**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      DC 20549**





**FORM
      10-K**


(Mark
      One)


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


For
      the
      fiscal year ended December 31, 2006





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





Commission
      File Number 0-16761


**HIGHLANDS
      BANKSHARES, INC.**


(Exact
      name of registrant as specified in its charter)


West
                Virginia
            55-0650743(State
                or other jurisdiction of incorporation or organization)
            (I.R.S.
                Employer Identification No.)





P.O.
                Box 929 Petersburg, WV
            26847(Address
                of principal executive offices)
            (Zip
                Code)





Registrant’s
      telephone number, including area code: 304-257-4111





Securities
      registered pursuant to Section 12(b) of the Act: None





Securities
      registered pursuant to Section 12(g) of the Act: Common Stock, $5
      par





Indicate
      by check mark if the registrant is a well-know seasoned issuer, as defined
      in
      Rule 405 or the Securities Act o Yes ý No





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Act o Yes ý No





Indicate
      by check mark whether the registrant has (1) filed all reports required to
      be
      filed by Section 13 or 15(d) of the Exchange Act 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 ý No o





Indicate
      by check mark if disclosure of delinquent filers in response to Item 405 of
      Regulation S-K is not contained in this form, 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. ý





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer.  o Large
      Accelerated Filer o Accelerated Filer ý  Non-accelerated
      filer





Indicate
      by check mark whether the registrant is a shell company (as defined in rule
      126-2 of the Act) Yes o No ý





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:





The
      aggregate market value of the 1,319,381 shares of common stock of the registrant
      issued and outstanding held by nonaffiliates on June 30, 2006 was approximately
      $42,880,000 based on the closing sales price of $32.50 on June 30, 2006. For
      the
      purposes of this calculation, the term “affiliate” refers to all directors and
      executive officers of the registrant.





Indicate
      the number of shares outstanding of each of the registrant’s classes of common
      stock as of the last practicable date: As of March 15, 2007: 1,436,874 shares
      of
      common stock.





DOCUMENTS
      INCORPORATED BY REFERENCE





Portions
      of the Proxy Statement for the 2007 Annual Shareholders’ Meeting are
      incorporated by reference into Part III, Items 10,11,12,13 and 14.













FORM10-K
                INDEX**Part
                I**
            
            PageItem
                1.
            Business
            1Item
                1A.
            Risk
                Factors
            5Item
                1B.
            Unresolved
                Staff Comments
            8Item
                2.
            Properties
            8Item
                3.
            Legal
                Proceedings
            8Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            8**Part
                II**Item
                5.
            Market
                for Registrant’s Common Equity, Related Stockholder Matters and Issuer
                Purchases of Equity Securities
            8Item
                6.
            Selected
                Financial Data
            10Item
                7.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            11Item
                7A.
            Quantitative
                and Qualitative Disclosures About Market Risk
            31Item
                8.
            Financial
                Statements and Supplementary Data
            33Item
                9.
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosure
            62Item
                9A.
            Controls
                and Procedures
            62Item
                9B.
            Other
                Information
            62**Part
                III**Item
                10.
            Directors
                and Officers of Registrant
            62Item
                11.
            Executive
                Compensation
            62Item
                12.
            Security
                Ownership of Certain Beneficial Owners and Management and Related
                Stockholder Matters
            63Item
                13.
            Certain
                Relationships and Related Transactions
            63Item
                14.
            Principal
                Accounting Fees and Services
            63**Part
                IV**Item
                15.
            Exhibits
                and Financial Statement Schedules
            64Signatures
            65





*Index*





Page
                One





**PART
      I**





**Item
                1.**
            **Business**





General





Highlands
      Bankshares, Inc. (hereinafter referred to as “Highlands,” or the “Company”),
      incorporated under the laws of West Virginia in 1985, is a multi bank holding
      company subject to the provisions of the Bank Holding Company Act of 1956,
      as
      amended, and owns 100% of the outstanding stock of its subsidiary Banks, The
      Grant County Bank and Capon Valley Bank (hereinafter referred to as the “Banks”
or “Capon” and/or “Grant”), and its life insurance subsidiary, HBI Life
      Insurance Company (hereinafter referred to as “HBI Life”).





The
      Grant
      County Bank was chartered on August 6, 1902, and Capon Valley Bank was chartered
      on July 1, 1918. Both are state banks chartered under the laws of the State
      of
      West Virginia. HBI Life was chartered in April 1988 under the laws of the State
      of Arizona.





Services
      Offered by the Banks





The
      Banks
      offer all services normally offered by a full service commercial bank, including
      commercial and individual demand and time deposit accounts, commercial and
      individual loans, drive in banking services and automated teller machines.
      No
      material portion of the Banks' deposits have been obtained from a single or
      small group of customers and the loss of the deposits of any one customer or
      of
      a small group of customers would not have a material adverse effect on the
      business of the Banks. Credit life and accident and health insurance are sold
      to
      customers of the subsidiary Banks through HBI Life.





Employees





As
      of
      December 31, 2006, The Grant County Bank had 72 full time equivalent employees,
      Capon Valley Bank had 49 full time equivalent employees and Highlands had 3
      full
      time equivalent employees. No person is employed by HBI Life on a full time
      basis.





Competition





The
      Banks' primary trade area is generally defined as Grant, Hardy, Mineral,
      Randolph, Pendleton and Tucker Counties in West Virginia, the western portion
      of
      Frederick County in Virginia and portions of Western Maryland. This area
      includes the towns of Petersburg, Wardensville, Moorefield and Keyser and
      several rural towns. The Banks' secondary trade area includes portions of
      Hampshire County in West Virginia. The Banks primarily compete with four state
      chartered banks, three national banks and three credit unions. In addition,
      the
      Banks compete with money market mutual funds and investment brokerage firms
      for
      deposits in their service area. No financial institution has been chartered
      in
      the area within the last five years although branches of state and nationally
      chartered banks have located in this area within this time period. Competition
      for new loans and deposits in the Banks' service area is quite
      intense.





Regulation
      and Supervision





The
      Company, as a registered bank holding company, and its subsidiary Banks, as
      insured depository institutions, operate in a highly regulated environment
      and
      are regularly examined by federal and state regulators. The following
      description briefly discusses certain provisions of federal and state laws
      and
      regulations and the potential impact of such provisions to which the Company
      and
      subsidiary are subject. These federal and state laws and regulations are
      designed to reduce potential loss exposure to the depositors of such depository
      institutions and to the Federal Deposit Insurance Corporation’s insurance fund
      and are not intended to protect the Company’s security holders. Proposals to
      change the laws and regulations governing the banking industry are frequently
      raised in Congress, in state legislatures, and before the various bank
      regulatory agencies. The likelihood and timing of any changes and the impact
      such changes might have on the Company are impossible to determine with any
      certainty. A change in applicable laws or regulations, or a change in the way
      such laws or regulations are interpreted by regulatory agencies or courts,
      may
      have a material impact on the business, operations and earnings of the Company.
      To the extent that the following information describes statutory or regulatory
      provisions, it is qualified entirely by reference to the particular statutory
      or
      regulatory provision.


*Index*





Page
                Two





As
      a bank
      holding company registered under the Bank Holding Company Act of 1956, as
      amended (the “BHCA”), the Company is subject to regulation by the Federal
      Reserve Board. Federal banking laws require a bank holding company to serve
      as a
      source of financial strength to its subsidiary depository institutions and
      to
      commit resources to support such institutions in circumstances where it might
      not do so otherwise. Additionally, the Federal Reserve Board has jurisdiction
      under the BHCA to approve any bank or non-bank acquisition, merger or
      consolidation proposed by a bank holding company. The BHCA generally limits
      the
      activities of a bank holding company and its subsidiaries to that of banking,
      managing or controlling banks as to be a proper incident thereto. The BHCA
      also
      prohibits a bank holding company, with certain exceptions, from acquiring more
      than 5% of the voting shares of any company and from engaging in any business
      other than banking or managing or controlling banks. The Federal Reserve Board
      has by regulation determined that certain activities are closely related to
      banking within the meaning of the BHCA. These activities include: operating
      a
      mortgage company, finance company, credit card company or factoring company;
      performing certain data processing operations; providing investment and
      financial advice; and acting as an insurance agent for certain types of
      credit-related insurance.





The
      Gramm-Leach-Bliley Act (“Gramm-Leach”) became law in November 1999. Gramm-Leach
      established a comprehensive framework to permit affiliations among commercial
      banks, investment banks, insurance companies, securities firms, and other
      financial service providers. Gramm-Leach permits qualifying bank holding
      companies to register with the Federal Reserve Board as “financial holding
      companies” and allows such companies to engage in a significantly broader range
      of financial activities than were historically permissible for bank holding
      companies. Although the Federal Reserve Board provides the principal regulatory
      supervision of financial services permitted under Gramm-Leach, the Securities
      and Exchange Commission and state regulators also provide substantial
      supervisory oversight. In addition to broadening the range of financial services
      a bank holding company may provide, Gramm-Leach also addressed customer privacy
      and information sharing issues and set forth certain customer disclosure
      requirements. The Company has no current plans to petition the Federal Reserve
      Board for consideration as a financial holding company.





The
      Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
      (“Riegle-Neal”) permits bank holding companies to acquire banks located in any
      state. Riegle-Neal also allows national banks and state banks with different
      home states to merge across state lines and allows branch banking across state
      lines, unless specifically prohibited by state laws.





The
      International Money Laundering Abatement and Anti-Terrorist Financing Act of
      2001 (USA “Patriot Act”) was adopted in response to the September 11, 2001
      terrorist attacks. The Patriot Act provides law enforcement with greater powers
      to investigate terrorism and prevent future terrorist acts. Among the
      broad-reaching provisions contained in the Patriot Act are several designed
      to
      deter terrorists’ ability to launder money in the United States and provide law
      enforcement with additional powers to investigate how terrorists and terrorist
      organizations are financed. The Patriot Act creates additional requirements
      for
      banks, which were already subject to similar regulations. The Patriot Act
      authorizes the Secretary of Treasury to require financial institutions to take
      certain “special measures” when the Secretary suspects that certain transactions
      or accounts are related to money laundering. These special measures may be
      ordered when the Secretary suspects that a jurisdiction outside of the United
      States, a financial institution operating outside of the United States, a class
      of transactions involving a jurisdiction outside of the United States or certain
      types of accounts are of “primary money laundering concern.” The special
      measures include the following: (a) require financial institutions to keep
      records and report on transactions or accounts at issue; (b) require financial
      institutions to obtain and retain information related to the beneficial
      ownership of any account opened or maintained by foreign persons; (c) require
      financial institutions to identify each customer who is permitted to use the
      account; and (d) prohibit or impose conditions on the opening or maintaining
      of
      correspondence or payable-through accounts. Failure of a financial institution
      to maintain and implement adequate programs to combat money laundering and
      terrorist financing, or to comply with all of the relevant laws or regulations,
      could have serious legal and reputational consequences for the
      institution.





The
      operations of the insurance subsidiary are subject to the oversight and review
      of State of Arizona Department of Insurance.


*Index*





Page
                Three





On
      July
      30, 2002, the United States Congress enacted the Sarbanes-Oxley Act of 2002,
      a
      law that addresses corporate governance, auditing and accounting, executive
      compensation and enhanced timely disclosure of corporate information. As
      Sarbanes-Oxley directs, 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.
      Additionally, these individuals must 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 subsequent to the evaluations.
      Effective in 2007, Section 404 of Sarbanes-Oxley will become applicable to
      the
      Company.





Capital
      Adequacy





Federal
      banking regulations set forth capital adequacy guidelines, which are used by
      regulatory authorities to assess the adequacy of capital in examining and
      supervising a bank holding company and its insured depository institutions.
      The
      capital adequacy guidelines generally require bank holding companies to maintain
      total capital equal to at least 8% of total risk-adjusted assets, with at least
      one-half of total capital consisting of core capital (i.e., Tier I capital)
      and
      the remaining amount consisting of “other” capital-eligible items (i.e., Tier II
      capital), such as perpetual preferred stock, certain subordinated debt, and,
      subject to limitations, the allowance for loan losses. Tier I capital generally
      includes common stockholders’ equity plus, within certain limitations, perpetual
      preferred stock and trust preferred securities. For purposes of computing
      risk-based capital ratios, bank holding companies must meet specific capital
      guidelines that involve quantitative measures of assets, liabilities and certain
      off-balance sheet items, calculated under regulatory accounting practices.
      The
      Company’s and its subsidiaries’ capital accounts and classifications are also
      subject to qualitative judgments by the regulators about components, risk
      weightings, and other factors.





In
      addition to total and Tier I capital requirements, regulatory authorities also
      require bank holding companies and insured depository institutions to maintain
      a
      minimum leverage capital ratio of 3%. The leverage ratio is determined as the
      ratio of Tier I capital to total average assets, where average assets exclude
      goodwill, other intangibles, and other specifically excluded assets. Regulatory
      authorities have stated that minimum capital ratios are adequate for those
      institutions that are operationally and financially sound, experiencing solid
      earnings, have high levels of asset quality and are not experiencing significant
      growth. The guidelines also provide that banking organizations experiencing
      internal growth or making acquisitions will be expected to maintain strong
      capital positions substantially above the minimum supervisory levels. In those
      instances where these criteria are not evident, regulatory authorities expect,
      and may require, bank holding companies and insured depository institutions
      to
      maintain higher than minimum capital levels.





Additionally,
      federal banking laws require regulatory authorities to take “prompt corrective
      action” with respect to depository institutions that do not satisfy minimum
      capital requirements. The extent of these powers depends upon whether the
      institutions in question are “well capitalized”, “adequately capitalized”,
“undercapitalized”, “significantly undercapitalized” or “critically
      undercapitalized”, as such terms are defined under uniform regulations defining
      such capital levels issued by each of the federal banking agencies. As an
      example, a depository institution that is not well capitalized is generally
      prohibited from accepting brokered deposits and offering interest rates on
      deposits higher than the prevailing rate in its market. Additionally, a
      depository institution is generally prohibited from making any capital
      distribution (including payment of a dividend) or paying any management fee
      to
      its holding company, may be subject to asset growth limitations and may be
      required to submit capital restoration plans if the depository institution
      is
      considered undercapitalized.


*Index*





Page
                Four








The
      Company’s and its subsidiaries’ regulatory capital ratios are presented in the
      following table:





Actual
                Ratio
            Actual
                Ratio
            RegulatoryDecember
                31, 2006
            December
                31, 2005
            MinimumTotal
                Risk Based CapitalHighlands
                Bankshares
            13.45%
            13.85%The
                Grant County Bank
            12.63%
            13.67%
            8.00%Capon
                Valley Bank
            14.56%
            13.45%
            8.00%Tier
                1 Leverage RatioHighlands
                Bankshares
            9.26%
            9.45%The
                Grant County Bank
            8.85%
            8.81%
            4.00%Capon
                Valley Bank
            9.53%
            8.87%
            4.00%Tier
                1 Risk Based Capital RatioHighlands
                Bankshares
            12.21%
            12.60%The
                Grant County Bank
            11.39%
            12.47%
            4.00%Capon
                Valley Bank
            13.30%
            12.20%
            4.00%




Dividends
      and other Payments





The
      Company is a legal entity separate and distinct from its subsidiaries. Dividends
      and management fees from Grant County Bank and Capon Valley Bank are essentially
      the sole source of cash for the Company, although HBI Life will periodically
      pay
      dividends to the Company. The right of the Company, and shareholders of the
      Company, to participate in any distribution of the assets or earnings of Grant
      County Bank and Capon Valley Bank through the payment of such dividends or
      otherwise is necessarily subject to the prior claims of creditors of Grant
      County Bank and Capon Valley Bank, except to the extent that claims of the
      Company in its capacity as a creditor may be recognized. Moreover, there are
      various legal limitations applicable to the payment of dividends to the Company
      as well as the payment of dividends by the Company to its shareholders. Under
      federal law, Grant County Bank and Capon Valley Bank may not, subject to certain
      limited expectations, make loans or extensions of credit to, or invest in the
      securities of, or take securities of the Company as collateral for loans to
      any
      borrower. Grant County Bank and Capon Valley Bank are also subject to collateral
      security requirements for any loans or extensions of credit permitted by such
      exceptions.





Grant
      County Bank and Capon Valley Bank are subject to various statutory restrictions
      on their ability to pay dividends to the Company. Specifically, the approval
      of
      the appropriate regulatory authorities is required prior to the payment of
      dividends by Grant County Bank and Capon Valley Bank in excess of earnings
      retained in the current year plus retained net profits for the preceding two
      years. The payment of dividends by the Company, Grant County Bank and Capon
      Valley Bank may also be limited by other factors, such as requirements to
      maintain adequate capital above regulatory guidelines. The Federal Reserve
      Board
      and the Federal Deposit Insurance Corporation have the authority to prohibit
      any
      bank under their jurisdiction from engaging in an unsafe and unsound practice
      in
      conducting its business. Depending upon the financial condition of Grant County
      Bank and Capon Valley Bank, the payment of dividends could be deemed to
      constitute such an unsafe or unsound practice. The Federal Reserve Board and
      the
      FDIC have indicated their view that it generally would be an unsafe and unsound
      practice to pay dividends except out of current operating earnings. The Federal
      Reserve Board has stated that, as a matter of prudent banking, a bank or bank
      holding company should not maintain its existing rate of cash dividends on
      common stock unless (1) the organization’s net income available to common
      shareholders over the past year has been sufficient to fund fully the dividends
      and (2) the prospective rate or earnings retention appears consistent with
      the
      organization’s capital needs, asset quality, and overall financial condition.
      Moreover, the Federal Reserve Board has indicated that bank holding companies
      should serve as a source of managerial and financial strength to their
      subsidiary banks. Accordingly, the Federal Reserve Board has stated that a
      bank
      holding company should not maintain a level of cash dividends to its
      shareholders that places undue pressure on the capital of bank subsidiaries,
      or
      that can be funded only through additional borrowings or other arrangements
      that
      may undermine the bank holding company’s ability to serve as a source of
      strength.


*Index*





Page
                Five





Governmental
      Policies





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 bank loans, investments and
      deposits and affect interest rates charged on loans or paid for time and savings
      deposits. Federal Reserve 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.





Various
      other legislation, including proposals to overhaul the banking regulatory system
      and to limit the investments that a depository institution may make with insured
      funds, are from time to time introduced in Congress. The Company cannot
      determine the ultimate effect that such potential legislation, if enacted,
      would
      have upon its financial condition or operations.





Available
      Information





The
      Company files annual, quarterly and current reports, proxy statements and other
      information with the SEC. The Company’s SEC filings are filed electronically and
      are available to the public via the internet at the SEC’s website, www.sec.gov.
      In addition, any document filed by the Company with the SEC can be read and
      copies obtained at the SEC’s public reference facilities at 100 F Street, NE,
      Washington, DC 20549. Copies of documents can be obtained at prescribed rates
      by
      writing to the Public Reference Section of the SEC at 100 F Street NE,
      Washington, DC 20549. The public may obtain information on the operation of
      the
      Public Reference Room by calling the SEC at 1-800-SEC-0330. Copies of documents
      can also be obtained free of charge by writing to Highlands Bankshares, Inc.,
      P.O. Box 929, Petersburg, WV 26847.





Executive
      Officers





Name
            Age
            Position
                with the Company
            Principal
                Occupation (Past Five Years)Clarence
                E.
              Porter
            58
            President
                & Chief Executive Officer; Treasurer
            CEO
                of Highlands since 2004; President of The Grant County Bank since
                1991R.
                Alan
              Miller
            37
            Finance
                Officer
            Finance
                Officer of Highlands since 2002; Senior Manager of Finance, Cable
&
                Wireless USA prior to 2002Alan
                L. Brill
            52
            Secretary;
                President of Capon Valley Bank
            President
                of Capon Valley Bank since 2001








**Item
                  1A.**
              **Risk
                  Factors**





Due
      to
      Increased Competition, the Company May Not Be Able to Attract and Retain Banking
      Customers At Current Levels.





If,
      due
      to competition from competitors in the Company’s market area, the Company is
      unable to attract new and retain current customers, loan and deposit growth
      could decrease causing the Company’s results of operations and financial
      condition to be negatively impacted. The Company faces competition from the
      following:





·
            Local,
                regional and national banks;


·
            Savings
                and loans;


·
            Internet
                banks;


·
            Credit
                unions;


·
            Insurance
                companies;


·
            Finance
                companies; and


·
            Brokerage
                firms serving the Company’s market areas.


*Index*





Page
                Six





The
      Company’s Lending Limit May Prevent It from Making Large Loans.





In
      the
      future, the Company may not be able to attract larger volume customers because
      the size of loans that the company can offer to potential customers is less
      than
      the size of the loans that many of the Company’s larger competitors can offer.
      We anticipate that our lending limit will continue to increase proportionately
      with the Company’s growth in earnings; however, the Company may not be able to
      successfully attract or maintain larger customers.





Certain
      Loans That the Banks Make Are Riskier than Loans for Real Estate Lending.





The
      Banks
      make loans that involve a greater degree of risk than loans involving
      residential real estate lending. Commercial business loans may involve greater
      risks than other types of lending because they are often made based on varying
      forms of collateral, and repayment of these loans often depends on the success
      of the commercial venture. Consumer loans may involve greater risk because
      adverse changes in borrowers’ incomes and employment after funding of the loans
      may impact their abilities to repay the loans.





The
      Company Is Subject to Interest Rate Risk.





Aside
      from credit risk, the most significant risk resulting from the Company’s normal
      course of business, extending loans and accepting deposits, is interest rate
      risk. If market interest rate fluctuations cause the Company’s cost of funds to
      increase faster than the yield of its interest-earning assets, then its net
      interest income will be reduced. The Company’s results of operations depend to a
      large extent on the level of net interest income, which is the difference
      between income from interest-earning assets, such as loans and investment
      securities, and interest expense on interest-bearing liabilities, such as
      deposits and borrowings. Interest rates are highly sensitive to many factors
      that are beyond the Company’s control, including general economic conditions and
      the policies of various governmental and regulatory authorities.





The
      Company May Not Be Able to Retain Key Members of Management.





The
      departure of one or more of the Company’s officers or other key personnel could
      adversely affect the Company’s operations and financial position. The Company’s
      management makes most decisions that involve the Company’s operations.





An
      Economic Slowdown in the Company’s Market Area Could Hurt Our Business.





An
      economic slowdown in our market area could hurt our business. An economic
      slowdown could have the following consequences:


·
              Loan
                  delinquencies may increase;
 ·
              Problem
                  assets and foreclosures may
                  increase;
 ·
              Demand
                  for the products and services of the Company may decline;
                  and
 ·
              Collateral
                  (including real estate) for loans made by the company may decline
                  in
                  value, in turn reducing customers’ borrowing power and making existing
                  loans less secure.


The
      Company and the Bank are Extensively Regulated.





The
      operations of the Company are subject to extensive regulation by federal, state
      and local governmental authorities and are subject to various laws and judicial
      and administrative decisions imposing requirements and restrictions on them.
      Policies adopted or required by these governmental authorities can affect the
      Company’s business operations and the availability, growth and distribution of
      the Company’s investments, borrowings and deposits. Proposals to change the laws
      governing financial institutions are frequently raised in Congress and before
      bank regulatory authorities. Changes in applicable laws or policies could
      materially affect the Company’s business, and the likelihood of any major
      changes in the future and their effects are impossible to determine.


*Index*





Page
                Seven





The
      Company’s Allowance for Loan Losses May Not Be Sufficient.





In
      the
      future, the Company could experience negative credit quality trends that could
      lead to a deterioration of asset quality. Such deterioration could require
      the
      company to incur loan charge-offs in the future and incur additional loan loss
      provision, both of which would have the effect of decreasing earnings. The
      Company maintains an allowance for possible loan losses which is a reserve
      established through a provision for possible loan losses charged to expense
      that
      represents management’s best estimate of probable losses that have been incurred
      within the existing portfolio of loans. Any increases in the allowance for
      possible loan losses will result in a decrease in net income and, possibly,
      capital, and may not have a material adverse effect on the Company’s financial
      condition and results of operation.





A
      Shareholder May Have Difficulty Selling Shares.





Because
      a
      very limited public market exists for the Company’s common stock, a shareholder
      may have difficulty selling his or her shares in the secondary market. We cannot
      predict when, if ever, we could meet the listing qualifications of the Nasdaq
      Stock Market’s National Market Tier or any exchange. We cannot assure investors
      that there will be a more active public market for the shares in the near
      future.





Shares
      of the Company’s Common Stock Are Not FDIC Insured .





Neither
      the Federal Deposit Insurance Corporation nor any other governmental agency
      insures the shares of the Company’s common stock. Therefore, the value of
      investors’ shares in the Company will be based on their market value and may
      decline.





Customers
      May Default on the Repayment of Loans.





The
      Bank’s customers may default on the repayment of loans, which may negatively
      impact the Company’s earnings due to loss of principal and interest income.
      Increased operating expenses may result from the allocation of management time
      and resources to the collection and workout of the loan. Collection efforts
      may
      or may not be successful causing the Company to write off the loan or repossess
      the collateral securing the loan, which may or may not exceed the balance of
      the
      loan.








The
      Company’s Controls and Procedures May Fail or Be Circumvented.





Management
      regularly reviews and updates the Company’s internal controls, disclosure
      controls and procedures, and corporate governance policies and procedures.
      Any
      system of controls, no matter how well designed and operated, is based in part
      on certain assumptions and can provide only reasonable, not absolute, assurances
      that the objectives of the system are met. Any failure or circumvention of
      the
      Company’s controls and procedures or failure to comply with regulations related
      to controls and procedures could have a material adverse effect on the Company’s
      business, results of operations and financial conditions.





**Item1B.**
            **Unresolved
                Staff Comments**





None


*Index*





Page
                Eight







**Item
                2.**
            **Properties**





**Location**
            
            **Description**3
                N. Main Street, Petersburg, WV 26847
            
            Primary
                Office, The Grant County BankRoute
                33, Riverton, WV 26814
            
            Branch
                Office, The Grant County Bank500
                S. Main Street, Moorefield, WV 26836
            
            Branch
                Office, The Grant County BankRoute
                220 & Josie Dr., Keyser, WV 26726
            
            Branch
                Office, The Grant County BankMain
                Street, Harman, WV 26270
            
            Branch
                Office, The Grant County BankWilliam
                Avenue, Davis, WV 26260
            
            Branch
                Office, The Grant County BankRoute
                32 & Cortland Rd., Davis, WV 26260
            
            Branch
                Office, The Grant County Bank2
                W. Main Street, Wardensville, WV 26851
            
            Primary
                Office, Capon Valley Bank717
                N. Main Street, Moorefield, WV 26836
            
            Branch
                Office, Capon Valley BankRoute
                55, Baker, WV 26801
            
            Branch
                Office, Capon Valley Bank6701
                Northwestern Pike, Gore, VA 22637
            
            Branch
                Office, Capon Valley Bank





All
      facilities are owned by the Company.





**Item3.**
            **Legal
                Proceedings**





Management
      is not aware of any material pending or threatened litigation in which Highlands
      or its subsidiaries may be involved as a defendant. In the normal course of
      business, the Banks periodically must initiate suits against borrowers as a
      final course of action in collecting past due loans.





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





Highlands
      Bankshares, Inc. did not submit any matters to a vote of security holders during
      the fourth quarter of 2006.








**PART
      II**





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





The
      Company had approximately 1,100 shareholders of record as of December 31, 2006.
      This amount includes all shareholders, whether titled individually or held
      by a
      brokerage firm or custodian in street name. The Company's stock is not traded
      on
      any national or regional stock exchange although brokers may occasionally
      initiate or be a participant in a trade. The Company’s stock is listed on the
      Over The Counter Bulletin Board. Terms of an exchange between individual parties
      may not be known to the Company.


*Index*





Page
                Nine











The
      following table outlines the dividends paid and market prices of the Company's
      stock based on prices disclosed to management. Prices have been provided using
      a
      nationally recognized online stock quote system. Such prices may not include
      retail mark-ups, mark-downs or commissions. Dividends are subject to the
      restrictions described in Note 10 to the Financial Statements.





Estimated
                Market Price Range2006
            
            Dividends
                Per Share
            High
            LowFirst
                Quarter
            
            .23
            32.25
            31.00Second
                Quarter
            
            .23
            32.50
            31.15Third
                Quarter
            
            .23
            32.50
            31.03Fourth
                Quarter
            
            .25
            32.75
            31.502005First
                Quarter
            
            .20
            28.90
            24.80Second
                Quarter
            
            .20
            29.10
            26.74Third
                Quarter
            
            .20
            30.79
            28.11Fourth
                Quarter
            
            .22
            32.00
            30.79








Set
      forth
      below is a line graph comparing the cumulative total return of Highlands
      Bankshares’ common stock from December 31, 2000 assuming reinvestment of
      dividends, with that of the Standard & Poor's 500 Index ("S&P 500") and
      the the Nasdaq Bank Index.









*Index*





Page
                Ten








**Item
                6.**
            **Selected
                Financial Data**





Years
                Ending December 31,(in
                thousands of dollars, except for per share amounts)2006
            
            2005
            
            2004
            
            2003
            
            2002Total
                Interest Income
            
            $
            23,894
            
            $
            19,813
            
            $
            17,729
            
            $
            18,283
            
            $
            18,970Total
                Interest Expense
            
            
            7,909
            
            
            5,761
            
            
            4,711
            
            
            6,338
            
            
            7,705Net
                Interest Income
            
            
            15,985
            
            
            14,052
            
            
            13,018
            
            
            11,945
            
            
            11,265Provision
                for Loan Losses
            
            
            682
            
            
            875
            
            
            920
            
            
            1,820
            
            
            820Net
                Interest Income After Provision for Loan Losses
            
            
            15,303
            
            
            13,177
            
            
            12,098
            
            
            10,125
            
            
            10,445Other
                Income
            
            
            1,997
            
            
            1,669
            
            
            1,597
            
            
            1,367
            
            
            1,304Other
                Expenses
            
            
            10,394
            
            
            9,128
            
            
            8,938
            
            
            8,247
            
            
            8,048Income
                Before Income Taxes
            
            
            6,906
            
            
            5,718
            
            
            4,757
            
            
            3,245
            
            
            3,701Income
                Tax Expense
            
            
            2,391
            
            
            1,916
            
            
            1,551
            
            
            1,012
            
            
            1,179Net
                Income
            
            $
            4,515
            
            $
            3,802
            
            $
            3,206
            
            $
            2,233
            
            $
            2,522Total
                Assets at Year End
            
            $
            357,316
            
            $
            337,573
            
            $
            299,992
            
            $
            301,168
            
            $
            296,672Long
                Term Debt at Year End
            
            $
            14,992
            
            $
            15,063
            
            $
            8,377
            
            $
            5,295
            
            $
            4,030Net
                Income Per Share of Common Stock
            
            $
            3.14
            
            $
            2.65
            
            $
            2.23
            
            $
            1.55
            
            $
            1.73Dividends
                Per Share of Common Stock
            
            $
            .94
            
            $
            .82
            
            $
            .63
            
            $
            .56
            
            $
            .51Return
                on Average Assets
            
            
            1.29
            %
            
            1.21
            %
            
            1.07
            %
            
            .73
            %
            
            .89
            %Return
                on Average Equity
            
            
            12.67
            %
            
            11.53
            %
            
            10.36
            %
            
            7.60
            %
            
            8.87
            %Dividend
                Payout Ratio
            
            
            29.91
            %
            
            30.99
            %
            
            28.23
            %
            
            36.03
            %
            
            29.26
            %Year
                End Equity to Assets Ratio
            
            
            10.38
            %
            
            10.07
            %
            
            10.55
            %
            
            9.81
            %
            
            9.69
            %2002
                per share figures restated to reflect stock split effected in form
                of
                dividend in 2002





*Index*





Page
                Eleven








**Item
                7.**
            **Management’s
                Discussion and Analysis of Financial Condition and Results of Operations**





**Forward
      Looking Statements**





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





**Introduction**





The
      following discussion focuses on significant results of the Company’s operations
      and significant changes in our financial condition or results of operations
      for
      the periods indicated in the discussion. This discussion should be read in
      conjunction with the preceding financial statements and related notes. Current
      performance does not guarantee, and may not be indicative of, similar
      performance in the future.





**Critical
      Accounting Policies**





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





Allowance
      for Loan Losses





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





*Index*





Page
                Twelve





The
      Company’s allowance for loan losses is the accumulation of various components
      that are calculated based on independent methodologies. All components of the
      allowance represent an estimation performed pursuant to either SFAS No. 5 or
      SFAS No. 114. Management’s estimate of each SFAS No. 5 component is based on
      certain observable data that management believes are most reflective of the
      underlying credit losses being estimated. This evaluation includes credit
      quality trends; collateral values; loan volumes; geographic, borrower and
      industry concentrations; seasoning of the loan portfolio; the findings of
      internal credit quality assessments and results from external bank regulatory
      examinations. These factors, as well as historical losses and current economic
      and business conditions, are used in developing estimated loss factors used
      in
      the calculations.





Reserves
      for commercial loans are determined by applying estimated loss factors to the
      portfolio based on management’s evaluation and “risk grading” of the commercial
      loan portfolio. Reserves are provided for noncommercial loan categories using
      estimated loss factors applied to the total outstanding loan balance of each
      loan category. Specific reserves are typically provided on all impaired
      commercial loans in excess of a defined threshold that are classified in the
      Special Mention, Substandard or Doubtful risk grades. The specific reserves
      are
      determined on a loan-by-loan basis based on management’s evaluation the
      Company’s exposure for each credit, given the current payment status of the loan
      and the value of any underlying collateral.





While
      management uses the best information available to establish the allowance for
      loan and lease losses, future adjustments to the allowance may be necessary
      if
      economic conditions differ substantially from the assumptions used in making
      the
      valuations or, if required by regulators, based upon information available
      to
      them at the time of their examinations. Such adjustments to original estimates,
      as necessary, are made in the period in which these factors and other relevant
      considerations indicate that loss levels may vary from previous
      estimates.




Post
      Retirement Benefits and Life Insurance Investments





The
      Company has invested in and owns life insurance polices on key officers. The
      policies are designed so that the company recovers the interest expenses
      associated with carrying the policies and the officer will, at the time of
      retirement, receive any earnings in excess of the amounts earned by the Company.
      The Company recognizes as an asset the net amount that could be realized under
      the insurance contract as of the balance sheet date. This amount represents
      the
      cash surrender value of the policies less applicable surrender charges. The
      portion of the benefits, which will be received by the executives at the time
      of
      their retirement, is considered, when taken collectively, to constitute a
      retirement plan. Therefore the Company accounts for these policies using
      guidance found in Statement of Financial Accounting Standards No. 106,
      "Employers' Accounting for Post Retirement Benefits Other Than Pensions.” SFAS
      No. 106 requires that an employers' obligation under a deferred compensation
      agreement be accrued over the expected service life of the employee through
      their normal retirement date.





Assumptions
      are used in estimating the present value of amounts due officers after their
      normal retirement date. These assumptions include the estimated income to be
      derived from the investments and an estimate of the Company’s cost of funds in
      these future periods. In addition, the discount rate used in the present value
      calculation will change in future years based on market conditions.





Intangible
      Assets





Generally
      accepted accounting principles were applied to allocate the intangible
      components of the purchase of the National Bank of Davis in November 2005.
      This
      excess was allocated between identifiable intangibles (i.e. core deposit
      intangibles) and unidentified intangibles (i.e. goodwill). Goodwill is required
      to be evaluated for impairment on an annual basis, and the value of the goodwill
      adjusted accordingly, should impairment be found. As of December 31, 2006,
      the
      Company did not identify an impairment of this intangible.





*Index*





Page
                Thirteen








Recent
      Accounting Pronouncements





In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No.
      158, “Employers Accounting for Defined Benefit Pension and Other Postretirement
      Plans—an amendment of FASB Statements No. 87, 88, 106 and 132R” (SFAS 158). SFAS
      158 requires an employer to recognize the over-funded or under-funded status
      of
      a defined benefit postretirement plan as an asset or liability in its statement
      of financial position and to recognize changes in that funded status, through
      comprehensive income, in the year in which the changes occur. The funded status
      of a benefit plan will be measured as the difference between plan assets at
      fair
      value and benefit obligation. For any other postretirement plan, the benefit
      obligation is the accumulated postretirement benefit obligation. SFAS 158 also
      requires an employer to measure the funded status of a plan as of the date
      of
      its year-end statement of financial position. The Statement also requires
      additional disclosures in the notes to financial statements about certain
      effects on net periodic benefit cost for the next fiscal year that arise from
      delayed recognition of the gains or losses, prior service costs or credits,
      and
      transition asset or obligation. Under SFAS 158 a company is required to
      initially recognize the funded status of a defined benefit postretirement plan
      to provide the required disclosures as of the end of the fiscal year ending
      after December 15, 2006. The requirement to measure plan assets and benefit
      obligations as of the date of the employer’s fiscal year end statement of
      financial position is effective for fiscal years ending after December 15,
      2008.
      The Grant County Bank is a member of the West Virginia Bankers' Association
      Retirement Plan, a defined benefit plan under SFAS 158.





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





**Overview
      of 2006 Results**





Highlands
      Bankshares experienced an 18.75% increase in net income for 2006 as compared
      to
      2005. Increases in net interest income, driven by balance sheet increases and
      a
      net interest margin of 5.05%, and an increase of $328,000 in non-interest income
      offset increases in non-interest expense. Return on Average Assets (ROAA) for
      2006 was 1.29% compared to an ROAA in 2005 of 1.21%. Return on Average Equity
      (ROAE) for the year was 12.67% compared to ROAE of 11.53% for 2005. Earnings
      per
      share increased from $2.65 in 2005 to $3.14 in 2006.





Total
      assets grew 5.85% from December 31, 2005 to December 31, 2006. Average earning
      assets were 8.72% greater in 2006 than during 2005. Loan balances continue
      to
      make up the bulk of earning assets. During 2006 average loan balances
      represented 87.47% of total average balances of earning assets.





The
      Company’s provision for loan losses during 2006 was $193,000 less than that
      taken in 2005. In spite of the decrease in provision, the ratio of the allowance
      for loan losses to gross loans increased from 1.16 at December 31, 2005 to
      1.19
      at December 31, 2006 as net loan charge-offs, as a percentage of gross loans,
      fell from .17% in 2005 to .11% in 2006.





Due
      largely to an increase in service fees on deposit accounts, non-interest income
      increased 19.65%. In addition to the increase in service fees, the Company
      experienced an increase in earnings on investments in life insurance policies,
      mainly as the result of a $155,000 one-time gain from the settlement of two
      of
      these policies. Insurance earnings declined significantly from 2005 to 2006,
      as
      over the past several years the volume of new consumer installment loans, the
      primary market for the Company’s insurance products, has declined.





Due
      largely to the general increase in operational size, and, to a lesser degree,
      due to normal inflationary pressures on costs, non-interest expense increased
      13.87% in 2006 as compared to 2005. Of the increase in non-interest expense,
      the
      majority was an increase in the cost of salaries and employee benefits, though
      occupancy and equipment expense and data processing expense also experienced
      year over year increases.





Highlands'
      results of operations are discussed in greater detail following this
      overview.


*Index*





Page
                Fourteen








The
      following table illustrates Highlands’ quarterly financial results for the year
      ended December 31, 2006 (in thousands of dollars):





Quarterly
                Financial ResultsFor
                The Year Ended December 31, 2006(in
                thousands, except per share amounts)FourthQuarter
            
            ThirdQuarter
            
            SecondQuarter
            
            FirstQuarterTotal
                Interest Income
            
            $
            6,477
            
            $
            6,140
            
            $
            5,735
            
            $
            5,542Total
                Interest Expense
            
            
            2,338
            
            
            2,047
            
            
            1,831
            
            
            1,693Net
                Interest Income
            
            
            4,139
            
            
            4,093
            
            
            3,904
            
            
            3,849Provision
                for Loan Losses
            
            
            173
            
            
            155
            
            
            176
            
            
            177Net
                Interest Income After Provision for Loan Losses
            
            
            3,966
            
            
            3,938
            
            
            3,728
            
            
            3,671Other
                Income
            
            
            442
            
            
            469
            
            
            647
            
            
            439Other
                Expenses
            
            
            2,619
            
            
            2,619
            
            
            2,615
            
            
            2,541Income
                Before Income Taxes
            
            
            1,789
            
            
            1,788
            
            
            1,760
            
            
            1,569Income
                Tax Expense
            
            
            635
            
            
            632
            
            
            559
            
            
            565Net
                Income
            
            $
            1,154
            
            $
            1,156
            
            $
            1,201
            
            $
            1,004Net
                Income Per Share of Common Stock
            
            $
            .80
            
            $
            .80
            
            $
            .84
            
            $
            .70Dividends
                Per Share of Common Stock
            
            $
            .25
            
            $
            .23
            
            $
            .23
            
            $
            .23





*Index*





Page
                Fifteen





The
      following table illustrates Highlands’ quarterly financial results for the year
      ended December 31, 2006 (in thousands of dollars):








Quarterly
                Financial ResultsFor
                The Year Ended December 31, 2005(in
                thousands, except per share amounts)Fourth
                Quarter
            
            Third
                Quarter
            
            Second
                Quarter
            
            First
                QuarterTotal
                Interest Income
            
            $
            5,406
            
            $
            5,008
            
            $
            4,783
            
            $
            4,616Total
                Interest Expense
            
            
            1,612
            
            
            1,493
            
            
            1,392
            
            
            1,264Net
                Interest Income
            
            
            3,794
            
            
            3,515
            
            
            3,391
            
            
            3,352Provision
                for Loan Losses
            
            
            185
            
            
            255
            
            
            210
            
            
            225Net
                Interest Income After Provision for Loan Losses
            
            
            3,609
            
            
            3,260
            
            
            3,181
            
            
            3,127Other
                Income
            
            
            415
            
            
            445
            
            
            445
            
            
            364Other
                Expenses
            
            
            2,390
            
            
            2,299
            
            
            2,229
            
            
            2,210Income
                Before Income Taxes
            
            
            1,634
            
            
            1,406
            
            
            1,397
            
            
            1,281Income
                Tax Expense
            
            
            542
            
            
            463
            
            
            479
            
            
            432Net
                Income
            
            $
            1,092
            
            $
            943
            
            $
            918
            
            $
            849Net
                Income Per Share of Common Stock
            
            $
            .76
            
            $
            .66
            
            $
            .64
            
            $
            .59Dividends
                Per Share of Common Stock
            
            $
            .22
            
            $
            .20
            
            $
            .20
            
            $
            .20





**Impact
      of Acquisition on Operational Results**





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





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





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





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








*Index*





Page
                Sixteen





**Net
      Interest Income**





2006
      Compared to 2005





The
      acquisition of the branches, as discussed earlier, has had significant impact
      on
      the Company’s net interest income. The following discussion highlights recent
      trends in the Company’s management of its net interest margin. The comparison of
      net interest income in 2006 as compared to 2005, as discussed below, should
      be
      considered in conjunction with the comments relating to the impact on net
      interest income of the acquisition of the National Bank of Davis, found earlier
      in Management’s Discussion and Analysis under the heading of “Impact of
      Acquisition on Operational Results.”





Net
      interest income, on a fully taxable equivalent basis, increased 13.73% from
      2005
      to 2006. This increase is both attributable to a general growth in the Company’s
      net interest balance sheet and also to increases in rates. Though the relative
      mix of earning assets and earning liabilities and also the ratio of earning
      assets to earning liabilities was roughly similar from 2005 to 2006 and
      therefore changes in the mix of these assets and liabilities or the ratio of
      the
      same did not contribute greatly to the increase in net interest income, the
      ratio of assets to liabilities and the percentage of earning assets made up
      of
      higher earning loan balances continues to be favorable to the Company’s net
      interest income and also its net interest margin.





Average
      balances of earning assets increased 8.72% from 2005 to 2006 and the ratio
      of
      earning assets to earning liabilities remained steady, 1.24 in 2006 and 1.25
      in
      2005. Average balances of interest bearing liabilities increased 9.26%.





As
      the
      Federal Reserve Board (“the Fed”) continued to increase rates into the early
      portions of 2006, the Company continued to experience average rate increases
      on
      both earnings of assets and on the costs of interest bearing liabilities. The
      increase in the average rates earned on interest earning assets of 74 basis
      points outpaced the average rates paid on interest bearing liabilities, which
      experienced a 64 basis point increase. Due to the rate increases by the Fed,
      rates earned on new loan balances continue to increase and due to the volume
      of
      adjustable rate mortgages in the Company’s portfolio, a significant portion of
      existing loan balances continue to reprice upward. This increase in rates earned
      on loans has been offset to some extent by higher rates paid on new time
      deposits, and as older time deposits mature and are renewed, higher rates are
      paid on the renewed balances.





During
      the later portions of 2006, the Fed halted its increases in the target rate
      for
      Federal Funds and rates have flattened as a result. If the Fed continues its
      pattern into the coming periods of holding rates constant, the Company expects
      average rates on loans and deposits to continue to increase as new loans and
      deposits are made and older loans and deposits mature or are repriced at higher
      rates. However, management anticipates that a Fed pattern of constant rates
      will
      cause the increase in average rates to slow somewhat.





During
      the past several years, management has undertaken a strategy of funding loan
      growth by reductions in balances of comparatively lower earning assets such
      as
      federal funds sold and securities, rather than pay above market rates to obtain
      new deposits. Management weighed the relative cost of these deposits versus
      earning on certain assets in making this decision. During 2006, the relative
      earnings of federal funds sold and securities as compared to loans increased.
      This increase, coupled with strong loan demand created a need for a change
      in
      the funding strategy. During the later portions of 2006, the Company began
      offering competitive rates to attract new deposit balances with which to fund
      new loan growth. The resulting increase in interest bearing liabilities has
      not
      negatively impacted net interest margin. Although significant loan growth may
      create a need for corresponding deposit growth, and to obtain this growth,
      the
      Company may be required to pay above market rates to obtain new deposit
      balances. Management anticipates that net interest income will continue to
      not
      be adversely impacted, though net interest margin percentages may decline.





*Index*





Page
                Seventeen











The
      table
      below sets forth an analysis of net interest income for the years ended December
      31, 2006 and 2005 (average balances and interest income/expense shown in
      thousands of dollars):





2006
            
            2005Average
              Balance
            
            Income
              /Expense
            
            Yield
              /Rate
            
            Average
              Balance
            
            Income
              /Expense
            
            Yield
              /RateEarning
                AssetsLoans
            
            $
            277,871
            
            $
            22,118
            
            
            7.96
            %
            $
            254,700
            
            $
            18,622
            
            
            7.31
            %Taxable
                investment securities
            
            
            24,970
            
            
            1,095
            
            
            4.39
            %
            
            23,313
            
            
            707
            
            
            3.03
            %Nontaxable
                investment securities
            
            
            2,987
            
            
            173
            
            
            5.79
            %
            
            2,951
            
            
            163
            
            
            5.52
            %Interest
                bearing deposits
            
            
            1,576
            
            
            72
            
            
            4.57
            %
            
            1,268
            
            
            38
            
            
            3.00
            %Federal
                funds sold
            
            
            10,287
            
            
            500
            
            
            4.87
            %
            
            9,970
            
            
            343
            
            
            3.44
            %Total
                Earning Assets
            
            
            317,691
            
            
            23,958
            
            
            7.54
            %
            
            292,202
            
            
            19,873
            
            
            6.80
            %Allowance
                for loan losses
            
            
            (3,283
            )
            
            
            
            
            
            
            
            (2,807
            )Other
                non-earning assets
            
            
            28,648
            
            
            
            
            
            
            
            
            25,291Total
                Assets
            
            $
            343,056
            
            
            
            
            
            
            
            $
            314,686Interest
                Bearing LiabilitiesDemand
                deposits
            
            $
            25,658
            
            $
            224
            
            
            .87
            %
            $
            23,554
            
            $
            189
            
            
            .80
            %Savings
                deposits
            
            
            50,235
            
            
            549
            
            
            1.09
            %
            
            49,391
            
            
            437
            
            
            .88
            %Time
                deposits
            
            
            164,005
            
            
            6,429
            
            
            3.92
            %
            
            146,211
            
            
            4,504
            
            
            3.08
            %Borrowed
                money
            
            
            15,643
            
            
            707
            
            
            4.52
            %
            
            14,728
            
            
            631
            
            
            4.28
            %Total
                Interest Bearing Liabilities
            
            
            255,541
            
            
            7,909
            
            
            3.10
            %
            
            233,884
            
            
            5,761
            
            
            2.46
            %Demand
                deposits
            
            
            48,056
            
            
            
            
            
            
            
            
            41,360Other
                liabilities
            
            
            3,810
            
            
            
            
            
            
            
            
            6,459Stockholders’
                equity
            
            
            35,649
            
            
            
            
            
            
            
            
            32,983Total
                Liabilities and Stockholders’ Equity
            
            $
            343,056
            
            
            
            
            
            
            
            $
            314,686Net
                Interest Income
            
            
            
            
            $
            16,049
            
            
            
            
            
            
            
            $
            14,112Net
                Yield on Earning Assets
            
            
            
            
            
            
            
            
            5.05
            %
            
            
            
            
            
            
            
            4.83
            %Notes:(1)
                Yields are computed on a taxable equivalent basis using a 37% tax
                rate(2)
                Average balances are based upon daily balances(3)
                Includes loans in non-accrual status(4)
                Income on loans includes fees





*Index*





Page
                Eighteen





The
      table
      below illustrates the effects on net interest income of changes in average
      volumes of interest bearing liabilities and earning assets from 2005 to 2006
      and
      changes in average rates on interest bearing liabilities and earning assets
      from
      2005 to 2006 (in thousands of dollars):





EFFECT
                OF RATE-VOLUME CHANGES ON NET INTEREST INCOME(On
                a fully taxable equivalent basis)(In
                thousands of dollars)Increase
                (Decrease) 2006 Compared to 2005Due
                to change in:Average
                Volume
            
            Average
                Rate
            
            Total
                ChangeInterest
                IncomeLoans
            
            $
            1,694
            
            $
            1,802
            
            $
            3,496Taxable
                investment securities
            
            
            50
            
            
            338
            
            
            388Nontaxable
                investment securities
            
            
            2
            
            
            8
            
            
            10Interest
                bearing deposits
            
            
            9
            
            
            25
            
            
            34Federal
                funds sold
            
            
            11
            
            
            146
            
            
            157Total
                Interest Income
            
            
            1,766
            
            
            2,319
            
            
            4,085Interest
                ExpenseDemand
                deposits
            
            
            17
            
            
            18
            
            
            35Savings
                deposits
            
            
            7
            
            
            105
            
            
            112Time
                deposits
            
            
            548
            
            
            1,377
            
            
            1,925Borrowed
                money
            
            
            39
            
            
            37
            
            
            76Total
                Interest Expense
            
            
            611
            
            
            1,537
            
            
            2,148Net
                Interest Income
            
            $
            1,155
            
            $
            782
            
            $
            1,937





Changes
      in volume are calculated based on the difference in average balance multiplied
      by the prior year average rate. Changes due to rate changes are calculated
      by
      subtracting the change due to volume from the total change.





2005
      Compared to 2004





Net
      interest income, on a fully taxable equivalent basis, increased 7.81% in 2005
      as
      compared to 2004. As the Federal Reserve Board (the “Fed”) continued to increase
      the target rates for federal funds, both interest rates paid on deposits and
      interest earned on assets increased. The increases by the Fed had the greatest
      impact on the rates earned on federal funds sold, deposits in other banks and
      on
      interest bearing deposits. Average balances of earning assets increased $12.39
      million while average balances of interest bearing liabilities increased only
      $5.68 million. This relative increase, coupled with increases in loan balances,
      (a comparatively higher earning asset as a percentage of total average earning
      assets) had the greatest impact in the increase in net interest income and
      the
      increase of 15 basis points in net interest margin.





Throughout
      2004 and into the early part of 2005, the Company chose to fund loan growth
      through the reduction of balances of federal funds sold, deposits in other
      banks
      and securities (relatively low earning assets) rather than pay above market
      rates to attract new deposits. This strategy caused overall average balances
      of
      interest bearing deposits to decrease slightly, investments in securities to
      decrease moderately and federal funds sold to decrease substantially. Average
      rates paid on interest bearing liabilities increased 40 basis points from 2004
      to 2005 compared to the slightly larger 44 basis point increase experienced
      with
      interest earning assets.





While
      the
      rate increases enacted by the Fed had an immediate impact on the yields of
      federal funds sold and interest bearing deposits, continued heavy competition
      for new loans caused a more subdued increase in average rates earned on loans.


*Index*





Page
                Nineteen





In
      addition to funding loan growth through reductions in balances of relatively
      lower earning assets, the Company also chose to utilize its borrowing capacity
      from the Federal Home Loan Bank (“FHLB”) more in 2005 than in the past. The
      lending options offered by the FHLB allowed the subsidiary Banks to borrow
      in
      certain instances at favorable rates and/or favorable repayment terms and assist
      in the Company’s management of its assets and liabilities.





Average
      balances of many of the categories of both earning assets and interest bearing
      liabilities were increased by the purchase of The National Bank of Davis
      (“Davis”). However, because this purchase occurred late in 2005, and because of
      the relatively small size of Davis compared to Highlands Bankshares, the impact
      on net interest margin for 2005 was not significant. At the time of purchase,
      Davis had a comparatively conservative balance sheet. Davis’ loan to deposit
      ratio at the time of purchase was 33.14% and Davis’ ratio of earning assets to
      interest bearing liabilities was 84.45% compared to a Highlands 2005 average
      ratio of earning assets to interest bearing liabilities of 124.93%.





The
      table
      below sets forth an analysis of net interest income for the years ended December
      31, 2005 and 2004 (average balances and interest income/expense shown in
      thousands of dollars):




2005
            
            2004Average
              Balance
            
            Income
              /Expense
            
            Yield
              /Rate
            
            Average
              Balance
            
            Income
              /Expense
            
            Yield
              /RateEarning
                AssetsLoans
            
            $
            254,700
            
            $
            18,622
            
            
            7.31
            %
            $
            235,023
            
            $
            16,752
            
            
            7.13
            %Taxable
                investment securities
            
            
            23,313
            
            
            707
            
            
            3.03
            %
            
            25,944
            
            
            674
            
            
            2.60
            %Nontaxable
                investment securities
            
            
            2,951
            
            
            163
            
            
            5.52
            %
            
            3,298
            
            
            194
            
            
            5.89
            %Interest
                bearing deposits
            
            
            1,268
            
            
            38
            
            
            3.00
            %
            
            1,430
            
            
            18
            
            
            1.26
            %Federal
                funds sold
            
            
            9,970
            
            
            343
            
            
            3.44
            %
            
            14,119
            
            
            163
            
            
            1.15
            %Total
                Earning Assets
            
            
            292,202
            
            
            19,873
            
            
            6.80
            %
            
            279,814
            
            
            17,801
            
            
            6.36
            %Allowance
                for loan losses
            
            
            (2,807
            )
            
            
            
            
            
            
            
            (2,418
            )Other
                non-earning assets
            
            
            25,291
            
            
            
            
            
            
            
            
            23,024Total
                Assets
            
            $
            314,686
            
            
            
            
            
            
            
            $
            300,420Interest
                Bearing LiabilitiesDemand
                deposits
            
            $
            23,554
            
            $
            189
            
            
            .80
            %
            $
            24,031
            
            $
            95
            
            
            .40
            %Savings
                deposits
            
            
            49,391
            
            
            437
            
            
            .88
            %
            
            52,079
            
            
            296
            
            
            .57
            %Time
                deposits
            
            
            146,211
            
            
            4,504
            
            
            3.08
            %
            
            145,834
            
            
            4,042
            
            
            2.77
            %Borrowed
                money
            
            
            14,728
            
            
            631
            
            
            4.28
            %
            
            6,264
            
            
            278
            
            
            4.44
            %Total
                Interest Bearing Liabilities
            
            
            233,884
            
            
            5,761
            
            
            2.46
            %
            
            228,208
            
            
            4,711
            
            
            2.06
            %Demand
                deposits
            
            
            41,360
            
            
            
            
            
            
            
            
            37,325Other
                liabilities
            
            
            6,459
            
            
            
            
            
            
            
            
            3,954Stockholders’
                equity
            
            
            32,983
            
            
            
            
            
            
            
            
            30,933Total
                Liabilities and Stockholders’ Equity
            
            $
            314,686
            
            
            
            
            
            
            
            $
            300,420Net
                Interest Income
            
            
            
            
            $
            14,112
            
            
            
            
            
            
            
            $
            13,090Net
                Yield on Earning Assets
            
            
            
            
            
            
            
            
            4.83
            %
            
            
            
            
            
            
            
            4.68
            %Notes:(1)
                Yields are computed on a taxable equivalent basis using a 37% tax
                rate(2)
                Average balances are based upon daily balances(3)
                Includes loans in non-accrual status(4)
                Income on loans includes fees





*Index*





Page
                Twenty





The
      table
      below illustrates the effects on net interest income of changes in average
      volumes of interest bearing liabilities and earning assets from 2004 to 2005
      and
      changes in average rates on interest bearing liabilities and earning assets
      from
      2004 to 2005 (in thousands of dollars):





EFFECT
                OF RATE-VOLUME CHANGES ON NET INTEREST INCOME(On
                a fully taxable equivalent basis)(In
                thousands of dollars)Increase
                (Decrease) 2005 Compared to 2004Due
                to change in:Average
                Volume
            
            Average
                Rate
            
            Total
                ChangeInterest
                IncomeLoans
            
            $
            1,402
            
            $
            468
            
            $
            1,870Taxable
                investment securities
            
            
            (68
            )
            
            101
            
            
            33Nontaxable
                investment securities
            
            
            (20
            )
            
            (11
            )
            
            (31
            )Interest
                bearing deposits
            
            
            (2
            )
            
            22
            
            
            20Federal
                funds sold
            
            
            (48
            )
            
            228
            
            
            180Total
                Interest Income
            
            
            1,264
            
            
            808
            
            
            2,012Interest
                ExpenseDemand
                deposits
            
            
            (2
            )
            
            96
            
            
            94Savings
                deposits
            
            
            (15
            )
            
            156
            
            
            141Time
                deposits
            
            
            10
            
            
            452
            
            
            462Borrowed
                money
            
            
            376
            
            
            (23
            )
            
            353Total
                Interest Expense
            
            
            369
            
            
            681
            
            
            1,050Net
                Interest Income
            
            $
            895
            
            $
            127
            
            $
            1,022





Changes
      in volume are calculated based on the difference in average balance multiplied
      by the prior year average rate. Changes due to rate changes are calculated
      by
      subtracting the change due to volume from the total change.





**Loan
      Portfolio**





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





The
      following table summarizes the Company’s loan portfolio at December 31, 2006,
      2005, 2004, 2003 and 2002 (in thousands of dollars):


*Index*





Page
                Twenty One





At
                December 31,2006
            
            2005
            
            2004
            
            2003
            
            2002Real
                estate mortgage
            
            $
            164,243
            
            $
            153,646
            
            $
            140,762
            
            $
            129,671
            
            $
            121,558Real
                estate construction
            
            
            14,828
            
            
            12,201
            
            
            8,850
            
            
            7,552
            
            
            6,813Commercial
            
            
            70,408
            
            
            57,908
            
            
            52,813
            
            
            42,911
            
            
            47,089Installment
            
            
            43,337
            
            
            46,265
            
            
            46,092
            
            
            46,501
            
            
            50,294Total
                Loans
            
            
            292,816
            
            
            270,020
            
            
            248,517
            
            
            226,635
            
            
            225,754Allowance
                for loan losses
            
            
            (3,482
            )
            
            (3,129
            )
            
            (2,530
            )
            
            (2,463
            )
            
            (1,793
            )Net
                Loans
            
            $
            289,334
            
            $
            266,891
            
            $
            245,987
            
            $
            224,172
            
            $
            223,961





Commercial
      loan balances include certain loans secured by commercial real estate. As of
      December 31, 2006 the Company maintained balances of loans secured by real
      estate of $226,310,000.





There
      were no foreign loans outstanding during any of the above periods.





The
      following table illustrates the Company’s loan maturity distribution as of
      December 31, 2006 (in thousands of dollars):





Maturity
                RangeLess
                than 1 Year
            
            1-5
                Years
            
            Over
                5 Years
            
            TotalLoan
                TypeCommercial
            
            $
            46,937
            
            $
            12,379
            
            $
            11,092
            
            $
            70,408Real
                estate mortgage and construction
            
            
            60,347
            
            
            52,802
            
            
            65,922
            
            
            179,071Installment
            
            
            15,760
            
            
            26,726
            
            
            851
            
            
            43,337Total
                Loans
            
            $
            123,044
            
            $
            91,907
            
            $
            77,865
            
            $
            292,816








**Credit
      Quality**





The
      principal economic risk associated with each of the categories of loans in
      the
      Company’s portfolio is the creditworthiness of its borrowers. Within each
      category, such risk is increased or decreased depending on prevailing economic
      conditions. The risk associated with the real estate mortgage loans and
      installment loans to individuals varies based upon employment levels, consumer
      confidence, fluctuations in value of residential real estate and other
      conditions that affect the ability of consumers to repay indebtedness. The
      risk
      associated with commercial, financial and agricultural loans varies based upon
      the strength and activity of the local economies of the Company’s market areas.
      The risk associated with real estate construction loans varies based upon the
      supply of and demand for the type of real estate under
      construction.




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


*Index*





Page
                Twenty Two





Nonperforming
      loans include non-accrual loans, loans 90 days or more past due and restructured
      loans. Non-accrual loans are loans on which interest accruals have been
      discontinued. Loans are typically placed in non-accrual status when the
      collection of principal or interest is 90 days past due and collection is
      uncertain based on the net realizable value of the collateral and/or the
      financial strength of the borrower. Also, the existence of any guaranties by
      federal or state agencies is given consideration in this decision. The policy
      is
      the same for all types of loans. Restructured loans are loans for which a
      borrower has been granted a concession on the interest rate or the original
      repayment terms because of financial difficulties. Nonperforming loans do not
      represent or result from trends or uncertainties which management reasonably
      expects will materially impact future operating results, liquidity, or capital
      resources. Nonperforming loans are listed in the table below.





Nonperforming
      loans decreased 11.96% from December 31, 2005 to December 31, 2006, but still
      remain below the Company’s 5-year average. At December 31, 2006, nonperforming
      loans represented .58% of the Company’s balances of gross loans as compared to
      .72% at December 31, 2005.





The
      following table summarizes the Company’s nonperforming loans (in thousands of
      dollars):





At
                December 31,2006
            
            2005
            
            2004
            
            2003
            
            2002Loans
                accounted for on a non-accrual basisConsumer
            
            $
            83
            
            $
            124
            
            $
            252
            
            $
            228
            
            $
            9Real
                estate
            
            
            161
            
            
            619
            
            
            278
            
            
            1,436
            
            
            290Total
                Non-accrual Loans
            
            
            244
            
            
            743
            
            
            530
            
            
            1,664
            
            
            299Restructured
                Loans
            
            
            0
            
            
            0
            
            
            0
            
            
            631
            
            
            662Loans
                delinquent 90 days or moreConsumer
            
            
            122
            
            
            74
            
            
            140
            
            
            25
            
            
            161Commercial
            
            
            0
            
            
            966
            
            
            355
            
            
            1,255
            
            
            1,312Real
                estate
            
            
            1,335
            
            
            149
            
            
            40
            
            
            318
            
            
            445Total
                delinquent loans
            
            
            1,457
            
            
            1,189
            
            
            535
            
            
            1,598
            
            
            1,918Total
                Nonperforming Loans
            
            $
            1,701
            
            $
            1,932
            
            $
            1,065
            
            $
            3,893
            
            $
            2,879





The
      Company held no real estate acquired through foreclosure at December 31, 2006.
      Real estate acquired through foreclosure was $44,800 at December 31, 2005 and
      $327,650 at December 31, 2004. The Company's practice is to value real estate
      acquired through foreclosure at the lower of (i) an independent current
      appraisal or market analysis less anticipated costs of disposal, or (ii) the
      existing loan balance.





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





In
      recent
      periods, the Company’s loan portfolio has also begun to reflect a concentration
      in loans collateralized by heavy equipment, particularly in the trucking, mining
      and timber industries. In part because of rising fuel costs, the trucking sector
      has experienced a recent downturn. However, the Company has experienced no
      material losses related to foreclosures of loans collateralized by heavy
      equipment. While close monitoring of this sector is necessary, management
      expects no significant losses in the foreseeable future.


*Index*





Page
                Twenty Three





**Allowance
      For Loan Losses**





The
      allowance for loan losses is an estimate of the losses in the current loan
      portfolio. The allowance is based on two principles of accounting: (i) SFAS
      No.
      5, Accounting for Contingencies which requires that losses be accrued when
      they
      are probable of occurring and estimable and (ii) SFAS No. 114, Accounting by
      Creditors for Impairment of a Loan, which requires that loans be identified
      which have characteristics of impairment as individual risks, (e.g. the
      collateral, present value of cash flows or observable market values are less
      than the loan balance).





Each
      of
      the Company's banking subsidiaries, Capon Valley Bank and The Grant County
      Bank,
      determines the adequacy of its allowance for loan losses independently. Although
      the loan portfolios of the two Banks are similar to each other, some differences
      exist which result in divergent risk patterns and different charge-off rates
      amongst the functional areas of the Banks’ portfolio. Each Bank pays particular
      attention to individual loan performance, collateral values, borrower financial
      condition and economic conditions. The determination of an adequate allowance
      at
      each Bank is done in a three-step process. The first step is to identify
      impaired loans. Impaired loans are problem loans above a certain threshold,
      which have estimated losses, calculated based on the fair value of the
      collateral with which the loan is secured.





A
      summary
      of the loans, which the Company has identified as impaired, follows (in
      thousands of dollars):





December
                31, 2006IdentifiedLoan
                Type
            
            Balance
            
            ImpairmentMortgage
            
            $
            774
            
            $
            107Commercial
            
            
            977
            
            
            520Installment
            
            
            144
            
            
            93




The
      second step is to identify loans above a certain threshold, which are problem
      loans due to the borrowers' payment history or deteriorating financial
      condition. Losses in this category are determined based on historical loss
      rates
      adjusted for current economic conditions. The final step is to calculate a
      loss
      for the remainder of the portfolio using historical loss information for each
      type of loan classification. The determination of specific allowances and
      weighting is somewhat subjective and actual losses may be greater or less than
      the amount of the allowance. However, management believes that the allowance
      represents a fair assessment of the losses that exist in the current loan
      portfolio.





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





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





The
      ratio
      of the allowance for loan losses to total loans outstanding was 1.19% at
      December 31, 2006, 1.16% at December 31, 2005 and 1.02% at December 31, 2004.
      At
      December 31, 2006, the ratio of the allowance for loan losses to nonperforming
      loans was 204.70% compared to 161.96% at December 31, 2005 and 237.56% at
      December 31, 2004.


*Index*





Page
                Twenty Four





During
      2005, the Company’s balances of non-performing loans and delinquent loans began
      to increase above levels experienced during 2003 and 2004. As a result, during
      2005, management deemed it necessary to increase the allowance for loan losses
      as a percent of gross loans. Until the later months of 2006, the levels of
      non-performing and delinquent loans remained elevated and management deemed
      it
      necessary to maintain a ratio of allowance for loan losses as compared to gross
      loans above that of the Company’s recent historical averages. However, during
      2006, the Company experienced a decline in net charge-offs, and the maintenance
      of the allowance for loan losses as a percentage of gross was achieved even
      while the provision against operations for the allowance for loan losses was
      greatly reduced.





An
      analysis of the changes in the allowance for loan losses is set forth in the
      following table (in thousands of dollars):





2006
            
            2005
            
            2004
            
            2003
            
            2002Balance
                at beginning of period
            
            $
            3,129
            
            $
            2,530
            
            $
            2,463
            
            $
            1,793
            
            $
            1,603Charge-offs:Commercial
                loans
            
            
            27
            
            
            45
            
            
            97
            
            
            557
            
            
            246Real
                estate loans
            
            
            1
            
            
            8
            
            
            422
            
            
            65
            
            
            110Consumer
                loans
            
            
            551
            
            
            567
            
            
            642
            
            
            839
            
            
            424Total
                Charge-offs:
            
            
            579
            
            
            620
            
            
            1,161
            
            
            1,461
            
            
            780Recoveries:Commercial
                loans
            
            
            5
            
            
            28
            
            
            37
            
            
            75
            
            
            10Real
                estate loans
            
            
            20
            
            
            0
            
            
            36
            
            
            54
            
            
            68Consumer
                loans
            
            
            225
            
            
            150
            
            
            235
            
            
            182
            
            
            72Total
                Recoveries
            
            
            250
            
            
            178
            
            
            308
            
            
            311
            
            
            150Net
                Charge-offs
            
            
            329
            
            
            442
            
            
            853
            
            
            1,150
            
            
            630Provision
                for loan losses
            
            
            682
            
            
            875
            
            
            920
            
            
            1,820
            
            
            820Other
                additions
            
            
            
            
            
            166Balance
                at end of period
            
            $
            3,482
            
            $
            3,129
            
            $
            2,530
            
            $
            2,463
            
            $
            1,793Percent
                of net charge-offs to average net loans outstanding during the
                period
            
            
            .11
            %
            
            .17
            %
            
            .51
            %
            
            .29
            %
            
            .25
            %








Cumulative
      net loan losses, after recoveries, for the five-year period ending December
      31,
      2006 are as follows (in thousands of dollars):





Dollars
            
            Percent
                of TotalCommercial
            
            $
            817
            
            
            24
            %Real
                Estate
            
            
            428
            
            
            13
            %Consumer
            
            
            2,159
            
            
            63
            %Total
            
            $
            3,404





*Index*





Page
                Twenty Five





The
      following table shows the allocation of loans in the loan portfolio and the
      corresponding amounts of the allowance allocated by loan type (dollar amounts
      in
      thousands of dollars):





At
                December 31,2006
            
            2005
            
            2004
            
            2003
            
            2002Amount
            
            Percent
                ofLoans
            
            Amount
            
            Percent
                of
              Loans
            
            Amount
            
            Percent
                of
              Loans
            
            Amount
            
            Percent
              ofLoans
            
            Amount
            
            Percent
                of
              LoansCommercial
            
            $
            1,492
            
            
            24
            %
            $
            900
            
            
            21
            %
            $
            697
            
            
            21
            %
            $
            779
            
            
            19
            %
            $
            543
            
            
            21
            %Mortgage
            
            
            996
            
            
            61
            %
            
            1,139
            
            
            62
            %
            
            853
            
            
            60
            %
            
            725
            
            
            61
            %
            
            504
            
            
            57
            %Consumer
            
            
            967
            
            
            15
            %
            
            1,082
            
            
            17
            %
            
            970
            
            
            19
            %
            
            819
            
            
            20
            %
            
            652
            
            
            22
            %Unallocated
            
            
            27
            
            
            
            
            
            8
            
            
            
            
            
            10
            
            
            
            
            
            140
            
            
            
            
            
            94Totals
            
            $
            3,482
            
            
            100
            %
            $
            3,129
            
            
            100
            %
            $
            2,530
            
            
            100
            %
            $
            2,463
            
            
            100
            %
            $
            1,793
            
            
            100
            %





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





The
      above
      figures act as the beginning for the allocation of overall allowances.
      Additional changes have been made in the allocation of the allowance to address
      unknowns and contingent items. The unallocated portion is not computed using
      a
      specific formula and is management’s best estimate of what should be allocated
      for contingencies in the current portfolio.





**Non-interest
      Income**





2006
      compared to 2005





Non-interest
      income increased 19.65% from 2005 to 2006.





Contributing
      heavily to this increase was a $337,000 increase in deposit service charges,
      mainly resulting from a rise in insufficient fund charges to demand deposit
      customers. This rise in insufficient funds charges was the result of both an
      increase in average balances of demand deposits and also the implementation
      in
      late 2005 by Capon Valley Bank of a courtesy overdraft program.





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





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


*Index*





Page
                Twenty Six





2005
      compared to 2004





Service
      charge income increased $66,000, almost exclusively in the income received
      from
      customer overdraft charges. As the Company’s account base grew and non-interest
      bearing checking volume grew, revenue from insufficient funds charges also
      increased. Also, late in 2005, Capon Valley Bank implemented a program commonly
      referred to as “Courtesy Overdraft.”





Income
      from insurance operations, which is underwriting income by HBI Life and
      commission income earned by the subsidiary Banks, decreased slightly during
      2005
      as compared to 2004. As new consumer installment loan volume has declined the
      income from insurance operations has also declined as insurance originations
      come mostly from installment lending.





During
      2005, the Company recorded non-recurring income totaling $33,000. A portion
      of
      this income related to the gain on the sale of the Company's interest in an
      automated debit card company. Secondly, during the fourth quarter of 2005,
      a
      portion of the parking area of one of the Company’s branch locations was
      purchased as part of a street widening project, and the Company recorded a
      gain
      of $19,000 related to this sale.





**Non-interest
      Expense**





2006
      compared to 2005





Non-interest
      expense increased 13.87% from 2005 to 2006.





Employee
      salary and benefits expense increased 14.02%. The table below summarizes the
      changes in salaries and benefits expense (all dollar amounts expressed in
      thousands of dollars):





**Increase**
            
            **Percent**Increases
                in salary expense and related payroll tax due to changes in average
                number
                of full time equivalent employees
            
            $
            290Increases
                in salary expense and related payroll tax due to average pay rate
                increases
            
            
            176Total
                increase in salary expense and related payroll tax
            
            
            466
            
            
            12.80
            %Increase
                in the cost of employee insurance benefits
            
            
            97
            
            
            15.22
            %Increase
                in the cost of executive retirement benefits related to investments
                in
                insurance contracts
            
            
            49
            
            
            26.01
            %Increase
                in the cost of employee post retirement benefit plans
            
            
            86
            
            
            17.21
            %





Occupancy
      and equipment expense increased largely because of an increase in the number
      of
      physical structures owned by the Company as a result of the acquisition of
      two
      branches in late 2005. Data processing increased 28.20% as the volume of
      accounts, both loan and deposit, increased. This increase in customer volume
      was
      both the result of the additional customers acquired with the branches purchase
      and also continued endogenous growth of legacy operations.





The
      amortization of core deposit intangibles (see Notes Two and Nineteen of the
      Financial Statements) increased $137,000 from 2005 to 2006.





Legal
      and
      professional fees fell slightly from 2005 to 2006 as a result of lessened
      consulting engagements relating to regulatory compliance issues.


*Index*





Page
                Twenty Seven





2005
      compared to 2004





Expenses
      related to salaries and benefits increased 1.99% in 2005 as compared to 2004.
      An
      increase in full-time equivalent employees was responsible for about half of
      this increase. Costs of post retirement benefits for employees declined
      primarily due to lower costs that resulted from the retirement of an employee
      in
      2004. Occupancy and equipment expense increased slightly as the properties
      of
      the Company remained relatively constant (not inclusive of the physical assets
      obtained with the purchase of The National Bank of Davis). Data processing
      expense fell 5.81% in 2005 as compared to 2004, due mainly to a decrease in
      the
      contractual rate charged to the subsidiary Banks by the primary supplier of
      account processing functions. Legal and professional fees increased $98,000
      in
      2005 as compared to 2004. Significant costs relating to compliance efforts
      under
      Rule 404 of the Sarbanes Oxley Act of 2002 and increased audit procedures
      required by bank regulatory authorities were responsible for the largest portion
      of the increase in legal and professional fees.





**Securities**





The
      Company's securities portfolio serves several purposes. Portions of the
      portfolio are used to secure certain public and trust deposits. The remaining
      portfolio is held as investments or used to assist the Company in liquidity
      and
      asset liability management. Total securities, including restricted securities,
      represented 7.13% of total assets at December 31, 2006.





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





The
      Company identifies at the time of acquisition those securities that are
      available for sale. These securities are valued at their market value with
      any
      difference in market value and amortized cost shown as an adjustment in
      stockholders' equity. Changes within the year in market values are reflected
      as
      changes in other comprehensive income, net of the deferred tax effect. As of
      December 31, 2006, the cost basis of the securities available for sale exceeded
      their fair value by $6,000 ($4,000 after tax effect of $2,000).





The
      following table summarizes the carrying value of the Company’s securities at
      December 31, 2006, 2005 and 2004 (in thousands of dollars):





Held
                to Maturity
            
            Available
                for SaleCarrying
                Value
            
            Carrying
                ValueDecember
                31,
            
            December
                31,2006
            
            2005
            
            2004
            
            2006
            
            2005
            
            2004U.S.
                Treasuries and Agencies
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            14,403
            
            $
            17,234
            
            $
            18,164Obligations
                of states and political subdivisions
            
            
            170
            
            
            491
            
            
            1,162
            
            
            2,744
            
            
            2,705
            
            
            1,817Mortgage
                backed securities
            
            
            0
            
            
            0
            
            
            0
            
            
            6,554
            
            
            7,163
            
            
            4,693Marketable
                equities
            
            
            0
            
            
            0
            
            
            0
            
            
            28
            
            
            28
            
            
            28Total
            
            $
            170
            
            $
            491
            
            $
            1,162
            
            $
            23,729
            
            $
            27,130
            
            $
            24,702





*Index*





Page
                Twenty Eight





The
      carrying amount and estimated market value of debt securities (in thousands
      of
      dollars) at December 31, 2006 by contractual maturity are shown below. Expected
      maturities will differ from contractual maturities because borrowers may have
      the right to call or prepay obligations with or without call or prepayment
      penalties.





Amortized
                Cost
            
            Fair
                Value
            
            Equivalent
                Average YieldSecurities
                Held to MaturityDue
                in 3 months or less
            
            $
            170
            
            $
            170
            
            
            7.49
            %Total
                Held to Maturity
            
            $
            170
            
            $
            170
            
            
            7.49
            %Securities
                Available for SaleDue
                in 3 months or less
            
            $
            2,112
            
            $
            2,109
            
            
            4.36
            %Due
                in 3 months through one year
            
            
            6,339
            
            
            6,313
            
            
            4.59
            %Due
                after one year through five years
            
            
            14,908
            
            
            14,931
            
            
            4.98
            %Due
                after five years through ten years
            
            
            80
            
            
            80
            
            
            6.32
            %Due
                after ten years
            
            
            268
            
            
            268
            
            
            4.58
            %Equity
                securities with no maturity
            
            
            28
            
            
            28
            
            
            8.40
            %Total
                Available For Sale
            
            $
            23,735
            
            $
            23,729
            
            
            4.83
            %








Yields
      on
      tax exempt securities are stated at actual yields.





Management
      has generally kept the maturities of investments relatively short providing
      for
      flexibility in investing. Such a philosophy allows the Company to better match
      deposit maturities with investment maturities and thus react more quickly to
      interest rate changes.





**Deposits**





The
      Company's primary source of funds is local deposits. The Company's deposit
      base
      is comprised of demand deposits, savings and money market accounts and other
      time deposits. The majority of the Company's deposits are provided by
      individuals and businesses located within the communities served.





Total
      balances of deposits increased 5.55% from December 31, 2005 to December 31,
      2006.





Although
      the Company does not actively solicit large certificates of deposit (those
      more
      than $100,000) due to the unstable nature of these deposits, the balances of
      such deposits increased 20.71% from December 31, 2005 to December 31, 2006.
      This
      increase is, in part, attributable to rate specials offered by the subsidiary
      Banks during the second half of 2006.





A
      summary
      of the maturity range of deposits over $100,000 is as follows (in thousands
      of
      dollars):





At
                December 31,2006
            
            2005
            
            2004Three
                months or less
            
            $
            9,533
            
            $
            7,662
            
            $
            6,598Four
                to twelve months
            
            
            30,810
            
            
            14,835
            
            
            13,861One
                year to three years
            
            
            8,156
            
            
            17,736
            
            
            15,323Four
                years to five years
            
            
            6,368
            
            
            5,222
            
            
            3,620Total
            
            $
            54,867
            
            $
            45,455
            
            $
            39,402





*Index*





Page
                Twenty Nine





**Borrowed
      Money**





Long
      Term Borrowings





The
      Company borrows funds from the Federal Home Loan Bank (“FHLB”) to reduce market
      rate risks, provide liquidity, and to fund capital additions. These borrowings
      may have fixed or variable interest rates and are amortized over a period of
      one
      to twenty years, or may be comprised of single payment borrowings with periodic
      interest payments and principal amounts due at maturity. Borrowings from this
      institution allow the Banks to offer long-term, fixed rate loans to their
      customers and match the interest rate exposure of the receivable and the
      liability and to meet liquidity needs and to manage interest rate risk through
      the use of long-term fixed rate borrowings. During 2006, the Company borrowed
      an
      additional $2,300,000 from the FHLB and made payments of $ 2,371,000 on
      outstanding balances.





Short
      Term Borrowings





Although
      the Company has traditionally not experienced the need for overnight or other
      short-term borrowings, loan growth during the fourth quarter of 2004
      necessitated an overnight borrowing of $2,000,000 that was still outstanding
      at
      December 31, 2004. During the first quarter of 2005, the Company initiated
      $
      1,500,000 in new short-term borrowings and made repayments of $ 3,500,000.
      At
      December 31, 2006, the Company had no balances of short-term borrowings. Though
      this funding tool may be required in coming periods, Management prefers to
      fund
      growth through longer-term vehicles and expects instances of overnight
      borrowings to be limited.





**Capital
      Resources**





The
      assessment of capital adequacy depends on a number of factors such as asset
      quality, liquidity, earnings performance and changing competitive conditions
      and
      economic forces. The Company seeks to maintain a strong capital base to support
      its growth and expansion activities, to provide stability to current operations
      and to promote public confidence.





The
      Company's capital position continues to exceed regulatory minimums. The primary
      indicators relied on by the Federal Reserve Board and other bank regulators
      in
      measuring strength of capital position are the Tier 1 Capital, Total Capital
      and
      Leverage ratios. Tier 1 Capital consists of common stockholders' equity adjusted
      for unrealized gains and losses on securities. Total Capital consists of Tier
      1
      Capital and a portion of the allowance for loan losses. Risk-based capital
      ratios are calculated with reference to risk-weighted assets, which consist
      of
      both on and off-balance sheet risks.





The
      capital management function is an ongoing process. Central to this process
      is
      internal equity generation accomplished by earnings retention. During 2006,
      2005, and 2004, total stockholders' equity increased by $3,084,000, $2,337,000
      and $ 2,106,000, respectively, as a result of earnings retention and changes
      in
      the other comprehensive income. The return on average equity was 12.67% in
      2006
      compared to 11.53% for 2005 and 10.36% for 2004. Total cash dividends declared
      represent 29.91% of net income for 2006 compared to 30.99% of net income for
      2005 and 28.23% for 2004. Book value per share was $25.80 at December 31, 2006
      compared to $23.66 at December 31, 2005.








*Index*





Page
                Thirty





**Liquidity**





Operating
      liquidity is the ability to meet present and future financial obligations.
      Short-term liquidity is provided primarily through cash balances, deposits
      with
      other financial institutions, federal funds sold, non-pledged securities and
      loans maturing within one year. Additional sources of liquidity available to
      the
      Company include, but are not limited to, loan repayments, the ability to obtain
      deposits through the adjustment of interest rates and the purchasing of federal
      funds. To further meet its liquidity needs, the Company also maintains lines
      of
      credit with correspondent financial institutions, the Federal Reserve Bank
      of
      Richmond and the Federal Home Loan Bank of Pittsburgh.





Historically,
      the Company’s primary need for additional levels of operational liquidity has
      been to fund increases in loan balances. The
      Company has normally funded increases in loans by increasing deposits and
      decreases in secondary liquidity sources such as balances of federal funds
      sold
      and balances of securities. Although total deposit balances have decreased
      and
      increased slightly in the last two years, the Company has maintained or
      increased levels of secondary liquidity resources and does not anticipate that
      an unexpectedly high level of loan demand in coming periods would impact
      liquidity to the extent that the Company would be required to pay above market
      rates to obtain deposits.





The
      parent Company’s operating funds, funds with which to pay shareholder dividends
      and funds for the exploration of new business ventures have been supplied
      primarily through dividends paid by the Company’s two subsidiary Banks, Capon
      Valley Bank and The Grant County Bank. The various regulatory authorities impose
      restrictions on dividends paid by a state bank. A state bank cannot pay
      dividends without the consent of the relevant banking authorities in excess
      of
      the total net profits of the current year and the combined retained profits
      of
      the previous two years. As of January 1, 2006, the subsidiary Banks could pay
      dividends to Highlands Bankshares, Inc. of approximately $5,698,000 without
      permission of the regulatory authorities. The special dividend in October 2005
      from The Grant County Bank to Highlands Bankshares to fund the acquisition
      of
      The National Bank of Davis exceeded Grant’s dividend limit as of the date of the
      dividend. As part of the regulatory application process for the acquisition,
      the
      applicable banking authorities approved this dividend and the Company believes
      that the special, one time, dividend will not restrict Grant’s ability to pay
      dividends to the parent company in the coming periods.





**Effects
      of Inflation**





Inflation
      primarily affects industries having high levels of property, plant and equipment
      or inventories. Although the Company is not significantly affected in these
      areas, inflation does have an impact on the growth of assets. As assets grow
      rapidly, it becomes necessary to increase equity capital at proportionate levels
      to maintain the appropriate equity to asset ratios. Traditionally, the Company's
      earnings and high capital retention levels have enabled the Company to meet
      these needs.





The
      Company's reported earnings results have been minimally affected by inflation.
      The different types of income and expense are affected in various ways. Interest
      rates are affected by inflation, but the timing and magnitude of the changes
      may
      not coincide with changes in the consumer price index. Management actively
      monitors interest rate sensitivity, as illustrated by the gap analysis shown
      under the section titled Interest Rate Sensitivity, in order to minimize the
      effects of inflationary trends on interest rates. Other areas of non-interest
      expenses may be more directly affected by inflation.


*Index*





Page
                Thirty One





**Item
                7A.**
            **Quantitative
                and Qualitative Disclosures About Market
                Risk**





The
      greatest portion of the Company’s net income is derived from net interest
      income. As such, the greatest component of market risk is interest rate
      volatility. In conjunction with maintaining a satisfactory level of liquidity,
      management must also control the degree of interest rate risk assumed on the
      balance sheet. Managing this risk involves regular monitoring of the interest
      sensitive assets relative to interest sensitive liabilities over specific time
      intervals. Early withdrawal of deposits, greater than expected balances of
      new
      deposits, prepayments of loans and loan delinquencies are some of the factors
      that could affect actual versus expected cash flows. In addition, changes in
      rates on interest sensitive assets and liabilities may not be equal, which
      could
      result in a change in net interest margin. While the Company does not match
      each
      of its interest sensitive assets against specific interest sensitive
      liabilities, it does review its positions regularly and takes actions to
      reposition itself when necessary. With the largest amount of interest sensitive
      assets and liabilities re-pricing within one year, the Company believes it
      is in
      an excellent position to respond quickly to rapid market rate
      changes.





Interest
      rate market conditions may also affect portfolio composition of both assets
      and
      liabilities. Traditionally, the Company’s subsidiary Banks have primarily
      offered one-year adjustable rate mortgages (ARMs) to its mortgage loan
      customers. However, the low interest rate environment during 2003, 2004 and
      2005
      created intense competition, especially from larger banking institutions and
      finance companies offering long term fixed rate mortgages. As a result, the
      Company in recent periods has begun to write more mortgage loans with adjustable
      rates and maturities greater than one year. The increase in new ARM and balloon
      loans with two, three and five year adjustable rates has caused a shift in
      the
      maturity composition of the loan portfolio. This shift to longer term rates
      is
      partially responsible for the average rates earned on the loan portfolio to,
      in
      2005 and into 2006, lag behind increases in rates paid on deposits and rates
      earned on other earning assets. During the later portions of 2006, as the longer
      term ARM and balloon loans written in 2003, 2004 and 2005 began to re-price
      and
      as market rates for deposits began to flatten as compared to the growth seen
      in
      2005 and early 2006, the Company experienced a reversal in this lag as average
      loan rates began to increase more than average deposit rates.





Competition
      for new loans remains heavy. The result of this competition has also had the
      effect of causing increases in rates earned on loans to lag behind the increase
      in those seen on interest bearing liabilities. Should these influences continue
      into the future, the Company may experience a decrease in its net interest
      margin.





As
      a
      result of the low interest rate environment in past years, depositors seemed
      reluctant to commit to longer-term time deposits and in many instances appeared
      to hold monies temporarily in interest bearing transaction accounts in
      anticipation of rising rates in the future. This trend began to reverse in
      2005
      and the reversal continued into 2006 as time deposit balances increased as
      customers began moving deposits from the lower earning transaction accounts
      and
      into time deposits. Should interest rates begin to rise sharply in the coming
      periods, management believes that additional monies now in interest bearing
      transaction and savings accounts may further shift to time deposits, and this
      will cause a rise in the Company’s cost of funds. Alternatively, these balances
      may be transferred by customers to other financial institutions offering higher
      deposit rates or customers may require the Company to match such rates to retain
      the deposit.





At
      present, the Company’s largest challenge in managing its net interest income is
      the funding of loan growth. High levels of loan growth would require new
      funding, which has historically been met by increases in deposits. As
      competition for deposits increases and should the Company need funds to finance
      loan growth, it may be forced to pay higher rates than other local banking
      organizations to obtain these deposits. This would result in a reduction in
      the
      Company’s net interest margin and its net income. During 2004 and 2005 and into
      early 2006, loan growth was funded through reduction in balances of
      comparatively lower earning assets like securities and federal funds sold and
      borrowing from the FHLB. The result was that during 2004 deposit balances fell,
      especially balances of time deposits. Balances of federal funds sold and
      securities also fell and net interest margin increased as a result of this.
      During 2005, deposit balances increased slightly, and this, coupled with cash
      flows from operations, allowed federal funds sold balances to increase. In
      addition, the purchase of The National Bank of Davis added balances of liquid
      funds, both in cash balances and balances of federal funds sold and this will
      allow for loan growth in the coming periods without the immediate need for
      attracting significant amounts of new deposits.








*Index*





Page
                Thirty Two





In
      2006,
      the Company’s continued loan growth created a need for new deposit balances and
      the Company began offering more competitive rates on its deposits. As a result,
      deposit balances increased and the average rates paid on deposits increased.





Although
      it is expected that deposit rates will continue to rise, mnagement believes
      that
      with a significant portion of its loan portfolio re-pricing within one year
      that
      rising rates will not have a significant negative impact on the Company’s net
      interest earnings.





The
      following table illustrates the Company’s sensitivity to interest rate changes
      as of December 31, 2006 (in thousands of dollars):





1-90
              Days
            
            91-365
              Days
            
            1
                to 3
              Years
            
            3
                to 5
              Years
            
            More
                that 5
              years
                or no
              Maturity
            
            TotalEARNING
                ASSETSLoans
            
            $
            53,243
            
            $
            126,394
            
            $
            85,254
            
            $
            11,653
            
            $
            16,272
            
            $
            292,816Federal
                funds sold
            
            
            12,210
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            12,210Securities
            
            
            11,614
            
            
            6,237
            
            
            4,424
            
            
            1,624
            
            
            
            
            
            23,899Deposits
                in other banks
            
            
            1,321
            
            
            303
            
            
            
            
            
            
            
            
            
            
            
            1,624Total
            
            
            78,388
            
            
            132,934
            
            
            89,678
            
            
            13,277
            
            
            16,272
            
            
            330,549INTEREST
                BEARING LIABILITIESInterest
                bearing demand deposits
            
            
            25,363
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            25,363Savings
                deposits
            
            
            46,227
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            46,227Time
                deposits
            
            
            29,537
            
            
            102,577
            
            
            29,937
            
            
            20,117
            
            
            
            
            
            182,168Borrowed
                money
            
            
            2,447
            
            
            1,752
            
            
            1,028
            
            
            1,165
            
            
            8,600
            
            
            14,992Total
            
            
            103,574
            
            
            104,329
            
            
            30,965
            
            
            21,282
            
            
            8,600
            
            
            268,750Rate
                sensitivity gap
            
            $
            (25,186
            )
            $
            28,605
            
            $
            58,713
            
            $
            (8,005
            )
            $
            7,672
            
            $
            61,799Cumulative
                gap
            
            $
            (25,186
            )
            $
            3,419
            
            $
            62,132
            
            $
            54,127
            
            $
            61,799





*Index*





Page
                Thirty Three





**Item
                8.**
            **Financial
                Statements and Supplementary
                Data**





**HIGHLANDS
                BANKSHARES, INC.****CONSOLIDATED
                BALANCE SHEETS****December
                31, 2006 and 2005****(in
                thousands of dollars)**2006
            
            2005ASSETSCash
                and due from banks
            
            $
            7,111
            
            $
            8,850Interest
                bearing deposits in banks
            
            
            1,624
            
            
            963Federal
                funds sold
            
            
            12,210
            
            
            10,808Investment
                securities held to maturity
            
            
            170
            
            
            491Investment
                securities available for sale
            
            
            23,729
            
            
            27,130Restricted
                investments
            
            
            1,570
            
            
            1,250Loans
            
            
            292,816
            
            
            270,020Allowance
                for loan losses
            
            
            (3,482
            )
            
            (3,129
            )Bank
                premises and equipment
            
            
            8,099
            
            
            7,684Interest
                receivable
            
            
            2,173
            
            
            1,818Investment
                in life insurance contracts
            
            
            6,066
            
            
            6,396Goodwill
            
            
            1,534
            
            
            1,534Other
                intangible assets
            
            
            1,498
            
            
            1,674Other
                assets
            
            
            2,198
            
            
            2,084Total
                Assets
            
            $
            357,316
            
            $
            337,573LIABILITIESDepositsNon-interest
                bearing deposits
            
            
            46,726
            
            $
            47,753Interest
                bearing transaction and savings accounts
            
            
            71,590
            
            
            80,597Time
                deposits over $100,000
            
            
            54,867
            
            
            45,455All
                other time deposits
            
            
            127,301
            
            
            110,887Total
                Deposits
            
            
            300,484
            
            
            284,692Long
                term debt
            
            
            14,992
            
            
            15,063Accrued
                expenses and other liabilities
            
            
            4,764
            
            
            3,826Total
                Liabilities
            
            
            320,240
            
            
            303,581STOCKHOLDERS’
                EQUITYCommon
                Stock, $5 par value, 3,000,000 shares authorized, 1,436,874 shares
                issued
                and outstanding
            
            
            7,184
            
            
            7,184Surplus
            
            
            1,662
            
            
            1,662Retained
                earnings
            
            
            28,816
            
            
            25,651Other
                accumulated comprehensive loss
            
            
            (586
            )
            
            (505
            )Total
                Stockholders’ Equity
            
            
            37,076
            
            
            33,992Total
                Liabilities and Stockholders’ Equity
            
            $
            357,316
            
            $
            337,573The
                accompanying notes are an integral part of these
                statements





*Index*





Page
                Thirty Four





**HIGHLANDS
                BANKSHARES, INC.****CONSOLIDATED
                STATEMENTS OF INCOME****FOR
                THE YEARS ENDED DECEMBER 31, 2006, 2005 and 2004**(in
                thousands of dollars, except per share data)2006
            
            2005
            
            2004Interest
                and Dividend IncomeLoans,
                including fees
            
            $
            22,118
            
            $
            18,622
            
            $
            16,752Federal
                funds sold
            
            
            500
            
            
            343
            
            
            163Interest
                bearing deposits
            
            
            72
            
            
            38
            
            
            18Investment
                securities
            
            
            1,204
            
            
            810
            
            
            796Total
                Interest Income
            
            
            23,894
            
            
            19,813
            
            
            17,729Interest
                ExpenseInterest
                on deposits
            
            
            7,202
            
            
            5,130
            
            
            4,433Interest
                on borrowed money
            
            
            707
            
            
            631
            
            
            278Total
                Interest Expense
            
            
            7,909
            
            
            5,761
            
            
            4,711Net
                Interest Income
            
            
            15,985
            
            
            14,052
            
            
            13,018Provision
                for Loan Losses
            
            
            682
            
            
            875
            
            
            920Net
                Interest Income after Provision for Loan Losses
            
            
            15,303
            
            
            13,177
            
            
            12,098Non-interest
                IncomeService
                charges
            
            
            1,213
            
            
            876
            
            
            810Insurance
                commissions and income
            
            
            126
            
            
            227
            
            
            240Life
                insurance investment income
            
            
            380
            
            
            234
            
            
            251Gain
                on securities transactions
            
            
            
            
            
            6
            
            
            4Other
                operating income
            
            
            278
            
            
            326
            
            
            292Total
                Non-interest Income
            
            
            1,997
            
            
            1,669
            
            
            1,597Non-interest
                ExpensesSalaries
                and benefits
            
            
            5,671
            
            
            4,973
            
            
            4,876Occupancy
                expense
            
            
            467
            
            
            412
            
            
            401Equipment
                expense
            
            
            879
            
            
            836
            
            
            813Data
                processing expense
            
            
            811
            
            
            632
            
            
            671Legal
                and professional fees
            
            
            420
            
            
            440
            
            
            342Directors
                fees
            
            
            392
            
            
            341
            
            
            328Other
                operating expenses
            
            
            1,754
            
            
            1,494
            
            
            1,507Total
                Non-interest Expenses
            
            
            10,394
            
            
            9,128
            
            
            8,938Income
                Before Income Tax Expense
            
            
            6,906
            
            
            5,718
            
            
            4,757Income
                Tax Expense
            
            
            2,391
            
            
            1,916
            
            
            1,551Net
                Income
            
            $
            4,515
            
            $
            3,802
            
            $
            3,206Earnings
                Per Share
            
            $
            3.14
            
            $
            2.65
            
            $
            2.23Dividends
                Per Share
            
            
            .94
            
            
            .82
            
            
            .63Weighted
                Average Shares Outstanding
            
            
            1,436,874
            
            
            1,436,874
            
            
            1,436,874The
                accompanying notes are an integral part of these
                statements





*Index*





Page
                Thirty Five





**HIGHLANDS
                        BANKSHARES, INC.****CONSOLIDATED
                        STATEMENTS OF STOCKHOLDERS’ EQUITY**(in
                        thousands of dollars)Common
                      Stock
                    
                    
                    Surplus
                    
                    
                    Retained
                      Earnings
                    
                    
                    Accumulated
                      Other
                      Comprehensive
                      Income
                        (Loss)
                    
                    
                    TotalBalances
                        January 1, 2004
                    
                    $
                    7,184
                    
                    
                    $
                    1,662
                    
                    
                    $
                    20,727
                    
                    
                    $
                    (24
                    )
                    
                    $
                    29,549Comprehensive
                        Income:Net
                        income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3,206
                    
                    
                    
                    
                    
                    
                    
                    3,206Change
                        in other comprehensive income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (195
                    )
                    
                    
                    (195
                    )Total
                        Comprehensive Income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3,011Cash
                        Dividends
                    
                    
                    
                    
                    
                    
                    
                    
                    (905
                    )
                    
                    
                    
                    
                    
                    (905
                    )Balances
                        December 31, 2004
                    
                    
                    7,184
                    
                    
                    
                    1,662
                    
                    
                    
                    23,028
                    
                    
                    
                    (219
                    )
                    
                    
                    31,655Comprehensive
                        Income:Net
                        income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3,802
                    
                    
                    
                    
                    
                    
                    
                    3,802Change
                        in other comprehensive income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (286
                    )
                    
                    
                    (286
                    )Total
                        Comprehensive Income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3,516Cash
                        Dividends
                    
                    
                    
                    
                    
                    
                    
                    
                    (1,179
                    )
                    
                    
                    
                    
                    
                    (1,179
                    )Balances
                        December 31, 2005
                    
                    
                    7,184
                    
                    
                    
                    1,662
                    
                    
                    
                    25,651
                    
                    
                    
                    (505
                    )
                    
                    
                    33,992Comprehensive
                        Income:Net
                        income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    4,515
                    
                    
                    
                    
                    
                    
                    
                    4,515Change
                        in other comprehensive income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (81
                    )
                    
                    
                    (81
                    )Total
                        Comprehensive Income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    4,434Cash
                        Dividends
                    
                    
                    
                    
                    
                    
                    
                    
                    (1,350
                    )
                    
                    
                    
                    
                    
                    (1,350
                    )Balances
                        December 31, 2006
                    
                    $
                    7,184
                    
                    
                    $
                    1,662
                    
                    
                    $
                    28,816
                    
                    
                    $
                    (586
                    )
                    
                    $
                    37,076The
                        accompanying notes are an integral part of these
                        statements





*Index*





Page
                Thirty Six





**HIGHLANDS
                    BANKSHARES, INC.****CONSOLIDATED
                    STATEMENTS OF CASH FLOWS****FOR
                    THE YEARS ENDED DECEMBER 31, 2006, 2005 and 2004**(in
                    thousands of dollars)Years
                    Ended December 31,2006
                
                
                2005
                
                
                2004CASH
                    FLOWS FROM OPERATING ACTIVITIESNet
                    Income
                
                $
                4,515
                
                
                $
                3,802
                
                
                $
                3,206Adjustments
                    to reconcile net income to net cash provided by operating
                    activitiesGain
                    on securities transactions
                
                
                0
                
                
                
                (6
                )
                
                
                (4
                )(Gain)
                    loss on sale of property
                
                
                (7
                )
                
                
                (19
                )
                
                
                1Depreciation
                
                
                691
                
                
                
                692
                
                
                
                666Income
                    from life insurance contracts
                
                
                (380
                )
                
                
                (234
                )
                
                
                (251
                )Net
                    amortization of securities premiums
                
                
                (182
                )
                
                
                39
                
                
                
                248Provision
                    for loan losses
                
                
                682
                
                
                
                875
                
                
                
                920Deferred
                    income tax benefit
                
                
                (115
                )
                
                
                (170
                )
                
                
                (103
                )Amortization
                    of intangibles
                
                
                176
                
                
                
                38
                
                
                
                10Decrease
                    (Increase) in interest receivable
                
                
                (355
                )
                
                
                (294
                )
                
                
                282Decrease
                    (Increase) in other assets
                
                
                1
                
                
                
                95
                
                
                
                555Increase
                    (Decrease) in accrued expenses
                
                
                938
                
                
                
                207
                
                
                
                (69
                )Net
                    Cash Provided by Operating Activities
                
                
                5,964
                
                
                
                5,025
                
                
                
                5,461CASH
                    FLOWS FROM INVESTING ACTIVITIESSale
                    of property
                
                
                7
                
                
                
                19
                
                
                
                0Proceeds
                    from maturity of securities held to maturity
                
                
                320
                
                
                
                670
                
                
                
                201Proceeds
                    from maturity of securities available for sale
                
                
                11,539
                
                
                
                12,654
                
                
                
                15,244Purchase
                    of securities available for sale
                
                
                (7,870
                )
                
                
                (8,083
                )
                
                
                (7,832
                )Increase
                    in restricted investments
                
                
                (320
                )
                
                
                (77
                )
                
                
                (232
                )Net
                    change in interest bearing deposits in other banks
                
                
                (661
                )
                
                
                (312
                )
                
                
                536Net
                    increase in loans
                
                
                (23,125
                )
                
                
                (13,442
                )
                
                
                (22,734
                )Settlement
                    on insurance contract, net of gain
                
                
                555
                
                
                
                0
                
                
                
                0Net
                    change in federal funds sold
                
                
                (1,402
                )
                
                
                (768
                )
                
                
                12,712Purchase
                    of property and equipment
                
                
                (1,117
                )
                
                
                (281
                )
                
                
                (265
                )Purchase
                    of branch operations, net of cash received
                
                
                0
                
                
                
                (893
                )
                
                
                0Net
                    Cash Provided by (Used in) Investing Activities
                
                
                (22,074
                )
                
                
                (10,513
                )
                
                
                (2,370
                )CASH
                    FLOWS FROM FINANCING ACTIVITIESNet
                    change in time deposits
                
                
                25,826
                
                
                
                5,793
                
                
                
                (15,993
                )Net
                    change in other deposit accounts
                
                
                (10,034
                )
                
                
                (1,150
                )
                
                
                7,699Additional
                    long term debt
                
                
                2,300
                
                
                
                8,200
                
                
                
                3,800Repayment
                    of long term debt
                
                
                (2,371
                )
                
                
                (1,513
                )
                
                
                (719
                )Additional
                    (repayment of) short term borrowings
                
                
                
                
                
                
                (2,000
                )
                
                
                2,000Dividends
                    paid in cash
                
                
                (1,350
                )
                
                
                (1,179
                )
                
                
                (905
                )Net
                    Cash Provided by (Used in) Financing Activities
                
                
                14,371
                
                
                
                8,151
                
                
                
                (4,118
                )CASH
                    AND CASH EQUIVALENTSNet
                    increase (decrease) in cash and due from banks
                
                
                (1,739
                )
                
                
                2,663
                
                
                
                (1,027
                )Cash
                    and due from banks, beginning of year
                
                
                8,850
                
                
                
                6,187
                
                
                
                7,214Cash
                    and due from banks, end of year
                
                $
                7,111
                
                
                $
                8,850
                
                
                $
                6,187Supplemental
                    Disclosures, Cash Paid For:Interest
                    Expense
                
                $
                7,529
                
                
                $
                5,523
                
                
                $
                4,920Income
                    Taxes
                
                $
                2,381
                
                
                $
                1,984
                
                
                $
                1,183The
                    accompanying notes are an integral part of these
                    statements





*Index*





Page
                Thirty Seven





**Note
                One: Summary of Operations**





Highlands
      Bankshares, Inc. (the "Company") is a bank holding company and operates under
      a
      charter issued by the state of West Virginia. The Company owns all of the
      outstanding stock of The Grant County Bank ("Grant") and Capon Valley Bank
      ("Capon"), which operate under charters issued by the state of West Virginia.
      The Company also owns all of the outstanding stock of HBI Life Insurance
      Company, Inc. ("HBI Life"), which operates under a charter issued in Arizona.
      State chartered banks are subject to regulation by the West Virginia Division
      of
      Banking, The Federal Reserve Bank and the Federal Deposit Insurance Corporation,
      while the insurance company is regulated by the Arizona Department of Insurance.
      The Banks provide services to customers located mainly in Grant, Hardy,
      Hampshire, Mineral, Pendleton, Randolph and Tucker counties of West Virginia,
      including the towns of Petersburg, Keyser, Moorefield, Davis and Wardensville
      through ten locations and the county of Frederick in Virginia through a single
      location. The insurance company sells life and accident coverage exclusively
      through the Company's subsidiary Banks.





**Note
                Two: Summary of Significant Accounting
                Policies**





The
      accounting and reporting policies of Highlands Bankshares, Inc. and its
      subsidiaries conform to accounting principles generally accepted in the United
      States of America and to accepted practice within the banking
      industry.





(a)
              Principles
                  of Consolidation





The
      consolidated financial statements include the accounts of The Grant County
      Bank,
      Capon Valley Bank and HBI Life Insurance Company. During 2005, the Company
      purchased all of the outstanding shares of The National Bank of Davis (“Davis”)
      (see Note Nineteen) and these operations are included subsequent to the
      purchase. All significant inter-company accounts and transactions have been
      eliminated.





(b)
              Use
                  of Estimates in the Preparation of Financial
                  Statements





In
      preparing the financial statements, management is required to make estimates
      and
      assumptions that affect the reported amounts in those statements; actual results
      could differ significantly from those estimates. A material estimate that is
      particularly susceptible to significant changes in the near term is the
      determination of the allowance for loan losses, which is sensitive to changes
      in
      local economic conditions.





(c)
              Cash
                  and Cash Equivalents





For
      purposes of the statements of cash flows, cash and cash equivalents include
      cash
      on hand and non-interest bearing funds at correspondent
      institutions.





(d)
              Foreclosed
                  Real Estate





The
      components of foreclosed real estate are adjusted to the fair value of the
      property at the time of acquisition, less estimated costs of disposal. The
      current year provision for a valuation allowance has been recorded as an expense
      to current operations.





(e)
              Securities





Securities
      that the Company has both the positive intent and ability to hold to maturity
      (at time of purchase) are classified as held to maturity securities. All other
      securities are classified as available for sale. Securities held to maturity
      are
      carried at historical cost and adjusted for amortization of premiums and
      accretion of discounts, using the effective interest method. Securities
      available for sale are carried at fair value with any valuation adjustments
      reported, net of deferred taxes, as other accumulated comprehensive
      income.





Restricted
      investments consist of investments in the Federal Home Loan Bank of Pittsburgh,
      the Federal Reserve Bank of Richmond and West Virginia Bankers’ Title Insurance
      Company. Such investments are required as members of these institutions and
      these investments cannot be sold without a change in the members' borrowing
      or
      service levels. Because there is no readily determinable market value for these
      investments, restricted investments are carried at cost on the Company’s balance
      sheet.








*Index*





Page
                Thirty Eight








Interest
      and dividends on securities and amortization of premiums and discounts on
      securities are reported as interest income using the effective interest method.
      Gains (losses) realized on sales and calls of securities are determined using
      the specific identification method.





(f)
              Loans





Loans
      are
      carried on the balance sheet net of unearned interest and allowance for loan
      losses. Interest income on loans is determined using the effective interest
      method based on the daily amount of principal outstanding except where serious
      doubt exists as to collectibility of the loan, in which case the accrual of
      income is discontinued. Loans are placed on non-accrual status or charged off
      if
      collection of principal or interest becomes doubtful. The interest on these
      loans is accounted for on a cash-basis or cost-recovery method until qualifying
      for return to accrual status. Loans are returned to accrual status when all
      the
      principal and interest amounts contractually due are brought current and the
      loan is performing as agreed.





(g)
              Allowance
                  For Loan Losses





The
      allowance for loan losses is established as losses are estimated to have
      occurred through a provision for loan losses charged to earnings. Loan losses
      are charged against the allowance when management believes the uncollectibility
      of a loan balance is confirmed. Subsequent recoveries, if any, are credited
      to
      the allowance.





The
      allowance for loan losses is evaluated on a regular basis by management and
      is
      based upon management's periodic review of the collectibility of the loans
      in
      light of historical experience, the nature and volume of the loan portfolio,
      adverse situations that may affect the borrower's ability to repay, estimated
      value of any underlying collateral and prevailing economic conditions. This
      evaluation is inherently subjective, as it requires estimates that are
      susceptible to significant revision as more information becomes
      available.





The
      impairment of loans that have been separately identified for evaluation is
      measured based on the present value of expected future cash flows or,
      alternatively, the observable market price of the loans or the fair value of
      the
      collateral. However, for those loans that are collateral dependent (that is,
      if
      repayment of those loans is expected to be provided solely by the underlying
      collateral) and for which management has determined foreclosure is possible,
      the
      measure of impairment of those loans is to be based on the fair value of the
      collateral. Large groups of smaller balance homogenous loans are collectively
      evaluated for impairment. Accordingly, the Company does not separately identify
      individual consumer and residential loans for impairment
      disclosures.





(h)
              Per
                  Share Calculations





Earnings
      per share are based on the weighted average number of shares outstanding.





(i)
              Bank
                  Premises and Equipment





Bank
      premises and equipment are stated at cost less accumulated depreciation. Assets
      acquired in the acquisition of Davis have been recorded at their fair value.
      Depreciation is charged to income over the estimated useful lives of the assets
      using a combination of the straight line and accelerated methods. The costs
      of
      maintenance, repairs, renewals, and improvements to buildings, equipment and
      furniture and fixtures are charged to operations as incurred. Gains and losses
      on routine dispositions are reflected in other income or expense.





*Index*





Page
                Thirty Nine





(j)
              Recent
                  Accounting Standards





In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No.
      158, “Employers Accounting for Defined Benefit Pension and Other Postretirement
      Plans—an amendment of FASB Statements No. 87, 88, 106 and 132R” (SFAS 158). SFAS
      158 requires an employer to recognize the over-funded or under-funded status
      of
      a defined benefit postretirement plan as an asset or liability in its statement
      of financial position and to recognize changes in that funded status, through
      comprehensive income, in the year in which the changes occur. The funded status
      of a benefit plan will be measured as the difference between plan assets at
      fair
      value and benefit obligation. For any other postretirement plan, the benefit
      obligation is the accumulated postretirement benefit obligation. SFAS 158 also
      requires an employer to measure the funded status of a plan as of the date
      of
      its year-end statement of financial position. The Statement also requires
      additional disclosures in the notes to financial statements about certain
      effects on net periodic benefit cost for the next fiscal year that arise from
      delayed recognition of the gains or losses, prior service costs or credits,
      and
      transition asset or obligation. Under SFAS 158 a company is required to
      initially recognize the funded status of a defined benefit postretirement plan
      to provide the required disclosures as of the end of the fiscal year ending
      after December 15, 2006. The requirement to measure plan assets and benefit
      obligations as of the date of the employer’s fiscal year end statement of
      financial position is effective for fiscal years ending after December 15,
      2008.
      The Grant County Bank is a member of the West Virginia Bankers' Association
      Retirement Plan, a defined benefit plan under SFAS 158.





No
      other
      recent accounting pronouncements had a material impact on the Company’s
      consolidated financial statements, and is is believed that none will have a
      material impact on the Company’s operations in future years.





(k)
              Income
                  Taxes





Amounts
      provided for income tax expense are based on income reported for financial
      statement purposes rather than amounts currently payable under federal and
      state
      tax laws. Deferred taxes, which arise principally from differences between
      the
      period in which certain income and expenses are recognized for financial
      accounting purposes and the period in which they affect taxable income, are
      included in the amounts provided for income taxes.





(l)
              Comprehensive
                  Income





Accounting
      principles generally require that recognized revenue, expenses, gains and losses
      be included in net income. Certain changes in assets and liabilities, such
      as
      unrealized gains and losses on available-for-sale securities and accrued pension
      liabilities, are reported along with net income as the components of
      comprehensive income.





(m)
              Bank
                  Owned Life Insurance
                  Contracts





The
      Company has invested in and owns life insurance polices on key officers. The
      policies are designed so that the Company recovers the interest expenses
      associated with carrying the policies and the officer will, at the time of
      retirement, receive any earnings in excess of the amounts earned by the
      Company.





The
      Company recognizes as an asset the net amount that could be realized under
      the
      insurance contract as of the balance sheet date. This amount represents the
      cash
      surrender value of the policies less applicable surrender charges.





The
      portion of the benefits, which will be received by the executives at the time
      of
      their retirement, is considered, when taken collectively, to constitute a
      retirement plan. Therefore the Company accounts for these policies using
      guidance found in Statement of Financial Accounting Standards No. 106,
      "Employers' Accounting for Post Retirement Benefits Other Than Pensions.” SFAS
      No. 106 requires that an employers' obligation under a deferred compensation
      agreement be accrued over the expected service life of the employee through
      their normal retirement date.





(n)
              Advertising





Advertising
      costs are expensed as they are incurred. Advertising expense for the years
      ended
      December 31, 2006, 2005 and 2004 was $ 198,000, $158,000 and $161,000
      respectively .


*Index*





Page
                Forty





(o)
              Goodwill
                  and Other Intangible Assets





Goodwill
      represents the cost in excess of the fair value of net assets acquired
      (including identifiable intangibles) in transactions accounted for as purchases.
      In accordance with provisions of SFAS No. 142, "Goodwill and Other Intangible
      Assets", goodwill is not amortized over an estimated useful life, but rather
      will be tested at least annually for impairment. As of December 31, 2006, the
      Company found the goodwill acquired in the Davis acquisition to not be
      impaired.





Core
      deposit and other intangible assets include premiums paid for acquisitions
      of
      core deposits (core deposit intangibles) and other identifiable intangible
      assets. Intangible assets other than goodwill, which are determined to have
      finite lives, are amortized based upon the estimated economic benefits received,
      which is ten years for the core deposit intangibles.





(p)
              Reclassifications





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








**Note
                Three: Securities**





The
      income derived from taxable and non-taxable securities for the years ended
      December 31, 2006, 2005 and 2004 is shown below (in thousands of
      dollars):





Year
                      Ended December 31,2006
                  
                  
                  2005
                  
                  
                  2004Investment
                      securities, taxable
                  
                  
                  1,095
                  
                  
                  
                  707
                  
                  
                  
                  674Investment
                      securities, nontaxable
                  
                  
                  109
                  
                  
                  
                  103
                  
                  
                  
                  122








The
      carrying amount and estimated fair value of securities held to maturity at
      December 31, 2006 and 2005 are as follows (in thousands of
      dollars):





Held
                    to Maturity SecuritiesAmortized
                  Cost
                
                
                Unrealized
                  Gains
                
                
                Unrealized
                  Losses
                
                
                Fair
                  ValueDecember
                    31, 2006State
                    and municipals
                
                $
                170
                
                
                $
                --
                
                
                $
                --
                
                
                $
                170Total
                    Securities Held to Maturity
                
                $
                170
                
                
                $
                --
                
                
                $
                --
                
                
                $
                170December
                    31, 2005State
                    and municipals
                
                $
                491
                
                
                $
                3
                
                
                $
                --
                
                
                $
                494Total
                    Securities Held to Maturity
                
                $
                491
                
                
                $
                3
                
                
                $
                --
                
                
                $
                494





Securities
      having a carrying value of $7,273,000 at December 31, 2006 were pledged to
      secure public deposits and for other purposes required by law.


*Index*





Page
                Forty One





The
      carrying amount and estimated fair value of securities available for sale at
      December 31, 2006 and 2005 are as follows (in thousands of
      dollars):





Available
                    for Sale SecuritiesAmortized
                  Cost
                
                
                Unrealized
                  Gains
                
                
                Unrealized
                  Losses
                
                
                Fair
                  ValueDecember
                    31, 2006U.S.
                    Treasuries and Agencies
                
                $
                14,397
                
                
                $
                46
                
                
                $
                40
                
                
                $
                14,403Mortgage
                    backed securities
                
                
                6,547
                
                
                
                32
                
                
                
                25
                
                
                
                6,554State
                    and municipals
                
                
                2,763
                
                
                
                3
                
                
                
                22
                
                
                
                2,744Marketable
                    equities
                
                
                28
                
                
                
                ---
                
                
                
                ---
                
                
                
                28Total
                    Securities Available for Sale
                
                $
                23,735
                
                
                $
                81
                
                
                $
                87
                
                
                $
                23,729December
                    31, 2005U.S.
                    Treasuries and Agencies
                
                $
                17,352
                
                
                $
                19
                
                
                $
                137
                
                
                $
                17,234Mortgage
                    backed securities
                
                
                7,172
                
                
                
                30
                
                
                
                39
                
                
                
                7,163State
                    and municipals
                
                
                2,719
                
                
                
                6
                
                
                
                20
                
                
                
                2,705Marketable
                    equities
                
                
                28
                
                
                
                ---
                
                
                
                ---
                
                
                
                28Total
                    Securities Available for Sale
                
                $
                27,271
                
                
                $
                55
                
                
                $
                196
                
                
                $
                27,130





The
      carrying amount and fair value of debt securities at December 31, 2006, by
      contractual maturity are shown below (in thousands of dollars). Expected
      maturities will differ from contractual maturities because borrowers may have
      the right to call or prepay obligations with or without call or prepayment
      penalties.





Securities
                          Held to MaturityAmortized
                          Cost
                      
                      
                      Fair
                          ValueDue
                          in one year or less
                      
                      $
                      170
                      
                      
                      $
                      170Total
                          Securities Held to Maturity
                      
                      $
                      170
                      
                      
                      $
                      170Securities
                          Available for SaleAmortized
                          Cost
                      
                      
                      Fair
                          ValueDue
                          in one year or less
                      
                      $
                      8,408
                      
                      
                      $
                      8,380Due
                          after one year through five years
                      
                      
                      8,753
                      
                      
                      
                      8,767Mortgage
                          backed securities
                      
                      
                      6,546
                      
                      
                      
                      6,554Equity
                          securities with no maturity
                      
                      
                      28
                      
                      
                      
                      28Total
                          Securities Available for Sale
                      
                      $
                      23,735
                      
                      
                      $
                      23,729





*Index*





Page
                Forty Two





Information
      pertaining to securities with gross unrealized losses at December 31, 2006
      and
      2005, aggregated by investment category and length of time that individual
      securities have been in a continuous loss position is shown in the table below
      (in thousands of dollars):





Total
                
                
                Less
                    than 12 Months
                
                
                12
                    Months or GreaterFair
                  Value
                
                
                Gross
                  Unrealized
                  Losses
                
                
                Fair
                  Value
                
                
                Gross
                  Unrealized
                  Losses
                
                
                Fair
                  Value
                
                
                Gross
                  Unrealized
                  LossesDecember
                    31, 2006Investment
                    CategoryU.S.
                    Treasury and Agency
                
                $
                9,635
                
                
                $
                (40
                )
                
                $
                3,426
                
                
                $
                (6
                )
                
                $
                6,209
                
                
                $
                (34
                )Mortgage
                    backed securities
                
                
                3,233
                
                
                
                (25
                )
                
                
                34
                
                
                
                (1
                )
                
                
                3,199
                
                
                
                (24
                )State
                    and municipals
                
                
                2,106
                
                
                
                (22
                )
                
                
                891
                
                
                
                (7
                )
                
                
                1,215
                
                
                
                (15
                )Total
                
                $
                14,974
                
                
                $
                (87
                )
                
                $
                4,351
                
                
                $
                (14
                )
                
                $
                10,623
                
                
                $
                (73
                )December
                    31, 2005Investment
                    CategoryU.S.
                    Treasury and Agency
                
                $
                15,077
                
                
                $
                (137
                )
                
                $
                6,643
                
                
                $
                (52
                )
                
                $
                8,434
                
                
                $
                (85
                )Mortgage
                    backed securities
                
                
                4,289
                
                
                
                (39
                )
                
                
                3,569
                
                
                
                (27
                )
                
                
                720
                
                
                
                (12
                )State
                    and municipals
                
                
                2,042
                
                
                
                (20
                )
                
                
                1,117
                
                
                
                (15
                )
                
                
                925
                
                
                
                (5
                )Total
                
                $
                21,408
                
                
                $
                (196
                )
                
                $
                11,329
                
                
                $
                (94
                )
                
                $
                10,079
                
                
                $
                (102
                )





The
      number of securities available for sale that were in an unrealized loss position
      at December 31, 2006 is summarized in the table below:





Total
                
                
                Loss
                    Position
                  less
                    than 12
                  Months
                
                
                Loss
                    Position
                  greater
                    than 12
                  MonthsU.S.
                    Treasuries and Agencies
                
                
                23
                
                
                
                10
                
                
                
                13Mortgage
                    backed securities
                
                
                14
                
                
                
                13
                
                
                
                1States
                    and municipals
                
                
                10
                
                
                
                5
                
                
                
                5Total
                
                
                47
                
                
                
                28
                
                
                
                19








It
      is
      management’s determination that all securities held at December 31, 2006, which
      have fair values less than the amortized cost, have gross unrealized losses
      related to increases in the current interest rates for similar issues of
      securities and that no material impairment for any securities in the portfolio
      exist because of downgrades of the securities or as a result of a change in
      the
      financial condition of any of the issuers.


*Index*





Page
                Forty Three








**Note
                Four: Restricted
                Investments**





Restricted
      investments at December 31, 2006 consist of investments in the Federal Reserve
      Bank (FRB), Federal Home Loan Bank (FHLB) and West Virginia Bankers’ Title
      Insurance Company. These investments are carried at face value. The level of
      investment in the FRB and FHLB is dictated by the level of participation with
      each institution. All of these investments are restricted as to transferability.
      Investments in the FHLB act as a collateral against the outstanding borrowings
      from that institution.








**Note
                Five: Loans**





Loans
      outstanding as of December 31, 2006 and 2005 are summarized as follows (in
      thousands of dollars):





2006
                  
                  
                  2005Commercial
                  
                  $
                  70,408
                  
                  
                  $
                  57,908Real
                      Estate Construction
                  
                  
                  14,828
                  
                  
                  
                  12,201Real
                      Estate Mortgage
                  
                  
                  164,243
                  
                  
                  
                  153,646Consumer
                      Installment
                  
                  
                  43,337
                  
                  
                  
                  46,265Total
                      Loans
                  
                  $
                  292,816
                  
                  
                  $
                  270,020











The
      following is a summary of information pertaining to impaired and non accrual
      loans at December 31, 2006 and 2005 (in thousands of dollars):





2006
                  
                  
                  2005Year
                      end balance, impaired loans
                  
                  $
                  1,895
                  
                  
                  $
                  1,494Allowance
                      for impairments, year end
                  
                  
                  720
                  
                  
                  
                  353Average
                      balance impaired loans, year ended December 31
                  
                  
                  1,773
                  
                  
                  
                  1,576Income
                      recorded on impaired loans, year ended December 31
                  
                  
                  131
                  
                  
                  
                  104





No
      loans
      were identified as impaired as of December 31 for which an allowance was not
      provided.





Certain
      loans identified as impaired are placed into non-accrual status, based upon
      the
      loans’ performance compared with contractual terms. Not all loans identified as
      impaired are placed upon non-accrual status. The interest on loans identified
      as
      impaired and also placed in non-accrual status and not recognized as income
      throughout the year was of an immaterial amount in both 2006 and
      2005.





Balances
      of non-accrual loans and loans past due ninety days or greater and still
      accruing interest at December 31, 2006 and 2005 are shown below (in thousands
      of
      dollars):





2006
                  
                  
                  2005Non-accrual
                      loans at year end
                  
                  $
                  244
                  
                  
                  $
                  743Loans
                      past due ninety days or greater and still accruing interest
                      at year
                      end
                  
                  
                  1,457
                  
                  
                  
                  1,189





*Index*





Page
                Forty Four





**Note
                Six: Allowance For Loan
                Losses**





A
      summary
      of the changes in the allowance for loan losses for the years ended December
      31,
      2006, 2005 and 2004 is show below (in thousands of dollars):





2006
                
                
                2005
                
                
                2004Balance
                    at beginning of year
                
                $
                3,129
                
                
                $
                2,530
                
                
                $
                2,463Provision
                    charged to operating expenses
                
                
                682
                
                
                
                875
                
                
                
                920Other
                    additions
                
                
                0
                
                
                
                166
                
                
                
                0Loan
                    recoveries
                
                
                250
                
                
                
                178
                
                
                
                308Loans
                    charged off
                
                
                (579
                )
                
                
                (620
                )
                
                
                (1,161
                )Balance
                    at end of year
                
                $
                3,482
                
                
                $
                3,129
                
                
                $
                2,530Allowance
                    for Loan Losses as percentage of outstanding loans at year
                    end
                
                
                1.19
                %
                
                
                1.16
                %
                
                
                1.02
                %








**Note
                Seven: Bank Premises and
                Equipment**





Bank
      premises and equipment as of December 31, 2006 and 2005 are summarized as
      follows (in thousands of dollars):





2006
                  
                  
                  2005Land
                  
                  $
                  1,398
                  
                  
                  $
                  1,323Buildings
                      and improvements
                  
                  
                  7,897
                  
                  
                  
                  7,350Furniture
                      and equipment
                  
                  
                  5,383
                  
                  
                  
                  4,902Total
                      Cost
                  
                  
                  14,678
                  
                  
                  
                  13,575Less
                      accumulated depreciation
                  
                  
                  (6,579
                  )
                  
                  
                  (5,891
                  )Net
                      Book Value
                  
                  $
                  8,099
                  
                  
                  $
                  7,684





Provisions
      for depreciation charged to operations during 2006, 2005 and 2004 were as
      follows (in thousands of dollars):





Year
                      
                      Provision
                          for
                        Depreciation2006
                      
                      $
                      6912005
                      
                      
                      6922004
                      
                      
                      666





*Index*





Page
                Forty Five





**Note
                Eight: Deposits**





At
      December 31, 2006, the scheduled maturities of time deposits were as follows
      (in
      thousands of dollars):





Year
                      
                      Amount
                          Maturing2007
                      
                      $
                      132,1142008
                      
                      
                      23,8442009
                      
                      
                      6,0932010
                      
                      
                      9,1872011
                      
                      
                      10,930Total
                      
                      $
                      182,168





Interest
      expense on time deposits of $100,000 and over aggregated $2,086,000, $1,453,000
      and $1,349,000 for 2006, 2005 and 2004, respectively.





The
      aggregate amount of demand deposit overdrafts reclassified as loan balances
      were
      $138,000 and $115,000 at December 31, 2006 and 2005, respectively.








**Note
                Nine: Borrowed Money**





The
      Company has borrowed money from the Federal Home Loan Bank of Pittsburgh (FHLB).
      These borrowings have typically been for maturities of six months or longer.
      The
      various borrowings mature from 2007 to 2020. The interest rates on the various
      borrowings at December 31, 2006 range from 3.30% to 6.12%. The weighted average
      interest rate on the borrowings at December 31, 2006 was 4.50%. The Company
      has
      total borrowing capacity from the FHLB of $166,278,000. The Banks have pledged
      certain investments and mortgage loans as collateral on the FHLB borrowings
      in
      the approximate amount of $ 166,278,000 at December 31, 2006.





The
      subsidiary Banks also have short term borrowing capacity from each of their
      respective correspondent banks. As of December 31, 2006 the Company has total
      borrowing capacity from its correspondent banks of $25,300,000. The interest
      rates on these lines are variable and are subject to change daily based on
      current market conditions.





Repayments
      of long-term debt are due either monthly, quarterly or in a single payment
      at
      maturity. The maturities of long-term debt as of December 31, 2006 are as
      follows (in thousands of dollars):





Year
                    
                    Balance2007
                    
                    $
                    4,1992008
                    
                    
                    5682009
                    
                    
                    4602010
                    
                    
                    4812011
                    
                    
                    683Thereafter
                    
                    
                    8,601Total
                    
                    $
                    14,992





In
      addition to the above facility, the Company has a line of credit with an
      unrelated financial institution for $2,500,000. The Company has not drawn on
      this line and the full amount is available for future borrowings, if needed.





*Index*





Page
                Forty Six








**Note
                Ten: Restrictions on Dividends of Subsidiary
                Banks**





The
      principal source of funds of Highlands Bankshares, Inc. is dividends paid by
      its
      subsidiary Banks. The various regulatory authorities impose restrictions on
      dividends paid by a state bank. A state bank cannot pay dividends (without
      the
      consent of state banking authorities) in excess of the total net profits (net
      income less dividends paid) of the current year to date and the combined
      retained profits of the previous two years. As of January 1, 2007, the Banks
      could pay dividends to Highlands Bankshares, Inc. of approximately $5,698,000
      without permission of the regulatory authorities.








**Note
                Eleven: Income Tax Expense**





The
      components of income tax expense for the years ended December 31, 2006, 2005
      and
      2004 are summarized in the table below (in thousands of dollars):





2006
                    
                    
                    2005
                    
                    
                    2004Current
                        ExpenseFederal
                    
                    $
                    2,154
                    
                    
                    $
                    1,814
                    
                    
                    $
                    1,420State
                    
                    
                    352
                    
                    
                    
                    272
                    
                    
                    
                    234Total
                        Current Expense
                    
                    
                    2,506
                    
                    
                    
                    2,086
                    
                    
                    
                    1,654Deferred
                        Expense (Benefit)Federal
                    
                    
                    (107
                    )
                    
                    
                    (149
                    )
                    
                    
                    (99
                    )State
                    
                    
                    (8
                    )
                    
                    
                    (21
                    )
                    
                    
                    (4
                    )Total
                        Current Expense (Benefit)
                    
                    
                    (115
                    )
                    
                    
                    (170
                    )
                    
                    
                    (103
                    )Income
                        Tax Expense
                    
                    $
                    2,391
                    
                    
                    $
                    1,916
                    
                    
                    $
                    1,551





The
      deferred tax effects of temporary differences for the years ended December
      31,
      2006, 2005 and 2004 are as follows (in thousands of dollars):





2006
                    
                    
                    2005
                    
                    
                    2004Provision
                        for loan losses
                    
                    $
                    (140
                    )
                    
                    $
                    (193
                    )
                    
                    $
                    (8
                    )Depreciation
                    
                    
                    (45
                    )
                    
                    
                    (45
                    )
                    
                    
                    18Deferred
                        compensation
                    
                    
                    (39
                    )
                    
                    
                    59
                    
                    
                    
                    (125
                    )Loss
                        carry forward
                    
                    
                    71
                    
                    
                    
                    0
                    
                    
                    
                    0Miscellaneous
                    
                    
                    38
                    
                    
                    
                    9
                    
                    
                    
                    12Net
                        (increase) decrease in deferred income tax benefit
                    
                    $
                    (115
                    )
                    
                    $
                    (170
                    )
                    
                    $
                    (103
                    )





*Index*





Page
                Forty Seven





The
      net
      deferred tax assets arising from temporary differences as of December 31, 2006
      and 2005 are as follows (in thousands of dollars):





2006
                  
                  
                  2005Deferred
                      Tax AssetsProvision
                      for loan losses
                  
                  $
                  1,008
                  
                  
                  $
                  868Insurance
                      commissions
                  
                  
                  39
                  
                  
                  
                  45Loss
                      carry forward
                  
                  
                  0
                  
                  
                  
                  71Deferred
                      compensation
                  
                  
                  817
                  
                  
                  
                  778Pension
                      obligation
                  
                  
                  244
                  
                  
                  
                  150Unrealized
                      loss on securities available for sale
                  
                  
                  1
                  
                  
                  
                  52Other
                  
                  
                  4
                  
                  
                  
                  6Total
                      Assets
                  
                  
                  2,113
                  
                  
                  
                  1,970Deferred
                      Tax LiabilitiesAccretion
                      income
                  
                  
                  69
                  
                  
                  
                  29Depreciation
                  
                  
                  397
                  
                  
                  
                  442Total
                      Liabilities
                  
                  
                  466
                  
                  
                  
                  471Net
                      Deferred Tax Asset
                  
                  $
                  1,647
                  
                  
                  $
                  1,499





The
      following table summarizes the differences between income tax expense and the
      amount computed by applying the federal statutory rate for the three years
      ended
      December 31, 2006, 2005 and 2004 (in thousands of dollars):





2006
                    
                    
                    2005
                    
                    
                    2004Amounts
                        at federal statutory rates
                    
                    $
                    2,348
                    
                    
                    $
                    1,944
                    
                    
                    $
                    1,617Additions
                        (reductions) resulting from:Tax
                        exempt income
                    
                    
                    (31
                    )
                    
                    
                    (50
                    )
                    
                    
                    (78
                    )Partially
                        exempt income
                    
                    
                    (25
                    )
                    
                    
                    (40
                    )
                    
                    
                    (41
                    )State
                        income taxes, net
                    
                    
                    222
                    
                    
                    
                    178
                    
                    
                    
                    147Income
                        from life insurance contracts
                    
                    
                    (143
                    )
                    
                    
                    (91
                    )
                    
                    
                    (94
                    )Other
                    
                    
                    20
                    
                    
                    
                    (25
                    )
                    
                    
                    0Income
                        tax expense
                    
                    $
                    2,391
                    
                    
                    $
                    1,916
                    
                    
                    $
                    1,551





*Index*





Page
                Forty Eight





**Note
                Twelve: Transactions with Related
                Parties**





During
      the year, officers and directors (and companies controlled by them) of the
      Company and subsidiary Banks were customers of and had transactions with the
      subsidiary Banks in the normal course of business. These transactions were
      made
      on substantially the same terms as those prevailing for other customers and
      did
      not involve any abnormal risk. Aggregate loan balances include open lines of
      credit, which are included in the balances above inclusive of unused amounts.
      The table below summarizes changes to balances of loans made to related parties
      during the years ended December 31, 2006 and 2005 (in thousands of
      dollars):


2006
                  
                  
                  2005Loans
                      to related parties, beginning of year
                  
                  $
                  5,065
                  
                  
                  $
                  5,084New
                      loans
                  
                  
                  549
                  
                  
                  
                  1,218Repayments
                  
                  
                  (558
                  )
                  
                  
                  (1,237
                  )Other
                      changes related to changes in executive officer or director
                      status
                  
                  
                  87
                  
                  
                  
                  0Loans
                      to related parties, end of year
                  
                  $
                  5,143
                  
                  
                  $
                  5,065





At
      December 31, 2006, deposits of related parties including directors, executive
      officers, and their related interests of Highlands Bankshares, Inc. and
      subsidiaries approximated $6,665,000.





**Note
                Thirteen: Concentrations**





The
      Banks
      grant commercial, residential real estate and consumer loans to customers
      located primarily in the eastern portion of the State of West Virginia. Although
      the Banks have a diversified loan portfolio, a substantial portion of the
      debtors' ability to honor their contracts is dependent upon the agribusiness,
      mining, trucking and logging sectors. Collateral required by the Banks is
      determined on an individual basis depending on the purpose of the loan and
      the
      financial condition of the borrower. The ultimate collectibility of the loan
      portfolios is susceptible to changes in local economic conditions. Of the
      $292,816,000 and $270,020,000 loans held by the Company at December 31, 2006
      and
      2005, respectively, $226,313,000 and $200,026,000 are secured by real estate.





The
      Company’s subsidiaries had cash deposited in and federal funds sold to other
      commercial banks totaling $14,918,000 and $12,380,000 at December 31, 2006
      and
      2005, respectively. Deposits with other correspondent banks are generally
      unsecured and have limited insurance under current banking insurance
      regulations, which management considers to be a normal business risk.





**Note
                Fourteen: Employee
                Benefits**





In
      addition to an Employee Stock Ownership Plan (ESOP), which provides stock
      ownership to all employees of the Company, the Company’s two subsidiary Banks,
      The Grant County Bank (Grant) and Capon Valley Bank (Capon) have separate
      retirement and profit sharing plans which cover substantially all full time
      employees at each Bank. A summary of the employee benefits provided by each
      Bank
      is provided below.





The
      Company’s ESOP plan provides stock ownership to all employees of the Company.
      The Plan provides total vesting upon the attainment of seven years of service.
      Contributions to the plan are made at the discretion of the board of directors
      and are allocated based on the compensation of each employee relative to total
      compensation paid by the Company. All shares held by the Plan are considered
      outstanding in the computation of earnings per share. Shares of Company stock,
      when distributed, will have restrictions on transferability.





Certain
      executives of both Grant and Capon have post retirement benefits related to
      the
      Banks’ investment in life insurance policies (see Note Twenty).





Expenses
      related to all retirement benefit plans charged to operations totaled $808,000
      in 2006, $505,000 in 2005 and $437,000 in 2004.





Capon
      Valley Bank





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





*Index*





Page
                Forty Nine





The
      Grant County Bank





Grant
      is
      a member of the West Virginia Bankers’ Association Retirement Plan (“the Plan”).
      This plan is a defined benefit plan with benefits under the plan based on
      compensation and years of service with full vesting after seven years of
      service. Prior to 2002, the Plan’s assets were in excess of the projected
      benefit obligations and thus Grant was not required to make contributions to
      the
      Plan. Since 2004, Grant has been required to make contributions and expects
      to
      be required to make contributions in 2007. At December 31, 2006, Grant has
      recognized liabilities of $680,331 relating to unfunded pension liabilities.
      As
      a result of the Plan’s inability to meet expected returns in recent years, a
      portion of this liability is reflected as a decrease in other comprehensive
      income of $584,471 (net of $343,261 tax benefit).





The
      following table provides a reconciliation of the changes in the Plan’s
      obligations and fair value of assets as of December 31, 2006 and 2005 using
      a
      measurement date of November 1, 2006 (in thousands of dollars):





2006
                        
                        
                        2005Change
                            in Benefit ObligationBenefit
                            obligation, beginning
                        
                        $
                        3,310
                        
                        
                        $
                        2,743Service
                            Cost
                        
                        
                        131
                        
                        
                        
                        123Interest
                            Cost
                        
                        
                        192
                        
                        
                        
                        179Actuarial
                            Loss (Gain)
                        
                        
                        (52
                        )
                        
                        
                        325Benefits
                            Paid
                        
                        
                        (54
                        )
                        
                        
                        (60
                        )Benefit
                            obligation, ending
                        
                        $
                        3,527
                        
                        
                        $
                        3,310Accumulated
                            Benefit Obligation
                        
                        $
                        3,088
                        
                        
                        $
                        2,852Change
                            in Plan AssetsFair
                            value of assets, beginning
                        
                        $
                        2,422
                        
                        
                        $
                        1,768Actual
                            return on assets, net of administrative expenses
                        
                        
                        307
                        
                        
                        
                        148Employer
                            contributions
                        
                        
                        186
                        
                        
                        
                        566Benefits
                            paid
                        
                        
                        (54
                        )
                        
                        
                        (60
                        )Fair
                            value of assets, ending
                        
                        $
                        2,861
                        
                        
                        $
                        2,422Funded
                            StatusFair
                            value of plan assets
                        
                        $
                        2,861
                        
                        
                        $
                        2,422Projected
                            benefit obligation
                        
                        
                        3,527
                        
                        
                        
                        (3,310
                        )Funded
                            status
                        
                        
                        (666
                        )
                        
                        
                        (888
                        )Amounts
                            Recognized in the Statement of Financial PositionAssets
                        
                        $
                        0
                        
                        
                        $
                        0Liabilities
                        
                        
                        (666
                        )
                        
                        
                        (888
                        )Total
                        
                        $
                        (666
                        )
                        
                        $
                        (888
                        )Amounts
                            Recognized in Accumulated Other Comprehensive IncomeTransition
                            Obligation (Asset)Prior
                            Service Cost
                        
                        $
                        14
                        
                        
                        $
                        25Net
                            (Gain)/Loss
                        
                        
                        914
                        
                        
                        
                        1,121Total
                        
                        $
                        928
                        
                        
                        $
                        1,146





*Index*





Page
                Fifty





The
      adoption of SFAS No. 158 had no effect on the Company’s consolidated net income
      for the year ended December 31, 2006 or for any prior period. The incremental
      effects of adopting the provisions of SFAS No. 158 on the Company’s consolidated
      balance sheet at December 31, 2006 are presented in the following table (in
      thousands of dollars):





December
                    31, 2006Prior
                    to Adopting
                  SFAS
                    No. 158
                
                
                Effect
                    of
                  Adopting
                    SFAS
                  No.
                    158
                
                
                As
                  ReportedAccrued
                    pension liability
                
                $
                144
                
                
                $
                522
                
                
                $
                666Deferred
                    income tax benefit
                
                
                150
                
                
                
                193
                
                
                
                343Accumulated
                    other comprehensive loss
                
                
                255
                
                
                
                329
                
                
                
                584











The
      following table provides the components of the net periodic pension expense
      for
      the Plan for the years ended December 31, 2006, 2005 and 2004 (in thousands
      of
      dollars):





2006
                    
                    
                    2005
                    
                    
                    2004Service
                        cost
                    
                    $
                    131
                    
                    
                    $
                    123
                    
                    
                    $
                    114Interest
                        cost
                    
                    
                    192
                    
                    
                    
                    179
                    
                    
                    
                    162Expected
                        return on plan assets
                    
                    
                    (212
                    )
                    
                    
                    (176
                    )
                    
                    
                    (166
                    )Amortization
                        of net obligation at transitionRecognized
                        net actuarial loss
                    
                    
                    61
                    
                    
                    
                    27
                    
                    
                    
                    14Amortization
                        of prior service cost
                    
                    
                    11
                    
                    
                    
                    11
                    
                    
                    
                    11Net
                        Periodic Pension Expense
                    
                    $
                    183
                    
                    
                    $
                    164
                    
                    
                    $
                    135





The
      expected pension expense for 2007 is $156,000. The amount of the Company’s
      minimum contribution for 2007 is $156,000.





The
      table
      below summarizes the benefits expected to be paid to participants in the plan
      (in thousands of dollars):





Year
                    
                    Expected
                        Benefit
                      Payments2007
                    
                    $
                    1052008
                    
                    
                    1132009
                    
                    
                    1442010
                    
                    
                    1482011
                    
                    
                    165Years
                        2012 - 2016
                    
                    
                    1,293








The
      weighted average assumption used in the measurement of Grant’s benefit
      obligation and net periodic pension expense is as follows:





2006
                  
                  
                  2005
                  
                  
                  2004Discount
                      rate
                  
                  
                  5.8
                  %
                  
                  
                  6.5
                  %
                  
                  
                  6.5
                  %Expected
                      return on plan assets
                  
                  
                  8.5
                  %
                  
                  
                  8.5
                  %
                  
                  
                  8.5
                  %Rate
                      of compensation increase
                  
                  
                  3.0
                  %
                  
                  
                  3.5
                  %
                  
                  
                  3.5
                  %





*Index*





Page
                Fifty One





The
      plan
      sponsor estimates the expected long-term rate of return on assets in
      consultation with their advisors and the plan actuary. This rate is intended
      to
      reflect the average rate of earnings expected to be earned on the funds invested
      or to be invested to provide plan benefits. Historical performance is reviewed,
      especially with respect to real rate of return (net of inflation) for the major
      asset classes held or anticipated to be held by the trust. Undue weight is
      not
      given to recent experience, which may not continue over the measurement period,
      with higher significance placed on current forecasts of future long-term
      economic conditions.





The
      following table provides the pension plan’s asset allocation as of December 31,
      2006 and 2005:





2006
                    
                    
                    2005Equity
                        Securities
                    
                    
                    74
                    %
                    
                    
                    73
                    %Debt
                        Securities
                    
                    
                    20
                    %
                    
                    
                    22
                    %Other
                    
                    
                    6
                    %
                    
                    
                    5
                    %





The
      trust
      fund is sufficiently diversified to maintain a reasonable level of risk without
      imprudently sacrificing return. The targeted asset allocation and allowable
      range of allocation is set forth in the table below:





Target
                      Allocation
                  Allowable
                      Allocation RangeEquity
                      Securities
                  75%
                  40%-80%Debt
                      Securities
                  25%
                  20%-40%Other
                  0%
                  3%-10%





The
      Investment Manager selects investment fund managers with demonstrated experience
      and expertise, and funds with demonstrated historical performance, for the
      implementation of the Plan’s investment strategy. The Investment Manager will
      consider both actively and passively managed investment strategies and will
      allocate funds across the asset classes to develop an efficient investment
      structure.





The
      Grant
      County Bank also maintains a profit sharing plan covering substantially all
      employees to which contributions are made at the discretion of the board of
      directors. Plan contributions by the employer are fully vested in the year
      of
      contribution.








**Note
                Fifteen: Commitments and
                Guarantees**





The
      Banks
      make commitments to extend credit in the normal course of business and issue
      standby letters of credit to meet the financing needs of their customers. The
      amount of the commitments represents the Banks' exposure to credit loss that
      is
      not included in the balance sheet.





The
      Banks
      use the same credit policies in making commitments and issuing letters of credit
      as used for the loans reflected in the balance sheet. Commitments to extend
      credit are agreements to lend to a customer as long as there is no violation
      of
      any condition established in the contract. Commitments generally have fixed
      expiration dates or other termination clauses and may require payment of a
      fee.
      Since many of the commitments are expected to expire without being drawn upon,
      the total commitment amounts do not necessarily represent future cash
      requirements. The Banks evaluate each customer's creditworthiness on a
      case-by-case basis. The amount of collateral obtained, if deemed necessary
      by
      the Banks upon the extension of credit, is based on management's credit
      evaluation of the borrower. Collateral held varies but may include accounts
      receivable, inventory, property, plant and equipment.





As
      of
      December 31, 2006 and 2005, the Banks had outstanding the following commitments
      (in thousands of dollars):





2006
                  
                  
                  2005Commitments
                      to extend credit
                  
                  $
                  18,933
                  
                  
                  $
                  21,087Standby
                      letter of credit
                  
                  
                  957
                  
                  
                  
                  423





*Index*





Page
                Fifty Two





**Note
                Sixteen: Disclosures About Fair Value of Financial
                Instruments**





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





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





Cash,
      Due from Banks and Money Market Investments


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





Securities


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





Restricted
      Investments


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





Loans


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





Deposits


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





Long
      Term Debt


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





Short
      Term Debt


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





Interest
      Payable and Receivable


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


Life
      Insurance


The
      carrying amount of life insurance contracts is assumed to be a reasonable fair
      value. Life insurance contracts are carried on the balance sheet at their
      redemption value as of December 31, 2006. This redemption value is based on
      existing market conditions and therefore represents the fair value of the
      contract.





Off-Balance-Sheet
      Items


The
      carrying amount and estimated fair value of off-balance-sheet items were not
      material at December 31, 2006 or 2005.


*Index*





Page
                Fifty Three





The
      carrying amount and estimated fair values of financial instruments as of
      December 31, 2006 and 2005 are as follows (in thousands of
      dollars):





2006
                
                
                2005Carrying
                  Amount
                
                
                Estimated
                  Fair
                    Value
                
                
                Carrying
                  Amount
                
                
                Estimated
                  Fair
                    ValueFinancial
                    Assets:Cash
                    and due from banks
                
                $
                7,111
                
                
                $
                7,111
                
                
                $
                8,850
                
                
                $
                8,850Interest
                    bearing deposits
                
                
                1,624
                
                
                
                1,624
                
                
                
                963
                
                
                
                963Federal
                    funds sold
                
                
                12,210
                
                
                
                12,210
                
                
                
                10,808
                
                
                
                10,808Securities
                    held to maturity
                
                
                170
                
                
                
                170
                
                
                
                491
                
                
                
                494Securities
                    available for sale
                
                
                23,729
                
                
                
                23,729
                
                
                
                27,130
                
                
                
                27,130Restricted
                    investments
                
                
                1,570
                
                
                
                1,570
                
                
                
                1,250
                
                
                
                1,250Loans,
                    net
                
                
                292,816
                
                
                
                293,661
                
                
                
                266,891
                
                
                
                268,347Interest
                    receivable
                
                
                2,173
                
                
                
                2,173
                
                
                
                1,818
                
                
                
                1,818Life
                    insurance contracts
                
                
                6,066
                
                
                
                6,066
                
                
                
                6,396
                
                
                
                6,396Financial
                    Liabilities:Demand
                    and savings deposits
                
                
                118,316
                
                
                
                118,316
                
                
                
                128,350
                
                
                
                128,350Time
                    deposits
                
                
                182,168
                
                
                
                183,505
                
                
                
                156,342
                
                
                
                156,541Long
                    term debt
                
                
                14,992
                
                
                
                14,641
                
                
                
                15,063
                
                
                
                14,819Interest
                    payable
                
                
                1,014
                
                
                
                1,014
                
                
                
                633
                
                
                
                633








**Note
                Seventeen: Regulatory
                Matters**





The
      Company is subject to various regulatory capital requirements administered
      by
      the federal banking agencies. Failure to meet minimum capital requirements
      can
      initiate certain mandatory - and possibly additional discretionary - actions
      by
      regulators that, if undertaken, could have a direct material effect on the
      Company's financial statements. Under capital adequacy guidelines and the
      regulatory framework for prompt corrective action, the Company must meet
      specific capital guidelines that involve quantitative measures of the Company's
      assets, liabilities, and certain off-balance-sheet items as calculated under
      regulatory accounting practices. The Company's capital amounts and
      classification are also subject to qualitative judgments by the regulators
      about
      components, risk weightings and other factors.





Quantitative
      measures established by regulation to ensure capital adequacy require the
      Company to maintain minimum amounts and ratios (set forth in the table below)
      of
      total and Tier I capital (as defined in the regulations) to risk-weighted assets
      (as defined), and of Tier I capital (as defined) to average assets (as defined).
      The Company meets all capital adequacy requirements to which it is subject
      and
      as of the most recent examination, the Company was classified as well
      capitalized.





To
      be
      categorized as well capitalized the Company must maintain minimum total
      risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the
      table. There are no conditions or events that management believes have changed
      the Company's category from a well-capitalized status.


*Index*





Page
                Fifty Four





The
      Company’s actual and required capital amounts and ratios at December 31, 2006 is
      presented in the following table (in thousands of dollars):





December
                          31, 2006Regulatory
                          RequirementsActual
                      
                      
                      Adequately
                          Capitalized
                      
                      
                      Well
                          CapitalizedAmount
                      
                      
                      Percentage
                      
                      
                      Amount
                      
                      
                      Percentage
                      
                      
                      Amount
                      
                      
                      PercentageTotal
                          Risk Based Capital RatioHighlands
                          Bankshares
                      
                      $
                      35,692
                      
                      
                      
                      13.45
                      %
                      
                      $
                      21,231
                      
                      
                      
                      8.00
                      %Capon
                          Valley Bank
                      
                      
                      14,237
                      
                      
                      
                      14.56
                      %
                      
                      
                      7,825
                      
                      
                      
                      8.00
                      %
                      
                      $
                      9,781
                      
                      
                      
                      10.00
                      %The
                          Grant County Bank
                      
                      
                      21,151
                      
                      
                      
                      12.63
                      %
                      
                      
                      13,395
                      
                      
                      
                      8.00
                      %
                      
                      
                      16,744
                      
                      
                      
                      10.00
                      %Tier
                          1 Leverage RatioHighlands
                          Bankshares
                      
                      
                      32,392
                      
                      
                      
                      9.26
                      %
                      
                      
                      13,998
                      
                      
                      
                      4.00
                      %Capon
                          Valley Bank
                      
                      
                      13,011
                      
                      
                      
                      9.53
                      %
                      
                      
                      5,463
                      
                      
                      
                      4.00
                      %
                      
                      
                      6,829
                      
                      
                      
                      5.00
                      %The
                          Grant County Bank
                      
                      
                      19,076
                      
                      
                      
                      8.85
                      %
                      
                      
                      8,624
                      
                      
                      
                      4.00
                      %
                      
                      
                      10,780
                      
                      
                      
                      5.00
                      %Tier
                          1 Risk Based Capital RatioHighlands
                          Bankshares
                      
                      
                      32,392
                      
                      
                      
                      12.21
                      %
                      
                      
                      10,616
                      
                      
                      
                      4.00
                      %Capon
                          Valley Bank
                      
                      
                      13,011
                      
                      
                      
                      13.30
                      %
                      
                      
                      3,912
                      
                      
                      
                      4.00
                      %
                      
                      
                      5,869
                      
                      
                      
                      6.00
                      %The
                          Grant County Bank
                      
                      
                      19,076
                      
                      
                      
                      11.39
                      %
                      
                      
                      6,697
                      
                      
                      
                      4.00
                      %
                      
                      
                      10,046
                      
                      
                      
                      6.00
                      %





The
      Company’s actual and required capital amounts and ratios at December 31, 2005 is
      presented in the following table (in thousands of dollars):





December
                          31, 2005Regulatory
                          RequirementsActual
                      
                      
                      Adequately
                          Capitalized
                      
                      
                      Well
                          CapitalizedAmount
                      
                      
                      Percentage
                      
                      
                      Amount
                      
                      
                      Percentage
                      
                      
                      Amount
                      
                      
                      PercentageTotal
                          Risk Based Capital RatioHighlands
                          Bankshares
                      
                      $
                      34,041
                      
                      
                      
                      13.85
                      %
                      
                      $
                      19,663
                      
                      
                      
                      8.00
                      %Capon
                          Valley Bank
                      
                      
                      12,910
                      
                      
                      
                      13.45
                      %
                      
                      
                      7,679
                      
                      
                      
                      8.00
                      %
                      
                      $
                      9,599
                      
                      
                      
                      10.00
                      %The
                          Grant County Bank
                      
                      
                      20,448
                      
                      
                      
                      13.67
                      %
                      
                      
                      11,967
                      
                      
                      
                      8.00
                      %
                      
                      
                      14,958
                      
                      
                      
                      10.00
                      %Tier
                          1 Leverage RatioHighlands
                          Bankshares
                      
                      
                      30,959
                      
                      
                      
                      9.45
                      %
                      
                      
                      13,104
                      
                      
                      
                      4.00
                      %Capon
                          Valley Bank
                      
                      
                      11,709
                      
                      
                      
                      8.87
                      %
                      
                      
                      5,280
                      
                      
                      
                      4.00
                      %
                      
                      
                      6,600
                      
                      
                      
                      5.00
                      %The
                          Grant County Bank
                      
                      
                      18,650
                      
                      
                      
                      8.81
                      %
                      
                      
                      8,468
                      
                      
                      
                      4.00
                      %
                      
                      
                      10,585
                      
                      
                      
                      5.00
                      %Tier
                          1 Risk Based Capital RatioHighlands
                          Bankshares
                      
                      
                      30,959
                      
                      
                      
                      12.60
                      %
                      
                      
                      9,828
                      
                      
                      
                      4.00
                      %Capon
                          Valley Bank
                      
                      
                      11,709
                      
                      
                      
                      12.20
                      %
                      
                      
                      3,839
                      
                      
                      
                      4.00
                      %
                      
                      
                      5,759
                      
                      
                      
                      6.00
                      %The
                          Grant County Bank
                      
                      
                      18,650
                      
                      
                      
                      12.47
                      %
                      
                      
                      5,982
                      
                      
                      
                      4.00
                      %
                      
                      
                      8,974
                      
                      
                      
                      6.00
                      %








Capital
      ratios and amounts are applicable both at the individual Bank level and on
      a
      consolidated basis. At December 31, 2006, both subsidiary Banks had capital
      levels in excess of minimum requirements.





In
      addition, HBI Life Insurance Company is subject to certain capital requirements
      and dividend restrictions. At present, HBI Life is well within any capital
      limitations and no conditions or events have occurred to change this capital
      status, nor does management expect any such occurrence in the foreseeable
      future.


*Index*





Page
                Fifty Five





**Note
                Eighteen: Changes in Other Comprehensive
                Income**





The
      components of changes in other comprehensive income and related tax effects
      for
      the years ended December 31, 2006, 2005 and 2004 are as follows (in thousands
      of
      dollars):





2006
                
                
                2005
                
                
                2004Balance
                    January 1
                
                $
                (505
                )
                
                $
                (219
                )
                
                $
                (24
                )Unrealized
                    holding gains (losses) on available for sale securities net of
                    income
                    taxes of $50,000 for 2006, $27,000 for 2005 and $92,000 for
                    2004
                
                
                86
                
                
                
                (46
                )
                
                
                (176
                )Accrued
                    pension obligation net of income taxes of $97,000 for 2006, $141,000
                    for
                    2005 and $ 12,000 for 2004
                
                
                (167
                )
                
                
                (240
                )
                
                
                (19
                )Net
                    change for the year
                
                
                (81
                )
                
                
                (286
                )
                
                
                (195
                )Balance
                    December 31
                
                $
                (586
                )
                
                $
                (505
                )
                
                $
                (219
                )








**Note
                Nineteen: Branches Acquisition and Related Intangible
                Assets**





On
      August
      22, 2005, Highlands Bankshares entered into an agreement to purchase all of
      the
      outstanding shares of common stock of the National Bank of Davis (“Davis”),
      located in Davis, West Virginia. Davis is located in Tucker County and is
      contiguous to other counties that have Company branches. The Agreement can
      be
      found by accessing the website of the Securities and Exchange Commission under
      the filings of Highlands Bankshares, Inc. and as part of the Current Report
      on
      Form 8-K filed August, 23, 2005.





The
      Agreement was consummated on October 31, 2005 and the shareholders of Davis
      were
      paid a cash purchase price of $5,200,000. In addition to this amount, Highlands
      incurred additional expenses of $56,000 related to the purchase. Shortly after
      the purchase, Davis offices became branches of The Grant County Bank. Funding
      for the purchase was provided by a special, one time, dividend from The Grant
      County Bank to Highlands Bankshares. The purchase of Davis added two banking
      locations and 11 full time equivalent employees to the operations of Highlands.
      All operations of Davis subsequent to October 31, 2005 are reflected in the
      operations of the Company.





Upon
      acquisition, the net assets of Davis were recorded at fair value. Portions
      of
      the cost of acquisition, including expenses incurred relating to the purchase,
      were allocated as intangible assets. These intangible assets are comprised
      of
      both core deposit intangibles and goodwill. The amount of core deposit
      intangibles was valued based on comparable premiums paid on deposits for
      purchases of banking branches by other financial institutions in Virginia,
      West
      Virginia, and the entire Southeast region of the United States. After tangible
      assets were valued at fair value and the allocation made to core deposit
      intangibles, the remainder of the purchase price was allocated to goodwill.
      The
      amount of core deposit intangibles will be amortized over a ten-year period.
      Goodwill will not be amortized and will be tested for impairment on an annual
      basis. As of December 31, 2006, the goodwill acquired in the acquisition of
      Davis was not deemed to be impaired.





Amortization
      of intangibles charged to operations was $176,000 in 2006, $38,000 in 2005
      and
      $11,000 in 2004.





In
      addition to the intangible assets acquired with the Davis purchase, the Company,
      at December 31, 2006 has a core deposit intangible of $39,000 (net of
      accumulated amortization) related to a branch acquisition in the year 2000.


*Index*





Page
                Fifty Six





A
      summary
      of the Company’s intangible assets at December 31, 2006 and 2005 is shown in the
      table below (in thousands of dollars):





December
                        31,2006
                    
                    
                    2005Core
                        Deposit Intangibles
                    
                    $
                    1,760
                    
                    
                    $
                    1,760(Accumulated
                        Depreciation)
                    
                    
                    (262
                    )
                    
                    
                    (86
                    )Goodwill
                    
                    
                    1,534
                    
                    
                    
                    1,534Total
                        Intangible Assets
                    
                    $
                    3,032
                    
                    
                    $
                    3,208





The
      expected amortization of the intangible balances at December 31, 2006 for the
      next five years is summarized in the table below (in thousands of
      dollars):





Year
                    
                    Expected
                        Expense2007
                    
                    $
                    1762008
                    
                    
                    1762009
                    
                    
                    1762010
                    
                    
                    1722011
                    
                    
                    165








**Note
                Twenty: Investment in Life Insurance
                Contracts**





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





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





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





Balance
                        December 31, 2005
                    
                    $
                    6,396Increases
                        in value of policies
                    
                    
                    225Settlement
                        payout
                    
                    
                    (555
                    )Balance
                        December 31, 2006
                    
                    $
                    6,066





*Index*





Page
                Fifty Seven








**Note
                Twenty One: Parent Corporation Only Financial
                Statements**





**Balance
                    Sheets****(in
                    thousands of dollars)**December
                    31,2006
                
                
                2005AssetsCash
                
                $
                187
                
                
                $
                154Investment
                    in subsidiaries
                
                
                37,025
                
                
                
                33,819Income
                    taxes receivable
                
                
                0
                
                
                
                24Other
                    assets
                
                
                40
                
                
                
                45Total
                    Assets
                
                $
                37,252
                
                
                $
                34,042LiabilitiesAccrued
                    expenses
                
                $
                71
                
                
                $
                44Income
                    taxes payable
                
                
                105
                
                
                
                0Other
                    liabilities
                
                0
                
                
                
                6Total
                    Liabilities
                
                
                176
                
                
                
                50Stockholders’
                    EquityCommon
                    stock, par value $5 per share, 3,000,000 shares authorized, 1,436,874
                    issued and outstanding
                
                
                7,184
                
                
                
                7,184Surplus
                
                
                1,662
                
                
                
                1,662Retained
                    earnings
                
                
                28,816
                
                
                
                25,651Other
                    accumulated comprehensive income
                
                
                (586
                )
                
                
                (505
                )Total
                    Stockholders’ Equity
                
                
                37,076
                
                
                
                33,992Total
                    Liabilities and Stockholders’ Equity
                
                $
                37,252
                
                
                $
                34,042








*Index*





Page
                Fifty Eight








**Statements
                      of Income and Retained Earnings****(in
                      thousands of dollars)**2006
                  
                  
                  2005
                  
                  
                  2004IncomeDividends
                      from subsidiaries
                  
                  $
                  1,651
                  
                  
                  $
                  1,528
                  
                  
                  $
                  940Management
                      fees from subsidiaries
                  
                  
                  240
                  
                  
                  
                  63
                  
                  
                  
                  ---Total
                      Income
                  
                  
                  1,891
                  
                  
                  
                  1,591
                  
                  
                  
                  940ExpensesSalary
                      and benefits expense
                  
                  
                  302
                  
                  
                  
                  203
                  
                  
                  
                  155Professional
                      fees
                  
                  
                  191
                  
                  
                  
                  231
                  
                  
                  
                  82Directors
                      fees
                  
                  
                  74
                  
                  
                  
                  65
                  
                  
                  
                  62Other
                      expenses
                  
                  
                  70
                  
                  
                  
                  106
                  
                  
                  
                  83Total
                      Expenses
                  
                  
                  637
                  
                  
                  
                  605
                  
                  
                  
                  382Net
                      income before income tax benefit and undistributed subsidiary
                      net
                      income
                  
                  
                  1,254
                  
                  
                  
                  986
                  
                  
                  
                  558Income
                      tax benefit
                  
                  
                  162
                  
                  
                  
                  214
                  
                  
                  
                  142Income
                      before undistributed subsidiary net income
                  
                  
                  1,416
                  
                  
                  
                  1,200
                  
                  
                  
                  700Undistributed
                      subsidiary net income
                  
                  
                  3,099
                  
                  
                  
                  2,602
                  
                  
                  
                  2,506Net
                      Income
                  
                  $
                  4,515
                  
                  
                  $
                  3,802
                  
                  
                  $
                  3,206Retained
                      earnings, beginning of period
                  
                  $
                  25,651
                  
                  
                  $
                  23,028
                  
                  
                  $
                  20,727Dividends
                      paid in cash
                  
                  
                  (1,350
                  )
                  
                  
                  (1,179
                  )
                  
                  
                  (905
                  )Net
                      income
                  
                  
                  4,515
                  
                  
                  
                  3,802
                  
                  
                  
                  3,206Retained
                      earnings, end of period
                  
                  $
                  28,816
                  
                  
                  $
                  25,651
                  
                  
                  $
                  23,028








*Index*





Page
                Fifty Nine








**Statements
                    of Cash Flows****(in
                    thousands of dollars)**Years
                    Ended December 31,2006
                
                
                2005
                
                
                2004Cash
                    Flows From Operating ActivitiesNet
                    Income
                
                $
                4,515
                
                
                $
                3,802
                
                
                $
                3,206Adjustments
                    to net incomeUndistributed
                    subsidiary income
                
                
                (3,099
                )
                
                
                (2,602
                )
                
                
                (2,506
                )Depreciation
                    and amortization
                
                
                7
                
                
                
                6Increase
                    (decrease) in payables
                
                
                126
                
                
                
                (24
                )
                
                
                (46
                )(Increase)
                    decrease in receivables
                
                
                24
                
                
                
                33
                
                
                
                450(Increase)
                    decrease in other assets
                
                
                (1
                )
                
                
                5
                
                
                
                (13
                )Net
                    Cash Provided by Operating Activities
                
                
                1,572
                
                
                
                1,220
                
                
                
                1,091Cash
                    Flows From Investing ActivitiesAdvances
                    from (payments to) subsidiaries
                
                
                (417
                )
                
                
                (199
                )
                
                
                (483
                )Received
                    from subsidiaries
                
                
                229
                
                
                
                177
                
                
                
                281Purchase
                    of property and equipment
                
                
                (1
                )
                
                
                (21
                )
                
                
                0Special
                    dividend from subsidiary
                
                
                0
                
                
                
                5,200
                
                
                
                0Net
                    Cash Provided by (used in) Investing Activities
                
                
                (189
                )
                
                
                5,157
                
                
                
                (202
                )Cash
                    Flows From Financing ActivitiesPurchase
                    of branch operations
                
                
                0
                
                
                
                (5,200
                )
                
                
                0Dividends
                    paid in cash
                
                
                (1,350
                )
                
                
                (1,179
                )
                
                
                (905
                )Net
                    Cash Used in Financing Activities
                
                
                (1,350
                )
                
                
                (6,379
                )
                
                
                (905
                )Net
                    Increase (Decrease) in Cash
                
                
                33
                
                
                
                (2
                )
                
                
                (16
                )Cash,
                    beginning of year
                
                
                154
                
                
                
                156
                
                
                
                172Cash,
                    end of year
                
                $
                187
                
                
                $
                154
                
                
                $
                156














*Index*





Page
                Sixty








REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM








Board
      of
      Directors


Highlands
      Bankshares, Inc.


Petersburg,
      West Virginia








We
      have
      audited the accompanying consolidated balance sheet of Highlands Bankshares,
      Inc. and subsidiaries as of December 31, 2005, the related consolidated
      statements of income, stockholders’ equity, and cash flows for the years ended
      December 31, 2005 and 2004. These financial statements are the responsibility
      of
      the Company’s management. Our responsibility is to express an opinion on these
      financial statements based on our audits.





We
      conducted our audits in accordance with standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. The company is not required to
      have, nor were we engaged to perform, an audit of its internal control over
      financial reporting. Our audit included consideration of internal control over
      financial reporting as a basis for designing audit procedures that are
      appropriate in the circumstances, but not for the purpose of expressing an
      opinion on the effectiveness of the company's internal control over financial
      reporting. Accordingly, we express no such opinion. An audit includes examining,
      on a test basis, evidence supporting the amounts and disclosures in the
      financial statements, assessing the accounting principles used and significant
      estimates made by management, as well as evaluating the overall financial
      statement presentation. We believe that our audits provide a reasonable basis
      for our opinion.





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








/s/
                S. B. Hoover & Company, L.L.P.










February
      28, 2006


Harrisonburg,
      VA








*Index*





Page
                Sixty One

















REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To
      the
      Shareholders and Board of Directors of


Highlands
      Bankshares, Inc.


Petersburg,
      West Virginia








We
      have
      audited the accompanying consolidated balance sheet of Highlands
      Bankshares, Inc. and
      subsidiaries as of December
      31, 2006 ,
      and the
      related consolidated statements of income, stockholders' equity and cash flows
      for the year then ended. These consolidated financial statements are the
      responsibility of the corporation's management. Our responsibility is to express
      an opinion on these consolidated financial statements based on our audit. The
      consolidated financial statements of Highlands
      Bankshares, Inc. for each
      of the two years in the period ended December 31, 2005, were audited by other
      auditors whose report dated February 28, 2006, expressed an unqualified opinion
      on those financial statements.





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





In
      our
      opinion, the 2006 consolidated financial statements referred to above present fairly, in all
      material respects, the financial position of Highlands
      Bankshares, Inc. and
      subsidiaries as of December
      31, 2006 ,
      and the
      results of their operations and their cash flows for the year then ended in
      conformity with accounting principles generally accepted in the United States
      of
      America.





As
      discussed in Notes 2 and 14 to the financial statements, Highlands Bankshares,
      Inc. changed its policy for accounting for its defined benefit pension plan
      in
      2006 to conform with Statement of Financial Accounting Standards No.
      158.





/s/
                SMITH ELLIOTT KEARNS & COMPANY,
                LLC













Chambersburg,
      Pennsylvania


March
      21,
      2007








*Index*








Page
                Sixty Two








**Item9.**
              **Changes
                  in and Disagreements With Accountants on Accounting and Financial
                  Disclosure**





None.








**Item
                  9A.**
              **Controls
                  and Procedures**





The
      Company’s management, with the participation of the Company’s Chief Executive
      Officer and Chief Financial Officer, has evaluated the effectiveness of the
      Company’s disclosure controls and procedures as of December 31, 2006. Based on
      this evaluation, the Company’s Chief Executive Officer and Chief Financial
      Officer concluded that the Company’s disclosure controls and procedures are
      effective in timely alerting them to material information relating to the
      Company required to be included in the Company’s periodic SEC filings.





**Changes
      in Internal Controls**





During
      the period reported upon, there were no significant changes in internal controls
      of Highlands Bankshares, Inc. pertaining to its financial reporting and control
      of its assets or in other factors that materially affected or are reasonably
      likely to materially affect such control.





**Item
                  9B.**
              **Other
                  Information**





None.





**PART
      III**





**Item10.**
              **Directors,
                  Executive Officers and Corporate
                  Governance**





Information
      required by this item is set forth under the caption “Compliance with Section
      16(a) of the Securities Exchange Act” of our 2007 Proxy Statement, to be filed
      within 120 days after the end of the Company’s fiscal year end, and is
      incorporated herein by reference





**Item
                  11.**
              **Executive
                  Compensation**





Information
      required by this item is set forth under the caption “EXECUTIVE COMPENSATION” of
      our 2007 Proxy Statement, to be filed within 120 days after the end of the
      Company’s fiscal year end, and is incorporated herein by reference.





*Index*





Page
                Sixty Three








**Item12.**
              **Security
                  Ownership of Certain Beneficial Owners and Management and Related
                  Stockholder Matters**





Information
      required by this item is set forth under the caption “SECURITY OWNERSHIP OF
      CERTAIN BENEFICIAL OWNERS AND MANAGEMENT” of our 2007 Proxy Statement, to be
      filed within 120 days after the end of the Company’s fiscal year end, and is
      incorporated herein by reference.








**Item13.**
              **Certain
                  Relationships and Related Transactions and Director
                  Independence**





Information
      required by this item is set forth under the caption “Certain Related
      Transactions” of our 2007 Proxy Statement, to be filed within 120 days after the
      end of the Company’s fiscal year end, and is incorporated herein by
      reference.





Most
      of
      the directors, limited liability companies of which they may be members,
      partnerships of which they may be general partners and corporations of which
      they are officers or directors, maintain normal banking relationships with
      the
      Bank. Loans made by the Bank to such persons or other entities were made in
      the
      ordinary course of business, were made, at the date of inception, on
      substantially the same terms, including interest rates and collateral, as those
      prevailing at the time for comparable transactions with other persons, and
      did
      not involve more than normal risk of collectibility or present other unfavorable
      features. See Note Twelve of the consolidated financial statements.





Director
      John Van Meter is a partner with the law firm of VanMeter and VanMeter, which
      has been retained by the Company as legal counsel, and it is anticipated that
      the relationship will continue. Director Jack H. Walters is a partner with
      the
      law firm of Walters, Krauskopf & Baker, which provides legal counsel to the
      Company, and it is anticipated that the relationship will continue.








**Item14.**
              **Principal
                  Accounting Fees and
                  Services**





Information
      required by this item is set forth under the caption “FEES OF INDEPENDENT PUBLIC
      ACCOUNTANTS” of our 2007 Proxy Statement, to be filed within 120 days after the
      end of the Company’s fiscal year end, and is incorporated herein by
      reference.





*Index*





Page
                Sixty Four





**PART
      IV**





**Item15.**
              **Exhibits,
                  Financial Statement
                  Schedules**





(a)(1)
              Financial
                  Statements:
                Reference
                  is made to Part II, Item 8 of the Annual Report on Form
                  10-K(a)(2)
              Financial
                  Statement Schedules: These schedules are omitted as the required
                  information is inapplicable or the information is presented in
                  the
                  consolidated financial statements or related
                  notes


(a)(3)
                Exhibits:ExhibitNumber
                Description3(i)
                Articles
                    of Incorporation of Highlands Bankshares, Inc. are incorporated
                    by
                    reference to Appendix C to Highlands Bankshares, Inc.'s Form
                    S-4 filed
                    October 20, 1986Amendments
                    to the original Articles of Incorporation are incorporated by
                    reference;
                    filed as Exhibit 3(i) with 1997 Form 10-KSB3(ii)
                Bylaws
                    of Highlands Bankshares, Inc. are incorporated by reference to
                    Appendix D
                    to Highlands Bankshares Inc.’s Form S-4 filed October 20,
                    1986Amended
                    Bylaws of Highlands Bankshares, Inc. are incorporated by reference
                    to
                    Exhibit 3(ii) to Highlands Bankshares Inc.’s Form 10Q filed May 15,
                    200314
                Code
                    of Ethics1621
                Subsidiaries
                    of the Registrant31.1
                Certification
                    of Chief Executive Officer Pursuantto
                    section 302 of the Sarbanes-Oxley Act of
                  2002
                    Chapter 63, Title 18 USC Section 1350 (A) and (B).31.2
                Certification
                    of Chief Financial OfficerPursuant
                    to section 302 of the Sarbanes-Oxley Act of
                  2002
                    Chapter 63, Title 18 USC Section 1350 (A) and (B).32.1
                Statement
                    of Chief Executive Officer Pursuant to 18 U.S.C. §1350.32.2
                Statement
                    of Chief Financial Officer Pursuant to 18 U.S.C.§1350.





(b)
              See
                  (a)(3) above(c)
              See
                  (a)(1) and (a)(2) above





*Index*





Page
                Sixty Five





Signatures





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





HIGHLANDS
      BANKSHARES, INC.








/s/
                C.E. Porter
            
            /s/
                R. Alan MillerC.E.
                Porter
            
            R.
                Alan MillerPresident
                & Chief Executive Officer
            
            Chief
                Financial OfficerMarch
                22, 2007
            
            March
                22, 2007





Pursuant
      to the requirements of the Securities and 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.





Name
            Signature
            Title
            DateLeslie
                A. Barr
            
            DirectorJack
                H. Walters
            /s/
                Jack H. Walters
            Director
            March
                22, 2007Thomas
                B. McNeill, Sr.
            /s/
                Thomas B. McNeill, Sr.
            Director
            March
                22, 2007L.
                Keith Wolfe
            
            DirectorKathy
                G. Kimble
            /s/
                Kathy G. Kimble
            Director
            March
                22, 2007Steven
                C. Judy
            /s/
                Steven C. Judy
            Director
            March
                22, 2007Courtney
                R. Tusing
            /s/
                Courtney R. Tusing
            Director
            March
                22, 2007John
                G. Van Meter
            /s/
                John G. Van Meter
            Director
              Chairman
                of The Board
            March
                22, 2007Alan
                L. Brill
            /s/
                Alan L. Brill
            Director
              Secretary
            March
                22, 2007C.
                E. Porter
            /s/
                C.E. Porter
            Director
              President
                & CEO
              Treasurer
            March
                22, 2007