10-K

UNITED STATES

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 the fiscal year ended December 31, 2005

Commission file number 000-27622

HIGHLANDS BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

Virginia (State or other jurisdiction of incorporation or organization)	54-1796693 (I.R.S. Employer Identification No.)
340 West Main Street Abingdon, Virginia (Address of principal executive offices)	24210-1128 (Zip Code)

Registrant’s telephone number, including area code: (276) 628-9181

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Name of each exchange on which registered
None	n/a

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.625 par value

(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes      No X 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15d of the Act. Yes__ No X 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 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 pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ X ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated” in Rule 12b-2 of the Exchange Act.(Check one):

Large accelerated filer  [  ]   Accelerated filer  [  ]    Non-accelerated filer [X]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes [  ] No [X ]

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $54,569,279

Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date. As of March 10, 2006, there were 5,263,400 shares of Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE

Annual Report to Shareholders for the fiscal year ended December 31, 2005—Part II

Proxy Statement for the 2006 Annual Meeting of Shareholders—Part III

	Table of Contents
		Page Number
Part I
Item 1.	Business	3
Item 1A.	Risk Factors	16
Item 1B.	Unresolved Staff Comments	19
Item 2.	Properties	19
Item 3.	Legal Proceedings	20
Item 4.	Submission of Matters to a Vote of Security Holders	20
Part II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder    Matters and Issuer Purchases of Equity Securities	21
Item 6.	Selected Financial Data	23
Item 7.	Management’s Discussion  and Analysis of Financial Condition   and Results of Operation	24
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	44
Item 8.	Financial Statements and Supplementary Data	47
Item 9.	Changes in and Disagreements with Accountants on   Accounting and Financial Disclosure	47
Item 9A.	Controls and Procedures	47
Item 9B.	Other Information	47
Part III
Item 10.	Directors and Executive Officers of the Registrant	48
Item 11.	Executive Compensation	48
Item 12.	Security Ownership of Certain Beneficial Owners and   Management and Related Stockholder Matters	48
Item 13.	Certain Relationships and Related Transactions	48
Item 14.	Principal Accounting Fees and Services	48
Part IV
Item 15.	Exhibits, Financial Statement Schedules	49

Forward-Looking Information

Certain information in this report may include “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These forward-looking statements are generally identified by phrases such as “the Company expects,” “the Company believes” or words of similar import. These statements speak only as of the date of this report. The statements are based on current expectations, are inherently uncertain, are subject to risks, and should be viewed with caution. Such forward-looking statements involve known and unknown risks including, but not limited to, the following factors:

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The ability to successfully manage the Company’s growth or implement its growth strategies if it is unable to identify attractive markets, locations or opportunities to expand in the future;

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The ability to continue to attract low cost core deposits to fund asset growth;

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Maintaining capital levels adequate to support the Company’s growth;

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Maintaining cost controls and asset qualities as the Company opens or acquires new branches;

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Reliance on the Company’s management team, including its ability to attract and retain key personnel;

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The successful management of interest rate risk;

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Changes in general economic and business conditions in the Company’s market area;

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Changes in interest rates and interest rate policies;

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Risks inherent in making loans such as repayment risks and fluctuating collateral values;

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Competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;

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Demand, development and acceptance of new products and services;

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Problems with technology utilized by the Company;

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Changing trends in customer profiles and behavior; and

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Changes in banking and other laws and regulations applicable to the Company.

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Part I.

Item I. Business

History and Business

Highlands Bankshares, Inc. (the “Company”) is a one-bank holding company organized under the laws of Virginia in 1995 and registered under the Bank Holding Company Act (BHCA). The Company conducts the majority of its business operations through its wholly-owned bank subsidiary, Highlands Union Bank (the “Bank”). The Company has two direct subsidiaries as of December 31, 2005: the Bank, which was formed in 1985, and Highlands Capital Trust I (HCTI), a statutory business trust (the “Trust”) which was formed in 1998.

The Bank maintains a website at www.hubank.com. The Company makes available through the website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports, free of charge, as soon as reasonably practicable after the material is electronically filed with the Securities and Exchange Commission.

Highlands Union Bank

The Bank is a Virginia state chartered bank that was incorporated in 1985. The Bank has two wholly owned subsidiaries, Highlands Union Insurance Services, Inc. (HUIS), which was formed in 1999, and Highlands Union Financial Services, Inc. (HUFS), which was formed in 2001. In February 2005, the Bank became an equity owner in Bankers’ Investments, LLC, headquartered in Richmond, Virginia. The Bank’s equity investment was $250,000 for two units of ownership. Bankers’ Investments, LLC was formed for the purpose of providing owner banks the ability to offer a full line of financial services to their customers. At the time of the Bank’s investment there were 32 owner banks. The Bank operates a full-service banking business from its headquarters in Abingdon, Virginia, and its ten full service branch offices. The Bank offers general retail and commercial banking services to individuals, businesses and local government unit customers. These products and services include accepting deposits in the form of checking accounts, money market deposit accounts, interest-bearing demand deposit accounts, savings accounts and time deposits; making commercial, commercial and residential real estate, construction, agricultural and consumer loans; offering letters of credit; providing other consumer financial services, such as automatic funds transfer, collections, night depository, safe deposit, travelers checks and savings bond sales; and providing other miscellaneous services normally offered by commercial banks. The Bank makes loans in all major loan categories, including commercial, commercial and residential real estate, construction, agricultural and consumer loans.

At December 31, 2005, the Bank had total assets of $593.88 million. Total deposits at this date were $490.40 million. The Bank’s net income for 2005 was $5.33 million which produced a return on average assets of 0.92% and a return on average stockholders' equity of 13.34%. Refer to Note 21 of the Notes to Consolidated Financial Statements for the Bank’s risk-based capital ratios.

Highlands Union Insurance Services, Inc.

Highlands Union Insurance Services, Inc., a wholly owned subsidiary of the Bank, was formed in 1999. The Bank, through HUIS, joined a consortium of approximately 47 other financial institutions to form Bankers’ Insurance, LLC. Bankers’ Insurance, LLC, as of

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December 31, 2005, had purchased seven full service insurance agencies across the state of Virginia. HUIS is used to sell insurance services through the Bankers’ Insurance, LLC.

Highlands Union Financial Services, Inc.

Highlands Union Financial Services, Inc., a wholly-owned subsidiary of the Bank, was formed in 2001   HUFS was formed in order for the Bank to continue to offer, through a third-party, mutual funds, annuities and other financial services to its customers in all market areas served.

Commercial Loans

The Bank makes both secured and unsecured loans to businesses and to individuals for business purposes. Loan requests are granted based upon several factors including credit history, past and present relationships with the Bank, marketability of collateral and the cash flow of the borrowers. Unsecured commercial loans must be supported by a satisfactory balance sheet and income statement. Collateralized business loans may be secured by a security interest in marketable equipment, accounts receivable, business equipment and/or general intangibles of the business. In addition, or as an alternative, the loan may be secured by a deed of trust lien on business real estate. The risks associated with commercial loans are related to the strength of the individual business, the value of loan collateral and the general health of the economy. The Bank has established credit review and credit analysis departments as well as specific underwriting policies to aid in mitigating credit risk.

Residential Real Estate Loans

Loans secured by residential real estate are originated by the Bank. The Bank also offers secondary market fixed rate mortgages through multiple sources. These loans and servicing rights are generally sold immediately into the secondary market and fees received are booked into income. These loans must meet certain criteria generally set by the secondary market. All residential loans originated by the Bank are held in the Bank’s loan portfolio. Residential real estate loans carry risk associated with the continued credit-worthiness of the borrower and changes in the value of the collateral. The Bank has established credit review and credit analysis departments as well as specific underwriting policies to aid in mitigating credit risk.

Construction Loans

The Bank makes loans for the purpose of financing the construction of business and residential structures to financially responsible business entities and individuals. These loans are subject to the same credit criteria as commercial and residential real estate loans. In addition to the risks associated with all real estate loans, construction loans bear the risks that the project will not be finished according to schedule, the project will not be finished according to budget and the value of the collateral may at any point in time may be less than the principal amount of the loan. Construction loans also bear the risk that the general contractor, who may or may not be the Bank’s loan customer, is unable to finish the construction project as planned because of financial pressures unrelated to the project. Loans to customers that are made as permanent financing of construction loans may likewise under certain circumstances be affected by external financial pressures. The Bank has established credit review and credit analysis departments as well as specific underwriting policies to aid in mitigating credit risk.

Consumer Loans

The Bank routinely makes consumer loans, both secured and unsecured. The credit history, cash flow and character of individual borrowers is evaluated as a part of the credit decision. Loans used to purchase vehicles or other specific personal property and loans associated with real estate are usually secured with a lien on the subject vehicle or property. Negative

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changes in a customer's financial circumstances due to a large number of factors, such as illness or loss of employment, can place the repayment of a consumer loan at risk. In addition, deterioration in collateral value can add risk to consumer loans.

Sales and Purchases of Loans

The Bank will occasionally buy or sell all or a portion of a loan. The Bank will consider selling a loan or a participation in a loan, if: (i) the full amount of the loan will exceed the Bank’s legal lending limit, $7.23 million at December 31, 2005, to a single borrower; (ii) the full amount of the loan, when combined with a borrower's previously outstanding loans, will exceed the Bank’s legal lending limit to a single borrower; (iii) the Board of Directors or an internal Loan Committee believes that a particular borrower has a sufficient level of debt with the Bank; (iv) the borrower requests the sale; (v) the loan to deposit ratio is at or above the optimal level as determined by bank management; and/or (vi) the loan may create too great a concentration of loans in one particular location or in one particular type of loan. The Bank will consider purchasing a loan, or a participation in a loan, from another financial institution if the loan meets all applicable credit quality standards and (i) the Bank’s loan to deposit ratio is at a level where additional loans would be desirable; and/or (ii) a common customer requests the purchase.

The following table sets forth, for the three fiscal years ended December 31, 2005, 2004 and 2003, the percentage of total operating revenue contributed by each class of similar services which contributed 15% or more of total operating revenues of the Company during such periods.

Period	Class of Service	Percentage of Total Revenues
December 31, 2005	Interest and Fees on Loans	72.09%
December 31, 2004	Interest and Fees on Loans	72.21%
December 31, 2003	Interest and Fees on Loans	72.97%

Market Area

Highlands Union Bank Market Area

The Bank’s primary market area consists of all of Washington County, Virginia, portions of Smyth County, Virginia, the City of Bristol, Virginia, the City of Bristol, Tennessee and adjacent portions of Sullivan County, Tennessee, the Town of Rogersville, Tennessee and adjacent portions of Hawkins County, the City of Sevierville, Tennessee and adjacent portions of Sevier County, Tennessee, the Town of Banner Elk and adjacent portions of Avery County, North Carolina and the Town of Boone and adjacent portions of Watauga County, North Carolina, the Town of West Jefferson, North Carolina and adjacent portions of Ashe County, North Carolina. The local economy is diverse and is oriented toward retail and service, light manufacturing, higher education and agriculture.

The information presented below is based on the most recent information available to the Company.

The independent city of Bristol, Virginia is located in far southwestern Virginia and lies directly on the Virginia-Tennessee state line. Washington County surrounds Bristol to the west, north and east. The community is part of the Johnson City-Kingsport-Bristol Combined Statistical Area (CSA). The three largest employment sectors are services, manufacturing and retail trade. The Tri-Cities is home to more than 140 manufacturing and distribution firms. The latest unemployment figures reflect an unemployment rate of 5.0% as of August 2004. Per capita income reported in 2002 is $24,343.00. Bristol / Washington County's largest employer is Bristol Compressors located between Bristol and Abingdon, Virginia. Bristol Compressors is a

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subsidiary of York International and manufactures reciprocating compressors from 1 to 25 tons and, through a joint venture in Scroll Technologies, scroll compressors from 2 to 7 -1/2 tons. These compressors are used in York International’s products and are sold to original equipment manufacturers and wholesale distributors. Approximately 75% of Bristol Compressor's revenues are attributable to sales of products to other air conditioning equipment manufacturers or wholesale distributors. York International was acquired by Johnson Controls on December 9, 2005. The future business plans for Bristol Compressors is yet undecided.

The Bank has a branch office located in Marion which is the county seat of Smyth County, Virginia. Marion is approximately 30 miles northeast of Abingdon, Virginia. The three largest employment sectors are services, manufacturing and retail trade. The latest unemployment figures reflect an unemployment rate of 4.5% as of November 2004. Per capita income reported in 2002 is $20,817.00. Smyth County’s largest employer is General Dynamics. The company designs, develops and produces high-performance armament systems; a full range of advanced composite-based products; biological and chemical detection systems; tactical deception equipment; and mobile shelter systems. The Smyth County facility currently employs more than 650 people and includes three manufacturing sites totaling more than one million square feet.

Bristol, Tennessee is located in Sullivan County Tennessee and is Bristol, Virginia’s twin city. Bristol, Tennessee’s three largest employment sectors are services, manufacturing and retail trade. The latest unemployment figures reflect an unemployment rate of 5.8% for 2003. Per capita income reported in 2001 was $25,809.00. Bristol, Tennessee’s largest employer is Exide Technologies Battery Plant. This plant is approximately 631,000 square feet and is used for battery manufacturing. The plant currently employs approximately 1,000 workers.

Rogersville, Tennessee is located in Hawkins County approximately 45 miles southwest of Bristol, Tennessee. Rogersville’s three largest employment sectors are services, manufacturing and retail trade. The latest unemployment figures reflect an unemployment rate of 7.1% for 2003. Per capita income reported in 2001 was $20,066.00. In Hawkins County, large manufacturers include AFG Industries, with 900 employees; TRW Corp., with 700 employees; Hutchinson Sealing Systems, with 520 employees; Rockwell Automation, Dodge Division, with 420 employees; International Playing Card & Label, with 270 employees; and Cooper Standard Automotive, with 520 employees.

Sevierville, Tennessee is located in Sevier County, Tennessee. Sevierville, Tennessee is located approximately 20 miles east of Knoxville, Tennessee. Sevierville serves as the county seat and is the largest city located in Sevier County. Major employers for the county include tourism, retail, and service related industries. There is some industrial base that mitigates some of the seasonal employment fluctuation from the tourism and related businesses. Major industrial employers include Dan River, which manufacturers cotton fabrics, Blalock Lumber (asphalt and ready-mixconcrete), TRW (engine valves and components), and Federal Mogul (automotiveparts). The latest unemployment figures reflect an unemployment rate of 3.7% for 2000. Per capital income reported in 2000 was $18,576.

Boone, North Carolina is located in Watauga County in the northwestern mountains of North Carolina. Watauga County’s three largest employment sectors are private industry, education services and retail trade. The latest unemployment figures reflect an unemployment rate of 1.5% as of September 2004. Per capita income reported in 2002 was $24,265.00. Watauga County, North Carolina’s largest employer is Appalachian State University. Appalachian State is the sixth largest university in the University of North Carolina system. Employment at Appalachian State University has remained relatively stable over the past three years.

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Banner Elk, North Carolina is located in Avery County in the northwestern mountains of North Carolina. Avery County’s three largest employment sectors are private industry, government and health care / social assistance. The latest unemployment figures reflect an unemployment rate of 2.4% as of September 2004. Per capita income reported in 2002 was $22,876.00. Avery County, North Carolina’s largest employers are Leviton Manufacturing Co., Inc., and Ashe County Board of Education.

West Jefferson, North Carolina is located in Ashe County in the northwestern mountains of North Carolina. Ashe County’s three largest employment sectors are trade / transportation / utilities, construction and health care / education. The latest unemployment figures reflect an unemployment rate of 5.7% as of June 2005. Per capita income reported in 2003 was $23,702.00. Ashe County, North Carolina’s largest employers are Avery Health Care System and Ethan Allen, Inc.

Competition

The banking and financial service business in Virginia, generally, and in the Bank’s market areas specifically, is highly competitive. The increasingly competitive environment is a result of changes in regulation, changes in technology and product delivery systems and new competition from non-traditional financial services. The Bank competes for loans and deposits with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, money market funds, credit unions and other non-bank financial service providers. Many of these competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader array of financial services than the Bank. In order to compete, the Bank relies upon service-based business philosophies, personal relationships with customers, specialized services tailored to meet customers' needs and the convenience of office locations and extended hours of operation. In addition, the Bank is generally competitive with other financial institutions in their market areas with respect to interest rates paid on deposit accounts, interest rates charged on loans and other service charges on loans and deposit accounts.

Certain Regulatory Considerations

The Company and the Bank are subject to various state and federal banking laws and regulations which impose specific requirements or restrictions on and provide for general regulatory oversight with respect to virtually all aspects of operations. As a result of the substantial regulatory burdens on banking and financial institutions, including the Company and the Bank, such institutions are disadvantaged relative to other competitors who are not as highly regulated, and their costs of doing business are much higher. The following is a summary of the material provisions of certain statutes, rules and regulations which affect the Company and the Bank. This summary is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below, and is not intended to be an exhaustive description of the statutes or regulations which are applicable to the businesses of the Company and the Bank. Any change in applicable laws or regulations may have a material adverse effect on the business and prospects of the Company and the Bank.

Highlands Bankshares, Inc.

The Company is a bank holding company within the meaning of the BHCA and Chapter 13 of the Virginia Banking Act, as amended (the Virginia Banking Act). The activities of the Company also are governed by the Gramm-Leach-Bliley Act of 1999.

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The Bank Holding Company Act. The BHCA is administered by the Federal Reserve Board, and the Company is required to file with the Federal Reserve Board an annual report and any additional information the Federal Reserve Board may require under the BHCA. The Federal Reserve Board also is authorized to examine the Company and its subsidiaries. The BHCA requires every bank holding company to obtain the approval of the Federal Reserve Board before (i) it or any of its subsidiaries (other than a bank) acquires substantially all the assets of any bank; (ii) it acquires ownership or control of any voting shares of any bank if after the acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of the bank; or (iii) it merges or consolidates with any other bank holding company.

The BHCA and the Change in Bank Control Act, together with regulations promulgated by the Federal Reserve Board, require that, depending on the particular circumstances, either Federal Reserve Board approval must be obtained or notice must be furnished to the Federal Reserve Board and not disapproved prior to any person or company acquiring "control" of a bank holding company, such as the Company, subject to certain exemptions. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the Company. Control is rebuttably presumed to exist if a person acquires 10% or more, but less than 25%, of any class of voting securities of the Company. The regulations provide a procedure for challenging the rebuttable control presumption.

Under the BHCA, a bank holding company is generally prohibited from engaging in, or acquiring direct or indirect control of more than 5% of the voting shares of any company engaged in non-banking activities, unless the Federal Reserve Board, by order or regulation, has found those activities to be so closely related to banking or managing or controlling banks as to be incident to banking. The Federal Reserve Board imposes certain capital requirements on the Company under the BHCA, including a minimum leverage ratio and a minimum ratio of "qualifying" capital to risk-weighted assets. Subject to its capital requirements and certain other restrictions, the Company can borrow money to make a capital contribution to the Bank, and these loans may be repaid from dividends paid from the Bank to the Company (although the ability of the Bank to pay dividends are subject to regulatory restrictions). The Company can raise capital for contribution to the Bank by issuing securities without having to receive regulatory approval, subject to compliance with federal and state securities laws.

    The Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act (the GLBA), enacted on November 12, 1999, broadly rewrote financial services legislation. The GLBA permits significant combinations among different sectors of the financial services industry; allows for significant expansion of financial service activities by Bank holding companies and provides for a regulatory framework by various governmental authorities responsible for different financial activities; and offers certain financial privacy protections to consumers. The GLBA repealed affiliation and management interlock prohibitions of the Depression-era Glass-Steagall Act and, by amending the Bank Holding Company Act, the GLBA added new substantive provisions to the non-banking activities permitted under the BHCA with the creation of the financial holding company. The GLBA preempts most state laws that prohibit financial holding companies from engaging in insurance activities. The GLBA permits affiliations between banks and securities firms within the same holding company structure, and the Act permits financial holding companies to directly engage in a broad range of securities and merchant banking activities. The Company has not elected to become a financial holding company.

    The Gramm-Leach-Bliley Act led to important changes in the manner in which financial services are delivered in the United States. Bank holding companies and their subsidiary banks are able to offer a much broader array of financial services; however, there is greater competition in all sectors of the financial services market.

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    The Virginia Banking Act. All Virginia bank holding companies must register with the Virginia State Corporation Commission (the Commission) under the Virginia Banking Act. A registered bank holding company must provide the Commission with information with respect to the financial condition, operations, management and inter-company relationships of the holding company and its subsidiaries. The Commission also may require such other information as is necessary to keep itself informed about whether the provisions of Virginia law and the regulations and orders issued under Virginia law by the Commission have been complied with, and may make examinations of any bank holding company and its subsidiaries. The Virginia Banking Act allows bank holding companies located in any state to acquire a Virginia bank or bank holding company if the Virginia bank or bank holding company could acquire a bank holding company in their state and the Virginia bank or bank holding company to be acquired has been in existence and continuously operated for more than two years. The Virginia Banking Act permits bank holding companies from throughout the United States to enter the Virginia market, subject to federal and state approval.

Sarbanes-Oxley Act of 2002. On July 30, 2002, the President signed into law the Sarbanes-Oxley Act of 2002 (the “Act”) implementing legislative reforms intended to address corporate and accounting fraud. In addition to the establishment of a new accounting oversight board that enforces auditing, quality control and independence standards and is funded by fees from all publicly traded companies, the law restricts provision of both auditing and consulting services by accounting firms. To ensure auditor independence, any non-audit services being provided to an audit client requires pre-approval by the issuer’s audit committee members. In addition, the audit partners must be rotated. Under the Act, legal counsel is required to report evidence of a material violation of the securities laws or a breach of fiduciary duty by a company to its chief executive officer or its chief financial officer, and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the board of directors or the board itself.

Longer prison terms and increased penalties are also applied to corporate executives who violate federal securities laws, the period during which certain types of suits can be brought against a company or its officers has been extended, and bonuses issued to top executives prior to restatement of a company’s financial statements are subject to disgorgement if such restatement was due to corporate misconduct. Executives are also prohibited from insider trading during retirement plan “blackout” periods, and loans to company executives are restricted. The Act accelerates the time frame for disclosures by public companies, as they must immediately disclose any material changes in their financial condition or operations. Directors and executive officers must also provide information for most changes in ownership in a company’s securities within two business days of the change.

The Act also prohibits any officer or director of a company or any other person acting under their direction from taking any action to fraudulently influence, coerce, manipulate or mislead any independent public or certified accountant engaged in the audit of the company’s financial statements for the purpose of rendering the financial statement’s materially misleading. The Act also requires the SEC to prescribe rules requiring inclusion of an internal control report and assessment by management in the annual report to stockholders. In addition, the Act requires that each financial report required to be prepared in accordance with (or reconciled to) accounting principles generally accepted in the United States of America and filed with the SEC reflect all material correcting adjustments that are identified by a “registered public accounting firm” in accordance with accounting principles generally accepted in the United States of America and the rules and regulations of the SEC.

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The Company’s chief executive officer and chief financial officer are each required to certify that the Company’s quarterly and annual reports do not contain any untrue statement of a material fact. The Act imposes several requirements, including having these officers certify that: they are responsible for establishing, maintaining and regularly evaluating the effectiveness of the Company’s internal controls; they have made certain disclosures to the Company’s auditors and the audit committee of the Board of Directors about the Company’s internal controls; and they have included information in the Company’s quarterly and annual reports about their evaluation and whether there have been significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls during the last quarter.

Highlands Union Bank

General. The Bank, as a state chartered member of the Federal Reserve, is subject to regulation and examination by the Virginia State Corporation Commission and the Federal Reserve Board. In addition, the Bank is subject to the rules and regulations of the Federal Deposit Insurance Corporation. Deposits in the Bank are insured by the FDIC up to a maximum amount (generally $100,000 per depositor, subject to aggregation rules). The Federal Reserve Board and the Virginia Bureau of Financial Institutions regulate or monitor all areas of the Bank’s operations, including security devices and procedures, adequacy of capitalization and loss reserves, loans, investments, borrowings, deposits, mergers, issuances of securities, payment of dividends, interest rates payable on deposits, interest rates or fees chargeable on loans, establishment of branches, corporate reorganizations and maintenance of books and records. The Federal Reserve Board requires the Bank to maintain certain capital ratios. The Bank is required by the Federal Reserve Board to prepare quarterly reports on the Bank’s financial condition and to conduct an annual audit of its financial affairs in compliance with minimum standards and procedures prescribed by the Federal Reserve Board. The Bank also is required by the Federal Reserve Board to adopt internal control structures and procedures in order to safeguard assets and monitor and reduce risk exposure. While appropriate for safety and soundness of banks, these requirements impact banking overhead costs.

Community Reinvestment Act. The Bank is subject to the provisions of the Community Reinvestment Act of 1977 (the CRA), which requires the appropriate federal bank regulatory agency, in connection with its regular examination of a bank, to assess the Bank’s record in meeting the credit needs of the community served by the bank, including low and moderate-income neighborhoods. The focus of the regulations is on the volume and distribution of a Bank’s loans, with particular emphasis on lending activity in low and moderate-income areas and to low and moderate-income persons. The regulations place substantial importance on a Bank’s product delivery system, particularly branch locations. The regulations require banks, including the Bank, to comply with significant data collection requirements. The regulatory agency's assessment of the Bank’s record is made available to the public. Further, this assessment is required for any bank which has applied to, among other things, establish a new branch office that will accept deposits, relocate an existing office, or merge, consolidate with or acquire the assets or assume the liabilities of a federally regulated financial institution. Management expects that the banks' compliance with the CRA, as well as other fair lending laws, will face ongoing government scrutiny and that costs associated with compliance will continue to increase. The Bank received "Satisfactory" CRA ratings in the last examination by bank regulators.

Federal Deposit Insurance Corporation Improvement Act of 1991. The Federal Deposit Insurance Corporation Improvement Act (FDICIA) requires each federal banking regulatory agency to prescribe, by regulation, standards for all insured depository institutions and depository institution holding companies relating to (i) internal controls, information systems and audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate exposure; (v) asset growth; (vi) compensation, fees and benefits; and (vii) such other

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operational and managerial standards as the agency determines to be appropriate. The compensation standards would prohibit employment contracts, compensation or benefit arrangements, stock option plans, fee arrangements or other compensatory arrangements that provide excessive compensation, fees or benefits or could lead to material financial loss. In addition, each federal banking regulatory agency must prescribe by regulation standards specifying (i) a maximum ratio of classified assets to capital; (ii) minimum earnings sufficient to absorb losses without impairing capital; (iii) to the extent feasible, a minimum ratio of market value to book value for publicly traded shares of depository institutions and depository institution holding companies; and (iv) such other standards relating to asset quality, earnings and valuation as the agency determines to be appropriate. If an insured institution fails to meet any of the standards promulgated by regulation, then such institution will be required to submit a plan to its federal regulatory agency specifying the steps it will take to correct the deficiency.

Prompt corrective action measures in FDICIA impose significant restrictions and requirements on depository institutions that fail to meet their minimum capital requirements. Under Section 38 of the Federal Deposit Insurance Act (“FDI Act”), the federal banking regulatory agencies have developed a classification system pursuant to which all depository institutions are placed into one of five categories based on their capital levels and other supervisory criteria:  well capitalized, adequately capitalized; undercapitalized; significantly undercapitalized; and critically undercapitalized.

The Bank met the requirements at December 31, 2005 to be classified as “well capitalized.”  This classification is determined solely for the purposes of applying the prompt corrective action regulations and may not constitute an accurate representation of the Bank’s overall financial condition.

An undercapitalized depository institution is required to submit a capital restoration plan to its principal federal regulator. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital and is guaranteed by the parent holding company. If a depository institution fails to submit an acceptable plan, it will be treated as if it were significantly undercapitalized.

Unless its principal federal regulator has accepted its capital plan, an undercapitalized bank may not increase its average total assets in any calendar quarter. If an undercapitalized institution’s capital plan has been accepted, asset growth will be permissible only if the growth is consistent with the plan and the institution’s ratio of tangible equity to assets increases during the quarter at a rate sufficient to enable the institutions to become adequately capitalized within a reasonable time.

An institution that is an undercapitalized depository institution may not solicit deposits by offering rates of interest that are significantly higher than the prevailing rates on insured deposits in the institution’s normal market areas or in the market area in which the deposits would otherwise be accepted. An undercapitalized depository institution may not branch, acquire an interest in another business or institution or enter a new line of business unless its capital plan has been accepted and its principal federal regulator approves the proposed action.

An insured depository institution may not pay management fees to any person having control of the institution nor may an institution, except under certain circumstances and with prior regulatory approval, make any capital distribution if, after making such payment or distribution, the institution would be undercapitalized.

11

Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. Critically undercapitalized institutions are subject to appointment of a receiver or conservator.

If its principal federal regulator determines that an adequately capitalized institution is in an unsafe or unsound condition or is engaging in an unsafe or unsound practice, it may require the institution to submit a corrective action plan, restrict its asset growth and prohibit branching, new acquisitions and new lines of business. An institution’s principal federal regulator may deem it to be engaging in unsafe or unsound practices if it receives a less than satisfactory rating for asset quality, management, earnings or liquidity in its most recent examination.

In addition, regulators were required to draft a new set of non-capital measures of bank safety, such as loan underwriting standards and minimum earnings levels, effective December 1, 1993. The legislation also requires regulators to perform annual on-site bank examinations, place limits on real estate lending by banks and tightens auditing requirements.

Section 36 of FDICIA significantly affects financial institutions with more then $500 million in total assets. However, The FDIC has amended Part 363 of its regulations by raising the asset-size threshold from $500 million to $1 billion for internal control assessments by management and external auditors. For institutions between $500 million and $1 billion in assets, only a majority, rather than all, of the members of the audit committee, who must be outside directors, must be independent of management. The final rule became effective December 28, 2005. Below are the key FDICIA requirements including the significant changes relating to the amendments to Part 363:

·

Institutions must have an adequate system of internal control according to some generally accepted framework.

·

Section I agreed-upon-procedures testing of compliance with laws and regulations must be performed by either internal audit or the entity's independent public accountants.

·

Section II agreed-upon-procedure testing of compliance with laws and regulations must be performed by the entity's independent public accountant if management elected to have internal auditors perform Section I agreed-upon procedures.

·

Management must perform its own investigation and review of the effectiveness of internal controls and compliance with laws.

·

A management report must be submitted and signed by the chief executive officer and chief accountant (or chief financial officer), which states management's responsibility for the internal control system, an assessment of the effectiveness of the system at fiscal year-end, and an assessment of compliance with laws and regulations during the fiscal year.

·

An independent public accountant's report that attests to management's assertions concerning the Bank’s internal control and procedure for financial reporting is required.

·

As amended, for covered institutions with between $500 million and $1 billion in total assets, management is no longer required to assess and report on the effectiveness of internal control over financial reporting, the external auditors are no longer required to examine and attest to management's internal control assertions, and only a majority of the outside directors on the audit committee must be independent of management.

12

·

The amendments provide relief from these requirements to covered institutions with total assets of less than $1 billion only for purposes of Part 363. These covered institutions must continue to fully comply with the remaining provisions of Part 363, including the annual financial statement audit requirement.

·

The amendments do not relieve public covered institutions from their obligations to comply with the provisions of the Sarbanes-Oxley Act and the Securities and Exchange Commission's implementing rules on internal control reporting by management and external auditors and, if applicable, audit committee independence.

·

The amendments took effect December 28, 2005, and applied to institutions whose fiscal years end on or after September 30, 2005.

Branching. In 1986, the Virginia Banking Act was amended to remove the geographic restrictions governing the establishment of branch banking offices. Subject to the approval of the appropriate federal and state bank regulatory authorities, the Bank as a state bank, may establish a branch office anywhere in Virginia.

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the Interstate Act) allows bank holding companies to acquire banks in any state, without regard to state law, except that if the state has a minimum requirement for the amount of time a bank must be in existence, that law must be preserved. The Interstate Act also permits banks to acquire out-of-state branches through interstate mergers, if the state has not opted out of interstate branching. De novo branching, where an out-of-state bank holding company sets up a new branch in another state, requires a state's specific approval. An acquisition or merger is not permitted under the Interstate Act if the bank, including its insured depository affiliates, will control more than 10% of the total amount of deposits of insured depository institutions in the United States, or will control 30% or more of the total amount of deposits of insured depository institutions in any state.

Virginia has, by statute, elected to opt-in fully to interstate branching under the Interstate Act. Under the Virginia statute, Virginia state banks may, with the approval of the Virginia State Corporation Commission, establish and maintain a de novo branch or acquire one or more branches in a state other than Virginia, either separately or as part of a merger. Procedures also are established to allow out-of-state domiciled banks to establish or acquire branches in Virginia, provided the "home" state of the bank permits Virginia banks to establish or acquire branches within its borders. The activities of these branches are subject to the same laws as Virginia domiciled banks, unless such activities are prohibited by the law of the state where the bank is organized. The Virginia State Corporation Commission has the authority to examine and supervise out-of-state state banks to ensure that the branch is operating in a safe and sound manner and in compliance with the laws of Virginia. The Virginia statute authorizes the Bureau of Financial Institutions to enter into cooperative agreements with other state and federal regulators for the examination and supervision of out-of-state banks with Virginia operations, or Virginia domiciled banks with operations in other states. Likewise, national banks, with the approval of the OCC, may branch into and out of the state of Virginia. Any Virginia branch of an out-of-state state chartered bank is subject to Virginia law (enforced by the Virginia Bureau of Financial Institutions) with respect to intrastate branching, consumer protection, fair lending and community reinvestment as if it were a branch of a Virginia bank, unless preempted by federal law.

Deposit Insurance. The FDIC establishes rates for the payment of premiums by federally insured financial institutions. A Bank Insurance Fund (the BIF) is maintained for commercial banks, with insurance premiums from the industry used to offset losses from insurance payouts when banks fail. Beginning in 1993, insured depository institutions like the Bank paid for deposit

13

insurance under a risk-based premium system. Beginning in 1997, all banks, including the Bank, were subject to an additional FDIC assessment which funds interest payments for bank issues to resolve problems associated with the savings and loan industry. This assessment will continue until 2018-2019. The assessment will vary over the period from 1.29 cents to 2.43 cents per $100 of deposits.

USA Patriot Act. The USA Patriot Act became effective in late 2001. It was passed to facilitate the sharing of information among government entities and financial institutions to combat terrorism and money laundering. The USA Patriot Act creates an obligation on banks to report customer activities that may involve terrorist activities or money laundering.

Government Policies. The operations of the Bank are affected not only by general economic conditions, but also by the policies of various regulatory authorities. In particular, 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 loans, investments and deposits and affect interest rates charged on loans or paid for time and savings deposits. Federal Reserve Board 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.

Limits on Dividends and Other Payments. As a state member bank subject to the regulations of the Federal Reserve Board, the Bank must obtain the approval of the Federal Reserve Board for any dividend if the total of all dividends declared in any calendar year would exceed the total of its net profits, as defined by the Federal Reserve Board, for that year, combined with its retained net profits for the preceding two years. In addition, a state member bank may not pay a dividend in an amount greater than its undivided profits then on hand after deducting its losses and bad debts. For this purpose, bad debts are generally defined to include the principal amount of loans which are in arrears with respect to interest by six months or more, unless such loans are fully secured and in the process of collection. Moreover, for purposes of this limitation, a state member bank is not permitted to add the balance in its allowance for loan losses account to its undivided profits then on hand; however, it may net the sum of its bad debts as so defined against the balance in its allowance for loan losses account and deduct from undivided profits only bad debts as so defined in excess of that account.

In addition, the Federal Reserve Board is authorized to determine, under certain circumstances relating to the financial condition of a state member bank, that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The payment of dividends that depletes a Bank’s capital base could be deemed to constitute such an unsafe or unsound practice. The Federal Reserve Board has indicated that banking organizations should generally pay dividends only out of current operating earnings.

Virginia law also imposes restrictions on the ability of the Bank to pay dividends. A Virginia state bank is permitted to declare a dividend out of its "net undivided profits", after providing for all expenses, losses, interest and taxes accrued or due by the bank. In addition, a deficit in capital originally paid in must be restored to its initial level, and no dividend can be paid which could impair the Bank’s paid in capital. The Bureau of Financial Institutions further has authority to limit the payment of dividends by a Virginia bank if it determines the limitation is in the public interest and is necessary to ensure the Bank’s financial soundness.

FDICIA provides that no insured depository institution may make any capital distribution (which would include a cash dividend) if, after making the distribution, the institution would not satisfy one or more of its minimum capital requirements.

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Capital Requirements. The Federal Reserve Board has adopted risk-based capital guidelines which are applicable to the Company and the Bank. The Federal Reserve Board guidelines redefine the components of capital, categorize assets into different risk classes and include certain off-balance sheet items in the calculation of risk-weighted assets. The minimum ratio of qualified total capital to risk-weighted assets (including certain off-balance sheet items, such as standby letters of credit) is 8.0%. At least half of the total capital must be comprised of Tier 1 capital for a minimum ratio of Tier 1 Capital to risk-weighted assets of 4.0%. The remainder may consist of a limited amount of subordinated debt, other preferred stock, certain other instruments and a limited amount of loan and lease loss reserves.

In addition, the Federal Reserve Board has established minimum leverage ratio (Tier 1 capital to total average assets less intangibles) guidelines that are applicable to the Company and the Bank. These guidelines provide for a minimum ratio of 4.0% for banks that meet certain specified criteria, including that they have the highest regulatory CAMELS rating and are not anticipating or experiencing significant growth and have well-diversified risk. All other banks will be required to maintain an additional cushion of at least 100 to 200 basis points, based upon their particular circumstances and risk profiles. The guidelines also provide that banks experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.

Bank regulators from time to time have indicated a desire to raise capital requirements applicable to banking organizations beyond current levels. In addition, the number of risks which may be included in risk-based capital restrictions, as well as the measurement of these risks, is likely to change, resulting in increased capital requirements for banks. The Company and the Bank are unable to predict whether higher capital ratios would be imposed and, if so, at what levels and on what schedule.

Other Legislative and Regulatory Concerns

Other legislative and regulatory proposals regarding changes in banking and the regulation of banks, thrifts and other financial institutions are periodically considered by the executive branch of the federal government, Congress and various state governments, including Virginia. New proposals could significantly change the regulation of banks and the financial services industry. It cannot be predicted what might be proposed or adopted or how these proposals would affect the Company.

Other Business Concerns

The banking industry is particularly sensitive to interest rate fluctuations, as the spread between the rates which must be paid on deposits and those which may be charged on loans is an important component of profit. In addition, the interest which can be earned on a Bank’s invested funds has a significant effect on profits. Rising interest rates typically reduce the demand for new loans, particularly the real estate loans which represent a significant portion of the Bank’s loan demand.

Employees

The Company, the Bank, HCTI, HUFS and HUIS are organized in a holding company/subsidiary structure. As of December 31, 2005, the Company had no employees, except for officers, and it conducted substantially all of its operations through its subsidiaries. All cash compensation paid to the Company’s officers was paid by the Bank, including fees

15

paid to its directors. Stock based compensation, through the form of stock options, is paid / granted through the Company.

During 2005, compensation paid to HUFS officers and employees was paid through the Bank. At December 31, 2005, the Bank employed 231 full time equivalent employees at its main office, operations center and branch offices. The Company, HCTI, HUFS and HUIS had no employees at this time.

The Company’s relationship with its employees is considered to be good. Employment has remained very stable over the last several years with very little turnover. There are no employment contracts in existence for any employee or officer.

Item 1A. Risk Factors

Our business is subject to various risks, including the risks described below. Our business, operating results and financial condition could be materially and adversely affected by any of these risks. Please note that additional risks not presently known to us or that we currently deem immaterial may also impair our business and operations.

Changes in interest rates could have an adverse effect on our income.

Our profitability depends to a large extent upon our net interest income. Net interest income is the difference between interest income on interest-earning assets, such as loans and investments, and interest expense on interest-bearing liabilities, such as deposits and borrowings. Our net interest income will be adversely affected if market interest rates change so that the interest we pay on deposits and borrowings increases faster than the interest we earn on loans and investments. Changes in interest rates also affect the value of our loans. An increase in interest rates could adversely affect borrowers’ ability to pay the principal or interest on existing loans or reduce their desire to borrow more money. This may lead to an increase in our nonperforming assets or a decrease in loan originations, either of which could have a material and negative effect on our results of operations. Interest rates are highly sensitive to many factors that are partly or completely outside of our control, including governmental monetary policies, domestic and international economic and political conditions and general economic conditions such as inflation, recession, unemployment and money supply. Fluctuations in market interest rates are neither predictable nor controllable and may have a material and negative effect on our business, financial condition and results of operations. We attempt to minimize our exposure to interest rate risk, but we will be unable to eliminate it.

Our concentration in loans secured by real estate may increase our credit losses, which would negatively affect our financial results.

A significant portion of our loan portfolio is dependent on real estate. In addition to the financial strength and cash flow characteristics of the borrower in each case, we often secure loans with real estate collateral. At December 31, 2005, approximately 79.42% of our loans have real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. An adverse change in the economy affecting values of real estate generally or in our primary markets specifically could significantly impair the value of our collateral and result in a significant portion of our portfolio being under-collateralized. In such a case, it would be likely that we would be required to increase our provision for loan losses, which would negatively affect our results of operations. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our ability to recover fully on defaulted loans by foreclosing and selling the real estate collateral would be diminished and we would be more likely to suffer losses on defaulted loans, which could adversely affect our profitability and financial condition. Risk of loan defaults and foreclosures are unavoidable in the banking industry, and we try to limit our

16

exposure to this risk by monitoring our extensions of credit carefully. We cannot fully eliminate credit risk, and as a result credit losses may occur in the future.

If our allowance for loan losses becomes inadequate, our results of operations may be adversely affected.

We maintain an allowance for loan losses that we believe is a reasonable estimate of known and inherent losses in our loan portfolio. Through a periodic review and consideration of the loan portfolio, management determines the amount of the allowance for loan losses by considering general market conditions, credit quality of the loan portfolio, the collateral supporting the loans and performance of our customers relative to their financial obligations with us. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, that may be beyond our control, and these losses may exceed our current estimates. Rapidly growing loan portfolios are, by their nature, unseasoned. As a result, estimating loan loss allowances is more difficult, and may be more susceptible to changes in estimates, and to losses exceeding estimates, than more seasoned portfolios. Al though we believe the allowance for loan losses is a reasonable estimate of known and inherent losses in our loan portfolio, we cannot fully predict such losses or that our loan loss allowance will be adequate in the future. Excessive loan losses could have a material impact on our financial performance. Because of our growth strategy, we expect that our earnings will be negatively impacted by loan growth, which requires additions to our allowance for loan losses. Consistent with our loan loss reserve methodology, we expect to make additions to our loan loss reserve levels as a result of our growth strategy, which may affect our short-term earnings.

Federal and state regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in the amount of our provision or loans charged-off as required by these regulatory agencies could have a negative effect on our operating results.

Our profitability and the value of your investment may suffer because of rapid and unpredictable changes in the highly regulated environment in which we operate.

We are subject to extensive supervision by several governmental regulatory agencies at the federal and state levels. Recently enacted, proposed and future banking legislation and regulations have had, and will continue to have, or may have a significant impact on the financial services industry. These regulations, which are intended to protect depositors and not our shareholders, and the interpretation and application of them by federal and state regulators, are beyond our control, may change rapidly and unpredictably and can be expected to influence our earnings and growth. Our success depends on our continued ability to maintain compliance with these regulations. Some of these regulations may increase our costs and thus place other financial institutions that are not subject to similar regulation in stronger, more favorable competitive positions.

We rely heavily on our management team and the unexpected loss of any of those personnel could adversely affect our operations; we depend on our ability to attract and retain key personnel.

        We are a customer-focused and relationship-driven organization. We expect our future growth to be driven in a large part by the relationships maintained with our customers by our Executive Vice President and Chief Executive Officer, Samuel L. Neese, and our other executive and senior lending officers, all of whom have many years of experience in our industry. We have not entered into employment agreements with any of the

17

executive or senior officers. The unexpected loss of Mr. Neese or other key employees could have a material adverse effect on our business and possibly result in reduced revenues and earnings. We do not maintain key man life insurance policies on any of our executives.

We will face risks with respect to future expansion.

Our current strategy is to continue growing in the southwest Virginia, western North Carolina and northeastern Tennessee markets. Our expansion strategy will involve a number of risks such as the time and expense associated with evaluating new markets for expansion, hiring local management and opening new offices. Any future expansion efforts may entail substantial costs and may not produce the additional growth or earnings that were anticipated, which could adversely affect our results of operations. Any expansion plans we undertake may also divert the attention of our management from the operation of our current business, which could also have an adverse effect on our results of operations.

The success of our growth strategy depends on our ability to identify and recruit individuals with experience and relationships in the markets in which we intend to expand.

We intend to expand our banking network over the next several years in the southwest Virginia, western North Carolina and northeastern Tennessee markets. We believe that to expand into new markets successfully, we must identify and recruit experienced key management members with local expertise and relationships in these markets. We expect that competition for qualified management in the markets in which we expand will be intense and that there will be a limited number of qualified persons with knowledge of and experience in the community banking industry in these markets. The process of identifying and recruiting individuals with the combination of skills and attributes required to carry out our strategy is often lengthy. Even if we identify individuals that we believe could assist us in establishing a presence in a new market, we may be unable to recruit these individuals away from more established banks. Many experienced banking professionals employed by our competitors are covered by agreements not to compete or solicit their existing customers if they were to leave their current employment. These agreements make the recruitment of these professionals more difficult. Our inability to identify, recruit and retain talented personnel to manage new offices effectively and in a timely manner would limit our growth and could materially adversely affect our business, financial condition and results of operations.

Our future success is dependent on our ability to compete effectively in the highly competitive banking industry.

We face vigorous competition from other banks and other financial institutions, including savings and loan associations, savings banks, finance companies and credit unions for deposits, loans and other financial services in our market area. Our business operations are centered primarily in Virginia, North Carolina, and Tennessee. Increased competition within this region may result in reduced loan originations and deposits. Ultimately, we may not be able to compete successfully against current and future competitors. A number of these banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services. To a limited extent, we also compete with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations which may offer more favorable financing than we can. Many of our non-bank competitors are not subject to the same extensive regulations that govern us. As a result, these non-bank competitors have advantages over us in providing certain

18

services. This competition may reduce or limit our margins and our market share and may adversely affect our results of operations and financial condition.

Our business is subject to various lending and other economic risks that could adversely impact our results of operations and financial condition.

Changes in economic conditions, particularly an economic slowdown, could hurt our business. Our business is directly affected by political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in governmental monetary and fiscal policies and inflation, all of which are beyond our control. A deterioration in economic conditions, in particular an economic slowdown within our geographic region, could result in the following consequences, any of which could hurt our business materially:

·

loan delinquencies may increase;  

·

problem assets and foreclosures may increase;

·

demand for our products and services may decline; and

·

collateral for loans made by us may decline in value, in turn reducing a client’s borrowing power, and reducing the value of assets and collateral associated with our loans held for investment.

We do business in a small geographic area, and a large percentage of our loans are made in our market area. If the region suffers a significant or prolonged period of economic downturn, there is a greater likelihood that more of our customers could become delinquent on their loans or other obligations to, which could adversely affect our performance. If more competitors come into our market area, our business could suffer.

There is a limited trading market for our common stock; it may be difficult to sell our shares after you have purchased them.

Our common stock is currently listed on the Over The Counter Bulletin Board and the Pink Sheets under the symbol “HBKA.OB.” The volume of trading activity in our stock is relatively low, thirty-four trades in the last six months. Even if a more active market develops, there can be no assurance that such market will continue, or that you will be able to sell your shares at or above the offering price. You should carefully consider the lack of liquidity of your investment in the common shares when making your investment decision.

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

The Company’s and the Bank’s headquarters are located at 340 W. Main Street, Abingdon, Virginia. In addition to the Bank’s Main Office location, the Bank owns ten branch

19

offices: one in the Town of Abingdon, Virginia; one in Washington County, Virginia, two in the City of Bristol, Virginia; one in the Town of Glade Spring, Virginia; one in the Town of Marion, Virginia; one in the City of Bristol, Tennessee; one in the Town of Rogersville, Tennessee; one in the Town of Boone, North Carolina; and one in the Town of Banner Elk, North Carolina. The Bank owns the land and buildings of all of these branch offices as well as the main office for the Company and Bank. The Bank also owns the land and building used for Financial Services, Collections, Human Resources and Credit Cards in Abingdon, Virginia. The Bank owns a piece of vacant land in Marion, Virginia that used to house a drive-up ATM. The Bank owns a vacant piece of land in Bristol, Tennessee that is being held for a potential future branch site. The Bank owns a tract of land in Sevierville, Tennessee that will be used for the development of a branch bank office in 2006. The Bank leases office space in Abingdon, Virginia for operational purposes, leases office space in West Jefferson, North Carolina for a loan production office and leases office space in Sevierville, Tennessee for a loan production office. The Company owns the land and buildings used as the Bank’s Operations Center and Technology House in Abingdon, Virginia. The Company owns the land and vacant building on property adjacent to the Company’s Operation Center in Abingdon, Virginia. The Company owns vacant land in proximity to its Main Branch Office in Abingdon, Virginia. The Company exercised an option to purchase approximately five acres of vacant land in Abingdon, Virginia for future possible development of a corporate headquarters. Subsequent to December 31, 2005, the Company entered into an option to purchase an additional nine and one-half acres adjacent to the orginal five acres for future development needs.

All of the Company’s existing properties are in good operating condition and are adequate for the Company’s present and anticipated future needs.

Item 3. Legal Proceedings

The Company is not currently involved in any pending legal proceedings, other than routine litigation incidental to the Bank’s banking business. These proceedings are not material to the Company or the Bank.

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

    None

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Part II

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

Common Stock Information and Dividends

There are two distinct markets for the Company’s common stock. The Company’s common stock is traded on the Over-The-Counter Bulletin Board (OTCBB) and the Pink Sheets by five broker dealers under the symbol HBKA.OB. The Company also maintains a list of individuals, in its local market, who are interested in purchasing its common stock and connects these people with shareholders who are interested in selling their stock. These parties negotiate the per share price independent of the Company. The stock transfer agent of the Company attempts to keep a record of the prices of stock trades by asking the parties about the trade price per share. Please refer to the table below entitled Common Stock Performance for a breakdown of the trades known to the Company for the four quarters of each of 2005 and 2004. The amounts below have been adjusted to reflect the Company’s 2:1 stock split paid on September 9, 2005.

Common Stock Performance – December 31, 2005
	High	Low	Quarterly Average	Dividends per Share
First Quarter	$15.00	$13.68	$14.58	$        -
Second Quarter	$15.00	$12.13	$14.84	$ 0.075
Third Quarter	$17.00	$13.05	$14.60	$        -
Fourth Quarter	$19.00	$14.75	$15.93	$        -
Common Stock Performance – December 31, 2004
	High	Low	Quarterly Average	Dividends per Share
First Quarter	$14.00	$12.90	$13.90	$       -
Second Quarter	$14.50	$12.88	$13.55	$  0.06
Third Quarter	$15.00	$12.75	$14.00	$       -
Fourth Quarter	$15.00	$12.88	$14.71	$       -

The Company’s primary source of funds for dividend payments is dividends from its subsidiary bank. Bank regulatory agencies restrict dividend payments of the subsidiaries, as more fully disclosed in Note 11 of Notes to Consolidated Financial Statements.

As of March 10, 2006, the Company had approximately 1,291 shareholders of record.

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Issuer Repurchases of Equity Securities

The following table sets forth information with respect to repurchases of common stock that the Company made during the fourth quarter of 2005:

Period	Total Number of Shares Purchased	Average Price Paid per Share	Total Number of Shares Purchased as Part of Publicly Announced Programs (1)	Maximum Number of Shares that May Yet Be Purchased Under the Program (in thousands)
October 2005	-	$        -	-	207,478
November 2005	21,500	$16.00	21,500	185,978
December 2005	8,667	$16.00	8,667	177,311
Total	30,167	$16.00	30,167	177,311

(1)

On December 8, 2004, the Company’s board of directors approved a stock repurchase program to purchase over 12 months up to 258,000 shares (adjusted for 2:1 split) of its outstanding common stock (the “Program”). The Company disclosed the Program in a Current Report on Form 8-K filed on January 26, 2005. The Company has allocated $3.8 million to the Program and anticipates funding for the Program to come from available corporate funds.

(2)

On December 14, 2005, the Registrant’s board of directors approved a stock repurchase program to purchase over the next 12 months up to 151,000 shares of its outstanding common stock (the “Program”). The Registrant has allocated $2.5 million to the Program and anticipates funding for the Program to come from available corporate funds. The Program replaces a prior authorization to repurchase shares of common stock that expired on December 7, 2005. The Registrant currently has 5,280,615 shares of common stock outstanding.

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Item 6. Selected Financial Data

The Company and Subsidiaries Selected Consolidated Financial Data:

(Amounts in thousands, except per share data)

		Years Ended December 31,
		2005	2004	2003	2002	2001
	Interest income	$  32,189	$  29,460	$  29,463	$  30,944	$  32,998
	Interest expense	14,490	12,162	12,877	14,266	18,887
	Net interest income	17,699	17,298	16,586	16,678	14,111
Selected Income Statement Data	Provision for loan    losses	1,155	1,300	2,053	1,825	1,448
	Non-interest income	4,850	4,572	4,652	3,646	3,364
	Non-interest expense	14,998	14,871	13,470	13,046	11,619
	Income taxes	1,363	1,042	1,195	1,349	1,107
	Net income	5,033	4,657	4,520	4,104	3,301
	Basic net income	$     0.95	$     0.88	$     0.85	$     0.78	$     0.63
	Diluted net income	0.94	0.87	0.85	0.77	0.62
*Per share data	Cash dividends    declared	0.075	0.06	0.05	0.045	0.04
	Book value per share	7.98	7.37	6.67	6.08	5.19
Selected Balance Sheet Data at End of Year	Loans, net	$407,274	$387,133	$373,534	$335,644	$322,042
	Total securities	140,284	133,203	124,964	104,925	100,270
	Total assets	599,341	567,060	543,416	485,603	453,745
	Total deposits	486,908	468,657	450,009	410,301	392,093
	Stockholders’ equity	42,132	39,299	35,434	32,199	27,452
Selected Balance Sheet Daily Averages	Loans, net	$396,530	$381,178	$355,593	$332,207	$306,661
	Total securities	130,367	129,611	115,313	99,768	87,238
	Total assets	584,500	556,995	517,497	465,175	430,723
	Total deposits	480,080	459,761	439,330	398,972	370,111
	Stockholders’ equity	40,290	38,895	36,886	31,286	25,683
	Return on average assets	0.86%	0.83%	0.87%	0.87%	0.77%
Selected Ratios	Return on average equity	12.43%	12.55%	13.27%	13.82%	12.78%
	Dividend payout ratio	7.94%	6.87%	5.86%	5.80%	6.39%
	Average equity to average assets	6.89%	6.64%	6.59%	6.32%	6.00%

* Data adjusted for 2:1 split paid September 9, 2005.

23

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

The purpose of this discussion is to provide information about the financial condition and results of operations of the Company and its wholly-owned subsidiaries and other information included in this report. This discussion should be read in conjunction with the Company’s Consolidated Financial Statements and Notes to Consolidated Financial Statements.

Caution About Forward-Looking Statements

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company's actual results could differ materially form those set forth in the forward-looking statements.

Such forward-looking statements involve known and unknown risks including, but not limited to, the following factors:

·

The ability to successfully manage the Company’s growth or implement its growth strategies if it is unable to identify attractive markets, locations or opportunities to expand in the future;

·

The ability to continue to attract low cost core deposits to fund asset growth;

·

Maintaining capital levels adequate to support the Company’s growth;

·

Maintaining cost controls and asset qualities as the Company opens or acquires new branches;

·

Reliance on the Company’s management team, including its ability to attract and retain key personnel;

·

The successful management of interest rate risk;

·

Changes in general economic and business conditions in the Company’s market area;

·

Changes in interest rates and interest rate policies;

·

Risks inherent in making loans such as repayment risks and fluctuating collateral values;

·

Competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;

·

Demand, development and acceptance of new products and services;

·

Problems with technology utilized by the Company

·

Changing trends in customer profiles and behavior; and

·

Changes in banking and other laws and regulations applicable to the Company.

Overview

The Company is a bank holding company located in southwest Virginia. It conducts commercial banking operations primarily through its full service banking subsidiary, Highlands Union Bank (“the Bank”). The Bank has two wholly owned subsidiaries, Highlands Union Financial Services, Inc. and Highlands Union Insurance Services, Inc.. These two subsidiaries offer investment and insurance products. Revenues and net income derived from these two sources are not significant at this time. Management characterizes the Bank as a "community bank".

24

The Bank offers general retail and commercial banking services to individuals, businesses and local government unit customers. These products and services include accepting deposits in the form of checking accounts, money market deposit accounts, interest-bearing demand deposit accounts, savings accounts and time deposits; making real estate, commercial, revolving, consumer, credit card and agricultural loans; offering letters of credit; providing other consumer financial services, such as automatic funds transfer, collections, night depository, safe deposit, travelers checks and savings bond sales; and providing other miscellaneous services normally offered by commercial banks. The Bank makes loans in all major loan categories, including commercial, commercial and residential real estate, construction and consumer loans.

The Company makes money primarily by earning an interest rate spread between the interest rates it earns on loans and securities and interest rates it pays on deposits and other borrowed money. The Company also earns money through fees, service charges and other non-interest income.

Critical Accounting Policies

General

The financial condition and results of operations presented in the Consolidated Financial Statements, accompanying Notes to Consolidated Financial Statements and management’s discussion and analysis are, to a large degree, dependent upon the accounting policies of the Company. The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change.

Presented below is a discussion of the accounting policy that management believes is important to the understanding of the Company’s financial condition and results of operations. This critical accounting policy requires management’s most difficult, subjective and complex judgments about matters that are inherently uncertain. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood. See also Note 1 of the Notes to Consolidated Financial Statements.

Allowance for Loan Losses

The Company monitors and maintains an allowance for loan losses to absorb the estimate of probable losses inherent in the loan portfolio. The allowance for loan losses is based on management’s judgment and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit and asset quality, as well as other internal and external factors, such as general economic conditions. The Company recognizes the inherent imprecision in estimates of losses due to various uncertainties, and variability related to the factors used. If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the Consolidated Financial Statements.

25

Performance Summary

The following table shows the Company’s key performance ratios for the periods ended December 31, 2005, 2004 and 2003:

	12/31/05	12/31/05	12/31/03
Return on Average Assets	0.86%	0.83%	0.87%
Return on Average Equity	12.43%	12.55%	13.27%
Basic Earnings Per Share	$0.95	$.88	$.85
Fully Diluted Earnings Per Share	$0.94	$.87	$.85
Net Interest Margin (1)	3.52%	3.60%	3.67%
(2) Net Interest Margin - Year-to-date tax equivalent net interest income divided by year-to-date average earning assets. (2) Earnings per share and fully diluted earnings per share have been restated to reflect the 2 for 1 stock split which occurred on September 9, 2005.

Growth

The following table shows the Company’s key growth indicators for the periods ending December 31, 2005, 2004 and 2003:

	12/31/05	12/31/04	12/31/03
Securities	$135,726	$128,953	$122,064
Loans, net	$407,274	$387,133	$373,534
Deposits	$486,908	$468,657	$450,009
Assets	$599,341	$567,060	$543,416

26

Asset Quality

The following table shows the Company’s key asset quality indicators for the periods ending December 31, 2005, 2004 and 2003:

	12/31/05	12/31/04	12/31/03
Non- accrual loans	$2,920	$3,902	$3,723
Loans past due over 90 days	1,281	661	802
Other real estate owned	810	1,047	370
Allowance for loan losses to total loans	1.06%	1.07%	1.13%
Net charge-off ratio	0.24%	0.36%	0.44%

For further information see the discussion under "Provision and Allowances for Loan Losses".

27

Results of Operations

(dollar amounts in thousands)

Net Interest Income

2005 versus 2004

Net interest income for 2005 was $17,699 or an increase of $401 over 2004. During 2005 interest income increased $2,729. This was a result of both existing interest earning assets re-pricing at higher rates and new loans made and securities purchased at higher rates. Throughout 2005 the Federal Reserve Board continued its policy of raising short term rates. Interest-bearing liabilities also re-priced upward, causing an increase in interest expense of $2,328. The net result of these events was a slight decrease in the Company’s net interest margin to 3.52% in 2005 from 3.60% in 2004. To help offset the margin reduction and in anticipation of short term rates falling over the next year or two, the Company continued to increase its portfolio of fixed rate municipal bonds. The Company also continued to increase its portfolio of adjustable rate mortgages to help offset any increase in interest rate risk resulting in these municipal bond purchases. The Company has also made a concerted effort to lock in longer term funding by increasing its long term funding from the Federal Home Loan Bank. The current trend is the result of short-term interest rates rising after an unusually long period of low interest rates. The tax equivalent yield on earning assets for 2005 was 6.19%, increasing 24 basis points during the year. During the same period, the yield on interest bearing liabilities increased by 41 basis points.

2004 versus 2003

Net interest income for 2004 was $17,298, an increase of $712 over 2003. During 2004 interest income decreased $3 as assets re-priced downward. Interest-bearing liabilities also repriced downward, causing a decline in interest expense. The net result of these events was a slight decrease in the net interest margin to 3.60% in 2004 from 3.67% in 2003. The tax equivalent yield on earning assets for 2004 was 5.95%, declining 39 basis points during the year. During the same period, the yield on interest bearing liabilities decreased by 36 basis points. The continued period of low interest rates resulted in many of the 1-4 family adjustable rate mortgages as well as adjustable rate securities to continue to reprice downward. New loans and securities were also made at lower rates.

28

Analysis of Net Interest Earnings

The following table shows the major categories of interest-earning assets and interest-bearing liabilities, the interest earned or paid, the average yield or rate on the average balance outstanding, net interest income and net yield on average interest-earning assets and average interest spread for the years indicated.

	Year Ended December 31,
	2005			2004				2003
	(Dollars in Thousands)
	Average Balance	Interest Income/ Expense	Yield/ Rate	Average Balance	Interest Income/ Expense	Yield/ Rate	Average Balance		Interest Income/ Expense	Yield/ Rate
ASSETS
Interest earning assets   (taxable-equivalent basis):
Loans (net of unearned   discount (2)	$400,759	$ 26,703	6.66%	$385,434	$ 24,575	6.38%	$359,187		$ 24,893	6.93%
Securities (1)(3)	136,567	5,319	4.87	130,629	4,870	4.73	115,313		4,495	4.87
Federal funds sold	4,157	167	4.02	973	15	1.54	7,757		75	0.97
Total interest-earning   assets	$541,483	$  32,189	6.19%	$517,036	$  29,460	5.95%	$482,257		$  29,463	6.34%
LIABILITIES
Interest bearing   liabilities:
Interest bearing dep.	$405,363	$ 11,282	2.78%	$392,475	$ 9,310	2.37%	$380,229		$ 10,335	2.72%
Other interest bearing   liabilities	60,872	3,208	5..27	57,602	2,852	4.95	41,119		2,542	6.18
Total interest-bearing   liabilities	$466,235	$  14,490	3.11%	$450,077	$  12,162	2.70%	$421,348		$  12,877	3.06%
Net interest income		$ 17,699			$ 17,298				$ 16,586
Net margin on interest   earning assets on a   tax equivalent basis			3.52%			3.60%				3.67%
Average interest spread			3.08%			3.25%				3.29%
(1) Tax equivalent adjustments (using 34% federal tax rates) have been made in calculating yields on tax-free investments. Virginia banks are exempt from state income tax.
(2) For the purposes of these computations, non-accruing loans are included in the daily average loan amounts outstanding.
(3) The yield on securities classified as available for sale is computed based on the average balance of the historical amortized cost balance without the effects of the fair value adjustment required by Financial Accounting Standard 115.

29

Analysis of Changes in Interest Income and Interest Expense

The Company's primary source of revenue is net interest income, which is the difference between the interest and fees earned on loans and investments and the interest paid on deposits and other funds. The Company's net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities and by changes in yields earned on interest-earning assets and rates paid on interest-bearing liabilities. The following table sets forth, for the years indicated, a summary of the changes in interest income and interest expense resulting from changes in average asset and liability balances (volume) and changes in average interest rates (rate).

Increase/(Decrease) Due to Volume and Rate

	2005 Compared to 2004			2004 Compared to 2003
Increase (Decrease) in	Increase (decrease) due to change in volume	Increase (decrease) due to change in rate	Net increase (decrease)	Increase (decrease) due to change in volume	Increase (decrease) due to change in rate	Net increase (decrease)
	(Dollars in Thousands)
INTEREST INCOME Securities	$    306	$     143	$     449	$    708	$     (333)	$     375
Federal funds sold	128	24	152	(104)	44	(60)
Loans	1,021	1,107	2,128	1,674	(1,992)	(318)
Total Income Change	$ 1,455	$ 1,274	$   2,729	$ 2,278	$ (2,281)	$     (   3)
INTEREST EXPENSE Savings and time deposits	$    358	$  1,614	$ 1,972	$    290	$  (1,315)	$ (1,025)
Other interest-bearing   liabilities	173	183	356	816	(506)	310
Total Expense Change	$    531	$ 1,797	$  2,328	$ 1,106	$ (1,821)	$    (715)
Increase (Decrease) in   Net Interest Income	$    924	$    (523)	$   401	$ 1,172	$    (460)	$     712

Non-interest Income

(dollar amounts in thousands)

2005 versus 2004

Non-interest income for 2004 was $4,850, a 6.08% increase over 2004.  During the fourth quarter of 2005, the Company implemented an overdraft privilege program as an additional service to its customer base. The number of checks processed continues to decline as the number of electronic transactions increases. Merchant and debit card fee income increased by $128 over 2004 due to increases in merchant fees and visa check card interchange fees. The use of debit cards continued to increase significantly over the prior period.   

Net securities gains and losses increased $159 from 2004. The majority of sales consisted of tax-exempt municipal bonds and agency preferred stocks (see the “Securities” section for further discussion). Income received during 2005 from the Company’s investment in Virginia Title Company, LLC. totaled $126. Earnings related to its investment in Bank Owned Life Insurance totaled $340, or a decrease of $14 as compared to 2004.

30

Management of the Company is continually looking for and researching areas to increase the amount of non-interest income. During 2005, the Company became on equity owner in BI Investments, which is a full service dealer broker created in conjunction with the Virginia Bankers Association. Bankers’ Investments allows the Company to offer a full range of investment products. Management believes this investment will increase its ability to generate future sales for a wide array of financial services products.

2004 vs. 2003

Non-interest income for 2004 was $4,572, a 1.72% decrease from 2003. Merchant and debit card fee income increased by $108 over 2003 due to increases in merchant and interchange fees. Net securities gains and losses were down $189 from 2003. Income received during 2004 from the Company’s investment in Virginia Title Company, LLC totaled $184, an increase of $23 over 2003. Earnings related to its investment in Bank Owned Life Insurance totaled $354 or a decrease of $4 as compared to 2003.

Non-interest Expense

(dollar amounts in thousands)

2005 versus 2004

   Non-interest expense is comprised of salaries and employee benefit costs, occupancy expenses, furniture and equipment expenses and other operating expenses. Non-interest expense for 2005 was $14,998, essentially the same as 2004. Salaries and employee benefits increased by 1.26% or $110. The Company opened a new branch in Banner Elk, NC. in February 2004 and opened a loan production office in West Jefferson, NC during the fourth quarter of 2004. A full year of expense was incurred during 2005 for these two locations. Other non-interest expenses remained comparable to 2004. Recent technology enhancements have allowed the bank to leverage its existing personnel base to help minimize overall increases in personnel costs. No new facilities were opened in 2005.

2004 versus 2003

Non-interest expense for 2004 was $14,871, an increase of $1,401 or 10.40% over 2003. The most significant changes occurred in salaries and employee benefits.  Salaries and employee benefits increased by 12.28% or $951 due to growth of the Company mainly in the area of branch expansion. The Company opened a new branch in Blountville, TN. in August of 2003, opened a new branch in Banner Elk, NC. in February of 2004 and opened a loan production office in West Jefferson, NC during the fourth quarter of 2004. Other non- interest expenses increased also due to Company growth. During the third quarter of 2004, the Company installed a check imaging and distributive capture system and began producing image statements to its customers. This move will allow the company to take advantage of the benefits related to the Check 21 Act which was signed into law in October 2004. These systems should also have a positive impact on personnel expense in the future as the handling of checks is diminished.

31

Income Taxes

(dollar amounts in thousands)

2005 vs. 2004

Income tax expense for 2005 increased by $321 when compared to 2004 primarily due to the increase in pretax income and the capital loss treatment pertaining to the sale of approximately $4,597 of agency preferred stocks. Tax exempt income continues to be the primary difference between the"expected" and reported tax expense.   

2004 vs. 2003

Income tax expense for 2004 decreased by $153 when compared to 2003 primarily due to the additional income related to tax exempt municipal bond income and tax exempt earnings related to its Bank Owned Life Insurance.

Provision and Allowance for Loan Losses

(dollar amounts in thousands)

2005 vs. 2004

The adequacy of the allowance for loan losses is based on management's judgment and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit and asset quality, as well as other internal and external factors, such as general economic conditions. The internal credit review department performs pre-credit analyses of large credits and also conducts credit review activities that provide management with an early warning of asset quality deterioration. The internal credit review department also prepares regular analyses of the adequacy of the allowance for loans losses. These analyses include calculations based upon a mathematical formula that considers identified potential losses and makes pool allocations for historical losses for various loan types. The Company uses a rolling three year history by loan category in determining pool allocation factors. In addition, an amount is allocated based upon such factors as changing trends in the loan mix, the effects of changes in business conditions and market area, unemployment trends, the effects of any changes in loan policies, and the effects of competition and regulatory factors on the loan portfolio.

The internal credit review department as well as management has determined that the Company's allowance for loan losses is sufficient. Loans past due ninety days or more and still accruing were $1,281 at December 31, 2005, compared to $661 at December 31, 2004. Net charge-offs to total loans decreased from 0.36% in 2004 to 0.24% in 2005. This was in large part due to the changes implemented in 2004 related to credit scoring, underwriting, analysis and review.

2004 vs. 2003

During the first half of 2004, the Company greatly enhanced both its credit review and credit analysis departments. Additional staffing was added and enhanced procedures and systems were also implemented. Loans past due ninety days or more and still accruing were $661 at December 31, 2004, lower than the $802 at December 31, 2003. Net charge-offs to total loans decreased from .44% in 2003 to .36% in 2004.

32

The following table presents the Company’s loan loss experience for the past five years:

	Years Ended December 31, (Dollars in Thousands)
	2005	2004	2003	2002	2001
Allowance for loan losses at   beginning of year	$4,181	$4,274	$      3,877	$      3,418	$      2,950
Loans charged off:
Commercial	131	219	299	389	107
Real Estate – mortgage	205	192	270	94	10
Consumer	791	1,089	1,211	1,043	1,087
Other	0	0	0	0	0
Total	$      1,127	$      1,500	$      1,780	$      1,526	$      1,204
Recoveries of loans previously   charged off:
Commercial	$            17	$             2	$             8	$             5	$             3
Real Estate – mortgage	10	1	0	0	0
Consumer	123	104	116	155	221
Other	0	0	0	0	0
Total	$         150	$         107	$         124	$         160	$         224
Net loans charged off	$      977	$      1,393	$      1,656	$      1,366	$         980
Provision for loan losses	1,155	1,300	2,053	1,825	1,448
Allowance for loan losses end of year	$      4,359	$      4,181	$      4,274	$      3,877	$      3,418
Average total loans (net of unearned income)	$  400,759	$  385,434	$  359,187	$  335,823	$  309,753
Total loans (net of unearned income) at year-end	$  411,633	$  391,314	$  377,808	$  339,521	$  325,460
Ratio of net charge-offs to average loans	0.244%	0.361%	0.461%	0.407%	0.316%
Ratio of provision for loan losses to average loan	0..288%	0.337%	0.572%	0.543%	0.467%
Ratio of provision for loan losses to net charge-off	118.219%	123.973%	123.973%	133.602%	147.755%
Allowance for loan losses to year-end loans	1.059%	1.068%	1.131%	1.142%	1.050%

Factors influencing management's judgment in determining the amount of the loan loss provision charged to operating expense include the quality of the loan portfolio as determined by management, the historical loan loss experience, diversification as to type of loans in the portfolio, the amount of secured as compared with unsecured loans and the value of underlying collateral, banking industry standards and averages, and general economic conditions.

Non-performing loans

(dollar amounts in thousands)

The loan portfolio of the Bank is reviewed regularly by senior officers to evaluate loan performance. The frequency of the review is based on a rating of credit worthiness of the borrower utilizing various factors such as net worth, credit history and customer relationship. The evaluations emphasize different factors depending upon the type of loan involved. Commercial and real estate loans are reviewed on the basis of projections of cash flow and estimated net realizable value through an evaluation of collateral and the financial strength of the borrower. Installment loans are evaluated largely on the basis of delinquency data because of the large number of such loans and relatively small size of each individual loan.

33

Management’s review of commercial and other loans may result in a determination that a loan should be placed on a non-accrual of interest basis. It is the policy of the Bank to discontinue the accrual of interest on any loan on which full repayment of principal and / or interest is doubtful. Subsequent collection of interest is recognized as income on a cash basis upon receipt. Placing a loan on non-accrual status for the purpose of income recognition is not in itself a reliable indication of potential loss of principal. Other factors, such as the value of the collateral securing the loan and the financial condition of the borrower, serve as more reliable indications of potential loss of principal.

The policy of the Bank is that non-performing loans consist of loans accounted for on a non-accrual basis and loans which are contractually past due 90 days or more in regards to interest and/ or principal payments. The following table presents non-performing assets as of the five periods ended December 31, 2005, 2004, 2003, 2002 and 2001, respectively.

	2005	2004	2003	2002	2001
	(Amounts in thousands)
Non-performing loans	$     4,201	$     4,653	$      4,521	$      2,606	$      2,063
Non-accrual loans	$     2,920	$     3,902	$      3,723	$      1,728	$      1,159
Loans past-due 90 days and more and still accruing	$        1,281	$        661	$        802	$        891	$         950
Interest income lost on non-accruing loans	$        227	$        237	$        235	$        104	$           73
Interest income realized on loans past-due 90 days and more and still accruing	$          68	$          44	$          15	$          18	$           15

34

Allocation of the allowance for loan losses

The following table provides an allocation of the allowance for loan losses as of December 31, 2005, 2004, 2003, 2002 and 2001.

	Year Ended December 31, Percent of Loans on each Category (Dollars in Thousands)
	2005(1)			2004(1)			2003
	Allowance for Loan Loss	Percentage of Total Loan Loss	Percentage of Total Loans	Allowance for Loan Loss	Percentage of Total Loan Loss	Percentage of Total Loans	Allowance for Loan Loss	Percentage of Total Loan Loss	Percentage of Total Loans
Commercial	$        710	16.29%	9.38%	$        705	16.86%	9.13%	$        830	19.42%	10.37%
Real Estate	1,255	28.79	79.42	1,302	31.16	76.40	224	5.24	73.25
Consumer	858	19.68	10.07	953	22.79	13.25	3,220	75.34	15.08
Other / Unallocated	1536	35.24	1.13	1,221	29.19	1.22	0	0.00	1.30
Total	$    4,359	100.00%	100.00%	$    4,181	100.00%	100.00%	$    4,274	100.00%	100.00%

	2002			2001
	Allowance for Loan Loss	Percentage of Total Loan Loss	Percentage of Total Loans	Allowance for Loan Loss	Percentage of Total Loan Loss	Percentage of Total Loans
Commercial	$        972	25.06%	10.87%	$        857	25.06%	7.98%
Real Estate	228	5.89	70.60	201	5.89	66.09
Consumer	2,672	68.93	17.05	2,356	68.93	24.92
Other	5	0.12	1.48	4	0.12	1.01
Total	$    3,877	100.00%	100.00%	$    3,418	100.00%	100.00%

1)

Percentages for 2005 and 2004 are categorized differently from prior years due to the Company’s change in its methodology of the calculation of the Allowance for Loan Loss reserve. More enhanced pooling allocation factors are now being used, in addition to more detailed historical data being utilized. The allowance for loan loss reserve is computed quarterly by the Company’s internal credit review department and is reviewed by the Senior Financial Officers of the Company. Management believes its method, implemented in 2004, pertaining to the allocation of loan loss reserve is both adequate and more properly allocates the reserve among the various categories.

35

Financial Condition

Balance Sheet

(dollar amounts in thousands)

2005 vs. 2004

Total assets for the Company increased by $32,281 or 5.69% in 2005. Interest earning assets grew by $25,796 or 4.90% for the year. Interest bearing liabilities increased by $21,410 or 4.73% in 2005. Asset growth was primarily attributable to increased market share in both North Carolina and Tennessee.

2004 vs. 2003

Total assets for the Company increased by $23,644 or 4.35% in 2004. Interest earning assets grew by $23,070 or 4.59% for the year. Interest bearing liabilities increased by $6,253 or 1.40% in 2004. Non-interest bearing deposits increased by $13,849 or 23.45% during 2004. Asset growth was primarily attributable to loan growth in western North Carolina.

Loans

(dollar amounts in thousands)

2005 vs. 2004

Loans net of unearned income and deferred fees increased by $20,319 or 5.19% in 2005. Loans secured by real estate showed an increase of approximately $27,825, offset by a decline in loans secured by collateral other than real estate of approximately $10,562. The decline in loans secured by collateral other than real estate was primarily due to the Company’s decision to discontinue its dealer finance division in the first quarter of 2005. This decision was made due to the competitive nature of this program and the risks associated from these indirect loans. Management also believes the decline in loans secured by collateral other than real estate was also due to the following:

·

General economic conditions and the lack of employment opportunity in

portions of the Company's market area.

·

A decline in consumer requests for new car financing because of special

financing incentives offered by automobile companies.

·

Stricter credit scoring / underwriting implemented in 2004.

·

Consumers taking advantage of low mortgage rates to refinance home

mortgages to obtain funds that might otherwise have been borrowed

through a consumer loan.

Reversal of this trend may occur to some extent as economic conditions change and higher interest rates make mortgage refinancing less appealing. However, management believes that automotive related financing offers and competition from the credit card sector will remain. Since loans to individuals are generally higher yielding, this trend will not have a favorable effect on net interest income in the future but should have a favorable impact on future net charge-offs as the percentage of real estate secured loans to total loans increases.

36

2004 vs. 2003

Loans net of unearned income and deferred fees increased by $13,506 or 3.57% in 2004. Loans secured by real estate showed an increase of approximately $22,354, offset by a decline in loans secured by collateral other than real estate of $7,152 and a decrease in unsecured loans of $1,692. The majority of the increase in loans during 2004 was the result of the continued growing market share in North Carolina. Again, the decline in non-real estate secured loans was due to the above mentioned reasons.

37

Loan Portfolio

The table below classifies gross loans by major category and percentage distribution at December 31, 2005 for each of the past five years:

	December 31, (Dollars in thousands)
	2005		2004		2003		2002		2001
	Amount	Percentage	Amount	Percentage	Amount	Percentage	Amount	Percentage	Amount	Percentage
Real Estate Secured:
Residential 1-4 family	$ 151,815	36.88%	$ 146,970	37.54%	$141,693	37.49%	$ 128,462	37.82%	$114,556	35.18%
Multi-family	4,148	1.01	3,379	0.86	2,651	0.70	3,383	1.00	3,011	0.92
Commercial, Construction       and Land Development	140,178	34.05	122,997	31.42	113,146	29.93	85,468	25.16	80,673	24.77
Second Mortgages	10,962	2.66	7,419	1.89	6,976	1.85	11,676	3.43	7,737	2.38
Equity Line of Credit	9,800	2.38	8,981	2.29	7,430	1.96	5,253	1.54	4,166	1.28
Farmland	10,015	2.43	9,347	2.39	4,843	1.28	5,589	1.65	5,065	1.56
	$ 326,918	79.41%	$ 299,093	76.39%	$276,739	73.21%	$ 239,831	70.60%	$215,208	66.09%
Secured, Other:
Personal	$   33,395	8.11%	$   44,222	11.30%	$   48,637	12.87%	$   49,483	14.57%	$  60,532	18.59%
Commercial	25,628	6.23	24,992	6.38	27,247	7. 21	26,043	7.67	26,002	7.98
Agricultural	3,653	.89	4,024	1.03	4,506	1.19	4,209	1.23	3,274	1.01
	$   62,676	15.23%	$   73,238	18.71%	$   80,390	21.27%	$   79,735	23.47%	$  89,808	27.58%
Unsecured:	$   22,048	5.36%	$   19,176	4.90%	$   20,868	5.52%	$   20,135	5.93%	$  20,614	6.33%
Loans, gross	$ 411,642	100.00%	$ 391,507	100.00%	$ 377,997	100.00%	$ 339,701	100.00%	$325,630	100.00%

38

The following table shows the maturity of loans outstanding, inclusive of contractual amortization, as of December 31, 2005

	December 31, 2005 (Amounts in Thousands)
	Within One Year		After One Year But Within Five Years		After Five Years
	Fixed	Floating	Fixed	Floating	Fixed	Floating	Total
Real Estate Secured:
Residential 1-4 Family	$11,185	$5,128	$23,627	$9,489	$28,973	$73,413	$151,815
Multi-family	251	0	3,335	0	562	0	4,148
Commercial, Construction    & Land Development	29,884	18,464	58,302	5,834	15,836	11,858	140,178
Second Mortgages	1,663	501	3,572	86	4,164	976	10,962
Equity Line of Credit	0	667	0	3,269	0	5,864	9,800
Farmland	237	2,565	6,600	54	377	182	10,015
Secured, Other:
Personal	10,922	1	21,711	3	711	47	33,395
Commercial	8,886	4,588	11,626	127	401	0	25,628
Agricultural	507	1,861	1,148	67	70	0	3,653
Unsecured	7,596	10,850	2,289	956	317	40	22,048
Loans, Gross	$ 71,131	$ 44,625	$132,210	$ 19,885	$ 51,411	$ 92,380	$411,642

39

Securities

(dollar amounts in thousands)

2005 vs. 2004

Investment securities available for sale increased $6,773 (market value) from December 31, 2004 to December 31, 2005. Purchases during the year consisted primarily of 1 year adjustable rate mortgage backed securities and fixed rate municipal bonds. As short term interest rates have risen during the year, management has continued its investment strategy to purchase securities that will not only blend in with the Company’s overall asset liability strategy but also maximize yield. A majority of the monthly paydowns were again prepayments on variable rate securities as a result of prepayments occurring on the underlying mortgages. The senior financial officers review and manage the securities portfolio on an ongoing basis.

At December 31, 2005, net unrealized losses in the Company’s securities portfolio classified available for sale totaled $1,727. The majority of these unrealized losses were related to the Company’s holdings ($6,250 in book value) of Federal Home Loan Mortgage Corporation and Federal National Mortgage Association agency preferred stock. As discussed in Footnote 2 in the Company’s Consolidated Financial Statements, management of the Company does not consider any of these losses to be other than temporary. It is management’s opinion that the unrealized losses are primarily related to interest rate changes. Management also feels that the market values of these particular instruments have also been negatively affected by the accounting related irregularities at both Fannie Mae and Freddie Mac. The Company has both the ability and intent to hold these instruments for a time necessary to recover its cost. Even with the intent and ability to hold these securities, the Board and Management elected to sell approximately $4,597 of agency preferred stock realizing a net capital loss of approximately $383. This decision was specifically a risk management decision to reduce the Company’s amount of holdings in this type of investment. Management at that time felt that the amount of holdings in these instruments needed to be reduced as a percentage of the entire securities portfolio. These instruments are stocks and do not have a stated maturity date. The Company continues to hold a “laddered” structure of these investments (a single 1- year floater, two 2- year floaters and a single 5- year floater). It should be noted that these instruments have gained approximately 35% in value since December 31, 2005 as interest rates have continued to rise. As these instruments have moved closer to their reset dates and as their related indexes have adjusted upward, their values also have been increasing which supports management’s belief that these losses are temporary and related primarily to the interest rate cycle.

Also during the year, the Company elected to sell a portion of its municipal bond portfolio (approximately $17,353 in book value) and recognized gains totaling approximately $921. Management took the opportunity to sell the municipal bonds and realize the gain and subsequently re-invest the proceeds back into more municipal bonds at similar yields. The average life of the municipals that management purchased was only 2-4 years longer than the municipals that were sold.

2004 vs. 2003

Investment Securities available for sale increased $6.89 million (market value) from December 31, 2003 to December 31, 2004. During 2004, the majority of the increase was purchases of adjustable rate mortgage backed securities, many of which had an initial reset date of 3 or 5 years.

40

Investment Portfolio

The following table presents the maturity distribution, market value, amortized cost and approximate tax equivalent yield (assuming a 34% federal income tax rate) of the investment portfolio at December 31, 2005.

			(Dollars in Thousands)
	Within One Year			One Year Through Five Years		Five Years Through Ten Years		After Ten Years		Yield		Market Value		Amortized Cost
Mortgage-backed Sec – fixed rate		$          -			$   1,913		$      4,671		$   3,523		4.18%		$ 10,107		$ 10,351
Mtg.-backed Sec – variable rate		-			-		51		51,969		3.81		52,020		52,583
State & Municipal’s –  tax exempt		-			461		251		56,003		5.89		56,715		56,880
State & Municipal’s –  taxable		-			487		553		-		4.21		1,040		1,062
U.S. Agencies – fixed rate		-			738		-		-		4.10		738		750
Agency Preferred – variable rate		-			-		-		4,677		4.00		4,677		6,250
Corporate bonds – fixed rate		-			-		-		1,422		6.12		1,422		1,424
Corporate bonds – variable rate		-			-		456		8,390		5.73		8,846		8,881
SBA bonds – variable rate		-			-		-		140		4.14		140		140
CMO’s – variable rate		-			-		-		21		4.30		21		21
TOTAL		$         -			$   3,599		$    5,982		$126,145				$135,726		$138,342
Total fixed rate securities		$         -			$  3,599		$   5,475		$ 60,948				$ 70,022		$ 70,467
Total variable rate securities		$         -			$        -		$    507		$ 65,197				$ 65,704		$ 67,875

Deposits

(dollar amounts in thousands)

2005 vs. 2004

Total deposits grew by $18,251 or 3.89% in 2005. Non-interest bearing demand deposits increased by $7,141. Total time deposits increased by $20,238. Savings accounts declined during the year as customers began placing more funds back into the equity markets or moving their funds to time deposits. The increase in time deposits is primarily a result of rising interest rates and the growth in the North Carolina and Tennessee markets. The majority of the increase in time deposits was related to the growth in the Bank’s “HUB Choice” 25- month CD which gives the customer a one time option to increase the rate during the term of the certificate. This product has been widely accepted due to the expectation of rising interest rates.

2004 vs. 2003

    Total deposits grew by $18,648 or 4.14% in 2004. Non-interest bearing demand deposits increased by $13,849. Interest bearing demand and savings accounts declined during the year as customers began placing more funds back into the equity markets. The small increase in time deposits during 2004 was a continuation of the trend of customers being unwilling to choose longer term deposit instruments. This trend is expected to reverse when longer term interest rates move to higher levels, which will provide an incentive for customers to invest for longer periods.

41

The following table provides a breakdown of deposits at December 31 for the years indicated:

	December 31,
	(Amounts in Thousands)
	2005	2004	2003
Non-interest bearing demand deposits	$    80,047	$    72,906	$    59,057
Interest bearing demand deposits	59,144	58,526	64,048
Savings deposits	67,440	77,186	80,764
Time deposits	280,277	260,039	246,140
Total Deposits	$  486,908	$  468,657	$  450,009

The average daily amount of deposits and rates paid on such deposits is summarized for the periods indicated in the following table:

	Year Ended December 31, (Dollars in Thousands)
	2005		2004		2003
	Amount	Rate	Amount	Rate	Amount	Rate
Non-interest bearing   demand deposits	$  74,444	0.00%	$  67,274	0.00%	$  59,094	0.00%
Interest-bearing demand   deposits	59,078	1.49	63,095	1.19	58,771	1.40
Savings deposits	71,623	1.08	82,241	1.07	77,470	1.55
Time deposits	274,663	3.50	247,139	3.11	243,995	3.41
Total	$479,808		$459,749		$439,330

The remaining maturities of time deposits greater than or equal to $100,000 at December 31, 2005 are as follows (Amount in thousands):

Maturity	Amount
3 months or less	$     10,343
Over 3 months through 6 months	17,618
Over 6 months through 12 months	15,033
Over 12 months	45,487
Total	$    88,481

Effects of Inflation

The Company's consolidated statements of income generally reflect the effects of inflation. Since interest rates, loan demand, and deposit levels are related to inflation, the resulting changes are included in net income. The most significant item which does not reflect the effects of inflation is depreciation expense. Historical dollar values used to determine depreciation expense do not reflect the effects of inflation on the market value of depreciable assets after their acquisition.

42

Liquidity and Capital Resources

(dollar amounts in thousands)

Liquidity is the measure of the Bank’s ability to generate sufficient funds in order to meet customers’ demands for withdrawal of deposit balances and for the funding of loan requests. The Bank maintains cash reserves, in accordance with Federal Reserve Bank guidelines, and has sufficient flow of funds from investment security payments as well as loan payments to meet current liquidity needs.

Management of the Bank continuously monitors and plans the Bank’s liquidity position for the future. Liquidity is provided from cash and due from banks, federal funds sold, loan and investment security payments, core deposits, the national certificate of deposit market, lines of credit with correspondent banks and lines of credit with the Federal Home Loan Bank, Management believes that these sources of funds provide sufficient and timely liquidity for the foreseeable future.

Recent Accounting Pronouncements

See Note 1 of Notes to Consolidated Financial Statements for information relating to recent accounting pronouncements.

Off-Balance Sheet Arrangements

See Note 16 of Notes to Consolidated Financial Statements for information relating to Off-Balance Sheet Arrangements.

Contractual Obligations

Listed below are the contractual obligations of the Company and its subsidiaries at December 31, 2005 aggregated by type and due date. Optional call date provisions are reflected in the table below.

	Total	Less than one year	One to Three Years	Three to Five Years	More Than Five Years
Long-term debt obligations	$ 38,475	$           0	$   23,707	$  14,200	$        568
Capital lease obligations	-	-	-	-	-
Operating lease obligations	101	51	50	-	-
Purchase obligations (1)	90	90	-	-	-
Other long-term liabilities reflected on the Company’s  balance sheet	6,300	-	6,300	-	-

(1)

The above purchase obligations represent approximate amounts to be disbursed for the Company’s expansion of its Abingdon, Virginia property located at 250 W. Valley St. (see Properties section for further explanation).

43

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Sensitivity Analysis

Interest rate risk refers to the exposure of the Company’s earnings and market value of equity (“MVE”) to changes in interest rates. The amount of change in net interest income and MVE resulting from shifts in interest rates is determined by contractual maturity of fixed rate instruments, the repricing date for variable rate instruments, competition and customer reactions.

The Company runs simulation models through a range of positive and negative interest rate movements to determine the effect these shifts in interest rates would have on the market value of the Company’s equity. The market value is determined by applying a discount rate to the Company’s interest-earning assets and interest-bearing liabilities that are not carried at market value, based on current rate levels at the time the model is run and calculating the present value of future cash flows.

There are several common components of interest rate risk that must be effectively managed to maintain minimal impact on the Company’s earnings and capital. Repricing risk comes largely from timing differences in the pricing of interest-earning assets and interest-bearing liabilities. Reinvestment risk refers to the reinvestment of cash flows from interest and principal payments and maturing assets at lower or higher rates. Basis risk arises when different yield curves or pricing indices do not change at precisely the same moment in time or magnitude so that earning assets and interest-bearing liabilities with the same maturity are not affected equally. Yield curve risk refers to unequal movements in short-term and long-term interest rates.

The Company is not a party to derivative financial instruments with off-balance sheet risks such as futures, forwards, swaps, and options. The Company, however, is a party to financial instruments with off-balance sheet risks such as commitments to extend credit and standby letters of credit and recourse obligations in the normal course of business to meet the financing needs of its customers. See Note 16 of Notes to Consolidated Financial Statements for additional information relating to financial instruments with off-balance sheet risk. Management does not plan any future involvement in high risk derivative products.

44

The following table provides the maturities of investment securities, loans, and deposits as of December 31, 2005, and measures the interest rate sensitivity gap for each range of maturity indicated. The amounts below also reflect various prepayment assumptions.

	December 31, 2005 (Dollars in Thousands) Maturing
	Within One Year	After One But Within Five Years	After Five Years	Total
ASSETS
Interest-bearing     Investment Securities	$    13,207	$   26,071	$     101,006	$  140,284
Fed Funds Sold	110	-	-	110
Loans	171,783	188,868	50,982	411,633
Other interest bearing assets	-	-	-	-
Non-interest bearing     Other Assets	-	-	47,314	47,314
Total Assets	$  185,100	$  214,939	$  199,302	$  599,341
LIABILITIES AND SHARE-   HOLDERS’ EQUITY
Interest-bearing
(1) All Interest bearing Deposits	$  262,744	$   140,170	$      3,947	$  406,861
Other Interest bearing Liab.	9,708	57,207	568	67,483
Non-interest-bearing
Demand Deposit Non-Interest	-	-	80,047	80,047
Other Liabilities	-	-	2,818	2,818
Shareholders’ Equity	-	-	42,132	42,132
Total Liabilities and Shareholders’       Equity	$  272,452	$  197,377	$   129,512	$  599,341
Interest Rate Sensitivity GAP	$(87,352)	$    17,562	$     69,790	$             -
(1) For purposes of this schedule, the Company includes 100% of its statement savings, NOW and MMDA in the one year column.

Asset Liability Management

The Company’s primary objectives for asset and liability management are to establish internal controls and procedures that will result in managing interest rate risk, liquidity management, capital planning, asset mix and volume control, and loan and deposit pricing. The Asset and Liability Committee (ALCO) is headed by the CEO and includes management personnel from the different areas of the Bank. The ALCO meets on a monthly basis.

In determining the appropriate level of interest rate risk, the ALCO reviews the changes in projected net interest income subject to various changes in interest rates. To help effectively measure interest rate risk, the ALCO utilizes rate sensitivity and simulation analysis to determine the impact on net interest income as well as the changes in the Economic Value of Equity. Simulation analysis is used to subject or “shock” the current re-pricing and maturing amounts to rising and falling interest rates. Rate change increments of 1% and 2% up and down are used in the monthly simulation analysis. Loan and investment security prepayments are estimated using current market information.

While this planning process is designed to protect the Company over the long-term, it does not provide near-term protection from interest rate shocks, as interest rate sensitive assets and liabilities

45

do not, by their nature, move up or down in tandem in response to changes in the overall rate environment. The Company's profitability in the near term may be temporarily affected either positively by a falling interest rate scenario or negatively by a period of rising rates.

The following table shows the estimated cumulative impact on net interest income (NII) for the next 12 months as of December 31, 2005, subject to the specified interest rate changes. For purposes of this schedule the Company used a parallel rate shock on its interest earning assets and interest bearing liabilities. A parallel rate shock means that a 100 basis point increase in the rate index (prime rate) would result in an immediate 100 basis point increase on interest earning assets and interest bearing liabilities subject to the interest rate reset date. The Company uses a 50 basis point slope for its computation. The slope is the number of basis points per month that an index can increase or decrease until it reaches the target rate.

Rate change increment	% change in NII	$ change in NII
Up 100  basis points	-1.55%	-310,000
Up 200 basis points	-3.53%	-705,000
Down 100 basis points	1.18%	236,000
Down 200  basis points	-.28%	-55,000

The above schedule assumes that 100% of the Company’s interest bearing checking accounts and 100% of its statement savings accounts would reprice according to the above increments. The above schedule also assumes an approximate growth of 8% over the next 12 months for all of the Company’s rate sensitive categories.

46

Item 8. Financial Statements and Supplementary Data

The following financial statements are incorporated by reference from the Annual Report to Shareholders for the fiscal year ended December 31, 2005:

Independent Registered Auditor’s Report;

Consolidated Statements of Financial Condition as of December 31, 2005, 2004 and 2003;

Consolidated Statements of Operations for each of the years in the three year period ended December 31, 2005;

Consolidated Statements of Stockholder’s Equity for each of the years in the three year period ended December 31, 2005;

Consolidated Statements of Cash Flows for each of the years in the three year period ended December 31, 2005; and

Notes to Consolidated Financial Statements for December 31, 2005, 2004 and 2003.

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

None.

Item 9A. Controls and Procedures

Senior management regularly monitors and reviews the internal controls established for the various operating activities of the Bank. Additionally, the Company has created a Disclosure Review Committee to review not only internal controls but the information used by Company’s financial officers to prepare the Company’s periodic SEC filings and corresponding financial statements. The Committee is comprised of the Senior Management Team of the Bank and meets at least quarterly. Internal audits conducted by the Company’s internal audit department are also reviewed by senior officers to assist them in assessing the adequacy of the Company’s internal control structure. These audits are also discussed in detail with the Company’s Audit Committee.

We have carried out an evaluation, under the supervision and the participation of our management, including our Executive Vice President and Chief Executive Officer, our Executive Vice President and Chief Operations Officer, our Chief Financial Officer and our Vice President of Accounting, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Act”), as of the end of the fiscal year covered by this report. Based upon that evaluation, our CEO, COO, CFO and VP Accounting concluded that our disclosure controls and procedures are effective in providing reasonable assurance that (a) the information required to be disclosed by us in the reports that we file or submit under the Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and (b) such information is accumulated and communicated to our management, including our CEO, COO, CFO and VP Accounting, as appropriate to allow timely decisions regarding required disclosure.

There were not any changes in the Corporation’s internal controls over financial reporting during the fourth fiscal quarter of the fiscal year covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Item 9B. Other Information

None

47

Part III.

Item 10. Directors and Executive Officers of the Registrant

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “The Nominees,” “Executive Officers Who Are Not Directors,” “Section 16(a) Beneficial Ownership Reporting Compliance,” “The Board of Directors and its Committees – Audit Committee” and “Code of Ethics” in the Company’s Proxy Statement for the 2006 Annual Meeting of Shareholders is incorporated herein by reference.

Item 11. Executive Compensation

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “Director Compensation,” “Executive Officer Compensation,” “Stock Options,” “Option Exercises and Holdings” and “Compensation Committee Interlocks and Insider Participation” in the Company’s Proxy Statement for the 2006 Annual Meeting of Shareholders is incorporated herein by reference.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “Security Ownership of Management and Certain Beneficial Owners” and “Equity Compensation Plans” in the Company’s Proxy Statement for the 2006 Annual Meeting of Shareholders is incorporated herein by reference.

Item 13. Certain Relationships and Related Transactions

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the heading “Certain Transactions” in the Company’s Proxy Statement for the 2006 Annual Meeting of Shareholders is incorporated herein by reference.

Item 14. Principal Accounting Fees and Services

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “Services and Fees” and “Pre-Approved Policies and Procedures” in the Company’s Proxy Statement for the 2006 Annual Meeting of Shareholders is incorporated herein by reference.

48

Part IV.

Item 15. Exhibits, Financial Statement Schedules

(a)  (1)

The response to this portion of Item 15 is submitted as a separate section of this report.

(2)

All applicable financial statement schedules required by Regulation S-X are included in the Notes to the 2005 Consolidated Financial Statements.

(3)

Exhibits:

3.1

Articles of Incorporation of Highlands Bankshares, Inc. (as restated in electronic format only as of July 27, 2005), filed as Exhibit 3.1 to the Current Report on Form 8-K, File No. 000-27622, filed with the Commission on August 2, 2005, incorporated herein by reference.

3.2

Bylaws of Highlands Bankshares, Inc. attached as Exhibit 3.2 to the Registration Statement on Form 8-A, File No. 000-27622, filed with the Commission on January 24, 1996, incorporated herein by reference.

10.1

Highlands Union Bank 1995 Stock Option Plan, attached as Exhibit 10.1 to the Annual Report on Form 10-K for the fiscal year ended December 31, 2002, File No. 000-27622, incorporated herein by reference.

11

Statement regarding computation of per share earnings (included as Note 1 of the Notes to Consolidated Financial Statements in the 2005 Annual Report to Shareholders and incorporated herein by reference).

13.1

Annual Report to Shareholders.

21

Subsidiaries of the Corporation.

23.1

Consent of Brown, Edwards & Company, L.L.P.

31.1

Section 302 Certification of Chief Executive Officer.

31.2

Section 302 Certification of Chief Operations Officer.

31.3

Section 302 Certification of Chief Financial Officer of the Corporation.

31.4

Section 302 Certification of Chief Financial Officer of the Bank.

32.1

Statement of Chief Executive Officer Pursuant to 18 U.S.C. § 1350.

32.2

Statement of Chief Operations Officer Pursuant to 18 U.S.C. § 1350.

32.3

Statement of Chief Financial Officer of the Corporation Pursuant to 18 U.S.C. § 1350.

32.4

Statement of Chief Financial Officer of the Bank Pursuant to 18 U.S.C. § 1350.

49

(b)

       Exhibits.

       The response to this portion of Item 15 as listed in Item 15(a)(3) above is submitted  as a separate section of this report.

(c)

       Financial Statement Schedules.

The response to this portion of Item 15 is submitted as a separate section of this   report.

50

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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.

Date:  March 26, 2006

BY: /s/ Samuel L. Neese

      Samuel L. Neese

      Executive Vice President and

      Chief Executive Officer

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 on the dates indicated on March 26, 2006.

Signature	Title	Date
/s/ James D. Morefield James D. Morefield	Chairman of the Board, and Director	March 26, 2006
/s/ Dr. James D. Moore, Jr. Dr. James D. Moore, Jr.	President	March 26, 2006
/s/ J. Carter Lambert J. Carter Lambert	Vice Chairman	March 26, 2006
/s/ Samuel L. Neese Samuel L. Neese	Executive Vice President, and Chief Executive Officer	March 26, 2006
/s/ James T. Riffe James T. Riffe	Executive Vice President and Cashier	March 26, 2006
/s/ William E. Chaffin William E. Chaffin	Director	March 26, 2006
/s/ E. Craig Kendrick E. Craig Kendrick	Director	March 26, 2006

51

/s/ Clydes B. Kiser Clydes B. Kiser	Director	March 26, 2006
/s/ Charles P. Olinger Charles P. Olinger	Director	March 26, 2006
/s/ William J. Singleton William J. Singleton	Director	March 26, 2006
/s/ Dr. H. Ramsey White, Jr. Dr. H. Ramsey White, Jr.	Director	March 26, 2006

52

EXHIBIT INDEX

Exhibit No.

Description

3.1

Articles of Incorporation of Highlands Bankshares, Inc. (as restated in electronic format only as of July 27, 2005), filed as Exhibit 3.1 to the Current Report on Form 8-K, File No. 000-27622, filed with the Commission on August 2, 2005, incorporated herein by reference.

3.2

Bylaws of Highlands Bankshares, Inc. attached as Exhibit 3.2 to the Registration Statement on Form 8-A, File No. 000-27622, filed with the Commission on January 24, 1996, incorporated herein by reference.

10.1

Highlands Union Bank 1995 Stock Option Plan, attached as Exhibit 10.1 to the Annual Report on Form 10-K for the fiscal year ended December 31, 2002, File No. 000-27622, incorporated herein by reference.

11

Statement regarding computation of per share earnings (included as Note 1 of the Notes to Consolidated Financial Statements in the 2003 Annual Report to Shareholders and incorporated herein by reference).

13.1

Annual Report to Shareholders.

21

Subsidiaries of the Corporation.

23.1

Consent of Brown, Edwards & Company, L.L.P.

31.1

Section 302 Certification of Chief Executive Officer.

31.2

Section 302 Certification of Chief Operations Officer.

31.3

Section 302 Certification of Chief Financial Officer of the Corporation.

31.4

Section 302 Certification of Chief Financial Officer of the Bank.

32.1

Statement of Chief Executive Officer Pursuant to 18 U.S.C. § 1350.

32.2

Statement of Chief Operations Officer Pursuant to 18 U.S.C. § 1350.

32.3

Statement of Chief Financial Officer of the Corporation Pursuant to 18 U.S.C. § 1350.

32.4

Statement of Chief Financial Officer of the Bank Pursuant to 18 U.S.C. § 1350.

53

EX-13

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED FINANCIAL REPORT

DECEMBER 31, 2005

C O N T E N T S

Page

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

2

FINANCIAL STATEMENTS

  Consolidated Balance Sheets

3

  Consolidated Statements of Income

4

  Consolidated Statements of Stockholders' Equity

5

  Consolidated Statements of Cash Flows

6

  Notes to Consolidated Financial Statements

7 – 35

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON THE FINANCIAL STATEMENTS

Board of Directors and Stockholders

Highlands Bankshares, Inc. and Subsidiaries

Abingdon, Virginia

We have audited the accompanying consolidated balance sheets of Highlands Bankshares, Inc. and Subsidiaries as of December 31, 2005, 2003, and 2002 and the related consolidated statements of income and comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

          We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. 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 financial statements referred to above present fairly, in all material respects, the financial position of Highlands Bankshares, Inc. and Subsidiaries as of December 31, 2005, 2004, and 2003, and the consolidated results of their operations and cash flows for each of the three years in the period ended December 31, 2005 in conformity with U.S. generally accepted accounting principles.

    CERTIFIED PUBLIC ACCOUNTANTS

Bristol, Virginia

January 31, 2006

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

December 31, 2005, 2004 and 2003

(Amounts in thousands)

ASSETS	2005	2004	2003
Cash and due from banks	$       16,631	$       11,795	$        14,473
Federal funds sold	110	1,714	389
Total Cash and Cash Equivalents	16,741	13,509	14,862
Investment securities available-for-sale (Note 2)	135,726	128,953	122,064
Other Investments, at cost (Note 3)	4,558	4,250	2,900
Loans, net of allowance for loan losses of $4,359, $4,181       and $4,274 in 2005, 2004, and 2003 respectively (Note 4)	407,274	387,133	373,534
Premises and equipment, net (Note 5)	17,234	16,638	15,465
Interest receivable	3,543	2,757	2,749
Other assets	14,265	13,820	11,842
Total Assets	$     599,341	$     567,060	$      543,416
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits (Note 8)
Noninterest bearing	$       80,047	$       72,906	$        59,057
Interest bearing	406,861	395,751	390,952
Total Deposits	486,908	468,657	450,009
Federal funds purchased	4,610	-	-
Interest, taxes and other liabilities	2,818	1,921	2,244
Other short term borrowings (Note 9)	18,098	25,548	33,000
Long-term debt (Note 10)	38,475	25,335	16,429
Capital securities (Note 11)	6,300	6,300	6,300
	70,301	59,104	57,973
Total Liabilities	557,209	527,761	507,982
STOCKHOLDERS' EQUITY
Common stock, 5,281, 5,330, and 5,318 shares             issued and outstanding as of December 31, 2005,           2004, and 2003, respectively. Authorized 40,000                 shares, par value $.625 per share  (Notes 13 and 15)	3,300	3,331	3,324
Additional paid-in capital	6,788	6,418	6,305
Retained Earnings	33,771	30,321	25,984
Accumulated other comprehensive loss	(1,727)	(771)	(179)
Total Stockholders' Equity	42,132	39,299	35,434
Total Liabilities and Stockholders' Equity	$     599,341	$     567,060	$      543,416

The Notes to Consolidated Financial Statements are an integral part of these statements.

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31, 2005, 2004 and 2003

(Amounts in thousands, except per share data)

INTEREST INCOME	2005	2004	2003
Loans receivable and fees on loans	$      26,703	$      24,575	$      24,893
Securities available for sale:
Taxable	2,544	2,164	2,214
Tax-exempt	2,593	2,547	2,183
Other Investment Income	182	159	98
Federal funds sold	167	15	75
Total Interest Income	32,189	29,460	29,463
INTEREST EXPENSE
Deposits	11,282	9,310	10,335
Federal funds purchased	29	72	13
Other borrowed funds	3,179	2,780	2,529
Total interest expense	14,490	12,162	12,877
Net interest income	17,699	17,298	16,586
PROVISION FOR LOAN LOSSES (Note 4)	1,155	1,300	2,053
Net interest income after provision for loan losses	16,544	15,998	14,533
NON-INTEREST INCOME
Securities gains	559	400	589
Service charges on deposit accounts	2,635	2,647	2,665
Other service charges, commissions and fees	1,047	880	778
Other operating income	609	645	620
Total Non-Interest Income	4,850	4,572	4,652
NON-INTEREST EXPENSE
Salaries and employee benefits (Note 14)	8,807	8,697	7,746
Occupancy expense of bank premises	862	774	582
Furniture and equipment expense	1,414	1,538	1,607
Other operating expenses (Note 23)	3,915	3,862	3,535
Total Non-Interest Expenses	14,998	14,871	13,470
Income Before Income Taxes	6,396	5,699	5,715
Income Tax Expense (Note 7)	1,363	1,042	1,195
Net Income	$        5,033	$        4,657	$        4,520
Earnings Per Common Share (Note 13)	$          0.95	$          0.88	$          0.85
Earnings Per Common Share - assuming dilution  (Note 13)	$          0.94	$          0.87	$          0.85

The Notes to Consolidated Financial Statements are an integral part of these statements.

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

Years Ended December 31, 2005, 2004, and 2003

(Amounts in thousands)

					Accumulated Other Comprehensive Income
			Additional Paid-in Capital	Retained Earnings		Total Stockholders' Equity
	Common Stock
	Shares	Par Value
Balance, December 31, 2002	5,296	$    3,309	$    6,150	$    21,729	$        1,011	$     32,199
Comprehensive income:
Net income	-	-	-	4,520	-	4,520
Change in unrealized gain (loss) on securities available-for-sale, net of deferred income tax benefit of $413	-	-	-	-	(801)	(801)
Less: reclassification adjustment, net of income tax expense of $200	-	-	-	-	(389)	(389)
Total comprehensive income	-	-	-	-	-	3,330
Common stock issued for stock options exercised	20	14	140	-	-	154
Common stock issued for  dividend reinvestment and optional  cash purchase plan	2	1	15	-	-	16
Cash dividend	-	-	-	(265)	-	(265)
Balance, December 31, 2003	5,318	3,324	6,305	25,984	(179)	35,434
Comprehensive income:
Net income	-	-	-	4,657	-	4,657
Change in unrealized gain (loss) on securities available-for-sale, net of deferred income tax benefit of $169	-	-	-	-	(328)	(328)
Less: reclassification adjustment, net of income tax expense of $136	-	-	-	-	(264)	(264)
Total comprehensive income	-	-	-	-	-	4,065
Common stock issued for stock options exercised	10	6	92	-	-	98
Common stock issued for  dividend reinvestment and optional  cash purchase plan	2	1	21	-	-	22
Cash dividend	-	-	-	(320)	-	(320)
Balance, December 31, 2004	5,330	3,331	6,418	30,321	(771)	39,299
Comprehensive income:
Net income	-	-	-	5,033	-	5,033
Change in unrealized gain (loss) on securities available-for-sale, net of deferred income tax benefit of $302	-	-	-	-	(587)	(587)
Less: reclassification adjustment, net of income tax expense of $190	-	-	-	-	(369)	(369)
Total comprehensive income	-	-	-	-	-	4,077
Common stock issued for stock options exercised	23	14	248	-	-	262
Common stock issued for  dividend reinvestment and optional  cash purchase plan	9	6	122	-	-	128
Cash dividend				(400)		(400)
Repurchase Common Stock	(81)	(51)	-	(1,183)	-	(1,234)
Balance, December 31, 2005	5,281	$    3,300	$      6,788	$    33,771	$      (1,727)	$     42,132

The Notes to Consolidated Financial Statements are an integral part of these statements

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2005, 2004, and 2003

(Amount in thousands)

	2005	2004	2003
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$         5,033	$         4,657	$          4,520
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision for loan losses	1,155	1,300	2,053
Provision for deferred income taxes	(129)	92	(27)
Depreciation and amortization	1,076	1,024	882
Net realized gains on available-for-sale securities	(559)	(400)	(589)
Net amortization on securities	614	589	302
Amortization of capital issue costs	24	13	12
Increase in interest receivable	(786)	(8)	(41)
(Increase) decrease in other assets	172	(1,937)	(565)
Increase (decrease) in interest, taxes and other
liabilities	898	(323)	(65)
Net Cash provided by operating activities	7,498	5,007	6,482
CASH FLOWS FROM INVESTING ACTIVITIES:
Securities available for sale:
Proceeds from sale of debt and equity securities	23,011	12,018	7,178
Proceeds from maturities of debt and equity securities	21,992	21,138	25,435
Purchase of debt and equity securities	(53,279)	(41,131)	(53,451)
Purchase of other investments	(308)	(1,300)	(718)
Net increase in loans	(21,297)	(14,899)	(39,943)
Premises and equipment expenditures	(1,688)	(2,088)	(2,920)
Net Cash used in investing activities	(31,569)	(26,262)	(64,419)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in certificates of deposit	20,237	13,900	11,186
Net increase (decrease) in demand, savings and other deposits	(1,986)	4,748	28,522
Net increase in federal funds purchased	4,610	-	-
Net increase (decrease) in short term borrowings	(7,450)	(7,495)	13,906
Net increase in long-term debt	13,140	8,949	1,979
Repurchase of capital securities	-	-	(1,200)
Cash dividends paid	(400)	(320)	(265)
Proceeds from exercise of common stock options	262	98	154
Proceeds from issuance of common stock	128	22	16
Repurchase of common stock	(1,234)	-	-
Net Cash provided by financing activities	27,303	19,902	54,298
Net increase (decrease) in cash and cash equivalents	3,232	(1,353)	(3,639)
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR	13,509	14,862	18,501
CASH AND CASH EQUIVALENTS AT END OF YEAR	$       16,741	$       13,509	$       14,862
SUPPLEMENTAL DISCLOSURE OF NON-CASH TRANSACTIONS
Land, premises and equipment purchased through seller financed    transactions	$                -	$                -	$            250
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for:
Interest	$       13,912	$       12,101	$       13,090
Income taxes	$         1,269	$         1,196	$         1,150

The Notes to Consolidated Financial Statements are an integral part of these statements

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note  1.

 Summary of Significant Accounting Policies

Basis of Presentation and Consolidation

The accompanying consolidated financial statements include the accounts of Highlands Bankshares, Inc., (the “Parent Company”) and its wholly-owned subsidiaries, Highlands Union Bank (the "Bank"). The statements also include Highlands Union Insurance Services, Inc., (the “Insurance Services”), and Highlands Union Financial Services, Inc., (the “Financial Services”) which are both wholly-owned subsidiaries of the Bank. All significant intercompany balances and transactions have been eliminated in consolidation. The accounting and reporting policies of Highlands Bankshares, Inc. and Subsidiaries, (the “Company”) conform to U.S. generally accepted accounting principals and to predominate practices within the banking industry.

Nature of Operations

The Company operates in Abingdon, Virginia, and surrounding southwest Virginia, eastern Tennessee, and western North Carolina under the laws of the Commonwealth of Virginia. The Parent Company was organized on December 29, 1995. The Parent Company is supervised by the Federal Reserve Bank under the Bank Holding Company Act of 1956, as amended. The Bank began banking operations on April 27, 1985 under a state bank charter and provides a full line of financial services to individuals and businesses. The Bank’s primary lending products include mortgage, consumer and commercial loans, and their primary deposit products are checking, savings, and certificates of deposit. As a state bank and a member of the Federal Reserve Bank of Richmond, the Bank is subject to regulation by the Virginia State Bureau of Financial Institutions, the Federal Deposit Insurance Corporation, and the Federal Reserve Bank. Highlands Capital Trust I became effective January 14, 1998. The nature of the trust is described more fully in Note 11. Highlands Union Insurance Services, Inc. became effective October 8, 1999 for the purpose of selling insurance through Bankers Insurance LLC. The Bank operated a financial services department for the purpose of brokering various investment vehicles until January 2, 2001. At that time, Highlands Union Financial Services, Inc. was created to convert that department into a separate legal entity in order to transact financial services in all of the Bank’s market areas. During 2004, changes to the NASD rules required financial services to be operated underneath the bank structure once again. This change occurred August 1, 2004. The only activity running through Highlands Union Financial Services now relates to commissions from the sale of life insurance.

Cash and Cash Equivalents

For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash and due from banks and federal funds sold, all of which mature within ninety days. The Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts. The Company believes it is not exposed to any significant credit risk on cash and cash equivalents.

Securities Available-for-Sale

Securities classified as available-for-sale are those debt and equity securities that the Company intends to hold for an indefinite period of time, but not necessarily to maturity. Any decision to sell a security classified as available-for-sale would be based on various factors, including significant movements in interest rates, changes in the maturity mix of the Company's assets and liabilities, liquidity needs, regulatory capital considerations, and other similar factors.

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note  1.

Summary of Significant Accounting Policies (Continued)

Securities Available-for-Sale (Continued)

Securities available-for-sale are carried at fair value. Unrealized gains or losses are reported as increases or decreases in other comprehensive income, net of the related deferred income tax effect. Realized gains or losses are recorded on the trade date and are determined on the basis of the amortized cost of specific securities sold. Realized gains or losses are included in earnings. Premiums and discounts are recognized in interest income using the interest method over the period to maturity.

Loans

The Company grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans throughout  southwest  Virginia. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on  originated   loans. Interest income is accrued on the unpaid balance. Loan origination fees, net of certain direct origination costs, are deferred and amortized to income over the estimated lives of the loans using the straight-line method. The aforementioned method is not materially different from the interest method. The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection. Credit card loans and other personal loans are typically charged off no later than 180 days past due.  In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.

All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Allowance for Loan Losses

The Company monitors and maintains an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio. The Company maintains policies and procedures that address the systems of controls over the following areas of maintenance of the allowance: the systematic methodology used to determine the appropriate level of the allowance to provide assurance the loan loss reserve is maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan portfolio; and the loan grading system.

The Company’s Credit Review and Analysis Department evaluates various loans individually for impairment as required by Statement of Financial Accounting Standards (“SFAS”) No. 114, Accounting by Creditors for Impairment of a Loan, and SFAS No. 118, Accounting by Creditors for Impairment of a Loan – Income Recognition and Disclosures. Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by management. The evaluations are based

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note  1.

Summary of Significant Accounting Policies (Continued)

Allowance for Loan Losses (Continued)

upon discounted expected cash flows or collateral valuations. If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment. If a loan evaluated individually is not impaired, then the loan is assessed for impairment under SFAS No. 5, Accounting for Contingencies, with a group of loans that have similar characteristics.

For loans without individual measures of impairment, the Company makes estimates of losses for groups of loans as required by SFAS No. 5. Loans are grouped by similar characteristics, including the type of loan, the assigned loan grade and the general collateral type. A loss rate reflecting the expected loss inherent in a group of loans is derived based upon estimates of default rates for a given loan grade, the predominant collateral type for the group and the terms of the loan. The resulting estimate of losses for groups of loans are adjusted for relevant environmental factors and other conditions of the portfolio of loans, including:  borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability of lending management; and national and local economic conditions.

The amounts of estimated impairment for individually evaluated loans and groups of loans are added together for a total estimate of loan losses. This estimate of losses is compared to the allowance for loan losses of the Company as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made. If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates. If the estimate of losses is below the range of reasonable estimates, the allowance would be reduced by way of a credit to the provision for loan losses. The Company recognizes the inherent imprecision in estimates of losses due to various uncertainties  and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high or too low. If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the consolidated financial statements.

Premises and Equipment

Land is carried at cost.  Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed on the straight-line method over estimated useful lives. Maintenance and repairs are charged to current operations while improvements are capitalized. Disposition gains and losses are reflected in current operations. Purchased software costs are included in other assets and expensed over periods ranging from 3-5 years.

Intangible Assets

Capital issue costs relating to the junior subordinated debt securities are stated at cost less accumulated amortization. Amortization is computed on the straight-line method over the life of the securities - 30 years.

Foreclosed Assets

Assets acquired through, or in lieu of, loan foreclosure or repossession are held for sale and are initially recorded at fair value at the date of foreclosure or repossession, establishing a new cost

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

                                             (Amounts in thousands)

Note  1.

Summary of Significant Accounting Policies (Continued)

Foreclosed Assets (Continued)

basis. Subsequent to foreclosure or repossession, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net expenses from foreclosed and repossessed assets. Foreclosed and repossessed assets at December 31, 2005, 2004 and 2003 were $951, $1,174 and $439, respectively.

Income Taxes

Under the asset and liability method, deferred income taxes are recognized for the tax consequences of “temporary differences” by applying enacted statutory tax rates to the differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Under SFAS No. 109, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date.

Earnings Per Common Share

Earnings per common share are calculated based on the weighted average outstanding shares during the year. Earnings per common share assuming dilution are calculated based on the weighted average outstanding shares during the year plus common stock equivalents at year end.

Stock Compensation Plans

Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, encourages all entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock. Stock options issued under the Corporation’s stock option plan have no intrinsic value at the grant date, and under Opinion No. 25 no compensation cost is recognized for them. The Company applies APB Opinion 25 and related interpretations in accounting for the stock option plan. Accordingly, no compensation cost has been recognized. Had compensation cost for the Corporation’s stock option plan been determined based on the fair value at the grant dates for awards under the plan consistent with the method prescribed by FASB Statement No. 123, the Company’s net income and earnings per share would have been adjusted to the pro forma amounts indicated below:

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

                                              (Amounts in thousands)

Stock Compensation Plans (Continued)

		Years Ended December 31,
		2005	2004	2003
Net income	As reported	$        5,033	$        4,657	$       4,520
	Pro forma	$        4,826	$        4,452	$       4,316
Earnings per share	As reported	$          0.95	$          0.88	$         0.85
	Pro forma	$          0.91	$          0.84	$         0.82
Earnings per share assuming	As reported	$          0.94	$          0.87	$         0.85
dilution	Pro forma	$          0.90	$          0.83	$         0.81

The pro forma amounts shown above reflect the options granted during the year discounted using the expected life, expected volatility and risk-free interest rates as shown below. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:

	Years Ended December 31,
	2005	2004	2003
Expected life	10 years	10 years	10 years
Expected volatility	12.64%	8.87%	6.20%
Risk-free interest rates	4.00%	4.23%	5.15%

Use of Estimates

In preparing consolidated financial statements in conformity with U.S. generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenue and expenses during the reporting period. Actual results could differ from those
estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, and the valuation of foreclosed real estate, deferred tax assets and investment securities.

Business Segments

The Company reports its activities as a single business segment. In determining the appropriateness of segment definition, the Company considers components of the business about which financial information is available and regularly evaluated relative to resource allocation and performance assessment.

Recent Accounting Pronouncements

On December 16, 2004, the Financial  Accounting Standards Board issued Statement of Financial  Accounting  Standard (SFAS) No. 123R,  Share-Based  Payment,  that addresses the accounting for share-based payment transactions in which a company receives  employee  services in exchange for either  equity  instruments  of the company or liabilities  that are based on the fair value of the company's equity instruments  or that may be settled by the issuance of such equity  

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

                                                            (Amounts in thousands)

Recent Accounting Pronouncements (Continued)

instruments. SFAS No. 123R  eliminates  the ability to account for  share-based  compensation transactions  using the intrinsic method and requires that such  transactions be accounted for using a  fair-value-based  method and recognized as expense in the consolidated  statement  of  income. The effective date of SFAS No. 123R (as amended by the Securities and Exchange Commission)  is for  interim and annual  periods beginning  after June 15, 2005. The provisions of SFAS No. 123R do not have an impact on the Company's results of operations at the present time. The Company will begin recognizing compensation expense in 2006 for options that have been issued but not yet vested prior to January 1, 2006. Projected compensation expense associated with adopting SFAS No. 123R will approximate $0 in 2006. This estimate applies only to options issued through December 31, 2005, but not yet vested prior to January 1, 2006. Any options issued after December 31, 2005 would increase compensation expense above this estimate for 2006.

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). This interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” addresses consolidation by business enterprises of variable interest entities. Under current practice, two enterprises generally have been included in consolidated financial statements because one enterprise controls the other through voting interests. FIN 46 defines the concept of “variable interests” and requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among the parties involved. The interpretation may be applied prospectively with a cumulative-effect adjustment as of the date on which it is first applied or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated. In December 2003, the FASB issued FIN 46R, which among other things, revised the implementation dates. The Company is required to immediately apply FIN 46 and FIN 46R (“the Interpretation”) to any entity that is subject to the Interpretation and that is created after December 31, 2003. The Company is also required to apply the Interpretation to any entity subject to the Interpretation that was created before December 31, 2003 by the beginning of the first annual period beginning after December 15, 2004. The Company’s adoption of this standard did not have an impact on the Company’s consolidated financial statements.

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

                                                            (Amounts in thousands)

Note  2.

Investment Securities Available-For-Sale

The amortized cost and market value of securities available-for-sale are as follows:

	2005
	Amortized Cost	Gross Unrealized Gains	Gross Unrealized Losses	Fair Value
U.S Government agencies and    corporations	$     750	$              -	$   12	$        738
State and political subdivisions	57,942	255	442	57,755
Mortgage backed securities	62,933	89	897	62,125
Other securities	16,717	18	1,627	15,108
	$ 138,342	$       362	$      2,978	$    135,726

	2004
	Amortized Cost	Gross Unrealized Gains	Gross Unrealized Losses	Fair Value
U.S Government agencies and    corporations	$     1,247	$              8	$              -	$        1,255
State and political subdivisions	47,379	1,034	239	48,174
Mortgage backed securities	61,349	184	373	61,160
Other securities	20,146	52	1,834	18,364
	$ 130,121	$       1,278	$      2,446	$    128,953

	2003
	Amortized Cost	Gross Unrealized Gains	Gross Unrealized Losses	Fair Value
U.S Government agencies and    corporations	$     3,247	$            15	$              -	$        3,262
State and political subdivisions	48,275	1,035	679	48,631
Mortgage backed securities	53,583	220	329	53,474
Other securities	17,231	98	632	16,697
	$ 122,336	$       1,368	$      1,640	$    122,064

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note  2.

Investment Securities Available-For-Sale (Continued)

The following table presents the age of gross unrealized losses and fair value by investment category.

	---------------------------------------December 31, 2005----------------------------
	Less Than 12 months		12 Months or More		Total
	Fair Value	Unrealized Losses	Fair Value	Unrealized Losses	Fair Value	Unrealized Losses
Mortgage-backed securities	$  25,250	$      275	$  26,281	$        622	$51,531	$       897
States and pol. subdivisions	25,573	267	5,264	175	30,837	442
Other securities	2,522	23	5,134	1,616	7,656	1,639
Total	$  53,345	$      565	$ 36,679	$    2,413	$90,024	$    2,978

Management does not believe any individual unrealized loss as of December 31, 2005 represents an other-than-temporary impairment. The unrealized losses are primarily attributable to changes in interest rates. The Company has both the intent and ability to hold the securities contained in the previous table for a time necessary to recover the amortized cost.

Investment securities available-for-sale with a carrying value of $15,356, $12,324, and $10,316 at December 31, 2005, 2004 and 2003 respectively, and a market value of $15,211, $12,552, and $10,614 at December 31, 2005, 2004 and 2003, respectively were pledged as collateral on public deposits and for other purposes as required or permitted by law.

The amortized cost and estimated fair value of securities available-for-sale at December 31, 2005 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Amortized Cost	Approximate Market Value
Due in one year or less	$         2,287	$           2,338
Due after one year through five years	1,708	1,686
Due after five years through ten years	808	804
Due after ten years	53,889	53,665
	58,692	58,493
Mortgage-backed securities	62,933	62,125
Other securities	16,717	15,108
	$     138,342	$     135,726

For the years ended December 31, 2005, 2004, and 2003, proceeds from sale of securities were      $23,011, $12,018 and $9,394, respectively. Gross realized gains and losses on investment securities available for sale were as follows:

	2005	2004	2003
Realized gains	$           957	$           407	$         589
Realized losses	$           398	$               7	$              -
Tax provision	$           321	$           136	$         200

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 3. Other Investments

Federal Home Loan Bank (FHLB) stock, Federal Reserve Bank (FRB) stock and Community Bankers’ Bank Stock with a carrying value of $4,005, $3,700 and $2,900 at December 31, 2005, 2004 and 2003, respectively are listed as “ Other Investments” on the Company’s Balance Sheets. These investments are considered to be restricted as the Company is required by these agencies to hold these investments, and the only market for this stock is the issuing agency.

Other investments also include the Company’s equity ownership investment in the Davenport Financial Fund, LLC., which is a fund that purchases various bank stocks in the Mid-Atlantic area. The Company accounts for this investment under the equity method. The Company’s original investment in this fund was $500 and the carrying value at December 31, 2005 and 2004 was $553 and $550, repectively.

Note  4.

Loans

The composition of net loans is as follows:

	2005	2004	2003
Real Estate Secured:
Residential 1-4 family	$151,815	$    146,970	$    141,693
Multifamily	4,148	3,379	2,651
Commercial, Construction and Land Development	140,178	122,997	113,146
Second mortgages	10,962	7,419	6,976
Equity lines of credit	9,800	8,981	7,430
Farmland	10,015	9,347	4,843
	326,918	299,093	276,739
Secured, Other:
Personal	33,395	44,222	48,637
Commercial	25,628	24,992	27,247
Agricultural	3,653	4,024	4,506
	62,676	73,238	80,390
Unsecured	21,801	19,033	20,448
Overdrafts	247	143	420
	22,048	19,176	20,868
	411,642	391,507	377,997
Less:
Allowance for loan losses	4,359	4,181	4,274
Net deferred fees	9	193	189
	4,368	4,374	4,463
Loans, net	$    407,274	$    387,133	$    373,534

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note  4.

Loans (Continued)

Activity in the allowance for loan losses is as follows:

	2005	2004	2003
Balance, beginning	$        4,181	$        4,274	$        3,877
Provision charged to operations	1,155	1,300	2,053
Loans charged to reserve	(1,127)	(1,500)	(1,780)
Recoveries	150	107	124
Balance, ending	$        4,359	$        4,181	$        4,274

The following is a summary of information pertaining to impaired loans:

	December 31,
	2005	2004	2003
Impaired loans without a valuation  allowance	$            -	$            -	$           -
Impaired loans with a valuation allowance	1,660	1,502	2,064
Total impaired loans	$    1,660	$    1,502	$   2,064
Valuation allowance related to impaired loans	$       281	$       326	$      838
Total non-accrual loans	$    2,920	$    3,902	$   3,723
Total loans past due 90 days or more and still accruing	$    1,281	$       661	$      802
Average investment in impaired loans	$    3,084	$    1,841	$   1,597
Interest income recognized on impaired loans	$           1	$         24	$          8
Interest income recognized on a cash basis on impaired loans	$            -	$         24	$          8

No additional funds are committed to be advanced in connection with impaired loans.

Note 5. Premises and Equipment

                Premises and equipment are comprised of the following:

	2005	2004	2003
Land	$          6,039	$        4,907	$        4,984
Bank Premises	10,274	10,193	8,989
Equipment	8,693	7,906	6,777
	25,006	23,006	20,750
Less: accumulated depreciation	7,850	6,814	5,899
	17,156	16,192	14,851
Construction in Progress	78	446	614
	$        17,234	$      16,638	$      15,465

Depreciation expense was $1,056, $1,004, and $862 for 2005, 2004, and 2003, respectively. Construction in progress for 2005 consists primarily of expenditures related to a future branch

located in Sevierville, Tennessee.

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 6. Bank Owned Life Insurance

The Company maintains insurance on the lives of certain key directors and officers. As beneficiary, the Company receives the cash surrender value if the policy is terminated, and upon death of the insured, receives all benefits payable. The current value of the policies at December 31, 2005, 2004 and 2003 are $8,623, $8,282 and $7,929, respectively and are included in “Other Assets” in the balance sheet.

Note  7.

Income Taxes

The components of the net deferred tax asset, included in other assets, are as follows:

	2005	2004	2003
Deferred tax assets:
Allowance for loan loss	$          1,355	$        1,231	$       1,167
Deferred compensation	2	2	2
Net unrealized loss on securities     available-for-sale	889	397	92
	2,246	1,630	1,261
Deferred tax liability:
Depreciation	(599)	(651)	(496)
	(599)	(651)	(496)
Net deferred tax asset	$          1,647	$           979	$          766

The components of income tax expense related to continuing operations are as follows:

	2005	2004	2003
Federal:
Current	$          1,492	$            950	$         1,168
Deferred	(129)	92	(27)
Total	$          1,363	$         1,042	$         1,195

The Company’s income tax expense differs from the expected tax expense at the statutory federal rate of 34% as follows:

	2005	2004	2003
Statutory rate applied to earnings before   income taxes	$          2,175	$         1,938	$         1,943
Tax exempt interest	(882)	(866)	(742)
Other, net	70	(30)	(6)
Total	$          1,363	$         1,042	$         1,195

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 8. Deposits

The composition of deposits is as follows:

	2005	2004	2003
Non-interest bearing demand	$        80,047	$      72,906	$     59,057
Interest bearing demand	59,144	58,526	64,048
Savings deposits	67,440	77,186	80,764
Time deposits, in amounts of $100,000    or more	88,481	76,817	69,804
Other time deposits	191,796	183,222	176,336
Total deposits	$      486,908	$    468,657	$   450,009

The scheduled maturities of time deposits at December 31, 2005 are as follows:

2005	$     136,100
2006	68,916
2007	34,924
2008	14,984
2009	21,345
Thereafter	4,008
	$      280,27

Note 9. Other Short-Term Borrowings

Other short-term borrowings in the balance sheet consist of three Federal Home Loan Bank advances that are secured by a floating blanket lien on a specific class of mortgage loans of the Bank. The Federal Home Loan Bank has the option to convert all of these advances which total $18 million to a three month LIBOR-based floating rate advance. These notes carry interest rates of 6.280%, 6.170%, 2.910%. Also included in other short-term borrowing are the contractual principal payments due over the next 12 months on two seller financed mortgages secured by Bank property and an FHLB advance granted through the FHLB’s Affordable Housing Program. The remaining balances on these three borrowings are included in long-term debt.

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 10.

Long-Term Debt

At December 31, Highlands Bankshares, Inc. and Subsidiaries had the following long-term debt agreements:

	2005	2004	2003
Note payable FHLB dated 03/26/98 for $6 million with an annual interest rate of 5.51%, due 03/26/08. The note requires quarterly interest payments and had an early conversion option that expired on 03/26/03. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.	$           6,000	$         6,000	$         6,000
Note payable FHLB dated 08/13/99 for $4 million with an annual interest rate of 6.385%, due 08/13/09. The note requires quarterly interest payments and had an early conversion option at 08/13/04. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.	4,000	4,000	Included in short term borrowings
Note payable FHLB dated 02/13/2002 for $5 million with an annual interest rate of 4.640%, due 02/13/2012. The note requires quarterly interest payments and has an early conversion option at 02/13/07. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.	5,000	5,000	5,000
Note payable FHLB dated 05/07/2002 for $5 million with an annual interest rate of 4.720%, due 05/07/2012. The note requires quarterly interest payments and has an early conversion option at 05/07/2007. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.	5,000	5,000	5,000
Note payable FHLB dated 05/28/04 for $5 million with an annual interest rate of 2.910%, due 05/28/2009. The note requires quarterly interest payments and has an early conversion option at 05/28/2006. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.	Included in short term borrowings	5,000	N/A

                HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 10. Long-Term Debt (Continued)

	2005	2004	2003
Note payable FHLB dated 02/02/05 for $7.5 million with an annual interest rate of 3.440%, due 02/02/2015. The note requires quarterly interest payments and has an early conversion option at 02/02/2008. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.	$           7,500	N/A	N/A
Note payable FHLB dated 03/04/05 for $5 million with an annual interest rate of 4.165%, due 03/04/2015. The note requires quarterly interest payments and has an early conversion option at 03/04/2010. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.	5,000	N/A	N/A
Note payable FHLB dated 06/29/05 for $5 million with an annual interest rate of 3.760%, due 06/29/2015. The note requires quarterly interest payments and has an early conversion option at 06/29/2010. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.	5,000	N/A	N/A
Note payable FHLB dated 08/23/05 for $750,000 with an annual interest rate of 0%, due 08/24/2020. The note requires monthly principal payments and was granted as part of the FHLB’s affordable housing program. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank.	692	N/A	N/A
Other notes payable resulting from seller-financing transactions for $500 with annual interest rates ranging from 3.2% to 8.0%, and due dates ranging from 2010-2013. The notes require monthly installments of principal and interest of $6. The loans are secured by a first deed of trust on real estate.	283	335	429
Total long-term debt	$       38,475	$       25,335	$      16,429

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 10. Long-Term Debt (Continued)

Contractual principal maturities of long-term debt at December 31, 2005 are as follows:

2006	$               -
2007	101
2008	6,106
2009	4,109
2010	91
Thereafter	28,068
	$        38,475

Note 11.

Capital Securities

On January 21, 1998, Highlands Capital Trust I, issued $7,500 of 9.25% Capital Securities which will mature on January 15, 2028. The principal asset of the Trust is $7,500 of the Parent Company’s junior subordinated debt securities with like maturities and like interest rates to the Capital Securities. Additionally, the Trust has issued 9,000 shares of common securities to the Parent Company. The 9.25% Capital Securities had $6,300 outstanding at December 31, 2005, and an estimated fair value of $6,598. The related junior subordinated debt securities had an estimated fair value of $6,598. Highlands Bankshares, Inc. repurchased 48,000 or 16% of the shares of Highlands Capital Trust I on April 18, 2003, on the open market, at $26.15 per share. The price paid per share corresponds to the January 2008 call price. The premium paid of $55 is being expensed over the period to the January 2008 call date.

The Capital Securities, the assets of the Trust and the common securities issued by the Trust are redeemable in whole or in part on or after January 15, 2008, or at any time in whole but not in part from the date of issuance on the occurrence of certain events.

The Capital Securities may be included in Tier I capital for regulatory capital adequacy determination purposes up to 25% of Tier I capital after its inclusion.  The portion of the Capital Securities not considered as Tier I capital may be included in Tier II capital. Distributions to the holders of the Capital Securities are included in interest expense.

The obligations of the Parent Company with respect to the issuance of the Capital Securities constitute a full and unconditional guarantee by the Parent Company of the Trust’s obligations with respect to the Capital Securities.

Subject to certain exceptions and limitations, the Parent Company may elect from time to time to defer interest payments on the junior subordinated debt securities, which would result in a deferral of distribution payments on the related Capital Securities.

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

                            (Amounts in thousands, except per share data)

Note 12.

Operating Leases

The following is a schedule by years of future minimum rental payments required under operating leases that have initial or remaining non-cancelable terms in excess of one year.

Year ending December 31:
2005	$                51
2006	36
2007	14
Total minimum payments required	$              101

Total operating lease expense was $ 52, $66 and $227 for December 31, 2005, 2004, and 2003 respectively.

Note 13.

Common Stock and Earnings Per Common Share

On July 13, 2005, the Board approved a 2 for 1 stock split to shareholders of record on July 27, 2005 payable on September 9, 2005. As a result, authorized shares increased from 20,000 to 40,000 and par value decreased from $1.25 to $0.625 per share. Shares issued and outstanding at December 31, 2005, 2004 and 2003 were 5,281, 5,330 and 5,318 respectively. All references in the financial statements to number of shares, per share amounts and market prices of the Company’s common stock have been retroactively restated to reflect the increased number of common shares outstanding.

Earnings per common share is computed using the weighted average outstanding shares for the years ended December 31. Outstanding stock options (Note 15) have a dilutive effect on earnings per share, which is determined using the treasury stock method.

The following is a reconciliation of the numerators and the denominators of the basic and diluted earnings per common share computation:

	2005	2004	2003
Income available to common stockholders	$          5,033	$         4,657	$         4,520
Weighted average shares outstanding	5,302	5,324	5,306
Shares outstanding including assumed   conversion	5,367	5,378	5,350
Basic earnings per share	$           0.95	$          0.88	$          0.85
Fully diluted earnings per share	$           0.94	$          0.87	$          0.85

Highlands Bankshares, Inc. paid dividends of $400, $320, and $265 or $0.075 per share, $0.06 per share, and $0.05 per share in 2005, 2004 and 2003, respectively.

Note 14.

  Profit Sharing and Retirement Savings Plan

The Bank has a 401(K) savings plan available to substantially all employees meeting minimum eligibility requirements. The Bank makes a discretionary 2% profit sharing contribution to all employees exclusive of employee contributions and employer matching.   Employees may elect to make voluntary contributions to the plan up to 15% of their base pay. In addition to the 2%

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands, except per share data)

Note 14.

  Profit Sharing and Retirement Savings Plan (Continued)

profit sharing contribution, the Bank matches 50% of the employee’s initial 6% contribution; therefore, the maximum employer matching contribution per employee could be 3% of base pay. The cost of Bank contributions under the savings plan was $275, $252 and $223, in 2005, 2004 and 2003 respectively.

Note 15.

  Stock Option Plan

In 1996, Highlands Bankshares, Inc., adopted a non-qualified stock incentive option plan, for key employees, officers, and directors and reserved 150,000 shares of common stock for issuance thereunder. This number of shares increased to 600,000 as a result of the 1999 two-for-one stock split and the 2005 two-for-one stock split. The plan is identical to and replaced the plan previously adopted by Highlands Union Bank.

The exercise price of each option equals the market price of the Company’s stock on the date of grant and an option’s maximum term is ten years. Option exercise prices are determined by the Board of Directors based on recent open market sales, but shall not be less than the greater of the par value of such stock or 100% of the book value of such stock as shown by the Company’s last published statement prior to granting of the option. Proceeds received upon exercise of options are credited to common stock, to the extent of par value of the related shares, and the balance is credited to surplus. Shares under options which are canceled are available for subsequent grant.

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands, except  per share data)

Note 15. Stock Option Plan (Continued)

A summary of the status of the Company’s stock option plan is presented below:

	2005		2004		2003
	Weighted Average Exercise Price	Number of Shares	Weighted Average Exercise Price	Number of Shares	Weighted Average Exercise Price	Number of Shares
Options outstanding at January 1	$   11.82	345,910	$   11.24	297,716	$   10.49	266,436
Granted	15.00	63,400	14.50	61,400	13.00	59,700
Exercised	11.29	(23,290)	10.50	(9,206)	6.72	(22,020)
Expired	13.29	(5,050)	13.15	(4,000)	10.61	(6,400)
Options outstanding and    exercisable at December 31	$   12.36	380,970	$   11.82	345,910	$   11.24	297,716
Weighted-average fair value of    options granted during the year	$   15.00		$   14.50		$   13.00

Information pertaining to options outstanding at December 31, 2005 is as follows:

	Options Outstanding and Exercisable
Range of Exercise Prices	Number Outstanding	Weighted Average Remaining Contractual Life	Weighted Average Exercise Price
$  3.75  -  $  3.75	5,800	0.33 years	$        3.75
$  5.75  -  $  7.13	43,858	2.22 years	$        6.93
$  9.50  -  $15.00	331,312	7.05 years	$      13.23
Outstanding at end of year	380,970	6.40 years	$      12.36

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 16.

  Off-Balance Sheet Activities

The Bank is party to various financial instruments with off-balance sheet risk arising in the normal course of business to meet the financing needs of their customers. Those financial instruments include commitments to extend credit and commercial letters of credit of approximately $3,716, $3,066, and $3,485, unfunded commitments under lines of credit of $43,973, $34,902 and $29,655 and commitments to grant loans of $7,713, $10,210 and $5,073 for the years ended December 31, 2005, 2004 and 2003 respectively. These instruments contain various elements of credit and interest rate risk in excess of the amount recognized in the statements of financial condition.

The Bank's exposure to credit loss, in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit, is the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations that they do for on-balance sheet instruments.

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. The commitments for equity lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Company, is based on management’s credit evaluation of the customer.

Unfunded commitments under lines of credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit usually do not contain a specified maturity date and may not be drawn upon to the total extent to which the Company is committed.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds collateral supporting those commitments if deemed necessary.

Note 17.

  Commitments and Contingencies

The Bank has made arrangements with and has available from corresponding banks, approximately $157,215 of lines of credit to fund any necessary cash requirements. The Bank has $56,238 of Federal Home Loan Bank advances outstanding as of December 31, 2005. A specific class of mortgage loans, with a balance of $143,304 at December 31, 2005 were pledged to the FHLB as collateral.

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 18.

  Fair Values of Financial Instruments

The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows.   Accordingly, the fair value estimates may not be realized in an immediate settlement of   the   instrument.   SFAS 107 excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

The following methods and assumptions were used by the Company in estimating fair value disclosures for financial instruments:

Cash and Cash Equivalents

The carrying amount reported in the balance sheets for cash, short-term investments and federal funds sold approximates fair value.

Securities Available for Sale

Fair value for securities are based on quoted market prices.

Other Investments

Other investments include Federal Home Loan Bank, Federal Reserve Bank and Community Bankers Bank. The carrying value of those securities approximates fair value based on the redemption provisions of those Banks. Other investments also include the Company’s equity ownership investment in the Davenport Financial Fund, LLC. The Company accounts for this investment under the equity method.

Loans

The fair value of loans represent the amount at which the loans of the Bank could be exchanged on the open market, based upon the current lending rate for similar types of lending arrangements discounted over the remaining life of the loans.

Deposits

The fair value of deposits represent the amount at which the deposit liabilities of the Bank could be exchanged on the open market, based upon the current deposit rates for similar types of deposit arrangements discounted over the remaining life of the deposits.

Other Short-Term Borrowings

The carrying amounts of borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days approximate their fair values. Fair values of other short-

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 18.

  Fair Values of Financial Instruments (Continued)

Other Short-Term Borrowings (Continued)

term borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements. Estimated maturity dates are also included in the calculation of fair value for these borrowings.

Long-Term Debt and Capital Securities

Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate fair value of existing debt.

Off-Balance-Sheet Instruments

The amount of off-balance sheet commitments to extend credit, standby letters of credit, and financial guarantees, is considered equal to fair value. Because of the uncertainty involved in attempting to assess the likelihood and timing of commitments being drawn upon, coupled with the lack of an established market and the wide diversity of fee structures, the Company does not believe it is meaningful to provide an estimate of fair value that differs from the given value of the commitment.

The carrying amounts and fair values of the Company's financial instruments at December 31 were as follows:

	2005		2004		2003
	Carrying Amount	Fair Value	Carrying Amount	Fair Value	Carrying Amount	Fair Value
Cash and cash equivalents	$  16,741	$  16,741	$  13,509	$  13,509	$  14,473	$  14,473
Securities available for  sale	135,726	135,726	128,953	128,953	119,164	119,164
Other investments	4,558	4,558	4,250	4,250	2,900	2,900
Loans, net	407,274	404,868	387,133	386,217	373,534	376,354
Deposits	(486,908)	(485,718)	(468,657)	(469,070)	(450,009)	(453,395)
Other short-term   borrowings	(18,098)	(17,373)	(25,548)	(26,128)	(33,043)	(33,909)
Long-term debt	(38,475)	(38,418)	(25,335)	(26,615)	(16,386)	(17,228)
Capital Securities	(6,300)	(6,598)	(6,300)	(6,692)	(6,300)	(6,794)

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 19.

  Related Party Transactions

In the normal course of business, the Bank has made loans to its directors and officers and their affiliates. All loans and commitments made to such officers and directors and to companies in which they are officers or have significant ownership interest have been made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons, and did not, in the opinion of management, involve more than normal credit risk or present other unfavorable features. The activity in such loans is as follows:

	2005	2004	2003
Balance, beginning	$   12,109	$   11,582	$   9,434
Additions	3,497	5,459	8,357
Reductions	(3,837)	(4,932)	(6,209)
Balance, ending	$  11,769	$  12,109	$  11,582
Unused commitments	$     1,918	$       958	$       796

  Deposits from related parties held by the Bank at December 31, 2005, 2004, and 2003 were $4,963 and $3,199 and $3,398, respectively.

Note 20.

  Restrictions on Cash

The Bank is required to maintain reserve balances in cash with the Federal Reserve Bank. The total of those reserve balances at December 31, 2005, 2004 and 2003 were $7,076, $6,109 and $5,723, respectively.

Note 21.

  Minimum Regulatory Capital Requirements

The Company and the Bank are subject to various regulatory capital requirements administered by its primary regulator, the Federal Reserve Bank of Richmond. Failure to meet the minimum regulatory capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators, that if undertaken, could have a direct material effect on the Company and Bank and the consolidated financial statements. Under the regulatory capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines involving quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification under the prompt corrective action guidelines are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 21. Minimum Regulatory Capital Requirements (Continued)

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of total risk-based capital and Tier I capital to risk-weighted assets (as defined in the regulations), and Tier I capital to adjusted total assets (as defined). Management believes, as of December 31, 2005, 2004, and 2003, that the Company and the Bank met all the capital adequacy requirements to which they are subject.

As of December 31, 2005 the most recent notification from the State Corporation Commission Bureau of Financial Institutions categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To remain categorized as well capitalized, the Bank will have to maintain minimum total risk-based capital to risk-weighted assets, Tier I capital to risk-weighted assets, and Tier I capital to adjusted total assets ratios as disclosed in the table below. There are no conditions or events since the most recent notification that management believes have changed the Bank’s category.

The Company’s actual and required capital amounts and ratios are as follows:

	Actual		For Capital Adequacy Purposes
	Amount	Ratio	Amount	Ratio
As of December 31, 2005:
Total Risk-Based Capital (to Risk-Weighted    Assets)	$   52,749	12.99%	$ 32,485	=,> 8%
Tier 1 Capital (to Risk-Weighted Assets)	48,390	11.92%	16,243	=,> 4%
Tier 1 Capital (to Adjusted Total Assets)	48,390	8.08%	23,954	=,> 4%
As of December 31, 2004:
Total Risk-Based Capital (to Risk-Weighted    Assets)	$   49,185	12.89%	$ 30,518	=,> 8%
Tier 1 Capital (to Risk-Weighted Assets)	45,004	11.80%	15,259	=,> 4%
Tier 1 Capital (to Adjusted Total Assets)	45,004	7.86%	22,906	=,> 4%
As of December 31, 2003:
Total Risk-Based Capital (to Risk-Weighted    Assets)	$   44,823	12.51%	$ 28,653	=,> 8%
Tier 1 Capital (to Risk-Weighted Assets)	40,549	11.32%	14,327	=,> 4%
Tier 1 Capital (to Adjusted Total Assets)	40,549	7.52%	21,563	=,> 4%

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 21. Minimum Regulatory Capital Requirements (Continued)

The Bank’s actual and required capital amounts and ratios are as follows:

	Actual		For Capital Adequacy Purposes		To be Well Capitalized under the Prompt Corrective Action Provisions
	Amount	Ratio	Amount	Ratio	Amount	Ratio
As of December 31, 2005:
Total Risk-Based Capital (to Risk-Weighted  Assets)	$   43,986	10.93%	$  32,208	=,> 8%	$ 40,260	=,> 10%
Tier 1 Capital (to Risk-Weighted Assets)	39,647	9.85%	16,104	=,> 4%	24,156	=,> 6%
Tier 1 Capital (to Adjusted Total Assets)	39,647	6.70%	23,671	=,> 4%	29,588	=,> 5%
As of December 31, 2004:
Total Risk-Based Capital (to Risk-Weighted  Assets)	$   41,317	10.96%	$  30,169	=,> 8%	$ 37,711	=,> 10%
Tier 1 Capital (to Risk-Weighted Assets)	37,156	9.85%	15,085	=,> 4%	22,627	=,> 6%
Tier 1 Capital (to Adjusted Total Assets)	37,156	6.56%	22,661	=,> 4%	28,326	=,> 5%
As of December 31, 2003:
Total Risk-Based Capital (to Risk-Weighted Assets)	$   38,508	10.85%	$  28,397	=,> 8%	$ 35,496	=,> 10%
Tier 1 Capital (to Risk-Weighted Assets)	34,254	9.65%	14,198	=,> 4%	21,297	=,> 6%
Tier 1 Capital (to Adjusted Total Assets)	34,254	6.44%	21,272	=,> 4%	26,591	=,> 5%

Note 22.

  Restrictions on Dividends

The Parent Company’s principal asset is its investment in the Bank, a wholly owned consolidated subsidiary. The primary source of income for the Parent Company historically has been dividends from the Bank. Regulatory agencies limit the amount of funds that may be transferred from the Bank to the Parent Company in the form of dividends, loans or advances.

Under applicable laws and without prior regulatory approval, the total dividend payments of the Bank in any calendar year are restricted to the net profits of that year, as defined, combined with the retained net profits for the two preceding years. The total dividends that may be declared in 2006 without regulatory approval total $5,683 plus year-to-date 2006 net profits as of the declaration date.

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

                                           (Amounts in thousands)

Note 23.

  Other Operating Income and Expenses

Other operating income and expenses that exceed 1% of the total of interest income and other income presented separately consist of the following:

	2005	2004	2003
BOLI income	$      341	$      354	$      357
Postage and freight	$      343	$      321	$       306
Other Contracted Services	$      415	$      285	$       227
Bank Franchise Taxes	$      335	$      273	$       246

Note 24. Condensed Parent Company Financial Statements

The condensed financial statements below relate to Highlands Bankshares, Inc., as of December 31, 2005, 2004, and 2003 and for the years then ended. Equity in undistributed earnings of subsidiary includes the change in unrealized gains or losses on securities, net of tax.

CONDENSED BALANCE SHEETS
	2005	2004	2003
ASSETS
Cash	$     3,154	$     2,953	$     1,232
Capital securities repurchased	1,200	1,200	1,200
Other investments	550	549	-
Loans, net of allowance for loan losses of $20     in 2005, 2004, and 2003	2,754	2,438	3,383
Equity in subsidiary	39,688	37,751	35,440
Premises and equipment, net	2,078	1,695	1,431
Other assets	356	393	406
Total Assets	$   49,780	$   46,979	$   43,092
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest, taxes and other liabilities	$        148	$        180	$        158
Capital securities	7,500	7,500	7,500
Total Liabilities	7,648	7,680	7,658
STOCKHOLDERS’ EQUITY	42,132	39,299	35,434
Total Liabilities and Stockholders’ Equity	$   49,780	$   46,979	$   43,092

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 24. Condensed Parent Company Financial Statements (Continued)

CONDENSED STATEMENTS OF INCOME
	2005	2004	2003
Dividends from subsidiary	$      2,500	$      2,000	$      1,200
Interest income	280	307	355
Other income	226	276	226
Interest expense	(694)	(698)	(694)
Operating expense	(173)	(131)	(133)
	2,139	1,754	954
Income tax benefit	122	84	84
Equity in undistributed earnings of subsidiary	2,772	2,819	3,482
Net income	$     5,033	$      4,657	$      4,520

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 24. Condensed Parent Company Financial Statements (Continued)

CONDENSED STATEMENTS OF CASH FLOWS
	2005	2004	2003
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$     5,033	$     4,657	$     4,520
Adjustments to reconcile net income to net cash   Provided by operating activities:
Depreciation and amortization	74	54	49
Provision for deferred income taxes	3	2	5
Equity in undistributed earnings of subsidiary	(2,772)	(2,819)	(3,482)
Increase in other assets	(113)	(134)	(162)
Increase (decrease)  in other liabilities	(32)	22	(4)
Net cash provided by operating activities	2,193	1,782	926
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of other investments	-	(500)	-
Net (increase) decrease in loans	(316)	945	498
Premises and equipment expenditures	(432)	(306)	-
Net cash provided by (used in) investing   activities	(748)	139	498
CASH FLOWS FROM FINANCING ACTIVITIES:
Cash dividends paid	(400)	(320)	(265)
Repurchase of capital securities	-	-	(1,200)
Proceeds from issuance of common stock	128	22	16
Proceeds from exercise of common stock options	262	98	154
Repurchase of Common Stock	(1,234)	-	-
Net cash used in financing activities	(1,244)	(200)	(1,295)
Net increase in cash and cash equivalents	201	1,721	129
CASH AND CASH EQUIVALENTS AT   BEGINNING OF YEAR	2,953	1,232	1,103
CASH AND CASH EQUIVALENTS AT END OF   YEAR	$3,154	$2,953	$     1,232

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 25. Quarterly Data (Unaudited)

Consolidated quarterly results of operations were as follows:
	2005
	March 31	June 30	Sept. 30	Dec. 31
Interest Income	$  7,663	$  8,004	$  8,051	$  8,471
Interest Expense	(3,298)	(3,494)	(3,733)	(3,965)
Net interest income	4,365	4,510	4,318	4,506
Provision for loan losses	(288)	(247)	(247)	(373)
Net interest income after provision for possible loan losses	4,077	4,263	4,071	4,133
Other income	1,244	1,224	1,117	1,265
Other expenses	(3,782)	(3,807)	(3,680)	(3,729)
Income before income taxes	1,539	1,680	1,508	1,669
Income taxes	(295)	(464)	(274)	(330)
Net income	$  1,244	$  1,216	$   1,234	$  1,339
Earnings per common share:
Basic	$    0.24	$    0.23	$     0.23	$    0.25
Diluted	$    0.23	$    0.23	$     0.23	$    0.25
	2004
	March 31	June 30	Sept. 30	Dec. 31
Interest Income	$  7,341	$  7,223	$  7,326	$  7,570
Interest Expense	(2,972)	(2,926)	(3,033)	(3,231)
Net interest income	4,369	4,297	4,293	4,339
Provision for loan losses	(348)	(341)	(373)	(238)
Net interest income after provision for possible loan losses	4,021	3,956	3,920	4,101
Other income	1,031	1,189	1,276	1,076
Other expenses	(3,587)	(3,647)	(3,780)	(3,857)
Income before income taxes	1,465	1,498	1,416	1,320
Income taxes	(275)	(289)	(255)	(223)
Net income	$  1,190	$  1,209	$   1,161	$  1,097
Earnings per common share:
Basic	$    0.23	$    0.22	$     0.22	$    0.21
Diluted	$    0.23	$    0.22	$     0.22	$    0.20

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

(Amounts in thousands)

Note 25. Quarterly Data (Unaudited) (Continued)

	2003
	March 31	June 30	Sept. 30	Dec. 31
Interest Income	$  7,403	$  7,357	$  7,371	$  7,332
Interest Expense	(3,337)	(3,279)	(3,189)	(3,072)
Net interest income	4,066	4,078	4,182	4,260
Provision for loan losses	(470)	(510)	(447)	(626)
Net interest income after provision for possible loan losses	3,596	3,568	3,735	3,634
Other income	1,095	1,317	1,044	1,196
Other expenses	(3,268)	(3,364)	(3,389)	(3,449)
Income before income taxes	1,423	1,521	1,390	1,381
Income taxes	(338)	(338)	(274)	(245)
Net income	$  1,085	$  1,183	$   1,116	$  1,136
Earnings per common share:
Basic	$    0.21	$    0.22	$     0.21	$    0.21
Diluted	$    0.21	$    0.22	$     0.21	$    0.21

Note 26. Subsequent Events

On January 9, 2006 the Company executed an agreement to purchase a certain tract of land located in Abingdon, Virginia. The closing is expected to occur in March of 2006. The purchase price of the subject property is $510.

On January 9, 2006, the Board of Directors approved management to sign contracts for the construction of a branch bank office in Sevierville, Tennessee. The estimated cost of this contract is $680,000.

EX-21

Exhibit 21

Subsidiaries of Highlands Bankshares, Inc.

Name of Subsidiary

State of Incorporation

Highlands Union Bank

Virginia

Highlands Union Insurance Services, Inc.

Virginia

Highlands Union Financial Services, Inc.

Virginia

Highlands Capital Trust I

Delaware

EX-23

CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

We consent to the incorporation by reference in the Highlands Bankshares, Inc. registration statement on Form S-3D (Registration No. 333-83618) of our report dated January 31, 2006 on our audits of the consolidated financial statements of Highlands Bankshares, Inc. and Subsidiaries as of December 31, 2005, 2004 and 2003, and for the periods then ended.  Such report is included in the Highlands Bankshares, Inc. 2005 Annual Report to Stockholders, which is filed as exhibit 13 to Form 10-K for the year ended December 31, 2005.

         BROWN, EDWARDS & COMPANY, L.L.P.

Bristol, Virginia

March 23, 2006

EX-31

Exhibit 31.1

Rule 13a-14(a) Certification of Executive Vice

 President and Chief Executive Officer

I, Samuel L. Neese, certify that:

1.   I have reviewed this annual report on Form 10-K of Highlands Bankshares, Inc.

2.   Based on my  knowledge,  this  report  does not  contain any untrue statement of a material fact or omit to state a material fact  necessary to make the statements made, in light of the  circumstances  under which such statements were made,  not  misleading  with  respect to the period  covered by this report;

3.   Based on my  knowledge,  the  financial  statements,  and  other  financial information  included  in this  report,  fairly  present in all  material respects the financial  condition,  results of operations  and cash flows of the registrant as of, and for, the periods presented in this report;

4.   The registrant's  other  certifying  officers  and  I are  responsible  for establishing and maintaining  disclosure  controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a)  designed  such  disclosure  controls  and  procedures,  or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant,  including its consolidated  subsidiaries,  is made  known to us by  others  within  those entities,  particularly  during the period in which this   report is being prepared;

(b)  evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our  conclusions  about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(c)  disclosed  in  this   report  any  change  in the  registrant's internal  control  over  financial reporting  that  occurred  during  the registrant's most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect,  the registrant's  internal control  over financial reporting; and

5.   The registrant's other certifying  officers and I have disclosed,  based on our most recent evaluation of internal control over financial reporting,  to the registrant's  auditors  and the audit  committee  of the  registrant's  board of directors (or persons performing the equivalent functions):

(a)  all significant  deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely  affect the  registrant's  ability to record,  process, summarize and report financial information; and

(b)  any fraud, whether or not material,  that involves management or other employees who have a significant role in the registrant's  internal control over financial reporting.

Date: March 31, 2006        

/s/ Samuel L. Neese

                            ----------------------------------------------------

                            Samuel L.  Neese

                            Executive Vice President and Chief Executive Officer

EX-31

Exhibit 31.2

Rule 13a-14(a) Certification of Executive Vice President and Cashier

I, James T. Riffe, certify that:

1.   I have reviewed this annual report on Form 10-K of Highlands Bankshares, Inc.

2.   Based on my  knowledge,  this  report  does not  contain any untrue statement of a material fact or omit to state a material fact  necessary to make the statements made, in light of the  circumstances  under which such statements were made,  not  misleading  with  respect to the period  covered by this report;

3.   Based on my  knowledge,  the  financial  statements,  and  other  financial information  included  in this  report,  fairly  present in all  material respects the financial  condition,  results of operations  and cash flows of the registrant as of, and for, the periods presented in this report;

4.   The registrant's  other  certifying  officers  and  I are  responsible  for establishing and maintaining  disclosure  controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a)  designed  such  disclosure  controls  and  procedures,  or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant,  including its consolidated  subsidiaries,  is made  known to us by  others  within  those entities,  particularly  during the period in which this   report is being prepared;

(b)  evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our  conclusions  about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(c)  disclosed  in  this   report  any  change  in the  registrant's internal  control  over  financial reporting  that  occurred  during  the registrant's most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect,  the registrant's  internal control  over financial reporting; and

5.   The registrant's other certifying  officers and I have disclosed,  based on our most recent evaluation of internal control over financial reporting,  to the registrant's  auditors  and the audit  committee  of the  registrant's  board of directors (or persons performing the equivalent functions):

(a)  all significant  deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely  affect the  registrant's  ability to record,  process, summarize and report financial information; and

(b)  any fraud, whether or not material,  that involves management or other employees who have a significant role in the registrant's  internal control over financial reporting.

Date: March 31, 2006        

/s/ James T. Riffe

                             ----------------------------------------------------

                            James T. Riffe

                            Executive Vice President and Cashier

EX-31

 Exhibit 31.3

Rule 13a-14(a) Certification of Chief Financial Officer

I, Robert M. Little, Jr., certify that:

1.   I have reviewed this annual report on Form 10-K of Highlands Bankshares, Inc.

2.   Based on my  knowledge,  this  report  does not  contain any untrue statement of a material fact or omit to state a material fact  necessary to make the statements made, in light of the  circumstances  under which such statements were made,  not  misleading  with  respect to the period  covered by this report;

3.   Based on my  knowledge,  the  financial  statements,  and  other  financial information  included  in this  report,  fairly  present in all  material respects the financial  condition,  results of operations  and cash flows of the registrant as of, and for, the periods presented in this report;

4.   The registrant's  other  certifying  officers  and  I are  responsible  for establishing and maintaining  disclosure  controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a)  designed  such  disclosure  controls  and  procedures,  or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant,  including its consolidated  subsidiaries,  is made  known to us by  others  within  those entities,  particularly  during the period in which this   report is being prepared;

(b)  evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our  conclusions  about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(c)  disclosed  in  this   report  any  change  in the  registrant's internal  control  over  financial reporting  that  occurred  during  the registrant's most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect,  the registrant's  internal control  over financial reporting; and

5.   The registrant's other certifying  officers and I have disclosed,  based on our most recent evaluation of internal control over financial reporting,  to the registrant's  auditors  and the audit  committee  of the  registrant's  board of directors (or persons performing the equivalent functions):

(a)  all significant  deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely  affect the  registrant's  ability to record,  process, summarize and report financial information; and

(b)  any fraud, whether or not material,  that involves management or other employees who have a significant role in the registrant's  internal control over financial reporting.

Date: March 31, 2006        

/s/ Robert M. Little, Jr.

                            ----------------------------------------------------

                            Robert M. Little, Jr.

                            Chief Financial Officer

EX-31

 Exhibit 31.4

Rule 13a-14(a) Certification of Vice President of Accounting

I, James R. Edmondson, certify that:

1.   I have reviewed this annual report on Form 10-K of Highlands Bankshares, Inc.

2.   Based on my  knowledge,  this  report  does not  contain any untrue statement of a material fact or omit to state a material fact  necessary to make the statements made, in light of the  circumstances  under which such statements were made,  not  misleading  with  respect to the period  covered by this report;

3.   Based on my  knowledge,  the  financial  statements,  and  other  financial information  included  in this  report,  fairly  present in all  material respects the financial  condition,  results of operations  and cash flows of the registrant as of, and for, the periods presented in this report;

4.   The registrant's  other  certifying  officers  and  I are  responsible  for establishing and maintaining  disclosure  controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a)  designed  such  disclosure  controls  and  procedures,  or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant,  including its consolidated  subsidiaries,  is made  known to us by  others  within  those entities,  particularly  during the period in which this   report is being prepared;

(b)  evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our  conclusions  about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(c)  disclosed  in  this   report  any  change  in the  registrant's internal  control  over  financial reporting  that  occurred  during  the registrant's most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect,  the registrant's  internal control  over financial reporting; and

5.   The registrant's other certifying  officers and I have disclosed,  based on our most recent evaluation of internal control over financial reporting,  to the registrant's  auditors  and the audit  committee  of the  registrant's  board of directors (or persons performing the equivalent functions):

(a)  all significant  deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely  affect the  registrant's  ability to record,  process, summarize and report financial information; and

(b)  any fraud, whether or not material,  that involves management or other employees who have a significant role in the registrant's  internal control over financial reporting.

Date: March 31, 2006        

/s/ James R. Edmondson

                            ----------------------------------------------------

                            James R. Edmondson

                            Vice President of Accounting

EX-32

Exhibit 32.1

Certification

Pursuant To 18 U.S.C. Section 1350,

As Adopted Pursuant to

Section 906 Of The Sarbanes-Oxley Act of 2002

In connection with the Annual Report of Highlands Bankshares, Inc. (the “Company”) on Form 10-K for the period ended December 31, 2005 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Samuel L. Neese, Executive Vice President and Chief Executive Officer of the Company, certify pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge:

1.

The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934; and

2.

The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ Samuel L. Neese

Samuel L. Neese

Executive Vice President and Chief Executive Officer

March 31, 2006

EX-32

Exhibit 32.2

Certification

Pursuant To 18 U.S.C. Section 1350,

As Adopted Pursuant to

Section 906 Of The Sarbanes-Oxley Act of 2002

In connection with the Annual Report of Highlands Bankshares, Inc. (the “Company”) on Form 10-K for the period ended December 31, 2005 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, James T. Riffe, Executive Vice President and Cashier of the Company, certify pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge:

1.

The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934; and

2.

The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ James T. Riffe

James T. Riffe

Executive Vice President and Cashier

March 31, 2006

EX-32

Exhibit 32.3

Certification

Pursuant To 18 U.S.C. Section 1350,

As Adopted Pursuant to

Section 906 Of The Sarbanes-Oxley Act of 2002

In connection with the Annual Report of Highlands Bankshares, Inc. (the “Company”) on Form 10-K for the period ended December 31, 2005 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Robert M. Little, Jr., Chief Financial Officer of the Company, certify pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge:

1.

The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934; and

2.

The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ Robert M. Little, Jr.

Robert M. Little, Jr.

Chief Financial Officer

March 31, 2006

EX-32

Exhibit 32.4

Certification

Pursuant To 18 U.S.C. Section 1350,

As Adopted Pursuant to

Section 906 Of The Sarbanes-Oxley Act of 2002

In connection with the Annual Report of Highlands Bankshares, Inc. (the “Company”) on Form 10-K for the period ended December 31, 2005 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, James R. Edmondson, Vice President of Accounting of the Company, certify pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge:

1.

The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934; and

2.

The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ James R. Edmondson

James R. Edmondson

Vice President of Accounting

March 31, 2006