UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

     (Mark One)

Commission File Number 000-30447

VALLEY COMMUNITY BANCSHARES, INC.

(253) 848-2316
(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 is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.)

Yes o No x

The number of shares of the issuer’s Common Stock, $1.00 par value, outstanding at May 4, 2004 was 1,238,083.

VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
INDEX TO QUARTERLY REPORT ON FORM 10-Q

PART I FINANCIAL INFORMATION

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Item 1. FINANCIAL STATEMENTS

VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
CONDENSED CONSOLIDATED BALANCE SHEET
(unaudited)
(dollars in thousands)

The accompanying notes are an integral part of these financial statements

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VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENT OF INCOME
(unaudited)
(dollars in thousands, except for per share amounts)

The accompanying notes are an integral part of these financial statements

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VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(unaudited)
(dollars in thousands, except for per share amounts)

The accompanying notes are an integral part of these financial statements

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VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — Basis of Presentation

Valley Community Bancshares, Inc. (the “Company”) prepared the condensed consolidated financial statements of the Company for the three-month periods ended March 31, 2004 and March 31, 2003 without audit by the Company’s independent auditors. However, the financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America for interim financial information and with instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of the Company’s management, all adjustments consisting of normal recurring accruals necessary for a fair presentation of the financial condition and results of operations for the interim periods included herein have been made. The consolidated balance sheet of the Company as of December 31, 2003 has been derived from the audited consolidated balance sheet of the Company as of that date. The results of operations for the three-months ended March 31, 2004, are not necessarily indicative of the results to be anticipated for the year ending December 31, 2004.

Certain information and note disclosures normally included in the Company’s annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. Therefore, these consolidated financial statements and notes thereto should be read in conjunction with a reading of the financial statements for the year ended December 31, 2003 and notes thereto included in the Company’s Form 10-K filed with the Securities and Exchange Commission. Certain amounts in the 2003 financial statements have been reclassified to conform to the 2004 presentation.

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements. Changes in these estimates and assumptions are considered reasonably possible and may have a material impact on the consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein. The Company considers the allowance for loan loss a critical accounting policy subject to estimate.

Stock Option Plan

The Company accounts for the stock option plan under recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations using the intrinsic value method. No stock-based employee compensation cost is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition method as provided under FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

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Note 2 — Earnings per share

Basic earnings per share amounts are computed based on the weighted average number of shares outstanding during the period after giving retroactive effect to stock dividends and stock splits. Diluted earnings per share amounts are computed by determining the number of additional shares that are deemed outstanding due to stock options under the treasury stock method.

The following table sets forth the computation of basic and diluted earnings per share for the three-months ended March 31, 2004 and 2003 (dollars in thousands, except per share amounts):

Note 3 –Comprehensive Income

Total comprehensive income, which includes net income and unrealized gains and losses on the Company’s available-for-sale securities, amounted to $509,000 and $387,000, respectively, for the three months ended March 31, 2004 and 2003, respectively.

Note 4 — Investment Securities

Investment securities have been classified as available-for-sale in according with management’s intent. The carrying amount of securities and their estimated fair values are as follows (in thousands):

March 31, 2004

Securities Available-For-Sale

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December 31, 2003

Securities Available-For-Sale

At March 31, 2004 and December 31, 2003, there were approximately 13 and 20 investment securities, respectively, that had fair values less than amortized cost and therefore contains unrealized losses. The Company has evaluated these securities and has determined that the decline in value is temporary and is related to the change in market interest rates since purchase. The decline in value is not related to any company or industry specific event. The Company anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market interest rate environment.

Note 5 — Loans

The major classifications of loans at March 31, 2004 and December 31, 2003 are summarized as follows (dollars in thousands):

VALLEY COMMUNITY BANCSHARES, INC.
Loan Portfolio
(dollars in thousands)

Note 6 – Allowance for Loan Losses

Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provision required to maintain an adequate allowance. In assessing the adequacy of the allowance, management reviews the size, quality and risks of loans in the portfolio and considers factors such as specific known risks, past experience, the status and amount of nonperforming assets and economic conditions. A specific percentage is allocated to each major classification and not specifically reserved while additional amounts are added for individual loans considered to have specific loss potential. Loans identified as losses are charged-off. Based on total allocations, the provision is recorded to maintain the allowance at a level deemed appropriate by management. While management uses available information to recognize losses on loans, there can be no assurance that future additions to the allowance will not be necessary.

The allowance for loan losses at March 31, 2004 and December 31, 2003, totaled $1,388,000. Management believes that the allowance for loan losses at March 31, 2004 adequately reflects the risks in the loan portfolio. Various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses. Such agencies may require the Bank to recognize changes to the allowance based on their judgments of information available to them at the time of their examination.

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The following table summarizes the activity in the allowance for loan losses (dollars in thousands):

VALLEY COMMUNITY BANCSHARES, INC.
Loan Loss Experience

Note 7 – Business Segment Information

Beginning January 1999 and through December 2002, the Company owned two community-banking institutions, Puyallup Valley Bank and Valley Bank. These banks were managed at the subsidiary bank level. Each subsidiary bank had a board of directors and an executive management team responsible for the operation and performance of the respective subsidiary bank.

On January 17, 2003, the Company merged the subsidiary banks into one community bank named Valley Bank. In addition, the company consolidated its board of directors and executive management team into a new organizational structure, while converting separated banking systems into a single operation. As a result of these system and organizational changes, the financial information that is used by the chief operating decision maker in allocating resources and assessing performance is only provided for one reportable segment for the three-month period ended March 31, 2004 and 2003.

Note 8 – Recent Accounting Pronouncements

The following accounting pronouncements were recently issued by the Financial Accounting Standards Board (“FASB”) and Accounting Standards Executive Committee (“AcSEC”) of the American Institute of Certified Public Accountants.

In December 2003, the FASB amended FASB Statement No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits—an amendment of FASB Statements No. 87, 88, and 106. This Statement revises employers’ disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by FASB Statements No. 87, Employers’ Accounting for Pensions, No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, and No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions. This Statement retains the disclosure requirements contained in FASB Statement No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits, which it replaces. It requires additional disclosures to those in the original Statement 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. The required information should be provided separately for pension plans and for other postretirement benefit plans. This Statement is effective for financial statements with fiscal years ending after December 15, 2003. The interim-period disclosures required by this Statement are effective for interim periods beginning after December 15, 2003. This statement did not result in a material impact of the Company’s financial position or results of operation.

In December 2003, the FASB issued a revision of FIN 46 (“FIN 46®”) which replaced the Interpretation issued in January 2003. The revised Interpretation clarifies some of the provisions of FIN 46 and provides additional exemptions for certain entities. The provisions of FIN 46® are required to be adopted for periods ending after March 15, 2004.

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The adoption of FIN 46® did not have a material impact on the Company’s financial condition, results of operations or cash flows.

In December 2003, AcSEC issued Statement of Position (“SOP”) 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer. The SOP is effective for loans acquired in fiscal years beginning after December 15, 2004, with earlier application encouraged. A certain transition provision applies for certain aspects of loans currently within the scope of Practice Bulletin 6, Amortization of Discounts on Certain Acquired Loans. The SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. Loans acquired in business combinations are included in the scope of the SOP. The SOP does not apply to loans originated by the entity. The Company has not yet adopted the provisions of the SOP and does not expect them to have a material impact on the Company’s financial condition, results of operations or cash flows.

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

Valley Community Bancshares, Inc.

Valley Community Bancshares, Inc. (the “Company”) is a bank holding company registered under the Bank Holding Company Act of 1956, as amended. The Company was organized and incorporated under the laws of the State of Washington as a holding company for its principal banking subsidiary, Valley Bank, a state chartered, Federal Deposit Insurance Corporation (the “FDIC”) insured commercial bank, through a reorganization completed on July 1, 1998. Valley Bank is referred to as the “Bank” in this Form 10-Q.

The Company’s main office is located in Puyallup, Washington, which also serves as the main office of Valley Bank. The Bank provides a full range of commercial banking services to small and medium-sized businesses, professionals and other individuals through eight banking offices located in Puyallup, Auburn, and Kent, Washington, and their environs.

The principal sources of the Company’s revenue are (i) interest and fees on loans; (ii) deposit service charges; (iii) merchant credit card processing fees; (iv) interest bearing deposits with Bank; (v) interest on investments (principally government securities) and (vi) origination fees on mortgage loans brokered. The Bank’s lending activity consists of short-to-medium-term commercial and consumer loans, including operating loans and lines of credit, equipment loans, automobile loans, recreational vehicle and truck loans, personal loans or lines of credit, home improvement loans and rehabilitation loans. The Bank also offer cash management services, merchant credit card processing, safe deposit boxes, wire transfers, direct deposit of payroll and social security checks, automated teller machine access, and automatic drafts for various accounts.

Valley Bank

Valley Bank is a Washington state-chartered commercial bank, which commenced operations as Puyallup Valley Bank in October 1973. In January 1999 the Company opened Valley Bank, a state chartered FDIC insured commercial bank subsidiary located in Auburn, Washington. On January 17, 2003, Puyallup Valley Bank and Valley Bank merged and renamed the resulting institution Valley Bank.

The Bank provides full-service banking to businesses and residents within the Puyallup, Auburn and Kent communities and its surrounding areas. The Bank places particular emphasis on serving the small to medium-sized business segment of the market by making available a line of banking products tailored to their needs, with those services delivered by experienced professionals concerned with building long-term relationships. The Bank conducts business out of eight full-service offices and one drive-up facility.

The Bank also provides mortgage banking services to its customers through Puget Sound Mortgage Brokers. The Bank purchased various tangible and intangible assets of Puget Sound Mortgage Brokers, Inc., a Washington Corporation on May 16, 2002. The mortgage operation is operated as a division of the Bank and operates in a leased facility in Puyallup.

Valley Bank is a wholly owned subsidiary of the Company.

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Results of Operations

The Company’s net income is derived principally from the operating results of its banking subsidiary Valley Bank. Valley Bank is a well-established commercial bank and generates substantially all of the Company’s operating income.

The Company earned net income of $468,000 or $0.38 per diluted share for the three months ended March 31, 2004, compared to net income of $445,000 or $0.36 per diluted share, for the three months ended March 31, 2003, an increase of 5.2 percent. The Company’s return on average assets was 1.05 percent for the three months ended March 31, 2004, compared to 1.04 percent for the three months ended March 31, 2003.

The improvement in net income for the three months ended March 31, 2004 was the result of an increase in net interest income and a decrease in non-interest expense partially offset by a decrease in non-interest income. The major reasons for the quarterly change are as follows:

•		A higher volume of earning assets along with continued reduction in deposit interest expense was primarily responsible for the increase in net interest income during the first quarter of 2004 when compared to the same period a year ago.
•		Non-interest expense was higher in 2003, when compared to 2004, largely as a result of non-recurring merger related expenses (between Puyallup Valley Bank and Valley Bank) incurred in 2003.
•		Non-interest income decreased during 2004 as a result of a significant reduction in origination fees on mortgage loans brokered as residential loan customers slowed their mortgage refinancing activity.

The Company anticipates higher non-interest expenses during the second quarter of 2004 as the implementation of the Bank’s internet banking product is completed. The Company does not anticipate sufficient revenues to offset the added costs of this product, as result profitability is anticipated to be negatively impacted on a go forward basis.

The following table shows the various performance ratios for the Company for the three months ended March 31, 2004 and 2003, respectively:

VALLEY COMMUNITY BANCSHARES, INC.
Selected Financial Data ¹
(dollars in thousands, except per share amounts)

Net Interest Income

Net interest income is the most significant component contributing to net income. It is the difference between interest earned on earning assets (primarily loans and investments) and interest paid on interest bearing liabilities (deposits and borrowings). The volume of and yields earned on earning assets and the volume of and the rates paid on interest bearing liabilities determine net interest income. Interest earned and interest paid is also affected by general economic conditions, particularly changes in market interest rates, and by government policies and the action of regulatory authorities.

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The earnings on certain assets are exempt from federal income tax. It is customary in the financial services industry to analyze changes in net interest income on a “tax equivalent” (TE) basis. TE is a non-GAAP performance measure used by management in operating the business, which management believes provides investors with a more accurate picture of the interest margin for comparative purposes. Under this method, nontaxable income from loans and investments is adjusted to an amount, which would have been earned if such income were subject to federal income tax.

The discussion below presents an analysis based on tax equivalent amounts at a 34% tax rate.

VALLEY COMMUNITY BANCSHARES, INC.
Net Interest Income, adjusted to a Tax Equivalent Basis
(dollars in thousands),

TE net interest income, divided by average earning assets is referred to as net interest margin. For the three months ended March 31, 2004 the Company’s net interest margin was 4.84 percent compared to 4.92 percent for the three months ended March 31, 2003. TE net interest income was $2,011,000 for the three months ended March 31, 2004 compared to $1,942,000 for the three months ended March 31, 2003. The increase in TE net interest income, for the three months ended March 31, 2004 compared to the same period a year ago, was the result of earnings realized on a higher volume of earning assets and a continued reduction in deposit interest expense, partially offset by a reduction in the interest rate earned on earning assets.

TE interest income was $2,232,000 for the three months ended March 31, 2004 compared to $2,321,000 for the three months ended March 31, 2003. The three-month decrease was the result of a decrease in the yield earned on earning assets partially offset by the additional earnings received on the increased volume of earning assets. The yield on interest-earning assets decreased to 5.37 percent for the three months ended March 31, 2004 compared to 5.88 percent during the same period a year ago. The yield decrease reflects an overall decline in market interest rates.

Interest expense was $221,000 for the three months ended March 31, 2004 compared to $379,000 for the three months ended March 31, 2003. The cost of funds decreased to 0.74 percent for the three months ended March 31, 2004 compared to 1.28 percent during the same period a year ago. The decrease for the three-month period was due to a decrease in the Company’s cost of funds resulting from an overall decline in market interest rates.

Market interest rates continue to be at historical lows as a result of a slow national and regional economy and because of an aggressively accommodating Federal Reserve monetary policy beginning in 2001. The significant decrease in market interest rates initially had a positive impact on the Company’s net interest margin as the Company experienced a greater reduction in deposit costs in comparison to the reduction in the earnings on loans and investments. However, during 2003 and 2004 market interest remained relatively low which resulted in a greater reduction in the earnings on loans and investments as compared to the reduction in deposit costs.

The Company’s current interest rate risk position suggests that in the event of an increase in market interest rates, the Company’s TE net interest income and margin may decrease. The decrease results because the Company has a greater amount of interest bearing liabilities subject to repricing when compared to the repricing of interest earning assets. Any TE net interest income and margin decrease is dependent on the timing and magnitude of any interest rate increase. This decrease may be somewhat offset because the rate paid on deposits, with administered interest rates, generally do not increase as rapidly as an account whose rates change with market interest rates. In the event of continued low market interest rates, the Company anticipates a further decrease in net interest margin as interest-earning assets reprice to the lower interest rate levels while the ability to lower deposit rates are somewhat limited.

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The following table sets forth information concerning the Company’s average balance and average interest rates earned or paid, interest rate spread and net interest margin for the three months ended March 31, 2004 and 2003:

VALLEY COMMUNITY BANCSHARES, INC.
AVERAGE BALANCES AND INTEREST RATES EARNED/PAID
(dollars in thousands)

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The following table sets forth information concerning the Company’s change in TE net interest income for the periods that are attributable to changes in interest rate and changes in volume for the three month period ended March 31, 2004 compared to the three month period ended March 31, 2003:

VALLEY COMMUNITY BANCSHARES, INC.
Volume/Rate Analysis 1 — For the Three Months ended March 31,
(dollars in thousands)

Provision for loan losses

Provisions for loan losses reduce net interest income. The Company provided $0 for loan losses for the three months ended March 31, 2004 and 2003.

Management believes the amount of the allowance for loan losses to be adequate to absorb losses in the current portfolio. This statement is based upon management’s continuing evaluation of inherent risks in the current loan portfolio, current levels of classified assets, and economic factors. The Company will continue to monitor the allowance and make future adjustments to the allowance as conditions dictate. For further discussion regarding the allowance for loan losses, see the discussion on allowance for loan losses under Risk Elements.

Noninterest income and expense

Net income is increased by noninterest income (primarily service charges, origination fees on mortgage loans brokered, and other operating income) and reduced by noninterest expenses (primarily salaries and employee benefits, occupancy, equipment, and other operating expenses).

Noninterest income was $276,000 for the three months ended March 31, 2004, a 18.6 percent decrease from $339,000 for the three months ended March 31, 2003. The decrease in noninterest income for the three-month period ended March 31, 2004 was the result of lower loan origination fees on mortgage loans brokered, partially offset by gains realized on the sale of investment securities and increased other operating income. The significant reduction in origination fees on mortgage loans brokered is the result of residential loan customer reducing their demand for mortgage refinance loans. The reduction in demand occurred because most mortgage loan refinance customers refinanced their mortgages shortly after the Federal Reserve lowered interest rates for the last time in 2003.

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The following table sets forth information concerning the various components of the Company’s noninterest income for the three months ended March 31, 2004 and 2003, respectively:

VALLEY COMMUNITY BANCSHARES, INC.
Noninterest Income
(dollars in thousands)

Noninterest expense was $1,572,000 for the three months ended March 31, 2004, a 2.0 percent decrease from $1,604,000 for the three months ended March 31, 2003. The decrease in noninterest expense for the three-month period ended March 31, 2004 was primarily the result of decreased salaries and employee benefits and from lower professional fees. The decrease in salaries and benefits was the result of decreased commissions paid to residential mortgage originators resulting from a drop in mortgage refinancing activity. The decrease in professional fees in 2004 occurred largely as a result of non-recurring merger related expenses (between Puyallup Valley Bank and Valley Bank) that were paid in 2003. The percentage of noninterest expense to average assets was 3.54 percent for the three months ended March 31, 2004, compared to 3.77 percent during the same period last year

The following table sets forth information concerning the various components of the Company’s noninterest expense for the three months ended March 31, 2004 and 2003, respectively:

VALLEY COMMUNITY BANCSHARES, INC.
Noninterest Expense
(dollars in thousands)

The Company’s efficiency ratio, which is the ratio of noninterest expense to net interest income plus noninterest income, was 69.9 percent for the three months ended March 31, 2004 compared to 71.3 percent for the three months ended March 31, 2003. The decrease in the ratio was primarily due to an increase in net interest income and a decrease in noninterest expense, partially offset by a decrease in noninterest income.

Provision for income tax

The Company’s provision for income tax is a significant reduction of operating income. The provision for the three months March 31, 2004, was $208,000 compared to $200,000 for the three month ended March 31, 2003. The provision represents an effective tax rate of 31 percent during 2004 and 2003, respectively. The Company’s marginal tax rate is currently 34 percent. The difference between the Company’s effective and marginal tax rate is primarily related to investments made in tax-exempt securities.

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Financial Condition

The Company’s total consolidated assets decreased 2.1 percent to $178.3 million as of March 31, 2004, compared to $182.2 million as of December 31, 2003. Loans increased and deposits decreased 1.5 percent and 2.6 percent, respectively during the three month period ended March 31, 2004. The decrease in deposits was funded by a draw down of federal funds sold. Stockholders’ equity decreased slightly as a result of the payment of a 60¢ per share cash dividend to stockholders partially offset by earnings during the three-month period ended March 31, 2004 and a increase in other comprehensive income.

Investment Portfolio

The major classifications of investments at March 31, 2004 and December 31, 2003, are summarized in Note 4 – Investment Securities in the Notes to Condensed Consolidated Financial Statements.

At March 31, 2004, the Company had $37.0 million of securities available-for-sale, compared to $38.6 million as of December 31, 2003. The Company purchased approximately $4.0 million in securities this year, although investment securities decreased by $1.5 million during 2004. They were funded primarily with $5.5 million of securities either maturing or sold during 2004.

At March 31, 2004, all of the Company’s securities were classified as available-for-sale. Management believes that holding securities as available-for-sale provides greater flexibility to respond to interest rate changes and liquidity needs to fund loan growth.

Loan Portfolio

The major classifications of loans at March 31, 2004 and December 31, 2003, are summarized in Note 5 – Loans in the Notes to Condensed Consolidated Financial Statements.

In addition to the major classifications of loans summarized in Note 5, the Company has additional loan concentrations exceeding 10 percent of total loans at March 31, 2004. They include loans to medical doctors and dentists in the amount of approximately $23.1 million.

Loans were $116.0 million as of March 31, 2004, compared to $114.3 million as of December 31, 2003, an increase of 1.5 percent. The increase was primarily in real estate construction and real estate commercial loans, partially offset by a decrease in real estate mortgage loans. The percentage of loans to total assets increased to 65.0 percent at March 31, 2004 compared to 62.7 percent at December 31, 2003. It continues to be management’s intent to grow the loan portfolio and to increase the percent of loans to assets, which potentially could improve the Company’s net interest margin.

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Risk Elements

The following table sets forth information concerning the Company’s non-performing assets as of the dates indicated (dollars in thousands):

VALLEY COMMUNITY BANCSHARES, INC.
Non-performing Assets

As of March 31, 2004, the Company had $10,000 in nonperforming assets, which include nonaccrual loans, loans 90 days or more past due and still accruing interest, and restructured loans. The Company had $10,000 in nonperforming assets as of December 31, 2003.

The accrual of interest on nonaccrual and other impaired loans is discontinued at 90 days or when, in the opinion of management, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received. Interest income on restructured loans is recognized pursuant to the terms of the new loan agreement. Interest income on other impaired loans is monitored and based upon the terms of the underlying loan agreement. However, the recorded net investment in impaired loans, including accrued interest, is limited to the present value of the expected cash flows of the impaired loan or the observable fair market value of the loan’s collateral.

During the three-month periods ended March 31, 2004, and 2003 there was one loan on nonaccrual status. The gross income that would have been recorded for the three-month periods ended March 31, 2004, and 2003 if the nonaccrual loan had been current and in accordance with its original term was insignificant. Interest recognized on the loan for the year was insignificant.

Potential Problem Loans

At March 31, 2004 and December 31, 2003, the Company had two potential problem commercial real estate loans totaling approximately $2,342,000 and $2,349,000, respectively. The Company believes that the loans are secured by sufficient collateral and guarantor financial strength to repay the loans, although there can be no assurances given with respect to potential losses in these credits. These loans are in addition to those categorized as non-performing listed above. Although these loans are currently classified as performing, management has information regarding credit weakness inherent in the loans.

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Summary of Loan Loss Experience

Changes in the Allowance for Loan Losses

The activity in the allowance for loan losses is summarized in Note 6 - Allowance for Loan Losses in the Notes to Condensed Consolidated Financial Statements.

The allowance for loan losses is increased by charges to income and decreased by charge-offs (net of recoveries), and established through a provision for loan losses charged to expense. Loans are charged against the allowance for credit losses when management believes that the collectibility of the principal is unlikely. The allowance is an amount that management believes will be adequate to absorb losses inherent in existing loans, commitments to extend credit and standby letters of credit based on evaluations of collectibility and prior loss experience of loans, commitments to extend credit and standby letters of credit. The evaluations take into consideration such factors as changes in the nature and volume of the portfolio, overall portfolio quality, loan concentrations, specific problem loans, commitments, standby letters of credit and current economic conditions that may affect the borrowers’ ability to pay.

The majority of the Company’s loan portfolio consists of commercial loans and single-family residential loans secured by real estate in the Puyallup and Pierce County areas and also in the Auburn, Kent and King County areas. Real estate prices in this market are stable at this time but may weaken as a result of a slow local and national economy. Therefore, the ultimate collectibility of a substantial portion of the Company’s loan portfolio may be susceptible to change as local market conditions change in the future.

While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require the Company to recognize additional losses based on their judgment about information available to them at the time of their examination.

The following table sets forth other information regarding the allowance for loan losses for the dates indicated (dollars in thousands):

VALLEY COMMUNITY BANCSHARES, INC.
Loan Loss Experience

The ratio of the allowance for loan losses as a percentage of average loans decreased to1.20 percent at March 31, 2004 compared to 1.21 percent and 1.30 percent at December 31, 2003 and March 31, 2003, respectively. The decrease in the ratio during the past year was due to several factors including positive credit performance trends, no loan charge-offs, slowing loan demand, the effects of an improving economy, and management’s current evaluation of the loan portfolio. Management continues to emphasize credit quality and carefully monitors the loan portfolio especially given the softness within the local economy. Any changes to the Company’s loan loss allowance will be considered as circumstances warrant.

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Analysis of the Allowance for Loan Losses

The allowance for loan losses is maintained at a level considered adequate by management to provide for loan losses inherent in the loan portfolio based on management’s assessment of various factors affecting the loan portfolio, including, local economic conditions, growth of the loan portfolio and its composition. Non-performing loans and net charge-offs during the periods presented have been minimal demonstrating strong credit quality.

Management determines the amount of the allowance for loan losses by utilizing a loan grading system to determine risk in the loan portfolio and by considering the results of credit reviews. The loan portfolio is separated by quality and then by loan type. Loans of acceptable quality are evaluated as a group, by loan type, with a specific loss rate assigned to the total loans in each type, but unallocated to any individual loan. Conversely, each adversely classified loan is individually analyzed, to determine an estimated loss amount. A valuation allowance is also assigned to these adversely classified loans, but at a higher loss rate due to the greater risk of loss. For those loans where the estimated loss is greater than the background percentage, the estimated loss amount is considered specifically allocated to the allowance. Although management has allocated a portion of the allowance to the loan categories using the method described above, the adequacy of the allowance must be considered as a whole. To mitigate the imprecision in most estimates of expected loan losses, the allocated component of the allowance is supplemented by an unallocated component. The unallocated portion includes management’s judgmental determination of the amounts necessary for qualitative factors such as the consideration of new products and policies, economic conditions, concentrations of credit risk, and the experience and abilities of lending personnel. Loan concentrations, quality, terms and basic underlying assumptions remained substantially unchanged during the period.

The Company uses the historical loss experience method in conjunction with the specific identification method for calculation of the amount of allowance for loan losses. A six-year average historical loan loss rate is calculated. This experience loss rate is applied to graded loans that are not adversely classified for a subtotal of needed allowance. Loans adversely classified are analyzed for potential loss on an individual basis. This subtotal is added to the experience subtotal and the total is compared to the allowance for loan losses.

The Company also evaluates current conditions and may adjust the historical loss estimate by qualitative factors that effect loan repayment. These factors may include levels of, and trends in, delinquencies and non-accruals; trends in volume and terms of loans; effects of any changes in lending policies; experience, ability and depth of management and lending staff; national and local economic trends; concentrations of credit; and any legal and regulatory requirements.

Deposits

The Company’s primary source of funds is customer deposits. The Company attempts to maintain a high percentage of noninterest-bearing deposits, which are a low cost funding source. In addition, the Company offers a variety of interest-bearing accounts designed to attract both short-term and longer-term deposits from customers. Interest-bearing accounts earn interest at rates established by management based on competitive market factors and the Company’s need for funds. The Company traditionally has not purchased brokered deposits and does not intend to do so in the future.

Deposits decreased 2.6 percent to $153.1 million as of March 31, 2004, compared to $157.2 million as of December 31, 2003. The decrease occurred in money market deposits, savings deposits and time certificates of deposit less than $100,000 during the three-month period, partially offset by an increase in demand deposits and in time certificates of deposit greater than $100,000.

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The following table sets forth the balances for each major category of deposit by amount and percent during the periods indicated:

VALLEY COMMUNITY BANCSHARES, INC.
Deposits
(dollars in thousands)

Liquidity and Capital Resources

Management actively analyzes and manages the Company’s liquidity position. The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all financial commitments and to capitalize on opportunities for profitable business expansion. Management believes that the Company’s cash flow will be sufficient to support its existing operations for the foreseeable future.

Cash flows from operations contribute to liquidity as well as proceeds from maturities of securities and customer deposits. As indicated on the Company’s Condensed Consolidated Statement of Cash Flows, net cash from operating activities for the three months ended March 31, 2004 contributed $910,000 to liquidity compared to $676,000 for the three months ended March 31, 2003. The majority of the Company’s funding comes from customer deposits within its operating region. However, during the three months ended March 31, 2004 customer deposits decreased $4.1 million compared to a $.76 million increase for the three months ended March 31, 2003. For the three months ended March 31, 2004, decreases in money market, savings, and time certificates of deposit less than $100,000 was responsible for the majority of the deposit run-off. Other sources of liquidity include investments in federal funds and interest-bearing deposits with banks and the Company’s securities portfolio. The Company generally maintains a ladder of securities that provides prepayments and payments at maturity and a portfolio of available-for-sale securities that could be converted to cash quickly. Proceeds from maturity and sale of securities provided $5.5 million for the three months ended March 31, 2004 compared to $8.4 million for the three months ended March 31, 2003.

At March 31, 2004, the Company held cash and due from banks, interest-bearing deposits with banks, and federal funds sold of approximately $19.4 million. In addition, at such date $37.0 million of the Company’s investments were classified as available for sale.

The Bank has the capacity to borrow funds, up to ten percent of assets, from the Federal Home Loan Bank of Seattle (“FHLB”) through pre-approved credit lines as a secondary source of liquidity. However, these credit lines have pledge requirements whereby the Bank must maintain unencumbered collateral with a value at least equal to the outstanding balance. In addition to the FHLB credit line, the Bank has committed line of credit agreements totaling approximately $9.5 million from unaffiliated banks. At March 31, 2004, the Bank had no advances outstanding to the FHLB or from unaffiliated banks.

The Bank has commitments to extend credit, which may have an impact on the Company’s liquidity position. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the commitment. Commitments generally have fixed expiration dates. Since some commitments are expected to expire without being drawn upon, the total commitment amounts do not represent future cash requirements. The Company experience suggests customers draw on approximately 75 percent of loan commitments. Commitments to extend credit at March 31, 2004 and December 31, 2003 were $18.6 and $21.5 million, respectively.

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The Company’s total stockholders’ equity decreased to $23.5 million at March 31, 2004 from $23.7 million at December 31, 2003. The slight decrease was the result of a 60¢ dividend per share paid to stockholders of record on December 31, 2003, partially offset by net income earned during the three months ended March 31, 2004 and higher unrealized gains recorded on securities available for sale, net of income tax. At March 31, 2004, stockholders’ equity was 13.2 percent of total assets, compared to 13.0 percent at December 31, 2003.

The market value of available-for-sale securities was greater than book value at both March 31, 2004 and December 31, 2003, primarily as a result of low market interest rates, which resulted in unrealized gains in the investment portfolio. In the event market interest rates increase, the market value of the Company’s investment portfolio may decrease. Because changes in the market value of available-for-sale securities are a component of other comprehensive income, within stockholders’ equity, a decrease in market value of securities would negatively impact stockholders’ equity. At March 31, 2004, the Company performed a simulation analysis of changes in the market value of the investment portfolio given a 300 basis point increase in interest rates. The analysis indicated a decrease in market value of approximately $1.3 million net of federal income tax. Although stockholder’s equity would be reduced by approximately 5.5 percent, the Company would still be well in excess of capital adequacy requirements in the event the Company would be required to liquidate these securities for unforeseen liquidity needs.

Capital Adequacy Requirements

The Federal Reserve and the FDIC have adopted risk-based capital guidelines for banks and bank holding companies that are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies and account for off-balance sheet items. The guidelines are minimums, and the federal regulators have noted that banks and bank holding companies contemplating significant expansion programs should not allow expansion to diminish their capital ratios and should maintain ratios in excess of the minimums. Failure to achieve and maintain adequate capital levels may give rise to supervisory action through the issuance of a capital directive to ensure the maintenance of required capital levels.

The current guidelines require all federally-regulated banks to maintain a minimum risk-based total capital ratio equal to 8%, of which at least 4% must be Tier 1 capital. Tier 1 capital includes common shareholders’ equity, qualifying perpetual preferred stock, and minority interests in equity accounts of consolidated subsidiaries, but excludes goodwill and most other intangibles and the allowance for loan and lease losses. Tier 2 capital includes the excess of any preferred stock not included in Tier 1 capital, mandatory convertible securities, hybrid capital instruments, subordinated debt and intermediate term-preferred stock, 20% of unrealized gain of equity securities, and general reserves for loan and lease losses up to 1.25% of risk-weighted assets. The Bank has not received any notice indicating that it will be subject to higher capital requirements.

Under these guidelines, bank assets are given risk-weights of 0%, 20%, 50% or 100%. Most loans are assigned to the 100% risk category, except for first mortgage loans fully secured by residential property and, under certain circumstances, residential construction loans (both carry a 50% rating). Most investment securities are assigned to the 20% category, except for municipal or state revenue bonds (which have a 50% rating) and direct obligations of or obligations guaranteed by the United States Treasury or United States Government Agencies (which have a 0% rating). The Agencies have also implemented a leverage ratio, which is equal to Tier 1 capital as a percentage of average total assets less intangibles, to be used as a supplement to the risk-based guidelines. The principal objective of the leverage ratio is to limit the maximum degree to which a bank may leverage its equity capital base. The minimum required leverage ratio for top-rated institutions is 3%, but most institutions are required to maintain an additional cushion of at least 100 to 200 basis points. Any institution operating at or near the 3% level is expected to be a strong banking organization without any supervisory, financial or operational weaknesses or deficiencies. Any institutions experiencing or anticipating significant growth would be expected to maintain capital ratios, including tangible capital positions, well above the minimum levels.

The capital levels of the Company currently exceed applicable regulatory guidelines, and the Bank is qualified as “well-capitalized” at March 31, 2004. Management believes that under the current regulations the Bank will continue to meet well-capitalized capital requirements in the foreseeable future. However, events beyond the control of the Bank such as a downturn in the economy where the Bank have most of their loans, could adversely affect future earnings and, consequently, the ability of the Bank to meet future well-capitalized capital requirements.

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The capital amounts and ratios for the Company and the Bank as of March 31, 2004, are presented in the following table (dollars in thousands):

VALLEY COMMUNITY BANCSHARES, INC.
Capital

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company’s results of operation are dependent upon its ability to manage interest rate risk. Management considers interest rate risk to be a significant risk that could have a material effect on the Company’s financial condition and results of operations. The Company does not currently use derivatives to manage market and interest rate risk.

A number of measures are used to monitor and manage interest rate risk, including income simulations and interest sensitivity (gap) analyses. An income simulation model is the primary tool used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Key assumptions in the model include repayment speeds on certain assets, cash flows and maturities of other investment securities, loan and deposit volumes and pricing. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income.

Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors. At March 31, 2004, based on the measures used to monitor and manage interest rate risk, there has not been a material change in the Company’s interest rate risk since December 31, 2003. For additional information, refer to the Company’s annual report on Form 10-K for the year ended December 31, 2003.

Item 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures: An evaluation of the Company’s disclosure controls and procedures (as defined in Section 13(a)-14(c) of the Securities Exchange Act of 1934 (the “Act”)) was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer and several other members of the Company’s senior management as of March 31, 2004. The Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures as currently in effect are effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is (i) accumulated and communicated to the Company’s management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

(b) Changes in Internal Controls: In the quarter ended March 31, 2004, the Company did not make any significant changes in, nor take any corrective actions regarding, its internal controls or other factors that has materially affected or is reasonably likely to affect these controls.

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

FORWARD-LOOKING STATEMENTS

This quarterly report on Form 10-Q includes forward-looking statements about the future operations of the Company. These forward-looking statements involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the following factors: unexpected costs in connection with internet banking initiative, competitive pressure in the banking industry significantly increasing; increases or decreases in the interest rate environment reducing margins; general economic conditions, either nationally or regionally, are less favorable than expected, resulting in, among other things, a deterioration in credit quality and an increase in the provision for possible loan losses; changes in the regulatory environment; loan delinquency rates; changes in business conditions; volatility of rate sensitive deposits; operational risks including data processing system failures or fraud; asset/liability matching risks and liquidity risks; and changes in the securities markets. Because of these uncertainties, actual future results may be materially different from the results indicated by these forward-looking statements. In addition, the Company’s past results do not necessarily indicate its future results. See also the risk factors in the Company’s 2003 Annual Report on Form 10-K.

PART II — OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

     The Company faces ordinary routine litigation arising in the normal course of business. In the opinion of management, liabilities (if any) arising from such claims will not have a material adverse effect upon the business, results of operations or financial condition of the Company.

Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

     Not applicable

Item 3. DEFAULTS UPON SENIOR SECURITIES

     Not applicable

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     Not applicable

Item 5. OTHER INFORMATION

     Not applicable.

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Item 6. EXHIBITS AND REPORTS ON FORM 8-K

     (a) Exhibits

3.1 Articles of Incorporation of Valley Community Bancshares, Inc. *
3.2 Restated Bylaws of Valley Community Bancshares, Inc. ^
10. Material contracts of Valley Community Bancshares, Inc.

10.1 Severance agreement for Mr. Brown *
10.2 Severance agreement for Mr. Thompson *
10.3 Severance agreement for Mr. Riordan *
10.4 Deferred Compensation Agreement for Mr. Brown *
10.5 Deferred Compensation Agreement for Mr. Thompson #
10.6 1998 Stock Option Plan *
10.7 401(k) Defined Contribution Plan and Noncontributory Profit Sharing Plan Adoption Agreement *

31. Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.1 Certification of Chief Executive Officer
31.2 Certification of Chief Financial Officer

32. Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(b) Reports on Form 8-K

The Company filed a current report on Items 7 and 12 of Form 8-K on January 29, 2004. The report included a press release announcing the full year 2003 financial results.

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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.

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