10-K 1 hbi10k2005.txt FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2005 Commission file number 0-16761 Highlands Bankshares, Inc. (Exact name of registrant as specified in its charter) West Virginia 55-0650743 State or other jurisdiction of incorporation (I.R.S. Employer or organization Identification No.) P.O. Box 929 Petersburg, WV 26847 (Address of principal executive offices) Registrant'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 if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [ ] No [X] Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes [ ] No [X] Indicate by check mark whether the registrant has (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers in response to Item 405 of Regulation S-K is not contained in this form, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.[ ] Large Accelerated Filer [ ] Accelerated Filer [X] Non-accelerated filer Indicate by check mark whether the registrant is a shell company (as defined in rule 126-2 of the Act) Yes [ ] No [ X ] The aggregate market value of the 1,319,431 shares of Common Stock of the registrant issued and outstanding held by nonaffiliates on June 30, 2005 was approximately $ 37,748,921 based on the closing sales price of $ 28.61 per share on June 30, 2005. For purposes of this calculation, the term "affiliate" refers to all directors and executive officers of the registrant. State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: As of March 21, 2006 - 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 2006 Annual Meeting of Shareholders (the "Proxy Statement") are incorporated by reference in Part III , Items #10,#11,#12,#13 and #14 of this Annual Report on Form 10-K (the "Form 10-K"). 2 FORM 10-K INDEX Page Part I Item 1. Business 3 Item 1A. Risk Factors 8 Item 1B. Unresolved Staff Comments 10 Item 2. Properties 10 Item 3. Legal Proceedings 10 Item 4. Submission of Matters to a Vote of Security Holders 10 Part II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 11 Item 6. Selected Financial Data 12 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 12 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 35 Item 8. Financial Statements and Supplementary Data 37 Item 9. Changes in and Disagreement with Accountants on Accounting and Financial Disclosure 62 Item 9A. Controls and Procedures 62 Item 9B. Other Information 62 Part III Item 10. Directors and Executive Officers of Registrant 62 Item 11. Executive Compensation 62 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 63 Item 13. Certain Relationships and Related Transactions 63 Item 14. Principal Accounting Fees and Services 63 Part IV Item 15. Exhibits and Financial Statement Schedules 63 Signatures 65 3 PART I Item 1. Business General Highlands Bankshares, Inc. (hereinafter referred to as "Highlands," or the "Company"), incorporated under the laws of West Virginia in 1985, is a multi-bank holding company subject to the provisions of the Bank Holding Company Act of 1956, as amended, and owns 100% of the outstanding stock of its subsidiary banks, The Grant County Bank and Capon Valley Bank (hereinafter referred to as the "Banks"), and its life insurance subsidiary, HBI Life Insurance Company (hereinafter referred to as "HBI Life"). The Grant County Bank was chartered on August 6, 1902, and Capon Valley Bank was chartered on July 1, 1918. Both are state banks chartered under the laws of the State of West Virginia. HBI Life was chartered in April 1988 under the laws of the State of Arizona. Services Offered by the Banks The Banks offer all services normally offered by a full service commercial bank, including commercial and individual demand and time deposit accounts, commercial and individual loans, drive-in banking services and automated teller machines. No material portion of the banks' deposits have been obtained from a single or small group of customers and the loss of the deposits of any one customer or of a small group of customers would not have a material adverse effect on the business of the banks. Credit life and accident and health insurance are sold to customers of the subsidiary banks through HBI Life. Employees As of December 31, 2005, The Grant County Bank had 70 full time equivalent employees, Capon Valley Bank had 47 full time equivalent employees and Highlands had three full time equivalent employees. 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, Pendleton and Tucker Counties in West Virginia, the western portion of Frederick County in Virginia and portions of Western Maryland. This area includes the towns 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, three national banks and three credit unions. In addition, the banks compete with money market mutual funds and investment brokerage firms for deposits in their service area. No financial institution has been chartered in the area within the last five years although branches of state and nationally chartered banks have located in this area within this time period. Competition for new loans and deposits in the banks' service area is quite intense. 4 Item 1. Business (continued) Regulation and Supervision The Company, as a registered bank holding company, and its subsidiary banks, as insured depository institutions, operate in a highly regulated environment and are regularly examined by federal and state regulators. The following description briefly discusses certain provisions of federal and state laws and regulations and the potential impact of such provisions to which the Company and subsidiary are subject. These federal and state laws and regulations are designed to reduce potential loss exposure to the depositors of such depository institutions and to the Federal Deposit Insurance Corporation's insurance fund and are not intended to protect the Company's security holders. Proposals to change the laws and regulations governing the banking industry are frequently raised in Congress, in state legislatures, and before the various bank regulatory agencies. The likelihood and timing of any changes and the impact such changes might have on the Company are impossible to determine with any certainty. A change in applicable laws or regulations, or a change in the way such laws or regulations are interpreted by regulatory agencies or courts, may have a material impact on the business, operations and earnings of the Company. To the extent that the following information describes statutory or regulatory provisions, it is qualified entirely by reference to the particular statutory or regulatory provision. As a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the "BHCA"), the Company is subject to regulation by the Federal Reserve Board. Federal banking laws require a bank holding company to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so otherwise. Additionally, the Federal Reserve Board has jurisdiction under the BHCA to approve any bank or nonbank acquisition, merger or consolidation proposed by a bank holding company. The BHCA generally limits the activities of a bank holding company and its subsidiaries to that of banking, managing or controlling banks as to be a proper incident thereto. The BHCA also prohibits a bank holding company, with certain exceptions, from acquiring more than 5% of the voting shares of any company and from engaging in any business other than banking or managing or controlling banks. The Federal Reserve Board has by regulation determined that certain activities are closely related to banking within the meaning of the BHCA. These activities include: operating a mortgage company, finance company, credit card company or factoring company; performing certain data processing operations; providing investment and financial advice; and acting as an insurance agent for certain types of credit-related insurance. The Gramm-Leach-Bliley Act ("Gramm-Leach") became law in November 1999. Gramm-Leach established a comprehensive framework to permit affiliations among commercial banks, investment banks, insurance companies, securities firms, and other financial service providers. Gramm-Leach permits qualifying bank holding companies to register with the Federal Reserve Board as "financial holding companies" and allows such companies to engage in a significantly broader range of financial activities than were historically permissible for bank holding companies. Although the Federal Reserve Board provides the principal regulatory supervision of financial services permitted under Gramm-Leach, the Securities and Exchange Commission and state regulators also provide substantial supervisory oversight. In addition to broadening the range of financial services a bank holding company may provide, Gramm-Leach also addressed customer privacy and information sharing issues and set forth certain customer disclosure requirements. The Company has no current plans to petition the Federal Reserve Board for consideration as a financial holding company. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 ("Riegle-Neal") permits bank holding companies to acquire banks located in any state. Riegle-Neal also allows national banks and state banks with different home states to merge across state lines and allows branch banking across state lines, unless specifically prohibited by state laws. 5 Item 1. Business (continued) Regulation and Supervision (continued) The International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001 (USA "Patriot Act") was adopted in response to the September 11, 2001 terrorist attacks. The Patriot Act provides law enforcement with greater powers to investigate terrorism and prevent future terrorist acts. Among the broad-reaching provisions contained in the Patriot Act are several designed to deter terrorists' ability to launder money in the United States and provide law enforcement with additional powers to investigate how terrorists and terrorist organizations are financed. The Patriot Act creates additional requirements for banks, which were already subject to similar regulations. The Patriot Act authorizes the Secretary of Treasury to require financial institutions to take certain "special measures" when the Secretary suspects that certain transactions or accounts are related to money laundering. These special measures may be ordered when the Secretary suspects that a jurisdiction outside of the United States, a financial institution operating outside of the United States, a class of transactions involving a jurisdiction outside of the United States or certain types of accounts are of "primary money laundering concern." The special measures include the following: (a) require financial institutions to keep records and report on transactions or accounts at issue; (b) require financial institutions to obtain and retain information related to the beneficial ownership of any account opened or maintained by foreign persons; (c) require financial institutions to identify each customer who is permitted to use the account; and (d) prohibit or impose conditions on the opening or maintaining of correspondence or payable-through accounts. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution. The operations of the insurance subsidiary are subject to the oversight and review of State of Arizona Department of Insurance. On July 30, 2002, the United States Congress enacted the Sarbanes-Oxley Act of 2002, a law that addresses corporate governance, auditing and accounting, executive compensation and enhanced timely disclosure of corporate information. As Sarbanes-Oxley directs, the Company's chief executive officer and chief financial officer are each required to certify that the Company's quarterly and annual reports do not contain any untrue statement of a material fact. Additionally, these individuals must certify that: they are responsible for establishing, maintaining and regularly evaluating the effectiveness of the company's internal controls; they have made certain disclosures to the company's auditors and the audit committee of the board of directors about the company's internal controls; and they have included information in the company's quarterly and annual reports about their evaluation and whether there have been significant changes in the company's internal controls or in other factors that could significantly affect internal controls subsequent to the evaluations. Effective in 2007, Section 404 of Sarbanes-Oxley will become applicable to the Company. Capital Adequacy Federal banking regulations set forth capital adequacy guidelines, which are used by regulatory authorities to assess the adequacy of capital in examining and supervising a bank holding company and its insured depository institutions. The capital adequacy guidelines generally require bank holding companies to maintain total capital equal to at least 8% of total risk-adjusted assets, with at least one-half of total capital consisting of core capital (i.e., Tier I capital) and the remaining amount consisting of "other" capital-eligible items (i.e., Tier II capital), such as perpetual preferred stock, certain subordinated debt, and, subject to limitations, the allowance for loan losses. Tier I capital generally includes common stockholders' equity plus, within certain limitations, perpetual preferred stock and trust preferred securities. For purposes of computing risk-based capital ratios, bank holding companies must meet specific capital guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items, calculated under regulatory accounting practices. The Company's and its subsidiaries' capital accounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. In addition to total and Tier I capital requirements, regulatory authorities also require bank holding companies and insured depository institutions to maintain a minimum leverage capital ratio of 3%. The leverage ratio is determined as the ratio of Tier I capital to total average assets, where average assets exclude goodwill, other intangibles, and other specifically excluded assets. Regulatory authorities have stated that minimum capital ratios are adequate for those institutions that are operationally and financially sound, experiencing solid earnings, have high levels of asset quality and are not experiencing significant growth. The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels. In those instances where these criteria are not evident, regulatory authorities expect, and may require, bank holding companies and insured depository institutions to maintain higher than minimum capital levels. 6 Item 1. Business (continued) Capital Adequacy (continued) Additionally, federal banking laws require regulatory authorities to take "prompt corrective action" with respect to depository institutions that do not satisfy minimum capital requirements. The extent of these powers depends upon whether the institutions in question are "well capitalized", "adequately capitalized", "undercapitalized", "significantly undercapitalized" or "critically undercapitalized", as such terms are defined under uniform regulations defining such capital levels issued by each of the federal banking agencies. As an example, a depository institution that is not well capitalized is generally prohibited from accepting brokered deposits and offering interest rates on deposits higher than the prevailing rate in its market. Additionally, a depository institution is generally prohibited from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company, may be subject to asset growth limitations and may be required to submit capital restoration plans if the depository institution is considered undercapitalized. The Company's and its subsidiaries' regulatory capital ratios are presented in the following table: Actual Actual Ratio Ratio December 31, December 31, Regulatory 2005 2004 Minimum ------- ----------- ---------- Total Risk Based Capital Ratio ------------------------------ Highlands Bankshares 13.85% 14.71% The Grant County Bank 13.67% 15.54% 8.00% Capon Valley Bank 13.45% 12.82% 8.00% Tier 1 Leverage Ratio --------------------- Highlands Bankshares 9.45% 10.14% The Grant County Bank 8.81% 10.90% 4.00% Capon Valley Bank 8.87% 8.57% 4.00% Tier 1 Risk Based Capital Ratio ------------------------------- Highlands Bankshares 12.60% 13.58% The Grant County Bank 12.47% 14.50% 4.00% Capon Valley Bank 12.20% 11.57% 4.00% Dividends and other Payments The Company is a legal entity separate and distinct from its subsidiaries. Dividends and management fees from Grant County Bank and Capon Valley Bank are essentially the sole source of cash for the Company, although HBI Life will periodically pay dividends to the Company. The right of the Company, and shareholders of the Company, to participate in any distribution of the assets or earnings of Grant County Bank and Capon Valley Bank through the payment of such dividends or otherwise is necessarily subject to the prior claims of creditors of Grant County Bank and Capon Valley Bank, except to the extent that claims of the Company in its capacity as a creditor may be recognized. Moreover, there are various legal limitations applicable to the payment of dividends to the Company as well as the payment of dividends by the Company to its shareholders. Under federal law, Grant County Bank and Capon Valley Bank may not, subject to certain limited expectations, make loans or extensions of credit to, or invest in the securities of, or take securities of the Company as collateral for loans to any borrower. Grant County Bank and Capon Valley Bank are also subject to collateral security requirements for any loans or extensions of credit permitted by such exceptions. 7 Item 1. Business (continued) Dividends and other Payments (continued) Grant County Bank and Capon Valley Bank are subject to various statutory restrictions on their ability to pay dividends to the Company. Specifically, the approval of the appropriate regulatory authorities is required prior to the payment of dividends by Grant County Bank and Capon Valley Bank in excess of earnings retained in the current year plus retained net profits for the preceding two years. The payment of dividends by the Company, Grant County Bank and Capon Valley Bank may also be limited by other factors, such as requirements to maintain adequate capital above regulatory guidelines. The Federal Reserve Board and the Federal Deposit Insurance Corporation have the authority to prohibit any bank under their jurisdiction from engaging in an unsafe and unsound practice in conducting its business. Depending upon the financial condition of Grant County Bank and Capon Valley Bank, the payment of dividends could be deemed to constitute such an unsafe or unsound practice. The Federal Reserve Board and the FDIC have indicated their view that it generally would be an unsafe and unsound practice to pay dividends except out of current operating earnings. The Federal Reserve Board has stated that, as a matter of prudent banking, a bank or bank holding company should not maintain its existing rate of cash dividends on common stock unless (1) the organization's net income available to common shareholders over the past year has been sufficient to fund fully the dividends and (2) the prospective rate or earnings retention appears consistent with the organization's capital needs, asset quality, and overall financial condition. Moreover, the Federal Reserve Board has indicated that bank holding companies should serve as a source of managerial and financial strength to their subsidiary banks. Accordingly, the Federal Reserve Board has stated that a bank holding company should not maintain a level of cash dividends to its shareholders that places undue pressure on the capital of bank subsidiaries, or that can be funded only through additional borrowings or other arrangements that may undermine the bank holding company's ability to serve as a source of strength. Governmental Policies The Federal Reserve Board regulates money and credit and interest rates in order to influence general economic conditions. These policies have a significant influence on overall growth and distribution of bank loans, investments and deposits and affect interest rates charged on loans or paid for time and savings deposits. Federal Reserve monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. Various other legislation, including proposals to overhaul the banking regulatory system and to limit the investments that a depository institution may make with insured funds, are from time to time introduced in Congress. The Company cannot determine the ultimate effect that such potential legislation, if enacted, would have upon its financial condition or operations. Available Information The Company Files annual, quarterly and current reports, proxy statements and other information with the SEC. The Company's SEC filings are filed electronically and are available to the publice via the internet at the SEC's website, www.sec.gov. In addition, any document filed by the Company with the SEC can be read and copies obtained at the SEC's public reference facilities at 450 Fifth Street, NW, Washington, DC 20549. Copies of documents can be obtained at prescribed rates by writing to the Public Reference Section of the SEC at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Copies of documents can also be obtained free of charge by writing to Highlands Bankshares, Inc., P.O. Box 929, Petersburg, WV 26847. Executive Officers Position with Principal Occupation Name Age the Company (Past Five Years) ---------------- --------- ----------------- ----------------------------- Clarence E. Porter 57 President & Chief CEO of Highlands since 2004; Executive Officer; President of The Grant County Treasurer Bank since 1991 R. Alan Miller 36 Finance Officer Finance Officer of Highlands since 2002; Senior Manager of Finance, Cable & Wireless USA prior to 2002 Alan L. Brill 51 Secretary; President of Capon Valley Bank President of Capon since 2001; Executive Vice- Valley Bank President & Chief Operating Officer of Capon Valley bank from 1997 to 2001 8 Item 1A. Risk Factors Due to Increased Competition, the Company May Not Be Able to Attract and Retain Banking Customers At Current Levels. If, due to competition from competitors in the Company's market area, the Company is unable to attract new and retain current customers, loan and deposit growth could decrease causing the Company's results of operations and financial condition to be negatively impacted. The Company faces competition from the following: o local, regional and national banks; o savings and loans; o internet banks; o credit unions; o insurance companies; o finance companies; and o brokerage firms serving the Company's market areas. The Company's Lending Limit May Prevent It from Making Large Loans. In the future, the Company may not be able to attract larger volume customers because the size of loans that the company can offer to potential customers is less than the size of the loans that many of the company's larger competitors can offer. We anticipate that our lending limit will continue to increase proportionately with the company's growth in earnings; however, the Company may not be able to successfully attract or maintain larger customers. Certain Loans That the Bank Makes Are Riskier than Loans for Real Estate Lending. The Banks make loans that involve a greater degree of risk than loans involving residential real estate lending. Commercial business loans may involve greater risks than other types of lending because they are often made based on varying forms of collateral, and repayment of these loans often depends on the success of the commercial venture. Consumer loans may involve greater risk because adverse changes in borrowers' incomes and employment after funding of the loans may impact their abilities to repay the loans. The Company Is Subject to Interest Rate Risk. Aside from credit risk, the most significant risk resulting from the company's normal course of business, extending loans and accepting deposits, is interest rate risk. If market interest rate fluctuations cause the Company's cost of funds to increase faster than the yield of its interest-earning assets, then its net interest income will be reduced. The Company's results of operations depend to a large extent on the level of net interest income, which is the difference between income from interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings. Interest rates are highly sensitive to many factors that are beyond the Company's control, including general economic conditions and the policies of various governmental and regulatory authorities. The Company May Not Be Able to Retain Key Members of Management. The departure of one or more of the Company's officers or other key personnel could adversely affect the Company's operations and financial position. The Company's management makes most decisions that involve the Company's operations. An Economic Slowdown in the Company's Market Area Could Hurt Our Business. An economic slowdown in our market area could hurt our business. An economic slowdown could have the following consequences: o Loan delinquencies may increase; o Problem assets and foreclosures may increase; o Demand for the products and services of the Company may decline; and o Collateral (including real estate) for loans made by the company may decline in value, in turn reducing customers' borrowing power and making existing loans less secure. 9 Item 1A. Risk Factors (continued) The Company and the Bank are Extensively Regulated. The operations of the Company are subject to extensive regulation by federal, state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on them. Policies adopted or required by these governmental authorities can affect the Company's business operations and the availability, growth and distribution of the Company's investments, borrowings and deposits. Proposals to change the laws governing financial institutions are frequently raised in Congress and before bank regulatory authorities. Changes in applicable laws or policies could materially affect the Company's business, and the likelihood of any major changes in the future and their effects are impossible to determine. The Company's Allowance for Loan Losses May Not Be Sufficient. In the future, the Company could experience negative credit quality trends that could head to a deterioration of asset quality. Such a deterioration could require the company to incur loan charge-offs in the future and incur additional loan loss provision, both of which would have the effect of decreasing earnings. The Company maintains an allowance for possible loan losses which is a reserve established through a provision for possible loan losses charged to expense that represents management's best estimate of probable losses that have been incurred within the existing portfolio of loans. Any increases in the allowance for possible loan losses will result in a decrease in net income and, possibly, capital, and may not have a material adverse effect on the Company's financial condition and results of operation. A Shareholder May Have Difficulty Selling Shares. Because a very limited public market exists for the parent's common stock, a shareholder may have difficulty selling his or her shares in the secondary market. We cannot predict when, if ever, we could meet the listing qualifications of the Nasdaq Stock Market's National Market Tier or any exchange. We cannot assure you that there will be a more active public market for the shares in the near future. Shares of the Company's Common Stock Are Not FDIC Insured. Neither the Federal Deposit Insurance Corporation nor any other governmental agency insures the shares of the Company's common stock. Therefore, the value of your shares in the Company will be based on their market value and may decline. 10 Item 1A. Risk Factors (continued) Customers May Default on the Repayment of Loans. The Bank's customers may default on the repayment of loans, which may negatively impact the Company's earnings due to loss of principal and interest income. Increased operating expenses may result from the allocation of management time and resources to the collection and work-out of the loan. Collection efforts may or may not be successful causing the Company to write off the loan or repossess the collateral securing the loan which may or may not exceed the balance of the loan. The Company's Controls and Procedures May Fail or Be Circumvented. Management regularly reviews and updates the Company's internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, no matter how well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Company's controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Company's business, results of operations and financial conditions. Item 1B. Unresolved Staff Comments None Item 2. Properties The Grant County Bank's main office is located on Main Street in Petersburg, West Virginia. The Bank also has branch facilities located in Riverton, Moorefield, Keyser, Harman , Davis and Canaan Valley, West Virginia. The Riverton branch building is leased while all other locations are owned by the Bank. Capon Valley Bank's main office is located in Wardensville, West Virginia. The Bank also has branch facilities in Moorefield and Baker, West Virginia and in Gore, Virginia. All facilities are owned by the Bank. Item 3. Legal Proceedings Management is not aware of any material pending or threatened litigation in which Highlands or its subsidiaries may be involved as a defendant. In the normal course of business, the banks periodically must initiate suits against borrowers as a final course of action in collecting past due loans. In late February of 2006, a third party alleged that an error had been made regarding the safekeeping of a deposit, specifically two certificates of deposit totaling $2,000,000 that had been assigned as collateral for a performance bond had been released to the owners. It was alleged that the error was related to a trust account held by the now discontinued subsidiary of Highlands, Highlands Bankshares Trust Company. This third party indicated that if it experienced a loss relating to this bond, that it may pursue legal action as a potential remedy for this loss. At this time, the potential for legal action or the amount of any potential liability to Highlands Bankshares or its subsidiaries is unknown. Item 4. Submission of Matters to a Vote of Security Holders Highlands did not submit any matters to a vote of security holders during the fourth quarter of 2005. 11 PART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company had approximately 1,119 shareholders of record as of December 31, 2005. This amount includes all shareholders, whether titled individually or held by a brokerage firm or custodian in street name. The Company's stock is not traded on any national or regional stock exchange although brokers may occasionally initiate or be a participant in a trade. The Company's stock is listed on the Nasdaq Over The Counter Bulletin Board. Terms of an exchange between individual parties may not be known to the Company. The following outlines the dividends paid and market prices of the Company's stock based on prices disclosed to management. Prices have been provided using a nationally recognized online stock quote system. Such prices may not include retail mark-ups, mark-downs or commissions. Dividends are subject to the restrictions described in Note 10 to the Financial Statements. Estimated Dividends Market Price Range Per Share High Low --------- ----- ------ 2005 First Quarter .20 28.90 24.80 Second Quarter .20 29.10 26.74 Third Quarter .20 30.79 28.11 Fourth Quarter .22 32.00 30.79 2004 First Quarter .15 29.00 27.15 Second Quarter .15 28.49 26.45 Third Quarter .15 26.45 24.50 Fourth Quarter .18 26.00 24.15 Highlands has not initiated any plans to repurchase its stock nor has it repurchased any stock during the fourth quarter of 2005. 12 Item 6. Selected Financial Data Years Ending December 31, (In Thousands of Dollars Except for Per Share Amounts) 2005 2004 2003 2002 2001 ------ ------ -------- ------- ------- Total Interest Income 19,813 17,729 18,283 18,970 20,207 Total Interest Expense 5,761 4,711 6,338 7,705 10,049 ------- ------- ------ ------ ------ Net Interest Income 14,052 13,018 11,945 11,265 10,158 Provision for Loan Losses 875 920 1,820 820 600 ------- ------ ------ ------ ------ Net Interest Income After Provision for Loan Losses 13,177 12,098 10,125 10,445 9,558 Other Income 1,669 1,597 1,367 1,304 1,194 Other Expenses 9,128 8,938 8,247 8,048 7,431 ------- -------- ------ ----- ------ Income before Income Taxes 5,718 4,757 3,245 3,701 3,321 Income Tax Expense 1,916 1,551 1,012 1,179 979 ----- ----- ------- ------- ----- Net Income $ 3,802 $ 3,206 $ 2,233 $ 2,522 $ 2,342 ====== ====== ====== ====== ====== Total Assets at Year End $337,573 $299,992 $301,168 $296,672 $277,042 ======== ======== ======== ======= ======= Net Income per Share* $ 2.65 $ 2.23 $ 1.55 $ 1.73 $ 1.56 Dividends per Share* $ .82 $ .63 $ .56 $ .51 $ .45 Return on Average Assets 1.21% 1.07% .73% .89% .89% Return on Average Equity 11.53% 10.36% 7.60% 8.87% 8.57% Dividend Payout Ratio 30.99% 28.23% 36.03% 29.26% 29.15% Year End Equity to Assets Ratio 10.07% 10.55% 9.81% 9.69% 10.06% *-- 2002 and 2001 per share figures restated to reflect stock split effected in form of dividend in 2002. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Policies The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The financial statements contained within these statements 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. 13 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) 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 and Life Insurance Investments The Company has invested in and owns life insurance polices on key officers. The policies are designed so that the company recovers the interest expenses associated with carrying the policies and the officer will, at the time of retirement, receive any earnings in excess of the amounts earned by the Company. The Company recognizes as an asset the net amount that could be realized under the insurance contract as of the balance sheet date. This amount represents the cash surrender value of the policies less applicable surrender charges. The portion of the benefits which will be received by the executives at the time of their retirement is considered, when taken collectively, to constitute a retirement plan. Therefore the Company accounts for these policies using guidance found in Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Post Retirement Benefits Other Than Pensions." SFAS No. 106 requires that an employers' obligation under a deferred compensation agreement be accrued over the expected service life of the employee through their normal retirement date. 14 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Post Retirement Benefits and Life Insurance Investments (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. Intangible Assets Generally accepted accounting principles were applied to allocate the intangible components of the purchase of the National Bank of Davis in November 2005. This excess was allocated between identifiable intangibles (i.e. core deposit intangibles) and unidentified intangibles (i.e. goodwill). Goodwill is required to be evaluated for impairment on an annual basis, and the value of the goodwill adjusted accordingly, should impairment be found. As of December 31, 2005, the Company did not identify an impairment of this intangible. Recent Accounting Pronouncements No recent accounting pronouncements had a material impact on the Company's consolidated financial statements. Forward Looking Statements Certain statements in this report may constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualified words (and their derivatives) such as "expect," "believe," "estimate," "plan," "project," or other future events. Although the Company believes that its expectations with respect to certain forward-looking statements are based upon reasonable assumptions within the bounds of its existing knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Actual future results and trends may differ materially from historical results or those anticipated depending on a variety of factors, including, but not limited to, the effects of and changes in: general economic conditions, the interest rate environment, legislative and regulatory requirements, competitive pressures, the effects of bankruptcy or delinquency of large commercial customers, the effects on the results of operations of Highlands resulting from the purchase of the National Bank of Davis, the impact on costs of legal and professional fees resulting from changes in the regulatory environment, the effect of rising fuel costs on the trucking industry and the economy as a whole, assumptions used in the determination of the allowance for loan losses, new products and delivery systems, inflation, changes in the stock and bond markets, technology, and consumer spending and savings habits. The Company does not update any forward-looking statements that may be made from time to time by or on behalf of the Company. 15 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Overview of 2005 Results Highlands Bankshares results of operations for 2005 produced income of $3,802,000, an increase of 18.59% over 2004 income. Loan demand remained strong in 2005 and average loan balances increased 8.37% as compared to 2004. During the year, management continued the strategy of funding new loan growth, to the extent possible, through reductions in balances of lower earning assets such as securities and federal funds sold rather than pay above market rates to obtain new deposits. As a result, net interest income increased 7.94% as compared to 2004. The provision for loan losses charged to operations declined $45,000 as compared to 2004, largely as a result of decreased net charge-offs during the year. In spite of the lower provision, the allowance for loan losses as a percent of gross loans increased from 1.02% at December 31, 2004 to 1.16% at December 31, 2005. Non-interest income increased 6.01% during 2005 as compared to 2004, as increases in service charge income offset decreases in the earnings from life insurance commissions and other insurance operations. Non-interest expense increased a modest 2.39% as an increase in legal and professional fees resulting from expanded audit procedures offset a decrease in data processing expense. Occupancy and equipment expense remained relatively flat. Expenses related to salaries and benefits paid employees increased 2.48% largely due to an increase in the expenses of post retirement benefits of employees. During the fourth quarter of 2005, Highlands Bankshares purchased all of the outstanding shares of common stock of The National Bank of Davis ("Davis") and subsequently merged Davis into The Grant County Bank. This purchase added approximately $27,772,000 in assets and $25,705,000 in liabilities, respectively, to Highlands' base of operations. As a result of the purchase and merger, Grant added two banking locations in Tucker County, West Virginia. A summary of the financial results of Highlands Bankshares, Inc., by quarter for both 2005 and 2004, appears on the following page. 16 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Quarterly Financial Results (in thousands of dollars, except per share amounts) Fourth Third Second First Quarter Quarter Quarter Quarter ------- ------- ------- -------- 2005 ----- Interest income $ 5,406 $ 5,008 $ 4,783 $ 4,616 Interest expense 1,612 1,493 1,392 1,264 ------ ------ ------ ------ Net interest income 3,794 3,515 3,391 3,352 Provision for loan losses 185 255 210 225 ------- ------- ------- -------- Net interest income after provision for loan losses 3,609 3,260 3,181 3,127 Noninterest income 415 445 445 364 Noninterest expense 2,390 2,299 2,229 2,210 ------ ------ ------ ------ Income before income tax expense 1,634 1,406 1,397 1,281 Income tax expense 542 463 479 432 ------- ------- ------ ------ Net Income $ 1,092 $ 943 $ 918 $ 849 ======= ====== ====== ====== Per common share Net income (basic) $ .76 $ .66 $ .64 $ .59 Cash dividends .22 .20 .20 .20 Fourth Third Second First Quarter Quarter Quarter Quarter 2004 ----- Interest income $ 4,563 $ 4,436 $ 4,400 $ 4,330 Interest expense 1,160 1,142 1,161 1,248 ------ ------ ------ ------ Net interest income 3,403 3,294 3,239 3,082 Provision for loan losses 320 195 210 195 ------- ------- ------- ------- Net interest income after provision for loan losses 3,083 3,099 3,029 2,887 Noninterest income 402 451 410 334 Noninterest expense 2,303 2,242 2,229 2,164 ------ ------ ------ ------ Income before income tax provision 1,182 1,308 1,210 1,057 Income tax expense 361 432 413 345 ------- ------- ------ ------ Net Income $ 821 $ 876 $ 797 $ 712 ====== ====== ====== ====== Per common share Net income (basic) $ .57 $ .61 $ .55 $ .50 Cash dividends .18 .15 .15 .15 17 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Purchase of National Bank of Davis On August 22, 2005, Highlands Bankshares entered into an agreement to purchase the outstanding shares of common stock of The National Bank of Davis ("Davis"), located in Davis, West Virginia. The Agreement can be found by accessing the website of the Securities and Exchange Commission under the filings of Highlands Bankshares, Inc. and as part of the Current Report on Form 8-K filed August, 23, 2005. The Agreement was consummated on October 31, 2005 and the shareholders of Davis were paid $10,400 per share for a total purchase price of $5,200,000. Highlands incurred additional expenses related to the purchase of $56,000. On November 15, 2005, Davis was merged into The Grant County Bank, with Grant County Bank surviving the merger and with both banking locations of Davis becoming branches of The Grant County Bank. Funding for the purchase was provided by a special, one-time dividend from The Grant County Bank to Highlands Bankshares. The purchase of Davis added two banking locations and 12 full-time equivalent employees to the operations of Highlands. Portions of the acquisition price were allocated to core deposit intangibles and goodwill. The acquisition was accounted for as a purchase and the acquisition costs, including fees and expenses, were allocated among the assets acquired and the liabilities assumed. Other assets and liabilities were valued as of the date of the purchase. Following is selected historical financial data for The National Bank of Davis. The September 30, 2005 balance sheet and income statement for The National Bank of Davis are unaudited. The December 31, 2004 balance sheet was audited by a public accounting firm who rendered an unqualified opinion. Because The National Bank of Davis was not required to file with the Securities and Exchange Commission, the audit was not required to be conducted in compliance with PCAOB standards. Thus, certain auditing standards passed by the PCAOB were not applicable to the audit of The National Bank of Davis. 18 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Purchase of National Bank of Davis (continued) The National Bank of Davis Balance Sheets (in thousands of dollars) September 30, December 31, 2005 2004 ---- ---- Assets Cash and cash equivalents $ 615 $ 1,152 Federal funds sold 5,764 4,735 Securities (net of valuation allowance) 9,876 10,287 Other investments 8 8 Loans 8,709 8,405 Allowance for loan losses (167) (165) Bank premises and equipment (net of depreciation) 676 712 Interest receivable 106 152 Investment in life insurance contracts 353 346 Other assets 62 93 -------- -------- Total Assets $ 26,002 $ 25,725 ======== ======== Liabilities Noninterest bearing demand deposits $ 5,492 $ 5,687 Interest bearing demand deposits and savings 9,578 8,903 Time deposits 9,120 9,329 Accrued expenses and other liabilities 72 110 --------- -------- Total Liabilities 24,262 24,029 -------- -------- Stockholders' Equity Common stock 50 50 Surplus 200 200 Retained Earnings 1,565 1,463 Accumulated other comprehensive loss (75) (17) -------- -------- Total Stockholders' Equity 1,740 1,696 -------- -------- Total Liabilities and Stockholders' Equity $ 26,002 $ 25,725 ========= ======== 19 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Purchase of National Bank of Davis (continued) The National Bank of Davis Statement of Income (in thousands of dollars) Nine Month Twelve Month Period Ended Period Ended September 30, December 31, 2005 2004 --------- ------------ (Unaudited) (Audited) Interest Income Interest and fees on loans $ 465 $ 636 Interest on federal funds sold 105 50 Interest on securities 321 516 --------- -------- Total Interest Income 891 1,202 Interest Expense Interest on deposits 180 271 -------- --------- Net Interest Income 711 931 Provision for Loan Losses -- 15 --------- -------- Net Interest Income after Provision for Loan Losses 711 916 -------- --------- Noninterest Income Service Charges 37 48 Investment in life insurance contracts 6 12 Other noninterest income 10 41 -------- --------- Total noninterest income 53 101 --------- --------- Noninterest expense Salaries and employee benefits 310 411 Equipment & occupancy expense 119 183 Data processing expense 32 26 Other noninterest expense 196 298 -------- -------- Total noninterest expense 657 918 -------- -------- Income Before Income Tax Expense 107 99 Expense (Benefit) Income Tax 6 (11) --------- --------- Net Income $ 101 $ 110 ======== ======== 20 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Net Interest Income 2005 Compared to 2004 Net interest income, on a fully taxable equivalent basis, increased 7.81% in 2005 as compared to 2004. As the Federal Reserve Board (the "Fed") continued to increase the target rates for federal funds, both interest rates paid on deposits and interest earned on assets increased. The increases by the Fed had the greatest impact on the rates earned on federal funds sold, deposits in other banks and on interest bearing deposits. Average balances of earning assets increased $12.39 million while average balances of interest bearing liabilities increased only $5.68 million. This relative increase, coupled with increases in loan balances, (a comparatively higher earning asset as a percentage of total average earning assets) had the greatest impact in the increase in net interest income and the increase of 15 basis points in net interest margin. Throughout 2004 and into the early part of 2005, the Company chose to fund loan growth through the reduction of balances of federal funds sold, deposits in other banks and securities (relatively low earning assets) rather than pay above market rates to attract new deposits. This strategy caused overall average balances of interest bearing deposits to decrease slightly, investments in securities to decrease moderately and Fed Funds sold to decrease substantially. Average rates paid on interest bearing liabilities increased 40 basis points from 2004 to 2005 compared to the slightly larger 44 basis point increase experienced with interest earning assets. While the rate increases enacted by the Fed had an immediate impact on the yields of federal funds sold and interest bearing deposits, continued heavy competition for new loans caused a more subdued increase in average rates earned on loans . In addition to funding loan growth through reductions in balances of relatively lower earning assets, the Company also chose to utilize its borrowing capacity from the Federal Home Loan Bank ("FHLB") more in 2005 than in the past. The lending options offered by the FHLB allowed the subsidiary banks to borrow in certain instances at favorable rates and/or favorable repayment terms and assist in the Company's management of its assets and liabilities. Average balances of many of the categories of both earning assets and interest bearing liabilities were increased by the purchase of The National Bank of Davis ("Davis"). However, because this purchase occurred late in 2005, and because of the relatively small size of Davis compared to Highlands Bankshares, the impact on net interest margin for 2005 was not significant. At the time of purchase, Davis had a comparatively conservative balance sheet. Davis' loan to deposit ratio at the time of purchase was 33.14% and Davis' ratio of earning assets to interest bearing liabilities was 84.45% compared to a Highlands 2005 average ratio of earning assets to interest bearing liabilities of 124.93%. The purchase of Davis will have a greater impact on net interest margin in 2006 than in 2005. The inclusion of Davis' assets and liabilities may have the impact of lowering Highlands' net interest margin during 2006, but the anticipated increase in earning assets should have the effect of increasing net interest income in future years. 2004 Compared to 2003 Net interest income increased 8.98% in 2004 as compared to 2003. The repeated lowering of target interest rates by the Federal Reserve Board (the "Fed") seen during the greater part of 2002 and 2003 ceased during 2004 and then reversed into an upward trend of the Fed raising target rates. In spite of the increases in rates by the Fed during 2004, average rates earned on earning assets and average rates paid on interest bearing liabilities generally continued to decrease as the Company saw old balances of both assets and liabilities mature and be rewritten at lower rates. 21 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Net Interest Income (continued) 2004 Compared to 2003 (continued) The competitive atmosphere for both loans and deposits and the changing interest rate environment combined with flat loan growth during the early periods of 2004 created the need for achieving improved net interest margin through closer asset/liability management. Because of the flat loan growth early in the year and a favorable liquidity position, Management chose to keep deposit rates at or below those of the competition and balances of time deposits and the average rates paid on those deposits fell throughout 2004. As loan growth increased later in the year, Management chose to continue with deposit rates at or lower than the local competition and fund the loan growth through reductions in balances of comparatively lower earning assets like Fed Funds Sold and investment securities. Income from interest earning assets decreased $575,000 in 2004. Although average rates within each asset class fell, average rates received as a whole fell only slightly as lower earning assets (Fed Funds sold, deposits in other banks) were replaced by relatively higher earning loan balances. Average balances of earning assets decreased $4,296,000. The decline in average rates on earning assets and average balances of earning assets were more than offset by declines in both average rates paid on deposits and on average balances of deposits. Interest expense decreased $1,627,000 due to a decrease in average interest bearing liabilities of 4.30% and a 60 basis point decline in average rates. Because of the restricted availability of deposits to the subsidiary banks caused by the Company's rural location and because of high levels of competition, the Company, in order to fund loan growth, has historically been forced to pay rates on time deposits often at rates above most regional and national banks. During 2004, slowing loan growth reduced the need for deposit balances and the Company was able to pay rates on deposits, especially time deposits, which more closely approximated, and were often below, those rates paid by regional and national banks. Because of this reduction in rates and as older deposits at higher rates matured and were rewritten at lower rates created by the lower rate environment, interest expense on deposits decreased. Because of the favorable liquidity position by the Company throughout most of 2004, the subsidiary banks continued to pay rates on time deposits lower than those of much of the local competition. As time deposits matured, many customers chose to move balances to other financial institutions, resulting in a lower average balance of time deposits for 2004 as compared to 2003. Customers appeared during the year to be reluctant to place money into time deposits. It appeared that expectation of rising rates made depositors reluctant to commit to longer term time deposits and many of the monies previously deposited into certificates moved to the interest bearing transaction accounts. This further lowered overall interest expense. Average balances of transaction based interest bearing accounts (money market and savings accounts) increased 8.21% from 2003 to 2004 while average balances of time deposits decreased 11.15%. In the second half of 2004, the Fed began to raise the target Fed Funds rate, and as competition for deposits in the banks' local markets increased, the Company chose to fund new loan growth through funds borrowed from the Federal Home Loan Bank (FHLB). The rates and terms available on these funds were comparatively more attractive than offering above average market rates on deposits. As a result, balances of funds borrowed from the FHLB at December 31, 2004 were nearly double the levels at December 31, 2003. 21 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Net Interest Income (continued) A summary of the Company's net interest margin and average balance sheets for the years ended December 31, 2005, 2004 and 2003 is illustrated below (in thousands of dollars):
2005 2004 2003 ------- ----- ------ Average Income Yield Average Income Yield Average Income Yield Balance(2) /Expense /Rate Balance /Expense /Rate Balance /Expense /Rate ---------- -------- ------ --------- -------- ------- --------- -------- ------ Earning Assets -------------- Loans(3,4) $ 254,700 $ 18,6227 .31% $ 235,023 $ 16,7527 .13% $ 226,281 $ 16,966 7.50% Investment Securities Taxable 23,313 707 3.03 25,944 674 2.60 28,107 885 3.15 Nontaxable(1) 2,951 163 5.52 3,298 194 5.89 3,748 254 6.78 Interest bearing deposits 1,268 38 3.00 1,430 18 1.26 5,342 53 .99 Federal funds sold 9,970 343 3.44 14,119 163 1.15 20,632 218 1.06 -------- ------- ----- ---------- -------- ----- -------- ------ ----- Total earning assets 292,202 19,873 6.80 279,814 17,801 6.36 284,110 18,376 6.47 Allowance for loan losses (2,807) (2,418) (2,163) Other nonearning assets 25,291 23,024 23,343 ------- -------- --------- Total Assets $ 314,686 $ 300,420 $ 305,290 ======== ======== ======== Interest Bearing Liabilities ---------------------------- Demand deposits $ 23,554 $ 189 .80 $ 24,031 $ 95 .40 $ 21,434 $ 134 .63 Savings deposits 49,391 437 .88 52,079 296 .57 48,128 381 .79 Time deposits 146,211 4,504 3.08 145,834 4,042 2.77 164,126 5,585 3.40 Borrowed money 14,728 631 4.28 6,264 278 4.44 4,780 238 4.98 -------- ------ ---- --------- -------- ----- -------- ------ ---- Total interest bearing Liabilities 233,884 5,761 2.46 228,208 4,711 2.06 238,468 6,338 2.66 Demand deposits 41,360 37,325 35,086 Other liabilities 6,459 3,954 2,337 Stockholders' equity 32,983 30,933 29,399 -------- --------- -------- Total Liabilities and Shareholders' Equity $ 314,686 $ 300,420 $ 305,290 ======== ======== ======== Net Interest Income $ 14,112 $ 13,090 $ 12,038 Net Yield on Earning Assets 4.83% 4.68% 4.24%
Notes: (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) Income on loans includes fees 23 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Net Interest Income (continued) EFFECT OF RATE-VOLUME CHANGES ON NET INTEREST INCOME (On a fully taxable equivalent basis) (In thousands of dollars) Increase (Decrease) Increase (Decrease) 2005 Compared to 2004 2004 Compared to 2003 Due to change in: Due to change in: Average Average Total Average Average Total Volume Rate Change Volume Rate Change Interest Income Loans $ 1,402 $ 468 $ 1,870 $ 655 $ (869) $ (214) Investment securities Taxable (68) 101 33 (191) (20) (211) Nontaxable (20) (11) (31) (60) (60) Interest bearing deposits (2) 22 20 (39) 4 (35) Federal funds sold (48) 228 180 (69) 14 (55) ------ ------ ------- ------ ------ ------ Total Interest Income 1,264 808 2,072 296 (871) (575) ------ ----- ----- ----- ---- ---- Interest Expense Demand deposits (2) 96 94 16 (55) (39) Savings deposits (15) 156 141 31 (116) (85) Time deposits 10 452 462 (622) (921) (1,543) Borrowed money 376 (23) 353 74 (34) 40 ------ ------ ------- ------- ------- ----- Total Interest Expense 369 681 1,050 (501) (1,126) (1,627) ------ ------ ------- ------- ------- ------ Net Interest Income $ 895 $ 127 $ 1,022 $ 797 $ 255 $1,052 ======= ===== ======= ===== ===== ====== Changes in volume are calculated based on the difference in average balance multiplied by the prior year average rate. Changes due to rate changes are calculated by subtracting the change due to volume from the total change. Loan Portfolio The Company is an active residential mortgage and construction lender and 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, Tucker and Pendleton counties in West Virginia and Frederick County, Virginia. 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. 24 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Loan Portfolio (continued) The following table summarizes the Company's loan portfolio (in thousands of dollars): At December 31, 2005 2004 2003 2002 2001 ------ ----- ------- ------ ------- Real Estate Mortgage $ 153,646 $ 140,762 $ 129,671 $ 121,558 $ 111,668 Construction 12,201 8,850 7,552 6,813 3,868 Commercial 57,908 52,813 42,911 47,089 42,204 Installment 46,265 46,092 46,501 50,294 47,730 --------- -------- -------- -------- -------- Total Loans 270,020 248,517 226,635 225,754 205,470 Allowance for Loan losses (3,129) (2,530) (2,463) (1,793) (1,603) ------- ------- ------- ------- ------- Loans, net $ 266,891 $ 245,987 $ 224,172 $ 223,961 $ 203,867 ======== ======== ======== ======== ======== Commercial loan balances include certain commercial loans which are secured by real estate. As of December 31, 2005, 2004 and 2003 the Company maintained balances of loans secured by real estate of $200.03 million, $180.17 million and $163.60 million. There were no foreign loans outstanding during any of the above periods. The following table shows the Company's loan maturity distribution as of December 31, 2005: Maturity Range Less than 1-5 Over 1 Year Years 5 Years Total -------- ----- ------- ------- (in thousands of dollars) Loan Type Commercial and agricultural $ 35,940 $ 12,506 $ 9,462 $ 57,908 Real estate mortgage and construction 43,852 56,520 65,475 165,847 Consumer installment 15,057 29,635 1,573 46,265 -------- -------- -------- ------- Total $ 94,849 $ 98,661 $ 76,510 $270,020 ======= ======= ======== ======== 25 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Credit Quality The principal economic risk associated with each of the categories of loans in the Company's portfolio is the creditworthiness of its borrowers. Within each category, such risk is increased or decreased depending on prevailing economic conditions. The risk associated with the real estate mortgage loans and installment loans to individuals varies based upon employment levels, consumer confidence, fluctuations in value of residential real estate and other conditions that affect the ability of consumers to repay indebtedness. The risk associated with commercial, financial and agricultural loans varies based upon the strength and activity of the local economies of the Company's market areas. The risk associated with real estate construction loans varies based upon the supply of and demand for the type of real estate under construction. An inherent risk in the lending of money is that the borrower will not be able to repay the loan under the terms of the original agreement. The allowance for loan losses (see subsequent section) provides for this risk and is reviewed periodically for adequacy. This review also considers concentrations of loans in terms of geography, business type or level of risk. While lending is geographically diversified within the service area, the Company does have some concentration of loans in the area of agriculture (primarily poultry farming), and the timber and coal extraction industries. Management recognizes these concentrations and considers them when structuring its loan portfolio. 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 typically placed in nonaccrual status when the collection of principal or interest is 90 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 for which a borrower has been granted a concession on the interest rate or the original repayment terms because of financial difficulties. Nonperforming loans do not represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources. Nonperforming loans are listed in the table below. Nonperforming loans increased from December 31, 2004 to December 31, 2005. At December 31, 2005, nonperforming loans represented .72% of the Company's balances of gross loans as compared to .43% at December 31, 2004. The following table summarizes the Company's nonperforming loans (in thousands of dollars): At December 31, 2005 2004 2003 2002 2001 ----- ------ ------ ----- ----- Loans accounted for on a nonaccrual basis Consumer $ 124 $ 252 $ 228 $ 9 $ -- Real Estate 619 278 1,436 290 474 ----- ------ ------- ------- -------- Total nonaccrual loans 743 530 1,664 299 474 Restructured loans --- --- 631 662 --- Loans delinquent 90 days or more Commercial 74 140 25 161 607 Real estate 966 355 1,255 1,312 1,352 Consumer 149 40 318 445 336 ------ ----- ------ ------ ------ Total delinquent loans 1,189 535 1,598 1,918 2,295 Total nonperforming Loans $ 1,932 $ 1,065 $ 3,893 $ 2,879 $ 2,769 ====== ====== ====== ====== ====== 26 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Credit Quality (continued) Real estate acquired through foreclosure was $44,800 at December 31, 2005, $327,650 at December 31, 2004 and $291,414 at December 31, 2003. The foreclosed property held at December 31, 2005 was 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. 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. In recent periods, the Company's loan portfolio has also begun to reflect a concentration in loans collateralized by heavy equipment, particularly in the trucking, mining and timber industries. In part because of rising fuel costs, the trucking sector has experienced a recent downturn. However, the Company has experienced no material losses related to foreclosures of loans collateralized by heavy equipment. While close monitoring of this sector is necessary, Management expects no significant losses in the foreseeable future. As of December 31, 2005, the Company had three potential problem loans as defined in SEC Industry Guide III that would require disclosure. These loans are described below. In July 2004, the Company received notice that a large commercial loan customer had filed for Chapter 11 bankruptcy protection. Depending upon the final outcome of the bankruptcy proceedings, the Company may be forced to reclassify the loans made to this customer, which total approximately $1.38 million, to non-accrual status. If these loans are reclassified to non-accrual, this will have a negative impact on interest revenue and net income to the extent that any interest accruing to the loans of this customer would not be recognized as income. At present, the interest earned on the loans to this customer total approximately $100,000 per annum. The loans to this customer are deemed by Management to be well secured, and if a foreclosure is required, the Company expects there to be no loss on the sale of the collateral. Since the bankruptcy filing, this customer has continued to make payments of both principal and interest, and though remaining moderately delinquent, these payments have been sufficient to consistently keep the customer less than 60 days past due. As of December 31, 2005, a large commercial loan customer with outstanding loan balances of approximately $450,000 was over 60 days past due and recent payment history indicates this customer may lack sufficient cash flow to bring the loan current. During January, this customer brought all its loans current but has subsequently become delinquent. Recently, the Company obtained information that led to a belief that the bankruptcy of this customer may be imminent; however, the Company has received no formal notice of bankruptcy proceedings. As such, all loans outstanding to this customer have been moved to non-accrual status. In addition, the Company has begun taking steps to repossess certain items collateralizing this customer's loans. Management believes the loans to this customer to be well secured and expects no material loss related to this customer. As of December 31, 2005 a third large commercial loan customer with balances of approximately $2,500,000 had become delinquent, leading to management's belief that this customer may lack sufficient cash flow to continue to make timely payments on the loan. Should delinquencies for this customer continue or grow worse, it may become necessary to reclassify the loans of this customer to non-accrual status. At present, the interest income earned on loans to this customer is approximately $200,000. In the event that foreclosure would become necessary for this loan customer, Management believes the loans to this customer to be well secured and no material loss would occur. In the weeks immediately following December 31, 2005, this customer had paid all accounts current, and this customer remains current as of the date of this filing. 27 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Allowance For Loan Losses The allowance for loan losses is an estimate of the losses in the current loan portfolio. The allowance is based on two principles of accounting: (i) SFAS No. 5, Accounting for Contingencies which requires that losses be accrued when they are probable of occurring and estimable and (ii) SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires that loans be identified which have characteristics of impairment as individual risks, (e.g. the collateral, present value of cash flows or observable market values are less than the loan balance). Each of Company's banking subsidiaries, Capon Valley Bank and The Grant County Bank, determines the adequacy of its allowance for loan losses independently. Although the loan portfolios of the two banks are similar to each other, some differences exist which result in divergent risk patterns and different charge-off rates amongst the functional areas of the banks' portfolio. Each bank pays particular attention to individual loan performance, collateral values, borrower financial condition and economic conditions. The determination of an adequate allowance at each bank is done in a three step process. The first step is to identify impaired loans. Impaired loans are problem loans above a certain threshold which have estimated losses calculated based on the fair value of the collateral with which the loan is secured. A summary of the loans which the Company has identified as impaired follows (in thousands of dollars): December 31, 2005 Identified Loan Type Balance Impairment --------- ------- ---------- Mortgage $ 1,113 $ 198 Commercial 94 19 Installment 286 137 The second step is to identify loans above a certain threshold which are problem loans due to the borrowers' payment history or deteriorating financial condition. Losses in this category are determined based on historical loss rates adjusted for current economic conditions. The final step is to calculate a loss for the remainder of the portfolio using historical loss information for each type of loan classification. The determination of specific allowances and weighting is somewhat subjective and actual losses may be greater or less than the amount of the allowance. However, Management believes that the allowance represents a fair assessment of the losses that exist in the current loan portfolio. The required level of the allowance for loan losses is computed quarterly and the allowance adjusted prior to the issuance of the quarterly financial statements. All loan losses charged to the allowance are approved by the boards of directors of each bank at their regular meetings. The allowance is reviewed for adequacy after considering historical loss rates, current economic conditions (both locally and nationally) and any known credit problems that have not been considered under the above formula. Management has analyzed the potential risk of loss on the Company's loan portfolio given the loan balances and the value of the underlying collateral and has recognized losses where appropriate. Nonperforming loans are closely monitored on an ongoing basis as part of the Company's loan review process. The ratio of the allowance for loan losses to total loans outstanding was 1.16% at December 31, 2005, 1.02% at December 31, 2004 and 1.09% at December 31, 2003. At December 31, 2005, the ratio of the allowance for loan losses to nonperforming loans was 161.96% compared to 237.56% at December 31, 2004 and 63.27% at December 31, 2003. Following higher than normal net charge-offs during 2003 and 2004, and balances of non-performing loans at December 31, 2004 being significantly lower than historically experienced by Highlands, the ratio of the allowance for loan losses to nonperforming loans had been reduced. Throughout 2005, the Company has experienced an increase in its delinquencies and in non-performing loans. As a result, management has deemed it necessary that the ratio of allowance for loan losses as a percent of gross loans increase. The increase was attained due to significantly lower credit losses than in prior years as opposed to an increase in the provision for loan losses. 28 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Allowance For Loan Losses (continued) An analysis of the loan loss allowance is set forth in the following table (in thousands of dollars): 2005 2004 2003 2002 2001 ----- ----- ------ ------ ------ Balance at beginning of Period $ 2,530 $ 2,463 $ 1,793 $ 1,603 $ 1,493 Charge-offs Commercial loans 45 97 557 246 239 Real estate loans 8 422 65 110 92 Consumer loans 567 642 839 424 369 ----- ------ ------ ----- ---- Total 620 1,161 1,461 780 700 Recoveries Commercial loans 28 37 75 10 57 Real estate loans 36 54 68 12 Consumer loans 150 235 182 72 141 ----- ----- ---- ---- ----- Total 178 308 311 150 210 Net charge-offs 442 853 1,150 630 490 Provision for loan losses 875 920 1,820 820 600 Other additions 166 Balance at end of period $ 3,129 $ 2,530 $ 2,463 $ 1,793 $ 1,603 ====== ====== ===== ====== ====== Percent of net charge-offs to average net loans outstanding during the period .17% .51% .29% .25% .23% Cumulative net loan losses, after recoveries, for the five year period ending December 31, 2005 are as follows (in thousands of dollars): Dollars Percent of Total Commercial $ 977 27% Real estate 527 15% Consumer 2,061 58% ------ ----- Total $ 3,565 100% ====== === The following table shows the allocation of loans in the loan portfolio and the corresponding amounts of the allowance allocated by loan types (dollar amounts in thousands):
At December 31, 2005 2004 2003 2002 2001 ---- ----- ----- ---- ---- Percent Percent Percent Percent Percent Of of of of of Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans Commercial $ 900 21% $ 697 21% $ 779 19% $ 543 21% $ 487 21% Mortgage 1,139 62% 853 60% 725 61% 504 57% 576 56% Consumer 1,082 17% 970 19% 819 20% 652 22% 450 23% Unallocated 8 10 140 94 90 ----- ----- ------ --- ----- ---- ----- ---- ------ ----- Totals $ 3,129 100% $ 2,530 100% $ 2,463 100% $ 1,793 100% $ 1,603 100% ====== ==== ===== ==== ====== ==== ====== ==== ====== ====
29 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Allowance For Loan Losses (continued) As certain loans identified as impaired are paid current, collateral values increase or loans are removed from watch lists for other reasons, and as other loans become identified as impaired, and because delinquency levels within each of the portfolios change, the allocation of the allowance among the loan types may change. Management feels that the allowance is a fair representation of the losses present in the portfolio given historical loss trends, economic conditions and any known credit problems as of any quarter's end. Management believes that the allowance is to be taken as a whole, and allocation between loan types is an estimation of potential losses within each type given information known at the time. The above figures act as the beginning for the allocation of overall allowances. Additional changes have been made in the allocation of the allowance to address unknowns and contingent items. The unallocated portion is not computed using a specific formula and is management's best estimate of what should be allocated for contingencies in the current portfolio. Noninterest Income 2005 compared to 2004 Non interest income increased 6.01% in 2005 as compared to 2004. Service charge income increased $66,000, almost exclusively in the income received from customer overdraft charges. As the Company's account base has grown and non-interest bearing checking volume has grown, revenue from insufficient funds charges has also increased. Late in 2005, Capon Valley Bank implemented a program commonly referred to as "Courtesy Overdraft." Based upon observances of other banking institutions which have implemented similar programs, Management believes that the income derived from insufficient funds charges will increase overall service change income during 2006. Income from insurance operations, which is underwriting income by HBI Life and commission income earned by the subsidiary banks, decreased slightly during 2005 as compared to 2004. As new consumer installment loan volume has declined the income from insurance operations has also declined as insurance originations come mostly from installment lending. During 2005, the company recorded non-recurring income totaling $33,000. A portion of this income related to the gain on the sale of the Company's interest in an automated debit card company. Secondly, during the fourth quarter of 2005, a portion of the parking area of one of the Company's branch locations was purchased as part of a street widening project, and the Company recorded a gain of $19,000 related to this sale. 30 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Noninterest Income (continued) 2004 compared to 2003 Noninterest income increased 18.58% from 2003 to 2004. Much of this increase was attributable to an increase in the transaction charges for non-sufficient funds of checking account customers which contributed heavily to a $194,000 increase in service charges. During 2004 the volume of new consumer installment loans declined and impacted insurance earnings. As credit life and accident and health insurance are sold primarily to installment loan customers, the volume of new insurance business has decreased with the decline in installment lending. In spite of declines in sales of credit life and accident insurance, insurance earnings increased 26.32% in 2004 as compared to 2003. As new policies are written, there are requirements that portions of the premiums be held in reserve in anticipation of future claims. Throughout 2004, as the volume of new insurance business fell older policies matured without claims. As a result of this, required balances of these reserves were reduced and this positively impacted the income of HBI Life Insurance Company. Because of the closing of the trust subsidiary, trust fees fell $49,000 during 2004 as compared to 2003. Noninterest Expenses 2005 compared to 2004 Expenses related to salaries and benefits increased 1.99% in 2005 as compared to 2004. An increase in full-time equivalent employees was responsible for about half of this increase. Costs of post retirement benefits for employees declined primarily due to lower costs that resulted from the retirement of an employee in 2004. Occupancy and equipment expense increased slightly as the properties of the Company remained relatively constant (not inclusive of the physical assets obtained with the purchase of The National Bank of Davis). Because of the purchase of The National Bank of Davis and the related depreciation of the property and equipment obtained in the purchase, Management expects occupancy and equipment expense to increase during 2006 as compared to 2005. Data processing expense fell 5.81% in 2005 as compared to 2004, due mainly to a decrease in the contractual rate charged to the subsidiary banks by the primary supplier of account processing functions. Legal and professional fees increased $98,000 in 2005 as compared to 2004. Significant costs relating to compliance efforts under Rule 404 of the Sarbanes Oxley Act of 2002 and increased audit procedures required by bank regulatory authorities, were responsible for the largest portion of the increase in legal and professional fees. Management expects that the cost of such services will decline during 2006 as the bulk of the compliance costs have been incurred. 31 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Noninterest Expenses (continued) 2004 Compared to 2003 Expenses related to salaries and benefits increased 8.83% in 2004 as compared to 2003. Of the increase in salary and benefit expense, a large portion was attributable to an increase in costs of employee insurance and to an increase in wages and corresponding payroll taxes. A slight decline in full time equivalent employees was offset by the increase in wages due to normal pay increases. Both subsidiary banks experienced increases in costs related to the post-retirement benefits . However, this cost was partially offset by improved earnings of the policies used to fund these benefits. Costs of retirement benefits increased primarily due to rising costs of The Grant County Bank's defined benefit pension plan. Equipment and data processing expenses increased largely as a result of the purchase, implementation and upgrades of processing equipment intended to improve operational efficiency. During 2003 and 2004, both subsidiary banks implemented telephone banking services and statement imaging services. Both projects required significant new equipment which increased depreciation expense. Legal and professional fees increased 17.53% as expanded audit procedures were made necessary by the organization's growth and changes in the regulatory environment. 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, including restricted securities, increased to $28,871,000 or 8.55% of total assets at December 31, 2005. 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 institutions and cannot be transferred without the issuer's permission. The Company's purchases of securities have generally been limited to securities of high credit quality with short to medium term maturities. The Company identifies at the time of acquisition those securities that are available for sale. These securities are valued at their market value with any difference in market value and amortized cost shown as an adjustment in stockholders' equity. Changes within the year in market values are reflected as changes in other comprehensive income, net of the deferred tax effect. As of December 31, 2005, the cost basis of the securities available for sale exceeded their fair value by $140,000 ($88,000 after tax effect of $52,000). 32 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Securities (continued) The following table summarizes the carrying value of the Company's securities at the dates indicated (in thousands of dollars): Held to Maturity Available for Sale Carrying Value Carrying Value December 31, December 31, 2005 2004 2003 2005 2004 2003 ----- ------ ----- ----- ----- ----- U.S. Treasuries and agencies $ $ $ $17,234 $18,164 $23,240 Obligations of states and political subdivisions 491 1,162 1,364 2,705 1,817 2,604 Mortgage backed Securities 2 7,163 4,693 6,758 Marketable equities 28 28 29 ------ ------ ------- ----- ------ ----- Total $ 491 $ 1,162 $ 1,366 $27,130 $24,702 $32,631 ===== ===== ===== ====== ====== ====== The carrying amount and estimated market value of debt securities (in thousands of dollars) at December 31, 2005 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 Amortized Fair Average Cost Value Yield -------- ----- ------- Securities Held to Maturity Due in one year or less $ 321 $ 324 4.69% Due after one year through five years 170 170 5.09% ------- ------ ----- Total Held to Maturity $ 491 $ 494 4.83% ====== ==== ===== Equivalent Amortized Fair Average Cost Value Yield --------- ----- ---------- Securities Available for Sale Due in one year or less $ 14,638 $ 14,525 3.27% Due after one year through five years 11,784 11,760 4.41% Due after five years through ten years 579 577 3.41% Due after ten years 242 240 3.12% Equity securities with no maturity 28 28 8.40% -------- -------- ----- Total Available for sale $ 27,271 $ 27,130 3.77% ======= ======= ===== 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. 33 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Deposits The Company's primary source of funds is local deposits. The Company's deposit base is comprised of demand deposits, savings and money market accounts and other time deposits. The majority of the Company's deposits are provided by individuals and businesses located within the communities served. Total balances of deposits increased 11.91% from December 31, 2004 to December 31, 2005. Of the increase in deposits, 10.09% is attributable to the purchase of The National Bank of Davis. Although the Company does not actively solicit large certificates of deposit (those more than $100,000) due to the unstable nature of these deposits, the balances of such deposits increased 15.36% from December 31, 2004 to December 31, 2005. Of the increase, 5.89% is attributable to the purchase of The National Bank of Davis. A summary of the maturity of large deposits over $100,000 is as follows: December 31, ---------------------------- Maturity Range 2005 2004 2003 -------------- ---- ---- ---- (In Thousands of Dollars) Three months or less $ 7,662 $ 6,598 $ 7,950 Four to twelve months 14,835 13,861 19,080 One year to three years 17,736 15,323 12,307 Four years to five years 5,222 3,620 8,008 -------- -------- -------- Total $ 45,455 $ 39,402 $ 47,345 ======= ======= ======== Borrowed Money Long Term Borrowings The Company borrows funds from the Federal Home Loan Bank ("FHLB") to reduce market rate risks, provide liquidity, and to fund capital additions. These borrowings may have fixed or variable interest rates and are amortized over a period of one to twenty years, or may be comprised of single payment borrowings with periodic interest payments and principal amounts due at maturity. Borrowings from this institution allow the banks to offer long-term, fixed rate loans to their customers and match the interest rate exposure of the receivable and the liability and to meet liquidity needs and to manage interest rate risk through the use of long-term fixed rate borrowings. During 2005, the Company borrowed an additional $8,200,000 from the FHLB and made payments of $ 1,513,000 on outstanding balances. Short Term Borrowings Although the Company has traditionally not experienced the need for overnight or other short-term borrowings, loan growth during the fourth quarter of 2004 necessitated an overnight borrowing of $2,000,000 that was still outstanding at December 31, 2004. During the first quarter of 2005, the Company initiated $ 1,500,000 in new short term borrowings and made repayments of $ 3,500,000. At December 31, 2005, the Company had no balances of short term borrowings. Though this funding tool may be required in coming periods, Management prefers to fund growth through longer term vehicles and expects instances of overnight borrowings to be limited. Parent Company Line of Credit During the fourth quarter of 2003, the Company secured a $2,500,000 open line of credit with another commercial bank. This line of credit is 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, 2004 or 2005 from this line and it is not anticipated that any borrowings from this debt facility will be used to fund operating or liquidity needs. 34 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) 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 adjusted for unrealized gains and losses on securities. Total Capital consists of Tier 1 Capital and a portion of the allowance for loan losses. Risk-based capital ratios are calculated with reference to risk-weighted assets which consist of both on and off-balance sheet risks. The capital management function is an ongoing process. Central to this process is internal equity generation accomplished by earnings retention. During 2005, 2004, and 2003, total stockholders' equity increased by $2,337,000, $2,106,000 and $ 1,184,000, respectively, as a result of earnings retention and changes in the other comprehensive income. The return on average equity was 11.54% in 2005 compared to 10.36% for 2004 and 7.60% for 2003. Total cash dividends declared represent 30.99% of net income for 2005 compared to 28.23% of net income for 2004 and 36.03% for 2003. Book value per share was $23.66 at December 31, 2005 compared to $22.03 at December 31, 2004. Liquidity Operating liquidity is the ability to meet present and future financial obligations. Short term liquidity is provided primarily through cash balances, deposits with other financial institutions, federal funds sold, non-pledged securities and loans maturing within one year. Additional sources of liquidity available to the Company include, but are not limited to, loan repayments, the ability to obtain deposits through the adjustment of interest rates and the purchasing of federal funds. To further meet its liquidity needs, the Company also maintains lines of credit with correspondent financial institutions, the Federal Reserve Bank of Richmond and the Federal Home Loan Bank of Pittsburgh. Historically, the Company's primary need for additional levels of operational liquidity has been to fund increases in loan balances. The Company has normally funded increases in loans by increasing deposits and decreases in secondary liquidity sources such as balances of Fed Funds sold and balances of securities. Although total deposit balances have decreased and increased slightly in the last two years, the Company has maintained or increased levels of secondary liquidity resources and does not anticipate that an unexpectedly high level of loan demand in coming periods would impact liquidity to the extent that the Company would be required to pay above market rates to obtain deposits. The parent Company's operating funds, funds with which to pay shareholder dividends and funds for the exploration of new business ventures have been supplied primarily through dividends paid by the Company's two subsidiary banks Capon Valley Bank and The Grant County Bank. 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, 2006 , the subsidiary banks could pay dividends to Highlands Bankshares, Inc. of approximately $5,018,000 without permission of the regulatory authorities. The special dividend in October 2005 from The Grant County Bank to Highlands Bankshares to fund the acquisition of The National Bank of Davis exceeded Grant's dividend limit as of the date of the dividend. As part of the regulatory application process for the acquisition, the applicable banking authorities approved this dividend and the Company believes that the special, one time, dividend will not restrict Grant's ability to pay dividends to the parent company in the coming periods. 35 Item 7. Management's Discussion of Analysis of Financial Condition and Results of Operations (continued) Effects of Inflation Inflation primarily affects industries having high levels of property, plant and equipment or inventories. Although the Company is not significantly affected in these areas, inflation does have an impact on the growth of assets. As assets grow rapidly, it becomes necessary to increase equity capital at proportionate levels to maintain the appropriate equity to asset ratios. Traditionally, the Company's earnings and high capital retention levels have enabled the Company to meet these needs. The Company's reported earnings results have been minimally affected by inflation. The different types of income and expense are affected in various ways. Interest rates are affected by inflation, but the timing and magnitude of the changes may not coincide with changes in the consumer price index. Management actively monitors interest rate sensitivity, as illustrated by the gap analysis shown under the section titled Interest Rate Sensitivity, in order to minimize the effects of inflationary trends on interest rates. Other areas of noninterest expenses may be more directly affected by inflation. Item 7A. Quantitative and Qualitative Disclosures About Market Risk The greatest portion of the Company's net income is derived from net interest income. As such, the greatest component of market risk is interest rate volatility. In conjunction with maintaining a satisfactory level of liquidity, management must also control the degree of interest rate risk assumed on the balance sheet. Managing this risk involves regular monitoring of the interest sensitive assets relative to interest sensitive liabilities over specific time intervals. Early withdrawal of deposits, greater than expected balances of new deposits, prepayments of loans and loan delinquencies are some of the factors that could affect actual versus expected cash flows. In addition, changes in rates on interest sensitive assets and liabilities may not be equal, which could result in a change in net interest margin. While the Company does not match each of its interest sensitive assets against specific interest sensitive liabilities, it does review its positions regularly and takes actions to reposition itself when necessary. With the largest amount of interest sensitive assets and liabilities repricing within one year, the Company believes it is in an excellent position to respond quickly to rapid market rate changes. Interest rate market conditions may also affect portfolio composition of both assets and liabilities. Traditionally, the Company's subsidiary banks have primarily offered one year adjustable rate mortgages (ARMs) to its mortgage loan customers. However, the low interest rate environment during 2003, 2004 and 2005 created intense competition, especially from larger banking institutions and finance companies offering long term fixed rate mortgages. As a result, the Company in recent periods has begun to write more mortgage loans with adjustable rates and maturities greater than one year. The increase in new ARM and balloon loans with two, three and five year adjustable rates has caused a shift in the maturity composition of the loan portfolio. This shift to longer term rates is partially responsible for the average rates earned on the loan portfolio to lag behind increases in rates paid on deposits and rates earned on other earning assets. In addition, competition for new loans remains heavy. The result of this competition has also had the effect of causing increases in rates earned on loans to lag behind the increase in those seen on interest bearing liabilities. Should these influences continue into the future, the Company may experience a decrease in its net interest margin. As a result of the low interest rate environment in past years, depositors seemed reluctant to commit to longer term time deposits and in many instances appeared to hold monies temporarily in interest bearing transaction accounts in anticipation of rising rates in the future. This trend began to reverse in 2005 as time deposit balances have increased as customers began moving deposits from the lower earning transaction accounts and into time deposits. Should interest rates begin to rise sharply in the coming periods, Management believes that additional monies now in interest bearing transaction and savings accounts may further shift to time deposits, and this will cause a rise in the Company's cost of funds. Alternatively, these balances may be transferred by customers to other financial institutions offering higher deposit rates or customers may require the Company to match such rates to retain the deposit. 36 PART II: Item 7A. Quantitative and Qualitative Disclosures About Market Risk (continued) At present, the Company's largest challenge in managing its net interest income is the funding of loan growth. High levels of loan growth would require new funding which has historically been met by increases in deposits. As competition for deposits increases and should the Company need funds to finance loan growth, it may be forced to pay higher rates than other local banking organizations to obtain these deposits. This would result in a reduction in the Company's net interest margin and its net income. During 2004 and 2005, loan growth was funded through reduction in balances of comparatively lower earning assets like securities and federal funds sold and borrowing from the FHLB. The result was that during 2004 deposits balances fell, especially balances of time deposits. Balances of federal funds sold and securities also fell and net interest margin increased as a result of this. During 2005, deposit balances increased slightly, and this, coupled with cash flows from operations, allowed federal funds sold balances to increase. In addition, the purchase of The National Bank of Davis added balances of liquid funds, both in cash balances and balances of federal funds sold and this will allow for loan growth in the coming periods without the immediate need for attracting significant amounts of new deposits. Although it is expected that deposit rates will continue to rise, management believes that with a significant portion of its loan portfolio repricing within one year that rising rates will not have a significant negative impact on the Company's net interest earnings. The following table illustrates the Company's sensitivity to interest rate changes as of December 31, 2005 (in thousands of dollars): More than 5 Years 1-90 91-365 1 to 3 3 to 5 or no Days Days Years Years Maturity Total EARNING ASSETS Loans $ 33,172 $99,308 $98,933 $17,008 $21,599 $270,020 Fed funds sold 10,808 10,808 Securities and other investments 12,522 9,741 4,475 840 1,293 28,871 Deposits in other banks 660 203 100 963 ------ ------- ------ ------ ------ ------- Total 57,162 109,252 103,508 17,848 22,892 310,662 ------ ------- ------- ------ ------ ------- INTEREST BEARING LIABILITIES Interest bearing demand deposits 25,650 25,650 Savings deposits 54,947 54,947 Time deposits 18,305 61,091 57,985 18,961 156,342 Borrowed money 1,434 893 2,467 942 9,327 15,063 -------- ------ ------ ------ ------- -------- Total 100,336 61,984 60,452 19,903 9,327 252,002 ------- ------ ------ ------ ------- ------- Rate sensitivity GAP $(43,174) $47,268 $43,056 $ (2,055) $ 13,565 $ 58,660 Cumulative GAP $(43,174) $ 4,094 $47,150 $ 45,095 $ 58,660 Ratio of cumulative interest sensitive assets to cumulative interest sensitive liabilities 56.97% 102.52% 121.17% 118.58% 123.28% 37 Item 8. Financial Statements and Supplementary Data HIGHLANDS BANKSHARES, INC. CONSOLIDATED BALANCE SHEETS December 31, 2005 and 2004 (in thousands of dollars) December 31, 2005 2004 ----- ------ ASSETS Cash and due from banks $ 8,850 $ 6,187 Interest bearing deposits in banks 963 651 Federal funds sold 10,808 4,006 Investments Securities held to maturity 491 1,162 Securities available for sale 27,130 24,702 Restricted investments 1,250 1,165 Loans 270,020 248,517 Allowance for loan losses (3,129) (2,530) Bank premises and equipment 7,684 6,810 Interest receivable 1,818 1,436 Investment in life insurance contracts 6,396 5,809 Goodwill 1,534 Other intangible assets 1,674 60 Other assets 2,084 2,017 --------- --------- Total Assets $ 337,573 $ 299,992 ========= ========= LIABILITIES Deposits Noninterest bearing $ 47,753 $ 37,522 Savings and interest bearing demand 80,597 75,342 Time deposits over $100,000 45,455 39,402 All other time deposits 110,887 102,125 ------- ------- Total Deposits 284,692 254,391 ------- ------- Short term borrowings 2,000 Long term debt 15,063 8,377 Accrued expenses and other liabilities 3,826 3,569 --------- --------- Total Liabilities 303,581 268,337 --------- -------- STOCKHOLDERS' EQUITY Common Stock, $5 par value, 3,000,000 shares authorized, 1,436,874 shares issued and outstanding 7,184 7,184 Surplus 1,662 1,662 Retained Earnings 25,651 23,028 Other accumulated comprehensive loss (505) (219) --------- ------- Total Stockholders' Equity 33,992 31,655 --------- ------- Total Liabilities and Shareholders' Equity $ 337,573 $ 299,992 ======== ======== The accompanying notes are an integral part of this statement 38 Item 8. Financial Statements and Supplementary Data (continued) HIGHLANDS BANKSHARES, INC. CONSOLIDATED STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003 (in thousands of dollars, except per share data) Years ended December, 31 2005 2004 2003 ----- ----- ----- Interest and Dividend Income Loans, including fees $ 18,622 $16,752 $16,966 Federal funds sold 343 163 218 Interest bearing deposits 38 18 54 Investment securities - taxable 707 674 885 Investment securities - nontaxable 103 122 160 ------- ------ ------ Total Interest Income 19,813 17,729 18,283 ------ ------ ------ Interest Expense Interest on deposits 5,130 4,433 6,100 Interest on borrowed money 631 278 238 ------- ------- ------ Total Interest Expense 5,761 4,711 6,338 ------- ------ ------ Net Interest Income 14,052 13,018 11,945 ------ ------ ------ Provision for Loan Losses 875 920 1,820 ------ ------ ------ Net Interest Income after Provision for Loan Losses 13,177 12,098 10,125 ------ ------ ------ Noninterest Income Service charges 876 810 616 Insurance commissions and income 227 240 190 Life insurance investment income 234 251 221 Other operating income 326 292 336 Gain(loss) on security transactions 6 4 4 ------ ------ ------- Total noninterest income 1,669 1,597 1,367 ------- ------ ------ Noninterest Expenses Salaries and benefits 4,973 4,876 4,480 Occupancy expense 412 401 382 Equipment expense 836 813 726 Data processing expense 632 671 600 Legal and professional fees 440 342 291 Directors fees 341 328 311 Other operating expenses 1,494 1,507 1,457 ----- ----- ----- Total noninterest expenses 9,128 8,938 8,247 ----- ----- ----- Income before income tax expense 5,718 4,757 3,245 Income tax expense 1,916 1,551 1,012 ----- ----- ----- Net Income $ 3,802 $ 3,206 $ 2,233 ======= ======= ====== Weighted Average Shares Outstanding 1,436,874 1,436,874 1,436,874 Earnings Per Share $ 2.65 $ 2.23 $ 1.55 Dividends Per Share $ .82 $ .63 $ .56 The accompanying notes are an integral part of this statement 39 Item 8. Financial Statements and Supplementary Data (continued) HIGHLANDS BANKSHARES, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (in thousands of dollars) Accumulated Other Comprehensive Common Retained Income Stock Surplus Earnings (Loss) Total ------ ------- -------- ---------- ------ Balances January 1, 2003 $7,184 $1,662 $19,299 $ 220 $28,365 Comprehensive Income: Net income 2,233 2,233 Change in other comprehensive income (244) (244) -------- Total Comprehensive Income 1,989 Cash Dividends (805) (805) ------ ----- ------ ------ -------- Balances December 31, 2003 7,184 1,662 20,727 (24) 29,549 Comprehensive Income: Net income 3,206 3,206 Change in other comprehensive income (195) (195) ----- Total Comprehensive Income 3,011 Cash Dividends (905) (905) ----- ----- ------ ------ ------ Balances December 31, 2004 7,184 1,662 23,028 (219) 31,655 Comprehensive Income: Net income 3,802 3,802 Change in other comprehensive income (286) (286) ----- Total Comprehensive Income 3,516 Cash Dividends (1,179) (1,179) ----- ----- ------ ----- ------- Balances December 31, 2005 $7,184 $ 1,662 $ 25,651 $ (505) $33,992 ===== ===== ====== ====== ====== The accompanying notes are an integral part of this statement 40 Item 8. Financial Statements and Supplementary Data (continued) HIGHLANDS BANKSHARES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 and 2003 (in thousands of dollars) Years Ended December 31, 2005 2004 2003 ----- ----- ---- CASH FLOWS FROM OPERATING ACTIVITIES Net Income $ 3,802 $ 3,206 $ 2,233 Adjustments to reconcile net income to net cash provided by operating activities Gain on securities transactions (6) (4) (4) (Gain)Loss on sale of property (19) 1 Depreciation 692 666 577 Income from life insurance contracts (234) (251) (220) Net amortization of securities premiums 39 248 463 Provision for loan losses 875 920 1,820 Deferred income tax benefit (170) (103) (187) Amortization of Goodwill 38 10 10 Decrease (Increase) in interest receivable (294) 282 103 Decrease (Increase) in other assets 95 555 (493) Increase (Decrease) in accrued expenses 207 (69) 872 ------ ------ ------ Net Cash Provided by Operating Activities 5,025 5,461 5,174 ----- ----- ----- CASH FLOWS FROM INVESTING ACTIVITIES Sale of property 19 Proceeds from maturity of securities held to maturity 670 201 1 Proceeds from maturity of securities available for sale 12,654 15,244 19,576 Purchase of securities available for sale (8,083) (7,832) (29,410) Increase in restricted investments (77) (232) (261) Net change in interest bearing deposits in other banks (312) 536 3,312 Net increase in loans (13,442) (22,734) (2,031) Net change in federal funds sold (768) 12,712 (2,093) Purchase of property and equipment (281) (265) (914) Purchase of branch operations, net of cash received (893) - - ------- ------- ------- Net Cash Used In Investing Activities (10,513) (2,370) (11,820) --------- ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES Net change in time deposits 5,793 (15,993) (640) Net change in other deposit accounts (1,150) 7,699 5,813 Additional long term debt 8,200 3,800 1,785 Change in short term borrowings (2,000) 2,000 Repayment of long term debt (1,513) (719) (519) Dividends paid in cash (1,179) (905) (805) -------- ------- ------ Net Cash Provided by (Used in) Financings Activities 8,151 (4,118) 5,634 -------- ------- ------ CASH AND CASH EQUIVALENTS Net increase (decrease) in cash and due from banks 2,663 (1,027) (1,012) Cash and due from banks, beginning of year 6,187 7,214 8,226 ----- ------- ------- Cash and due from banks, end of year $ 8,850 $ 6,187 $ 7,214 ========= ======== ======== Supplemental Disclosures Cash Paid for: Interest expense $ 5,523 $ 4,920 $ 6,360 Income taxes $ 1,984 $ 1,183 $ 1,448 The accompanying notes are an integral part of this statement 41 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements NOTE 1 SUMMARY OF OPERATIONS Highlands Bankshares, Inc. (the "Company") is a bank holding company and operates under a charter issued by the state of West Virginia. The Company owns all of the outstanding stock of The Grant County Bank ("Grant") and Capon Valley Bank ("Capon"), which operate under charters issued by the state of West Virginia. The Company also owns all of the outstanding stock of HBI Life Insurance Company, Inc. ("HBI Life"), which operates under a charter issued in Arizona. 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, Randolph and Tucker counties of West Virginia, including the towns of Petersburg, Keyser, Moorefield, Davis and Wardensville through ten 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. 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 and HBI Life Insurance Company. During 2005, the Company purchased all of the outstanding shares of The National Bank of Davis ("Davis") (see Note 19) and these operations are included subsequent to the purchase. 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. 42 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) (e) Securities Securities that the Company has both the positive intent and ability to hold to maturity (at time of purchase) are classified as held to maturity securities. All other securities are classified as available for sale. Securities held to maturity are carried at historical cost and adjusted for amortization of premiums and accretion of discounts, using the effective interest method. Securities available for sale are carried at fair value with any valuation adjustments reported, net of deferred taxes, as other accumulated comprehensive income. Restricted investments consist of investments in the Federal Home Loan Bank of Pittsburgh and the Federal Reserve Bank of Richmond. Such investments are required as members of these institutions and these investments cannot be sold without a change in the members' borrowing or service levels. Interest and dividends on securities and amortization of premiums and discounts on securities are reported as interest income using the effective interest method. Gains (losses) realized on sales and calls of securities are determined using the specific identification method. (f) Loans Loans are carried on the balance sheet net of unearned interest and allowance for loan losses. Interest income on loans is determined using the effective interest method based on the daily amount of principal outstanding except where serious doubt exists as to collectibility of the loan, in which case the accrual of income is discontinued. Loans are placed on nonaccrual status or charged off if collection of principal or interest becomes doubtful. The interest on these loans is accounted for on a cash-basis or cost-recovery method until qualifying for return to accrual status. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and the loan is performing as agreed. (g) Allowance For Loan Losses The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions. Management uses three steps in calculating the balance of the reserve. The first step is the specific classification which examines problem loans and applies a weight factor to each category. The weight factor is based upon historical data and the loans within each category are reviewed on a monthly basis to determine changes in their status. The second step applies a predetermined rate against total loans with unspecified reserves. Again, this rate is based upon experience and can change over time. The third step is an unallocated allowance which is determined by economic events and conditions that may have a real, but as yet undetermined, impact upon the portfolio. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. The impairment of loans that have been separately identified for evaluation is measured based on the present value of expected future cash flows or , alternatively, the observable market price of the loans or the fair value of the collateral. However, for those loans that are collateral dependent (that is, if repayment of those loans is expected to be provided solely by the underlying collateral) and for which management has determined foreclosure is possible, the measure of impairment of those loans is to be based on the fair value of the collateral. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Corporation does not separately identify individual consumer and residential loans for impairment disclosures. 43 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) (h) Per Share Calculations Earnings per share are based on the weighted average number of shares outstanding. (i) Bank Premises and Equipment Bank premises and equipment are stated at cost less accumulated depreciation. Assets acquired in the acquisition of Davis have been recorded at their fair value. Depreciation is charged to income over the estimated useful lives of the assets using a combination of the straight-line and accelerated methods. The costs of maintenance, repairs, renewals, and improvements to buildings, equipment and furniture and fixtures are charged to operations as incurred. Gains and losses on routine dispositions are reflected in other income or expense. (j) Recent Accounting Standards Based on the Company's review of recent accounting standards, it is believed that none will have a material effect on the Company's operations in future years. (k) Income Taxes Amounts provided for income tax expense are based on income reported for financial statement purposes rather than amounts currently payable under federal and state tax laws. Deferred taxes, which arise principally from differences between the period in which certain income and expenses are recognized for financial accounting purposes and the period in which they affect taxable income, are included in the amounts provided for income taxes. (l) Comprehensive Income Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities and accrued pension liabilities, are reported along with net income as the components of comprehensive income. (m) Bank Owned Life Insurance Contracts The Company has invested in and owns life insurance polices on key officers. The policies are designed so that the company recovers the interest expenses associated with carrying the policies and the officer will, at the time of retirement, receive any earnings in excess of the amounts earned by the Company. The Company recognizes as an asset the net amount that could be realized under the insurance contract as of the balance sheet date. This amount represents the cash surrender value of the policies less applicable surrender charges. The portion of the benefits which will be received by the executives at the time of their retirement is considered, when taken collectively, to constitute a retirement plan. Therefore the Company accounts for these policies using guidance found in Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Post Retirement Benefits Other Than Pensions." SFAS No. 106 requires that an employers' obligation under a deferred compensation agreement be accrued over the expected service life of the employee through their normal retirement date. (n) Goodwill and Other Intangible Assets Goodwill represents the cost in excess of the fair value of net assets acquired (including identifiable intangibles) in transactions accounted for as purchases. In accordance with provisions of SFAS No. 142, "Goodwill and Other Intangible Assets", goodwill is not amortized over an estimated useful life, but rather will be tested at least annually for impairment. As of December 31, 2005, the Company found the goodwill acquired in the Davis acquisition not be impaired. Core deposit and other intangible assets include premiums paid for acquisitions of core deposits (core deposit intangibles) and other identifiable intangible assets. Intangible assets other than goodwill, which are determined to have finite lives, are amortized based upon the estimated economic benefits received. 44 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 3 CASH AND DUE FROM BANKS The Banks are required to maintain average reserve balances based on a percentage of deposits. The Banks have generally met this requirement through average cash on hand and balances held with their correspondent institutions. NOTE 4 SECURITIES The carrying amount and estimated fair value of securities are as follows (in thousands of dollars): Carrying Unrealized Unrealized Fair Amount Gains Losses Value Held to Maturity December 31, 2005 State and municipals $ 491 $ 3 $ -- $ 494 ------ ------- --------- ------- Total Securities Held to Maturity $ 491 $ 3 $ -- $ 494 ======= ======== ========= ======= December 31, 2004 State and municipals $ 1,162 $ 25 $ -- $ 1,187 -------- -------- -------- -------- Total Securities Held to Maturity $ 1,162 $ 25 $ -- $ 1,187 ======== ======== ========= ======== Available for Sale December 31, 2005 U.S. Treasuries and Agencies $17,352 $ 19 $ 137 $ 17,234 Mortgage backed securities 7,172 30 39 7,163 State and municipals 2,719 6 20 2,705 Marketable equities 28 -- -- 28 --------- -------- -------- -------- Total Securities Available For Sale $27,271 $ 55 $ 196 $ 27,130 ========= ======== ========= ======== December 31, 2004 U.S. Treasuries and Agencies $18,248 $ --- $ 84 $ 18,164 Mortgage backed securities 4,669 24 4,693 State and municipals 1,811 6 1,817 Marketable equities 28 --- -- 28 ---------- -------- --------- -------- Total Securities Available For Sale $24,756 $ 30 $ 84 $ 24,702 ========= ======== ======== ======== 45 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 4 SECURITIES (continued) Restricted investments consist of investments in the Federal Home Loan Bank and the Federal Reserve Bank. Investments are carried at face value and the level of investment is dictated by the level of participation with each institution. Amounts are restricted as to transferability. Investments in the Federal Home Loan Bank act as collateral against the outstanding borrowings from that institution. The carrying amount and fair value of debt securities at December 31, 2005, by contractual maturity are shown below (in thousands of dollars). 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. Fair Cost Value Securities Held to Maturity Due in one year or less $ 321 $ 324 Due after one year through five years 170 170 ------ ------ Total Held to Maturity $ 491 $ 494 ====== ====== Fair Cost Value Securities Available for Sale Due in one year or less $12,062 $11,992 Due after one year through five years 7,084 7,030 Due after five years through ten years 426 423 Due after ten years 242 239 Mortgage backed securities 7,429 7,418 ------ ------ Total Debt Securities 27,243 27,102 Equity securities with no maturity 28 28 ------ ------ Total Available for Sale $27,271 $27,130 ====== ====== The carrying amounts (which approximate market value) of securities pledged by the banks primarily to secure deposits amounted to $7,957,000 at December 31, 2005 and $4,765,000 at December 31, 2004. Information pertaining to securities with gross unrealized losses at December 31, 2005, aggregated by investment category and length of time that individual securities have been in a continuous loss position is shown in the table below (in thousands of dollars):
Total Less than 12 Months 12 Months or Greater ----- -------------------- ------------------- Gross Gross Gross Fair Unrealized Fair Unrealized Fair Unrealized Value Losses Value Losses Value Losses Investment category U.S. Treasury and Agency $ 15,077 $ (137) $ 6,643 $ (52) $ 8,434 $ (85) Mortgage backed securities 4,289 (39) 3,569 (27) 720 (12) State and municipals 2,042 (20) 1,117 (15) 925 (5) ----- ------- ------- -------- ------- ------- Total $ 21,408 $ (196) $ 11,329 $ (94) $ 10,079 $ (102) ========= ======== ====== ======= ====== =======
The information contained in the table above is required by a recently issued pronouncement and is being reported for the first time. Data in a format required to readily complete an accurate table for December 31, 2004 has not been retained and thus only data for December 31, 2005 has been included. It is management's determination that all securities held at December 31, 2005 which have fair values less than the amortized cost have gross unrealized losses related to increases in the current interest rates for similar issues of securities and that no material impairment for any securities in the portfolio exist because of downgrades of the securities or as a result of a change in the financial condition of any of the issuers. 46 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 5 LOANS Loans outstanding as of December 31, 2005 and 2004 are summarized as follows (in thousands of dollars): 2005 2004 ------ ------ Commercial $57,908 $52,814 Real estate construction 12,201 8,850 Real estate mortgage 153,646 140,761 Consumer installment 46,265 46,092 --------- ------ Total Loans $270,020 $248,517 ======= ======= The following is a summary of information pertaining to impaired and non-accrual loans at December 31, 2005 and 2004 (in thousands of dollars): 2005 2004 ----- ------ Impaired Loans Year End Balance $ 1,494 $ 3,013 Allowance for impairments 353 347 Average balance in year 1,576 2,950 Income recorded in year 104 210 No loans were identified as impaired for which an allowance was not provided. Certain loans identified as impaired are placed upon nonaccrual status based upon the loans' performance with contractual terms. Not all loans identified as impaired are placed on non-accrual status. The interest on loans identified as impaired, placed in non-accrual status and on which income was not recognized as income was not material in 2005 or 2004. Nonaccrual Loans at Year End $ 743 $ 530 Loans past due ninety days and still accruing interest at year end 1,189 535 NOTE 6 ALLOWANCE FOR LOAN LOSSES A summary of the changes in the allowance for loan losses for the years ended December 31, 2005, 2004 and 2003 is shown in the following schedule (in thousands of dollars): 2005 2004 2003 ---- ----- ----- Balance at beginning of year $ 2,530 $ 2,463 $ 1,793 Provision charged to operating expenses 875 920 1,820 Other additions 166 Loan recoveries 178 308 311 Loans charged off (620) (1,161) (1,461) ------ ------ ------ Balance at end of year $ 3,129 $ 2,530 $ 2,463 ====== ====== ====== Percentage of Outstanding Loans 1.16% 1.02% 1.09% Loans outstanding of the National Bank of Davis as of the effective purchase date were recorded on the balance sheet of Highlands net of an allowance of $166,000 for potential loan losses. 47 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 7 BANK PREMISES AND EQUIPMENT Bank premises and equipment as of December 31, 2005 and 2004 are summarized as follows (in thousands of dollars): 2005 2004 ------ ------ Land $ 1,323 $ 1,137 Buildings and improvements 7,350 6,332 Furniture and equipment 4,902 4,592 ------- ------- Total Cost 13,575 12,061 Less accumulated depreciation (5,891) (5,251) -------- -------- Net Book Value $ 7,684 $ 6,810 ======= ======= Provisions for depreciation charged to operations were $692,000 in 2005, $666,000 in 2004 and $577,000 in 2003. NOTE 8 DEPOSITS At December 31, 2005, the scheduled time deposit maturities were as follows (in thousands of dollars): Amount Year Maturing ----- --------- 2006 $ 78,344 2007 45,087 2008 13,100 2009 5,907 2010 13,904 ------- Total $156,342 ======= Deposits more than $100,000 (45,455) ------- All Other Time Deposits $110,887 ======= NOTE 9 BORROWED MONEY The Company has borrowed money from the Federal Home Loan Bank of Pittsburgh (FHLB) and these borrowings have typically been for maturities of six months or longer. The interest rates on the various notes payable range from 3.30% to 6.12% as of December 31, 2005. The weighted average interest rate was 4.35% at December 31, 2005 and the rate on individual loans may be fixed or variable. The Company has total borrowing capacity from the FHLB of $122,927,000. All notes are secured by the general assets of the Banks. Repayments of long term debt are due either monthly, quarterly, or in a single payment at maturity. Interest expense of $631,000, $278,000, and $238,000 was incurred on these debts in 2005, 2004 and 2003, respectively. The maturities of long term debt as of December 31, 2005 are as follows (in thousands of dollars): 2006 $ 2,327 2007 1,899 2008 568 2009 460 2010 482 Thereafter 9,327 ------- Total $15,063 ====== In addition to the above facility, the Company has a line of credit with an unrelated financial institution for $2.5 million as of December 31, 2005. The Company has not drawn on this line and the full amount is available for future borrowings if needed. 48 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 10 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, 2006, the banks could pay dividends to Highlands Bankshares, Inc. of approximately $5,018,000 without permission of the regulatory authorities. NOTE 11 INCOME TAX EXPENSE The components of income tax expense for the years ended December 31, 2005, 2004 and 2003 are summarized as follows (in thousands of dollars): 2005 2004 2003 ------ ------- ------ Current Expense Federal $ 1,814 $ 1,420 $ 1,008 State 272 234 191 ------ ------- --- Total Current Expense 2,086 1,654 1,199 ----- ----- ----- Deferred Expense (Benefit) Federal (149) (99) (169) State (21) (4) (18) ------- ------- ------- Total Deferred Expense (Benefit) (170) (103) (187) ----- ----- ----- Income Tax Expense $ 1,916 $ 1,551 $ 1,012 ====== ====== ====== The deferred tax effects of temporary differences for the years ended December 31, 2005, 2004 and 2003 are as follows (in thousands of dollars): 2005 2004 2003 ---- ------- ----- Tax Effect of Temporary Diffences: Provision for loan losses $ (193) $ (8) $ (180) Depreciation (45) 18 77 Deferred compensation 59 (125) (84) Miscellaneous 9 12 -- -------- ------ -------- Net increase in deferred income tax benefit $ (170) $ (103) $ (187) ======= ======= ====== The net deferred tax assets arising from temporary differences as of December 31, 2005 and 2004 are as follows (in thousands of dollars): 2005 2004 ------ ------ Deferred Tax Assets Provision for loan losses $ 868 $ 645 Insurance commissions 45 50 Loss carryforward 71 Deferred compensation 778 740 Pension obligation 150 94 Unrealized loss on securities available for sale 52 11 Other 6 12 ------- -------- Total Assets 1,970 1,552 ------ ------ Deferred Tax Liabilities Accretion income 29 18 Depreciation 442 487 ------ ------- Toal Liabilities 471 505 ------ ------- Net Deferred Tax Asset $ 1,499 $ 1,047 ====== ====== The loss benefit carryforward relates to tax losses at Davis prior to the purchase and are projected to be utilized by the end of 2006. 49 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 11 INCOME TAX EXPENSE (CONTINUED) The following table summarizes the difference between income tax expense and the amount computed by applying the federal statutory rate for the years ended December 31, 2005, 2004 and 2003 (in thousands of dollars): 2005 2004 2003 ----- ------ ------ Amounts at federal statutory rates $ 1,944 $ 1,617 $ 1,103 Additions (reductions) resulting from: Tax exempt income (50) (78) (109) Partially exempt income (40) (41) (35) State income taxes, net 178 147 110 Income from life insurance contracts (91) (94) (83) Other (25) 26 ------- ------- ------ Income tax expense $ 1,916 $ 1,551 $ 1,012 ====== ====== ====== NOTE 12 TRANSACTIONS WITH RELATED PARTIES During the year, officers and directors (and companies controlled by them) of the Company and subsidiary banks were customers of and had transactions with the subsidiary Banks in the normal course of business. These transactions were made on substantially the same terms as those prevailing for other customers and did not involve any abnormal risk. The aggregate amount of loans outstanding to related parties of $5,084,000 at December 31, 2004 was increased during 2005 by $1,218,000 as a result of new loans and reduced $1,237,000 by payments. The balance of loans to related parties was $5,065,000 at December 31, 2005. Other changes in balances represent additions to, deletions from or changes in executive officer or director status. Aggregate loan balances include open lines of credit which are included in the balances above inclusive of unused amouts. NOTE 13 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, mining, 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 $270,020,000 loans held by the Company at December 31, 2005, $200,026,000 is secured by real estate. The Banks had cash deposited in and federal funds sold to other commercial banks totaling $12,380,000 at December 31, 2005. NOTE 14 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. Capon has a defined contribution pension plan with 401(k) features that is funded with discretionary contributions. Capon matches on a limited basis the contributions of the employees. Investment of employee balances is done through the direction of each employee. Employer contributions are vested over a six year period. Grant is a member of the West Virginia Bankers' Association Retirement Plan. Benefits under the plan are based on compensation and years of service with full vesting after seven years of service. Prior to 2002, the Plan's assets were in excess of the projected benefit obligations and thus Grant was not required to make contributions to the Plan in 2003. Grant was required to make contributions in 2004 and 2005 and will be required to make a contribution in 2006. Grant has recognized liabilities of $429,000 at December 31, 2005 relating to unfunded pension liabilities. As a result of the plan's inability to meet expected returns in recent years, a portion of this liability is reflected as a decrease in other comprehensive income of $418,000 (net of $245,000 tax benefit). 50 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 14 EMPLOYEE BENEFITS (continued) The following table provides a reconciliation of the changes in the defined benefit plan's obligations and fair value of assets as of October 31, 2005 and 2004 (in thousands of dollars): 2005 2004 ------ ------- Change in Benefit Obligation Benefit obligation, beginning $ 2,743 $ 2,390 Service cost 123 113 Interest cost 179 160 Actuarial loss 325 133 Benefits paid (60) (53) ------- ------- Benefit obligation, ending $ 3,310 $ 2,743 ====== ====== Accumulated Benefit Obligation $ 2,852 $ 2,229 ====== ====== Change in Plan Assets Fair value of assets, beginning $ 1,768 $ 1,621 Actual return on assets, net of administrative expenses 148 117 Employer contributions 566 85 Benefits paid (60) (55) ------- ------- Fair value of assets, ending $ 2,422 $ 1,768 ====== ====== Funded Status Fair value of plan assets $ 2,422 $ 1,768 Projected benefit obligation (3,310) (2,743) ------ ------ Funded Status (888) (975) Unrecognized prior service cost 25 35 Unrecognized net loss 1,121 796 Unfunded accumulated benefit obligation (687) (317) -------- -------- Accrued benefit cost included in other liabilities $ (429) $ (461) ======= ======= Balance Sheet Date Data Prepaid pension asset $ 258 $ Accrued pension liability 144 51 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 14 EMPLOYEE BENEFITS (continued) The following table provides the components of the net periodic pension expense for the plan for the years ended December 31, 2005, 2004 and 2003 (in thousands of dollars): 2005 2004 2003 ----- ------ ----- Service cost $ 123 $ 114 $ 93 Interest cost 179 162 143 Expected return on plan assets (176) (166) (165) Amortization of net obligation at transition (9) Recognized net actuarial loss 27 14 Amortization of prior service cost 11 11 11 ------ ------ ------ Net periodic pension expense $ 164 $ 135 $ 73 ===== ===== ====== The estimated pension expense for 2006 is $179,000. The amount of the Company's minimum contributions for 2006 has not yet been determined. The weighted average asumptions used in the measurement of The Grant County Bank's benefit obligation and net periodic pension expense are as follows: 2005 2004 2003 ---- ---- ---- Discount rate 6.50% 6.50% 7.00% Expected return on plan assets 8.50% 8.50% 8.50% Rate of compensation increase 3.50% 3.50% 3.50% The plan sponsor estimates the expected long-term rate of return on assets in consultation with their advisors and the plan actuary. This rate is intended to reflect the average rate of earnings expected to be earned on the funds invested or to be invested to provide plan benefits. Historical performance is reviewed, especially with respect to real rate of return (net of inflation) for the major asset classes held or anticipated to be held by the trust. Undue weight is not given to recent experience, which may not continue over the measurement period, with higher significance placed on current forecasts of future long-term economic conditions. The following table provides the pension plan's asset allocation as of December 31: 2005 2004 ------ ----- Equity securities 73% 72% Debt securities 22% 23% Other 5% 5% The trust fund is sufficiently diversified to maintain a reasonable level of risk without imprudently sacrificing return. The targeted asset allocation and allowable range of allocation is set forth in the table below: Target Allowable Allocation Allocation Range ---------- ------------------- Equity securities 70% 40-80% Debt securities 25% 20-40% Other 5% 3-10% 52 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 14 EMPLOYEE BENEFITS (continued) The Investment Manager selects investment fund managers with demonstrated experience and expertise, and funds with demonstrated historical performance, for the implementation of the Plan's investment strategy. The Investment Manager will consider both actively and passively managed investment strategies and will allocate funds across the asset classes to develop an efficient investment structure. The Grant County Bank also maintains a profit sharing plan covering substantially all employees to which contributions are made at the discretion of the Board of Directors. Plan contributions by the employer are fully vested in the year of contribution. The Company has established an employee stock ownership plan which provides stock ownership to all employees of the Company. The Plan provides total vesting upon the attainment of seven years of service. Contributions to the plan are made at the discretion of the Board of Directors and are allocated based on the compensation of each employee relative to total compensation paid by the Company. All shares held by the Plan are considered outstanding in the computation of earnings per share. Shares of Company stock, when distributed, will have restrictions on transferability. Expenses related to all retirement benefit plans charged to operations totaled $505,000 in 2005, $437,000 in 2004 and $279,000 in 2003. NOTE 15 COMMITMENTS AND GUARANTEES The Banks make commitments to extend credit in the normal course of business and issue standby letters of credit to meet the financing needs of their customers. The amount of the commitments represents the Banks' exposure to credit loss that is not included in the balance sheet. As of the balance sheet dates, the Banks had outstanding the following commitments (in thousands of dollars): 2005 2004 ------- ------- Commitments to extend credit $ 21,087 $ 15,158 Standby letters of credit 423 186 The Banks use the same credit policies in making commitments and issuing letters of credit as used for the loans reflected in the balance sheet. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Banks evaluate each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Banks upon the extension of credit, is based on management's credit evaluation of the borrower. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment. NOTE 16 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. 53 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 16 DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (continued) The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash, Due from Banks and Money Market Investments ------------------------------------------------- The carrying amount of cash, due from bank balances, interest bearing deposits and federal funds sold is a reasonable estimate of fair value. Securities ---------- Fair values of securities are based on quoted market prices or dealer quotes. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Restricted Investments ---------------------- The carrying amount of restricted investments is a reasonable estimate of fair value. Loans ------ The fair value of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities, taking into consideration the credit risk in various loan categories. Deposits --------- The fair value of demand, interest checking, regular savings and money market deposits is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. Long Term Debt -------------- The fair value of fixed rate loans is estimated using the rates currently offered by the Federal Home Loan Bank for indebtedness with similar maturities. Short Term Debt --------------- The fair value of short term variable rate debt is deemed to be equal to the carrying value. Interest Payable and Receivable ------------------------------- The carrying value of amounts of interest receivable and payable is a reasonable estimate of fair value. Life Insurance -------------- The carrying amount of life insurance contracts is assumed to be a reasonable fair value. Life insurance contracts are carried on the balance sheet at their redemption value as of December 31, 2005. 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, 2005 or 2004. 54 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 16 DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (continued) The carrying amount and estimated fair values of financial instruments as of December 31, 2005 and 2004 are as follows (in thousands of dollars): 2005 2004 Estimated Estimated Carrying Fair Carrying Fair Amount Value Amount Value ------- ------- -------- ---------- Financial Assets: Cash and due from banks $ 8,850 $ 8,850 $ 6,187 $ 6,187 Interest bearing deposits 963 963 651 651 Federal funds sold 10,808 10,808 4,006 4,006 Securities held to maturity 491 494 1,162 1,187 Securities available for sale 27,130 27,130 24,702 24,702 Restricted investments 1,250 1,250 1,165 1,165 Loans, net 266,891 268,347 245,987 247,228 Interest receivable 1,818 1,818 1,436 1,436 Life insurance contracts 6,396 6,396 5,809 5,809 Financial Liabilities: Demand and savings deposits 128,350 128,350 112,864 112,733 Time deposits 156,342 156,541 141,527 147,320 Short term debt 2,000 2,000 Long term debt 15,063 14,819 8,377 8,085 Interest payable 633 633 396 396 NOTE 17 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. 55 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 17 REGULATORY MATTERS (continued) The Company's actual and required capital amounts and ratios are presented in the following table (in thousands of dollars): December 31, 2005 Regulatory Requirements ----------------------- Adequately Well Actual Capitalized Capitalized ------ ----------- ----------- $ Percentage $ Percentage $ Percentage --- --------- --- --------- --- ---------- Total Risk Based Capital Ratio ------------------------------ Highlands Bankshares $34,041 13.85% $19,663 8.00% Capon Valley Bank 12,910 13.45% 7,679 8.00% 9,599 10.00% The Grant County Bank 20,448 13.67% 11,967 8.00% 14,958 10.00% Tier 1 Leverage Ratio Highlands Bankshares 30,959 9.45% 13,104 4.00% Capon Valley Bank 11,709 8.87% 5,280 4.00% 6,600 5.00% The Grant County Bank 18,650 8.81% 8,468 4.00% 10,585 5.00% Tier 1 Risk Based Capital Ratio ------------------------------- Highlands Bankshares 30,959 12.60% 9,828 4.00% Capon Valley Bank 11,709 12.20% 3,839 4.00% 5,759 6.00% The Grant County Bank 18,650 12.47% 5,982 4.00% 8,974 6.00% December 31, 2004 Regulatory Requirements ----------------------- Adequately Well Actual Capitalized Capitalized ------ ----------- ----------- $ Percentage $ Percentage $ Percentage --- ---------- --- ---------- --- ---------- Total Risk Based Capital Ratio ------------------------------ Highlands Bankshares $33,120 14.71% $18,012 8.00% Capon Valley Bank 12,208 12.82% 7,618 8.00% 9,523 10.00% The Grant County Bank 20,097 15.54% 10,346 8.00% 12,932 10.00% Tier 1 Leverage Ratio Highlands Bankshares 30,590 10.14% 12,067 4.00% Capon Valley Bank 11,020 8.57% 5,144 4.00% 6,600 5.00% The Grant County Bank 18,754 10.90% 6,882 4.00% 8,603 5.00% Tier 1 Risk Based Capital Ratio ------------------------------- Highlands Bankshares 30,959 13.58% 9,010 4.00% Capon Valley Bank 11,020 11.57% 3,810 4.00% 5,715 6.00% The Grant County Bank 18,754 14.50% 5,171 4.00% 7,757 6.00% Capital ratios and amounts are applicable both at the individual bank level and on a consolidated basis. At December 31, 2005, both subsidiary banks had capital levels in excess of minimum requirements. In addition, HBI Life Insurance Company is subject to certain capital requirements and dividend restrictions. At present, HBI Life is well within any capital limitations and no conditions or events have occurred to change this capital status, nor does management expect any such occurrence in the foreseeable future. 56 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 18 CHANGES IN OTHER COMPREHENSIVE INCOME The components of change in other comprehensive income and related tax effects are as follows (in thousands of dollars): 2005 2004 2003 ----- ----- ----- Beginning Balance January 1 $ (219) $ (24) $ 220 Unrealized holding (losses) on available for sales securities net of income taxes of $27,000 for 2005, $92,000 for 2004 and $83,000 for 2003 (46) (176) (159) Accrued pension obligation net of income taxes of $141,000 for 2005, $12,000 for 2004 and $50,000 in 2003 (240) (19) (85) ------- ------- ------ Net change for the year (286) (195) (244) ------- ------- ------ Ending Balance December 31 $ (505) $ (219) $ (24) ======= ======= ========= NOTE 19 BRANCHES ACQUISITION On August 22, 2005, Highlands Bankshares entered into an agreement to purchase all of the outstanding shares of common stock of the National Bank of Davis ("Davis"), located in Davis, West Virginia. Davis is located in Tucker County and is contiguous to other counties that have Company branches. The locations acquired are in/near a variety of recreational facilities including ski resorts, golf courses and governmental parks. Management believes the location is a natural extension of its footprint and will give it access to additional lending opportunities, especially with regards to recreational home lending. This opportunity and the potential to consolidate operations and eliminate overhead were the two greatest factors in arriving at the purchase price. The Agreement can be found by accessing the website of the Securities and Exchange Commission under the filings of Highlands Bankshares, Inc. and as part of the Current Report on Form 8-K filed August, 23, 2005. The Agreement was consummated on October 31, 2005 and the shareholders of Davis were paid a cash purchase price of $5,200,000. In addition to this amount, Highlands incurred additional expenses of $56,000 related to the purchase. Shortly after the purchase, Davis offices became branches of The Grant County Bank. Funding for the purchase was provided by a special, one time , dividend from The Grant County Bank to Highlands Bankshares. The purchase of Davis added two banking locations and 12 full time equivalent employees to the operations of Highlands. All operations of Davis subsequent to October 31, 2005 are reflected in the operations of the Company. Upon acquisition, the net assets of Davis were recorded at fair value. Portions of the cost of acquisition, including expenses incurred relating to the purchase, were allocated as intangible assets. These intangible assets are comprised of both core deposit intangibles and goodwill. The amount of core deposit intangibles was valued based on comparable premiums paid on deposits for purchases of banking branches by other financial institutions in Virginia, West Virginia, and the entire Southeast region of the United States. After tangible assets were valued at fair value and the allocation made to core deposit intangibles, the remainder of the purchase price was allocated to goodwill. The amount of core deposit intangibles will be amortized over a ten year period. Goodwill will not be amortized and will be tested for impairment on an annual basis. As of December 31, 2005, the goodwill acquired in the acquisition of Davis was not deemed to be impaired. Goodwill is not expected to be deductible for income tax purposes. The capital position of Grant as of the date of the merger was considered adequate and there is no requirement that additional capital be infused to Grant as the result of this acquisition. 57 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 19 BRANCHES ACQUISITION (continued) A reconciliation of the purchase price for Davis to goodwill is shown below (in thousands of dollars): Amount Contract Price $ 5,200 Transaction costs 56 --------- Total $ 5,256 Tangible Assets Acquired Cash and cash equivalents 4,363 Federal funds sold 6,034 Securities available for sale 7,123 Other investments 8 Loans net of allowance for loan losses 8,337 Life insurance contracts 353 Premises and equipment 1,304 Interest receivable 88 Other assets 166 -------- Total Tangible Assets Acquired 27,776 ------ Liabilities Assumed Non interest bearing deposits 6,543 Interest bearing transaction deposits 10,093 Time deposits 9,022 Interest payable 31 Other liabilities 17 ------ Total Liabilities Assumed 25,706 ------ Amounts Allocated to Intangibles $ 3,186 ===== Amounts allocated to core deposit intangibles $ 1,652 ------ Balance allocated to goodwill $ 1,534 ====== The following illustrates how the results of operations might have looked had the operations of the Company and the operations of Davis been combined for 2005, 2004 and 2003 (in thousands): 2005 2004 2003 ---- ---- ---- Gross Revenues $20,902 $18,930 $19,552 Net Income 3,652 3,259 2,327 Earnings per Share 2.54 2.27 1.62 Davis reflects ten months of pre-consolidation activity in 2005 and a full year in 2004 and 2003. Included in the combined operations are security losses at Davis of $195,000 that were recognized prior to the sale but would not have been recognized in the normal course of business. 58 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 20 PARENT CORPORATION ONLY FINANCIAL STATEMENTS Balance Sheets (in thousands of dollars) December 31, 2005 2004 Assets Cash $ 154 $ 156 Investment in subsidiaries 33,852 31,536 Income taxes receivable 18 58 Other assets 53 34 ------- ------ Total Assets $34,077 $31,784 ======= ====== Liabilities Accrued expenses $ 51 $ 75 Due to subsidiaries 34 54 ------- ------ Total Liabilities 85 129 ------ ------ Stockholders' Equity Common stock, par value $5 per share, 3,000,000 shares authorized, 1,436,874 issued and outstanding 7,184 7,184 Surplus 1,662 1,662 Retained earnings 25,651 23,028 Other accumulated comprehensive income (505) (219) ------- ------ Total Stockholders' Equity 33,992 31,655 ------ ------ Total Liabilities and Stockholders' Equity $34,077 $31,784 ====== ====== 59 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 20 PARENT CORPORATION ONLY FINANCIAL STATEMENTS (continued) Statements of Income and Retained Earnings (in thousands of dollars) Years Ended December 31, 2005 2004 2003 ---- ---- ---- Income Dividends from subsidiaries $1,528 $ 940 $ 905 Management fees from subsidiaries 63 ----- ----- Total Income 1,591 940 905 ------ ----- ----- Expenses Salary and benefits expense 203 155 145 Professional fees 231 82 39 Directors fees 65 62 55 Other expense 106 83 89 ------ ------ ------ Total Expenses 605 382 328 ------ ------ ------ Net income before income tax benefits and undistributed subsidiary net income 986 558 577 Income Tax Benefit 214 142 115 ----- ------ ----- Income before undistributed subsidiary net income 1,200 700 692 Undistributed subsidiary net income 2,602 2,506 1,541 ----- ----- ----- Net Income $3,802 $3,206 $2,233 ====== ====== ====== Retained Earnings, beginning of period $23,028 $20,727 $19,299 Dividends paid in cash (1,179) (905) (805) Net income 3,802 3,206 2,233 ------ ------ ------ Retained Earnings, end of period $25,651 $23,028 $20,727 ====== ====== ====== 60 Item 8. Financial Statements and Supplementary Data (continued) Notes to Consolidated Financial Statements (continued) NOTE 20 PARENT CORPORATION ONLY FINANCIAL STATEMENTS (continued) Statements of Cash Flows (in thousands of dollars) Years Ended December 31, 2005 2004 2003 ------- ------- -------- Cash Flows From Operating Activities Net Income $ 3,802 $ 3,206 $ 2,233 Adjustments to net income Undistributed subsidiary income (2,602) (2,506) (1,541) Depreciation and amortization 7 2 Increase (decrease) in payables (24) (46) 112 (Increase) decrease in receivables 40 450 (256) (Increase) decrease in other assets (5) (13) 15 ------- -------- ------ Net Cash Provided by Operating Activities 1,218 1,091 565 ------ ------- ------ Cash Flows From Investing Activities Advances from (payments to) subsidiaries (197) (483) 289 Received from subsidiaries 177 281 Purchase of property and equipment (21) Special dividend from subsidiary 5,200 --- --- ------ ------ ----- Net Cash Provided by (used in) Investing Activities 5,159 (202) 289 ------ ------ ------ Cash Flows From Financing Activities Purchase of branch operations (5,200) Dividends paid in cash (1,179) (905) (804) -------- ------- ------ Net Cash Used in Financing Activities (6,379) (905) (804) ------- ------- ------ Net increase (decrease) in Cash (2) (16) 50 Cash, beginning of year 156 172 122 ------- ------ ------ Cash, end of year $ 154 $ 156 $ 172 ======= ======= ======= 61 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Stockholders and Board of Directors Highlands Bankshares, Inc. Petersburg, West Virginia We have audited the accompanying consolidated balance sheets of Highlands Bankshares, Inc. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, stockholders' equity and comprehensive income, and cash flows for each of the years in the three year period ended December 31, 2005. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, 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, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the three year period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. /s/ S. B. Hoover & Company, L.L.P. February 28, 2006 Harrisonburg, Virginia 62 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None Item 9A. Controls and Procedures The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures as of December 31, 2005. Based on this evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective as of December 31, 2005. Changes in Internal Controls During the period reported upon, there was a change in internal control which management deems necessary to report. On October 31, 2005, Highlands purchased all of the outstanding shares of stock in The National Bank of Davis. On November 15, 2005, Highlands merged Davis into The Grant County Bank. As of December 31, 2005, full transition of the legacy Davis systems, including, but not limited to, core processing of transactions, accounting, and certain policies and procedures was not complete. Given the design and assessment of internal controls present at Highlands, this incomplete transition has created a requirement for additional controls to be put in place to reasonably ensure that fraudulent activity of any amount material to these results or in any amount and relating to this incomplete transition is not occurring. Achievement of full transition of legacy Davis systems into Highlands systems currently in place is ongoing and is expected to be completed by the second quarter of 2006. Until such time that full transition has occurred, management of Highlands will continue added internal control measures to reasonably ensure that controls pertaining to financial reporting and safeguarding of assets are effective. During the period reported upon, and related to the legacy operations of Highlands Bankshares, there were no significant changes in the internal controls of Highlands Bankshares, Inc. pertaining to its financial reporting and control of its assets or in other factors that could significantly affect these controls. Due to the nature of the Company's business as stewards of assets of customers, internal controls are of the utmost importance. The company has established procedures undertaken during the normal course of business in an effort to reasonably ensure that fraudulent activity of either an amount material to these results or in any amount is not occurring. In addition to these controls and review by executive officers, the Company retains the services of 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 this firm are presented both to Management of the subsidiary banks and to the Audit Committee. Item 9B. Other Information None PART III Item 10. Directors and Executive Officers of the Registrant Information required by this item is set forth under the caption "Compliance with Section 16(a) of the Securities Exchange Act" of our 2006 Proxy Statement, to be filed within 120 days after the end of the Company's fiscal year end, and is incorporated herein by reference Item 11. Executive Compensation Information required by this item is set forth under the caption "EXECUTIVE COMPENSATION" of our 2006 Proxy Statement, to be filed within 120 days after the end of the Company's fiscal year end, and is incorporated herein by reference. 63 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Information required by this item is set forth under the caption "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT" of our 2006 Proxy Statement, to be filed within 120 days after the end of the Company's fiscal year end, and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions Information required by this item is set forth under the caption "Certain Related Transactions" of our 2006 Proxy Statement, to be filed within 120 days after the end of the Company's fiscal year end, and is incorporated herein by reference. Most of the directors, limited liability companies of which they may be members, partnerships of which they may be general partners and corporations of which they are officers or directors, maintain normal banking relationships with the Bank. Loans made by the Bank to such persons or other entities were made in the ordinary course of business, were made, at the date of inception, on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons, and did not involve more than normal risk of collectibility or present other unfavorable features. See Note 14 of the consolidated financial statements. John VanMeter is a partner with the law firm of VanMeter and VanMeter, which has been retained by the Company as legal counsel and it is anticipated that the relationship will continue. Jack H. Walters is a partner with the law firm of Walters, Krauskopf & Baker, which provides legal counsel to the Company and it is anticipated that the relationship will continue. Item 14. Principal Accounting Fees and Services Information required by this item is set forth under the caption "FEES OF INDEPENDENT PUBLIC ACCOUNTANTS" of our 2006 Proxy Statement, to be filed within 120 days after the end of the Company's fiscal year end, and is incorporated herein by reference. PART IV Item 15. Exhibits and Financial Statement Schedules (a)(1) Financial Statements: Reference is made to Part II, Item 8 of this Annual Report on Form 10-K. (a)(2) Financial Statement Schedules: These schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. 64 Item 15. Exhibits, Financial Statement Schedules (continued) (a)(3) Exhibits: Exhibit Number Description 3 (i) Articles of Incorporation of Highlands Bankshares, Inc. are incorporated by reference to Appendix C to Highlands Bankshares, Inc.'s Form S-4 filed October 20, 1986 Amendments to the original Articles of Incorporation are incorporated by reference; filed as Exhibit 3(i) with 1997 Form 10-KSB. 3 (ii) Bylaws of Highlands Bankshares, Inc. are incorporated by reference to Appendix D to Highlands Bankshares Inc.'s Form S-4 filed October 20, 1986 Amended Bylaws of Highlands Bankshares, Inc. are incorporated by reference to Exhbit 3(ii) to Highlands Bankshares Inc.'s Form 10Q filed May 15, 2003 14 Code of Ethics 21 Subsidiaries of the Registrant 31.1 Certification of Chief Executive Officer Pursuant to section 302 of the Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 USC Section 1350 (A) and (B). 31.2 Certification of Chief Financial Officer Pursuant to section 302 of the Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 USC Section 1350 (A) and (B). 32.1 Statement of Chief Executive Officer Pursuant to 18 U.S.C.ss.1350. 32.2 Statement of Chief Financial Officer Pursuant to 18 U.S.C. ss.1350. (b) See (a)(3) above (c) See (a)(1) and (a)(2) above 65 Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HIGHLANDS BANKSHARES, INC. /s/ C. E. PORTER /s/ R. ALAN MILLER --------------------------- --------------------------- C.E. Porter R. Alan Miller President and Chief Executive Officer Chief Financial Officer March 24, 2006 March 24, 2006 Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Name Signature Title Date Leslie A. Barr /s/ LESLIE A. BARR Director March 22, 2006 --------------------- Jack H. Walters /s/ JACK H. WALTERS Director March 22, 2006 --------------------- Thomas B. McNeill, Sr. /s/ THOMAS B. MCNEILL, SR. Director March 22, 2006 -------------------------- L. Keith Wolfe /s/ L. KEITH WOLFE Director March 23, 2006 --------------------- Kathy G. Kimble /s/ KATHY G. KIMBLE Director March 23, 2006 --------------------- Steven C. Judy /s/ STEVEN C. JUDY Director March 23, 2006 --------------------- Courtney R. Tusing /s/ COURTNEY R. TUSING Director March 22, 2006 ---------------------- John G. Vanmeter /s/ JOHN G. VANMETER Director March 22, 2006 --------------------- Chairman of the Board Alan L. Brill /s/ ALAN L. BRILL Director March 22, 2006 --------------------- Secretary C.E. Porter /s/ C. E. PORTER Director March 22, 2006 --------------------- President, Chief Executive Officer and Treasurer