Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation
    The following discussion of the Company's financial condition and results of operations should be read in conjunction with the Company's financial statements and related notes and other statistical information included in this report.

Critical Accounting Policies
    The Company’s financial condition and results of operations are sensitive to accounting measurements and estimates of inherently uncertain matters. When applying accounting policies in areas that are subjective in nature, management uses its best judgment to arrive at the carrying value of certain assets. One of the most critical accounting policies applied is related to the valuation of the loan portfolio.
    The allowance for loan losses (ALLL) represents management’s best estimate of inherent probable losses in the loan portfolio as of the balance sheet date. It is one of the most difficult and subjective judgments. The adequacy of the allowance for loan losses is evaluated no less than quarterly. The determination of the balance of the allowance for loan losses is based on management’s judgments about the credit quality of the loan portfolio as of the review date. It should be sufficient to absorb losses in the loan portfolio as determined by management’s consideration of factors including an analysis of historical losses, specific reserves for non-performing or past due loans, delinquency trends, portfolio composition (including segment growth or shifting of balances between segments, products and processes, and concentrations of credit, both regional and by relationship), lending staff experience and changes, critical documentation and policy exceptions, risk rating analysis, interest rates and the competitive environment, economic conditions in the Bank’s service area, and results of independent reviews, including audits and regulatory examinations.

    In 2007, the Company determined that the allowance for loan losses was overstated as a result of provisions charged to earnings in years prior to 2003. A prior period adjustment to revalue the ALLL has been recorded, resulting in the restatement of balances, variances, and ratios previously reported for years ended December 31, 2006, 2005, 2004, and 2003, and for all quarter ends in years 2007, 2006, 2005, 2004, and 2003. No provision for loan loss was charged to earnings in 2003 or any year after, therefore the prior period adjustment has no impact on previously reported earnings. Item 6, Selected Financial Data, provides details of the accounts and balances that have been restated for each of the affected periods.
    The origin of the overstatement of the Bank’s allowance for loan loss is in the practice of federal and state financial institution regulatory agencies which for many decades strongly recommended that commercial banks establish a reserve for loan losses as a percentage of gross loans. The target percentage increased through the real estate market downturn of the 1980s. It was common practice for banking regulators to recommend that a bank reserve a percentage of gross loans comparable to the average of its peers. Peer groups for this purpose might be determined by size or geography. A bank with higher than peer losses might be required to reserve at a higher rate, but banks with lower than peer losses were requested to reserve based on peer experience, not their own. The result was that banks like ours with conservative lending practices and lower loan losses recorded reserves, through gradual provisions charged to earnings over many years, which exceeded their identifiable or likely losses. Therefore, throughout the 1990s the Bank maintained an ALLL of approximately 1.35% of loans. Although the Bank did not make additional provisions to the ALLL after 2002, its ALLL did not decrease in the ensuing years due to its low level of net charge-offs. However, based on its conservative practices and uncertainty as to the proper method to determine the ALLL, as further discussed below, management determined to keep the ALLL at the then-current level until 2007.
    In recent years, bank regulatory agencies have shifted their focus to the methodology, or thought process, underlying the balance in the ALLL. They recommend that banks, like other industries, estimate their reserve for uncollectible receivables (loans), in accordance with generally accepted accounting principles. In December 1993, the Interagency Policy Statement on the Allowance for Loan and Lease Losses focused on the responsibilities of financial institution management and boards of directors regarding the ALLL. In July 1999, guidance jointly issued by banking regulators and the Securities and Exchange Commission (SEC) marked the beginning of the regulatory shift to GAAP, from what had become known in the banking industry as regulatory accounting principles (RAP). In July 2001, banking regulators issued the Policy Statement on Allowance for Loan and Lease Losses Methodology and Documentation for Banks and Savings Institutions, which instructed banking boards of directors to ensure that their ALLL is determined consistent with "the institutions’ stated policies and procedures, generally accepted accounting principles (GAAP), and ALLL supervisory guidance." Throughout the 2001 statement, the regulators acknowledge that variables such as the size of an institution and the complexity of its lending products and activities will result in policies and procedures "appropriately tailored" to the institution. Parallel guidance to registrants that are creditors in lending transactions was released in July 2001 by SEC as Staff Accounting Bulletin 102, Selected Loan Loss Allowance and Documentation Issues. The 2001 guidance, which reinforced the regulatory shift toward GAAP, recommended that reserves be based on historical and identified losses in the loan portfolio. As a result, the Company ceased to build its ALLL through charges to income until it was confident that the current guidance was widely applied by its regulators and implemented by the industry.

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    In response to the definitive guidance provided in the 2006 Statement, which management believes, unlike the prior statements, was accepted in the industry as definitive guidance, management determined that a revaluation of the ALLL was necessary. Management and the boards of directors of the Bank and the Company agreed that the accounting adjustment required to bring the ALLL to its appropriate level, based on the application of current methodology, would materially distort earnings if adjusted in the prescribed manner, through current earnings. With the concurrence of its independent auditors, management has elected to record the revaluation of the ALLL as a prior period adjustment. The result of the restatement of prior years is to increase net loans, total assets, the net credit for deferred income taxes, and retained earnings in each restated year. The restatement of these balances results in restated variances between years and relationship ratios within a single year, such as loans to deposits and capital ratios. These restatements are referenced throughout the following Management’s Discussion and Analysis. It is the belief of management that the restatements of balances, variances and ratios support the position that this adjustment will not alter conclusions drawn by those who relied on the Company’s originally filed statements for the restated periods, or those who rely on the Company’s current financial reports including the restatements for quarterly and annual reports from March 2003, through September 2007.
    See "Loan Quality and the Allowance for Loan Losses" for additional related disclosure and discussion.

Overview
    Consolidated income of the Company is derived primarily from operations of the Bank. Net income for 2007 was $7,296,587 compared to $7,400,369 for 2006 and $6,797,638 for 2005. The Company had a return on average equity of 10.06% and return on average assets of 1.96% for 2007, compared to returns on average equity of 10.68% and 9.83%, and returns on average assets of 1.96% and 1.70%, for 2006 (restated) and 2005 (restated), respectively. The effect of restatement is to reduce returns on average equity by .19% and .18% and returns on average assets by .01% and .01%, for 2006 and 2005, respectively.

Net Interest Income
    The primary source of income for the Company is net interest income, which is the difference between revenue on interest-earning assets, such as investment securities and loans, and interest expense incurred on interest-bearing sources of funds, such as deposits and borrowings. The level of net interest income is determined primarily by the average balances of interest-earning assets and the Company’s funding sources, and the rate spreads between interest-earning assets and funding sources. Changes in net interest income from period to period result from increases or decreases in the volume of interest-earning assets and interest-bearing liabilities, and increases or decreases in the average rates earned and paid on such assets and liabilities. The volume of interest-earning assets and interest-bearing liabilities is affected by the ability to manage the earning-asset portfolio, which includes loans, and the availability of particular sources of funds, such as noninterest-bearing deposits.
    The key performance measure for net interest income is the "net margin on interest-earning assets," or net interest income divided by average interest-earning assets. The Company's net interest margin for 2007 on a non-GAAP tax-equivalent basis was 5.07%, compared to 5.00% and 4.43% for 2006 (restated) and 2005 (restated), respectively. The effect of restatement was to lower the net interest margin from the originally reported levels of 5.02% and 4.45% for 2006 and 2005, respectively. Because most of the Bank’s loans are written with a demand feature, the income of the Bank should not change dramatically as interest rates change. Management of the Company expects to maintain the net margin on interest-earning assets. The net margin may decline, however, if competition increases, loan demand decreases, or the cost of funds rises faster than the return on loans and securities. Although such expectations are based on management's judgment, actual results will depend on a number of factors that cannot be predicted with certainty, and fulfillment of management's expectations cannot be assured.
    The following tables present information including average balances of interest-earning assets and interest-bearing liabilities, the amount of related interest income and interest expense, and the resulting yields by category of interest-earning asset and interest-bearing liability. In these tables, dividends and interest on tax-exempt securities and loans are reported on a fully taxable equivalent basis, which is a non-GAAP measure as defined in SEC Regulation G and Item 10 of SEC Regulation S-K. Management believes that these measures provide better yield comparability as a tool for managing net interest income.

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       In the preceding table, the variance that is both rate and volume related is reported with the rate variance.

    Because loans are expected to produce higher yields than investment securities and other interest-earning assets (assuming that loan losses are not excessive), the absolute volume of loans and the volume as a percentage of total earning assets is an important determinant of net interest margin. Average loans, net of the allowance for loan losses, were $235,014,000, $226,672,000, and $186,418,000 during 2007, 2006 (restated), and 2005 (restated), respectively, which constituted 68.66%, 65.60%, and 50.87%, of average interest-earning assets for the periods. The Company’s ratio of net loans to deposits was 82.40%, 80.33%, and 66.40% at December 31, 2007, 2006 (restated), and 2005 (restated), respectively. Average net loans to average deposits were 80.02%, 75.71%, and 57.86% for 2007, 2006 (restated), and 2005 (restated). The increase in the loan to deposit ratio from 2006 to 2007 is attributable to 3.68% growth in the average loan portfolio accompanied by a modest 1.91% reduction in average deposits during 2007. The increase in the loan to deposit ratio from 2005 to 2006 is attributable to 21.59% growth in the average loan portfolio accompanied by a 7.08% reduction in average deposits during 2006. Throughout 2005, 2006 and 2007, the Bank continued to enjoy increased loan opportunity due to steady demand and competitive pricing. The effect of restatement of the ratios in this section is to increase each restated 2006 and 2005 ratio by less than 1.00%.

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    The following table sets forth the maturity distribution, classified according to sensitivity to changes in interest rates, for selected components of the Company's loan portfolio as of December 31, 2007.

    As of December 31, 2007, $232,459,631 or 97.56%, of the total loans were either variable rate loans or loans written on demand.

    The Company has the following commitments, lines of credit, and letters of credit outstanding as of December 31, 2007, 2006, and 2005, respectively.

    Loan commitments are agreements to lend to a customer as long as there is no violation of any condition to the contract. Loan commitments generally have interest at current market rates, fixed expiration dates, and may require the payment of a fee. Letters of credit are commitments issued to guarantee the performance of a customer to a third party. Loan commitments and letters of credit are made on the same terms, including collateral, as outstanding loans. The Company's exposure to loss in the event of nonperformance by the borrower is represented by the contract amount of the commitment.

    Unallocated reserves are not associated with a specific portfolio segment or a specific loan, but may be appropriate if properly supported and in accordance with GAAP. Because no portion of the ALLL is calculated on a total loan portfolio basis, management anticipates having low levels of unallocated reserves in future periods. The unallocated portion in the preceding table appears higher in years prior to 2007, because management had not adopted this methodology at those year-ends. The unallocated reserves in years prior to 2007 cannot be allocated as specific reserves due to application of FAS 16 Prior Period Adjustments, paragraph 3, which prohibits the retrospective valuation of aged accounts receivable (past due loans) because the passage of time has revealed their ultimate resolution. Management believes that the ALLL reflected in this table for years prior to 2007 does not materially differ from the balance that would have been calculated at each of those year-ends had current methodology been applied then.

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    Loans are considered impaired when, based on current information, management considers it unlikely that collection of principal and interest payments will be made according to contractual terms. Generally, loans are not reviewed for impairment until the accrual of interest has been discontinued, although management may categorize a performing loan as impaired based on knowledge of the borrower’s financial condition, devaluation of collateral, or other circumstances that are deemed relevant to loan collection. Impaired loans may have specific reserves, or valuation allowances, allocated to them in the ALLL. Estimates of loss reserves on impaired loans are determined based on two of the measurement methods described in Financial Accounting Standard 114 (FAS 114): (1) the loan’s observable fair price, or (2) the fair value of collateral, if repayment of the loan is expected to be provided by underlying collateral. Loans determined to be impaired, but for which no specific valuation allowance is made because management believes the loan is secured with adequate collateral or the Bank will not take a loss on such loan, are grouped with other homogeneous loans for evaluation under formula-based criteria described previously.
    The following table sets forth principal balances of impaired loans and the related valuation allowances as of December 31, 2007. Included in principal balances of impaired loans as of December 31, 2007, is $436,802 which is guaranteed by a government agency. Management had identified no impaired loans as of December 31, 2006, 2005, 2004, and 2003.

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Liquidity and Interest Rate Sensitivity
    The primary objective of asset/liability management is to ensure the steady growth of the Company's primary source of earnings, net interest income. Net interest income can fluctuate with significant interest rate movements. To lessen the impact of these margin swings, the balance sheet should be structured so that repricing opportunities exist for both assets and liabilities in roughly equivalent amounts at approximately the same time intervals. Imbalances in these repricing opportunities at any point in time constitute interest rate sensitivity.
    Liquidity represents the ability to provide steady sources of funds for loan commitments and investment activities, as well as to provide sufficient funds to cover deposit withdrawals and payment of debt and operating obligations. These funds can be obtained by converting assets to cash or by attracting new deposits. Average liquid assets (cash and amounts due from banks, interest-bearing deposits in other banks, federal funds sold, and investment securities) were 42.03% of average deposits for 2007, compared to 45.61% and 62.06% for 2006 and 2005, respectively.
    Average net loans to average deposits were 80.12%, 75.71%, and 57.86% for 2007, 2006 (restated), and 2005 (restated). The increase in the loan to deposit ratio from 2006 to 2007 is attributable to 3.68% growth in the average loan portfolio accompanied by a 1.91% reduction in average deposits during 2007. The increase in the loan to deposit ratio from 2005 to 2006 is attributable to 21.59% growth in the average net loan portfolio accompanied by a 7.08% reduction in average deposits during 2006. Funding for loan growth was provided by reduction of the investment portfolio. As loans earn at higher average rates than investments, this shift has a positive effect on earnings. The increase in loans does not negatively impact the Company’s ability to meet liquidity demands. Restatement of loan to deposit ratios for 2006 and 2005 resulted in increases of 67 and 62 basis points, respectively.
    As of December 31, 2007, $33,390,316 (50.15%) of total debt securities mature in one year or less, of which, $16,935,694 are classified as "available-for-sale." Federal funds sold provide additional liquidity. Other sources of liquidity include letters of credit, overnight federal funds, and reverse repurchase agreements available from correspondent banks. The total lines and letters of credit available from correspondent banks were $21,000,000 as of December 31, 2007 and 2006, and $19,000,000 as of December 31, 2005.

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    Interest rate sensitivity refers to the responsiveness of interest-bearing assets and liabilities to changes in market interest rates. The rate-sensitive position, or gap, is the difference in the volume of rate-sensitive assets and liabilities at a given time interval. The general objective of gap management is to actively manage rate-sensitive assets and liabilities to reduce the impact of interest rate fluctuations on the net interest margin. Management generally attempts to maintain a balance between rate-sensitive assets and liabilities as the exposure period is lengthened to minimize the overall interest rate risk to the Company.
    Interest rate sensitivity may be controlled on either side of the balance sheet. On the asset side, management exercises some control over maturities. Also, loans are written to provide repricing opportunities on fixed rate notes. The Company's investment portfolio, including federal funds sold, provides the most flexible and fastest control over rate sensitivity since it can generally be restructured more quickly than the loan portfolio.
    On the liability side, deposit products are structured to offer incentives to attain the maturity distribution desired. Competitive factors sometimes make control over deposits more difficult and, therefore, less effective as an interest rate sensitivity management tool.
    The asset mix of the balance sheet is continually evaluated in terms of several variables: yield, credit quality, appropriate funding sources, and liquidity. Management of the liability mix of the balance sheet focuses on expanding the various funding sources.
    As of December 31, 2007, the Company was cumulatively asset-sensitive for all time horizons. For asset-sensitive institutions, if interest rates should decrease, the net interest margins should decline. Since all interest rates and yields do not adjust at the same velocity, the gap is only a general indicator of rate sensitivity.

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Deposits and Other Interest-Bearing Liabilities
    Average interest-bearing liabilities decreased $2,808,000 (1.27%) to $218,248,000 in 2007, from $221,056,000 in 2006. Average interest-bearing deposits decreased $1,142,000 (.53%) to $213,891,000 in 2007 from $215,033,000 in 2006, while average noninterest-bearing demand deposits decreased $4,573,000 (5.42%) to $79,807,000 in 2007 from $84,380,000 in 2006. At December 31, 2007, total deposits were $288,943,547, compared to $290,324,760 at December 31, 2006, a decrease of .48%.
    Average interest-bearing liabilities decreased $22,107,000 (9.09%) to $221,056,000 in 2006, from $243,163,000 in 2005. Average interest-bearing deposits decreased $21,654,000 (9.15%) to $215,033,000 in 2006 from $236,687,000 in 2005, while average noninterest-bearing demand deposits decreased $1,146,000 (1.34%) to $84,380,000 in 2006 from $85,526,000 in 2005. At December 31, 2006, total deposits were $290,324,760, compared to $310,857,607 at December 31, 2005, a decrease of 6.61%.
    Management believes that decreasing deposit volume in 2006 resulted from a return by investors to non-deposit investment products and strong competition for deposits in the local market. Deposit balances stabilized in 2007 with only modest balance reductions relative to the previous year. During 2007, non-deposit investment products became less attractive as the stock market experienced a downturn. Competition for deposits continued although banks began to lower the high rates on time deposits that were offered in 2006. Management monitors deposit decreases closely and implements counter-measures as needed, including but not limited to rate increases on existing products and the development of new products.
    The following table sets forth the deposits of the Company by category as of December 31, 2007, 2006, and 2005, respectively.

    Core deposits, which exclude certificates of deposit of $100,000 or more, provide a relatively stable funding source for the Company's loan portfolio and other earning assets. The Company's core deposits decreased $9,280,378 during 2007, $30,616,403 during 2006 and $8,168,720 during 2005. Management attributes the variance from 2005 to 2006 to aggressive competition for time deposits in a rising rate environment. Rate increases implemented in 2006 to retain deposits caused a shift of funds from core deposits into time deposits of $100,000 or more. From December 31, 2005 to 2006, time deposits of $100,000 or more increased $10,083,556 (56.40%). During 2006, as in 2005, management believes that market conditions lead to a reversal of some of the deposit influx that occurred in 2001 through 2004 as funds migrated from the stock market into insured deposits. During 2007, deposits continued to shift from more liquid demand and savings products to higher rate time deposits. Over year ended December 31, 2007, time deposits of $100,000 or more increased $7,899,165 (28.25%).

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    Large certificate of deposit customers tend to be extremely sensitive to interest rate levels, making these deposits less reliable sources of funding for liquidity planning purposes than core deposits. Some financial institutions partially fund their balance sheets using large certificates of deposit obtained through brokers. These brokered deposits are generally expensive and are unreliable as long-term funding sources. Accordingly, the Company does not accept brokered deposits under these conditions. During 2007, the Bank joined the Certificate of Deposit Account Registry Service (CDARS). This service allows the Bank to offer depositors up to $50 million in FDIC insurance through a network of member banks. While CDARS deposits are considered to be brokered deposits for regulatory reporting, they are not considered volatile as they typically remain in the program until maturity.

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Noninterest Expense
    Noninterest expense increased $207,404 (2.82%) from 2006 to 2007. Increased personnel costs of $275,975 include a $102,262 (28.96%) increase in group insurance expense. Occupancy expense decreased $9,527, including a $32,313 (30.69%) decrease in building maintenance related to non-recurring repairs to branches in 2006. Furniture and equipment expense is down $14,969, which is attributable to lower service contract costs. Other operating expense decreased $44,075, which includes a $50,367 (46.22%) reduction in courier costs resulting from the Bank’s implementation of branch-based electronic image capture. .
    Noninterest expense increased $195,005 (2.72%) from 2005 to 2006. Increased personnel costs of $159,652 include a $48,300 cash bonus paid in February 2006, and a $28,197 increase in expense related to the Bank’s employee retirement plan. Occupancy expense increased $69,284 which includes a $29,430 (24.93%) increase in utility costs. Furniture and equipment expense are down $12,404, which is largely attributable to lower depreciation expense. Other operating expense decreased $21,527, as the net result of several increases and decreases. Increased directors’ fees resulted from a fee increase, an additional Board seat, and one additional meeting in 2006 as compared to 2005. Postage costs are down by $30,200 due to the timing of as-needed meter replenishment, and the Company’s efforts to reduce unnecessary mailings. Professional fees in 2005 included non-recurring consulting fees of $19,052.
    The following table presents the principal components of noninterest expense for the years ended December 31, 2007, 2006, and 2005, respectively.

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Capital
    Under capital guidelines adopted by the Federal Reserve Board and the FDIC, the Company and the Bank are currently required to maintain a minimum risk-based total capital ratio of 8%, with at least 4% being Tier 1 capital. Tier 1 capital consists of common stockholders’ equity, qualifying perpetual preferred stock, and minority interests in equity accounts of consolidated subsidiaries, less certain intangibles. In addition, the Company and the Bank must maintain a minimum Tier 1 leverage ratio (Tier 1 capital to total assets) of at least 4%, but this minimum ratio is increased by 100 to 200 basis points for other than the highest-rated institutions.
    At December 31, 2007, 2006, and 2005, the Company and the Bank were well-capitalized, exceeding all minimum requirements, as set forth in the following table.

    The effect of the restatement of prior years is to increase the total risk-based capital ratios for both the Company and the Bank, with no increase greater than 1.0%, and to lower the Tier 1 risk-based capital ratios and the Tier 1 leverage capital ratios for both the Company and the Bank, with no reduction greater than .4%.

Accounting Rule Changes
    The following accounting pronouncements have been approved by the Financial Accounting Standards Board but have not become effective as of December 31, 2007. These pronouncements would apply to the Company if the Company or the Bank entered into an applicable activity.
    FASB Statement No. 157, "Fair Value Measurements" defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements.  SFAS No. 157 will be applied prospectively and is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years.  Management does not expect SFAS No. 157 to have a material impact on the Company’s consolidated financial statements. It will require additional disclosure as to ranking of valuation methods in deriving fair value.
    FASB Statement No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007.  Management does not expect SFAS No. 159 to have a material impact on the Company’s consolidated financial statements.

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Impact of Inflation
    Unlike most industrial companies, the assets and liabilities of financial institutions such as the Company and the Bank are primarily monetary in nature. Therefore, interest rates have a more significant effect on the Company's performance than do the effects of changes in the general rate of inflation and change in prices. In addition, interest rates do not necessarily move in the same direction or in the same magnitude as the prices of goods and services. As discussed previously, management seeks to manage the relationships between interest sensitive assets and liabilities in order to protect against wide interest rate fluctuations, including those resulting from inflation. See "Liquidity and Interest Rate Sensitivity" above.

    In response to this Item, the information included on pages 1 through 22 of the Company's Annual Report to Stockholders for the year ended December 31, 2007, is incorporated herein by reference.

    There have been no changes in or disagreements with accountants on accounting or financial disclosure during the fiscal year covered by this report.

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    Disclosure controls and procedures are designed and maintained by the Company to ensure that information required to be disclosed in the Company’s publicly filed reports is recorded, processed, summarized and reported in a timely manner. Such information must be available to management, including the Chief Executive Officer (CEO) and Treasurer, to allow them to make timely decisions about required disclosures. Even a well-designed and maintained control system can provide only reasonable, not absolute, assurance that its objectives are achieved. Inherent limitations in any system of controls include flawed judgment, errors, omissions, or intentional circumvention of controls.
    The Company’s management, including the CEO and Treasurer, performed an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of December 31, 2007. Based on that evaluation, the Company’s management, including the CEO and Treasurer, has concluded that the Company’s disclosure controls and procedures are effective. The projection of an evaluation of controls to future periods is subject to the risk that procedures may become inadequate due to changes in conditions including the degree of compliance with procedures.

    Calvin B. Taylor Bankshares, Inc. maintains a system of internal control over financial reporting, which is designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation of reliable published financial statements. The system includes an organizational structure and division of responsibility, established policies and procedures including a code of conduct to foster a strong ethical climate, and the careful selection, training and development of our staff. The system contains self-monitoring mechanisms, and an internal auditor monitors the operation of the internal control system and reports findings and recommendations to management and the board of directors. Corrective actions are taken to address control deficiencies and other opportunities for improving the system as they are identified. The board, operating through its audit committee, which is composed entirely of directors who are not officers or employees of the Company, provides oversight to the financial reporting process.
    There are inherent limitations in the effectiveness of any system of internal controls, including the possibility of human error and the circumvention or overriding of controls. Accordingly, even an effective internal control system can provide only reasonable assurance with respect to financial statement preparation. Furthermore, the effectiveness of an internal control system may vary over time and with circumstances.
    The Company assessed its internal control system as of December 31, 2007 in relation to criteria for effective internal control over financial reporting as described in Internal Control – Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on its assessment, the Company believes that, as of December 31, 2007, its system of internal control over financial reporting met those criteria.

                                                                            Calvin B. Taylor Bankshares, Inc.
                                                                            Registrant

Date: March 12, 2008                                  By: /s/ Raymond M. Thompson
                                                                            Raymond M. Thompson, Director
                                                                            President and Chief Executive Officer

Date: March 11, 2008                                 By: /s/Jennifer G. Hawkins
                                                                            Jennifer G. Hawkins
                                                                            Treasurer / Principal Financial Officer

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Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders
Calvin B. Taylor Bankshares, Inc.
Berlin, Maryland

    We have audited management’s assessment, included in the accompanying Management Report on Internal Control Over Financial Reporting, that Calvin B. Taylor Bankshares, Inc. and Subsidiary maintained effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

    We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

    A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

    Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

    In our opinion, management’s assessment that Calvin B. Taylor Bankshares, Inc. and Subsidiary maintained effective internal control over financial reporting as of December 31, 2007, is fairly stated, in all material respects, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Calvin B. Taylor Bankshares, Inc. and Subsidiary maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

    We have audited, in accordance with the standards of the Public Company Accounting Oversight Board in the United States of America, the balance sheets and the related statements of income, changes in stockholders’ equity and cash flows of Calvin B. Taylor Bankshares, Inc. and Subsidiary, and our report dated March 12, 2008, expressed an unqualified opinion.

/s/ Rowles & Company, LLP
Baltimore, Maryland

March 12, 2008

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    During the quarter ended on the date of this report, there were no significant changes in the Company’s internal controls over financial reporting that have had or are reasonably likely to have a material affect on the Company’s internal control over financial reporting. As of December 31, 2007, the Company’s management, including the CEO and Treasurer, has concluded that the Company’s internal controls over financial reporting are effective.

    The Board of Directors has adopted a written Audit Policy, which serves as a charter for the Audit Committee. The Audit Committee is comprised of seven independent directors, including Chairman James R. Bergey, Jr. who serves as the financial expert. The Audit Committee is scheduled to meet quarterly and held six meetings in 2007.

    The information required by this item is included in the Company's Proxy Statement to be filed in connection with the 2008 Annual Meeting of Stockholders, and is incorporated herein by reference.

Item 11. Executive Compensation

    The information required by this item is included in the Company's Proxy Statement to be filed in connection with the 2008 Annual Meeting of Stockholders, and is incorporated herein by reference.

    The information required by this item is included in the Company's Proxy Statement to be filed in connection with the 2008 Annual Meeting of Stockholders, and is incorporated herein by reference.

    The information required by this item is included in the Company's Proxy Statement to be filed in connection with the 2008 Annual Meeting of Stockholders, and is incorporated herein by reference.

    The information required by this item is included in the Company's Proxy Statement to be filed in connection with the 2008 Annual Meeting of Stockholders, and is incorporated herein by reference.

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    (a) Exhibits

    (a)(1), (2) Annual Report to Stockholders for the year ended December 31, 2007

    3.1 Articles of Incorporation of the Company, incorporated by reference to Exhibit 3.1 of Registration Statement Form S-4, File No. 33-99762.

    3.2 Bylaws of the Company, incorporated by reference to Exhibit 3.2 of Registration Statement Form S-4, File No. 33-99762.

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SIGNATURES

    Pursuant to the requirements of Section 13 or 15(d) 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.

                                                                    CALVIN B. TAYLOR BANKSHARES, INC.
                                                                    (Registrant)

Date: March 12, 2008                                 By: /s/ Raymond M. Thompson
                                                                            Raymond M. Thompson, Director
                                                                            President and Chief Executive Officer

Date: March 11, 2008                                 By: /s/ Jennifer G. Hawkins
                                                                            Jennifer G. Hawkins
                                                                            Treasurer / Principal Financial Officer

    Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Date: March 12, 2008                                 By: /s/ James R. Bergey, Jr.
                                                                            James R. Bergey, Jr., Director

Date: March 12, 2008                                 By: /s/ John H. Burbage, Jr.
                                                                            John H. Burbage, Jr., Director

Date: March 12, 2008                                 By: /s/ Todd E. Burbage
                                                                            Todd E. Burbage, Director

Date: March 12, 2008                                 By: /s/ Charlotte K. Cathell
                                                                            Charlotte K. Cathell, Director

Date: March 12, 2008                                 By: /s/ Reese F. Cropper, Jr.
                                                                            Reese F. Cropper, Jr.
                                                                            Chairman of the Board of Directors

Date: March 12, 2008                                  By: /s/ Reese F. Cropper, III
                                                                            Reese F. Cropper, III, Director

Date: March 12, 2008                                 By: /s/ Hale Harrison
                                                                            Hale Harrison, Director

Date: March 12, 2008                                 By: /s/ Gerald T. Mason
                                                                            Gerald T. Mason, Director

Date: March 12, 2008                                 By: /s/ William H. Mitchell
                                                                            William H. Mitchell, Director
                                                                            Vice President

Date: March 12, 2008                                 By: /s/ Joseph E. Moore
                                                                            Joseph E. Moore, Director

Date: March 12, 2008                                 By: /s/ Michael L. Quillin, Sr.
                                                                            Michael L. Quillin, Sr., Director

Date: March 12, 2008                                 By: /s/ Raymond M. Thompson
                                                                            Raymond M. Thompson, Director
                                                                            President and Chief Executive Officer

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Certification - Pursuant to 18 U.S.C. 1350
Section 906 of the Sarbanes-Oxley Act of 2002

We, the undersigned, certify that to the best of our knowledge, based upon a review of the Annual Report on Form 10-K for the period ended December 31, 2007 of the Registrant (the "Report"):

                                                                            Calvin B. Taylor Bankshares, Inc.

Date: March 12, 2008                                  By: /s/ Raymond M. Thompson
                                                                            Raymond M. Thompson, Director
                                                                            President and Chief Executive Officer

Date: March 11, 2008                                 By: /s/Jennifer G. Hawkins
                                                                            Jennifer G. Hawkins
                                                                            Treasurer / Principal Financial Officer

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Certification of Principal Executive Officer
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, Raymond M. Thompson, certify that:

I have reviewed this annual report on Form 10-K of Calvin B. Taylor Bankshares, Inc.;

Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f) for the registrant and have:

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors:

                                                                        Calvin B. Taylor Bankshares, Inc.

Date: March 12, 2008                                  By: /s/ Raymond M. Thompson
                                                                            Raymond M. Thompson, Director
                                                                            President and Chief Executive Officer

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Certification of Principal Financial Officer
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, Jennifer G. Hawkins, certify that:

I have reviewed this annual report on Form 10-K of Calvin B. Taylor Bankshares, Inc.;

Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f) for the registrant and have:

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors:

                                                                        Calvin B. Taylor Bankshares, Inc.

Date: March 11, 2008                                 By: /s/Jennifer G. Hawkins
                                                                            Jennifer G. Hawkins
                                                                            Treasurer / Principal Financial Officer

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