The purpose of this discussion is to focus on significant changes in the financial condition and results of operations of the Company during the past three years. The discussion and analysis are intended to supplement and highlight information contained in the accompanying Consolidated Financial Statements and the selected financial data presented elsewhere in this Annual Report on Form 10-K. Financial institutions acquired by the Company during the past three years and accounted for as purchases are reflected in the financial position and results of operations of the Company since the date of their acquisition.

RECLASSIFICIATION

In certain circumstances, reclassifications have been made to prior period information to conform to the 2008 presentation.

CRITICAL ACCOUNTING POLICIES

The accounting and reporting policies followed by the Company conform with U.S. generally accepted accounting principles ("GAAP") and they conform to general practices within the banking industry. The Company's critical accounting policies, which are summarized below, relate to (1) the allowance for loan losses and (2) goodwill impairment. A summary of the Company's significant accounting policies is set forth in Note 1 to the Consolidated Financial Statements.

The financial information contained within the Company's financial statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset, or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method.

Allowance for Loan Losses and Reserve for Unfunded Lending Commitments

The allowance for loan losses is an estimate of the losses inherent in the loan portfolio at the balance sheet date. The allowance is based on two basic principles of accounting: (i) Statement of Financial Accounting Standards ("SFAS") 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that losses on impaired loans be accrued based on the differences between the value of collateral, present value of future cash flows, or values observable in the secondary market, and the loan balance.

The Company's allowance for loan losses has three basic components: the formula allowance, the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change. The formula allowance uses a historical loss view as an indicator of future losses along with various qualitative factors, including levels and trends in delinquencies, nonaccrual loans, charge-offs and recoveries; trends in volume and terms of loans; effects of changes in underwriting standards; experience of lending staff and economic conditions; and portfolio concentrations. In the formula allowance, the historical loss rate is combined with the qualitative factors, resulting in an adjusted loss factor for each risk-grade category of loans. The adjusted loss factor is multiplied by the period-end balances for each risk-grade category. The formula allowance is calculated for a range of outcomes. The specific allowance uses various techniques to arrive at an estimate of loss for specifically identified impaired loans. The unallocated allowance includes estimated losses whose impact on the portfolio has yet to be recognized in either the formula or specific allowance. The use of these values is inherently subjective and actual losses could be greater or less than the estimates.

The reserve for unfunded loan commitments is an estimate of the losses inherent in off-balance-sheet loan commitments at the balance sheet date. It is calculated by multiplying an estimated loss factor by an estimated probability of funding, and then by the period-end amounts for unfunded commitments. The reserve for unfunded loan commitments is included in other liabilities.

Goodwill Impairment

The Company tests goodwill on an annual basis or more frequently if events or circumstances indicate that there may have been impairment. If the carrying amount of goodwill exceeds its implied fair value, the Company would recognize an impairment loss in an amount equal to that excess. The goodwill impairment test requires management to make judgments in determining the assumptions used in the calculations. The goodwill impairment testing conducted by the Company in 2008 indicated that goodwill is not impaired and is properly recorded in the financial statements.

NON-GAAP PRESENTATIONS

The analysis of net interest income in this document is performed on a taxable equivalent basis to facilitate performance comparisons among various taxable and tax-exempt assets.

EXECUTIVE OVERVIEW

American National Bankshares Inc. is the holding company of American National Bank and Trust Company, a community bank serving Southern and Central Virginia and the northern portion of Central North Carolina with twenty banking offices and a loan production office.

American National Bank and Trust Company provides a full array of financial products and services, including commercial, mortgage, and consumer banking; trust and investment services; and insurance. Services are also provided through twenty-four ATMs, "AmeriLink" Internet banking, and 24-hour "Access American" telephone banking.

Additional information is available on the Company's website at www.amnb.com. The shares of American National Bankshares Inc. are traded on the NASDAQ Global Select Market under the symbol "AMNB."

The Company's mission, vision, and guiding principles are as follows:

Mission We provide quality financial services with exceptional customer service.

Vision We will enhance the value of our shareholders' investment by being our communities' preferred provider of relationship-based financial services.

Guiding Principles To achieve our vision and carry out our mission, we:
· operate a sound, efficient, and highly profitable company,

· identify and respond to our internal and external customers' needs and expectations in an ever changing financial services environment,

· provide quality sales and quality service to our customers,

· produce profitable growth,

· provide an attractive return for our shareholders,

· furnish positive leadership for the well-being of all communities we serve,

· continuously develop a challenging and rewarding work environment for our employees, and

· conduct our work with integrity and professionalism.

RESULTS OF OPERATIONS

Net Interest Income

Net interest income is the difference between interest income on earning assets, primarily loans and securities, and interest expense on interest bearing liabilities, primarily deposits. Fluctuations in interest rates as well as volume and mix changes in earning assets and interest bearing liabilities can materially impact net interest income. The following discussion of net interest income is presented on a taxable equivalent basis to facilitate performance comparisons among various taxable and tax-exempt assets, such as certain state and municipal securities. A tax rate of 35% was used in adjusting interest on tax-exempt assets to a fully taxable equivalent basis. Net interest income divided by average earning assets is referred to as the net interest margin. The net interest spread represents the difference between the average rate earned on earning assets and the average rate paid on interest bearing liabilities.

Net interest income decreased $2,226,000, or 7.4% from 2007 to 2008, following a $757,000, or 2.6% increase in 2007 from 2006 levels. The decrease in 2008 was primarily due to an 8.7% decline in the net interest margin from 4.24% in 2007 to 3.87% in 2008, the effect of which was partially offset by a 1.6% increase in the level of average interest earning assets. The increase in 2007 was primarily due to balance sheet growth including the acquisition of Community First Financial Corporation in April 2006. Additionally, purchase accounting adjustments from the Community First acquisition had a positive impact on net interest income in 2007. Payoffs of acquired loans accounted for under American Institute of Certified Public Accountants Statement of Position 03-3 resulted in $571,000 of interest income in 2007. Interest income related to the valuation of other loans acquired from Community First was $536,000 in 2008 and 2007. Similarly, interest expense related to the valuation of acquired deposits was $0 and $88,000 in 2008 and 2007, respectively. The net interest margin decreased from 4.24% in 2007 to 3.87% in 2008, after increasing from 4.20% in 2006, due primarily to the fact that loans, the largest component of earning assets, reprice at a much faster pace than deposits in interest bearing liabilities. During 2008, the Federal Open Market Committee of the Federal Reserve Board reduced the intended federal funds rate seven times from 4.25% to 0.25%. This had a dramatic effect on the Company's net interest margin.

To meet its funding needs for the Community First acquisition, the Company issued $20,619,000 of Trust Preferred Securities during the second quarter of 2006. Interest expense associated with these securities was $1,373,000 for 2008 and 2007 and $1,007,000 for 2006.

The following presentation is an analysis of net interest income and related yields and rates, on a taxable equivalent basis, for the years 2006 through 2008. Nonaccrual loans are included in average balances. Interest income on nonaccrual loans, if recognized, is recorded on a cash basis or when the loan returns to accrual status.

                                             Table 1 - Net Interest Income Analysis
                                             (in thousands, except yields and rates)

                      Average Balance                            Interest Income/Expense                Average Yield/Rate

                    2008          2007          2006          2008         2007         2006        2008       2007       2006
Loans:
Commercial        $  91,117     $  89,673     $  84,676     $  5,515     $  6,980     $  6,481       6.05 %     7.78 %     7.65 %
Real Estate         467,508       449,683       416,530       29,712       33,621       29,813       6.36       7.48       7.16
Consumer              8,774        10,420        12,287          795          975        1,152       9.06       9.36       9.38
Total loans         567,399       549,776       513,493       36,022       41,576       37,446       6.35       7.56       7.29

Securities:
Federal
agencies             45,660        68,521        94,589        2,215        3,032        3,745       4.85       4.42       3.96
Mortgage-backed      47,997        25,406        21,197        2,433        1,255          988       5.07       4.94       4.66
State and
municipal            45,573        46,069        46,735        2,505        2,530        2,624       5.50       5.49       5.61
Other                 6,141         7,484        11,059          277          438          621       4.51       5.85       5.62
Total
securities          145,371       147,480       173,580        7,430        7,255        7,978       5.11       4.92       4.60

Deposits in
other banks           9,239        13,431        12,922          301          679          620       3.26       5.06       4.80

Total interest
earning assets      722,009       710,687       699,995       43,753       49,510       46,044       6.06       6.97       6.58

Nonearning
assets               63,859        62,952        57,807

Total assets      $ 785,868     $ 773,639     $ 757,802

Deposits:
Demand            $ 109,492     $ 107,834     $ 105,320          803        1,550        1,513       0.73       1.44       1.44
Money market         53,659        52,843        48,124        1,011        1,429        1,180       1.88       2.70       2.45
Savings              61,620        66,246        77,445          331          845          963       0.54       1.28       1.24
Time                258,773       261,286       255,856       10,135       11,711        9,693       3.92       4.48       3.79
Total deposits      483,544       488,209       486,745       12,280       15,535       13,349       2.54       3.18       2.74

Customer
repurchase
agreements           52,264        48,088        40,970        1,377        1,841        1,384       2.63       3.83       3.38
Other
short-term
borrowings            9,818           346         1,240          252           19           69       2.57       5.49       5.56
Long-term
borrowings           34,235        32,245        31,847        1,930        1,975        1,859       5.64       6.12       5.84
Total interest bearing
  liabilities       579,861       568,888       560,802       15,839       19,370       16,661       2.73       3.40       2.97

Noninterest
bearing
demand deposits      98,157       102,003       102,117
Other
liabilities           4,933         4,894         5,059
Shareholders'
equity              102,917        97,854        89,824
Total
liabilities and
  shareholders'
equity            $ 785,868     $ 773,639     $ 757,802

Interest rate
spread                                                                                               3.33 %     3.57 %     3.61 %
Net interest
margin                                                                                               3.87 %     4.24 %     4.20 %

Net interest income (taxable equivalent
basis)                                                        27,914       30,140       29,383
Less: Taxable equivalent
adjustment                                                       881          913          974
Net interest
income                                                      $ 27,033     $ 29,227     $ 28,409

Table 2 presents the dollar amount of changes in interest income and interest expense, and distinguishes between changes resulting from fluctuations in average balances of interest earning assets and interest bearing liabilities (volume), and changes resulting from fluctuations in average interest rates on such assets and liabilities (rate). Changes attributable to both volume and rate have been allocated proportionately.

                       Table 2 - Changes in Net Interest Income (Rate / Volume Analysis)
                                                 (in thousands)

                                       2008 vs. 2007                                2007 vs. 2006
                                                   Change                                      Change
                            Increase           Attributable to          Increase           Attributable to
Interest income            (Decrease)        Rate         Volume       (Decrease)        Rate         Volume
Loans:
Commercial                $     (1,465 )   $  (1,576 )   $     111     $       499     $     111     $     388
Real Estate                     (3,909 )      (5,200 )       1,291           3,808         1,367         2,441
Consumer                          (180 )         (30 )        (150 )          (177 )          (2 )        (175 )
Total loans                     (5,554 )      (6,806 )       1,252           4,130         1,476         2,654
Securities:
Federal agencies                  (817 )         270        (1,087 )          (713 )         404        (1,117 )
Mortgage-backed                  1,178            34         1,144             267            62           205
State and municipal                (25 )           2           (27 )           (94 )         (57 )         (37 )
Other securities                  (161 )         (90 )         (71 )          (183 )          25          (208 )
Total securities                   175           216           (41 )          (723 )         434        (1,157 )
Deposits in other banks           (378 )        (201 )        (177 )            59            34            25
Total interest income           (5,757 )      (6,791 )       1,034           3,466         1,944         1,522

Interest expense
Deposits:
Demand                            (747 )        (770 )          23              37             1            36
Money market                      (418 )        (440 )          22             249           127           122
Savings                           (514 )        (459 )         (55 )          (118 )          24          (142 )
Time                            (1,576 )      (1,464 )        (112 )         2,018         1,808           210
Total deposits                  (3,255 )      (3,133 )        (122 )         2,186         1,960           226
Customer repurchase
agreements                        (464 )        (613 )         149             457           198           259
Other borrowings                   188          (427 )         615              66            95           (29 )
Total interest expense          (3,531 )      (4,173 )         642           2,709         2,253           456
Net interest income       $     (2,226 )   $  (2,618 )   $     392     $       757     $    (309 )   $   1,066

Noninterest Income

Noninterest income is generated from a variety of sources, including fee-based deposit services, trust and investment services, mortgage banking, and retail brokerage. Noninterest income also includes net gains or losses on sales, calls, or impairment of investment securities.

Noninterest income was $7,913,000 in 2008, down 10.3% from 2007, resulting primarily from decreases in trust fees, service charges on deposit accounts, mortgage banking income, brokerage, income from investment in insurance companies, and losses of $450,000 on securities.

Noninterest income was $8,822,000 in 2007, up 4.3% over 2006. Increases in trust fees, mortgage banking income, brokerage, and other fee income were partially offset by decreases in deposit account service charges and by a $362,000 impairment charge on securities.

Fees from the management of trusts, estates, and asset management accounts totaled $3,467,000 in 2008, down from $3,578,000 in 2007 and up from $3,374,000 in 2006. These changes were due primarily to market value decline or appreciation in the securities markets as a substantial proportion of these fees are earned as a percentage of the account balances.

Service charges on deposits accounts decreased 8.2% in 2008 and 4.6% in 2007, primarily due to reduced customer overdraft activity.

Other fees and commissions primarily include income generated from the Company's debit card, ATM, safe deposit box, merchant credit card, and wire transfer services. Insurance commission revenue is also included in this category. Other fees and commissions were $ 857,000 in 2008, $786,000 in 2007, and $744,000 in 2006. The increase in both 2008 and 2007 is primarily the result of growth in debit card revenue due to increased customer debit card activity.

Mortgage banking income represents fees from originating and selling residential mortgage loans. Mortgage banking income was $788,000 in 2008, $954,000 in 2007, and $709,000 in 2006. Changes in interest rates directly impact the volume of mortgage activity and, in turn, the amount of mortgage banking fee income earned.

Securities are sold from time to time for balance sheet management purposes or because an investment no longer meets the Company's policy requirements. Net losses on sales or calls of securities were $450,000 in 2008, resulting from $51,000 in gains and $501,000 in losses. Net gains on sales or calls of securities were $135,000 in 2007 and $62,000 in 2006.

During 2008, the Company sold all remaining shares it held in Federal National Mortgage Association ("FNMA") and Federal Home Loan Mortgage Corporation ("FHLMC") preferred stock, resulting in a loss of $501,000 which is referenced above. In December 2007, the Company recorded a $362,000 impairment charge relating to its holdings of FHLMC and FNMA preferred stock. The impairment charges are recorded as a reduction of noninterest income.

Other noninterest income was $496,000 in 2008, $650,000 in 2007, and $496,000 in 2006. The 2008 decline resulted primarily from a $138,000 reduction in revenue from the Company's investments in Bankers Insurance, LLC and Virginia Title Center, LLC. The 2007 increase was largely the result of increased dividend revenue from the Company's two insurance company investments. Additionally, a full year of revenue from the Company's bank owned life insurance ("BOLI") policies increased this income category by $34,000 in 2007.

                               Table 3 - Noninterest income
                                      (in thousands)

                                                   Years Ended December 31,
                                                 2008         2007        2006

         Trust fees                            $   3,467     $ 3,578     $ 3,374
         Service charges on deposit accounts       2,324       2,531       2,654
         Other fees and commissions                  857         786         744
         Mortgage banking income                     788         954         709
         Brokerage fees                              431         550         419
         Securities gains (losses), net             (450 )       135          62
         Impairment of securities                      -        (362 )         -
         Investment in insurance companies           142         280         220
         Bank owned life insurance                   136         134         100
         Check order charges                         129         127         113
         Other                                        89         109          63
                                               $   7,913     $ 8,822     $ 8,458

Noninterest Expense

Noninterest expense consists primarily of personnel, occupancy, equipment, and other expenses. Noninterest expense was $22,124,000 in 2008, up 3.7% over 2007, due primarily to increased health insurance costs and provision for unfunded lending commitments. Noninterest expense was $21,326,000 in 2007, up 5.2% over 2006, due primarily to increased staff levels and a full year of expenses associated with the April 2006 Community First acquisition.

Personnel expenses comprise over half of the Company's noninterest expense. Combined salary and benefits expense increased 2.9% in 2008 when compared to 2007. Employee insurance costs represent 73% of the 2008 increase. Personnel expenses increased 3.4% in 2007 when compared to 2006. Combined higher staff levels and a full year of the expenses associated with the Community First acquisition were partially offset by a reduction in profit sharing and incentive compensation expense. Profit sharing and incentive expense was $0 in 2008, $287,000 in 2007, and $867,000 in 2006.

Occupancy and equipment expense increased form $3,527,000 in 2007 to $3,701,000 in 2008, an increase of 4.9%. The increase was primarily due to increases in software maintenance and depreciation. Occupancy and equipment expense increased from $2,977,000 in 2006 to $3,527,000 in 2007, an increase of 18.5%. The increase was due in large part to a full year of expenses associated with the Community First acquisition, increased building maintenance costs, the expenses of two new branch offices, and costs related to new technology for check processing and network security.

Bank franchise tax expense was $694,000 in 2008, compared with $663,000 in 2007 and $651,000 in 2006. This expense is based in large part on the level of shareholders' equity.

Core deposit intangible expense was $377,000 in 2008 and 2007, and $414,000 in 2006. The 2008 and 2007 expense consists entirely of amortization of the core deposit intangible asset from the Community First acquisition; beginning April 2006, this asset is being amortized on a straight-line basis over ninety-nine months. Core deposit intangible expense in 2006 also includes amortization of the core deposit intangible asset arising from a 1996 branch purchase.

Other noninterest expense consists of a variety of expenses including those related to professional services, advertising and marketing, FDIC assessment, telephone systems, ATM and Internet banking services, trust services, supplies, Federal Reserve services, and provision for unfunded lending commitments. Other noninterest expense totaled $4,559,000 in 2008, $4,322,000 in 2007, and $4,196,000 in 2006. Other noninterest expense increased 5.5% in 2008, and was largely the result of an increase in the provision for unfunded lending commitments of $297,000 over the amount in 2007. Other noninterest expense increased 3.0% in 2007, and was largely the result of higher trust service costs and a full year of expenses associated with the acquisition of Community First.

                              Table 4 - Noninterest expense
                                     (in thousands)

                                                       Years Ended December 31,
                                                    2008         2007         2006

     Salaries                                     $  9,792     $  9,688     $  9,520
     Employee benefits                               3,001        2,749        2,506
     Occupancy and equipment                         3,701        3,527        2,977
     Bank franchise tax                                694          663          651
     Core deposit intangible amortization              377          377          414
     Telephone                                         433          395          361
     Provision for unfunded lending commitments        324           27          123
     Stationery and printing supplies                  306          335          395
     Trust services contracted                         278          237          187
     Postage                                           245          273          240
     ATM and VISA network fees                         243          329          303
     Director fees                                     225          205          194
     Advertising and marketing                         203          300          267
     Legal                                             194          119          148
     Internet banking fees                             193          194          173
     FDIC assessment                                   180           87           84
     Regulatory assessments                            179          187          170
     Automobile                                        174          147          103
     Auditing                                          173          168          142
     Loan expenses                                     140          108           67
     Contributions                                     118          120          138
     Dues and subscriptions                            113          106          108
. . .