**HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES**

 

**CONSOLIDATED FINANCIAL REPORT**

 

**DECEMBER 31, 2007**

 

 

 

 

 

 

 

 

C O N T E        N T S

 

 

|                                                                                             |   | Page   |
|--------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                             |   |   |
| REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING                    FIRM                       |   | 2      |
|                                                                                             |   |   |
| Management’s Annual Report on Internal Control over                    Financial Reporting |   | 3      |
|                                                                                             |   |   |
| FINANCIAL STATEMENTS                                                                             |   |   |
| Consolidated Balance Sheets                                                                      |   | 4      |
| Consolidated Statements of Income                                                                |   | 5      |
| Consolidated Statements of Stockholders' Equity                                                  |   | 6      |
| Consolidated Statements of Cash Flows                                                            |   | 7      |
| Notes to Consolidated Financial Statements                                                       |   | 8-37   |
|                                                                                             |   |   |

 

 

 

 

 

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REPORT OF        INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

 

To the        Board of Directors and Stockholders of

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, 2007 and 2006, and the related        consolidated statements of income, stockholders’ equity, and cash flows for each of        the years in the two-year period ended December 31, 2007. The Company’s management is        responsible for these financial statements. Our responsibility is to express an opinion on        these 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 financial statements        are free of material misstatement. The Company is not required to have, nor were we engaged        to perform, an audit of its internal control over financial reporting. Our audit included        consideration of internal control over financial reporting as a basis for designing audit        procedures that are appropriate in the circumstances, but not for the purpose of expressing        an opinion on the effectiveness of the Company’s internal control over financial        reporting. Accordingly, we express no such opinion. An audit also includes examining, on a        test basis, evidence supporting the amounts and disclosures in the financial statements,        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 consolidated financial statements referred to above        present fairly, in all material respects, the financial position of Highlands Bankshares,        Inc. and Subsidiaries as of December 31, 2007 and 2006, and the consolidated results of its        operations and its cash flows for each of the years in the two-year period ended December        31, 2007 in conformity with accounting principles generally accepted in the United States        of America.

 

 

 

 

|   | CERTIFIED PUBLIC ACCOUNTANTS |
|--------|------------------------------|

 

 

February        6, 2008

 

 

2

 

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**Management's Annual Report on Internal Control Over Financial        Reporting.**

         

Management        is responsible for establishing and maintaining adequate internal control over financial        reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act). Our internal        control over financial reporting includes those policies and procedures that (i) pertain to        the maintenance of records that, in reasonable detail, accurately and fairly reflect the        transactions and dispositions of our assets; (ii) provide reasonable assurance that        transactions are recorded as necessary to permit preparation of financial statements in        accordance with generally accepted accounting principles, and that our receipts and        expenditures are being made only in accordance with authorizations of our management and        directors; and (iii) provide reasonable assurance regarding prevention or timely detection        of unauthorized acquisition, use, or disposition of our assets that could have a material        effect on the financial statements.

 

Because of        the inherent limitations in any internal control, no matter how well designed,        misstatements may occur and not be prevented or detected. Accordingly, even effective        internal control over financial reporting can provide only reasonable assurance with        respect to financial statement preparation. Further, the evaluation of the effectiveness of        internal control over financial reporting was made as of a specific date, and continued        effectiveness in future periods is subject to the risks that controls may become inadequate        because of changes in conditions or that the degree of compliance with the policies and        procedures may decline.

 

Management        conducted an evaluation of the effectiveness of our system of internal control over        financial reporting as of December 31, 2007 based on the framework set forth in "Internal        Control - Integrated Framework" issued by the Committee of Sponsoring Organizations of the        Treadway Commission. Based on its evaluation, management concluded that, as of December 31,        2007, Highlands Bankshares, Inc.’s internal control over financial reporting was        effective.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

3

 

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HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

         

CONSOLIDATED BALANCE SHEETS

December        31, 2007 and 2006

(Amounts        in thousands)

 

| ASSETS                                                                                                                                                                                                  |   |    2007 |   | 2006            |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|--------|-----------------|
| Cash and due from banks                                                                                                                                                                                 |   | $ 23,998               |   | $ 15,147        |
| Federal funds sold                                                                                                                                                                                      |   | 8,129                  |   | 2,832           |
|                                                                                                                                                                                                    |   |                   |   |            |
| Total Cash and Cash Equivalents                                                                                                                                                                         |   | 32,127                 |   | 17,979          |
|                                                                                                                                                                                                    |   |                   |   |            |
| Investment securities available-for-sale (Note 2)                                                                                                                                                       |   | 131,132                |   | 137,984         |
| Other Investments, at cost (Note 3)                                                                                                                                                                     |   | 5,735                  |   | 4,969           |
| Loans, net of allowance for loan losses of $4,630 and $4,565 in                    2007 and 2006, respectively (Note 4)                                                                                 |   |  

446,661        |   |  

433,034 |
| Premises and equipment, net (Note 5)                                                                                                                                                                    |   | 23,162                 |   | 19,316          |
| Interest receivable                                                                                                                                                                                     |   | 4,079                  |   | 4,079           |
| Other assets                                                                                                                                                                                            |   | 17,898                 |   | 15,288          |
|                                                                                                                                                                                                    |   |                   |   |            |
| Total Assets                                                                                                                                                                                            |   | $ 660,794              |   | $ 632,649       |
|                                                                                                                                                                                                    |   |                   |   |            |
| LIABILITIES AND STOCKHOLDERS' EQUITY                                                                                                                                                                    |   |                   |   |            |
| Deposits (Note 8)                                                                                                                                                                                       |   |                   |   |            |
| Noninterest bearing                                                                                                                                                                                     |   | $ 83,986               |   | $ 79,681        |
| Interest bearing                                                                                                                                                                                        |   | 428,761                |   | 420,428         |
|                                                                                                                                                                                                    |   |                   |   |            |
| Total Deposits                                                                                                                                                                                          |   | 512,747                |   | 500,109         |
|                                                                                                                                                                                                    |   |                   |   |            |
| Federal funds purchased                                                                                                                                                                                 |   | -                      |   | -               |
| Interest, taxes and other liabilities                                                                                                                                                                   |   | 3,662                  |   | 4,058           |
| Short term borrowings (Note 9)                                                                                                                                                                          |   | 44,105                 |   | 35,601          |
| Long-term debt (Note 10)                                                                                                                                                                                |   | 47,269                 |   | 40,874          |
| Capital securities (Note 11)                                                                                                                                                                            |   | 6,300                  |   | 6,300           |
|                                                                                                                                                                                                    |   | 101,336                |   | 86,833          |
|                                                                                                                                                                                                    |   |                   |   |            |
| Total Liabilities                                                                                                                                                                                       |   | 614,083                |   | 586,942         |
|                                                                                                                                                                                                    |   |                   |   |            |
| STOCKHOLDERS' EQUITY                                                                                                                                                                                    |   |                   |   |            |
| Common stock, 5,108 and 5,187 shares

issued and outstanding as of December 31, 2007 and

2006, respectively. Authorized 40,000 shares, par value $0.625                    per share (Notes 13 and 15) |   | 3,193                  |   | 3,242           |
|                                                                                                                                                                                                    |   |
| Additional paid-in capital                                                                                                                                                                              |   | 7,405                  |   | 7,026           |
| Retained Earnings                                                                                                                                                                                       |   | 38,247                 |   | 36,267          |
| Accumulated other comprehensive loss                                                                                                                                                                    |   | (2,134)                |   | (828)           |
|                                                                                                                                                                                                    |   |                   |   |            |
| Total Stockholders' Equity                                                                                                                                                                              |   | 46,711                 |   | 45,707          |
|                                                                                                                                                                                                    |   |                   |   |            |
| Total Liabilities and Stockholders' Equity                                                                                                                                                              |   | $ 660,794              |   | $ 632,649       |

 

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, 2007 and 2006

(Amounts        in thousands, except per share data)

 

| INTEREST INCOME                                                            | 2007     |   | 2006     |   |
|----------------------------------------------------------------------------|----------|--------|----------|--------|
|                                                                       |     |   |     |   |
| Loans receivable and fees on loans                                         | $ 32,832 |   | $ 30,319 |   |
| Securities available for sale:                                             |     |   |     |   |
| Taxable                                                                    | 3,652    |   | 3,307    |   |
| Tax-exempt                                                                 | 3,047    |   | 2,875    |   |
| Other Investment Income                                                    | 476      |   | 358      |   |
| Federal funds sold                                                         | 338      |   | 153      |   |
| Total Interest Income                                                      | 40,345   |   | 37,012   |   |
|                                                                       |     |   |     |   |
| INTEREST EXPENSE                                                           |     |   |     |   |
| Deposits                                                                   | 16,886   |   | 14,429   |   |
| Federal funds purchased                                                    | 84       |   | 122      |   |
| Other borrowed funds                                                       | 4,471    |   | 3,940    |   |
| Total interest expense                                                     | 21,441   |   | 18,491   |   |
|                                                                       |     |   |     |   |
| Net interest income                                                        | 18,904   |   | 18,521   |   |
|                                                                       |     |   |     |   |
| PROVISION FOR LOAN LOSSES (Note 4)                                         | 685      |   | 1,147    |   |
|                                                                       |     |   |     |   |
| Net interest income after provision for loan losses                        | 18,219   |   | 17,374   |   |
|                                                                       |     |   |     |   |
| NON-INTEREST INCOME                                                        |     |   |     |   |
| Securities gains                                                           | 80       |   | 99       |   |
| Service charges on deposit accounts                                        | 2,369    |   | 2,805    |   |
| Other service charges, commissions and fees                                | 1,364    |   | 1,220    |   |
| Other operating income                                                     | 800      |   | 704      |   |
| Total Non-Interest Income                                                  | 4,613    |   | 4,828    |   |
|                                                                       |     |   |     |   |
| NON-INTEREST EXPENSE                                                       |     |   |     |   |
| Salaries and employee benefits (Note 14 and 15)                            | 9,879    |   | 9,068    |   |
| Occupancy expense of bank premises                                         | 997      |   | 911      |   |
| Furniture and equipment expense                                            | 1,524    |   | 1,545    |   |
| Other operating expenses (Note 23)                                         | 4,720    |   | 4,362    |   |
| Total Non-Interest Expenses                                                | 17,120   |   | 15,886   |   |
|                                                                       |     |   |     |   |
| Income Before Income Taxes                                                 | 5,712    |   | 6,316    |   |
|                                                                       |     |   |     |   |
| Income Tax Expense (Note 7)                                                | 811      |   | 1,108    |   |
|                                                                       |     |   |     |   |
| Net Income                                                                 | $ 4,901  |   | $ 5,208  |   |
|                                                                       |     |   |     |   |
| Earnings Per Common Share (Note 13)                                        | $ 0.95   |   | $ 1.00   |   |
|                                                                       |     |   |     |   |
| Earnings Per Common Share - assuming dilution (Note                    13) | $ 0.94   |   | $ 0.98   |   |

         

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, 2007 and 2006

(Amounts        in thousands)

 

|                                                                                                                             |         |      |                         |               | Accumulated

Other

Comprehensive

Income |     |
|----------------------------------------------------------------------------------------------------------------------------------|--------------|-----------|------------------------------|--------------------|-------------------------------------------|----------|
|                                                                                                                             |         |      | Additional

Paid-in

Capital | Retained

Earnings | Total

Stockholders'

Equity              |
|                                                                                                                             | Common Stock |
|                                                                                                                             | Shares       | Par Value |
|                                                                                                                             |         |      |                         |               |                                      |     |
| Balance, December 31, 2005                                                                                                       | 5,281        | $ 3,300   | $ 6,788                      | $ 33,771           | $ (1,727)                                 | $ 42,132 |
|                                                                                                                             |         |      |                         |               |                                      |     |
| Comprehensive income:                                                                                                            |         |      |                         |               |                                      |     |
| Net income                                                                                                                       | -            | -         | -                            | 5,208              | -                                         | 5,208    |
| Change in unrealized gain (loss) on securities                    available-for-sale, net of deferred income tax expense of $497 | -            | -         | -                            | -                  | 964                                       | 964      |
| Less: reclassification adjustment, net of income tax expense of                    $34                                           | -            | -         | -                            | -                  | (65)                                      | (65)     |
|                                                                                                                             |         |      |                         |               |                                      |     |
| Total comprehensive income                                                                                                       | -            | -         | -                            | -                  | -                                         | 6107     |
|                                                                                                                             |         |      |                         |               |                                      |     |
| Common stock issued for stock options exercised                                                                                  | 27           | 17        | 238                          | -                  | -                                         | 255      |
| Cash dividend                                                                                                                    |         |      |                         | (787)              |                                      | (787)    |
| Repurchase Common Stock                                                                                                          | (121)        | (75)      | -                            | (1,925)            | -                                         | (2,000)  |
|                                                                                                                             |         |      |                         |               |                                      |     |
| Balance, December 31, 2006                                                                                                       | 5,187        | $ 3,242   | $ 7,026                      | $ 36,267           | $ (828)                                   | $ 45,707 |
|                                                                                                                             |         |      |                         |               |                                      |     |
| Comprehensive income:                                                                                                            |         |      |                         |               |                                      |     |
| Net income                                                                                                                       | -            | -         | -                            | 4,901              | -                                         | 4,901    |
| Change in unrealized gain (loss) on securities                    available-for-sale, net of deferred income tax benefit of $645 | -            | -         | -                            | -                  | (1,253)                                   | (1,253)  |
| Less: reclassification adjustment, net of income tax expense of                    $27                                           | -            | -         | -                            | -                  | (53)                                      | (53)     |
|                                                                                                                             |         |      |                         |               |                                      |     |
| Total comprehensive income                                                                                                       | -            | -         | -                            | -                  | -                                         | 3,595    |
|                                                                                                                             |         |      |                         |               |                                      |     |
| Common stock issued for stock options exercised                                                                                  | 40           | 25        | 379                          | -                  | -                                         | 404      |
| Cash dividend                                                                                                                    |         |      |                         | (1,032)            |                                      | (1,032)  |
| Repurchase Common Stock                                                                                                          | (118)        | (74)      | -                            | (1,889)            | -                                         | (1,963)  |
|                                                                                                                             |         |      |                         |               |                                      |     |
| Balance, December 31, 2007                                                                                                       | 5,109        | $ 3,193   | $ 7,405                      | $ 38,247           | $ (2,134)                                 | $ 46,711 |

 

 

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

 

6

 

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HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years        Ended December 31, 2007 and 2006

(Amount        in thousands)

 

|                                                                             | 2007     |   | 2006     |
|----------------------------------------------------------------------------------|----------|--------|----------|
| CASH FLOWS FROM OPERATING ACTIVITIES:                                            |     |   |     |
| Net income                                                                       | $ 4,901  |   | $ 5,208  |
| Adjustments to reconcile net income to net cash                                  |     |   |     |
| provided by operating activities:                                                |     |   |     |
| Provision for loan losses                                                        | 685      |   | 1,147    |
| Provision for deferred income taxes                                              | (69)     |   | (109)    |
| Depreciation and amortization                                                    | 1,245    |   | 1,186    |
| Net realized gains on available-for-sale securities                              | (80)     |   | (99)     |
| Net amortization on securities                                                   | 407      |   | 507      |
| Amortization of capital issue costs                                              | 27       |   | 27       |
| Increase in interest receivable                                                  | --       |   | (536)    |
| (Increase) decrease in other assets                                              | (1,935)  |   | (1,451)  |
| Increase (decrease) in interest, taxes and other                                 |     |   |     |
| liabilities                                                                      | (396)    |   | 1,240    |
| Net Cash provided by operating activities                                        | 4,785    |   | 7,120    |
|                                                                             |     |   |     |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                            |     |   |     |
| Securities available for sale:                                                   |     |   |     |
| Proceeds from sale of debt and equity securities                                 | 3,246    |   | 10,453   |
| Proceeds from maturities of debt and equity                    securities        | 25,412   |   | 22,638   |
| Purchase of debt and equity securities                                           | (24,112) |   | (34,394) |
| Purchase of other investments                                                    | (766)    |   | (411)    |
| Net increase in loans                                                            | (14,311) |   | (26,908) |
| Premises and equipment expenditures                                              | (5,052)  |   | (3,221)  |
| Net Cash used in investing activities                                            | (15,583) |   | (31,843) |
|                                                                             |     |   |     |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                            |     |   |     |
| Net increase in certificates of deposit                                          | 11,633   |   | 28,636   |
| Net increase (decrease) in demand, savings and other                    deposits | 1,005    |   | (15,435) |
| Net increase (decrease) in federal funds purchased                               | --       |   | (4,610)  |
| Net increase (decrease) in short term borrowings                                 | 8,504    |   | 17,503   |
| Net increase in long-term debt                                                   | 6,395    |   | 2,399    |
| Repurchase of capital securities                                                 | -        |   | -        |
| Cash dividends paid                                                              | (1,032)  |   | (787)    |
| Proceeds from exercise of common stock options                                   | 404      |   | 255      |
| Proceeds from issuance of common stock                                           | -        |   | -        |
| Repurchase of common stock                                                       | (1,963)  |   | (2,000)  |
| Net Cash provided by financing activities                                        | 24,946   |   | 25,961   |
| Net increase in cash and cash equivalents                                        | 14,148   |   | 1,238    |
|                                                                             |     |   |     |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR                                   | 17,979   |   | 16,741   |
|                                                                             |     |   |     |
| CASH AND CASH EQUIVALENTS AT END OF YEAR                                         | $ 32,127 |   | $ 17,979 |
|                                                                             |     |   |     |
|                                                                             |     |   |     |
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:                               |     |   |     |
| Cash paid during the year for:                                                   |     |   |     |
| Interest                                                                         | $ 21,282 |   | $ 17,499 |
| Income taxes                                                                     | $ 1,540  |   | $ 1,299  |

 

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

 

7

 

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HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(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 its 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 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.

 

 

8

 

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HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(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

         

 

9

 

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HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(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 considered 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

         

 

10

 

----

 

HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(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, 2007 and 2006 were $1,176 and        $1,970 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* 

 

Effective January 1, 2006 the Company adopted FASB (SFAS) No. 123(R),        Share-Based Payment, which is a revision of SFAS No. 123. Generally, the approach in SFAS        No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R)        requires all share-based payments to employees, including grants of employee stock options,        to be recognized in the income statement based on their grant-date fair values. Pro forma        disclosure is no longer an alternative. No options were granted during 2007 or 2006 so no        compensation has been recognized.

         

*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 thoseestimates. 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.

         

         

         

         

         

         

 

11

 

----

 

HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(Amounts        in thousands)

         

|   | **Note 1.** | **Summary of Significant Accounting Policies                    (Continued)** |
|--------|-------------|-------------------------------------------------------------------------------|

         

*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* 

In September 2006, the FASB issued SFAS No. 157, “Fair Value        Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring        fair value in generally accepted accounting principles and expands disclosures about fair        value measurements. SFAS No. 157 applies under other accounting pronouncements that require        or permit fair value measurements. The Company is required to adopt SFAS No. 157 effective        at the beginning of fiscal year 2008. The Company is evaluating the impact this statement        will have on its consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option        for Financial Assets and Financial Liabilities.” SFAS No. 159 provides all entities        with an option to report selected financial assets and liabilities at fair value. The        Statement is effective as of the beginning of an entity’s first fiscal year beginning        after November 15, 2007, with early adoption available in certain circumstances. The        Company is evaluating the impact this statement will have on its consolidated financial        statements.

In December 2007, the FASB issued SFAS No. 141 (revised 2007) (“SFAS        141R”), “Business Combinations” and SFAS No. 160 (“SFAS        160”), “Noncontrolling Interests in Consolidated Financial Statements, an        amendment of Accounting Research Bulletin No. 51". SFAS 141R will change how business        acquisitions are accounted for and will impact financial statements both on the acquisition        date and in subsequent periods. SFAS 160 will change the accounting and reporting for        minority interests, which will be recharacterized as noncontrolling interests and        classified as a component of equity. SFAS 141R and SFAS 160 are effective for us beginning        in the first quarter of fiscal 2009. Early adoption is not permitted. The Company is        evaluating the impact these statements will have on its consolidated financial        statements.

In December 2007, the FASB issued SFAS No. 160. “Noncontrolling        Interests in Consolidated Financial Statements-and Amendment of ARB No. 51.” SFAS 160        establishes accounting and reporting standards pertaining to ownership interests in        subsidiaries held by parties other than the parent, the amount of net income attributable        to the parent and to the noncontrolling interest, changes in a parent’s ownership        interest, and the valuation of any retained noncontrolling equity investment when a        subsidiary is deconsolidated. This statement also establishes disclosure requirements that        clearly identify and distinguish between the interests of the parent and the interests of        the non-controlling owners. SFAS 160 is effective for fiscal years beginning on or        after

 

 

12

 

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HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(Amounts        in thousands**)**

 

|   | **Note 1.** | **Summary of Significant Accounting Policies                    (Continued)** |
|--------|-------------|-------------------------------------------------------------------------------|

 

December 15, 2008. The adoption of SFAS 160 is not currently expected to        have a material effect on the Company’s consolidated financial position, results of        operations, or cash flows.

         

Several other new accounting standards became effective during the periods        presented or will be effective subsequent to December 31, 2007. None of these new standards        had or is expected to have a significant impact on the Company’s consolidated        financial statements.

         

|   | **Note 2.** | **Investment Securities Available-For-Sale** |
|--------|-------------|----------------------------------------------|

         

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

         

|                                              | 2007                             |
|---------------------------------------------------|----------------------------------|
|                                              | Amortized Cost                   |   | Gross Unrealized Gains |   | Gross Unrealized Losses |   | Fair Value |
|                                              |
|                                              |                             |   |   |   |   |   |   |
| U.S. Government agencies

  and corporations | $     15,272 |   | $     97 |   | $                                1 |   | $        15,368 |
| State and political

  subdivisions     | 63,761                           |   | 423 |   | 823 |   | 63,361 |
| Mortgage backed securities                        | 35,160                           |   | 107 |   | 290 |   | 34,977 |
| Other securities                                  | 20,172                           |   | 14 |   | 2,761 |   | 17,426 |
|                                              |                             |   |   |   |   |   |   |
|                                              | $   134,365            |   | $    641 |   | $      3,875 |   | $      131,132 |

         

 

13

 

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HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(Amounts        inthousands**)**

         

|   | **Note 2.** | **Investment Securities Available-For-Sale                    (Continued)** |
|--------|-------------|-----------------------------------------------------------------------------|

                                                                              

|                                             | 2006           |
|--------------------------------------------------|----------------|
|                                             | Amortized Cost |   | Gross Unrealized Gains |   | Gross Unrealized Losses |   | Fair Value |
|                                             |
|                                             |           |   |   |   |   |   |   |
| U.S Government agencies and

  corporations | $ 10,417       |   | $ 22 |   | $ 88 |   | $ 10,351 |
| State and political subdivisions                 | 60,587         |   | 501 |   | 196 |   | 60,892 |
| Mortgage backed securities                       | 49,642         |   | 127 |   | 650 |   | 49,120 |
| Other securities                                 | 18,592         |   | 24 |   | 994 |   | 17,621 |
|                                             |           |   |   |   |   |   |   |
|                                             | $ 139,238      |   | $ 674 |   | $ 1,928 |   | $ 137,984 |

 

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

         

|                         | ---------------------------------------December 31,                    2007--------------------------- |
|------------------------------|--------------------------------------------------------------------------------------------------------|
|                         | Less Than 12 months                                                                                    | 12 Months or More | Total |
|                         | Fair Value                                                                                             | Unrealized Losses | Fair Value | Unrealized Losses | Fair Value | Unrealized Losses |
|                         |                                                                                                   |   |   |   |   |   |
| Mortgage-backed securities   | $ 8,508                                                                                                | $ 61 | $ 16,186 | $ 229 | $24,694 | $ 290 |
| States and pol. subdivisions | 19,648                                                                                                 | 578 | 6,852 | 245 | 26,500 | 823 |
| Other securities             | 9,523                                                                                                  | 507 | 6,308 | 2,255 | 15,831 | 2,762 |
|                         |                                                                                                   |   |   |   |   |   |
| Total                        | $ 37,679                                                                                               | $ 1,146 | $ 29,346 | $ 2,729 | $67,025 | $ 3,875 |

         

Management does not believe any individual unrealized loss as of December        31, 2007 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 $60,832        and $15,009 at December 31, 2007 and 2006 respectively, and a market value of $60,705 and        $15,038 at December 31, 2007 and 2006, respectively were pledged as collateral on public        deposits, FHLB advances and for other purposes as required or permitted by law.

 

14

 

----

 

HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(Amounts        in thousands)

 

|   | **Note 2.** | **Investment Securities Available-For-Sale                    (Continued)** |
|--------|-------------|-----------------------------------------------------------------------------|

         

The amortized cost and estimated fair value of securities available-for-sale        at December 31, 2007 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                | $ 750          |   | $ 750                     |
| Due after one year through five years  | 1,009          |   | 1,006                     |
| Due after five years through ten years | 3,986          |   | 4,002                     |
| Due after ten years                    | 73,288         |   | 72,972                    |
|                                   | 79,033         |   | 78,730                    |
|                                   |           |   |                      |
| Mortgage-backed securities             | 35,160         |   | 34,977                    |
| Other securities                       | 20,172         |   | 17,425                    |
|                                   | $ 134,365      |   | $ 131,132                 |

         

For the years ended December 31, 2007 and 2006, proceeds from sale of        securities were $3,246 and $10,453, respectively. Gross realized gains and losses on        investment securities available for sale were as follows:

 

|            |   | 2007   |   | 2006   |
|-----------------|--------|--------|--------|--------|
|            |   |   |   |   |
| Realized gains  |   | $ 80   |   | $ 153  |
| Realized losses |   | $ --   |   | $ 54   |
| Tax provision   |   | $ 27   |   | $ 34   |

 

|   | **Note 3.** | **Other Investments** |
|--------|-------------|-----------------------|

         

Federal Home Loan Bank (FHLB) stock, Federal Reserve Bank (FRB) stock,        Bankers’ Bank stock (TBB) and Community Bankers’ Bank stock with a carrying        value of $5,735 and $4,969 at December 31, 2007 and 2006, respectively are stated at cost        and included 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.

 

 

15

 

----

 

HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(Amounts        in thousands)

         

 

|   | **Note 4.** | **Loans** |
|--------|-------------|-----------|

         

The composition of net loans is as follows:

         

|                                          | 2007      |   | 2006      |
|-----------------------------------------------|-----------|--------|-----------|
| Real Estate Secured:                          |      |   |      |
| Residential 1-4 family                        | $ 163,917 |   | $ 156,753 |
| Multifamily                                   | 9,420     |   | 10,520    |
| Commercial, Construction and Land Development | 159,794   |   | 152,491   |
| Second mortgages                              | 17,965    |   | 15,305    |
| Equity lines of credit                        | 9,783     |   | 9,493     |
| Farmland                                      | 9,475     |   | 9,343     |
|                                          | 370,354   |   | 353,905   |
|                                          |      |   |      |
| Secured, Other:                               |      |   |      |
| Personal                                      | 24,741    |   | 27,384    |
| Commercial                                    | 26,433    |   | 26,943    |
| Agricultural                                  | 4,232     |   | 5,093     |
|                                          | 55,406    |   | 59,420    |
|                                          |      |   |      |
| Unsecured                                     | 25,828    |   | 24,565    |
| Overdrafts                                    | 364       |   | 280       |
|                                          | 26,192    |   | 24,845    |
|                                          |      |   |      |
|                                          | 451,952   |   | 438,170   |
| Less:                                         |      |   |      |
| Allowance for loan losses                     | 4,630     |   | 4,565     |
| Net deferred fees                             | 661       |   | 571       |
|                                          | 5,291     |   | 5,136     |
|                                          |      |   |      |
| Loans, net                                    | $ 446,661 |   | $ 433,034 |

         

Activity in the allowance for loan losses is as follows:

         

|                            | 2007    |   | 2006    |
|---------------------------------|---------|--------|---------|
|                            |    |   |    |
| Balance, beginning              | $ 4,565 |   | $ 4,359 |
| Provision charged to operations | 685     |   | 1,147   |
| Loans charged to reserve        | (832)   |   | (1,080) |
| Recoveries                      | 212     |   | 139     |
|                            |    |   |    |
| Balance, ending                 | $ 4,630 |   | $ 4,565 |

         

 

16

 

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HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(Amounts        in thousands)

 

|   | **Note 4.** | **Loans (Continued)** |
|--------|-------------|-----------------------|

         

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

         

|                                                                            | December 31, |
|---------------------------------------------------------------------------------|--------------|
|                                                                            | 2007         |   | 2006 |
|                                                                            |         |   |   |
| Impaired loans without a valuation allowance                                    | $ -          |   | $ - |
| Impaired loans with a valuation allowance                                       | 7,649        |   | 4,561 |
| Total impaired loans                                                            | $ 7,649      |   | $ 4,561 |
| Valuation allowance related to impaired loans                                   | $ 1,646      |   | $ 1,748 |
|                                                                            |         |   |   |
| Total non-accrual loans                                                         | $ 7,849      |   | $ 2,696 |
| Total loans past due 90 days or more and still                    accruing      | $ 268        |   | $ 704 |
| Average investment in impaired loans                                            | $ 5,874      |   | $ 4,307 |
| Interest income recognized on impaired loans                                    | $ 136        |   | $ 248 |
| Interest income recognized on a cash basis on impaired                    loans | $ -          |   | $  - |

 

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: |
|--------|---------------------------------------------------------------------------|

 

|                           | 2007     |   | 2006     |
|--------------------------------|----------|--------|----------|
|                           |     |   |     |
| Land                           | $ 10,024 |   | $ 6,854  |
| Bank Premises                  | 12,854   |   | 11,778   |
| Equipment                      | 10,348   |   | 9,673    |
|                           | 33,226   |   | 28,305   |
| Less: accumulated depreciation | 10,102   |   | 8,989    |
|                           | 23,124   |   | 19,316   |
| Construction in Progress       | 38       |   | --       |
|                           |     |   |     |
|                           | $ 23,162 |   | $ 19,316 |

 

Depreciation expense was $1,206 and $1,146 for 2007 and 2006,        respectively.

 

17

 

----

 

HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(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, 2007 and 2006 are $11,977 and $8,994, respectively and are        included in “Other Assets” in the balance sheet. In addition to the original        purchase in 2002, the Company purchased an additional 2.5 million of Bank Owned Life        Insurance in April of 2007.

         

|   | **Note 7.** | **Income Taxes** |
|--------|-------------|------------------|

 

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

 

|                                                  | 2007    |   | 2006    |
|-------------------------------------------------------|---------|--------|---------|
|                                                  |    |   |    |
| Deferred tax assets:                                  |    |   |    |
| Allowance for loan loss                               | $ 1,574 |   | $ 1,551 |
| Deferred compensation                                 | -       |   | -       |
| Net unrealized loss on securities

available-for-sale | 1,100   |   | 427     |
|                                                  | 2,674   |   | 1,978   |
|                                                  |    |   |    |
| Deferred tax liability:                               |    |   |    |
| Depreciation                                          | (511)   |   | (557)   |
|                                                  | (511)   |   | (557)   |
|                                                  |    |   |    |
| Net deferred tax asset                                | $ 2,163 |   | $ 1,421 |

 

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

         

|     | 2007   |   | 2006    |
|----------|--------|--------|---------|
|     |   |   |    |
| Federal: |   |   |    |
| Current  | $ 880  |   | $ 1217  |
| Deferred | (69)   |   | (109)   |
|     |   |   |    |
| Total    | $ 811  |   | $ 1,108 |

 

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

 

|                                                    | 2007    |   | 2006    |
|---------------------------------------------------------|---------|--------|---------|
|                                                    |    |   |    |
| Statutory rate applied to earnings before

income taxes | $ 1,942 |   | $ 2,147 |
| Tax exempt interest                                     | (1036)  |   | (977)   |
| Other, net                                              | (95)    |   | (62)    |
|                                                    |    |   |    |
| Total                                                   | $ 811   |   | $ 1,108 |

         

 

18

 

----

 

HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(Amounts        in thousands)

 

|   | **Note 8.** | **Deposits** |
|--------|-------------|--------------|

         

The composition of deposits is as follows:

 

|                                           | 2007      |   | 2006      |
|------------------------------------------------|-----------|--------|-----------|
|                                           |      |   |      |
| Non-interest bearing demand                    | $ 83,986  |   | $ 79,681  |
| Interest bearing demand                        | 61,284    |   | 59,849    |
| Savings deposits                               | 46,931    |   | 51,666    |
| Time deposits, in amounts of $100,000

or more | 112,150   |   | 101,944   |
| Other time deposits                            | 208,396   |   | 206,969   |
|                                           |      |   |      |
| Total deposits                                 | $ 512,747 |   | $ 500,109 |

         

The scheduled maturities of time deposits at December 31, 2007 are as        follows:

         

| 2008       | $ 223,604 |
|------------|-----------|
| 2009       | 39,921    |
| 2010       | 23,263    |
| 2011       | 9,199     |
| 2012       | 22,812    |
| Thereafter | 1,747     |
|       |      |
|       | $ 320,546 |

         

|   | **Note 9.** | **Other Short-Term Borrowings** |
|--------|-------------|---------------------------------|

 

Other short-term borrowings in the balance sheet consist of six Federal Home        Loan Bank advances that are secured by a lien on a specific class of residential and        commercial mortgage loans of the Bank. The advances are also secured by a specific group of        available for sale securities held in safekeeping by the FHLB. The Federal Home Loan Bank        has the option to convert 5 of these advances which total $38 million to a three month        LIBOR-based floating rate advance. These five notes carry interest rates of 6.280%, 6.170%,        3.44%, 4.47%, and 4.33%. The sixth advance which totals $6 million has a final maturity in        March of 2008 and carries a rate of 5.51%. 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.

 

19

 

----

 

HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(Amounts        in thousands)

 

**Note 10. Long-Term Debt**

         

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

         

|                                                                                                                                                                                                                                                                                                                                                                                                                                                | 2007                              |   | 2006                               |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------|--------|------------------------------------|
| 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 and a specific group of securities available for sale. | Included in short term borrowings |   | $ 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 and a                    specific group of securities available for sale.             | $ 4,000                           |   | $ 4,000                            |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                |                              |   |                               |
| 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 and a                    specific group of securities available for sale.         | Paid off                          |   | Included in

short term borrowings |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                |                              |   |                               |
| 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                    and a specific group of securities available for sale.       | Paid off                          |   | Included in short term borrowings  |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                |                              |   |                               |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                     |                                   |        |                                    |  |

         

 

20

 

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HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(Amounts        in thousands)

 

**Note 10. Long-Term Debt (Continued)**

         

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | 2007                              |   | 2006    |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------|--------|---------|
| 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                    and a specific group of securities available for sale.                                 | Included in short term borrowings |   | $ 7,500 |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                              |   |    |
| 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                    and a specific group of securities available for sale.                                   | $ 5,000                           |   | $ 5,000 |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                              |   |    |
| 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                    and a specific group of securities available for sale.                                   | $ 5,000                           |   | $ 5,000 |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                              |   |    |
| 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 and a specific group of securities available for                    sale. | $ 597                             |   | $ 645   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                              |   |    |
| 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.                                                                                      | $ 172                             |   | $ 229   |

         

 

21

 

----

 

HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(Amounts        in thousands)

 

**Note 10. Long-Term Debt (Continued)**

 

|                                                                                                                                                                                                                                                                                                                                                                                                                                          | 2007     |   | 2006     |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|--------|----------|
| Note payable FHLB dated 05/16/06 for $12.5 million with an                    annual interest rate of 4.80%, due 05/16/2016. The note requires quarterly                    interest payments and has an early conversion option at 05/18/2009. The loan is                    secured by a floating blanket lien on a specific class of mortgage loans of the                    Bank and a specific group of securities available for sale. | $ 12,500 |   | $ 12,500 |
|                                                                                                                                                                                                                                                                                                                                                                                                                                          |     |   |     |
| Note payable FHLB dated 05/18/07 for $5 million with an annual                    interest rate of 4.34%, due 05/18/2017. The note requires quarterly interest                    payments and has an early conversion option at 05/18/2009. The loan is secured                    by a floating blanket lien on a specific class of mortgage loans of the Bank                    and a specific group of securities available for sale.    | $ 5,000  |   | N/A      |
|                                                                                                                                                                                                                                                                                                                                                                                                                                          |     |   |     |
| Note payable FHLB dated 09/13/07 for $15 million with an annual                    interest rate of 3.84%, due 09/13/2017. The note requires quarterly interest                    payments and has an early conversion option at 09/13/2009. The loan is secured                    by a floating blanket lien on a specific class of mortgage loans of the Bank                    and a specific group of securities available for sale.   | $ 15,000 |   | N/A      |
| Total long-term debt                                                                                                                                                                                                                                                                                                                                                                                                                          | $ 47,269 |   | $ 40,874 |

 

 

Contractual principal maturities of long-term debt at December 31, 2007 are        as follows:

         

|                          2008               | $                               - |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------|
|                                             2009 | 4,111                                                                                    |
|                                             2010 | 90                                                                                       |
|                                             2011 | 82                                                                                       |
|                                             2012 | 85                                                                                       |
|                                            Thereafter | 42,901                                                                                   |
|                                                                                                                                                                     |                                                                                     |
|                                                                                                                                                                     | $   47,269                                                                     |

         

 

22

 

----

 

HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(Amounts        in thousands, except per share data)

         

**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, 2007, and an estimated fair value of        $6,590. The related junior subordinated debt securities had an estimated fair value of        $6,590. 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. See Footnote 26 for additional information concerning the Capital        Securities.

         

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.

         

See Footnote 26 for additional information concerning the Capital        Securities.

         

**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:                    |                                                                                                           |
|-----------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------|
|                                                                                                                                          |                                                                                                           |
|                                    2008                            | $                32            |
|                                    2009                            | $                  9 |
|                                                                                                                                          |                                                                                                           |
|                                    Total minimum payments required | $                 41      |

         

Total operating lease expense was $66 and $63 for December 31, 2007 and        2006, respectively.

         

 

 

 

23

 

----

 

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

         

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2007

(Amounts in thousands, except per share data)

         

**Note 13. Common Stock and Earnings Per Common Share**

         

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:

 

|                                             | 2007    |   | 2006    |
|--------------------------------------------------|---------|--------|---------|
|                                             |    |   |    |
| Income available to common

stockholders         | $ 4,901 |   | $ 5,208 |
| Weighted average shares outstanding              | 5,155   |   | 5,225   |
| Shares outstanding including assumed

conversion | 5,223   |   | 5,306   |
| Basic earnings per share                         | $ 0.95  |   | $ 1.00  |
| Fully diluted earnings per share                 | $ 0.94  |   | $ 0.98  |

         

Highlands Bankshares, Inc. paid dividends of $1,032 and $787 or $0.20 per        share and $0.15 per share in 2007 and 2006, 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% 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 $313 and $291 in 2007 and 2006 respectively.

 

24

 

----

                    HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

         

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2007

(Amounts in thousands, except per share data)

         

**Note 15. Stock Option Plan and Equity Compensation Plan**

 

In 1996, Highlands Bankshares, Inc. adopted a 10 year 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.

         

The Company sponsors an equity compensation plan, adopted by the Board of        Directors in 2006, which provides for the granting of nonqualified stock options, stock        appreciation rights, stock awards and stock units. Under the plan, the Company may grant        options to its directors, officers and employees for up to 200,000 shares of common stock.        The Company did not grant any equity compensation in 2007 or 2006.

 

 

 

25

 

----

            HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

         

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2007

(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:

 

|                                                            | 2007                            | 2006             |
|-----------------------------------------------------------------|---------------------------------|------------------|
|                                                            |                            |             |   |   |
|                                                            | Weighted Average Exercise Price | Number of Shares | Weighted Average Exercise Price | Number of Shares |
|                                                            |                            |             |   |   |
|                                                            |                            |             |   |   |
| Options outstanding at January 1                                | $ 12.58                         | 353,752          | $ 12.36 | 380,970 |
| Granted                                                         | -                               | -                | - | - |
| Exercised                                                       | 10.31                           | (39,431)         | 9.52 | (27,218) |
| Expired                                                         | -                               | -                | - | - |
|                                                            |                            |             |   |   |
| Options outstanding and

exercisable at December 31             | $ 12.86                         | 314,321          | $ 12.58 | 353,752 |
|                                                            |                            |             |   |   |
| Weighted-average fair value of

options granted during the year | $ -                             |             | $ - |   |

         

Information pertaining to options outstanding at December 31, 2007 is as        follows:

         

|                       | Options Outstanding and Exercisable |
|----------------------------|-------------------------------------|
| Range of Exercise Prices   | Number Outstanding                  |   | Weighted Average Remaining Contractual Life |   | Weighted Average Exercise Price |
|                       |                                |   |   |   |   |
| $ 7.50 - $ 7.75            | 21,600                              |   | .67 years |   | $ 7.60 |
| $ 9.50 - $12.50            | 89,930                              |   | 2.79 years |   | $ 11.63 |
| $ 13.00 - $15.00           | 202,791                             |   | 6.12 years |   | $ 13.97 |
|                       |                                |   |   |   |   |
| Outstanding at end of year | 314,321                             |   | 4.79 years |   | $ 12.86 |

         

 

26

 

----

                                                                                                                       

                    HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

         

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2007

(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 $3,155 and $4,170, unfunded commitments under lines of        credit of $47,070 and $46,917 and commitments to grant loans of $6,513 and $11,619 for the        years ended December 31, 2007 and 2006 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 $180,537 of lines of credit to fund any necessary cash requirements.        The Bank has $91,144 of Federal Home Loan Bank advances outstanding as of December 31,        2007. A specific class of commercial and residential mortgage loans, with a balance of        $178,793 at December 31, 2007 and a specific group of securities available for sale with a        book value of $45,042 at December 31, 2007 were pledged to the FHLB as        collateral.

 

27

 

----

 

HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(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.

 

*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-

 

28

 

----

HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(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 or established call prices 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:

         

|                           | 2007            |       | 2006   |
|--------------------------------|-----------------|------------|--------|
|                           | Carrying Amount | Fair Value |   | Carrying Amount | Fair Value |
|                           |            |
|                           |            |       |   |   |   |
| Cash and cash equivalents      | $ 32,127        | $ 32,127   |   | $ 17,979 | $ 17,979 |
| Securities available for

sale | 131,132         | 131,132    |   | 137,984 | 137,984 |
| Other investments              | 5,735           | 5,735      |   | 4,969 | 4,969 |
| Loans, net                     | 446,661         | 446,296    |   | 433,034 | 437,698 |
| Deposits                       | (512,747)       | (515,344)  |   | (500,109) | (499,549) |
| Other short-term

borrowings   | (44,105)        | (45,722)   |   | (35,601) | (36,222) |
| Long-term debt                 | (47,269)        | (48,950)   |   | (40,874) | (40,839) |
| Capital Securities             | (6,300)         | (6,590)    |   | (6,300) | (6,428) |

         

         

         

         

         

         

 

29

 

----

 

HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(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:

         

|               | 2007     |   | 2006     |
|--------------------|----------|--------|----------|
|               |     |   |     |
| Balance, beginning | $ 10,889 |   | $ 11,769 |
| Additions          | 5,152    |   | 2,499    |
| Reductions         | (4,777)  |   | (3,379)  |
|               |     |   |     |
| Balance, ending    | $ 11,264 |   | $ 10,889 |
|               |     |   |     |
| Unused commitments | $ 865    |   | $ 1,406  |
|               |     |   |     |

 

Deposits from related parties held by the Bank at December 31, 2007 and 2006        were $4,995 and $4,845, 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, 2007 and 2006 were $7,634        and $7,588, 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.

         

 

30

 

----

HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(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, 2007 and 2006, that the Company and the Bank met all the capital adequacy requirements        to which they are subject.

         

As of December 31, 2007 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, 2007:                            |     |   |                          |   |   |   |   |
| Total Risk-Based Capital (to Risk-Weighted

Assets) | $ 57,507 |   | 12.63%                        |   | $ 36,438 |   | =,> 8% |
| Tier 1 Capital (to Risk-Weighted Assets)            | 52,877   |   | 11.61%                        |   | 18,219 |   | =,> 4% |
| Tier 1 Capital (to Adjusted Total Assets)           | 52,877   |   | 8.01%                         |   | 26,410 |   | =,> 4% |
|                                                |     |   |                          |   |   |   |   |
| As of December 31, 2006:                            |     |   |                          |   |   |   |   |
| Total Risk-Based Capital (to Risk-Weighted

Assets) | $ 56,325 |   | 12.75%                        |   | $ 35,332 |   | =,> 8% |
| Tier 1 Capital (to Risk-Weighted Assets)            | 51,760   |   | 11.72%                        |   | 17,666 |   | =,> 4% |
| Tier 1 Capital (to Adjusted Total Assets)           | 51,760   |   | 8.19%                         |   | 25,284 |   | =,> 4% |
|                                                |     |   |                          |   |   |   |   |

         

 

31

 

----

HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(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, 2007:                           |     |                          |                                                                                    |   |   |   |
| Total Risk-Based Capital (to Risk-Weighted Assets) | $ 49,807 | 11.04%                        | $ 36,080                                                                                | =,> 8% | $ 45,100 | =,> 10% |
| Tier 1 Capital (to Risk-Weighted Assets)           | 45,177   | 10.02%                        | 18,040                                                                                  | =,> 4% | 27,060 | =,> 6% |
| Tier 1 Capital (to Adjusted Total Assets)          | 45,177   | 6.89%                         | 26,230                                                                                  | =,> 4% | 32,789 | =,> 5% |
|                                               |     |                          |                                                                                    |   |   |   |
| As of December 31, 2006:                           |     |                          |                                                                                    |   |   |   |
| Total Risk-Based Capital (to Risk-Weighted Assets) | $ 50,466 | 11.60%                        | $ 34,810                                                                                | =,> 8% | $ 43,512 | =,> 10% |
| Tier 1 Capital (to Risk-Weighted Assets)           | 45,926   | 10.55%                        | 17,405                                                                                  | =,> 4% | 26,107 | =,> 6% |
| Tier 1 Capital (to Adjusted Total Assets)          | 45,926   | 7.34%                         | 25,020                                                                                  | =,> 4% | 31,275 | =,> 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 2008 without regulatory approval total $5,829        plus year-to-date 2008 net profits as of the declaration date.

         

 

32

 

----

HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(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:

         

|                      | 2007   |   | 2006   |
|---------------------------|--------|--------|--------|
|                      |   |   |   |
| BOLI income               | $ 483  |   | $ 371  |
|                      |   |   |   |
| Postage and freight       | $ 356  |   | $ 336  |
|                      |   |   |   |
| Other Contracted Services | $ 519  |   | $ 474  |
|                      |   |   |   |
| Bank Franchise Taxes      | $ 438  |   | $ 436  |

                                                                                                            

**Note 24. Condensed Parent Company Financial Statements**

 

The condensed financial statements below relate to Highlands Bankshares,        Inc., as of December 31, 2007 and 2006 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                                                                                |     |   |     |
|---------------------------------------------------------------------------------------------------------|----------|--------|----------|
|                                                                                                    | 2007     |   | 2006     |
| ASSETS                                                                                                  |     |   |     |
| Cash                                                                                                    | $ 4,553  |   | $ 661    |
| Capital securities repurchased                                                                          | 1,200    |   | 1,200    |
| Other investments                                                                                       | 152      |   | -        |
| Loans, net of allowance for loan losses of $0 and $25 in 2007                    and 2006, respectively | --       |   | 2,080    |
| Equity in subsidiary                                                                                    | 45,310   |   | 46,172   |
| Premises and equipment, net                                                                             | 2,897    |   | 2,937    |
| Other assets                                                                                            | 252      |   | 306      |
|                                                                                                    |     |   |     |
| Total Assets                                                                                            | $ 54,364 |   | $ 53,356 |
|                                                                                                    |     |   |     |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                              |     |   |     |
| Interest, taxes and other liabilities                                                                   | $ 153    |   | $ 149    |
| Capital securities                                                                                      | 7,500    |   | 7,500    |
| Total Liabilities                                                                                       | 7,653    |   | 7,649    |
|                                                                                                    |     |   |     |
| STOCKHOLDERS’ EQUITY                                                                              | 46,711   |   | 45,707   |
|                                                                                                    |     |   |     |
| Total Liabilities and Stockholders’ Equity                                                        | $ 54,364 |   | $ 53,356 |

 

 

33

 

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HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(Amounts        in thousands)

 

**Note 24. Condensed Parent Company Financial Statements        (Continued)**

         

| CONDENSED STATEMENTS OF INCOME                 |    |   |    |
|------------------------------------------------|---------|--------|---------|
|                                           | 2007    |   | 2006    |
|                                           |    |   |    |
| Dividends from subsidiary                      | $ 5,000 |   | $ -     |
| Interest income                                | 128     |   | 260     |
| Other income                                   | 226     |   | 257     |
| Interest expense                               | (694)   |   | (694)   |
| Operating expense                              | (204)   |   | (200)   |
|                                           | 4,456   |   | (377)   |
|                                           |    |   |    |
|                                           |    |   |    |
| Income tax benefit                             | 185     |   | 128     |
| Equity in undistributed earnings of subsidiary | 260     |   | 5,457   |
|                                           |    |   |    |
| Net income                                     | $ 4,901 |   | $ 5,208 |

         

 

 

34

 

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HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(Amounts        in thousands)

         

|   | **Note 24.** | **Condensed Parent Company Financial Statements                    (Continued)** |
|--------|--------------|----------------------------------------------------------------------------------|

         

| CONDENSED STATEMENTS OF CASH FLOWS                                                 |    |   |    |
|------------------------------------------------------------------------------------|---------|--------|---------|
|                                                                               | 2007    |   | 2006    |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                              |    |   |    |
| Net income                                                                         | $ 4,901 |   | $ 5,208 |
| Adjustments to reconcile net income to net cash

Provided by operating activities: |    |   |    |
| Depreciation and amortization                                                      | 93      |   | 96      |
| Provision for loan losses                                                          | (25)    |   | 5       |
| Net realized gains on other investments                                            | -       |   | (30)    |
| Provision for deferred income taxes                                                | 3       |   | 6       |
| Equity in undistributed earnings of subsidiary                                     | (260)   |   | (5,457) |
| Increase in other assets                                                           | (179)   |   | (132)   |
| Increase (decrease) in other liabilities                                           | 4       |   | 1       |
|                                                                               |    |   |    |
| Net cash provided by operating activities                                          | 4,537   |   | (303)   |
|                                                                               |    |   |    |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                              |    |   |    |
| (Purchase) sale of other investments                                               | (152)   |   | 580     |
| Net (increase) decrease in loans                                                   | 2,105   |   | 669     |
| Premises and equipment expenditures                                                | (7)     |   | (907)   |
|                                                                               |    |   |    |
| Net cash provided by (used in) investing

activities                               | 1,946   |   | 342     |
|                                                                               |    |   |    |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                              |    |   |    |
|                                                                               |    |   |    |
| Cash dividends paid                                                                | (1,032) |   | (787)   |
| Repurchase of capital securities                                                   | -       |   | -       |
| Proceeds from issuance of common stock                                             | -       |   | -       |
| Proceeds from exercise of common stock options                                     | 404     |   | 255     |
| Repurchase of Common Stock                                                         | (1,963) |   | (2,000) |
|                                                                               |    |   |    |
| Net cash used in financing activities                                              | (2,591) |   | (2,532) |
|                                                                               |    |   |    |
| Net increase in cash and cash equivalents                                          | 3,892   |   | (2,493) |
|                                                                               |    |   |    |
| CASH AND CASH EQUIVALENTS AT

BEGINNING OF YEAR                                    | 661     |   | 3,154   |
|                                                                               |    |   |    |
| CASH AND CASH EQUIVALENTS AT END OF

YEAR                                          | $ 4,553 |   | $ 661   |

         

 

35

 

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HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(Amounts        in thousands)

         

**Note 25. Quarterly Data (Unaudited)**

 

| Consolidated quarterly results of operations were as                    follows: |     |   |     |   |     |
|----------------------------------------------------------------------------------|----------|--------|----------|--------|----------|
|                                                                             | 2007     |
|                                                                             | March 31 |   | June 30  |   | Sept. 30 |   | Dec. 31 |
|                                                                             |     |   |     |   |     |   |   |
| Interest Income                                                                  | $ 9,960  |   | $ 10,081 |   | $ 10,031 |   | $ 10,273 |
| Interest Expense                                                                 | (5,221)  |   | (5,279)  |   | (5,458)  |   | (5,483) |
|                                                                             |     |   |     |   |     |   |   |
| Net interest income                                                              | 4,739    |   | 4,802    |   | 4,573    |   | 4,790 |
| Provision for loan losses                                                        | (190)    |   | (143)    |   | (93)     |   | (259) |
| Net interest income after provision for

possible loan losses                    | 4,549    |   | 4,659    |   | 4,480    |   | 4,531 |
| Other income                                                                     | 1,052    |   | 1,147    |   | 1,201    |   | 1,213 |
| Other expenses                                                                   | (4,139)  |   | (4,237)  |   | (4,285)  |   | (4,459) |
|                                                                             |     |   |     |   |     |   |   |
| Income before income taxes                                                       | 1,462    |   | 1,569    |   | 1,396    |   | 1,285 |
| Income taxes                                                                     | (229)    |   | (248)    |   | (180)    |   | (154) |
|                                                                             |     |   |     |   |     |   |   |
| Net income                                                                       | $ 1,233  |   | $ 1,321  |   | $ 1,216  |   | $ 1,131 |
|                                                                             |     |   |     |   |     |   |   |
| Earnings per common share:                                                       |     |   |     |   |     |   |   |
| Basic                                                                            | $ 0.24   |   | $ 0.26   |   | $ 0.24   |   | $ 0.22 |
| Diluted                                                                          | $ 0.23   |   | $ 0.25   |   | $ 0.23   |   | $ 0.22 |
|                                                                             |     |   |     |   |     |   |   |
|                                                                             | 2006     |
|                                                                             | March 31 |   | June 30  |   | Sept. 30 |   | Dec. 31 |
|                                                                             |     |   |     |   |     |   |   |
| Interest Income                                                                  | $ 8,562  |   | $ 9,081  |   | $ 9,527  |   | $ 9,842 |
| Interest Expense                                                                 | (4,081)  |   | (4,442)  |   | (4,850)  |   | (5,118) |
|                                                                             |     |   |     |   |     |   |   |
| Net interest income                                                              | 4,481    |   | 4,639    |   | 4,677    |   | 4,724 |
| Provision for loan losses                                                        | (256)    |   | (328)    |   | (317)    |   | (246) |
| Net interest income after provision for

possible loan losses                    | 4,225    |   | 4,311    |   | 4,360    |   | 4,478 |
| Other income                                                                     | 1,153    |   | 1,188    |   | 1,245    |   | 1,242 |
| Other expenses                                                                   | (3,787)  |   | (3,918)  |   | (3,996)  |   | (4,185) |
|                                                                             |     |   |     |   |     |   |   |
| Income before income taxes                                                       | 1,591    |   | 1,581    |   | 1,609    |   | 1,535 |
| Income taxes                                                                     | (300)    |   | (289)    |   | (278)    |   | (241) |
|                                                                             |     |   |     |   |     |   |   |
| Net income                                                                       | $ 1,291  |   | $ 1,292  |   | $ 1,331  |   | $ 1,294 |
|                                                                             |     |   |     |   |     |   |   |
| Earnings per common share:                                                       |     |   |     |   |     |   |   |
| Basic                                                                            | $ 0.25   |   | $ 0.25   |   | $ 0.26   |   | $ 0.24 |
| Diluted                                                                          | $ 0.24   |   | $ 0.24   |   | $ 0.25   |   | $ 0.24 |

 

 

36

 

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HIGHLANDS        BANKSHARES, INC. AND SUBSIDIARIES

 

NOTES TO        CONSOLIDATED FINANCIAL STATEMENTS

December        31, 2007

(Amounts        in thousands)

 

 

|   | **Note 26. Subsequent Event** |
|--------|-------------------------------|

 

On January 15, 2008 (the “Redemption Date”), after receiving        regulatory approval, Highlands Bankshares, Inc. (the “Company”) redeemed        $3,862,500 in principal amount of its Junior Subordinated Debt Securities due        January 15, 2028 (the “Debt Securities”). All of the Debt Securities are        held by Highlands Capital Trust I (the “Trust”), the Company’s        partially-owned subsidiary. The redemption price paid for the Debt Securities was 104.625%        of the principal amount of the Debt Securities redeemed, plus accrued and unpaid interest        to but excluding the Redemption Date.

         

Simultaneously, Wilmington Trust Company, the trustee of the Trust, used the        proceeds received from the redemption of the Debt Securities to redeem a “like        amount” of the Trust’s outstanding Common Securities and Preferred Securities        (the “Preferred Securities”). The Trust redeemed $3,750,000 in principal amount        of the Preferred Securities (50% of the total outstanding) at a price equal to 104.625% of        the $25.00 liquidation amount per redeemed Preferred Security, plus accumulated        distributions thereon to but excluding the Redemption Date (the “Preferred Securities        Redemption”). Prior to the Preferred Securities Redemption, the Company held        $1,200,000 in liquidation amount of the Preferred Securities then outstanding. In        connection with the Preferred Securities Redemption, 50% or $600,000 in liquidation amount        of the Preferred Securities held by the Company were redeemed.

         

The Trust also redeemed $112,500 in liquidation amount or 50% of its        outstanding Common Securities, all of which were held by the Company. The redemption price        paid for the Common Securities was 104.625% of the $25.00 liquidation amount per redeemed        Common Security, plus accumulated distributions thereon to but excluding the Redemption        Date.

         

As a result of these transactions, the Company expects to incur a charge to        earnings of approximately $168,000, net of tax. This charge includes the early redemption        premium and the impairment of unamortized debt issuance costs relating to the redeemed Debt        Securities.

 

 

 

37