10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005

Commission file no: 0-22955

BAY BANKS OF VIRGINIA, INC.

(Exact name of registrant as specified in its charter)

VIRGINIA	54-1838100
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

100 SOUTH MAIN STREET, KILMARNOCK, VIRGINIA	22482
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code: 804.435.1171

Securities registered under Section 12(b) of the Exchange Act: None

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

Common Stock ($5.00 Par Value)

(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    YES  ¨    NO  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    YES  ¨    NO  x

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Large accelerated filer  ¨ Accelerated filer  ¨ Non-accelerated filer  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    YES  ¨    NO  x

The aggregate market value of voting stock held by non-affiliates of the registrant at June 30, 2005, based on the closing sale price of the registrant’s common stock on June 27, 2005, was $37,921,952.

The number of shares outstanding of the registrant’s common stock as of March 17, 2006 was 2,371,466.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive Proxy Statement for its Annual Meeting of Shareholders to be held on May 16, 2005 are incorporated by reference into Part III of this Form 10-K.

BAY BANKS OF VIRGINIA

INDEX

		Page
	PART I
Item 1:	Business	3
Item 1A:	Risk Factors	8
Item 1B:	Unresolved Staff Comments	9
Item 2:	Properties	9
Item 3:	Legal Proceedings	10
Item 4:	Submission of Matters to a Vote of Security Holders	10
	PART II
Item 5:	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	10
Item 6:	Selected Financial Data	11
Item 7:	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11
Item 7A:	Quantitative and Qualitative Disclosures About Market Risk	23
Item 8:	Financial Statements and Supplementary Data	23
Item 9:	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	45
Item 9A:	Controls and Procedures	45
Item 9B:	Other Information	45
	PART III
Item 10:	Directors and Executive Officers of the Registrant	45
Item 11:	Executive Compensation	45
Item 12:	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	45
Item 13:	Certain Relationships and Related Transactions	46
Item 14:	Principal Accounting Fees and Services	46
	PART IV
Item 15:	Exhibits, Financial Statement Schedules	47

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PART I

ITEM 1: BUSINESS

GENERAL

Bay Banks of Virginia, Inc. (the “Company”) is a bank holding company that conducts substantially all of its operations through its subsidiaries, Bank of Lancaster (the “Bank”), and Bay Trust Company (the “Trust Company”). Bay Banks of Virginia, Inc., was incorporated under the laws of the Commonwealth of Virginia on June 30, 1997, in connection with the holding company reorganization of the Bank of Lancaster.

The Bank is a state-chartered bank and a member of the Federal Reserve System. The Bank services individual and commercial customers, the majority of which are in the Northern Neck of Virginia, by providing a full range of banking and related financial services, including checking, savings, other depository services, commercial and industrial loans, residential and commercial mortgages, home equity loans, and consumer installment loans.

The Bank has two offices located in Kilmarnock, Virginia, and one office each in White Stone, Warsaw, Montross, Heathsville, and Callao, Virginia. A substantial amount of the Bank’s deposits are interest bearing, and the majority of the Bank’s loan portfolio is secured by real estate. Deposits of the Bank are insured by the Bank Insurance Fund of the Federal Deposit Insurance Corporation (the “FDIC”). The Bank opened for business in 1930 and has partnered with the community to ensure responsible growth and development since that time.

In August of 1999, Bay Banks of Virginia formed Bay Trust Company. This subsidiary of the Company was created to purchase and manage the assets of the trust department of the Bank of Lancaster. The sale and transfer of assets from the Bank to the Trust Company was completed as of the close of business on December 31, 1999. As of January 1, 2000, the Bank of Lancaster no longer owned or managed the trust function, and thereby no longer receives an income stream from the trust department. Income generated by the Trust Company is consolidated with the Bank’s income and the Company’s income for the purposes of the Company’s consolidated financial statements. The Trust Company opened for business on January 1, 2000, in its permanent location on Main Street in Kilmarnock, Virginia.

The Company’s marketplace is situated on the “Northern Neck” peninsula of Virginia, plus Middlesex County. The “Northern Neck” includes the counties of Lancaster, Northumberland, Richmond, and Westmoreland. The Company’s primary trading area is dominated by smaller, retired households with relatively high per capita incomes. Growth in households, employment, and retail sales is moderate but the local economic conditions are stable as growth has been positive for several years. Health care, tourism, and related services are the major employment sectors in the “Northern Neck.”

The Company had total assets of $301.8 million, deposits of $258.8 million, and shareholders equity of $26.6 million as of December 31, 2005.

Through the Bank of Lancaster and Bay Trust Company, Bay Banks of Virginia provides a wide range of services to its customers in its market area. These services are summarized as follows.

Real Estate Lending. The Bank’s real estate loan portfolio is the largest segment of the loan portfolio. The Bank offers fixed and adjustable rate mortgages on one-to-four family residential properties. These mortgages are underwritten and documented within the guidelines of the regulations of the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Bank underwrites mainly adjustable rate mortgages as the marketplace allows. Construction loans with a twelve-month term are also a significant component of the Bank’s portfolio. Underwritten at 80% loan to value, and to qualified builders and individuals, these loans are disbursed as construction progresses and verified by Bank inspection. The Bank also offers commercial loans that are secured by real estate. These loans are typically written at 80% loan to value and are either variable with the prime rate of interest, or adjustable in one, three, or five year terms.

The Company also offers secondary market loan origination. Through the Bank, customers may apply for a home mortgage that will be underwritten in accordance with the guidelines of the Federal Home Loan Mortgage Corporation. These loans are then sold into the secondary market on a loan by loan basis. The Bank earns origination fees through offering this service. Customers, upon approval, receive a fixed or adjustable rate of interest with amortization terms up to 30 years. Since these loans are sold into the secondary market, the Company earns no future interest income, nor does it incur any interest rate or re-pricing risk.

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Consumer Lending. In an effort to offer a full range of services, the Bank’s consumer lending includes automobile and boat financing, home improvement loans, and unsecured personal loans. These loans historically entail greater risk than loans secured by real estate, but also offer a higher return.

Commercial Lending. Commercial lending activities include small business loans, asset based loans, and other secured and unsecured loans and lines of credit. Commercial lending may entail greater risk than residential mortgage lending, and is therefore underwritten with strict risk management standards. Among the criteria for determining the borrower’s ability to repay is a cash flow analysis of the business and business collateral.

Business Development. The Bank offers several services to commercial customers. These services include Analysis Checking, Cash Management Deposit Accounts, Wire Services, Direct Deposit Payroll Service, Internet Banking, Telephone Banking, and a full line of Commercial Lending options. The Bank also offers Small Business Administration loan products to include the 504 Program which provides long term funding for commercial real estate and long lived equipment. This allows commercial customers to apply for favorable rate loans for the development of business opportunities, while providing the Bank with a partial guarantee of the outstanding loan balance.

Bay Services Company, Inc. The Bank has one wholly owned subsidiary, Bay Services Company, Inc., a Virginia corporation organized in 1994 (“Bay Services”). Bay Services owns an interest in a land title insurance agency, Bankers Title of Fredericksburg, and an investment and insurance services company, Bankers Investment Group. Bankers Title of Fredericksburg sells title insurance to mortgage loan customers, including customers of the Bank of Lancaster and the other financial institutions that have an ownership interest in the agency. Bankers Investment Group provides the Bank’s non-deposit products department with insurance and investment products for marketing within the Bank’s primary marketing area.

Bay Trust Company. The Trust Company offers a broad range of trust and related fiduciary services. Among these are estate settlement and testamentary trusts, revocable and irrevocable personal trusts, managed agency, custodial accounts, and rollover Individual Retirement Accounts, both self-directed and managed.

COMPETITION

The Company’s marketplace is highly competitive. The Company is subject to competition from a variety of commercial banks and financial service companies, large national and regional financial institutions, large regional credit unions, mortgage companies, consumer finance companies, mutual funds and insurance companies. Competition for loans and deposits is affected by numerous factors, including interest rates and institutional reputation.

SUPERVISION AND REGULATION

Bank holding companies and banks are regulated under both federal and state law. The Company is subject to regulation by the Federal Reserve. Under the Bank Holding Company Act of 1956, the Federal Reserve exercises supervisory responsibility for any non-bank acquisition, merger or consolidation. In addition, the Bank Holding Company Act limits the activities of a bank holding company and its subsidiaries to that of banking, managing or controlling banks, or any other activity that is closely related to banking. In addition, the Company is registered under the bank holding company laws of Virginia, and as such is subject to regulation and supervision by the Virginia State Corporation Commission’s Bureau of Financial Institutions.

The following description summarizes the significant state and Federal laws to which the Company and the Bank are subject. To the extent statutory or regulatory provisions or proposals are set forth the description is qualified in its entirety by reference to the particular statutory or regulatory provisions or proposals.

4

The Bank is supervised and regularly examined by the Federal Reserve and the Virginia State Corporation Commission’s Bureau of Financial Institutions. These on-site examinations verify compliance with regulations governing corporate practices, capitalization, and safety and soundness. Further, the Bank is subject to the requirements of the Community Reinvestment Act (the “CRA”). The CRA requires financial institutions to meet the credit needs of the local community, including low to moderate-income needs. Compliance with the CRA is monitored through regular examination by the Federal Reserve.

Federal Reserve regulations permit bank holding companies to engage in non-banking activities closely related to banking or to managing or controlling banks. These activities include the making or servicing of loans, performing certain data processing services, and certain leasing and insurance agency activities.

The Company owns 100% of the stock of the Bank of Lancaster. The Bank is prohibited by the Federal Reserve from holding or purchasing its own shares except in limited circumstances. Further, the Bank is subject to certain requirements as imposed by state banking statutes and regulations. The Bank is limited by the Federal Reserve regarding what dividends it can pay the Company. Any dividend in excess of the total of the Bank’s net profit for that year plus retained earnings from the prior two years must be approved by the proper regulatory agencies. Further, under the Federal Deposit Insurance Corporation Improvement Act of 1991 (the “FDICIA”), insured depository institutions are prohibited from making capital distributions, if, after making such distributions, the institution would become “undercapitalized” as defined by regulation. Based upon the Bank’s current financial position, it is not anticipated that this statute will impact the continued operation of the Bank.

As a bank holding company, Bay Banks of Virginia is required to file with the Federal Reserve an annual report and such additional information as it may require pursuant to the Bank Holding Company Act. The Federal Reserve may also conduct examinations of the Company and any or all of its subsidiaries.

CAPITAL REQUIREMENTS

The Federal Reserve, the Office of the Comptroller of the Currency and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to banking organizations. In addition, those regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels because of its financial condition or actual or anticipated growth. Under the risk-based capital requirements of these federal bank regulatory agencies, the Company and the Bank are required to maintain a minimum ratio of total capital to risk-weighted assets of 8%. At least half of the total capital is required to be “Tier 1 capital”, which consists principally of common and certain qualifying preferred shareholders’ equity, less certain intangibles and other adjustments. The remainder (“Tier 2 capital”) consists of a limited amount of subordinated and other qualifying debt (including certain hybrid capital instruments) and a limited amount of the general loan loss allowance. The Tier 1 and total capital to risk-weighted asset ratios of the Company as of December 31, 2005 were 10.3% and 11.2%, respectively.

In addition, each of the federal regulatory agencies has established a minimum leverage capital ratio (Tier 1 capital to average risk-weighted assets) (“Tier 1 leverage ratio”). These guidelines provide for a minimum Tier 1 leverage ratio of 4% for banks and bank holding companies that meet certain specified criteria, including that they have the highest regulatory examination rating and are not contemplating significant growth or expansion. The Tier 1 leverage ratio of the Company as of December 31, 2005, was 7.9%, which is well above the minimum requirement. The guidelines also provide that banking organizations that are 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.

5

DEPOSIT INSURANCE

Pursuant to FDICIA, the FDIC adopted a risk-based assessment system for insured depository institutions that takes into account the risks attributable to different categories and concentrations of assets and liabilities. The risk-based system assigns an institution to one of three capital categories: (i) well-capitalized, (ii) adequately capitalized, or (iii) undercapitalized. The FDIC also assigns an institution to one of three supervisory subgroups within each capital group. The supervisory subgroup to which an institution is assigned is based on an evaluation provided to the FDIC by the institution’s primary federal regulator and information which the FDIC determines to be relevant to the institution’s financial condition and the risk posed to the deposit insurance funds (which may include, if applicable, information provided by the institution’s state supervisor). An institution’s insurance assessment rate is then determined based on the capital category and supervisory category to which it is assigned.

Under the final risk-based assessment system there are nine assessment risk classifications (i.e., combinations of capital groups and supervisory subgroups) to which different assessment rates are applied. Assessment rates for deposit insurance currently range from zero basis points to .27%. The capital and supervisory subgroup to which an institution is assigned by the FDIC is confidential and may not be disclosed. A bank’s rate of deposit insurance assessments will depend upon the category and subcategory to which the bank is assigned by the FDIC. Any increase in insurance assessments could have an adverse effect on the earnings of insured institutions, including the Bank.

In February 2006, Congress enacted the Federal Deposit Insurance Reform Act of 2005 (the “FDIR Act”). As a result of the passage of the FDIR Act, over the course of the next year, among other things: (i) the Bank Insurance Fund will be merged with the Savings Association Insurance Fund creating the Deposit Insurance Fund (the “DIF”); (ii) the $100,000 per account insurance level will be indexed to reflect inflation; (iii) deposit insurance coverage for certain retirement accounts will be increased to $250,000; and (iv) a cap will be placed on the level of the DIF and dividends will be paid to banks once the level of the DIF exceeds the specified threshold.

SAFETY AND SOUNDNESS REGULATIONS

The FDIC has adopted guidelines that establish standards for safety and soundness of banks. They are designed to identify potential safety and soundness problems and ensure that banks address those concerns before they pose a risk to the deposit insurance fund. If the FDIC determines that an institution fails to meet any of these standards, the agency can require the institution to prepare and submit a plan to come into compliance. If the agency determines that the plan is unacceptable or is not implemented, the agency must, by order, require the institution to correct the deficiency. The federal banking agencies have broad powers under current federal law to make prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institution in question is considered “well capitalized,” “adequately capitalized,” “under capitalized,” “significantly under capitalized,” or “critically undercapitalized.” All such terms are defined under uniform regulation defining such capital levels issued by each of the federal banking agencies. The Bank is considered well capitalized.

The FDIC also has safety and soundness regulations and accompanying guidelines on asset quality and earnings standards. The guidelines provide six standards for establishing and maintaining a system to identify problem assets and prevent those assets from deteriorating. The guidelines also provide standards for evaluating and monitoring earnings and for ensuring that earnings are sufficient to maintain adequate capital and reserves. If an institution fails to comply with a safety and soundness standard, the agency may require the institution to submit and implement an acceptable compliance plan, or face enforcement action.

THE GRAMM-LEACH BLILEY ACT OF 1999

The Gramm-Leach-Bliley Act of 1999 (“GLBA”) was signed into law on November 12, 1999. The main purpose of GLBA is to permit greater affiliations within the financial services industry, primarily banking, securities and insurance. The provisions of GLBA that are believed to be of most significance to the Company are discussed below.

GLBA repealed sections 20 and 32 of the Glass-Steagall Act, which sections separated commercial banking from investment banking, and substantially amends the Bank Holding Company Act, which prior to GLBA limited the ability of bank holding companies to engage in the securities and insurance businesses. To achieve this purpose, GLBA created a new type of company, the “financial holding company.” A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including

• securities activities such as underwriting, dealing, brokerage, investment and merchant banking; and

• insurance underwriting, sales and brokerage activities.

6

A bank holding company may elect to become a financial holding company only if all of its depository institution subsidiaries are well-capitalized, well-managed and have at least a satisfactory CRA rating. While the Bank meets these criteria, the Company has not elected to be treated as a financial holding company.

GLBA established a system of functional regulation under which the federal banking agencies regulate the banking activities of financial holding companies and banks’ financial subsidiaries, the Securities and Exchange Commission (“SEC”) regulates their securities activities, and state insurance regulators will regulate their insurance activities.

GLBA and certain regulations issued by federal banking agencies also provide protection against the transfer and use by financial institutions of consumers’ nonpublic personal information. A financial institution must provide to its customers, at the beginning of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. The privacy provisions generally prohibit a financial institution from providing a customer’s personal financial information to unaffiliated third parties unless the institution discloses to the customer that the information may be so provided and the customer is given the opportunity to opt out of such disclosure.

Neither the provisions of GLBA nor the Act’s implementing regulations have had a material impact on the Company’s or the Bank’s regulatory capital ratios (as discussed above) or ability to continue to operate in a safe and sound manner.

USA PATRIOT ACT OF 2001

In October, 2001, the USA Patriot Act of 2001 was enacted in response to the terrorist attacks in New York, Pennsylvania and Northern Virginia, which occurred on September 11, 2001. The Patriot Act is intended is to strengthen U.S. law enforcements’ and the intelligence communities’ abilities to work cohesively to combat terrorism on a variety of fronts. The continuing and potential impact of the Patriot Act and related regulations and policies on financial institutions of all kinds is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws, and imposes various regulations, including standards for verifying client identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.

CHECK 21

On October 28, 2003, President Bush signed into law the Check Clearing for the 21^st Century Act, also known as Check 21. Check 21 gives “substitute checks,” such as a digital image of a check, and copies made from that image, the same legal standing as the original paper check. Some of the major provisions of Check 21 include:

• allowing check truncation without making it mandatory;

• demanding that every financial institution communicate to accountholders in writing a description of its substitute check processing program and their rights under the law;

• legalizing substitutions for and replacements of paper checks without agreement from consumers;

• retaining in place the previously mandated electronic collection and return of checks between financial institutions only when individual agreements are in place;

• requiring that when accountholders request verification, financial institutions produce the original check (or a copy that accurately represents the original) and demonstrate that the account debit was accurate and valid; and

• requiring recrediting of funds to an individual’s account on the next business day after a consumer proves that the financial institution has erred.

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This legislation will likely affect bank capital spending as many financial institutions assess whether technological or operational changes are necessary to stay competitive and take advantage of the new opportunities presented by Check 21.

REPORTING OBLIGATIONS UNDER SECURITIES LAWS

The Company is subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), including the filing of annual, quarterly and other reports with the SEC. As an Exchange Act reporting company, the Company is directly affected by the Sarbanes-Oxley Act of 2002 and regulations promulgated thereunder by the SEC, which are aimed at improving corporate governance and reporting procedures. The Company is complying with the new rules and regulations implemented pursuant to the Sarbanes-Oxley Act and intends to comply with any applicable rules and regulations implemented in the future.

ITEM 1A: RISK FACTORS

The Company’s financial performance and stock price can be subject to a variety of risks. Following are descriptions of some of the risks management has identified.

General and local economic conditions can have an effect on the Company’s profitability.

If an economic downturn has a negative impact on household or corporate income levels, it could lead to decreased demand for either loan or deposit products and could increase the possibility of some customers’ failure to pay interest or principal on their loans.

Various regulations and statutes affect the Company’s ability to take certain actions.

We operate in a highly regulated industry and are subject to examination, supervision, and comprehensive regulation by several regulatory agencies. Compliance with these regulations is costly and restricts activities such as payment of dividends, mergers and acquisitions, investments, loans, interest rates charged, interest rates paid, and locations of offices. We are also required to maintain adequate capital. The laws and regulations applicable to the banking industry can change at any time, and it is difficult to predict their effects on profitability.

Concentration of credit exposure to residential real estate can cause the Company’s profitability to be sensitive to changes in this market.

If the local residential real estate market were to experience a downturn, our ability to generate new loans could be effected. Also, if these borrowers become less able to perform the obligations of their mortgage agreements, our earnings could be negatively impacted.

Changes in the financial services industry can change the environment in which the Company competes.

In addition to the challenge of competing against other banks in attracting and retaining customers for traditional banking services, competitors also include companies who offer services that banks have not been able or allowed to offer their customers in the past. This environment is primarily a result of changes in regulation and consolidation among financial services providers.

Operational risk exposure is common to all companies.

This include reputational risk, legal and compliance risk, risk of fraud or theft by employees or outsiders, unauthorized transactions by employees, and operational errors, including clerical or record-keeping errors or those resulting from faulty or disabled computer or communications systems.

The Company may also be subject to disruptions of its operating systems arising from events that are wholly or partially beyond its control (e.g. computer viruses or electrical or telecommunications outages), which may give rise to disruption of service to customers and to financial loss or liability. There is also the risk that the Company’s (or its suppliers’) business continuity plans and data security systems prove inadequate.

8

Changes in interest rates can affect the Company’s income and cash flows.

The difference between the interest rates earned on such assets as loans and investments and the interest rates paid on such liabilities as deposits and borrowings determine, to a great extent, the Company’s levels of income and cash flow. These rates are sensitive to many factors that are beyond the Company’s control, including general economic conditions and the policies of various governmental and regulatory agencies (in particular, the Federal Reserve Bank). Changes in monetary policy, including changes in interest rates, will influence the origination of loans, the prepayment speeds of loans, the purchase of investments, the generation of deposits, the rates received on loans and investment securities, and the rates paid on deposits or other sources of funding. The impact of these changes can be magnified if the Company does not effectively manage the relative sensitivity of its assets and liabilities to changes in market interest rates.

Changes in accounting standards can impact reported earnings.

Accounting standard setters, including the Financial Accounting Standards Board (“FASB”), the Public Company Accounting and Oversight Board (“PCAOB”), the SEC, and other regulatory bodies, periodically change the financial accounting and reporting standards that govern the preparation of the Company’s financial statements. These changes can be difficult to predict and can materially effect how the Company records and reports its financial condition and results of operations.

The use of estimates is required in the preparation of the Company’s financial statements.

Accounting principles generally accepted in the United States of America require management to make significant estimates, the largest of which is the allowance for loan losses. The Company cannot provide complete assurance that these estimates will not significantly change or that losses will not occur if the provided allowance(s) is not adequate. See the Critical Accounting Policies section in Item 7.

The Company’s stock is traded ‘over the counter,’ which causes it to have less liquidity.

The trading volume of our stock is low relative to larger companies. We cannot predict the effect, if any, the availability of shares of our common stock in the market will have on its market price. We can give no assurance that sales of substantial amounts of our common stock in the market would not cause the price of our common stock to decline. The market price of our common stock may fluctuate, and this may be unrelated to our financial performance. General market price declines, overall market volatility, or financial services industry price declines could adversely effect the market price of our common stock.

ITEM 1B: UNRESOLVED STAFF COMMENTS

None.

ITEM 2: PROPERTIES

The Company, through its subsidiaries, owns or leases buildings that are used in the normal course of business. The main office is located at 100 South Main Street, Kilmarnock, Virginia, in a building owned by the Company. The Company’s subsidiaries own or lease various other offices in the counties or towns in which they operate.

9

Unless otherwise noted, the properties listed below are owned by the Company and its subsidiaries as of December 31, 2005.

Corporate Headquarters:	100 South Main Street, Kilmarnock, Virginia
Bank of Lancaster:	100 South Main Street, Kilmarnock, Virginia
	708 Rappahannock Drive, White Stone, Virginia
	432 North Main Street, Kilmarnock, Virginia
	4935 Richmond Road, Warsaw, Virginia
	15648 Kings Highway, Montross, Virginia
	6941 Northumberland Highway, Heathsville, Virginia
	18 Sandy Street, Callao, Virginia
	23 West Church Street, Kilmarnock, Virginia
Bay Trust Company:	1 North Main Street, Kilmarnock, Virginia
	15648 Kings Highway, Montross, Virginia

ITEM 3: LEGAL PROCEEDINGS

In the ordinary course of its operations, the Company is a party to various legal proceedings. Based upon information currently available, management believes that such legal proceedings, in the aggregate, will not have a material adverse effect on the business, financial condition, or results of operations of the Company.

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of security holders during the fourth quarter of the year-ended December 31, 2005.

PART II

ITEM 5: MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

The Company’s common stock trades on the OTC Bulletin Board under the symbol “BAYK” and transactions generally involve a small number of shares. There were 2,385,966 shares of the Company’s stock outstanding at the close of business on December 31, 2005, which were held by 762 shareholders of record.

The following table summarizes the high and low closing sales prices and dividends declared for the two years ended December 31, 2005.

	Market Values								Declared
	2005				2004				Dividends
	High		Low		High		Low		2005	2004
First Quarter	$	15.75	$	14.85	$	17.00	$	15.25	0.155	0.15
Second Quarter		16.00		14.35		16.00		14.75	0.155	0.15
Third Quarter		15.75		14.60		15.50		14.50	0.155	0.15
Fourth Quarter		15.00		14.00		15.00		14.25	0.16	0.155

A discussion of certain restrictions and limitations on the ability of the Bank to pay dividends to the Company and the ability of the Company to pay dividends on its common stock, is set forth in Part I, Business, of this Form 10-K under the heading “Supervision and Regulation.”

The dividend amount on the Company’s common stock is established by the Board of Directors on a quarterly basis with dividends paid on a quarterly basis. In making its decision on the payment of dividends on the Company’s common stock, the Board considers operating results, financial condition, capital adequacy, regulatory requirements, shareholder return, and other factors.

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The Company began a share repurchase program in August of 1999 and has continued the program into 2005. The combined plans authorize the repurchase of 180,000 shares.

	Total Number of Shares Purchased	Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
October, 2005	—	$	—	—	37,628
November, 2005	—		—	—	37,628
December, 2005	1,000		14.38	1,000	36,628
Total	1,000	$	14.38	1,000

ITEM 6: SELECTED FINANCIAL DATA

Selected Financial Data

Years Ended December 31, (Dollars in Thousands, except per share data)	2005			2004			2003			2002			2001
FINANCIAL CONDITION
Total Assets	$	301,821		$	303,470		$	290,711		$	263,060		$	245,594
Total Loans, net of allowance		229,656			213,350			188,451			168,442			150,253
Total Deposits		258,787			261,946			257,083			231,516			219,194
Shareholders’ Equity		26,613			25,820			25,078			24,757			22,617
Average Assets		304,722			298,825			278,887			252,001			228,412
Average Loans, net of allowance		223,941			203,509			172,923			166,313			150,193
Average Deposits		262,595			261,782			245,799			229,379			202,223
Average Equity		26,332			25,521			25,420			23,687			22,215
Average basic shares outstanding		2,367,834			2,337,788			2,313,596			2,301,364			2,310,522
Average Diluted shares outstanding		2,378,324			2,356,598			2,338,481			2,309,959			2,344,806
RESULTS OF OPERATIONS
Interest Income	$	16,238		$	14,085		$	13,329		$	14,144		$	15,442
Interest Expense		5,129			4,310			4,766			5,391			7,321
Net Interest Income		11,109			9,775			8,563			8,753			8,121
Provision for Loan Losses		559			300			312			471			325
Net Interest Income after Provision		10,550			9,475			8,251			8,282			7,796
Gain/(Loss) on Sales of Investments		(4	)		246			371			3			22
Non-interest Income net of Securities Gains		2,744			2,544			2,589			2,088			2,063
Non-interest Expense		9,785			9,323			8,536			7,203			7,043
Income before Taxes		3,505			2,941			2,675			3,170			2,839
Income Taxes		959			760			661			869			830
Net Income		2,547			2,181			2,013			2,301			2,009
PER SHARE DATA
Basic Earnings per share (EPS)	$	1.08		$	0.93		$	0.87		$	1.00		$	0.87
Diluted Earnings per share (EPS)		1.07			0.93			0.86			0.99			0.86
Cash Dividends per share		0.625			0.605			0.57			0.50			0.47
Book Value per share		11.15			10.97			10.78			10.73			9.81
RATIOS
Total Capital to Risk Weighted Assets		11.2	%		11.2	%		12.1	%		12.5	%		13.3	%
Tier 1 Capital to Risk Weighted Assets		10.3	%		10.3	%		11.1	%		11.5	%		12.3	%
Leverage Ratio		7.9	%		7.4	%		7.3	%		7.9	%		8.1	%
Return on Average Assets		0.8	%		0.7	%		0.7	%		0.9	%		0.9	%
Return on Average Equity		9.7	%		8.5	%		7.9	%		9.7	%		9.0	%
Loan Loss Reserve to Loans		0.9	%		0.9	%		1.0	%		1.0	%		1.0	%
Dividends paid as a percent of Net Income		58.1	%		64.8	%		65.5	%		50.0	%		53.6	%
Average Equity as a percent of Average Assets		8.6	%		8.5	%		9.1	%		9.4	%		9.7	%

ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion provides information about the major components of the results of operations and financial condition, liquidity and capital resources of Bay Banks of Virginia, Inc., and its subsidiaries. This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements presented in Item 8, Financial Statements and Supplementary Data, in this Form 10-K.

11

CRITICAL ACCOUNTING POLICIES

GENERAL. The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (“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: (1) Statement of Financial Accounting Standards (“SFAS”) No. 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (2) SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The use of these values is inherently subjective and our actual losses could be greater or less than the estimates.

The allowance for loan losses is increased by charges to income and decreased by charge-offs (net of recoveries). Management’s periodic evaluation of the adequacy of the allowance is based on past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, and current economic conditions.

OVERVIEW

2005 Compared to 2004

Bay Banks of Virginia, Inc. recorded earnings for 2005 of $2,546,585, or $1.08 per basic share and $1.07 per diluted share,, as compared to 2004 earnings of $2,181,360 and $0.93 per basic share and $0.93 per diluted share . This is an increase in net income of 16.7% as compared to 2004. Net interest income for 2005 increased to $11,109,370, up 13.6% as compared to $9,774,657 for 2004. Non-interest income for 2005, before net securities losses, was $2,744,036 as compared to 2004 non-interest income, before net securities gains, of $2,543,569, an increase of 7.8%. Non-interest expenses increased to $9,785,359, up 4.9% over 2004 non-interest expenses of $9,322,862.

Performance as measured by the Company’s return on average assets (“ROA”) was 0.84% for the year ended December 31, 2005 compared to 0.73% for 2004. Performance as measured by return on average equity (“ROE”) was 9.67% for the year ended December 31, 2005, compared to 8.55% for 2004.

2004 Compared to 2003

Earnings for the Company were $2,181,360 for 2004, up 8.4% as compared to 2003 earnings of $2,013,185. The 2004 basic and diluted earnings per share were $0. 93,, as compared to 2003 basic earnings per share of $0.87 and diluted earnings per share of $0.86. Net interest income was $9,774,657 for 2004 as compared to $8,562,995 for 2003, an increase of 14.1%. Non-interest income before net securities gains for 2004 was $2,543,569, down 1.7% over 2003 non-interest income before net securities gains of $2,588,894. Non-interest expenses for 2004 were $9,322,862, up 9.2% as compared to 2003 non-interest expenses of $8,536,017.

Performance as measured by the Company’s ROA was 0.73% for the year ended December 31, 2004, compared to 0.72% for 2003. Performance as measured by ROE was 8.55% for the year ended December 31, 2004, compared to 7.92% for 2003.

12

Return on Equity and Assets

Years Ended December 31,	2005			2004			2003
Net Income	$	2,546,585		$	2,181,360		$	2,013,185
Average Total Assets	$	304,722,476		$	298,825,499		$	278,887,000
Return on Assets		0.84	%		0.73	%		0.72	%
Average Equity	$	26,331,616		$	25,521,263		$	25,420,209
Return on Equity		9.67	%		8.55	%		7.92	%
Dividends declared per share	$	0.625		$	0.605		$	0.570
Average Shares Outstanding		2,367,834			2,337,788			2,313,596
Average Diluted Shares Outstanding		2,378,324			2,356,598			2,338,481
Net Income per Share	$	1.08		$	0.93		$	0.87
Net Income per Diluted Share	$	1.07		$	0.93		$	0.86
Dividend Payout Ratio		58.1	%		64.8	%		65.5	%
Average Equity to Assets Ratio		8.6	%		8.5	%		9.1	%

RESULTS OF OPERATIONS

Net Interest Income

The principal source of earnings for the Company is net interest income. Net interest income is the amount by which interest income exceeds interest expense. The net interest margin is net interest income expressed as a percentage of interest earning assets. Changes in the volume and mix of interest earning assets and interest bearing liabilities, the associated yields and rates, and the volume of non-performing assets have a significant impact on net interest income, the net interest margin, and net income.

Net interest income, on a fully tax equivalent basis, which reflects the tax benefits of nontaxable interest income, was $11.5 million in 2005, $10.2 million in 2004 and $9.0 million in 2003. This represents an increase in net interest income of 12.9% for 2005 as compared to 2004 and an increase of 13.6% for 2004 compared to 2003. The interest rate spread on average earning assets compared to liabilities was 3.65%, 3.37% and 3.24 % for 2005, 2004, and 2003, respectively.

The Company’s net interest margin increased to 4.04% for 2005 as compared to 3.67% for 2004. The net interest margin was 3.53% for 2003. The yield on earning assets increased to 5.85% for 2005 as compared to 5.22% and 5.41% for years 2004 and 2003, respectively. The cost of interest bearing liabilities increased to 2.20% for 2005 as compared to 1.85% and 2.17% for years 2004 and 2003, respectively. Average earning assets increased 2.4% to $284.3 million for 2005 as compared to $277.5 million for 2004. Average earning assets were $253.6 million for 2003. Average interest bearing liabilities decreased to $233.3 million at year-end 2005 as compared to $233.5 million at year-end 2004. Average interest bearing liabilities were $220.0 million at year-end 2003.

13

Average Balances, Income and Expenses, Yields and Rates

(Fully taxable equivalent basis)
Years Ended December 31, (Dollars in Thousands)	2005						2004						2003
	Average Balance		Income/ Expense		Yield/ Rate		Average Balance		Income/ Expense		Yield/ Rate		Average Balance		Income/ Expense		Yield/ Rate
INTEREST EARNING ASSETS:
Taxable Investments	$	31,201	$	1,259	4.03	%	$	37,903	$	1,338	3.53	%	$	32,269	$	1,578	4.89	%
Tax-Exempt Investments (1)		19,751		1,135	5.74	%		20,356		1,176	5.78	%		19,335		1,159	6.00	%
Total Investments		50,952		2,394	4.70	%		58,259		2,514	4.31	%		51,604		2,737	5.30	%
Gross Loans (2)		226,042		14,000	6.19	%		205,473		11,787	5.74	%		174,715		10,694	6.12	%
Interest-bearing Deposits		118		5	4.26	%		123		2	1.42	%		162		1	0.46	%
Fed Funds Sold		7,239		225	3.11	%		13,682		183	1.34	%		27,120		291	1.07	%
Total Interest Earning Assets	$	284,351	$	16,624	5.85	%	$	277,537	$	14,486	5.22	%	$	253,601	$	13,723	5.41	%
INTEREST-BEARING LIABILITIES:
Savings Deposits	$	65,877	$	1,395	2.12	%	$	66,724	$	1,031	1.55	%	$	62,258	$	1,056	1.70	%
NOW Deposits		47,638		272	0.57	%		46,248		230	0.50	%		41,582		307	0.74	%
Time Deposits => $100,000		30,101		1,056	3.51	%		31,051		989	3.19	%		27,187		971	3.57	%
Time Deposits < $100,000		58,766		1,926	3.28	%		62,616		1,922	3.07	%		67,169		2,238	3.33	%
Money Market Deposit Accounts		16,481		104	0.63	%		17,014		62	0.36	%		16,650		143	0.86	%
Total Deposits	$	218,863	$	4,753	2.17	%	$	223,653	$	4,234	1.89	%	$	214,846	$	4,715	2.19	%
Fed Funds Purchased	$	374	$	16	3.90	%	$	3	$	—	1.00	%	$	—	$	—	0.00	%
Securities Sold Under Repurchase Agreements		5,092		110	2.16	%		5,105		26	0.51	%		5,128		51	1.00	%
FHLB Advance		8,993		250	2.78	%		4,754		50	1.05	%		—		—	0.00	%
Total Interest-Bearing Liabilities	$	233,322	$	5,129	2.20	%	$	233,515	$	4,310	1.85	%	$	219,974	$	4,766	2.17	%
Net Yield on Earning Assets			$	11,495	4.04	%			$	10,176	3.67	%			$	8,957	3.53	%
Net Interest Rate Spread					3.65	%					3.37	%					3.24	%

Notes:

(1) - Income and yield is tax-equivalent assuming a federal tax rate of 34%

(2) - Includes Visa credit card program and nonaccrual loans.

Although loan balances increased 7.6% from year-end 2004 to year-end 2005, the Company’s balance sheet decreased 0.5% during 2005, and year-end deposits decreased 1.2% Loan growth was primarily composed of single-family residential adjustable-rate mortgages. Total deposit balances decreased mainly due to savings and interest-bearing demand deposits, which decreased 7.8% . The Company remains slightly asset sensitive, which is favorable in a rising rate environment because assets will re-price faster than liabilities. The Company has realized the benefit of asset sensitivity as short-term interest rates increased during 2005.

The marketplace continues to experience good levels of sales of existing homes and new construction. The Company has remained competitive in its loan pricing, but has systematically been able to increase loan offering rates as the marketplace allows.

During 2005, the Company was able to minimize increases in interest expense through increases in balances of non-interest bearing deposits, and by lagging deposit rate increases as long as possible, even in the environment of rising rates. Non-interest bearing deposits grew by 9.7% as compared to year-end 2004 and savings and interest bearing deposit accounts declined by 7.8%. Controlling the pressure on deposit rates, and increased loan volume, provided an additional $1.3 million in net interest income.

14

Volume and Rate Analysis of Changes in Net Interest Income

Years Ended December 31, (Dollars in Thousands)	2005 vs. 2004									2004 vs. 2003
	Increase (Decrease) Due to Changes in:									Increase (Decrease) Due to Changes in:
	Volume			Rate			Total			Volume			Rate			Total
Earning Assets:
Taxable investments	$	(254	)	$	175		$	(79	)	$	246		$	(486	)	$	(240	)
Tax-exempt investments		(33	)		(8	)		(41	)		60			(43	)		17
Gross loans		1,199			1,014			2,213			1,796			(703	)		1,093
Interest-bearing deposits		—			3			3			—			1			1
Federal funds sold		(119	)		161			42			(168	)		60			(108	)
Total earning assets	$	793		$	1,345		$	2,138		$	1,934		$	(1,171	)	$	763
Interest-Bearing Liabilities:
NOW checking	$	8		$	34		$	42		$	32		$	(109	)	$	(77	)
Savings deposits		(13	)		377			364			73			(98	)		(25	)
Money market accounts		(2	)		44			42			3			(84	)		(81	)
Certificates of deposit < $100,000		(122	)		126			4			(147	)		(162	)		(309	)
Certificates of deposit >= $100,000		(31	)		98			67			129			(111	)		18
Federal funds purchased		16			—			16			—			—			—
Securities sold under repurchase agreements		—			84			84			—			(25	)		(25	)
FHLB advances		71			129			200			50			—			50
Total interest-bearing liabilities	$	(73	)	$	892		$	819		$	140		$	(589	)	$	(449	)
Change in net interest income	$	866		$	453		$	1,319		$	1,794		$	(582	)	$	1,212

Notes:

(1) Changes caused by the combination of rate and volume are allocated based on the percentage caused by each.

(2) Income and yields are reported on a tax-equivalent basis, assuming a federal tax rate of 34%.

Interest Sensitivity

Earnings performance and the maintenance of sufficient liquidity depend heavily on efficient management of the interest sensitivity gap. The interest sensitivity gap is the difference between interest sensitive assets and interest sensitive liabilities in a specific time interval. The interest sensitivity gap can be managed by re-pricing assets or liabilities, which are variable rate instruments, by replacing an asset or liability at maturity or by adjusting the interest rate during the life of the asset or liability. By matching the volume of assets and liabilities that mature in the same time interval, the Company can insulate against interest rate risk and minimize the impact of rising or falling rates.

The Company employs a variety of measurement techniques to identify and manage its exposure to changing interest rates and subsequent changes in liquidity. The Company utilizes a simulation model that estimates interest income volatility and interest rate risk. In addition, the Company utilizes an Asset Liability Committee (the “ALCO”) composed of appointed members from management and the Board of Directors. Through the use of simulation, the ALCO estimates the overall magnitude of interest rate risk and then formulates policy with which to manage asset growth and pricing, funding sources and pricing, and off-balance sheet commitments. These decisions are based on management’s expectations regarding future interest rate movements, economic conditions both locally and nationally, and other business and risk factors.

Earnings Simulation Analysis

The Company employs a simulation model that captures the impact of changing interest rates on the interest income received and interest expense paid on all assets and liabilities reflected on the balance sheet. The method is subject to the accuracy of the assumptions that underlie the process, but it provides a valuable analysis of the sensitivity of earnings to changes in interest rates.

15

The following table reflects the interest rate sensitivity, at twenty-four months, on net interest income for the Company using different rate scenarios.

Change in Prime Rate	% Change in Net Interest Income
+ 200 basis points	6.37%
Flat	0
- 200 basis points	-4.12%

Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution’s performance than do general levels of inflation. Interest rates do not necessarily move in the same magnitude as the prices of goods and services. However, inflation does have an effect on non-interest expenses, which tend to rise during periods of general inflation. The values of real estate held as collateral by the Company for loans and foreclosed property can be affected by inflation or changing prices due to market conditions.

Management believes the most significant impact on financial results is the Company’s ability to react to changes in interest rates. Management attempts to maintain a favorable position between rate-sensitive assets and rate-sensitive liabilities in order to protect against wide interest rate fluctuations.

Economic Value of Equity Simulation

Economic value of equity simulation is used to calculate the estimated fair value of assets and liabilities over different interest rate environments. Economic values are calculated based on discounted cash flow analysis with the net economic value of equity being the fair value of all assets minus the fair value of all liabilities. The change in economic value over varying rate environments is an indication of long term interest rate sensitivity of the balance sheet. The following chart reflects the change in the economic value of equity over varying rate environments:

Change in Prime Rate	Economic Value of Equity (Dollars in Thousands)		Change in Economic Value of Equity (Dollars in Thousands)
+ 200 basis points	$	58,051	$	2,034
+100 basis points		57,504		1,487
Flat		56,017		0
- 100 basis points		53,516		-2,500
-200 basis points		50,433		-5,584

Non-Interest Income

Total non-interest income decreased to $2.7 million in 2005 as compared to $2.8 million in 2004, a reduction of 1.8%. Non-interest income in 2003 was $3.0 million. The decrease in non-interest income was due mainly to declines in gains on sales of securities. However, non-interest income shows an increase when gains and losses on securities sales is removed. This increase was driven mainly by increases in other service charges and fees, which increased by $69 thousand to $954 thousand in 2005 from $885 thousand in 2004. The largest component of other service charges and fees is non-interest VISA income, which increased 17.5% to $583 thousand in 2005 from $497 thousand in 2004. Fiduciary income and service charges and fees on deposit accounts also increased, by $57 thousand and $63 thousand for 2005 and 2004, respectively. Gains on sale of other real estate are dependent upon the volume and nature of the properties that the Company buys back through foreclosure.

Secondary market lending fees declined during 2005. These fees are generated when a loan is sold into the secondary market. When the Bank is evaluating a potential loan, many factors influence the determination of whether that loan will be sold or held in the Bank’s own portfolio, including the size of the desired loan, the term, the rate, and the structure. The Bank originates both secondary and portfolio loans. Loans are sold into the secondary market both with servicing retained and released.

16

Non-Interest Expense

During 2005, total non-interest expenses increased 4.9%, to $9.8 million from $9.3 million in 2004, and $8.5 million in 2003. Non-interest expenses are comprised of salaries and benefits, occupancy expense, state bank franchise tax, Visa program expense, telephone expense and other operating expenses.

Salary and benefit expense continues to be the major component of non-interest expenses. Salary and benefits expense decreased 1.9% to $5.0 million in 2005, as compared to $5.1 million in 2004 and $4.4 million in 2003.

Occupancy expense increased 22.3% to $1.7 million during 2005 as compared to $1.4 million in 2004 and 2003. This was due to increases in depreciation and furniture fixtures and equipment purchases related to the construction of the addition to the Company’s home office building. State bank franchise tax expense increased 8.0% to $218 thousand as compared to $202 thousand for 2004. Expenses related to the Visa program increased by 10.0% to $464 thousand as compared to $422 thousand for 2004. However, when considering the non-interest income generated by the VISA program, it is making a net positive contribution. Telephone expense increased 10.9% to $185 thousand as compared to $167 thousand for 2004. Other expense increased by 8.4%, to $2.2 million, as compared to 2004. Management continues its program of identifying variable expenses that can be reduced or eliminated.

Income Taxes

Income tax expense in 2005 was $959 thousand, $760 thousand in 2004 and $661 thousand in 2003. Income tax expense corresponds to an effective rate of 27.4%, 25.8% and 24.7% for the three years ended December 31, 2005, 2004, and 2003, respectively. Note 12 to the Consolidated Financial Statements provides a reconciliation between the amounts of income tax expense computed using the federal statutory income tax rate and actual income tax expense. Also included in Note 12 to the Consolidated Financial Statements is information regarding deferred taxes for 2005, 2004, and 2003.

Loans

Loan production remained strong during 2005. During 2005, as shown below, loans increased by 7.8% to $230.8 million as compared to 2004 balances of $214.1 million. Loans secured by real estate represent the largest category, comprising 85.3% of the loan portfolio at December 31, 2005. Of these balances, 1-4 family residential was 53.5% of total loans, down from 56.1% at year-end 2004. Commercial loan balances increased 5.3% to $22.7 million from $21.5 million at year-end 2004. Commercial loan balances were 9.8% of total loans at year-end 2005 as compared to 10.1% at year-end 2004. Consumer installment and other loans decreased 0.8% to $11.2 million from $11.3 million at year-end 2004.

Types of Loans

Years ended December 31, (Thousands)	2005		2004		2003		2002		2001
Commercial	$	22,668	$	21,519	$	24,819	$	16,763	$	11,399
Real Estate – Construction		40,999		31,184		24,959		19,131		13,914
Real Estate – Mortgage		155,949		150,129		127,576		121,213		115,029
Installment and Other		11,176		11,266		11,602		11,795		10,560
Total	$	230,792	$	214,098	$	188,957	$	168,902	$	150,903

Notes:

Deferred loan costs and fees not included.

Allowance for loan losses not included.

17

Loan Maturity Schedule of Selected Loans

as of December 31, 2005

	One Year or Less				One to Five Years				Over Five Years
(Thousands)	Fixed Rate		Variable Rate		Fixed Rate		Variable Rate		Fixed Rate		Variable Rate
Commercial	$	2,570	$	15,934	$	2,469	$	0	$	1,695	$	0
Real Estate – Construction		3,547		5,890		13,544		716		17,302		0
Real Estate – Mortgage		3,785		63,908		11,384		64,819		11,997		56
Installment and Other		3,475		1,864		5,590		0		247		0
Totals	$	13,377	$	87,596	$	32,987	$	65,535	$	31,241	$	56

Notes:

Loans with immediate repricing are shown in the ‘One Year or Less’ category.

Variable rate loans are categorized based on their next repricing date.

Asset Quality-Provision and Allowance for Loan Losses

The provision for loan losses is a charge against earnings that is necessary to maintain the allowance for loan losses at a level consistent with management’s evaluation of the loan portfolio’s inherent risk. The allowance for loan losses is analyzed for adequacy on a quarterly basis to determine the required amount of provision. A loan-by-loan review is conducted on all classified loans. Inherent losses on these individual loans are determined and these losses are compared to historical loss data for each loan type. Management then reviews the various analyses and determines the appropriate allowance. As of December 31, 2005, management considered the allowance for loan losses to be a reasonable estimate of potential loss exposure inherent in the loan portfolio.

Allowance for Loan Losses

Years Ended December 31, (Thousands)	2005			2004			2003			2002			2001
Balance, beginning of period	$	2,032		$	1,902		$	1,697		$	1,493		$	1,370
Loans charged off:
Commercial	$	0		$	(4	)	$	(11	)	$	(203	)	$	(62	)
Real estate – construction		0			0			0			0			0
Real estate – mortgage		(289	)		(49	)		(12	)		(22	)		(42	)
Installment & Other (including Visa program)		(228	)		(139	)		(97	)		(64	)		(117	)
Total loans charged off	$	(517	)	$	(202	)	$	(120	)	$	(289	)	$	(221	)
Recoveries of loans previously charged off:
Commercial	$	0		$	10		$	0		$	4		$	0
Real estate – construction		0			0			0			0			0
Real estate – mortgage		0			1			0			1			0
Installment & Other (including Visa program)		83			21			13			17			19
Total recoveries	$	83		$	32		$	13		$	22		$	19
Net charge offs	$	(434	)	$	(170	)	$	(107	)	$	(267	)	$	(202	)
Provision for loan losses	$	559		$	300		$	312		$	471		$	325
Balance, end of period	$	2,157		$	2,032		$	1,902		$	1,697		$	1,493
Average loans outstanding during the period	$	226,042		$	205,473		$	174,715		$	159,951		$	151,668
Ratio of net charge-offs during the period to average loans outstanding during the period		0.19	%		0.08	%		0.06	%		0.17	%		0.13	%

18

Management maintains a list of loans which have a potential weakness that may need special attention. Such loans are monitored and used in the determination of the sufficiency of the Company’s allowance for loan losses. As of December 31, 2005, the allowance for loan losses was $2.1 million or 0.9% of total loans as compared to $2.0 million or 0.9% for 2004.

Allocation of the Allowance for Loan Losses

Years Ended December 31, (Thousands)	2005				2004				2003				2002				2001
	Allocation of Allowance		Percent of Portfolio		Allocation of Allowance		Percent of Portfolio		Allocation of Allowance		Percent of Portfolio		Allocation of Allowance		Percent of Portfolio		Allocation of Allowance		Percent of Portfolio
Commercial	$	1,313	9.8	%	$	1,186	10.1	%	$	924	13.1	%	$	822	9.9	%	$	237	7.5	%
Real estate - construction		71	17.8	%		108	14.6	%		83	13.2	%		73	11.2	%		21	9.2	%
Real estate - mortgage		532	67.6	%		563	70.1	%		675	67.5	%		674	71.2	%		1,032	75.8	%
Installment and Other		241	4.8	%		175	5.2	%		220	6.2	%		128	7.7	%		203	7.5	%
Total	$	2,157	100.0	%	$	2,032	100.0	%	$	1,902	100.0	%	$	1,697	100.0	%	$	1,493	100.0	%

Nonperforming Assets

As of December 31, 2005, loans upon which the accrual of interest had been discontinued were $251 thousand. Loans upon which the accrual of interest had been discontinued at year-end 2004 were $1.3 million. Potential problem loans totaled approximately $2.7 million on December 31, 2005, compared to approximately $2.4 million on December 31, 2004. Other real estate owned, including foreclosed property, at year-end 2005, was $562 thousand as compared to $17 thousand for 2004. This increase is due to a single commercial real estate property. After foreclosure, management periodically performs valuations and the real estate is carried at the lower of carrying amount or fair value less cost to sell. Management expects no losses on the sale of other real estate owned.

Non-Performing Assets

Years ended December 31, (Dollars in Thousands)	2005			2004			2003			2002			2001
Non-accrual Loans	$	251		$	1,321		$	1,434		$	268		$	163
Restructured Loans		—			—			—			—			—
Foreclosed Properties		562			17			77			580			614
Total Non-performing Assets	$	813		$	1,338		$	1,511		$	848		$	777
Loans past due 90+ days as to principal or interest payments & accruing interest	$	576		$	314		$	982		$	673		$	825
Allowance for Loan Losses	$	2,157		$	2,032		$	1,902		$	1,697		$	1,493
Non-Performing Assets to Total Loans and OREO		0.4	%		0.6	%		0.8	%		0.5	%		0.5	%
Allowance to Total Loans and OREO		0.9	%		0.9	%		1.0	%		1.0	%		1.0	%
Allowance to Non-Performing Assets		2.65	%		1.52	%		1.26	%		2.00	%		1.92	%

Securities

As of December 31, 2005, investment securities totaled $46.2 million, a decrease of 11.8% as compared to 2004 year-end balances of $52.3 million. As an alternative to Federal Funds Sold the Company held $5.5 million in auction rate securities at December 31, 2005. The reduction in the investment portfolio balance was due mainly to sales of auction rate securities, calls of agency and municipal securities, and sales of some corporate and other securities.

Investments by Type

Years Ended December 31, (Book Values in Thousands)	2005		2004		2003
U.S. Government Agencies	$	12,271	$	12,179	$	20,644
State and Municipal Obligations		31,131		30,535		36,499
Other Securities		2,910		8,773		7,889
Total	$	46,312	$	51,487	$	65,032

19

Securities available for sale are carried at fair market value, with after-tax market value gains or losses disclosed as an “unrealized” component of shareholder’s equity entitled “Accumulated other comprehensive income (loss).” Also known as unrealized gains or losses on investments, other comprehensive income is impacted by rising or falling interest rates. As the market value of a fixed income investment will increase as interest rates fall, it will also decline as interest rates rise. The after tax unrealized gains or losses are recorded as other comprehensive income (loss) in the equity of the Company, but have no impact on earnings until such time as the investment is sold, or ‘realized.’ As of December 31, 2005, the Company had accumulated other comprehensive losses of $93 thousand as compared to $567 thousand accumulated other comprehensive income at year-end 2004.

The Company seeks to diversify its portfolio to minimize risk and to maintain a majority of its portfolio in securities issued by states and political subdivisions due to the tax benefits such securities provide. The Company owns no derivatives, and participates in no hedging activities.

Investment Maturities and Average Yields

As of December 31, 2005

(Dollars inThousands)	One Year or Less Or No Maturity			One to Five Years			Five to Ten Years			Over Ten Years			Total
U.S. Government Agencies:
Book Value	$	1,820		$	7,667		$	2,784		$	0		$	12,271
Market Value	$	1,804		$	7,511		$	2,708		$	0		$	12,023
Weighted average yield		2.89	%		4.00	%		4.36	%		0.00	%		3.92	%
States & Municipal Obligations:
Book Value	$	7,014		$	12,730		$	10,893		$	494		$	31,131
Market Value	$	7,023		$	12,865		$	10,789		$	487		$	31,164
Weighted average yield		6.18	%		5.64	%		5.15	%		5.27	%		5.58	%
Other Securities:
Book Value	$	0		$	2,592		$	0		$	318		$	2,910
Market Value	$	0		$	2,657		$	0		$	318		$	2,975
Weighted average yield		0.00	%		5.13	%		0.00	%		4.93	%		5.11	%
Total Securities:
Book Value	$	8,834		$	22,989		$	13,677		$	812		$	46,312
Market Value	$	8,827		$	23,033		$	13,497		$	805		$	46,162
Weighted average yield		5.50	%		5.04	%		4.99	%		5.14	%		5.11	%

Notes:

Yields on tax-exempt securities have been computed on a tax-equivalent basis.

Average yields on securities held for sale are based on amortized cost.

Deposits

As of December 31, 2005, total deposits decreased to $258.8 million as compared to year-end 2004 deposits of $261.9 million, which is probably because the Company lagged deposit rate increases as long as possible in an environment of rising rates. However, non-interest bearing demand deposits increased 9.7% to $42.7 million during 2005 from $38.9 million at year-end 2004. Savings and interest bearing transaction account balances decreased 7.7% to $123.6 million from $133.9 million at year-end 2004. Time deposits increased 3.8% to $92.6 million from $89.2 million at year-end 2004.

20

Average Deposits & Rates

Years Ended December 31, (Thousands)	2005				2004				2003
	Average Balance		Yield/ Rate		Average Balance		Yield/ Rate		Average Balance		Yield/ Rate
Non-interest bearing Demand Deposits	$	43,732	0.00	%	$	38,129	0.00	%	$	30,953	0.00	%
Interest bearing Deposits:
NOW Accounts	$	47,638	0.57	%	$	46,248	0.50	%	$	41,582	0.74	%
Regular Savings		65,877	2.12	%		66,724	1.55	%		62,258	1.70	%
Money Market Deposit Accounts		16,481	0.63	%		17,014	0.36	%		16,650	0.86	%
Time Deposits:
CD’s $100,000 or more		30,101	3.51	%		31,051	3.19	%		27,187	3.57	%
CD’s less than $100,000		58,766	3.28	%		62,616	3.07	%		67,169	3.33	%
Total Interest bearing Deposits	$	218,863	2.17	%	$	223,653	1.89	%	$	214,846	2.19	%
Total Average Deposits	$	262,595	1.81	%	$	261,782	1.62	%	$	245,799	1.92	%

Maturity Schedule of Time Deposits of $100,000 and over

Years Ended December 31, (Thousands)	2005		2004		2003
3 months or less	$	1,112	$	1,864	$	3,221
3-6 months		537		1,733		2,843
6-12 months		10,144		3,917		3,632
Over 12 months		18,341		22,050		22,019
Totals	$	30,134	$	29,564	$	31,716

Capital Resources

Capital resources represent funds, earned or obtained, over which a financial institution can exercise greater or longer control in comparison with deposits and borrowed funds. The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to size, composition, and quality of the Company’s resources 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 to absorb potential losses, yet allow management to effectively leverage its capital to maximize return to shareholders.

The Company is required to maintain minimum amounts of capital to total “risk weighted” assets, as defined by Federal Reserve Capital Guidelines. According to Capital Guidelines for Bank Holding Companies, the Company is required to maintain a minimum Total Capital to Risk Weighted Asset ratio of 8.0%, a Tier 1 Capital to Risk Weighted Asset ratio of 4.0% and a Tier 1 Capital to Adjusted Average Asset ratio (Leverage ratio) of 4.0%. As of December 31, 2005, the Company maintained these ratios at 11.2%, 10.3%, and 7.9%, respectively. At year -end 2004, these ratios were 11.2%, 10.3%, and 7.4%, respectively.

Total capital, before accumulated other comprehensive income, increased 5.7% to $26.7 million as of year- end 2005 as compared to $25.3 million at year-end 2004. Accumulated other comprehensive loss was $92.6 thousand at year-end 2005, down 116.3% from a gain of $567 thousand at year-end 2004. The Company accounts for other comprehensive income in the investment portfolio by adjusting capital for any after tax effect of unrealized gains and losses at the end of a given accounting period.

21

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. Liquid assets include cash, interest-bearing deposits with banks, Federal Funds Sold, investments and loans maturing within one year. The Company’s ability to obtain deposits and purchase funds at favorable rates determines its liability liquidity. Management believes that the Company maintains overall liquidity that is sufficient to satisfy its depositors’ requirements and to meet its customers’ credit needs.

At December 31, 2005, liquid assets totaled $40.2 million or 13.3% of total assets. Additional sources of liquidity available to the Company include its capacity to borrow additional funds when necessary. The Bank maintains Federal Funds lines with regional banks totaling approximately $16.8 million. In addition, the subsidiary Bank has a line of credit with the Federal Home Loan Bank of Atlanta of approximately $30.0 million, with $20.0 million available.

The impact of contractual obligations is limited to one FHLB advance for $10 million, which matures in May of 2010.

Off Balance Sheet Commitments

In the normal course of business, the Company offers various financial products to its customers to meet their credit and liquidity needs. These instruments frequently involve elements of liquidity, credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. 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 written is represented by the contractual amount of these instruments. Subject to its normal credit standards and risk monitoring procedures, the Company makes contractual commitments to extend credit. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being completely drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Conditional commitments are issued by the Company in the form of performance stand-by letters of credit, which guarantee the performance of a customer to a third-party. The credit risk of issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

Off Balance Sheet Arrangements

December 31, (Dollars in Thousands)	2005		2004
Total Loan Commitments Outstanding	$	42,844	$	42,232
Standy-by Letters of Commitment		862		522

The Company maintains liquidity and credit facilities with non-affiliated banks in excess of the total loan commitments and stand-by letters of credit. As these commitments are earning assets only upon take-down of the instrument by the customer, thereby increasing loan balances, management expects the revenue of the Company to be enhanced as these credit facilities are utilized.

STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains statements concerning the Company’s expectations, plans, objectives, future financial performance and other statements that are not historical facts. These statements may constitute “forward-looking statements” as defined by federal securities laws. These statements may address issues that involve estimates and assumptions made by management, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements. Factors that could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to, changes in: interest rates, general economic conditions, the legislative/regulatory climate, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Company’s market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein, and readers are cautioned not to place undue reliance on such statements, which speak only as of the date they are made.

22

ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

This information is incorporated herein by reference from Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Form 10-K.

ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

CONSOLIDATED BALANCE SHEETS

December 31, 2005 and 2004

	2005			2004
ASSETS
Cash and due from banks	$	5,213,462		$	8,572,672
Interest-bearing deposits		108,403			104,949
Federal funds sold		4,138,806			13,989,278
Securities available for sale, at fair value		45,728,286			51,916,490
Securities held to maturity at amortized cost (fair value, $434,155 and $426,320)		443,243			429,815
Loans, net of allowance for loan losses of $2,157,716 and $2,032,185		229,655,864			213,350,454
Premises and equipment, net		9,966,200			9,086,442
Accrued interest receivable		1,320,101			1,163,976
Other real estate owned		561,745			16,601
Core deposit intangible		2,807,842			2,807,842
Other assets		876,590			2,031,067
Total assets	$	301,820,542		$	303,469,586
LIABILITIES
Noninterest-bearing deposits	$	42,664,536		$	38,877,338
Savings and interest-bearing demand deposits		123,557,342			133,887,530
Time deposits		92,564,678			89,181,113
Total deposits	$	258,786,556		$	261,945,981
Securities sold under repurchase agreements		5,048,450			6,342,456
Federal Home Loan Bank advances		10,000,000			7,500,000
Other liabilities		1,372,563			1,861,627
Total liabilities	$	275,207,569		$	277,650,064
SHAREHOLDERS’ EQUITY
Common stock ($5 par value; Authorized - 5,000,000 shares;
Outstanding - 2,385,966 and 2,354,187 shares, respectively)	$	11,929,830		$	11,770,937
Additional paid-in capital		4,849,436			4,621,295
Retained Earnings		9,926,321			8,860,506
Accumulated other comprehensive income/(loss), net		(92,614	)		566,784
Total shareholders’ equity	$	26,612,973		$	25,819,522
Total liabilities and shareholders’ equity	$	301,820,542		$	303,469,586

See Notes to Consolidated Financial Statements.

23

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31, 2005, 2004 and 2003

	2005			2004		2003
Interest Income
Loans, including fees	$	14,000,190		$	11,786,878	$	10,694,171
Securities:
Taxable		1,263,562			1,339,455		1,578,987
Tax-exempt		748,849			776,149		765,126
Federal funds sold		225,293			182,669		291,172
Total interest income		16,237,894			14,085,151		13,329,456
Interest Expense
Deposits		4,753,448			4,234,460		4,715,282
Federal funds purchased		15,762			162		—
Securities sold under repurchase agreements		109,753			25,980		51,179
FHLB advances		249,561			49,892		—
Total interest expense		5,128,524			4,310,494		4,766,461
Net Interest Income		11,109,370			9,774,657		8,562,995
Provision for loan losses		559,068			300,000		312,000
Net interest income after provision for loan losses		10,550,302			9,474,657		8,250,995
Non-interest Income
Income from fiduciary activities		722,133			664,806		621,546
Service charges and fees on deposit accounts		731,833			669,029		598,666
Other service charges and fees		953,969			884,840		663,169
Secondary market lending fees		163,362			184,048		362,813
Securities gains/(losses)		(3,701	)		246,010		370,728
Other real estate gains		10,581			13,958		191,959
Other income		162,158			126,888		150,741
Total non-interest income		2,740,335			2,789,579		2,959,622
Non-interest Expense
Salaries and employee benefits		5,022,866			5,119,549		4,382,830
Occupancy expense		1,717,148			1,403,372		1,359,399
Bank franchise tax		218,255			201,910		212,449
Visa expense		464,033			421,745		369,384
Telephone expense		185,916			167,636		186,911
Other expense		2,177,141			2,008,650		2,025,044
Total non-interest expense		9,785,359			9,322,862		8,536,017
Net income before income taxes		3,505,278			2,941,374		2,674,600
Income tax expense		958,693			760,014		661,415
Net Income	$	2,546,585		$	2,181,360	$	2,013,185
Basic Earnings Per Share
Average basic shares outstanding		2,367,834			2,337,788		2,313,596
Earnings per share, basic	$	1.08		$	0.93	$	0.87
Diluted Earnings Per Share
Average diluted shares outstanding		2,378,324			2,356,598		2,338,481
Earnings per share, diluted	$	1.07		$	0.93	$	0.86

See Notes to Consolidated Financial Statements.

24

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

Years Ended December 31, 2005, 2004 and 2003

	Common Stock			Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total Shareholders’ Equity
Balance at December 31, 2002	$	11,536,800		$	4,080,693		$	7,514,790		$	1,624,516		$	24,756,799
Comprehensive Income:
Net Income		—			—			2,013,185			—			2,013,185
Changes in unrealized holding gains (losses) on securities arising during the period, net of taxes of ($213,980)											(415,375	)		(415,375	)
Reclassification adjustment for securities gains included in net income, net of taxes of ($126,048)											(244,680	)		(244,680	)
Total comprehensive income														1,353,130
Cash dividends paid —$0.57 per share		—			—			(1,318,104	)		—			(1,318,104	)
Stock repurchases		(34,750	)		(11,350	)		(63,258	)		—			(109,358	)
Sale of common stock:
Dividends Reinvested		123,351			264,836			—			—			388,187
Stock Options exercised		5,000			2,750			—			—			7,750
Balance at December 31, 2003	$	11,630,401		$	4,336,929		$	8,146,613		$	964,461		$	25,078,404
Comprehensive Income:
Net Income		—			—			2,181,360			—			2,181,360
Changes in unrealized holding gains (losses) on securities arising during the period, net of taxes of ($121,220)											(235,310	)		(235,310	)
Reclassification adjustment for securities gains included in net income, net of taxes of ($83,644)											(162,367	)		(162,367	)
Total comprehensive income														1,783,683
Cash dividends paid —$0.605 per share		—			—			(1,414,327	)		—			(1,414,327	)
Stock repurchases		(17,250	)		(6,432	)		(28,963	)		—			(52,645	)
Sale of common stock:
Dividends Reinvested		132,891			267,346			—			—			400,237
Stock Options exercised		24,895			23,452			(24,177	)		—			24,170
Balance at December 31, 2004	$	11,770,937		$	4,621,295		$	8,860,506		$	566,784		$	25,819,522
Comprehensive Income:
Net Income		—			—			2,546,585			—			2,546,585
Changes in unrealized holding gains (losses) on securities arising during the period, net of taxes of ($340,948)											(661,841	)		(661,841	)
Reclassification adjustment for securities losses included in net income, net of taxes of $1,258											2,443			2,443
Total comprehensive income														1,887,187
Cash dividends paid —$0.625 per share		—			—			(1,480,770	)		—			(1,480,770	)
Stock repurchases		(14,570	)		(28,814	)		—			—			(43,384	)
Sale of common stock:
Dividends Reinvested		112,733			229,285			—			—			342,018
Stock Options exercised		60,730			27,670			—			—			88,400
Balance at December 31, 2005	$	11,929,830		$	4,849,436		$	9,926,321		$	(92,614	)	$	26,612,973

See Notes to Consolidated Financial Statements.

25

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2005, 2004, and 2003

	2005			2004			2003
Cash Flows From Operating Activities
Net Income	$	2,546,585		$	2,181,360		$	2,013,185
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		849,979			770,720			701,317
Net amortization and accretion of securities		26,534			(46,387	)		(38,054	)
Provision for loan losses		559,068			300,000			312,000
Net securities (gains)/losses		3,701			(246,010	)		(370,728	)
Gain on sale of other real estate owned		(10,581	)		(13,958	)		(191,959	)
Deferred income taxes		(125,383	)		(21,911	)		251,178
(Increase) / decrease in accrued income and other assets		(2,298	)		(497,657	)		398,607
Increase / (decrease) in other liabilities		(23,991	)		17,976			(146,128	)
Net cash provided by operating activities		3,823,614			2,444,133			2,929,418
Cash Flows From Investing Activities
Proceeds from maturities of available-for-sale securities		1,183,377			3,612,682			6,126,479
Proceeds from sales of available-for-sale securities		7,239,500			29,345,288			17,583,327
Purchases of available-for-sale securities		(3,277,424	)		(19,120,688	)		(40,643,573	)
(Increase) / decrease in interest bearing deposits		(3,454	)		(2,081	)		56,862
(Increase) / decrease in Federal funds sold		9,850,472			(81,753	)		6,071,163
Loan originations and principal collections, net		(17,420,548	)		(25,199,501	)		(20,387,529	)
Purchases of premises and equipment		(1,729,087	)		(1,445,386	)		(1,144,625	)
Proceeds from sale of other real estate owned		21,507			73,871			762,344
Net cash (used in) investing activities		(4,135,657	)		(12,817,568	)		(31,575,552	)
Cash Flows From Financing Activities
Net increase / (decrease) in demand, savings, and other interest-bearing deposits		(6,542,990	)		12,347,178			20,264,297
Net increase / (decrease) in time deposits		3,383,565			(7,484,391	)		5,302,715
Net increase / (decrease) in securities sold under repurchase agreements		(1,294,006	)		(136,145	)		1,996,837
Increase in FHLB advances		2,500,000			7,500,000			—
Proceeds from issuance of common stock		430,418			424,407			395,937
Dividends paid		(1,480,770	)		(1,414,327	)		(1,318,104	)
Repurchase of common stock		(43,384	)		(52,645	)		(109,358	)
Net cash (used in) / provided by financing activities		(3,047,167	)		11,184,077			26,532,324
Net increase / (decrease) in cash and due from banks		(3,359,210	)		810,642			(2,113,810	)
Cash and due from banks at beginning of period		8,572,672			7,762,030			9,875,840
Cash and due from banks at end of period	$	5,213,462		$	8,572,672		$	7,762,030
Supplemental Disclosures:
Interest paid	$	5,108,832		$	4,310,795		$	4,835,012
Income taxes paid		1,091,464			560,000			662,129
Unrealized loss on investment securities		(999,088	)		(602,541	)		(1,000,083	)
Loans transferred to other real estate owned		556,070			69,424			65,113

See Notes to Consolidated Financial Statements.

26

NOTES TO FINANCIAL STATEMENTS

Note 1. Nature of Business and Significant Accounting Policies

Principles of consolidation. The consolidated financial statements of Bay Banks of Virginia, Inc. (the “Company”), include the accounts of Bay Banks of Virginia, Inc. and its subsidiaries, Bank of Lancaster, and Bay Trust Company. All significant intercompany balances and transactions have been eliminated in consolidation.

Nature of business. Bay Banks of Virginia, Inc. is a bank holding company that conducts substantially all of its operations through its subsidiaries.

The Bank of Lancaster (the “Bank”) is state-chartered and a member of the Federal Reserve System and services individual and commercial customers, the majority of which are in the Northern Neck of Virginia. The Bank has offices in the counties of Lancaster, Northumberland, Richmond, and Westmoreland, Virginia. Each branch offers a full range of deposit and loan products to its retail and commercial customers. A substantial amount of the Bank’s deposits are interest bearing. The majority of the Bank’s loan portfolio is secured by real estate.

Bay Trust Company (the “Trust Company”) offers full service trust and estate planning from its office on Main Street in Kilmarnock, Virginia. The Trust Company offers testamentary trust, revocable and irrevocable trusts, personal trusts, custodial trusts, and managed agency, as well as discount brokerage services.

Use of estimates. The preparation of the consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions. The amounts recorded in the consolidated financial statements may be affected by those estimates and assumptions. Actual results may vary 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, the valuation of foreclosed real estate and deferred taxes.

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 or trading, 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. 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. In estimating other-than-temporary impairment losses, management considers the following: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of available-for-sale securities are determined using the specific identification method. Premiums and discounts are recognized in interest income using the interest method over the terms of the securities.

Securities sold under repurchase agreements. Securities sold under repurchase agreements, which are classified as secured borrowings, generally mature within one year from the transaction date. Securities sold under repurchase agreements are reflected at the amount of cash received in connection with the transaction. The Company is required to provide collateral based on the fair value of the underlying securities.

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 in this 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 charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan originations fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.

The accrual of interest on mortgage and commercial loans is generally discontinued at the time the loan is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of

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the collateral and the financial strength of the borrower. Loans greater than 90 days past due may remain on accrual status if management determines the credit is well-secured. Past due status is based on contractual terms of the loan. For those loans that are carried on nonaccrual status, interest is recognized on the cash basis.

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.

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.

The allowance consists of specific, general, and unallocated components. The specific component relates to loans that are classified as doubtful, substandard, or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

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, unless such loans are the subject of a restructuring agreement.

Premises and equipment. Land is carried at cost. Premises and equipment are carried at cost less accumulated depreciation. Depreciation is computed principally by the straight-line method over the estimated useful lives of the premises and equipment. Estimated useful lives range from 10-40 years for buildings, and from 3-10 years for furniture, fixtures and equipment. Maintenance and repairs are charged to expense as incurred, and major improvements are capitalized.

Other real estate owned. Real estate properties acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at the lower of the carrying value or fair value on the date of foreclosure to establish a new cost basis. After foreclosure, management periodically performs valuations and the real estate is carried at the lower of carrying amount or fair value less cost to sell.

Income taxes. Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences 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.

Pension benefits. The noncontributory defined benefit pension plan covers substantially all full-time employees. The plan provides benefits that are based on employees’ average compensation during the five consecutive years of highest compensation. The funding policy is to make the minimum annual contribution that is required by applicable regulations, plus such amounts as may be determined to be appropriate from time-to-time.

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Post retirement benefits. The Company provides certain health care benefits for all retired employees that meet eligibility requirements. The Company’s share of the estimated cost of benefits that will be paid after retirement is generally being accrued by charges to expense over the employees’ service periods to the dates they are fully eligible for benefits, except that the Company’s unfunded cost that existed at the adoption date is being accrued primarily in a straight-line manner that will result in its full accrual by the end of the transition obligation amortization period.

Trust assets and income. Customer assets held by the Trust Company, other than cash on deposit, are not included in these financial statements, since such items are not assets of the Trust Company. Trust fees are recorded on the accrual basis.

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. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by the Company relate solely to outstanding stock options. Earnings per share calculations are presented in Note 16.

Off-balance-sheet financial instruments. In the ordinary course of business the Company has entered into off-balance-sheet financial instruments such as home equity lines of credit, commitments under credit card arrangements and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.

Significant group concentration of credit risk. Most of the Company’s business activity is with customers located in the counties of Lancaster, Northumberland, Richmond and Westmoreland, Virginia. The Company makes residential, commercial and consumer loans and a significant amount of the loan portfolio is comprised of real estate mortgage loans, which primarily are for single-family residences. The adequacy of collateral on real estate mortgage loans is highly dependent on changes to real estate values.

Advertising. Advertising costs are expensed as incurred.

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

Stock-based compensation plans. SFAS No. 123, Accounting for Stock-Based Compensation, encourages all entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock. Stock options issued under the Company’s stock option plan have no intrinsic value at the grant date, and under Opinion No. 25 no compensation cost is recognized for them.

Had compensation cost for the Company’s stock option plans been determined based on the fair value at the grant dates for awards under the plan consistent with the method prescribed by SFAS No. 123, the Company’s net income and earnings per share would have been adjusted to the pro forma amounts as follows:

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Years Ended December 31,	2005			2004			2003
Net income, as reported	$	2,546,585		$	2,181,360		$	2,013,185
Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects		(30,351	)		(26,205	)		(89,199	)
Pro forma net income	$	2,516,234		$	2,155,155		$	1,923,986
Earnings per share:
Basic - as reported	$	1.08		$	0.93		$	0.87
Basic - pro forma	$	1.06		$	0.92		$	0.83
Diluted - as reported	$	1.07		$	0.93		$	0.86
Diluted - pro forma	$	1.06		$	0.91		$	0.82

The fair value of each option granted was estimated on the date of grant using the Black-Scholes option pricing model. The assumptions used in the 2005 grants were a risk free rate of 4.24%, volatility of 8.61%, a dividend yield of 2.92%, and an expected life of ten years. The assumptions used for the 2004 grants were a risk free rate of 4.24%, volatility of 8.98%, a dividend yield of 2.75%, and an expected life of ten years. The assumptions used for the 2003 grants were a risk free rate of 3.80%, volatility of 9.52%, a dividend yield of 2.58%, and an expected life of ten years.

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

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

In December 2004, the FASB issued Statement No. 123 (Revised 2004) (“SFAS No. 123R”), “Share-Based Payment”, which requires that the compensation cost relating to share-based payment transactions be recognized in financial statements. SFAS No. 123R replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Share-based compensation arrangements include share options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. SFAS No. 123R requires all share-based payments to employees to be valued using a fair value method on the date of grant and expensed based on that fair value over the applicable vesting period. SFAS No. 123R also amends SFAS No. 95 “Statement of Cash Flows” requiring the benefits of tax deductions in excess of recognized compensation cost be reported as financing instead of operating cash flows. The Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 107 (“SAB 107”), which expresses the SEC’s views regarding the interaction between SFAS No. 123R and certain SEC rules and regulations. Additionally, SAB No. 107 provides

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guidance related to share-based payment transactions for public companies. The Company will be required to apply SFAS No. 123R as of the annual reporting period that begins after September 15, 2005. The Company does not anticipate this statement will have a material effect on its financial statements.

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

Note 2. Unidentifiable Intangibles

The Company has unidentifiable intangibles recorded on the financial statements relating to the purchase of five branches. The balance of the intangibles at December 31, 2005, as reflected on the consolidated balance sheet was $2,807,842. Management has determined that these purchases qualified as acquisitions of businesses and therefore discontinued amortization, effective January 1, 2002, in accordance with Statement of Financial Accounting Standard No. 142. The core deposit intangibles balance is tested for impairment at least annually. Based on the testing, there were no impairment charges in 2005, 2004, or 2003.

Note 3. Investment Securities

The aggregate amortized cost and fair values of the available for sale securities portfolio at December 31, was as follows:

December 31, 2005	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
U.S. Government agencies	$	12,270,642	$	4,336	$	(251,563	)	$	12,023,415
State and municipal obligations		30,687,331		279,400		(236,528	)		30,730,203
Corporate Bonds		1,537,938		64,030		—			1,601,968
Restricted Securities		1,372,700		—		—			1,372,700
Total	$	45,868,611	$	347,766	$	(488,091	)	$	45,728,286
December 31, 2004	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
U.S. Government agencies	$	12,178,591	$	25,767	$	(85,636	)	$	12,118,722
State and municipal obligations		30,105,661		773,164		(45,322	)		30,833,503
Corporate Bonds		7,539,474		190,791		—			7,730,265
Restricted Securities		1,234,000		—		—			1,234,000
Total	$	51,057,726	$	989,722	$	(130,958	)	$	51,916,490

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The aggregate amortized cost and fair values of the held to maturity securities portfolio at December 31, 2005 and 2004, was as follows:

December 31, 2005	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
State and municipal obligations	$	443,243	$	—	$	(9,088	)	$	434,155
December 31, 2004	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
State and municipal obligations	$	429,815	$	—	$	(3,495	)	$	426,320

Gross realized gains and gross realized losses on sales of securities were as follows:

Years ended December 31,	2005			2004		2003
Gross realized gains	$	14,347		$	246,345	$	370,728
Gross realized losses		(18,048	)		335		—
Net realized gains/(losses)	$	(3,701	)	$	246,010	$	370,728

The aggregate amortized cost and market values of the investment securities portfolio by contractual maturity at December 31, 2005 are shown below:

	Amortized Cost		Fair Value
Due in one year or less	$	8,834,438	$	8,826,925
Due after one year through five years		21,933,400		21,978,961
Due after five through ten years		13,677,406		13,497,596
Due after ten years		493,910		486,259
Restricted securities		1,372,700		1,372,700
Total	$	46,311,854	$	46,162,441

Securities with a market value of $11,651,583 and $11,877,145 at December 31, 2005 and 2004, respectively, were pledged as collateral for public deposits, repurchase agreements and for other purposes as required by law.

Securities in an unrealized loss position at December 31, 2005 and 2004, by duration of the unrealized loss, are shown as follows. No impairment has been recognized on any of the securities in a loss position because of management’s intent and demonstrated ability to hold securities to scheduled maturity or call dates. The unrealized loss positions at December 31, 2005 and 2004 were directly related to interest rate movements as there is minimal credit risk exposure in these investments. All securities are investment grade or better. Bonds with unrealized loss positions at 2005 year-end included 25 federal agencies and 43 municipal bonds, as shown below.

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	Less than 12 months				12 months or more				Total
December 31, 2005	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
U.S. Government agencies	$	3,432,253	$	58,478	$	7,887,867	$	193,085	$	11,320,120	$	251,563
States and municipal obligations		8,847,041		144,698		3,025,121		100,918		11,872,162		245,616
Total temporarily impaired securities	$	12,279,294	$	203,176	$	10,912,988	$	294,003	$	23,192,282	$	497,179
	Less than 12 months				12 months or more				Total
December 31, 2004	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
U.S. Government agencies	$	7,907,795	$	53,196	$	1,652,560	$	32,440	$	9,560,355	$	85,636
States and municipal obligations		4,715,650		36,936		552,331		11,881		5,267,981		48,817
Total temporarily impaired securities	$	12,623,445	$	90,132	$	2,204,891	$	44,321	$	14,828,336	$	134,453

Note 4. Loans

The following is a summary of the balances of loans:

December 31,	2005			2004
Mortgage loans on real estate:
Construction	$	40,998,818		$	31,184,514
Secured by farmland		1,329,479			2,017,226
Secured by 1-4 family residential		123,573,952			120,060,032
Other real estate loans		31,045,731			28,050,397
Commercial and industrial loans (not secured by real estate)		22,668,129			21,519,358
Consumer installment loans		10,580,279			9,897,965
All other loans		595,920			1,368,180
Net deferred loan costs and fees		1,021,272			1,284,967
Total loans	$	231,813,580		$	215,382,639
Allowance for loan losses		(2,157,716	)		(2,032,185	)
Loans, net	$	229,655,864		$	213,350,454

Note 5. Allowance for Loan Losses

An analysis of the change in the allowance for loan losses follows:

	2005			2004			2003
Balance, beginning of year	$	2,032,185		$	1,901,576		$	1,696,914
Provision for loan losses		559,068			300,000			312,000
Recoveries		83,367			31,874			13,032
Loans charged off		(516,904	)		(201,265	)		(120,370	)
Balance, end of year	$	2,157,716		$	2,032,185		$	1,901,576

Information about impaired loans is as follows:
	2005		2004
Impaired loans for which an allowance has been provided	$	14,188	$	979,701
Allowance provided for impaired loans, included in the allowance for loan losses	$	14,188	$	572,930
Average balance impaired loans	$	655,279	$	983,541
Interest income recognized	$	19,388	$	3

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At December 31, 2005 and 2004, non-accrual loans excluded from impaired loan disclosure under FASB No. 114 totaled $236,570 and $341,001, respectively. If interest on non-accrual loans had been accrued, such income would have approximated $13,313 in 2005 and $71,704 in 2004.

Note 6. Premises and Equipment, net

Components of premises and equipment included in the consolidated balance sheets at December 31, 2005 and 2004, were as follows:

	2005			2004
Land and improvements	$	989,855		$	734,430
Buildings and improvements		8,375,084			7,086,141
Furniture and equipment		7,640,381			7,477,309
Total cost	$	17,005,320		$	15,297,880
Less accumulated amortization and depreciation		(7,039,120	)		(6,211,438	)
Premises and equipment, net	$	9,966,200		$	9,086,442

Amortization and depreciation expense for the years ended December 31, 2005, 2004 and 2003 totaled $849,979, $770,720 and $701,317, respectively.

Note 7. Deposits

The aggregate amount of time deposits in denominations of $100,000 or more at December 31, 2005 and 2004 was $30,133,949 and $29,563,261 respectively.

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

2006	$	42,225,379
2007		13,085,983
2008		17,520,862
2009		1,995,181
2010		17,731,563
Thereafter		5,710
		$92,564,678

At December 31, 2005 and 2004, overdraft demand deposits reclassified to loans totaled $25,397 and $40,524 respectively.

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Note 8. Employee Benefit Plans

The following tables provide the reconciliation of changes in the benefit obligations and fair value of assets and a statement of funded status for the pension plan and postretirement plan of the Company.

	Pension Benefits									Postretirement Benefits
	2005			2004			2003			2005			2004			2003
Change in benefit obligation
Benefit obligation, beginning of year	$	3,297,737		$	2,557,250		$	1,940,693		$	550,636		$	515,383		$	576,206
Service cost		305,389			237,011			187,941			17,017			15,316			13,180
Interest cost		197,786			166,221			135,849			33,373			32,609			39,117
Actuarial (gain) / loss		(67,723	)		409,503			297,493			(19,841	)		9,582			(91,153	)
Benefit payments		(193,276	)		(72,248	)		(4,726	)		(21,288	)		(22,254	)		(21,967	)
Benefit obligation, end of year	$	3,539,913		$	3,297,737		$	2,557,250		$	559,897		$	550,636		$	515,383
Change in plan assets
Fair value of plan assets, beginning of year	$	2,656,552		$	1,472,804		$	1,098,955		$	—		$	—		$	—
Actual return on plan assets		297,340			159,928			178,794			—			—			—
Employer contributions		148,928			1,096,068			199,781			21,288			22,254			21,967
Benefits payments		(193,276	)		(72,248	)		(4,726	)		(21,288	)		(22,254	)		(21,967	)
Fair value of plan assets, end of year	$	2,909,544		$	2,656,552			1,472,804			—			—			—
Funded Status
Funded status	$	(630,369	)	$	(641,185	)	$	(1,084,446	)	$	(559,897	)	$	(550,636	)	$	(515,383	)
Unrecognized prior service cost		57,874			74,246			90,618			—			—			—
Unrecognized transition (asset) / obligation		—			—			—			23,304			26,217			29,130
Unrecognized actuarial loss		1,179,603			1,410,099			1,071,063			222,930			255,925			266,343
(Accrued) / prepaid benefit cost	$	607,108		$	843,160		$	77,235		$	(313,663	)	$	(268,494	)	$	(219,910	)
Weighted-average assumptions as of December 31:
Discount rate		5.75	%		6.00	%		6.50	%		5.75	%		6.00	%		6.50	%
Expected return on plan assets		8.50	%		8.50	%		8.50	%		N/A			N/A			N/A
Rate of compensation increase		5.00	%		5.00	%		5.00	%		5.00	%		5.00	%		5.00	%
Components of net periodic benefit cost
Service cost	$	305,389		$	237,011		$	187,941		$	17,017		$	15,316		$	13,180
Interest cost		197,786			166,221			135,849			33,373			32,609			39,117
Expected return on plan assets		(198,116	)		(134,758	)		(108,177	)		—			—			—
Recognized net actuarial loss		63,549			45,297			40,632			13,154			20,000			30,537
Amortization of prior service cost		16,372			16,372			16,372			—			—			—
Amortization of transition obligation		—			—			(18,311	)		2,913			2,913			2,913
Net periodic benefit cost	$	384,980		$	330,143		$	254,306		$	66,457		$	70,838		$	85,747

The accumulated benefit obligation for the defined benefit pension plan was $2,125,816, $1,855,516, and $1,441,461 at December 31, 2005, 2004, and 2003, respectively.

Long-term rate of return. The plan sponsor selects the assumption for the expected long-term rate of return on assets 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).

35

Asset allocation. The pension plan’s weighted average asset allocations for 2005 and 2004, by asset category, are as follows:

Asset category	2005		2004
Mutual funds – fixed income	35	%	41	%
Mutual funds – equity	65	%	55	%
Other	0	%	4	%
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 50% fixed income and 50% equities. 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 $148,927 to its pension plan for the 2006 plan year. Estimated future benefit payments are $2,143 for 2006, $18,624 for 2007, $23,425 for 2008, $34,084 for 2009, $82,061 for 2010 and $1,057,717 for 2011 through 2015.

Postretirement benefits plan. The weighted average discount rates used for the post retirement benefits calculation was 5.75%, 6.0%, and 6.5% at the end of 2005, 2004, and 2003, respectively. The weighted average rate of compensation increase was 5.0% for 2005, 2004, and 2003. For measurement purposes, the assumed annual rate of increase in per capita health care costs of covered benefits was 10.0% in 2006 and 2007, 8.0% in 2008 and 2009, and 6.0% in 2010 and thereafter. If assumed health care cost trend rates were increased by 1 percentage point each year, the accumulated postretirement benefit obligation at December 31, 2005, would be increased by $9,078, and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year ended December 31, 2005, would be increased by $599. If assumed health care cost trend rates were decreased by 1 percentage point each year, the accumulated postretirement benefit obligation at December 31, 2005, would be decreased by $8,345, and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year ended December 31, 2005, would be decreased by $1,587.

The Company expects to contribute $26,381 to its postretirement plan in 2006.

In addition, as of December 31, 2005 and 2004, the Company paid approximately $15,858 and $16,674, respectively, for employees who retired prior to adoption of FASB No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions.

401(k) retirement plan. The Company has a 401(k) retirement plan covering substantially all employees who have completed six months of service. Employees may contribute up to 15% of their salaries and the Company matches 100% of the first 2% and 25% of the next 2% of employee’s contributions. Additional contributions can be made at the discretion of the Company’s Board of Directors. Contributions to this plan amounted to $66,238, $65,914, and $60,022, for the years ended December 31, 2005, 2004 and 2003, respectively.

Note 9. Financial Instruments With Off-Balance Sheet Risk

In the normal course of business, the Company offers various financial products to its customers to meet their credit and liquidity needs. These instruments involve elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. 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 written is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Unless otherwise noted, the Company does not require collateral or other security to support financial instruments with credit risk.

36

Subject to its normal credit standards and risk monitoring procedures, the Company makes contractual commitments to extend credit. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being completely drawn upon, the total commitment amounts do not necessarily represent future cash requirements. At December 31, 2005 and 2004, the Company had outstanding loan commitments approximating $42,844,000 and $42,232,000, respectively.

Conditional commitments are issued by the Company in the form of performance stand-by letters of credit, which guarantee the performance of a customer to a third party. At December 31, 2005 and 2004, commitments under outstanding performance stand-by letters of credit aggregated $861,550 and $522,358, respectively. The credit risk of issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

The Company had unused lines of credit with nonaffiliated banks totaling $36,785,000 and $28,250,000 as of December 31, 2005, and 2004.

Note 10. Restrictions on Cash and Due From Banks

The Federal Reserve requires banks to maintain cash reserves against certain categories of deposit liabilities. At December 31, 2005, and 2004, the aggregate amount of daily average required reserves for the final weekly reporting period was $25 thousand and $3.3 million, respectively.

The Company has approximately $590,674 in deposits in financial institutions in excess of amounts insured by the Federal Deposit Insurance Corporation at December 31, 2005.

Note 11. Long-Term Debt

At December 31, 2005, the Company had Federal Home Loan Bank of Atlanta (“FHLB”) debt consisting of one advance for $10.0 million. The interest rate is variable at the one-month London Interbank Offering Rate (“LIBOR”) minus 50 basis points until May 19, 2006, after which it is fixed at 3.83%, maturing on May 19, 2010. At December 31, 2005, the actual rate was 3.87%. Interest is payable monthly. This instrument has an early conversion option which gives FHLB the option to convert, in whole only, into a one-month LIBOR-based floating rate advance, effective May 19, 2006. If the FHLB elects to convert, the Company may elect to terminate, in whole or in part, without a prepayment fee.

Advances on the FHLB line are secured by a blanket lien on qualified 1 to 4 family residential real estate loans. Immediate available credit, as of December 31, 2005, was $20.3 million.

Note 12. Income Taxes

The provision for income taxes consisted of the following for the years ended December 31:

	2005			2004			2003
Currently payable	$	1,084,076		$	781,925		$	410,237
Deferred		(125,383	)		(21,911	)		251,178
	$	958,693		$	760,014		$	661,415

The reasons for the differences between the statutory Federal income tax rates and the effective tax rates are summarized as follows:

	2005		2004		2003
Statutory rates	34.0	%	34.0	%	34.0	%
Effect of tax-exempt income	(6.7	)	(8.2	)	(9.3	)
	27.3	%	25.8	%	24.7	%

37

The components of the net deferred tax assets and liabilities included in other liabilities are as follows:

December 31,	2005			2004
Deferred tax assets
Allowance for loan losses	$	610,546		$	567,866
Interest on non-accrual loans		5,479			42,003
Post retirement benefits		106,645			102,653
Deferred compensation		107,004			110,108
Unrealized loss on available-for-sale securities		47,711			—
Other		5,215			2,257
Total deferred tax assets	$	882,600		$	824,887
Deferred tax liabilities
Unrealized gain on available-for-sale securities		—			(291,980	)
Pension plan		(206,263	)		(286,674	)
Depreciation		(429,273	)		(484,874	)
Amortization of intangible		(316,666	)		(237,500	)
Deferred loan fees and costs		(347,233	)		(436,889	)
Other		(109,659	)		(78,538	)
Total deferred tax liabilities		(1,409,094	)		(1,816,455	)
Net deferred tax liabilities	$	(526,494	)	$	(991,568	)

Note 13. Regulatory Requirements and Restrictions

The primary source of funds available to the Parent Company is the payment of dividends by the subsidiary Bank. Banking regulations limit the amount of dividends that may be paid without prior approval of the Bank’s regulatory agency. As of December 31, 2005, the aggregate amount of unrestricted funds, which could be transferred from the banking subsidiary to the Parent Company, without prior regulatory approval, totaled $4,563,978 or 17.1% of consolidated net assets. The Company and Bank are subject to various regulatory capital requirements administered by the Federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company and Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classifications 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, that as of December 31, 2005 and 2004, the Company and the Bank meet all capital adequacy requirements to which they are subject.

As of December 31, 2005, the most recent notification from the Federal Reserve Bank categorized the Bank as well capitalized under the 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 Bank’s category.

38

The Company’s and the Bank’s actual capital amounts and ratios as of December 31, 2005 and 2004, are presented in the tables below:

	Actual				Minimum Capital Requirement				Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions
(Amounts in Thousands)	Amount		Ratio		Amount		Ratio		Amount		Ratio
As of December 31, 2005:
Total Capital (to Risk Weighted Assets)
Consolidated	$	26,056	11.19	%	$	18,626	8.00	%		N/A	N/A
Bank of Lancaster	$	24,549	10.62	%	$	18,487	8.00	%	$	23,109	10.00	%
Tier 1 Capital (to Risk Weighted Assets)
Consolidated	$	23,898	10.26	%	$	9,313	4.00	%		N/A	N/A
Bank of Lancaster	$	22,391	9.69	%	$	9,244	4.00	%	$	13,866	6.00	%
Tier 1 Capital (to Average Assets)
Consolidated	$	23,898	7.92	%	$	12,075	4.00	%		N/A	N/A
Bank of Lancaster	$	22,391	7.46	%	$	12,013	4.00	%	$	15,016	5.00	%
As of December 31, 2004:
Total Capital (to Risk Weighted Assets)
Consolidated	$	24,477	11.24	%	$	17,415	8.00	%		N/A	N/A
Bank of Lancaster	$	22,741	10.53	%	$	17,284	8.00	%	$	21,605	10.00	%
Tier 1 Capital (to Risk Weighted Assets)
Consolidated	$	22,444	10.31	%	$	8,708	4.00	%		N/A	N/A
Bank of Lancaster	$	20,708	9.58	%	$	8,642	4.00	%	$	12,963	6.00	%
Tier 1 Capital (to Average Assets)
Consolidated	$	22,444	7.42	%	$	12,098	4.00	%		N/A	N/A
Bank of Lancaster	$	20,708	6.88	%	$	12,039	4.00	%	$	15,049	5.00	%

Note 14. Employee Stock Ownership Plan

The Company has a noncontributory Employee Stock Ownership Plan (“ESOP”) for the benefit of all eligible employees who have completed twelve months of service and who have attained the age of 21 years. Contributions to the plan are at the discretion of the Company’s Board of Directors. Contributions are allocated in the ratio to which the covered compensation of each participant bears to the aggregate covered compensation of all participants for the plan year. Allocations are limited to 25% of eligible participant compensation. Participant accounts are 30% vested after three years, 40% vested after four years with vesting increasing 20% each year thereafter, until 100% vested. The plan had 124,505 allocated shares as of December 31, 2005. Contributions to the plan were $65,000, $50,000 and $50,000 for 2005, 2004 and 2003, respectively. Dividends on the Company’s stock held by the ESOP were $77,462, $77,053 and $73,794 in 2005, 2004 and 2003, respectively. Shares held by the ESOP are considered outstanding for purposes of computing net earnings per share.

Note 15. Stock-Based Compensation Plans

The Company has three stock-based compensation plans. The 1994 Incentive Stock Option Plan expired and no additional shares may be granted under this plan. The 2003 Incentive Stock Option Plan makes 175,000 shares available for grant. Under this plan, the exercise price of each option equals the market price of the Company’s common stock on the date of grant and an option’s maximum term is ten years. Options granted are exercisable only after meeting certain performance targets during a specified time period. If the targets are not met, the options are forfeited. The third plan is the 1998 Non-Employee Directors Stock Option Plan, which grants 500 shares to each non-employee director annually. This plan had 17,500 shares available for grant at December 31, 2005.

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A summary of the status of the stock option plans as of December 31, 2005, 2004 and 2003, and changes during the years ending on those dates, is presented below:

	2005				2004				2003
	Shares		Weighted Average Price		Shares		Weighted Average Price		Shares		Weighted Average Price
Outstanding at beginning of year	192,121		$	13.57	182,682		$	13.58	164,872		$	14.13
Granted	30,600			15.37	32,000			15.91	30,500			14.86
Exercised	(18,470	)		9.99	(7,700	)		8.70	(1,000	)		7.75
Forfeited	(27,312	)		15.11	(14,861	)		14.80	(11,690	)		16.58
Outstanding at end of year	176,939		$	15.01	192,121		$	13.57	182,682		$	13.58
Options exercisable at year-end	152,639				167,121				158,682

The weighted average fair value of options granted during 2005, 2004, and 2003, was $2.00, $2.26, and $2.10, respectively.

The status of the options outstanding at December 31, 2005 is as follows:

	Options Outstanding		Options Exercisable
Range of Exercise Prices	Number Outstanding	Weighted Average Remaining Contractual Life	Number Exercisable	Weighted Average Exercise Price
$ 8.25 - $13.75	31,368	1.20 yrs	31,368	$	11.00
$ 14.50 - $17.50	145,571	6.52 yrs	121,271		15.93
	176,939	5.58 yrs	152,639	$	14.92

Note 16. Earnings Per Share

The following shows the weighted average number of shares used in computing the earnings per share and the effect on weighted average number of shares of diluted potential common stock.

Years Ended December 31,	2005		2004		2003
Net Income available to common shareholders	$	2,546,585	$	2,181,360	$	2,013,185
Average number of common shares outstanding		2,367,834		2,337,788		2,313,596
Effect of dilutive options		10,490		18,810		24,885
Average number of potential common shares		2,378,324		2,356,598		2,338,481

As of December 31, 2005, 2004, and 2003, options on 129,776 shares, 124,414 shares, and 74,308 shares, respectively, were not included in computing earnings per common share – assuming dilution, because their effects were antidilutive.

Note 17. Related Parties

The Company has entered into transactions with its directors and principal officers of the Company, their immediate families and affiliated companies in which they are the principal stockholders (related parties). The aggregate amount of loans to such related parties was approximately $2,497,513 and $2,694,486 at December 31, 2005 and 2004, respectively. All such loans, in the opinion of the management, were made in

40

the normal course of business on the same terms, including interest rate and collateral, as those prevailing at the time for comparable transactions.

Balance, January 1, 2005$	$	2,694,486
New loans and extensions to existing loans		151,620
Repayments and other reductions		(348.593	)
Balance, December 31, 2005$	$	2,497,513

Commitments to extend credit to directors and their related interests were $1,185,123 and $1,146,368 at December 31, 2005 and 2004, respectively.

Note 18. Fair Value of Financial Instruments

The estimated fair values of financial instruments are shown in the following table. The carrying amounts in the table are included in the balance sheet under the applicable captions.

	December 31, 2005				December 31, 2004
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Financial Assets:
Cash and due from banks	$	5,213,462	$	5,213,462	$	8,572,672	$	8,572,672
Interest-bearing deposits		108,403		108,403		104,949		104,949
Federal funds sold		4,138,806		4,138,806		13,989,278		13,989,278
Securities available-for-sale		45,728,286		45,728,286		51,916,490		51,916,490
Securities held-to-maturity		443,243		434,155		429,815		426,320
Loans, net		229,655,864		232,727,778		213,350,454		217,070,284
Accrued interest receivable		1,320,101		1,320,101		1,163,976		1,163,976
Financial liabilities:
Noninterest-bearing deposits	$	42,664,536	$	42,664,536	$	38,877,338	$	38,877,338
Savings and other interest-bearing deposits		123,557,342		123,654,743		133,887,530		133,892,391
Time deposits		92,564,678		92,544,381		89,181,113		90,479,859
Securities sold under repurchase agreements		5,048,450		5,048,450		6,342,456		6,342,456
FHLB Advances		10,000,000		10,001,838		7,500,000		7,498,740
Accrued interest payable		239,033		239,033		219,340		219,340

The above presentation of fair values is required by Statement on Financial Accounting Standards No. 107, Disclosures About Fair Value of Financial Instruments. The fair values shown do not necessarily represent the amounts which would be received on immediate settlement of the instruments. Statement No. 107 excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

The following methods and assumptions were used to estimate the fair value of each class of financial instrument.

The carrying amounts of cash and due from banks, federal funds sold, non-interest-bearing deposits, and securities sold under repurchase agreements, represent items which do not present significant market risks, are payable on demand, or are of such short duration that carrying value approximates market value.

Available-for-sale securities are carried at the quoted market prices for the individual securities held. Therefore carrying value equals market value. Held-to-maturity securities are carried at book value, and fair value for these securities is obtained from quoted market prices.

The fair value of loans is estimated by discounting future cash flows using the interest rates at which similar loans would be made to borrowers.

41

Other time deposits are presented at estimated fair value using interest rates offered for deposits of similar remaining maturities.

The fair value of the FHLB advance is estimated by discounting its future cash flows using the interest rate offered for similar advances.

The fair value of commitments to extend credit is estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness 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 standby 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, 2005 and 2004, the fair value of loan commitments and standby letters of credit was immaterial.

Note 19. Condensed Financial Information of Parent Company

Financial information pertaining only to Bay Banks of Virginia, Inc. is as follows:

Condensed Balance Sheets
	2005		2004
Assets
Cash and due from banks	$	209,430	$	438,152
Investments in subsidiaries		26,108,877		25,131,737
Premises and equipment, net		106,288		131,811
Other assets		412,834		372,507
Total assets	$	26,837,429	$	26,074,207
Liabilities and Shareholders’ Equity
Liabilities
Deferred directors’ compensation	$	314,717	$	297,763
Other liabilities		4,780		51,963
Total liabilities	$	319,497	$	349,726
Total shareholder’s equity		26,517,932		25,724,481
Total liabilities and shareholders’ equity	$	26,837,429	$	26,074,207

Condensed Statements of Income
	2005			2004			2003
Dividends from subsidiaries	$	1,200,000		$	750,000		$	1,275,000
Other income		28,467			5,825			26,043
Total non-interest income		1,228,467			755,825			1,301,043
Total non-interest expense		427,402			338,987			364,746
Income before income taxes and equity in undistributed earnings of subsidiaries		801,065			416,838			936,297
Income tax benefit		(108,981	)		(85,413	)		(115,159	)
Income before equity in undistributed earnings of subsidiaries		910,046			502,251			1,051,456
Equity in undistributed earnings of subsidiaries		1,636,539			1,679,109			961,729
Net income	$	2,546,585		$	2,181,360		$	2,013,185

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Condensed Statements of Cash Flows
	2005			2004			2003
Cash Flows from Operating Activities:
Net income	$	2,546,585		$	2,181,360		$	2,013,185
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		19,836			24,625			25,826
Equity in undistributed earnings of subsidiaries		(1,636,539	)		(1,679,109	)		(961,729	)
(Increase) in other assets		(19,863	)		(15,905	)		(79,416	)
Net change in deferred directors’ compensation		16,954			23,325			14,771
Increase / (decrease) in other liabilities		(61,959	)		96,548			(275,132	)
Net cash provided by operating activities	$	865,014		$	630,844		$	737,505
Cash Flows from Investing Activities:
Investment in subsidiaries		—			(160,000	)		—
Net cash used in investing activities	$	—		$	(160,000	)	$	—
Cash Flows from Financing Activities:
Proceeds from issuance of common stock		430,418			424,407			395,937
Dividends paid		(1,480,770	)		(1,414,327	)		(1,318,104	)
Repurchase of stock		(43,384	)		(52,645	)		(109,358	)
Net cash used in financing activities		(1,093,736	)		(1,042,565	)		(1,031,525	)
Net decrease in cash and due from banks		(228,722	)		(571,721	)		(294,020	)
Cash and due from banks at January 1,		438,152			1,009,873			1,303,893
Cash and due from banks at December 31,	$	209,430		$	438,152		$	1,009,873

Note 20. Quarterly Condensed Statements of Income (unaudited)

2005 Quarter ended	March 31		June 30		September 30		December 31
(in thousands)
Total interest income	$	3,782	$	3,994	$	4,163	$	4,299
Net interest income after provision for loan losses		2,511		2,627		2,702		2,710
Other income		607		684		755		694
Other expenses		2,289		2,430		2,506		2,560
Income before income taxes		828		881		951		844
Net income		604		639		687		617
(in dollars)
Earnings per common share-assuming dilution	$	0.25	$	0.27	$	0.29	$	0.26
Dividends per common share	$	0.155	$	0.155	$	0.155	$	0.16
2004 Quarter ended	March 31		June 30		September 30		December 31
(in thousands)
Total interest income	$	3,400	$	3,435	$	3,554	$	3,696
Net interest income after provision for loan losses		2,262		2,306		2,410		2,497
Other income		691		654		685		760
Other expenses		2,387		2,324		2,318		2,294
Income before income taxes		565		636		776		964
Net income		397		451		590		743
(in dollars)
Earnings per common share-assuming dilution	$	0.17	$	0.19		0.25	$	0.32
Dividends per common share	$	0.15	$	0.15	$	0.15	$	0.155

43

Report of Independent Registered Public Accounting Firm

To the Shareholders and Board of Directors

Bay Banks of Virginia, Inc.

Kilmarnock, Virginia

We have audited the accompanying consolidated balance sheets of Bay Banks of Virginia, Inc. and Subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in shareholders’ equity and cash flows for each of the three years ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provided 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 Bay Banks of Virginia, Inc. and Subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.

Winchester, Virginia

January 27, 2006

44

ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A: CONTROLS AND PROCEDURES

As of the end of the period to which this report relates, the Company has carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-14 of the Exchange Act. Based upon that evaluation, the Company’s Chief Executive Officer and Principal Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic SEC filings. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to the date the Company carried out its evaluation.

ITEM 9B: OTHER INFORMATION

None.

PART III

ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

All required information is detailed in the Company’s 2006 definitive proxy statement for the annual meeting of shareholders (“Definitive Proxy Statement”), which is expected to be filed with the SEC within the required time period, and is incorporated herein by reference.

ITEM 11: EXECUTIVE COMPENSATION

Information on executive compensation is provided in the Definitive Proxy Statement and is incorporated herein by reference.

ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

Information on security ownership of certain beneficial owners and management and related stockholder matters is provided in the Definitive Proxy Statement, and is incorporated herein by reference.

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The following table summarizes information, as of December 31, 2005, relating to the Company’s stock incentive plans, pursuant to which grants of options to acquire shares of common stock may be granted from time to time.

At December 31, 2005	Number of Shares To be Issued Upon Exercise Of Outstanding Options, Warrants and Rights(1)		Weighted-Average Exercise Price of Outstanding Options, Warrants and Rights		Number of Shares Remaining Available for Future Issuance Under Equity Compensation Plan
Equity compensation plans Approved by shareholders	180,439	(1)	$	15.01	151,842
Equity compensation plans not approved by shareholders	—			—	—
Total	180,439		$	15.01	151,842

(1) Consists of options granted pursuant to the Company’s incentive stock option plans.

ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Information on certain relationships and related transactions are detailed in the Definitive Proxy Statement and incorporated herein by reference.

ITEM 14: PRINCIPAL ACCOUNTING FEES AND SERVICES

Information on principal accounting fees and services is provided in the Definitive Proxy Statement and is incorporated herein by reference.

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PART IV

ITEM 15: EXHIBITS, FINANCIAL STATEMENT SCHEDULES.

(a)1. Financial Statements are included in Part II, Item 8, Financial Statements and Supplementary Data

(a)2. All required tables are included in Part I, Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations

(a)3. Exhibits:

No.	Description
3.1	Articles of Incorporation, as amended, of Bay Banks of Virginia, Inc. (Incorporated by reference to previously filed Form 10-K for the year ended December 31, 2002).
3.2	Bylaws, as amended, of Bay Banks of Virginia, Inc. (Incorporated by reference to previously filed Form 10-K for the year ended December 31, 2004).
10.1	1994 Incentive Stock Option Plan (Incorporated by reference to the previously filed Form S-4EF, Commission File number 333-22579, dated February 28, 1997).
10.2	1998 Non-Employee Directors Stock Option Plan (Incorporated by reference to the previously filed Form 10-K for the year ended December 31, 1999).
10.3	2003 Incentive Stock Option Plan. (Incorporated by reference to Form S-8, Commission File Number 333-112947, previously filed on February 19, 2004).
11.0	Statement re: Computation of per share earnings. (Incorporated herein by reference to Note 1 of the 2005 Annual Report to Shareholders).
21.0	Subsidiaries of the Company (filed herewith).
23.1	Consent of Yount, Hyde & Barbour, P.C. (filed herewith)
31.1	Section 302 Certification (filed herewith).
31.2	Section 302 Certification (filed herewith).
32.0	Section 906 Certification (filed herewith).

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 22nd day of March, 2006.

Bay Banks of Virginia, Inc.
(registrant)
By:	/s/ Austin L. Roberts, III
	Austin L. Roberts, III,
	President and Chief Executive Officer
	(Principal Executive Officer)

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant, and in the capacities indicated, on the 22^nd day of March 2006.

/s/ Ammon G. Dunton, Jr.

Ammon G. Dunton, Jr.

Chairman, Board of Directors

Director

/s/ Austin L. Roberts, III

Austin L. Roberts, III

President and CEO

Director

/s/ Robert C. Berry, Jr.

Robert C. Berry, Jr.

Director

/s/ Weston F. Conley, Jr.

Weston F. Conley, Jr.

Director

/s/ Richard A. Farmar, III

Richard A. Farmar, III

Director

/s/ Allen C. Marple

Allen C. Marple

Director

/s/ Robert J. Wittman

Robert J. Wittman

Director

/s/ Deborah M. Evans

Deborah M. Evans

Treasurer and Principal Financial Officer

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EX-21.0

Exhibit 21.0

Subsidiaries of Bay Banks of Virginia, Inc.

Subsidiary	State of Incorporation
Bank of Lancaster	Virginia
Bay Trust Company	Virginia

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EX-23.1

Exhibit 23.1

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors

Bay Banks Of Virginia, Inc.

Kilmarnock, Virginia

We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (No. 333-112947) and in the related Prospectus, of our report, dated January 27, 2006, relating to the consolidated financial statements of Bay Banks of Virginia, Inc. and subsidiaries, included in the Annual Report of Shareholders and in this Annual Report on Form 10-K for the year ended December 31, 2005.

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

Winchester, Virginia

March 22, 2006

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EX-31.1

Exhibit 31.1

CERTIFICATIONS

I, Austin L. Roberts, III, certify that:

1. I have reviewed this Annual Report on Form 10-K of Bay Banks of Virginia Inc.;

2. Based on my knowledge, this 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 report;

3. Based on my knowledge, the financial statements, and other financial information included in this 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 report;

4. The registrant’s other certifying officer(s), 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 we have:

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

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

(c) disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting;

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

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

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

Date: March 22, 2006

/s/ Austin L. Roberts, III

Austin L. Roberts, III

President and Chief Executive Officer

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EX-31.2

Exhibit 31.2

CERTIFICATIONS

I, Deborah M. Evans , certify that:

1. I have reviewed this Annual Report on Form 10-K of Bay Banks of Virginia, Inc.;

2. Based on my knowledge, this 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 report;

3. Based on my knowledge, the financial statements, and other financial information included in this 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 report;

4. The registrant’s other certifying officer(s) 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 we have:

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

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

(c) disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting: and;

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

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

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

Date: March 22, 2006

/s/ Deborah M. Evans

Deborah M. Evans

Treasurer and Principal Financial Officer

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EX-32.0

Exhibit 32.0

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 on Form 10-K for the year ended December 31, 2005 of Bay Banks of Virginia, Inc. (the “Company”), as filed with the Securities and Exchange Commission on the date hereof (the “Report”), the undersigned Chief Executive Officer and Principal Financial Officer of the Company hereby certify, pursuant to 18 U.S.C. §1350, as adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002 that based on their knowledge and belief: (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 results of operations of the Company as of and for the periods covered in the Report.

/s/ Austin L. Roberts, III

Austin L. Roberts, III President and CEO

/s/ Deborah M. Evans

Deborah M. Evans, Treasurer and Principal Financial Officer

March 22, 2006

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