10-K 1 hbi10k2003.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, 2003 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 registrant has (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X} No [ ] Indicate by check mark if disclosure of delinquent filers in response to Item 405 of Regulation S-K is not contained in this form, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Indicate by check mark whether the issuer is an accelerated filer (as defined in Rule 12b-2 of the Act). [ ] The aggregate market value of the 1,319,837 shares of Common Stock of the registrant issued and outstanding held by nonaffiliates on June 30, 2003 was approximately $ 34,381,754 based on the closing sales price of $ 26.05 per share on June 30, 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, 2004 - 1,436,874 DOCUMENTS INCORPORATED BY REFERENCE: Portions of the Registrant's Proxy Statement to be used in connection with the solicitation of proxies for the Registrant's 2004 Annual Meeting of Shareholders (the "Proxy Statement") are incorporated by reference in Part III of this Annual Report of Form 10-K (the "Form 10-K"). 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 Registrant's 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 7 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 25 Item 8. Financial Statements and Supplementary Data 30 Item 9. Changes in and Disagreement with Accountants on Accounting and Financial Disclosure 54 Item 9a. Controls and Procedures 54 Part III Item 10. Directors and Executive Officers of Registrant 54 Item 11. Executive Compensation 55 Item 12. Security Ownership of Certain Beneficial Owners and Management 55 Item 13. Certain Relationships and Related Transactions 55 Item 14. Principal Accounting Fees and Services 55 Part IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K 55 Signatures 57 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 and 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, 2003, The Grant County Bank had 61 full time equivalent employees, Capon Valley Bank had 47 full time equivalent employees, Highlands had two full time equipment employees and HBTC had one full time equivalent employee. No person is employed by HBI Life on a full time basis. Competition The banks' primary trade area is generally defined as Grant, Hardy, Mineral, Randolph, and the northern portion of Pendleton County in West Virginia, the western portion of Frederick County in Virginia and portions of Western Maryland. This area includes the cities of Petersburg, Wardensville, Moorefield and Keyser and several rural towns. The banks' secondary trade area includes portions of Hampshire County in West Virginia. The banks primarily compete with four state chartered banks and six national banks. In addition, the banks compete with money market mutual funds, credit unions and investment brokerage firms for deposits in their service area. No financial institution has been chartered in the area within the last five years although branches of state and nationally chartered banks have located in this area within this time period. Competition for new loans and deposits in the banks' service area is quite intense. 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 operations. 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. The Bank also has branch facilities in Harman, Moorefield, Keyser and Riverton, West Virginia which provide banking services in Randolph County, Hardy County, Mineral County, and northwest Pendleton County, respectively. The Riverton branch building is leased while all other locations are owned by the Bank. Capon Valley Bank has its main office in Wardensville, West Virginia and branch offices located in Moorefield and Baker, West Virginia and Gore, Virginia. Capon's offices serve mainly Hardy County and Hampshire County, West Virginia, with the Gore branch serving Frederick County, Virginia. All facilities 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, 2003. Part II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The Company had approximately 865 registered stockholders of record as of March 8, 2004. 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 initiated a 200% stock dividend. Share prices for the first and second quarters of 2002 have been adjusted to account for this stock split effected in the form of dividend. Dividends Market Price Range 2003 Per Share High Low ---- --------- ---- --- First Quarter .1400 26.50 21.60 Second Quarter .1400 26.25 25.50 Third Quarter .1400 31.00 26.05 Fourth Quarter .1400 31.00 29.00 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 6 Item 6. Selected Financial Data -----------Years Ending December 31,-------- (In Thousands Except for Share Amounts) 2003 2002 2001 2000 1999 Total Interest Income $18,283 $18,970 $20,207 $18,207 $16,243 Total Interest Expense 6,338 7,705 10,049 8,790 7,663 ----- ------ ------ ------ ------ Net Interest Income 11,945 11,265 10,158 9,417 8,580 Provision for Loan Losses 1,820 820 600 500 320 ----- ------ ------ ------ ------ Net Interest Income after Provision for Loan Losses 10,125 10,445 9,558 8,917 8,260 Other Income 1,367 1,304 1,194 1,263 1,026 Other Expenses 8,247 8,047 7,431 6,836 6,104 ----- ------ ------ ------ ------ Income before Income Taxes 3,245 3,702 3,321 3,344 3,182 Income Tax Expense 1,012 1,180 979 1,092 978 ----- ------ ------ ------ ------ Net Income $ 2,233 $ 2,522 $ 2,342 $ 2,252 $ 2,204 ====== ====== ====== ====== ====== Net Income Per Share* $ 1.55 $ 1.73 $ 1.56 $ 1.50 $ 1.46 Dividends Per Share* $ .56 $ .51 $ .45 $ .41 $ .39 Total Assets at Year End $301,168 $292,672 $277,042 $248,782 $220,587 ======= ======= ======= ======= ======= Return on Average Assets .73% .89% .89% .97% 1.02% Return on Average Equity 7.60% 8.87% 8.57% 8.89% 9.42% Dividend Payout Ratio 36.03% 29.26% 29.15% 27.64% 26.41% Year End Equity to Assets Ratio 9.81% 9.69% 10.06% 10.43% 10.90% *--Prior years' per share figures restated to reflect stock split effected in form of dividend in 2002. 7 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Policies The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The financial statements contained within these statements are, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of these transactions would be the same, the timing of events that would impact these transactions could change. Allowance for Loan Losses The allowance for loan losses is an estimate of the losses in the loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS No. 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The Company's allowance for loan losses is the accumulation of various components that are calculated based on independent methodologies. All components of the allowance represent an estimation performed pursuant to either SFAS No. 5 or SFAS No. 114. Management's estimate of each SFAS No. 5 component is based on certain observable data that management believes are most reflective of the underlying credit losses being estimated. This evaluation includes credit quality trends; collateral values; loan volumes; geographic, borrower and industry concentrations; seasoning of the loan portfolio; the findings of internal credit quality assessments and results from external bank regulatory examinations. These factors, as well as historical losses and current economic and business conditions, are used in developing estimated loss factors used in the calculations. Reserves for commercial loans are determined by applying estimated loss factors to the portfolio based on management's evaluation and "risk grading" of the commercial loan portfolio. Reserves are provided for noncommercial loan categories using estimated loss factors applied to the total outstanding loan balance of each loan category. Specific reserves are typically provided on all impaired commercial loans in excess of a defined threshold that are classified in the Special Mention, Substandard or Doubtful risk grades. The specific reserves are determined on a loan-by-loan basis based on management's evaluation the Company's exposure for each credit, given the current payment status of the loan and the value of any underlying collateral. While management uses the best information available to establish the allowance for loan and lease losses, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the valuations or, if required by regulators, based upon information available to them at the time of their examinations. Such adjustments to original estimates, as necessary, are made in the period in which these factors and other relevant considerations indicate that loss levels may vary from previous estimates. Post Retirement Benefits The Company has invested in and owns life insurance polices on key officers. The policies are designed so that the company recovers the interest expenses associated with carrying the polices and the officer will, at the time of retirement, receive any earnings in excess of the amounts earned by the Company. The Company recognizes as an asset the net amount that could be realized under the insurance contract as of the balance sheet date. This amount represents the cash surrender value of the policies less applicable surrender charges. The portion of the benefits which will be received by the executives at the time of their retirement is considered, when taken collectively, to constitute a retirement plan. Therefore the Company accounts for these policies using guidance found in Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Post Retirement Benefits Other Than Pensions." SFAS No. 106 requires that an employers' obligation under a deferred compensation agreement be accrued over the expected service life of the employee through their normal retirement date. 8 Post Retirement Benefits (Continued) Assumptions are used in estimating the present value of amounts due officers after their normal retirement date. These assumptions include the estimated income to be derived from the investments and an estimate of the Company's cost of funds in these future periods. In addition, the discount rate used in the present value calculation will change in future years based on market conditions. Recent Accounting Pronouncements No recent accounting pronouncements had a material impact on the Company's consolidated financial statements. Prior Period Adjustment See Footnote 3 of the financial statements (page 39 of this report) for a discussion of the prior period adjustment relating to post-retirement benefits. Forward Looking Statements Certain statements in this report may constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualified words (and their derivatives) such as "expect," "believe," "estimate," "plan," "project," or other future events. Although the Company believes that its expectations with respect to certain forward-looking statements are based upon reasonable assumptions within the bounds of its existing knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Actual future results and trends may differ materially from historical results or those anticipated depending on a variety of factors, including, but not limited to, the effects of and changes in: general economic conditions, the interest rate environment, legislative and regulatory requirements, competitive pressures, new products and delivery systems, inflation, changes in the stock and bond markets, technology, and consumer spending and savings habits. The Company does not update any forward-looking statements that may be made from time to time by or on behalf of the Company. Overview The Company experienced an 11.43% decrease in net income in 2003 as compared to 2002. Annual net income of $2,233,332 represents a return on average equity of 7.60% for 2003 compared to 8.87% for 2002. Return on average assets for 2003 and 2002 were .73% and .89%, respectively. Earnings per share decreased 10.40% from 2002 to 2003. Increases of $680,000 in net interest income and $63,000 in non-interest income were offset by increases in the provision for loan losses and an increase in non-interest expense. The most significant impact do earnings during 2003 was an increase in the provision for loan losses to $1,820,000 compared to $820,000 during 2002. Continued stagnant economic conditions, coupled with rising delinquency rates in the company's loan portfolio prompted an increase in the provision. The allowance for loan losses as a percent of gross loans was 1.09% at December 31, 2003 compared to .79% at December 31, 2002. Net Interest Margin 2003 compared to 2002 Net interest income increased 6.04% in 2003 compared to 2002. 9 Net Interest Margin (Continued) 2003 compared to 2002 (continued) Although reductions in target rates by the Federal Reserve Board (the "Fed") were less frequent during the past 18 months as compared to 2001 and the first half of 2002, the effects of these earlier cuts were apparent in the yields on the Company's earning assets and on average rates paid on interest bearing liabilities. As older deposits matured and were replaced by lower rate deposits, the average cost for deposits fell 87 basis points. As higher yielding loans matured, they were replaced by lower yielding loans or variable rate loans repriced and thus the average yield on loans fell 51 basis points. Taxable equivalent yields on securities also fell as higher yielding securities matured or were called and were replaced by securities with lower yields. The strong loan demand experienced in recent periods has slowed in 2003 and average loan balances grew 4.56% over 2002 average balances compared to a growth of 9.30% from 2001 to 2002. Year end balances of loans for 2003 as compared to 2002 were .39% higher. The high loan growth during 2002 and 2001 was funded in part through reductions in securities balances, reductions in balances of Federal Funds sold and through increases in balances of deposits. As loan demand flattened during 2003 and demand for deposit products remained stable, the Company has increased investments of both Fed Funds sold and securities. In the past, competition for deposits in the Company's service area was strong and this caused the Company's subsidiary banks to pay higher rates on deposits than larger, statewide financial institutions. Slowing loan growth in 2003 reduced the need for deposit growth, and the Company has made efforts in recent periods to reduce this rate disparity. Average rates paid on time deposits fell 96 basis points in 2003 as compared to 2002 and are now approaching the peer group levels. Rates on transaction accounts continued to mirror the peer group. The Company anticipates that it's net interest margin will remain stable or rise slightly in the first six months of 2004 as higher rate liabilities continue to mature. The Company expects loan and deposit demand to remain modest. Changes in the rate of economic recovery could have a significant impact on the current interest rate environment, with implications both to the volume and rates of interest earning assets and interest bearing liabilities. 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, an increase of 10.98%. Average earning assets grew 7.27% compared to growth of 5.99% of interest bearing liabilities. Falling interest rates caused the average yield on earning assets to fall 103 basis points while the average cost of interest bearing liabilities fell 134 basis points. Loan growth was strong with average loans outstanding growing 9.30% from 2001 to 2002 as falling interest rates throughout 2002, coupled with stable local economic conditions propelled loan demand. Increases in loan growth were primarily funded through increases in deposit growth and reductions in balances of fed funds sold, securities and interest bearing deposits in other banks. A summary of the net interest margin analysis is shown as Table I on Page 26. 10 Provision for Loan Losses The Company's provisions for loan losses were $1,820,000 for 2003, $820,000 for 2002, and $600,000 for 2001. The higher 2003 provision was a result of some deterioration in the quality of the loan portfolio. Balances of non-performing loans (non-accrual loans, restructured loans, and loans 90 days or more delinquent) increased $1,014,000 from December 31, 2002 to December 31, 2003, an increase of 35.22%. Non-performing loans were 1.72% of gross loans as of December 31, 2003 compared to 1.28% at December 31, 2002. Net charge-offs during 2003 were $1,151,000 compared to $630,000 during 2002. The ratio of net charge-offs to average net loans during 2003 was .51% and the three year average of net charge-offs to average net loans was .35%. Both rates are above peer group average which is about .27% for the three year period. The increase in net charge-offs was centered largely in the consumer installment and commercial loan portfolios as net charge-offs of commercial loans increased $246,000 and net charge-offs of consumer loans increased $307,000 compared to 2002. See Allowance for Loan Losses section on pages 15-19 for an expanded explanation of lending losses. Noninterest Income 2003 Compared to 2002 Noninterest income for 2003 increased 4.87% from 2002. As average deposit volumes continued to grow, income from service charges increased $30,000. Income from insurance related activity continues to grow as increases in loan volume and customer penetration rates have resulted in higher commissions and fees from insurance activity. Income from investments in life insurance contracts decreased 7.25% as interest rate declines and continued low market rates led to lower returns. 2002 Compared to 2001 Noninterest income for 2002 increased $109,000 from 2001, an increase of 9.17%. Service charge income increased slighltly as deposit and loan volume increased. Due to decreases in interest rates and changes in economic conditions, income from investments in life insurance contracts fell 3.19%. Gains on sales of other real estate owned were $40,550 during 2002 compared to no gains recorded in 2001. Discontinuation of Trust Operations During the fourth quarter of 2003, the Board of Directors of Highlands Bankshares, Inc. decided to close Highlands Bankshares Trust Company, Inc. The development of the market for trust services in the Company's primary and secondary service areas has been less than anticipated. On a fully consolidated basis, Highlands Bankshares Trust Company, Inc. contributed the following losses to consolidated net income of Highlands Bankshares, Inc.: $84,223 in 2001, $85,959 in 2002 and $55,721 in 2003. There are certain capital implications to the Company and to the subsidiary banks related to the closing of Highlands Bankshares Trust Company which are discussed on page 22. It is anticipated that all trust operations will be closed by May 15, 2004. 11 Noninterest Expenses 2003 Compared to 2002 Total noninterest expense increased 2.47% in 2003 as compared to 2002. Salary and benefit expense increased $88,000, or 2.00%, in 2003 as compared to 2002. Increases in costs of retirement benefits associated with bank owned life insurance contracts contributed $91,000 of the increase. An increase in full time average equivalent employees of .70% was offset by a decline in per employee costs of .92%. Occupancy expense remained flat as no new locations were added and no existing locations improved. Equipment expense increased $63,000, or 9.57%. A significant portion of the increase in equipment expense related to improvements and upgrades to the Company's data processing infrastructure. During 2003, the Company's subsidiary banks introduced telephone banking and began a project for introducing check imaging. Both projects required new equipment which increased depreciation expense and will cause continued higher depreciation expenses in 2004 as compared to prior periods. Data processing expenses paid to outside parties increased 4.38% as growth of operations required additional processing volumes. Legal and professional fees increased $63,000, or 27.67% from 2002, largely as a result of the contracting with a public accounting firm to begin independent internal audit procedures at the subsidiary banks. Directors fees increased $84,000 in 2003 as compared to 2002, an increase of 37.02%. This increase was the result of an increase in meetings held during 2003 as compared to 2002, an increase in the number of directors at the subsidiary banks, and an increase in directors' per meeting fees beginning in May. Other expenses decreased from 2002 to 2003 as expenses related expanded advertising campaigns undertaken in 2002 and costs associated with The Grant County Bank's 100th Anniversary celebration were not present in 2003. Travel and entertainment expense and nonincome tax expense also decreased in 2003. These decreases were offset in part by increases in office supply expenses and insurance expense. 2002 Compared to 2001 Total noninterest expenses increased 8.30% in 2002 compared with 2001. Salaries and benefits increased 5.62% due to an increase in full time equivalent employees, 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. 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. 12 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 $881,000, or .38% in 2003. Balances of loans secured by real estate grew 4.63% from December 31, 2002 to December 31, 2003. The Company's loan to deposit ratio was 86.28% at December 31, 2003 compared to 87.68% at December 31, 2002. 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 summarizes the Company's loan portfolio, net of unearned income: At December 31, ---------------------------------------- 2002 2002 2001 ---- ---- ---- (In Thousands of Dollars) Real Estate: Mortgage $129,671 $121,558 $111,668 Construction 7,552 6,813 3,868 Commercial 42,911 47,089 42,204 Installment 46,501 50,294 47,730 ------ ------- ------- Total Loans 226,635 225,754 205,470 Allowance for loan losses (2,463) (1,793) (1,603) ------- -------- ------- Loans, net $ 224,172 $ 223,961 $203,867 ============ ============ ======= There were no foreign loans outstanding during any of the above periods. 13 Financial Condition (Continued) Loan Portfolio (Continued) The following table shows the maturity of loans outstanding (in thousands of dollars) as of December 31, 2003, 2002 and 2001. Maturity Range 2003 2002 2001 -------------- ---- ---- ---- Predetermined Rates: 0 - 12 months $132,237 $145,473 $ 99,049 13 - 60 months 80,099 68,699 68,106 More than 60 months 12,635 11,353 37,841 Nonaccrual Loans 1,664 229 474 ------- ------- ------- Total Loans $226,635 $225,754 $205,470 ======= ======= ======= The following table shows the Company's loan maturity distribution (in thousands of dollars) as of December 31, 2003: Maturity Range Less Than 1-5 Over Loan Type 1 Year Years 5 Years Total --------- ------- ----- ------- ----- Commercial and Agricultural Loans $ 28,080 $ 7,129 $ 7,702 $ 42,911 Real Estate - mortgage 79,828 44,722 5,095 129,645 Real Estate - construction 7,552 7,552 Consumer - installment 16,777 28,248 1,502 46,527 ------- ------- ------- ------- Total $132,237 $ 80,099 $ 14,299 $226,635 ======= ======= ======= ======= 14 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 $291,414 at December 31, 2003, $517,050 at December 31, 2002 and $58,250 at December 31, 2001. All of the foreclosed properties held at December 31, 2003 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 35.22% at December 31, 2003 compared to 2002. Balances of nonaccrual loans increased from $299,000 at December 31, 2002 to $1,664,000 at December 31, 2003 as the result of increased delinquencies making necessary the movement of loan balances to nonaccrual status. Of the loans on nonaccrual status as of December 31, 2003, 86.30% were loans secured by real estate. The following table summarizes the nonperforming loans: At December 31, ------------------------------- 2003 2002 2001 ---- ---- ---- (Dollars in Thousands) Loans accounted for on a nonaccrual basis Consumer $ 228 $ 9 $ Real estate 1,436 290 474 ------ ---- ----- Total nonaccrual loans 1,664 299 474 ----- ----- ------ Restructured loans 631 662 0 ----- ------ ------- Loans contractually past due 90 days or more as to interest or principal payments (not included in nonaccrual loans above) Commercial 25 161 607 Real estate 1,255 1,312 1,352 Installments 318 445 336 ------- ----- ------ Total Delinquent Loans 1,598 1,918 2,295 ------- ----- ------ Total Nonperforming Loans $ 3,893 $2,879 $ 2,769 ====== ===== ====== 15 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, 2003, 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, 2003, 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 losses at December 31, 2003 was $2,463,000. This is an increase of 37.37% over the balance at December 31, 2002. The Company's provision for loan losses in 2003 was $1,820,000 compared to $820,000 in 2002. The increase in the provision for loan losses from 2002 to 2003 was necessitated by increases in non-performing loans and an increase in net charge-offs as compared to prior years. 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 estimable 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). 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 current loan portfolio. Both banks classify loans into the following categories: impaired, doubtful, substandard, special mention and other loans past due 90 days or more and assigns loss rates 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 provided for at 100% of the identified impairment. 16 Allowance for Loan Losses (Continued) Loans 90 days or more past due and nonaccrual loans are included in one of the five categories above. 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 provided for 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 differ and change. The remaining portfolio balances are assigned a loss factor based on the historical net loss rates, reduced by recoveries. 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. 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 required level of the allowance for loan losses is computed quarterly and the allowance adjusted prior to the issuance of the quarterly financial statements. All loan losses charged to the allowance are approved by the boards of directors of each bank at their regular meetings. The allowance is reviewed for adequacy after considering historical loss rates, current economic conditions (both locally and nationally) and any known credit problems that have not been considered under the above formula. Management has analyzed the potential risk of loss on the Company's loan portfolio given the loan balances and the value of the underlying collateral and has recognized losses where appropriate. Nonperforming loans are closely monitored on an ongoing basis as part of the Company's loan review process. The ratio of the allowance for loan losses to total loans outstanding was 1.09% at December 31, 2003, .79% at December 31, 2002 and .78% at December 31, 2001. At December 31, 2003, the ratio of the allowance for loan losses to nonperforming loans was 63.27% compared to 62.28% at December 31, 2002 and 57.89% at December 31, 2001. Because of its large impact on the local economy, Management continues to monitor the economic health of the poultry industry. The Company has direct loans to poultry growers and the industry is a large employer in the Company's trade area. Loan requests for poultry house loans or expansion continue to be presented for approval. In June of 2003, Pilgrim's Pride Corporation announced the purchase of certain divisions of ConAgra Foods, Inc. including processing facilities operated by ConAgra in Hardy County. Management anticipates that this purchase will have no adverse impact on operations of either subsidiary bank or on the operations of the non-bank subsidiaries. In the fall of 2002, Perdue Farms, Inc. ceased operations at its Petersburg processing plant. At present, this facility sits 17 Allowance for Loan Losses (Continued) idle. In part because of this closure, the unemployment rate in Grant County grew from 6.7% in October of 2002 to 11.30% in January of 2004. While management believes that this closure has contributed to the slow-down in loan growth, the overall impact of the closure on the Company has been minimized by the Company's geographic diversity as the other counties in the Company's primary service area maintain better economies. In recent periods, the Company's loan portfolio has also begun to gain a concentration in loans collateralized by heavy equipment, particularly in the trucking and timber industries. In part because of rising fuel costs, and because of continued stagnant economic conditions, the trucking sector has experienced a recent downturn. However, the Company has experienced no material losses related to foreclosures of loans collateralized by heavy equipment. While close monitoring of this sector is necessary, management expects no significant losses in the foreseeable future. An analysis of the loan loss allowance is set forth in the following table (in thousands): 2003 2002 2001 2000 1999 ---- ---- ---- ---- ---- Balance at beginning of period $ 1,793 $ 1,603 $ 1,493 $ 1,318 $ 1,355 Charge-offs: Commercial loans 557 246 239 172 107 Real estate loans 65 110 92 128 87 Consumer loans 839 424 369 215 254 ------- ------- ------ ------- ------ 1,461 780 700 515 448 ------- -------- ------ ------- ------ Recoveries: Commercial loans 75 10 57 2 16 Real estate loans 54 68 12 30 1 Consumer loans 182 72 141 71 74 ------- -------- ------ ------- ------ 311 150 210 103 91 ------- ------- ------ ------- ------ Net charge-offs 1,150 630 490 412 357 Provision for loan losses 1,820 820 600 500 320 Other 87 ------ ------- ------ ------- ------ Balance at end of period $ 2,463 $ 1,793 $ 1,603 $ 1,493 $ 1,318 ======== ======== ======== ======== ======= Percent of net charge-offs to average net loans outstanding during the period .51% .29% .25% .23% .23% ====== ======== ======== ======== ===== 18 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, ------------------------------------------------------------------------------------------------- 2003 2002 2001 2000 1999 -------------- ----------------- -------------- ---------------- -----------------
Percent Percent Percent Percent Percent of of of of of Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans (Dollars in Thousands) Commercial $ 779 19% $ 543 21% $ 487 21% $ 507 20% $ 395 19% Real estate Mortgage 725 61 504 57 576 56 239 56 211 58 Installment 819 20 652 22 450 23 598 24 580 23 Unallocated 140 94 90 149 132 ------ --- ---- --- ---- ---- ---- --- ---- --- Total $ 2,463 100% $1,793 100% $1,603 100% $1,493 100% $1,318 100% ====== === ===== === ===== ===== ===== === ====== =======
19 Allowance for Loan Losses (Continued) Cumulative net loan losses, after recoveries, for the five year period ending December 31, 2003 are as follows: Dollars Percent of Total Commercial $ 1,161 38.16% Real estate 317 10.43% Consumer 1,561 51.37% ----- ------ Total $ 3,039 100.00% ====== ====== The above acts as a starting point for allocating the overall allowances. Additional changes have been made in the allocation of the allowance to address unknowns and contingent items. The unallocated portion is not computed using a specific formula and is management's best estimate of what should be allocated for contingencies in the current portfolio. Losses in 2003 were above peer group amounts. Because of the increase in delinquencies, Management deemed it necessary to chargeoff larger volumes of loans during 2003 than in 2002, but expects that in the foreseeable future, charge-offs will not continue to deviate substantially from historical rates. The allowance as of December 31, 2003 was 1.09% of loans outstanding which is comparable to peer group levels. Management believes the present allowance, which is 3.49 times the average annual net charge-off rate over the last three year period, is adequate based on its knowledge of the loan portfolio and historical performance. 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 increased to $34,929,000 or 11.60% of total assets at December 31, 2003. Total securities were $25,537,000 or 8.73% of total assets at December 31, 2002. The securities portfolio consists of three components: securities held to maturity, securities available for sale and restricted securities. Securities are classified as held to maturity when management has the intent and the Company has the ability at the time of purchase to hold the securities to maturity. Held to maturity securities are carried at cost, adjusted for amortization of premiums and accretion of discounts. Securities to be held for indefinite periods of time are classified as available for sale and accounted for at market value. Securities available for sale include securities that may be sold in response to changes in market interest rates, changes in the security's prepayment risk, increases in loan demand, general liquidity needs and other similar factors. Restricted securities are those investments purchased as a requirement of membership in certain governmental lending insitutions and cannot be transferred without the issuer's permission. The Company's purchases of securities have generally been limited to securities of high credit quality with short to medium term maturities. 20 Securities (continued) 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, 2003, the fair value of the securities available for sale exceeded their cost basis by $213,000 ($134,000 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, 2003 2002 2001 2003 2002 2001 ---- ---- ---- ---- ---- ---- (In Thousands of Dollars) (In Thousands of Dollars) U.S. treasuries, agencies and corporations $ $ $ $23,240 $13,534 $16,432 Obligations of states and political subdivisions 1,364 1,365 1,597 2,604 4,350 6,380 Mortgage-backed securities 2 4 6 6,758 5,582 6,609 ---- ----- ---- ---- ------ ------ Total Debt Securities 1,366 1,369 1,603 32,602 23,466 29,421 Other securities 29 30 39 ------ ------ ----- ------ ------ ------ Total $ 1,366 $ 1,369 $1,603 $32,631 $23,496 $29,460 ====== ====== ===== ====== ====== ====== The carrying amount and estimated market value of debt securities (in thousands of dollars) at December 31, 2003 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 $ 675 $ 700 5.52% Due after one year through five years 691 737 7.03% ------- ------- ------ Total Held to Maturity $ 1,366 $ 1,437 6.29% ======== ========= ===== Equivalent Securities Available for Sale Amortized Fair Average Cost Value Yield ------------ ----------- --------- Due in one year or less $ 7,207 $ 7,256 3.13% Due after one year through five years 19,454 19,571 2.34% Due after five years through ten years 2,142 2,193 4.03% Due after ten years 3,582 3,582 3.21% -------- --------- ----- Total Fixed Rate Securities 32,385 32,602 2.73% Equities 32 29 4.01% -------- --------- ----- Total Available for Sale $ 32,417 $ 32,631 2.73% ======== ========= ===== Yields on tax exempt securities are stated at actual yields. Management has generally kept the maturities of investments relatively short providing for flexibility in investing. Such a philosophy allows the Company to better match deposit maturities with investment maturities and thus react more quickly to interest rate changes. 21 Deposits The Company's primary source of funds is local deposits. The Company's deposit base is comprised of demand deposits, savings and money market accounts and other time deposits. The Company's deposits are provided by individuals and businesses located within the communities served. The average balance of interest bearing deposits increased 8.39% in 2003 compared to average levels in 2002. The average balance of noninterest bearing deposits increased 8.87% over average 2002 balances. The average rate paid on deposits decreased to 2.61% in 2003 from 3.48% in 2002 and 4.84% in 2001. 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. 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 2003 was the result of overall deposit growth. A summary of the maturity of large deposits is as follows: December 31, Maturity Range 2003 2002 2001 -------------- ---- ---- ---- (In Thousands of Dollars) Three months or less $ 7,950 $ 7,570 $ 8,980 Four to twelve months 19,080 22,030 21,965 One year to three years 12,307 8,598 10,018 Four years to five years 8,008 7,195 4,219 -------- -------- -------- Total $ 47,345 $ 45,393 $ 45,182 ======= ======= ======== 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. During 2003, the Company borrowed an additional $1,785,000 from the FHLB and made payments of $520,000 on outstanding balances. During the fourth quarter of 2003, the Company secured a $2,500,000 open line of credit with another commercial bank. This line of credit was secured by equity securities in a subsidiary company. This debt instrument was obtained as both a precautionary and opportunistic device for funding should a need arise in the future. There were no advances in 2003 from this line and it is not anticipated that any borrowings from this debt facility will be used to fund operating or liquidity needs. 22 Capital Resources The assessment of capital adequacy depends on a number of factors such as asset quality, liquidity, earnings performance and changing competitive conditions and economic forces. The Company seeks to maintain a strong capital base to support its growth and expansion activities, to provide stability to current operations and to promote public confidence. The Company's capital position continues to exceed regulatory minimums. The primary indicators relied on by the Federal Reserve Board and other bank regulators in measuring strength of capital position are the Tier 1 Capital, Total Capital and Leverage ratios. Tier 1 Capital consists of common stockholders' equity. Total Capital consists of Tier 1 Capital and a portion of the allowance for loan losses. Risk-based capital ratios are calculated with reference to risk-weighted assets which consist of both on and off-balance sheet risks. The following table shows risk-based capital ratios and stockholders' equity to total assets: Regulatory December 31, Minimum 2003 2002 Capital Ratios Risk-based capital to risk-weighted assets Tier 1 8.00% 13.40% 13.20% Total 4.00% 14.55% 14.03% Stockholders' equity to total assets 5.00% 9.81% 9.75% The capital management function is an ongoing process. Central to this process is internal equity generation accomplished by earnings retention. During 2003, 2002, and 2001, total stockholders' equity increased by $1,185,000, $504,000 and $1,593,000, respectively, as a result of earnings retention and changes in the unrealized gains (losses) on securities available for sale. The 2002 increase is reflective of a repurchase of Company stock in the amount of $1,271,000. The return on average equity was 7.60% in 2003 compared to 8.87% for 2002 and 8.57% for 2001. Total cash dividends declared represent 36.03% of net income for 2003 compared to 29.26% of net income for 2002 and 29.15% for 2001. Book value per share was $20.56 at December 31, 2003 compared to $19.74 at December 31, 2002. In 2001, the Company created Highlands Bankshares Trust Company (HBTC) with a capital infusion of $2,143,567. This capital infusion was funded through dividends by the subsidiary banks. During the fourth quarter of 2003, the Company decided to discontinue operations of HBTI and it is anticipated that the closure will be completed by May 15, 2004. Capital invested in HBTC is reflected in the consolidated capital levels cited above. The closure will most likely increase the capital of the subsidiary banks but will have no effect on consolidated capital. Liquidity and Interest Rate Sensitivity Liquidity Operating 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. 23 Liquidity and Interest Rate Sensitivity (continued) Liquidity (continued) 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. In the year ending December 31, 2003, cash and due from banks decreased $1,013,000 as cash used in financing and investing activities was greater than cash provided by operations. Investing activity saw an increase in net loans of $2,031,000, a decrease in deposits at other institutions of $3,312,000, an increase in fed funds sold of $2,093,000 and an increase of holdings of securities and other investments of $9,392,000. New equipment and facility additions were $915,000 in 2003 compared with $314,000 in 2002. Funding these investments was an increase in deposits of $5,173,000, additional borrowings of $1,785,000 and retained operating income of $1,429,000. The parent Company's operating funds, funds with which to pay shareholder dividends and funds for the exploration of new business ventures have been, in the past, supplied primarily through 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 the relevant banking authorities in excess of the total net profits of the current year and the combined retained profits of the previous two years. As of January 1, 2004, the subsidiary banks could pay dividends to Highlands Bankshares, Inc. of approximately $2,123,000 without permission of the regulatory authorities. The following tables summarize the dividend limits (in thousands) as of January 1, 2004 for Capon Valley Bank (CVB) and The Grant County Bank (GCB). 2002 2003 Dividend Net Net Limit Income Dividends Income Dividends January 1, 2004 --------------------------------------------------------- CVB $1,075 $ 975 $ 475 $ $ 575 GCB 1,628 975 1,801 905 1,549 ------ ------- ------- ------- ------- Total $2,703 $1,950 $ 2,276 $ 905 $ 2,124 In addition to funds from the subsidiaries, the Company has at its disposal other options for funding which include, but are not limited to, Trust Preferred Securities and debt. During the fourth quarter of 2003, the Company secured a $2,500,000 open line of credit with another commercial bank. This line of credit was secured by equity securities in a subsidiary company. This debt instrument was obtained as both a precautionary and opportunistic device for funding should a need arise in the future. It is not anticipated that any borrowings from this debt facility will be used to fund operating liquidity needs. Aside from regulatory restrictions on dividends, the Company's subsidiary banks must maintain certain regulatory minimum levels of capital. During 2001 and 2002, the Company funded the creation of Highlands Bankshares Trust Company and repurchased shares of the Company's stock through dividends from the subsidiary banks. Although these large subsidiary dividends, coupled with decreased returns on average assets during recent quarters, have reduced the Banks' dividend paying capacity, Management does not anticipate the need for a reduction in shareholder dividends in the foreseeable future. 24 Liquidity and Interest Rate Sensitivity (Continued) Liquidity (continued) 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, 2003, the Company had a negative gap position as of 90 days into the future. This gap becomes slightly positive at one year into the future. With assets repricing at a level of 103.21% 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 with increases in liabilities. Even with gradual rises in interest rates, the Company expects its cost of funds should remain stable throughout the early part of 2004 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, although recent competitive trends have forced the company to make loans with three and five year fixed terms. For this reason, 87.16% of all loans will reprice within three years of December 31, 2003. 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 III (page 28) shows the maturity of liabilities and assets in future periods. Table II (page 27) shows the effects of rate and volume changes on the net interest margin for the past three year period. 25 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. 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 29) 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 website 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) 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. 26 TABLE I NET INTEREST MARGIN AND AVERAGE BALANCE ANALYSIS (Dollar amounts in thousands)
2003 2002 2001 -------------------------------- ----------------------------------- ------------------------------ Income/ Yield/ Income/ Yield/ Income/ Yield/ EARNING ASSETS Average 2 Expense Rate Average 2 Expense Rate Average 2 Expense Rate -------------- ------- -------- --------- ---------- ------- ------ ---------- ------- ------- Loans 1,3 $ 226,281 $ 16,966 7.50 $ 216,408 $ 17,324 8.01 $ 197,989 $ 17,895 9.04 Investment securities: Taxable 4 28,107 885 3.15 25,247 1,165 4.61 24,686 1,445 5.85 Nontaxable 1,4 3,748 254 6.78 5,451 318 5.83 3,501 267 7.63 ------- --------- ----- ------ ----- ----- ------- ------- Total Investment Securities 31,855 1,139 3.58 30,698 1,483 4.83 28,187 1,712 6.07 Interest bearing deposits in banks 5,342 53 .99 4,271 104 2.44 5,813 248 4.27 Federal funds sold 20,632 218 1.06 11,431 177 1.55 13,019 451 3.46 ------ ----- ----- ------ ----- ----- ------ ------ ----- Total Earning Assets 284,109 18,376 6.47 262,808 19,088 7.26 245,008 20,306 8.29 ------- -------- ---- --------- ------- ---- ------- ------ ------- Allowance for loan losses (2,163) (1,793) (1,613) Nonearnings assets 23,343 21,840 20,550 ------- ------ ------ Total Assets $305,290 $282,855 $263,945 ======= ========= ======= INTEREST-BEARING LIABILITIES Deposits: Demand $ 21,434 $ 134 .63 $ 19,910 $ 225 1.31 $ 16,960 $ 242 1.42 Savings 48,128 381 .79 43,868 651 1.48 36,479 824 2.26 Time deposits 164,126 5,585 3.40 151,813 6,619 4.36 149,867 8,771 5.85 ------- ------- --------- --------- ------ ----- ------- ------- ----- Total Deposits 233,688 6,100 2.61 215,591 7,495 3.48 203,306 9,837 4.84 Other borrowed money 4,780 238 4.98 4,280 210 4.91 4,149 212 5.11 ----- ----- ----- ----- ----- ----- ------ ------ ----- Total Interest Bearing Liabilities 238,468 6,338 2.66 219,871 7,705 3.50 207,455 10,049 4.84 ------- ----- ----- ------- ----- ----- ------- ------- ---- Noninterest bearing deposits 35,086 32,226 26,735 Other liabilities 2,337 2,320 2,436 ------- ----- ------ Total Liabilities 275,891 254,417 236,626 Stockholders' Equity 29,399 28,438 27,319 ------ ------ ------ Total Liabilities and Equity $305,290 $282,855 $263,945 ======= ========= ======== Net Interest Earnings $ 12,038 $ 11,383 $ 10,257 ======== ========= ======== Net Yield on Interest Earning Assets 4.24% 4.33% 4.19% ==== ====== ======
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. 27 TABLE II EFFECT OF RATE-VOLUME CHANGES ON NET INTEREST INCOME (On a fully taxable equivalent basis) (In thousands of dollars)
2003 Compared to 2002 2002 Compared to 2001 --------------------------- ------------------------- Increase (Decrease) Increase (Decrease) Due to Change in: Total Due to Change in: Total 1 Average Average Increase 1 Average Average Increase Volume Rate (Decrease) Volume Rate (Decrease) -------- -------- ----------- ------- --------- -------- Interest Income: Loans 2 $ 740 $(1,098) $(358) $1,474 $(2,045) $ (571) Investment Securities: Taxable 90 (370) (280) 26 (306) (280) Nontaxable (115) 51 (64) 114 (63) 51 ------ ---- ----- ---- ---- ---- Total Investment Securities (25) (319) (344) 140 (369) (229) Interest bearing deposits in banks 11 (62) (51) (38) (106) (144) Federal funds sold 97 (56) 41 (25) (249) (274) ----- ----- ---- ----- ----- ----- Total Interest Income 823 (1,535) (712) 1,552 (2,769) (1,218) ----- ------- ----- ----- ------- ------- Interest Expense: Deposits: Demand 10 (101) (91) 33 (50) (17) Savings 34 (304) (270) 110 (283) (173) All other time deposits 419 (1,453) (1,034) 85 (2,237) (2,152) Other borrowed money 25 3 28 6 (8) (2) ----- ---- ---- ---- ----- ----- Total Interest Expense 488 (1,855) (1,367) 234 (2,578) (2,344) ----- ------- ------- ---- ------- ------- Net Interest Income $ 335 $ 320 $ 655 $ 1,317 $ (191) $ 1,126 ===== ==== ==== ===== ==== =====
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. 28 TABLE III INTEREST RATE SENSITIVITY ANALYSIS (In thousands of dollars) DECEMBER 31, 2003 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 $34,344 $97,894 $65,287 $14,812 $14,298 $226,635 Fed funds sold 16,718 16,718 Securities 11,850 11,374 10,359 628 718 34,929 Interest bearing time deposits 887 300 1,187 ------ ------ ------ ------ ----- ------ Total 63,799 109,568 75,646 15,440 15,016 279,469 -------- --------- ------ ------ ------ ----- INTEREST BEARING LIABILITIES Transaction accounts 22,958 22,958 Money market accounts 16,953 16,953 Savings accounts 32,187 32,187 Time deposits more than $100,000 7,950 19,080 12,307 8,008 47,345 Time deposits less than $100,000 20,571 47,611 30,031 12,093 110,306 Other borrowed money 95 578 828 1,159 2,635 5,295 ------ ------ ------ ------ ----- ------ Total 100,714 67,269 43,166 21,260 2,635 235,044 --------- ------ ------ ------ ------- ------ Discrete interest sensitivity GAP (36,915) 42,299 32,480 (5,820) 12,381 Cumulative interest sensitivity GAP (36,915) 5,384 37,864 32,044 44,425 Ratio of cumulative interest sensitive assets to cumulative interest sensitive liabilities 63.35% 103.21% 117.93% 113.79% 118.90% Assumes all transaction, money market and savings deposit accounts reprice within 90 days. 29 TABLE IV QUARTERLY FINANCIAL RESULTS (In thousands, except per share amounts) Fourth Third Second First Quarter Quarter Quarter Quarter 2003 Interest income $ 4,473 $ 4,604 $ 4,630 $ 4,576 Interest expense 1,369 1,543 1,668 1,758 -------- -------- -------- -------- Net interest income 3,104 3,061 2,962 2,818 Provision for loan losses 825 240 545 210 -------- -------- -------- -------- Net interest income after provision 2,279 2,821 2,417 2,608 Non-interest income 337 348 339 343 Non-interest expense 2,244 2,076 1,953 1,974 -------- -------- -------- -------- Income before income tax provision 372 1,093 803 977 Income tax provision 85 363 247 317 -------- -------- -------- -------- Net Income $ 287 $ 730 $ 556 $ 660 ======== ======== ======== ======== Per common share:* Net income (basic) $ .20 $ .51 $ .38 $ .46 Net income (diluted) .20 .51 .38 .46 Cash dividends .14 .14 .14 .14 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 2,109 2,041 1,978 1,921 -------- -------- -------- -------- Income before income tax provision 855 1,086 943 820 Income tax provision 269 360 306 245 -------- -------- -------- -------- Net Income $ 586 $ 726 $ 637 $ 575 ======== ======== ======== ======== Per common share:* Net income (basic) $ .41 $ .50 $ .44 $ .38 Net income (diluted) .41 .50 .44 .38 Cash dividends .13 .13 .13 .12 *--Prior period per share figures restated to reflect stock split effected in form of dividend in 2002. See Note 20 of the financial statements for significant expenses recognized in the fourth quarter of 2003. 30 Item 8. Financial Statements Index to Financial Statements Financial Highlights............................................ 31 Consolidated Balance Sheets as of December 31, 2002 and 2001................................ 32 Consolidated Statements of Income for the Years Ended December 31, 2002, 2001 and 2000............ 33 Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 2002, 2001 and 2000............ 34 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.................................... 53 31 FINANCIAL HIGHLIGHTS HIGHLANDS BANKSHARES, INC. Years Ended December 31, 2003 2002 2001 2000 1999 ---- ---- ---- ---- ---- (Dollars in Thousands except per share data) (Restated) RESULTS OF OPERATIONS Interest income $18,283 $ 18,970 $20,207 $ 18,207 $16,243 Interest expense (6,338) (7,705) (10,049) (8,790) (7,663) -------- -------- ------- ------- ------ Net Interest Income 11,945 11,265 10,158 9,417 8,580 Provision for loan losses (1,820) (820) (600) (500) (320) Noninterest income 1,367 1,304 1,194 1,263 1,026 Noninterest expenses (8,247) (8,047) (7,431) (6,836) (6,104) Income taxes (1,012) (1,180) (979) (1,092) (978) -------- ------- ------ ------- ------ Net Income $ 2,233 $ 2,522 $ 2,342 $ 2,252 $ 2,204 ======= ======= ====== ======= ====== PROFITABILITY RATIOS Return on Average Assets .73% .89% .89% .97% 1.02% Return on Average Equity 7.60% 8.87% 8.57% 8.89% 9.42% PER COMMON SHARE * Net Income $ 1.55 $ 1.73 $ 1.56 $ 1.50 $ 1.46 Cash Dividends Declared .56 .51 .45 .41 .39 Book Value 20.57 19.74 18.50 17.24 15.97 Last Reported Market Price 28.00 21.51 16.33 16.67 20.00 AT YEAR END Assets $301,168 $292,672 $277,042 $248,782 $220,587 Deposits 262,685 257,512 242,042 216,571 192,345 Loans 226,635 225,754 205,469 189,268 166,614 Stockholders' Equity 29,549 28,365 27,861 25,958 24,043 Data for years prior to 2003 have been restated to reflect a prior period adjustment. (See note 3 to the financial statements). 32 CONSOLIDATED BALANCE SHEETS HIGHLANDS BANKSHARES, INC. December 31, ASSETS 2003 2002 Cash and due from banks (notes 4 and 15) $ 7,213,641 $ 8,226,301 Interest bearing deposits in banks (note 15) 1,187,322 4,499,666 Federal funds sold (note 15) 16,718,000 14,625,343 Investments: Securities held to maturity (note 5) 1,365,618 1,369,112 Securities available for sale (note 5) 32,630,627 23,496,039 Restricted investments 933,150 671,811 Loans (notes 6, 14, 15 and 16) 226,634,839 225,754,224 Allowance for loan losses (note 7) (2,462,764) (1,793,345) ------------ ---------- Net Loans 224,172,075 223,960,879 Bank premises and equipment (note 8) 7,210,041 6,873,307 Interest receivable 1,718,298 1,821,476 Investment in life insurance contracts (note 3 and 12) 5,558,578 5,338,036 Other assets 2,460,616 1,790,372 ----------- ---------- Total Assets $301,167,966 $292,672,342 =========== =========== LIABILITIES Deposits: Noninterest bearing $ 32,935,656 $ 31,785,317 Interest bearing Money market and interest checking 22,957,597 20,935,592 Money market savings 16,953,182 16,996,289 Savings accounts 32,187,457 29,503,487 Time deposits over $100,000 (note 9) 47,345,230 45,392,941 All other time deposits (note 9) 110,306,225 112,898,645 ------------ ----------- Total Deposits 262,685,347 257,512,271 Accrued expenses and other liabilities 3,638,241 2,765,949 Long term debt (note 10) 5,294,892 4,029,582 ------------ ---------- Total Liabilities 271,618,480 264,307,802 ------------ ----------- STOCKHOLDERS' EQUITY Common stock, $5 par value, 3,000,000 shares authorized, 1,436,874 shares issued 7,184,370 7,184,370 Surplus 1,661,987 1,661,987 Retained earnings (note 3 and 11) 20,726,938 19,298,162 Other accumulated comprehensive income (note 19) (23,809) 220,021 ----------- ---------- Total Stockholders' Equity 29,549,486 28,364,540 ----------- --------- Total Liabilities and Stockholders' Equity $301,167,966 $292,672,342 =========== =========== The accompanying notes are an integral part of this statement. 33 CONSOLIDATED STATEMENTS OF INCOME HIGHLANDS BANKSHARES, INC. Years Ended December 31, 2003 2002 2001 ----- ----- ----- Interest and Dividend Income Loans, including fees $16,966,107 $17,323,503 $17,894,665 Federal funds sold 218,341 176,787 450,657 Interest bearing deposits 53,380 103,982 248,442 Investment securities - taxable 885,165 1,164,634 1,445,327 Investment securities - nontaxable 160,164 201,184 167,930 ---------- -------- -------- Total Interest Income 18,283,157 18,970,090 20,207,021 ----------- ---------- ---------- Interest Expense Interest on deposits 6,100,104 7,494,500 9,836,905 Interest on long term debt 238,173 210,232 211,827 --------- -------- -------- Total Interest Expense 6,338,277 7,704,732 10,048,732 --------- --------- ---------- Net Interest Income 11,944,880 11,265,358 10,158,289 Provision for loan losses 1,820,000 820,000 600,000 ---------- -------- -------- Net Interest Income after Provision for Loan Losses 10,124,880 10,445,358 9,558,289 ----------- ---------- --------- Noninterest Income Service charges 616,416 586,821 581,224 Insurance commissions and income 189,567 142,780 100,801 Life insurance investment income 220,542 237,774 245,598 Other operating income 336,168 336,109 266,421 Gain on security transactions 4,251 ---------- -------- -------- Total Noninterest Income 1,366,944 1,303,484 1,194,044 ---------- --------- --------- Noninterest Expenses Salaries and benefits 4,480,285 4,392,419 4,158,882 Occupancy expense 381,560 380,021 381,029 Equipment expense 725,642 662,266 630,840 Data processing expense 599,565 574,400 529,054 Legal and professional fees 290,699 227,696 186,079 Directors fees 311,191 227,106 222,605 Other operating expenses 1,457,344 1,583,819 1,322,574 ----------- --------- --------- Total Noninterest Expenses 8,246,286 8,047,727 7,431,063 ---------- --------- --------- Income before Income Tax Expense 3,245,538 3,701,115 3,321,270 Income tax expense 1,012,206 1,179,542 979,699 ----------- --------- -------- NET INCOME $2,233,332 $2,521,573 $2,341,571 ========== ========= ========= Weighted Average Shares Outstanding 1,436,874 1,455,511 1,505,694 Earnings Per Share $ 1.55 $ 1.73 $ 1.56 Cash Dividends Paid Per Share $ .56 $ .51 $ .45 The accompanying notes are an integral part of this statement. 34 CONSOLIDATED STATEMENTS OF CHANGES ON STOCKHOLDERS' EQUITY HIGHLANDS BANKSHARES, INC.
Accumulated Other Common Retained Comprehensive Treasury Stock Surplus Earnings Income (Loss) Stock Total Balances, January 1, 2001 as Previously Stated $ 2,733,820 $1,661,987 $ 22,825,747 $ 38,761 $ (992,701) $ 26,267,614 Adjustment for Accrual of Indexed Retirement Plan Liabilities (310,010) (310,000) -------- -------- --------- ---------- ---------- ----------- Balances, January 1, 2001 (as Restated) 2,733,820 1,661,987 22,515,737 38,761 (992,701) 25,957,604 Comprehensive Income: Net income 2,341,571 2,341,571 comprehensive income 244,149 244,149 (note 19) Total Comprehensive Income 2,585,720 Cash dividends (682,581) (682,581) -------- ---------- ---------- -------- --------- ----------- Balance December 31, 2001 2,733,820 1,661,987 24,174,727 282,910 (992,701) 27,860,743 Comprehensive Income: Net income 2,521,573 2,521,573 Change in other comprehensive income (62,889) (62,889) (note 19) Total Comprehensive Income 2,458,684 Treasury stock (1,217,055) (1,217,055) repurchased 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 (737,832) (737,832) -------- ------- ---------- -------- -------- ---------- Balance December 31, 2002 7,184,370 1,661,987 19,298,162 220,021 28,364,540 Comprehensive Income: Net income 2,233,332 2,233,332 Change in other comprehensive income (243,830) (243,830) (note 19) Total Comprehensive Income 1,989,502 Cash dividends (804,556) (804,556) --------- --------- ------------ --------- ---------- -------- Balance December 31, 2003 $ 7,184,370 $1,661,987 $20,726,938 $ (23,809) $ $29,549,486 =========== =========== ========== ====== ========= ==============
The accompanying notes are an integral part of this statement. 35 CONSOLIDATED STATEMENTS OF CASH FLOWS HIGHLANDS BANKSHARES, INC. Years Ended December 31, 2003 2002 2001 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $2,233,332 $2,521,573 $2,341,571 Adjustments to reconcile net income to net cash provided by operating activities: Gain on Securities Transactions (4,251) Depreciation 577,497 525,685 523,626 Income from life insurance contracts (220,542) (237,774) (245,958) Net amortization of security premiums 463,016 294,266 122,343 Provision for loan losses 1,820,000 820,000 600,000 Deferred income tax benefit (187,266) (163,806) (98,821) Change in other assets and liabilities: Interest receivable 103,178 (3,592) 83,412 Other assets (482,978) (494,313) (127,198) Accrued expenses 872,292 150,103 371,847 --------- ---------- -------- Net Cash Provided by Operating Activities 5,174,278 3,412,142 3,570,822 --------- -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from maturity of securities held to maturity 1,455 232,337 621,481 Proceeds from maturity of securities available for sale 19,575,620 12,406,125 17,116,010 Proceeds from sales of securities available for sale 484,797 Purchase of securities available for sale (29,410,378) (7,207,357) (23,472,091) Net change in restricted investments (261,339) 119,839 (28,600) Net change in deposits in other banks 3,312,344 1,833,885 27,380 Net increase in loans (2,031,196)(20,914,267) (16,691,860) Net change in federal funds sold (2,092,657) (1,340,934) (6,244,900) Purchase of property and equipment (914,620) (314,479) (776,171) Proceeds from sale of property and equipment 6,358 ---------- ---------- ------- Net Cash Used in Investing Activities (11,820,771)(14,700,054) (29,442,393) ----------- ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES: Net change in time deposits (640,128) 1,653,838 19,729,800 Net change in other deposit accounts 5,813,207 13,816,761 5,740,629 Additional long term debt 1,785,000 1,395,300 Repayment of long term debt (519,690) (493,860) (881,177) Repurchase of treasury stock (1,217,055) Dividends paid in cash (804,556) (737,832) (682,581) -------- --------- --------- Net Cash Provided by Financing Activities 5,633,833 13,021,852 25,301,971 --------- --------- ---------- CASH AND CASH EQUIVALENTS: Net (decrease) increase in cash and due from banks (1,012,660) 1,733,940 (569,600) Cash and due from banks, beginning of year 8,226,301 6,492,361 7,061,961 --------- ---------- --------- Cash and due from banks, end of year $7,213,641 $ 8,226,301 $6,492,361 ========== ========== ========= Supplemental Disclosures: Cash paid for: Interest expense $6,359,833 $ 7,920,454 $10,042,704 Income taxes 1,447,717 1,421,272 1,367,143 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. State chartered banks are subject to regulation by the West Virginia Division of Banking, The Federal Reserve Bank and the Federal Deposit Insurance Corporation while the insurance company is regulated by the Arizona Department of Insurance. The Banks provide services to customers located mainly in Grant, Hardy, Hampshire, Mineral, Pendleton and Randolph counties of West Virginia, including the towns of Petersburg, Keyser, Moorefield and Wardensville through eight locations and the county of Frederick in Virginia through a single location. The insurance company sells life and accident coverage exclusively through the Company's subsidiary banks. The Trust Company utilizes the subsidiary banks to facilitate the sales of trust services to its customers and citizens in those locales. NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: The accounting and reporting policies of Highlands Bankshares, Inc. and its subsidiaries conform to accounting principles generally accepted in the United States of America and to accepted practice within the banking industry. (a) Principles of Consolidation The consolidated financial statements include the accounts of The Grant County Bank, Capon Valley Bank, HBI Life Insurance Company and Highlands Bankshares Trust Company. All significant intercompany accounts and transactions have been eliminated. (b) Use of Estimates in the Preparation of Financial Statements In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts in those statements; actual results could differ significantly from those estimates. A material estimate that is particularly susceptible to significant changes in the near term is the determination of the allowance for loan losses, which is sensitive to changes in local economic conditions. (c) Cash and Cash Equivalents Cash and cash equivalents include cash on hand and noninterest bearing funds at correspondent institutions. (d) Foreclosed Real Estate The components of foreclosed real estate are adjusted to the fair value of the property at the time of acquisition, less estimated costs of disposal. The current year provision for a valuation allowance has been recorded as an expense to current operations. 37 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED): (e) Securities Securities that the Company has both the positive intent and ability to hold to maturity (at time of purchase) are classified as held to maturity securities. All other securities are classified as available for sale. Securities held to maturity are carried at historical cost and adjusted for amortization of premiums and accretion of discounts, using the effective interest method. Securities available for sale are carried at fair value with any valuation adjustments reported, net of deferred taxes, as other accumulated comprehensive income. Restricted investments consist of investments in the Federal Home Loan Bank of Pittsburgh and the Federal Reserve Bank of Richmond. Such investments are required as members of these institutions and these investments cannot be sold without a change in the members' borrowing or service levels. Interest and dividends on securities and amortization of premiums and discounts on securities are reported as interest income using the effective interest method. Gains (losses) realized on sales and calls of securities are determined using the specific identification method. (f) Loans Loans are carried on the balance sheet net of unearned interest and allowance for loan losses. Interest income on loans is determined using the effective interest method based on the daily amount of principal outstanding except where serious doubt exists as to collectibility of the loan, in which case the accrual of income is discontinued. Loans are placed on nonaccrual status or charged off if collection of principal or interest becomes doubtful. The interest on these loans is accounted for on cash-basis or cost-recovery method until qualifying for return to accrual status. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and the loan is performing as agreed. (g) Allowance For Loan Losses The allowance for loan losses is based upon management's knowledge and review of the loan portfolio. Estimation of the adequacy of the allowance involves exercise of judgement, use of assumptions with respect to present economic conditions and knowledge of the environment in which the Banks operate. Among the factors considered in determining the level of the allowance are changes in composition of the loan portfolio, amounts of delinquent and nonaccrual loans, past loan loss experience and the value of collateral securing the loans. (h) Per Share Calculations Earnings per share are based on the weighted average number of shares outstanding. In the third quarter of 2002, the Company declared a stock split in the form of dividend. Prior period per share amounts, including earnings per share, dividends per share, book value per share, and market price have been adjusted to reflect this split. 38 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED): (i) Bank Premises and Equipment Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is charged to income over the estimated useful lives of the assets using a combination of the straight-line and accelerated methods. The costs of maintenance, repairs, renewals, and improvements to buildings, equipment and furniture and fixtures are charged to operations as incurred. Gains and losses on routine dispositions are reflected in other income or expense. (j) 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. (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. (l) Bank Owned Life Insurance Contracts The Company has invested in and owns life insurance polices on key officers. The policies are designed so that the company recovers the interest expenses associated with carrying the polices and the officer will, at the time of retirement, receive any earnings in excess of the amounts earned by the Company. The Company recognizes as an asset the net amount that could be realized under the insurance contract as of the balance sheet date. This amount represents the cash surrender value of the policies less applicable surrender charges. The portion of the benefits which will be received by the executives at the time of their retirement is considered, when taken collectively, to constitute a retirement plan. Therefore the Company accounts for these policies using guidance found in Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Post Retirement Benefits Other Than Pensions." SFAS No. 106 requires that an employers' obligation under a deferred compensation agreement be accrued over the expected service life of the employee through their normal retirement date (See Note 3). 39 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 3 PRIOR PERIOD ADJUSTMENT: The Company has invested in and owns life insurance polices on key officers. It also has agreements with key officers to provide retirement benefits upon their retirement. The benefit agreements are designed so that the Company recovers the cost of funds associated with carrying the policies and the officer will, at the time of retirement, receive any earnings in excess of the amounts earned by the Company. Officers receive benefits after retirement in conjunction with the earnings of the policies which occur both before and after the officers' retirement. Prior to 2003, the Company considered these contracts as a deferred compensation agreement commonly referred to as "a revenue neutral plan". As such, the company had accounted only for the costs of benefits payable to the officers that are associated with the current earnings of the policies. Increases to the surrender value of the policies had been accounted for as current income and an expense was accrued for the portion of those current earnings payable to the officers upon retirement. Recent regulatory guidance issued in 2003 requires that if the contracts, taken collectively, represent the equivalent of a retirement plan, the costs of benefits payable to the officer(s) that are associated with future earnings of the policies subsequent to the officer's retirement must be estimated and a liability accrued. (See Note 2(l)). The Company, employing its deferred compensation consultants, has estimated the future liabilities for retired executives for the duration of the agreements. The following table outlines the differences in the amounts originally reported and the corrected amounts for the years ending December 31, 2002 and 2001.
Year Ending Year Ending December 31, 2002 December 31, 2001 As Reported As Restated As Reported As Restated Accrued expenses and other liabilities $1,890,096 $ 2,765,949 $1,902,794 $2,615,847 Other assets 1,466,306 1,790,372 971,993 1,235,822 Income before income tax expense $3,863,916 $ 3,701,115 $3,542,244 $3,321,270 Income tax expense 1,239,778 1,179,542 1,061,459 979,699 --------- ---------- --------- ---------- Net income $2,624,138 $ 2,521,573 $2,480,785 $2,341,571 Earnings per share $ 1.80 $ 1.73 $ 1.65 $ 1.56
As Reported As Restated Retained earnings, December 31, 2002 $ 19,849,947 $19,298,162 Retained earnings, December 31, 2001 $ 24,623,951 $24,174,727 Retained earnings, December 31, 2000 $ 22,825,747 $22,515,737 The financial statements for 2002 and 2001 have been restated to reflect the above. 40 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 4 CASH AND DUE FROM BANKS: The Banks are required to maintain average reserve balances based on a percentage of deposits. The Banks have generally met this requirement through average cash on hand and balances with their correspondent institutions. NOTE 5 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, 2003 Mortgage-backed $ 2,250 $ 24 $ $ 2,274 State and municipals 1,363,368 71,179 1,434,547 ---------- -------- ------- --------- Total Securities Held to Maturity $1,365,618 $ 71,203 $ $1,436,821 =========== ====== ======== ========= 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 ========= ======== ======== ========= Available for Sale December 31, 2003 U. S. Treasuries and Agencies $23,132,304 $ 107,997 $ $23,240,301 Mortgage-backed 6,686,154 71,523 6,757,677 State and municipals 2,566,909 36,991 2,603,900 Marketable equities 31,847 3,098 28,749 -------- --------- ------ --------- Total Securities Available for Sale$32,417,214 $ 216,511 $ 3,098 $32,630,627 ========== ======= ===== ========== 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 ========== ======= ===== ========== 41 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 5 SECURITIES (CONTINUED: The carrying amount and fair value of debt securities at December 31, 2003, 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 $ 200,000 $ 204,322 Due after one year through five years 1,163,344 1,230,249 Mortgage-backed securities 2,274 2,250 --------- --------- Total Held to Maturity $1,365,618 $1,436,821 ========= ========= Securities Available for Sale Fair Cost Value Due in one year or less $ 7,236,915 $ 7,285,843 Due after one year through five years 18,389,287 18,472,235 Due after five years through ten years 1,003,737 1,017,831 Due after ten years 1,120,849 1,120,273 Mortgage-backed securities 4,634,579 4,705,696 --------- --------- Total Fixed Rate Securities 32,385,367 32,601,878 Equities 31,847 28,749 --------- --------- Total Available for Sale $32,417,214 $32,630,627 ========== ========== The carrying amounts (which approximate market value) of securities pledged by the banks to primarily secure deposits amounted to $6,869,000 at December 31, 2003 and $6,035,000 at December 31, 2002. NOTE 6 LOANS: Loans outstanding as of December 31, 2003 and 2002 are summarized as follows: 2003 2002 ---- ---- Commercial $42,911,284 $47,089,188 Real estate construction 7,552,000 6,813,000 Real estate mortgages 129,669,971 121,557,830 Consumer installment 46,501,584 50,294,206 ---------- ---------- Total $226,634,839 $225,754,224 =========== =========== 42 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 6 LOANS (CONTINUED): The following is a summary of information pertaining to impaired, restricted and non-accrual loans (in thousands): December 31 2003 2002 ---- - ---- Impaired loans $ 2,954 $ 1,489 Valutaion allowance 589 321 No loans were identified as impaired for which an allowance was not made. Total non-accrual loans $ 1,664 $ 299 Total loans past-due ninety days and still accruing interest 1,598 1,918 NOTE 7 ALLOWANCE FOR LOAN LOSSES: A summary of changes in the allowance for loan losses for the years ended December 31, 2003, 2002 and 2001 is shown in the following schedule: 2003 2002 2001 ---- ------ ----- Balance at beginning of year $ 1,793,345 $ 1,602,536 $ 1,492,936 Provision charged to operating expenses 1,820,000 820,000 600,000 Loan recoveries 311,222 151,227 209,552 Loans charged off (1,461,803) (780,418) (699,952) ------------ --------- ---------- Balance at end of year $ 2,462,764 $ 1,793,345 $ 1,602,536 ========= ========= ========== Percentage of outstanding loans 1.09% .79% .78% NOTE 8 BANK PREMISES AND EQUIPMENT: Bank premises and equipment as of December 31 are summarized as follows: 2003 2002 Land $1,137,485 $1,137,485 Buildings and improvements 6,316,682 6,165,529 Furniture and equipment 4,417,097 3,670,567 --------- --------- Total cost 11,871,264 10,973,581 Less - accumulated depreciation (4,661,223) (4,100,274) --------- ----------- Net Book Value $7,210,041 $ 6,873,307 ========== ========= Provisions for depreciation charged to operations were $577,496 in 2003, $525,685 in 2002 and $523,626 in 2001. 43 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 9 DEPOSITS: At December 31, 2003, the scheduled time deposit maturities are as follows: 2004 $95,211,625 2005 25,426,196 2006 16,912,217 2007 12,310,741 2008 7,790,676 ---------- Total $157,651,455 NOTE 10 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, 2003 were fixed at the time of the advance and range from 3.80% to 6.12%. The weighted average interest rate was 4.74% at December 31, 2003. 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 $238,173, $210,231, and $211,827 was incurred on these debts in 2003, 2002, and 2001, respectively. The maturities of long term debt as of December 31, 2003 are as follows: 2004 $ 673,525 2005 403,551 2006 423,974 2007 445,464 2008 420,756 Thereafter 2,927,622 ----------- Total $ 5,294,892 =========== NOTE 11 RESTRICTIONS ON DIVIDENDS OF SUBSIDIARY BANKS: The principal source of funds of Highlands Bankshares, Inc. is dividends paid by subsidiary banks. The various regulatory authorities impose restrictions on dividends paid by a state bank. A state bank cannot pay dividends (without the consent of state banking authorities) in excess of the total net profits (net income less dividends paid) of the current year to date and the combined retained profits of the previous two years. As of January 1, 2004, the banks could pay dividends to Highlands Bankshares, Inc. of approximately $2,123,000 without permission of the regulatory authorities. 44 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 12 INCOME TAX EXPENSE: The components of income tax expense for the years ended December 31, are summarized as follows: 2003 2002 2001 ----------- --------- ------- Current Expense Federal $1,008,463 $1,104,987 $968,401 State 191,009 238,361 110,119 -------- ------- ------- Total Current Expense 1,199,472 1,343,348 1,078,520 --------- --------- --------- Deferred Expense (Benefit) Federal (169,499) (149,096) (90,821) State (17,767) (14,710) (8,000) --------- -------- -------- Total Deferred Benefit (187,266) (163,806) (98,821) --------- ---------- ------- Income Tax Expense $1,012,206 $1,179,542 $ 979,699 ========= ========= ======== The deferred tax effects of temporary differences for the years ended December 31 are as follows: 2003 2002 2001 ---- ---- ---- Tax effect of temporary differences: Provision for loan losses $(180,899) $(57,117) $ 37,802 Sale of loans (664) 14,346 (28,271) Pension expense 5,121 (16,584) (31,690) Depreciation 77,341 41,065 47,406 Deferred compensation (84,144) (119,326) (139,011) Miscellaneous (4,021) (26,190) 14,943 ---------- -------- --------- Net increase in deferred income tax benefit $(187,266) $ (163,806) $(98,821) ========= ========= ======= The net deferred tax assets arising from temporary differences as of December 31 are summarized as follows: 2003 2002 Deferred Tax Assets: Provision for loan losses $ 665,217 $ 484,928 Insurance commissions 56,000 40,820 Sale of loans 8,308 16,070 Deferred compensation 624,761 540,452 Pension obligation 90,524 42,558 Other 19,481 ------ ---- Total Assets 1,444,810 1,144,309 -------- --------- Deferred Tax Liabilities: ------------------------- Unrealized gain on securities available for sale 80,357 171,921 Accretion income 15,182 17,217 Other liabilities 10,530 Property basis differences 476,210 398,862 --------- -------- Total Liabilities 571,749 598,530 ---------- -------- Net Deferred Tax Asset $ 873,061 $ 545,779 ========= ======== 45 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 12 INCOME TAX EXPENSE (CONTINUED): The following table summarizes the difference between income tax expense and the amount computed by applying the federal statutory income tax rate for the years ended December 31: 2003 2002 2001 ---- ---- ---- Amounts at federal statutory rates $ 1,103,483 $ 1,258,379 $ 1,129,232 Additions (reductions) resulting from: Tax-exempt income (109,391) (115,818) (102,365) Partially exempt income (34,958) (30,158) (28,142) State income taxes, net 109,565 127,979 99,485 Income from life insurance contracts (82,844) (89,317) (97,014) State income tax adjustment (30,000) Other 26,351 28,477 8,503 --------- -------- -------- Income tax expense $ 1,012,206 $ 1,179,542 $ 979,699 ========== ========== ========= NOTE 13 EMPLOYEE BENEFITS: The Company's two subsidiary banks each have separate retirement and profit sharing plans which cover substantially all full time employees at each bank. The Capon Valley Bank has a defined contribution pension plan with 401(k) features that is funded with discretionary contributions by the Bank. The bank matches on a limited basis the contributions of the employees. Investment of employee balances is done through the direction of each employee. The Grant County Bank is a member of the West Virginia Bankers' Association Retirement Plan. Benefits under the plan are based on compensation and years of service with 100% vesting after seven years of service. Prior to 2002, the Plan's assets were in excess of the projected benefit obligations and thus the Bank was not required to make contributions to the Plan in 2003, 2002 or 2001. It will be required to make a contribution in 2004 due to the inability of the investment portfolio in recent years to meet its expected return, The Bank has recognized liabilities of $391,000 at December 31, 2003 as a result of this shortfall. This has resulted in a decline in other comprehensive income of $158,000 (which is net of an income tax effect of $93,000) and an intangible asset of $140,000. 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 provides stock ownership to all employees of the Company. The Plan provides total vesting upon the attainment of seven years of service. Contributions to the plan are made at the discretion of the Board of Directors and are allocated based on the compensation of each employee relative to total compensation paid by the Company. All shares held by the Plan are considered outstanding in the computation of earnings per share. Shares of Company stock, when distributed, will have restrictions on transferability. Employer contributions related to the above pension plans charged to operations totaled $278,884 in 2003, $231,607 in 2002 and $234,455 in 2001. 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 $2,948,917 at December 31, 2002 was increased during 2003 by $670,068 as a result of new loans and reduced $1,034,721 by payments. The balance of loans to related parties was $2,584,264 at December 31, 2003. NOTE 15 CONCENTRATIONS: The Banks grant commercial, residential real estate and consumer loans to customers located primarily in the eastern portion of the State of West Virginia. Although the Banks have a diversified loan portfolio, a substantial portion of the debtors' ability to honor their contracts is dependent upon the agribusiness trucking and logging sectors. Collateral required by the Banks is determined on an individual basis depending on the purpose of the loan and the financial condition of the borrower. The ultimate collectibility of the loan portfolios is susceptible to changes in local economic conditions. Of the $227,000,000 loans held by the Company, $162,000,000 are secured by real estate. The Banks had cash deposited in and federal funds sold to other commercial banks totaling $24,772,476 and $24,166,439 at December 31, 2003 and 2002, respectively. NOTE 16 COMMITMENTS AND GUARANTEES: The Banks make commitments to extend credit in the normal course of business and issue standby letters of credit to meet the financing needs of their customers. The amount of the commitments represents the Banks' exposure to credit loss that is not included in the balance sheet. As of the balance sheet dates, the Banks had outstanding the following commitments: 2003 2002 Commitments to extend credit $16,041,000 $12,029,000 Standby letters of credit 136,000 204,000 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 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. Life Insurance The carrying amount of life insurance contracts is assumed to be a reasonable fair value. Life insurance contracts are carried on the balance sheet at their redemption value as of December 31, 2003. This redemption value is based on existing market conditions and therefore represents the fair value of the contract. Off-Balance-Sheet Items The carrying amount and estimated fair value of off-balance-sheet items were not material at December 31, 2003. 48 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 17 DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED): The carrying amount and estimated fair values of financial instruments as of December 31 are as follows:
2003 2002 ---- ---- Estimated Estimated Carrying Fair Carrying Fair Amount Value Amount Value Financial Assets: Cash and due from banks $ 7,213,641 $ 7,213,641 $ 8,226,301 $ 8,226,301 Interest bearing deposits 1,187,322 1,187,322 4,499,666 4,499,666 Federal funds sold 16,718,000 16,718,000 14,625,343 14,625,343 Securities held to maturity 1,365,618 1,436,821 1,369,112 1,451,553 Securities available for sale 32,630,627 32,630,627 23,496,039 23,496,039 Other investments 933,150 933,150 671,811 671,811 Loans, net 224,172,075 226,635,330 223,960,879 224,178,804 Interest receivable 1,718,298 1,718,298 1,821,476 1,821,476 Life insurance contracts 5,558,578 5,558,578 5,338,036 5,338,036 Financial Liabilities: Demand and savings deposits 105,033,892 105,033,892 99,220,685 99,220,685 Time deposits 157,651,455 169,037,413 158,291,586 159,022,847 Long term debt 5,294,892 5,495,346 4,029,582 4,117,444 Interest payable 604,682 604,682 849,472 849,472
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. 49 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 18 REGULATORY MATTERS (CONTINUED): The Company's actual capital ratios are presented in the following table: Actual Regulatory Requirements December Adequately Well 2003 2002 Capitalized Capitalized Total risk-based ratio 14.55% 14.03% 8.00% 10.00% Tier 1 risk-based ratio 13.40% 13.20% 4.00% 6.00% Total assets leverage ratio 9.42% 9.75% 4.00% 5.00% Capital ratios and amounts are applicable both at the individual bank level and on a consolidated basis. At December 31, 2003, both subsidiary banks had capital levels in excess of minimum requirements. In addition, 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. 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, 2003 2002 2001 ------ ------- ------- Beginning balance January 1 $ 220,021 $ 282,910 $ 38,761 Unrealized holding gains (losses) on available-for-sale securities, net of income taxes of $(80,800), $5,143 and $143,388 in 2003, 2002, and 2001, respectively (158,392) 9,575 244,149 Accrued pension obligation net of income taxes of $50,188 in 2003 and $42,558 in 2002 (85,438) (72,464) ---------- --------- ------ Net change for the year (243,830) (62,889) 244,149 Ending balance December 31 $ (23,809) $ 220,021 $ 282,910 =========== ======== ======= 50 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 20 FOURTH QUARTER ADJUSTMENTS: Within the fourth quarter of 2003, the Company had two charges to operations that were material to the Company's operations in that quarter. First, the Company recognized an expense for the entire year for the post retirement benefits that are to be accrued under SFAS No. 106. The charge to operations was recognized when the Company decided to continue existing agreements with employees and was able to determine its liability under SFAS No. 106. Prior to September 30, 2003, the Company was awaiting financial information on the amount of the liability and had not yet determined whether the agreements would be continued. The amount of expense recognized for post retirement benefits was $77,736 or $48,974 on an after tax basis. Also in the fourth quarter, the Company charged to operations an additional loan loss provision in order to recognize additional losses identified in the loan portfolio. The provision was to cover potential losses in the installment portfolio which has seen an increase in delinquencies and credit losses due to a stagnant economy and other individual credit problems. The fourth quarter provision of $825,000 ($520,000 after income taxes) was about $500,000 ($315,000 after income taxes) greater than the average of the previous three quarters for 2003. NOTE 21 PARENT CORPORATION ONLY FINANCIAL STATEMENTS: BALANCE SHEETS Assets December 31, 2003 2002 Cash $ 172,352 $ 122,102 Investment in subsidiaries 29,504,788 28,207,422 Income taxes receivable 508,183 251,826 Other assets 21,919 39,554 -------- --------- Total Assets $30,207,242 $28,620,904 =========== ========== Liabilities Accrued expenses $ 120,728 $ 8,735 Due to subsidiaries 537,028 247,631 -------- -------- Total Liabilities $ 657,756 $ 256,366 --------- --------- Stockholders' Equity Common stock, par value $5 per share 3,000,000 shares authorized, 1,436,874 shares issued $7,184,370 $7,184,370 Surplus 1,661,987 1,661,987 Retained earnings 20,726,938 19,298,159 Other accumulated comprehensive income (loss) (23,809) 220,022 ----------- --------- Total Stockholders' Equity $29,549,486 $28,364,538 ----------- ---------- Total Liabilities and Stockholders' Equity $30,207,242 $28,620,904 ========= ========== 51 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 21 PARENT CORPORATION ONLY FINANCIAL STATEMENTS (CONTINUED): STATEMENTS OF INCOME AND RETAINED EARNINGS Years Ended December 31, 2003 2002 2001 ---- ---- ---- Income Dividends from subsidiaries $ 904,649 $ 2,137,042 $ 3,063,877 Other income 29 480 -------- --------- -------- Total $ 904,678 $ 2,137,522 $ 3,063,877 ----------- --------- --------- Expenses Salary and benefits expense $ 144,513 $ 190,239 $ 169,325 Professional fees 38,978 36,330 34,413 Directors' fees 55,410 43,051 40,550 Other expenses 88,776 70,296 70,120 ---------- -------- -------- Total $ 327,677 $ 339,916 $ 314,408 ------------ -------- --------- Net income before income tax benefit and undistributed subsidiary net income (deficit) $ 577,001 $ 1,797,606 $ 2,749,469 Income tax benefit 115,280 132,536 112,779 ----------- --------- --------- Income before undistributed subsidiary net income ((deficit) 692,281 1,930,142 2,862,248 Undistributed subsidiary net income (deficit) 1,541,051 591,431 (520,677) ----------- -------- --------- Net Income $ 2,233,332 $2,521,573 $ 2,341,571 ========== ========= ========== Retained earnings, Beginning of period 19,298,159 24,174,728 22,515,738 Dividends paid in cash (804,553) (737,836) (682,581) Stock split paid in stock (4,789,580) Treasury stock retired (1,870,726) Net Income 2,233,332 2,521,573 2,341,571 ---------- ---------- ---------- Retained Earnings, End of Period $ 20,726,938 $ 19,298,159 $24,174,728 =========== =========== ========== 52 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HIGHLANDS BANKSHARES, INC. NOTE 21 PARENT CORPORATION ONLY FINANCIAL STATEMENTS (CONTINUED): STATEMENTS OF CASH FLOWS Years Ended December 31, 2003 2002 2001 ----- ------ ----- Cash Flows from Operating Activities: Net income $2,233,332 $2,521,573 $2,341,571 Adjustments Undistributed subsidiary income (deficit) (1,540,929) (591,431) 520,677 Depreciation 1,952 1,609 397 Loss on investment 15,304 Increase (decrease) in payables 111,993 85,448 (35,584) (Increase) decrease in receivables (256,357) (122,482) 67,486 Decrease (increase) in other assets 15,415 (14,197) (4,411) -------- --------- -------- Net Cash Provided by Operating Activities 565,406 1,895,824 2,890,136 --------- --------- --------- Cash Flows from Investing Activities: Advances from (payments to) subsidiaries 289,397 79,028 (37,899) Investment in subsidiaries (2,143,577) Other investments (5,000) -------- -------- -------- Net Cash Provided by (Used in) Investing Activities 289,397 79,028 (2,186,476) Cash Flows from Financing Activities: Purchase of treasury stock (1,217,055) Dividends paid (804,553) (737,836) (682,581) ----------- --------- -------- Net Cash Used in Financing Activities (804,553) (1,954,891) (682,581) ----------- ----------- -------- Net Increase in Cash 50,250 19,961 21,079 Cash, Beginning of Year 122,102 102,141 81,062 --------- -------- -------- Cash, End of Year $ 172,352 $ 122,102 $ 102,141 ======== ======== ======== 53 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, 2003 and 2002, and the related consolidated statements of income, changes in stockholders' equity and cash flows for the three years ended December 31, 2003. 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 auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Highlands Bankshares, Inc. and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for the three years ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. As described in Note 3 to the financial statements, the Company determined that an error existed in the 2002 and 2001 financial statements due to the lack of an accrual of post retirement benefits. The correction has been accounted for as a prior period adjustment and is described more fully in Note 3. /s/ S. B. Hoover & Company, L.L.P. February 16, 2004 Harrisonburg, Virginia 54 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None Item 9A. 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. 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 communications between and among the Chief Executive Officer and Chief Financial 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 the end of the period covered by this report. The Company's chief executive officer and chief financial officer, based on their evaluation as of the end of the period covered by this Annual Report of the Company's disclosure controls and procedures (as defined in Rule 13(a)-14(e) of the Securities Exchange Act of 1934), have concluded that the Company's disclosure controls and procedures are adequate and effective for purposes of Rule 13(a)-14(c) and timely, alerting them to financial information relating to the Company required to be included in the Company's filings with the Securities and Exchange Commission under the Securities Exchange Act of 1934. Changes in Internal Controls During the period reported upon, there were no significant changes in the internal controls of Highlands Bankshares, Inc. pertaining to its financial reporting and control of its assets or in other factors that could significantly affect these controls. Due to the nature of the Company's business as stewards of assets of customers, internal controls are of the utmost importance. The company has established procedures undertaken during the normal course of business to reasonably ensure that fraudulent activity of either an amount material to these results or in any amount is not occurring. In addition to these controls and review by executive officers, the Company retains the services of Yount, Hyde & Barbour, P.C., a public accounting firm, to complete regular internal audits to examine the processes and procedures of the Company and its subsidiary banks to ensure that these processes are both reasonably effective to prevent fraud, both internal and external, and that these processes comply with relevant regulatory guidelines of all relevant banking authorities. The findings of Yount, Hyde & Barbour are presented both to Management of the subsidiary banks and to the Audit Committee. Part III Item 10. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act Information required by this item is set forth under the caption "INFORMATION CONCERNING DIRECTORS AND NOMINEES" under the caption "Compliance with Section 16(a) of the Securities Exchange Act" of our 2004 Proxy Statement and is incorporated herein by reference. Highlands has adopted a Code of Ethics that applies to all employees, including Highlands' chief executive officer and chief financial officer and other senior officers. The Code of Ethics is attached to this document as Exhibit 14. If we make any substantive amendments to this Code or grant any waiver from a provision of the code to our chief executive officer or chief financial officer, we will disclose the amendment or waiver in a report on Form 8-K. 55 Item 11. Executive Compensation Information required by this item is set forth under the caption "EXECUTIVE COMPENSATION" of our 2004 Proxy Statement and is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management Information required by this item is set forth under the caption "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT" of our 2004 Proxy Statement and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions Information required by this item is set forth under the caption "Certain Related Transactions" of our 2004 Proxy Statement and is incorporated herein by reference. Most of the directors, partnerships of which they may be general partners and corporations of which they are officers or directors, maintain normal banking relationships with the Bank. Loans made by the Bank to such persons or other entities were made 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 & Baker, which provides legal counsel to the Company and it is anticipated that the relationship will continue. Item 14. Fees of Independent Public Accountants Information required by this item is set forth under the caption "FEES OF INDEPENDENT PUBLIC ACCOUNTANTS" of our 2004 Proxy Statement and is incorporated herein by reference. Part IV Item 15. Exhibits and Reports on Form 8-K a) Exhibits Exhibit No. Description 2 Not applicable 3 (1) 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 (2) Bylaws of Highlands Bankshares, Inc. are incorporated by reference to Appendix D to Highland Bankshares, Inc.'s Form S-4 filed October 20, 1986. Amended Bylaws of Highlands Bankshares, Inc. are incorporated by reference to Exhibit 3(ii) to Highland Bankshares, Inc.'s Form 10-Q filed May 15, 2003. 56 Item 15. Exhibits and Reports on Form 8-K (Continued) a) Exhibits (Continued) Exhibit No. Description 14 Code of Ethics 21.0 Subsidiary Listing of the Registrant 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. b) Reports on Form 8-K No reports on Form 8-K were filed in the fourth quarter of 2003. 57 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/ C. E. PORTER -------------------------- C. E. Porter President, Chief Executive Officer Date March 29, 2004 ------------------------- By /s/ R. ALAN MILLER -------------------------- R. Alan Miller Finance Officer Date March 29, 2004 ------------------------- 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 Leslie A. Barr President March 30, 2004 & Chief Executive Officer --------------- Director Alan L. Brill Secretary March 30, 2004 -------------- Kathy G. Kimble Director March 30, 2004 ------------- Steven C. Judy Director March 29, 2004 ------------- Thomas B. McNeil, Sr. Director ------------- Clarence E. Porter Treasurer March 29, 2004 ------------- Courtney R. Tusing Director ------------- John G. VanMeter Chairman of the Board March 30, 2004 Director ------------- Jack H. Walters Director March 30, 2004 ------------- L. Keith Wolfe Director March 30, 2004 -------------