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, 2009





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
value





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 checkmark whether the registrant has submitted electronically and posted on
its corporate Website, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of
this chapter) during the preceding 12 months (or for such shorter period that
the registrant was required to submit and post such files).


Yes o        No
o





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
o Non-accelerated
filer x
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 1,234,252 shares of common stock of the
registrant, issued and outstanding, held by non- affiliates on June 30, 2009,
was approximately $32,707,686 based on the closing sale price of $26.50 per
share on June 30, 2009.  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 29, 2010: 1,336,873 shares of
common stock.





DOCUMENTS
INCORPORATED BY REFERENCE





Part III
incorporates certain information by reference from the registrant’s definitive
proxy statement for the 2010 annual meeting of stockholders, which proxy
statement will be filed on or about April 15, 2010








FORM 10-K INDEX








Part
      I
            
            PageItem 1.
            Business
            3Item 1A.
            Risk Factors
            Not
      applicableItem 1B.
            Unresolved Staff Comments
            9Item 2.
            Properties
            9Item 3.
            Legal Proceedings
            9Item 4.
            (Removed and Reserved)
            9Part
      IIItem 5.
            Market for Registrant’s Common Equity, Related Stockholder
      Matters and Issuer Purchases of Equity Securities
            9Item 6.
            Selected Financial Data
            10Item 7.
            Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
            11Item
      7A.
            Quantitative
      and Qualitative Disclosures About Market Risk
            Not
      applicableItem 8.
            Financial Statements and Supplementary
    Data
            26Item 9.
            Changes in and Disagreements with Accountants on Accounting
      and Financial Disclosure
            58Item 9A(T).
            Controls and Procedures
            58Item 9B.
            Other Information
            58Part
      III*Item 10.
            Directors and Executive Officers and Corporate
      Governance
            59*Item 11.
            Executive Compensation
            59*Item 12.
            Security Ownership of Certain Beneficial Owners and
      Management and Related Stockholder Matters
            59*Item 13.
            Certain Relationships,  Related Transactions and
      Director Independence
            59*Item 14.
            Principal Accounting Fees and Services
            60Part
      IVItem 15.
            Exhibits and Financial Statement
    Schedules
            60Signatures
            61








* The
information required by Items 10, 11, 12, 13 and 14, to the extent not included
in this document, is incorporated herein by reference to the information
included under the captions “Compliance with Section 16(a) of the Securities
Exchange Act,” “ELECTION OF DIRECTORS,” “INFORMATION CONCERNING DIRECTORS AND
NOMINEES,” “REPORT OF THE AUDIT COMMITTEE,” “EXECUTIVE COMPENSATION,” “SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT” and “CERTAIN RELATED
TRANSACTIONS” in the registrant’s definitive proxy statement which is expected
to be filed on or about April 15, 2010.





2
 Index




PART
I





Item 1.
            Business





General





Highlands
Bankshares, Inc. (hereinafter referred to as “Highlands,” or the “Company”),
incorporated under the laws of  the State 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. Highlands 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, internet 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, 2009, The Grant County Bank had 69 full time equivalent employees,
Capon Valley Bank had 47 full time equivalent employees and Highlands had 4 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 other state and
nationally chartered banks have opened branches 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.





3
 Index




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, with the managing or
controlling of 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 determined by regulation 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 (“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 an
institution.





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





4
 Index




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 the
following:  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.





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.





5
 Index




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





Actual
      Ratio
            
            
            Actual
      Ratio
            
            
            RegulatoryDecember 31, 2009
            
            
            December 31, 2008
            
            
            MinimumTotal Risk Based CapitalHighlands
      Bankshares
            
            
            14.33
            %
            
            
            14.20
            %The
      Grant County Bank
            
            
            14.12
            %
            
            
            13.99
            %
            
            
            8.00
            %Capon
      Valley Bank
            
            
            12.86
            %
            
            
            12.77
            %
            
            
            8.00
            %Tier 1 Leverage RatioHighlands
      Bankshares
            
            
            9.81
            %
            
            
            10.18
            %The
      Grant County Bank
            
            
            9.91
            %
            
            
            10.00
            %
            
            
            4.00
            %Capon
      Valley Bank
            
            
            8.38
            %
            
            
            9.11
            %
            
            
            4.00
            %Tier 1 Risk Based Capital
    RatioHighlands
      Bankshares
            
            
            13.08
            %
            
            
            12.98
            %The
      Grant County Bank
            
            
            12.89
            %
            
            
            12.79
            %
            
            
            4.00
            %Capon
      Valley Bank
            
            
            11.60
            %
            
            
            11.52
            %
            
            
            4.00
            %





Dividends and Other
Payments





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





6
 Index




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.





Beginning
in late 2008, the economic environment caused higher levels of bank failures,
which dramatically increased FDIC resolution costs and led to a significant
reduction in the Deposit Insurance Fund. As a result, the FDIC has significantly
increased the initial base assessment rates paid by financial institutions for
deposit insurance. The base assessment rate was increased by seven basis points
(7 cents for every $100 of deposits) for the first quarter of 2009. Effective
April 1, 2009, initial base assessment rates were changed to range from 12
basis points to 45 basis points across all risk categories with possible
adjustments to these rates based on certain debt-related components. These
increases in the base assessment rate have increased our deposit insurance costs
and negatively impacted our earnings. In addition, in May 2009, the FDIC imposed
a special assessment on all insured institutions due to recent bank and savings
association failures. The emergency assessment amounted to five basis points on
each institution's assets minus tier one (core) capital as of June 30,
2009, subject to a maximum equal to 10 basis points times the institution's
assessment base. The Company’s special assessment, which was reflected in
earnings for the quarter ended June 30, 2009, was approximately $179,000.
The FDIC may impose additional emergency special assessments if necessary to
maintain public confidence in federal deposit insurance or as a result of
deterioration in the deposit insurance fund reserve ratio due to institution
failures. Any additional emergency special assessment imposed by the FDIC will
negatively impact our earnings.





On
November 12, 2009, the FDIC adopted a final rule requiring that all
institutions prepay their assessments for the fourth quarter of 2009 and all of
2010, 2011 and 2012. This pre-payment was due on December 30, 2009.
However, the FDIC may exempt certain institutions from the prepayment
requirement if the FDIC determines that the prepayment would adversely affect
the safety and soundness of the institution.





The
Company is subject to extensive regulation, supervision and examination by
federal and state banking authorities. Any change in applicable regulations or
laws could have a substantial impact on the Company and the Company’s
operations. Additional legislation and regulations that could significantly
affect the Company’s powers, authority and operations may be enacted or adopted
in the future, which could have a material adverse effect on the Company’s
financial condition and results of operations. New legislation proposed by
Congress may give bankruptcy courts the power to reduce the increasing number of
home foreclosures by giving bankruptcy judges the authority to restructure
mortgages and reduce a borrower's payments. Property owners would be allowed to
keep their property while working out their debts. Other similar bills placing
additional temporary moratoriums on foreclosure sales or otherwise modifying
foreclosure procedures to the benefit of borrowers and the detriment of lenders
may be enacted by either Congress or the States of West Virginia, Pennsylvania
or Maryland in the future. These laws may further restrict the Company’s
collection efforts on one-to-four single-family mortgage loans. Additional
legislation proposed or under consideration in Congress would give current debit
and credit card holders the chance to opt out of an overdraft protection program
and limit overdraft fees, which could result in additional operational costs and
a reduction in the Company’s non-interest income.





Further,
the Company’s regulators have significant discretion and authority to prevent or
remedy unsafe or unsound practices or violations of laws by financial
institutions and holding companies in the performance of their supervisory and
enforcement duties. In this regard, banking regulators are considering
additional regulations governing compensation, which may adversely affect the
Company’s ability to attract and retain employees. On





7
 Index




June 17,
2009, the Obama Administration published a comprehensive regulatory reform plan
that is intended to modernize and protect the integrity of the United States
financial system. The President's plan contains several elements that would have
a direct effect on the Company. The reform plan proposes the creation of a new
federal agency, the Consumer Financial Protection Agency, which would be
dedicated to protecting consumers in the financial products and services market.
The creation of this agency could result in new regulatory requirements and
raise the cost of regulatory compliance. In addition, legislation stemming from
the reform plan could require changes in regulatory capital requirements, and
compensation practices. If implemented, the foregoing regulatory reforms may
have a material impact on the Company’s operations. However, because the
legislation needed to implement the President's reform plan has not been
introduced, and because the final legislation may differ significantly from the
legislation proposed by the Administration, the Company cannot determine the
specific impact of regulatory reform at this time.





Available
Information





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





Executive
Officers





Age
            
            Position with the Company
            
            Principal Occupation (Past Five
      Years)C.E.
      Porter
            
            61
            
            Chief
      Executive Officer
            
            CEO
      of Highlands since 2004, President of The Grant County Bank since
      1991Alan
      L. Brill
            
            55
            
            Secretary
      and Treasurer; President of Capon Valley Bank
            
            President
      of Capon Valley Bank since 2001




8
 Index




Item 1A.
            Risk
      Factors





Not
required for smaller reporting companies.





Item 1B.
            Unresolved
      Staff Comments





None.





Item 2.
            Properties





The table
below lists the primary properties utilized in operations by the Company. All
listed properties are owned by the Company.





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 Bank17558
      SR55, Baker, WV  26801
            Branch
      Office, Capon Valley Bank6701
      Northwestern Pike, Gore, VA  22637
            Branch
      Office, Capon Valley Bank5511
      Main Street, Stephens City, VA 22655
            Future
      Branch Office, Capon Valley Bank








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.
            (Removed
      and Reserved)








PART
II





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




The
Company had approximately 845 shareholders as of December 31, 2009. 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 under the symbol HBSI.OB.  The Company
may not know terms of an exchange between individual parties.





The table
on the following page 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 Nine to
the Financial Statements.





9
 Index




Highlands
      Bankshares, Inc. Common StockEstimated
      Market RangeDividends Per Share
            
            
            High
            
            
            Low2009First
      Quarter
            
            $
            .29
            
            
            $
            35.00
            
            
            $
            26.50Second
      Quarter
            
            $
            .29
            
            
            $
            27.65
            
            
            $
            27.25Third
      Quarter
            
            $
            .29
            
            
            $
            27.50
            
            
            $
            21.50Fourth
      Quarter
            
            $
            .29
            
            
            $
            22.50
            
            
            $
            21.002008First
      Quarter
            
            $
            .27
            
            
            $
            30.00
            
            
            $
            27.00Second
      Quarter
            
            $
            .27
            
            
            $
            38.00
            
            
            $
            27.75Third
      Quarter
            
            $
            .27
            
            
            $
            38.00
            
            
            $
            31.00Fourth
      Quarter
            
            $
            .27
            
            
            $
            35.00
            
            
            $
            29.00





Item 6.
            Selected
      Financial Data





The
following table is not required for smaller reporting companies; however, the
Company believes this information may be important to the reader.





Years
      Ending December 31,(In
      thousands of dollars, except for per share amounts)2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Total
      Interest Income
            
            $
            24,274
            
            
            $
            26,203
            
            
            $
            27,664
            
            
            $
            23,894
            
            
            $
            19,813Total
      Interest Expense
            
            
            7,841
            
            
            
            8,866
            
            
            
            10,703
            
            
            
            7,909
            
            
            
            5,761Net
      Interest Income
            
            
            16,433
            
            
            
            17,337
            
            
            
            16,961
            
            
            
            15,985
            
            
            
            14,052Provision
      for Loan Losses
            
            
            1,864
            
            
            
            909
            
            
            
            837
            
            
            
            682
            
            
            
            875Net
      Interest Income After Provision for Loan Losses
            
            
            14,569
            
            
            
            16,428
            
            
            
            16,124
            
            
            
            15,303
            
            
            
            13,177Other
      Income
            
            
            2,532
            
            
            
            2,699
            
            
            
            2,080
            
            
            
            1,997
            
            
            
            1,669Other
      Expenses
            
            
            12,053
            
            
            
            11,419
            
            
            
            10,952
            
            
            
            10,394
            
            
            
            9,128Income
      Before Income Taxes
            
            
            5,048
            
            
            
            7,708
            
            
            
            7,252
            
            
            
            6,906
            
            
            
            5,718Income
      Tax Expense
            
            
            1,692
            
            
            
            2,738
            
            
            
            2,599
            
            
            
            2,391
            
            
            
            1,916Net
      Income
            
            $
            3,356
            
            
            $
            4,970
            
            
            $
            4,653
            
            
            $
            4,515
            
            
            $
            3,802Total
      Assets at Year End
            
            $
            407,810
            
            
            $
            378,295
            
            
            $
            380,936
            
            
            $
            357,316
            
            
            $
            337,573Long
      Term Debt at Year End
            
            $
            10,866
            
            
            $
            11,317
            
            
            $
            11,819
            
            
            $
            14,992
            
            
            $
            15,063Net
      Income Per Share of Common Stock
            
            $
            2.51
            
            
            $
            3.59
            
            
            $
            3.24
            
            
            $
            3.14
            
            
            $
            2.65Dividends
      Per Share of Common Stock
            
            $
            1.16
            
            
            $
            1.08
            
            
            $
            1.00
            
            
            $
            .94
            
            
            $
            .82Return
      on Average Assets
            
            
            0.84
            %
            
            
            1.32
            %
            
            
            1.24
            %
            
            
            1.29
            %
            
            
            1.21
            %Return
      on Average Equity
            
            
            8.33
            %
            
            
            12.38
            %
            
            
            12.03
            %
            
            
            12.67
            %
            
            
            11.53
            %Dividend
      Payout Ratio
            
            
            46.19
            %
            
            
            30.12
            %
            
            
            30.88
            %
            
            
            29.91
            %
            
            
            30.99
            %Year
      End Equity to Assets Ratio
            
            
            10.16
            %
            
            
            10.41
            %
            
            
            10.66
            %
            
            
            10.38
            %
            
            
            10.07
            %





10
 Index




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





Forward Looking
Statements





Certain
statements in this report may constitute “forward-looking statements” within the
meaning of the Private Securities Litigation Reform Act of
1995.  Forward-looking statements are statements that include
projections, predictions, expectations or beliefs about future events or results
or otherwise are not statements of historical fact.  Such statements
are often characterized by the use of qualified words (and their derivatives)
such as “expect,” “believe,” “estimate,” “plan,” “project,” “anticipate” or
other similar words.  Although the Company believes that its
expectations with respect to certain forward-looking statements are based upon
reasonable assumptions within the bounds of its existing knowledge of its
business and operations, there can be no assurance that actual results,
performance or achievements of the Company will not differ materially from any
future results, performance or achievements expressed or implied by such
forward-looking statements.  Actual future results and trends may
differ materially from historical results or those anticipated depending on a
variety of factors, including, but not limited to the effects of or 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 does 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; (6) the
quality of the Company’s securities portfolio may deteriorate: (7) the Company
is unable to control costs and expenses as anticipated; (8) the FDIC further
increases or requires prepayment of FDIC assessments; and (9) future legislation
including the financial reform bill in Congress limits the Company’s activities
and results in higher costs. 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 financial statements and related notes included in this
report. 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 that may be sustained in
the loan portfolio. The allowance is based on two basic principles of
accounting: (i) ASC 450, “Contingencies”, which requires that losses
be accrued when they are probable of occurring and estimable and (ii) ASC 310,
“Receivables”, 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.





11
 Index





The
allowance for loan losses includes two basic components: estimated credit losses
on individually evaluated loans that are determined to be impaired, and
estimated credit losses inherent in the remainder of the loan portfolio. Under
authoritative accounting guidance, an individual loan is impaired when, based on
current information and events, it is probable that a Company will be unable to
collect all amounts due according to the contractual terms of the loan
agreement. An individually evaluated loan that is determined not to be impaired
is evaluated under ASC 450 when specific characteristics of the loan indicate
that it is probable there would be estimated credit losses in a group of loans
with those characteristics.





Authoritative
accounting guidance does not specify how an institution should identify loans
that are to be evaluated for collectibility, nor does it specify how an
institution should determine that a loan is impaired. Each subsidiary of the
Company uses its standard loan review procedures in making those judgments so
that allowance estimates are based on a comprehensive analysis of the loan
portfolio. For loans that are individually evaluated and found to be impaired,
the associated allowance is based upon the estimated fair value, less costs to
sell, of any collateral securing the loan as compared to the existing balance of
the loan as of the date of analysis.





All other
loans, including individually evaluated loans determined not to be impaired
under authoritative accounting guidance, are included in a group of loans that
are measured under ASC 450 to provide for estimated credit losses that have been
incurred on groups of loans with similar risk characteristics. The methodology
for measuring estimated credit losses on groups of loans with similar risk
characteristics in accordance with authoritative accounting guidance is based on
each group’s historical net charge-off rate, adjusted for the effects of the
qualitative or environmental factors that are likely to cause estimated credit
losses as of the evaluation date to differ from the group’s historical loss
experience.





Post Retirement Benefits and
Life Insurance Investments





The
Company has invested in and owns life insurance policies 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 ASC 715, “Compensation – Retirement
Benefits” which requires that an employer’s 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





The
Company carries intangible assets related to the purchase of two banks. Amounts
paid to purchase these banks were allocated as intangible assets. Generally
accepted accounting principles were applied to allocate the intangible
components of the purchases. The excess was allocated between identifiable
intangibles (core deposit intangibles) and unidentified intangibles (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, 2009, the Company did not identify an
impairment of this intangible.





In
addition to the intangible assets associated with the purchases of banks, the
company also carries intangible assets relating to the purchase of naming rights
to certain features of a performing arts center in Petersburg, WV.





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





12
 Index





Recent Accounting
Pronouncements





Refer to
Note 2 of the Company’s consolidated financial statements for a discussion of
recent accounting pronouncements.





Overview of 2009
Results





Net
income for 2009 decreased by 32.47% as compared to 2008. The Company experienced
a 5.21% decrease in net interest income due to a continuing decline in net
interest margin.  The Company also experienced a significant increase
in the provision for loan losses of 105.06% or $955,000 from 2008 to 2009 due to
an increase in non-performing assets. Non-interest income decreased 6.19%
primarily as a  result of decreases in non-recurring income as well as
a reduction in life insurance investment income. Non-interest expense increased
5.55% due largely to an increase in salary and benefits expense and increases in
FDIC insurance premiums.





The table
below compares selected commonly used measures of bank performance for the
twelve month periods ended December 31, 2009 and 2008:





2009
            
            
            2008Annualized
      return on average assets
            
            
            0.84
            %
            
            
            1.32
            %Annualized
      return on average equity
            
            
            8.33
            %
            
            
            12.38
            %Net
      interest margin (1)
            
            
            4.50
            %
            
            
            4.97
            %Efficiency
      Ratio (2)
            
            
            63.55
            %
            
            
            56.99
            %Earnings
      per share (3)
            
            $
            2.51
            
            
            $
            3.59





(1) On a
fully taxable equivalent basis and including loan origination fees


(2)
Non-interest expenses for the period indicated divided by the sum of net
interest income and non-interest income for the period indicated.


(3) Per
weighted average shares of common stock outstanding for the period indicated.
Earnings per share for 2008 reflect share repurchase of 100,001 shares during
the second and third quarters of 2008.





The
change in non-interest income from 2008 to 2009 was impacted significantly by
non-recurring items. The table below summarizes the impact of non-recurring
items on both 2009 and 2008 non-interest income:





Impact
      of non- recurring item, year ended December 31,2009
            
            
            2008
            
            
            Increase
              (Decrease)Description of non-recurring
      itemGains
      (losses) recorded on calls of securities available for
sale
            
            $
            (7
            )
            
            $
            110
            
            
            $
            (117
            )Gains
      (losses) recorded on sale of other real estate owned
            
            
            80
            
            
            
            4
            
            
            
            76Gain
      on life insurance settlement
            
            
            0
            
            
            
            30
            
            
            
            (30
            )Net
      gains recorded on sale of fixed assets
            
            
            2
            
            
            
            32
            
            
            
            (30
            )Total
      impact of non-recurring items on non-interest income
            
            $
            75
            
            
            $
            176
            
            
            $
            (101
            )





Net Interest
Income





2009 Compared to
2008





Net
interest income, on a fully taxable equivalent basis, decreased 5.11% from 2008
to 2009 as average balances of both earning assets and interest bearing
liabilities increased from year to year.  The decrease in net interest
income was most impacted by changes in average rates earned on assets and paid
on interest bearing liabilities and by changes in the relative mix of earning
assets and interest bearing liabilities.




For the
year ended December 31, 2009, the Company’s average earning assets increased
4.83%; however, the percent of average loan balances, the highest earning of the
Company’s earning assets, to total average earning assets remained relatively
flat at 90.30% in 2009 compared to 90.04% in 2008.  The benefits of
the Company’s increase in earning assets were offset by an increase in average
interest bearing liabilities from 2008 to 2009 of 5.98%.  The average
balances of time deposits and long-term debt, both comparatively more expensive
interest





13
 Index




bearing
liabilities, increased 8.39% from 2008 to 2009. These changes in the relative
mix of earning assets and interest bearing liabilities and the change in the
average yields negatively impacted the Company’s net interest
income.





Rate cuts
by the Federal Reserve (“the Fed”) for the target rate for federal funds sold
continue to impact yields on earning assets and average rates paid on interest
bearing liabilities. The Company experienced declining rates for 2009 as
compared to 2008 on all components of earning assets and on the savings and time
deposit components of interest bearing liabilities.





The
Company believes that its deposits will be sufficient to fund the current and
expected loan demand.  Should the loan demand increase beyond the Company’s
current expectations, the Company may be required to fund these loans with
borrowings which could result in a reduction of net interest
margin.  However, management believes total net interest income would
not be adversely affected.


.


Also,
balances of non-performing loans and other real estate acquired through
foreclosure have increased from December 31, 2008 to December 31, 2009.
Increases in balances of non-accrual loans and other real estate acquired
through foreclosure often have adverse effects on net interest income. Should
balances of non-accrual loans and other real estate acquired through foreclosure
continue to increase, net interest margin may decrease
accordingly.  Further discussion relating to the Company’s loan
portfolio and credit quality can be found as part of this Management’s
Discussion and Analysis under the headings of “Loan Portfolio” and “Credit
Quality.”


The table
below illustrates the effects on net interest income of changes in average
volumes of interest bearing liabilities and earning assets from 2008 to 2009 and
changes in average rates on interest bearing liabilities and earning assets from
2008 to 2009 (in thousands of dollars):





EFFECT OF
RATE-VOLUME CHANGES ON NET INTEREST


(On a
fully taxable equivalent basis)


Increase
(Decrease) 2009 Compared to 2008





Due
      to change in:Average Volume
            
            
            Average Rate
            
            
            Total ChangeInterest IncomeLoans
            
            $
            1,146
            
            
            $
            (2,587
            )
            
            $
            (1,441
            )Taxable
      investment securities
            
            
            (19
            )
            
            
            (239
            )
            
            
            (258
            )Non-taxable
      investment securities
            
            
            39
            
            
            
            (4
            )
            
            
            35Interest
      bearing deposits
            
            
            (3
            )
            
            
            (34
            )
            
            
            (37
            )Federal
      funds sold
            
            
            2
            
            
            
            (216
            )
            
            
            (214
            )Total
      Interest Income
            
            
            1,165
            
            
            
            (3,080
            )
            
            
            (1,915
            )Interest ExpenseDemand
      deposits
            
            
            (3
            )
            
            
            (0
            )
            
            
            (3
            )Savings
      deposits
            
            
            2
            
            
            
            (193
            )
            
            
            (191
            )Time
      deposits
            
            
            583
            
            
            
            (1,431
            )
            
            
            (848
            )Borrowings
            
            
            (5
            )
            
            
            22
            
            
            
            17Total
      Interest Expense
            
            
            577
            
            
            
            (1,602
            )
            
            
            (1,025
            )Net
      Interest Income
            
            $
            588
            
            
            $
            (1,478
            )
            
            $
            ( 890
            )




14
 Index




The table
below sets forth an analysis of net interest income for the years ended December
31, 2009 and 2008 (average balances and interest income/expense shown in
thousands of dollars):





2009
            
            
            2008Average
              Balance
            
            
            Income
              /Expense
            
            
            Yield
              /Rate
            
            
            Average
              Balance
            
            
            Income
              /Expense
            
            
            Yield
              /RateEarning
      AssetsLoans
            
            $
            331,740
            
            
            $
            23,368
            
            
            
            7.04
            %
            
            $
            315,473
            
            
            $
            24,809
            
            
            
            7.86
            %Taxable
      investment securities
            
            
            20,180
            
            
            
            729
            
            
            
            3.61
            %
            
            
            20,745
            
            
            
            987
            
            
            
            4.76
            %Non-taxable
      investment securities
            
            
            4,059
            
            
            
            240
            
            
            
            5.92
            %
            
            
            3,392
            
            
            
            205
            
            
            
            6.04
            %Interest
      bearing deposits
            
            
            1,028
            
            
            
            7
            
            
            
            .68
            %
            
            
            1,419
            
            
            
            44
            
            
            
            3.10
            %Federal
      funds sold
            
            
            10,288
            
            
            
            20
            
            
            
            .19
            %
            
            
            9,354
            
            
            
            234
            
            
            
            2.50
            %Total
      Earning Assets
            
            
            367,295
            
            
            
            24,364
            
            
            
            6.63
            %
            
            
            350,383
            
            
            
            26,279
            
            
            
            7.50
            %Allowance
      for loan losses
            
            
            (3,755
            )
            
            
            
            
            
            
            
            
            
            
            (3,637
            )Other
      non-earning assets
            
            
            34,097
            
            
            
            
            
            
            
            
            
            
            
            30,276Total
      Assets
            
            $
            397,637
            
            
            
            
            
            
            
            
            
            
            $
            377,022Interest
      Bearing LiabilitiesDemand
      deposits
            
            $
            22,430
            
            
            $
            74
            
            
            
            .33
            %
            
            $
            23,258
            
            
            $
            77
            
            
            
            .33
            %Savings
      deposits
            
            
            49,618
            
            
            
            192
            
            
            
            .39
            %
            
            
            49,363
            
            
            
            383
            
            
            
            .78
            %Time
      deposits
            
            
            213,483
            
            
            
            7,049
            
            
            
            3.30
            %
            
            
            195,963
            
            
            
            7,897
            
            
            
            4.03
            %Overnight
      and other short-term debt
            
            
            1,407
            
            
            
            7
            
            
            
            0.50
            %
            
            
            1,412
            
            
            
            19
            
            
            
            1.35
            %Long-term
      debt
            
            
            11,237
            
            
            
            519
            
            
            
            4.62
            %
            
            
            11,357
            
            
            
            490
            
            
            
            4.31
            %Total
      Interest Bearing Liabilities
            
            
            298,175
            
            
            
            7,841
            
            
            
            2.63
            %
            
            
            281,353
            
            
            
            8,866
            
            
            
            3.15
            %Demand
      deposits
            
            
            50,650
            
            
            
            
            
            
            
            
            
            
            
            49,827Other
      liabilities
            
            
            8,524
            
            
            
            
            
            
            
            
            
            
            
            5,711Stockholders’
      equity
            
            
            40,288
            
            
            
            
            
            
            
            
            
            
            
            40,131Total
      Liabilities and Stockholders’ Equity
            
            $
            397,637
            
            
            
            
            
            
            
            
            
            
            $
            377,022Net
      Interest Income
            
            
            
            
            
            $
            16,523
            
            
            
            
            
            
            
            
            
            
            $
            17,413Net
      Yield on Earning Assets
            
            
            
            
            
            
            
            
            
            
            4.50
            %
            
            
            
            
            
            
            
            
            
            
            4.97
            %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





15
 Index




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 the Company’s focus on providing
community-based financial services, the Company does not attempt to diversify
its loan portfolio geographically by making significant amounts of loans to
borrowers outside of its primary service area.





The table
below summarizes the Company’s loan portfolio at December 31, 2009, 2008, 2007,
2006 and 2005 (in thousands of dollars):





At
      December 31,2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Real
      estate mortgage
            
            $
            162,619
            
            
            $
            156,877
            
            
            $
            169,122
            
            
            $
            164,243
            
            
            $
            153,646Real
      estate construction
            
            
            30,759
            
            
            
            27,210
            
            
            
            15,560
            
            
            
            14,828
            
            
            
            12,201Commercial
            
            
            97,606
            
            
            
            97,709
            
            
            
            79,892
            
            
            
            70,408
            
            
            
            57,908Installment
            
            
            44,499
            
            
            
            43,958
            
            
            
            45,625
            
            
            
            43,337
            
            
            
            46,265Total
      Loans
            
            
            335,483
            
            
            
            325,754
            
            
            
            310,199
            
            
            
            292,816
            
            
            
            270,020Allowance
      for loan losses
            
            
            (4,021
            )
            
            
            (3,667
            )
            
            
            (3,577
            )
            
            
            (3,482
            )
            
            
            (3,129
            )Net
      Loans
            
            $
            331,462
            
            
            $
            322,087
            
            
            $
            306,622
            
            
            $
            289,334
            
            
            $
            266,891





Commercial
loan balances include certain loans secured by commercial real estate. As of
December 31, 2009 the Company maintained balances of loans secured by real
estate of $274,610,000 or 81.86% of total loans compared to $261,289,000 or
80.21% of total loans at December 31, 2008.  The increase in real
estate secured loans of $13,321,000 during 2009 exceeds the increase in total
loans of $9,729,000 during 2009.





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, 2009 (in thousands of dollars):





Maturity
      RangeLess than 1 Year
            
            
            1-5 Years
            
            
            Over 5 Years
            
            
            TotalLoan TypeCommercial
            
            $
            34,241
            
            
            $
            20,615
            
            
            $
            42,750
            
            
            $
            97,606Real
      estate mortgage and construction
            
            
            61,927
            
            
            
            42,567
            
            
            
            88,884
            
            
            
            193,378Installment
            
            
            14,017
            
            
            
            25,287
            
            
            
            5,195
            
            
            
            44,499Total
      Loans
            
            $
            110,185
            
            
            $
            88,469
            
            
            $
            136,829
            
            
            $
            335,483





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 risks associated with
real estate construction loans vary based upon the supply of and demand for the
type of real estate under construction.





16
 Index




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 at least quarterly 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. The Company recognizes these concentrations and considers them when
structuring its loan portfolio.





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.





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





At
      December 31,2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Loans
      accounted for on a non-accrual basisConsumer
            
            $
            269
            
            
            $
            180
            
            
            $
            71
            
            
            $
            83
            
            
            $
            124Commercial
            
            
            90
            
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            0Real
      estate
            
            
            2,208
            
            
            
            1,166
            
            
            
            845
            
            
            
            161
            
            
            
            619Total
      Non-accrual Loans
            
            
            2,567
            
            
            
            1,346
            
            
            
            916
            
            
            
            244
            
            
            
            743Restructured
      Loans
            
            
            1,836
            
            
            
            705
            
            
            
            198
            
            
            
            0
            
            
            
            0Loans
      delinquent 90 days or moreConsumer
            
            
            167
            
            
            
            575
            
            
            
            497
            
            
            
            122
            
            
            
            74Commercial
            
            
            90
            
            
            
            65
            
            
            
            3
            
            
            
            0
            
            
            
            966Real
      estate
            
            
            1,935
            
            
            
            2,832
            
            
            
            1,744
            
            
            
            1,335
            
            
            
            149Total
      delinquent loans
            
            
            2,192
            
            
            
            3,472
            
            
            
            2,244
            
            
            
            1,457
            
            
            
            1,189Total
      Non-performing loans
            
            $
            6,595
            
            
            $
            5,523
            
            
            $
            3,358
            
            
            $
            1,701
            
            
            $
            1,932





The
carrying value of real estate acquired through foreclosure was $3,223,000 at
December 31, 2009 and $1,359,000 at December 31, 2008. 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.   The Company does
not anticipate further losses from the disposal of other real estate
owned.





Because
of its large impact on the local economy, the Company 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. Because of the impact of the slowing
economic conditions on the housing market, the timber sector has experienced a
recent downturn. However, the Company has experienced no material losses related
to foreclosures of loans collateralized by assets typical to the timber harvest
industry. While close monitoring of this sector is necessary, the Company
expects no significant losses in the foreseeable future.





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) ASC 450, “Contingencies” which requires
that losses be accrued when they are probable of occurring and estimable and
(ii) ASC 310, “Receivables”, 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).





17
 Index





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, 2009IdentifiedLoan Type
            
            Balance
            
            
            ImpairmentConsumer
      mortgage
            
            $
            2,124
            
            
            $
            335Commercial
            
            
            276
            
            
            
            66Commercial
      mortgage
            
            
            689
            
            
            
            87Installment
            
            
            336
            
            
            
            174$
            3,425
            
            
            $
            662





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 which are also adjusted for
current economic conditions. 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, the Company 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.  In
addition, the Company’s audit committee periodically reviews the allowance
methodology for consistency and reasonableness.  Also, both banks have
outsourced independent loan review performed at least annually the results of
which are reviewed by both bank boards and the Company’s audit committee with
changes factored into the allowance calculations.  Independent
outsourced loan review considers the adequacy of loan underwriting, asset
quality, the accuracy of the banks’ loan risk ratings and the appropriateness of
specific reserves as well as the overall reasonableness of the allowance for
loan losses.  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.





The
Company 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
2009, the Company’s experienced level of net charge-offs, as compared to gross
loan balances, was significantly greater than that experienced in
2008.  As a result of the impact of increased net charge-offs, an
increase in specific reserves as well as continued increases in loan balances,
the Company’s provision for loan losses during 2009 was $955,000 greater than in
2008. The Company’s ratio of allowance for loan losses to gross loans increased
from 1.13% at December 31, 2008 to 1.20% at December 31, 2009.  At
December 31, 2009, the ratio of the allowance for loan losses to non-performing
loans was 60.97% compared to 66.40% at December 31, 2008. No loss is expected
for loans classified as troubled-debt restructurings in the table above. When
considering the removal of restructured loans from the non-performing assets,
the coverage ratio increases to 84.49% at Decmeber 31, 2009 from 76.11% at
December 31, 2008.  These loans are performing in accordance with
their restructured terms and were not on non-accrual at December 31,
2009.





18
 Index




Cumulative
net loan losses, after recoveries, for the five-year period ending December 31,
2009 are as follows (in thousands of dollars):





Dollars
            
            
            Percent of TotalCommercial
            
            $
            1,180
            
            
            
            31
            %Real
      Estate
            
            
            631
            
            
            
            16
            %Consumer
            
            
            2,031
            
            
            
            53
            %Total
            
            $
            3,842





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





2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Balance
      at beginning of period
            
            $
            3,667
            
            
            $
            3,577
            
            
            $
            3,482
            
            
            $
            3,129
            
            
            $
            2,530Charge-offs:Commercial
      loans
            
            
            492
            
            
            
            198
            
            
            
            540
            
            
            
            27
            
            
            
            45Real
      estate loans
            
            
            445
            
            
            
            228
            
            
            
            47
            
            
            
            1
            
            
            
            8Consumer
      loans
            
            
            863
            
            
            
            524
            
            
            
            494
            
            
            
            551
            
            
            
            567Total
      Charge-offs:
            
            
            1,800
            
            
            
            950
            
            
            
            1,081
            
            
            
            579
            
            
            
            620Recoveries:Commercial
      loans
            
            
            10
            
            
            
            20
            
            
            
            59
            
            
            
            5
            
            
            
            28Real
      estate loans
            
            
            72
            
            
            
            2
            
            
            
            4
            
            
            
            20
            
            
            
            0Consumer
      loans
            
            
            208
            
            
            
            109
            
            
            
            276
            
            
            
            225
            
            
            
            150Total
      Recoveries
            
            
            290
            
            
            
            131
            
            
            
            339
            
            
            
            250
            
            
            
            178Net
      Charge-offs
            
            
            1,510
            
            
            
            819
            
            
            
            742
            
            
            
            329
            
            
            
            442Provision
      for loan losses
            
            
            1,864
            
            
            
            909
            
            
            
            837
            
            
            
            682
            
            
            
            875Other
      additions
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            166Balance
      at end of period
            
            $
            4,021
            
            
            $
            3,667
            
            
            $
            3,577
            
            
            $
            3,482
            
            
            $
            3,129Percent
      of net charge-offs to average net loans outstanding during the
      period
            
            
            .46
            %
            
            
            .26
            %
            
            
            .24
            %
            
            
            .11
            %
            
            
            .17
            %





The table
below 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 31,2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Amount
            
            
            Percent
              of
              Loans
            
            
            Amount
            
            
            Percent
              of
              Loans
            
            
            Amount
            
            
            Percent
              of
              Loans
            
            
            Amount
            
            
            Percent
              of
              Loans
            
            
            Amount
            
            
            Percent
              of
              LoansCommercial
            
            $
            1,669
            
            
            
            29
            %
            
            $
            1,349
            
            
            
            30
            %
            
            $
            1,140
            
            
            
            26
            %
            
            $
            1,492
            
            
            
            24
            %
            
            $
            900
            
            
            
            21
            %Mortgage
            
            
            1,034
            
            
            
            58
            %
            
            
            994
            
            
            
            57
            %
            
            
            1,200
            
            
            
            59
            %
            
            
            996
            
            
            
            61
            %
            
            
            1,139
            
            
            
            62
            %Consumer
            
            
            1,220
            
            
            
            13
            %
            
            
            1,285
            
            
            
            13
            %
            
            
            1,172
            
            
            
            15
            %
            
            
            967
            
            
            
            15
            %
            
            
            1,082
            
            
            
            17
            %Unallocated
            
            
            98
            
            
            
            
            
            
            
            39
            
            
            
            
            
            
            
            65
            
            
            
            
            
            
            
            27
            
            
            
            
            
            
            
            8Totals
            
            $
            4,021
            
            
            
            100
            %
            
            $
            3,667
            
            
            
            100
            %
            
            $
            3,577
            
            
            
            100
            %
            
            $
            3,482
            
            
            
            100
            %
            
            $
            3,129
            
            
            
            100
            %




19
 Index




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, the allocation of the allowance among the
loan types may change.  The allocation also changes because
delinquency levels within each of the respective portfolios
change.  The Company 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. The Company
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 the Company’s best estimate of
what should be allocated for contingencies in the current
portfolio.





Non-Interest
Income





2009 Compared to
2008





Non-interest
income decreased 6.19%, or $167,000 from 2009 to 2008.





Of this
decrease, a large portion related to the recording of non-recurring income items
in 2009 as compared to 2008. Further discussions of non-recurring income, net of
non-recurring losses, for 2009 as compared to 2008, is found in the overview
section above. In addition, the increases in non-recurring income items, slight
decreases in service charges on deposit accounts and life insurance investment
income comprise the largest portion of the decrease in non-interest
income.





Service
charges on deposit accounts decreased 1.60% from 2008 to 2009 as customers
became more fee conscious of costs related to non-sufficient funds charges.
During the latter part of 2007, The Grant County Bank implemented what is
commonly referred to as a “courtesy overdraft” program which led to increases in
service charges on deposit accounts in 2008 and 2007.  This income has
now stabilized and is not expected to increase at the rate previously
experienced.





Earnings
on life insurance investment income decreased $48,000 from 2008 to
2009.  This income is tied to the Company’s investments in life
insurance contracts as explained in Note Twenty of the consolidated financial
statements.





Net
insurance earnings and commissions decreased $59,000 from 2008 to 2009.
Insurance earnings for the Company consist of commissions earned by the
subsidiary banks on life and accident and health insurance sold in relation to
the extension of credit and insurance revenues, net of benefits paid, expense
allowances and policy and claim reserves earned by the life insurance
subsidiary.  As the Company’s balances of installment loans and the
new volume of installment loans, which are primary markets for credit life and
accident and health insurance, have decreased over the past several years, gross
revenues from insurance earnings have decreased. In relation to this decrease,
required policy reserves have also declined.  The table below
illustrates the components of insurance commissions and income for 2008 and 2009
(in thousands of dollars).





2009
            
            
            2008
            
            
            Increase
              (Decrease)RevenuesGross
      commissions and insurance revenues
            
            $
            195
            
            
            $
            303
            
            
            $
            (108
            )ExpensesBenefits
      Paid
            
            
            44
            
            
            
            23
            
            
            
            21Changes
      in required policy and claim reserves
            
            
            (90
            )
            
            
            (38
            )
            
            
            (52
            )Expense
      allowance
            
            
            89
            
            
            
            107
            
            
            
            (18
            )Total
      Expenses
            
            
            43
            
            
            
            92
            
            
            
            (49
            )Net
      insurance income
            
            $
            152
            
            
            $
            211
            
            
            $
            59




20
 Index




Non-interest
Expense





2009 compared to
2008





Non-interest
expense increased 5.55% in 2009 as compared to 2008.





Changes in salary and
benefits expense





The
following table compares the components of salary and benefits expense for the
twelve month periods ended December 31, 2009 and 2008 (in thousands of
dollars):





Salary
      and Benefits Expense2009
            
            
            2008
            
            
            Increase
              (Decrease)Employee
      salaries
            
            $
            4,443
            
            
            $
            4,198
            
            
            $
            245Employee
      benefit insurance
            
            
            976
            
            
            
            878
            
            
            
            98Payroll
      taxes
            
            
            352
            
            
            
            346
            
            
            
            6Post
      retirement plans
            
            
            803
            
            
            
            866
            
            
            
            (63
            )Total
            
            $
            6,574
            
            
            $
            6,288
            
            
            $
            286





The table
below illustrates the change in salary expense between 2009 compared to salary
expense for 2008 occurring because of increases in average pay per employee and
increases in the average number of full time employees (in thousands of
dollars):





AmountChanges
      due to increase in average cost per full time equivalent
      employee
            
            $
            443Changes
      due to decrease in the average full time equivalent employees for the
      periods
            
            
            (198
            )Total
      increase in salary expense
            
            $
            245





Increases
in average cost per full-time employee are primarily due to merit pay increases
in non-executive compensation as well as an increase in benefit
expense.





Changes in data processing
expense





Data
processing expense decreased 19.24%. The Company has moved toward increased
electronic transfer of information between branch locations, converted to a
different outsourced system and centralized data processing
locations.  Data processing costs have been significantly reduced for
2009 as compared to 2008 as a result of a $10,000 data processing monthly credit
from the vendor that expired at the end of November 2009.  Excluding
this credit data processing expense decreased 6.18% from 2008 to
2009.





Changes in occupancy and
equipment expense





The
following table illustrates the components of occupancy and equipment expense
for the twelve month periods ended December 31, 2009 and 2008 (in thousands of
dollars):





2009
            
            
            2008
            
            
            Increase
              (Decrease)Depreciation
      of buildings and equipment
            
            $
            672
            
            
            $
            702
            
            
            $
            (30
            )Maintenance
      expense on buildings and equipment
            
            
            401
            
            
            
            439
            
            
            
            (38
            )Utilities
      expense
            
            
            121
            
            
            
            94
            
            
            
            27Real
      estate and personal property tax
            
            
            101
            
            
            
            88
            
            
            
            13Other
      expense related to occupancy and equipment
            
            
            90
            
            
            
            95
            
            
            
            (5
            )Total
      occupancy and equipment expense
            
            $
            1,385
            
            
            $
            1,418
            
            
            $
            (33
            )





Changes in miscellaneous
non-interest expense





Directors
fees increased by 13.20% during 2009 due primarily to an increase in the overall
rate paid per meeting attended.  Legal and professional fees decreased
slightly by $8,000 or 1.72% from 2008 to 2009.  The table below
illustrates components of other non interest expense for 2009 and 2008 (in
thousands of dollars). The primary driver of the increase in miscellaneous
non-interest expense is related to the $499,000 or 648.05% increase in FDIC
premiums for 2009 compared to 2008.  Significant other non-interest
expense are in the following table:





21
 Index




2009
            
            
            2008
            
            
            Increase
              (Decrease)Office
      supplies and postage & freight expense
            
            
            487
            
            
            
            502
            
            
            
            (15
            )ATM
      expense
            
            
            192
            
            
            
            193
            
            
            
            (1
            )Advertising
      and marketing expense
            
            
            159
            
            
            
            189
            
            
            
            (30
            )Amortization
      of intangible assets
            
            
            194
            
            
            
            182
            
            
            
            12Franchise
      taxes
            
            
            110
            
            
            
            125
            
            
            
            (15
            )FDIC
      assessment
            
            
            576
            
            
            
            77
            
            
            
            499Miscellaneous
      components of other non-interest expense
            
            
            836
            
            
            
            782
            
            
            
            54Total
            
            $
            2,554
            
            
            $
            2,050
            
            
            $
            504





Securities
Portfolio





The
Company's securities portfolio serves several purposes.  Portions of
the portfolio are used to secure certain public 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 7.14% of total assets and 70.30% of total
shareholders’ equity at December 31, 2009.




The
securities portfolio typically will consist of three components: securities held
to maturity, securities available for sale and restricted
securities.  Securities are classified as held to maturity when the
Company has the intent and 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, 2009, the fair value of the securities
available for sale exceed their cost basis by $513,000 ($323,000 after tax
effect of $190,000).





The table
below summarizes the carrying value of the Company’s securities at December 31,
2009, 2008 and 2007 (in thousands of dollars):





Available
      for Sale
              Carrying
      Value
              December
      31,2009
            
            
            2008
            
            
            2007U.S.
      Treasuries and Agencies
            
            $
            12,426
            
            
            $
            7,726
            
            
            $
            15,245Mortgage
      backed securities
            
            
            5,836
            
            
            
            10,342
            
            
            
            7,784State
      and municipals
            
            
            3,946
            
            
            
            3,609
            
            
            
            3,039Certificates
      of deposit
            
            
            4,703
            
            
            
            0
            
            
            
            0Marketable
      equities
            
            
            25
            
            
            
            15
            
            
            
            22Total
            
            $
            26,936
            
            
            $
            21,692
            
            
            $
            26,090




22
 Index





The
carrying amount and estimated market value of debt securities (in thousands of
dollars) at December 31, 2009 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 through one year
            
            $
            4,329
            
            
            $
            4,385
            
            
            
            2.64
            %Due
      after one year through five
            
            
            16,124
            
            
            
            16,365
            
            
            
            2.20
            %Due
      five years through ten years
            
            
            325
            
            
            
            326
            
            
            
            4.47
            %Mortgage
      backed securities
            
            
            5,630
            
            
            
            5,835
            
            
            
            5.06
            %Equity
      securities with no maturity
            
            
            15
            
            
            
            25Total
      Available For Sale
            
            $
            26,423
            
            
            $
            26,936
            
            
            
            2.91
            %





Yields on
tax exempt securities are stated at actual yields.





Any
changes in market values of securities deemed by management to be attributable
to reasons other than changes in market rates of interest would be recorded
through results of operations.  It is the Company’s determination that
all securities held at December 31, 2009 which have fair values less than the
amortized cost, have these 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. A summary of the length of time of unrealized losses for all
securities held at December 31, 2009 can be found in the footnotes to the
consolidated financial statements. The Company reviews all securities with
unrealized losses, and all securities in the portfolio on a regular basis to
determine whether the potential for other than temporary impairment exists. One
of the criteria for making this determination is the rating given to each bond
by the major ratings agencies Moodys and Standard & Poors.





A summary
of the Company’s securities portfolio at December 31, 2009, based on the ratings
of the securities in the portfolio given by these ratings agencies is shown
below (in thousands of dollars):





Amortized
              Cost
            
            
            Gross
      Unrealized
              Gains
            
            
            Gross
      Unrealized
              Losses
            
            
            Market
              ValueRatings
      Provided by Ratings AgenciesMoody’s
            
            S&PU.S. Treasuries and
AgenciesAaa
            
            AAA
            
            
            $
            12,250
            
            
            $
            177
            
            
            $
            1
            
            
            $
            12,426Mortgage Backed SecuritiesAaa
            
            AAA
            
            
            $
            5,630
            
            
            $
            206
            
            
            $
            0
            
            
            $
            5,836State and MunicipalsAaa
            
            AA+
            
            
            $
            2,026
            
            
            $
            41
            
            
            $
            0
            
            
            $
            2,067Aa3
            
            AAA
            
            
            
            335
            
            
            
            23
            
            
            
            0
            
            
            
            358Aa3
            
            A+
            
            
            
            511
            
            
            
            40
            
            
            
            0
            
            
            
            551Aa3
            
            No
      Rating
            
            
            
            140
            
            
            
            7
            
            
            
            0
            
            
            
            147A3
            
            No
      Rating
            
            
            
            140
            
            
            
            1
            
            
            
            0
            
            
            
            141Baa1
            
            A
            
            
            
            130
            
            
            
            0
            
            
            
            0
            
            
            
            130No
      Rating
            
            No
      Rating
            
            
            
            550
            
            
            
            2
            
            
            
            0
            
            
            
            552Marketable EquitiesNo
      Rating
            
            
            $
            15
            
            
            $
            10
            
            
            $
            0
            
            
            $
            25




23
 Index




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 10.62% from December 31, 2008 to December 31,
2009.





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





At
      December 31,2009
            
            
            2008
            
            
            2007Three
      months or less
            
            $
            11,133
            
            
            $
            12,136
            
            
            $
            19,609Four
      to twelve months
            
            
            36,512
            
            
            
            32,828
            
            
            
            30,204One
      year to three years
            
            
            23,447
            
            
            
            14,127
            
            
            
            10,067Four
      years to five years
            
            
            4,504
            
            
            
            5,688
            
            
            
            5,606Total
            
            $
            75,596
            
            
            $
            64,779
            
            
            $
            65,486




Debt
Instruments





Long-Term
Borrowings





The
Company borrows funds from the Federal Home Loan Bank (“FHLB”) to reduce market
rate risks or to provide operating liquidity.  The Company typically
will initiate these borrowings in response to a specific need for managing
market risks or for a specific liquidity need and will attempt to match features
of these borrowings to best suit the specific need. Therefore, the borrowings on
the Company’s balance sheet as of December 31, 2009 and throughout the twelve
month period ended December 31, 2009 have varying features of amortization or
single payment with periodic, regular interest payment and also have interest
rates which vary based on the terms and on the features of the specific
borrowing. More information regarding the Company’s FHLB advances can be found
in Note Thirteen of the consolidated financial statements.





Short-Term
Borrowings





As it
becomes necessary for short-term liquidity needs and when beneficial for
assisting in managing profitability the Company will periodically utilize either
the FHLB or other available credit facilities for overnight or other short term
borrowings. The use of short-term debt instruments is not a frequently utilized
borrowing mechanism of the Company; however, during the third and fourth
quarters of 2008, circumstances prescribed use of these borrowing facilities. At
December 31, 2009, the Company had no balance in overnight and other short-term
borrowings.





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 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. The Company looks first and
foremost to maintain capital levels adequate to satisfy regulatory requirements
through earnings retention. The maintenance of capital adequacy is weighed
against the management of capital for satisfactory return on equity, typically
via use of dividends and/or share repurchases. During 2009, the Company’s
capital position increased by $2,023,000 versus a decrease of $1,194,000 during
2008 when the Company purchased treasury stock of $3,372,000. The return on
average equity was 8.33% in 2009 compared to 12.38% for 2008. Total cash
dividends declared represent 46.19% of net income for 2009





24
 Index




compared
to 30.12% for 2008.  Book value per share was $30.98 at December 31,
2009 compared to $29.47 at December 31, 2008.





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 balances of borrowed funds and
decreases in secondary liquidity sources such as balances of federal funds sold
and balances of securities. The Company maintains credit facilities which are
typically sufficient to adequately fulfill any short-term liquidity needs, and
management of deposit balances and long term borrowings are utilized for longer
term liquidity management. Increases in liquidity requirements may cause the
Company to offer above market rates on deposit products to attract new
depositors, which would impact the Company’s net interest income.





The
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 December 31, 2009, the subsidiary
Banks could pay dividends to the Company of approximately $4,973,000 without
permission of the regulatory authorities.





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.  The Company actively monitors 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.





25
 Index




Item 8.
            Financial
      Statements and Supplementary Data





HIGHLANDS
BANKSHARES, INC.


CONSOLIDATED
BALANCE SHEETS


December
31, 2009 and 2008


(In
thousands of dollars)





2009
            
            
            2008ASSETSCash
      and due from banks
            
            $
            7,062
            
            
            $
            7,589Interest
      bearing deposits in banks
            
            
            1,880
            
            
            
            502Federal
      funds sold
            
            
            8,936
            
            
            
            160Investment
      securities available for sale
            
            
            26,936
            
            
            
            21,692Restricted
      investments
            
            
            2,185
            
            
            
            2,177Loans
            
            
            335,483
            
            
            
            325,754Allowance
      for loan losses
            
            
            (4,021
            )
            
            
            (3,667
            )Bank
      premises and equipment
            
            
            9,326
            
            
            
            8,031Interest
      receivable
            
            
            1,908
            
            
            
            2,164Investment
      in life insurance contracts
            
            
            6,755
            
            
            
            6,499Foreclosed
      Assets
            
            
            3,223
            
            
            
            1,359Goodwill
            
            
            1,534
            
            
            
            1,534Other
      intangible assets
            
            
            1,020
            
            
            
            1,215Other
      assets
            
            
            5,583
            
            
            
            3,286Total
      Assets
            
            $
            407,810
            
            
            $
            378,295LIABILITIESDepositsNon-interest
      bearing deposits
            
            $
            52,378
            
            
            $
            49,604Interest
      bearing transaction and savings accounts
            
            
            73,053
            
            
            
            68,610Time
      deposits over $100,000
            
            
            75,596
            
            
            
            64,779All
      other time deposits
            
            
            148,850
            
            
            
            133,294Total
      Deposits
            
            
            349,877
            
            
            
            316,287Overnight
      and other short-term debt instruments
            
            
            0
            
            
            
            4,800Long-term
      debt instruments
            
            
            10,866
            
            
            
            11,317Accrued
      expenses and other liabilities
            
            
            5,645
            
            
            
            6,492Total
      Liabilities
            
            
            366,388
            
            
            
            338,896STOCKHOLDERS’
      EQUITYCommon
      Stock, $5 par value, 3,000,000 shares authorized, 1,436,874
      shares  issued
            
            
            7,184
            
            
            
            7,184Surplus
            
            
            1,662
            
            
            
            1,662Treasury
      stock (100,001 shares, at cost)
            
            
            (3,372
            )
            
            
            (3,372
            )Retained
      earnings
            
            
            36,963
            
            
            
            35,157Accumulated
      other comprehensive loss
            
            
            (1,015
            )
            
            
            (1,232
            )Total
      Stockholders’ Equity
            
            
            41,422
            
            
            
            39,399Total
      Liabilities and Stockholders’ Equity
            
            $
            407,810
            
            
            $
            378,295





The
accompanying notes are an integral part of these financial
statements.





26
 Index




HIGHLANDS
BANKSHARES, INC.


CONSOLIDATED
STATEMENTS OF INCOME


FOR
THE YEARS ENDED DECEMBER 31, 2009 and 2008


(in
thousands of dollars, except per share data)





2009
            
            
            2008Interest
      and Dividend IncomeLoans,
      including fees
            
            $
            23,368
            
            
            $
            24,809Federal
      funds sold
            
            
            20
            
            
            
            234Interest
      bearing deposits
            
            
            7
            
            
            
            44Investment
      securities
            
            
            879
            
            
            
            1,116Total
      Interest Income
            
            
            24,274
            
            
            
            26,203Interest
      ExpenseInterest
      on deposits
            
            
            7,315
            
            
            
            8,357Interest
      on overnight and other short term debt instruments
            
            
            7
            
            
            
            19Interest
      on long term debt instruments
            
            
            519
            
            
            
            490Total
      Interest Expense
            
            
            7,841
            
            
            
            8,866Net
      Interest Income
            
            
            16,433
            
            
            
            17,337Provision
      for Loan Losses
            
            
            1,864
            
            
            
            909Net
      Interest Income after Provision for Loan Losses
            
            
            14,569
            
            
            
            16,428Non-interest
      IncomeService
      charges
            
            
            1,718
            
            
            
            1,746Life
      insurance investment income
            
            
            233
            
            
            
            281Gain
      (loss) on securities transactions
            
            
            (7
            )
            
            
            110Gain
      on sale of foreclosed property
            
            
            80
            
            
            
            4Gain
      on sale of fixed assets
            
            
            2
            
            
            
            32Other
      operating income
            
            
            506
            
            
            
            526Total
      Non-interest Income
            
            
            2,532
            
            
            
            2,699Non-interest
      ExpensesSalaries
      and benefits
            
            
            6,574
            
            
            
            6,288Occupancy
      and equipment expense
            
            
            1,385
            
            
            
            1,418Data
      processing expense
            
            
            680
            
            
            
            842Legal
      and professional fees
            
            
            457
            
            
            
            465Directors
      fees
            
            
            403
            
            
            
            356Other
      operating expenses
            
            
            2,554
            
            
            
            2,050Total
      Non-interest Expenses
            
            
            12,053
            
            
            
            11,419Income
      Before Income Tax Expense
            
            
            5,048
            
            
            
            7,708Income
      Tax Expense
            
            
            1,692
            
            
            
            2,738Net
      Income
            
            $
            3,356
            
            
            $
            4,970Earnings
      Per Weighted Average Share Outstanding
            
            $
            2.51
            
            
            $
            3.59Dividends
      Per Share
            
            $
            1.16
            
            
            $
            1.08Weighted
      Average Shares Outstanding
            
            
            1,336,873
            
            
            
            1,383,214





The
accompanying notes are an integral part of these financial
statements.





27
 Index




HIGHLANDS
BANKSHARES, INC.


CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY


(in
thousands of dollars)





Common Stock
            
            
            Surplus
            
            
            Treasury Stock
            
            
            Retained Earnings
            
            
            Accumulated Other Comprehensive Income
      (Loss)
            
            
            TotalBalances
      at January 1, 2008
            
            $
            7,184
            
            
            $
            1,662
            
            
            $
            0
            
            
            $
            32,032
            
            
            $
            (285
            )
            
            $
            40,593Cumulative
      effect adjustment to
              Retained
      earnings for change in
              Accounting
      principle
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (348
            )
            
            
            
            
            
            
            (348
            )Comprehensive
      income:Net
      income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            4,970
            
            
            
            
            
            
            
            4,970Change
      in other comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (947
            )
            
            
            (947
            )Total
      comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            4,023Purchase
      of treasury stock
            
            
            
            
            
            
            
            
            
            
            (3,372
            )
            
            
            
            
            
            
            
            
            
            
            (3,372
            )Cash
      dividends
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (1,497
            )
            
            
            
            
            
            
            (1,497
            )Balances
      at December 31, 2008
            
            
            7,184
            
            
            
            1,662
            
            
            
            (3,372
            )
            
            
            35,157
            
            
            
            (1,232
            )
            
            
            39,399Comprehensive
      income:Net
      income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            3,356
            
            
            
            
            
            
            
            3,356Change
      in other comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            217
            
            
            
            217Total
      comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            3,573Cash
      dividends
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (1,550
            )
            
            
            
            
            
            
            (1,550
            )Balances
      at December 31, 2009
            
            $
            7,184
            
            
            $
            1,662
            
            
            $
            (3,372
            )
            
            $
            36,963
            
            
            $
            (1,015
            )
            
            $
            41,422





The
accompanying notes are an integral part of these financial
statements.





28
 Index




HIGHLANDS
BANKSHARES, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


FOR
THE YEARS ENDED DECEMBER 31, 2009 and 2008


(In
thousands of dollars)





Years
      Ended December 31,2009
            
            
            2008CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      Income
            
            $
            3,356
            
            
            $
            4,970Adjustments
      to reconcile net income to net cash provided by operating
      activities(Gain)
      loss on securities transactions
            
            
            7
            
            
            
            (110
            )(Gain)
      on sale of property and equipment
            
            
            (2
            )
            
            
            (32
            )(Gain)
      on sale of OREO
            
            
            (80
            )
            
            
            (4
            )Depreciation
            
            
            672
            
            
            
            702Income
      from life insurance contracts
            
            
            (233
            )
            
            
            (281
            )Net
      amortization of securities premiums
            
            
            95
            
            
            
            32Provision
      for loan losses
            
            
            1,864
            
            
            
            909Write-down
      on OREO property
            
            
            107
            
            
            
            0Deferred
      income tax expense (benefit)
            
            
            120
            
            
            
            (65
            )Amortization
      of intangibles
            
            
            195
            
            
            
            182Decrease
      in interest receivable
            
            
            256
            
            
            
            109Increase
      in other assets
            
            
            (2,348
            )
            
            
            (2,284
            )Increase
      (decrease) in accrued expenses
            
            
            (881
            )
            
            
            946Net
      purchase of intangible assets
            
            
            0
            
            
            
            175Net
      Cash Provided by Operating Activities
            
            
            3,128
            
            
            
            5,248CASH
      FLOWS FROM INVESTING ACTIVITIESProceeds
      from sale of OREO and fixed assets
            
            
            1,095
            
            
            
            46Proceeds
      from maturity of securities available for sale
            
            
            12,357
            
            
            
            17,096Purchase
      of securities available for sale
            
            
            (17,542
            )
            
            
            (12,537
            )Net
      change in other investments
            
            
            (9
            )
            
            
            (679
            )Net
      change in interest bearing deposits in other banks
            
            
            (1,378
            )
            
            
            1,351Net
      change in federal funds sold
            
            
            (8,776
            )
            
            
            14,086Net
      increase in loans
            
            
            (14,224
            )
            
            
            (16,374
            )Settlement
      on insurance contract, net of gain
            
            
            0
            
            
            
            82Purchase
      of property and equipment
            
            
            (1,967
            )
            
            
            (643
            )Net
      Cash Provided by (Used in) Investing Activities
            
            
            (30,444
            )
            
            
            2,428CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      change in time deposits
            
            
            26,373
            
            
            
            (3,324
            )Net
      change in other deposit accounts
            
            
            7,217
            
            
            
            (4,127
            )Additional
      long-term debt
            
            
            0
            
            
            
            1,500Repayment
      of long-term debt
            
            
            (451
            )
            
            
            (2,002
            )Additional
      (repayment of) short-term borrowings
            
            
            (4,800
            )
            
            
            4,800Purchase
      of treasury stock
            
            
            0
            
            
            
            (3,372
            )Dividends
      paid in cash
            
            
            (1,550
            )
            
            
            (1,497
            )Net
      Cash Provided by (Used in) Financing Activities
            
            
            26,789
            
            
            
            (8,022
            )CASH
      AND CASH EQUIVALENTSNet
      (decrease) in cash and due from banks
            
            
            (527
            )
            
            
            (346
            )Cash
      and due from banks, beginning of year
            
            
            7,589
            
            
            
            7,935Cash
      and due from banks, end of year
            
            $
            7,062
            
            
            $
            7,589Supplemental
      Disclosures, Cash Paid For:Interest
      Expense
            
            $
            8,028
            
            
            $
            9,147Income
      Taxes
            
            $
            1,511
            
            
            $
            2,827





The
accompanying notes are an integral part of these financial
statements





29
 Index




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 by the State
of 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
in 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”)
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 consolidated financial statements in conformity with accounting
principles generally accepted in the United States, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities as of the date of the balance sheet and reported amounts of revenues
and expenses during the reporting period. 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 consolidated 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 collectability 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.





30
 Index




(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 collectability 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
allowance for loan losses includes two basic components: estimated credit losses
on individually evaluated loans that are determined to be impaired (allocated
component) and estimated credit losses inherent in the remainder of the loan
portfolio (general component). For those loans that are classified as impaired,
an allowance is established when the discounted cash flows (or collateral value
or observable market price) of the impaired loan is lower than the carrying
value of that loan.  The general component covers nonclassifed loans
and is based on historical charge-off experience and expected loss given default
derived from each subsidiary banks internal risk rating
process.  Other adjustments may be made to the allowance for pools of
loans after an assessment of internal or external influences on credit quality
that are not fully reflected in the historical loss or risk rating
data.





A loan is
considered impaired when, based on current information and events, it is
probable that the Company will be unable to collect the scheduled payment of
principal or interest when due according to the contractual terms of the loan
agreement.  Factors considered by management in determining impairment
include payment status, collateral value, and the probability of collecting
scheduled principal and interest payments when due.  Loans that
experience insignificant payment delays and payment shortfalls generally are not
classified as impaired.  Management determines the significance of
payment delays and payment shortfalls on a case-by-case basis, taking into
consideration all of the circumstances surrounding the loan and the borrower,
including the length of the delay, the borrower’s prior payment record, and the
amount of the shortfall in relation to the principal and interest
owed.





Authoritative
accounting guidance does not specify how an institution should identify loans
that are to be evaluated for collectibility, nor does it specify how an
institution should determine that a loan is impaired. Each subsidiary of the
Company uses its standard loan review procedures in making those judgments so
that allowance estimates are based on a comprehensive analysis of the loan
portfolio. For loans that are individually evaluated and found to be impaired,
the associated allowance is based upon the estimated fair value, less costs to
sell, of any collateral securing the loan as compared to the existing balance of
the loan as of the date of analysis.





31
 Index




All other
loans, including individually evaluated loans determined not to be impaired, are
included in a group of loans that are measured under the general component of
the allowance for loan losses to provide for estimated credit losses that have
been incurred on groups of loans with similar risk characteristics. The
methodology for measuring estimated credit losses on groups of loans with
similar risk characteristics is based on each group’s historical net charge-off
rate, adjusted for the effects of the qualitative or environmental factors that
are likely to cause estimated credit losses as of the evaluation date to differ
from the group’s historical loss experience.





(h)
            Per
      Share Calculations





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





(i)
            Bank
      Premises and Equipment





Land is
carried at cost.  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.





(k)
            Bank
      Owned Life Insurance Contracts





The
Company has invested in and owns life insurance policies on certain 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. Authoritative accounting guidance 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.





(l)
            Advertising





Advertising costs are expensed as they
are incurred.  Advertising expense for the years ended December 31,
2009 and 2008 was $159,000 and $ 189,000, respectively.





(m)
            Goodwill
      and Other Intangible Assets





In accordance with authoritative
accounting guidance, goodwill is not amortized over an estimated useful life,
but rather will be tested at least annually for impairment. Core deposit and
other intangible assets include premiums paid for acquisitions of core deposits
(core deposit intangibles) and other identifiable intangible
assets.  Intangible assets other than goodwill, which are determined
to have finite lives, are amortized based upon the estimated economic benefits
received.





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





32
 Index




assets
associated with the purchase of banking organizations, the Company also carries
intangible assets related to the purchase of certain naming rights to a
performing arts center in Petersburg, WV.





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.





(n)
            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 to be 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, 2009 there was no
liability for unrecognized tax benefits.





(o)
            Reclassifications





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





(p)
            Recent
      Accounting Standards





Adoption
of New Accounting Standards




In June
2009, FASB issued new accounting guidance related to U.S. GAAP (FASB ASC 105,
Generally Accepted Accounting Principles).  This guidance establishes
FASB ASC as the source of authoritative U.S. GAAP recognized by FASB to be
applied by nongovernmental entities.  Rules and interpretive releases
of the SEC under authority of federal securities laws are also sources of
authoritative U.S. GAAP for SEC registrants.  FASB ASC supersedes all
existing non-SEC accounting and reporting standards.  All other
nongrandfathered, non-SEC accounting literature not included in FASB ASC has
become nonauthoritative.  FASB will no longer issue new standards in
the form of Statements, FASB Staff Positions or Emerging Issues Task Force
Abstracts.  Instead, it will issue Accounting Standards Updates
(ASUs), which will serve to update FASB ASC, provide background information
about the guidance and provide the basis for conclusions on the changes to FASB
ASC.  FASB ASC is not intended to change U.S. GAAP or any requirements
of the SEC.





The
Company adopted new guidance impacting Financial Accounting Standards Board
Topic 805: Business Combinations (Topic 805) on January 1, 2009. This
guidance requires the acquiring entity in a business combination to recognize
the full fair value of assets acquired and liabilities assumed in the
transaction (whether a full or partial acquisition); establishes the
acquisition-date fair value as the measurement objective for all assets acquired
and liabilities assumed; requires expensing of most transaction and
restructuring costs; and requires the acquirer to disclose to investors and
other users all of the information needed to evaluate and





33
 Index




understand
the nature and financial effect of the business combination. The adoption of the
new guidance did not have a material impact on the Company’s consolidated
financial statements.





In April
2009, the FASB issued new guidance impacting Topic 805. This guidance addresses
application issues raised by preparers, auditors, and members of the legal
profession on initial recognition and measurement, subsequent measurement and
accounting, and disclosure of assets and liabilities arising from contingencies
in a business combination. This guidance was effective for business combinations
entered into on or after January 1, 2009. This guidance did not have a
material impact on the Company’s consolidated financial statements.





In
December 2008, the FASB issued new guidance impacting FASB Topic 715-20:
Compensation Retirement Benefits – Defined Benefit Plans – General. The
objectives of this guidance are to provide users of the financial statements
with more detailed information related to the major categories of plan assets,
the inputs and valuation techniques used to measure the fair value of plan
assets and the effect of fair value measurements using significant unobservable
inputs (Level 3) on changes in plan assets for the period, as well as how
investment allocation decisions are made, including the factors that are
pertinent to an understanding of investment policies and strategies. The
disclosures about plan assets required by this guidance are included in Note 15
of the Company’s consolidated financial statements.





In April
2009, the FASB issued new guidance impacting FASB Topic 820: Fair Value
Measurements and Disclosures (Topic 820). This interpretation provides
additional guidance for estimating fair value when the volume and level of
activity for the asset or liability have significantly decreased. This also
includes guidance on identifying circumstances that indicate a transaction is
not orderly and requires additional disclosures of valuation inputs and
techniques in interim periods and defines the major security types that are
required to be disclosed. This guidance was effective for interim and annual
periods ending after June 15, 2009, and should be applied prospectively. The
adoption of the standard did not have a material impact on the Company’s
consolidated financial statements.





In April
2009, the FASB issued new guidance impacting FASB Topic 320-10: Investments –
Debt and Equity Securities. This guidance amends GAAP for debt securities to
make the guidance more operational and to improve the presentation and
disclosure of other-than-temporary impairments on debt and equity securities in
the financial statements. This guidance was effective for interim and annual
periods ending after June 15, 2009, with earlier adoption permitted for periods
ending after March 15, 2009. The Company did not have any cumulative effect
adjustment related to the adoption of this guidance.





In May
2009, the FASB issued new guidance impacting FASB Topic 855: Subsequent Events.
This update provides guidance on management’s assessment of subsequent events
that occur after the balance sheet date through the date that the financial
statements are issued. This guidance is generally consistent with current
accounting practice. In addition, it requires certain additional disclosures.
This guidance was effective for periods ending after June 15, 2009 and had
no impact on the Company’s consolidated financial statements.





In August
2009, the FASB issued new guidance impacting Topic 820. This guidance is
intended to reduce ambiguity in financial reporting when measuring the fair
value of liabilities. This guidance was effective for the first reporting period
(including interim periods) after issuance and had no impact on the Company’s
consolidated financial statements.





In
September 2009, the FASB issued new guidance impacting Topic 820. This creates a
practical expedient to measure the fair value of an alternative investment that
does not have a readily determinable fair value. This guidance also requires
certain additional disclosures. This guidance is effective for interim and
annual periods ending
after December 15, 2009. Adoption of the standard did not have a material
impact on the Company’s consolidated financial statements





In
October 2009, the Securities and Exchange Commission issued Release No.
33-99072, Internal Control over Financial Reporting in Exchange Act Periodic
Reports of Non-Accelerated Filers. Release No. 33-99072 delays the requirement
for non-accelerated filers to include an attestation report of their independent
auditor on internal control over financial reporting with their annual report
until the fiscal year ending on or after June 15, 2010.





In
January 2010, the FASB issued ASU 2010-02, Consolidation (Topic 810): Accounting
and reporting for Decreases in Ownership of a Subsidiary – a Scope
Clarification. ASU 2010-02 amends Subtopic 810-10 to address implementation
issues related to changes in ownership provisions including clarifying the scope
of the





34
 Index





decrease
in ownership and additional disclosures.  ASU 2010-02 is effective
beginning in the period that an entity adopts Statement 160.  If an
entity has previously adopted Statement 160, ASU 2010-02 is effective beginning
in the first interim or annual reporting period ending on or after December 15,
2009 and should be applied retrospectively to the first period Statement 160 was
adopted.   The Company does not expect the adoption of ASU
2010-02 to have a material impact on its consolidated financial
statements.





Accounting
Standards Not Yet Effective





In
June 2009, the FASB issued new guidance relating to the accounting for
transfers of financial assets. The new guidance, which was issued as SFAS
No. 166, Accounting for Transfers of Financial Assets, an amendment to SFAS
No. 140, was adopted into Codification in December 2009 through the
issuance of Accounting Standards Updated (ASU) 2009-16. The new standard
provides guidance to improve the relevance, representational faithfulness, and
comparability of the information that an entity provides in its financial
statements about a transfer
of financial assets; the effects of a transfer on its financial position,
financial performance, and cash flows; and a transferor’s continuing
involvement, if any, in transferred financial assets.  The Company
will adopt the new guidance in 2010 and is evaluating the impact it will have,
if any, on its consolidated financial statements.





In June
2009, the FASB issued new guidance relating to the variable interest
entities.  The new guidance, which was issued as SFAS No. 167,
Amendments to FASB Interpretation No. 46(R), was adopted into Codification
in December 2009. The objective of the guidance is to improve financial
reporting by enterprises involved with variable interest entities and to provide
more relevant and reliable information to users of financial statements. SFAS
No. 167 is effective as of January 1, 2010. The Company does not
expect the adoption of the new guidance to have a material impact on its
consolidated financial statements.





In
October 2009, the FASB issued ASU 2009-15, Accounting for Own-Share Lending
Arrangements in Contemplation of Convertible Debt Issuance or Other Financing.
ASU 2009-15 amends Subtopic 470-20 to expand accounting and reporting guidance
for own-share lending arrangements issued in contemplation of convertible debt
issuance. ASU 2009-15 is effective for fiscal years beginning on or after
December 15, 2009 and interim periods within those fiscal years for arrangements
outstanding as of the beginning of those fiscal years. The Company does not
expect the adoption of ASU 2009-15 to have a material impact on its consolidated
financial statements.





In
January 2010, the FASB issued ASU 2010-04, Accounting for Various Topics –
Technical Corrections to SEC Paragraphs. ASU 2010-04 makes technical corrections
to existing SEC guidance including the following topics: accounting for
subsequent investments, termination of an interest rate swap, issuance of
financial statements - subsequent events, use of residential method to value
acquired assets other than goodwill, adjustments in assets and liabilities for
holding gains and losses, and selections of discount rate used for measuring
defined benefit obligation. The Company does not expect the adoption of ASU
2010-04 to have a material impact on its consolidated financial
statements.





In
January 2010, the FASB issued ASU 2010-05, Compensation – Stock Compensation
(Topic 718): Escrowed Share Arrangements and the Presumption of Compensation.
ASU 2010-05 updates existing guidance to address the SEC staff’s views on
overcoming the presumption that for certain shareholders escrowed share
arrangements represent compensation.  The Company does not expect the
adoption of ASU 2010-05 to have a material impact on its consolidated financial
statements.





In
January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and
Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.
ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new
disclosures, and includes conforming amendments to guidance on employers’
disclosures about postretirement benefit plan assets. ASU 2010-06 is effective
for interim and annual periods beginning after December 15, 2009, except for
disclosures about purchases, sales, issuances, and settlements in the roll
forward of activity in Level 3 fair value measurements. Those disclosures are
effective for fiscal years beginning after December 15, 2010 and for interim
periods within those fiscal years.  The Company does not expect the
adoption of ASU 2010-06 to have a material impact on its consolidated financial
statements.





In
February 2010, the FASB issued ASU 2010-08, Technical Corrections to Various
Topics. ASU 2010-08 clarifies guidance on embedded derivatives and hedging. ASU
2010-08 is effective for interim and annual





35
 Index




periods
beginning after December 15, 2009. The Company does not expect the adoption of
ASU 2010-08 to have a material impact on its consolidated financial
statements.





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.





NOTE
THREE: SECURITIES





The
income derived from taxable and non-taxable securities for the years ended
December 31, 2009 and 2008 is shown below (in thousands of
dollars):





Year
      Ended December 312009
            
            
            2008Investment
      securities, taxable
            
            $
            728
            
            
            $
            987Investment
      securities, non-taxable
            
            
            151
            
            
            
            129








The
carrying amount and estimated fair value of securities available for sale at
December 31, 2009 and 2008 are as follows (in thousands of
dollars):





Available
      for Sale SecuritiesAmortized
      Cost
            
            
            Unrealized
      Gains
            
            
            Unrealized
      Losses
            
            
            Fair ValueDecember
      31, 2009U.S.
      Treasuries and Agencies
            
            $
            12,250
            
            
            $
            177
            
            
            $
            1
            
            
            $
            12,426Mortgage
      backed securities
            
            
            5,630
            
            
            
            206
            
            
            
            0
            
            
            
            5,836State
      and municipals
            
            
            3,832
            
            
            
            114
            
            
            
            0
            
            
            
            3,946Certificates
      of deposit
            
            
            4,696
            
            
            
            9
            
            
            
            2
            
            
            
            4,703Marketable
      equities
            
            
            15
            
            
            
            10
            
            
            
            0
            
            
            
            25Total
      Securities Available for Sale
            
            $
            26,423
            
            
            $
            516
            
            
            $
            3
            
            
            $
            26,936December
      31, 2008U.S.
      Treasuries and Agencies
            
            $
            7,504
            
            
            $
            222
            
            
            $
            0
            
            
            $
            7,726Mortgage
      backed securities
            
            
            10,211
            
            
            
            148
            
            
            
            17
            
            
            
            10,342State
      and municipals
            
            
            3,596
            
            
            
            29
            
            
            
            16
            
            
            
            3,609Marketable
      equities
            
            
            28
            
            
            
            ---
            
            
            
            13
            
            
            
            15Total
      Securities Available for Sale
            
            $
            21,339
            
            
            $
            399
            
            
            $
            46
            
            
            $
            21,692




36
 Index




The
carrying amount and fair value of debt securities at December 31, 2009, 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
            
            $
            4,329
            
            
            $
            4,386Due
      after one year through five years
            
            
            16,124
            
            
            
            16,363Due
      after five years through ten years
            
            
            325
            
            
            
            326Mortgage
      backed securities
            
            
            5,630
            
            
            
            5,836Equity
      securities with no maturity
            
            
            15
            
            
            
            25Total
      Securities Available for Sale
            
            $
            26,423
            
            
            $
            26,936





Securities
having a carrying value of $4,991,000 at December 31, 2009 and $5,632,000 at
December 31, 2008 were pledged to secure public deposits and for other purposes
required by law.





Information
pertaining to securities with gross unrealized losses at December 31, 2009 and
2008, 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, 2009Investment
      CategoryU.S.
      Treasuries and Agencies
            
            $
            999
            
            
            $
            (1
            )
            
            $
            999
            
            
            $
            (1
            )
            
            $
            0
            
            
            $
            (0
            )Mortgage
      backed securities
            
            
            24
            
            
            
            (0
            )
            
            
            24
            
            
            
            0
            
            
            
            0
            
            
            
            (0
            )Certificates
      of deposit
            
            
            246
            
            
            
            (2
            )
            
            
            246
            
            
            
            (2
            )
            
            
            0
            
            
            
            (0
            )Marketable
      equities
            
            
            0
            
            
            
            (0
            )
            
            
            0
            
            
            
            (0
            )
            
            
            0
            
            
            
            (0
            )Total
            
            $
            1,269
            
            
            $
            (3
            )
            
            $
            1,269
            
            
            $
            (3
            )
            
            $
            0
            
            
            $
            (0
            )December
      31, 2008Investment
      CategoryU.S.
      Treasuries and Agencies
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0Mortgage
      backed securities
            
            
            1,225
            
            
            
            (17
            )
            
            
            1,156
            
            
            
            (16
            )
            
            
            69
            
            
            
            (1
            )State
      and municipals
            
            
            1,908
            
            
            
            (16
            )
            
            
            1,708
            
            
            
            (15
            )
            
            
            200
            
            
            
            (1
            )Marketable
      equities
            
            
            15
            
            
            
            (13
            )
            
            
            0
            
            
            
            0
            
            
            
            15
            
            
            
            (13
            )Total
            
            $
            3,148
            
            
            $
            (46
            )
            
            $
            2,864
            
            
            $
            (31
            )
            
            $
            284
            
            
            $
            (15
            )




37
 Index




The
number of securities available for sale that were in an unrealized loss position
at December 31, 2009 is summarized in the table below:





Total
            
            
            Loss
      Position less than 12Months
            
            
            Loss
      Position greater than 12MonthsU.S.
      Treasuries and Agencies
            
            
            1
            
            
            
            1
            
            
            
            0Mortgage
      backed securities
            
            
            2
            
            
            
            2
            
            
            
            0Certificates
      of deposit
            
            
            1
            
            
            
            1
            
            
            
            0Total
            
            
            4
            
            
            
            4
            
            
            
            0





It is
management’s determination that all securities held at December 31, 2009, 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.





NOTE
FOUR: RESTRICTED INVESTMENTS





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




NOTE
FIVE: LOANS





Loans
outstanding as of December 31, 2009 and 2008 are summarized as follows (in
thousands of dollars):





2009
            
            
            2008Commercial
            
            $
            97,606
            
            
            $
            97,709Real
      Estate Construction
            
            
            30,759
            
            
            
            27,210Real
      Estate Mortgage
            
            
            162,619
            
            
            
            156,877Consumer
      Installment
            
            
            44,499
            
            
            
            43,958Total
      Loans
            
            $
            335,483
            
            
            $
            325,754





The
following is a summary of information pertaining to impaired and non accrual
loans at December 31, 2009 and 2008 (in thousands of dollars):





2009
            
            
            2008Year
      end balance, impaired loans
            
            $
            3,425
            
            
            $
            3,841Allowance
      for impairments, year end
            
            
            662
            
            
            
            272Average
      balance impaired loans, year ended December 31
            
            
            3,691
            
            
            
            2,333Income
      recorded on impaired loans, year ended December 31
            
            
            246
            
            
            
            179





No loans
were identified as impaired as of December 31 2009 or 2008 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, (foregone interest) was $157,000 in
2009.  Foregone interest was of an immaterial amount in
2008.





38
 Index




Balances
of non-accrual loans and loans past due ninety days or greater and still
accruing interest at December 31, 2009 and 2008 are shown below (in thousands of
dollars):





2009
            
            
            2008Non-accrual
      loans at year end
            
            $
            2,567
            
            
            $
            1,346Loans
      past due ninety days or greater and still accruing interest at year
      end
            
            
            2,192
            
            
            
            3,472




NOTE
SIX: EARNINGS PER SHARE





During
2009 and 2008, there were no changes to the outstanding shares of common stock.
During the second and third quarters of 2008, the Company purchased, at varying
intervals, 100,001 shares of outstanding common stock. The weighted average
shares, upon which earnings per share calculations for the twelve month period
ended December 31, 2008, were calculated based upon the date repurchased and the
number of shares repurchased on that date, as a percentage of the total period
represented.




NOTE
SEVEN: ALLOWANCE FOR LOAN LOSSES





A summary
of the changes in the allowance for loan losses for the years ended December 31,
2009 and 2008 is show below (in thousands of dollars):





2009
            
            
            2008Balance
      at beginning of year
            
            $
            3,667
            
            
            $
            3,577Provision
      charged to operating expenses
            
            
            1,864
            
            
            
            909Loan
      recoveries
            
            
            290
            
            
            
            131Loans
      charged off
            
            
            (1,800
            )
            
            
            (950
            )Balance
      at end of year
            
            $
            4,021
            
            
            $
            3,667Allowance
      for Loan Losses as percentage of outstanding loans at year
    end
            
            
            1.20
            %
            
            
            1.13
            %




NOTE
EIGHT: BANK PREMISES AND EQUIPMENT





Bank
premises and equipment as of December 31, 2009 and 2008 are summarized as
follows (in thousands of dollars):




2009
            
            
            2008Land
            
            $
            2,227
            
            
            $
            1,528Buildings
      and improvements
            
            
            8,736
            
            
            
            8,288Furniture
      and equipment
            
            
            5,519
            
            
            
            4,915Total
      Cost
            
            
            16,482
            
            
            
            14,731Less
      accumulated depreciation
            
            
            (7,156
            )
            
            
            (6,700
            )Net
      Book Value
            
            $
            9,326
            
            
            $
            8,031




39
 Index




Provisions
for depreciation charged to operations during 2009 and 2008 were as follows (in
thousands of dollars):




Year
            
            Provision
      for Depreciation2009
            
            $
            6722008
            
            
            702





NOTE
NINE: RESTRICTIONS ON DIVIDENDS OF SUBSIDIARY BANKS





The
principal source of funds of the Company 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 December 31, 2009,
the Banks could pay dividends to the Company of approximately $4,973,000 without
permission of the regulatory authorities.




NOTE
TEN: DEPOSITS





At
December 31, 2009, the scheduled maturities of time deposits were as follows (in
thousands of dollars):





Year
            
            Amount Maturing2010
            
            $
            137,5482011
            
            
            58,6432012
            
            
            15,9982013
            
            
            7,0572014
            
            
            5,1002015
            
            
            100Total
            
            $
            224,446





Interest
expense on time deposits of $100,000 and over aggregated $2,404,000 and
$2,678,000 for 2009 and 2008, respectively.





The
aggregate amount of demand deposit overdrafts reclassified as loan balances were
$290,000 and $175,000 at December 31, 2009 and 2008, respectively.




NOTE
ELEVEN: 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 $335,482,000 and $325,754,000 loans held by the Company at December 31, 2009
and 2008, respectively, $274,610,000 and $261,289,000 are secured by real
estate.





The
Company’s subsidiaries had cash deposited in and federal funds sold to other
commercial banks totaling $10,886,000 and $764,000 at December 31, 2009 and
2008, 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.





40
 Index




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. The table below summarizes
changes to balances of loans and to unused commitments to related parties during
the years ended December 31, 2009 and 2008 (in thousands of
dollars):




2009
            
            
            2008Loans
      to related parties, beginning of year
            
            $
            8,384
            
            
            $
            5,236New
      loans
            
            
            809
            
            
            
            3,989Repayments
            
            
            (881
            )
            
            
            (841
            )Loans
      to related parties, end of year
            
            $
            8,312
            
            
            $
            8,384





At
December 31, 2009, deposits of related parties including directors, executive
officers, and their related interests of the Company and subsidiaries
approximated $8,138,000, and at December 31, 2008, deposits of related parties
including directors, executive officers, and their related interests of the
Company and subsidiaries approximated $7,474,000.




NOTE
THIRTEEN: DEBT INSTRUMENTS





The
Company has borrowed money from the Federal Home Loan Bank of Pittsburgh (FHLB).
This debt consists of both borrowings with terms of maturities of six months or
greater and also certain debts with maturities of thirty days or
less.





The
borrowings with long term maturities may have either single payment maturities
or amortize. The various borrowings mature from 2010 to 2020.  The
interest rates on the various borrowings at December 31, 2009 range from 3.94%
to 5.96%. The weighted average interest rate on the borrowings at December 31,
2009 was 4.61%.  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, 2009 are as follows (in thousands of dollars):





Year
            
            Balance2010
            
            $
            1,4732011
            
            
            1,2552012
            
            
            5,6952013
            
            
            2892014
            
            
            622Thereafter
            
            
            1,532Total
            
            $
            10,866





In
addition to utilization of the FHLB for borrowings of long term debt, the
Company also can utilize the FHLB for overnight and other short term borrowings;
however, at December 31, 2009, the Company had no balances in overnight and
other short term borrowings. The Company has total borrowing capacity from the
FHLB of $151,757,000. The Banks have pledged mortgage loans as collateral on the
FHLB borrowings in the approximate amount of $151,914,000 at December 31,
2009.





The
subsidiary Banks also have short term borrowing capacity from each of their
respective correspondent banks. As of December 31, 2009 the Company has total
borrowing capacity from its correspondent banks of $13,200,000. The interest
rates on these lines are variable and are subject to change daily based on
current market conditions.





41
 Index




NOTE
FOURTEEN: INCOME TAX EXPENSE





The
Company 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 2006.





Included
in the balance sheet at December 31, 2009 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, 2009 and 2008
are summarized in the table on the following page (in thousands of
dollars):





2009
            
            
            2008Current
      ExpenseFederal
            
            $
            1,356
            
            
            $
            2,433State
            
            
            216
            
            
            
            370Total
      Current Expense
            
            
            1,572
            
            
            
            2,803Deferred
      Expense (Benefit)Federal
            
            
            110
            
            
            
            (60
            )State
            
            
            10
            
            
            
            (5
            )Total
      Current Expense (Benefit)
            
            
            120
            
            
            
            (65
            )Income
      Tax Expense
            
            $
            1,692
            
            
            $
            2,738





The
deferred tax effects of temporary differences for the years ended December 31,
2009 and 2008 are as follows (in thousands of dollars):





2009
            
            
            2008Provision
      for loan losses
            
            $
            (119
            )
            
            $
            (61
            )Depreciation
            
            
            93
            
            
            
            13Deferred
      compensation
            
            
            135
            
            
            
            18Loss
      carry forward
            
            
            0
            
            
            
            0Miscellaneous
            
            
            11
            
            
            
            (35
            )Net
      increase in deferred income tax benefit
            
            $
            120
            
            
            $
            (65
            )




42
 Index




The net
deferred tax assets arising from temporary differences as of December 31, 2009
and 2008 are shown in the table on the following page (in thousands of
dollars):





2009
            
            
            2008Deferred
      Tax AssetsProvision
      for loan losses
            
            $
            1,204
            
            
            $
            1,086Insurance
      commissions
            
            
            24
            
            
            
            35Deferred
      compensation
            
            
            938
            
            
            
            932Pension
      obligation
            
            
            466
            
            
            
            677Other
            
            
            2
            
            
            
            0Total
      Assets
            
            
            2,634
            
            
            
            2,730Deferred
      Tax LiabilitiesAccretion
      income
            
            
            10
            
            
            
            9Unrealized
      gains on securities available for sale
            
            
            190
            
            
            
            131Depreciation
            
            
            462
            
            
            
            362Other
            
            
            0
            
            
            
            6Total
      Liabilities
            
            
            662
            
            
            
            508Net
      Deferred Tax Asset
            
            $
            1,972
            
            
            $
            2,222





The
following table summarizes the differences between income tax expense and the
amount computed by applying the federal statutory rate for the two years ended
December 31, 2009 and 2008 (in thousands of dollars):





2009
            
            
            2008Amounts
      at federal statutory rates
            
            $
            1,716
            
            
            $
            2,621Additions
      (reductions) resulting from:Tax
      exempt income
            
            
            (104
            )
            
            
            (64
            )Partially
      exempt income
            
            
            (28
            )
            
            
            (34
            )State
      income taxes, net
            
            
            170
            
            
            
            233Income
      from life insurance contracts
            
            
            (94
            )
            
            
            (87
            )Non
      deductible income related to branch acquisitions
            
            
            65
            
            
            
            66Other
            
            
            (33
            )
            
            
            3Income
      tax expense
            
            $
            1,692
            
            
            $
            2,738





NOTE
FIFTEEN: 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 $803,000 in 2009 and
$866,000 in 2008.





43
 Index




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; however no
contribution is expected in 2010. At December 31, 2009, Grant has recognized
liabilities of $1,278,000 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
$1,338,000 (net of $786,000 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, 2009 and 2008 using a
measurement date of December 31, 2009 and December 31, 2008 respectively (in
thousands of dollars):





2009
            
            
            2008Change in Benefit
ObligationBenefit
      obligation, beginning
            
            $
            4,492
            
            
            $
            3,859Service
      Cost
            
            
            168
            
            
            
            179Interest
      Cost
            
            
            276
            
            
            
            283Actuarial
      Loss (Gain)
            
            
            281
            
            
            
            260Benefits
      Paid
            
            
            (81
            )
            
            
            (89
            )Benefit
      obligation, ending
            
            $
            5,136
            
            
            $
            4,492Accumulated
      Benefit Obligation
            
            $
            4,261
            
            
            $
            3,858Change in Plan AssetsFair
      value of assets, beginning
            
            $
            2,650
            
            
            $
            3,335Actual
      return on assets, net of administrative expenses
            
            
            699
            
            
            
            (1,042
            )Employer
      contributions
            
            
            590
            
            
            
            446Benefits
      paid
            
            
            (81
            )
            
            
            (89
            )Fair
      value of assets, ending
            
            $
            3,858
            
            
            $
            2,650Funded StatusFair
      value of plan assets
            
            $
            3,858
            
            
            $
            2,650Projected
      benefit obligation
            
            
            5,136
            
            
            
            4,492Funded
      status
            
            
            (1,278
            )
            
            
            (1,842
            )Liabilities
      Recognized in the Statement of Financial Position
            
            $
            (1,278
            )
            
            $
            (1,842
            )Amounts
      Recognized in Accumulated Other Comprehensive IncomePrior
      Service Cost
            
            $
            0
            
            
            $
            0Net
      (Gain)/Loss
            
            
            2,124
            
            
            
            2,310Total
            
            $
            2,124
            
            
            $
            2,310




44
 Index




The
following table provides the components of the net periodic pension expense for
the Plan for the years ended December 31, 2009 and 2008 (in thousands of
dollars):





2009
            
            
            2008Service
      cost
            
            $
            168
            
            
            $
            154Interest
      cost
            
            
            276
            
            
            
            243Expected
      return on plan assets
            
            
            (306
            )
            
            
            (294
            )Recognized
      net actuarial loss
            
            
            47
            
            
            
            47Amortization
      of prior service cost
            
            
            0
            
            
            
            3Adjustment
      due to change in measurement date
            
            
            25
            
            
            
            25Net
      Periodic Pension Expense
            
            $
            210
            
            
            $
            178





The
expected pension expense for 2010 is $252,000.





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





Year
            
            Expected
      Benefit Payments2010
            
            $
            1692011
            
            
            1982012
            
            
            2132013
            
            
            2622014
            
            
            360Years
      2015 – 2019
            
            
            1,956





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





2009
            
            
            2008Discount
      rate
            
            
            6.25
            %
            
            
            6.25
            %Expected
      return on plan assets
            
            
            8.00
            %
            
            
            8.00
            %Rate
      of compensation increase
            
            
            3.00
            %
            
            
            3.00
            %








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





The
following table provides the pension plan’s asset allocation as of December 31,
2009 and 2008:





2009
            
            
            2008Equity
      Securities
            
            
            63
            %
            
            
            64
            %Debt
      Securities
            
            
            32
            %
            
            
            30
            %Other
            
            
            5
            %
            
            
            6
            %




45
 Index




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.





Fair
Value





The fair
value of the Company’s pension plan assets at December 31, 2009, by asset
category is as follows:





Fair Value Measurements
    UsingBalance
      as of December 31,
            
            
            Quoted
      Prices In Active Markets for Identical Assets
            
            
            Significant
      Other Observable Inputs
            
            
            Significant
      Unobservable InputsAsset Category
            
            2009
            
            
            (Level 1)
            
            
            (Level 2)
            
            
            (Level 3)Cash
      and cash equivalents
            
            $
            193
            
            
            $
            193
            
            
            $
            0
            
            
            $
            0Equity
      securities:U.S.
      Companies
            
            
            1,814
            
            
            
            1,814International
      Companies
            
            
            425
            
            
            
            425Debt
      Securities
            
            
            1,233
            
            
            
            
            
            
            
            1,233Real
      Estate
            
            
            193
            
            
            
            193





NOTE
SIXTEEN: 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.





46
 Index




As of
December 31, 2009 and 2008, the Banks had outstanding the following commitments
(in thousands of dollars):





2009
            
            
            2008Commitments
      to extend credit
            
            $
            16,289
            
            
            $
            24,204Standby
      letter of credit
            
            
            858
            
            
            
            836








NOTE
SEVENTEEN: CHANGES IN OTHER COMPREHENSIVE INCOME





The
components of changes in other comprehensive income and related tax effects for
the years ended December 31, 2009 and 2008 are as follows (in thousands of
dollars):





2009
            
            
            2008Balance
      January 1
            
            $
            (1,232
            )
            
            $
            (285
            )Unrealized
      holding gains on available for sale securities net of income taxes of
      $59,000 for 2009 and  $31,000 for 2008
            
            
            93
            
            
            
            162Less
      classification adjustment for (gains) losses realized in net
      income
            
            
            7
            
            
            
            (110
            )Accrued
      pension obligation net of income taxes of $69,000 for 2009 and $587,000
      for 2008
            
            
            117
            
            
            
            (999
            )Net
      change for the year
            
            
            217
            
            
            
            (947
            )Balance
      December 31
            
            $
            (1,015
            )
            
            $
            (1,232
            )




NOTE
EIGHTEEN: ADJUSTMENT TO RETAINED EARNINGS FOR CHANGE IN ACCOUNTING
PRINCIPLE





In 2006,
the FASB issued pronouncements that require 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 pronouncements became effective for the Company on January
1, 2008.





These
pronouncements provided an option for affected companies to record the resulting
liability as a cumulative effect adjustment to retained earnings at the
beginning of the period in which recorded or to record through retrospective
application to prior periods. The Company opted to record the liability as a
cumulative effect adjustment to prior period retained earnings and as such
recorded a liability and corresponding reduction of prior period retained
earnings of $348,000. There is no corresponding deferred tax consequence
relating to this liability. The recording of the cumulative effect adjustment to
retained earnings is reflected in the December 31, 2008 balance of retained
earnings and is shown as an adjustment to retained earnings in the Consolidated
Statements of Stockholders’ Equity.





NOTE
NINETEEN: FAIR VALUE MEASUREMENTS





The
Company uses fair value measurements to record fair value adjustments to certain
assets and liabilities and to determine fair value disclosures.  In
accordance with the authoritative accounting guidance regarding fair value
measurements and disclosures, the fair value of a financial instrument is the
price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the measurement
date.  Fair value is best determined based on quoted market
prices.  However, in the event there are no quoted market prices are
available, fair values are based on estimates using present value or other
valuation techniques.  Those techniques are significantly affected by
the assumptions used, including the discount rate and estimates of
future





47
 Index




cash
flows.  Accordingly, the fair value estimates may not be realized in
an immediate settlement of the instrument.





The
recent fair value guidance provides a consistent definition of fair value, which
focuses on exit price in an orderly transaction (that is, not a forced
liquidation or distressed sale) between market participants as the measurement
date under current market conditions.  If there has been a significant
decrease in the volume and level of activity for the asset or liability, a
change in valuation technique or the use of multiple valuation techniques may be
appropriate.  In such instances, determining the price at which
willing market participants would transact at the measurement date under current
market conditions depends on the facts and circumstances and requires the use of
significant judgment.  The fair value is a reasonable amount within
the range that is most representative of fair value under current market
conditions.




In
accordance with this guidance, the Company groups its financial assets and
liabilities generally measured at fair value in three levels, based on the
markets in which the assets and liabilities are traded and the reliability of
the assumptions used to determine fair value. The three levels are defined as
follow:


·
            Level One:
      Inputs to the valuation methodology are quoted prices (unadjusted) for
      identical assets or liabilities in active
  markets.


·
            Level Two:
      Inputs to the valuation methodology include quoted prices for similar
      assets and liabilities in active markets, and inputs that are observable
      for the asset or liability, either directly or indirectly, for
      substantially the full term of the financial
  instrument.


·
            Level Three:
      Inputs to the valuation methodology are unobservable and significant to
      the fair value measurement.




Following
is a description of the valuation methodologies used for instruments measured at
fair value on the Company’s balance sheet, as well as the general classification
of such instruments pursuant to the valuation hierarchy:




Securities




Where
quoted prices are available in an active market, securities are classified
within level 1 of the valuation hierarchy. Level 1 securities would include
highly liquid government bonds, mortgage products and exchange traded equities.
If quoted market prices are not available, then fair values are estimated by
using pricing models, quoted prices of securities with similar characteristics,
or discounted cash flow. Level 2 securities would include U.S. agency
securities, mortgage-backed agency securities, obligations of states and
political subdivisions and certain corporate, asset backed and other securities.
In certain cases where there is limited activity or less transparency around
inputs to the valuation, securities are classified within level 3 of the
valuation hierarchy.  Currently, all of the Company’s securities are
considered to be Level 2 securities.




Impaired
Loans




The fair
value measurement guidance applies to loans measured for impairment using the
practical expedients permitted by authoritative accounting guidance, including
impaired loans measured at an observable market price (if available), or at the
fair value of the loan’s collateral (if the loan is collateral dependent). Fair
value of the loan’s collateral, when the loan is dependent on collateral, is
determined by appraisals or independent valuation which is then adjusted for the
cost related to liquidation of the collateral. At December 31, 2009, the Company
had identified $2,763,000 in impaired loans net of allowance for impairments
(see Note Five).




Other Real Estate
Owned




Certain
assets such as other real estate owned (OREO) are measured at fair value. Real
estate acquired through foreclosure are recorded at an estimated fair value less
cost to sell. At or near the time of foreclosure, a real estate appraisal is
obtained on the properties.  The real estate is then valued at the
lesser of the appraised value or the loan balance, including interest
receivable, at the time of foreclosure less an estimate of costs to sell the
property.  Appraised values are typically determined utilizing an
income or market valuation approach based on an appraisal conducted by an
independent, licensed appraiser (Level 2).  If the acquired property
is a house or building in the process of construction or if an appraisal of the
real estate property is over two years old, the fair value is considered Level
3.  The estimate of costs to sell the property is based on historical
transactions of similar holdings.





48
 Index




The
Company, at December 31, 2009, had no liabilities subject to fair value
reporting requirements. The tables below summarizes assets at December 31, 2009
and 2008 measured at fair value on a recurring basis (in thousands of
dollars):





2009Level 1
            
            
            Level 2
            
            
            Level 3
            
            
            Total
      Fair Value MeasurementsSecurities
      available for sale
            
            $
            0
            
            
            $
            26,936
            
            
            $
            0
            
            
            $
            26,936Total
            
            $
            0
            
            
            $
            26,936
            
            
            $
            0
            
            
            $
            26,936





2008Level 1
            
            
            Level 2
            
            
            Level 3
            
            
            Total
      Fair Value MeasurementsSecurities
      available for sale
            
            $
            0
            
            
            $
            21,692
            
            
            $
            0
            
            
            $
            21,692Total
            
            $
            0
            
            
            $
            21,692
            
            
            $
            0
            
            
            $
            21,692





The
tables below summarizes assets at December 31, 2009 and 2008 measured at fair
value on a non-recurring basis (in thousands of dollars):





2009Level 1
            
            
            Level 2
            
            
            Level 3
            
            
            Total
      Fair Value MeasurementsOther
      real estate owned
            
            $
            0
            
            
            $
            3,223
            
            
            $
            0
            
            
            $
            3,223Impaired
      Loans
            
            $
            0
            
            
            
            602
            
            
            
            2,161
            
            
            
            2,763Total
            
            $
            0
            
            
            $
            3,825
            
            
            $
            2,161
            
            
            $
            5,986





2008Level 1
            
            
            Level 2
            
            
            Level 3
            
            
            Total
      Fair Value MeasurementsOther
      real estate owned
            
            $
            0
            
            
            $
            1,359
            
            
            $
            0
            
            
            $
            1,359Impaired
      Loans
            
            $
            0
            
            
            
            3,569
            
            
            
            0
            
            
            
            3,569Total
            
            $
            0
            
            
            $
            4,928
            
            
            $
            0
            
            
            $
            4,928




The
information above discusses financial instruments carried on the Company’s
balance sheet at fair value. Other financial instruments on the Company’s
balance sheet, while not carried at fair value, do have market values which may
differ from the carrying value. The following information shows the carrying
values and estimated fair values of financial instruments and discusses the
methods and assumptions used in determining these fair values.





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





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.





49
 Index




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, and considers the limited marketability of such securities.





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
Instruments


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
Instruments


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, 2009 and 2008.  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, 2009 or 2008.





The
carrying amount and estimated fair values of financial instruments as of
December 31, 2009 and 2008 are shown in the table below (in thousands of
dollars):


2009
            
            
            2008Carrying
      Amount
            
            
            Estimated
      Fair Value
            
            
            Carrying
      Amount
            
            
            Estimated
      Fair ValueFinancial
      Assets:Cash
      and due from banks
            
            $
            7,062
            
            
            $
            7,062
            
            
            $
            7,589
            
            
            $
            7,589Interest
      bearing deposits
            
            
            1,880
            
            
            
            1,880
            
            
            
            502
            
            
            
            502Federal
      funds sold
            
            
            8,936
            
            
            
            8,936
            
            
            
            160
            
            
            
            160Securities
      available for sale
            
            
            26,936
            
            
            
            26,936
            
            
            
            21,692
            
            
            
            21,692Restricted
      investments
            
            
            2,185
            
            
            
            2,185
            
            
            
            2,177
            
            
            
            2,177Loans,
      net
            
            
            331,462
            
            
            
            332,999
            
            
            
            322,087
            
            
            
            323,788Interest
      receivable
            
            
            1,908
            
            
            
            1,908
            
            
            
            2,164
            
            
            
            2,164Life
      insurance contracts
            
            
            6,755
            
            
            
            6,755
            
            
            
            6,499
            
            
            
            6,499Financial
      Liabilities:Demand
      and savings deposits
            
            
            125,431
            
            
            
            125,431
            
            
            
            118,214
            
            
            
            118,214Time
      deposits
            
            
            224,446
            
            
            
            226,057
            
            
            
            198,073
            
            
            
            200,970Overnight
      and other short-term debt instruments
            
            
            0
            
            
            
            0
            
            
            
            4,800
            
            
            
            4,800Long-term
      debt instruments
            
            
            10,866
            
            
            
            11,733
            
            
            
            11,317
            
            
            
            11,930Interest
      payable
            
            
            656
            
            
            
            656
            
            
            
            848
            
            
            
            848




50
 Index




NOTE
TWENTY: INVESTMENTS 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 third quarter of 2008, the Company received payment in settlement relating
to one of these policies. This payment related to the death of an insured and
resulted in a one-time, non-recurring gain of $30,000.





A summary
of the changes to the balance of investments in insurance contracts for the
twelve month periods ended December 31, 2009 and December 31, 2008 are shown in
the table below (in thousands of dollars):





2009
            
            
            2008Balance,
      beginning of period
            
            $
            6,499
            
            
            $
            6,300Increases
      in value of policies
            
            
            256
            
            
            
            252Settlement
      payout
            
            
            (0
            )
            
            
            (53
            )Balance,
      end of period
            
            $
            6,755
            
            
            $
            6,499





NOTE
TWENTY ONE: 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.





Capital
ratios and amounts are applicable both at the individual Bank level and on a
consolidated basis.  At December 31, 2009 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.





51
 Index





The
actual and required capital amounts and ratios of the Company and its subsidiary
banks at December 31, 2009 are presented in the following table (in thousands of
dollars):





December
      31, 2009Regulatory
      RequirementsActual
            
            
            Adequately
      Capitalized
            
            
            Well
      CapitalizedAmount
            
            
            Percentage
            
            
            Amount
            
            
            Percentage
            
            
            Amount
            
            
            PercentageTotal Risk Based Capital
    RatioHighlands
      Bankshares
            
            $
            43,697
            
            
            
            14.33
            %
            
            $
            24,401
            
            
            
            8.00
            %Capon
      Valley Bank
            
            
            14,925
            
            
            
            12.86
            %
            
            
            9,285
            
            
            
            8.00
            %
            
            $
            11,606
            
            
            
            10.00
            %The
      Grant County Bank
            
            
            26,630
            
            
            
            14.12
            %
            
            
            15,090
            
            
            
            8.00
            %
            
            
            18,862
            
            
            
            10.00
            %Tier 1 Leverage RatioHighlands
      Bankshares
            
            
            39,882
            
            
            
            9.81
            %
            
            
            16,263
            
            
            
            4.00
            %Capon
      Valley Bank
            
            
            13,466
            
            
            
            8.38
            %
            
            
            6,428
            
            
            
            4.00
            %
            
            
            8,035
            
            
            
            5.00
            %The
      Grant County Bank
            
            
            24,309
            
            
            
            9.91
            %
            
            
            9,814
            
            
            
            4.00
            %
            
            
            12,267
            
            
            
            5.00
            %Tier 1 Risk Based Capital
    RatioHighlands
      Bankshares
            
            
            39,882
            
            
            
            13.08
            %
            
            
            12,200
            
            
            
            4.00
            %Capon
      Valley Bank
            
            
            13,466
            
            
            
            11.60
            %
            
            
            4,642
            
            
            
            4.00
            %
            
            
            6,964
            
            
            
            6.00
            %The
      Grant County Bank
            
            
            24,309
            
            
            
            12.89
            %
            
            
            7,545
            
            
            
            4.00
            %
            
            
            11,317
            
            
            
            6.00
            %





The
actual and required capital amounts and ratios of the Company and its subsidiary
banks at December 31, 2008 is presented in the following table (in thousands of
dollars):





December
      31, 2008Regulatory
      RequirementsActual
            
            
            Adequately
      Capitalized
            
            
            Well
      CapitalizedAmount
            
            
            Percentage
            
            
            Amount
            
            
            Percentage
            
            
            Amount
            
            
            PercentageTotal Risk Based Capital
    RatioHighlands
      Bankshares
            
            $
            41,440
            
            
            
            14.20
            %
            
            $
            23,342
            
            
            
            8.00
            %Capon
      Valley Bank
            
            
            14,588
            
            
            
            12.77
            %
            
            
            9,136
            
            
            
            8.00
            %
            
            $
            11,421
            
            
            
            10.00
            %The
      Grant County Bank
            
            
            24,799
            
            
            
            13.99
            %
            
            
            14,180
            
            
            
            8.00
            %
            
            
            17,725
            
            
            
            10.00
            %Tier 1 Leverage RatioHighlands
      Bankshares
            
            
            37,882
            
            
            
            10.18
            %
            
            
            14,891
            
            
            
            4.00
            %Capon
      Valley Bank
            
            
            13,159
            
            
            
            9.11
            %
            
            
            5,775
            
            
            
            4.00
            %
            
            
            7,219
            
            
            
            5.00
            %The
      Grant County Bank
            
            
            22,663
            
            
            
            10.00
            %
            
            
            9,066
            
            
            
            4.00
            %
            
            
            11,333
            
            
            
            5.00
            %Tier 1 Risk Based Capital
    RatioHighlands
      Bankshares
            
            
            37,882
            
            
            
            12.98
            %
            
            
            11,671
            
            
            
            4.00
            %Capon
      Valley Bank
            
            
            13,159
            
            
            
            11.52
            %
            
            
            4,568
            
            
            
            4.00
            %
            
            
            6,852
            
            
            
            6.00
            %The
      Grant County Bank
            
            
            22,663
            
            
            
            12.79
            %
            
            
            7,090
            
            
            
            4.00
            %
            
            
            10,635
            
            
            
            6.00
            %




NOTE
TWENTY TWO: INTANGIBLE ASSETS





The
Company’s balance sheet contains several components of intangible assets. At
December 31, 2009, the total balance of intangible assets was comprised of
Goodwill and Core Deposit Intangible Assets acquired as a result of the
acquisition of other banks and also an intangible asset related to the purchased
naming rights for a performing arts center located within the Company’s primary
business area.





52
 Index




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 was granted
naming rights for this performing arts center. During the second quarter of
2008, the performing arts center reached an agreement with another party for the
same rights but at better terms and cancelled the contractual agreement with The
Grant County Bank. The $250,000 paid to the performing arts center was
subsequently returned during the third quarter of 2008. After the cancellation
of the original contract, the performing arts center and The Grant County Bank
reached another agreement whereby a contribution of $75,000 was made in return
for naming rights to only a portion of the same arts center.





A summary
of the changes in balances of intangible assets for the twelve month periods
ended December 31, 2009 and 2008 are shown below (in thousands of
dollars):





2009
            
            
            2008Balance
      beginning of period
            
            $
            2,749
            
            
            $
            3,106Amortization
      of intangible assets
            
            
            (195
            )
            
            
            (182
            )Purchase
      of naming rights contract
            
            
            0
            
            
            
            75Cancellation
      of naming rights contract
            
            
            (0
            )
            
            
            (250
            )Balance
      end of period
            
            $
            2,554
            
            
            $
            2,749








The
expected amortization of the intangible balances at December 31, 2009 for the
next five years is summarized in the table below (in thousands of
dollars):





Year
            
            Expected Expense2010
            
            $
            1902011
            
            
            1842012
            
            
            1782013
            
            
            1652014
            
            
            165thereafter
            
            
            138Total
            
            $
            1,020





NOTE
TWENTY THREE: SUBSEQUENT EVENTS





The
Company evaluates subsequent events that have occurred after the balance sheet,
but before the financial statements are issued.  There are two types
of subsequent events:  (1) recognized, or those that provide
additional evidence about conditions that existed at the date of the balance
sheet, including the estimates inherent in the process of preparing financial
statements, and (2) non-recognized, or those that provide evidence about
conditions that did not exist at the date of the balance sheet but arose after
that date.





Based on
management’s evaluation through March 29, 2010, the date these financial
statements were issued, the Company did not identify any recognized or
non-recognized subsequent events that would have required adjustment or
disclosure in the consolidated financial statements.





53
 Index




NOTE
TWENTY FOUR: PARENT COMPANY FINANCIAL STATEMENTS





Balance
Sheets


(in
thousands of dollars)





December
      31,2009
            
            
            2008AssetsCash
            
            $
            314
            
            
            $
            182Investment
      in subsidiaries
            
            
            40,590
            
            
            
            38,994Income
      taxes receivable
            
            
            459
            
            
            
            261Fixed
      assets, net of accumulated depreciation
            
            
            60
            
            
            
            0Other
      assets
            
            
            6
            
            
            
            34Total
      Assets
            
            $
            41,429
            
            
            $
            39,471LiabilitiesAccrued
      expenses
            
            $
            7
            
            
            $
            72Other
      liabilities
            
            
            0
            
            
            
            0Total
      Liabilities
            
            
            7
            
            
            
            72Stockholders’
      EquityCommon
      stock, par value $5 per share, 3,000,000 shares authorized, 1,436,874
      issued
            
            
            7,184
            
            
            
            7,184Surplus
            
            
            1,662
            
            
            
            1,662Treasury
      stock, at cost, 100,001 shares
            
            
            (3,372
            )
            
            
            (3,372
            )Retained
      earnings
            
            
            36,963
            
            
            
            35,157Other
      accumulated comprehensive income
            
            
            (1,015
            )
            
            
            (1,232
            )Total
      Stockholders’ Equity
            
            
            41,422
            
            
            
            39,399Total
      Liabilities and Stockholders’ Equity
            
            $
            41,429
            
            
            $
            39,471





54
 Index




Statements
of Income and Retained Earnings


(in
thousands of dollars)





Years ended December 31,2009
            
            
            2008IncomeDividends
      from subsidiaries
            
            $
            2,061
            
            
            $
            5,142Management
      fees from subsidiaries
            
            
            218
            
            
            
            212Other
      income
            
            
            0
            
            
            
            25Total
      Income
            
            
            2,279
            
            
            
            5,379ExpensesSalary
      and benefits expense
            
            
            409
            
            
            
            361Professional
      fees
            
            
            192
            
            
            
            137Directors
      fees
            
            
            88
            
            
            
            79Other
      expenses
            
            
            125
            
            
            
            165Total
      Expenses
            
            
            814
            
            
            
            742Net
      income before income tax benefit and undistributed subsidiary net
      income
            
            
            1,465
            
            
            
            4,637Income
      tax benefit
            
            
            228
            
            
            
            198Income
      before undistributed subsidiary net income
            
            
            1,693
            
            
            
            4,835Undistributed
      subsidiary net income
            
            
            1,663
            
            
            
            135Net
      Income
            
            $
            3,356
            
            
            $
            4,970Retained
      earnings, beginning of period
            
            $
            35,157
            
            
            $
            32,032Cumulative
      effect adjustment to retained earnings for change in accounting
      principle
            
            
            (0
            )
            
            
            (348
            )Dividends
      paid in cash
            
            
            (1,550
            )
            
            
            (1,497
            )Net
      income
            
            
            3,356
            
            
            
            4,970Retained
      earnings, end of period
            
            $
            36,963
            
            
            $
            35,157




55
 Index




Statements
of Cash Flows


(in
thousands of dollars)





Years
      Ended December 31,2009
            
            
            2008Cash
      Flows From Operating ActivitiesNet
      Income
            
            $
            3,356
            
            
            $
            4,970Adjustments
      to net incomeDepreciation
            
            
            2
            
            
            
            0Undistributed
      subsidiary income
            
            
            (1,663
            )
            
            
            (135
            )Gain
      on sale of fixed assets
            
            
            (0
            )
            
            
            (25
            )Deferred
      tax benefit
            
            
            2
            
            
            
            (3
            )Increase
      (decrease) in payables
            
            
            (65
            )
            
            
            72(Increase)
      decrease in receivables
            
            
            (198
            )
            
            
            15(Increase)
      decrease in other assets
            
            
            26
            
            
            
            10Net
      Cash Provided by Operating Activities
            
            
            1,460
            
            
            
            4,904Cash
      Flows From Investing ActivitiesNet
      advances from (payments to) subsidiaries
            
            
            284
            
            
            
            (11
            )Proceeds
      from sale of fixed assets
            
            
            0
            
            
            
            46Purchase
      of fixed assets
            
            
            (62
            )
            
            
            0Net
      Cash Provided by Investing Activities
            
            
            222
            
            
            
            35Cash
      Flows From Financing ActivitiesPurchase
      of treasury stock
            
            
            0
            
            
            
            (3,372
            )Dividends
      paid in cash
            
            
            (1,550
            )
            
            
            (1,497
            )Net
      Cash Used in Financing Activities
            
            
            (1,550
            )
            
            
            (4,869
            )Net
      Increase in Cash
            
            
            132
            
            
            
            70Cash,
      beginning of year
            
            
            182
            
            
            
            112Cash,
      end of year
            
            $
            314
            
            
            $
            182




56
 Index











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, 2009 and 2008, and the related
consolidated statements of income, stockholders' equity and cash flows for each
of the years in the two-year period ended December 31, 2009. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.





We
conducted our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain
reasonable assurance about whether the consolidated financial statements are
free of material misstatement.
The Company is not required to have, nor were we engaged to perform, an audit of
its internal
control over financial reporting. Our audit included consideration of internal
control over financial
reporting as a basis for designing audit procedures that are appropriate in the
circumstances, but not for
the purpose of expressing an opinion on the effectiveness of the Company’s
internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis,
evidence supporting the amounts and disclosures in the 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 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, 2009
and 2008, and the results of their operations and their cash flows for each of
the years in the two-year
period ended December 31, 2009 in conformity with accounting principles
generally accepted in the
United States of America.





As
discussed in Note Eighteen to the consolidated financial statements, the Company
changed its method of accounting for split-dollar post-retirement benefits in
2008 as required by the provisions of EITF 06-04.





/s/
      SMITH ELLIOTT KEARNS & COMPANY,
LLC


Chambersburg,
Pennsylvania


March 29,
2010





57
 Index




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 Interim Principal Financial Officer, has evaluated the effectiveness
of the Company’s disclosure controls and procedures as of December 31, 2009.
Based on this evaluation, the Company’s Chief Executive Officer and Interim
Principal 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.





Management’s
Report on Internal Control Over Financial Reporting





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, 2009. 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,
2009.





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 the Company 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.





58
 Index




Item 10.
            Directors,
      Executive Officers and Corporate
Governance





Information
required by this item is set forth as portions of our 2010 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 2010 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 Ethics 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 2010 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 2010 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 2010 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 Van Meter and Van Meter, 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.





59
 Index




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 2010 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 Statements and Schedules





(a)(1)
            Financial
      Statements:


Reference
is made to Part II, Item 8 of the Annual Report on Form 10-K


(a)(2)
            Financial
      Statement Schedules: These schedules are omitted as the required
      information is inapplicable or the information is presented in the
      consolidated financial statements or related
  notes


(a)(3)
            Exhibits.
      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




60
 Index




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/ Alan BrillC.E.
      Porter
            
            Alan
      BrillPresident
      & Chief Executive Officer
            
            Interim
      Principal Financial OfficerDate:  March
      29, 2010
            
            Date:
      March 29, 2010





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
            /s/
      Leslie A. Barr
            Director
            March
      29, 2010Alan
      L. Brill
            /s/
      Alan L. Brill
            Director;
              Secretary
            March
      29, 2010Jack
      H. Walters
            /s/
      Jack H. Walters
            Director
            March
      29, 2010Gerald
      W. Smith
            /s/
      Gerald W. Smith
            Director
            March
      29, 2010Morris
      M. Homan
            /s/
      Morris M. Homan
            Director
            March
      29, 2010Kathy
      G. Kimble
            /s/
      Kathy G. Kimble
            Director
            March
      29, 2010Steven
      C. Judy
            /s/
      Steven C. Judy
            Director
            March
      29, 2010C.E.
      Porter
            /s/
      C.E. Porter
            Director;
              President
      & Chief Executive Officer
            March
      29, 2010John
      G. Van Meter
            /s/
      John G. Van Meter
            Director;
              Chairman
      of The Board of Directors
            March
      29, 2010L.
      Keith Wolfe
            /s/
      L. Keith Wolfe
            Director
            March
      29, 2010




61
 Index




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.






62