Potomac Bancshares, Inc. Form 10-QSB
 
U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
FORM 10-QSB
 
(Mark One)
x
 
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For quarterly period ended September 30, 2002
 
¨
 
TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
 
For the transition period from                      to                     
 
Commission file number 0-24958
 
 
POTOMAC BANCSHARES, INC.
(Exact Name of Small Business Issuer as Specified in Its Charter)
 
West Virginia
  
55-0732247
(State or Other Jurisdiction
of Incorporation or Organization)
  
(IRS Employer
Identification Number)
 
111 East Washington Street, Charles Town WV
  
25414-1071
(Address of Principal Executive Offices)
  
(Zip Code)
 
304-725-8431
(Issuer’s Telephone Number, Including Area Code)
 
NO CHANGE
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)
 
 
Check whether the issuer: (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  ¨
 
 
APPLICABLE ONLY TO ISSUERS INVOLVED IN
BANKRUPTCY PROCEEDINGS DURING THE
PRECEDING FIVE YEARS
 
Check whether the registrant filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Exchange Act after the distribution of securities under a plan confirmed by a court.  Yes  ¨  No  ¨
 
Not applicable
 
 
APPLICABLE ONLY TO CORPORATE ISSUERS
 
State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: 595,690 shares
 
Transitional Small Business Disclosure Format (check one):    Yes  ¨  No  x
 

 
PART I.    FINANCIAL INFORMATION
 
Item 1.    Financial Statements
 
POTOMAC BANCSHARES, INC.
 
CONSOLIDATED BALANCE SHEETS
(000 Omitted)
 
    
September 30
2002
   
December 31
2001
    
(Unaudited)
     
ASSETS:
              
Cash and due from banks
   
$
8,895
   
$
9,351
Interest-bearing deposits in financial institutions
   
 
2,066
   
 
2,466
Securities purchased under agreements to resell and federal funds sold
   
 
5,351
   
$
3,912
Securities held to maturity (fair value of $14,382 at September 30, 2002 and $19,614 at December 31, 2001)
   
 
14,013
   
 
18,990
Securities available for sale, at fair value
   
 
40,650
   
 
30,708
Loans held for sale
   
 
774
   
 
916
Loans, net of allowance for loan losses of $1,603 at September 30, 2002 and $1,402 at December 31, 2001
   
 
110,573
   
 
100,987
Bank premises and equipment, net
   
 
3,678
   
 
3,388
Accrued interest receivable
   
 
1,242
   
 
1,145
Other assets
   
 
1,189
   
 
1,229
    
  
Total Assets
   
$
188,431
   
$
173,092
    
  
LIABILITIES AND STOCKHOLDERS’ EQUITY:
              
Liabilities:
              
Noninterest-bearing deposits
   
$
20,123
   
$
20,611
Interest-bearing deposits
   
 
138,905
   
 
126,283
    
  
Total Deposits
   
 
159,028
   
 
146,894
Accrued interest payable
   
 
178
   
 
223
Securities sold under agreements to repurchase
   
 
4,417
   
 
2,949
Federal Home Loan Bank advances
   
 
2,121
   
 
2,352
Other liabilities
   
 
1,128
   
 
1,257
    
  
Total Liabilities
   
$
166,872
   
$
153,675
    
  
Stockholders’ Equity:
              
Common stock, $1 per share par value; 5,000,000 shares authorized; 600,000 shares issued
   
$
600
   
$
600
Surplus
   
 
5,400
   
 
5,400
Undivided profits
   
 
14,853
   
 
13,208
Accumulated other comprehensive income
   
 
876
   
 
209
    
  
    
 
21,729
   
 
19,417
Less treasury shares, September 30, 2002; 4,310 shares
   
 
170
   
 
—  
    
  
Total Stockholders’ Equity
   
 
21,559
   
 
19,417
    
  
Total Liabilities and Stockholders’ Equity
   
$
188,431
   
$
173,092
    
  
 
See Notes to Consolidated Financial Statements
 

 
POTOMAC BANCSHARES, INC.
 
CONSOLIDATED STATEMENTS OF INCOME
(000 omitted except for per share data)
(Unaudited)
 
    
For the Three Months Ended September 30
   
For the Nine Months Ended September 30
    
2002
   
2001
   
2002
   
2001
Interest Income:
                            
Interest and fees on loans
   
$
2,222
   
$
2,140
   
$
6,521
   
$
6,045
Interest on securities held to maturity—taxable
   
 
247
   
 
313
   
 
794
   
 
848
Interest on securities available for sale—taxable
   
 
390
   
 
280
   
 
1,081
   
 
847
Interest on securities purchased under agreements to resell and federal funds sold
   
 
23
   
 
65
   
 
68
   
 
356
Other interest and dividends
   
 
21
   
 
32
   
 
60
   
 
52
    
  
  
  
Total Interest and Dividend Income
   
$
2,903
   
$
2,830
   
$
8,524
   
$
8,148
Interest Expense:
                            
Interest on deposits
   
 
664
   
 
938
   
 
1,986
   
 
2,883
Interest on securities sold under agreements to repurchase
   
 
25
   
 
11
   
 
66
   
 
14
Federal Home Loan Bank advances
   
 
30
   
 
34
   
 
93
   
 
34
    
  
  
  
Total Interest Expense
   
 
719
   
 
983
   
 
2,145
   
 
2,931
Net Interest Income
   
$
2,184
   
$
1,847
   
$
6,379
   
$
5,217
Provision for Loan Losses
   
 
94
   
 
59
   
 
293
   
 
99
    
  
  
  
Net Interest Income after Provision for Loan Losses
   
$
2,090
   
$
1,788
   
$
6,086
   
$
5,118
    
  
  
  
Noninterest Income:
                            
Trust and financial services
   
$
106
   
$
133
   
$
338
   
$
392
Service charges on deposit accounts
   
 
277
   
 
100
   
 
822
   
 
296
Insurance commissions
   
 
19
   
 
23
   
 
59
   
 
52
Loan servicing fees
   
 
—  
   
 
—  
   
 
1
   
 
1
Net gain on sale of loans
   
 
54
   
 
27
   
 
117
   
 
32
Other operating income
   
 
70
   
 
54
   
 
180
   
 
139
    
  
  
  
Total Noninterest Income
   
$
526
   
$
337
   
$
1,517
   
$
912
    
  
  
  
Noninterest Expenses:
                            
Salaries and employee benefits
   
$
826
   
$
783
   
$
2,536
   
$
2,298
Net occupancy expense of premises
   
 
81
   
 
80
   
 
239
   
 
213
Furniture and equipment expenses
   
 
146
   
 
110
   
 
384
   
 
309
Other operating expenses
   
 
415
   
 
170
   
 
1,235
   
 
859
    
  
  
  
Total Other Expenses
   
$
1,468
   
$
1,143
   
$
4,394
   
$
3,679
    
  
  
  
Income before Income Tax Expense
   
$
1,148
   
$
982
   
 
3,209
   
$
2,351
Income Tax Expense
   
 
407
   
 
345
   
 
1,144
   
 
842
    
  
  
  
Net Income
   
$
741
   
$
637
   
$
2,065
   
$
1,509
    
  
  
  
Earnings Per Share, basic and diluted
   
$
1.24
   
$
1.06
   
$
3.45
   
$
2.52
    
  
  
  
 
See Notes to Consolidated Financial Statements

POTOMAC BANCSHARES, INC.
 
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
FOR THE NINE MONTHS ENDED SEPTEMBER 2002 AND 2001
(000 Omitted)
(Unaudited)
 
    
Common
Stock
   
Surplus
   
Undivided
Profits
     
Treasury
Stock
       
Accumulated
Other
Comprehensive
Income (Loss)
       
Comprehensive
Income
   
Total
  
Balances, December 31, 2000
   
$
600
   
$
5,400
   
$
12,008
 
   
$
—  
 
     
$
(44
)
            
$
17,964
 
Comprehensive income
                                                             
Net income
   
 
—  
   
 
—  
   
 
1,509
 
   
 
—  
 
     
 
—  
 
     
$
1,509
   
 
1,509
 
Other comprehensive income,unrealized holding gains arising during the period (net of tax, $190)
   
 
—  
   
 
—  
   
 
—  
 
   
 
—  
 
     
 
368
 
     
 
368
   
 
368
 
                                                 
        
Total comprehensive income
                                                
$
1,877
         
                                                 
        
Cash dividends
   
 
—  
   
 
—  
   
 
(330
)
   
 
—  
 
     
 
—  
 
            
 
(330
)
    
  
  
  
    
           
Balances, September 30, 2001
   
$
600
   
$
5,400
   
$
13,187
 
   
$
—  
 
     
$
324
 
            
$
19,511
 
    
  
  
  
    
           
Balances, December 31, 2001
   
$
600
   
$
5,400
   
$
13,208
 
   
$
—  
 
     
$
209
 
            
$
19,417
 
Comprehensive income
                                                             
Net income
   
 
—  
   
 
—  
   
 
2,065
 
   
 
—  
 
     
 
—  
 
     
$
2,065
   
 
2,065
 
Other comprehensive income,unrealized holding gains arising during the period (net of tax, $344)
   
 
—  
   
 
—  
   
 
—  
 
   
 
—  
 
     
 
667
 
     
 
667
   
 
667
 
                                                 
        
Total comprehensive income
                                                
$
2,732
         
                                                 
        
Cash dividends
   
 
—  
   
 
—  
   
 
(420
)
   
 
—  
 
     
 
—  
 
            
 
(420
)
Purchase of treasury shares; 4,310 shares
   
 
—  
   
 
—  
   
 
—  
 
   
 
(170
)
     
 
—  
 
            
 
(170
)
    
  
  
  
    
           
Balances, September 30, 2002
   
$
600
   
$
5,400
   
$
14,853
 
   
$
(170
)
     
$
876
 
            
$
21,559
 
    
  
  
  
    
           
 
 
See Notes to Consolidated Financial Statements

POTOMAC BANCSHARES, INC.
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
(000 Omitted)
(Unaudited)
 
    
For the Nine Months Ended
  
    
September 30
2002
     
September 30
2001
  
CASH FLOWS FROM OPERATING ACTIVITIES
                  
Net income
   
$
2,065
 
   
$
1,509
 
Adjustments to reconcile net income to net cash provided by operating activities:
                  
Provision for loan losses
   
 
293
 
   
 
99
 
Depreciation
   
 
228
 
   
 
184
 
Deferred tax expense (benefit)
   
 
(96
)
   
 
—  
 
Discount accretion and premium amortization on securities, net
   
 
35
 
   
 
(21
)
Changes in assets and liabilities:
                  
(Increase) in accrued interest receivable
   
 
(97
)
   
 
(97
)
(Increase) in other assets
   
 
(208
)
   
 
(108
)
Proceeds from sale of loans
   
 
6,727
 
   
 
1,603
 
Origination of loans for sale
   
 
(6,585
)
   
 
(1,850
)
(Decrease) in accrued interest payable
   
 
(45
)
   
 
(37
)
Increase (decrease) in other liabilities
   
 
(130
)
   
 
50
 
    
  
Net cash provided by operating activities
   
$
2,187
 
   
$
1,332
 
    
  
CASH FLOWS FROM INVESTING ACTIVITIES
                  
Proceeds from maturity of securities held to maturity
   
$
5,000
 
   
$
8,000
 
Proceeds from maturity of securities available for sale
   
 
9,250
 
   
 
6,000
 
Purchase of securities held to maturity
   
 
—  
 
   
 
(9,035
)
Purchase of securities available for sale
   
 
(18,239
)
   
 
(14,139
)
Net (increase) in loans
   
 
(9,878
)
   
 
(15,080
)
Purchases of bank premises and equipment
   
 
518
)
   
 
(348
)
Proceeds from sale of real estate
   
 
—  
 
   
 
13
 
    
  
Net cash (used in) investing activities
   
$
(14,385
)
   
$
(24,589
)
    
  
CASH FLOWS FROM FINANCING ACTIVITIES
                  
Net increase (decrease) in noninterest-bearing deposits
   
$
(488
)
   
$
859
 
Net increase in interest-bearing deposits
   
 
12,622
 
   
 
12,608
 
Net proceeds in securities sold under agreements to repurchase
   
 
1,468
 
   
 
1,990
 
Proceeds (repayment) of Federal Home Loan Bank advances
   
 
(231
)
   
 
2,426
 
Purchase of treasury shares
   
 
(170
)
   
 
—  
 
Cash dividends
   
 
(420
)
   
 
(330
)
    
  
Net cash provided by financing activities
   
$
12,781
 
   
$
17,553
 
    
  
Increase (decrease) in cash and cash equivalents
   
$
583
 
   
$
(5,704
)
CASH AND CASH EQUIVALENTS
                  
Beginning
   
 
15,729
 
   
 
23,419
 
    
  
Ending
   
$
16,312
 
   
$
17,715
 
    
  
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
                  
Cash payments for:
                  
Interest
   
$
2,190
 
   
$
2,968
 
    
  
Income taxes
   
$
1,311
 
   
$
818
 
    
  
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES
                  
Unrealized gain on securities available for sale
   
$
1,011
 
   
$
558
 
    
  
 
See Notes to Consolidated Financial Statements

POTOMAC BANCSHARES, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2002 (Unaudited) and December 31, 2001
 
1.
 
In the opinion of management, the accompanying financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position as of September 30, 2002, and December 31, 2001, the results of operations for the three months ended September 30, 2002 and 2001, and the results of operations and cash flows for the nine months ended September 30, 2002 and 2001. The statements should be read in conjunction with Notes to Consolidated Financial Statements included in the Potomac Bancshares, Inc. annual report for the year ended December 31, 2001. The results of operations for the nine month periods ended September 30, 2002 and 2001, are not necessarily indicative of the results to be expected for the full year.
 
2.
 
Securities held to maturity as of September 30, 2002 and December 31, 2001 are summarized below:
 
    
September 30, 2002
    
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
(Losses)
   
Fair
Value
    
(000 Omitted)
Securities held to maturity:
                            
Obligations of U.S. Government agencies
   
$
14,013
   
$
369
   
$
  —  
   
$
14,382
    
  
  
  
 
    
December 31, 2001
    
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
(Losses)
   
Fair
Value
    
(000 Omitted)
Securities held to maturity:
                            
Obligations of U.S. Government agencies
   
$
18,990
   
$
624
   
$
  —  
   
$
19,614
    
  
  
  
 
Securities available for sale as of September 30, 2002 and December 31, 2001 are summarized below:
 
    
September 30, 2002
    
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
(Losses)
   
Fair
Value
    
(000 Omitted)
Securities available for sale:
                            
Obligations of U.S. Government agencies
   
$
39,322
   
$
1,328
   
$
  —  
   
$
40,650
    
  
  
  
 
    
December 31, 2001
    
Amortized Cost
   
Gross
Unrealized Gains
   
Gross
Unrealized (Losses)
     
Fair
Value
    
(000 Omitted)
Securities available for sale:
                              
Obligations of U.S. Government agencies
   
$
30,391
   
$
378
   
$
(61
)
   
$
30,708
    
  
  
  

 
3.
 
The consolidated loan portfolio, stated at face amount, is composed of the following:
 
    
September 30
2002
   
December 31
2001
    
(000 Omitted)
Mortgage loan on real estate:
              
Construction, land development and other land
   
$
2,166
   
$
530
Farmland
   
 
1,851
   
 
1,801
One to four family residential
   
 
64,160
   
 
56,283
Other
   
 
19,642
   
 
19,275
Loans to farmers (except those secured by real estate)
   
 
134
   
 
46
Commercial and industrial loans (except those secured by real estate)
   
 
3,612
   
 
2,952
Loans to individuals for personal expenditures
   
 
19,894
   
 
21,214
All other loans
   
 
717
   
 
288
    
  
Total loans
   
$
112,176
   
$
102,389
Less: Allowance for loan losses
   
 
1,603
   
 
1,402
    
  
    
$
110,573
   
$
100,987
    
  
 
4.
 
The following is a summary of transactions in the allowance for loan losses:
 
    
September 30
2002
     
December 31
2001
  
    
(000 Omitted)
  
Balance at beginning of period
   
$
1,402
 
   
$
1,268
 
Provision charged to operating expense
   
 
293
 
   
 
221
 
Recoveries added to the allowance
   
 
40
 
   
 
35
 
Loan losses charged to the allowance
   
 
(132
)
   
 
(122
)
    
  
Balance at end of period
   
$
1,603
 
   
$
1,402
 
    
  
 
5.
 
Information about impaired and nonaccrual loans as of September 30, 2002 and December 31, 2001 is as follows:
 
The Corporation had no impaired loans at September 30, 2002 and December 31, 2001.
 
Nonaccrual loans excluded from impaired loan disclosures under FASB 114 amounted to $27 thousand at September 30, 2002 and $9 thousand at December 31, 2001.

 
6.
 
Recent Accounting Pronouncements
 
In April 2002, the Financial Accounting Standards Board issued Statement 145, Rescission of FASB No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. This Statement rescinds FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, FASB Statement No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. This Statement also rescinds FASB Statement No. 44, Accounting for Intangible Assets of Motor Carriers. This Statement amends FASB Statement No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions of this Statement related to the rescission of Statement 4 shall be applied in fiscal years beginning after May 15, 2002. The provisions of this Statement related to Statement 13 are effective for transactions occurring after May 15, 2002, with early application encouraged.
 
In June 2002, the Financial Accounting Board issued Statement 146, Accounting for Costs Associated with Exit or Disposal Activities. This Statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullified Emerging Issue Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The standard requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged.
 
The Financial Accounting Standards Board issued Statement No. 147, Acquisitions of Certain Financial Institutions, an Amendment of FASB Statement No. 72 and 144 and FASB Interpretation No. 9 in October 2002. FASB Statement No. 72, Accounting for Certain Acquisitions of Banking or Thrift Institutions, and FASB Interpretation No.9, Applying APB Opinions No.16 and 17 When a Savings and Loan Association or a Similar Institution is Acquired in a Business Combination Accounted for by the Purchase Method, provided interpretive guidance on the application of the purchase method to acquisitions of financial institutions. Except for transactions between two or more mutual enterprises, this Statement removes acquisitions of financial institutions form the scope of both Statement 72 and Interpretations 9 and requires that those transactions be accounted for in accordance with FASB Statement No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets. thus, the requirement in paragraph 5 of Statement 72 to recognize (and subsequently amortize) any excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired as an unidentifiable intangible asset no longer applies to acquisitions with the scope of this Statement. In addition, this Statement amends FASB Statement No. 144, Accounting for the Impairment of Disposal of Long-Lived Assets, to include in its scope long-term customer-relationship intangible assets of financial institutions such as depositor- and borrower-relationship assets and credit cardholder intangible assets. Consequently, those intangible assets are subject to the same undiscounted cash flow recoverability test and impairment loss recognition and measurement provisions that Statement 144 requires for other long-lived assets that are held and used.
 
Paragraph 5 of this Statement, which relates to the application of the purchase method of accounting, is effective for acquisitions for which the date of acquisition is on or after October 1, 2002. The provisions in paragraph 6 related to accounting for the impairment of disposal of certain long-term customer-relationship intangible assets are effective on October 1, 2002. Transition provisions for previously recognized unidentifiable intangible assets in paragraphs 8-14 are effective on October 1, 2002, with earlier application permitted.
 
This Statement clarifies that a branch acquisition that meets the definition of a business should be accounted for as a business combination, otherwise the transaction should be accounted for as an acquisition of net assets that does not result in the recognition of goodwill.
 
The transition provisions state that if the transaction that gave rise to the unidentifiable intangible asset was a business combination, the carrying amount of that asset shall be reclassified to goodwill as of the later of the date of acquisition or the date Statement 142 was first applied (fiscal years beginning after December 15, 2001). Any previously issued interim statements that reflect amortization of the unidentifiable intangible asset subsequent to the Statement 142 application date shall be restated to remove that amortization expense. The carrying amounts of any recognized intangible assets that meet the recognition criteria of Statement 141 that have been included in the amount reported as an unidentifiable intangible asset and for which separate accounting records have been maintained shall be reclassified and accounted for as assets apart from the unidentifiable intangible asset and shall not be reclassified to goodwill.
 
These new accounting statements will not have a material impact on the consolidated financial statements of the Corporation.

 
7.
 
Weighted Average Number of Shares Outstanding
 
    
2002
   
2001
Weighted average number of shares outstanding for the three months ending September 30
   
595,690
   
600,000
Weighted average number of shares outstanding for the nine months ending September 30
   
597,948
   
600,000
 
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
CRITICAL ACCOUNTING POLICIES
 
General
 
The Corporation’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of actors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.
 
Allowance for Loan Losses
 
The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimatable and (ii) SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.
 
Our allowance for loan losses has two basic components: the formula allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a historical loss view as an indicator of future losses and, as a result, could differ from the loss incurred in the future. However, since this history is updated with the most recent loss information, the errors that might otherwise occur are mitigated. The unallocated allowance captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in the formula allowance.
 
FINANCIAL OVERVIEW
 
Between December 31, 2001 and September 30, 2002, total assets increased $15 million from $173 million at December 31, 2001 to $188 million at September 30, 2002. Total securities (held to maturity and available for sale) increased $5 million and loans increased $9 million. Securities purchased under agreements to resell and federal funds sold increased only $1 million. These asset changes were made in response to the continual growth in deposits that are showing a $12 million increase since December 2001.
 
The September 30, 2002 annualized return on average assets is 1.54% compared to 1.27% at December 31, 2001. At September 30, 2002 the annualized return on average equity is 13.62% compared to 10.68% at December 31, 2001. The leverage capital (equity to assets) ratio is 11.44% at September 30, 2002 compared to 11.30% at December 31, 2001.

 
The table shown below is an analysis of the Corporation’s allowance for loan losses. Net charge-offs for the Corporation have been very low when compared with the size of the total loan portfolio. Management monitors the loan portfolio on a continual basis with procedures that allow for problem loans and potentially problem loans to be highlighted and watched. Written reports detailing this loan information are prepared on a quarterly basis. Based on experience, the loan policies, and the current monitoring program, management believes the loan loss allowance is very adequate.
 
      
September 30, 2002
  
      
(000 Omitted)
  
Balance at beginning of period
     
$
1,402
 
Charge-offs:
           
Commercial, financial and agricultural
     
 
—  
 
Real estate—construction
     
 
—  
 
Real estate—mortgage
     
 
—  
 
Consumer
     
 
132
 
      
Total charge-offs
     
 
132
 
      
Recoveries:
           
Commercial, financial and agricultural
     
 
—  
 
Real estate—construction
     
 
—  
 
Real estate—mortgage
     
 
—  
 
Consumer
     
 
40
 
      
Total recoveries
     
 
40
 
      
Net charge-offs
     
 
92
 
Additions charged to operations
     
 
293
 
      
Balance at end of period
     
$
1,603
 
      
Ratio of net charge-offs during the period to average loans outstanding during the period
     
 
.0854
%
      
 
Loans are placed on nonaccrual status when a loan is specifically determined to be impaired or when principal or interest is delinquent for 90 days or more. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received. Following is a table showing the risk elements in the loan portfolio.
 
      
September 30, 2002
  
      
(000 Omitted)
  
Nonaccrual loans
     
$
27
 
Restructured loans
     
 
—  
 
Foreclosed properties
     
 
—  
 
      
Total nonperforming assets
     
$
27
 
      
Loans past due 90 days accruing interest
     
$
10
 
      
Allowance for loan losses to period end loans
     
 
1.43
%
      
Nonperforming assets to period end loans and foreclosed properties
     
 
.0241
%
      
 
At September 30, 2002, other potential problem loans totalled $513 thousand. Loans are viewed as potential problem loans according to the ability of such borrowers to comply with current repayment terms. These loans are subject to constant management attention, and their status is reviewed on a regular basis. Management has allocated a portion of the allowance for loan losses for these loans according to the review of the potential loss in each loan situation.
 
The overall increase in deposits at September 30, 2002 compared to December 31, 2001 was $12 million, or 8%. Most account types have increased with increases up to 20%. The 20% growth is in Select checking, the account that pays a higher rate of interest on deposits over $5 thousand. Management has kept this rate relatively high since average balances in these accounts are $60 thousand and over and belong in large part to a portion of our core deposit base. Other new deposits are attributed to a combination of factors including the opening of a new branch in Martinsburg, West Virginia, new loan clients opening new deposit accounts and a certificate of deposit promotion that ran in August and the first part of September.

The comparison of the income statements for the three months and nine months ended September 30, 2002 and 2001 shows similar changes in most income and expense categories. Net interest income in 2002 increased 22% when comparing the nine month figures to 2001. Interest income increased 5%. Although loan volume has increased, since rates have decreased total interest and fees on loans has increased only 9%. The securities portfolio (HTM and AFS) has increased and even with reduced rates, interest income on the portfolio has increased 11%. Interest on fed funds sold and securities purchased under agreements to resell has decreased because volume and rates have decreased. The change in interest expense is a little more dramatic than the change in interest income, showing a reduction of 27% when comparing 2002 expense with 2001. This is due entirely to decreased interest rates being paid on deposits since 2002 interest-bearing deposit volumes have increased 14% when compared with September 2001 deposits. Net income for the nine month period in 2002 has increased 37% when compared to 2001.
 
Noninterest income increased 66% in 2002 compared to 2001 for the nine month period. The majority of the increase (86%) is fees derived from an overdraft protection program the bank implemented in December of 2001. Fees from this program have remained consistent through the third quarter of 2002. Other increases in noninterest income include increased fees due to a successful debit card promotion resulting in increased customer usage of the cards, increased fees for letters of credits due to increases in volume and increased safe deposit rental fees.
 
Noninterest expense increased 19% in 2002 compared to 2001 for the nine month period. Salaries and benefits increased 10% due to annual salary increases, higher salaries for key people, more incentives and implementation of a 401k plan. Occupancy expense increases are a combination of increased expenses due to growth and the addition of an annual contract for grounds maintenance and beautification for all branches. Furniture and equipment expenses increased due to the beginning of a major upgrade to most computer related systems in the bank and increased equipment maintenance expenses. Other operating expenses increased 44% in 2002 compared to 2001 for the nine month period. Major components of this increase follow. Advertising expense is up 22% in 2002 compared to 2001 because the bank is utilizing the services of a professional to design ads so that our image in advertising is more consistent as well as more appropriately directed for specific products and/or events. Market area expansion also had an affect on increased advertising expense. Postage expense increased since rates increased and with increased mailings related to customer base growth. Training and study expense increased due to a major emphasis on training for all employees. Home equity closing costs increased due to increased loan volume. State franchise tax increased due to the phase out of a credit against the tax based on the stock value.
 
Liquid assets of the Corporation include cash and due from banks, fed funds sold, securities purchased under agreements to resell, securities available for sale, and loans and investments maturing within one year. The Corporation’s statement of cash flows shows the details of a portion of this liquidity. Net income after certain adjustments for noncash transactions provided cash from operating activities. Funds from maturity of securities, existing cash and financing activities funded the investing activities of increasing the loan and securities portfolios and adding to premises and equipment. Financing activities providing cash included increased deposits and increased securities sold under agreements to repurchase. In addition to the use of cash for investing activities, financing activities using cash included scheduled repayments on a Federal Home Loan Bank advance, paying cash dividends and purchasing treasury shares. Cash and cash equivalents increased during this period. The Corporation has additional liquidity options through credit lines at the Federal Home Loan Bank and Bank of America. Management believes the liquidity of the Corporation is adequate to meet present and future financial obligations.
 
Item 3.    Controls and Procedures
 
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures within 90 days of the filing date of this quarterly report. Based on that evaluation, our principal executive officer and principal financial officer have concluded that these controls and procedures are effective. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
 
Disclosure controls and procedures are our controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.

PART II.    OTHER INFORMATION
 
Item 1.    Legal Proceedings.
 
There are no material legal proceedings to which the Registrant or its subsidiary, directors or officers is a party or by which they, or any of them, are threatened. All legal proceedings presently pending or threatened against Potomac Bancshares, Inc. and its subsidiary involve routine litigation incidental to the business of the Company or the subsidiary and are either not material in respect to the amount in controversy or fully covered by insurance.
 
Item 6.    Exhibits and Reports on Form 8-K.
 
(a)  Exhibits:
 
2.
   
Plan of acquisition, reorganization, arrangement, liquidation or succession.
    
Not applicable
4.
   
Instruments defining the rights of security holders, including indentures.
Not applicable
10.
   
Material contracts.
Not applicable
11.
   
Statement re: computation of per share earnings.
Not applicable
15.
   
Letter on unaudited interim financial information.
Not applicable
18.
   
Letter on change in accounting principles.
Not applicable
19.
   
Reports furnished to security holders.
Not applicable
22.
   
Published report regarding matters submitted to vote of security holders.
Not applicable
23.
   
Consent of experts and counsel.
Not applicable
24.
   
Power of attorney.
Not applicable
99.1
   
Certification Pursuant to 18 U.S.C. Section 1350, Chief Executive Officer (pursuant to Section 906 of
Sarbanes-Oxley Act of 2002)
99.2
   
Certification Pursuant to 18 U.S.C. Section 1350, Chief Financial Officer (pursuant to Section 906 of
Sarbanes-Oxley Act of 2002)
99.3
   
Certification Pursuant to 18 U.S.C. Section 1350, Chief Executive Officer (pursuant to Section 302 of
Sarbanes-Oxley Act of 2002)
99.4
   
Certification Pursuant to 18 U.S.C. Section 1350, Chief Financial Officer (pursuant to Section 302 of
Sarbanes-Oxley Act of 2002)
 
(b)  Reports on Form 8-K:
 
NONE

 
SIGNATURES
 
In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
        
POTOMAC BANCSHARES, INC.
Date
   
November 8 , 2002
  
/s/    Robert F. Baronner, Jr.
        
Robert F. Baronner, Jr.
President & CEO
          
Date
   
November 8, 2002    
  
/s/    L. Gayle Marshall Johnson
        
L. Gayle Marshall Johnson
Vice President & Chief Financial Officer