**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      DC 20549**








**FORM
      10-Q**





(Mark
      One)


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


For
      the
      quarterly period ended June 30, 2006





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





Commission
      File Number: 0-16761





**HIGHLANDS
      BANKSHARES, INC.**


(Exact
      name of registrant as specified in its charter)





West
                Virginia
            55-0650793(State
                or Other Jurisdiction of Incorporation
              or
                Organization)
            (IRS
                Employer Idendification No.)





P.O.
      Box
      929


Petersburg,
      WV 26847


(Address
      of Principal Executive Offices, Including Zip Code)





304-257-4111


(Registrant’s
      Telephone Number, Including Area Code)





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





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





Large
                Accelerated Filero
            Accelerated
                Filero
            Non
                Accelerated filerý





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





Indicate
      the number of shares outstanding of each of the issuer’s classes of common stock
      as of the latest practicable date. As of July 31, 2006: 1,436,874 shares of
      Common Stock, $5 Par Value








HIGHLANDS
                BANKSHARES, INC.Quarterly
                Report on Form 10Q For The Period Ended June 30,2006INDEXPagePART
                I
            FINANCIAL
                INFORMATIONItem
                1.
            Financial
                StatementsUnaudited
                Consolidated Statements of
                IncomeSix
                Months Ended June 30, 2006 and 2005
            2Unaudited
                Consolidated Statements of IncomeThree
                Months Ended June 30, 2006 and 2005
            3Unaudited
                Consolidated Balance Sheet for June 30,
                2006and
                Audited Consolidated Balance Sheet for December 31,
                2005
            4Unaudited
                Consolidated Statements of Changes in
                Stockholders’Equity
                for the Six Months Ended June 30, 2006 and
                2005
            5Unaudited
                Consolidated Statements of Cash Flows for the
                SixMonths
                Ended June 30, 2006 and 2005
            6Notes
                to Consolidated Financial
                Statements
            7Item
                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
            22Item
                1A.
            Risk
                Factors
            23Item
                2.
            Unregistered
                Sales of Equity Securities and Use of
                Proceeds
            23Item
                3.
            Defaults
                Upon Senior Securites
            23Item
                4.
            Submission
                of Matters to a Vote of Security
                Holders
            23Item
                5.
            Other
                Information
            23Item
                6.
            Exhibits
            23SIGNATURES
            24





Page
      2


**Part
      I.**


**Item
      1. Financial Statements**





HIGHLANDS
                BANKSHARES, INC.CONSOLIDATED
                STATEMENTS OF INCOME(In
                Thousands of Dollars, Except Per Share Data)Six
                Months Ended June 30,2006
            
            2005(unaudited)
            
            (unaudited)Interest
                IncomeInterest
                and fees on loans
            
            $
            10,450
            
            $
            8,915Interest
                on federal funds sold
            
            
            214
            
            
            101Interest
                on deposits in other banks
            
            
            22
            
            
            11Interest
                and dividends on securities
            
            
            589
            
            
            371Total
                Interest Income
            
            
            11,275
            
            
            9,398Interest
                ExpenseInterest
                on deposits
            
            
            3,170
            
            
            2,347Interest
                on borrowed money
            
            
            354
            
            
            309Total
                Interest Expense
            
            
            3,524
            
            
            2,656Net
                Interest Income
            
            
            7,751
            
            
            6,742Provision
                for Loan Losses
            
            
            353
            
            
            435Net
                Interest Income After Provision for Loan Losses
            
            
            7,398
            
            
            6,307Noninterest
                IncomeService
                Charges
            
            
            576
            
            
            403Investment
                in insurance contracts
            
            
            284
            
            
            121Other
                noninterest income
            
            
            227
            
            
            297Total
                Noninterest Income
            
            
            1,087
            
            
            821Noninterest
                ExpenseSalaries
                and employee benefits
            
            
            2,815
            
            
            2,465Equipment
                and occupancy expense
            
            
            649
            
            
            606Data
                processing expense
            
            
            372
            
            
            305Directors
                fees
            
            
            197
            
            
            174Legal
                and professional fees
            
            
            238
            
            
            168Other
                noninterest expense
            
            
            885
            
            
            733Total
                Noninterest Expense
            
            
            5,156
            
            
            4,451Income
                Before Provision For Income Taxes
            
            
            3,329
            
            
            2,677Provision
                for Income Taxes
            
            
            1,124
            
            
            910Net
                Income
            
            $
            2,205
            
            $
            1,767Per
                Share DataNet
                Income
            
            $
            1.53
            
            $
            1.23Cash
                Dividends
            
            $
            .46
            
            $
            .40Weighted
                Average Common Shares Outstanding
            
            
            1,436,874
            
            
            1,436,874The
                accompanying notes are an integral part of these
                statements.





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          3







HIGHLANDS
                BANKSHARES, INC.CONSOLIDATED
                STATEMENTS OF INCOME(In
                Thousands of Dollars, Except Per Share Data)Three
                Months Ended June 30,2006
            
            2005(unaudited)
            
            (unaudited)Interest
                IncomeInterest
                and fees on loans
            
            $
            5,316
            
            $
            4,526Interest
                on federal funds sold
            
            
            106
            
            
            72Interest
                on deposits in other banks
            
            
            10
            
            
            6Interest
                and dividends on securities
            
            
            303
            
            
            179Total
                Interest Income
            
            
            5,735
            
            
            4,783Interest
                ExpenseInterest
                on deposits
            
            
            1,650
            
            
            1,232Interest
                on borrowed money
            
            
            181
            
            
            160Total
                Interest Expense
            
            
            1,831
            
            
            1,392Net
                Interest Income
            
            
            3,904
            
            
            3,391Provision
                for Loan Losses
            
            
            176
            
            
            210Net
                Interest Income After Provision for Loan Losses
            
            
            3,728
            
            
            3,181Noninterest
                IncomeService
                Charges
            
            
            349
            
            
            230Investment
                in insurance contracts
            
            
            215
            
            
            54Other
                noninterest income
            
            
            83
            
            
            167Total
                Noninterest Income
            
            
            647
            
            
            451Noninterest
                ExpenseSalaries
                and employee benefits
            
            
            1,400
            
            
            1,240Equipment
                and occupancy expense
            
            
            325
            
            
            307Data
                processing expense
            
            
            194
            
            
            152Directors
                fees
            
            
            97
            
            
            89Legal
                and professional fees
            
            
            137
            
            
            86Other
                noninterest expense
            
            
            462
            
            
            361Total
                Noninterest Expense
            
            
            2,615
            
            
            2,235Income
                Before Provision For Income Taxes
            
            
            1,760
            
            
            1,397Provision
                for Income Taxes
            
            
            559
            
            
            479Net
                Income
            
            $
            1,201
            
            $
            918Per
                Share DataNet
                Income
            
            $
            .84
            
            $
            .64Cash
                Dividends
            
            $
            .23
            
            $
            .20Weighted
                Average Common Shares Outstanding
            
            
            1,436,874
            
            
            1,436,874The
                accompanying notes are an integral part of these
                statements.





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          4




HIGHLANDS
                BANKSHARES, INC.CONSOLIDATED
                BALANCE SHEETS(In
                Thousands of Dollars)June
                30, 2006
            
            December
                31, 2005(unaudited)
            
            (audited)ASSETSCash
                and due from banks—noninterest bearing
            
            $
            8,564
            
            $
            8,850Deposits
                in other banks—interest bearing
            
            
            1,719
            
            
            963Federal
                funds sold
            
            
            5,879
            
            
            10,808Securities
                held to maturity
            
            
            491
            
            
            491Securities
                available for sale, at market value
            
            
            26,751
            
            
            27,130Restricted
                investments
            
            
            1,457
            
            
            1,250Loans
            
            
            273,350
            
            
            270,020Allowance
                for loan losses
            
            
            (3,293
            )
            
            (3,129
            )Bank
                premises and equipment, net of depreciation
            
            
            7,726
            
            
            7,684Interest
                receivable
            
            
            1,944
            
            
            1,818Investment
                in life insurance contracts
            
            
            5,957
            
            
            6,396Goodwill
            
            
            1,534
            
            
            1,534Other
                intangible assets
            
            
            1,586
            
            
            1,674Other
                Assets
            
            
            2,269
            
            
            2,084Total
                Assets
            
            $
            335,934
            
            $
            337,573LIABILITIESNoninterest
                bearing deposits
            
            $
            48,150
            
            $
            47,753Savings
                and interest bearing demand deposits
            
            
            75,255
            
            
            80,597Time
                deposits
            
            
            157,372
            
            
            156,342Total
                Deposits
            
            
            280,777
            
            
            284,692Long
                term debt
            
            
            15,781
            
            
            15,063Accrued
                expenses and other liabilities
            
            
            3,921
            
            
            3,826Total
                Liabilities
            
            
            300,479
            
            
            303,581STOCKHOLDERS’
                EQUITYCommon
                Stock, $5 par value, 3,000,000 shares authorized, 1,436,874 shares
                issued
                and outstanding
            
            
            7,184
            
            
            7,184Surplus
            
            
            1,662
            
            
            1,662Retained
                Earnings
            
            
            27,196
            
            
            25,651Other
                accumulated comprehensive loss
            
            
            (587
            )
            
            (505
            )Total
                Stockholders’ Equity
            
            
            35,455
            
            
            33,992Total
                Liabilities and Stockholders’ Equity
            
            $
            335,934
            
            $
            337,573The
                accompanying notes are an integral part of these
                statements.





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          5




HIGHLANDS
                BANKSHARES, INC.CONSOLIDATED
                STATEMENTS OF CHANGES IN STOCKHOLDERS’
                EQUITY(In
                Thousands of Dollars)CommonStock
            
            Surplus
            
            RetainedEarnings
            
            Accumulated
              Other
              Comprehensive
              Income
            
            TotalBalances
                at December 31, 2005
            
            $
            7,184
            
            $
            1,662
            
            $
            25,651
            
            $
            (505
            )
            $
            33,992Net
                Income
            
            
            
            
            
            
            
            
            2,205
            
            
            
            
            
            2,205Net
                change in unrealized appreciation on investment securities available
                for
                sale, net of taxes
            
            
            
            
            
            
            
            
            
            
            
            (82
            )
            
            (82
            )Total
                Comprehensive Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            2,123Dividends
                Paid
            
            
            
            
            
            
            
            
            (660
            )
            
            
            
            
            (660
            )Balances
                June 30, 2006
            
            $
            7,184
            
            $
            1,662
            
            $
            27,196
            
            $
            (587
            )
            $
            35,455








CommonStock
            
            Surplus
            
            RetainedEarnings
            
            Accumulated
              Other
              Comprehensive
              Income
            
            TotalBalances
                at December 31, 2004
            
            $
            7,184
            
            $
            1,662
            
            $
            23,028
            
            $
            (219
            )
            $
            31,655Net
                Income
            
            
            
            
            
            
            
            
            1,767
            
            
            
            
            
            1,767Net
                change in unrealized appreciation on investment securities available
                for
                sale, net of taxes
            
            
            
            
            
            
            
            
            
            
            
            (23
            )
            
            (23
            )Total
                Comprehensive Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,744Dividends
                Paid
            
            
            
            
            
            
            
            
            (575
            )
            
            
            
            
            (575
            )Balances
                June 30, 2005
            
            $
            7,184
            
            $
            1,662
            
            $
            24,220
            
            $
            (242
            )
            $
            32,824The
                accompanying notes are an integral part of these
                statements.













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          6




HIGHLANDS
                BANKSHARES, INC.CONSOLIDATED
                STATEMENTS OF CASH FLOWS(In
                Thousands of Dollars)Six
                Months Ended June 30,2006
            
            2005(unaudited)
            
            (unaudited)Cash
                Flows From Operating ActivitiesNet
                Income
            
            $
            2,205
            
            $
            1,767Adjustments
                to reconcile net income to netcash
                provided by operating activitiesDepreciation
            
            
            331
            
            
            330Increase
                in cash value of life insurance contracts
            
            
            (116
            )
            
            (121
            )Net
                amortization of securities
            
            
            (11
            )
            
            40Provision
                for loan losses
            
            
            353
            
            
            434Amortization
                of intangibles
            
            
            88
            
            
            5Decrease
                (increase) in interest receivable
            
            
            (126
            )
            
            (80
            )Decrease
                (increase) in other assets
            
            
            (185
            )
            
            203Increase
                in accrued expenses
            
            
            95
            
            
            529Net
                Cash Provided by Operating Activities
            
            
            2,634
            
            
            3,107Cash
                Flows From Investing ActivitiesIncrease
                (decrease) in federal funds sold
            
            
            4,929
            
            
            (6,625
            )Proceeds
                from maturities of securities available for sale
            
            
            5,714
            
            
            5,029Purchase
                of securities available for sale
            
            
            (5,406
            )
            
            (3,359
            )Proceeds
                from maturities of securities held to maturity
            
            
            
            
            
            471Increase
                in restricted investments
            
            
            (207
            )
            
            (118
            )Net
                change in interest bearing deposits in other banks
            
            
            (756
            )
            
            (712
            )Settlement
                on insurance contract
            
            
            555Purchase
                of property and equipment
            
            
            (373
            )
            
            (65
            )Net
                Change in Loans
            
            
            (3,519
            )
            
            (5,606
            )Net
                Cash Used in Investing Activities
            
            
            937
            
            
            (10,985
            )Cash
                Flows From Financing ActivitiesNet
                change in deposits
            
            
            (3,915
            )
            
            4,184Additional
                long term debt
            
            
            2,300
            
            
            7,700Repayment
                of long term debt
            
            
            (1,582
            )
            
            (238
            )Additional
                short term borrowings
            
            
            0
            
            
            1,500Repayment
                of short term borrowings
            
            
            0
            
            
            (3,500
            )Dividends
                paid in cash
            
            
            (660
            )
            
            (575
            )Net
                Cash Provided by Financing Activities
            
            
            (3,857
            )
            
            9,071Net
                Increase (Decrease) in Cash and Cash Equivalents
            
            
            (286
            )
            
            1,193Cash
                and Cash Equivalents, Beginning of Period
            
            
            8,850
            
            
            6,187Cash
                and Cash Equivalents, End of Period
            
            $
            8,564
            
            $
            7,380Supplemental
                DisclosuresCash
                paid for income taxes
            
            $
            1,186
            
            $
            911Cash
                paid for interest
            
            $
            3,494
            
            $
            2,556The
                accompanying notes are an integral part of these
                statements.





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          7







**HIGHLANDS
      BANKSHARES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





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





The
      consolidated financial statements conform to U. S. generally accepted accounting
      principles and to general industry practices. In the opinion of management,
      the
      accompanying unaudited consolidated financial statements contain all
      adjustments, consisting solely of normal recurring adjustments, necessary to
      present fairly the financial position as of June 30, 2006 and the results of
      operations for the three and six month periods ended June 30, 2006 and 2005.





The
      results of operations for the three and six month periods ended June 30, 2006
      and 2005 are not necessarily indicative of the results to be expected for the
      full year.





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








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





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





The
      amortized cost and market value of securities held to maturity as of June 30,
      2006 and December 31, 2005 are as follows (in thousands of
      dollars):





June
                30, 2006
            
            December
                31, 2005Amortized
            
            Market
            
            Amortized
            
            MarketCost
            
            Value
            
            Cost
            
            ValueHeld
                to Maturity SecuritiesObligations
                of states and municipalities
            
            $
            491
            
            $
            491
            
            $
            491
            
            $
            491Total
                Held to Maturity Securities
            
            $
            491
            
            $
            491
            
            $
            491
            
            $
            491Available
                For Sale SecuritiesU.S.
                Treasuries and Agencies
            
            $
            18,137
            
            $
            17,975
            
            $
            17,352
            
            $
            17,234Mortgage
                backed securities
            
            
            6,422
            
            
            6,354
            
            
            7,172
            
            
            7,163Obligations
                of states and municipalities
            
            
            2,434
            
            
            2,394
            
            
            2,719
            
            
            2,705Marketable
                equities
            
            
            28
            
            
            28
            
            
            28
            
            
            28Total
                Available For Sale Securities
            
            $
            27,021
            
            $
            26,751
            
            $
            27,271
            
            $
            27,130





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


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          8




**HIGHLANDS
      BANKSHARES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





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





Investments
      in insurance contracts consist of single premium insurance contracts which
      have
      the purpose of providing a rate of return to the Company and of providing life
      insurance and retirement benefits to certain executives.





During
      the second quarter of 2006, the Company received payment in settlement relating
      to two of these policies. This payment related to the death of an insured and
      resulted in a one-time, non-recurring income of $155,000.





A
      summary
      of the changes to the balance of investments in insurance contracts from
      December 31, 2005 to June 30, 2006 is shown in the table below (in thousands
      of
      dollars):





Balance
                December 31, 2005
            
            $
            6,396Increases
                in value of policies
            
            
            116Settlement
                payout
            
            
            (555
            )Balance
                June 30, 2006
            
            $
            5,957











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





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





**NOTE
      5** **LOANS**





A
      summary
      of loans outstanding as of June 30, 2006 and December 31, 2005 is shown in
      the
      table below (in thousands of dollars):





June
                30,
            
            December
                31,2006
            
            2005Loan
                TypeCommercial
            
            $
            58,906
            
            $
            57,908Real
                Estate construction
            
            
            18,278
            
            
            12,201Real
                Estate mortgage
            
            
            152,729
            
            
            153,646Consumer
                installment
            
            
            43,437
            
            
            46,265Total
                Loans
            
            $
            273,350
            
            $
            270,020





In
      addition to loans to fund construction and traditional mortgage loans, portions
      of the loan portfolio identified as commercial are also secured by real estate.
      At June 30, 2006, the total balance of loans in the portfolio secured by real
      estate was $209,288,000. ****





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          9




**HIGHLANDS
      BANKSHARES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





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





A
      summary
      of the transactions in the allowance for loan losses for the six month periods
      ended June 30, 2006 and 2005 is shown below (in thousands of
      dollars):





2006
            
            2005Balance,
                beginning of period
            
            $
            3,129
            
            $
            2,530Provisions
                charged to operations
            
            
            353
            
            
            435Loan
                recoveries
            
            
            129
            
            
            85Loan
                charge-offs
            
            
            (318
            )
            
            (270
            )Balance,
                end of period
            
            $
            3,293
            
            $
            2,780








**NOTE
      7**  **DEPOSITS**





Balances
      of time deposits over $100,000 and of all other time deposits at June 30, 2006
      and December 31, 2005 are shown below (in thousands of dollars):





June
                30,
            
            December
                31,2006
            
            2005Time
                deposits over $100,000
            
            $
            47,051
            
            $
            45,455All
                other time deposits
            
            
            110,321
            
            
            110,887Total
                Time Deposits
            
            $
            157,372
            
            $
            156,342





Interest
      expense for time deposits over $100,000 for the three and six month periods
      ended June 30, 2006 and 2005 is shown below (in thousands of
      dollars):




Six
                Months Ended June 30,
            
            Three
                Months Ended June 30,2006
            2005
            
            2006
            2005$
                886
            $
                637
            
            $
                450
            $
                333





**NOTE
      8**  **DEBT
      INSTRUMENTS**





The
      Company continues to borrow money from the Federal Home Loan Bank of Pittsburgh
      (FHLB) to meet specific  funding
      needs. The interest rates of the notes payable as of June 30, 2006, range from
      3.30% to 6.12%. The weighted average interest rate was 4.51% at June 30, 2006.
      The debt is secured by the general assets of the subsidiary banks.





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





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          10







**HIGHLANDS
      BANKSHARES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**NOTE
      9**  **EMPLOYEE
      BENEFITS**





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





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





The
      Grant
      County Bank is a member of the West Virginia Bankers' Association Retirement
      Plan. Benefits under the plan are based on compensation and years of service
      with 100% vesting after seven years of service. Prior to 2002, the Plan's assets
      were in excess of the projected benefit obligations and thus the Bank was not
      required to make contributions to the Plan in 2003, 2002 or 2001. The bank
      was
      required to make contributions in 2004 and 2005, has made contributions in
      the
      first six months of 2006, and intends to make further contributions, estimated
      at $92,000, during the second half of 2006. The
      Bank
      has recognized liabilities of $414,000 at June 30, 2006 relating to this plan.
      T he
      following table provides the components of the net periodic benefit cost for
      the
      plan for the six month periods ended June 30, 2006 and 2005 (in thousands of
      dollars):





2006
            
            2005Service
                cost
            
            $
            55
            
            $
            61Interest
                cost
            
            
            81
            
            
            90Expected
                return on plan assets
            
            
            (90
            )
            
            (89
            )Amortization
                of unrecognized prior service costs
            
            
            5
            
            
            5Recognized
                net actuarial loss
            
            
            26
            
            
            13Net
                periodic expense
            
            $
            77
            
            $
            80





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





**Introduction**





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





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


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          11







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





**Critical
      Accounting Policies**





The
      Company’s financial statements are prepared in accordance with accounting
      principles generally accepted in the United States (“GAAP”). The financial
      statements contained within these statements are, to a significant extent,
      financial information that is based on measures of the financial effects of
      transactions and events that have already occurred. A variety of factors could
      affect the ultimate value that is obtained either when earning income,
      recognizing an expense, recovering an asset or relieving a liability. In
      addition, GAAP itself may change from one previously acceptable method to
      another method. Although the economics of these transactions would be the same,
      the timing of events that would impact these transactions could change.





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





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





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





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








**Recent
      Accounting Pronouncements**





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


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          12







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





**Forward
      Looking Statements**





Certain
      statements in this report may constitute “forward-looking statements” within the
      meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking
      statements are statements that include projections, predictions, expectations
      or
      beliefs about future events or results or otherwise are not statements of
      historical fact. Such statements are often characterized by the use of qualified
      words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,”
“project,” “anticipate” or other similar words. Although the Company believes
      that its expectations with respect to certain forward-looking statements are
      based upon reasonable assumptions within the bounds of its existing knowledge
      of
      its business and operations, there can be no assurance that actual results,
      performance or achievements of the Company will not differ materially from
      any
      future results, performance or achievements expressed or implied by such
      forward-looking statements. Actual future results and trends may differ
      materially from historical results or those anticipated depending on a variety
      of factors, including, but not limited to, the effects of and changes in:
      general economic conditions, the interest rate environment, legislative and
      regulatory requirements, competitive pressures, new products and delivery
      systems, inflation, changes in the stock and bond markets, technology, downturns
      in the trucking and timber industries, effects of mergers and/or downsizing
      in
      the poultry industry in Hardy County, and consumer spending and savings habits.
      Additionally, actual future results and trends may differ from historical or
      anticipated results to the extent: (1) any significant downturn in certain
      industries, particularly the trucking and timber industries are experienced;
      (2)
      loan demand decreases from prior periods; (3) the Company may make additional
      loan loss provisions due to negative credit quality trends in the future that
      may lead to a deterioration of asset quality; (4) the Company may not continue
      to experience significant recoveries of previously charged-off loans or loans
      resulting in foreclosure; (5) the performance of the coal extraction industry
      in
      the local market may not perform as anticipated; and (6) the Company is unable
      to control costs and expenses as anticipated. The Company does not update any
      forward-looking statements that may be made from time to time by or on behalf
      of
      the Company.





**Overview**





Net
      income year to date in 2006 for Highlands Bankshares increased 24.79% over
      the
      first six months of 2005. Annualized return on average assets for the first
      six
      months of 2006 was 1.32% compared to 1.16% for the same period in 2005 and
      annualized return on average equity year to date 2006 was 12.78% compared to
      11.01% for the first six months of 2005.





Although
      total assets have declined slightly since December 31, 2005, and demand for
      new
      loans appears to have slowed as compared to 2005, net interest margins continue
      to be strong, and net interest income increased 14.97% as compared to the first
      six months of 2005.





Because
      of decreases in the charge-offs of loans, net of recoveries, the provision
      for
      loan losses taken against operations declined $82,000 year to date as compared
      to 2005. In spite of this decrease in provision, the allowance for loan losses
      as a percent of gross loans increased from 1.16% at December 31, 2005 to 1.20%
      at June 30, 2006.





Noninterest
      income increased $266,000 from a year ago as increases in charges to customers
      for overdrafted checks offset a decline in insurance earnings. Noninterest
      expense increased 15.84% in large part due to the operational expansion as
      the
      result of the purchase of two branches during the fourth quarter of 2005.





During
      the second quarter, Highlands received payment relating to the settlement of
      a
      bank owned life insurance policy. This payment resulted in a one-time,
      non-recurring $155,000 impact on income.





Income
      for the second quarter increased 30.83% as compared to the second quarter of
      2005. Return on average assets for the quarter was 1.45% and return on average
      equity 13.85%.





Highlands'
      results of operations are discussed in greater detail following this overview.
      Unless otherwise specifically noted, the underlying causes for changes in the
      results for the quarter ended June 30, 2006 as compared to the same quarter
      in
      2005 are substantially the same as the causes discussed for the six months
      ended
      June 30, 2006 as compared to the six months ended June 30, 2005.





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          13







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




**Impact
      of Acquisition on Operational Results**





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





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





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





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





**Noninterest
      Income**





Noninterest
      income increased 32.40% for the first six months of 2006 as compared to the
      same
      period in 2005.





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





Also
      contributing to the increase in non-interest income was an increase in earnings
      on investments in life insurance contracts brought about by the settlement
      of
      two policies due to the death of an insured (see Note 3).





These
      increases were offset by a decline in insurance earnings. Insurance income
      continues to decrease due to the fact that the volume of new installment loans,
      the primary market for credit life and accident and health insurance, continues
      to fall.


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          14





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





**Net
      Interest Income**





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





Average
      rates earned on earning assets, year to date, increased 63 basis points over
      the
      same period a year ago, while the average rate paid on earning assets increased
      51 basis points.





Because
      of continued high competition for loans, and because loans are typically slower
      to reprice than other earning assets, the average rates earned on loans
      year-to-date increased 58 basis points compared to a 153 basis point increase
      on
      federal funds sold and a 218 basis point increase on the average rates earned
      on
      interest bearing deposits during the same period. Because the Company has
      typically kept a large portion of its investment portfolio with a relatively
      short maturity, rates earned on investments also experienced a significant
      increase as compared to 2005.





As
      competitive rates paid on time deposits have increased and older time deposits
      have matured, the Company’s cost on these deposits has increased 68 basis points
      from the first six months of 2005 to the same period in 2006.





During
      2006, the Company has seen slowing loan growth as compared to the growth
      experienced in the later months of 2004 and into 2005. While average loan
      balances during the first two quarters of 2006 are 8.37% greater than the same
      period in 2005, a significant amount of this increase can be attributed to
      the
      purchase of the National Bank of Davis in the fourth quarter of 2005 (see Note
      4) and loan growth experienced during the second half of 2005. As such, the
      Company has not experienced an extreme need for new funding for loan growth
      during 2006 and has been able, to some degree, to control deposit costs because
      there has been no pressing need to compete heavily for new deposits. A decline
      in deposit balances during the second quarter of 2006 has somewhat depleted
      the
      Company’s balances of liquid funds and should loan demand increase significantly
      during the second half of 2006 and the Company need to fund growing loan
      balances, it may be forced to pay above market rates for deposits with which
      to
      fund loan growth, thereby increasing the cost of funds and decreasing net
      interest margin percents. However, should this occur, the Company expects that
      net interest income would continue to increase, or to remain relatively
      constant, even if margin percents were to decline.





The
      table
      on page 15 sets forth an analysis of net interest income for the six month
      periods ended June 30, 2006 and 2005 (Average balances and interest/expense
      shown in thousands of dollars):





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          15







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





**Net
      Interest Income (continued)**








2006
            
            2005Average
            
            Income/
            
            
            
            Average
            
            Income/Balance
            
            Expense
            
            Rate
            
            Balance
            
            Expense
            
            RateInterest
                IncomeLoans1,2
            
            $
            271,863
            
            $
            10,450
            
            
            7.75
            %
            $
            250,869
            
            $
            8,915
            
            
            7.17
            %Federal
                funds sold
            
            
            9,725
            
            
            214
            
            
            4.44
            %
            
            6,991
            
            
            101
            
            
            2.91
            %Interest
                bearing deposits
            
            
            1,101
            
            
            22
            
            
            4.03
            %
            
            1,197
            
            
            11
            
            
            1.85
            %Taxable
                investment securities
            
            
            26,213
            
            
            531
            
            
            4.09
            %
            
            22,752
            
            
            317
            
            
            2.81
            %Nontaxable
                investment securities3
            
            
            3,157
            
            
            92
            
            
            5.88
            %
            
            2,950
            
            
            85
            
            
            5.81
            %Total
                Earning Assets
            
            
            312,059
            
            
            11,309
            
            
            7.31
            %
            
            284,759
            
            
            9,429
            
            
            6.68
            %Cash
                and cash equivalents
            
            
            7,928
            
            
            
            
            
            
            
            
            6,774Allowance
                for loan losses
            
            
            (3,182
            )
            
            
            
            
            
            
            
            (2,637
            )Insurance
                contracts
            
            
            6,398
            
            
            
            
            
            
            
            
            5,866Nonearning
                assets
            
            
            14,445
            
            
            
            
            
            
            
            
            13,715Total
                Assets
            
            $
            337,648
            
            
            
            
            
            
            
            $
            308,477Interest
                ExpenseInterest
                bearing demand deposits
            
            $
            25,995
            
            $
            111
            
            
            .86
            %
            $
            25,352
            
            $
            86
            
            
            .68
            %Savings
                and money markets
            
            
            52,605
            
            
            263
            
            
            1.01
            %
            
            49,012
            
            
            192
            
            
            .79
            %Time
                deposits
            
            
            156,467
            
            
            2,796
            
            
            3.60
            %
            
            142,889
            
            
            2069
            
            
            2.92
            %Short
                term borrowings
            
            
            0
            
            
            0
            
            
            
            
            
            58
            
            
            1
            
            
            2.40
            %Long
                term debt
            
            
            15,808
            
            
            354
            
            
            4.52
            %
            
            13,941
            
            
            309
            
            
            4.46
            %Total
                Interest Bearing Liabilities
            
            
            250,875
            
            
            3,524
            
            
            2.83
            %
            
            231,252
            
            
            2,657
            
            
            2.32
            %Demand
                deposits
            
            
            47,987
            
            
            
            
            
            
            
            
            39,413Other
                liabilities
            
            
            3,996
            
            
            
            
            
            
            
            
            5,442Stockholders’
                equity
            
            
            34,790
            
            
            
            
            
            
            
            
            32,370Total
                liabilities and stockholders’ equity
            
            $
            337,648
            
            
            
            
            
            
            
            $
            308,477Net
                Interest Income
            
            
            
            
            $
            7,785
            
            
            
            
            
            
            
            $
            6,772Net
                Yield on Earning Assets3
            
            
            
            
            
            
            
            
            5.03
            %
            
            
            
            
            
            
            
            4.80
            %1Balances
                of loans include loans in nonaccrual status2Interest
                income on loans includes fees3Yields
                are on a fully taxable equivalent
                basis





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          16







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





**Net
      Interest Income (continued)**





The
      table
      below sets forth an analysis of net interest income for the three month periods
      ended June 30, 2006 and 2005 (Average balances and interest/expense shown in
      thousands of dollars):





2006
            
            2005Average
            
            Income/
            
            
            
            Average
            
            Income/Balance
            
            Expense
            
            Rate
            
            Balance
            
            Expense
            
            RateInterest
                IncomeLoans1,2
            
            $
            272,374
            
            $
            5,316
            
            
            7.83
            %
            $
            253,413
            
            $
            4,526
            
            
            7.16
            %Federal
                funds sold
            
            
            8,658
            
            
            106
            
            
            4.91
            %
            
            10,429
            
            
            72
            
            
            2.77
            %Interest
                bearing deposits
            
            
            1,157
            
            
            10
            
            
            3.46
            %
            
            1,524
            
            
            6
            
            
            1.58
            %Taxable
                investment securities
            
            
            26,243
            
            
            273
            
            
            4.17
            %
            
            21,816
            
            
            151
            
            
            2.78
            %Nontaxable
                investment securities3
            
            
            3,206
            
            
            47
            
            
            5.88
            %
            
            2,950
            
            
            44
            
            
            5.98
            %Total
                Earning Assets
            
            
            311,638
            
            
            5,752
            
            
            7.40
            %
            
            290,132
            
            
            4,799
            
            
            6.63
            %Cash
                and cash equivalents
            
            
            7,790
            
            
            
            
            
            
            
            
            7,023Allowance
                for loan losses
            
            
            (3,209
            )
            
            
            
            
            
            
            
            (2,684
            )Insurance
                contracts
            
            
            6,378
            
            
            
            
            
            
            
            
            5,893Nonearning
                assets
            
            
            14,219
            
            
            
            
            
            
            
            
            11,010Total
                Assets
            
            $
            336,816
            
            
            
            
            
            
            
            $
            311,374Interest
                ExpenseInterest
                bearing demand deposits
            
            $
            25,897
            
            $
            57
            
            
            .88
            %
            $
            25,366
            
            $
            46
            
            
            .73
            %Savings
                and money markets
            
            
            51,159
            
            
            135
            
            
            1.06
            %
            
            49,102
            
            
            108
            
            
            .88
            %Time
                deposits
            
            
            156,211
            
            
            1,458
            
            
            3.74
            %
            
            142,458
            
            
            1,078
            
            
            3.04
            %Long
                term debt
            
            
            15,859
            
            
            181
            
            
            4.58
            %
            
            14,098
            
            
            160
            
            
            4.55
            %Total
                Interest Bearing Liabilities
            
            
            249,126
            
            
            1,831
            
            
            2.95
            %
            
            231,024
            
            
            1,392
            
            
            2.42
            %Demand
                deposits
            
            
            48,714
            
            
            
            
            
            
            
            
            40,472Other
                liabilities
            
            
            3,821
            
            
            
            
            
            
            
            
            7,212Stockholders’
                equity
            
            
            35,155
            
            
            
            
            
            
            
            
            32,666Total
                liabilities and stockholders’ equity
            
            $
            336,816
            
            
            
            
            
            
            
            $
            311,374Net
                Interest Income
            
            
            
            
            $
            3,921
            
            
            
            
            
            
            
            $
            3,407Net
                Yield on Earning Assets3
            
            
            
            
            
            
            
            
            5.05
            %
            
            
            
            
            
            
            
            4.71
            %1Balances
                of loans include loans in nonaccrual status2Interest
                income on loans includes fees3Yields
                are on a fully taxable equivalent
                basis








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          17





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





**Loan
      Portfolio**





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





**Credit
      Quality and Allowance for Loan Losses**





Non
      performing loans increased 56.26% from December 31, 2005 to June 30, 2006.
      Non
      performing loans represent 1.10% of gross loans at June 30, 2006, and .72%
      of
      gross loans at December 31, 2005.





Loans
      to
      several large commercial customers have become delinquent during 2006, causing
      the increase in non-performing loans. These loans, in most cases, are adequately
      secured by real estate, and should foreclosure become necessary, it is
      management’s opinion that no loss material to operational results would occur.
      Of the loans included below in the balances of nonperforming loans not
      adequately secured by real estate or other valuable assets, it is management’s
      opinion that amounts allowed for these loans in the allowance for loan losses
      is
      adequate to cover any potential loss and as such no loss material to operational
      results would occur.





The
      following table summarizes the Company’s non-performing loans at June 30, 2006
      and December 31, 2005 (in thousands of dollars):





June
                30,
            
            December
                31,2006
            
            2005Nonaccrual
                loans
            
            $
            711
            
            $
            743Loans
                past due 90 days and still accruing interest
            
            
            2,308
            
            
            1,189Total
                nonperforming loans
            
            $
            3,019
            
            $
            1,932





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





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





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          18





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





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





The
      carrying value of foreclosed property at June 30, 2006 was $50,000. All
      foreclosed property held as of June 30, 2006 was in the Company's primary
      service area. The Company's practice is to value real estate acquired through
      foreclosure at the lower of (i) an independent current appraisal or market
      analysis less anticipated costs of disposal, or (ii) the existing loan balance.
      The Company is actively marketing all foreclosed real estate and does not
      anticipate material write-downs in value before disposition.





Because
      of its large impact on the local economy, management continuously monitors
      the
      economic health of the poultry industry. The Company has direct loans to poultry
      growers and the industry is a large employer in the Company’s trade area.





In
      recent
      years, the Company’s loan portfolio has begun to reflect a concentration in
      loans collateralized by heavy equipment, particularly in the trucking, timber
      and coal extraction industries. In part because of rising fuel costs, and
      because of continued slow economic growth, the trucking sector experienced
      a
      recent downturn, and profitability growth within this sector still appears
      to be
      sluggish. While close monitoring of this sector is necessary, management expects
      no significant losses in the foreseeable future .
      The
      Company has loans to a large commercial customer, which are reported above as being over 90 days delinquent or have
      been
      placed in non-accrual status, and who is active in coal extraction. Management
      believes that this customer’s loans have become non-performing because of
      financial difficulties. Management also believes that the financial difficulties
      of this customer are unique to this customer and not indicative of a downturn
      in
      the local coal market. The majority of the coal extracted in the Company’s
      primary service area is used to supply an electrical power plant, also located
      in the Company’s primary service area. All indications are that this electrical
      power plant will continue to operate at or near capacity into the foreseeable
      future. Therefore, it is management’s belief that the health of the coal
      extraction industry in the Company’s primary service area remains stable and,
      other than the impact of the customer discussed above, loans to this local
      industry will continue to perform.





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




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





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





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          19





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





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





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





The
      following table shows the allocation for loans in the loan portfolio and the
      corresponding amounts of the allowance allocated by loan type as of June 30,
      2006 and December 31, 2005 (in thousands of dollars):





June
                30, 2006
            
            December
                31, 2005Percent
                of
            
            
            
            Percent
                ofAmount
            
            Loans
            
            Amount
            
            LoansLoan
                TypeCommercial
            
            $
            1,241
            
            
            22
            %
            $
            900
            
            
            22
            %Mortgage
                and construction
            
            
            1,076
            
            
            62
            %
            
            1,139
            
            
            62
            %Consumer
            
            
            891
            
            
            16
            %
            
            1,082
            
            
            17
            %Unallocated
            
            
            85
            
            
            
            
            
            8Totals
            
            $
            3,293
            
            
            
            
            $
            3,129








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





The
      following table summarizes the Company’s net charge-offs by loan type for the
      six month periods ended June 30, 2006 and 2005 (in thousands of
      dollars):





2006
            
            2005Charge-offsCommercial
            
            $
            (3
            )
            $
            (43
            )Mortgage
                and construction
            
            
            (1
            )
            
            (0
            )Consumer
            
            
            (314
            )
            
            (227
            )Total
                Charge-offs
            
            
            (318
            )
            
            (270
            )RecoveriesCommercial
            
            
            4
            
            
            4Mortgage
            
            
            0
            
            
            1Consumer
            
            
            125
            
            
            80Total
                Recoveries
            
            
            129
            
            
            85Total
                Net Charge-offs
            
            $
            (190
            )
            $
            (185
            )








The
      provision for loan losses taken during the first six months of 2006 was $82,000
      less than that taken during the same quarter in 2006. In spite of the decrease
      in the provision, the percentage of the allowance for loan losses to gross
      loans
      increased from 1.16% at December 31, 2005 to 1.20% at June 30, 2006. At June
      30
      2005, the ratio of the allowance for loan losses to gross loans was 1.09% The
      ratio of allowance for loan losses to nonperforming loans was 1.09 at June
      30,
      2006 compared to 1.62 at December 31, 2005.


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          20







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








**Noninterest
      Expense**





Noninterest
      expense increased 15.84% for the first six months of 2006 as compared to
      2005.





The
      addition of operations and the physical assets acquired with the purchase of
      the
      National Bank of Davis had a significant impact on the increase in non-interest
      expense. This purchase added eleven full time employees and two banking
      locations, increasing both the costs of salaries and benefits and occupancy
      and
      equipment expense. Also, the increase in both loan and deposit customers as
      a
      result of this acquisition caused an increase in data processing expense.
      Additionally, costs related to the conversion of the Davis data processing
      systems into the existing systems of The Grant County Bank continued into the
      second quarter of 2006.





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





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





Legal
      and
      professional fees increased both from the impact of increased operational size
      and usual inflationary trends and also because of an increase in the number
      of
      on-site engagements of audit firms during the second quarter of 2006 as compared
      to the second quarter of 2005.




**Borrowed
      Funds**





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





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





**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.


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          21




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





**Liquidity
      (continued)**





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 by
      decreasing secondary liquidity sources, such as balances of Fed Funds sold
      and
      balances of securities. Although total deposit balances have decreased slightly
      in recent periods, the Company has substantially maintained or increased levels
      of these secondary liquidity resources and does not anticipate that an
      unexpectedly high level of loan demand in coming periods would impact liquidity
      to the extent that the Company would be required to pay above market rates
      to
      obtain deposits.





The
      parent Company’s operating funds, funds with which to pay shareholder dividends
      and funds for the exploration of new business ventures, have been supplied
      primarily through dividends paid by the Company’s subsidiary banks, Capon Valley
      Bank (CVB) and The Grant County Bank (GCB). The various regulatory authorities
      impose restrictions on dividends paid by a state bank. A state bank cannot
      pay
      dividends without the consent of the relevant banking authorities in excess
      of
      the total net profits of the current year and the combined retained profits
      of
      the previous two years. As of July 1, 2006, the subsidiary banks could pay
      dividends to Highlands Bankshares, Inc. of approximately $6,494,000 without
      permission of the regulatory authorities.





**Capital**





The
      Company seeks to maintain a strong capital base to expand facilities, promote
      public confidence, support current operations and grow at a manageable level.
      As
      of June 30, 2006, the Company was above the regulatory minimum levels of
      capital. The table below summarizes the capital ratios for the Company and
      its
      subsidiary banks as of June 30, 2006 and December 31, 2005:





June
                30, 2006
            
            December
                31, 2005Actual
            
            Regulatory
            
            Actual
            
            RegulatoryRatio
            
            Minimum
            
            Ratio
            
            MinimumTotal
                Risk Based Capital RatioHighlands
                Bankshares
            
            
            13.80
            %
            
            
            8.00
            %
            
            
            13.85
            %
            
            
            8.00
            %Capon
                Valley Bank
            
            
            14.26
            %
            
            
            8.00
            %
            
            
            13.45
            %
            
            
            8.00
            %The
                Grant County Bank
            
            
            13.15
            %
            
            
            8.00
            %
            
            
            13.67
            %
            
            
            8.00
            %Tier
                1 Leverage RatioHighlands
                Bankshares
            
            
            9.32
            %
            
            
            3.00
            %
            
            
            9.45
            %
            
            
            3.00
            %Capon
                Valley Bank
            
            
            9.32
            %
            
            
            3.00
            %
            
            
            8.87
            %
            
            
            3.00
            %The
                Grant County Bank
            
            
            8.96
            %
            
            
            3.00
            %
            
            
            8.81
            %
            
            
            3.00
            %Tier
                1 Risk Based Capital RatioHighlands
                Bankshares
            
            
            12.55
            %
            
            
            4.00
            %
            
            
            12.60
            %
            
            
            4.00
            %Capon
                Valley Bank
            
            
            13.01
            %
            
            
            4.00
            %
            
            
            12.20
            %
            
            
            4.00
            %The
                Grant County Bank
            
            
            11.91
            %
            
            
            4.00
            %
            
            
            12.47
            %
            
            
            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 noninterest expenses
      may
      be more directly affected by inflation.





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          22






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





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





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





The
      Company’s management, with the participation of the Company’s Chief Executive
      Officer and Chief Financial Officer, has evaluated the effectiveness of the
      Company’s disclosure controls and procedures as of June 30, 2006. Based on this
      evaluation, the Company’s Chief Executive Officer and Chief Financial Officer
      concluded that the Company’s disclosure controls and procedures are effective as
      of June 30, 2006. The company has established procedures undertaken during
      the
      normal course of business in an effort to reasonably ensure that fraudulent
      activity of either an amount material to these results or in any amount is not
      occurring.





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.





Contained
      within the Company’s Report on Form 10-Q for the period ended March 31, 2006 and
      Report on Form 10-K for the year ended December 31, 2005 and in both instances
      under PART I, Item 4, the Company reported a requirement for additional controls
      to reasonably ensure that fraud of a material, or of any, amount were not
      occurring in relation to the purchase of the National Bank of Davis (Davis).
      In
      early April, 2006, all legacy Davis systems were merged fully with the systems
      of The Grant County Bank (Grant). Therefore, the requirement for additional
      controls related to this purchase are no longer necessary as the controls
      inherent to Grant’s operations are now sufficient to reasonably ensure that
      fraud of a material, or of any, amount is detected or prevented.





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





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





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





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


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          23




**PART
      II**  **OTHER
      INFORMATION (continued)**





**Item
      1A. Risk Factors**





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





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





None





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





None





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





On
      May 9,
      2006, the stockholders held their annual meeting. The following items were
      approved by the shareholders by the required majority or plurality:





1)
            Election
                of the Board of Directors as proposed in the proxy material without
                any
                additions or exceptions.





C.E.
                Porter
            965,770
                For
            12,324
                Withhold AuthorityL.
                Keith Wolfe
            971,932
                For
            6,162
                Withhold AuthorityThomas
                B. McNeill, Sr.
            970,171
                For
            7,923
                Withhold Authority







2)
            Ratification
                of Smith Elliott Kearns & Company, LLC as auditors for the year ending
                December 31, 2006: 975,061 For; 3,033
                Against





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





None





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





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





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          24






Signatures











Pursuant
      to the requirements of the Securities Exchange Act of 1934, the Registrant
      has
      duly caused this report to be signed on its behalf by the undersigned thereunto
      duly authorized.





HIGHLANDS
                BANKSHARES, INC./s/
                C.E. PorterC.E.
                PorterPresident
                & Chief Executive Officer/s/
                R. Alan MillerR.
                Alan MillerChief
                Financial OfficerAugust
                9, 2006








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