10KSB

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-KSB

(Mark one)

x Annual Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2003

¨ 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 0-24958

Potomac Bancshares, Inc.

(Name of Small Business Issuer in Its Charter)

West Virginia	55-0732247
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)

111 East Washington Street PO Box 906, Charles Town WV	25414-0906
(Address of Principal Executive Offices)	(Zip Code)

304-725-8431

(Issuer’s Telephone Number, Including Area Code)

Securities registered under Section 12(b) of the Exchange Act:

Title of Each Class	Name of Each Exchange on Which Registered
NONE

Securities registered under Section 12(g) of the Exchange Act:

Common Stock, $1.00 Par Value

(Title of Class)

Check whether the issuer: (l) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for past 90 days.

Yes x No ¨

Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B is not contained in this form, and no disclosure will be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. x

State issuer’s revenues for its most recent fiscal year.                     $13,629,758

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was sold, or the average bid and asked price of such common equity, as of a specified date within the past 60 days. $38,666,147 as of March 10, 2004

ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS

DURING THE PAST FIVE YEARS

Check whether the issuer has filed all documents and reports required by Section 12, 13 or 15(d) of the Exchange Act after the distribution of securities under a plan confirmed by a court.

Yes x No ¨ Not Applicable ¨

(APPLICABLE ONLY TO CORPORATE REGISTRANTS)

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

1,698,817 as of March 10, 2004

DOCUMENTS INCORPORATED BY REFERENCE

The following lists the documents that are incorporated by reference in the Form 10-KSB Annual Report, and the Parts and Items of the Form 10-KSB into which the documents are incorporated.

Document	Part of the Form 10-KSB Into Which the Document is Incorporated
Portions of Potomac Bancshares, Inc.’s 2003 Annual Report to Shareholders for the year ended December 31, 2003	Part II, Items 6 and 7
Portions of Potomac Bancshares, Inc.’s Proxy Statement for the 2004 Annual Meeting of Shareholders	Part III, Items 9, 10, 11, 12 and 14
Transitional Small Business Disclosure Format (check one): Yes ¨No x

PART I

Item 1. Description of Business.

History and Operations

The Board of Directors of Bank of Charles Town (the “bank”) caused Potomac Bancshares, Inc. (“Potomac”) to be formed on March 2, 1994, as a single-bank holding company. To date, Potomac’s only activities have involved the acquisition of the bank. Potomac acquired all of the shares of the bank’s common stock on July 29, 1994.

Bank of Charles Town is a West Virginia state-chartered bank that formed and opened for business in 1871. The Federal Deposit Insurance Corporation insures the bank’s deposits. The bank engages in general banking business primarily in Jefferson County and Berkeley County, West Virginia. The bank also provides services to Washington County and Frederick County, Maryland and Loudoun County, Frederick County and Clarke County, Virginia. The main office is in Charles Town, West Virginia at 111 East Washington Street, with branch offices in

• Harpers Ferry, West Virginia,

• Kearneysville, West Virginia,

• Martinsburg, West Virginia and

• Hedgesville, West Virginia.

The bank provides individuals, businesses and local governments with a broad range of banking services. These services include

• Commercial credit lines,

• Real estate loans, secondary and adjustable rate mortgages,

• Equipment loans and retail loan products,

• Checking and savings accounts,

• Certificates of deposit, and

• Individual retirement accounts.

Automated teller machines located at each of the five offices and Touchline 24, an interactive voice response system available at 1-304-728-2424, provide certain services to customers on a twenty-four hour basis. Bill paying and certain other banking services are available through the Internet. The trust and financial services department provides financial management, investment and trust services.

Lending Activities. The bank offers installment, term, and real estate loans for consumer and commercial purposes. These loans can be unsecured, secured by collateral being purchased or secured by other collateral.

Underwriting standards for all lending include

• Sound credit analysis,

• Proper documentation according to the bank’s loan policy standards,

• Promotion of profitable customer relationships with cross-selling of bank services,

• Avoidance of loan concentrations to a single industry or with a single class of collateral, and

• Diligent maintenance of past due and nonaccrual loans.

It is management’s goal to maintain a relatively equal lending distribution among the following loan categories:

• Commercial,

• Commercial real estate,

• Residential real estate and

• Consumer or retail.

The lending policies of the bank address the importance of a diversified portfolio and of a balance between maximum yield and minimum risk. It is the bank’s policy to avoid concentrations of loans such as loans to one industry, loans to one borrower or guarantor or loans secured by similar collateral.

The bank’s loan policy designates particular loan-to-value limits for real estate loans in accordance with recommendations in Section 304 of the Federal Deposit Insurance Corporation Improvement Act of 1991. As stated in the loan policy, there may be certain lending situations not subject to these loan-to-value limits and from time to time the Board of Directors may permit exceptions to the established limits. Any exceptions are sufficiently documented.

Loans secured by real estate are made to individuals and businesses for

• The purchase of raw land and land development,

• Commercial, multi-family and other non-residential construction,

• Purchase of improved property,

• Purchase of owner occupied one to four family residential property,

• Lines of credit, and

• Home equity loans.

Approximately 74% of the bank’s loans are secured by real estate. These loans had an average delinquency rate of .65% and a loss rate of .01% during 2003. The average delinquency rate and loss rate are based on comparisons to 2003 average total loans.

As of December 31, 2003, aggregate dollar amounts in loan categories secured by real estate are as follows:

•     Construction and land development	$	13,956,590
•     Secured by farmland		3,711,332
•     Secured by 1-4 family residential		60,903,351
•     Other		25,313,790
	$	103,885,063

Commercial loans not secured by real estate with an aggregate balance of $17,649,329 at December 31, 2003 make up approximately 13% of the total loan portfolio. The bank’s loan policy for commercial loans including those commercial loans secured by real estate is to

• Grant loans on a sound and collectible basis,

• Invest the bank’s funds profitably for the benefit of shareholders and the protection of depositors and

• Serve the legitimate credit needs of the community in which the bank is located.

Average delinquency for commercial loans not secured by real estate was 0% and the loss rate was 0% during 2003.

Retail loans to individuals for personal expenditures are approximately 12% of the bank’s total loans at December 31, 2003. The aggregate balance of these loans was $17,549,454 at December 31, 2003. The majority of these loans are installment loans with the remainder made as term loans.

There is some risk in every retail loan transaction. The bank accepts moderate levels of risk while minimizing retail loan losses through careful investigation into the character of each borrower, determining the source of repayment before closing each loan, collateralizing most loans, exercising care in documentation procedures, administering an aggressive retail loan collection program, and following the retail loan policies. Loans to individuals for personal expenditures had an average delinquency rate of .23% and a loss rate of .79% in 2003 (based on comparisons to 2003 average total loans).

The remaining aggregate dollar amount of the bank’s loans is $973,978 (less than 1% of total loans) at December 31, 2003. This amount includes:

•     Obligations of states and political subdivisions secured by real estate	$	590,294
•     Loans for agricultural purposes		257,000
•     Other loans		126,684

These categories of loans had a 0% average delinquency rate and a 0% average loss rate in 2003 compared to 2003 average total loans.

Investment Activities. The bank’s investment policy governs its investment activities.

The policy states that excess daily funds are to be invested in federal funds sold and securities purchased under agreements to resell. The daily funds are used to cover deposit draw downs by customers, to fund loan commitments and to help maintain the bank’s asset/liability mix.

According to the policy, funds in excess of those invested in federal funds sold and securities purchased under agreements to resell are to be invested in U.S. Treasury bills, notes or bonds, obligations of U.S. Government agencies, obligations of political subdivisions of the State of West Virginia with a rating of not less than AAA and, with prior approval of the Board of Directors, bank qualified local industrial revenue bonds to be carried in the bank’s loan portfolio.

The policy governs various other factors including maturities, the closeness of purchase price to par, amounts that may be purchased and percentages of the various types of investments that may be held.

Deposit Activities. The bank offers noninterest-bearing and interest-bearing checking accounts and statement savings accounts. The bank offers automatically renewable certificates of deposit in various terms from 91 days to five years. Individual retirement accounts in the form of certificates of deposit are also available.

To open a deposit account, the depositor must meet the following requirements for low risk individuals:

• Present a valid identification,

• Have a social security number,

• Must be a U.S. citizen or possess evidence of legal alien status, and

• Must be at least 18 years of age or share account with a person at least 18 years of age.

Depositors who are considered medium or high risk (i.e. out-of-state driver’s license and/or resident), additional verification requirements apply. The bank fully complies with the Patriot Act.

Competition

As of March 3, 2004, there were 65 bank holding companies (including multi-bank and one bank holding companies) operating in the State of West Virginia. These holding companies are headquartered in various West Virginia cities and control banks throughout the State of West Virginia, including banks that compete with the bank in its market area.

The bank’s market area is generally defined as Jefferson County and Berkeley County, West Virginia. As of June 30, 2003, there were six banks in Jefferson County with 13 banking offices. The total deposits of these commercial banks as of June 30, 2003 were $533.4 million, and the bank ranked number one with $156.4 million or 29% of the total deposits in the market at that time. The bank has two branch offices in Berkeley County at this time. Opening in July 2001 and June 2003, these branches have less than 1% of the market share of deposits in Berkeley County where there are nine banks with 27 banking offices.

For most of the services that the bank performs, there is also competition from financial institutions other than commercial banks. For instance, credit unions, some insurance companies, and issuers of commercial paper and money market funds actively compete for funds and for various types of loans. In addition, personal and corporate trust and investment counseling services are offered by insurance companies, investment counseling firms and other business firms and individuals. Due to the geographic location of the bank’s primary market area, the existence of larger financial institutions in Maryland, Virginia and Washington, D.C. influences the competition in the market area. In addition, larger regional and national corporations continue to be increasingly visible in offering a broad range of financial services to all types of commercial and consumer customers. The principal competitive factors in the markets for deposits and loans are interest rates, either paid or charged. The chartering of numerous new banks in West Virginia and the opening of numerous federally chartered savings and loan associations have increased competition for the bank. The 1986 legislation passed by the West Virginia Legislature allowing statewide branch banking provided increased opportunities for the bank, but it also increased competition for the bank in its service area. With the beginning of reciprocal interstate banking in 1988, bank holding companies (such as Potomac Bancshares, Inc.) also face additional competition in efforts to acquire other subsidiaries throughout West Virginia.

In 1994, Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act. Under this Act, bank holding companies are permitted to acquire banks located in states other than the bank holding company’s home state without regard to whether the transaction is permitted under state law. Commencing on June 1, 1997, the Act allowed national banks and state banks with different home states to merge across state lines, unless the home state of a participating bank enacted legislation prior to May 31, 1997, that expressly prohibits interstate mergers. Additionally, the Act allows banks to branch across state lines, unless the state where the new branch will be located enacted legislation restricting or prohibiting de novo interstate branching on or before May 31, 1997. West Virginia adopted legislation, effective May 31, 1997, that allowed for interstate branch banking by merger across state lines and allowed for de novo branching and branching by purchase and assumption on a reciprocal basis with the home state of the bank in question. The effect of this legislation has been increased competition for West Virginia banks, including the bank.

Employees

Potomac currently has no employees.

As of March 10, 2004, the bank had 80 full-time employees and 16 part-time employees.

Supervision and Regulation

Introduction. Potomac is a bank holding company within the provisions of the Bank Holding Company Act of 1956, is registered as such, and is subject to supervision by the Board of Governors of the Federal Reserve System (“Board of Governors”). The Bank Holding Company Act requires Potomac to secure the prior approval of the Board of Governors before Potomac acquires ownership or control of more than five percent (5%) of the voting shares or substantially all of the assets of any institution, including another bank.

As a bank holding company, Potomac is required to file with the Board of Governors annual reports and such additional information as the Board of Governors may require pursuant to the Bank Holding Company Act. The Board of Governors may also make examinations of Potomac and its banking subsidiaries. Furthermore, under Section 106 of the 1970 Amendments to the Bank Holding Company Act and the regulations of the Board of Governors, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or any provision of credit, sale or lease of property or furnishing of services.

Potomac’s depository institution subsidiaries are subject to affiliate transaction restrictions under federal law that limit the transfer of funds by the subsidiary banks to their respective parents and any nonbanking subsidiaries, whether in the form of loans, extensions of credit, investments or asset purchases. Such transfers by any subsidiary bank to its parent corporation or any nonbanking subsidiary are limited in an amount to 10% of the institution’s capital and surplus and, with respect to such parent and all such nonbanking subsidiaries, to an aggregate of 20% of any such institution’s capital and surplus.

Potomac is required to register annually with the Commissioner of Banking of West Virginia (“Commissioner”) and to pay a registration fee to the Commissioner based on the total amount of bank deposits in banks with respect to which it is a bank holding company. Although legislation allows the Commissioner to prescribe the registration fee, it limits the fee to ten dollars per million dollars of deposits rounded off to the nearest million dollars. Potomac is also subject to regulation and supervision by the Commissioner.

Potomac is required to secure the approval of the West Virginia Board of Banking before acquiring ownership or control of more than five percent of the voting shares or substantially all of the assets of any institution, including another bank. West Virginia banking law prohibits any West Virginia or non-West Virginia bank or bank holding company from acquiring shares of a bank if the acquisition would cause the combined deposits of all banks in the State of West Virginia, with respect to which it is a bank holding company, to exceed 25% of the total deposits of all depository institutions in the State of West Virginia.

Depository Institution Subsidiaries. The bank is subject to FDIC deposit insurance assessments. As of January 1, 2003, FDIC set the Financing Corporation (FICO) Bank Insurance Fund (BIF) premium for the bank at the annual rate of 1.540 basis points or .0001540 times the total deposits of the bank. This premium is not tied to the bank’s risk classification. The rate of the premium based on the bank’s risk classification is at 0.00%. It is possible that BIF insurance assessments will be changed, and it is also possible that there may be a special additional assessment. A large special assessment could have an adverse impact on Potomac’s results of operations.

Capital Requirements. The Federal Reserve Board has issued risk-based capital guidelines for bank holding companies, such as Potomac. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations, takes off-balance sheet exposures into explicit account in assessing capital adequacy, and minimizes disincentives to holding liquid, low-risk assets. Under the guidelines and related policies, bank holding companies must maintain capital sufficient to meet both a risk-based asset ratio test and leverage ratio test on a consolidated basis. The risk-based ratio is determined by allocating assets and specified off-balance sheet commitments into four weighted categories, with higher levels of capital being required for categories perceived as representing greater risk. The leverage ratio is determined by relating core capital (as described below) to total assets adjusted as specified in the guidelines. Bank is subject to substantially similar capital requirements adopted by applicable regulatory agencies.

Generally, under the applicable guidelines, the financial institution’s capital is divided into two tiers. “Tier 1”, or core capital, includes common equity, noncumulative perpetual preferred stock (excluding auction rate issues) and minority interests in equity accounts or consolidated subsidiaries, less goodwill. Bank holding companies, however, may include cumulative perpetual preferred stock in their Tier 1 capital, up to a limit of 25% of such Tier 1 capital. “Tier 2”, or supplementary capital, includes, among other things, cumulative and limited-life preferred stock, hybrid capital instruments, mandatory convertible securities, qualifying subordinated debt, and the allowance for loan losses, subject to certain limitations, less required deductions. “Total capital” is the sum of Tier 1 and Tier 2 capital.

Financial institutions are required to maintain a risk-based ratio of 8%, of which 4% must be Tier 1 capital. The appropriate regulatory authority may set higher capital requirements when an institution’s particular circumstances warrant.

Financial institutions that meet certain specified criteria, including excellent asset quality, high liquidity, low interest rate exposure and the highest regulatory rating, are required to maintain a minimum leverage ratio of 3%. Financial institutions not meeting these criteria are required to maintain a leverage ratio which exceeds 3% by a cushion of at least 100 to 200 basis points, and, therefore, the ratio of Tier 1 capital to total assets should not be less than 4%.

The guidelines also provide that financial institutions experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. Furthermore, the Federal Reserve Board’s guidelines indicate that the Federal Reserve Board will continue to consider a “tangible Tier 1 leverage ratio” in evaluating proposals for expansion or new activities. The tangible Tier 1 leverage is the ratio of an institution’s Tier 1 capital, less all intangibles, to total assets, less all intangibles.

Failure to meet applicable capital guidelines could subject the financial institution to a variety of enforcement remedies available to the federal regulatory authorities, including limitations on the ability to pay dividends, the issuance by the regulatory authority of a capital directive to increase capital and the termination of deposit insurance by the FDIC, as well as to the measures described in the “Federal Deposit Insurance Corporation Improvement Act of 1991” as applicable to undercapitalized institutions.

The Federal Reserve Board, as well as the FDIC, has adopted changes to their risk-based and leverage ratio requirements that require that all intangible assets, with certain exceptions, be deducted from Tier 1 capital. Under the Federal Reserve Board’s rules, the only types of intangible assets that may be included in (i.e., not deducted from) a bank holding company’s capital are readily marketable purchased mortgage servicing rights (“PMSRs”) and purchased credit card relationships (“PCCRs”), provided that, in the aggregate, that total amount of PMSRs and PCCRs included in capital does not exceed 50% of Tier 1 capital. PCCRs are subject to a separate limit of 25% of Tier 1 capital. The amount of PMSRs and PCCRs that a bank holding company may include in its capital is limited to the lesser of (i) 90% of such assets’ fair market value (as determined under the guidelines), or (ii) 100% of such assets’ book value, each determined quarterly. Identifiable intangible assets (i.e., intangible assets other than goodwill) other than PMSRs and PCCRs, including core deposit intangibles, acquired on or before February 19, 1992 (the date the Federal Reserve Board issued its original proposal for public comment), generally will not be deducted from capital for supervisory purposes, although they will continue to be deducted for purposes of evaluating applications filed by bank holding companies.

As of December 31, 2003, Potomac had capital in excess of all applicable requirements as shown below:

	Actual			Required			Excess
	(Amounts in thousands)
Tier 1 capital:
Common stock	$	1,800
Surplus		4,200
Retained earnings		16,543
		22,543
Less cost of shares acquired for the treasury		1,709
Total tier 1 capital	$	20,834		$	5,679		$	15,155
Tier 2 capital:
Allowance for loan losses (1)		1,724
Total risk-based capital	$	22,558		$	11,358		$	11,200
Risk-weighted assets	$	141,978
Tier 1 capital	$	20,834		$	6,129		$	14,705
Average total assets	$	204,287
Capital ratios:
Tier 1 risk-based capital ratio		14.67	%		4.00	%		10.67	%
Total risk-based capital ratio		15.89	%		8.00	%		7.89	%
Tier 1 capital to average total assets (leverage)		10.20	%		4.00	%		6.20	%

(1) Limited to 1.25% of gross risk-weighted assets.

Gramm-Leach-Bliley Act of 1999. On November 4, 1999, Congress adopted the Gramm-Leach-Bliley Act of 1999. This Act, also known as the Financial Modernization Law, repealed a number of federal limitations on the powers of banks and bank holding companies originally adopted in the 1930’s. Under the Act, banks, insurance companies, securities firms and other service providers may now affiliate. In addition to broadening the powers of banks, the Act created a new form of entity, called a financial holding company, which may engage in any activity that is financial in nature or incidental or complimentary to financial activities.

The Federal Reserve Board provides the principal regulatory supervision of financial services permitted under the Act. However, the Securities and Exchange Commission and state insurance and securities regulators also assume substantial supervisory powers and responsibilities.

The Act addresses a variety of other matters, including customer privacy issues. The obtaining of certain types of information by false or fraudulent pretenses is a crime. Banks and other financial institutions must notify their customers about their policies on sharing information with certain third parties. In some instances, customers may refuse to permit their information to be shared. The Act also requires disclosures of certain automatic teller machine fees and contains certain amendments to the federal Community Reinvestment Act.

Permitted Non-Banking Activities. Under the Gramm-Leach-Bliley Act, bank holding companies may become financial holding companies and engage in certain non-banking activities. Potomac has not yet filed to become a financial holding company and presently does not engage in, nor does it have any immediate plans to engage in, any such non-banking activities.

A notice of proposed non-banking activities must be furnished to the Federal Reserve and the Banking Board before Potomac engages in such activities, and an application must be made to the Federal Reserve and Banking Board concerning acquisitions by Potomac of corporations engaging in those activities. In addition, the Federal Reserve may, by order issued on a case-by-case basis, approve additional non-banking activities.

The Bank. The bank is a state-chartered bank that is not a member of the Federal Reserve system and is subject to regulation and supervision by the FDIC and the Commissioner.

Compliance with Environmental Laws. The costs and effects of compliance with federal, state and local environmental laws will not have a material effect or impact on Potomac or the bank.

Available Information. The company files annual, quarterly and current reports, proxy statements and other information with the SEC. The company’s SEC filings are filed electronically and are available to the public through the Internet at the SEC’s website at http://www.sec.gov. In addition, any document filed by the company with the SEC can be read and copied at the SEC’s public reference facilities at 450 Fifth Street, NW, Washington, DC 20549. Copies of documents can be obtained at prescribed rates by writing to the Public Reference Section of the SEC at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Copies of documents can also be obtained free of charge by any shareholder by writing to Gayle Marshall Johnson, Vice President and Chief Financial Officer, Potomac Bancshares, Inc., PO Box 906, Charles Town, WV 25414.

Item 2. Description of Property.

Potomac currently has no property.

The bank owns the land and buildings of the main office and the branch office facilities in Harpers Ferry, Kearneysville and Hedgesville.

The main office property is located at 111 East Washington Street, Charles Town, West Virginia. This property consists of two separate two story buildings located side by side with adjoining corridors. During 2000, the construction of the newer of these two buildings was completed. The first floor of the new building houses the Trust and Financial Services Division. The second floor of the new building houses certain administrative and loan offices. Both of these floors open into the older bank premises. The basement of the new building is currently being remodeled for use as offices and a board/conference room. Record storage formerly kept in the basement is now held offsite.

The older premise, constructed in 1967, was renovated at the same time the new building was constructed. The renovation includes all new lighting, new ceilings, new floor and wall coverings as well as some minor structural changes for more efficient operations.

The Harpers Ferry branch office is located at 1318 Washington Street, Bolivar, West Virginia. The office is a one story brick building constructed in 1975. There is another building on this property that existed at the time of the bank’s purchase. This separate building is rented to an outside party by the bank.

The branch facility in Kearneysville, West Virginia was erected in 1985. This one story brick building opened for business in April of 1985. During 1993, an addition was constructed, doubling the size of this facility.

The branch facility in Hedgesville, West Virginia was erected in 2003. This one story brick building opened for business in June of 2003.

The bank leases the facilities housing the branch office in Martinsburg, West Virginia that opened in July 2001. The amended lease expires in February 2008. The bank has an additional lease for property adjoining the original leased property. This property will be used for construction of a new Martinsburg branch office building. Construction should begin mid 2004 and be completed in late 2004.

There are no encumbrances on any of these properties. In the opinion of management, these properties are adequately covered by insurance.

Item 3. Legal Proceedings.

Currently Potomac is involved in no legal proceedings.

The bank is involved in various legal proceedings arising in the normal course of business, and in the opinion of the bank, the ultimate resolution of these proceedings will not have a material effect on the financial position or operations of the bank.

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

Not Applicable.

PART II

Item 5. Market for Common Equity and Related Stockholder Matters.

The following information reflects comparative per share data for the periods indicated for Potomac common stock for (a) trading values, and (b) dividends. This information has been restated to reflect a 200% stock dividend declared on February 11, 2003. As of March 15, 2004, there were approximately 1,100 shareholders.

Potomac’s common stock is not traded on any stock exchange or over the counter. Potomac (symbol PTBS) is on the OTC Bulletin Board, a network available to brokers. Scott and Stringfellow, Inc., Koonce Securities Inc. and Ferris, Baker Watts, Inc. are market makers for Potomac common stock. A market maker is one who makes a market for a particular stock. Information about sales (but not necessarily all sales) of Potomac common stock is available on the Internet through many of the stock information services using Potomac’s symbol. Shares of Potomac common stock are occasionally bought and sold by private individuals, firms or corporations, and, in many instances, Potomac does not have knowledge of the purchase price or the terms of the purchase. The trading values for 2002 and 2003 are based on information available is a result of our participation on the Bulletin Board described above and information gathered on the Internet. No attempt was made by Potomac to verify or determine the accuracy of the representations made to Potomac or gathered on the Internet.

		Price Range				Cash Dividends Paid per Share
		High		Low
2002	First Quarter	$	12.78	$	11.75	$	N/A
	Second Quarter		13.66		12.17		23
	Third Quarter		14.17		13.37		N/A
	Fourth Quarter		15.50		13.92		25
2003	First Quarter	$	19.00	$	15.50	$	1300
	Second Quarter		20.00		18.30		1325
	Third Quarter		25.00		19.00		1350
	Fourth Quarter		23.75		22.10		1375

Beginning in 2003 common stock dividends are paid on a quarterly basis. Prior to 2003 the company had paid dividends on a semi-annual basis.

The primary source of funds for dividends paid by Potomac is the dividend income received from the bank. The bank’s ability to pay dividends is subject to restrictions under federal and state law, and under certain cases, approval by the FDIC and the Commissioner could be required. Management of Potomac anticipates that the dividends paid by Potomac will likely be similar to those paid in the past, but dividends will only be paid when and as declared by the board of directors.

Item 6. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The information contained on pages 6-14 of the Annual Report to Shareholders for the year ended December 31, 2003, is incorporated herein by reference.

Financial Instruments With Off-Balance-Sheet Risk. The company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. Those financial instruments include commitments to extend credit and standby letters of credit. Those instruments 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 those instruments reflect the extent of involvement the company has 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 instruments for commitments to extend credit and standby letters of credit 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.

A summary of the contract or notional amount of the company’s exposure to off-balance-sheet risk as of December 31, 2003 and 2002, is as follows:

	2003		2002
Financial instruments whose contract amounts represent credit risk:
Commitments to extend credit	$	24,847,726	$	19,990,685
Standby letters of credit		5,006,967		1,638,028

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 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 accounts receivable, inventory, property and equipment, and income-producing commercial properties.

Unfunded commitments under commercial lines of credit are commitments for possible future extensions of credit to existing customers. These lines of credit are uncollateralized and usually do not contain a specified maturity date and may not be drawn upon to the extent to which the company is committed.

Standby letters of credit 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, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The company generally holds collateral supporting those commitments if deemed necessary.

At December 31, 2003, the company had rate lock commitments to originate mortgage loans amounting to $976,088 and loans held for sale of $564,213. The company has entered into corresponding mandatory commitments, on a best-efforts basis, to sell these loans. These commitments to sell loans are designed to eliminate the company’s exposure to fluctuations in interest rates in connection with rate lock commitments and loans held for sale.

Short-Term Borrowings. Short-term borrowings consist of securities sold under agreements to repurchase, which are secured transactions with customers and generally mature the day following the day sold. Balances outstanding under repurchase agreements were $9.1 million on December 31, 2003 and $6.1 million on December 31, 2002.

The table below presents selected information on these short-term borrowings:

	December 31
	2003			2002
Balance outstanding at year end	$	9,199,345		$	6,102,441
Maximum balance at any month-end during the year	$	9,518,662		$	6,244,907
Average balance for the year	$	8,549,015		$	4,196,410
Weighted average rate for the year		2.01	%		2.35	%
Weighted average rate at year end		2.00	%		2.15	%
Estimated fair value	$	9,199,345		$	6,102,441

Item 7. Financial Statements.

The information contained on pages 15-35 of the Annual Report to Shareholders for the year ended December 31, 2003, is incorporated herein by reference.

Item 8. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure.

Not Applicable.

Item 8A. Controls and Procedures.

The company’s chief executive officer and chief financial officer, based on their evaluation as of the date of this report of the company’s disclosure controls and procedures (as defined in Rule 13(a)-14(e) of the Securities Exchange Act of 1934), have concluded that the company’s disclosure controls and procedures are adequate and effective for purposes of Rule 13(a)-14(c) and timely, alerting them to material information relating to the company required to be included in the company’s filings with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

There were no significant changes in the company’s internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation.

Appearing immediately following the signatures of this annual report on Form 10-KSB, certificates of the chief executive officer and chief financial officer appear. This form of certification is required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002. This section of the annual report on Form 10-KSB is the information concerning the controls evaluation referred to in the Section 302 certifications. This information should be read in conjunction with those certifications for a more complete understanding of the topics presented. Disclosure controls are procedures that a company designs with the objective of ensuring that information required to be disclosed in their reports filed under the Securities Exchange Act of 1934 (such as this Form 10-KSB), is recorded, processed, summarized and reported within the time period specified under the SEC’s rules and forms.

Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to management, including the CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure. Internal controls are procedures that a company designs with the objective of providing reasonable assurance that transactions are properly authorized, assets are safeguarded against unauthorized or improper use and transactions are properly recorded and reported all to permit the preparation of a company’s financial statements in conformity with generally accepted accounting principles.

The company’s management, including the CEO and CFO, does not expect that our disclosure controls or internal controls will prevent all error and fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments and decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of control also is based in part upon certain assumptions about the likelihood of future events and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

Based upon the controls evaluation conducted by our CEO and CFO, they have concluded that, subject to the limitations noted above, the company’s disclosure controls are effective to ensure that material information relating to Potomac and its subsidiaries is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared, and that our internal controls are effective to provide reasonable assurance that our financial statements are fairly presented in conformity with generally accepted accounting principles.

PART III

Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act.

The information contained on pages 8-10 and 17 of the Proxy Statement dated March 30, 2004, for the April 27, 2004 Annual Meeting under the captions “Management Nominees to the Board of Potomac” and “Directors Continuing to Serve Unexpired Terms,” and page 17 under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference.

The Executive Officers are as follows:

Name	Position Since	Age	Principal Occupation
Robert F. Baronner, Jr.	President & CEO 2001	45	Employed by bank as of 1/1/01 as President & CEO; former Senior Credit Officer BB&T Northern WestVirginia May 2000 – December 2000; former Executive Vice President One Valley Bank East September 1997—April 2000.
William R. Harner	Sr. Vice President 1994	63	Employed at bank from 1967 to 2004; Sr. Vice President & Cashier 1988-2004 (retired).
Gayle Marshall Johnson	Vice President & Chief Financial Officer 1994	54	Employed with the bank 1977-1985 and 1988-present; Vice President and Chief Financial Officer since 1990.
Donald S. Smith	Assistant Secretary 1994	75	Employed at bank 1947 to 1991; President 1979 to 1991 (retired).

The bank has adopted a Code of Ethics that applies to all employees, including Potomac’s and the bank’s chief executive officer and chief financial officer and other senior officers. The Code of Ethics is attached to this document as Exhibit 14.1. If we make any substantive amendments to this code or grant any waiver from a provision of the code to our chief executive officer or chief financial officer, we will disclose the amendment or waiver in a report on Form 8-K.

Item 10. Executive Compensation.

The information contained on pages 12-13 and 15-16 of the Proxy Statement dated March 30, 2004, for the April 27, 2004 Annual Meeting under the captions “Executive Compensation,” “Employee Benefit Plans,” “Employment Agreement,” and “Compensation of Directors” is incorporated herein by reference.

Item 11. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

The information contained on pages 10-12 of the Proxy Statement dated March 30, 2004, for the April 27, 2004 Annual Meeting under the captions “Principal Holders of Voting Securities” and “Ownership of Securities by Nominees, Directors and Officers” is incorporated herein by reference.

Item 12. Certain Relationships and Related Transactions.

The information contained on page 16 of the Proxy Statement dated March 30, 2004, for the April 27, 2004 Annual Meeting under the caption “Certain Transactions with Directors, Officers and Their Associates” is incorporated herein by reference.

Item 13. Exhibits List and Reports on Form 8-K.

(a) 2.1   Agreement and Plan of Merger dated March 8, 1994, by and between Potomac Bancshares, Inc., and Bank of Charles Town filed with and incorporated by reference from the Registration on Form S-4 filed with the Securities and Exchange Commission on June 10, 1994, Registration No. 33-80092.

     3.1    Articles of Incorporation of Potomac Bancshares, Inc. filed with and incorporated by reference from the Registration on Form S-4 filed with the Securities and Exchange Commission on June 10, 1994, Registration No. 33-80092.

     3.2    Amendments to Articles of Incorporation of Potomac Bancshares, Inc. adopted by shareholders on April 25, 1995 and filed with the West Virginia Secretary of State on May 23, 1995, and incorporated by reference from Potomac’s Form 10-KSB for the year ended December 31, 1995 and filed with the Securities and Exchange Commission, File No. 0-24958.

     3.3    Bylaws of Potomac Bancshares, Inc. filed with and incorporated by reference from the Registration on Form S-4 filed with the Securities and Exchange Commission on June 10, 1994, Registration No. 33-80092.

     3.4    Amended and Restated Bylaws of Potomac Bancshares, Inc. adopted by shareholders April 25, 1995 and incorporated by reference from Potomac’s Form 10-KSB for the year ended December 31, 1995, and filed with the Securities and Exchange Commission, File No. 0-24958.

     10.1  2003 Stock Incentive Plan adopted by the Potomac Board February 20, 2003 and approved by the Company’s shareholders on May 13, 2003.

     10.2  Employment Agreement of Mr. Robert F. Baronner, Jr., filed with and incorporated by reference from Form 10-KSB for the year ended December 31, 2001, and filed with the Securities and Exchange Commission, File No. 0-24958.

     13     2003 Annual Report to Shareholders, portions are incorporated by reference in Form 10KSB Annual Report*

     14.1  Code of Ethics

     21     Subsidiaries of the Registrant

     23.1  Consent of Independent Accountants

     31.1  Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer

     31.2  Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer

     32.1  Section 1350 Certification of Chief Executive Officer

     32.2  Section 1350 Certification of Chief Financial Officer

     99.1  Proxy Statement for the 2004 Annual Meeting for Potomac, portions are incorporated by reference in Form 10KSB Annual Report*

* Filed herewith.

(b) A Form 8-K report was filed on November 4, 2003. The report was to announce the 2003 fourth quarter dividend of $.1375 cents per share. The dividend was payable on December 1, 2003 to shareholders of record November 15, 2003. There were no financial statements filed with the report.

Item 14. Principal Accountant Fees and Services.

The information contained on page 7-8 of the Proxy Statement dated March 30, 2004, for the April 27, 2004 Annual Meeting under the caption “Audit Committee Report” is incorporated herein by reference.

SIGNATURES

In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

POTOMAC BANCSHARES, INC.
By	/s/ Robert F. Baronner, Jr.	March 29, 2004
	Robert F. Baronner, Jr. President & Chief Executive Officer

By	/s/ Gayle Marshall Johnson	March 29, 2004
	Gayle Marshall Johnson Vice President & Chief Financial Officer

In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Signature & Title		Date
By	/s/ J. Scott Boyd	March 29, 2004
	J. Scott Boyd, Director
By	/s/ John P. Burns, Jr.	March 29, 2004
	John P. Burns, Jr., Director
By	/s/ Guy Gareth Chicchirichi	March 29, 2004
	Guy Gareth Chicchirichi, Director
By	/s/ Margaret Cogswell	March 29, 2004
	Margaret Cogswell, Director
By	/s/ Thomas C. G. Coyle	March 29, 2004
	Thomas C. G. Coyle, Director
By	/s/ William R. Harner	March 29, 2004
	William R. Harner, Director and Secretary

Signature & Title		Date
By	/s/ E. William Johnson	March 29, 2004
	E. William Johnson, Director
By	/s/ Barbara H. Pichot	March 29, 2004
	Barbara H. Pichot, Director
By	/s/ John C. Skinner, Jr.	March 29, 2004
	John C. Skinner, Jr., Director
By	/s/ Donald S. Smith	March 29, 2004
	Donald S. Smith, Director
By	/s/ C. Larry Togans	March 29, 2004
	C. Larry Togans, Director

EX-10.1

Exhibit 10.1

POTOMAC BANCSHARES, INC.

2003 STOCK INCENTIVE PLAN

ARTICLE I

Purpose

The purposes of this Stock Incentive Plan (the “Plan”) are to enable Potomac Bancshares, Inc. (the “Company”) to (i) provide opportunities for certain persons, including officers and directors who provide services to the Company and its Subsidiary and key employees of the Company and its Subsidiary, as determined by the Committee, to acquire a proprietary interest in the Company, (ii) increase incentives for the Eligible Participants to contribute to the Company’s performance and future success and (iii) attract and retain individuals with exceptional business, managerial and administrative talent upon whom, in large measure, the sustained progress, growth and profitability of the Company depend.

ARTICLE II

Plan Overview

The Plan provides for the grant of Incentive Stock Options and Nonqualified Stock Options, as those terms are defined below, as contemplated by Sections 422 and 421 of Internal Revenue Code of 1986, as amended, and the rules and regulations promulgated thereunder (the “Code”).

ARTICLE III

Definitions

For Plan purposes, except where the context clearly indicates otherwise, the following terms shall have the following meanings:

3.01    “Adoption Date” shall have the meaning set forth in Article XIII.

3.02    “Board” shall mean the Board of Directors of the Company.

3.03    “Committee” shall mean the non-employee members of the Personnel Committee of the Board, or such other Committee of the Board as the Board shall designate from time to time, in either case which Committee shall consist of three or more directors appointed by the Board from time to time, each of whom is a Disinterested Person.

3.04    “Common Stock” shall mean the voting Common Stock of the Company.

3.05    “Company” shall mean Potomac Bancshares, Inc.

3.06    “Disinterested Person” shall mean an administrator of this Plan who is a non-employee Director, as that term is defined in Rule 16b-3 issued pursuant to the Securities Exchange Act of 1934.

3.07    “Effective Date” shall have the meaning set forth in Article XIII.

3.08    “Eligible Participants” shall mean Employees and members of the Board of Directors.

3.09    “Employee” shall mean an individual in the employ of the Company and/or its Subsidiary, subject to the control and direction of the employer entity as to both work to be performed and the manner and method of performance.

3.10    “Exercise Price” shall have the meaning set forth in Article VII.

3.11    “Fair Market Value” of the Common Stock shall mean the value per share of the Company’s Common Stock, determined without regard to any restriction other than a restriction which, by its terms, will never lapse, as determined through the good faith efforts of the Committee, consistent with applicable requirements of the Code.

3.12    “Incentive Stock Option” or “ISO” shall mean a stock option granted under this Plan which complies with all the terms and conditions for an incentive stock option, as set forth in the Code.

3.13    “Nonqualified Stock Option” or “NQO” shall mean a stock option granted under this Plan which does not comply with one or more requirements for an incentive stock option, as set forth in the Code.

3.14    “Option” shall mean an Incentive Stock Option or a Nonqualified Stock Option granted under this Plan.

3.15    “Option Shares” shall mean shares of the Company’s Common Stock received by an Optionee upon exercise of an Option.

3.16    “Optionee” shall mean an Eligible Participant who has been granted one or more Options.

3.17    “Reorganization” shall have the meaning set forth in Article IX.

3.18    “Stock Adjustment” shall have the meaning set forth in Article VIII.

3.19    “Stock Option Agreement” shall mean the written agreement entered into by the Company and each Optionee evidencing the terms and conditions of an Option.

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3.20    “Subsidiary” shall mean a subsidiary corporation within the meaning of 424(f) of the Code.

3.21    “Ten Percent Share Owner” shall mean an employee of the Company who owns, whether outright or by attribution under Section 424(d) of the Code, Common Stock possessing more than ten percent of the total combined voting power of all classes of stock of the Company.

ARTICLE IV

Administration

4.01    The Committee. The Committee shall administer the Plan and shall, subject to approval by the Board of Directors, have full power and authority to, in addition to other powers set forth herein, construe and interpret the Plan, establish any and all rules and regulations for the operation of the Plan, establish any and all rules and regulations for the operation of the Committee and the performance by the Committee of its purposes and functions, and perform all other acts, including the delegation of administrative responsibilities, that it deems reasonable and proper.

The Committee shall hold its meetings at such times and places as it shall deem advisable. A majority of the members of the Committee shall constitute a quorum of the Committee. All actions of the Committee shall be taken by a majority of its members. Any action of the Committee may be taken by a written instrument signed by a majority of the Committee’s members, and any action so taken shall be as effective as if it had been taken by a vote of the Committee.

4.02    Powers of the Committee. The Committee, subject to approval by the Board of Directors, shall have full power and authority to, among other things:

(a) determine those persons who are Eligible Participants;

(b) determine any conditions precedent and other applicable criteria in allocating and granting Options;

(c) determine the number and type of each Option and the number of shares of Common Stock covered by each Option and whether the Option is for voting or nonvoting common;

(d) determine the Exercise Price of each Option (subject to the terms and conditions set forth in this Plan and in any Stock Option Agreement);

(e) determine the grant date and exercise date of any Option;

(f) impose any vesting restrictions or other restrictions on exercise of an Option;

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(g) accelerate the exercise or vesting date of an Option;

(h) impose cancellation, transfer, forfeiture and other repurchase restrictions and limitations on any Option and the Option Shares; and

(i) determine any and all other terms, provisions and/or conditions upon the grant or exercise of an Option or the sale, exchange, gift, transfer, pledge or other disposition of Options and/or the Option Shares.

The terms and conditions of each Stock Option Agreement shall be determined solely in the discretion of the Committee, subject to the terms and conditions of this Plan. The terms and conditions of each Option and related Stock Option Agreement may be different as among Optionees and/or as among Options granted to the same Optionee, except as otherwise provided herein.

4.03    Corrective Measures. The Committee may correct any defect, supply any omission or reconcile any inconsistency in the Plan, any Option, or any Stock Option Agreement, in the manner and to the extent it shall deem necessary, including amendments hereto or thereto approved by not less than a majority of the Committee; provided, however, that any such Committee action shall be effective only if (i) any stockholder consent required by applicable provisions of the Code is obtained, and (ii) such action is otherwise consistent with the applicable provisions of the Code.

4.04    Decisions Final. Any decision made or action taken by the Committee or the Board arising out of or in connection with the interpretation and administration of the Plan shall be final and conclusive and shall be binding upon Optionees and their assigns.

ARTICLE V

Number of Shares Subject to the Plan

The aggregate number of shares of Common Stock available for grants of Options under this Plan shall be 90,000 shares, subject to adjustment in accordance with Article VIII of the Plan, and the aggregate number of shares of Common Stock for which Options may be granted under this Plan shall not exceed such number. Such shares may be either authorized but unissued shares or treasury shares. If an Option or portion thereof shall expire or terminate for any reason without having been exercised, the unpurchased shares covered by such Option shall be available for future grants of Options; provided, however, that in no event shall the Committee have any obligation to make such shares available for the granting of other Options under the Plan.

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ARTICLE VI

Eligibility

Consistent with this Plan’s purposes and the terms herein, Options may be granted to Eligible Participants at times and based on criteria the Committee, in its sole discretion, determines are appropriate.

ARTICLE VII

Option Terms and Conditions

All Options granted under this Plan shall be evidenced by a Stock Option Agreement in substantially the form attached hereto, or such other form as the Committee shall approve from time to time. The Stock Option Agreement shall be subject to the provisions of the Plan and such other provisions as the Committee may adopt, subject to the approval of the Board of Directors, including the following provisions:

A.    Exercise Price. The exercise price per share for each Option granted under this Plan shall be set forth in the Stock Option Agreement; provided, however, that if such Option is an ISO, the exercise price per share shall not be less than the Fair Market Value of a share of Common Stock on the date such ISO is granted (the “Exercise Price”).

B.    Term of Option. No Option shall be granted pursuant to the Plan after the date ten (10) years after the earlier of the Adoption Date or the Effective Date, as those terms are defined in Article XIII. Options which are outstanding after such date will, however, remain in effect until such Options are exercised or expire pursuant to their terms. An Option shall not be exercisable after the expiration of ten years from the date such Option is granted.

C.    Transfer of Options. Options granted under the Plan shall be transferrable by will or by the laws of descent and distribution. In addition, Nonqualified Stock Options granted under the Plan can be transferred during the lifetime of the Optionee only if all of the following conditions are satisfied: (1) the Committee has approved the proposed transfer in writing; (2) the proposed transfer is to be made without consideration; (3) the proposed transferee is a member or members of the Optionee’s immediate family (i.e., a child, or children, a grandchild or grandchildren, or the Optionee’s spouse) and/or to a trust established for the benefit of an immediate family member or members, or a family limited partnership which includes the Optionee and/or members of the Optionee’s immediate family, or a trust established for the benefit of the Optionee, and/or an immediate family member or members and a charity exempt from taxation under Internal Revenue Code 501 (c)(3); and (4) after transfer, each Option transferred by the Optionee shall remain subject to the provisions of the Plan under which it was granted.

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D.    Time of Exercise. Each Option granted under this Plan shall be exercisable on the date or dates, and during the period, and for the number of shares specified in the Stock Option Agreement. The Committee may establish vesting provisions applicable to an Option such that the Option becomes fully exercisable, for example, in a series of cumulating portions. The Committee may, upon request, permit the accelerated exercise of any Option, the exercise of all or a portion of which is subject to vesting provisions. Also, exercise of an Option shall be accelerated upon the occurrence of an event of acceleration as described in any applicable Stock Option Agreement or this Plan.

E.    Exercise. An Option or portion thereof shall be exercised by delivery of a written notice of exercise to the Secretary of the Company and payment of the full Exercise Price. Until the certificates for Option Shares represented by an exercised Option are issued to an Optionee, such Optionee shall have none of the rights of a stockholder. No Option Shares shall be delivered upon any exercise of an Option until the requirements of all applicable laws, rules and regulations have, in the opinion of the Company’s counsel, been satisfied. Under normal circumstances, certificates for Option Shares to be delivered upon exercise of an Option shall be delivered within thirty (30) days following exercise of an Option.

F.    Payment. The Exercise Price payable upon exercise of an Option or portion thereof may be paid:

(i) in United States dollars in cash or by check, bank draft or money order,

(ii) by delivery of shares of Common Stock with an aggregate value equal to the Exercise Price, or

(iii) by a combination of both (i) and (ii) above.

If the Optionee delivers shares of Common Stock as payment upon exercise of an Option, the Committee shall determine acceptable methods for tendering such shares by the Optionee, and may impose such limitations and prohibitions on the use of Common Stock for such purposes as it deems appropriate.

G.    Termination of Service. Subject to the terms set forth in any employment or other binding agreement, in the event an Optionee’s Current Position, as defined below, with the Company shall terminate (i) “for cause,” as defined below, while holding one or more Options, that portion of each Option which is not then currently exercisable shall expire coincident with the termination of the Optionee’s Current Position, or (ii) for a reason other than “for cause,” other than by reason of disability or death as discussed below, any Options or portion thereof which are exercisable on the date of such termination shall be exercisable until a date three (3) months after such date of termination or shall expire

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coincident with such three (3) month period, except to the extent the Committee shall determine otherwise by rules established and administered in a consistent and nondiscriminatory manner in compliance with the terms of this Plan and the Code. For purposes hereof, “Current Position” shall mean the Optionee’s position with the Company as an employee or director. For purposes hereof, “for cause” shall mean termination of an Eligible Participant’s Current Position with the Company because of such Eligible Participant’s (i) willful misfeasance, willful waste of corporate assets, gross negligence or willful and continued failure to substantially perform his reasonably assigned duties or (ii) willful engagement and dishonest or illegal conduct that is demonstrably injurious to the Company.

Upon the termination of an Eligible Participant’s Current Position with the Company by reason of disability or death, the Option may be exercised during the following periods, but only to the extent that the Option was outstanding and exercisable on any such date of disability or death:

(i) One (1) year after termination of Current Position due to disability within the meaning of Section 22(e)(3) of the Code; or

(ii) Six (6) months after termination of Current Position due to the Optionee’s death.

For the purposes of this Plan, it shall not be considered a termination of Current Position when an Optionee is placed by the Company on military or sick leave or such other type of leave of absence that is deemed by the Committee to continue intact the employment relationship.

However, non-employee directors who resign, other than “for cause” and other than by reason of disability or death, as a member of the Board of Directors of the Company after serving as a director for a minimum of five years, shall be permitted to exercise any vested Option at any time prior to the expiration date of the Option.

Notwithstanding anything in this Section VII.G. to the contrary, the Committee, in its discretion, but subject to the approval of the Board of Directors, may waive any restrictions, including applicable exercise periods.

H.    Special Rules for Incentive Stock Options.

(a) Employment Status. An ISO may only be granted to Employees and must be granted for a reason connected with employment, as defined in the Code, by the Company and shall not be exercisable unless the Optionee was, at all times during the period beginning on the date of the grant of the Option and ending on the date three (3) months (one year if the Optionee is disabled, within the meaning of Section 22(e)(3) of the Code) before the exercise of the Option, an employee of the Company or a Subsidiary, except that such

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employment requirement does not apply in the event of an Optionee’s death as provided in Section 421(c)(1) of the Code.

(b) Ten Percent Stockholder. No ISO shall be granted under this Plan to a Ten Percent Share Owner unless (a) such ISO is granted at an exercise price not less than 110% of Fair Market Value of the Common Stock on the date of grant, and (b) such ISO expires on a date not later than five years from the date of grant.

(c) Aggregate Value of Options. The aggregate Fair Market Value (determined at the time the ISO is granted) of ISOs granted by the Company (under this and all other Plans) to an Optionee which are exercisable for the first time by such Optionee in any single calendar year shall not exceed $100,000.

(d) Notification of Disqualifying Dispositions. Any Optionee who disposes of Option Shares acquired pursuant to the exercise of an ISO during the period within two years from the date such Option is granted or within one year after the transfer of the Option Shares to such Optionee pursuant to the ISO’s exercise (the “ISO Nontransfer Periods”) shall notify the Company of such disposition and of the amount realized upon such disposition.

ARTICLE VIII

Adjustments

In the event of a stock dividend, stock split or other subdivision, consolidation, reorganization or similar change in the outstanding shares of Common Stock or capital structure of the Company (collectively, a “Stock Adjustment”), the following shall occur under the Plan: (i) the number of shares of Common Stock reserved or otherwise available under Article V for Options, and subject to outstanding Options, shall be adjusted proportionately (and automatically reduced by any fraction resulting from such adjustment); and (ii) the Exercise Price per share of outstanding Options shall be adjusted so that the aggregate Exercise Price payable pursuant to each outstanding Option after the Stock Adjustment shall equal the aggregate amount so payable prior to the Stock Adjustment. In the event of any dispute concerning such adjustment, the decision of the Committee shall be conclusive. If a Stock Adjustment is made, the Committee shall notify all Optionees of such adjustment within thirty (30) days of making such an adjustment, which notification shall state the adjusted number of shares of Common Stock for which a particular Option is exercisable.

ARTICLE IX

Corporate Reorganization or Initial Public Offering

9.01    Merger, Consolidation or Change of Control. In connection with any merger, consolidation, change in control or similar reorganization,

8

excluding an initial public offering (“Reorganization”), the Committee may in its discretion:

(i) Negotiate a binding agreement whereby any acquiring or successor corporation will assume each Option then outstanding or substitute an equivalent option meeting the requirements of Section 424(a) of the Code for each Option outstanding.

(ii) Accelerate any applicable vesting provisions; or

(iii) Authorize cash payments to Optionees equal to the difference between the aggregate Exercise Price of each Option then outstanding irrespective of the Option’s current exercisability, and (i) in the event the Common Stock is not publicly traded, the Fair Market Value of the shares covered by such Option or, (ii) the average of the daily Closing Prices, as defined below, per share of Common Stock for the ten (10) consecutive trading days commencing fifteen (15) trading days before such date as determined by the Committee. For purposes hereof, “Closing Price”shall mean, with respect to each share of Common Stock for any day, (a) the last reported sale price or, in case no such sale takes place on such day, the average of the closing bid and asking price, in either case as reported on the principal national securities exchange on which the Common Stock is listed or admitted for trading or (b) if the Common Stock is not listed or admitted for trading on any national securities exchange, the last reported sale price, or in the case no such sale takes place on such day, the average of the highest reported bid and the lowest reported asked quotation for the Common Stock, in either case as reported on the Automatic Quotation System of NASDAQ or a similar service if NASDAQ is no longer reporting such information. Any cash payment which the Company may be required to make pursuant to such Committee authorization shall be made within sixty days following such authorization and fully discharge any and all obligations the Company may have in connection with the Options.

Notwithstanding the forgoing, the Committee shall have no obligation to take any action in connection with a Reorganization.

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ARTICLE X

Securities and Other Regulation

10.01    Applicable Law. The obligation of the Company to issue Common Stock upon the exercise of Options shall be subject to all applicable laws, regulations, rules and orders which shall then be in effect and required by governmental entities and the stock exchanges on which the Common Stock may then be traded.

10.02    Disclosure and Certificate Legend. Any person exercising an Option shall make such representations and furnish such information as may, in the opinion of counsel for the Company, be appropriate to permit the Company to issue the Option Shares in compliance with the provisions of the Securities Act of 1933 and any applicable state securities laws or any comparable laws. If appropriate under applicable law, the Company may legend the stock certificates evidencing the shares in a manner that is the same or similar to that which follows: “The securities evidenced by this certificate have been issued to the registered owner in reliance upon written representations that these shares have been purchased for investment. These shares may not be sold, transferred, or assigned unless, in the opinion of the Company and its legal counsel, such sale, transfer, or assignment will not be in violation of the Securities Act of 1933, as amended, applicable rules and regulations of the Securities and Exchange Commission, and any applicable state securities laws.”

Nothing contained herein shall be deemed to require the Company to file any registration statement under the Securities Act of 1933 or other applicable securities laws with respect to any Options or Option Shares.

ARTICLE XI

Amendment and Termination of Plan

11.01    Amendment or Termination. The Board, without further approval of the stockholders of the Company, may at any time and from time to time suspend or terminate the Plan in whole or in part or amend the Plan in such respects as the Board may deem appropriate and in the best interests of the Company; provided, however, that no such amendment shall be made more than once every six months, other than to comport with changes in the Code, or without approval of a majority of the stockholders entitled to vote thereon which would:

(a) change the class of persons from which Eligible Participants are selected;

(b) increase the total number of shares of Common Stock which may be issued pursuant to Options, except as provided in Article VIII;

(c) reduce the Exercise Price;

10

(d) extend the period for granting Options; or

(e) otherwise materially increase the benefits accruing to Optionees.

11.02    No Impairment. No amendment, suspension or termination of the Plan shall, without the Optionee’s written consent, alter or impair any of the rights or obligations under any Option theretofore granted to such Optionee under this Plan.

11.03    Conforming Amendments. The Board may amend the Plan, subject to the limitations cited above, in such manner as it deems necessary to permit the granting of Options meeting the requirements of future amendments, if any, to the Code.

ARTICLE XII

Miscellaneous Provisions

12.01    Right to Continued Employment. No person shall have any claim or right to be granted an Option, and the grant of Options shall not be construed as giving an Optionee the right to be retained in the employ of, or retain any other relationship with, the Company. Further, the Company expressly reserves the right at any time to dismiss an Optionee with or without cause, free from any liability or claim under the Plan, except as provided herein or in another binding agreement.

12.02    Rights as Stockholders. No Optionee or his heirs, successors or assigns shall have any rights with respect to any shares of Common Stock subject to an Option until the date of the issuance of stock certificates for such Option Shares. No adjustment shall be made for dividends (ordinary or extraordinary, whether in cash, securities or other property) or other rights distributed with respect to the Common Stock for which the record date is prior to the date such stock certificate is issued, except as provided in Article VIII.

12.03    Non-Transferability. No right or interest in any Option granted under the Plan shall be assignable or transferable, except as set forth in Section VII.C. hereof, and no right or interest of any Optionee shall be subject to attachment or garnishment proceedings.

12.04    Withholding Taxes. To cover applicable withholding for income and employment taxes in the event of the exercise of an NQO or upon a disqualifying disposition during the ISO Nontransfer Periods, or at such times as it may be necessary, the Company shall withhold shares of Common Stock otherwise to be received by the Optionee equal in value to the federal and state withholding taxes due upon said exercise. The withholding by the Company for such tax liability shall be mandatory; provided, however, the payment of such liability by the Company on behalf of the Optionee does not cause the Company to

11

be in violation of any loan covenant or other agreement or law to which it may be subject. In such event, the Optionee must satisfy such liability in cash upon the request of the Company and comply with all applicable securities laws.

12.05    Plan Expenses. Any expenses of administering the Plan shall be borne by the Company.

12.06    Use of Exercise Proceeds. The Payment received from Optionees from the exercise of Options shall be used for the general corporate purposes of the Company.

12.07    No Liability of Committee Members and Indemnification Thereof. No member of the Committee shall be personally liable by reason of any contract or other instrument executed by him or on his behalf in his capacity as a member of the Committee, nor for any mistake of judgment made in good faith, and the Company shall indemnify and hold harmless each member of the Committee and each other officer, employee or director of the Company to whom any duty or power relating to the administration or interpretation of the Plan may be allocated or delegated, against any cost and expense, including legal fees and costs, or liability, including any sum paid in settlement of a claim with the approval of the Board, arising out of any act or omission to act in connection with the Plan unless arising out of such person’s own fraud or bad faith, provided that within fifteen business days after the institution of any such action, suit or proceeding by service of process on the Committee member, such member shall give the Company written notice thereof and an opportunity, at the Company’s expense, to undertake to defend the same before such Committee member undertakes such defense on his own behalf, and provided that the Committee member cooperates with the Company in such defense and takes no actions (including inaction) which would materially prejudice the Company. The foregoing right to indemnification shall be in addition to such other rights as the Committee member or other person may enjoy as a matter of law or by reason of insurance coverage of any kind. Rights granted hereunder shall be in addition to and not in lieu of any rights to indemnification to which the Committee member or other person may be entitled pursuant to the bylaws of the Company or its subsidiaries.

12.08    Severability. In the event any provision of the Plan shall be held to be illegal, invalid or unenforceable for any reason, the illegality, invalidity or unenforceability of such provision shall not affect the remaining provisions of the Plan, but shall be fully severable and the Plan shall be construed and enforced as if the illegal, invalid or unenforceable provision had never been included herein.

ARTICLE XIII

Board of Directors Adoption and Stockholder Approval of the Plan

This Plan was adopted by the Board on February 20, 2003, (the “Adoption Date”) and shall be approved by the Company’s stockholders at the

12

first stockholders’ meeting following such date which shall be within twelve (12) months of the Adoption Date. The plan shall be effective on the date the Plan is approved by the Company’s stockholders (the “Effective Date”). Stockholder approval shall comply with all applicable provisions of the Company’s charter, bylaws, and applicable state law prescribing the method and degree of stockholder approval required for the issuance of corporate stock or options. In the event stockholder approval is not obtained within the requisite period, any Options granted under this Plan between the Adoption Date and the date twelve (12) months thereafter shall be void.

POTOMAC BANCSHARES, INC.
By:
	Its

13

EX-13

Exhibit 13

Potomac Bancshares, Inc. cover page

1

CONTENTS

President’s Report	3
Description of Business	4
Board of Directors	4
Selected Consolidated Financial Data	5
Management’s Discussion and Analysis of Financial Condition and Results of Operations	6-14
Independent Auditor’s Report	15
Consolidated Financial Statements
Consolidated Balance Sheets	16
Consolidated Statements of Income	17
Consolidated Statements of Changes in Stockholders’ Equity	18
Consolidated Statements of Cash Flows	19
Notes to Consolidated Financial Statements	20-35
Annual Report on Form 10-KSB	36
General Information	36

FORWARD–LOOKING STATEMENTS

The Private Securities Litigation Reform Act of 1995 evidences Congress’ determination that the disclosure of forward-looking information is desirable for investors and encourages such disclosure by providing a safe harbor for forward-looking statements by corporate management. This Annual Report, including the President’s Letter and the Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements that involve risk and uncertainty. “Forward-looking statements are easily identified by the use of words such as “could,” “anticipate,” “estimate,” “believe,” and similar words that refer to a future outlook. To comply with the terms of the safe harbor, the company notes that a variety of factors could cause the company’s actual results and experience to differ materially from the anticipated results or other expectations expressed in the company’s forward-looking statements.

The risks and uncertainties that may affect the operations, performance, development and results of the company’s business include, but are not limited to, the growth of the economy, interest rate movements, the impact of competitive products, services and pricing, customer business requirements, Congressional legislation and similar matters. We caution readers of this report not to place undue reliance on forward-looking statements which are subject to influence by the named risk factors and unanticipated future events. Actual results, accordingly, may differ materially from management expectations.

2

Area left blank for President’s Report

3

DESCRIPTION OF BUSINESS

Potomac Bancshares, Inc., a one-bank holding company, and subsidiary, Bank of Charles Town (BCT), are engaged in general banking business serving primarily Berkeley County and Jefferson County, West Virginia. The company also provides services to Washington County and Frederick County, Maryland and Loudoun County, Frederick County, and Clarke County, Virginia. The main office is in Charles Town with branch offices in Harpers Ferry, Kearneysville, Martinsburg and Hedgesville.

The company provides individuals, businesses, and local governments with a broad range of banking services including commercial credit lines, real estate loans, equipment loans, secondary and adjustable rate mortgages and retail loan products, checking and savings accounts, certificates of deposit, and individual retirement accounts. Automated teller machines located at each of the five offices and Touchline 24, an interactive voice response system available at 1-304-728-2424, provide certain services to customers on a twenty-four hour basis. Bill paying and certain other banking services are available through the Internet. The trust and financial services department provides financial management, investment and trust services.

Bank of Charles Town is a West Virginia state chartered bank which formed and opened for business in 1871. The bank’s deposits are insured by Federal Deposit Insurance Corporation.

BOARD OF DIRECTORS

Potomac Bancshares, Inc. and Bank of Charles Town

Robert F. Baronner, Jr. President & CEO Bank of Charles Town	Margaret Cogswell Executive Director Hospice of the Panhandle	Barbara H. Pichot Partner CoxHollida LLP
J. Scott Boyd President Jefferson Pharmacy, Inc.	Thomas C. G. Coyle Retired Owner-Operator Riddleberger’s Store	John C. Skinner Jr. Owner Nichols & Skinner, L.C.
John P. Burns, Jr. Partner Burns Farm	William R. Harner Retired Senior Vice President & Cashier Bank of Charles Town	Donald S. Smith Retired President Bank of Charles Town
Guy Gareth Chicchirichi Executive Manager Guy’s Buick-Pontiac-Oldsmobile-GMC Truck, Inc.	E. William Johnson Professor of Economics Shepherd College	C. Larry Togans Retired U.S. Geological Survey

4

SELECTED CONSOLIDATED FINANCIAL DATA

(Dollars in Thousands Except Per Share Data)

	2003			2002			2001			2000			1999
Summary of Operations
Interest income	$	10,786		$	11,279		$	10,956		$	10,328		$	10,009
Interest expense		2,235			2,823			3,758			3,968			4,191
Net interest income		8,551			8,456			7,198			6,360			5,818
Provision for (recovery of) loan losses		148			423			221			(70	)		125
Net interest income after provision for (recovery of) loan losses		8,403			8,033			6,977			6,430			5,693
Noninterest income		2,844			2,096			1,358			1,148			1,170
Noninterest expense		7,141			6,262			5,160			4,711			4,423
Income before income taxes		4,106			3,867			3,175			2,867			2,440
Income tax expense		1,432			1,408			1,166			1,053			897
Net income	$	2,674		$	2,459		$	2,009		$	1,814		$	1,543
Per Share Data **
Net income, basic and diluted	$	1.53		$	1.37		$	1.12		$	1.01		$	.86
Cash dividends declared		.54			.48			.45			.42			.38
Book value at period end		12.53			11.96			10.79			9.98			9.27
Weighted-average shares outstanding		1,750,070			1,791,027			1,800,000			1,800,000			1,800,000
Average Balance Sheet Summary
Assets	$	197,052		$	181,741		$	158,385		$	145,339		$	147,612
Loans		125,407			109,461			93,816			81,755			78,710
Securities		47,087			50,454			41,870			44,935			48,865
Deposits		163,328			153,148			135,658			126,617			129,711
Stockholders’ equity		21,274			20,542			18,812			17,345			16,539
Performance Ratios
Return on average assets		1.36	%		1.35	%		1.27	%		1.25	%		1.05	%
Return on average equity		12.57	%		11.97	%		10.68	%		10.46	%		9.33	%
Dividend payout ratio		35.29	%		35.04	%		40.18	%		41.58	%		44.19	%
Capital Ratios
Leverage ratio		10.20	%		10.77	%		11.30	%		12.32	%		11.55	%
Risk-based capital ratios
Tier 1 capital		14.67	%		18.34	%		19.90	%		22.70	%		23.19	%
Total capital		15.89	%		19.60	%		21.15	%		23.95	%		24.45	%

** All figures have been restated to reflect a 200% stock dividend declared on February 11, 2003.

5

AVERAGE BALANCES, INCOME/EXPENSE AND AVERAGE YIELD/RATE

This schedule is a comparison of interest earning assets and interest-bearing liabilities showing average yields or rates derived from average balances and actual income and expenses. Income and rates on tax exempt loans are computed on a tax equivalent basis using a federal tax rate of 34%. Loans placed on nonaccrual status are reflected in the balances.

	2003							2002							2001
	Average Balances			Income/ Expense		Average Yield/Rate		Average Balances			Income/ Expense		Average Yield/Rate		Average Balances			Income Expense		Average Yield/Rate
ASSETS
Loans
Taxable	$	123,701,192		$	8,745,268	7.07	%	$	107,619,793		$	8,556,920	7.95	%	$	92,434,336		$	8,070,799	8.73	%
Tax exempt		1,705,694			156,334	9.17	%		1,841,205			159,231	8.65	%		1,381,761			137,003	9.92	%
Total loans		125,406,886			8,901,602	7.10	%		109,460,998			8,716,151	7.96	%		93,816,097			8,207,802	8.75	%
Taxable securities		47,086,793			1,828,230	3.88	%		50,454,026			2,444,342	4.84	%		41,870,474			2,318,806	5.54	%
Securities purchased under agreements to resell and federal funds sold		4,533,462			44,348	.98	%		6,402,575			90,452	1.41	%		10,366,914			393,154	3.79	%
Other earning assets		2,014,531			64,847	3.22	%		3,300,322			82,074	2.49	%		2,113,431			82,289	3.89	%
Total earning assets		179,041,672		$	10,839,027	6.05	%		169,617,921		$	11,333,019	6.68	%		148,166,916		$	11,002,051	7.43	%
Allowance for loan losses		(1,709,640	)						(1,528,580	)						(1,287,062	)
Cash and due from banks		9,788,819							8,015,469							6,352,987
Premises and equipment, net		4,868,176							3,660,177							3,278,950
Other assets		5,063,309							1,976,220							1,872,882
Total assets	$	197,052,336						$	181,741,207						$	158,384,673
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits
Savings and interest-bearing demand deposits	$	92,950,732		$	461,726	.50	%	$	86,844,968		$	852,591	.98	%	$	73,730,903		$	1,461,562	1.98	%
Time deposits		47,991,306			1,497,233	3.12	%		45,911,558			1,750,221	3.81	%		42,830,718			2,198,395	5.13	%
Total interest-bearing deposits		140,942,038			1,958,959	1.39	%		132,756,526			2,602,812	1.96	%		116,561,621			3,659,957	3.14	%
Securities sold under agreements to repurchase and federal funds purchased		8,549,015			171,458	2.01	%		4,196,410			98,536	2.35	%		1,093,284			31,160	2.85	%
Advances from FHLB		1,878,255			104,349	5.56	%		2,196,854			121,834	5.55	%		1,304,876			66,663	5.12	%
Total interest bearing liabilities		151,369,308		$	2,234,766	1.48	%		139,149,790		$	2,823,182	2.03	%		118,959,781		$	3,757,780	3.16	%
Noninterest-bearing demand deposits		22,385,873							20,391,089							19,096,124
Other liabilities		2,022,763							1,658,519							1,516,895
Stockholders’ equity		21,274,392							20,541,809							18,811,873
Total liabilities and stockholders’ equity	$	197,052,336						$	181,741,207						$	158,384,673
Net interest income				$	8,604,261						$	8,509,837						$	7,244,271
Net interest spread						4.57	%						4.65	%						4.27	%
Interest expense as a percent of average earning assets						1.25	%						1.66	%						2.54	%
Net interest margin						4.81	%						5.02	%						4.89	%

6

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

CRITICAL ACCOUNTING POLICIES

GENERAL

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

ALLOWANCE FOR LOAN LOSSES

The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS 5, Accounting for Contingencies, which requires that estimated losses be accrued when they are probable of occurring and (ii) SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

Our allowance for loan losses has two basic components: the formula allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a historical loss view as an indicator of future losses and, as a result, could differ from the loss incurred in the future. However, since this history is updated with the most recent loss information, the errors that might otherwise occur are mitigated. The unallocated allowance captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in the formula allowance.

GENERAL

Total assets increased $13.8 million or 7.1% in 2003 compared to 2002. Increases included growth in loans of 19.7% or $23 million and additions to premises and equipment of 12.0% or $.5 million. Increases in premises and equipment included completion of two major projects begun in 2002: the new branch office facility in Hedgesville, WV and the computer conversion to the Jack Henry & Associates products. The other assets category increased due to the purchase of $3,000,000 of bank owned life insurance at the beginning of 2003. Both securities categories decreased as of December 31, 2003 compared to December 31, 2002. The 14.1% or $7.3 million decrease in the securities portfolio was utilized as part of the increase in loans.

Growth on the liability side of the balance sheet was in deposit increases of $11.1 million or 6.8% and in daily cash management account increases (securities sold under agreements to repurchase) of $3.1 million of 50.7%.

This balance sheet growth is indicative of the bank’s continuing ability to attract and maintain a solid customer base.

The increase in net income of $214 thousand or 8.7% in 2003 compared to 2002 results from decreased interest expense, increased noninterest income and reduced additions to the provision for loan losses.

Management is unaware of any trends, events or uncertainties that would have a material effect on liquidity, capital resources or operations. There are no current recommendations by regulatory authorities that, if they were to be implemented, would have a material effect on the company.

7

The following table sets forth selected quarterly results (with dollars in thousands) of the company for 2003 and 2002.

	2003								2002
	Three Months Ended								Three Months Ended
	Dec 31		Sept 30		June 30		Mar 31		Dec 31		Sept 30		June 30		Mar 31
Interest income	$	2,769	$	2,684	$	2,675	$	2,658	$	2,755	$	2,903	$	2,844	$	2,777
Interest expense		532		532		583		588		678		719		703		723
Net interest income		2,237		2,152		2,092		2,070		2,077		2,184		2,141		2,054
Provision for loan losses		—		64		27		57		130		94		109		90
Net interest income after provision for loan losses		2,237		2,088		2,065		2,013		1,947		2,090		2,032		1,964
Noninterest income		727		744		687		686		579		526		512		479
Noninterest expense		1,875		1,785		1,794		1,687		1,868		1,468		1,558		1,368
Income before income taxes		1,089		1,047		958		1,012		658		1,148		986		1,075
Income tax expense		383		361		339		349		264		407		351		386
Net income	$	706	$	686	$	619	$	663	$	394	$	741	$	635	$	689
Earnings per share, basic and diluted	$	.41	$	.40	$	.35	$	.37	$	.23	$	.41	$	.35	$	.38

NET INTEREST INCOME

Net interest income increased 1.1% in 2003 compared to 2002 resulting from a decrease of over 20% or $588 thousand in interest expense in 2003 compared to 2002. Interest income decreased as well by $493 thousand or 4.4% in 2003 when compared to 2002.

The only 2.2% increase in interest and fees on loans in 2003 compared to 2002 was due to the lower interest rates and would have been even less if the volume of the loan portfolio had not increased from $117 million at December 31, 2002 to $140 million at December 31, 2003. The average rate of the taxable portion of the portfolio dropped to 7.07% in 2003 from 7.95% in 2002. The average rate on tax exempt loans increased in 2003 to 9.17% on a tax equivalent basis from 8.65% in 2002. However, tax exempt loans are only a little over 1% of the total loan portfolio. During the past several years efforts of the bank’s loan personnel have been successful in increasing the number of floating rate loans. In times of lower interest rates this will reduce our income but the floating rates position the bank well as rates increase.

Interest income on securities held to maturity and securities available for sale decreased 25.2% in 2003 compared to 2002 primarily due to the decreased interest rates and to a lesser degree the decrease in size of the security portfolio. Interest income from securities purchased under agreements to resell and federal funds sold also decreased in 2003 compared to 2002 due about equally to decreased rates and decreased volume. During 2003 and 2002, interest income from securities purchased under agreements to resell and federal funds sold have made up less than 1% of the total interest income of the bank. Management has made a conscious effort to keep less funds in daily investments that pay lower rates than investments in loans and securities.

Reduced interest rates were almost entirely responsible for the decrease in interest expense in 2003 compared to 2002 since the volume of interest-bearing deposits increased $7.3 million in 2003 compared to 2002. The average rate on interest-bearing deposits dropped to 1.39% in 2003 compared to 1.96% in 2002.

In 2003, the average yield for earning assets was 6.05% compared to 6.68% in 2002. Although offering rates on loans have not changed much during the past several years, the bank had many higher rate loans that reached maturity or repricing dates during 2003 and so have repriced or new loans were made at the lower rates. The average rate paid on all interest-bearing liabilities was 1.48% in 2003 compared to 2.03% in 2002.

The net interest spread (difference between yield on earning assets and rate paid on interest-bearing liabilities) decreased in 2003 to 4.57% from 4.65% in 2002. The net interest margin (total interest income less total interest expense divided by average earning assets) also decreased in 2003 to 4.81% from 5.02% in 2002. Net interest spread and net interest margin decreased in 2003 since the reduction in rates has finally penetrated the loan and securities portfolios. Additionally, some time deposit rates have been increased to attract funds to support the expanding loan portfolio.

8

VOLUME AND RATE ANALYSIS

This schedule analyzes the change in net interest income attributable to changes in volume of the various portfolios and changes in interest rates. The change due to both rate and volume variances has been allocated between rate and volume based on the percentage relationship of such variances to each other. Income and rates on tax exempt loans are computed on a tax equivalent basis using a federal tax rate of 34%. Nonaccruing loans are included in average loans outstanding.

	2003 Compared to 2002									2002 Compared to 2001
	Change in Income/Expense			Volume Effect			Rate Effect			Change in Income/Expense			Volume Effect			Rate Effect
INTEREST INCOME
Taxable loans	$	188,348		$	726,569		$	(538,221	)	$	486,121		$	1,065,725		$	(579,604	)
Tax exempt loans		(2,897	)		(15,813	)		12,916			22,228			36,154			(13,926	)
Taxable securities		(616,112	)		(155,114	)		(460,998	)		125,536			327,216			(201,680	)
Securities purchased under agreements to resell and federal funds sold		(46,104	)		(22,549	)		(23,555	)		(302,702	)		(114,566	)		(188,136	)
Other earning assets		(17,227	)		(69,610	)		52,383			(215	)		599			(814	)
TOTAL	$	(493,992	)	$	463,483		$	(957,475	)	$	330,968		$	1,315,128		$	(984,160	)
INTEREST EXPENSE
Savings and interest-bearing demand deposits	$	(390,865	)	$	65,509		$	(456,374	)	$	(608,971	)	$	331,045		$	(940,016	)
Time deposits		(252,988	)		84,387			(337,375	)		(448,174	)		173,900			(622,074	)
Securities sold under agreements to repurchase and federal funds purchased		72,922			84,743			(11,821	)		67,376			71,815			(4,439	)
Advances from FHLB		(17,485	)		(17,705	)		220			55,171			49,134			6,037
TOTAL	$	(588,416	)	$	216,934		$	(805,350	)	$	(934,598	)	$	625,894		$	(1,560,492	)
NET INTEREST INCOME	$	94,424		$	246,549		$	(152,125	)	$	1,265,566		$	689,234		$	576,332

NONINTEREST INCOME AND EXPENSE

Noninterest income increased 35.6% or $747 thousand in 2003 compared to 2002. Trust and financial services income increased 20.7% or $96 thousand in 2003 compared with 2002 including growth in the income of BCT Investments as well as the original trust department. Service charges on deposit accounts increased 8.5% or $95 thousand in 2003 compared to 2002 due to increased volume during the year which included the opening of the branch office in Hedgesville and increases in the fees themselves as of August 1, 2003. Gains associated with sale of loans in the secondary market increased 104.9% or $184 thousand in 2003 compared to 2002 with the continuation of refinancing frenzy during the early part of 2003. However, there was a slow down in the refinancing during the latter part of 2003, and management expects the income in this market to decrease slightly in 2004. The purchase of bank owned life insurance provided income of $165 thousand through the increase in cash surrender values of the policies. Other significant additions to noninterest income for 2003 were gains on sales of securities of $99 thousand and an income increase of $42 thousand in credit and debit card fees.

Noninterest expenses increased 14.0% or $879 thousand in 2003 compared to 2002. Salaries and employee benefits increased 12.3% or $434 thousand in 2003 compared to 2002. An increase of 7.2% in salaries, wages and related taxes in 2003 compared to 2002 included annual increases and incentives for officers and employees and staffing additions particularly with the new branch office in Hedgesville. The expense of group insurance provided for the employees by the bank increased 22.4% or $83 thousand in 2003 compared to 2002 as a result of the continual rise of health care costs. Pension expenses tripled from $64 thousand in 2002 to $192 thousand in 2003 due to decreased market value of pension fund assets resulting from lower interest rates during the past several years. Furniture and equipment expense increased 36.4% or $238 thousand with the completion of the core conversion to Jack Henry products in March 2003 and regularly scheduled equipment replacement to maintain the bank’s high information technology standards. Advertising and marketing expenses increased in 2003 by 13.7% or $28 thousand compared to 2002, and communications increased in 2003 by 24.2% or $28 thousand compared to 2002. Increases in both of these areas are due to growth of the company and the bank’s continual effort to communicate with our customers and the public regarding product and service information. Postage expense decreased 7.9% or $11 thousand in 2003 compared to 2002 due to completion of conversion communications with our customers as well as a savings through the use of check imaging for customer statements rather than the bulky return of checks themselves. ATM and check card expenses significantly increased 49.1% or $54 thousand due primarily to the volume increases.

9

INTEREST RATE SENSITIVITY

The table below shows the opportunities the company will have to reprice interest earning assets and interest-bearing liabilities as of December 31, 2003.

	Mature or Reprice
	Within Three Months			After Three Months But Within Twelve Months			After One Year But Within Five Years		After Five Years		Nonsensitive
Interest Earning Assets:
Loans	$	26,931,872		$	18,451,981		$	60,184,401	$	34,489,570	$	—
Securities		6,001,584			5,132,337			33,292,344		—		—
Securities purchased under agreements to resell and federal funds sold		2,390,020			—			—		—		—
Other earning assets		335,615			—			—		—		554,500
Total	$	35,659,091		$	23,584,318		$	93,476,745	$	34,489,570	$	554,500
Interest-Bearing Liabilities:
Time deposits $100,000 and over	$	1,687,234		$	5,332,693		$	5,443,933	$	—	$	—
Other time deposits		8,554,668			17,075,015			12,865,092		—		—
Gold and Platinum accounts (NOW accounts)		55,374,953			—			—		—		22,295,123
Savings accounts		—			—			—		—		19,231,712
Securities sold under agreements to repurchase		9,199,345			—			—		—		—
Federal Home Loan Bank advances		84,571			260,798			1,369,885		—		—
Total	$	74,900,771		$	22,668,506		$	19,678,910	$	—	$	41,526,835
Rate Sensitivity Gap	$	(39,241,680	)	$	915,812		$	73,797,835	$	34,489,570
Cumulative Gap	$	(39,241,680	)	$	(38,325,868	)	$	35,471,967	$	69,961,537

The matching of the maturities or repricing opportunities of interest earning assets and interest-bearing liabilities may be analyzed by examining the extent to which these assets and liabilities are interest rate sensitive and by monitoring an institution’s interest rate sensitivity gap. An asset or liability is interest rate sensitive within a specific time period if it will mature or reprice within that period. The interest rate sensitivity gap is the difference between the amount of interest earning assets that will mature or reprice within a specific time period and the amount of interest-bearing liabilities that will mature or reprice within the same time period.

A gap is considered negative when the amount of liabilities maturing or repricing in a specific period exceeds the amount of assets maturing or repricing in the same period. An even match between assets and liabilities in each time frame is the safest position especially in times of rapidly rising or declining rates. During other times, the even match is not as critical. The advantages or disadvantages of positive and negative gaps depend totally on the direction in which interest rates are moving. An asset sensitive institution’s net interest margin and net interest income generally will be impacted favorably by rising interest rates, while that of a liability sensitive institution generally will be impacted favorably by declining interest rates.

During the first twelve months shown in the schedule above, the company is liability sensitive and after that time period the company is asset sensitive. During January, February and March of 2004, $39 million more liabilities may reprice or will mature than assets. During April through December of 2004, $1 million more assets may reprice or will mature than liabilities. The net effect for 2004 is that $38 million more liabilities may reprice or mature than assets. Therefore, the company will be impacted favorably if interest rates continue to decline and unfavorably if interest rates rise.

10

LOAN PORTFOLIO

Loans at December 31, 2003 and 2002 are summarized below:

	2003		2002		2001		2000		1999
Commercial, financial and agricultural	$	17,906,329	$	3,695,732	$	2,998,473	$	2,235,977	$	2,823,556
Mortgage loans on real estate:
Construction and land development		13,956,590		2,210,582		530,000		14,000		31,000
Secured by farm land		3,711,332		1,821,345		1,801,165		2,762,776		2,604,920
Secured by 1-4 family residential		60,903,351		63,239,443		56,283,230		45,055,946		43,798,037
Other real estate		25,313,790		26,151,183		19,275,005		12,150,047		11,859,376
Consumer loans		17,549,454		19,197,747		21,213,959		22,022,827		16,879,468
All other loans		716,978		729,717		287,836		205,262		333,695
	$	140,057,824	$	117,045,749	$	102,389,668	$	84,446,835	$	78,330,052

Loans have increased 19.7% in 2003 over 2002 when comparing year-end totals without reducing the portfolio numbers by the allowance for loan losses. An experienced and aggressive loan production staff has enabled the bank to continue to grow the loan portfolio. Particular areas of growth during 2003 were in commercial loans and in real estate construction and land development loans. As loans increase in these two areas, management is being diligent to assure that risk is minimal. After considerable growth in 2002 in loans secured by 1-4 family residential property and other real estate loans, the December 31, 2003 totals are slightly less than at December 31, 2002. Refinancing of residential property slowed in the latter part of 2003 and the winter weather during November and December added to the slowdown in loan production.

There were no categories of loans that exceeded 10% of outstanding loans at December 31, 2003 that were not disclosed in the table above.

REMAINING MATURITIES OF SELECTED LOANS

At December 31, 2003	Commercial, Financial and Agricultural		Real Estate- Construction
Loans maturing within one year	$	2,063,107	$	7,815,691
Variable rate loans due after one year		9,549,427		2,930,884
Fixed rate loans due after one year through five years		3,336,822		2,372,620
Fixed rate loans due after five years		2,956,973		837,395
Total maturities	$	17,906,329	$	13,956,590

ALLOWANCE FOR LOAN LOSSES

The table shown below is an analysis of the company’s allowance for loan losses. Historically, net charge-offs (loans charged off as uncollectible less any amounts recovered on these loans) for the company have been very low when compared with the size of the total loan portfolio. Management continually monitors the loan portfolio with quarterly procedures that allow for problem loans and potentially problem loans to be highlighted and watched. Based on experience, the loan policies and the current monitoring program, management believes the allowance for loan losses is adequate.

	2003			2002			2001			2000			1999
Balance at beginning of period	$	1,641,819		$	1,402,247		$	1,268,235		$	1,217,919		$	1,140,000
Charge-offs:
Commercial, financial and agricultural		—			—			12,456			—			—
Real estate – construction		—			—			—			—			—
Real estate – mortgage		—			—			6,658			—			26,854
Consumer		191,644			287,133			102,574			105,677			62,510
Total charge-offs		191,644			287,133			121,688			105,677			89,364
Recoveries:
Commercial, financial and agricultural		—			—			667			—			—
Real estate – construction		—			—			—			—			—
Real estate – mortgage		8,216			398			492			201,284			17,000
Consumer		117,733			103,307			33,966			24,709			25,283
Total recoveries		125,949			103,705			35,125			225,993			42,283
Net charge-offs		65,695			183,428			86,563			(120,316	)		47,081
Additions charged to operations		147,500			423,000			220,575			(70,000	)		125,000
Balance at end of period	$	1,723,624		$	1,641,819		$	1,402,247		$	1,268,235		$	1,217,919
Ratio of net charge-offs during the period to average loans outstanding during the period		0.05	%		0.17	%		0.09	%		0.15	%		0.06	%

11

ALLOCATION OF ALLOWANCE FOR LOAN LOSSES

The following table shows an allocation of the allowance among loan categories based upon analysis of the loan portfolio’s composition, historical loan loss experience, and other factors, and the ratio of the related outstanding loan balances to total loans. This analysis is recorded each quarter with monitoring procedures where all loans are examined and problem loans and potentially problem loans are highlighted for continued observance.

	2003				2002				2001				2000				1999
	Allowance		% Loans in Category to Total Loans		Allowance		% Loans in Category to Total Loans		Allowance		% Loans in Category to Total Loans		Allowance		% Loans in Category to Total Loans		Allowance		% Loans in Category to Total Loans
Commercial, financial and agricultural	$	179,063	12.78	%	$	36,957	3.16	%	$	14,992	2.92	%	$	46,934	2.65	%	$	14,118	3.61	%
Mortgage loans on real estate:
Construction and land development		139,566	9.96	%		22,106	1.89	%		2,650	.52	%		70	.02	%		155	.04	%
Secured by farm land		37,113	2.65	%		1,821	1.56	%		9,006	1.76	%		13,814	3.27	%		13,025	3.32	%
Secured by 1-4 family residential		254,295	43.50	%		293,367	54.03	%		315,375	54.97	%		268,879	53.35	%		265,168	55.91	%
Other real estate		253,138	18.07	%		319,405	22.34	%		250,993	18.83	%		365,623	14.39	%		246,681	15.14	%
Consumer loans		534,790	12.53	%		424,360	16.40	%		119,331	20.72	%		119,779	26.08	%		93,869	21.55	%
All other loans		6,381	.51	%		5,030	.62	%		1,439	.28	%		1,026	.24	%		1,668	.43	%
Unallocated		319,278	—			538,773	—			688,461	—			452,110	—			583,235	—
	$	1,723,624	100.00	%	$	1,641,819	100.00	%	$	1,402,247	100.00	%	$	1,268,235	100.00	%	$	1,217,919	100.00	%

RISK ELEMENTS IN THE LOAN PORTFOLIO

	2003			2002			2001			2000			1999
Nonaccrual loans	$	250,946		$	—		$	9,060		$	—		$	112,844
Restructured loans		—			—			—			—			—
Foreclosed properties		—			—			—			12,647			201,429
Total nonperforming assets	$	250,946		$	—		$	9,060		$	12,647		$	314,273
Loans past due 90 days accruing interest	$	153,293		$	41,161		$	29,293		$	790,349		$	559,924
Allowance for loan losses to period end loans		1.23	%		1.40	%		1.37	%		1.50	%		1.55	%
Nonperforming assets to period end loans and foreclosed properties		.18	%		.00	%		.01	%		.01	%		.07	%

Loans are placed on nonaccrual status when a loan is specifically determined to be impaired or when principal or interest is delinquent for 90 days or more. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received.

Impaired loans excluded from nonperforming assets amounted to $340,752 at December 31, 2003. There were no impaired loans at December 31, 2002 or 2001.

Nonaccrual loans excluded from impaired loan disclosure under SFAS No. 114 at December 31, 2003 and 2001 totaled $250,946 and $9,060, respectively. There were no nonaccrual loans excluded from impaired loan disclosure under SFAS No. 114 at December 31, 2002.

At December 31, 2003, other potential problem loans totaled $770,923. Loans are viewed as potential problem loans according to the ability of such borrowers to comply with current repayment terms. These loans are subject to constant management attention, and their status is reviewed on a regular basis. Management has allocated a portion of the allowance for these loans according to the review of the potential loss in each loan situation.

12

SECURITIES PORTFOLIO

In accordance with Financial Accounting Standards Board Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” the company records securities being held to maturity at amortized cost and securities available for sale at fair value. The effect of unrealized gains and losses, net of tax effects, is recognized in stockholders’ equity.

The schedule below summarizes the book value of the portfolio by maturity classifications and shows the weighted average yield in each group.

	2003 Carrying Value		Weighted Average Yield		2002 Carrying Value		Weighted Average Yield		2001 Carrying Value		Weighted Average Yield
Securities held to maturity
Obligations of U.S. Government agencies:
Maturing within one year	$	6,001,584	5.02	%	$	2,998,336	7.08	%	$	6,970,170	6.18	%
Maturing after one year but within five years		—	—			6,014,853	5.25	%	$	12,020,204	5.67	%
Total securities held to maturity	$	6,001,584			$	9,013,189			$	18,990,374
Securities available for sale
Obligations of U.S. Government agencies:
Maturing within one year	$	5,132,337	4.73	%	$	7,116,270	4.23	%	$	6,334,725	5.50	%
Maturing after one year but within five years		33,292,344	3.47	%		35,611,850	4.45	%		24,373,092	4.74	%
Total securities available for sale	$	38,424,681			$	42,728,120			$	30,707,817
Total securities	$	44,426,265			$	51,741,309			$	49,698,191

DEPOSITS

When comparing the 2003 and 2002 year end balances, total deposits increased $11.1 million or 6.8% in 2003. Interest- bearing deposits increased $7.3 million or 5.2% and noninterest-bearing deposits increased $3.8 million or 17.7%. Deposit growth has continued during 2003 for a number of reasons including Bank of Charles Town remaining one of few area banks with no monthly maintenance fees on deposit accounts. Our customer base continues to expand in Berkeley County, West Virginia with the opening of the branch office in Hedgesville in June 2003 in addition to our Martinsburg branch office that opened in July 2001. All checking accounts have now been renamed Silver (noninterest-bearing), Gold (a NOW account) and Platinum (a NOW account that pays a higher rate of interest of balances of $5,000 or more) and various services are packaged with each account type. The bulk of the growth in interest-bearing accounts has been in the certificate of deposit accounts with some growth in the Platinum accounts.

Schedule of Average Deposits and Average Rates Paid

	Year Ended December 31
	2003				2002				2001
	Average Balance		Average Rate		Average Balance		Average Rate		Average Balance		Average Rate
Noninterest-bearing demand deposits	$	22,385,873			$	20,391,089			$	19,096,124
Interest-bearing demand deposits		71,461,468	.56	%		62,936,496	1.20	%		49,488,124	2.19	%
Savings deposits		21,489,264	.30	%		23,908,472	.41	%		24,242,779	1.55	%
Time deposits		47,991,306	3.12	%		45,911,558	3.81	%		42,830,718	5.13	%
Total interest-bearing deposits		140,942,038	1.39	%		132,756,526	1.96	%		116,561,621	3.14	%
Total deposits	$	163,327,911			$	153,147,615			$	135,657,745

At December 31, 2003 time deposits of $100 thousand or more were 7.19% of total deposits compared with 5.43% at December 31, 2002. Maturities of time deposits of $100 thousand or more at December 31, 2003 are as follows:

Within three months	$	1,687,234
Over three through six months		1,356,073
Over six months through twelve months		3,976,620
Over twelve months		5,443,933
Total	$	12,463,860

13

ANALYSIS OF CAPITAL

The adequacy of the company’s capital is reviewed by management on an ongoing basis in terms of the size, composition, and quality of the company’s asset and liability levels, and consistency with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses.

The Federal Reserve, the Comptroller of the Currency and the Federal Deposit Insurance Corporation have adopted capital guidelines to supplement the existing definitions of capital for regulatory purposes and to establish minimum capital standards. Specifically, the guidelines categorize assets and off-balance sheet items into four risk-weighted categories. The minimum ratio of qualifying total capital to risk-weighted assets is 8.0%, of which at least 4.0% must be Tier 1 capital, composed of common equity, retained earnings and a limited amount of perpetual preferred stock, less certain goodwill items. The company had a ratio of total capital to risk-weighted assets of 15.89% and a ratio of Tier 1 capital to risk-weighted assets of 14.67 % at December 31, 2003. These two ratios have decreased because of the use of capital to repurchase shares of Potomac stock for the treasury and because of the asset growth during 2003. Even with these reductions in these ratios, both exceed the capital requirements adopted by the federal regulatory agencies.

	(In thousands)
	2003			2002			2001
Tier 1 capital:
Common stock	$	1,800		$	600		$	600
Surplus		4,200			5,400			5,400
Retained earnings		16,543			14,801			13,208
		22,543			20,801			19,208
Less cost of shares acquired for the treasury		1,709			248			—
Total tier 1 capital	$	20,834		$	20,553		$	19,208
Tier 2 capital:
Allowance for loan losses (1)		1,724			1,403			1,209
Total risk-based capital	$	22,558		$	21,956		$	20,417
Risk-weighted assets	$	141,978		$	112,038		$	96,545
Capital ratios:
Tier 1 risk-based capital ratio		14.67	%		18.34	%		19.90	%
Total risk-based capital ratio		15.89	%		19.60	%		21.15	%
Leverage ratio		10.20	%		10.77	%		11.30	%

(1) Limited to 1.25% of gross risk-weighted assets.

LIQUIDITY

Liquidity represents an institution’s ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. This could also be termed the management of the cash flows of an organization. Liquid assets include cash and due from banks, interest-bearing deposits in financial institutions, securities purchased under agreements to resell, federal funds sold, securities available for sale, and loans and investments maturing within one year. The company’s liquidity during 2003 is detailed in the statement of cash flows included in the financial statements. Operating cash flows are derived from net income adjusted for items that do not involve cash. Cash flows from investing activities during included maturity, call or sale of securities and payments on and maturities of loans. Cash flows from financing activities include increases in any deposit accounts, proceeds from securities sold under agreements to repurchase and proceeds from borrowed funds. As a result of the company’s management of liquid assets and the ability to generate liquidity through liability funding, management believes that the company’s overall liquidity is sufficient to satisfy its depositors’ requirements and to meet its customers’ credit needs.

At December 31, 2003, cash and due from banks, interest-bearing deposits in financial institutions, securities purchased under agreements to resell, federal funds sold and loans and securities maturing within one year were $43,967,531.

Borrowing capabilities provide additional liquidity. The subsidiary bank maintains a federal funds line of $7 million with another financial institution. The subsidiary bank is also a member of the Federal Home Loan Bank of Pittsburgh and has short and/or long-term borrowing capabilities of approximately $64,695,000. In June 2001, the subsidiary bank borrowed $2.5 million amortized over seven years from the Federal Home Loan Bank.

14

INDEPENDENT AUDITOR’S REPORT

To the Board of Directors and Stockholders

Potomac Bancshares, Inc. and Subsidiary

Charles Town, West Virginia

We have audited the accompanying consolidated balance sheets of Potomac Bancshares, Inc. and subsidiary as of December 31, 2003 and 2002, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for the years ended December 31, 2003, 2002 and 2001. 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 auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes 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 Potomac Bancshares, Inc. and subsidiary as of December 31, 2003 and 2002, and the results of their operations and their cash flows for the years ended December 31, 2003, 2002 and 2001, in conformity with accounting principles generally accepted in the United States of America.

Winchester, Virginia

February 5, 2004

15

CONSOLIDATED BALANCE SHEETS

December 31, 2003 and 2002

	2003		2002
ASSETS
Cash and due from banks	$	10,298,159	$	11,243,060
Interest-bearing deposits in financial institutions		335,615		1,969,773
Securities purchased under agreements to resell and federal funds sold		2,390,020		3,915,285
Securities held to maturity (fair value $6,039,375 in 2003 and $9,313,460 in 2002)		6,001,584		9,013,189
Securities available for sale, at fair value		38,424,681		42,728,120
Loans held for sale		564,213		1,923,694
Loans, net of allowance for loan losses of $1,723,624 in 2003 and $1,641,819 in 2002		138,334,200		115,403,930
Premises and equipment, net		4,991,513		4,456,560
Accrued interest receivable		908,983		1,064,815
Other assets		4,393,614		1,158,487
Total Assets	$	206,642,582	$	192,876,913
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES
Deposits
Noninterest-bearing	$	25,395,596	$	21,573,475
Interest-bearing		147,860,423		140,606,257
Total Deposits	$	173,256,019	$	162,179,732
Accrued interest payable		127,809		160,263
Securities sold under agreements to repurchase		9,199,345		6,102,441
Federal Home Loan Bank advances		1,715,254		2,042,149
Other liabilities		1,012,450		1,079,932
Commitments and contingent liabilities		—		—
Total Liabilities	$	185,310,877	$	171,564,517
STOCKHOLDERS’ EQUITY
Common stock, $1 per share par value; 5,000,000 shares authorized; issued, 2003, 1,800,000 shares; 2002, 600,000 shares	$	1,800,000	$	600,000
Surplus		4,200,000		5,400,000
Undivided profits		16,543,225		14,801,225
Accumulated other comprehensive income		497,607		758,816
	$	23,040,832	$	21,560,041
Less cost of shares acquired for the treasury, 2003, 97,329 shares; 2002, 6,110 shares		1,709,127		247,645
Total Stockholders’ Equity	$	21,331,705	$	21,312,396
Total Liabilities and Stockholders’ Equity	$	206,642,582	$	192,876,913

See Notes to Consolidated Financial Statements.

16

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31, 2003, 2002 and 2001

	2003		2002		2001
Interest and Dividend Income:
Interest and fees on loans	$	8,848,449	$	8,662,013	$	8,161,221
Interest on securities held to maturity - taxable		359,636		953,715		1,132,929
Interest on securities available for sale - taxable		1,468,594		1,490,627		1,185,877
Interest on securities purchased under agreements to resell and federal funds sold		44,348		90,452		393,154
Other interest and dividends		64,847		82,074		82,289
Total Interest and Dividend Income	$	10,785,874	$	11,278,881	$	10,955,470
Interest Expense:
Interest on deposits	$	1,958,959	$	2,602,812	$	3,659,957
Interest on securities sold under agreements to repurchase		171,458		98,536		31,160
Federal Home Loan Bank advances		104,349		121,834		66,663
Total Interest Expense	$	2,234,766	$	2,823,182	$	3,757,780
Net Interest Income	$	8,551,108	$	8,455,699	$	7,197,690
Provision for Loan Losses		147,500		423,000		220,575
Net Interest Income after Provision for Loan Losses	$	8,403,608	$	8,032,699	$	6,977,115
Noninterest Income:
Trust and financial services	$	560,693	$	464,633	$	510,933
Service charges on deposit accounts		1,217,020		1,121,826		474,556
Net gain on sale of loans		359,840		175,645		87,382
Cash surrender value of life insurance		165,495		—		—
Gain on sale of securities available for sale		99,087		—		—
Other operating income		441,749		334,550		285,154
Total Noninterest Income	$	2,843,884	$	2,096,654	$	1,358,025
Noninterest Expenses:
Salaries and employee benefits	$	3,954,725	$	3,520,647	$	3,143,150
Net occupancy expense of premises		378,562		324,661		296,740
Furniture and equipment expenses		891,177		653,302		464,058
Advertising and marketing		228,705		201,201		166,780
Stationery and supplies		190,124		190,788		125,173
Postage		132,313		143,587		105,042
Communications		144,216		116,160		95,730
ATM and check card expense		164,175		110,098		91,361
Other operating expenses		1,057,809		1,002,019		672,106
Total Noninterest Expenses	$	7,141,806	$	6,262,463	$	5,160,140
Income before Income Tax Expense	$	4,105,686	$	3,866,890	$	3,175,000
Income Tax Expense		1,432,018		1,407,720		1,165,733
Net Income	$	2,673,668	$	2,459,170	$	2,009,267
Earnings Per Share, basic and diluted	$	1.53	$	1.37	$	1.12

See Notes to Consolidated Financial Statements.

17

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

Years Ended December 31, 2003, 2002 and 2001

	Common Stock		Surplus			Undivided Profits			Treasury Stock			Accumulated Other Comprehensive Income (Loss)			Comprehensive Income			Total
Balances, December 31, 2000	$	600,000	$	5,400,000		$	12,008,205		$	—		$	(44,457	)				$	17,963,748
Comprehensive income
Net income – 2001		—		—			2,009,267			—			—		$	2,009,267			2,009,267
Other comprehensive income:
Unrealized holding gains arising during the period (net of tax, $130,601)		—		—			—			—			253,519			253,519			253,519
Total comprehensive income															$	2,262,786
Cash dividends – 2001 ($.45 per share)		—		—			(810,000	)		—			—						(810,000	)
Balances, December 31, 2001	$	600,000	$	5,400,000		$	13,207,472		$	—		$	209,062					$	19,416,534
Comprehensive income Net income – 2002		—		—			2,459,170			—			—		$	2,459,170			2,459,170
Other comprehensive income:
Unrealized holding gains arising during the period (net of tax, $372,679)		—		—			—			—			723,436			723,436			723,436
Minimum pension liability adjustment (net of tax, $89,473)		—		—			—			—			(173,682	)		(173,682	)		(173,682	)
Total comprehensive income															$	3,008,924
Cash dividends – 2002 ($.48 per share)		—		—			(865,417	)		—			—						(865,417	)
Purchase of common stock for the treasury		—		—			—			(247,645	)		—						(247,645	)
Balances, December 31, 2002	$	600,000	$	5,400,000		$	14,801,225		$	(247,645	)	$	758,816					$	21,312,396
Comprehensive income
Net income – 2003		—		—			2,673,668			—			—		$	2,673,668			2,673,668
Other comprehensive income:
Unrealized holding (losses) arising during the period (net of tax, ($257,725))		—		—			—			—			(500,288	)		(500,288	)		(500,288	)
Add: reclassification for gains included in net income (net of tax, $33,690)		—		—			—			—			65,397			65,397			65,397
Minimum pension liability adjustment (net of tax, $89,473)		—		—			—			—			173,682			173,682			173,682
Total comprehensive income															$	2,412,459
Stock split in the form of a 200% stock dividend		1,200,000		(1,200,000	)		—			—			—						—
Cash dividends – 2003 ($.54 per share)		—		—			(931,668	)		—			—						(931,668	)
Purchase of common stock for the treasury		—		—			—			(1,461,482	)		—						(1,461,482	)
Balances, December 31, 2003	$	1,800,000	$	4,200,000		$	16,543,225		$	(1,709,127	)	$	497,607					$	21,331,705

See Notes to Consolidated Financial Statements.

18

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2003, 2002 and 2001

	2003			2002			2001
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	2,673,668		$	2,459,170		$	2,009,267
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		147,500			423,000			220,575
Depreciation		623,154			417,120			288,464
Deferred tax expense (benefit)		20,060			1,517			(98,262	)
Discount (accretion) and premium amortization on securities, net		153,505			74,352			(14,578	)
(Gain) on sale of other real estate		—			—			(2,468	)
(Gain) on sale of securities available for sale		(99,087	)		—			—
Proceeds from sale of loans		21,104,470			10,417,951			4,652,242
Origination of loans for sale		(19,744,989	)		(11,426,069	)		(5,567,818	)
Changes in assets and liabilities:
(Increase) decrease in accrued interest receivable		155,832			79,652			(93,250	)
(Increase) decrease in other assets		(3,120,624	)		(214,413	)		31,788
(Decrease) in accrued interest payable		(32,454	)		(63,189	)		(79,232	)
Increase (decrease) in other liabilities		195,672			(440,486	)		247,211
Net cash provided by operating activities	$	2,076,707		$	1,728,605		$	1,593,939
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from maturity of securities held to maturity	$	3,000,000		$	10,000,000		$	8,000,000
Proceeds from maturity of securities available for sale		7,000,000			9,250,000			12,000,000
Proceeds from sale of securities available for sale		8,117,925			—			—
Proceeds from call of securities available for sale		3,000,000			—			—
Purchases of securities held to maturity		—			—			(9,035,270	)
Purchases of securities available for sale		(14,516,225	)		(20,271,354	)		(24,174,178	)
Net (increase) in loans		(23,077,770	)		(14,839,508	)		(18,029,396	)
Purchases of premises and equipment		(1,158,107	)		(1,485,648	)		(499,381	)
Proceeds from sale of other real estate		—			—			15,115
Net cash (used in) investing activities	$	(17,634,177	)	$	(17,346,510	)	$	(31,723,110	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in noninterest-bearing deposits	$	3,822,121		$	961,940		$	1,188,875
Net increase in interest-bearing deposits		7,254,166			14,323,558			16,760,417
Net proceeds in securities sold under agreements to repurchase		3,096,904			3,153,385			2,949,056
Net proceeds (repayment) of Federal Home Loan Bank advances		(326,895	)		(309,409	)		2,351,558
Purchase of treasury shares		(1,461,482	)		(247,645	)		—
Cash dividends		(931,668	)		(865,417	)		(810,000	)
Net cash provided by financing activities	$	11,453,146		$	17,016,412		$	22,439,906
Increase (decrease) in cash and cash equivalents	$	(4,104,324	)		1,398,507		$	(7,689,265	)
CASH AND CASH EQUIVALENTS
Beginning		17,128,118			15,729,611			23,418,876
Ending	$	13,023,794		$	17,128,118		$	15,729,611
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash payments for:
Interest	$	2,267,220		$	2,886,371		$	3,837,012
Income taxes	$	1,208,522		$	1,702,789		$	1,123,613
SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND FINANCING ACTIVITIES
Unrealized gain (loss) on securities available for sale	$	(658,926	)	$	1,096,115		$	384,120
Minimum pension liability adjustment	$	(263,155	)	$	263,155		$	—

See Notes to Consolidated Financial Statements.

19

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Nature of Banking Activities and Significant Accounting Policies

Potomac Bancshares, Inc. and subsidiary (the company) grant commercial, financial, agricultural, residential and consumer loans to customers, primarily in Berkeley County and Jefferson County, West Virginia. The company’s market area also includes Washington County and Frederick County, Maryland and Frederick County, Loudoun County and Clarke County, Virginia. The loan portfolio is well diversified and loans generally are collateralized by assets of the customers. The loans are expected to be repaid from cash flows or proceeds from the sale of selected assets of the borrowers.

The accounting and reporting policies of the company conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. The following is a summary of the more significant policies.

Principles of Consolidation

The consolidated financial statements of Potomac Bancshares, Inc. and its wholly-owned subsidiary, Bank of Charles Town (the bank), include the accounts of both companies. All material intercompany balances and transactions have been eliminated in consolidation.

Interest-bearing Deposits in Financial Institutions

Interest-bearing deposits in financial institutions mature within one year and are carried at cost.

Securities

Debt securities that management has the positive intent and ability to hold to maturity are classified as “held to maturity” and recorded at amortized cost. Securities not classified as held to maturity, including equity securities with readily determinable fair values, are classified as “available for sale” and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income.

Purchased premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

Loans

The company grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans. The ability of the company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions of the company’s market area.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for the allowance for loan losses. Interest income is accrued on the unpaid principal balance.

The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection. Consumer loans are typically charged off not later than 180 days past due. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.

All interest accrued but not collected for loans that are placed on nonaccrual or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

20

Note 1. Nature of Banking Activities and Significant Accounting Policies (Continued)

Allowance for Loan Losses (Continued)

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

A loan is considered impaired when, based on current information and events, 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. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the company does not separately identify individual consumer and residential loans for impairment disclosures.

Loans Held for Sale

Loans originated and intended for sale in the secondary market are carried at the lower of cost or market determined in the aggregate.

Premises and Equipment

Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed primarily on the straight-line and declining-balance methods. Estimated useful lives range from five to forty years for premises and improvements and five to twenty-five years for furniture and equipment.

Maintenance and repairs of property and equipment are charged to operations and major improvements are capitalized. Upon retirement, sale or other disposition of property and equipment, the cost and accumulated depreciation are eliminated from the accounts and gain or loss is included in operations.

Other Real Estate

Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lower of the loan balance or the fair value at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net expenses from foreclosed assets.

Employee Benefit Plans

The company has a noncontributory, defined benefit pension plan covering employees meeting certain age and service requirements. The company computes the net periodic pension cost of the plan in accordance with Financial Accounting Standards Board Statement No. 87, “Employers’ Accounting for Pensions.”

The company sponsors a postretirement life insurance plan covering retirees with 25 years of service over the age of 60 and a health care plan for all retirees and one current employee that have met certain eligibility requirements. The company computes the net periodic postretirement benefit cost of the plan in accordance with Financial Accounting Standards Board Statement No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.”

The company sponsors a 401(k) profit sharing plan available to fulltime employees meeting certain age and service requirements. Under this plan the employer may make a discretionary matching contribution each plan year and may also make other discretionary contributions to the plan.

21

Note 1. Nature of Banking Activities and Significant Accounting Policies (Continued)

Stock Split

On February 11, 2003, the Board of Directors declared a stock split in the form of a 200% stock dividend. Shares increased from 600,000 to 1,800,000.

Earnings Per Share

Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. The weighted-average number of common shares outstanding was 1,750,070, 1,791,027 and 1,800,000 at December 31, 2003, 2002 and 2001. 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. The company had no potential common stock as of December 31, 2003, 2002, and 2001. All amounts have been retroactively restated for the stock split.

Income Taxes

Deferred income tax assets and liabilities are determined using the balance sheet method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary difference between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.

Cash and Cash Equivalents

For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, interest-bearing deposits in financial institutions, securities purchased under agreements to resell and federal funds sold. Generally, securities purchased under agreements to resell and federal funds sold are purchased and sold for one-day periods.

Trust Division

Securities and other property held by the Trust Division in a fiduciary or agency capacity are not assets of the company and are not included in the accompanying financial statements.

Use of Estimates

In preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, and the valuation of foreclosed real estate and deferred tax assets.

Advertising

The company follows the policy of charging the costs of advertising to expense as incurred.

Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities and minimum pension liability adjustment, 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.

Stock Incentive Plan

The 2003 Stock Incentive Plan was approved by stockholders on May 13, 2003 which authorized up to 90,000 shares to be granted. No shares were granted in 2003.

Reclassifications

Certain reclassifications have been made to prior period amounts to conform to the current year presentation.

22

Note 1. Nature of Banking Activities and Significant Accounting Policies (Continued)

Recent Accounting Pronouncements

In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” which amends SFAS No. 123 to provide alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation and revised disclosure requirements. The provisions of the Statement were effective December 31, 2002. The company established a plan in 2003. No shares have been granted as of December 31, 2003. Management currently intends to continue to account for stock-based compensation under the intrinsic value method set forth in Accounting Principles Board (“APB”) Opinion 25 and related interpretations. For this reason, the transition guidance of SFAS No. 148 does not have an impact on the company’s consolidated financial position or consolidated results of operations.

In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). The Interpretation elaborates on the disclosures to be made by a guarantor in its financial statements under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The recognition requirements of the Interpretation were effective beginning January 1, 2003. The initial adoption of the Interpretation did not materially affect the company, and management does not anticipate that the recognition requirements of this Interpretation will have a materially adverse impact on either the company’s consolidated financial position or consolidated results of operations in the future.

In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). This Interpretation provides guidance with respect to the identification of variable interest entities and when the assets, liabilities, noncontrolling interests, and results of operations of a variable interest entity need to be included in a company’s consolidated financial statements. The Interpretation requires consolidation by business enterprises of variable interest entities in cases where (a) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity, or (b) in cases where the equity investors lack one or more of the essential characteristics of a controlling financial interest, which include the ability to make decisions about the entity’s activities through voting rights, the obligations to absorb the expected losses of the entity if they occur, or the right to receive the expected residual returns of the entity if they occur. The implementation of FIN 46 did not have a significant impact on either the company’s consolidated financial position or consolidated results of operations. Interpretive guidance relating to FIN 46 is continuing to evolve and the company’s management will continue to assess various aspects of consolidations and variable interest entity accounting as additional guidance becomes available.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” The Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” The Statement is effective for contracts entered into or modified after June 30, 2003, with certain exceptions, and for hedging relationships designated after June 30, 2003 and is not expected to have an impact on the company’s consolidated financial statements.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of these instruments were previously classified as equity. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatory redeemable financial instruments of nonpublic entities. Adoption of the Statement did not result in an impact on the company’s consolidated financial statements.

23

Note 1. Nature of Banking Activities and Significant Accounting Policies (Continued)

Recent Accounting Pronouncements (Continued)

In November 2003, the FASB’s Emerging Issues Task Force (EITF) reached a consensus on a new disclosure requirement related to unrealized losses on investment securities. The new disclosure requires a table of securities which have unrealized losses as of the reporting date. The table must distinguish between those securities which have been in a continuous unrealized loss position for twelve months or more and those securities which have been in a continuous unrealized loss position for less than twelve months. The table is to include the aggregate unrealized losses of securities whose fair values are below book values as of the reporting date, and the aggregate fair value of securities whose fair values are below book values as of the reporting date. In addition to the quantitative disclosure, FASB requires a narrative discussion that provides sufficient information to allow financial statement users to understand the quantitative disclosures and the information that was considered in determining whether impairment was not other-than-temporary. The new disclosure requirements apply to fiscal years ending after December 15, 2003. The company has included the required disclosures in their consolidated financial statements.

In December 2003, the FASB issued a revised version of SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits an amendment of FASB Statements No. 87, 88 and 106.” This Statement revises employers’ disclosures about pension plans and other postretirement benefits. It does not change the measurement or recognition of those plans required by FASB Statements No. 87, No. 88, and No. 106. This Statement retains the disclosure requirements contained in the original FASB Statement No. 132, which it replaces. However, it requires additional disclosures to those in the original Statement 132 about the assets, obligations, cash flows, and net periodic benefit costs of defined benefit pension plans and other defined benefit postretirement plans. The required information should be provided separately for pension plans and for other postretirement benefit plans. The disclosures for earlier annual periods presented for comparative purposes are required to be restated for (a) the percentages of each major category of plan assets held, (b) the accumulated benefit obligation, and (c) the assumptions used in the accounting for the plans. This Statement is effective for financial statements with fiscal years ending after December 15, 2003. The interim-period disclosures required by this Statement are effective for interim periods beginning after December 15, 2003. The company has included the required disclosures in its consolidated financial statements.

Note 2. Securities

The amortized cost and fair value of securities being held to maturity as of December 31, 2003 and 2002, are as follows:

	2003
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)		Fair Value
Obligations of U.S. Government agencies	$	6,001,584	$	37,791	$	—	$	6,039,375
	2002
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)		Fair Value
Obligations of U.S. Government agencies	$	9,013,189	$	300,271	$	—	$	9,313,460

The amortized cost and fair value of the securities being held to maturity as of December 31, 2003, by contractual maturity, are shown below:

	Amortized Cost		Fair Value
Due in one year or less	$	6,001,584	$	6,039,375

24

Note 2. Securities (Continued)

The amortized cost and fair value of securities available for sale as of December 31, 2003 and 2002 are as follows:

	2003
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
Obligations of U.S. Government agencies	$	37,670,732	$	822,146	$	(68,197	)	$	38,424,681

	2002
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)		Fair Value
Obligations of U.S. Government agencies	$	41,315,245	$	1,412,875	$	—	$	42,728,120

The amortized cost and fair value of the securities available for sale as of December 31, 2003, by contractual maturity, are shown below:

	Amortized Cost		Fair Value
Due in one year or less	$	5,014,426	$	5,132,337
Due after one year through five years		32,656,306		33,292,344
	$	37,670,732	$	38,424,681

Proceeds from sales of securities available for sale were $8,117,925 during 2003. Gross gains of $99,087 were realized on those sales. There were no sales of securities during 2002 and 2001.

The primary purpose of the investment portfolio is to generate income and meet liquidity needs of the company through readily saleable financial instruments. The portfolio is made up of fixed rate bonds, whose prices move inversely with rates. At the end of any accounting period, the investment portfolio has unrealized gains and losses. The company monitors the portfolio which is subject to liquidity needs, market rate changes and credit risk changes to see if adjustments are needed. The primary concern in a loss situation is the credit quality of the business behind the instrument. The primary cause of impairments is the decline in the prices of the bonds as rates have risen. There are approximately 4 accounts in the consolidated portfolio that have losses. These securities have not suffered credit deterioration and the company has the ability to hold these issues to maturity; therefore, the gross unrealized losses are considered temporary as of December 31, 2003.

The following table summarizes the fair value and gross unrealized losses for securities aggregated by investment category and length of time that individual securities have been in a continuous gross unrealized loss position as of December 31, 2003.

	Less than 12 months					More than 12 months				Total
	Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses
Obligations of U.S. Government agencies	$	8,445,781	$	(68,197	)	$	—	$	—	$	8,445,781	$	(68,197	)

Securities with a carrying value of $27,333,119 and $23,600,125 at December 31, 2003 and 2002, were pledged to secure public funds and other balances as required by law.

25

Note 3. Loans and Related Party Transactions

The loan portfolio is composed of the following:

	December 31
	2003		2002
Mortgage loans on real estate:
Construction and land development	$	13,956,590	$	2,210,582
Secured by farm land		3,711,332		1,821,345
Secured by 1-4 family residential		60,903,351		63,239,443
Other real estate		25,313,790		26,151,183
Loans to farmers (except those secured by real estate)		257,000		248,494
Commercial loans (except those secured by real estate)		17,649,329		3,447,238
Consumer loans		17,549,454		19,197,747
All other loans		716,978		729,717
Total loans	$	140,057,824	$	117,045,749
Less: allowance for loan losses		1,723,624		1,641,819
	$	138,334,200	$	115,403,930

At December 31, 2003 and 2002, overdraft demand deposits reclassified to loans totaled $126,684 and $113,408, respectively.

The Securities and Exchange Commission requires disclosure of loans which exceed $60,000 to executive officers and directors of the company or to their associates. Such loans were made on substantially the same terms as those prevailing for comparable transactions with similar risks. At December 31, 2003 and 2002, these loans totaled $876,995 and $869,861 respectively. During 2003, total principal additions were $213,910 and total principal payments were $206,776.

Note 4. Allowance for Loan Losses

The following is a summary of transactions in the allowance for loan losses for 2003, 2002 and 2001:

	2003			2002			2001
Balances at beginning of year	$	1,641,819		$	1,402,247		$	1,268,235
Provision charged to operating expense		147,500			423,000			220,575
Recoveries added to the allowance		125,949			103,705			35,125
Loan losses charged to the allowance		(191,644	)		(287,133	)		(121,688	)
Balances at end of year	$	1,723,624		$	1,641,819		$	1,402,247

Information about impaired loans as of and for the years ended December 31, 2003 and 2002 is as follows:

	2003		2002
Impaired loans for which an allowance has been provided	$	340,752	$	—
Impaired loans for which no allowance has been provided		—		—
Total impaired loans	$	340,752	$	—
Allowance provided for impaired loans, included in the allowance for loan losses	$	60,752	$	—
	2003		2002
Average balance in impaired loans	$	68,319	$	—
Interest income recognized	$	36,013	$	—

Nonaccrual loans excluded from impaired loan disclosure under SFAS No. 114 at December 31, 2003 and 2001 totaled $250,946 and $9,060, respectively. If interest on these loans had been accrued, such income would have approximated $18,390 in 2003 and $497 in 2001. There were no nonaccrual loans excluded from impaired loan disclosure under SFAS No. 114 at December 31, 2002.

26

Note 5. Premises and Equipment, Net

Premises and equipment consists of the following:

	December 31
	2003		2002
Premises and improvements	$	4,883,577	$	4,278,073
Furniture and equipment		4,538,879		3,986,277
	$	9,422,456	$	8,264,350
Less accumulated depreciation		4,430,943		3,807,790
	$	4,991,513	$	4,456,560

Depreciation included in operating expense for 2003, 2002 and 2001, was $623,154, $417,120 and $228,464 respectively.

Note 6. Deposits

The aggregate amount of time deposits with a balance of $100,000 or more was $12,463,860 and $8,804,364 at December 31, 2003 and 2002, respectively.

At December 31, 2003, the scheduled maturities of all time deposits are as follows:

2004	$	32,649,610
2005		10,077,662
2006		4,076,691
2007		1,019,172
2008		3,135,500
	$	50,958,635

Note 7. Borrowings

Short-term borrowings consist of securities sold under agreements to repurchase which are secured transactions with customers and generally mature the day following the date sold.

In June 2001, the bank incurred fixed rate long term debt consisting of a Federal Home Loan Bank seven year loan with an original balance of $2,500,000 and monthly payments of interest and principal with an interest rate of 5.51%. The loan is secured by capital stock, deposits, mortgage collateral and securities collateral of the bank.

Principal payments on the note are due as follows:

2004	$	345,369
2005		364,886
2006		385,507
2007		407,293
2008		212,199
	$	1,715,254

The company has unused lines of credit with the Federal Home Loan Bank and other financial institutions totaling approximately $71,695,000 at December 31, 2003.

Note 8. Employee Benefit Plans

The company sponsors a noncontributory, defined benefit pension plan covering full-time employees over 21 years of age upon completion of one year of service. Benefits are based on average compensation for the five consecutive full calendar years of service which produce the highest average. The company computes the net periodic pension cost of the plan in accordance with Financial Accounting Standards Statement No. 87, “Employers’ Accounting for Pensions.”

27

Note 8. Employee Benefit Plans (Continued)

The company sponsors a postretirement life insurance plan covering retirees with 25 years of service over the age of 60 and health care plan for all retirees and one current employee that have met certain eligibility requirements. The plan is contributory for future retirees, with retiree contributions that are currently set at 20% of the required premium. The company accounts for its share of the costs of those benefits in accordance with Financial Accounting Standards Statement No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” Under that Statement, the company’s share of the estimated costs that will be paid after retirement is generally being accrued by charges to expense over the employees’ active service periods to the dates they are fully eligible for benefits, except that the company’s unfunded cost that existed at January 1, 1995 is being accrued primarily in a straight-line manner that will result in its full accrual by December 31, 2014.

The company sponsors a 401(k) profit sharing plan available to fulltime employees meeting certain age and service requirements. Employees become eligible to participate in the plan upon reaching age 21 and completing one year of service. Entry dates are January 1, April 1, July 1 and October 1. Employees can make a salary deferral election authorizing the employer to withhold up to the amount allowed by law each calendar year. The employer may make a discretionary matching contribution each plan year. The employer may also make other discretionary contributions to the plan. The company made 401(k) matching contributions of $44,659, $30,302 and $17,011 in 2003, 2002 and 2001, respectively.

Information about the plans follow:

	Pension Benefits						Postretirement Benefits
	2003			2002			2003			2002
Change in Benefit Obligation:
Benefit obligation, beginning	$	4,501,006		$	4,117,159		$	487,761		$	562,161
Service cost		160,276			112,001			5,780			5,806
Interest cost		310,616			293,612			31,258			38,012
Actuarial (gain) loss		(760,263	)		105,507			(59,144	)		(86,390	)
Benefits paid		(141,581	)		(127,273	)		(24,263	)		(31,828	)
Benefit obligation, ending	$	4,070,054		$	4,501,006		$	441,392		$	487,761
Change in Plan Assets:
Fair value of plan assets, beginning	$	3,022,631		$	3,407,698		$	—		$	—
Actual return on plan assets		257,223			(432,486	)		—			—
Employer contributions		218,425			174,692			24,263			31,828
Benefits paid		(141,581	)		(127,273	)		(24,263	)		(31,828	)
Fair value of plan assets, ending	$	3,356,698		$	3,022,631		$	—		$	—
Funded status	$	(713,356	)		(1,478,375	)	$	(441,392	)	$	(487,761	)
Unrecognized net (gain) loss		226,184			964,911			(84,850	)		(25,933	)
Unrecognized net obligation (asset) at transition		(35,735	)		(56,037	)		191,528			208,940
Unrecognized prior service cost		560			716			—			—
Minimum liability adjustment		—			(263,155	)		—			—
Accrued benefit cost included in other liabilities	$	(522,347	)	$	(831,940	)	$	(334,714	)	$	(304,754	)

The accumulated benefit obligation for the defined benefit pension plan was $3,383,520 and $3,854,571 at December 31, 2003 and 2002, respectively.

	Pension Benefits									Postretirement Benefits
	2003			2002			2001			2003			2002		2001
Components of Net Periodic Benefit Cost:
Service cost	$	160,276		$	112,001		$	106,081		$	5,780		$	5,806	$	5,482
Interest cost		310,616			293,612			282,256			31,258			38,012		38,252
Expected return on plan assets		(312,182	)		(321,263	)		(345,418	)		—			—		—
Amortization of net (gain) loss		—			—			—			(227	)		167		10,854
Amortization of prior service cost		155			155			155			—			—		—
Amortization of net obligation at transition		(20,302	)		(20,302	)		(20,302	)		17,412			17,412		17,412
Recognized actuarial loss		33,423			—			—			—			—		—
Net periodic benefit cost	$	171,986		$	64,203		$	22,772		$	54,223		$	61,397	$	72,000

28

Note 8. Employee Benefit Plans (Continued)

Weighted-Average Assumptions:
Discount rate	7.00	%	7.00	%	7.25	%	6.75	%	7.00	%	7.00	%
Expected return on plan assets	8.50	%	8.50	%	8.50	%	—		—		—
Rate of compensation increase	4.00	%	4.00	%	4.25	%	3.00	%	3.00	%	3.00	%

Long-Term Rate of Return

The plan sponsor selects the expected long-term rate-of-return-on-assets assumption in consultation with their investment advisors and actuary. This rate is intended to reflect the average rate of earnings expected to be earned on the funds invested or to be invested to provide plan benefits. Historical performance is reviewed, especially with respect to real rates of return (net of inflation), for the major asset classes held or anticipated to be held by the trust, and for the trust itself. Undue weight is not given to recent experience that may not continue over the measurement period, with higher significance placed on current forecasts of future long-term economic conditions.

Because assets are held in a qualified trust, anticipated returns are not reduced for taxes. Further, solely for this purpose, the plan is assumed to continue in force and not terminate during the period during which assets are invested. However, consideration is given to the potential impact of current and future investment policy, cash flow into and out of the trust, and expenses (both investment and non-investment) typically paid from plan assets (to the extent such expenses are not explicitly estimated within periodic cost).

Asset Allocation

The pension plan’s weighted-average asset allocations at October 31, 2003 and 2002, by asset category are as follows:

	Plan Assets at October 31
	2003		2002
Asset Category
Equities	63	%	63	%
Fixed income/cash	37	%	37	%
Total	100	%	100	%

The trust fund is sufficiently diversified to maintain a reasonable level of risk without imprudently sacrificing return, with a targeted asset allocation of 60% equities and 40% fixed income/cash. The investment manager selects investment fund managers with demonstrated experience and expertise, and funds with demonstrated historical performance, for the implementation of the plan’s investment strategy. The investment manager will consider both actively and passively managed investment strategies and will allocate funds across the asset classes to develop an efficient investment structure.

It is the responsibility of the trustee to administer the investments of the trust within reasonable costs, being careful to avoid sacrificing quality. These costs include, but are not limited to, management and custodial fees, consulting fees, transaction costs and other administrative costs chargeable to the trust.

The company expects to contribute $218,425 to its pension plan in 2004.

For measurement purposes, an 8.64% annual rate of increase in per capita health care costs of covered benefits was assumed for 2003, a 9% increase was assumed for 2002 and a 10% increase was assumed for 2001, with such annual rate of increase gradually declining to 5% in 2013.

Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A 1% change in assumed health care cost trend rates would have the following effects:

	1% Increase		1% Decrease
Effect on the health care component of the accumulated postretirement benefit obligation	$	17,900	$	(16,000	)
Effect on total of service and interest cost components of net periodic postretirement health care benefit cost		1,175		(1,100	)

The company expects to contribute $49,911 to its post retirement plan in 2004.

29

Note 9. Income Taxes

Net deferred tax assets consist of the following components as of December 31, 2003 and 2002:

	2003		2002
Deferred tax assets:
Reserve for loan losses	$	431,044	$	403,230
Accrued pension expense		184,432		193,387
Minimum pension liability adjustment		—		89,473
Accrued postretirement benefits		113,779		103,617
Nonaccrual interest		6,252		—
	$	735,507	$	789,707
Deferred tax liabilities:
Depreciation	$	129,468	$	74,134
Securities available for sale		256,343		480,378
	$	385,811	$	554,512
Net deferred tax assets	$	349,696	$	235,195

The provision for income taxes charged to operations for the years ended December 31, 2003, 2002 and 2001 consists of the following:

	2003		2002		2001
Current tax expense	$	1,411,958	$	1,406,203	$	1,263,995
Deferred tax expense (benefit)		20,060		1,517		(98,262	)
	$	1,432,018	$	1,407,720	$	1,165,733

The income tax provision differs from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the years ended December 31, 2003, 2002 and 2001 due to the following:

	2003			2002			2001
Computed “expected” tax expense	$	1,395,933		$	1,314,743		$	1,079,500
Increase (decrease) in income taxes resulting from:
Tax exempt interest income		(90,033	)		(33,793	)		(28,503	)
State income taxes, net of federal income tax benefit		121,925			123,186			114,303
Other		4,193			3,584			433
	$	1,432,018		$	1,407,720		$	1,165,733

Note 10. Commitments and Contingent Liabilities

In the normal course of business, there are outstanding, various commitments and contingent liabilities which are not reflected in the accompanying financial statements. The company does not anticipate losses as a result of these transactions.

See Note 12 with respect to financial instruments with off-balance-sheet risk.

The company has approximately $700,420 in deposits in other financial institutions in excess of amounts insured by the Federal Deposit Insurance Corporation (FDIC) at December 31, 2003.

The company must maintain a reserve against its deposits in accordance with Regulation D of the Federal Reserve Act. For the final bi-weekly reporting periods which included December 31, 2003 and 2002, the aggregate amounts of daily average required balances were approximately $6,633,000 and $5,980,000, respectively.

Note 11. Retained Earnings

Transfers of funds from the banking subsidiary to the parent company in the form of loans, advances and cash dividends are restricted by federal and state regulatory authorities. As of December 31, 2003, the aggregate amount of unrestricted funds which could be transferred from the banking subsidiary to the parent company, without prior regulatory approval, totaled $2,827,868 or 13.3% of the consolidated net assets.

30

Note 12. Financial Instruments With Off-Balance-Sheet Risk

The company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. Those financial instruments include commitments to extend credit and standby letters of credit. Those instruments 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 those instruments reflect the extent of involvement the company has 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 instruments for commitments to extend credit and standby letters of credit 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.

A summary of the contract or notional amount of the company’s exposure to off-balance-sheet risk as of December 31, 2003 and 2002, is as follows:

	2003		2002
Financial instruments whose contract amounts represent credit risk:
Commitments to extend credit	$	24,847,726	$	19,990,685
Standby letters of credit		5,006,967		1,638,028

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 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 accounts receivable, inventory, property and equipment, and income-producing commercial properties.

Unfunded commitments under commercial lines of credit are commitments for possible future extensions of credit to existing customers. These lines of credit are uncollateralized and usually do not contain a specified maturity date and may not be drawn upon to the extent to which the company is committed.

Standby letters of credit 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, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The company generally holds collateral supporting those commitments if deemed necessary.

At December 31, 2003, the company had rate lock commitments to originate mortgage loans amounting to $976,088 and loans held for sale of $564,213. The company has entered into corresponding mandatory commitments, on a best-efforts basis, to sell these loans. These commitments to sell loans are designed to eliminate the company’s exposure to fluctuations in interest rates in connection with rate lock commitments and loans held for sale.

Note 13. Fair Value of Financial Instruments and Interest Rate Risk

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Short-Term Investments

For those short-term instruments, the carrying amount is a reasonable estimate of fair value.

Securities

For securities held for investment purposes, fair values are based on quoted market prices or dealer quotes.

Loans

For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for other loans were estimated using discounted cash flow analyses, using interest rates currently being offered.

Loans Held for Sale

The carrying amount of loans held for sale approximates fair value.

31

Note 13. Fair Value of Financial Instruments and Interest Rate Risk (Continued)

Deposit Liabilities

The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.

Short-term Borrowings

The carrying amounts of borrowings under repurchase agreements approximate fair value.

FHLB Advances

The fair values of the company’s FHLB advances are estimated using discounted cash flow analysis based on the company’s incremental borrowing rates for similar types of borrowing arrangements.

Accrued Interest

The carrying amounts of accrued interest approximate fair value.

Off-Balance Sheet Financial Instruments

The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date.

At December 31, 2003 and 2002, the fair value of loan commitments and standby-letters of credit was immaterial.

The estimated fair values of the company’s financial instruments are as follows:

	2003				2002
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
	(in thousands)				(in thousands)
Financial assets:
Cash	$	10,634	$	10,634	$	13,213	$	13,213
Securities purchased under agreements to resell and federal funds sold		2,390		2,390		3,915		3,915
Securities held to maturity		6,002		6,039		9,013		9,313
Securities available for sale		38,425		38,425		42,728		42,728
Loans, net		138,334		140,427		115,404		114,516
Loans held for sale		564		564		1,924		1,924
Accrued interest receivable		909		909		1,065		1,065
Financial liabilities:
Deposits		173,256		173,279		162,180		162,332
Repurchase agreements		9,199		9,199		6,102		6,102
FHLB advances		1,715		1,715		2,042		2,170
Accrued interest payable		128		128		160		160

The company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the company’s overall interest rate risk.

32

Note 14. Regulatory Matters

The company (on a consolidated basis) 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 – possibly additional discretionary – actions by regulators that, if undertaken, could have a direct material effect on the company’s and bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the company and 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 table below) 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). Management believes, as of December 31, 2003 and 2002, that the company and the bank meet all capital adequacy requirements to which they are subject.

As of December 31, 2003, the most recent notification from the Federal Deposit Insurance Corporation 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 table. There are no conditions or events since that notification that management believes have changed the institution’s category.

The company’s and the bank’s actual capital amounts and ratios are also presented in the table.

	Actual				Minimum Capital Requirement				Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Amount		Ratio		Amount		Ratio
	(Amount in Thousands)
As of December 31, 2003:
Total capital (to risk-weighted assets):
Consolidated	$	22,558	15.89	%	$	11,358	8.0	%		N/A	N/A
Bank of Charles Town	$	22,513	15.86	%	$	11,356	8.0	%	$	14,195	10.0	%
Tier 1 capital (to risk-weighted assets):
Consolidated	$	20,834	14.67	%	$	5,679	4.0	%		N/A	N/A
Bank of Charles Town	$	20,789	14.64	%	$	5,678	4.0	%	$	8,517	6.0	%
Tier 1 capital (to average assets):
Consolidated	$	20,834	10.20	%	$	8,171	4.0	%		N/A	N/A
Bank of Charles Town	$	20,789	10.18	%	$	8,170	4.0	%	$	10,213	5.0	%
As of December 31, 2002:
Total capital (to risk-weighted assets):
Consolidated	$	21,956	19.60	%	$	8,963	8.0	%		N/A	N/A
Bank of Charles Town	$	21,911	19.56	%	$	8,962	8.0	%	$	11,203	10.0	%
Tier 1 capital (to risk-weighted assets):
Consolidated	$	20,553	18.34	%	$	4,482	4.0	%		N/A	N/A
Bank of Charles Town	$	20,508	18.31	%	$	4,481	4.0	%	$	6,722	6.0	%
Tier 1 capital (to average assets):
Consolidated	$	20,553	10.77	%	$	7,636	4.0	%		N/A	N/A
Bank of Charles Town	$	20,508	10.74	%	$	7,635	4.0	%	$	9,543	5.0	%

33

Note 15. Parent Company Only Financial Statements

POTOMAC BANCSHARES, INC.

(Parent Company Only)

Balance Sheets

December 31, 2003 and 2002

	2003		2002
ASSETS
Cash	$	23,140	$	36 549
Investment in subsidiary		21,286,416		21,266,822
Other assets		24,907		14,021
Total Assets	$	21,334,463	$	21,317,392
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES, other	$	2,758	$	4,996
STOCKHOLDERS’ EQUITY
Common stock	$	1,800,000	$	600,000
Surplus		4,200,000		5,400,000
Undivided profits		16,543,225		14,801,225
Accumulated other comprehensive income		497,607		758,816
	$	23,040,832	$	21,560,041
Less cost of shares acquired for the treasury		1,709,127		247,645
Total Stockholders’ Equity	$	21,331,705	$	21,312,396
Total Liabilities and Stockholders’ Equity	$	21,334,463	$	21,317,392

POTOMAC BANCSHARES, INC.

(Parent Company Only)

Statements of Income

Years Ended December 31, 2003, 2002 and 2001

	2003			2002			2001
Income
Dividends from subsidiary	$	2,443,150		$	1,163,062		$	810,000
Expenses
Legal and professional		33,243			12,315			4,433
Other operating expenses		41,767			30,718			27,844
Total Expenses	$	75,010		$	43,033		$	32,277
Income before Income Tax (Benefit) and Equity in Undistributed Income of Subsidiary	$	2,368,140		$	1,120,029		$	777,723
Income Tax (Benefit)		(24,725	)		(13,839	)		(9,781	)
Income before Equity in Undistributed Income of Subsidiary	$	2,392,865		$	1,133,868		$	787,504
Equity in Undistributed Income of Subsidiary		280,803			1,325,302			1,221,763
Net Income	$	2,673,668		$	2,459,170		$	2,009,267

34

Note 15. Parent Company Only Financial Statements (Continued)

POTOMAC BANCSHARES, INC.

(Parent Company Only)

Statements of Cash Flows

Years Ended December 31, 2003, 2002 and 2001

	2003			2002			2001
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	2,673,668		$	2,459,170		$	2,009,267
Adjustments to reconcile net income to net cash provided by operating activities:
Equity in undistributed (income) of subsidiary		(280,803	)		(1,325,302	)		(1,221,763	)
(Increase) in other assets		(10,886	)		(4,059	)		(918	)
(Decrease) in other liabilities		(2,238	)		—			—
Net cash provided by operating activities	$	2,379,741		$	1,129,809		$	786,586
CASH FLOWS FROM FINANCING ACTIVITIES
Cash dividends	$	(931,668	)	$	(865,417	)	$	(810,000	)
Purchase of treasury shares		(1,461,482	)		(247,645	)		—
Net cash (used in) financing activities	$	(2,393,150	)	$	(1,113,062	)	$	(810,000	)
Increase (decrease) in cash and cash equivalents	$	(13,409	)	$	16,747		$	(23,414	)
CASH AND CASH EQUIVALENTS
Beginning		36,549			19,802			43,216
Ending	$	23,140		$	36,549		$	19,802

35

ANNUAL REPORT ON FORM 10-KSB

A copy of the company’s 2003 annual report on Form 10-KSB filed with Securities and Exchange Commission may be obtained without charge upon written request by any stockholder to:

Gayle Marshall Johnson

Vice President and Chief Financial Officer

Potomac Bancshares, Inc.

111 East Washington Street

PO Box 906

Charles Town, West Virginia 25414-0906

GENERAL INFORMATION

COMMON STOCK PRICES AND DIVIDENDS

Trading of Potomac Bancshares, Inc. common stock is not extensive and cannot be described as a public trading market. Potomac Bancshares, Inc. (symbol PTBS) is on the Bulletin Board, a network available to brokers. Scott & Stringfellow, Inc., Koonce Securities Inc. and Ferris, Baker Watts, Inc. are market makers for Potomac’s stock. A market maker is one who makes a market for a particular stock. Information about sales (but not necessarily all sales) of Potomac’s stock is available on the Internet through many of the stock information services using Potomac’s symbol. As of December 31, 2003, there were 1,702,671 common shares outstanding held by approximately 1,100 shareholders.

The per share sale prices of the company’s stock for 2002 and 2003 are based on information available as a result of our participation on the Bulletin Board described above and information gathered on the Internet. The dividends for 2002 and 2003 are also listed.

	High		Low		Dividends
2002
First Quarter	$	12.78	$	11.75	$	N/A
Second Quarter		13.67		12.17		0.23
Third Quarter		14.17		13.37		N/A
Fourth Quarter		15.50		13.92		0.25
2003
First Quarter	$	19.00	$	15.50	$	0.1300
Second Quarter		20.00		18.30		0.1325
Third Quarter		25.00		19.00		0.1350
Fourth Quarter		23.75		22.10		0.1375

Beginning in 2003 common stock dividends are paid on a quarterly basis. Prices and dividends in the above schedule have been restated to reflect a 200% stock dividend declared on February 11, 2003. Prior to 2003 the company had paid dividends on a semi-annual basis. Management intends to continue to recommend dividends to be paid as profits and maintenance of satisfactory equity capital allow.

STOCK TRANSFER AGENT

American Stock Transfer

    & Trust Company

59 Maiden Lane

New York NY 10038

(212) 936-5100

ANNUAL MEETING

The annual meeting of stockholders will be held at the Clarion Hotel & Conference Center, Shepherdstown, Jefferson County, West Virginia, on Tuesday, April 27, 2004, beginning at 10:30 a.m.

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EX-14.1

Exhibit 14.1

CODE OF ETHICS

The bank’s reputation for honesty and integrity is determined by the personal reputations of our individual staff members. To protect this reputation and to warrant our customers’ trust, each of us must strive to avoid situations that might cause a conflict of interest among the bank, its customers, its suppliers, and ourselves. The following principles have been established as the bank’s code of ethics. Any exceptions to these policies must be approved in writing.

Conflict of Interest

It is the policy of the bank that all staff members conduct their business affairs in such a manner and with such ethics and integrity that no conflict of interest, real or implied, could exist.

Extension of Credit to Relatives and Business Associates

No employees shall make or approve loans to any bank, partnership, estate, trust, association, or other entity or person in which the employee has an interest directly or indirectly (whether as a director, officer, shareholder, manager, lender, joint venture, or other otherwise controlling investor), or in which a relative has such an interest or business associate. Any such request for credit extension is to be referred to another bank officer with no connection or affiliation to the potential borrower. All transactions are to be arm’s-length transactions.

Employee Indebtedness

Borrowing by an employee from an individual or business customer of the bank should be avoided (unless the customer is a recognized lending institution). The approval or denial of such a request imposes a wrongful burden on the customer and can impair the judgment of the employee when making business decisions involving the customer.

Executive officers of the bank are reminded of the reporting requirements of Regulation O. If you are unclear about these requirements, please contact the president.

Personal Finances

Because of our position of trust in the community, personal finances should be managed with prudence. Personal financial affairs should be conducted in such a manner as to be above regulatory or auditing criticisms or concerns. Officers should discuss any financial emergency with the president. Employees may discuss any financial emergency with the human resources department.

All employees should assume the position of a regular customer when handling their personal bank business. All transactions should be handled in the normal over-the-counter procedure. No employees will be permitted to transact their own or a relative’s bank business. Avoid direct or indirect financial interest with competitors, customers, and suppliers.

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Outside Employment

The bank does not wish to control the personal affairs of employees, nor will it attempt to regulate the use of their time outside their employment with us. However, the bank does not look with favor upon a full-time employee working elsewhere if such outside employment in any way affects the individual’s work, fellow employees, or the bank. Of particular concern and requiring the president’s approval are jobs working for a competitor, supplier, or customer. Engaging in self-employment that in any way competes with the bank is prohibited.

Gifts and Fees

Employees and their families (as well as their agents or attorneys) are not to solicit or accept a personal benefit from any customer, vendor, individual, or organization seeking to do business with the bank. A personal benefit is any type of gift, gratuity, loan, fee, compensation, or anything of monetary value. Any deviation from the above must be specifically approved in writing by the president. The bank does recognize that situations may arise when it would be appropriate for a staff member to accept the benefit of a gift. Such situations include:

• Gifts of nominal value (not in excess of $50.00) given at Christmas or other holidays or special occasions that represent expressions of friendship.

• Reasonable entertainment such as luncheon, dinner, or business meetings with present or prospective customers and suppliers, when the return of the expenditure on a comparable basis is likely to occur and is properly chargeable as a business expense.

• Gifts or bequests based strictly on a family relationship.

Political Contributions and Activities

Individual participation in political and civic activities is encouraged, including the making of personal contributions to political candidates or activities. The bank, or anyone acting on its behalf, is prohibited from making an expenditure or contribution either directly or indirectly in connection with an election to political office.

Therefore, the bank will not make political contributions to individual candidates or political parties. Employees who wish to donate money or services to a candidate or party may do so as individuals, and not as representatives of the bank. To avoid any interpretation of bank sponsorship or endorsement, neither the bank’s name nor its address should be used. Do not use the bank name in or associated with any political advertisements or literature.

Business Conduct

In the conduct of the bank’s business, no bribe, kickback, or similar remuneration or consideration of any kind is to be given or offered to any individual or organization. The activities of the bank must always be in full compliance with all applicable laws and regulations. The bank expects its staff to comply fully with the letter, spirit, and intent of all laws and regulations.

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It is the policy of the bank to comply fully with the anti-bribery provisions. It is a criminal offense for any U.S. enterprise to offer a bribe to an official, political party, party official, or candidate for political office for the purpose of obtaining, retaining, or directing business to any person, regardless of whether that person is the one making the bribe. A bribe may take the form of an offer, payment, promise to pay, or authorization of the payment of any money or anything of value.

Customer Referral

Bank employees may be requested by bank customers and the general public to provide a referral to professional services, such as attorneys, securities brokers, certified public accountants, insurance agents, and real estate agents. Employees shall, when approved by management, recommend several qualified sources from which the customer can select. Bank employees should not make any adverse or negative comments regarding any outside professional. If an employee cannot give a positive recommendation regarding the outside professional, the employee should indicate to the customer that the employee has no recommendation to give regarding the particular professional. If you do make a positive referral, it should be limited to a statement that you have heard good comments regarding the professional but you or the bank cannot make any specific referrals or endorsements. The employee should exercise extreme care not to make any statement that could subject either the employee or the bank, or both, to an action for libel or slander.

In several instances, discussions with customers may lead to a request that the employee give an opinion or statement about the legality of a particular transaction. Employees are not qualified to give legal advice. The bank also does not engage in the business of giving investment or tax advice. These are areas that are best left to the professional in that particular field. Extreme care must be exercised in discussions with customers, and nothing should be said that could be construed as the giving of legal advice, tax advice, or investment advice.

Employee Purchases Of Bank Stock

In an effort to prevent conflicts of interests only or violations of SEC regulations, purchases or sales of Potomac Bancshares, Inc. stock are to be made through a registered securities broker/dealer. If you have any questions consult your supervisor.

Fiduciary Appointment

Without specific approval, employees are not to act as agent or deputy in any signing capacity on any account (except for members of their families) held in the bank. Further, employees may not act as executor, administrator, trustee, guardian, custodian, or in any fiduciary capacity without authority granted by the bank. This would normally be granted only to act for spouse, mother, father, brother, sister, son, daughter, or dependent.

There may be instances whereby a bank employee is requested to accept an appointment as a fiduciary or co-fiduciary (personal representative, trustee, administrator, guardian, executor, or custodian) with the bank, another person, or a firm or corporation. Except where the request is for a member of the immediate family, all employees must obtain prior approval of the bank’s board of directors before acceptance of the positions. Employees are reminded to consult senior management because federal or state regulations govern the acceptance of fees as a fiduciary.

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Confidential Information

All of our records are confidential and may not be copied or disclosed without authorization from management. Never discuss customer affairs, accounts, files, or printed material, except on a need-to-know basis with other employees. Confidential information includes all personnel and payroll records, information about our customers, and anything else about the way we operate.

On a periodic basis, the bank is examined. The reports that examiners furnish must remain the property of the regulatory agency and are strictly confidential. Information contained in the reports is privileged information and should not be communicated to anyone not officially connected with the bank.

The bank respects the right of employees to privacy in matters that have no relation to their employment. Matters of a personal nature concerning fellow employees should be treated with the utmost confidentiality.

Financial information regarding the bank is not to be released to any person unless it has been published in reports to shareholders or otherwise made available to the public in agreement with applicable disclosure regulations currently in effect. Any questions regarding disclosures of confidential financial information should be reviewed with the president and legal counsel prior to disclosure.

Confidential information obtained as a result of comments made within our bank should not be used for private interests.

Abuse or misuse of confidential information will result in severe discipline, and possibly termination.

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EX-21

Exhibit 21

Subsidiaries of the Registrant

Wholly-owned subsidiary: Bank of Charles Town

111 East Washington Street

PO Box 906

Charles Town WV 25414-0906

EX-23.1

Exhibit 23.1

CONSENT OF INDEPENDENT ACCOUNTANTS

We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-113479) and in the related Prospectus, of our report, dated February 5, 2004, relating to the consolidated financial statements of Potomac Bancshares, Inc. included in the 2003 Annual Report of Shareholders and incorporated by reference in the Annual Report on Form 10-KSB for the year ended December 31, 2003.

/s/ Yount, Hyde & Barbour, P.C.

Winchester, Virginia

March 29, 2004

EX-31.1

Exhibit 31.1

CERTIFICATION

I, Robert F. Baronner, Jr., certify that:

1. I have reviewed this annual report on Form 10-KSB of Potomac Bancshares, Inc.;

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

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

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of the date of this annual report (the “Evaluation Date”); and

c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: March 29, 2004            

/s/ Robert F. Baronner, Jr.                                                     

Robert F. Baronner, Jr.

President and Chief Executive Officer

EX-31.2

Exhibit 31.2

CERTIFICATION

I, Gayle Marshall Johnson, certify that:

1. I have reviewed this annual report on Form 10-QSB of Potomac Bancshares, Inc.;

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

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

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of the date of this annual report (the “Evaluation Date”); and

c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: March 29, 2004                

/s/ Gayle Marshall Johnson                                             

Gayle Marshall Johnson

Vice President and Chief Financial Officer

EX-32.1

Exhibit 32.1

Certification Pursuant to

18 U.S.C. Section 1350

As Adopted Pursuant to

Section 906 of the Sarbanes-Oxley Act of 2002

In connection with the Annual Report of Potomac Bancshares, Inc. (the “Company”) on Form 10-KSB for the period ending December 31, 2003 as filed with the Securities and Exchange Commission on the date hereof (the ”Report”), I, Robert F. Baronner, Jr., President and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. 1350, as adopted pursuant to 906 of the Sarbanes-Oxley Act of 2002, that:

1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company.

/s/ Robert F. Baronner, Jr.                                

Robert F. Baronner, Jr.

President and Chief Executive Officer

March 29, 2004

EX-32.2

Exhibit 32.2

Certification Pursuant to

18 U.S.C. Section 1350

As Adopted Pursuant to

Section 906 of the Sarbanes-Oxley Act of 2002

In connection with the Annual Report of Potomac Bancshares, Inc. (the “Company”) on Form 10-KSB for the period ending December 31, 2003 as filed with the Securities and Exchange Commission on the date hereof (the ”Report”), I, L. Gayle Marshall Johnson, Vice President and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. 1350, as adopted pursuant to 906 of the Sarbanes-Oxley Act of 2002, that:

1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company.

/s/ Gayle Marshall Johnson                                    

Gayle Marshall Johnson

Vice President and Chief Financial Officer

March 29, 2004

EX-99.1

Exhibit 99.1

POTOMAC BANCSHARES, INC.

Charles Town, West Virginia

NOTICE OF REGULAR ANNUAL MEETING OF SHAREHOLDERS

TO BE HELD APRIL 27, 2004

To the Shareholders:

The Regular Annual Meeting of Shareholders of Potomac Bancshares, Inc. (“Potomac”), will be held at Clarion Hotel and Conference Center, Shepherdstown, West Virginia, at 10:30 a.m., on April 27, 2004, for the purposes of considering and voting upon proposals:

1. To elect a class of directors for a term of three years.

2. To ratify the selection by the board of directors of Yount, Hyde & Barbour, P.C., as independent certified public accountants for the year 2004.

3. To approve any other business that may properly be brought before the meeting or any adjournment thereof.

Only those shareholders of record at the close of business on March 12, 2004, shall be entitled to notice of the meeting and to vote at the meeting.

By Order of the Board of Directors

Robert F. Baronner, Jr.

President and Chief Executive Officer

PLEASE SIGN AND RETURN THE ENCLOSED PROXY AS PROMPTLY AS POSSIBLE, WHETHER OR NOT YOU PLAN TO ATTEND THE MEETING IN PERSON. IF YOU DO ATTEND THE MEETING, YOU HAVE THE OPTION TO WITHDRAW YOUR PROXY.

March 30, 2004

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POTOMAC BANCSHARES, INC.

111 EAST WASHINGTON STREET

P.O. BOX 906

CHARLES TOWN, WEST VIRGINIA

(304) 725-8431

PROXY STATEMENT

ANNUAL MEETING OF SHAREHOLDERS - APRIL 27, 2004

Potomac Bancshares, Inc. is furnishing this statement in connection with its solicitation of proxies for use at the annual meeting of shareholders of Potomac Bancshares, Inc. to be held on April 27, 2004, at the time and for the purposes set forth in the accompanying notice of regular annual meeting of shareholders.

Solicitation of Proxies

Potomac’s management, at the direction of Potomac’s board of directors, is making this proxy solicitation. These proxies enable shareholders to vote on all matters scheduled to come before the meeting. If the enclosed proxy is signed and returned, it will be voted as directed; or if not directed, the proxy will be voted “FOR” all of the various proposals to be submitted to the vote of shareholders described in the enclosed notice of regular annual meeting and this proxy statement. A shareholder executing the proxy may revoke it at any time before it is voted by:

• notifying Potomac in person,

• giving written notice to Potomac of the revocation of the proxy,

• submitting to Potomac a subsequently-dated proxy, or

• attending the meeting and withdrawing the proxy before it is voted at the meeting.

Potomac will pay the expenses of this proxy solicitation. In addition to this solicitation by mail, officers and regular employees of Potomac and Bank of Charles Town may, to a limited extent, solicit proxies personally or by telephone or telegraph, although no person will be engaged specifically for that purpose.

Eligibility of Stock for Voting Purposes

Under Potomac’s bylaws, the board of directors has fixed March 12, 2004, as the record date for determining the shareholders entitled to notice of, and to vote at, the meeting or any adjournment thereof. Only shareholders of record at the close of business on that date are entitled to notice of and to vote at the annual meeting or any adjournment thereof.

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As of the record date for the annual meeting, 1,698,817 shares of the capital stock of Potomac were outstanding and entitled to vote. The principal holders of Potomac common stock are discussed under the section of this proxy statement entitled, “Principal Holders of Voting Securities”. As of the record date, Potomac had a total of approximately 1,100 shareholders of record.

PURPOSES OF MEETING

1. ELECTION OF DIRECTORS

General

Potomac’s articles of incorporation currently provide for a classified board of directors. There are three classes with each being elected for a three-year term. There are presently 12 directors on the board, four of whom are nominees for election at the 2004 annual meeting. All four of the nominees are non-employee directors.

Directors are elected by a plurality of the shares voted. As required by West Virginia law, each share is entitled to one vote per nominee, unless a shareholder requests cumulative voting for directors at least 48 hours before the meeting. If a shareholder properly requests cumulative voting for directors, then each shareholder will have the right to vote the number of shares owned by that shareholder for as many persons as there are directors to be elected, or to cumulate such shares and give one candidate as many votes as the number of directors multiplied by the number of shares owned shall equal, or to distribute them on the same principle among as many candidates as the shareholder sees fit. If any shares are voted cumulatively for the election of directors, the proxies, unless otherwise directed, shall have full discretion and authority to cumulate their votes and vote for less than all such nominees. For all other purposes, each share is entitled to one vote.

Potomac does not have a separate nominating committee and the board of directors serves this function. The board of directors makes nominations based upon its belief that candidates for director should have certain minimum qualifications, including:

• Directors should be of the highest ethical character.

• Directors should have excellent personal and professional reputations in the company’s market area.

• Directors should be accomplished in their professions or careers.

• Directors should be able to read and understand financial statements and either have knowledge of, or the ability and willingness to learn, financial institution law.

• Directors should have relevant experience and expertise to evaluate financial data and provide direction and advice to the chief executive officer and the ability to exercise sound business judgment.

• Directors must be willing and able to expend the time to attend meetings of the board of directors of the company and the bank and to serve on board committees.

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• The board of directors will consider whether a nominee is independent, as legally defined. In addition, directors should avoid the appearance of any conflict and should be independent of any particular constituency and be able to serve all shareholders of the company.

• Because the directors of the company also serve as directors of the bank, a majority of directors must be residents of West Virginia, as required by state banking law.

• Directors must be acceptable to the company’s and the bank’s regulatory agencies, including the Federal Reserve Board, the Federal Deposit Insurance Corporation and the West Virginia Division of Banking and must not be under any legal disability which prevents them from serving on the board of directors or participating in the affairs of a financial institution.

• Directors must own or acquire sufficient capital stock to satisfy the requirements of federal law and the bylaws of the bank.

• Directors must be at least 21 years of age.

The board of directors of the company reserves the right to modify these minimum qualifications from time to time, except where the qualifications are required by the laws relating to financial institutions.

The process of identifying and evaluating nominees is as follows: In the case of incumbent directors whose terms are set to expire, the board considers the directors’ overall service to the company during their term, including such factors as the number of meetings attended, the level of participation, quality of performance and any transactions between such directors of the company and the bank. The board also reviews the payment history of loans, if any, made to such directors of the bank to ensure that the directors are not chronically delinquent and in default. The board considers whether any transactions between the directors and the bank have been criticized by any banking regulatory agency or the bank’s external auditors and whether corrective action, if required, has been taken and was sufficient. The board also confirms that such directors remain eligible to serve on the board of directors of a financial institution under federal and state law. For new director candidates, the board uses its network of contacts in the company’s market area to compile a list of potential candidates. The board then meets to discuss each candidate and whether he or she meets the criteria set forth above. The board then discusses each candidate’s qualifications and chooses a candidate by majority vote.

The board will consider director candidates recommended by stockholders, provided that the recommendations are received at least 120 days before the next annual meeting of shareholders. In addition, the procedures set forth below are followed by stockholders for submitting nominations. The board does not intend to alter the manner in which it evaluates candidates, regardless of whether or not the candidate was recommended or nominated by a shareholder.

Potomac’s bylaws provide that nominations for election to the board of directors, other than those made by or on behalf of Potomac’s existing management, must be made by a shareholder in writing delivered or mailed to the President not less than 14 days nor more than 50 days prior to the meeting called for the election of directors; provided, however, that if less than 21 days’ notice of the meeting is given to shareholders, the nominations must be mailed or delivered to the President not later than the close of business on the 7th day following the day on which the notice of meeting was mailed. The notice of nomination must contain the following information, to the extent known:

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• name and address of proposed nominee(s);

• principal occupation of nominee(s);

• total shares to be voted for each nominee;

• name and address of notifying shareholder; and

• number of shares owned by notifying shareholder.

Nominations not made in accordance with these requirements may be disregarded by the chairman of the meeting and in such case the votes cast for each such nominee will likewise be disregarded.

The table beginning on page 6 of this proxy statement contains background information on each director nominee.

Committees of the Board

Potomac’s board of directors has a standing audit committee. The report of this committee is given on pages 4 and 5 of this proxy statement. Other functions of board committees for Potomac have been carried out by the board of directors as a whole or through committees of the board of directors of Bank of Charles Town. While there is no such requirement, the board of directors of the bank and Potomac are, and have at all times been, identical.

The audit committee consists of four independent directors: J. Scott Boyd, Guy Gareth Chicchirichi, E. William Johnson and Donald S. Smith. All members of the committee meet the Nasdaq definition for independence. The audit committee is appointed and approved by the boards of Potomac and the bank. The committee is to assist these boards in monitoring (1) the integrity of the financial statements of the corporation, (2) the compliance by the corporation with legal and regulatory requirements and (3) the independence of the corporation’s internal and external auditors. During 2003, the audit committee held seven meetings.

The company’s board of directors has determined that E. William Johnson meets the requirements of an audit committee financial expert as defined by the Securities and Exchange Commission.

The bank has a standing asset/liability/investment management committee, Community Reinvestment Act committee, personnel committee, trust committee, trust investment review committee and executive committee.

The asset/liability/investment management committee consists of six members: Robert F. Baronner, Jr., Guy Gareth Chicchirichi, William R. Harner, E. William Johnson, Gayle Marshall Johnson, and David S. Smith. This committee is comprised of board members and officers whose responsibilities are to manage the balance sheet of the bank by maximizing and maintaining the spread between interest earned and interest paid while assuming acceptable business risks and ensuring adequate liquidity. The committee recommends investment policies to the board and reviews investments as necessary. This committee held four meetings during 2003.

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The Community Reinvestment Act (CRA) committee consists of eight members: Robert F. Baronner, Jr., Donna J. Burns, Margaret Cogswell, Thomas C. G. Coyle, David Irwin, Marcia Lerch, Susan Myers and Linda Wasilius. The CRA committee is responsible for recommending to the board of directors policies that address fair lending concerns and the requirements of the CRA. Fair lending concerns are directed at preventing lending practices that discriminate either overtly or that have the effect of discrimination. The Community Reinvestment Act requires that banks meet the credit needs of their communities, including those of low- and moderate-income borrowers. This committee held two meetings in 2003.

The personnel committee consists of seven members: Robert F. Baronner, Jr. (ex-officio), J. Scott Boyd, Guy Gareth Chicchirichi, Thomas C.G. Coyle, Tammy Miller, John C. Skinner, Jr. and Donald S. Smith. The personnel committee’s responsibilities include evaluating staff performance and requirements, reviewing salaries, and making necessary recommendations to the board regarding these responsibilities. The committee held one meeting in 2003. The executive officer who serves on this committee did not make recommendations or participate in meetings relating to his own salary. See “Personnel Committee Report on Executive Compensation.”

The trust committee consists of six members: Robert F. Baronner, Jr., John P. Burns, Jr., Thomas C.G. Coyle, William R. Harner, Robert L. Hersey and John C. Skinner, Jr. The trust committee is responsible for the general supervision of the fiduciary activities performed by the Trust and Financial Services Division in order to ensure proper administration of all aspects of the bank’s fiduciary business. It sets forth prudent policies and guidelines under which the department can fulfill its fiduciary responsibilities in a timely and efficient manner and meet state and federal regulatory requirements. The committee makes periodic reports to the board of directors and oversees the activities of the trust investment review committee. The trust committee held six regular meetings in 2003.

The trust investment review committee, consisting of two trust officers, the president and chief executive officer, and one director (Robert L. Hersey, David S. Smith, Robert F. Baronner, Jr. and William R. Harner), meets regularly to review investments in trust accounts and to determine that these investments remain within the guidelines of the account. This committee held 10 meetings during 2003.

The executive committee consists of seven members: Robert F. Baronner, Jr., J. Scott Boyd, John P. Burns, Jr., William R. Harner, E. William Johnson, John C. Skinner, Jr. and Donald S. Smith. This committee meets on an as needed basis to review and approve loans that exceed the chief executive officer’s lending authority. This committee held six meetings in 2003.

Neither Potomac nor the bank has a nominating committee. Rather, the board of directors of each selects nominees to fill vacancies on the boards.

The board of directors of Potomac met for four regular quarterly meetings and seven special meetings in 2003. The board of directors of the bank held regular monthly meetings the second Tuesday of each month in 2003. Special meetings are held from time to time as required. During 2003, the bank board held 12 regular meetings and one special meeting. During the year, each of the directors attended at least 75% of all meetings of the boards of Potomac and the bank and all committees of the boards on which they served.

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Audit Committee Report

The audit committee’s report to the shareholders which follows was approved and adopted by the committee on March 3, 2004, and by the board of directors on March 9, 2004. The members of the audit committee are all independent in accordance with the requirements of NASDAQ.

The audit committee oversees Potomac’s financial reporting process on behalf of the board of directors. Management has the primary responsibility for the financial statements and the reporting process including the systems of internal controls.

The audit committee has reviewed and discussed the audited financial statements with management, discussed with the independent auditor the matters required by SAS 61, received communications from the independent auditor as to their independence, and discussed independence with the auditor.

The audit committee has received the written disclosures and the letter from the independent accountant required by Independence Standards Board No. 1, “Independence Discussions with Audit Committees”, and has discussed with the independent accountant the independent accountant’s independence.

Based on its review and discussions with management and the independent auditor, the audit committee recommended to the board of directors that the audited financial statements be included in the Form 10-KSB filed by the corporation.

The audit committee and the board of directors have adopted a written charter for the audit committee which is included as Attachment A at the end of this proxy statement.

The following fees were paid to Yount, Hyde & Barbour, P.C., Potomac Bancshares, Inc.’s certified public accountants, for services provided to the corporation for the fiscal year ending December 31, 2003.

	2003				2002
	Fees		Percentage		Fees		Percentage
Audit fees	$	37,600	67.2	%	$	36,886	72.4	%
Audit-related fees		14,288	25.6	%		10,210	20.0	%
Tax fees		4,000	7.2	%		3,900	7.6	%
All other fees		—	0.0	%		—	0.0	%
	$	55,888	100.0	%	$	50,996	100.0	%

A description of these fees is as follows:

• Audit fees: Audit and review service and review of documents filed with SEC.

• Audit-related fees: Agreed upon procedures related to the Trust Department’s Regulation 9 examination and IT review.

• Tax fees: Preparation of federal and state tax returns.

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The audit committee of the board believes that the non-audit services provided by Yount, Hyde & Barbour are compatible with maintaining the auditor’s independence. The audit committee charter requires that the audit committee pre-approve all services performed by the independent auditors. However, the pre-approval requirement is waived for non-audit services if the amount of the non-audit service is not more than 5% of the total amount paid to the independent auditors during the fiscal year in which the services are provided and such services were not recognized at the time of the engagement to be non-audit services and such services are promptly brought to the committee’s attention and approved prior to the completion of the audit. All of the services described above for which Yount, Hyde & Barbour, P.C., billed the company for the fiscal year ended December 31, 2003, were pre-approved by the company’s audit committee. For the fiscal year ended December 31, 2003, the company’s audit committee did not waive the pre-approval requirement of any non-audit services to be provided to the company by Yount, Hyde & Barbour, P.C.

This report should not be deemed incorporated by reference by any general statement incorporating by reference this proxy statement into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that Potomac specifically incorporates this report by reference, and shall not otherwise be filed with such Acts.

E. William Johnson, Chairman

J. Scott Boyd

Guy Gareth Chicchirichi

Donald S. Smith

Management Nominees to the Board of Potomac

The management nominees for the board of directors are:

Nominees	Age	Served As Director of Potomac Since	Family Relation- ship With Other Nominees	Year in Which Term Expires	Principal Occupation or Employment Last Five Years
J. Scott Boyd	47	1999	None	2004	Pharmacist and President of Jefferson Pharmacy, Inc. in Jefferson County, West Virginia since 1982; President and Chairman of Board of Directors of In Home Medications West Virginia, Inc.
John P. Burns, Jr.	62	1994	None	2004	Owner/operator of a beef and grain farm in Jefferson County, West Virginia; President, Jefferson County Fair Association; Director, Valley Farm Credit.

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Management Nominees to the Board of Potomac (Continued)

Barbara H. Pichot	56	2004	None	2004	Certified public accountant and partner in CoxHollida LLP, a public accounting firm in Berkeley County, West Virginia, since 1981; President, Hospice of the Panhandle; member Board of Governors, Shepherd College.
C. Larry Togans	57	2004	None	2004	Retired Deputy, Branch of Human Resources, U. S. Geological Survey, employed 1973 to 2001.

Directors Continuing to Serve Unexpired Terms

Directors	Age	Served As Director of Potomac Since	Family Relation- ship With Other Nominees	Year in Which Term Expires	Principal Occupation or Employment Last Five Years
Robert F. Baronner, Jr.	45	2001	None	2005	Employed by bank as of 1/1/01 as President and Chief Executive Officer; former Senior Credit Officer, BB&T Northern West Virginia, May 2000 to December 2000; former Executive Vice President, One Valley Bank East September 1997 to April 2000.
Guy Gareth Chicchirichi	62	1994	None	2005	Executive Manager, Secretary/Treasurer, Guy’s Buick-Pontiac-Oldsmobile-GMC Truck, Inc., Jefferson County, West Virginia; charter member of Charles Town Rotary Club; Director, Jefferson County Boys & Girls’ Club.
Margaret Cogswell	45	2003	None	2005	Executive Director, Hospice of the Panhandle, Berkeley County, West Virginia since 1986.
Thomas C. G. Coyle	75	1994	None	2005	Retired owner/operator of Riddleberger’s Store, Jefferson County, West Virginia; Trustee and Elder, Charles Town Presbyterian Church; Director, Edge Hill Cemetery.
William R. Harner	63	1994	None	2006	Employed at Bank 1967 to 2004; Senior Vice President and Cashier 1988 to 2004 (retired); Senior Vice President of Potomac since 1994.
E. William Johnson	59	1994	None	2006	Professor of Economics, Shepherd College, Jefferson County, West Virginia.

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Directors Continuing to Serve Unexpired Terms (Continued)

John C. Skinner, Jr.	62	1994	None	2006	Attorney, owner of Nichols & Skinner, L. C., Jefferson County, West Virginia; Bank attorney since 1986; Potomac attorney since 1994.
Donald S. Smith	75	1994	None	2006	Employed at Bank 1947 to 1991; President 1978 to 1991 (retired); Vice President and Assistant Secretary of Potomac since 1994.

Principal Holders of Voting Securities

The following shareholder beneficially owns more than 5% of Potomac’s common stock as of March 5, 2004.

Name of Beneficial Owner	Amount and Nature of Beneficial Ownership	Percent of Common Stock
Estate of Virginia F. Burns PO Drawer 40 Charles Town WV 25414	100,240 shares	5.9006

Ownership of Securities by Nominees, Directors and Officers

The following table shows the amount of Potomac’s outstanding common stock beneficially owned by nominees, directors and principal officers of Potomac individually and as a group. Beneficial ownership has been determined in accordance with the provisions of Rule 13d-3 of the Securities Exchange Act of 1934 under which a person is deemed to be the beneficial owner of a security if he or she has or shares the power to vote or direct the voting of the security or the power to dispose of or direct the disposition of the security, or if he or she has the right to acquire beneficial ownership of the security within sixty days. No shares are disclosed in the amounts below that are exercisable by any nominee, director or principal officer. The information is furnished as of March 5, 2004, on which date 1,698,817 shares were outstanding.

Non-Nominees	Amount and Nature of Beneficial Ownership	Percent of Common Stock
Robert F. Baronner, Jr. PO Box 906 Charles Town, WV 25414-0906	4,093 shares	.2410
Guy Gareth Chicchirichi RR 6 Box 38 Charles Town WV 25414-9704	7,494 shares	.4411
Margaret Cogswell 122 Waverly Court Martinsburg WV 25401	50 shares	.0029

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Non-Nominees (Continued)	Amount and Nature of Beneficial Ownership	Percent of Common Stock
Thomas C.G. Coyle 808 High Street Charles Town WV 25414	10,893 shares	.6412
William R. Harner PO Box 906 Charles Town WV 25414-0906	4,200 shares	.2472
E. William Johnson Division of Business and Social Sciences Shepherd College Shepherdstown WV 25443	2,325 shares	.1369
John C. Skinner, Jr. PO Box 487 Charles Town WV 25414	11,712 shares	.6894
Donald S. Smith PO Box 264 Charles Town WV 25414-0264	17,700 shares	1.0419
Nominees	Amount and Nature of Beneficial Ownership	Percent of Common Stock
J. Scott Boyd 201 S Preston Street Ranson WV 25438	1,100 shares	.0648
John P. Burns, Jr. 12 Burns Farm Lane Charles Town WV 25414	9,188 shares	.5408
Barbara H. Pichot PO Box 1207 Martinsburg WV 25402	290 shares	.0171
C. Larry Togans 225 Tuscawilla Hills Charles Town WV 25414	50 shares	.0029

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Officers (Non-Nominees)	Amount and Nature of Beneficial Ownership	Percent of Common Stock
David W. Irvin PO Box 906 Charles Town WV 25414	569 shares	.0335
Gayle Marshall Johnson PO Box 906 Charles Town WV 25414-906	1,524 shares	.0897
All nominees, directors & principal officers as a group (14 persons)	71,188 shares	4.1904

Executive Compensation

Potomac’s officers did not receive compensation as such during 2003. The following table sets forth the annual and long-term compensation for services in all capacities to the bank for the fiscal years ended December 31, 2003, 2002 and 2001 of the chief executive officer. Neither Potomac nor the bank has any stock option plans, employee stock ownership plans or other employee benefit plans except for the pension plan, 401(k) plan and 2003 stock option plan described in this proxy statement. No options were granted in 2003 through the stock option plan.

Summary Compensation Table

Name And Principal Position	Year	Annual Compensation			Long-Term Compensation			All Other Compensation ($)
					Awards		Payouts
		Salary ($)	Bonus ($)	Other Annual Compen- sation ($)	Restricted Stock Award(s) ($)	Securities Under- Lying Options/ SARs(#)	LTIP Payouts ($)
Robert F. Baronner, Jr. President and Chief Executive Officer	2003 2002 2001	137,000 126,469 107,224	20,448 20,895 17,200	9,120 9,120 9,175	N/A N/A N/A	N/A N/A N/A	N/A N/A N/A	0 0 0
David W. Irwin Senior Vice President and Commercial Loan Division Manager	2003 2002	77,156 74,562	52,456 65,011	N/A N/A	N/A N/A	N/A N/A	N/A N/A	0 0

Employee Benefit Plans

Potomac sponsors a noncontributory, defined benefit pension plan under which benefits are determined based on an employee’s average annual compensation for any five consecutive full calendar years of service which produce the highest average. An employee is any person (but not including a person acting only as a director) who is regularly employed on a full-time basis. An employee becomes eligible to participate in the plan upon completion of at least one year of service and attainment of age 21.

Normal retirement is at age 65 with the accrued monthly benefit determined on actual date of retirement. An employee may take early retirement from age 60 and the accrued monthly benefit as of the normal retirement date is actuarially reduced. There is no reduction if an employee is 62 years of age and has 30 years service.

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PENSION PLAN TABLE

Average Remuneration		Years of Service
		5		10		15		20		25		30
$	10,000	$	760	$	1,520	$	2,280	$	3,040	$	3,800	$	3,800
	15,000		1,260		2,520		3,780		5,040		6,300		6,300
	20,000		1,760		3,520		5,280		7,040		8,800		8,800
	25,000		2,260		4,520		6,780		9,040		11,300		11,300
	30,000		2,760		5,520		8,280		11,040		13,800		13,800
	40,000		3,760		7,520		11,280		15,040		18,800		18,800
	50,000		4,760		9,520		14,280		19,040		23,800		23,800
	60,000		5,760		11,520		17,280		23,040		28,800		28,800
	70,000		6,760		13,520		20,280		27,040		33,800		33,800
	80,000		7,760		15,520		23,280		31,040		38,800		38,800

Compensation covered by the pension plan is based upon total pay. Effective for plan years beginning after December 31, 1993, the Internal Revenue Code (the “Code”) prohibits compensation in excess of $150,000 (as indexed) to be taken into account in determining one’s pension benefit.

As of December 31, 2003, the current credited years of service for each of the following officers is:

Name	Current Credited Years of Service
Robert F. Baronner, Jr.	3 Years
David W. Irwin	2 Years

During 2002, the corporation established a 401(k) profit sharing plan available initially to all fulltime employees. After initiation of the plan, employees become eligible to participate in the plan upon reaching age 21 and completing one year of service. Employees can make a salary deferral election authorizing the employer to withhold up to the amount allowed by law each calendar year. The employer may make a discretionary matching contribution each plan year. The employer may also make other discretionary contributions to the plan.

During 2003 the Potomac board and the shareholders adopted and approved the 2003 Stock Incentive Plan which reserves 90,000 shares of common stock that may be granted as incentive stock options (“ISO”) and non-statutory stock options. There were no options granted in 2003.

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Personnel Committee Report on Executive Compensation

The personnel committee is comprised of seven members: Robert F. Baronner, Jr. (ex-officio), J. Scott Boyd, Guy Gareth Chicchirichi, Thomas C.G. Coyle, Tammy Miller (Human Resources Director), John C. Skinner, Jr. and Donald S. Smith. The personnel committee reviews and recommends to the board changes to the compensation levels of all executive officers of the bank. The committee seeks to attract and retain highly capable and well-qualified executives and to compensate executives at levels commensurate with their amount of service to the bank. The committee met November 25, 2003 to review and approve the bank’s 2004 compensation levels. The bank’s chief executive officer reviews each executive officer’s compensation and makes recommendations to the committee. The committee reviews these recommendations and independently evaluates each executive’s job performance and contribution to the bank. The committee also considers the inflation rate and the compensation levels of executive officers holding similar positions with the bank’s competitors. For instance, the committee compares the compensation levels of its executive officers with the levels, when known, of such institutions as United National Bank, Jefferson Security Bank, City National Bank and BB&T. Compensation levels for executives of the bank are competitive when compared to these institutions.

The chief executive officer’s salary and bonus is tied to performance goals of the bank and the bank’s profitability for the prior fiscal year. Robert F. Baronner, Jr. served on the committee and was the bank’s chief executive officer; however, he did not make any recommendations relating to his salary and was not present at committee meetings when his compensation was being discussed.

In 2003 Mr. Baronner had the opportunity to earn up to 20% of his base salary in bonus. This incentive program is based on a number of factors including average market price per share, net income per share, loan and deposit growth, the bank’s efficiency ratio, credit quality, and trust department income. During 2003, Mr. Baronner earned $20,448 out of a possible bonus of $27,400.

In 2001 Potomac and the bank entered into an employment agreement with Mr. Baronner. The first year’s base salary for 2001 for Mr. Baronner as stated in the employment agreement was set after discussions with a professional executive recruiter as well as research regarding market rates for similar positions for candidates with equivalent education and experience. The salary is set each year as the agreement renews and is based on performance goals of the bank and the bank’s profitability as discussed above.

The Internal Revenue Code disallows deductions of compensation exceeding $1,000,000 for certain executive compensation. The committee has not adopted a policy in this regard because none of the bank’s executives received compensation approaching the $1,000,000 level.

This report should not be deemed incorporated by reference by any general statement incorporating by reference this proxy statement into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that Potomac specifically incorporates this report by reference, and shall not otherwise be filed under such Acts. This report is submitted by:

Robert F. Baronner, Jr. (ex-officio)

J. Scott Boyd

Guy Gareth Chicchirichi

Thomas C.G. Coyle

John C. Skinner, Jr.

Donald S. Smith

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Performance Graph

The following graph compares the yearly percentage change in Potomac’s cumulative total shareholder return on common stock for the five-year period ending December 31, 2002, with the cumulative total return of the Media General Index (SIC Code Index 6712 - Bank Holding Companies). Shareholders may obtain a copy of the index by calling Media General Financial Services, Inc. at telephone number (800) 446-7922. There is no assurance that Potomac’s stock performance will continue in the future with the same or similar trends as depicted in the graph.

The graph shall not be deemed incorporated by reference by any general statement incorporating by reference this proxy statement into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that Potomac specifically incorporates this graph by reference, and shall not otherwise be filed under such Acts.

Employment Agreement

Potomac and the bank have an employment agreement with Robert F. Baronner, Jr., president and chief executive officer of Potomac and the bank. The agreement is for a one-year term, with additional renewals for one year each, unless terminated by one of the parties. The agreement provided for an annual salary of $110,000 plus director’s fees in 2001. The subsequent annual salaries are set each year as the agreement renews. The personnel committee set the annual salary at $147,000 for 2004. Under the agreement, if Mr. Baronner’s employment is terminated (other than for cause), he is entitled to one year’s salary and benefits. In the event of an actual or constructive termination of Mr. Baronner’s employment after a change in control of Potomac or the bank, Mr. Baronner would receive two years’ compensation and benefits for 18 months.

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Compensation of Directors

Directors of Potomac were not compensated for their services as directors for 2003. Directors of the bank were compensated at the rate of $760 for each regular board meeting attended in 2003. Directors are additionally compensated $100 for each committee meeting attended. Directors who are operating officers of the bank are not compensated for committee meetings attended.

Certain Transactions with Directors, Officers and Their Associates

Potomac and the bank have had, and expect to have in the future, transactions in the ordinary course of business with directors, officers, principal shareholders and their associates. All of these transactions remain on substantially the same terms, including interest rates, collateral and repayment terms on the extension of credit, as those prevailing at the same time for comparable transactions with unaffiliated persons, and in the opinion of management of Potomac and the bank, did not involve more than the normal risk of collectibility or present other unfavorable features.

Nichols and Skinner, L.C., a law firm in which Director John C. Skinner, Jr. is a shareholder, performed legal services for the bank and Potomac in 2003 and will perform similar services in 2004. On the basis of information provided by Mr. Skinner, it is believed that less than five percent of the gross revenues of this law firm in 2003 resulted from payment for legal services by Potomac and the bank. In the opinion of Potomac and the bank, the transactions with Nichols and Skinner, L.C., were on terms as favorable to Potomac and the bank as they would have been with third parties not otherwise affiliated with Potomac or the bank.

J. Scott Boyd, Thomas C.G. Coyle, William R. Harner, and Donald S. Smith, directors of the bank and Potomac, have been indebted to the bank during 2003 in an amount in excess of $60,000. In the opinion of Potomac and the bank, these loans were made in the ordinary course of business, were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons, and do not involve more than the normal risk of collectability or present other unfavorable features.

2. RATIFICATION OF SELECTION OF AUDITORS

The board of directors has selected the firm of Yount, Hyde & Barbour, P.C. to serve as independent auditors for Potomac for the calendar year 2004. If the shareholders do not ratify the appointment of Yount, Hyde & Barbour, P.C., the board will consider the appointment of other auditors. Potomac is advised that no member of this accounting firm has any direct or indirect material interest in Potomac, or any of its subsidiaries.

A representative of Yount, Hyde & Barbour, P.C., will be present at the annual meeting to respond to appropriate questions and to make a statement if he so desires. The enclosed proxy will be voted “FOR” the ratification of the selection of Yount, Hyde & Barbour, P.C., unless otherwise directed. The affirmative vote of a majority of the shares of Potomac’s common stock represented at the annual meeting of shareholders is required to ratify the appointment of Yount, Hyde & Barbour, P.C.

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FORM 10-KSB ANNUAL REPORT

TO THE SECURITIES AND EXCHANGE COMMISSION

Upon written request by any shareholder to Gayle Marshall Johnson, Vice President and Chief Financial Officer, Potomac Bancshares, Inc., 111 East Washington Street, PO Box 906, Charles Town, West Virginia 25414-0906, a copy of Potomac’s 2003 Annual Report on Form 10-KSB will be provided without charge.

SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

Section 16(a) of the Securities Exchange Act of 1934 requires Potomac’s directors and executive officers, and persons who own more than ten percent of a registered class of Potomac’s equity securities, to file with the Securities and Exchange Commission initial reports of ownership and reports of changes in ownership of common stock and other equity securities of Potomac. Officers, directors and shareholders owning more than ten percent are required by SEC regulation to furnish Potomac with copies of all Section 16(a) forms which they file.

To Potomac’s knowledge, based solely upon review of the copies of such reports furnished to Potomac and written representations that no other reports were required, during the two fiscal years ended December 31, 2003, all Section 16(a) filing requirements applicable to its officers, directors and persons owning more than ten percent were complied with.

OTHER MATTERS

If any of the nominees for election as directors should be unable to serve as a director by reason of death or other unexpected occurrence, a proxy will be voted for a substitute nominee or nominees designated by the board of Potomac unless the board of directors adopts a resolution pursuant to the bylaws reducing the number of directors.

The board of directors is unaware of any other matters to be considered at the meeting but, if any other matters properly come before the meeting, persons named in the proxy will vote such proxy in accordance with their judgment on such matters.

SHAREHOLDER PROPOSALS FOR 2005

Any shareholder who wishes to have a proposal placed before the next Annual Meeting of Shareholders must submit the proposal to Robert F. Baronner, Jr., President & Chief Executive Officer of Potomac, at its executive offices, no later than November 30, 2004, to have it considered for inclusion in the proxy statement of the annual meeting in 2005.

Robert F. Baronner, Jr.

President and Chief Executive Officer

Charles Town, West Virginia

March 30, 2004

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Attachment A

AUDIT COMMITTEE CHARTER

STATEMENT OF POLICY

A soundly conceived, effective Audit Committee is essential to the management, operation, and financial reporting process of Potomac Bancshares, Inc. The Audit Committee shall provide assistance to the corporate directors in fulfilling their responsibilities to the shareholders, potential shareholders, and investment community relating to corporate accounting, reporting practices of the corporation, and the quality and integrity of the financial reports of the corporation. In so doing, it is the responsibility of the Audit Committee to maintain free and open means of communication between the directors, the independent auditors, the internal auditors, and the financial management of the corporation.

ORGANIZATION

Members

There shall be a committee of the Board of Directors known as the Audit Committee. This committee shall be composed of at least three (3) directors who are independent of the management of the corporation and are free of any relationship that, in the opinion of the Board of Directors, would interfere with their exercise of independent judgement as a committee member. Independent shall be defined using the NASDAQ’s standards as stated below:

A director will not be considered independent, if among other things, he or she has:

• been employed by the corporation or its affiliates in the current or past three years;

• accepted any compensation from the corporation or its affiliates except for board or committee service and retirement plan benefits.

• an immediate family member who is or has been in the past three years, employed by the corporation or its affiliates as an executive officer;

• been a partner, controlling shareholder or an executive officer of any for profit business to which the corporation made, or from which it received, payments; or

• been employed as an executive of another entity where any of the company’s executives serve on that entity’s compensation committee.

The Proxy Statement shall disclose whether or not committee membership is comprised of one “Audit Committee financial expert” as defined by Section 407 of the Sarbanes-Oxley Act of 2002. If not, the reasons shall be disclosed.

At the Committee’s discretion, management of the corporation may attend meetings of the Audit Committee, but this attendance shall be in a non-voting capacity.

Committee membership standards will be maintained in accordance with applicable banking laws and regulations.

Meetings

The Audit Committee shall meet at its own discretion, with special meetings called as deemed necessary. The Committee reserves the right to meet without members of corporate management, internal audit, or the independent accounting firm.

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Minutes

Minutes shall be prepared for all meetings of the Audit Committee to document the Committee’s discharge of its responsibilities. The minutes shall provide an accurate record of the proceedings, and shall be reviewed and approved by the Audit Committee.

AUTHORITY

The authority for the Audit Committee is derived from the full Board of Directors of Potomac Bancshares, Inc.

The Audit Committee is appointed by the Board to assist in monitoring (1) the integrity of the financial statements of the Company, (2) the compliance by the company with legal and regulatory requirements and (3) the independence and performance of the company’s internal and external auditors.

The Audit Committee shall have the authority to retain special legal, accounting or other consultants to advise the Committee. The Audit Committee may request any officer or employee of the company or the company’s outside council or independent auditor to attend a meeting of the Committee or to meet with any members of, or consultants to, the Committee.

RESPONSIBILITIES

In fulfilling the stated role of the Audit Committee, the primary and general responsibilities will be as follows:

• To provide for an internal audit function to serve the corporation in an examining and advisory capacity

• To provide for external audits of all corporate subsidiaries by suitable independent accountants

• To serve as a focal point and reporting outlet for communications among non-committee directors, corporate management, internal auditors, and independent accountants

• To maintain a “Whistle Blower” Policy required by Section 301 of the Sarbanes-Oxley Act of 2002.

• To assist the Board of Directors in fulfilling its fiduciary responsibilities for financial reporting and internal accounting and operations controls

• To act as an agent for the Board of Directors to help insure the independence of internal auditors and independent accountants, the integrity of management, and the adequacy of disclosures to stockholders.

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Specific duties of the Audit Committee include, but are not limited to the following items:

1. Review and reassess the adequacy of this Charter annually and submit it to the Board for approval.

2. Ensure required Audit Committee disclosures are included in the Proxy Statement. The Committee may delegate this responsibility to the financial expert.

3. Preapprove all services performed by the independent auditors. The preapproval requirement is waived for non-audit services if the amount of the non-audit service is not more than five percent of the total amount paid to the independent auditors during the fiscal year in which the services are provided and such services were not recognized at the time of the engagement to be non-audit services and such services are promptly brought to the committee’s attention and approved prior to the completion of the audit.

4. Prior to filing the annual report, review the annual audited financial statements with management and the independent auditors, including major issues regarding accounting and auditing principals and practices as well as the adequacy of internal controls that could significantly affect the Company’s financial statements.

5. Based on the review and discussions noted in no. 4 above, recommend to the Board of Directors that the audited financial statements be included in the company’s annual report on Form 10-K.

6. Review the financial information and disclosures in the Form 10-Q and the independent auditors review results. The Committee may delegate this responsibility to the Committee financial expert.

7. Recommend to the Board the appointment of the independent auditor, which firm is ultimately accountable to the Audit Committee and the Board.

8. Receive annual reports from the independent auditor regarding the auditor’s independence and discuss such reports with the auditor.

9. Review the regular internal audit reports to management prepared by the internal auditing department and management’s responses.

10. Discuss with the independent auditor the matters required to be discussed by Statement on Auditing Standards No 61 relating to the conduct of the audit.

11. Review with the independent auditor any problems or difficulties the auditor may have encountered and any management letter provided by the auditor and the Company’s response to that letter.

12. Perform any other activities consistent with this Charter, the organization’s By-laws and governing law, as the Committee or the Board deems necessary or appropriate.

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