SECURITIES AND EXCHANGE COMMISSION
                             Washington, D. C. 20549

                                    FORM 10-K

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

     For fiscal year ended December 31, 2004Commission 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           (I.R.S. Employer
            incorporation or organization)           Identification No.)

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

               Issuer's telephone number including area code: (304) 257-4111

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

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

     Indicate by check mark 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 issuer is an accelerated filer (as
defined in Rule 12b-2 of the Act). [ ]

     The aggregate market value of the 1,319,777 shares of Common Stock of the
registrant issued and outstanding held by nonaffiliates on June 30, 2004 was
approximately $ 34,657,344 based on the closing sales price of $ 26.26 per share
on June 30, 2004. For purposes of this calculation, the term "affiliate" refers
to all directors and executive officers of the registrant.

     State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date: As of March 21, 2005 -
1,436,874

                      DOCUMENTS INCORPORATED BY REFERENCE:

     Portions of the Registrant's Proxy Statement to be used in connection with
the solicitation of proxies for the Registrant's 2005 Annual Meeting of
Shareholders (the "Proxy Statement") are incorporated by reference in Part III ,
Items 10,11,12,13 and 14 of this Annual Report of Form 10-K (the "Form 10-K").


<PAGE> 2

                                FORM 10-K INDEX

Part I

Item  1.  Business                                                       3
Item  2.  Properties                                                     8
Item  3.  Legal Proceedings                                              8
Item  4.  Submission of Matters to a Vote of Security Holders            8

Part II

Item  5.  Market for Registrant's Common Equity,
          Related Stockholder Matters and Issuer Repurchases
          of Securities                                                  8
Item  6.  Selected Financial Data                                        9
Item  7.  Management's Discussion and Analysis of Financial
          Condition and Results of Operation                            10
Item  7A. Quantitative and Qualitative Disclosures About Market Risk    31
Item  8.  Financial Statements and Supplementary Data                   33
Item  9.  Changes in and Disagreement with Accountants on
          Accounting and Financial Disclosure                           57
Item 9A.  Controls and Procedures                                       57
Item 9B.  Other Information                                             57

Part III

Item 10.  Directors and Executive Officers of Registrant                57
Item 11.  Executive Compensation                                        57
Item 12.  Security Ownership of Certain Beneficial Owners and
          Management And Related Stockholder Matters                    58
Item 13.  Certain Relationships and Related Transactions                58
Item 14.  Principal Accountant's Fees and Services                      58

Part IV

Item 15.  Exhibits and Financial Statement Schedules                    59

Signatures                                                              60


<PAGE> 3

Part I

Item 1. Business

     General

     Highlands Bankshares, Inc. (hereinafter referred to as "Highlands," or the
"Company"), incorporated under the laws of West Virginia in 1985, is a
multi-bank holding company subject to the provisions of the Bank Holding Company
Act of 1956, as amended, and owns 100% of the outstanding stock of its
subsidiary banks, The Grant County Bank and Capon Valley Bank (hereinafter
referred to as the "Banks"), 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, 2004, The Grant County Bank had 61 full time equivalent
employees, Capon Valley Bank had 48 full time equivalent employees and Highlands
had one full time equipment employee. 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, and the northern portion of Pendleton County in West
Virginia, the western portion of Frederick County in Virginia and portions of
Western Maryland. This area includes the cities 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 and six national banks. In addition, the
banks compete with money market mutual funds, credit unions and investment
brokerage firms for deposits in their service area. No financial institution has
been chartered in the area within the last five years although branches of state
and nationally chartered banks have located in this area within this time
period. Competition for new loans and deposits in the banks' service area is
quite intense.


<PAGE> 4


     Regulation and Supervision

     Overview: 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.

     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 nonbank
acquisition, merger or consolidation proposed by a bank holding company. The
BHCA generally limits the activities of a bank holding company and its
subsidiaries to that of banking, managing or controlling banks as to be a proper
incident thereto. The BHCA also prohibits a bank holding company, with certain
exceptions, from acquiring more than 5% of the voting shares of any company and
from engaging in any business other than banking or managing or controlling
banks. The Federal Reserve Board has by regulation determined that certain
activities are closely related to banking within the meaning of the BHCA. These
activities include: operating a mortgage company, finance company, credit card
company or factoring company; performing certain data processing operations;
providing investment and financial advice; and acting as an insurance agent for
certain types of credit-related insurance.

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

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


<PAGE> 5


     Regulation and Supervision (continued)

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

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

     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.


<PAGE> 6


     Regulation and Supervision (continued)

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

                                December 31, 2004       December 31, 2003
                                Actual  Regulatory      Actual      Regulatory
                                 Ratio    Minimum        Ratio        Minimum

Total Risk Based Capital Ratio
Highlands Bankshares             14.71%     8.00%         14.55%       8.00%
Capon Valley Bank                12.82%     8.00%         11.93%       8.00%
The Grant County Bank            15.68%     8.00%         13.89%       8.00%

Tier 1 Leverage Ratio
Highlands Bankshares             10.14%     3.00%          9.42%       3.00%
Capon Valley Bank                 8.57%     3.00%          7.31%       3.00%
The Grant County Bank            11.01%     3.00%          9.05%       3.00%

Tier 1 Risk Based Capital Ratio
Highlands Bankshares             13.58%     4.00%         13.40%       4.00%
Capon Valley Bank                11.57%     4.00%         10.68%       4.00%
The Grant County Bank            14.64%     4.00%         12.81%       4.00%


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


<PAGE> 7


     Regulation and Supervision (continued)

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

     A summary of the available dividends for each subsidiary bank can be found
on page 28 under the heading of Liquidity.

     Governmental Policies: The Federal Reserve Board regulates money and credit
and interest rates in order to influence general economic conditions. These
policies have a significant influence on overall growth and distribution of bank
loans, investments and deposits and affect interest rates charged on loans or
paid for time and savings deposits. Federal Reserve monetary policies have had a
significant effect on the operating results of commercial banks in the past and
are expected to continue to do so in the future.

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


     Available Information: The Company files annual, quarterly and current
reports, proxy statements and other information with the SEC. The Company's SEC
filings are filed electronically and are available to the public through the
Internet at the SEC's website at www.sec.gov. In addition, any document filed by
the Company with the SEC can be read and copies at the SEC's public reference
facilities at 450 Fifth Street, N.W., Washington, DC 20549. Copies of documents
can be obtained at prescribed rates by writing to the Public Reference Section
of the SEC at 450 Fifth Street, N.W., Washington, D.C. 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 Alan Miller at Highlands Bankshares, Inc., P.O. Box 9029,
Petersburg, West Virginia 26847.


<PAGE> 8


Item 2. Properties

     The Grant County Bank's main office is located on Main Street in
Petersburg, West Virginia. The Bank also has branch facilities in Harman,
Moorefield, Keyser and Riverton, West Virginia which provide banking services in
Randolph County, Hardy County, Mineral County, and northwest Pendleton County,
respectively. The Riverton branch building is leased while all other locations
are owned by the Bank.

     Capon Valley Bank has its main office in Wardensville, West Virginia and
branch offices located in Moorefield and Baker, West Virginia and Gore,
Virginia. Capon's offices serve mainly Hardy County and Hampshire County, West
Virginia, with the Gore branch serving Frederick County, Virginia. All
facilities are owned by the 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 loans.


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

      Highlands has not submitted any matters to the vote of security holders
for the quarter ended December 31, 2004.


Part II

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

     The Company had approximately 860 registered stockholders of record as of
January 31, 2005 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 NASDAQ Over The Counter Bulletin Board. Terms
of an exchange between individual parties may not be known to the Company. The
following 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         Market Price Range
                                   Per Share       High            Low
      2004

     First Quarter                   .15          29.00           27.15
     Second Quarter                  .15          28.49           26.45
     Third Quarter                   .15          26.45           24.50
     Fourth Quarter                  .18          26.00           24.15

       2003

     First Quarter                   .14          26.50           21.60
     Second Quarter                  .14          26.25           25.50
     Third Quarter                   .14          31.00           26.05
     Fourth Quarter                  .14          31.00           29.00


<PAGE> 9


Item 6.                 Selected Financial Data


                                      Years Ending December 31,
                                (In Thousands Except for Share Amounts)
                            2004       2003      2002       2001      2000

Total Interest Income     $17,729   $ 18,283   $18,970   $ 20,207   $18,207
Total Interest Expense      4,711      6,338     7,705     10,049     8,790
                           ------    -------    ------    -------    ------
Net Interest Income        13,018     11,945    11,265     10,158     9,417

Provision for Loan Losses     920      1,820       820        600       500
                           ------    -------    ------    -------    ------
Net Interest Income after
   Provision for Loan
   Losses                  12,098     10,125    10,445      9,558     8,917

Other Income                1,597      1,367     1,304      1,194     1,263
Other Expenses              8,938      8,247     8,048      7,431     6,836
                           ------    -------    ------    -------    ------

Income before Income Taxes  4,757      3,245     3,701      3,321     3,344
Income Tax Expense          1,551      1,012     1,179        979     1,092
                           ------    -------    ------    -------    ------

   Net Income             $ 3,206   $  2,233   $ 2,522   $  2,342   $ 2,252
                           ======    =======    ======    =======    ======


Net Income Per Share*     $  2.23   $   1.55   $  1.73   $   1.56   $  1.50
Dividends Per Share*      $   .63   $    .56   $   .51   $    .45   $   .41

Total Assets at Year End $299,992   $301,168  $296,672   $277,042  $248,782
                         ========    =======   =======    =======   =======


Return on Average Assets    1.07%       .73%      .89%       .89%      .97%
Return on Average Equity   10.36%      7.60%     8.87%      8.57%     8.89%
Dividend Payout Ratio      28.23%     36.03%    29.26%     29.15%    27.64%
Year End Equity to Assets
   Ratio                   10.55%      9.81%     9.69%     10.06%    10.43%


*--Prior years' per share figures restated to reflect stock split effected in
form of dividend in 2002.


<PAGE> 10


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

Critical Accounting Policies

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

Allowance for Loan Losses

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

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

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

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


<PAGE> 11


Critical Accounting Policies (continued)

Post Retirement Benefits

     The Company has invested in and owns life insurance polices on key
officers. The policies are designed so that the company recovers the interest
expenses associated with carrying the polices 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.

Recent Accounting Pronouncements

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

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," or other future events. Although the
Company believes that its expectations with respect to certain forward-looking
statements are based upon reasonable assumptions within the bounds of its
existing knowledge of its business and operations, there can be no assurance
that actual results, performance or achievements of the Company will not differ
materially from any future results, performance or achievements expressed or
implied by such forward-looking statements. Actual future results and trends may
differ materially from historical results or those anticipated depending on a
variety of factors, including, but not limited to, the effects of and changes
in: general economic conditions, the interest rate environment, legislative and
regulatory requirements, competitive pressures, the effects of bankruptcy of two
large commercial customers, the effect of rising fuel costs on the trucking
industry and the economy as a whole, the transition involving the poultry
processing facility, assumptions made regarding determine of the allowance for
loan losses, new products and delivery systems, inflation, changes in the stock
and bond markets, technology, and consumer spending and savings habits. The
Company does not update any forward-looking statements that may be made from
time to time by or on behalf of the Company.


<PAGE> 12


Overview of 2004 Results

     Net income in 2004 increased $973,000, or 43.57%, over 2003 income. Net
income of $3,206,000 resulted in a Return on Average Assets (ROAA) of 1.07% for
2004 compared to .73% for 2003 and a Return on Average Equity (ROAE) of 10.36%
compared to 7.60% for 2003.

     An increase in net interest income of $1,073,000 came about largely because
of decreases in interest expense. Total interest expense for 2004 fell
$1,627,000, or 25.67% compared to 2003. During the later portions of 2003 and
first half of 2004, the Company found itself in a favorable liquidity position
with excess Federal Funds sold. This favorable liquidity position allowed the
company to selectively lower deposit rates to levels equal to or below
competition. In addition, because of the low rates earned during 2004 on
short-term investments such as Fed Funds sold and certain types of securities,
the Company chose to fund loan growth through reductions in these alternative
investments in lieu of competitively bidding to maintain excess deposits or gain
new deposits.

     Rising delinquencies during 2003 caused a comparatively large amount of net
charge-offs for 2003 and into 2004 and required a consequent provision for loan
losses in 2003 larger than historically needed. While remaining somewhat above
recent historically averages, net charge-offs for 2004 declined over the levels
seen in 2003 and decreasing balances of delinquent loans caused a reduced
provision for loan losses in 2004 compared to the provision taken in 2003. Asset
quality, as defined by the level of non-performing loans compared to gross loan
balances, has continued to improve as increased collection efforts and
charging-off of uncollectible loans have reduced balances of non-performing
loans.

     During 2004, Highlands Bankshares Trust Company, a wholly owned subsidiary
of the Company providing trust and other fiduciary services, was discontinued.
The revenue growth from operations of this subsidiary had been less than
anticipated. The decline in other income as a result of the discontinuation of
Highlands Bankshares Trust Company was more than offset by an increase in
service charges. This increase in service charge revenues was primarily the
result of an increase instituted in February of the per transaction charge for
customer checks written with insufficient funds in the account to cover the
check.

     The Company's loan growth had been relatively flat during 2004 prior to the
beginning of the fourth quarter . However, the last quarter of 2004 saw the
Company's loan balances begin to increase, as balances grew 2.48% (9.92%
annualized) from September 30, 2004 through year end. Although operating with
favorable liquidity in the early portions of 2004, as loan growth occurred in
the fourth quarter of 2004, the funding of new loans reduced the liquidity
position. At December 31, 2004, the Company's balances of Fed Funds sold and
cash deposits in other banks had been reduced by 73.99% over December 31, 2003
levels and balances of securities investments were $7,900,000 less at December
31, 2004 than one year earlier.

     Operational expenses increased moderately due to inflationary trends in
salaries and general administrative costs. New equipment purchases and continued
expansion and upgrading of existing work systems caused equipment and operating
expense to increase. Legal and professional fees increased 17.53% as expanded
audit procedures were made necessary by the organization's growth and changes in
the regulatory environment.


<PAGE> 13


                                      QUARTERLY FINANCIAL RESULTS
                                 (In thousands, except per share amounts)


                                 Fourth       Third      Second      First
                                 Quarter     Quarter     Quarter    Quarter
2004

Interest income                 $ 4,563     $ 4,436     $ 4,400     $ 4,330
Interest expense                  1,161       1,142       1,161       1,248
                                 ------      ------      ------      ------
   Net interest income            3,402       3,294       3,239       3,082

Provision for loan losses           320         195         210         195
                                 ------      ------      ------      ------

   Net interest income
      after provision             3,082       3,099       3,029       2,887

Non-interest income                 402         451         410         334
Non-interest expense              2,303       2,242       2,229       2,164
                                 ------      ------      ------      ------

   Income before income
      tax provision               1,181       1,308       1,210       1,057

Income tax provision                361         432         413         345
                                 ------      ------      ------      ------

   Net Income                   $   820     $   876     $   797     $   712
                                 ======      ======      ======      ======

Per common share:
   Net income (basic)           $   .57     $   .61     $   .55     $   .50
   Cash dividends                   .18         .15         .15         .15

2003

Interest income                 $ 4,473     $ 4,604     $ 4,630     $ 4,576
Interest expense                  1,369       1,543       1,668       1,758
                                 ------      ------      ------      ------
   Net interest income            3,104       3,061       2,962       2,818

Provision for loan losses           825         240         545         210
                                 ------      ------      ------      ------

   Net interest income
      after provision             2,279       2,821       2,417       2,608

Non-interest income                 337         348         339         343
Non-interest expense              2,244       2,076       1,953       1,974
                                 ------      ------      ------      ------

   Income before income
      tax provision                 372       1,093         803         977

Income tax provision                 85         363         247         317
                                 ------      ------      ------      ------

   Net Income                   $   287     $   730     $   556     $   660
                                 ======      ======      ======      ======

Per common share:
   Net income (basic)           $   .20     $   .51     $   .39     $   .46
   Cash dividends                   .14         .14         .14         .14


<PAGE> 14


Net Interest Margin

2004 Compared to 2003

     Net interest income increased 8.98% in 2004 as compared to 2003. The
repeated lowering of target interest rates by the Federal Reserve Board (the
"Fed") seen during the greater part of the last two years ceased during 2004 and
then reversed into an upward trend of the Fed raising target rates. In spite of
the increases in rates by the Fed during 2004, average rates earned on earning
assets and average rates paid on interest bearing liabilities generally
continued to decrease as the Company saw old balances of both assets an
liabilities mature and be re-written at lower rates.

     The competitive atmosphere for both loans and deposits and the changing
interest rate environment combined with flat loan growth during the early
periods of 2004 created the need for achieving improved net interest margin
through closer asset/liability management. Because of the flat loan growth early
in the year and a favorable liquidity position, Management chose to keep deposit
rates at or below those of the competition and balances of time deposits and the
average rates paid on those deposits fell throughout 2004. As loan growth
increased later in the year, Management chose to continue with deposit rates at
or lower than the local competition and fund the loan growth through reductions
in balances of comparatively lower earning assets like Fed Funds Sold and
investment securities.

     Income from interest earning assets decreased $575,000. Although average
rates within each asset class fell, average rates paid assets as a whole fell
only slightly as lower earning assets (Fed Funds sold, deposits in other banks)
were replaced by relatively higher earning loan balances. Average balances of
earning assets decreased $8,652,000. The decline in average rates on earning
assets and average balances of earning assets were more than offset by declines
in both average rates paid on deposits and on average balances of deposits.
Interest expense decreased $1,627,000 due to a decrease in average interest
bearing liabilities of 4.30% and a 60 basis point decline in average rates.

     Because of the restricted availability of deposits to the subsidiary banks
caused by the Company's rural location and because of high levels of
competition, the Company, in order to fund loan growth, has historically been
forced to pay rates on time deposits often at rates above most regional and
national banks. During 2004, slowing loan growth reduced the need for deposit
balances and the Company was able to pay rates on deposits, especially time
deposits, which more closely approximated, and were often below, those rates
paid by regional and national banks. Because of this reduction in rates and as
older deposits at higher rates matured and were re-written at lower rates
created by the depressed rate environment, interest expense on deposits
decreased. Because of the favorable liquidity position by the bank throughout
most of 2004, the subsidiary banks continued to pay rates on time deposits lower
than those of much of the local competition, and many customers, as time
deposits matured, chose to move balances to other financial institutions,
resulting in a lower average balance of time deposits for 2004 as compared to
2003.

     Customers appeared during the year to be reluctant to place money into time
deposits. It appears that expectation of rising rates in the near future has
made depositors reluctant to commit to longer term time deposits and that many
of the monies previously deposited into CD products have been moved to the
interest bearing transaction accounts, further improving interest expense.
Average balances of transaction based interest bearing accounts (Money Market
and Savings accounts) increased from 2003 to 2004 while average balances of time
deposits decreased 11.15%.

     Toward the later parts of 2004, as the Fed continued to raise the target
Fed Funds rate, and as competition for deposits in the banks' local markets
increased, the Company chose to fund new loan growth through funds borrowed from
the Federal Home Loan Bank (FHLB). The rates and terms available on these funds
were comparatively more attractive than offering above market rates on deposits.
As a result, balances of funds borrowed from the FHLB at December 31, 2004 were
nearly double the levels at December 31, 2003.


<PAGE> 15


Net Interest Margin (continued)

2003 Compared to 2002

     Although reductions in target rates by the Federal Reserve Board (the
"Fed") were less frequent during 2003 as compared to 2001 and the first half of
2002, the effects of these earlier cuts were apparent in the yields on the
Company's earning assets and on average rates paid on interest bearing
liabilities. As older deposits matured and were replaced by lower rate deposits,
the average cost for deposits fell 87 basis points. As higher yielding loans
matured, they were replaced by lower yielding loans or variable rate loans
repriced and thus the average yield on loans fell 51 basis points. Taxable
equivalent yields on securities also fell as higher yielding securities matured
or were called and were replaced by securities with lower yields.

     Strong loan demand experienced in 2001 and 2002 slowed in 2003 and average
loan balances grew 4.56% over 2002 average balances compared to a growth of
9.30% from 2001 to 2002. Year end balances of loans for 2003 as compared to 2002
were .39% higher.

     In the past, competition for deposits in the Company's service area was
strong and this caused the Company's subsidiary banks to pay higher rates on
deposits than larger, statewide financial institutions. Slowing loan growth in
2003 reduced the need for deposit growth, and the Company made efforts to reduce
this rate disparity. Average rates paid on time deposits fell 96 basis points in
2003 as compared to 2002 and are now approaching the peer group levels. Rates on
transaction accounts continued to mirror the peer group.


<PAGE> 16

<TABLE>

Net Interest Margin (continued)

     A summary of the Company's net interest margin and average balance sheet
for the years ended December 31, 2004, 2003 and 2002 is illustrated below (in
thousands of dollars):
<CAPTION>

                    NET INTEREST MARGIN AND AVERAGE BALANCE ANALYSIS

                                             2004                               2003                           2002

                                  Income/    Yield/                 Income/     Yield/             Income/     Yield/
                                 Average 2 Expense      Rate       Average 2  Expense   Rate      Average 2   Expense    Rate

Earning Assets
--------------
<S>                              <C>         <C>         <C>      <C>        <C>        <C>       <C>        <C>         <C>

Loans                            $ 235,023   $  16,752   7.13     $ 226,281  $  16,966   7.50     $ 216,408  $  17,324   8.01
Investment Securities
  Taxable                           25,944         674   2.60        28,107        885   3.15        25,247      1,165   4.61
  Nontaxable                         3,298         194   5.89         3,748        254   6.78         5,451        318   5.83
Interest Bearing
  Deposits                           1,430          18   1.26         5,342         53    .99         4,271        104   2.44
Federal Funds Sold                  14,119         163   1.15        20,632        218   1.06        11,431        177   1.55
                                  --------    --------   ----      --------   --------   ----      --------   --------   ----

Total Earning Assets               279,814      17,801   6.36       284,110     18,376   6.47       262,808     19,088   7.26
                                  --------    --------   ----      --------   --------   ----      --------   -------    ----
Non Earning Assets
Allowance for Loan
  Losses                            (2,418)                          (2,163)                         (1,793)
Non Earning  Assets                 27,380                           23,343                          21,840
                                  --------                         --------                        --------
Total Assets                     $ 300,420                        $ 305,290                       $ 282,855
                                  ========                         ========                        ========

Interest Bearing Liabilities
Demand Deposits                  $  24,031     $    95    .40     $  21,434  $     134   .63      $  19,910   $    225   1.31
Savings Deposits                    52,079         296    .57        48,128        381   .79         43,868        651   1.48
Time Deposits                      145,834       4,042   2.77       164,126      5,585  3.40        151,813      6,619   4.36
Other Borrowed
  Money                              6,264         278   4.44         4,780        238  4.98          4,280        210   4.91
                                  --------      ------   ----      --------   --------  ----       --------    -------   ----
Total Interest Bearing
  Liabilities                      228,208       4,711   2.06       238,468      6,338  2.66        219,871      7,705   3.50
                                  --------      ------   ----      --------   --------  ----       --------    -------   ----
Non Interest Bearing Liabilities
Demand Deposits                     37,325                           35,086                          32,226
Other Liabilities                    3,954                            2,337                           2,320
Shareholders' Equity                30,933                           29,399                          28,438
                                  --------                         --------                        --------
Total Liabilities and
   Shareholders Equity           $ 300,420                        $ 305,290                        $282,855
                                  ========                         ========                         =======

Net Interest Income                           $13,090                        $  12,038                        $ 11,383
                                               ======                         ========                         =======
Net Yield on Earning Assets                             4.68%                           4.24%                            4.33%
                                                       =====                            ====                             ====



1  Yields are computed on a taxable equivalent basis using a 37% income tax rate.
2  Average balances are based on daily balances.
3  Includes loans in nonaccrual status.
4  Average balances for securities available for sale are based on amortized
   carrying values and do not reflect changes in market values.
</TABLE>


<PAGE> 17


                  EFFECT OF RATE-VOLUME CHANGES ON NET INTEREST INCOME
                      (On a fully taxable equivalent basis)
                            (In thousands of dollars)


                      2004 Compared to 2003       2003 Compared to 2002
                       Increase (Decrease)         Increase (Decrease)

                  Due to change in:1   Total   Due to change in:1  Total
                    Average  Average Increase   Average  Average Increase
                    Volume    Rate  (Decrease)  Volume    Rate  (Decrease)

Interest Income
Loans2              $  655   $ (869)  $ (214)   $  790   $(1,148) $ (358)
Investment Securities
  Taxable             (191)     (20)    (211)      132     (412)    (280)
  Nontaxable           (60)       1      (60)      (99)      35      (64)
Interest bearing
 deposits              (39)       3      (35)       26     (77)      (51)
Federal fund sold      (69)      14      (55)      142     (101)      41
                     -----   ------   ------     -----   ------   ------

Total Interest
 Income                296     (871)    (575)      992   (1,704)    (712)
                     -----   ------   ------     -----   ------   ------


Interest Expense
Demand Deposits         16      (55)     (39)       17     (108)     (91)
Savings Deposits        31     (116)     (85)       63     (333)    (270)
Time Deposits         (622)    (921)  (1,543)      537   (1,571)  (1,034)
Borrowed Money          74      (34)      40        25        3       28
                     -----   ------   ------     -----   ------   ------

Total Interest
 Expense              (501)  (1,126)  (1,627)      642   (2,009)  (1,367)
                     -----   ------   ------     -----   ------   ------

Net Interest Income $ (287) $ 1,339  $ 1,052    $  895   $ (240)  $  655
                     =====   ======   ======     =====    ======   =====


1  Changes in volume are calculated based on the difference in average balance
   multiplied by the prior year average rate. Rate change differences are
   calculated based on the difference from one year to the next in the average
   rates earned or paid multiplied by the current year's balance.

2  Nonaccrual loans have been included in average asset balances.


<PAGE> 18


Asset Quality

Loan Portfolio

     The Company is an active residential mortgage and construction lender and
generally 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,
and northern Pendleton counties in WV and Frederick County, VA. 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.

     Although loan growth was relatively flat throughout 2003 and through the
first half of 2004, during the second half of the year ended December 31, 2004,
the company experienced high levels of loan growth. For the eighteen month
period begun December 31, 2003 and ended June 30, 2004, the Company's loans grew
$6.8 million or 3.00%. From June 30, 2004 to December 31, 2004, the Company
experienced loan growth of $15.09 million or 6.46% (12.92% annualized). The
Company has also seen a shift in the composition of it's loan portfolio. The
total balances of loans in the Company's portfolio secured by real estate
increased $16.57 million from December 31, 2003 to December 31, 2004,
representing 75.71% of the growth in loan balances over this same time period.

     The following table summarizes the Company's loan portfolio:


                                         At December 31,
                      2004        2003        2002        2001        2000
                      ----------------------------------------------------
                            (In Thousands of Dollars)
      Real Estate:
        Mortgage    $140,762    $129,671    $121,558    $111,668    $101,890
        Construction   8,850       7,552       6,813       3,868       4,061
      Commercial      52,813      42,911      47,089      42,204      37,681
      Installment     46,092      46,501      50,294      47,730      45,636

      Total Loans    248,517     226,635     225,754     205,470     189,268
      Allowance for
        loan losses   (2,530)     (2,463)     (1,793)     (1,603)     (1,493)
                     -------     -------     -------     -------     -------

      Loans, net    $245,987    $224,172    $223,961    $ 203,67    $187,775
                     =======     =======     =======     =======     =======


     Note: Commercial loan balances include commercial loans which are secured
by real estate. As December 31, 2004, 2003 and 2002 the Company maintained
balances of loans secured by real estate of $180.17 million, $163.60 million and
$154.76 million respectively.

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


<PAGE> 19


Asset Quality (continued)

Loan Portfolio (continued)


The following table shows the maturity of loans outstanding:

                                                   December 31,
       Maturity Range                       2004        2003        2002
       --------------                       ----        ----        ----
                                             (in thousands of dollars)
     Predetermined Rates:
       0 - 12 months                      $129,646    $132,237    $145,473
       13 - 60 months                      102,295      80,099      68,699
       More than 60 months                  16,046      12,635      11,353
     Nonaccrual Loans                          530       1,664         229
                                           -------     -------     -------

       Total Loans                        $248,517    $226,635    $225,754
                                           =======     =======     =======


     The following table shows the Company's loan maturity distribution (in
thousands of dollars) as of December 31, 2004:

                                             Maturity Range
                                Less Than     1-5        Over
       Loan Type                  1 Year     Years      5 Years    Total
       ---------                 -------     -----      -------    -----

     Commercial and
       Agricultural Loans     $ 30,492    $ 13,192    $  9,128    $ 52,813
     Real Estate - mortgage     74,195      60,843       5,723     140,761
     Real Estate - construction  8,850                               8,850
     Consumer - installment     16,638      28,259       1,195      46,092
                               -------     -------     -------     -------

       Total                  $130,176    $102,295    $ 16,046    $248,517
                               =======     =======     =======     =======

Credit Quality

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

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


<PAGE> 20


Asset Quality (continued)

Credit Quality (continued)

     Nonperforming loans include nonaccrual loans, loans 90 days or more past
due and restructured loans. Nonaccrual loans are loans on which interest
accruals have been discontinued. Loans are placed in nonaccrual status when the
collection of principal or interest is 120 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 which a borrower
has been granted a concession on the interest rate or the original repayment
terms because of financial difficulties. Nonperforming loans do not represent or
result from trends or uncertainties which management reasonably expects will
materially impact future operating results, liquidity, or capital resources.
Nonperforming loans are listed in the table below.

     Nonperforming loans decreased 77.78% at December 31, 2004 compared to 2003
as both balances of nonaccrual loans and loans contractually 90 days of more
past due decreased during the year. At December 31, 2004, the Company had two
loans totaling $631,000 which were classified as restructured loans. As of
December 31, 2004, these loans which had previously been classified as
restructured had timely payments for more than a twelve month period and terms
were not better than those that would be offered in a competitive environment.
For this reason, they were no longer classified as restructured. Balances of
non-performing loans have decreased both as a result of increased collections
efforts and as a result of higher than historically average charge-offs during
both 2003 and 2004.

     The following table summarizes the Company's nonperforming loans:

                                           At December 31,
                           2004      2003       2002      2001       2000
                           ----------------------------------------------
Loans accounted for on a
   nonaccrual basis
    Consumer              $  252    $  228     $    9    $   --     $   --
    Real estate              278     1,436        290       474         32
                           -----     -----      -----     -----      -----

   Total nonaccrual loans    530     1,664        299       474         32
                           -----     -----      -----     -----      -----

Restructured loans            --       631        662        --         --
                           -----     -----      -----     -----      -----

Loans contractually past
 due 90 days or more as to
 interest or principal
 payments (not included
 in nonaccrual loans above)
    Commercial               140        25        161       607         60
    Real estate              355     1,255      1,312     1,352      1,984
    Consumer                  40       318        445       336        297
                           -----     -----      -----    ------      -----

   Total Delinquent Loans $  535    $1,598     $1,918    $2,295     $2,341
                           =====     =====      =====     =====      =====

  Total Nonperforming
     Loans                $1,065    $3,893     $2,879    $2,769     $2,373
                           =====     =====      =====     =====      =====


     Real estate acquired through foreclosure was $327,650 at December 31, 2003,
$291,414 at December 31, 2003 and $517,050 at December 31, 2002. All of the
foreclosed properties held at December 31, 2004 were located in the Company's
primary service area. The Company's practice is to value real estate acquired
through foreclosure at the lower of (i) an independent current appraisal or
market analysis less anticipated costs of disposal, or (ii) the existing loan
balance. The Company is actively marketing all foreclosed real estate and does
not anticipate material write-downs in value before or at the time of
disposition.


<PAGE> 21


Asset Quality (continued)

Credit Quality (continued)

     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. During the spring of 2004, Pilgrim's Pride Corporation announced the
pending closure of its turkey processing facilities near Harrisonburg, VA. This
closure would have impacted the local economy because turkey growers contracted
with Pilgrim's Pride would either be forced to cease growing operations or turn
to alternative contractual arrangements. The number of direct grower loans held
by the Company and which would have been impacted by this potential closure is
small. Since the announcement of the pending closure, some of the growers
impacted by the closure who have loans with the Company have contracted with
another poultry integrator. The remainder have joined a cooperative organization
that will re-open the processing plant. As of this filing, this cooperative has
begun placing birds with growers in preparation for future processing.
Management will monitor the activities of this cooperative but expects no
adverse impact relating to the transitions involved with the poultry processing
facility and its related operations.

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

     As of December 31, 2004, the Company had two potential problem loan as
defined in SEC Industry Guide III that would require disclosure.

     In July, the Company received notice that a large commercial loan customer
had filed for Chapter 11 bankruptcy protection. Terms of the bankruptcy
proceedings have not been finalized. Depending upon the outcome of the
bankruptcy proceedings, the Company may be forced to reclassify the loans made
to this customer, which total approximately $1.4 million, to non-accrual status.
If these loans are reclassified to non-accrual, this will have a negative impact
on interest revenue and net income. The loans to this customer are deemed by
Management to be well secured, and if a foreclosure is required, the Company
expects there to be no loss on the sale of the collateral. Since the bankruptcy
filing, this customer has continued to make payments of both principal and
interest, and though remaining moderately delinquent, these payments have been
sufficient to consistently keep the customer less than 60 days past due. During
the fourth quarter of 2004, the Company was informed by another large commercial
loan customer that a Chapter 11 bankruptcy may be forthcoming. As of the date of
this filing, the Company has received no formal notice from this customer that a
bankruptcy filing has occurred. This customer continues to make payments of both
principal and interest, and though remaining moderately delinquent, these
payments have been sufficient to consistently keep the customer less than 60
days past due. Management deems the loans to this customer to be adequately
secured and, if foreclosure becomes necessary, expects no material loss.


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).


<PAGE> 22


Asset Quality (continued)

Allowance for loan losses (continued)

     Each of Company's banking subsidiaries, Capon Valley Bank and The Grant
County Bank, determines the adequacy of its allowance for loan losses
independently. Although the loan portfolios of the two banks are similar to each
other, some differences exist which result in divergent risk patterns and
different charge-off rates amongst the functional areas of the banks' portfolio.
Each bank pays particular attention to individual loan performance, collateral
values, borrower financial condition and economic conditions. The determination
of an adequate allowance at each bank is done in a three step process. The first
step is to identify impaired loans. Impaired loans are problem loans above a
certain threshold which have estimated losses calculated based on collateral
values and projected cash flows. The second step is to identify loans above a
certain threshold which are problem loans due to the borrowers' payment history
or deteriorating financial condition. Losses in this category are determined
based on historical loss rates adjusted for current economic conditions. The
final step is to calculate a loss for the remainder of the portfolio using
historical loss information for each type of loan classification. The
determination of specific allowances and weighting is somewhat subjective and
actual losses may be greater or less than the amount of the allowance. However,
Management believes that the allowance represents a fair assessment of the
losses that exist in the current loan portfolio.

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

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

     The ratio of the allowance for loan losses to total loans outstanding was
1.02% at December 31, 2004, 1.09% at December 31, 2003 and .79% at December 31,
2002. At December 31, 2004, the ratio of the allowance for loan losses to
nonperforming loans was 292.48% compared to 63.27% at December 31, 2003 and
62.28% at December 31, 2002.

     The charge off of a large number of poorly performing loans has contributed
in part to declining delinquency rates and has led to a decreased allowance
requirement in Management's estimation. Management believes that the credit
quality of the current loan portfolio is significantly improved and that in the
coming periods net charge-offs will decline compared to those seen in 2003 and
2004. Management believes losses will more closely reflect historical charge-off
rates, or may fall below historical averages.

     Because of the large increase in loan balances during the fourth quarter of
2004, a provision for loan losses of $320,000 was charged to operations as
compared to $195,000 in the third quarter, $210,000 in the second quarter and
$195,000 in the first quarter. Management anticipates that continued loan growth
will require a continuance of increased amounts of provision for loan losses in
2004 as compared to recent years. This belief is exclusive of any unanticipated
changes in asset quality which may require larger or smaller balances of the
allowance for loan losses as compared to total loans.


<PAGE> 23


Asset Quality (continued)

Allowance for loan losses (continued)


     An analysis of the loan loss allowance is set forth in the following table
(in thousands):

                             2004       2003     2002      2001       2000
                             ----       ----     ----      ----       ----

     Balance at beginning of
       period             $ 2,463   $  1,793   $ 1,603   $  1,493   $ 1,318

     Charge-offs:
       Commercial loans        97        557       246        239       172
       Real estate loans      422         65       110         92       128
       Consumer loans         642        839       424        369       215
                          -------    -------    ------    -------    ------

                            1,162      1,461       780        700       515
                          -------   --------    ------    -------    ------

     Recoveries:
       Commercial loans        37         75        10         57         2
       Real estate loans       36         54        68         12        30
       Consumer loans         235        182        72        141        71
                          -------   --------    ------    -------    ------

                              308        311       150        210       103
                          -------    -------    ------    -------    ------

     Net charge-offs          853      1,150       630        490       412

     Provision for loan
        losses                920      1,820       820        600       500
     Other                                                               87
                           ------    -------    ------    -------    ------
     Balance at end
        of period         $ 2,530   $  2,463   $ 1,793   $  1,603   $ 1,493
                           ======    =======    ======    =======    ======

     Percent of net charge-offs
       to average net loans
       outstanding during the
       period                 .36%       .51%      .29%        .25%    .23%
                           ======    =======    ======     =======   ======


     Cumulative net loan losses, after recoveries, for the five year period
ending December 31, 2004 are as follows (in thousands of dollars):

                                               Dollars    Percent of Total

                  Commercial                   $ 1,138         33.00%
                  Real estate                      617         17.90%
                  Consumer                       1,798         49.10%
                                                ------        -------

                    Total                      $ 3,535        100.00%
                                                ======        ======


<PAGE> 24


Asset Quality (continued)

Allowance for loan losses (continued)
<TABLE>

     The following table shows the allocation of loans in the loan portfolio and
the corresponding amounts of the allowance allocated by loan types (dollar
amounts in thousands):
<CAPTION>

                                               At December 31,
                  ------------------------------------------------------------------
                        2004          2003           2002          2001         2000
                  ------------------------------------------------------------------

                       Percent       Percent        Percent       Percent       Percent
                         Of            of             of            of            of
                 Amount Loans  Amount Loans   Amount Loans Amount Loans Amount   Loans

<S>              <C>     <C>   <C>    <C>     <C>    <C>  <C>      <C>  <C>       <C>
Commercial       $  697   21%  $  779  19%    $  543  21% $   487   21% $   507    20%
Mortgage            853   60%     725  61%       504  57%     576   56%     239    56%
Consumer            970   19%     819  20%       652  22%     450   23%     598    24%
Unallocated          10           140             94           90           149
                  -----  ---    ----- ---      ----- ---    -----  ---    -----   ---
   Totals        $2,530  100%  $2,463 100%    $1,793 100%  $1,603  100%  $1,493   100%
                  =====  ===    ===== ===      ===== ===    =====  ===    =====   ===

</TABLE>

     The above act as a starting point for allocating the 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.

Noninterest Income

2004 compared to 2003

     Noninterest income increased $254,000 from 2003 to 2004, an increase of
18.58%. Much of this increase can be attributed to an increase in the
per-transaction charges for non-sufficient funds charges to checking account
customers, which contributed to the $194,000 increase in service charges.

     During 2004 the volume of new consumer installment loans declined and has
impacted insurance earnings. As credit life and accident and health insurance
are sold primarily to these loan customers, the volume of new insurance business
has also decreased. In spite of declines in sales of credit life and accident
insurance, insurance earnings increased 26.32% in 2004 as compared to 2003. As
new policies are written, there are requirements that portions of the premiums
be held in reserve in anticipation of future claims. Throughout 2004, as the
volume of new insurance business has fallen, older policies have matured without
claims. As a result of this, required balances of these reserves has been
reduced and this has positively impacted the income of HBI Life Insurance
Company.

     Because of the closing of the trust subsidiary, trust fees fell $49,000
during 2004 as compared to 2003.


2003 Compared to 2002

     Noninterest income for 2003 increased 4.87% from 2002. As average deposit
volumes continued to grow, income from service charges increased $30,000. Income
from insurance related activity grew as increases in customer penetration rates
resulted in higher commissions and fees from insurance activity. Income from
investments in life insurance contracts decreased 7.25% as interest rate
declines and continued low market rates led to lower returns.


<PAGE> 25


Noninterest Income (continued)

Discontinuation of Trust Operations

     During the fourth quarter of 2003, the Board of Directors of Highlands
Bankshares, Inc. (HBI) decided to close Highlands Bankshares Trust Company, Inc.
(HBTI).The demand for trust services in the Company's primary and secondary
service areas had been less than anticipated. As of May 31, 2004, Highlands
Bankshares Trust Company, a wholly owned subsidiary of Highlands Bankshares,
Inc. ceased operations.

     On an unconsolidated basis, at the time of it's closing, HBTI had an
accumulated net loss of $3,217. This loss, in combination with an initial
capital contribution by HBI of $2,143,576, resulted in a net investment by HBI
at the time of closing of $2,140,359. Upon the cessation of operations of HBTI,
this capital investment was returned to Highlands Bankshares, Inc. in the form
of cash. At its regularly scheduled meeting in July, the Highlands Board of
Directors voted to invest this capital, less amounts used to pay second quarter
shareholder dividends, in the two subsidiary banks.

     The distribution of this available capital as investment in the subsidiary
banks was as follows (in thousands):

                                                         Capital
               Subsidiary Bank                         Investment

               Capon Valley Bank                        $   703
               The Grant County Bank                      1,157
                                                         ------
               Total                                    $ 1,860
                                                         ======

Noninterest Expenses

2004 Compared to 2003

     Expenses related to salaries and benefits increased 8.83% in 2004 as
compared to 2003. Of the increase in salary and benefit expense, a large portion
was attributable to an increase in costs of employee insurance and to an
increase in wages and corresponding payroll tax. Insurance costs increased
primarily due to rising premium costs. Of the increase in wages and payroll tax
costs, a slight decline in full time equivalent employees was offset by the
increase in wages due to normal pay increases. Both subsidiary banks experienced
increases in costs related to the post-retirement benefits of bank owned life
insurance polices however, this cost was partially offset by improved earnings
of the policies. Costs of retirement benefits increased primarily due to rising
costs of The Grant County Bank's defined benefit pension plan (see Note 13 of
the Financial Statements).

     Equipment and data processing expense increased largely as a result of the
purchase, implementation and upgrades over recent quarters of processing
equipment intended to improve operational efficiency. During 2003 and 2004, both
subsidiary banks implemented telephone banking services and statement imaging
services. Both projects required significant new equipment which increased
depreciation expense.

     Legal and professional fees increased 17.53% as expanded audit procedures
were made necessary by the organization's growth and changes in the regulatory
environment. Management anticipates that audit related fees will grow during
2004 as compliance with Rule 404 of the Sarbanes-Oxley Legislation will require
expanded services. Management has contracted with an external consulting firm to
assist with compliance with Rule 404.


<PAGE> 26


Noninterest Expenses (continued)

2003 Compared to 2002

     Total noninterest expense increased 2.47% in 2003 as compared to 2002.
Salary and benefit expense increased $88,000, or 2.00%, in 2003 as compared to
2002. Increases in costs of retirement benefits associated with bank owned life
insurance contracts contributed $91,000 of the increase. An increase in full
time average equivalent employees of .70% was offset by a decline in per
employee costs of .92%.

     Occupancy expense remained flat as no new locations were added and no
existing locations improved. Equipment expense increased $63,000, or 9.57%. A
significant portion of the increase in equipment expense related to improvements
and upgrades to the Company's data processing infrastructure.

     Legal and professional fees increased $63,000, or 27.67% from 2002, largely
as a result of the contracting with a public accounting firm to begin
independent internal audit procedures at the subsidiary banks. Directors fees
increased $84,000 in 2003 as compared to 2002, an increase of 37.02%. This
increase was the result of an increase in meetings held during 2003 as compared
to 2002, an increase in the number of directors at the subsidiary banks, and an
increase in directors' per meeting fees beginning in May.

     Other expenses decreased from 2002 to 2003 as expenses related expanded
advertising campaigns undertaken in 2002 and costs associated with The Grant
County Bank's 100th Anniversary celebration were not present in 2003. Travel and
entertainment expense and nonincome tax expense also decreased in 2003. These
decreases were offset in part by increases in office supply expenses and
insurance expense.

Securities

     The Company's securities portfolio serves several purposes. Portions of the
portfolio are used to secure certain public and trust deposits. The remaining
portfolio is held as investments or used to assist the Company in liquidity and
asset liability management. Total securities decreased to $27,029,000 or 9.01%
of total assets at December 31, 2004. Total securities were $34,930,000 or
11.60% of total assets at December 31, 2003.

     The securities portfolio consists of three components: securities held to
maturity, securities available for sale and restricted securities. Securities
are classified as held to maturity when management has the intent and the
Company has the ability at the time of purchase to hold the securities to
maturity. Held to maturity securities are carried at cost, adjusted for
amortization of premiums and accretion of discounts. Securities to be held for
indefinite periods of time are classified as available for sale and accounted
for at market value. Securities available for sale include securities that may
be sold in response to changes in market interest rates, changes in the
security's prepayment risk, increases in loan demand, general liquidity needs
and other similar factors. Restricted securities are those investments purchased
as a requirement of membership in certain governmental lending insitutions 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, 2004, the cost basis of the securities available for sale exceeded
their fair value by $54,000.


<PAGE> 27


Securities (continued)
<TABLE>

     The following table summarizes the carrying value of the Company's
securities at the dates indicated:
<CAPTION>

                                       Held to Maturity           Available for Sale
                                        Carrying Value               Carrying Value

                                          December 31,                December 31,
                                     2004    2003     2002      2004      2003      2002
                                     ----    ----     ----      ----      ----      ----
                                      (In Thousands of Dollars) (In Thousands of Dollars)
     <S>                            <C>      <C>      <C>      <C>       <C>       <C>
     U.S. treasuries, agencies
     and corporations               $        $        $        $18,164   $23,240   $13,534
     Obligations of states and
     political subdivisions          1,162    1,364    1,365     1,817     2,604     4,350
     Mortgage-backed securities                   2        4     4,693     6,758     5,582
                                     -----    -----    -----    ------    ------    ------
     Total Debt Securities           1,162    1,366    1,369    24,674    32,602    23,466
     Other securities                                               28        29        30
                                     -----    -----    -----    ------    ------    ------

     Total                          $1,162   $1,366   $1,369   $24,702   $32,631   $23,496
                                     =====    =====    =====    ======    ======    ======
</TABLE>

     The carrying amount and estimated market value of debt securities (in
thousands of dollars) at December 31, 2004 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.

                                                                   Equivalent
     Securities Held to Maturity         Amortized       Fair        Average
                                           Cost          Value        Yield

     Due in one year or less              $    842      $    853      6.96%
     Due after one year through five years     320           334      6.60%
                                           -------      --------    -------


     Total Held to Maturity               $  1,162      $  1,187      6.86%
                                           =======       =======     =====


                                                                   Equivalent
     Securities Available for Sale       Amortized       Fair        Average
                                           Cost          Value        Yield

     Due in one year or less              $ 11,275      $ 11,236      2.34%
     Due after one year through five years  10,897        10,875      3.07%
     Due after five years through ten years  1,715         1,715      3.80%
     Due after ten years                       841           848      3.00%
                                           -------       -------     -----

     Total Debt Securities                  24,728        24,663      2.78%

     Equities                                   28            28      8.40%
                                           -------       -------     -----

     Total Available for Sale             $ 24,756      $ 24,702      2.78%
                                           =======       =======     =====

     Yields on tax exempt securities are stated at actual yields.

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


<PAGE> 28


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 3.16% in from December 31, 2003 to
December 31, 2004. Balances of non-interest bearing checking accounts and
interest bearing transaction accounts increased during the year, while balances
of time deposits decreased 10.14%. The Company does not actively solicit large
certificates of deposit (those more than $100,000) due to the unstable nature of
these deposits. Balances of time deposits greater than $100,000 decreased 16.78%
from December 31, 2003 to December 31, 2004.

     A summary of the maturity of large deposits is as follows:

                                                  December 31,
                                          -----------------------------
         Maturity Range                   2004        2003        2002
         --------------                   ----        ----        ----
                                            (In Thousands of Dollars)

     Three months or less               $  6,598    $  7,950    $   7,570
     Four to twelve months                13,861      19,080       22,030
     One year to three years              15,323      12,307        8,598
     Four years to five years              3,620       8,008        7,195
                                        --------    --------     --------

       Total                            $ 39,402    $ 47,345    $  45,393
                                         =======     =======     ========

Borrowed Money

Long Term Borrowings

     The Company occasionally borrows funds from the Federal Home Loan Bank
("FHLB") to reduce market rate risks, provide liquidity, and to fund capital
additions. These borrowings may have fixed or variable interest rates and are
amortized over a period of one to twenty years, or may be comprised of single
payment borrowings with periodic interest payments and principal amounts due at
maturity. Borrowings from this institution allow the banks to offer long-term,
fixed rate loans to their customers and match the interest rate exposure of the
receivable and the liability. During 2004, the Company borrowed an additional
$3,800,000 from the FHLB and made payments of $719,000 on outstanding balances.

Short Term Borrowings

     Although the Company has traditionally not experienced the need for
overnight or other short-term borrowings, loan growth during the fourth quarter
of 2004 necessitated an overnight borrowing of $2,000,000 at December 31, 2004.
At no other point during the year did the Company borrow overnight funds, and
though this funding tool may be required in coming periods, Management prefers
to fund growth through longer term vehicles and expects instances of overnight
borrowings to be minimal.

Parent Company Line of Credit

     During the fourth quarter of 2003, the Company secured a $2,500,000 open
line of credit with another commercial bank. This line of credit was secured by
equity securities in a subsidiary company. This debt instrument was obtained as
both a precautionary and opportunistic device for funding should a need arise in
the future. There were no advances in 2003 or 2004 from this line and it is not
anticipated that any borrowings from this debt facility will be used to fund
operating or liquidity needs.


<PAGE> 29


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. Total Capital consists of Tier 1 Capital and a portion of
the allowance for loan losses. Risk-based capital ratios are calculated with
reference to risk-weighted assets which consist of both on and off-balance sheet
risks.

     The capital management function is an ongoing process. Central to this
process is internal equity generation accomplished by earnings retention. During
2004, 2003, and 2002, total stockholders' equity increased by $2,106,000,
$1,184,000 and $504,000, respectively, as a result of earnings retention and
changes in the unrealized gains (losses) on securities available for sale. The
2002 increase is reflective of a repurchase of Company stock in the amount of
$1,217,000. The return on average equity was 10.36% in 2004 compared to 7.60%
for 2003 and 8.87% for 2002. Total cash dividends declared represent 28.23% of
net income for 2004 compared to 36.03% of net income for 2003 and 29.26% for
2002. Book value per share was $22.03 at December 31, 2004 compared to $20.56 at
December 31, 2003.

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, unpledged
securities and loans maturing within one year. Additional sources of liquidity
available to the Company include, but are not limited to, loan repayments, the
ability to obtain deposits through the adjustment of interest rates and the
purchasing of federal funds. To further meet its liquidity needs, the Company
also maintains lines of credit with correspondent financial institutions, the
Federal Reserve Bank of Richmond and the Federal Home Loan Bank of Pittsburgh.

     Historically, the Company's primary need for additional levels of
operational liquidity has been to fund increases in loan balances. The Company
has normally funded increases in loans by increasing deposits and decreases in
secondary liquidity sources such as balances of fed funds sold and balances of
securities. During the month of September and the fourth quarter of 2004, the
Company saw a significant increase in new loans. These loans were funded
primarily through secondary liquidity sources. Deposit balances have also
decreased in recent periods. Should the Company continue to experience
significant loan growth, it may be necessary to raise rates on deposits above
current market levels in order to attract new deposits. The Company may also
utilize the available lines of credit with correspondent financial institutions
to fund loan growth.

     In the year ending December 31, 2004, cash and due from banks decreased
$1,027,000 as cash used in financing and investing activities was greater than
cash provided by operations. Investing activity saw cash used to fund an
increase in gross loans in an amount of $21,882,000 . This increase was funded
by a decrease in deposits at other institutions of $536,000, a decrease in fed
funds sold of $12,712,000 and a decrease of holdings of securities and other
investments of $7,901,000. New equipment and facility additions were $265,000 in
2004 compared with $915,000 in 2003. Decreases in deposit balances of $8,294,000
contributed to the decline in cash balances but was partially offset by a
$5,082,000 increase in net transactions in borrowed funds.


<PAGE> 30


Liquidity (continued)

     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 subsidiary banks,
Capon Valley Bank (CVB) and The Grant County Bank (GCB). 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, 2005, the subsidiary banks
could pay dividends to Highlands Bankshares, Inc. of approximately $3,944,000
without permission of the regulatory authorities.

     A summary of the amounts available follows (in thousands of dollars):

                                                                   Total
                              2003                 2004          Available
                         Income Dividend     Income  Dividend  for Dividends


     CVB                $  475   $   --      $ 1,217  $  437      $ 1,255
     GCB                $1,801   $  905      $2,,080  $  287      $ 2,689


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
noninterest expenses may be more directly affected by inflation.


<PAGE> 31


Item 7A. Quantitative and Qualitative Disclosures About Market Risk

     The greatest portion of the Company's net income is derived from net
interest income. As such, the greatest component of market risk is interest rate
volatility. In conjunction with maintaining a satisfactory level of liquidity,
management must also control the degree of interest rate risk assumed on the
balance sheet. Managing this risk involves regular monitoring of the interest
sensitive assets relative to interest sensitive liabilities over specific time
intervals. Early withdrawal of deposits, greater than expected balances of new
deposits, prepayments of loans and loan delinquencies are some of the factors
that could affect actual versus expected cash flows. In addition, changes in
rates on interest sensitive assets and liabilities may not be equal, which could
result in a change in net interest margin. While the Company does not match each
of its interest sensitive assets against specific interest sensitive
liabilities, it does review its positions regularly and takes actions to
reposition itself when necessary. With the largest amount of interest sensitive
assets and liabilities repricing 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 has created intense
competition, especially from larger banking institutions and finance companies
offering long term fixed rate mortgages. As a result, the Company in recent
periods has begun to write more mortgage loans with adjustable rates and
maturities greater than one year. The increase in new ARM loans with two, three
and five year adjustable rates has caused a shift in the maturity composition of
the loan portfolio. As of December 31, 2003, 58.35% of the Company's loan
portfolio repriced within one year. As of December 31, 2004, 52.33% of the
Company's loan portfolio repriced within one year.

     Also as a result of the low interest rate environment, depositors seem
reluctant to commit to longer term time deposits and in many instances appear to
be holding monies temporarily in interest bearing transaction accounts in
anticipation of rising rates in the coming periods. As of December 31, 2003,
balances of interest bearing transaction and savings accounts were $72,098,000.
These balances had grown to $75,342,000 by December 31, 2004. Were interest
rates to rise sharply in the coming periods, some of the monies now in interest
bearing transaction and savings accounts may shift to time deposits, causing a
rise in the Company's cost of funds. Alternatively, these balances may be
transferred by customers to other financial institutions offering higher deposit
rates, and requiring the Company to match such rates.

     Increased deposit incentives in the form of higher rate features may be
required in coming periods if loan demand grows at a rate whereby current
sources of funds will not be sufficient to support loan funding. This would have
the effect of increasing the Company's cost of funds. The subsidiary banks of
the Company maintain sufficient ability to borrow funds from the Federal Home
Loan Bank (FHLB) for use in loan funding and there has been no recent indication
which would lead Management to believe that FHLB borrowing rates would rise to
levels which would adversely effect interest margin spreads. While Management
does not foresee being forced in future periods to pay above market rates on its
funding, extreme loan growth may cause just this scenario to occur, thereby
reducing net interest margin spreads.

     The table on the following page illustrates the Company's sensitivity to
interest rate changes as of December 31, 2004 (in thousands).


<PAGE> 32


                           HIGHLANDS BANKSHARES, INC.
                      INTEREST RATE SENSITIVITY ANALYSIS
                                December 31, 2004
                            (In Thousands of Dollars)

                                                            More than
                                                             5 Years
                         1 - 90  91 - 365  1 to 3   3 to 5    or no
                          Days     Days     Years    Years  Maturity   Total
EARNING ASSETS

   Loans                $34,842  $ 95,334  $85,483  $16,812  $16,046  $248,517
   Fed funds sold         4,006                                          4,006
   Securities             7,572    11,124    7,434      155      744    27,029
   Time deposits in other
     banks                  351       300                                  651
                         ------   -------   ------   ------   ------   -------

   Total                 46,771   106,758   92,917   16,967   16,790   280,203
                         ------   -------   ------   ------   ------   -------



INTEREST BEARING LIABILITIES

   Interest bearing
      transaction        26,133                                         26,133
   Savings accounts      49,209                                         49,209
   Time deposits
      over $100,000       6,598   13,861   15,323    3,620              39,402
   Other time deposits   20,148   40,651   32,787    8,539             102,125
   Borrowed funds         2,118    1,369    2,395      942     3,553    10,377
                        -------   ------   ------   ------    ------  --------

   Total                104,206   55,881   50,505   13,101     3,552   227,245
                        -------   ------   ------   ------    ------   -------


Rate sensitivity GAP    (57,436)  50,878   42,412    3,866    13,237    52,957

Cumulative GAP          (57,436)  (6,558)  35,854   39,720    52,957

Ratio of cumulative
   interest sensitive
   assets to cumulative
   interest sensitive
   liabilities            44.88%   95.90%  117.03%  117.76%   123.30%


Assumes all transaction, money market and savings deposit accounts reprice
within 90 days.


<PAGE> 33


Item 8.  Financial Statements

                           HIGHLANDS BANKSHARES, INC.
                           CONSOLIDATED BALANCE SHEETS
                           DECEMBER 31, 2004 AND 2003
                            (in thousands of dollars)
                                                           December 31,
                                                        2004         2003
                                                       ------------------
ASSETS

Cash and Due From Banks                               $  6,187    $  7,214
Interest bearing deposits in banks                         651       1,187
Federal funds sold                                       4,006      16,718
Investments:
  Securities held to maturity                            1,162       1,366
  Securities available for sale                         24,702      32,631
  Restricted investments                                 1,165         933
Loans                                                  248,517     226,635
Allowance for loan losses                               (2,530)     (2,463)
Bank premises and equipment                              6,810       7,210
Interest receivable                                      1,436       1,718
Other Assets                                             2,077       2,461
Investment in life insurance contracts                   5,809       5,558
                                                       -------     -------

Total Assets                                          $299,992    $301,168
                                                       =======     =======

LIABILITIES

Deposits:
  Non interest bearing                                $ 37,522    $ 32,936
  Savings and interest bearing demand deposits          75,342      72,098
  Time deposits over $100,000                           39,402      47,345
  All other time deposits                              102,125     110,306
                                                       -------     -------

Total Deposits                                         254,391     262,685

Short term borrowings                                    2,000
Long term debt                                           8,377       5,295
Accrued expenses and other liabilities                   3,569       3,639
                                                       -------     -------

Total Liabilities                                      268,337     271,619
                                                       -------     -------

STOCKHOLDERS' EQUITY

Common Stock, $5 par value, 3,000,000 shares
  authorized, 1,436,874 shares issued                    7,184       7,184
Surplus                                                  1,662       1,662
Retained earnings                                       23,028      20,727
Other accumulated comprehensive loss                      (219)        (24)
                                                       -------     -------

Total Stockholders' Equity                              31,655      29,549
                                                       -------     -------

Total Liabilities and Shareholders' Equity            $299,992    $301,168
                                                       =======     =======


             The accompanying notes are an integral part of this statement.


<PAGE> 34


                           HIGHLANDS BANKSHARES, INC.
                        CONSOLIDATED STATEMENTS OF INCOME
                  FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
                     (in thousands of dollars except per share data)

                                          2004         2003          2002
                                          -------------------------------
Interest and Dividend Income
  Loans including fees                 $  16,752     $  16,966    $  17,324
  Federal funds sold                         163           218          177
  Interest bearing deposits                   18            54          104
  Investment securities--taxable             674           885        1,164
  Investment securities--nontaxable          122           160          201
                                        --------      --------     --------
  Total Interest Income                   17,729        18,283       18,970
                                        --------      --------     --------

Interest Expense
  Interest on deposits                     4,433         6,100        7,495
  Interest on borrowed money                 278           238          210
                                        --------      --------     --------
  Total interest expense                   4,711         6,338        7,705
                                        --------      --------     --------

Net Interest Income                       13,018        11,945       11,265
                                        --------      --------     --------

Provision for loan losses                    920         1,820          820

Net Interest Income after
  Provision for Loan Losses               12,098        10,125       10,445
                                        --------      --------     --------

Noninterest Income
  Service charges                            810           616          587
  Insurance commissions and income           240           190          143
  Life insurance investment income           251           221          238
  Other operating income                     292           336          336
  Gain on securities transactions              4             4            0
                                        --------      --------     --------
  Total Noninterest Income                 1,597         1,367        1,304
                                        --------      --------     --------

Noninterest Expenses
  Salaries and benefits                    4,876         4,480        4,393
  Occupancy expense                          401           382          380
  Equipment expense                          813           726          662
  Data processing expense                    671           600          574
  Legal and professional fees                342           291          228
  Directors fees                             328           311          227
  Other operating expenses                 1,507         1,457        1,584
                                        --------      --------     --------
  Total noninterest expenses               8,938         8,247        8,048
                                        --------      --------     --------

Income before income tax expense           4,757         3,245        3,701

Income tax expense                         1,551         1,012        1,179
                                        --------      --------     --------

Net Income                             $   3,206     $   2,233    $   2,522
                                        ========      ========     ========

Weighted Average Shares Outstanding    1,436,874     1,436,874    1,455,511
Earnings Per Share                     $    2.23     $    1.55    $    1.73
Dividends Per Share                    $     .63     $     .56    $     .51


               The accompanying notes are an integral part of this statement.


<PAGE> 35


                            HIGHLANDS BANKSHARES INC.
                     CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                            (in thousands of dollars)

                                                Accumulated
                                                   Other
                       Common          Retained Comprehensive Treasury
                        Stock  Surplus Earnings Income (Loss)  Stock    Total

Balances January 1,
   2002                $2,734   $1,662   $24,175  $  283     $ (993)  $ 27,861

Comprehensive Income:
   Net Income                              2,522                         2,522
   Change in other
      Comprehensive income                           (63)                  (63)
                                                                       -------

Total Comprehensive Income                                               2,459

Treasury stock repurchased                                   (1,217)    (1,217)
Treasury stock retired   (339)            (1,871)             2,210
Stock split effected
  in form of dividend   4,789             (4,789)
Cash Dividends                              (738)                         (738)
                        -----    -----   -------   -----     ------    -------

Balances December 31,
   2002                 7,184    1,662    19,299     220                28,365

Comprehensive Income:
   Net Income                              2,233                         2,233
   Change in other
      Comprehensive income                          (244)                 (244)
                                                                        ------

Total Comprehensive Income                                               1,989

Cash Dividends                              (805)                         (805)
                        -----    -----     -----   -----     ------     ------

Balances December 31,
   2003                 7,184    1,662    20,727     (24)               29,549

Comprehensive Income:
   Net Income                              3,206                         3,206
   Change in other
      Comprehensive income                          (195)                 (195)
                                                                        ------

Total Comprehensive Income                                               3,011

Cash Dividends                              (905)                         (905)
                        -----    -----     -----   -----      -----    -------

Balances December 31,
   2004                $7,184   $1,662   $23,028  $ (219)    $         $31,655
                        =====    =====    ======   =====      =====     ======

             The accompanying notes are an integral part of this statement.


<PAGE> 36


                           HIGHLANDS BANKSHARES, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                  FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
                            (in thousands of dollars)

                                                   Years Ended December 31,
                                               2004       2003        2002
                                               ----       ----        ----
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net income                                $ 3,206     $ 2,233     $ 2,522
  Adjustments to reconcile net income to
   net cash provided by operating activities:
     (Gain)/Loss on securities transactions       4          (4)
     Loss on sale of other assets                 1
     Depreciation                               666         577         526
     Income from life insurance contracts      (251)       (220)       (238)
     Net amortization of security premiums      248         463         294
     Provision for loan losses                  920       1,820         820
     Deferred income tax benefit               (103)       (187)       (164)
     Change in other assets and liabilities:
      Interest receivable                       282         103          (4)
      Other assets                              557        (483)       (494)
      Accrued expenses                          (69)        872         150
                                             ------     -------      ------
Net Cash Provided by Operating Activities     5,461       5,174       3,412
                                             ------      ------      ------

CASH FLOWS FROM INVESTING ACTIVITIES:
  Proceeds from maturity of securities
     held to maturity                           201           1         232
  Proceeds from maturity of securities
     available for sale                      15,244      19,576      12,406
  Proceeds from sales of securities available
   for sale                                                             485
  Purchase of securities available for sale  (7,832)    (29,410)     (7,207)
  Net change in restricted investments         (232)       (261)        120
  Net decrease in deposits in other banks       536       3,312       1,834
  Net increase in loans                     (22,734)     (2,031)    (20,914)
  Net change in federal funds sold           12,712      (2,093)     (1,341)
  Purchase of property and equipment           (265)       (914)       (315)
                                             ------     -------     -------
Net Cash Used in Investing Activities        (2,370)    (11,820)    (14,700)
                                             ------     -------     -------

CASH FLOWS FROM FINANCING ACTIVITIES:
  Net change in time deposits               (15,993)       (640)      1,654
  Net change in other deposit accounts        7,699       5,813      13,817
  Additional long term debt                   3,800       1,785
  Additional short term borrowings            2,000
  Repayment of long term debt                  (719)       (519)       (494)
  Repurchase of treasury stock                                       (1,217)
  Dividends paid in cash                       (905)       (805)       (738)
                                             ------      ------      ------
Net Cash Provided by (Used in)
   Financing Activities                      (4,118)      5,634      13,022
                                             ------      ------      ------

CASH AND CASH EQUIVALENTS:
  Net (decrease) increase in cash and
   due from banks                            (1,027)     (1,012)      1,734
  Cash and due from banks, beginning of year  7,214       8,226       6,492
                                             ------      ------      ------

  Cash and due from banks, end of year      $ 6,187     $ 7,214     $ 8,226
                                             ======      ======      ======

Supplemental Disclosures:
  Cash paid for:
   Interest expense                         $ 4,920     $ 6,360     $ 7,920
   Income taxes                             $ 1,183     $ 1,448     $ 1,421



         The accompanying notes are an integral part of this statement.


<PAGE> 37


Notes to Consolidated Financial Statements


NOTE 1     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, Capon Valley Bank, HBI
Life Insurance Company, Inc. and Highlands Bankshares Trust Company, which
operate under charters issued in Arizona and West Virginia. 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 and Randolph counties of West Virginia, including the towns
of Petersburg, Keyser, Moorefield and Wardensville through eight locations and
the county of Frederick in Virginia through a single location. The insurance
company sells life and accident coverage exclusively through the Company's
subsidiary banks. The Trust Company utilizes the subsidiary banks to facilitate
the sales of trust services to its customers and citizens in those locales.



NOTE 2     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, HBI Life Insurance Company and
           Highlands Bankshares Trust Company. All significant intercompany
           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
           Cash and cash equivalents include cash on hand and noninterest
           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.


<PAGE> 38


Notes to Consolidated Financial Statements


NOTE 2     SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED):

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

           Restricted investments consist of investments in the Federal Home
           Loan Bank of Pittsburgh and the Federal Reserve Bank of Richmond.
           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.

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

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

     (g)   Allowance For Loan Losses
           The allowance for loan losses is based upon management's knowledge
           and review of the loan portfolio. Estimation of the adequacy of the
           allowance involves exercise of judgement, use of assumptions with
           respect to present economic conditions and knowledge of the
           environment in which the Banks operate. Among the factors considered
           in determining the level of the allowance are changes in composition
           of the loan portfolio, amounts of delinquent and nonaccrual loans,
           past loan loss experience and the value of collateral securing the
           loans.


     (h)   Per Share Calculations
           Earnings per share are based on the weighted average number of shares
           outstanding. In the third quarter of 2002, the Company declared a
           stock split in the form of dividend. Prior period per share amounts,
           including earnings per share, dividends per share, book value per
           share, and market price have been adjusted to reflect this split.


<PAGE> 39


Notes to Consolidated Financial Statements


NOTE 2     SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED):

     (i)   Bank Premises and Equipment
           Bank premises and equipment are stated at cost less accumulated
           depreciation. 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)   Recent Accounting Standards
           Based on the Company's review of recent accounting standards, it is
           believed that none will have a material effect on the Company's
           operations in future years.

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


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

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

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

           The portion of the benefits which will be received by the executives
           at the time of their retirement is considered, when taken
           collectively, to constitute a retirement plan. Therefore the Company
           accounts for these policies using guidance found in Statement of
           Financial Accounting Standards No. 106, "Employers' Accounting for
           Post Retirement Benefits Other Than Pensions." SFAS No. 106 requires
           that an employers' obligation under a deferred compensation agreement
           be accrued over the expected service life of the employee through
           their normal retirement date (See Note 3).


<PAGE> 40


Notes to Consolidated Financial Statements


NOTE 3     CASH AND DUE FROM BANKS:

     The Banks are required to maintain average reserve balances based on a
percentage of deposits. The Banks have generally met this requirement through
average cash on hand and balances with their correspondent institutions.


NOTE 4      SECURITIES:

     The carrying amount and estimated fair value of securities are as follows
(in thousands of dollars):

                               Carrying   Unrealized   Unrealized     Fair
                                Amount       Gains       Losses       Value

     Held to Maturity

     December 31, 2004

     State and municipals       $ 1,162     $    25     $          $   1,187
                                 ------       -----      -----      --------

     Total Securities
        Held to Maturity        $ 1,162     $    25     $          $   1,187
                                 ======      ======      ======     ========


     December 31, 2003

     Mortgage-backed            $     2     $           $           $      2
     State and municipals         1,364          71                    1,435
                                 ------      ------      ------     --------

     Total Securities
        Held to Maturity        $ 1,366     $    71     $           $  1,437
                                 ======      ======      ======      =======


     Available for Sale

     December 31, 2004

     U. S. Treasuries
        and Agencies            $18,248     $           $    84     $ 18,164
Mortgage-backed                   4,669          24                    4,693
     State and municipals         1,811           6                    1,817
     Marketable equities             28                                   28
                                 ------      ------      ------      -------

     Total Securities
        Available for Sale      $24,756     $    30     $    84     $ 24,702
                                 ======      ======      ======      =======

     December 31, 2003

     U. S. Treasuries
        and Agencies            $23,132     $   108     $           $ 23,240
     Mortgage-backed              6,686          72                    6,758
     State and municipals         2,567          37                    2,604
     Marketable equities             32                       3           29
                                 ------      ------      ------      -------

     Total Securities
        Available for Sale      $32,417     $   217     $     3     $ 32,631
                                 ======      ======      ======      =======


<PAGE> 41


Notes to Consolidated Financial Statements


NOTE 4      SECURITIES (CONTINUED):

     The carrying amount and fair value of debt securities at December 31, 2004,
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.

     Securities Held to Maturity                                     Fair
                                                       Cost          Value

     Due in one year or less                         $    841     $    853
     Due after one year through five years                320          333
     Mortgage-backed securities                             1            1
                                                      -------      -------

        Total Held to Maturity                       $  1,162     $  1,187
                                                      =======      =======


     Securities Available for Sale                                   Fair
                                                       Cost          Value

     Due in one year or less                         $ 11,273     $ 11,237
     Due after one year through five years              9,981        9,929
     Due after five years through ten years               396          406
     Due after ten years                                   30           30
     Mortgage-backed securities                         3,048        3,072
                                                      -------      -------

     Total Debt Securities                             24,728       24,674
     Equities                                              28           28
                                                      -------      -------

        Total Available for Sale                     $ 24,756     $ 24,702
                                                      =======      =======

     The carrying amounts (which approximate market value) of securities pledged
by the banks primarily to secure deposits amounted to $4,765,000 at December 31,
2004 and $6,869,000 at December 31, 2003.


NOTE 5     LOANS:

     Loans outstanding as of December 31, 2004 and 2003 are summarized as
follows (in thousands):

                                                       2004          2003

     Commercial                                    $  52,814      $  42,911
     Real estate construction                          8,850          7,552
     Real estate mortgages                           140,761        129,670
     Consumer installment                             46,092         46,502
                                                     -------        -------

        Total                                       $248,517       $226,635
                                                     =======        =======


<PAGE> 42


Notes to Consolidated Financial Statements


NOTE 5     LOANS (CONTINUED):

     The following is a summary of information pertaining to impaired,
restricted and non-accrual loans (in thousands):

                                                          December 31
                                                      2004           2003
                                                      -------------------

     Impaired loans                                $   3,013      $   2,954
     Valuation allowance                                 347            589

     No loans were identified as impaired for which an allowance was not made.

     Total non-accrual loans                       $     530      $   1,664
     Total loans past-due ninety days
        and still accruing interest                      535          1,598
     Average balance of impaired loans                 2,950          2,425
     Income recorded on impaired loans                   210            182


NOTE 6     ALLOWANCE FOR LOAN LOSSES:

     A summary of changes in the allowance for loan losses for the years ended
December 31, 2004, 2003 and 2002 is shown in the following schedule (in
thousands of dollars):

                                       2004            2003          2002
                                       ----            ----          ----

     Balance at beginning of year   $    2,463    $    1,793    $     1,602
     Provision charged to
        operating expenses                 920         1,820            820
     Loan recoveries                       308           312            151
     Loans charged off                  (1,161)       (1,462)          (780)
                                    -----------    ---------     ----------

        Balance at end of year      $    2,530    $    2,463    $     1,793
                                     =========     =========     ==========

        Percentage of outstanding
           loans                          1.02%          1.09%          .79%


NOTE 7     BANK PREMISES AND EQUIPMENT:

     Bank premises and equipment as of December 31, 2004 and 2003 are summarized
as follows (in thousands of dollars):

                                                        2004       2003

     Land                                            $   1,137   $    1,137
     Buildings and improvements                          6,332        6,317
     Furniture and equipment                             4,592        4,417
                                                      --------    ---------

     Total cost                                         12,061       11,871
     Less - accumulated depreciation                    (5,251)      (4,661)
                                                      ---------   ---------

     Net Book Value                                  $   6,810   $    7,210
                                                      ========    =========


     Provisions for depreciation charged to operations were $666,000 in 2004,
$577,000 in 2003 and $526,000 in 2002.


<PAGE> 43


Notes to Consolidated Financial Statements


NOTE 8     DEPOSITS:

     At December 31, 2004, the scheduled time deposit maturities are as follows
(in thousands of dollars):


                        2005              $ 81,258
                        2006                29,428
                        2007                18,682
                        2008                 8,294
                        2009                 3,865
                                           -------

                          Total           $ 141,527
                                           ========


NOTE 9     LONG TERM DEBT:

     The Company has borrowed money from the Federal Home Loan Bank of
Pittsburgh (FHLB). The interest rates on all of the notes payable as of December
31, 2004 range from 2.51% to 6.12%. The weighted average interest rate was 4.21%
at December 31, 2004. The Company has total borrowing capacity from the FHLB of
$116,294,000. The debt is secured by the general assets of the Banks.

     Repayments of long term debt are due either monthly, quarterly, or in a
single payment at maturity. Interest expense of $278,000, $238,000, and $210,000
was incurred on these debts in 2004, 2003, and 2002, respectively. The
maturities of long term debt as of December 31, 2004 are as follows (in
thousands of dollars):

                      2005                         $  1,487
                      2006                              534
                      2007                            1,861
                      2008                              542
                      2009                              418
                      Thereafter                      3,535
                                                    -------

                        Total                      $  8,377
                                                    =======


NOTE 10    SHORT TERM BORROWINGS:

     As of December 31, 2004, the Company had $2,000,000 of overnight borrowings
from the Federal Home Loan Bank of Pittsburgh (FHLB). Other than the borrowings
outstanding as of this date, no other short term borrowings occurred in 2004.


NOTE 11    RESTRICTIONS ON DIVIDENDS OF SUBSIDIARY BANKS:

     The principal source of funds of Highlands Bankshares, Inc. is dividends
paid by 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, 2005, the banks
could pay dividends to Highlands Bankshares, Inc. of approximately $3,944,000
without permission of the regulatory authorities.


<PAGE> 44


Notes to Consolidated Financial Statements


NOTE 12    INCOME TAX EXPENSE:


     The components of income tax expense for the years ended December 31, are
summarized as follows (in thousands of dollars):

                                              2004        2003        2002
                                          ------------------------------------

     Current Expense
        Federal                             $ 1,420     $ 1,008     $ 1,105
        State                                   234         191         238
                                             ------      ------      ------

        Total Current Expense                 1,654       1,199       1,343
                                             ------      ------      ------

     Deferred Expense (Benefit)
        Federal                                 (99)       (169)       (149)
        State                                    (4)        (18)        (15)
                                             ------      ------      ------

        Total Deferred Benefit                 (103)       (187)       (164)
                                             ------      ------      ------

        Income Tax Expense                  $ 1,551     $ 1,012     $ 1,179
                                             ======      ======      ======

     The deferred tax effects of temporary differences for the years ended
December 31 are as follows:

                                              2004         2003       2002
                                              ----         ----       ----

     Tax effect of temporary differences:
        Provision for loan losses           $   (8)      $ (180)    $  (57)
        Depreciation                             18          77         41
        Deferred compensation                  (125)        (84)      (119)
        Miscellaneous                            12                    (29)
                                             ------       -----      -----

        Net increase in deferred income
           tax benefit                       $ (103)     $ (187)    $ (164)
                                             ======       =====      =====


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

                                                         2004        2003

     Deferred Tax Assets:
        Provision for loan losses                    $     645   $     665
        Insurance commissions                               50          56
        Sale of loans                                        5           8
        Deferred compensation                              740         625
        Pension obligation                                  94          91
        Unrealized loss on securities
           available for sale                               11
        Other                                                7
                                                      --------    --------

        Total Assets                                     1,552       1,445
                                                      --------    --------

     Deferred Tax Liabilities:
     -------------------------
        Unrealized gain on securities
           available for sale                                           81
        Accretion income                                    18          15
        Depreciation                                       487         476
                                                     ---------    --------

        Total Liabilities                                  505         572
                                                     ---------    --------

        Net Deferred Tax Asset                       $     1,047 $     873
                                                       =========  ========


<PAGE> 45


Notes to Consolidated Financial Statements


NOTE 12    INCOME TAX EXPENSE (CONTINUED):

     The following table summarizes the difference between income tax expense
and the amount computed by applying the federal statutory income tax rate for
the years ended December 31:

                                            2004         2003         2002
                                            ----         ----         ----

     Amounts at federal statutory rates  $   1,617   $   1,103   $   1,258
     Additions (reductions) resulting
        from:
           Tax-exempt income                   (78)       (109)       (116)
           Partially exempt income             (41)        (35)        (30)
           State income taxes, net             147         110         128
           Income from life insurance
            contracts                          (94)        (83)        (89)
           Other                                            26          28
                                         ---------    --------    --------

           Income tax expense            $   1,551   $   1,012   $   1,179
                                          ========    ========    ========


NOTE 13    EMPLOYEE BENEFITS:

     The Company's two subsidiary banks each have separate retirement and profit
sharing plans which cover substantially all full time employees at each bank.

     The Capon Valley Bank has a defined contribution pension plan with 401(k)
features that is funded with discretionary contributions by the Bank. The bank
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 6 year period.

     The Grant County Bank is a member of the West Virginia Bankers' Association
Retirement Plan. Benefits under the plan are based on compensation and years of
service with 100% vesting after seven years of service. Prior to 2002, the
Plan's assets were in excess of the projected benefit obligations and thus the
Bank was not required to make contributions to the Plan in 2003, 2002 or 2001.
The bank was required to make a contribution in 2004 and will be required to
make a contribution in 2005 due to the inability of the investment portfolio in
recent years to meet its expected return, The Bank has recognized liabilities of
$461,000 at December 31, 2004 as a result of this shortfall. This has resulted
in a cumulative decrease in other comprehensive income of $176,000 (which is net
of an income tax effect of $104,000) and an intangible asset of $35,000.

     The following table provides a reconciliation of the changes in the defined
benefit plan's obligations and fair value of assets over the two year period
ended December 31, 2004 (in thousands of dollars):

                                                    2004       2003

     Change in Benefit Obligation
        Benefit obligation, beginning             $ 2,390     $ 2,027
        Service cost                                  111          93
        Interest cost                                 164         143
        Actuarial loss                                135         163
        Benefits paid, plus interest weighted
           for timing                                 (57)        (37)
                                                        -           -

        Benefit obligation, ending                $ 2,743     $ 2,390
                                                   ======      ======

     Accumulated Benefit Obligation               $ 2,229     $ 2,012
                                                   ======      ======


<PAGE> 46


Notes to Consolidated Financial Statements


NOTE 13    EMPLOYEE BENEFITS (CONTINUED):

                                                    2004       2003

        Change in Plan Assets
          Fair value of assets, beginning         $ 1,621     $ 1,472
          Actual return on assets                     145         186
          Employer contributions                       85
          Benefits paid                               (55)        (37)
          Administrative expenses                     (28)
                                                   ------      ------

          Fair value of assets, ending            $ 1,768     $ 1,621
                                                   ======      ======

        Funded Status
          Fair value of plan assets               $ 1,768     $ 1,621
          Projected benefit obligation             (2,743)     (2,389)
                                                   ------      ------
          Funded status                              (975)       (769)
          Unrecognized prior service cost              35          46
          Unrecognized net loss                       796         628
          Unfunded accumulated
             benefit obligation                      (317)       (297)
                                                   ------      ------

          Accrued benefit cost included
             in other liabilities                 $  (461)    $  (391)
                                                   ======      ======


     The following table provides the components of the net periodic benefit
cost for the plan for the years ended December 31, 2004, 2003 and 2002 (in
thousands of dollars):

                                           2004       2003        2002
                                           ---------------------------

        Service Cost                      $  114     $    93     $    85
        Interest Cost                        162         143         126
        Expected return on plan assets      (166)       (165)       (166)
        Amortization of net obligation
           at transition                                  (9)        (15)
        Recognized net actuarial gain         14
        Amortization of prior service cost    11          11          11
                                           -----      ------      ------

           Net periodic benefit cost      $  134     $    73     $    41
                                           =====      ======      ======


     The weighted-average asumptions used in the measurement of The Grant County
Bank's benefit obligation and net periodic benefit costs are as follows:

                                                2004     2003     2002
                                                ----     ----     ----

           Discount rate                        6.50%    7.00%    7.25%
           Expected return on plan assets       8.50%    4.00%    4.25%
           Rate of compensation increase        3.50%    8.50%    8.50%

     The plan sponsor selects the expected long-term rate of return on assets
assumption 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.


<PAGE> 47


Notes to Consolidated Financial Statements


NOTE 13    EMPLOYEE BENEFITS (CONTINUED):

     The following table provides the pension plan's asset allocation as of
December 31:

                                                2004         2003

     Equity securities                          72%           70%
     Debt securities                            23%           26%
     Other                                       5%            4%


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


                                             Target     Allowable Allocation
                                           Allocation           Range

     Equity securities                         75%             40-80%
     Debt securities                           20%             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. Plan contributions by the employer are fully vested in
the year of contribution.

     The Company has established an employee stock ownership plan which 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.

     Employer contributions related to the above pension plans charged to
operations totaled $434,000 in 2004, $279,000 in 2003 and $232,000 in 2002.


NOTE 14    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 aggregate payoff amount of loans to
related parties of $3,773,000 at December 31, 2003 was increased during 2004 by
$1,167,000 as a result of new loans and reduced $857,000 by payments. The
balance of loans to related parties was $4,083,000 at December 31, 2004. Other
changes in balances represent additions to, deletions from or changes in
executive officer or director status.


<PAGE> 48


Notes to Consolidated Financial Statements


NOTE 15    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, 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
$249,000,000 loans held by the Company at December 31, 2004, $180,000,000 is
secured by real estate.

     The Banks had cash deposited in and federal funds sold to other commercial
banks totaling $8,036,000 at December 31, 2004.


NOTE 16    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. As of the balance sheet
dates, the Banks had outstanding the following commitments (in thousands of
dollars):
                                                        2004        2003

     Commitments to extend credit                     $ 15,158    $ 16,041
     Standby letters of credit                             186         136

     The Banks use the same credit policies in making commitments and issuing
letters of credit as it does 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.


NOTE 17    DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS:

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


<PAGE> 49


Notes to Consolidated Financial Statements


NOTE 17    DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED):

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

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

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

     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 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, 2004. 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, 2004 or 2003.


<PAGE> 50


Notes to Consolidated Financial Statements


NOTE 17    DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED):

     The carrying amount and estimated fair values of financial instruments as
of December 31, 2004 and 2003 are as follows (in thousands of dollars):

                                         2004                  2003
                                         ----                  ----
                                             Estimated             Estimated
                                 Carrying      Fair     Carrying     Fair
                                  Amount       Value      Amount       Value

     Financial Assets:
     Cash and due from banks      $  6,187   $  6,187   $  7,214   $  7,214
     Interest bearing deposits         651        651      1,187      1,187
     Federal funds sold              4,006      4,006     16,718     16,718
     Securities held to maturity     1,162      1,187      1,366      1,437
     Securities available for sale  24,702     24,702     32,631     32,631
     Other investments               1,165      1,165        933        933
     Loans, net                    245,987    247,228    224,172    226,635
     Interest receivable             1,436      1,436      1,718      1,718
     Life insurance contracts        5,809      5,809      5,558      5,558

     Financial Liabilities:
     Demand and savings
         deposits                  112,864    112,733    105,034    105,034
     Time deposits                 141,527    147,320    157,651    169,037
     Short term debt                 2,000      2,000
     Long term debt                  8,377      8,085      5,295      5,495
     Interest payable                  396        396        605        605


NOTE 18    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.


<PAGE> 51


Notes to Consolidated Financial Statements


NOTE 18    REGULATORY MATTERS (CONTINUED):

     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.

<TABLE>

     The Company's actual capital ratios are presented in the following table:

<CAPTION>

                                              Actual (in thousands)            Regulatory Requirements
                                                   December 31,
                                             2004                 2003         Adequately      Well
                                          $        %           $        %      Capitalized  Capitalized
     <S>                               <C>       <C>        <C>       <C>         <C>         <C>
     Total Risk Based Capital Ratio
     Highlands Bankshares              $33,120   14.71%     $31,095   14.55%      8.00%        None
     Capon Valley Bank                  12,208   12.82%      10,651   11.93%      8.00%       10.00%
     The Grant County Bank              20,097   15.68%      17,152   13.89%      8.00%       10.00%

     Tier1 Leverage Ratio
     Highlands Bankshares               30,590   10.14%      28,632    9.42%      3.00%        None
     Capon Valley Bank                  11,020    8.57%       9,535    7.31%      3.00%        5.00%
     The Grant County Bank              18,754   11.01%      15,814    9.05%      3.00%        5.00%

     Tier 1 Risk Based Capital Ratio
     Highlands Bankshares               30,590   13.58%      28,632   13.40%      4.00%        None
     Capon Valley Bank                  11,020   11.57%       9,535   10.60%      4.00%        6.00%
     The Grant County Bank              18,745   14.64%      15,814   12.81%      4.00%        6.00%
</TABLE>


     Capital ratios and amounts are applicable both at the individual bank level
and on a consolidated basis. At December 31, 2003, 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 except any such occurrence in the
foreseeable future.


<PAGE> 52


Notes to Consolidated Financial Statements


NOTE 19    CHANGES IN OTHER COMPREHENSIVE INCOME

     The components of change in other comprehensive income and related tax
effects are as follows (in thousands of dollars):

                                         Years Ended December 31,
                                       2004        2003       2002
                                       ----        ----       ----

     Beginning Balance January 1      $  (24)     $  220      $  283

     Unrealized holding gains (losses)
       on available for sale securities
       net of income taxes of $92,000,
       $(82,800) and $ 5,143 2004, 2003
       and 2002 respectively            (176)       (159)          9

     Accrued pension obligation net
     of income taxes of $11,571,
     $50,188, and $42,558 in 2004,
     2003 and 2002 respectively          (19)        (85)        (72)
                                       -----       -----       -----

     Net change for the year            (195)       (244)        (63)
                                       -----       -----       -----

     Ending balance December 31       $ (219)     $  (24)     $  220
                                       =====       =====       =====


NOTE 20    FOURTH QUARTER ADJUSTMENTS:

     Certain income and expenses related to employee post retirement benefits
are estimated throughout the year based upon information available during the
year. Specific required amounts needed to adjust to actual income and expenses
for these post retirement benefits are not available until December. Therefore,
annual adjustments to expenses related to these benefits are made in the fourth
quarter of each year. The net effect of these adjustments during the fourth
quarter of 2004 was to reduce pretax income by $71,000.

     Within the fourth quarter of 2003, the Company had two charges to
operations that were material to the Company's operations in that quarter.
First, the Company recognized an expense for the entire year for the post
retirement benefits that are to be accrued under SFAS No. 106. The charge to
operations was recognized when the Company decided to continue existing
agreements with employees and was able to determine its liability under SFAS No.
106. Prior to September 30, 2003, the Company was awaiting financial information
on the amount of the liability and had not yet determined whether the agreements
would be continued. The amount of expense recognized for post retirement
benefits was $78,000 or $49,000 on an after tax basis.

     Also in the fourth quarter of 2003, the Company charged to operations an
additional loan loss provision in order to recognize additional losses
identified in the loan portfolio. The provision was to cover potential losses in
the installment portfolio which had seen an increase in delinquencies and credit
losses due to a stagnant economy and other individual credit problems. The
fourth quarter provision of $825,000 ($520,000 after income taxes) was about
$500,000 ($315,000 after income taxes) greater than the average of the previous
three quarters for 2003.


<PAGE> 53


Notes to Consolidated Financial Statements


NOTE 21    PARENT CORPORATION ONLY FINANCIAL STATEMENTS:


     BALANCE SHEETS
     (in thousands of dollars)

                                             December 31,
                                         2004            2003
                                        ---------------------
     Assets
     Cash                              $    156         $   172
     Investment in subsidiaries          31,536          29,505
     Income taxes receivable                 58             508
     Other assets                            34              22
                                        -------          ------

     Total Assets                      $ 31,784         $30,207
                                        =======          ======

     Liabilities
     Accrued expenses                  $     75         $   121
     Due to subsidiaries                     54             537
                                        -------          ------

     Total Liabilities                      129             658
                                        -------          ------

     Stockholders' Equity
     Common stock, par value $5 per
     share 3,000,000 issued, 1,436,874
     Outstanding                          7,184           7,184
     Surplus                              1,662           1,662
     Retained earnings                   23,028          20,727
     Other accumulated
     Comprehensive loss                    (219)            (24)
                                        -------          ------

     Total Stockholders' Equity          31,655          29,549
                                        -------         -------

     Total Liabilities and
     Stockholders' Equity              $ 31,784        $ 30,207
                                        =======         =======


<PAGE> 54


Notes to Consolidated Financial Statements


NOTE 21    PARENT CORPORATION ONLY FINANCIAL STATEMENTS (CONTINUED):


                   STATEMENTS OF INCOME AND RETAINED EARNINGS

                                               Years Ended December
                                          2004         2003          2002
                                          ----         ----          ----
     Income
        Dividends from subsidiaries    $    940      $   905      $  2,137
                                        -------       ------       -------

     Total                                  940          905         2,137
                                        -------       ------       -------

     Expenses
     Salary and benefits expense            155          145           190
     Professional fees                       82           39            36
     Directors' fees                         62           55            43
     Other expense                           83           89            70
                                        -------      -------      --------

     Total                                  382          328           339
                                        -------       ------       -------

     Net income before income tax benefit
     and undistributed subsidiary net
     income (deficit)                       558          577         1,798


     Income Tax Benefit                     142          115           133
                                        -------       ------       -------

     Income before undistributed
     subsidiary net income                  700          692         1,931

     Undistributed subsidiary
     net income                           2,506        1,541           591
                                        -------       ------       -------

     Net Income                        $  3,206      $ 2,233      $  2,522
                                        =======       ======       =======



     Retained earnings,
     beginning of period               $ 20,727      $19,298      $ 24,174
     Dividends paid in cash                (905)        (804)         (738)
     Stock split                                                    (4,790)
     Treasury stock retired                                         (1,870)
     Net income                           3,206        2,233         2,522
                                        -------       ------       -------
     Retained earnings,
     end of period                     $ 23,028      $20,727      $ 19,298
                                        =======       ======       =======


<PAGE> 55


Notes to Consolidated Financial Statements


NOTE 21    PARENT CORPORATION ONLY FINANCIAL STATEMENTS (CONTINUED):


                            STATEMENTS OF CASH FLOWS

                                               Years Ended December
                                          2004         2003          2002
                                          ----         ----          ----

     Cash flows from operating activities:
     Net Income                        $  3,206      $ 2,233      $  2,522
     Adjustments to net income
      Undistributed subsidiary
        income                           (2,506)      (1,541)         (591)
      Depreciation                                         2             2
      Loss on investment                                                15
      Increase (decrease) in payables       (46)         112            85
      (Increase) decrease in receivables    450         (256)         (122)
      (Increase) decrease in other assets   (13)          15           (15)
                                         ------       ------       -------

     Net cash provided by operating
     activities                           1,091          565         1,896
                                        -------       ------       -------

     Cash flows from investing activities:
     Advances from (payments to)
      subsidiaries                         (483)         289            79
     Received from subsidiaries             281
                                        -------       ------       -------

     Net cash provided by (used in)
      investing activities                 (202)         289            79
                                        -------       ------       -------

     Cash flows from financing activities:
     Dividends paid in cash                (905)        (804)         (738)
     Purchase of treasury stock                                     (1,217)
                                        -------       ------       -------

     Net cash used in
     financing activities                  (905)        (804)       (1,955)


     Net increase (decrease) in cash        (16)          50            20

     Cash, beginning of year                172          122           102
                                        -------       ------       -------

     Cash, end of year                 $    156      $   172      $    122
                                        =======       ======       =======


<PAGE> 56


                        REPORT OF INDEPENDENT REGISTERED
                             PUBLIC ACCOUNTING FIRM




The Stockholders and Board of Directors
Highlands Bankshares, Inc.
Petersburg, West Virginia


     We have audited the accompanying consolidated balance sheets of Highlands
Bankshares, Inc. and subsidiaries as of December 31, 2004 and 2003, and the
related consolidated statements of income, changes in stockholders' equity and
cash flows for the three years ended December 31, 2004. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

     We conducted our audits in accordance with 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
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
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, 2004 and 2003, and the
results of their operations and their cash flows for the three years ended
December 31, 2004, in conformity with U.S. generally accepted accounting
principles.


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


February 22, 2005
Harrisonburg, Virginia


<PAGE> 57


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

     None


Item 9A.  Controls and Procedures

     The Company's management, with the participation of the Company's Chief
Executive Officer and Chief Financial Officer, has evaluated the effectiveness
of the Company's disclosure controls and procedures as of December 31, 2004.
Bases on this evaluation, the Company's Chief Executive Officer and Chief
Financial Officer concluded that the Company's disclosure controls and
procedures are effective as of December 31, 2004.

Changes in Internal Controls

     During the period reported upon, there were no significant changes in the
internal controls of Highlands Bankshares, Inc. pertaining to its financial
reporting and control of its assets or in other factors that could significantly
affect these controls.

     Due to the nature of the Company's business as stewards of assets of
customers, internal controls are of the utmost importance. The company has
established procedures undertaken during the normal course of business in an
effort to reasonably ensure that fraudulent activity of either an amount
material to these results or in any amount is not occurring. In addition to
these controls and review by executive officers, the Company retains the
services of Yount, Hyde & Barbour, P.C., a public accounting firm, to complete
regular internal audits to examine the processes and procedures of the Company
and its subsidiary banks to ensure that these processes are both reasonably
effective to prevent fraud, both internal and external, and that these processes
comply with relevant regulatory guidelines of all relevant banking authorities.
The findings of Yount, Hyde & Barbour are presented both to Management of the
subsidiary banks and to the Audit Committee.


Item 9B. Other Information

     None


Part III

Item  10.   Directors,  Executive Officers,  Promoters and Control Persons;
            Compliance with Section 16(a) of the Exchange Act

     Information required by this item is set forth under the caption
"COMPLIANCE WITH SECTION 16(A) OF THE SECURITIES EXCHANGE ACT" of our 2005 Proxy
Statement, to be filed within 120 days after the end of the Company's fiscal
year end, and is incorporated herein by reference.


Item 11. Executive Compensation

     Information required by this item is set forth under the caption "EXECUTIVE
COMPENSATION" of our 2005 Proxy Statement, to be filed within 120 days after the
end of the Company's fiscal year end, and is incorporated herein by reference.


<PAGE> 58


Item 12. Security Ownership of Certain Beneficial Owners and Management

     Information required by this item is set forth under the caption "SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT" of our 2005 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

     Information required by this item is set forth under the caption "Certain
Related Transactions" of our 2005 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, 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 14 of the consolidated financial
statements.

     John VanMeter 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. 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 Accountant's Fees and Services

     Information required by this item is set forth under the caption "FEES OF
INDEPENDENT PUBLIC ACCOUNTANTS" of our 2005 Proxy Statement, to be filed within
120 days after the end of the Company's fiscal year end, and is incorporated
herein by reference.


<PAGE> 59


Part IV

Item 15. Exhibits and Financial Statement Schedules

     A) Financial Statements:
            (1) Financial Statements: Reference is made to Part II, Item 8 of
            this Annual Report on Form 10-K.

            (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.

            (3) See Exhibits below.

         Exhibit No.                          Description

           3 (i)           Articles of  Incorporation  of  Highlands
                           Bankshares,  Inc. are incorporated by reference to
                           Appendix C to Highlands Bankshares, Inc.'s Form S-4
                           filed October 20, 1986.

                           Amendments to the original Articles of Incorporation
                           are incorporated by reference; filed as Exhibit 3(i)
                           with 1997 10-KSB.


           3 (ii)          Bylaws  of  Highlands   Bankshares,   Inc.  are
                           incorporated  by reference to Appendix D to Highland
                           Bankshares,  Inc.'s Form S-4 filed October 20, 1986.

                           Amended Bylaws of Highlands Bankshares,  Inc. are
                           incorporated by reference to Exhibit 3(ii) to
                           Highland  Bankshares,  Inc.'s Form 10-Q filed
                           May 15, 2003.

            14             Code of Ethics is incorporated by reference to
                           Exhibit 14 to Highlands Bankshares, Inc.'s Form
                           10-K filed March 30, 2004

            21             Subsidiary Listing of the Registrant

           31.1            Certification of Chief Executive Officer pursuant to
                           Section 302 of the Sarbanes-Oxley Act of 2002.

           31.2            Certification of Chief Financial  Officer pursuant
                           to Section 302 of the Sarbanes-Oxley Act of 2002.

           32.1            Certification of Chief  Executive Officer pursuant
                           to Section 1350 of the Sarbanes-Oxley Act of 2002.

           32.2            Certification of Chief Financial Officer pursuant to
                           Section 1350 of the Sarbanes-Oxley Act of 2002.



     A) See (A)(3) above.

     B) See (A)(1) and (A)(2) above.


<PAGE> 60



                                   Signatures

    Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

HIGHLANDS BANKSHARES, INC.

/s/ C.E. Porter                        /s/ R. Alan Miller
-----------------------------------    -----------------------
C.E. Porter                            R. Alan Miller
President & Chief Executive Officer    Chief Financial Officer
Date:  March 24, 2005                  Date: March 24, 2005


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

        Signature                         Title                  Date


/s/ Leslie A. Barr                                           March 31, 2005
-----------------------
Leslie A. Barr                          Director


/s/ Jack H. Walters                                          March 31, 2005
-----------------------
Jack H. Walters                         Director


/s/ Thomas B. McNeill, Sr.                                   March 31, 2005
-----------------------
Thomas B. McNeill, Sr.                  Director


/s/ L. Keith Wolfe                                           March 31, 2005
-----------------------
L. Keith Wolfe                          Director


/s/ Kathy  G. Kimble                                         March 31, 2005
-----------------------
Kathy G. Kimble                         Director


/s/ Steven C. Judy                                           March 31, 2005
-----------------------
Steven C. Judy                          Director


/s/ Courtney R. Tusing                                       March 31, 2005
-----------------------
Courtney R. Tusing                      Director


/s/ John G. Van Meter                   Director             March 31, 2005
-----------------------
John G. Van Meter                 Chairman of the Board


/s/ Alan L. Brill                       Director             March 31, 2005
-----------------------
Alan L. Brill                    Secretary of the Company


/s/ C. E. Porter                        Director             March 24, 2005
-----------------------
C. E. Porter              President and Chief Executive Officer
                               Treasurer of the Company