HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



CONSOLIDATED FINANCIAL REPORT



DECEMBER 31, 2005































C O N T E N T S





Page



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

2



FINANCIAL STATEMENTS

Consolidated Balance Sheets

3

Consolidated Statements of Income

4

Consolidated Statements of Stockholders' Equity

5

Consolidated Statements of Cash Flows

6

Notes to Consolidated Financial Statements

7  35































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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON THE FINANCIAL STATEMENTS











Board of Directors and Stockholders

Highlands Bankshares, Inc. and Subsidiaries

Abingdon, Virginia





We have audited the accompanying consolidated balance sheets of Highlands Bankshares, Inc. and Subsidiaries as of December 31, 2005, 2003, and 2002 and the related consolidated statements of income and comprehensive income, stockholders equity, and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.



We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.



In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Highlands Bankshares, Inc. and Subsidiaries as of December 31, 2005, 2004, and 2003, and the consolidated results of their operations and cash flows for each of the three years in the period ended December 31, 2005 in conformity with U.S. generally accepted accounting principles.



[financials002.gif]









CERTIFIED PUBLIC ACCOUNTANTS







Bristol, Virginia

January 31, 2006

















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HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



CONSOLIDATED BALANCE SHEETS

December 31, 2005, 2004 and 2003

(Amounts in thousands)



|                                                                                                                                                                                                                  |                |  |                |  |                
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------- |  | -------------- |  | ---------------
|ASSETS                                                                                                                                                                                                            | 2005           |  | 2004           |  | 2003           
|Cash and due from banks                                                                                                                                                                                           | $       16,631 |  | $       11,795 |  | $        14,473
|Federal funds sold                                                                                                                                                                                                | 110            |  | 1,714          |  | 389            
|                                                                                                                                                                                                                  |                |  |                |  |                
|Total Cash and Cash Equivalents                                                                                                                                                                                   | 16,741         |  | 13,509         |  | 14,862         
|                                                                                                                                                                                                                  |                |  |                |  |                
|Investment securities available-for-sale (Note 2)                                                                                                                                                                 | 135,726        |  | 128,953        |  | 122,064        
|Other Investments, at cost (Note 3)                                                                                                                                                                               | 4,558          |  | 4,250          |  | 2,900          
|Loans, net of allowance for loan losses of $4,359, $4,181
and $4,274 in 2005, 2004, and 2003 respectively (Note 4)                                                                                                | 407,274        |  | 387,133        |  | 373,534        
|Premises and equipment, net (Note 5)                                                                                                                                                                              | 17,234         |  | 16,638         |  | 15,465         
|Interest receivable                                                                                                                                                                                               | 3,543          |  | 2,757          |  | 2,749          
|Other assets                                                                                                                                                                                                      | 14,265         |  | 13,820         |  | 11,842         
|                                                                                                                                                                                                                  |                |  |                |  |                
|Total Assets                                                                                                                                                                                                      | $     599,341  |  | $     567,060  |  | $      543,416 
|                                                                                                                                                                                                                  |                |  |                |  |                
|LIABILITIES AND STOCKHOLDERS' EQUITY                                                                                                                                                                              |                |  |                |  |                
|Deposits (Note 8)                                                                                                                                                                                                 |                |  |                |  |                
|Noninterest bearing                                                                                                                                                                                               | $       80,047 |  | $       72,906 |  | $        59,057
|Interest bearing                                                                                                                                                                                                  | 406,861        |  | 395,751        |  | 390,952        
|                                                                                                                                                                                                                  |                |  |                |  |                
|Total Deposits                                                                                                                                                                                                    | 486,908        |  | 468,657        |  | 450,009        
|                                                                                                                                                                                                                  |                |  |                |  |                
|Federal funds purchased                                                                                                                                                                                           | 4,610          |  | -              |  | -              
|Interest, taxes and other liabilities                                                                                                                                                                             | 2,818          |  | 1,921          |  | 2,244          
|Other short term borrowings (Note 9)                                                                                                                                                                              | 18,098         |  | 25,548         |  | 33,000         
|Long-term debt (Note 10)                                                                                                                                                                                          | 38,475         |  | 25,335         |  | 16,429         
|Capital securities (Note 11)                                                                                                                                                                                      | 6,300          |  | 6,300          |  | 6,300          
|                                                                                                                                                                                                                  | 70,301         |  | 59,104         |  | 57,973         
|                                                                                                                                                                                                                  |                |  |                |  |                
|Total Liabilities                                                                                                                                                                                                 | 557,209        |  | 527,761        |  | 507,982        
|                                                                                                                                                                                                                  |                |  |                |  |                
|STOCKHOLDERS' EQUITY                                                                                                                                                                                              |                |  |                |  |                
|Common stock, 5,281, 5,330, and 5,318 shares
issued and outstanding as of December 31, 2005,
2004, and 2003, respectively. Authorized 40,000                 shares, par value $.625 per share  (Notes 13 and 15) | 3,300          |  | 3,331          |  | 3,324          
|                                                                                                                                                                                                                  |               
|Additional paid-in capital                                                                                                                                                                                        | 6,788          |  | 6,418          |  | 6,305          
|Retained Earnings                                                                                                                                                                                                 | 33,771         |  | 30,321         |  | 25,984         
|Accumulated other comprehensive loss                                                                                                                                                                              | (1,727)        |  | (771)          |  | (179)          
|                                                                                                                                                                                                                  |                |  |                |  |                
|Total Stockholders' Equity                                                                                                                                                                                        | 42,132         |  | 39,299         |  | 35,434         
|                                                                                                                                                                                                                  |                |  |                |  |                
|Total Liabilities and Stockholders' Equity                                                                                                                                                                        | $     599,341  |  | $     567,060  |  | $      543,416 



The Notes to Consolidated Financial Statements are an integral part of these statements.











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HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31, 2005, 2004 and 2003

(Amounts in thousands, except per share data)



|                                                         |                 |  |                 |  |                
|-------------------------------------------------------- | --------------- |  | --------------- |  | ---------------
|INTEREST INCOME                                          | 2005            |  | 2004            |  | 2003           
|                                                         |                 |  |                 |  |                
|Loans receivable and fees on loans                       | $      26,703   |  | $      24,575   |  | $      24,893  
|Securities available for sale:                           |                 |  |                 |  |                
|Taxable                                                  | 2,544           |  | 2,164           |  | 2,214          
|Tax-exempt                                               | 2,593           |  | 2,547           |  | 2,183          
|Other Investment Income                                  | 182             |  | 159             |  | 98             
|Federal funds sold                                       | 167             |  | 15              |  | 75             
|Total Interest Income                                    | 32,189          |  | 29,460          |  | 29,463         
|                                                         |                 |  |                 |  |                
|INTEREST EXPENSE                                         |                 |  |                 |  |                
|Deposits                                                 | 11,282          |  | 9,310           |  | 10,335         
|Federal funds purchased                                  | 29              |  | 72              |  | 13             
|Other borrowed funds                                     | 3,179           |  | 2,780           |  | 2,529          
|Total interest expense                                   | 14,490          |  | 12,162          |  | 12,877         
|                                                         |                 |  |                 |  |                
|Net interest income                                      | 17,699          |  | 17,298          |  | 16,586         
|                                                         |                 |  |                 |  |                
|PROVISION FOR LOAN LOSSES (Note 4)                       | 1,155           |  | 1,300           |  | 2,053          
|                                                         |                 |  |                 |  |                
|Net interest income after provision for loan losses      | 16,544          |  | 15,998          |  | 14,533         
|                                                         |                 |  |                 |  |                
|NON-INTEREST INCOME                                      |                 |  |                 |  |                
|Securities gains                                         | 559             |  | 400             |  | 589            
|Service charges on deposit accounts                      | 2,635           |  | 2,647           |  | 2,665          
|Other service charges, commissions and fees              | 1,047           |  | 880             |  | 778            
|Other operating income                                   | 609             |  | 645             |  | 620            
|Total Non-Interest Income                                | 4,850           |  | 4,572           |  | 4,652          
|                                                         |                 |  |                 |  |                
|NON-INTEREST EXPENSE                                     |                 |  |                 |  |                
|Salaries and employee benefits (Note 14)                 | 8,807           |  | 8,697           |  | 7,746          
|Occupancy expense of bank premises                       | 862             |  | 774             |  | 582            
|Furniture and equipment expense                          | 1,414           |  | 1,538           |  | 1,607          
|Other operating expenses (Note 23)                       | 3,915           |  | 3,862           |  | 3,535          
|Total Non-Interest Expenses                              | 14,998          |  | 14,871          |  | 13,470         
|                                                         |                 |  |                 |  |                
|Income Before Income Taxes                               | 6,396           |  | 5,699           |  | 5,715          
|                                                         |                 |  |                 |  |                
|Income Tax Expense (Note 7)                              | 1,363           |  | 1,042           |  | 1,195          
|                                                         |                 |  |                 |  |                
|Net Income                                               | $        5,033  |  | $        4,657  |  | $        4,520 
|                                                         |                 |  |                 |  |                
|Earnings Per Common Share (Note 13)                      | $          0.95 |  | $          0.88 |  | $          0.85
|                                                         |                 |  |                 |  |                
|Earnings Per Common Share - assuming dilution  (Note 13) | $          0.94 |  | $          0.87 |  | $          0.85







The Notes to Consolidated Financial Statements are an integral part of these statements.









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HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

Years Ended December 31, 2005, 2004, and 2003

(Amounts in thousands)

|                                                                                                              |              |            |                            |                   |                                        |             
|------------------------------------------------------------------------------------------------------------- | ------------ | ---------- | -------------------------- | ----------------- | -------------------------------------- | ------------
|                                                                                                              |              |            |                            |                   | Accumulated
Other
Comprehensive
Income |             
|                                                                                                              |              |            | Additional
Paid-in
Capital | Retained
Earnings | Total
Stockholders'
Equity            
|                                                                                                              | Common Stock
|                                                                                                              | Shares       | Par Value 
|                                                                                                              |              |            |                            |                   |                                        |             
|Balance, December 31, 2002                                                                                    | 5,296        | $    3,309 | $    6,150                 | $    21,729       | $        1,011                         | $     32,199
|                                                                                                              |              |            |                            |                   |                                        |             
|Comprehensive income:                                                                                         |              |            |                            |                   |                                        |             
|Net income                                                                                                    | -            | -          | -                          | 4,520             | -                                      | 4,520       
|Change in unrealized gain (loss) on securities available-for-sale, net of deferred income tax benefit of $413 | -            | -          | -                          | -                 | (801)                                  | (801)       
|Less: reclassification adjustment, net of income tax expense of $200                                          | -            | -          | -                          | -                 | (389)                                  | (389)       
|                                                                                                              |              |            |                            |                   |                                        |             
|Total comprehensive income                                                                                    | -            | -          | -                          | -                 | -                                      | 3,330       
|                                                                                                              |              |            |                            |                   |                                        |             
|Common stock issued for stock options exercised                                                               | 20           | 14         | 140                        | -                 | -                                      | 154         
|Common stock issued for  dividend reinvestment and optional  cash purchase plan                               | 2            | 1          | 15                         | -                 | -                                      | 16          
|Cash dividend                                                                                                 | -            | -          | -                          | (265)             | -                                      | (265)       
|                                                                                                              |              |            |                            |                   |                                        |             
|Balance, December 31, 2003                                                                                    | 5,318        | 3,324      | 6,305                      | 25,984            | (179)                                  | 35,434      
|                                                                                                              |              |            |                            |                   |                                        |             
|Comprehensive income:                                                                                         |              |            |                            |                   |                                        |             
|Net income                                                                                                    | -            | -          | -                          | 4,657             | -                                      | 4,657       
|Change in unrealized gain (loss) on securities available-for-sale, net of deferred income tax benefit of $169 | -            | -          | -                          | -                 | (328)                                  | (328)       
|Less: reclassification adjustment, net of income tax expense of $136                                          | -            | -          | -                          | -                 | (264)                                  | (264)       
|                                                                                                              |              |            |                            |                   |                                        |             
|Total comprehensive income                                                                                    | -            | -          | -                          | -                 | -                                      | 4,065       
|                                                                                                              |              |            |                            |                   |                                        |             
|Common stock issued for stock options exercised                                                               | 10           | 6          | 92                         | -                 | -                                      | 98          
|Common stock issued for  dividend reinvestment and optional  cash purchase plan                               | 2            | 1          | 21                         | -                 | -                                      | 22          
|Cash dividend                                                                                                 | -            | -          | -                          | (320)             | -                                      | (320)       
|                                                                                                              |              |            |                            |                   |                                        |             
|Balance, December 31, 2004                                                                                    | 5,330        | 3,331      | 6,418                      | 30,321            | (771)                                  | 39,299      
|                                                                                                              |              |            |                            |                   |                                        |             
|Comprehensive income:                                                                                         |              |            |                            |                   |                                        |             
|Net income                                                                                                    | -            | -          | -                          | 5,033             | -                                      | 5,033       
|Change in unrealized gain (loss) on securities available-for-sale, net of deferred income tax benefit of $302 | -            | -          | -                          | -                 | (587)                                  | (587)       
|Less: reclassification adjustment, net of income tax expense of $190                                          | -            | -          | -                          | -                 | (369)                                  | (369)       
|                                                                                                              |              |            |                            |                   |                                        |             
|Total comprehensive income                                                                                    | -            | -          | -                          | -                 | -                                      | 4,077       
|                                                                                                              |              |            |                            |                   |                                        |             
|Common stock issued for stock options exercised                                                               | 23           | 14         | 248                        | -                 | -                                      | 262         
|Common stock issued for  dividend reinvestment and optional  cash purchase plan                               | 9            | 6          | 122                        | -                 | -                                      | 128         
|Cash dividend                                                                                                 |              |            |                            | (400)             |                                        | (400)       
|Repurchase Common Stock                                                                                       | (81)         | (51)       | -                          | (1,183)           | -                                      | (1,234)     
|                                                                                                              |              |            |                            |                   |                                        |             
|Balance, December 31, 2005                                                                                    | 5,281        | $    3,300 | $      6,788               | $    33,771       | $      (1,727)                         | $     42,132

The Notes to Consolidated Financial Statements are an integral part of these statements









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HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2005, 2004, and 2003

(Amount in thousands)



|                                                                            |                    |  |                    |  |                 
|--------------------------------------------------------------------------- | ------------------ |  | ------------------ |  | ----------------
|                                                                            | 2005               |  | 2004               |  | 2003            
|CASH FLOWS FROM OPERATING ACTIVITIES:                                       |                    |  |                    |  |                 
|Net income                                                                  | $         5,033    |  | $         4,657    |  | $          4,520
|Adjustments to reconcile net income to net cash                             |                    |  |                    |  |                 
|provided by operating activities:                                           |                    |  |                    |  |                 
|Provision for loan losses                                                   | 1,155              |  | 1,300              |  | 2,053           
|Provision for deferred income taxes                                         | (129)              |  | 92                 |  | (27)            
|Depreciation and amortization                                               | 1,076              |  | 1,024              |  | 882             
|Net realized gains on available-for-sale securities                         | (559)              |  | (400)              |  | (589)           
|Net amortization on securities                                              | 614                |  | 589                |  | 302             
|Amortization of capital issue costs                                         | 24                 |  | 13                 |  | 12              
|Increase in interest receivable                                             | (786)              |  | (8)                |  | (41)            
|(Increase) decrease in other assets                                         | 172                |  | (1,937)            |  | (565)           
|Increase (decrease) in interest, taxes and other                            |                    |  |                    |  |                 
|liabilities                                                                 | 898                |  | (323)              |  | (65)            
|Net Cash provided by operating activities                                   | 7,498              |  | 5,007              |  | 6,482           
|                                                                            |                    |  |                    |  |                 
|CASH FLOWS FROM INVESTING ACTIVITIES:                                       |                    |  |                    |  |                 
|Securities available for sale:                                              |                    |  |                    |  |                 
|Proceeds from sale of debt and equity securities                            | 23,011             |  | 12,018             |  | 7,178           
|Proceeds from maturities of debt and equity securities                      | 21,992             |  | 21,138             |  | 25,435          
|Purchase of debt and equity securities                                      | (53,279)           |  | (41,131)           |  | (53,451)        
|Purchase of other investments                                               | (308)              |  | (1,300)            |  | (718)           
|Net increase in loans                                                       | (21,297)           |  | (14,899)           |  | (39,943)        
|Premises and equipment expenditures                                         | (1,688)            |  | (2,088)            |  | (2,920)         
|Net Cash used in investing activities                                       | (31,569)           |  | (26,262)           |  | (64,419)        
|                                                                            |                    |  |                    |  |                 
|CASH FLOWS FROM FINANCING ACTIVITIES:                                       |                    |  |                    |  |                 
|Net increase in certificates of deposit                                     | 20,237             |  | 13,900             |  | 11,186          
|Net increase (decrease) in demand, savings and other deposits               | (1,986)            |  | 4,748              |  | 28,522          
|Net increase in federal funds purchased                                     | 4,610              |  | -                  |  | -               
|Net increase (decrease) in short term borrowings                            | (7,450)            |  | (7,495)            |  | 13,906          
|Net increase in long-term debt                                              | 13,140             |  | 8,949              |  | 1,979           
|Repurchase of capital securities                                            | -                  |  | -                  |  | (1,200)         
|Cash dividends paid                                                         | (400)              |  | (320)              |  | (265)           
|Proceeds from exercise of common stock options                              | 262                |  | 98                 |  | 154             
|Proceeds from issuance of common stock                                      | 128                |  | 22                 |  | 16              
|Repurchase of common stock                                                  | (1,234)            |  | -                  |  | -               
|Net Cash provided by financing activities                                   | 27,303             |  | 19,902             |  | 54,298          
|Net increase (decrease) in cash and cash equivalents                        | 3,232              |  | (1,353)            |  | (3,639)         
|                                                                            |                    |  |                    |  |                 
|CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR                              | 13,509             |  | 14,862             |  | 18,501          
|                                                                            |                    |  |                    |  |                 
|CASH AND CASH EQUIVALENTS AT END OF YEAR                                    | $       16,741     |  | $       13,509     |  | $       14,862  
|                                                                            |                    |  |                    |  |                 
|SUPPLEMENTAL DISCLOSURE OF NON-CASH TRANSACTIONS                            |                    |  |                    |  |                 
|                                                                            |                    |  |                    |  |                 
|Land, premises and equipment purchased through seller financed
transactions | $                - |  | $                - |  | $            250
|                                                                            |                    |  |                    |  |                 
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:                          |                    |  |                    |  |                 
|Cash paid during the year for:                                              |                    |  |                    |  |                 
|Interest                                                                    | $       13,912     |  | $       12,101     |  | $       13,090  
|Income taxes                                                                | $         1,269    |  | $         1,196    |  | $         1,150 



The Notes to Consolidated Financial Statements are an integral part of these statements







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HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)





Note  1.

Summary of Significant Accounting Policies



Basis of Presentation and Consolidation



The accompanying consolidated financial statements include the accounts of Highlands Bankshares, Inc., (the Parent Company) and its wholly-owned subsidiaries, Highlands Union Bank (the "Bank").  The statements also include Highlands Union Insurance Services, Inc., (the Insurance Services), and Highlands Union Financial Services, Inc., (the Financial Services) which are both wholly-owned subsidiaries of the Bank.  All significant intercompany balances and transactions have been eliminated in consolidation.  The accounting and reporting policies of Highlands Bankshares, Inc. and Subsidiaries, (the Company) conform to U.S. generally accepted accounting principals and to predominate practices within the banking industry.



Nature of Operations



The Company operates in Abingdon, Virginia,
and surrounding southwest Virginia, eastern Tennessee, and western North Carolina under the laws of the Commonwealth of Virginia.  The Parent Company was organized on December 29, 1995.  The Parent Company is supervised by the Federal Reserve Bank under the Bank Holding Company Act of 1956, as amended. The Bank began banking operations on April 27, 1985 under a state bank charter and provides a full line of financial services to individuals and businesses.  The Banks primary lending products include mortgage, consumer and commercial loans, and their primary deposit products are checking, savings, and certificates of deposit.  As a state bank and a member of the Federal Reserve Bank of Richmond, the Bank is subject to regulation by the Virginia State Bureau of Financial Institutions, the Federal Deposit
 Insurance Corporation, and the Federal Reserve Bank.  Highlands Capital Trust I
 became effective January 14, 1998.  The nature of the trust is described more fully in Note
 11.  Highlands Union Insurance Services, Inc. became effective October 8, 1999 for the purpose of selling insurance through Bankers Insurance LLC.  The Bank operated a financial services department for the purpose of brokering various investment vehicles until January 2, 2001.  At that time, Highlands Union Financial Services, Inc. was created to convert that department into a separate legal entity in order to transact financial services in all of the Banks market areas. During 2004, changes to the NASD rules required financial services to be operated underneath the bank structure once again. This change occurred August 1, 2004. The only activity running through Highlands Union Financial Services now relates to commissions from the sale of life insurance.



Cash and Cash Equivalents



For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash and due from banks and federal funds sold, all of which mature within ninety days. The Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts. The Company believes it is not exposed to any significant credit risk on cash and cash equivalents.



Securities Available-for-Sale



Securities classified as available-for-sale are those debt and equity securities that the Company intends to hold for an indefinite period of time, but not necessarily to maturity.  Any decision to sell a security classified as available-for-sale would be based on various factors, including significant movements in interest rates, changes in the maturity mix of the Company's assets and liabilities, liquidity needs, regulatory capital considerations, and other similar factors.









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HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note  1.

Summary of Significant Accounting Policies (Continued)



Securities Available-for-Sale (Continued)



Securities available-for-sale are carried at fair value.  Unrealized gains or losses are reported as increases or decreases in other comprehensive income, net of the related deferred income tax effect.  Realized gains or losses are recorded on the trade date and are determined on the basis of the amortized cost of specific securities sold.  Realized gains or losses are included in earnings. Premiums and discounts are recognized in interest income using the interest method over the period to maturity.



Loans



The Company grants mortgage, commercial and consumer loans to customers.  A substantial portion of the loan portfolio is represented by mortgage loans throughout  southwest  Virginia. The ability of the Companys debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area.



Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on  originated   loans. Interest income is accrued on the unpaid balance.  Loan origination fees, net of certain direct origination costs, are deferred and amortized to income over the estimated lives of the loans using the straight-line method.  The aforementioned method is not materially different from the interest method. The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection.  Credit card loans and other personal loans are typically charged off no later
 than 180 days past due.   In all cases, loans are
 placed on non-accrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.



All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income.  The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual.  Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.



Allowance for Loan Losses



The Company monitors and maintains an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio.  The Company maintains policies and procedures that address the systems of controls over the following areas of maintenance of the allowance: the systematic methodology used to determine the appropriate level of the allowance to provide assurance the loan loss reserve is maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan portfolio; and the loan grading system.



The Companys Credit Review and Analysis
Department evaluates various loans individually for impairment as required by Statement of Financial Accounting Standards (SFAS) No. 114, Accounting by Creditors for Impairment of a Loan, and SFAS No. 118, Accounting by Creditors for Impairment of a Loan  Income Recognition and Disclosures.  Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by management.  The evaluations are based







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HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note  1.

Summary of Significant Accounting Policies (Continued)



Allowance for Loan Losses (Continued)



upon discounted expected cash flows or collateral valuations.  If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment.  If a loan evaluated individually is not impaired, then the loan is assessed for impairment under SFAS No. 5, Accounting for Contingencies, with a group of loans that have similar characteristics.



For loans without individual measures of impairment, the Company makes estimates of losses for groups of loans as required by SFAS No. 5.  Loans are grouped by similar characteristics, including the type of loan, the assigned loan grade and the general collateral type.  A loss rate reflecting the expected loss inherent in a group of loans is derived based upon estimates of default rates for a given loan grade, the predominant collateral type for the group and the terms of the loan.  The resulting estimate of losses for groups of loans are adjusted for relevant environmental factors and other conditions of the portfolio of loans, including:  borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability of lending management; and national and local economic conditions.



The amounts of estimated impairment for individually evaluated loans and groups of loans are added together for a total estimate of loan losses.  This estimate of losses is compared to the allowance for loan losses of the Company as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made.  If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates.  If the estimate of losses is below the range of reasonable estimates, the allowance would be reduced by way of a credit to the provision for loan losses.  The Company recognizes the inherent imprecision in estimates of losses due to various uncertainties  and variability related to the factors used, and therefore a reasonable range
around the estimate of losses is derived and used to ascertain whether the allowance is too high or too low.  If different
 assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the consolidated financial statements.



Premises and Equipment



Land is carried at cost.   Premises and
 equipment are stated at cost less accumulated depreciation. Depreciation is computed on the straight-line method over estimated useful lives.  Maintenance and repairs are charged to current operations while improvements are capitalized.  Disposition gains and losses are reflected in current operations. Purchased software costs are included in other assets and expensed over periods ranging from 3-5 years.



Intangible Assets



Capital issue costs relating to the junior
subordinated debt securities are stated at cost less accumulated amortization.  Amortization is computed on the straight-line method over the life of the securities - 30 years.



Foreclosed Assets



Assets acquired through, or in lieu of, loan foreclosure or repossession are held for sale and are initially recorded at fair value at the date of foreclosure or repossession, establishing a new cost







---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note  1.

Summary of Significant Accounting Policies (Continued)



Foreclosed Assets (Continued)



basis. Subsequent to foreclosure or repossession, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net expenses from foreclosed and repossessed assets. Foreclosed and repossessed assets at December 31, 2005, 2004 and 2003 were $951, $1,174 and $439, respectively.



Income Taxes



Under the asset and liability method, deferred income taxes are recognized for the tax consequences of temporary differences by applying enacted statutory tax rates to the differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities.  Under SFAS No. 109, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date.



Earnings Per Common Share



Earnings per common share are calculated based on the weighted average outstanding shares during the year.  Earnings per common share assuming dilution are calculated based on the weighted average outstanding shares during the year plus common stock equivalents at year end.



Stock Compensation Plans



Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, encourages all entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock.
Stock options issued under the Corporations stock option plan have no
intrinsic value at the grant date, and under Opinion No. 25 no compensation cost is recognized for them. The Company applies APB Opinion 25 and related
interpretations in accounting for the stock option plan.  Accordingly, no compensation
 cost has been recognized.  Had compensation cost for the Corporations stock option plan been determined based on the fair value at the grant dates for awards under the plan consistent with the method prescribed by FASB Statement No. 123, the Companys net income and earnings per share would have been adjusted to the pro forma amounts indicated below:





























---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Stock Compensation Plans (Continued)





|                            |             |                          |  |                 |  |               
|--------------------------- | ----------- | ------------------------ |  | --------------- |  | --------------
|                            |             | Years Ended December 31,
|                            |             | 2005                     |  | 2004            |  | 2003          
|                            |             |                          |  |                 |  |               
|Net income                  | As reported | $        5,033           |  | $        4,657  |  | $       4,520 
|                            | Pro forma   | $        4,826           |  | $        4,452  |  | $       4,316 
|                            |             |                          |  |                 |  |               
|Earnings per share          | As reported | $          0.95          |  | $          0.88 |  | $         0.85
|                            | Pro forma   | $          0.91          |  | $          0.84 |  | $         0.82
|                            |             |                          |  |                 |  |               
|Earnings per share assuming | As reported | $          0.94          |  | $          0.87 |  | $         0.85
|dilution                    | Pro forma   | $          0.90          |  | $          0.83 |  | $         0.81



The pro forma amounts shown above reflect the options granted during the year discounted using the expected life, expected volatility and risk-free interest rates as shown below.  The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:



|                         |                          |  |          |  |         
|------------------------ | ------------------------ |  | -------- |  | --------
|                         | Years Ended December 31,
|                         | 2005                     |  | 2004     |  | 2003    
|                         |                          |  |          |  |         
|Expected life            | 10 years                 |  | 10 years |  | 10 years
|Expected volatility      | 12.64%                   |  | 8.87%    |  | 6.20%   
|Risk-free interest rates | 4.00%                    |  | 4.23%    |  | 5.15%   





Use of Estimates

In preparing consolidated financial statements in conformity with U.S. generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenue and expenses during the reporting period.  Actual results could differ from those 
estimates.  Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, and the valuation of foreclosed real estate, deferred tax assets and investment securities.





Business Segments



The Company reports its activities as a single business segment.  In determining the appropriateness of segment definition, the Company considers components of the business about which financial information is available and regularly evaluated relative to resource allocation and performance assessment.



Recent Accounting Pronouncements



On December 16, 2004, the Financial  Accounting Standards Board issued Statement of Financial  Accounting  Standard (SFAS) No. 123R,  Share-Based  Payment,  that addresses the accounting for share-based payment transactions in which a company receives  employee  services in exchange for either  equity  instruments  of the company or liabilities  that are based on the fair value of the company's equity instruments  or that may be settled by the issuance of such equity







---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Recent Accounting Pronouncements (Continued)



instruments. SFAS No. 123R  eliminates  the ability to account for  share-based  compensation transactions  using the intrinsic method and requires that such  transactions be accounted for using a  fair-value-based  method and recognized as expense in the consolidated  statement  of  income.  The effective date of SFAS No. 123R (as amended by the Securities and Exchange Commission)  is for  interim and annual  periods beginning  after June 15, 2005.  The provisions of SFAS No. 123R do not have an impact on the Company's results of operations at the present time.  The Company will begin recognizing compensation expense in 2006 for options that have been issued but not yet vested prior to January 1, 2006.  Projected compensation expense associated with adopting
 SFAS No. 123R will approximate $0 in 2006. This estimate applies only to options issued through December 31, 2005, but not yet vested prior to January 1, 2006.  Any options issued after
December 31, 2005 would increase compensation expense above this estimate for 2006.





In January 2003, the FASB issued Interpretation
 No. 46, Consolidation of Variable Interest Entities (FIN 46). This interpretation
of Accounting Research Bulletin No. 51, Consolidated Financial Statements, addresses
 consolidation by business enterprises of variable interest entities. Under current practice, two
 enterprises generally have been included in consolidated financial statements because one enterprise
 controls the other through voting interests. FIN 46 defines the concept of variable interests
and requires existing unconsolidated variable interest entities to be consolidated by their primary
beneficiaries if the entities do not effectively disperse risks among the parties involved. The
interpretation may be applied prospectively with a cumulative-effect adjustment as of the date on
which it is first applied or by restating previously issued financial statements for one or more years
with a cumulative-effect adjustment as of the beginning of the first year restated. In December 2003, the FASB issued
FIN 46R, which among other things, revised the implementation dates. The Company is required to immediately apply FIN 46 and FIN 46R (the Interpretation) to any entity that is subject to the Interpretation and that is created after December 31, 2003. The Company is also required to apply the Interpretation to any entity subject to the Interpretation that was created before December 31, 2003 by the beginning of the first annual period beginning after December 15, 2004. The Companys adoption of this standard did not have an impact on the Companys consolidated financial statements.















































---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note  2.

Investment Securities Available-For-Sale



The amortized cost and market value of securities available-for-sale are as follows:



|                                            |                |  |                        |  |                         |  |             
|------------------------------------------- | -------------- |  | ---------------------- |  | ----------------------- |  | ------------
|                                            | 2005          
|                                            | Amortized Cost |  | Gross Unrealized Gains |  | Gross Unrealized Losses |  | Fair Value  
|                                           
|                                            |                |  |                        |  |                         |  |             
|U.S Government agencies and    corporations | $     750      |  | $              -       |  | $   12                  |  | $        738
|State and political subdivisions            | 57,942         |  | 255                    |  | 442                     |  | 57,755      
|Mortgage backed securities                  | 62,933         |  | 89                     |  | 897                     |  | 62,125      
|Other securities                            | 16,717         |  | 18                     |  | 1,627                   |  | 15,108      
|                                            |                |  |                        |  |                         |  |             
|                                            | $ 138,342      |  | $       362            |  | $      2,978            |  | $    135,726





|                                            |                |  |                        |  |                         |  |               
|------------------------------------------- | -------------- |  | ---------------------- |  | ----------------------- |  | --------------
|                                            | 2004          
|                                            | Amortized Cost |  | Gross Unrealized Gains |  | Gross Unrealized Losses |  | Fair Value    
|                                           
|                                            |                |  |                        |  |                         |  |               
|U.S Government agencies and    corporations | $     1,247    |  | $              8       |  | $              -        |  | $        1,255
|State and political subdivisions            | 47,379         |  | 1,034                  |  | 239                     |  | 48,174        
|Mortgage backed securities                  | 61,349         |  | 184                    |  | 373                     |  | 61,160        
|Other securities                            | 20,146         |  | 52                     |  | 1,834                   |  | 18,364        
|                                            |                |  |                        |  |                         |  |               
|                                            | $ 130,121      |  | $       1,278          |  | $      2,446            |  | $    128,953  



|                                            |                |  |                        |  |                         |  |               
|------------------------------------------- | -------------- |  | ---------------------- |  | ----------------------- |  | --------------
|                                            | 2003          
|                                            | Amortized Cost |  | Gross Unrealized Gains |  | Gross Unrealized Losses |  | Fair Value    
|                                           
|                                            |                |  |                        |  |                         |  |               
|U.S Government agencies and    corporations | $     3,247    |  | $            15        |  | $              -        |  | $        3,262
|State and political subdivisions            | 48,275         |  | 1,035                  |  | 679                     |  | 48,631        
|Mortgage backed securities                  | 53,583         |  | 220                    |  | 329                     |  | 53,474        
|Other securities                            | 17,231         |  | 98                     |  | 632                     |  | 16,697        
|                                            |                |  |                        |  |                         |  |               
|                                            | $ 122,336      |  | $       1,368          |  | $      1,640            |  | $    122,064  

























---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note  2.

Investment Securities Available-For-Sale (Continued)



The following table presents the age of gross unrealized losses and fair value by investment category.

|                             |                                                                                      |                   |            |                   |            |                  
|---------------------------- | ------------------------------------------------------------------------------------ | ----------------- | ---------- | ----------------- | ---------- | -----------------
|                             | ---------------------------------------December 31, 2005----------------------------
|                             | Less Than 12 months                                                                  | 12 Months or More | Total     
|                             | Fair Value                                                                           | Unrealized Losses | Fair Value | Unrealized Losses | Fair Value | Unrealized Losses
|                             |                                                                                      |                   |            |                   |            |                  
|Mortgage-backed securities   | $  25,250                                                                            | $      275        | $  26,281  | $        622      | $51,531    | $       897      
|States and pol. subdivisions | 25,573                                                                               | 267               | 5,264      | 175               | 30,837     | 442              
|Other securities             | 2,522                                                                                | 23                | 5,134      | 1,616             | 7,656      | 1,639            
|                             |                                                                                      |                   |            |                   |            |                  
|Total                        | $  53,345                                                                            | $      565        | $ 36,679   | $    2,413        | $90,024    | $    2,978       



Management does not believe any individual unrealized loss as of December 31, 2005 represents an other-than-temporary impairment. The unrealized losses are primarily attributable to changes in interest rates. The Company has both the intent and ability to hold the securities contained in the previous table for a time necessary to recover the amortized cost.



Investment securities available-for-sale with a carrying value of $15,356, $12,324, and $10,316 at December 31, 2005, 2004 and 2003 respectively, and a market value of $15,211, $12,552, and $10,614 at December 31, 2005, 2004 and 2003, respectively were pledged as collateral on public deposits and for other purposes as required or permitted by law.



The amortized cost and estimated fair value of securities available-for-sale at December 31, 2005 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.



|                                       |                 |  |                         
|-------------------------------------- | --------------- |  | ------------------------
|                                       | Amortized Cost  |  | Approximate
Market Value
|                                       |                
|Due in one year or less                | $         2,287 |  | $           2,338       
|Due after one year through five years  | 1,708           |  | 1,686                   
|Due after five years through ten years | 808             |  | 804                     
|Due after ten years                    | 53,889          |  | 53,665                  
|                                       | 58,692          |  | 58,493                  
|                                       |                 |  |                         
|Mortgage-backed securities             | 62,933          |  | 62,125                  
|Other securities                       | 16,717          |  | 15,108                  
|                                       | $     138,342   |  | $     135,726           





For the years ended December 31, 2005, 2004, and 2003, proceeds from sale of securities were      $23,011, $12,018 and $9,394, respectively.  Gross realized gains and losses on investment securities available for sale were as follows:



|                |  |                 |  |                   |  |                 
|--------------- |  | --------------- |  | ----------------- |  | ----------------
|                |  | 2005            |  | 2004              |  | 2003            
|                |  |                 |  |                   |  |                 
|Realized gains  |  | $           957 |  | $           407   |  | $         589   
|Realized losses |  | $           398 |  | $               7 |  | $              -
|Tax provision   |  | $           321 |  | $           136   |  | $         200   







---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note 3.  Other Investments



Federal Home Loan Bank (FHLB) stock, Federal Reserve Bank (FRB) stock and Community Bankers Bank Stock with a carrying value of $4,005, $3,700 and $2,900 at December 31, 2005, 2004 and 2003, respectively are listed as  Other Investments on the Companys Balance Sheets.  These investments are considered to be restricted as the Company is required by these agencies to hold these investments, and the only market for this stock is the issuing agency.



Other investments also include the Companys equity ownership investment in the Davenport Financial Fund, LLC., which is a fund that purchases various bank stocks in the Mid-Atlantic area. The Company accounts for this investment under the equity method. The Companys original investment in this fund was $500 and the carrying value at December 31, 2005 and 2004 was $553 and $550, repectively.



Note  4.

Loans



The composition of net loans is as follows:



|                                              |              |  |              |  |             
|--------------------------------------------- | ------------ |  | ------------ |  | ------------
|                                              | 2005         |  | 2004         |  | 2003        
|Real Estate Secured:                          |              |  |              |  |             
|Residential 1-4 family                        | $151,815     |  | $    146,970 |  | $    141,693
|Multifamily                                   | 4,148        |  | 3,379        |  | 2,651       
|Commercial, Construction and Land Development | 140,178      |  | 122,997      |  | 113,146     
|Second mortgages                              | 10,962       |  | 7,419        |  | 6,976       
|Equity lines of credit                        | 9,800        |  | 8,981        |  | 7,430       
|Farmland                                      | 10,015       |  | 9,347        |  | 4,843       
|                                              | 326,918      |  | 299,093      |  | 276,739     
|                                              |              |  |              |  |             
|Secured, Other:                               |              |  |              |  |             
|Personal                                      | 33,395       |  | 44,222       |  | 48,637      
|Commercial                                    | 25,628       |  | 24,992       |  | 27,247      
|Agricultural                                  | 3,653        |  | 4,024        |  | 4,506       
|                                              | 62,676       |  | 73,238       |  | 80,390      
|                                              |              |  |              |  |             
|Unsecured                                     | 21,801       |  | 19,033       |  | 20,448      
|Overdrafts                                    | 247          |  | 143          |  | 420         
|                                              | 22,048       |  | 19,176       |  | 20,868      
|                                              |              |  |              |  |             
|                                              | 411,642      |  | 391,507      |  | 377,997     
|Less:                                         |              |  |              |  |             
|Allowance for loan losses                     | 4,359        |  | 4,181        |  | 4,274       
|Net deferred fees                             | 9            |  | 193          |  | 189         
|                                              | 4,368        |  | 4,374        |  | 4,463       
|                                              |              |  |              |  |             
|Loans, net                                    | $    407,274 |  | $    387,133 |  | $    373,534





















---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note  4.

Loans (Continued)



Activity in the allowance for loan losses is as follows:



|                                |                |  |                |  |               
|------------------------------- | -------------- |  | -------------- |  | --------------
|                                | 2005           |  | 2004           |  | 2003          
|                                |                |  |                |  |               
|Balance, beginning              | $        4,181 |  | $        4,274 |  | $        3,877
|Provision charged to operations | 1,155          |  | 1,300          |  | 2,053         
|Loans charged to reserve        | (1,127)        |  | (1,500)        |  | (1,780)       
|Recoveries                      | 150            |  | 107            |  | 124           
|                                |                |  |                |  |               
|Balance, ending                 | $        4,359 |  | $        4,181 |  | $        4,274



The following is a summary of information pertaining to impaired loans:



|                                                             |                |  |                |  |              
|------------------------------------------------------------ | -------------- |  | -------------- |  | -------------
|                                                             | December 31,  
|                                                             | 2005           |  | 2004           |  | 2003         
|                                                             |                |  |                |  |              
|Impaired loans without a valuation  allowance                | $            - |  | $            - |  | $           -
|Impaired loans with a valuation allowance                    | 1,660          |  | 1,502          |  | 2,064        
|Total impaired loans                                         | $    1,660     |  | $    1,502     |  | $   2,064    
|Valuation allowance related to impaired loans                | $       281    |  | $       326    |  | $      838   
|                                                             |                |  |                |  |              
|Total non-accrual loans                                      | $    2,920     |  | $    3,902     |  | $   3,723    
|Total loans past due 90 days or more and still accruing      | $    1,281     |  | $       661    |  | $      802   
|Average investment in impaired loans                         | $    3,084     |  | $    1,841     |  | $   1,597    
|Interest income recognized on impaired loans                 | $           1  |  | $         24   |  | $          8 
|Interest income recognized on a cash basis on impaired loans | $            - |  | $         24   |  | $          8 



No additional funds are committed to be advanced in connection with impaired loans.



Note 5. Premises and Equipment



Premises and equipment are comprised of the following:



|                               |                  |  |                |  |               
|------------------------------ | ---------------- |  | -------------- |  | --------------
|                               | 2005             |  | 2004           |  | 2003          
|                               |                  |  |                |  |               
|Land                           | $          6,039 |  | $        4,907 |  | $        4,984
|Bank Premises                  | 10,274           |  | 10,193         |  | 8,989         
|Equipment                      | 8,693            |  | 7,906          |  | 6,777         
|                               | 25,006           |  | 23,006         |  | 20,750        
|Less: accumulated depreciation | 7,850            |  | 6,814          |  | 5,899         
|                               | 17,156           |  | 16,192         |  | 14,851        
|Construction in Progress       | 78               |  | 446            |  | 614           
|                               |                  |  |                |  |               
|                               | $        17,234  |  | $      16,638  |  | $      15,465 



Depreciation expense was $1,056, $1,004, and $862 for 2005, 2004, and 2003, respectively. Construction in progress for 2005 consists primarily of expenditures related to a future branch

located in Sevierville, Tennessee.







---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note 6.  Bank Owned Life Insurance



The Company maintains insurance on the lives of certain key directors and officers.  As beneficiary, the Company receives the cash surrender value if the policy is terminated, and upon death of the insured, receives all benefits payable.  The current value of the policies at December 31, 2005, 2004 and 2003 are $8,623, $8,282 and $7,929, respectively and are included in Other Assets in the balance sheet.



Note  7.

Income Taxes



The components of the net deferred tax asset, included in other assets, are as follows:



|                                                     |                  |  |                 |  |               
|---------------------------------------------------- | ---------------- |  | --------------- |  | --------------
|                                                     | 2005             |  | 2004            |  | 2003          
|                                                     |                  |  |                 |  |               
|Deferred tax assets:                                 |                  |  |                 |  |               
|Allowance for loan loss                              | $          1,355 |  | $        1,231  |  | $       1,167 
|Deferred compensation                                | 2                |  | 2               |  | 2             
|Net unrealized loss on securities
available-for-sale | 889              |  | 397             |  | 92            
|                                                     | 2,246            |  | 1,630           |  | 1,261         
|                                                     |                  |  |                 |  |               
|Deferred tax liability:                              |                  |  |                 |  |               
|Depreciation                                         | (599)            |  | (651)           |  | (496)         
|                                                     | (599)            |  | (651)           |  | (496)         
|                                                     |                  |  |                 |  |               
|Net deferred tax asset                               | $          1,647 |  | $           979 |  | $          766
|                                                     |                  |  |                 |  |               



The components of income tax expense related to continuing operations are as follows:



|         |                  |  |                  |  |                
|-------- | ---------------- |  | ---------------- |  | ---------------
|         | 2005             |  | 2004             |  | 2003           
|         |                  |  |                  |  |                
|Federal: |                  |  |                  |  |                
|Current  | $          1,492 |  | $            950 |  | $         1,168
|Deferred | (129)            |  | 92               |  | (27)           
|         |                  |  |                  |  |                
|Total    | $          1,363 |  | $         1,042  |  | $         1,195



The Companys income tax expense differs from the expected tax expense at the statutory federal rate of 34% as follows:



|                                                       |                  |  |                 |  |                
|------------------------------------------------------ | ---------------- |  | --------------- |  | ---------------
|                                                       | 2005             |  | 2004            |  | 2003           
|                                                       |                  |  |                 |  |                
|Statutory rate applied to earnings before
income taxes | $          2,175 |  | $         1,938 |  | $         1,943
|Tax exempt interest                                    | (882)            |  | (866)           |  | (742)          
|Other, net                                             | 70               |  | (30)            |  | (6)            
|                                                       |                  |  |                 |  |                
|Total                                                  | $          1,363 |  | $         1,042 |  | $         1,195









---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note 8. Deposits



The composition of deposits is as follows:



|                                              |                 |  |               |  |             
|--------------------------------------------- | --------------- |  | ------------- |  | ------------
|                                              | 2005            |  | 2004          |  | 2003        
|                                              |                 |  |               |  |             
|Non-interest bearing demand                   | $        80,047 |  | $      72,906 |  | $     59,057
|Interest bearing demand                       | 59,144          |  | 58,526        |  | 64,048      
|Savings deposits                              | 67,440          |  | 77,186        |  | 80,764      
|Time deposits, in amounts of $100,000
or more | 88,481          |  | 76,817        |  | 69,804      
|Other time deposits                           | 191,796         |  | 183,222       |  | 176,336     
|                                              |                 |  |               |  |             
|Total deposits                                | $      486,908  |  | $    468,657  |  | $   450,009 







The scheduled maturities of time deposits at December 31, 2005 are as follows:





|           |              
|---------- | -------------
|2005       | $     136,100
|2006       | 68,916       
|2007       | 34,924       
|2008       | 14,984       
|2009       | 21,345       
|Thereafter | 4,008        
|           |              
|           | $      280,27







Note 9. Other Short-Term Borrowings



Other short-term borrowings in the balance sheet consist of three Federal Home Loan Bank advances that are secured by a floating blanket lien on a specific class of mortgage loans of the Bank.  The Federal Home Loan Bank has the option to convert all of these advances which total $18 million to a three month LIBOR-based floating rate advance.  These notes carry interest rates of 6.280%, 6.170%, 2.910%. Also included in other short-term borrowing are the contractual principal payments due over the next 12 months on two seller financed mortgages secured by Bank property and an FHLB advance granted through the FHLBs Affordable Housing Program. The remaining balances on these three borrowings are included in long-term debt.























---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note 10.

Long-Term Debt



At December 31, Highlands Bankshares, Inc. and Subsidiaries had the following long-term debt agreements:



|                                                                                                                                                                                                                                                                                                                  |                                   |  |                 |  |                                  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------- |  | --------------- |  | ---------------------------------
|                                                                                                                                                                                                                                                                                                                  | 2005                              |  | 2004            |  | 2003                             
|Note payable FHLB dated 03/26/98 for $6 million with an annual interest rate of 5.51%, due 03/26/08. The note requires quarterly interest payments and had an early conversion option that expired on 03/26/03. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank. | $           6,000                 |  | $         6,000 |  | $         6,000                  
|                                                                                                                                                                                                                                                                                                                  |                                   |  |                 |  |                                  
|Note payable FHLB dated 08/13/99 for $4 million with an annual interest rate of 6.385%, due 08/13/09. The note requires quarterly interest payments and had an early conversion option at 08/13/04. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.             | 4,000                             |  | 4,000           |  | Included in
short term borrowings
|                                                                                                                                                                                                                                                                                                                  |                                   |  |                 |  |                                  
|Note payable FHLB dated 02/13/2002 for $5 million with an annual interest rate of 4.640%, due 02/13/2012. The note requires quarterly interest payments and has an early conversion option at 02/13/07. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.         | 5,000                             |  | 5,000           |  | 5,000                            
|                                                                                                                                                                                                                                                                                                                  |                                   |  |                 |  |                                  
|Note payable FHLB dated 05/07/2002 for $5 million with an annual interest rate of 4.720%, due 05/07/2012. The note requires quarterly interest payments and has an early conversion option at 05/07/2007. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.       | 5,000                             |  | 5,000           |  | 5,000                            
|                                                                                                                                                                                                                                                                                                                  |                                   |  |                 |  |                                  
|Note payable FHLB dated 05/28/04 for $5 million with an annual interest rate of 2.910%, due 05/28/2009. The note requires quarterly interest payments and has an early conversion option at 05/28/2006. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.         | Included in
short term borrowings |  | 5,000           |  | N/A                              
|                                                                                                                                                                                                                                                                                                                  |                                   |  |                 |  |                                  











---



HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)





Note 10.  Long-Term Debt (Continued)



|                                                                                                                                                                                                                                                                                                                   |                   |  |                |  |              
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ----------------- |  | -------------- |  | -------------
|                                                                                                                                                                                                                                                                                                                   | 2005              |  | 2004           |  | 2003         
|Note payable FHLB dated 02/02/05 for $7.5 million with an annual interest rate of 3.440%, due 02/02/2015. The note requires quarterly interest payments and has an early conversion option at 02/02/2008. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.        | $           7,500 |  | N/A            |  | N/A          
|                                                                                                                                                                                                                                                                                                                   |                   |  |                |  |              
|Note payable FHLB dated 03/04/05 for $5 million with an annual interest rate of 4.165%, due 03/04/2015. The note requires quarterly interest payments and has an early conversion option at 03/04/2010. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.          | 5,000             |  | N/A            |  | N/A          
|                                                                                                                                                                                                                                                                                                                   |                   |  |                |  |              
|Note payable FHLB dated 06/29/05 for $5 million with an annual interest rate of 3.760%, due 06/29/2015. The note requires quarterly interest payments and has an early conversion option at 06/29/2010. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.          | 5,000             |  | N/A            |  | N/A          
|                                                                                                                                                                                                                                                                                                                   |                   |  |                |  |              
|Note payable FHLB dated 08/23/05 for $750,000 with an annual interest rate of 0%, due 08/24/2020. The note requires monthly principal payments and was granted as part of the FHLBs affordable housing program. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank. | 692               |  | N/A            |  | N/A          
|                                                                                                                                                                                                                                                                                                                   |                   |  |                |  |              
|Other notes payable resulting from seller-financing transactions for $500 with annual interest rates ranging from 3.2% to 8.0%, and due dates ranging from 2010-2013. The notes require monthly installments of principal and interest of $6. The loans are secured by a first deed of trust on real estate.       | 283               |  | 335            |  | 429          
|                                                                                                                                                                                                                                                                                                                   |                   |  |                |  |              
|Total long-term debt                                                                                                                                                                                                                                                                                               | $       38,475    |  | $       25,335 |  | $      16,429









---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)





Note 10.  Long-Term Debt (Continued)





Contractual principal maturities of long-term debt at December 31, 2005 are as follows:



|           |                  
|---------- | -----------------
|2006       | $               -
|2007       | 101              
|2008       | 6,106            
|2009       | 4,109            
|2010       | 91               
|Thereafter | 28,068           
|           |                  
|           | $        38,475  







Note 11.

Capital Securities



On January 21, 1998, Highlands Capital Trust I, issued $7,500 of 9.25% Capital Securities which will mature on January 15, 2028.  The principal asset of the Trust is $7,500 of the Parent Companys junior subordinated debt securities with like maturities and like interest rates to the Capital Securities.  Additionally, the Trust has issued 9,000 shares of common securities to the Parent Company.  The 9.25% Capital Securities had $6,300 outstanding at December 31, 2005, and an estimated fair value of $6,598. The related junior subordinated debt securities had an estimated fair value of $6,598. Highlands Bankshares, Inc. repurchased 48,000 or 16% of the shares of Highlands Capital Trust I on April 18, 2003, on the open market, at $26.15 per share. The price paid per share corresponds to the January 2008 call price. The premium paid of $55 is being expensed
over the period to the January 2008 call date.



The Capital Securities, the assets of the Trust and the common securities issued by the Trust are redeemable in whole or in part on or after January 15, 2008, or at any time in whole but not in part from the date of issuance on the occurrence of certain events.



The Capital Securities may be included in Tier I capital for regulatory capital adequacy determination purposes up to 25% of Tier I capital after its inclusion.   The portion of the Capital Securities not considered as Tier I capital may be included in Tier II capital.  Distributions to the holders of the Capital Securities are included in interest expense.



The obligations of the Parent Company with respect to the issuance of the Capital Securities constitute a full and unconditional guarantee by the Parent Company of the Trusts obligations with respect to the Capital Securities.



Subject to certain exceptions and limitations, the Parent Company may elect from time to time to defer interest payments on the junior subordinated debt securities, which would result in a deferral of distribution payments on the related Capital Securities.



















---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands, except per share data)





Note 12.

Operating Leases



The following is a schedule by years of future minimum rental payments required under operating leases that have initial or remaining non-cancelable terms in excess of one year.



|                                |                    
|------------------------------- | -------------------
|Year ending December 31:        |                    
|                                |                    
|2005                            | $                51
|2006                            | 36                 
|2007                            | 14                 
|                                |                    
|Total minimum payments required | $              101 



Total operating lease expense was $ 52, $66 and $227 for December 31, 2005, 2004, and 2003 respectively.



Note 13.

Common Stock and Earnings Per Common Share



On July 13, 2005, the Board approved a 2 for 1 stock split to shareholders of record on July 27, 2005 payable on September 9, 2005. As a result, authorized shares increased from 20,000 to 40,000 and par value decreased from $1.25 to $0.625 per share. Shares issued and outstanding at December 31, 2005, 2004 and 2003 were 5,281, 5,330 and 5,318 respectively. All references in the financial statements to number of shares, per share amounts and market prices of the Companys common stock have been retroactively restated to reflect the increased number of common shares outstanding.



Earnings per common share is computed using the weighted average outstanding shares for the years ended December 31.  Outstanding stock options (Note 15) have a dilutive effect on earnings per share, which is determined using the treasury stock method.



The following is a reconciliation of the numerators and the denominators of the basic and diluted earnings per common share computation:



|                                                |                  |  |                 |  |                
|----------------------------------------------- | ---------------- |  | --------------- |  | ---------------
|                                                | 2005             |  | 2004            |  | 2003           
|                                                |                  |  |                 |  |                
|Income available to common stockholders         | $          5,033 |  | $         4,657 |  | $         4,520
|Weighted average shares outstanding             | 5,302            |  | 5,324           |  | 5,306          
|Shares outstanding including assumed
conversion | 5,367            |  | 5,378           |  | 5,350          
|Basic earnings per share                        | $           0.95 |  | $          0.88 |  | $          0.85
|Fully diluted earnings per share                | $           0.94 |  | $          0.87 |  | $          0.85



Highlands Bankshares, Inc. paid dividends of $400, $320, and $265 or $0.075 per share, $0.06 per share, and $0.05 per share in 2005, 2004 and 2003, respectively.



Note 14.

Profit Sharing and Retirement Savings Plan



The Bank has a 401(K) savings plan available to substantially all employees meeting minimum eligibility requirements.  The Bank makes a discretionary 2% profit sharing contribution to all employees exclusive of employee contributions and employer matching.    Employees may elect to make voluntary contributions to the plan up to 15% of their base pay.  In addition to the 2%







---



HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands, except per share data)



Note 14.

Profit Sharing and Retirement Savings Plan (Continued)



profit sharing contribution, the Bank matches 50% of the employees initial 6% contribution; therefore, the maximum employer matching contribution per employee could be 3% of base pay.  The cost of Bank contributions under the savings plan was $275, $252 and $223, in 2005, 2004 and 2003 respectively.



Note 15.

Stock Option Plan



In 1996, Highlands Bankshares, Inc., adopted a non-qualified stock incentive option plan, for key employees, officers, and directors and reserved 150,000 shares of common stock for issuance thereunder.  This number of shares increased to 600,000 as a result of the 1999 two-for-one stock split and the 2005 two-for-one stock split. The plan is identical to and replaced the plan previously adopted by Highlands Union Bank.



The exercise price of each option equals the market price of the Companys stock on the date of grant and an options maximum term is ten years.  Option exercise prices are determined by the Board of Directors based on recent open market sales, but shall not be less than the greater of the par value of such stock or 100% of the book value of such stock as shown by the Companys last published statement prior to granting of the option.  Proceeds received upon exercise of options are credited to common stock, to the extent of par value of the related shares, and the balance is credited to surplus. Shares under options which are canceled are available for subsequent grant.









---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands, except  per share data)





Note 15.  Stock Option Plan (Continued)





A summary of the status of the Companys stock option plan is presented below:



|                                                               |                                 |                  |                                 |                  |                                 |                 
|-------------------------------------------------------------- | ------------------------------- | ---------------- | ------------------------------- | ---------------- | ------------------------------- | ----------------
|                                                               | 2005                            | 2004             | 2003                           
|                                                               |                                 |                  |                                 |                  |                                 |                 
|                                                               | Weighted Average Exercise Price | Number of Shares | Weighted Average Exercise Price | Number of Shares | Weighted Average Exercise Price | Number of Shares
|                                                               |                                 |                  |                                 |                  |                                 |                 
|                                                               |                                 |                  |                                 |                  |                                 |                 
|Options outstanding at January 1                               | $   11.82                       | 345,910          | $   11.24                       | 297,716          | $   10.49                       | 266,436         
|Granted                                                        | 15.00                           | 63,400           | 14.50                           | 61,400           | 13.00                           | 59,700          
|Exercised                                                      | 11.29                           | (23,290)         | 10.50                           | (9,206)          | 6.72                            | (22,020)        
|Expired                                                        | 13.29                           | (5,050)          | 13.15                           | (4,000)          | 10.61                           | (6,400)         
|                                                               |                                 |                  |                                 |                  |                                 |                 
|Options outstanding and
exercisable at December 31             | $   12.36                       | 380,970          | $   11.82                       | 345,910          | $   11.24                       | 297,716         
|                                                               |                                 |                  |                                 |                  |                                 |                 
|Weighted-average fair value of
options granted during the year | $   15.00                       |                  | $   14.50                       |                  | $   13.00                       |                 



Information pertaining to options outstanding at December 31, 2005 is as follows:



|                           |                                     |  |                                             |  |                                
|-------------------------- | ----------------------------------- |  | ------------------------------------------- |  | -------------------------------
|                           | Options Outstanding and Exercisable
|Range of Exercise Prices   | Number Outstanding                  |  | Weighted Average Remaining Contractual Life |  | Weighted Average Exercise Price
|                           |                                     |  |                                             |  |                                
|$  3.75  -  $  3.75        | 5,800                               |  | 0.33 years                                  |  | $        3.75                  
|$  5.75  -  $  7.13        | 43,858                              |  | 2.22 years                                  |  | $        6.93                  
|$  9.50  -  $15.00         | 331,312                             |  | 7.05 years                                  |  | $      13.23                   
|                           |                                     |  |                                             |  |                                
|Outstanding at end of year | 380,970                             |  | 6.40 years                                  |  | $      12.36                   









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HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)





Note 16.

Off-Balance Sheet Activities



The Bank is party to various financial instruments with off-balance sheet risk arising in the normal course of business to meet the financing needs of their customers.  Those financial instruments include commitments to extend credit and commercial letters of credit of approximately $3,716, $3,066, and $3,485, unfunded commitments under lines of credit of $43,973, $34,902 and $29,655 and commitments to grant loans of $7,713, $10,210 and $5,073 for the years ended December 31, 2005, 2004 and 2003 respectively.  These instruments contain various elements of credit and interest rate risk in excess of the amount recognized in the statements of financial condition.



The Bank's exposure to credit loss, in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit, is the contractual amount of those instruments.  The Bank uses the same credit policies in making commitments and conditional obligations that they do for on-balance sheet instruments.



Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  The commitments for equity lines of credit may expire without being drawn upon.  Therefore, the total commitment amounts do not necessarily represent future cash requirements.  The amount of collateral obtained, if it is deemed necessary by the Company, is based on managements credit evaluation of the customer.



Unfunded commitments under lines of credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers.  These lines of credit usually do not contain a specified maturity date and may not be drawn upon to the total extent to which the Company is committed.



Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party.  Those letters of credit are primarily issued to support public and private borrowing arrangements.  Essentially all letters of credit issued have expiration dates within one year.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  The Company holds collateral supporting those commitments if deemed necessary.





Note 17.

Commitments and Contingencies



The Bank has made arrangements with and has available from corresponding banks, approximately $157,215 of lines of credit to fund any necessary cash requirements. The Bank has $56,238 of Federal Home Loan Bank advances outstanding as of December 31, 2005. A specific class of mortgage loans, with a balance of $143,304 at December 31, 2005 were pledged to the FHLB as collateral.

















---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note 18.

Fair Values of Financial Instruments



The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation.  Fair value is best determined based upon quoted market prices.  However, in many instances, there are no quoted market prices for the Companys various financial instruments.  In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.  Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows.    Accordingly, the fair value estimates may not be realized in an immediate settlement of   the   instrument.    SFAS 107 excludes certain financial instruments and all non-financial instruments from its disclosure
 requirements.  Accordingly, the aggregate fair value amounts presented
 may not necessarily represent the underlying fair value of the Company.



The following methods and assumptions were used by the Company in estimating fair value disclosures for financial instruments:



Cash and Cash Equivalents



The carrying amount reported in the balance sheets for cash, short-term investments and federal funds sold approximates fair value.



Securities Available for Sale



Fair value for securities are based on quoted market prices.



Other Investments



Other investments include Federal Home Loan Bank, Federal Reserve Bank and Community Bankers Bank. The carrying value of those securities approximates fair value based on the redemption provisions of those Banks. Other investments also include the Companys equity ownership investment in the Davenport Financial Fund, LLC. The Company accounts for this investment under the equity method.



Loans



The fair value of loans represent the amount at which the loans of the Bank could be exchanged on the open market, based upon the current lending rate for similar types of lending arrangements discounted over the remaining life of the loans.



Deposits



The fair value of deposits represent the amount at which the deposit liabilities of the Bank could be exchanged on the open market, based upon the current deposit rates for similar types of deposit arrangements discounted over the remaining life of the deposits.



Other Short-Term Borrowings



The carrying amounts of borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days approximate their fair values.  Fair values of other short-







---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)





Note 18.

Fair Values of Financial Instruments (Continued)



Other Short-Term Borrowings (Continued)



term borrowings are estimated using discounted cash flow analyses based on the Companys current incremental borrowing rates for similar types of borrowing arrangements. Estimated maturity dates are also included in the calculation of fair value for these borrowings.



Long-Term Debt and Capital Securities



Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate fair value of existing debt.



Off-Balance-Sheet Instruments



The amount of off-balance sheet commitments to extend credit, standby letters of credit, and financial guarantees, is considered equal to fair value.  Because of the uncertainty involved in attempting to assess the likelihood and timing of commitments being drawn upon, coupled with the lack of an established market and the wide diversity of fee structures, the Company does not believe it is meaningful to provide an estimate of fair value that differs from the given value of the commitment.



The carrying amounts and fair values of the Company's financial instruments at December 31 were as follows:



|                              |                 |            |      |                 |            |  |                 |           
|----------------------------- | --------------- | ---------- | ---- | --------------- | ---------- |  | --------------- | ----------
|                              | 2005            |            | 2004 |                 | 2003      
|                              | Carrying Amount | Fair Value |      | Carrying Amount | Fair Value |  | Carrying Amount | Fair Value
|                              |                 |           
|                              |                 |            |      |                 |            |  |                 |           
|Cash and cash equivalents     | $  16,741       | $  16,741  |      | $  13,509       | $  13,509  |  | $  14,473       | $  14,473 
|Securities available for
sale | 135,726         | 135,726    |      | 128,953         | 128,953    |  | 119,164         | 119,164   
|Other investments             | 4,558           | 4,558      |      | 4,250           | 4,250      |  | 2,900           | 2,900     
|Loans, net                    | 407,274         | 404,868    |      | 387,133         | 386,217    |  | 373,534         | 376,354   
|Deposits                      | (486,908)       | (485,718)  |      | (468,657)       | (469,070)  |  | (450,009)       | (453,395) 
|Other short-term
borrowings   | (18,098)        | (17,373)   |      | (25,548)        | (26,128)   |  | (33,043)        | (33,909)  
|Long-term debt                | (38,475)        | (38,418)   |      | (25,335)        | (26,615)   |  | (16,386)        | (17,228)  
|Capital Securities            | (6,300)         | (6,598)    |      | (6,300)         | (6,692)    |  | (6,300)         | (6,794)   





























---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)





Note 19.

Related Party Transactions



In the normal course of business, the Bank has made loans to its directors and officers and their affiliates.  All loans and commitments made to such officers and directors and to companies in which they are officers or have significant ownership interest have been made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons, and did not, in the opinion of management, involve more than normal credit risk or present other unfavorable features.  The activity in such loans is as follows:





|                   |             |  |             |  |            
|------------------ | ----------- |  | ----------- |  | -----------
|                   | 2005        |  | 2004        |  | 2003       
|                   |             |  |             |  |            
|Balance, beginning | $   12,109  |  | $   11,582  |  | $   9,434  
|Additions          | 3,497       |  | 5,459       |  | 8,357      
|Reductions         | (3,837)     |  | (4,932)     |  | (6,209)    
|                   |             |  |             |  |            
|Balance, ending    | $  11,769   |  | $  12,109   |  | $  11,582  
|                   |             |  |             |  |            
|Unused commitments | $     1,918 |  | $       958 |  | $       796
|                   |             |  |             |  |            



Deposits from related parties held by the Bank at December 31, 2005, 2004, and 2003 were $4,963 and $3,199 and $3,398, respectively.





Note 20.

Restrictions on Cash



The Bank is required to maintain reserve balances in cash with the Federal Reserve Bank.  The total of those reserve balances at December 31, 2005, 2004 and 2003 were $7,076, $6,109 and $5,723, respectively.





Note 21.

Minimum Regulatory Capital Requirements



The Company and the Bank are subject to various regulatory capital requirements administered by its primary regulator, the Federal Reserve Bank of Richmond.  Failure to meet the minimum regulatory capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators, that if undertaken, could have a direct material effect on the Company and Bank and the consolidated financial statements.  Under the regulatory capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines involving quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification under the prompt corrective action guidelines are also subject to qualitative
 judgments by the regulators about components, risk weightings, and other factors.  Prompt corrective action provisions are not applicable to bank holding companies.











---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)





Note 21.  Minimum Regulatory Capital Requirements (Continued)



Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of total risk-based capital and Tier I capital to risk-weighted assets (as defined in the regulations), and Tier I capital to adjusted total assets (as defined).  Management believes, as of December 31, 2005, 2004, and 2003, that the Company and the Bank met all the capital adequacy requirements to which they are subject.



As of December 31, 2005 the most recent notification from the State Corporation Commission Bureau of Financial Institutions categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.  To remain categorized as well capitalized, the Bank will have to maintain minimum total risk-based capital to risk-weighted assets, Tier I capital to risk-weighted assets, and Tier I capital to adjusted total assets ratios as disclosed in the table below.  There are no conditions or events since the most recent notification that management believes have changed the Banks category.



The Companys actual and required capital amounts and ratios are as follows:



|                                                   |            |  |                               |  |          |  |       
|-------------------------------------------------- | ---------- |  | ----------------------------- |  | -------- |  | ------
|                                                   | Actual     |  | For Capital Adequacy Purposes
|                                                   |           
|                                                   | Amount     |  | Ratio                         |  | Amount   |  | Ratio 
|As of December 31, 2005:                           |            |  |                               |  |          |  |       
|Total Risk-Based Capital (to Risk-Weighted
Assets) | $   52,749 |  | 12.99%                        |  | $ 32,485 |  | =,> 8%
|Tier 1 Capital (to Risk-Weighted Assets)           | 48,390     |  | 11.92%                        |  | 16,243   |  | =,> 4%
|Tier 1 Capital (to Adjusted Total Assets)          | 48,390     |  | 8.08%                         |  | 23,954   |  | =,> 4%
|                                                   |            |  |                               |  |          |  |       
|As of December 31, 2004:                           |            |  |                               |  |          |  |       
|Total Risk-Based Capital (to Risk-Weighted
Assets) | $   49,185 |  | 12.89%                        |  | $ 30,518 |  | =,> 8%
|Tier 1 Capital (to Risk-Weighted Assets)           | 45,004     |  | 11.80%                        |  | 15,259   |  | =,> 4%
|Tier 1 Capital (to Adjusted Total Assets)          | 45,004     |  | 7.86%                         |  | 22,906   |  | =,> 4%
|                                                   |            |  |                               |  |          |  |       
|As of December 31, 2003:                           |            |  |                               |  |          |  |       
|Total Risk-Based Capital (to Risk-Weighted
Assets) | $   44,823 |  | 12.51%                        |  | $ 28,653 |  | =,> 8%
|Tier 1 Capital (to Risk-Weighted Assets)           | 40,549     |  | 11.32%                        |  | 14,327   |  | =,> 4%
|Tier 1 Capital (to Adjusted Total Assets)          | 40,549     |  | 7.52%                         |  | 21,563   |  | =,> 4%





























---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note 21.  Minimum Regulatory Capital Requirements (Continued)



The Banks actual and required capital amounts and ratios are as follows:



|                                                    |            |                               |                                                                      |        |          |        
|--------------------------------------------------- | ---------- | ----------------------------- | -------------------------------------------------------------------- | ------ | -------- | -------
|                                                    | Actual     | For Capital Adequacy Purposes | To be Well Capitalized under the Prompt Corrective Action Provisions
|                                                    | Amount     | Ratio                         | Amount                                                               | Ratio  | Amount   | Ratio  
|                                                    |            |                               |                                                                      |        |          |        
|As of December 31, 2005:                            |            |                               |                                                                      |        |          |        
|Total Risk-Based Capital (to Risk-Weighted  Assets) | $   43,986 | 10.93%                        | $  32,208                                                            | =,> 8% | $ 40,260 | =,> 10%
|Tier 1 Capital (to Risk-Weighted Assets)            | 39,647     | 9.85%                         | 16,104                                                               | =,> 4% | 24,156   | =,> 6% 
|Tier 1 Capital (to Adjusted Total Assets)           | 39,647     | 6.70%                         | 23,671                                                               | =,> 4% | 29,588   | =,> 5% 
|                                                    |            |                               |                                                                      |        |          |        
|As of December 31, 2004:                            |            |                               |                                                                      |        |          |        
|Total Risk-Based Capital (to Risk-Weighted  Assets) | $   41,317 | 10.96%                        | $  30,169                                                            | =,> 8% | $ 37,711 | =,> 10%
|Tier 1 Capital (to Risk-Weighted Assets)            | 37,156     | 9.85%                         | 15,085                                                               | =,> 4% | 22,627   | =,> 6% 
|Tier 1 Capital (to Adjusted Total Assets)           | 37,156     | 6.56%                         | 22,661                                                               | =,> 4% | 28,326   | =,> 5% 
|                                                    |            |                               |                                                                      |        |          |        
|As of December 31, 2003:                            |            |                               |                                                                      |        |          |        
|Total Risk-Based Capital (to Risk-Weighted Assets)  | $   38,508 | 10.85%                        | $  28,397                                                            | =,> 8% | $ 35,496 | =,> 10%
|Tier 1 Capital (to Risk-Weighted Assets)            | 34,254     | 9.65%                         | 14,198                                                               | =,> 4% | 21,297   | =,> 6% 
|Tier 1 Capital (to Adjusted Total Assets)           | 34,254     | 6.44%                         | 21,272                                                               | =,> 4% | 26,591   | =,> 5% 





Note 22.

Restrictions on Dividends



The Parent Companys principal asset is its investment in the Bank, a wholly owned consolidated subsidiary.  The primary source of income for the Parent Company historically has been dividends from the Bank.  Regulatory agencies limit the amount of funds that may be transferred from the Bank to the Parent Company in the form of dividends, loans or advances.



Under applicable laws and without prior regulatory approval, the total dividend payments of the Bank in any calendar year are restricted to the net profits of that year, as defined, combined with the retained net profits for the two preceding years.  The total dividends that may be declared in 2006 without regulatory approval total $5,683 plus year-to-date 2006 net profits as of the declaration date.











---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note 23.

Other Operating Income and Expenses



Other operating income and expenses that exceed 1% of the total of interest income and other income presented separately consist of the following:



|                          |            |  |            |  |            
|------------------------- | ---------- |  | ---------- |  | -----------
|                          | 2005       |  | 2004       |  | 2003       
|                          |            |  |            |  |            
|BOLI income               | $      341 |  | $      354 |  | $      357 
|                          |            |  |            |  |            
|Postage and freight       | $      343 |  | $      321 |  | $       306
|                          |            |  |            |  |            
|Other Contracted Services | $      415 |  | $      285 |  | $       227
|                          |            |  |            |  |            
|Bank Franchise Taxes      | $      335 |  | $      273 |  | $       246





Note 24.  Condensed Parent Company Financial Statements



The condensed financial statements below relate to Highlands Bankshares, Inc., as of December 31, 2005, 2004, and 2003 and for the years then ended.  Equity in undistributed earnings of subsidiary includes the change in unrealized gains or losses on securities, net of tax.







|                                                                       |              |  |              |  |             
|---------------------------------------------------------------------- | ------------ |  | ------------ |  | ------------
|CONDENSED BALANCE SHEETS                                               |              |  |              |  |             
|                                                                       | 2005         |  | 2004         |  | 2003        
|ASSETS                                                                 |              |  |              |  |             
|Cash                                                                   | $     3,154  |  | $     2,953  |  | $     1,232 
|Capital securities repurchased                                         | 1,200        |  | 1,200        |  | 1,200       
|Other investments                                                      | 550          |  | 549          |  | -           
|Loans, net of allowance for loan losses of $20
in 2005, 2004, and 2003 | 2,754        |  | 2,438        |  | 3,383       
|Equity in subsidiary                                                   | 39,688       |  | 37,751       |  | 35,440      
|Premises and equipment, net                                            | 2,078        |  | 1,695        |  | 1,431       
|Other assets                                                           | 356          |  | 393          |  | 406         
|                                                                       |              |  |              |  |             
|Total Assets                                                           | $   49,780   |  | $   46,979   |  | $   43,092  
|                                                                       |              |  |              |  |             
|LIABILITIES AND STOCKHOLDERS EQUITY                                   |              |  |              |  |             
|Interest, taxes and other liabilities                                  | $        148 |  | $        180 |  | $        158
|Capital securities                                                     | 7,500        |  | 7,500        |  | 7,500       
|Total Liabilities                                                      | 7,648        |  | 7,680        |  | 7,658       
|                                                                       |              |  |              |  |             
|STOCKHOLDERS EQUITY                                                   | 42,132       |  | 39,299       |  | 35,434      
|                                                                       |              |  |              |  |             
|Total Liabilities and Stockholders Equity                             | $   49,780   |  | $   46,979   |  | $   43,092  











---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)





Note 24.  Condensed Parent Company Financial Statements (Continued)





|                                               |              |  |              |  |             
|---------------------------------------------- | ------------ |  | ------------ |  | ------------
|CONDENSED STATEMENTS OF INCOME                 |              |  |              |  |             
|                                               | 2005         |  | 2004         |  | 2003        
|                                               |              |  |              |  |             
|Dividends from subsidiary                      | $      2,500 |  | $      2,000 |  | $      1,200
|Interest income                                | 280          |  | 307          |  | 355         
|Other income                                   | 226          |  | 276          |  | 226         
|Interest expense                               | (694)        |  | (698)        |  | (694)       
|Operating expense                              | (173)        |  | (131)        |  | (133)       
|                                               | 2,139        |  | 1,754        |  | 954         
|                                               |              |  |              |  |             
|                                               |              |  |              |  |             
|Income tax benefit                             | 122          |  | 84           |  | 84          
|Equity in undistributed earnings of subsidiary | 2,772        |  | 2,819        |  | 3,482       
|                                               |              |  |              |  |             
|Net income                                     | $     5,033  |  | $      4,657 |  | $      4,520













---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note 24.  Condensed Parent Company Financial Statements (Continued)



|                                                                                  |             |  |             |  |            
|--------------------------------------------------------------------------------- | ----------- |  | ----------- |  | -----------
|CONDENSED STATEMENTS OF CASH FLOWS                                                |             |  |             |  |            
|                                                                                  | 2005        |  | 2004        |  | 2003       
|CASH FLOWS FROM OPERATING ACTIVITIES:                                             |             |  |             |  |            
|Net income                                                                        | $     5,033 |  | $     4,657 |  | $     4,520
|Adjustments to reconcile net income to net cash
Provided by operating activities: |             |  |             |  |            
|Depreciation and amortization                                                     | 74          |  | 54          |  | 49         
|Provision for deferred income taxes                                               | 3           |  | 2           |  | 5          
|Equity in undistributed earnings of subsidiary                                    | (2,772)     |  | (2,819)     |  | (3,482)    
|Increase in other assets                                                          | (113)       |  | (134)       |  | (162)      
|Increase (decrease)  in other liabilities                                         | (32)        |  | 22          |  | (4)        
|                                                                                  |             |  |             |  |            
|Net cash provided by operating activities                                         | 2,193       |  | 1,782       |  | 926        
|                                                                                  |             |  |             |  |            
|CASH FLOWS FROM INVESTING ACTIVITIES:                                             |             |  |             |  |            
|Purchase of other investments                                                     | -           |  | (500)       |  | -          
|Net (increase) decrease in loans                                                  | (316)       |  | 945         |  | 498        
|Premises and equipment expenditures                                               | (432)       |  | (306)       |  | -          
|                                                                                  |             |  |             |  |            
|Net cash provided by (used in) investing
activities                               | (748)       |  | 139         |  | 498        
|                                                                                  |             |  |             |  |            
|CASH FLOWS FROM FINANCING ACTIVITIES:                                             |             |  |             |  |            
|                                                                                  |             |  |             |  |            
|Cash dividends paid                                                               | (400)       |  | (320)       |  | (265)      
|Repurchase of capital securities                                                  | -           |  | -           |  | (1,200)    
|Proceeds from issuance of common stock                                            | 128         |  | 22          |  | 16         
|Proceeds from exercise of common stock options                                    | 262         |  | 98          |  | 154        
|Repurchase of Common Stock                                                        | (1,234)     |  | -           |  | -          
|                                                                                  |             |  |             |  |            
|Net cash used in financing activities                                             | (1,244)     |  | (200)       |  | (1,295)    
|                                                                                  |             |  |             |  |            
|Net increase in cash and cash equivalents                                         | 201         |  | 1,721       |  | 129        
|                                                                                  |             |  |             |  |            
|CASH AND CASH EQUIVALENTS AT
BEGINNING OF YEAR                                    | 2,953       |  | 1,232       |  | 1,103      
|                                                                                  |             |  |             |  |            
|CASH AND CASH EQUIVALENTS AT END OF
YEAR                                          | $3,154      |  | $2,953      |  | $     1,232









---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note 25.  Quarterly Data (Unaudited)



|                                                              |           |  |           |  |            |  |          
|------------------------------------------------------------- | --------- |  | --------- |  | ---------- |  | ---------
|Consolidated quarterly results of operations were as follows: |           |  |           |  |           
|                                                              | 2005     
|                                                              | March 31  |  | June 30   |  | Sept. 30   |  | Dec. 31  
|                                                              |           |  |           |  |            |  |          
|Interest Income                                               | $  7,663  |  | $  8,004  |  | $  8,051   |  | $  8,471 
|Interest Expense                                              | (3,298)   |  | (3,494)   |  | (3,733)    |  | (3,965)  
|                                                              |           |  |           |  |            |  |          
|Net interest income                                           | 4,365     |  | 4,510     |  | 4,318      |  | 4,506    
|Provision for loan losses                                     | (288)     |  | (247)     |  | (247)      |  | (373)    
|Net interest income after provision for
possible loan losses  | 4,077     |  | 4,263     |  | 4,071      |  | 4,133    
|Other income                                                  | 1,244     |  | 1,224     |  | 1,117      |  | 1,265    
|Other expenses                                                | (3,782)   |  | (3,807)   |  | (3,680)    |  | (3,729)  
|                                                              |           |  |           |  |            |  |          
|Income before income taxes                                    | 1,539     |  | 1,680     |  | 1,508      |  | 1,669    
|Income taxes                                                  | (295)     |  | (464)     |  | (274)      |  | (330)    
|                                                              |           |  |           |  |            |  |          
|Net income                                                    | $  1,244  |  | $  1,216  |  | $   1,234  |  | $  1,339 
|                                                              |           |  |           |  |            |  |          
|Earnings per common share:                                    |           |  |           |  |            |  |          
|Basic                                                         | $    0.24 |  | $    0.23 |  | $     0.23 |  | $    0.25
|Diluted                                                       | $    0.23 |  | $    0.23 |  | $     0.23 |  | $    0.25
|                                                              |           |  |           |  |            |  |          
|                                                              | 2004     
|                                                              | March 31  |  | June 30   |  | Sept. 30   |  | Dec. 31  
|                                                              |           |  |           |  |            |  |          
|Interest Income                                               | $  7,341  |  | $  7,223  |  | $  7,326   |  | $  7,570 
|Interest Expense                                              | (2,972)   |  | (2,926)   |  | (3,033)    |  | (3,231)  
|                                                              |           |  |           |  |            |  |          
|Net interest income                                           | 4,369     |  | 4,297     |  | 4,293      |  | 4,339    
|Provision for loan losses                                     | (348)     |  | (341)     |  | (373)      |  | (238)    
|Net interest income after provision for
possible loan losses  | 4,021     |  | 3,956     |  | 3,920      |  | 4,101    
|Other income                                                  | 1,031     |  | 1,189     |  | 1,276      |  | 1,076    
|Other expenses                                                | (3,587)   |  | (3,647)   |  | (3,780)    |  | (3,857)  
|                                                              |           |  |           |  |            |  |          
|Income before income taxes                                    | 1,465     |  | 1,498     |  | 1,416      |  | 1,320    
|Income taxes                                                  | (275)     |  | (289)     |  | (255)      |  | (223)    
|                                                              |           |  |           |  |            |  |          
|Net income                                                    | $  1,190  |  | $  1,209  |  | $   1,161  |  | $  1,097 
|                                                              |           |  |           |  |            |  |          
|Earnings per common share:                                    |           |  |           |  |            |  |          
|Basic                                                         | $    0.23 |  | $    0.22 |  | $     0.22 |  | $    0.21
|Diluted                                                       | $    0.23 |  | $    0.22 |  | $     0.22 |  | $    0.20









---

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)



Note 25.  Quarterly Data (Unaudited) (Continued)





|                                                             |           |  |           |  |            |  |          
|------------------------------------------------------------ | --------- |  | --------- |  | ---------- |  | ---------
|                                                             | 2003     
|                                                             | March 31  |  | June 30   |  | Sept. 30   |  | Dec. 31  
|                                                             |           |  |           |  |            |  |          
|Interest Income                                              | $  7,403  |  | $  7,357  |  | $  7,371   |  | $  7,332 
|Interest Expense                                             | (3,337)   |  | (3,279)   |  | (3,189)    |  | (3,072)  
|                                                             |           |  |           |  |            |  |          
|Net interest income                                          | 4,066     |  | 4,078     |  | 4,182      |  | 4,260    
|Provision for loan losses                                    | (470)     |  | (510)     |  | (447)      |  | (626)    
|Net interest income after provision for
possible loan losses | 3,596     |  | 3,568     |  | 3,735      |  | 3,634    
|Other income                                                 | 1,095     |  | 1,317     |  | 1,044      |  | 1,196    
|Other expenses                                               | (3,268)   |  | (3,364)   |  | (3,389)    |  | (3,449)  
|                                                             |           |  |           |  |            |  |          
|Income before income taxes                                   | 1,423     |  | 1,521     |  | 1,390      |  | 1,381    
|Income taxes                                                 | (338)     |  | (338)     |  | (274)      |  | (245)    
|                                                             |           |  |           |  |            |  |          
|Net income                                                   | $  1,085  |  | $  1,183  |  | $   1,116  |  | $  1,136 
|                                                             |           |  |           |  |            |  |          
|Earnings per common share:                                   |           |  |           |  |            |  |          
|Basic                                                        | $    0.21 |  | $    0.22 |  | $     0.21 |  | $    0.21
|Diluted                                                      | $    0.21 |  | $    0.22 |  | $     0.21 |  | $    0.21
|                                                             |           |  |           |  |            |  |          







Note 26.  Subsequent Events



On January 9, 2006 the Company executed an agreement to purchase a certain tract of land located in Abingdon, Virginia. The closing is expected to occur in March of 2006. The purchase price of the subject property is $510.



On January 9, 2006, the Board of Directors approved management to sign contracts for the construction of a branch bank office in Sevierville, Tennessee. The estimated cost of this contract is $680,000.