UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
DC 20549





FORM
10-K


(Mark
One)


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


For the
fiscal year ended December 31, 2007





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  x 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  x 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 x  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. x





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 xNon-accelerated filer o     Smaller
Reporting Company





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





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





The
aggregate market value of the 1,316,864 shares of common stock of the
registrant, issued and outstanding, held by non- affiliates on June 30, 2007,
was approximately $44,444,160 based on the closing sales price of $33.75 on June
30, 2007.  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, 2008: 1,436,874 shares of
common stock.





DOCUMENTS
INCORPORATED BY REFERENCE





Portions
of the Proxy Statement for the 2008 Annual Shareholders’ Meeting, to be held May
13, 2008, are incorporated by reference into Part III, Items 10,11,12,13 and
14.










FORM 10-K INDEXPart
      I
            
            PageItem
      1.
            Business
            1Item
      1A.
            Risk Factors
            5Item
      1B.
            Unresolved Staff Comments
            7Item
      2.
            Properties
            7Item
      3.
            Legal Proceedings
            7Item
      4.
            Submission of Matters to a Vote of Security
      Holders
            7Part
      IIItem
      5.
            Market for Registrant’s Common Equity, Related
      Stockholder Matters and Issuer Purchases of Equity
      Securities
            8Item
      6.
            Selected Financial Data
            9Item
      7.
            Management’s Discussion and Analysis of Financial
      Condition and Results of Operations
            10Item
      7A.
            Quantitative and Qualitative Disclosures About Market
      Risk
            29Item
      8.
            Financial Statements and Supplementary
      Data
            31Item
      9.
            Changes in and Disagreements with Accountants
      on Accounting and Financial Disclosure
            61Item
      9A(T).
            Controls and Procedures
            61Item
      9B.
            Other Information
            61Part
      IIIItem
      10.
            Directors and Executive Officers and Corporate
      Governance
            62Item
      11.
            Executive Compensation
            62Item
      12.
            Security Ownership of Certain Beneficial Owners and
      Management and Related Stockholder Matters
            62Item
      13.
            Certain Relationships,  Related
      Transactions and Director Independence
            62Item
      14.
            Principal Accounting Fees and
    Services
            63Part
      IVItem
      15.
            Exhibits and Financial Statement
    Schedules
            63Signatures
            64





Index





Page
One





PART
I





Item1.
            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, 2007, The Grant County Bank had 72 full time equivalent employees,
Capon Valley Bank had 56 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.





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.





Index





Page
Three





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.





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





Actual
      Ratio
            
            
            Actual
      Ratio
            
            
            RegulatoryDecember 31, 2007
            
            
            December 31, 2006
            
            
            MinimumTotal Risk Based
      CapitalHighlands
      Bankshares
            
            
            14.53
            %
            
            
            13.45
            %The
      Grant County Bank
            
            
            13.23
            %
            
            
            12.63
            %
            
            
            8.00
            %Capon
      Valley Bank
            
            
            14.78
            %
            
            
            14.56
            %
            
            
            8.00
            %Tier 1 Leverage
      RatioHighlands
      Bankshares
            
            
            9.95
            %
            
            
            9.26
            %The
      Grant County Bank
            
            
            9.09
            %
            
            
            8.85
            %
            
            
            4.00
            %Capon
      Valley Bank
            
            
            10.00
            %
            
            
            9.53
            %
            
            
            4.00
            %Tier 1 Risk Based
      Capital RatioHighlands
      Bankshares
            
            
            13.28
            %
            
            
            12.21
            %The
      Grant County Bank
            
            
            12.09
            %
            
            
            11.39
            %
            
            
            4.00
            %Capon
      Valley Bank
            
            
            13.53
            %
            
            
            13.30
            %
            
            
            4.00
            %





Index





Page
Four





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 exceptions, 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.





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.





Index





Page
Five





Executive
Officers





Name
            
            Age
            
            Position with the Company
            
            Principal Occupation (Past Five
      Years)Clarence
      E. Porter
            
            59
            
            President
      & Chief Executive Officer; Treasurer
            
            CEO
      of Highlands since 2004; President of The Grant County Bank since
      1991R.
      Alan Miller
            
            38
            
            Finance
      Officer
            
            Finance
      Officer of Highlands since 2002; Senior Manager of Finance, Cable &
      Wireless USA prior to 2002Alan
      L. Brill
            
            53
            
            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.








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.





Index





Page
Six





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;


·
            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; and,


·
            Certain
      industries which are integral to the economy within the Company’s primary
      market area, may experience a
downturn








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.





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.





Index





Page
Seven





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.





Item 1B.
            Unresolved
      Staff Comments





None





Item 2.
            Properties





Location
            
            Description3
      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.





Item 3.
            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 indebtedness.





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 2007.





Index





Page
Eight





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 as of December 31, 2007. 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. The Company may not know terms of
an exchange between individual parties.





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 Range2007
            
            Dividends Per Share
            
            
            High
            
            
            LowFirst
      Quarter
            
            $
            .25
            
            
            $
            34.50
            
            
            $
            32.50Second
      Quarter
            
            $
            .25
            
            
            $
            34.75
            
            
            $
            33.55Third
      Quarter
            
            $
            .25
            
            
            $
            34.85
            
            
            $
            33.35Fourth
      Quarter
            
            $
            .25
            
            
            $
            34.85
            
            
            $
            29.402006First
      Quarter
            
            $
            .23
            
            
            $
            32.25
            
            
            $
            31.00Second
      Quarter
            
            $
            .23
            
            
            $
            32.50
            
            
            $
            31.15Third
      Quarter
            
            $
            .23
            
            
            $
            32.50
            
            
            $
            31.03Fourth
      Quarter
            
            $
            .25
            
            
            $
            32.75
            
            
            $
            31.50





Set forth
below is a line graph comparing the cumulative total return of Highlands
Bankshares’ common stock from December 31, 2002, assuming reinvestment of
dividends, with that of the Standard & Poor's 500 Index ("S&P 500") and
the NASDAQ Bank Index.










Index




Page
Nine




Item 6.
              Selected
      Financial Data




Years
      Ending December 31,(In
      thousands of dollars, except for per share amounts)2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Total
      Interest Income
            
            $
            27,664
            
            
            $
            23,894
            
            
            $
            19,813
            
            
            $
            17,729
            
            
            $
            18,283Total
      Interest Expense
            
            
            10,703
            
            
            
            7,909
            
            
            
            5,761
            
            
            
            4,711
            
            
            
            6,338Net
      Interest Income
            
            
            16,961
            
            
            
            15,985
            
            
            
            14,052
            
            
            
            13,018
            
            
            
            11,945Provision
      for Loan Losses
            
            
            837
            
            
            
            682
            
            
            
            875
            
            
            
            920
            
            
            
            1,820Net
      Interest Income After Provision for Loan Losses
            
            
            16,124
            
            
            
            15,303
            
            
            
            13,177
            
            
            
            12,098
            
            
            
            10,125Other
      Income
            
            
            2,080
            
            
            
            1,997
            
            
            
            1,669
            
            
            
            1,597
            
            
            
            1,367Other
      Expenses
            
            
            10,952
            
            
            
            10,394
            
            
            
            9,128
            
            
            
            8,938
            
            
            
            8,247Income
      Before Income Taxes
            
            
            7,252
            
            
            
            6,906
            
            
            
            5,718
            
            
            
            4,757
            
            
            
            3,245Income
      Tax Expense
            
            
            2,599
            
            
            
            2,391
            
            
            
            1,916
            
            
            
            1,551
            
            
            
            1,012Net
      Income
            
            $
            4,653
            
            
            $
            4,515
            
            
            $
            3,802
            
            
            $
            3,206
            
            
            $
            2,233Total
      Assets at Year End
            
            $
            380,936
            
            
            $
            357,316
            
            
            $
            337,573
            
            
            $
            299,992
            
            
            $
            301,168Long
      Term Debt at Year End
            
            $
            11,819
            
            
            $
            14,992
            
            
            $
            15,063
            
            
            $
            8,377
            
            
            $
            5,295Net
      Income Per Share of Common Stock
            
            $
            3.24
            
            
            $
            3.14
            
            
            $
            2.65
            
            
            $
            2.23
            
            
            $
            1.55Dividends
      Per Share of Common Stock
            
            $
            1.00
            
            
            $
            .94
            
            
            $
            .82
            
            
            $
            .63
            
            
            $
            .56Return
      on Average Assets
            
            
            1.24
            %
            
            
            1.29
            %
            
            
            1.21
            %
            
            
            1.07
            %
            
            
            .73
            %Return
      on Average Equity
            
            
            12.03
            %
            
            
            12.67
            %
            
            
            11.53
            %
            
            
            10.36
            %
            
            
            7.60
            %Dividend
      Payout Ratio
            
            
            30.88
            %
            
            
            29.91
            %
            
            
            30.99
            %
            
            
            28.23
            %
            
            
            36.03
            %Year
      End Equity to Assets Ratio
            
            
            10.66
            %
            
            
            10.38
            %
            
            
            10.07
            %
            
            
            10.55
            %
            
            
            9.81
            %


Index




Page
Ten





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, those factors set forth in
“Risk Factors” and 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
Eleven





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,
2007, the Company did not identify an impairment of this
intangible.





In
addition to the intangible assets associated with the purchase of the National
Bank of Davis, the company also carries intangible assets related to the
Stockmans Bank and advertising intangibles relating to the purchase of naming
rights to a performing arts center currently under construction in Petersburg,
WV. The naming rights to this performing arts center were purchased on December
31, 2007 for $250,000 and will be amortized over a ten-year period beginning in
2008. The advertising intangible, in addition to the amortization, will be
evaluated for impairment on an annual basis.





A summary
of the change in balances of intangible assets can be found in Note Nineteen to
the Financial Statements.





Index





Page
Twelve





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.





In 2006,
the FASB issued EITF 06-04 and 06-10. This EITF requires that companies which
own life insurance policies insuring employees and for which the employees
receive a portion of the death benefits of the policies (commonly referred to as
“split dollar” policies) and for which these death benefits to the employee
continue post retirement record a liability for the present value of the cost of
these post retirement death benefits. These EITF pronouncements become effective
for Highlands Bankshares on January 1, 2008. The effects on Highlands’ financial
statements as of January 1, 2008 will be to reduce shareholders’ equity by
approximately $330,000 and increase liabilities by the same amount.





Overview
of 2007 Results





The
Company’s net income for 2007 increased 3.06% over income for 2006.





Net
interest income grew by $976,000 as the company’s average earning assets for the
year increased by 9.72% from 2006 to 2007. Loan balances continued to increase
as the balance of loans grew $17,383,000 from December 31, 2006 to December 31,
2007. The impact of the increase in earning assets on net interest income was
offset by a 10.67% increase in average balances of interest bearing liabilities.
Highlands continued to see increases in the rates earned on average assets and
paid on interest bearing liabilities as both assets and liabilities continued to
reprice upward as a result of Federal Reserve Board (the “Fed”) increases in the
target rates for federal funds sold during 2006.





The
Company’s provision for loan losses was $155,000 greater in 2007 than in 2006.
This was the result of both an increase in the balances of loans and an increase
in 2007 of net charge-offs as compared to recent years. At December 31, 2007 the
Company’s ratio of allowance for loan losses to gross loans was 1.15% as
compared to 1.19% at December 31, 2006.





Non-interest
income increased $83,000 from 2006 to 2007. During 2006, the Company recorded a
one time gain of $155,000 on an insurance settlement.





Non-interest
expense increased 5.37% during 2007 as compared to 2006. The largest increase
was in salary and benefit expense largely due to customary pay increases and an
increase in the costs of health insurance benefits provided to the employees of
the Company and the subsidiary banks. Legal and professional fees increased
9.76% due largely to costs associated with Sarbanes Oxley Rule 404
compliance.





The
Company’s balance sheet continued to grow in 2007 as asset balances increased
6.61% from December 31, 2006 to December 31, 2007. Balances of liabilities,
particularly deposits, also grew during 2007 with balances of deposits being
7.74% greater at December 31, 2007 than at December 31, 2006.





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





Index





Page
Thirteen





Quarterly
Financial Results





The
following table illustrates Highlands’ quarterly financial results for the year
ended December 31, 2007 (in thousands of dollars):





Quarterly
      Financial ResultsFor
      The Year Ended December 31, 2007(in
      thousands, except per share amounts)Fourth
              Quarter
            
            
            Third
              Quarter
            
            
            Second
              Quarter
            
            
            First
              QuarterTotal
      Interest Income
            
            $
            7,102
            
            
            $
            7,079
            
            
            $
            6,917
            
            
            $
            6,566Total
      Interest Expense
            
            
            2,799
            
            
            
            2,796
            
            
            
            2,660
            
            
            
            2,448Net
      Interest Income
            
            
            4,303
            
            
            
            4,283
            
            
            
            4,257
            
            
            
            4,118Provision
      for Loan Losses
            
            
            351
            
            
            
            145
            
            
            
            168
            
            
            
            173Net
      Interest Income After Provision for Loan Losses
            
            
            3,952
            
            
            
            4,138
            
            
            
            4,089
            
            
            
            3,945Other
      Income
            
            
            572
            
            
            
            542
            
            
            
            495
            
            
            
            471Other
      Expenses
            
            
            2,634
            
            
            
            2,857
            
            
            
            2,803
            
            
            
            2,658Income
      Before Income Taxes
            
            
            1,890
            
            
            
            1,823
            
            
            
            1,781
            
            
            
            1,758Income
      Tax Expense
            
            
            614
            
            
            
            690
            
            
            
            658
            
            
            
            637Net
      Income
            
            $
            1,276
            
            
            $
            1,133
            
            
            $
            1,123
            
            
            $
            1,121Net
      Income Per Share of Common Stock
            
            $
            .89
            
            
            $
            .79
            
            
            $
            .78
            
            
            $
            .78Dividends
      Per Share of Common Stock
            
            $
            .25
            
            
            $
            .25
            
            
            $
            .25
            
            
            $
            .25


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)Fourth
              Quarter
            
            
            Third
              Quarter
            
            
            Second
              Quarter
            
            
            First
              QuarterTotal
      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





Net Interest
Income





2007 Compared to
2006





Net
interest income, on a fully taxable equivalent basis, increased 6.09% from 2006
to 2007.





Although
the Company experienced an increase in income, margins shrank from 2006 to 2007.
This shrinking of the Company’s net interest margin occurred for multiple
reasons, included in which are the effect of the Fed’s decrease in the target
rate for fed funds sold during the later months of 2007, the relative repricing
of deposits as compared to earning assets and both the ratio of earning assets
to interest bearing deposits and the ratio of loans, a comparatively higher
earning asset, to other types of earning assets.





Although
the Company experienced an increase in loan balances from December 31, 2006 to
December 31, 2007 and a 9.01% increase in the average balances of loans for 2007
as compared to 2006, balances of deposits increased at a greater rate. Loan
balances increased $17,383,000 from December 31, 2006 to December 31, 2007 while
deposit balances increased $23,254,000 over the same time period, resulting in
an increase in federal funds sold during the last half of 2007. The relative
difference in these balances caused the Company’s average balances of federal
funds sold to be greater during 2007 than in 2006 and the decreases by the Fed
for the target rate for federal funds sold late in the year caused a significant
impact on the Company’s interest earnings.





Index





Page
Fifteen





Additionally,
although earning assets continued to reprice upward in 2007 as a result of the
increases in rates during 2006, the relative increase in rates paid on deposits,
particularly time deposits, was greater than the increase in average rates
earned on earning assets. Average rates earned on loans during 2007 were 39
basis points higher than in 2006 while the average rates paid on time deposits
were 76 basis points higher in 2007 than in 2006.





The table
below sets forth an analysis of net interest income for the years ended December
31, 2007 and 2006 (average balances and interest income/expense shown in
thousands of dollars):





2007
            
            
            2006Average
              Balance
            
            
            Income
              /Expense
            
            
            Yield
              /Rate
            
            
            Average
              Balance
            
            
            Income
              /Expense
            
            
            Yield
              /RateEarning
      AssetsLoans
            
            $
            302,906
            
            
            $
            25,295
            
            
            
            8.35
            %
            
            $
            277,871
            
            
            $
            22,118
            
            
            
            7.96
            %Taxable
      investment securities
            
            
            24,104
            
            
            
            1,314
            
            
            
            5.45
            %
            
            
            24,970
            
            
            
            1,095
            
            
            
            4.39
            %Nontaxable
      investment securities
            
            
            2,929
            
            
            
            178
            
            
            
            6.06
            %
            
            
            2,987
            
            
            
            173
            
            
            
            5.79
            %Interest
      bearing deposits
            
            
            2,610
            
            
            
            142
            
            
            
            5.44
            %
            
            
            1,576
            
            
            
            72
            
            
            
            4.57
            %Federal
      funds sold
            
            
            16,006
            
            
            
            801
            
            
            
            5.00
            %
            
            
            10,287
            
            
            
            500
            
            
            
            4.87
            %Total
      Earning Assets
            
            
            348,555
            
            
            
            27,730
            
            
            
            7.96
            %
            
            
            317,691
            
            
            
            23,958
            
            
            
            7.54
            %Allowance
      for loan losses
            
            
            (3,589
            )
            
            
            
            
            
            
            
            
            
            
            (3,283
            )Other
      non-earning assets
            
            
            29,504
            
            
            
            
            
            
            
            
            
            
            
            28,648Total
      Assets
            
            $
            374,470
            
            
            
            
            
            
            
            
            
            
            $
            343,056Interest
      Bearing LiabilitiesDemand
      deposits
            
            $
            25,363
            
            
            $
            217
            
            
            
            .86
            %
            
            $
            25,658
            
            
            $
            224
            
            
            
            .87
            %Savings
      deposits
            
            
            48,181
            
            
            
            685
            
            
            
            1.42
            %
            
            
            50,235
            
            
            
            549
            
            
            
            1.09
            %Time
      deposits
            
            
            196,648
            
            
            
            9,205
            
            
            
            4.68
            %
            
            
            164,005
            
            
            
            6,429
            
            
            
            3.92
            %Borrowed
      money
            
            
            12,613
            
            
            
            596
            
            
            
            4.73
            %
            
            
            15,643
            
            
            
            707
            
            
            
            4.52
            %Total
      Interest Bearing Liabilities
            
            
            282,805
            
            
            
            10,703
            
            
            
            3.78
            %
            
            
            255,541
            
            
            
            7,909
            
            
            
            3.10
            %Demand
      deposits
            
            
            48,101
            
            
            
            
            
            
            
            
            
            
            
            48,056Other
      liabilities
            
            
            4,886
            
            
            
            
            
            
            
            
            
            
            
            3,810Stockholders’
      equity
            
            
            38,678
            
            
            
            
            
            
            
            
            
            
            
            35,649Total
      Liabilities and Stockholders’ Equity
            
            $
            374,470
            
            
            
            
            
            
            
            
            
            
            $
            343,056Net
      Interest Income
            
            
            
            
            
            $
            17,027
            
            
            
            
            
            
            
            
            
            
            $
            16,049Net
      Yield on Earning Assets
            
            
            
            
            
            
            
            
            
            
            4.89
            %
            
            
            
            
            
            
            
            
            
            
            5.05
            %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
Sixteen





The table
below illustrates the effects on net interest income of changes in average
volumes of interest bearing liabilities and earning assets from 2006 to 2007 and
changes in average rates on interest bearing liabilities and earning assets from
2006 to 2007 (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) 2007 Compared to 2006Due
      to change in:Average Volume
            
            
            Average Rate
            
            
            Total ChangeInterest
      IncomeLoans
            
            $
            1,993
            
            
            $
            1,184
            
            
            $
            3,177Taxable
      investment securities
            
            
            (38
            )
            
            
            257
            
            
            
            219Nontaxable
      investment securities
            
            
            (3
            )
            
            
            8
            
            
            
            5Interest
      bearing deposits
            
            
            46
            
            
            
            23
            
            
            
            69Federal
      funds sold
            
            
            279
            
            
            
            22
            
            
            
            301Total
      Interest Income
            
            
            2,277
            
            
            
            1,494
            
            
            
            3,771Interest
      ExpenseDemand
      deposits
            
            
            (3
            )
            
            
            (5
            )
            
            
            (8
            )Savings
      deposits
            
            
            (22
            )
            
            
            159
            
            
            
            137Time
      deposits
            
            
            1,280
            
            
            
            1,496
            
            
            
            2,776Borrowed
      money
            
            
            (137
            )
            
            
            27
            
            
            
            (110
            )Total
      Interest Expense
            
            
            1,118
            
            
            
            1,677
            
            
            
            2,795Net
      Interest Income
            
            $
            1,159
            
            
            $
            (183
            )
            
            $
            976





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.





2006 Compared to
2005





The
acquisition of two branches 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” found in the Company’s 2006 Annual Report on Form
10-K.





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%.





Index





Page
Seventeen





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.





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
            
            
            
            
            
            
            
            
            
            
            $
            314,868Interest
      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.





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.





Index





Page
Nineteen





The
following table summarizes the Company’s loan portfolio at December 31, 2007,
2006, 2005, 2004 and 2003 (in thousands of dollars):





At
      December 31,2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Real
      estate mortgage
            
            $
            169,122
            
            
            $
            164,243
            
            
            $
            153,646
            
            
            $
            140,762
            
            
            $
            129,671Real
      estate construction
            
            
            15,560
            
            
            
            14,828
            
            
            
            12,201
            
            
            
            8,850
            
            
            
            7,552Commercial
            
            
            79,892
            
            
            
            70,408
            
            
            
            57,908
            
            
            
            52,813
            
            
            
            42,911Installment
            
            
            45,625
            
            
            
            43,337
            
            
            
            46,265
            
            
            
            46,092
            
            
            
            46,501Total
      Loans
            
            
            310,199
            
            
            
            292,816
            
            
            
            270,020
            
            
            
            248,517
            
            
            
            226,635Allowance
      for loan losses
            
            
            (3,577
            )
            
            
            (3,482
            )
            
            
            (3,129
            )
            
            
            (2,530
            )
            
            
            (2,463
            )Net
      Loans
            
            $
            306,622
            
            
            $
            289,334
            
            
            $
            266,891
            
            
            $
            245,987
            
            
            $
            224,172





Commercial
loan balances include certain loans secured by commercial real estate. As of
December 31, 2007 the Company maintained balances of loans secured by real
estate of $240,208,000.





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, 2007 (in thousands of dollars):





Maturity
      RangeLess than 1 Year
            
            
            1-5 Years
            
            
            Over 5 Years
            
            
            TotalLoan
      TypeCommercial
            
            $
            58,094
            
            
            $
            8,043
            
            
            $
            13,755
            
            
            $
            79,892Real
      estate mortgage and construction
            
            
            59,129
            
            
            
            56,430
            
            
            
            69,123
            
            
            
            184,682Installment
            
            
            15,991
            
            
            
            28,286
            
            
            
            1,348
            
            
            
            45,625Total
      Loans
            
            $
            133,214
            
            
            $
            92,759
            
            
            $
            84,226
            
            
            $
            310,199





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 vary 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





Non-performing
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. Non-performing loans do not represent or
result from trends or uncertainties which management reasonably expects will
materially impact future operating results, liquidity, or capital resources.
Non-performing loans are listed in the table below.





Non-performing
loans increased 97.41% from December 31, 2006 to December 31, 2007. At December
31, 2007, non-performing loans represented 1.08% of the Company’s balances of
gross loans as compared to .58% at December 31, 2006.





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





At
      December 31,2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Loans
      accounted for on a non-accrual basisConsumer
            
            $
            71
            
            
            $
            83
            
            
            $
            124
            
            
            $
            252
            
            
            $
            228Real
      estate
            
            
            845
            
            
            
            161
            
            
            
            619
            
            
            
            278
            
            
            
            1,436Total
      Non-accrual Loans
            
            
            916
            
            
            
            244
            
            
            
            743
            
            
            
            530
            
            
            
            1,664Restructured
      Loans
            
            
            198
            
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            631Loans
      delinquent 90 days or moreConsumer
            
            
            497
            
            
            
            122
            
            
            
            74
            
            
            
            140
            
            
            
            25Commercial
            
            
            3
            
            
            
            0
            
            
            
            966
            
            
            
            355
            
            
            
            1,255Real
      estate
            
            
            1,744
            
            
            
            1,335
            
            
            
            149
            
            
            
            40
            
            
            
            318Total
      delinquent loans
            
            
            2,244
            
            
            
            1,457
            
            
            
            1,189
            
            
            
            535
            
            
            
            1,598Total
      Non-performing Loans
            
            $
            3,358
            
            
            $
            1,701
            
            
            $
            1,932
            
            
            $
            1,065
            
            
            $
            3,893





The
carrying value of real estate acquired through foreclosure was $336,000 at
December 31, 2007.   The Company held no real estate acquired
through foreclosure at December 31, 2006.  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 One





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’ portfolios.  Each Bank pays
particular attention to individual loan performance, collateral values, borrower
financial condition and economic conditions.  The determination of an
adequate allowance at each Bank is done in a three-step process.  The
first step is to identify impaired loans. Impaired loans are problem loans above
a certain threshold, which have estimated losses, calculated based on 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, 2007IdentifiedLoan
      Type
            
            Balance
            
            
            ImpairmentMortgage
            
            $
            741
            
            
            $
            77Commercial
            
            
            385
            
            
            
            108Installment
            
            
            90
            
            
            
            58








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. Non-performing loans are closely monitored on an
ongoing basis as part of the Company's loan review process.





During
2007 the Company experienced a higher level of net charge-offs, as compared to
gross loan balances, than what had been experienced during 2005 and 2006. As a
result, and in addition to continued increases in loan balances, the Company’s
provision for loan losses during 2007 was $155,000 greater than in 2006. The
Company’s ratio of allowance for loan losses to gross loans fell from 1.19% at
December 31, 2006 to 1.15% at December 31, 2007.  At December 31,
2007, the ratio of the allowance for loan losses to non-performing loans was
106.52% compared to 204.70% at December 31, 2006 and 161.96% at December 31,
2005.





Index





Page
Twenty Two





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





2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Balance
      at beginning of period
            
            $
            3,482
            
            
            $
            3,129
            
            
            $
            2,530
            
            
            $
            2,463
            
            
            $
            1,793Charge-offs:Commercial
      loans
            
            
            540
            
            
            
            27
            
            
            
            45
            
            
            
            97
            
            
            
            557Real
      estate loans
            
            
            47
            
            
            
            1
            
            
            
            8
            
            
            
            422
            
            
            
            65Consumer
      loans
            
            
            494
            
            
            
            551
            
            
            
            567
            
            
            
            642
            
            
            
            839Total
      Charge-offs:
            
            
            1,081
            
            
            
            579
            
            
            
            620
            
            
            
            1,161
            
            
            
            1,461Recoveries:Commercial
      loans
            
            
            59
            
            
            
            5
            
            
            
            28
            
            
            
            37
            
            
            
            75Real
      estate loans
            
            
            4
            
            
            
            20
            
            
            
            0
            
            
            
            36
            
            
            
            54Consumer
      loans
            
            
            276
            
            
            
            225
            
            
            
            150
            
            
            
            235
            
            
            
            182Total
      Recoveries
            
            
            339
            
            
            
            250
            
            
            
            178
            
            
            
            308
            
            
            
            311Net
      Charge-offs
            
            
            742
            
            
            
            329
            
            
            
            442
            
            
            
            853
            
            
            
            1,150Provision
      for loan losses
            
            
            837
            
            
            
            682
            
            
            
            875
            
            
            
            920
            
            
            
            1,820Other
      additions
            
            
            
            
            
            
            
            
            
            
            166Balance
      at end of period
            
            $
            3,577
            
            
            $
            3,482
            
            
            $
            3,129
            
            
            $
            2,530
            
            
            $
            2,463Percent
      of net charge-offs to average net loans outstanding during the
      period
            
            
            .24
            %
            
            
            .11
            %
            
            
            .17
            %
            
            
            .51
            %
            
            
            .29
            %





Cumulative
net loan losses, after recoveries, for the five-year period ending December 31,
2007 are as follows (in thousands of dollars):





Dollars
            
            
            Percent of TotalCommercial
            
            $
            1,062
            
            
            
            30
            %Real
      Estate
            
            
            429
            
            
            
            12
            %Consumer
            
            
            2,025
            
            
            
            58
            %Total
            
            $
            3,516








Index





Page
Twenty Three





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 31,2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Amount
            
            
            Percent
              of
              Loans
            
            
            Amount
            
            
            Percent
      of Loans
            
            
            Amount
            
            
            Percent
      of Loans
            
            
            Amount
            
            
            Percent
      of Loans
            
            
            Amount
            
            
            Percent
      of LoansCommercial
            
            $
            1,140
            
            
            
            26
            %
            
            $
            1,492
            
            
            
            24
            %
            
            $
            900
            
            
            
            21
            %
            
            $
            697
            
            
            
            21
            %
            
            $
            779
            
            
            
            19
            %Mortgage
            
            
            1,200
            
            
            
            59
            %
            
            
            996
            
            
            
            61
            %
            
            
            1,139
            
            
            
            62
            %
            
            
            853
            
            
            
            60
            %
            
            
            725
            
            
            
            61
            %Consumer
            
            
            1,172
            
            
            
            15
            %
            
            
            967
            
            
            
            15
            %
            
            
            1,082
            
            
            
            17
            %
            
            
            970
            
            
            
            19
            %
            
            
            819
            
            
            
            20
            %Unallocated
            
            
            65
            
            
            
            
            
            
            
            27
            
            
            
            
            
            
            
            8
            
            
            
            
            
            
            
            10
            
            
            
            
            
            
            
            140Totals
            
            $
            3,577
            
            
            
            100
            %
            
            $
            3,482
            
            
            
            100
            %
            
            $
            3,129
            
            
            
            100
            %
            
            $
            2,530
            
            
            
            100
            %
            
            $
            2,463
            
            
            
            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





2007 compared to
2006





Non
interest income increased $83,000 from 2006 to 2007. During 2006, the Company
recorded a one time gain of $155,000 on an insurance settlement.





Largely
because of continued increases in non-sufficient funds fees, as a result of
implementation of what is commonly referred to as a “courtesy overdraft” program
by Capon Valley Bank in late 2005, deposit account fees increased 14.67% from
2006 to 2007. The impact on non-interest income resulting from this program
continued to increase during 2007. During late 2007, The Grant County Bank
implemented a similar “courtesy overdraft” program, although the impact of
Grant’s program on 2007 non interest income was not significant.





Income
from investments in life insurance policies decreased $145,000 from 2006 to
2007. The decrease was largely the result of the non-recurring income recorded
during 2006 from the settlement of a bank owned life insurance
policy.





Insurance
commissions and insurance earnings generated by HBI Life Insurance Company
remained relatively steady from 2006 to 2007. The largest market for the
products offered, credit life and accident and health insurance, is installment
loan customers for the banks. From 2002 to 2006, as the number of installment
loan customers for the banks dropped significantly, insurance earnings for the
Company fell accordingly. The numbers of new installment loan customers have
begun to stabilize and as a result, the Company’s insurance income has also
stabilized.





Index





Page
Twenty Four





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.





Non-interest
Expense





2007 compared to
2006





Non-interest
expense increased 5.37% from 2006 to 2007.





Employee
salary and benefits expense increased 4.96%. The table below summarizes the
changes in salaries and benefits expense (all dollar amounts expressed in
thousands of dollars):





Increase
            
            
            PercentIncreases
      in salary expense and related payroll tax due to changes in average number
      of full time equivalent employees
            
            $
            155Increases
      in salary expense and related payroll tax due to average pay rate
      increases
            
            
            100Total
      increase in salary expense and related payroll tax
            
            
            255
            
            
            
            6.22
            %Increase
      in the cost of employee insurance benefits
            
            
            95
            
            
            
            12.91
            %Increase
      in the cost of executive retirement benefits related to investments in
      insurance contracts
            
            
            (89
            )
            
            
            (37.25
            %)Increase
      in the cost of employee post retirement benefit plans
            
            
            20
            
            
            
            3.33
            %





The
Company’s physical plant remained relatively unchanged from 2006 to 2007 other
than normal and customary upgrades of equipment and technology. As a result,
occupancy and equipment expense remained relatively flat from 2006 to
2007.





Data
processing increased 5.30% as the volume of accounts, both loan and deposit,
increased.





Legal and
professional fees increased 9.76% from 2006 to 2007 largely as a result of
increases in consulting engagements relating to regulatory compliance issues,
most notably Sarbanes Oxley Rule 404.





Index





Page
Twenty Five





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
            
            
            PercentIncreases
      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 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.





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 7.24% of total assets
at December 31, 2007.





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, 2007, the faire value of the securities
available for sale exceeded their cost basis by $270,000 ($169,000 after tax
effect of $101,000).





Index





Page
Twenty Six





The
following table summarizes the carrying value of the Company’s securities at
December 31, 2007, 2006 and 2005 (in thousands of dollars):





Held
      to Maturity
            
            
            Available
      for SaleCarrying
      Value
            
            
            Carrying
      ValueDecember
      31,
            
            
            December
      31,2007
            
            
            2006
            
            
            2005
            
            
            2007
            
            
            2006
            
            
            2005U.S.
      Treasuries and Agencies
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            15,245
            
            
            $
            14,403
            
            
            $
            17,234Obligations
      of states and political subdivisions
            
            
            0
            
            
            
            170
            
            
            
            491
            
            
            
            3,039
            
            
            
            2,744
            
            
            
            2,705Mortgage
      backed securities
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            7,784
            
            
            
            6,554
            
            
            
            7,163Marketable
      equities
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            22
            
            
            
            28
            
            
            
            28Total
            
            $
            0
            
            
            $
            170
            
            
            $
            491
            
            
            $
            26,090
            
            
            $
            23,729
            
            
            $
            27,130





The
carrying amount and estimated market value of debt securities (in thousands of
dollars) at December 31, 2007 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
      Available for SaleDue
      in 3 months or less
            
            $
            2,309
            
            
            $
            2,312
            
            
            
            5.04
            %Due
      in 3 months through one year
            
            
            6,825
            
            
            
            6,842
            
            
            
            4.90
            %Due
      after one year through five years
            
            
            15,782
            
            
            
            16,035
            
            
            
            5.22
            %Due
      after five years through ten years
            
            
            838
            
            
            
            840
            
            
            
            4.15
            %Due
      after ten years
            
            
            38
            
            
            
            39
            
            
            
            5.56
            %Equity
      securities with no maturity
            
            
            28
            
            
            
            22
            
            
            
            8.40
            %Total
      Available For Sale
            
            $
            25,820
            
            
            $
            26,090
            
            
            
            5.08
            %





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 7.74% from December 31, 2006 to December 31,
2007.





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 19.35% from December 31, 2006 to December 31, 2007. This
increase is, in part, attributable to rate specials offered by the subsidiary
Banks during the year.





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





At
      December 31,2007
            
            
            2006
            
            
            2005Three
      months or less
            
            $
            19,609
            
            
            $
            9,533
            
            
            $
            7,662Four
      to twelve months
            
            
            30,204
            
            
            
            30,810
            
            
            
            14,835One
      year to three years
            
            
            10,067
            
            
            
            8,156
            
            
            
            17,736Four
      years to five years
            
            
            5,606
            
            
            
            6,368
            
            
            
            5,222Total
            
            $
            65,486
            
            
            $
            54,867
            
            
            $
            45,455








Index





Page
Twenty Seven





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 2007, the
Company borrowed an additional $1,000,000 from the FHLB and made payments of $
4,173,000 on outstanding balances.





Short Term
Borrowings





At either
December 31, 2006 or 2007, 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 2007, 2006, and 2005, total stockholders' equity
increased by $3,517,000, $3,084,000 and $2,337,000, respectively, as a result of
earnings retention and changes in the other comprehensive income.  The
return on average equity was 12.03% in 2007 compared to 12.67% for 2006 and
11.53% for 2005.  Total cash dividends declared represent 30.88% of
net income for 2007 compared to 29.91% of net income for 2006 and 30.99% for
2005.  Book value per share was $28.25 at December 31, 2007 compared
to $25.80 at December 31, 2006.





Index





Page
Twenty Eight





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,
2008, the subsidiary Banks could pay dividends to Highlands Bankshares, Inc. of
approximately $6,505,000 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
Twenty Nine





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. This increase in average
maturity lengths may effect the timing of the repricing of the loan portfolio as
compared to the timing of the repricing of the deposit portfolio.





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 and 2007 and time deposit balances
increased as customers began moving deposits from the lower earning transaction
accounts and into time deposits. Also, because of increasing competition for
depositors, the Company’s subsidiary banks were required to, during 2006 and
into 2007, in order to fund loan growth, frequently offer deposit rates above
those of competitors. As a result, average rates paid on time deposits increased
significantly during 2007 as compared to the increases in average rates on
earning assets.





At
present, the Company’s largest challenge in managing its net interest income is
in managing its short term portfolio. As loan growth has slowed and deposit
demand remained strong, the Company, during 2007, experienced increases in the
balances of short-term, liquid earning assets like federal funds sold. The
impact of this increase in short term earning assets was seen during the last
periods of 2007 when the Fed decreased the target rate on federal funds sold.
The result of this increase was that these short term assets repriced quickly
downward, reducing interest income, while the interest bearing liability
portfolio will not reprice downward as quickly.





The
recent decreases in the rates earned on short term assets and the possibility of
further future decreases, coupled with the pontential of the Company having
continued elevated balances of short-term earning assets might further erode net
interest income should demand for new loans continue to remain flat. This
combination of occurrances would have the effect of reducing the Company’s
ability to convert short term earning assets, which typically have lower average
rates of return to loans which typically carry comparatively higher rates of
return. Also, should demand for new loans continue to remain flat, the Company
may be required to slow its demand for new deposits by lowering the rates paid
on these deposits.





Index





Page
Thirty





The
following table illustrates the Company’s sensitivity to interest rate changes
as of December 31, 2007 (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
            
            $
            50,434
            
            
            $
            112,514
            
            
            
            93,253
            
            
            
            22,498
            
            
            
            31,500
            
            
            
            310,199Federal
      funds sold
            
            
            14,246
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            14,246Securities
            
            
            8,938
            
            
            
            4,228
            
            
            
            8,826
            
            
            
            1,087
            
            
            
            3,011
            
            
            
            26,090Deposits
      in other banks
            
            
            1,544
            
            
            
            100
            
            
            
            209
            
            
            
            
            
            
            
            
            
            
            
            1,853Total
            
            
            75,162
            
            
            
            116,842
            
            
            
            102,288
            
            
            
            23,585
            
            
            
            34,511
            
            
            
            352,388INTEREST
      BEARING LIABILITIESInterest
      bearing demand deposits
            
            
            23,967
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            23,967Savings
      deposits
            
            
            49,769
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            49,769Time
      deposits
            
            
            56,008
            
            
            
            92,610
            
            
            
            35,187
            
            
            
            17,592
            
            
            
            
            
            
            
            201,397Borrowed
      money
            
            
            154
            
            
            
            426
            
            
            
            1,941
            
            
            
            6,965
            
            
            
            2,333
            
            
            
            11,819Total
            
            
            129,898
            
            
            
            93,036
            
            
            
            37,128
            
            
            
            24,557
            
            
            
            2,333
            
            
            
            286,952Rate
      sensitivity gap
            
            $
            (54,736
            )
            
            $
            23,806
            
            
            $
            65,160
            
            
            $
            (972
            )
            
            $
            32,178
            
            
            $
            65,436Cumulative
      gap
            
            $
            (54,736
            )
            
            $
            (30,930
            )
            
            $
            34,230
            
            
            $
            33,258
            
            
            $
            65,436




Index





Page
Thirty One





Item 8.
            Financial
      Statements and Supplementary Data





HIGHLANDS
      BANKSHARES, INC.CONSOLIDATED
      BALANCE SHEETSDecember
      31, 2007 and 2006(In
      thousands of dollars)2007
            
            
            2006ASSETSCash
      and due from banks
            
            $
            7,935
            
            
            $
            7,111Interest
      bearing deposits in banks
            
            
            1,853
            
            
            
            1,624Federal
      funds sold
            
            
            14,246
            
            
            
            12,210Investment
      securities held to maturity
            
            
            0
            
            
            
            170Investment
      securities available for sale
            
            
            26,090
            
            
            
            23,729Restricted
      investments
            
            
            1,498
            
            
            
            1,570Loans
            
            
            310,199
            
            
            
            292,816Allowance
      for loan losses
            
            
            (3,577
            )
            
            
            (3,482
            )Bank
      premises and equipment
            
            
            8,104
            
            
            
            8,131Interest
      receivable
            
            
            2,273
            
            
            
            2,173Investment
      in life insurance contracts
            
            
            6,300
            
            
            
            6,066Goodwill
            
            
            1,534
            
            
            
            1,534Other
      intangible assets
            
            
            1,572
            
            
            
            1,498Other
      assets
            
            
            2,909
            
            
            
            2,166Total
      Assets
            
            $
            380,936
            
            
            $
            357,316LIABILITIESDepositsNon-interest
      bearing deposits
            
            
            48,605
            
            
            $
            46,726Interest
      bearing transaction and savings accounts
            
            
            73,736
            
            
            
            71,590Time
      deposits over $100,000
            
            
            65,486
            
            
            
            54,867All
      other time deposits
            
            
            135,911
            
            
            
            127,301Total
      Deposits
            
            
            323,738
            
            
            
            300,484Long
      term debt
            
            
            11,819
            
            
            
            14,992Accrued
      expenses and other liabilities
            
            
            4,786
            
            
            
            4,764Total
      Liabilities
            
            
            340,343
            
            
            
            320,240STOCKHOLDERS’
      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
            
            
            32,032
            
            
            
            28,816Other
      accumulated comprehensive loss
            
            
            (285
            )
            
            
            (586
            )Total
      Stockholders’ Equity
            
            
            40,593
            
            
            
            37,076Total
      Liabilities and Stockholders’ Equity
            
            $
            380,936
            
            
            $
            357,316





The
accompanying notes are an integral part of these statements





Index





Page
Thirty Two





HIGHLANDS
      BANKSHARES, INC.CONSOLIDATED
      STATEMENTS OF INCOMEFOR
      THE YEARS ENDED DECEMBER 31, 2007, 2006 and 2005(in
      thousands of dollars, except per share data)2007
            
            
            2006
            
            
            2005Interest
      and Dividend IncomeLoans,
      including fees
            
            $
            25,295
            
            
            $
            22,118
            
            
            $
            18,622Federal
      funds sold
            
            
            801
            
            
            
            500
            
            
            
            343Interest
      bearing deposits
            
            
            142
            
            
            
            72
            
            
            
            38Investment
      securities
            
            
            1,426
            
            
            
            1,204
            
            
            
            810Total
      Interest Income
            
            
            27,664
            
            
            
            23,894
            
            
            
            19,813Interest
      ExpenseInterest
      on deposits
            
            
            10,107
            
            
            
            7,202
            
            
            
            5,130Interest
      on borrowed money
            
            
            596
            
            
            
            707
            
            
            
            631Total
      Interest Expense
            
            
            10,703
            
            
            
            7,909
            
            
            
            5,761Net
      Interest Income
            
            
            16,961
            
            
            
            15,985
            
            
            
            14,052Provision
      for Loan Losses
            
            
            837
            
            
            
            682
            
            
            
            875Net
      Interest Income after Provision for Loan Losses
            
            
            16,124
            
            
            
            15,303
            
            
            
            13,177Non-interest
      IncomeService
      charges
            
            
            1,391
            
            
            
            1,213
            
            
            
            876Insurance
      commissions and income
            
            
            132
            
            
            
            126
            
            
            
            227Life
      insurance investment income
            
            
            235
            
            
            
            380
            
            
            
            234Gain
      on securities transactions
            
            
            1
            
            
            
            0
            
            
            
            6Other
      operating income
            
            
            321
            
            
            
            278
            
            
            
            326Total
      Non-interest Income
            
            
            2,080
            
            
            
            1,997
            
            
            
            1,669Non-interest
      ExpensesSalaries
      and benefits
            
            
            5,952
            
            
            
            5,671
            
            
            
            4,973Occupancy
      expense
            
            
            517
            
            
            
            467
            
            
            
            412Equipment
      expense
            
            
            867
            
            
            
            879
            
            
            
            836Data
      processing expense
            
            
            854
            
            
            
            811
            
            
            
            632Legal
      and professional fees
            
            
            461
            
            
            
            420
            
            
            
            440Directors
      fees
            
            
            371
            
            
            
            392
            
            
            
            341Other
      operating expenses
            
            
            1,930
            
            
            
            1,754
            
            
            
            1,494Total
      Non-interest Expenses
            
            
            10,952
            
            
            
            10,394
            
            
            
            9,128Income
      Before Income Tax Expense
            
            
            7,252
            
            
            
            6,906
            
            
            
            5,718Income
      Tax Expense
            
            
            2,599
            
            
            
            2,391
            
            
            
            1,916Net
      Income
            
            $
            4,653
            
            
            $
            4,515
            
            
            $
            3,802Earnings
      Per Share
            
            $
            3.24
            
            
            $
            3.14
            
            
            $
            2.65Dividends
      Per Share
            
            
            1.00
            
            
            
            .94
            
            
            
            .82Weighted
      Average Shares Outstanding
            
            
            1,436,874
            
            
            
            1,436,874
            
            
            
            1,436,874





The
accompanying notes are an integral part of these statements





Index





Page
Thirty Three





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, 2005
            
            $
            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
            )
            
            
            37,076Comprehensive
      Income:Net
      income
            
            
            
            
            
            
            
            
            
            
            4,653
            
            
            
            
            
            
            
            4,653Change
      in other comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            301
            
            
            
            301Total
      Comprehensive Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            4,954Cash
      Dividends
            
            
            
            
            
            
            
            
            
            
            (1,437
            )
            
            
            
            
            
            
            (1,437
            )Balances
      December 31, 2007
            
            $
            7,184
            
            
            $
            1,662
            
            
            $
            32,032
            
            
            $
            (285
            )
            
            $
            40,593





The
accompanying notes are an integral part of these statements





Index





Page
Thirty Four





HIGHLANDS
      BANKSHARES, INC.CONSOLIDATED
      STATEMENTS OF CASH FLOWSFOR
      THE YEARS ENDED DECEMBER 31, 2007, 2006 and 2005(In
      thousands of dollars)Years
      Ended December 31,2007
            
            
            2006
            
            
            2005CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      Income
            
            $
            4,653
            
            
            $
            4,515
            
            
            $
            3,802Adjustments
      to reconcile net income to net cash provided by operating
      activitiesGain
      on securities transactions
            
            
            (1
            )
            
            
            0
            
            
            
            (6
            )(Gain)
      loss on sale of property
            
            
            38
            
            
            
            (7
            )
            
            
            (19
            )Depreciation
            
            
            704
            
            
            
            691
            
            
            
            692Income
      from life insurance contracts
            
            
            (234
            )
            
            
            (380
            )
            
            
            (234
            )Net
      amortization of securities premiums
            
            
            (142
            )
            
            
            (182
            )
            
            
            39Provision
      for loan losses
            
            
            837
            
            
            
            682
            
            
            
            875Deferred
      income tax benefit
            
            
            (131
            )
            
            
            (115
            )
            
            
            (170
            )Amortization
      of intangibles
            
            
            176
            
            
            
            176
            
            
            
            38Decrease
      (Increase) in interest receivable
            
            
            (100
            )
            
            
            (355
            )
            
            
            (294
            )Decrease
      (Increase) in other assets
            
            
            (585
            )
            
            
            1
            
            
            
            95Increase
      (Decrease) in accrued expenses
            
            
            22
            
            
            
            938
            
            
            
            207Purchase
      of Intangibles
            
            
            (250
            )
            
            
            0
            
            
            
            0Net
      Cash Provided by Operating Activities
            
            
            4,987
            
            
            
            5,964
            
            
            
            5,025CASH
      FLOWS FROM INVESTING ACTIVITIESSale
      of property
            
            
            0
            
            
            
            7
            
            
            
            19Proceeds
      from maturity of securities held to maturity
            
            
            170
            
            
            
            320
            
            
            
            670Proceeds
      from maturity of securities available for sale
            
            
            10,918
            
            
            
            11,539
            
            
            
            12,654Purchase
      of securities available for sale
            
            
            (12,862
            )
            
            
            (7,870
            )
            
            
            (8,083
            )Net
      change in other investments
            
            
            72
            
            
            
            (320
            )
            
            
            (77
            )Net
      change in interest bearing deposits in other banks
            
            
            (229
            )
            
            
            (661
            )
            
            
            (312
            )Net
      increase in loans
            
            
            (18,125
            )
            
            
            (23,125
            )
            
            
            (13,442
            )Settlement
      on insurance contract, net of gain
            
            
            0
            
            
            
            555
            
            
            
            0Net
      change in federal funds sold
            
            
            (2,036
            )
            
            
            (1,402
            )
            
            
            (768
            )Purchase
      of property and equipment
            
            
            (715
            )
            
            
            (1,117
            )
            
            
            (281
            )Purchase
      of branch operations, net of cash received
            
            
            0
            
            
            
            0
            
            
            
            (893
            )Net
      Cash Provided by (Used in) Investing Activities
            
            
            (22,807
            )
            
            
            (22,074
            )
            
            
            (10,513
            )CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      change in time deposits
            
            
            19,229
            
            
            
            25,826
            
            
            
            5,793Net
      change in other deposit accounts
            
            
            4,025
            
            
            
            (10,034
            )
            
            
            (1,150
            )Additional
      long term debt
            
            
            1,000
            
            
            
            2,300
            
            
            
            8,200Repayment
      of long term debt
            
            
            (4,173
            )
            
            
            (2,371
            )
            
            
            (1,513
            )Additional
      (repayment of) short term borrowings
            
            
            0
            
            
            
            0
            
            
            
            (2,000
            )Dividends
      paid in cash
            
            
            (1,437
            )
            
            
            (1,350
            )
            
            
            (1,179
            )Net
      Cash Provided by (Used in) Financing Activities
            
            
            18,644
            
            
            
            14,371
            
            
            
            8,151CASH
      AND CASH EQUIVALENTSNet
      increase (decrease) in cash and due from banks
            
            
            824
            
            
            
            (1,739
            )
            
            
            2,663Cash
      and due from banks, beginning of year
            
            
            7,111
            
            
            
            8,850
            
            
            
            6,187Cash
      and due from banks, end of year
            
            $
            7,935
            
            
            $
            7,111
            
            
            $
            8,850Supplemental
      Disclosures, Cash Paid For:Interest
      Expense
            
            $
            10,141
            
            
            $
            7,529
            
            
            $
            5,523Income
      Taxes
            
            $
            3,085
            
            
            $
            2,381
            
            
            $
            1,984





The
accompanying notes are an integral part of these statements





Index





Page
Thirty Five





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 and related disclosures, management is
required to make estimates and assumptions that affect the reported amounts in
those statements and disclosures; 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)
            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.





Index





Page
Thirty Six





f)
            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.





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.





(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.





(j)
            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.





Index





Page
Thirty Seven





(k)
            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 it is believed that none will have a
material impact on the Company’s operations in future years.





In 2006,
the FASB issued EITF 06-04 and 06-10. This EITF requires that companies which
own life insurance policies insuring employees and for which the employees
receive a portion of the death benefits of the policies (commonly referred to as
“split dollar” policies) and for which these death benefits to the employee
continue post retirement record a liability for the present value of the cost of
these post retirement death benefits. These EITF pronouncements become effective
for Highlands Bankshares on January 1, 2008. The effects on Highlands’ financial
statements as of January 1, 2008 will be to reduce shareholders’ equity by
approximately $330,000 and increase liabilities by the same amount.





(l)
            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.





When tax
returns are filed, it is highly certain that some positions taken would be
sustained upon examination by the taxing authorities, while others are subject
to uncertainty about the merits of the position taken or the amount of the
position that would be ultimately sustained.  The benefit of a tax
position is recognized in the financial statements in the period during which,
based on all available evidence, management believes it is more likely than not
that the position will be sustained upon examination, including the resolution
of appeals or litigation processes, if any.  Tax positions taken are
not offset or aggregated with other positions.  Tax positions that
meet the more-likely-than-not recognition threshold are measured as the largest
amount of tax benefit that is more than 50 percent likely of being realized upon
settlement with the applicable taxing authority.  The portion of the
benefits associated with tax positions taken that exceeds the amount measured as
described above would be reflected as a liability for unrecognized tax benefits
in the accompanying balance sheet along with any associated interest and
penalties that would be payable to the taxing authorities upon
examination.





Interest
and penalties associated with unrecognized tax benefits would be classified as
additional income taxes in the statement of income.





At December 31, 2007 there was no
liability for unrecognized tax benefits.





(m)
            Advertising





Advertising costs are expensed as they
are incurred.  Advertising expense for the years ended December 31,
2007, 2006 and 2005 was $ 193,000, $198,000 and $158,000
respectively.





Index





Page
Thirty Eight





(n)
            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.





(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, 2007, 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 related to business acquisitions. In addition to the intangible assets
associated with the purchase of banking organizations, the company also carries
intangible assets related to the relating to the purchase of naming rights to a
performing arts center currently under construction in Petersburg, WV. The
naming rights to this performing arts center were purchased on December 31, 2007
for $250,000 and will be amortized over a ten-year period beginning in
2008.





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, 2007, 2006 and 2005 is shown below (in thousands of
dollars):





Year
      Ended December 31,2007
            
            
            2006
            
            
            2005Investment
      securities, taxable
            
            $
            1,314
            
            
            $
            1,095
            
            
            $
            707Investment
      securities, nontaxable
            
            
            112
            
            
            
            109
            
            
            
            103





Index





Page
Thirty  Nine





The
Company’s balance sheet included no securities classified as Held to Maturity at
December 31, 2007. The carrying amount and estimated fair value of securities
held to maturity at December 31, 2006 is 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
            
            
            $
            --
            
            
            $
            --
            
            
            $
            170





Securities
having a carrying value of $6,859,000 at December 31, 2007 and $7,273,000 at
December 31, 2006 were pledged to secure public deposits and for other purposes
required by law.





The
carrying amount and estimated fair value of securities available for sale at
December 31, 2007 and 2006 are as follows (in thousands of
dollars):





Available
      for Sale SecuritiesAmortized
      Cost
            
            
            Unrealized
      Gains
            
            
            Unrealized
      Losses
            
            
            Fair ValueDecember
      31, 2007U.S.
      Treasuries and Agencies
            
            $
            15,040
            
            
            $
            207
            
            
            $
            2
            
            
            $
            15,245Mortgage
      backed securities
            
            
            7,718
            
            
            
            74
            
            
            
            8
            
            
            
            7,784State
      and municipals
            
            
            3,034
            
            
            
            8
            
            
            
            3
            
            
            
            3,039Marketable
      equities
            
            
            28
            
            
            
            ---
            
            
            
            6
            
            
            
            22Total
      Securities Available for Sale
            
            $
            25,820
            
            
            $
            289
            
            
            $
            19
            
            
            $
            26,090December
      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
            
            
            $
            23,729





The
carrying amount and fair value of debt securities at December 31, 2007, 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
      Available for SaleAmortized Cost
            
            
            Fair ValueDue
      in one year or less
            
            $
            7,705
            
            
            $
            7,583Due
      after one year through five years
            
            
            9,839
            
            
            
            10,169Due
      after five years through ten years
            
            
            530
            
            
            
            532Mortgage
      backed securities
            
            
            7,718
            
            
            
            7,784Equity
      securities with no maturity
            
            
            28
            
            
            
            22Total
      Securities Available for Sale
            
            $
            25,820
            
            
            $
            26,090


Index
  Page
Forty





Information
pertaining to securities with gross unrealized losses at December 31, 2007 and
2006, 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, 2007Investment
      CategoryU.S.
      Treasury and Agency
            
            $
            1,497
            
            
            $
            (2
            )
            
            $
            0
            
            
            $
            0
            
            
            $
            1,497
            
            
            $
            (2
            )Mortgage
      backed securities
            
            
            2,574
            
            
            
            (8
            )
            
            
            1,005
            
            
            
            (1
            )
            
            
            1,569
            
            
            
            (7
            )State
      and municipals
            
            
            575
            
            
            
            (3
            )
            
            
            0
            
            
            
            0
            
            
            
            575
            
            
            
            (3
            )Other
      equity securities
            
            
            22
            
            
            
            (6
            )
            
            
            22
            
            
            
            (6
            )
            
            
            0
            
            
            
            0Total
            
            $
            4,668
            
            
            $
            (19
            )
            
            $
            1,027
            
            
            $
            (7
            )
            
            $
            3,641
            
            
            $
            (12
            )December
      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
            )





The
number of securities available for sale that were in an unrealized loss position
at December 31, 2007 is summarized in the table below:





Total
            
            
            Loss
      Position less than 12Months
            
            
            Loss
      Position greater than 12MonthsU.S.
      Treasuries and Agencies
            
            
            3
            
            
            
            0
            
            
            
            3Mortgage
      backed securities
            
            
            9
            
            
            
            2
            
            
            
            7States
      and municipals
            
            
            3
            
            
            
            0
            
            
            
            3Other
      equity securities
            
            
            1
            
            
            
            1
            
            
            
            0Total
            
            
            16
            
            
            
            3
            
            
            
            13





It is
management’s determination that all securities held at December 31, 2007, 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
exists 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 One





Note
Four: Restricted Investments





Restricted
investments at December 31, 2007 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
investments 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, 2007 and 2006 are summarized as follows (in
thousands of dollars):





2007
            
            
            2006Commercial
            
            $
            79,892
            
            
            $
            70,408Real
      Estate Construction
            
            
            15,560
            
            
            
            14,828Real
      Estate Mortgage
            
            
            169,122
            
            
            
            164,243Consumer
      Installment
            
            
            45,625
            
            
            
            43,337Total
      Loans
            
            $
            310,199
            
            
            $
            292,816





The
following is a summary of information pertaining to impaired and non accrual
loans at December 31, 2007, 2006 and 2005 (in thousands of
dollars):





2007
            
            
            2006
            
            
            2005Year
      end balance, impaired loans
            
            $
            1,216
            
            
            $
            1,895
            
            
            $
            1,494Allowance
      for impairments, year end
            
            
            243
            
            
            
            720
            
            
            
            353Average
      balance impaired loans, year ended December 31
            
            
            1,995
            
            
            
            1,773
            
            
            
            1,576Income
      recorded on impaired loans, year ended December 31
            
            
            160
            
            
            
            131
            
            
            
            104





No loans
were identified as impaired as of December 31 2007 or 2006 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 2007 and
2006.





Balances
of non-accrual loans and loans past due ninety days or greater and still
accruing interest at December 31, 2007 and 2006 are shown below (in thousands of
dollars):





2007
            
            
            2006Non-accrual
      loans at year end
            
            $
            916
            
            
            $
            244Loans
      past due ninety days or greater and still accruing interest at year
      end
            
            
            2,244
            
            
            
            1,457








Index





Page
Forty Two





Note
Six: Allowance For Loan Losses





A summary
of the changes in the allowance for loan losses for the years ended December 31,
2007, 2006 and 2005 is show below (in thousands of dollars):





2007
            
            
            2006
            
            
            2005Balance
      at beginning of year
            
            $
            3,482
            
            
            $
            3,129
            
            
            $
            2,530Provision
      charged to operating expenses
            
            
            837
            
            
            
            682
            
            
            
            875Other
      additions
            
            
            0
            
            
            
            0
            
            
            
            166Loan
      recoveries
            
            
            339
            
            
            
            250
            
            
            
            178Loans
      charged off
            
            
            (1,081
            )
            
            
            (579
            )
            
            
            (620
            )Balance
      at end of year
            
            $
            3,577
            
            
            $
            3,482
            
            
            $
            3,129Allowance
      for Loan Losses as percentage of outstanding loans at year
    end
            
            
            1.15
            %
            
            
            1.19
            %
            
            
            1.16
            %





Note
Seven: Bank Premises and Equipment





Bank
premises and equipment as of December 31, 2007 and 2006 are summarized as
follows (in thousands of dollars):





2007
            
            
            2006Land
            
            $
            1,549
            
            
            $
            1,398Buildings
      and improvements
            
            
            7,963
            
            
            
            7,897Furniture
      and equipment
            
            
            4,789
            
            
            
            5,415Total
      Cost
            
            
            14,301
            
            
            
            14,710Less
      accumulated depreciation
            
            
            (6,197
            )
            
            
            (6,579
            )Net
      Book Value
            
            $
            8,104
            
            
            $
            8,131





Provisions
for depreciation charged to operations during 2007, 2006 and 2005 were as
follows (in thousands of dollars):





Year
            
            Provision
      for Depreciation2007
            
            $
            7042006
            
            
            6912005
            
            
            692




Index





Page
Forty Three





Note
Eight: Deposits





At
December 31, 2007, the scheduled maturities of time deposits were as follows (in
thousands of dollars):





Year
            
            Amount Maturing2008
            
            $
            148,6182009
            
            
            24,9682010
            
            
            10,2192011
            
            
            10,1332012
            
            
            7,459Total
            
            $
            201,397





Interest
expense on time deposits of $100,000 and over aggregated $3,078,000, $2,042,000
and $1,453,000 for 2007, 2006 and 2005, respectively.





The
aggregate amount of demand deposit overdrafts reclassified as loan balances were
$285,000 and $138,000 at December 31, 2007 and 2006, 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 2008 to 2020.  The interest rates on
the various borrowings at December 31, 2007 range from 3.80% to 6.12%. The
weighted average interest rate on the borrowings at December 31, 2007 was 4.54%.
The Company has total borrowing capacity from the FHLB of $181,099,000. The
Banks have pledged certain investments and mortgage loans as collateral on the
FHLB borrowings in the approximate amount of $ 181,224,000 at December 31,
2007.





The
subsidiary Banks also have short term borrowing capacity from each of their
respective correspondent banks. As of December 31, 2007 the Company has total
borrowing capacity from its correspondent banks of $31,200,000. 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 monthly, quarterly or in a single payment at maturity.
The maturities of long-term debt as of December 31, 2007 are as follows (in
thousands of dollars):





Year
            
            Balance2008
            
            $
            5802009
            
            
            4602010
            
            
            1,4812011
            
            
            1,2632012
            
            
            5,703Thereafter
            
            
            2,332Total
            
            $
            11,819




Index





Page
Forty Four





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, 2008, the Banks could pay dividends to Highlands Bankshares, Inc. of
approximately $6,505,000 without permission of the regulatory
authorities.





Note
Eleven: Income Tax Expense





Highlands
files an income tax return in the U.S. federal jurisdiction and an income tax
return in the State of West Virginia. With few exceptions, the Company is no
longer subject to U.S. federal, state or local income tax examinations by tax
authorities for years before 2004.





The
Company adopted the provisions of FASB Interpretations No. 48, Accounting for Uncertainty in Income
Taxes, on January 1, 2007 with no impact on the financial
statements.





Included
in the balance sheet at December 31, 2007 are tax positions related to loan
charge offs for which the ultimate deductibility is highly certain but for which
there is uncertainty about the timing of such deductibility.  Because
of the impact of deferred tax accounting, other than interest and penalties, the
disallowance of the shorter deductibility period would not affect the annual
effective tax rate but would accelerate the payment of cash to the taxing
authority to an earlier period.





The
components of income tax expense for the years ended December 31, 2007, 2006 and
2005 are summarized in the table below (in thousands of dollars):





2007
            
            
            2006
            
            
            2005Current
      ExpenseFederal
            
            $
            2,400
            
            
            $
            2,154
            
            
            $
            1,814State
            
            
            330
            
            
            
            352
            
            
            
            272Total
      Current Expense
            
            
            2,730
            
            
            
            2,506
            
            
            
            2,086Deferred
      Expense (Benefit)Federal
            
            
            (121
            )
            
            
            (107
            )
            
            
            (149
            )State
            
            
            (10
            )
            
            
            (8
            )
            
            
            (21
            )Total
      Current Expense (Benefit)
            
            
            (131
            )
            
            
            (115
            )
            
            
            (170
            )Income
      Tax Expense
            
            $
            2,599
            
            
            $
            2,391
            
            
            $
            1,916





The
deferred tax effects of temporary differences for the years ended December 31,
2007, 2006 and 2005 are as follows (in thousands of dollars):





2007
            
            
            2006
            
            
            2005Provision
      for loan losses
            
            $
            (18
            )
            
            $
            (140
            )
            
            $
            (193
            )Depreciation
            
            
            (45
            )
            
            
            (45
            )
            
            
            (45
            )Deferred
      compensation
            
            
            (59
            )
            
            
            (39
            )
            
            
            59Loss
      carry forward
            
            
            0
            
            
            
            71
            
            
            
            0Miscellaneous
            
            
            (9
            )
            
            
            38
            
            
            
            9Net
      (increase) decrease in deferred income tax benefit
            
            $
            (131
            )
            
            $
            (115
            )
            
            $
            (170
            )




Index





Page
Forty Five





The net
deferred tax assets arising from temporary differences as of December 31, 2007
and 2006 are as follows (in thousands of dollars):





2007
            
            
            2006Deferred
      Tax AssetsProvision
      for loan losses
            
            $
            1,022
            
            
            $
            1,008Insurance
      commissions
            
            
            41
            
            
            
            39Deferred
      compensation
            
            
            870
            
            
            
            817Pension
      obligation
            
            
            175
            
            
            
            244Unrealized
      loss on securities available for sale
            
            
            
            
            
            
            1Other
            
            
            16
            
            
            
            4Total
      Assets
            
            
            2,124
            
            
            
            2,113Deferred
      Tax LiabilitiesAccretion
      income
            
            
            70
            
            
            
            69Unrealized
      gain on securities available for sale
            
            
            101
            
            
            
            0Depreciation
            
            
            352
            
            
            
            397Total
      Liabilities
            
            
            523
            
            
            
            466Net
      Deferred Tax Asset
            
            $
            1,601
            
            
            $
            1,647





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, 2007, 2006 and 2005 (in thousands of dollars):





2007
            
            
            2006
            
            
            2005Amounts
      at federal statutory rates
            
            $
            2,466
            
            
            $
            2,348
            
            
            $
            1,944Additions
      (reductions) resulting from:Tax
      exempt income
            
            
            (38
            )
            
            
            (63
            )
            
            
            (50
            )Partially
      exempt income
            
            
            (26
            )
            
            
            (25
            )
            
            
            (40
            )State
      income taxes, net
            
            
            208
            
            
            
            222
            
            
            
            178Income
      from life insurance contracts
            
            
            (89
            )
            
            
            (143
            )
            
            
            (91
            )Non
      deductible income related to branch acquisitions
            
            
            68
            
            
            
            68
            
            
            
            3Other
            
            
            10
            
            
            
            (16
            )
            
            
            (22
            )Income
      tax expense
            
            $
            2,599
            
            
            $
            2,391
            
            
            $
            1,916




Index





Page
Forty Six





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, 2007 and 2006 (in thousands
of dollars):





2007
            
            
            2006Loans
      to related parties, beginning of year
            
            $
            5,143
            
            
            $
            5,065New
      loans
            
            
            719
            
            
            
            549Repayments
            
            
            (679
            )
            
            
            (558
            )Other
      changes related to changes in executive officer or director
      status
            
            
            0
            
            
            
            87Loans
      to related parties, end of year
            
            $
            5,183
            
            
            $
            5,143





At
December 31, 2007, deposits of related parties including directors, executive
officers, and their related interests of Highlands Bankshares, Inc. and
subsidiaries approximated $7,465,000, and 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 $310,199,000 and $292,816,000 loans held by the Company at December 31, 2007
and 2006, respectively, $240,208,000 and $226,313,000 are secured by real
estate.





The
Company’s subsidiaries had cash deposited in and federal funds sold to other
commercial banks totaling $16,599,000 and $14,192,000 at December 31, 2007 and
2006, 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 $762,000
in 2007, $832,000 in 2006 and $505,000 in 2005.





Index





Page
Forty Seven





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.





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 2008. At December 31, 2007, Grant has
recognized liabilities of $481,000 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 $456,000 (net of $267,000 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, 2007 and 2006 using a
measurement date of November 1, 2007 (in thousands of dollars):





2007
            
            
            2006Change in Benefit
      ObligationBenefit
      obligation, beginning
            
            $
            3,527
            
            
            $
            3,310Service
      Cost
            
            
            139
            
            
            
            131Interest
      Cost
            
            
            222
            
            
            
            192Actuarial
      Loss (Gain)
            
            
            70
            
            
            
            (52
            )Benefits
      Paid
            
            
            (99
            )
            
            
            (54
            )Benefit
      obligation, ending
            
            $
            3,859
            
            
            $
            3,527Accumulated
      Benefit Obligation
            
            $
            3,310
            
            
            $
            3,088Change in Plan
      AssetsFair
      value of assets, beginning
            
            $
            2,861
            
            
            $
            2,422Actual
      return on assets, net of administrative expenses
            
            
            433
            
            
            
            307Employer
      contributions
            
            
            186
            
            
            
            186Benefits
      paid
            
            
            (99
            )
            
            
            (54
            )Fair
      value of assets, ending
            
            $
            3,381
            
            
            $
            2,861Funded
      StatusFair
      value of plan assets
            
            $
            3,381
            
            
            $
            2,861Projected
      benefit obligation
            
            
            3,859
            
            
            
            3,527Funded
      status
            
            
            (478
            )
            
            
            (666
            )Liabilities
      Recognized in the Statement of Financial Position
            
            $
            (478
            )
            
            $
            (666
            )Amounts
      Recognized in Accumulated Other Comprehensive IncomeTransition
      Obligation (Asset)Prior
      Service Cost
            
            $
            3
            
            
            $
            14Net
      (Gain)/Loss
            
            
            720
            
            
            
            914Total
            
            $
            723
            
            
            $
            928





Index





Page
Forty Eight





The
following table provides the components of the net periodic pension expense for
the Plan for the years ended December 31, 2007, 2006 and 2005 (in thousands of
dollars):





2007
            
            
            2006
            
            
            2005Service
      cost
            
            $
            139
            
            
            $
            131
            
            
            $
            123Interest
      cost
            
            
            221
            
            
            
            192
            
            
            
            179Expected
      return on plan assets
            
            
            (235
            )
            
            
            (212
            )
            
            
            (176
            )Amortization
      of net obligation at transitionRecognized
      net actuarial loss
            
            
            66
            
            
            
            61
            
            
            
            27Amortization
      of prior service cost
            
            
            11
            
            
            
            11
            
            
            
            11Net
      Periodic Pension Expense
            
            $
            202
            
            
            $
            183
            
            
            $
            164





The
expected pension expense for 2008 is $153,000. The amount of the Company’s
minimum contribution for 2008 is $250,000.





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





Year
            
            Expected
      Benefit Payments2008
            
            $1112009
            
            1442010
            
            1492011
            
            1672012
            
            181Years
      2013 - 2017
            
            1,388





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





2007
            
            
            2006
            
            
            2005Discount
      rate
            
            
            6.00
            %
            
            
            5.75
            %
            
            
            6.5
            %Expected
      return on plan assets
            
            
            8.50
            %
            
            
            8.50
            %
            
            
            8.50
            %Rate
      of compensation increase
            
            
            3.00
            %
            
            
            3.00
            %
            
            
            3.50
            %





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.





Index





Page
Forty Nine





The
following table provides the pension plan’s asset allocation as of December 31,
2007 and 2006:





2007
            
            
            2006Equity
      Securities
            
            
            68
            %
            
            
            74
            %Debt
      Securities
            
            
            27
            %
            
            
            20
            %Other
            
            
            5
            %
            
            
            6
            %





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
            
            70%
            
            40%-80%Debt
      Securities
            
            25%
            
            20%-40%Other
            
            5%
            
            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.  Portions of employer contributions to this plan are, at
individual employees’ discretion, available to employees as immediate cash
payment while portions are allocated for deferred payment to the employee. The
portions of the plan contribution by the employer which are allocated for
deferred payment to the employee are vested over a five year
period.





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, 2007 and 2006, the Banks had outstanding the following commitments
(in thousands of dollars):





2007
            
            
            2006Commitments
      to extend credit
            
            $
            20,536
            
            
            $
            18,933Standby
      letter of credit
            
            
            709
            
            
            
            957





Index





Page
Fifty





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, 2007.  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, 2007 or 2006.





Index





Page
Fifty One





The
carrying amount and estimated fair values of financial instruments as of
December 31, 2007 and 2006 are as follows (in thousands of
dollars):





2007
            
            
            2006Carrying
              Amount
            
            
            Estimated
              Fair Value
            
            
            Carrying
              Amount
            
            
            Estimated
              Fair ValueFinancial
      Assets:Cash
      and due from banks
            
            $
            7,935
            
            
            $
            7,935
            
            
            $
            7,111
            
            
            $
            7,111Interest
      bearing deposits
            
            
            1,853
            
            
            
            1,853
            
            
            
            1,624
            
            
            
            1,624Federal
      funds sold
            
            
            14,246
            
            
            
            14,246
            
            
            
            12,210
            
            
            
            12,210Securities
      held to maturity
            
            
            0
            
            
            
            0
            
            
            
            170
            
            
            
            170Securities
      available for sale
            
            
            26,090
            
            
            
            26,090
            
            
            
            23,729
            
            
            
            23,729Restricted
      investments
            
            
            1,498
            
            
            
            1,498
            
            
            
            1,570
            
            
            
            1,570Loans,
      net
            
            
            310,199
            
            
            
            311,217
            
            
            
            292,816
            
            
            
            293,661Interest
      receivable
            
            
            2,273
            
            
            
            2,273
            
            
            
            2,173
            
            
            
            2,173Life
      insurance contracts
            
            
            6,300
            
            
            
            6,300
            
            
            
            6,066
            
            
            
            6,066Financial
      Liabilities:Demand
      and savings deposits
            
            
            122,341
            
            
            
            122,341
            
            
            
            118,316
            
            
            
            118,316Time
      deposits
            
            
            201,397
            
            
            
            203,414
            
            
            
            182,168
            
            
            
            183,505Long
      term debt
            
            
            11,819
            
            
            
            11,921
            
            
            
            14,992
            
            
            
            14,641Interest
      payable
            
            
            1,132
            
            
            
            1,132
            
            
            
            1,014
            
            
            
            1,014





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 Two





The
Company’s actual and required capital amounts and ratios at December 31, 2007is
presented in the following table (in thousands of dollars):







December
      31, 2007Regulatory
      RequirementsActual
            
            
            Adequately
      Capitalized
            
            
            Well
      CapitalizedAmount
            
            
            Percentage
            
            
            Amount
            
            
            Percentage
            
            
            Amount
            
            
            PercentageTotal Risk Based Capital
    RatioHighlands
      Bankshares
            
            $
            41,329
            
            
            
            14.53
            %
            
            $
            22,754
            
            
            
            8.00
            %Capon
      Valley Bank
            
            
            15,334
            
            
            
            14.78
            %
            
            
            8,299
            
            
            
            8.00
            %
            
            $
            10,374
            
            
            
            10.00
            %The
      Grant County Bank
            
            
            23,877
            
            
            
            13.23
            %
            
            
            14,437
            
            
            
            8.00
            %
            
            
            18,047
            
            
            
            10.00
            %Tier 1 Leverage RatioHighlands
      Bankshares
            
            
            37,773
            
            
            
            9.95
            %
            
            
            15,185
            
            
            
            4.00
            %Capon
      Valley Bank
            
            
            14,035
            
            
            
            10.00
            %
            
            
            5,611
            
            
            
            4.00
            %
            
            
            7,014
            
            
            
            5.00
            %The
      Grant County Bank
            
            
            21,816
            
            
            
            9.09
            %
            
            
            9,598
            
            
            
            4.00
            %
            
            
            11,997
            
            
            
            5.00
            %Tier 1 Risk Based Capital
    RatioHighlands
      Bankshares
            
            
            37,773
            
            
            
            13.28
            %
            
            
            11,377
            
            
            
            4.00
            %Capon
      Valley Bank
            
            
            14,035
            
            
            
            13.53
            %
            
            
            4,150
            
            
            
            4.00
            %
            
            
            6,225
            
            
            
            6.00
            %The
      Grant County Bank
            
            
            21,816
            
            
            
            12.09
            %
            
            
            7,219
            
            
            
            4.00
            %
            
            
            10,828
            
            
            
            6.00
            %





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
      Capitalized`
            
            Amount
            
            
            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
            %





Capital
ratios and amounts are applicable both at the individual Bank level and on a
consolidated basis.  At December 31, 2007 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 Three





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, 2007, 2006 and 2005 are as follows (in thousands of
dollars):





2007
            
            
            2006
            
            
            2005Balance
      January 1
            
            $
            (586
            )
            
            $
            (505
            )
            
            $
            (219
            )Unrealized
      holding gains (losses) on available for sale securities net of income
      taxes of $101,000 for 2007, $50,000 for 2006 and $27,000 for
      2005
            
            
            173
            
            
            
            86
            
            
            
            46
            )Accrued
      pension obligation net of income taxes of $(76,000) for 2007, $97,000 for
      2006 and $141,000 for 2005
            
            
            128
            
            
            
            (167
            )
            
            
            (240
            )Net
      change for the year
            
            
            301
            
            
            
            (81
            )
            
            
            (286
            )Balance
      December 31
            
            $
            (285
            )
            
            $
            (586
            )
            
            $
            (505
            )





Note
Nineteen:  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. The goodwill acquired in the acquisition of Davis
was not deemed to be impaired at December 31, 2007, 2006 nor 2005.





Amortization
of intangibles charged to operations was $176,000 in 2007, $176,000 in 2006 and
$38,000 in 2005.





In
addition to the intangible assets acquired with the Davis purchase, the Company,
at December 31, 2007 has a core deposit intangible of $28,000 (net of
accumulated amortization) related to a branch acquisition in the year
2000.





During
the fourth quarter of 2007, The Grant County Bank entered into an agreement to
contribute $250,000 toward the erection of a performing arts center located
within the Company’s primary business area. In return, the bank has been granted
naming rights for this performing arts center. The bank is treating this
contribution as an intangible asset and is amortizing over a ten year period,
beginning in 2008, with a 10% residual asset to remain at the end of the
amortization period.





Index





Page
Fifty Four





A summary
of the Company’s intangible assets at December 31, 2007 and 2006 is shown in the
table below (in thousands of dollars):





Core
      deposit intangible
              associated
      with purchase of
              Stockman’s Bank
            
            
            Core
      deposit intangible
              associated
      with purchase of
              National
      Bank of Davis
            
            
            Goodwill
      associated with
              purchase
      of National Bank of
              Davis
            
            
            Advertising
      intangible
              associated
      with purchased
              naming
      rights
            
            
            TotalBalance
      at 12/31/06
            
            $
            39
            
            
            $
            1,459
            
            
            $
            1,534
            
            
            $
            0
            
            
            $
            3,032Amortization
            
            
            (11
            )
            
            
            (165
            )
            
            
            0
            
            
            
            0
            
            
            
            (176
            )Impairment
      allowance
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            0Purchase
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            250
            
            
            
            250Balance
      at 12/31/07
            
            $
            28
            
            
            $
            1,294
            
            
            $
            1,534
            
            
            $
            250
            
            
            $
            3,106





The
expected amortization of the intangible balances at December 31, 2007 for the
next five years is summarized in the table below (in thousands of
dollars):





Year
            
            Expected Expense2008
            
            $
            1982009
            
            
            1982010
            
            
            1942011
            
            
            1882012
            
            
            188Total
            
            $
            966





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 for the
twelve month periods ended December 31, 2006 and December 31, 2007 are shown in
the table below (in thousands of dollars):





2007
            
            
            2006Balance,
      beginning of period
            
            $
            6,066
            
            
            $
            6,396Increases
      in value of policies
            
            
            234
            
            
            
            225Settlement
      payout
            
            
            0
            
            
            
            (555
            )Balance,
      end of period
            
            $
            6,300
            
            
            $
            6,066





Index





Page
Fifty Five





Note
Twenty One:   Parent Corporation Only Financial
Statements





Balance
      Sheets(in
      thousands of dollars)December
      31,2007
            
            
            2006AssetsCash
            
            $
            112
            
            
            $
            187Investment
      in subsidiaries
            
            
            40,142
            
            
            
            37,025Income
      taxes receivable
            
            
            276
            
            
            
            0Other
      assets
            
            
            63
            
            
            
            40Total
      Assets
            
            $
            40,593
            
            
            $
            37,252LiabilitiesAccrued
      expenses
            
            $
            0
            
            
            $
            71Income
      taxes payable
            
            
            0
            
            
            
            105Other
      liabilities
            
            
            0
            
            
            
            0Total
      Liabilities
            
            
            0
            
            
            
            176Stockholders’
      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
            
            
            32,032
            
            
            
            28,816Other
      accumulated comprehensive income
            
            
            (285
            )
            
            
            (586
            )Total
      Stockholders’ Equity
            
            
            40,593
            
            
            
            37,076Total
      Liabilities and Stockholders’ Equity
            
            $
            40,593
            
            
            $
            37,252





Index





Page
Fifty Six





Statements
      of Income and Retained Earnings(in
      thousands of dollars)2007
            
            
            2006
            
            
            2005IncomeDividends
      from subsidiaries
            
            $
            1,637
            
            
            $
            1,651
            
            
            $
            1,528Management
      fees from subsidiaries
            
            
            204
            
            
            
            240
            
            
            
            63Total
      Income
            
            
            1,841
            
            
            
            1,891
            
            
            
            1,591ExpensesSalary
      and benefits expense
            
            
            358
            
            
            
            302
            
            
            
            203Professional
      fees
            
            
            175
            
            
            
            191
            
            
            
            231Directors
      fees
            
            
            73
            
            
            
            74
            
            
            
            65Other
      expenses
            
            
            131
            
            
            
            70
            
            
            
            106Total
      Expenses
            
            
            737
            
            
            
            637
            
            
            
            605Net
      income before income tax benefit and undistributed subsidiary net
      income
            
            
            1,104
            
            
            
            1,254
            
            
            
            986Income
      tax benefit
            
            
            211
            
            
            
            162
            
            
            
            214Income
      before undistributed subsidiary net income
            
            
            1,315
            
            
            
            1,416
            
            
            
            1,200Undistributed
      subsidiary net income
            
            
            3,338
            
            
            
            3,099
            
            
            
            2,602Net
      Income
            
            $
            4,653
            
            
            $
            4,515
            
            
            $
            3,802Retained
      earnings, beginning of period
            
            $
            28,816
            
            
            $
            25,651
            
            
            $
            23,028Dividends
      paid in cash
            
            
            (1,437
            )
            
            
            (1,350
            )
            
            
            (1,179
            )Net
      income
            
            
            4,653
            
            
            
            4,515
            
            
            
            3,802Retained
      earnings, end of period
            
            $
            32,032
            
            
            $
            28,816
            
            
            $
            25,651





Index





Page
Fifty Seven





Statements
      of Cash Flows(in
      thousands of dollars)Years
      Ended December 31,2007
            
            
            2006
            
            
            2005Cash
      Flows From Operating ActivitiesNet
      Income
            
            $
            4,653
            
            
            $
            4,515
            
            
            $
            3,802Adjustments
      to net incomeUndistributed
      subsidiary income
            
            
            (3,338
            )
            
            
            (3,099
            )
            
            
            (2,602
            )Depreciation
      and amortization
            
            
            8
            
            
            
            7
            
            
            
            6Increase
      (decrease) in payables
            
            
            (176
            )
            
            
            126
            
            
            
            (24
            )(Increase)
      decrease in receivables
            
            
            (271
            )
            
            
            24
            
            
            
            33(Increase)
      decrease in other assets
            
            
            (36
            )
            
            
            (1
            )
            
            
            5Net
      Cash Provided by Operating Activities
            
            
            840
            
            
            
            1,572
            
            
            
            1,220Cash
      Flows From Investing ActivitiesAdvances
      from (payments to) subsidiaries
            
            
            (777
            )
            
            
            (417
            )
            
            
            (199
            )Received
      from subsidiaries
            
            
            1,300
            
            
            
            229
            
            
            
            177Purchase
      of property and equipment
            
            
            (1
            )
            
            
            (1
            )
            
            
            (21
            )Special
      dividend from subsidiary
            
            
            0
            
            
            
            0
            
            
            
            5,200Net
      Cash Provided by (used in) Investing Activities
            
            
            522
            
            
            
            (189
            )
            
            
            5,157Cash
      Flows From Financing ActivitiesPurchase
      of branch operations
            
            
            0
            
            
            
            0
            
            
            
            (5,200
            )Dividends
      paid in cash
            
            
            (1,437
            )
            
            
            (1,350
            )
            
            
            (1,179
            )Net
      Cash Used in Financing Activities
            
            
            (1,437
            )
            
            
            (1,350
            )
            
            
            (6,379
            )Net
      Increase (Decrease) in Cash
            
            
            (75
            )
            
            
            33
            
            
            
            (2
            )Cash,
      beginning of year
            
            
            187
            
            
            
            154
            
            
            
            156Cash,
      end of year
            
            $
            112
            
            
            $
            187
            
            
            $
            154





Index





Page
Fifty Eight





REPORT OF
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





Board of
Directors


Highlands
Bankshares, Inc.


Petersburg,
West Virginia





We have
audited the accompanying consolidated statements of income, stockholders’
equity, and cash flows for the year ended December 31,
2005.   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 audit.





We
conducted our audit 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 audit provides a reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the results of Highlands Bankhares, Inc.’s operations
and its cash flows for the year ended December 31, 2005 in conformity with U.S.
generally accepted accounting principles.





/s/
      S. B. Hoover & Company, L.L.P.February
      28, 2006Harrisonburg,
      VA





Index





Page
Fifty Nine





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 sheets of Highlands Bankshares,
Inc. and subsidiaries as of December 31, 2007and 2006, and the related
consolidated statements of income, stockholders' equity and cash flows for the
years 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
audits. The consolidated financial statements of Highlands Bankshares, Inc. for
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 audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the consolidated financial statements are free of material misstatement. The
corporation 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 corporation’s internal control
over financial reporting. Accordingly, we express no such opinion.  An
audit also includes examining, on a test basis, evidence supporting the amounts
and disclosures in the consolidated 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 2007 and 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, 2007 and 2006, and the
results of their operations and their cash flows for the years 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, LLCChambersburg,
      PennsylvaniaMarch
      27, 2008





Index





Page
Sixty





MANAGEMENT’S
REPORT ON INTERNAL CONTROLS





Highlands
Bankshares, Inc. is responsible for the preparation, integrity, and fair
presentation of the consolidated financial statements included in this annual
report. The consolidated financial statements and notes included in this annual
report have been prepared in conformity with United States generally accepted
accounting principles and necessarily include some amounts that are based on
management’s best estimates and judgments.




The
management of Highland’s Bankshares, Inc. and its wholly owned subsidiaries is
responsible for establishing and maintaining adequate internal control over
financial reporting as defined in Rule 13a-15(f) of the Exchange Act. Because of
its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements or may not prevent the possibility that a
control can be circumvented or overriddenAlso,
projections of any evaluation of effectiveness to future periods are subject to
the risk that controls may become inadequate because of changes in conditions,
or that the degree of compliance with the policies or procedures may
deteriorate.




Management
assessed the effectiveness of the Company’s internal control over financial
reporting as of December 31, 2007. In making this assessment, management
used the criteria set forth by the Committee of Sponsoring Organizations of the
Treadway Commission (“COSO”) in Internal Control-Integrated Framework. Based on
the assessment using those criteria, management concluded that the internal
control over financial reporting was effective as of December 31,
2007.








/s/ C.E. PorterC.E.
      PorterChief
      Executive OfficerMarch
      27, 2008








/s/ R. Alan MillerR.
      Alan MillerChief
      Financial OfficerMarch
      27, 2008





Index





Page
Sixty One





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





None.





Item 9A(T).
              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, 2007. 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.





This
Annual Report does not include an attestation report of the Company’s registered
public accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by the
Company’s registered public accounting firm pursuant to temporary rules of the
Securities and Exchange Commission that permit the Company to provide only
management’s report in the Annual Report.





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.





Index





Page
Sixty Two





PART
III





Item 10.
            Directors,
      Executive Officers and Corporate
Governance





Information
required by this item is set forth as portions of our 2008 Proxy Statement, to
be filed within 120 days after the end of the Company’s fiscal year end, and is
incorporated herein by reference. Applicable information required by this item
can be found in the 2008 Proxy Statement under the following
captions:





·
            “Compliance
      with Section 16(a) of the Securities Exchange
  Act”


·
            “ELECTION
      OF DIRECTORS”


·
            “INFORMATION
      CONCERNING DIRECTORS AND NOMINEES”


·
            “REPORT
      OF THE AUDIT COMMITTEE”





The
Company has adopted a Code of Ethics that applies to the Company’s Chief
Executive Officer, Chief Financial Officer, Chief Accounting Officer and all
directors, officers and employees of the Company.  A copy of the
Company’s Code of Ethics covering all employees will be mailed without charge
upon request to Corporate Governance, Highlands Bankshares, Inc., P.O. Box 929,
Main Street, Petersburg, West Virginia  26847.  Any
amendments to or waiver from any provision of the Code of Ethics, applicable to
the Company’s Chief Executive Officer, Chief Financial Officer, or Chief
Accounting Officer will be disclosed in a timely fashion via the Company’s
filing of a Current Report on Form 8-K regarding and amendments to, or waivers
of, any provision of the Code of Ethis applicable to the Company’s Chief
Executive Officer, Chief Financial Officer or Chief Accounting
Officer.





Item 11.
            Executive
      Compensation





Information
required by this item is set forth under the caption “EXECUTIVE COMPENSATION” of
our 2008 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 12.
            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 2008 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 13.
            Certain
      Relationships and Related Transactions and Director
      Independence





Information
required by this item is set forth under the caption “CERTAIN RELATED
TRANSACTIONS” of our 2008 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.





Index





Page
Sixty Three





Item 14.
            Principal
      Accounting Fees and Services





Information
required by this item is set forth under the caption “Fees of Independent
Registered Certified Public Accountants”of our 2008
Proxy Statement, to be filed within 120 days after the end of the Company’s
fiscal year end, and is incorporated herein by reference.





PART
IV





Item 15.
            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)
            FinancialStatement
      Schedules: These schedules are omitted as the required information isinapplicable
      or the information is presented in the consolidated financial statements
      or related notes




(a)(3)
              Exhibits.
      The exhibits listed in the “Exhibits Index” on Page 65 of this Annual
      Report on Form 10-K included herein are filed herewith or are incorporated
      by reference from previous
filings.




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




Index





Page
Sixty Four





Signatures





Pursuant
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 OfficerDate:
      March 27, 2008
            
            Date:
      March 27, 2008





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
      11, 2008Thomas
      B. McNeill, Sr.
            
            /s/ Thomas B. McNeill, Sr.
            
            Director
            
            March
      11, 2008L.
      Keith Wolfe
            
            /s/ L. Keith Wolfe
            
            Director
            
            March
      11, 2008Kathy
      G. Kimble
            
            /s/ Kathy G. Kimble
            
            Director
            
            March
      11, 2008Steven
      C. Judy
            
            /s/ Steven C. Judy
            
            Director
            
            March
      11, 2008Courtney
      R. Tusing
            
            /s/ Courtney R. Tusing
            
            Director
            
            March
      11, 2008John
      G. Van Meter
            
            
            
            Director
      Chairman of The BoardAlan
      L. Brill
            
            
            
            Director
      SecretaryC.
      E. Porter
            
            /s/ C.E. Porter
            
            Director
      President & CEO Treasurer
            
            March
      11, 2008





Index





Page
Sixty Five





EXHIBIT
      INDEXExhibit
      Number
            
            Description3(i)
            
            Articles
      of Incorporation of Highlands Bankshares, Inc., as restated, are hereby
      incorporated by reference to Exhibit 3(i) to Highlands Bankshares Inc.’s
      Form 10-Q filed November 13, 2007 .3(ii)
            
            Amended
      Bylaws of Highlands Bankshares, Inc. are incorporated by reference to
      Exhibit 3(ii) to Highlands Bankshares Inc.’s Report on Form 8-K filed
      January 9, 200814
            
            Code
      of Ethics. TheHIGHLANDS
      BANKSHARES, INC. CODE OF BUSINESS CONDUCT AND ETHICS is hereby
      incorporated by reference filed as Exhibit 14.1 with Highlands Bankshares
      Inc.’s Report on Form 8-K filed January 14, 200821
            
            Subsidiaries
      of the Registrant (filed herewith)31.1
            
            Certification
      of Chief Executive Officer Pursuant to 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 Officer  Pursuant 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.





Exhibit
      21 Subsidiaries of the Registrant(a)
            The
      Grant County Bank (incorporated in West Virginia) doing business as The
      Grant County Bank(b)
            Capon
      Valley Bank (incorporated in West Virginia) doing business as Capon Valley
      Bank(c)
            HBI
      Life Insurance Company (incorporated in Arizona) doing business as HBI
      Life