(8) Stock Options

The Company has two incentive stock option plans. The 1997 Incentive Stock Plan (the “1997 Plan”), pursuant to which the Company’s Board of Directors maycould grant stock options to officers and key employees, became effective as of May 1, 1997. The 1997 Plan authorizesauthorized grants of options to purchase up to 50,000 shares of the Company’s authorized but unissued common stock. Accordingly, 50,000 shares of authorized but unissued common stock were reserved for use in the 1997 Plan. All stock options arewere granted with an exercise price equal to the stock’s fair market value at the date of grant. At JuneSeptember 30, 2008, there were no additional shares available for grant under the 1997 Plan as the plan expired on May 1, 2007.

A summary of stock option information follows:

The 2004 Incentive Stock Plan (the “2004 Plan”), pursuant to which the Company’s Board of Directors may grant stock options to officers and key employees, was approved by shareholders on April 13, 2004 and became effective as of May 1, 2004. The 2004 Plan authorizes grants of options to purchase up to 100,000 shares of the Company’s authorized but unissued common stock. Accordingly, 100,000 shares of authorized but unissued common stock were reserved for use in the 2004 Plan. All stock options are to be granted with an exercise price equal to the stock’s fair market value at the date of grant, expiring ten years from the date of grant. At JuneSeptember 30, 2008, no options had been granted under the 2004 Plan and all 100,000 shares were available for grant under the 2004 Plan.

Effective January 1, 2006, the Company adopted SFAS No. 123(R),Share-Based Payment, using the modified prospective method and, accordingly, did not restate the consolidated statements of operations

for periods prior to January 1, 2006. This pronouncement amended SFAS No. 123,Accounting for Stock-Based Compensation, and superseded Accounting Principles Board

(APB) Opinion No. 25,Accounting for Stock Issued to Employees. Under SFAS No. 123(R), the Company measures compensation cost for all stock-based awards at fair value on the date of grant and recognizes compensation expense in the consolidated statements of income over the service period in which the awards are expected to vest. The stock-based compensation expensed to salaries and employee benefits was $0 in the first halfnine months of 2008 as compared to $3 in the first halfnine months of 2007.

(9) Subsequent Declaration of Cash Dividend

On July 8,October 14, 2008 the Board of Directors declared a quarterly cash dividend in the amount of $0.15 per common share payable on August 1,November 7, 2008 to shareholders of record as of July 18,October 24, 2008.

(10) Impact of Recently Issued Accounting Standards

In February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities—including an amendment of FASB Statement No. 115. SFAS No. 159 permits entities to elect to measure eligible financial instruments at fair value. An entity must report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date, and recognize upfront costs and fees related to those items in earnings as incurred and not on a deferred basis. Unrealized gains and losses on items for which the fair value option has been elected must be reported in earnings at each subsequent reporting date. The fair value option can be applied instrument by instrument; however, the election is irrevocable. The Company’s adoption of SFAS No. 159 on January 1, 2008 had no financial impact because the Company did not elect the fair value option for any of its financial assets or liabilities.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

The following discussion is qualified in its entirety by the more detailed information in the unaudited consolidated financial statements and accompanying notes appearing elsewhere in this Form 10-Q. In addition to the historical information contained herein, this report

contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies, and expectations of management, 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, declining collateral values, general economic conditions including continued deterioration in general business and economic conditions and in the financial markets, deterioration in the value of securities held in our investment securities portfolio, the legislative/regulatory climate, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Board of Governors of the Federal Reserve System and the impact of any policies or programs implemented pursuant to the Emergency Economic Stabilization Act of 2008 (the “EESA”), the quality or composition of the 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 contained herein, and you should not place undue reliance on such statements, which reflect our position as of the date of this report.

While the Company has not experienced a major increase in loan losses during the current economic climate, a continuation of the recent turbulence in significant portions of the global financial markets, particularly if it worsens, could impact our performance, both directly by affecting our revenues and the value of our assets and liabilities, and indirectly by affecting our counterparties and the economy generally. Dramatic declines in the housing market in the past year have resulted in significant write-downs of asset values by financial institutions in the United States. Concerns about the stability of the U.S. financial markets generally have reduced the availability of funding to certain financial institutions, leading to a tightening of credit, reduction of business activity, and increased market volatility. There can be no assurance that the EESA or the actions taken by the U.S. Treasury hereunder will stabilize the U.S. financial system or alleviate the industry or economic factors that may adversely affect our business. In addition, our business and financial performance could be impacted as the financial industry restructures in the current environment, both by changes in the creditworthiness and performance of our counterparties and by changes in the competitive landscape.

THE COMPANY

Pinnacle Bankshares Corporation, a Virginia corporation (“Bankshares”), was organized in 1997 and is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended. Bankshares is headquartered in Altavista, Virginia, and conducts all of its business activities through the branch offices of its wholly-owned subsidiary bank, The First National Bank of Altavista (the “Bank”). Bankshares exists primarily for the purpose of holding the stock of its subsidiary, the Bank, and of such other subsidiaries as it may acquire or establish.

The following discussion supplements and provides information about the major components of the results of operations and financial condition, liquidity and capital resources of Bankshares and its subsidiary (collectively the “Company”). This discussion and analysis should be read in conjunction with the Company’s unaudited consolidated financial statements and accompanying notes.

OVERVIEW AND RESULTS OF OPERATIONS

Total assets at JuneSeptember 30, 2008 were $303,672,$313,019, up 8.49%11.83% from $279,913 at December 31, 2007. The principal components of the Company’s assets at the end of the period were $265,291$278,486 in net loans and $17,709$16,338 in securities. During the six-monthnine-month period ended JuneSeptember 30, 2008, net loans increased 13.98%19.65% or $32,539$45,734 from $232,752 at December 31, 2007. The Company’s lending activities are a principal source of its income. Also during the six-monthnine-month period, securities decreased 9.81%16.79% or $1,926$3,297 from December 31, 2007.

Total liabilities at JuneSeptember 30, 2008 were $276,313,$285,384, up 9.17%12.76% from $253,097 at December 31, 2007, as a result of an increase in savings and NOW accounts of $439$10,133 or 0.59%13.53%, an increase in time deposits of $8,557$18,934 or 5.71%12.64% and a decrease in demand deposits of $1,175$2,280 or 4.31%8.37% from December 31, 2007. The Company’s deposits are provided by individuals and businesses located within the communities the Company serves. The Company also usedhas $5,000 in Federal Home Loan Bank advances as of $15,000 in the first half ofSeptember 30, 2008 to help fund loan growth.

Total stockholders’ equity at JuneSeptember 30, 2008 was $27,359$27,635 including $22,254$22,525 in retained earnings and $137$132 of accumulated other comprehensive losses net of the related deferred tax liability, which represents net unrealized losses on available-for-sale securities and the funded status of the Company’s defined benefit postretirement plan. At December 31, 2007, total stockholders’ equity was $26,816.

The Company had net income of $1,045$1,507 for the sixnine months ended JuneSeptember 30, 2008, compared with net income of $1,228$2,014 for the comparable period in 2007, a decrease of 14.90%25.17%. The Company had net income of $552$462 for the three months ended JuneSeptember 30, 2008, compared with net income of $660$786 for the comparable period in 2007, a decrease of 16.36%41.22%. The decrease in net income for the three and sixnine months ended JuneSeptember 30, 2008 was due to higher overhead costs, and loan loss provision expense and compression of the Company’s net interest margin.

Profitability as measured by the Company’s return on average assets (ROA) was 0.73%0.68% for the sixnine months ended JuneSeptember 30, 2008, down from 0.94%1.01% for the same period of 2007. Another key indicator of performance, the return on average equity (ROE), for the sixnine months ended JuneSeptember 30, 2008 was 7.70%7.37%, down from 9.83%10.63% for the sixnine months ended JuneSeptember 30, 2007.

The results of operations for the sixnine months ended JuneSeptember 30, 2008 are not necessarily indicative of the results to be expected for the full year ending December 31, 2008.

NET INTEREST INCOME

Net interest income represents the principal source of earnings for the Company. Changes in the amounts and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income.

Net interest income was $5,064$7,709 for the sixnine months ended JuneSeptember 30, 2008 compared to $4,938$7,563 for the sixnine months ended JuneSeptember 30, 2007 and is attributable to interest income from loans and securities exceeding the cost associated with interest paid on deposits.

Net interest income was $2,594$2,645 for the three months ended JuneSeptember 30, 2008 compared to $ 2,525$2,625 for the three months ended JuneSeptember 30, 2007. The net interest margin decreased to 3.75%3.71% for the sixnine months ended JuneSeptember 30, 2008, from 4.01%4.03% for the sixnine months ended JuneSeptember 30, 2007. Loan yield has fallen at a faster pace than the rate paid for deposits in the past year as the Company is asset sensitive and interest rates fell precipitously in the first quarter of 2008.

Interest income on loans and securities increased 2.78%2.27% and 0.87%1.30% for the sixnine and three months ended JuneSeptember 30, 2008, respectively, compared to the same periods of 2007 as net loan volume increased by $41,812$54,104 since JuneSeptember 30, 2007 while the yield on loans and securities decreased by 4654 basis points in the same time period.

Interest and fees on loans was $8,646$13,188 for the six-monthnine-month period ended JuneSeptember 30, 2008, up from $8,138$12,439 for the same period in 2007.

Interest and fees on loans was $4,381$4,542 for the three-month period ended JuneSeptember 30, 2008, up from $4,191$4,301 for the same period in 2007. Interest from securities and federal funds sold was $519$744 for the sixnine months ended JuneSeptember 30, 2008, down from $779$1,184 for the sixnine months ended JuneSeptember 30, 2007. Interest from securities and federal funds sold was $233$225 for the three months ended JuneSeptember 30, 2008, down from $383$405 for the three months ended JuneSeptember 30, 2007.

Total interestInterest expense increased 3.07%2.69% for the sixnine months ended JuneSeptember 30, 2008 and decreased 1.42%increased 1.97% for the three months ended JuneSeptember 30, 2008, compared to the same periods of 2007 as deposits have increased by $18,220$28,379 in the past twelve months while the yield on depositscost to fund earning assets has fallen by 2022 basis points in the same time period.

Interest on deposits and borrowed funds was $4,101$6,223 for the sixnine months ended JuneSeptember 30, 2008, up from $3,979$6,060 for the sixnine months ended JuneSeptember 30, 2007. Interest on deposits and borrowed funds was $2,020$2,122 for the three months ended JuneSeptember 30, 2008, downup from $2,049$2,081 for the three months ended JuneSeptember 30, 2007.

NONINTEREST INCOME

Noninterest income increased $172$246 or 13.59%12.64% for the sixnine months ended JuneSeptember 30, 2008 compared to the same period of 2007. Noninterest income increased $103$74 or 15.65%10.88% for the three months ended JuneSeptember 30, 2008 compared to the same period of 2007. The Company’s principal sources of noninterest income are service charges and fees on deposit accounts, particularly transaction accounts, and commissions and fees. The increase for the first sixnine months of 2008 compared to the same period of 2007 was primarily due mainly to a $34 or 4.96%an increase in service charges, fees on sales of mortgage loans and a $56 or 27.86% increase in investment sales commissions, and fees attributable mainlyalthough commissions decreased $23 in the third quarter of 2008 when compared to commissions on investment sales.the third quarter of 2007.

NONINTEREST EXPENSE

Noninterest expense increased $459$877 or 10.90%13.99% for the sixnine months ended JuneSeptember 30, 2008 compared to the same period of 2007. Noninterest expense increased $289$418 or 13.79%20.33% for the three months ended JuneSeptember 30, 2008 compared to the same period of 2007. The increase in noninterest expense for the three and six-monthnine-month periods is attributed primarily to the effect of overall growth of the Company on personnel expenses and fixed asset costs.

ALLOWANCE AND PROVISION FOR LOAN LOSSES

The Company expensed a provision for loan losses of $295$543 in the first sixnine months of 2008 and $157$248 in the secondthird quarter of 2008 in

recognition of management’s estimate of risks inherent with lending activities. Among other factors, management considers the Company’s historical loss experience, the size and composition of the loan portfolio, the value and adequacy of collateral and guarantors, non-performing credits, and current and anticipated economic conditions in making its estimate of risk. There are additional risks of future loan losses that cannot be precisely quantified or attributed to particular loans or classes of loans. Since those risks include general economic trends as well as conditions affecting individual borrowers, the allowance for loan losses is an estimate. The allowance is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance. The allowance for loan losses was $1,896$2,075 as of JuneSeptember 30, 2008, representing approximately 0.71%0.74% of total loans outstanding, compared to $1,819$1,802 or 0.81%0.80% of total loans outstanding as of JuneSeptember 30, 2007. The Company has not experienced a major increase in loan losses during the current economic climate.climate although management expects an increase in loan losses over the next year as non-performing loans have approximately tripled since December 31, 2007. Management believes the allowance was adequate as of JuneSeptember 30, 2008 to provide for loan losses inherent in the Company’s loan portfolio. Management evaluates the reasonableness of the allowance for loan losses on a quarterly basis and adjusts the provision as deemed appropriate. The Company has not experienced a major increase in loan losses during the current economic climate.

NON-PERFORMINGNONPERFORMING ASSETS AND IMPAIRED LOANS

Non-performingNonperforming assets, which consist of nonaccrual loans and foreclosed properties, were $768$1,995 at JuneSeptember 30, 2008 and $634 at December 31, 2007. OneThe current economic climate is the major factor in the increase in non-performing assets. Management is diligently monitoring its loan portfolio to find loans that could experience problems in performance and evaluating the Company’s collateral position. The increase in non-performing is mainly due to four commercial relationships. Management believes that losses of approximately $400 may be realized from these relationships and has adjusted the provision for losses accordingly. No foreclosed property valued at $239 was held as of JuneSeptember 30, 2008 and no foreclosed property was held ator December 31,2007.31, 2007. Nonaccrual loans were $529$1,995 at JuneSeptember 30, 2008 and $634 at December 31, 2007. Loans are generally placed in nonaccrual status when the collection of principal and interest is 90 days or more past due, unless the obligation is both

well-secured and in the process of collection. A loan is considered an impaired loan when, based on then current information and facts, it is probable that the Company will not be able to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans equaled nonaccrual loans at JuneSeptember 30, 2008.

LIQUIDITY

Liquidity represents an institution’s ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds from alternative funding sources. The Company’s liquidity is provided by cash and due from banks, federal funds sold, investments available for sale, managing investment maturities, interest-earning deposits in other financial institutions and loan repayments. The Company’s ability to obtain deposits and purchase funds at favorable rates also affects its liquidity. As a result of the Company’s management of liquid assets and its ability to generate liquidity through alternative funding sources, management believes that the Bank maintains overall liquidity that is sufficient to satisfy its depositors’ requirements and to meet customers’ credit needs. The Company’s ratio of liquid assets to deposits and short-term borrowings was 8.49%6.97% as of JuneSeptember 30, 2008 and 13.64%13.66% as of December 31, 2007. The growth of the Company’s loan portfolio has been the major factor in the decline of the liquidity ratio. The Company’ net loan-to-deposit ratio was 99.94% as of September 30, 2008 compared to 92.41% as of December 31, 2007. The Company loan growth rate is expected to slow in the near future and the deposit growth rate has been accelerating in recent months.

The Company has an established federal funds line with a regional correspondent bank of $13,680$13,850 that had no outstanding balance as of JuneSeptember 30, 2008 and an established line with the FHLB that had $15,000$5,000 outstanding under a total line of $37,527$40,700 as of JuneSeptember 30, 2008. The Company as of August 13, 2008 now has $5,000 outstanding under the FHLB line. Additional sources of liquidity available to the Company include its capacity to borrow additional funds up to $11,500 through two other correspondent banks. The Company derives cash flows from its operating, investing, and financing activities. Cash flows of the Company are primarily used to fund loans and securities and are provided by the deposits and borrowings of the Company.

CAPITAL

The Company believes thatis monitoring its financial position at JuneSeptember 30, 2008 reflectsand reviewing liquidity and capital levels. Adequate liquidity and capital levels adequateare necessary to fund anticipated future business expansion. Capital ratios are well above required regulatory minimums for a well-capitalized institution. The assessment of capital adequacy depends on a number of factors such as asset quality, liquidity, earnings performance, and changing competitive conditions and economic forces. The adequacy of the Company’s capital isand alternatives for increasing the Company’s capital position are reviewed by management regularly. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and to absorb potential losses.

Stockholders’ equity reached $27,359$27,635 at JuneSeptember 30, 2008 compared to $26,816 at December 31, 2007. At JuneSeptember 30, 2008, the Company’s leverage ratio (Tier 1 capital divided by quarterly average assets) was 9.11%8.85% compared to 9.54% at December 31, 2007. Each of these ratios exceeded the required minimum leverage ratio of 4%. The Company’s capital ratios have declined this year due to our overall growth rate of our assets exceeding our capital growth rates as net interest margin compression, an increase in provision for loan losses and an increase in noninterest expenses have affected our profitability and our ability to internally generate capital through retained earnings.

OFF-BALANCE SHEET ARRANGEMENTS

There were no material changes in the Company’s off-balance sheet arrangements and commitments from the information provided in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. The Company, in the normal course of business, may at times be a party to financial instruments such as standby letters of credit. Standby letters of credit as of JuneSeptember 30, 2008 equaled $1,200.$1,600. Other commitments include commitments to extend credit. Not all of these commitments will be acted upon; therefore, the cash requirements will likely be significantly less than the commitments themselves. As of JuneSeptember 30, 2008, the Company had unused loan commitments of $49,224,$46,213, including $34,643$36,133 in unused commitments with an original maturity exceeding one year.

CRITICAL ACCOUNTING POLICIES

Certain critical accounting policies affect the more significant judgments and estimates used in the preparation of the consolidated financial statements. The Company’s most critical accounting policy relates to the Company’s allowance for loan losses, which reflects the estimated losses resulting from the inability of the Company’s borrowers to make required loan payments. If the financial condition of the Company’s borrowers were to deteriorate, resulting in an impairment of their ability to make payments, the Company’s estimates would be updated, and additional provisions for loan losses could be required. Further information regarding the estimates used in determining the allowance for loan losses is contained in the discussions on “Allowance and Provision for Loan Losses” on page 1720 herein and “Loans and Allowance for Loan Losses” on page 32 of the Company’s 2007 Annual Report to Shareholders.

RECENT ACCOUNTING PRONOUNCEMENTS

In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements, which establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 defines fair value as the price