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SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For fiscal year ended December 31, 2003 Commission file number: 0-16761
Highlands Bankshares, Inc.
(Exact name of registrant as specified in its charter)
West Virginia 55-0650743
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
P. O. Box 929, Petersburg, West Virginia 26847 (Address of
principal executive offices) (Zip Code)
Issuer's telephone number including area code: (304) 257-4111
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock - $5 Par
Indicate by check mark whether the registrant has (1) filed all reports
required to be filed by Section 13 or 15(d) of the Exchange Act during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes [X} No [ ]
Indicate by check mark if disclosure of delinquent filers in response to
Item 405 of Regulation S-K is not contained in this form, and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. [ ]
Indicate by check mark whether the issuer is an accelerated filer (as
defined in Rule 12b-2 of the Act). [ ]
The aggregate market value of the 1,319,837 shares of Common Stock of the
registrant issued and outstanding held by nonaffiliates on June 30, 2003 was
approximately $ 34,381,754 based on the closing sales price of $ 26.05 per share
on June 30, 2003. For purposes of this calculation, the term "affiliate" refers
to all directors and executive officers of the registrant.
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date: As of March 1, 2004 -
1,436,874
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Registrant's Proxy Statement to be used in connection with
the solicitation of proxies for the Registrant's 2004 Annual Meeting of
Shareholders (the "Proxy Statement") are incorporated by reference in Part III
of this Annual Report of Form 10-K (the "Form 10-K").
TRANSITIONAL SMALL BUSINESS DISCLOSURE FORMAT YES [ ] NO [ X ]
2
FORM 10-K INDEX
Page
Part I
Item 1. Description of Business 3
Item 2. Description of Properties 4
Item 3. Legal Proceedings 5
Item 4. Submission of Matters to a Vote of Security Holders 5
Part II
Item 5. Market for Registrant's Common Equity and
Related Stockholder Matters 5
Item 6. Selected Financial Data 6
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operation 7
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 25
Item 8. Financial Statements and Supplementary Data 30
Item 9. Changes in and Disagreement with Accountants on
Accounting and Financial Disclosure 54
Item 9a. Controls and Procedures 54
Part III
Item 10. Directors and Executive Officers of Registrant 54
Item 11. Executive Compensation 55
Item 12. Security Ownership of Certain Beneficial Owners and
Management 55
Item 13. Certain Relationships and Related Transactions 55
Item 14. Principal Accounting Fees and Services 55
Part IV
Item 15. Exhibits, Financial Statement Schedules and Reports on
Form 8-K 55
Signatures 57
3
Part I
Item 1. Description of Business
General
Highlands Bankshares, Inc. (hereinafter referred to as "Highlands," or the
"Company"), incorporated under the laws of West Virginia in 1985, is a
multi-bank holding company subject to the provisions of the Bank Holding Company
Act of 1956, as amended, and owns 100% of the outstanding stock of its
subsidiary banks, The Grant County Bank and Capon Valley Bank (hereinafter
referred to as the "Banks"), its life insurance subsidiary, HBI Life Insurance
Company (hereinafter referred to as "HBI Life") and its trust subsidiary,
Highlands Bankshares Trust Company (hereinafter referred to as "HBTC").
The Grant County Bank was chartered on August 6, 1902, and Capon Valley Bank
was chartered on July 1, 1918. Both are state banks chartered under the laws of
the State of West Virginia. HBI Life was chartered in April 1988 under the laws
of the State of Arizona. HBTC was chartered in December 2000 under the laws of
the state of West Virginia.
Services Offered by the Banks
The Banks offer all services normally offered by a full service commercial
bank, including commercial and individual demand and time deposit accounts,
commercial and individual loans, drive-in banking services and automated teller
machines. No material portion of the banks' deposits have been obtained from a
single or small group of customers and the loss of the deposits of any one
customer or of a small group of customers would not have a material adverse
effect on the business of the banks. Credit life and accident and health
insurance are sold to customers of the subsidiary banks through HBI Life. Trust
services are offered through HBTC.
Employees
As of December 31, 2003, The Grant County Bank had 61 full time equivalent
employees, Capon Valley Bank had 47 full time equivalent employees, Highlands
had two full time equipment employees and HBTC had one full time equivalent
employee. No person is employed by HBI Life on a full time basis.
Competition
The banks' primary trade area is generally defined as Grant, Hardy, Mineral,
Randolph, and the northern portion of Pendleton County in West Virginia, the
western portion of Frederick County in Virginia and portions of Western
Maryland. This area includes the cities of Petersburg, Wardensville, Moorefield
and Keyser and several rural towns. The banks' secondary trade area includes
portions of Hampshire County in West Virginia. The banks primarily compete with
four state chartered banks and six national banks. In addition, the banks
compete with money market mutual funds, credit unions and investment brokerage
firms for deposits in their service area. No financial institution has been
chartered in the area within the last five years although branches of state and
nationally chartered banks have located in this area within this time period.
Competition for new loans and deposits in the banks' service area is quite
intense.
Regulation and Supervision
Highlands is subject to the periodic reporting requirements of the
Securities Exchange Act of 1934. These include, but are not limited to, the
filing of annual, quarterly and other current reports with the Securities and
Exchange Commission.
4
Regulation and Supervision (Continued)
Highlands, as a bank holding company, is subject to the provisions of the
Bank Holding Company Act of 1956, as amended (the "Act"). It is registered as
such and is supervised by the Federal Reserve Board. The Act requires Highlands
to secure the prior approval of the Federal Reserve Board before Highlands
acquires ownership or control of more than five percent of the voting shares, or
substantially all of the assets of any institution, including another bank.
As a bank holding company, Highlands is required to file with the Federal
Reserve Board an annual report and such additional information as it may require
pursuant to the Act. The Federal Reserve Board may also conduct examinations of
Highlands and any or all of its subsidiaries. Under Section 106 of the 1970
Amendments to the Act and the regulations of the Federal Reserve Board, a bank
holding company and its subsidiaries are prohibited from engaging in certain
tie-in arrangements in connection with an extension of credit, provision of
credit, sale, or lease of property or furnishing of services.
Federal Reserve Bank regulations permit bank holding companies to engage in
non-banking activities closely related to banking or to managing or controlling
banks. These activities include the making or servicing of loans, trust
services, performing certain data processing services, and certain leasing and
insurance agency activities. HBI Life acts as reinsurer of the credit life
insurance coverage sold by the Banks to bank customers. HBTC provides trust
services to customers of the Banks. Approval of the Federal Reserve Board is
necessary to engage in any of these activities or to acquire corporations
engaging in these activities.
The operations of the Banks are subject to federal and state statutes which
apply to state chartered banks. Bank operations are also subject to the
regulations of the Federal Deposit Insurance Corporation (the "FDIC"), which
insures the banks' deposits. In addition, the Capon Valley Bank is a member of
the Federal Reserve Bank System and is subject to the regulations of the Federal
Reserve Bank Board.
The supervisory authorities regularly examine such areas as reserves, loans,
investments, management practices, and other aspects of the banks' operations.
These examinations are designed primarily for the protection of depositors. In
addition to these regular examinations, the banks must furnish the various
regulatory authorities quarterly reports containing a full and accurate
statement of its operations.
The operations of the insurance subsidiary are subject to the oversight and
review of State of Arizona Department of Insurance.
The operations of the trust company are subject to the oversight and review
of the State of West Virginia and the Federal Reserve Bank.
Item 2. Description of Properties
The Grant County Bank's main office is located on Main Street in Petersburg,
West Virginia. The Bank also has branch facilities in Harman, Moorefield, Keyser
and Riverton, West Virginia which provide banking services in Randolph County,
Hardy County, Mineral County, and northwest Pendleton County, respectively. The
Riverton branch building is leased while all other locations are owned by the
Bank.
Capon Valley Bank has its main office in Wardensville, West Virginia and
branch offices located in Moorefield and Baker, West Virginia and Gore,
Virginia. Capon's offices serve mainly Hardy County and Hampshire County, West
Virginia, with the Gore branch serving Frederick County, Virginia. All
facilities include state-of-the-art drive in and automated teller operations.
All facilities are owned by the Bank and considered adequate for current
operations.
5
Item 3. Legal Proceedings
Management is not aware of any material pending or threatened litigation in
which Highlands or its subsidiaries may be involved as a defendant. In the
normal course of business, the banks periodically must initiate suits against
borrowers as a final course of action in collecting past due loans.
Item 4. Submission of Matters to a Vote of Security Holders
Highlands has not submitted any matters to the vote of security holders for
the quarter ending December 31, 2003.
Part II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
The Company had approximately 865 registered stockholders of record as of
March 8, 2004. This amount includes all shareholders, whether titled
individually or held by a brokerage firm or custodian in street name. The
Company's stock is not traded on any national or regional stock exchange
although brokers in Cumberland, Maryland or Winchester and Harrisonburg,
Virginia may occasionally initiate or be a participant in a trade. Terms of an
exchange between individual parties may not be known to the Company. The
following outlines the dividends paid and market prices of the Company's stock
based on prices disclosed to management. Prices have been provided using a
nationally recognized online stock quote system. Such prices may not include
retail mark-ups, mark-downs or commissions. During the third quarter of 2002,
the Company initiated a 200% stock dividend. Share prices for the first and
second quarters of 2002 have been adjusted to account for this stock split
effected in the form of dividend.
Dividends Market Price Range
2003 Per Share High Low
---- --------- ---- ---
First Quarter .1400 26.50 21.60
Second Quarter .1400 26.25 25.50
Third Quarter .1400 31.00 26.05
Fourth Quarter .1400 31.00 29.00
Dividends Market Price Range
2002 Per Share High Low
---- --------- ---- ---
First Quarter .1233 18.46 15.92
Second Quarter .1233 18.67 16.75
Third Quarter .1300 18.50 17.03
Fourth Quarter .1300 21.51 18.50
6
Item 6. Selected Financial Data
-----------Years Ending December 31,--------
(In Thousands Except for Share Amounts)
2003 2002 2001 2000 1999
Total Interest Income $18,283 $18,970 $20,207 $18,207 $16,243
Total Interest Expense 6,338 7,705 10,049 8,790 7,663
----- ------ ------ ------ ------
Net Interest Income 11,945 11,265 10,158 9,417 8,580
Provision for Loan Losses 1,820 820 600 500 320
----- ------ ------ ------ ------
Net Interest Income after
Provision for Loan Losses 10,125 10,445 9,558 8,917 8,260
Other Income 1,367 1,304 1,194 1,263 1,026
Other Expenses 8,247 8,047 7,431 6,836 6,104
----- ------ ------ ------ ------
Income before Income Taxes 3,245 3,702 3,321 3,344 3,182
Income Tax Expense 1,012 1,180 979 1,092 978
----- ------ ------ ------ ------
Net Income $ 2,233 $ 2,522 $ 2,342 $ 2,252 $ 2,204
====== ====== ====== ====== ======
Net Income Per Share* $ 1.55 $ 1.73 $ 1.56 $ 1.50 $ 1.46
Dividends Per Share* $ .56 $ .51 $ .45 $ .41 $ .39
Total Assets at Year End $301,168 $292,672 $277,042 $248,782 $220,587
======= ======= ======= ======= =======
Return on Average Assets .73% .89% .89% .97% 1.02%
Return on Average Equity 7.60% 8.87% 8.57% 8.89% 9.42%
Dividend Payout Ratio 36.03% 29.26% 29.15% 27.64% 26.41%
Year End Equity to Assets Ratio 9.81% 9.69% 10.06% 10.43% 10.90%
*--Prior years' per share figures restated to reflect stock split effected in
form of dividend in 2002.
7
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Critical Accounting Policies
The Company's financial statements are prepared in accordance with
accounting principles generally accepted in the United States ("GAAP"). The
financial statements contained within these statements are, to a significant
extent, financial information that is based on measures of the financial effects
of transactions and events that have already occurred. A variety of factors
could affect the ultimate value that is obtained either when earning income,
recognizing an expense, recovering an asset or relieving a liability. In
addition, GAAP itself may change from one previously acceptable method to
another method. Although the economics of these transactions would be the same,
the timing of events that would impact these transactions could change.
Allowance for Loan Losses
The allowance for loan losses is an estimate of the losses in the loan
portfolio. The allowance is based on two basic principles of accounting: (i)
SFAS No. 5, Accounting for Contingencies, which requires that losses be accrued
when they are probable of occurring and estimable and (ii) SFAS No. 114,
Accounting by Creditors for Impairment of a Loan, which requires that losses be
accrued based on the differences between the value of collateral, present value
of future cash flows or values that are observable in the secondary market and
the loan balance.
The Company's allowance for loan losses is the accumulation of various
components that are calculated based on independent methodologies. All
components of the allowance represent an estimation performed pursuant to either
SFAS No. 5 or SFAS No. 114. Management's estimate of each SFAS No. 5 component
is based on certain observable data that management believes are most reflective
of the underlying credit losses being estimated. This evaluation includes credit
quality trends; collateral values; loan volumes; geographic, borrower and
industry concentrations; seasoning of the loan portfolio; the findings of
internal credit quality assessments and results from external bank regulatory
examinations. These factors, as well as historical losses and current economic
and business conditions, are used in developing estimated loss factors used in
the calculations.
Reserves for commercial loans are determined by applying estimated loss
factors to the portfolio based on management's evaluation and "risk grading" of
the commercial loan portfolio. Reserves are provided for noncommercial loan
categories using estimated loss factors applied to the total outstanding loan
balance of each loan category. Specific reserves are typically provided on all
impaired commercial loans in excess of a defined threshold that are classified
in the Special Mention, Substandard or Doubtful risk grades. The specific
reserves are determined on a loan-by-loan basis based on management's evaluation
the Company's exposure for each credit, given the current payment status of the
loan and the value of any underlying collateral.
While management uses the best information available to establish the
allowance for loan and lease losses, future adjustments to the allowance may be
necessary if economic conditions differ substantially from the assumptions used
in making the valuations or, if required by regulators, based upon information
available to them at the time of their examinations. Such adjustments to
original estimates, as necessary, are made in the period in which these factors
and other relevant considerations indicate that loss levels may vary from
previous estimates.
Post Retirement Benefits
The Company has invested in and owns life insurance polices on key officers.
The policies are designed so that the company recovers the interest expenses
associated with carrying the polices and the officer will, at the time of
retirement, receive any earnings in excess of the amounts earned by the Company.
The Company recognizes as an asset the net amount that could be realized under
the insurance contract as of the balance sheet date. This amount represents the
cash surrender value of the policies less applicable surrender charges. The
portion of the benefits which will be received by the executives at the time of
their retirement is considered, when taken collectively, to constitute a
retirement plan. Therefore the Company accounts for these policies using
guidance found in Statement of Financial Accounting Standards No. 106,
"Employers' Accounting for Post Retirement Benefits Other Than Pensions." SFAS
No. 106 requires that an employers' obligation under a deferred compensation
agreement be accrued over the expected service life of the employee through
their normal retirement date.
8
Post Retirement Benefits (Continued)
Assumptions are used in estimating the present value of amounts due officers
after their normal retirement date. These assumptions include the estimated
income to be derived from the investments and an estimate of the Company's cost
of funds in these future periods. In addition, the discount rate used in the
present value calculation will change in future years based on market
conditions.
Recent Accounting Pronouncements
No recent accounting pronouncements had a material impact on the Company's
consolidated financial statements.
Prior Period Adjustment
See Footnote 3 of the financial statements (page 39 of this report) for a
discussion of the prior period adjustment relating to post-retirement benefits.
Forward Looking Statements
Certain statements in this report may constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. Forward-looking statements are statements that include projections,
predictions, expectations or beliefs about future events or results or otherwise
are not statements of historical fact. Such statements are often characterized
by the use of qualified words (and their derivatives) such as "expect,"
"believe," "estimate," "plan," "project," or other future events. Although the
Company believes that its expectations with respect to certain forward-looking
statements are based upon reasonable assumptions within the bounds of its
existing knowledge of its business and operations, there can be no assurance
that actual results, performance or achievements of the Company will not differ
materially from any future results, performance or achievements expressed or
implied by such forward-looking statements. Actual future results and trends may
differ materially from historical results or those anticipated depending on a
variety of factors, including, but not limited to, the effects of and changes
in: general economic conditions, the interest rate environment, legislative and
regulatory requirements, competitive pressures, new products and delivery
systems, inflation, changes in the stock and bond markets, technology, and
consumer spending and savings habits. The Company does not update any
forward-looking statements that may be made from time to time by or on behalf of
the Company.
Overview
The Company experienced an 11.43% decrease in net income in 2003 as compared
to 2002. Annual net income of $2,233,332 represents a return on average equity
of 7.60% for 2003 compared to 8.87% for 2002. Return on average assets for 2003
and 2002 were .73% and .89%, respectively. Earnings per share decreased 10.40%
from 2002 to 2003.
Increases of $680,000 in net interest income and $63,000 in non-interest
income were offset by increases in the provision for loan losses and an increase
in non-interest expense.
The most significant impact do earnings during 2003 was an increase in the
provision for loan losses to $1,820,000 compared to $820,000 during 2002.
Continued stagnant economic conditions, coupled with rising delinquency rates in
the company's loan portfolio prompted an increase in the provision. The
allowance for loan losses as a percent of gross loans was 1.09% at December 31,
2003 compared to .79% at December 31, 2002.
Net Interest Margin
2003 compared to 2002
Net interest income increased 6.04% in 2003 compared to 2002.
9
Net Interest Margin (Continued)
2003 compared to 2002 (continued)
Although reductions in target rates by the Federal Reserve Board (the "Fed")
were less frequent during the past 18 months as compared to 2001 and the first
half of 2002, the effects of these earlier cuts were apparent in the yields on
the Company's earning assets and on average rates paid on interest bearing
liabilities. As older deposits matured and were replaced by lower rate deposits,
the average cost for deposits fell 87 basis points. As higher yielding loans
matured, they were replaced by lower yielding loans or variable rate loans
repriced and thus the average yield on loans fell 51 basis points. Taxable
equivalent yields on securities also fell as higher yielding securities matured
or were called and were replaced by securities with lower yields.
The strong loan demand experienced in recent periods has slowed in 2003 and
average loan balances grew 4.56% over 2002 average balances compared to a growth
of 9.30% from 2001 to 2002. Year end balances of loans for 2003 as compared to
2002 were .39% higher.
The high loan growth during 2002 and 2001 was funded in part through
reductions in securities balances, reductions in balances of Federal Funds sold
and through increases in balances of deposits. As loan demand flattened during
2003 and demand for deposit products remained stable, the Company has increased
investments of both Fed Funds sold and securities.
In the past, competition for deposits in the Company's service area was
strong and this caused the Company's subsidiary banks to pay higher rates on
deposits than larger, statewide financial institutions. Slowing loan growth in
2003 reduced the need for deposit growth, and the Company has made efforts in
recent periods to reduce this rate disparity. Average rates paid on time
deposits fell 96 basis points in 2003 as compared to 2002 and are now
approaching the peer group levels. Rates on transaction accounts continued to
mirror the peer group.
The Company anticipates that it's net interest margin will remain stable or
rise slightly in the first six months of 2004 as higher rate liabilities
continue to mature. The Company expects loan and deposit demand to remain
modest. Changes in the rate of economic recovery could have a significant impact
on the current interest rate environment, with implications both to the volume
and rates of interest earning assets and interest bearing liabilities.
2002 compared to 2001
The Company's net interest margin on a tax equivalent basis was $11,383,000
for 2002 compared to $10,257,000 for 2001, an increase of 10.98%. Average
earning assets grew 7.27% compared to growth of 5.99% of interest bearing
liabilities. Falling interest rates caused the average yield on earning assets
to fall 103 basis points while the average cost of interest bearing liabilities
fell 134 basis points.
Loan growth was strong with average loans outstanding growing 9.30% from
2001 to 2002 as falling interest rates throughout 2002, coupled with stable
local economic conditions propelled loan demand. Increases in loan growth were
primarily funded through increases in deposit growth and reductions in balances
of fed funds sold, securities and interest bearing deposits in other banks.
A summary of the net interest margin analysis is shown as Table I on Page 26.
10
Provision for Loan Losses
The Company's provisions for loan losses were $1,820,000 for 2003, $820,000
for 2002, and $600,000 for 2001.
The higher 2003 provision was a result of some deterioration in the quality
of the loan portfolio. Balances of non-performing loans (non-accrual loans,
restructured loans, and loans 90 days or more delinquent) increased $1,014,000
from December 31, 2002 to December 31, 2003, an increase of 35.22%.
Non-performing loans were 1.72% of gross loans as of December 31, 2003 compared
to 1.28% at December 31, 2002. Net charge-offs during 2003 were $1,151,000
compared to $630,000 during 2002. The ratio of net charge-offs to average net
loans during 2003 was .51% and the three year average of net charge-offs to
average net loans was .35%. Both rates are above peer group average which is
about .27% for the three year period.
The increase in net charge-offs was centered largely in the consumer
installment and commercial loan portfolios as net charge-offs of commercial
loans increased $246,000 and net charge-offs of consumer loans increased
$307,000 compared to 2002. See Allowance for Loan Losses section on pages 15-19
for an expanded explanation of lending losses.
Noninterest Income
2003 Compared to 2002
Noninterest income for 2003 increased 4.87% from 2002. As average deposit
volumes continued to grow, income from service charges increased $30,000. Income
from insurance related activity continues to grow as increases in loan volume
and customer penetration rates have resulted in higher commissions and fees from
insurance activity. Income from investments in life insurance contracts
decreased 7.25% as interest rate declines and continued low market rates led to
lower returns.
2002 Compared to 2001
Noninterest income for 2002 increased $109,000 from 2001, an increase of
9.17%. Service charge income increased slighltly as deposit and loan volume
increased. Due to decreases in interest rates and changes in economic
conditions, income from investments in life insurance contracts fell 3.19%.
Gains on sales of other real estate owned were $40,550 during 2002 compared to
no gains recorded in 2001.
Discontinuation of Trust Operations
During the fourth quarter of 2003, the Board of Directors of Highlands
Bankshares, Inc. decided to close Highlands Bankshares Trust Company, Inc. The
development of the market for trust services in the Company's primary and
secondary service areas has been less than anticipated. On a fully consolidated
basis, Highlands Bankshares Trust Company, Inc. contributed the following losses
to consolidated net income of Highlands Bankshares, Inc.: $84,223 in 2001,
$85,959 in 2002 and $55,721 in 2003. There are certain capital implications to
the Company and to the subsidiary banks related to the closing of Highlands
Bankshares Trust Company which are discussed on page 22. It is anticipated that
all trust operations will be closed by May 15, 2004.
11
Noninterest Expenses
2003 Compared to 2002
Total noninterest expense increased 2.47% in 2003 as compared to 2002.
Salary and benefit expense increased $88,000, or 2.00%, in 2003 as compared to
2002. Increases in costs of retirement benefits associated with bank owned life
insurance contracts contributed $91,000 of the increase. An increase in full
time average equivalent employees of .70% was offset by a decline in per
employee costs of .92%.
Occupancy expense remained flat as no new locations were added and no
existing locations improved. Equipment expense increased $63,000, or 9.57%. A
significant portion of the increase in equipment expense related to improvements
and upgrades to the Company's data processing infrastructure. During 2003, the
Company's subsidiary banks introduced telephone banking and began a project for
introducing check imaging. Both projects required new equipment which increased
depreciation expense and will cause continued higher depreciation expenses in
2004 as compared to prior periods. Data processing expenses paid to outside
parties increased 4.38% as growth of operations required additional processing
volumes.
Legal and professional fees increased $63,000, or 27.67% from 2002, largely
as a result of the contracting with a public accounting firm to begin
independent internal audit procedures at the subsidiary banks. Directors fees
increased $84,000 in 2003 as compared to 2002, an increase of 37.02%. This
increase was the result of an increase in meetings held during 2003 as compared
to 2002, an increase in the number of directors at the subsidiary banks, and an
increase in directors' per meeting fees beginning in May.
Other expenses decreased from 2002 to 2003 as expenses related expanded
advertising campaigns undertaken in 2002 and costs associated with The Grant
County Bank's 100th Anniversary celebration were not present in 2003. Travel and
entertainment expense and nonincome tax expense also decreased in 2003. These
decreases were offset in part by increases in office supply expenses and
insurance expense.
2002 Compared to 2001
Total noninterest expenses increased 8.30% in 2002 compared with 2001.
Salaries and benefits increased 5.62% due to an increase in full time equivalent
employees, merit increases and higher benefit costs. Occupancy expense remained
substantially unchanged and equipment expense increased 4.98% as expanded
operations required new equipment purchases resulting in increased depreciation
and maintenance costs. Data processing expenses increased by 8.57% due to
general asset growth and expanded operations. Other changes contributing to the
increase in noninterest expenses were increases in marketing expenditure due to
expanded advertising campaigns and The Grant County Bank's 100th Anniversary
celebration, continuing costs associated with the start-up and expansion of
Highlands Bankshares Trust Company and increases in nonincome taxes.
Financial Condition
Loan Portfolio
The Company is an active residential mortgage and construction lender and
generally extends commercial loans to small and medium sized businesses within
its primary service area. The Company's commercial lending activity extends
across its primary service areas of Grant, Hardy, Hampshire, Mineral, Randolph,
and northern Pendleton counties in WV and Frederick County, VA. Consistent with
its focus on providing community-based financial services, the Company does not
attempt to diversify its loan portfolio geographically by making significant
amounts of loans to borrowers outside of its primary service area.
12
Financial Condition (continued)
Loan Portfolio (Continued)
The principal economic risk associated with each of the categories of loans
in the Company's portfolio is the creditworthiness of its borrowers. Within each
category, such risk is increased or decreased depending on prevailing economic
conditions. The risk associated with the real estate mortgage loans and
installment loans to individuals varies based upon employment levels, consumer
confidence, fluctuations in value of residential real estate and other
conditions that affect the ability of consumers to repay indebtedness. The risk
associated with commercial, financial and agricultural loans varies based upon
the strength and activity of the local economies of the Company's market areas.
The risk associated with real estate construction loans varies based upon the
supply of and demand for the type of real estate under construction.
Loans outstanding increased $881,000, or .38% in 2003. Balances of loans
secured by real estate grew 4.63% from December 31, 2002 to December 31, 2003.
The Company's loan to deposit ratio was 86.28% at December 31, 2003 compared to
87.68% at December 31, 2002. Loan demand is expected to remain satisfactory in
the near future with any growth a function of local and national economic
conditions.
The following table summarizes the Company's loan portfolio, net of unearned
income:
At December 31,
----------------------------------------
2002 2002 2001
---- ---- ----
(In Thousands of Dollars)
Real Estate:
Mortgage $129,671 $121,558 $111,668
Construction 7,552 6,813 3,868
Commercial 42,911 47,089 42,204
Installment 46,501 50,294 47,730
------ ------- -------
Total Loans 226,635 225,754 205,470
Allowance for loan losses (2,463) (1,793) (1,603)
------- -------- -------
Loans, net $ 224,172 $ 223,961 $203,867
============ ============ =======
There were no foreign loans outstanding during any of the above periods.
13
Financial Condition (Continued)
Loan Portfolio (Continued)
The following table shows the maturity of loans outstanding (in thousands
of dollars) as of December 31, 2003, 2002 and 2001.
Maturity Range 2003 2002 2001
-------------- ---- ---- ----
Predetermined Rates:
0 - 12 months $132,237 $145,473 $ 99,049
13 - 60 months 80,099 68,699 68,106
More than 60 months 12,635 11,353 37,841
Nonaccrual Loans 1,664 229 474
------- ------- -------
Total Loans $226,635 $225,754 $205,470
======= ======= =======
The following table shows the Company's loan maturity distribution (in
thousands of dollars) as of December 31, 2003:
Maturity Range
Less Than 1-5 Over
Loan Type 1 Year Years 5 Years Total
--------- ------- ----- ------- -----
Commercial and
Agricultural Loans $ 28,080 $ 7,129 $ 7,702 $ 42,911
Real Estate - mortgage 79,828 44,722 5,095 129,645
Real Estate - construction 7,552 7,552
Consumer - installment 16,777 28,248 1,502 46,527
------- ------- ------- -------
Total $132,237 $ 80,099 $ 14,299 $226,635
======= ======= ======= =======
14
Financial Condition (Continued)
Loan Portfolio (Continued)
Nonperforming loans include nonaccrual loans, loans 90 days or more past
due and restructured loans. Nonaccrual loans are loans on which interest
accruals have been discontinued. Loans are placed in nonaccrual status when the
collection of principal or interest is 120 days past due and collection is
uncertain based on the net realizable value of the collateral and/or the
financial strength of the borrower. Also, the existence of any guaranties by
federal or state agencies is given consideration in this decision. The policy is
the same for all types of loans. Restructured loans are loans which a borrower
has been granted a concession on the interest rate or the original repayment
terms because of financial difficulties. Nonperforming loans do not represent or
result from trends or uncertainties which management reasonably expects will
materially impact future operating results, liquidity, or capital resources.
Nonperforming loans are listed in the table below.
Real estate acquired through foreclosure was $291,414 at December 31, 2003,
$517,050 at December 31, 2002 and $58,250 at December 31, 2001. All of the
foreclosed properties held at December 31, 2003 were located in the Company's
primary service area. The Company's practice is to value real estate acquired
through foreclosure at the lower of (i) an independent current appraisal or
market analysis less anticipated costs of disposal, or (ii) the existing loan
balance. The Company is actively marketing all foreclosed real estate and does
not anticipate material write-downs in value before or at the time of
disposition.
Nonperforming loans increased 35.22% at December 31, 2003 compared to 2002.
Balances of nonaccrual loans increased from $299,000 at December 31, 2002 to
$1,664,000 at December 31, 2003 as the result of increased delinquencies making
necessary the movement of loan balances to nonaccrual status. Of the loans on
nonaccrual status as of December 31, 2003, 86.30% were loans secured by real
estate.
The following table summarizes the nonperforming loans:
At December 31,
-------------------------------
2003 2002 2001
---- ---- ----
(Dollars in Thousands)
Loans accounted for on a
nonaccrual basis
Consumer $ 228 $ 9 $
Real estate 1,436 290 474
------ ---- -----
Total nonaccrual loans 1,664 299 474
----- ----- ------
Restructured loans 631 662 0
----- ------ -------
Loans contractually past due 90 days
or more as to interest or principal
payments (not included in nonaccrual
loans above)
Commercial 25 161 607
Real estate 1,255 1,312 1,352
Installments 318 445 336
------- ----- ------
Total Delinquent Loans 1,598 1,918 2,295
------- ----- ------
Total Nonperforming Loans $ 3,893 $2,879 $ 2,769
====== ===== ======
15
Financial Condition (Continued)
Loan Portfolio (Continued)
An inherent risk in the lending of money is that the borrower will not be
able to repay the loan under the terms of the original agreement. The allowance
for loan losses (see subsequent section) provides for this risk and is reviewed
periodically for adequacy. This review also considers concentrations of loans in
terms of geography, business type or level of risk. While lending is
geographically diversified within the service area, the Company does have some
concentration of loans in the area of agriculture (primarily poultry farming),
timber and related industries. Management recognizes these concentrations and
considers them when structuring its loan portfolio. As of December 31, 2003,
management is not aware of any significant potential problem loans for which the
debtor is currently meeting their obligations as stated in the loan agreement
but which may change in future periods.
As of December 31, 2003, the Company did not have any potential problem
loans as defined in Guide 3 that would require disclosure.
Allowance for Loan Losses
The allowance for loan losses at December 31, 2003 was $2,463,000. This is
an increase of 37.37% over the balance at December 31, 2002. The Company's
provision for loan losses in 2003 was $1,820,000 compared to $820,000 in 2002.
The increase in the provision for loan losses from 2002 to 2003 was necessitated
by increases in non-performing loans and an increase in net charge-offs as
compared to prior years.
The allowance for loan losses is an estimate of the losses in the current
loan portfolio. The allowance is based on two principles of accounting: (i) SFAS
5, Accounting for Contingencies which requires that losses be accrued when they
are probable of occurring and estimable and (ii) SFAS 114, Accounting by
Creditors for Impairment of a Loan, which requires that loans be identified
which have characteristics of impairment as individual risks, (e.g. the
collateral, present value of cash flows or observable market values are less
than the loan balance).
Each of Company's banking subsidiaries, Capon Valley Bank and The Grant
County Bank, determines its allowance for loan losses independently. Each bank
pays particular attention to individual loan performance, collateral values,
borrower financial condition and overall national and local economic conditions.
The determination of adequate allowance at each bank is done in a three step
process. The first step is to identify problem loans above a certain threshold
and estimated losses are calculated based on collateral values and projected
cash flows. The second step is to identify loans above a certain threshold which
are problem loans due to the borrowers' payment history or deteriorating
financial condition. Losses in this category are determined based on historical
loss rates adjusted for current economic conditions. The final step is to
calculate a loss for the remainder of the portfolio using historical loss
information for each type of loan classification. The determination of specific
allowances and weights is in some part subjective and actual losses may be
greater or less than the amount of the allowance. However, Management believes
that the allowance represents a fair assessment of the losses that exist in the
current loan portfolio.
Both banks classify loans into the following categories: impaired,
doubtful, substandard, special mention and other loans past due 90 days or more
and assigns loss rates to each. Within these categories, Real Estate,
Installment Loans, Commercial Loans and Lines of Credit are assigned a specific
loss rate based on historical losses and management's estimate of losses. The
allowance associated with loans classed as impaired is provided for at 100% of
the identified impairment.
16
Allowance for Loan Losses (Continued)
Loans 90 days or more past due and nonaccrual loans are included in one of
the five categories above. Generally, all loans in excess of $250,000 are
evaluated individually as well as any loan regardless of size that is classified
as loss, doubtful, substandard or special mention. This detailed review
identifies each applicable loan for specific impairment and a specific
allocation for that impaired amount is provided for as the first element in the
calculation. Rates assigned each category may vary over time and between the
banks as historical loss rates, loan structure and economic conditions differ
and change.
The remaining portfolio balances are assigned a loss factor based on the
historical net loss rates, reduced by recoveries. Loss experience per
classification varies significantly based on risk and collateral. Installment
and commercial loans generally have higher loss volumes than secured real estate
loans. The net result creates a low and high range of allocated allowance. The
Company's actual allowance balance is compared to this range and adjusted as
deemed necessary.
The required level of the allowance for loan losses is computed quarterly
and the allowance adjusted prior to the issuance of the quarterly financial
statements. All loan losses charged to the allowance are approved by the boards
of directors of each bank at their regular meetings. The allowance is reviewed
for adequacy after considering historical loss rates, current economic
conditions (both locally and nationally) and any known credit problems that have
not been considered under the above formula.
Management has analyzed the potential risk of loss on the Company's loan
portfolio given the loan balances and the value of the underlying collateral and
has recognized losses where appropriate. Nonperforming loans are closely
monitored on an ongoing basis as part of the Company's loan review process. The
ratio of the allowance for loan losses to total loans outstanding was 1.09% at
December 31, 2003, .79% at December 31, 2002 and .78% at December 31, 2001. At
December 31, 2003, the ratio of the allowance for loan losses to nonperforming
loans was 63.27% compared to 62.28% at December 31, 2002 and 57.89% at December
31, 2001.
Because of its large impact on the local economy, Management continues to
monitor the economic health of the poultry industry. The Company has direct
loans to poultry growers and the industry is a large employer in the Company's
trade area. Loan requests for poultry house loans or expansion continue to be
presented for approval. In June of 2003, Pilgrim's Pride Corporation announced
the purchase of certain divisions of ConAgra Foods, Inc. including processing
facilities operated by ConAgra in Hardy County. Management anticipates that this
purchase will have no adverse impact on operations of either subsidiary bank or
on the operations of the non-bank subsidiaries. In the fall of 2002, Perdue
Farms, Inc. ceased operations at its Petersburg processing plant. At present,
this facility sits
17
Allowance for Loan Losses (Continued)
idle. In part because of this closure, the unemployment rate in Grant County
grew from 6.7% in October of 2002 to 11.30% in January of 2004. While management
believes that this closure has contributed to the slow-down in loan growth, the
overall impact of the closure on the Company has been minimized by the Company's
geographic diversity as the other counties in the Company's primary service area
maintain better economies.
In recent periods, the Company's loan portfolio has also begun to gain a
concentration in loans collateralized by heavy equipment, particularly in the
trucking and timber industries. In part because of rising fuel costs, and
because of continued stagnant economic conditions, the trucking sector has
experienced a recent downturn. However, the Company has experienced no material
losses related to foreclosures of loans collateralized by heavy equipment. While
close monitoring of this sector is necessary, management expects no significant
losses in the foreseeable future.
An analysis of the loan loss allowance is set forth in the following table
(in thousands):
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
Balance at beginning of
period $ 1,793 $ 1,603 $ 1,493 $ 1,318 $ 1,355
Charge-offs:
Commercial loans 557 246 239 172 107
Real estate loans 65 110 92 128 87
Consumer loans 839 424 369 215 254
------- ------- ------ ------- ------
1,461 780 700 515 448
------- -------- ------ ------- ------
Recoveries:
Commercial loans 75 10 57 2 16
Real estate loans 54 68 12 30 1
Consumer loans 182 72 141 71 74
------- -------- ------ ------- ------
311 150 210 103 91
------- ------- ------ ------- ------
Net charge-offs 1,150 630 490 412 357
Provision for loan
losses 1,820 820 600 500 320
Other 87
------ ------- ------ ------- ------
Balance at end of
period $ 2,463 $ 1,793 $ 1,603 $ 1,493 $ 1,318
======== ======== ======== ======== =======
Percent of net
charge-offs
to average net
loans outstanding
during the
period .51% .29% .25% .23% .23%
====== ======== ======== ======== =====
18
The following table shows the amount and percentage of the Company's
allowance for loan losses allocated to each major category of loans:
At December 31,
-------------------------------------------------------------------------------------------------
2003 2002 2001 2000 1999
-------------- ----------------- -------------- ---------------- -----------------
Percent Percent Percent Percent Percent
of of of of of
Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans
(Dollars in Thousands)
Commercial $ 779 19% $ 543 21% $ 487 21% $ 507 20% $ 395 19%
Real estate
Mortgage 725 61 504 57 576 56 239 56 211 58
Installment 819 20 652 22 450 23 598 24 580 23
Unallocated 140 94 90 149 132
------ --- ---- --- ---- ---- ---- --- ---- ---
Total $ 2,463 100% $1,793 100% $1,603 100% $1,493 100% $1,318 100%
====== === ===== === ===== ===== ===== === ====== =======
19
Allowance for Loan Losses (Continued)
Cumulative net loan losses, after recoveries, for the five year period
ending December 31, 2003 are as follows:
Dollars Percent of Total
Commercial $ 1,161 38.16%
Real estate 317 10.43%
Consumer 1,561 51.37%
----- ------
Total $ 3,039 100.00%
====== ======
The above acts as a starting point for allocating the overall allowances.
Additional changes have been made in the allocation of the allowance to address
unknowns and contingent items. The unallocated portion is not computed using a
specific formula and is management's best estimate of what should be allocated
for contingencies in the current portfolio.
Losses in 2003 were above peer group amounts. Because of the increase in
delinquencies, Management deemed it necessary to chargeoff larger volumes of
loans during 2003 than in 2002, but expects that in the foreseeable future,
charge-offs will not continue to deviate substantially from historical rates.
The allowance as of December 31, 2003 was 1.09% of loans outstanding which is
comparable to peer group levels. Management believes the present allowance,
which is 3.49 times the average annual net charge-off rate over the last three
year period, is adequate based on its knowledge of the loan portfolio and
historical performance.
Securities
The Company's securities portfolio serves several purposes. Portions of the
portfolio are used to secure certain public and trust deposits. The remaining
portfolio is held as investments or used to assist the Company in liquidity and
asset liability management. Total securities increased to $34,929,000 or 11.60%
of total assets at December 31, 2003. Total securities were $25,537,000 or 8.73%
of total assets at December 31, 2002.
The securities portfolio consists of three components: securities held to
maturity, securities available for sale and restricted securities. Securities
are classified as held to maturity when management has the intent and the
Company has the ability at the time of purchase to hold the securities to
maturity. Held to maturity securities are carried at cost, adjusted for
amortization of premiums and accretion of discounts. Securities to be held for
indefinite periods of time are classified as available for sale and accounted
for at market value. Securities available for sale include securities that may
be sold in response to changes in market interest rates, changes in the
security's prepayment risk, increases in loan demand, general liquidity needs
and other similar factors. Restricted securities are those investments purchased
as a requirement of membership in certain governmental lending insitutions and
cannot be transferred without the issuer's permission. The Company's purchases
of securities have generally been limited to securities of high credit quality
with short to medium term maturities.
20
Securities (continued)
The Company identifies at the time of acquisition those securities that are
available for sale. These securities are valued at their market value with any
difference in market value and amortized cost shown as an adjustment in
stockholders' equity. Changes within the year in market values are reflected as
changes in stockholders' equity, net of the deferred tax effect. As of December
31, 2003, the fair value of the securities available for sale exceeded their
cost basis by $213,000 ($134,000 after the related tax effect).
The following table summarizes the carrying value of the Company's
securities at the dates indicated:
Held to Maturity Available for Sale
Carrying Value Carrying Value
--------------------------------------------------------
December 31, December 31,
2003 2002 2001 2003 2002 2001
---- ---- ---- ---- ---- ----
(In Thousands of Dollars) (In Thousands of Dollars)
U.S. treasuries,
agencies
and corporations $ $ $ $23,240 $13,534 $16,432
Obligations of
states and
political
subdivisions 1,364 1,365 1,597 2,604 4,350 6,380
Mortgage-backed
securities 2 4 6 6,758 5,582 6,609
---- ----- ---- ---- ------ ------
Total Debt
Securities 1,366 1,369 1,603 32,602 23,466 29,421
Other securities 29 30 39
------ ------ ----- ------ ------ ------
Total $ 1,366 $ 1,369 $1,603 $32,631 $23,496 $29,460
====== ====== ===== ====== ====== ======
The carrying amount and estimated market value of debt securities (in thousands
of dollars) at December 31, 2003 by contractual maturity are shown below.
Expected maturities will differ from contractual maturities because borrowers
may have the right to call or prepay obligations with or without call or
prepayment penalties.
Equivalent
Securities Held to Maturity Amortized Fair Average
Cost Value Yield
------------ ----------- ---------
Due in one year or less $ 675 $ 700 5.52%
Due after one year through
five years 691 737 7.03%
------- ------- ------
Total Held to Maturity $ 1,366 $ 1,437 6.29%
======== ========= =====
Equivalent
Securities Available for Sale Amortized Fair Average
Cost Value Yield
------------ ----------- ---------
Due in one year or less $ 7,207 $ 7,256 3.13%
Due after one year through
five years 19,454 19,571 2.34%
Due after five years through
ten years 2,142 2,193 4.03%
Due after ten years 3,582 3,582 3.21%
-------- --------- -----
Total Fixed Rate Securities 32,385 32,602 2.73%
Equities 32 29 4.01%
-------- --------- -----
Total Available for Sale $ 32,417 $ 32,631 2.73%
======== ========= =====
Yields on tax exempt securities are stated at actual yields.
Management has generally kept the maturities of investments relatively
short providing for flexibility in investing. Such a philosophy allows the
Company to better match deposit maturities with investment maturities and thus
react more quickly to interest rate changes.
21
Deposits
The Company's primary source of funds is local deposits. The Company's
deposit base is comprised of demand deposits, savings and money market accounts
and other time deposits. The Company's deposits are provided by individuals and
businesses located within the communities served.
The average balance of interest bearing deposits increased 8.39% in 2003
compared to average levels in 2002. The average balance of noninterest bearing
deposits increased 8.87% over average 2002 balances. The average rate paid on
deposits decreased to 2.61% in 2003 from 3.48% in 2002 and 4.84% in 2001. The
majority of the Company's deposits are higher yielding time deposits as most of
its customers are individuals who seek higher yields than savings accounts or
don't wish to accept the risks of the stock market.
The Company does not actively solicit large certificates of deposit (those
more than $100,000) due to the unstable nature of these deposits. Any increase
in balances of these large deposits in 2003 was the result of overall deposit
growth. A summary of the maturity of large deposits is as follows:
December 31,
Maturity Range 2003 2002 2001
-------------- ---- ---- ----
(In Thousands of Dollars)
Three months or less $ 7,950 $ 7,570 $ 8,980
Four to twelve months 19,080 22,030 21,965
One year to three years 12,307 8,598 10,018
Four years to five years 8,008 7,195 4,219
-------- -------- --------
Total $ 47,345 $ 45,393 $ 45,182
======= ======= ========
Borrowed Money
The Company occasionally borrows funds from the Federal Home Loan Bank to
reduce market rate risks and to fund capital additions. Such borrowings may have
fixed or variable interest rates and are amortized over a period of ten to
twenty years. Borrowings from this institution allow the banks to offer
long-term, fixed rate loans to their customers and match the interest rate
exposure of the receivable and the liability. During 2003, the Company borrowed
an additional $1,785,000 from the FHLB and made payments of $520,000 on
outstanding balances.
During the fourth quarter of 2003, the Company secured a $2,500,000 open
line of credit with another commercial bank. This line of credit was secured by
equity securities in a subsidiary company. This debt instrument was obtained as
both a precautionary and opportunistic device for funding should a need arise in
the future. There were no advances in 2003 from this line and it is not
anticipated that any borrowings from this debt facility will be used to fund
operating or liquidity needs.
22
Capital Resources
The assessment of capital adequacy depends on a number of factors such as
asset quality, liquidity, earnings performance and changing competitive
conditions and economic forces. The Company seeks to maintain a strong capital
base to support its growth and expansion activities, to provide stability to
current operations and to promote public confidence.
The Company's capital position continues to exceed regulatory minimums. The
primary indicators relied on by the Federal Reserve Board and other bank
regulators in measuring strength of capital position are the Tier 1 Capital,
Total Capital and Leverage ratios. Tier 1 Capital consists of common
stockholders' equity. Total Capital consists of Tier 1 Capital and a portion of
the allowance for loan losses. Risk-based capital ratios are calculated with
reference to risk-weighted assets which consist of both on and off-balance sheet
risks.
The following table shows risk-based capital ratios and stockholders'
equity to total assets:
Regulatory December 31,
Minimum 2003 2002
Capital Ratios
Risk-based capital to risk-weighted
assets
Tier 1 8.00% 13.40% 13.20%
Total 4.00% 14.55% 14.03%
Stockholders' equity to total assets 5.00% 9.81% 9.75%
The capital management function is an ongoing process. Central to this
process is internal equity generation accomplished by earnings retention. During
2003, 2002, and 2001, total stockholders' equity increased by $1,185,000,
$504,000 and $1,593,000, respectively, as a result of earnings retention and
changes in the unrealized gains (losses) on securities available for sale. The
2002 increase is reflective of a repurchase of Company stock in the amount of
$1,271,000. The return on average equity was 7.60% in 2003 compared to 8.87% for
2002 and 8.57% for 2001. Total cash dividends declared represent 36.03% of net
income for 2003 compared to 29.26% of net income for 2002 and 29.15% for 2001.
Book value per share was $20.56 at December 31, 2003 compared to $19.74 at
December 31, 2002.
In 2001, the Company created Highlands Bankshares Trust Company (HBTC) with
a capital infusion of $2,143,567. This capital infusion was funded through
dividends by the subsidiary banks. During the fourth quarter of 2003, the
Company decided to discontinue operations of HBTI and it is anticipated that the
closure will be completed by May 15, 2004. Capital invested in HBTC is reflected
in the consolidated capital levels cited above. The closure will most likely
increase the capital of the subsidiary banks but will have no effect on
consolidated capital.
Liquidity and Interest Rate Sensitivity
Liquidity
Operating liquidity is the ability to meet present and future financial
obligations through either the sale or maturity of existing assets or the
acquisition of additional funds through liability management. Liquid assets
include cash, interest bearing deposits with banks, federal funds sold,
investments and loans maturing within one year. The Company's ability to obtain
deposits and purchase funds at favorable rates determines its liability
liquidity. As a result of the Company's management of liquid assets and the
ability to generate liquidity through liability funding, Management believes
that the Company maintains overall liquidity sufficient to satisfy its
depositors' requirements and meet its customers' credit needs.
23
Liquidity and Interest Rate Sensitivity (continued)
Liquidity (continued)
Additional sources of liquidity available to the Company include, but are
not limited to, loan repayments, the ability to obtain deposits through the
adjustment of interest rates and the purchasing of federal funds. To further
meet its liquidity needs, the Company also maintains lines of credit with
correspondent financial institutions, the Federal Reserve Bank of Richmond and
the Federal Home Loan Bank of Pittsburgh. In the past, growth in deposits and
proceeds from the maturity of investment securities have been sufficient to fund
the net increase in loans.
In the year ending December 31, 2003, cash and due from banks decreased
$1,013,000 as cash used in financing and investing activities was greater than
cash provided by operations. Investing activity saw an increase in net loans of
$2,031,000, a decrease in deposits at other institutions of $3,312,000, an
increase in fed funds sold of $2,093,000 and an increase of holdings of
securities and other investments of $9,392,000. New equipment and facility
additions were $915,000 in 2003 compared with $314,000 in 2002. Funding these
investments was an increase in deposits of $5,173,000, additional borrowings of
$1,785,000 and retained operating income of $1,429,000.
The parent Company's operating funds, funds with which to pay shareholder
dividends and funds for the exploration of new business ventures have been, in
the past, supplied primarily through dividends paid by subsidiary banks. The
various regulatory authorities impose restrictions on dividends paid by a state
bank. A state bank cannot pay dividends without the consent of the relevant
banking authorities in excess of the total net profits of the current year and
the combined retained profits of the previous two years. As of January 1, 2004,
the subsidiary banks could pay dividends to Highlands Bankshares, Inc. of
approximately $2,123,000 without permission of the regulatory authorities. The
following tables summarize the dividend limits (in thousands) as of January 1,
2004 for Capon Valley Bank (CVB) and The Grant County Bank (GCB).
2002 2003 Dividend
Net Net Limit
Income Dividends Income Dividends January 1, 2004
---------------------------------------------------------
CVB $1,075 $ 975 $ 475 $ $ 575
GCB 1,628 975 1,801 905 1,549
------ ------- ------- ------- -------
Total $2,703 $1,950 $ 2,276 $ 905 $ 2,124
In addition to funds from the subsidiaries, the Company has at its disposal
other options for funding which include, but are not limited to, Trust Preferred
Securities and debt. During the fourth quarter of 2003, the Company secured a
$2,500,000 open line of credit with another commercial bank. This line of credit
was secured by equity securities in a subsidiary company. This debt instrument
was obtained as both a precautionary and opportunistic device for funding should
a need arise in the future. It is not anticipated that any borrowings from this
debt facility will be used to fund operating liquidity needs.
Aside from regulatory restrictions on dividends, the Company's subsidiary
banks must maintain certain regulatory minimum levels of capital. During 2001
and 2002, the Company funded the creation of Highlands Bankshares Trust Company
and repurchased shares of the Company's stock through dividends from the
subsidiary banks. Although these large subsidiary dividends, coupled with
decreased returns on average assets during recent quarters, have reduced the
Banks' dividend paying capacity, Management does not anticipate the need for a
reduction in shareholder dividends in the foreseeable future.
24
Liquidity and Interest Rate Sensitivity (Continued)
Liquidity (continued)
The Company is not aware of any trends, events or uncertainties that will
have or that are reasonably likely to have a material effect on the Company's
liquidity, capital resources or operations. The Company is not aware of any
proposals from any regulatory authority which, if implemented, would have such
an effect.
Interest Rate Sensitivity
In conjunction with maintaining a satisfactory level of liquidity,
management must also control the degree of interest rate risk assumed on the
balance sheet. Managing this risk involves regular monitoring of the interest
sensitive assets relative to interest sensitive liabilities over specific time
intervals.
At December 31, 2003, the Company had a negative gap position as of 90 days
into the future. This gap becomes slightly positive at one year into the future.
With assets repricing at a level of 103.21% of the volume of interest bearing
liabilities during the first year, the impact to earnings of interest rate
changes should be minimal due to the ability to match increases in assets with
increases in liabilities. Even with gradual rises in interest rates, the Company
expects its cost of funds should remain stable throughout the early part of 2004
as any effects of rising rates are offset by the maturity of older time deposits
paying at a higher rate of interest than the current prevailing rates.
With the largest amount of interest sensitive assets and liabilities
repricing within one year, the Company monitors this position closely. Early
withdrawal of deposits, prepayments of loans and loan delinquencies are some of
the factors that could affect actual versus expected cash flows. In addition,
changes in rates on interest sensitive assets and liabilities may not be equal,
which could result in a change in the net interest margin. While the Company
does not match each of its interest sensitive assets against specific interest
sensitive liabilities, it does periodically review its cumulative position of
interest sensitive assets and liabilities.
The majority of the Company's commercial and real estate loans are made
with repricing frequencies of three months to three years, although recent
competitive trends have forced the company to make loans with three and five
year fixed terms. For this reason, 87.16% of all loans will reprice within three
years of December 31, 2003. Installment loans generally have a fixed rate of
interest but have limited amortization periods. These loans have an average life
to maturity of less than two years. Management believes that its philosophy of
requiring loan repricing within a three to five year period to be the most
prudent approach to asset/liability management.
In the area of investments, the Company employs a management technique
known as "laddering" to minimize interest rate exposures and provide a constant
flow of maturities subject to repricing at current market rates. To assist in
the management of investments, the Company employs an independent investment
counsel that advises it in planning and risk diversification. The Company
utilizes many forms of investments with a significant use of mortgage-backed
securities issued by federally chartered institutions. The Company does not
employ the use of derivatives in its approach to controlling market risk.
Although the majority of its investments are classified as available for sale,
the Company rarely sells securities except in unusual circumstances.
Table III (page 28) shows the maturity of liabilities and assets in future
periods. Table II (page 27) shows the effects of rate and volume changes on the
net interest margin for the past three year period.
25
Effects of Inflation
Inflation significantly affects industries having high levels of property,
plant and equipment or inventories. Although the Company is not significantly
affected in these areas, inflation does have an impact on the growth of assets.
As assets grow rapidly, it becomes necessary to increase equity capital at
proportionate levels to maintain the appropriate equity to asset ratios.
Traditionally, the Company's earnings and high capital retention levels have
enabled the Company to meet these needs.
The Company's reported earnings results have been minimally affected by
inflation. The different types of income and expense are affected in various
ways. Interest rates are affected by inflation, but the timing and magnitude of
the changes may not coincide with changes in the consumer price index.
Management actively monitors interest rate sensitivity, as illustrated by the
Gap Analysis (Table IV, page 29) in order to minimize the effects of
inflationary trends on interest rates. Other areas of noninterest expenses may
be more directly affected by inflation.
Securities and Exchange Commission website
The Securities and Exchange Commission maintains a WEB site that contains
reports, proxy and information statements and other information regarding
registrants (including the Company) that file electronically with the
Commission. That address is (http: //www.sec.gov)
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
This information is incorporated herein by reference from Item 7,
Management's Discussion and Analysis of Financial Condition and Results of
Operations.
26
TABLE I
NET INTEREST MARGIN AND AVERAGE BALANCE ANALYSIS
(Dollar amounts in thousands)
2003 2002 2001
-------------------------------- ----------------------------------- ------------------------------
Income/ Yield/ Income/ Yield/ Income/ Yield/
EARNING ASSETS Average 2 Expense Rate Average 2 Expense Rate Average 2 Expense Rate
- -------------- ------- -------- --------- ---------- ------- ------ ---------- ------- -------
Loans 1,3 $ 226,281 $ 16,966 7.50 $ 216,408 $ 17,324 8.01 $ 197,989 $ 17,895 9.04
Investment securities:
Taxable 4 28,107 885 3.15 25,247 1,165 4.61 24,686 1,445 5.85
Nontaxable 1,4 3,748 254 6.78 5,451 318 5.83 3,501 267 7.63
------- --------- ----- ------ ----- ----- ------- -------
Total Investment
Securities 31,855 1,139 3.58 30,698 1,483 4.83 28,187 1,712 6.07
Interest bearing deposits
in banks 5,342 53 .99 4,271 104 2.44 5,813 248 4.27
Federal funds sold 20,632 218 1.06 11,431 177 1.55 13,019 451 3.46
------ ----- ----- ------ ----- ----- ------ ------ -----
Total Earning
Assets 284,109 18,376 6.47 262,808 19,088 7.26 245,008 20,306 8.29
------- -------- ---- --------- ------- ---- ------- ------ -------
Allowance for loan
losses (2,163) (1,793) (1,613)
Nonearnings assets 23,343 21,840 20,550
------- ------ ------
Total Assets $305,290 $282,855 $263,945
======= ========= =======
INTEREST-BEARING LIABILITIES
Deposits:
Demand $ 21,434 $ 134 .63 $ 19,910 $ 225 1.31 $ 16,960 $ 242 1.42
Savings 48,128 381 .79 43,868 651 1.48 36,479 824 2.26
Time deposits 164,126 5,585 3.40 151,813 6,619 4.36 149,867 8,771 5.85
------- ------- --------- --------- ------ ----- ------- ------- -----
Total Deposits 233,688 6,100 2.61 215,591 7,495 3.48 203,306 9,837 4.84
Other borrowed money 4,780 238 4.98 4,280 210 4.91 4,149 212 5.11
----- ----- ----- ----- ----- ----- ------ ------ -----
Total Interest Bearing
Liabilities 238,468 6,338 2.66 219,871 7,705 3.50 207,455 10,049 4.84
------- ----- ----- ------- ----- ----- ------- ------- ----
Noninterest bearing
deposits 35,086 32,226 26,735
Other liabilities 2,337 2,320 2,436
------- ----- ------
Total Liabilities 275,891 254,417 236,626
Stockholders' Equity 29,399 28,438 27,319
------ ------ ------
Total Liabilities
and Equity $305,290 $282,855 $263,945
======= ========= ========
Net Interest Earnings $ 12,038 $ 11,383 $ 10,257
======== ========= ========
Net Yield on Interest
Earning Assets 4.24% 4.33% 4.19%
==== ====== ======
1 Yields are computed on a taxable equivalent basis using a 37% income tax
rate.
2 Average balances are based on daily balances.
3 Includes loans in nonaccrual status.
4 Average balances for securities available for sale are based on amortized
carrying values and do not reflect changes in market values.
27
TABLE II
EFFECT OF RATE-VOLUME CHANGES ON NET INTEREST INCOME
(On a fully taxable equivalent basis)
(In thousands of dollars)
2003 Compared to 2002 2002 Compared to 2001
--------------------------- -------------------------
Increase (Decrease) Increase (Decrease)
Due to Change in: Total Due to Change in: Total
1 Average Average Increase 1 Average Average Increase
Volume Rate (Decrease) Volume Rate (Decrease)
-------- -------- ----------- ------- --------- --------
Interest Income:
Loans 2 $ 740 $(1,098) $(358) $1,474 $(2,045) $ (571)
Investment Securities:
Taxable 90 (370) (280) 26 (306) (280)
Nontaxable (115) 51 (64) 114 (63) 51
------ ---- ----- ---- ---- ----
Total Investment
Securities (25) (319) (344) 140 (369) (229)
Interest bearing
deposits
in banks 11 (62) (51) (38) (106) (144)
Federal funds sold 97 (56) 41 (25) (249) (274)
----- ----- ---- ----- ----- -----
Total Interest Income 823 (1,535) (712) 1,552 (2,769) (1,218)
----- ------- ----- ----- ------- -------
Interest Expense:
Deposits:
Demand 10 (101) (91) 33 (50) (17)
Savings 34 (304) (270) 110 (283) (173)
All other time
deposits 419 (1,453) (1,034) 85 (2,237) (2,152)
Other borrowed money 25 3 28 6 (8) (2)
----- ---- ---- ---- ----- -----
Total Interest Expense 488 (1,855) (1,367) 234 (2,578) (2,344)
----- ------- ------- ---- ------- -------
Net Interest Income $ 335 $ 320 $ 655 $ 1,317 $ (191) $ 1,126
===== ==== ==== ===== ==== =====
1 Changes in volume are calculated based on the difference in average balance
multiplied by the prior year average rate. Rate change differences are the
difference in the volume changes and the actual dollar amount of interest
income or expense changes.
2 Nonaccrual loans have been included in average asset balances.
28
TABLE III
INTEREST RATE SENSITIVITY ANALYSIS
(In thousands of dollars)
DECEMBER 31, 2003
More than
5 Years
1 - 90 91 - 365 1 to 3 3 to 5 or Without
Days Days Years Years Maturity Total
EARNINGS ASSETS
Loans $34,344 $97,894 $65,287 $14,812 $14,298 $226,635
Fed funds sold 16,718 16,718
Securities 11,850 11,374 10,359 628 718 34,929
Interest bearing
time
deposits 887 300 1,187
------ ------ ------ ------ ----- ------
Total 63,799 109,568 75,646 15,440 15,016 279,469
-------- --------- ------ ------ ------ -----
INTEREST BEARING LIABILITIES
Transaction accounts 22,958 22,958
Money market accounts 16,953 16,953
Savings accounts 32,187 32,187
Time deposits more
than
$100,000 7,950 19,080 12,307 8,008 47,345
Time deposits less than
$100,000 20,571 47,611 30,031 12,093 110,306
Other borrowed money 95 578 828 1,159 2,635 5,295
------ ------ ------ ------ ----- ------
Total 100,714 67,269 43,166 21,260 2,635 235,044
--------- ------ ------ ------ ------- ------
Discrete interest
sensitivity GAP (36,915) 42,299 32,480 (5,820) 12,381
Cumulative interest
sensitivity GAP (36,915) 5,384 37,864 32,044 44,425
Ratio of cumulative
interest
sensitive assets to
cumulative
interest sensitive
liabilities 63.35% 103.21% 117.93% 113.79% 118.90%
Assumes all transaction, money market and savings deposit accounts reprice
within 90 days.
29
TABLE IV
QUARTERLY FINANCIAL RESULTS
(In thousands, except per share amounts)
Fourth Third Second First
Quarter Quarter Quarter Quarter
2003
Interest income $ 4,473 $ 4,604 $ 4,630 $ 4,576
Interest expense 1,369 1,543 1,668 1,758
-------- -------- -------- --------
Net interest income 3,104 3,061 2,962 2,818
Provision for loan losses 825 240 545 210
-------- -------- -------- --------
Net interest income after
provision 2,279 2,821 2,417 2,608
Non-interest income 337 348 339 343
Non-interest expense 2,244 2,076 1,953 1,974
-------- -------- -------- --------
Income before income tax
provision 372 1,093 803 977
Income tax provision 85 363 247 317
-------- -------- -------- --------
Net Income $ 287 $ 730 $ 556 $ 660
======== ======== ======== ========
Per common share:*
Net income (basic) $ .20 $ .51 $ .38 $ .46
Net income (diluted) .20 .51 .38 .46
Cash dividends .14 .14 .14 .14
2002
Interest income $ 4,718 $ 4,809 $ 4,706 $ 4,737
Interest expense 1,817 1,801 1,931 2,156
-------- -------- -------- --------
Net interest income 2,901 3,008 2,775 2,581
Provision for loan losses 350 210 140 120
-------- -------- -------- --------
Net interest income after
provision 2,551 2,798 2,635 2,461
Non-interest income 412 328 285 279
Non-interest expense 2,109 2,041 1,978 1,921
-------- -------- -------- --------
Income before income tax
provision 855 1,086 943 820
Income tax provision 269 360 306 245
-------- -------- -------- --------
Net Income $ 586 $ 726 $ 637 $ 575
======== ======== ======== ========
Per common share:*
Net income (basic) $ .41 $ .50 $ .44 $ .38
Net income (diluted) .41 .50 .44 .38
Cash dividends .13 .13 .13 .12
*--Prior period per share figures restated to reflect stock split effected in
form of dividend in 2002.
See Note 20 of the financial statements for significant expenses recognized in
the fourth quarter of 2003.
30
Item 8. Financial Statements
Index to Financial Statements
Financial Highlights............................................ 31
Consolidated Balance Sheets
as of December 31, 2002 and 2001................................ 32
Consolidated Statements of Income
for the Years Ended December 31, 2002, 2001 and 2000............ 33
Consolidated Statements of Changes in Stockholders' Equity
for the Years Ended December 31, 2002, 2001 and 2000............ 34
Consolidated Statements of Cash Flows
for the Years Ended December 31, 2002, 2001 and 2000............ 35
Notes to Consolidated Financial Statements...................... 36
Independent Auditors' Report.................................... 53
31
FINANCIAL HIGHLIGHTS
HIGHLANDS BANKSHARES, INC.
Years Ended December 31,
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
(Dollars in Thousands except per share data)
(Restated)
RESULTS OF OPERATIONS
Interest income $18,283 $ 18,970 $20,207 $ 18,207 $16,243
Interest expense (6,338) (7,705) (10,049) (8,790) (7,663)
-------- -------- ------- ------- ------
Net Interest Income 11,945 11,265 10,158 9,417 8,580
Provision for loan losses (1,820) (820) (600) (500) (320)
Noninterest income 1,367 1,304 1,194 1,263 1,026
Noninterest expenses (8,247) (8,047) (7,431) (6,836) (6,104)
Income taxes (1,012) (1,180) (979) (1,092) (978)
-------- ------- ------ ------- ------
Net Income $ 2,233 $ 2,522 $ 2,342 $ 2,252 $ 2,204
======= ======= ====== ======= ======
PROFITABILITY RATIOS
Return on Average Assets .73% .89% .89% .97% 1.02%
Return on Average Equity 7.60% 8.87% 8.57% 8.89% 9.42%
PER COMMON SHARE *
Net Income $ 1.55 $ 1.73 $ 1.56 $ 1.50 $ 1.46
Cash Dividends Declared .56 .51 .45 .41 .39
Book Value 20.57 19.74 18.50 17.24 15.97
Last Reported Market
Price 28.00 21.51 16.33 16.67 20.00
AT YEAR END
Assets $301,168 $292,672 $277,042 $248,782 $220,587
Deposits 262,685 257,512 242,042 216,571 192,345
Loans 226,635 225,754 205,469 189,268 166,614
Stockholders' Equity 29,549 28,365 27,861 25,958 24,043
Data for years prior to 2003 have been restated to reflect a prior period
adjustment. (See note 3 to the financial statements).
32
CONSOLIDATED BALANCE SHEETS
HIGHLANDS BANKSHARES, INC.
December 31,
ASSETS 2003 2002
Cash and due from banks (notes 4 and 15) $ 7,213,641 $ 8,226,301
Interest bearing deposits in banks (note 15) 1,187,322 4,499,666
Federal funds sold (note 15) 16,718,000 14,625,343
Investments:
Securities held to maturity (note 5) 1,365,618 1,369,112
Securities available for sale (note 5) 32,630,627 23,496,039
Restricted investments 933,150 671,811
Loans (notes 6, 14, 15 and 16) 226,634,839 225,754,224
Allowance for loan losses (note 7) (2,462,764) (1,793,345)
------------ ----------
Net Loans 224,172,075 223,960,879
Bank premises and equipment (note 8) 7,210,041 6,873,307
Interest receivable 1,718,298 1,821,476
Investment in life insurance contracts
(note 3 and 12) 5,558,578 5,338,036
Other assets 2,460,616 1,790,372
----------- ----------
Total Assets $301,167,966 $292,672,342
=========== ===========
LIABILITIES
Deposits:
Noninterest bearing $ 32,935,656 $ 31,785,317
Interest bearing
Money market and interest checking 22,957,597 20,935,592
Money market savings 16,953,182 16,996,289
Savings accounts 32,187,457 29,503,487
Time deposits over $100,000 (note 9) 47,345,230 45,392,941
All other time deposits (note 9) 110,306,225 112,898,645
------------ -----------
Total Deposits 262,685,347 257,512,271
Accrued expenses and other liabilities 3,638,241 2,765,949
Long term debt (note 10) 5,294,892 4,029,582
------------ ----------
Total Liabilities 271,618,480 264,307,802
------------ -----------
STOCKHOLDERS' EQUITY
Common stock, $5 par value, 3,000,000
shares authorized, 1,436,874 shares issued 7,184,370 7,184,370
Surplus 1,661,987 1,661,987
Retained earnings (note 3 and 11) 20,726,938 19,298,162
Other accumulated comprehensive income (note 19) (23,809) 220,021
----------- ----------
Total Stockholders' Equity 29,549,486 28,364,540
----------- ---------
Total Liabilities and Stockholders' Equity $301,167,966 $292,672,342
=========== ===========
The accompanying notes are an integral part of this statement.
33
CONSOLIDATED STATEMENTS OF INCOME
HIGHLANDS BANKSHARES, INC.
Years Ended December 31,
2003 2002 2001
----- ----- -----
Interest and Dividend Income
Loans, including fees $16,966,107 $17,323,503 $17,894,665
Federal funds sold 218,341 176,787 450,657
Interest bearing deposits 53,380 103,982 248,442
Investment securities - taxable 885,165 1,164,634 1,445,327
Investment securities - nontaxable 160,164 201,184 167,930
---------- -------- --------
Total Interest Income 18,283,157 18,970,090 20,207,021
----------- ---------- ----------
Interest Expense
Interest on deposits 6,100,104 7,494,500 9,836,905
Interest on long term debt 238,173 210,232 211,827
--------- -------- --------
Total Interest Expense 6,338,277 7,704,732 10,048,732
--------- --------- ----------
Net Interest Income 11,944,880 11,265,358 10,158,289
Provision for loan losses 1,820,000 820,000 600,000
---------- -------- --------
Net Interest Income after
Provision for Loan Losses 10,124,880 10,445,358 9,558,289
----------- ---------- ---------
Noninterest Income
Service charges 616,416 586,821 581,224
Insurance commissions and income 189,567 142,780 100,801
Life insurance investment income 220,542 237,774 245,598
Other operating income 336,168 336,109 266,421
Gain on security transactions 4,251
---------- -------- --------
Total Noninterest Income 1,366,944 1,303,484 1,194,044
---------- --------- ---------
Noninterest Expenses
Salaries and benefits 4,480,285 4,392,419 4,158,882
Occupancy expense 381,560 380,021 381,029
Equipment expense 725,642 662,266 630,840
Data processing expense 599,565 574,400 529,054
Legal and professional fees 290,699 227,696 186,079
Directors fees 311,191 227,106 222,605
Other operating expenses 1,457,344 1,583,819 1,322,574
----------- --------- ---------
Total Noninterest Expenses 8,246,286 8,047,727 7,431,063
---------- --------- ---------
Income before Income Tax Expense 3,245,538 3,701,115 3,321,270
Income tax expense 1,012,206 1,179,542 979,699
----------- --------- --------
NET INCOME $2,233,332 $2,521,573 $2,341,571
========== ========= =========
Weighted Average Shares Outstanding 1,436,874 1,455,511 1,505,694
Earnings Per Share $ 1.55 $ 1.73 $ 1.56
Cash Dividends Paid Per Share $ .56 $ .51 $ .45
The accompanying notes are an integral part of this statement.
34
CONSOLIDATED STATEMENTS OF CHANGES ON STOCKHOLDERS' EQUITY
HIGHLANDS BANKSHARES, INC.
Accumulated
Other
Common Retained Comprehensive Treasury
Stock Surplus Earnings Income (Loss) Stock Total
Balances, January 1,
2001 as Previously
Stated $ 2,733,820 $1,661,987 $ 22,825,747 $ 38,761 $ (992,701) $ 26,267,614
Adjustment for Accrual
of Indexed Retirement
Plan Liabilities (310,010) (310,000)
-------- -------- --------- ---------- ---------- -----------
Balances, January 1,
2001 (as Restated) 2,733,820 1,661,987 22,515,737 38,761 (992,701) 25,957,604
Comprehensive Income:
Net income 2,341,571 2,341,571
comprehensive income 244,149 244,149
(note 19)
Total Comprehensive
Income 2,585,720
Cash dividends (682,581) (682,581)
-------- ---------- ---------- -------- --------- -----------
Balance
December 31, 2001 2,733,820 1,661,987 24,174,727 282,910 (992,701) 27,860,743
Comprehensive Income:
Net income 2,521,573 2,521,573
Change in other
comprehensive income (62,889) (62,889)
(note 19)
Total Comprehensive
Income 2,458,684
Treasury stock (1,217,055) (1,217,055)
repurchased
Treasury stock retired (339,030) (1,870,726) 2,209,756
Stock split effected in
form of dividend 4,789,580 (4,789,580)
Cash dividends (737,832) (737,832)
-------- ------- ---------- -------- -------- ----------
Balance
December 31, 2002 7,184,370 1,661,987 19,298,162 220,021 28,364,540
Comprehensive Income:
Net income 2,233,332 2,233,332
Change in other
comprehensive income (243,830) (243,830)
(note 19)
Total Comprehensive
Income 1,989,502
Cash dividends (804,556) (804,556)
--------- --------- ------------ --------- ---------- --------
Balance
December 31, 2003 $ 7,184,370 $1,661,987 $20,726,938 $ (23,809) $ $29,549,486
=========== =========== ========== ====== ========= ==============
The accompanying notes are an integral part of this statement.
35
CONSOLIDATED STATEMENTS OF CASH FLOWS
HIGHLANDS BANKSHARES, INC.
Years Ended December 31,
2003 2002 2001
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $2,233,332 $2,521,573 $2,341,571
Adjustments to reconcile net income to
net cash provided by operating
activities:
Gain on Securities Transactions (4,251)
Depreciation 577,497 525,685 523,626
Income from life insurance
contracts (220,542) (237,774) (245,958)
Net amortization of security
premiums 463,016 294,266 122,343
Provision for loan losses 1,820,000 820,000 600,000
Deferred income tax benefit (187,266) (163,806) (98,821)
Change in other assets and liabilities:
Interest receivable 103,178 (3,592) 83,412
Other assets (482,978) (494,313) (127,198)
Accrued expenses 872,292 150,103 371,847
--------- ---------- --------
Net Cash Provided by Operating
Activities 5,174,278 3,412,142 3,570,822
--------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturity of securities
held to maturity 1,455 232,337 621,481
Proceeds from maturity of securities
available
for sale 19,575,620 12,406,125 17,116,010
Proceeds from sales of securities
available
for sale 484,797
Purchase of securities available
for sale (29,410,378) (7,207,357) (23,472,091)
Net change in restricted investments (261,339) 119,839 (28,600)
Net change in deposits in other banks 3,312,344 1,833,885 27,380
Net increase in loans (2,031,196)(20,914,267) (16,691,860)
Net change in federal funds sold (2,092,657) (1,340,934) (6,244,900)
Purchase of property and equipment (914,620) (314,479) (776,171)
Proceeds from sale of property
and equipment 6,358
---------- ---------- -------
Net Cash Used in Investing Activities (11,820,771)(14,700,054) (29,442,393)
----------- ---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in time deposits (640,128) 1,653,838 19,729,800
Net change in other deposit accounts 5,813,207 13,816,761 5,740,629
Additional long term debt 1,785,000 1,395,300
Repayment of long term debt (519,690) (493,860) (881,177)
Repurchase of treasury stock (1,217,055)
Dividends paid in cash (804,556) (737,832) (682,581)
-------- --------- ---------
Net Cash Provided by Financing
Activities 5,633,833 13,021,852 25,301,971
--------- --------- ----------
CASH AND CASH EQUIVALENTS:
Net (decrease) increase in cash and
due from banks (1,012,660) 1,733,940 (569,600)
Cash and due from banks, beginning
of year 8,226,301 6,492,361 7,061,961
--------- ---------- ---------
Cash and due from banks, end of year $7,213,641 $ 8,226,301 $6,492,361
========== ========== =========
Supplemental Disclosures:
Cash paid for:
Interest expense $6,359,833 $ 7,920,454 $10,042,704
Income taxes 1,447,717 1,421,272 1,367,143
The accompanying notes are an integral part of this statement.
36
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 1 SUMMARY OF OPERATIONS:
Highlands Bankshares, Inc. (the "Company") is a bank holding
company and operates under a charter issued by the state of West
Virginia. The Company owns all of the outstanding stock of The
Grant County Bank, Capon Valley Bank, HBI Life Insurance Company,
Inc. and Highlands Bankshares Trust Company, which operate under
charters issued in Arizona and West Virginia. State chartered
banks are subject to regulation by the West Virginia Division of
Banking, The Federal Reserve Bank and the Federal Deposit
Insurance Corporation while the insurance company is regulated by
the Arizona Department of Insurance. The Banks provide services to
customers located mainly in Grant, Hardy, Hampshire, Mineral,
Pendleton and Randolph counties of West Virginia, including the
towns of Petersburg, Keyser, Moorefield and Wardensville through
eight locations and the county of Frederick in Virginia through a
single location. The insurance company sells life and accident
coverage exclusively through the Company's subsidiary banks. The
Trust Company utilizes the subsidiary banks to facilitate the
sales of trust services to its customers and citizens in those
locales.
NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
The accounting and reporting policies of Highlands Bankshares,
Inc. and its subsidiaries conform to accounting principles
generally accepted in the United States of America and to accepted
practice within the banking industry.
(a) Principles of Consolidation
The consolidated financial statements include the
accounts of The Grant County Bank, Capon Valley Bank, HBI Life
Insurance Company and Highlands Bankshares Trust Company. All
significant intercompany accounts and transactions have been
eliminated.
(b) Use of Estimates in the Preparation of Financial
Statements
In preparing the financial statements, management is
required to make estimates and assumptions that affect the
reported amounts in those statements; actual results could
differ significantly from those estimates. A material estimate
that is particularly susceptible to significant changes in the
near term is the determination of the allowance for loan
losses, which is sensitive to changes in local economic
conditions.
(c) Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and
noninterest bearing funds at correspondent institutions.
(d) Foreclosed Real Estate
The components of foreclosed real estate are
adjusted to the fair value of the property at the time of
acquisition, less estimated costs of disposal. The current
year provision for a valuation allowance has been recorded as
an expense to current operations.
37
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED):
(e) Securities
Securities that the Company has both the positive intent
and ability to hold to maturity (at time of purchase) are
classified as held to maturity securities. All other
securities are classified as available for sale. Securities
held to maturity are carried at historical cost and adjusted
for amortization of premiums and accretion of discounts, using
the effective interest method. Securities available for sale
are carried at fair value with any valuation adjustments
reported, net of deferred taxes, as other accumulated
comprehensive income.
Restricted investments consist of investments in the
Federal Home Loan Bank of Pittsburgh and the Federal Reserve
Bank of Richmond. Such investments are required as members of
these institutions and these investments cannot be sold
without a change in the members' borrowing or service levels.
Interest and dividends on securities and amortization of
premiums and discounts on securities are reported as interest
income using the effective interest method. Gains (losses)
realized on sales and calls of securities are determined using
the specific identification method.
(f) Loans
Loans are carried on the balance sheet net of unearned
interest and allowance for loan losses. Interest income on
loans is determined using the effective interest method based
on the daily amount of principal outstanding except where
serious doubt exists as to collectibility of the loan, in
which case the accrual of income is discontinued. Loans are
placed on nonaccrual status or charged off if collection of
principal or interest becomes doubtful. The interest on these
loans is accounted for on cash-basis or cost-recovery method
until qualifying for return to accrual status. Loans are
returned to accrual status when all the principal and interest
amounts contractually due are brought current and the loan is
performing as agreed.
(g) Allowance For Loan Losses
The allowance for loan losses is based upon management's
knowledge and review of the loan portfolio. Estimation of the
adequacy of the allowance involves exercise of judgement, use
of assumptions with respect to present economic conditions and
knowledge of the environment in which the Banks operate. Among
the factors considered in determining the level of the
allowance are changes in composition of the loan portfolio,
amounts of delinquent and nonaccrual loans, past loan loss
experience and the value of collateral securing the loans.
(h) Per Share Calculations
Earnings per share are based on the weighted average
number of shares outstanding. In the third quarter of 2002,
the Company declared a stock split in the form of dividend.
Prior period per share amounts, including earnings per share,
dividends per share, book value per share, and market price
have been adjusted to reflect this split.
38
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED):
(i) Bank Premises and Equipment
Bank premises and equipment are stated at cost less
accumulated depreciation. Depreciation is charged to income
over the estimated useful lives of the assets using a
combination of the straight-line and accelerated methods.
The costs of maintenance, repairs, renewals, and
improvements to buildings, equipment and furniture and
fixtures are charged to operations as incurred. Gains and
losses on routine dispositions are reflected in other income
or expense.
(j) Income Taxes
Amounts provided for income tax expense are based on
income reported for financial statement purposes rather than
amounts currently payable under federal and state tax laws.
Deferred taxes, which arise principally from differences
between the period in which certain income and expenses are
recognized for financial accounting purposes and the period in
which they affect taxable income, are included in the amounts
provided for income taxes.
(k) Comprehensive Income
Accounting principles generally require that
recognized revenue, expenses, gains and losses be included in
net income. Certain changes in assets and liabilities, such as
unrealized gains and losses on available-for-sale securities
and accrued pension liabilities, are reported along with net
income as the components of comprehensive income.
(l) Bank Owned Life Insurance Contracts
The Company has invested in and owns life insurance
polices on key officers. The policies are designed so that the
company recovers the interest expenses associated with
carrying the polices and the officer will, at the time of
retirement, receive any earnings in excess of the amounts
earned by the Company.
The Company recognizes as an asset the net amount that
could be realized under the insurance contract as of the
balance sheet date. This amount represents the cash surrender
value of the policies less applicable surrender charges.
The portion of the benefits which will be received by
the executives at the time of their retirement is considered,
when taken collectively, to constitute a retirement plan.
Therefore the Company accounts for these policies using
guidance found in Statement of Financial Accounting Standards
No. 106, "Employers' Accounting for Post Retirement Benefits
Other Than Pensions." SFAS No. 106 requires that an employers'
obligation under a deferred compensation agreement be accrued
over the expected service life of the employee through their
normal retirement date (See Note 3).
39
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 3 PRIOR PERIOD ADJUSTMENT:
The Company has invested in and owns life insurance polices
on key officers. It also has agreements with key officers to
provide retirement benefits upon their retirement. The benefit
agreements are designed so that the Company recovers the cost of
funds associated with carrying the policies and the officer will,
at the time of retirement, receive any earnings in excess of the
amounts earned by the Company. Officers receive benefits after
retirement in conjunction with the earnings of the policies which
occur both before and after the officers' retirement.
Prior to 2003, the Company considered these contracts as a
deferred compensation agreement commonly referred to as "a revenue
neutral plan". As such, the company had accounted only for the
costs of benefits payable to the officers that are associated with
the current earnings of the policies. Increases to the surrender
value of the policies had been accounted for as current income and
an expense was accrued for the portion of those current earnings
payable to the officers upon retirement.
Recent regulatory guidance issued in 2003 requires that if
the contracts, taken collectively, represent the equivalent of a
retirement plan, the costs of benefits payable to the officer(s)
that are associated with future earnings of the policies
subsequent to the officer's retirement must be estimated and a
liability accrued. (See Note 2(l)).
The Company, employing its deferred compensation
consultants, has estimated the future liabilities for retired
executives for the duration of the agreements. The following table
outlines the differences in the amounts originally reported and
the corrected amounts for the years ending December 31, 2002 and
2001.
Year Ending Year Ending
December 31, 2002 December 31, 2001
As Reported As Restated As Reported As Restated
Accrued expenses and
other liabilities $1,890,096 $ 2,765,949 $1,902,794 $2,615,847
Other assets 1,466,306 1,790,372 971,993 1,235,822
Income before income
tax expense $3,863,916 $ 3,701,115 $3,542,244 $3,321,270
Income tax expense 1,239,778 1,179,542 1,061,459 979,699
--------- ---------- --------- ----------
Net income $2,624,138 $ 2,521,573 $2,480,785 $2,341,571
Earnings per share $ 1.80 $ 1.73 $ 1.65 $ 1.56
As Reported As Restated
Retained earnings,
December 31, 2002 $ 19,849,947 $19,298,162
Retained earnings,
December 31, 2001 $ 24,623,951 $24,174,727
Retained earnings,
December 31, 2000 $ 22,825,747 $22,515,737
The financial statements for 2002 and 2001 have been restated
to reflect the above.
40
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 4 CASH AND DUE FROM BANKS:
The Banks are required to maintain average reserve balances based
on a percentage of deposits. The Banks have generally met this
requirement through average cash on hand and balances with their
correspondent institutions.
NOTE 5 SECURITIES:
The carrying amount and estimated fair value of securities are as
follows:
Carrying Unrealized Unrealized Fair
Amount Gains Losses Value
Held to Maturity
December 31, 2003
Mortgage-backed $ 2,250 $ 24 $ $ 2,274
State and
municipals 1,363,368 71,179 1,434,547
---------- -------- ------- ---------
Total Securities
Held to Maturity $1,365,618 $ 71,203 $ $1,436,821
=========== ====== ======== =========
December 31, 2002
Mortgage-backed $ 4,285 $ $ $ 4,285
State and municipals 1,364,827 82,441 1,447,268
--------- -------- -------- ---------
Total Securities
Held to Maturity $1,369,112 $ 82,441 $ $1,451,553
========= ======== ======== =========
Available for Sale
December 31, 2003
U. S. Treasuries
and Agencies $23,132,304 $ 107,997 $ $23,240,301
Mortgage-backed 6,686,154 71,523 6,757,677
State and municipals 2,566,909 36,991 2,603,900
Marketable equities 31,847 3,098 28,749
-------- --------- ------ ---------
Total Securities
Available for Sale$32,417,214 $ 216,511 $ 3,098 $32,630,627
========== ======= ===== ==========
December 31, 2002
U. S. Treasuries
and Agencies $8,844,027 $ 116,835 $ $8,960,862
Mortgage-backed 5,410,267 171,891 5,582,158
State and municipals 4,238,055 111,515 4,349,570
Marketable equities 33,585 3,471 30,114
Corporate
obligations 4,506,319 67,016 4,573,335
----------- ------ -------- -----------
Total Securities
Available for
Sale $23,032,253 $ 467,257 $ 3,471 $23,496,039
========== ======= ===== ==========
41
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 5 SECURITIES (CONTINUED:
The carrying amount and fair value of debt securities at December 31,
2003, by contractual maturity, are shown below. Expected maturities
will differ from contractual maturities because borrowers may have the
right to call or prepay obligations with or without call or prepayment
penalties.
Securities Held to Maturity Fair
Cost Value
Due in one year or less $ 200,000 $ 204,322
Due after one year through five years 1,163,344 1,230,249
Mortgage-backed securities 2,274 2,250
--------- ---------
Total Held to Maturity $1,365,618 $1,436,821
========= =========
Securities Available for Sale Fair
Cost Value
Due in one year or less $ 7,236,915 $ 7,285,843
Due after one year through five years 18,389,287 18,472,235
Due after five years through ten years 1,003,737 1,017,831
Due after ten years 1,120,849 1,120,273
Mortgage-backed securities 4,634,579 4,705,696
--------- ---------
Total Fixed Rate Securities 32,385,367 32,601,878
Equities 31,847 28,749
--------- ---------
Total Available for Sale $32,417,214 $32,630,627
========== ==========
The carrying amounts (which approximate market value) of securities
pledged by the banks to primarily secure deposits amounted to
$6,869,000 at December 31, 2003 and $6,035,000 at December 31, 2002.
NOTE 6 LOANS:
Loans outstanding as of December 31, 2003 and 2002 are summarized as
follows:
2003 2002
---- ----
Commercial $42,911,284 $47,089,188
Real estate construction 7,552,000 6,813,000
Real estate mortgages 129,669,971 121,557,830
Consumer installment 46,501,584 50,294,206
---------- ----------
Total $226,634,839 $225,754,224
=========== ===========
42
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 6 LOANS (CONTINUED):
The following is a summary of information pertaining to impaired,
restricted and non-accrual loans (in thousands):
December 31
2003 2002
---- - ----
Impaired loans $ 2,954 $ 1,489
Valutaion allowance 589 321
No loans were identified as impaired for which an allowance was not
made.
Total non-accrual loans $ 1,664 $ 299
Total loans past-due ninety days
and still accruing interest 1,598 1,918
NOTE 7 ALLOWANCE FOR LOAN LOSSES:
A summary of changes in the allowance for loan losses for the years
ended December 31, 2003, 2002 and 2001 is shown in the following
schedule:
2003 2002 2001
---- ------ -----
Balance at beginning
of year $ 1,793,345 $ 1,602,536 $ 1,492,936
Provision charged to
operating expenses 1,820,000 820,000 600,000
Loan recoveries 311,222 151,227 209,552
Loans charged off (1,461,803) (780,418) (699,952)
------------ --------- ----------
Balance at end of year $ 2,462,764 $ 1,793,345 $ 1,602,536
========= ========= ==========
Percentage of outstanding
loans 1.09% .79% .78%
NOTE 8 BANK PREMISES AND EQUIPMENT:
Bank premises and equipment as of December 31 are summarized as
follows:
2003 2002
Land $1,137,485 $1,137,485
Buildings and improvements 6,316,682 6,165,529
Furniture and equipment 4,417,097 3,670,567
--------- ---------
Total cost 11,871,264 10,973,581
Less - accumulated depreciation (4,661,223) (4,100,274)
--------- -----------
Net Book Value $7,210,041 $ 6,873,307
========== =========
Provisions for depreciation charged to operations were $577,496 in
2003, $525,685 in 2002 and $523,626 in 2001.
43
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 9 DEPOSITS:
At December 31, 2003, the scheduled time deposit maturities are as
follows:
2004 $95,211,625
2005 25,426,196
2006 16,912,217
2007 12,310,741
2008 7,790,676
----------
Total $157,651,455
NOTE 10 LONG TERM DEBT:
The Company has borrowed money from the Federal Home Loan Bank of
Pittsburgh (FHLB). The interest rates on all of the notes payable as
of December 31, 2003 were fixed at the time of the advance and range
from 3.80% to 6.12%. The weighted average interest rate was 4.74% at
December 31, 2003. The Company has total borrowing capacity from the
FHLB of $89,360,000. The debt is secured by the general assets of the
Banks.
Repayments of long term debt are due either monthly or quarterly.
Interest expense of $238,173, $210,231, and $211,827 was incurred on
these debts in 2003, 2002, and 2001, respectively. The maturities of
long term debt as of December 31, 2003 are as follows:
2004 $ 673,525
2005 403,551
2006 423,974
2007 445,464
2008 420,756
Thereafter 2,927,622
-----------
Total $ 5,294,892
===========
NOTE 11 RESTRICTIONS ON DIVIDENDS OF SUBSIDIARY BANKS:
The principal source of funds of Highlands Bankshares, Inc. is
dividends paid by subsidiary banks. The various regulatory authorities
impose restrictions on dividends paid by a state bank. A state bank
cannot pay dividends (without the consent of state banking
authorities) in excess of the total net profits (net income less
dividends paid) of the current year to date and the combined retained
profits of the previous two years. As of January 1, 2004, the banks
could pay dividends to Highlands Bankshares, Inc. of approximately
$2,123,000 without permission of the regulatory authorities.
44
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 12 INCOME TAX EXPENSE:
The components of income tax expense for the years ended December 31,
are summarized as follows:
2003 2002 2001
----------- --------- -------
Current Expense
Federal $1,008,463 $1,104,987 $968,401
State 191,009 238,361 110,119
-------- ------- -------
Total Current Expense 1,199,472 1,343,348 1,078,520
--------- --------- ---------
Deferred Expense (Benefit)
Federal (169,499) (149,096) (90,821)
State (17,767) (14,710) (8,000)
--------- -------- --------
Total Deferred Benefit (187,266) (163,806) (98,821)
--------- ---------- -------
Income Tax Expense $1,012,206 $1,179,542 $ 979,699
========= ========= ========
The deferred tax effects of temporary differences for the years ended
December 31 are as follows:
2003 2002 2001
---- ---- ----
Tax effect of temporary differences:
Provision for loan losses $(180,899) $(57,117) $ 37,802
Sale of loans (664) 14,346 (28,271)
Pension expense 5,121 (16,584) (31,690)
Depreciation 77,341 41,065 47,406
Deferred compensation (84,144) (119,326) (139,011)
Miscellaneous (4,021) (26,190) 14,943
---------- -------- ---------
Net increase in deferred income
tax benefit $(187,266) $ (163,806) $(98,821)
========= ========= =======
The net deferred tax assets arising from temporary differences as of
December 31 are summarized as follows:
2003 2002
Deferred Tax Assets:
Provision for loan losses $ 665,217 $ 484,928
Insurance commissions 56,000 40,820
Sale of loans 8,308 16,070
Deferred compensation 624,761 540,452
Pension obligation 90,524 42,558
Other 19,481
------ ----
Total Assets 1,444,810 1,144,309
-------- ---------
Deferred Tax Liabilities:
-------------------------
Unrealized gain on securities
available for sale 80,357 171,921
Accretion income 15,182 17,217
Other liabilities 10,530
Property basis differences 476,210 398,862
--------- --------
Total Liabilities 571,749 598,530
---------- --------
Net Deferred Tax Asset $ 873,061 $ 545,779
========= ========
45
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 12 INCOME TAX EXPENSE (CONTINUED):
The following table summarizes the difference between income tax
expense and the amount computed by applying the federal statutory
income tax rate for the years ended December 31:
2003 2002 2001
---- ---- ----
Amounts at federal
statutory rates $ 1,103,483 $ 1,258,379 $ 1,129,232
Additions (reductions) resulting
from:
Tax-exempt income (109,391) (115,818) (102,365)
Partially exempt income (34,958) (30,158) (28,142)
State income taxes, net 109,565 127,979 99,485
Income from life insurance
contracts (82,844) (89,317) (97,014)
State income tax adjustment (30,000)
Other 26,351 28,477 8,503
--------- -------- --------
Income tax expense $ 1,012,206 $ 1,179,542 $ 979,699
========== ========== =========
NOTE 13 EMPLOYEE BENEFITS:
The Company's two subsidiary banks each have separate retirement and
profit sharing plans which cover substantially all full time employees
at each bank. The Capon Valley Bank has a defined contribution pension
plan with 401(k) features that is funded with discretionary
contributions by the Bank. The bank matches on a limited basis the
contributions of the employees. Investment of employee balances is
done through the direction of each employee.
The Grant County Bank is a member of the West Virginia Bankers'
Association Retirement Plan. Benefits under the plan are based on
compensation and years of service with 100% vesting after seven years
of service. Prior to 2002, the Plan's assets were in excess of the
projected benefit obligations and thus the Bank was not required to
make contributions to the Plan in 2003, 2002 or 2001. It will be
required to make a contribution in 2004 due to the inability of the
investment portfolio in recent years to meet its expected return, The
Bank has recognized liabilities of $391,000 at December 31, 2003 as a
result of this shortfall. This has resulted in a decline in other
comprehensive income of $158,000 (which is net of an income tax effect
of $93,000) and an intangible asset of $140,000. The amounts of the
accrued liability and the net pension expense reflected in operations
are not significant. In addition, The Grant County Bank also maintains
a profit sharing plan covering substantially all employees to which
contributions are made at the discretion of the Board of Directors.
The Company has established an employee stock ownership plan which
provides stock ownership to all employees of the Company. The Plan
provides total vesting upon the attainment of seven years of service.
Contributions to the plan are made at the discretion of the Board of
Directors and are allocated based on the compensation of each employee
relative to total compensation paid by the Company. All shares held by
the Plan are considered outstanding in the computation of earnings per
share. Shares of Company stock, when distributed, will have
restrictions on transferability.
Employer contributions related to the above pension plans charged to
operations totaled $278,884 in 2003, $231,607 in 2002 and $234,455 in
2001.
46
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 14 TRANSACTIONS WITH RELATED PARTIES:
During the year, officers and directors (and companies controlled by
them) were customers of and had transactions with the subsidiary Banks
in the normal course of business. These transactions were made on
substantially the same terms as those prevailing for other customers
and did not involve any abnormal risk. The aggregate payoff amount of
loans to related parties of $2,948,917 at December 31, 2002 was
increased during 2003 by $670,068 as a result of new loans and reduced
$1,034,721 by payments. The balance of loans to related parties was
$2,584,264 at December 31, 2003.
NOTE 15 CONCENTRATIONS:
The Banks grant commercial, residential real estate and consumer loans
to customers located primarily in the eastern portion of the State of
West Virginia. Although the Banks have a diversified loan portfolio, a
substantial portion of the debtors' ability to honor their contracts
is dependent upon the agribusiness trucking and logging sectors.
Collateral required by the Banks is determined on an individual basis
depending on the purpose of the loan and the financial condition of
the borrower. The ultimate collectibility of the loan portfolios is
susceptible to changes in local economic conditions. Of the
$227,000,000 loans held by the Company, $162,000,000 are secured by
real estate.
The Banks had cash deposited in and federal funds sold to other
commercial banks totaling $24,772,476 and $24,166,439 at December 31,
2003 and 2002, respectively.
NOTE 16 COMMITMENTS AND GUARANTEES:
The Banks make commitments to extend credit in the normal course
of business and issue standby letters of credit to meet the financing
needs of their customers. The amount of the commitments represents the
Banks' exposure to credit loss that is not included in the balance
sheet. As of the balance sheet dates, the Banks had outstanding the
following commitments:
2003 2002
Commitments to extend credit $16,041,000 $12,029,000
Standby letters of credit 136,000 204,000
The Banks use the same credit policies in making commitments and
issuing letters of credit as it does for the loans reflected in the
balance sheet.
Commitments to extend credit are agreements to lend to a customer as
long as there is no violation of any condition established in the
contract. Commitments generally have fixed expiration dates or other
termination clauses and may require payment of a fee. Since many of
the commitments are expected to expire without being drawn upon, the
total commitment amounts do not necessarily represent future cash
requirements. The Banks evaluate each customer's creditworthiness on a
case-by-case basis. The amount of collateral obtained, if deemed
necessary by the Banks upon extension of credit, is based on
management's credit evaluation of the borrower. Collateral held varies
but may include accounts receivable, inventory, property, plant and
equipment.
47
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 17 DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS:
The fair value of the Company's assets and liabilities is influenced
heavily by market conditions. Fair value applies to both assets and
liabilities, either on or off the balance sheet. Fair value is defined
as the amount at which a financial instrument could be exchanged in a
current transaction between willing parties, other than in a forced or
liquidation sale.
The following methods and assumptions were used to estimate the fair
value of each class of financial instruments for which it is
practicable to estimate that value:
Cash, Due from Banks and Money Market Investments
The carrying amount of cash, due from bank balances, interest bearing
deposits and federal funds sold is a reasonable estimate of fair
value.
Securities
Fair values of securities are based on quoted market prices or dealer
quotes. If a quoted market price is not available, fair value is
estimated using quoted market prices for similar securities.
Loans
The fair value of loans is estimated by discounting the future cash
flows using the current rates at which similar loans would be made to
borrowers with similar credit ratings and for the same remaining
maturities, taking into consideration the credit risk in various loan
categories.
Deposits
The fair value of demand, interest checking, regular savings and money
market deposits is the amount payable on demand at the reporting date.
The fair value of fixed maturity certificates of deposit is estimated
using the rates currently offered for deposits of similar remaining
maturities.
Long Term Debt
The fair value of fixed rate loans is estimated using the rates
currently offered by the Federal Intermediate Credit Bank for
indebtedness with similar maturities.
Interest Payable and Receivable
The carrying value of amounts of interest receivable and payable is a
reasonable estimate of fair value.
Life Insurance
The carrying amount of life insurance contracts is assumed to be a
reasonable fair value. Life insurance contracts are carried on the
balance sheet at their redemption value as of December 31, 2003. This
redemption value is based on existing market conditions and therefore
represents the fair value of the contract.
Off-Balance-Sheet Items
The carrying amount and estimated fair value of off-balance-sheet
items were not material at December 31, 2003.
48
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 17 DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
(CONTINUED):
The carrying amount and estimated fair values of financial instruments
as of December 31 are as follows:
2003 2002
---- ----
Estimated Estimated
Carrying Fair Carrying Fair
Amount Value Amount Value
Financial Assets:
Cash and due from banks $ 7,213,641 $ 7,213,641 $ 8,226,301 $ 8,226,301
Interest bearing deposits 1,187,322 1,187,322 4,499,666 4,499,666
Federal funds sold 16,718,000 16,718,000 14,625,343 14,625,343
Securities held to maturity 1,365,618 1,436,821 1,369,112 1,451,553
Securities available for sale 32,630,627 32,630,627 23,496,039 23,496,039
Other investments 933,150 933,150 671,811 671,811
Loans, net 224,172,075 226,635,330 223,960,879 224,178,804
Interest receivable 1,718,298 1,718,298 1,821,476 1,821,476
Life insurance contracts 5,558,578 5,558,578 5,338,036 5,338,036
Financial Liabilities:
Demand and savings
deposits 105,033,892 105,033,892 99,220,685 99,220,685
Time deposits 157,651,455 169,037,413 158,291,586 159,022,847
Long term debt 5,294,892 5,495,346 4,029,582 4,117,444
Interest payable 604,682 604,682 849,472 849,472
NOTE 18 REGULATORY MATTERS:
The Company is subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum
capital requirements can initiate certain mandatory - and possibly
additional discretionary - actions by regulators that, if undertaken,
could have a direct material effect on the Company's financial
statements. Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Company must meet specific
capital guidelines that involve quantitative measures of the Company's
assets, liabilities, and certain off-balance-sheet items as calculated
under regulatory accounting practices. The Company's capital amounts
and classification are also subject to qualitative judgments by the
regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital
adequacy require the Company to maintain minimum amounts and ratios
(set forth in the table below) of total and Tier I capital (as defined
in the regulations) to risk-weighted assets (as defined), and of Tier
I capital (as defined) to average assets (as defined). The Company
meets all capital adequacy requirements to which it is subject and as
of the most recent examination, the Company was classified as well
capitalized.
To be categorized as well capitalized the Company must maintain
minimum total risk-based, Tier I risk-based, and Tier I leverage
ratios as set forth in the table. There are no conditions or events
that management believes have changed the Company's category from a
well capitalized status.
49
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 18 REGULATORY MATTERS (CONTINUED):
The Company's actual capital ratios are presented in the following
table:
Actual Regulatory Requirements
December Adequately Well
2003 2002 Capitalized Capitalized
Total risk-based ratio 14.55% 14.03% 8.00% 10.00%
Tier 1 risk-based ratio 13.40% 13.20% 4.00% 6.00%
Total assets leverage
ratio 9.42% 9.75% 4.00% 5.00%
Capital ratios and amounts are applicable both at the individual bank
level and on a consolidated basis. At December 31, 2003, both
subsidiary banks had capital levels in excess of minimum requirements.
In addition, Highlands Bankshares Trust Company and HBI Life Insurance
Company are subject to certain capital requirements. At present, both
companies are well within any capital limitations and no conditions or
events have occurred to change this capital status, nor does
management except any such occurrence in the foreseeable future.
NOTE 19 CHANGES IN OTHER COMPREHENSIVE INCOME
The components of change in other comprehensive income and related tax
effects are as follows:
Years Ended December 31,
2003 2002 2001
------ ------- -------
Beginning balance January 1 $ 220,021 $ 282,910 $ 38,761
Unrealized holding gains (losses)
on available-for-sale
securities, net of income
taxes of $(80,800), $5,143
and $143,388 in 2003,
2002, and 2001, respectively (158,392) 9,575 244,149
Accrued pension obligation
net of income taxes of
$50,188 in 2003 and
$42,558 in 2002 (85,438) (72,464)
---------- --------- ------
Net change for the year (243,830) (62,889) 244,149
Ending balance December 31 $ (23,809) $ 220,021 $ 282,910
=========== ======== =======
50
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 20 FOURTH QUARTER ADJUSTMENTS:
Within the fourth quarter of 2003, the Company had two charges to
operations that were material to the Company's operations in that
quarter. First, the Company recognized an expense for the entire year
for the post retirement benefits that are to be accrued under SFAS No.
106. The charge to operations was recognized when the Company decided
to continue existing agreements with employees and was able to
determine its liability under SFAS No. 106. Prior to September 30,
2003, the Company was awaiting financial information on the amount of
the liability and had not yet determined whether the agreements would
be continued. The amount of expense recognized for post retirement
benefits was $77,736 or $48,974 on an after tax basis.
Also in the fourth quarter, the Company charged to operations an
additional loan loss provision in order to recognize additional losses
identified in the loan portfolio. The provision was to cover potential
losses in the installment portfolio which has seen an increase in
delinquencies and credit losses due to a stagnant economy and other
individual credit problems. The fourth quarter provision of $825,000
($520,000 after income taxes) was about $500,000 ($315,000 after
income taxes) greater than the average of the previous three quarters
for 2003.
NOTE 21 PARENT CORPORATION ONLY FINANCIAL STATEMENTS:
BALANCE SHEETS
Assets December 31,
2003 2002
Cash $ 172,352 $ 122,102
Investment in subsidiaries 29,504,788 28,207,422
Income taxes receivable 508,183 251,826
Other assets 21,919 39,554
-------- ---------
Total Assets $30,207,242 $28,620,904
=========== ==========
Liabilities
Accrued expenses $ 120,728 $ 8,735
Due to subsidiaries 537,028 247,631
-------- --------
Total Liabilities $ 657,756 $ 256,366
--------- ---------
Stockholders' Equity
Common stock, par value $5 per share
3,000,000 shares authorized, 1,436,874
shares issued $7,184,370 $7,184,370
Surplus 1,661,987 1,661,987
Retained earnings 20,726,938 19,298,159
Other accumulated comprehensive
income (loss) (23,809) 220,022
----------- ---------
Total Stockholders' Equity $29,549,486 $28,364,538
----------- ----------
Total Liabilities and Stockholders'
Equity $30,207,242 $28,620,904
========= ==========
51
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 21 PARENT CORPORATION ONLY FINANCIAL STATEMENTS (CONTINUED):
STATEMENTS OF INCOME AND RETAINED EARNINGS
Years Ended December 31,
2003 2002 2001
---- ---- ----
Income
Dividends from subsidiaries $ 904,649 $ 2,137,042 $ 3,063,877
Other income 29 480
-------- --------- --------
Total $ 904,678 $ 2,137,522 $ 3,063,877
----------- --------- ---------
Expenses
Salary and benefits expense $ 144,513 $ 190,239 $ 169,325
Professional fees 38,978 36,330 34,413
Directors' fees 55,410 43,051 40,550
Other expenses 88,776 70,296 70,120
---------- -------- --------
Total $ 327,677 $ 339,916 $ 314,408
------------ -------- ---------
Net income before income
tax benefit
and undistributed
subsidiary net
income (deficit) $ 577,001 $ 1,797,606 $ 2,749,469
Income tax benefit 115,280 132,536 112,779
----------- --------- ---------
Income before undistributed
subsidiary net income
((deficit) 692,281 1,930,142 2,862,248
Undistributed subsidiary net
income (deficit) 1,541,051 591,431 (520,677)
----------- -------- ---------
Net Income $ 2,233,332 $2,521,573 $ 2,341,571
========== ========= ==========
Retained earnings,
Beginning of period 19,298,159 24,174,728 22,515,738
Dividends paid in cash (804,553) (737,836) (682,581)
Stock split paid in stock (4,789,580)
Treasury stock retired (1,870,726)
Net Income 2,233,332 2,521,573 2,341,571
---------- ---------- ----------
Retained Earnings,
End of Period $ 20,726,938 $ 19,298,159 $24,174,728
=========== =========== ==========
52
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
HIGHLANDS BANKSHARES, INC.
NOTE 21 PARENT CORPORATION ONLY FINANCIAL STATEMENTS (CONTINUED):
STATEMENTS OF CASH FLOWS
Years Ended December 31,
2003 2002 2001
----- ------ -----
Cash Flows from Operating Activities:
Net income $2,233,332 $2,521,573 $2,341,571
Adjustments
Undistributed subsidiary income
(deficit) (1,540,929) (591,431) 520,677
Depreciation 1,952 1,609 397
Loss on investment 15,304
Increase (decrease) in payables 111,993 85,448 (35,584)
(Increase) decrease in
receivables (256,357) (122,482) 67,486
Decrease (increase) in other
assets 15,415 (14,197) (4,411)
-------- --------- --------
Net Cash Provided by Operating
Activities 565,406 1,895,824 2,890,136
--------- --------- ---------
Cash Flows from Investing Activities:
Advances from (payments to)
subsidiaries 289,397 79,028 (37,899)
Investment in subsidiaries (2,143,577)
Other investments (5,000)
-------- -------- --------
Net Cash Provided by (Used in)
Investing Activities 289,397 79,028 (2,186,476)
Cash Flows from Financing
Activities:
Purchase of treasury stock (1,217,055)
Dividends paid (804,553) (737,836) (682,581)
----------- --------- --------
Net Cash Used in Financing
Activities (804,553) (1,954,891) (682,581)
----------- ----------- --------
Net Increase in Cash 50,250 19,961 21,079
Cash, Beginning of Year 122,102 102,141 81,062
--------- -------- --------
Cash, End of Year $ 172,352 $ 122,102 $ 102,141
======== ======== ========
53
INDEPENDENT AUDITORS' REPORT
The Stockholders and Board of Directors
Highlands Bankshares, Inc.
Petersburg, West Virginia
We have audited the accompanying consolidated balance sheets of Highlands
Bankshares, Inc. and subsidiaries as of December 31, 2003 and 2002, and the
related consolidated statements of income, changes in stockholders' equity and
cash flows for the three years ended December 31, 2003. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Highlands
Bankshares, Inc. and subsidiaries as of December 31, 2003 and 2002, and the
results of their operations and their cash flows for the three years ended
December 31, 2003, in conformity with accounting principles generally accepted
in the United States of America.
As described in Note 3 to the financial statements, the Company determined that
an error existed in the 2002 and 2001 financial statements due to the lack of an
accrual of post retirement benefits. The correction has been accounted for as a
prior period adjustment and is described more fully in Note 3.
/s/ S. B. Hoover & Company, L.L.P.
February 16, 2004
Harrisonburg, Virginia
54
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
None
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
As a result of the enactment of the Sarbanes-Oxley Act of 2002, issuers
such as Highlands Bankshares, Inc. that file periodic reports under the
Securities Exchange Act of 1934 (the "Act") are now required to include in those
reports certain information concerning the issuer's controls and procedures for
complying with the disclosure requirements of the federal securities laws. These
disclosure controls and procedures include, without limitation, controls and
procedures designed to ensure that information required to be disclosed by an
issuer in the reports it files or submits under the Act, is communicated to the
issuer's management, including its principal executive officer or officers and
principal financial officer or officers, or persons performing similar
functions, as appropriate to allow timely decisions regarding required
disclosure.
We have established our disclosure controls and procedures to ensure that
material information related to Highlands Bankshares, Inc. is made known to our
principal executive officers and principal finance officer on a regular basis,
in particular during the periods in which our quarterly and annual reports are
being prepared. These disclosure controls and procedures consist principally of
communications between and among the Chief Executive Officer and Chief Financial
Officer, and the other executive officers of Highlands Bankshares, Inc. and its
subsidiaries to identify any new transactions, events, trends, contingencies or
other matters that may be material to the Company's operations. As required, we
will evaluate the effectiveness of these disclosure controls and procedures on a
quarterly basis, and most recently did so as of the end of the period covered by
this report.
The Company's chief executive officer and chief financial officer, based on
their evaluation as of the end of the period covered by this Annual Report of
the Company's disclosure controls and procedures (as defined in Rule 13(a)-14(e)
of the Securities Exchange Act of 1934), have concluded that the Company's
disclosure controls and procedures are adequate and effective for purposes of
Rule 13(a)-14(c) and timely, alerting them to financial information relating to
the Company required to be included in the Company's filings with the Securities
and Exchange Commission under the Securities Exchange Act of 1934.
Changes in Internal Controls
During the period reported upon, there were no significant changes in the
internal controls of Highlands Bankshares, Inc. pertaining to its financial
reporting and control of its assets or in other factors that could significantly
affect these controls.
Due to the nature of the Company's business as stewards of assets of
customers, internal controls are of the utmost importance. The company has
established procedures undertaken during the normal course of business to
reasonably ensure that fraudulent activity of either an amount material to these
results or in any amount is not occurring. In addition to these controls and
review by executive officers, the Company retains the services of Yount, Hyde &
Barbour, P.C., a public accounting firm, to complete regular internal audits to
examine the processes and procedures of the Company and its subsidiary banks to
ensure that these processes are both reasonably effective to prevent fraud, both
internal and external, and that these processes comply with relevant regulatory
guidelines of all relevant banking authorities. The findings of Yount, Hyde &
Barbour are presented both to Management of the subsidiary banks and to the
Audit Committee.
Part III
Item 10. Directors, Executive Officers, Promoters and Control Persons;
Compliance with Section 16(a) of the Exchange Act
Information required by this item is set forth under the caption
"INFORMATION CONCERNING DIRECTORS AND NOMINEES" under the caption "Compliance
with Section 16(a) of the Securities Exchange Act" of our 2004 Proxy Statement
and is incorporated herein by reference.
Highlands has adopted a Code of Ethics that applies to all employees,
including Highlands' chief executive officer and chief financial officer and
other senior officers. The Code of Ethics is attached to this document as
Exhibit 14. If we make any substantive amendments to this Code or grant any
waiver from a provision of the code to our chief executive officer or chief
financial officer, we will disclose the amendment or waiver in a report on Form
8-K.
55
Item 11. Executive Compensation
Information required by this item is set forth under the caption "EXECUTIVE
COMPENSATION" of our 2004 Proxy Statement and is incorporated herein by
reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Information required by this item is set forth under the caption "SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT" of our 2004 Proxy
Statement and is incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions
Information required by this item is set forth under the caption "Certain
Related Transactions" of our 2004 Proxy Statement and is incorporated herein by
reference.
Most of the directors, partnerships of which they may be general partners
and corporations of which they are officers or directors, maintain normal
banking relationships with the Bank. Loans made by the Bank to such persons or
other entities were made only in the ordinary course of business, were made on
substantially the same terms, including interest rates and collateral, as those
prevailing at the time for comparable transactions with other persons, and did
not involve more than normal risk of collectibility or present other unfavorable
features. See Note 14 of the consolidated financial statements.
John VanMeter is a partner with the law firm of VanMeter and VanMeter,
which has been retained by the Company as legal counsel and it is anticipated
that the relationship will continue. Jack H. Walters is a partner with the law
firm of Walters, Krauskopf & Baker, which provides legal counsel to the Company
and it is anticipated that the relationship will continue.
Item 14. Fees of Independent Public Accountants
Information required by this item is set forth under the caption "FEES OF
INDEPENDENT PUBLIC ACCOUNTANTS" of our 2004 Proxy Statement and is incorporated
herein by reference.
Part IV
Item 15. Exhibits and Reports on Form 8-K
a) Exhibits
Exhibit No. Description
2 Not applicable
3 (1) Articles of Incorporation of Highlands Bankshares,
Inc. are incorporated by reference to Appendix C to
Highlands Bankshares, Inc.'s Form S-4 filed October
20, 1986.
Amendments to the original Articles of Incorporation
are incorporated by reference; filed as Exhibit 3(i)
with 1997 10-KSB.
3 (2) Bylaws of Highlands Bankshares, Inc. are
incorporated by reference to Appendix D to Highland
Bankshares, Inc.'s Form S-4 filed October 20, 1986.
Amended Bylaws of Highlands Bankshares, Inc. are
incorporated by reference to Exhibit 3(ii) to
Highland Bankshares, Inc.'s Form 10-Q filed May 15,
2003.
56
Item 15. Exhibits and Reports on Form 8-K (Continued)
a) Exhibits (Continued)
Exhibit No. Description
14 Code of Ethics
21.0 Subsidiary Listing of the Registrant
31.1 Certification of Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer pursuant to
Section
302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer and Chief
Financial Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
b) Reports on Form 8-K
No reports on Form 8-K were filed in the fourth quarter of 2003.
57
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
HIGHLANDS BANKSHARES, INC.
By /s/ C. E. PORTER
--------------------------
C. E. Porter
President, Chief Executive Officer
Date March 29, 2004
-------------------------
By /s/ R. ALAN MILLER
--------------------------
R. Alan Miller
Finance Officer
Date March 29, 2004
-------------------------
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and as of the date indicated.
Signature Title Date
Leslie A. Barr President March 30, 2004
& Chief Executive Officer ---------------
Director
Alan L. Brill Secretary March 30, 2004
--------------
Kathy G. Kimble Director March 30, 2004
-------------
Steven C. Judy Director March 29, 2004
-------------
Thomas B. McNeil, Sr. Director
-------------
Clarence E. Porter Treasurer March 29, 2004
-------------
Courtney R. Tusing Director
-------------
John G. VanMeter Chairman of the Board March 30, 2004
Director -------------
Jack H. Walters Director March 30, 2004
-------------
L. Keith Wolfe Director March 30, 2004
-------------