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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-Q

[X] Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2004

[   ] Transition Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the transition period from ____________ to _____________

Commission file number:  0-27622

HIGHLANDS BANKSHARES, INC.

(Exact Name of Registrant as Specified in its Charter)

Registrant’s telephone number, including area code:  (276) 628-9181

Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.)  Yes           No     X  

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date.

2,663,600 shares of common stock, par value $1.25 per share,

outstanding as of  November 12, 2004.

Highlands Bankshares, Inc.

FORM 10-Q

For the Quarter Ended September 30, 2004

INDEX

PART I. FINANCIAL INFORMATION

PAGE

     Item 1.  Financial Statements

          Consolidated Balance Sheets

               September 30, 2004 (Unaudited) and December 31, 2003 (Note 1)

3

          Consolidated Statements of Income (Unaudited)

               for the Three Months and Nine Months Ended

               September 30, 2004 and 2003

4

.

          Consolidated Statements of Cash Flows (Unaudited)

               for the Nine Months Ended

               September 30, 2004 and 2003

5

          Consolidated Statements of Changes in

                Stockholders’ Equity (Unaudited) for the Three Months and

                Nine Months Ended September 30, 2004 and 2003

6-7

Notes to Consolidated Financial Statements (Unaudited)

8-12

    Item 2. Management’s Discussion and Analysis of

                  Financial Condition and Results of Operations

13-16

     Item 3. Quantitative and Qualitative Disclosures About Market Risk

17

     Item 4.  Controls and Procedures

18

PART II.  OTHER INFORMATION

     Item 1.  Legal Proceedings

19

     Item 2.  Unregistered Sales of Equity Securities and

                   Use of Proceeds

19

     Item 3.  Defaults Upon Senior Securities

19

     Item 4.  Submission of Matters to a Vote of Security Holders

19

     Item 5.  Other Information

19

     Item 6.  Exhibits

20

SIGNATURES

21

2

PART I. FINANCIAL INFORMATION

 ITEM 1.  FINANCIAL STATEMENTS

Consolidated Balance Sheets

(Amounts in thousands)

See accompanying Notes to Consolidated Financial Statements

3

Consolidated Statements of Income

(Amounts in thousands, except for per share data)

(Unaudited)

See accompanying Notes to Consolidated Financial Statements

4

Consolidated Statements of Cash Flows

(Amounts in thousands)

(Unaudited)

See accompanying Notes to Consolidated Financial Statements

5

Consolidated Statements of Changes in Stockholders’ Equity

(Amounts in thousands)

(Unaudited)

See accompanying Notes to Consolidated Financial Statements

(continued)

6

Consolidated Statements of Changes in Stockholders’ Equity (continued)

(Amounts in thousands)

(Unaudited)

See accompanying Notes to Consolidated Financial Statements

7

Notes to Consolidated Financial Statements

(Unaudited)

Note 1  -  General

The consolidated financial statements of Highlands Bankshares, Inc. (the “Company”) and its wholly-owned subsidiaries, Highlands Union Bank and Highlands Capital Trust I, conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. The accompanying interim period consolidated financial statements are unaudited; however, in the opinion of management, all adjustments consisting of normal recurring adjustments which are necessary for a fair presentation of the consolidated financial statements have been included. The results of operations for the nine months ended September 30, 2004 are not necessarily indicative of results of operations for the full year or any other interim period. The interim period consolidated financial statements and financial information included herein should be read in conjunction with the notes to consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 (the “2003 Form 10-K”).

Note 2  -  Allowance for Loan Losses

A summary of transactions in the consolidated allowance for loan losses for the nine months ended September 30 is as follows (in thousands):

Note 3  -  Income Taxes

Income tax expense for the nine months ended September 30 is different than the amount computed by applying the statutory corporate federal income tax rate of 34% to income before taxes.  The reasons for these differences are as follows (in thousands):

8

Notes to Consolidated Financial Statements

(Unaudited)

Note 4  – Capital Requirements

Regulators of the Company and its subsidiaries, including Highlands Union Bank (the “Bank”), have implemented risk-based capital guidelines which require the maintenance of certain minimum capital as a percent of assets and certain off-balance sheet items adjusted for predefined credit risk factors.  The regulatory minimum for Tier 1 and combined Tier 1 and Tier 2 capital ratios are 4.0% and 8.0%, respectively.  Tier 1 capital includes tangible equity reduced by goodwill and certain other intangibles.  Tier 2 capital includes portions of the allowance for loan losses, not to exceed Tier 1 capital. In addition to the risk-based guidelines, a minimum leverage ratio (Tier 1 capital as a percentage of average total consolidated assets) of 4.0% is required.  This minimum may be increased by at least 1.0% or 2.0% for entities with higher levels of risk or that are experiencing or anticipating significant growth.  The following table contains the capital ratios for the Company and the Bank at September 30, 2004.

Note 5 - Capital Securities

The Company completed a $7.5 million capital issue of trust preferred debt securities on January 23, 1998.  These securities were issued by Highlands Capital Trust, a wholly owned subsidiary of the Company, at a price per share of $25.00.  These securities were issued at a 9.25% fixed rate with a 30 year term and a 10 year call provision at the Company’s discretion. This capital was raised to meet current and future opportunities of the Company. During the first quarter of 2003, the Company received regulatory approval to re-purchase 48,000 shares or 16% of these securities. The shares were repurchased in April 2003 at a price of $26.15 per share, which is equal to the 2008 call price. As a result, $6.3 million par value of trust preferred securities are outstanding and are eligible to be included in Tier 1 or Tier 2 capital of the Company.

Note 6 – Earnings Per Share

The following table contains information regarding the Company’s computation of basic earnings per share and diluted earnings per share for the nine months ended September 30, 2004 and 2003.

The number of shares used for the calculation of diluted earnings per share include unexercised stock options that may be exercised immediately for 175,958 and 156,611 shares of common stock at September 30, 2004 and 2003, respectively.

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Notes to Consolidated Financial Statements

(Unaudited)

Note 7 – Dividend Reinvestment and Stock Purchase Plan

On March 1, 2002 the Company initiated a Dividend Reinvestment and Stock Purchase Plan for its shareholders. The Plan enables shareholders to reinvest their cash dividends to purchase additional shares of the Company’s common stock. Shareholders also have the option to make additional cash purchases of stock ranging from $100 to $5,000 per quarter. Shares in the Plan, which covers 50,000 shares of common stock, are purchased in the open market or directly from the Company. The Plan has been widely accepted by the shareholder base.

Note 8 – Commitments and Contingencies

The Bank is party to various financial instruments with off-balance sheet risk arising in the normal course of business to meet the financing need of its customers. Those financial instruments include commitments to extend credit and standby letters of credit. Those commitments include: standby letters of credit of approximately $3.30 million; equity lines of credit of $7.49 million; credit card lines of credit of $1.29 million; other unsecured revolving credit lines of $1.82 million; commercial real estate, construction and land development commitments of $819 thousand; and other unused commitments to fund loans of $19.87 million.

On April 2, 2004 the Bank executed contracts for the purchase and implementation of a check imaging, distributive capture, and teller proof system. The estimated cost for the entire project is approximately $1.1 million. As of September 30, 2004, the basic imaging and distributive capture systems were fully implemented. Additional ancillary components related to the imaging system will be installed over the next three to four months. Management anticipates the teller proof system will be implemented over the next six to 12 months.

As of September 30, 2004 the Company had begun construction of a two-story addition to its property located at 250 W. Valley Street in Abingdon, Virginia. The addition will add approximately 3,600 square feet at an approximate cost of $250,000. The property currently houses IT-related departments and personnel.

Note 9 – Summary of Significant Accounting Policies Update For Certain Required Disclosures

The Company has a stock option plan for certain executives and directors accounted for under the intrinsic value method in accordance with Accounting Principles Board (“APB”) Opinion No. 25. Because the exercise price of the Company’s employee / director stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. The effect of option shares on earnings per share relates to the dilutive effect of the underlying options outstanding. To the extent the granted exercise share price was less than the current market price (“in the money”), there would be an economic incentive for the shares to be exercised and an increase in the dilutive effect on earnings per share.

In December 2002, the Financial Accounting Standards Board (“FASB”) issued Financial Accounting Standard (“FAS”) 148, “Accounting for Stock-Based Compensation.” This new standard provides alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based compensation. In addition, the Statement amends the disclosure requirements of FAS 123 to require prominent disclosure in both annual and interim financial statements about the method of accounting for stock-based compensation and the underlying effect of the method used on reported results until exercised.

10

Assuming use of the fair value method of accounting for stock options, pro forma net income and earnings per share for the three and nine month periods ended September 30, 2004 and 2003 would have been estimated as follows:

11

In November 2002, the FASB issued Interpretation No. 45 (FIN 45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” This interpretation expands the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees and requires the guarantor to recognize a liability for the fair value of an obligation assumed under a guarantee. FIN 45 clarifies the requirements of FAS5, “Accounting for Contingencies”, relating to guarantees. In general, FIN 45 applies to contracts or indemnification agreements that contingently require the guarantor to make payments to the guaranteed party based on changes in an underlying value that is related to an asset, liability, or equity security of the guaranteed party. Certain guarantee contracts are excluded from both the disclosure and recognition requirements of this interpretation, including, among others, guarantees relating to employee compensation, residual value guarantees under capital lease arrangements, commercial letters of credit, loan commitments, subordinated interests in a special purpose entity, and guarantees of a company’s own future performance.  

Other guarantees are subject to the disclosure requirements of FIN 45 but not to the recognition provisions and include, among others, a guarantee accounted for as a derivative instrument under FAS 133, a parent company’s guarantee of debt owed to a third party by its subsidiary or vice versa, and a guarantee that is based on performance rather than price. FIN 45 requires disclosure of the nature of the guarantee, the maximum potential amount of future payments that the guarantor could be required to make under the guarantee, and the current amount of the liability, if any, for the guarantor’s obligations under the guarantee.  The requirements of FIN 45 did not have a material impact on the Company’s results of operations, financial position, or liquidity in the first nine months of 2004.

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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis is provided to address information about the Company’s financial condition and results of operations that is not otherwise apparent from the Consolidated Financial Statements included in this report.  Reference should be made to those statements for an understanding of the following discussion and analysis.

Critical Accounting Policies

General

The financial condition and results of operations presented in the Consolidated Financial Statements, accompanying Notes to Consolidated Financial Statements and management’s discussion and analysis are, to a large degree, dependent upon the accounting policies of the Company.  The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change.  

Presented below is a discussion of those accounting policies that management believes are the most important to the portrayal and understanding of the Company’s financial condition and results of operations.  These critical accounting policies require management’s most difficult, subjective and complex judgments about matters that are inherently uncertain.  In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.  See also Note 1 of the Notes to Consolidated Financial Statements in the 2003 Form 10-K.

Allowance for Loan Losses

The Company monitors and maintains an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio.  The Company maintains policies and procedures that address the systems of controls over the following areas of maintenance of the allowance: the systematic methodology used to determine the appropriate level of the allowance to provide assurance the systems are maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan portfolio; and the loan grading system.

The Company’s Credit Review and Analysis Department evaluates various loans individually for impairment as required by Statement of Financial Accounting Standards (“SFAS”) No. 114, Accounting by Creditors for Impairment of a Loan, and SFAS No. 118, Accounting by Creditors for Impairment of a Loan – Income Recognition and Disclosures.  Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by management.  The evaluations are based upon discounted expected cash flows or collateral valuations.  If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment.  If a loan evaluated individually is not impaired, then the loan is assessed for impairment under SFAS No. 5, Accounting for Contingencies, with a group of loans that have similar characteristics.

For loans without individual measures of impairment, the Company makes estimates of losses for groups of loans as required by SFAS No. 5.  Loans are grouped by similar characteristics, including the type of loan, the assigned loan grade and the general collateral type.  A loss rate reflecting the expected loss inherent in a group of loans is derived based upon estimates of default rates for a given loan grade, the predominant collateral type for the group and the terms of the loan.  The resulting estimate of losses for groups of loans are adjusted for relevant environmental factors and other conditions of the portfolio of loans, including:  borrower and industry concentrations; levels and trends in delinquencies, charge-offs

13

and recoveries; changes in underwriting standards and risk selection; level of experience, ability and depth of lending management; and national and local economic conditions.  

The amounts of estimated impairment for individually evaluated loans and groups of loans are added together for a total estimate of loans losses.  This estimate of losses is compared to the allowance for loan losses of the Company as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made.  If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates.  If the estimate of losses is below the range of reasonable estimates, the allowance would be reduced by way of a credit to the provision for loan losses.  The Company recognizes the inherent imprecision in estimates of losses due to various uncertainties  and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high.  If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the Consolidated Financial Statements.  

Results of Operations

Results of operations for the three-month and nine-month periods ended September 30, 2004 reflected net income of $1.16 million and $3.56 million, respectively, an increase of 5.23% and 4.03% over the corresponding periods in 2003. This increase was in part due to the Bank’s ability to maintain a net interest margin that approximated the prior year’s margin as well as a decrease in its provision for loan loss reserve over the prior year. During the last three years, the Bank has been in a liability sensitive position. Over this time period, the Bank’s interest-bearing liabilities have been repricing at a quicker pace than its interest-earning assets as interest rates have fallen. This trend has slowed over the past few months. Total interest income for the nine months ended September 30, 2004 was approximately $242 thousand less than the comparable 2003 period due to new loan and investment securities volume being recorded at lower  rates and existing adjustable rate loans and investment securities repricing down to lower rates. The Company’s total interest expense decreased for the nine months ended September 30, 2004, compared to the comparable 2003 period, by approximately $874 thousand due to new interest-bearing deposits being recorded at lower rates and existing interest-bearing deposits repricing lower as they mature or reprice. Provisions for possible loan losses decreased $365 thousand for the nine months ended September 30, 2004 compared to the comparable 2003 period. Operating results of the Company when measured as a percentage of average equity reveals a slight decrease in return on average equity for the nine-month period ended September 30, 2004,  to 13.00% from 13.33% for the corresponding period in 2003.

Return on average assets of 0.86% for the nine months ended September 30, 2004 reflects a decrease from 0.88% for the comparable 2003 period.

Net interest income for the three-month and nine-month periods ended September 30, 2004 increased 2.63% and 5.13%, respectively, or approximately $110 thousand and $632 thousand as compared to the corresponding 2003 periods.  Average interest-earning assets increased approximately $35.62 million from the nine- month period ended September 30, 2003 to the same period in 2004 while average interest-bearing liabilities increased $31.02 million over the same periods. The tax-equivalent yield on average interest-earning assets was 5.95% for the nine-month period ended September 30, 2004 representing a decrease of 37 basis points over the yield of 6.32% for the same period in 2003.  The yield on average interest-bearing liabilities decreased 48 basis points to 2.66% for the nine month period ended September 30, 2004 as compared to 3.14% for the same period in 2003.

The provisions for possible loan losses for the three-month and nine-month periods ended September 30, 2004 totaled $373 thousand and $1.06 million, respectively, a $74 thousand and $365 thousand decrease from the corresponding periods in 2003. These decreases in the provision for possible loan losses are due

14

to both a reduced level of charge-offs during 2004 as well as slower loan growth compared to the prior period. Loan growth totaled $15.05 million in the first nine months of 2004 compared to $29.01 million of loan growth in the first nine months of 2003. The Company continually monitors the loan portfolio for signs of credit weaknesses or developing collection problems. The Company reengineered its credit review and analysis areas during 2004 with increased additional staffing and improved loan evaluation and tracking tools. This reengineering was a result of the increased growth into new market areas as well as the increased complexity relating to the lending function. Loan loss provisions for each period are determined after evaluating the loan portfolio and determining the level necessary to absorb current charge-offs and maintain the reserve at adequate levels.  Net charge-offs for the first nine months of 2004 were $966 thousand compared with $1.12 million for the first nine months of 2003. Year–to–date net charge-offs were 0.25% and 0.30% of total loans for the periods ended September 30, 2004 and September 30, 2003, respectively. Loan loss reserves increased 12.72% to $4.37 million at September 30, 2004 from the $4.18 million at September 30, 2003.  The Company’s allowance for loan loss reserves at September 30, 2004 decreased  to 1.11% of total loans versus 1.14% at September 30, 2003.  At December 31, 2003, the allowance for loan loss reserve as a percentage of total loans was 1.13%.    

Financial Position

Total loans have increased from $368.53 million at September 30, 2003 to $392.85 million at September 30, 2004. For the nine-month period ended September 30, 2004, total loans have increased $15.05 million. The loan to deposit ratio has increased from 80.80% at September 30, 2003 to 84.34% at September 30, 2004. The loan to deposit ratio at December 31, 2003 was 83.96%. The main reasons for the increase in the loan to deposit ratio are both an increase in customer deposit competition as well as stronger loan demand in the third quarter of 2004. Investor confidence still however seems to be somewhat cautious, and it appears that individual investors are now only gradually moving their funds back into stock and other equity instruments. Deposits at September 30, 2004 show an increase of $15.76 million since December 31, 2003 and $9.66 million since September 30, 2003. Consumers have continued to invest their monies primarily in savings and checking accounts due to the continued market uncertainty. Likewise, with the less favorable economic environment, customers are not borrowing money as readily as they have in past years. The majority of the Company’s loan growth for the first nine months of 2004 has primarily been in real estate secured loans.  Loan demand continues at a moderate pace even during a period of economic uncertainty and within a competitive market area.

Non-performing assets are comprised of loans on non-accrual status, loans contractually past due 90 days or more and still accruing interest, other real estate owned and repossessions.  Non-performing assets were $6.58 million or 1.68% of total loans at September 30, 2004 compared with $4.96 million or 1.31% of total loans at December 31, 2003 and $6.46 million or 1.75% of total loans at September 30, 2003. This increase in non-performing assets at September 30, 2004 can be attributed in large part to less favorable economic conditions within the Company’s primary market areas. The downturn in the economy has resulted in a number of plant layoffs and downsizings that have contributed to this increase in non-performing assets.

Securities and other investments totaled approximately $133.68 million (market value) at September 30, 2004, which reflected an increase of $8.71 million or 6.97% from the December 31, 2003 total of $124.96 million. The majority of the Company’s investment purchases during the nine-month period were tax-exempt municipals, pooled trust preferred issues and adjustable rate mortgage-backed securities. Investment securities available for sale at September 30, 2004 were comprised of mortgage backed securities (approximately 46.63% of the total securities portfolio), municipal issues (approximately 35.65%), collateralized mortgage obligations (CMO’s) (approximately 0.02%), corporate bonds (approximately 5.87%), SBA backed securities and asset-backed securities (approximately 0.16%), U. S. government agencies (approximately 1.69%), and equity securities (approximately 7.33%).  The Company’s entire securities portfolio was classified as available for sale at both September 30, 2004 and 2003. Other investments at the Bank level include holdings of Federal Reserve, Federal Home Loan Bank and Community Bankers’ Bank stock. These investments (carrying value of $3.52 million and

15

approximately 2.64% of the total investment portfolio) are considered to be restricted as the Company is required to hold these investments and the only market for these investments is the issuing agency. Other investments also include the Company’s equity ownership investment in the Davenport Financial Fund, which is a fund that purchases various bank stocks in the Mid- Atlantic area.

In June 2002, the Bank purchased $7.0 million of Bank-Owned Life Insurance (BOLI) covering the lives of selected officers as well as the Directors of the Bank. The monthly earnings related to the insurance policies will be used to offset future employee benefit costs. An additional $380 thousand of BOLI was purchased during the third quarter of 2002.

In April 2002, the Bank became an equity owner in the Virginia Title Center, LLC, headquartered in Roanoke, Virginia. Virginia Title Center, LLC was formed for the purpose of issuing title insurance and is owned by several Virginia banks. It is anticipated that this investment will generate on-going non-interest income for the Bank.

Liquidity and Capital Resources

Total stockholders’ equity of the Company was $38.51 million at September 30, 2004, representing an increase of $4.40 million or 12.91% over the amount at September 30, 2003.  Total stockholders’ equity at December 31, 2003 was $35.43 million. Liquidity is the ability to provide sufficient cash levels to meet financial commitments and to fund loan demand and deposit withdrawals. The Company maintains a significant level of immediate liquidity in the form of cash and cash equivalents that consists of both cash on hand and balances at correspondent banks ($20.29 million at September 30, 2004) and also investment securities available for sale ($130.15 million).  Cash and cash equivalents are immediately available for satisfaction of deposit withdrawals, customer credit needs, and operations of the Company.  The Company also maintains a significant amount of available credit with both the Federal Home Loan Bank and several correspondent financial institutions. Investment securities available for sale represent a secondary level of liquidity available for conversion to liquid funds in the event of extraordinary needs. The Company also utilizes a national certificate of deposit network to attract longer term funding.Management believes that the Company maintains overall liquidity sufficient to satisfy its depositors’ requirements and meet its customers’ credit needs.

Forward-Looking Information

Certain information contained in this discussion may include “ forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “ Exchange Act”). These forward-looking statements are generally identified by phrases such as “the Company expects,” “the Company believes” or words of similar import. These statements speak only as of the date of this report. The statements are based on current expectations, are inherently uncertain, are subject to risks, and should be viewed with caution. Such forward-looking statements involve known and unknown risks including, but not limited to, changes in general economic and business conditions, interest rate fluctuations, competition within and from outside the banking industry, the ability to continue to attract low cost core deposits to fund asset growth, demand, development and acceptance of new products and services in the banking industry, risk inherent in making loans such as repayment risks and fluctuating collateral values, problems with technology utilized by the Company, changing trends in customer profiles and changes in laws and regulations applicable to the Company. Although the Company believes that its expectations are based upon reliable assumptions within the bounds of its 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.

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ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk (IRR) and Asset Liability Management

The Company’s profitability is dependent to a large extent upon its net interest income (NII), which is the difference between its interest income on interest-bearing assets, such as loans and investments, and its interest expense on interest-bearing liabilities, such as deposits and borrowings. The Company, like other financial institutions, is subject to interest rate risk to the degree that its interest-earning assets reprice differently than its interest-bearing liabilities. The Company manages its mix of assets and liabilities with the goals of limiting its exposure to interest rate risk, ensuring adequate liquidity, and coordinating its sources and uses of funds. Specific strategies for management of interest rate risk (IRR) on the lending side of the balance sheet have included the use of ballooning fixed rate loans and maintaining a significant level of 1, 3 and 5-year adjustable rate mortgages. On the investment side, the Company maintains a significant portion of its portfolio in adjustable rate securities. These strategies help to reduce the average maturity of the Company’s interest-earning assets.

The Company attempts to control its IRR exposure to protect net interest income and net earnings from fluctuations in the general level of interest rates. To measure its exposure to IRR, the Company performs monthly simulations of NII using financial models that project NII through a range of possible interest rate environments including rising, declining, flat and most likely rate scenarios. The results of these simulations indicate the existence and severity of IRR in each of those rate environments based upon the current balance sheet position and assumptions as to changes in the volume and mix of interest-earning assets and interest-bearing liabilities and management’s estimate of yields attainable in those future rate environments and rates which will be paid on various deposit instruments and borrowings. The Company runs these rate shock scenarios for 12 and 24 month projections out from the current month of the model.

Over the past 36 months, management has made a concerted effort to shift a portion of its short-term liablilities to longer-term maturities. This is being done to help maintain a favorable interest spread once interest rates rise in the future.  The Company has been able to achieve this balance sheet restructuring in several ways. Beginning in August 2001, the Company began offering higher than market rates on its 24-month, 36-month, 48-month and 60-month certificates of deposit accounts and individual retirement accounts. Beginning in August of 2004, the Company also been offering a 25 month certificate in which the customer has a one time option to adjust the rate at any time during the term of the certificate. By offering these rates and products, the Company has been able to shift existing customers’ time deposits, as well as attracting new time deposit customers, to longer term maturities. Additionally, the Company has also increased its amount of long term borrowings with the Federal Home Loan Bank as well as attracted some longer term certificates through a national certificate of deposit network known as Qwikrate. The Company has also seen significant increases in its mortgage lending. The increase in this loan category has been primarily in adjustable rate mortgages with one and three-year interest rate resets.

Management also maintains a favorable fixed versus variable asset mix by the blend of securities purchased. Over the last several months, the majority of investments purchased have been adjustable rate mortgage backed securities and municipal bonds. These purchases have provided the Bank with both an acceptable level of return and a satisfactory interest rate risk position.

The earnings sensitivity measurements completed on a monthly basis indicate that the performance criteria against which sensitivity is measured are currently within the Company’s defined policy limits. A more complete discussion of the overall interest rate risk is included in the 2003 Form 10-K.

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ITEM 4. Controls and Procedures

On an on-going basis, senior management monitors and reviews the internal controls established for the Company. Additionally, the Company has created a Disclosure Review Committee to review not only internal controls but the information used by the Company’s financial officers to prepare the Company’s periodic filings with the Securities and Exchange Commission (the “SEC”) and corresponding financial statements. The Committee is comprised of the Senior Management Team of the Bank and meets at least quarterly.  Internal audits conducted by the Company’s internal audit department are also reviewed by senior officers to assist them in assessing the adequacy of the Company’s internal control structure. These audits are also discussed in detail with the Company’s Audit Committee.

We have carried out an evaluation, under the supervision and the participation of our management, including our Executive Vice President and Chief Executive Officer, our Executive Vice President and Chief Operations Officer, our Chief Financial Officer and our Vice President of Accounting, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer, Chief Operating Officer, Chief Financial Officer and Vice President of Accounting concluded that our disclosure controls and procedures are effective in providing reasonable assurance that (a) the information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (b) such information is accumulated and communicated to our management, including our Chief Executive Officer, Chief Operating Officer, Chief Financial Officer and Vice President of Accounting, as appropriate to allow timely decisions regarding required disclosure.

There have not been any changes in the Company’s internal controls over financial reporting during the third quarter of 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1.  Legal Proceedings

None.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3.  Defaults Upon Senior Securities

None

Item 4.  Submission of Matters to a Vote of Security Holders

None

Item 5.  Other Information

None

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Item 6.  

Exhibits

31.1

Rule 13a-14(a) Certification of Executive Vice President and Chief Executive Officer

31.2

Rule 13a-14(a) Certification of Executive Vice President and Cashier

31.3

Rule 13a-14(a) Certification of Chief Financial Officer

31.4

Rule 13a-14(a) Certification of Vice President of Accounting

32.1

Certification Statement of Executive Vice President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350.

32.2

Certification Statement of Executive Vice President and Cashier pursuant to 18 U.S.C. Section 1350.

32.3

Certification Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.

32.4

Certification Statement of Vice President of Accounting pursuant to 18 U.S.C. Section 1350.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

HIGHLANDS BANKSHARES, INC.

 (Registrant)

Date:  November 12, 2004

/s/ Samuel L. Neese                     

Samuel L. Neese

Executive Vice President and

Chief Executive Officer

Date:  November 12, 2004

/s/ James T. Riffe

James T. Riffe

Executive Vice President & Cashier

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Exhibits Index

31.1

Rule 13a-14(a) Certification of Executive Vice President and Chief Executive Officer

31.2

Rule 13a-14(a) Certification of Executive Vice President and Cashier

31.3

Rule 13a-14(a) Certification of Chief Financial Officer

31.4

Rule 13a-14(a) Certification of Vice President of Accounting

32.1

Certification Statement of Executive Vice President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350.

32.2

Certification Statement of Executive Vice President and Cashier pursuant to 18 U.S.C. Section 1350.

32.3

Certification Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.

32.4

Certification Statement of Vice President of Accounting pursuant to 18 U.S.C. Section 1350.