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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, 2004Commission 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. [X]
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 1,319,777 shares of Common Stock of the
registrant issued and outstanding held by nonaffiliates on June 30, 2004 was
approximately $ 34,657,344 based on the closing sales price of $ 26.26 per share
on June 30, 2004. For purposes of this calculation, the term "affiliate" refers
to all directors and executive officers of the registrant.
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date: As of March 21, 2005 -
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 2005 Annual Meeting of
Shareholders (the "Proxy Statement") are incorporated by reference in Part III ,
Items 10,11,12,13 and 14 of this Annual Report of Form 10-K (the "Form 10-K").
2
FORM 10-K INDEX
Part I
Item 1. Business 3
Item 2. Properties 8
Item 3. Legal Proceedings 8
Item 4. Submission of Matters to a Vote of Security Holders 8
Part II
Item 5. Market for Registrant's Common Equity,
Related Stockholder Matters and Issuer Repurchases
of Securities 8
Item 6. Selected Financial Data 9
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operation 10
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 31
Item 8. Financial Statements and Supplementary Data 33
Item 9. Changes in and Disagreement with Accountants on
Accounting and Financial Disclosure 57
Item 9A. Controls and Procedures 57
Item 9B. Other Information 57
Part III
Item 10. Directors and Executive Officers of Registrant 57
Item 11. Executive Compensation 57
Item 12. Security Ownership of Certain Beneficial Owners and
Management And Related Stockholder Matters 58
Item 13. Certain Relationships and Related Transactions 58
Item 14. Principal Accountant's Fees and Services 58
Part IV
Item 15. Exhibits and Financial Statement Schedules 59
Signatures 60
3
Part I
Item 1. Business
General
Highlands Bankshares, Inc. (hereinafter referred to as "Highlands," or the
"Company"), incorporated under the laws of West Virginia in 1985, is a
multi-bank holding company subject to the provisions of the Bank Holding Company
Act of 1956, as amended, and owns 100% of the outstanding stock of its
subsidiary banks, The Grant County Bank and Capon Valley Bank (hereinafter
referred to as the "Banks"), and its life insurance subsidiary, HBI Life
Insurance Company (hereinafter referred to as "HBI Life").
The Grant County Bank was chartered on August 6, 1902, and Capon Valley
Bank was chartered on July 1, 1918. Both are state banks chartered under the
laws of the State of West Virginia. HBI Life was chartered in April 1988 under
the laws of the State of Arizona.
Services Offered by the Banks
The Banks offer all services normally offered by a full service commercial
bank, including commercial and individual demand and time deposit accounts,
commercial and individual loans, drive-in banking services and automated teller
machines. No material portion of the banks' deposits have been obtained from a
single or small group of customers and the loss of the deposits of any one
customer or of a small group of customers would not have a material adverse
effect on the business of the banks. Credit life and accident and health
insurance are sold to customers of the subsidiary banks through HBI Life.
Employees
As of December 31, 2004, The Grant County Bank had 61 full time equivalent
employees, Capon Valley Bank had 48 full time equivalent employees and Highlands
had one full time equipment 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.
4
Regulation and Supervision
Overview: The Company, as a registered bank holding company, and its
subsidiary banks, as insured depository institutions, operate in a highly
regulated environment and are regularly examined by federal and state
regulators. The following description briefly discusses certain provisions of
federal and state laws and regulations and the potential impact of such
provisions to which the Company and subsidiary are subject. These federal and
state laws and regulations are designed to reduce potential loss exposure to the
depositors of such depository institutions and to the Federal Deposit Insurance
Corporation's insurance fund and are not intended to protect the Company's
security holders. Proposals to change the laws and regulations governing the
banking industry are frequently raised in Congress, in state legislatures, and
before the various bank regulatory agencies. The likelihood and timing of any
changes and the impact such changes might have on the Company are impossible to
determine with any certainty. A change in applicable laws or regulations, or a
change in the way such laws or regulations are interpreted by regulatory
agencies or courts, may have a material impact on the business, operations and
earnings of the Company. To the extent that the following information describes
statutory or regulatory provisions, it is qualified entirely by reference to the
particular statutory or regulatory provision.
As a bank holding company registered under the Bank Holding Company Act of
1956, as amended (the "BHCA"), the Company is subject to regulation by the
Federal Reserve Board. Federal banking laws require a bank holding company to
serve as a source of financial strength to its subsidiary depository
institutions and to commit resources to support such institutions in
circumstances where it might not do so otherwise. Additionally, the Federal
Reserve Board has jurisdiction under the BHCA to approve any bank or nonbank
acquisition, merger or consolidation proposed by a bank holding company. The
BHCA generally limits the activities of a bank holding company and its
subsidiaries to that of banking, managing or controlling banks as to be a proper
incident thereto. The BHCA also prohibits a bank holding company, with certain
exceptions, from acquiring more than 5% of the voting shares of any company and
from engaging in any business other than banking or managing or controlling
banks. The Federal Reserve Board has by regulation determined that certain
activities are closely related to banking within the meaning of the BHCA. These
activities include: operating a mortgage company, finance company, credit card
company or factoring company; performing certain data processing operations;
providing investment and financial advice; and acting as an insurance agent for
certain types of credit-related insurance.
The Gramm-Leach-Bliley Act ("Gramm-Leach") became law in November 1999.
Gramm-Leach established a comprehensive framework to permit affiliations among
commercial banks, investment banks, insurance companies, securities firms, and
other financial service providers. Gramm-Leach permits qualifying bank holding
companies to register with the Federal Reserve Board as "financial holding
companies" and allows such companies to engage in a significantly broader range
of financial activities than were historically permissible for bank holding
companies. Although the Federal Reserve Board provides the principal regulatory
supervision of financial services permitted under Gramm-Leach, the Securities
and Exchange Commission and state regulators also provide substantial
supervisory oversight. In addition to broadening the range of financial services
a bank holding company may provide, Gramm-Leach also addressed customer privacy
and information sharing issues and set forth certain customer disclosure
requirements. The Company has no current plans to petition the Federal Reserve
Board for consideration as a financial holding company.
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
("Riegle-Neal") permits bank holding companies to acquire banks located in any
state. Riegle-Neal also allows national banks and state banks with different
home states to merge across state lines and allows branch banking across state
lines, unless specifically prohibited by state laws.
5
Regulation and Supervision (continued)
The International Money Laundering Abatement and Anti-Terrorist Financing
Act of 2001 (USA "Patriot Act") was adopted in response to the September 11,
2001 terrorist attacks. The Patriot Act provides law enforcement with greater
powers to investigate terrorism and prevent future terrorist acts. Among the
broad-reaching provisions contained in the Patriot Act are several designed to
deter terrorists' ability to launder money in the United States and provide law
enforcement with additional powers to investigate how terrorists and terrorist
organizations are financed. The Patriot Act creates additional requirements for
banks, which were already subject to similar regulations. The Patriot Act
authorizes the Secretary of Treasury to require financial institutions to take
certain "special measures" when the Secretary suspects that certain transactions
or accounts are related to money laundering. These special measures may be
ordered when the Secretary suspects that a jurisdiction outside of the United
States, a financial institution operating outside of the United States, a class
of transactions involving a jurisdiction outside of the United States or certain
types of accounts are of "primary money laundering concern." The special
measures include the following: (a) require financial institutions to keep
records and report on transactions or accounts at issue; (b) require financial
institutions to obtain and retain information related to the beneficial
ownership of any account opened or maintained by foreign persons; (c) require
financial institutions to identify each customer who is permitted to use the
account; and (d) prohibit or impose conditions on the opening or maintaining of
correspondence or payable-through accounts. Failure of a financial institution
to maintain and implement adequate programs to combat money laundering and
terrorist financing, or to comply with all of the relevant laws or regulations,
could have serious legal and reputational consequences for the institution.
The operations of the insurance subsidiary are subject to the oversight and
review of State of Arizona Department of Insurance.
Capital Adequacy: Federal banking regulations set forth capital adequacy
guidelines, which are used by regulatory authorities to assess the adequacy of
capital in examining and supervising a bank holding company and its insured
depository institutions. The capital adequacy guidelines generally require bank
holding companies to maintain total capital equal to at least 8% of total
risk-adjusted assets, with at least one-half of total capital consisting of core
capital (i.e., Tier I capital) and the remaining amount consisting of "other"
capital-eligible items (i.e., Tier II capital), such as perpetual preferred
stock, certain subordinated debt, and, subject to limitations, the allowance for
loan losses. Tier I capital generally includes common stockholders' equity plus,
within certain limitations, perpetual preferred stock and trust preferred
securities. For purposes of computing risk-based capital ratios, bank holding
companies must meet specific capital guidelines that involve quantitative
measures of assets, liabilities and certain off-balance sheet items, calculated
under regulatory accounting practices. The Company's and its subsidiaries'
capital accounts and classifications are also subject to qualitative judgments
by the regulators about components, risk weightings, and other factors.
In addition to total and Tier I capital requirements, regulatory
authorities also require bank holding companies and insured depository
institutions to maintain a minimum leverage capital ratio of 3%. The leverage
ratio is determined as the ratio of Tier I capital to total average assets,
where average assets exclude goodwill, other intangibles, and other specifically
excluded assets. Regulatory authorities have stated that minimum capital ratios
are adequate for those institutions that are operationally and financially
sound, experiencing solid earnings, have high levels of asset quality and are
not experiencing significant growth. The guidelines also provide that banking
organizations experiencing internal growth or making acquisitions will be
expected to maintain strong capital positions substantially above the minimum
supervisory levels. In those instances where these criteria are not evident,
regulatory authorities expect, and may require, bank holding companies and
insured depository institutions to maintain higher than minimum capital levels.
6
Regulation and Supervision (continued)
Additionally, federal banking laws require regulatory authorities to take
"prompt corrective action" with respect to depository institutions that do not
satisfy minimum capital requirements. The extent of these powers depends upon
whether the institutions in question are "well capitalized", "adequately
capitalized", "undercapitalized", "significantly undercapitalized" or
"critically undercapitalized", as such terms are defined under uniform
regulations defining such capital levels issued by each of the federal banking
agencies. As an example, a depository institution that is not well capitalized
is generally prohibited from accepting brokered deposits and offering interest
rates on deposits higher than the prevailing rate in its market. Additionally, a
depository institution is generally prohibited from making any capital
distribution (including payment of a dividend) or paying any management fee to
its holding company, may be subject to asset growth limitations and may be
required to submit capital restoration plans if the depository institution is
considered undercapitalized. The Company's and its subsidiaries' regulatory
capital ratios are presented in the following table:
December 31, 2004 December 31, 2003
Actual Regulatory Actual Regulatory
Ratio Minimum Ratio Minimum
Total Risk Based Capital Ratio
Highlands Bankshares 14.71% 8.00% 14.55% 8.00%
Capon Valley Bank 12.82% 8.00% 11.93% 8.00%
The Grant County Bank 15.68% 8.00% 13.89% 8.00%
Tier 1 Leverage Ratio
Highlands Bankshares 10.14% 3.00% 9.42% 3.00%
Capon Valley Bank 8.57% 3.00% 7.31% 3.00%
The Grant County Bank 11.01% 3.00% 9.05% 3.00%
Tier 1 Risk Based Capital Ratio
Highlands Bankshares 13.58% 4.00% 13.40% 4.00%
Capon Valley Bank 11.57% 4.00% 10.68% 4.00%
The Grant County Bank 14.64% 4.00% 12.81% 4.00%
Dividends and Other Payments: The Company is a legal entity separate and
distinct from its subsidiaries. Dividends from Grant County Bank and Capon
Valley Bank are essentially the sole source of cash for the Company. The right
of the Company, and shareholders of the Company, to participate in any
distribution of the assets or earnings of Grant County Bank and Capon Valley
Bank through the payment of such dividends or otherwise is necessarily subject
to the prior claims of creditors of Grant County Bank and Capon Valley Bank,
except to the extent that claims of the Company in its capacity as a creditor
may be recognized. Moreover, there are various legal limitations applicable to
the payment of dividends to the Company as well as the payment of dividends by
the Company to its shareholders. Under federal law, Grant County Bank and Capon
Valley Bank may not, subject to certain limited expectations, make loans or
extensions of credit to, or invest in the securities of, or take securities of
the Company as collateral for loans to any borrower. Grant County Bank and Capon
Valley Bank are also subject to collateral security requirements for any loans
or extensions of credit permitted by such exceptions.
7
Regulation and Supervision (continued)
Grant County Bank and Capon Valley Bank are subject to various statutory
restrictions on its ability to pay dividends to the Company. Specifically, the
approval of the appropriate regulatory authorities are required prior to the
payment of dividends by Grant County Bank and Capon Valley Bank in excess of its
earnings retained in the current year plus retained net profits for the
preceding two years. The payment of dividends by the Company and Grant County
Bank and Capon Valley Bank may also be limited by other factors, such as
requirements to maintain adequate capital above regulatory guidelines. The OCC
has the authority to prohibit any bank under its jurisdiction from engaging in
an unsafe and unsound practice in conducting its business. Depending upon the
financial condition of Grant County Bank and Capon Valley Bank, the payment of
dividends could be deemed to constitute such an unsafe or unsound practice. The
Federal Reserve Board and the OCC have indicated their view that it generally
would be an unsafe and unsound practice to pay dividends except out of current
operating earnings. The Federal Reserve Board has stated that, as a matter of
prudent banking, a bank or bank holding company should not maintain its existing
rate of cash dividends on common stock unless (1) the organization's net income
available to common shareholders over the past year has been sufficient to fund
fully the dividends and (2) the prospective rate or earnings retention appears
consistent with the organization's capital needs, asset quality, and overall
financial condition. Moreover, the Federal Reserve Board has indicated that bank
holding companies should serve as a source of managerial and financial strength
to their subsidiary banks. Accordingly, the Federal Reserve Board has stated
that a bank holding company should not maintain a level of cash dividends to its
shareholders that places undue pressure on the capital of bank subsidiaries, or
that can be funded only through additional borrowings or other arrangements that
may undermine the bank holding company's ability to serve as a source of
strength.
A summary of the available dividends for each subsidiary bank can be found
on page 28 under the heading of Liquidity.
Governmental Policies: The Federal Reserve Board regulates money and credit
and interest rates in order to influence general economic conditions. These
policies have a significant influence on overall growth and distribution of bank
loans, investments and deposits and affect interest rates charged on loans or
paid for time and savings deposits. Federal Reserve monetary policies have had a
significant effect on the operating results of commercial banks in the past and
are expected to continue to do so in the future.
Various other legislation, including proposals to overhaul the banking
regulatory system and to limit the investments that a depository institution may
make with insured funds, are from time to time introduced in Congress. The
Company cannot determine the ultimate effect that such potential legislation, if
enacted, would have upon its financial condition or operations.
Available Information: The Company files annual, quarterly and current
reports, proxy statements and other information with the SEC. The Company's SEC
filings are filed electronically and are available to the public through the
Internet at the SEC's website at www.sec.gov. In addition, any document filed by
the Company with the SEC can be read and copies at the SEC's public reference
facilities at 450 Fifth Street, N.W., Washington, DC 20549. Copies of documents
can be obtained at prescribed rates by writing to the Public Reference Section
of the SEC at 450 Fifth Street, N.W., Washington, D.C. 20549. The public may
obtain information on the operation of the Public Reference Room by calling the
SEC at 1-800-SEC-0330. Copies of documents can also be obtained free of charge
by writing to Alan Miller at Highlands Bankshares, Inc., P.O. Box 9029,
Petersburg, West Virginia 26847.
8
Item 2. Properties
The Grant County Bank's main office is located on Main Street in
Petersburg, West Virginia. The Bank also has branch facilities 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 are owned by the Bank.
Item 3. Legal Proceedings
Management is not aware of any material pending or threatened litigation in
which Highlands or its subsidiaries may be involved as a defendant. In the
normal course of business, the banks periodically must initiate suits against
borrowers as a final course of action in collecting past due loans.
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 ended December 31, 2004.
Part II
Item 5. Market for Registrant's Common Equity, Related Stockholder
Matters and Issuer Repurchases
The Company had approximately 860 registered stockholders of record as of
January 31, 2005 This amount includes all shareholders, whether titled
individually or held by a brokerage firm or custodian in street name. The
Company's stock is not traded on any national or regional stock exchange
although brokers may occasionally initiate or be a participant in a trade. The
Company's stock is listed on the NASDAQ Over The Counter Bulletin Board. Terms
of an exchange between individual parties may not be known to the Company. The
following outlines the dividends paid and market prices of the Company's stock
based on prices disclosed to management. Prices have been provided using a
nationally recognized online stock quote system. Such prices may not include
retail mark-ups, mark-downs or commissions.
Dividends Market Price Range
Per Share High Low
2004
First Quarter .15 29.00 27.15
Second Quarter .15 28.49 26.45
Third Quarter .15 26.45 24.50
Fourth Quarter .18 26.00 24.15
2003
First Quarter .14 26.50 21.60
Second Quarter .14 26.25 25.50
Third Quarter .14 31.00 26.05
Fourth Quarter .14 31.00 29.00
9
Item 6. Selected Financial Data
Years Ending December 31,
(In Thousands Except for Share Amounts)
2004 2003 2002 2001 2000
Total Interest Income $17,729 $ 18,283 $18,970 $ 20,207 $18,207
Total Interest Expense 4,711 6,338 7,705 10,049 8,790
------ ------- ------ ------- ------
Net Interest Income 13,018 11,945 11,265 10,158 9,417
Provision for Loan Losses 920 1,820 820 600 500
------ ------- ------ ------- ------
Net Interest Income after
Provision for Loan
Losses 12,098 10,125 10,445 9,558 8,917
Other Income 1,597 1,367 1,304 1,194 1,263
Other Expenses 8,938 8,247 8,048 7,431 6,836
------ ------- ------ ------- ------
Income before Income Taxes 4,757 3,245 3,701 3,321 3,344
Income Tax Expense 1,551 1,012 1,179 979 1,092
------ ------- ------ ------- ------
Net Income $ 3,206 $ 2,233 $ 2,522 $ 2,342 $ 2,252
====== ======= ====== ======= ======
Net Income Per Share* $ 2.23 $ 1.55 $ 1.73 $ 1.56 $ 1.50
Dividends Per Share* $ .63 $ .56 $ .51 $ .45 $ .41
Total Assets at Year End $299,992 $301,168 $296,672 $277,042 $248,782
======== ======= ======= ======= =======
Return on Average Assets 1.07% .73% .89% .89% .97%
Return on Average Equity 10.36% 7.60% 8.87% 8.57% 8.89%
Dividend Payout Ratio 28.23% 36.03% 29.26% 29.15% 27.64%
Year End Equity to Assets
Ratio 10.55% 9.81% 9.69% 10.06% 10.43%
*--Prior years' per share figures restated to reflect stock split effected in
form of dividend in 2002.
10
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.
11
Critical Accounting Policies (continued)
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.
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.
Forward Looking Statements
Certain statements in this report may constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. Forward-looking statements are statements that include projections,
predictions, expectations or beliefs about future events or results or otherwise
are not statements of historical fact. Such statements are often characterized
by the use of qualified words (and their derivatives) such as "expect,"
"believe," "estimate," "plan," "project," or other future events. Although the
Company believes that its expectations with respect to certain forward-looking
statements are based upon reasonable assumptions within the bounds of its
existing knowledge of its business and operations, there can be no assurance
that actual results, performance or achievements of the Company will not differ
materially from any future results, performance or achievements expressed or
implied by such forward-looking statements. Actual future results and trends may
differ materially from historical results or those anticipated depending on a
variety of factors, including, but not limited to, the effects of and changes
in: general economic conditions, the interest rate environment, legislative and
regulatory requirements, competitive pressures, the effects of bankruptcy of two
large commercial customers, the effect of rising fuel costs on the trucking
industry and the economy as a whole, the transition involving the poultry
processing facility, assumptions made regarding determine of the allowance for
loan losses, new products and delivery systems, inflation, changes in the stock
and bond markets, technology, and consumer spending and savings habits. The
Company does not update any forward-looking statements that may be made from
time to time by or on behalf of the Company.
12
Overview of 2004 Results
Net income in 2004 increased $973,000, or 43.57%, over 2003 income. Net
income of $3,206,000 resulted in a Return on Average Assets (ROAA) of 1.07% for
2004 compared to .73% for 2003 and a Return on Average Equity (ROAE) of 10.36%
compared to 7.60% for 2003.
An increase in net interest income of $1,073,000 came about largely because
of decreases in interest expense. Total interest expense for 2004 fell
$1,627,000, or 25.67% compared to 2003. During the later portions of 2003 and
first half of 2004, the Company found itself in a favorable liquidity position
with excess Federal Funds sold. This favorable liquidity position allowed the
company to selectively lower deposit rates to levels equal to or below
competition. In addition, because of the low rates earned during 2004 on
short-term investments such as Fed Funds sold and certain types of securities,
the Company chose to fund loan growth through reductions in these alternative
investments in lieu of competitively bidding to maintain excess deposits or gain
new deposits.
Rising delinquencies during 2003 caused a comparatively large amount of net
charge-offs for 2003 and into 2004 and required a consequent provision for loan
losses in 2003 larger than historically needed. While remaining somewhat above
recent historically averages, net charge-offs for 2004 declined over the levels
seen in 2003 and decreasing balances of delinquent loans caused a reduced
provision for loan losses in 2004 compared to the provision taken in 2003. Asset
quality, as defined by the level of non-performing loans compared to gross loan
balances, has continued to improve as increased collection efforts and
charging-off of uncollectible loans have reduced balances of non-performing
loans.
During 2004, Highlands Bankshares Trust Company, a wholly owned subsidiary
of the Company providing trust and other fiduciary services, was discontinued.
The revenue growth from operations of this subsidiary had been less than
anticipated. The decline in other income as a result of the discontinuation of
Highlands Bankshares Trust Company was more than offset by an increase in
service charges. This increase in service charge revenues was primarily the
result of an increase instituted in February of the per transaction charge for
customer checks written with insufficient funds in the account to cover the
check.
The Company's loan growth had been relatively flat during 2004 prior to the
beginning of the fourth quarter . However, the last quarter of 2004 saw the
Company's loan balances begin to increase, as balances grew 2.48% (9.92%
annualized) from September 30, 2004 through year end. Although operating with
favorable liquidity in the early portions of 2004, as loan growth occurred in
the fourth quarter of 2004, the funding of new loans reduced the liquidity
position. At December 31, 2004, the Company's balances of Fed Funds sold and
cash deposits in other banks had been reduced by 73.99% over December 31, 2003
levels and balances of securities investments were $7,900,000 less at December
31, 2004 than one year earlier.
Operational expenses increased moderately due to inflationary trends in
salaries and general administrative costs. New equipment purchases and continued
expansion and upgrading of existing work systems caused equipment and operating
expense to increase. Legal and professional fees increased 17.53% as expanded
audit procedures were made necessary by the organization's growth and changes in
the regulatory environment.
13
QUARTERLY FINANCIAL RESULTS
(In thousands, except per share amounts)
Fourth Third Second First
Quarter Quarter Quarter Quarter
2004
Interest income $ 4,563 $ 4,436 $ 4,400 $ 4,330
Interest expense 1,161 1,142 1,161 1,248
------ ------ ------ ------
Net interest income 3,402 3,294 3,239 3,082
Provision for loan losses 320 195 210 195
------ ------ ------ ------
Net interest income
after provision 3,082 3,099 3,029 2,887
Non-interest income 402 451 410 334
Non-interest expense 2,303 2,242 2,229 2,164
------ ------ ------ ------
Income before income
tax provision 1,181 1,308 1,210 1,057
Income tax provision 361 432 413 345
------ ------ ------ ------
Net Income $ 820 $ 876 $ 797 $ 712
====== ====== ====== ======
Per common share:
Net income (basic) $ .57 $ .61 $ .55 $ .50
Cash dividends .18 .15 .15 .15
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 $ .39 $ .46
Cash dividends .14 .14 .14 .14
14
Net Interest Margin
2004 Compared to 2003
Net interest income increased 8.98% in 2004 as compared to 2003. The
repeated lowering of target interest rates by the Federal Reserve Board (the
"Fed") seen during the greater part of the last two years ceased during 2004 and
then reversed into an upward trend of the Fed raising target rates. In spite of
the increases in rates by the Fed during 2004, average rates earned on earning
assets and average rates paid on interest bearing liabilities generally
continued to decrease as the Company saw old balances of both assets an
liabilities mature and be re-written at lower rates.
The competitive atmosphere for both loans and deposits and the changing
interest rate environment combined with flat loan growth during the early
periods of 2004 created the need for achieving improved net interest margin
through closer asset/liability management. Because of the flat loan growth early
in the year and a favorable liquidity position, Management chose to keep deposit
rates at or below those of the competition and balances of time deposits and the
average rates paid on those deposits fell throughout 2004. As loan growth
increased later in the year, Management chose to continue with deposit rates at
or lower than the local competition and fund the loan growth through reductions
in balances of comparatively lower earning assets like Fed Funds Sold and
investment securities.
Income from interest earning assets decreased $575,000. Although average
rates within each asset class fell, average rates paid assets as a whole fell
only slightly as lower earning assets (Fed Funds sold, deposits in other banks)
were replaced by relatively higher earning loan balances. Average balances of
earning assets decreased $8,652,000. The decline in average rates on earning
assets and average balances of earning assets were more than offset by declines
in both average rates paid on deposits and on average balances of deposits.
Interest expense decreased $1,627,000 due to a decrease in average interest
bearing liabilities of 4.30% and a 60 basis point decline in average rates.
Because of the restricted availability of deposits to the subsidiary banks
caused by the Company's rural location and because of high levels of
competition, the Company, in order to fund loan growth, has historically been
forced to pay rates on time deposits often at rates above most regional and
national banks. During 2004, slowing loan growth reduced the need for deposit
balances and the Company was able to pay rates on deposits, especially time
deposits, which more closely approximated, and were often below, those rates
paid by regional and national banks. Because of this reduction in rates and as
older deposits at higher rates matured and were re-written at lower rates
created by the depressed rate environment, interest expense on deposits
decreased. Because of the favorable liquidity position by the bank throughout
most of 2004, the subsidiary banks continued to pay rates on time deposits lower
than those of much of the local competition, and many customers, as time
deposits matured, chose to move balances to other financial institutions,
resulting in a lower average balance of time deposits for 2004 as compared to
2003.
Customers appeared during the year to be reluctant to place money into time
deposits. It appears that expectation of rising rates in the near future has
made depositors reluctant to commit to longer term time deposits and that many
of the monies previously deposited into CD products have been moved to the
interest bearing transaction accounts, further improving interest expense.
Average balances of transaction based interest bearing accounts (Money Market
and Savings accounts) increased from 2003 to 2004 while average balances of time
deposits decreased 11.15%.
Toward the later parts of 2004, as the Fed continued to raise the target
Fed Funds rate, and as competition for deposits in the banks' local markets
increased, the Company chose to fund new loan growth through funds borrowed from
the Federal Home Loan Bank (FHLB). The rates and terms available on these funds
were comparatively more attractive than offering above market rates on deposits.
As a result, balances of funds borrowed from the FHLB at December 31, 2004 were
nearly double the levels at December 31, 2003.
15
Net Interest Margin (continued)
2003 Compared to 2002
Although reductions in target rates by the Federal Reserve Board (the
"Fed") were less frequent during 2003 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.
Strong loan demand experienced in 2001 and 2002 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.
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 made efforts 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.
16
Net Interest Margin (continued)
A summary of the Company's net interest margin and average balance sheet
for the years ended December 31, 2004, 2003 and 2002 is illustrated below (in
thousands of dollars):
NET INTEREST MARGIN AND AVERAGE BALANCE ANALYSIS
2004 2003 2002
Income/ Yield/ Income/ Yield/ Income/ Yield/
Average 2 Expense Rate Average 2 Expense Rate Average 2 Expense Rate
Earning Assets
- --------------
Loans $ 235,023 $ 16,752 7.13 $ 226,281 $ 16,966 7.50 $ 216,408 $ 17,324 8.01
Investment Securities
Taxable 25,944 674 2.60 28,107 885 3.15 25,247 1,165 4.61
Nontaxable 3,298 194 5.89 3,748 254 6.78 5,451 318 5.83
Interest Bearing
Deposits 1,430 18 1.26 5,342 53 .99 4,271 104 2.44
Federal Funds Sold 14,119 163 1.15 20,632 218 1.06 11,431 177 1.55
-------- -------- ---- -------- -------- ---- -------- -------- ----
Total Earning Assets 279,814 17,801 6.36 284,110 18,376 6.47 262,808 19,088 7.26
-------- -------- ---- -------- -------- ---- -------- ------- ----
Non Earning Assets
Allowance for Loan
Losses (2,418) (2,163) (1,793)
Non Earning Assets 27,380 23,343 21,840
-------- -------- --------
Total Assets $ 300,420 $ 305,290 $ 282,855
======== ======== ========
Interest Bearing Liabilities
Demand Deposits $ 24,031 $ 95 .40 $ 21,434 $ 134 .63 $ 19,910 $ 225 1.31
Savings Deposits 52,079 296 .57 48,128 381 .79 43,868 651 1.48
Time Deposits 145,834 4,042 2.77 164,126 5,585 3.40 151,813 6,619 4.36
Other Borrowed
Money 6,264 278 4.44 4,780 238 4.98 4,280 210 4.91
-------- ------ ---- -------- -------- ---- -------- ------- ----
Total Interest Bearing
Liabilities 228,208 4,711 2.06 238,468 6,338 2.66 219,871 7,705 3.50
-------- ------ ---- -------- -------- ---- -------- ------- ----
Non Interest Bearing Liabilities
Demand Deposits 37,325 35,086 32,226
Other Liabilities 3,954 2,337 2,320
Shareholders' Equity 30,933 29,399 28,438
-------- -------- --------
Total Liabilities and
Shareholders Equity $ 300,420 $ 305,290 $282,855
======== ======== =======
Net Interest Income $13,090 $ 12,038 $ 11,383
====== ======== =======
Net Yield on Earning Assets 4.68% 4.24% 4.33%
===== ==== ====
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.
17
EFFECT OF RATE-VOLUME CHANGES ON NET INTEREST INCOME
(On a fully taxable equivalent basis)
(In thousands of dollars)
2004 Compared to 2003 2003 Compared to 2002
Increase (Decrease) Increase (Decrease)
Due to change in:1 Total Due to change in:1 Total
Average Average Increase Average Average Increase
Volume Rate (Decrease) Volume Rate (Decrease)
Interest Income
Loans2 $ 655 $ (869) $ (214) $ 790 $(1,148) $ (358)
Investment Securities
Taxable (191) (20) (211) 132 (412) (280)
Nontaxable (60) 1 (60) (99) 35 (64)
Interest bearing
deposits (39) 3 (35) 26 (77) (51)
Federal fund sold (69) 14 (55) 142 (101) 41
----- ------ ------ ----- ------ ------
Total Interest
Income 296 (871) (575) 992 (1,704) (712)
----- ------ ------ ----- ------ ------
Interest Expense
Demand Deposits 16 (55) (39) 17 (108) (91)
Savings Deposits 31 (116) (85) 63 (333) (270)
Time Deposits (622) (921) (1,543) 537 (1,571) (1,034)
Borrowed Money 74 (34) 40 25 3 28
----- ------ ------ ----- ------ ------
Total Interest
Expense (501) (1,126) (1,627) 642 (2,009) (1,367)
----- ------ ------ ----- ------ ------
Net Interest Income $ (287) $ 1,339 $ 1,052 $ 895 $ (240) $ 655
===== ====== ====== ===== ====== =====
1 Changes in volume are calculated based on the difference in average balance
multiplied by the prior year average rate. Rate change differences are
calculated based on the difference from one year to the next in the average
rates earned or paid multiplied by the current year's balance.
2 Nonaccrual loans have been included in average asset balances.
18
Asset Quality
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.
Although loan growth was relatively flat throughout 2003 and through the
first half of 2004, during the second half of the year ended December 31, 2004,
the company experienced high levels of loan growth. For the eighteen month
period begun December 31, 2003 and ended June 30, 2004, the Company's loans grew
$6.8 million or 3.00%. From June 30, 2004 to December 31, 2004, the Company
experienced loan growth of $15.09 million or 6.46% (12.92% annualized). The
Company has also seen a shift in the composition of it's loan portfolio. The
total balances of loans in the Company's portfolio secured by real estate
increased $16.57 million from December 31, 2003 to December 31, 2004,
representing 75.71% of the growth in loan balances over this same time period.
The following table summarizes the Company's loan portfolio:
At December 31,
2004 2003 2002 2001 2000
----------------------------------------------------
(In Thousands of Dollars)
Real Estate:
Mortgage $140,762 $129,671 $121,558 $111,668 $101,890
Construction 8,850 7,552 6,813 3,868 4,061
Commercial 52,813 42,911 47,089 42,204 37,681
Installment 46,092 46,501 50,294 47,730 45,636
Total Loans 248,517 226,635 225,754 205,470 189,268
Allowance for
loan losses (2,530) (2,463) (1,793) (1,603) (1,493)
------- ------- ------- ------- -------
Loans, net $245,987 $224,172 $223,961 $ 203,67 $187,775
======= ======= ======= ======= =======
Note: Commercial loan balances include commercial loans which are secured
by real estate. As December 31, 2004, 2003 and 2002 the Company maintained
balances of loans secured by real estate of $180.17 million, $163.60 million and
$154.76 million respectively.
There were no foreign loans outstanding during any of the above periods.
19
Asset Quality (continued)
Loan Portfolio (continued)
The following table shows the maturity of loans outstanding:
December 31,
Maturity Range 2004 2003 2002
-------------- ---- ---- ----
(in thousands of dollars)
Predetermined Rates:
0 - 12 months $129,646 $132,237 $145,473
13 - 60 months 102,295 80,099 68,699
More than 60 months 16,046 12,635 11,353
Nonaccrual Loans 530 1,664 229
------- ------- -------
Total Loans $248,517 $226,635 $225,754
======= ======= =======
The following table shows the Company's loan maturity distribution (in
thousands of dollars) as of December 31, 2004:
Maturity Range
Less Than 1-5 Over
Loan Type 1 Year Years 5 Years Total
--------- ------- ----- ------- -----
Commercial and
Agricultural Loans $ 30,492 $ 13,192 $ 9,128 $ 52,813
Real Estate - mortgage 74,195 60,843 5,723 140,761
Real Estate - construction 8,850 8,850
Consumer - installment 16,638 28,259 1,195 46,092
------- ------- ------- -------
Total $130,176 $102,295 $ 16,046 $248,517
======= ======= ======= =======
Credit Quality
The principal economic risk associated with each of the categories of loans
in the Company's portfolio is the creditworthiness of its borrowers. Within each
category, such risk is increased or decreased depending on prevailing economic
conditions. The risk associated with the real estate mortgage loans and
installment loans to individuals varies based upon employment levels, consumer
confidence, fluctuations in value of residential real estate and other
conditions that affect the ability of consumers to repay indebtedness. The risk
associated with commercial, financial and agricultural loans varies based upon
the strength and activity of the local economies of the Company's market areas.
The risk associated with real estate construction loans varies based upon the
supply of and demand for the type of real estate under construction.
An inherent risk in the lending of money is that the borrower will not be
able to repay the loan under the terms of the original agreement. The allowance
for loan losses (see subsequent section) provides for this risk and is reviewed
periodically for adequacy. This review also considers concentrations of loans in
terms of geography, business type or level of risk. While lending is
geographically diversified within the service area, the Company does have some
concentration of loans in the area of agriculture (primarily poultry farming),
timber and related industries. Management recognizes these concentrations and
considers them when structuring its loan portfolio.
20
Asset Quality (continued)
Credit Quality (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.
Nonperforming loans decreased 77.78% at December 31, 2004 compared to 2003
as both balances of nonaccrual loans and loans contractually 90 days of more
past due decreased during the year. At December 31, 2004, the Company had two
loans totaling $631,000 which were classified as restructured loans. As of
December 31, 2004, these loans which had previously been classified as
restructured had timely payments for more than a twelve month period and terms
were not better than those that would be offered in a competitive environment.
For this reason, they were no longer classified as restructured. Balances of
non-performing loans have decreased both as a result of increased collections
efforts and as a result of higher than historically average charge-offs during
both 2003 and 2004.
The following table summarizes the Company's nonperforming loans:
At December 31,
2004 2003 2002 2001 2000
----------------------------------------------
Loans accounted for on a
nonaccrual basis
Consumer $ 252 $ 228 $ 9 $ -- $ --
Real estate 278 1,436 290 474 32
----- ----- ----- ----- -----
Total nonaccrual loans 530 1,664 299 474 32
----- ----- ----- ----- -----
Restructured loans -- 631 662 -- --
----- ----- ----- ----- -----
Loans contractually past
due 90 days or more as to
interest or principal
payments (not included
in nonaccrual loans above)
Commercial 140 25 161 607 60
Real estate 355 1,255 1,312 1,352 1,984
Consumer 40 318 445 336 297
----- ----- ----- ------ -----
Total Delinquent Loans $ 535 $1,598 $1,918 $2,295 $2,341
===== ===== ===== ===== =====
Total Nonperforming
Loans $1,065 $3,893 $2,879 $2,769 $2,373
===== ===== ===== ===== =====
Real estate acquired through foreclosure was $327,650 at December 31, 2003,
$291,414 at December 31, 2003 and $517,050 at December 31, 2002. All of the
foreclosed properties held at December 31, 2004 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.
21
Asset Quality (continued)
Credit Quality (continued)
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. During the spring of 2004, Pilgrim's Pride Corporation announced the
pending closure of its turkey processing facilities near Harrisonburg, VA. This
closure would have impacted the local economy because turkey growers contracted
with Pilgrim's Pride would either be forced to cease growing operations or turn
to alternative contractual arrangements. The number of direct grower loans held
by the Company and which would have been impacted by this potential closure is
small. Since the announcement of the pending closure, some of the growers
impacted by the closure who have loans with the Company have contracted with
another poultry integrator. The remainder have joined a cooperative organization
that will re-open the processing plant. As of this filing, this cooperative has
begun placing birds with growers in preparation for future processing.
Management will monitor the activities of this cooperative but expects no
adverse impact relating to the transitions involved with the poultry processing
facility and its related operations.
In recent periods, the Company's loan portfolio has also begun to reflect a
concentration in loans collateralized by heavy equipment, particularly in the
trucking, mining and timber industries. In part because of rising fuel costs,
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.
As of December 31, 2004, the Company had two potential problem loan as
defined in SEC Industry Guide III that would require disclosure.
In July, the Company received notice that a large commercial loan customer
had filed for Chapter 11 bankruptcy protection. Terms of the bankruptcy
proceedings have not been finalized. Depending upon the outcome of the
bankruptcy proceedings, the Company may be forced to reclassify the loans made
to this customer, which total approximately $1.4 million, to non-accrual status.
If these loans are reclassified to non-accrual, this will have a negative impact
on interest revenue and net income. The loans to this customer are deemed by
Management to be well secured, and if a foreclosure is required, the Company
expects there to be no loss on the sale of the collateral. Since the bankruptcy
filing, this customer has continued to make payments of both principal and
interest, and though remaining moderately delinquent, these payments have been
sufficient to consistently keep the customer less than 60 days past due. During
the fourth quarter of 2004, the Company was informed by another large commercial
loan customer that a Chapter 11 bankruptcy may be forthcoming. As of the date of
this filing, the Company has received no formal notice from this customer that a
bankruptcy filing has occurred. This customer continues to make payments of both
principal and interest, and though remaining moderately delinquent, these
payments have been sufficient to consistently keep the customer less than 60
days past due. Management deems the loans to this customer to be adequately
secured and, if foreclosure becomes necessary, expects no material loss.
Allowance for loan losses
The allowance for loan losses is an estimate of the losses in the current
loan portfolio. The allowance is based on two principles of accounting: (i) SFAS
No. 5, Accounting for Contingencies which requires that losses be accrued when
they are probable of occurring and estimable and (ii) SFAS No. 114, Accounting
by Creditors for Impairment of a Loan, which requires that loans be identified
which have characteristics of impairment as individual risks, (e.g. the
collateral, present value of cash flows or observable market values are less
than the loan balance).
22
Asset Quality (continued)
Allowance for loan losses (continued)
Each of Company's banking subsidiaries, Capon Valley Bank and The Grant
County Bank, determines the adequacy of its allowance for loan losses
independently. Although the loan portfolios of the two banks are similar to each
other, some differences exist which result in divergent risk patterns and
different charge-off rates amongst the functional areas of the banks' portfolio.
Each bank pays particular attention to individual loan performance, collateral
values, borrower financial condition and economic conditions. The determination
of an adequate allowance at each bank is done in a three step process. The first
step is to identify impaired loans. Impaired loans are problem loans above a
certain threshold which have estimated losses calculated based on 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 weighting is somewhat subjective and
actual losses may be greater or less than the amount of the allowance. However,
Management believes that the allowance represents a fair assessment of the
losses that exist in the current loan portfolio.
The required level of the allowance for loan losses is computed quarterly
and the allowance adjusted prior to the issuance of the quarterly financial
statements. All loan losses charged to the allowance are approved by the boards
of directors of each bank at their regular meetings. The allowance is reviewed
for adequacy after considering historical loss rates, current economic
conditions (both locally and nationally) and any known credit problems that have
not been considered under the above formula.
Management has analyzed the potential risk of loss on the Company's loan
portfolio given the loan balances and the value of the underlying collateral and
has recognized losses where appropriate. Nonperforming loans are closely
monitored on an ongoing basis as part of the Company's loan review process.
The ratio of the allowance for loan losses to total loans outstanding was
1.02% at December 31, 2004, 1.09% at December 31, 2003 and .79% at December 31,
2002. At December 31, 2004, the ratio of the allowance for loan losses to
nonperforming loans was 292.48% compared to 63.27% at December 31, 2003 and
62.28% at December 31, 2002.
The charge off of a large number of poorly performing loans has contributed
in part to declining delinquency rates and has led to a decreased allowance
requirement in Management's estimation. Management believes that the credit
quality of the current loan portfolio is significantly improved and that in the
coming periods net charge-offs will decline compared to those seen in 2003 and
2004. Management believes losses will more closely reflect historical charge-off
rates, or may fall below historical averages.
Because of the large increase in loan balances during the fourth quarter of
2004, a provision for loan losses of $320,000 was charged to operations as
compared to $195,000 in the third quarter, $210,000 in the second quarter and
$195,000 in the first quarter. Management anticipates that continued loan growth
will require a continuance of increased amounts of provision for loan losses in
2004 as compared to recent years. This belief is exclusive of any unanticipated
changes in asset quality which may require larger or smaller balances of the
allowance for loan losses as compared to total loans.
23
Asset Quality (continued)
Allowance for loan losses (continued)
An analysis of the loan loss allowance is set forth in the following table
(in thousands):
2004 2003 2002 2001 2000
---- ---- ---- ---- ----
Balance at beginning of
period $ 2,463 $ 1,793 $ 1,603 $ 1,493 $ 1,318
Charge-offs:
Commercial loans 97 557 246 239 172
Real estate loans 422 65 110 92 128
Consumer loans 642 839 424 369 215
------- ------- ------ ------- ------
1,162 1,461 780 700 515
------- -------- ------ ------- ------
Recoveries:
Commercial loans 37 75 10 57 2
Real estate loans 36 54 68 12 30
Consumer loans 235 182 72 141 71
------- -------- ------ ------- ------
308 311 150 210 103
------- ------- ------ ------- ------
Net charge-offs 853 1,150 630 490 412
Provision for loan
losses 920 1,820 820 600 500
Other 87
------ ------- ------ ------- ------
Balance at end
of period $ 2,530 $ 2,463 $ 1,793 $ 1,603 $ 1,493
====== ======= ====== ======= ======
Percent of net charge-offs
to average net loans
outstanding during the
period .36% .51% .29% .25% .23%
====== ======= ====== ======= ======
Cumulative net loan losses, after recoveries, for the five year period
ending December 31, 2004 are as follows (in thousands of dollars):
Dollars Percent of Total
Commercial $ 1,138 33.00%
Real estate 617 17.90%
Consumer 1,798 49.10%
------ -------
Total $ 3,535 100.00%
====== ======
24
Asset Quality (continued)
Allowance for loan losses (continued)
The following table shows the allocation of loans in the loan portfolio and
the corresponding amounts of the allowance allocated by loan types (dollar
amounts in thousands):
At December 31,
------------------------------------------------------------------
2004 2003 2002 2001 2000
------------------------------------------------------------------
Percent Percent Percent Percent Percent
Of of of of of
Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans
Commercial $ 697 21% $ 779 19% $ 543 21% $ 487 21% $ 507 20%
Mortgage 853 60% 725 61% 504 57% 576 56% 239 56%
Consumer 970 19% 819 20% 652 22% 450 23% 598 24%
Unallocated 10 140 94 90 149
----- --- ----- --- ----- --- ----- --- ----- ---
Totals $2,530 100% $2,463 100% $1,793 100% $1,603 100% $1,493 100%
===== === ===== === ===== === ===== === ===== ===
The above act 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.
Noninterest Income
2004 compared to 2003
Noninterest income increased $254,000 from 2003 to 2004, an increase of
18.58%. Much of this increase can be attributed to an increase in the
per-transaction charges for non-sufficient funds charges to checking account
customers, which contributed to the $194,000 increase in service charges.
During 2004 the volume of new consumer installment loans declined and has
impacted insurance earnings. As credit life and accident and health insurance
are sold primarily to these loan customers, the volume of new insurance business
has also decreased. In spite of declines in sales of credit life and accident
insurance, insurance earnings increased 26.32% in 2004 as compared to 2003. As
new policies are written, there are requirements that portions of the premiums
be held in reserve in anticipation of future claims. Throughout 2004, as the
volume of new insurance business has fallen, older policies have matured without
claims. As a result of this, required balances of these reserves has been
reduced and this has positively impacted the income of HBI Life Insurance
Company.
Because of the closing of the trust subsidiary, trust fees fell $49,000
during 2004 as compared to 2003.
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 grew as increases in customer penetration rates
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.
25
Noninterest Income (continued)
Discontinuation of Trust Operations
During the fourth quarter of 2003, the Board of Directors of Highlands
Bankshares, Inc. (HBI) decided to close Highlands Bankshares Trust Company, Inc.
(HBTI).The demand for trust services in the Company's primary and secondary
service areas had been less than anticipated. As of May 31, 2004, Highlands
Bankshares Trust Company, a wholly owned subsidiary of Highlands Bankshares,
Inc. ceased operations.
On an unconsolidated basis, at the time of it's closing, HBTI had an
accumulated net loss of $3,217. This loss, in combination with an initial
capital contribution by HBI of $2,143,576, resulted in a net investment by HBI
at the time of closing of $2,140,359. Upon the cessation of operations of HBTI,
this capital investment was returned to Highlands Bankshares, Inc. in the form
of cash. At its regularly scheduled meeting in July, the Highlands Board of
Directors voted to invest this capital, less amounts used to pay second quarter
shareholder dividends, in the two subsidiary banks.
The distribution of this available capital as investment in the subsidiary
banks was as follows (in thousands):
Capital
Subsidiary Bank Investment
Capon Valley Bank $ 703
The Grant County Bank 1,157
------
Total $ 1,860
======
Noninterest Expenses
2004 Compared to 2003
Expenses related to salaries and benefits increased 8.83% in 2004 as
compared to 2003. Of the increase in salary and benefit expense, a large portion
was attributable to an increase in costs of employee insurance and to an
increase in wages and corresponding payroll tax. Insurance costs increased
primarily due to rising premium costs. Of the increase in wages and payroll tax
costs, a slight decline in full time equivalent employees was offset by the
increase in wages due to normal pay increases. Both subsidiary banks experienced
increases in costs related to the post-retirement benefits of bank owned life
insurance polices however, this cost was partially offset by improved earnings
of the policies. Costs of retirement benefits increased primarily due to rising
costs of The Grant County Bank's defined benefit pension plan (see Note 13 of
the Financial Statements).
Equipment and data processing expense increased largely as a result of the
purchase, implementation and upgrades over recent quarters of processing
equipment intended to improve operational efficiency. During 2003 and 2004, both
subsidiary banks implemented telephone banking services and statement imaging
services. Both projects required significant new equipment which increased
depreciation expense.
Legal and professional fees increased 17.53% as expanded audit procedures
were made necessary by the organization's growth and changes in the regulatory
environment. Management anticipates that audit related fees will grow during
2004 as compliance with Rule 404 of the Sarbanes-Oxley Legislation will require
expanded services. Management has contracted with an external consulting firm to
assist with compliance with Rule 404.
26
Noninterest Expenses (continued)
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.
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.
Securities
The Company's securities portfolio serves several purposes. Portions of the
portfolio are used to secure certain public and trust deposits. The remaining
portfolio is held as investments or used to assist the Company in liquidity and
asset liability management. Total securities decreased to $27,029,000 or 9.01%
of total assets at December 31, 2004. Total securities were $34,930,000 or
11.60% of total assets at December 31, 2003.
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.
The Company identifies at the time of acquisition those securities that are
available for sale. These securities are valued at their market value with any
difference in market value and amortized cost shown as an adjustment in
stockholders' equity. Changes within the year in market values are reflected as
changes in other comprehensive income, net of the deferred tax effect. As of
December 31, 2004, the cost basis of the securities available for sale exceeded
their fair value by $54,000.
27
Securities (continued)
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,
2004 2003 2002 2004 2003 2002
---- ---- ---- ---- ---- ----
(In Thousands of Dollars) (In Thousands of Dollars)
U.S. treasuries, agencies
and corporations $ $ $ $18,164 $23,240 $13,534
Obligations of states and
political subdivisions 1,162 1,364 1,365 1,817 2,604 4,350
Mortgage-backed securities 2 4 4,693 6,758 5,582
----- ----- ----- ------ ------ ------
Total Debt Securities 1,162 1,366 1,369 24,674 32,602 23,466
Other securities 28 29 30
----- ----- ----- ------ ------ ------
Total $1,162 $1,366 $1,369 $24,702 $32,631 $23,496
===== ===== ===== ====== ====== ======
The carrying amount and estimated market value of debt securities (in
thousands of dollars) at December 31, 2004 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 $ 842 $ 853 6.96%
Due after one year through five years 320 334 6.60%
------- -------- -------
Total Held to Maturity $ 1,162 $ 1,187 6.86%
======= ======= =====
Equivalent
Securities Available for Sale Amortized Fair Average
Cost Value Yield
Due in one year or less $ 11,275 $ 11,236 2.34%
Due after one year through five years 10,897 10,875 3.07%
Due after five years through ten years 1,715 1,715 3.80%
Due after ten years 841 848 3.00%
------- ------- -----
Total Debt Securities 24,728 24,663 2.78%
Equities 28 28 8.40%
------- ------- -----
Total Available for Sale $ 24,756 $ 24,702 2.78%
======= ======= =====
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.
28
Deposits
The Company's primary source of funds is local deposits. The Company's
deposit base is comprised of demand deposits, savings and money market accounts
and other time deposits. The majority of the Company's deposits are provided by
individuals and businesses located within the communities served.
Total balances of deposits decreased 3.16% in from December 31, 2003 to
December 31, 2004. Balances of non-interest bearing checking accounts and
interest bearing transaction accounts increased during the year, while balances
of time deposits decreased 10.14%. The Company does not actively solicit large
certificates of deposit (those more than $100,000) due to the unstable nature of
these deposits. Balances of time deposits greater than $100,000 decreased 16.78%
from December 31, 2003 to December 31, 2004.
A summary of the maturity of large deposits is as follows:
December 31,
-----------------------------
Maturity Range 2004 2003 2002
-------------- ---- ---- ----
(In Thousands of Dollars)
Three months or less $ 6,598 $ 7,950 $ 7,570
Four to twelve months 13,861 19,080 22,030
One year to three years 15,323 12,307 8,598
Four years to five years 3,620 8,008 7,195
-------- -------- --------
Total $ 39,402 $ 47,345 $ 45,393
======= ======= ========
Borrowed Money
Long Term Borrowings
The Company occasionally borrows funds from the Federal Home Loan Bank
("FHLB") to reduce market rate risks, provide liquidity, and to fund capital
additions. These borrowings may have fixed or variable interest rates and are
amortized over a period of one to twenty years, or may be comprised of single
payment borrowings with periodic interest payments and principal amounts due at
maturity. Borrowings from this institution allow the banks to offer long-term,
fixed rate loans to their customers and match the interest rate exposure of the
receivable and the liability. During 2004, the Company borrowed an additional
$3,800,000 from the FHLB and made payments of $719,000 on outstanding balances.
Short Term Borrowings
Although the Company has traditionally not experienced the need for
overnight or other short-term borrowings, loan growth during the fourth quarter
of 2004 necessitated an overnight borrowing of $2,000,000 at December 31, 2004.
At no other point during the year did the Company borrow overnight funds, and
though this funding tool may be required in coming periods, Management prefers
to fund growth through longer term vehicles and expects instances of overnight
borrowings to be minimal.
Parent Company Line of Credit
During the fourth quarter of 2003, the Company secured a $2,500,000 open
line of credit with another commercial bank. This line of credit 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 or 2004 from this line and it is not
anticipated that any borrowings from this debt facility will be used to fund
operating or liquidity needs.
29
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 capital management function is an ongoing process. Central to this
process is internal equity generation accomplished by earnings retention. During
2004, 2003, and 2002, total stockholders' equity increased by $2,106,000,
$1,184,000 and $504,000, 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
$1,217,000. The return on average equity was 10.36% in 2004 compared to 7.60%
for 2003 and 8.87% for 2002. Total cash dividends declared represent 28.23% of
net income for 2004 compared to 36.03% of net income for 2003 and 29.26% for
2002. Book value per share was $22.03 at December 31, 2004 compared to $20.56 at
December 31, 2003.
Liquidity
Operating liquidity is the ability to meet present and future financial
obligations. Short term liquidity is provided primarily through cash balances,
deposits with other financial institutions, federal funds sold, unpledged
securities and loans maturing within one year. Additional sources of liquidity
available to the Company include, but are not limited to, loan repayments, the
ability to obtain deposits through the adjustment of interest rates and the
purchasing of federal funds. To further meet its liquidity needs, the Company
also maintains lines of credit with correspondent financial institutions, the
Federal Reserve Bank of Richmond and the Federal Home Loan Bank of Pittsburgh.
Historically, the Company's primary need for additional levels of
operational liquidity has been to fund increases in loan balances. The Company
has normally funded increases in loans by increasing deposits and decreases in
secondary liquidity sources such as balances of fed funds sold and balances of
securities. During the month of September and the fourth quarter of 2004, the
Company saw a significant increase in new loans. These loans were funded
primarily through secondary liquidity sources. Deposit balances have also
decreased in recent periods. Should the Company continue to experience
significant loan growth, it may be necessary to raise rates on deposits above
current market levels in order to attract new deposits. The Company may also
utilize the available lines of credit with correspondent financial institutions
to fund loan growth.
In the year ending December 31, 2004, cash and due from banks decreased
$1,027,000 as cash used in financing and investing activities was greater than
cash provided by operations. Investing activity saw cash used to fund an
increase in gross loans in an amount of $21,882,000 . This increase was funded
by a decrease in deposits at other institutions of $536,000, a decrease in fed
funds sold of $12,712,000 and a decrease of holdings of securities and other
investments of $7,901,000. New equipment and facility additions were $265,000 in
2004 compared with $915,000 in 2003. Decreases in deposit balances of $8,294,000
contributed to the decline in cash balances but was partially offset by a
$5,082,000 increase in net transactions in borrowed funds.
30
Liquidity (continued)
The parent Company's operating funds, funds with which to pay shareholder
dividends and funds for the exploration of new business ventures have been
supplied primarily through dividends paid by the Company's subsidiary banks,
Capon Valley Bank (CVB) and The Grant County Bank (GCB). 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, 2005, the subsidiary banks
could pay dividends to Highlands Bankshares, Inc. of approximately $3,944,000
without permission of the regulatory authorities.
A summary of the amounts available follows (in thousands of dollars):
Total
2003 2004 Available
Income Dividend Income Dividend for Dividends
CVB $ 475 $ -- $ 1,217 $ 437 $ 1,255
GCB $1,801 $ 905 $2,,080 $ 287 $ 2,689
Effects of Inflation
Inflation primarily affects industries having high levels of property,
plant and equipment or inventories. Although the Company is not significantly
affected in these areas, inflation does have an impact on the growth of assets.
As assets grow rapidly, it becomes necessary to increase equity capital at
proportionate levels to maintain the appropriate equity to asset ratios.
Traditionally, the Company's earnings and high capital retention levels have
enabled the Company to meet these needs.
The Company's reported earnings results have been minimally affected by
inflation. The different types of income and expense are affected in various
ways. Interest rates are affected by inflation, but the timing and magnitude of
the changes may not coincide with changes in the consumer price index.
Management actively monitors interest rate sensitivity, as illustrated by the
gap analysis shown under the section titled Interest Rate Sensitivity, in order
to minimize the effects of inflationary trends on interest rates. Other areas of
noninterest expenses may be more directly affected by inflation.
31
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The greatest portion of the Company's net income is derived from net
interest income. As such, the greatest component of market risk is interest rate
volatility. In conjunction with maintaining a satisfactory level of liquidity,
management must also control the degree of interest rate risk assumed on the
balance sheet. Managing this risk involves regular monitoring of the interest
sensitive assets relative to interest sensitive liabilities over specific time
intervals. Early withdrawal of deposits, greater than expected balances of new
deposits, prepayments of loans and loan delinquencies are some of the factors
that could affect actual versus expected cash flows. In addition, changes in
rates on interest sensitive assets and liabilities may not be equal, which could
result in a change in net interest margin. While the Company does not match each
of its interest sensitive assets against specific interest sensitive
liabilities, it does review its positions regularly and takes actions to
reposition itself when necessary. With the largest amount of interest sensitive
assets and liabilities repricing within one year, the Company believes it is in
an excellent position to respond quickly to rapid market rate changes.
Interest rate market conditions may also affect portfolio composition of
both assets and liabilities. Traditionally, the Company's subsidiary banks have
primarily offered one year adjustable rate mortgages (ARMs) to its mortgage loan
customers. However, the low interest rate environment has created intense
competition, especially from larger banking institutions and finance companies
offering long term fixed rate mortgages. As a result, the Company in recent
periods has begun to write more mortgage loans with adjustable rates and
maturities greater than one year. The increase in new ARM loans with two, three
and five year adjustable rates has caused a shift in the maturity composition of
the loan portfolio. As of December 31, 2003, 58.35% of the Company's loan
portfolio repriced within one year. As of December 31, 2004, 52.33% of the
Company's loan portfolio repriced within one year.
Also as a result of the low interest rate environment, depositors seem
reluctant to commit to longer term time deposits and in many instances appear to
be holding monies temporarily in interest bearing transaction accounts in
anticipation of rising rates in the coming periods. As of December 31, 2003,
balances of interest bearing transaction and savings accounts were $72,098,000.
These balances had grown to $75,342,000 by December 31, 2004. Were interest
rates to rise sharply in the coming periods, some of the monies now in interest
bearing transaction and savings accounts may shift to time deposits, causing a
rise in the Company's cost of funds. Alternatively, these balances may be
transferred by customers to other financial institutions offering higher deposit
rates, and requiring the Company to match such rates.
Increased deposit incentives in the form of higher rate features may be
required in coming periods if loan demand grows at a rate whereby current
sources of funds will not be sufficient to support loan funding. This would have
the effect of increasing the Company's cost of funds. The subsidiary banks of
the Company maintain sufficient ability to borrow funds from the Federal Home
Loan Bank (FHLB) for use in loan funding and there has been no recent indication
which would lead Management to believe that FHLB borrowing rates would rise to
levels which would adversely effect interest margin spreads. While Management
does not foresee being forced in future periods to pay above market rates on its
funding, extreme loan growth may cause just this scenario to occur, thereby
reducing net interest margin spreads.
The table on the following page illustrates the Company's sensitivity to
interest rate changes as of December 31, 2004 (in thousands).
32
HIGHLANDS BANKSHARES, INC.
INTEREST RATE SENSITIVITY ANALYSIS
December 31, 2004
(In Thousands of Dollars)
More than
5 Years
1 - 90 91 - 365 1 to 3 3 to 5 or no
Days Days Years Years Maturity Total
EARNING ASSETS
Loans $34,842 $ 95,334 $85,483 $16,812 $16,046 $248,517
Fed funds sold 4,006 4,006
Securities 7,572 11,124 7,434 155 744 27,029
Time deposits in other
banks 351 300 651
------ ------- ------ ------ ------ -------
Total 46,771 106,758 92,917 16,967 16,790 280,203
------ ------- ------ ------ ------ -------
INTEREST BEARING LIABILITIES
Interest bearing
transaction 26,133 26,133
Savings accounts 49,209 49,209
Time deposits
over $100,000 6,598 13,861 15,323 3,620 39,402
Other time deposits 20,148 40,651 32,787 8,539 102,125
Borrowed funds 2,118 1,369 2,395 942 3,553 10,377
------- ------ ------ ------ ------ --------
Total 104,206 55,881 50,505 13,101 3,552 227,245
------- ------ ------ ------ ------ -------
Rate sensitivity GAP (57,436) 50,878 42,412 3,866 13,237 52,957
Cumulative GAP (57,436) (6,558) 35,854 39,720 52,957
Ratio of cumulative
interest sensitive
assets to cumulative
interest sensitive
liabilities 44.88% 95.90% 117.03% 117.76% 123.30%
Assumes all transaction, money market and savings deposit accounts reprice
within 90 days.
33
Item 8. Financial Statements
HIGHLANDS BANKSHARES, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2004 AND 2003
(in thousands of dollars)
December 31,
2004 2003
------------------
ASSETS
Cash and Due From Banks $ 6,187 $ 7,214
Interest bearing deposits in banks 651 1,187
Federal funds sold 4,006 16,718
Investments:
Securities held to maturity 1,162 1,366
Securities available for sale 24,702 32,631
Restricted investments 1,165 933
Loans 248,517 226,635
Allowance for loan losses (2,530) (2,463)
Bank premises and equipment 6,810 7,210
Interest receivable 1,436 1,718
Other Assets 2,077 2,461
Investment in life insurance contracts 5,809 5,558
------- -------
Total Assets $299,992 $301,168
======= =======
LIABILITIES
Deposits:
Non interest bearing $ 37,522 $ 32,936
Savings and interest bearing demand deposits 75,342 72,098
Time deposits over $100,000 39,402 47,345
All other time deposits 102,125 110,306
------- -------
Total Deposits 254,391 262,685
Short term borrowings 2,000
Long term debt 8,377 5,295
Accrued expenses and other liabilities 3,569 3,639
------- -------
Total Liabilities 268,337 271,619
------- -------
STOCKHOLDERS' EQUITY
Common Stock, $5 par value, 3,000,000 shares
authorized, 1,436,874 shares issued 7,184 7,184
Surplus 1,662 1,662
Retained earnings 23,028 20,727
Other accumulated comprehensive loss (219) (24)
------- -------
Total Stockholders' Equity 31,655 29,549
------- -------
Total Liabilities and Shareholders' Equity $299,992 $301,168
======= =======
The accompanying notes are an integral part of this statement.
34
HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
(in thousands of dollars except per share data)
2004 2003 2002
-------------------------------
Interest and Dividend Income
Loans including fees $ 16,752 $ 16,966 $ 17,324
Federal funds sold 163 218 177
Interest bearing deposits 18 54 104
Investment securities--taxable 674 885 1,164
Investment securities--nontaxable 122 160 201
-------- -------- --------
Total Interest Income 17,729 18,283 18,970
-------- -------- --------
Interest Expense
Interest on deposits 4,433 6,100 7,495
Interest on borrowed money 278 238 210
-------- -------- --------
Total interest expense 4,711 6,338 7,705
-------- -------- --------
Net Interest Income 13,018 11,945 11,265
-------- -------- --------
Provision for loan losses 920 1,820 820
Net Interest Income after
Provision for Loan Losses 12,098 10,125 10,445
-------- -------- --------
Noninterest Income
Service charges 810 616 587
Insurance commissions and income 240 190 143
Life insurance investment income 251 221 238
Other operating income 292 336 336
Gain on securities transactions 4 4 0
-------- -------- --------
Total Noninterest Income 1,597 1,367 1,304
-------- -------- --------
Noninterest Expenses
Salaries and benefits 4,876 4,480 4,393
Occupancy expense 401 382 380
Equipment expense 813 726 662
Data processing expense 671 600 574
Legal and professional fees 342 291 228
Directors fees 328 311 227
Other operating expenses 1,507 1,457 1,584
-------- -------- --------
Total noninterest expenses 8,938 8,247 8,048
-------- -------- --------
Income before income tax expense 4,757 3,245 3,701
Income tax expense 1,551 1,012 1,179
-------- -------- --------
Net Income $ 3,206 $ 2,233 $ 2,522
======== ======== ========
Weighted Average Shares Outstanding 1,436,874 1,436,874 1,455,511
Earnings Per Share $ 2.23 $ 1.55 $ 1.73
Dividends Per Share $ .63 $ .56 $ .51
The accompanying notes are an integral part of this statement.
35
HIGHLANDS BANKSHARES INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(in thousands of dollars)
Accumulated
Other
Common Retained Comprehensive Treasury
Stock Surplus Earnings Income (Loss) Stock Total
Balances January 1,
2002 $2,734 $1,662 $24,175 $ 283 $ (993) $ 27,861
Comprehensive Income:
Net Income 2,522 2,522
Change in other
Comprehensive income (63) (63)
-------
Total Comprehensive Income 2,459
Treasury stock repurchased (1,217) (1,217)
Treasury stock retired (339) (1,871) 2,210
Stock split effected
in form of dividend 4,789 (4,789)
Cash Dividends (738) (738)
----- ----- ------- ----- ------ -------
Balances December 31,
2002 7,184 1,662 19,299 220 28,365
Comprehensive Income:
Net Income 2,233 2,233
Change in other
Comprehensive income (244) (244)
------
Total Comprehensive Income 1,989
Cash Dividends (805) (805)
----- ----- ----- ----- ------ ------
Balances December 31,
2003 7,184 1,662 20,727 (24) 29,549
Comprehensive Income:
Net Income 3,206 3,206
Change in other
Comprehensive income (195) (195)
------
Total Comprehensive Income 3,011
Cash Dividends (905) (905)
----- ----- ----- ----- ----- -------
Balances December 31,
2004 $7,184 $1,662 $23,028 $ (219) $ $31,655
===== ===== ====== ===== ===== ======
The accompanying notes are an integral part of this statement.
36
HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
(in thousands of dollars)
Years Ended December 31,
2004 2003 2002
---- ---- ----
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 3,206 $ 2,233 $ 2,522
Adjustments to reconcile net income to
net cash provided by operating activities:
(Gain)/Loss on securities transactions 4 (4)
Loss on sale of other assets 1
Depreciation 666 577 526
Income from life insurance contracts (251) (220) (238)
Net amortization of security premiums 248 463 294
Provision for loan losses 920 1,820 820
Deferred income tax benefit (103) (187) (164)
Change in other assets and liabilities:
Interest receivable 282 103 (4)
Other assets 557 (483) (494)
Accrued expenses (69) 872 150
------ ------- ------
Net Cash Provided by Operating Activities 5,461 5,174 3,412
------ ------ ------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturity of securities
held to maturity 201 1 232
Proceeds from maturity of securities
available for sale 15,244 19,576 12,406
Proceeds from sales of securities available
for sale 485
Purchase of securities available for sale (7,832) (29,410) (7,207)
Net change in restricted investments (232) (261) 120
Net decrease in deposits in other banks 536 3,312 1,834
Net increase in loans (22,734) (2,031) (20,914)
Net change in federal funds sold 12,712 (2,093) (1,341)
Purchase of property and equipment (265) (914) (315)
------ ------- -------
Net Cash Used in Investing Activities (2,370) (11,820) (14,700)
------ ------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in time deposits (15,993) (640) 1,654
Net change in other deposit accounts 7,699 5,813 13,817
Additional long term debt 3,800 1,785
Additional short term borrowings 2,000
Repayment of long term debt (719) (519) (494)
Repurchase of treasury stock (1,217)
Dividends paid in cash (905) (805) (738)
------ ------ ------
Net Cash Provided by (Used in)
Financing Activities (4,118) 5,634 13,022
------ ------ ------
CASH AND CASH EQUIVALENTS:
Net (decrease) increase in cash and
due from banks (1,027) (1,012) 1,734
Cash and due from banks, beginning of year 7,214 8,226 6,492
------ ------ ------
Cash and due from banks, end of year $ 6,187 $ 7,214 $ 8,226
====== ====== ======
Supplemental Disclosures:
Cash paid for:
Interest expense $ 4,920 $ 6,360 $ 7,920
Income taxes $ 1,183 $ 1,448 $ 1,421
The accompanying notes are an integral part of this statement.
37
Notes to Consolidated Financial Statements
NOTE 1 SUMMARY OF OPERATIONS:
Highlands Bankshares, Inc. (the "Company") is a bank holding company and
operates under a charter issued by the state of West Virginia. The Company owns
all of the outstanding stock of The Grant County Bank, 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.
38
Notes to Consolidated Financial Statements
NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED):
(e) Securities
Securities that the Company has both the positive intent and ability
to hold to maturity (at time of purchase) are classified as held to
maturity securities. All other securities are classified as available
for sale. Securities held to maturity are carried at historical cost
and adjusted for amortization of premiums and accretion of discounts,
using the effective interest method. Securities available for sale
are carried at fair value with any valuation adjustments reported,
net of deferred taxes, as other accumulated comprehensive income.
Restricted investments consist of investments in the Federal Home
Loan Bank of Pittsburgh and the Federal Reserve Bank of Richmond.
Such investments are required as members of these institutions and
these investments cannot be sold without a change in the members'
borrowing or service levels.
Interest and dividends on securities and amortization of premiums and
discounts on securities are reported as interest income using the
effective interest method. Gains (losses) realized on sales and calls
of securities are determined using the specific identification
method.
(f) Loans
Loans are carried on the balance sheet net of unearned interest and
allowance for loan losses. Interest income on loans is determined
using the effective interest method based on the daily amount of
principal outstanding except where serious doubt exists as to
collectibility of the loan, in which case the accrual of income is
discontinued. Loans are placed on nonaccrual status or charged off if
collection of principal or interest becomes doubtful. The interest on
these loans is accounted for on a cash-basis or cost-recovery method
until qualifying for return to accrual status. Loans are returned to
accrual status when all the principal and interest amounts
contractually due are brought current and the loan is performing as
agreed.
(g) Allowance For Loan Losses
The allowance for loan losses is 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.
39
Notes to Consolidated Financial Statements
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) Recent Accounting Standards
Based on the Company's review of recent accounting standards, it is
believed that none will have a material effect on the Company's
operations in future years.
(k) Income Taxes
Amounts provided for income tax expense are based on income reported
for financial statement purposes rather than amounts currently
payable under federal and state tax laws. Deferred taxes, which arise
principally from differences between the period in which certain
income and expenses are recognized for financial accounting purposes
and the period in which they affect taxable income, are included in
the amounts provided for income taxes.
(l) Comprehensive Income
Accounting principles generally require that recognized revenue,
expenses, gains and losses be included in net income. Certain changes
in assets and liabilities, such as unrealized gains and losses on
available-for-sale securities and accrued pension liabilities, are
reported along with net income as the components of comprehensive
income.
(m) Bank Owned Life Insurance Contracts
The Company has invested in and owns life insurance polices on key
officers. The policies are designed so that the company recovers the
interest expenses associated with carrying the policies and the
officer will, at the time of retirement, receive any earnings in
excess of the amounts earned by the Company.
The Company recognizes as an asset the net amount that could be
realized under the insurance contract as of the balance sheet date.
This amount represents the cash surrender value of the policies less
applicable surrender charges.
The portion of the benefits which will be received by the executives
at the time of their retirement is considered, when taken
collectively, to constitute a retirement plan. Therefore the Company
accounts for these policies using guidance found in Statement of
Financial Accounting Standards No. 106, "Employers' Accounting for
Post Retirement Benefits Other Than Pensions." SFAS No. 106 requires
that an employers' obligation under a deferred compensation agreement
be accrued over the expected service life of the employee through
their normal retirement date (See Note 3).
40
Notes to Consolidated Financial Statements
NOTE 3 CASH AND DUE FROM BANKS:
The Banks are required to maintain average reserve balances based on a
percentage of deposits. The Banks have generally met this requirement through
average cash on hand and balances with their correspondent institutions.
NOTE 4 SECURITIES:
The carrying amount and estimated fair value of securities are as follows
(in thousands of dollars):
Carrying Unrealized Unrealized Fair
Amount Gains Losses Value
Held to Maturity
December 31, 2004
State and municipals $ 1,162 $ 25 $ $ 1,187
------ ----- ----- --------
Total Securities
Held to Maturity $ 1,162 $ 25 $ $ 1,187
====== ====== ====== ========
December 31, 2003
Mortgage-backed $ 2 $ $ $ 2
State and municipals 1,364 71 1,435
------ ------ ------ --------
Total Securities
Held to Maturity $ 1,366 $ 71 $ $ 1,437
====== ====== ====== =======
Available for Sale
December 31, 2004
U. S. Treasuries
and Agencies $18,248 $ $ 84 $ 18,164
Mortgage-backed 4,669 24 4,693
State and municipals 1,811 6 1,817
Marketable equities 28 28
------ ------ ------ -------
Total Securities
Available for Sale $24,756 $ 30 $ 84 $ 24,702
====== ====== ====== =======
December 31, 2003
U. S. Treasuries
and Agencies $23,132 $ 108 $ $ 23,240
Mortgage-backed 6,686 72 6,758
State and municipals 2,567 37 2,604
Marketable equities 32 3 29
------ ------ ------ -------
Total Securities
Available for Sale $32,417 $ 217 $ 3 $ 32,631
====== ====== ====== =======
41
Notes to Consolidated Financial Statements
NOTE 4 SECURITIES (CONTINUED):
The carrying amount and fair value of debt securities at December 31, 2004,
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 $ 841 $ 853
Due after one year through five years 320 333
Mortgage-backed securities 1 1
------- -------
Total Held to Maturity $ 1,162 $ 1,187
======= =======
Securities Available for Sale Fair
Cost Value
Due in one year or less $ 11,273 $ 11,237
Due after one year through five years 9,981 9,929
Due after five years through ten years 396 406
Due after ten years 30 30
Mortgage-backed securities 3,048 3,072
------- -------
Total Debt Securities 24,728 24,674
Equities 28 28
------- -------
Total Available for Sale $ 24,756 $ 24,702
======= =======
The carrying amounts (which approximate market value) of securities pledged
by the banks primarily to secure deposits amounted to $4,765,000 at December 31,
2004 and $6,869,000 at December 31, 2003.
NOTE 5 LOANS:
Loans outstanding as of December 31, 2004 and 2003 are summarized as
follows (in thousands):
2004 2003
Commercial $ 52,814 $ 42,911
Real estate construction 8,850 7,552
Real estate mortgages 140,761 129,670
Consumer installment 46,092 46,502
------- -------
Total $248,517 $226,635
======= =======
42
Notes to Consolidated Financial Statements
NOTE 5 LOANS (CONTINUED):
The following is a summary of information pertaining to impaired,
restricted and non-accrual loans (in thousands):
December 31
2004 2003
-------------------
Impaired loans $ 3,013 $ 2,954
Valuation allowance 347 589
No loans were identified as impaired for which an allowance was not made.
Total non-accrual loans $ 530 $ 1,664
Total loans past-due ninety days
and still accruing interest 535 1,598
Average balance of impaired loans 2,950 2,425
Income recorded on impaired loans 210 182
NOTE 6 ALLOWANCE FOR LOAN LOSSES:
A summary of changes in the allowance for loan losses for the years ended
December 31, 2004, 2003 and 2002 is shown in the following schedule (in
thousands of dollars):
2004 2003 2002
---- ---- ----
Balance at beginning of year $ 2,463 $ 1,793 $ 1,602
Provision charged to
operating expenses 920 1,820 820
Loan recoveries 308 312 151
Loans charged off (1,161) (1,462) (780)
----------- --------- ----------
Balance at end of year $ 2,530 $ 2,463 $ 1,793
========= ========= ==========
Percentage of outstanding
loans 1.02% 1.09% .79%
NOTE 7 BANK PREMISES AND EQUIPMENT:
Bank premises and equipment as of December 31, 2004 and 2003 are summarized
as follows (in thousands of dollars):
2004 2003
Land $ 1,137 $ 1,137
Buildings and improvements 6,332 6,317
Furniture and equipment 4,592 4,417
-------- ---------
Total cost 12,061 11,871
Less - accumulated depreciation (5,251) (4,661)
--------- ---------
Net Book Value $ 6,810 $ 7,210
======== =========
Provisions for depreciation charged to operations were $666,000 in 2004,
$577,000 in 2003 and $526,000 in 2002.
43
Notes to Consolidated Financial Statements
NOTE 8 DEPOSITS:
At December 31, 2004, the scheduled time deposit maturities are as follows
(in thousands of dollars):
2005 $ 81,258
2006 29,428
2007 18,682
2008 8,294
2009 3,865
-------
Total $ 141,527
========
NOTE 9 LONG TERM DEBT:
The Company has borrowed money from the Federal Home Loan Bank of
Pittsburgh (FHLB). The interest rates on all of the notes payable as of December
31, 2004 range from 2.51% to 6.12%. The weighted average interest rate was 4.21%
at December 31, 2004. The Company has total borrowing capacity from the FHLB of
$116,294,000. The debt is secured by the general assets of the Banks.
Repayments of long term debt are due either monthly, quarterly, or in a
single payment at maturity. Interest expense of $278,000, $238,000, and $210,000
was incurred on these debts in 2004, 2003, and 2002, respectively. The
maturities of long term debt as of December 31, 2004 are as follows (in
thousands of dollars):
2005 $ 1,487
2006 534
2007 1,861
2008 542
2009 418
Thereafter 3,535
-------
Total $ 8,377
=======
NOTE 10 SHORT TERM BORROWINGS:
As of December 31, 2004, the Company had $2,000,000 of overnight borrowings
from the Federal Home Loan Bank of Pittsburgh (FHLB). Other than the borrowings
outstanding as of this date, no other short term borrowings occurred in 2004.
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, 2005, the banks
could pay dividends to Highlands Bankshares, Inc. of approximately $3,944,000
without permission of the regulatory authorities.
44
Notes to Consolidated Financial Statements
NOTE 12 INCOME TAX EXPENSE:
The components of income tax expense for the years ended December 31, are
summarized as follows (in thousands of dollars):
2004 2003 2002
------------------------------------
Current Expense
Federal $ 1,420 $ 1,008 $ 1,105
State 234 191 238
------ ------ ------
Total Current Expense 1,654 1,199 1,343
------ ------ ------
Deferred Expense (Benefit)
Federal (99) (169) (149)
State (4) (18) (15)
------ ------ ------
Total Deferred Benefit (103) (187) (164)
------ ------ ------
Income Tax Expense $ 1,551 $ 1,012 $ 1,179
====== ====== ======
The deferred tax effects of temporary differences for the years ended
December 31 are as follows:
2004 2003 2002
---- ---- ----
Tax effect of temporary differences:
Provision for loan losses $ (8) $ (180) $ (57)
Depreciation 18 77 41
Deferred compensation (125) (84) (119)
Miscellaneous 12 (29)
------ ----- -----
Net increase in deferred income
tax benefit $ (103) $ (187) $ (164)
====== ===== =====
The net deferred tax assets arising from temporary differences as of
December 31 are summarized as follows(in thousands of dollars):
2004 2003
Deferred Tax Assets:
Provision for loan losses $ 645 $ 665
Insurance commissions 50 56
Sale of loans 5 8
Deferred compensation 740 625
Pension obligation 94 91
Unrealized loss on securities
available for sale 11
Other 7
-------- --------
Total Assets 1,552 1,445
-------- --------
Deferred Tax Liabilities:
-------------------------
Unrealized gain on securities
available for sale 81
Accretion income 18 15
Depreciation 487 476
--------- --------
Total Liabilities 505 572
--------- --------
Net Deferred Tax Asset $ 1,047 $ 873
========= ========
45
Notes to Consolidated Financial Statements
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:
2004 2003 2002
---- ---- ----
Amounts at federal statutory rates $ 1,617 $ 1,103 $ 1,258
Additions (reductions) resulting
from:
Tax-exempt income (78) (109) (116)
Partially exempt income (41) (35) (30)
State income taxes, net 147 110 128
Income from life insurance
contracts (94) (83) (89)
Other 26 28
--------- -------- --------
Income tax expense $ 1,551 $ 1,012 $ 1,179
======== ======== ========
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. Employer
contributions are vested over a 6 year period.
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.
The bank was required to make a contribution in 2004 and will be required to
make a contribution in 2005 due to the inability of the investment portfolio in
recent years to meet its expected return, The Bank has recognized liabilities of
$461,000 at December 31, 2004 as a result of this shortfall. This has resulted
in a cumulative decrease in other comprehensive income of $176,000 (which is net
of an income tax effect of $104,000) and an intangible asset of $35,000.
The following table provides a reconciliation of the changes in the defined
benefit plan's obligations and fair value of assets over the two year period
ended December 31, 2004 (in thousands of dollars):
2004 2003
Change in Benefit Obligation
Benefit obligation, beginning $ 2,390 $ 2,027
Service cost 111 93
Interest cost 164 143
Actuarial loss 135 163
Benefits paid, plus interest weighted
for timing (57) (37)
- -
Benefit obligation, ending $ 2,743 $ 2,390
====== ======
Accumulated Benefit Obligation $ 2,229 $ 2,012
====== ======
46
Notes to Consolidated Financial Statements
NOTE 13 EMPLOYEE BENEFITS (CONTINUED):
2004 2003
Change in Plan Assets
Fair value of assets, beginning $ 1,621 $ 1,472
Actual return on assets 145 186
Employer contributions 85
Benefits paid (55) (37)
Administrative expenses (28)
------ ------
Fair value of assets, ending $ 1,768 $ 1,621
====== ======
Funded Status
Fair value of plan assets $ 1,768 $ 1,621
Projected benefit obligation (2,743) (2,389)
------ ------
Funded status (975) (769)
Unrecognized prior service cost 35 46
Unrecognized net loss 796 628
Unfunded accumulated
benefit obligation (317) (297)
------ ------
Accrued benefit cost included
in other liabilities $ (461) $ (391)
====== ======
The following table provides the components of the net periodic benefit
cost for the plan for the years ended December 31, 2004, 2003 and 2002 (in
thousands of dollars):
2004 2003 2002
---------------------------
Service Cost $ 114 $ 93 $ 85
Interest Cost 162 143 126
Expected return on plan assets (166) (165) (166)
Amortization of net obligation
at transition (9) (15)
Recognized net actuarial gain 14
Amortization of prior service cost 11 11 11
----- ------ ------
Net periodic benefit cost $ 134 $ 73 $ 41
===== ====== ======
The weighted-average asumptions used in the measurement of The Grant County
Bank's benefit obligation and net periodic benefit costs are as follows:
2004 2003 2002
---- ---- ----
Discount rate 6.50% 7.00% 7.25%
Expected return on plan assets 8.50% 4.00% 4.25%
Rate of compensation increase 3.50% 8.50% 8.50%
The plan sponsor selects the expected long-term rate of return on assets
assumption in consultation with their advisors and the plan actuary. This rate
is intended to reflect the average rate of earnings expected to be earned on the
funds invested or to be invested to provide plan benefits. Historical
performance is reviewed, especially with respect to real rate of return (net of
inflation) for the major asset classes held or anticipated to be held by the
trust. Undue weight is not given to recent experience, which may not continue
over the measurement period, with higher significance placed on current
forecasts of future long-term economic conditions.
47
Notes to Consolidated Financial Statements
NOTE 13 EMPLOYEE BENEFITS (CONTINUED):
The following table provides the pension plan's asset allocation as of
December 31:
2004 2003
Equity securities 72% 70%
Debt securities 23% 26%
Other 5% 4%
The trust fund is sufficiently diversified to maintain a reasonable level
of risk without imprudently sacrificing return. The with a targeted asset
allocation and allowable range of allocation is set forth in the table below:
Target Allowable Allocation
Allocation Range
Equity securities 75% 40-80%
Debt securities 20% 20-40%
Other 5% 3-10%
The Investment Manager selects investment fund managers with demonstrated
experience and expertise, and funds with demonstrated historical performance,
for the implementation of the Plan's investment strategy. The Investment Manager
will consider both actively and passively managed investment strategies and will
allocate funds across the asset classes to develop an efficient investment
structure.
The Grant County Bank also maintains a profit sharing plan covering
substantially all employees to which contributions are made at the discretion of
the Board of Directors. Plan contributions by the employer are fully vested in
the year of contribution.
The Company has established an employee stock ownership plan which provides
stock ownership to all employees of the Company. The Plan provides total vesting
upon the attainment of seven years of service. Contributions to the plan are
made at the discretion of the Board of Directors and are allocated based on the
compensation of each employee relative to total compensation paid by the
Company. All shares held by the Plan are considered outstanding in the
computation of earnings per share. Shares of Company stock, when distributed,
will have restrictions on transferability.
Employer contributions related to the above pension plans charged to
operations totaled $434,000 in 2004, $279,000 in 2003 and $232,000 in 2002.
NOTE 14 TRANSACTIONS WITH RELATED PARTIES:
During the year, officers and directors (and companies controlled by them)
of the Company and subsidiary banks were customers of and had transactions with
the subsidiary Banks in the normal course of business. These transactions were
made on substantially the same terms as those prevailing for other customers and
did not involve any abnormal risk. The aggregate payoff amount of loans to
related parties of $3,773,000 at December 31, 2003 was increased during 2004 by
$1,167,000 as a result of new loans and reduced $857,000 by payments. The
balance of loans to related parties was $4,083,000 at December 31, 2004. Other
changes in balances represent additions to, deletions from or changes in
executive officer or director status.
48
Notes to Consolidated Financial Statements
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
$249,000,000 loans held by the Company at December 31, 2004, $180,000,000 is
secured by real estate.
The Banks had cash deposited in and federal funds sold to other commercial
banks totaling $8,036,000 at December 31, 2004.
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 (in thousands of
dollars):
2004 2003
Commitments to extend credit $ 15,158 $ 16,041
Standby letters of credit 186 136
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 the extension of credit, is based on
management's credit evaluation of the borrower. Collateral held varies but may
include accounts receivable, inventory, property, plant and equipment.
NOTE 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.
49
Notes to Consolidated Financial Statements
NOTE 17 DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED):
The following methods and assumptions were used to estimate the fair value
of each class of financial instruments for which it is practicable to estimate
that value:
Cash, Due from Banks and Money Market Investments
The carrying amount of cash, due from bank balances, interest bearing
deposits and federal funds sold is a reasonable estimate of fair value.
Securities
Fair values of securities are based on quoted market prices or dealer
quotes. If a quoted market price is not available, fair value is estimated
using quoted market prices for similar securities.
Loans
The fair value of loans is estimated by discounting the future cash flows
using the current rates at which similar loans would be made to borrowers
with similar credit ratings and for the same remaining maturities, taking
into consideration the credit risk in various loan categories.
Deposits
The fair value of demand, interest checking, regular savings and money
market deposits is the amount payable on demand at the reporting date. The
fair value of fixed maturity certificates of deposit is estimated using the
rates currently offered for deposits of similar remaining maturities.
Long Term Debt
The fair value of fixed rate loans is estimated using the rates currently
offered by the Federal Home Loan Bank Bank for indebtedness with similar
maturities.
Short Term Debt
The fair value of short term variable rate debt is deemed to be equal to
the carrying value.
Interest Payable and Receivable
The carrying value of amounts of interest receivable and payable is a
reasonable estimate of fair value.
Life Insurance
The carrying amount of life insurance contracts is assumed to be a
reasonable fair value. Life insurance contracts are carried on the balance
sheet at their redemption value as of December 31, 2004. 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, 2004 or 2003.
50
Notes to Consolidated Financial Statements
NOTE 17 DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED):
The carrying amount and estimated fair values of financial instruments as
of December 31, 2004 and 2003 are as follows (in thousands of dollars):
2004 2003
---- ----
Estimated Estimated
Carrying Fair Carrying Fair
Amount Value Amount Value
Financial Assets:
Cash and due from banks $ 6,187 $ 6,187 $ 7,214 $ 7,214
Interest bearing deposits 651 651 1,187 1,187
Federal funds sold 4,006 4,006 16,718 16,718
Securities held to maturity 1,162 1,187 1,366 1,437
Securities available for sale 24,702 24,702 32,631 32,631
Other investments 1,165 1,165 933 933
Loans, net 245,987 247,228 224,172 226,635
Interest receivable 1,436 1,436 1,718 1,718
Life insurance contracts 5,809 5,809 5,558 5,558
Financial Liabilities:
Demand and savings
deposits 112,864 112,733 105,034 105,034
Time deposits 141,527 147,320 157,651 169,037
Short term debt 2,000 2,000
Long term debt 8,377 8,085 5,295 5,495
Interest payable 396 396 605 605
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.
51
Notes to Consolidated Financial Statements
NOTE 18 REGULATORY MATTERS (CONTINUED):
Quantitative measures established by regulation to ensure capital adequacy
require the Company to maintain minimum amounts and ratios (set forth in the
table below) of total and Tier I capital (as defined in the regulations) to
risk-weighted assets (as defined), and of Tier I capital (as defined) to average
assets (as defined). The Company meets all capital adequacy requirements to
which it is subject and as of the most recent examination, the Company was
classified as well capitalized.
To be categorized as well capitalized the Company must maintain minimum
total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in
the table. There are no conditions or events that management believes have
changed the Company's category from a well capitalized status.
The Company's actual capital ratios are presented in the following table:
Actual (in thousands) Regulatory Requirements
December 31,
2004 2003 Adequately Well
$ % $ % Capitalized Capitalized
Total Risk Based Capital Ratio
Highlands Bankshares $33,120 14.71% $31,095 14.55% 8.00% None
Capon Valley Bank 12,208 12.82% 10,651 11.93% 8.00% 10.00%
The Grant County Bank 20,097 15.68% 17,152 13.89% 8.00% 10.00%
Tier1 Leverage Ratio
Highlands Bankshares 30,590 10.14% 28,632 9.42% 3.00% None
Capon Valley Bank 11,020 8.57% 9,535 7.31% 3.00% 5.00%
The Grant County Bank 18,754 11.01% 15,814 9.05% 3.00% 5.00%
Tier 1 Risk Based Capital Ratio
Highlands Bankshares 30,590 13.58% 28,632 13.40% 4.00% None
Capon Valley Bank 11,020 11.57% 9,535 10.60% 4.00% 6.00%
The Grant County Bank 18,745 14.64% 15,814 12.81% 4.00% 6.00%
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, HBI Life Insurance Company is subject to certain capital
requirements and dividend restrictions. At present, HBI Life is well within any
capital limitations and no conditions or events have occurred to change this
capital status, nor does management except any such occurrence in the
foreseeable future.
52
Notes to Consolidated Financial Statements
NOTE 19 CHANGES IN OTHER COMPREHENSIVE INCOME
The components of change in other comprehensive income and related tax
effects are as follows (in thousands of dollars):
Years Ended December 31,
2004 2003 2002
---- ---- ----
Beginning Balance January 1 $ (24) $ 220 $ 283
Unrealized holding gains (losses)
on available for sale securities
net of income taxes of $92,000,
$(82,800) and $ 5,143 2004, 2003
and 2002 respectively (176) (159) 9
Accrued pension obligation net
of income taxes of $11,571,
$50,188, and $42,558 in 2004,
2003 and 2002 respectively (19) (85) (72)
----- ----- -----
Net change for the year (195) (244) (63)
----- ----- -----
Ending balance December 31 $ (219) $ (24) $ 220
===== ===== =====
NOTE 20 FOURTH QUARTER ADJUSTMENTS:
Certain income and expenses related to employee post retirement benefits
are estimated throughout the year based upon information available during the
year. Specific required amounts needed to adjust to actual income and expenses
for these post retirement benefits are not available until December. Therefore,
annual adjustments to expenses related to these benefits are made in the fourth
quarter of each year. The net effect of these adjustments during the fourth
quarter of 2004 was to reduce pretax income by $71,000.
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 $78,000 or $49,000 on an after tax basis.
Also in the fourth quarter of 2003, 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 had 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.
53
Notes to Consolidated Financial Statements
NOTE 21 PARENT CORPORATION ONLY FINANCIAL STATEMENTS:
BALANCE SHEETS
(in thousands of dollars)
December 31,
2004 2003
---------------------
Assets
Cash $ 156 $ 172
Investment in subsidiaries 31,536 29,505
Income taxes receivable 58 508
Other assets 34 22
------- ------
Total Assets $ 31,784 $30,207
======= ======
Liabilities
Accrued expenses $ 75 $ 121
Due to subsidiaries 54 537
------- ------
Total Liabilities 129 658
------- ------
Stockholders' Equity
Common stock, par value $5 per
share 3,000,000 issued, 1,436,874
Outstanding 7,184 7,184
Surplus 1,662 1,662
Retained earnings 23,028 20,727
Other accumulated
Comprehensive loss (219) (24)
------- ------
Total Stockholders' Equity 31,655 29,549
------- -------
Total Liabilities and
Stockholders' Equity $ 31,784 $ 30,207
======= =======
54
Notes to Consolidated Financial Statements
NOTE 21 PARENT CORPORATION ONLY FINANCIAL STATEMENTS (CONTINUED):
STATEMENTS OF INCOME AND RETAINED EARNINGS
Years Ended December
2004 2003 2002
---- ---- ----
Income
Dividends from subsidiaries $ 940 $ 905 $ 2,137
------- ------ -------
Total 940 905 2,137
------- ------ -------
Expenses
Salary and benefits expense 155 145 190
Professional fees 82 39 36
Directors' fees 62 55 43
Other expense 83 89 70
------- ------- --------
Total 382 328 339
------- ------ -------
Net income before income tax benefit
and undistributed subsidiary net
income (deficit) 558 577 1,798
Income Tax Benefit 142 115 133
------- ------ -------
Income before undistributed
subsidiary net income 700 692 1,931
Undistributed subsidiary
net income 2,506 1,541 591
------- ------ -------
Net Income $ 3,206 $ 2,233 $ 2,522
======= ====== =======
Retained earnings,
beginning of period $ 20,727 $19,298 $ 24,174
Dividends paid in cash (905) (804) (738)
Stock split (4,790)
Treasury stock retired (1,870)
Net income 3,206 2,233 2,522
------- ------ -------
Retained earnings,
end of period $ 23,028 $20,727 $ 19,298
======= ====== =======
55
Notes to Consolidated Financial Statements
NOTE 21 PARENT CORPORATION ONLY FINANCIAL STATEMENTS (CONTINUED):
STATEMENTS OF CASH FLOWS
Years Ended December
2004 2003 2002
---- ---- ----
Cash flows from operating activities:
Net Income $ 3,206 $ 2,233 $ 2,522
Adjustments to net income
Undistributed subsidiary
income (2,506) (1,541) (591)
Depreciation 2 2
Loss on investment 15
Increase (decrease) in payables (46) 112 85
(Increase) decrease in receivables 450 (256) (122)
(Increase) decrease in other assets (13) 15 (15)
------ ------ -------
Net cash provided by operating
activities 1,091 565 1,896
------- ------ -------
Cash flows from investing activities:
Advances from (payments to)
subsidiaries (483) 289 79
Received from subsidiaries 281
------- ------ -------
Net cash provided by (used in)
investing activities (202) 289 79
------- ------ -------
Cash flows from financing activities:
Dividends paid in cash (905) (804) (738)
Purchase of treasury stock (1,217)
------- ------ -------
Net cash used in
financing activities (905) (804) (1,955)
Net increase (decrease) in cash (16) 50 20
Cash, beginning of year 172 122 102
------- ------ -------
Cash, end of year $ 156 $ 172 $ 122
======= ====== =======
56
REPORT OF INDEPENDENT REGISTERED
PUBLIC ACCOUNTING FIRM
The Stockholders and Board of Directors
Highlands Bankshares, Inc.
Petersburg, West Virginia
We have audited the accompanying consolidated balance sheets of Highlands
Bankshares, Inc. and subsidiaries as of December 31, 2004 and 2003, and the
related consolidated statements of income, changes in stockholders' equity and
cash flows for the three years ended December 31, 2004. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. 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, 2004 and 2003, and the
results of their operations and their cash flows for the three years ended
December 31, 2004, in conformity with U.S. generally accepted accounting
principles.
S. B. Hoover & Company, L.L.P.
February 22, 2005
Harrisonburg, Virginia
57
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure
None
Item 9A. Controls and Procedures
The Company's management, with the participation of the Company's Chief
Executive Officer and Chief Financial Officer, has evaluated the effectiveness
of the Company's disclosure controls and procedures as of December 31, 2004.
Bases on this evaluation, the Company's Chief Executive Officer and Chief
Financial Officer concluded that the Company's disclosure controls and
procedures are effective as of December 31, 2004.
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 in an
effort to reasonably ensure that fraudulent activity of either an amount
material to these results or in any amount is not occurring. In addition to
these controls and review by executive officers, the Company retains the
services of 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.
Item 9B. Other Information
None
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
"COMPLIANCE WITH SECTION 16(A) OF THE SECURITIES EXCHANGE ACT" of our 2005 Proxy
Statement, to be filed within 120 days after the end of the Company's fiscal
year end, and is incorporated herein by reference.
Item 11. Executive Compensation
Information required by this item is set forth under the caption "EXECUTIVE
COMPENSATION" of our 2005 Proxy Statement, to be filed within 120 days after the
end of the Company's fiscal year end, and is incorporated herein by reference.
58
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 2005 Proxy
Statement, to be filed within 120 days after the end of the Company's fiscal
year end, and is incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions
Information required by this item is set forth under the caption "Certain
Related Transactions" of our 2005 Proxy Statement, to be filed within 120 days
after the end of the Company's fiscal year end, and is incorporated herein by
reference.
Most of the directors, partnerships of which they may be general partners
and corporations of which they are officers or directors, maintain normal
banking relationships with the Bank. Loans made by the Bank to such persons or
other entities were made in the ordinary course of business, were made, at the
date of inception, on substantially the same terms, including interest rates and
collateral, as those prevailing at the time for comparable transactions with
other persons, and did not involve more than normal risk of collectibility or
present other unfavorable features. See Note 14 of the consolidated financial
statements.
John VanMeter is a partner with the law firm of VanMeter and VanMeter,
which has been retained by the Company as legal counsel and it is anticipated
that the relationship will continue. Jack H. Walters is a partner with the law
firm of Walters, Krauskopf & Baker, which provides legal counsel to the Company
and it is anticipated that the relationship will continue.
Item 14. Principal Accountant's Fees and Services
Information required by this item is set forth under the caption "FEES OF
INDEPENDENT PUBLIC ACCOUNTANTS" of our 2005 Proxy Statement, to be filed within
120 days after the end of the Company's fiscal year end, and is incorporated
herein by reference.
59
Part IV
Item 15. Exhibits and Financial Statement Schedules
A) Financial Statements:
(1) Financial Statements: Reference is made to Part II, Item 8 of
this Annual Report on Form 10-K.
(2) Financial Statement Schedules: These schedules are omitted as
the required information is inapplicable or the information is
presented in the consolidated financial statements or related notes.
(3) See Exhibits below.
Exhibit No. Description
3 (i) Articles of Incorporation of Highlands
Bankshares, Inc. are incorporated by reference to
Appendix C to Highlands Bankshares, Inc.'s Form S-4
filed October 20, 1986.
Amendments to the original Articles of Incorporation
are incorporated by reference; filed as Exhibit 3(i)
with 1997 10-KSB.
3 (ii) Bylaws of Highlands Bankshares, Inc. are
incorporated by reference to Appendix D to Highland
Bankshares, Inc.'s Form S-4 filed October 20, 1986.
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.
14 Code of Ethics is incorporated by reference to
Exhibit 14 to Highlands Bankshares, Inc.'s Form
10-K filed March 30, 2004
21 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 pursuant
to Section 1350 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer pursuant to
Section 1350 of the Sarbanes-Oxley Act of 2002.
A) See (A)(3) above.
B) See (A)(1) and (A)(2) above.
60
Signatures
Pursuant to the requirements 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.
/s/ C.E. Porter /s/ R. Alan Miller
- ----------------------------------- -----------------------
C.E. Porter R. Alan Miller
President & Chief Executive Officer Chief Financial Officer
Date: March 24, 2005 Date: March 24, 2005
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and as of the date indicated.
Signature Title Date
/s/ Leslie A. Barr March 31, 2005
- -----------------------
Leslie A. Barr Director
/s/ Jack H. Walters March 31, 2005
- -----------------------
Jack H. Walters Director
/s/ Thomas B. McNeill, Sr. March 31, 2005
- -----------------------
Thomas B. McNeill, Sr. Director
/s/ L. Keith Wolfe March 31, 2005
- -----------------------
L. Keith Wolfe Director
/s/ Kathy G. Kimble March 31, 2005
- -----------------------
Kathy G. Kimble Director
/s/ Steven C. Judy March 31, 2005
- -----------------------
Steven C. Judy Director
/s/ Courtney R. Tusing March 31, 2005
- -----------------------
Courtney R. Tusing Director
/s/ John G. Van Meter Director March 31, 2005
- -----------------------
John G. Van Meter Chairman of the Board
/s/ Alan L. Brill Director March 31, 2005
- -----------------------
Alan L. Brill Secretary of the Company
/s/ C. E. Porter Director March 24, 2005
- -----------------------
C. E. Porter President and Chief Executive Officer
Treasurer of the Company