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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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 [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.)

Yes [  ] No [X]

The number of shares of the issuer’s Common Stock, $1.00 par value, outstanding at May 2, 2003 was 1,171,546.

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

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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

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 period ended March 31, 2003 and March 31, 2002 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, 2002 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, 2003, are not necessarily indicative of the results to be anticipated for the year ending December 31, 2003.

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, 2002 and notes thereto included in the Company’s Form 10-K filed with the Securities and Exchange Commission. Certain amounts in the 2002 financial statements have been reclassified to conform to the 2003 presentation.

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States 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.

VALLEY COMMUNITY BANCSHARES, INC.
Stock Option Plan

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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, 2003 and 2002 (dollars in thousands, except per share amounts):

VALLEY COMMUNITY BANCSHARES, INC.
Earning Per Share

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 $387,000 and $440,000, respectively, for the three months ended March 31, 2003 and 2002, respectively.

Note 4 - Investment Securities

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

March 31,2003

Securities Available-For Sale

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December 31, 2002

Securities Available-For-Sale

Note 5 - Loans

The major classifications of loans at March 31, 2003 and December 31, 2002 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, 2003 and December 31, 2002, totaled $1,388,000, respectively. Management believes that the allowance for loan losses at March 31, 2003 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, 2003.

Note 8 – Impact of New Accounting Issues

During the first quarter of 2003 the Financial Accounting Standard Board (“FASB”) issued the following new accounting pronouncements.

In November 2002, the FASB issued Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. The Interpretation elaborates on the disclosures to be made by sellers or guarantors of products and services, as well as those entities guaranteeing the financial performance of others. The Interpretation further clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the obligations it has undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of the Interpretation are effective on a prospective basis to guarantees issued or modified after December 31, 2002, and the disclosure requirements are effective for financial statements of periods ending after December 15, 2002. Implementation of the Interpretation did not result in a material impact on the Company’s financial position or results of operations.

In January 2003, FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (VIE). It defined a VIE as a corporation, partnership, trust, or any other legal structure used for the business purpose that either a) does not have equity investors with voting rights or b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. This interpretation will require a VIE to be consolidated by a company if that company is subject to a majority of the risk of loss from the VIE’s activities or entitled to receive a majority of the entity’s residual return. The provisions of interpretation No. 46 are required to be applied immediately to VIEs created after January 31, 2003. The Company does not have any VIE and accordingly the implementation of the Interpretation did not result in an impact on its financial position or results of operations.

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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 banking offices located in Puyallup, Auburn, and Kent, Washington, and their environs.

The principal source 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, in an effort to consolidate operations, 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.

On May 16, 2002, The Bank purchased various tangible and intangible assets of Puget Sound Mortgage Brokers, Inc., a Washington Corporation located in Puyallup Washington. The purchase price was not material to The Bank or to the consolidated financial condition and results of operations of the Company. The purchase was made to further enhance the Bank’s mortgage banking operations. The mortgage operation is operated as a division of the Bank using the name Puget Sound Mortgage Brokers and operates in a leased facility.

On September 5, 2002 the Bank opened a new banking facility in Kent Washington. The new office operates in a leased facility until a permanent facility can be located.

On March 19, 2003 The Bank’s Board of Directors approved the expansion into Gig Harbor, Washington. The new office opened in April 2003as a loan production office in a leased facility until a permanent banking facility can be located. The Bank hired Mr. Tom Leander, founder and President of the former Harbor Bank in Gig Harbor to initiate the expansion.

Valley Bank is a wholly owned subsidiary of the Company.

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Results of Operations

The Company earned net income of $445,000 or $0.38 per diluted share for the three months ended March 31, 2003, compared to net income of $550,000 or $0.46 per diluted share, for the three months ended March 31, 2002, a decrease of 19 percent. The Company’s return on average assets was 1.04 percent for the three months ended March 31, 2003, compared to 1.42 percent for the three months ended March 31, 2002.

The decrease in net income for the three-month period ended March 31, 2003 was primarily the result of increased noninterest expense, partially offset by increased noninterest income, a lower provision for loan losses and reduced income tax. The increased staffing levels of the Bank’s new Kent facility and Puget Sound Mortgage Brokers significantly increased salaries and employee benefits and occupancy during the three-month period. A decrease in the Company’s net interest margin also negatively impacted earnings during the three-month period.

Management anticipates higher operating costs as a result of opening the new Kent and Gig Harbor offices. Profitability of the Company will continue to be negatively impacted until the new offices generate sufficient revenues to offset the added operating costs. It is anticipated the new offices will not breakeven until after 2003.

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 the majority of the Company’s operating income.

The following table shows the various performance ratios for the Company for the three months ended March 31, 2003 and 2002, respectively:

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

Net Interest Income

Net interest income it 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.

The earnings from certain assets are exempt from federal income tax, and it is customary in the financial services industry to analyze changes in net interest income on a “tax equivalent” (TE) basis. 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.

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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),

Tax equivalent net interest income, divided by average earning assets is referred to as net interest margin. For the three months ended March 31, 2003 the Company’s net interest margin was 4.92 percent compared to 5.46 percent for the three months ended March 31, 2002.

TE interest income was $2,321,000 for the three months ended March 31, 2003 compared to $2,455,000 for the three months ended March 31, 2002. The three-month decrease was primarily the result of a significant decrease in the yield earned on earning assets. The yield on interest-earning assets decreased to 5.88 percent for the three months ended March 31, 2003 compared to 6.86 percent during the same period a year ago. The decrease in TE interest income was primarily the result of a lower yield realized on interest bearing deposits with Bank, investment securities, and loans. The yield decrease reflects an overall decline in market interest rates resulting from a soft economic environment.

Interest expense was $379,000 for the three months ended March 31, 2003 compared to $503,000 for the three months ended March 31, 2002. The cost of funds decreased to 1.28 percent for the three months ended March 31, 2003 compared to 1.88 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. The decrease in market interest rates during 2002 had a positive impact on the Company’s net interest margin. Because of the Company’s liability sensitive position at that time, the Company experienced a greater reduction in deposit costs in comparison to the reduction in the earnings on loans and investments. During 2003, market interest remained relatively low resulting in a greater reduction in the earnings on loans and investments compared to the reduction in deposit costs.

In the event of an increase market interest rates, the Company’s TE net interest income and margin may decrease because the Company has a significant amount of interest bearing liabilities subject to repricing when compared to interest earning assets. This maybe 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.

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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:

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