**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      DC 20549**








**FORM
      10-Q**





(Mark
      One)


ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT
      OF 1934


For
      the
      quarterly period ended March 31, 2006





o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT
      OF 1934





Commission
      File Number: 0-16761





**HIGHLANDS
      BANKSHARES, INC.**


(Exact
      name of registrant as specified in its charter)





West
                Virginia
            55-0650793(State
                or Other Jurisdiction of
            (IRS
                EmployerIncorporation
                or Organization)
            Identification
                No.)





P.O.
      Box
      929


Petersburg,
      WV 26847


(Address
      of Principal Executive Offices, Including Zip Code)





304-257-4111


(Registrant’s
      Telephone Number, Including Area Code)





Indicate
      by check mark whether the registrant (1) filed all reports required to be filed
      by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past
      12
      months (or for such shorter period that the registrant was required to file
      such
      reports), and (2) has been subject to such filing requirements for the past
      90
      days. Yes ý No o





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filed, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
      One):





Large
                Accelerated Filero
            Accelerated
                Filero
            Non
                Accelerated filerý




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act). o Yes  ý No





Indicate
      the number of shares outstanding of each of the issuer’s classes of common stock
      as of the latest practicable date. As of April 30, 2006: 1,436,874 shares of
      Common Stock, $5 Par Value








HIGHLANDS
                BANKSHARES, INC.Quarterly
                Report on Form 10Q For The Period Ended March 31, 2006INDEXPagePART
                I
            FINANCIAL
                INFORMATIONItem
                1.
            Financial
                StatementsUnaudited
                Consolidated Statements of IncomeThree
                Months Ended March 31, 2006 and
                2005
            2Unaudited
                Consolidated Balance Sheet for March 31,
                2006and
                Audited Consolidated Balance Sheet for December
                31, 2005
            3Unaudited
                Consolidated Statements of Changes in
                Stockholders’Equity
                for the Three Months Ended March 31, 2006 and
                2005
            4Unaudited
                Consolidated Statements of Cash Flows for
                the ThreeMonths
                Ended March 31, 2006 and
                2005
            5Notes
                to Consolidated Financial
                Statements
            6Item
                2.
            Management’
Discussion
                and Analysis of Financial Conditionand
                Results of Operations
            9Item
                3.
            Quantitative
                and Qualitative Disclosures About Market
                Risk
            20Item
                4.
            Controls
                and Procedures
            20PART
                II
            OTHER
                INFORMATIONItem
                1.
            Legal
                Proceedings
            21Item
                1A.
            Risk
                Factors
            21Item
                2.
            Unregistered
                Sales of Equity Securities and Use of
                Proceeds
            21Item
                3.
            Defaults
                Upon Senior Securites
            21Item
                4.
            Submission
                of Matters to a Vote of Security
                Holders
            21Item
                5.
            Other
                Information
            21Item
                6.
            Exhibits
            21SIGNATURES
            
            22
















PART
                I
            FINANCIAL
                INFORMATION
            Page
                2Item
                1.Financial
                Statements








HIGHLANDS
                BANKSHARES, INC.CONSOLIDATED
                STATEMENTS OF INCOME(In
                Thousands of Dollars, Except Per Share Data)Three
                Months Ended March, 312006
            
            2005(unaudited)
            
            (unaudited)Interest
                IncomeInterest
                and fees on loans
            
            $
            5,134
            
            $
            4,390Interest
                on federal funds sold
            
            
            108
            
            
            30Interest
                on deposits in other banks
            
            
            13
            
            
            5Interest
                and dividends on securities
            
            
            287
            
            
            191Total
                Interest Income
            
            
            5,542
            
            
            4,616Interest
                ExpenseInterest
                on deposits
            
            
            1,520
            
            
            1,115Interest
                on borrowed money
            
            
            173
            
            
            149Total
                Interest Expense
            
            
            1,693
            
            
            1,264Net
                Interest Income
            
            
            3,849
            
            
            3,352Provision
                for Loan Losses
            
            
            178
            
            
            225Net
                Interest Income After Provision for Loan Losses
            
            
            3,671
            
            
            3,127Noninterest
                IncomeService
                Charges
            
            
            227
            
            
            173Investment
                in insurance contracts
            
            
            69
            
            
            67Insurance
                related income
            
            
            43
            
            
            37Other
                noninterest income
            
            
            100
            
            
            93Total
                Noninterest Income
            
            
            439
            
            
            370Noninterest
                ExpenseSalaries
                and employee benefits
            
            
            1,414
            
            
            1,225Equipment
                and occupancy expense
            
            
            324
            
            
            299Data
                processing expense
            
            
            177
            
            
            153Directors
                fees
            
            
            101
            
            
            85Legal
                and professional fees
            
            
            102
            
            
            82Other
                noninterest expense
            
            
            423
            
            
            372Total
                Noninterest Expense
            
            
            2,541
            
            
            2,216Income
                Before Provision For Income Taxes
            
            
            1,569
            
            
            1,281Provsion
                for Income Taxes
            
            
            565
            
            
            432Net
                Income
            
            $
            1,004
            
            $
            849Per
                Share DataNet
                Income
            
            $
            .70
            
            $
            .59Cash
                Dividends
            
            $
            .23
            
            $
            .20Weighted
                Average Common Shares Outstanding
            
            
            1,436,874
            
            
            1,436,874The
                accompanying notes are an integral part of these
                statements.


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      3


HIGHLANDS
                BANKSHARES, INC.CONSOLIDATED
                BALANCE SHEETS(In
                Thousands of Dollars)March
                31, 2006
            
            December
                31, 2005(unaudited)
            
            (audited)ASSETSCash
                and due from banks—noninterest bearing
            
            $
            8,189
            
            $
            8,850Deposits
                in other banks—interest bearing
            
            
            670
            
            
            963Federal
                funds sold
            
            
            11,920
            
            
            10,808Securities
                held to maturity
            
            
            491
            
            
            491Securities
                available for sale, at marketvalue
            
            
            28,380
            
            
            27,130Restricted
                investments
            
            
            1,297
            
            
            1,250Loans
            
            
            270,920
            
            
            270,020Allowance
                for loan losses
            
            
            (3,167
            )
            
            (3,129
            )Bank
                premises and equipment, net of depreciation
            
            
            7,621
            
            
            7,684Interest
                receivable
            
            
            1,780
            
            
            1,818Investment
                in life insurance contracts
            
            
            6,459
            
            
            6,396Goodwill
            
            
            1,534
            
            
            1,534Other
                intangible assets
            
            
            1,630
            
            
            1,674Other
                Assets
            
            
            2,063
            
            
            2,084Total
                Assets
            
            $
            339,787
            
            $
            337,573LIABILITIESNoninterest
                bearing deposits
            
            $
            48,727
            
            $
            47,753Savings
                and interest bearing demand deposits
            
            
            78,411
            
            
            80,597Time
                deposits
            
            
            157,575
            
            
            156,342Total
                Deposits
            
            
            284,713
            
            
            284,692Long
                term debt
            
            
            15,923
            
            
            15,063Accrued
                expenses and other liabilities
            
            
            4,509
            
            
            3,826Total
                Liabilities
            
            
            305,145
            
            
            303,581STOCKHOLDERS’
                EQUITYCommon
                Stock, $5 par value, 3,000,000 shares authorized, 1,436,874 shares
                issued
                and outstanding
            
            
            7,184
            
            
            7,184Surplus
            
            
            1,662
            
            
            1,662Retained
                Earnings
            
            
            26,325
            
            
            25,651Other
                accumulated comprehensive loss
            
            
            (529
            )
            
            (505
            )Total
                Stockholders’ Equity
            
            
            34,642
            
            
            33,992Total
                Liabilities and Stockholders’ Equity
            
            $
            339,787
            
            $
            337,573The
                accompanying notes are an integral part of these
                statements.





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      4





HIGHLANDS
                BANKSHARES, INC.CONSOLIDATED
                STATEMENTS OF CHANGES IN STOCKHOLDERS’
                EQUITY(In
                Thousands of Dollars)Common
              Stock
            
            Surplus
            
            Retained
              Earnings
            
            Accumulated
              Other
              Comprehensive
              Income
            
            TotalBalances
                at December 31, 2005
            
            $
            7,184
            
            $
            1,662
            
            $
            25,651
            
            $
            (505
            )
            $
            33,992Net
                Income
            
            
            
            
            
            
            
            
            1,004
            
            
            
            
            
            1,004Net
                change in unrealized appreciation on
              investment
                securities available for sale, net
              of
                taxes
            
            
            
            
            
            
            
            
            
            
            
            (24
            )
            
            (24
            )Total
                Comprehensive Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            980Dividends
                Paid
            
            
            
            
            
            
            
            
            (330
            )
            
            
            
            
            (330
            )Balances
                March 31, 2006
            
            $
            7,184
            
            $
            1,662
            
            $
            26,325
            
            $
            (529
            )
            $
            34,642








Common
              Stock
            
            Surplus
            
            Retained
              Earnings
            
            Accumulated
              Other
                ComprehensiveIncome
            
            TotalBalances
                at December 31, 2004
            
            $
            7,184
            
            $
            1,662
            
            $
            23,028
            
            $
            (219
            )
            $
            31,665Net
                Income
            
            
            
            
            
            
            
            
            849
            
            
            
            
            
            849Net
                change in unrealized appreciation on
              investment
                securities available for sale, net
              of
                taxes
            
            
            
            
            
            
            
            
            
            
            
            (67
            )
            
            (67
            )Total
                Comprehensive Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            782Dividends
                Paid
            
            
            
            
            
            
            
            
            (287
            )
            
            
            
            
            (287
            )Balances
                March 31, 2005
            
            $
            7,184
            
            $
            1,662
            
            $
            23,590
            
            $
            (286
            )
            $
            32,150The
                accompanying notes are an integral part of these
                statements.





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      5


HIGHLANDS
                BANKSHARES, INC.CONSOLIDATED
                STATEMENTS OF CASH
                FLOWS(In
                Thousands of Dollars)Three
                Months Ended March 31,2006
            
            2005(unaudited)
            
            (unaudited)Cash
                Flows From Operating ActivitiesNet
                Income
            
            $
            1,004
            
            $
            849Adjustments
                to reconcile net income to netcash
                provided by operating activitiesDepreciation
            
            
            166
            
            
            164Income
                from insurance contracts
            
            
            (63
            )
            
            (61
            )Net
                amortization of securities
            
            
            (12
            )
            
            83Provision
                for loan losses
            
            
            178
            
            
            225Amortization
                of intangibles
            
            
            44
            
            
            3Decrease
                (increase) in interest receivable
            
            
            38
            
            
            (145
            )Decrease
                in other assets
            
            
            21
            
            
            154Increase
                in accrued expenses
            
            
            683
            
            
            620Net
                Cash Provided by Operating Activities
            
            
            2,059
            
            
            1,892Cash
                Flows From Investing ActivitiesIncrease
                in federal funds sold
            
            
            (1,112
            )
            
            (923
            )Proceeds
                from maturities of securities available for sale
            
            
            2,376
            
            
            1,616Purchase
                of securities available for sale
            
            
            (3,638
            )
            
            (1,491
            )Increase
                in restricted investments
            
            
            (47
            )
            
            (48
            )Net
                change in interest bearing deposits in other banks
            
            
            293
            
            
            (154
            )Purchase
                of property and equipment
            
            
            (103
            )
            
            (28
            )Net
                Change in Loans
            
            
            (1,040
            )
            
            (5,446
            )Net
                Cash Used in Investing Activities
            
            
            (3,271
            )
            
            (6,474
            )Cash
                Flows From Financing ActivitiesNet
                change in deposits
            
            
            21
            
            
            1,167Additional
                long term debt
            
            
            2,300
            
            
            6,300Repayment
                of long term debt
            
            
            (1,440
            )
            
            (118
            )Additional
                short term borrowings
            
            
            0
            
            
            1,500Repayment
                of short term borrowings
            
            
            0
            
            
            (3,500
            )Dividends
                paid in cash
            
            
            (330
            )
            
            (287
            )Net
                Cash Provided by Financing Activities
            
            
            551
            
            
            5,062Net
                Increase (Decrease) in Cash and Cash Equivalents
            
            
            (661
            )
            
            480Cash
                and Cash Equivalents, Beginning of Period
            
            
            8,850
            
            
            6,187Cash
                and Cash Equivalents, End of Period
            
            $
            8,189
            
            $
            6,667Supplemental
                DisclosuresCash
                paid for income taxes
            
            $
            30
            
            $
            --Cash
                paid for interest
            
            $
            1,667
            
            $
            1,226The
                accompanying notes are an integral part of these
                statements.





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Page
      6


**HIGHLANDS
      BANKSHARES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**NOTE
      1**  **ACCOUNTING
      PRINCIPLES**





The
      consolidated financial statements conform to U. S. generally accepted accounting
      principles and to general industry practices. In the opinion of management,
      the
      accompanying unaudited consolidated financial statements contain all
      adjustments, consisting solely of normal recurring adjustments, necessary to
      present fairly the financial position as of March 31, 2006 and the results
      of
      operations for the three month periods ended March 31, 2006 and 2005.





The
      results of operations for the three month periods ended March 31, 2006 and
      2005
      are not necessarily indicative of the results to be expected for the full year.





The
      notes
      included herein should be read in conjunction with the notes to financial
      statements included in the Company’s 2005 annual report on Form 10-K.





**NOTE
      2**  **SECURITIES
      AND RESTRICTED INVESTMENTS**





The
      Company’s securities portfolio serves several purposes. Portions of the
      portfolio secure certain public and trust deposits while the remaining portions
      are held as investments or used to assist the Company in liquidity and
      asset/liability management.





The
      amortized cost and market value of securities held to maturity as of March
      31,
      2006 and December 31, 2005 are as follows (in thousands of
      dollars):





March
                31, 2006
            
            December
                31, 2005Amortized
            
            Market
            
            Amortized
            
            MarketCost
            
            Value
            
            Cost
            
            ValueHeld
                to Maturity SecuritiesObligations
                of states and municipalities
            
            $
            491
            
            $
            491
            
            $
            491
            
            $
            491Total
                Held to Maturity Securities
            
            $
            491
            
            $
            491
            
            $
            491
            
            $
            491Available
                For Sale SecuritiesU.S.
                Treasuries and Agencies
            
            $
            18,755
            
            $
            18,633
            
            $
            17,352
            
            $
            17,234Mortgage
                backed securities
            
            
            7,059
            
            
            7,034
            
            
            7,172
            
            
            7,163Obligations
                of states and municipalities
            
            
            2,712
            
            
            2,685
            
            
            2,719
            
            
            2,705Marketable
                equities
            
            
            28
            
            
            28
            
            
            28
            
            
            28Total
                Available For Sale Securities
            
            $
            28,554
            
            $
            28,380
            
            $
            27,271
            
            $
            27,130




Restricted
      investments consist of investments in the Federal Home Loan Bank and the Federal
      Reserve Bank. Investments are carried at face value and the level of investment
      is dictated by the level of participation with each institution. Amounts are
      restricted as to transferability. Investments in the Federal Home Loan Bank
      act
      as collateral against the outstanding borrowings from that
      institution.










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Page
      7 ****





**HIGHLANDS
      BANKSHARES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**NOTE
      3**  **INVESTMENTS
      IN INSURANCE CONTRACTS**





Investments
      in insurance contracts consist of single premium insurance contracts which
      have
      the dual purposes of providing a rate of return to the Company which
      approximately equals the Company’s average cost of funds and of providing life
      insurance and retirement benefits to certain executives.




**NOTE
      4**  **BRANCHES
      ACQUISITION**





During
      the fourth quarter of 2005, Highlands Bankshares purchased all of the
      outstanding shares of common stock of the National Bank of Davis (“Davis”),
      located in Davis, West Virginia. Shortly after the purchase, Davis offices
      became branches of The Grant County Bank. The net assets of Davis were recorded
      at fair value. Portions of the cost of acquisition, including certain expenses
      related to the purchase, were allocated as intangible assets. All results of
      operations subsequent to the purchase of the branches acquired are included
      in
      consolidated income totals.





**NOTE
      5**  **LOANS**





A
      summary
      of loans outstanding as of March 31, 2006 and December 31, 2005 is shown in
      the
      table below (in thousands of dollars):





March
                31,
            
            December
                31,2006
            
            2005Loan
                TypeCommercial
            
            $
            60,068
            
            $
            57,908Real
                Estate construction
            
            
            14,523
            
            
            12,201Real
                Estate mortgage
            
            
            152,447
            
            
            153,646Consumer
                installment
            
            
            43,882
            
            
            46,265Total
                Loans
            
            $
            270,920
            
            $
            270,020





In
      addition to loans to fund construction and traditional mortgage loans, portions
      of the portfolio identified as commercial are also secured by real estate. At
      March 31, 2006, the total balance of loans in the portfolio secured by real
      estate was $203,575,000.




**NOTE
      6**  **ALLOWANCE
      FOR LOAN LOSSES**





A
      summary
      of the transactions in the allowance for loan losses for the three month periods
      ended March 31, 2006 and 2005 is shown below (in thousands of
      dollars):





2006
            
            2005Balance,
                beginning of period
            
            $
            3,129
            
            $
            2,530Provisions
                charged to operations
            
            
            178
            
            
            225Loan
                recoveries
            
            
            72
            
            
            43Loan
                charge-offs
            
            
            (212
            )
            
            (175
            )Balance,
                end of period
            
            $
            3,167
            
            $
            2,623







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      8





**HIGHLANDS
      BANKSHARES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**








**NOTE
      7**  **DEPOSITS**





Balances
      of time deposits over $100,000 and of all other time deposits at March 31,
      2006
      and December 31, 2005 are shown below (in thousands of dollars):





March
                31,
            
            December
                31,2006
            
            2005Time
                deposits over $100,000
            
            $
            46,529
            
            $
            45,455All
                other time deposits
            
            
            111,046
            
            
            110,887Total
                Time Deposits
            
            $
            157,575
            
            $
            156,342





Interest
      expense for time deposits over $100,000 and for all other time deposits for
      the
      three month periods ended March 31, 2006 and 2005 is shown below (in thousands
      of dollars):





2006
            
            2005Time
                deposits over $100,000
            
            $
            436
            
            $
            304All
                other time deposits
            
            
            1,084
            
            
            687Total
                interest paid on time deposits
            
            $
            1,520
            
            $
            991




**NOTE
      8**  **EMPLOYEE
      BENEFITS**





The
      Company's two subsidiary banks each have separate retirement and profit sharing
      plans which cover substantially all full time employees at each bank.





The
      Capon
      Valley Bank has a defined contribution pension plan with 401(k) features that
      is
      funded with discretionary contributions by the Bank. The bank matches on a
      limited basis the contributions of the employees. Investment of employee
      balances is done through the direction of each employee. Employer contributions
      are vested over a six year period.





The
      Grant
      County Bank is a member of the West Virginia Bankers' Association Retirement
      Plan. Benefits under the plan are based on compensation and years of service
      with 100% vesting after seven years of service. Prior to 2002, the Plan's assets
      were in excess of the projected benefit obligations and thus the Bank was not
      required to make contributions to the Plan in 2003, 2002 or 2001. The bank
      was
      required to make contributions in 2004 and 2005 and will be required to make
      contributions in 2006. The
      Bank
      has recognized liabilities of $421,000 at March 31, 2006 as a result of this
      shortfall.  T he
      following table provides the components of the net periodic benefit cost for
      the
      plan for the three month periods ended March 31, 2006 and 2005 (in thousands
      of
      dollars):





2006
            
            2005Service
                cost
            
            $
            30
            
            $
            31Interest
                cost
            
            
            43
            
            
            45Expected
                return on plan assets
            
            
            (44
            )
            
            (47
            )Amortization
                of unrecognized prior service costs
            
            
            2
            
            
            3Recognized
                net actuarial loss
            
            
            6
            
            
            7Net
                periodic expense
            
            $
            37
            
            $
            39











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Page
      9





**HIGHLANDS
      BANKSHARES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**NOTE
      9**  **DEBT
      INSTRUMENTS**





The
      Company continues to borrow money from the Federal Home Loan Bank of Pittsburgh
      (FHLB) to meet specific  funding
      needs. The interest rates of the notes payable as of March
      31,
      2006 range
      from 3.30% to 6.12%. The weighted average interest rate was 4.51% at March
      31,
      2006. The debt is secured by the general assets of the Banks.





D uring
      the
      first quarter of 2005, the Company initiated short term borrowings from the
      FHLB
      of $1,500,000 and made repayments of $3,500,000. No short
      term borrowings have been initiated subsequent to the first quarter of 2005.










**Item
      2.** **Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations**





**Introduction**





The
      following discussion focuses on significant results of the Company’s operations
      and significant changes in our financial condition or results of operations
      for
      the periods indicated in the discussion. This discussion should be read in
      conjunction with the preceding financial statements and related notes, as well
      as the Company’s Report on Form 10-K for the period ended December 31, 2005.





Current
      performance does not guarantee, and may not be indicative of, similar
      performance in the future.





**Critical
      Accounting Policies**





The
      Company’s financial statements are prepared in accordance with accounting
      principles generally accepted in the United States (“GAAP”). The financial
      statements contained within these statements are, 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 either 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. Although the economics of these transactions would be the same,
      the timing of events that would impact these transactions could change.





Disclosure
      of the Company’s significant accounting policies is included in Note 2 to the
      Consolidated Financial Statements of the Company’s Annual Report on Form 10-K
      for the period ended December 31, 2005. Some of the policies are particularly
      sensitive, requiring significant judgments, estimates and assumptions by
      management.





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          to Index


Page
      10





**Item
      2.** **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations** **(continued)**





**Critical
      Accounting Policies (continued)**





The
      allowance for loan losses is an estimate of the losses that may be sustained
      in
      the loan portfolio. The allowance is based on two basic principles of
      accounting: (i) SFAS No. 5, Accounting for Contingencies, which requires that
      losses be accrued when they are probable of occurring and estimable and (ii)
      SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires
      that losses be accrued based on the differences between the value of collateral,
      present value of future cash flows or values that are observable in the
      secondary market and the loan balance. Additional information pertaining to
      the
      allowance for loan losses and provision for loan losses is contained on pages
      15-17 of this report.





The
      Company has invested in and owns life insurance polices on certain officers.
      The
      policies are designed so that the company recovers the interest expenses
      associated with carrying the polices and the officer will, at the time of
      retirement, receive any earnings in excess of the amounts earned by the Company.
      The Company recognizes as an asset the net amount that could be realized under
      the insurance contract as of the balance sheet date. This amount represents
      the
      cash surrender value of the policies less applicable surrender charges. The
      portion of the benefits which will be received by the executives at the time
      of
      their retirement is considered, when taken collectively, to constitute a
      retirement plan. Therefore the Company accounts for these policies using
      guidance found in Statement of Financial Accounting Standards No. 106,
      "Employers' Accounting for Post Retirement Benefits Other Than Pensions.” SFAS
      No. 106 requires that an employers' obligation under a deferred compensation
      agreement be accrued over the expected service life of the employee through
      their normal retirement date. Assumptions
      are used in estimating the present value of amounts due officers after their
      normal retirement date. These assumptions include the estimated income to be
      derived from the investments and an estimate of the Company’s cost of funds in
      these future periods. In addition, the discount rate used in the present value
      calculation will change in future years based on market conditions.





During
      2005, the Company purchased all the outstanding shares of the National Bank
      of
      Davis. The net assets of this purchase were recorded at fair value, including
      goodwill. Goodwill represents the cost in excess of the fair value of net assets
      acquired (including identifiable intangibles) in transactions accounted for
      as
      purchases. In accordance with provisions of SFAS No. 142, " *Goodwill
      and Other Intangible Assets* ",
      goodwill is not amortized over an estimated useful life, but rather will be
      tested at least annually for impairment. Core deposit and other intangible
      assets include premiums paid for acquisitions of core deposits (core deposit
      intangibles) and other identifiable intangible assets. Intangible assets other
      than goodwill, which are determined to have finite lives, are amortized based
      upon the estimated economic benefits received .




**Recent
      Accounting Pronouncements**





No
      recent
      accounting pronouncements had a material impact on the Company’s consolidated
      financial statements.


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Page
      11





**Item
      2.** **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations** **(continued)**





**Forward
      Looking Statements**





Certain
      statements in this report may constitute “forward-looking statements” within the
      meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking
      statements are statements that include projections, predictions, expectations
      or
      beliefs about future events or results or otherwise are not statements of
      historical fact. Such statements are often characterized by the use of qualified
      words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,”
“project,” “anticipate” or other similar words. Although the Company believes
      that its expectations with respect to certain forward-looking statements are
      based upon reasonable assumptions within the bounds of its existing knowledge
      of
      its business and operations, there can be no assurance that actual results,
      performance or achievements of the Company will not differ materially from
      any
      future results, performance or achievements expressed or implied by such
      forward-looking statements. Actual future results and trends may differ
      materially from historical results or those anticipated depending on a variety
      of factors, including, but not limited to, the effects of and changes in:
      general economic conditions, the interest rate environment, legislative and
      regulatory requirements, competitive pressures, new products and delivery
      systems, inflation, changes in the stock and bond markets, technology, downturns
      in the trucking and timber industries, effects of mergers and/or downsizing
      in
      the poultry industry in Hardy County, and consumer spending and savings habits.
      Additionally, actual future results and trends may differ from historical or
      anticipated results to the extent: (1) any significant downturn in certain
      industries, particularly the trucking and timber industries are experienced;
      (2)
      loan demand decreases from prior periods; (3) the Company may make additional
      loan loss provisions due to negative credit quality trends in the future that
      may lead to a deterioration of asset quality; (4) the Company may not continue
      to experience significant recoveries of previously charged-off loans or loans
      resulting in foreclosure; and (5) the Company is unable to control costs and
      expenses as anticipated. The Company does not update any forward-looking
      statements that may be made from time to time by or on behalf of the
      Company.





**Overview
      of First Quarter Results**





Income
      for the quarter increased 18.26% as compared to the first quarter of 2005.
      Annualized return on average assets was 1.21% compared to 1.13% a year ago
      and
      annualized return on average equity for the quarter was 11.78% compared to
      10.70% for the first quarter of 2005.





Net
      interest income, on a fully taxable equivalent basis increased 14.79% over
      the
      first quarter of 2005 as earning assets continued to increase and the Company
      experienced a 13 basis point increase in its net interest margin. From 2005
      to
      2006, the Company experienced increases in the average rates earned on earning
      assets of 49 basis points and an increase in the average rates paid on interest
      bearing liabilities, also of 49 basis points. However, this parallel increase
      was offset by an increase in the ratio of average earning assets to average
      interest bearing liabilities.





Noninterest
      income increased largely as a result of increases in income from customer
      overdraft charges.





Noninterest
      expense increased in large part due to the additional operational expenses
      of
      the two branches added during the fourth quarter of 2005.





**Impact
      of Acquisition on Operational Results**





During
      the fourth quarter of 2005, the Company acquired two additional branches through
      the purchase of the National Bank of Davis. Further information regarding this
      purchase can be found in the Company’s Annual Report on Form 10-K for 2005. This
      acquisition has significantly impacted the results of operations for the first
      quarter of 2006, both in revenues and costs.





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          to Index





Page
      12


**Item
      2.**  **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations** **(continued)**





**Impact
      of Acquisition on Operational Results (continued)**





The
      acquisition added significant balances of both earning assets and interest
      bearing liabilities to the Company’s operations. The addition of these assets
      and liabilities have impacted the asset/liability management strategy of the
      Company, specifically The Grant County Bank into which the branches were
      integrated. Because of the full integration of these assets and liabilities,
      determination of the exact dollar amount of the impact on the Company’s net
      interest income is difficult to determine. However, the addition has increased
      net interest income as compared to the first quarter of 2005 both because of
      the
      increased balances of earning assets and interest bearing liabilities and
      because of the increased options for asset/liability management resulting from
      the purchase.





The
      addition of two branches and eleven full time equivalent employees as the result
      of the purchase of the National Bank of Davis has also caused an increase in
      noninterest expense. Specifically, occupancy and equipment expense has increased
      because of the added physical locations, salary and benefits expense have
      increased because of the additional employees, and data processing expense
      has
      increased because of the additional loan and deposit customers. Additionally,
      certain other noninterest expenses have increased because of the acquisition.





Noninterest
      income has also been impacted by the acquisition, but to a lesser degree than
      the impact of the acquisition on net interest income and noninterest expense.





**Net
      Interest Income**





A
      continuation of increases by the Federal Reserve Board (“The Fed”) throughout
      2005 and continuing into 2006 for the target rate for federal funds sold has
      caused both rates earned on assets and rates paid on liabilities to increase.





The
      increase in net interest income was the result of an increase in the average
      ratio of interest earning assets to interest bearing liabilities for the first
      quarter of 2006 as compared to 2005 coupled with changes in the mixes of both
      earning assets and interest bearing liabilities. Average balances of earning
      assets increased 11.81% as compared to a year ago and average balances of
      interest bearing liabilities increased 9.85%. A summary of the effect of rate
      and volume changes by asset and liability type on change in earnings or expense
      is found on page 13.





As
      the
      Fed has increased the target rate for federal funds sold, the average earnings
      on securities and federal funds sold and the interest paid on deposits has,
      to a
      large degree, outpaced the growth in the average rates earned on loans. High
      levels of competition for new loans are appearing to keep rates on loans from
      increasing at the same rate as other earning assets and on deposits.





A
      large
      portion of the increases in both earning assets and interest bearing liabilities
      is attributable to the acquisition of the National Bank of Davis. Along with
      the
      additional balances of earning assets and interest bearing liabilities, this
      acquisition has given management further options in regard to its asset and
      liability management strategies. At the time of purchase, Davis had a relatively
      conservative balance sheet in comparison to Highlands Bankshares with a loan
      to
      deposit ratio of 33.14%. The result of this low loan to deposit ratio was that,
      upon acquisition, Highlands added significant balances of federal funds sold
      and
      securities. The addition of these balances of liquid assets has given the
      Company further options with which to fund loans and has allowed management
      to
      strategically manage deposit rates as a need for further deposit balances was
      lessened.




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          to Index


Page
      13





**Item
      2.** **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations** **(continued)**





**Net
      Interest Income (continued)**





During
      the later portions of 2004 and during 2005, the Company chose to fund loan
      growth through reductions in deposits and also reductions of comparatively
      lower
      earning assets like federal funds sold and securities rather than compete for
      deposits based upon rate. As The Fed has continued to increase the target rate
      for federal funds sold, the average rates earned by securities, federal funds
      sold and deposits in other banks have increased more than the rates on loans.
      As
      such, Management has somewhat eased its strategy for funding loans through
      reductions in these lower earning assets because in some instances the rates
      paid on these assets are greater than the cost of interest on new deposits.
      As a
      result, and coupled with a slight decline in new loan demand during the first
      quarter of the year, during 2006 balances of these lower earning assets have
      grown more quickly than the balances of loans.




EFFECT
                OF RATE/VOLUME CHANGES ON NET INTEREST INCOME(On
                a fully taxable equivalent basis)(In
                thousands of dollars)Due
                to change in:Average
            
            Average
            
            TotalVolume
            
            Rate
            
            ChangeInterest
                IncomeLoans
            
            $
            407
            
            $
            337
            
            $
            744Taxable
                investment securities
            
            
            16
            
            
            77
            
            
            93Nontaxable
                investment securities
            
            
            2
            
            
            2
            
            
            4Interest
                bearing deposits
            
            
            1
            
            
            7
            
            
            8Federal
                funds sold
            
            
            62
            
            
            16
            
            
            78Total
                Interest Income
            
            $
            488
            
            $
            439
            
            $
            927Interest
                ExpenseDemand
                deposits
            
            $
            1
            
            $
            14
            
            $
            15Savings
                deposits
            
            
            9
            
            
            34
            
            
            43Time
                deposits
            
            
            97
            
            
            250
            
            
            347Borrowed
                funds
            
            
            31
            
            
            (7
            )
            
            24Total
                Interest Expense
            
            $
            138
            
            $
            291
            
            $
            429








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          to Index





Page
      14





**Item
      2.** **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations** **(continued)**





**Net
      Interest Income (continued)**




The
      table
      below sets forth an analysis of net interest income for the three month periods
      ended March 31, 2006 and 2005 (Average balances and interest/expense shown
      in
      thousands of dollars):





2006
            
            2005Average
            
            Income/
            
            
            
            Average
            
            Income/Balance
            
            Expense
            
            Rate
            
            Balance
            
            Expense
            
            RateInterest
                IncomeLoans1,2
            
            $
            271,345
            
            $
            5,134
            
            
            7.67
            %
            $
            248,299
            
            $
            4,390
            
            
            7.17
            %Federal
                funds sold
            
            
            10,805
            
            
            108
            
            
            4.05
            %
            
            3,514
            
            
            30
            
            
            3.46
            %Interest
                bearing deposits
            
            
            1,043
            
            
            13
            
            
            4.98
            %
            
            867
            
            
            5
            
            
            2.34
            %Taxable
                investment securities
            
            
            26,177
            
            
            258
            
            
            4.00
            %
            
            23,834
            
            
            165
            
            
            2.81
            %Nontaxable
                investment securities3
            
            
            3,113
            
            
            45
            
            
            5.86
            %
            
            2,951
            
            
            41
            
            
            5.63
            %Total
                Earning Assets
            
            
            312,483
            
            
            5,558
            
            
            7.21
            %
            
            279,465
            
            
            4,631
            
            
            6.72
            %Cash
                and cash equivalents
            
            
            8,008
            
            
            
            
            
            
            
            
            6,517Allowance
                for loan losses
            
            
            (3,156
            )
            
            
            
            
            
            
            
            (2,590
            )Insurance
                contracts
            
            
            6,419
            
            
            
            
            
            
            
            
            5,702Nonearning
                assets
            
            
            14,104
            
            
            
            
            
            
            
            
            16,453Total
                Assets
            
            $
            337,858
            
            
            
            
            
            
            
            $
            305,547Interest
                ExpenseInterest
                bearing demand deposits
            
            $
            26,092
            
            $
            54
            
            
            .84
            %
            $
            25,314
            
            $
            39
            
            
            .62
            %Savings
                and money markets
            
            
            54,068
            
            
            128
            
            
            .96
            %
            
            48,919
            
            
            85
            
            
            .70
            %Time
                deposits
            
            
            156,726
            
            
            1,338
            
            
            3.46
            %
            
            142,738
            
            
            991
            
            
            2.82
            %Short
                term borrowings
            
            
            0
            
            
            0
            
            
            
            
            
            117
            
            
            1
            
            
            3.47
            %Long
                term debt
            
            
            15,757
            
            
            173
            
            
            4.45
            %
            
            12,895
            
            
            148
            
            
            4.65
            %Total
                Interest Bearing Liabilities
            
            
            252,643
            
            
            1,693
            
            
            2.72
            %
            
            229,983
            
            
            1,264
            
            
            2.23
            %Demand
                deposits
            
            
            47,191
            
            
            
            
            
            
            
            
            38,229Other
                liabilities
            
            
            3,465
            
            
            
            
            
            
            
            
            5,150Stockholders’
                equity
            
            
            34,559
            
            
            
            
            
            
            
            
            32,185Total
                liabilities and stockholders’ equity
            
            $
            337,858
            
            
            
            
            
            
            
            $
            305,547Net
                Interest Income
            
            
            
            
            $
            3,865
            
            
            
            
            
            
            
            $
            3,367Net
                Yield on Earning Assets3
            
            
            
            
            
            
            
            
            5.02
            %
            
            
            
            
            
            
            
            4.89
            %





1 Balances
      of loans include loans in nonaccrual status


2 Interest
      income on loans includes fees


3 Yields
      are on a fully taxable equivalent basis







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          to Index





Page
      15





**Item
      2.** **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations** **(continued)**





**Loan
      Portfolio**





The
      Company is an active residential mortgage and construction lender and generally
      extends commercial loans to small and medium sized businesses within its primary
      service area. The Company's commercial lending activity extends across its
      primary service areas of Grant, Hardy, Hampshire, Mineral, Randolph, and
      northern Pendleton counties in West Virginia and Frederick County, Virginia.
      Consistent with its focus on providing community-based financial services,
      the
      Company does not attempt to diversify its loan portfolio geographically by
      making significant amounts of loans to borrowers outside of its primary service
      area.





**Credit
      Quality and Allowance for Loan Losses**





Non
      performing loans decreased 16.56% from December 31, 2005 to March 31, 2006.
      Non
      performing loans represent .60% of gross loans at March 31, 2006 and .72% of
      gross loans at December 31, 2005.





The
      following table summarizes the Company’s non-performing loans at March 31, 2006
      and December 31, 2005 (in thousands of dollars):





March
                31,
            
            December
                31,2006
            
            2005Nonaccrual
                loans
            
            $
            530
            
            $
            743Loans
                past due 90 days and still accruing interest
            
            
            1,082
            
            
            1,189Total
                nonperforming loans
            
            $
            1,612
            
            $
            1,932





Nonperforming
      loans include nonaccrual loans, loans 90 days or more past due and restructured
      loans. Nonaccrual loans are loans on which interest accruals have been suspended
      or discontinued permanently. Restructured loans are loans on which the original
      interest rate or repayment terms have been changed due to financial hardship
      of
      the borrower.





Loans
      are
      typically placed on non-accrual status once they have reached certain levels
      of
      delinquency, depending on loan type, and it is no longer reasonable to expect
      collection of principal and interest because collateral is insufficient to
      cover
      both the principal and interest due. After loans are placed on non-accrual
      status, they are returned to accrual status if the obligation is brought current
      by the borrower, or they are charged off if payment is not made and management
      believes that collection of the amounts due is doubtful. Charged-off loans
      are
      charged against the allowance for loan losses. Any subsequent collection or
      sale
      of repossessed collateral is added to the allowance as a recovery.





As
      of
      March 31, 2006, the Company had three potential problem loans as defined in
      SEC
      Industry Guide III that would require disclosure. These loans are described
      below.




During
      the early part of 2006, a large commercial loan customer became delinquent
      and
      Management has reason to believe that the customer may lack sufficient cash
      flow
      to bring the loans current. At March 31, 2006, this customer had loans
      outstanding with the Company totaling approximately $853,000. Should these
      loans
      deteriorate further, the Company may be required to move these loans to
      nonaccrual status. Interest income on the loans to this customer total
      approximately $68,000 per annum. These loans are considered by Management to
      be
      adequately secured, and, if foreclosure becomes necessary, Management expects
      no
      material loss to result. At present, the loans to this customer are moderately
      delinquent.




During
      the later days of 2005, a second large commercial loan customer with loans
      totaling $2,155,000 became delinquent and has remained moderately delinquent
      throughout the first quarter of 2006. Should these loans deteriorate further,
      the Company may be required to move these loans to nonaccrual status. Interest
      income on the loans to this customer total approximately $175,000 per annum.
      The
      loans to this customer are considered by management to be adequately secured
      and
      should the status of these loans deteriorate to a point where foreclosure
      becomes necessary, Management expects that no material loss would occur.





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Page
      16





**Item
      2.** **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations** **(continued)**





**Credit
      Quality and Allowance for Loan Losses (continued)**





In
      July
      2004, the Company received notice that a large commercial loan customer had
      filed for Chapter 11 bankruptcy protection. Depending upon the final outcome
      of
      the bankruptcy proceedings, the Company may be forced to reclassify the loans
      made to this customer, which total approximately $1.38 million, to non-accrual
      status. If these loans are reclassified to non-accrual, this will have a
      negative impact on interest revenue and net income to the extent that any
      interest accruing to the loans of this customer would not be recognized as
      income. At present, the interest earned on the loans to this customer total
      approximately $100,000 per annum. The loans to this customer are deemed by
      Management to be adequately secured, and if a foreclosure is required, the
      Company expects there to be no material loss on the sale of the collateral.
      Since the bankruptcy filing, this customer has continued to make payments of
      both principal and interest, and though remaining moderately delinquent, these
      payments have been sufficient to consistently keep the customer less than 60
      days past due.





The
      carrying value of foreclosed property at March 31, 2006 was $50,000. All
      foreclosed property held as of March 31, 2006 was in the Company's primary
      service area. The Company's practice is to value real estate acquired through
      foreclosure at the lower of (i) an independent current appraisal or market
      analysis less anticipated costs of disposal, or (ii) the existing loan balance.
      The Company is actively marketing all foreclosed real estate and does not
      anticipate material write-downs in value before disposition.





Because
      of its large impact on the local economy, Management continuously monitors
      the
      economic health of the poultry industry. The Company has direct loans to poultry
      growers and the industry is a large employer in the Company’s trade area. In
      recent periods, the Company’s loan portfolio has begun to reflect a
      concentration in loans collateralized by heavy equipment, particularly in the
      trucking, timber and coal extraction industries. In part because of rising
      fuel
      costs, and because of continued slow economic growth, the trucking sector
      experienced a recent downturn, and profitability growth within this sector
      still
      appears to be sluggish. While close monitoring of this sector is necessary,
      management expects no significant losses in the foreseeable future .





An
      inherent risk in the lending of money is that the borrower will not be able
      to
      repay the loan under the terms of the original agreement. The allowance for
      loan
      losses provides for this risk and is reviewed periodically for adequacy. This
      review also considers concentrations of loans in terms of geography, business
      type or level of risk. While lending is geographically diversified within the
      service area, the Company does have some concentration of loans in the area
      of
      agriculture (primarily poultry farming), timber and related industries.
      Management recognizes these concentrations and considers them when structuring
      its loan portfolio.




Each
      of
      the Company's banking subsidiaries, Capon Valley Bank and The Grant County
      Bank,
      determines its adequacy of its allowance for loan losses independently. Although
      the loan portfolios of the two banks are similar to each other, some differences
      exist which result in divergent risk patterns and different charge-off rates
      amongst the functional areas of the banks’ portfolios. Each bank pays particular
      attention to individual loan performance, collateral values, borrower financial
      condition and economic conditions. The determination of an adequate allowance
      at
      each bank is done in a three step process. The first step is to identify
      impaired loans. Impaired loans are problem loans above a certain threshold
      which
      have estimated losses calculated based on collateral values and projected cash
      flows. The second step is to identify loans above a certain threshold which
      are
      problem loans due to the borrowers' payment history or deteriorating financial
      condition. Losses in this category are determined based on historical loss
      rates
      adjusted for current economic conditions. The final step is to calculate a
      loss
      for the remainder of the portfolio using historical loss information for each
      type of loan classification. The determination of specific allowances and
      weighting is somewhat subjective and actual losses may be greater or less than
      the amount of the allowance. However, Management believes that the allowance
      represents a fair assessment of the losses that exist in the current loan
      portfolio.





The
      required level of the allowance for loan losses is computed quarterly and the
      allowance adjusted prior to the issuance of the quarterly financial statements.
      All loan losses charged to the allowance are approved by the boards of directors
      of each bank at their regular meetings. The allowance is reviewed for adequacy
      after considering historical loss rates, current economic conditions (both
      locally and nationally) and any known credit problems that have not been
      considered under the above formula.


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Page
      17





**Item
      2.** **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations** **(continued)**





**Credit
      Quality and Allowance for Loan Losses (continued)**





Management
      has analyzed the potential risk of loss on the Company's loan portfolio given
      the loan balances and the value of the underlying collateral and has recognized
      losses where appropriate. Nonperforming loans are closely monitored on an
      ongoing basis as part of the Company's loan review process.





The
      following table shows the allocation for loans in the loan portfolio and the
      corresponding amounts of the allowance allocated by loan type as of March 31,
      2006 and December 31, 2005 (in thousands of dollars):





March
                31, 2006
            
            December
                31, 2005Percent
                of
            
            
            Percent
                ofAmount
            
            Loans
            
            Amount
            
            LoansLoan
                TypeCommercial
            
            $
            891
            
            
            22
            %
            $
            900
            
            
            22
            %Mortgage
                and construction
            
            
            1,231
            
            
            62
            %
            
            1,139
            
            
            62
            %Consumer
            
            
            935
            
            
            16
            %
            
            1,082
            
            
            17
            %Unallocated
            
            
            110
            
            
            
            
            
            8Totals
            
            $
            3,167
            
            
            
            
            $
            3,129




As
      certain loans identified as impaired are paid current, collateral values
      increase or loans are removed from watch lists for other reasons, and as other
      loans become identified as impaired, and because delinquency levels within
      each
      of the portfolios change, the allocation of the allowance among the loan types
      may change. Management feels that the allowance is a fair representation of
      the
      losses present in the portfolio given historical loss trends, economic
      conditions and any known credit problems as of a given date. Management believes
      that the allowance is to be taken as a whole, and allocation between loan types
      is an estimation of potential losses within each type given information known
      at
      the time.





The
      following table summarizes the Company’s net charge-offs by loan type for the
      three month periods ended March 31, 2006 and 2005 (in thousands of
      dollars):





2006
            
            2005Charge-offsCommercial
            
            $
            (2
            )
            $
            (11
            )Mortgage
                and construction
            
            
            (1
            )
            
            (1
            )Consumer
            
            
            (209
            )
            
            (163
            )Total
                Charge-offs
            
            
            (212
            )
            
            (175
            )RecoveriesCommercial
            
            
            3
            
            
            1Mortgage
            
            
            0
            
            
            0Consumer
            
            
            69
            
            
            42Total
                Recoveries
            
            
            72
            
            
            43Total
                Net Charge-offs
            
            $
            (140
            )
            $
            (132
            )




The
      provision for loan losses taken during the first quarter of 2005 was $47,000
      less than that taken during the same quarter in 2006. In spite of the decrease
      in the provision, the ratio of the allowance for loan losses to gross loans
      increased from 1.16% at December 31, 2005 to 1.17% at March 31, 2006. At March
      31, 2005, the ratio of the allowance for loan losses to gross loans was 1.03%
      The ratio of allowance for loan losses to nonperforming loans was 1.96 at March
      31, 2006 compared to 1.62 at December 31, 2005.





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Page
      18





**Item
      2.** **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations** **(continued)**





**Noninterest
      Income**





Noninterest
      income increased 18.65% for the first quarter of 2006 as compared to the same
      period in 2005. This increase was impacted most by an increase in income
      received from customer overdraft charges. During the fourth quarter of 2005,
      Capon Valley Bank instituted a program commonly referred to as “courtesy
      overdraft.” This program, coupled with an increase in the volume of checking
      accounts at both subsidiary banks, was the primary reason for the increase
      in
      income from overdraft charges.




**Noninterest
      Expense**





Noninterest
      expense increased 14.67% for the first three months of 2006 as compared to
      2005.





The
      addition of operations and the physical assets acquired with the purchase of
      the
      National Bank of Davis had a significant impact on the increases in non-interest
      expense. This purchase added eleven full time equivalent employees and two
      banking locations, increasing both the costs of salaries and benefits and
      occupancy and equipment expense. Also, the increase in both loan and deposit
      customers caused an increase in data processing expense. Additionally, during
      the first quarter the Company experienced costs related to the conversion of
      the
      legacy Davis data processing systems into existing systems of The Grant County
      Bank.





Not
      all
      of the increase in noninterest expense can be attributed to the increased
      operational size of the Company as a result of the purchase of the additional
      branches. Continued growth in the operations of the Company caused marginal
      increases in both data processing and other types of noninterest expenses.
      Also,
      customary annual pay increases contributed to the rise in salary and benefits
      expense.





Directors’
      fees increased $16,000 as the result of an increase in the per-meeting fees
      earned by directors.





**Borrowed
      Funds**





The
      Company borrows funds from the Federal Home Loan Bank (“FHLB”) to reduce market
      rate risks, provide liquidity, and to fund capital additions. These borrowings
      may have fixed or variable interest rates and are amortized over a period of
      one
      to twenty years, or may be comprised of single payment borrowings with periodic
      interest payments and principal amounts due at maturity. In an attempt to manage
      interest expense and interest rate risk and as competition for deposits has
      increased, the Company has, during recent periods, used these available debt
      vehicles to fund loan growth more frequently than was utilized in the past.





During
      the fourth quarter of 2003, the Company obtained a $2,500,000 open line of
      credit with another commercial bank. This line of credit was secured by an
      equity interest in Capon Valley Bank, a subsidiary company. This debt instrument
      was obtained as a precautionary device for funding should a need arise in the
      future. Since this line of credit was obtained, there have been no advances
      of
      funds on this debt facility. It is not anticipated that any borrowings from
      this
      debt facility will be used to fund operating or liquidity needs.










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Page
      19





**Item
      2.** **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations** **(continued)**





**Liquidity**





Operating
      liquidity is the ability to meet present and future financial obligations.
      Short
      term liquidity is provided primarily through cash balances, deposits with other
      financial institutions, federal funds sold, non-pledged securities and loans
      maturing within one year. Additional sources of liquidity available to the
      Company include, but are not limited to, loan repayments, the ability to obtain
      deposits through the adjustment of interest rates and the purchasing of federal
      funds. To further meet its liquidity needs, the Company also maintains lines
      of
      credit with correspondent financial institutions, the Federal Reserve Bank
      of
      Richmond and the Federal Home Loan Bank of Pittsburgh.





Historically,
      the Company’s primary need for additional levels of operational liquidity has
      been to fund increases in loan balances. The
      Company has normally funded increases in loans by increasing deposits and
      decreases in secondary liquidity sources such as balances of Fed Funds sold
      and
      balances of securities. Although total deposit balances have decreased slightly
      in recent periods, the Company has substantially maintained or increased levels
      of these secondary liquidity resources and does not anticipate that an
      unexpectedly high level of loan demand in coming periods would impact liquidity
      to the extent that the Company would be required to pay above market rates
      to
      obtain deposits.





The
      parent Company’s operating funds, funds with which to pay shareholder dividends
      and funds for the exploration of new business ventures have been supplied
      primarily through dividends paid by the Company’s subsidiary banks Capon Valley
      Bank (CVB) and The Grant County Bank (GCB). The various regulatory authorities
      impose restrictions on dividends paid by a state bank. A state bank cannot
      pay
      dividends without the consent of the relevant banking authorities in excess
      of
      the total net profits of the current year and the combined retained profits
      of
      the previous two years. As of April 1, 2006, the subsidiary banks could pay
      dividends to Highlands Bankshares, Inc. of approximately $5,707,000 without
      permission of the regulatory authorities.





**Capital**





The
      Company seeks to maintain a strong capital base to expand facilities, promote
      public confidence, support current operations and grow at a manageable level.
      As
      of March 31, 2006, the Company was above the regulatory minimum levels of
      capital. The table below summarizes the capital ratios for the Company and
      its
      subsidiary banks as of March 31, 2006 and December 31, 2005:





March
                31, 2006
            
            December
                31, 2005Actual
            
            Regulatory
            
            Actual
            
            RegulatoryRatio
            
            Minimum
            
            Ratio
            
            MinimumTotal
                Risk Based Capital RatioHighlands
                Bankshares
            
            
            13.56
            %
            
            8.00
            %
            
            13.85
            %
            
            8.00
            %Capon
                Valley Bank
            
            
            13.64
            %
            
            8.00
            %
            
            13.45
            %
            
            8.00
            %The
                Grant County Bank
            
            
            13.04
            %
            
            8.00
            %
            
            13.67
            %
            
            8.00
            %Tier
                1 Leverage RatioHighlands
                Bankshares
            
            
            9.07
            %
            
            3.00
            %
            
            9.45
            %
            
            3.00
            %Capon
                Valley Bank
            
            
            9.09
            %
            
            3.00
            %
            
            8.87
            %
            
            3.00
            %The
                Grant County Bank
            
            
            8.57
            %
            
            3.00
            %
            
            8.81
            %
            
            3.00
            %Tier
                1 Risk Based Capital RatioHighlands
                Bankshares
            
            
            12.31
            %
            
            4.00
            %
            
            12.60
            %
            
            4.00
            %Capon
                Valley Bank
            
            
            12.39
            %
            
            4.00
            %
            
            12.20
            %
            
            4.00
            %The
                Grant County Bank
            
            
            11.82
            %
            
            4.00
            %
            
            12.47
            %
            
            4.00
            %








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Page
      20





**Item
      2.** **Management’s
      Discussion and Analysis of Financial Condition and Results of Operations** **(continued)**





**Effects
      of Inflation**





Inflation
      primarily affects industries having high levels of property, plant and equipment
      or inventories. Although the Company is not significantly affected in these
      areas, inflation does have an impact on the growth of assets. As assets grow
      rapidly, it becomes necessary to increase equity capital at proportionate levels
      to maintain the appropriate equity to asset ratios. Traditionally, the Company's
      earnings and high capital retention levels have enabled the Company to meet
      these needs. The
      Company's reported earnings results have been minimally affected by inflation.
      The different types of income and expense are affected in various ways. Interest
      rates are affected by inflation, but the timing and magnitude of the changes
      may
      not coincide with changes in the consumer price index. Management actively
      monitors interest rate sensitivity in order to minimize the effects of
      inflationary trends on interest rates. Other areas of noninterest expenses
      may
      be more directly affected by inflation.




**Item
      3.** **Quantitative
      and Qualitative Disclosures About Market Risk**





There
      have been no material changes in Quantitative and Qualitative Disclosures about
      Market Risk as reported in the Company’s Annual Report on Form 10-K for the
      period ended December 31, 2005.





**Item
      4.** **Controls
      and Procedures**





The
      Company’s management, with the participation of the Company’s Chief Executive
      Officer and Chief Financial Officer, has evaluated the effectiveness of the
      Company’s disclosure controls and procedures as of March 31, 2006. Based on this
      evaluation, the Company’s Chief Executive Officer and Chief Financial Officer
      concluded that the Company’s disclosure controls and procedures are effective as
      of March 31, 2006. The company has established procedures undertaken during
      the
      normal course of business in an effort to reasonably ensure that fraudulent
      activity of either an amount material to these results or in any amount is
      not
      occurring





On
      October 31, 2005, the Company purchased all of the outstanding shares of stock
      in The National Bank of Davis. On November 15, 2005, Highlands merged Davis
      into
      The Grant County Bank. As of March 31, 2006, full transition of the legacy
      Davis
      systems, including, but not limited to, core processing of transactions,
      accounting, and certain policies and procedures was not complete. Given the
      design and assessment of internal controls present at the Company, this
      incomplete transition created a requirement for additional controls to be put
      in
      place to reasonably ensure that fraudulent activity of an amount material to
      these results or in any amount and relating to this incomplete transition is
      not
      occurring. At March 31, 2006, transition of legacy Davis systems into the
      Company’s systems currently in place was ongoing, but has been completed
      subsequently. During the time of transition, management added internal control
      measures in conjunction with this transition, in an attempt to reasonably ensure
      that controls pertaining to financial reporting and safeguarding of assets
      are
      effective.




Changes
      in Internal Controls





During
      the period reported upon, there were no significant changes in internal controls
      of Highlands Bankshares, Inc. pertaining to its financial reporting and control
      of its assets or in other factors that materially affected or are reasonably
      likely to materially affect such control.





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Page
      21





**PART
      II****OTHER
      INFORMATION**





**Item
      1.****Legal
      Proceedings**





Management
      is not aware of any material pending or threatened litigation in which the
      Company or its subsidiaries may be involved as a defendant. In the normal course
      of business, the banks periodically must initiate suits against borrowers as
      a
      final course of action in collecting past due loans. In addition, to
      management’s knowledge, no governmental authorities have initiated or
      contemplated legal action against the Company.





In
      late
      February of 2006, a third party alleged that an error had been made regarding
      the safekeeping of a deposit, specifically two certificates of deposit totaling
      $2,000,000 that had been assigned as collateral for a performance bond had
      been
      released to the owners. It was alleged that the error was related to a trust
      account held by the now discontinued subsidiary of Highlands, Highlands
      Bankshares Trust Company. This third party indicated that if it experienced
      a
      loss relating to this bond, that it may pursue legal action as a potential
      remedy for this loss. At this time, the potential for legal action or the amount
      of any potential liability to Highlands Bankshares or its subsidiaries is
      unknown. Since the time of the notification, Highlands has been informed by
      legal counsel of the former depositor that the third party referred to above
      had
      been remunerated in an amount equal to the deposit.





**Item
      1A.   Risk Factors**





There
      have been no material changes to the Company’s risk factors since these factors
      were previously disclosed in the Company’s Annual Report on Form 10-K for the
      period ended December 31, 2005.





**Item
      2.** **Unregistered
      Sales of Equity Securities and Use of
      Proceeds.**





None





**Item
      3.****Defaults
      Upon Senior Securities**





None





**Item
      4.****Submission
      of Matters to a Vote of Security Holders**





None





**Item
      5.****Other
      Information**





None




**Item
      6.****Exhibits**





3(i)
            Articles
                of Incorporation of Highlands Bankshares, Inc. are incorporated by
                reference to Appendix C to Highlands Bankhares, Inc.’s Form S-4 filed
                October 20, 1986.3(ii)
            Bylaws
                of Highlands Bankshares, Inc. are incorporated by reference to Exhibit
                3(ii) to Highlands Bankshares, Inc.’s Form 10-Q filed May 15,
                2003.31.1
            Certification
                of Chief Executive Officer Pursuant to section 302 of the Sarbanes-Oxley
                Act of 2002 Chapter 63, Title 18 U.S.C. Section 1350 (A) and
                (B).31.2
            Certification
                of Chief Financial Officer Pursuant to section 302 of the Sarbanes-Oxley
                Act of 2002 Chapter 63, Title 18 U.S.C. Section 1350 (A) and
                (B).32.1
            Statement
                of Chief Executive Officer Pursuant to 18 U.S.C. §
1350.32.2
            Statement
                of Chief Financial Officer Pursuant to 18 U.S.C. §
                1350.





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Page
      22





Signatures




Pursuant
      to the requirements 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.





HIGHLANDS
                BANKSHARES, INC./s/
                C.E. PorterC.E.
                PorterPresident
                & Chief Executive Officer/s/
                R. Alan MillerR.
                Alan MillerChief
                Financial OfficerMay
                5, 2006











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