UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-Q

[X] Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the quarterly period ended March 31, 2014

[   ] Transition Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the transition period from ____________ to _____________

Commission File Number:  0-27622

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.)
P.O. Box 1128 Abingdon, Virginia (Address of principal executive offices)	24212-1128 (Zip Code)

276-628-9181

(Registrant’s telephone number, including area code)

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 o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes x  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or smaller reporting company (See definition of “large accelerated filer, accelerated filer and smaller reporting company” in Rule 12b-2 of the Act). Large Accelerated Filer  o   Accelerated Filer  o   Non-Accelerated Filer o  Smaller Reporting Company  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso  No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 7,684,401 shares of common stock, par value $0.625 per share,

outstanding as of  May 14, 2014

1

Highlands Bankshares, Inc.

FORM 10-Q

For the Quarter Ended March 31, 2014

INDEX

PART I. FINANCIAL INFORMATION	PAGE
Item 1.  Financial Statements
Consolidated Balance Sheets   at March 31, 2014 (Unaudited) and December 31, 2013
	3
Consolidated Statements of Income (Unaudited)   for the Three Months Ended March 31, 2014 and 2013	4
Consolidated Statements of Comprehensive Income (Unaudited)   for the Three Months Ended March 31, 2014 and 2013	5
Consolidated Statements of Cash Flows (Unaudited)   for the Three Months Ended March 31, 2014 and 2013	6
Consolidated Statements of Changes in   Stockholders’ Equity (Unaudited) for the Three Months   Ended March 31, 2014 and 2013	7
Notes to Consolidated Financial Statements (Unaudited)	8-36
Item 2. Management’s Discussion and Analysis of               Financial Condition and Results of Operations	37-42
Item 3. Quantitative and Qualitative Disclosures About Market Risk	42
Item 4.  Controls and Procedures	43
PART II.  OTHER INFORMATION
Item 1.  Legal Proceedings	43
Item 1A. Risk Factors	44
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds	44
Item 3.  Defaults Upon Senior Securities	44
Item 4.  Mine Safety Disclosures	44
Item 5.  Other Information	44
Item 6.  Exhibits	44
SIGNATURES AND CERTIFICATIONS	45

2

PART I.

FINANCIAL INFORMATION

ITEM 1.  Financial Statements

Consolidated Balance Sheets

(Amounts in thousands)

	(Unaudited)  March 31, 2014			(Note 1) December 31, 2013
ASSETS
Cash and due from banks	$	16,321		$	16,965
Federal funds sold		73,587			67,030
Total Cash and Cash Equivalents		89,908			83,995
Investment securities available for sale  (amortized cost $54,996 at  March 31, 2014, $56,582 at December 31, 2013)		54,253			55,318
Other investments, at cost		4,538			4,710
Loans, net of allowance for loan losses of  $6,679 at March 31, 2014, $6,825 at December 31, 2013		399,386			396,961
Premises and equipment, net		20,193			20,188
Deferred tax assets		10,129			10,444
Interest receivable		2,307			2,171
Bank owned life Insurance		14,239			14,132
Other real estate owned		7,754			7,834
Other assets		2,594			2,559
Total Assets	$	605,301		$	598,312
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES
Deposits:
Non-interest bearing	$	113,441		$	107,328
Interest bearing		380,747			380,946
Total Deposits		494,188			488,274
Interest, taxes and other liabilities		2,865			2,595
Other short-term borrowings		23,473			23,500
Long-term debt		47,789			47,802
Capital securities		3,150			3,150
Total Other Liabilities		77,277			77,047
Total Liabilities		571,465			565,321
STOCKHOLDERS’ EQUITY
Common stock (5,011 shares issued and outstanding)		3,132			3,132
Additional paid-in capital		7,783			7,783
Retained earnings		23,411			22,910
Accumulated other comprehensive loss		(490	)		(834	)
Total Stockholders’ Equity		33,836			32,991
Total Liabilities and Stockholders’ Equity	$	605,301		$	598,312

 

See accompanying Notes to Consolidated Financial Statements

3

Consolidated Statements of Income

(Amounts in thousands, except per share data)

(Unaudited)

	Three Months Ended  March 31, 2014		Three Months Ended March 31, 2013
INTEREST INCOME
Loans receivable and fees on loans	$	5,392	$	5,403
Securities available for sale:
Taxable		222		203
Exempt from taxable income		123		141
Other investment income		45		30
Federal funds sold		38		40
Total Interest Income		5,820		5,817
INTEREST EXPENSE
Deposits		663		785
Other borrowed funds		741		715
Total Interest Expense		1,404		1,500
Net Interest Income		4,416		4,317
Provision for Loan Losses		265		219
Net Interest Income after Provision for Loan Losses		4,151		4,098
NON-INTEREST INCOME
Securities gains (losses), net		-		(4	)
Service charges on deposit accounts		452		499
Other service charges, commissions and fees		399		407
Other  operating income		149		165
Total Non-Interest Income		1,000		1,067
NON-INTEREST EXPENSE
Salaries and employee benefits		2,467		2,403
Occupancy expense of bank premises		280		303
Furniture and equipment expense		302		310
Other operating expense		1,189		1,351
Foreclosed Assets – Write-down and Operating Expenses		273		218
Total Non-Interest Expense		4,511		4,585
Income Before Income Taxes		640		580
Income Tax Expense (Note 3)		139		116
Net Income	$	501	$	464
Basic Earnings  Per Common Share (Note 6)	$	0.10	$	0.09
Earnings Per Common Share – Assuming Dilution	$	0.10	$	0.09
Dividends Per Share	$	-	$	-

See accompanying Notes to Consolidated Financial Statements

4

Consolidated Statements of Comprehensive Income

(Amounts in thousands)

(Unaudited)

	Three Months Ended  March 31, 2014		Three Months Ended March 31, 2013
Net Income	$	501	$	464
Other Comprehensive Income
Unrealized gains  (losses) on securities during  the period		521		(142	)
Less: reclassification adjustment for losses  included in net income		-		4
Other Comprehensive Income, before tax		521		(138	)
Income tax expense (benefit) related to other comprehensive income		177		(45	)
Other Comprehensive Income (Loss)		344		(93	)
Comprehensive Income	$	845	$	371

See accompanying Notes to Consolidated Financial Statements

5

Consolidated Statements of Cash Flows

(Amounts in thousands)

(Unaudited)

	Three Months Ended			Three Months Ended
	March 31, 2014			March 31, 2013
CASH FLOWS FROM OPERATING  ACTIVITIES:
Net income	$	501		$	464
Adjustments to reconcile net income  to net cash provided by operating activities
Provision for loan losses		265			219
Depreciation and amortization		221			236
Net realized losses on available for sale securities		-			4
Net amortization on securities		117			179
Amortization of Capital issue costs		1			1
Increase in interest receivable		(136	)		(32	)
Valuation adjustment of other real estate owned		111			61
Decrease in other assets		43			319
Increase in interest, taxes and other liabilities		297			203
Net cash provided by operating activities		1,420			1,654
CASH FLOWS FROM INVESTING ACTIVITIES:
Securities available for sale:
Proceeds from sale of securities		-			1,341
Proceeds from maturities of debt and equity securities		1,469			2,359
Purchase of debt and equity securities		-			(4,195	)
Redemption of other investments		172			220
Net increase in loans		(3,020	)		(5,262	)
Proceeds from sales of other real estate owned		219			1,300
Premises and equipment expenditures		(221	)		(91	)
Net cash used in investing activities		(1,381	)		(4,328	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net decrease in time deposits		(3,049	)		(6,656	)
Net increase in demand, savings and other deposits		8,963			11,508
Decrease in short-term borrowings		(27	)		(6	)
Decrease in long-term debt		(13	)		(40	)
Net cash provided by financing activities		5,874			4,806
Net increase in cash and cash equivalents		5,913			2,132
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR		83,995			81,208
CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	89,908		$	83,340
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the year for:
Interest	$	1,139		$	1,504
Income taxes	$	-		$	-
SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
Transfer of loans to other real estate owned	$	330		$	339
Loans originated from sales of other real estate owned	$	56		$	271

See accompanying Notes to Consolidated Financial Statements

6

Consolidated Statements of Changes in Stockholders’ Equity

(Amounts in thousands)

(Unaudited)

									Accumulated
					Additional				Other			Total
	Common Stock				Paid-in		Retained		Comprehensive			Stockholders’
	Shares		Par Value		Capital		Earnings		Income			Equity
Balance, December 31, 2012		5,011	$	3,132	$	7,783	$	21,428	$	(1,871	)	$	30,472
Net income		-		-		-		464		-			464
Other comprehensive loss		-		-		-		-		(93	)		(93	)
Balance, March 31, 2013		5,011	$	3,132	$	7,783	$	21,892	$	(1,964	)	$	30,843
Balance, December 31, 2013		5,011	$	3,132	$	7,783	$	22,910	$	(834	)	$	32,991
Net income		-		-		-		501		-			501
Other comprehensive income		-		-		-		-		344			344
Balance, March 31, 2014		5,011	$	3,132	$	7,783	$	23,411	$	(490	)	$	33,836

See accompanying Notes to Consolidated Financial Statements

7

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Note 1  -  General

The consolidated financial statements of Highlands Bankshares, Inc. (the “Company”) conform to United States generally accepted accounting principles and to banking industry practices. The accompanying consolidated interim financial statements are unaudited. In the opinion of management, all adjustments necessary for a fair presentation of the consolidated financial statements have been included. All such adjustments are of a normal and recurring nature. The consolidated balance sheet as of December 31, 2013 has been extracted from the audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 (the “2013 Form 10-K”). The notes included herein should be read in conjunction with the notes to consolidated financial statements included in the 2013 Form 10-K. The results of operations for the three-month period ended March 31, 2014 are not necessarily indicative of the results to be expected for the full year.

The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Note 2  -  Loans and Allowance for Loan Losses  (amounts in thousands)

The composition of net loans is as follows:

	March 31, 2014		December 31, 2013
Real Estate Secured:
Residential 1-4 family	$	181,396	$	175,860
Multifamily		20,178		20,592
Construction and Land Loans		18,248		18,509
Commercial, Owner Occupied		71,757		71,459
Commercial, Non-owner occupied		35,331		37,117
Second mortgages		7,807		7,934
Equity lines of credit		7,536		7,884
Farmland		8,922		9,322
		351,175		348,677
Secured (other) and unsecured
Personal		19,900		20,472
Commercial		32,263		31,575
Agricultural		3,065		3,376
		55,228		55,423
Overdrafts		285		304
		406,688		404,404
Less:
Allowance for loan losses		6,679		6,825
Net deferred fees		623		618
		7,302		7,443
Loans, net	$	399,386	$	396,961

8

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

The following table is an analysis of past due loans as of March 31, 2014:

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Financing Receivables		Recorded Investment > 90 Days and Accruing
Real Estate Secured
Residential 1-4 family	$	4,646	$	1,433	$	3,264	$	9,343	$	172,053	$	181,396	$	-
Equity lines of credit		60		58		281		399		7,137		7,536		-
Multifamily		-		-		-		-		20,178		20,178		-
Farmland		227		206		129		562		8,360		8,922		-
Construction, Land Development, Other Land Loans		726		24		1,.642		2,392		15,856		18,248		-
Commercial Real Estate- Owner Occupied		594		329		2,096		3,019		68,738		71,757		-
Commercial Real Estate- Non Owner Occupied		1,559		-		2,608		4,167		31,164		35,331		-
Second Mortgages		39		68		81		188		7,619		7,807		-
Non Real Estate Secured
Personal		389		78		234		701		19,484		20,185		25
Commercial		321		133		228		682		31,581		32,263		-
Agricultural		-		-		-		-		3,065		3,065		-
Total	$	8,561	$	2,329	$	10,563	$	21,453	$	385,235	$	406,688	$	25

9

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

The following table is an analysis of past due loans as of December 31, 2013:

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Financing Receivables		Recorded Investment > 90 Days and Accruing
Real Estate Secured
Residential 1-4 family	$	3,219	$	1,805	$	2,699	$	7,723	$	168,137	$	175,860	$	-
Equity lines of credit		-		-		318		318		7,566		7,884		-
Multifamily		-		97		-		97		20,495		20,592		-
Farmland		38		-		129		167		9,155		9,322		-
Construction,  Land Development, Other Land Loans		303		117		1,615		2,035		16,474		18,509		-
Commercial Real Estate- Owner Occupied		665		26		1,610		2,301		69,158		71,459		-
Commercial Real Estate- Non Owner Occupied		234		2,257		637		3,128		33,989		37,117		-
Second Mortgages		341		3		56		400		7,534		7,934		-
Non Real Estate Secured
Personal		357		177		146		680		20,096		20,776		2
Commercial		1,344		121		266		1,731		29,844		31,575		-
Agricultural		29		-		-		29		3,347		3,376		-
Total	$	6,530	$	4,603	$	7,476	$	18,609	$	385,795	$	404,404	$	2

Loans are considered delinquent when payments have not been made according to the terms of the contract. 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.

The following is a summary of non-accrual loans at March 31, 2014 and December 31, 2013:

	March 31, 2014		December 31, 2013
Real Estate Secured
Residential 1-4 Family	$	3,264	$	2,890
Multifamily		-		-
Construction and Land Loans		1,696		1,694
Commercial-Owner Occupied		3,491		3,005
Commercial- Non Owner Occupied		2,608		2,429
Second Mortgages		81		92
Equity Lines of Credit		281		318
Farmland		129		146
Secured (other) and Unsecured
Personal		209		144
Commercial		228		266
Agricultural		-		-
Total	$	11,987	$	10,984

10

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

The following tables represent a summary of credit quality indicators of the Company’s loan portfolio at March 31, 2014 and December 31, 2013.  The grades are assigned and/or modified by the Company’s credit review and credit analysis departments based on the creditworthiness of the borrower and the overall strength of the loan.

Credit Risk Profile by Internally Assigned Grade as of March 31, 2014

Grade (1)	Residential 1-4 Family		Multifamily		Farmland		Construction, Land Loans		Commercial Real Estate- Owner Occupied		Commercial Real Estate Non-Owner Occupied
Quality		32,803		-		527		3,138		4,053		1,428
Satisfactory		92,752		16,094		3,246		7,982		29,430		14,723
Acceptable		42,005		1,958		4,024		4,214		21,688		10,220
Special Mention		4,540		2,126		459		1,299		7,592		2,298
Substandard		9,296		-		666		1,615		8,994		6,662
Doubtful		-		-		-		-		-		-
Total	$	181,396	$	20,178	$	8,922	$	18,248	$	71,757	$	35,331

Credit Risk Profile by Internally Assigned Grade as of December 31, 2013

Grade (1)	Residential 1-4 Family		Multifamily		Farmland		Construction, Land Loans		Commercial Real Estate- Owner Occupied		Commercial Real Estate Non-Owner Occupied
Quality		33,137		-		823		3,425		5,831		1,495
Satisfactory		90,569		15,419		4,128		8,123		27,712		15,153
Acceptable		38,958		3,049		3,699		3,733		22,007		11,148
Special Mention		4,678		2,124		6		1,652		6,823		2,507
Substandard		8,518		-		666		1,576		8,620		6,814
Doubtful		-		-		-		-		466		-
Total	$	175,860	$	20,592	$	9,322	$	18,509	$	71,459	$	37,117

(1)  Quality--This grade is reserved for the Bank’s top quality loans. These loans have excellent sources of repayment, with no significant identifiable risk of collection.  Generally, loans assigned this rating will demonstrate the following characteristics:

·   Conformity in all respects with Bank policy, guidelines, underwriting standards, and Federal and State regulations (no exceptions of any kind).

·   Documented historical cash flow that meets or exceeds required minimum Bank guidelines, or that can be supplemented with verifiable cash flow from other sources.

·   Adequate secondary sources to liquidate the debt, including combinations of liquidity, liquidation of collateral, or liquidation value to the net worth of the borrower or guarantor.

For existing loans, all of the requirements above apply plus all payments have been made as agreed, current financial information on all borrowers and guarantors has been obtained and analyzed, and overall business operating trends are either stable or improving.

Satisfactory-This grade is given to performing loans. These loans have adequate sources of repayment, with little identifiable risk of collection. Loans assigned this rating will demonstrate the following characteristics:

·   General conformity to the Bank's policy requirements, product guidelines and underwriting standards.  Any exceptions that are identified during the underwriting and approval process have been adequately mitigated by other factors.

·   Documented historical cash flow that meets or exceeds required minimum Bank guidelines, or that can be supplemented with verifiable cash flow from other sources.  

11

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

·   Adequate secondary sources to liquidate the debt, including combinations of liquidity, liquidation of collateral, or liquidation value to the net worth of the borrower or guarantor

For existing loans, all of the requirements outlined above will apply, plus all payments have been made as agreed, current financial information on all borrowers and guarantors has been obtained and analyzed, and overall business operating trends are stable with any declines considered minor and temporary.

Acceptable-This grade is given to loans that show signs of weakness in either adequate sources of repayment or collateral, but have demonstrated mitigating factors that minimize the risk of delinquency or loss.  Loans assigned this rating may demonstrate some or all of the following characteristics:

·   Additional exceptions to the Bank's policy requirements, product guidelines or underwriting standards that present a higher degree of risk to the Bank.  Although the combination and/or severity of identified exceptions is greater, all exceptions have been properly mitigated by other factors.

·   Unproved, insufficient or marginal primary sources of repayment that appear sufficient to service the debt at this time.  Repayment weaknesses may be due to minor operational issues, financial trends, or reliance on projected (not historic) performance.

·   Marginal or unproven secondary sources to liquidate the debt, including combinations of liquidation of collateral and liquidation value to the net worth of the borrower or guarantor.

For existing loans, payments have generally been made as agreed with only minor and isolated delinquencies.

Special Mention -This grade is given to Watch List loans that include the following characteristics:

·   Loans with underwriting guideline tolerances and/or exceptions with no identifiable mitigating factors.

·   Extending loans that are currently performing satisfactorily but with potential weaknesses that may, if not corrected, weaken the asset or inadequately protect the Bank's position at some future date. Potential weaknesses are the result of deviations from prudent lending practices.

·   Loans where adverse economic conditions that develop subsequent to the loan origination do not jeopardize liquidation of the debt, but do substantially increase the level of risk may also warrant this rating.

Substandard-Loans in this category are characterized by deterioration in quality exhibited by any number of well-defined weaknesses requiring corrective action. A substandard loan is inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans classified as substandard must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt; they are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

 The weaknesses may include, but are not limited to:

·   High debt to worth ratios and or declining or negative earnings trends

·   Declining or inadequate liquidity

·   Improper loan structure  or questionable repayment sources

·   Lack of well-defined secondary repayment source, and

·   Unfavorable competitive comparisons.

Such loans are no longer considered to be adequately protected due to the borrower's declining net worth, lack of earnings capacity, declining collateral margins and/or unperfected collateral positions. A possibility of loss of a portion of the loan balance cannot be ruled out. The repayment ability of the borrower is marginal or weak and the loan may have exhibited excessive overdue status or extensions and/or renewals.

12

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Doubtful -Loans classified Doubtful have all the weaknesses inherent in loans classified Substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values highly questionable and improbable. The ability of the borrower to service the debt is extremely weak, overdue status is constant, the debt has been placed on non-accrual status, and no definite repayment schedule exists.

However, these loans are not yet rated as loss because certain events may occur which would salvage the debt. Among these events are:

·   Injection of capital

·   Alternative financing

·   Liquidation of assets or the pledging of additional collateral.

Credit Risk Profile based on payment activity as of  March 31, 2014

	Consumer - Non Real Estate		Equity Line of Credit / Second Mortgages		Commercial - Non Real Estate		Agricultural - Non Real Estate
Performing	$	19,951	$	14,981	$	32,035	$	3,065
Nonperforming (>90 days past due)		234		362		228		-
Total	$	20,185	$	15,343	$	32,263	$	3,065

Credit Risk Profile based on payment activity as of  December 31, 2013

	Consumer - Non Real Estate		Equity Line of Credit / Second Mortgages		Commercial - Non Real Estate		Agricultural - Non Real Estate
Performing	$	20,650	$	15,444	$	31,309	$	3,376
Nonperforming (>90 days past due)		146		374		266		-
Total	$	20,796	$	15,818	$	31,575	$	3,376

13

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

The following tables reflect the Bank’s impaired loans at March 31, 2014:

March 31, 2014	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With No Related Allowance
Real Estate Secured
Residential 1-4 family	$	5,587	$	5,587	$	-	$	5,815	$	32
Equity lines of credit		349		349		-		357		1
Multifamily		-		-		-		-		-
Farmland		466		466		-		475		4
Construction, Land Development, Other Land Loans		1,551		1,551		-		1,623		-
Commercial Real Estate- Owner Occupied		7,036		7,036		-		6,215		63
Commercial Real Estate- Non Owner Occupied		6,571		6,571		-		6,513		93
Second Mortgages		61		61		-		61		1
Non Real Estate Secured
Personal /Consumer		-		-		-		27		-
Commercial		319		319		-		208		4
Agricultural		-		-		-		-		-
Total	$	21,940	$	21,940	$	-	$	21,294	$	198

March 31, 2014	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With an Allowance Recorded
Real Estate Secured
Residential 1-4 family	$	2,725	$	2,725	$	379	$	2,876	$	35
Equity lines of credit		-		-		-		19		-
Multifamily		-		-		-		-		-
Farmland		200		200		25		200		3
Construction, Land Development, Other Land Loans		-		-		-		-		-
Commercial Real Estate- Owner Occupied		2,904		2,904		588		3,216		17
Commercial Real Estate- Non Owner Occupied		4,431		4,581		1,074		4,506		12
Second Mortgages		-		-		-		28		-
Non Real Estate Secured
Personal /Consumer		92		92		42		113		1
Commercial		483		483		327		704		7
Agricultural		183		183		59		182		3
Total	$	11,018	$	11,168	$	2,494	$	11,844	$	78

14

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

The following tables reflect the Bank’s impaired loans at December 31, 2013:

December 31, 2013	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no Related Allowance
Real Estate Secured
Residential 1-4 family	$	6,042	$	6,042	$	-	$	6,300	$	198
Equity lines of credit		364		364		-		182		6
Multifamily		-		-		-		-		-
Farmland		483		483		-		391		11
Construction, Land Development, Other Land Loans		1,694		1,694		-		1,677		1
Commercial Real Estate- Owner Occupied		5,393		5,393		-		5,201		173
Commercial Real Estate- Non Owner Occupied		6,454		6,454		-		4,943		250
Second Mortgages		62		62		-		191		3
Non Real Estate Secured
Personal		53		53		-		31		3
Commercial		96		96		-		82		5
Agricultural		-		-		-		10		-
Total	$	20,641	$	20,641	$	-	$	19,008	$	650

December 31, 2013	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With an Allowance Recorded
Real Estate Secured
Residential 1-4 family	$	3,026	$	3,026	$	394	$	3,756	$	145
Equity lines of credit		38		38		38		19		1
Multifamily		-		-		-		202		-
Farmland		200		200		25		201		8
Construction, Land Development, Other Land Loans		-		-		-		-		-
Commercial Real Estate- Owner Occupied		3,528		3,528		630		3,113		72
Commercial Real Estate- Non Owner Occupied		4,581		4,581		1,230		3,788		93
Second Mortgages		56		56		45		28		1
Non Real Estate Secured
Personal		133		133		84		77		6
Commercial		924		924		695		791		34
Agricultural		181		181		56		448		4
Total	$	12,667	$	12,667	$	3,197	$	12,423	$	364

15

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

The following tables present the balance in the allowance for loan losses and the recorded investment in loans by loan category and is segregated by impairment

evaluation method as of March 31, 2014 and March 31, 2013.

Three  months ended March 31, 2014	Residential 1-4 Family		Multifamily		Construction and Land Loans			Commercial Owner Occupied			Commercial Non-Owner Occupied		Second Mortgages			Equity Line of Credit			Farmland			Personal and Overdrafts		Commercial and Agricultural			Unallocated		Total
Allowance for Credit Losses:
Beginning Balance December 31,  2013	$	975	$	143	$	230		$	1,029		$	1,415	$	153		$	50		$	65		$	483	$	1,264		$	1,018	$	6,825
Provision for Credit Losses		148		5		(14	)		(23	)		73		(7	)		(39	)		(5	)		243		(163	)		47		265
Charge-offs		68		-		-			-			159		25			-			-			78		114			-		444
Recoveries		-		-		2			-			-		1			-			-			23		7			-		33
Net Charge-offs		68		-		(2	)		-			159		24			-			-			55		107			-		411
Ending Balance  March 31, 2014		1,055		148		218			1,006			1,329		122			11			60			671		994			1,065		6,679
Ending Balance: Individually evaluated for impairment		379		-		-			588			1,074		-			-			25			42		386			-		2,494
Ending Balance:  Collectively Evaluated for Impairment		676		148		218			418			255		122			11			35			629		608			1,065		4,185
Loans:
Ending Balance: Individually Evaluated for Impairment		8,312		-		1,551			9,940			11,002		61			349			666			92		985			-		32,958
Ending Balance: Collectively Evaluated for Impairment		173,084		20,178		16,697			61,817			24,329		7,746			7,187			8,256			20,093		34,343			-		373,730
Ending Balance: March 31, 2014	$	181,396	$	20,178	$	18,248		$	71,757		$	35,331	$	7,807		$	7,536		$	8,922		$	20,185	$	35,328			-	$	406,688

16

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Three  months ended March 31, 2013	Residential 1-4 Family			Multifamily		Construction and Land Loans			Commercial Owner Occupied			Commercial Non-Owner Occupied		Second Mortgages		Equity Line of Credit		Farmland		Personal and Overdrafts		Commercial and Agricultural		Unallocated			Total
Allowance for Credit Losses:
Beginning Balance December 31,  2012	$	1,242		$	280	$	823		$	1,039		$	1,075	$	161	$	30	$	97	$	486	$	1,530	$	686			7,449
Provision for Credit Losses		(212	)		-		(130	)		(45	)		279		34		1		12		134		261		(115	)		219
Charge-offs		33			-		31			-			-		11		-		-		88		101		-			264
Recoveries		4			-		1			-			-		-		-		-		19		7		-			31
Net Charge-offs		29			-		30			-			-		11		-		-		69		94		-			233
Ending Balance  March 31, 2013		1,001			280		663			994			1,354		184		31		109		551		1,697		571			7,435
Ending Balance: Individually evaluated for impairment		268			-		64			323			814		33		-		-		66		959		-			2,527
Ending Balance:  Collectively Evaluated for Impairment		733			280		599			671			540		151		31		109		485		738		571			4,908
Loans:
Ending Balance: Individually Evaluated for Impairment		9,470			-		1,838			8,392			11,342		660		-		295		93		1,766		-			33,856
Ending Balance: Collectively Evaluated for Impairment		158,768			18,030		17,641			57,829			25,534		8,151		8,576		12,227		21,716		33,411		-			361,883
Ending Balance: March 31, 2013	$	168,238		$	18,030	$	19,479		$	66,221		$	36,876	$	8,811	$	8,576	$	12,522	$	21,809	$	35,177		-		$	395,739

17

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

A loan is considered impaired and an allowance for loan losses is established on loans for which it is probable that the full collection of principal and interest is in doubt. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value based on recent appraisal and /or tax assessment value, liquidation value and/or discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At March  31, 2014 and December 31, 2013, all of the total impaired loans were evaluated based on the fair value of the collateral. On a quarterly basis, the ALLL methodology begins with the determination of individually impaired loans. All loans that are rated “7” (Doubtful) are assessed as impaired based on the expectation that the full collection of principal and interest is in doubt. All loans that are rated “6” (Substandard) or are expected to be downgraded to “6”, require additional analysis to determine whether they may be impaired. All loans that are rated “5” (Special Mention) are presumed not to be impaired. However, “5” rated loans with the following characteristics warrant further analysis before completing an assessment of impairment:

•   A loan is 60 days or more delinquent on scheduled principal or interest;

•   A loan is presently in an unapproved over advanced position;

•   A loan is newly modified; or

•   A loan is expected to be modified.

The Company’s credit administration personnel and senior financial officers are responsible for tracking, coding, and monitoring loans that become Troubled Debt Restructurings  (“TDRs”). Concessions are made to existing borrowers in the form of modified interest rates and / or payment terms. The loans are segregated for regulatory and external reporting. Each specific TDR is reviewed to determine if the accrual of interest should be discontinued and also reviewed for impairment. The Company’s senior credit administration officer performs this analysis on a quarterly basis in addition to determining any other loans that are impaired within the loan portfolio. The Company had a total of $11,830 and $17,810 of loans categorized as troubled debt restructurings as of March 31, 2014 and December 31, 2013, respectively. Interest is accrued on TDRs if the loan is otherwise not impaired and the full collection of principal and interest under the modified terms is still deemed probable.

In the determination of the allowance for loan losses, management considers troubled debt restructurings and subsequent defaults in these restructurings by adjusting the loan grades of such loans. Defaults resulting in charge-offs affect the historical loss experience ratios which are a component of the allowance calculation. Additionally, specific reserves may be established on restructured loans evaluated individually.

The following tables summarize the troubled debt restructurings during the three months ended March 31, 2014 and 2013.

18

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Troubled Debt Restructurings –Three months ended March 31, 2014 Interest only	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post - Modification Recorded Investment
Real Estate Secured
Residential 1-4 family
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied		1		1,395		1,395
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Commercial
Agricultural
Total		1		1,395		1,395

Troubled Debt Restructurings Below Market Rate	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post - Modification Recorded Investment
Real Estate Secured
Residential 1-4 family		1		879		879
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied		1		707		707
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Commercial
Agricultural
Total		2		1,586		1,586

19

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Troubled Debt Restructurings Loan term extension	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post - Modification Recorded Investment
Real Estate Secured
Residential 1-4 family
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Business Commercial
Agricultural		1		129		129
Total		1		129		129
Troubled Debt Restructurings All	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post - Modification Recorded Investment
Total Restructurings		4		3,110		3.110

Troubled Debt Restructurings That subsequently defaulted	Number of Contracts	Pre- Modification  Outstanding Recorded Investment	Post - Modification Recorded Investment
Real Estate Secured
Residential 1-4 family
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Commercial
Agricultural
Total	-	-	-

20

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Troubled Debt Restructurings Below Market Rate	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post - Modification Recorded Investment
Real Estate Secured		1		875		874
Residential 1-4 family
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied		2		6,507		6,504
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Commercial
Agricultural
Total		3		7,382		7,378

Troubled Debt Restructurings – Three months ended March 31, 2013 Interest only	Number of Contracts	Pre- Modification  Outstanding Recorded Investment	Post - Modification Recorded Investment
Real Estate Secured
Residential 1-4 family
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Commercial
Agricultural
Total

21

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Troubled Debt Restructurings Loan term extension	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post - Modification Recorded Investment
Real Estate Secured
Residential 1-4 family		2		308		308
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Commercial		1		71		71
Agricultural		1		129		129
Total		4		508		508
Troubled Debt Restructurings All	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post - Modification Recorded Investment
Total Restructurings		7		7,890		7,886

Troubled Debt Restructurings That subsequently defaulted	Number of Contracts	Pre- Modification  Outstanding Recorded Investment	Post - Modification Recorded Investment
Real Estate Secured
Residential 1-4 family
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Commercial
Agricultural
Total	-	-	-

22

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

The loan review function performs various tasks that are utilized to discover weaknesses within the loan portfolio.  These include annual reviews on loan relationships that are greater than $500,000.  The relationship review includes a discussion on the collateral, repayment history, guarantor(s) financial position, and debt service coverage on an individual and global level.  These reviews are based primarily upon federal tax returns for cash flow determination, internally prepared interim statements and personal financial statements.  Debt service coverage (DSC) is calculated on each individual customer, or guarantor, as well as the aggregate or global DSC.  The DSC is discounted to determine a “stressed” DSC.  Collateral evaluation includes an inspection of the collateral file to determine if the Bank is indeed properly securitized.  Collateral is discounted, when appropriate, to determine a “stressed” loan to value ratio.   In addition to annual loan relationship reviews, quarterly reviews on all loan relationships over $100,000 that are graded Substandard, Doubtful and Loss are also completed.  This quarterly review process is comprised of a shortened version of the full relationship review.  These quarterly reviews include a discussion on personal credit management, DSC and LTV.  In addition to these quarterly reviews of  non-pass watch list relationships, a semi-annual review is conducted on all Special Mention loan relationships that are on the watch list.  These reviews are prepared in the same manner as the quarterly non-pass relationship reviews.  The appropriateness of the risk rating of each relationship is assessed, with changes to the risk rating being made by the Senior Credit Review Officer, when deemed appropriate. Other measures taken to determine potential problem relationships include the monthly preparation of the watch list.  During that process, past due loan reports are reviewed, as well as any other information that might be presented by loan officers, regarding a particular loan relationship that is exhibiting stress.  To be considered as a watch list relationship, distinct characteristics must be exhibited.  These include, but are not limited to late payments greater than 60 days, a low DSC calculation, bankruptcy filings, casualty losses, or other issues that would cause a perceived increase in the risk of loss to the Bank. The final segment of the loan review process involves special reviews.  These reviews target specific segments of the loan portfolio, i.e. credit cards, equity lines, consumer loans, construction loans, and other specific segments of the loan portfolio that management wishes to have reviewed.  However, currently, the primary emphasis of the loan review function is loan relationship review work, and watch list management.

The segments of the Company’s loan portfolio are disaggregated to a level that allows management to monitor risk and performance. In reviewing risk, management has determined there to be several different risk categories within the loan portfolio. The allowance for loan losses consists of amounts applicable to: (i) the commercial loan portfolio; (ii) the commercial real estate loan portfolio; (iii) the construction loan portfolio; (iv) the consumer loan portfolio; and, (v) the residential loan portfolio. The commercial real estate (“CRE”) loan segment is further disaggregated into two classes. Non-owner occupied CRE loans, which include loans secured by non-owner occupied nonfarm nonresidential properties, generally have a greater risk profile than all other CRE loans, which include multifamily structures and owner-occupied commercial structures. The construction loan segment is further disaggregated into two classes. One-to-four family residential construction loans are generally made to individuals for the acquisition of and/or construction on a lot or lots on which a residential dwelling is to be built. Commercial construction loans are generally made to developers or investors for the purpose of acquiring, developing and constructing residential or commercial structures. Construction lending is generally considered to involve a higher degree of credit risk than long-term permanent financing.

The following describes the Company’s basic methodology for computing its ALLL.

On a quarterly basis, the ALLL methodology begins with the identification of loans subject to ASC 310.  All loans that are rated “7” (Doubtful) are assessed as impaired based on the expectation that the full collection of principal and interest is in doubt. All loans that are rated “6” (Substandard) or are expected to be downgraded to “6”, require additional analysis to determine whether they may be impaired under ASC 310. All loans that are rated “5” (Special Mention) are presumed not to be impaired. However, “5” rated loans, together with any Troubled Debt Restructured (TDR) loan, may warrant further analysis before completing an assessment of impairment.

For ASC 310 loans that are individually evaluated and found to be impaired (primarily those designated as Substandard and Doubtful), the associated ALLL will be based upon one of the three impairment measurement methods specified within ASC 310:

(1)   Present value of expected future cash flows discounted at the loan’s effective interest rate;

(2)   Loan’s observable market price; or

(3)   Fair value of the collateral.

23

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

To determine the amount of loan loss exposure for the impaired ASC 310 loans, the value of collateral for secured loans is evaluated to determine the current value and potential exposure.  The collateral value is adjusted for its age and condition, and, for real estate, adjusted for condition, location, and age of the most current appraisal.  If the adjusted value of the collateral is less than the current principal balance, the difference is designated as direct exposure for loan loss calculations.  The total balance of unsecured loans is considered as direct exposure.

ASC 450 Loan Loss:

For all other loans, including individual loans determined not to be impaired under ASC 310, the associated ALLL is calculated in accordance with ASC 450 that provides for estimated credit losses likely to be realized on groups of loans with similar risk characteristics. The Company uses standard call report categories to segregate loans into groups with similar risk characteristics. Estimated credit losses reflect significant factors that affect the collectability of the portfolio as of the evaluation date. Key factors that influence risk within the Company’s loan portfolio are divided into three major categories:

(1) Historical Loss Factor: To calculate the anticipated loan loss in each call report category for ASC 450 loans, the Company begins with the net loss in each category for each of the last twelve quarters. The Company uses a rolling twelve quarter weighted historical loss average where the most recent quarters are weighted heavier than the earlier quarters so that the calculation reflects current risk trends within the portfolio.  The weighting used by the Company is similar to the Rule of 78’s with the net losses of the most recent quarter weighted at 12/78ths and those in the first quarter in the twelve quarter period weighted at 1/78th.   Therefore, the net losses of the most recent year represent approximately 54% of the calculation compared with 33% if a simple average of losses over the three-year period was used.  The total of weighted factors for each call report category is applied to the current outstanding loan balance in each category to calculate expected loss based on historical data for a group of loans with similar risk characteristics.  The same weighting is applied to all loan types.

(2)External economic factors:  Economic conditions have a significant impact on Company’s loan portfolio because deteriorating conditions can adversely impact both collateral values and the customer’s ability to service debt.  Management has selected the following external factors as indicators of economic conditions:

a.   National GDP Growth Rate

b.   Local Unemployment Rates

c.   The Prime Rate

The values for external factors are updated on a quarterly basis based on current economic data.

(3)Internal process factors:  Internal factors that influence loss rates as a result of risk management and control practices include the following:

d.   Past-Due Loans

e.   Non-Accrual Loans

f.   CRE Concentrations

g.   Loan Volume Level

h.   Level and Trend of Classified Loans

  The values for internal factors are updated on a quarterly basis based on current portfolio metrics.

Once the quarterly ALLL is computed, the calculations are reviewed by the Company’s credit administration committee which is comprised of the CEO, CFO, and Senior Lending Officers, including Credit Review personnel.  The Company’s controller also performs a detailed review of the computations, estimates, etc. included in the ALLL calculation. The ALLL is then reviewed and approved by the Board of Directors.

24

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Note 3  -  Income Taxes

Income tax expense (benefit) for the three months ended March 31 is different than the amount computed by applying the statutory corporate federal income tax rate of 34% to income before taxes.  The reasons for these differences are as follows:

	2014			2013
Tax expense at statutory rate	$	218		$	198
Reduction in taxes from:
Tax-exempt interest		(42	)		(48	)
Other, net		(37	)		(34	)
Income tax expense	$	139		$	116

Note 4  - Capital Requirements

Regulators of the Company and its subsidiary, Highlands Union Bank (the “Bank”), have implemented risk-based capital guidelines which require compliance with certain minimum capital ratios as a percent of assets and other certain off-balance sheet items that are adjusted for predefined credit risk factors.  The regulatory minimum for Tier 1 and combined Tier 1 and Tier 2 capital ratios are 4.0% and 8.0%, respectively.  Tier 1 capital includes tangible equity reduced by goodwill and certain other intangibles.  Tier 2 capital includes portions of the allowance for loan losses, not to exceed Tier 1 capital. In addition to the risk-based guidelines, a minimum leverage ratio (Tier 1 capital as a percentage of average total consolidated assets) of 4.0% is required. The following table presents the capital ratios for the Company and the Bank.

March 31, 2014
Entity	Tier 1			Total Risk Based			Leverage
Highlands Bankshares, Inc.		8.79	%		10.05	%		5.28	%
Highlands Union Bank		10.05	%		11.31	%		6.06	%

December 31, 2013
Entity	Tier 1			Total Risk Based			Leverage
Highlands Bankshares, Inc.		8.55	%		9.81	%		5.22	%
Highlands Union Bank		9.77	%		11.03	%		5.98	%

25

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Note 5 - Capital Securities

The Company completed a $7.5 million capital issue of 9.25% Preferred Securities (the “Trust Preferred Securities”) on January 23, 1998.  These Trust Preferred Securities were issued by Highlands Capital Trust I, a wholly owned subsidiary of the Company.

Subject to certain exceptions and limitations, the Company may elect from time to time to defer interest payments on the debt securities, which would result in a deferral of distribution payments on the related Trust Preferred Securities. Effective April 15, 2010, the Company began deferring interest payments on the debt securities held by Highlands Capital Trust I.  As a result, distribution payments to holders of the Trust Preferred Securities are also being deferred. The deferral period can last up to 5 years, or until April 2015.

Note 6 – Per Share Amounts

The following table contains information regarding the Company’s computation of basic earnings per share and diluted earnings per share for the three months ended March 31, 2014 and March 31, 2013.

	Basic EPS		Weighted Average Number of Shares		Diluted EPS		Weighted Average Number of Shares
Quarter Ended:
March 31, 2014	$	0.10		5,011,152	$	0.10		5,011,152
March 31, 2013	$	0.09		5,011,152	$	0.09		5,011,152

Note 7 – Commitments and Contingencies

The Bank is a party to various financial instruments with off-balance sheet risk arising in the normal course of business to meet the financing needs of its customers. Those financial instruments include commitments to extend credit and standby letters of credit. At March 31, 2014, these commitments included: standby letters of credit of $342; equity lines of credit of $8,080; credit card lines of credit of $6,280; commercial real estate, construction and land development commitments of $2,530; and other unused commitments to fund interest earning assets of $27,020.

26

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Note  8 – Fair Value

The Company utilizes fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. Securities available-for-sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Fair Value Hierarchy

Under ASC Topic 820 on Fair Value Measurements and Disclosures, the Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

Level 1	Valuation is based upon quoted prices for identical instruments traded in active markets.
Level 2	Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
Level 3	Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon third party models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality, the Company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

27

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Recurring - Investment Securities Available for Sale

Securities classified as available for sale are reported at fair value utilizing Level 2. For Level 2 securities, the Company obtains fair value measurements from multiple independent third party sources. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, and the bond’s terms and conditions, among other things.

The following tables summarize the Company’s available for sale securities portfolio measured at fair value on a recurring basis as of March 31, 2014 and December 31, 2013, segregated by the level of the valuation inputs within the fair value hierarchy.

March 31, 2014
	Level 1		Level 2		Level 3		Total Fair Value
Available for Sale Securities
State and Political Subdivisions	$	-	$	9,772	$	-	$	9,772
Mortgage Backed Securities	$	-	$	29,676	$	-	$	29,676
Single Issue Trust Preferred	$	-	$	887	$	-	$	887
SBA Pools	$	-	$	13,418	$	-	$	13,418
SLMA	$	-	$	500	$	-	$	500
Total AFS Securities	$	-	$	54,253	$	-	$	54,253

December 31, 2013
	Level 1		Level 2		Level 3		Total Fair Value
Available for Sale Securities
State and Political Subdivisions	$	-	$	9,537	$	-	$	9,537
Mortgage Backed Securities	$	-	$	30,740	$	-	$	30,740
Single Issue Trust Preferred	$	-	$	883	$	-	$	883
SBA Pools	$	-	$	13,659	$	-	$	13,659
SLMA	$	-	$	499	$	-	$	499
Total AFS Securities	$	-	$	55,318	$	-	$	55,318

28

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Non Recurring - Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value, recent appraisal value and /or tax assessed value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At March 31, 2014 and December 31, 2013, all of the total impaired loans were evaluated based on the fair value of the collateral.  The Company frequently obtains appraisals prepared by external professional appraisers and applies discounts ranging from 8% to 40% depending on type of property, condition, location, etc. The Company also in certain instances, prepares internally generated valuations from on-site inspections, third-party valuation models or other information.

Non Recurring -Foreclosed Assets / Repossessions

Foreclosed assets and repossessions are adjusted to fair value upon transfer of the loans to foreclosed assets and repossessions. Subsequently, foreclosed assets and repossessions are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices or recent appraised values of the collateral which the Company considers as nonrecurring Level 2.  When the current appraised value is not available and /or further discounted below the most recent appraised value less selling costs due to such things as absorption rates and market conditions, the Company records the foreclosed assets within Level 3 of the fair value hierarchy.

The following table summarizes the Company’s assets at fair value on a non - recurring basis as of March 31, 2014 and December 31, 2013 segregated by the level of the valuation inputs within the fair value hierarchy. The tables disclose the recorded investment of impaired loans requiring a specific allowance.

March 31, 2014	Level 1		Level 2		Level 3		Total Fair Value
Impaired Loans	$	-	$	-	$	11,018	$	11,018
Repossessions/OREO, net	$	-	$	-	$	7,764	$	7,764

December 31, 2013	Level 1		Level 2		Level 3		Total Fair Value
Impaired Loans	$	-	$	-	$	12,667	$	12,667
Repossessions/OREO, net	$	-	$	1,218	$	6,618	$	7,836

29

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis for which the Company uses Level 3 inputs to determine fair value (dollars in thousands):

			Quantitative Information about Level 3 Fair Value Measurements
	March 31,		December 31,		Valuation	Unobservable	Range
	2014		2013		Techniques	Input (2)	(Weighted Average)
OREO	$	7,764	$	6,618	Appraisal of collateral (1)	Appraisal adjustments	0% to 45% (13%)
						Liquidation expenses	0% to 10% (9%)
Impaired loans	$	11,018	$	12,667	Fair value of collateral –real estate  (1), (3)	Appraisal adjustments	0% to 10% (9%)
					Fair value of collateral –equipment, inventory, other  (1), (3)	Appraisal adjustments	25% to 50% (33%)
						Liquidation expenses	0% to 10% -9%)

Valuation adjustments and liquidation cost adjustments represent unobservable inputs for OREO and impaired loans.  The ranges of discounts applied are based on age of independent appraisals, type and condition of collateral, current market conditions, and experience with the local market.

(1)  Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various level 3 inputs which are not identifiable.

(2)  Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses.  The range and weighted average of liquidation expenses and other appraisal adjustments are presented as a percent of the appraisal.

(3)  Includes qualitative adjustments by management.

30

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

General

The Company has no liabilities carried at fair value or measured at fair value on a recurring or non-recurring basis.

Fair Value of Financial Instruments

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based 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.  Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

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 values are determined in the manner as described above.

Other Investments

Other investments include Federal Home Loan Bank stock, Federal Reserve Bank stock, Community Bankers Bank stock, and Pacific Coast Bankers Bank.  The carrying value of those securities approximates fair value based on the redemption provisions of those Banks. Also included in other investments are certificates of deposit purchased from other FDIC insured banks in which the carrying amount approximates fair value.

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.For fixed rate loans and for variable rate loans with infrequent re-pricing or re-pricing limits, fair value is based on discounted cash flows using current market rates applied to the cash flow analysis.

Deposits

The fair value of time deposits is based on discounted cash flows using current market rates applied to the cash flow analysis for each time deposit. Other non-maturity deposits are reported at their carrying values.

Other Short-Term Borrowings

Fair values of other short-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.

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Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Long-term Debt and Capital Securities

Rates currently available to the Company for debt with similar terms and remaining maturities or established call prices 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 March 31, 2014 and December 31, 2013 were as follows:

	March 31, 2014						December 31, 2013
	Carrying Amount			Fair Value			Carrying Amount			Fair Value
Cash and cash equivalents	$	89,908		$	89,908		$	83,995		$	83,995
Securities available for sale		54,253			54,253			55,318			55,318
Other investments		4,538			4,538			4,710			4,710
Loans, net		399,386			395,838			396,961			390,401
Deposits		(494,188	)		(472,924	)		(488,274	)		(466,120	)
Other short-term borrowings		(23,473	)		(25,365	)		(23,500	)		(25,538	)
Long-term debt		(47,789	)		(50,925	)		(47,802	)		(50,892	)
Capital Securities		(3,150	)		(3,175	)		(3,150	)		(3,175	)

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Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Note  9. -Investment Securities Available For Sale

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

	March 31, 2014
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
State and political subdivisions	$	9,788		96		112	$	9,772
Mortgage backed securities		29,785		199		307		29,676
Single Issue Trust Preferred		907		-		20		887
SBA Pools		14,016		23		622		13,418
SLMA		500		-		-		500
	$	54,996	$	318	$	1,061	$	54,253

	December 31, 2013
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
State and political subdivisions	$	9,795		51		309	$	9,537
Mortgage backed securities		30,984		190		434		30,740
Single Issue Trust Preferred		907		-		24		883
SBA Pools		14,396		30		767		13,659
SLMA		500		-		1		499
	$	56,582	$	271	$	1,535	$	55,318

Investment securities available for sale with a carrying value of $43,266 and $40,077 at March 31, 2014 and December 31, 2013, respectively, and a market value of $42,683 and $39,889 at March 31, 2014 and December 31, 2013, respectively, were pledged as collateral on public deposits, FHLB advances and for other purposes as required or permitted by law.

33

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

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

	March 31, 2014
	Less Than 12 months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
States and political subdivisions	$	1,110	$	8	$	909	$	104	$	2,019	$	112
Mortgage-backed securities		12,903		177		3,912		130		16,815		307
Single Issue Trust Preferred		-		-		887		20		887		20
SBA Pools		4,578		248		7,457		374		12,035		622
SLMA		-		-		-		-		-		-
Total	$	18,591	$	433	$	13,165	$	628	$	31,756	$	1,061

	December 31, 2013
	Less Than 12 months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
State and political subdivisions	$	4,812	$	144	$	849	$	165	$	5,661	$	309
Mortgage-backed securities		16,586		308		1,733		126		18,319		434
Single Issue Trust Preferred		-		-		883		24		883		24
SBA Pools		7,273		482		4,802		285		12,075		767
SLMA		499		1		-		-		499		1
Total	$	29,170	$	935	$	8,267	$	600	$	37,437	$	1,535

34

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

The Company assesses its securities for OTTI quarterly by reviewing credit ratings, financial and regulatory reports as well as other pertinent published financial data. As of March 31, 2014 and December 31, 2013, the Company's assessment revealed no impairment other than that deemed temporary on those securities.

The amortized cost and estimated fair value of securities available for sale at March 31, 2014 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	$	500	$	500
Due after one year through five years		898		895
Due after five years through ten years		3,019		3,055
Due after ten years		20,794		20,127
		25,211		24,577
Mortgage-backed securities		29,785		29,676
	$	54,996	$	54,253

Note 10–Formal Written Agreement

On October 13, 2010, the Company and Bank entered into a written agreement (“Written Agreement”) with the Federal Reserve Bank of Richmond (the “Reserve Bank”).  Under the terms of the Written Agreement, the Bank has agreed to develop and submit to the Reserve Bank for approval within the time periods specified therein written plans or programs to:

·   strengthen board oversight of the management and operations of the Bank;

·   strengthen credit risk management and administration;

·   provide for the effective grading of the Bank’s loan portfolio;

·   summarize the findings of its review of the adequacy of the staffing of its loan review function;

·   improve the Bank’s position with respect to loans, relationships, or other assets in excess of $500,000 that currently are or in the future become past due more than 90 days, on the Bank’s problem loan list, or adversely classified in any report of examination of the Bank;

·   review and revise the Bank’s methodology for determining the allowance for loan and lease losses (“ALLL”) and maintain an adequate ALLL;

·   maintain sufficient capital at the Company and the Bank;

·   establish a revised written contingency funding plan;

·   establish a revised written strategic and capital plan;

·   establish a revised investment policy;

·   improve the Bank’s earnings and overall condition;

·   revise the Bank’s information technology program;

·   establish a disaster recovery and business continuity program; and,

·   establish a committee to monitor compliance with all aspects of the written agreement.

Further, both the Company and the Bank have agreed to refrain from declaring or paying dividends without prior regulatory approval.  The Company has agreed that it will not take any other form of payment representing a reduction in Bank’s capital or make any distributions of interest, principal or other

35

sums on subordinated debentures or trust preferred securities without prior regulatory approval.  The Company also has agreed not to incur, increase or guarantee any debt or not to purchase or redeem any shares of its stock without prior regulatory approval.

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Note  11 – Summary of Significant Accounting Policy Update For Certain Required Disclosures

In July 2013, the FASB issued ASU 2013-11, Income Taxes (Topic 740) - Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss or a Tax Credit Carryforward Exists. ASU 2013-11 is intended to clarify the presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss or a tax credit carrryforward exists. This presentation had not been addressed in Topic 740 and there was diversity in reporting practices in those instances. ASU 2013-11 requires an unrecognized tax benefit to be presented as a liability and not netted against a deferred tax asset. ASU 2013-11 is effective for reporting periods beginning after December 15, 2013. Adoption by the Company is not expected to have an impact on the consolidated financial statements and related disclosures.

Accounting Standards Update (ASU) No. 2014-04, Receivables - Troubled Debt Restructurings by Creditors - Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure wasissued by the FASB on January 20, 2014.  The amendments are intended to clarify when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan should be derecognized and the real estate recognized.  These amendments clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either: (a) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure; or (b) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additional disclosures are required.  The amendments are effective for public business entities for annual periods and interim periods within those annual periods beginning after December 15, 2014.

Note 12 – Subsequent Event

On April 16, 2014, the management and board of directors of Highlands Bankshares, Inc. announced the    completion of a $16,500 private placement capital raise. Purchasers in the private placement included outside investors, as well as certain directors and executive officers of the Company. The Company sold 2,673,249 newly issued shares of the Company’s common stock at $3.50 per share, and 2,048,179 shares of Series-A convertible perpetual preferred stock at $3.50 per share. The Company expects to follow this private placement with a rights offering to shareholders of record as of April 15, 2014, other than directors and executive officers. The rights offering will allow shareholders as of the record date to purchase up to an aggregate $3,750 of common stock at the same price of $3.50 per share. The private placement was disclosed on Form 8-K on April 16, 2014. The Company immediately paid off its Holding Company Loan in the amount of $3.44 million to Community Bankers Bank on April 16, 2014 with the funds received from the capital raise.

36

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis is provided to address information about the Company’s financial condition and results of operations that is not otherwise apparent from the Consolidated Financial Statements and the notes thereto or included in this report.  Reference should be made to those statements and the notes thereto for an understanding of the following discussion and analysis.

The Company generates a significant amount of its income from the net interest income earned by the Bank. Net interest income is the difference between interest income and interest expense. Interest income depends on the amount of interest-earning assets outstanding during the period and the interest rates earned thereon. The Company’s cost of money is a function of the average amount of deposits and borrowed money outstanding during the period and the interest rates paid thereon. The quality of the assets further influences the amount of interest income lost on non-accrual loans and the amount of additions to the allowance for loan losses. Highlands Union Insurance Services and Highlands Union Financial Services, which are subsidiaries of Highlands Union Bank, generate fee income by providing insurance and financial service products to its clients.

Critical Accounting Policy

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.  For a discussion of the Company’s critical accounting policies related to its allowance for loan losses and other than temporary impairment, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

Regulatory Economic Environment

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law.  The Dodd-Frank Act contains significant modifications to the current bank regulatory structure and requires various federal agencies to adopt a broad range of new rules and regulations.  While not fully determinable at this time, the impact of the Dodd-Frank Act and the rules and regulations that have been or will be promulgated thereunder could significantly affect our operations, increase our operating costs and divert management resources and attention from the primary business of the Bank.

Formal Written Agreement

As discussed in Footnote 10, on October 13, 2010, the Company and Bank entered into a written agreement (“Written Agreement”) with the Federal Reserve Bank of Richmond (the “Reserve Bank”).  Under the terms of the Written Agreement, the Bank has agreed to develop and submit to the Reserve Bank for approval within the time periods specified therein written plans or programs to:

·   strengthen board oversight of the management and operations of the Bank;

·   strengthen credit risk management and administration;

·   provide for the effective grading of the Bank’s loan portfolio;

·   summarize the findings of its review of the adequacy of the staffing of its loan review function;

·   improve the Bank’s position with respect to loans, relationships, or other assets in excess of $500,000 that currently are or in the future become past due more than 90 days, on the Bank’s problem loan list, or adversely classified in any report of examination of the Bank;

·   review and revise the Bank’s methodology for determining the allowance for loan and lease losses (“ALLL”) and maintain an adequate ALLL;

·   maintain sufficient capital at the Company and the Bank;

·   establish a revised written contingency funding plan;

·   establish a revised written strategic and capital plan;

37

·   establish a revised investment policy;

·   improve the Bank’s earnings and overall condition;

·   revise the Bank’s information technology program;

·   establish a disaster recovery and business continuity program; and,

·   establish a committee to monitor compliance with all aspects of the written agreement.

Further, both the Company and the Bank have agreed to refrain from declaring or paying dividends without prior regulatory approval.  The Company has agreed that it will not take any other form of payment representing a reduction in the Bank’s capital or make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities without prior regulatory approval.  The Company also has agreed not to incur, increase or guarantee any debt or not to purchase or redeem any shares of its stock without prior regulatory approval.

The following summarizes the Company’s progress to comply with the items in the Written Agreement as of March 31, 2014.

·   A new board oversight policy has been approved and implemented;

·   Completed revising the Bank’s loan grading system and ALLL methodology;

·   Implemented Problem Loan Action reports and Problem Asset reports for all assets over $500,000. These are reviewed with the Board and forwarded to the Federal Reserve Bank on a quarterly basis;

·   Completed revising the written contingency funding plan;

·   Implemented stress testing of the loan portfolio;

·   Completed revising the investment policy;

·   Completed a three year capital plan targeted to improve the Company’s and Bank’s capital levels to include strategically reducing the risk weighted assets of the Company and improvement in earnings;

·   Completed a Business Continuity Plan and Disaster Recovery Plan; and,

·   Formed a Directors’ compliance committee to monitor the progress of each item in the written agreement. The committee meets at least quarterly and files a report with the Federal Reserve Bank.

Results of Operations

Results of operations for the three-month periods ended March 31, 2014 and March 31, 2013 reflected net income of $501 thousand and $464 thousand, respectively. For the first three months of 2014, provisions for loan loss reserves increased $46 thousand over the corresponding period in 2013.

Net interest income for the three-month period ended March 31, 2014 increased $99 thousand or 2.29% compared to the three months ended March 31, 2013, due to the Company’s interest bearing assets growing more than its interest bearing liabilities. Average interest-earning assets increased $14.64 million from the three-month period ended March 31, 2013 to the current three-month period, while average interest-bearing liabilities decreased $4.47 million over the same period. The tax-equivalent yield on average interest-earning assets was 4.39% for the three-month period ended March 31, 2014 representing a decrease of 13 basis points from the same period in 2013.  The average balance of federal funds sold during the quarter was $69.20 million as a result of an increase in deposits during the quarter and a reduction in the securities portfolio. The average rate on federal funds sold was .22% during the quarter. The rate on average interest-bearing liabilities decreased 7 basis points to 1.24% for the three-month period ended March 31, 2014 as compared to 1.31% for the same period in 2013.

Total interest income for the three months ended March 31, 2014 was $3 thousand more than the comparable 2013 period due primarily to the increase in average interest bearing assets. Yields on typical investment securities during the current economic cycle have decreased significantly; therefore, management has intentionally maintained a significant amount of cash and federal funds sold during 2013 and 2014.

The Company’s total interest expense decreased by $96 thousand for the three months ended March 31, 2014 as compared to the same period in 2013 due primarily to a reduction in time deposits and also due to new interest-bearing deposits recorded at lower rates and existing interest-bearing deposits re-pricing lower as they mature or renew.

38

During the first three months of 2014, the Company’s non-interest income decreased by $67 thousand over the corresponding period for 2013. Service charges on deposit accounts decreased by $47 thousand over the corresponding period in 2013.

Total non-interest expense for the three-month period ended March 31, 2014 decreased $74 thousand from the comparable period in 2013. Salaries and employee benefits increased $64 thousand for the three months ended March 31, 2013 as compared to the prior year period.

For the three months ended March 31, 2014, other operating expenses that exceeded 1% of total interest income and other operating income were FDIC premiums totaling $330 thousand, charges for other contracted services totaling $151 thousand, software licensing and maintenance costs totaling $142 thousand, and postage and freight charges totaling $75 thousand.

For the three months ended March 31, 2013, other operating expenses that exceeded 1% of total interest income and other operating income were FDIC premiums totaling $330 thousand, charges for other contracted services totaling $151 thousand, software licensing and maintenance costs totaling $196 thousand, legal expenses totaling $88 thousand, bank stock taxes totaling $75 thousand, and postage and freight charges totaling $95 thousand.

Operating results of the Company when measured as a percentage of average equity reveals a decrease in return on average equity to 6.01% for the three-month period ended March 31, 2014 from 6.05% for the corresponding period in 2013. Return on average assets for the three months ended March 31, 2014 was 0.33% compared to 0.31% for the three months ended March 31, 2013.The provision for loan losses for the three-month period ended March 31, 2014 totaled $265 thousand, a $46 thousand increase as compared to the corresponding period in 2013. The Company continually monitors the loan portfolio for signs of credit weaknesses or developing collection problems. Loan loss provisions for each period are determined after evaluating the loan portfolio and determining the level necessary to absorb current charge-offs and maintain the reserve at adequate levels.  Net charge-offs for the first three months of 2014 were $411 thousand compared with $233 thousand for the first three months of 2013. Year–to–date net charge-offs were 0.10% and 0.06% of total loans for the periods ended March 31, 2014 and March 31, 2013, respectively. Loan loss reserves decreased 10.17% to $6.68 million at March 31, 2014 from March 31, 2013.  The Company’s allowance for loan loss reserves at March 31, 2013 decreased to 1.64% of total loans versus 1.88% at March 31, 2013.  At December 31, 2013, the allowance for loan loss reserve as a percentage of total loans was 1.69%.

Financial Position

Total loans, net of deferred fees, increased from $395.19 million at March 31, 2013 to $406.07 million at March 31, 2014.  Total loans, net of fees, at December 31, 2013 were $403.79 million. The loan to deposit ratio increased from 80.62% at March 31, 2013 to 82.17% at March 31, 2014. The loan to deposit ratio at December 31, 2013 was 82.70%. Deposits at March 31, 2014 have increased $3.99 million since March 31, 2013 and have increased $5.91 million since December 31, 2013. During the last 24 months, the Company has continued to lower the interest rates paid on time deposits in a continuing effort to reduce its cost of funds. Since March 31, 2013, interest bearing deposits (primarily time deposits) have decreased $4.19 million while non-interest bearing deposits have increased $8.19 million.

The Company currently has approximately $67.84 million in outstanding FHLB advances. No new advances were originated during the last 12 months. The Company secures all of its existing and future advances from the FHLB with a selected group of in-house residential and commercial real estate secured loans and a selected group of securities that are held in safekeeping by the FHLB.

Non-performing assets are comprised of loans on non-accrual status, loans contractually past due 90 days or more and still accruing interest, other real estate owned and repossessions. Non-performing assets were $19.78 million or 3.27% of total assets at March 31, 2014, compared with $18.82 million or 3.14% of total assets at

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December 31, 2013 and $28.20 million or 4.71% of total assets at March 31, 2013. The increase in NPAs during the quarter was primarily due to a net increase in non-accrual loans of approximately $1,000. The Company continues to focus its efforts on reducing its NPAs, primarily by reducing non accrual loans and selling OREO property.

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-approval analyses of large credits and also conducts credit review activities that provide management with an early warning of loan deterioration. The senior credit administration officer prepares quarterly analyses of the adequacy of the allowance for loan losses. These analyses include individual loans considered impaired for direct exposure. In addition, potential losses on loan pools and pool allocations are based upon historical losses and other factors, as adjusted, for various loan types. The calculation for allowance for loan losses is reviewed by both the Credit Administration Committee and the Board of Directors.

At March 31, 2014 and December 31, 2013, the internal credit review department as well as management determined that the Company's allowance for loan losses is sufficient and is appropriate based on the requirements of U.S. Generally Accepted Accounting Principles.

At March 31, 2014 OREO balances were $7,754 and consisted of 29 relationships. At December 31, 2013 OREO balances were $7,834 and consisted of 29 relationships. The following chart details each category type, number of relationships, and balance.

OREO Property at 3/31/14
OREO Description	Number		Balance at 3/31/14
			(in thousands)
Land Development  - Vacant Land		10	$	1,722
1-4 Family		10		2,567
Multifamily		1		424
Commercial Real Estate		8		3,041
Total		29	$	7,754

OREO Property at 12/31/2013
OREO Description	Number		Balance at 12/31/13
			(in thousands)
Land Development  - Vacant Land		12	$	1,854
1-4 Family		8		2,409
Multifamily		1		523
Commercial Real Estate		8		3,048
Total		29	$	7,834

The Company’s major markets are Southwestern Virginia, Tri-city Tennessee, Sevierville and Knoxville, Tennessee, Boone and Banner Elk, North Carolina. There has been greater deterioration in the Sevierville, Tennessee commercial real estate market compared to the other markets we serve. The following table provides information about properties owned in each geographic area, the number of individual properties and book value.

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	March 31, 2014				December 31, 2013
Geographic Area	Number		Value (in thousands)		Number		Value (in thousands)
Sevierville and Knoxville TN Area		9	$	3,247		9	$	3,412
Southwest VA and Tri-city TN Area		13		2,964		12		2,882
Boone and Banner Elk NC Area		7		1,543		8		1,540
Total		29	$	7,754		29	$	7,834

The Company formed a special assets committee to focus directly on selling OREO properties and reducing other non-performing assets. The committee is comprised of lending officers from all of the Bank’s three market areas. The ability to sell OREO which has been negatively affected by the current economic climate and the resulting reduction of non-performing assets, will to a large degree, depend on how quickly specific market areas rebound from the recession. Management has allocated significant resources to facilitate sales of OREO to reduce the Company’s non-performing assets. During 2013, the Company initiated a more aggressive approach to sell OREO, including conducting on-site auctions on several OREO properties. This aggressive approach resulted in reducing the Company’s OREO balance by 53% or $8,805 during the year. The Bank is actively marketing all of its property through its website, listing agents, and other marketing methods.

Investment securities and other investments totaled $58.79 million (market value) at March 31, 2014 which reflects a decrease of $1.24 million from the December 31, 2013 total of $60.03 million. Investment securities available for sale and other investments at March 31, 2014 were comprised of mortgage backed securities / CMOs (50.47% of the total securities portfolio), municipal issues (16.62%), corporate bonds (2.36%), and SBAs pools (22.82%).  The Company’s entire securities portfolio was classified as available for sale at both March 31, 2014 and December 31, 2013.

Other investments include the Bank’s holdings of Federal Reserve, Federal Home Loan Bank, Pacific Coast Bankers Bank, Community Bankers Bank stock. These investments (carrying value of $4.29 million and 7.29% of the total) are considered to be restricted as the Company is required to hold these investments and the only market for these investments is the issuing agency. Also included in Other Investments is a certificate of deposit purchased from another FDIC insured institution.  The balance of this CD was $250,000 at March 31, 2014 and December 31, 2013 respectively.

Liquidity and Capital Resources

Total stockholders’ equity of the Company was $33.84 million at March 31, 2014, representing an increase of $2.99 million or 9.70% from March 31, 2013. Total stockholders’ equity at December 31, 2013 was $32.99 million. The increase in stockholders’ equity from March 31, 2013 to March 31, 2014 is due to both the net earnings achieved over the last 12 months and the increase in other accumulated comprehensive income related to the Company’s available for sale securities.

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).  See Footnote 4 for a more detailed discussion of the Company’s and Bank’s regulatory capital ratios. The Board of Directors and management are committed to increasing our capital levels and we are continuing to explore options for raising additional capital.

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Liquidity is the ability to provide sufficient cash levels to meet financial commitments and to fund loan demand and deposit withdrawals. The Company and subsidiary Bank maintain a significant level of liquidity in the form of cash and cash equivalents ($89.91 million as of March 31, 2014) and unrestricted investment securities available for sale ($11.57 million).  Cash and cash equivalents are immediately available for satisfaction of deposit withdrawals, customer credit needs, and operations of the Bank.  The Bank also maintains a significant amount of available credit with both the Federal Home Loan Bank and a correspondent financial institution. The Bank also has the ability to attract certificates of deposit outside its market area by posting rates on the internet. The primary investors utilizing this network are credit unions. Unencumbered investment securities available for sale represent a secondary level of liquidity available for conversion to liquid funds in the event of extraordinary needs. Also, as discussed in Footnote 12, the Company paid off the Holding Company Loan to Community Bankers Bank totaling $3,440 subsequent to March 31, 2014 with proceeds received from the private placement capital raise. The Company believes that it maintains sufficient liquidity to meet its current and projected requirements and needs.

Caution About Forward-Looking Statements

This quarterly report 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, including certain plans, expectations, goals and projections, which are inherently subject to numerous assumptions, risks and uncertainties. The Company's actual results could differ materially from those set forth or implied 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 attract and maintain capital levels adequate to support the Company’s asset  levels;

·   Our inability to comply with the Written Agreement dated October 13, 2010;

·   Our inability to comply with servicing the Company’s Trust Preferred Securities,

·   Continued problems related to the national credit crisis and the sluggish recovery;

·   Unemployment continuing to rise;

·   Difficult market conditions in our industry;

·   Unprecedented levels of market volatility;

·   Effects of the soundness of other financial institutions;

·   Potential impact on us of recently enacted legislation;

·   Further deterioration in the housing market and collateral values;

·   The ability to successfully manage the Company’s strategic plan.

·   The ability to continue to attract low cost core deposits

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

·   The successful management of interest rate risk;

·   Further adverse 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.

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

Not Applicable

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ITEM 4. Controls and Procedures

We have carried out an evaluation, under the supervision and the participation of our management, including our Chief Executive Officer, Chief Financial Officer and 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) under the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer,  Chief Financial Officer and Vice President of 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 Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (b) such information is accumulated and communicated to our management, including our Chief Executive Officer, Chief Financial Officer and Vice President of Accounting, as appropriate to allow timely decisions regarding required disclosure.

There have not been any changes in the Company’s internal controls over financial reporting during the first quarter of 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1.  Legal Proceedings

In 2010, Edith Moser (“Moser”) filed two complaints in the Circuit Court of Washington County, VA, claiming that Highlands Union Bank (the “Bank”) improperly handled the repossession and disposition of collateral from a warehouse in June/July 2008.  Moser also claims that the Bank acted as her business advisor and breached fiduciary duties owed to her in this capacity.  One complaint seeks $700,000 in damages for conversion based solely on the repossession/disposition of collateral.  The second complaint seeks $7,850,000 in damages for breach of fiduciary duty, violation of UCC Article 9, actual fraud, unjust enrichment, and business conspiracy.  In response, the Bank filed demurrers to both complaints, both of which were granted in part and denied in part with leave granted to amend. Moser chose not to amend either complaint, opting instead to consolidate her remaining claims into one action.  Moser’s remaining claims against the Bank are for violation of UCC Article 9, fraud, unjust enrichment of personal property, and conversion of personal property.  No trial date has been set. The Bank disputes the allegations and believes that they are without merit.  The Bank intends to continue to vigorously defend itself.  Management is unable to evaluate the likelihood of an unfavorable outcome or estimate the amount or range of potential loss.

On January 27, 2014, Angela Welch, as Chapter 7 Trustee for the bankruptcy estate of Frank Michael Mongelluzzi, named the Bank as a defendant in a lawsuit filed in the U.S. District Court for the Middle District of Florida, Tampa Division.  The  complaint states three counts: the first for avoidance and recovery of fraudulent transfers pursuant to 11 U.S.C. § 544(b) and Florida Statutes §§ 726.105(1)(a) and 726.108, and/or otherwise applicable law; the second for avoidance and recovery of fraudulent transfers pursuant to 11 U.S.C. § 544(b) and Florida Statutes §§ 726.105(1)(b) and 726.108, and/or otherwise applicable law; and the third for avoidance and recovery of fraudulent transfers pursuant to 11 U.S.C. § 544(b) and Florida Statutes §§ 726.106(1) and 726.108, and/or otherwise applicable law.  Each count seeks the recovery of $1,246,103 in overdraft repayments made by the debtor to the Bank, prejudgment interest, and costs.  The matter is in the pleading stage.  The Bank has responded with a motion to dismiss and intends to vigorously defend itself.  Management is unable to evaluate the likelihood of an unfavorable outcome or estimate the amount or range of potential loss.

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Item 1A. Risk Factors

Not applicable

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3.  Defaults Upon Senior Securities

None

Item 4.  Mine Safety Disclosures

Not Applicable

Item 5.  Other Information

None

Item 6.  Exhibits

31.1	Rule 13a-14(a) Certification of Executive Vice President and Chief Executive Officer
31.2	Rule 13a-14(a) Certification of Chief Financial Officer
31.3	Rule 13a-14(a) Certification of Vice President of Accounting
32.1	Certification Statement of Executive Vice President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350.
32.2	Certification Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.
32.3	Certification Statement of Vice President of Accounting pursuant to 18 U.S.C. Section 1350
101	The following materials from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Cash Flows; (v) Consolidated Statements of Changes in Stockholders' Equity and (vi) related notes (furnished herewith).

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SIGNATURES

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

	HIGHLANDS BANKSHARES, INC.
		(Registrant)
Date:  May 14, 2014	By:	/s/ Samuel L. Neese
		Samuel L. Neese
		Executive Vice President and
		Chief Executive Officer
Date:  May 14, 2014	By:	/s/ Robert M.Little, Jr.
		Robert M.Little, Jr.
		Chief Financial Officer
Date:  May 14, 2014	By:	/s/ James R. Edmondson
		James R. Edmondson
		Vice President -Accounting

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Exhibits Index

31.1	Rule 13a-14(a) Certification of Executive Vice President and Chief Executive Officer
31.2	Rule 13a-14(a) Certification of Chief Financial Officer
31.3	Rule 13a-14(a) Certification of Vice President of Accounting
32.1	Certification Statement of Executive Vice President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350.
32.2	Certification Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.
32.3	Certification Statement of Vice President of Accounting pursuant to 18 U.S.C. Section 1350
101	The following materials from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Cash Flows; (v) Consolidated Statements of Changes in Stockholders' Equity and (vi) related notes (furnished herewith).

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