| CORRECTION OF ERRORS RELATED TO PURCHASE ACCOUNTING |
2. CORRECTION OF ERRORS RELATED TO PURCHASE ACCOUNTING In December 2009, we acquired Greater Atlantic Bank from the FDIC. We identified an error in the calculation of the FDIC indemnification asset and other purchase accounting errors, and on February 7, 2012, we filed a Form 8-K disclosing that we will restate our financial statements for year ended December 31, 2009, the interim quarterly periods and year ended December 31, 2010 and the interim quarterly periods through September 30, 2011. Our Form 10-K for the year ended December 31, 2011 filed on April 16, 2012 describes the restatement in more detail. Specifically, a redundant credit loss assumption was applied to the acquired residential and home equity loan portfolios for purposes of calculating the expected credit losses for these portfolios recoverable from the FDIC. This error resulted in an overstatement of the FDIC indemnification asset. The correction of the error resulted in the removal of the gain of $11.2 million as reported, as well as adjustments to other amounts originally reported in 2009. We engaged a different advisor to assist with calculating the correct initial fair value of the indemnification asset; accretion of the acquired loan discount; calculation of estimated amounts due back to the FDIC in the event that losses do not achieve a specified level (the clawback liability); and other purchase accounting adjustments. Correcting the 2009 purchase accounting entries required adjustments to certain reported amounts in 2010 and 2011. Restatement of the quarterly condensed financial information was also necessary. See Footnote 22 to the consolidated financial statements. Notes (a) through (e) below describe the restatement adjustments to the consolidated statements of comprehensive income and cash flows for the year ended December 31, 2010 presented in the following tables. | (a) | Correct the initial fair value of the FDIC indemnification asset as of the date of acquisition in 2009, the carrying amount as of December 31, 2010 and the related accretion. |
| (b) | Correct the accretion amounts for the accretable discount on the acquired loans. On the statement of cash flows as reported, the accretion of the loan discount was included in loan originations and payments, net with investing activities. |
| (c) | Record a liability for amounts expected to be paid to the FDIC at the maturity of the indemnification agreement as credit losses are not expected to reach levels established in the Purchase and Assumption Agreement for the acquisition of Greater Atlantic Bank. This liability was reflected at the net present value of expected cash outflows of $586 thousand, and is accreted through other operating expenses to the expected cash disbursement. |
| (d) | Record the tax effects for the impact of the adjustments. |
| (e) | Corrections to the statement of cash flows to reflect the impact of the aforementioned adjustments as well as to present the accretion of the loan discount in operating activities. |
| | | Impact on Consolidated Statements of Comprehensive Income | | | | | | | For the Year Ended | | | | | | | | | | | | December 31, 2010 | | | | | | | | | As Previously | | | | | | | | | | | | Reported | | | As Restated | | | Adjustment | | | Interest and dividend income : | | | | | | | | | | | Interest and fees on loans | | $ | 30,333 | | | $ | 33,450 | | | $ | 3,117 | | b | Interest and dividends on taxable securities | | | 2,635 | | | | 2,635 | | | | - | | | Interest and dividends on other earning assets | | | 205 | | | | 205 | | | | - | | | Total interest and dividend income | | | 33,173 | | | | 36,290 | | | | 3,117 | | | Interest expense: | | | | | | | | | | | | | | Interest on deposits | | | 7,172 | | | | 7,172 | | | | - | | | Interest on borrowings | | | 1,341 | | | | 1,341 | | | | - | | | Total interest expense | | | 8,513 | | | | 8,513 | | | | - | | | | | | | | | | | | | | | | | | Net interest income | | | 24,660 | | | | 27,777 | | | | 3,117 | | | | | | | | | | | | | | | | | | Provision for loan losses | | | 9,025 | | | | 9,025 | | | | - | | | Net interest income after provision
for loan losses | | | 15,635 | | | | 18,752 | | | | 3,117 | | | | | | | | | | | | | | | | | | Noninterest income (loss): | | | | | | | | | | | | | | Account maintenance and deposit service fees | | | 900 | | | | 900 | | | | - | | | Income from bank-owned life insurance | | | 554 | | | | 554 | | | | - | | | Gain on sale of SBA loans | | | - | | | | - | | | | - | | | Bargain purchase gain on acquisitions | | | - | | | | - | | | | - | | | Net loss on other assets | | | (274 | ) | | | (274 | ) | | | - | | | Total other-than-temporary impairment losses (OTTI) | | | (288 | ) | | | (288 | ) | | | - | | | Portion of OTTI recognized in other comprehensive | | | | | | | | | | | | | | income (before taxes) | | | - | | | | - | | | | - | | | Net credit related OTTI recognized in earnings | | | (288 | ) | | | (288 | ) | | | - | | | Gain on sales of securities available for sale | | | 142 | | | | 142 | | | | - | | | | Other | | | 341 | | | | 341 | | | | - | | | | | | | | | | | | | | | | | | Total noninterest income | | | 1,375 | | | | 1,375 | | | | - | | | | | | | | | | | | | | | | | | Noninterest expenses: | | | | | | | | | | | | | | Salaries and benefits | | | 6,186 | | | | 6,186 | | | | - | | | Occupancy expenses | | | 2,101 | | | | 2,101 | | | | - | | | Furniture and equipment expenses | | | 591 | | | | 591 | | | | - | | | Amortization of core deposit intangible | | | 943 | | | | 943 | | | | - | | | Virginia franchise tax expense | | | 735 | | | | 735 | | | | - | | | FDIC assessment | | | 705 | | | | 705 | | | | - | | | Data processing expense | | | 587 | | | | 587 | | | | - | | | Telephone and communication expense | | | 403 | | | | 403 | | | | - | | | Change in FDIC indemnification asset | | | 281 | | | | (60 | ) | | | (341 | ) | a | Acquisition expenses | | | - | | | | - | | | | - | | | Other operating expenses | | | 1,979 | | | | 2,006 | | | | 27 | | c | Total noninterest expenses | | | 14,511 | | | | 14,197 | | | | (314 | ) | | Income (loss) before income taxes | | | 2,499 | | | | 5,930 | | | | 3,431 | | | Income tax expense (benefit) | | | 698 | | | | 1,876 | | | | 1,178 | | d | Net income | | $ | 1,801 | | | $ | 4,054 | | | $ | 2,253 | | | Other comprehensive income: | | | | | | | | | | | | | | Unrealized gain on available for sale securities | | $ | 261 | | | $ | 261 | | | $ | - | | | Realized amount on securities sold, net | | | (142 | ) | | | (142 | ) | | | - | | | Non-credit component of other-than-temporary impairment | | | | | | | | | | | | | | on held-to-maturity securities | | | 238 | | | | 238 | | | | - | | | Accretion of amounts previously recorded upon transfer | | | | | | | | | | | | | | to held-to-maturity from available-for sale | | | (123 | ) | | | (123 | ) | | | - | | | Net unrealized gain | | | 234 | | | | 234 | | | | - | | | Tax effect | | | 79 | | | | 79 | | | | - | | | Other comprehensive income | | | 155 | | | | 155 | | | | - | | | Comprehensive income | | $ | 1,956 | | | $ | 4,209 | | | $ | 2,253 | | | Earnings per share, basic and diluted | | $ | 0.16 | | | $ | 0.35 | | | $ | 0.19 | | |
| | | Impact on Consolidated Statements Cash Flows | | | | | For the Year
Ended | | | | | December 31, 2010 | | | | | As Previously | | | | | | | | | | | | Reported | | | As Restated | | | Adjustment | | | Operating activities: | | | | | | | | | | | Net income (loss) | | $ | 1,801 | | | $ | 4,054 | | | $ | 2,253 | | | Adjustments to reconcile net income (loss) to net cash and | | | | | | | | | | | | | | cash equivalents provided by operating activities: | | | | | | | | | | | | | | Depreciation | | | 537 | | | | 537 | | | | - | | | Amortization of core deposit intangible | | | 943 | | | | 943 | | | | - | | | Other amortization , net | | | 109 | | | | 109 | | | | - | | | Accretion of loan discount | | | - | | | | (5,781 | ) | | | (5,781 | ) | b | Decrease (increase) in FDIC indemnification asset | | | 281 | | | | (60 | ) | | | (341 | ) | a | Provision for loan losses | | | 9,025 | | | | 9,025 | | | | - | | | Earnings on bank-owned life insurance | | | (554 | ) | | | (554 | ) | | | - | | | Stock based compensation expense | | | 82 | | | | 82 | | | | - | | | Gain on sale of loans | | | - | | | | - | | | | - | | | Impairment on securities | | | 288 | | | | 288 | | | | - | | | Gain on sales of securities | | | (142 | ) | | | (142 | ) | | | - | | | Gain on branch acquisition | | | - | | | | - | | | | - | | | Gain on Greater Atlantic acquisition | | | - | | | | - | | | | - | | | Net loss on other real estate owned | | | 274 | | | | 274 | | | | - | | | Provision for deferred income taxes | | | - | | | | (1,724 | ) | | | (1,724 | ) | e | Net (increase) decrease in other assets | | | (113 | ) | | | (328 | ) | | | (215 | ) | e | Net increase (decrease) in other liabilities | | | (3,912 | ) | | | (3,885 | ) | | | 27 | | e | Net cash and cash equivalents provided by operating activities | | | 8,619 | | | | 2,838 | | | | (5,781 | ) | | Investing activities: | | | | | | | | | | | | | | Purchases of securities available-for-sale | | | - | | | | - | | | | | | | Proceeds from sales of securities available for sale | | | 4,728 | | | | 4,728 | | | | - | | | Proceeds from paydowns, maturities and calls of securities available for sale | | | 2,857 | | | | 2,857 | | | | - | | | Purchases of securities held to maturity | | | - | | | | - | | | | - | | | Proceeds from paydowns, maturities and calls of securities held to maturity | | | 12,892 | | | | 12,892 | | | | - | | | Loan originations and payments, net | | | (9,633 | ) | | | (3,852 | ) | | | 5,781 | | b | Proceeds from sale of SBA loans | | | - | | | | - | | | | - | | | Net cash received in branch acquisition | | | - | | | | - | | | | - | | | Net cash received in Greater Atlantic acquisition | | | - | | | | - | | | | - | | | Net increase in stock in Federal Reserve Bank and Federal Home Loan Bank | | | (410 | ) | | | (410 | ) | | | - | | | Proceeds from sale of other real estate owned | | | 2,570 | | | | 2,570 | | | | - | | | Purchases of bank premises and equipment | | | (1,971 | ) | | | (1,971 | ) | | | - | | | Net cash and cash equivalents provided by investing activities | | | 11,033 | | | | 16,814 | | | | 5,781 | | | Financing activities: | | | | | | | | | | | | | | Net decrease in deposits | | | (24,817 | ) | | | (24,817 | ) | | | - | | | Proceeds from Federal Home Loan Bank advances | | | 5,000 | | | | 5,000 | | | | - | | | Repayment of Federal Home Loan Bank advances | | | - | | | | - | | | | - | | | Net increase (decrease) in securities sold under agreement to repurchase and | | | | | | | | | | | - | | | other short-term borrowings | | | 1,888 | | | | 1,888 | | | | - | | | Issuance of common stock, net of issuance costs | | | - | | | | - | | | | - | | | Additional cost of 2009 common stock issuance | | | (48 | ) | | | (48 | ) | | | - | | | Net cash and cash equivalents used in financing activities | | | (17,977 | ) | | | (17,977 | ) | | | - | | | Increase (decrease) in cash and cash equivalents | | | 1,675 | | | | 1,675 | | | | - | | | Cash and cash equivalents at beginning of period | | | 8,070 | | | | 8,070 | | | | - | | | Cash and cash equivalents at end of period | | $ | 9,745 | | | $ | 9,745 | | | $ | - | | | Supplemental disclosure of cash flow information | | | | | | | | | | | | | | Cash payments for: | | | | | | | | | | | | | | Interest | | $ | 8,851 | | | $ | 8,851 | | | | - | | | Income taxes | | | 1,557 | | | | 1,557 | | | | - | | | Supplemental schedule of noncash investing and financing activities | | | | | | | | | | | | | | Transfer from non-covered loans to other real estate owned | | | 3,209 | | | | 3,209 | | | | - | | | Transfer from covered loans to other real estate owned | | | 676 | | | | 676 | | | | - | |
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