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, 2008
 
 [  ]
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    [  ]
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  [  ]  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 [   ]
 
 Indicate
by check mark if disclosure of delinquent filers in response to Item 405 of
Regulation S-K is not contained in this form, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer.[  ] Large Accelerated
Filer[  ] Accelerated Filer [X] Non-accelerated filer [ ] Smaller
Reporting Company
 
 Indicate
by check mark whether the registrant is a shell company (as defined in rule
126-2 of the Act)   Yes
[   ]        No [ X
]
 
 State the
aggregate market value of the voting and non-voting common equity held by
non-affiliates computed by reference to the price at which the common equity was
last sold, or the average bid and asked price of such common equity, as of the
last business day of the registrant’s most recently completed second fiscal
quarter:
 
 The
aggregate market value of the 1,241,108 shares of common stock of the
registrant, issued and outstanding, held by non- affiliates on June 30, 2008,
was approximately $41,701,232 based on the closing sale price of $33.60 per
share on June 30, 2008.  For the purposes of this calculation, the
term “affiliate” refers to all directors and executive officers of the
registrant.
 
 Indicate
the number of shares outstanding of each of the registrant’s classes of common
stock as of the last practicable date: As of March 15, 2009: 1,336,873 shares of
common stock.
 
 DOCUMENTS
INCORPORATED BY REFERENCE
 
 Portions
of the Proxy Statement for the 2009 Annual Shareholders’ Meeting, to be held May
12, 2009, are incorporated by reference into Part III, Items 10,11,12,13 and
14.
 
  
  
 
 FORM
      10-K INDEXPart
      I
                
                PageItem 1.
                Business
                1Item 1A.
                Risk Factors
                7Item 1B.
                Unresolved Staff Comments
                9Item 2.
                Properties
                9Item 3.
                Legal Proceedings
                9Item 4.
                Submission of Matters to a Vote of Security
      Holders
                9Part
      IIItem 5.
                Market for Registrant’s Common Equity, Related Stockholder
      Matters and Issuer Purchases of Equity Securities
                9Item 6.
                Selected Financial Data
                11Item 7.
                Management’s Discussion and Analysis of Financial Condition and
      Results of Operations
                12Item 7A.
                Quantitative and Qualitative Disclosures About Market
      Risk
                32Item 8.
                Financial Statements and Supplementary Data
                34Item 9.
                Changes in and Disagreements with Accountants on Accounting and
      Financial Disclosure
                65Item 9A(T).
                Controls and Procedures
                65Item 9B.
                Other Information
                65Part
      IIIItem 10.
                Directors and Executive Officers and Corporate
      Governance
                65Item 11.
                Executive Compensation
                66Item 12.
                Security Ownership of Certain Beneficial Owners and Management
      and Related Stockholder Matters
                66Item 13.
                Certain Relationships,  Related Transactions and
      Director Independence
                66Item 14.
                Principal Accounting Fees and Services
                66Part
      IVItem 15.
                Exhibits and Financial Statement Schedules
                67Signatures
                68
 
 
 Index
 
 Page
      OnePART IItem 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 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, 2008, The Grant County Bank had 72 full time equivalent employees,
Capon Valley Bank had 52 full time equivalent employees and Highlands had 3 full
time equivalent employees. No person is employed by HBI Life on a full time
basis.
 
 Competition
 
 The
Banks' primary trade area is generally defined as Grant, Hardy, Mineral,
Randolph, Pendleton and Tucker Counties in West Virginia, the western portion of
Frederick County in Virginia and portions of Western Maryland. This area
includes the towns of Petersburg, Wardensville, Moorefield and Keyser and
several rural towns. The Banks' secondary trade area includes portions of
Hampshire County in West Virginia. The Banks primarily compete with four state
chartered banks, three national banks and three credit unions. In addition, the
Banks compete with money market mutual funds and investment brokerage firms for
deposits in their service area.  No financial institution has been
chartered in the area within the last five years although 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.
  Index
  
 Page
      Two
 
 As a bank
holding company registered under the Bank Holding Company Act of 1956, as
amended (the “BHCA”), the Company is subject to regulation by the Federal
Reserve Board.  Federal banking laws require a bank holding company to
serve as a source of financial strength to its subsidiary depository
institutions and to commit resources to support such institutions in
circumstances where it might not do so otherwise.  Additionally, the
Federal Reserve Board has jurisdiction under the BHCA to approve any bank or
non-bank acquisition, merger or consolidation proposed by a bank holding
company.  The BHCA generally limits the activities of a bank holding
company and its subsidiaries to that of banking, 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.
  Index
  
 Page
      Three
 
 On July
30, 2002, the United States Congress enacted the Sarbanes-Oxley Act of 2002, a
law that addresses corporate governance, auditing and accounting, executive
compensation and enhanced timely disclosure of corporate
information.  As Sarbanes-Oxley directs, the Company’s Chief Executive
Officer and Chief Financial Officer are each required to certify that the
Company’s quarterly and annual reports do not contain any untrue statement of a
material fact.  Additionally, these individuals must certify 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.
  Index
  
 Page
      Four
 
 The
Company’s and its subsidiaries’ regulatory capital ratios are presented in the
table below:
 
 Actual
      Ratio
                                    
                                    Actual
      Ratio
                                    
                                    RegulatoryDecember 31, 2008
                                    
                                    December 31, 2007
                                    
                                    MinimumTotal Risk Based CapitalHighlands
      Bankshares
                                    
                                    
                                    14.20
                                    %
                                    
                                    
                                    14.53
                                    %The
      Grant County Bank
                                    
                                    
                                    13.99
                                    %
                                    
                                    
                                    13.23
                                    %
                                    
                                    
                                    8.00
                                    %Capon
      Valley Bank
                                    
                                    
                                    12.77
                                    %
                                    
                                    
                                    14.78
                                    %
                                    
                                    
                                    8.00
                                    %Tier 1 Leverage RatioHighlands
      Bankshares
                                    
                                    
                                    10.18
                                    %
                                    
                                    
                                    9.95
                                    %The
      Grant County Bank
                                    
                                    
                                    10.00
                                    %
                                    
                                    
                                    9.09
                                    %
                                    
                                    
                                    4.00
                                    %Capon
      Valley Bank
                                    
                                    
                                    9.11
                                    %
                                    
                                    
                                    10.00
                                    %
                                    
                                    
                                    4.00
                                    %Tier 1 Risk Based Capital
    RatioHighlands
      Bankshares
                                    
                                    
                                    12.98
                                    %
                                    
                                    
                                    13.28
                                    %The
      Grant County Bank
                                    
                                    
                                    12.79
                                    %
                                    
                                    
                                    12.09
                                    %
                                    
                                    
                                    4.00
                                    %Capon
      Valley Bank
                                    
                                    
                                    11.52
                                    %
                                    
                                    
                                    13.53
                                    %
                                    
                                    
                                    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.
  Index
  
 Page
      Five
 
 Governmental
Policies
 
 The
Federal Reserve Board regulates money and credit and interest rates in order to
influence general economic conditions.  These policies have a
significant influence on overall growth and distribution of bank loans,
investments and deposits and affect interest rates charged on loans or paid for
time and savings deposits.  Federal Reserve monetary policies have had
a significant effect on the operating results of commercial banks in the past
and are expected to continue to do so in the future.
 
 Various
other legislation, including proposals to overhaul the banking regulatory system
and to limit the investments that a depository institution may make with insured
funds, are from time to time introduced in Congress.  The Company
cannot determine the ultimate effect that such potential legislation, if
enacted, would have upon its financial condition or operations.
 
 Financial Market and
Economic Conditions May Adversely Affect Our Business.
 
 The
United States is considered to be in a recession, and many businesses are having
difficulty due to reduced consumer spending and the lack of liquidity in the
credit markets.  Unemployment has increased
significantly.
 
 Because
of declines in home prices and the values of subprime mortgages across the
country, financial institutions and the securities markets have been adversely
affected by significant declines in the values of most asset classes and by a
serious lack of liquidity.  These conditions have led to the failure
or merger of a number of prominent financial institutions.  In 2008,
the U.S. government, the Federal Reserve and other regulators have taken
numerous steps to increase liquidity and to restore investor confidence, but
asset values have continued to decline and access to liquidity continues to be
very limited.
 
 Highlands’
financial performance and the ability of borrowers to pay interest on and repay
principal of outstanding loans and the value of collateral securing those loans
depends on the business environment in the markets where Highlands
operates.
 
 An Increase in FDIC
Assessments Could Impact Our Financial Performance.
 
 The FDIC
imposes an assessment against all depository institutions for deposit
insurance.  See “Supervision and Regulation – FDIC
Assessments.”  In the current economic environment, it is likely that
this assessment will increase in general for financial institutions across the
country, including the Bank, thereby increasing operating costs.
 
 The FDIC
imposes an assessment against all depository institutions for deposit
insurance.  This assessment is based on the risk category of the
institution and, prior to 2009, ranged from five to 43 basis points of an
institution’s deposits.  On October 7, 2008, as a result of decreases
in the reserve ratio of the DIF, the FDIC issued a proposed rule establishing a
Restoration Plan for the DIF.  The rulemaking proposed that, effective
January 1, 2009, assessment rates would increase uniformly by seven basis points
for the first quarter 2009 assessment period.  The rulemaking proposed
to alter the way in which the FDIC’s risk-based assessment system differentiates
for risk and set new deposit insurance assessment rates, effective April 1,
2009.  Under the proposed rule, the FDIC would first establish an
institution’s initial base assessment rate.  This initial base
assessment rate would range, depending on the risk category of the institution,
from 10 to 45 basis points.  The FDIC would then adjust the initial
base assessment (higher or lower) to obtain the total base assessment
rate.  The adjustment to the initial base assessment rate would be
based upon an institution’s levels of unsecured debt, secured liabilities, and
brokered deposits.  The total base assessment rate would range from
eight to 77.5 basis points of the institution’s deposits.  On December
22, 2008, the FDIC published a final rule raising the current deposit insurance
assessment rates uniformly for all institutions by seven basis points (to a
range from 12 to 50 basis points) for the first quarter of
2009.  However, the FDIC approved an extension of the comment period
on the parts of the proposed rulemaking that would become effective on April 1,
2009.  The FDIC expects to issue a second final rule early in 2009, to
be effective April 1, 2009, to change the way that the FDIC’s assessment
differentiates for risk and to set new assessment rates beginning with the
second quarter of 2009.  On February 27, 2009, the FDIC proposed an
emergency assessment charged to all financial institutions of 0.20% of insured
deposits as of June 30, 2009, payable on September 30, 2009.  In March
of 2009, the FDIC reduced the amount of the proposed assessment to 0.10% of
insured deposits as of June 30, 2009.
  Index
  
 Page
      Six
 
 Troubled Asset Relief
Program – Capital Purchase Program
 
 On
October 3, 2008, the Federal government enacted the Emergency Economic
Stabilization Act of 2008 (“EESA”).  EESA was enacted to provide
liquidity to the U.S. financial system and lessen the impact of looming economic
problems.  The EESA included broad authority.  The
centerpiece of the EESA is the Troubled Asset Relief Program
(“TARP”).  EESA’s broad authority was interpreted to allow the U.S.
Treasury to purchase equity interests in both healthy and troubled financial
institutions.  The equity purchase program is commonly referred to as
the Capital Purchase Program (“CPP”).  The company elected not to
participate in the CPP.
 
 America Recovery and
Reinvestment Act of 2009
 
 On
February 17, 2009, President Obama signed into law the American Recovery and
Reinvestment Act of 2009 (“ARRA”), more commonly known as the economic stimulus
or economic recovery package.  ARRA includes a wide variety of
programs intended to stimulate the economy and provide for extensive
infrastructure, energy, health, and education needs.
 
 Future
Legislation
 
 Various
other legislative and regulatory initiatives, 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 and state legislatures, as well as regulatory agencies.  Such
legislation may change banking statutes and the operating environment of
Highlands and its subsidiary banks in substantial and unpredictable ways, and
could increase or decrease the cost of doing business, limit or expand
permissible activities or affect the competitive balance depending upon whether
any of this potential legislation will be enacted, and if enacted, the effect
that it or any implementing regulations, would have on the financial condition
or results of operations of Highlands or any of its
subsidiaries.  With the recent enactments of EESA and ARRA, the nature
and extent of future legislative and regulatory changes affecting financial
institutions is very unpredictable at this time.  The Company cannot
determine the ultimate effect that such potential legislation, if enacted, would
have upon its financial condition or operations.
  Available
Information
 
 The
Company files annual, quarterly and current reports, proxy statements and other
information with the SEC. The Company’s SEC filings are filed electronically and
are available to the public via the Internet at the SEC’s website, www.sec.gov.
In addition, any document filed by the Company with the SEC can be read and
copies obtained at the SEC’s public reference facilities at 100 F Street, NE,
Washington, DC 20549. Copies of documents can be obtained at prescribed rates by
writing to the Public Reference Section of the SEC at 100 F Street NE,
Washington, DC 20549. The public may obtain information on the operation of the
Public Reference Room by calling the SEC at 1-800-SEC-0330. Copies of documents
can also be obtained free of charge by writing to Highlands Bankshares, Inc.,
P.O. Box 929, Petersburg, WV 26847.
 
 Executive
Officers
 
 Age
                  Position with the Company
                  Principal Occupation (Past Five
      Years)C.E.
      Porter
                  60
                  Chief
      Executive Officer
                  CEO
      of Highlands since 2004, President of The Grant County Bank since
      1991R.
      Alan Miller
                  39
                  Principal
      Financial Officer
                  PFO
      of Highlands since 2002Alan
      L. Brill
                  54
                  Secretary;
      President of Capon Valley Bank
                  President
      of Capon Valley Bank since
2001
 
  Index
  
 Page
      Seven
 
 Item1A.
                Risk
      Factors
 
 Due to Increased
Competition, the Company May Not Be Able to Attract and Retain Banking Customers
At Current Levels.
 
 If, due
to competition from competitors in the Company’s market area, the Company is
unable to attract new and retain current customers, loan and deposit growth
could decrease causing the Company’s results of operations and financial
condition to be negatively impacted.  The Company faces competition
from the following:
 
 ·
              Local,
      regional and national banks;
 ·
              Savings
      and loans;
 ·
              Internet
      banks;
 ·
              Credit
      unions;
 ·
              Insurance
      companies;
 ·
              Finance
      companies; and
 ·
              Brokerage
      firms serving the Company’s market
areas.
  The Company’s Lending Limit
May Prevent It from Making Large Loans.
 
 In the
future, the Company may not be able to attract larger volume customers because
the size of loans that the company can offer to potential customers is less than
the size of the loans that many of the Company’s larger competitors can offer.
We anticipate that our lending limit will continue to increase proportionately
with the Company’s growth in earnings; however, the Company may not be able to
successfully attract or maintain larger customers.
 
 Certain Loans That the Banks
Make Are Riskier than Loans for Real Estate Lending.
 
 The Banks
make loans that involve a greater degree of risk than loans involving
residential real estate lending. Commercial business loans may involve greater
risks than other types of lending because they are often made based on varying
forms of collateral, and repayment of these loans often depends on the success
of the commercial venture. Consumer loans may involve greater risk because
adverse changes in borrowers’ incomes and employment after funding of the loans
may impact their abilities to repay the loans.
 
 The Company Is Subject to
Interest Rate Risk.
 
 Aside
from credit risk, the most significant risk resulting from the Company’s normal
course of business, extending loans and accepting deposits, is interest rate
risk. If market interest rate fluctuations cause the Company’s cost of funds to
increase faster than the yield of its interest-earning assets, then its net
interest income will be reduced. The Company’s results of operations depend to a
large extent on the level of net interest income, which is the difference
between income from interest-earning assets, such as loans and investment
securities, and interest expense on interest-bearing liabilities, such as
deposits and borrowings. Interest rates are highly sensitive to many factors
that are beyond the Company’s control, including general economic conditions and
the policies of various governmental and regulatory authorities.
 
 The Company May Not Be Able
to Retain Key Members of Management.
 
 The
departure of one or more of the Company’s officers or other key personnel could
adversely affect the Company’s operations and financial position. The Company’s
management makes most decisions that involve the Company’s
operations.
 
 Customers May Default on the
Repayment of Loans.
 
 The
Bank’s customers may default on the repayment of loans, which may negatively
impact the Company’s earnings due to loss of principal and interest
income.  Increased operating expenses may result from the allocation
of management time and resources to the collection and workout of the
loan.  Collection efforts may or may not be successful causing the
Company to write off the loan or repossess the collateral securing the loan,
which may or may not exceed the balance of the loan.
 
  Index
  
 Page
      Eight
 
 An Economic Slowdown in the
Company’s Market Area Could Hurt Our Business.
 
 An
economic slowdown in our market area could hurt our business.  An
economic slowdown could have the following consequences:
 
 ·
              Loan
      delinquencies may increase;
 ·
              Problem
      assets and foreclosures may
increase;
 ·
              Demand
      for the products and services of the Company may
  decline;
 ·
              Collateral
      (including real estate) for loans made by the company may decline in
      value, in turn reducing  customers’ borrowing power and making
      existing loans less secure;
 ·
              Certain
      industries which are integral to the economy within the Company’s primary
      market area, may experience a downturn;
and,
 ·
              The
      current economic environment poses significant challenges for the Company
      as well as other financial institutions across the country. These
      challenges could adversely affect our financial condition and results of
      operations.
 
 The Company and the Bank are
Extensively Regulated.
 
 The
operations of the Company are subject to extensive regulation by federal, state
and local governmental authorities and are subject to various laws and judicial
and administrative decisions imposing requirements and restrictions on
them.  Policies adopted or required by these governmental authorities
can affect the Company’s business operations and the availability, growth and
distribution of the Company’s investments, borrowings and
deposits.  Proposals to change the laws governing financial
institutions are frequently raised in Congress and before bank regulatory
authorities.  Changes in applicable laws or policies could materially
affect the Company’s business, and the likelihood of any major changes in the
future and their effects are impossible to determine.
 
 The Company’s Allowance for
Loan Losses May Not Be Sufficient.
 
 In the
future, the Company could experience negative credit quality trends that could
lead to a deterioration of asset quality.  Such deterioration could
require the company to incur loan charge-offs in the future and incur additional
loan loss provision, both of which would have the effect of decreasing
earnings.  The Company maintains an allowance for possible loan losses
which is a reserve established through a provision for possible loan losses
charged to expense that represents management’s best estimate of probable losses
that have been incurred within the existing portfolio of loans.  Any
increases in the allowance for possible loan losses will result in a decrease in
net income and, possibly, capital, and may not have a material adverse effect on
the Company’s financial condition and results of operation.
 
 A Shareholder May Have
Difficulty Selling Shares.
 
 Because a
very limited public market exists for the Company’s common stock, a shareholder
may have difficulty selling his or her shares in the secondary
market.  We cannot predict when, if ever, we could meet the listing
qualifications of the NASDAQ Stock Market’s National Market Tier or any
exchange.  We cannot assure investors that there will be a more active
public market for the shares in the near future.
 
 Shares of the Company’s
Common Stock Are Not FDIC Insured.
 
 Neither
the Federal Deposit Insurance Corporation nor any other governmental agency
insures the shares of the Company’s common stock.  Therefore, the
value of investors’ shares in the Company will be based on their market value
and may decline.
 
 The Company’s Controls and
Procedures May Fail or Be Circumvented.
 
 Management
regularly reviews and updates the Company’s internal controls, disclosure
controls and procedures, and corporate governance policies and
procedures.  Any system of controls, no matter how well designed and
operated, is based in part on certain assumptions and can provide only
reasonable, not absolute, assurances that the objectives of the system are
met.  Any failure or circumvention of the Company’s controls and
procedures or failure to comply with regulations related to controls and
procedures could have a material adverse effect on the Company’s business,
results of operations and financial conditions
 
  Index
  
 Page
      Nine
 
 Item1B.
              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 BankRoute
      55, Baker, WV  26801
                    Branch
      Office, Capon Valley Bank6701
      Northwestern Pike, Gore, VA  22637
                    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.
              Submission
      of Matters to a Vote of Security
Holders
 
 Highlands
Bankshares, Inc. did not submit any matters to a vote of security holders during
the fourth quarter of 2008.
 
 
 
 PART
      II
 
 Item 5.
              Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases ofEquity
      Securities
  The
Company had approximately 1,100 shareholders as of December 31, 2008. 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.
  Index
  
 Page
      Ten
 
 Highlands
      Bankshares, Inc. Common StockEstimated
      Market RangeDividends Per Share
                          
                          
                          High
                          
                          
                          Low2008First
      Quarter
                          
                          $
                          .27
                          
                          
                          $
                          30.00
                          
                          
                          $
                          27.00Second
      Quarter
                          
                          $
                          .27
                          
                          
                          $
                          38.00
                          
                          
                          $
                          27.75Third
      Quarter
                          
                          $
                          .27
                          
                          
                          $
                          38.00
                          
                          
                          $
                          31.00Fourth
      Quarter
                          
                          $
                          .27
                          
                          
                          $
                          35.00
                          
                          
                          $
                          29.002007First
      Quarter
                          
                          $
                          .25
                          
                          
                          $
                          34.50
                          
                          
                          $
                          32.50Second
      Quarter
                          
                          $
                          .25
                          
                          
                          $
                          34.75
                          
                          
                          $
                          33.55Third
      Quarter
                          
                          $
                          .25
                          
                          
                          $
                          34.85
                          
                          
                          $
                          33.35Fourth
      Quarter
                          
                          $
                          .25
                          
                          
                          $
                          34.85
                          
                          
                          $
                          29.40
 
 
 Set forth
below is a line graph comparing the cumulative total return of Highlands
Bankshares’ common stock from December 31, 2003, assuming reinvestment of
dividends, with that of the Standard & Poor's 500 Index ("S&P 500") and
the NASDAQ Bank Index.
 
 
 
  Index
  
 Page
      Eleven
 
 Item6.
              Selected
      Financial Data
 
 
 Years
      Ending December 31,(In
      thousands of dollars, except for per share amounts)2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Total
      Interest Income
                  
                  $
                  26,203
                  
                  
                  $
                  27,664
                  
                  
                  $
                  23,894
                  
                  
                  $
                  19,813
                  
                  
                  $
                  17,729Total
      Interest Expense
                  
                  
                  8,866
                  
                  
                  
                  10,703
                  
                  
                  
                  7,909
                  
                  
                  
                  5,761
                  
                  
                  
                  4,711Net
      Interest Income
                  
                  
                  17,337
                  
                  
                  
                  16,961
                  
                  
                  
                  15,985
                  
                  
                  
                  14,052
                  
                  
                  
                  13,018Provision
      for Loan Losses
                  
                  
                  909
                  
                  
                  
                  837
                  
                  
                  
                  682
                  
                  
                  
                  875
                  
                  
                  
                  920Net
      Interest Income After Provision for Loan Losses
                  
                  
                  16,428
                  
                  
                  
                  16,124
                  
                  
                  
                  15,303
                  
                  
                  
                  13,177
                  
                  
                  
                  12,098Other
      Income
                  
                  
                  2,699
                  
                  
                  
                  2,080
                  
                  
                  
                  1,997
                  
                  
                  
                  1,669
                  
                  
                  
                  1,597Other
      Expenses
                  
                  
                  11,419
                  
                  
                  
                  10,952
                  
                  
                  
                  10,394
                  
                  
                  
                  9,128
                  
                  
                  
                  8,938Income
      Before Income Taxes
                  
                  
                  7,708
                  
                  
                  
                  7,252
                  
                  
                  
                  6,906
                  
                  
                  
                  5,718
                  
                  
                  
                  4,757Income
      Tax Expense
                  
                  
                  2,738
                  
                  
                  
                  2,599
                  
                  
                  
                  2,391
                  
                  
                  
                  1,916
                  
                  
                  
                  1,551Net
      Income
                  
                  $
                  4,970
                  
                  
                  $
                  4,653
                  
                  
                  $
                  4,515
                  
                  
                  $
                  3,802
                  
                  
                  $
                  3,206Total
      Assets at Year End
                  
                  $
                  378,295
                  
                  
                  $
                  380,936
                  
                  
                  $
                  357,316
                  
                  
                  $
                  337,573
                  
                  
                  $
                  299,992Long
      Term Debt at Year End
                  
                  $
                  11,317
                  
                  
                  $
                  11,819
                  
                  
                  $
                  14,992
                  
                  
                  $
                  15,063
                  
                  
                  $
                  8,377Net
      Income Per Share of Common Stock
                  
                  $
                  3.59
                  
                  
                  $
                  3.24
                  
                  
                  $
                  3.14
                  
                  
                  $
                  2.65
                  
                  
                  $
                  2.23Dividends
      Per Share of Common Stock
                  
                  $
                  1.08
                  
                  
                  $
                  1.00
                  
                  
                  $
                  .94
                  
                  
                  $
                  .82
                  
                  
                  $
                  .63Return
      on Average Assets
                  
                  
                  1.32
                  %
                  
                  
                  1.24
                  %
                  
                  
                  1.29
                  %
                  
                  
                  1.21
                  %
                  
                  
                  1.07
                  %Return
      on Average Equity
                  
                  
                  12.38
                  %
                  
                  
                  12.03
                  %
                  
                  
                  12.67
                  %
                  
                  
                  11.53
                  %
                  
                  
                  10.36
                  %Dividend
      Payout Ratio
                  
                  
                  30.12
                  %
                  
                  
                  30.88
                  %
                  
                  
                  29.91
                  %
                  
                  
                  30.99
                  %
                  
                  
                  28.23
                  %Year
      End Equity to Assets Ratio
                  
                  
                  10.41
                  %
                  
                  
                  10.66
                  %
                  
                  
                  10.38
                  %
                  
                  
                  10.07
                  %
                  
                  
                  10.55
                  %
 
 
  Index
  
 Page
      Twelve
 
 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, those factors set forth in
“Risk Factors” and the effects of and changes in:  general economic
conditions, the interest rate environment, legislative and regulatory
requirements, competitive pressures, new products and delivery systems,
inflation, changes in the stock and bond markets, technology, downturns in the
trucking and timber industries, effects of mergers and/or downsizing in the
poultry industry in Hardy County, and consumer spending and savings
habits.  Additionally, actual future results and trends may differ
from historical or anticipated results to the extent: (1) any significant
downturn in certain industries, particularly the trucking and timber and coal
extraction industries are experienced; (2) loan demand decreases from prior
periods; (3) the Company may make additional loan loss provisions due to
negative credit quality trends in the future that may lead to a deterioration of
asset quality; (4) the Company may not continue to experience significant
recoveries of previously charged-off loans or loans resulting in foreclosure;
(5) increased liquidity needs may cause an increase in funding costs; (6) the
quality of the Company’s securities portfolio may deteriorate and, (7) the
Company is unable to control costs and expenses as anticipated. The Company does
not update any forward-looking statements that may be made from time to time by
or on behalf of the Company.
 
 Introduction
 
 The
following discussion focuses on significant results of the Company’s operations
and significant changes in our financial condition or results of operations for
the periods indicated in the discussion. This discussion should be read in
conjunction with the preceding financial statements and related notes. Current
performance does not guarantee, and may not be indicative of, similar
performance in the future.
 
 Critical Accounting
Policies
 
 The Company’s financial statements are
prepared in accordance with accounting principles generally accepted in the
United States (“GAAP”). The financial statements contained within these
statements are, to a significant extent, financial information that is based on
measures of the financial effects of transactions and events that have already
occurred. A variety of factors could affect the ultimate value that is obtained
either when earning income, recognizing an expense, recovering an asset or
relieving a liability. In addition, GAAP itself may change from one previously
acceptable method to another method. Although the economics of these
transactions would be the same, the timing of events that would impact these
transactions could change.
 
 Allowance for Loan
Losses
 
 The
allowance for loan losses is an estimate of the losses that may be sustained in
the loan portfolio. The allowance is based on two basic principles of
accounting: (i) Statement of Financial Accounting Standards No. 5, Accounting for Contingencies(SFAS 5), which
requires that losses be accrued when they are probable of occurring and
estimable and (ii) Statement of Financial Accounting Standards No. 114, Accounting by Creditors for
Impairment of a Loan(SFAS 114), which requires that losses
be accrued based on the differences between the value of collateral, present
value of future cash flows or values that are observable in the secondary market
and the loan balance.
 
 
  Index
  
 Page
      Thirteen
 
 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
SFAS 114, an individual loan is impaired when, based on current information and
events, it is probable that a creditor 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 under SFAS 114 is evaluated
under SFAS 5 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.
 
 SFAS 114
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 Highlands 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
within the scope of SFAS 114 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 SFAS 114, are included in a group of loans that are measured under SFAS 5
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 SFAS 5 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 Statement of Financial Accounting Standards No. 106,
"Employers' Accounting for Post Retirement Benefits Other Than Pensions.” SFAS
No. 106 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, 2008, 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.
  Index
  
 Page
      Fourteen
 
 Recent Accounting
Pronouncements
 
 In
September 2006, the Financial Accounting Standards Board (FASB) reached a
consensus on Emerging Issues Task Force (“EITF”) Issue 06-4, “Accounting for
Deferred Compensation and Postretirement Benefit Aspects of Endorsement
Split-Dollar Life Insurance Arrangements,” (“EITF Issue 06-4”). In March 2007,
the FASB reached a consensus on EITF Issue 06-10, “Accounting for Collateral
Assignment Split-Dollar Life Insurance Arrangements,” (“EITF Issue 06-10”). Both
of these standards require a company to recognize an obligation over an
employee’s service period based upon the substantive agreement with the employee
such as the promise to maintain a life insurance policy or provide a death
benefit postretirement. These EITF pronouncements became effective for Highlands
Bankshares on January 1, 2008. These EITF 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. Highlands
Bankshares opted to record the liability as a cumulative effect adjustment to
retained earnings and as such recorded a liability and corresponding reduction
of retained earnings of $348,000. There is no corresponding deferred tax
consequence relating to this liability.
 
 In
September 2006, the FASB issued Statement of Financial Accounting Standards No.
157, “Fair Value Measurements” (SFAS 157).  SFAS 157 defines fair
value, establishes a framework for measuring fair value in generally accepted
accounting principles, and expands disclosures about fair value
measurements.  SFAS 157 does not require any new fair value
measurements, but rather, provides enhanced guidance to other pronouncements
that require or permit assets or liabilities to be measured at fair
value.  This Statement is effective for financial statements issued
for fiscal years beginning after November 15, 2007 and interim periods within
those years.  The FASB has approved a one-year deferral for the
implementation of the Statement for nonfinancial assets and nonfinancial
liabilities that are recognized or disclosed at fair value in the financial
statements on a nonrecurring basis.SFAS 157 had no material
impact on the Company’s December 31, 2008  financial statements.
Additional disclosure information required by this pronouncement is included as
a footnote to the financial statements.
 
 In
February 2007, the FASB issued Statement of Financial Accounting Standards No.
159, “The Fair Value Option for Financial Assets and Financial Liabilities”
(SFAS 159).  This Statement permits entities to choose to measure many
financial instruments and certain other items at fair value. The objective of
this Statement is to improve financial reporting by providing entities with the
opportunity to mitigate volatility in reported earnings caused by measuring
related assets and liabilities differently without having to apply complex hedge
accounting provisions. The fair value option established by this Statement
permits all entities to choose to measure eligible items at fair value at
specified election dates. A business entity shall report unrealized gains and
losses on items for which the fair value option has been elected in earnings at
each subsequent reporting date. The fair value option may be applied instrument
by instrument and is irrevocable. SFAS 159 is effective as of the beginning of
an entity’s first fiscal year that begins after November 15, 2007, with early
adoption available in certain circumstances. The Company adopted SFAS 159
effective January 1, 2008. The Company decided not to report any existing
financial assets or liabilities at fair value that are not already reported,
thus the adoption of this statement did not have a material impact on the
consolidated financial statements.
 
 In
November 2007, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin No. 109, “Written Loan Commitments Recorded at Fair Value
Through Earnings” (SAB 109). SAB 109 expresses the current view of the staff
that the expected net future cash flows related to the associated servicing of
the loan should be included in the measurement of all written loan commitments
that are accounted for at fair value through earnings. SEC registrants are
expected to apply the views in Question 1 of SAB 109 on a prospective basis to
derivative loan commitments issued or modified in fiscal quarters beginning
after December 15, 2007.  SAB 109 did not have a
material impact on the Company’s consolidated financial statements.
 
 In April
2008, the FASB issued FASB Staff Position (FSP) No. 142-3, “Determination of the
Useful Life of Intangible Assets” (“FSP No. 142-3”). FSP No. 142-3 amends the
factors an entity should consider in developing renewal or extension assumptions
used in determining the useful life of recognized intangible assets under FASB
SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). The
intent of FSP No. 142-3 is to improve the consistency between the useful life of
a recognized intangible asset under SFAS No. 142 and the period of expected cash
flows used to measure the fair value of the assets under SFAS No. 141(R). FSP
No. 142-3 is effective for the Company on January 1, 2009,
and applies prospectively to intangible assets that are acquired individually or
with a group of other assets in business combinations and asset
acquisitions.The
adoption of FSP No. 142-3 is not expected to have a material impact on the
Company’s consolidated financial statements.
  Index
  
 Page
      Fifteen
 
 In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles,” (“SFAS No. 162”). SFAS No. 162 identifies the sources of
accounting principles and the framework for selecting the principles to be used
in the preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles. SFAS No.
162 is effective 60 days following the SEC’s approval of the Public Company
Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present
Fairly in Conformity With Generally Accepted Accounting Principles.” Management
does not expect the adoption of the provision of SFAS No. 162 to have any impact
on the consolidated financial statements.
 
 In
October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active,” (“FSP 157-3”).
FSP 157-3 clarifies the application of SFAS No. 157 in determining the fair
value of a financial asset during periods of inactive markets. FSP 157-3 was
effective as of September 30, 2008 and did not have material impact on the
Company’s 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.
 
 Overview of 2008
Results
 
 Net
income for 2008 increased by 6.81% as compared to 2007. The Company experienced
a 2.22% increase in net interest income, which was partially offset by a $72,000
increase in the provision for loan losses. Non interest income increased 29.76%
mostly as a result of increases in charges relating to non-sufficient funds fees
charged to checking accounts and increases in insurance earnings. Non interest
expense increased 4.26% due largely to an increase in salary and benefits
expense and to increases in other operational expense as the result of expanding
operational growth and usual inflationary pressures.
 
 The table
below compares selected commonly used measures of bank performance for the
twelve month periods ended December 31, 2008, 2007 and 2006:
 
 2008
                      
                      
                      2007
                      
                      
                      2006Annualized
      return on average assets
                      
                      
                      1.32
                      %
                      
                      
                      1.24
                      %
                      
                      
                      1.29
                      %Annualized
      return on average equity
                      
                      
                      12.38
                      %
                      
                      
                      12.03
                      %
                      
                      
                      12.67
                      %Net
      interest margin (1)
                      
                      
                      4.97
                      %
                      
                      
                      4.89
                      %
                      
                      
                      5.05
                      %Efficiency
      Ratio (2)
                      
                      
                      56.99
                      %
                      
                      
                      57.52
                      %
                      
                      
                      57.80
                      %Earnings
      per share (3)
                      
                      $
                      3.59
                      
                      
                      $
                      3.24
                      
                      
                      $
                      3.14(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.
 
  Index
  
 Page
      Sixteen
 
 The
change in net income from 2007 to 2008 was impacted significantly by
non-recurring items. The table below summarizes the impact of non-recurring
items on both 2008 and 2007 income.
 
 Impact
      of non recurring item, year ended December 31,2008
                    
                    
                    2007
                    
                    
                    Increase
                      (Decrease)Description of non recurring
      itemGains
      (losses) recorded on calls of securities available for
sale
                    
                    $
                    110
                    
                    
                    $
                    1
                    
                    
                    $
                    109Gains
      (losses) recorded on sale of other real estate owned
                    
                    
                    4
                    
                    
                    
                    0
                    
                    
                    
                    4Gain
      on life insurance settlement
                    
                    
                    30
                    
                    
                    
                    0
                    
                    
                    
                    30Net
      gains (losses) recorded on sale of fixed assets
                    
                    
                    32
                    
                    
                    
                    (38
                    )
                    
                    
                    70Total
      impact of non recurring items on before tax income
                    
                    
                    176
                    
                    
                    
                    (37
                    )
                    
                    
                    213Income
      tax effect
                    
                    
                    (55
                    )
                    
                    
                    13
                    
                    
                    
                    (68
                    )Total
      impact of non recurring items on net income
                    
                    $
                    121
                    
                    
                    $
                    (24
                    )
                    
                    $
                    145
 
 
 Quarterly Financial
Results
 
 Quarterly
      Financial Results For the Year Ended December 31,
2008(in
      thousands, except per share amounts)Fourth
      Quarter
                    
                    
                    Third
      Quarter
                    
                    
                    Second
      Quarter
                    
                    
                    FirstQuarterTotal
      Interest Income
                    
                    $
                    6,325
                    
                    
                    $
                    6,471
                    
                    
                    $
                    6,570
                    
                    
                    $
                    6,837Total
      Interest Expense
                    
                    
                    2,026
                    
                    
                    
                    2,054
                    
                    
                    
                    2,204
                    
                    
                    
                    2,582Net
      Interest Income
                    
                    
                    4,299
                    
                    
                    
                    4,417
                    
                    
                    
                    4,366
                    
                    
                    
                    4,255Provision
      for Loan Losses
                    
                    
                    273
                    
                    
                    
                    238
                    
                    
                    
                    219
                    
                    
                    
                    179Net
      Interest Income After Provision for Loan Losses
                    
                    
                    4,026
                    
                    
                    
                    4,179
                    
                    
                    
                    4,147
                    
                    
                    
                    4,076Other
      Income
                    
                    
                    675
                    
                    
                    
                    687
                    
                    
                    
                    680
                    
                    
                    
                    657Other
      Expenses
                    
                    
                    2,848
                    
                    
                    
                    2,910
                    
                    
                    
                    2,875
                    
                    
                    
                    2,786Income
      Before Income Taxes
                    
                    
                    1,853
                    
                    
                    
                    1,956
                    
                    
                    
                    1,952
                    
                    
                    
                    1,947Income
      Tax Expense
                    
                    
                    642
                    
                    
                    
                    656
                    
                    
                    
                    731
                    
                    
                    
                    709Net
      Income
                    
                    $
                    1,211
                    
                    
                    $
                    1,300
                    
                    
                    $
                    1,221
                    
                    
                    $
                    1,238Net
      Income Per Share of Common Stock outstanding
                    
                    $
                    .90
                    
                    
                    $
                    .97
                    
                    
                    $
                    .86
                    
                    
                    $
                    .86Dividends
      Per Share of Common Stock
                    
                    $
                    .27
                    
                    
                    $
                    .27
                    
                    
                    $
                    .27
                    
                    
                    $
                    .27
 
  Index
  
 Page
      Seventeen
 
 Quarterly
      Financial Results For the Year Ended December 31,
2007(in
      thousands, except per share amounts)Fourth
                      Quarter
                    
                    
                    Third
                      Quarter
                    
                    
                    Second
                      Quarter
                    
                    
                    First
                      QuarterTotal
      Interest Income
                    
                    $
                    7,102
                    
                    
                    $
                    7,079
                    
                    
                    $
                    6,917
                    
                    
                    $
                    6,566Total
      Interest Expense
                    
                    
                    2,799
                    
                    
                    
                    2,796
                    
                    
                    
                    2,660
                    
                    
                    
                    2,448Net
      Interest Income
                    
                    
                    4,303
                    
                    
                    
                    4,283
                    
                    
                    
                    4,257
                    
                    
                    
                    4,118Provision
      for Loan Losses
                    
                    
                    351
                    
                    
                    
                    145
                    
                    
                    
                    168
                    
                    
                    
                    173Net
      Interest Income After Provision for Loan Losses
                    
                    
                    3,952
                    
                    
                    
                    4,138
                    
                    
                    
                    4,089
                    
                    
                    
                    3,945Other
      Income
                    
                    
                    572
                    
                    
                    
                    542
                    
                    
                    
                    495
                    
                    
                    
                    471Other
      Expenses
                    
                    
                    2,634
                    
                    
                    
                    2,857
                    
                    
                    
                    2,803
                    
                    
                    
                    2,658Income
      Before Income Taxes
                    
                    
                    1,890
                    
                    
                    
                    1,823
                    
                    
                    
                    1,781
                    
                    
                    
                    1,758Income
      Tax Expense
                    
                    
                    614
                    
                    
                    
                    690
                    
                    
                    
                    658
                    
                    
                    
                    637Net
      Income
                    
                    $
                    1,276
                    
                    
                    $
                    1,133
                    
                    
                    $
                    1,123
                    
                    
                    $
                    1,121Net
      Income Per Share of Common Stock outstanding
                    
                    $
                    .89
                    
                    
                    $
                    .79
                    
                    
                    $
                    .78
                    
                    
                    $
                    .78Dividends
      Per Share of Common Stock
                    
                    $
                    .25
                    
                    
                    $
                    .25
                    
                    
                    $
                    .25
                    
                    
                    $
                    .25
 
 Net Interest
Income
 
 2008 Compared to
2007
 
 Net
interest income, on a fully taxable equivalent basis, increased 2.27% from 2007
to 2008. As average balances of both earning assets and interest bearing
liabilities remained relatively flat from year to year, this increase 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, 2008, the Company’s average balances of both earning
assets and interest bearing liabilities remained relatively unchanged as
compared to 2007. However, changes in the relative mix of earning assets and
interest bearing liabilities for 2008 as compared to 2007 impacted the Company’s
net interest earnings. The percent of average loan balances, the highest earning
of the Company’s earning assets, to total average earning assets increased from
86.90% in 2007 to 90.04% in 2008, and the percent of average balances of time
deposits and long term debt, both comparatively more expensive interest bearing
liabilities, decreased slightly from 2007 to 2008. These changes in the relative
mix of earning assets and interest bearing liabilities positively impacted the
Company’s net interest income, contributing to the decline in average rates paid
on interest bearing liabilities being greater than the decline seen on average
rates on earning assets.
 
 Recent
rate cuts by the Federal Reserve (“the Fed”) for the target rate for federal
funds sold continues to impact yields on earning assets and average rates paid
on interest bearing liabilities. The Company experienced declining rates for
2008 as compared to 2007 on all components of earning assets and on all
components of interest bearing liabilities.
 
 During
the fourth quarter of 2008, loan demand increased as compared to the first nine
months of the year. The Company has substantially funded this loan growth
through reductions in balances of federal funds sold, which stood at $21,714,000
at March 31, 2008, but decreased to nearly zero by the end of the year. In
addition, competition for deposits appears to have increased, and, rather than
increase deposit rates above that of the local competition, the Company allowed
deposit balances to shrink. The result was that this fourth quarter loan growth
required overnight and short term borrowings. The impact of these borrowings has
been positive in the short term as a result of the low rate of interest paid on
these borrowings versus those paid on time deposits or other long term debt
instruments.
  Index
  
 Page
      Eighteen
 
 In the
coming periods, should loan demand remain strong, the Company may be required to
increase deposit rates to attract increased deposit balances to fund this
potential loan growth, or may be required to further utilize its long term debt
potential. This may have the effect of causing net interest margin to shrink,
however, management anticipates, were this need to occur, that total net
interest income should not be adversely affected.
 
 Further
discussion relating to potential risks relating to interest rates which might
impact the Company’s net interest income in future periods occurs in Item 7A.
Quantitative and Qualitative Disclosures About Market Risk.
 
 Also,
balances of non performing loans have increased from December 31, 2007 to
December 31, 2008 and balances of other real estate acquired through
foreclosures have increased over the same time period. 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 2007 to 2008 and
changes in average rates on interest bearing liabilities and earning assets from
2007 to 2008 (in thousands of dollars):
 
 
 EFFECT
      OF RATE-VOLUME CHANGES ON NET INTEREST(On
      a fully taxable equivalent basis)Increase
      (Decrease) 2008 Compared to 2007Due
      to change in:Average Volume
                        
                        
                        Average Rate
                        
                        
                        Total ChangeInterest IncomeLoans
                        
                        $
                        988
                        
                        
                        $
                        (1,474
                        )
                        
                        $
                        (486
                        )Taxable
      investment securities
                        
                        
                        (160
                        )
                        
                        
                        (167
                        )
                        
                        
                        (327
                        )Nontaxable
      investment securities
                        
                        
                        28
                        
                        
                        
                        (1
                        )
                        
                        
                        27Interest
      bearing deposits
                        
                        
                        (37
                        )
                        
                        
                        (61
                        )
                        
                        
                        (98
                        )Federal
      funds sold
                        
                        
                        (166
                        )
                        
                        
                        (401
                        )
                        
                        
                        (567
                        )Total
      Interest Income
                        
                        
                        653
                        
                        
                        
                        (2,104
                        )
                        
                        
                        (1,451
                        )Interest ExpenseDemand
      deposits
                        
                        
                        (7
                        )
                        
                        
                        (133
                        )
                        
                        
                        (140
                        )Savings
      deposits
                        
                        
                        9
                        
                        
                        
                        (311
                        )
                        
                        
                        (302
                        )Time
      deposits
                        
                        
                        (28
                        )
                        
                        
                        (1,280
                        )
                        
                        
                        (1,308
                        )Overnight
      and other short term debt
                        
                        
                        19
                        
                        
                        
                        0
                        
                        
                        
                        19Long
      term debt
                        
                        
                        (54
                        )
                        
                        
                        (52
                        )
                        
                        
                        (106
                        )Total
      Interest Expense
                        
                        
                        (61
                        )
                        
                        
                        (1,776
                        )
                        
                        
                        (1,837
                        )Net
      Interest Income
                        
                        $
                        714
                        
                        
                        $
                        (328
                        )
                        
                        $
                        386
 
 
  Index
  
 Page
      Nineteen
 
 The table
below sets forth an analysis of net interest income for the years ended December
31, 2008 and 2007 (average balances and interest income/expense shown in
thousands of dollars):
 
 2008
                        
                        
                        2007Average
                          Balance
                        
                        
                        Income
                          /Expense
                        
                        
                        Yield
                          /Rate
                        
                        
                        Average
                          Balance
                        
                        
                        Income
                          /Expense
                        
                        
                        Yield
                          /RateEarning
      AssetsLoans
                        
                        $
                        315,473
                        
                        
                        $
                        24,809
                        
                        
                        
                        7.86
                        %
                        
                        $
                        302,906
                        
                        
                        $
                        25,295
                        
                        
                        
                        8.35
                        %Taxable
      investment securities
                        
                        
                        20,745
                        
                        
                        
                        987
                        
                        
                        
                        4.76
                        %
                        
                        
                        24,104
                        
                        
                        
                        1,314
                        
                        
                        
                        5.45
                        %Nontaxable
      investment securities
                        
                        
                        3,392
                        
                        
                        
                        205
                        
                        
                        
                        6.04
                        %
                        
                        
                        2,929
                        
                        
                        
                        178
                        
                        
                        
                        6.06
                        %Interest
      bearing deposits
                        
                        
                        1,419
                        
                        
                        
                        44
                        
                        
                        
                        3.10
                        %
                        
                        
                        2,610
                        
                        
                        
                        142
                        
                        
                        
                        5.44
                        %Federal
      funds sold
                        
                        
                        9,354
                        
                        
                        
                        234
                        
                        
                        
                        2.50
                        %
                        
                        
                        16,006
                        
                        
                        
                        801
                        
                        
                        
                        5.00
                        %Total
      Earning Assets
                        
                        
                        350,383
                        
                        
                        
                        26,279
                        
                        
                        
                        7.50
                        %
                        
                        
                        348,555
                        
                        
                        
                        27,730
                        
                        
                        
                        7.96
                        %Allowance
      for loan losses
                        
                        
                        (3,637
                        )
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (3,589
                        )Other
      non-earning assets
                        
                        
                        30,276
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        29,504Total
      Assets
                        
                        $
                        377,022
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        374,470Interest
      Bearing LiabilitiesDemand
      deposits
                        
                        $
                        23,258
                        
                        
                        $
                        77
                        
                        
                        
                        .33
                        %
                        
                        $
                        25,363
                        
                        
                        $
                        217
                        
                        
                        
                        .86
                        %Savings
      deposits
                        
                        
                        49,363
                        
                        
                        
                        383
                        
                        
                        
                        .78
                        %
                        
                        
                        48,181
                        
                        
                        
                        685
                        
                        
                        
                        1.42
                        %Time
      deposits
                        
                        
                        195,963
                        
                        
                        
                        7,897
                        
                        
                        
                        4.03
                        %
                        
                        
                        196,648
                        
                        
                        
                        9,205
                        
                        
                        
                        4.68
                        %Overnight
      and other short term debt
                        
                        
                        1,412
                        
                        
                        
                        19
                        
                        
                        
                        1.35
                        %Long
      term debt
                        
                        
                        11,357
                        
                        
                        
                        490
                        
                        
                        
                        4.31
                        %
                        
                        
                        12,613
                        
                        
                        
                        596
                        
                        
                        
                        4.73
                        %Total
      Interest Bearing Liabilities
                        
                        
                        281,353
                        
                        
                        
                        8,866
                        
                        
                        
                        3.15
                        %
                        
                        
                        282,805
                        
                        
                        
                        10,703
                        
                        
                        
                        3.78
                        %Demand
      deposits
                        
                        
                        49,827
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        48,101Other
      liabilities
                        
                        
                        5,711
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        4,886Stockholders’
      equity
                        
                        
                        40,131
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        38,678Total
      Liabilities and Stockholders’ Equity
                        
                        $
                        377,022
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        374,470Net
      Interest Income
                        
                        
                        
                        
                        
                        $
                        17,413
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        17,027Net
      Yield on Earning Assets
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        4.97
                        %
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        4.89
                        %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
 
 
 2007 Compared to
2006
 
 Net
interest income, on a fully taxable equivalent basis, increased 6.09% from 2006
to 2007.
 
 Although
the Company experienced an increase in income, margins shrank from 2006 to 2007.
This shrinking of the Company’s net interest margin occurred for multiple
reasons, included in which are the effect of the Fed’s decrease in the target
rate for fed funds sold during the later months of 2007, the relative repricing
of deposits as compared to earning assets and both the ratio of earning assets
to interest bearing deposits and the ratio of loans, a comparatively higher
earning asset, to other types of earning assets.
 
 
  Index
  
 Page
      Twenty
 
 Although
the Company experienced an increase in loan balances from December 31, 2006 to
December 31, 2007 and a 9.01% increase in the average balances of loans for 2007
as compared to 2006, balances of deposits increased at a greater rate. Loan
balances increased $17,383,000 from December 31, 2006 to December 31, 2007 while
deposit balances increased $23,254,000 over the same time period, resulting in
an increase in federal funds sold during the last half of 2007. The relative
difference in these balances caused the Company’s average balances of federal
funds sold to be greater during 2007 than in 2006 and the decreases by the Fed
for the target rate for federal funds sold late in the year caused a significant
impact on the Company’s interest earnings.
 
 Although
earning assets continued to reprice upward in 2007 as a result of the increases
in rates during 2006, the relative increase in rates paid on deposits,
particularly time deposits, was greater than the increase in average rates
earned on earning assets. Average rates earned on loans during 2007 were 39
basis points higher than in 2006 while the average rates paid on time deposits
were 76 basis points higher in 2007 than in 2006.
 
 The table
below sets forth an analysis of net interest income for the years ended December
31, 2007 and 2006 (average balances and interest income/expense shown in
thousands of dollars):
 
 2007
                        
                        
                        2006Average
                          Balance
                        
                        
                        Income
                          /Expense
                        
                        
                        Yield
                          /Rate
                        
                        
                        Average
                          Balance
                        
                        
                        Income
                          /Expense
                        
                        
                        Yield
                          /RateEarning
      AssetsLoans
                        
                        $
                        302,906
                        
                        
                        $
                        25,295
                        
                        
                        
                        8.35
                        %
                        
                        $
                        277,871
                        
                        
                        $
                        22,118
                        
                        
                        
                        7.96
                        %Taxable
      investment securities
                        
                        
                        24,104
                        
                        
                        
                        1,314
                        
                        
                        
                        5.45
                        %
                        
                        
                        24,970
                        
                        
                        
                        1,095
                        
                        
                        
                        4.39
                        %Nontaxable
      investment securities
                        
                        
                        2,929
                        
                        
                        
                        178
                        
                        
                        
                        6.06
                        %
                        
                        
                        2,987
                        
                        
                        
                        173
                        
                        
                        
                        5.79
                        %Interest
      bearing deposits
                        
                        
                        2,610
                        
                        
                        
                        142
                        
                        
                        
                        5.44
                        %
                        
                        
                        1,576
                        
                        
                        
                        72
                        
                        
                        
                        4.57
                        %Federal
      funds sold
                        
                        
                        16,006
                        
                        
                        
                        801
                        
                        
                        
                        5.00
                        %
                        
                        
                        10,287
                        
                        
                        
                        500
                        
                        
                        
                        4.87
                        %Total
      Earning Assets
                        
                        
                        348,555
                        
                        
                        
                        27,730
                        
                        
                        
                        7.96
                        %
                        
                        
                        317,691
                        
                        
                        
                        23,958
                        
                        
                        
                        7.54
                        %Allowance
      for loan losses
                        
                        
                        (3,589
                        )
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (3,283
                        )Other
      non-earning assets
                        
                        
                        29,504
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        28,648Total
      Assets
                        
                        $
                        374,470
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        343,056Interest
      Bearing LiabilitiesDemand
      deposits
                        
                        $
                        25,363
                        
                        
                        $
                        217
                        
                        
                        
                        .86
                        %
                        
                        $
                        25,658
                        
                        
                        $
                        224
                        
                        
                        
                        .87
                        %Savings
      deposits
                        
                        
                        48,181
                        
                        
                        
                        685
                        
                        
                        
                        1.42
                        %
                        
                        
                        50,235
                        
                        
                        
                        549
                        
                        
                        
                        1.09
                        %Time
      deposits
                        
                        
                        196,648
                        
                        
                        
                        9,205
                        
                        
                        
                        4.68
                        %
                        
                        
                        164,005
                        
                        
                        
                        6,429
                        
                        
                        
                        3.92
                        %Long
      term debt
                        
                        
                        12,613
                        
                        
                        
                        596
                        
                        
                        
                        4.73
                        %
                        
                        
                        15,643
                        
                        
                        
                        707
                        
                        
                        
                        4.52
                        %Total
      Interest Bearing Liabilities
                        
                        
                        282,805
                        
                        
                        
                        10,703
                        
                        
                        
                        3.78
                        %
                        
                        
                        255,541
                        
                        
                        
                        7,909
                        
                        
                        
                        3.10
                        %Demand
      deposits
                        
                        
                        48,101
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        48,056Other
      liabilities
                        
                        
                        4,886
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        3,810Stockholders’
      equity
                        
                        
                        38,678
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        35,649Total
      Liabilities and Stockholders’ Equity
                        
                        $
                        374,470
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        343,056Net
      Interest Income
                        
                        
                        
                        
                        
                        $
                        17,027
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        16,049Net
      Yield on Earning Assets
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        4.89
                        %
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        5.05
                        %Notes:(1)
      Yields are computed on a taxable equivalent basis using a 37% tax
      rate(2)
      Average balances are based upon daily balances(3)
      Includes loans in non-accrual status(4)
      Income on loans includes fees
 
  Index
  
 Page
      Twenty One
 
 The table
below illustrates the effects on net interest income of changes in average
volumes of interest bearing liabilities and earning assets from 2006 to 2007 and
changes in average rates on interest bearing liabilities and earning assets from
2006 to 2007 (in thousands of dollars):
 
 
 EFFECT
      OF RATE-VOLUME CHANGES ON NET INTEREST INCOME(On
      a fully taxable equivalent basis)(In
      thousands of dollars)Increase
      (Decrease) 2007 Compared to 2006Due
      to change in:Average Volume
                        
                        
                        Average Rate
                        
                        
                        Total ChangeInterest IncomeLoans
                        
                        $
                        1,993
                        
                        
                        $
                        1,184
                        
                        
                        $
                        3,177Taxable
      investment securities
                        
                        
                        (38
                        )
                        
                        
                        257
                        
                        
                        
                        219Nontaxable
      investment securities
                        
                        
                        (3
                        )
                        
                        
                        8
                        
                        
                        
                        5Interest
      bearing deposits
                        
                        
                        46
                        
                        
                        
                        23
                        
                        
                        
                        69Federal
      funds sold
                        
                        
                        279
                        
                        
                        
                        22
                        
                        
                        
                        301Total
      Interest Income
                        
                        
                        2,277
                        
                        
                        
                        1,494
                        
                        
                        
                        3,771Interest ExpenseDemand
      deposits
                        
                        
                        (3
                        )
                        
                        
                        (5
                        )
                        
                        
                        (8
                        )Savings
      deposits
                        
                        
                        (22
                        )
                        
                        
                        159
                        
                        
                        
                        137Time
      deposits
                        
                        
                        1,280
                        
                        
                        
                        1,496
                        
                        
                        
                        2,776Long
      term debt
                        
                        
                        (137
                        )
                        
                        
                        27
                        
                        
                        
                        (110
                        )Total
      Interest Expense
                        
                        
                        1,118
                        
                        
                        
                        1,677
                        
                        
                        
                        2,795Net
      Interest Income
                        
                        $
                        1,159
                        
                        
                        $
                        (183
                        )
                        
                        $
                        976
 
 Loan
Portfolio
 
 The
Company is an active residential mortgage and construction lender and extends
commercial loans to small and medium sized businesses within its primary service
area.  The Company’s commercial lending activity extends across its
primary service areas of Grant, Hardy, Hampshire, Mineral, Randolph, Tucker and
Pendleton counties in West Virginia and Frederick County,
Virginia.  Consistent with its focus on providing community-based
financial services, the Company does not attempt to diversify its loan portfolio
geographically by making significant amounts of loans to borrowers outside of
its primary service area.
 
 The table
below summarizes the Company’s loan portfolio at December 31, 2008, 2007, 2006,
2005 and 2004 (in thousands of dollars):
 
 At
      December 31,2008
                    
                    
                    2007
                    
                    
                    2006
                    
                    
                    2005
                    
                    
                    2004Real
      estate mortgage
                    
                    $
                    156,877
                    
                    
                    $
                    169,122
                    
                    
                    $
                    164,243
                    
                    
                    $
                    153,646
                    
                    
                    $
                    140,762Real
      estate construction
                    
                    
                    27,210
                    
                    
                    
                    15,560
                    
                    
                    
                    14,828
                    
                    
                    
                    12,201
                    
                    
                    
                    8,850Commercial
                    
                    
                    97,709
                    
                    
                    
                    79,892
                    
                    
                    
                    70,408
                    
                    
                    
                    57,908
                    
                    
                    
                    52,813Installment
                    
                    
                    43,958
                    
                    
                    
                    45,625
                    
                    
                    
                    43,337
                    
                    
                    
                    46,265
                    
                    
                    
                    46,092Total
      Loans
                    
                    
                    325,754
                    
                    
                    
                    310,199
                    
                    
                    
                    292,816
                    
                    
                    
                    270,020
                    
                    
                    
                    248,517Allowance
      for loan losses
                    
                    
                    (3,667
                    )
                    
                    
                    (3,577
                    )
                    
                    
                    (3,482
                    )
                    
                    
                    (3,129
                    )
                    
                    
                    (2,530
                    )Net
      Loans
                    
                    $
                    322,087
                    
                    
                    $
                    306,622
                    
                    
                    $
                    289,334
                    
                    
                    $
                    266,891
                    
                    
                    $
                    245,987
 
  Index
  
 Page
      Twenty Two
 
 Commercial
loan balances include certain loans secured by commercial real estate. As of
December 31, 2008 the Company maintained balances of loans secured by real
estate of $261,289,000.
 
 There
were no foreign loans outstanding during any of the above periods.
 
 The
following table illustrates the Company’s loan maturity distribution as of
December 31, 2008 (in thousands of dollars):
 
 Maturity
      RangeLess than 1 Year
                      
                      
                      1-5 Years
                      
                      
                      Over 5 Years
                      
                      
                      TotalLoan TypeCommercial
                      
                      $
                      64,525
                      
                      
                      $
                      16,715
                      
                      
                      $
                      16,469
                      
                      
                      $
                      97,709Real
      estate mortgage and construction
                      
                      
                      71,288
                      
                      
                      
                      86,414
                      
                      
                      
                      26,385
                      
                      
                      
                      184,087Installment
                      
                      
                      20,538
                      
                      
                      
                      23,324
                      
                      
                      
                      96
                      
                      
                      
                      43,958Total
      Loans
                      
                      $
                      156,351
                      
                      
                      $
                      126,453
                      
                      
                      $
                      42,950
                      
                      
                      $
                      325,754
 
 Credit
Quality
 
 The
principal economic risk associated with each of the categories of loans in the
Company’s portfolio is the creditworthiness of its borrowers.  Within
each category, such risk is increased or decreased depending on prevailing
economic conditions.  The risk associated with the real estate
mortgage loans and installment loans to individuals varies based upon employment
levels, consumer confidence, fluctuations in value of residential real estate
and other conditions that affect the ability of consumers to repay
indebtedness.  The risk associated with commercial, financial and
agricultural loans varies based upon the strength and activity of the local
economies of the Company’s market areas.  The risk associated with
real estate construction loans vary based upon the supply of and demand for the
type of real estate under construction.
 
 An
inherent risk in the lending of money is that the borrower will not be able to
repay the loan under the terms of the original agreement.  The
allowance for loan losses (see subsequent section) provides for this risk and is
reviewed periodically for adequacy.  This review also considers
concentrations of loans in terms of geography, business type or level of
risk.  While lending is geographically diversified within the service
area, the Company does have some concentration of loans in the area of
agriculture (primarily poultry farming), and the timber and coal extraction
industries. Management recognizes these concentrations and considers them when
structuring its loan portfolio.
 
 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.
  Index
  
 Page
      Twenty Three
 
 The
following table summarizes the Company’s non-performing loans (in thousands of
dollars):
 
 At
      December 31,2008
                      
                      
                      2007
                      
                      
                      2006
                      
                      
                      2005
                      
                      
                      2004Loans
      accounted for on a non-accrual basisConsumer
                      
                      $
                      180
                      
                      
                      $
                      71
                      
                      
                      $
                      83
                      
                      
                      $
                      124
                      
                      
                      $
                      252Real
      estate
                      
                      
                      1,166
                      
                      
                      
                      845
                      
                      
                      
                      161
                      
                      
                      
                      619
                      
                      
                      
                      278Total
      Non-accrual Loans
                      
                      
                      1,346
                      
                      
                      
                      916
                      
                      
                      
                      244
                      
                      
                      
                      743
                      
                      
                      
                      530Restructured
      Loans
                      
                      
                      705
                      
                      
                      
                      198
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0Loans
      delinquent 90 days or moreConsumer
                      
                      
                      575
                      
                      
                      
                      497
                      
                      
                      
                      122
                      
                      
                      
                      74
                      
                      
                      
                      140Commercial
                      
                      
                      65
                      
                      
                      
                      3
                      
                      
                      
                      0
                      
                      
                      
                      966
                      
                      
                      
                      355Real
      estate
                      
                      
                      2,832
                      
                      
                      
                      1,744
                      
                      
                      
                      1,335
                      
                      
                      
                      149
                      
                      
                      
                      40Total
      delinquent loans
                      
                      
                      3,472
                      
                      
                      
                      2,244
                      
                      
                      
                      1,457
                      
                      
                      
                      1,189
                      
                      
                      
                      535Total
      Non-performing loans
                      
                      $
                      5,523
                      
                      
                      $
                      3,358
                      
                      
                      $
                      1,701
                      
                      
                      $
                      1,932
                      
                      
                      $
                      1,065
 
 The
carrying value of real estate acquired through foreclosure was $1,359,000 at
December 31, 2008 and $336,000 at December 31, 2007. The Company's practice is
to value real estate acquired through foreclosure at the lower of (i) an
independent current appraisal or market analysis less anticipated costs of
disposal, or (ii) the existing loan balance.
 
 Because
of its large impact on the local economy, management continues to monitor the
economic health of the poultry industry. The Company has direct loans to poultry
growers and the industry is a large employer in the Company’s trade area. In
recent periods, the Company’s loan portfolio has also begun to reflect a
concentration in loans collateralized by heavy equipment, particularly in the
trucking, mining and timber industries. 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, management 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) SFAS No. 5, Accounting for Contingencies which
requires that losses be accrued when they are probable of occurring and
estimable and (ii) SFAS No. 114, Accounting by Creditors for Impairment of a
Loan, which requires that loans be identified which have characteristics of
impairment as individual risks, (e.g. the collateral, present value of cash
flows or observable market values are less than the loan balance).
 
 Each of
the Company's banking subsidiaries, Capon Valley Bank and The Grant County Bank,
determines the adequacy of its allowance for loan losses independently. Although
the loan portfolios of the two Banks are similar to each other, some differences
exist which result in divergent risk patterns and different charge-off rates
amongst the functional areas of the Banks’ portfolios.  Each Bank pays
particular attention to individual loan performance, collateral values, borrower
financial condition and economic conditions.  The determination of an
adequate allowance at each Bank is done in a three-step process.  The
first step is to identify impaired loans. Impaired loans are problem loans above
a certain threshold, which have estimated losses, calculated based on the fair
value of the collateral with which the loan is secured.
  Index
  
 Page
      Twenty Four
 
 
 A summary
of the loans which the Company has identified as impaired follows (in thousands
of dollars):
 
 December
      31, 2008IdentifiedLoan Type
                      
                      Balance
                      
                      
                      ImpairmentMortgage
                      
                      $
                      2,237
                      
                      
                      $
                      25Commercial
                      
                      
                      1,460
                      
                      
                      
                      171Installment
                      
                      
                      144
                      
                      
                      
                      76
 
 
 The
second step is to identify loans above a certain threshold, which are problem
loans due to the borrowers' payment history or deteriorating financial
condition.  Losses in this category are determined based on historical
loss rates adjusted for current economic conditions.  The final step
is to calculate a loss for the remainder of the portfolio using historical loss
information for each type of loan classification. The determination of specific
allowances and weighting is somewhat subjective and actual losses may be greater
or less than the amount of the allowance.  However, management
believes that the allowance represents a fair assessment of the losses that
exist in the current loan portfolio.
 
 The
required level of the allowance for loan losses is computed quarterly and the
allowance adjusted prior to the issuance of the quarterly financial
statements.  All loan losses charged to the allowance are approved by
the boards of directors of each Bank at their regular meetings.  The
allowance is reviewed for adequacy after considering historical loss rates,
current economic conditions (both locally and nationally) and any known credit
problems that have not been considered under the above formula.
 
 Management
has analyzed the potential risk of loss on the Company's loan portfolio given
the loan balances and the value of the underlying collateral and has recognized
losses where appropriate. Non-performing loans are closely monitored on an
ongoing basis as part of the Company's loan review process.
 
 During
2008, the Company’s experienced level of net charge-offs, as compared to gross
loan balances, was slightly greater than that experienced in 2007, Although the
volumes of loans charged off during 2008 was less than experienced in 2007,
recoveries on loans previously charged off also declined, resulting in an
increased volume of net charge-offs. As a result of the impact of the increased
net charge-offs, and in addition to continued increases in loan balances, the
Company’s provision for loan losses during 2008 was $72,000 greater than in
2007. The Company’s ratio of allowance for loan losses to gross loans fell from
1.15% at December 31, 2007 to 1.13% at December 31, 2008.  At December
31, 2008, the ratio of the allowance for loan losses to non-performing loans was
66.40% compared to 106.52% at December 31, 2007 and 204.70% at December 31,
2006.
 
 Cumulative
net loan losses, after recoveries, for the five-year period ending December 31,
2008 are as follows (in thousands of dollars):
 
 Dollars
                      
                      
                      Percent of TotalCommercial
                      
                      $
                      758
                      
                      
                      
                      24
                      %Real
      Estate
                      
                      
                      644
                      
                      
                      
                      20
                      %Consumer
                      
                      
                      1,783
                      
                      
                      
                      56
                      %Total
                      
                      $
                      3,185
 
  Index
  
 Page
      Twenty Five
 
 An
analysis of the changes in the allowance for loan losses is set forth in the
following table (in thousands of dollars):
 
 2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Balance
      at beginning of period
                  
                  $
                  3,577
                  
                  
                  $
                  3,482
                  
                  
                  $
                  3,129
                  
                  
                  $
                  2,530
                  
                  
                  $
                  2,463Charge-offs:Commercial
      loans
                  
                  
                  198
                  
                  
                  
                  540
                  
                  
                  
                  27
                  
                  
                  
                  45
                  
                  
                  
                  97Real
      estate loans
                  
                  
                  228
                  
                  
                  
                  47
                  
                  
                  
                  1
                  
                  
                  
                  8
                  
                  
                  
                  422Consumer
      loans
                  
                  
                  524
                  
                  
                  
                  494
                  
                  
                  
                  551
                  
                  
                  
                  567
                  
                  
                  
                  642Total
      Charge-offs:
                  
                  
                  950
                  
                  
                  
                  1,081
                  
                  
                  
                  579
                  
                  
                  
                  620
                  
                  
                  
                  1,161Recoveries:Commercial
      loans
                  
                  
                  20
                  
                  
                  
                  59
                  
                  
                  
                  5
                  
                  
                  
                  28
                  
                  
                  
                  37Real
      estate loans
                  
                  
                  2
                  
                  
                  
                  4
                  
                  
                  
                  20
                  
                  
                  
                  0
                  
                  
                  
                  36Consumer
      loans
                  
                  
                  109
                  
                  
                  
                  276
                  
                  
                  
                  225
                  
                  
                  
                  150
                  
                  
                  
                  235Total
      Recoveries
                  
                  
                  131
                  
                  
                  
                  339
                  
                  
                  
                  250
                  
                  
                  
                  178
                  
                  
                  
                  308Net
      Charge-offs
                  
                  
                  819
                  
                  
                  
                  742
                  
                  
                  
                  329
                  
                  
                  
                  442
                  
                  
                  
                  853Provision
      for loan losses
                  
                  
                  909
                  
                  
                  
                  837
                  
                  
                  
                  682
                  
                  
                  
                  875
                  
                  
                  
                  920Other
      additions
                  
                  
                  0
                  
                  
                  
                  0
                  
                  
                  
                  0
                  
                  
                  
                  166
                  
                  
                  
                  0Balance
      at end of period
                  
                  $
                  3,667
                  
                  
                  $
                  3,577
                  
                  
                  $
                  3,482
                  
                  
                  $
                  3,129
                  
                  
                  $
                  2,530Percent
      of net charge-offs to average net loans outstanding during the
      period
                  
                  
                  .26
                  %
                  
                  
                  .24
                  %
                  
                  
                  .11
                  %
                  
                  
                  .17
                  %
                  
                  
                  .51
                  %
 
 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 31,2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Amount
                  
                  
                  Percent
                    of
                    Loans
                  
                  
                  Amount
                  
                  
                  Percent
                    of
                    Loans
                  
                  
                  Amount
                  
                  
                  Percent
                    of
                    Loans
                  
                  
                  Amount
                  
                  
                  Percent
                    of
                    Loans
                  
                  
                  Amount
                  
                  
                  Percent
                    of
                    LoansCommercial
                  
                  $
                  1,349
                  
                  
                  
                  30
                  %
                  
                  $
                  1,140
                  
                  
                  
                  26
                  %
                  
                  $
                  1,492
                  
                  
                  
                  24
                  %
                  
                  $
                  900
                  
                  
                  
                  21
                  %
                  
                  $
                  697
                  
                  
                  
                  21
                  %Mortgage
                  
                  
                  994
                  
                  
                  
                  57
                  %
                  
                  
                  1,200
                  
                  
                  
                  59
                  %
                  
                  
                  996
                  
                  
                  
                  61
                  %
                  
                  
                  1,139
                  
                  
                  
                  62
                  %
                  
                  
                  853
                  
                  
                  
                  60
                  %Consumer
                  
                  
                  1,285
                  
                  
                  
                  13
                  %
                  
                  
                  1,172
                  
                  
                  
                  15
                  %
                  
                  
                  967
                  
                  
                  
                  15
                  %
                  
                  
                  1,082
                  
                  
                  
                  17
                  %
                  
                  
                  970
                  
                  
                  
                  19
                  %Unallocated
                  
                  
                  39
                  
                  
                  
                  
                  
                  
                  
                  65
                  
                  
                  
                  
                  
                  
                  
                  27
                  
                  
                  
                  
                  
                  
                  
                  8
                  
                  
                  
                  
                  
                  
                  
                  10Totals
                  
                  $
                  3,667
                  
                  
                  
                  100
                  %
                  
                  $
                  3,577
                  
                  
                  
                  100
                  %
                  
                  $
                  3,482
                  
                  
                  
                  100
                  %
                  
                  $
                  3,129
                  
                  
                  
                  100
                  %
                  
                  $
                  2,530
                  
                  
                  
                  100
                  %
 
 As
certain loans identified as impaired are paid current, collateral values
increase or loans are removed from watch lists for other reasons, and as other
loans become identified as impaired, and because delinquency levels within each
of the portfolios change, the allocation of the allowance among the loan types
may change. Management feels that the allowance is a fair representation of the
losses present in the portfolio given historical loss trends, economic
conditions and any known credit problems as of any quarter's end. Management
believes that the allowance is to be taken as a whole, and allocation between
loan types is an estimation of potential losses within each type given
information known at the time.
 
 The above
figures act as the beginning for the allocation of overall
allowances.  Additional changes have been made in the allocation of
the allowance to address unknowns and contingent items. The unallocated portion
is not computed using a specific formula and is management’s best estimate of
what should be allocated for contingencies in the current
portfolio.
  Index
  
 Page
      Twenty Six
 
 Non Interest
Income
 
 2008 Compared to
2007
 
 Non
interest income increased 29.76%, or $619,000 from 2007 to 2008.
 
 Of this
increase, a large portion related to the recording of non-recurring income items
in 2008 as compared to 2007. Further discussions of non recurring income, net of
non recurring losses, for 2008 as compared to 2007, is found in the overview
section above. In addition, the increases in non recurring income items,
increases in service charges on deposit accounts and increases in net insurance
earnings and commissions comprise the largest portion of the increase in non
interest income.
 
 Service
charges on deposit accounts increased 25.52% from 2007 to 2008. Of this
increase, $323,000 was related to non sufficient funds charges on demand deposit
accounts. During the latter part of 2007, The Grant County Bank implemented what
is commonly referred to as a “courtesy overdraft” program which led to much of
this increase.
 
 Net
insurance earnings and commissions increased $78,000 from 2007 to 2008.
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, the primary market 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, resulting in a larger net earnings for the
life insurance subsidiary in 2008 as compared to 2007. The table below
illustrates the components of insurance commissions and income for 2007 and 2008
(in thousands of dollars).
 
 2008
                  
                  
                  2007
                  
                  
                  Increase
                    (Decrease)RevenuesGross
      commissions and insurance revenues
                  
                  $
                  303
                  
                  
                  $
                  322
                  
                  
                  $
                  (19
                  )ExpensesBenefits
      Paid
                  
                  
                  23
                  
                  
                  
                  21
                  
                  
                  
                  2Changes
      in required policy and claim reserves
                  
                  
                  (38
                  )
                  
                  
                  68
                  
                  
                  
                  (106
                  )Expense
      allowance
                  
                  
                  107
                  
                  
                  
                  100
                  
                  
                  
                  7Total
      Expenses
                  
                  
                  92
                  
                  
                  
                  189
                  
                  
                  
                  (97
                  )Net
      insurance income
                  
                  $
                  211
                  
                  
                  $
                  133
                  
                  
                  $
                  78
 
 2007 Compared to
2006
 
 Non
interest income increased $83,000 from 2006 to 2007.
 
 During
2006, the Company recorded a one time gain of $155,000 on an insurance
settlement. Income from investments in life insurance policies decreased
$145,000 from 2006 to 2007. The decrease was largely the result of the
non-recurring income recorded during 2006 from the settlement of a bank owned
life insurance policy.
 
 Largely
because of continued increases in non-sufficient funds fees, as a result of
implementation of what is commonly referred to as a “courtesy overdraft” program
by Capon Valley Bank in late 2005, deposit account fees increased 14.67% from
2006 to 2007. The impact on non-interest income resulting from this program
continued to increase during 2007. During late 2007, The Grant County Bank
implemented a similar “courtesy overdraft” program, although the impact of
Grant’s program on 2007 non interest income was not significant.
 
 Insurance
commissions and insurance earnings generated by HBI Life Insurance Company
remained relatively steady from 2006 to 2007.
  Index
  
 Page
      Twenty Seven
 
 Non-interest
Expense
 
 2008 compared to
2007
 
 Non-interest
expense increased 4.26% in 2008 as compared to 2007.
 
 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, 2008 and 2007 (in thousands of
dollars):
 
 Salary
      and Benefits Expense2008
                    
                    
                    2007
                    
                    
                    Increase
                      (Decrease)Employee
      salaries
                    
                    $
                    4,198
                    
                    
                    $
                    4,040
                    
                    
                    $
                    158Employee
      benefit insurance
                    
                    
                    878
                    
                    
                    
                    830
                    
                    
                    
                    48Payroll
      taxes
                    
                    
                    346
                    
                    
                    
                    320
                    
                    
                    
                    26Post
      retirement plans
                    
                    
                    866
                    
                    
                    
                    762
                    
                    
                    
                    104Total
                    
                    $
                    6,288
                    
                    
                    $
                    5,952
                    
                    
                    $
                    336
 
 The table
below illustrates the change in salary expense between 2008 compared to salary
expense for 2007 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 salary per full time equivalent
      employee
                    
                    $
                    138Changes
      due to increase in the average full time equivalent employees for the
      periods
                    
                    
                    20Total
      increase in salary expense
                    
                    $
                    158
 
 Changes in data processing
expense
 
 Data
processing expense decreased 1.41%. As the company has moved toward increased
electronic transfer of information between branch locations and centralized data
processing locations, data processing costs have been slightly reduced for 2008
as compared to 2007.
 
 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, 2008 and 2007 (in thousands of
dollars):
 
 2008
                  
                  
                  2007
                  
                  
                  Increase
                    (Decrease)Depreciation
      of buildings and equipment
                  
                  $
                  702
                  
                  
                  $
                  704
                  
                  
                  $
                  (2
                  )Maintenance
      expense on buildings and equipment
                  
                  
                  439
                  
                  
                  
                  414
                  
                  
                  
                  25Utilities
      expense
                  
                  
                  94
                  
                  
                  
                  99
                  
                  
                  
                  (5
                  )Real
      estate and personal property tax
                  
                  
                  88
                  
                  
                  
                  87
                  
                  
                  
                  1Other
      expense related to occupancy and equipment
                  
                  
                  95
                  
                  
                  
                  80
                  
                  
                  
                  15Total
      occupancy and equipment expense
                  
                  $
                  1,418
                  
                  
                  $
                  1,384
                  
                  
                  $
                  34
 
 Changes in miscellaneous non
interest expense
 
 Most
other components of other non interest expense remained comparatively flat for
2008 as compared to  2007. The typical increases in costs associated
with inflation and the increasing size of the organization were offset by
decreases in state franchise tax expense as a result of a reduction in the
effective rate of this tax and also decreases in advertising and marketing
expense and a slight decline in legal and professional fees.
 
  Index
  
 Page
      Twenty Eight
 
 The table
below illustrates components of other non interest expense for 2008 and 2007 (in
thousands of dollars). All significant individual components of other non
interest expense are itemized.
 
 2008
                  
                  
                  2007
                  
                  
                  Increase
                    (Decrease)Office
      supplies and postage & freight expense
                  
                  
                  502
                  
                  
                  
                  492
                  
                  
                  
                  10ATM
      expense
                  
                  
                  193
                  
                  
                  
                  187
                  
                  
                  
                  6Advertising
      and marketing expense
                  
                  
                  189
                  
                  
                  
                  193
                  
                  
                  
                  (4
                  )Amortization
      of intangible assets
                  
                  
                  182
                  
                  
                  
                  176
                  
                  
                  
                  6Miscellaneous
      components of other non interest expense
                  
                  
                  984
                  
                  
                  
                  882
                  
                  
                  
                  102Total
                  
                  $
                  2,050
                  
                  
                  $
                  1,930
                  
                  
                  $
                  120
 
 2007 compared to
2006
 
 Non-interest
expense increased 5.37% from 2006 to 2007.
 
 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, 2007 and 2006 (in thousands of
dollars):
 
 Salary
      and Benefits Expense2007
                    
                    
                    2006
                    
                    
                    Increase
                      (Decrease)Employee
      salaries
                    
                    $
                    4,040
                    
                    
                    $
                    3,773
                    
                    
                    $
                    267Employee
      benefit insurance
                    
                    
                    831
                    
                    
                    
                    735
                    
                    
                    
                    96Payroll
      taxes
                    
                    
                    319
                    
                    
                    
                    331
                    
                    
                    
                    (12
                    )Post
      retirement plans
                    
                    
                    762
                    
                    
                    
                    832
                    
                    
                    
                    (70
                    )Total
                    
                    $
                    5,952
                    
                    
                    $
                    5,671
                    
                    
                    $
                    281
 
 
 The table
below illustrates the change in salary expense between 2007 compared to salary
expense for 2006 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 salary per full time equivalent
      employee
                    
                    $
                    120Changes
      due to increase in the average full time equivalent employees for the
      periods
                    
                    
                    147Total
      increase in salary expense
                    
                    $
                    267
 
 Changes in miscellaneous non
interest expense
 
 The
Company’s physical plant remained relatively unchanged from 2006 to 2007 other
than normal and customary upgrades of equipment and technology. As a result,
occupancy and equipment expense remained relatively flat from 2006 to 2007. Data
processing increased 5.30% as the volume of accounts, both loan and deposit,
increased. Legal and professional fees increased 9.76% from 2006 to 2007 largely
as a result of increases in consulting engagements relating to regulatory
compliance issues, most notably Sarbanes Oxley Rule 404.
  Securities
Portfolio
 
 The
Company's securities portfolio serves several purposes.  Portions of
the portfolio are used to secure certain public and trust
deposits.  The remaining portfolio is held as investments or used to
assist the Company in liquidity and asset liability management.  Total
securities, including restricted securities, represented 6.31% of total assets
and 60.58% of total shareholders’ equity at December 31, 2008.
 
  Index
  
 Page
      Twenty Nine
 
 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 management has the intent and the Company has the ability at the
time of purchase to hold the securities to maturity.  Held to maturity
securities are carried at cost, adjusted for amortization of premiums and
accretion of discounts. Securities to be held for indefinite periods of time are
classified as available for sale and accounted for at market
value.  Securities available for sale include securities that may be
sold in response to changes in market interest rates, changes in the security's
prepayment risk, increases in loan demand, general liquidity needs and other
similar factors.  Restricted securities are those investments
purchased as a requirement of membership in certain governmental lending
institutions and cannot be transferred without the issuer’s
permission.  The Company's purchases of securities have generally been
limited to securities of high credit quality with short to medium term
maturities.
 
 The
Company identifies at the time of acquisition those securities that are
available for sale. These securities are valued at their market value with any
difference in market value and amortized cost shown as an adjustment in
stockholders' equity.  Changes within the year in market values are
reflected as changes in other comprehensive income, net of the deferred tax
effect.  As of December 31, 2008, the fair value of the securities
available for sale exceed their cost basis by $354,000 ($223,000 after tax
effect of $131,000).
 
 The table
below summarizes the carrying value of the Company’s securities at December 31,
2008, 2007 and 2006 (in thousands of dollars):
 
 Available
      for SaleCarrying
      ValueDecember
      31,2008
                    
                    
                    2007
                    
                    
                    2006U.S.
      Treasuries and Agencies
                    
                    $
                    7,726
                    
                    
                    $
                    15,245
                    
                    
                    $
                    14,403Obligations
      of states and political subdivisions
                    
                    
                    3,609
                    
                    
                    
                    3,039
                    
                    
                    
                    2,744Mortgage
      backed securities
                    
                    
                    10,342
                    
                    
                    
                    7,784
                    
                    
                    
                    6,554Marketable
      equities
                    
                    
                    15
                    
                    
                    
                    22
                    
                    
                    
                    28Total
                    
                    $
                    21,692
                    
                    
                    $
                    26,090
                    
                    
                    $
                    23,729
 
 The
carrying amount and estimated market value of debt securities (in thousands of
dollars) at December 31, 2008 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
                      
                      $
                      749
                      
                      
                      $
                      764
                      
                      
                      
                      3.14
                      %Due
      after one year through three
                      
                      
                      7,024
                      
                      
                      
                      7,168
                      
                      
                      
                      4.26
                      %Due
      after three years through five years
                      
                      
                      2,667
                      
                      
                      
                      2,750
                      
                      
                      
                      3.70
                      %Due
      five years through ten years
                      
                      
                      660
                      
                      
                      
                      653
                      
                      
                      
                      3.98
                      %Mortgage
      backed securities
                      
                      
                      10,211
                      
                      
                      
                      10,342
                      
                      
                      
                      4.58
                      %Equity
      securities with no maturity
                      
                      
                      28
                      
                      
                      
                      15Total
      Available For Sale
                      
                      $
                      21,339
                      
                      
                      $
                      21,692
                      
                      
                      
                      4.29
                      %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 management’s determination that
all securities held at December 31, 2008 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, 2008 can be found in the footnotes to the
financial statements. Management 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.
 
  Index
  
 Page
      Thirty
  A summary
of the Company’s securities portfolio at December 31, 2008, 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
                                
                                
                                $
                                7,504
                                
                                
                                $
                                222
                                
                                
                                $
                                0
                                
                                
                                $
                                7,726Mortgage Backed
      SecuritiesAaa
                                
                                
                                AAA
                                
                                
                                $
                                10,211
                                
                                
                                $
                                148
                                
                                
                                $
                                17
                                
                                
                                $
                                10,342State and
      MunicipalsAaa
                                
                                
                                AAA
                                
                                
                                $
                                1,375
                                
                                
                                $
                                0
                                
                                
                                $
                                9
                                
                                
                                $
                                1,366Aa2
                                
                                
                                AA
                                
                                
                                
                                607
                                
                                
                                
                                13
                                
                                
                                
                                0
                                
                                
                                
                                620Aa3
                                
                                
                                AA-
                                
                                
                                
                                753
                                
                                
                                
                                13
                                
                                
                                
                                0
                                
                                
                                
                                766A3
                                
                                
                                A-
                                
                                
                                
                                180
                                
                                
                                
                                3
                                
                                
                                
                                0
                                
                                
                                
                                183Baa1
                                
                                
                                BBB+
                                
                                
                                
                                285
                                
                                
                                
                                0
                                
                                
                                
                                0
                                
                                
                                
                                285No
      Rating
                                
                                
                                
                                396
                                
                                
                                
                                0
                                
                                
                                
                                7
                                
                                
                                
                                389Marketable
      EquitiesNo
      Rating
                                
                                
                                $
                                28
                                
                                
                                $
                                0
                                
                                
                                $
                                13
                                
                                
                                $
                                15
  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 decreased 2.30% from December 31, 2007 to December 31,
2008.
 
 A summary
of the maturity range of deposits over $100,000 is as follows (in thousands of
dollars):
 
 At
      December 31,2008
                    
                    
                    2007
                    
                    
                    2006Three
      months or less
                    
                    $
                    12,136
                    
                    
                    $
                    19,609
                    
                    
                    $
                    9,533Four
      to twelve months
                    
                    
                    32,828
                    
                    
                    
                    30,204
                    
                    
                    
                    30,810One
      year to three years
                    
                    
                    14,127
                    
                    
                    
                    10,067
                    
                    
                    
                    8,156Four
      years to five years
                    
                    
                    5,688
                    
                    
                    
                    5,606
                    
                    
                    
                    6,368Total
                    
                    $
                    64,779
                    
                    
                    $
                    65,486
                    
                    
                    $
                    54,867
 
 
 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.  Management 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, 2008 and throughout the twelve
month period ended December 31, 2008 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. During 2008, the Company borrowed an additional $1,500,000 from the
FHLB and made payments of $2,002,000 on outstanding balances.
 
  Index
  
 Page
      Thirty One
 
 Short Term
Borrowings
 
 As it
becomes necessary for short term liquidity needs and when beneficial for
assisting in managing the profitability of the Company, management 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, 2008, the Company had balances of
$4,800,000 in overnight and other short term borrowings. During the fourth
quarter of 2008, the Company’s average balance of short term debt was
$4,141,000. The average rate paid during the quarter on these borrowings was
..83%,
 
 Capital
Resources
 
 The
assessment of capital adequacy depends on a number of factors such as asset
quality, liquidity, earnings performance and changing competitive conditions and
economic forces.  The Company seeks to maintain a strong capital base
to support its growth and expansion activities, to provide stability to current
operations and to promote public confidence.
 
 The
Company's capital position continues to exceed regulatory
minimums.  The primary indicators relied on by the Federal Reserve
Board and other bank regulators in measuring strength of capital position are
the Tier 1 Capital, Total Capital and Leverage ratios.  Tier 1 Capital
consists of common stockholders' equity adjusted for unrealized gains and losses
on securities.  Total Capital consists of Tier 1 Capital and a portion
of the allowance for loan losses.  Risk-based capital ratios are
calculated with reference to risk-weighted assets, which consist of both on and
off-balance sheet risks.
 
 The
capital management function is an ongoing process. 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 2006 and 2007, the
Company’s capital position increased by $3,517,000 and $3,084,000 respectively.
During 2008, the Company’s capital position decreased by $1,194,000. The
Company, during the second and third quarters of the year repurchased 6.96% of
its outstanding common shares. The return on average equity was 12.38% in 2008
compared to 12.03% for 2007 and 12.67% for 2006.  Total cash dividends
declared represent 30.12% of net income for 2008 compared to 30.88% of net
income for 2007 and 29.91% for 2006.  Book value per share was $29.47
at December 31, 2008 compared to $28.25 at December 31, 2007.
 
 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 fund 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. Further
discussion relating to these risks can be found in Item 7A. Quantitative and
Qualitative Disclosures About Market Risk.
 
 The
parent Company’s operating funds, funds with which to pay shareholder dividends
and funds for the exploration of new business ventures have been supplied
primarily through dividends paid by the Company’s two subsidiary Banks, Capon
Valley Bank and The Grant County Bank.  The various regulatory
authorities impose restrictions on dividends paid by a state bank.  A
state bank cannot pay dividends without the consent of the relevant banking
authorities in excess of the total net profits of the current year and the
combined retained profits of the previous two years.  As of January 1,
2009, the subsidiary Banks could pay dividends to Highlands Bankshares, Inc. of
approximately $3,238,000 without permission of the regulatory
authorities.
 
  Index
  
 Page
      Thirty Two
 
 Effects of
Inflation
 
 Inflation
primarily affects industries having high levels of property, plant and equipment
or inventories. Although the Company is not significantly affected in these
areas, inflation does have an impact on the growth of assets.  As
assets grow rapidly, it becomes necessary to increase equity capital at
proportionate levels to maintain the appropriate equity to asset
ratios.  Traditionally, the Company's earnings and high capital
retention levels have enabled the Company to meet these needs.
 
 The
Company's reported earnings results have been minimally affected by
inflation.  The different types of income and expense are affected in
various ways.  Interest rates are affected by inflation, but the
timing and magnitude of the changes may not coincide with changes in the
consumer price index.  Management actively monitors interest rate
sensitivity, as illustrated by the gap analysis shown under the section titled
Interest Rate Sensitivity, in order to minimize the effects of inflationary
trends on interest rates. Other areas of non-interest expenses may be more
directly affected by inflation.
 
 Item 7A.
              Quantitative
      and Qualitative Disclosures About Market
Risk
 
 The
greatest portion of the Company’s net income is derived from net interest income
after provision for loans losses. As such, factors that may have significant
effects on the Company’s net interest income comprise the greatest market risks
to the Company. The three largest components of risks to the Company’s ability
to generate net interest income are competitive pressures for loans and
deposits, interest rate volatility, and economic conditions which may have an
effect on demand for loans or on the quality of the existing loan portfolio,
which may affect the levels of provision for loan losses required to maintain an
adequate allowance for loan losses.
 
 Management
must attempt to estimate and weigh the above factors in attempting to maintain a
satisfactory level of liquidity and control the degree of interest rate risk
assumed on the balance sheet in an effort to maximize net interest income given
current and anticipated market conditions.
 
 Competition for Loans and
Deposits
 
 Competition
for new loans remains heavy. The result of this competition has also had the
effect of causing increases in rates earned on loans to decrease as the Company
has often had to price loans to match competitive pressures in order to maintain
its demand for new loans. Should this influence continue into the future, the
Company may experience a decrease in its net interest margin.
 
 The
competitive pressures have also affected deposit volumes and demand for the
Company’s deposit products. To attract new deposit balances, the Company has
often been required to increase deposit rates to match rates offered by
competing financial institutions. Should this influence continue into the
future, the Company may experience a decrease in its net interest
margin.
 
 Management
can, to some degree, offset the effects of competitive rates on deposit products
through other funding sources, such as long term and overnight borrowings.
During the fourth quarter of 2008, the Company increasingly used its overnight
borrowing capabilities to fund loan growth. The Company does not consider short
term borrowings to be a significant part of its balance sheet management
strategy, but will continue to utilize its capacity in this funding source when
conditions warrant.
 
 Economic
Conditions
 
 Economic
conditions, both nationally and locally, could have a significant impact on the
Company’s earnings and specifically on its net interest income after provision
for loan losses.
 
 Deteriorating
economic conditions often have the effect of increasing balances of
non-performing loans and the potential subsequent effect of increasing
charge-offs. Both increasing balances of non-performing loans and increasing
charge-offs may require the Company to increase its provision for loan losses to
maintain an adequate balance of its allowance for loan losses, thus having a
negative impact on the Company’s net interest margin after provision for loan
losses. In addition, non-performing loans may be placed in non-accrual status,
thus reducing the Company’s recognized interest revenue.
  Index
  
 Page
      Thirty Three
 
 Interest Rate
Volatility
 
 Managing
the risk of interest rate volatility involves regular monitoring of the interest
sensitive assets relative to interest sensitive liabilities over specific time
intervals.  Early withdrawal of deposits, greater than expected
balances of new deposits, prepayments of loans and loan delinquencies are some
of the factors that could affect actual versus expected cash
flows.  In addition, changes in rates on interest sensitive assets and
liabilities may not be equal, which could result in a change in net interest
margin.  While the Company does not match each of its interest
sensitive assets against specific interest sensitive liabilities, it does review
its positions regularly and takes actions to reposition itself when necessary.
With the largest amount of interest sensitive assets and liabilities re-pricing
within one year, the Company believes it is in an excellent position to respond
quickly to rapid market rate changes.
 
 Interest
rate market conditions may also affect portfolio composition of both assets and
liabilities. Traditionally, the Company’s subsidiary Banks have primarily
offered one-year adjustable rate mortgages (ARMs) to its mortgage loan
customers. However, the low interest rate environment during the past several
years created intense competition, especially from larger banking institutions
and finance companies offering long term fixed rate mortgages. As a result, the
Company, in recent periods, has begun to write more mortgage loans with
adjustable rate maturities greater than one year. This increase in average
maturity lengths may affect the timing of the repricing of the loan portfolio as
compared to the timing of the repricing of the deposit portfolio.
 
 At
December 31, 2008, the Company’s balance sheet was, in the coming quarter of
2009, liability sensitive in that more liabilities reprice within 90 days than
do assets. With decreases in rates seen during the third and fourth quarters of
2008, as evidenced by decreases by the Federal Reserve Board of the target rate
for federal funds sold, this position of being liability sensitive should have a
more positive impact on the Company’s net interest income than if the Company
were asset sensitive for the same time period. The following table illustrates
the Company’s sensitivity to interest rate changes as of December 31, 2008 (in
thousands of dollars):
 
 1-90
      Days
                
                
                91-365
      Days
                
                
                1
      to 3
                  Years
                
                
                3
      to 5
                  Years
                
                
                More
                  than
      5
                  Years
      or
                  no
                  Maturity
                
                
                TotalEARNING
      ASSETSLoans
                
                $
                64,009
                
                
                $
                116,825
                
                
                $
                87,250
                
                
                $
                26,561
                
                
                $
                31,109
                
                
                $
                325,754Federal
      funds sold
                
                
                160
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                160Restricted
      investments
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                2,177
                
                
                
                2,177Interest
      bearing deposits
                
                
                193
                
                
                
                309
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                502Securities
                
                
                1,589
                
                
                
                6,027
                
                
                
                7,373
                
                
                
                2,364
                
                
                
                4,339
                
                
                
                21,692Total
      Earning Assets
                
                $
                65,951
                
                
                
                123,161
                
                
                
                94,623
                
                
                
                28,925
                
                
                
                37,625
                
                
                
                350,285INTEREST
      BEARING LIABILITIESInterest
      bearing transaction accounts
                
                
                68,610
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                68,610Time
      deposits greater than $100,000
                
                
                12,136
                
                
                
                32,828
                
                
                
                14,127
                
                
                
                5,688
                
                
                
                
                
                
                
                64,779Time
      deposits less than $100,000
                
                
                21,124
                
                
                
                68,306
                
                
                
                35,029
                
                
                
                8,835
                
                
                
                
                
                
                
                133,294Debt
      instruments
                
                
                4,911
                
                
                
                340
                
                
                
                2,728
                
                
                
                5,984
                
                
                
                2,154
                
                
                
                16,117Total
      Interest bearing liabilities
                
                
                106,781
                
                
                
                101,474
                
                
                
                51,884
                
                
                
                20,507
                
                
                
                2,154
                
                
                
                282,800Rate
      sensitivity gap
                
                $
                (40,830
                )
                
                $
                21,687
                
                
                $
                42,739
                
                
                $
                8,418
                
                
                $
                35,471
                
                
                $
                67,485Cumulative
      gap
                
                $
                (40,830
                )
                
                $
                (19,143
                )
                
                $
                23,596
                
                
                $
                32,014
                
                
                $
                67,485
 
  Index
  
 Page
      Thirty Four
 
 Item8.
              Financial
      Statements and Supplementary Data
 
 HIGHLANDS
      BANKSHARES, INC.CONSOLIDATED
      BALANCE SHEETSDecember
      31, 2008 and 2007(In
      thousands of dollars)2008
                    
                    
                    2007ASSETSCash
      and due from banks
                    
                    $
                    7,589
                    
                    
                    $
                    7,935Interest
      bearing deposits in banks
                    
                    
                    502
                    
                    
                    
                    1,853Federal
      funds sold
                    
                    
                    160
                    
                    
                    
                    14,246Investment
      securities available for sale
                    
                    
                    21,692
                    
                    
                    
                    26,090Restricted
      investments
                    
                    
                    2,177
                    
                    
                    
                    1,498Loans
                    
                    
                    325,754
                    
                    
                    
                    310,199Allowance
      for loan losses
                    
                    
                    (3,667
                    )
                    
                    
                    (3,577
                    )Bank
      premises and equipment
                    
                    
                    8,031
                    
                    
                    
                    8,104Interest
      receivable
                    
                    
                    2,164
                    
                    
                    
                    2,273Investment
      in life insurance contracts
                    
                    
                    6,499
                    
                    
                    
                    6,300Goodwill
                    
                    
                    1,534
                    
                    
                    
                    1,534Other
      intangible assets
                    
                    
                    1,215
                    
                    
                    
                    1,572Other
      assets
                    
                    
                    4,645
                    
                    
                    
                    2,909Total
      Assets
                    
                    $
                    378,295
                    
                    
                    $
                    380,936LIABILITIESDepositsNon-interest
      bearing deposits
                    
                    $
                    49,604
                    
                    
                    $
                    48,605Interest
      bearing transaction and savings accounts
                    
                    
                    68,610
                    
                    
                    
                    73,736Time
      deposits over $100,000
                    
                    
                    64,779
                    
                    
                    
                    65,486All
      other time deposits
                    
                    
                    133,294
                    
                    
                    
                    135,911Total
      Deposits
                    
                    
                    316,287
                    
                    
                    
                    323,738Overnight
      and other short term debt instruments
                    
                    
                    4,800
                    
                    
                    
                    0Long
      term debt instruments
                    
                    
                    11,317
                    
                    
                    
                    11,819Accrued
      expenses and other liabilities
                    
                    
                    6,492
                    
                    
                    
                    4,786Total
      Liabilities
                    
                    
                    338,896
                    
                    
                    
                    340,343STOCKHOLDERS’
      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 at December 31, 2008)
                    
                    
                    (3,372
                    )
                    
                    
                    0Retained
      earnings
                    
                    
                    35,157
                    
                    
                    
                    32,032Other
      accumulated comprehensive loss
                    
                    
                    (1,232
                    )
                    
                    
                    (285
                    )Total
      Stockholders’ Equity
                    
                    
                    39,399
                    
                    
                    
                    40,593Total
      Liabilities and Stockholders’ Equity
                    
                    $
                    378,295
                    
                    
                    $
                    380,936The
      accompanying notes are an integral part of these
statements
 
  Index
  
 Page
      Thirty Five
 
 HIGHLANDS
      BANKSHARES, INC.CONSOLIDATED
      STATEMENTS OF INCOMEFOR
      THE YEARS ENDED DECEMBER 31, 2008, 2007 and 2006(in
      thousands of dollars, except per share data)2008
                  
                  
                  2007
                  
                  
                  2006Interest
      and Dividend IncomeLoans,
      including fees
                  
                  $
                  24,809
                  
                  
                  $
                  25,295
                  
                  
                  $
                  22,118Federal
      funds sold
                  
                  
                  234
                  
                  
                  
                  801
                  
                  
                  
                  500Interest
      bearing deposits
                  
                  
                  44
                  
                  
                  
                  142
                  
                  
                  
                  72Investment
      securities
                  
                  
                  1,116
                  
                  
                  
                  1,426
                  
                  
                  
                  1,204Total
      Interest Income
                  
                  
                  26,203
                  
                  
                  
                  27,664
                  
                  
                  
                  23,894Interest
      ExpenseInterest
      on deposits
                  
                  
                  8,357
                  
                  
                  
                  10,107
                  
                  
                  
                  7,202Interest
      on overnight and other short term debt instruments
                  
                  
                  19
                  
                  
                  
                  0
                  
                  
                  
                  0Instrument
      on long term debt instruments
                  
                  
                  490
                  
                  
                  
                  596
                  
                  
                  
                  707Total
      Interest Expense
                  
                  
                  8,866
                  
                  
                  
                  10,703
                  
                  
                  
                  7,909Net
      Interest Income
                  
                  
                  17,337
                  
                  
                  
                  16,961
                  
                  
                  
                  15,985Provision
      for Loan Losses
                  
                  
                  909
                  
                  
                  
                  837
                  
                  
                  
                  682Net
      Interest Income after Provision for Loan Losses
                  
                  
                  16,428
                  
                  
                  
                  16,124
                  
                  
                  
                  15,303Non-interest
      IncomeService
      charges
                  
                  
                  1,746
                  
                  
                  
                  1,391
                  
                  
                  
                  1,213Life
      insurance investment income
                  
                  
                  281
                  
                  
                  
                  235
                  
                  
                  
                  380Gain
      on securities transactions
                  
                  
                  110
                  
                  
                  
                  1
                  
                  
                  
                  0Gain
      on sale of fixed assets
                  
                  
                  32
                  
                  
                  
                  0
                  
                  
                  
                  0Other
      operating income
                  
                  
                  530
                  
                  
                  
                  453
                  
                  
                  
                  404Total
      Non-interest Income
                  
                  
                  2,699
                  
                  
                  
                  2,080
                  
                  
                  
                  1,997Non-interest
      ExpensesSalaries
      and benefits
                  
                  
                  6,288
                  
                  
                  
                  5,952
                  
                  
                  
                  5,671Occupancy
      and equipment expense
                  
                  
                  1,418
                  
                  
                  
                  1,384
                  
                  
                  
                  1,346Data
      processing expense
                  
                  
                  842
                  
                  
                  
                  854
                  
                  
                  
                  811Legal
      and professional fees
                  
                  
                  465
                  
                  
                  
                  461
                  
                  
                  
                  420Directors
      fees
                  
                  
                  356
                  
                  
                  
                  371
                  
                  
                  
                  392Other
      operating expenses
                  
                  
                  2,050
                  
                  
                  
                  1,930
                  
                  
                  
                  1,754Total
      Non-interest Expenses
                  
                  
                  11,419
                  
                  
                  
                  10,952
                  
                  
                  
                  10,394Income
      Before Income Tax Expense
                  
                  
                  7,708
                  
                  
                  
                  7,252
                  
                  
                  
                  6,906Income
      Tax Expense
                  
                  
                  2,738
                  
                  
                  
                  2,599
                  
                  
                  
                  2,391Net
      Income
                  
                  $
                  4,970
                  
                  
                  $
                  4,653
                  
                  
                  $
                  4,515Earnings
      Per Weighted Average Share Outstanding
                  
                  $
                  3.59
                  
                  
                  $
                  3.24
                  
                  
                  $
                  3.14Dividends
      Per Share
                  
                  $
                  1.08
                  
                  
                  $
                  1.00
                  
                  
                  $
                  .94Weighted
      Average Shares Outstanding
                  
                  
                  1,383,214
                  
                  
                  
                  1,436,874
                  
                  
                  
                  1,436,874The
      accompanying notes are an integral part of these
statements
 
 
  Index
  
 Page
      Thirty Six
 
 HIGHLANDS
      BANKSHARES, INC.CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ EQUITY(in
      thousands of dollars)Common
                          Stock
                        
                        
                        Surplus
                        
                        
                        Treasury
      Stock
                        
                        
                        Retained
      Earnings
                        
                        
                        Accumulated
      Other Comprehensive Income
                        
                        
                        TotalBalances
      at December 31, 2005
                        
                        $
                        7,184
                        
                        
                        $
                        1,662
                        
                        
                        $
                        0
                        
                        
                        $
                        25,651
                        
                        
                        $
                        (505
                        )
                        
                        $
                        33,992Comprehensive
      income:Net
      income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        4,515
                        
                        
                        
                        
                        
                        
                        
                        4,515Change
      in other comprehensive income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (81
                        )
                        
                        
                        (81
                        )Total
      comprehensive income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        4,434Cash
      dividends
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (1,350
                        )
                        
                        
                        
                        
                        
                        
                        (1,350
                        )Balances
      at December 31, 2006
                        
                        
                        7,184
                        
                        
                        
                        1,662
                        
                        
                        
                        0
                        
                        
                        
                        28,816
                        
                        
                        
                        (586
                        )
                        
                        
                        37,076Comprehensive
      income:Net
      income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        4,653
                        
                        
                        
                        
                        
                        
                        
                        4,653Change
      in other comprehensive income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        301
                        
                        
                        
                        301Total
      comprehensive income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        4,954Cash
      dividends
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (1,437
                        )
                        
                        
                        
                        
                        
                        
                        (1,437
                        )Balances
      at December 31, 2007
                        
                        
                        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
                        )
                        
                        $
                        39,399
 
 
 
  Index
  
 Page
      Thirty Seven
 
 HIGHLANDS
      BANKSHARES, INC.CONSOLIDATED
      STATEMENTS OF CASH FLOWSFOR
      THE YEARS ENDED DECEMBER 31, 2008, 2007 and 2006(In
      thousands of dollars)Years
      Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      Income
                    
                    $
                    4,970
                    
                    
                    $
                    4,653
                    
                    
                    $
                    4,515Adjustments
      to reconcile net income to net cash provided by operating
      activitiesGain
      on securities transactions
                    
                    
                    (110
                    )
                    
                    
                    (1
                    )
                    
                    
                    0(Gain)
      loss on sale of property
                    
                    
                    (32
                    )
                    
                    
                    38
                    
                    
                    
                    (7
                    )Other
      (gain)/loss
                    
                    
                    (4
                    )
                    
                    
                    0
                    
                    
                    
                    0Depreciation
                    
                    
                    702
                    
                    
                    
                    704
                    
                    
                    
                    691Income
      from life insurance contracts
                    
                    
                    (281
                    )
                    
                    
                    (234
                    )
                    
                    
                    (380
                    )Net
      amortization of securities premiums
                    
                    
                    32
                    
                    
                    
                    (142
                    )
                    
                    
                    (182
                    )Provision
      for loan losses
                    
                    
                    909
                    
                    
                    
                    837
                    
                    
                    
                    682Deferred
      income tax benefit
                    
                    
                    (65
                    )
                    
                    
                    (131
                    )
                    
                    
                    (115
                    )Amortization
      of intangibles
                    
                    
                    182
                    
                    
                    
                    176
                    
                    
                    
                    176Decrease
      (Increase) in interest receivable
                    
                    
                    109
                    
                    
                    
                    (100
                    )
                    
                    
                    (355
                    )Decrease
      (Increase) in other assets
                    
                    
                    (2,284
                    )
                    
                    
                    (585
                    )
                    
                    
                    1Increase
      (Decrease) in accrued expenses
                    
                    
                    946
                    
                    
                    
                    22
                    
                    
                    
                    938Net
      purchase of intangible assets
                    
                    
                    175
                    
                    
                    
                    (250
                    )
                    
                    
                    0Net
      Cash Provided by Operating Activities
                    
                    
                    5,248
                    
                    
                    
                    4,987
                    
                    
                    
                    5,964CASH
      FLOWS FROM INVESTING ACTIVITIESSale
      of property
                    
                    
                    46
                    
                    
                    
                    0
                    
                    
                    
                    7Proceeds
      from maturity of securities held to maturity
                    
                    
                    0
                    
                    
                    
                    170
                    
                    
                    
                    320Proceeds
      from maturity of securities available for sale
                    
                    
                    17,096
                    
                    
                    
                    10,198
                    
                    
                    
                    11,539Purchase
      of securities available for sale
                    
                    
                    (12,537
                    )
                    
                    
                    (12,862
                    )
                    
                    
                    (7,870
                    )Net
      change in other investments
                    
                    
                    (679
                    )
                    
                    
                    72
                    
                    
                    
                    (320
                    )Net
      change in interest bearing deposits in other banks
                    
                    
                    1,351
                    
                    
                    
                    (229
                    )
                    
                    
                    (661
                    )Net
      increase in loans
                    
                    
                    (16,374
                    )
                    
                    
                    (18,125
                    )
                    
                    
                    (23,125
                    )Settlement
      on insurance contract, net of gain
                    
                    
                    82
                    
                    
                    
                    0
                    
                    
                    
                    555Net
      change in federal funds sold
                    
                    
                    14,086
                    
                    
                    
                    (2,036
                    )
                    
                    
                    (1,402
                    )Purchase
      of property and equipment
                    
                    
                    (643
                    )
                    
                    
                    (715
                    )
                    
                    
                    (1,117
                    )Net
      Cash Provided by (Used in) Investing Activities
                    
                    
                    2,428
                    
                    
                    
                    (22,807
                    )
                    
                    
                    (22,074
                    )CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      change in time deposits
                    
                    
                    (3,324
                    )
                    
                    
                    19,229
                    
                    
                    
                    25,826Net
      change in other deposit accounts
                    
                    
                    (4,127
                    )
                    
                    
                    4,025
                    
                    
                    
                    (10,034
                    )Additional
      long term debt
                    
                    
                    1,500
                    
                    
                    
                    1,000
                    
                    
                    
                    2,300Repayment
      of long term debt
                    
                    
                    (2,002
                    )
                    
                    
                    (4,173
                    )
                    
                    
                    (2,371
                    )Additional
      (repayment of) short term borrowings
                    
                    
                    4,800
                    
                    
                    
                    0
                    
                    
                    
                    0Purchase
      of treasury stock
                    
                    
                    (3,372
                    )
                    
                    
                    0
                    
                    
                    
                    0Dividends
      paid in cash
                    
                    
                    (1,497
                    )
                    
                    
                    (1,437
                    )
                    
                    
                    (1,350
                    )Net
      Cash Provided by (Used in) Financing Activities
                    
                    
                    (8,022
                    )
                    
                    
                    18,644
                    
                    
                    
                    14,371CASH
      AND CASH EQUIVALENTSNet
      increase (decrease) in cash and due from banks
                    
                    
                    (346
                    )
                    
                    
                    824
                    
                    
                    
                    (1,739
                    )Cash
      and due from banks, beginning of year
                    
                    
                    7,935
                    
                    
                    
                    7,111
                    
                    
                    
                    8,850Cash
      and due from banks, end of year
                    
                    $
                    7,589
                    
                    
                    $
                    7,935
                    
                    
                    $
                    7,111Supplemental
      Disclosures, Cash Paid For:Interest
      Expense
                    
                    $
                    9,147
                    
                    
                    $
                    10,141
                    
                    
                    $
                    7,529Income
      Taxes
                    
                    $
                    2,827
                    
                    
                    $
                    3,085
                    
                    
                    $
                    2,381The
      accompanying notes are an integral part of these
statements
  Index
  Page
      Thirty Eight
 
 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 financial statements, management is required to make estimates and
assumptions that affect the reported amounts in those statements; actual results
could differ significantly from those estimates.  A material estimate
that is particularly susceptible to significant changes in the near term is the
determination of the allowance for loan losses, which is sensitive to changes in
local economic conditions.
 
 (c)
              Cash
      and Cash Equivalents
 
 For
purposes of the statements of cash flows, cash and cash equivalents include cash
on hand and non-interest bearing funds at correspondent
institutions.
 
 (d)
              Foreclosed
      Real Estate
 
 The
components of foreclosed real estate are adjusted to the fair value of the
property at the time of acquisition, less estimated costs of
disposal.  The current year provision for a valuation allowance has
been recorded as an expense to current operations.
 
 (e)
              Loans
 
 Loans are
carried on the balance sheet net of unearned interest and allowance for loan
losses.  Interest income on loans is determined using the effective
interest method based on the daily amount of principal outstanding except where
serious doubt exists as to collectibility of the loan, in which case the accrual
of income is discontinued. Loans are placed on non-accrual status or charged off
if collection of principal or interest becomes doubtful. The interest on these
loans is accounted for on a cash-basis or cost-recovery method until qualifying
for return to accrual status. Loans are returned to accrual status when all the
principal and interest amounts contractually due are brought current and the
loan is performing as agreed.
  Index
  
 Page
      Thirty Nine
 
 
 (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 an estimate of the losses that may be sustained in
the loan portfolio. The allowance is based on two basic principles of
accounting: (i) Statement of Financial Accounting Standards No. 5, Accounting for Contingencies(SFAS 5), which
requires that losses be accrued when they are probable of occurring and
estimable, and (ii) Statement of Financial Accounting Standards No. 114, Accounting by Creditors for
Impairment of a Loan(SFAS 114), 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.
 
 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
SFAS 114, an individual loan is impaired when, based on current information and
events, it is probable that a creditor 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 under SFAS 114 is evaluated
under SFAS 5 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.
 
 SFAS 114
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 Highlands Bankshares 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
within the scope of SFAS 114 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 SFAS 114, are included in a group of loans that are measured under SFAS 5
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 SFAS 5 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.
  Index
  
 Page
      Forty
 
 
 (i)
              Bank
      Premises and Equipment
 
 Bank
premises and equipment are stated at cost less accumulated depreciation. Assets
acquired in the acquisition of Davis have been recorded at their fair
value.  Depreciation is charged to income over the estimated useful
lives of the assets using a combination of the straight line and accelerated
methods. The costs of maintenance, repairs, renewals, and improvements to
buildings, equipment and furniture and fixtures are charged to operations as
incurred.  Gains and losses on routine dispositions are reflected in
other income or expense.
 
 (j)
              Comprehensive
      Income
 
 Accounting
principles generally require that recognized revenue, expenses, gains and losses
be included in net income.  Certain changes in assets and liabilities,
such as unrealized gains and losses on available-for-sale securities and accrued
pension liabilities, are reported along with net income as the components of
comprehensive income.
 
 (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. Therefore the Company accounts for these policies using
guidance found in Statement of Financial Accounting Standards No. 106,
"Employers' Accounting for Post Retirement Benefits Other Than Pensions.” SFAS
No. 106 requires that an employers' obligation under a deferred compensation
agreement be accrued over the expected service life of the employee through
their normal retirement date. Assumptions are used in estimating the present
value of amounts due officers after their normal retirement
date.  These assumptions include the estimated income to be derived
from the investments and an estimate of the Company’s cost of funds in these
future periods.  In addition, the discount rate used in the present
value calculation will change in future years based on market
conditions.
 
 
 (l)
              Advertising
 
 Advertising costs are expensed as they
are incurred.  Advertising expense for the years ended December 31,
2008, 2007 and 2006 was $ 189,000, $193,000 and $198,000
respectively.
 
 
 (m)
              Goodwill
      and Other Intangible Assets
 
 In accordance with provisions of SFAS
No. 142, "Goodwill and Other
Intangible Assets",
goodwill is not amortized over an estimated useful life, but rather will be
tested at least annually for impairment. 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 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.
 
  Index
  
 Page
      Forty One
 
 (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, 2008 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
 
 In
September 2006, the FASB issued Statement of Financial Accounting Standards No.
158, “Employers Accounting for Defined Benefit Pension and Other Postretirement
Plans—an amendment of FASB Statements No. 87, 88, 106 and 132R” (SFAS 158). SFAS
158 requires an employer to recognize the over-funded or under-funded status of
a defined benefit postretirement plan as an asset or liability in its statement
of financial position and to recognize changes in that funded status, through
comprehensive income, in the year in which the changes occur. The funded status
of a benefit plan will be measured as the difference between plan assets at fair
value and benefit obligation. For any other postretirement plan, the benefit
obligation is the accumulated postretirement benefit obligation. SFAS 158 also
requires an employer to measure the funded status of a plan as of the date of
its year-end statement of financial position. The Statement also requires
additional disclosures in the notes to financial statements about certain
effects on net periodic benefit cost for the next fiscal year that arise from
delayed recognition of the gains or losses, prior service costs or credits, and
transition asset or obligation. Under SFAS 158 a company is required to
initially recognize the funded status of a defined benefit postretirement plan
to provide the required disclosures as of the end of the fiscal year ending
after December 15, 2006. The requirement to measure plan assets and benefit
obligations as of the date of the employer’s fiscal year end statement of
financial position is effective for fiscal years ending after December 15, 2008.
The Grant County Bank is a member of the West Virginia Bankers' Association
Retirement Plan, a defined benefit plan under SFAS 158.
  Index
  
 Page
      Forty Two
 
 In
September 2006, the Financial Accounting Standards Board (FASB) reached a
consensus on Emerging Issues Task Force (“EITF”) Issue 06-4, “Accounting for
Deferred Compensation and Postretirement Benefit Aspects of Endorsement
Split-Dollar Life Insurance Arrangements,” (“EITF Issue 06-4”). In March 2007,
the FASB reached a consensus on EITF Issue 06-10, “Accounting for Collateral
Assignment Split-Dollar Life Insurance Arrangements,” (“EITF Issue 06-10”). Both
of these standards require a company to recognize an obligation over an
employee’s service period based upon the substantive agreement with the employee
such as the promise to maintain a life insurance policy or provide a death
benefit postretirement. These EITF pronouncements became effective for Highlands
Bankshares on January 1, 2008. These EITF 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. Highlands
Bankshares opted to record the liability as a cumulative effect adjustment to
retained earnings and as such recorded a liability and corresponding reduction
of retained earnings of $348,000. There is no corresponding deferred tax
consequence relating to this liability.
 
 In
September 2006, the FASB issued Statement of Financial Accounting Standards No.
157, “Fair Value Measurements” (SFAS 157).  SFAS 157 defines fair
value, establishes a framework for measuring fair value in generally accepted
accounting principles, and expands disclosures about fair value
measurements.  SFAS 157 does not require any new fair value
measurements, but rather, provides enhanced guidance to other pronouncements
that require or permit assets or liabilities to be measured at fair
value.  This Statement is effective for financial statements issued
for fiscal years beginning after November 15, 2007 and interim periods within
those years.  The FASB has approved a one-year deferral for the
implementation of the Statement for nonfinancial assets and nonfinancial
liabilities that are recognized or disclosed at fair value in the financial
statements on a nonrecurring basis.SFAS 157 had no material
impact on the Company’s December 31, 2008  financial statements.
Additional disclosure information required by this pronouncement is included in
Note Nineteen.
 
 In
February 2007, the FASB issued Statement of Financial Accounting Standards No.
159, “The Fair Value Option for Financial Assets and Financial Liabilities”
(SFAS 159).  This Statement permits entities to choose to measure many
financial instruments and certain other items at fair value. The objective of
this Statement is to improve financial reporting by providing entities with the
opportunity to mitigate volatility in reported earnings caused by measuring
related assets and liabilities differently without having to apply complex hedge
accounting provisions. The fair value option established by this Statement
permits all entities to choose to measure eligible items at fair value at
specified election dates. A business entity shall report unrealized gains and
losses on items for which the fair value option has been elected in earnings at
each subsequent reporting date. The fair value option may be applied instrument
by instrument and is irrevocable. SFAS 159 is effective as of the beginning of
an entity’s first fiscal year that begins after November 15, 2007, with early
adoption available in certain circumstances. The Company adopted SFAS 159
effective January 1, 2008. The Company decided not to report any existing
financial assets or liabilities at fair value that are not already reported,
thus the adoption of this statement did not have a material impact on the
consolidated financial statements.
 
 In
November 2007, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin No. 109, “Written Loan Commitments Recorded at Fair Value
Through Earnings” (SAB 109). SAB 109 expresses the current view of the staff
that the expected net future cash flows related to the associated servicing of
the loan should be included in the measurement of all written loan commitments
that are accounted for at fair value through earnings. SEC registrants are
expected to apply the views in Question 1 of SAB 109 on a prospective basis to
derivative loan commitments issued or modified in fiscal quarters beginning
after December 15, 2007.  SAB 109 did not have a
material impact on the Company’s consolidated financial statements.
 
 In April
2008, the FASB issued FASB Staff Position (FSP) No. 142-3, “Determination of the
Useful Life of Intangible Assets” (“FSP No. 142-3”). FSP No. 142-3 amends the
factors an entity should consider in developing renewal or extension assumptions
used in determining the useful life of recognized intangible assets under FASB
SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). The
intent of FSP No. 142-3 is to improve the consistency between the useful life of
a recognized intangible asset under SFAS No. 142 and the period of expected cash
flows used to measure the fair value of the assets under SFAS No. 141(R). FSP
No. 142-3 is effective for the Company on January 1, 2009, and applies
prospectively to intangible assets that are acquired individually or with a
group of other assets in business combinations and asset acquisitions.The adoption of FSP No.
142-3 is not expected to have a material impact on the Company’s consolidated
financial statements.
  Index
  
 Page
      Forty Three
 
 In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles,” (“SFAS No. 162”). SFAS No. 162 identifies the sources of
accounting principles and the framework for selecting the principles to be used
in the preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles. SFAS No.
162 is effective 60 days following the SEC’s approval of the Public Company
Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present
Fairly in Conformity With Generally Accepted Accounting Principles.” Management
does not expect the adoption of the provision of SFAS No. 162 to have any impact
on the consolidated financial statements.
 
 In
October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active,” (“FSP 157-3”).
FSP 157-3 clarifies the application of SFAS No. 157 in determining the fair
value of a financial asset during periods of inactive markets. FSP 157-3 was
effective as of September 30, 2008 and did not have material impact on the
Company’s 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, 2008, 2007 and 2006 is shown below (in thousands of
dollars):
 
 Year
      Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Investment
      securities, taxable
                    
                    $
                    987
                    
                    
                    $
                    1,314
                    
                    
                    $
                    1,095Investment
      securities, nontaxable
                    
                    
                    129
                    
                    
                    
                    112
                    
                    
                    
                    109
 
 
 The
carrying amount and estimated fair value of securities available for sale at
December 31, 2008 and 2007 are as follows (in thousands of
dollars):
 
 Available
      for Sale SecuritiesAmortized
                    Cost
                  
                  
                  Unrealized
                    Gains
                  
                  
                  Unrealized
                    Losses
                  
                  
                  Fair ValueDecember
      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
                  
                  
                  $
                  21,692December
      31, 2007U.S.
      Treasuries and Agencies
                  
                  $
                  15,040
                  
                  
                  $
                  207
                  
                  
                  $
                  2
                  
                  
                  $
                  15,245Mortgage
      backed securities
                  
                  
                  7,718
                  
                  
                  
                  74
                  
                  
                  
                  8
                  
                  
                  
                  7,784State
      and municipals
                  
                  
                  3,034
                  
                  
                  
                  8
                  
                  
                  
                  3
                  
                  
                  
                  3,039Marketable
      equities
                  
                  
                  28
                  
                  
                  
                  ---
                  
                  
                  
                  6
                  
                  
                  
                  22Total
      Securities Available for Sale
                  
                  $
                  25,820
                  
                  
                  $
                  289
                  
                  
                  $
                  19
                  
                  
                  $
                  26,090
 
  Index
  
 Page
      Forty Four
 
 The
carrying amount and fair value of debt securities at December 31, 2008, 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
                    
                    $
                    749
                    
                    
                    $
                    764Due
      after one year through three years
                    
                    
                    7,024
                    
                    
                    
                    7,168Due
      after three years through five years
                    
                    
                    2,667
                    
                    
                    
                    2,750Due
      after five years through ten years
                    
                    
                    660
                    
                    
                    
                    653Mortgage
      backed securities
                    
                    
                    10,211
                    
                    
                    
                    10,342Equity
      securities with no maturity
                    
                    
                    28
                    
                    
                    
                    15Total
      Securities Available for Sale
                    
                    $
                    21,339
                    
                    
                    $
                    21,692
 
 Securities
having a carrying value of $5,632,000 at December 31, 2008 and $6,859,000 at
December 31, 2007 were pledged to secure public deposits and for other purposes
required by law.
 
 Information
pertaining to securities with gross unrealized losses at December 31, 2008 and
2007, 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, 2008Investment
      CategoryMortgage
      backed securities
                  
                  
                  1,225
                  
                  
                  
                  (17
                  )
                  
                  
                  1,156
                  
                  
                  
                  (16
                  )
                  
                  
                  69
                  
                  
                  
                  (1
                  )State
      and municipals
                  
                  
                  1,908
                  
                  
                  
                  (16
                  )
                  
                  
                  1,708
                  
                  
                  
                  (15
                  )
                  
                  
                  200
                  
                  
                  
                  (1
                  )Other
      equity securities
                  
                  
                  15
                  
                  
                  
                  (13
                  )
                  
                  
                  0
                  
                  
                  
                  0
                  
                  
                  
                  15
                  
                  
                  
                  (13
                  )Total
                  
                  $
                  3,148
                  
                  
                  $
                  (46
                  )
                  
                  $
                  2,864
                  
                  
                  $
                  (31
                  )
                  
                  $
                  284
                  
                  
                  $
                  (15
                  )December
      31, 2007Investment
      CategoryU.S.
      Treasury and Agency
                  
                  $
                  1,497
                  
                  
                  $
                  (2
                  )
                  
                  $
                  0
                  
                  
                  $
                  0
                  
                  
                  $
                  1,497
                  
                  
                  $
                  (2
                  )Mortgage
      backed securities
                  
                  
                  2,574
                  
                  
                  
                  (8
                  )
                  
                  
                  1,005
                  
                  
                  
                  (1
                  )
                  
                  
                  1,569
                  
                  
                  
                  (7
                  )State
      and municipals
                  
                  
                  575
                  
                  
                  
                  (3
                  )
                  
                  
                  0
                  
                  
                  
                  0
                  
                  
                  
                  575
                  
                  
                  
                  (3
                  )Other
      Equity Securities
                  
                  
                  22
                  
                  
                  
                  (6
                  )
                  
                  
                  22
                  
                  
                  
                  (6
                  )
                  
                  
                  0
                  
                  
                  
                  0Total
                  
                  $
                  4,668
                  
                  
                  $
                  (19
                  )
                  
                  $
                  1,027
                  
                  
                  $
                  (7
                  )
                  
                  $
                  3,641
                  
                  
                  $
                  (12
                  )
 
  Index
  
 Page
      Forty Five
 
 The
number of securities available for sale that were in an unrealized loss position
at December 31, 2008 is summarized in the table below:
 
 Total
                  
                  
                  Loss
      Position
                    less
      than 12
                    Months
                  
                  
                  Loss
      Position
                    greater
      than 12
                    MonthsMortgage
      backed securities
                  
                  
                  13
                  
                  
                  
                  9
                  
                  
                  
                  4States
      and municipals
                  
                  
                  5
                  
                  
                  
                  4
                  
                  
                  
                  1Other
      equity securities
                  
                  
                  1
                  
                  
                  
                  0
                  
                  
                  
                  1Total
                  
                  
                  19
                  
                  
                  
                  13
                  
                  
                  
                  6
 
 It is
management’s determination that all securities held at December 31, 2008, 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, 2008 and 2007 are summarized as follows (in
thousands of dollars):
 
 2008
                    
                    
                    2007Commercial
                    
                    $
                    97,709
                    
                    
                    $
                    79,892Real
      Estate Construction
                    
                    
                    27,210
                    
                    
                    
                    15,560Real
      Estate Mortgage
                    
                    
                    156,877
                    
                    
                    
                    169,122Consumer
      Installment
                    
                    
                    43,958
                    
                    
                    
                    45,625Total
      Loans
                    
                    $
                    325,754
                    
                    
                    $
                    310,199
 
 The
following is a summary of information pertaining to impaired and non accrual
loans at December 31, 2008, 2007 and 2006 (in thousands of
dollars):
 
 2008
                    
                    
                    2007
                    
                    
                    2006Year
      end balance, impaired loans
                    
                    $
                    3,841
                    
                    
                    $
                    1,216
                    
                    
                    $
                    1,895Allowance
      for impairments, year end
                    
                    
                    272
                    
                    
                    
                    243
                    
                    
                    
                    720Average
      balance impaired loans, year ended December 31
                    
                    
                    2,333
                    
                    
                    
                    1,995
                    
                    
                    
                    1,773Income
      recorded on impaired loans, year ended December 31
                    
                    
                    179
                    
                    
                    
                    160
                    
                    
                    
                    131
 
 No loans
were identified as impaired as of December 31 2008 or 2007 for which an
allowance was not provided.
 
 Certain
loans identified as impaired are placed into non-accrual status, based upon the
loans’ performance compared with contractual terms. Not all loans identified as
impaired are placed upon non-accrual status. The interest on loans identified as
impaired and also placed in non-accrual status and not recognized as income
throughout the year was of an immaterial amount in both 2008 and
2007.
  Index
  
 Page
      Forty Six
 
 Balances
of non-accrual loans and loans past due ninety days or greater and still
accruing interest at December 31, 2008 and 2007 are shown below (in thousands of
dollars):
 
 2008
                    
                    
                    2007Non-accrual
      loans at year end
                    
                    $
                    1,346
                    
                    
                    $
                    916Loans
      past due ninety days or greater and still accruing interest at year
      end
                    
                    
                    3,472
                    
                    
                    
                    2,244
 
 
 NOTE
      SIX: EARNINGS PER SHARE
 
 During
2007, 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,
2008, 2007 and 2006 is show below (in thousands of dollars):
 
 2008
                  
                  
                  2007
                  
                  
                  2006Balance
      at beginning of year
                  
                  $
                  3,577
                  
                  
                  $
                  3,482
                  
                  
                  $
                  3,129Provision
      charged to operating expenses
                  
                  
                  909
                  
                  
                  
                  837
                  
                  
                  
                  682Loan
      recoveries
                  
                  
                  131
                  
                  
                  
                  339
                  
                  
                  
                  250Loans
      charged off
                  
                  
                  (950
                  )
                  
                  
                  (1,081
                  )
                  
                  
                  (579
                  )Balance
      at end of year
                  
                  $
                  3,667
                  
                  
                  $
                  3,577
                  
                  
                  $
                  3,482Allowance
      for Loan Losses as percentage of outstanding loans at year
    end
                  
                  
                  1.13
                  %
                  
                  
                  1.15
                  %
                  
                  
                  1.19
                  %
 
 
 NOTE
      EIGHT: BANK PREMISES AND EQUIPMENT
 
 Bank
premises and equipment as of December 31, 2008 and 2007 are summarized as
follows (in thousands of dollars):
 2008
                    
                    
                    2007Land
                    
                    $
                    1,528
                    
                    
                    $
                    1,549Buildings
      and improvements
                    
                    
                    8,288
                    
                    
                    
                    7,963Furniture
      and equipment
                    
                    
                    4,915
                    
                    
                    
                    4,789Total
      Cost
                    
                    
                    14,731
                    
                    
                    
                    14,301Less
      accumulated depreciation
                    
                    
                    (6,700
                    )
                    
                    
                    (6,197
                    )Net
      Book Value
                    
                    $
                    8,031
                    
                    
                    $
                    8,104
 
  Index
  
 Page
      Forty Seven
 
 Provisions
for depreciation charged to operations during 2008, 2007 and 2006 were as
follows (in thousands of dollars):
 Year
                  
                  Provision
      for
                    Depreciation2008
                  
                  $
                  7022007
                  
                  
                  7042006
                  
                  
                  691
 
 NOTE
      NINE: RESTRICTIONS ON DIVIDENDS OF SUBSIDIARY
  BANKS
 
 The
principal source of funds of Highlands Bankshares, Inc. is dividends paid by its
subsidiary Banks.  The various regulatory authorities impose
restrictions on dividends paid by a state bank.  A state bank cannot
pay dividends (without the consent of state banking authorities) in excess of
the total net profits (net income less dividends paid) of the current year to
date and the combined retained profits of the previous two years. As of January
1, 2008, the Banks could pay dividends to Highlands Bankshares, Inc. of
approximately $3,238,000 without permission of the regulatory
authorities.
 
 
 NOTE
      TEN: DEPOSITS
 
 At
December 31, 2008, the scheduled maturities of time deposits were as follows (in
thousands of dollars):
 
 Year
                      
                      Amount Maturing2009
                      
                      $
                      134,3942010
                      
                      
                      29,9742011
                      
                      
                      19,1812012
                      
                      
                      8,1962013
                      
                      
                      6,328Total
                      
                      $
                      198,073
 
 Interest
expense on time deposits of $100,000 and over aggregated $2,678,000, $3,078,000
and $2,042,000 for 2008, 2007 and 2006, respectively.
 
 The
aggregate amount of demand deposit overdrafts reclassified as loan balances were
$175,000 and $285,000 at December 31, 2008 and 2007, 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 $325,754,000 and $310,199,000 loans held by the Company at December 31, 2008
and 2007, respectively, $261,289,000 and $240,208,000 are secured by real
estate.
 
 The
Company’s subsidiaries had cash deposited in and federal funds sold to other
commercial banks totaling $764,000 and $16,599,000 at December 31, 2008 and
2007, 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.
  Index
  
 Page
      Forty Eight
 
 NOTE
      TWELVE: TRANSACTIONS WITH RELATED
PARTIES
 
 During
the year, officers and directors (and companies controlled by them) of the
Company and subsidiary Banks were customers of and had transactions with the
subsidiary Banks in the normal course of business.  These transactions
were made on substantially the same terms as those prevailing for other
customers and did not involve any abnormal risk.. The table below summarizes
changes to balances of loans and to unused commitments to related parties during
the years ended December 31, 2008 and 2007 (in thousands of
dollars):
  
  2008
                    
                    
                    2007Loans
      to related parties, beginning of year
                    
                    $
                    5,244
                    
                    
                    $
                    5,143New
      loans
                    
                    
                    3,989
                    
                    
                    
                    719Repayments
                    
                    
                    (841
                    )
                    
                    
                    (617
                    )Loans
      to related parties, end of year
                    
                    $
                    8,392
                    
                    
                    $
                    5,244
 
 At
December 31, 2008, deposits of related parties including directors, executive
officers, and their related interests of Highlands Bankshares, Inc. and
subsidiaries approximated $7,474,000, and at December 31, 2007, deposits of
related parties including directors, executive officers, and their related
interests of Highlands Bankshares, Inc. and subsidiaries approximated
$7,465,000.
 
 
 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 month 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 2009 to 2020.  The
interest rates on the various borrowings at December 31, 2008 range from 3.94%
to 5.96%. The weighted average interest rate on the borrowings at December 31,
2008 was 4.62%.  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, 2008 are as follows (in thousands of dollars):
 
 Year
                        
                        Balance2009
                        
                        $
                        4512010
                        
                        
                        1,4732011
                        
                        
                        1,2552012
                        
                        
                        5,6952013
                        
                        
                        289Thereafter
                        
                        
                        2,154Total
                        
                        $
                        11,317
 
 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.
At December 31, 2008, the Company had balances of $4,800,000 in overnight and
other short term borrowings. All of this short term debt was through the FHLB.
The Company has total borrowing capacity from the FHLB of $171,211,000. The
Banks have pledged certain investments and mortgage loans as collateral on the
FHLB borrowings in the approximate amount of $174,173,000 at December 31,
2008.
 
 The
subsidiary Banks also have short term borrowing capacity from each of their
respective correspondent banks. As of December 31, 2008 the Company has total
borrowing capacity from its correspondent banks of $31,200,000. The interest
rates on these lines are variable and are subject to change daily based on
current market conditions.
  Index
  
 Page
      Forty Nine
 
 NOTE
      FOURTEEN: INCOME TAX EXPENSE
 
 Highlands
files an income tax return in the U.S. federal jurisdiction and an income tax
return in the State of West Virginia. With few exceptions, the Company is no
longer subject to U.S. federal, state or local income tax examinations by tax
authorities for years before 2005.
 
 The
Company adopted the provisions of FASB Interpretations No. 48, Accounting for Uncertainty in Income
Taxes, on January 1, 2007, with no impact on the financial
statements.
 
 Included
in the balance sheet at December 31, 2008 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, 2008, 2007 and
2006 are summarized in the table on the following page (in thousands of
dollars):
 
 2008
                    
                    
                    2007
                    
                    
                    2006Current
      ExpenseFederal
                    
                    $
                    2,433
                    
                    
                    $
                    2,400
                    
                    
                    $
                    2,154State
                    
                    
                    370
                    
                    
                    
                    330
                    
                    
                    
                    352Total
      Current Expense
                    
                    
                    2,803
                    
                    
                    
                    2,730
                    
                    
                    
                    2,506Deferred
      Expense (Benefit)Federal
                    
                    
                    (60
                    )
                    
                    
                    (121
                    )
                    
                    
                    (107
                    )State
                    
                    
                    (5
                    )
                    
                    
                    (10
                    )
                    
                    
                    (8
                    )Total
      Current Expense (Benefit)
                    
                    
                    (65
                    )
                    
                    
                    (131
                    )
                    
                    
                    (115
                    )Income
      Tax Expense
                    
                    $
                    2,738
                    
                    
                    $
                    2,599
                    
                    
                    $
                    2,391
 
 The
deferred tax effects of temporary differences for the years ended December 31,
2008, 2007 and 2006 are as follows (in thousands of dollars):
 
 2008
                    
                    
                    2007
                    
                    
                    2006Provision
      for loan losses
                    
                    $
                    (61
                    )
                    
                    $
                    (18
                    )
                    
                    $
                    (140
                    )Depreciation
                    
                    
                    13
                    
                    
                    
                    (45
                    )
                    
                    
                    (45
                    )Deferred
      compensation
                    
                    
                    18
                    
                    
                    
                    (59
                    )
                    
                    
                    (39
                    )Loss
      carry forward
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    71Miscellaneous
                    
                    
                    (35
                    )
                    
                    
                    (9
                    )
                    
                    
                    38Net
      increase in deferred income tax benefit
                    
                    $
                    (65
                    )
                    
                    $
                    (131
                    )
                    
                    $
                    (115
                    )
 
 
  Index
  
 Page
      Fifty
 
 The net
deferred tax assets arising from temporary differences as of December 31, 2008
and 2007 are shown in the table on the following page (in thousands of
dollars):
 
 2008
                    
                    
                    2007Deferred
      Tax AssetsProvision
      for loan losses
                    
                    $
                    1,086
                    
                    
                    $
                    1,022Insurance
      commissions
                    
                    
                    35
                    
                    
                    
                    41Deferred
      compensation
                    
                    
                    932
                    
                    
                    
                    870Pension
      obligation
                    
                    
                    677
                    
                    
                    
                    175Other
                    
                    
                    0
                    
                    
                    
                    16Total
      Assets
                    
                    
                    2,730
                    
                    
                    
                    2,124Deferred
      Tax LiabilitiesAccretion
      income
                    
                    
                    9
                    
                    
                    
                    70Unrealized
      gain on securities available for sale
                    
                    
                    131
                    
                    
                    
                    101Depreciation
                    
                    
                    362
                    
                    
                    
                    352Other
                    
                    
                    6
                    
                    
                    
                    0Total
      Liabilities
                    
                    
                    508
                    
                    
                    
                    523Net
      Deferred Tax Asset
                    
                    $
                    2,222
                    
                    
                    $
                    1,601
 
 The
following table summarizes the differences between income tax expense and the
amount computed by applying the federal statutory rate for the three years ended
December 31, 2008, 2007 and 2006 (in thousands of dollars):
 
 2008
                    
                    
                    2007
                    
                    
                    2006Amounts
      at federal statutory rates
                    
                    $
                    2,621
                    
                    
                    $
                    2,466
                    
                    
                    $
                    2,348Additions
      (reductions) resulting from:Tax
      exempt income
                    
                    
                    (64
                    )
                    
                    
                    (63
                    )
                    
                    
                    (50
                    )Partially
      exempt income
                    
                    
                    (34
                    )
                    
                    
                    (25
                    )
                    
                    
                    (40
                    )State
      income taxes, net
                    
                    
                    233
                    
                    
                    
                    222
                    
                    
                    
                    178Income
      from life insurance contracts
                    
                    
                    (87
                    )
                    
                    
                    (143
                    )
                    
                    
                    (91
                    )Non
      deductible income related to branch acquisitions
                    
                    
                    66
                    
                    
                    
                    68
                    
                    
                    
                    3Other
                    
                    
                    3
                    
                    
                    
                    (16
                    )
                    
                    
                    (22
                    )Income
      tax expense
                    
                    $
                    2,738
                    
                    
                    $
                    2,599
                    
                    
                    $
                    2,391
 
 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 $866,000 in 2008,
$762,000 in 2007 and $832,000 in 2006.
  Index
  
 Page
      Fifty One
 
 Capon Valley
Bank
 
 Capon has
a defined contribution pension plan with 401(k) features that is funded with
discretionary contributions. Capon matches on a limited basis the contributions
of the employees. Investment of employee balances is done through the direction
of each employee. Employer contributions are vested over a six-year
period.
 
 The Grant County
Bank
 
 Grant is
a member of the West Virginia Bankers’ Association Retirement Plan (the “Plan”).
This Plan is a defined benefit plan with benefits under the Plan based on
compensation and years of service with full vesting after seven years of
service. Prior to 2002, the Plan’s assets were in excess of the projected
benefit obligations and thus Grant was not required to make contributions to the
Plan. Since 2004, Grant has been required to make contributions and has an
expected contribution in 2009 of $589,570. At December 31, 2008, Grant has
recognized liabilities of $1,842,000 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 $1,455,000 (net of $854,000 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, 2008 and 2007 using a
measurement date of December 31, 2008 and November 1, 2007 respectively (in
thousands of dollars):
 
 2008
                          
                          
                          2007Change in Benefit
ObligationBenefit
      obligation, beginning
                          
                          $
                          3,859
                          
                          
                          $
                          3,527Service
      Cost
                          
                          
                          179
                          
                          
                          
                          131Interest
      Cost
                          
                          
                          283
                          
                          
                          
                          192Actuarial
      Loss (Gain)
                          
                          
                          260
                          
                          
                          
                          (52
                          )Benefits
      Paid
                          
                          
                          (89
                          )
                          
                          
                          (54
                          )Benefit
      obligation, ending
                          
                          $
                          4,492
                          
                          
                          $
                          3,859Accumulated
      Benefit Obligation
                          
                          $
                          3,858
                          
                          
                          $
                          3,310Change in Plan AssetsFair
      value of assets, beginning
                          
                          $
                          3,335
                          
                          
                          $
                          2,861Actual
      return on assets, net of administrative expenses
                          
                          
                          (1,042
                          )
                          
                          
                          433Employer
      contributions
                          
                          
                          446
                          
                          
                          
                          139Benefits
      paid
                          
                          
                          (89
                          )
                          
                          
                          (99
                          )Fair
      value of assets, ending
                          
                          $
                          2,650
                          
                          
                          $
                          3,334Funded StatusFair
      value of plan assets
                          
                          $
                          2,650
                          
                          
                          $
                          3,334Projected
      benefit obligation
                          
                          
                          4,492
                          
                          
                          
                          3,859Funded
      status
                          
                          
                          (1,842
                          )
                          
                          
                          (478
                          )Liabilities
      Recognized in the Statement of Financial Position
                          
                          $
                          (1,842
                          )
                          
                          $
                          (478
                          )Amounts
      Recognized in Accumulated Other Comprehensive IncomePrior
      Service Cost
                          
                          $
                          0
                          
                          
                          $
                          3Net
      (Gain)/Loss
                          
                          
                          2,310
                          
                          
                          
                          720Total
                          
                          $
                          2,310
                          
                          
                          $
                          723
 
  Index
  
 Page
      Fifty Two
 
 The
following table provides the components of the net periodic pension expense for
the Plan for the years ended December 31, 2008, 2007 and 2006 (in thousands of
dollars):
 
 2008
                    
                    
                    2007
                    
                    
                    2006Service
      cost
                    
                    $
                    154
                    
                    
                    $
                    139
                    
                    
                    $
                    131Interest
      cost
                    
                    
                    243
                    
                    
                    
                    221
                    
                    
                    
                    192Expected
      return on plan assets
                    
                    
                    (294
                    )
                    
                    
                    (235
                    )
                    
                    
                    (212
                    )Recognized
      net actuarial loss
                    
                    
                    47
                    
                    
                    
                    66
                    
                    
                    
                    61Amortization
      of prior service cost
                    
                    
                    3
                    
                    
                    
                    11
                    
                    
                    
                    11Adjustment
      due to change in measurement date
                    
                    
                    25
                    
                    
                    
                    0
                    
                    
                    
                    0Net
      Periodic Pension Expense
                    
                    $
                    178
                    
                    
                    $
                    202
                    
                    
                    $
                    183
 
 The
expected pension expense for 2008 is $210,000.
 
 The table
below summarizes the benefits expected to be paid to participants in the plan
(in thousands of dollars):
 
 Year
                  
                  Expected
      Benefit
                    Payments2009
                  
                  $
                  1562010
                  
                  
                  1632011
                  
                  
                  1862012
                  
                  
                  2022013
                  
                  
                  243Years
      2014 – 2018
                  
                  
                  1,635
 
 The
weighted average assumption used in the measurement of Grant’s benefit
obligation and net periodic pension expense is as follows:
 
 2008
                          
                          2007
                          
                          2006Discount
      rate
                          
                          
                          6.25
                          %
                          
                          
                          6.00
                          %
                          
                          
                          5.75
                          %Expected
      return on plan assets
                          
                          
                          8.00
                          %
                          
                          
                          8.50
                          %
                          
                          
                          8.50
                          %Rate
      of compensation increase
                          
                          
                          3.00
                          %
                          
                          
                          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,
2008 and 2007:
 
 2008
                        
                        2007Equity
      Securities
                        
                        
                        64
                        %
                        
                        
                        67
                        %Debt
      Securities
                        
                        
                        30
                        %
                        
                        
                        28
                        %Other
                        
                        
                        6
                        %
                        
                        
                        5
                        %
 
  Index
  
 Page
      Fifty Three
 
 
 
 The trust
fund is sufficiently diversified to maintain a reasonable level of risk without
imprudently sacrificing return. The targeted asset allocation and allowable
range of allocation is set forth in the table below:
 
 Target Allocation
                    Allowable Allocation
  RangeEquity
      Securities
                    70%
                    40%-80%Debt
      Securities
                    25%
                    20%-40%Other
                    5%
                    3%-10%
 
 The
Investment Manager selects investment fund managers with demonstrated experience
and expertise, and funds with demonstrated historical performance, for the
implementation of the Plan’s investment strategy.  The Investment
Manager will consider both actively and passively managed investment strategies
and will allocate funds across the asset classes to develop an efficient
investment structure.
 
 The Grant
County Bank also maintains a profit sharing plan covering substantially all
employees to which contributions are made at the discretion of the board of
directors.  Portions of employer contributions to this plan are, at
individual employees’ discretion, available to employees as immediate cash
payment while portions are allocated for deferred payment to the employee. The
portions of the plan contribution by the employer which are allocated for
deferred payment to the employee are vested over a five year
period.
 
 
 NOTE
      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.
 
 As of
December 31, 2008 and 2007, the Banks had outstanding the following commitments
(in thousands of dollars):
 
 2008
                    
                    
                    2007Commitments
      to extend credit
                    
                    $
                    24,204
                    
                    
                    $
                    20,536Standby
      letter of credit
                    
                    
                    836
                    
                    
                    
                    709
 
  Index
  
 Page
      Fifty Four
 
 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, 2008, 2007 and 2006 are as follows (in thousands of
dollars):
 
 2008
                  
                  
                  2007
                  
                  
                  2006Balance
      January 1
                  
                  $
                  (285
                  )
                  
                  $
                  (586
                  )
                  
                  $
                  (505
                  )Unrealized
      holding gains (losses) on available for sale securities net of income
      taxes of $31,000 for 2008, $101,000 for 2007 and $50,000 for
      2006
                  
                  
                  52
                  
                  
                  
                  173
                  
                  
                  
                  86Accrued
      pension obligation net of income taxes of $587,000 for 2008, $(76,000) for
      2007 and $97,000 for 2006
                  
                  
                  (999
                  )
                  
                  
                  128
                  
                  
                  
                  (167
                  )Net
      change for the year
                  
                  
                  (947
                  )
                  
                  
                  301
                  
                  
                  
                  (81
                  )Balance
      December 31
                  
                  $
                  (1,232
                  )
                  
                  $
                  (285
                  )
                  
                  $
                  (586
                  )
 
 
 NOTE
      EIGHTEEN: ADJUSTMENT TO RETAINED EARNINGS FOR CHANGE IN ACCOUNTINGPRINCIPLE
 
 In 2006,
the FASB issued EITF 06-04 and EITF 06-10. These EITF pronouncements require
that companies which own life insurance policies insuring employees and for
which the employees receive a portion of the death benefits of the policies
(commonly referred to as “split dollar” policies) and for which these death
benefits to the employee continue post retirement record a liability for the
present value of the cost of these post retirement death benefits. These EITF
pronouncements became effective for Highlands Bankshares on January 1,
2008.
 
 These
EITF 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. Highlands Bankshares 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
Statement of Changes in Stockholders’ Equity.
 
 NOTE
      NINETEEN: FAIR VALUE MEASUREMENTS
  SFAS
No. 157, Fair Value
Measurements, defines fair value, establishes a framework for measuring
fair value, establishes a three-level valuation hierarchy for disclosure of fair
value measurement and enhances disclosure requirements for fair value
measurements. The valuation hierarchy is based upon the transparency of inputs
to the valuation of an asset or liability as of the measurement date. 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:
 
  Index
  
 Page
      Fifty Five
  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
  SFAS No.
157 applies to loans measured for impairment using the practical expedients
permitted by SFAS No. 114, Accounting by Creditors for
Impairment of a Loan, 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, 2008, the Company had identified $3,841,000 in
impaired loans (see Note Five).
  Other Real Estate
Owned
  Certain
assets such as other real estate owned (OREO) are measured at fair value less
cost to sell. We believe that the fair value component in its valuation follows
the provisions of SFAS No. 157.
 
 The
Company, at December 31, 2008, had no liabilities subject to fair value
reporting requirements. The table below summarizes assets at December 31, 2008
measured at fair value on a recurring basis (in thousands of
dollars):
 
 Level 1
                  
                  
                  Level 2
                  
                  
                  Level 3
                  
                  
                  Total
      Fair
                    Value
                    MeasurementsSecurities
      available for sale
                  
                  $
                  0
                  
                  
                  $
                  21,692
                  
                  
                  $
                  0
                  
                  
                  $
                  21,692Impaired
      Loans
                  
                  
                  0
                  
                  
                  
                  3,841
                  
                  
                  
                  0
                  
                  
                  
                  3,841Total
                  
                  $
                  0
                  
                  
                  $
                  25,533
                  
                  
                  $
                  0
                  
                  
                  $
                  25,533
 
 In
February 2008, the FASB issued Staff Position No. 157-2 (“FSP 157-2”) which
delayed the effective date of SFAS 157 for certain nonfinancial assets and
nonfinancial liabilities except for those items that are recognized or disclosed
at fair value in the financial statements on a recurring basis.  FSP
157-2 defers the effective date of SFAS 157 for such nonfinancial assets and
nonfinancial liabilities to fiscal years beginning after November 15, 2008, and
interim periods within those fiscal years.  Thus, the Corporation has
only partially applied SFAS 157.  Those items affected by FSP 157-2
include other real estate owned (“OREO”), goodwill and core deposit
intangibles.
 
 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. SFAS 107,Disclosures about Fair Value of
Financial Instrument, requires disclosure relating to these market
values. 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.
 
  Index
  
 Page
      Fifty Six
 
 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.
 
 Securities
 Fair
values of securities are based on quoted market prices or dealer
quotes.  If a quoted market price is not available, fair value is
estimated using quoted market prices for similar securities.
 
 Restricted
Investments
 The
carrying amount of restricted investments is a reasonable estimate of fair
value.
 
 Loans
 The fair
value of loans is estimated by discounting the future cash flows using the
current rates at which similar loans would be made to borrowers with similar
credit ratings and for the same remaining maturities, taking into consideration
the credit risk in various loan categories.
 
 Deposits
 The fair
value of demand, interest checking, regular savings and money market deposits is
the amount payable on demand at the reporting date.  The fair value of
fixed maturity certificates of deposit is estimated using the rates currently
offered for deposits of similar remaining maturities.
 
 Long Term
Debt
 The fair
value of fixed rate loans is estimated using the rates currently offered by the
Federal Home Loan Bank for indebtedness with similar maturities.
 
 Short Term
Debt
 The fair
value of short-term variable rate debt is deemed to be equal to the carrying
value.
 
 Interest Payable and
Receivable
 The
carrying value of amounts of interest receivable and payable is a reasonable
estimate of fair value.
  Life
Insurance
 The
carrying amount of life insurance contracts is assumed to be a reasonable fair
value. Life insurance contracts are carried on the balance sheet at their
redemption value as of December 31, 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, 2008 or 2007.
  Index
  
 Page
      Fifty Seven
 
 The
carrying amount and estimated fair values of financial instruments as of
December 31, 2008 and 2007 are shown in the table below (in thousands of
dollars):
 
 2008
                  
                  
                  2007Carrying
                    Amount
                  
                  
                  Estimated
                    Fair Value
                  
                  
                  Carrying
                    Amount
                  
                  
                  Estimated
                    Fair ValueFinancial
      Assets:Cash
      and due from banks
                  
                  $
                  7,589
                  
                  
                  $
                  7,589
                  
                  
                  $
                  7,935
                  
                  
                  $
                  7,935Interest
      bearing deposits
                  
                  
                  502
                  
                  
                  
                  502
                  
                  
                  
                  1,853
                  
                  
                  
                  1,853Federal
      funds sold
                  
                  
                  160
                  
                  
                  
                  160
                  
                  
                  
                  14,246
                  
                  
                  
                  14,246Securities
      available for sale
                  
                  
                  21,692
                  
                  
                  
                  21,692
                  
                  
                  
                  26,090
                  
                  
                  
                  26,090Restricted
      investments
                  
                  
                  2,177
                  
                  
                  
                  2,177
                  
                  
                  
                  1,498
                  
                  
                  
                  1,498Loans,
      net
                  
                  
                  322,087
                  
                  
                  
                  323,788
                  
                  
                  
                  310,199
                  
                  
                  
                  311,217Interest
      receivable
                  
                  
                  2,164
                  
                  
                  
                  2,164
                  
                  
                  
                  2,273
                  
                  
                  
                  2,273Life
      insurance contracts
                  
                  
                  6,499
                  
                  
                  
                  6,499
                  
                  
                  
                  6,300
                  
                  
                  
                  6,300Financial
      Liabilities:Demand
      and savings deposits
                  
                  
                  118,214
                  
                  
                  
                  118,214
                  
                  
                  
                  122,341
                  
                  
                  
                  122,341Time
      deposits
                  
                  
                  198,073
                  
                  
                  
                  200,970
                  
                  
                  
                  201,397
                  
                  
                  
                  203,414Overnight
      and other short term debt instruments
                  
                  
                  4,800
                  
                  
                  
                  4,800Long
      term debt instruments
                  
                  
                  11,317
                  
                  
                  
                  11,930
                  
                  
                  
                  11,819
                  
                  
                  
                  11,921Interest
      payable
                  
                  
                  848
                  
                  
                  
                  848
                  
                  
                  
                  1,132
                  
                  
                  
                  1,132
 
 
 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, 2008 and December 31, 2007 are shown in
the table below (in thousands of dollars):
 
 2008
                    
                    
                    2007Balance,
      beginning of period
                    
                    $
                    6,300
                    
                    
                    $
                    6,066Increases
      in value of policies
                    
                    
                    252
                    
                    
                    
                    234Settlement
      payout
                    
                    
                    (53
                    )
                    
                    
                    0Balance,
      end of period
                    
                    $
                    6,499
                    
                    
                    $
                    6,300
 
  Index
  
 Page
      Fifty Eight
 
 
 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, 2008 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.
 
 The
actual and required capital amounts and ratios of the Company and its subsidiary
banks at December 31, 2008 are 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
                        %
 
  Index
  
 Page
      Fifty Nine
 
 The
actual and required capital amounts and ratios of the Company and its subsidiary
banks at December 31, 2007 is presented in the following table (in thousands of
dollars):
 
 December
      31, 2007Regulatory
      RequirementsActual
                            
                            
                            Adequately
      Capitalized
                            
                            
                            Well
      CapitalizedAmount
                            
                            
                            Percentage
                            
                            
                            Amount
                            
                            
                            Percentage
                            
                            
                            Amount
                            
                            
                            PercentageTotal Risk Based Capital
    RatioHighlands
      Bankshares
                            
                            $
                            41,329
                            
                            
                            
                            14.53
                            %
                            
                            $
                            22,754
                            
                            
                            
                            8.00
                            %Capon
      Valley Bank
                            
                            
                            15,334
                            
                            
                            
                            14.78
                            %
                            
                            
                            8,299
                            
                            
                            
                            8.00
                            %
                            
                            $
                            10,374
                            
                            
                            
                            10.00
                            %The
      Grant County Bank
                            
                            
                            23,877
                            
                            
                            
                            13.23
                            %
                            
                            
                            14,437
                            
                            
                            
                            8.00
                            %
                            
                            
                            18,047
                            
                            
                            
                            10.00
                            %Tier 1 Leverage RatioHighlands
      Bankshares
                            
                            
                            37,773
                            
                            
                            
                            9.95
                            %
                            
                            
                            15,185
                            
                            
                            
                            4.00
                            %Capon
      Valley Bank
                            
                            
                            14,035
                            
                            
                            
                            10.00
                            %
                            
                            
                            5,611
                            
                            
                            
                            4.00
                            %
                            
                            
                            7,014
                            
                            
                            
                            5.00
                            %The
      Grant County Bank
                            
                            
                            21,816
                            
                            
                            
                            9.09
                            %
                            
                            
                            9,598
                            
                            
                            
                            4.00
                            %
                            
                            
                            11,997
                            
                            
                            
                            5.00
                            %Tier 1 Risk Based Capital
    RatioHighlands
      Bankshares
                            
                            
                            37,773
                            
                            
                            
                            13.28
                            %
                            
                            
                            11,377
                            
                            
                            
                            4.00
                            %Capon
      Valley Bank
                            
                            
                            14,035
                            
                            
                            
                            13.53
                            %
                            
                            
                            4,150
                            
                            
                            
                            4.00
                            %
                            
                            
                            6,225
                            
                            
                            
                            6.00
                            %The
      Grant County Bank
                            
                            
                            21,816
                            
                            
                            
                            12.09
                            %
                            
                            
                            7,219
                            
                            
                            
                            4.00
                            %
                            
                            
                            10,828
                            
                            
                            
                            6.00
                            %
 
 
 NOTE
      TWENTY TWO: INTANGIBLE ASSETS
 
 The
Company’s balance sheet contains several components of intangible assets. At
December 31, 2008, 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.
 
 During
the fourth quarter of 2007, The Grant County Bank entered into an agreement to
contribute $250,000 toward the erection of a performing arts center located
within the Company’s primary business area. In return, the bank has been granted
naming rights for this performing arts center. 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, 2008, 2007 and 2006 is shown below (in thousands of
dollars):
 
 2008
                    
                    
                    2007
                    
                    
                    2006Balance
      beginning of period
                    
                    $
                    3,106
                    
                    
                    $
                    3,032
                    
                    
                    $
                    3,208Amortization
      of intangible assets
                    
                    
                    (182
                    )
                    
                    
                    (176
                    )
                    
                    
                    (176
                    )Purchase
      of naming rights contract
                    
                    
                    75
                    
                    
                    
                    250
                    
                    
                    
                    0Cancellation
      of naming rights contract
                    
                    
                    (250
                    )
                    
                    
                    0
                    
                    
                    
                    0Balance
      end of period
                    
                    $
                    2,749
                    
                    
                    $
                    3,106
                    
                    
                    $
                    3,032
 
  Index
  
 Page
      Sixty
 
 The
expected amortization of the intangible balances at December 31, 2008 for the
next five years is summarized in the table below (in thousands of
dollars):
 
 Year
                        
                        Expected Expense2009
                        
                        $
                        1952010
                        
                        
                        1902011
                        
                        
                        1842012
                        
                        
                        1782013
                        
                        
                        165Total
                        
                        $
                        912
 
 
 NOTE
      TWENTY THREE: SUBSEQUENT EVENTS
 
 On
January 30, 2009, Capon Valley Bank, a subsidiary of Highlands Bankshares, Inc.
purchased real estate and an existing building at 5511 Main St., Stephens City,
VA. The building, with 3,600 square foot of capacity, was formerly occupied as a
branch by another commercial bank. The total purchase price of the real estate
and building was $1,075,000. Capon Valley Bank intends to, in the future, use
this location as a full service branch of the bank, pending approval of
applicable regulatory authorities.
 
 
 NOTE
      TWENTY FOUR: PARENT COMPANY FINANCIAL
STATEMENTS
 
 Balance
      Sheets(in
      thousands of dollars)December
      31,2008
                  
                  
                  2007AssetsCash
                  
                  $
                  182
                  
                  
                  $
                  112Investment
      in subsidiaries
                  
                  
                  38,994
                  
                  
                  
                  40,142Income
      taxes receivable
                  
                  
                  261
                  
                  
                  
                  276Other
      assets
                  
                  
                  34
                  
                  
                  
                  63Total
      Assets
                  
                  $
                  39,471
                  
                  
                  $
                  40,593LiabilitiesAccrued
      expenses
                  
                  $
                  72
                  
                  
                  $
                  0Other
      liabilities
                  
                  
                  0
                  
                  
                  
                  0Total
      Liabilities
                  
                  
                  72
                  
                  
                  
                  0Stockholders’
      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 at December 31, 2008
                  
                  
                  (3,372
                  )
                  
                  
                  0Retained
      earnings
                  
                  
                  35,157
                  
                  
                  
                  32,032Other
      accumulated comprehensive income
                  
                  
                  (1,232
                  )
                  
                  
                  (285
                  )Total
      Stockholders’ Equity
                  
                  
                  39,399
                  
                  
                  
                  40,593Total
      Liabilities and Stockholders’ Equity
                  
                  $
                  39,471
                  
                  
                  $
                  40,593
 
  Index
  
 Page
      Sixty One
 
 Statements
      of Income and Retained Earnings(in
      thousands of dollars)2008
                    
                    
                    2007
                    
                    
                    2006IncomeDividends
      from subsidiaries
                    
                    $
                    5,142
                    
                    
                    $
                    1,637
                    
                    
                    $
                    1,651Management
      fees from subsidiaries
                    
                    
                    212
                    
                    
                    
                    204
                    
                    
                    
                    240Other
      income
                    
                    
                    25
                    
                    
                    
                    0
                    
                    
                    
                    0Total
      Income
                    
                    
                    5,379
                    
                    
                    
                    1,841
                    
                    
                    
                    1,891ExpensesSalary
      and benefits expense
                    
                    
                    361
                    
                    
                    
                    358
                    
                    
                    
                    302Professional
      fees
                    
                    
                    137
                    
                    
                    
                    175
                    
                    
                    
                    191Directors
      fees
                    
                    
                    79
                    
                    
                    
                    73
                    
                    
                    
                    74Other
      expenses
                    
                    
                    165
                    
                    
                    
                    131
                    
                    
                    
                    70Total
      Expenses
                    
                    
                    742
                    
                    
                    
                    737
                    
                    
                    
                    637Net
      income before income tax benefit and undistributed subsidiary net
      income
                    
                    
                    4,637
                    
                    
                    
                    1,104
                    
                    
                    
                    1,254Income
      tax benefit
                    
                    
                    198
                    
                    
                    
                    211
                    
                    
                    
                    162Income
      before undistributed subsidiary net income
                    
                    
                    4,835
                    
                    
                    
                    1,315
                    
                    
                    
                    1,416Undistributed
      subsidiary net income
                    
                    
                    135
                    
                    
                    
                    3,338
                    
                    
                    
                    3,099Net
      Income
                    
                    $
                    4,970
                    
                    
                    $
                    4,653
                    
                    
                    $
                    4,515Retained
      earnings, beginning of period
                    
                    $
                    32,032
                    
                    
                    $
                    28,816
                    
                    
                    $
                    25,651Cumulative
      effect adjustment to retained earnings for change in accounting
      principle
                    
                    
                    (348
                    )
                    
                    
                    0
                    
                    
                    
                    0Dividends
      paid in cash
                    
                    
                    (1,497
                    )
                    
                    
                    (1,437
                    )
                    
                    
                    (1,350
                    )Net
      income
                    
                    
                    4,970
                    
                    
                    
                    4,653
                    
                    
                    
                    4,515Retained
      earnings, end of period
                    
                    $
                    35,157
                    
                    
                    $
                    32,032
                    
                    
                    $
                    28,816
 
  Index
  
 Page
      Sixty Two
 
 
 Statements
      of Cash Flows(in
      thousands of dollars)Years
      Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006Cash
      Flows From Operating ActivitiesNet
      Income
                  
                  $
                  4,970
                  
                  
                  $
                  4,653
                  
                  
                  $
                  4,515Adjustments
      to net incomeUndistributed
      subsidiary income
                  
                  
                  (135
                  )
                  
                  
                  (3,338
                  )
                  
                  
                  (3,099
                  )Gain
      on sale of fixed assets
                  
                  
                  (25
                  )
                  
                  
                  0
                  
                  
                  
                  0Deferred
      tax benefit
                  
                  
                  (3
                  )
                  
                  
                  0
                  
                  
                  
                  0Depreciation
      and amortization
                  
                  
                  0
                  
                  
                  
                  8
                  
                  
                  
                  7Increase
      (decrease) in payables
                  
                  
                  72
                  
                  
                  
                  (176
                  )
                  
                  
                  126(Increase)
      decrease in receivables
                  
                  
                  15
                  
                  
                  
                  (271
                  )
                  
                  
                  24(Increase)
      decrease in other assets
                  
                  
                  10
                  
                  
                  
                  (36
                  )
                  
                  
                  (1
                  )Net
      Cash Provided by Operating Activities
                  
                  
                  4,904
                  
                  
                  
                  840
                  
                  
                  
                  1,572Cash
      Flows From Investing ActivitiesNet
      advances from (payments to) subsidiaries
                  
                  
                  (11
                  )
                  
                  
                  523
                  
                  
                  
                  (188
                  )Proceeds
      from sale of fixed assets
                  
                  
                  46
                  
                  
                  
                  0
                  
                  
                  
                  0Purchase
      of fixed assets
                  
                  
                  (0
                  )
                  
                  
                  (1
                  )
                  
                  
                  (1
                  )Net
      Cash Provided by (used in) Investing Activities
                  
                  
                  35
                  
                  
                  
                  522
                  
                  
                  
                  (189
                  )Cash
      Flows From Financing ActivitiesPurchase
      of treasury stock
                  
                  
                  (3,372
                  )
                  
                  
                  0
                  
                  
                  
                  0Dividends
      paid in cash
                  
                  
                  (1,497
                  )
                  
                  
                  (1,437
                  )
                  
                  
                  (1,350
                  )Net
      Cash Used in Financing Activities
                  
                  
                  (4,869
                  )
                  
                  
                  (1,437
                  )
                  
                  
                  (1,350
                  )Net
      Increase (Decrease) in Cash
                  
                  
                  70
                  
                  
                  
                  (75
                  )
                  
                  
                  33Cash,
      beginning of year
                  
                  
                  112
                  
                  
                  
                  187
                  
                  
                  
                  154Cash,
      end of year
                  
                  $
                  182
                  
                  
                  $
                  112
                  
                  
                  $
                  187
 
 
  Index
  
 Page
      Sixty Three
 
 
 
  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, 2008 and 2007, and the related consolidated statements of income,
stockholders' equity and cash flows for each of the years in the three-year
period ended December 31, 2008.  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, 2008 and 2007, and the results of their operations and their cash
flows for each of the years in the three-year period ended December 31, 2008 in
conformity with accounting principles generally accepted in the United States of
America.
 
 As discussed in Notes two and fifteen
to the consolidated financial statements, Highlands Bankshares, Inc. changed its
policy for accounting for its defined benefit pension plan in 2006 to conform
with Statement of Financial Accounting Standards No. 158.  As
discussed in Notes Two and 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 23,
2009
 
 
 
 
  Index
  
 Page
      Sixty Four
 
 
 MANAGEMENT’S
REPORT ON INTERNAL CONTROLS
 
 
 Highlands
Bankshares, Inc. is responsible for the preparation, integrity, and fair
presentation of the consolidated financial statements included in this annual
report. The consolidated financial statements and notes included in this annual
report have been prepared in conformity with United States generally accepted
accounting principles and necessarily include some amounts that are based on
management’s best estimates and judgments.
  The
management of Highland’s Bankshares, Inc. and its wholly owned subsidiaries is
responsible for establishing and maintaining adequate internal control over
financial reporting as defined in Rule 13a-15(f) of the Exchange Act. Because of
its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements or may not prevent the possibility that a
control can be circumvented or overriddenAlso,
projections of any evaluation of effectiveness to future periods are subject to
the risk that controls may become inadequate because of changes in conditions,
or that the degree of compliance with the policies or procedures may
deteriorate.
  Management
assessed the effectiveness of the Company’s internal control over financial
reporting as of December 31, 2008. 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,
2008.
 
 
 /s/ C.E. PorterC.E.
      PorterChief
      Executive OfficerMarch
      23, 2009
 
 
 /s/ R. Alan MillerR.
      Alan MillerPrincipal
      Financial OfficerMarch
      23, 2009
 
 
 
 
  Index
  
 Page
      Sixty Five
 
 
 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 Principal Financial Officer, has evaluated the effectiveness of the
Company’s disclosure controls and procedures as of December 31, 2008. Based on
this evaluation, the Company’s Chief Executive Officer and 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.
 
 This
Annual Report does not include an attestation report of the Company’s registered
public accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by the
Company’s registered public accounting firm pursuant to temporary rules of the
Securities and Exchange Commission that permit the Company to provide only
management’s report in the Annual Report.
 
 Changes in Internal
Controls
  During
the period reported upon, there were no significant changes in internal controls
of Highlands Bankshares, Inc. pertaining to its financial reporting and control
of its assets or in other factors that materially affected or are reasonably
likely to materially affect such control.
 
 
 Item9B.
              Other
      Information
 
 None.
 
 
 Item 10.
              Directors,
      Executive Officers and Corporate
Governance
 
 Information
required by this item is set forth as portions of our 2009 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 2009 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, Principal 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, Principal 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’ps Chief
Executive Officer, Chief Financial Officer or Chief Accounting
Officer.
 
  Index
  
 Page
      Sixty Six
 
 Item 11.
              Executive
      Compensation
 
 Information
required by this item is set forth under the caption “EXECUTIVE COMPENSATION” of
our 2009 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 2009 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 2009 Proxy Statement, to be filed within 120 days after the
end of the Company’s fiscal year end, and is incorporated herein by
reference.
 
 Most of
the directors, limited liability companies of which they may be members,
partnerships of which they may be general partners and corporations of which
they are officers or directors, maintain normal banking relationships with the
Bank.  Loans made by the Bank to such persons or other entities were
made in the ordinary course of business, were made, at the date of inception, on
substantially the same terms, including interest rates and collateral, as those
prevailing at the time for comparable transactions with other persons, and did
not involve more than normal risk of collectibility or present other unfavorable
features.  See Note Twelve of the consolidated financial
statements.
 
 Director
John Van Meter is a partner with the law firm of VanMeter and VanMeter, which
has been retained by the Company as legal counsel, and it is anticipated that
the relationship will continue.  Director Jack H. Walters is a partner
with the law firm of Walters, Krauskopf & Baker, which provides legal
counsel to the Company, and it is anticipated that the relationship will
continue.
 
 
 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 2009
Proxy Statement, to be filed within 120 days after the end of the Company’s
fiscal year end, and is incorporated herein by reference.
  Index
  
 Page
      Sixty Seven
 
 
 PART IV.
 
 Item15.
              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
 
 
 
 
 
 
 
 
 
 
  Index
  
 Page
      Sixty EightSignatures
 
 Pursuant
to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of
1934, the registrant has duly cause this report to be signed on its behalf by
the undersigned, thereunto duly authorized.
 
 HIGHLANDS
BANKSHARES, INC.
 
 /s/ C.E. Porter
                
                /s/ R. Alan MillerC.E.
      Porter
                
                R.
      Alan MillerPresident
      & Chief Executive Officer
                Principal
      Financial OfficerDate:  March
      23, 2009
                
                Date:
      March 23, 2009
 
 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
                      _____________________________
                      DirectorAlan
      L. Brill
                      /s/
      Alan L. Brill
                      Director;
                        Secretary
                      March
      23, 2009Jack
      H. Walters
                      /s/
      Jack H. Walters
                      Director
                      March
      23, 2009Thomas
      B. McNeill, Sr.
                      /s/
      Thomas B. McNeill, Sr.
                      Director
                      March
      23, 2009Morris
      M. Homan
                      /s/
      Morris M. Homan
                      Director
                      March
      23, 2009Kathy
      G. Kimble
                      /s/
      Kathy G. Kimble
                      Director
                      March
      23, 2009Steven
      C. Judy
                      /s/
      Steven C. Judy
                      Director
                      March
      23, 2009C.E.
      Porter
                      /s/
      C.E. Porter
                      Director;
                        President
      & Chief
                        Executive
      Officer
                      March
      23, 2009John
      G. Van Meter
                      _____________________________
                      Director;
                        Chairman
      of The
                        Board
      of DirectorsL.
      Keith Wolfe
                      /s/
      L. Keith Wolfe
                      Director
                      March
      23, 2009
 
  Index
  
 Page
      Sixty Nine
 
 
 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 of2002
      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 of2002
      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.