UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2004

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number: 0-20146

EAGLE FINANCIAL SERVICES, INC.

(Exact name of registrant as specified in its charter)

Virginia	54-1601306
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)

2 East Main Street P.O. Box 391 Berryville, Virginia 22611	22611
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code: (540) 955-2510

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The number of shares of the registrant’s Common Stock ($2.50 par value) outstanding as of November 8, 2004 was 1,508,677.

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION
Item 1.	Financial Statements:	1
	Consolidated Balance Sheets at September 30, 2004 and December 31, 2003	1
	Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2004 and 2003	2
	Consolidated Statements of Changes in Shareholders’ Equity for the Nine Months Ended September 30, 2004 and 2003	3
	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2004 and 2003	4
	Notes to Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	21
Item 4.	Controls and Procedures	21
PART II - OTHER INFORMATION
Item 1.	Legal Proceedings	22
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	22
Item 3.	Defaults Upon Senior Securities	22
Item 4.	Submission of Matters to a Vote of Security Holders	22
Item 5.	Other Information	22
Item 6.	Exhibits	22

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

EAGLE FINANCIAL SERVICES, INC.

Consolidated Balance Sheets

	September 30, 2004		December 31, 2003
	(Unaudited)
Assets
Cash and due from banks	$	9,021,001	$	11,338,480
Federal funds sold		8,945,000		—
Securities available for sale, at fair value		49,124,054		33,732,750
Securities held to maturity (fair value; $19,096,053 and $14,503,515, respectively)		18,804,025		14,157,933
Loans, net of allowance for loan losses of $3,145,593 and $2,866,991, respectively		292,198,361		273,663,299
Bank premises and equipment, net		13,851,748		13,438,334
Other assets		5,638,975		5,678,916
Total assets	$	397,583,164	$	352,009,712
Liabilities and Shareholders’ Equity
Liabilities
Deposits:
Noninterest bearing demand deposits	$	73,494,068	$	65,147,427
Savings and interest bearing demand deposits		173,228,259		145,707,873
Time deposits		75,250,994		64,676,240
Total deposits	$	321,973,321	$	275,531,540
Federal funds purchased, securities sold under agreements to repurchase and other short-term borrowings		6,042,943		16,939,199
Federal Home Loan Bank advances		30,000,000		23,044,000
Trust preferred capital notes		7,000,000		7,000,000
Other liabilities		1,387,173		1,128,836
Commitments and contingent liabilities		—		—
Total liabilities	$	366,403,437	$	323,643,575
Shareholders’ Equity
Preferred Stock, $10 par value; 500,000 shares authorized and unissued	$	—	$	—
Common Stock, $2.50 par value; authorized 5,000,000 shares; issued 1,505,310 and 1,497,714 shares, respectively		3,763,275		3,744,285
Surplus		4,377,864		4,005,715
Retained Earnings		22,464,081		19,934,792
Accumulated other comprehensive income, net		574,507		681,345
Total shareholders’ equity	$	31,179,727	$	28,366,137
Total liabilities and shareholders’ equity	$	397,583,164	$	352,009,712

See Notes to Consolidated Financial Statements

1

EAGLE FINANCIAL SERVICES, INC.

Consolidated Statements of Income

(Unaudited)

	Three Months Ended September 30				Nine Months Ended September 30
	2004		2003		2004		2003
Interest Income
Interest and fees on loans	$	4,325,495	$	3,857,859	$	12,449,356	$	11,213,816
Interest on federal funds sold		48,359		7,970		57,529		37,665
Interest on securities held to maturity:
Taxable interest income		38,976		90,123		128,278		277,815
Interest income exempt from federal income taxes		113,220		81,365		301,065		246,345
Interest and dividends on securities available for sale
Taxable interest income		382,053		268,486		985,430		770,825
Interest income exempt from federal income taxes		18,342		16,048		51,864		48,144
Dividends		26,999		30,183		88,486		97,400
Interest on deposits in banks		512		479		1,537		865
Total interest income	$	4,953,956	$	4,352,513	$	14,063,545	$	12,692,875
Interest Expense
Interest on deposits	$	767,122	$	633,106	$	2,010,997	$	2,160,459
Interest on federal funds purchased and securities sold under agreements to repurchase		22,967		17,561		71,511		37,669
Interest on Federal Home Loan Bank advances		278,428		201,507		802,679		597,946
Interest on trust preferred capital notes		90,447		79,890		253,275		248,235
Total interest expense	$	1,158,964	$	932,064	$	3,138,462	$	3,044,309
Net interest income	$	3,794,992	$	3,420,449	$	10,925,083	$	9,648,566
Provision For Loan Losses		75,000		105,000		390,000		475,000
Net interest income after provision for loan losses	$	3,719,992	$	3,315,449	$	10,535,083	$	9,173,566
Noninterest Income
Trust department income	$	119,280	$	97,370	$	344,575	$	366,116
Service charges on deposits		476,078		325,173		1,222,664		936,793
Other service charges and fees		547,168		538,060		1,432,172		1,481,707
Securities gains, net		—		—		155,517		—
Other operating income		230,640		51,921		357,826		108,364
	$	1,373,166	$	1,012,524	$	3,512,754	$	2,892,980
Noninterest Expenses
Salaries and wages	$	1,499,684	$	1,350,925	$	4,237,533	$	3,703,441
Pension and other employee benefits		371,303		302,431		1,135,853		886,175
Occupancy expenses		234,259		151,032		702,735		465,919
Equipment expenses		203,299		172,273		655,590		566,970
Advertising and marketing expenses		115,917		163,489		308,990		318,017
Stationery and supplies		39,308		77,113		186,239		203,500
Other operating expenses		558,432		526,925		1,849,959		1,615,364
	$	3,022,202	$	2,744,188	$	9,076,899	$	7,759,386
Income before income taxes	$	2,070,956	$	1,583,785	$	4,970,938	$	4,307,160
Income Tax Expense		614,425		477,815		1,511,529		1,304,452
Net Income	$	1,456,531	$	1,105,970	$	3,459,409	$	3,002,708
Earnings Per Share
Net income per common share, basic and diluted	$	0.97	$	0.74	$	2.30	$	2.02

See Notes to Consolidated Financial Statements

2

EAGLE FINANCIAL SERVICES, INC.

Consolidated Statements of Changes in Shareholders’ Equity

(Unaudited)

	Common Stock			Surplus			Retained Earnings			Accumulated Other Comprehensive Income			Comprehensive Income			Total
Balance, December 31, 2002	$	3,696,926		$	3,545,408		$	17,012,437		$	147,020					$	24,401,791
Comprehensive income:
Net income								3,002,708					$	3,002,708			3,002,708
Other comprehensive income:
Unrealized holding gains arising during the period, net of deferred income taxes of $57,325											111,279			111,279			111,279
Total comprehensive income													$	3,113,987
Issuance of common stock, employee benefit plan		3,210			32,357												35,567
Issuance of common stock, dividend investment plan		26,819			273,429												300,248
Dividends declared ($0.55 per share)								(815,609	)								(815,609	)
Fractional shares purchased		(5	)		(62	)											(67	)
Balance, September 30, 2003	$	3,726,950		$	3,851,132		$	19,199,536		$	258,299					$	27,035,917
Balance, December 31, 2003	$	3,744,285		$	4,005,715		$	19,934,792		$	681,345					$	28,366,137
Comprehensive income:
Net income								3,459,409					$	3,459,409			3,459,409
Other comprehensive income (loss):
Unrealized holding losses arising during the period, net of deferred income taxes of $2,161														(4,197	)
Reclassification adjustment, net of income taxes of $52,876														(102,641	)
Other comprehensive (loss), net of income taxes of $55,037											(106,838	)		(106,838	)		(106,838	)
Total comprehensive income													$	3,352,571
Amortization of unearned compensation, restricted stock awards					57,105												57,105
Issuance of common stock, dividend investment plan		18,990			315,044												334,034
Dividends declared ($0.62 per share)								(930,120	)								(930,120	)
Balance, September 30, 2004	$	3,763,275		$	4,377,864		$	22,464,081		$	574,507					$	31,179,727

See Notes to Consolidated Financial Statements

3

EAGLE FINANCIAL SERVICES, INC.

Consolidated Statements of Cash Flows

(Unaudited)

	Nine Months Ended September 30,
	2004			2003
Cash Flows from Operating Activities
Net income	$	3,459,409		$	3,002,708
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		526,882			357,023
Amortization of intangible and other assets		161,462			160,616
(Gain) loss on equity investment		7,961			(1,653	)
Provision for loan losses		390,000			475,000
Accrual of restricted stock awards		57,105			—
(Gain) on sales and calls of securities		(155,517	)		—
Premium amortization on securities, net		138,057			184,557
Changes in assets and liabilities:
(Increase) in other assets		(129,482	)		(758,192	)
Increase in other liabilities		313,374			220,644
Net cash provided by operating activities	$	4,769,251		$	3,640,703
Cash Flows from Investing Activities
Proceeds from maturities and principal payments of securities held to maturity	$	2,840,947		$	3,508,313
Proceeds from maturities and principal payments of securities available for sale		6,974,877			6,623,735
Proceeds from sales and calls of securities available for sale		2,283,504			—
Purchases of securities held to maturity		(7,750,860	)		(4,047,767	)
Purchases of securities available for sale		(24,530,279	)		(14,667,332	)
Purchases of bank premises and equipment		(940,296	)		(4,971,053	)
Net (increase) in loans		(18,925,062	)		(39,978,242	)
Net cash (used in) investing activities	$	(40,047,169	)	$	(53,532,346	)
Cash Flows from Financing Activities
Net increase in demand deposits, money market and savings accounts	$	35,867,027		$	42,915,104
Net increase (decrease) in certificates of deposit		10,574,754			(9,302,369	)
Net increase (decrease) in federal funds purchased and securities sold under agreements to repurchase		(10,896,256	)		10,370,933
Proceeds from issuance of common stock, employee benefit plan		—			35,567
Net increase in Federal Home Loan Bank advances		6,956,000			—
Cash dividends paid		(596,086	)		(515,361	)
Fractional shares purchased		—			(67	)
Net cash provided by financing activities	$	41,905,439		$	43,503,807
Increase (decrease) in cash and cash equivalents	$	6,627,521		$	(6,387,836	)
Cash and Cash Equivalents
Beginning		11,338,480			16,198,473
Ending	$	17,966,001		$	9,810,637
Supplemental Disclosures of Cash Flow Information
Cash payments for:
Interest	$	3,085,687		$	3,099,924
Income taxes	$	1,243,500		$	1,212,230
Supplemental Schedule of Noncash Investing and Financing Activities:
Issuance of common stock, dividend investment plan	$	334,034		$	300,248
Unrealized gain (loss) on securities available for sale	$	(161,875	)	$	168,604

See Notes to Consolidated Financial Statements

4

EAGLE FINANCIAL SERVICES, INC.

Notes to Consolidated Financial Statements (Unaudited)

September 30, 2004

General

The accompanying unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America.

In the opinion of management, the accompanying unaudited financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position at September 30, 2004 and December 31, 2003, the results of operations for the three and nine months ended September 30, 2004 and 2003, and cash flows for the nine months ended September 30, 2004 and 2003. The statements should be read in conjunction with the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 (the “2003 Form 10-K”).

The Company owns 100% of Bank of Clarke County (the “Bank”) and Eagle Financial Statutory Trust I (the “Trust”). The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Certain amounts in the consolidated financial statements have been reclassified to conform to current year presentations.

The results of operations for the three and nine month periods ended September 30, 2004, are not necessarily indicative of the results to be expected for the full year.

NOTE 1. Stock-Based Compensation

The Company has a stock-based compensation plan which it accounts for under the recognition and measurement principles of the Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. No stock-based compensation cost is reflected in net income, as each option granted under the plan 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 if the Company had applied the fair value recognition provisions of the Financial Accounting Standards Board Statement No. 123, “Accounting for Stock-Based Compensation,” to its stock-based compensation plan for the three and nine months ended September 30, 2004 and 2003.

	Three Months Ended September 30,					Nine Months Ended September 30,
	2004			2003		2004			2003
Net income, as reported	$	1,456,531		$	1,105,970	$	3,459,409		$	3,002,708
Deduct: Total stock-based compensation expense based on fair value of all awards, net of taxes		(5,809	)		—		(17,428	)		—
Pro forma net income	$	1,450,722		$	1,105,970	$	3,441,981		$	3,002,708
Earnings per share:
Basic - as reported	$	0.97		$	0.74	$	2.30		$	2.02
Basic - pro forma		0.96			0.74		2.29			2.02
Diluted - as reported		0.97			0.74		2.30			2.02
Diluted - pro forma		0.96			0.74		2.29			2.02

5

NOTE 2. Earnings Per Common Share
Basic earnings per share represents income available to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options and are determined using the treasury method. The following table shows the weighted average number of shares used in computing earnings per share and the effect on the weighted average number of shares of dilutive potential common stock. Potential dilutive common stock had no effect on income available to common shareholders.
	Three Months Ended September 30,		Nine Months Ended September 30,
	2004	2003	2004	2003
Average number of common shares outstanding	1,503,986	1,489,626	1,501,440	1,485,352
Effect of dilutive options	15	—	290	—
Average number of common shares outstanding used to calculate diluted earnings per share	1,504,001	1,489,626	1,501,730	1,485,352

6

NOTE 3. Securities

The amortized costs and fair values of securities available for sale at September 30, 2004 and December 31, 2003 were as follows:

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
	September 30, 2004
Obligations of U.S. government corporations and agencies	$	20,534,830	$	195,562	$	(6,255	)	$	20,724,137
Mortgage-backed securities		17,252,831		165,101		(3,320	)		17,414,612
Obligations of states and political subdivisions		1,550,012		93,890		—			1,643,902
Corporate securities		7,279,915		425,488		—			7,705,403
Restricted stock		1,636,000		—		—			1,636,000
	$	48,253,588	$	880,041	$	(9,575	)	$	49,124,054
	December 31, 2003
Obligations of U.S. government corporations and agencies	$	10,003,586	$	109,479	$	(6,815	)	$	10,106,250
Mortgage-backed securities		9,885,793		48,160		(29,392	)		9,904,561
Obligations of states and political subdivisions		1,312,322		115,307		—			1,427,629
Corporate securities		10,146,008		795,602		—			10,941,610
Restricted stock		1,352,700		—		—			1,352,700
	$	32,700,409	$	1,068,548	$	(36,207	)	$	33,732,750

Proceeds from the sales and calls of securities available for sale during 2004 were $2,283,504. Gross gains of $155,798 and gross losses of $281 were realized on sales and calls during the first nine months of 2004. There were no sales or calls of securities available for sale during the first nine months of 2003.

The following table summarizes the fair value and gross unrealized losses for securities available for sale, totaled by the length of time that individual securities have been in a continuous gross unrealized loss position, at September 30, 2004:

	Less than 12 months				12 months or more				Total
	Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses
Mortgage-backed securities	$	—	$	—	$	1,261,635	$	3,320	$	1,261,635	$	3,320
Obligations of U.S. government corporations and agencies		2,485,595		6,255		—		—		2,485,595		6,255
	$	2,485,595	$	6,255	$	1,261,635	$	3,320	$	3,747,230	$	9,575

The securities in the table, which represent six issuers, have not suffered credit deterioration and the Company has the ability and intent to hold these issues until maturity and, therefore, any gross unrealized losses are considered temporary at September 30, 2004.

7

The amortized costs and fair values of securities held to maturity at September 30, 2004 and December 31, 2003 were as follows:

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
	September 30, 2004
Obligations of U.S. government corporations and agencies	$	1,002,979	$	—	$	(12,349	)	$	990,630
Mortgage-backed securities		1,377,800		38,189		—			1,415,989
Obligations of states and political subdivisions		16,423,246		307,463		(41,275	)		16,689,434
	$	18,804,025	$	345,652	$	(53,624	)	$	19,096,053
	December 31, 2003
Obligations of U.S. government corporations and agencies	$	1,504,292	$	4,259	$	(13,396	)	$	1,495,155
Mortgage-backed securities		2,142,321		67,545		(2,195	)		2,207,671
Obligations of states and political subdivisions		10,511,320		298,622		(9,253	)		10,800,689
	$	14,157,933	$	370,426	$	(24,844	)	$	14,503,515

The following table summarizes the fair value and gross unrealized losses for securities held to maturity, totaled by the length of time that individual securities have been in a continuous gross unrealized loss position, at September 30, 2004:

	Less than 12 months				12 months or more				Total
	Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses
Obligations of U.S. government corporations and agencies	$	494,065	$	5,935	$	496,565	$	6,414	$	990,630	$	12,349
Obligations of states and political subdivisions		3,559,340		41,275		—		—		3,559,340		41,275
	$	4,053,405	$	47,210	$	496,565	$	6,414	$	4,549,970	$	53,624

The securities in the table, which represent thirteen issuers, have not suffered credit deterioration and the Company has the ability and intent to hold these issues until maturity and, therefore, any gross unrealized losses are considered temporary at September 30, 2004.

8

NOTE 4. Loans

Net loans at September 30, 2004 and December 31, 2003 are summarized as follows:

	September 30, 2004			December 31, 2003
	(in thousands)
Mortgage loans on real estate:
Construction and land development	$	29,848		$	24,536
Secured by farmland		3,569			2,721
Secured by 1-4 family residential properties		136,990			137,166
Secured by nonfarm, nonresidential properties		67,694			57,341
Loans to farmers		1,306			1,065
Commercial and industrial loans		22,992			20,763
Consumer installment loans		32,660			32,177
All other loans		285			761
	$	295,344		$	276,530
Less: Allowance for loan losses		(3,146	)		(2,867	)
	$	292,198		$	273,663

NOTE 5. Allowance for Loan Losses

The following table summarizes changes in the allowance for loan losses for the nine months ended September 30, 2004 and 2003 and the year ended December 31, 2003:

	September 30, 2004			September 30, 2003			December 31, 2003
Balance, beginning	$	2,866,991		$	2,376,463		$	2,376,463
Provision charged to operating expense		390,000			475,000			650,000
Recoveries added to the allowance		92,403			77,051			98,216
Loan losses charged to the allowance		(203,801	)		(131,564	)		(257,688	)
Balance, ending	$	3,145,593		$	2,796,950		$	2,866,991

9

NOTE 6. Pension and Postretirement Benefit Plans

The following tables provide the components of net periodic benefit cost for the three and nine months ended September 30, 2004 and 2003:

	Pension Benefits						Postretirement Benefits
	Three Months Ended September 30,						Three Months Ended September 30,
	2004			2003			2004		2003
Components of Net Periodic Benefit Cost:
Service cost	$	67,659		$	48,756		$	—	$	—
Interest cost		49,651			41,447			5,046		5,050
Expected return on plan assets		(47,551	)		(27,088	)		—		—
Amortization of prior service costs		2,886			2,886			—		—
Amortization of net obligation at transition		—			—			653		653
Recognized net actuarial loss		19,503			17,126			2,322		2,018
Net periodic benefit cost	$	92,148		$	83,127		$	8,021	$	7,721
	Nine Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004		2003
Components of Net Periodic Benefit Cost:
Service cost	$	202,977		$	146,268		$	—	$	—
Interest cost		148,953			124,341			15,138		15,150
Expected return on plan assets		(142,653	)		(81,264	)		—		—
Amortization of prior service costs		8,658			8,658			—		—
Amortization of net obligation at transition		—			—			1,959		1,959
Recognized net actuarial loss		58,509			51,378			6,966		6,054
Net periodic benefit cost	$	276,444		$	249,381		$	24,063	$	23,163

Note 9 to the consolidated financial statements in the 2003 Form 10-K stated that the Company would contribute $200,000 to its pension plan during 2004. Based on more recent projections of the fair value of plan assets as compared to the projected benefit obligation, the Company will increase its contribution during 2004 to $300,000. The Company has made total contributions of $200,000 during the first nine months of 2004.

NOTE 7. Trust Preferred Capital Notes

On May 23, 2002, Eagle Financial Statutory Trust I (the Trust), a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable capital securities, also known as trust preferred securities. On June 26, 2002, $7,000,000 of trust preferred securities were issued through a pooled underwriting totaling approximately $554,000,000. The securities have a LIBOR-indexed floating rate of interest. The interest rate at September 30, 2004 was 5.40%. The securities have a mandatory redemption date of June 26, 2032, and are subject to varying call provisions beginning June 26, 2007. The principal asset of the Trust is $7,000,000 of the Company’s junior subordinated debt securities with maturities and interest rates similar to the trust preferred securities.

The trust preferred securities may be included in Tier 1 capital for regulatory capital adequacy purposes as long as their amount does not exceed 25% of Tier 1 capital, including total trust preferred securities. The portion of the trust preferred securities not considered as Tier 1 capital, if any, may be included in Tier 2 capital. The total amount ($7,000,000) of trust preferred securities issued by the Trust can be included in the Company’s Tier 1 capital.

The obligations of the Company with respect to the issuance of the trust preferred securities constitute a full and unconditional guarantee by the Company of the Trust’s obligations with respect to the trust preferred securities.

Subject to certain exceptions and limitations, the Company may elect from time to time to defer interest payments on the junior subordinated debt securities, which would result in a deferral of distribution payments on the related trust preferred securities.

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NOTE 8. Recent Accounting Pronouncements

Emerging Issues Task Force Issue No. 03-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-1”) was issued and is effective March 31, 2004. The EITF 03-1 provides guidance for determining the meaning of “other –than-temporarily impaired” and its application to certain debt and equity securities within the scope of Statement of Financial Accounting Standards No. 115 “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”) and investments accounted for under the cost method. The guidance requires that investments which have declined in value due to credit concerns or solely due to changes in interest rates must be recorded as other-than-temporarily impaired unless the Company can assert and demonstrate its intention to hold the security for a period of time sufficient to allow for a recovery of fair value up to or beyond the cost of the investment which might mean maturity. This issue also requires disclosures assessing the ability and intent to hold investments in instances in which an investor determines that an investment with a fair value less than cost is not other-than-temporarily impaired.

On September 30, 2004, the Financial Accounting Standards Board decided to delay the effective date for the measurement and recognition guidance contained in Issue 03-1. This delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. The disclosure guidance in Issue 03-1 was not delayed.

EITF No. 03-16, “Accounting for Investments in Limited Liability Companies was ratified by the Board and is effective for reporting periods beginning after June 15, 2004.” APB Opinion No. 18, “The Equity Method of Accounting Investments in Common Stock,” prescribes the accounting for investments in common stock of corporations that are not consolidated. AICPA Accounting Interpretation 2, “Investments in Partnerships Ventures,” of Opinion 18, indicates that “many of the provisions of the Opinion would be appropriate in accounting” for partnerships. In EITF Abstracts, Topic No. D-46, “Accounting for Limited Partnership Investments,” the SEC staff clarified its view that investments of more than 3 to 5 percent are considered to be more than minor and, therefore, should be accounted for using the equity method. Limited liability companies (LLCs) have characteristics of both characteristics of both corporations and partnerships, but are dissimilar from both in certain respects. Due to those similarities and differences, diversity in practice exists with respect to accounting for non-controlling investments in LLCs. The consensus reached was that an LLC should be viewed as similar to a corporation or similar to a partnership for purposes of determining whether a non-controlling investment should be accounted for using the cost method or the equity method of accounting.

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

CRITICAL ACCOUNTING POLICIES

The financial statements of the Company are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within these statements is, to a significant extent, based on measurements of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset or relieving a liability. The Company uses historical loss factors as one element in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from the historical factors that are used. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of the transactions would be the same, the timing of events that would impact the transactions could change.

The allowance for loan losses is an estimate of the losses that may be sustained in the Company’s loan portfolio. The allowance for loan losses is based on two accounting principles: (1) Statement of Financial Accounting Standards (SFAS) No. 5, Accounting for Contingencies, which requires that losses be accrued when their occurrence is probable and they can be estimated, and (2) SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the loan balance and the value of its collateral, the present value of future cash flows, or the price established in the secondary market. The Company’s allowance for loan losses has three basic components: the formula allowance, the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when actual events occur. The formula allowance uses historical experience factors to estimate future losses and, as a result, the estimated amount of losses can differ significantly from the actual amount of losses which would be incurred in the future. However, the potential for significant differences is mitigated by continuously updating the loss history of the Company. The specific allowance is based upon the evaluation of specific loans on which a loss may be realized. Factors such as past due history, ability to pay, and collateral value are used to identify those loans on which a loss may be realized. Each of these loans is then classified as to how much loss would be realized on its disposition. The sum of the losses on the individual loans becomes the Company’s specific allowance. This process is inherently subjective and actual losses may be greater than or less than the estimated specific allowance. The unallocated allowance captures losses that are attributable to various economic events which may affect a certain loan type within the loan portfolio or a certain industrial or geographic sector within the Company’s market. As the loans, which are affected by these events, are identified or losses are experienced on the loans which are affected by these events, they will be reflected within the specific or formula allowances.

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CREDIT POLICIES

The lending activities are performed and the credit policy issues are administered by the Company’s subsidiary, Bank of Clarke County (the “Bank”). The principal risk associated with the Bank’s loan portfolio is the creditworthiness of its borrowers. In an effort to manage this risk, the Bank’s policy gives loan amount approval limits to individual loan officers based on their position and level of experience. Credit risk is increased or decreased, depending on the type of loan and prevailing economic conditions. In consideration of the different types of loans in the portfolio, the risk associated with real estate mortgage loans, commercial loans and consumer loans varies based on employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay debt.

The Company has written policies and procedures to help manage credit risk. The Company utilizes a loan review process that includes formulation of portfolio management strategy, guidelines for underwriting standards and risk assessment, procedures for ongoing identification and management of credit deterioration, and regular portfolio reviews to establish loss exposure and to ascertain compliance with the Bank’s policies.

The Bank uses a Directors Loan Committee and lending limits approved by the Directors Loan Committee to approve loan requests. The loan officers are categorized based on the amount of secured and unsecured lending authority they possess. The highest authority (Category I) is comprised of the Bank’s Chief Executive Officer, the Senior Loan Officer, and the Associate Senior Loan Officer. There are four additional categories (Categories II, III, IV and V) with different amounts of secured and unsecured authority. Two officers in Category I may combine their authority to approve a loan request of up to $1,500,000 secured or $750,000 unsecured. An officer in Category II, III, IV or V may combine his or her authority with one officer in a higher category to approve a loan request. Any loan request which exceeds the combined authority of the categories must be presented to the Directors Loan Committee. The Directors Loan Committee, which currently consists of four directors (three directors constitute a quorum, of whom any two may act), approves loan requests which exceed the combined authority of two loan officers as described above. The minimum amount which requires Director Loan Committee approval, which is derived by combining the authorities of a Category I and Category V officer, is $775,000 secured and $380,000 unsecured. The Directors Loan Committee also reviews and approves changes to the Bank’s Loan Policy as presented by management.

The following sections discuss the major loan categories within the total loan portfolio:

One-to-Four-Family Residential Real Estate Lending

Residential lending activity may be generated by the Bank’s loan officer solicitations, referrals by real estate professionals, and existing or new bank customers. Loan applications are taken by a Bank loan officer. As part of the application process, information is gathered concerning income, employment and credit history of the applicant. The valuation of residential collateral is provided by independent fee appraisers who have been approved by the Bank’s Directors Loan Committee. In connection with residential real estate loans, the Bank requires title insurance, hazard insurance and, if applicable, flood insurance. In addition to traditional residential mortgage loans secured by a first or junior lien on the property, the Bank offers home equity lines of credit.

Commercial Real Estate Lending

Commercial real estate loans are secured by various types of commercial real estate in the Bank’s market area, including multi-family residential buildings, commercial buildings and offices, small shopping centers and churches. Commercial real estate loan originations are obtained through broker referrals, direct solicitation of developers and continued business from customers. In its underwriting of commercial real estate, the Bank’s loan to original appraised value ratio is generally 80% or less. Commercial real estate lending entails significant additional risk as compared with residential mortgage lending. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the repayment of loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or the economy, in general. The Bank’s commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrower’s creditworthiness, prior credit history and reputation, and the Bank typically requires personal guarantees or endorsements of the borrowers’ principal owners.

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Construction and Land Development Lending

The Bank makes local construction loans, primarily residential, and land acquisition and development loans. The construction loans are secured by residential houses under construction and the underlying land for which the loan was obtained. The average life of most construction loans is less than one year and the Bank offers both fixed and variable rate interest structures. The interest rate structure offered to customers depends on the total amount of these loans outstanding and the impact of the interest rate structure on the Bank’s overall interest rate risk. There are two characteristics of construction lending which impact its overall risk as compared to residential mortgage lending. First, there is more concentration risk due to the extension of a large loan balance through several lines of credit to a single developer or contractor. Second, there is more collateral risk due to the fact that loan funds are provided to the borrower based upon the estimated value of the collateral after completion. This could cause an inaccurate estimate of the amount needed to complete construction or an excessive loan-to-value ratio. To mitigate the risks associated with construction lending, the Bank generally limits loan amounts to 80% of the estimated appraised value of the finished home. The Bank also obtains a first lien on the property as security for its construction loans and typically requires personal guarantees from the borrower’s principal owners. Finally, the Bank performs inspections of the construction projects to ensure that the percentage of construction completed correlates with the amount of draws on the construction line of credit.

Commercial and Industrial Lending

Commercial business loans generally have more risk than residential mortgage loans, but have higher yields. To manage these risks, the Bank generally obtains appropriate collateral and personal guarantees from the borrower’s principal owners and monitors the financial condition of its business borrowers. Residential mortgage loans generally are made on the basis of the borrower’s ability to make repayment from employment and other income and are secured by real estate whose value tends to be readily ascertainable. In contrast, commercial business loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business and are secured by business assets, such as commercial real estate, accounts receivable, equipment and inventory. As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself. Furthermore, the collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much precision as residential real estate.

Consumer Lending

The Bank offers various secured and unsecured consumer loans, which include personal installment loans, personal lines of credit, automobile loans, and credit card loans. The Bank originates its consumer loans within its geographic market area and these loans are generally made to customers with whom the Bank has an existing relationship. Consumer loans generally entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciable assets such as automobiles. In such cases, any repossessed collateral on a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

The underwriting standards employed by the Bank for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of ability to meet existing obligations and payments on the proposed loan. The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment, and from any verifiable secondary income. Although creditworthiness of the applicant is the primary consideration, the underwriting process also includes an analysis of the value of the security in relation to the proposed loan amount.

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RESULTS OF OPERATIONS

Net Income

Net income for the first nine months of 2004 was $3,459,409, an increase of $456,701 or 15.2% as compared to net income for the first nine months of 2003 of $3,002,708. Earnings per share, basic and diluted, were $2.02 and $2.30 for the first nine months of 2003 and 2004, respectively.

Net income for the third quarter of 2004 was $1,456,531, an increase of $350,561 or 31.7% as compared to net income for the third quarter of 2003 of $1,105,970. Earnings per share, basic and diluted, were $0.74 and $0.97 for the third quarter of 2003 and 2004, respectively.

Return on average assets (ROA) measures how efficiently the Company uses its assets to produce net income. The ROA of the Company, on an annualized basis, for the first nine months of 2003 and 2004 was 1.37% and 1.23%, respectively. Return on average equity (ROE) measures the utilization of shareholders’ equity in generating net income. The ROE of the Company, on an annualized basis, for the first nine months of 2003 and 2004 was 15.88% and 15.56%, respectively.

Net Interest Income

Net interest income is the Company’s primary source of earnings. Net interest income was $9,648,566 and $10,925,083 for the first nine months of 2003 and 2004, respectively, which represents an increase of $1,276,517 or 13.2%. Net interest income was $3,420,449 and $3,794,992 for the third quarter of 2003 and 2004, respectively, which represents an increase of $374,543 or 11.0%.

Tax equivalent net interest income divided by total average earnings assets equals the net interest margin. The net interest margin for the first nine months of 2003 and 2004 was 4.47% and 4.32%, respectively. The yield on earning assets decreased from 5.86% to 5.54% and the cost of interest bearing liabilities decreased from 1.75% to 1.54% for the first nine months of 2003 and 2004, respectively.

Provision for Loan Losses

The provision for loan losses is based upon management’s estimate of the amount required to maintain an adequate allowance for loan losses as discussed within the Critical Accounting Policies section above. The provision for loan losses was $390,000 for the first nine months of 2004 as compared to $475,000 for the first nine months of 2004. The provision for loan losses was $75,000 for the third quarter of 2004 as compared to $105,000 for the third quarter of 2003.

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Noninterest Income

Total noninterest income for the first nine months of 2003 and 2004 was $2,892,980 and $3,512,754, respectively, which represents an increase of $619,774 or 21.4%. Total noninterest income for the third quarter of 2003 and 2004 was $1,012,524 and $1,373,166, respectively, which represents an increase of $360,642 or 35.6%. The following paragraphs provide information about activities which are included within the respective Consolidated Statements of Income headings.

The Company earned $155,517 on sales and calls of securities during the first nine months of 2004. These sales and calls were comprised of mortgage-backed securities and corporate securities. Other operating income includes $133,633 in life insurance proceeds paid to the Bank on the death of a retired officer covered by its Executive Supplemental Income Plan. Note 10 to the consolidated financial statements in the 2003 Form 10-K discusses the Executive Supplemental Income Plan and the related life insurance policies which have been acquired on the covered officers to discharge the Bank’s obligations under the plan.

Trust department income decreased $21,541 or 5.9% from $366,116 for the first nine months of 2003 to $344,575 for the first nine months of 2004. Trust department income increased $21,910 or 22.5% from $97,370 for the third quarter of 2003 to $119,280 for the third quarter of 2004. The amount of Trust department income is determined by the number of active accounts and total assets under management. Income can fluctuate due to the number of estates settled within any period.

Service charges on deposit accounts increased $285,871 or 30.5% from $936,793 to $1,222,664 for the first nine months of 2003 and 2004, respectively. Service charges on deposit accounts increased $150,905 or 46.4% from $325,173 to $476,078 for the third quarter of 2003 and 2004, respectively. The amount of service charges on deposit accounts is derived from the volume of demand and savings accounts and the Bank continues to see an increase in these account types. In addition, a portion of the increase during the first nine months of 2004 can be attributed to the Bank introducing an overdraft privilege product. Management expects continued growth in the number of deposit accounts, therefore, expects the amount of service charges on deposit account to increase in future periods.

Other service charges and fees decreased $49,535 or 3.3% from $1,481,707 for the first nine months of 2003 to $1,432,172 for the first nine months of 2004. Other service charges and fees increased $9,108 or 1.7% from $538,060 for the third quarter of 2003 to $547,168 for the third quarter of 2004. A portion of the decrease during the first nine months of 2004 can be attributed to a decrease in the amount of fees received from the origination of mortgage loans for the secondary market. The Company expects this trend to continue as refinancing activity has slowed down. Despite the decrease during the first nine months of 2004, there are certain items within this category, namely fees generated from the Bank’s ATM network, fees generated from the Bank’s credit card program, and safe deposit box rental income which were greater in 2004 as compared to 2003.

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Noninterest Expenses

Total noninterest expenses increased $1,317,513 or 17.0% from $7,759,386 to $9,076,899 for the first nine months of 2003 and 2004, respectively. Total nonintereset expenses increased $278,014 or 10.1% from $2,744,188 for the third quarter of 2003 to $3,022,202 for the third quarter of 2004. The efficiency ratio of the Company, a measure of its performance based upon the relationship between noninterest expenses and operating income, was 60.92% and 61.90% for the first nine months of 2003 and 2004, respectively. Changes in the efficiency ratio can be attributed to the percentage change in tax-equivalent net interest income and noninterest income as compared to the percentage change in noninterest expenses. It is management’s objective to maintain an efficiency ratio at or below 65.00% for the Company. The following paragraphs provide information about expenses which are included within the respective Consolidated Statements of Income headings.

Salaries and benefits increased $783,770 or 17.1% from $4,589,616 for the first nine months of 2003 to $5,373,386 for the first nine months of 2004. Salaries and benefits increased $217,631 or 13.2% from $1,653,356 for the third quarter of 2003 to $1,870,987 for the third quarter of 2004. This increase can be attributed to annual salary adjustments and the hiring of additional personnel to accommodate the continued growth of the Company.

Occupancy expenses increased $236,816 or 50.8% from $465,919 to $702,735 for the first nine months of 2003 and 2004, respectively. Occupancy expenses increased $83,227 or 55.1% from $151,032 to $234,259 for the third quarter of 2003 and 2004, respectively. These increases can be attributed to the addition of the Millbrook Branch and the relocation of the Old Post Office Branch and Loan Department to the Old Town Center.

Equipment expenses increased $88,620 or 15.6% from $566,970 to $655,590 for the first nine months of 2003 and 2004, respectively. Equipment expenses increased $31,026 or 18.0% from $172,273 to $203,299 for the third quarter of 2003 and 2004, respectively. This increase can be attributed to investments in hardware and software related to the Bank’s core software conversion which occurred at the end of the first quarter during 2003.

Advertising and marketing expenses decreased $9,027 or 2.8% from $318,017 to $308,990 for the first nine months of 2003 and 2004, respectively. Advertising and marketing expenses decreased $47,572 or 29.1% from $163,489 to $115,917 for the third quarter of 2003 and 2004, respectively. This category contains numerous expense types such as advertising, public relations, business development and charitable contributions. The annual budgeted amount of advertising and marketing expenses is directly related to the Company’s growth in assets, however, this amount varies from quarter to quarter based on planned events and advertising campaigns. Expenses are allocated in a manner which focuses on effectively reaching the existing and potential customers within the market and contributing to the community.

Other operating expenses increased $234,595 or 14.5% from $1,615,364 to $1,849,959 for the first nine months of 2003 and 2004, respectively. Other operating expenses increased $31,507 or 6.0% from $526,925 to $558,432 for the third quarter of 2003 and 2004, respectively. This category is primarily comprised of the cost for services required during normal operations of the Company. These services include postage, insurance, ATM network fees, credit card processing fees, and auditing fees. These expenses are directly affected by the number of branch locations and volume of accounts at the Bank.

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FINANCIAL CONDITION

Securities

Total securities were $67.9 million at September 30, 2004 as compared to $47.9 million at December 31, 2003. This represents an increase of $20.0 million or 41.8%. The Company realized a gain of $155,517 during the first nine months of 2004 from the sales and calls of securities having an amortized cost of $2.1 million. The Company had securities purchases totaling $32.3 million during the first nine months of 2004, $20.3 million of which was during the third quarter. The Company had total maturities and principal repayments of $9.8 million during the first nine months of 2004. The Company did not have any securities from a single issuer, other than U.S. government agencies, whose amount exceeded 10% of shareholders’ equity as of September 30, 2004. Note 3 to the Consolidated Financial Statements provides additional details about the Company’s securities portfolio at September 30, 2004 and December 31, 2003.

The Company had $18.8 million and $14.2 million in securities classified as held to maturity at September 30, 2004 and December 31, 2003, respectively. The Company had $49.1 million and $33.7 million in securities classified as available for sale at September 30, 2004 and December 31, 2003, respectively. Most securities purchased during 2003 and 2004 were designated as available for sale due to their low yields. The ability to dispose of available for sale securities prior to maturity provides management more options to react to future rate changes and provides more liquidity when needed to meet short-term obligations.

Loan Portfolio

The Company’s primary use of funds is supporting lending activities from which it derives the greatest amount of interest income. Total loans outstanding were $295.3 million and $276.5 million at September 30, 2004 and December 31, 2003, respectively. This represents an increase of $18.8 million or 6.8% for the first nine months of 2004. The Company’s loan growth can be attributed to competitive loan pricing, experienced loan officers, and continuous sales efforts. Based on the current loan pipeline, the Company expects loan growth to continue for the remainder of 2004. The ratio of loans to deposits decreased from 100.4% at December 31, 2003 to 91.7% at September 30, 2004. The loan portfolio consists primarily of loans for owner-occupied single family dwellings, loans to acquire consumer products such as automobiles, and loans to small farms and businesses.

Loans secured by real estate were $238.1 million or 80.6% and $221.8 million or 80.2% of total loans at September 30, 2004 and December 31, 2003, respectively. This represents an increase of $16.3 million or 7.4% during the first nine months of 2004. These loans are well-secured and based on conservative appraisals in a stable market. The Company generally does not make real estate loans outside its primary market area. Consumer installment loans increased $0.5 million or 1.5% from $32.2 million at December 31, 2003 to $32.7 million at September 30, 2004. Consumer installment loans represent 11.6% and 11.1% of total loans at December 31, 2003 and September 30, 2004, respectively. This type of loan is primarily comprised of vehicle loans which have been difficult to increase due to manufacturer financing options and customers using alternative financing such as home equity lines of credit whose interest is tax-deductible. Commercial and industrial loans were $20.8 million or 7.5% and $23.0 million or 7.8% of total loans at December 31, 2003 and September 30, 2004, respectively. This represents an increase of $2.2 million or 10.7% for the first nine months of 2004.

Allowance for Loan Losses

The purpose of and the methods for measuring the allowance for loan losses are discussed in the Critical Accounting Policies section above. Charged-off loans were $131,564 and $203,801 for the nine months ended September 30, 2003 and 2004, respectively. Recoveries were $77,051 and $92,403 for the nine months ended September 30, 2003 and 2004, respectively. This resulted in net charge-offs of $54,513 and $111,398 for the nine months ended September 30, 2003 and 2004, respectively. The allowance for loan losses as a percentage of loans was 1.04% and 1.07% at December 31, 2003 and September 30, 2004, respectively. Management believes that the allowance for loan losses is adequate based on the loan portfolio’s current risk characteristics.

Risk Elements and Nonperforming Assets

Nonperforming assets consist of nonaccrual loans, restructured loans, and other real estate owned (foreclosed properties). Total nonaccrual loans were $130,646 and $34,780 at September 30, 2004 and December 31, 2003, respectively. The Company did not have any restructured loans or other real estate owned at September 30, 2004 or December 31, 2003. The percentage of nonperforming assets to loans and other real estate owned was 0.04% and 0.01% at September 30, 2004 and December 31, 2003, respectively. Total loans past due 90 days or more and still accruing interest were $71,673 or 0.02% and $69,885 or 0.03% of total loans at September 30, 2004 and December 31, 2003, respectively.

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The loans past due 90 days or more and still accruing interest are secured and in the process of collection and, therefore, are not classified as nonaccrual. Any loan past due 90 days or more which is not in the process of collection or where the collection of its principal or interest is doubtful would be placed on nonaccrual status. Once a loan is placed on nonaccrual status, accrued interest is reversed from income, the accrual of interest is discontinued, and interest income is recognized on a cash basis. Management evaluates the financial condition of these borrowers and the value of any collateral on these loans. The results of these evaluations are used to estimate the amount of losses which may be realized on the disposition of these nonaccrual loans. The allowance for loan losses at September 30, 2004 includes $23,815 in specific allocations for the nonaccrual loans. Management evaluates borrowers on an ongoing basis to identify those loans on which a loss may be realized. The methods for identifying these loans and establishing estimated losses for these loans are discussed in the Critical Accounting Policies section above. Once management determines that a loan requires a specific allowance, it becomes a potential problem loan. The amount of potential problem loans was $409,795 and $593,706 at September 30, 2004 and December 31, 2003, respectively. This represents a decrease of $183,911 or 31.0% during the first nine months of 2004. At September 30, 2004, these loans were primarily well-secured and in the process of collection, and the allowance for loan losses includes $33,530 in specific allocations for these loans.

Deposits

Total deposits were $322.0 million and $275.5 million at September 30, 2004 and December 31, 2003, respectively. This represents an increase of $46.5 million or 16.9% during the first nine months of 2004.

Noninterest bearing demand deposits increased $8.4 million or 12.9% from $65.1 million at December 31, 2003 to $73.5 million at September 30, 2004. Savings and interest-bearing demand deposits, which includes NOW accounts, money market accounts and regular savings accounts, increased $27.5 million or 18.9% from $145.7 million at December 31, 2003 to $173.2 million at September 30, 2004. A portion of the increase in these account types can be attributed to new deposit accounts gained through the Bank’s branch network. The significant growth in savings and interest bearing demand deposits can be attributed to the introduction of a tiered savings account which offers an above-market yield on deposit balances of $50,000 or more. Time deposits increased $10.6 million or 16.4% from $64.7 million at December 31, 2003 to $75.3 million at September 30, 2004. This increase in time deposits can be attributed to obtaining certificates of deposits of $100,000 or more which are comprised primarily of public funds.

The Company attempts to fund asset growth with deposit accounts and focus upon core deposit growth as its primary source of funding. Core deposits consist of demand deposits, interest-bearing demand deposits, money market accounts, savings accounts, and time deposits of less than $100,000. Core deposits totaled $292.4 million or 90.8% and $254.0 million or 92.2% of total deposits at September 30, 2004 and December 31, 2003, respectively. Certificates of deposit of $100,000 or more totaled $29.6 million or 9.2% and $21.5 million or 7.8% of total deposits at September 30, 2004 and December 31, 2003, respectively. The Company expects the pace of deposit growth to slow during the remainder of 2004.

CAPITAL RESOURCES

Total shareholders’ equity was $31.2 million or 7.84% and $28.4 million or 8.06% of total assets at September 30, 2004 and December 31, 2003, respectively. Shareholders’ equity per share increased $1.77 or 9.4% to $20.71 per share at September 30, 2004 from $18.94 per share at December 31, 2003. During the first three quarters of 2004, the Company paid $0.62 per share in dividends as compared to $0.55 per share for the same period of 2003. Total dividends paid during 2003 were $0.75 per share. The Company has a Dividend Investment Plan that reinvests the dividends of participating shareholders in Company stock.

Federal regulatory risk-based capital guidelines require percentages to be applied to various assets, including off-balance sheet assets, based on their perceived risk in order to calculate risk-weighted assets. Tier 1 capital consists of total shareholders’ equity plus qualifying trust preferred securities outstanding less net unrealized gains and losses on available for sale securities, goodwill and other intangible assets. Total capital is comprised of Tier 1 capital plus the allowable portion of the allowance for loan losses and any excess trust preferred securities that do not qualify as Tier 1 capital. The $7.0 million in trust preferred securities, issued by the Company during 2002, qualifies as Tier 1 capital because this amount does not exceed 25% of total capital, including the trust preferred securities. Financial institutions must maintain a Tier 1 risk-based capital ratio of at least 4% and a total risk-based capital ratio of at least 8%. Additionally, they must maintain a minimum Tier 1 leverage ratio of 4%. The Company’s Tier 1 risk-based capital ratio was 12.60% at September 30, 2004 as compared to 12.86% at December 31, 2003. The Company’s total risk-based capital ratio was 13.66% at September 30, 2004 as compared to 13.93% at December 31, 2003. The Company’s Tier 1 capital to average total assets ratio was 9.53% at September 30, 2004 as compared to 10.00% at December 31, 2003. Each of these ratios has decreased slightly as asset growth has exceeded shareholders’ equity growth, which is comprised of retained earnings and additional shares issued through the Dividend Investment Plan, during the first nine months of 2004. The Company monitors these ratios on a quarterly basis and has several strategies, including without limitation the issuance of common stock or trust preferred securities, to ensure that these ratios remain above regulatory minimums.

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LIQUIDITY

Liquidity management involves meeting the present and future financial obligations of the Company with the sale or maturity of assets or with the occurrence of additional liabilities. Liquidity needs are met with cash on hand, deposits in banks, federal funds sold, securities classified as available for sale and loans maturing within one year. At September 30, 2004, liquid assets totaled $135.7 million as compared to $103.7 million at December 31, 2003. These amounts represent 37.0% and 32.0% of total liabilities at September 30, 2004 and December 31, 2003, respectively. The Company minimizes liquidity demand by utilizing core deposits to fund asset growth. Securities provide a constant source of liquidity through paydowns and maturities. Also, the Company maintains short-term borrowing arrangements, namely federal funds lines of credit, with larger financial institutions as an additional source of liquidity. Finally, the Bank’s membership with the Federal Home Loan Bank of Atlanta provides a source of borrowings with numerous rate and term structures. The Company’s senior management monitors the liquidity position regularly and attempts to maintain a position which utilizes available funds most efficiently. Management believes that the Company maintains overall liquidity sufficient to satisfy the depositors’ requirements and meet its customers’ credit needs.

FORWARD LOOKING STATEMENTS

The Company makes forward looking statements in this quarterly report that are subject to risks and uncertainties. These forward looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward looking statements. These forward looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:

• the ability to successfully manage growth or implement growth strategies if the Bank is unable to identify attractive markets, locations or opportunities to expand in the future;

• competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;

• changes in general economic and business conditions in the market area;

• changes in interest rates and interest rate policies;

• the successful management of interest rate risk;

• risks inherent in making loans such as repayment risks and fluctuating collateral values;

• reliance on the management team, including the ability to attract and retain key personnel;

• maintaining capital levels adequate to support growth;

• maintaining cost controls and asset qualities as new branches are opened or acquired;

• demand, development and acceptance of new products and services;

• problems with technology utilized by the Bank;

• changing trends in customer profiles and behavior; and

• changes in banking and other laws and regulations.

Because of these uncertainties, actual future results may be materially different from the results indicated by these forward looking statements. In addition, past results of operations do not necessarily indicate future results.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

There have been no material changes in Quantitative and Qualitative Disclosures about Market Risk as reported in the 2003 Form 10-K.

Item 4. Controls and Procedures

The Company, under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2004 to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

There were no changes in the Company’s internal control over financial reporting during the Company’s quarter ended September 30, 2004 that have materially affected, or are reasonable likely to materially affect, the Company’s internal control over financial reporting.

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PART II - OTHER INFORMATION

Item 1. Legal Proceedings

During the normal course of business, various legal claims arise from time to time which, in the opinion of management, will have no material effect on the Company’s consolidated financial statements. The Company is not involved in any material pending legal proceedings.

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

None.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Submission of Matters to a Vote of Security Holders

None.

Item 5. Other Information

None.

Item 6. Exhibits

The following exhibits are filed with this Form 10-Q and this list includes the exhibit index:

Exhibit No.	Description
31.1	Certification by Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification by Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32	Certification by Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, this 10th day of November, 2004.

Eagle Financial Services, Inc.

/S/ JOHN R. MILLESON

John R. Milleson

President and Chief Executive Officer

/S/ JAMES W. MCCARTY, JR.

James W. McCarty, Jr.

Vice President, Chief Financial Officer, and

Secretary-Treasurer

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