FAUQUIER BANKSHARES, INC.

INDEX

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Part I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Fauquier Bankshares, Inc. and Subsidiaries

See accompanying Notes to Consolidated Financial Statements.

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Fauquier Bankshares, Inc. and Subsidiaries

See accompanying Notes to Consolidated Financial Statements.

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Fauquier Bankshares, Inc. and Subsidiaries

See accompanying Notes to Consolidated Financial Statements.

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Fauquier Bankshares, Inc. and Subsidiaries

See accompanying Notes to Consolidated Financial Statements.

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Fauquier Bankshares, Inc. and Subsidiaries

See accompanying Notes to Consolidated Financial Statements.

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FAUQUIER BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

1.		General
		The consolidated statements include the accounts of Fauquier Bankshares, Inc. (the Corporation) and its wholly-owned subsidiary, The Fauquier Bank (the Bank), of which Fauquier Bank Services, Inc. is its sole subsidiary. In consolidation, significant intercompany financial balances and transactions have been eliminated. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial positions as of June 30, 2004 and December 31, 2003, and the results of operations and cash flows for the six months ended June 30, 2004 and 2003. The results of operations for the six and three months ended June 30, 2004 and 2003 are not necessarily indicative of the results expected for the full year.
2.		Securities
		The amortized cost of securities available for sale, with unrealized gains and losses follows:

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

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The following table shows the Corporation’s investments with gross unrealized losses and their fair value, aggregated by investment category and the length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2004

The nature of the securities which are temporarily impaired can be segmented into four groups. The first group consists of four Federal Agency securities totaling $11.0 million with a temporary loss of $276,436. The securities within this group have maturity dates ranging from 30 months to 47 months. Three of the securities within this group have call dates ranging from one month to 12 months. The Corporation has the ability to hold these bonds to their call date or their maturity.

The second group consists of three Federal agency mortgage-backed securities and five Federal agency collateralized mortgage obligation securities totaling $16.4 million with a temporary loss of $283,252. The securities within this group have estimated maturity dates ranging from 22 months to 96 months, and return principal on a monthly basis representing the repayment and prepayment of the underlying mortgages. The Corporation has the ability to hold these bonds to their maturity.

The third group consists of two corporate bonds, rated A2 by Moody’s, totaling $3.0 million with a temporary loss of $90,000. This bond has a remaining maturity of approximately 29 years, but can be called at par on its five year anniversary. If not called, the bond reprices every three months at a fixed index above LIBOR. The Corporation has the ability to hold this bond to its maturity.

The final security is preferred stock with Freddie Mac totaling $487,500 with a temporary loss of $63,000. The Corporation has the ability to hold this stock.

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3.		Loans
		A summary of the balances of loans follows:

Analysis of the allowance for loan losses follows:

Nonperforming assets consist of the following:

Total loans past due 90 days or more and still accruing interest totaled $260,000 on June 30, 2004 and $840,000 on December 31, 2003, respectively.

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4.		Company-Obligated Mandatorily Redeemable Capital Securities of Subsidiary Trust
		On March 26, 2002, the Company’s wholly-owned Connecticut statutory business trust privately issued $4 million face amount of the trust’s Floating Rate Capital Securities (“Capital Securities”) in a pooled capital securities offering. Simultaneously, the trust used the proceeds of that sale to purchase $4 million principal amount of the Company’s Floating Rate Junior Subordinated Deferrable Interest Debentures due 2032 (“Subordinated Debentures”). Both the Capital Securities and the Subordinated Debentures are callable at any time after five years from the issue date. The Subordinated Debentures are an unsecured obligation of the Company and are junior in right of payment to all present and future senior indebtedness of the Company. The Capital Securities are guaranteed by the Company on a subordinated basis.
		The Capital Securities are presented in the consolidated balance sheets of the Company under the caption “Company-Obligated Mandatorily Redeemable Capital Securities.” The Company records distributions payable on the Capital Securities as an Interest Expense in its consolidated statements of income. The cost of issuance of the Capital Securities was approximately $128,000. This cost is being amortized over a five year period from the issue date.
5.		Earnings Per Share
		The following table shows the weighted average number of shares used in computing earnings per share and the effect on weighted average number of shares of dilutive potential common stock. Dilutive potential common stock had no effect on income available to common shareholders.

6.		Stock-Based Compensation
		At June 30, 2004, the Corporation has one stock-based compensation plan. The Corporation accounts for the plan under the recognition and measurement principles of APB Opinion 25, Accounting for Stock Issued to Employees, and related interpretations. 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 the grant. The following table illustrates the effect on net income and earnings per share for the Corporation had the fair value recognition provisions of FASB Statement No. 12, Accounting for Stock-Based Compensation, been applied to stock-based compensation.

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7.		Employee Benefit Plan
		The following table provides a reconciliation of the changes in the defined benefit plan’s obligations for the periods ending June 30, 2004 and 2003.

The Corporation previously disclosed in its financial statements for the year ended December 31, 2003, that it expected to contribute $68,000 to its pension plan in 2004. As of June 30, 2004, contributions totaling $412,000 have been made. The Corporation presently anticipates no additional contributions to fund its pension plan in 2004.

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

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

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

GENERAL

Fauquier Bankshares, Inc. (“Bankshares”) was incorporated under the laws of the Commonwealth of Virginia on January 13, 1984. Bankshares is a registered bank holding company and owns all of the voting shares of TFB, a Virginia state-chartered bank that commenced operations in 1902. Bankshares engages in its business through TFB, and has no significant operations other than owning the stock of TFB. Bankshares had issued and outstanding 3,322,226 shares of common stock, par value $3.13 per share, held by approximately 394 holders of record on June 30, 2004.

TFB has eight full service branch offices located in the Virginia communities of Warrenton, Catlett, The Plains, New Baltimore, Sudley Road-Manassas, Old Town-Manassas and Bealeton. The branch in Bealeton opened during May 2004. The executive offices of Bankshares and the main office of TFB are located at 10 Courthouse Square, Warrenton, Virginia 20186.

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

TFB provides a range of consumer and commercial banking services to individuals and businesses. The deposits of TFB are insured up to applicable limits by the Bank Insurance Fund of the Federal Deposit Insurance Fund (the “FDIC”). The basic services offered by TFB include: demand deposit accounts, savings and money market deposit accounts, NOW accounts, time deposits, safe deposit services, credit cards, cash management, automated clearing house services (“ACH”) including direct deposits, notary services, night depository, traveler’s checks, cashier’s checks, domestic collections, savings bonds, automated teller services, drive-in tellers, internet banking, banking by telephone, and banking by mail. In addition, TFB makes secured and unsecured commercial and real estate loans, issues stand-by letters of credit and grants available credit for installment, unsecured and secured personal loans, residential mortgages and home equity loans, as well as automobile and other types of consumer financing. TFB provides automated teller machine (“ATM”) cards, as a part of the Star and Plus ATM networks, thereby permitting customers to utilize the convenience of larger ATM networks.

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TFB operates a Wealth Management Services (“WMS”) division that began with the granting of trust powers to TFB in 1919. The WMS division provides personalized services that include investment management, trust, estate settlement, retirement, insurance, and brokerage services. TFB, through its subsidiary Fauquier Bank Services, Inc., has equity ownership interests in Bankers Insurance, LLC, a Virginia independent insurance company, and Bankers Investments Group, LLC, a full service broker/dealer. Bankers Insurance consists of a consortium of 56 Virginia community bank owners and Bankers Investments Group is owned by 29 Virginia community banks.

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

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

CRITICAL ACCOUNTING POLICIES

GENERAL. Bankshares’ financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use in our estimates. In addition, GAAP itself may change from one previously acceptable accounting method to another method. Although the economics of 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) Statement of Financial Accounting Standards (“SFAS”) No. 5 “Accounting for Contingencies,” which requires that losses be accrued when they are probable of occurring and estimable and (ii) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

Our allowance for loan losses has three basic components: the specific allowance, 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 specific allowance is used to individually allocate an allowance for larger balance, non-homogeneous loans. The specific allowance uses various techniques to arrive at an estimate of loss. First, analysis of the borrower’s overall financial condition, resources and payment record, the prospects for support from financial guarantors; and the fair market value of collateral are used to estimate the probability and severity of inherent losses. Additionally, the migration of historical default rates and loss severities, internal risk ratings, industry and market conditions and trends, and other environmental factors are considered. The use of these values is inherently subjective and our actual losses could be greater or less than the estimates.

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The formula allowance is used for estimating the loss on pools of smaller-balance, homogeneous loans; including 1-4 family mortgage loans, installment loans, other consumer loans, and outstanding loan commitments. Also, the formula allowance is used for the remaining pool of larger balance, non-homogeneous loans which were not allocated a specific allowance upon their review. The formula allowance begins with estimates of probable losses inherent in the homogeneous portfolio based upon various statistical analyses. These include analysis of historical and peer group delinquency and credit loss experience, together with analyses that reflect current trends and conditions. We also consider trends and changes in the volume and term of loans, changes in the credit process and/or lending policies and procedures, and an evaluation of overall credit quality. The formula allowance uses a historical loss view as an indicator of future losses. As a result, even though this history is regularly updated with the most recent loss information, it could differ from the loss incurred in the future.

The 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 either the formula or specific allowances. In addition, an unallocated reserve is maintained to recognize the imprecision in estimating and measuring inherent losses on individual loans or pools of loans.

EXECUTIVE OVERVIEW

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

Through the merger and consolidation of other area banks, TFB has become the primary independent community bank in its immediate geographic market. TFB continually seeks to be the principal financial service provider for its market area by providing high quality customer service, efficient technological support, value-added products, and a strong commitment to the community.

Net income of $1.08 million for the quarter ending June 30, 2004 was a 14.6% increase from the June 2003 quarter net income of $0.95 million. Net income for the six months ended June 30, 2004 was $2.15 million or $0.61 per diluted share compared with $2.04 million or $0.59 per diluted share for the six months ended June 30, 2003. The net income results were consistent with management’s internal projections. Bankshares and TFB experienced growth across all of its primary operating businesses, with growth in commercial and retail lending, deposit accounts and core deposits, and assets under WMS management. During the first quarter of 2003, TFB modified its loan pricing strategies and expanded its loan product offerings in an effort to increase lending activity without sacrificing the existing credit quality standards. The result of this has been a 27.6% increase in net loan outstandings from June 30, 2003 to June 30, 2004. Total deposits increased 12.5% from June 30, 2003 to June 30, 2004, with TFB gaining in-market customers dissatisfied with the service and pricing resulting from the consolidation of other local community banks into larger, out-of-market financial institutions. WMS assets under management grew by $29.2 million to $228.6 million, or 14.6%, from June 30, 2003 to June 30, 2004, with WMS revenue increasing from $435,000 to $633,000 or 45.7% for the respective six month periods, as management focused more people, marketing, and other resources toward the WMS business.

Management continued the expansion of its branch network into southern Fauquier County with a new branch which opened in Bealeton, Virginia during May of 2004. Additionally, TFB looks to add to its branch network in western Prince William County, as well as Fauquier County. TFB is looking toward these new retail markets for growth in deposits and WMS income. Management also seeks to increase the level of its fee income from deposits and WMS through the increase of its market share within its current marketplace.

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COMPARISION OF OPERATING RESULTS FOR THE THREE MONTHS ENDED JUNE 30, 2004 AND JUNE 30, 2003

NET INCOME. Net income for the three months ended June 30, 2004 was $1.08 million or $0.31 per diluted share compared with $946,000 or $0.27 per diluted share for the three months ended June 30, 2003. The $138,000 or 14.6% increase in net income for the quarter was fundamentally in-line with management expectations.

NET INTEREST INCOME. Net interest income increased $693,000 or 19.3% to $4.28 million for the three months ended June 30, 2004 compared with $3.59 million for the three months ended June 30, 2003. The increase in net interest income resulted from increased interest and fee income on loans as a result of the increase in volume of loans outstanding. The net interest margin, computed on a tax equivalent basis, for the June 2004 quarter was 4.62% compared with 4.63% for the same quarter one year earlier. The decrease in the net interest margin can be attributed primarily to the continuation of the low interest rate environment, and the corresponding reduction in the average rate on earning assets, which declined on a tax equivalent basis to 5.73% for the quarter ended June 30, 2004, from 5.94% for the quarter ended June 30, 2003.

Average interest-earning assets grew 18.9% to $372.4 million for the second quarter of 2004 compared with $313.2 million for the second quarter of 2003. Total interest income increased $702,000 or 15.2% to $5.32 million for the three months ended June 30, 2004, compared with $4.62 million for the three months ended June 30, 2003, as a result of the growth in interest-earning assets. Interest and dividends on investment securities decreased $35,000 or 7.6%. Investment securities averaged $47.7 million for the second quarter of 2004 compared with $62.5 million for the same quarter one year earlier. The yield on investment securities was 3.61% on a tax-equivalent basis for the second quarter of 2004, compared with 2.99% for the second quarter of 2003. Interest and fees on loans increased $739,000 or 17.9% to $4.87 million for the June 2004 quarter compared with the same quarter one year earlier. Average loans outstanding totaled $313.9 million and earned 6.21% on a tax-equivalent basis for the quarter ended June 30, 2004, compared with $238.7 million and 6.96%, respectively, for the quarter ended June 30, 2003.

Total interest expense increased $9,000 or 0.9% to $1.04 million for the three months ended June 30, 2004 from $1.03 million for the three months ended June 30, 2003. Average interest-bearing liabilities grew 15.9% to $291.4 million for the second quarter of 2004 compared with $251.5 million for the second quarter of 2003, while the average cost on interest-bearing liabilities decreased to 1.43% from 1.64% for the same respective time periods. The decrease in total interest expense and the average cost of interest-bearing liabilities was due to the continuation of the low shorter-term interest rate environment. Average certificates of deposit balances for the second quarter of 2004 were $77.8 million at an average cost of 2.50%, compared with $80.8 million at an average cost of 2.70% for the same quarter one year earlier. Interest-bearing NOW account deposits averaged $77.9 million at an average cost of 0.69% for the June 2004 quarter, compared with $50.9 million at an average cost of 0.20% for the June 2003 quarter. Both the growth in average balances and the increase in the average cost was attributable to the introduction of a new high balance, premium interest rate NOW account. Interest-bearing money market deposits averaged $69.6 million at an average cost of 0.80% for the quarter ended June 30, 2004, compared with $60.4 million at an average cost of 1.20% for the same quarter one year earlier. Savings account deposits averaged $40.6 million at an average cost of 0.35% for the June 2004 quarter, compared with $40.4 million at an average cost of 0.54% for the June 2003 quarter. Average FHLB of Atlanta advances were $21.3 million at an average cost of 3.64% for the second quarter of 2004, and $15.0 million at an average cost of 4.64% one year earlier.

Net interest income is the largest component of net income, and equals the difference between income generated on interest-earning assets and interest expense incurred on interest-bearing liabilities. Future trends regarding net interest income are dependent on the absolute level of market interest rates, the shape of the yield curve, the amount of lost income from non-performing assets, the amount of prepaying loans, the mix and amount of various deposit types, and many other factors, as well as the overall volume of interest-earning assets. These factors are individually difficult to predict, and when taken together, the uncertainty of future trends compounds. Based on management’s current projections, net interest income may increase in 2004 and beyond as average interest-earning assets increase, but this may be offset in part or in whole by a possible contraction in TFB’s net interest margin resulting from competitive market conditions. Additionally, TFB’s balance sheet is positioned for a stable or rising interest rate environment. This means that net interest income is projected to increase if market interest rates rise, and decrease if market interest rates fall. The specific nature of TFB’s variability in net interest income due to changes in interest rates, also known as interest rate risk, is to a large degree the result of TFB’s deposit base structure. During the second quarter of 2004, demand deposits, NOW accounts, and savings deposits averaged 24%, 22%, and 12% of total average deposits, respectively, while the more interest-rate sensitive time certificates of deposit averaged 22% of total average deposits.

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The following table sets forth information relating to Bankshares’ average balance sheet and reflects the average yield on assets and the average annualized cost of liabilities for the three month periods ended June 30, 2004 and 2003. These yields and costs are derived by annualizing the income or expense for the periods presented, and dividing the product of the annualizaton by the respective average daily balances of assets and liabilities for the periods presented.

AVERAGE BALANCES, INCOME AND EXPENSES, AND AVERAGE YIELDS AND RATES
(In Thousands)

(1)

Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%. The amount of the tax equivalent adjustment for the three month periods ending June 30, 2004 and 2003 is $56,000 and $69,000, respectively.

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RATE/VOLUME ANALYSIS

The following table sets forth certain information regarding changes in interest income and interest expense of Bankshares for the three month periods ended June 30, 2004 and 2003. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to changes in volume (change in volume multiplied by the prior period rate); and changes in rate (change in rate multiplied by the prior period volume). Changes which cannot be separately identified are allocated proportionately between changes in volume and changes in rate.

RATE / VOLUME VARIANCE
(In Thousands)