10QSB

FORM 10-QSB

U. S. SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

x Quarterly Report under Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2004

Commission file number 01-17377

COMMONWEALTH BANKSHARES, INC.

(Exact name of small business issuer as specified in its charter)

VIRGINIA	54-1460991
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

403 Boush Street Norfolk, Virginia	23510
(Address of principal executive offices)	(Zip Code)

(757) 446-6900

Issuer’s telephone number

Not Applicable

(Former name, former address and former fiscal year, if changed since last report.)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date.

Common Stock, $2.50 Par Value – 2,017,351 shares as of September 30, 2004

Commonwealth Bankshares, Inc. and Subsidiaries

Table of Contents

PART I - FINANCIAL INFORMATION	Page
ITEM 1 – FINANCIAL STATEMENTS (unaudited)
Consolidated Balance Sheets	3
September 30, 2004
December 31, 2003
Consolidated Statements of Income	4
Three months ended September 30, 2004
Three months ended September 30, 2003
Nine months ended September 30, 2004
Nine months ended September 30, 2003
Consolidated Statements of Comprehensive Income	5
Nine months ended September 30, 2004
Nine months ended September 30, 2003
Consolidated Statements of Shareholders’ Equity	6
Nine months ended September 30, 2004
Year ended December 31, 2003
Year ended December 31, 2002
Consolidated Statements of Cash Flows	7
Nine months ended September 30, 2004
Nine months ended September 30, 2003
Notes to Consolidated Financial Statements	8 - 10
ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	11 -17
ITEM 3 – CONTROLS AND PROCEDURES	18
PART II - OTHER INFORMATION
ITEM 1 – LEGAL PROCEEDINGS	19
ITEM 2 – CHANGES IN SECURITIES	19
ITEM 3 – DEFAULTS UPON SENIOR SECURITIES	19
ITEM 4 – SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	19
ITEM 5 – OTHER INFORMATION	19
ITEM 6 – EXHIBITS AND REPORTS ON FORM 8-K	19
SIGNATURES	20

2

Commonwealth Bankshares, Inc. and Subsidiaries

Consolidated Balance Sheets

	September 30, 2004 (Unaudited)			December 31, 2003 (Audited)
Assets:
Cash and cash equivalents:
Cash and due from banks	$	5,055,005		$	8,116,202
Interest bearing deposits in banks		196,515			134,300
Federal funds sold		478,373			340,621
Total cash and cash equivalents		5,729,893			8,591,123
Investment securities:
Available for sale, at fair market value		7,515,093			11,594,084
Held to maturity		596,845			836,647
Total investment securities		8,111,938			12,430,731
Federal Home Loan Bank stock		2,766,500			1,849,600
Federal Reserve Bank stock		338,900			338,900
Loans held for sale		28,797,551			56,132,136
Loans, net of unearned income		289,644,968			230,049,792
Allowance for loan losses		(3,496,628	)		(2,503,000	)
Net loans		286,148,340			227,546,792
Premises and equipment, net		5,211,334			5,353,554
Interest receivable		1,524,047			1,504,761
Real estate acquired in settlement of loans		—			1,094,637
Deferred tax assets		1,556,879			1,301,962
Other assets		1,859,989			2,151,057
Total assets	$	342,045,371		$	318,295,253
Liabilities and shareholders’ equity:
Deposits:
Noninterest bearing demand	$	35,101,728		$	31,974,911
Interest bearing		219,435,982			218,683,381
Total deposits		254,537,710			250,658,292
Interest payable		848,493			740,436
Other liabilities		3,720,538			4,250,450
Short-term borrowing		55,215,150			37,003,714
Long-term debt		444,784			426,496
Convertible preferred securities		5,365,005			6,025,300
Total liabilities		320,131,680			299,104,688
Shareholders’ equity
Common stock, $2.50 par value. Authorized 5,000,000 shares; issued and outstanding 2,017,351 shares in 2004 and 1,888,271 in 2003		5,043,379			4,720,678
Additional paid-in capital		7,312,126			6,547,479
Retained earnings		9,429,189			7,529,445
Accumulated other comprehensive income, net of tax		128,997			392,963
Total shareholders’ equity		21,913,691			19,190,565
Total liabilities and shareholders’ equity	$	342,045,371		$	318,295,253

3

Commonwealth Bankshares, Inc. and Subsidiaries

Consolidated Statements of Income (Unaudited)

	Three months ended				Nine months ended
	September 30, 2004		September 30, 2003		September 30, 2004		September 30, 2003
Interest income:
Loans, including fees	$	5,622,696	$	4,750,203	$	15,366,167	$	13,889,259
Investment securities		137,860		202,592		411,038		623,188
Other		3,598		4,103		32,898		8,473
Total interest income		5,764,154		4,956,898		15,810,103		14,520,920
Interest expense:
Deposits		1,886,948		1,943,242		5,739,871		5,749,798
Other borrowings		310,537		176,395		628,192		533,797
Total interest expense		2,197,485		2,119,637		6,368,063		6,283,595
Net interest income		3,566,669		2,837,261		9,442,040		8,237,325
Provision for loan losses		270,000		135,000		1,105,000		375,000
Net interest income after provision for loan losses		3,296,669		2,702,261		8,337,040		7,862,325
Noninterest income:
Service charges on deposit accounts		278,067		217,134		788,095		662,681
Other service charges and fees		154,276		137,520		425,994		391,912
Gain on sale of available for sale securities		353		–		441,227		—
Other income		339,366		98,860		415,544		223,822
Total noninterest income		772,062		453,514		2,070,860		1,278,415
Noninterest expense:
Salaries and employee benefits		1,374,343		1,036,971		3,545,599		3,032,356
Occupancy		235,936		219,281		695,369		684,211
Furniture and equipment		286,306		234,823		777,627		759,749
Other		807,509		574,072		2,102,073		1,737,732
Total noninterest expense		2,704,094		2,065,147		7,120,668		6,214,048
Income before provision for income taxes		1,364,637		1,090,628		3,287,232		2,926,692
Provision for income taxes		459,310		255,657		1,092,427		837,094
Net income	$	905,327	$	834,971	$	2,194,805	$	2,089,598
Basic earnings per share	$	0.45	$	0.47	$	1.12	$	1.20
Diluted earnings per share	$	0.36	$	0.33	$	0.89	$	0.84
Dividends paid per share	$	0.05	$	0.04	$	0.15	$	0.12
Basic weighted average shares outstanding		2,001,219		1,765,561		1,962,374		1,737,700
Diluted weighted average shares outstanding		2,729,342		2,825,731		2,722,635		2,823,450

4

Commonwealth Bankshares, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income (Unaudited)

	Nine months ended
	September 30, 2004			September 30, 2003
Net income	$	2,194,805		$	2,089,598
Other comprehensive income, net of income tax:
Net change in unrealized gain on securities available for sale		(263,966	)		56,728
Comprehensive income	$	1,930,839		$	2,146,326

5

Commonwealth Bankshares, Inc. and Subsidiaries

Consolidated Statements of Shareholders’ Equity

Nine Months Ended September 30, 2004, and Years Ended 2003 and 2002

	Common Shares	Common Amount		Additional Paid-in Capital		Retained Earnings			Accumulated Other Comprehensive Income			Total
Balance, January 1, 2002	1,703,002	$	4,257,506	$	5,477,930	$	3,775,600		$	62,242		$	13,573,278
Comprehensive income:
Net income	—		—		—		1,674,187			—			1,674,187
Change in unrealized gains on securities available for sale, net of tax effect	—		—		—		—			247,732			247,732
Total comprehensive income													1,921,919
Issuance of common stock	18,619		46,547		82,121		—			—			128,668
Cash dividends - $.105 per share	—		—		—		(179,235	)		—			(179,235	)
Balance, December 31, 2002	1,721,621		4,304,053		5,560,051		5,270,552			309,974			15,444,630
Comprehensive income:
Net income	—		—		—		2,542,491			—			2,542,491
Change in unrealized gains on securities available for sale, net of tax effect	—		—		—		—			82,989			82,989
Total comprehensive income													2,625,480
Issuance of common stock	166,650		416,625		987,428		—			—			1,404,053
Cash dividends - $0.16 per share	—		—		—		(283,598	)		—			(283,598	)
Balance, December 31, 2003	1,888,271		4,720,678		6,547,479		7,529,445			392,963			19,190,565
Comprehensive income:
Net income	—		—		—		2,194,805			—			2,194,805
Change in unrealized gains on securities available for sale, net of tax effect	—		—		—		—			(263,966	)		(263,966	)
Total comprehensive income													1,930,839
Issuance of common stock	129,080		322,701		764,647		—			—			1,087,348
Cash dividends - $.15 per share	—		—		—		(295,061	)		—			(295,061	)
Balance, September 30, 2004	2,017,351	$	5,043,379	$	7,312,126	$	9,429,189		$	128,997		$	21,913,691

6

Commonwealth Bankshares, Inc. and Subsidiaries

Consolidated Statements of Cash Flows (Unaudited)

	Nine months ended
	September 30, 2004			September 30, 2003
Operating activities:
Net income	$	2,194,805		$	2,089,598
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		1,105,000			375,000
Depreciation and amortization		690,431			669,050
Gain on sale of investment securities available for sale		(441,227	)		—
Loss on sale of real estate acquired in settlement of loans		10,396			—
Deferred tax assets		(118,934	)		(232,097	)
Increase in interest receivable		(19,286	)		(120,259	)
Loans held for sale		27,334,585			5,862,401
Increase (decrease) in interest payable		108,057			(102,667	)
Other		(40,027	)		300,071
Net cash provided by operating activities		30,823,800			8,841,097
Investing activities:
Purchase of investment securities		(5,625,324	)		(3,235,000	)
Sales and maturities of investment securities		9,985,395			6,121,000
Net (purchase)/sale of equity securities, restricted		(916,900	)		183,420
Sale of real estate acquired in settlement of loans		229,241			—
Net change in loans		(58,838,048	)		(27,553,133	)
Purchases of premises and equipment		(562,528	)		(347,775	)
Net cash used in investing activities		(55,728,164	)		(24,831,488	)
Financing activities:
Net change in:
Deposits		3,879,418			18,819,225
Short-term borrowing		18,211,436			(1,238,812	)
Principal payments on long-term debt		18,288			(26,112	)
Dividends reinvested and sale of stock		229,053			97,902
Dividends paid		(295,061	)		(208,348	)
Net cash provided by financing activities		22,043,134			17,443,855
Net increase (decrease) in cash and cash equivalents		(2,861,230	)		1,453,464
Cash and cash equivalents at January 1		8,591,123			7,525,592
Cash and cash equivalents at September 30	$	5,729,893		$	8,979,056
Supplemental cash flow disclosure:
Interest paid during the period	$	6,260,006		$	6,386,262
Supplemental noncash disclosure:
Transfer between loans and real estate acquired in settlement of loans	$	855,000		$	—
Conversion of convertible preferred securities for common stock	$	660,295		$	950,700
Issuance of common stock for acquisition of mortgage company	$	198,000		$	—

7

Commonwealth Bankshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

September 30, 2004

Note A – Basis of Presentation

The accounting and reporting policies of Commonwealth Bankshares, Inc. (the “Parent”) and its subsidiaries, Commonwealth Bankshares Capital Trust I (the “Trust”), and Bank of the Commonwealth (the “Bank”) and its subsidiaries, BOC Title of Hampton Roads, Inc., BOC Insurance Agencies of Hampton Roads, Inc., and Community Home Mortgage, Inc., are in accordance with accounting principles generally accepted in the United States of America and conform to accepted practices within the banking industry. The accompanying consolidated financial statements include the accounts of the Parent, the Trust, and the Bank and its subsidiaries, collectively referred to as “the Company”. All significant intercompany balances and transactions have been eliminated in consolidation. Community Home Mortgage, Inc., a mortgage brokerage firm that originates, processes and sells residential mortgages throughout Virginia and Maryland was acquired on July 13, 2004, and accordingly the consolidated financial statements include transactions subsequent to the acquisition date.

The accompanying unaudited financial statements have been prepared in accordance with generally accepted accounting principles in the United States for interim financial reporting and with the instructions to Form 10-QSB. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. For further information, refer to the financial statements and footnotes thereto included in the Company’s annual report on Form 10-KSB for the year ended December 31, 2003.

Certain 2003 amounts have been reclassified to conform to the 2004 presentation.

Note B – Earnings Per Share

Basic earnings per common share is calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing net income by the weighted average of common and potential dilutive common equivalent shares outstanding during the period.

The following is a reconciliation of the basic and diluted earnings per share computations.

	Three months ended				Nine months ended
	September 30, 2004		September 30, 2003		September 30, 2004		September 30, 2003
Earnings available to common shareholders	$	905,327	$	834,971	$	2,194,805	$	2,089,598
Weighted average shares outstanding		2,001,219		1,765,561		1,962,374		1,737,700
Basic earnings per common share	$	0.45	$	0.47	$	1.12	$	1.20
Effect of dilutive securities:
Earning available to common shareholders	$	905,327	$	834,971	$	2,194,805	$	2,089,598
Convertible preferred securities interest net of tax effect		70,818		85,644		219,445		277,969
Earnings available to common plus assumed conversions	$	976,145	$	920,615	$	2,414,250	$	2,367,567
Effect of dilutive securities on EPS:
Weighted average shares outstanding		2,001,219		1,765,561		1,962,374		1,737,700
Effect of stock options		49,428		188,127		56,625		188,127
Effect of convertible preferred securities		678,695		872,043		703,636		897,623
Diluted average shares outstanding		2,729,342		2,825,731		2,722,635		2,823,450
Diluted earnings per share	$	0.36	$	0.33	$	0.89	$	0.84

8

Note C – Investment Securities

The amortized cost and estimated fair market values of investment securities were:

	September 30, 2004				December 31, 2003
	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
Available for sale:
U.S. Government and agency securities	$	3,009,983	$	3,037,168	$	809,125	$	809,190
Mortgage-backed securities		1,572,423		1,597,166		2,147,959		2,181,133
State and municipal securities		2,487,237		2,639,434		4,352,146		4,647,489
Equities and other bonds		250,000		241,325		3,689,458		3,956,272
Total investment securities available for sale	$	7,319,643	$	7,515,093	$	10,998,688	$	11,594,084
Held to maturity:
Mortgage-backed securities	$	435,890	$	438,062	$	582,399	$	582,949
State and municipal securities		160,955		179,871		254,248		275,901
Total investment securities held to maturity	$	596,845	$	617,933	$	836,647	$	858,850

Note D - Loans

Major classifications of loans are summarized as follows:

	September 30, 2004			December 31, 2003
Commercial	$	44,878,482		$	45,583,991
Commercial construction		19,028,055			7,759,122
Commercial mortgage		168,959,059			131,743,596
Residential mortgage		46,934,304			36,268,976
Installment loans to individuals		10,001,396			8,226,346
Other		1,085,713			1,368,563
Gross loans		290,887,009			230,950,594
Unearned income		(1,242,041	)		(900,802	)
Total loans	$	289,644,968		$	230,049,792

Non-performing assets are as follows:

	September 30, 2004			December 31, 2003
Loans 90 days past due and still accruing interest	$	—		$	—
Nonaccrual loans		1,932,505			2,845,100
Real estate acquired in settlement of loans		—			1,094,637
Total non-performing assets	$	1,932,505		$	3,939,737
Allowance as a percentage of non-performing assets		180.94	%		63.53	%
Non-performing assets as a percentage of total assets		0.56	%		1.24	%

9

Note E – Allowance For Loan Losses

Transitions affecting the allowance for loan losses during the nine months ended September 30, 2004 and 2003 were as follows:

	September 30, 2004			September 30, 2003
Balance at beginning of year	$	2,503,000		$	2,335,000
Provision for loan losses		1,105,000			375,000
Loans charged off		(118,976	)		(349,863	)
Recoveries		7,604			10,885
Balance at end of period	$	3,496,628		$	2,371,022

Note F – Premises and Equipment

Premises and equipment are summarized as follows:

	September 30, 2004		December 31, 2003
Land	$	345,403	$	345,403
Building and improvements		3,028,688		2,943,032
Leasehold improvements		752,635		696,226
Furniture and equipment		6,622,318		6,160,615
Construction in progress		42,260		29,510
		10,791,304		10,174,786
Less accumulated depreciation		5,579,970		4,821,232
	$	5,211,334	$	5,353,554

Note G – Subsequent Events

On October 19, 2004, the Company declared a $0.05 per share cash dividend payable November 30, 2004, to shareholders of record on November 22, 2004.

Subsequent to September 30, 2004 through October 31, 2004, 6,750 shares of the 8.0% cumulative preferred securities were converted to 4,218 shares of the Parent’s common stock.

On October 14, 2004, the Company completed a $15 million private placement of its common stock. Pursuant to the terms of the Private Placement Memorandum, dated August 30, 2004, the Company sold 943,396 shares of its common stock at a price of $15.90 per share. Anderson & Strudwick, Inc. acted as the Company’s exclusive placement agent for this transaction. The aggregate placement agent fee was 5.0% of the offerings gross proceeds, which amounted to $750,000. The company plans to use the net proceeds from the offering for general corporate purposes, including the support of future asset growth and the increase in lending limits of its bank subsidiary, Bank of the Commonwealth.

10

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

General

The sole business of Commonwealth Bankshares, Inc. is to serve as a holding company for Bank of the Commonwealth. The Company was incorporated as a Virginia corporation on June 6, 1988, and on November 7, 1988 it acquired the Bank.

Bank of the Commonwealth was formed on August 28, 1970 under the laws of Virginia. Since the Bank opened for business on April 14, 1971, its main banking and administrative offices have been located in Norfolk, Virginia. The Bank currently operates three branches in Norfolk, four branches in Virginia Beach, one branch in Chesapeake, and one branch in Portsmouth.

In addition to historical information, the following discussion contains forward looking statements that are subject to risks and uncertainties that could cause the Company’s actual results to differ materially from those anticipated. These forward looking statements include, but are not limited to, the effect of increasing interest rates on the Company’s profitability and the adequacy of the Company’s allowance for future loan losses. Several factors, including the local and national economy and the demand for loans may adversely affect the Company’s ability to achieve the expected results. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date hereof.

Critical Accounting Policies

Certain critical accounting policies affect the more significant judgments and estimates used in the preparation of the consolidated financial statements. The Company’s most critical accounting policy relates to the Company’s allowance for loan losses, which reflects the estimated losses resulting from the inability of the Company’s borrowers to make required loan payments. If the financial condition of the Company’s borrowers were to deteriorate resulting in an impairment of their ability to make payments, the Company’s estimates would be updated and additional provisions for loan losses may be required.

Stock Compensation Plans

Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, encourages all entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock. Stock options issued under the Company’s stock option plan have no intrinsic value at the grant date, and under Opinion No. 25 no compensation cost is recognized for them. The Company has elected to continue with the accounting methodology in Opinion No. 25. The fair value based method of accounting did not have a material effect on the Company’s net income and earnings per share.

Financial Condition

Total assets at September 30, 2004 reached a new high of $342.0 million, up 7.5% or $23.8 million from $318.3 million at December 31, 2003. Total loans, the Company’s largest and most profitable asset, ended the quarter at a record $289.6 million, up $59.6 million or 25.9% from December 31, 2003. The favorable financing environment along with the efforts of the Company’s officers to develop new loan relationships combined with the support of existing customers continue to generate record loan demand for the Company. Loans held for sale declined $27.3 million or 48.7% which tempered the growth in total assets.

11

As of September 30, 2004, 80.1% of the Company’s loan portfolio consisted of commercial loans, which are considered to provide higher yields, but also generally carry a greater risk. It should be noted that 72.6% of these commercial loans are collateralized with real estate, and accordingly do not represent an unfavorable risk. At September 30, 2004, 74.2% of the Bank’s total loan portfolio consisted of loans collateralized with real estate.

To fund the Company’s record loan demand, and to take advantage of the gains in the investment portfolio given the existing market conditions and the likelihood of interest rates increasing, the Company sold securities from its investment portfolio. The sale resulted in the Company recognizing a gain on securities sold of $240,054 during the first quarter of 2004. In addition, $2.5 million of investments were called at a premium, resulting in a $200,820 gain recognized in the second quarter of 2004 and contributed to the decrease in the investment portfolio of $4.3 million.

Deposits are the most significant source of the Company’s funds for use in lending and general business purposes. Total deposits at September 30, 2004 grew to $254.5 million, an increase of $3.9 million from December 31, 2003. Non-interest bearing demand deposits increased by $3.1 million or 9.8% and interest bearing deposits grew by $752.6 thousand or 0.3%. Time deposits, a higher interest bearing liability, declined $3.5 million during the first nine months of 2004, with interest bearing demand and savings accounts increasing $3.1 million and $1.1 million, respectively. Management believes the growth in deposits is a result of the increased promotional efforts put forth by the Company as well as the efforts of our experienced staff to attract new customers through our special deposit promotions, product enhancements, and offering unsurpassed service. The Company’s deposits are provided by individuals and businesses located within communities served.

As of September 30, 2004, short term borrowings (advances from FHLB) were $55.2 million, compared to $37.0 million outstanding on December 31, 2003. The increase in short term borrowings was primarily a result of our loan demand increasing at a faster pace than our deposit growth. Loans held for sale is funded in part by FHLB advances, and an increase in deposits.

Results of Operation

During the first nine months of 2004, the Company reached a record $2.2 million in net income, an increase of 5.0% over the comparable period in 2003. Net income for the quarter ended September 30, 2004 totaled $905.3 thousand, an increase of 8.4% over the $835.0 thousand reported in the third quarter of 2003. On a per share basis, diluted earnings increased to 89 cents for the nine months ended September 30, 2004 compared to 84 cents for the same period in 2003. For the quarter ended September 30, 2004, diluted earnings per share equaled 36 cents up 9.1% from the 33 cents reported in the third quarter of 2003.

Profitability as measured by the Company’s return on average assets (ROA) was 1.07% and 1.16% for the three months ended September 30, 2004 and 2003 and .93% and 1.01% for the nine months ended September 30, 2004 and 2003, respectively. ROA was impacted by an increase in net income of 8.4% for the third quarter which was offset by an increase in average assets of $51.5 million or 18.0% from September 30, 2003 to September 30, 2004. The return on average equity (ROE) was 16.99% and 19.25% for the three months ended September 30, 2004 and 2003 and 14.41% and 16.72% for the nine months ended September 30, 2004 and 2003, respectively. The decrease in ROE is the result of the growth in the third quarter’s average equity of $4.0 million or 23.1% from September 30, 2003 to September 30, 2004.

12

A fundamental source of the Company’s earnings, net interest income, is defined as the difference between income on earning assets and the cost of funds supporting those assets. Significant categories of earning assets are loans and securities, while deposits and short-term borrowings represent the major portion of interest bearing liabilities. The level of net interest income is impacted primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates when compared to previous periods of operations. Net interest income was $9.4 million for the nine months ended September 30, 2004, an increase of $1.2 million or 14.6% over the comparable period in 2003. For the quarter ended September 30, 2004, net interest income was $3.6 million, up 25.7% over the quarter ended September 30, 2003.

Total interest income was $15.8 million for the nine months ended September 30, 2004, an increase of $1.3 million, or 8.9% over the same period of 2003. For the quarter ended September 30, 2004, total interest income was $5.8 million, up 16.3% from the quarter ended September 30, 2003. Strong loan demand continued into the third quarter of 2004 generating record increases in interest income. Interest income on loans increased $1.5 million or 10.6% to $15.4 million for the nine months ended September 30, 2004. For the three months ended September 30, 2004, interest income on loans increased 18.4% to $5.6 million compared to $4.8 million for the comparable period in 2003.

Interest expense of $6.4 million for the nine months ended September 30, 2004 represented a $84.5 thousand increase from the comparable period in 2003. For the quarter ended September 30, 2004, interest expense was $2.2 million, up $77.8 thousand from the quarter ended September 30, 2003. This slight increase is due to the decrease in overall rates paid on liabilities as a result of the lower interest rate environment, which was offset by the record increase in the Company’s average interest bearing liabilities. Average deposits and short term borrowings increased $18.1 million and $14.4 million, respectively, from September 30, 2004 to September 30, 2003.

The provision for loan losses is the annual cost of maintaining an allowance for inherent credit losses. The amount of the provision each year and the level of the allowance are matters of judgment and are impacted by many factors, including actual credit losses during the period, the prospective view of credit losses, loan performance measures and trends (such as delinquencies and charge-offs), and other factors, both internal and external that may affect the quality and future loss experience of the credit portfolio. At September 30, 2004, the Company had total allowance for loan losses of $3.5 million or 1.21% of total loans. The provision for loan losses was $1.1 million for the first nine months of 2004 compared to $375.0 thousand for the same period of 2003. Loan charge-offs for the nine months ended September 30, 2004 totaled $119.0 thousand and recoveries for the same period totaled $7.6 thousand.

Since December 31, 2003, non-performing assets decreased $1.9 million to $1.9 million as of September 30, 2004. The decline was a result of the sale of the two properties included in real estate acquired in settlement of loans. Nonaccrual loans at September 30, 2004 consisted of ten (10) loans which totaled $1.9 million. $1.4 million of the total represents one significant commercial credit. Management is closely monitoring this credit, but is currently not able to estimate the size of the loss due to uncertainties regarding the liquidation of the collateral and the outcome of a suit against the loan guarantors. Management believes the maximum potential after tax loss could be approximately $700.0 thousand. Due to the uncertainty of the outcome coupled with the aforementioned strong loan growth experienced during the last year, out of an abundance of caution management increased its monthly provision. For the three months and nine months ended September 30, 2004 the provision was increased by $135.0 thousand and $730.0 thousand, respectively from the same period in 2003. When determinable, the loss, if any, will be a one time charge to the allowance for loan losses. Management believes that the current monthly provision and allowance for loan losses is sufficient to absorb any potential loss associated with this credit and the potential loss will not negatively impact the Company’s ability to conduct its business on a going forward basis. The remaining $0.5 million in nonaccrual loans represents nine (9) loans, with the majority making monthly payments and in most cases are secured with workout arrangements currently in place. Based on current expectations relative to portfolio characteristics and performance measures including loss projections, management considers the level of the allowance to be adequate.

13

Noninterest income for the nine months ended September 30, 2004 equaled $2.1 million, an increase of $792.4 thousand over the $1.3 million reported for the nine months ended September 30, 2003. For the three months ended September 30, 2004, noninterest income was $772.1 thousand, up $318.5 thousand or 70.2% over the comparable period in 2003. Revenues generated from the recently acquired (third quarter 2004) mortgage company contributed $295.7 thousand to other income. The $240.1 thousand gain recognized on the sale of securities available for sale in the first quarter of 2004 and the $200.8 thousand gain recognized on the call of securities in the second quarter of 2004 contributed to the increase in other income for the nine months ended September 30, 2004.

Noninterest expense consists of salaries and benefits provided to employees of the Company, expenses related to premises and equipment, data processing expenses, and operating expenses associated with day to day business affairs. Noninterest expense for the nine months ended September 30, 2004 totaled $7.1 million, an increase of $906.6 thousand over the $6.2 million recorded during the nine months ended September 30, 2003. For the quarter ended September 30, 2004, noninterest expense was $2.7 million, an increase of $638.9 thousand over the comparable period in 2003. The increase was primarily due to an 16.9% rise in salaries and employee benefits resulting from the addition of several new positions during 2003 and the first quarter of 2004, the acquisition of the mortgage company, and an increase in medical insurance costs for our employees. The Company is currently servicing a record number of deposit and loan accounts. To support this growth, along with the legislation and requirements relating to the Sarbanes-Oxley Act, the Bank Secrecy Act, the Patriot Act, the Fair Credit Reporting Act, the Gramm Leach Bliley Act, and others, the Company had to deploy significant resources including additional employees who can devote the time and attention necessary to ensure ongoing compliance with each of these important policies. The Company invested in an extensive multimedia advertising campaign utilizing billboards, radio, and newspaper to promote and reinforce its presence throughout Southside Hampton Roads during 2004, which contributed significantly to a $135.9 thousand or 91.0% increase in advertising and marketing expense during the nine months ended September 30, 2004 as compared to the comparable period in 2003.

Capital Position

Shareholders’ equity for the Company increased to $21.9 million from $19.2 million or 14.2% from December 31, 2003 to September 30, 2004. Shareholders’ equity for September 30, 2004 reflects a $129.0 thousand net unrealized gain on securities available for sale in accordance with FASB 115, as compared to a $393.0 thousand net unrealized gain as of December 31, 2003.

The Federal Reserve Board, the Office of Controller of the Currency, and the FDIC has issued risk-based capital guidelines for U.S. banking organizations. These guidelines provide a capital framework that is sensitive to differences in risk profiles among banking companies.

Risk-based capital ratios are another measure of capital adequacy. At September 30, 2004, the Bank’s risk-adjusted capital ratios were 8.92% for Tier 1 and 10.14% for total capital, well above the required minimums of 4.0% and 8.0%, respectively. These ratios are calculated using regulatory capital (either Tier 1 or total capital) as the numerator and both on and off-balance sheet risk-weighted assets as the denominator. Tier 1 capital consists primarily of common equity less goodwill and certain other intangible assets. Total capital adds certain qualifying debt instruments and a portion of the allowance for loan losses to Tier 1 capital. One of four risk weights, primarily based on credit risk, is applied to both on and off-balance sheet assets to determine the asset denominator. Under Federal Reserve Bank rules, the Bank was considered “well capitalized,” the highest category of capitalization defined by the regulators, as of September 30, 2004.

In order to maintain a strong equity capital position and to protect against the risks of loss in the investment and loan portfolios and on other assets, management will continue to monitor the Company’s capital position. Several measures have been or will be employed to maintain the strong capital position, including but not limited to continuing its efforts to return all non-performing assets to performing status, monitoring the Bank’s growth, and continued utilization of its formal asset/liability policy.

14

Cash Dividend

In compliance with the Company’s dividend payout policy, on February 27, 2004, May 24, 2004 and August 31, 2004 the Company paid a cash dividend of 5 cents per share, totaling $96.4 thousand, $98.6 thousand and $100.1 thousand, respectively. Management has increased its dividends paid out to its shareholders in order to share in the Company’s record earnings. Total dividends of 15 cents per share paid during the first nine months of 2004 are a 25.0% increase over the 12 cents total dividends paid during the same time period in 2003.

Interest Sensitivity and Liquidity

The Company’s primary component of market risk is interest rate volatility. Fluctuations in interest rates will impact both the level of interest income and interest expense and the market value of the Company’s interest earning assets and interest bearing liabilities.

The Company’s Asset/Liability Management Committee (ALCO) is responsible for formulating liquidity strategies, monitoring performance based on established objectives and approving new liquidity initiatives. ALCO’s overall objective is to optimize net interest income within the constraints of prudent capital adequacy, liquidity needs, the interest rate and economic outlook, market opportunities, and customer requirements. General strategies to accomplish this objective include maintaining a strong balance sheet, achieving solid core deposit growth, taking on manageable interest rate risk, and adhering to conservative financial management on a daily basis. These strategies are monitored regularly by ALCO and reviewed periodically with the Board of Directors.

The primary goal of the Company’s asset/liability management strategy is to maximize its net interest income over time while keeping interest rate risk exposure within levels established by the Company’s management. The Company’s ability to manage its interest rate risk depends generally on the Company’s ability to match the maturities and repricing characteristics of its assets and liabilities while taking into account the separate goals of maintaining asset quality and liquidity and achieving the desired level of net interest income. The principal variables that affect the Company’s management of its interest rate risk include the Company’s existing interest rate gap position, management’s assessment of future interest rates, and the withdrawal of liabilities over time.

The Company’s primary technique for managing its interest rate risk exposure is the management of the Company’s interest sensitivity gap. The interest sensitivity gap is defined as the difference between the amount of interest earning assets anticipated, based upon certain assumptions, to mature or reprice within a specific time period and the amount of interest bearing liabilities anticipated, based upon certain assumptions, to mature or reprice within that time period. At September 30, 2004, the Company’s one year “negative gap” (interest bearing liabilities maturing or repricing within the same period exceed interest earning assets maturing or repricing within the same period) was approximately ($1.0) million, or (.30%) of total assets. At December 31, 2003, the Company’s one year “positive gap” was approximately $6.3 million, or 1.99% of total assets.

The following tables set forth the amount of interest earning assets and interest bearing liabilities outstanding at September 30, 2004 and December 31, 2003 that are subject to re-pricing or that mature in each of the future time periods shown. Loans and securities with call or balloon provisions are included in the period in which they balloon or may first be called. Except as stated above, the amount of assets and liabilities shown that re-price or mature during a particular period were determined in accordance with the contractual terms of the asset or liability.

15

Interest Rate Sensitivity Analysis

	September 30, 2004
(in thousands)	Within 90 Days			91 Days to One Year			After One but Within Five Years			After Five Years			Total
Interest Earning Assets:
Investment securities	$	2,606		$	2,439		$	220		$	2,847		$	8,112
Federal Home Loan Bank and Federal Reserve Bank stock		—			—			—			3,105			3,105
Loans held for sale		28,798			—			—			—			28,798
Loans		107,474			14,441			88,983			79,989			290,887
Interest bearing deposits in banks		197			—			—			—			197
Federal Funds Sold		478			—			—			—			478
Total	$	139,553		$	16,880		$	89,203		$	85,941		$	331,577
Cumulative totals		139,553			156,433			245,636			331,577
Interest Bearing Liabilities
Deposits:
Demand	$	36,848		$	—		$	—		$	—		$	36,848
Savings		9,137			—			—			—			9,137
Time deposits, $100,000 and over		3,995			14,573			30,231			5,086			53,885
Other time deposits		8,034			29,241			79,176			3,115			119,566
Short-term borrowings		55,215			—			—			—			55,215
Long-term debt		403			10			32			—			445
Convertible preferred securities		—			—			—			5,365			5,365
Total	$	113,632		$	43,824		$	109,439		$	13,566		$	280,461
Cumulative totals		113,632			157,456			266,895			280,461
Interest sensitivity gap	$	25,921		$	(26,944	)	$	(20,236	)	$	72,375		$	51,116
Cumulative interest sensitivity gap	$	25,921		$	(1,023	)	$	(21,259	)	$	51,116
Cumulative interest sensitivity gap as a percentage of total assets		7.58	%		(0.30	)%		(6.22	)%		14.94	%

16

Interest Rate Sensitivity Analysis

	December 31, 2003
(in thousands)	Within 90 Days			91 Days to One Year			After One but Within Five Years			After Five Years			Total
Interest Earning Assets:
Investment securities	$	2,231		$	15		$	2,559		$	7,626		$	12,431
Federal Home Loan Bank and Federal Reserve Bank stock		—			—			—			2,398			2,398
Loans held for sale		56,132			—			—			—			56,132
Loans		72,860			15,271			73,376			69,444			230,951
Interest bearing deposits		134			—			—			—			134
Federal funds sold		341			—			—			—			341
Total	$	131,698		$	15,286		$	75,935		$	79,468		$	302,387
Cumulative totals		131,698			146,984			222,919			302,387
Interest Bearing Liabilities
Deposits:
Demand	$	33,730		$	—		$	—		$	—		$	33,730
Savings		7,997			—			—			—			7,997
Time deposits, $100,000 and over		1,393			15,388			31,051			—			47,832
Other time deposits		4,454			40,264			84,406			—			129,124
Short-term borrowing		37,004			—			—			—			37,004
Long-term debt		426			—			—			—			426
Convertible preferred securities		—			—			—			6,025			6,025
Total	$	85,004		$	55,652		$	115,457		$	6,025		$	262,138
Cumulative totals		85,004			140,656			256,113			262,138
Interest sensitivity gap	$	46,694		$	(40,366	)	$	(39,522	)	$	73,443		$	40,249
Cumulative interest sensitivity gap	$	46,694		$	6,328		$	(33,194	)	$	40,249
Cumulative interest sensitivity gap as a percentage of total assets		14.67	%		1.99	%		(10.43	)%		12.65	%

17

Item 3. Controls and Procedures

(a) As of September 30, 2004, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-15 (e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s Exchange Act filings.

(b) There have been no significant changes in the Company’s internal controls or in other factors which could significantly affect its internal controls subsequent to the date the Company carried out its evaluation.

18

Part II. OTHER INFORMATION

Item 1. Legal proceedings

As of September 30, 2004, there were no significant legal proceedings against the Company.

Item 2. Changes in securities

There were no changes in the Company’s securities during the quarter.

Item 3. Defaults upon senior securities

There were no defaults upon senior securities during the quarter.

Item 4. Submission of matters to a vote of security holders

There was no submission of matters to a vote of security holders during the quarter.

Item 5. Other information

None.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

31.1 Certification of CEO pursuant to Rule 13a-14(a).

31.2 Certification of Principal Financial Officer pursuant to Rule 13a-14(a).

32.1 Certification of CEO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2 Certification of Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b) Report on Form 8-K

Form 8K – filed July 16, 2004, announcing the acquisition of Community Home Mortgage of Virginia, Inc., is incorporated herein by reference.

Form 8K – filed July 27, 2004, related to the declaration of a dividend payable during the third quarter of 2004, is incorporated herein by reference.

Form 8K – filed August 12, 2004, related to the earnings release for the second quarter ended June 30, 2004, is incorporated herein by reference.

Form 8K – filed October 14, 2004, announcing the completion of a $15 million private placement of its common stock, is incorporated herein by reference.

19

SIGNATURES

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

	Commonwealth Bankshares, Inc.
	(Registrant)
Date: November 12, 2004	by:	/s/ E.J. Woodard, Jr., CLBB
		E. J. Woodard, Jr., CLBB
		Chairman of the Board,
		President and Chief Executive Officer
Date: November 12, 2004	by:	/s/ Cynthia A. Sabol, CPA
		Cynthia A. Sabol, CPA
		Executive Vice President,
		& Chief Financial Officer

20

EX-31.1

Exhibit 31.1

CERTIFICATION

I, Edward J. Woodard, Jr., CLBB, Chairman of the Board, President, and Chief Executive Officer certify that:

1. I have reviewed this quarterly report on Form 10-QSB of Commonwealth Bankshares, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(A) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

(B) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and

(C) Disclosed in this quarterly report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors:

(A) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(B) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: November 12, 2004	/s/ E. J. Woodard, Jr., CLBB
	E. J. Woodard, Jr., CLBB,
	Chairman of the Board,
	President & CEO

1

EX-31.2

Exhibit 31.2

CERTIFICATION

I, Cynthia A. Sabol, Executive Vice President and Chief Financial Officer certify that:

1. I have reviewed this quarterly report on Form 10-QSB of Commonwealth Bankshares, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(A) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

(B) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and

(C) Disclosed in this quarterly report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors:

(A) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(B) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: November 12, 2004	/s/ Cynthia A. Sabol, CPA
	Cynthia A. Sabol, CPA,
	Executive Vice President,
	Chief Financial Officer

1

EX-32.1

Exhibit 32.1

Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, the Company’s Chief Executive Officer certifies as follows:

(a) This report on Form 10-QSB fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934.

(b) The information contained in this Report on Form 10-QSB fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: November 12, 2004	/s/ E. J. Woodard, Jr., CLBB
	E. J. Woodard, Jr., CLBB,
	Chairman of the Board,
	President & CEO

1

EX-32.2

Exhibit 32.2

Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, the Company’s Chief Financial Officer certifies as follows:

(a) This report on Form 10-QSB fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934.

(b) The information contained in this Report on Form 10-QSB fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: November 12, 2004	/s/ Cynthia A. Sabol, CPA
	Cynthia A. Sabol, CPA,
	Executive Vice President,
	Chief Financial Officer

1