UNITED
      STATESSECURITIES
      AND EXCHANGE COMMISSIONWashington,
      DC 20549








FORM
10-Q





(Mark
One)


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


For the
quarterly period ended March 31, 2010.





[  ]  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 Incorporation or Organization)
            (IRS
      Employer 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) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.  Yes [X]   No [  ]





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Date File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this
Chapter) during the preceding 12 months (or for such shorter period that
the registrant was required to submit and post such files).  Yes
[    ]  No [    ]





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filed, a non-accelerated filer, or a smaller reporting
company.  See the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.





Large
      Accelerated Filer    [  ]
            Accelerated
      Filer    [  ]
            Non-accelerated
      filer     [  ](Do not check
      if a smaller reporting company)
            Smaller
      reporting company   [X]





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).   [  ] Yes[X] 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 May 12, 2010:  1,336,873
shares of Common Stock, $5 Par Value











HIGHLANDS
      BANKSHARES, INC.Quarterly
      Report on Form 10-Q For The Period Ended March 31, 2010INDEXPagePART I
            FINANCIAL INFORMATIONItem 1.
            Financial StatementsUnaudited
      Consolidated Statements of IncomeThree Months Ended March 31, 2010
      and 2009
            1Unaudited
      Consolidated Balance Sheet for March 31, 2010and Audited
      Consolidated Balance Sheet for December 31, 2009
            2Unaudited
      Consolidated Statements of Changes in Stockholders’Equity for the
      Three Months Ended March 31, 2010 and 2009
            3Unaudited
      Consolidated Statements of Cash Flows for the ThreeMonths Ended
      March 31, 2010 and 2009
            4Notes to Consolidated Financial Statements
            5Item 2.
            Management’
      Discussion and Analysis of Financial Conditionand Results of
      Operations
            10Item 3.
            Quantitative and Qualitative Disclosures About Market
      Risk
            22Item 4.
            Controls and Procedures
            22PART II
            OTHER INFORMATIONItem 1.
            Legal Proceedings
            23Item 1A.
            Risk Factors
            23Item 2.
            Unregistered Sales of Equity Securities and Use of
      Proceeds
            23Item 3.
            Defaults Upon Senior Securities
            23Item 4.
            (Removed and Reserved)
            23Item 5.
            Other Information
            23Item 6.
            Exhibits
            23SIGNATURES
            
            24





Index


PART I.


Item 1.
            Financial
      Statements


HIGHLANDS BANKSHARES, INC.CONSOLIDATED
      STATEMENTS OF INCOME(In
      Thousands of Dollars, Except Per Share Data)Three
      Months Ended March 312010
                
                
                2009(unaudited)
                
                
                (unaudited)Interest
      IncomeInterest
      and fees on loans
                
                $
                5,482
                
                
                $
                5,890Interest
      on federal funds sold
                
                
                5
                
                
                
                5Interest
      on deposits in other banks
                
                
                3
                
                
                
                3Interest
      and dividends on securities
                
                
                187
                
                
                
                227Total
      Interest Income
                
                
                5,677
                
                
                
                6,125Interest
      ExpenseInterest
      on deposits
                
                
                1,606
                
                
                
                1,838Interest
      on borrowed money
                
                
                115
                
                
                
                137Total
      Interest Expense
                
                
                1,721
                
                
                
                1,975Net
      Interest Income
                
                
                3,956
                
                
                
                4,150Provision
      for Loan Losses
                
                
                1,092
                
                
                
                284Net
      Interest Income After Provision for Loan Losses
                
                
                2,864
                
                
                
                3,866Non-interest
      IncomeService
      charges
                
                
                357
                
                
                
                367Life
      insurance investment income
                
                
                66
                
                
                
                61Gains
      (losses) on securities transactions
                
                
                33
                
                
                
                (13
                )Gains
      on sale of foreclosed property
                
                
                4
                
                
                
                0Other
      non-interest income
                
                
                87
                
                
                
                114Total
      Non-interest Income
                
                
                547
                
                
                
                529Non-interest
      ExpenseSalaries
      and employee benefits
                
                
                1,720
                
                
                
                1,661Occupancy
      and equipment expense
                
                
                368
                
                
                
                329Data
      processing expense
                
                
                271
                
                
                
                169Directors
      fees
                
                
                99
                
                
                
                103Legal
      and professional fees
                
                
                182
                
                
                
                123Other
      non-interest expense
                
                
                558
                
                
                
                505Total
      Non-interest Expense
                
                
                3,198
                
                
                
                2,890Income
      Before Provision For Income Taxes
                
                
                213
                
                
                
                1,505Provision
      for Income Taxes
                
                
                52
                
                
                
                542Net
      Income
                
                $
                161
                
                
                $
                963Per
      Share DataNet
      Income
                
                $
                0.12
                
                
                $
                0.72Cash
      Dividends
                
                $
                0.27
                
                
                $
                0.29Weighted
      Average Common Shares Outstanding
                
                
                1,336,873
                
                
                
                1,336,873
 The
accompanying notes are an integral part of these financial
statements.


1
 Index


HIGHLANDS BANKSHARES, INC.CONSOLIDATED
      BALANCE SHEETS(In
      thousands of dollars)
  March 31, 2010
              
              
              December 31, 2009(unaudited)
              
              
              (audited)ASSETSCash
      and due from banks
              
              $
              6,098
              
              
              $
              7,062Interest
      bearing deposits in banks
              
              
              2,707
              
              
              
              1,880Federal
      funds sold
              
              
              12,556
              
              
              
              8,936Investment
      securities available for sale
              
              
              28,071
              
              
              
              26,936Restricted
      investments
              
              
              2,185
              
              
              
              2,185Loans
              
              
              334,053
              
              
              
              335,483Allowance
      for loan losses
              
              
              (4,512
              )
              
              
              (4,021
              )Bank
      premises and equipment, net of depreciation
              
              
              9,427
              
              
              
              9,326Interest
      receivable
              
              
              1,798
              
              
              
              1,908Investment
      in life insurance contracts
              
              
              6,821
              
              
              
              6,755Foreclosed
      Assets
              
              
              3,522
              
              
              
              3,223Goodwill
              
              
              1,534
              
              
              
              1,534Other
      intangible assets
              
              
              971
              
              
              
              1,020Other
      assets
              
              
              5,239
              
              
              
              5,583Total
      Assets
              
              $
              410,470
              
              
              $
              407,810LIABILITIESDepositsNon-interest
      bearing deposits
              
              $
              52,311
              
              
              $
              52,378Interest
      bearing transaction and savings accounts
              
              
              76,841
              
              
              
              73,053Time
      deposits over $100,000
              
              
              75,299
              
              
              
              75,596All
      other time deposits
              
              
              148,244
              
              
              
              148,850Total
      Deposits
              
              
              352,695
              
              
              
              349,877Long
      term debt instruments
              
              
              10,750
              
              
              
              10,866Accrued
      expenses and other liabilities
              
              
              5,844
              
              
              
              5,645Total
      Liabilities
              
              
              369,289
              
              
              
              366,388STOCKHOLDERS’
      EQUITYCommon
      Stock, $5 par value, 3,000,000 shares authorized, 1,436,874
      shares issued7,184
              
              
              
              7,184Surplus
              
              
              1,662
              
              
              
              1,662Treasury
      stock (100,001 shares, at cost)
              
              
              (3,372
              )
              
              
              (3,372
              )Retained
      earnings
              
              
              36,763
              
              
              
              36,963Other
      accumulated comprehensive loss
              
              
              (1,056
              )
              
              
              (1,015
              )Total
      Stockholders’ Equity
              
              
              41,181
              
              
              
              41,422Total
      Liabilities and Stockholders’ Equity
              
              $
              410,470
              
              
              $
              407,810The
      accompanying notes are an integral part of these financial
      statements






2
 Index




HIGHLANDS
      BANKSHARES, INC.CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’
    EQUITY(In
      Thousands of Dollars)  Common
      Stock
                
                
                Surplus
                
                
                TreasuryStock
                
                
                Retained
      Earnings
                
                
                AccumulatedOtherComprehensiveIncome (Loss)
                
                
                TotalBalances
      at December 31, 2008
                
                $
                7,184
                
                
                $
                1,662
                
                
                $
                (3,372
                )
                
                $
                35,157
                
                
                $
                (1,232
                )
                
                $
                39,399Other
      Comprehensive Income:Net
      Income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                963
                
                
                
                
                
                
                
                963Change
      in other comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                68
                
                
                
                68Total
      Comprehensive Income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                1,031Dividends
      Paid
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (388
                )
                
                
                
                
                
                
                (388
                )Balances
      March 31, 2009
                
                $
                7,184
                
                
                $
                1,662
                
                
                $
                (3,372
                )
                
                $
                35,732
                
                
                $
                (1,164
                )
                
                $
                40,042Balances
      at December 31, 2009
                
                $
                7,184
                
                
                $
                1,662
                
                
                $
                (3,372
                )
                
                $
                36,963
                
                
                $
                (1,015
                )
                
                $
                41,422Other
      Comprehensive Income:Net
      Income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                161
                
                
                
                
                
                
                
                161Change
      in other comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (41
                )
                
                
                (41
                )Total
      Comprehensive Income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                120Dividends
      Paid
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (361
                )
                
                
                
                
                
                
                (361
                )Balances
      March 31, 2010
                
                $
                7,184
                
                
                $
                1,662
                
                
                $
                (3,372
                )
                
                $
                36,763
                
                
                $
                (1,056
                )
                
                $
                41,181The
      accompanying notes are an integral part of these financial
      statements






3
 Index




HIGHLANDS
      BANKSHARES, INC.CONSOLIDATED
      STATEMENTS OF CASH FLOWS(In
      Thousands of Dollars)
  Three
      Months Ended March 31,2010
                
                
                2009(unaudited)
                
                
                (unaudited)Cash
      Flows From Operating ActivitiesNet
      Income
                
                $
                161
                
                
                $
                963Adjustments
      to reconcile net income to netcash
      provided by operating activitiesLoss
      (gain) on securities transactions
                
                
                (33
                )
                
                
                13(Gain)
      on sale of OREO
                
                
                (4
                )
                
                
                0Depreciation
                
                
                182
                
                
                
                155Change
      in insurance contracts
                
                
                (66
                )
                
                
                (61
                )Net
      amortization of securities
                
                
                31
                
                
                
                24Provision
      for loan losses
                
                
                1,092
                
                
                
                284Write-down
      of OREO
                
                
                18
                
                
                
                0Amortization
      of intangibles
                
                
                49
                
                
                
                49Decrease
      in interest receivable
                
                
                110
                
                
                
                141(Increase)
      decrease in other assets
                
                
                344
                
                
                
                (47
                )Increase
      in accrued expenses and other liabilities
                
                
                223
                
                
                
                484Net
      Cash Provided by Operating Activities
                
                
                2,107
                
                
                
                2,005Cash
      Flows From Investing Activities(Increase)
      in federal funds sold
                
                
                (3,620
                )
                
                
                (8,824
                )Proceeds
      from maturities of securities available for sale
                
                
                1,442
                
                
                
                1,963Purchase
      of securities available for sale
                
                
                (2,640
                )
                
                
                (1,000
                )(Increase)
      in restricted investments
                
                
                0
                
                
                
                (8
                )Proceeds
      from sale of fixed assets and OREO
                
                
                63
                
                
                
                0(Increase)
      in interest bearing deposits in banks
                
                
                (827
                )
                
                
                (22
                )Purchase
      of property and equipment
                
                
                (283
                )
                
                
                (1,159
                )Net
      (increase) decrease in loans
                
                
                453
                
                
                
                (7,138
                )Net
      Cash (Used in) Investing Activities
                
                
                (5,412
                )
                
                
                (16,188
                )Cash
      Flows From Financing ActivitiesNet
      change in time deposits
                
                
                (904
                )
                
                
                9,519Net
      change in other deposit accounts
                
                
                3,722
                
                
                
                4,411Net
      change in short term borrowings
                
                
                0
                
                
                
                200Repayment
      of long term borrowings
                
                
                (116
                )
                
                
                (110
                )Dividends
      paid in cash
                
                
                (361
                )
                
                
                (388
                )Net
      Cash Provided by Financing Activities
                
                
                2,341
                
                
                
                13,632Net
      (decrease)  in Cash and Cash Equivalents
                
                
                (964
                )
                
                
                (551
                )Cash
      and Cash Equivalents, Beginning of Period
                
                
                7,062
                
                
                
                7,589Cash
      and Cash Equivalents, End of Period
                
                $
                6,098
                
                
                $
                7,038Supplemental
      DisclosuresCash
      paid for income taxes
                
                $
                0
                
                
                $
                0Cash
      paid for interest
                
                $
                1,733
                
                
                $
                2,044The
      accompanying notes are an integral part of these financial
      statements.






4
 Index





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
      ONE:
            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, 2010 and the results of
operations for the three month periods ended March 31, 2010 and
2009.





The
results of operations for the three month periods ended March 31, 2010 and 2009
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 2009 annual report on Form
10-K.





Certain
reclassifications have been made to prior period balances to conform with the
current years’ presentation format.





NOTE
      TWO:
            LOANS





A summary
of loans outstanding as of March 31, 2010 and December 31, 2009 is shown in the
table below (in thousands of dollars):





March
      31, 2010
              
              
              December
      31, 2009Loan
      TypeReal
      Estate mortgage
              
              $
              159,807
              
              
              $
              162,619Real
      Estate construction
              
              
              29,914
              
              
              
              30,759Commercial
              
              
              100,120
              
              
              
              97,606Installment
              
              
              44,212
              
              
              
              44,499Total
      Loans
              
              $
              334,053
              
              
              $
              335,483Allowance
      for loan losses
              
              $
              (4,512
              )
              
              $
              (4,021
              )


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, 2010, the total balance of loans in the
portfolio secured by real estate was $274,804,000.





NOTE
      THREE:
            ALLOWANCE
      FOR LOAN LOSSES





A summary
of the transactions in the allowance for loan losses for the three month periods
ended March 31, 2010 and 2009 is shown below (in thousands of
dollars):





2010
              
              
              2009Balance,
      beginning of period
              
              $
              4,021
              
              
              $
              3,667Provisions
      charged to operations
              
              
              1,092
              
              
              
              284Loan
      recoveries
              
              
              93
              
              
              
              65Loan
      charge-offs
              
              
              (694
              )
              
              
              (437
              )Balance,
      end of period
              
              $
              4,512
              
              
              $
              3,579





The
following summary provides information regarding impaired loans as of March 31,
2010 and December 31, 2009 (in thousands of dollars):




2010
              
              
              2009Period
      end balance, impaired loans
              
              $
              5,029
              
              
              $
              3,425Allowance
      for impairments, period end
              
              
              1,097
              
              
              
              662


5
 Index







NOTE
      FOUR:
            INVESTMENT
      IN INSURANCE CONTRACTS





Investment
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
      FIVE:
            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 as of March 31, 2010 and December
31, 2009 is shown in the table below (in thousands of dollars). All of the
securities on the Company’s balance sheet are classified as available for
sale.





March
      31, 2010
              
              
              December
      31, 2009Amortized
              
              
              Market
              
              
              Amortized
              
              
              MarketCost
              
              
              Value
              
              
              Cost
              
              
              ValueAvailable For Sale
    SecuritiesU.S.
      Treasuries and Agencies
              
              $
              13,227
              
              
              $
              13,375
              
              
              $
              12,250
              
              
              $
              12,426Mortgage
      backed securities
              
              
              5,196
              
              
              
              5,395
              
              
              
              5,630
              
              
              
              5,836States
      and municipalities
              
              
              3,589
              
              
              
              3,666
              
              
              
              3,832
              
              
              
              3,946Certificates
      of deposit
              
              
              5,595
              
              
              
              5,607
              
              
              
              4,696
              
              
              
              4,703Marketable
      equities
              
              
              15
              
              
              
              28
              
              
              
              15
              
              
              
              25Total
      Available For Sale Securities
              
              $
              27,622
              
              
              $
              28,071
              
              
              $
              26,423
              
              
              $
              26,936


Information
pertaining to securities with gross unrealized losses at March 31, 2010 and
December 31, 2009, aggregated by investment category and length of time that
individual securities have been in a continuous loss position is shown in the
table below (in thousands of dollars):





Total
              
              
              Less
      than 12 Months
              
              
              12
      Months or GreaterFair
      Value
              
              
              Gross
                Unrealized
                Losses
              
              
              Fair
                Value
              
              
              Gross
                Unrealized
                Losses
              
              
              Fair
                Value
              
              
              Gross
                Unrealized
                LossesMarch 31, 2010Investment
      CategoryU.S.
      Treasuries and Agencies
              
              
              999
              
              
              
              (1
              )
              
              
              999
              
              
              
              (1
              )
              
              
              0
              
              
              
              0Mortgage
      backed securities
              
              
              26
              
              
              
              0
              
              
              
              26
              
              
              
              0
              
              
              
              0
              
              
              
              0Certificates
      of deposit
              
              
              1,230
              
              
              
              (8
              )
              
              
              1,230
              
              
              
              (8
              )
              
              
              0
              
              
              
              0Marketable
      equities
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0Total
              
              $
              2,255
              
              
              $
              (9
              )
              
              $
              2,255
              
              
              $
              (9
              )
              
              $
              0
              
              
              $
              0December 31, 2009Investment
      CategoryU.S.
      Treasuries and Agencies
              
              
              999
              
              
              
              (1
              )
              
              
              999
              
              
              
              (1
              )
              
              
              0
              
              
              
              0Mortgage
      backed securities
              
              
              24
              
              
              
              0
              
              
              
              24
              
              
              
              0
              
              
              
              0
              
              
              
              0Certificates
      of deposit
              
              
              246
              
              
              
              (2
              )
              
              
              246
              
              
              
              (2
              )
              
              
              0
              
              
              
              0Marketable
      equities
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0Total
              
              $
              1,269
              
              
              $
              (3
              )
              
              $
              1,269
              
              
              $
              (3
              )
              
              $
              0
              
              
              $
              0





6
 Index





Restricted
investments consist of investments in the Federal Home Loan Bank, the Federal
Reserve Bank and West Virginia Bankers’ Title Insurance
Company.  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. The
Company’s investment in Federal Home Loan Bank (FHLB) stock totaled $2.1 million
at March 31, 2010.  FHLB stock is generally viewed as a long term
investment and as a restricted investment security, which is carried at cost,
because there is no market for the stock other than the FHLBs or member
institutions.  Therefore, when evaluating FHLB stock for impairment,
its value is based on ultimate recoverability of the par value rather than by
recognizing temporary declines in value.  Despite the FHLB’s temporary
suspension of cash dividend payments and repurchases of excess capital stock in
2009, the Company does not consider this investment to be other than temporarily
impaired at March 31, 2010 and no impairment has been recognized.





NOTE
      SIX:
            EARNINGS
      PER SHARE





There
have been no changes in the Company’s outstanding shares of common stock since
the fourth quarter of 2008.





NOTE
      SEVEN:
            BORROWINGS





The
Company has borrowed money from the Federal Home Loan Bank of Pittsburgh (FHLB).
This debt consists of both borrowings with terms of maturities of six months or
greater and also certain debts with maturities of thirty days or
less.





The
borrowings with long term maturities may have either single payment maturities
or amortize. The interest rates on the various long term borrowings at March 31,
2010 range from 3.94% to 5.96%. The weighted average interest rate on the
borrowings at March 31, 2010 was 4.61%.





In
addition to utilization of the FHLB for borrowings of long term debt, the
Company also can utilize the FHLB for overnight and other short term borrowings.
At March 31, 2010 and December 31, 2009, the Company had no overnight or other
short term borrowings.





NOTE
      EIGHT:
            INTANGIBLE
      ASSETS





The
Company’s balance sheet contains several components of intangible assets. At
March 31, 2010, the total balance of intangible assets was comprised of Goodwill
and Core Deposit Intangible Assets acquired as a result of the acquisition of
other banks and also an intangible asset related to the purchased naming rights
for a performing arts center located within the Company’s primary business area.
The Company performs an impairment test on an annual basis.  No
impairment has been recorded to date.





NOTE
      NINE:
            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.





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. The bank was required to
make contributions in 2006, 2007 and 2008 and made a contribution of $589,000 in
the third quarter of 2009. The Bank has recognized liabilities of $1,340,000 at
March 31, 2010. The following table provides the components of the net periodic
benefit cost for the plan for the three month periods ended March 31, 2010 and
2009 (in thousands of dollars):





2010
              
              
              2009Service
      cost
              
              $
              47
              
              
              $
              51Interest
      cost
              
              
              76
              
              
              
              81Expected
      return on plan assets
              
              
              (84
              )
              
              
              (98
              )Recognized
      net actuarial loss
              
              
              24
              
              
              
              16Amortization
      of unrecognized prior service costs
              
              
              0
              
              
              
              1Net
      periodic expense
              
              $
              63
              
              
              $
              51








7
 Index








NOTE
      TEN:
            FAIR
      VALUE MEASUREMENTS







ASC 820,
Fair Value Measurements and
Disclosures(previously SFAS No. 157, Fair Value Measurements),
defines fair value, establishes a framework for measuring fair value,
establishes a three-level valuation hierarchy for disclosure of fair value
measurement and enhances disclosure requirements for fair value measurements.
The valuation hierarchy is based upon the transparency of inputs to the
valuation of an asset or liability as of the measurement date. The three levels
are defined as follow:


·
            Level One:
      Inputs to the valuation methodology are quoted prices (unadjusted) for
      identical assets or liabilities in active
  markets.


·
            Level Two:
      Inputs to the valuation methodology include quoted prices for similar
      assets and liabilities in active markets, and inputs that are observable
      for the asset or liability, either directly or indirectly, for
      substantially the full term of the financial
  instrument.


·
            Level Three:
      Inputs to the valuation methodology are unobservable and significant to
      the fair value measurement.




Following
is a description of the valuation methodologies used for instruments measured at
fair value on the Company’s balance sheet, as well as the general classification
of such instruments pursuant to the valuation hierarchy:





The
Company, at March 31, 2010 and December 31, 2009, had no liabilities subject to
fair value reporting requirements. The table below summarizes assets at March
31, 2010 and December 31, 2009 measured at fair value on a recurring basis (in
thousands of dollars):





31-Mar-10
              
              Level 1
              
              
              Level 2
              
              
              Level 3
              
              
              Total
      Fair Value
                MeasurementsU.S.
      Treasuries and Agencies
              
              $
              0
              
              
              $
              13,375
              
              
              $
              0
              
              
              $
              13,375Mortgage
      backed securities
              
              
              0
              
              
              
              5,395
              
              
              
              0
              
              
              
              5,395States
      and municipalities
              
              
              0
              
              
              
              3,666
              
              
              
              0
              
              
              
              3,666Certificates
      of deposit
              
              
              0
              
              
              
              5,607
              
              
              
              0
              
              
              
              5,607Marketable
      equities
              
              
              0
              
              
              
              28
              
              
              
              0
              
              
              
              28Total
      Available For Sale Securities
              
              $
              0
              
              
              $
              28,071
              
              
              $
              0
              
              
              $
              28,071


31-Mar-09
              
              Level 1
              
              
              Level 2
              
              
              Level 3
              
              
              Total
      Fair Value
                MeasurementsU.S.
      Treasuries and Agencies
              
              $
              0
              
              
              $
              7,596
              
              
              $
              0
              
              
              $
              7,596Mortgage
      backed securities
              
              
              0
              
              
              
              9,520
              
              
              
              0
              
              
              
              9,520States
      and municipalities
              
              
              0
              
              
              
              3,669
              
              
              
              0
              
              
              
              3,669Marketable
      equities
              
              
              0
              
              
              
              16
              
              
              
              0
              
              
              
              16Total
      Available For Sale Securities
              
              $
              0
              
              
              $
              20,801
              
              
              $
              0
              
              
              $
              20,801


Where
quoted prices are available in an active market, securities are classified
within level 1 of the valuation hierarchy. Level 1 securities would include
highly liquid government bonds, mortgage products and exchange traded equities.
If quoted market prices are not available, then fair values are estimated by
using pricing models, quoted prices of securities with similar characteristics,
or discounted cash flow. Level 2 securities would include U.S. agency
securities, mortgage-backed agency securities, obligations of states and
political subdivisions and certain corporate, asset backed and other securities.
In certain cases where there is limited activity or less transparency around
inputs to the valuation, securities are classified within level 3 of the
valuation hierarchy.  Currently, all of the Company’s securities are
considered to be Level 2 securities.





The table
below summarizes assets at March 31, 2010 and December 31, 2009, measured at
fair value on a non recurring basis (in thousands of dollars):





31-Mar-10
            
            Level 1
            
            
            Level 2
            
            
            Level 3
            
            
            Total
      Fair Value
              MeasurementsOther
      real estate owned
            
            $
            0
            
            
            $
            3,522
            
            
            $
            0
            
            
            $
            3,522Impaired
      Loans
            
            
            0
            
            
            
            1,078
            
            
            
            2,854
            
            
            
            3,932Total
            
            $
            0
            
            
            $
            4,600
            
            
            $
            2,854
            
            
            $
            7,454




31-Dec-09
              
              Level 1
              
              
              Level 2
              
              
              Level 3
              
              
              Total
      Fair Value
                MeasurementsOther
      real estate owned
              
              $
              0
              
              
              $
              3,223
              
              
              $
              0
              
              
              $
              3,223Impaired
      Loans
              
              
              0
              
              
              
              602
              
              
              
              2,161
              
              
              
              2,763Total
              
              $
              0
              
              
              $
              3,825
              
              
              $
              2,161
              
              
              $
              5,986








8
 Index




Certain
assets such as other real estate owned (OREO) are measured at fair value less
cost to sell. Management believes that the fair value component in its valuation
follows the provisions of ASC 820. Management estimates the fair value of real
estate acquired through foreclosure at an estimated fair value less costs to
sell. At or near the time of foreclosure, the subsidiary banks obtain real
estate appraisals on the properties acquired through foreclosure. The real
estate is then valued at the lesser of the appraised value or the loan balance,
including interest receivable, at the time of foreclosure less an estimate of
costs to sell the property. The estimate of costs to sell the property is based
on historical transactions at the subsidiary banks of similar
holdings.





ASC 820
applies to loans measured for impairment using the practical expedients
permitted by Generally Accepted Accounting Pronouncements (“GAAP”), including
impaired loans measured at an observable market price (if available), or at the
fair value of the loan’s collateral (if the loan is collateral dependent). Fair
value of the loan’s collateral, when the loan is dependent on collateral, is
determined by appraisals or independent valuation which is then adjusted for the
cost related to liquidation of the collateral. The impairment of loans is
measured by the Company based on the estimated value of underlying collateral of
the loan. The value of the collateral is typically based on either an appraisal
of the collateral or management’s best estimation of the realizable value of the
collateral, less estimated costs to sell.





The
information above discusses financial instruments carried on the Company’s
balance sheet at fair value. Other financial instruments on the Company’s
balance sheet, while not carried at fair value, do have market values which may
differ from the carrying value. GAAP requires disclosure relating to these
market values. The following information shows the carrying values and estimated
fair values of financial instruments and discusses the methods and assumptions
used in determining these fair values.





The fair
value of the Company's assets and liabilities is influenced heavily by market
conditions. Fair value applies to both assets and liabilities, either on or off
the balance sheet.  Fair value is defined as the amount at which a
financial instrument could be exchanged in a current transaction between willing
parties, other than in a forced or liquidation sale.





The
methods and assumptions detailed below were used to estimate the fair value of
each class of financial instruments for which it is practicable to estimate that
value are discussed following:





Cash, Due from Banks and
Money Market Investments


The
carrying amount of cash, due from bank balances, interest bearing deposits and
federal funds sold is a reasonable estimate of fair value.





Securities


Fair
values of securities are based on quoted market prices or dealer
quotes.  If a quoted market price is not available, fair value is
estimated using quoted market prices for similar securities.





Restricted
Investments


The
carrying amount of restricted investments is a reasonable estimate of fair
value.





Loans


The fair
value of loans is estimated by discounting the future cash flows using the
current rates at which similar loans would be made to borrowers with similar
credit ratings and for the same remaining maturities, taking into consideration
the credit risk in various loan categories.





Deposits


The fair
value of demand, interest checking, regular savings and money market deposits is
the amount payable on demand at the reporting date.  The fair value of
fixed maturity certificates of deposit is estimated using the rates currently
offered for deposits of similar remaining maturities.





Long Term
Debt


The fair
value of fixed rate loans is estimated using the rates currently offered by the
Federal Home Loan Bank for indebtedness with similar maturities.





Short Term
Debt


The fair
value of short-term variable rate debt is deemed to be equal to the carrying
value.




Interest Payable and
Receivable


The
carrying value of amounts of interest receivable and payable is a reasonable
estimate of fair value.






9
 Index





Life
Insurance


The
carrying amount of life insurance contracts is assumed to be a reasonable fair
value. Life insurance contracts are carried on the balance sheet at their
redemption value as of March 31, 2010.  This redemption value is based
on existing market conditions and therefore represents the fair value of the
contract.





Off-Balance-Sheet
Items


The
carrying amount and estimated fair value of off-balance-sheet items were not
material at March 31, 2010 or December 31, 2009.





The
carrying amount and estimated fair values of financial instruments as of March
31, 2010 and December 31, 2009 are shown in the table below (in thousands of
dollars):




March 31, 2010
              
              
              December 31, 2009Carrying
              
              
              Estimated
              
              
              Carrying
              
              
              EstimatedAmount
              
              
              Fair
      Value
              
              
              Amount
              
              
              Fair
      ValueFinancial
      Assets:Cash
      and due from banks
              
              
              6,098
              
              
              
              6,098
              
              
              
              7,062
              
              
              
              7,062Interest
      bearing deposits
              
              
              2,707
              
              
              
              2,707
              
              
              
              1,880
              
              
              
              1,880Federal
      funds sold
              
              
              12,556
              
              
              
              12,556
              
              
              
              8,936
              
              
              
              8,936Securities
      available for sale
              
              
              28,071
              
              
              
              28,071
              
              
              
              26,936
              
              
              
              26,936Restricted
      investments
              
              
              2,185
              
              
              
              2,185
              
              
              
              2,185
              
              
              
              2,185Loans,
      net
              
              
              329,541
              
              
              
              331,069
              
              
              
              331,462
              
              
              
              332,999Interest
      receivable
              
              
              1,798
              
              
              
              1,798
              
              
              
              1,908
              
              
              
              1,908Life
      insurance contracts
              
              
              6,821
              
              
              
              6,821
              
              
              
              6,755
              
              
              
              6,755Financial
      Liabilities:Demand
      and savings deposits
              
              
              129,152
              
              
              
              129,152
              
              
              
              125,431
              
              
              
              125,431Time
      deposits
              
              
              223,543
              
              
              
              225,148
              
              
              
              224,446
              
              
              
              226,057Overnight
      and other short term debt instruments
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0Long
      term debt instruments
              
              
              10,750
              
              
              
              11,275
              
              
              
              10,866
              
              
              
              11,733Interest
      payable
              
              
              598
              
              
              
              598
              
              
              
              656
              
              
              
              656





NOTE
ELEVEN:   SUBSEQUENT EVENTS





Based on
the definitions and requirements of U.S. Generally Accepted Accounting
Principles, the Company has evaluated events and transactions subsequent to
March 31, 2010 through the date these consolidated financial statements were
issued.  During that period, the Company entered contractual
agreements in the amount totaling approximately $500,000 for the completion of
the Company’s new location in Stephen City, VA.  The new location is
scheduled to open during the third quarter of 2010.





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 Annual Report on Form 10-K for the period ended December 31,
2009.  Current performance does not guarantee, and may not be
indicative of, similar performance in the future.








10
 Index








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, continued challenges in the
current economic environment affecting our financial condition and results of
operations, continued deterioration in the financial condition of the U.S.
banking system impacting the valuations of investments the Company has made in
the securities of other financial institutions, and consumer spending and
savings habits, particularly in the current economic
environment.  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; (5) the Company is unable to control
costs and expenses as anticipated, and (6) any additional assessments imposed by
the FDIC. Additionally, consideration should be given to the cautionary language
contained elsewhere in this Form 10-Q.  The Company does not update
any forward-looking statements that may be made from time to time by or on
behalf of the Company.





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 Two to the
Consolidated Financial Statements of the Company’s Annual Report on Form 10-K
for the period ended December 31, 2009. Some of the policies are particularly
sensitive, requiring significant judgments, estimates and assumptions by
management.





Allowance for Loan
Losses





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) ASC 450, Contingencies, which requires
that losses be accrued when they are probable of occurring and estimable and
(ii) ASC 310, Loans and Debt
Securities Acquired with Deteriorated Credit Quality(previously
Statement of Financial Accounting Standards 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.





The
allowance for loan losses includes two basic components: estimated credit losses
on individually evaluated loans that are determined to be impaired, and
estimated credit losses inherent in the remainder of the loan portfolio. Under
GAAP, an individual loan is impaired when, based on current information and
events, it is probable that a creditor will be unable to collect all amounts due
according to the contractual terms of the loan agreement. An individually
evaluated loan that is determined not to be impaired is evaluated under ASC 450
when specific characteristics of the loan indicate that it is probable there
would be estimated credit losses in a group of loans with those
characteristics.





GAAP does
not specify how an institution should identify loans that are to be evaluated
for collectability, nor does it specify how an institution should determine that
a loan is impaired. Each subsidiary of Highlands uses its standard loan review
procedures in making those judgments so that allowance estimates are based on a
comprehensive analysis of the loan portfolio. For loans that are individually
evaluated and found to be impaired, the associated allowance is based upon the
estimated fair value, less costs to sell, of any collateral securing the loan as
compared to the existing balance of the loan as of the date of
analysis.




All other
loans, including individually evaluated loans determined not to be impaired, are
included in a group of loans that are measured under ASC 450 to provide for
estimated credit losses that have been incurred on groups of loans with similar
risk characteristics. The methodology for measuring estimated credit losses on
groups of loans with similar risk characteristics in accordance with ASC 450 is
based on each group’s historical net charge-off rate, adjusted for the effects
of the qualitative or environmental factors that are likely to cause estimated
credit losses as of the evaluation date to differ from the group’s historical
loss experience.




11
 Index


Intangible
Assets





The
Company carries intangible assets related to the purchase of two banks. Amounts
paid to purchase these banks were allocated as intangible assets. Generally
accepted accounting principles were applied to allocate the intangible
components of the purchases. The excess was allocated between identifiable
intangibles (core deposit intangibles) and unidentified intangibles (goodwill).
Goodwill is required to be evaluated for impairment on an annual basis, and the
value of the goodwill adjusted accordingly, should impairment be
found.  As of December 31, 2009, the Company did not identify an
impairment of this intangible. In addition to the intangible assets associated
with the purchases of banks, the company also carries intangible assets relating
to the purchase of naming rights to certain features of a performing arts center
in Petersburg, WV. Intangible assets other than goodwill, which are determined
to have finite lives, are amortized based upon the estimated economic benefits
received.





Post Retirement Benefits and
Life Insurance Investments





The
Company has invested in and owns life insurance policies on key officers. The
policies are designed so that the company recovers the interest expenses
associated with carrying the policies 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 ASC 715, Compensation –Retirement
Benefits.  ASC 715 requires that an employer’s 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.





Adoption of New Accounting
Standards




In June
2009, FASB issued new accounting guidance related to U.S. GAAP (FASB ASC 105,
Generally Accepted Accounting Principles).  This guidance establishes
FASB ASC as the source of authoritative U.S. GAAP recognized by FASB to be
applied by nongovernmental entities.  Rules and interpretive releases
of the SEC under authority of federal securities laws are also sources of
authoritative U.S. GAAP for SEC registrants.  FASB ASC supersedes all
existing non-SEC accounting and reporting standards.  All other
non-grandfathered, non-SEC accounting literature not included in FASB ASC has
become non-authoritative.  FASB will no longer issue new standards in
the form of Statements, FASB Staff Positions or Emerging Issues Task Force
Abstracts.  Instead, it will issue Accounting Standards Updates
(ASUs), which will serve to update FASB ASC, provide background information
about the guidance and provide the basis for conclusions on the changes to FASB
ASC.  FASB ASC is not intended to change U.S. GAAP or any requirements
of the SEC.





The
Company adopted new guidance impacting Financial Accounting Standards Board
Topic 805: Business Combinations (Topic 805) on January 1, 2009. This
guidance requires the acquiring entity in a business combination to recognize
the full fair value of assets acquired and liabilities assumed in the
transaction (whether a full or partial acquisition); establishes the
acquisition-date fair value as the measurement objective for all assets acquired
and liabilities assumed; requires expensing of most transaction and
restructuring costs; and requires the acquirer to disclose to investors and
other users all of the information needed to evaluate and understand the nature
and financial effect of the business combination. The adoption of the new
guidance did not have a material impact on the Company’s consolidated financial
statements.





In April
2009, the FASB issued new guidance impacting Topic 805. This guidance addresses
application issues raised by preparers, auditors, and members of the legal
profession on initial recognition and measurement, subsequent measurement and
accounting, and disclosure of assets and liabilities arising from contingencies
in a business combination. This guidance was effective for business combinations
entered into on or after January 1, 2009. This guidance did not have a
material impact on the Bank’s/Company’s (consolidated) financial
statements.




In
December 2008, the FASB issued new guidance impacting FASB Topic 715-20:
Compensation Retirement Benefits – Defined Benefit Plans – General. The
objectives of this guidance are to provide users of the financial statements
with more detailed information related to the major categories of plan assets,
the inputs and valuation techniques used to measure the fair value of plan
assets and the effect of fair value measurements using significant unobservable
inputs (Level 3) on changes in plan assets for the period, as well as how
investment allocation decisions are made, including the factors that are
pertinent to an understanding of investment policies and strategies. The
disclosures about plan assets required by this guidance are included in Note
fifteen of the Company’s consolidated financial statements included in the
Company’s Annual Report on Form 10-K for the period ended December 31,
2009.






12
 Index





In April
2009, the FASB issued new guidance impacting FASB Topic 820: Fair Value
Measurements and Disclosures (Topic 820). This interpretation provides
additional guidance for estimating fair value when the volume and level of
activity for the asset or liability have significantly decreased. This also
includes guidance on identifying circumstances that indicate a transaction is
not orderly and requires additional disclosures of valuation inputs and
techniques in interim periods and defines the major security types that are
required to be disclosed. This guidance was effective for interim and annual
periods ending after June 15, 2009, and should be applied prospectively. The
adoption of the standard did not have a material impact on the Company’s
consolidated financial statements.





In April
2009, the FASB issued new guidance impacting FASB Topic 320-10: Investments –
Debt and Equity Securities. This guidance amends GAAP for debt securities to
make the guidance more operational and to improve the presentation and
disclosure of other-than-temporary impairments on debt and equity securities in
the financial statements. This guidance was effective for interim and annual
periods ending after June 15, 2009, with earlier adoption permitted for periods
ending after March 15, 2009. The Company did not have any cumulative effect
adjustment related to the adoption of this guidance.





In May
2009, the FASB issued new guidance impacting FASB Topic 855: Subsequent Events.
This update provides guidance on management’s assessment of subsequent events
that occur after the balance sheet date through the date that the financial
statements are issued. This guidance is generally consistent with current
accounting practice. In addition, it requires certain additional disclosures.
This guidance was effective for periods ending after June 15, 2009 and had
no impact on the Company’s consolidated financial statements.





In August
2009, the FASB issued new guidance impacting Topic 820. This guidance is
intended to reduce ambiguity in financial reporting when measuring the fair
value of liabilities. This guidance was effective for the first reporting period
(including interim periods) after issuance and had no impact on the Company’s
consolidated financial statements.





In
September 2009, the FASB issued new guidance impacting Topic 820. This creates a
practical expedient to measure the fair value of an alternative investment that
does not have a readily determinable fair value. This guidance also requires
certain additional disclosures. This guidance is effective for interim and
annual periods ending after December 15, 2009. The Company does not expect
the adoption of the new guidance to have a material impact on its consolidated
financial statements





In
October 2009, the Securities and Exchange Commission issued Release No.
33-99072, Internal Control over Financial Reporting in Exchange Act Periodic
Reports of Non-Accelerated Filers. Release No. 33-99072 delays the requirement
for non-accelerated filers to include an attestation report of their independent
auditor on internal control over financial reporting with their annual report
until the fiscal year ending on or after June 15, 2010.





In
January 2010, the FASB issued ASU 2010-02, Consolidation (Topic 810): Accounting
and reporting for Decreases in Ownership of a Subsidiary – a Scope
Clarification. ASU 2010-02 amends Subtopic 810-10 to address implementation
issues related to changes in ownership provisions including clarifying the scope
of the decrease in ownership and additional disclosures.  ASU 2010-02
is effective beginning in the period that an entity adopts Statement
160.  If an entity has previously adopted Statement 160, ASU 2010-02
is effective beginning in the first interim or annual reporting period ending on
or after December 15, 2009 and should be applied retrospectively to the first
period Statement 160 was adopted.   The adoption of ASU 2010-02
did not have a material impact on the Company’s consolidated financial
statements.





In
June 2009, the FASB issued new guidance relating to the accounting for
transfers of financial assets. The new guidance, which was issued as SFAS
No. 166, Accounting for Transfers of Financial Assets, an amendment to SFAS
No. 140, was adopted into Codification in December 2009 through the
issuance of Accounting Standards Updated ASU 2009-16. The new standard provides
guidance to improve the relevance, representational faithfulness, and
comparability of the information that an entity provides in its financial
statements about a transfer of financial assets; the effects of a transfer on
its financial position, financial performance, and cash flows; and a
transferor’s continuing involvement, if any, in transferred financial
assets.  The adoption of the standard did not have a material impact
on the Company’s consolidated financial statements.





In June
2009, the FASB issued new guidance relating to the variable interest
entities.  The new guidance, which was issued as SFAS No. 167,
Amendments to FASB Interpretation No. 46(R), was adopted into Codification
in December 2009. The objective of the guidance is to improve financial
reporting by enterprises involved with variable interest entities and to provide
more relevant and reliable information to users of financial statements. SFAS
No. 167 is effective as of January 1, 2010. The adoption of the
standard did not have a material impact on the Company’s consolidated financial
statements.





In
October 2009, the FASB issued ASU 2009-15, Accounting for Own-Share Lending
Arrangements in Contemplation of Convertible Debt Issuance or Other Financing.
ASU 2009-15 amends Subtopic 470-20 to expand accounting and reporting guidance
for own-share lending arrangements issued in contemplation of convertible debt
issuance. ASU 2009-15 is effective for fiscal years beginning on or after
December 15, 2009 and interim periods within those fiscal years for arrangements
outstanding as of the beginning of those fiscal years. The adoption of ASU
2009-15 did not have a material impact on the Company’s consolidated financial
statements.






13
 Index







In
January 2010, the FASB issued ASU 2010-04, Accounting for Various Topics –
Technical Corrections to SEC Paragraphs. ASU 2010-04 makes technical corrections
to existing SEC guidance including the following topics: accounting for
subsequent investments, termination of an interest rate swap, issuance of
financial statements - subsequent events, use of residential method to value
acquired assets other than goodwill, adjustments in assets and liabilities for
holding gains and losses, and selections of discount rate used for measuring
defined benefit obligation. The adoption of ASU 2010-04 did not have a material
impact on the Company’s consolidated financial statements.





In
January 2010, the FASB issued ASU 2010-05, Compensation – Stock Compensation
(Topic 718): Escrowed Share Arrangements and the Presumption of Compensation.
ASU 2010-05 updates existing guidance to address the SEC staff’s views on
overcoming the presumption that for certain shareholders escrowed share
arrangements represent compensation.  The Company does not expect the
adoption of ASU 2010-05 to have a material impact on its consolidated financial
statements.





In
January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and
Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.
ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new
disclosures, and includes conforming amendments to guidance on employers’
disclosures about postretirement benefit plan assets. ASU 2010-06 is effective
for interim and annual periods beginning after December 15, 2009, except for
disclosures about purchases, sales, issuances, and settlements in the roll
forward of activity in Level 3 fair value measurements. Those disclosures are
effective for fiscal years beginning after December 15, 2010 and for interim
periods within those fiscal years.  The Company does not expect the
adoption of ASU 2010-06 to have a material impact on its consolidated financial
statements.





In
February 2010, the FASB issued ASU 2010-08, Technical Corrections to Various
Topics. ASU 2010-08 clarifies guidance on embedded derivatives and hedging. ASU
2010-08 is effective for interim and annual periods beginning after December 15,
2009. The adoption of ASU 2010-08 did not have a material impact on the
Company’s consolidated financial statements.





In
February 2010, the FASB issued Accounting Standards Update No. 2010-09,
“Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure
Requirements.”  ASU 2010-09 addresses both the interaction of the
requirements of Topic 855 with the SEC’s reporting requirements and the intended
breadth of the reissuance disclosures provisions related to subsequent
events.  An entity that is an SEC filer is not required to disclose
the date through which subsequent events have been evaluated.  ASU
2010-09 is effective immediately.The adoption of the new
guidance did not have a material impact on the Company’s consolidated financial
statements.








Overview of First Three
Months Results





Net
income for the first three months of 2010, as compared to the same period in
2009, decreased by 83.28% driven primarily by increased provision for loan loss
expense and increased FDIC premiums.





Total
assets increased 0.61% from December 31, 2009 to March 31, 2010 with gross loan
balances decreasing 0.43% from December 31, 2009. Although average balances of
earning assets for the first three months of 2010 were 4.79% higher than for the
same period in 2009, average balances of interest bearing liabilities increased
6.65% for the same comparative time period, which contributed largely to the
4.80% decrease in net interest income.





The
Company’s provision for loan losses increased to 1.35% of total gross loans
during the first three months of 2010 as compared to 1.08% the same period in
2009.  The increase is driven by the changes in loan loss experience
factors which have increased as a result of the current economic
conditions.





Non-interest
income increased $18,000 in the first three months of 2010 as compared to the
same period in 2009 driven primarily by the shift in income associated with
security transactions.





Non-interest
expense increased $309,000 in the first three months of 2010 as compared to the
same period in 2009 primarily due to increases in FDIC premiums, increases in
data processing costs, and increases in employee related costs.








14
 Index








Performance
Measures





The
following table compares selected commonly used measures of bank performance for
the three month periods ended March 31, 2010 and 2009:


Three
      months ended March 31,2010
              
              
              2009Annualized
      return on average assets
              
              
              0.16
              %
              
              
              1.00
              %Annualized
      return on average equity
              
              
              1.57
              %
              
              
              9.69
              %Net
      interest margin (1)
              
              
              4.23
              %
              
              
              4.66
              %Efficiency
      Ratio (2)
              
              
              71.02
              %
              
              
              61.87
              %Earnings
      per share (3)
              
              $
              0.12
              
              
              $
              0.72




(1)
            On
      a fully taxable equivalent basis and including loan origination
      fees.


(2)
            Non-interest
      expenses for the period indicated divided by the sum of net interest
      income and non-interest income for the period
  indicated.


(3)
            Per
      weighted average shares of common stock outstanding for the period
      indicated.





Securities
Portfolio





The
Company's securities portfolio serves several purposes.  Portions of
the portfolio are used to secure certain public and trust
deposits.  The remaining portfolio is held as investments or used to
assist the Company in liquidity and asset liability management.  Total
securities, including restricted securities, represented 7.37% of total assets
and 73.47% of total shareholders’ equity at March 31, 2010.





The
securities portfolio typically will consist of three
components:  securities held to maturity, securities available for
sale and restricted securities.  Securities are classified as held to
maturity when management has the intent and the Company has the ability at the
time of purchase to hold the securities to maturity.  Held to maturity
securities are carried at cost, adjusted for amortization of premiums and
accretion of discounts. Securities to be held for indefinite periods of time are
classified as available for sale and accounted for at market
value.  Securities available for sale include securities that may be
sold in response to changes in market interest rates, changes in the security's
prepayment risk, increases in loan demand, general liquidity needs and other
similar factors.  Restricted securities are those investments
purchased as a requirement of membership in certain governmental lending
institutions and cannot be transferred without the issuer’s
permission.  The Company's purchases of securities have generally been
limited to securities of high credit quality with short to medium term
maturities.





The
Company identifies at the time of acquisition those securities that are
available for sale. These securities are valued at their market value with any
difference in market value and amortized cost shown as an adjustment in
stockholders' equity.  Changes in market values of securities which
are considered temporary changes due to changes in the market rate of interest
are reflected as changes in other comprehensive income, net of the deferred tax
effect.  Any changes in market values of securities deemed by
management to be attributable to reasons other than changes in market rates of
interest would be recorded through results of operations.   As of
March 31, 2010, management determined that all securities with fair values
less   than the amortized cost, are related to increases in the
current interest rates for similar issues of securities, and that no other than
temporary impairment for any securities in the portfolio exists because of
downgrades of the securities or as a result of a change in the financial
condition of any of the issuers. A summary of the length of time of unrealized
losses for all securities held at March 31, 2010 can be found in Note Five to
the financial statements. Management reviews all securities with unrealized
losses, and all securities in the portfolio on a regular basis to determine
whether the potential for other than temporary impairment exists.





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,
Tucker, and northern Pendleton counties in West Virginia, Frederick County,
Virginia and Garrett County, Maryland.  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.





15
 Index








Credit Quality and Allowance
for Loan Losses





Non-performing
loans increased 23.35% from December 31, 2009 to March 31, 2010 primarily as a
result of increased non-accrual loans.  Non-accrual loans have
increased as a result of the continued deterioration of loan performance due to
the current economic conditions.  As a result of the continuing
decline of property values, management has chosen to be more conservative in it
evaluation of potential non-performing loans.  Borrowers of
restructured credits are performing in accordance with the revised terms of
their contracts.  Based on Management’s analysis, these loans are well
secured and no losses are anticipated; therefore, no additional allowance was
provided for these restructured credits.    Non-performing
loans represented as a percentage of total loans increased to 2.44% during the
first three months of 2010 primarily due to the increase in non-accrual loans
mentioned above.  The allowance for loan losses as a percentage of
total loans increased from the December 31, 2009 level of 1.20% to
1.35%.  As noted in Note Three to the unaudited consolidated financial
statements, the carrying value of impaired loans increased from $3.4 million at
December 31, 2009 to $5.0 million at March 31, 2010.





Each of
the Company’s banking subsidiaries determines the adequacy of its allowance for
loan losses independently using the same allowance for loan loss
methodology.  The allowance is calculated quarterly and 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 elsewhere in the calculation.  Although the loan portfolios
of the two banks are similar to each other, some differences exist which result
in divergent risk patterns and different historical charge-off rates amongst the
functional areas of the banks’ loan portfolios.  Each bank pays
particular attention to the individual loan performance, collateral values,
borrower financial condition and economic conditions.  A committee,
with representatives from both subsidiary banks, meets to discuss the overall
economic conditions that impact both subsidiary banks in the same
fashion.





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.  Impaired loans and their resulting valuation allowance
are disclosed in Note Three to the Company’s unaudited consolidated financial
statements.  The second step is to identify loans above a certain
threshold which are problem loans due to the borrower’s 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 subjective and actual losses may be greater or less than the
current amount of the allowance.  However, Management believes the
current level of the allowance for loan losses represents a fair assessment of
the losses inherent in the loan portfolio.





The
following table illustrates certain ratios related to quality of the Company’s
loan portfolio:





March 31, 2010
              
              
              December 31, 2009Allowance
      for loan losses as a percentage of gross loans
              
              
              1.35
              %
              
              
              1.20
              %Non
      performing loans as a percentage of gross loans
              
              
              2.44
              %
              
              
              1.97
              %Ratio
      of allowance for loan losses to non-performing loans
              
              
              0.55
              
              
              
              0.61


Non-performing
loans include non-accrual loans, loans 90 days or more past due and still
accruing interest and restructured loans.  Non-accrual loans are loans
on which interest accruals have been suspended.  Loans are typically
placed on non-accrual status once they have reached certain delinquency status,
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.  Restructured loans are loans on which the original interest
rate or repayment terms have been changed due to financial hardship of the
borrower.  The following table summarizes the Company’s non-performing
loans at March 31, 2010 and December 31, 2009 (in thousands of
dollars):





March
      31, 2010
              
              
              December
      31, 2009Non-accrual
      loans
              
              $
              6,019
              
              
              $
              2,567Loans
      past due 90 days and still accruing interest
              
              
              681
              
              
              
              2,192Restructured
      Loans
              
              
              1,435
              
              
              
              1,836Total
      non-performing loans
              
              $
              8,135
              
              
              $
              6,595


16
 Index








The
following table summarizes the Company’s net charge-offs by loan type for the
three month periods ended March 31, 2010 and 2009 (in thousands of
dollars):




2010
              
              
              2009Charge-offsCommercial
              
              $
              (154
              )
              
              $
              (98
              )Mortgage
      and construction
              
              
              (313
              )
              
              
              (136
              )Consumer
              
              
              (227
              )
              
              
              (204
              )Total
      Charge-offs
              
              
              (694
              )
              
              
              (438
              )RecoveriesCommercial
              
              
              0
              
              
              
              3Mortgage
              
              
              0
              
              
              
              0Consumer
              
              
              93
              
              
              
              62Total
      Recoveries
              
              
              93
              
              
              
              65Total
      Net Charge-offs
              
              $
              (601
              )
              
              $
              (373
              )


Management
believes that the allowance is to be taken as a whole, and the allocation
between loan types is an estimation of potential losses within each type given
information known at the time.  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, 2010 and December 31, 2009 (in
thousands of dollars):





March
      31, 2010
              
              
              December
      31, 2009Amount
              
              
              Percent
      of Loans
              
              
              Amount
              
              
              Percent
      of LoansLoan TypeCommercial-Mortgage
              
              $
              1,863
              
              
              
              39
              %
              
              $
              1,314
              
              
              
              39
              %Commercial-Other
              
              
              349
              
              
              
              5
              %
              
              
              340
              
              
              
              4
              %Consumer-Mortgage
              
              
              1,013
              
              
              
              45
              %
              
              
              1,051
              
              
              
              45
              %Consumer-Other
              
              
              1,287
              
              
              
              11
              %
              
              
              1,316
              
              
              
              12
              %Totals
              
              $
              4,512
              
              
              
              100
              %
              
              $
              4,021
              
              
              
              100
              %


Because
of its large impact on the local economy, management continues to monitor 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
addition, multiple manufacturers of household cabinetry are large employers in
the Company’s primary trade area. Due to the downturn in the housing market
nationally, there have been indications that the demand for cabinetry has
decreased, impacting the performance of these manufacturers. Because of the
impact on the local economy, management has begun to monitor the performance of
this industry as it relates to local employment trends. In recent periods, the
Company’s loan portfolio has also begun to reflect a concentration in loans
collateralized by heavy equipment, particularly in the trucking, mining and
timber industries. Because of the impact of the slowing economic conditions on
the housing market, the timber sector has experienced a recent downturn. While
the Company has experienced some losses related to the downturn in this
industry, no material losses related to foreclosures of loans collateralized by
assets typical to the timber harvest industry have occurred.





Net Interest
Income





The
Company’s net interest income, on a fully taxable equivalent basis, decreased
4.80% for the first three months of 2010 as compared to the same period in 2009
as average balances of earning assets increased 4.79% as compared to a 6.65%
increase in the average balances of interest bearing liabilities.




Decreases
during recent years in the target rate for federal funds sold have caused
overall rates on both interest bearing liabilities and earning assets to
decrease. These effects are still being seen in the Company’s net interest
income as variable loans reprice and older balances of other earning assets and
interest bearing liabilities mature and are replaced with new assets and
liabilities at lower rates.  Rates paid on interest bearing
liabilities have decreased but the decreases have not been as large as the
decreases in rates experienced with loans.






17
 Index








Also, the
Company has recently placed larger balances of loans into non-accrual status
than have been placed there historically. This, combined with increases in
balances of Other Real Estate Owned due to foreclosures, has had a negative
impact on interest income.





The table
below illustrates the effects on net interest income, on a fully taxable
equivalent basis, and for the first three months of each year, of changes in
average volumes of interest bearing liabilities and earning assets from 2009 to
2010 and changes in average rates on interest bearing liabilities and earning
assets from 2009 to 2010 (in thousands of dollars):





EFFECT
      OF RATE-VOLUME CHANGES ON NET INTEREST INCOMEIncrease
      (Decrease) Three Months Ended March 31, 2010 Compared to Three Months
      Ended March 31, 2009Due
      to change in:Average Volume
              
              
              Average Rate
              
              
              Total ChangeInterest
      IncomeLoans
              
              $
              82
              
              
              $
              (490
              )
              
              $
              (408
              )Federal
      funds sold
              
              
              1
              
              
              
              (1
              )
              
              
              0Interest
      bearing deposits
              
              
              2
              
              
              
              (2
              )
              
              
              0Taxable
      investment securities
              
              
              41
              
              
              
              (85
              )
              
              
              (44
              )Nontaxable
      investment securities
              
              
              8
              
              
              
              (10
              )
              
              
              (2
              )Total
      Interest Income
              
              $
              134
              
              
              $
              (588
              )
              
              $
              (454
              )Interest
      ExpenseDemand
      deposits
              
              
              0
              
              
              
              (6
              )
              
              
              (6
              )Savings
      deposits
              
              
              3
              
              
              
              (12
              )
              
              
              (9
              )Time
      deposits
              
              
              150
              
              
              
              (367
              )
              
              
              (217
              )Borrowings
              
              
              (71
              )
              
              
              49
              
              
              
              (22
              )Total
      Interest Expense
              
              
              82
              
              
              
              (336
              )
              
              
              (254
              )Net
      Interest Income
              
              $
              52
              
              
              $
              (252
              )
              
              $
              (200
              )




18
 Index








The table
below sets forth an analysis of net interest income for the three month periods
ended March 31, 2010 and 2009 (Average balances and interest/expense shown in
thousands of dollars):




2010
              
              2009Average
              
              
              Income/
              
              
              
              
              
              Average
              
              
              Income/Balance
              
              
              Expense
              
              
              Rate
              
              
              Balance
              
              
              Expense
              
              
              RateEarning
      AssetsLoans
              
              $
              334,232
              
              
              $
              5,482
              
              
              
              6.56
              %
              
              $
              329,207
              
              
              $
              5,890
              
              
              
              7.16
              %Taxable
      investment securities
              
              
              23,684
              
              
              
              148
              
              
              
              2.51
              %
              
              
              17,092
              
              
              
              192
              
              
              
              4.49
              %Non-taxable
      investment securities
              
              
              3,871
              
              
              
              53
              
              
              
              5.49
              %
              
              
              3,255
              
              
              
              55
              
              
              
              6.76
              %Interest
      bearing deposits
              
              
              2,144
              
              
              
              3
              
              
              
              0.48
              %
              
              
              547
              
              
              
              3
              
              
              
              2.19
              %Federal
      funds sold
              
              
              11,515
              
              
              
              5
              
              
              
              0.18
              %
              
              
              8,192
              
              
              
              5
              
              
              
              0.24
              %Total
      Earning Assets
              
              
              375,446
              
              
              
              5,691
              
              
              
              6.06
              %
              
              
              358,293
              
              
              
              6,145
              
              
              
              6.86
              %Allowance
      for loan losses
              
              
              (3,954
              )
              
              
              
              
              
              
              
              
              
              
              (3,686
              )Other
      non-earning assets
              
              
              38,143
              
              
              
              
              
              
              
              
              
              
              
              31,993Total
      Assets
              
              $
              409,635
              
              
              
              
              
              
              
              
              
              
              $
              386,600Interest
      Bearing LiabilitiesDemand
      deposits
              
              $
              23,000
              
              
              $
              7
              
              
              
              0.12
              %
              
              $
              22,463
              
              
              $
              13
              
              
              
              0.23
              %Savings
      deposits
              
              
              51,668
              
              
              
              46
              
              
              
              0.36
              %
              
              
              47,840
              
              
              
              55
              
              
              
              0.46
              %Time
      deposits
              
              
              224,235
              
              
              
              1,553
              
              
              
              2.77
              %
              
              
              202,579
              
              
              
              1,770
              
              
              
              3.49
              %Overnight
      and other short-tem debt
              
              
              0
              
              
              
              0
              
              
              
              
              
              
              
              5,038
              
              
              
              5
              
              
              
              0.40
              %Long-term
      debt
              
              
              10,813
              
              
              
              115
              
              
              
              4.26
              %
              
              
              12,486
              
              
              
              132
              
              
              
              4.23
              %Total
      Interest Bearing Liabilities
              
              
              309,716
              
              
              
              1,721
              
              
              
              2.22
              %
              
              
              290,406
              
              
              
              1,975
              
              
              
              2.72
              %Demand
      deposits
              
              
              52,484
              
              
              
              
              
              
              
              
              
              
              
              49,070Other
      liabilities
              
              
              6,439
              
              
              
              
              
              
              
              
              
              
              
              7,385Stockholders’
      equity
              
              
              40,996
              
              
              
              
              
              
              
              
              
              
              
              39,739Total
      liabilities and stockholders’ equity
              
              $
              409,635
              
              
              
              
              
              
              
              
              
              
              $
              386,600Net
      Interest Income
              
              
              
              
              
              $
              3,970
              
              
              
              
              
              
              
              
              
              
              $
              4,170Net
      Yield on Earning Assets
              
              
              
              
              
              
              
              
              
              
              4.23
              %
              
              
              
              
              
              
              
              
              
              
              4.66
              %Notes:Yields
      are computed on a taxable equivalent basis using a 37% tax
      rateAverage
      balances are based upon daily balancesIncludes
      loans in non-accrual statusIncome
      on loans includes fees


Non-interest
Income





Non-interest
income increased $18,000, or 3.40%, during the first three months of 2010
compared to the same period in 2009 driven primarily by the shift in income
associated with security transactions.





Service
charges on deposit accounts decreased 2.72%. The largest portion of these
charges is non-sufficient funds fees on non-interest bearing transaction
accounts. The subsidiary banks continued to see decreases in service charges
associated with the program commonly referred to as the “courtesy overdraft”
program.




During
the periods 2004 through the present, the Company’s volume of new installment
loans decreased. These loans are the primary market for credit life and accident
and health insurance. As a result, earnings on the sales of these insurance
policies decreased over this same period as old policies matured but were not
replaced by new policies at the same rate of maturity of the older credit
related policies. There was a slight increase in life insurance investment
income during the first three months of 2010 compared to the same period in 2009
as a result of an adjustment to the income projection for 2010 to be more in
line with prior year’s annual income.






19
 Index





Non-interest
Expense





Non-interest
expense increased 10.69% for the first three months of 2010 as compared to the
same period in 2009.





Changes in salary and
benefits expense





The
following table compares the components of salary and benefits expense for the
three month periods ended March 31, 2010 and 2009 (in thousands of
dollars):





Salary
      and Benefits Expense2010
              
              
              2009
              
              
              Increase
                (Decrease)Employee
      salaries
              
              $
              1,097
              
              
              $
              1,103
              
              
              $
              (6
              )Employee
      benefit insurance
              
              
              271
              
              
              
              227
              
              
              
              44Payroll
      taxes
              
              
              101
              
              
              
              103
              
              
              
              (2
              )Post
      retirement plans
              
              
              251
              
              
              
              228
              
              
              
              23Total
              
              $
              1,720
              
              
              $
              1,661
              
              
              $
              59


The table
below illustrates the change in salary expense for the first three months of
2010 as compared to the same period in 2009 occurring because of increases in
average pay per employee and increases in the average number of full time
employees (in thousands of dollars):





AmountChanges
      due to adjustment in average salary per full time equivalent
      employee
              
              $
              3Changes
      due to fluctuations in the average full time equivalent employees for the
      periods
              
              
              (9
              )Total
      decrease in salary expense
              
              $
              (6
              )


Changes in data processing
expense





Data
processing expense increased 60.36%. During 2009, the Company completed the
installation of its new core data processing system. During the negotiations for
the new system, the vendor provided incentives in the form of credits for the
Company’s then current contractual arrangements. This contributed significantly
to the decline in data processing costs during 2009. The expiration of this
monthly credit at the end of November 2009 coupled with a change in
classification of ATM processing fees resulted in the increase.  Prior
to the implementation of the new system all ATM processing costs were classified
as other non-interest expenses.





Changes in occupancy and
equipment expense





The
following table illustrates the components of occupancy and equipment expense
for the three month periods ended March 31, 2010 and 2009 (in thousands of
dollars):





2010
              
              
              2009
              
              
              Increase
                (Decrease)Depreciation
      of buildings and equipment
              
              $
              183
              
              
              $
              155
              
              
              $
              28Maintenance
      expense on buildings and equipment
              
              
              102
              
              
              
              97
              
              
              
              5Utilities
      expense
              
              
              40
              
              
              
              36
              
              
              
              4Real
      estate and personal property tax
              
              
              21
              
              
              
              20
              
              
              
              1Other
      expense related to occupancy and equipment
              
              
              22
              
              
              
              21
              
              
              
              1Total
      occupancy and equipment expense
              
              $
              368
              
              
              $
              329
              
              
              $
              39





The
increases in depreciation costs are associated with the aforementioned
investment in the new core data processing system implemented in November
2009.







20
 Index








Changes in miscellaneous
non-interest expense





Other
non-interest expense increased $92,000 or 18.2% compared to the comparable
period in 2009.  FDIC premium increases were the main driver for this
increase.  During the third quarter of 2009, the FDIC premiums for the
Company’s subsidiary banks increased as a result of the recent economic
conditions requiring the use of the FDIC reserve funds.  During the
first three months of 2010, the subsidiary banks’ FDIC premiums increased 195%
or $107,000.  The additional increases in miscellaneous and other
costs were associated with professional fees.  These costs were
somewhat offset by reduced cost associated with the subsidiary banks’ ATM
processing services that are now being included in the data processing costs
category.





The table
below illustrates components of other non-interest expense for the three month
periods ended March 31, 2010 and 2009 (in thousands of dollars). Significant
individual components of other non-interest expense are itemized.




2010
              
              
              2009
              
              
              Increase
                (Decrease)Office
      supplies and postage & freight expense
              
              $
              121
              
              
              $
              122
              
              
              $
              (1
              )FDIC
      Premiums
              
              
              162
              
              
              
              55
              
              
              
              107ATM
      expense
              
              
              (12
              )
              
              
              53
              
              
              
              (65
              )Amortization
      of intangible assets
              
              
              49
              
              
              
              49
              
              
              
              0Advertising
      and marketing expense
              
              
              37
              
              
              
              38
              
              
              
              (1
              )Miscellaneous
      components of other non interest expense
              
              
              201
              
              
              
              188
              
              
              
              13Total
              
              $
              558
              
              
              $
              505
              
              
              $
              53


Borrowed
Funds





The
Company borrows funds from the Federal Home Loan Bank (“FHLB”) to reduce market
rate risks or to provide operating liquidity.  Management typically
will initiate these borrowings in response to a specific need for managing
market risks or for a specific liquidity need and will attempt to match features
of these borrowings to best suit the specific need. Therefore, the borrowings on
the Company’s balance sheet as of March 31, 2010 and throughout the periods
ended March  31, 2010 and December 31, 2009 have varying features of
amortization or single payment with periodic, regular interest payment and also
have interest rates which vary based on the terms and on the features of the
specific borrowing.








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 with decreases in liquid assets
such as balances of federal funds sold and balances of securities. The Company
also utilizes existing borrowing facilities for additional levels of operating
liquidity. In choosing which sources of operating liquidity to utilize,
management evaluates the implications of each liquidity source and its impact on
profitability, balance sheet stability and potential future liquidity
needs.





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 March 31,
2010, the subsidiary banks could pay dividends to Highlands Bankshares, Inc. of
approximately $2,349,000 without permission of the regulatory
authorities.








21
 Index








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, 2010, 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, 2010 and December 31,
2009:




March
      31, 2010
              
              
              December
      31, 2009Actual
              
              
              Regulatory
              
              
              Actual
              
              
              RegulatoryRatio
              
              
              Minimum
              
              
              Ratio
              
              
              MinimumTotal Risk Based Capital
    RatioHighlands
      Bankshares
              
              
              14.28
              %
              
              
              8.00
              %
              
              
              14.33
              %
              
              
              8.00
              %Capon
      Valley Bank
              
              
              12.75
              %
              
              
              8.00
              %
              
              
              12.86
              %
              
              
              8.00
              %The
      Grant County Bank
              
              
              14.18
              %
              
              
              8.00
              %
              
              
              14.12
              %
              
              
              8.00
              %Tier 1 Leverage RatioHighlands
      Bankshares
              
              
              9.76
              %
              
              
              4.00
              %
              
              
              9.81
              %
              
              
              4.00
              %Capon
      Valley Bank
              
              
              8.24
              %
              
              
              4.00
              %
              
              
              8.38
              %
              
              
              4.00
              %The
      Grant County Bank
              
              
              9.95
              %
              
              
              4.00
              %
              
              
              9.91
              %
              
              
              4.00
              %Tier 1 Risk Based Capital
    RatioHighlands
      Bankshares
              
              
              13.03
              %
              
              
              4.00
              %
              
              
              13.08
              %
              
              
              4.00
              %Capon
      Valley Bank
              
              
              11.49
              %
              
              
              4.00
              %
              
              
              11.60
              %
              
              
              4.00
              %The
      Grant County Bank
              
              
              12.93
              %
              
              
              4.00
              %
              
              
              12.89
              %
              
              
              4.00
              %


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 non-interest expenses may be more directly affected by
inflation.





Item
3.              Quantitative and Qualitative
Disclosures About Market
Risk





Not
required for smaller reporting companies.





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, 2010. 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, 2010. 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.








22
 Index







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.








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.





Item
1A.           Risk
Factors





Not
required for smaller reporting companies.





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





None





Item3.              Defaults
Upon Senior Securities





None





Item
4.              (Removed
and Reserved)





None





Item
5.              Other
Information





None





Item
6.              Exhibits





EXHIBIT
      INDEXExhibit
              Number
            Description3(i)
            Articles
      of Incorporation of Highlands Bankshares, Inc., as restated, are hereby
      incorporated by reference to Exhibit 3(i) to Highlands Bankshares Inc.’s
      Form 10-Q filed November 13, 2007.3(ii)
            Amended
      Bylaws of Highlands Bankshares, Inc. are incorporated by reference to
      Exhibit 3(ii) to Highlands Bankshares Inc.’s Report on Form 8-K filed
      January 9, 2008.31.1
            Certification
      of Chief Executive Officer Pursuant to section 302 of the
      Sarbanes-Oxley  Act  of
              2002
      Chapter 63, Title 18 USC Section 1350 (A) and (B).31.2
            Certification
      of Principal Financial Officer  Pursuant to section 302 of the
      Sarbanes-Oxley  Act of
              2002
      Chapter 63, Title 18 USC Section 1350 (A) and (B).32.1
            Statement
      of Chief Executive Officer Pursuant to 18  U.S.C.
      §1350.32.2
            Statement
      of Principal Financial Officer Pursuant to 18 U.S.C.
  §1350.








23
 Index








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/ Jeffrey B. ReedyJeffrey
      B. ReedyChief
      Financial OfficerMay
      13, 2010










24