UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549



FORM 10-K



ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934



For the fiscal year ended December 31, 2005



Commission file number 000-27622



HIGHLANDS BANKSHARES, INC.

(Exact name of registrant as specified in its charter)



|                                                                                 |                                                
|-------------------------------------------------------------------------------- | -----------------------------------------------
|Virginia
(State or other jurisdiction
of incorporation or organization)          | 54-1796693
(I.R.S. Employer
Identification No.)
|340 West Main Street
Abingdon, Virginia
(Address of principal executive offices) | 24210-1128
(Zip Code)                          



Registrants telephone number, including area code:(276) 628-9181



Securities registered pursuant to Section 12(b) of the Act:



|                    |                                          
|------------------- | -----------------------------------------
|Title of each class | Name of each exchange
on which registered
|None                | n/a                                      



Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.625 par value

(Title of class)



Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  NoX



Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15d of the Act. Yes__ NoX



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



Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  [ X ]



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

Large accelerated filer  [  ]   Accelerated filer  [  ]    Non-accelerated filer [X]



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



State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrants most recently completed second fiscal quarter. $54,569,279



Indicate the number of shares outstanding of each of the registrants classes of common stock as of the latest practicable date.  As of March 10, 2006, there were 5,263,400 shares of Common Stock.



DOCUMENTS INCORPORATED BY REFERENCE

Annual Report to Shareholders for the fiscal year ended December 31, 2005Part II

Proxy Statement for the 2006 Annual Meeting of ShareholdersPart III

---



|         |                                                                                                                 |            
|-------- | --------------------------------------------------------------------------------------------------------------- | -----------
|         | Table of Contents                                                                                               |            
|         |                                                                                                                 | Page Number
|Part I   |                                                                                                                 |            
|         |                                                                                                                 |            
|Item 1.  | Business                                                                                                        | 3          
|Item 1A. | Risk Factors                                                                                                    | 16         
|Item 1B. | Unresolved Staff Comments                                                                                       | 19         
|Item 2.  | Properties                                                                                                      | 19         
|Item 3.  | Legal Proceedings                                                                                               | 20         
|Item 4.  | Submission of Matters to a Vote of Security Holders                                                             | 20         
|         |                                                                                                                 |            
|         |                                                                                                                 |            
|Part II  |                                                                                                                 |            
|         |                                                                                                                 |            
|Item 5.  | Market for Registrants Common Equity, Related Stockholder    Matters and Issuer Purchases of Equity Securities | 21         
|Item 6.  | Selected Financial Data                                                                                         | 23         
|Item 7.  | Managements Discussion  and Analysis of Financial Condition
and Results of Operation                           | 24         
|Item 7A. | Quantitative and Qualitative Disclosures About Market Risk                                                      | 44         
|Item 8.  | Financial Statements and Supplementary Data                                                                     | 47         
|Item 9.  | Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure                            | 47         
|Item 9A. | Controls and Procedures                                                                                         | 47         
|Item 9B. | Other Information                                                                                               | 47         
|         |                                                                                                                 |            
|         |                                                                                                                 |            
|Part III |                                                                                                                 |            
|         |                                                                                                                 |            
|Item 10. | Directors and Executive Officers of the Registrant                                                              | 48         
|Item 11. | Executive Compensation                                                                                          | 48         
|Item 12. | Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters                  | 48         
|Item 13. | Certain Relationships and Related Transactions                                                                  | 48         
|Item 14. | Principal Accounting Fees and Services                                                                          | 48         
|         |                                                                                                                 |            
|         |                                                                                                                 |            
|Part IV  |                                                                                                                 |            
|         |                                                                                                                 |            
|Item 15. | Exhibits, Financial Statement Schedules                                                                         | 49         
|         |                                                                                                                 |            
|         |                                                                                                                 |            





























---





Forward-Looking Information



Certain information in this report may include forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act). These forward-looking statements are generally identified by phrases such as the Company expects, the Company believes or words of similar import. These statements speak only as of the date of this report. The statements are based on current expectations, are inherently uncertain, are subject to risks, and should be viewed with caution. Such forward-looking statements involve known and unknown risks including, but not limited to, the following factors:



·

The ability to successfully manage the Companys growth or implement its growth strategies if it is unable to identify attractive markets, locations or opportunities to expand in the future;

·

The ability to continue to attract low cost core deposits to fund asset growth;

·

Maintaining capital levels adequate to support the Companys growth;

·

Maintaining cost controls and asset qualities as the Company opens or acquires new branches;

·

Reliance on the Companys management team, including its ability to attract and retain key personnel;

·

The successful management of interest rate risk;

·

Changes in general economic and business conditions in the Companys market area;

·

Changes in interest rates and interest rate policies;

·

Risks inherent in making loans such as repayment risks and fluctuating collateral values;

·

Competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;

·

Demand, development and acceptance of new products and services;

·

Problems with technology utilized by the Company;

·

Changing trends in customer profiles and behavior; and

·

Changes in banking and other laws and regulations applicable to the Company.



































2





---



Part I.



Item I.  Business



History and Business

Highlands Bankshares, Inc. (the Company) is a one-bank holding company organized under the laws of Virginia in 1995 and registered under the Bank Holding Company Act (BHCA). The Company conducts the majority of its business operations through its wholly-owned bank subsidiary, Highlands Union Bank (the Bank). The Company has two direct subsidiaries as of December 31, 2005: the Bank, which was formed in 1985, and Highlands Capital Trust I (HCTI), a statutory business trust (the Trust) which was formed in 1998.

The Bank maintains a website at www.hubank.com. The Company makes available through the website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports, free of charge, as soon as reasonably practicable after the material is electronically filed with the Securities and Exchange Commission.

Highlands Union Bank

The Bank is a Virginia state chartered bank that was incorporated in 1985. The Bank has two wholly owned subsidiaries, Highlands Union Insurance Services, Inc. (HUIS), which was formed in 1999, and Highlands Union Financial Services, Inc. (HUFS), which was formed in 2001. In February 2005, the Bank became an equity owner in Bankers Investments, LLC, headquartered in Richmond, Virginia. The Banks equity investment was $250,000 for two units of ownership. Bankers Investments, LLC was formed for the purpose of providing owner banks the ability to offer a full line of financial services to their customers. At the time of the Banks investment there were 32 owner banks. The Bank operates a full-service banking business from its headquarters in Abingdon, Virginia,
and its ten full service branch offices. The Bank offers general retail and commercial banking
services to individuals, businesses and local government unit customers. These products and services include
accepting deposits in the form of checking accounts, money market deposit accounts, interest-bearing
demand deposit accounts, savings accounts and time deposits; making commercial, commercial and residential real estate, construction, agricultural and consumer loans; offering letters of credit; providing other consumer financial services, such as automatic funds transfer, collections, night depository, safe deposit, travelers checks and savings bond sales; and providing other miscellaneous services normally offered by commercial banks. The Bank makes loans in all major loan categories, including commercial, commercial and residential real estate, construction,
agricultural and consumer loans.

At December 31, 2005, the Bank had total assets of $593.88 million. Total deposits at this date were $490.40
million. The Banks net income for 2005 was $5.33 million which produced a return on average assets of 0.92% and
a return on average stockholders' equity of 13.34%. Refer to Note 21 of the Notes to Consolidated Financial Statements
for the Banks risk-based capital ratios.

Highlands Union Insurance Services, Inc.

Highlands Union Insurance Services, Inc., a wholly owned subsidiary of the Bank, was formed in 1999. The Bank, through HUIS, joined a consortium of approximately 47 other financial institutions to form Bankers Insurance, LLC. Bankers Insurance, LLC, as of



3





---

December 31, 2005, had purchased seven full service insurance agencies across the state of Virginia. HUIS is used to sell insurance services through the Bankers Insurance, LLC.

Highlands Union Financial Services, Inc.

Highlands Union Financial Services, Inc., a wholly-owned subsidiary of the Bank, was formed in 2001   HUFS was formed in order for the Bank to continue to offer,
 through a third-party, mutual funds, annuities and other financial services to its customers in all market areas served.

Commercial Loans

The Bank makes both secured and unsecured loans to businesses and to individuals for business purposes. Loan requests are granted based upon several factors including credit history, past and present relationships with the Bank, marketability of collateral and the cash flow of the borrowers. Unsecured commercial loans must be supported by a satisfactory balance sheet and income statement. Collateralized business loans may be secured by a security interest in marketable equipment, accounts receivable, business equipment and/or general intangibles of the business. In addition, or as an alternative, the loan may be secured by a deed of trust lien on business real estate. The risks associated with commercial loans are related to the strength of the individual business, the
value of loan collateral and the general health of the economy. The Bank has established credit review and credit analysis departments as well as specific underwriting policies to aid in mitigating credit risk.

Residential Real Estate Loans

Loans secured by residential real estate are originated by the Bank. The Bank also offers secondary market fixed rate mortgages through multiple sources. These loans and servicing rights are generally sold immediately into the secondary market and fees received are booked into income. These loans must meet certain criteria generally set by the secondary market. All residential loans originated by the Bank are held in the Banks loan portfolio. Residential real estate loans carry risk associated with the continued credit-worthiness of the borrower and changes in the value of the collateral.
The Bank has established credit review and credit analysis departments as well as specific underwriting policies to aid in mitigating credit risk.

Construction Loans

The Bank makes loans for the purpose of financing the construction of business and residential structures to financially responsible business entities and individuals. These loans are subject to the same credit criteria as commercial and residential real estate loans. In addition to the risks associated with all real estate loans, construction loans bear the risks that the project will not be finished according to schedule, the project will not be finished according to budget and the value of the collateral may at any point in time may be less than the principal amount of the loan. Construction loans also bear the risk that the general contractor, who may or may not be the Banks loan customer, is unable to finish the construction project as planned
because of financial pressures unrelated to the project. Loans to customers
 that are made as permanent financing of construction loans may likewise under certain circumstances be affected by external financial pressures. The Bank has established credit review and credit analysis departments as well as specific underwriting policies to aid in mitigating credit risk.

Consumer Loans

The Bank routinely makes consumer loans, both secured and unsecured. The credit history, cash flow and character of individual borrowers is evaluated as a part of the credit decision. Loans used to purchase vehicles or other specific personal property and loans associated with real estate are usually secured with a lien on the subject vehicle or property. Negative



4





---

changes in a customer's financial circumstances due to a large number of factors, such as illness or loss of employment, can place the repayment of a consumer loan at risk. In addition, deterioration in collateral value can add risk to consumer loans.

Sales and Purchases of Loans

The Bank will occasionally buy or sell all or a portion of a loan. The Bank will consider selling a loan or a participation in a loan, if: (i) the full amount of the loan will exceed the Banks legal lending limit,
 $7.23 million at December 31, 2005, to a single borrower; (ii) the full amount of the loan, when combined with a borrower's previously outstanding loans, will exceed the Banks legal lending limit to a single borrower; (iii) the Board of Directors or an internal Loan Committee believes that a particular borrower has a sufficient level of debt with the Bank; (iv) the borrower requests the sale; (v) the loan to deposit ratio is at or above the optimal level as
determined by bank management; and/or (vi) the loan may create too great a concentration of loans in one particular location or in one particular type of loan.
 The Bank will consider purchasing a loan, or a participation in a loan, from another financial institution if the loan meets all applicable credit quality standards and (i) the Banks
loan to deposit ratio is at a level where additional loans would be desirable; and/or (ii) a common
customer requests the purchase.

The following table sets forth, for the three fiscal years ended December 31, 2005, 2004 and 2003, the percentage of total operating revenue contributed by each class of similar services which contributed 15% or more of total operating revenues of the Company during such periods.

|                  |                            |                             
|----------------- | -------------------------- | ----------------------------
|Period            | Class of Service           | Percentage of Total Revenues
|                  |                            |                             
|December 31, 2005 | Interest and Fees on Loans | 72.09%                      
|December 31, 2004 | Interest and Fees on Loans | 72.21%                      
|December 31, 2003 | Interest and Fees on Loans | 72.97%                      

Market Area

Highlands Union Bank Market Area

The Banks primary market area consists of all of Washington County, Virginia, portions of Smyth County, Virginia, the City of Bristol, Virginia, the City of Bristol, Tennessee and adjacent portions of Sullivan County, Tennessee, the Town of Rogersville, Tennessee and adjacent portions of Hawkins County, the City of Sevierville, Tennessee and adjacent portions of Sevier County, Tennessee, the Town of Banner Elk and adjacent portions of Avery County, North Carolina and the Town of Boone and adjacent portions of Watauga County, North Carolina, the Town of West Jefferson, North Carolina and adjacent portions of Ashe County, North Carolina. The local economy is diverse and is oriented toward retail and service, light manufacturing, higher education and agriculture.

The information presented below is based on the most recent information available to the Company.

The independent city of Bristol, Virginia is located in far southwestern Virginia and lies directly on the Virginia-Tennessee state line. Washington County surrounds Bristol to the west, north and east. The community is part of the Johnson City-Kingsport-Bristol Combined Statistical Area (CSA). The three largest employment sectors are services, manufacturing and retail trade. The Tri-Cities is home to more than 140 manufacturing and distribution firms. The latest unemployment figures reflect an unemployment rate of 5.0% as of August 2004. Per capita income reported in 2002 is $24,343.00. Bristol / Washington County's largest employer is Bristol Compressors located between Bristol and Abingdon, Virginia. Bristol Compressors is a



5





---

subsidiary of York International and manufactures reciprocating compressors from 1 to 25 tons and, through a joint venture in Scroll Technologies, scroll compressors from 2 to 7 -1/2 tons. These compressors are used in York Internationals products and are sold to original equipment manufacturers and wholesale distributors. Approximately 75% of Bristol Compressor's revenues are attributable to sales of products to other air conditioning equipment manufacturers or wholesale distributors. York International was acquired by Johnson Controls on December 9, 2005. The future business plans for Bristol Compressors is yet undecided.



The Bank has a
 branch office located in Marion which is the county seat of Smyth County, Virginia. Marion is
approximately 30 miles northeast of Abingdon, Virginia. The three largest employment sectors are
services, manufacturing and retail trade. The latest unemployment figures reflect an unemployment
 rate of 4.5% as of November 2004. Per capita income reported in 2002 is $20,817.00. Smyth Countys
largest employer is General Dynamics. The company designs, develops and produces high-performance armament systems; a full range of advanced composite-based products; biological and chemical detection systems; tactical deception equipment;
 and mobile shelter systems. The Smyth County facility currently employs
more than 650 people and includes three manufacturing sites totaling more than one million square feet.



Bristol, Tennessee is located in Sullivan County Tennessee and is Bristol, Virginias twin city. Bristol, Tennessees three largest employment sectors are services, manufacturing and retail trade. The latest unemployment figures reflect an unemployment rate of 5.8% for 2003. Per capita income reported in 2001 was $25,809.00. Bristol, Tennessees largest employer is Exide Technologies Battery Plant. This plant is approximately 631,000 square feet and is used for battery manufacturing. The plant currently employs approximately 1,000 workers.



Rogersville,
Tennessee is located in Hawkins County approximately 45 miles southwest
of Bristol, Tennessee. Rogersvilles three largest employment sectors
 are services, manufacturing and retail trade. The latest unemployment figures
 reflect an unemployment rate of 7.1% for 2003. Per capita income reported in
 2001 was $20,066.00. In Hawkins County, large manufacturers include AFG Industries,
with 900 employees; TRW Corp., with 700 employees; Hutchinson Sealing Systems, with 520 employees; Rockwell
Automation, Dodge Division, with 420 employees; International Playing Card & Label, with 270 employees; and
Cooper Standard Automotive, with 520 employees.



Sevierville, Tennessee is located in Sevier County, Tennessee. Sevierville, Tennessee is located approximately 20 miles east of Knoxville, Tennessee. Sevierville serves as the county seat and is the largest city located in Sevier County. Major employers for the county include tourism, retail, and service related industries. There is some industrial base that mitigates some of the seasonal employment fluctuation from the tourism and related businesses. Major industrial employers include Dan River, which manufacturers cotton fabrics, Blalock Lumber (asphalt and ready-mixconcrete), TRW (engine valves and components), and Federal Mogul (automotiveparts). The latest unemployment figures reflect an unemployment rate of 3.7% for 2000. Per capital income reported in 2000 was $18,576.



Boone, North Carolina is located in Watauga County in the northwestern mountains of North Carolina.  Watauga Countys three largest employment sectors are private industry, education services and retail trade. The latest unemployment figures reflect an unemployment rate of 1.5% as of September 2004. Per capita income reported in 2002 was $24,265.00. Watauga County, North Carolinas largest employer is Appalachian State University. Appalachian State is the sixth largest university in the University of North Carolina system. Employment at Appalachian State University has remained relatively stable over the past three years.



6





---



Banner Elk, North Carolina is located in Avery County in the northwestern mountains of North Carolina.  Avery Countys three largest employment sectors are private industry, government and health care / social assistance. The latest unemployment figures reflect an unemployment rate of 2.4% as of September 2004. Per capita income reported in 2002 was $22,876.00. Avery County, North Carolinas largest employers are Leviton Manufacturing Co., Inc., and Ashe County Board of Education.



West Jefferson, North Carolina is located in Ashe County in the northwestern mountains of North Carolina.  Ashe Countys three largest employment sectors are trade / transportation / utilities, construction and health care / education. The latest unemployment figures reflect an unemployment rate of 5.7% as of June 2005. Per capita income reported in 2003 was $23,702.00. Ashe County, North Carolinas largest employers are Avery Health Care System and Ethan Allen, Inc.



Competition



The banking and financial service business in Virginia, generally, and in the Banks market areas specifically, is highly competitive. The increasingly competitive environment is a result of changes in regulation, changes in technology and product delivery systems and new competition from non-traditional financial services. The Bank competes for loans and deposits with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, money market funds, credit unions and other non-bank financial service providers. Many of these competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader array of financial services than the Bank. In order to compete, the Bank relies upon service-based business philosophies,
personal relationships with customers, specialized services tailored to meet customers' needs and the convenience of office locations and extended hours of operation. In addition, the Bank is
 generally competitive with other financial institutions in their market areas with respect to interest
rates paid on deposit accounts, interest rates charged on loans and other service charges on loans and deposit accounts.



Certain Regulatory Considerations



The Company
and the Bank are subject to various state and federal banking laws and regulations which impose specific
requirements or restrictions on and provide for general regulatory oversight with respect to virtually all
aspects of operations. As a result of the substantial regulatory burdens on banking and financial
 institutions, including the Company and the Bank, such institutions are disadvantaged relative to other
competitors who are not as highly regulated, and their costs of doing business are much higher. The
 following is a summary of the material provisions of certain statutes, rules and regulations which
affect the Company and the Bank. This summary is qualified in its entirety by reference to the particular
statutory and regulatory provisions referred to below, and is not intended to be an exhaustive description
 of the statutes or regulations which are applicable to the businesses of the Company and the Bank. Any change in applicable laws or regulations may have a material adverse effect on the business and
prospects of the Company and the Bank.



Highlands Bankshares, Inc.



The Company is a
bank holding company within the meaning of the BHCA and Chapter 13 of the Virginia Banking Act, as amended (the Virginia Banking Act). The activities of the Company also are governed by the Gramm-Leach-Bliley Act of 1999.



7





---

The Bank Holding Company Act. The BHCA is administered by the Federal Reserve Board, and the Company is required to file with the Federal Reserve Board an annual report and any additional information the Federal Reserve Board may require under the BHCA. The Federal Reserve Board also is authorized to examine the Company and its subsidiaries. The BHCA requires every bank holding company to obtain the approval of the Federal Reserve Board before (i) it or any of its subsidiaries (other than a bank) acquires substantially all the assets of any bank; (ii) it acquires ownership or control of any voting shares of any bank if after the acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of the bank; or (iii) it merges or consolidates with any other bank holding company.



The BHCA and the Change in Bank Control Act, together with regulations promulgated by the Federal Reserve Board, require that, depending on the particular circumstances, either Federal Reserve Board approval must be obtained or notice must be furnished to the Federal Reserve Board and not disapproved prior to any person or company acquiring "control" of a bank holding company, such as the Company, subject to certain exemptions. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the Company. Control is rebuttably presumed to exist if a person acquires 10% or more, but less than 25%, of any class of voting securities of the Company. The regulations provide a procedure for challenging the rebuttable control presumption.



Under the BHCA,
a bank holding company is generally prohibited from engaging in, or acquiring direct or indirect control
of more than 5% of the voting shares of any company engaged in non-banking activities, unless the Federal
Reserve Board, by order or regulation, has found those activities to be so closely related to banking or
managing or controlling banks as to be incident to banking. The Federal Reserve Board imposes certain
capital requirements on the Company under the BHCA, including a minimum leverage ratio and a minimum
ratio of "qualifying" capital to risk-weighted assets. Subject to its capital requirements
and certain other restrictions, the Company can borrow money to make a capital contribution to the
Bank, and these loans may be repaid from dividends paid from the Bank to the Company (although the
ability of the Bank to pay dividends are subject to regulatory restrictions). The Company can raise
capital for contribution to the Bank by issuing securities without having to receive regulatory approval,
subject to compliance with federal and state securities laws.



The Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act (the GLBA), enacted on November 12, 1999, broadly rewrote financial services legislation. The GLBA permits significant combinations among different sectors of the financial services industry; allows for significant expansion of financial service activities by Bank holding companies and provides for a regulatory framework by various governmental authorities responsible for different financial activities; and offers certain financial privacy protections to consumers. The GLBA repealed affiliation and management interlock prohibitions of the Depression-era Glass-Steagall Act and, by amending the Bank Holding Company Act, the GLBA added new substantive provisions to the non-banking activities permitted under the BHCA with the creation of the financial holding company. The GLBA preempts most
state laws that prohibit financial holding companies from engaging in insurance activities. The GLBA permits affiliations between banks
 and securities firms within the same holding company structure, and the Act permits financial holding companies to directly engage in a broad range of securities and merchant banking activities. The Company has not elected to become a financial holding company.



The Gramm-Leach-Bliley Act led to important changes in the manner in which financial services are delivered in the United States. Bank holding companies and their subsidiary banks are able to offer a much broader array of financial services; however, there is greater competition in all sectors of the financial services market.



8





---

The Virginia Banking Act. All Virginia bank holding companies must register with the Virginia State Corporation Commission (the Commission) under the Virginia Banking Act. A registered bank holding company must provide the Commission with information with respect to the financial condition, operations, management and inter-company relationships of the holding company and its subsidiaries. The Commission also may require such other information as is necessary to keep itself informed about whether the provisions of Virginia law and the regulations and orders issued under Virginia law by the Commission have been complied with, and may make examinations of any bank holding company and its subsidiaries. The Virginia Banking Act allows bank holding companies located in any state to acquire a Virginia bank or bank
holding company if the Virginia bank or bank holding company could acquire a bank holding company in their state and the Virginia bank or bank
holding company to be acquired has been in existence and continuously operated for more than two years.
The Virginia Banking Act permits bank holding companies from throughout the United States to enter the Virginia market, subject to federal and state approval.



Sarbanes-Oxley
 Act of 2002. On July 30, 2002, the President signed into law the Sarbanes-Oxley Act of 2002
(the Act) implementing legislative reforms intended to address corporate and accounting fraud.
 In addition to the establishment of a new accounting oversight board that enforces auditing, quality control
 and independence standards and is funded by fees from all publicly traded companies, the law restricts
provision of both auditing and consulting services by accounting firms. To ensure auditor independence,
any non-audit services being provided to an audit client requires pre-approval by the issuers audit
committee members. In addition, the audit partners must be rotated. Under the Act, legal counsel is required
 to report evidence of a material violation of the securities laws or a breach of fiduciary duty by a company
 to its chief executive officer or its chief financial officer, and, if such officer does not appropriately
respond, to report such evidence to the audit committee
 or other similar committee of the board of directors or the board itself.



Longer prison terms and increased penalties are also applied to corporate executives who violate federal securities laws, the period during which certain types of suits can be brought against a company or its officers has been extended, and bonuses issued to top executives prior to restatement of a companys financial statements are subject to disgorgement if such restatement was due to corporate misconduct. Executives are also prohibited from insider trading during retirement plan blackout periods, and loans to company executives are restricted. The Act accelerates the time frame for disclosures by public companies, as they must immediately disclose any material changes in their financial condition or operations. Directors and executive officers must also provide information for most changes in ownership in a companys securities within two business days of the change.



The Act also
prohibits any officer or director of a company or any other person acting under their direction from
taking any action to fraudulently influence, coerce, manipulate or mislead any independent public or
certified accountant engaged in the audit of the companys financial statements for the purpose of
rendering the financial statements materially misleading. The Act also requires the SEC to prescribe
rules requiring inclusion of an internal control report and assessment by management in the annual report to
stockholders. In addition, the Act requires that each financial report required to be prepared in accordance
 with (or reconciled to) accounting principles generally accepted in the United States of America and
filed with the SEC reflect all material correcting adjustments that are identified by a registered
 public accounting firm in accordance with accounting principles generally accepted in the United States of America and the rules and regulations of the SEC.





9





---

The Companys chief executive officer and chief financial officer are each required to certify that the Companys quarterly and annual reports do not contain any untrue statement of a material fact. The Act imposes several requirements, including having these officers certify that: they are responsible for establishing, maintaining and regularly evaluating the effectiveness of the Companys internal controls; they have made certain disclosures to the Companys auditors and the audit committee of the Board of Directors about the Companys internal controls; and they have included information in the Companys quarterly and annual reports about their evaluation and whether there have been significant changes in the Companys internal controls or in other factors that could significantly affect internal controls during the last quarter.



Highlands Union Bank



General. The
Bank, as a state chartered member of the Federal Reserve, is subject to regulation and examination by the Virginia State Corporation Commission and the Federal Reserve Board. In addition, the Bank is subject to the rules and regulations of the Federal Deposit Insurance Corporation. Deposits in the Bank are insured by the FDIC up to a maximum amount (generally $100,000 per depositor, subject to aggregation rules). The Federal Reserve Board and the Virginia Bureau of Financial Institutions regulate or monitor all areas of the Banks operations, including security devices and procedures, adequacy of capitalization and loss reserves, loans, investments, borrowings, deposits, mergers, issuances of securities, payment of dividends, interest rates payable on deposits, interest rates or fees chargeable on loans, establishment of branches, corporate reorganizations and maintenance of books and records. The
 Federal Reserve Board requires the Bank to maintain certain capital ratios. The Bank is required by the
 Federal Reserve Board to prepare quarterly reports on the Banks financial condition and to conduct an annual audit of its financial affairs in compliance with minimum standards and procedures prescribed by the Federal Reserve Board. The Bank also is required by the Federal Reserve Board to adopt internal control structures and procedures in order to safeguard assets and monitor and reduce risk exposure. While appropriate for safety and soundness of banks, these requirements impact banking overhead costs.



Community
Reinvestment Act. The Bank is subject to the provisions of the Community Reinvestment Act of 1977
 (the CRA), which requires the appropriate federal bank regulatory agency, in connection with its regular
 examination of a bank, to assess the Banks record in meeting the credit needs of the community
 served by the bank, including low and moderate-income neighborhoods. The focus of the regulations is on
 the volume and distribution of a Banks loans, with particular emphasis on lending activity in low
and moderate-income areas and to low and moderate-income persons. The regulations place substantial
importance on a Banks product delivery system, particularly branch locations. The regulations
require banks, including the Bank, to comply with significant data collection requirements. The regulatory
 agency's assessment of the Banks record is made available to the public. Further, this assessment is required for any bank which has applied to, among other things, establish a new branch office
that will accept deposits, relocate an existing office, or merge, consolidate with or acquire the assets
 or assume the liabilities of a federally regulated financial institution. Management expects that
 the banks' compliance with the CRA, as well as other fair lending laws, will face ongoing government scrutiny and that costs associated with compliance will continue to increase. The Bank received "Satisfactory" CRA ratings in the last examination by bank regulators.



Federal Deposit Insurance Corporation Improvement Act of 1991. The
Federal Deposit Insurance Corporation Improvement Act (FDICIA) requires each federal banking regulatory agency to prescribe, by regulation, standards for all insured depository institutions and depository institution holding companies relating to (i) internal controls, information systems and audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate exposure; (v) asset growth; (vi) compensation, fees and benefits; and (vii) such other



10





---

operational
 and managerial standards as the agency determines to be appropriate.  The compensation standards would
 prohibit employment contracts, compensation or benefit arrangements, stock option plans, fee arrangements or other compensatory arrangements that provide excessive compensation, fees or benefits or
could lead to material financial loss.  In addition, each federal banking regulatory agency must
 prescribe by regulation standards specifying (i) a maximum ratio of classified assets to capital; (ii)
minimum earnings sufficient to absorb losses without impairing capital; (iii) to the extent feasible, a minimum ratio of market value to book value for publicly traded shares of depository institutions and depository institution holding companies; and (iv) such other standards relating to asset quality, earnings and valuation as the agency
 determines to be appropriate.  If an insured institution
fails to meet any of the standards promulgated by regulation, then such institution will be required to
 submit a plan to its federal regulatory agency specifying the steps it will take to correct the
deficiency.



Prompt corrective action measures in FDICIA impose significant restrictions and requirements on depository institutions that fail to meet their minimum capital requirements.  Under Section 38 of the Federal Deposit Insurance Act (FDI Act), the federal banking regulatory agencies have developed a classification system pursuant to which all depository institutions are placed into one of five categories based on their capital levels and other supervisory criteria:  well capitalized, adequately capitalized; undercapitalized; significantly undercapitalized; and critically undercapitalized.



The Bank met the requirements at December 31, 2005 to be classified as well capitalized.  This classification is determined solely for the purposes of applying the prompt corrective action regulations and may not constitute an accurate representation of the Banks overall financial condition.



An undercapitalized depository institution is required to submit a capital restoration plan to its principal federal regulator.  The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institutions capital and is guaranteed by the parent holding company.  If a depository institution fails to submit an acceptable plan, it will be treated as if it were significantly undercapitalized.



Unless its principal federal regulator has accepted its capital plan, an undercapitalized bank may not increase its average total assets in any calendar quarter.  If an undercapitalized institutions capital plan has been accepted, asset growth will be permissible only if the growth is consistent with the plan and the institutions ratio of tangible equity to assets increases during the quarter at a rate sufficient to enable the institutions to become adequately capitalized within a reasonable time.



An institution that is an undercapitalized depository institution may not solicit deposits by offering rates of interest that are significantly higher than the prevailing rates on insured deposits in the institutions normal market areas or in the market area in which the deposits would otherwise be accepted. An undercapitalized depository institution may not branch, acquire an interest in another business or institution or enter a new line of business unless its capital plan has been accepted and its principal federal regulator approves the proposed action.



An insured depository institution may not pay management fees to any person having control of the institution nor may an institution, except under certain circumstances and with prior regulatory approval, make any capital distribution if, after making such payment or distribution, the institution would be undercapitalized.





11





---

Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks.  Critically undercapitalized institutions are subject to appointment of a receiver or conservator.



If its principal federal regulator determines that an adequately capitalized institution is in an unsafe or unsound condition or is engaging in an unsafe or unsound practice, it may require the institution to submit a corrective action plan, restrict its asset growth and prohibit branching, new acquisitions and new lines of business.  An institutions principal federal regulator may deem it to be engaging in unsafe or unsound practices if it receives a less than satisfactory rating for asset quality, management, earnings or liquidity in its most recent examination.



In addition, regulators were required to draft a new set of non-capital measures of bank safety, such as loan underwriting standards and minimum earnings levels, effective December 1, 1993.  The legislation also requires regulators to perform annual on-site bank examinations, place limits on real estate lending by banks and tightens auditing requirements.



Section 36 of FDICIA significantly affects financial institutions with more then $500 million in total assets. However, The FDIC has amended Part 363 of its regulations by raising the asset-size threshold from $500 million to $1 billion for internal control assessments by management and external auditors. For institutions between $500 million and $1 billion in assets, only a majority, rather than all, of the members of the audit committee, who must be outside directors, must be independent of management. The final rule became effective December 28, 2005. Below are the key FDICIA requirements including the significant changes relating to the amendments to Part 363:

·

Institutions must have an adequate system of internal control according to some generally accepted framework.

·

Section I agreed-upon-procedures testing of compliance with laws and regulations must be performed by either internal audit or the entity's independent public accountants.

·

Section II agreed-upon-procedure testing of compliance with laws and regulations must be performed by the entity's independent public accountant if management elected to have internal auditors perform Section I agreed-upon procedures.

·

Management must perform its own investigation and review of the effectiveness of internal controls and compliance with laws.

·

A management report must be submitted and signed by the chief executive officer and chief accountant (or chief financial officer), which states management's responsibility for the internal control system, an assessment of the effectiveness of the system at fiscal year-end, and an assessment of compliance with laws and regulations during the fiscal year.

·

An independent public accountant's report that attests to management's assertions concerning the Banks internal control and procedure for financial reporting is required.

·

As amended, for covered institutions with between $500 million and $1 billion in total assets, management is no longer required to assess and report on the effectiveness of internal control over financial reporting, the external auditors are no longer required to examine and attest to management's internal control assertions, and only a majority of the outside directors on the audit committee must be independent of management.



12





---

·

The amendments provide relief from these requirements to covered institutions with total assets of less than $1 billion only for purposes of Part 363. These covered institutions must continue to fully comply with the remaining provisions of Part 363, including the annual financial statement audit requirement.

·

The amendments do not relieve public covered institutions from their obligations to comply with the provisions of the Sarbanes-Oxley Act and the Securities and Exchange Commission's implementing rules on internal control reporting by management and external auditors and, if applicable, audit committee independence.

·

The amendments took effect December 28, 2005, and applied to institutions whose fiscal years end on or after September 30, 2005.



Branching. In 1986, the Virginia Banking Act was amended to remove the geographic restrictions governing the establishment of branch banking offices. Subject to the approval of the appropriate federal and state bank regulatory authorities, the Bank as a state bank, may establish a branch office anywhere in Virginia.



The Riegle-Neal
Interstate Banking and Branching Efficiency Act of 1994 (the Interstate Act) allows bank holding
companies to acquire banks in any state, without regard to state law, except that if the state has a
minimum requirement for the amount of time a bank must be in existence, that law must be preserved. The
 Interstate Act also permits banks to acquire out-of-state branches through interstate mergers, if the
 state has not opted out of interstate branching. De novo branching, where an out-of-state bank holding
company sets up a new branch in another state, requires a state's specific approval. An acquisition or
 merger is not permitted under the Interstate Act if the bank, including its insured depository affiliates,
will control more than 10% of the total amount of deposits of insured depository institutions in the United
States, or will control 30% or more of the total amount of deposits of insured depository institutions in any state.



Virginia has, by
 statute, elected to opt-in fully to interstate branching under the Interstate Act. Under the Virginia
statute, Virginia state banks may, with the approval of the Virginia State Corporation Commission,
establish and maintain a de novo branch or acquire one or more branches in a state other than Virginia,
 either separately or as part of a merger. Procedures also are established to allow out-of-state domiciled banks to establish or acquire branches in Virginia, provided the "home" state of the bank permits Virginia banks to establish or acquire branches within its borders. The activities of these branches are subject to the same laws as Virginia domiciled banks, unless such activities are prohibited by the law of the state where the bank is organized. The Virginia State Corporation Commission has the authority to examine and supervise out-of-state state banks to ensure that the branch is operating
in a safe and sound manner and in compliance with the laws of Virginia. The Virginia statute authorizes
 the Bureau of Financial Institutions to enter into cooperative agreements with other state and federal
regulators for the examination and supervision of out-of-state banks with Virginia operations, or Virginia
domiciled banks with operations in other states. Likewise, national banks, with the approval of the OCC, may
branch into and out of the state of Virginia. Any Virginia branch of an out-of-state state chartered bank is
subject to Virginia law (enforced by the Virginia Bureau of Financial Institutions) with respect to
intrastate branching, consumer protection, fair lending and community reinvestment as if it were a branch
of a Virginia bank, unless preempted by federal law.



Deposit Insurance. The FDIC establishes rates for the payment of premiums by federally insured financial institutions. A Bank Insurance Fund (the BIF) is maintained for commercial banks, with insurance premiums from the industry used to offset losses from insurance payouts when banks fail. Beginning in 1993, insured depository institutions like the Bank paid for deposit



13





---

insurance
 under a risk-based premium system. Beginning in 1997, all banks, including the Bank, were subject to an additional FDIC assessment which funds interest payments for bank issues to resolve problems associated with the savings and loan industry. This assessment will continue until 2018-2019. The assessment will vary over the period from 1.29 cents to 2.43 cents per $100 of deposits.



USA Patriot Act. The USA Patriot Act became effective in late 2001. It was passed to facilitate the sharing of information among government entities and financial institutions to combat terrorism and money laundering. The USA Patriot Act creates an obligation on banks to report customer activities that may involve terrorist activities or money laundering.



Government Policies. The operations of the Bank are affected not only by general economic conditions, but also by the policies of various regulatory authorities. In particular, the Federal Reserve Board regulates money and credit and interest rates in order to influence general economic conditions. These policies have a significant influence on overall growth and distribution of loans, investments and deposits and affect interest rates charged on loans or paid for time and savings deposits. Federal Reserve Board monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.



Limits on
 Dividends and Other Payments. As a state member bank subject to the regulations of the Federal Reserve
Board, the Bank must obtain the approval of the Federal Reserve Board for any dividend if the total of all
 dividends declared in any calendar year would exceed the total of its net profits, as defined by the Federal
 Reserve Board, for that year, combined with its retained net profits for the preceding two years. In
addition, a state member bank may not pay a dividend in an amount greater than its undivided profits then
on hand after deducting its losses and bad debts. For this purpose, bad debts are generally defined to
include the principal amount of loans which are in arrears with respect to interest by six months or more,
 unless such loans are fully secured and in the process of collection. Moreover, for purposes of this
limitation, a state member bank is not permitted to add the balance in its allowance for loan losses account to its undivided profits then on hand; however, it may net the sum of its
 bad debts as so defined against the balance in its allowance for loan losses account and deduct from
 undivided profits only bad debts as so defined in excess of that account.



In addition, the Federal Reserve Board is authorized to determine, under certain circumstances relating to the financial condition of a state member bank, that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The payment of dividends that depletes a Banks capital base could be deemed to constitute such an unsafe or unsound practice. The Federal Reserve Board has indicated that banking organizations should generally pay dividends only out of current operating earnings.



Virginia law also imposes restrictions on the ability of the Bank to pay dividends. A Virginia state bank is permitted to declare a dividend out of its "net undivided profits", after providing for all expenses, losses, interest and taxes accrued or due by the bank. In addition, a deficit in capital originally paid in must be restored to its initial level, and no dividend can be paid which could impair the Banks paid in capital. The Bureau of Financial Institutions further has authority to limit the payment of dividends by a Virginia bank if it determines the limitation is in the public interest and is necessary to ensure the Banks financial soundness.



FDICIA provides that no insured depository institution may make any capital distribution (which would include a cash dividend) if, after making the distribution, the institution would not satisfy one or more of its minimum capital requirements.



14





---

Capital Requirements. The Federal Reserve Board has adopted risk-based capital guidelines which are applicable to the Company and the Bank. The Federal Reserve Board guidelines redefine the components of capital, categorize assets into different risk classes and include certain off-balance sheet items in the calculation of risk-weighted assets. The minimum ratio of qualified total capital to risk-weighted assets (including certain off-balance sheet items, such as standby letters of credit) is 8.0%. At least half of the total capital must be comprised of Tier 1 capital for a minimum ratio of Tier 1 Capital to risk-weighted assets of 4.0%. The remainder may consist of a limited amount of subordinated debt, other preferred stock, certain other instruments and a limited amount of loan and lease loss reserves.



In addition, the Federal Reserve Board has established minimum leverage ratio (Tier 1 capital to total average assets less intangibles) guidelines that are applicable to the Company and the Bank. These guidelines provide for a minimum ratio of 4.0% for banks that meet certain specified criteria, including that they have the highest regulatory CAMELS rating and are not anticipating or experiencing significant growth and have well-diversified risk. All other banks will be required to maintain an additional cushion of at least 100 to 200 basis points, based upon their particular circumstances and risk profiles. The guidelines also provide that banks experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.



Bank regulators from time to time have indicated a desire to raise capital requirements applicable to banking organizations beyond current levels. In addition, the number of risks which may be included in risk-based capital restrictions, as well as the measurement of these risks, is likely to change, resulting in increased capital requirements for banks. The Company and the Bank are unable to predict whether higher capital ratios would be imposed and, if so, at what levels and on what schedule.



Other Legislative and Regulatory Concerns



Other legislative and regulatory proposals regarding changes in banking and the regulation of banks, thrifts and other financial institutions are periodically considered by the executive branch of the federal government, Congress and various state governments, including Virginia. New proposals could significantly change the regulation of banks and the financial services industry. It cannot be predicted what might be proposed or adopted or how these proposals would affect the Company.



Other Business Concerns



The banking industry is particularly sensitive to interest rate fluctuations, as the spread between the rates which must be paid on deposits and those which may be charged on loans is an important component of profit. In addition, the interest which can be earned on a Banks invested funds has a significant effect on profits. Rising interest rates typically reduce the demand for new loans, particularly the real estate loans which represent a significant portion of the Banks loan demand.



Employees



The Company, the Bank, HCTI, HUFS and HUIS are organized in a holding company/subsidiary structure. As of December 31, 2005, the Company had no employees, except for officers, and it conducted substantially all of its operations through its subsidiaries. All cash compensation paid to the Companys officers was paid by the Bank, including fees



15





---

paid to its directors. Stock based compensation, through the form of stock options, is paid / granted through the Company.



During 2005, compensation paid to HUFS officers and employees was paid through the Bank. At December 31, 2005, the Bank employed 231 full time equivalent employees at its main office, operations center and branch offices. The Company, HCTI, HUFS and HUIS had no employees at this time.



The Companys relationship with its employees is considered to be good. Employment has remained very stable over the last several years with very little turnover. There are no employment contracts in existence for any employee or officer.



Item 1A. Risk Factors



Our business is subject to various risks, including
the risks described below.  Our business, operating results and financial condition could be materially and adversely affected by any of these risks.  Please note that additional risks not presently known to us or that we currently deem immaterial may also impair our business and operations.



Changes in interest rates could have an adverse effect on our income.



Our profitability
depends to a large extent upon our net interest income. Net interest income is the difference between
interest income on interest-earning assets, such as loans and investments, and interest expense on interest-bearing liabilities, such as deposits and borrowings. Our net interest income will be adversely affected if market interest rates change so that the interest we pay on deposits and borrowings increases faster than the interest we earn on loans and investments. Changes in interest rates also affect the value of our loans. An increase in interest rates could adversely
 affect borrowers ability to pay the principal or interest on existing loans or reduce their desire to borrow more money. This may lead to an increase in our nonperforming assets or a decrease in loan originations, either of which could have a material and negative effect on our
results of operations. Interest rates are highly sensitive to many factors that are partly or completely outside of our control,
including governmental monetary policies, domestic and international economic and political
conditions and general economic conditions such as inflation, recession, unemployment and money supply. Fluctuations in market interest rates are neither predictable nor controllable and may have a material and negative effect on our business, financial condition and results of operations. We attempt to minimize our exposure to interest rate risk, but we will be unable to eliminate it.



Our concentration in loans secured
by real estate may increase our credit losses, which would negatively affect our financial results.



A significant
 portion of our loan portfolio is dependent on real estate. In addition to the financial strength and cash
 flow characteristics of the borrower in each case, we often secure loans with real estate collateral. At
 December 31, 2005, approximately 79.42% of our loans have real estate as a primary or secondary component
 of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. An adverse change in the economy affecting values of real estate generally or in our primary markets specifically could significantly impair the value of our collateral and result in a significant portion of our portfolio being under-collateralized. In such a case, it would be likely that we would be required to increase our provision for loan losses, which would negatively affect our results of
 operations. If we are required to liquidate the collateral securing a loan to satisfy the debt during a
 period of reduced real estate values, our ability to recover fully on defaulted loans by foreclosing and selling the real estate collateral would be diminished and we would be more likely to suffer losses on defaulted loans, which could adversely affect our profitability and financial condition. Risk of loan defaults and foreclosures are unavoidable in the banking industry, and we try to limit our



16





---

exposure to this risk by monitoring our extensions of credit carefully. We cannot fully eliminate credit risk, and as a result credit losses may occur in the future.



If our allowance for loan losses becomes inadequate, our results of operations may be adversely affected.



We maintain an allowance for loan losses that we believe is a reasonable estimate of known and inherent losses in our loan portfolio. Through a periodic review and consideration of the loan portfolio, management determines the amount of the allowance for loan losses by considering general market conditions, credit quality of the loan portfolio, the collateral supporting the loans and performance of our customers relative to their financial obligations with us. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, that may be beyond our control, and these losses may exceed our current estimates. Rapidly growing loan portfolios are, by their nature, unseasoned. As a result, estimating loan loss allowances is more difficult,
and may be more susceptible to changes in estimates, and to losses exceeding estimates, than more
seasoned portfolios. Al
though we believe the allowance for loan losses is a reasonable estimate of known and inherent
losses in our loan portfolio, we cannot fully predict such losses or that our loan loss allowance
 will be adequate in the future. Excessive loan losses could have a material impact on our financial
performance. Because of our growth strategy, we expect that our earnings will be negatively impacted by loan growth, which requires additions to our allowance for loan losses. Consistent with our loan loss reserve methodology, we expect to make additions to our loan loss reserve levels as a result of our growth strategy, which may affect our short-term earnings.



Federal and
 state regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in the amount of our provision or loans charged-off as required by these regulatory agencies could have a negative effect on our operating results.



Our profitability and the
value of your investment may suffer because of rapid and unpredictable changes in the highly regulated environment in which we operate.



We are subject
 to extensive supervision by several governmental regulatory agencies at the federal and state levels. Recently enacted, proposed and future banking legislation and regulations have had, and will continue to have, or may have a significant impact on the financial services industry. These regulations, which are intended to protect depositors and not our shareholders, and the interpretation and application of them by federal and state regulators, are beyond our control, may change rapidly and unpredictably and can be expected to influence our earnings and growth. Our success depends on our continued ability to maintain compliance with these regulations. Some of these regulations may increase our costs and thus place other financial institutions that are not subject to similar regulation in stronger, more favorable competitive positions.



We rely heavily on our management
team and the unexpected loss of any of those personnel could adversely affect our operations; we depend on our ability to attract and retain key personnel.



We are a customer-focused and relationship-driven organization. We expect our future growth to be driven in a large part by the relationships maintained with our customers by our Executive Vice President and Chief Executive Officer, Samuel L. Neese, and our other executive and senior lending officers,
 all of whom have many years of experience in our industry. We have not entered into employment agreements with any of the



17





---

executive or senior officers. The unexpected loss of Mr. Neese or other key employees could have a material adverse effect on our business and possibly result in reduced revenues and earnings. We do not maintain key man life insurance policies on any of our executives.



We will face risks with respect to future expansion.



Our current strategy is to continue growing in the southwest Virginia, western North Carolina and northeastern Tennessee markets. Our expansion strategy will involve a number of risks such as the time and expense associated with evaluating new markets for expansion, hiring local management and opening new offices. Any future expansion efforts may entail substantial costs and may not produce the additional growth or earnings that were anticipated, which could adversely affect our results of operations. Any expansion plans we undertake may also divert the attention of our management from the operation of our current business, which could also have an adverse effect on our results of operations.



The success of our growth strategy depends on our ability to identify and recruit individuals with experience and relationships in the markets in which we intend to expand.



We intend to expand our banking network over the next several years in the southwest Virginia, western North Carolina and northeastern Tennessee markets. We believe that to expand into new markets successfully, we must identify and recruit experienced key management members with local expertise and relationships in these markets. We expect that competition for qualified management in the markets in which we expand will be intense and that there will be a limited number of qualified persons with knowledge of and experience in the community banking industry in these markets. The process of identifying and recruiting individuals with the combination of skills and attributes required to carry out our strategy is often lengthy. Even if we identify individuals that we believe could assist us in establishing a presence in
 a new market, we may be unable to recruit these individuals away from more established banks.
Many experienced banking professionals employed by our competitors are covered by agreements not to compete or
 solicit their existing customers if they were to leave their current employment. These agreements make the recruitment of these professionals more difficult. Our inability to identify, recruit and retain talented personnel to manage new offices effectively and in a timely manner would limit our growth and could materially adversely affect our business, financial condition and results of operations.



Our future success is dependent on our ability to compete effectively in the highly competitive banking industry.



We face vigorous
competition from other banks and other financial institutions, including savings and loan associations,
savings banks, finance companies and credit unions for deposits, loans and other financial services in our
 market area. Our business operations are centered primarily in Virginia, North Carolina, and Tennessee.
Increased competition within this region may result in reduced loan originations and deposits. Ultimately,
 we may not be able to compete successfully against current and future competitors. A number of these banks
and other financial institutions are significantly larger than we are and have substantially greater access
to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array
 of banking services. To a limited extent, we also compete with other providers of financial services, such
as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations which may offer more favorable financing
than we can. Many of our non-bank competitors are not subject to the same extensive regulations that govern us. As a result, these non-bank competitors have advantages over us in providing certain



18





---

services. This competition may reduce or limit our margins and our market share and may adversely affect our results of operations and financial condition.



Our business is subject to various lending and other economic risks that could adversely impact our results of operations and financial condition.



Changes in economic conditions, particularly an economic slowdown, could hurt our business. Our business is directly affected by political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in governmental monetary and fiscal policies and inflation, all of which are beyond our control. A deterioration in economic conditions, in particular an economic slowdown within our geographic region, could result in the following consequences, any of which could hurt our business materially:

·

loan delinquencies may increase;

·

problem assets and foreclosures may increase;

·

demand for our products and services may decline; and

·

collateral for loans made by us may decline in value, in turn reducing a clients borrowing power, and reducing the value of assets and collateral associated with our loans held for investment.



We do business in
 a small geographic area, and a large percentage of our loans are made in our market area. If the region
 suffers a significant or prolonged period of economic downturn, there is a greater likelihood that more
of our customers could become delinquent on their loans or other obligations to, which could adversely affect
 our performance. If more competitors come into our market area, our business could suffer.



There is a limited trading market for our common stock; it may be difficult to sell our shares after you have purchased them.



Our common stock is currently listed on the Over The Counter Bulletin Board and the Pink Sheets under the symbol HBKA.OB. The volume of trading activity in our stock is relatively low,
thirty-four trades in the last six months. Even if a more active market develops, there can be no assurance that such market will continue, or that you will be able to sell your shares at or above the offering price. You should carefully consider the lack of liquidity of your investment in the common shares when making your investment decision.



Item 1B.  Unresolved Staff Comments



None.



Item 2. Properties



The Companys and the Banks headquarters are located at 340 W. Main Street, Abingdon, Virginia. In addition to the Banks Main Office location, the Bank owns ten branch



19





---

offices:
one in the Town of Abingdon, Virginia; one in Washington County, Virginia, two in the City of Bristol,
Virginia; one in the Town of Glade Spring, Virginia; one in the Town of Marion, Virginia; one in the City
 of Bristol, Tennessee; one in the Town of Rogersville, Tennessee; one in the Town of Boone, North
Carolina; and one in the Town of Banner Elk, North Carolina. The Bank owns the land and buildings of all of these branch offices as well as the main office for the Company and Bank. The Bank also owns the land and building used for Financial Services, Collections, Human Resources and Credit Cards in Abingdon, Virginia. The Bank owns a piece of vacant land in Marion, Virginia that used to house a drive-up ATM. The Bank owns a vacant piece of land in Bristol, Tennessee that is being held for a potential future branch site. The Bank owns a tract of
 land in Sevierville, Tennessee that will be used for the development of a branch bank office in 2006. The Bank leases office space in Abingdon,
 Virginia for operational purposes, leases office space in West Jefferson, North Carolina for
a loan production office and leases office space in Sevierville, Tennessee for a loan production office. The Company owns the land and buildings used as the Banks Operations Center and Technology House in Abingdon, Virginia. The Company owns the land and vacant building on property adjacent to the Companys Operation Center in Abingdon, Virginia. The Company owns vacant land in proximity to its Main Branch Office in Abingdon, Virginia. The Company exercised an option to purchase approximately five acres of vacant land in Abingdon, Virginia for future possible development of a corporate headquarters. Subsequent to December 31, 2005, the Company entered into an option to purchase an additional nine and one-half acres adjacent to the orginal five acres for future development needs.



All of the Companys existing properties are in good operating condition and are adequate for the Companys present and anticipated future needs.



Item 3.  Legal Proceedings



The Company is not currently involved in any pending legal proceedings, other than routine litigation incidental to the Banks banking business. These proceedings are not material to the Company or the Bank.



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



None







































20





---

Part II



Item 5. Market for Registrant's Common Equity,  Related Stockholder Matters and Issuer Purchases of Equity Securities



Common Stock Information and Dividends

There are two distinct markets for the Companys common stock.  The Companys common stock is traded on the Over-The-Counter Bulletin Board (OTCBB) and the Pink Sheets by five broker dealers under the symbol HBKA.OB. The Company also maintains a list of individuals, in its local market, who are interested in purchasing its common stock and connects these people with shareholders who are interested in selling their stock. These parties negotiate the per share price independent of the Company. The stock transfer agent of the Company attempts to keep a record of the prices of stock trades by asking the parties about the trade price per share.  Please refer to the table below entitled Common Stock Performance for a breakdown of the trades known to the Company for the four
 quarters of each of 2005 and 2004. The amounts below have been adjusted to reflect the
Companys 2:1 stock split paid on September 9, 2005.



|                                             |        |        |                   |                    
|-------------------------------------------- | ------ | ------ | ----------------- | -------------------
|Common Stock Performance  December 31, 2005
|                                             |        |        |                   |                    
|                                             | High   | Low    | Quarterly Average | Dividends per Share
|                                             |        |        |                   |                    
|First Quarter                                | $15.00 | $13.68 | $14.58            | $        -         
|                                             |        |        |                   |                    
|Second Quarter                               | $15.00 | $12.13 | $14.84            | $ 0.075            
|                                             |        |        |                   |                    
|Third Quarter                                | $17.00 | $13.05 | $14.60            | $        -         
|                                             |        |        |                   |                    
|Fourth Quarter                               | $19.00 | $14.75 | $15.93            | $        -         
|                                             |        |        |                   |                    
|Common Stock Performance  December 31, 2004
|                                             |        |        |                   |                    
|                                             | High   | Low    | Quarterly Average | Dividends per Share
|                                             |        |        |                   |                    
|First Quarter                                | $14.00 | $12.90 | $13.90            | $       -          
|                                             |        |        |                   |                    
|Second Quarter                               | $14.50 | $12.88 | $13.55            | $  0.06            
|                                             |        |        |                   |                    
|Third Quarter                                | $15.00 | $12.75 | $14.00            | $       -          
|                                             |        |        |                   |                    
|Fourth Quarter                               | $15.00 | $12.88 | $14.71            | $       -          





The Companys primary source of funds for dividend payments is dividends from its subsidiary bank. Bank regulatory agencies restrict dividend payments of the subsidiaries, as more fully disclosed in Note 11 of Notes to Consolidated Financial Statements.



As of March 10, 2006, the Company had approximately 1,291 shareholders of record.













21





---

Issuer Repurchases of Equity Securities



The following table sets forth information with respect to repurchases of common stock that the Company made during the fourth quarter of 2005:



|              |                                  |                              |                                                                             |                                                                                    
|------------- | -------------------------------- | ---------------------------- | --------------------------------------------------------------------------- | -----------------------------------------------------------------------------------
|Period        | Total Number of Shares Purchased | Average Price Paid per Share | Total Number of Shares Purchased as Part of Publicly Announced Programs (1) | Maximum Number of Shares that May Yet Be Purchased Under the Program
(in thousands)
|              |                                  |                              |                                                                             |                                                                                    
|October 2005  | -                                | $        -                   | -                                                                           | 207,478                                                                            
|              |                                  |                              |                                                                             |                                                                                    
|November 2005 | 21,500                           | $16.00                       | 21,500                                                                      | 185,978                                                                            
|              |                                  |                              |                                                                             |                                                                                    
|December 2005 | 8,667                            | $16.00                       | 8,667                                                                       | 177,311                                                                            
|              |                                  |                              |                                                                             |                                                                                    
|Total         | 30,167                           | $16.00                       | 30,167                                                                      | 177,311                                                                            



(1)

On December 8, 2004, the Companys board of directors approved a stock repurchase program to purchase over 12 months up to 258,000 shares (adjusted for 2:1 split) of its outstanding common stock (the Program).  The Company disclosed the Program in a Current Report on Form 8-K filed on January 26, 2005.  The Company has allocated $3.8 million to the Program and anticipates funding for the Program to come from available corporate funds.



(2)

On December 14, 2005, the Registrants board of directors approved a stock repurchase program to purchase over the next 12 months up to 151,000 shares of its outstanding common stock (the Program).  The
Registrant has allocated $2.5 million to the Program and anticipates funding for the Program to come from available corporate funds.  The Program replaces a prior authorization to repurchase shares of common stock that expired on December 7, 2005.  The Registrant currently has 5,280,615 shares of common stock outstanding.



























































22





---

Item 6. Selected Financial Data



The Company and Subsidiaries Selected Consolidated Financial Data:



(Amounts in thousands, except per share data)

|                                           |                                  |                          |            |            |            |           
|------------------------------------------ | -------------------------------- | ------------------------ | ---------- | ---------- | ---------- | ----------
|                                           |                                  | Years Ended December 31,
|                                           |                                  | 2005                     | 2004       | 2003       | 2002       | 2001      
|                                           |                                  |                          |            |            |            |           
|                                           | Interest income                  | $  32,189                | $  29,460  | $  29,463  | $  30,944  | $  32,998 
|Interest expense                           | 14,490                           | 12,162                   | 12,877     | 14,266     | 18,887    
|                                           | Net interest income              | 17,699                   | 17,298     | 16,586     | 16,678     | 14,111    
|Selected Income
Statement Data             | Provision for loan
losses        | 1,155                    | 1,300      | 2,053      | 1,825      | 1,448     
|                                           | Non-interest income              | 4,850                    | 4,572      | 4,652      | 3,646      | 3,364     
|                                           | Non-interest expense             | 14,998                   | 14,871     | 13,470     | 13,046     | 11,619    
|                                           | Income taxes                     | 1,363                    | 1,042      | 1,195      | 1,349      | 1,107     
|                                           | Net income                       | 5,033                    | 4,657      | 4,520      | 4,104      | 3,301     
|                                           |                                  |                          |            |            |            |           
|                                           | Basic net income                 | $     0.95               | $     0.88 | $     0.85 | $     0.78 | $     0.63
|                                           | Diluted net income               | 0.94                     | 0.87       | 0.85       | 0.77       | 0.62      
|*Per share data                            | Cash dividends
declared          | 0.075                    | 0.06       | 0.05       | 0.045      | 0.04      
|                                          
|                                           | Book value per share             | 7.98                     | 7.37       | 6.67       | 6.08       | 5.19      
|                                           |                                  |                          |            |            |            |           
|Selected Balance Sheet Data at End of Year | Loans, net                       | $407,274                 | $387,133   | $373,534   | $335,644   | $322,042  
|Total securities                           | 140,284                          | 133,203                  | 124,964    | 104,925    | 100,270   
|Total assets                               | 599,341                          | 567,060                  | 543,416    | 485,603    | 453,745   
|Total deposits                             | 486,908                          | 468,657                  | 450,009    | 410,301    | 392,093   
|                                           | Stockholders equity             | 42,132                   | 39,299     | 35,434     | 32,199     | 27,452    
|                                           |                                  |                          |            |            |            |           
|Selected Balance Sheet Daily Averages      | Loans, net                       | $396,530                 | $381,178   | $355,593   | $332,207   | $306,661  
|Total securities                           | 130,367                          | 129,611                  | 115,313    | 99,768     | 87,238    
|Total assets                               | 584,500                          | 556,995                  | 517,497    | 465,175    | 430,723   
|Total deposits                             | 480,080                          | 459,761                  | 439,330    | 398,972    | 370,111   
|                                           | Stockholders equity             | 40,290                   | 38,895     | 36,886     | 31,286     | 25,683    
|                                           |                                  |                          |            |            |            |           
|                                           | Return on average assets         | 0.86%                    | 0.83%      | 0.87%      | 0.87%      | 0.77%     
|Selected Ratios                            | Return on average equity         | 12.43%                   | 12.55%     | 13.27%     | 13.82%     | 12.78%    
|                                           | Dividend payout ratio            | 7.94%                    | 6.87%      | 5.86%      | 5.80%      | 6.39%     
|                                           | Average equity to average assets | 6.89%                    | 6.64%      | 6.59%      | 6.32%      | 6.00%     
|                                           |                                  |                          |            |            |            |           



* Data adjusted for 2:1 split paid September 9, 2005.

















23





---

Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operation



The purpose of this discussion is to provide information
 about the financial condition and results of operations of the Company and its wholly-owned
subsidiaries and other information included in this report.
This discussion should be read in conjunction with the Companys Consolidated Financial Statements and Notes to Consolidated Financial Statements.



Caution About Forward-Looking Statements



This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company's actual results could differ materially form those set forth in the forward-looking statements.



Such forward-looking statements involve known and unknown risks including, but not limited to, the following factors:



·

The ability to successfully manage the Companys growth or implement its growth strategies if it is unable to identify attractive markets, locations or opportunities to expand in the future;

·

The ability to continue to attract low cost core deposits to fund asset growth;

·

Maintaining capital levels adequate to support the Companys growth;

·

Maintaining cost controls and asset qualities as the Company opens or acquires new branches;

·

Reliance on the Companys management team, including its ability to attract and retain key personnel;

·

The successful management of interest rate risk;

·

Changes in general economic and business conditions in the Companys market area;

·

Changes in interest rates and interest rate policies;

·

Risks inherent in making loans such as repayment risks and fluctuating collateral values;

·

Competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;

·

Demand, development and acceptance of new products and services;

·

Problems with technology utilized by the Company

·

Changing trends in customer profiles and behavior; and

·

Changes in banking and other laws and regulations applicable to the Company.



Overview



The Company is a bank holding company located in southwest Virginia. It conducts commercial banking operations primarily through its full service banking subsidiary, Highlands Union Bank (the Bank). The Bank has two wholly owned subsidiaries, Highlands Union Financial Services, Inc. and Highlands Union Insurance Services, Inc.. These two subsidiaries offer investment and insurance products. Revenues and net income derived from these two sources are not significant at this time. Management characterizes the Bank as a "community bank".





24





---

The Bank offers general retail and commercial banking services to individuals, businesses and local government unit customers. These products and services include accepting deposits in the form of checking accounts, money market deposit accounts, interest-bearing demand deposit accounts, savings accounts and time deposits; making real estate, commercial, revolving, consumer, credit card and agricultural loans; offering letters of credit; providing other consumer financial services, such as automatic funds transfer, collections, night depository, safe deposit, travelers checks and savings bond sales; and providing other miscellaneous services normally offered by commercial banks. The Bank makes loans in all major loan categories, including commercial, commercial and residential real estate, construction and consumer loans.



The Company makes money primarily by earning an interest rate spread between the interest rates it earns on loans and securities and interest rates it pays on deposits and other borrowed money. The Company also earns money through fees, service charges and other non-interest income.



Critical Accounting Policies



General



The financial condition and results of operations presented in the Consolidated Financial Statements, accompanying Notes to Consolidated Financial Statements and managements discussion and analysis are, to a large degree, dependent upon the accounting policies of the Company.  The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change.



Presented below is a discussion of the accounting policy that management believes is important to the understanding of the Companys financial condition and results of operations.  This critical accounting policy requires managements most difficult, subjective and complex judgments about matters that are inherently uncertain.  In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.  See also Note 1 of the Notes to Consolidated Financial Statements.



Allowance for Loan Losses



The Company monitors and maintains an allowance for loan losses to absorb the estimate of probable losses inherent in the loan portfolio.  The allowance for loan losses is based on managements judgment and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit and asset quality, as well as other internal and external factors, such as general economic conditions. The Company recognizes the inherent imprecision in estimates of losses due to various uncertainties, and variability related to the factors used. 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.

















25





---





Performance Summary



The following table shows the Companys key performance ratios for the periods ended December 31, 2005, 2004 and 2003:



|                                                                                                                                                                                                                                                                                 |          |          |         
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------- | -------- | --------
|                                                                                                                                                                                                                                                                                 |          |          |         
|                                                                                                                                                                                                                                                                                 | 12/31/05 | 12/31/05 | 12/31/03
|Return on Average Assets                                                                                                                                                                                                                                                         | 0.86%    | 0.83%    | 0.87%   
|Return on Average Equity                                                                                                                                                                                                                                                         | 12.43%   | 12.55%   | 13.27%  
|Basic Earnings Per Share                                                                                                                                                                                                                                                         | $0.95    | $.88     | $.85    
|Fully Diluted Earnings Per Share                                                                                                                                                                                                                                                 | $0.94    | $.87     | $.85    
|Net Interest Margin (1)                                                                                                                                                                                                                                                          | 3.52%    | 3.60%    | 3.67%   
|                                                                                                                                                                                                                                                                                 |          |          |         
|(2)
Net Interest Margin - Year-to-date tax equivalent net interest income divided by year-to-date average earning assets.
(2)
Earnings per share and fully diluted earnings per share have been restated to reflect the 2 for 1 stock split which occurred on September 9, 2005.









Growth



The following table shows the Companys key growth indicators for the periods ending December 31, 2005, 2004 and 2003:



|           |          |          |         
|---------- | -------- | -------- | --------
|           | 12/31/05 | 12/31/04 | 12/31/03
|           |          |          |         
|Securities | $135,726 | $128,953 | $122,064
|Loans, net | $407,274 | $387,133 | $373,534
|Deposits   | $486,908 | $468,657 | $450,009
|Assets     | $599,341 | $567,060 | $543,416





















26





---

Asset Quality



The following table shows the Companys key asset quality indicators for the periods ending December 31, 2005, 2004 and 2003:







|                                         |          |          |         
|---------------------------------------- | -------- | -------- | --------
|                                         | 12/31/05 | 12/31/04 | 12/31/03
|                                         |          |          |         
|Non- accrual loans                       | $2,920   | $3,902   | $3,723  
|Loans past due over 90 days              | 1,281    | 661      | 802     
|Other real estate owned                  | 810      | 1,047    | 370     
|Allowance for loan losses to total loans | 1.06%    | 1.07%    | 1.13%   
|Net charge-off ratio                     | 0.24%    | 0.36%    | 0.44%   





For further information see the discussion under "Provision and Allowances for Loan Losses".





























































27





---

Results of Operations

(dollar amounts in thousands)



Net Interest Income



2005 versus 2004



Net interest income for 2005 was $17,699 or an increase of $401 over 2004. During 2005 interest income increased $2,729. This was a result of both existing interest earning assets re-pricing at higher rates and new loans made and securities purchased at higher rates. Throughout 2005 the Federal Reserve Board continued its policy of raising short term rates. Interest-bearing liabilities also re-priced upward, causing an increase in interest expense of $2,328. The net result of these events was a slight decrease in the Companys net interest margin to 3.52% in 2005 from 3.60% in 2004. To help offset the margin reduction and in anticipation of short term rates falling over the next year or two, the Company continued to increase its portfolio of fixed rate municipal bonds. The Company also continued to increase its portfolio of
 adjustable rate mortgages to help offset any increase in interest rate risk resulting in these
 municipal bond purchases. The Company has also made a concerted effort to lock in longer term funding by increasing its long term funding from the Federal Home Loan Bank. The current trend is the result of short-term interest rates rising after an unusually long period of low interest rates. The tax equivalent yield on earning assets for 2005 was 6.19%, increasing 24 basis points during the year. During the same period, the yield on interest bearing liabilities increased by 41 basis points.



2004 versus 2003



Net interest income for 2004 was $17,298, an increase of $712 over 2003. During 2004 interest income decreased $3 as assets re-priced downward. Interest-bearing liabilities also repriced downward, causing a decline in interest expense. The net result of these events was a slight decrease in the net interest margin to 3.60% in 2004 from 3.67% in 2003. The tax equivalent yield on earning assets for 2004 was 5.95%, declining 39 basis points during the year. During the same period, the yield on interest bearing liabilities decreased by 36 basis points. The continued period of low interest rates resulted in many of the 1-4 family adjustable rate mortgages as well as adjustable rate securities to continue to reprice downward. New loans and securities were also made at lower rates.







































28





---

Analysis of Net Interest Earnings



The following table shows the major categories of interest-earning assets and interest-bearing liabilities, the interest earned or paid, the average yield or rate on the average balance outstanding, net interest income and net yield on average interest-earning assets and average interest spread for the years indicated.



|                                                                                                                                                                                                                                               |                         |                         |             |                 |                         |             |                 |                         |             |  | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------- | ----------------------- | ----------- | --------------- | ----------------------- | ----------- | --------------- | ----------------------- | ----------- |  | 
|                                                                                                                                                                                                                                               | Year Ended December 31,
|                                                                                                                                                                                                                                               | 2005                    | 2004                    | 2003       
|                                                                                                                                                                                                                                               | (Dollars in Thousands) 
|                                                                                                                                                                                                                                               | Average
Balance         | Interest Income/Expense | Yield/
Rate | Average
Balance | Interest Income/Expense | Yield/
Rate | Average
Balance | Interest Income/Expense | Yield/
Rate
|ASSETS                                                                                                                                                                                                                                         |                         |                         |             |                 |                         |             |                 |                         |            
|Interest earning assets
(taxable-equivalent basis):                                                                                                                                                                                            |                         |                         |             |                 |                         |             |                 |                         |            
|Loans (net of unearned
discount (2)                                                                                                                                                                                                            | $400,759                | $ 26,703                | 6.66%       | $385,434        | $ 24,575                | 6.38%       | $359,187        | $ 24,893                | 6.93%      
|Securities (1)(3)                                                                                                                                                                                                                              | 136,567                 | 5,319                   | 4.87        | 130,629         | 4,870                   | 4.73        | 115,313         | 4,495                   | 4.87       
|Federal funds sold                                                                                                                                                                                                                             | 4,157                   | 167                     | 4.02        | 973             | 15                      | 1.54        | 7,757           | 75                      | 0.97       
|Total interest-earning
assets                                                                                                                                                                                                                  | $541,483                | $  32,189               | 6.19%       | $517,036        | $  29,460               | 5.95%       | $482,257        | $  29,463               | 6.34%      
|LIABILITIES                                                                                                                                                                                                                                    |                         |                         |             |                 |                         |             |                 |                         |            
|Interest bearing
liabilities:                                                                                                                                                                                                                  |                         |                         |             |                 |                         |             |                 |                         |            
|Interest bearing dep.                                                                                                                                                                                                                          | $405,363                | $ 11,282                | 2.78%       | $392,475        | $ 9,310                 | 2.37%       | $380,229        | $ 10,335                | 2.72%      
|Other interest bearing
liabilities                                                                                                                                                                                                             | 60,872                  | 3,208                   | 5..27       | 57,602          | 2,852                   | 4.95        | 41,119          | 2,542                   | 6.18       
|Total interest-bearing
liabilities                                                                                                                                                                                                             | $466,235                | $  14,490               | 3.11%       | $450,077        | $  12,162               | 2.70%       | $421,348        | $  12,877               | 3.06%      
|Net interest income                                                                                                                                                                                                                            |                         | $ 17,699                |             |                 | $ 17,298                |             |                 | $ 16,586                |            
|Net margin on interest
earning assets on a
tax equivalent basis                                                                                                                                                                                |                         |                         | 3.52%       |                 |                         | 3.60%       |                 |                         | 3.67%      
|Average interest spread                                                                                                                                                                                                                        |                         |                         | 3.08%       |                 |                         | 3.25%       |                 |                         | 3.29%      
|                                                                                                                                                                                                                                               |                         |                         |             |                 |                         |             |                 |                         |            
|(1)
Tax equivalent adjustments (using 34% federal tax rates) have been made in calculating yields on tax-free investments. Virginia banks are exempt from state income tax.                                                                   
|(2)
For the purposes of these computations, non-accruing loans are included in the daily average loan amounts outstanding.                                                                                                                    
|(3)
The yield on securities classified as available for sale is computed based on the average balance of the historical amortized cost balance without the effects of the fair value adjustment required by Financial Accounting Standard 115.

























29





---

Analysis of Changes in Interest Income and Interest Expense



The Company's primary source of revenue is net interest income, which is the difference between the interest and fees earned on loans and investments and the interest paid on deposits and other funds. The Company's net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities and by changes in yields earned on interest-earning assets and rates paid on interest-bearing liabilities. The following table sets forth, for the years indicated, a summary of the changes in interest income and interest expense resulting from changes in average asset and liability balances (volume) and changes in average interest rates (rate).



Increase/(Decrease) Due to Volume and Rate



|                                           |                                             |                                           |                         |                                             |                                           |                        
|------------------------------------------ | ------------------------------------------- | ----------------------------------------- | ----------------------- | ------------------------------------------- | ----------------------------------------- | -----------------------
|                                           | 2005 Compared to 2004                       | 2004 Compared to 2003                    
|Increase (Decrease) in                     | Increase (decrease) due to change in volume | Increase (decrease) due to change in rate | Net increase
(decrease) | Increase (decrease) due to change in volume | Increase (decrease) due to change in rate | Net increase
(decrease)
|                                           | (Dollars in Thousands)                     
|INTEREST INCOME
Securities                 | $    306                                    | $     143                                 | $     449               | $    708                                    | $     (333)                               | $     375              
|Federal funds sold                         | 128                                         | 24                                        | 152                     | (104)                                       | 44                                        | (60)                   
|Loans                                      | 1,021                                       | 1,107                                     | 2,128                   | 1,674                                       | (1,992)                                   | (318)                  
|Total Income Change                        | $ 1,455                                     | $ 1,274                                   | $   2,729               | $ 2,278                                     | $ (2,281)                                 | $     (   3)           
|INTEREST EXPENSE
Savings and time deposits | $    358                                    | $  1,614                                  | $ 1,972                 | $    290                                    | $  (1,315)                                | $ (1,025)              
|Other interest-bearing
liabilities         | 173                                         | 183                                       | 356                     | 816                                         | (506)                                     | 310                    
|Total Expense Change                       | $    531                                    | $ 1,797                                   | $  2,328                | $ 1,106                                     | $ (1,821)                                 | $    (715)             
|Increase (Decrease) in
Net Interest Income | $    924                                    | $    (523)                                | $   401                 | $ 1,172                                     | $    (460)                                | $     712              





Non-interest Income

(dollar amounts in thousands)



2005 versus 2004



Non-interest income for 2004 was $4,850, a 6.08% increase over 2004.   During the fourth quarter of 2005, the Company implemented an overdraft privilege program as an additional service to its customer base.  The number of checks processed continues to decline as the number of electronic transactions increases.  Merchant and debit card fee income increased by $128 over 2004 due to increases in merchant fees and visa check card interchange fees. The use of debit cards continued to increase significantly over the prior period.



Net securities gains and losses increased $159 from 2004. The majority of sales consisted of tax-exempt municipal bonds and agency preferred stocks (see the Securities section for further discussion). Income received during 2005 from the Companys investment in Virginia Title Company, LLC. totaled $126. Earnings related to its investment in Bank Owned Life Insurance totaled $340, or a decrease of $14 as compared to 2004.





30





---

Management of the Company is continually looking for and researching areas to increase the amount of non-interest income. During 2005, the Company became on equity owner in BI Investments, which is a full service dealer broker created in conjunction with the Virginia Bankers Association. Bankers Investments allows the Company to offer a full range of investment products. Management believes this investment will increase its ability to generate future sales for a wide array of financial services products.





2004 vs. 2003



Non-interest income for 2004 was $4,572, a 1.72% decrease from 2003. Merchant and debit card fee income increased by $108 over 2003 due to increases in merchant and interchange fees. Net securities gains and losses were down $189 from 2003. Income received during 2004 from the Companys investment in Virginia Title Company, LLC totaled $184, an increase of $23 over 2003. Earnings related to its investment in Bank Owned Life Insurance totaled $354 or a decrease of $4 as compared to 2003.



Non-interest Expense

(dollar amounts in thousands)



2005 versus 2004



Non-interest expense is comprised of salaries and employee benefit costs, occupancy expenses, furniture and equipment expenses and other operating expenses. Non-interest expense for 2005 was $14,998, essentially the same as 2004. Salaries and employee benefits increased by 1.26% or $110. The Company opened a new branch in Banner Elk, NC. in February 2004 and opened a loan production office in West Jefferson, NC during the fourth quarter of 2004. A full year of expense was incurred during 2005 for these two locations. Other non-interest expenses remained comparable to 2004. Recent technology enhancements have allowed the bank to leverage its existing personnel base to help minimize overall increases in personnel costs.  No new facilities were opened in 2005.





2004 versus 2003



Non-interest expense for 2004 was $14,871, an increase of $1,401 or 10.40% over 2003. The most significant changes occurred in salaries and employee benefits.   Salaries and employee benefits increased by 12.28% or $951 due to growth of the Company mainly in the area of branch expansion. The Company opened a new branch in Blountville, TN. in August of 2003, opened a new branch in Banner Elk, NC. in February of 2004 and opened a loan production office in West Jefferson, NC during the fourth quarter of 2004. Other non- interest expenses increased also due to Company growth. During the third quarter of 2004, the Company installed a check imaging and distributive capture system and began producing image statements to its customers. This move will allow the company to take advantage of the
benefits related to the Check 21 Act which was signed into law in October
2004.  These systems should also have a positive impact on personnel expense
 in the future as the handling of checks is diminished.















31





---

Income Taxes

(dollar amounts in thousands)



2005 vs. 2004



Income tax expense for 2005 increased by $321 when compared to 2004 primarily due to the increase in pretax income and the capital loss treatment pertaining to the sale of approximately $4,597 of agency preferred stocks. Tax exempt income continues to be the primary difference between the"expected" and reported tax expense.



2004 vs. 2003



Income tax expense for 2004 decreased by $153 when compared to 2003 primarily due to the additional income related to tax exempt municipal bond income and tax exempt earnings related to its Bank Owned Life Insurance.



Provision and Allowance for Loan Losses

(dollar amounts in thousands)



2005 vs. 2004



The adequacy of the allowance for loan losses is based on management's judgment and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit and asset quality, as well as other internal and external factors, such as general economic conditions.  The internal credit review department performs pre-credit analyses of large credits and also conducts credit review activities that provide management with an early warning of asset quality deterioration. The internal credit review department also prepares regular analyses of the adequacy of the allowance for loans losses. These analyses include calculations based upon a mathematical formula that considers identified potential losses and makes pool allocations for historical losses for various loan types. The Company uses a
rolling three year history by loan category in determining pool allocation factors. In addition, an amount is allocated based upon such factors as changing trends in the loan mix,
 the effects of changes in business conditions and market area, unemployment trends, the effects of any changes in loan policies, and the effects of competition and regulatory factors on the loan portfolio.



The internal credit review department as well as management has determined that the Company's allowance for loan losses is sufficient. Loans past due ninety days or more and still accruing were $1,281 at December 31, 2005, compared to $661 at December 31, 2004. Net charge-offs to total loans decreased from 0.36% in 2004 to 0.24% in 2005. This was in large part due to the changes implemented in 2004 related to credit scoring, underwriting, analysis and review.



2004 vs. 2003



During the first half of 2004, the Company greatly enhanced both its credit review and credit analysis departments. Additional staffing was added and enhanced procedures and systems were also implemented.  Loans past due ninety days or more and still accruing were $661 at December 31, 2004, lower than the $802 at December 31, 2003.  Net charge-offs to total loans decreased from .44% in 2003 to .36% in 2004.









32





---

The following
 table presents the Companys loan loss experience for the past five years:



|                                                     |                                                 |                 |                 |                 |                
|---------------------------------------------------- | ----------------------------------------------- | --------------- | --------------- | --------------- | ---------------
|                                                     | Years Ended December 31,
(Dollars in Thousands)
|                                                     | 2005                                            | 2004            | 2003            | 2002            | 2001           
|Allowance for loan losses at
beginning of year       | $4,181                                          | $4,274          | $      3,877    | $      3,418    | $      2,950   
|Loans charged off:                                   |                                                 |                 |                 |                 |                
|Commercial                                           | 131                                             | 219             | 299             | 389             | 107            
|Real Estate  mortgage                               | 205                                             | 192             | 270             | 94              | 10             
|Consumer                                             | 791                                             | 1,089           | 1,211           | 1,043           | 1,087          
|Other                                                | 0                                               | 0               | 0               | 0               | 0              
|Total                                                | $      1,127                                    | $      1,500    | $      1,780    | $      1,526    | $      1,204   
|Recoveries of loans previously
charged off:          |                                                 |                 |                 |                 |                
|Commercial                                           | $            17                                 | $             2 | $             8 | $             5 | $             3
|Real Estate  mortgage                               | 10                                              | 1               | 0               | 0               | 0              
|Consumer                                             | 123                                             | 104             | 116             | 155             | 221            
|Other                                                | 0                                               | 0               | 0               | 0               | 0              
|Total                                                | $         150                                   | $         107   | $         124   | $         160   | $         224  
|                                                     |                                                 |                 |                 |                 |                
|Net loans charged off                                | $      977                                      | $      1,393    | $      1,656    | $      1,366    | $         980  
|                                                     |                                                 |                 |                 |                 |                
|Provision for loan losses                            | 1,155                                           | 1,300           | 2,053           | 1,825           | 1,448          
|Allowance for loan losses end of year                | $      4,359                                    | $      4,181    | $      4,274    | $      3,877    | $      3,418   
|Average total loans (net of unearned income)         | $  400,759                                      | $  385,434      | $  359,187      | $  335,823      | $  309,753     
|Total loans (net of unearned income) at year-end     | $  411,633                                      | $  391,314      | $  377,808      | $  339,521      | $  325,460     
|Ratio of net charge-offs to average loans            | 0.244%                                          | 0.361%          | 0.461%          | 0.407%          | 0.316%         
|Ratio of provision for loan losses to average loan   | 0..288%                                         | 0.337%          | 0.572%          | 0.543%          | 0.467%         
|Ratio of provision for loan losses to net charge-off | 118.219%                                        | 123.973%        | 123.973%        | 133.602%        | 147.755%       
|Allowance for loan losses to year-end loans          | 1.059%                                          | 1.068%          | 1.131%          | 1.142%          | 1.050%         



Factors influencing management's judgment in determining the amount of the loan loss provision charged to operating expense include the quality of the loan portfolio as determined by management, the historical loan loss experience, diversification as to type of loans in the portfolio, the amount of secured as compared with unsecured loans and the value of underlying collateral, banking industry standards and averages, and general economic conditions.



Non-performing loans

(dollar amounts in thousands)



The loan portfolio of the Bank is reviewed regularly by senior officers to evaluate loan performance. The frequency of the review is based on a rating of credit worthiness of the borrower utilizing various factors such as net worth, credit history and customer relationship. The evaluations emphasize different factors depending upon the type of loan involved. Commercial and real estate loans are reviewed on the basis of projections of cash flow and estimated net realizable value through an evaluation of collateral and the financial strength of the borrower. Installment loans are evaluated largely on the basis of delinquency data because of the large number of such loans and relatively small size of each individual loan.



33

---

Managements review of commercial and other loans may result in a determination that a loan should be placed on a non-accrual of interest basis. It is the policy of the Bank to discontinue the accrual of interest on any loan on which full repayment of principal and / or interest is doubtful. Subsequent collection of interest is recognized as income on a cash basis upon receipt. Placing a loan on non-accrual status for the purpose of income recognition is not in itself a reliable indication of potential loss of principal. Other factors, such as the value of the collateral securing the loan and the financial condition of the borrower, serve as more reliable indications of potential loss of principal.

The policy of the Bank is that non-performing loans consist of loans accounted for on a non-accrual basis and loans which are contractually past due 90 days or more in regards to interest and/ or principal payments. The following table presents non-performing assets as of the five periods ended December 31, 2005, 2004, 2003, 2002 and 2001, respectively.





|                                                                               |                        |               |               |               |               
|------------------------------------------------------------------------------ | ---------------------- | ------------- | ------------- | ------------- | --------------
|                                                                               | 2005                   | 2004          | 2003          | 2002          | 2001          
|                                                                               | (Amounts in thousands)
|                                                                               |                        |               |               |               |               
|Non-performing loans                                                           | $     4,201            | $     4,653   | $      4,521  | $      2,606  | $      2,063  
|                                                                               |                        |               |               |               |               
|Non-accrual loans                                                              | $     2,920            | $     3,902   | $      3,723  | $      1,728  | $      1,159  
|                                                                               |                        |               |               |               |               
|Loans past-due 90 days and more and still accruing                             | $        1,281         | $        661  | $        802  | $        891  | $         950 
|                                                                               |                        |               |               |               |               
|Interest income lost on non-accruing loans                                     | $        227           | $        237  | $        235  | $        104  | $           73
|                                                                               |                        |               |               |               |               
|Interest income realized on loans past-due 90 days and more and still accruing | $          68          | $          44 | $          15 | $          18 | $           15























34





---

Allocation of the allowance for loan losses



The following table provides an allocation of the allowance for loan losses as of December 31, 2005, 2004, 2003, 2002 and 2001.





|                    |                                                                                   |                               |                           |                         |                               |                           |                         |                               |                          
|------------------- | --------------------------------------------------------------------------------- | ----------------------------- | ------------------------- | ----------------------- | ----------------------------- | ------------------------- | ----------------------- | ----------------------------- | -------------------------
|                    | Year Ended December 31,
Percent of Loans on each Category

(Dollars in Thousands)
|                    | 2005(1)                                                                           | 2004(1)                       | 2003                     
|                    | Allowance for
Loan Loss                                                           | Percentage of Total Loan Loss | Percentage of
Total Loans | Allowance for
Loan Loss | Percentage of Total Loan Loss | Percentage of
Total Loans | Allowance for
Loan Loss | Percentage of Total Loan Loss | Percentage of
Total Loans
|Commercial          | $        710                                                                      | 16.29%                        | 9.38%                     | $        705            | 16.86%                        | 9.13%                     | $        830            | 19.42%                        | 10.37%                   
|Real Estate         | 1,255                                                                             | 28.79                         | 79.42                     | 1,302                   | 31.16                         | 76.40                     | 224                     | 5.24                          | 73.25                    
|Consumer            | 858                                                                               | 19.68                         | 10.07                     | 953                     | 22.79                         | 13.25                     | 3,220                   | 75.34                         | 15.08                    
|Other / Unallocated | 1536                                                                              | 35.24                         | 1.13                      | 1,221                   | 29.19                         | 1.22                      | 0                       | 0.00                          | 1.30                     
|Total               | $    4,359                                                                        | 100.00%                       | 100.00%                   | $    4,181              | 100.00%                       | 100.00%                   | $    4,274              | 100.00%                       | 100.00%                  





|            |                         |                               |                           |                         |                               |                          
|----------- | ----------------------- | ----------------------------- | ------------------------- | ----------------------- | ----------------------------- | -------------------------
|            | 2002                    | 2001                         
|            | Allowance for
Loan Loss | Percentage of Total Loan Loss | Percentage of
Total Loans | Allowance for
Loan Loss | Percentage of Total Loan Loss | Percentage of
Total Loans
|Commercial  | $        972            | 25.06%                        | 10.87%                    | $        857            | 25.06%                        | 7.98%                    
|Real Estate | 228                     | 5.89                          | 70.60                     | 201                     | 5.89                          | 66.09                    
|Consumer    | 2,672                   | 68.93                         | 17.05                     | 2,356                   | 68.93                         | 24.92                    
|Other       | 5                       | 0.12                          | 1.48                      | 4                       | 0.12                          | 1.01                     
|Total       | $    3,877              | 100.00%                       | 100.00%                   | $    3,418              | 100.00%                       | 100.00%                  



1)

Percentages for 2005 and 2004 are categorized differently from prior years due to the Companys change in its methodology of the calculation of the Allowance for Loan Loss reserve. More enhanced pooling allocation factors are now being used, in addition to more detailed historical data being utilized. The allowance for loan loss reserve is computed quarterly by the Companys internal credit review department and is reviewed by the Senior Financial Officers of the Company. Management believes its method, implemented in 2004, pertaining to the allocation of loan loss reserve is both adequate and more properly allocates the reserve among the various categories.



35





---

Financial Condition



Balance Sheet

(dollar amounts in thousands)



2005 vs. 2004



Total assets for the Company increased by $32,281 or 5.69% in 2005. Interest earning assets grew by $25,796 or 4.90% for the year. Interest bearing liabilities increased by $21,410 or 4.73% in 2005. Asset growth was primarily attributable to increased market share in both North Carolina and Tennessee.



2004 vs. 2003



Total assets for the Company increased by $23,644 or 4.35% in 2004. Interest earning assets grew by $23,070 or 4.59% for the year. Interest bearing liabilities increased by $6,253 or 1.40% in 2004. Non-interest bearing deposits increased by $13,849 or 23.45% during 2004.  Asset growth was primarily attributable to loan growth in western North Carolina.



Loans

(dollar amounts in thousands)



2005 vs. 2004



Loans net of unearned income and deferred fees increased by $20,319 or 5.19% in 2005.  Loans secured by real estate showed an increase of approximately $27,825, offset by a decline in loans secured by collateral other than real estate of approximately $10,562. The decline in loans secured by collateral other than real estate was primarily due to the Companys decision to discontinue its dealer finance division in the first quarter of 2005. This decision was made due to the competitive nature of this program and the risks associated from these indirect loans. Management also believes the decline in loans secured by collateral other than real estate was also due to the following:



·

General economic conditions and the lack of employment opportunity in

portions of the Company's market area.

·

A decline in consumer requests for new car financing because of special



financing incentives offered by automobile companies.

·

Stricter credit scoring / underwriting implemented in 2004.



·

Consumers taking advantage of low mortgage rates to refinance home



mortgages to obtain funds that might otherwise have been borrowed



through a consumer loan.





Reversal of this trend may occur to some extent as economic conditions change and higher interest rates make mortgage refinancing less appealing. However, management believes that automotive related financing offers and competition from the credit card sector will remain.  Since loans to individuals are generally higher yielding, this trend will not have a favorable effect on net interest income in the future but should have a favorable impact on future net charge-offs as the percentage of real estate secured loans to total loans increases.











36





---

2004 vs. 2003



Loans net of unearned income and deferred fees increased by $13,506 or 3.57% in 2004. Loans secured by real estate showed an increase of approximately $22,354, offset by a decline in loans secured by collateral other than real estate of $7,152 and a decrease in unsecured loans of $1,692. The majority of the increase in loans during 2004 was the result of the continued growing market share in North Carolina. Again, the decline in non-real estate secured loans was due to the above mentioned reasons.



37





---

Loan Portfolio



The table below classifies gross loans by major category and percentage distribution at December 31, 2005 for each of the past five years:





|                                              |                                     |            |            |            |            |            |            |            |           |           
|--------------------------------------------- | ----------------------------------- | ---------- | ---------- | ---------- | ---------- | ---------- | ---------- | ---------- | --------- | ----------
|                                              | December 31,
(Dollars in thousands)
|                                              | 2005                                | 2004       | 2003       | 2002       | 2001      
|                                              | Amount                              | Percentage | Amount     | Percentage | Amount     | Percentage | Amount     | Percentage | Amount    | Percentage
|Real Estate Secured:                          |                                     |            |            |            |            |            |            |            |           |           
|Residential 1-4 family                        | $ 151,815                           | 36.88%     | $ 146,970  | 37.54%     | $141,693   | 37.49%     | $ 128,462  | 37.82%     | $114,556  | 35.18%    
|Multi-family                                  | 4,148                               | 1.01       | 3,379      | 0.86       | 2,651      | 0.70       | 3,383      | 1.00       | 3,011     | 0.92      
|Commercial, Construction
and Land Development | 140,178                             | 34.05      | 122,997    | 31.42      | 113,146    | 29.93      | 85,468     | 25.16      | 80,673    | 24.77     
|Second Mortgages                              | 10,962                              | 2.66       | 7,419      | 1.89       | 6,976      | 1.85       | 11,676     | 3.43       | 7,737     | 2.38      
|Equity Line of Credit                         | 9,800                               | 2.38       | 8,981      | 2.29       | 7,430      | 1.96       | 5,253      | 1.54       | 4,166     | 1.28      
|Farmland                                      | 10,015                              | 2.43       | 9,347      | 2.39       | 4,843      | 1.28       | 5,589      | 1.65       | 5,065     | 1.56      
|                                              | $ 326,918                           | 79.41%     | $ 299,093  | 76.39%     | $276,739   | 73.21%     | $ 239,831  | 70.60%     | $215,208  | 66.09%    
|Secured, Other:                               |                                     |            |            |            |            |            |            |            |           |           
|Personal                                      | $   33,395                          | 8.11%      | $   44,222 | 11.30%     | $   48,637 | 12.87%     | $   49,483 | 14.57%     | $  60,532 | 18.59%    
|Commercial                                    | 25,628                              | 6.23       | 24,992     | 6.38       | 27,247     | 7. 21      | 26,043     | 7.67       | 26,002    | 7.98      
|Agricultural                                  | 3,653                               | .89        | 4,024      | 1.03       | 4,506      | 1.19       | 4,209      | 1.23       | 3,274     | 1.01      
|                                              | $   62,676                          | 15.23%     | $   73,238 | 18.71%     | $   80,390 | 21.27%     | $   79,735 | 23.47%     | $  89,808 | 27.58%    
|                                              |                                     |            |            |            |            |            |            |            |           |           
|Unsecured:                                    | $   22,048                          | 5.36%      | $   19,176 | 4.90%      | $   20,868 | 5.52%      | $   20,135 | 5.93%      | $  20,614 | 6.33%     
|                                              |                                     |            |            |            |            |            |            |            |           |           
|Loans, gross                                  | $ 411,642                           | 100.00%    | $ 391,507  | 100.00%    | $ 377,997  | 100.00%    | $ 339,701  | 100.00%    | $325,630  | 100.00%   
|                                              |                                     |            |            |            |            |            |            |            |           |           

























38





---

The following table shows the maturity of loans outstanding, inclusive of contractual amortization, as of December 31, 2005



|                                            |                                          |                                      |                  |          |          |          |         
|------------------------------------------- | ---------------------------------------- | ------------------------------------ | ---------------- | -------- | -------- | -------- | --------
|                                            | December 31, 2005
(Amounts in Thousands)
|                                            | Within One Year                          | After One Year But Within Five Years | After Five Years |         
|                                            | Fixed                                    | Floating                             | Fixed            | Floating | Fixed    | Floating | Total   
|                                            |                                          |                                      |                  |          |          |          |         
|Real Estate Secured:                        |                                          |                                      |                  |          |          |          |         
|Residential 1-4 Family                      | $11,185                                  | $5,128                               | $23,627          | $9,489   | $28,973  | $73,413  | $151,815
|Multi-family                                | 251                                      | 0                                    | 3,335            | 0        | 562      | 0        | 4,148   
|Commercial, Construction
& Land Development | 29,884                                   | 18,464                               | 58,302           | 5,834    | 15,836   | 11,858   | 140,178 
|Second Mortgages                            | 1,663                                    | 501                                  | 3,572            | 86       | 4,164    | 976      | 10,962  
|Equity Line of Credit                       | 0                                        | 667                                  | 0                | 3,269    | 0        | 5,864    | 9,800   
|Farmland                                    | 237                                      | 2,565                                | 6,600            | 54       | 377      | 182      | 10,015  
|Secured, Other:                             |                                          |                                      |                  |          |          |          |         
|Personal                                    | 10,922                                   | 1                                    | 21,711           | 3        | 711      | 47       | 33,395  
|Commercial                                  | 8,886                                    | 4,588                                | 11,626           | 127      | 401      | 0        | 25,628  
|Agricultural                                | 507                                      | 1,861                                | 1,148            | 67       | 70       | 0        | 3,653   
|Unsecured                                   | 7,596                                    | 10,850                               | 2,289            | 956      | 317      | 40       | 22,048  
|                                            |                                          |                                      |                  |          |          |          |         
|Loans, Gross                                | $ 71,131                                 | $ 44,625                             | $132,210         | $ 19,885 | $ 51,411 | $ 92,380 | $411,642
|                                            |                                          |                                      |                  |          |          |          |         
|                                            |                                          |                                      |                  |          |          |          |         
|                                            |                                          |                                      |                  |          |          |          |         
|                                            |                                          |                                      |                  |          |          |          |         































39





---

Securities

(dollar amounts in thousands)



2005 vs. 2004



Investment securities available for sale increased $6,773 (market value) from December 31, 2004 to December 31, 2005.  Purchases during the year consisted primarily of 1 year adjustable rate mortgage backed securities and fixed rate municipal bonds. As short term interest rates have risen during the year, management has continued its investment strategy to purchase securities that will not only blend in with the Companys overall asset liability strategy but also maximize yield. A majority of the monthly paydowns were again prepayments on variable rate securities as a result of prepayments occurring on the underlying mortgages. The senior financial officers review and manage the securities portfolio on an ongoing basis.



At December 31, 2005, net unrealized losses in the Companys securities portfolio classified available for sale totaled $1,727. The majority of these unrealized losses were related to the Companys holdings ($6,250 in book value) of Federal Home Loan Mortgage Corporation and Federal National Mortgage Association agency preferred stock. As discussed in Footnote 2 in the Companys Consolidated Financial Statements, management of the Company does not consider any of these losses to be other than temporary. It is managements opinion that the unrealized losses are primarily related to interest rate changes. Management also feels that the market values of these particular instruments have also been negatively affected by the accounting related irregularities at both Fannie Mae and Freddie Mac. The Company has
 both the ability and intent to hold these instruments for a time necessary to recover its cost. Even with the intent and ability to hold these securities, the Board and Management elected
 to sell approximately $4,597 of agency preferred stock realizing a net capital loss of approximately $383.
 This decision was specifically a risk management decision to reduce the Companys amount of holdings
in this type of investment. Management at that time felt that the amount of holdings in these instruments
needed to be reduced as a percentage of the entire securities portfolio. These instruments are stocks and do
 not have a stated maturity date. The Company continues to hold a laddered structure of these
investments (a single 1- year floater, two 2- year floaters and a single 5- year floater). It should be noted
 that these instruments have gained approximately 35% in value since December 31, 2005 as interest rates
 have continued to rise. As these instruments have moved closer to their reset dates and as their related
indexes have adjusted upward, their values also have been increasing which supports managements belief
 that these losses are temporary and related primarily to the interest rate cycle.



Also during the year, the Company elected to sell a portion of its municipal bond portfolio (approximately $17,353 in book value) and recognized gains totaling approximately $921. Management took the opportunity to sell the municipal bonds and realize the gain and subsequently re-invest the proceeds back into more municipal bonds at similar yields. The average life of the municipals that management purchased was only 2-4 years longer than the municipals that were sold.



2004 vs. 2003



Investment Securities available for sale increased $6.89 million (market value) from December 31, 2003 to December 31, 2004.  During 2004, the majority of the increase was purchases of adjustable rate mortgage backed securities, many of which had an initial reset date of 3 or 5 years.













40





---

Investment Portfolio



The following table presents the maturity distribution, market value, amortized cost and approximate tax equivalent yield (assuming a 34% federal income tax rate) of the investment portfolio at December 31, 2005.





| |                                   |                             |                              |                 |           |              |                |          |  |  |  |  |  |  |  |  |  |  | 
| | --------------------------------- | --------------------------- | ---------------------------- | --------------- | --------- | ------------ | -------------- | -------- |  |  |  |  |  |  |  |  |  |  | 
| |                                   |                             | (Dollars in Thousands)      
| | Within One
Year                   | One Year
Through
Five Years | Five Years
Through
Ten Years | After Ten
Years | Yield     | Market
Value | Amortized
Cost
| | Mortgage-backed Sec  fixed rate  | $          -                | $   1,913                    | $      4,671    | $   3,523 | 4.18%        | $ 10,107       | $ 10,351
| | Mtg.-backed Sec  variable rate   | -                           | -                            | 51              | 51,969    | 3.81         | 52,020         | 52,583  
| | State & Municipals   tax exempt | -                           | 461                          | 251             | 56,003    | 5.89         | 56,715         | 56,880  
| | State & Municipals   taxable    | -                           | 487                          | 553             | -         | 4.21         | 1,040          | 1,062   
| | U.S. Agencies  fixed rate        | -                           | 738                          | -               | -         | 4.10         | 738            | 750     
| | Agency Preferred  variable rate  | -                           | -                            | -               | 4,677     | 4.00         | 4,677          | 6,250   
| | Corporate bonds  fixed rate      | -                           | -                            | -               | 1,422     | 6.12         | 1,422          | 1,424   
| | Corporate bonds  variable rate   | -                           | -                            | 456             | 8,390     | 5.73         | 8,846          | 8,881   
| | SBA bonds  variable rate         | -                           | -                            | -               | 140       | 4.14         | 140            | 140     
| | CMOs  variable rate             | -                           | -                            | -               | 21        | 4.30         | 21             | 21      
| | TOTAL                             | $         -                 | $   3,599                    | $    5,982      | $126,145  |              | $135,726       | $138,342
| | Total fixed rate securities       | $         -                 | $  3,599                     | $   5,475       | $ 60,948  |              | $ 70,022       | $ 70,467
| | Total variable rate securities    | $         -                 | $        -                   | $    507        | $ 65,197  |              | $ 65,704       | $ 67,875





Deposits

(dollar amounts in thousands)



2005 vs. 2004



Total deposits grew by $18,251 or 3.89% in 2005. Non-interest bearing demand deposits increased by $7,141. Total time deposits increased by $20,238. Savings accounts declined during the year as customers began placing more funds back into the equity markets or moving their funds to time deposits. The increase in time deposits is primarily a result of rising interest rates and the growth in the North Carolina and Tennessee markets. The majority of the increase in time deposits was related to the growth in the Banks HUB Choice 25- month CD which gives the customer a one time option to increase the rate during the term of the certificate. This product has been widely accepted due to the expectation of rising interest rates.



2004 vs. 2003



Total deposits grew by $18,648 or 4.14% in 2004. Non-interest bearing demand deposits increased by $13,849. Interest bearing demand and savings accounts declined during the year as customers began placing more funds back into the equity markets. The small increase in time deposits during 2004 was a continuation of the trend of customers being unwilling to choose longer term deposit instruments. This trend is expected to reverse when longer term interest rates move to higher levels, which will provide an incentive for customers to invest for longer periods.











41





---

The following table provides a breakdown of deposits at December 31 for the years indicated:



|                                     |                        |             |            
|------------------------------------ | ---------------------- | ----------- | -----------
|                                     | December 31,          
|                                     | (Amounts in Thousands)
|                                     | 2005                   | 2004        | 2003       
|                                     |                        |             |            
|Non-interest bearing demand deposits | $    80,047            | $    72,906 | $    59,057
|Interest bearing demand deposits     | 59,144                 | 58,526      | 64,048     
|Savings deposits                     | 67,440                 | 77,186      | 80,764     
|Time deposits                        | 280,277                | 260,039     | 246,140    
|Total Deposits                       | $  486,908             | $  468,657  | $  450,009 



The average daily amount of deposits and rates paid on such deposits is summarized for the periods indicated in the following table:



|                                     |                                                |      |       |           |  |       |           |  |      
|------------------------------------ | ---------------------------------------------- | ---- | ----- | --------- |  | ----- | --------- |  | -----
|                                     | Year Ended December 31,
(Dollars in Thousands)
|                                     | 2005                                           | 2004 | 2003 
|                                     | Amount                                         |      | Rate  | Amount    |  | Rate  | Amount    |  | Rate 
|Non-interest bearing
demand deposits | $  74,444                                      |      | 0.00% | $  67,274 |  | 0.00% | $  59,094 |  | 0.00%
|Interest-bearing demand
deposits     | 59,078                                         |      | 1.49  | 63,095    |  | 1.19  | 58,771    |  | 1.40 
|Savings deposits                     | 71,623                                         |      | 1.08  | 82,241    |  | 1.07  | 77,470    |  | 1.55 
|Time deposits                        | 274,663                                        |      | 3.50  | 247,139   |  | 3.11  | 243,995   |  | 3.41 
|Total                                | $479,808                                       |      |       | $459,749  |  |       | $439,330  |  |      



The remaining maturities of time deposits greater than or equal to $100,000 at December 31, 2005 are as follows (Amount in thousands):



|                                |             
|------------------------------- | ------------
|Maturity                        | Amount      
|3 months or less                | $     10,343
|Over 3 months through 6 months  | 17,618      
|Over 6 months through 12 months | 15,033      
|Over 12 months                  | 45,487      
|Total                           | $    88,481 





Effects of Inflation



The Company's consolidated statements of income generally reflect the effects of inflation. Since interest rates, loan demand, and deposit levels are related to inflation, the resulting changes are included in net income. The most significant item which does not reflect the effects of inflation is depreciation expense. Historical dollar values used to determine depreciation expense do not reflect the effects of inflation on the market value of depreciable assets after their acquisition.

















42





---

Liquidity and Capital Resources

(dollar amounts in thousands)



Liquidity is the measure of the Banks ability to generate sufficient funds in order to meet customers demands for withdrawal of deposit balances and for the funding of loan requests. The Bank maintains cash reserves, in accordance with Federal Reserve Bank guidelines, and has sufficient flow of funds from investment security payments as well as loan payments to meet current liquidity needs.



Management of the Bank continuously monitors and plans the Banks liquidity position for the future. Liquidity is provided from cash and due from banks, federal funds sold, loan and investment security payments, core deposits, the national certificate of deposit market, lines of credit with correspondent banks and lines of credit with the Federal Home Loan Bank, Management believes that these sources of funds provide sufficient and timely liquidity for the foreseeable future.



Recent Accounting Pronouncements



See Note 1 of Notes to Consolidated Financial Statements for information relating to recent accounting pronouncements.



Off-Balance Sheet Arrangements



See Note 16 of Notes to Consolidated Financial Statements for information relating to Off-Balance Sheet Arrangements.



Contractual Obligations



Listed below are the contractual obligations of the Company and its subsidiaries at December 31, 2005 aggregated by type and due date. Optional call date provisions are reflected in the table below.



|                                                                      |          |                    |                    |                     |                     
|--------------------------------------------------------------------- | -------- | ------------------ | ------------------ | ------------------- | --------------------
|                                                                      | Total    | Less than one year | One to Three Years | Three to Five Years | More Than Five Years
|                                                                      |          |                    |                    |                     |                     
|Long-term debt obligations                                            | $ 38,475 | $           0      | $   23,707         | $  14,200           | $        568        
|Capital lease obligations                                             | -        | -                  | -                  | -                   | -                   
|Operating lease obligations                                           | 101      | 51                 | 50                 | -                   | -                   
|Purchase obligations (1)                                              | 90       | 90                 | -                  | -                   | -                   
|Other long-term liabilities reflected on the Companys  balance sheet | 6,300    | -                  | 6,300              | -                   | -                   
|                                                                      |          |                    |                    |                     |                     

(1)

The above purchase obligations represent approximate amounts to be disbursed for the Companys expansion of its Abingdon, Virginia property located at 250 W. Valley St. (see Properties section for further explanation).























43





---

Item 7A. Quantitative and Qualitative Disclosures About Market Risk



Interest Rate Sensitivity Analysis



Interest rate risk refers to the exposure of the Companys earnings and market value of equity (MVE) to changes in interest rates. The amount of change in net interest income and MVE resulting from shifts in interest rates is determined by contractual maturity of fixed rate instruments, the repricing date for variable rate instruments, competition and customer reactions.



The Company runs simulation models through a range of positive and negative interest rate movements to determine the effect these shifts in interest rates would have on the market value of the Companys equity. The market value is determined by applying a discount rate to the Companys interest-earning assets and interest-bearing liabilities that are not carried at market value, based on current rate levels at the time the model is run and calculating the present value of future cash flows.



There are several common components of interest rate risk that must be effectively managed to maintain minimal impact on the Companys earnings and capital. Repricing risk comes largely from timing differences in the pricing of interest-earning assets and interest-bearing liabilities. Reinvestment risk refers to the reinvestment of cash flows from interest and principal payments and maturing assets at lower or higher rates. Basis risk arises when different yield curves or pricing indices do not change at precisely the same moment in time or magnitude so that earning assets and interest-bearing liabilities with the same maturity are not affected equally. Yield curve risk refers to unequal movements in short-term and long-term interest rates.



The Company is not a party to derivative financial instruments with off-balance sheet risks such as futures, forwards, swaps, and options. The Company, however, is a party to financial instruments with off-balance sheet risks such as commitments to extend credit and standby letters of credit and recourse obligations in the normal course of business to meet the financing needs of its customers. See Note 16 of Notes to Consolidated Financial Statements for additional information relating to financial instruments with off-balance sheet risk. Management does not plan any future involvement in high risk derivative products.









































44





---

The following table provides the maturities of investment securities, loans, and deposits as of December 31, 2005, and measures the interest rate sensitivity gap for each range of maturity indicated.  The amounts below also reflect various prepayment assumptions.



|                                                                                                                            |                                                   |                                 |                  |                
|--------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------- | ------------------------------- | ---------------- | ---------------
|                                                                                                                            | December 31, 2005
(Dollars in Thousands)
Maturing
|                                                                                                                            | Within One
Year                                   | After One But
Within Five Years | After Five
Years | Total          
|ASSETS                                                                                                                      |                                                   |                                 |                  |                
|Interest-bearing
Investment Securities                                                                                      | $    13,207                                       | $   26,071                      | $     101,006    | $  140,284     
|Fed Funds Sold                                                                                                              | 110                                               | -                               | -                | 110            
|Loans                                                                                                                       | 171,783                                           | 188,868                         | 50,982           | 411,633        
|Other interest bearing assets                                                                                               | -                                                 | -                               | -                | -              
|Non-interest bearing
Other Assets                                                                                           | -                                                 | -                               | 47,314           | 47,314         
|                                                                                                                            |                                                   |                                 |                  |                
|Total Assets                                                                                                                | $  185,100                                        | $  214,939                      | $  199,302       | $  599,341     
|                                                                                                                            |                                                   |                                 |                  |                
|LIABILITIES AND SHARE-
HOLDERS EQUITY                                                                                      |                                                   |                                 |                  |                
|Interest-bearing                                                                                                            |                                                   |                                 |                  |                
|(1) All Interest bearing Deposits                                                                                           | $  262,744                                        | $   140,170                     | $      3,947     | $  406,861     
|Other Interest bearing Liab.                                                                                                | 9,708                                             | 57,207                          | 568              | 67,483         
|Non-interest-bearing                                                                                                        |                                                   |                                 |                  |                
|Demand Deposit Non-Interest                                                                                                 | -                                                 | -                               | 80,047           | 80,047         
|Other Liabilities                                                                                                           | -                                                 | -                               | 2,818            | 2,818          
|Shareholders Equity                                                                                                        | -                                                 | -                               | 42,132           | 42,132         
|Total Liabilities and Shareholders
Equity                                                                                  | $  272,452                                        | $  197,377                      | $   129,512      | $  599,341     
|                                                                                                                            |                                                   |                                 |                  |                
|Interest Rate Sensitivity GAP                                                                                               | $(87,352)                                         | $    17,562                     | $     69,790     | $             -
|                                                                                                                            |                                                   |                                 |                  |                
|(1)
For purposes of this schedule, the Company includes 100% of its statement savings, NOW and MMDA in the one year column.





Asset Liability Management



The Companys primary objectives for asset and liability management are to establish internal controls and procedures that will result in managing interest rate risk, liquidity management, capital planning, asset mix and volume control, and loan and deposit pricing. The Asset and Liability Committee (ALCO) is headed by the CEO and includes management personnel from the different areas of the Bank. The ALCO meets on a monthly basis.



In determining the appropriate level of interest rate risk, the ALCO reviews the changes in projected net interest income subject to various changes in interest rates. To help effectively measure interest rate risk, the ALCO utilizes rate sensitivity and simulation analysis to determine the impact on net interest income as well as the changes in the Economic Value of Equity. Simulation analysis is used to subject or shock the current re-pricing and maturing amounts to rising and falling interest rates. Rate change increments of 1% and 2% up and down are used in the monthly simulation analysis. Loan and investment security prepayments are estimated using current market information.



While this planning process is designed to protect the Company over the long-term, it does not provide near-term protection from interest rate shocks, as interest rate sensitive assets and liabilities



45





---

do not, by their nature, move up or down in tandem in response to changes in the overall rate environment.
The Company's profitability in the near term may be temporarily affected either positively by a falling interest rate scenario or negatively by a period of rising rates.



The following table shows the estimated cumulative impact on net interest income (NII) for the next 12 months as of December 31, 2005, subject to the specified interest rate changes. For purposes of this schedule the Company used a parallel rate shock on its interest earning assets and interest bearing liabilities. A parallel rate shock means that a 100 basis point increase in the rate index (prime rate) would result in an immediate 100 basis point increase on interest earning assets and interest bearing liabilities subject to the interest rate reset date. The Company uses a 50 basis point slope for its computation. The slope is the number of basis points per month that an index can increase or decrease until it reaches the target rate.



|                       |                 |                
|---------------------- | --------------- | ---------------
|Rate change increment  | % change in NII | $ change in NII
|                       |                 |                
|Up 100  basis points   | -1.55%          | -310,000       
|Up 200 basis points    | -3.53%          | -705,000       
|Down 100 basis points  | 1.18%           | 236,000        
|Down 200  basis points | -.28%           | -55,000        





The above schedule assumes that 100% of the Companys interest bearing checking accounts and 100% of its statement savings accounts would reprice according to the above increments. The above schedule also assumes an approximate growth of 8% over the next 12 months for all of the Companys rate sensitive categories.























































46





---

Item 8. Financial Statements and Supplementary Data



The following financial statements are incorporated by reference from the Annual Report to Shareholders for the fiscal year ended December 31, 2005:



Independent Registered Auditors Report;

Consolidated Statements of Financial Condition as of December 31, 2005, 2004 and 2003;

Consolidated Statements of Operations for each of the years in the three year period ended December 31, 2005;

Consolidated Statements of Stockholders Equity for each of the years in the three year period ended December 31, 2005;

Consolidated Statements of Cash Flows for each of the years in the three year period ended December 31, 2005; and

Notes to Consolidated Financial Statements for December 31, 2005, 2004 and 2003.



Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure



None.



Item 9A. Controls and Procedures



Senior management regularly monitors and reviews the internal controls established for the various operating activities of the Bank. Additionally, the Company has created a Disclosure Review Committee to review not only internal controls but the information used by Companys financial officers to prepare the Companys periodic SEC filings and corresponding financial statements. The Committee is comprised of the Senior Management Team of the Bank and meets at least quarterly.  Internal audits conducted by the Companys internal audit department are also reviewed by senior officers to assist them in assessing the adequacy of the Companys internal control structure. These audits are also discussed in detail with the Companys Audit Committee.



We have carried out an evaluation, under the supervision and the participation of our management, including our Executive Vice President and Chief Executive Officer, our Executive Vice President and Chief Operations Officer, our Chief Financial Officer and our Vice President of Accounting, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Act), as of the end of the fiscal year covered by this report. Based upon that evaluation, our CEO, COO, CFO and VP Accounting concluded that our disclosure controls and procedures are effective in providing reasonable assurance that (a) the information required to be disclosed by us in the reports that we file or submit under the Act is recorded, processed, summarized and
reported within the time periods specified in the Securities and Exchange Commissions rules and forms, and (b) such information is accumulated
 and communicated to our management, including our CEO, COO, CFO and VP Accounting, as
appropriate to allow timely decisions regarding required disclosure.



There were not any changes in the Corporations internal controls over financial reporting during the fourth fiscal quarter of the fiscal year covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



Item 9B. Other Information



None



47





---

Part III.



Item 10.  Directors and Executive Officers of the Registrant



Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings The Nominees, Executive Officers Who Are Not Directors, Section 16(a) Beneficial Ownership Reporting Compliance, The Board of Directors and its Committees  Audit Committee and Code of Ethics in the Companys Proxy Statement for the 2006 Annual Meeting of Shareholders is incorporated herein by reference.



Item 11. Executive Compensation



Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings Director Compensation, Executive Officer Compensation, Stock Options, Option Exercises and Holdings and Compensation Committee Interlocks and Insider Participation in the Companys Proxy Statement for the 2006 Annual Meeting of Shareholders is incorporated herein by reference.



Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters



Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings Security Ownership of Management and Certain Beneficial Owners and Equity Compensation Plans in the Companys Proxy Statement for the 2006 Annual Meeting of Shareholders is incorporated herein by reference.



Item 13. Certain Relationships and Related Transactions



Pursuant to General Instruction G(3) of Form 10-K, the information contained under the heading Certain Transactions in the Companys Proxy Statement for the 2006 Annual Meeting of Shareholders is incorporated herein by reference.



Item 14. Principal Accounting Fees and Services



Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings Services and Fees and Pre-Approved Policies and Procedures in the Companys Proxy Statement for the 2006 Annual Meeting of Shareholders is incorporated herein by reference.

































48





---

Part IV.



Item 15. Exhibits, Financial Statement Schedules



(a)  (1)

The response to this portion of Item 15 is submitted as a separate section of this report.



(2)

All applicable financial statement schedules required by Regulation S-X are included in the Notes to the 2005 Consolidated Financial Statements.



(3)

Exhibits:



3.1

Articles of Incorporation of Highlands Bankshares, Inc. (as restated in electronic format only as of July 27, 2005), filed as Exhibit 3.1 to the Current Report on Form 8-K, File No. 000-27622, filed with the Commission on August 2, 2005, incorporated herein by reference.



3.2

Bylaws of Highlands Bankshares, Inc. attached as Exhibit 3.2 to the Registration Statement on Form 8-A, File No. 000-27622, filed with the Commission on January 24, 1996, incorporated herein by reference.



10.1

Highlands Union Bank 1995 Stock Option Plan, attached as Exhibit 10.1 to the Annual Report on Form 10-K for the fiscal year ended December 31, 2002, File No. 000-27622, incorporated herein by reference.



11

Statement regarding computation of per share earnings (included as Note 1 of the Notes to Consolidated Financial Statements in the 2005 Annual Report to Shareholders and incorporated herein by reference).



13.1

Annual Report to Shareholders.



21

Subsidiaries of the Corporation.



23.1

Consent of Brown, Edwards & Company, L.L.P.



31.1

Section 302 Certification of Chief Executive Officer.



31.2

Section 302 Certification of Chief Operations Officer.



31.3

Section 302 Certification of Chief Financial Officer of the Corporation.



31.4

Section 302 Certification of Chief Financial Officer of the Bank.



32.1

Statement of Chief Executive Officer Pursuant to 18 U.S.C. § 1350.



32.2

Statement of Chief Operations Officer Pursuant to 18 U.S.C. § 1350.



32.3

Statement of Chief Financial Officer of the Corporation Pursuant to 18 U.S.C. § 1350.



32.4

Statement of Chief Financial Officer of the Bank Pursuant to 18 U.S.C. § 1350.





49





---

(b)

Exhibits.



The response to this portion of Item 15 as listed in Item 15(a)(3) above is submitted  as a separate section of this report.



(c)

Financial Statement Schedules.



The response to this portion of Item 15 is submitted as a separate section of this   report.







50





---

SIGNATURES



Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



HIGHLANDS BANKSHARES, INC.



Date:  March 26, 2006

BY:/s/ Samuel L. Neese

Samuel L. Neese

Executive Vice President and

Chief Executive Officer



Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated on March 26, 2006.





|                                                    |                                                       |               
|--------------------------------------------------- | ----------------------------------------------------- | --------------
|Signature                                           | Title                                                 | Date          
|/s/ James D. Morefield
James D. Morefield           | Chairman of the Board, and Director                   | March 26, 2006
|/s/ Dr. James D. Moore, Jr.
Dr. James D. Moore, Jr. | President                                             | March 26, 2006
|/s/ J. Carter Lambert
J. Carter Lambert             | Vice Chairman                                         | March 26, 2006
|/s/ Samuel L. Neese
Samuel L. Neese                 | Executive Vice President, and Chief Executive Officer | March 26, 2006
|/s/ James T. Riffe
James T. Riffe                   | Executive Vice President and Cashier                  | March 26, 2006
|/s/ William E. Chaffin
William E. Chaffin           | Director                                              | March 26, 2006
|/s/ E. Craig Kendrick
E. Craig Kendrick             | Director                                              | March 26, 2006



51





---



|                                                      |          |               
|----------------------------------------------------- | -------- | --------------
|/s/ Clydes B. Kiser
Clydes B. Kiser                   | Director | March 26, 2006
|/s/ Charles P. Olinger
Charles P. Olinger             | Director | March 26, 2006
|/s/ William J. Singleton
William J. Singleton         | Director | March 26, 2006
|/s/ Dr. H. Ramsey White, Jr.
Dr. H. Ramsey White, Jr. | Director | March 26, 2006







52





---

EXHIBIT INDEX



Exhibit No.

Description



3.1

Articles of Incorporation of Highlands Bankshares, Inc. (as restated in electronic format only as of July 27, 2005), filed as Exhibit 3.1 to the Current Report on Form 8-K, File No. 000-27622, filed with the Commission on August 2, 2005, incorporated herein by reference.



3.2

Bylaws of Highlands Bankshares, Inc. attached as Exhibit 3.2 to the Registration Statement on Form 8-A, File No. 000-27622, filed with the Commission on January 24, 1996, incorporated herein by reference.



10.1

Highlands Union Bank 1995 Stock Option Plan, attached as Exhibit 10.1 to the Annual Report on Form 10-K for the fiscal year ended December 31, 2002, File No. 000-27622, incorporated herein by reference.



11

Statement regarding computation of per share earnings (included as Note 1 of the Notes to Consolidated Financial Statements in the 2003 Annual Report to Shareholders and incorporated herein by reference).



13.1

Annual Report to Shareholders.



21

Subsidiaries of the Corporation.



23.1

Consent of Brown, Edwards & Company, L.L.P.



31.1

Section 302 Certification of Chief Executive Officer.



31.2

Section 302 Certification of Chief Operations Officer.



31.3

Section 302 Certification of Chief Financial Officer of the Corporation.



31.4

Section 302 Certification of Chief Financial Officer of the Bank.



32.1

Statement of Chief Executive Officer Pursuant to 18 U.S.C. § 1350.



32.2

Statement of Chief Operations Officer Pursuant to 18 U.S.C. § 1350.



32.3

Statement of Chief Financial Officer of the Corporation Pursuant to 18 U.S.C. § 1350.



32.4

Statement of Chief Financial Officer of the Bank Pursuant to 18 U.S.C. § 1350.

















53