Edgar Filing: FAUQUIER BANKSHARES, INC.

form10q.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 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 March 31, 2013

o	Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from _____________to_____________

Commission File No.: 000-25805

Fauquier Bankshares, Inc.

(Exact name of registrant as specified in its charter)

Virginia		54-1288193
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

10 Courthouse Square, Warrenton, Virginia		20186
(Address of principal executive offices)		(Zip Code)

(540) 347-2700

(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 o

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 (Section 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 o

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 o

Accelerated filer o

Non-accelerated filer o

Smaller reporting company x

Indicate by check mark if the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)

Yes o No x

The registrant had 3,713,342 shares of common stock outstanding as of May 8, 2013.

FAUQUIER BANKSHARES, INC.

INDEX

Part I. FINANCIAL INFORMATION
		Page
Item 1.	Financial Statements	3

	Consolidated Balance Sheets as of March 31, 2013 (unaudited) and December 31, 2012	3

	Consolidated Statements of Income (unaudited) for the Three Months Ended March 31, 2013 and 2012	4

	Consolidated Statements of Comprehensive Income (unaudited) for the Three Months Ended March 31, 2013 and 2012	5

	Consolidated Statements of Changes in Shareholders’ Equity (unaudited) for the Three Months Ended March 31, 2013 and 2012	6

	Consolidated Statements of Cash Flows (unaudited) for the Three Months Ended March 31, 2013 and 2012	7

	Notes to Consolidated Financial Statements	8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	29

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	43

Item 4.	Controls and Procedures	43

Part II. OTHER INFORMATION

Item 1.	Legal Proceedings	43

Item 1A.	Risk Factors	43

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	43

Item 3.	Defaults Upon Senior Securities	43

Item 4.	Mine Safety Disclosures	43

Item 5.	Other Information	43

Item 6.	Exhibits	44

SIGNATURES		45

Part I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Fauquier Bankshares, Inc. and Subsidiaries

Consolidated Balance Sheets

	March 31,			December 31,
	2013			2012
(In thousands)	(Unaudited)			(Audited)
Assets
Cash and due from banks	$	4,495		$	4,684
Interest-bearing deposits in other banks		58,867			59,740
Federal funds sold		10			11
Securities available for sale		45,701			48,092
Restricted investments		2,138			2,337
Loans		449,679			451,366
Allowance for loan losses		(6,088	)		(6,258	)
Net loans		443,591			445,108
Bank premises and equipment, net		14,608			14,763
Accrued interest receivable		1,404			1,283
Other real estate owned, net of allowance		1,406			1,406
Bank-owned life insurance		12,138			12,038
Other assets		12,415			11,925
Total assets	$	596,773		$	601,387

Liabilities
Deposits:
Noninterest-bearing	$	85,225		$	89,264
Interest-bearing:
NOW accounts		183,705			191,039
Savings accounts and money market accounts		113,492			108,794
Time deposits		127,182			126,037
Total interest-bearing		424,379			425,870
Total deposits		509,604			515,134

Federal Home Loan Bank advances		28,185			28,200
Company-obligated mandatorily redeemable capital securities		4,124			4,124
Other liabilities		6,651			6,181
Commitments and contingencies		-			-
Total liabilities		548,564			553,639

Shareholders' Equity
Common stock, par value, $3.13; authorized 8,000,000 shares; issued and outstanding: 2013: 3,713,342 shares including 34,109 non-vested shares: 2012: 3,695,160 shares including 31,423 non-vested shares		11,516			11,467
Retained earnings		38,498			37,993
Accumulated other comprehensive income (loss), net		(1,805	)		(1,712	)
Total shareholders' equity		48,209			47,748
Total liabilities and shareholders' equity	$	596,773		$	601,387

See accompanying Notes to Consolidated Financial Statements.

Fauquier Bankshares, Inc. and Subsidiaries

Consolidated Statements of Income

(Unaudited)

For the Three Months Ended March 31, 2013 and 2012

(In thousands)	2013		2012
Interest Income
Interest and fees on loans	$	5,400	$	6,121
Interest and dividends on securities available for sale:
Taxable interest income		195		266
Interest income exempt from federal income taxes		61		61
Dividends		21		22
Interest on deposits in other banks		44		37
Total interest income		5,721		6,507

Interest Expense
Interest on deposits		584		815
Interest on Federal Home Loan Bank advances		245		247
Distribution on capital securities of subsidiary trusts		49		50
Total interest expense		878		1,112

Net interest income		4,843		5,395

Provision for loan losses		167		500

Net interest income after provision for loan losses		4,676		4,895

Other Income
Trust and estate income		338		342
Brokerage income		133		82
Service charges on deposit accounts		584		692
Other service charges, commissions and income		385		366
Gain on sale of securities		-		1
Total other income		1,440		1,483

Other Expenses
Salaries and benefits		2,395		2,703
Occupancy expense of premises		485		472
Furniture and equipment		267		276
Marketing expense		140		165
Legal, audit and consulting expense		305		257
Data processing expense		321		312
Federal Deposit Insurance Corporation expense		136		117
Loss on sale or impairment and expense of other real estate owned, net		1		5
Other operating expenses		791		804
Total other expenses		4,841		5,111

Income before income taxes		1,275		1,267

Income tax expense		313		313

Net Income	$	962	$	954
(In dollars)
Earnings per Share, basic	$	0.26	$	0.26

Earnings per Share, assuming dilution	$	0.26	$	0.26

Dividends per Share	$	0.12	$	0.12

See accompanying Notes to Consolidated Financial Statements.

Fauquier Bankshares, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(Unaudited)

For the Three Months Ended March 31, 2013 and 2012

(In thousands)	2013			2012
Net Income	$	962		$	954
Other comprehensive income, net of tax:
Interest rate swap, net of tax effect of $(17) in 2013 and $81 in 2012		34			(157	)
Change in fair value of securities available-for-sale net of tax effect of $65 in 2013 and $29 in 2012		(127	)		(56	)
Total other comprehensive income (loss), net of tax of $48 in 2013 and $110 in 2012		(93	)		(213	)
Comprehensive Income	$	869		$	741

See accompanying Notes to Consolidated Financial Statements

Fauquier Bankshares, Inc. and Subsidiaries

Consolidated Statements of Changes in Shareholders' Equity

For the Three Months Ended March 31, 2013 and 2012

(In thousands)	Common Stock		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total
Balance, December 31, 2011	$	11,384	$	37,504		$	(1,317)		$	47,571
Net income				954						954
Other comprehensive income net of tax effect of $110							(213	)		(213	)
Cash dividends ($.12 per share)				(443	)					(443	)
Amortization of unearned compensation, restricted stock awards				34						34
Issuance of common stock – non-vested shares (13,074 shares)		41		(41	)					-
Issuance of common stock - vested shares (13,477 shares)		42		111						153
Balance, March 31, 2012	$	11,467	$	38,119		$	(1,530	)	$	48,056

Balance, December 31, 2012	$	11,467		37,993			(1,712	)		47,748
Net income				962						962
Other comprehensive income net of tax effect of $48							(93	)		(93	)
Cash dividends ($.12 per share)				(446	)					(446	)
Amortization of unearned compensation, restricted stock awards				39						39
Issuance of common stock – non-vested shares (9,784 shares)		31		(31	)					-
Issuance of common stock - vested shares (5,712 shares)		18		50						68
Tax benefit of restricted stock grant		-		(69	)					(69	)
Balance, March 31, 2013	$	11,516	$	38,498		$	(1,805	)	$	48,209

See accompanying Notes to Consolidated Financial Statements

Fauquier Bankshares, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

For the Three Months Ended March 31, 2013 and 2012

(Unaudited)

(In thousands)	2013			2012
Cash Flows from Operating Activities
Net income	$	962		$	954
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		281			280
Provision for loan losses		167			500
(Gain) loss on interest rate swaps		(9	)		-
(Gain) on sale and call of securities		-			(1	)
Amortization of security premiums, net		34			6
Amortization of unearned compensation, net of forfeiture		39			34
Tax benefit of vested stock grant		(69	)		-
Changes in assets and liabilities:
(Increase) in other assets		(657	)		(115	)
Increase (decrease) in other liabilities		546			(1,166	)
Net cash provided by operating activities		1,294			492

Cash Flows from Investing Activities
Proceeds from maturities, calls and principal payments of securities available for sale		7,737			3,947
Purchase of securities available for sale		(5,573	)		(12,899	)
Purchase of premises and equipment		(126	)		(568	)
Redemptions (purchases) of restricted securities		199			(14	)
Net decrease in loans		1,299			1,248
Proceeds from sale of other real estate owned		-			-
Net cash provided by (used in) investing activities		3,536			(8,286	)

Cash Flows from Financing Activities
Net increase (decrease) in demand deposits, NOW accounts and savings accounts		(6,675	)		(6,571	)
Net increase (decrease) in certificates of deposit		1,145			(12,820	)
Decrease in FHLB advances		15			-
Cash dividends paid on common stock		(446	)		(443	)
Issuance of common stock		68			153
Net cash (used in) financing activities		(5,893	)		(19,681	)

(Decrease) in cash and cash equivalents		(1,063	)		(27,475	)

Cash and Cash Equivalents
Beginning		64,435			72,160

Ending	$	63,372		$	44,685

Supplemental Disclosures of Cash Flow Information
Cash payments for:
Interest	$	867		$	1,105

Income taxes	$	-		$	-

Supplemental Disclosures of Noncash Investing Activities
Unrealized (loss) on securities available for sale, net of tax effect	$	(127	)	$	(56	)
Unrealized gain (loss) on interest rate swap, net of taxes	$	34		$	(157	)

See accompanying Notes to Consolidated Financial Statements.

Index

FAUQUIER BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

Note 1.

General

The consolidated financial statements include the accounts of Fauquier Bankshares, Inc. (“the Company”) and its wholly-owned subsidiaries: The Fauquier Bank (“the Bank”) and Fauquier Statutory Trust II; and the Bank's wholly-owned subsidiary, Fauquier Bank Services, Inc. In consolidation, significant intercompany financial balances and transactions have been eliminated. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial positions as of March 31, 2013 and December 31, 2012 and the results of operations for the three months ended March 31, 2013 and 2012. The notes included herein should be read in conjunction with the consolidated financial statements and accompanying notes included in the Company’s 2012 Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”).

The results of operations for the three months ended March 31, 2013 are not necessarily indicative of the results expected for the full year.

Recent Accounting Pronouncements

In December 2011, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“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 adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In July 2012, the FASB issued ASU 2012-02, “Intangibles-Goodwill and Other (Topic 350) – Testing Indefinite-Lived Intangible Assets for Impairment.” The objective of this amendment is to reduce the cost and complexity of performing an impairment test for indefinite-lived intangible assets by simplifying how an entity tests those assets for impairment and to improve consistency in impairment testing guidance among long-lived asset categories. The amendments permit an entity first to assess qualitative factors to determine whether it is more likely than not that an indefinite-lived tangible asset is impaired as a basis for determining whether it is necessary to perform the quantitive impairment test in accordance with Subtopic 350-30, Intangibles-Goodwill and Other-General Intangibles Other than Goodwill. The more-likely-than-not threshold is defined as having likelihood of more than 50 percent. Previous guidance in subtopic 350-30 required an entity to test indefinite-lived intangible assets for impairment, on at least an annual basis, by comparing the fair value of the asset with its carrying amount. If the carrying amount of the intangible asset exceeds its fair value, an entity should recognize an impairment loss in the amount of that excess. In accordance with the amendments in this ASU, an entity will have an option not to calculate annually the fair value of an indefinite-lived intangible asset if the entity determines that it is not more likely than not that asset is impaired. Permitting an entity to assess qualitative factors when testing indefinite-lived intangible assets for impairment results in guidance that is similar to the goodwill impairment testing guidance in ASU 2011-08. The amendments in this ASU are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted, including for annual and interim impairment tests performed as of a date before July 27, 2012, if a public entity’s financial statements for the most recent annual or interim period have not yet been issued. The Company does not expect the adoption of ASU 2012-12 to have an impact on its consolidated financial statements.

In January 2013, the FASB issued ASU 2013-01, “Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities.” The amendments in this ASU clarify the scope for derivatives accounted for in accordance with Topic 815, Derivatives and Hedging, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements and securities borrowing and securities lending transactions that are either offset or subject to netting arrangements. An entity is required to apply the amendments for fiscal years, and interim periods within those years, beginning on or after January 1, 2013. The adoption of the new guidance did not have a material impact on the Company's consolidated financial statements.

In February 2013, the FASB issued ASU 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” The amendments in this ASU require an entity to present (either on the face of the statement where net income is presented or in the notes) the effects on the line items of net income of significant amounts reclassified out of accumulated other comprehensive income. In addition, the amendments require a cross-reference to other disclosures currently required for other reclassification items to be reclassified directly to net income in their entirety in the same reporting period. Companies should apply these amendments for fiscal years, and interim periods within those years, beginning on or after December 15, 2012. The Company has included the required disclosures from ASU 2013-02 in the consolidated financial statements.

Index

Note 2.

Securities

The amortized cost and fair value of securities available for sale, with unrealized gains and losses follows:

	March 31, 2013
	Amortized		Gross Unrealized		Gross Unrealized
(In thousands)	Cost		Gains		(Losses)			Fair Value
Obligations of U.S. Government corporations and agencies	$	37,051	$	669	$	(26	)	$	37,694
Obligations of states and political subdivisions		6,785		547		-			7,332
Corporate bonds		3,826		-		(3,513	)		313
Mutual funds		348		14		-			362
	$	48,010	$	1,230	$	(3,539	)	$	45,701

	December 31, 2012
		Amortized	Gross Unrealized		Gross Unrealized
	Cost		Gains		(Losses)			Fair Value
Obligations of U.S. Government corporations and agencies	$	39,240	$	794	$	(20	)	$	40,014
Obligations of states and political subdivisions		6,786		604		-			7,390
Corporate bonds		3,836		-		(3,511	)		325
Mutual funds		346		17		-			363
	$	50,208	$	1,415	$	(3,531	)	$	48,092

The amortized cost and fair value of securities available for sale, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations without penalties.

	March 31, 2013
(In thousands)	Amortized Cost		Fair Value
Due in one year or less	$	-	$	-
Due after one year through five years		11,051		11,088
Due after five years through ten years		11,958		12,588
Due after ten years		24,653		21,663
Equity securities		348		362
	$	48,010	$	45,701

There were no impairment losses on securities during the quarters ended March 31, 2013 and 2012.

During the three months ended March 31, 2013 and 2012, no securities were sold. During the three months ended March 31, 2013, four securities were called totaling a fair value of $5.0 million. During the three months ended March 31, 2012, two securities were called, totaling a fair value of $2.0 million.

Index

Notes to Consolidated Financial Statements

The following table shows the Company securities with gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2013 and December 31, 2012, respectively.

(In thousands)	Less than 12 Months					12 Months or More					Total
March 31, 2013	Fair Value		Unrealized (Losses)			Fair Value		Unrealized (Losses)			Fair Value		Unrealized (Losses)

Obligations of U.S. Government, corporations and agencies	$	7,508	$	(26	)	$	-	$	-		$	7,508	$	(26	)
Corporate bonds		-		-			313		(3,513	)		313		(3,513	)
Total temporary impaired securities	$	7,508	$	(26	)	$	313	$	(3,513	)	$	7,821	$	(3,539	)

	Less than 12 Months					12 Months or More					Total
December 31, 2012	Fair Value			Unrealized (Losses)		Fair Value		Unrealized (Losses)			Fair Value		Unrealized (Losses)

Obligations of U.S. Government, corporations and agencies	$	2,165	$	(20	)	$	-	$	-		$	2,165	$	(20	)
Corporate bonds		-		-			325		(3,511	)		325		(3,511	)
Total temporary impaired securities	$	2,165	$	(20	)	$	325	$	(3,511	)	$	2,490	$	(3,531	)

The nature of securities which were temporarily impaired for a continuous 12 month period or more at March 31, 2013 consisted of four corporate bonds with a cost basis net of other-than-temporary impairment (“OTTI”) totaling $3.8 million and a temporary loss of approximately $3.5 million. The method for valuing these four corporate bonds came from Moody's Analytics. Moody’s Analytics employs a two-step discounted cash-flow valuation process. The first step is to evaluate the financial condition of the individual creditors in order to estimate the credit quality of the collateral pool and the structural supports. Step two is to apply a discount rate to the cash flows to calculate a value. These four corporate bonds are the “Class B” or subordinated “mezzanine” tranche of pooled trust preferred securities. The trust preferred securities are collateralized by the interest and principal payments made on trust preferred capital offerings by a geographically diversified pool of approximately 60 different financial institutions per bond. They have an estimated maturity of 25 years. These bonds could have been called at par on the five year anniversary date of issuance, which has already passed for all four bonds. The bonds reprice every three months at a fixed rate index above the three-month London Interbank Offered Rate (“LIBOR”). These bonds have sufficient collateralization and cash flow projections to satisfy their valuation based on the cash flow portion of the OTTI test under authoritative accounting guidance as of March 31, 2013. Three bonds totaling $79,000 at fair value, are greater than 90 days past due, and are classified as nonperforming corporate bond investments in the nonperforming asset table in Note 3. One bond totaling $234,000 has been performing for three consecutive quarters, is projected to repay the full outstanding interest and principal, and is now classified as a performing corporate bond investment.

Index

Notes to Consolidated Financial Statements

Additional information regarding each of the pooled trust preferred securities as of March 31, 2013 follows:

(Dollars in thousands)

Cost, net of OTTI loss		Fair Value		Percent of Underlying Collateral Performing			Percent of Underlying Collateral in Deferral			Percent of Underlying Collateral in Default			Estimated incremental defaults required to break yield (1)	Current Moody's Rating	Cumulative Amount of OTTI Loss		Cumulative Other Comprehensive Loss, net of tax benefit

$	361	$	32		65.2	%		6.8	%		28.0	%	broken	Ca	$	599	$	216
	1,600		234		68.3	%		15.3	%		16.4	%	8.6%	Ca		357		902
	1,303		28		64.0	%		28.2	%		7.8	%	broken	Ca		697		842
	562		19		66.0	%		23.0	%		11.0	%	broken	C		438		358
$	3,826	$	313												$	2,091	$	2,318

(1)

A break in yield for a given tranche investment means that defaults and/or deferrals have reached such a level that the specific tranche would not receive all of the contractual principal and interest cash flow by its maturity, resulting in not a temporary shortfall, but an actual loss. This column represents the percentage of additional defaults among the currently performing and deferred collateral that would result in OTTI loss.

The Company monitors these pooled trust preferred securities in its portfolio as to collateral, issuer defaults and deferrals, which as a general rule, indicate that additional impairment may have occurred. Due to the continued stress on banks in general, and the issuer banks in particular, as a result of overall economic conditions, the Company acknowledges that they may have to recognize additional impairment in future periods; however the extent, timing, and probability of any additional impairment cannot be reasonably estimated at this time.

The following roll forward reflects the amount related to credit losses recognized in earnings (in accordance with FASB Accounting Standards Codification (“ASC”) 320-10-35-34D):

(In thousands)

Beginning balance as of December 31, 2012	$	2,115
Add: Amount related to the credit loss for which an other-than- temporary impairment was not previously recognized		-
Add: Increases to the amount related to the credit loss for which an other-than temporary impairment was previously recognized		-
Less: Realized losses for securities sold		-
Less: Securities for which the amount previously recognized in other comprehensive income was recognized in earnings because the Company intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis.		-
Less: Increases in cash flows expected to be collected that are recognized over the remaining life of the security (See FASB ASC 320-10-35-35)		(24	)
Ending balance as of March 31, 2013	$	2,091

The carrying value of securities pledged to secure deposits and for other purposes amounted to $42.2 million and $41.5 million at March 31, 2013 and December 31, 2012, respectively.

Index

Notes to Consolidated Financial Statements

Note 3. Loans and Allowance for Loan Losses

Allowance for Loan Losses and Recorded Investment in Loans Receivable

	As of and for the Three Months Ended March 31, 2013
(In thousands)	Commercial and Industrial			Commercial Real Estate			Construction and Land		Consumer			Residential Real Estate			Home Equity Line of Credit			Unallocated		Total
Allowance for Loan Losses
Beginning balance at 12/31/2012	$	932		$	1,685		$	402	$	40		$	1,691		$	1,336		$	172	$	6,258
Charge-offs		(256	)		-			-		(47	)		-			(59	)		-		(362	)
Recoveries		8			-			-		17			-			-			-		25
Provision (recovery)		58			(16	)		4		15			(133	)		212			27		167
Ending balance at 3/31/2013	$	742		$	1,669		$	406	$	25		$	1,558		$	1,489		$	199	$	6,088

Ending balances individually evaluated for impairment	$	168		$	-		$	293	$	-		$	176		$	150		$	-	$	787

Ending balances collectively evaluated for impairment	$	574		$	1,669		$	113	$	25		$	1,382		$	1,339		$	199	$	5,301

Loans Receivable
Individually evaluated for impairment	$	395		$	11,000		$	4,150	$	2		$	2,449		$	564				$	18,560
Collectively evaluated for impairment		24,214			181,589			35,764		12,793			132,944			43,815					431,119
Ending balance at 3/31/2013	$	24,609		$	192,589		$	39,914	$	12,795		$	135,393		$	44,379				$	449,679

	As of and for the Year Ended December 31, 2012
(In thousands)	Commercial and Industrial			Commercial Real Estate			Construction and Land		Consumer			Residential Real Estate			Home Equity Line of Credit			Unallocated			Total
Allowance for Loan Losses
Beginning balance at 12/31/2011	$	795		$	2,899		$	195	$	31		$	1,584		$	698		$	526		$	6,728
Charge-offs		(526	)		(5,004	)		-		(117	)		(126	)		(536	)		-			(6,309	)
Recoveries		7			9			-		14			2			-			-			32
Provision (recovery)		656			3,781			207		112			231			1,174			(354	)		5,807
Ending balance at 12/31/2012	$	932		$	1,685		$	402	$	40		$	1,691		$	1,336		$	172		$	6,258

Ending balances individually evaluated for impairment	$	428		$	-		$	293	$	-		$	176		$	112		$	-		$	1,009

Ending balances collectively evaluated for impairment	$	504		$	1,685		$	109	$	40		$	1,515		$	1,224		$	172		$	5,249

Loans Receivable
Individually evaluated for impairment	$	674		$	9,612		$	4,175	$	4		$	2,372		$	228					$	17,065
Collectively evaluated for impairment		26,466			183,393			35,870		9,557			134,218			44,797						434,301
Ending balance at 12/31/2012	$	27,140		$	193,005		$	40,045	$	9,561		$	136,590		$	45,025					$	451,366

The Company’s allowance for loan losses has three basic components: the specific allowance, the general allowance, and the unallocated components. The specific allowance is used to individually allocate an allowance for larger balance, non-homogeneous loans identified as impaired. The general allowance is used for estimating the loss on pools of smaller-balance, homogeneous loans; including 1-4 family mortgage loans, installment loans and other consumer loans. Also, the general allowance is used for the remaining pool of larger balance, non-homogeneous loans which were not identified as impaired. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodolgies for estimating specific and general losses in the portfolio.

Index

Notes to Consolidated Financial Statements

Credit Quality Indicators

	As of March 31, 2013
(In thousands)	Commercial and Industrial		Commercial Real Estate		Construction and Land		Consumer		Residential Real Estate		Home Equity Line of Credit		Total
Grade:
Pass	$	19,854	$	157,400	$	35,764	$	9,972	$	120,213	$	42,376	$	385,579
Special mention		2,151		17,539		-		2,818		7,030		-		29,538
Substandard		2,424		17,650		4,014		5		7,493		2,001		33,587
Doubtful		180		-		136		-		657		2		975
Loss		-		-		-		-		-		-		-
Total	$	24,609	$	192,589	$	39,914	$	12,795	$	135,393	$	44,379	$	449,679

	As of December 31, 2012
(In thousands)	Commercial and Industrial		Commercial Real Estate		Construction and Land		Consumer		Residential Real Estate		Home Equity Line of Credit		Total
Grade:
Pass	$	21,704	$	152,483	$	35,871	$	9,552	$	120,451	$	40,189	$	380,250
Special mention		2,635		21,455		-		-		9,016		2,878		35,984
Substandard		2,391		19,067		4,038		9		6,456		1,958		33,919
Doubtful		410		-		136		-		667		-		1,213
Loss		-		-		-		-		-		-		-
Total	$	27,140	$	193,005	$	40,045	$	9,561	$	136,590	$	45,025	$	451,366

Age Analysis of Past Due Loans Receivable

	As of March 31, 2013
(In thousands)	30-59 Days Past Due		60-89 Days Past Due		90 Days or More Past Due		Total Past Due		Current		Total Financing Receivables		Carrying Amount > 90 Days and Accruing		Nonaccruals
Commercial and industrial	$	349	$	49	$	154	$	552	$	24,057	$	24,609	$	-	$	395
Commercial real estate		356		-		7,096		7,452		185,137		192,589		-		7,265
Construction and land		808		-		136		944		38,970		39,914		-		136
Consumer		1,786		2,371		-		4,157		8,638		12,795		-		2
Residential real estate		999		1,474		1,282		3,755		131,638		135,393		-		2,006
Home equity line of credit		760		267		564		1,591		42,788		44,379		-		564
Total	$	5,058	$	4,161	$	9,232	$	18,451	$	431,228	$	449,679	$	-	$	10,368

	As of December 31, 2012
(In thousands)	30-59 Days Past Due		60-89 Days Past Due		90 Days or More Past Due		Total Past Due		Current		Total Financing Receivables		Carrying Amount > 90 Days and Accruing		Nonaccruals
Commercial and industrial	$	92	$	52	$	41	$	185	$	26,955	$	27,140	$	-	$	643
Commercial real estate		-		-		7,712		7,712		185,293		193,005		-		7,712
Construction and land		508		250		136		894		39,151		40,045		-		136
Consumer		39		10		5		54		9,507		9,561		1		4
Residential real estate		2,397		397		1,474		4,268		132,322		136,590		-		1,927
Home equity line of credit		1,424		-		311		1,735		43,290		45,025		131		228
Total	$	4,460	$	709	$	9,679	$	14,848	$	436,518	$	451,366	$	132	$	10,650

Index

Notes to Consolidated Financial Statements

Impaired Loans Receivable

	March 31, 2013
(In thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no specific allowance recorded:
Commercial and industrial	$	92	$	92	$	-	$	100	$	-
Commercial real estate		11,000		13,912		-		11,225		46
Construction and land		3,689		3,689		-		3,702		35
Residential real estate		1,792		1,792		-		1,821		4
Home equity line of credit		-		-		-		-		-
Consumer		2		2		-		3		-

With an allowance recorded:
Commercial and industrial		303		303		168		304		-
Commercial real estate		-		-		-		-		-
Construction and land		463		463		293		463		5
Residential real estate		657		657		176		662		-
Home equity line of credit		564		564		150		564		-
Consumer		-		-		-		-		-

Total:
Commercial and industrial		395		395		168		404		-
Commercial real estate		11,000		13,912		-		11,225		46
Construction and land		4,152		4,152		293		4,165		40
Residential real estate		2,449		2,449		176		2,483		4
Home equity line of credit		564		564		150		564		-
Consumer		2		2		-		3		-
Total	$	18,562	$	21,474	$	787	$	18,844	$	90

	December 31, 2012
(In thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no specific allowance recorded:
Commercial and industrial	$	109	$	109	$	-	$	136	$	2
Commercial real estate		9,612		12,523		-		11,613		650
Construction and land		3,711		3,711		-		4,134		200
Residential real estate		1,705		1,705		-		1,734		39
Home equity line of credit		47		47		-		47		1
Consumer		4		4		-		5		-
With an allowance recorded:
Commercial and industrial		565		565		428		575		5
Commercial real estate		-		-		-		-		-
Construction and land		464		464		293		594		21
Residential real estate		667		667		176		692		-
Home equity line of credit		181		181		112		180		3
Consumer		-		-		-		-		-
Total:
Commercial and industrial		674		674		428		711		7
Commercial real estate		9,612		12,523		-		11,613		650
Construction and land		4,175		4,175		293		4,728		221
Residential real estate		2,372		2,372		176		2,426		39
Home equity line of credit		228		228		112		227		4
Consumer		4		4		-		5		-
Total	$	17,065	$	19,976	$	1,009	$	19,710	$	921

Index

Notes to Consolidated Financial Statements

Authoritative accounting guidance requires that the impairment of loans that have been separately identified for evaluation is to be measured based on the present value of expected future cash flows or, alternatively, the observable market price of the loans or the fair value of the collateral. However, for those loans that are collateral dependent (that is, if repayment of those loans is expected to be provided solely by the underlying collateral) and for which management has determined foreclosure is probable, the measure of impairment is to be based on the net realizable value of the collateral. Authoritative accounting guidance also requires certain disclosures about investments in impaired loans and the allowance for loan losses and interest income recognized on loans.

A loan is considered impaired when it is probable that the Bank will be unable to collect all principal and interest amounts according to the contractual terms of the loan agreement. Factors involved in determining impairment include, but are not limited to, expected future cash flows, financial condition of the borrower, and the current economic conditions. A performing loan may be considered impaired if the factors above indicate a need for impairment. A loan on non-accrual status may not be impaired if it is in the process of collection or if the shortfall in payment is insignificant. A delay of less than 30 days or a shortfall of less than 5% of the required principal and interest payments generally is considered “insignificant” and would not indicate an impairment situation, if in management’s judgment the loan will be paid in full. Loans that meet the regulatory definitions of doubtful or loss generally qualify as impaired loans under authoritative accounting guidance. As is the case for all loans, charge-offs for impaired loans occur when the loan or portion of the loan is determined to be uncollectible.

At March 31, 2013, there were $8.9 million of commercial loans classified as substandard which were deemed not to be impaired. Impaired loans totaled $18.6 million at March 31, 2013, representing an increase of $1.5 million from December 31, 2012. The increase was due primarily to the addition of one loan which was classified as impaired because it was restructured. It is performing in accordance with the modified terms. Approximately $18.2 million of loans classified as impaired at March 31, 2013 were collateralized by commercial buildings, residential real estate, or land.

No additional funds are committed to be advanced in connection with impaired loans.

Troubled Debt Restructurings

	Three Months Ended March 31, 2013						Three Months Ended March 31, 2012
			Pre-Modification		Post-Modification				Pre-Modification		Post-Modification
	Number		Outstanding		Outstanding		Number		Outstanding		Outstanding
	of		Recorded		Recorded		of		Recorded		Recorded
(Dollars in thousands)	Contracts		Investment		Investment		Contracts		Investment		Investment
Troubled Debt Restructurings
Commercial and industrial		-	$	-	$	-		-	$	-	$	-
Commercial real estate		2		2,010		2,010		-		-		-
Construction and Land		-		-		-		-		-		-
Consumer		-		-		-		-		-		-
Residential real estate		-		-		-		-		-		-
Home equity line of credit		-		-		-		-		-		-

Troubled Debt Restructurings That Subsequently Defaulted
Commercial and industrial		1	$	237	$	237		-	$	-	$	-
Commercial real estate		-		-		-		-		-		-
Construction and Land		-		-		-		-		-		-
Consumer		-		-		-		-		-		-
Residential real estate		-		-		-		-		-		-
Home equity line of credit		-		-		-		-		-		-

During the quarter ended March 31, 2013, there were two loans totaling $2.0 million that were identified as Troubled Debt Restructurings (“TDRs”), and one previously identified TDR, totaling $237,000, that defaulted. At the end of the quarter, ten TDRs, totaling $8.4 million, were in the portfolio. Seven of the loans, totaling $7.4 million, were on accrual status and performing in accordance with the modified terms. The remaining three loans, representing two borrowers and totaling $1.0 million, remained in nonaccrual status due to irregular payments, although none were ninety days or more past due. Appropriate specific reserves had been established. Restructured loans are included in the specific reserve calculation in the allowance for loan losses and are included in impaired loans.

Index

Notes to Consolidated Financial Statements

Non-performing Assets, Restructured Loans Still Accruing, and Loans Contractually Past Due

(Dollars in thousands)	March 31, 2013			December 31, 2012			March 31, 2012
Non-accrual loans	$	10,368		$	10,650		$	4,846
Other real estate owned		1,406			1,406			1,776
Non-performing corporate bond investments, at fair value		79			325			276
Total non-performing assets		11,853			12,381			6,898
Restructured loans still accruing		7,384			5,556			-
Loans past due 90 or more days and still accruing		-			132			86
Total non-performing and other risk assets	$	19,237		$	18,069		$	6,984

Allowance for loan losses to total loans		1.35	%		1.39	%		1.50	%
Non-accrual loans to total loans		2.31	%		2.36	%		1.06	%
Allowance for loan losses to non-accrual loans		58.72	%		58.76	%		141.91	%
Total non-accrual loans and restructured loans still accruing to total loans		3.95	%		3.59	%		1.06	%
Allowance for loan losses to non-accrual loans and restructured loans still accruing		34.29	%		38.62	%		141.91	%
Total non-performing assets to total assets		1.99	%		2.06	%		1.16	%

Restructured loans on non-accrual status are included with non-accrual loans and not with restructured loans in the above table.

Index

Notes to Consolidated Financial Statements

Note 4.

Company-Obligated Mandatorily Redeemable Capital Securities

On September 21, 2006, the Company’s wholly-owned Connecticut statutory business trust privately issued $4.0 million face amount of the trust’s Floating Rate Capital Securities in a pooled capital securities offering (“Trust II”). Simultaneously, the trust used the proceeds of that sale to purchase $4.0 million principal amount of the Company’s Floating Rate Junior Subordinated Deferrable Interest Debentures due 2036. The interest rate on the capital security resets every three months at 1.70% above the then current three month LIBOR. Interest is paid quarterly. Total capital securities at March 31, 2013 and December 31, 2012 were $4,124,000. The Trust II issuance of capital securities and the respective subordinated debentures are callable at any time after five years from the issue date. The subordinated debentures are an unsecured obligation of the Company and are junior in right of payment to all present and future senior indebtedness of the Company. The capital securities are guaranteed by the Company on a subordinated basis.

Note 5.

Derivative Instruments and Hedging Activities

Accounting principles generally accepted in the United States (“U.S. GAAP”) requires that all derivatives be recognized in the Consolidated Financial Statements at their fair values. On the date that the derivative contract is entered into, the Company designates the derivative as a hedge of variable cash flows to be paid or received in conjunction with recognized assets or liabilities, as a cash-flow or fair value hedge. For a derivative treated as a cash flow hedge, the ineffective portion of changes in fair value is reported in current period earnings. The effective portion of the cash flow hedge is recorded as an adjustment to the hedged item through other comprehensive income. For a derivative treated as a fair value hedge, the gain or loss on the derivative as well as the offsetting loss or gain on the hedged item attributable to the hedged risk are recognized in current earnings in interest income. The Company uses interest rate swaps to reduce interest rate risks and to manage net interest income.

The Company formally assesses, both at the hedges’ inception, and on an on-going basis, whether derivatives used in hedging transactions have been highly effective in offsetting changes in cash flows of hedged items and whether those derivatives are expected to remain highly effective in subsequent periods. The Company discontinues hedge accounting when (a) it determines that a derivative is no longer effective in offsetting changes in cash flows of a hedged item; (b) the derivative expires or is sold, terminated or exercised; (c) probability exists that the forecasted transaction will no longer occur; or (d) management determines that designating the derivative as a hedging instrument is no longer appropriate. In all cases in which hedge accounting is discontinued and a derivative remains outstanding, the Company will carry the derivative at fair value in the Consolidated Financial Statements, recognizing changes in fair value in current period income in the consolidated statement of income.

The Company follows U.S. GAAP, FASB ASU 815-10-50 “Disclosures about Derivative Instruments and Hedging Activities”, which includes the disclosure requirements for derivative instruments and hedging activities to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows.

Interest differentials paid or received under the swap agreements are reflected as adjustments to interest income. These interest rate swap agreements include both cash flow and fair value hedge derivative instruments that qualify for hedge accounting. 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 counter party, the risk in these transactions is the cost of replacing the agreements at current market rates.

The Company entered into an interest rate swap agreement on July 1, 2010 to manage the interest rate exposure on its Floating Rate Junior Subordinated Deferrable Interest Debentures due 2036. By entering into this agreement, the Company converts a floating rate liability into a fixed rate liability through 2020. Under the terms of the agreement, the Company receives interest quarterly at the rate equivalent to three month LIBOR plus 1.70% repricing every three months on the same date as the Company’s Floating Rate Junior Subordinated Deferrable Interest Debentures due 2036 and pays interest expense monthly at the fixed rate of 4.91%. The interest expense on the interest rate swap was $29,000 and $27,000 for the quarters ended March 31, 2013 and 2012, respectively. The swap is designated as a cash flow hedge and changes in the fair value are recorded as an adjustment through other comprehensive income.

The Company entered into three swap agreements to manage the interest rate risk related to three commercial loans. The agreements allow the Company to convert fixed rate assets to floating rate assets through 2021 and 2022. The Company receives interest monthly at the rate equivalent to one month LIBOR plus a spread repricing on the same date as the loans and pays interest at fixed rates. The interest expense on the interest rate swaps was $27,000 and $23,000 for the quarters ended March 31, 2013 and 2012, respectively and is recorded in loan interest income. These swaps are designated as fair value hedges and changes in fair value are recorded in current earnings.

Index

Notes to Consolidated Financial Statements

The effects of derivative instruments on the Consolidated Financial Statements for March 31, 2013 and December 31, 2012 are as follows:

(In thousands)	March 31, 2013
Derivatives designated as hedging instruments	Notional/ Contract Amount		Estimated Net Fair Value			Fair Value Balance Sheet Location	Expiration Date
Interest rate swap-10 year cash flow	$	4,000	$	(495	)	Other Liabilities	9/15/2020
Interest rate swap-10 year fair value		2,193		(123	)	Other Liabilities	8/15/2021
Interest rate swap-10 year fair value		2,068		(118	)	Other Liabilities	8/15/2021
Interest rate swap-10 year fair value		1,044		6		Other Assets	9/26/2022

			March 31, 2013
Derivatives in cash flow hedging relationships	Amount of Gain (Loss) Recognized in OCI on Derivatives, net of tax (Effective Portion)		Location of Gain or (Loss) Recognized in Income on Derivative (Ineffective Portion)	Amount of Gain (Loss) Recognized in Income on Derivative (Ineffective Portion)
Interest rate swap	$	34	Not applicable	$	-

(In thousands)	March 31, 2013
Derivatives in fair value hedging relationships	Income Statement Classification	Gain or (Loss) on Swaps
Interest rate swaps	Interest income	$	9

(In thousands)	December 31, 2012
Derivatives designated as hedging instruments	Notional/ Contract Amount		Estimated Net Fair Value			Fair Value Balance Sheet Location	Expiration Date
Interest rate swap-10 year cash flow	$	4,000	$	(547	)	Other Liabilities	9/15/2020
Interest rate swap-10 year fair value		2,204		(148	)	Other Liabilities	8/15/2021
Interest rate swap-10 year fair value		2,078		(141	)	Other Liabilities	8/15/2021
Interest rate swap-10 year fair value		1,050		(5	)	Other Liabilities	9/26/2022

	December 31, 2012
Derivatives in cash flow hedging relationships	Amount of Gain (Loss) Recognized in OCI on Derivatives, net of tax (Effective Portion)			Location of Gain or (Loss) Recognized in Income on Derivative (Ineffective Portion)	Amount of Gain (Loss) Recognized in Income on Derivative (Ineffective Portion)
Interest rate swap	$	(157	)	Not applicable	$	-

(In thousands)	December 31, 2012
Derivatives in fair value hedging relationships	Income Statement Classification	Gain or (Loss) on Swaps
Interest rate swaps	Interest income	$	(51	)

Index

Notes to Consolidated Financial Statements

Note 6. Earnings Per Share

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

	Three Months Ended				Three Months Ended
	March 31, 2013				March 30, 2012
	Shares		Per Share Amount		Shares		Per Share Amount
Basic earnings per share		3,703,039	$	0.26		3,680,230	$	0.26
Effect of dilutive securities, stock-based awards		12,546				11,614
		3,715,585	$	0.26		3,691,844	$	0.26

Note 7.

Stock Based Compensation

Stock Incentive Plan

On May 19, 2009, the shareholders of the Company approved the Company’s Stock Incentive Plan (the “Plan”), which superseded and replaced the Omnibus Stock Ownership and Long Term Incentive Plan.

Under the Plan, stock options, stock appreciation rights, non-vested and/or restricted shares, and long-term performance unit awards may be granted to directors and certain employees for purchase of the Company’s common stock. The effective date of the Plan is March 19, 2009, the date the Company’s Board approved the Plan, and it has a termination date of December 31, 2019. The Company’s Board may terminate, suspend or modify the Plan within certain restrictions. The Plan authorizes for issuance 350,000 shares of the Company’s common stock. The Plan requires that options be granted at an exercise price equal to at least 100% of the fair market value of the common stock on the date of the grant. Such options are generally not exercisable until three years from the date of issuance and generally require continuous employment during the period prior to exercise. The options will expire in no more than ten years after the date of grant. The stock options, stock appreciation rights, restricted shares, and long-term performance unit awards for certain employees are generally subject to vesting requirements and are subject to forfeiture if vesting and other contractual provision requirements are not met. Effective January 1, 2000, the Omnibus Stock Ownership and Long-Term Incentive Plan for employees was amended and restated to include non-employee directors. The Company did not grant stock options during the three months ended March 31, 2013 and at March 31, 2012, there were no options outstanding.

Restricted Shares

The restricted shares are accounted for using the fair market value of the Company’s common stock on the date the restricted shares were awarded. The restricted shares issued to certain officers are subject to a vesting period, whereby, the restrictions on the shares lapse on the third year anniversary of the date the restricted shares were awarded. Compensation expense for these shares is accrued over the three year period. During the quarter ended March 31, 2010, the restricted shares previously issued to non-employee directors were no longer subject to a vesting period, and the previously deferred compensation expense on these shares was fully recognized during 2010. In 2012 and 2011, compensation expense for the non-employee director shares was recognized at the date the shares were granted.

The Company has granted awards of non-vested shares to certain officers and vested shares to non-employee directors under the above-described incentive plans: 12,470 shares and 11,925 shares of unvested restricted stock to executive officers, and 5,712 shares and 5,632 shares of vested restricted stock to non-employee directors on February 21, 2013 and February 16, 2012, respectively. Compensation expense for these non-vested shares amounted to $39,000 and $34,000, net of forfeiture, for the three months ended March 31, 2013 and 2012, respectively. The restricted shares issued to non-employee directors are no longer subject to a vesting period. Beginning in 2011, compensation expense for the non-employee director shares is recognized at the date the shares are granted. During each of the quarters ended March 31, 2013 and 2012, compensation expense for non-employee director shares was $68,000. As of March 31, 2013, there was $267,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the plans. This type of deferred compensation cost is recognized over a period of three years.

Index

Notes to Consolidated Financial Statements

A summary of the status of the Company’s non-vested restricted shares granted under the above-described plans is presented below:

	Three Months Ended March 31, 2013
	Shares			Weighted Average Fair Value

Non-vested at January 1, 2013		31,423		$	13.30

Granted		18,182			11.91
Vested		(15,496	)		13.09
Forfeited		-
Non-vested at March 31, 2013		34,109			12.65

The Company granted performance-based stock rights relating to 12,470 and 11,925 shares to certain officers on February 21, 2013, and February 16, 2012, under the Plan. The performance-based stock rights are accounted for using the fair market value of the Company’s common stock on the date the restricted shares were awarded, and adjusted as the market value of the stock changes. The performance-based stock rights shares issued to executive officers are subject to a vesting period, whereby the restrictions on the shares lapse on the third year anniversary of the date the restricted shares were awarded. Until vesting, the shares are not issued and not included in shares outstanding. The awards are subject to the Company reaching a predetermined three year performance average on the return on average equity ratio, also as compared to a predetermined peer group of banks. The compensation expense for performance-based stock rights totaled $27,000 and $48,000 for the three months ended March 31, 2013 and 2012, respectively.

As of December 31, 2012, there was $389,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the plans. This type of deferred compensation cost is recognized over a period of three years dependent upon management reaching predetermined goals. During the quarter ended March 31, 2013, goals for rights granted in 2010 were not attained and 9,784 shares were forfeited, reducing the unearned compensation by $117,000.

A summary of the status of the Company’s non-vested performance-based stock rights is presented below:

	Three Months Ended March 31, 2013
	Performance Based Stock Rights			Weighted Average Fair Value

Non-vested at January 1, 2013		31,423		$	13.30

Granted		12,470			11.91
Vested		-
Forfeited		(9,784	)		12.44
Non-vested at March 31, 2013		34,109			12.65

Index

Notes to Consolidated Financial Statements

Note 8.

Employee Benefit Plans

The Company has a defined contribution retirement plan under Internal Revenue Code (“Code”) Section 401(k) covering employees who have completed 3 months of service and who are at least 18 years of age. Under the plan, a participant may contribute an amount up to 100% of their covered compensation for the year, not to exceed the dollar limit set by law (Code Section 402(g)). The Company will make an annual matching contribution equal to 100% on the first 1% of compensation deferred and 50% on the next 5% of compensation deferred, for a maximum match of 3.5% of compensation. Beginning in 2010, the Company began making an additional safe harbor contribution equal to 6% of compensation to all eligible participants. The Company’s 401(k) expenses for the quarters ended March 31, 2013 and 2012 were $161,000 and $171,000, respectively.

The Company also maintains a Director Deferred Compensation Plan (“Deferred Compensation Plan”). This plan provides that any non-employee director of the Company or the Bank may elect to defer receipt of all or any portion of his or her compensation as a director. A participating director may elect to have amounts deferred under the Deferred Compensation Plan held in a deferred cash account, which is credited on a quarterly basis with interest equal to the highest rate offered by the Bank at the end of the preceding quarter. Alternatively, a participant may elect to have a deferred stock account in which deferred amounts are treated as if invested in the Company’s common stock at the fair market value on the date of deferral. The value of a stock account will increase and decrease based upon the fair market value of an equivalent number of shares of common stock. In addition, the deferred amounts deemed invested in common stock will be credited with dividends on an equivalent number of shares. Amounts considered invested in the Company’s common stock are paid, at the election of the director, either in cash or in whole shares of the common stock and cash in lieu of fractional shares. Directors may elect to receive amounts contributed to their respective accounts in one or up to five installments.

The Company has a nonqualified deferred compensation plan for a former key employee’s retirement, in which the contribution expense is solely funded by the Company. The retirement benefit to be provided is variable based upon the performance of underlying life insurance policy assets. Deferred compensation expense amounted to $8,322 for the quarters ended March 31, 2013 and 2012.

Concurrent with the establishment of the Deferred Compensation Plan, the Company purchased life insurance policies on this employee with the Company named as owner and beneficiary. These life insurance policies are intended to be utilized as a source of funding the Deferred Compensation Plan. The Company has recorded other assets of $1.2 million representing cash surrender value of these policies at both March 31, 2013 and December 31, 2012.

Index

Notes to Consolidated Financial Statements

Note 9.

Fair Value Measurement

The Company followsASC 820 “Fair Value Measurement and Disclosures” to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. ASC 820 clarifies that 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.

ASC 820 specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels of the fair value hierarchy under ASC 820 based on these two types of inputs are as follows:

Level 1 –

Valuation is based on quoted prices in active markets for identical assets and liabilities.

Level 2 –

Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.

Level 3 –

Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

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

Securities available for sale: Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data (Level 2). If the inputs used to provide the evaluation for certain securities are unobservable and/or there is little, if any market activity then the security would fall to the lowest level of the hierarchy (Level 3). The Company's investment portfolio is primarily valued using fair value measurements that are considered to be Level 2. The Company has contracted with a third party portfolio accounting service vendor for valuation of its securities based on market data. IDC utilizes evaluated pricing models that vary by asset class and include available trade, bid, and other market information. Generally, the methodology includes broker quotes, proprietary modes, vast descriptive terms and conditions databases, as well as extensive quality control programs. The carrying value of restricted Federal Reserve Bank of Richmond, Community Bankers Bank and Federal Home Loan Bank of Atlanta (“FHLB”) stock approximates fair value based on the redemption provisions of each entity and are therefore excluded from the following table.

Interest rate swaps: Interest rate swaps are recorded at fair value on a recurring basis. The Company utilizes interest rate swap agreements as part of the management of interest rate risk to modify the repricing characteristics of certain portions of the Company’s interest-bearing assets and liabilities. The Company has contracted with a third party to provide valuations for interest rate swaps using standard valuation techniques and therefore classifies such valuation as Level 2. The Company has considered counterparty credit risk in the valuation of its interest rate swap assets and has considered its own credit risk in the valuation of its interest rate swap liabilities.

Index

Notes to Consolidated Financial Statements

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of March 31, 2013 and December 31, 2012 by levels within the valuation hierarchy:

	Fair Value Measurements Using
(In thousands)	Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets at March 31, 2013:
Available-for-sale securities:
Obligations of U.S. Government corporations and agencies	$	37,694	$	-	$	37,694	$	-
Obligations of states and political subdivisions		7,332		-		7,332		-
Corporate bonds		313		-		-		313
Mutual funds		362		362		-		-
Total available-for sale securities		45,701		362		45,026		313

Interest rate swaps		6		-		6		-
Total assets at fair value	$	45,707	$	362	$	45,707	$	313

Liabilities at March 31, 2013:
Interest rate swaps	$	736	$	-	$	736	$	-
Total liabilities at fair value	$	736	$	-	$	736	$	-

Assets at December 31, 2012:
Available-for-sale securities:
Obligations of U.S. Government corporations and agencies	$	40,014	$	-	$	40,014	$	-
Obligations of states and political subdivisions		7,390		-		7,390		-
Corporate bonds		325		-		-		325
Mutual funds		363		363		-		-
Total available-for sale securities		48,092		363		47.404		325

Interest rate swaps		-		-		-		-
Total assets at fair value	$	48,092	$	363	$	47,404	$	325

Liabilities at December 31, 2012:
Interest rate swaps	$	841	$	-	$	841	$	-
Total liabilities at fair value	$	841	$	-	$	841	$	-

Change in Level 3 Fair Value

The changes in Level 3 assets measured at estimated fair value on a recurring basis during the three months ended March 31, 2013 and year ended December 31, 2012 were as follows:

	Total Gains (Losses) Realized/Unrealized
(In thousands)	Balance January 1, 2013		Included in Earnings		Included in Other Comprehensive Income			Transfers in and/or out of Level 3 and 2		Balance March 31, 2013
Available-for-sale securities	$	325	$	-	$	(12	)	$	-	$	313

	Total Gains (Losses) Realized/Unrealized
(In thousands)	Balance January 1, 2012		Included in Earnings		Included in Other Comprehensive Income			Transfers in and/or out of Level 3 and 2		Balance December 31, 2012
Available-for-sale securities	$	335	$	-	$	(10	)	$	-	$	325

Certain assets are measured at fair value on a nonrecurring basis in accordance with U. S. 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.

Index

Notes to Consolidated Financial Statements

The following describes the valuation techniques used by the Company to measure certain financial 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 according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral securing the loans. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the Company’s collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal, of one year or less, 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 more than one year old and not solely based on observable market comparables or management determines the fair value of the collateral is further impaired below the appraised value, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal, of one year or less, if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivable collateral are based on financial statement balances or aging reports (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. At March 31, 2013, the Company’s Level 3 loans for which a reserve has been taken, consisted of two loans totaling $303,000 secured by business assets and inventory with a reserve of $168,000, and one loan totaling $327,000 secured by real estate with a reserve of $203,000.

Other Real Estate Owned (“OREO”): Foreclosed assets are adjusted to fair value upon transfer of the loans to OREO. Subsequently, OREO is carried at the lower of carrying value or fair market value less selling costs. Fair value is based upon independent market prices, appraised values of the collateral, or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company considers the OREO as nonrecurring Level 2. When a current appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company considers records the OREO as nonrecurring Level 3. Total valuation of OREO property was $1,406,000 at both March 31, 2013 and December 31, 2012.

The following table summarizes the Company’s financial assets that were measured at fair value on a nonrecurring basis during the period.

	Carrying Value at March 31, 2013
	Balance as of March 31, 2013		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)
Assets:
Impaired loans, net	$	1,200	$	-	$	941	$	259
Other real estate owned, net		1,406		-		1,406		-

	Carrying Value at December 31, 2012
	Balance as of December 31, 2012		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)
Assets:
Impaired loans, net	$	868	$	-	$	491	$	377
Other real estate owned, net		1,406		-		1,406		-

Index

Notes to Consolidated Financial Statements

The following table displays quantitative information about Level 3 Fair Value Meaurements at March 31, 2013.

	Quantitative Information about Level 3 Fair Value Measurements
(In thousands)	Fair Value		Valuation Technique(s)	Unobservable Input	Weighted Average
Corporate securities available for sale	$	313	Discounted cash flow	Discount based on prepayment rate, probability of default and loss severity		30	%
Impaired Loans:
Commercial and industrial loans		135	Appraised values	*		54	%
Commercial real estate loans		-	Appraised values	*		-
Construction and land loans		124	Appraised values	*		23	%
Residential real estate loans		-	Appraised values	*		-
Total Impaired Loans		259
Total	$	572

* Discount applied based on age of appraisals, current market conditions, and experience within local market.

The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instruments. ASC 820 excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

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

Cash and cash equivalents

The carrying amounts of cash and short-term instruments with a maturity of three months or less approximate fair value. Instruments with maturities of greater than three months are estimated using a discounted cash flow calculation that applies interest rates currently being offered on similar instruments.

Securities

For securities and marketable equity securities held for investment purposes, fair values are based on quoted market prices or dealer quotes. For other securities held as investments, fair value equals quoted market price, if available. If a quoted market price is not available, fair values are based on quoted market prices for similar securities. See Note 2 “Securities” of the Notes to Consolidated Financial Statements for further discussion on determining fair value for pooled trust preferred securities.

Loans Receivable

For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for certain mortgage loans (e.g., one-to-four family residential), credit card loans, and other consumer loans are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics. Fair values for other loans (i.e., commercial real estate and investment property mortgage loans, commercial and industrial loans) are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values for nonperforming loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.

Index

Notes to Consolidated Financial Statements

Accrued Interest

The carrying amounts of accrued interest approximate fair value.

Life Insurance

The carrying amount of life insurance contracts is assumed to be a reasonable fair value. Life insurance contracts are carried on the balance sheet at their redemption value. This redemption value is based on existing market conditions and therefore represents the fair value of the contract.

Interest Rate Swaps

The fair values are based on quoted market prices or mathematical models using current and historical data.

Deposit Liabilities

The fair values disclosed for demand deposits (i.e., interest and non-interest bearing checking, statement savings and money market accounts) are, by definition, equal to the amount payable at the reporting date (that is, their carrying amounts). Fair values of fixed rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered to a schedule of aggregated expected monthly maturities on time deposits.

Federal Funds Purchased

The carrying amounts of the Company’s federal funds purchased approximate fair value.

Borrowed Funds

The fair values of the Company’s FHLB advances and other borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Off-Balance-Sheet Financial Instruments

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 creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.

The fair values 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 March 31, 2013 and December 31, 2012, the fair values of loan commitments and standby letters of credit were deemed immaterial.

Index

Notes to Consolidated Financial Statements

The estimated fair values of the Company's financial instruments are as follows:

	Fair Value Measurements at March 31, 2013
(In thousands)	Carrying Value as of March 31, 2013		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)		Fair Value as of March 31, 2013
Assets
Cash and short-term investments	$	63,372	$	60,873	$	2,525	$	-	$	63,398
Securities available for sale		45,701		362		45,026		313		45,701
Restricted investments		2,138		-		2,138		-		2,138
Net Loans		443,591		-		445,283		259		445,542
Accrued interest receivable		1,404		-		1,404		-		1,404
Interest rate swaps		6		-		6		-		6
BOLI		12,138		-		12,138		-		12,138
Total Financial Assets	$	568,350	$	61,235	$	508,520	$	572	$	570,327

Liabilities
Deposits	$	509,604	$	-	$	512,147	$	-	$	512,147
Borrowings		28,185		-		28,628		-		28,628
Company obligated mandatorily redeemable capital securities		4,124		-		4,117		-		4,117
Accrued interest payable		323		-		323		-		323
Interest rate swaps		736		-		736		-		736
Total Financial Liabilities	$	542,972	$	-	$	545,951	$	-	$	545,951

	Fair Value Measurements at December 31, 2012
(In thousands)	Carrying Value as of December 31, 2012		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)		Fair Value as of December 31, 2012
Assets
Cash and short-term investments	$	64,435	$	61,935	$	2,530	$	-	$	64,465
Securities available for sale		48,092		363		47,404		325		48,092
Restricted investments		2,337		-		2,337		-		2,337
Net Loans		445,108		-		443,045		377		443,422
Accrued interest receivable		1,283		-		1,283		-		1,283
Interest rate swaps		-		-		-		-		-
BOLI		12,038		-		12,038		-		12,038
Total Financial Assets	$	573,293	$	62,298	$	508,637	$	702	$	571,637

Liabilities
Deposits	$	515,134	$	-	$	517,811	$	-	$	517,811
Borrowings		28,200		-		28,877		-		28,877
Company obligated mandatorily redeemable capital securities		4,124		-		5,258		-		5,258
Accrued interest payable		312		-		312		-		312
Interest rate swaps		841		-		841		-		841
Total Financial Liabilities	$	548,611	$	-	$	553,099	$	-	$	553,099

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

Notes to Consolidated Financial Statements

Note 10. Accumulated Other Comprehensive Income

Changes in Accumulated Other Comprehensive Income by Component (1)

(In thousands)	Gains and Losses on Cash Flow Hedges			Unrealized Gains and Losses on Available-for-Sale Securities			Supplemental Executive Retirement Plans		Total
Balance December 31, 2012	$	(361	)	$	(1,398	)	$	47	$	(1,712	)
Other comprehensive income (loss) before reclassifications		34			(127	)		-		(93	)
Amounts reclassified from accumulated other comprehensive income		-			-			-		-
Net current-period other comprehensive income		34			(127	)		-		(93	)
Balance March 31, 2013	$	(327	)	$	(1,525	)	$	47	$	(1,805	)


Balance December 31, 2011	$	(180	)	$	(1,376	)	$	239	$	(1,318	)
Other comprehensive income (loss) before reclassifications		(157	)		(56	)		-		(213	)
Amounts reclassified from accumulated other comprehensive income		-			-			-		-
Net current-period other comprehensive income		(157	)		(56	)		-		(213	)
Balance March 31, 2012	$	(337	)	$	(1,432	)	$	239	$	(1,530	)

(1) All amounts are net of tax. Amounts in parentheses indicate debits.

There were no reclassification adjustments out of other comprehensive income in the quarters ended March 31, 2013 and 2012.

Note 11.

Subsequent Events

In accordance with ASC 855-10/SFAS 165, the Company evaluates subsequent events that have occurred after the balance sheet date, but before the financial statements are issued. There are two types of subsequent events: (1) recognized, or those that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements, and (2) non-recognized, or those that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date.

Based on the evaluation, the Company did not identify any recognized or non-recognized subsequent events that would have required adjustment to, or disclosure in, the financial statements.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

In addition to the historical information contained herein, this report contains forward-looking statements. Forward-looking statements are based on certain assumptions and describe future plans, strategies, and expectations of Fauquier Bankshares, Inc. (“the Company”), and are generally identifiable by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” “may,” “will” or similar expressions. Although we believe our plans, intentions and expectations reflected in these forward-looking statements are reasonable, we can give no assurance that these plans, intentions, or expectations will be achieved. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain, and actual results could differ materially from those contemplated. Factors that could have a material adverse effect on our operations and future prospects 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 Board of Governors of the Federal Reserve System, the quality or composition of the Bank’s loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in our market area, our plans to expand our branch network and increase our market share, and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements in this report and you should not place undue reliance on such statements, which reflect our position as of the date of this report.

GENERAL

The Company was incorporated under the laws of the Commonwealth of Virginia on January 13, 1984. The Company is a registered bank holding company and owns all of the voting shares of The Fauquier Bank (“the Bank”). The Company engages in its business through the Bank, a Virginia state-chartered bank that commenced operations in 1902. The Company has no significant operations other than owning the stock of the Bank. The Company had issued and outstanding 3,713,342 shares of common stock, par value $3.13 per share, held by approximately 392 holders of record on March 31, 2013. The Bank has ten full service branch offices located in the Virginia communities of Old Town-Warrenton, Warrenton, Catlett, The Plains, Sudley Road-Manassas, Old Town-Manassas, New Baltimore, Bealeton, Bristow and Haymarket. An eleventh branch office is currently projected to open in Gainesville, Virginia during 2013. The executive offices of the Company and the main office of the Bank are located at 10 Courthouse Square, Warrenton, Virginia 20186.

The Bank’s general market area principally includes Fauquier County, western Prince William County, and neighboring communities and is located approximately fifty (50) miles southwest of Washington, D.C.

The Bank provides a range of consumer and commercial banking services to individuals, businesses and industries. The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation (“FDIC”). The basic services offered by the Bank include: interest bearing and non-interest-bearing demand deposit accounts, money market deposit accounts, NOW accounts, time deposits, safe deposit services, credit cards, cash management, direct deposits, notary services, night depository, prepaid debit cards, cashier’s checks, domestic collections, savings bonds, automated teller services, drive-in tellers, internet banking, telephone banking, and banking by mail. In addition, the Bank makes secured and unsecured commercial and real estate loans, issues stand-by letters of credit and grants available credit for installment, unsecured and secured personal loans, residential mortgages and home equity loans, as well as automobile and other types of consumer financing. The Bank provides automated teller machine (“ATM”) cards, as a part of the Maestro, Accel-Exchange and Plus ATM networks, thereby permitting customers to utilize the convenience of larger ATM networks. The Bank also is a member of the Certificate of Deposit Account Registry Service (“CDARS”) and Insured Cash Sweep Service (“ICS”), to provide customers multi-million dollar FDIC insurance on CD investments and deposit sweeps through the transfer and/or exchange with other FDIC insured institutions. CDARS and ICS are registered service marks of Promontory Interfinancial Network, LLC.

The Bank operates a Wealth Management Services (“WMS” or “Wealth Management”) division that began with the granting of trust powers to the Bank in 1919. The WMS division provides personalized services that include investment management, trust, estate settlement, retirement, insurance, and brokerage services.

The Bank, through its subsidiary Fauquier Bank Services, Inc., has equity ownership interests in Bankers Insurance, LLC, a Virginia independent insurance company, Bankers Title Shenandoah, LLC, a title insurance company, and Infinex Investments, Inc., a full service broker/dealer. Bankers Insurance and Bankers Title Shenandoah are owned by a consortium of Virginia community banks, and Infinex is owned by banks and banking associations in various states.

The revenues of the Bank are primarily derived from interest on, and fees received in connection with, real estate and other loans, and from interest and dividends from investment and mortgage-backed securities, and short-term investments. The principal sources of funds for the Bank’s lending activities are its deposits, repayment of loans, the sale and maturity of investment securities, and borrowings from the Federal Home Loan Bank (“FHLB”) of Atlanta. Additional revenues are derived from fees for deposit-related and WMS-related services. The Bank’s principal expenses are the interest paid on deposits and operating and general administrative expenses.

As is the case with banking institutions generally, the Bank’s operations are materially and significantly influenced by general economic conditions and by related monetary and fiscal policies of financial institution regulatory agencies, including the Board of Governors of the Federal Reserve System (“Federal Reserve”). As a Virginia-chartered bank and a member of the Federal Reserve, the Bank is supervised and examined by the Federal Reserve and the Virginia State Corporation Commission. Interest rates on competing investments and general market rates of interest influence deposit flows and costs of funds. Lending activities are affected by the demand for financing of real estate and other types of loans, which in turn is affected by the interest rates at which such financing may be offered and other factors affecting local demand and availability of funds. The Bank faces strong competition in the attraction of deposits (its primary source of lendable funds) and in the origination of loans.

As of March 31, 2013, the Company had total consolidated assets of $596.8 million, total loans net of allowance for loan losses of $443.6 million, total consolidated deposits of $509.6 million, and total consolidated shareholders’ equity of $48.2 million.

Index

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, 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 our estimates. In addition, GAAP itself may change from one previously acceptable accounting method to another method. Although the economics of the Company’s transactions would be the same, the timing of events that would impact the Company’s 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 three basic principles of accounting: (i) Accounting Standards Codification (“ASC”) 450 “Contingencies” (previously 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, (ii) ASC 310 “Receivables” (previously 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 and (iii) Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 102, “Selected Loan Loss Allowance Methodology and Documentation Issues,” which requires adequate documentation to support the allowance for loan losses estimate.

The Company’s allowance for loan losses has three basic components: the specific allowance, the general allowance and the unallocated component. Each of these components is determined based upon estimates that can and do change when the actual events occur. The specific allowance is used to individually allocate an allowance for larger balance, non-homogeneous loans identified as impaired. The specific allowance uses various techniques to arrive at an estimate of loss. Analysis of the borrower’s overall financial condition, resources and payment record, the prospects for support from financial guarantors, and the fair market value of collateral are used to estimate the probability and severity of inherent losses. The general allowance is used for estimating the loss on pools of smaller-balance, homogeneous loans; including 1-4 family mortgage loans, installment loans, other consumer loans, and outstanding loan commitments. Also, the general allowance is used for the remaining pool of larger balance, non-homogeneous loans which were not identified as impaired. The general allowance begins with estimates of probable losses inherent in the homogeneous portfolio based upon various statistical analyses. These include analysis of historical delinquency and credit loss experience, together with analyses that reflect current trends and conditions. The Company also considers trends and changes in the volume and term of loans, changes in the credit process and/or lending policies and procedures, and an evaluation of overall credit quality. The general allowance uses a historical loss view as an indicator of future losses. As a result, even though this history is regularly updated with the most recent loss information, it could differ from the loss incurred in the future. The general allowance also captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized. 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.

Specifically, the Company uses both external and internal qualitative factors when determining the non-loan-specific allowances. The external factors utilized include: unemployment in the Company’s defined market area of Fauquier County, Prince William County, and the City of Manassas (“market area”), as well as state and national unemployment trends; new residential construction permits for the market area; bankruptcy statistics for the Virginia Eastern District and trends for the United States; and foreclosure statistics for the market area and the state. Quarterly, these external qualitative factors as well as relevant anecdotal information are evaluated from data compiled from local periodicals such as The Washington Post, The Fauquier Times Democrat, and The Bull Run Observer, which cover the Company’s market area. Additionally, data is gathered from the Federal Reserve Beige Book for the Richmond Federal Reserve District, Global Insight’s monthly economic review, the George Mason School of Public Policy Center for Regional Analysis, and daily economic updates from various other sources. Internal Bank data utilized includes: loans past due aging statistics, nonperforming loan trends, trends in collateral values, loan concentrations, loan review status downgrade trends, and lender turnover and experience trends. Both external and internal data is analyzed on a rolling eight quarter basis to determine risk profiles for each qualitative factor. Ratings are assigned through a defined matrix to calculate the allowance consistent with authoritative accounting literature. A narrative summary of the reserve allowance is produced quarterly and reported directly to the Company’s Board of Directors. The Company’s application of these qualitative factors to the allowance for loan losses has been consistent over the reporting period.

The Company employs an independent outsourced loan review function, which annually substantiates and/or adjusts internally generated risk ratings. This independent review is reported directly to the Company’s Board of Directors’ audit committee, and the results of this review are factored into the calculation of the allowance for loan losses.

Index

EXECUTIVE OVERVIEW

This discussion is intended to focus on certain financial information regarding the Company and the Bank and may not contain all the information that is important to the reader. The purpose of this discussion is to provide the reader with a more thorough understanding of our financial statements. As such, this discussion should be read carefully in conjunction with the consolidated financial statements and accompanying notes contained elsewhere in this report.

The Bank is the primary independent community bank in its immediate market area as measured by deposit market share. It seeks to be the primary financial service provider for its market area by providing the right mix of consistently high quality customer service, efficient technological support, value-added products, and a strong commitment to the community. The Company and the Bank’s primary operating businesses are in commercial and retail lending, deposit accounts and core deposits, and assets under WMS management.

Net income of $962,000 for the first quarter of 2013 was a 0.8% increase from the net income for the first quarter of 2012 of $954,000. Loans, net of reserve, totaling $443.6 million at March 31, 2013, decreased 0.3% when compared with December 31, 2012, and decreased 1.5% when compared with March 31, 2012. Deposits, totaling $509.6 million at March 31, 2013, decreased 1.1% compared with December 31, 2012, and decreased 0.3% when compared with March 31, 2012. Assets under WMS management, totaling $348.0 million in market value at March 31, 2013, increased 13.3% from March 31, 2012.

Net interest income is the largest component of net income, and equals the difference between income generated on interest-earning assets and interest expense incurred on interest-bearing liabilities. Future trends regarding net interest income are dependent on the absolute level of market interest rates, the shape of the yield curve, the amount of lost income from non-performing assets, the amount of prepaying loans, the mix and amount of various deposit types, competition for loans and deposits, and many other factors, as well as the overall volume of interest-earning assets. These factors are individually difficult to predict, and when taken together, the uncertainty of future trends compounds. Based on management’s current projections, net interest income may increase as average interest-earning assets increase, but this may be offset in part or in whole by a possible contraction in the Bank’s net interest margin resulting from competitive market conditions and/or a flat or inverted yield curve. A steeper yield curve is projected to result in an increase in net interest income, while a flatter or inverted yield curve is projected to result in a decrease in net interest income. The current absolute level of historically low market interest rates, as well as the current slowness of new loan production, is also projected to result in a decrease in net interest income.

The Bank’s non-performing assets totaled $11.9 million or 1.99% of total assets at March 31, 2013, as compared with $12.4 million or 2.06% of total assets at December 31, 2012, and $6.9 million or 1.16% of total assets at March 31, 2012. Nonaccrual loans totaled $10.4 million or 2.31% of total loans at March 31, 2013 compared with $10.7 million or 2.36% of total loans at December 31, 2012, and $4.8 million or 1.06% of total loans at March 31, 2012. The provision for loan losses was $167,000 for the first three months of 2013 compared with $500,000 for the first three months of 2012. The $333,000 decrease in the provision for loan losses was primarily due to reduction in nonperforming loans since December 31, 2012. Loan charge-offs, net of recoveries, totaled $337,000 or 0.07% of total average loans for the first three months of 2013. During the first three month period of 2012, there were net charge-offs of $351,000 or 0.08% of total average loans. Total allowance for loan losses was $6.1 million or 1.35% of total loans at March 31, 2013 compared with $6.3 million or 1.39% of loans at December 31, 2012 and $6.9 million or 1.50% of loans at March 31, 2012.

Index

COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED MARCH 31, 2013 and MARCH 31, 2012

NET INCOME

Net income of $962,000 for the first quarter of 2013 was a 0.8% increase from the net income for the first quarter of 2012 of $954,000. Earnings per share on a fully diluted basis were $0.26 for the first quarter of 2013 compared with $0.26 for the first quarter of 2012. Profitability as measured by return on average assets increased from 0.64% in the first quarter of 2012 to 0.66% for the same period in 2013. Profitability as measured by return on average equity increased from 7.97% to 8.12% over the same respective quarters in 2012 and 2013. The increase in net income was primarily due to the $333,000 and $269,000 reductions in the provision for loan losses and total other expenses, respectively, in the first quarter of 2013 compared with the first quarter of 2012, substantially offset by the $552,000 decrease in net interest income over the same periods.

NET INTEREST INCOME AND EXPENSE

Net interest income decreased $552,000 or 10.2% to $4.84 million for the quarter ended March 31, 2013 from $5.40 million for the quarter ended March 31, 2012. The decrease in net interest income was due primarily to the decline in loan and security balances, increase in nonaccrual loans and reduced yields on earning assets. This was partially offset by reduced rates on deposits over the same period. The Company’s net interest margin decreased from 3.89% in the first quarter of 2012 to 3.59% in the first quarter of 2013.

Total interest income decreased $786,000 or 12.1% to $5.72 million for the first quarter of 2013 from $6.51 million for the first quarter of 2012. This decrease was primarily due to a 45 basis point decline in the yield on earning assets and reduced loan balances from first quarter 2012 to first quarter 2013.

The tax-equivalent average yield on loans was 4.90% for the first quarter of 2013, down from 5.42% in the first quarter of 2012. Average loan balances decreased $6.3 million or 1.4% from $456.6 million during the first quarter of 2012 to $450.4 million during the first quarter of 2013. The decrease in balances and yield resulted in a $721,000 or 11.8% decline in interest and fee income from loans for the first quarter of 2013 compared with the same period in 2012. On a tax equivalent basis, the decrease was $731,000 or 11.8%.

Average investment security balances decreased $6.6 million from $56.0 million in the first quarter of 2012 to $49.4 million in the first quarter of 2013. The tax-equivalent average yield on investments decreased from 2.72% for the first quarter of 2012 to 2.50% for the first quarter of 2013. Interest and dividend income on security investments decreased $72,000 or 20.6%, from $349,000 for the first quarter of 2012 to $277,000 for the first quarter of 2013. Interest income on deposits in other banks increased $7,000 from first quarter 2012 to first quarter 2013 resulting from higher earning balances at the Federal Reserve.

Total interest expense decreased $234,000 or 21.0% from $1.11 million for the first quarter of 2012 to $878,000 for the first quarter of 2013 primarily due to the decline in interest paid on time deposits.

Interest paid on deposits decreased $231,000 or 28.3% from $815,000 for the first quarter of 2012 to $584,000 for the first quarter of 2013. Average balances on time deposits declined $29.6 million or 18.9% from $156.6 million to $127.0 million while the average rate decreased from 1.60% to 1.39% in the first quarter of 2012 to the first quarter of 2013, resulting in $192,000 less interest expense. Average money market accounts decreased $2.5 million or 5.4% from the first quarter of 2012 to the first quarter of 2013 while the rate declined from 0.23% to 0.18%, resulting in $7,000 less interest expense. Average savings account balances increased $3.1 million from the first quarter of 2012 to the first quarter of 2013, while their average rate was 0.16% for both quarters, resulting in an increase of $1,000 of interest expense for the first quarter of 2013. Average NOW deposit balances increased $8.2 million from the first quarter of 2012 to the first quarter of 2013, while the average rate decreased from 0.31% to 0.23%, resulting in a decrease of $32,000 in NOW interest expense for the first quarter of 2013.

From the first quarter of 2012 to the first quarter of 2013, interest expense on FHLB of Atlanta advances decreased $2,000. Interest expense on capital securities decreased from the first quarter of 2012 to the first quarter of 2013 from $50,000 to $49,000.

The average rate on total interest-bearing liabilities decreased from 0.95% in the first quarter of 2012 to 0.78% for the first quarter of 2013.

Index

The following table sets forth information relating to the Company’s average balance sheet and reflects the average yield on assets and average cost of liabilities for the periods indicated and the average yields and rates paid for the periods indicated. These yields and costs are derived by dividing income or expense by the average daily balances of assets and liabilities, respectively, for the periods presented.

Average Balances, Income and Expense, and Average Yields and Rates

	Three Months Ended March 31, 2013								Three Months Ended March 31, 2012
(Dollars in thousands)	Average			Income/		Average			Average			Income/		Average
Assets	Balances			Expense		Rate			Balances			Expense		Rate
Loans
Taxable	$	432,054		$	5,325		5.00	%	$	442,503		$	6,024		5.46	%
Tax-exempt (1)		7,290			114		6.35	%		9,099			146		6.44	%
Nonaccrual (2)		11,033			-					5,046			-
Total Loans		450,377			5,439		4.90	%		456,648			6,170		5.42	%

Securities
Taxable		42,517			216		2.03	%		49,090			288		2.34	%
Tax-exempt (1)		6,852			93		5.44	%		6,896			93		5.41	%
Total securities		49,369			309		2.50	%		55,986			381		2.72	%

Deposits in banks		54,146			44		0.33	%		51,354			37		0.29	%
Federal funds sold		11			-		0.16	%		8			-		0.22	%
Total earning assets		553,903		$	5,792		4.24	%		563,996		$	6,588		4.69	%

Less: Reserve for loan losses		(6,446	)							(6,891	)
Cash and due from banks		5,057								4,958
Bank premises and equipment, net		14,712								14,991
Other real estate owned		1,406								1,776
Other assets		25,518								23,530
Total Assets	$	594,150							$	602,360

Liabilities and Shareholders' Equity
Deposits
Demand deposits	$	85,213							$	75,625

Interest-bearing deposits
NOW accounts		183,557		$	105		0.23	%		175,315		$	137		0.31	%
Money market accounts		43,795			19		0.18	%		46,275			26		0.23	%
Savings accounts		67,608			26		0.16	%		64,517			25		0.16	%
Time deposits		126,980			434		1.39	%		156,561			626		1.60	%
Total interest-bearing deposits		421,940			584		0.56	%		442,668			814		0.74	%


Federal funds purchased		3			-		0.55	%		8			-		0.76	%
Federal Home Loan Bank advances		28,193			245		3.53	%		25,000			247		3.96	%
Capital securities of subsidiary trust		4,124			49		4.83	%		4,124			50		4.86	%
Total interest-bearing liabilities		454,260			878		0.78	%		471,800			1,111		0.95	%

Other liabilities		6,651								6,903
Shareholders' equity		48,026								48,032
Total Liabilities & Shareholders' Equity	$	594,150							$	602,360

Net interest spread				$	4,914		3.46	%				$	5,477		3.74	%

Interest expense as a percent of average earning assets							0.64	%							0.80	%
Net interest margin							3.59	%							3.89	%

(1) Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%.

(2) Nonaccrual loans are included in the average balance of total loans and total earning assets.

Index

RATE/VOLUME ANALYSIS

The following table sets forth certain information regarding changes in interest income and interest expense of the Company for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to changes in volume (change in volume multiplied by old rate); and changes in rates (change in rate multiplied by old volume). Changes in rate-volume, which cannot be separately identified, are allocated proportionately between changes in rate and changes in volume.

Rate / Volume Variance

	Three Months Ended March 31, 2013 Compared to Three Months Ended March 31, 2012
				Due to			Due to
(In thousands)	Change			Volume			Rate
Interest Income
Loans; taxable	$	(699	)	$	(142	)	$	(557	)
Loans; tax-exempt (1)		(32	)		(29	)		(3	)
Securities; taxable		(72	)		(38	)		(34	)
Securities; tax-exempt (1)		-			(1	)		1
Deposits in banks		7			2			5
Federal funds sold		-			-			-
Total Interest Income		(796	)		(208	)		(588	)

Interest Expense
NOW accounts		(32	)		6			(38	)
Money market accounts		(7	)		(1	)		(6	)
Savings accounts		1			1			-
Time deposits		(192	)		(118	)		(74	)
Federal funds purchased and securities sold under agreements to repurchase		-			-			-
Federal Home Loan Bank advances		(2	)		32			(34	)
Capital securities of subsidiary trust		(1	)		-			(1	)
Total Interest Expense		(233	)		(80	)		(153	)
Net Interest Income	$	(563	)	$	(128	)	$	(435	)

(1) Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%.

PROVISION FOR LOAN LOSSES

The provision for loan losses was $167,000 for the first quarter of 2013 compared with $500,000 for the first quarter of 2012. The amount of the provision for loan loss was based upon management’s continual evaluation of the adequacy of the allowance for loan losses, which encompasses the overall risk characteristics of the loan portfolio, trends in the Bank’s delinquent and non-performing loans, estimated values of collateral, and the impact of economic conditions on borrowers. Greater weight is given to the loss history by loan category, prolonged changes in portfolio delinquency trends by loan category, and changes in economic trends. There can be no assurances, however, that future losses will not exceed estimated amounts, or that increased amounts of provisions for loan losses will not be required in future periods.

OTHER INCOME

Total other income decreased by $42,000 from $1.48 million for the first quarter of 2012 to $1.44 million in the first quarter of 2013. Non-interest income is derived primarily from recurring non-interest fee income, which consists primarily of fiduciary trust and other Wealth Management fees, brokerage fees, service charges on deposit accounts, debit card interchange income and other fee income. The decrease was primarily due to a $108,000 decrease in service charges on deposit accounts during the first quarter of 2013 compared with the first quarter of 2012, partially offset by a $51,000 increase in brokerage fees over the same time period.

Trust and estate income decreased $4,000 or 1.2% from the first quarter of 2012 to the first quarter of 2013 primarily due to a $30,000 decrease in estate settlement revenue, mostly offset by increased revenues on larger managed account balances resulting from the increase in the various equity markets.

Brokerage service revenues increased $51,000 or 62.2% from the first quarter of 2012 to the first quarter of 2013 due to higher volumes of products sold as well as those which generate higher commissions.

Service charges on deposit accounts decreased $108,000 or 15.6% to $584,000 for the first quarter of 2013 compared to one year earlier. The change is primarily due to changes in the processing of overdrafts, including waiving all charges on low dollar overdrafts, as well as a change in overdraft activities by customers.

Other service charges, commissions and fees increased $19,000 or 5.2% from $366,000 in first quarter of 2012 to $385,000 in the first quarter of 2013. Included in other service charges, commissions, and income is debit card interchange income which totaled $243,000 and $244,000 for the first quarters of 2013 and 2012, respectively. Also included is Bank Owned Life Insurance (“BOLI”) income, which was $100,000 during the first quarter of 2013, compared with $104,000 one year earlier. Total BOLI was $12.1 million in cash value at March 31, 2013, compared with $11.7 million one year earlier.

OTHER EXPENSE

Total other expense decreased $269,000 or 5.3% during the first quarter of 2013 compared with the first quarter of 2012, primarily due to the reductions in salary and benefit expense.

Salaries and employees’ benefits decreased $308,000 or 11.4% from first quarter 2012 to first quarter 2013. The decrease is primarily due to the $192,000 reduction of accrued incentive compensation expense for the first quarter of 2013 compared with the first quarter of 2012. The incentive compensation was reduced based on the likelihood that the Company would only partially reach the necessary predetermined profitability goals. In addition, active full-time equivalent employees were reduced from 157.5 as of March 31, 2012 to 141.4 as of March 31, 2013. At March 31, 2013, the Company had approximately eight full-time equivalent positions to be filled.

Occupancy expense increased $13,000 or 2.8%, while furniture and equipment expense decreased $9,000 or 3.3%, from first quarter 2012 to first quarter 2013.

Marketing expense decreased $25,000 or 15.2% from the first quarter of 2012 to $140,000 for the first quarter of 2013. The decrease in marketing expense is primarily related to a reduction in expenses for promotional items.

Legal, accounting and consulting expense increased $48,000 or 18.7% from the first quarter of 2012 to $305,000 for the first quarter of 2013 due to legal expenses associated with the management and disposition of problem hospitality loans.

Data processing expense increased $9,000 or 2.9% for the first quarter of 2013 compared with the same time period in 2012 due to the growth in customer accounts and transactions processed. The Bank outsources much of its data processing to third-party vendors.

FDIC deposit insurance expense increased 16.2% from $117,000 for the first quarter of 2012 to $136,000 for the first quarter of 2013 due to changes in the factors used to calculate FDIC expense.

Other operating expenses decreased $12,000 or 1.5% in the first quarter of 2013 compared with the first quarter of 2012. The decrease was primarily due to decreased expenses related to shareholder communications.

INCOME TAXES

Income tax expense was $313,000 for both the quarter ended March 31, 2013 and the quarter ended March 31, 2012. The effective tax rate was 24.5% and 24.7% for the first quarter of 2013 and 2012, respectively. The effective tax rate differed from the statutory federal income tax rate of 34% due to the Bank’s investment in tax-exempt loans and securities, income from the BOLI purchases, and community development tax credits.

COMPARISON OF FINANCIAL CONDITION AT MARCH 31, 2013 and DECEMBER 31, 2012

Total assets were $596.8 million at March 31, 2013 compared with $601.4 million at December 31, 2012, a decrease of 0.8% or $4.6 million. Balance sheet categories reflecting significant changes included securities and deposits. Each of these categories is discussed below.

INVESTMENT SECURITIES. Total investment securities were $45.7 million at March 31, 2013, reflecting a decrease of $2.4 million from $48.1 million at December 31, 2012. The decrease is due to exercise of call provisions on government backed mortgage pools.

DEPOSITS. For the three months ended March 31, 2013, total deposits decreased by $5.5 million or 1.1% when compared with total deposits at December 31, 2012. Non-interest-bearing deposits decreased by $4.0 million and interest-bearing deposits decreased by $1.5 million. Included in interest-bearing deposits at March 31, 2013 and December 31, 2012 were $26.1 million and $26.0 million, respectively, of brokered deposits as defined by the Federal Reserve. Of the $26.1 million in brokered deposits, $21.8 million represent deposits of Bank customers, exchanged through the CDARS’ network. With the CDARS’ program, funds are placed into certificate of deposits issued by other banks in the network, in increments of less than $250,000, to ensure both principal and interest are eligible for complete FDIC coverage. These deposits are exchanged with other member banks on a dollar-for-dollar basis, bringing the full amount of our customers' deposits back to the Bank and making these funds fully available for lending in our community. The decrease in the Bank’s non-interest-bearing deposits and interest-bearing deposits during the first three months of 2013 were the result of many factors difficult to segregate and quantify, and equally difficult to use as factors for future projections. The economy, local competition, retail customer preferences, changes in seasonal cash flows by both commercial and retail customers, changes in business cash management practices by Bank customers, the relative pricing from wholesale funding sources, the in-and-outflow of local government tax receipts, and the Bank’s funding needs all contributed to the change in deposit balances. The Bank projects to increase its transaction accounts and other deposits during the remainder of 2013 and beyond through the expansion of its branch network, as well as by offering value-added NOW and demand deposit products, and selective rate premiums on its interest-bearing deposits.

ASSET QUALITY

Non-performing assets primarily consist of loans that are 90 days or more past due and for which the accrual of interest has been discontinued. Management evaluates all loans that are 90 days or more past due, as well as borrowers that have suffered financial distress, to determine if they should be placed on non-accrual status. Factors considered by management include the net realizable value of collateral, if any, and other resources of the borrower that may be available to satisfy the delinquency.

Loans are placed on non-accrual status when principal or interest is delinquent for 90 days or more, unless the loans are well secured and in the process of collection. Any unpaid interest previously accrued on such loans is reversed from income. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of the loan principal balance. Interest income on other non-accrual loans is recognized only to the extent of interest payments received.

In accordance with ASC 855-10/SFAS 165 and discussed in Note 23: “Subsequent Events” in the Company’s 2012 Annual Report on Form 10-K, two events subsequent to December 31, 2012 were recognized with respect to the audited financial statements for the year ended December 31, 2012. These events occurred subsequent to the Company's February 4, 2013 press release with respect to unaudited financial statements and fourth quarter 2012 earnings. The first event on March 14, 2013: the Company's Board of Directors approved a settlement on a large nonperforming commercial real estate/hospitality loan based on an updated appraisal received concurrently with a proposed settlement offer. This resulted in a $607,000 addition to the provision for loan loss and an additional charge-off of $1.0 million on the loan and a remaining loan balance of $4.0 million. During the quarter ended March 31, 2013, this loan was paid down by an additional $440,000, with the remaining balance of $3.56 million to be repaid during the quarter ending June 30, 2013. The second event occurring during March 2013: the Company received an updated appraisal on an other real estate owned (“OREO”) property which resulted in a $370,000 addition to the reserve for OREO loss.

Non-performing assets totaled $11.9 million or 1.99% of total assets at March 31, 2013, compared with $12.4 million or 2.06% of total assets at December 31, 2012, and $6.9 million or 1.16% of total assets at March 31, 2012. Included in non-performing assets at March 31, 2013 were $79,000 of non-performing pooled trust preferred bonds at market value, $1.4 million of OREO and $10.4 million of non-accrual loans. Non-accrual loans as a percentage of total loans were 2.31% at March 31, 2013, as compared with 2.36% and 1.06% at December 31, 2012 and March 31, 2012, respectfully.

There were no loans that were past due 90 days or more and still accruing interest at March 31, 2013, compared with $132,000 on December 31, 2012 and $86,000 at March 31, 2012. During the quarter ended March 31, 2013, there were two loans totaling $2.0 million that were identified as Troubled Debt Restructurings (“TDRs”), and one previously identified TDR, totaling $237,000, that defaulted. At the end of the quarter, ten TDRs, totaling $8.4 million, were in the portfolio. Seven of the loans, totaling $7.4 million, were on accrual status and performing in accordance with the modified terms. The remaining three loans, representing two borrowers and totaling $1.0 million, remained in nonaccrual status due to irregular payments, although none were greater than ninety days past due.

For additional information regarding non-performing assets and potential loan problems, see “Loans and Allowance for Loan Losses” in Note 3 of the Notes to Consolidated Financial Statements contained herein.

At March 31, 2013, no concentration of loans to commercial borrowers engaged in similar activities exceeded 10% of total gross loans. The largest industry concentration at March 31, 2013 was approximately $15.8 million or 3.52% of loans to the hospitality industry (hotels, motels, inns, etc.) The deterioration of credit quality among hospitality loan relationships was the primary cause of the increases in non-performing loans, loan charge-offs and the provision for loan losses during 2012, as well as the level of non-performing loans at March 31, 2013.

The following table sets forth certain credit information with respect to the Bank’s hospitality loan portfolio, as well as reserve and charge-off activity, at the dates indicated. Please note that all hospitality loans are part of the commercial real estate loan segment as discussed throughout this report, in particular in Note 3 “Loans and Allowance for Loan Losses” of the Notes to Consolidated Financial Statements.

Hospitality Loans

(Dollars in thousands)	Outstanding Balance		Number of Loan Relationships		Reserve Allocation		U.S. Government Guarantee
At December 31, 2012:
Pass	$	8,885		3	$	65	$	-
Special mention		-		-		-		-
Substandard		7,230		2		-		2,358
Doubtful		-		-		-		-
Loss		-		-		-		-
Total hospitality loans	$	16,115		5	$	65	$	2,358

At March 31, 2013:
Pass	$	9,021		3	$	95	$	-
Special mention		-		-		-		-
Substandard		6,789		2		-		2,358
Doubtful		-		-		-		-
Loss		-		-		-		-
Total hospitality loans	$	15,810		5	$	95	$	2,358

At December 31, 2012:
Not impaired	$	8,885		3	$	65	$	-
Impaired		7,230		2		-		2,358
Total hospitality loans	$	16,115		5	$	65	$	2,358

At March 31, 2013:
Not impaired	$	9,021		3	$	95	$	-
Impaired		6,789		2		-		2,358
Total hospitality loans	$	15,810		5	$	95	$	2,358


At December 31, 2012:
Performing	$	8,885		3	$	65	$	-
Non-performing		7,230		2		-		2,358
Total hospitality loans	$	16,115		5	$	65	$	2,358

At March 31, 2013:
Performing	$	9,021		3	$	95	$	-
Non-performing		6,789		2		-		2,358
Total hospitality loans	$	15,810		5	$	95	$	2,358

Hospitality Loan Activity

(In thousands)	Outstanding Balance			Number of Loan Relationships		Reserve Allocation		U.S. Government Guarantees

Balance at December 31, 2012:	$	16,115			5	$	65	$	2,358
Disbursements		204			-		-		-
Amortization/prepayments on performing		(69	)		-		-		-
Amortization/prepayments on non-performing		(440	)		-		-		-
Charge-offs		-			-		-		-
Provision for loan losses		-			-		30		-
Balance at March 31, 2013	$	15,810			5	$	95	$	2,358

Based on regulatory guidelines, the Bank is required to monitor the commercial investment real estate loan portfolio for: (a) concentrations above 100% of Tier 1 capital and loan loss reserve for construction and land loans and (b) 300% for permanent investor real estate loans. As of March 31, 2013, construction and land loans were $30.7 million or 54.0% of the concentration limit. Commercial investor real estate loans, including construction and land loans, were $134.9 million or 237.3% of the concentration guideline.

CONTRACTUAL OBLIGATIONS

As of March 31, 2013, there have been no other material changes outside the ordinary course of business to the contractual obligations disclosed in “Management’s Discussion and Analysis and Results of Operations” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

OFF-BALANCE SHEET ARRANGEMENTS

As of March 31, 2013, there have been no material changes to the off-balance sheet arrangements disclosed in “Management’s Discussion and Analysis and Results of Operations” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

CAPITAL

The Company and the Bank are subject to various regulatory capital requirements administered by banking agencies. Failure to meet minimum capital requirements can trigger certain mandatory and discretionary actions by regulators that could have a direct material effect on the Company’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 Company’s and the Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. 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 in the regulations), and of Tier 1 Capital to average assets (as defined in the regulations). Management believes, as of March 31, 2013, that the Company and the Bank more than satisfy all capital adequacy requirements to which they are subject.

At March 31, 2013 and December 31, 2012, the Company exceeded its regulatory capital ratios, as set forth in the following table:

Risk Based Capital Ratios

		March 31, 2013		December 31, 2012
(Dollars in thousands)
Tier 1 Capital:
Shareholders' Equity	$	48,209		$	47,748

Plus: Unrealized loss on securities available for sale, net		1,524			1,397
Less: Unrealized loss on equity securities, net		-			-
Plus: Accumulated net loss on hedges		281			315
Plus: Company-obligated madatorily redeemable capital securities		4,000			4,000
Less: Disallowed deferred tax assets		-			-
Total Tier 1 Capital		54,014			53,460

Tier 2 Capital:
Allowable Allowance for Loan Losses		5,443			5,493

Total Capital:		59,457			58,952

Risk Weighted Assets:	$	434,809		$	438,705

Regulatory Capital Ratios:
Leverage Ratio		9.09	%		9.12	%
Tier 1 to Risk Weighted Assets		12.42	%		12.19	%
Total Capital to Risk Weighted Assets		13.67	%		13.44	%

CAPITAL RESOURCES AND LIQUIDITY

Shareholders’ equity totaled $48.2 million at March 31, 2013 compared with $47.7 million at December 31, 2012 and $48.1 million at March 31, 2012. The amount of equity reflects management’s desire to increase shareholders’ return on equity while maintaining a strong capital base. On January 17, 2013, the Company’s Board of Directors authorized the Company to repurchase up to 110,855 shares (3% of common stock outstanding on January 1, 2013) beginning January 1, 2013 and continuing until the next Board reset. No shares were repurchased during the three month period ended March 31, 2013. Accumulated other comprehensive income/loss increased to an unrealized loss net of tax benefit of $1.8 million at March 31, 2013 compared with $1.7 million at December 31, 2012 and $1.5 million at March 31, 2012.

As discussed in “Company-Obligated Mandatorily Redeemable Capital Securities” in Note 4 of the Notes to Consolidated Financial Statements contained herein, during 2006, the Company established a subsidiary trust that issued $4.0 million of capital securities as part of a separate pooled trust preferred security offering with other financial institutions. Under applicable regulatory guidelines, the capital securities are treated as Tier 1 capital for purposes of the Federal Reserve’s capital guidelines for bank holding companies, as long as the capital securities and all other cumulative preferred securities of the Company together do not exceed 25% of Tier 1 capital. As discussed above under “Capital,” banking regulations have established minimum capital requirements for financial institutions, including risk-based capital ratios and leverage ratios. As of March 31, 2013, the appropriate regulatory authorities have categorized the Company and the Bank as “well capitalized.”

The primary sources of funds are deposits, repayment of loans, maturities of investments, funds provided from operations, federal funds lines of credit with the Federal Reserve and other banks, and advances from the FHLB of Atlanta. While scheduled repayments of loans and maturities of investment securities are predictable sources of funds, deposit flows and loan repayments are greatly influenced by the general level of interest rates, economic conditions and competition. The Bank uses its sources of funds to fund existing and future loan commitments, to fund maturing certificates of deposit and demand deposit withdrawals, to invest in other interest-earning assets, to maintain liquidity, and to meet operating expenses. Management monitors projected liquidity needs and determines the desirable funding level based in part on the Bank’s commitments to make loans and management’s assessment of the Bank’s ability to generate funds. Management is not aware of any market or institutional trends, events or uncertainties that are expected to have a material effect on the liquidity, capital resources or operations of the Company or the Bank. Nor is management aware of any current recommendations by regulatory authorities that would have a material effect on liquidity, capital resources or operations. The Bank’s internal sources of such liquidity are deposits, loan and investment repayments, and securities available for sale. The Bank’s primary external sources of liquidity are federal funds lines of credit with the Federal Reserve Bank and other banks and advances from the FHLB of Atlanta.

Cash and amounts due from depository institutions, interest-bearing deposits in other banks, and federal funds sold totaled $63.4 million at March 31, 2013 compared with $64.4 million at December 31, 2012. These assets provide a primary source of liquidity for the Bank. In addition, management has designated the entire investment portfolio as available for sale, of which approximately $2.8 million was unpledged and readily salable at March 31, 2013. Furthermore, the Bank has an available line of credit with the FHLB of Atlanta with a borrowing limit of approximately $119.9 million at March 31, 2013 to provide additional sources of liquidity, as well as available federal funds purchased lines of credit with the Federal Reserve and various other commercial banks totaling approximately $69.2 million. At March 31, 2013, $28.2 million of the FHLB of Atlanta line of credit and no federal funds purchased lines of credit were in use.

The following table sets forth information relating to the Company’s sources of liquidity and the outstanding commitments for use of liquidity at March 31, 2013 and December 31, 2012. The liquidity coverage ratio is derived by dividing the total sources of liquidity by the outstanding commitments for use of liquidity.

Liquidity Sources and Uses

	March 31, 2013							December 31, 2012
(Dollars in thousands)	Total		In Use		Available			Total		In Use		Available
Sources:
Federal funds borrowing lines of credit	$	69,150	$	-	$	69,150		$	69,692	$	-	$	69,692
Federal Home Loan Bank advances		119,891		28,185		91,706			118,636		28,200		90,436
Federal funds sold and interest-bearing deposits in other banks, excluding requirements						25,347							39,044
Securities, available for sale and unpledged at fair value						2,812							5,917
Total short-term funding sources					$	189,015						$	205,089

Uses:
Unfunded loan commitments and lending lines of credit					$	69,419						$	61,615
Letters of credit						4,720							4,001
Total potential short-term funding uses					$	74,139						$	65,616

Ratio of short-term funding sources to potential short-term funding uses						254.9	%						312.6	%

IMPACT OF INFLATION AND CHANGING PRICES

The consolidated financial statements and the accompanying notes presented elsewhere in this document have been prepared in accordance with U.S. GAAP, which require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time and due to inflation. Unlike most industrial companies, virtually all the assets and liabilities of the Company and the Bank are monetary in nature. The impact of inflation is reflected in the increased cost of operations. As a result, interest rates have a greater impact on our performance than inflation does. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.

CHANGES IN ACCOUNTING PRINCIPLES

For information regarding recent accounting pronouncements and their effect on the Company, see “Recent Accounting Pronouncements” in Note 1 of the Notes to Consolidated Financial Statements contained herein.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

An important component of both earnings performance and liquidity is management of interest rate sensitivity. Interest rate sensitivity reflects the potential effect on net interest income and economic value of equity from a change in market interest rates. The Bank is subject to interest rate sensitivity to the degree that its interest-earning assets mature or reprice at different time intervals than its interest-bearing liabilities. However, the Bank is not subject to the other major categories of market risk such as foreign currency exchange rate risk or commodity price risk. The Bank uses a number of tools to manage its interest rate risk, including simulating net interest income under various scenarios, monitoring the present value change in equity under the same scenarios, and monitoring the difference or gap between rate sensitive assets and rate sensitive liabilities over various time periods. Management believes that rate risk is best measured by simulation modeling.

There have been no material changes to the quantitative and qualitative disclosures made in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

The Company maintains disclosure controls and procedures that are designed to provide assurance that the information required to be disclosed in the reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods required by the Securities and Exchange Commission. An evaluation of the effectiveness of the design and operations of the Company’s disclosure controls and procedures at the end of the period covered by this report was carried out under the supervision and with the participation of the management of Fauquier Bankshares, Inc., including the Chief Executive Officer and the Chief Financial Officer. Based on such an evaluation, the Chief Executive Officer and the Chief Financial Officer concluded the Company’s disclosure controls and procedures were effective as of the end of such period.

The Company regularly assesses the adequacy of its internal control over financial reporting and enhances its controls in response to internal control assessments and internal and external audit and regulatory recommendations. There have not been any significant changes in the Company’s internal control over financial reporting or in other factors that have materially affected or are reasonably likely to materially affect, such controls during the quarter ended March 31, 2013.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

There is no pending or threatened legal proceedings to which the Company or the Bank is a party or to which the property of either the Company or the Bank is subject to that, in the opinion of management, may materially impact the financial condition of either the Company or the Bank.

ITEM 1A. RISK FACTORS

Not applicable to smaller reporting companies.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

On January 17, 2013, the Company’s Board of Directors authorized the Company to repurchase up to 110,855 shares (3% of common stock outstanding on January 1, 2013) beginning January 1, 2013 and continuing until the next Board reset. No shares were repurchased during the three month period ended March 31, 2013.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable

ITEM 5. OTHER INFORMATION

None

Exhibit	Exhibit
Number	Description

3.1	Articles of Incorporation of Fauquier Bankshares, Inc., as amended, incorporated by reference to Exhibit 3.1 to Form 10-K filed March 15, 2010.

3.2	By-laws of Fauquier Bankshares, Inc., as amended and restated, incorporated by reference to Exhibit 3.2 to Form 10-Q filed August 9, 2010.

31.1	Certification of CEO pursuant to Rule 13a-14(a).

31.2	Certification of CFO pursuant to Rule 13a-14(a).

32.1	Certification of CEO pursuant to 18 U.S.C. Section 1350.

32.2	Certification of CFO pursuant to 18 U.S.C. Section 1350.

101.00*	The following materials from the Company’s Form 10-Q Report for the quarterly period ended March 31, 2013, formatted in XBRL: (1) Consolidated Balance Sheets, (2) Consolidated Statements of Income, (3) Consolidated Statements of Comprehensive Income (4) Consolidated Statement of Changes in Shareholders’ Equity, (5) Consolidated Statements of Cash Flows and (6) the Notes to Consolidated Financial Statements.

*Furnished, not filed

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

FAUQUIER BANKSHARES, INC.

(Registrant)

/s/ Randy K. Ferrell

Randy K. Ferrell

President & Chief Executive Officer

Dated: May 15, 2013

/s/ Eric P. Graap

Eric P. Graap

Executive Vice President & Chief Financial Officer

Dated: May 15, 2013