564. The average age of the third-party appraisal or independent assessment used to measure impairment on our collateral-dependent loans at September 30, 2011 was 14 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 September 30, 2011 and December 31, 2010, respectively, was $16,673,160 and $11,867,568, of these $13,103,948 and $7,051,584 were measured for impairment using appraisals aged less than 18 months. The remaining $3,569,212 and $4,815,984 of collateral-dependent impaired loans was measured for impairment using existing appraisals discounted 15-20% for age and other pertinent factors. As of September 30, 2011 and December 31, 2010, respectively, $3,415,937 and $2,632,439 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.

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.

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 4. Allowance for Loan Losses and Impaired Loans, continued

Impaired Loans, continued

The following table is a summary of information related to impaired loans as of September 30, 2011 and December 31, 2010:

Impaired Loans

			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
	Investment(1)		Balance		Allowance		Investment		Recognized
September 30, 2011
With no related allowance recorded:
1-4 Residential Construction	$	63,000	$	115,238	$	-	$	42,000	$	-
Land development & other land		4,426,406		5,398,995		-		2,886,034		7,496
Farmland		4,715,378		4,715,378		-		3,294,435		38,555
1-4 residential mortgage		3,411,471		3,903,614		-		4,832,156		23,466
Commercial mortgage		3,525,041		3,819,675		-		2,915,316		4,925
Commercial & agricultural		103,696		103,696		-		117,290		113
Subtotal		16,244,992		18,056,596		-		14,087,231		74,555

With an allowance recorded:
1-4 Residential Construction		-		-		-		-		-
Land development & other land		-		-		-		-		-
Farmland		1,426,473		1,426,473		192,500		1,383,249		-
1-4 residential mortgage		1,510,657		1,510,657		123,374		938,957		16,931
Commercial mortgage		354,545		432,929		79,708		199,415		549
Commercial & agricultural		197,000		197,000		34,554		68,553		-
Subtotal		3,488,675		3,567,059		430,136		2,590,174		17,480

Totals:
1-4 Residential Construction		63,000		115,238		-		42,000		-
Land development & other land		4,426,406		5,398,995		-		2,886,034		7,496
Farmland		6,141,851		6,141,851		192,500		4,677,684		38,555
1-4 residential mortgage		4,922,128		5,414,271		123,374		5,771,113		40,397
Commercial mortgage		3,879,586		4,252,604		79,708		3,114,731		5,474
Commercial & agricultural		300,696		300,696		34,554		185,843		113
Total	$	19,733,667	$	21,623,655	$	430,136	$	16,677,405	$	92,035

December 31, 2010
With no related allowance recorded:
Land development & other land	$	2,718,524	$	2,859,524	$	-	$	3,281,024	$	93,528
Farmland		2,492,274		2,492,274		-		1,456,624		6,962
1-4 residential mortgage		3,770,194		4,034,833		-		3,937,023		650
Commercial mortgage		1,896,597		2,013,961		-		1,752,938		-
Commercial & agricultural		-		-		-		154,225		-
Subtotal		10,877,589		11,400,592		-		10,581,834		101,140

With an allowance recorded:
Land development & other land		-		-		-		-		-
Farmland		421,166		421,166		32,410		421,166		-
1-4 residential mortgage		1,282,727		1,282,727		55,185		558,976		8,391
Commercial mortgage		124,082		124,082		28,082		124,082		-
Commercial & agricultural		-		-		-		-		-
Subtotal		1,827,975		1,827,975		115,677		1,104,224		8,391

Totals:
Land development & other land		2,718,524		2,859,524		-		3,281,024		93,528
Farmland		2,913,440		2,913,440		32,410		1,877,790		6,962
1-4 residential mortgage		5,052,921		5,317,560		55,185		4,495,999		9,041
Commercial mortgage		2,020,679		2,138,043		28,082		1,877,020		-
Commercial & agricultural		-		-		-		154,225		-
Total	$	12,705,564	$	13,228,567	$	115,677	$	11,686,058	$	109,531

(1)	Recorded investment is the loan balance, net of any charge-offs

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

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 4. Allowance for Loan Losses and Impaired Loans, continued

The average recorded investment in impaired loans and interest income recognized on impaired loans for the nine month periods ended September 30, 2011 and 2010 (all approximate) are summarized below:

	2011		2010

Average investment in impaired loans	$	16,677,405	$	14,121,437
Interest income recognized on impaired loans	$	229,645	$	158,410
Interest income recognized on a cash basis on impaired loans	$	209,605	$	158,887

Troubled Debt Restructuring

As a result of adopting the amendments in ASU 2011-02, the Bank reassessed restructurings that occurred on or after the beginning of the fiscal year of adoption (January 1, 2011) to determine whether they are considered troubled debt restructurings (TDRs) under the amended guidance. The Bank identified as TDRs certain loans for which the allowance for loan losses had previously been measured under a general allowance methodology. Upon identifying those loans as TDRs, the Bank identified them as impaired under the guidance in ASC 310-10-35. The amendments in ASU 2011-02 require prospective application of the impairment measurement guidance in ASC 310-10-35 for those loans newly identified as impaired. At the end of the first interim period of adoption (September 30, 2011), the recorded investment in loans for which the allowance was previously measured under a general allowance methodology and are now impaired under ASC 310-10-35 was $203,507. The allowance for loan losses associated with those loans on the basis of a current evaluation of loss was $0.

	For the nine months ended
	September 30, 2011
	Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Troubled Debt Restructurings
Land Development & Other land		2	$	520,539	$	520,539
Farmland		3		1,555,408		1,551,337
1-4 Residential Mortgage		10		1,484,129		1,523,795
Commercial Mortgage		2		499,763		499,763
Commercial & Agricultural		5		104,902		104,902

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 4. Allowance for Loan Losses and Impaired Loans, continued

Troubled Debt Restructuring, continued

	For the three months ended
	September 30, 2011
	Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Troubled Debt Restructurings
Land Development & Other land		-	$	-	$	-
Farmland		1		948,264		950,000
1-4 Residential Mortgage		3		524,278		524,088
Commercial Mortgage		1		195,000		195,000
Commercial & Agricultural		5		104,902		104,902

During the nine months ended September 30, 2011, the Bank modified 22 loans that were considered to be troubled debt restructurings. We extended the terms for 11 of these loans and made payment concessions (principal and/or interest) for 11 of these loans. Additional funds were advanced on one loan in order to improve the Bank’s collateral position.

	Nine months ended
	September 30, 2011
	Number of Contracts		Recorded Investment
Troubled Debt Restructurings That Subsequently Defaulted During the Period:
Land Development & Other land		1	$	181,900
Farmland		1		350,000
1-4 Residential Mortgage		1		130,000
Commercial Mortgage		1		296,163
Commercial & Agricultural		-		-

	Three months ended
	September 30, 2011
	Number of Contracts		Recorded Investment
Troubled Debt Restructurings That Subsequently Defaulted During the Period:
Land Development & Other land		1	$	181,900
Farmland		1		350,000
1-4 Residential Mortgage		-		-
Commercial Mortgage		-		-
Commercial & Agricultural		-		-

During the nine months ended September 30, 2011, 4 loans that had previously been restructured, were in default, two of which went into default in the quarter. Restructured loans are deemed to be in default if they become past due by 30 days or more.

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 5. Income Taxes

A reconciliation of income tax expense computed at the statutory federal income tax rate to income tax expense included in the statements of income for the nine months ended September 30, 2011 and 2010 follows:

	2011			2010

Tax at statutory federal rate	$	(859,094	)	$	425,642
Tax exempt interest income		(125,710	)		(115,658	)
Other tax exempt income		(82,620	)		(76,500	)
Other		14,424			17,516
	$	(1,053,000	)	$	251,000

Note 6. Employee Benefit Plan

The Bank has a qualified noncontributory defined benefit pension plan that covers substantially all of its employees. The benefits are primarily based on years of service and earnings. The following is a summary of net periodic pension costs for the nine-month and three-month periods ended September 30, 2011 and 2010.

	Nine-months ended Sep 30,						Three-months ended Sep 30,
	2011			2010			2011			2010

Service cost	$	343,497		$	308,880		$	114,499			102,960
Interest cost		329,802			312,774			109,934			104,258
Expected return on plan assets		(581,046	)		(495,213	)		(193,682	)		(165,071	)
Amortization of prior service cost		2,424			2,424			808			808
Amortization of net (gain) or loss		33,762			29,097			11,254			9,699
Net periodic benefit cost	$	128,439		$	157,962		$	42,813		$	52,654

It is Bank policy to contribute the maximum tax-deductible amount each year as determined by the plan administrator. A contribution of $1,021,577 was made in the second quarter of 2011.

Note 7. Commitments and Contingencies

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 September 30, 2011 and December 31, 2010 is as follows:

	September 30,		December 31,
	2011		2010

Commitments to extend credit	$	13,044,521	$	13,652,036
Standby letters of credit		-		-
	$	13,044,521	$	13,652,036

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 7. Commitments and Contingencies, continued

Commitments to extend credit are agreements to lend to a customer, at a fixed or variable interest rate, 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.

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 that the Bank deems necessary.

Note 8. Fair Value

FASB ASC 825, “Financial Instruments”, requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet. In cases where quoted market prices are not available, fair values are based on estimates using present value of future cash flows or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. FASB ASC 825 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

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

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

Interest-bearing deposits with banks: Due to their short-term nature, the carrying value of interest-bearing deposits approximate their fair value.

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.

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.

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 8. Fair Value, continued

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):

	September 30, 2011				December 31, 2010
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
Financial assets
Cash and due from banks	$	9,972	$	9,972	$	9,201	$	9,201
Interest bearing deposits with banks		3,311		3,311		3,306		3,306
Federal funds sold		38,984		38,984		27,746		27,746
Securities, available for sale		47,447		47,447		46,841		46,841
Securities, held to maturity		867		903		851		888
Restricted equity securities		1,474		1,474		1,617		1,617
Loans, net of allowance for loan losses		221,386		226,362		248,513		250,800
Cash value of life insurance		8,677		8,677		8,434		8,434
Accrued interest receivable		1,842		1,842		2,132		2,132

Financial liabilities
Deposits		305,133		309,432		311,817		314,484
Long-term debt		20,000		22,476		25,000		27,672
Accrued interest payable		591		591		312		312

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 or foreclosed assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Fair Value Hierarchy

Under FASB ASC 820, “Fair Value Measurements and Disclosures”, 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.

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 8. Fair Value, continued

Fair Value Hierarchy, continued

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. Once a loan is identified as individually impaired, management measures impairment in accordance with FASB ASC 310, “Receivables”. 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 September 30, 2011, substantially all of the impaired loans were evaluated based on the fair value of the collateral. In accordance with FASB ASC 820, 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.

Derivative Assets and Liabilities

Derivative instruments held or issued by the Company for risk management purposes are traded in over-the-counter markets where quoted market prices are not readily available. Management engages third-party intermediaries to determine the fair market value of these derivative instruments and classifies these instruments as Level 2. Examples of Level 2 derivatives are interest rate swaps, caps and floors. No derivative instruments were held as of September 30, 2011 or December 31, 2010.

Foreclosed Assets

Foreclosed assets are adjusted to fair value, less selling costs, 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.

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 8. Fair Value, continued

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

	Total		Level 1		Level 2		Level 3
September 30, 2011
Investment securities available for sale
U.S. Government agency securities	$	3,122,736	$	-	$	3,122,736	$	-
Government sponsored enterprises		23,926,832		-		23,926,832		-
Mortgage-backed securities		9,809,506		-		9,809,506		-
State and municipal securities		10,587,614		-		10,587,614		-
Total investment securities
available for sale	$	47,446,688	$	-	$	47,446,688	$	-
Total assets at fair value	$	47,446,688	$	-	$	47,446,688	$	-

Total liabilities at fair value	$	-	$	-	$	-	$	-

December 31, 2010
Investment securities available for sale
U.S. Government agency securities	$	1,291,595	$	-	$	1,291,595	$	-
Government sponsored enterprises		23,469,366		-		23,469,366		-
Mortgage-backed securities		10,630,694		-		10,630,694		-
State and municipal securities		11,449,592		-		11,449,592		-
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	$	-	$	-	$	-	$	-

There were no significant transfers to or from Levels 1 and 2 during the nine-month period ended September 30, 2011 or for the year ended December 31, 2010.

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 principles. 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.

	Total		Level 1		Level 2		Level 3
September 30, 2011
Loans	$	6,474,475	$	-	$	5,640,390	$	834,085
Foreclosed assets		1,758,340		-		1,503,340		255,000
Total assets at fair value	$	8,232,815	$	-	$	7,143,730	$	1,089,085

Total liabilities at fair value	$	-	$	-	$	-	$	-

December 31, 2010
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	$	-	$	-	$	-	$	-

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

(unaudited)

Note 9. Formal Agreement

On August 9, 2011, the Bank entered into a Formal Agreement with the OCC. Under the terms of the Formal Agreement, the Board of Directors will perform a review of the Bank’s management and thereafter on an ongoing basis ensure that the Bank has competent management to operate the Bank. In addition, the Bank has agreed to develop, implement and ensure compliance with written plans to (a) maintain sufficient capital, (b) improve and sustain earnings, (c) improve the Bank’s position with respect to loans, relationships or other assets criticized in any report of examination of the Bank, and (d) strengthen the loan review system to ensure timely identification and categorization of problem credits. The agreement calls for the maintenance of a minimum Tier 1 leverage ratio of 8.25%, a Tier 1 risk-based capital ratio of 12.00% and a total risk-based capital ratio of 13.00%. In addition, as part of the Bank’s plan to maintain sufficient capital, the Bank must adopt a dividend policy that permits the declaration of a dividend only when the Bank is in compliance with its approved capital program and certain federal statutes and with the prior written determination of no supervisory objection by the OCC. The Bank has also agreed that it will not extend, renew or capitalize accrued interest on any credit to any borrower whose loans or other extensions of credit have been criticized in any report of examination of the Bank and whose aggregate loans or other extensions exceed $250,000 absent prior approval by the Board of Directors consistent with the requirements of the Formal Agreement.

The Bank has already appointed a committee to monitor compliance with the Formal Agreement. Management and the Board of Directors are in the process of addressing the requirements of the Formal Agreement and have already taken important steps towards complying with its terms.

Note 10. Subsequent Events

Subsequent events are events or transactions that occur after the balance sheet date but before financial statements are issued. Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements. Non-recognized subsequent events are events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date. 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.

Part I. Financial Information

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

General

The following discussion provides information about the major components of the results of operations and financial condition of the Company. This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in this report.

Critical Accounting Policies

For a discussion of the Company’s critical accounting policies, including its allowance for loan losses, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

Results of Operations

Overall, the Company recorded a pre-tax loss of $1,278,408 for the quarter ended September 30, 2011 compared to pre-tax earnings of $594,165 for the same period in 2010. Income tax expense decreased by $643,000 from the third quarter of 2010 to 2011 resulting in a net loss of $781,408 for the third quarter of 2011 compared to net income of $448,165 for the same period in 2010. The decrease in pretax earnings of $1,872,573 from the third quarter of 2010 to the third quarter of 2011 was due primarily to a decrease in net interest income of $512,670 combined with increases in loan loss provisions of $793,097 and costs related to foreclosed assets of $384,610.

Total interest income decreased by $890,666 for the quarter ended September 30, 2011 compared to the quarter ended September 30, 2010, while interest expense on deposits and other borrowings decreased by $377,996 over the same period. The decrease in interest income was attributable primarily to a decrease in the average outstanding balance of loans for the third quarter of 2011 as compared to the same quarter in 2010, an increase in the amount of loans on non-accrual status, and a decrease in the average yield on loans and investment securities in the third quarter of 2011 compared to 2010. From December 31, 2009 to September 30, 2011 the bank has experienced a decrease in loans of 16.17%, from $270.2 million to $226.5 million caused by continued weakness in loan demand in the bank’s market area. In response to the decrease in loan demand management has continued to reduce interest rates on deposits, leading to the reduction in interest expense on deposits of $468,828. Interest on borrowings increased by $90,832 for the quarter due to a penalty of approximately $115,000 incurred with the prepayment of a $5,000,000 advance from the Federal Home Loan Bank of Atlanta. The result was a decrease in net interest income of $512,670, or 17.06% for the quarter ended September 30, 2011, compared to the same quarter last year.

The provision for loan losses was $1,506,071 for the quarter ended September 30, 2011 and $712,974 for the same period in 2010. The increase was due to increased charge-offs as well as increasing loan loss reserve levels in light of current economic conditions and an increase in the bank’s level of foreclosure activity. The reserve for loan losses at September 30, 2011 was approximately 2.26% of total loans, compared to 1.62% at September 30, 2010. Management believes the provision and the resulting allowance for loan losses are adequate.

Total noninterest income was $809,691 in the third quarter of 2011 compared to $951,176 in the third quarter of 2010. The $141,485 decrease was due to a nonrecurring gain on the sale of a cost-based investment totaling $213,499 that was recognized in the third quarter of 2010. Net realized gains on securities totaled $244,351 for the third quarter of 2011 compared to $170,134 for the third quarter of 2010.

Total noninterest expenses increased by $425,321 for the quarter ended September 30, 2011 compared to the quarter ended September 30, 2010 due primarily to an increase in expenses related to foreclosed assets of $384,610. This includes $355,396 in net losses on the sale of foreclosed assets as indicated below in the discussion of financial condition. Salaries and employee benefit expenses increased by $42,424. Total occupancy expenses increased by $19,646 compared to the prior year while equipment related expenses decreased by $25,697 over the same period.

Part I. Financial Information

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

For the nine months ended September 30, 2011, total interest income decreased by $2,192,275 compared to the nine-month period ended September 30, 2010, while interest expense decreased by $1,194,278 over the same period, resulting in a decrease in net interest income of $997,997, or 11.13%. As indicated in the quarterly discussion above, the decrease in interest income was due primarily to the lower average balance in loans, increased levels of non-accrual loans, and a decrease in the average yield on loans and investment securities. The decrease in interest expense was due mainly to decreases in deposit rates.

The provision for loan losses for the nine-month period ended September 30, 2011 totaled $4,139,570 compared to $1,562,733 for the nine-month period ended September 30, 2010. The increase of $2,576,837 was due to increased charge-offs as well as increasing loan loss reserve levels in light of current economic conditions and an increase in the bank’s level of foreclosure activity.

The increase in noninterest income of $178,509 for the first nine months of 2011, compared to the same period in 2010 was primarily the result of an increase in net realized gains on the sale of investment securities of $306,263.

Total noninterest expenses increased by $382,311 for the nine-month period ended September 30, 2011, compared to the same period in 2010. This came as a result of an increase in expenses related to foreclosed assets totaling $584,234. Salaries and employee benefits decreased by $18,041 while equipment and other expenses decreased by $98,287 and $95,045 respectively, as management continued efforts to contain costs.

In total, net income before taxes decreased by $3,778,636 over the first nine months of 2011 compared to the first nine months of 2010 due primarily to the decrease in net interest income combined with the increased provision for loan losses. Income tax expense decreased by $1,304,000 over the prior year, resulting in a decrease in net income of $2,474,636 for the nine months ended September 30, 2011.

Financial Condition

Total assets decreased by $12,205,481, or 3.31%, from December 31, 2010 to September 30, 2011. Net loans decreased by $27,126,738, federal funds sold increased by $11,238,414 and investment securities increased by $621,884. The decrease in loans and related increase in federal funds sold and investment securities is the result of continued weakness in loan demand in the bank’s market area.

Total deposits decreased by $6,684,038, or 2.14%, from December 31, 2010 to September 30, 2011. The decrease in deposits came as management maintained lower deposit interest rates in response to the aforementioned decrease in loan demand.

Nonperforming assets, including nonaccrual loans, loans past due more than ninety days and foreclosed assets, increased from $19,902,561 at December 31, 2010 to $25,853,025 at September 30, 2011. Foreclosed assets consist of eighteen properties totaling $4,181,066 at September 30, 2011. One commercial real estate property represents a significant portion of the balance in foreclosed assets with a value of $2,422,726. Ten of these properties with a combined carrying value of $425,885 were sold at auction in September, with closings scheduled in October and two other properties are currently under contract. A total of thirteen foreclosed properties were disposed of in the first nine months of 2011. Proceeds from the sale of these properties totaled $1,366,050 representing a net loss on disposal of $355,396. All foreclosed properties are being marketed for sale. Loans past due more than ninety days, and still accruing interest, increased from $935,975 at December 31, 2010 to $1,308,894 at September 30, 2011.

Nonaccrual loans increased from $15,709,861 at December 31, 2010 to $20,363,065 at September 30, 2011. During the first nine months of 2011, loans totaling $15,445,582 were added to nonaccrual status while loans totaling $10,792,378 were removed from nonaccrual status. Loans are generally placed in nonaccrual status when principal or interest has been in default for a period of 90 days or more unless the loan is both well secured and in the process of collection.

Part I. Financial Information

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Loans less than 90 days past due may be placed in nonaccrual status if management determines that payment in full of principal or interest is not expected. 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 continues to closely monitor nonperforming assets and their impact on earnings and loan loss reserves.

At September 30, 2011, the allowance for loan losses included $430,136 specifically reserved for impaired loans in the amount of $3,488,675. Based on impairment analysis, loans totaling $16,244,992 were also considered to be impaired but did not require a specific reserve or the related reserve had previously been charged-off. Impaired loans at December 31, 2010 totaled $12,705,564, of which $1,827,975 required specific reserves of $115,677.

Certain types of loans, such as option ARM (adjustable rate mortgage) 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 September 30, 2011 totaled $9.0 million, or 3.97% of total loans. Historical charge-off rates in this category have not varied significantly from other real estate secured loans.

Stockholders’ equity totaled $29,779,100 at September 30, 2011 compared to $30,409,770 at December 31, 2010. The $630,670 decrease was the result of the net loss of $1,473,747, payment of dividends totaling $171,897, offset by an increase in the market value of securities classified as available for sale of $1,014,974.

Regulatory guidelines relating to capital adequacy provide minimum risk-based ratios at the Bank level which assess capital adequacy while encompassing all credit risks, including those related to off-balance sheet activities. The Bank exceeds all regulatory capital guidelines and is considered to be “well capitalized.”

Liquidity and Capital Resources

Liquidity is the ability to convert assets to cash to fund depositors’ withdrawals or borrowers’ loans without significant loss. Unsecured federal fund lines available from correspondent banks totaled $6,000,000 at September 30, 2011. No balances were outstanding on these lines at September 30, 2011 or December 31, 2010. Long-term debt consists of borrowings from the Federal Home Loan Bank and Deutsche Bank. Borrowings from the Federal Home Loan Bank, which are secured by a blanket collateral agreement on the Bank’s 1 to 4 family residential real estate loans, totaled $10,000,000 at September 30, 2011 and $15,000,000 at December 31, 2010. Borrowings from Deutsche Bank, which are secured by the pledging of specific investment securities, totaled $10,000,000 at each of September 30, 2011, and December 31, 2010. The unused credit line from the Federal Home Loan Bank as of September 30, 2011 is approximately $43,670,000.

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 Bank’s investment security portfolio also serves as a source of liquidity. 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 portion of its investment portfolio in unpledged assets with average lives or repricing terms of less than 60 months. These investments are a preferred source of funds because their market value is not as sensitive to changes in interest rates as investments with longer durations.

Part I. Financial Information

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

As a result of the steps described above, management believes that the Company maintains overall liquidity sufficient to satisfy its depositors’ requirements and meet its customers’ credit needs.

Formal Agreement

On August 9, 2011, the Bank entered into a Formal Agreement with the OCC. Under the terms of the Formal Agreement, the Board of Directors will perform a review of the Bank’s management and thereafter on an ongoing basis ensure that the Bank has competent management to operate the Bank. In addition, the Bank has agreed to develop, implement and ensure compliance with written plans to (a) maintain sufficient capital, (b) improve and sustain earnings, (c) improve the Bank’s position with respect to loans, relationships or other assets criticized in any report of examination of the Bank, and (d) strengthen the loan review system to ensure timely identification and categorization of problem credits. As part of the Bank’s plan to maintain sufficient capital, the Bank must adopt a dividend policy that permits the declaration of a dividend only when the Bank is in compliance with its approved capital program and certain federal statutes and with the prior written determination of no supervisory objection by the OCC. The Bank has also agreed that it will not extend, renew or capitalize accrued interest on any credit to any borrower whose loans or other extensions of credit have been criticized in any report of examination of the Bank and whose aggregate loans or other extensions exceed $250,000 absent prior approval by the Board of Directors consistent with the requirements of the Formal Agreement.

Forward-Looking Statements

Certain information contained in this discussion may include “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements are generally identified by phrases such as “the Company expects,” “the Company believes” or words of similar import. Such forward-looking statements involve known and unknown risks including, but not limited to, changes in general economic and business conditions, interest rate fluctuations, competition within and from outside the banking industry, new products and services in the banking industry, risk inherent in making loans such as repayment risks and fluctuating collateral values, problems with technology utilized by the Company, changing trends in customer profiles and changes in laws and regulations applicable to the Company. Although the Company believes that its expectations with respect to the forward-looking statements are based upon reliable assumptions within the bounds of its knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. For additional information on known and unknown risks, see the “Forward Looking Statements” section in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

Part I. Financial Information

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Not applicable to smaller reporting companies.

Part I. Financial Information

Item 4. Controls and Procedures

As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s President and Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934. Based upon that evaluation, the Company’s President and Chief Executive Officer and Chief Financial Officer concluded that its disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiary) required to be included in its periodic filings with the Securities and Exchange Commission.

The Company’s management is also responsible for establishing and maintaining adequate internal control over financial reporting. There were no changes in the Company’s internal control over financial reporting identified in connection with the evaluation of it that occurred during the Company’s last fiscal quarter that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

Part II. Other Information

Item 1. Legal Proceedings

There are no pending legal proceedings to which the Company or the Bank is a party or of which any of their property is subject.

Item 1A. Risk Factors

Other than as set forth below, there were no material changes to the Company’s risk factors as disclosed in its Annual Report on Form 10-K for the year ended December 31, 2010 and Quarterly Report on Form 10-Q for the period ended June 30, 2011.

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

Not applicable

Item 3. Defaults Upon Senior Securities

Not applicable

Item 4. Removed and Reserved

Item 5. Other Information

None

Item 6. Exhibits

	10.1	Formal Agreement by and between Grayson National Bank and the Comptroller of the Currency, incorporated herein by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2011.

	31.1	Rule 13(a)-14(a) Certification of Chief Executive Officer.

	31.2	Rule 13(a)-14(a) Certification of Chief Financial Officer.

	32.1	Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C.Section 1350.

	101	Interactive Data File.

Part II. Other Information

SIGNATURES

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

	GRAYSON BANKSHARES, INC.



Date: November 14, 2011	By:	Jacky K. Anderson
		Jacky K. Anderson
		President and Chief Executive Officer


	By:	Blake M. Edwards
		Blake M. Edwards
		Chief Financial Officer

Exhibit Index

	Exhibit No.	Description

	10.1	Formal Agreement by and between Grayson National Bank and the Comptroller of the Currency, incorporated herein by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2011.

	31.1	Rule 13(a)-14(a) Certification of Chief Executive Officer.

	31.2	Rule 13(a)-14(a) Certification of Chief Financial Officer.

	32.1	Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C.Section 1350.

	101	Interactive Data File.

Positive
Negative
Uncertain
Constraining
Legalese
Litigious
Readability	8th grade Bad

Grayson Bankshares (GSON) Inactive 10-Q2011 Q3 Quarterly report

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