10-K 1 hbi10k02.txt FORM 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For fiscal year ended December 31, 2002 Commission file number: 0-16761 Highlands Bankshares, Inc. (Exact name of registrant as specified in its charter) West Virginia 55-0650743 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) P. O. Box 929, Petersburg, West Virginia 26847 (Address of principal executive offices) (Zip Code) Issuer's telephone number including area code: (304) 257-4111 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock - $5 Par Indicate by check mark whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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. [ X ] Indicate by check mark whether the issuer is an accelerated filer (as defined in Rule 12b-2 of the Act). [ ___ ] Indicate by check mark if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ X ] Issuer's revenues for its most recent fiscal year: $20,273,574 The aggregate market value of the 1,323,687 shares of Common Stock of the registrant issued and outstanding held by nonaffiliates on March 1, 2003 was approximately $ 33,092,175 based on the closing sales price of $ 25.00 per share on March 1, 2003. For purposes of this calculation, the term "affiliate" refers to all directors and executive officers of the registrant. State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: As of March 1, 2003 - 1,436,874 DOCUMENTS INCORPORATED BY REFERENCE: Proxy Statement of Highlands Bankshares, Inc. filed via Form DEF 14A on March 5, 2003. TRANSITIONAL SMALL BUSINESS DISCLOSURE FORMAT YES [ ] NO [ X ] 2 FORM 10-K INDEX Page Part I Item 1. Description of Business 3 Item 2. Description of Properties 4 Item 3. Legal Proceedings 5 Item 4. Submission of Matters to a Vote of Security Holders 5 Part II Item 5. Market for Common Equity and Related Stockholder Matters 5 Item 6. Selected Financial Data 6 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation 6 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 28 Item 8. Financial Statements 29 Item 9. Changes in and Disagreement with Accountants on Accounting and Financial Disclosure 58 Part III Item 10. Directors and Executive Officers of the Registrant 58 Item 11. Executive Compensation 58 Item 12. Security Ownership of Certain Beneficial Owners and Management 58 Item 13. Certain Relationships and Related Transactions 58 Item 14. Controls and Procedures 58 Part IV Item 15. Exhibits and Reports on Form 8-K 59 Signatures 61 Certification of Chief Executive Officer 62 Certification of Executive Officer(s) 63 Certification of Chief Financial Officer 65 Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C.ss.1350) 66 3 Part I Item 1. Description of Business General Highlands Bankshares, Inc. (hereinafter referred to as "Highlands," or the "Company"), incorporated under the laws of West Virginia in 1985, is a multi-bank holding company subject to the provisions of the Bank Holding Company Act of 1956, as amended, and owns 100% of the outstanding stock of its subsidiary banks, The Grant County Bank and Capon Valley Bank (hereinafter referred to as the "Banks"), its life insurance subsidiary, HBI Life Insurance Company (hereinafter referred to as "HBI Life") and its trust subsidiary, Highlands Bankshares Trust Company (hereinafter referred to as "HBTC"). The Grant County Bank was chartered on August 6, 1902, and Capon Valley Bank was chartered on July 1, 1918. Both are state banks chartered under the laws of the State of West Virginia. HBI Life was chartered in April 1988 under the laws of the State of Arizona. HBTC was chartered in December 2000 under the laws of the state of West Virginia. Services Offered by the Banks The Banks offer all services normally offered by a full service commercial bank, including commercial and individual demand and time deposit accounts, commercial and individual loans, drive-in banking services and automated teller machines. No material portion of the banks' deposits have been obtained from a single or small group of customers and the loss of the deposits of any one customer or of a small group of customers would not have a material adverse effect on the business of the banks. Credit life accident and health insurance are sold to customers of the subsidiary banks through HBI Life. Trust services are offered through HBTC. Employees As of December 31, 2002, The Grant County Bank had 60 full time equivalent employees and Capon Valley Bank had 44 full time equivalent employees. Highlands employs two persons and HBTC had one full time equivalent employee at year-end. No person is employed by HBI Life on a full time basis. Competition The banks' primary trade area is generally defined as Grant, Hardy, Mineral, Randolph, and the northern portion of Pendleton County in West Virginia, Frederick County, Virginia and portions of Western Maryland. This area includes the cities of Petersburg, Wardensville, Moorefield and Keyser and several rural towns. The banks' secondary trade area includes portions of Hampshire County in West Virginia. The banks compete with four state chartered banks and six national banks. In addition, the banks compete with money market mutual funds and investment brokerage firms for deposits in their service area. No financial institution has been chartered in the area within the last five years although branches of state and nationally chartered banks have located in this area within this time period. Competition for new loans and deposits in the banks' service area is quite intense and all banks have been forced to pay rates on deposits which exceed the national averages. Regulation and Supervision Highlands is subject to the periodic reporting requirements of the Securities Exchange Act of 1934. These include, but are not limited to, the filing of annual, quarterly and other current reports with the Securities and Exchange Commission. 4 Regulation and Supervision (Continued) Highlands, as a bank holding company, is subject to the provisions of the Bank Holding Company Act of 1956, as amended (the "Act"). It is registered as such and is supervised by the Federal Reserve Board. The Act requires Highlands to secure the prior approval of the Federal Reserve Board before Highlands acquires ownership or control of more than five percent of the voting shares, or substantially all of the assets of any institution, including another bank. As a bank holding company, Highlands is required to file with the Federal Reserve Board an annual report and such additional information as it may require pursuant to the Act. The Federal Reserve Board may also conduct examinations of Highlands and any or all of its subsidiaries. Under Section 106 of the 1970 Amendments to the Act and the regulations of the Federal Reserve Board, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with an extension of credit, provision of credit, sale, or lease of property or furnishing of services. Federal Reserve Bank regulations permit bank holding companies to engage in non-banking activities closely related to banking or to managing or controlling banks. These activities include the making or servicing of loans, trust services, performing certain data processing services, and certain leasing and insurance agency activities. HBI Life acts as reinsurer of the credit life insurance coverage sold by the Banks to bank customers. HBTC provides trust services to customers of the Banks. Approval of the Federal Reserve Board is necessary to engage in any of these activities or to acquire corporations engaging in these activities. The operations of the Banks are subject to federal and state statutes which apply to state chartered banks. Bank operations are also subject to the regulations of the Federal Deposit Insurance Corporation (the "FDIC"), which insures the banks' deposits. In addition, the Capon Valley Bank is a member of the Federal Reserve Bank System and is subject to the regulations of the Federal Reserve Bank Board. The supervisory authorities regularly examine such areas as reserves, loans, investments, management practices, and other aspects of the banks' operations. These examinations are designed primarily for the protection of depositors. In addition to these regular examinations, the banks must furnish the various regulatory authorities quarterly reports containing a full and accurate statement of its affairs. The operations of the insurance subsidiary are subject to the oversight and review of State of Arizona Department of Insurance. The operations of the trust company are subject to the oversight and review of the State of West Virginia and the Federal Reserve Bank. Item 2. Description of Properties The Grant County Bank's main office is located on Main Street in Petersburg, West Virginia. In July 2000, the Bank acquired a full service branch in Harman, West Virginia through the purchase of the Stockmans' Bank of Harman. This location primarily serves Randolph County. The Bank also has branch facilities in Moorefield, Keyser and Riverton, West Virginia which provide banking services in Hardy County, Mineral County, and northwest Pendleton County, respectively. The Riverton branch building is leased while all other locations are owned by the Bank. Capon Valley Bank has its main office in Wardensville, West Virginia and branch offices located in Moorefield and Baker, West Virginia and Gore, Virginia. The Wardensville location was substantially renovated and expanded in 2000 to enhance customer service. Capon's offices serve mainly Hardy County and Hampshire County, West Virginia, with the Gore branch servicing Frederick County, Virginia. All facilities include state-of-the-art drive in and automated teller operations. All facilities are owned by the Bank and considered adequate for current operations. 5 Item 3. Legal Proceedings Management is not aware of any material pending or threatened litigation in which Highlands or its subsidiaries may be involved as a defendant. In the normal course of business, the banks periodically must initiate suits against borrowers as a final course of action in collecting past due loans. Item 4. Submission of Matters to a Vote of Security Holders Highlands has not submitted any matters to the vote of security holders for the quarter ending December 31, 2002. Part II Item 5. Market for Common Equity and Related Stockholder Matters The Company had approximately 855 stockholders of record as of March 1, 2003. This amount includes all shareholders, whether titled individually or held by a brokerage firm or custodian in street name. The Company's stock is not traded on any national or regional stock exchange although brokers in Cumberland, Maryland or Winchester and Harrisonburg, Virginia may occasionally initiate or be a participant in a trade. Terms of an exchange between individual parties may not be known to the Company. The following outlines the dividends paid and market prices of the Company's stock based on prices disclosed to management. Prices have been provided using a nationally recognized online stock quote system. Such prices may not include retail mark-ups, mark-downs or commissions. During the third quarter of 2002, the Company declared a 200% stock dividend. Share prices for the first and second quarters of 2002 and for 2001 have been adjusted to account for this stock split effected in the form of dividend. Dividends Market Price Range 2002 Per Share High Low ---- --------- ---- --- First Quarter .1233 18.46 15.92 Second Quarter .1233 18.67 16.75 Third Quarter .1300 18.50 17.03 Fourth Quarter .1300 21.51 18.50 Dividends Market Price Range 2001 Per Share High Low ---- --------- ---- --- First Quarter .1133 17.00 15.67 Second Quarter .1133 16.67 15.71 Third Quarter .1133 16.75 15.92 Fourth Quarter .1133 16.67 15.53 6 Item 6. Selected Financial Data - - - - - Years Ending December 31, - - - - - (In Thousands Except for Share Amounts) 2002 2001 2000 1999 1998 Total Interest Income $18,970 $20,207 $18,207 $16,243 $15,772 Total Interest Expense 7,705 10,049 8,790 7,663 7,745 ------ ------ ------ ------ ------ Net Interest Income 11,265 10,158 9,417 8,580 8,027 Provision for Loan Losses 820 600 500 320 355 ------ ------ ------ ------ ------ Net Interest Income after Provision for Loan Losses 10,445 9,558 8,917 8,260 7,672 Other Income 1,304 1,194 1,263 1,026 735 Other Expenses 7,885 7,210 6,631 5,912 5,377 ------ ------ ------ ------ ------ Income before Income Taxes 3,864 3,542 3,549 3,374 3,030 Income Tax Expense 1,240 1,061 1,168 1,049 1,018 ------ ------ ------ ------ ------ Net Income $ 2,624 $ 2,481 $ 2,381 $ 2,325 $ 2,012 ====== ====== ====== ====== ====== Net Income Per Share* $ 1.80 $ 1.65 $ 1.58 $ 1.54 $ 1.34 Dividends Per Share* $ .51 $ .45 $ .41 $ .39 $ .36 Total Assets at Year End $292,348 $276,778 $248,600 $220,481 $210,981 ======= ======= ======= ======= ======= Return on Average Assets .93% .94% 1.03% 1.08% 1.01% Return on Average Equity 9.23% 9.08% 9.40% 9.94% 9.12% Dividend Payout Ratio 28.12% 27.51% 26.14% 25.04% 26.94% Year End Equity to Assets Ratio 9.89% 10.23% 10.57% 10.99% 10.83% *--Prior years' per share figures restated to reflect stock split effected in form of dividend in 2002. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Policies The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The financial statements contained within these statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of these transactions would be the same, the timing of events that would impact these transactions could change. The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS No. 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. 7 Recent Accounting Pronouncements In December 2001, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position ("SOP") no. 01-6, Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others, to reconcile and conform the accounting and financial reporting provisions established by carious AICPA industry audit guides. SOP No. 01-6 is effective for annual and interim financial statements issued for fiscal years beginning December 15, 2001 and did not have a material impact on the Company's consolidated financial statements. All other recent accounting pronouncements had no material impact on the Company's consolidated financial statements. Overview The Company's 2002 net income of $2,624,000 is a 5.78% increase in net income compared to 2001. This represents a return on average equity of 9.23% for 2002 compared to 9.08% for 2001. Returns on average assets for 2002 and 2001 were .93% and .94%, respectively. Earnings per share increased 9.09% from 2001 to 2002 due to the increase in net income and the repurchase of 22,940 common shares by the Company. Taxable equivalent interest income decreased by $1,218,000 in 2002 to $19,088,000. A 7.27% increase in the level of average earning assets was offset by a decrease in rates for 2002. Decreases in interest rates, coupled with a continued good local economy, drove a 9.30% increase in average loans outstanding. Noninterest income increased 9.21% in 2002 compared to 2001. Increases in service charge income, trust fees and other bank fees were offset in part by reductions in income from investments in life insurance contracts and reductions in income realized by the insurance company in 2002. Noninterest expenses increased 9.36% in 2002 due mainly to higher personnel and equipment expenses, and higher operating expenses consistent with loan and deposit growth. Net Interest Margin 2002 compared to 2001 The Company's net interest margin on a tax equivalent basis was $11,383,000 for 2002 compared to $10,257,000 for 2001. A 7.27% increase in average earning assets was offset by a reduction in yield on these assets of 102 basis points to cause a $1,218,000 reduction in interest income. However, the reduction in yields on earning assets was offset by a reduction of 134 basis points on rates paid on interest bearing liabilities to result in an increase in taxable equivalent net interest margin of $1,126,000. Average loans outstanding grew by 9.30% from 2001 to 2002 as falling interest rates throughout 2002, coupled with stable local economic conditions propelled loan demand. Loans outstanding at December 31, 2002 increased $20,285,000 compared to December 31, 2001. Increases in loan growth have been primarily funded through increases in deposit growth and reductions in balances of fed funds sold, securities and interest bearing deposits in other banks. Levels of competition for deposits in the Company's service area have caused the Company's subsidiary banks to traditionally pay higher rates on deposits than larger, statewide financial institutions. Recent efforts to reduce this discrepancy have been moderately successful and the companies cost of funds on deposits fell 136 basis points from 2001 to 2002 after having risen slightly from 2000 to 2001. Average deposit balances increased 7.73% in 2002 as compared to 2001. The depressed interest rate environment appears to have made customers reluctant to place deposits in long term time deposits, and time deposit balances increased only slightly in 2002 while average balances of noninterest bearing demand deposits, interest bearing demand deposits and savings deposits increased 19.74% in 2002 as compared to 2001. 8 Net Interest Margin (Continued) 2002 compared to 2001 (Continued) The Company anticipates its net interest margin to remain stable or rise slightly in the first six months of 2003 due to the maturing of higher rate liabilities. Current net interest margin should continue as long as interest rates remain stable or increase gradually and loan and deposit trends remain consistent. Rates paid on deposits are expected to stabilize over the next twelve months as the Federal Reserve Bank's rate cuts have been less frequent and the economy shows signs of recovery. Most loans have repricing opportunities within the next twelve months and the Company should be able to slightly improve its net interest margin in this anticipated rate environment. 2001 compared to 2000 The Company's net interest margin on a tax equivalent basis was $10,257,000 for 2001 compared to $9,515,000 for 2000. The increase was due to an increase in average earning assets (14.16%) while maintaining deposit and borrowings liability costs at 4.84% for both years. Average loans outstanding grew by 12.49% from 2000 to 2001. This growth reflected good local economic conditions, even in a declining interest rate environment. The overall cost of funds reflected the high level of competition for deposits in the Company's service area which has traditionally paid higher rates on deposits than larger, statewide financial institutions. Loans outstanding at December 31, 2001 increased 8.56% over amounts at December 31, 2000. The loan increase was the result of continued efforts to increase lending in existing markets. Loan growth was funded primarily by deposit growth, with a small amount of additional borrowings from the Federal Home Loan Bank. A summary of the net interest margin analysis is shown as Table II on Page 23. Provision for Loan Losses The Company's provisions for loan losses were $820,000 for 2002, $600,000 for 2001, and $500,000 for 2000. Net loan charge-offs were $630,000 in 2002 compared to $490,000 in 2001 and $412,000 in 2000. The Company's 2002 net charge off rate of .29% of average loans is approximately equal to its peer group. The Company's three year charge off rate of .26% of average loans outstanding is slightly above peer group. The increase in the provision for loan losses from 2001 to 2002 was necessitated by the 9.87% increase in loan balances from December 31, 2001 to December 31, 2002. This increase in loan balances, coupled with the increase in net loan charge-offs, required a greater provision in order to maintain adequate ratios between the allowance and a larger loan portfolio. Greater net charge-offs were observed in 2002 as compared to 2001. Net charge-offs on consumer loans increased 54.39% as recoveries on these loans fell from $141,000 in 2001 to $72,000 in 2002. Gross charge-offs on consumer loans increased 14.91% compared to a 5.06% increase in the overall consumer loan portfolio. Net charge-offs on commercial loans increased 29.67% from 2001 to 2002 due in large part to the default of one large commercial customer. Noninterest Income 2002 Compared to 2001 Noninterest income for 2002 increased $110,000 from 2001, an increase of 9.21%. Service charge income increased by .96% as deposit and loan volume increased. This increase in service charge income came in spite of a decrease in service charges related to a single large customer who paid large amounts of overdraft and other service charges fees in 2001 and 2000. Because of an infusion of cash from an investor this customer paid significantly less overdraft fees in 2002. Due to decreases in interest rates and changes in economic conditions, income from investments in life insurance contracts fell 3.33%. Trust fees increased 65.98% from 2001 due to a higher volume of customers. Gains on sales of other real estate owned were $40,550 during 2002 compared to no gains recorded in 2001. 9 Noninterest Income (Continued) 2001 Compared to 2000 Noninterest income for 2001 decreased 5.47% from 2000. Decreases in service charge income of 1.76% were largely due to the loss of one large corporate customer which was bought and financially managed from outside the local area. Decreases in insurance commissions of 23.70% were the result of above average claims experienced during the year. Offsetting these declines was greater income from investments in insurance contracts which showed improved profitability in 2001. There were no gains or losses on security transactions in 2001 as no securities were sold. The $104,000 gain on security transactions in 2000 was due to unusual circumstances involving securities involved in the acquisition of the Stockmans Bank and were not repeated in 2001. Noninterest Expenses 2002 Compared to 2001 Total noninterest expenses increased 9.36% in 2002 compared with 2001. Salaries and benefits increased 7.41% due to an increase in full time equivalent employees of 2.88%, merit increases and higher benefit costs. Occupancy expense remained substantially unchanged and equipment expense increased 4.98% as expanded operations required new equipment purchases resulting in increased depreciation and maintenance costs. Data processing expenses increased by 8.57% due to general asset growth and expanded operations. Other changes contributing to the increase in noninterest expenses were increases in marketing expenditure due to expanded advertising campaigns and The Grant County Bank's 100th Anniversary celebration, continuing costs associated with the start-up and expansion of Highlands Bankshares Trust Company and increases in nonincome taxes. Noninterest expense as a percentage of average assets was 2.79% in 2002 compared to 2.73% in 2001 and 2.86% in 2000. These ratios compare favorably to the Company's peer group. The Company's overall increase in noninterest expense is consistent with increases in loan and deposit volumes. 2001 Compared to 2000 Total noninterest expenses increased 8.74% in 2001 when compared with 2000 operations. Salaries and benefits increased 8.49% due to the increase in staff at the new branches, merit raises and higher benefit costs. Average full time equivalent employees increased 9.89% in 2001 due mainly to staffing the new branches in Gore, VA and Harman. The costs of occupancy and equipment increased 18.82% due to depreciation associated with the new and renovated facilities and equipment upgrades. Data processing expenses increased by 8.03% due to general asset growth and expanded locations. Other operating expenses increased 4.30% for all of the reasons cited above. The overall increase in noninterest expenses is a reflection of additional locations which generally take one to three years to become profitable. Financial Condition Loan Portfolio The Company is an active residential mortgage and construction lender and generally extends commercial loans to small and medium sized businesses within its primary service area. The Company's commercial lending activity extends across its primary service areas of Grant, Hardy, Hampshire, Mineral, Randolph, and northern Pendleton counties in WV and Frederick County, VA. Consistent with its focus on providing community-based financial services, the Company does not attempt to diversify its loan portfolio geographically by making significant amounts of loans to borrowers outside of its primary service area. 10 Financial Condition (Continued) Loan Portfolio (Continued) The principal economic risk associated with each of the categories of loans in the Company's portfolio is the creditworthiness of its borrowers. Within each category, such risk is increased or decreased depending on prevailing economic conditions. The risk associated with the real estate mortgage loans and installment loans to individuals varies based upon employment levels, consumer confidence, fluctuations in value of residential real estate and other conditions that affect the ability of consumers to repay indebtedness. The risk associated with commercial, financial and agricultural loans varies based upon the strength and activity of the local economies of the Company's market areas. The risk associated with real estate construction loans varies based upon the supply of and demand for the type of real estate under construction. Loans outstanding increased $20,285,000, or 9.87% in 2002. Mortgage and real estate construction loans grew 11.11%, consumer loans 5.06% and commercial loans 11.57%. The loan to deposit ratio was 87.67% at December 31, 2002 compared to 84.89% at December 31, 2001. Management believes this level of lending activity is satisfactory to generate adequate earnings without undue credit risk. Loan demand is expected to remain satisfactory in the near future with any growth a function of local and national economic conditions. The following table presents the year-end balances of loans, classified by type (in thousands): 2002 2001 2000 1999 1998 ---- ---- ---- ---- ---- Real estate loans: Construction and land development $ 6,813 $ 4,105 $ 4,096 $ 3,296 $ 2,969 Secured by farmland 11,220 9,464 10,059 9,219 9,586 Secured by 1-4 family residential properties 86,748 75,771 72,408 67,775 64,372 Secured by nonfarm, non- residential properties 51,152 48,282 39,122 33,064 28,142 Loans to farmers 593 1,238 567 391 449 Commercial and industrial loans 10,676 9,652 8,029 6,568 4,498 Consumer loans 55,642 56,366 54,691 46,266 38,353 Loans for nonrated industrial development obligations 458 275 All other loans 2,910 133 21 35 15 ------- ------ ------- ------ ------- Total Loans $225,754 $205,469 $189,268 $166,614 $148,384 ======= ======= ======= ======= ======= There were no foreign loans outstanding during any of the above periods. 11 Financial Condition (Continued) Loan Portfolio (Continued) The following table summarizes the Company's loan portfolio, net of unearned income: At December 31, ----------------------------------------------- 2002 2001 2000 ---- ---- ---- (In Thousands of Dollars) Real Estate: Mortgage $ 121,558 $ 111,668 $ 101,890 Construction 6,813 3,868 4,061 Commercial 47,089 42,204 37,681 Installment 50,351 47,927 46,191 -------- -------- -------- Subtotal 225,811 205,667 189,823 Less unearned discount (57) (197) (555) --------- --------- -------- Total Loans 225,754 205,470 189,268 Allowance for loan losses (1,793) (1,603) (1,493) -------- --------- -------- Loans, net $ 223,961 $ 203,867 $ 187,775 ======== ======== ======== The following table shows the maturity of loans outstanding (in thousands of dollars) as of December 31, 2002, 2001 and 2000. Maturity Range 2002 2001 2000 -------------- ---- ---- ---- Predetermined Rates: 0 - 12 months $145,473 $ 99,049 $105,054 13 - 60 months 68,699 68,106 75,918 More than 60 months 11,353 37,840 8,264 Nonaccrual Loans 229 474 32 ------- ------- ------- Total Loans $225,754 $205,469 $189,268 ======= ======= ======= The following table shows the Company's loan maturity distribution (in thousands of dollars) as of December 31, 2002: Maturity Range Less Than 1-5 Over Loan Type 1 Year Years 5 Years Total --------- ------- ----- ------- ----- Commercial and Agricultural Loans $ 35,569 $ 4,193 $ 7,327 $ 47,089 Real Estate - mortgage 82,030 35,570 3,958 121,558 Real Estate - construction 6,813 6,813 Consumer - installment 21,061 28,936 297 50,294 -------- ------- ------- -------- Total $ 145,473 $ 68,699 $ 11,582 $ 225,754 ======== ======= ======= ======== 12 Financial Condition (Continued) Loan Portfolio (Continued) Nonperforming loans include nonaccrual loans, loans 90 days or more past due and restructured loans. Nonaccrual loans are loans on which interest accruals have been discontinued. Loans are placed in nonaccrual status when the collection of principal or interest is 120 days past due and collection is uncertain based on the net realizable value of the collateral and/or the financial strength of the borrower. Also, the existence of any guaranties by federal or state agencies is given consideration in this decision. The policy is the same for all types of loans. Restructured loans are loans which a borrower has been granted a concession on the interest rate or the original repayment terms because of financial difficulties. Nonperforming loans do not represent or result from trends or uncertainties ___ which management reasonably ___ expects will materially impact future operating results, liquidity, or capital resources. Nonperforming loans are listed in the table below. Real estate acquired through foreclosure was $517,050 at December 31, 2002, $58,250 at December 31, 2001 and $110,000 at December 31, 2000. Of the foreclosed property held at December 31, 2002, one property, valued at $278,000, was in the Company's secondary service area and all remaining properties were located in the Company's primary service area. The Company's practice is to value real estate acquired through foreclosure at the lower of (i) an independent current appraisal or market analysis less anticipated costs of disposal, or (ii) the existing loan balance. The Company is actively marketing all foreclosed real estate and does not anticipate material write-downs in value before or at the time of disposition. Nonperforming loans increased 3.97% at December 31, 2002 compared to 2001. Nonaccrual loans decreased as the result of two bankruptcies present in 2001 which were resolved in 2002. Loans 90 and more days past due decreased 16.43% as compared to a 9.87% increase in total loans. Restructured loans also increased in 2002 due to the refinancing of two troubled commercial loans necessary to recoup timely payment of principal. In neither case were any principal amounts forgiven. Management does not anticipate any significant losses from the current level of nonperforming assets. The following table summarizes the nonperforming loans: At December 31, ------------------------------- 2002 2001 2000 ---- ---- ---- (Dollars in Thousands) Loans accounted for on a nonaccrual basis Consumer $ 9 $ $ Real estate 290 474 32 ------ ----- ------ Total nonaccrual loans 299 474 32 ------ ----- ------ Restructured loans 662 0 0 ------ ----- ------ Loans contractually past due 90 days or more as to interest or principal payments (not included in nonaccrual loans above) Commercial 161 607 60 Real estate 1,312 1,352 1,984 Installments 445 336 297 ------ ----- ------ Total Delinquent Loans 1,918 2,295 2,341 ------- ----- ------ Total Nonperforming Loans $ 2,879 $2,769 $ 2,373 ====== ===== ====== 13 Financial Condition (Continued) Loan Portfolio (Continued) An inherent risk in the lending of money is that the borrower will not be able to repay the loan under the terms of the original agreement. The allowance for loan losses (see subsequent section) provides for this risk and is reviewed periodically for adequacy. This review also considers concentrations of loans in terms of geography, business type or level of risk. While lending is geographically diversified within the service area, the Company does have some concentration of loans in the area of agriculture (primarily poultry farming), timber and related industries. Management recognizes these concentrations and considers them when structuring its loan portfolio. As of December 31, 2002, management is not aware of any significant potential problem loans for which the debtor is currently meeting their obligations as stated in the loan agreement but which may change in future periods. As of December 31, 2002, the Company did not have any potential problem loans as defined in Guide 3 that would require disclosure. Allowance for Loan Losses The allowance for loan loss at December 31, 2002 was $1,793,000, an 11.91% increase over the balance at December 31, 2001, while net loans grew 9.87% during the same period. The Company's provision for loan losses in 2002 was 36.67% greater than that provided for in 2001. The increase in the provision for loan losses from 2001 to 2002 was necessitated by the 9.87% increase in loan balances from December 31, 2001 to December 31, 2002. This increase in loan balances, coupled with the increase in net loan charge-offs, required a greater provision in order to maintain adequate ratios between the allowance and a larger loan portfolio. Greater net charge-offs were observed in 2002 as compared to 2001. Net charge-offs on consumer loans increased 54.39% as recoveries on these loans fell from $141,000 in 2001 to $72,000 in 2002 as gross charge-offs on consumer loans increased 14.91% compared to a 5.06% increase in the overall consumer loan portfolio. Net charge-offs on commercial loans increased 29.67% from 2001 to 2002 due in large part to the default of one large commercial customer. Management has analyzed the potential risk of loss on the Company's loan portfolio given the loan balances and the value of the underlying collateral and has recognized losses where appropriate. Nonperforming loans are closely monitored on an ongoing basis as part of the Company's loan review process. Management reviews the loan loss allowance at the end of each quarter. Based primarily on the Company's loan classification system, which classifies problem credits as substandard, doubtful or loss, additional provisions for losses are made monthly. The ratio of the allowance for loan losses to total loans outstanding was .79% at December 31, 2002, .78% at December 31, 2001 and .79% at December 31, 2000. At December 31, 2002, the ratio of the allowance for loan losses to nonperforming loans was 62.28% compared to 57.89% at December 31, 2001 and 62.92% at December 31, 2000. The allowance for loan losses is an estimate of the losses in the current loan portfolio. The allowance is based on two principles of accounting: (i) SFAS 5, Accounting for Contingencies which requires that losses be accrued when they are probable of occurring and estimatable and (ii) SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that loans be identified which have characteristics of impairment as individual risks, (e.g. the collateral, present value of cash flows or observable market values are less than the loan balance). 14 Allowance for Loan Losses (Continued) Each of Company's banking subsidiaries, Capon Valley Bank and The Grant County Bank, determines its allowance for loan losses independently. Each bank pays particular attention to individual loan performance, collateral values, borrower financial condition and overall national and local economic conditions. The determination of adequate allowance at each bank is done in a three step process. The first step is to identify problem loans above a certain threshold and estimated losses are calculated based on collateral values and projected cash flows. The second step is to identify loans above a certain threshold which are problem loans due to the borrowers' payment history or deteriorating financial condition. Losses in this category are determined based on historical loss rates adjusted for current economic conditions. The final step is to calculate a loss for the remainder of the portfolio using historical loss information for each type of loan classification. The determination of specific allowances and weights is in some part subjective and actual losses may be greater or less than the amount of the allowance. However, management believes that the allowance represents a fair assessment of the losses that exist in the loan portfolio. Both banks classify loans into the following categories, impaired, doubtful, substandard, special mention and other loans past due 90+ days and assign loss rate to each. Within these categories, Real Estate, Installment Loans, Commercial Loans and Lines of Credit are assigned a specific loss rate based on historical losses and management's estimate of losses. The allowance associated with loans classed as impaired is calculated at 100% of the identified impairment. Loans 90 days or more past due and nonaccrual loans are included in one of the five categories above. Credit card balances 90 days or more past due are categorized as substandard and are assigned a loss rate of 50%. Generally, all loans in excess of $250,000 are evaluated individually as well as any loan regardless of size that is classified as loss, doubtful, substandard or special mention. This detailed review identifies each applicable loan for specific impairment and a specific allocation for that impaired amount is set aside as the first element in the calculation. Rates assigned each category may vary over time and between the banks as historical loss rates, loan structure and economic conditions change. The remaining portfolio balances are assigned a loss factor based on the historical net loss after recoveries over the last five years. Loss experience per classification varies significantly based on risk and collateral. Installment and commercial loans generally have higher loss volumes than secured real estate loans. These actual loss experience factors are weighed by the average life of the loan category. Installments have a two to three year carrying life, real estate loans a five to six year life; and commercial loans a three to four year life. The net result creates a low and high range of allocated allowance. The Company's actual allowance balance is compared to this range and adjusted as deemed necessary. The adequacy of the allowance for loan losses is computed quarterly and the allowance adjusted prior to the issuance of the quarterly financial statements. All loan losses charged to the allowance are approved by the boards of directors of each bank at their regular meetings. The allowance is reviewed for adequacy after considering historical loss rates, current economic conditions (both locally and nationally) and any known credit problems that have not been considered under the above formula. Management continues to monitor the economic health of the poultry industry. The Company has direct loans to poultry growers and the industry is a large employer in the Company's trade area. Operating results for the industry have improved due to moderating grain prices and better turkey pricing but profitability in this industry is still quite volatile. Since Pilgrim's Pride's purchase of WLR Foods, Inc. in January of 2001 there has been little noticeable impact to the local economy, either positively or negatively. Loan requests for poultry house loans or expansion continue to be presented for approval. 15 Allowance for Loan Losses (Continued) An analysis of the loan loss allowance is set forth in the following table (in thousands): 2002 2001 2000 1999 1998 ---- ---- ---- ---- ---- Balance at beginning of period $ 1,603 $ 1,493 $ 1,318 $ 1,355 $ 1,370 Charge-offs: Commercial loans 246 239 172 107 135 Real estate loans 110 92 128 87 53 Consumer loans 424 369 215 254 289 ------- ------- ------ ------- ------ 780 700 515 448 477 ------- -------- ------ ------- ------ Recoveries: Commercial loans 10 57 2 16 6 Real estate loans 68 12 30 1 1 Consumer loans 72 141 71 74 100 ------- ------- ------ ------- ------ 150 210 103 91 107 ------ ------- ------ ------- ------ Net charge-offs 630 490 412 357 370 Provision for loan losses 820 600 500 320 355 Other 87 ------ ------- ------ ------- ------ Balance at end of period $ 1,793 $ 1,603 $ 1,493 $ 1,318 $ 1,355 ====== ======= ====== ======= ====== Percent of net charge-offs to average net loans outstanding during the period .29% .25% .23% .23% .26% ======= ========= ======== ========= ======== 16 The following table shows the amount and percentage of the Company's allowance for loan losses allocated to each major category of loans:
At December 31, ------------------------------------------------------------------------------------------------------------------- 2002 2001 2000 1999 1998 -------------------- --------------------- --------------------- -------------------- ---------------------- Percent Percent Percent Percent Percent of of of of of Loans Loans Loans Loans Loans Percent in Percent in Percent in Percent in Percent in of Category of Category of Category of Category of Category Allow- to Total Allow- to Total Allow- to Total Allow- to Total Allow- to Total Amount ance Loans Amount ance Loans Amount ance Loans Amount ance Loans Amount ance Loans ------ ---- ----- ------ ---- ----- ------ ---- ----- ------ ---- ----- ------ ---- ----- (Dollars in Thousands) Commercial $ 543 30% 21% $ 487 30% 21% $507 34% 20% $ 395 30% 19% $ 379 28% 23% Real estate Mortgage 504 28 57 576 36 56 239 16 56 211 16 58 434 32 56 Installment 652 37 22 450 28 23 598 40 24 580 44 23 406 30 21 Unallocated 94 5 90 06 149 10 132 10 136 10 ---- ---- ---- ---- -- --- --- ---- --- ------ ------- --- ----- ----- --- $1,793 100% 100% $1,603 100% 100% $1,493 100% 100% $1,318 100% 100% $1,355 100 % 100% ===== === === ===== === === ===== ==== === ======== ===== ===== ===== ===== ====
17 Allowance for Loan Losses (Continued) Cumulative net loan losses, after recoveries, for the five year period ending December 31, 2002 are as follows: Commercial $ 808 35.70% Real estate 358 15.85% Consumer 1,093 48.45% ------ ----- Total $ 2,259 100.00% The above will act as a basis for allocating the overall allowances. Additional changes have been made in the allocation of the allowance to address unknowns and contingent items. The unallocated portion is not computed using a specific formula and is management's best estimate of what should be allocated for contingencies in the current portfolio. 2002 losses were approximately equal to peer group amounts, and are considered reasonable in the eyes of management. The allowance as of December 31, 2002 was .79% of loans outstanding which is below peer group levels. Management believes the present allowance, which is 3.16 times the average annual net charge-off rate over the last three years, is adequate based on its knowledge of the loan portfolio and historical performance. During the course of routine examination of the Company's two subsidiary banks, The Grant County Bank and Capon Valley Bank, under the normal examination cycle by regulatory agencies, examiners have identified certain supervisory issues. Results of these regulatory examinations are not published or publicly available. Requirements of regulatory agencies in regards to certain calculated amounts such as the allowance for loan losses will at times differ from GAAP requirements. One of the regulatory agencies which exerts supervisory control on the Company's subsidiary banks has indicated that a requirement for an increased allowance for loan losses will be directed to one of the subsidiary banks. The final report is not expected to be received until mid April. The Company believes that the allowance for loan losses shown in these statements is adequate to cover potential losses in the current loan portfolio using guidance set forth in SFAS Nos. 5 and 114. As such, the current methodology for calculating the allowance for loan loss will be continued until such time as GAAP requirements change. If one or more of the regulatory agencies require differing amounts of allowance for loan losses, the subsidiary bank or banks to which this requirement might apply will calculate its allowance for loan losses for regulatory filings based on the regulatory guidance, while the Company will continue to report in its 10-Q, 10-K, Annual Report and other filings with the Securities and Exchange Commission an allowance for loan losses based on generally accepted accounting principles as promulgated by the FASB, the SEC and other accounting authorities. Securities The Company's securities portfolio serves several purposes. Portions of the portfolio are used to secure certain public and trust deposits. The remaining portfolio is held as investments or used to assist the Company in liquidity and asset liability management. Total securities decreased to $25,537,000 or 8.74% of total assets at December 31, 2002. Total securities were $31,855,000 or 11.51% of total assets at December 31, 2001. 18 Securities (Continued) The securities portfolio consists of three components: securities held to maturity, securities available for sale and restricted securities. Securities are classified as held to maturity when management has the intent and the Company has the ability at the time of purchase to hold the securities to maturity. Held to maturity securities are carried at cost, adjusted for amortization of premiums and accretion of discounts. Securities to be held for indefinite periods of time are classified as available for sale and accounted for at market value. Securities available for sale include securities that may be sold in response to changes in market interest rates, changes in the security's prepayment risk, increases in loan demand, general liquidity needs and other similar factors. Restricted securities are those investments purchased as a requirement of membership in certain loan banks and cannot be transferred without the issuer's permission. The Company's purchases of securities have generally been limited to securities of high credit quality with short to medium term maturities. The Company identifies at the time of acquisition those securities that are available for sale. These securities are valued at their market value with any difference in market value and amortized cost shown as an adjustment in stockholders' equity. Changes within the year in market values are reflected as changes in stockholders' equity, net of the deferred tax effect. As of December 31, 2002, the fair value of the securities available for sale exceeded their cost basis by $464,000 ($292,000 after the related tax effect). The following table summarizes the carrying value of the Company's securities at the dates indicated: Held to Maturity Available for Sale Carrying Value Carrying Value ----------------------------------------------------------- December 31, December 31, 2002 2001 2000 2002 2001 2000 ---- ---- ---- ---- ---- ---- (In Thousands of Dollars) (In Thousands of Dollars) U.S. treasuries, agencies and corporations $ $ $ 88 $13,534 $16,432 $18,719 Obligations of states and political subdivisions 1,365 1,597 2,131 4,350 6,380 789 Mortgage-backed securities 4 6 9 5,582 6,609 3,275 ------ ------ ----- ------ ------ ------ Total Debt Securities 1,369 1,603 2,228 23,466 29,421 22,783 Other securities 30 39 52 ------ ------ ----- ------ ------ ------ Total $ 1,369 $ 1,603 $2,228 $23,496 $29,460 $22,835 ====== ====== ===== ====== ====== ====== 19 Securities (Continued) The carrying amount and estimated market value of debt securities (in thousands of dollars) at December 31, 2002 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Equivalent Securities Held to Maturity Amortized Fair Average Cost Value Yield ------------ ----------- --------- Due in one year or less $ 4 $ 4 8.51% Due after one year through five years 1,365 1,448 7.15% --------- ---------- ------- Total Held to Maturity $ 1,369 $ 1,452 7.11% ======== ========= ===== Equivalent Securities Available for Sale Amortized Fair Average ----------------------------- Cost Value Yield ------------ ----------- --------- Due in one year or less $ 12,843 $ 12,990 4.38% Due after one year through five years 8,318 8,597 4.37% Due after five years through ten years 732 768 5.82% Due after ten years 1,105 1,111 4.47% -------- --------- ----- Total Fixed Rate Securities 22,998 23,466 5.24% Equities 34 30 8.92% -------- --------- ----- Total Available for Sale $ 23,032 $ 23,496 4.51% ======== ========= ===== Yields on tax exempt securities are stated at tax equivalent yields. Management has generally kept the maturities of investments relatively short providing for flexibility in investing. Such a philosophy allows the Company to better match deposit maturities with investment maturities and thus react more quickly to interest rate changes. Deposits The Company's predominant source of funds is local deposits. The Company's deposit base is comprised of demand deposits, savings and money market accounts and other time deposits. The Company's deposits are provided by individuals and businesses located within the communities served. The average balance of interest bearing deposits increased by 6.04% in 2002 over average levels in 2001. The average balance of noninterest bearing deposits increased 20.54% over average 2001 balances. The average rate paid on deposits decreased to 3.48% in 2002 from 4.84% in 2001 and 4.82% in 2000. The majority of the Company's deposits are higher yielding time deposits as most of its customers are individuals who seek higher yields than savings accounts or don't wish to accept the risks of the stock market. 20 Deposits (Continued) The Company does not actively solicit large certificates of deposit (those more than $100,000) due to the unstable nature of these deposits. Any increase in balances of these large deposits in 2002 are the result of overall deposit growth and higher than average rates offered by the Company. A summary of the maturity of large deposits is as follows: December 31, ---------------------------- Maturity Range 2002 2001 2000 -------------- ---- ---- ---- (In Thousands of Dollars) Three months or less $ 7,570 $ 8,980 $ 4,172 Four to twelve months 22,030 21,965 14,336 One year to three years 8,598 10,018 13,753 Four years to five years 7,195 4,219 2,623 -------- -------- -------- Total $ 45,393 $ 45,182 $ 34,884 ======= ======= ======== Borrowed Money The Company occasionally borrows funds from the Federal Home Loan Bank to reduce market rate risks and to fund capital additions. Such borrowings may have fixed or variable interest rates and are amortized over a period of ten to twenty years. Borrowings from this institution allow the banks to offer long-term, fixed rate loans to their customers and match the interest rate exposure of the receivable and the liability. The Company had no additional borrowings in 2002 and repayments within the year of $493,860. Capital Resources The assessment of capital adequacy depends on a number of factors such as asset quality, liquidity, earnings performance and changing competitive conditions and economic forces. The Company seeks to maintain a strong capital base to support its growth and expansion activities, to provide stability to current operations and to promote public confidence. The Company's capital position continues to exceed regulatory minimums. The primary indicators relied on by the Federal Reserve Board and other bank regulators in measuring strength of capital position are the Tier 1 Capital, Total Capital and Leverage ratios. Tier 1 Capital consists of common stockholders' equity. Total Capital consists of Tier 1 Capital and a portion of the allowance for loan losses. Risk-based capital ratios are calculated with reference to risk-weighted assets which consist of both on and off-balance sheet risks. 21 Capital Resources (Continued) The following table shows risk-based capital ratios and stockholders' equity to total assets: Regulatory December 31, Minimum 2002 2001 ----------- ---- ---- Capital Ratios -------------- Risk-based capital to risk-weighted assets Tier 1 8.00% 13.66% 13.66% Total 4.00% 14.03% 14.46% Stockholders' equity to total assets 5.00% 9.89% 10.06% The capital management function is an ongoing process. Central to this process is internal equity generation accomplished by earnings retention. During 2002, 2001, and 2000, total stockholders' equity increased by $606,000, $2,042,000 and $2,044,000, respectively, as a result of earnings retention and changes in the unrealized gains (losses) on securities available for sale. The repurchase of outstanding stock totaling $1,217,000 was the major reason that equity growth was less than previous years. The return on average equity was 9.23% in 2002 compared to 9.08% for 2001 and 9.40% for 2000. Total cash dividends declared represent 28.12% of net income for 2002 compared to 27.51% of net income for 2001 and 26.14% for 2000. Book value per share was $20.12 at December 31, 2002 compared to $18.80 at December 31, 2001 and $17.45 at December 31, 2000. Book value calculations have been adjusted for the stock split effected in form of dividend distributed during the third quarter of 2002. The Company's principal source of cash income is dividend payments from the Banks and insurance subsidiary. Certain limitations exist under applicable law and regulation by regulatory agencies regarding dividend payments to a parent by its subsidiaries. As of January 1, 2003, the Banks had approximately $411,000 of retained earnings available for distribution to the Company as dividends without prior regulatory approval. Liquidity and Interest Rate Sensitivity Liquidity. Liquidity is the ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest bearing deposits with banks, federal funds sold, investments and loans maturing within one year. The Company's ability to obtain deposits and purchase funds at favorable rates determines its liability liquidity. As a result of the Company's management of liquid assets and the ability to generate liquidity through liability funding, Management believes that the Company maintains overall liquidity sufficient to satisfy its depositors' requirements and meet its customers' credit needs. Additional sources of liquidity available to the Company include, but are not limited to, loan repayments, the ability to obtain deposits through the adjustment of interest rates and the purchasing of federal funds. To further meet its liquidity needs, the Company also maintains lines of credit with correspondent financial institutions, the Federal Reserve Bank of Richmond and the Federal Home Loan Bank of Pittsburgh. In the past, growth in deposits and proceeds from the maturity of investment securities have been sufficient to fund the net increase in loans. Investing activity saw an increase in net loans of $20,094,000, an increase in deposits at other institutions of $1,834,000 and an increase in fed funds sold of $1,341,000. New equipment and facility additions were $314,000 in 2002 compared with $776,000 in 2001. Funding these investments was an increase in deposits of $15,471,000, a decrease in investments of $6,318,000 and retained operating income of $1,886,000. 22 Liquidity and Interest Rate Sensitivity (Continued) In the year ending December 31, 2002, cash and due from banks increased $1,734,000 as cash provided by operations and financing activities was greater than cash used in investing activities. Cash provided by operations consists primarily of earnings from operations and noncash expenses such as the provision for loan losses, deferred income taxes and depreciation. The dividends paid of $738,000 in 2002 were an increase of 8.10% over 2001 amounts. The Company is not aware of any trends, events or uncertainties that will have or that are reasonably likely to have a material effect on the Company's liquidity, capital resources or operations. The Company is not aware of any proposals from any regulatory authority which, if implemented, would have such an effect. Interest Rate Sensitivity. In conjunction with maintaining a satisfactory level of liquidity, management must also control the degree of interest rate risk assumed on the balance sheet. Managing this risk involves regular monitoring of the interest sensitive assets relative to interest sensitive liabilities over specific time intervals. At December 31, 2002, the Company had a negative gap position as of 90 days into the future. This position causes a squeeze on income in the short term in reaction to rate changes by the Federal Reserve Bank. This gap becomes slightly positive by one year into the future. With assets repricing at a level of 102.99% of the volume of interest bearing liabilities during the first year, the impact to earnings of interest rate changes should be minimal due to the ability to match increases in assets and liabilities. Even with gradual rises in interest rates, the Company expects its cost of funds should remain stable throughout the early part of 2003 as any effects of rising rates are offset by the maturity of older time deposits paying at a higher rate of interest than the current prevailing rates. With the largest amount of interest sensitive assets and liabilities repricing within one year, the Company monitors this position closely. Early withdrawal of deposits, prepayments of loans and loan delinquencies are some of the factors that could affect actual versus expected cash flows. In addition, changes in rates on interest sensitive assets and liabilities may not be equal, which could result in a change in the net interest margin. While the Company does not match each of its interest sensitive assets against specific interest sensitive liabilities, it does periodically review its cumulative position of interest sensitive assets and liabilities. The majority of the Company's commercial and real estate loans are made with repricing frequencies of three months to three years. For this reason, 95% of all loans will reprice within three years of December 31, 2002. Installment loans generally have a fixed rate of interest but have limited amortization periods. These loans have an average life to maturity of less than two years. Management believes that its philosophy of requiring loan repricing within a three to five year period to be the most prudent approach to asset/liability management. In the area of investments, the Company employs a management technique known as "laddering" to minimize interest rate exposures and provide a constant flow of maturities subject to repricing at current market rates. To assist in the management of investments, the Company employs an independent investment counsel that advises it in planning and risk diversification. The Company utilizes many forms of investments with a significant use of mortgage-backed securities issued by federally chartered institutions. The Company does not employ the use of derivatives in its approach to controlling market risk. Although the majority of its investments are classified as available for sale, the Company rarely sells securities except in unusual circumstances. Table IV (page 25) shows the maturity of liabilities and assets in future periods. Table III (page 24) shows the effects of rate and volume changes on the net interest margin for the past three year period. 23 Effects of Inflation Inflation significantly affects industries having high levels of property, plant and equipment or inventories. Although the Company is not significantly affected in these areas, inflation does have an impact on the growth of assets. As assets grow rapidly, it becomes necessary to increase equity capital at proportionate levels to maintain the appropriate equity to asset ratios. Traditionally, the Company's earnings and high capital retention levels have enabled the Company to meet these needs. The Company's reported earnings results have been minimally affected by inflation, but isolating the effect is difficult. The different types of income and expense are affected in various ways. Interest rates are affected by inflation, but the timing and magnitude of the changes may not coincide with changes in the consumer price index. Management actively monitors interest rate sensitivity, as illustrated by the Gap Analysis (Table IV, page 25) in order to minimize the effects of inflationary trends on interest rates. Other areas of noninterest expenses may be more directly affected by inflation. Securities and Exchange Commission WEB Site The Securities and Exchange Commission maintains a WEB site that contains reports, proxy and information statements and other information regarding registrants (including the Company) that file electronically with the Commission. That address is (http: //www.sec.gov) 24 TABLE I
NET INTEREST MARGIN AND AVERAGE BALANCE ANALYSIS (Dollar amounts in thousands) 2002 2001 2000 ------------------------------ ------------------------------ -------------------------------- Income/ Yield/ Income/ Yield/ Income/ Yield/ EARNING ASSETS Average Expense Rate Average Expense Rate Average Expense Rate -------------- ------- ----------- --------- -------- --------- ------ ------- ------ ------ Loans 1,3 $ 216,408 $ 17,324 8.01 $ 197,989 $ 17,895 9.04 $ 176,010 $ 15,893 9.03 Investment securities: Taxable 4 25,247 1,165 4.61 24,686 1,445 5.85 26,583 1,641 6.17 Nontaxable 1,4 5,451 318 5.83 3,501 267 7.63 3,285 262 7.98 -------- ----- ----- ------ ----- ----- ------ ----- ------- Total Investment Securities 30,698 1,483 4.83 28,187 1,712 6.07 29,868 1,903 6.37 Interest bearing deposits in banks 4,271 104 2.44 5,813 248 4.27 3,464 179 5.17 Federal funds sold 11,431 177 1.55 13,019 451 3.46 5,276 330 6.25 ------ ----- ----- ------ ----- ----- ----- ----- ----- Total Earning Assets 262,808 19,088 7.26 245,008 20,306 8.29 214,618 18,305 8.53 ------- ------ ------ --------- ------ ------ --------- ----- ------- Allowance for loan losses (1,793) (1,613) (1,474) Nonearnings assets 21,840 20,550 18,608 ------- ------ ------ Total Assets $ 282,855 $ 263,945 $231,752 ======= ========= ======= INTEREST-BEARING LIABILITIES Deposits: Demand $ 34,502 $ 451 1.31 $ 28,330 $ 520 1.84 $ 30,015 $ 867 2.89 Savings 29,276 425 1.45 25,109 546 2.17 21,784 650 2.98 Time deposits 151,813 6,619 4.36 149,867 8,771 5.85 126,041 7,061 5.60 ------- ------- ------- --------- ------- ----- -------- ------- ------- Total Deposits 215,591 7,495 3.48 203,306 9,837 4.84 177,840 8,578 4.82 Other borrowed money 4,280 210 4.91 4,149 212 5.11 3,762 212 5.64 ----- ----- ----- ----- ----- ----- ------- ------ ----- Total Interest Bearing Liabilities 219,871 7,705 3.50 207,455 10,049 4.84 181,602 8,790 4.84 ------- ----- ----- ------ ----- ----- ------ ------- Noninterest bearing deposits 32,226 26,735 23,035 Other liabilities 2,320 2,436 1,793 ----- ----- ------ Total Liabilities 254,417 236,626 206,430 Stockholders' Equity 28,438 27,319 25,322 ------ ------ ------ Total Liabilities and Equity $282,855 $ 263,945 $231,752 ======= ========= ========= Net Interest Earnings $ 11,383 $ 10,257 $ 9,515 ======== ========= ======= Net Yield on Interest Earning Assets 4.33% 4.19% 4.43% ==== ===== =====
1 Yields are computed on a taxable equivalent basis using a 37% income tax rate. 2 Average balances are based on daily balances. 3 Includes loans in nonaccrual status. 4 Average balances for securities available for sale are based on amortized carrying values and do not reflect changes in market values. 25 TABLE II EFFECT OF RATE-VOLUME CHANGES ON NET INTEREST INCOME (On a fully taxable equivalent basis) (In thousands of dollars) 2002 Compared to 2001 2001 Compared to 2000 ------------------- ---------------------- Increase (Decrease) Increase (Decrease) Due to Change in: Total Due to Change in: Total Average Average Increase Average Average Increase Volume Rate (Decrease) Volume Rate (Decrease) ----- ------ -------- ------ ------ ------ Interest Income: Loans 2 $1,665 $(2,237) $(572) $1,985 $ 17 $2,002 Investment Securities: Taxable 33 (313) (280) (117) (79) (196) Nontaxable 149 (97) 52 17 (12) 5 ----- ----- ---- ----- ---- ---- Total Investment Securities 182 (410) (228) (100) (91) (191) Interest bearing deposits in banks (66) (78) (144) 121 (52) 69 Federal funds sold (55) (219) (274) 484 (363) 121 ------ ----- ----- ---- ----- ---- Total Interest Income 1,726 (2,944) (1,218) 2,490 (489) 2,001 ----- ------- ------- ----- ----- ----- Interest Expense: Deposits: Demand 113 (182) (69) (49) (298) (347) Savings 91 (212) (121) 99 (203) (104) All other time deposits 115 (2,267) (2,152) 1,334 376 1,710 Other borrowed money 7 (9) (2) 21 (21) 0 ----- ----- ----- ---- ----- ---- Total Interest Expense 326 (2,670) (2,344) 1,405 (146) 1,259 ---- ------- ------ ----- ----- ----- Net Interest Income $1,400 $ (274) $1,126 $1,085 $ (343) $ 742 ===== ==== ===== ===== ==== ==== 1 Changes in volume are calculated based on the difference in average balance multiplied by the prior year average rate. Rate change differences are the difference in the volume changes and the actual dollar amount of interest income or expense changes. 2 Nonaccrual loans have been included in average asset balances. 26 TABLE III INTEREST RATE SENSITIVITY ANALYSIS (In thousands of dollars) DECEMBER 31, 2001 More than 5 Years 1 - 90 91 - 365 1 to 3 3 to 5 or Without Days Days Years Years Maturity Total EARNINGS ASSETS Loans $39,347 $106,126 $61,137 $ 7,562 $11,582 $225,754 Fed funds sold 14,625 14,625 Securities 4,751 8,945 6,855 3,107 1,879 25,537 Interest bearing time deposits 4,300 200 4,500 ------ ------ ------ ------ ----- ------ Total 63,023 115,271 67,992 10,669 13,461 270,416 ------ ------- ------ ------ ------ ------- INTEREST BEARING LIABILITIES Transaction accounts 20,936 20,936 Money market accounts 16,996 16,996 Savings accounts 29,503 29,503 Time deposits more than $100,000 7,570 22,030 8,598 7,195 45,393 Time deposits less than $100,000 22,806 52,792 26,160 11,009 131 112,898 Other borrowed money 132 347 978 762 1,811 4,030 ------ ------ ------ ------ ----- ------ Total 97,943 75,169 35,736 18,966 1,942 229,756 -------- -------- -------- -------- ------- ------ Discrete interest sensitivity GAP (34,920) 40,102 32,256 (8,297) 11,519 Cumulative interest sensitivity GAP (34,920) 5,182 37,438 29,141 40,660 Ratio of cumulative interest sensitive assets to cumulative interest sensitive liabilities 64.35% 102.99% 117.93% 112.79% 117.70% Assumes all transaction, money market and savings deposit accounts reprice within 90 days. 27 TABLE IV QUARTERLY FINANCIAL RESULTS (In thousands, except per share amounts) Fourth Third Second First Quarter Quarter Quarter Quarter 2002 Interest income $ 4,718 $ 4,809 $ 4,706 $ 4,737 Interest expense 1,817 1,801 1,931 2,156 -------- -------- -------- -------- Net interest income 2,901 3,008 2,775 2,581 Provision for loan losses 350 210 140 120 -------- -------- -------- -------- Net interest income after provision 2,551 2,798 2,635 2,461 Non-interest income 412 328 285 279 Non-interest expense 2,068 2,000 1,937 1,880 -------- -------- -------- -------- Income before income tax provision 895 1,126 983 860 Income tax provision 284 375 321 260 -------- -------- -------- -------- Net Income $ 611 $ 751 $ 662 $ 600 ======== ======== ======== ======== Per common share:* Net income (basic) $ .42 $ .52 $ .46 $ .40 Net income (diluted) .42 .52 .46 .40 Cash dividends .13 .13 .13 .12 2001 Interest income $ 4,964 $ 5,126 $ 5,161 $ 4,956 Interest expense 2,451 2,562 2,537 2,499 -------- -------- -------- -------- Net interest income 2,513 2,564 2,624 2,457 Provision for loan losses 210 135 135 120 -------- -------- -------- -------- Net interest income after provision 2,303 2,429 2,489 2,337 Non-interest income 370 281 269 274 Non-interest expense 1,894 1,828 1,768 1,720 -------- -------- -------- -------- Income before income tax provision 779 882 990 891 Income tax provision 119 302 343 297 -------- -------- -------- -------- Net Income $ 660 $ 580 $ 647 $ 594 ======== ======== ======== ======== Per common share:* Net income (basic) $ .44 $ .39 $ .43 $ .39 Net income (diluted) .44 .39 .43 .39 Cash dividends .12 .11 .11 .11 *--Prior period per share figures restated to reflect stock split effected in form of dividend in 2002. 28 Item 7A. Quantitative and Qualitative Disclosures About Market Risk This information is incorporated herein by reference from Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, on Pages 6 through 27 of this Form 10-K. 29 Item 8. Financial Statements Index to Financial Statements Financial Highlights...................................... 30 Consolidated Balance Sheets as of December 31, 2002 and 2001.......................... 31 Consolidated Statements of Income for the Years Ended December 31, 2002, 2001 and 2000............................................. 32 Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 2002, 2001 and 2000.......................... 33 Consolidated Statements of Cash Flows for the Years Ended December 31, 2002, 2001 and 2000............................................. 35 Notes to Consolidated Financial Statements................................................ 36 Independent Auditors' Report.............................. 54 Management's Discussion and Analysis...................... 55 30 FINANCIAL HIGHLIGHTS HIGHLANDS BANKSHARES, INC. Years Ended December 31, 2002 2001 2000 1999 1998 ---- ---- ---- ---- ---- (Dollars in Thousands except per share data) RESULTS OF OPERATIONS Interest income $18,970 $ 20,207 $18,207 $ 16,243 $15,772 Interest expense (7,705) (10,049) (8,790) (7,663) (7,745) ------ -------- ------ ------- ------ Net Interest Income 11,265 10,158 9,417 8,580 8,027 Provision for loan losses (820) (600) (500) (320) (355) Noninterest income 1,304 1,194 1,263 1,026 735 Noninterest expenses (7,885) (7,210) (6,631) (5,912) (5,377) Income taxes (1,240) (1,061) (1,168) (1,049) (1,018) ------- ------- ------ ------- ------ Net Income $ 2,624 $ 2,481 $ 2,381 $ 2,325 $ 2,012 ====== ======= ====== ======= ====== PROFITABILITY RATIOS Return on Average Assets .93% .94% 1.03% 1.08% 1.01% Return on Average Equity 9.23% 9.08% 9.40% 9.94% 9.12% PER COMMON SHARE * Net Income $ 1.80 $ 1.65 $ 1.58 $ 1.54 $ 1.34 Cash Dividends Declared .51 .45 .41 .39 .36 Book Value 20.12 18.80 17.45 16.09 15.17 Last Reported Market Price 21.51 16.33 16.67 20.00 21.08 AT YEAR END Assets $292,348 $276,778 $248,600 $220,481 $210,981 Deposits 257,512 242,042 216,571 192,345 184,587 Loans 225,754 205,469 189,268 166,614 148,384 Stockholders' Equity 28,916 28,310 26,268 24,224 22,847 *--Prior years' per share figures restated to reflect stock split effected in form of dividend in 2002. 31 CONSOLIDATED BALANCE SHEETS HIGHLANDS BANKSHARES, INC. December 31, ASSETS 2002 2001 ---- ----- Cash and due from banks (notes 2, 3 and 16) $ 8,226,301 $ 6,492,361 Interest bearing deposits in banks (note 16) 4,499,666 6,333,551 Federal funds sold (note 16) 14,625,342 13,284,408 Investments: Securities held to maturity (note 4) 1,369,112 1,603,393 (fair value of $1,451,553 and $1,638,968 at December 31, 2002 and 2001, respectively) Securities available for sale (note 4) 23,496,039 29,460,117 Restricted investments (note 2d) 671,811 791,650 Loans (notes 5, 14, 15 and 16) 225,754,224 205,469,148 Less allowance for loan losses (note 6) (1,793,345) (1,602,536) ---------- ------------ Net Loans 223,960,879 203,866,612 Bank premises and equipment (note 7) 6,873,307 7,055,640 Interest receivable 1,821,476 1,817,884 Investment in life insurance contracts (note 12) 5,338,036 5,100,262 Other assets 1,466,306 971,993 ----------- ----------- Total Assets $292,348,275 $276,777,871 =========== =========== LIABILITIES Deposits: Noninterest bearing $ 31,785,317 $ 29,278,596 Interest bearing Money market and interest checking 20,935,592 17,935,755 Money market savings 16,996,289 11,407,235 Savings accounts 29,503,487 26,782,334 Time deposits over $100,000 (note 8) 45,392,941 45,181,560 All other time deposits (note 8) 112,898,645 111,456,188 ----------- ----------- Total Deposits 257,512,271 242,041,668 Accrued expenses and other liabilities 1,890,096 1,902,794 Long term debt (note 9) 4,029,582 4,523,442 ----------- ----------- Total Liabilities 263,431,949 248,467,904 ----------- ------------ STOCKHOLDERS' EQUITY (note 18) Common stock, $5 par value, 3,000,000 shares authorized, 1,436,874 shares issued in 2002, 7,184,370 2,733,820 546,764 shares issued in 2001 Surplus 1,661,987 1,661,987 Retained earnings (note 12) 19,849,947 24,623,951 Other accumulated comprehensive income 220,022 282,910 ----------- ----------- 28,916,326 29,302,668 Treasury stock (at cost, 44,866 shares in 2001) (992,701) ------------ ----------- Total Stockholders' Equity 28,916,326 28,309,967 ----------- ----------- Total Liabilities and Stockholders' Equity $292,348,275 $276,777,871 =========== ============ The accompanying notes are an integral part of this statement. 32 CONSOLIDATED STATEMENTS OF INCOME HIGHLANDS BANKSHARES, INC. Years Ended December 31, 2002 2001 2000 ----- ----- ----- INTEREST INCOME: Loans, including fees $17,323,503 $17,894,665 $15,891,868 Federal funds sold 176,787 450,657 330,761 Interest bearing deposits 103,982 248,442 179,100 Investment securities - taxable 1,164,634 1,445,327 1,641,057 Investment securities - nontaxable 201,184 167,930 164,486 ---------- --------- --------- Total Interest Income 18,970,090 20,207,021 18,207,272 ---------- ---------- ---------- INTEREST EXPENSE: Time deposits over $100,000 2,072,384 2,623,584 1,865,498 Other deposits 5,422,116 7,213,321 6,712,478 ---------- --------- --------- Total Interest on Deposits 7,494,500 9,836,905 8,577,976 Interest on Long Term Debt 210,232 211,827 212,054 ---------- --------- --------- Total Interest Expense 7,704,732 10,048,732 8,790,030 ---------- ---------- ---------- NET INTEREST INCOME 11,265,358 10,158,289 9,417,242 PROVISION FOR LOAN LOSSES (note 6) 820,000 600,000 500,000 ----------- --------- --------- Net Interest Income after Provision for Loan Losses 10,445,358 9,558,289 8,917,242 ---------- --------- --------- NONINTEREST INCOME: Service charges 586,821 581,224 591,614 Insurance commissions and income 86,658 100,801 132,105 Life insurance investment income 237,774 245,958 192,642 Other operating income 392,231 266,061 242,892 Gain on security transactions (note 4) 103,870 ----------- --------- --------- Total Noninterest Income 1,303,484 1,194,044 1,263,123 ---------- --------- --------- NONINTEREST EXPENSES: Salaries and benefits (note 11) 4,229,618 3,937,908 3,629,664 Occupancy expense 380,021 381,029 302,738 Equipment expense 662,266 630,840 548,850 Data processing expense 574,400 529,054 489,744 Other operating expenses 2,038,621 1,731,258 1,659,834 ---------- --------- --------- Total Noninterest Expenses 7,884,926 7,210,089 6,630,830 ---------- --------- --------- Income before Income Tax Expense 3,863,916 3,542,244 3,549,535 INCOME TAX EXPENSE (note 10) 1,239,778 1,061,459 1,168,624 ---------- --------- --------- NET INCOME $ 2,624,138 $2,480,785 $2,380,911 ========== ========= ========= Earnings Per Share* $ 1.80 $ 1.65 $ 1.58 ========== ========= ========= Cash Dividends Paid Per Share* $ .51 $ .45 $ .41 ========= ========= ========= Weighted Average Shares Outstanding* 1,455,511 1,505,694 1,505,694 *--Prior years' per share figures restated to reflect stock split in form of dividend in 2002. The accompanying notes are an integral part of this statement. 33 CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY HIGHLANDS BANKSHARES, INC.
Accumulated Other Common Retained Comprehensive Treasury Stock Surplus Earnings Income (Loss) Stock Total -------- ------- -------- ------------ -------- ---------- BALANCE DECEMBER 31, 1999 $2,733,820 $1,661,987 $ 21,067,191 $(246,250) $(992,701) $ 24,224,047 Comprehensive Income Net income 2,380,911 2,380,911 Change in other comprehensive income (note 19) 285,011 285,011 -------- Total Comprehensive Income 2,665,922 Cash dividends (622,355) (622,355) -------- -------- -------- -------- -------- -------- BALANCE DECEMBER 31, 2000 2,733,820 1,661,987 22,825,747 38,761 (992,701) 26,267,614 Comprehensive Income Net income 2,480,785 2,480,785 Change in other comprehensive income (note 19) 244,149 244,149 -------- Total Comprehensive Income 2,724,934 Cash dividends (682,581) (682,581) -------- -------- --------- -------- -------- --------- BALANCE DECEMBER 31, 2001 $ 2,733,820 $ 1,661,987 $24,623,951 $ 282,910 $(992,701) $ 28,309,967 ========== ========== ========== ========= ========= ===========
The accompanying notes are an integral part of this statement. 34 CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (continued) HIGHLANDS BANKSHARES, INC.
Accumulated Other Common Retained Comprehensive Treasury Stock Surplus Earnings Income (Loss) Stock Total BALANCE DECEMBER 31, 2001 2,733,820 1,661,987 24,623,951 282,910 (992,701) 28,309,967 Comprehensive Income Net income 2,624,138 2,624,138 Change in other comprehensive income (note 19) (62,888) (62,888) -------- Total Comprehensive Income 2,561,250 Treasury stock repurchased (1,217,055) (1,217,055) Treasury stock retired (339,030) (1,870,726) 2,209,756 Stock split effected in form of dividend 4,789,580 (4,789,580) Cash dividends (737,836) (737,836) -------- -------- ---------- -------- -------- ------------ BALANCE DECEMBER 31, 2002 $ 7,184,370 $ 1,661,987 $19,849,947 $ 220,022 $ 0 $28,916,326 ========== =========== ========== ======= ========== ==========
The accompanying notes are an integral part of this statement. 35 CONSOLIDATED STATEMENTS OF CASH FLOWS HIGHLANDS BANKSHARES, INC. Years Ended December 31, 2002 2001 2000 ---- ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $2,624,138 $2,480,785 $2,380,911 Adjustments to reconcile net income to net cash provided by operating activities: Gain on security transactions (103,870) Gain on sale of property and equipment (237) Depreciation 525,685 523,626 447,697 Income from life insurance contracts (237,774) (245,958) (192,642) Net amortization of security premiums 294,266 122,343 2,171 Provision for loan losses 820,000 600,000 500,000 Deferred income tax expense (benefit) (103,570) (17,061) 18,010 Change in other assets and liabilities: Interest receivable (3,592) 83,412 (158,422) Other assets (494,313) (127,198) 86,378 Accrued expenses (12,698) 150,873 315,869 ---------- --------- -------- Net Cash Provided by Operating Activities 3,412,142 3,570,822 3,295,865 --------- --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of branch, net of cash acquired (1,220,000) Proceeds from maturity of securities held to maturity 232,337 621,481 952,376 Proceeds from maturity of securities available for sale 12,406,125 17,116,010 7,590,970 Proceeds from sales of securities available for sale 484,797 2,115,255 Purchase of securities available for sale (7,207,357)(23,472,091) (3,978,886) Net change in restricted investments 119,839 (28,600) (17,500) Net change in deposits in other banks 1,833,885 27,380 (3,924,660) Net increase in loans (20,914,267)(16,691,860) (17,279,029) Change in federal funds sold (1,340,934) (6,244,900) (2,736,875) Purchase of property and equipment (314,479) (776,171) (1,287,893) Proceeds from sale of property and equipment 6,358 2,840 ------- --------- --------- Net Cash Used in Investing Activities (14,700,054)(29,442,393) (19,783,402) -------- ---------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Net change in time deposits 1,653,838 19,729,800 14,050,142 Net change in other deposit accounts 13,816,765 5,740,629 1,368,109 Additional long term debt 1,395,300 1,731,532 Repayment of long term debt (493,860) (881,177) (290,171) Repurchase of treasury stock (1,217,055) Dividends paid in cash (737,836) (682,581) (622,355) --------- ---------- ---------- Net Cash Provided by Financing Activities 13,021,852 25,301,971 16,237,257 ----------- ----------- ---------- CASH AND CASH EQUIVALENTS: Net (decrease) increase in cash and due from banks 1,733,940 (569,600) (250,280) Cash and due from banks, beginning of year 6,492,361 7,061,961 7,312,241 --------- --------- --------- Cash and due from banks, end of year $ 8,226,301 $6,492,361 $ 7,061,961 ========== ============ ========= Supplemental Disclosures: Cash paid for: Interest expense $7,920,454 $10,042,704 $8,610,571 Income taxes 1,421,272 1,367,143 1,203,000 The accompanying notes are an integral part of this statement. 36 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 1 SUMMARY OF OPERATIONS: Highlands Bankshares, Inc. (the "Company") is a bank holding company and operates under a charter issued by the state of West Virginia. The Company owns all of the outstanding stock of The Grant County Bank, Capon Valley Bank, HBI Life Insurance Company, Inc. and Highlands Bankshares Trust Company, which operate under charters issued in Arizona and West Virginia, respectively. State chartered banks are subject to regulation by the West Virginia Division of Banking, The Federal Reserve Bank and the Federal Deposit Insurance Corporation while the insurance company is regulated by the Arizona Department of Insurance. The Banks provide services to customers located mainly in Grant, Hardy, Hampshire, Mineral, Pendleton and Randolph counties of West Virginia, including the towns of Petersburg, Keyser, Moorefield and Wardensville through eight locations and the county of Frederick in Virginia through a single location. The insurance company sells life and accident coverage exclusively through the Company's subsidiary banks. The Trust Company utilizes the subsidiary banks to facilitate the sales of trust services to its customers and citizens in those locales. NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: The accounting and reporting policies of Highlands Bankshares, Inc. and its subsidiaries conform to accounting principles generally accepted in the United States of America and to accepted practice within the banking industry. (a) Principles of Consolidation The consolidated financial statements include the accounts of The Grant County Bank, Capon Valley Bank, HBI Life Insurance Company and Highlands Bankshares Trust Company. All significant intercompany accounts and transactions have been eliminated. (b) Use of Estimates in the Preparation of Financial Statements In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts in those statements; actual results could differ significantly from those estimates. A material estimate that is particularly susceptible to significant changes is the determination of the allowance for loan losses, which is sensitive to changes in local economic conditions. (c) Cash and Cash Equivalents Cash and cash equivalents include cash on hand and noninterest bearing funds at correspondent institutions. 37 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED): (d) Securities Securities that the Company has both the positive intent and ability to hold to maturity (at time of purchase) are classified as held to maturity securities. All other securities are classified as available for sale. Securities held to maturity are carried at historical cost and adjusted for amortization of premiums and accretion of discounts, using the effective interest method. Securities available for sale are carried at fair value with any valuation adjustments reported, net of deferred taxes, as other accumulated comprehensive income. Restricted investments consist of investments in the Federal Home Loan Bank of Pittsburgh and the Federal Reserve Bank of Richmond. Such investments are required as members of these institutions and these investments cannot be sold without a change in the members' borrowing or service levels. Interest and dividends on securities and amortization of premiums and discounts on securities are reported as interest income using the effective interest method. Gains (losses) realized on sales and calls of securities are determined using the specific identification method. (e) Loans Loans are carried on the balance sheet net of unearned interest and allowance for loan losses. Interest income on loans is determined using the effective interest method on the daily amount of principal outstanding except where serious doubt exists as to collectibility of the loan, in which case the accrual of income is discontinued. Loans are placed on nonaccrual or charged off if collection of principal or interest becomes doubtful. The interest on these loans is accounted for on cash-basis or cost-recovery method until qualifying for return to accrual. Loans are returned to accrual when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. (f) Allowance For Loan Losses The allowance for loan losses is based upon management's knowledge and review of the loan portfolio. Estimation of the adequacy of the allowance involves exercise of judgement, use of assumptions with respect to present economic conditions and knowledge of the environment in which the Banks operate. Among the factors considered in determining the level of the allowance are changes in composition of the loan portfolio, amounts of delinquent and nonaccrual loans, past loan loss experience and the value of collateral securing the loans. (g) Foreclosed Real Estate The components of foreclosed real estate are adjusted to the lower of cost or fair value less estimated costs of disposal. The current year provision for a valuation allowance has been recorded as an expense to current operations. 38 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED): (h) Bank Premises and Equipment Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is charged to income over the estimated useful lives of the assets using a combination of the straight-line and accelerated methods. The ranges of the useful lives of bank premises and equipment are as follows: Buildings and Improvements 15 - 40 years Furniture and Equipment 5 - 15 years Maintenance, repairs, renewals, and minor improvements are charged to operations as incurred. Gains and losses on routine dispositions are reflected in other income or expense. (i) Income Taxes Amounts provided for income tax expense are based on income reported for financial statement purposes rather than amounts currently payable under federal and state tax laws. Deferred taxes, which arise principally from differences between the period in which certain income and expenses are recognized for financial accounting purposes and the period in which they affect taxable income, are included in the amounts provided for income taxes. (j) Per Share Calculations Earnings per share are based on the weighted average number of shares outstanding. In the third quarter of 2002, the Company declared a stock split in the form of dividend. Prior period per share amounts, including earnings per share, dividends per share, book value per share, and market price have been adjusted to reflect this split. (k) Comprehensive Income Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities and accrued pension liabilities, are reported along with net income as the components of comprehensive income. NOTE 3 CASH AND DUE FROM BANKS: The Banks are required to maintain average reserve balances based on a percentage of deposits. The Banks have generally met this requirement through average cash on hand and balances with their correspondent institutions. 39 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 4 SECURITIES: The carrying amount and estimated fair value of securities are as follows: Carrying Unrealized Unrealized Fair Amount Gains Losses Value --------------------------------------------------- Held to Maturity December 31, 2002 Mortgage-backed $ 4,285 $ $ $ 4,285 State and municipals 1,364,827 82,441 1,447,268 --------- -------- -------- --------- Total Securities Held to Maturity $1,369,112 $ 82,441 $ $1,451,553 ========= ======== ======== ========= December 31, 2001 Mortgage-backed $ 6,022 $ 422 $ $ 6,444 State and municipals 1,597,371 35,153 1,632,524 --------- -------- -------- --------- Total Securities Held to Maturity $1,603,393 $ 35,575 $ $1,638,968 ========= ======== ======== ========= Available for Sale December 31, 2002 U. S. Treasuries and Agencies $8,844,027 $ 116,835 $ $8,960,862 Mortgage-backed 5,410,267 171,891 5,582,158 State and municipals 4,238,055 111,515 4,349,570 Marketable equities 33,585 3,471 30,114 Corporate obligations 4,506,319 67,016 4,573,335 ----------- -------- ------------ -------- Total Securities Available for Sale $23,032,253 $ 467,257 $ 3,471 $23,496,039 ========== ======== ======== ========== December 31, 2001 U. S. Treasuries and Agencies $10,562,796 $ 197,676 $ $10,760,472 Mortgage-backed 6,527,396 81,347 6,608,743 State and municipals 6,318,613 65,393 3,505 6,380,501 Marketable equities 42,206 3,106 39,100 Corporate obligations 5,560,038 111,263 5,671,301 --------- -------- -------- --------- Total Securities Available for Sale $29,011,049 $ 455,679 $ 6,611 $29,460,117 ========== ======== ======== ========== 40 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 4 SECURITIES (CONTINUED): The carrying amount and fair value of debt securities at December 31, 2002, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities Held to Maturity Fair Cost Value ---- ----------- Due in one year or less $ 0 $ 0 Due after one year through five years 1,364,827 1,447,268 Due after five years through ten years 0 0 Mortgage-backed securities 4,285 4,285 --------- --------- Total Held to Maturity $1,369,112 $1,451,553 ========= ========= Securities Available for Sale Fair Cost Value ---- ----------- Due in one year or less $12,809,523 $ 12,954,848 Due after one year through five years 4,378,878 4,503,513 Due after five years through ten years 255,000 274,781 Due after ten years 145,000 150,625 Mortgage-backed securities 5,410,267 5,582,158 ---------- ----------- Total Fixed Rate Securities 22,998,668 23,465,925 Equities 33,585 30,114 ---------- ----------- Total Available for Sale $23,032,253 $ 23,496,039 ========== =========== The carrying amounts (which approximate market value) of securities pledged by the banks to primarily secure deposits amounted to $6,035,000 at December 31, 2002 and $4,963,000 at December 31, 2001. There were no holdings totaling more than 10% of stockholders' equity with any issuer as of December 31, 2002 and 2001. All gains and losses arose from the sale of securities available for sale. There were no sales of securities in 2001 or 2002. In 2000, the company experienced a gain of $103,870 on sales of securities. 41 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 5 LOANS: Loans outstanding as of December 31 are summarized as follows: 2002 2001 Commercial $ 47,089,188 $ 42,204,159 Real estate construction 6,813,000 3,868,000 Real estate mortgages 121,557,830 111,668,376 Consumer installment 50,350,956 47,926,399 ----------- ----------- Subtotal 225,810,974 205,666,934 Unearned interest (56,750) (197,786) ----------- ----------- Total Loans $225,754,224 $205,469,148 =========== =========== NOTE 6 ALLOWANCE FOR LOAN LOSSES: A summary of changes in the allowance for loan losses for the years ended December 31 is shown in the following schedule: 2002 2001 2000 ---- ---- ---- Balance at beginning of year $ 1,602,536 $1,492,936 $ 1,318,332 Allowance relating to loans acquired in purchase 86,873 Provision charged to operating expenses 820,000 600,000 500,000 Loan recoveries 151,227 209,552 102,873 Loans charged off (780,418) (699,952) (515,142) ---------- --------- ---------- Balance at end of year $1,793,345 $1,602,536 $ 1,492,936 ========= ========= ========== Percentage of outstanding loans .79% .78% .79% 42 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 7 BANK PREMISES AND EQUIPMENT: Bank premises and equipment as of December 31 are summarized as follows: 2002 2001 ---- ---- Land $ 1,137,485 $ 1,137,485 Buildings and improvements 6,165,529 6,400,610 Furniture and equipment 3,670,567 3,644,925 ---------- ---------- Total cost 10,973,581 11,183,020 Less - accumulated depreciation (4,100,274) (4,127,380) ----------- ---------- Net Book Value $ 6,873,307 $ 7,055,640 ========== ========== Provisions for depreciation of $ 525,685 in 2002, $523,626 in 2001 and $447,697 in 2000 were charged to operations. NOTE 8 DEPOSITS: At December 31, 2002, the scheduled time deposit maturities are as follows: 2003 $106,197,392 2004 21,875,679 2005 11,538,659 2006 5,860,508 2007 12,819,348 ----------- Total $158,291,586 =========== NOTE 9 LONG TERM DEBT: The Company has borrowed money from the Federal Home Loan Bank of Pittsburgh (FHLB). The interest rates on all of the notes payable as of December 31, 2002 were fixed at the time of the advance and fixed rates range from 3.94% to 6.85%. The weighted average interest rate is 5.16% at December 31, 2002. The company has total borrowing capacity from the FHLB of $89,360,000. The debt is secured by the general assets of the Banks. Repayments of long term debt are due either monthly or quarterly. Interest expense of $210,231, $211,827, and $212,054 was incurred on these debts in 2002, 2001, and 2000, respectively. The maturities of long term debt as of December 31, 2002 are as follows: 2003 $ 459,510 2004 618,715 2005 341,450 2006 354,257 2007 367,790 Thereafter 1,887,860 ----------- Total $ 4,029,582 =========== 43 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 10 INCOME TAX EXPENSE: The components of income tax expense for the years ended December 31, are summarized as follows: 2002 2001 2000 ------------------------------------ Current Expense Federal $ 1,104,987 $ 968,401 $ 953,961 State 238,361 110,119 196,653 ---------- --------- -------- Total Current Expense 1,343,348 1,078,520 1,150,614 ---------- --------- -------- Deferred Expense (Benefit) Federal (93,744) (15,690) 16,431 State (9,826) (1,371) 1,579 ----------- --------- -------- Total Deferred Expense (Benefit) (103,570) (17,061) 18,010 ---------- --------- ---------- Income Tax Expense $ 1,239,778 $1,061,459 $1,168,624 ========== ========= ========= Income expense (benefits) relating to security transactions are as follows: $ 0 $ 0 $ 38,432 The deferred tax effects of temporary differences for the years ended December 31are as follows: 2002 2001 2000 ---- ---- ---- Tax effect of temporary differences: Provision for loan losses $ (57,117) $ 37,802 $(12,874) Sale of loans 14,346 (28,271) 3,693 Pension expense (16,584) (31,690) (24,694) Depreciation 41,065 47,406 52,928 Deferred compensation (59,090) (57,251) (38,471) Basis of securities sold 75,369 Miscellaneous (26,190) 14,943 (37,941) -------- --------- --------- Net (increase) decrease in deferred income tax benefit $(103,570) $(17,061) $ 18,010 ======== ======= ======= 44 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 10 INCOME TAX EXPENSE (CONTINUED): The net deferred tax assets arising from temporary differences as of December 31 are summarized as follows: 2002 2001 Deferred Tax Assets: Provision for loan losses $ 484,928 $ 419,951 Insurance commissions 40,820 32,130 Sale of loans 16,070 31,183 Deferred compensation 216,386 146,232 Pension obligation 42,558 Other 19,481 12,228 -------- -------- Total Assets 820,243 641,724 -------- -------- Deferred Tax Liabilities: ------------------------- Unrealized gain on securities available for sale 171,921 166,157 Accretion income 17,217 19,571 Other liabilities 10,530 28,471 Property basis differences 398,862 346,166 -------- -------- Total Liabilities 598,530 560,365 -------- -------- Net Deferred Tax Asset $ 221,713 $ 81,359 ======== ======== The following table summarizes the difference between income tax expense and the amount computed by applying the federal statutory income tax rate for the years ended December 31: 2002 2001 2000 ---- ---- ---- Amounts at federal statutory rates $ 1,313,660 $ $1,205,199 $1,206,848 Additions (reductions) resulting from: Tax-exempt income (115,818) (102,365) (82,259) Partially exempt income (30,158) (28,142) (36,606) State income taxes, net 132,934 105,278 115,964 Income from life insurance contracts (89,317) (97,014) (71,798) State income tax adjustment (30,000) 30,000 Other 28,477 8,503 6,475 ---------- --------- --------- Income tax expense $ 1,239,778 $1,061,459 $1,168,624 ========== ========== =========== 45 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 11 EMPLOYEE BENEFITS: The Company's two subsidiary banks each have separate retirement and profit sharing plans which cover substantially all full time employees at each bank. The Capon Valley Bank has a defined contribution pension plan with 401(k) features that is funded with discretionary contributions by the Company. The bank matches on a limited basis the contributions of the employees. Investment of employee balances is done through the direction of each employee. The Grant County Bank is a member of the West Virginia Bankers' Association Retirement Plan. Benefits under the plan are based on compensation and years of service with 100% vesting after seven years of service. Prior to 2002, the Plan's assets were in excess of the projected benefit obligations and thus the Bank was not required to make contributions to the Plan in 2002, 2001 or 2000. Due to the inability of the investment portfolio to achieve its expected return, the Bank has accrued additional liabilities of $163,000 at December 31, 2002. This has resulted in a decline in other comprehensive income of $72,000 (which is net of an income tax effect of $43,000) and an intangible asset of $48,000. The amounts of the accrued liability and the net pension expense reflected in operations are not significant. In addition, The Grant County Bank also maintains a profit sharing plan covering substantially all employees to which contributions are made at the discretion of the Board of Directors. The Company has established an employee stock ownership plan which will provide stock ownership to all employees of the Company. The Plan provides total vesting upon the attainment of seven years of service. Contributions to the plan are made at the discretion of the Board of Directors and are allocated based on the compensation of each employee relative to total compensation paid by the Company. All shares held by the Plan are considered outstanding in the computation of earnings per share. Shares of Company stock, when distributed, will have restrictions on transferability. Employer contributions related to the above benefit plans charged to operations totaled $231,607 in 2002, $234,455 in 2001 and $266,601 in 2000. NOTE 12 INVESTMENT IN LIFE INSURANCE CONTRACTS: The Company has invested in and owns life insurance polices on key officers. The policies are designed so that the company recovers the interest expenses associated with carrying the polices and the officer will, at the time of retirement, receive any earnings in excess of the amounts earned by the Company. The following is a summary of the activity relating to this investment: 2002 2001 2000 ---- ---- ---- Gross policy income $ 256,071 $ 262,413 $ 209,107 Insurance expense (18,297) (16,454) (16,465) -------- -------- --------- Net 237,774 245,959 192,642 Amounts earned by the company (113,413) (166,646) (121,068) --------- -------- ---- Deferred compensation for officers $ 124,361 $ 79,313 $ 71,574 ======== ======== ======== NOTE 13 RESTRICTIONS ON DIVIDENDS OF SUBSIDIARY BANKS: The principal source of funds of Highlands Bankshares, Inc. is dividends paid by subsidiary banks. The various regulatory authorities impose restrictions on dividends paid by a state bank. A state bank cannot pay dividends (without the consent of state banking authorities) in excess of the total net profits of the current year and the combined retained profits of the previous two years. As of January 1, 2003, the banks could pay dividends to Highlands Bankshares, Inc. of approximately $411,000 without permission of the regulatory authorities. 46 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 14 TRANSACTIONS WITH RELATED PARTIES: During the year, officers and directors (and companies controlled by them) were customers of and had transactions with the subsidiary Banks in the normal course of business. These transactions were made on substantially the same terms as those prevailing for other customers and did not involve any abnormal risk. The aggregate payoff amount of loans to related parties of $2,240,150 at December 31, 2001 was increased during 2002 $1,084,663 as a result of new loans and reduced $950,553 by payments. The ending balance of loans to related parties was $2,374,260 at December 31, 2002. NOTE 15 COMMITMENTS AND GUARANTEES: The Banks make commitments to extend credit in the normal course of business and issued standby letters of credit to meet the financing needs of their customers. The amount of the commitments represents the Banks' exposure to credit loss that is not included in the balance sheet. As of the balance sheet dates, the Banks had outstanding the following commitments: 2002 2001 Commitments to extend credit $12,029,000 $ 8,991,000 Standby letters of credit 204,000 252,000 The Banks use the same credit policies in making commitments and issuing letters of credit as it does for the loans reflected in the balance sheet. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Banks evaluate each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Banks upon extension of credit, is based on management's credit evaluation of the borrower. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment. 47 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 16 CONCENTRATIONS: The Banks grant commercial, residential real estate and consumer loans to customers located primarily in the eastern portion of the State of West Virginia. Although the Banks have a diversified loan portfolio, a substantial portion of the debtors' ability to honor their contracts is dependent upon the agribusiness economic sector. Collateral required by the Banks is determined on an individual basis depending on the purpose of the loan and the financial condition of the borrower. The ultimate collectibility of the loan portfolios is susceptible to changes in local economic conditions. Approximately 57% of the loan portfolio is secured by real estate. See note 5 for a complete breakdown of loans by type. The Banks had cash deposited in and federal funds sold to other commercial banks totaling $24,166,439 and $22,772,450 at December 31, 2002 and 2001, respectively. NOTE 17 DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS: The fair value of the Company's assets and liabilities is influenced heavily by market conditions. Fair value applies to both assets and liabilities, either on or off the balance sheet. Fair value is defined as the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash, Due from Banks and Money Market Investments The carrying amount of cash, due from bank balances, interest bearing deposits and federal funds sold is a reasonable estimate of fair value. Securities Fair values of securities are based on quoted market prices or dealer quotes. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Loans The fair value of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities, taking into consideration the credit risk in various loan categories. Deposits The fair value of demand, interest checking, regular savings and money market deposits is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. Long Term Debt The fair value of fixed rate loans is estimated using the rates currently offered by the Federal Intermediate Credit Bank for indebtedness with similar maturities. Interest Payable and Receivable The carrying value of amounts of interest receivable and payable is a reasonable estimate of fair value. 48 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 17 DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED): Life Insurance Contracts The carrying amount of life insurance contracts is assumed to be a reasonable fair value. Life insurance contracts are carried on the balance sheet at their redeemable value as of December 31, 2002. This redeemable value is based on existing market conditions and therefore represents the fair value of the contract. Off-Balance-Sheet Items The carrying amount and estimated fair value of off-balance-sheet items were not material at December 31, 2002. The carrying amount and estimated fair values of financial instruments as of December 31 are as follows: 2002 2001 ---- ---- Estimated Estimated Carrying Fair Carrying Fair Amount Value Amount Value ------------ ----------------------------------- Financial Assets: Cash and due from banks $ 8,226,301 $ 8,226,301 $6,492,361 $6,492,361 Interest bearing deposits 4,499,666 4,499,666 6,333,551 6,333,551 Federal funds sold 14,625,342 14,625,342 13,284,408 13,284,408 Securities held to maturity 1,369,112 1,451,553 1,603,393 1,638,968 Securities available for sale 23,496,039 23,496,039 29,460,117 29,460,117 Other investments 671,811 671,811 791,650 791,650 Loans, net 223,960,879 223,471,173 203,866,612 204,748,161 Interest receivable 1,821,476 1,821,476 1,817,884 1,817,884 Life insurance contracts 5,338,036 5,338,036 5,100,262 5,100,262 Financial Liabilities: Demand and savings deposits 99,220,685 99,220,685 85,403,920 85,403,920 Term deposits 158,291,586 159,022,847 156,637,748 158,647,902 Long term debt 4,029,582 4,117,444 4,523,442 4,477,891 Interest payable 849,472 849,472 848,606 848,606 49 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 18 REGULATORY MATTERS: The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Company's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). The Company meets all capital adequacy requirements to which it is subject and as of the most recent examination, the Company was classified as well capitalized. To be categorized as well capitalized the Company must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events that management believes have changed the Company's category from a well capitalized status. The Company's actual capital ratios are presented in the following table: Actual Regulatory Requirements December Adequately Well 2002 2001 Capitalized Capitalized Total risk-based ratio 14.03% 14.46% 8.00% 10.00% Tier 1 risk-based ratio 13.20% 13.66% 4.00% 6.00% Total assets leverage ratio 9.75% 10.06% 4.00% 5.00% Capital ratios and amounts are applicable both at the individual bank level and on a consolidated basis. At December 31, 2002, both subsidiary banks had capital levels in excess of minimum requirements. As such, both banks qualified as "well capitalized banks" for FDIC insurance purposes and thus were charged the minimum rate for insurance coverage. In addition, Highlands Bankshares Trust Company and HBI Life Insurance Company are subject to certain capital requirements. At present, both companies are well within any capital limitations and no conditions or events have occurred to change this capital status, nor does management except any such occurrence in the foreseeable future. 50 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 19 CHANGES IN OTHER COMPREHENSIVE INCOME The components of change in other comprehensive income and related tax effects are as follows: Years Ended December 31, 2002 2001 2000 ---- ---- ---- Beginning balance January 1 $ 282,910 $ 38,761 $ (246,250) Unrealized holding gains on available-for-sale securities net of income taxes of $205,819 350,449 Unrealized holding gains on available-for-sale securities net of income taxes of $143,388 244,149 Unrealized holding gains on available-for-sale securities net of income taxes of $5,143 9,575 Reclassification adjustment for gains on securities transactions, net of income taxes of $38,432 (65,438) Accrued pension obligation net of income taxes of $42,558 (72,463) -------- -------- -------- Net change for the year (62,888) 244,149 285,011 -------- -------- -------- Ending balance December 31 $ 220,022 $ 282,910 $ 38,761 ========== ========== ========== 51 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 20 PARENT CORPORATION ONLY FINANCIAL STATEMENTS: BALANCE SHEETS Assets December 31, 2002 2001 Cash $ 122,102 $ 102,141 Investment in subsidiaries 28,759,210 28,128,103 Other investments 15,304 Other assets 39,554 26,965 Income taxes receivable 251,826 208,372 --------- --------- Total Assets $29,172,692 $28,480,885 ========== ========== Liabilities Accrued expenses $ 8,735 $ 2,315 Due to subsidiaries 247,631 168,603 --------- --------- Total Liabilities 256,366 170,918 --------- --------- Stockholders' Equity Common stock, par value $5 per share 3,000,000 shares authorized, 1,436,874 shares issued in 2002 and 546,764 shares issued in 2001 $7,184,370 $2,733,820 Surplus 1,661,987 1,661,987 Retained earnings 19,849,947 24,623,951 Other accumulated comprehensive income 220,022 282,910 --------- --------- 28,916,326 29,302,668 Less treasury stock (at cost, 44,866 shares in 2001) (992,701) --------- --------- Total Stockholders' Equity 28,916,326 28,309,967 ---------- ---------- Total Liabilities and Stockholders' Equity $29,172,692 $28,480,885 ========== ========== 52 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 20 PARENT CORPORATION ONLY FINANCIAL STATEMENTS (CONTINUED): STATEMENTS OF INCOME AND RETAINED EARNINGS Years Ended December 31, 2002 2001 2000 ---- ---- ---- Income Dividends from subsidiaries $2,137,042 $3,063,877 $ 722,354 Other income 480 -------- -------- -------- Total $2,137,522 $3,063,877 $ 722,354 ---------- ---------- --------- Expenses Salary and benefits expense $ 190,239 $ 169,325 $ Professional fees 36,330 34,413 48,988 Directors' fees 43,051 40,550 32,650 Other expenses 70,296 70,120 31,172 -------- -------- -------- Total $ 339,916 $ 314,408 $ 112,810 ---------- ---------- --------- Net income before income tax benefit and undistributed income (deficit) of subsidiaries $1,797,606 $2,749,469 $ 609,544 Income tax benefit 132,536 112,779 43,006 -------- --------- -------- Income before undistributed income (deficit) of subsidiaries 1,930,142 2,862,248 652,550 Undistributed income (deficit) of Subsidiaries 693,996 (381,463) 1,728,361 -------- -------- --------- Net Income $2,624,138 $2,480,785 $2,380,911 --------- --------- --------- Retained earnings, Beginning of period 24,623,951 22,825,747 21,067,191 Dividends paid in cash (737,836) (682,581) (622,355) Stock split paid in stock (4,789,580) Treasury stock retired (1,870,726) Net Income 2,624,138 2,480,785 2,380,911 --------- ----------- -------- Retained Earnings, End of Period $19,849,947 $24,623,951 $22,825,747 ========== ========== ======= 53 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 20 PARENT CORPORATION ONLY FINANCIAL STATEMENTS (CONTINUED): STATEMENTS OF CASH FLOWS Years Ended December 31, 2002 2001 2000 Cash Flows from Operating Activities: Net income $2,624,138 $2,480,785 $2,380,911 Adjustments Undistributed subsidiary (income) deficit (693,996) 381,463 (1,728,361) Depreciation 1,609 397 446 Loss on investment 15,304 Increase (decrease) in payables 85,448 (35,584) 153,220 (Increase) decrease in receivables (43,454) 29,587 (124,691) Increase in other assets (14,197) (4,411) --------- -------- ------ Net Cash Provided by Operating Activities 1,974,852 2,852,237 681,525 --------- --------- -------- Cash Flows from Investing Activities: Investment in subsidiaries (2,143,577) Other investments (5,000) (12,584) -------- ---------- ------- Net Cash Used in Investing Activities (2,148,577) (12,584) Cash Flows from Financing Activities: Purchase of treasury stock (1,217,055) Dividends paid (737,836) (682,581) (622,355) --------- -------- ------- Net Cash Used in Financing Activities (1,954,891) (682,581) (622,355) ---------- --------- ------- Net Increase in Cash 19,961 21,079 46,586 Cash, Beginning of Year 102,141 81,062 34,476 -------- -------- -------- Cash, End of Year $ 122,102 $ 102,141 $ 81,062 ======== ======== ======== 54 INDEPENDENT AUDITORS' REPORT The Stockholders and Board of Directors Highlands Bankshares, Inc. Petersburg, West Virginia We have audited the accompanying consolidated balance sheets of Highlands Bankshares, Inc. and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the years in the three year period ended December 31, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with U.S. generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Highlands Bankshares, Inc. and subsidiaries as of December 31, 2002 and 2001, and the consolidated results of their operations and their cash flows for each of the years in the three year period ended December 31, 2002, in conformity with U.S. generally accepted accounting principles. /s/ S. B. Hoover & Company, L.L.P. January 31, 2003 Harrisonburg, Virginia Members of the American Institute of Certified Public Accountants and Virginia Society of Certified Public Accountants 55 MANAGEMENT'S DISCUSSION AND ANALYSIS HIGHLANDS BANKSHARES, INC. Results of Operations The Company produced another year of increased earnings in 2002. Despite decreases in loan interest rates, net interest margin increased from 2001, more than offsetting the costs of expanded operations. Net income increased 5.77% from $2.48 million in 2001 to $2.62 million in 2002. Total assets grew $15.57 million, a 5.63% increase. Loan demand remained strong with net loans increasing 9.86%. Loan growth was primarily funded through deposit growth and reductions in securities balances. Deposits increased $15.47 million from December 31, 2001 to December 31, 2002, with the largest increases being in transaction and savings accounts. A low interest rate environment appears to have made customers reluctant to place money in longer term time deposits and as a result time deposit balances grew at a modest 1.06%, while transaction and saving deposits increasing 16.18%. Deposit amounts increased at a greater rate during the second half of 2002, with the funds from deposits being placed by Highlands subsidiary banks in highly liquid cash and Federal Funds Sold balances in anticipation of continued strong loan demand. An increased provision for loan losses reflects a higher level of loans outstanding and management's belief that a slowing economy could result in some credit deterioration. Holdings of Other Real Estate Owned increased $458,800 due primarily to foreclosures on two properties. It is management's belief that these properties can be disposed of at or near their carrying value with no adverse effect on the Company's capital. Net interest income after the provision for loan loss rose $887,000 to $10.45 Million--an increase of 9.28%. Non interest income also rose 9.17% from 2001 to 2002. The growth in assets and deposits drove an increase in non-interest operational expenditures of 9.36%, with employee expense increasing 7.41% and data processing expense increasing 8.58%. Over recent years, Highlands Bankshares has taken steps to position itself for future earnings potential. Changes in West Virginia's state laws were revised in 2000 to allow trust operations within the subsidiary banks to be consolidated into one trust operation within Highlands Bankshares Trust Company. Highlands Bankshares Trust Company finished its second year of operations in 2002 with a 66% increase in trust fee revenue over 2001. Highlands' subsidiary banks, Capon Valley Bank and The Grant County Bank have over the last 5 years added branches in Baker, Harman and Moorefield, West Virginia and in Gore, Virginia. As of December 31, 2002, deposits in these branches comprised 12.18% of total deposits, and 43% of the growth in deposits from December 31, 1997 to December 31, 2002 came from these branches. As growth continues, we expect further operational economies of scale to be obtained, resulting in an increased return to shareholders. During 2002, there were changes to the management of Highlands Bankshares and The Grant County Bank. In May, D. Richardson II resigned his position as internal auditor of the holding company and became Chief Financial Officer of The Grant County Bank. In August, Alan Miller joined the holding company as Finance Officer. On December 31, 2002, Edgel Liller retired as Vice President & Cashier of The Grant County Bank after 18 years of service. Highlands Bankshares experienced record profitability during 2002 and we anticipate 2003 being another successful year. A slowing economy and a depressed interest rate environment leave us with many challenges. We are keeping a close eye on the Federal Reserve Bank regarding interest rate changes and feel that since most of our loans and many of our securities have adjustable rates, we are positioned favorably in an environment of changing interest rates. Certain localities within our primary area of operations have experienced recent economic downturns. However, with banking locations in six counties we feel that a level of diversity is achieved to minimize the impact of adverse changes in local economies. 56 MANAGEMENT'S DISCUSSION AND ANALYSIS HIGHLANDS BANKSHARES, INC. Results of Operations (Continued) Capital Adequacy Total stockholders' equity increased by 2.14% at December 3, 2002 compared to levels at December 31, 2001. This increase was not as high as recent years as we repurchased over $1.2 Million worth of shares on the open market and subsequently retired all shares of treasury stock in an effort to increase shareholder value. Recent rate declines have caused increases in the value of the available for sale portfolio and this has increased stockholder's equity by $9,574. Conversely, market fluctuations contributed to declines in asset values in the portfolio of the pension plan in which The Grant County Bank participates resulting in a decrease in stockholders' equity of $72,463. Our primary capital to asset ratio remains an excellent 9.89% and this compares favorably with our peers. The increased earnings for 2002 and our excellent capital position allowed us to increase dividends paid to stockholders by 11.82%, which represents the eleventh consecutive year of dividend increases. The retention of earnings from profitable operations allows the company to meet the needs of growing communities without the sale of additional stock. The company's Tier I capital to risk based asset ratio at December 31, 2002 was 13.20% compared to a regulatory minimum of 8.00%. The company has never experienced a problem with capital adequacy and does not anticipate any in the foreseeable future. Liquidity The company provides liquidity through the management of cash, federal funds sold, interest bearing bank deposits and short term investment securities. In addition, lines of credit with correspondent banks, the Federal Reserve Bank and the Federal Home Loan Bank of Pittsburgh exist to help manage short term liquidity needs although such lines are rarely utilized. The company's core deposits are very large and thus it has not had to aggressively pursue large deposits, which can be unstable. In the judgment of management, liquidity has not been a problem in prior periods and should not be one in the foreseeable future. 57 MANAGEMENT'S DISCUSSION AND ANALYSIS HIGHLANDS BANKSHARES, INC. Common Stock Performance and Dividends The Company is not traded on any national or regional stock exchange although brokers in Cumberland, Maryland, Winchester and Harrisonburg, Virginia may occasionally initiate or be a participant in a trade. Terms of an exchange between individual parties may not be known to the Company. The following table shows the market prices of the Company's stock based on prices disclosed to management. During the third quarter of 2002, the Company initiated a 200% stock dividend. Share prices for the first and second quarters of 2002 and for 2001 have been adjusted to account for this stock split effected in the form of dividend. Dividends Market Price Range 2002 Per Share High Low ---- --------- ---- --- First Quarter .12 18.46 15.92 Second Quarter .12 18.67 16.75 Third Quarter .1300 18.50 17.03 Fourth Quarter .1300 21.51 18.50 Dividends Market Price Range 2001 Per Share High Low ---- --------- ---- --- First Quarter .1133 17.00 15.67 Second Quarter .1133 16.67 15.71 Third Quarter .1133 16.75 15.92 Fourth Quarter .1133 16.67 15.53 General Information Stock transfers and inquiries should be addressed to our transfer agent at: Registrar and Transfer Company 10 Commerce Drive Cranford, New Jersey 07016-3572 Telephone: 1-800-368-5948 A copy of the Company's annual Form 10-K which is filed with the Securities and Exchange Commission may be obtained, without charge, upon written request to Treasurer of the Company at its headquarters. Such information will be available after March 31, 2003. Requests should be directed to: R. Alan Miller Finance Officer Highlands Bankshares, Inc. P. O. Box 929 Petersburg, WV 26847 58 Item 9. Changes in and Disagreements with Accountants on Accounting and ------- --------------------------------------------------------------------- Financial Disclosure None Part III Item 10. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act We are incorporating the Proxy Statement of Highlands Bankshares, Inc. via Form DEF 14A filed March 5, 2003. Item 11. Executive Compensation We are incorporating the Proxy Statement of Highlands Bankshares, Inc. via Form DEF 14A filed March 5, 2003. Item 12. Security Ownership of Certain Beneficial Owners and Management We are incorporating the Proxy Statement of Highlands Bankshares, Inc. via Form DEF 14A filed March 5, 2003. Item 13. Certain Relationships and Related Transactions We are incorporating the Proxy Statement of Highlands Bankshares, Inc. via Form DEF 14A filed March 5, 2003. Most of the directors, partnerships of which they may be general partners and corporations of which they are officers or directors, maintain normal banking relationships with the Bank. Loans made by the Bank to such persons or other entities were made only in the ordinary course of business, were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons, and did not involve more than normal risk of collectibility or present other unfavorable features. See Note 14 of the consolidated financial statements. John VanMeter is a partner with the law firm of VanMeter and VanMeter, which has been retained by the Company as legal counsel and it is anticipated that the relationship will continue. Jack H. Walters is a partner with the law firm of Walters & Krauskopf, which provides legal counsel to the Company and it is anticipated that the relationship will continue. Item 14. Controls and Procedures Evaluation of Disclosure Controls and Procedures ------------------------------------------------ . As a result of the enactment of the Sarbanes-Oxley Act of 2002, issuers such as Highlands Bankshares, Inc. that file periodic reports under the Securities Exchange Act of 1934 (the "Act") are now required to include in those reports certain information concerning the issuer's controls and procedures for complying with the disclosure requirements of the federal securities laws. Under rules adopted by the Securities and Exchange Commission effective August 29, 2002, these disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports it files or submits under the Act, is communicated to the issuer's management, including its principal executive officer or officers and principal financial officer or officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. We have established our disclosure controls and procedures to ensure that material information related to Highlands Bankshares, Inc. is made known to our principal executive officers and principal finance officer on a regular basis, in particular during the periods in which our quarterly and annual reports are being prepared. These disclosure controls and procedures consist principally of 59 Evaluation of Disclosure Controls and Procedures (Continued) communications between and among the President and the Finance Officer, and the other executive officers of Highlands Bankshares, Inc. and its subsidiaries to identify any new transactions, events, trends, contingencies or other matters that may be material to the Company's operations. As required, we will evaluate the effectiveness of these disclosure controls and procedures on a quarterly basis, and most recently did so as of January 31, 2003, a date within 90 days prior to the filing of this quarterly report. Based on this evaluation, the management of Highlands Bankshares, Inc., including the Finance Officer, concluded that such disclosure controls and procedures were operating effectively as designed as of the date of such evaluation. Changes in Internal Controls During the period reported upon, there were no significant changes in the internal controls of Highlands Bankshares, Inc. pertaining to its financial reporting and control of its assets or in other factors that could significantly affect these controls Part IV Item 15. Exhibits and Reports on Form 8-K a) Exhibits Exhibit No. Description 2 Not applicable 3 (i) Articles of Incorporation of Highlands Bankshares, Inc. are incorporated by reference to Appendix C to Highlands Bankshares, Inc.'s Form S-4 filed October 20, 1986. Amendments to the original Articles of Incorporation are incorporated by reference; filed as Exhibit 3(i) with 1997 10-KSB. 3 (ii) Bylaws of Highlands Bankshares, Inc. are incorporated by reference to Appendix D to Highland Bankshares, Inc.'s Form S-4 filed October 20, 1986. Amendments to the original Bylaws are incorporated by reference; filed as Exhibit 3(ii) with 1997 10-KSB 4 Not applicable 9 Not applicable 10 Not applicable 11 Not applicable 60 Item 15. Exhibits and Reports on Form 8-K (Continued) a) Exhibits (Continued) -------------------- Exhibit No. Description 12 Not applicable 16 Not applicable 18 Not applicable 21 Subsidiary listing of the Registrant is attached on Page 67 22 Not applicable 23 Consent of Certified Public Accountant attached on Page 68 24 Not applicable 28 Not applicable b) Reports on Form 8-K No reports on Form 8-K were filed in the fourth quarter of 2002. 61 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HIGHLANDS BANKSHARES, INC. By /s/ LESLIE A. BARR --------------------------------- Leslie A. Barr President, Chief Executive Officer Date March 26, 2003 ------------------------- By /s/ R. ALAN MILLER ------------------------------ R. Alan Miller Finance Officer Date March 26, 2003 ------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and as of the date indicated. Signature Title Date /s/ LESLIE A. BARR March 26, 2003 --------------------------- -------------- Leslie A. Barr President & Chief Executive Officer Director /s/ ALAN L. BRILL March 26, 2003 --------------------------- -------------- Alan L. Brill Secretary Kathy G. Kimble Director Steven C. Judy Director /s/ THOMAS B. MCNEIL, SR. March 26, 2003 --------------------------- -------------- Thomas B. McNeil, Sr. Director /s/ CLARENCE E. PORTER March 26, 2003 --------------------------- -------------- Clarence E. Porter Treasurer /s/ COURTNEY R. TUSING March 26, 2003 --------------------------- -------------- Courtney R. Tusing Director /s/ JOHN G. VANMETER March 26, 2003 --------------------------- -------------- John G. VanMeter Chairman of the Board Director /s/ JACK H. WALTERS March 26, 2003 --------------------------- -------------- Jack H. Walters Director L. Keith Wolfe Director 62 CERTIFICATION OF CHIEF EXECUTIVE OFFICER Pursuant to section 302 of the Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 USC Section 1350 (A) and (B) I, Leslie A. Barr, certify that: 1. I have reviewed this annual report on Form 10-K of Highlands Bankshares, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a).designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 26, 2003 ---------------------- /s/ LESLIE A. BARR ---------------------------------- Leslie A. Barr President 63 CERTIFICATION OF EXECUTIVE OFFICER Pursuant to section 302 of the Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 USC Section 1350 (A) and (B) I, Clarence E. Porter, certify that: 1. I have reviewed this annual report on Form 10-K of Highlands Bankshares, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a).designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 26, 2003 ------------------------- /s/ CLARENCE E. PORTER ---------------------------------- Clarence E. Porter Treasurer 64 CERTIFICATION OF EXECUTIVE OFFICER Pursuant to section 302 of the Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 USC Section 1350 (A) and (B) I, Alan L. Brill, certify that: 1. I have reviewed this annual report on Form 10-K of Highlands Bankshares, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a).designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. . Date: March 26, 2003 ----------------------- /s/ ALAN L. BRILL ---------------------------------- Alan L. Brill Secretary 65 CERTIFICATION OF CHIEF FINANCIAL OFFICER Pursuant to section 302 of the Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 USC Section 1350 (A) and (B) I, R. Alan Miller, certify that: 1. I have reviewed this annual report on Form 10-K of Highlands Bankshares, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a).designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 26, 2003 ------------------------- /s/ R. ALAN MILLER ---------------------------------- R. Alan Miller Finance Officer 66 Pursuant toss.906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C.ss.1350) The undersigned, as the Chief Executive Officer and Chief Financial Officer, respectively, of Highlands Bankshares Inc., certify that the Annual Report on Form 10-K for the period ended December 31, 2002, which accompanies this certification fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and the information contained in the periodic report fairly presents, in all material respects, the financial condition and results of operations of Highlands Bankshares Inc. at the dates and for the periods indicated. The foregoing certification is made pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss. 1350) and no purchaser or seller of securities or any other person shall be entitled to rely upon the foregoing certification for any purpose. The undersigned expressly disclaim any obligation to update the foregoing certification except as required by law. /s/ LESLIE A. BARR ------------------------- Leslie A. Barr Chief Executive Officer /s/ R. ALAN MILLER ------------------------- R. Alan Miller Finance Officer