Consolidated Financial Statements

EX-99.1 8 dex991.htm CONSOLIDATED FINANCIAL STATEMENTS Consolidated Financial Statements

Exhibit 99.1

Commonwealth Bankshares, Inc.

List of Financial Statements

The following consolidated financial statements of Commonwealth Bankshares, Inc. and subsidiaries are included:


		Page
•	Report of Independent Registered Public Accounting Firm	1

•	Consolidated Balance Sheets - December 31, 2005 and 2004	2

•	Consolidated Statements of Income - Years Ended December 31, 2005, 2004 and 2003	3

•	Consolidated Statements of Stockholders’ Equity - Years Ended December 31, 2005, 2004 and 2003	4

•	Consolidated Statements of Cash Flows - Years Ended December 31, 2005, 2004 and 2003	5

•	Notes to Consolidated Financial Statements - December 31, 2005, 2004 and 2003	6 - 25

Schedules to the consolidated financial statements required by Article 9 of Regulations S-X are not required under the related instructions or are inapplicable, and therefore have been omitted.

Report of Independent Registered Public Accounting Firm

Board of Directors

Commonwealth Bankshares, Inc.

Norfolk, Virginia

We have audited the accompanying consolidated balance sheets of Commonwealth Bankshares, Inc. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Commonwealth Bankshares, Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America.

/s/ PKF Witt Mares, PLC

Norfolk, Virginia

February 17, 2006

Commonwealth Bankshares, Inc.

Consolidated Balance Sheets

December 31, 2005 and 2004


	2005			2004
Assets

Cash and cash equivalents:
Cash and due from banks	$	11,895,510		$	8,330,545
Interest bearing deposits in banks		541,427			195,729
Federal funds sold		1,158,874			419,867

Total cash and cash equivalents		13,595,811			8,946,141

Investment securities:
Available for sale, at fair market value		8,394,193			6,370,932
Held to maturity, at amortized cost (fair market value was $538,131 and $592,019, respectively)		529,630			574,199

		8,923,823			6,945,131

Equity securities, restricted, at cost		5,327,400			3,617,600
Loans held for sale		—			31,106,533

Loans		508,903,377			315,754,561
Allowance for loan losses		(5,523,087	)		(2,839,315	)

Loans, net		503,380,290			312,915,246

Premises and equipment, net		8,155,332			5,141,006
Deferred tax assets		3,171,586			1,749,396
Accrued interest receivable		3,144,721			1,692,975
Other assets		3,755,375			1,946,757

	$	549,454,338		$	374,060,785

Liabilities and Stockholders’ Equity

Liabilities:
Deposits:
Noninterest-bearing demand deposits	$	41,999,286		$	38,145,358
Interest-bearing		341,890,635			239,486,894

Total deposits		383,889,921			277,632,252

Short-term borrowings		65,604,000			44,139,750
Long-term debt		5,383,394			5,441,656
Junior subordinated debt securities		4,925,379			5,237,255
Trust preferred capital notes		20,619,000			—
Accrued interest payable		1,296,920			803,289
Other liabilities		5,005,705			3,782,434

Total liabilities		486,724,319			337,036,636

Stockholders’ Equity:
Common stock, par value $2.50, 15,000,000 shares authorized; 4,073,547 and 2,984,794 shares issued and outstanding in 2005 and 2004, respectively		10,183,868			7,461,986
Additional paid-in capital		36,479,909			19,321,813
Retained earnings		16,071,813			10,187,132
Accumulated other comprehensive income (loss)		(5,571	)		53,218

Total stockholders’ equity		62,730,019			37,024,149

	$	549,454,338		$	374,060,785

See accompanying notes to the consolidated financial statements.

Commonwealth Bankshares, Inc.

Consolidated Statements of Income

Years Ended December 31, 2005, 2004 and 2003


	2005			2004		2003
Interest and dividend income:
Loans, including fees	$	33,752,053		$	21,382,824	$	18,520,947
Investment securities:
Taxable		204,208			306,417		470,348
Tax exempt		72,815			138,686		224,209
Dividend income, equity securities, restricted		209,068			91,136		119,009
Other interest income		50,422			37,497		29,733

Total interest income		34,288,566			21,956,560		19,364,246

Interest expense:
Deposits		9,899,218			7,568,202		7,696,596
Federal funds purchased		3,980			3,403		1,295
Federal Home Loan Bank		2,106,975			590,815		128,655
Junior subordinated debt securities		408,199			437,563		542,791
Trust preferred capital notes		107,648			—		—
Long-term debt		215,742			24,843		10,041

Total interest expense		12,741,762			8,624,826		8,379,378

Net interest income		21,546,804			13,331,734		10,984,868

Provision for loan losses		2,740,000			1,695,000		524,797

Net interest income after provision for loan losses		18,806,804			11,636,734		10,460,071

Noninterest income:
Service charges on deposit accounts		1,150,049			1,066,418		894,238
Other service charges and fees		548,063			577,591		515,164
Mortgage brokerage income		1,563,756			776,804		—
Title insurance income		303,386			—		—
Investment service income		32,367			—		—
Gain on sale / call of investment securities		—			490,699		—
Other		295,176			156,281		268,506

Total noninterest income		3,892,797			3,067,793		1,677,908

Noninterest expense:
Salaries and employee benefits		6,827,758			5,163,932		4,069,620
Net occupancy expense		1,057,557			923,469		919,568
Furniture and equipment expense		1,191,822			1,052,182		1,151,240
Other operating expense		3,560,318			2,957,904		2,251,732

Total noninterest expense		12,637,455			10,097,487		8,392,160

Income before provision for income taxes and noncontrolling interest		10,062,146			4,607,040		3,745,819

Provision for income taxes		3,418,867			1,505,831		1,203,328

Income before noncontrolling interest		6,643,279			3,101,209		2,542,491

Noncontrolling interest in subsidiary		(8,971	)		—		—

Net income	$	6,634,308		$	3,101,209	$	2,542,491

Earnings per share:
Basic	$	1.86		$	1.42	$	1.44

Diluted	$	1.65		$	1.16	$	1.03

See accompanying notes to the consolidated financial statements.

Commonwealth Bankshares, Inc.

Consolidated Statements of Stockholders’ Equity

Years Ended December 31, 2005, 2004 and 2003


	Common Shares	Common Amount		Additional Paid-in Capital		Retained Earnings			Accumulated Other Comprehensive Income (loss)			Total
Balance, January 1, 2003	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 - $.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	—		—		—		3,101,209			—			3,101,209
Change in unrealized gains on securities available for sale, net of tax effect	—		—		—		—			(339,745	)		(339,745	)

Total comprehensive income													2,761,464

Issuance of common stock	153,127		382,818		903,841		—			—			1,286,659
Issuance of common stock through private placement	943,396		2,358,490		11,870,493		—			—			14,228,983
Cash dividends - $.20 per share	—		—		—		(443,522	)		—			(443,522	)

Balance, December 31, 2004	2,984,794	$	7,461,986	$	19,321,813	$	10,187,132		$	53,218		$	37,024,149
Comprehensive income:
Net income	—		—		—		6,634,308			—			6,634,308
Change in unrealized gains on securities available for sale, net of tax effect	—		—		—		—			(58,789	)		(58,789	)

Total comprehensive income													6,575,519

Issuance of common stock	121,744		304,360		1,049,696		—			—			1,354,056
Issuance of common stock through private placement	967,009		2,417,522		16,108,400		—			—			18,525,922
Cash dividends - $0.21 per share	—		—		—		(749,627	)		—			(749,627	)

Balance, December 31, 2005	4,073,547	$	10,183,868	$	36,479,909	$	16,071,813		$	(5,571	)	$	62,730,019

See accompanying notes to the consolidated financial statements.

Commonwealth Bankshares, Inc.

Consolidated Statements of Cash Flows

Years Ended December 31, 2005, 2004 and 2003


	2005			2004			2003
Operating Activities:
Net income	$	6,634,308		$	3,101,209		$	2,542,491
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Provision for loan losses		2,740,000			1,695,000			524,797
Depreciation and amortization		994,729			925,559			901,592
Gain on sale of loans		—			—			(23,224	)
(Gain) loss on the sale of premises and equipment		(885	)		817			(2,594	)
Net amortization of premiums and accretion of discounts on investment securities		(4,745	)		—			—
Gain on the sale of investment securities available for sale		—			(490,346	)		—
Gain on the call of investment securities held to maturity		—			(353	)		—
Loss on the sale of other real estate owned		—			10,396			2,991
Deferred tax assets		(1,391,905	)		(272,413	)		(221,351	)
Net change in:
Loans held for sale		19,817,033			25,025,603			(28,339,903	)
Accrued interest receivable		(1,451,746	)		(188,214	)		(118,704	)
Other assets		(1,189,618	)		402,300			(257,234	)
Accrued interest payable		493,631			62,853			(141,548	)
Other liabilities		1,586,966			(468,016	)		1,775,577

Net cash provided by (used in) operating activities		28,227,768			29,804,395			(23,357,110	)

Investing Activities:
Purchase of securities available for sale		(4,049,205	)		(6,637,008	)		(4,041,380	)
Purchase of equity securities, restricted		(17,010,925	)		(10,318,050	)		(4,371,750	)
Net purchase of premises and equipment		(4,048,470	)		(727,328	)		(438,999	)
Net expenditures on other real estate owned		—			—			(127,006	)
Net change in loans		(181,877,544	)		(86,194,954	)		(35,031,206	)
Proceeds from:
Calls and maturities of securities held to maturity		52,602			263,153			210,433
Sales and maturities of securities available for sale		1,933,582			11,835,388			7,545,952
Sales of equity securities, restricted		15,301,125			8,888,950			3,154,600
Sale of other real estate owned		—			229,241			—
Sale of premises and equipment		2,300			—			—

Net cash used in investing activities		(189,696,535	)		(82,660,608	)		(33,099,356	)

Financing Activities:
Net change in:
Demand, interest-bearing demand and savings deposits		19,923,074			13,837,238			12,879,206
Time deposits		34,663,595			(1,863,278	)		9,692,437
Brokered time deposits		51,671,000			15,000,000			—
Short-term borrowings		21,464,250			7,136,036			35,115,711
Increase in long-term borrowings		—			5,046,912			—
Proceeds from issuance of trust preferred capital notes		20,000,000			—			—
Principal payments on long term-debt		(58,262	)		(31,752	)		(26,112	)
Dividends reinvested and sale of stock		19,204,407			14,529,597			144,353
Dividends paid		(749,627	)		(443,522	)		(283,598	)

Net cash provided by financing activities		166,118,437			53,211,231			57,521,997

Net increase in cash and cash equivalents		4,649,670			355,018			1,065,531
Cash and cash equivalents, January 1		8,946,141			8,591,123			7,525,592

Cash and cash equivalents, December 31	$	13,595,811		$	8,946,141		$	8,591,123

Supplemental cash flow disclosure:
Interest paid during the year	$	12,248,131		$	8,561,973		$	8,499,931

Income taxes paid during the year	$	4,528,000		$	1,628,731		$	1,581,658

Supplemental noncash disclosure:
Transfer between loans and other real estate owned	$	—		$	—		$	1,285,376

Sale of other real estate owned financed by Bank loans	$	—		$	855,000		$	—

Conversion of convertible preferred securities for common stock	$	537,191		$	788,045		$	1,259,700

Issuance of common stock for acquisition of mortgage company	$	—		$	198,000		$	—

Transfer from loans held for sale to loans	$	11,289,500		$	—		$	—

See accompanying notes to the consolidated financial statements.

Commonwealth Bankshares, Inc.

Notes to Consolidated Financial Statements

December 31, 2005, 2004 and 2003

Note 1.

Summary of Significant Accounting Policies

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. T/A Executive Title Center, BOC Insurance Agencies of Hampton Roads, Inc., Community Home Mortgage of Virginia Inc. T/A Bank of the Commonwealth Mortgage and Commonwealth Financial Advisors, LLC, are in accordance with accounting principles generally accepted in the United States of America and conform to accepted practices within the banking industry. A summary of significant accounting policies is briefly described below.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of the Parent, the Bank and its subsidiaries, collectively referred to as “the Company”. All significant intercompany balances and transactions have been eliminated in consolidation. FASB Interpretation No. 46 (R) requires that the company no longer consolidate Commonwealth Bankshares Capital Trust I. The junior subordinated debt of the Trust is reflected as a liability of the company.

Nature of Operations

The Bank operates under a state bank charter and provides full banking services, including trust services. As a state bank, the Bank is subject to regulation by the Virginia State Corporation Commission-Bureau of Financial Institutions and the Federal Reserve System. The Bank serves Norfolk, Virginia Beach, Chesapeake and Portsmouth, Virginia through its ten banking offices.

Cash and Cash Equivalents

For purposes of the consolidated statements of cash flows, cash and cash equivalents includes cash and due from banks, interest bearing deposits in banks and federal funds sold.

Restrictions on Cash and Due from Bank Accounts

The Company is required to maintain average reserve balances in cash with the Federal Reserve Bank (FRB). Required reserves were $1,603,000 and $307,000 for December 31, 2005 and 2004, respectively.

Investment Securities

Investment securities which the Company intends to hold until maturity or until called are classified as held to maturity. These investment securities are stated at cost, adjusted for amortization of premiums and accretion of discounts.

Investment securities which the Company intends to hold for indefinite periods of time, including investment securities used as part of the Company’s asset/liability management strategy, are classified as available for sale. These investment securities are carried at fair value. Net unrealized gains and losses, net of deferred income taxes, are excluded from earnings and reported as accumulated other comprehensive income (loss).

Gains and losses on the sale of investment securities are determined using the specific identification method.

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 (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

Equity Securities, Restricted

The Company, as a member of the Federal Home Loan Bank (“FHLB”) of Atlanta, is required to hold shares of capital stock in the FHLB in an amount equal to at least 0.20% of the members total assets plus 4.50% of the members outstanding advances.

As a member of the Federal Reserve Bank (“FRB”), the Company is required to hold shares of FRB capital stock, $100 par value, in an amount equal to 6% of the Company’s total common stock and capital surplus.

FHLB stock and FRB stock are carried at cost.

Loans Held for Sale

Loans held for sale consist primarily of mortgage loans in the process of being sold to third-party investors. The loans are carried at the lower of aggregate cost or fair value as determined by aggregate outstanding commitments from investors or current investor yield requirements.

Loans

The Company offers an array of lending and credit services to customers including mortgage, commercial and consumer loans. Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are stated at their outstanding unpaid principal balance net of any deferred fees or costs on originated loans, or unamortized premiums or discounts on purchased loans. Interest income is accrued on the unpaid principal balance. Discounts and premiums are amortized to income using the interest method. Loan origination fees, net of origination costs, are deferred and recognized as an adjustment to the yield (interest income) of the related loans.

Allowance for Loan Losses

A loan is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.

The adequacy of the allowance for loan losses is periodically evaluated by the Company, in order to maintain the allowance at a level that is sufficient to absorb probable credit losses. The allowance is comprised of a general allowance, specific allowance for identified problem loans and an unallocated allowance representing estimations done pursuant to either Standard of Financial Accounting Standards (SFAS) No. 5 “Accounting for Contingencies,” or SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” The specific component relates to loans that are classified as either doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of the loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. Such qualitative factors management considers are the known and inherent risks in the loan portfolio, including adverse circumstances that may affect the ability of the borrower to repay interest and/or principal, the estimated value of collateral, and an analysis of the levels and trends of delinquencies, charge-offs, level of concentrations within the portfolio, and the risk ratings of the various loan categories. Such factors as the level and trend of interest rates and the condition of the national and local economies are also considered. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for losses on loans. Such agencies may require the Company to recognize additions to the allowance based on their judgments of information available to them at the time of their examination.

The allowance for loan losses is established through charges to earnings in the form of a provision for loan losses. Increases and decreases in the allowance due to changes in the measurement of impaired loans, if applicable, are included in the provision for loan losses. Loans continue to be classified as impaired unless they are brought fully current and the collection of scheduled interest and principal is considered probable.

When a loan or portion of a loan is determined to be uncollectible, the portion deemed uncollectible is charged against the allowance. Subsequent recoveries, if any, are credited to the allowance.

Income Recognition on Impaired and Nonaccrual Loans

Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 120 days, unless such loans are well-secured and in the process of collection. If a loan or a portion of a loan is adversely classified, or is partially charged off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual, if repayment in full of principal and/or interest is in doubt.

Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance by the borrower, in accordance with the contractual terms of interest and principal.

While a loan is classified as nonaccrual and the future collectibility of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan has been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Cash interest receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered.

Premises and Equipment

Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed generally by the straight-line method for financial reporting purposes. Depreciation for tax purposes is computed based on accelerated methods. It is the Company’s policy for maintenance and repairs to be charged to expense as incurred and to capitalize major additions and improvements and depreciate the cost thereof over the estimated useful lives as follows:


Buildings and improvements		5 to 40 years
Furniture and equipment		3 to 15 years

Upon sale or retirement of depreciable properties, the cost and related accumulated depreciation are netted against proceeds and any resulting gain or loss is reflected in income.

Other Real Estate Owned

Other real estate owned is stated at the lower of cost or estimated fair market value of the property, less estimated disposal costs, if any. Cost includes loan principal and accrued interest. Any excess of cost over the estimated fair market value at the time of acquisition is charged to the allowance for loan losses. The estimated fair market value is reviewed periodically by management and any write-downs are charged against current earnings. Development and improvement costs relating to property are capitalized. Net operating income or expenses of such properties are included in other operating expenses.

Advertising Costs

The Company practices the policy of charging advertising costs to expense as incurred. Advertising expense totaled $834,276, $498,377 and $187,408 for the three years ended December 31, 2005, 2004 and 2003, respectively.

Income Taxes

Deferred income tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws on rates are enacted, deferred income tax assets and liabilities are adjusted through the provision for income taxes.

Stock Compensation Plans

At December 31, 2005, the Company has four stock-based compensation plans, which are described more fully in item 11 and Note 20. The Company accounts for those plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based compensation cost is reflected in net income, as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share for the year ended December 31, 2005, if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based compensation. The impact to compensation expense would not have been material for the years ended December 31, 2004 and 2003, had it been applied.


*(in thousands, except per share data)*	2005
Net income, as reported	$	6,634
Total stock-based compensation expense determined under fair value based method for all awards, (net of tax)		(976	)

Pro forma net income	$	5,658

Earnings per share:
Basic – as reported	$	1.86
Basic – pro forma	$	1.59
Diluted – as reported	$	1.65
Diluted – pro forma	$	1.42

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:


	2005
Expected life (years)		10
Annual Dividend paid	$	0.24
Dividend growth rate		20.00	%
Expected volatility		14.74	%
Risk-free interest rate		4.38	%

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, Share-Based Payment, that addresses the accounting for share-based payment transactions in which a company receives employee services in exchange for either equity instruments of the company or liabilities that are based on the fair value of the company’s equity instruments or that may be settled by the issuance of such equity instruments. SFAS No. 123R eliminates the ability to account for share-based compensation transactions using the intrinsic method and requires that such transactions be accounted for using a fair-value based method and recognized as expense in the consolidated statement of income. The effective date of SFAS No. 123R (as amended by the SEC) is for annual periods beginning after June 15, 2005. The provisions of SFAS No. 123R do not have an impact on the Company’s results of operations at the present time.

Option valuation models require the input of highly subjective assumptions. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a representative single measure of the fair value at which transactions may occur.

Fair Value of Financial Instruments

The carrying value of cash and cash equivalents, interest bearing deposits in banks, loans held for sale, accrued interest receivable, demand deposits, savings deposits, and short-term borrowings approximates fair value. The fair value of securities is based on quoted market prices. The remainder of the recorded financial instruments were valued based on the present value of estimated future cash flows, discounted at various rates in effect for similar instruments at year-end.

Fair values for off-balance sheet lending commitments approximate the contract or notional value taking into account the remaining terms of the agreements and the counterparties’ credit standings.

Per Share Data

Basic earnings per share is computed by dividing net income by the weighted average number of shares of common stock outstanding. Diluted earnings per share is computed by dividing net income by the weighted average common and potential dilutive common equivalent shares outstanding, determined as follows:


	2005		2004		2003
Earnings available to common shareholders	$	6,634,308	$	3,101,209	$	2,542,491
Weighted average shares outstanding		3,562,739		2,181,915		1,771,556

Basic earnings per common share	$	1.86	$	1.42	$	1.44

Effect of dilutive securities:
Earnings available to common shareholders	$	6,634,308	$	3,101,209	$	2,542,491
Convertible preferred securities interest net of tax effect		255,402		288,577		358,242

Earnings available to common plus assumed conversions	$	6,889,710	$	3,389,786	$	2,900,733

Effect of dilutive securities on EPS:
Weighted average shares outstanding		3,562,739		2,181,915		1,771,556
Effect of stock options		5,090		54,428		188,126
Effect of convertible preferred securities		610,307		693,499		865,020

Diluted average shares outstanding		4,178,136		2,929,842		2,824,702

Diluted earnings per common share	$	1.65	$	1.16	$	1.03

Segment Information

The Company has determined that it has one significant operating segment, the providing of general commercial financial services to customers located in the single geographic area of Hampton Roads, Virginia, and surrounding communities.

Comprehensive Income

SFAS No. 130, Reporting Comprehensive Income, establishes standards for the reporting and presentation of comprehensive income and its components (revenues, expenses, gains and losses) within the Company’s consolidated financial statements. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income.

Off-Balance Sheet Financial Instruments

In the ordinary course of business, the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit, commercial letters of credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they become payable.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results could differ from those estimates. A material estimate that is particularly susceptible to significant change in the near term relates to the determination of the allowance for loan losses.

Intangible Assets

Intangible assets include a non-compete agreement obtained through the acquisition of Community Home Mortgage of Virginia, Inc. The non-compete is included in other assets and is being amortized on a straight-line basis over the period of expected benefit, which is one year. Non-compete, net of amortization, amounted to $0 and $29,167 at December 31, 2005 and 2004, respectively.

Goodwill

In June 2001, FASB issued Statement of Financial Accounting Standard (SFAS) No. 141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations. Additionally, it further clarifies the criteria for the initial recognition and measurement of intangible assets separate from goodwill. SFAS No. 142 prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. The provisions of SFAS No. 142 discontinue the amortization of goodwill and intangible assets with indefinite lives. Instead, these assets will be subject to at least an annual impairment review, and more frequently if certain impairment indicators are evident.

Goodwill is included in other assets and totaled $249,480 at December 31, 2005 and 2004, respectively. Goodwill is not amortized, but instead tested for impairment at least annually. Based on the testing, there were no impairment charges in 2005 or 2004.

Recent Accounting Pronouncements

In November 2005, FASB Staff Position (“FSP”) 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, was issued. The guidance in FSP 115-1 amends SFAS No. 115 and APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. FSP 115-1 applies to investments in debt and equity securities and cost-method investments. The application guidance within FSP 115-1 includes items to consider in determining whether an investment is impaired, evaluating if an impairment is other-than-temporary and recognizing impairment losses equal to the difference between the investment’s cost and its fair value when an impairment is determined. FSP 115-1 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP 115-1 is required for all reporting periods beginning after December 15, 2005. Earlier application is permitted. The Company does not anticipate that FSP 115-1 will have a material effect on its financial statements.

In May 2005, FASB issued SFAS No. 154, Accounting Changes and Error Corrections- A Replacement of APB Opinion No. 20 and FASB Statement No. 3. The new standard changes the requirements for the accounting for and reporting of a change in accounting principle. Among other changes, SFAS No. 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. SFAS No. 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle and (2) correction of errors in previously issued financial statements should be termed a “restatement.” The new standard is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company does not anticipate that SFAS No. 154 will have a material effect on its financial statements.

In December 2004, FASB issued SFAS No. 123 (Revised 2004), Share-Based Payments (“SFAS No. 123(R)”). The new pronouncement replaces the existing requirements under SFAS No. 123 and Accounting Principals Board Opinion No. 25 (“APB Opinion No. 25”). According to SFAS No. 123(R), all forms of share-based payments to employees, including employee stock options and employee stock purchase plans, would be treated the same as any other form of compensation by recognizing the related cost in the statement of operations. This pronouncement eliminates the ability to account for stock-based compensation transactions using APB Opinion No. 25 and generally would require that such transactions be accounted for using a fair-value based method. For public companies, the FASB has determined that SFAS No. 123(R) is effective for awards and stock options granted, modified or settled in cash in interim or annual periods beginning after June 15, 2005. However, the Securities and Exchange Commission in release 33-8568 delayed the effective date for applying SFAS No. 123 (R) until January 1, 2006. SFAS No. 123(R) provides transition alternatives for public companies to restate prior interim periods or prior years. The Company expects to adopt the new standard as of its effective date. The final impact to compensation expense will be dependent on the number of equity instruments granted during any year, including their timing and vesting period, and the method used to calculate the fair value of the awards, among other factors.

In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer. SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities acquired in a transfer if those differences are attributable, at least in part, to credit quality. It includes loans purchased by the Company or acquired in business combinations. SOP 03-3 does not apply to loans originated by the Company. The Company adopted the provisions of SOP 03-3 effective January 1, 2005. The initial implementation had no material effect on the Company’s financial statements.

Reclassifications

Certain prior year amounts have been reclassified to conform to the 2005 presentation. These reclassifications have no effect on previously reported net income.

Note 2.

Acquisition

On July 13, 2004, the Company acquired Community Home Mortgage of Virginia, Inc. Community Home Mortgage of Virginia, Inc. is a mortgage brokerage firm that originates, processes and sells residential mortgages on a servicing released basis throughout Virginia and Maryland. Under the terms of the acquisition, the outstanding shares of Community Home Mortgage of Virginia, Inc.’s common stock were purchased for 11,820 shares of the Company’s common stock. In addition, Community Home Mortgage of Virginia, Inc. has entered into a one year non-compete agreement with both of its executive officers totaling $50,000.

The transaction was accounted for using the purchase method of accounting. The results of operations are included in the financial statements from the date of acquisition. The entire amount of goodwill, $249,480, resulting from this acquisition is expected to be deductible for tax purposes.

The acquisition of Community Home Mortgage of Virginia, Inc. is not considered to be a significant business combination for the Company. Therefore, no proforma effects of the acquisition are presented.

Note 3.

Concentrations of Credit Risk

At December 31, 2005, the Company’s cash and due from banks included two commercial bank deposit accounts aggregating $1,417,860 and $830,321 in excess of the Federal Deposit Insurance Corporation (FDIC) insured limit of $100,000 per institution.

Note 4.

Investment Securities

The amortized costs and fair values of investment securities are as follows:


	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
December 31, 2005

Available for sale:
U.S. Government and agency securities	$	6,009,424	$	3,501	$	(27,673	)	$	5,985,252
Mortgage-backed securities		1,093,497		4,219		(12,770	)		1,084,946
State and municipal securities		1,299,712		24,283		—			1,323,995

	$	8,402,633	$	32,003	$	(40,443	)	$	8,394,193

Held to maturity:
Mortgage-backed securities	$	357,610	$	543	$	(1,180	)	$	356,973
State and municipal securities		172,020		9,138		—			181,158

	$	529,630	$	9,681	$	(1,180	)	$	538,131

December 31, 2004

Available for sale:
U.S. Government and agency securities	$	3,009,891	$	9,000	$	(5	)	$	3,018,886
Mortgage-backed securities		1,473,523		13,178		—			1,486,701
State and municipal securities		1,556,885		66,685		—			1,623,570
Equities and other bonds		250,000		—		(8,225	)		241,775

	$	6,290,299	$	88,863	$	(8,230	)	$	6,370,932

Held to maturity:
Mortgage-backed securities	$	411,090	$	1,041	$	—		$	412,131
State and municipal securities		163,109		16,779		—			179,888

	$	574,199	$	17,820	$	—		$	592,019

Information pertaining to securities with gross unrealized losses at December 31, 2005 and 2004, aggregated by investment category and length of time that the individual securities have been in a continuous loss position, follows:


	Less Than 12 Months				12 Months or More				Total
	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
December 31, 2005
U.S. Government and agency securities	$	996,501	$	13,426	$	985,700	$	14,247	$	1,982,201	$	27,673
Mortgage-backed securities		386,814		2,290		479,403		10,480		866,217		12,770
State and municipal securities		—		—		—		—		—		—

Total temporarily impaired securities	$	1,383,315	$	15,716	$	1,465,103	$	24,727	$	2,848,418	$	40,443


	Less Than 12 Months				12 Months or More				Total
	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
December 31, 2004
U.S. Government and agency securities	$	9,972	$	5	$	—	$	—	$	9,972	$	5
Mortgage-backed securities		—		—		—		—		—		—
State and municipal securities		—		—		—		—		—		—
Equities and other bonds		—		—		241,775		8,225		241,775		8,225

Total temporarily impaired securities	$	9,972	$	5	$	241,775	$	8,225	$	251,747	$	8,230

The unrealized loss positions at December 31, 2005 were directly related to interest rate movements as there is minimal credit risk exposure in these investments. All securities are investment grade or better. Bonds with unrealized loss positions at December 31, 2005 included 3 federal agencies, 1 U.S. Treasury security and 15 mortgage backed securities.

No impairment has been recognized on any securities in a loss position because of management’s intent and demonstrated ability to hold securities to scheduled maturity or call dates.

A maturity schedule of investment securities as of December 31, 2005 is as follows:


	Available for Sale				Held to Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Due:
In one year or less	$	509,928	$	504,651	$	—	$	—
After one year through five years		5,986,035		5,975,916		172,020		181,158
After five years through ten years		813,173		828,680		—		—
After ten years		—		—		—		—

		7,309,136		7,309,247		172,020		181,158
Mortgage-backed securities		1,093,497		1,084,946		357,610		356,973

	$	8,402,633	$	8,394,193	$	529,630	$	538,131

At December 31, 2005 and 2004, the Company had investment securities with carrying values of $3,341,679 and $3,583,419, respectively, pledged to secure public deposits, $54,758 and $0, respectively, pledged to secure treasury, tax and loan deposits, $1,363,320 and $2,811,722, respectively, pledged to secure FHLB borrowings and $130,000 and $386,490, respectively, pledged to secure FRB borrowings. At December 31, 2005 and 2004, the Company had investment securities with carrying values of $9,927 and $9,977, respectively, pledged to secure a debtor in possession deposit.

Note 5.

Loans

Major classifications of loans at December 31, 2005 and 2004 were:


	2005			2004
Construction and development	$	103,090,975		$	20,912,504
Commercial		51,895,643			45,421,914
Commercial mortgage		257,204,304			187,934,731
Residential mortgage		86,353,111			51,320,177
Installment loans to individuals		11,596,862			10,574,566
Other		659,231			1,057,303

Gross loans		510,800,126			317,221,195
Unearned income		(1,896,749	)		(1,466,634	)
Allowance for loan losses		(5,523,087	)		(2,839,315	)

Loans, net	$	503,380,290		$	312,915,246

A summary of transactions in the allowance for loan losses for the years ended December 31, 2005, 2004 and 2003 were as follows:


	2005			2004			2003
Balance at beginning of year	$	2,839,315		$	2,503,000		$	2,335,000

Provision charged to operating expense		2,740,000			1,695,000			524,797
Loans charged-off		(81,359	)		(1,366,802	)		(369,892	)
Recoveries of loans previously charged-off		25,131			8,117			13,095

Balance at end of year	$	5,523,087		$	2,839,315		$	2,503,000

Accounting standards require certain disclosures concerning impaired loans, as defined by generally accepted accounting principles, regardless of whether or not an impairment loss exists. Impaired loans amount to $964,150, $1,231,070 and $2,845,100, with specific reserves allocated from the allowance for loan losses of $353,888, $401,213 and $1,259,382, as of December 31, 2005, 2004 and 2003, respectively. The average recorded investment in impaired loans was $1,097,610, $2,038,400 and $2,277,744 in 2005, 2004 and 2003, respectively. The Company recognized $4,228, $15,026 and $192,788 of interest income on impaired loans during 2005, 2004 and 2003, respectively. Nonaccrual loans amounted to $119,687, $451,482 and $2,845,100 as of December 31, 2005, 2004 and 2003, respectively, all of which are included in the impaired loans above. There were no loans 90 days past due and still accruing interest at December 31, 2005, 2004 and 2003.

Note 6.

Premises and Equipment

Premises and equipment are summarized as follows:


	December 31,
	2005			2004
Land	$	345,403		$	345,403
Buildings and improvements		3,029,245			3,028,688
Leasehold improvements		2,552,211			789,783
Furniture and equipment		8,779,399			6,766,101
Construction in progress		210,194			26,131

		14,916,452			10,956,106
Less accumulated depreciation		(6,761,120	)		(5,815,100	)

	$	8,155,332		$	5,141,006

Depreciation expense and amortization of leasehold improvements for the years ended December 31, 2005 and 2004 amounted to $994,729 and $925,559, respectively.

Note 7.

Deposits

Interest-bearing deposits consist of the following:


	December 31,
	2005		2004
Demand deposits	$	57,128,872	$	39,809,425
Savings deposits		8,334,688		9,584,989
Time deposits:
Time deposits $100,000 and over		74,863,127		51,109,486
Other time deposits		201,563,948		138,982,994

Total interest-bearing deposits	$	341,890,635	$	239,486,894

At December 31, 2005, the scheduled maturities of time deposits are as follows:


2006	$	80,772,470
2007		49,213,767
2008		54,062,444
2009		31,896,219
2010		22,237,481
Thereafter		38,244,694

	$	276,427,075

Note 8.

Short-Term Borrowings

The Company has a line of credit with the Federal Home Loan Bank with a maximum value of thirty percent of the Bank’s current assets, using a daily rate credit and due on demand. The advances from this line are collateralized by a blanket lien on the Company’s 1-4 family residential mortgages, commercial mortgage loans and multifamily first mortgage loans, with a carrying value of $192.5 million and $158.9 million as of December 31, 2005 and 2004, respectively. In addition, the Company pledged investment securities with a book value of $1.4 million and $2.8 million as of December 31, 2005 and 2004, respectively.


	2005			2004
Weighted average rate		3.46	%		1.82	%
Average balance	$	58,042,153		$	32,142,036
Maximum outstanding at a month-end	$	85,243,100		$	61,166,750
Balance at December 31,	$	65,604,000		$	44,139,750

The Company has an unsecured line of credit with Bank of America, SunTrust and Compass Bank for the purchase of federal funds in the amount of $10,000,000, $10,000,000 and $5,000,000, respectively. Each separate line of credit has a variable rate based on the lending bank’s daily federal funds sold and is due on demand.


	2005			2004
Weighted average rate		3.30	%		1.88	%
Average balance	$	119,726		$	181,626
Maximum outstanding at a month-end	$	—		$	—
Balance at December 31,	$	—		$	—

Note 9.

Long-Term Debt

Long-term debt at December 31, 2005 consists of: advances from the FHLB, which are collateralized by a blanket lien on the Company’s 1-4 family residential mortgages and commercial mortgage loans, and pledged securities; borrowings in the form of an industrial development revenue bond from the Norfolk Redevelopment and Housing Authority to finance the Headquarters of the Company and the Bank; and secured loans with third party financial institutions.

Advances from the FHLB at December 31, 2005 consist of $5,000,000 at a fixed interest rate of 4.02% which matures in December 2009. Outstanding borrowings on the industrial development revenue bond at December 31, 2005 were $374,272, which represents the Bank’s 54.4% ownership interest in the Headquarters property. Those borrowings are due in annual installments at amounts equal to 3.0% of the then outstanding principle balance, which matures in six years. The interest rate on this bond is payable monthly and is equal to 68.6% of the prime rate of SunTrust Bank in Richmond, VA. Secured loans with third party financial institutions consist of one automobile loan assumed through the acquisition of Community Home Mortgage of Virginia, Inc. The outstanding balance as of December 31, 2005 was $9,122. The interest rate on this loan is fixed at 7.5% and matures in two years.

The contractual maturities of long-term debt at December 31, 2005 are as follows:


	Fixed Rate		Floating Rate		Total
2006	$	6,157	$	26,112	$	32,269
2007		2,965		26,112		29,077
2008		—		26,112		26,112
2009		5,000,000		26,112		5,026,112
2010		—		26,112		26,112
Thereafter		—		243,712		243,712

Total long-term debt	$	5,009,122	$	374,272	$	5,383,394

Note 10.

Convertible Preferred Stock

On November 15, 2000, the Parent formed the Trust, a wholly owned subsidiary. The Trust issued 1,457,000 shares of 8.0% cumulative preferred securities maturing October 15, 2031 with an option to call on or after October 15, 2006 (call price of $5.00 per share) for $7,285,000. Conversion of the preferred securities into the Parent’s common stock at $8.00 per share may occur at any time prior to maturity. In 2005, 107,443 shares of the 8.0% cumulative preferred securities were converted to 67,142 shares of the Parent’s common stock. In 2004, 157,609 shares of the 8.0% cumulative preferred securities were converted to 98,498 shares of the Parent’s common stock.

The Trust also issued 45,063 shares of convertible common stock for $225,315. The Parent purchased all shares of the common stock. The proceeds from the sale of the preferred securities were utilized to purchase from the Parent junior subordinated debt securities (guaranteed by the Parent), of $7,510,315 bearing interest at 8.0% and maturing October 15, 2031.

Note 11.

Trust Preferred Capital Securities

On November 30, 2005, $20 million of trust preferred securities were placed through Commonwealth Bankshares Capital Trust II (the “Trust”). The Trust issuer has invested the total proceeds from the sale of the Trust Preferred in Junior Subordinated Deferrable Interest Debentures (the “Junior Subordinated Debentures”) issued by the Company. The trust preferred securities pay cumulative cash distributions quarterly at an annual fixed rate equal to 6.265% through the interest payment date in December 2010 and a variable rate per annum, reset quarterly, equal to LIBOR plus 1.40%, thereafter. The dividends paid to holders of the trust preferred securities, which are recorded as interest expense, are deductible for income tax purposes. The trust preferred securities are redeemable on or after December 30, 2010, in

whole or in part. Redemption is mandatory at December 30, 2040. The Company has fully and unconditionally guaranteed the trust preferred securities through the combined operation of the debentures and other related documents. The Company’s obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness of the Company.

The trust preferred securities may be included in Tier 1 capital for regulatory capital adequacy determination purposes up to 25% of Tier 1 capital after its inclusion. The portion of the securities not considered as Tier 1 capital will be included in Tier 2 capital. At December 31, 2005, $16,114,429 of the trust preferred securities qualified as Tier 1 capital.

Note 12.

Other Operating Expense

A summary of other operating expense for the years ended December 31, 2005, 2004 and 2003 is as follows:


	2005		2004		2003
Stationary and office supplies	$	234,132	$	160,775	$	188,138
Advertising and marketing		834,276		498,377		187,408
Telephone and postage		361,556		323,873		250,189
Professional		141,763		192,773		244,797
Bank franchise tax		362,551		199,261		182,932
Other outside services		575,680		541,691		341,290
Directors’ and advisory board fees		356,679		330,560		232,276
ATM, online banking and bank card expenses		265,037		256,579		232,809
Other		428,644		454,015		391,893

	$	3,560,318	$	2,957,904	$	2,251,732

Note 13.

Employee Benefit Plans

The Company maintains a defined contribution 401(k) profit sharing plan (the “Plan”). The Plan allows for a maximum voluntary salary deferral up to the statutory limitations. All full-time employees who have attained the age of twenty and-a-half and have completed six calendar months of employment with the Company are eligible to participate on the first day of the Plan year after meeting the eligibility requirements. The Plan provides for a matching contribution, which is determined by the Company each year. The Company may also make an additional discretionary contribution. For matching and discretionary employer contributions, an employee is 0% vested from zero to three years of service, 20% after three years, 40% after four years, 60% after five years, 80% after six years, and fully vested after seven years. The amounts charged to expense under this Plan were $125,000, $101,008 and $75,000 in 2005, 2004 and 2003, respectively.

Note 14.

Income Taxes

The current and deferred components of income tax expense are as follows:


	2005			2004
Current	$	4,810,772		$	1,778,319
Deferred		(1,391,905	)		(272,488	)

Provision for income taxes	$	3,418,867		$	1,505,831

A reconciliation between the provision for income taxes and the amount computed by multiplying income by the current statutory 34% federal income tax rate is as follows:


	2005			2004
Income tax expense at statutory rates	$	3,421,130		$	1,566,394
Increase (decrease) due to:
Tax exempt income		(31,508	)		(57,103	)
Nondeductible expenses		31,017			9,663
Other		(1,772	)		(13,123	)

Provision for income taxes	$	3,418,867		$	1,505,831

Deferred income taxes result from timing differences between taxable income and the income for financial reporting purposes. The only significant timing difference relates to the provision for loan losses.

Cumulative net deferred tax assets consist of the following components at December 31, 2005 and 2004:


	December 31,
	2005			2004
Deferred tax assets:
Allowance for loan losses	$	1,645,339		$	752,902
Deferred compensation		844,206			701,838
Accrued compensated absences		427,232			299,438
Deferred loan fees		642,341			491,575
Unrealized loss on securities		2,870			—
Other		13,100			5,909

Total deferred tax assets		3,575,088			2,251,662

Deferred tax liabilities:
Depreciation		(395,019	)		(471,163	)
Unrealized gains on securities		—			(27,415	)
Other		(8,483	)		(3,688	)

Total deferred tax liabilities		(403,502	)		(502,266	)

Net deferred tax asset	$	3,171,586		$	1,749,396

Note 15.

Related Parties Transactions

During the year, officers, directors, principal stockholders, and their affiliates (related parties) were customers of and had transactions with the Company in the ordinary course of business. In management’s opinion, these transactions were made on substantially the same terms as those prevailing for other customers for comparable transactions and did not involve more than normal risks. Loan activity to related parties is as follows:


	2005			2004
Beginning of year	$	8,283,012		$	5,941,501
Additional borrowings		4,393,202			4,090,988
Curtailments		(2,330,973	)		(1,749,477	)

End of year	$	10,345,241		$	8,283,012

Deposits from related parties held by the Company at December 31, 2005 and 2004 amounted to $8,333,746 and $8,288,644, respectively.

Note 16.

Dividend Limitations

Dividends may be paid to the Parent by the Bank under formulas established by the appropriate regulatory authorities. The amount of dividends the Bank may pay to the Parent, without prior approval, is limited to current year earnings plus earnings retained for the two preceding years. At December 31, 2005, the amount available was approximately $12.2 million.

Note 17.

Regulatory Matters

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 Capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined). For the Company, Tier 1 Capital consists of shareholders’ equity and qualifying trust preferred securities, excluding any net unrealized gain (loss) on securities available for sale, goodwill and intangible assets. For the Bank, Tier 1 Capital consists of shareholders’ equity excluding any net unrealized gain (loss) on securities available for sale, goodwill and intangible assets. For both the Company and the Bank, total capital consists of Tier 1 Capital and the allowance for loan losses. Risk-weighted assets for the Company and the Bank were $499,420 thousand and $497,927 thousand, respectively, at December 31, 2005 and $312,232 thousand and $311,608 thousand, respectively, at December 31, 2004. Management believes, as of December 31, 2005 and 2004, that the Company and the Bank met all capital adequacy requirements to which they are subject.

As of December 31, 2005, the most recent notification from the Federal Reserve Bank categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the following tables. There are no conditions or events since the notification that management believes have changed the Bank’s category. The Company’s and the Bank’s actual capital amounts and ratios as of December 31, 2005 and 2004 are also presented in the table.


	Actual				Minimum Capital Requirement				Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions
*(in thousands)*	Amount		Ratio		Amount		Ratio		Amount		Ratio
As of December 31, 2005:
Total capital to risk weighted assets:
Consolidated	$	92,887	18.60	%	$	39,954	8.00	%		N/A	N/A
Bank		71,356	14.33	%		39,834	8.00	%	$	49,793	10.00	%
Tier I capital to risk weighted assets:
Consolidated		83,479	16.72	%		19,977	4.00	%		N/A	N/A
Bank		65,833	13.22	%		19,917	4.00	%		29,876	6.00	%
Tier I capital to average assets:
Consolidated		83,479	15.80	%		21,141	4.00	%		N/A	N/A
Bank		65,833	12.48	%		21,098	4.00	%		26,373	5.00	%
As of December 31, 2004:
Total capital to risk weighted assets:
Consolidated	$	44,769	14.34	%	$	24,979	8.00	%		N/A	N/A
Bank		42,855	13.75	%		24,929	8.00	%	$	31,161	10.00	%
Tier I capital to risk weighted assets:
Consolidated		41,930	13.43	%		14,489	4.00	%		N/A	N/A
Bank		40,016	12.84	%		12,464	4.00	%		18,696	6.00	%
Tier I capital to average assets:
Consolidated		41,930	11.69	%		14,346	4.00	%		N/A	N/A
Bank		40,016	11.18	%		14,321	4.00	%		17,901	5.00	%

Note 18.

Disclosures About Fair Value of Financial Instruments

The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. SFAS No. 107 excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

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

Cash and Cash Equivalents

The carrying amounts of cash and short-term instruments approximate fair values.

Equity Securities

The carrying amount approximates fair value.

Investment Securities

Fair values are based on published market prices or dealer quotes. Available-for-sale securities are carried at their aggregate fair value.

Loans Held for Sale and Loans Receivable, Net

For loans receivable with short-term and/or variable characteristics, the total receivables outstanding approximate fair value. The fair value of other loans is estimated by discounting the future cash flows using the build up approach to discount rate construction. Components of the discount rate include a risk free rate, credit quality component and a service charge component.

Accrued Interest Receivable and Accrued Interest Payable

The carrying amount approximates fair value.

Deposits

The fair value of noninterest bearing deposits and deposits with no defined maturity, by SFAS No. 107 definition, is the amount payable on demand at the reporting date. The fair value of time deposits is estimated by discounting the future cash flows using the build up approach to discount rate construction. Components of the discount rate include a risk free rate, credit quality component and a service charge component.

Short-term Borrowings

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within 90 days approximate their fair values.

Long-term Debt

The fair values of the Company’s long-term debt are estimated using discounted cash flow analysis based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

The estimated fair value and the carrying value of the Company’s recorded financial instruments are as follows:


	December 31, 2005				December 31, 2004
*(in thousands)*	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
Cash and cash equivalents	$	13,596	$	13,596	$	8,946	$	8,946
Investment securities		8,924		8,932		6,945		6,963
Equity securities		5,327		5,327		3,618		3,618
Loans held for sale and loans, net		503,380		520,528		344,022		352,730
Accrued interest receivable		3,145		3,145		1,693		1,693
Deposits		383,890		386,728		277,632		282,431
Short-term borrowings		65,604		65,604		44,140		44,140
Long-term debt		5,383		5,267		5,442		5,468
Accrued interest payable		1,297		1,297		803		803

Note 19.

Dividend Reinvestment and Stock Purchase Plan

In April 1999, the Company’s Board of Directors approved a Dividend Reinvestment and Stock Purchase Plan (the “Plan”). Under this Plan, shares purchased from the Company with reinvested dividends are issued at a five percent (5.0%) discount from market value. The Plan also permits participants to make optional cash payments of up to $20,000 per quarter for the purchase of additional shares of the Company’s common stock. The shares are issued at market value without incurring brokerage commissions.

Note 20.

Stock Options

The Company has a Stock Option Plan under which the Company may grant options to its directors and employees for shares of common stock.

A summary of the Company’s stock option activity and related information is as follows.


	Options Outstanding	Weighted Average Exercise Price
Balance at January 1, 2004:	236,776	$	9.31
Granted	60,000		18.77
Exercised	33,329		5.46
Expired	1,500		19.30

Balance at December 31, 2004:	261,947		11.91
Granted	217,000		23.45
Exercised	29,523		4.47
Expired	10,754		13.09

Balance at December 31, 2005:	438,670	$	18.09

Exercise prices for options outstanding and exercisable as of December 31, 2005 were as follows:


Range of Exercise Prices	Number of Options	Remaining Contractual Life (in Months)	Weighted Average Exercise Price
$ 5.04 - $ 7.13	61,410	19.32	$	5.9352
$ 9.04 - $10.02	57,860	35.87		9.2898
$18.77 - $19.30	102,400	102.97		18.9920
$23.00 - $26.25	217,000	117.25		23.4504

$ 5.04 - $26.25	438,670	89.47	$	18.0899

Note 21.

Related Party Leases

In 1984, the Bank entered into a lease with Boush Bank Building Associates, a limited partnership owned by several stockholders of the Company (the Partnership), to rent the Headquarters Building. The lease requires the Bank to pay all taxes, maintenance and insurance. The term of the lease is twenty-three years and eleven months. In connection with this property, the lessor has secured financing in the form of a $1,600,000 industrial development revenue bond from the Norfolk Redevelopment and Housing Authority payable in annual installments, commencing on January 1, 1987, at amounts equal to 3.0% of the then outstanding principal balance through the twenty-fifth year, when the unpaid balance will become due. Interest on this bond is payable monthly, at 68.6% of the prime rate of SunTrust Bank in Richmond, Virginia. Monthly rent paid by the Bank is equal to interest on the above bond, plus any interest associated with secondary financing provided the lessor by the Bank.

The Bank has the right to purchase, at its option, an undivided interest in the property at undepreciated original cost, and is obligated to purchase in each January after December 31, 1986, an undivided interest in an amount equal to 90.0% of the legal amount allowed by banking regulations for investments in fixed properties. Under this provision the Bank purchased 19.7% of this property for $362,200 in 1987. At the time of the 1987 purchase the Bank assumed $305,700 of the above-mentioned bond. Pursuant to the purchase option contained in the lease agreement, the Bank recorded an additional interest of $637,400 (34.7%) in the leased property as of December 31, 1988 by assuming a corresponding portion ($521,900) of the unpaid balance of the related revenue bond and applying the difference of $115,500 to amounts due from the lessor. Accordingly the Bank now owns 54.4%, of the Headquarters property. No purchases have been made after 1988. Total lease expense was $74,420, $69,187 and $66,100 for the years 2005, 2004 and 2003.

In addition, the Bank subleases approximately 4,000 square feet of third floor office space to outside parties. Total sublease rental income was $72,174, $61,954 and $60,614 for the years ended December 31, 2005, 2004 and 2003.

The Bank has also entered into a long-term lease with a related party to provide space for one branch located in Chesapeake, Virginia. This lease has been classified as an operating lease for financial reporting purposes. Future minimum lease payments of $107,016 are required each year for five years under the long-term non-cancelable lease agreement as of October 20, 1998, which expires in October 2007. Total lease expense was $115,350, $110,912 and $106,642 for the years 2005, 2004 and 2003, respectively.

Note 22.

Lease Commitments

The Company leases office space in Hampton Roads, Richmond and Gloucester, Virginia. The leases provide for options to renew for various periods. Pursuant to the terms of these leases, the following is a schedule, by year, of future minimum lease payments required under these non-cancelable operating lease agreements.


	Lease Payments
2006	$	688,463
2007		737,559
2008		772,338
2009		713,955
2010		638,665
Thereafter		3,767,195

	$	7,318,175

Total rental expense was $472,795, $340,063 and $295,504 for 2005, 2004 and 2003, respectively.

Note 23.

Financial Instruments with Off-Balance Sheet Risk

In the normal course of business, the Company is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees and involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of these instruments reflect the extent of the Company’s involvement in particular classes of financial instruments.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, standby letters of credit, and financial guarantees written is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

Unless otherwise noted, the Company does not require collateral or other security to support financial instruments with credit risk.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company’s experience has been that approximately 90% of loan commitments are drawn upon by customers. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held varies but may include property, plant and equipment and income-producing commercial properties.

Standby letters of credit and financial guarantees written are conditional commitments issued by the Company 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. The Company has not been required to perform on any financial guarantees during the past two years. The Company has not incurred any losses on its commitments in either 2005 or 2004.

The amounts of loan commitments, guarantees and standby letters of credit are set out in the following table as of December 31, 2005 and 2004.


	Variable Rate Commitments		Fixed Rate Commitments
December 31, 2005:
Loan commitments	$	122,205,562	$	50,263,467
Standby letters of credit and guarantees written	$	4,643,505	$	160,885
December 31, 2004:
Loan commitments	$	52,172,027	$	29,070,485
Standby letters of credit and guarantees written	$	1,034,369	$	236,397

Note 24.

Subsequent Events

On January 17, 2006, the directors of the Company declared a cash dividend in the amount of $0.06 per share on its common stock, payable February 28, 2006, to shareholders of record as of February 20, 2006.

Subsequent to December 31, 2005 through March 4, 2006, 99,612 shares of the 8% cumulative preferred securities were converted to 62,255 shares of the parent’s common stock.

In February 2006, the Company entered into a lease agreement for additional office space in the Morgan Building in Downtown Gloucester, Virginia. The premises will be used to support the future growth of its mortgage subsidiary and house its current title subsidiary office. The initial term of the lease commenced March 1, 2006 and runs through February 28, 2011. The annual base rent from the rental commencement date through February 28, 2007 is $52,200 and will subsequently increase each year based on the latest cost of living adjustment (COLA). Under the terms of the lease, the Company has the ability to renew, subject to a notice period of 30 days.

In February 2006, the Company entered into a lease agreement for additional office space in the Wainwright Building in Downtown Norfolk, Virginia. The premises will be used to support the future growth of its bank subsidiary. The initial term of the lease is scheduled to commence May 1, 2006 and run through December 31, 2015. The annual base rent from the rental commencement date through April 30, 2007 is $34,375 and will subsequently increase by 2% on each lease year anniversary date. Under the terms of the lease, the Company has the ability to renew for two (2) options for a period of five (5) years each.

Note 25.

Condensed Parent Company Only Financial Information

The condensed financial position as of December 31, 2005 and 2004 and the condensed results of operations and cash flows for each of the years in the three-year period ended December 31, 2005, of Commonwealth Bankshares, Inc., parent company only, are presented below.

Condensed Balance Sheets

December 31, 2005 and 2004


	2005		2004
Assets
Cash on deposit with subsidiary	$	20,570,679	$	1,098,449
Investment in subsidiaries		66,183,897		40,479,259
Due from subsidiary		751,315		751,315
Premises		97,651		101,036
Prepaid expense		20,691		6,314
Other assets		865,588		217,909

	$	88,489,821	$	42,654,282

Liabilities and Stockholders’ Equity
Accrued expenses	$	133,334	$	77,931
Accrued interest payable		82,089		89,632
Junior subordinated debt securities		4,925,379		5,462,570
Trust preferred capital notes		20,619,000		—
Total stockholders’ equity		62,730,019		37,024,149

	$	88,489,821	$	42,654,282

Condensed Statements of Income

Years Ended December 31, 2005, 2004 and 2003


	2005			2004		2003
Income:
Dividends from bank	$	—		$	750,000	$	756,502
Dividend from non-bank subsidiary		18,025			18,025		18,025

Rental income		6,000			6,000		6,000
Interest income		3,232			—		309

Total income		27,257			774,025		780,836

Expenses:
Interest expense		515,847			455,589		559,147
Professional fees		110,419			99,676		100,842
Other outside services		84,355			90,693		60,053
Other		11,705			8,143		6,324

Total expenses		722,326			654,101		726,366

Income (loss) before income taxes and equity in undistributed net income of subsidiaries		(695,069	)		119,924		54,470
Income tax benefits		242,452			214,226		245,220

Income (loss) before equity in undistributed net income of subsidiaries		(452,617	)		334,150		299,690
Equity in undistributed net income of subsidiaries		7,086,925			2,767,059		2,242,801

Net income	$	6,634,308		$	3,101,209	$	2,542,491

Condensed Statements of Cash Flows

Years Ended December 31, 2005, 2004 and 2003


	2005			2004			2003
Operating activities:
Net income	$	6,634,308		$	3,101,209		$	2,542,491
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation		3,385			3,385			3,386
Equity in undistributed net income of subsidiaries		(7,086,925	)		(2,767,059	)		(2,242,801	)
Net change in:
Prepaid expense		(14,377	)		8,378			22,377
Other assets		(28,160	)		14,026			16,441
Accrued expenses and other liabilities		55,403			24,014			27,202
Accrued interest payable		(7,543	)		(14,545	)		(22,664	)
Deferred taxes		(519	)		454			(401	)

Net cash provided by (used in) operating activities		(444,428	)		369,862			346,031

Investing Activities:
Increase in investment in subsidiary		(18,538,122	)		(14,189,197	)		—

Financing activities:
Proceeds from issuance of trust preferred capital notes		20,000,000			—			—
Dividends reinvested and sale of stock		19,204,407			14,529,597			144,353
Dividends paid		(749,627	)		(443,522	)		(283,598	)

Net cash provided by (used in) financing activities		38,454,780			14,086,075			(139,245	)

Net increase in cash on deposit with subsidiary		19,472,230			266,740			206,786
Cash on deposit with subsidiary, January 1		1,098,449			831,709			624,923

Cash on deposit with subsidiary, December 31	$	20,570,679		$	1,098,449		$	831,709

Note 26.

Quarterly Financial Data (unaudited)

Summarized unaudited quarterly financial data for the years ended December 31, 2005 and 2004 is as follows (in thousands):


	2005
	Fourth			Third		Second		First
Interest income	$	10,480		$	9,427	$	7,748	$	6,634
Interest expense		4,128			3,403		2,841		2,370

Net interest income		6,352			6,024		4,907		4,264
Provision for loan losses		900			825		685		330
Noninterest income		1,097			1,108		941		747
Noninterest expense		3,552			3,323		2,923		2,840

Income before provision for income taxes and noncontrolling interest		2,997			2,984		2,240		1,841
Provision for income taxes		1,018			1,014		763		624

Income before noncontrolling interest		1,979			1,970		1,477		1,217
Noncontrolling interest in subsidiary		(9	)		—		—		—

Net income	$	1,970		$	1,970	$	1,477	$	1,217

Basic Earnings per share	$	0.48		$	0.49	$	0.48	$	0.40

Diluted Earnings per share	$	0.43		$	0.43	$	0.41	$	0.35


	2004
	Fourth			Third		Second		First
Interest income	$	6,147		$	5,764	$	5,142	$	4,904
Interest expense		2,257			2,198		2,090		2,080

Net interest income		3,890			3,566		3,052		2,824
Provision for loan losses		590			270		370		465
Noninterest income		997			772		674		625
Noninterest expense		2,977			2,704		2,237		2,180

Income before provision for income taxes and noncontrolling interest		1,320			1,364		1,119		804
Provision for income taxes		414			459		374		259

Income before noncontrolling interest		906			905		745		545
Noncontrolling interest in subsidiary		—			—		—		—

Net income	$	906		$	905	$	745	$	545

Basic Earnings per share	$	0.32		$	0.45	$	0.38	$	0.28

Diluted Earnings per share	$	0.27		$	0.36	$	0.30	$	0.22