UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2012

or

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

For the transition period from             to             

Commission File Number: 0-20146

EAGLE FINANCIAL SERVICES, INC.

(Exact name of registrant as specified in its charter)

Virginia	54-1601306
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
2 East Main Street P.O. Box 391 Berryville, Virginia	22611
(Address of principal executive offices)	(Zip Code)

(540) 955-2510

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (232.405 of this Chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer	¨	Accelerated filer	¨
Non-accelerated filer	¨  (Do not check if a smaller reporting company.)	Smaller reporting company	x

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

The number of shares of the registrant’s Common Stock ($2.50 par value) outstanding as of November 2, 2012 was 3,344,737.

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION
Item 1.	Financial Statements:
	Consolidated Balance Sheets at September 30, 2012 and December 31, 2011	1
	Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2012 and 2011	2
	Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2012 and 2011	3
	Consolidated Statements of Changes in Shareholders’ Equity for the Nine Months Ended September 30, 2012 and 2011	4
	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2012 and 2011	5
	Notes to Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	28
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	37
Item 4.	Controls and Procedures	37
PART II - OTHER INFORMATION
Item 1.	Legal Proceedings	38
Item 1A.	Risk Factors	38
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	38
Item 3.	Defaults Upon Senior Securities	38
Item 4.	Mine Safety Disclosures	38
Item 5.	Other Information	38
Item 6.	Exhibits	38

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

EAGLE FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(dollars in thousands, except share amounts)

	September 30, 2012			December 31, 2011
	(Unaudited)
Assets
Cash and due from banks	$	7,978		$	7,610
Interest-bearing deposits with other institutions		13,834			14,331
Total cash and cash equivalents		21,812			21,941
Securities available for sale, at fair value		101,186			114,134
Restricted investments		2,777			3,520
Loans		427,499			410,424
Allowance for loan losses		(7,961	)		(8,743	)
Net Loans		419,538			401,681
Bank premises and equipment, net		16,420			15,200
Other real estate owned, net of allowance		2,364			2,378
Other assets		10,055			9,168
Total assets	$	574,152		$	568,022
Liabilities and Shareholders’ Equity
Liabilities
Deposits:
Noninterest bearing demand deposits	$	122,093		$	107,237
Savings and interest bearing demand deposits		219,984			210,158
Time deposits		115,101			131,070
Total deposits	$	457,178		$	448,465
Federal funds purchased and securities sold under agreements to repurchase		10,000			10,000
Federal Home Loan Bank advances		32,250			42,250
Trust preferred capital notes		7,217			7,217
Other liabilities		4,709			2,000
Total liabilities	$	511,354		$	509,932
Shareholders’ Equity
Preferred stock, $ 10 par value; 500,000 shares authorized and unissued	$	—		$	—
Common stock, $ 2.50 par value; authorized 10,000,000 shares; issued 2012, 3,324,636; issued 2011, 3,286,992		8,312			8,217
Surplus		10,218			9,568
Retained earnings		40,548			37,374
Accumulated other comprehensive income		3,720			2,931
Total shareholders’ equity	$	62,798		$	58,090
Total liabilities and shareholders’ equity	$	574,152		$	568,022

See Notes to Consolidated Financial Statements

1

EAGLE FINANCIAL SERVICES, INC.

Consolidated Statements of Income (Unaudited)

(dollars in thousands, except per share amounts)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2012		2011			2012			2011
Interest and Dividend Income
Interest and fees on loans	$	5,634	$	5,750		$	17,057		$	17,192
Interest and dividends on securities available for sale:
Taxable interest income		524		603			1,676			2,056
Interest income exempt from federal income taxes		337		367			1,048			1,029
Dividends		87		189			297			315
Interest on deposits in banks		4		11			9			31
Total interest and dividend income	$	6,586	$	6,920		$	20,087		$	20,623
Interest Expense
Interest on deposits	$	377	$	595		$	1,218		$	1,890
Interest on federal funds purchased and securities sold under agreements to repurchase		90		93			270			275
Interest on Federal Home Loan Bank advances		273		420			844			1,310
Interest on trust preferred capital notes		37		34			112			102
Interest on interest rate swap		43		46			126			136
Total interest expense	$	820	$	1,188		$	2,570		$	3,713
Net interest income	$	5,766	$	5,732		$	17,517		$	16,910
Provision For Loan Losses		1,050		1,050			1,650			2,850
Net interest income after provision for loan losses	$	4,716	$	4,682		$	15,867		$	14,060
Noninterest Income
Income from fiduciary activities	$	205	$	189		$	726		$	698
Service charges on deposit accounts		390		406			1,112			1,190
Other service charges and fees		898		861			2,576			2,473
Gain (loss) on securities		1		(8	)		15			155
Other operating income		59		24			167			80
Total noninterest income	$	1,553	$	1,472		$	4,596		$	4,596
Noninterest Expenses
Salaries and employee benefits	$	2,651	$	2,688		$	7,935		$	7,588
Occupancy expenses		279		286			858			877
Equipment expenses		162		164			502			507
Advertising and marketing expenses		132		157			347			408
Stationery and supplies		91		53			231			221
ATM network fees		139		131			396			377
Other real estate owned expense		8		39			58			146
(Gain) loss on the sale of other real estate owned		—		78			(15	)		255
FDIC assessment		96		170			202			546
Computer software expense		100		190			336			458
Bank franchise tax		94		102			290			275
Professional fees		237		105			757			634
Other operating expenses		588		482			1,662			1,477
Total noninterest expenses	$	4,577	$	4,645		$	13,559		$	13,769
Income before income taxes	$	1,692	$	1,509		$	6,904		$	4,887
Income Tax Expense		439		370			1,935			1,258
Net income	$	1,253	$	1,139		$	4,969		$	3,629
Earnings Per Share
Net income per common share, basic	$	0.38	$	0.34		$	1.50		$	1.10
Net income per common share, diluted	$	0.37	$	0.34		$	1.49		$	1.10

See Notes to Consolidated Financial Statements

2

EAGLE FINANCIAL SERVICES, INC.

Consolidated Statements of Comprehensive Income (Unaudited)

(dollars in thousands)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Net income	$	1,253		$	1,139		$	4,969		$	3,629
Other comprehensive income:
Unrealized gain on available for sale securities, net of deferred income taxes of $151 and $445 for the three months ended September 30, 2012 and 2011, respectively and $437 and $956 for the nine months ended September 30, 2012 and 2011, respectively		293			865			850			1,855
Change in market value of interest rate swap, net of deferred income taxes of $14 and $100 for the three months ended September 30, 2012 and 2011, respectively and $31 and $139 for the nine months ended September 30, 2012 and 2011, respectively		(25	)		(195	)		(61	)		(270	)
Total other comprehensive income		268			670			789			1,585
Total comprehensive income	$	1,521		$	1,809		$	5,758		$	5,214

See Notes to Consolidated Financial Statements

3

EAGLE FINANCIAL SERVICES, INC.

Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)

(dollars in thousands, except share and per share amounts)

	Common Stock		Surplus			Retained Earnings			Accumulated Other Comprehensive Income		Total
Balance, December 31, 2010	$	8,124	$	9,076		$	35,419		$	1,210	$	53,829
Net income							3,629					3,629
Other comprehensive income										1,585		1,585
Restricted stock awards, stock incentive plan (5,691 shares)		14		(14	)							—
Stock-based compensation expense				110								110
Issuance of common stock, dividend investment plan (29,201 shares)		73		380								453
Issuance of common stock, employee benefit plan (5,184 shares)		13		76								89
Dividends declared ($0.54 per share)							(1,772	)				(1,772	)
Balance, September 30, 2011	$	8,224	$	9,628		$	37,276		$	2,795	$	57,923
Balance, December 31, 2011	$	8,217	$	9,568		$	37,374		$	2,931	$	58,090
Net income							4,969					4,969
Other comprehensive income										789		789
Restricted stock awards, stock incentive plan (7,363 shares)		19		(19	)							—
Income tax benefit on vesting of restricted stock				2								2
Stock-based compensation expense				173								173
Issuance of common stock, dividend investment plan (24,101 shares)		61		402								463
Issuance of common stock, employee benefit plan (6,180 shares)		15		92								107
Dividends declared ($0.54 per share)							(1,795	)				(1,795	)
Balance, September 30, 2012	$	8,312	$	10,218		$	40,548		$	3,720	$	62,798

See Notes to Consolidated Financial Statements

4

EAGLE FINANCIAL SERVICES, INC.

Consolidated Statements of Cash Flows (Unaudited)

(dollars in thousands)

	Nine Months Ended September 30,
	2012			2011
Cash Flows from Operating Activities
Net income	$	4,969		$	3,629
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		624			629
Amortization of intangible and other assets		95			67
Provision for loan losses		1,650			2,850
Provision for other real estate owned		—			75
Loss on the sale of bank premises and equipment		—			1
(Gain) loss on the sale of other real estate owned		(15	)		255
Loss on the sale of repossessed assets		2			20
(Gain) on the sale of securities		(15	)		(155	)
Accrual of restricted stock awards		173			110
Premium amortization on securities, net		151			69
Changes in assets and liabilities:
(Increase) decrease in other assets		(1,431	)		423
Increase in other liabilities		2,618			1,678
Net cash provided by operating activities	$	8,821		$	9,651
Cash Flows from Investing Activities
Proceeds from maturities and principal payments of securities available for sale	$	17,299		$	30,281
Proceeds from the sale of securities		2,072			4,849
Purchases of securities available for sale		(5,272	)		(42,435	)
Proceeds from the sale of restricted investments		743			278
Purchases of bank premises and equipment		(1,845	)		(648	)
Proceeds from the sale of bank premises and equipment		—			3
Proceeds from the sale of other real estate owned		800			1,673
Proceeds from the sale of repossessed assets		71			123
Net (increase) in loans		(20,306	)		(3,991	)
Net cash (used in) investing activities	$	(6,438	)	$	(9,867	)
Cash Flows from Financing Activities
Net increase in demand deposits, money market and savings accounts	$	24,682		$	15,384
Net (decrease) increase in certificates of deposit		(15,969	)		5,327
Net (decrease) in federal funds purchased and securities sold under agreements to repurchase		—			(4,395	)
Net (decrease) in Federal Home Loan Bank advances		(10,000	)		(10,000	)
Issuance of common stock, employee benefit plan		107			89
Cash dividends paid		(1,332	)		(1,320	)
Net cash (used in) provided by financing activities	$	(2,512	)	$	5,085

(continued)

5

EAGLE FINANCIAL SERVICES, INC.

Consolidated Statements of Cash Flows (Unaudited)

(continued)

	Nine Months Ended September 30,
	2012			2011
(Decrease) increase in cash and cash equivalents	$	(129	)	$	4,869
Cash and Cash Equivalents
Beginning		21,941			13,970
Ending	$	21,812		$	18,839
Supplemental Disclosures of Cash Flow Information
Cash payments for:
Interest	$	2,625		$	3,687
Income taxes	$	1,445		$	850
Supplemental Schedule of Noncash Investing and Financing Activities:
Unrealized gain on securities available for sale	$	1,287		$	2,811
Change in market value of interest rate swap	$	(92	)	$	(409	)
Other real estate acquired in settlement of loans	$	771		$	3,657
Issuance of common stock, dividend investment plan	$	463		$	453

See Notes to Consolidated Financial Statements

6

EAGLE FINANCIAL SERVICES, INC.

Notes to Consolidated Financial Statements (Unaudited)

September 30, 2012

NOTE 1. General

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

In the opinion of management, the accompanying financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position at September 30, 2012 and December 31, 2011, the results of operations for the three and nine months ended September 30, 2012 and 2011 and cash flows for the nine months ended September 30, 2012 and 2011. The results of operations for the three and nine months ended September 30, 2012 are not necessarily indicative of the results to be expected for the full year. These financial statements should be read in conjunction with the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 (the “2011 Form 10-K”).

The Company owns 100% of Bank of Clarke County (the “Bank”) and Eagle Financial Statutory Trust II. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions between the Company and the Bank have been eliminated. The subordinated debt of Eagle Financial Statutory Trust II is reflected as a liability of the Company.

Certain amounts in the consolidated financial statements have been reclassified to conform to current year presentations.

NOTE 2. Stock-Based Compensation Plan

During 2003, the Company’s shareholders approved a stock incentive plan which allows key employees and directors to increase their personal financial interest in the Company. This plan permits the issuance of incentive stock options and non-qualified stock options and the award of stock appreciation rights, common stock, restricted stock, and phantom stock. The plan authorizes the issuance of up to 300,000 shares of common stock.

The Company periodically grants Restricted Stock to its directors and executive officers. Restricted Stock provides grantees with rights to shares of common stock upon completion of a service period or achievement of Company performance measures. During the restriction period, all shares are considered outstanding and dividends are paid to the grantee. In general, outside directors are periodically granted restricted shares which vest over a period of less than nine months. Beginning during 2006, executive officers are granted restricted shares which vest over a three year service period and restricted shares which vest based on meeting annual performance measures. The Company recognizes compensation expense over the restricted period. The following table presents Restricted Stock activity for the nine months ended September 30, 2012 and 2011:

	Nine Months Ended September 30,
	2012					2011
	Shares			Weighted Average Grant Date Fair Value		Shares			Weighted Average Grant Date Fair Value
Nonvested, beginning of period		13,700		$	16.11		12,772		$	16.89
Granted		14,500			17.87		12,300			16.76
Vested		(7,363	)		16.10		(5,691	)		17.26
Forfeited		(737	)		16.25		(2,081	)		18.38
Nonvested, end of period		20,100		$	17.37		17,300		$	16.50

7

NOTE 3. Earnings Per Common Share

Basic earnings per share represents income available to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. The number of potential common shares is determined using the treasury method and relates to outstanding stock options and unvested restricted stock grants.

The following table shows the weighted average number of shares used in computing earnings per share for the three and nine months ended September 30, 2012 and 2011 and the effect on the weighted average number of shares of dilutive potential common stock. Potential dilutive common stock had no effect on income available to common shareholders.

	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
Average number of common shares outstanding		3,341,050		3,302,082		3,328,065		3,287,943
Effect of dilutive common stock		11,287		9,390		9,643		7,953
Average number of common shares outstanding used to calculate diluted earnings per share		3,352,337		3,311,472		3,337,708		3,295,896

NOTE 4. Securities

Amortized costs and fair values of securities available for sale at September 30, 2012 and December 31, 2011 were as follows:

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
	September 30, 2012
	(in thousands)
Obligations of U.S. government corporations and agencies	$	15,788	$	938	$	—		$	16,726
Mortgage-backed securities		24,643		1,566		—			26,209
Obligations of states and political subdivisions		41,516		2,349		(23	)		43,842
Corporate securities		10,954		1,191		—			12,145
Equity securities		2,054		210		—			2,264
	$	94,955	$	6,254	$	(23	)	$	101,186
	December 31, 2011
	(in thousands)
Obligations of U.S. government corporations and agencies	$	17,655	$	878	$	—		$	18,533
Mortgage-backed securities		33,420		1,143		(17	)		34,546
Obligations of states and political subdivisions		43,640		2,159		(33	)		45,766
Corporate securities		12,421		707		(85	)		13,043
Equity securities		2,054		192		—			2,246
	$	109,190	$	5,079	$	(135	)	$	114,134

During the first nine months of 2012, the Company sold $2.1 million in available for sale securities for a net gain of $15 thousand. During the first nine months of 2011, the Company sold $4.8 million in available for sale securities for a net gain of $155 thousand.

8

The fair value and gross unrealized losses for securities available for sale, totaled by the length of time that individual securities have been in a continuous gross unrealized loss position, at September 30, 2012 and December 31, 2011 were as follows:

	Less than 12 months				12 months or more				Total
	Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses
	September 30, 2012
	(in thousands)
Obligations of U.S. government corporations and agencies	$	—	$	—	$	—	$	—	$	—	$	—
Mortgage-backed securities		—		—		—		—		—		—
Obligations of states and political subdivisions		1,098		13		273		10		1,371		23
Corporate securities		—		—		—		—		—		—
Equity securities		—		—		—		—		—		—
	$	1,098	$	13	$	273	$	10	$	1,371	$	23
	December 31, 2011
	(in thousands)
Obligations of U.S. government corporations and agencies	$	—	$	—	$	—	$	—	$	—	$	—
Mortgage-backed securities		4,003		17		—		—		4,003		17
Obligations of states and political subdivisions		282		2		294		31		576		33
Corporate securities		1,913		85		—		—		1,913		85
Equity securities		—		—		—		—		—		—
	$	6,198	$	104	$	294	$	31	$	6,492	$	135

Gross unrealized losses on available for sale securities included three (3) and nine (9) debt securities at September 30, 2012 and December 31, 2011, respectively. The Company evaluates securities for other-than-temporary impairment on at least a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. The Company’s mortgage-backed securities are issued by U.S. government agencies, which guarantee payments to investors regardless of the status of the underlying mortgages. Consideration is given to the length of time and the amount of an unrealized loss, the financial condition of the issuer, and the intent and ability of the Company to retain its investment in the issuer long enough to allow for an anticipated recovery in fair value. The fair value of a security reflects its liquidity as compared to similar instruments, current market rates on similar instruments, and the creditworthiness of the issuer. Absent any change in the liquidity of a security or the creditworthiness of the issuer, prices will decline as market rates rise and vice-versa. The primary cause of the unrealized losses at September 30, 2012 and December 31, 2011 was changes in market interest rates. Since the losses can be primarily attributed to changes in market interest rates and not expected cash flows or an issuer’s financial condition, the unrealized losses are deemed to be temporary. The Company’s holdings of corporate securities and equity securities represent investments in larger financial institutions. The current economic crisis involving housing, liquidity and credit were the primary causes of the unrealized losses on these securities at December 31, 2011. The Company monitors the financial condition of these issuers continuously and will record other-than-temporary impairment if the recovery of value is unlikely.

The Company’s securities are exposed to various risks, such as interest rate, market, currency and credit risks. Due to the level of risk associated with certain securities and the level of uncertainty related to changes in the value of securities, it is at least reasonably possible that changes in risks in the near term would materially affect securities reported in the financial statements. In addition, recent economic uncertainty and market events have led to unprecedented volatility in currency, commodity, credit and equity markets culminating in failures of some banking and financial services firms and government intervention to solidify others. These recent events underscore the level of investment risk associated with the current economic environment, and accordingly the level of risk in the Company’s securities.

Securities having a carrying value of $19.2 million at September 30, 2012 were pledged to secure securities sold under agreements to repurchase and other purposes required by law.

9

The composition of restricted investments at September 30, 2012 and December 31, 2011 was as follows:

	September 30, 2012		December 31, 2011
	(in thousands)
Federal Reserve Bank Stock	$	344	$	344
Federal Home Loan Bank Stock		2,293		3,036
Community Bankers’ Bank Stock		140		140
	$	2,777	$	3,520

NOTE 5. Allowance for Loan Losses

Changes in the allowance for loan losses for the nine months ended September 30, 2012 and 2011 and the year ended December 31, 2011 were as follows:

	Nine Months Ended September 30, 2012			Year Ended December 31, 2011			Nine Months Ended September 30, 2011
	(in thousands)
Balance, beginning	$	8,743		$	7,111		$	7,111
Provision charged to operating expense		1,650			3,750			2,850
Recoveries added to the allowance		215			848			568
Loan losses charged to the allowance		(2,647	)		(2,966	)		(2,638	)
Balance, ending	$	7,961		$	8,743		$	7,891

10

Nonaccrual and past due loans by class at September 30, 2012 and December 31, 2011 were as follows:

	As of September 30, 2012 (in thousands)
	30 - 59 Days Past Due		60 - 89 Days Past Due		90 or More Days Past Due		Total Past Due		Current		Total Loans		90 or More Days Past Due Still Accruing		Nonaccrual Loans
Commercial - Non Real Estate:
Commercial & Industrial	$	53	$	122	$	—	$	175	$	20,111	$	20,286	$	—	$	10
Commercial Real Estate:
Owner occupied		1,145		—		592		1,737		88,974		90,711		—		733
Non-owner occupied		1,176		371		—		1,547		38,014		39,561		—		660
Construction and Farmland:
Residential		—		—		—		—		11,824		11,824		—		—
Commercial		27		—		638		665		28,681		29,346		—		776
Consumer:
Installment		150		31		10		191		13,157		13,348		10		—
Residential:
Equity lines		243		390		—		633		32,141		32,774		—		443
Single family		1,369		1,171		101		2,641		181,078		183,719		—		2,469
Multifamily		—		—		—		—		2,811		2,811		—		—
All Other Loans		50		—		—		50		3,069		3,119		—		—
Total	$	4,213	$	2,085	$	1,341	$	7,639	$	419,860	$	427,499	$	10	$	5,091
	As of December 31, 2011 (in thousands)
	30 - 59 Days Past Due		60 - 89 Days Past Due		90 or More Days Past Due		Total Past Due		Current		Total Loans		90 or More Past Due Still Accruing		Nonaccrual Loans
Commercial - Non Real Estate:
Commercial & Industrial	$	114	$	421	$	—	$	535	$	22,331	$	22,866	$	—	$	—
Commercial Real Estate:
Owner occupied		174		9		447		630		82,476		83,106		—		600
Non-owner occupied		873		1,102		—		1,975		32,962		34,937		—		234
Construction and Farmland:
Residential		—		—		—		—		10,594		10,594		—		151
Commercial		—		—		—		—		24,375		24,375		—		—
Consumer:
Installment		114		13		5		132		13,053		13,185		5		—
Residential:
Equity Lines		217		30		—		247		33,182		33,429		—		177
Single family		2,187		194		717		3,098		176,111		179,209		89		1,287
Multifamily		—		—		—		—		4,517		4,517		—		—
All Other Loans		—		—		—		—		4,206		4,206		—		—
Total	$	3,679	$	1,769	$	1,169	$	6,617	$	403,807	$	410,424	$	94	$	2,449

11

Allowance for loan losses by segment at September 30, 2012 and December 31, 2011 were as follows:

	As of and for the Nine Months Ended September 30, 2012 (in thousands)
	Construction and Farmland			Residential Real Estate			Commercial Real Estate			Commercial			Consumer			All Other Loans			Unallocated			Total
Allowance for credit losses:
Beginning Balance	$	2,618		$	3,544		$	1,057		$	1,077		$	131		$	123		$	193		$	8,743
Charge-Offs		(1,303	)		(508	)		(660	)		(50	)		(103	)		(23	)		—			(2,647	)
Recoveries		3			60			58			30			57			7			—			215
Provision		212			361			1,681			(216	)		35			6			(429	)		1,650
Ending balance	$	1,530		$	3,457		$	2,136		$	841		$	120		$	113		$	(236	)	$	7,961
Ending balance: Individually evaluated for impairment	$	141		$	2,005		$	740		$	475		$	—		$	—		$	—		$	3,361
Ending balance: collectively evaluated for impairment	$	1,389		$	1,452		$	1,396		$	366		$	120		$	113		$	(236	)	$	4,600
Financing receivables:
Ending balance	$	41,170		$	219,304		$	130,272		$	20,286		$	13,348		$	3,119		$	—		$	427,499
Ending balance individually evaluated for impairment	$	1,982		$	8,823		$	6,220		$	713		$	—		$	—		$	—		$	17,738
Ending balance collectively evaluated for impairment	$	39,188		$	210,481		$	124,052		$	19,573		$	13,348		$	3,119		$	—		$	409,761
	As of and for the Twelve Months Ended December 31, 2011 (in thousands)
	Construction and Farmland			Residential Real Estate			Commercial Real Estate			Commercial			Consumer			All Other Loans			Unallocated			Total
Allowance for credit losses:
Beginning Balance	$	1,386		$	3,457		$	1,231		$	819		$	182		$	36		$	—		$	7,111
Charge-Offs		(721	)		(1,203	)		(14	)		(572	)		(331	)		(125	)		—			(2,966	)
Recoveries		5			298			2			292			195			56			—			848
Provision		1,948			992			(162	)		538			85			156			193			3,750
Ending balance	$	2,618		$	3,544		$	1,057		$	1,077		$	131		$	123		$	193		$	8,743
Ending balance: Individually evaluated for impairment	$	1,468		$	2,071		$	150		$	544		$	—		$	—		$	—		$	4,233
Ending balance: collectively evaluated for impairment	$	1,150		$	1,473		$	907		$	533		$	131		$	123		$	193		$	4,510
Financing receivables:
Ending balance	$	34,969		$	217,155		$	118,043		$	22,866		$	13,185		$	4,206		$	—		$	410,424
Ending balance individually evaluated for impairment	$	3,357		$	9,748		$	6,186		$	599		$	—		$	—		$	—		$	19,890
Ending balance collectively evaluated for impairment	$	31,612		$	207,407		$	111,857		$	22,267		$	13,185		$	4,206		$	—		$	390,534

12

Impaired loans by class at September 30, 2012 and December 31, 2011 were as follows:

	As of September 30, 2012 (in thousands)
	Unpaid Principal Balance		Recorded Investment		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance:
Commercial - Non Real Estate:
Commercial & Industrial	$	—	$	—	$	—	$	—	$	—
Commercial Real Estate:
Owner occupied		2,129		2,134		—		3,224		110
Non-owner occupied		2,121		2,127		—		2,139		102
Construction and Farmland:
Residential		—		—		—		—		—
Commercial		1,757		1,759		—		2,423		38
Residential:
Equity lines		167		167		—		189		—
Single family		3,847		3,856		—		4,164		108
Multifamily		—		—		—		—		—
All Other Loans		—		—		—		—		—
	$	10,021	$	10,043	$	—	$	12,139	$	358
With an allowance recorded:
Commercial - Non Real Estate:
Commercial & Industrial	$	713	$	718	$	475	$	744	$	31
Commercial Real Estate:
Owner occupied		—		—		—		—		—
Non-owner occupied		1,970		1,973		740		1,980		37
Construction and Farmland:
Residential		—		—		—		—		—
Commercial		225		226		141		227		7
Residential:
Equity lines		615		617		344		621		8
Single family		4,194		4,202		1,661		4,354		164
Multifamily		—		—		—		—		—
All Other Loans		—		—		—		—		—
	$	7,717	$	7,736	$	3,361	$	7,926	$	247
Total:
Commercial	$	713	$	718	$	475	$	744	$	31
Commercial Real Estate		6,220		6,234		740		7,343		249
Construction and Farmland		1,982		1,985		141		2,650		45
Residential		8,823		8,842		2,005		9,328		280
Other		—		—		—		—		—
Total	$	17,738	$	17,779	$	3,361	$	20,065	$	605

The average recorded investment of impaired loans for the three month period ended September 30, 2012 was $19.7 million. The interest income recognized on impaired loans for the three months ended September 30, 2012 was $210 thousand.

13

	As of December 31, 2011 (in thousands)
	Unpaid Principal Balance		Recorded Investment		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance:
Commercial - Non Real Estate:
Commercial & Industrial	$	5	$	5	$	—	$	2	$	—
Commercial Real Estate:
Owner occupied		2,521		2,529		—		2,575		132
Non-owner occupied		2,552		2,567		—		2,623		110
Construction and Farmland:
Residential		—		—		—		—		—
Commercial		361		361		—		466		21
Residential:
Equity lines		177		177		—		190		—
Single family		3,237		3,242		—		3,840		97
Multifamily		—		—		—		—		—
All Other Loans		—		—		—		—		—
	$	8,853	$	8,881	$	—	$	9,696	$	360
With an allowance recorded:
Commercial - Non Real Estate:
Commercial & Industrial	$	594	$	600	$	544	$	602	$	26
Commercial Real Estate:
Owner occupied		—		—		—		—		—
Non-owner occupied		1,112		1,124		150		1,128		64
Construction and Farmland:
Residential		—		—		—		—		—
Commercial		2,997		3,006		1,468		3,012		147
Residential:
Equity lines		402		404		325		404		13
Single family		5,932		5,940		1,746		6,029		236
Multifamily		—		—		—		—		—
All Other Loans		—		—		—		—		—
	$	11,037	$	11,074	$	4,233	$	11,175	$	486
Total:
Commercial	$	599	$	605	$	544	$	604	$	26
Commercial Real Estate		6,185		6,220		150		6,326		306
Construction and Farmland		3,358		3,367		1,468		3,478		168
Residential		9,748		9,763		2,071		10,463		346
Other		—		—		—		—		—
Total	$	19,890	$	19,955	$	4,233	$	20,871	$	846

When the ultimate collectability of the total principal of an impaired loan is in doubt and the loan is in nonaccrual status, all payments are applied to principal under the cost-recovery method. For financial statement purposes, the recorded investment in nonaccrual loans is the actual principal balance reduced by payments that would otherwise have been applied to interest. When reporting information on these loans to the applicable customers, the unpaid principal balance is reported as if payments were applied to principal and interest under the original terms of the loan agreements. Therefore, the unpaid principal balance reported to the customer would be higher than the recorded investment in the loan for financial statement purposes. When the ultimate collectability of the total principal of the impaired loan is not in doubt and the loan is in nonaccrual status, contractual interest is credited to interest income when received under the cash-basis method.

14

The Company uses a rating system for evaluating the risks associated with non-consumer loans. Consumer loans are not evaluated for risk unless the characteristics of the loan fall within classified categories. Descriptions of these ratings are as follows:

Pass	Pass loans exhibit acceptable operating trends, balance sheet trends, and liquidity. Sufficient cash flow exists to service the loan. All obligations have been paid by the borrower in an as agreed manner.
Watch	Watch loans exhibit income volatility, negative operating trends, and a highly leveraged balance sheet. A higher level of supervision is required for these loans as the potential for a negative event could impact the borrower’s ability to repay the loan.
Special mention	Special mention loans exhibit a potential weakness, if left uncorrected, may negatively affect the borrower’s ability to repay its debt obligation. The risk of default is not imminent and the borrower still demonstrates sufficient cash flow to support the loan.
Substandard	Substandard loans exhibit well defined weaknesses and have a potential of default. The borrowers exhibit adverse financial trends but still have the ability to service debt obligations.
Doubtful	Doubtful loans exhibit all of the characteristics inherent in substandard loans but the weaknesses make collection or full liquidation highly questionable.
Loss	Loss loans are considered uncollectible and of such little value that its continuance as a bankable asset is not warranted.

Credit quality information by class at September 30, 2012 and December 31, 2011 was as follows:

	As of September 30, 2012 (in thousands)
INTERNAL RISK RATING GRADES	Pass		Watch		Special Mention		Substandard		Doubtful		Loss		Total
Commercial-Non Real Estate:
Commercial & Industrial	$	15,197	$	2,435	$	599	$	2,055	$	—	$	—	$	20,286
Commercial Real Estate:
Owner Occupied		73,826		6,592		5,776		3,784		733		—		90,711
Non-owner occupied		23,927		5,335		2,085		7,843		371		—		39,561
Construction and Farmland:
Residential		11,416		408		—		—		—		—		11,824
Commercial		21,458		2,042		797		4,410		639		—		29,346
Residential:
Equity Lines		31,150		251		194		931		248		—		32,774
Single family		150,445		9,674		11,496		11,582		522		—		183,719
Multifamily		1,904		907		—		—		—		—		2,811
All other loans		3,119		—		—		—		—		—		3,119
Total	$	332,442	$	27,644	$	20,947	$	30,605	$	2,513	$	—	$	414,151

	Performing		Nonperforming
Consumer Credit Exposure by Payment Activity	$	13,157	$	191

15

	As of December 31, 2011 (in thousands)
INTERNAL RISK RATING GRADES	Pass		Watch		Special Mention		Substandard		Doubtful		Loss		Total
Commercial-Non Real Estate:
Commercial & Industrial	$	16,960	$	2,668	$	991	$	2,215	$	32	$	—	$	22,866
Commercial Real Estate:
Owner Occupied		65,651		6,613		5,759		4,641		442		—		83,106
Non-owner occupied		21,573		6,688		1,330		5,113		233		—		34,937
Construction and Farmland:
Residential		9,839		—		755		—		—		—		10,594
Commercial		15,990		1,657		2,595		4,029		104		—		24,375
Residential:
Equity Lines		31,862		227		355		985		—		—		33,429
Single family		150,520		5,939		10,249		11,134		1,367		—		179,209
Multifamily		2,320		1,230		967		—		—		—		4,517
All other loans		3,485		—		721		—		—		—		4,206
Total	$	318,200	$	25,022	$	23,722	$	28,117	$	2,178	$	—	$	397,239

	Performing		Nonperforming
Consumer Credit Exposure by Payment Activity	$	13,053	$	132

NOTE 6. Troubled Debt Restructurings

All loans deemed a troubled debt restructuring, or “TDR”, are considered impaired, and are evaluated for collateral and cash-flow sufficiency. A loan is considered a TDR when the Company, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that the Company would not otherwise consider. All of the following factors are indicators that the Bank has granted a concession (one or multiple items may be present):

• The borrower receives a reduction of the stated interest rate to a rate less than the institution is willing to accept at the time of the restructure for a new loan with comparable risk.

• The borrower receives an extension of the maturity date or dates at a stated interest rate lower than the current market interest rate for new debt with similar risk characteristics.

• The borrower receives a reduction of the face amount or maturity amount of the debt as stated in the instrument or other agreement.

• The borrower receives a deferral of required payments (principal and/or interest).

• The borrower receives a reduction of the accrued interest.

There were twenty-four (24) troubled debt restructured loans totaling $8.4 million at September 30, 2012. At December 31, 2011, there were twenty-five (25) troubled debt restructured loans totaling $10.7 million. There were no outstanding commitments to lend additional amounts to troubled debt restructured borrowers at September 30, 2012.

16

The following tables set forth information on the Company’s troubled debt restructurings by class of financing receivable occurring during the stated periods:

	Three Months Ended September 30, 2012 (in thousands)								Three Months Ended September 30, 2011 (in thousands)
	Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Impairment Accrued		Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Impairment Accrued
Construction and Farmland:
Commercial		1	$	95	$	95	$	—		—	$	—	$	—	$	—
Residential:
Single family		—		—		—		—		1		72		74		19
Total		1	$	95	$	95	$	—		1	$	72	$	74	$	19
	Nine Months Ended September 30, 2012 (in thousands)								Nine Months Ended September 30, 2011 (in thousands)
	Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Impairment Accrued		Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Impairment Accrued
Commercial Real Estate:
Owner occupied		1	$	162	$	162	$	—		—	$	—	$	—	$	—
Non-owner occupied		—		—		—		—		1		890		890		—
Construction and Farmland:
Residential		—		—		—		—		1		1,530		1,530		—
Commercial		1		95		95		—		—		—		—		—
Residential:
Single family		1		91		91		—		6		2,713		2,767		—
Total		3	$	348	$	348	$	—		8	$	5,133	$	5,187	$	—

During the three months ended September 30, 2012, the Company restructured one loan by granting concessions to a borrower experiencing financial difficulties. One construction and farmland loan was modified by changing the amortization period to reduce the payment amount. During the nine months ended September 30, 2012, the Company restructured three loans by granting concessions to borrowers experiencing financial difficulties. One residential loan was modified by granting an interest rate reduction. In addition, one owner occupied commercial real estate loan and one construction and farmland loan were modified by changing the amortization period to reduce the payment amount.

During the three months ended September 30, 2011, the Company restructured one loan by granting concessions to a borrower experiencing financial difficulties. A residential loan was modified by granting an interest rate reduction. During the nine months ended September 30, 2011, the Company restructured eight loans by granting concessions to borrowers experiencing financial difficulties. Two commercial real estate loans were combined into the one restructured commercial real estate loan reflected in the table above. Monthly payments on this loan were converted from principal and interest to interest only. The residential construction loan was modified by granting a reduction in the required monthly payment. Six single family residential loans were modified during the nine months ended September 30, 2011. Three of the loans were modified by granting interest rate reductions, another two had payment requirements modified from principal and interest to interest only while the remaining loan was modified by granting a reduction in the required monthly payment.

17

Loans by class of financing receivable modified as TDRs within the previous 12 months and for which there was a payment default during the stated periods were:

	Three Months Ended
	September 30, 2012				September 30, 2011
			(in thousands)
	Number of Contracts		Recorded Investment		Number of Contracts		Recorded Investment
Commercial Real Estate:
Non-owner occupied		1	$	93		—	$	—
Residential:
Single family		3		512		3		983
Total		4	$	605		3	$	983
	Nine Months Ended
	September 30, 2012				September 30, 2011
			(in thousands)
	Number of Contracts		Recorded Investment		Number of Contracts		Recorded Investment
Commercial Real Estate:
Owner occupied		—	$	—		2	$	613
Non-owner occupied		1		93		—		—
Residential:
Single family		4		870		5		1,904
Total		5	$	963		7	$	2,517

A loan is considered to be in payment default once it is thirty days contractually past due under the modified terms.

NOTE 7. Deposits

The composition of deposits at September 30, 2012 and December 31, 2011 was as follows:

	September 30, 2012		December 31, 2011
	(in thousands)
Noninterest bearing demand deposits	$	122,093	$	107,237
Savings and interest bearing demand deposits:
NOW accounts	$	83,477	$	78,927
Money market accounts		82,962		83,393
Regular savings accounts		53,545		47,838
	$	219,984	$	210,158
Time deposits:
Balances of less than $100,000	$	70,193	$	76,956
Balances of $100,000 and more		44,908		54,114
	$	115,101	$	131,070
	$	457,178	$	448,465

18

NOTE 8. Pension and Postretirement Benefit Plans

Effective December 31, 2006, the pension plan was amended and frozen so that no further benefits will accrue under the plan and no additional employees may become participants. The pension plan was terminated effective September 30, 2011 and after receiving final approval from the Internal Revenue Service, distributions in the form of lump-sum cash payments to plan participants, rollovers and purchasing annuity contracts were completed on December 19, 2011. No defined benefit pension plan expenses are projected going forward.

The Company provides certain health care and life insurance benefits for nine retired employees who have met certain eligibility requirements. All other employees retiring after reaching age 65 and having at least 15 years of service with the Company will be allowed to stay on the Company’s group life and health insurance policies, but will be required to pay premiums. The Company’s share of the estimated costs that will be paid after retirement is generally being accrued by charges to expense over the employees’ active service periods to the dates they are fully eligible for benefits, except that the Company’s unfunded cost that existed at January 1, 1993 is being accrued primarily in a straight-line manner that will result in its full accrual by December 31, 2013.

Generally Accepted Accounting Principles (“GAAP”) requires the Company to recognize the funded status (i.e. the difference between the fair value of plan assets and the projected benefit obligations) of its postretirement benefit plan in the consolidated balance sheet, with a corresponding adjustment to accumulated other comprehensive income, net of taxes.

Net periodic benefit costs of the postretirement benefit plan for the three months ended September 30, 2012 and 2011 were ($1) thousand. Net periodic benefit costs of the postretirement benefit plan for the nine months ended September 30, 2012 and 2011 were ($3) thousand.

NOTE 9. Trust Preferred Capital Notes

In September 2007, Eagle Financial Statutory Trust II (the “Trust II”), a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable capital securities. On September 20, 2007, Trust II issued $7,000,000 of trust preferred securities and $217,000 in common equity. The principal asset of Trust II is $7,217,000 of the Company’s junior subordinated debt securities with the same maturity and interest rate structures as the capital securities. The securities have a LIBOR-indexed floating rate of interest and the interest rate at September 30, 2012 was 2.04%. The securities have a mandatory redemption date of September 1, 2037, and were subject to varying call provisions beginning September 1, 2012. The Company does not expect to exercise any call provisions in the foreseeable future.

The trust preferred securities are included in Tier 1 capital for regulatory capital adequacy purposes as long as their amount does not exceed 25% of Tier 1 capital, including total trust preferred securities. The portion of the trust preferred securities not considered as Tier 1 capital, if any, may be included in Tier 2 capital. At September 30, 2012, the total amount ($7,000,000) of trust preferred securities issued by Trust II is included in the Company’s Tier 1 capital.

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

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

19

NOTE 10. Fair Value Measurements

GAAP requires the Company to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. The fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

“Fair Value Measurements” defines fair value, establishes a framework for measuring fair value, establishes a three-level valuation hierarchy for disclosure of fair value measurement and enhances disclosure requirements for fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:

•   Level 1	Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
•   Level 2	Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
•   Level 3	Inputs to the valuation methodology are unobservable and significant to the fair value measurement.

The following sections provide a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy:

Securities Available for Sale: Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flow. Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.

Interest Rate Swap: The fair value is estimated by a third party using inputs that are observable or that can be corroborated by observable market data, and therefore, are classified within Level 2 of the valuation hierarchy.

20

The following table presents balances of financial assets and liabilities measured at fair value on a recurring basis at September 30, 2012 and December 31, 2011:

			Fair Value Measurements at September 30, 2012 Using
	Balance as of September 30, 2012		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
			(Level 1)		(Level 2)		(Level 3)
			(in thousands)
Assets:
Securities available for sale
Obligations of U.S. government corporations and agencies	$	16,726	$	—	$	16,726	$	—
Mortgage-backed securities		26,209		—		26,209		—
Obligations of states and political subdivisions		43,842		—		43,842		—
Corporate securities		12,145		—		12,145		—
Equity securities:
Bank preferred stock		2,264		2,264		—		—
Total assets at fair value	$	101,186	$	2,264	$	98,922	$	—
Liabilities:
Interest rate swap		672		—		672		—
Total liabilities at fair value	$	672	$	—	$	672	$	—
			Fair Value Measurements at December 31, 2011 Using
	Balance as of December 31, 2011		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
			(Level 1)		(Level 2)		(Level 3)
			(in thousands)
Assets:
Securities available for sale
Obligations of U.S. government corporations and agencies	$	18,533	$	—	$	18,533	$	—
Mortgage-backed securities		34,546		—		34,546		—
Obligations of states and political subdivisions		45,766		—		45,766		—
Corporate securities		13,043				13,043
Equity securities:
Bank preferred stock		2,246		2,246		—		—
Total assets at fair value	$	114,134	$	2,246	$	111,888	$	—
Liabilities:
Interest rate swap		580		—		580		—
Total liabilities at fair value	$	580	$	—	$	580	$	—

21

Certain financial assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower of cost or market accounting or write downs of individual assets.

The following describes the valuation techniques used by the Company to measure certain financial and nonfinancial assets recorded at fair value on a nonrecurring basis in the financial statements:

Impaired Loans: Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due will not be collected according to the contractual terms of the loan agreement. The measurement of loss associated with impaired loans can be based on the observable market price of the loan, the fair value of the collateral securing the loan, or the present value of estimated future cash flows. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. Level 2 impaired loan value is determined by utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Level 3 impaired loan values are determined using inventory and accounts receivables collateral and are based on financial statement balances or aging reports. If the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old or has been discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and client’s business, then the fair value is considered Level 3. Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.

Other Real Estate Owned: Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lesser of the fair value of the property, less estimated selling costs or the loan balance outstanding at the date of foreclosure. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan losses. If there is a contract for the sale of a property, and management reasonably believes the contract will be executed, fair value is based on the sale price in that contract (Level 1). Lacking such a contract, the value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, then the fair value is considered Level 3. After foreclosure, valuations are periodically performed by management and property held for sale is carried at the lower of the new cost basis or fair value less cost to sell. Any subsequent valuation adjustments are applied to earnings in the consolidated statements of income. Impairment losses on property to be held and used are measured as the amount by which the carrying amount of a property exceeds its fair value. Costs of significant property improvements are capitalized, whereas costs relating to holding property are expensed. The portion of interest costs relating to development of real estate is capitalized. Valuations are periodically performed by management, and any subsequent write-downs are recorded as a charge to operations, if necessary, to reduce the carrying value of a property to the lower of its cost or fair value less cost to sell. We believe that the fair value component in its valuation follows the provisions of GAAP.

The following table displays quantitative information about Level 3 Fair Value Measurements for certain financial assets measured at fair value on a nonrecurring basis for September 30, 2012:

	Quantitative information about Level 3 Fair Value Measurements for  September 30, 2012
	Valuation Technique(s)	Unobservable Input	Range
Assets:
Impaired loans	Discounted appraised value	Selling cost	6% - 12%
Other real estate owned	Discounted appraised value	Selling cost	6% - 12%

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The following table summarizes the Company’s financial and nonfinancial assets that were measured at fair value on a nonrecurring basis at September 30, 2012 and December 31, 2011:

			Carrying value at September 30, 2012
	Balance as  of September 30, 2012		Identical Assets		Observable Inputs		Unobservable Inputs
			(Level 1)		(Level 2)		(Level 3)
			(in thousands)
Financial Assets:
Impaired loans	$	4,356	$	—	$	2,655	$	1,701
Nonfinancial Assets:
Other real estate owned		2,364		193		2,171		—
			Carrying value at December 31, 2011
	Balance as of December 31, 2011		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
			(Level 1)		(Level 2)		(Level 3)
			(in thousands)
Financial Assets:
Impaired loans	$	6,804	$	—	$	3,379	$	3,425
Nonfinancial Assets:
Other real estate owned		2,378		—		1,742		636

The changes in Level 3 financial assets measured at estimated fair value on a nonrecurring basis during the nine months ended September 30, 2012 were as follows:

	Fair Value Measurements at September 30, 2012
	Impaired Loans			Other Real Estate Owned
	(in thousands)
Balance - January 1, 2012	$	3,425		$	636
Sales proceeds		—			—
Valuation allowance		—			—
(Loss) on disposition		—			—
Transfers into Level 3		959			—
Transfers out of Level 3		(2,683	)		(636	)
Total assets at fair value	$	1,701		$	—

GAAP defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than through a forced or liquidation sale for purposes of this disclosure. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. The following methods and assumptions were used to estimate the fair value of the Company’s financial instruments:

Cash and short-term investments/accrued interest: The fair value was equal to the carrying amount.

Securities: The fair value, excluding restricted securities, was based on quoted market prices. The fair value of restricted securities approximated the carrying amount based on the redemption provisions of the issuers.

Loans: The fair value of variable rate loans, which reprice frequently and with no significant change in credit risk, was equal to the carrying amount. The fair value of all other loans was determined using discounted cash flow analysis. The discount rate was equal to the current interest rate on similar products.

23

Deposits and borrowings: The fair value of demand deposits, savings accounts, and certain money market deposits was equal to the carrying amount. The fair value of all other deposits and borrowings was determined using discounted cash flow analysis. The discount rate was equal to the current interest rate on similar products.

Off-balance-sheet financial instruments: The fair value of commitments to extend credit was estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the credit worthiness of the counterparties. The fair value of fixed rate loan commitments also considered the difference between current interest rates and the committed interest rates. The fair value of standby letters of credit was estimated using the fees currently charged for similar agreements or on the estimated cost to terminate or otherwise settle the obligations with the counterparties.

The carrying amount and fair value of the Company’s financial instruments at September 30, 2012 and December 31, 2011 were as follows:

	Fair Value Measurements at September 30, 2012 Using
	Carrying Value as of September 30, 2012		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs		Fair Value as of September 30, 2012
			(Level 1)		(Level 2)		(Level 3)
					(in thousands)
Financial Assets:
Cash and short-term investments	$	21,812	$	21,812	$	—	$	—	$	21,812
Securities		101,186		2,264		98,922		—		101,186
Restricted Investments		2,777		—		2,777		—		2,777
Loans, net		419,538		—		432,731		1,701		434,432
Accrued interest receivable		1,923		—		1,923		—		1,923
Financial Liabilities:
Deposits	$	457,178	$	—	$	458,504	$	—	$	458,504
Federal funds purchased and securities sold under agreements to repurchase		10,000		—		10,122		—		10,122
Federal Home Loan Bank advances		32,250		—		33,298		—		33,298
Trust preferred capital notes		7,217		—		7,217		—		7,217
Accrued interest payable		281		—		281		—		281
Interest rate swap contract		672		—		672		—		672
	December 31, 2011
	Carrying Value as of December 31, 2011				(in thousands)				Fair Value as of December 31, 2011
Financial assets:
Cash and short-term investments	$	21,941							$	21,941
Securities		114,134								114,134
Restricted Investments		3,520								3,520
Loans, net		401,681								418,230
Accrued interest receivable		2,037								2,037
Financial liabilities:
Deposits	$	448,465							$	449,990
Federal funds purchased and securities sold under agreements to repurchase		10,000								10,350
Federal Home Loan Bank advances		42,250								44,833
Trust preferred capital notes		7,217								7,217
Accrued interest payable		336								336
Interest rate swap contract		580								580

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

NOTE 11. Derivative Instruments and Hedging Activities

Interest Rate Swaps

The Company uses interest rate swaps to reduce interest rate risk and to manage interest expense. By entering into these agreements, the Company converts floating rate debt into fixed rate debt, or alternatively, converts fixed rate debt into floating rate debt. Interest differentials paid or received under the swap agreements are reflected as adjustments to interest expense. These interest rate swap agreements are derivative instruments that qualify for hedge accounting as discussed in Note 1. The notional amounts of the interest rate swaps are not exchanged and do not represent exposure to credit loss. In the event of default by a counterparty, the risk in these transactions is the cost of replacing the agreements at current market rates.

On December 4, 2008, the Company entered into an interest rate swap agreement related to the outstanding trust preferred capital notes. The swap agreement became effective on December 1, 2008. The notional amount of the interest rate swap was $7,000,000 and has an expiration date of December 1, 2016. Under the terms of the agreement, the Company pays interest quarterly at a fixed rate of 2.85% and receives interest quarterly at a variable rate of three month LIBOR. The variable rate resets on each interest payment date.

The following table summarizes the fair value of derivative instruments at September 30, 2012 and December 31, 2011:

	September 30, 2012				December 31, 2011
	Balance Sheet Location		Fair Value		Balance Sheet Location		Fair Value
			(dollars in thousands)
Derivatives designated as hedging instruments under GAAP
Interest rate swap contracts		Other Liabilities	$	672		Other Liabilities	$	580

The following tables present the effect of the derivative instrument on the Consolidated Balance Sheet at September 30, 2012 and 2011 and the Consolidated Statements of Income for the three and nine months ended September 30, 2012 and 2011:

	Three Months Ended September 30,
Derivatives in GAAP Cash Flow Hedging Relationships	Amount of Gain  (Loss) Recognized in OCI on Derivative (Effective Portion)				Location of Gain (Loss) Recognized in Income (Ineffective Portion)	Amount of Gain  (Loss) Recognized in Income (Ineffective Portion)
	2012		2011			2012		2011
	(dollars in thousands)					(dollars in thousands)
Interest rate swap contracts, net of tax	$	(25)	$	(195)	Not applicable	$	—	$	—
	Nine Months Ended September 30,
Derivatives in GAAP Cash Flow Hedging Relationships	Amount of Gain (Loss) Recognized in OCI on Derivative (Effective Portion)				Location of Gain (Loss) Recognized in Income (Ineffective Portion)	Amount of Gain (Loss) Recognized in Income (Ineffective Portion)
	2012		2011			2012		2011
	(dollars in thousands)					(dollars in thousands)
Interest rate swap contracts, net of tax	$	(61)	$	(270)	Not applicable	$	—	$	—

25

NOTE 12. New Branch Construction

On August 3, 2012, the Company entered into a $1.2 million contract to build its twelfth retail branch, located in Purcellville, Virginia. The branch is expected to be completed in early 2013.

NOTE 13. Recent Accounting Pronouncements

In April 2011, the FASB issued ASU 2011-03, “Transfers and Servicing (Topic 860) – Reconsideration of Effective Control for Repurchase Agreements.” The amendments in this ASU remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee and (2) the collateral maintenance implementation guidance related to that criterion. The amendments in this ASU are effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurement (Topic 820) – Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” This ASU is the result of joint efforts by the FASB and International Accounting Standards Board (IASB) to develop a single, converged fair value framework on how (not when) to measure fair value and what disclosures to provide about fair value measurements. The ASU is largely consistent with existing fair value measurement principles in U.S. GAAP (Topic 820), with many of the amendments made to eliminate unnecessary wording differences between U.S. GAAP and International Financial Reporting Standards (IFRS). The amendments are effective for interim and annual periods beginning after December 15, 2011 with prospective application. Early application is not permitted. The Company has included the required disclosures in its consolidated financial statements.

In June 2011, the FASB issued ASU 2011-05, “Comprehensive Income (Topic 220) – Presentation of Comprehensive Income.” The objective of this ASU is to improve the comparability, consistency and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income by eliminating the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amendments require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The single statement of comprehensive income should include the components of net income, a total for net income, the components of other comprehensive income, a total for other comprehensive income, and a total for comprehensive income. In the two-statement approach, the first statement should present total net income and its components followed consecutively by a second statement that should present all the components of other comprehensive income, a total for other comprehensive income, and a total for comprehensive income. The amendments do not change the items that must be reported in other comprehensive income, the option for an entity to present components of other comprehensive income either net of related tax effects or before related tax effects, or the calculation or reporting of earnings per share. The amendments in this ASU should be applied retrospectively. The amendments are effective for fiscal years and interim periods within those years beginning after December 15, 2011. Early adoption is permitted because compliance with the amendments is already permitted. The amendments do not require transition disclosures. The Company has included the required disclosures in its consolidated financial statements.

In September 2011, the FASB issued ASU 2011-08, “Intangible – Goodwill and Other (Topic 350) – Testing Goodwill for Impairment.” The amendments in this ASU permit an entity to first assess qualitative factors related to goodwill to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill test described in Topic 350. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. Under the amendments in this ASU, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. The amendments in this ASU are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity’s financial statements for the most recent annual or interim period have not yet been issued. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In December 2011, the FASB issued ASU 2011-11, “Balance Sheet (Topic 210) – Disclosures about Offsetting Assets and Liabilities.” This ASU requires entities to disclose both gross information and net information about both instruments and transactions eligible for offset in the balance sheet and instruments and transactions subject to an agreement similar to a master netting arrangement. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. The Company does not expect the adoption of ASU 2011-11 to have a material impact on its consolidated financial statements.

In December 2011, the FASB issued ASU 2011-12, “Comprehensive Income (Topic 220) – Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” The amendments are being made to allow the Board time to redeliberate whether to present on the face of the financial statements the effects of reclassifications out of accumulated other comprehensive income on the components of net income and other comprehensive income for all periods presented. While the Board is considering the operational concerns about the presentation requirements for reclassification adjustments and the needs of financial statement users for additional information about reclassification adjustments, entities should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect before ASU 2011-05. All other requirements in ASU 2011-05 are not affected by ASU 2011-12, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. Public entities should apply these requirements for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company has included the required disclosures in its consolidated financial statements.

26

In July 2012, the FASB issued ASU 2012-02, “Intangibles – Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment.” The amendments in this ASU apply to all entities that have indefinite-lived intangible assets, other than goodwill, reported in their financial statements. The amendments in this ASU provide an entity with the option to make a qualitative assessment about the likelihood that an indefinite-lived intangible asset is impaired to determine whether it should perform a quantitative impairment test. The amendments also enhance the consistency of impairment testing guidance among long-lived asset categories by permitting an entity to assess qualitative factors to determine whether it is necessary to calculate the asset’s fair value when testing an indefinite-lived intangible asset for impairment. The amendments are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted. The Company does not expect the adop