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EX-21 - EXHIBIT 21 - HIGHLANDS BANKSHARES INC /VA/ex21.htm
EX-23.1 - EXHIBIT 23.1 - HIGHLANDS BANKSHARES INC /VA/ex231.htm
EX-31.2 - EXHIBIT 31.2 - HIGHLANDS BANKSHARES INC /VA/ex312.htm
EX-31.3 - EXHIBIT 31.3 - HIGHLANDS BANKSHARES INC /VA/ex313.htm
EX-32.3 - EXHIBIT 32.3 - HIGHLANDS BANKSHARES INC /VA/ex323.htm
EX-32.1 - EXHIBIT 32.1 - HIGHLANDS BANKSHARES INC /VA/ex321.htm
EX-31.1 - EXHIBIT 31.1 - HIGHLANDS BANKSHARES INC /VA/ex311.htm
EX-32.2 - EXHIBIT 32.2 - HIGHLANDS BANKSHARES INC /VA/ex322.htm
10-K - FORM 10-K 12-31-2010 - HIGHLANDS BANKSHARES INC /VA/form10k12312010.htm
Exhibit 13.1


HIGHLANDS BANKSHARES, INC.  AND SUBSIDIARY

CONSOLIDATED FINANCIAL REPORT

DECEMBER 31, 2010












C O N T E N T S


   
Page
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 2
     
Management’s Annual Report on Internal Control over Financial Reporting
 
 3
     
FINANCIAL STATEMENTS
   
  Consolidated Balance Sheets
 
 4
  Consolidated Statements of Income
 
 5
  Consolidated Statements of Stockholders' Equity
 
 6
  Consolidated Statements of Cash Flows
 
 7
  Notes to Consolidated Financial Statements
 
 8 – 38
     
     


 
 

 



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



To the Board of Directors and Stockholders
Highlands Bankshares, Inc.  and Subsidiary
Abingdon, Virginia



We have audited the accompanying consolidated balance sheets of Highlands Bankshares, Inc. and Subsidiary as of December 31, 2010 and 2009, and the related consolidated statements of income, stockholders' equity and comprehensive income, and cash flows for each of the years in the two-year period ended December 31, 2010. Highlands Bankshares, Inc.’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

           In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Highlands Bankshares, Inc. and Subsidiary as of December 31, 2010 and 2009, and the consolidated results of its operations and its cash flows for each of the years in the two-year period ended December 31, 2010 in conformity with accounting principles generally accepted in the United States of America.  

                                                        
CERTIFIED PUBLIC ACCOUNTANTS


Christiansburg, Virginia
March 10, 2011

 
2

 



Management's Annual Report on Internal Control Over Financial Reporting.


Management is responsible for establishing and maintaining adequate internal control over financial reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act).  Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the financial statements.

Because of the inherent limitations in any internal control, no matter how well designed, misstatements may occur and not be prevented or detected.  Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation.  Further, the evaluation of the effectiveness of internal control over financial reporting was made as of a specific date, and continued effectiveness in future periods is subject to the risks that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies and procedures may decline.

Management conducted an evaluation of the effectiveness of our system of internal control over financial reporting as of December 31, 2010 based on the framework set forth in "Internal Control - Integrated Framework" issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Based on its evaluation, management concluded that, as of December 31, 2010, Highlands Bankshares, Inc.’s internal control over financial reporting was effective.


 
3

 

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS
December 31, 2010 and 2009
(Amounts in thousands)

 
 
2010
   
2009
 
        ASSETS
           
 Cash and due from banks
  $ 15,693     $ 14,300  
 Federal funds sold
    66,459       15,037  
                 
                Total Cash and Cash Equivalents
    82,152       29,337  
                 
 Investment securities available-for-sale (Note 3)
    56,096       70,948  
 Other Investments, at cost (Note 4)
    6,026       8,417  
 Loans, net of allowance for loan losses of  $10,320 and
  $11,681 in 2010 and 2009, respectively (Note 5)
    440,274       474,438  
 Premises and equipment, net (Note 6)
    23,509       24,613  
Deferred Tax Assets
    11,887       9,674  
 Interest receivable
    2,544       3,147  
 Bank Owned Life Insurance
    12,777       12,324  
  Other Real Estate Owned
    15,316       6,847  
 Other assets
    4,927       5,562  
                 
                Total Assets
  $ 655,508     $ 645,307  
                 
              LIABILITIES AND STOCKHOLDERS' EQUITY
               
 Deposits (Note 9)
               
  Noninterest bearing
  $ 85,923     $ 84,073  
  Interest bearing
    450,849       435,831  
                 
                Total Deposits
    536,772       519,904  
                 
 Interest, taxes and other liabilities
    1,786       1,950  
 Short term borrowings (Note 10)
    65,952       74,039  
 Long-term debt (Note 11)
    14,968       10,836  
 Capital securities (Note 12)
    3,150       3,150  
                Total Other Liabilities
    85,856       89,975  
                 
                Total Liabilities
    622,628       609,879  
                 
 STOCKHOLDERS' EQUITY
               
 Common stock, 5,011 and 5,011 shares  issued and
   Authorized 40,000 shares, par  value
   $0.625 per share  (Notes 14 and 16)
    3,132       3,132  
  
               
   Retained Earnings
    25,923       28,063  
    Accumulated other comprehensive (loss)
    (3,958 )     (3,550 )
                 
                Total Stockholders' Equity
    32,880       35,428  
                 
                Total Liabilities and Stockholders' Equity
  $ 655,508     $ 645,307  
 
The Notes to Consolidated Financial Statements are an integral part of these statements.

 
4

 

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2010 and 2009
(Amounts in thousands, except per share data)

   
2010
   
2009
 
INTEREST INCOME
           
      Loans receivable and fees on loans
  $ 28,140     $ 30,338  
      Securities available for sale:
               
         Taxable
    854       1,673  
         Tax-exempt
    1,723       2,373  
         Other investment income
    81       80  
      Federal funds sold
    60       10  
            Total Interest Income
    30,858       34,474  
                 
 INTEREST EXPENSE
               
     Deposits
    8,859       11,246  
     Federal funds purchased
    -       6  
     Other borrowed funds
    3,679       4,893  
           Total interest expense
    12,538       16,145  
                 
           Net interest income
    18,320       18,329  
                 
 PROVISION FOR LOAN LOSSES (Note 5)
    4,799       9,614  
                 
           Net interest income after provision for loan losses
    13,521       8,715  
                 
 NON-INTEREST INCOME
               
      Securities gains (losses)
    (163 )     380  
      Service charges on deposit accounts
    2,044       2,225  
      Other service charges, commissions and fees
    1,459       1,354  
      Other operating income
    686       1,683  
      Other than temporary impairment charge
    (1,263 )     (5,621 )
             Total Non-Interest Income
    2,763       21  
                 
 NON-INTEREST EXPENSE
               
      Salaries and employee benefits (Note 15)
    10,073       10,560  
      Occupancy expense of bank premises
    1,176       1,145  
      Furniture and equipment expense
    1,572       1,613  
      Other operating expenses (Note 24)
    5,452       5,662  
      Foreclosed Assets –Write-down and operating expenses
    2,416       1,369  
             Total Non-Interest Expenses
    20,689       20,349  
                 
            (Loss)  Income Before Income Taxes
    (4,405 )     (11,613 )
                 
      Income Tax Benefit (Note 8)
    (2,265 )     (5,234 )
                 
             Net Income (Loss)
  $ (2,140 )   $ (6,379 )      
                 
 Earnings (Loss) Per Common Share (Note 14)
  $ (0.43 )      $ (1.27 )
                 
 Earnings (Loss) Per Common Share - assuming dilution -Note 14 13)
  $ (0.43 )   $ (1.27 )
 
The Notes to Consolidated Financial Statements are an integral part of these statements.

 
5

 


HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Years Ended December 31, 2010 and 2009
(Amounts in thousands)
         
Accumulated
Other
Comprehensive
Income
 
     
Additional
Paid-in
Capital
Retained
Earnings
 Total
Stockholders'
Equity
 
  Common Stock
 
Shares
Par Value
             
Balance, December 31, 2008
5,001
$    3,126
$      7,688
$    34,994
$      (6,760)
$     39,048
             
Comprehensive income:
           
Net income
-
-
-
(6,379)
-
(6,379)
Change in unrealized gain (loss) on securities available-for-sale,
   net of deferred income tax benefit of $77
-
-
-
-
(148)
(148)
Less: reclassification adjustment, net of income tax expense of $1,730
-
-
-
-
3,358
3,358
             
Total comprehensive income
-
-
-
-
-
(3,169)
             
Common stock issued for stock options exercised
10
6
95
-
-
           101
Cash dividend
     
(552)
 
  (552)
             
Balance, December 31, 2009
5,011
$    3,132
$      7,783
$    28,063
$      (3,550)
$     35,428
             
Comprehensive income:
           
Net income
-
-
-
(2,140)
-
(2,140)
Change in unrealized gain (loss) on securities available-for-sale,
  net of deferred income tax benefit of $265
-
-
-
-
(515)
(515)
Less: reclassification adjustment, net of income tax benefit of $56
-
-
-
-
107
107
             
Total comprehensive income
-
-
-
-
-
(2,548)
             
 
-
-
-
-
-
               -
       
              -
 
  -
             
Balance, December 31, 2010
5,011
$    3,132
$      7,783
$    25,923
$      (3,958)
$     32,880









The Notes to Consolidated Financial Statements are an integral part of these statements

 
6

 

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2010 and 2009
(Amount in thousands)

   
2010
   
2009
 
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net income
  $ (2,140 )   $ (6,379 )
Adjustments to reconcile net income to net cash
               
provided by operating activities:
               
Provision for loan losses
    4,799       9,614  
Provision for deferred income taxes
    2,029       (4,210 )
Depreciation and amortization
    1,314       1,342  
Net realized (gains) losses on available-for-sale securities
    163       (380 )
Net amortization on securities
    248       377  
Amortization of capital issue costs
    5       5  
Other than temporary impairment charge
    1,263       5,621  
Valuation adjustment of other real estate owned
    1,739       1,393  
Decrease in interest receivable
    603       551  
(Increase) decrease in other assets
    (3,749 )     (3,460 )
Increase (decrease) in interest, taxes and other
               
  liabilities
    (164 )                   (1,844 )
Net Cash provided by operating activities
    6,110       2,630  
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Securities available for sale:
               
Proceeds from sale of debt and equity securities
    33,479       28,308  
Proceeds from maturities of debt and equity securities
    8,262       25,576  
Purchase of debt and equity securities
    (29,182 )     (18,938 )
Purchase (redemption) of other investments
    2,391       (1,788 )
Net (increase) decrease in loans
    13,976       (4,633 )
Proceeds from sales of other real estate owned
    5,032       1,387  
Proceeds from cash surrender value of Life Insurance
    -       604  
Premises and equipment expenditures
    (166 )     (1,715 )
Net Cash used in investing activities
    33,792       28,801  
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Net increase in certificates of deposit
    (7,549 )     (22,105 )
Net increase in demand, savings and other deposits
    24,417       19,273  
Net increase (decrease) in short term borrowings
    (8,087 )     (1,569 )
Net decrease )decrease) in long-term debt
    4,132       (13,824 )
Cash dividends paid
    -       (552 )
Proceeds from exercise of common stock options
    -       101  
Net Cash provided by financing activities
    12,913       (18,676 )
Net increase in cash and cash equivalents
    52,815       12,755  
                 
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR
    29,337       16,582  
                 
CASH AND CASH EQUIVALENTS AT END OF YEAR
  $ 82,152     $ 29,337  
                 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
               
Cash paid during the year for:
               
Interest
  $ 12,536     $ 17,361  
Income taxes
  $ -     $ 250  
                 
SUPPLEMENTAL DISCLOSSURES OF NONCASH TRANSACTIONS
               
Transfer of loans to other real estate owned
  $ 15,389     $ 5,836  
                 

The Notes to Consolidated Financial Statements are an integral part of these statements

 
7

 

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)


Note  1.                       Summary of Significant Accounting Policies

Basis of Presentation and Consolidation

The accompanying consolidated financial statements include the accounts of Highlands Bankshares, Inc., (the “Parent Company”) and its wholly-owned subsidiary, Highlands Union Bank (the "Bank").  The statements also include Highlands Union Insurance Services, Inc., (the “Insurance Services”), and Highlands Union Financial Services, Inc., (the “Financial Services”) which are both wholly-owned subsidiaries of the Bank.  All significant intercompany balances and transactions have been eliminated in consolidation.  The accounting and reporting policies of Highlands Bankshares, Inc. and Subsidiaries, (the “Company”) conform to U.S. generally accepted accounting principles and to predominate practices within the banking industry.

Nature of Operations

The Company operates in Abingdon, Virginia, and surrounding southwest Virginia, eastern Tennessee, and western North Carolina under the laws of the Commonwealth of Virginia.  The Parent Company was organized on December 29, 1995.  The Parent Company is supervised by the Federal Reserve Bank under the Bank Holding Company Act of 1956, as amended. The Bank began banking operations on April 27, 1985 under a state bank charter and provides a full line of financial services to individuals and businesses.  The Bank’s primary lending products include mortgage, consumer and commercial loans, and its primary deposit products are checking, savings, and certificates of deposit.  As a state bank and a member of the Federal Reserve Bank of Richmond, the Bank is subject to regulation by the Virginia State Bureau of Financial Institutions, the Federal Deposit Insurance Corporation, and the Federal Reserve Bank.  Highlands Capital Trust I became effective January 14, 1998.  The nature of the trust is described more fully in Note 11.  Highlands Union Insurance Services, Inc. became effective October 8, 1999 for the purpose of selling insurance through Bankers Insurance LLC. The only activity in Highlands Union Financial Services is the receipt of life insurance commissions.

Cash and Cash Equivalents

For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash and due from banks and federal funds sold, all of which mature within ninety days. The Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts. The Company believes it is not exposed to any significant credit risk on cash and cash equivalents.

Securities Available-for-Sale

Securities classified as available-for-sale are those debt and equity securities that the Company intends to hold for an indefinite period of time, but not necessarily to maturity.  Any decision to sell a security classified as available-for-sale would be based on various factors, including significant movements in interest rates, changes in the maturity mix of the Company's assets and liabilities, liquidity needs, regulatory capital considerations, and other similar factors.  Securities available-for-sale are carried at fair value.  Unrealized gains or losses are reported as increases or decreases in other comprehensive income, net of the related deferred income tax effect.  Realized gains or losses are included in earnings on the trade date and are determined on the basis of the amortized cost of specific securities sold.  Premiums and discounts are recognized in interest income using the interest method over the period to maturity. On a quarterly basis the Company reviews any securities which are considered to be impaired as defined by accounting guidance. During this review, the Company determines if the impairment is deemed to be other than temporary. If it is determined that the impairment is other than temporary, i.e. impaired because of credit issues, the investment is written down in the Statement of Operations in accordance with accounting guidance.

Loans

The Company makes mortgage, commercial and consumer loans to customers.  A substantial portion of the loan portfolio is represented by mortgage loans throughout southwest Virginia. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area.


 
8

 

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)

Note  1.                      Summary of Significant Accounting Policies (Continued)

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid balance.  Loan origination fees, net of certain direct origination costs, are deferred and amortized to income over the estimated lives of the loans using the straight-line method which is not materially different from the interest method. The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection.  Credit card loans and other personal loans are typically charged off no later than 180 days past due.   In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.

All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income.  The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual.  Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

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 loan loss reserve is 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 ASC 310,  Receivables –Subsequent Measurement.  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 considered for impairment under ASC 450, 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 ASC 450.  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 and recoveries; changes in underwriting standards and risk selection; level of experience and ability 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 loan 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 adjusting 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 or too low.  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.

Premises and Equipment

Land is carried at cost.   Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed on

 
9

 

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)

Note 1.                      Summary of Significant Accounting Policies (Continued)

Premises and Equipment (Continued)

the straight-line method over estimated useful lives.  Maintenance and repairs are charged to current operations while improvements are capitalized.  Disposition gains and losses are reflected in current operations. Purchased software costs are included in other assets and expensed over periods ranging from 3-5 years.

Intangible Assets

Capital issue costs relating to the junior subordinated debt securities are stated at cost less accumulated amortization.  Amortization is computed on the straight-line method over the life of the securities which is 30 years.

Foreclosed Assets

Assets acquired through, or in lieu of, loan foreclosure or repossession are held for sale and are initially recorded at fair value at the date of foreclosure or repossession, establishing a new cost basis. Subsequent to foreclosure or repossession, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and are included in net expenses from foreclosed and repossessed assets. Foreclosed and repossessed assets at December 31, 2010 and 2009 were $15,347 and $6,934 respectively.

Income Taxes

Under the asset and liability method, deferred income taxes are recognized for the tax consequences of “temporary differences” by applying enacted statutory tax rates to the differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities.  Under ASC 740, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Management evaluates the Company’s tax circumstance and filings under the most current and relevant accounting rules and believes the Company has incurred no liability for uncertain beneficial tax positions (or any related penalties and interest) for the periods open to normal jurisdictional examinations (2007 through 2009).

Earnings Per Common Share

Earnings per common share are calculated based on the weighted average outstanding shares during the year.  Earnings per common share assuming dilution are calculated based on the weighted average outstanding shares during the year plus common stock equivalents at year end.

Stock Compensation Plans

The Company accounts for stock compensation plans under the guidance of ASC 718 which requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their grant-date fair values.  No options were granted during 2010 or 2009.

Use of Estimates

In preparing consolidated financial statements in conformity with U.S. generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenue and expense during the reporting period.  Actual results could differ from those estimates.  Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, and the valuation of foreclosed real estate, deferred tax assets and investment securities.

Business Segments

The Company reports its activities as a single business segment.  In determining the appropriateness of segment definition, the Company considers components of the business about which financial information is available and regularly evaluated relative to resource allocation and performance assessment.

 
10

 

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)

Note 1. Summary of Significant Accounting Policies (Continued)

Recent Accounting Pronouncements

In July 2010, the Receivables topic of the ASC was amended to require expanded disclosures related to a company’s allowance for credit losses and the credit quality of its financing receivables. The amendments will require the allowance disclosures to be provided on a disaggregated basis.  The Company is required to begin to comply with the disclosures in its financial statements for the year ended December 31, 2010.  Disclosures about Troubled Debt Restructurings required by the Update have been deferred by FASB until 2011.

In December 2010, the Intangibles topic of the ASC was amended to modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. Any resulting goodwill impairment should be recorded as a cumulative-effect adjustment to beginning retained earnings upon adoption.  Impairments occurring subsequent to adoption should be included in earnings.  The amendment is effective for the Company beginning January 1, 2011. Early adoption is not permitted.
Also in December 2010, the Business Combinations topic of the ASC was amended to specify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only.  The amendment also requires that the supplemental pro forma disclosures include a description of the nature and amount of any material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings.  This amendment is effective for the Company for business combinations for which the acquisition date is on or after January 1, 2011, although early adoption is permitted.  The Company does not expect the amendment to have any impact on the financial statements.Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

Note 2.  Formal Written Agreement

On October 13, 2010, the Company and Bank entered into a written agreement (“Written Agreement”) with the Federal Reserve Bank of Richmond (the “Reserve Bank”).  Under the terms of the Written Agreement, the Bank has agreed to develop and submit to the Reserve Bank for approval within the time periods specified therein written plans or programs to:

·  
strengthen board oversight of the management and operations of the Bank;
·  
strengthen credit risk management and administration;
·  
provide for the effective grading of the Bank’s loan portfolio;
·  
summarize the findings of its review of the adequacy of the staffing of its loan review function;
·  
improve the Bank’s position with respect to loans, relationships, or other assets in excess of $500,000 that currently are or in the future become past due more than 90 days, on the Bank’s problem loan list, or adversely classified in any report of examination of the Bank;
·  
review and revise the Bank’s methodology for determining the allowance for loan and lease losses (“ALLL”) and maintain an adequate ALLL;
·  
maintain sufficient capital at the Company and the Bank;
·  
establish a revised written contingency funding plan;
·  
establish a revised investment policy;
·  
improve the Bank’s earnings and overall condition;
·  
revise the Bank’s information technology program; and
·  
establish a disaster recovery and business continuity program.
·  
establish a committee to monitor compliance with all aspects of the written agreement.

Further, both the Company and the Bank have agreed to refrain from declaring or paying dividends without prior regulatory approval.  The Company has agreed that it will not take any other form of payment representing a reduction in Bank’s capital or make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities without prior regulatory approval.  The Company also has agreed not to incur, increase or guarantee any debt or not to purchase or redeem any shares of its stock without prior regulatory approval.


 
11

 

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)

Note  3.                      Investment Securities Available-For-Sale

The amortized cost and market value of securities available-for-sale are as follows:

   
2010
 
   
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Fair Value
 
 
                         
U.S Government agencies
  $ -     $ -     $ -     $ -  
State and political subdivisions
    19,885       78       1,673       18,291  
Mortgage backed securities
    29,465       289       312       29,442  
Pooled Trust Preferred
    4,339       -       4,165       173  
Single Issue Trust Preferred
    1,926       -       122       1,804  
SBA Pools
    5,978       1       45       5,934  
SLMA
    500       -       48       452  
    $ 62,093     $ 368     $ 6,365     $ 56,096  


   
2009
 
   
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Fair Value
 
 
                         
U.S Government agencies
  $ 1,498     $ 9     $ -     $ 1,507  
State and political subdivisions
    48,002       399       1,053       47,348  
Mortgage backed securities
    18,425       314       2       18,737  
Pooled Trust Preferred
    5,644       -       4,447       1,197  
Single Issue Trust Preferred
    1,950       -       362       1,588  
SBA Pools
    45       -       1       44  
SLMA
    500       -       114       386  
Agency Preferred
    262       -       121       141  
    $ 76,326     $ 722     $ 6,100     $ 70,948  

The following tables presents the age of gross unrealized losses and fair value by investment category:

   
December 31, 2010
 
   
Less Than 12 months
   
12 Months or More
   
Total
 
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
 
                                     
States and pol. subdivisions
  $ 10,822     $ 807     $ 4,372     $ 865     $ 15,194     $ 1,672  
Mortgage-backed securities
    19,193       313       -       -       19,193       313  
Pooled Trust Preferred Securities
    -       -       173       4,165       173       4,165  
Single Issue Trust Preferred
    391       21       913       101       1,304       122  
SBA Pools
    4,018       45       -       -       4,018       45  
SLMA
    -       -       452       48       452       48  
                                                 
  Total
  $ 34,424     $ 1,186     $ 5,910     $ 5,179     $ 40,334     $ 6,365  


 
12

 


HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)

Note  3.                      Investment Securities Available-For-Sale (Continued)

   
December 31, 2009
 
   
Less Than 12 months
   
12 Months or More
   
Total
 
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
 
                                     
                                     
States and pol. subdivisions
  $ 12,363     $ 215     $ 7,975     $ 838     $ 20,338     $ 1,053  
Mortgage-backed securities
    1,465       1       224       1       1,689       2  
Pooled Trust Preferred Securities
    -       -       1,197       4,447       1,197       4,447  
Single Issue Trust Preferred
    -       -       1,588       362       1,588       362  
SBA Pools
    -       -       44       1       44       1  
SLMA
    -       -       386       114       386       114  
Agency Preferred
    86       15       55       106       141       121  
                                                 
  Total
  $ 13,914     $ 231     $ 11,469     $ 5,869     $ 25,383     $ 6,100  


The segment of our portfolio that contains the largest unrealized loss is our pooled trust preferred securities (TRUP CDOs) which represent trust preferred securities issued primarily by banks and a limited number of insurance companies and real estate investment trusts. As of December 31, 2010, our TRUP CDOs book value totaled $4.34 million.

The Company reviews its investment portfolio on a quarterly basis for indications of other-than-temporary impairment (“OTTI”).

During the first quarter of 2009, the FASB ASC Topic 320, Investments-Debt and Equity Securities, amended the assessment criteria for recognizing and measuring OTTI related to debt securities.

For other than temporary impairment analysis, the Company utilizes the current accounting guidance for OTTI that is intended to measure the change in projected cash flows for securitized assets. Specifically, we measure how the current projected cash flows differ from our most recent projection (e.g. as of the last quarter). A decrease in the present value of projected cash flows is considered an “adverse change” and may trigger a charge for other-than-temporary impairment. The Company formally analyzes the credit characteristics of the underlying collateral on each individual security as a basis for credit deferral / default assumptions.   This methodology is documented and reviewed with our audit committee quarterly for determining impairment each quarter.  Additionally, we utilize certain data contained in the baseline deferral / default assumptions that were developed by the FDIC (from default data during the 1988-1992 periods) . The Company’s credit evaluation of each of the entities comprising the underlying collateral considers all available information and evidence.  Our initial credit evaluation focuses on asset quality (using the Texas Ratio and Modified Texas Ratio), capitalization (using Leverage, Tier 1 and Total Risk Based Capital), third party ratings of financial strength, the ratio of reserve for loan losses to loans and current earnings performance. For those underlying issuers that are determined to be potentially impaired based on the initial review, we perform a more detailed quarterly trend analysis. This analysis focuses on trends related to non-performing assets, reserve for loan losses, capitalization and earnings performance. The results of the internal assessment are factored into an analysis stressing the projections of cash flow.

At December 31, 2010, the following assumptions were used in our cash flow projections:
· Deferral / default ranges for 2011 – 0.70% to 3.00%.
· Deferral / default ranges for 2012 – 1.00% to 2.00%.
· Deferral / default rate for 2013 – 1.00%.
· Deferral / default ranges for years thereafter – 0.25% to 0.36%.
· Prepayments - 1% annually, 100% at maturity
· The discount rate is calculated using the original discount  margin as of the purchase date based on the purchase  price added to the appropriate forward 3-month LIBOR rate.
· 15% recovery with 2 year lag extended to 5 years if has been in deferral for 2 years
· 0% recovery on existing defaults
· Cash flows are discounted at the effective interest rate.

 
13

 


HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)

Note  3. Investment Securities Available-For-Sale (Continued)

Underlying banks can prepay their trust preferred securities on a quarterly call date after a five year period from the original date of issue .We use a constant prepayment assumption of 1% annually and 100% at maturity. The extent of future prepayments is difficult to project. Since trust preferred securities will count as Tier 1 capital until the end of 2012, it is conceivable that there will not be an initial burst of prepayment activity as tax-deductible Tier 1 capital is still attractive. As large issuers lose Tier 1 treatment beginning in 2013, some of them will likely prepay their trust preferred securities; however, trust preferred will still be eligible as Tier 2 capital so that some large issuers may not prepay until closer to maturity. For issuers with assets of less than $15 billion but greater than $500 million, existing trust preferred securities were grandfathered but these issuers are prohibited from issuing new trust preferred securities that can be counted as Tier 1 capital, making it unlikely that these issuers will prepay their existing trust preferred. Our projections also include for existing deferrals a 15% recovery  after a two-year lag (if an issuer has been in deferral for two years, we extend the assumed recovery to the end of the 5-year deferral period, or an additional 3 years).

Deferral and default announcements that are received after the balance sheet date but before the filing date are incorporated into the OTTI calculation for the period end report. Typically deferral announcements are received on or around each payment date which is the last week of each quarter.

During 2010, we incurred credit-related OTTI charges on our TRUP CDOs of $1.26 million. For the 12 months ended December 31, 2009, we incurred credit-related OTTI charges on our TRUP CDOs of $5.62 million

Below is a table of the Company’s remaining pooled trust preferred balances as of December 31, 2010:

Description
Type
Class
Original Amount
$
Book Value
12/31/10
$
Fair Value
12/31/10
$
Unrealized Gain/(Loss)
$
Lowest Credit Rating
Percentage of Banks Currently Deferring or Defaulting
Number of Issuers Currently Performing
Excess/ (Negative) Subordination Percentage(1)
                     
Pretsel  4-B
Pooled
Mezz B
   700,000
   85
19
      (66)
Ca
27.10%
4
19.28 %
Prestel 11-B
Pooled
Mezz B
  500,000
   420
   66
 ( 354)
Ca
29.70%
47
(29.10)%
Prestel 12-B
Pooled
Mezz B
   750,000
    394
   16
 ( 378)
Ca
32.70%
47
(36.81)%
Prestel 13-B
Pooled
Mezz B
   500,000
    358
  33
( 325)
Ca
31.50%
46
(34.94)%
Prestel 15-B
Pooled
Mezz B
   500,000
    263
     4
( 259)
Ca
35.40%
52
(41.00)%
Prestel 18-C
Pooled
Mezz C
   500,000
   362
     4
(358)
Ca
24.60%
54
(16.78)%
Prestel 19-C
Pooled
Mezz C
   500,000
    346
     3
( 343)
Ca
24.60%
52
(18.99)%
Prestel 20-C
Pooled
Mezz C
   500,000
    102
     1
( 101)
Ca
30.60%
45
(25.42)%
Prestel 21-C
Pooled
Mezz C
   500,000
    293
     5
(288)
Ca
28.70%
51
(21.64)%
Prestel 22-C
Pooled
Mezz C
   500,000
    307
     4
(303)
Ca
29.70%
63
(23.97)%
Prestel 22-C
Pooled
Mezz C
   500,000
    331
   5
( 326)
Ca
29.70%
63
(23.97)%
Prestel 22-C
Pooled
Mezz C
500,000
    330
     5
(325)
Ca
29.70%
63
(23.97)%
Prestel 23-C
Pooled
Mezz C
500,000
   442
6
(436)
C
27.30%
93
(18.33)%
Tropc CDO III
Pooled
Subordinate
1,000,000
      306
2
(304)
C
39.20%
30
(33.23)%


(1) Excess subordination percentages are reviewed on a quarterly basis. .Excess subordination is computed by comparing the balances of the remaining performing collateral to the current balances of all traunches equal to and senior to the class that the Company owns. Negative excess subordination indicates there is not enough performing collateral in the pool to cover the outstanding balance of all classes equal to and senior to those the Company owns. The subordination percentage only applies to principal and does not include excess interest. The Company’s OTTI calculations compute the present value of the future cash flows (principal and interest) to determine impairment. The impairment charges to date on each pooled trust preferred security are reflective of the negative excess subordination percentages shown above.

The Company also assesses other securities for OTTI quarterly by reviewing credit ratings, financial and regulatory reports as well as other pertinent financial indicators published. As of December 31, 2010 and December 31, 2009, the Company's assessment revealed no impairment other than that deemed temporary.

Investment securities available-for-sale with a carrying value of $42,885 and $47,988 at December 31, 2010 and 2009 respectively, and a market value of $41,849 and $48,309 at December 31, 2010 and 2009, respectively were pledged as collateral on public deposits, FHLB advances and for other purposes as required or permitted by law.

 
14

 


HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)

Note  3. Investment Securities Available-For-Sale (Continued)

The amortized cost and estimated fair value of securities available-for-sale at December 31, 2010 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 
Amortized Cost
 
Fair Value
   
Due in one year or less
$                          -
 
$                             -
Due after one year through five years
810
 
775
Due after five years through ten years
2,860
 
2,846
Due after ten years
28,958
 
23,033
 
32,628
 
26,654
       
Mortgage-backed securities
29,465
 
29,442
 
$                 62,093
 
$                  56,096

For the years ended December 31, 2010 and 2009, proceeds from sale of securities were $33,479 and $28,308, respectively.  Gross realized gains and losses on investment securities available for sale were as follows:

   
2010
   
2009
 
             
Realized gains
  $ 259     $ 533  
Realized losses
  $ 422 )   $ (153 )
Net gains (losses)
  $ (163 )   $ 380  

Note 4.  Other Investments

Federal Home Loan Bank (FHLB) stock, Federal Reserve Bank (FRB) stock, Pacific Coast Bankers’ Bank and Community Bankers’ Bank  stock with a carrying value of $5,776 and $6,383 at December 31, 2010 and 2009, respectively are stated at cost and included as “ Other Investments” on the Company’s Balance Sheets. These investments are considered to be restricted as the Company is required by these entities to hold these investments, and the only market for this stock is the issuing agency.  Also included in “Other Investments” are Certificates of Deposits purchased from other FDIC insured institutions in 2009 and 2010.  The balances of these CDs were $250 and $2,034 at December 31, 2010 and 2009, respectively.

 
15

 


HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)

Note 5.  Loans and Allowance for Loan Losses

The composition of net loans is as follows:

   
2010
   
2009
 
Real Estate Secured:
           
Residential 1-4 family
  $ 175,522     $ 183,983  
Multifamily
    15,593       12,895  
Construction and Land Loans
    30,901       46,929  
Commercial, Owner Occupied
    78,279       85,791  
Commercial, Non-owner occupied
    43,652       41,032  
Second mortgages
    14,132       16,980  
Equity lines of credit
    10,016       10,164  
Farmland
    12,790       11,176  
      380,885       408,950  
                 
Secured (other) and unsecured
               
Personal
    26,773       29,703  
Commercial
    40,471       44,840  
Agricultural
    2,848       3,069  
      70,092       77,612  
                 
Overdrafts
    214       191  
                 
      451,191       486,753  
Less:
               
  Allowance for loan losses
    10,320       11,681  
  Net deferred fees
    597       634  
      10,017       12,315  
                 
Loans, net
  $ 440,274     $ 474,438  



 
16

 

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)
Note 5.  Loans and Allowance for Loan Losses (Continued)


Activity in the allowance for loan losses is as follows:

   
2010
   
2009
 
             
Balance, beginning
  $ 11,681     $ 5,171  
Provision charged to operations
    4,799       9,614  
Loans charged to reserve
    (6,244 )     (3,247 )
Recoveries
    84       143  
                 
Balance, ending
  $ 10,320     $ 11,681  


 
17

 


HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)

Note 5.  Loans and Allowance for Loan Losses (Continued)

The following table is an analysis of past due loans as of December 31, 2010:

   
30-59 Days Past Due
   
60-89 Days Past Due
   
Greater Than 90 Days
   
Total Past Due
   
Current
   
Total Financing Receivables
   
Recorded Investment > 90 Days and Accruing
 
                                           
Real Estate Secured
                                         
Residential 1-4 family
  $ 3,780     $ 1,245     $ 4,937     $ 9,962     $ 165,560     $ 175,522     $ 1,726  
Equity lines of credit
    -       99       -       99       9,917       10,016       -  
Multifamily
    -       -       40       40       15,553       15,593       -  
Farmland
    348       -       774       1,122       11,668       12,790       -  
Constuction, Land Development, Other Land Loans
    825       152       3,153       4,130       26,771       30,901       53  
Commercial Real Estate- Owner Occupied
    1,612       105       6,301       8,018       70,260       78,278       1,776  
Commercial Real Estate- Non Owner Occupied
    -       165       1,520       1,685       41,967       43,652       602  
Second Mortgages
    234       -       529       763       13,369       14,132       -  
Non Real Estate Secured
                                                       
Personal
    303       101       74       478       26,510       26,988       14  
Business
    190       406       1,456       2,052       38,419       40,471       289  
Agricultural
    7       -       96       103       2,745       2,848       68  
                                                         
          Total
  $ 7,299     $ 2,273     $ 18,880     $ 28,452     $ 422,739     $ 451,191     $ 4,528  
                                                         

The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection.  Credit card loans and other personal loans are typically charged off no later than 180 days past due.   In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.

The following is a summary of non-accrual loans at December 31, 2010:

   
Amount
 
Real Estate Secured
     
Residential 1-4 Family
  $ 3,211  
Multifamily
    40  
Construction and Land Loans
    3,100  
Commercial-Owner Occupied
    4,525  
Commercial- Non Owner Occupied
    918  
Second Mortgages
    529  
Equity Lines of Credit
    -  
Farmland
    774  
Secured (other) and Unsecured
       
Personal
    60  
Commercial
    1,167  
Agricultural
    29  
         
Total
  $ 14,353  


 
18

 


HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)

Note 5.  Loans and Allowance for Loan Losses (Continued)

The following tables represent a summary of credit quality indicators of the Bank’s loan portfolio at December 31, 2010:
The grades are assigned and or modified by the Company’s credit review and credit analysis departments based on the creditworthiness of the borrower and the overall strength of the loan.

Credit Risk Profile by Internally Assigned Grade
Grade (1)
 
Residential 1-4 Family
 
Multifamily
 
Farmland
 
Construction, Land Loans
 
Commercial Real Estate- Owner Occupied
 
Commercial Real Estate Non-Owner Occupied
                         
Quality
 
 40,371
 
 1,911
 
 977
 
 4,298
 
 7,102
 
 3,604
Satisfactory
 
 80,759
 
 9,258
 
 4,399
 
 7,355
 
 26,055
 
 16,729
Acceptable
 
 36,411
 
 1,806
 
 4,285
 
 5,585
 
 27,878
 
 13,013
Special Mention
 
 4,778
 
 946
 
 178
 
 2,346
 
 5,430
 
 304
Substandard
 
 12,832
 
 1,672
 
 2,951
 
 11,317
 
 11,390
 
 10,002
Doubtful
 
 371
 
 -
 
 -
 
 -
 
 424
 
 -
                         
     Total
 
$   175,522
 
$     15,593
 
$     12,790
 
$        30,901
 
$     78,278
 
$      43,652

 
(1)  Quality--This grade is reserved for the Bank’s top quality loans. These loans have excellent sources of repayment, with no significant identifiable risk of collection.  Generally, loans assigned this rating will demonstrate the following characteristics:
 
 
·  
Conformity in all respects with Bank policy, guidelines, underwriting standards, and Federal and State regulations (no exceptions of any kind).
 
 
·  
Documented historical cash flow that meets or exceeds required minimum Bank guidelines, or that can be supplemented with verifiable cash flow from other sources.
 
 
·  
Adequate secondary sources to liquidate the debt, including combinations of liquidity, liquidation of collateral, or liquidation value to the net worth of the borrower or guarantor.
 
 
For existing loans, all of the requirements above apply plus all payments have been made as agreed, current financial information on all borrowers and guarantors has been obtained and analyzed, and overall business operating trends are either stable or improving.
 
 
   Satisfactory-This grade is given to acceptable loans. These loans have adequate sources of repayment, with little identifiable risk of collection. Loans assigned this rating will demonstrate the following characteristics:
 
 
·  
General conformity to the Bank's policy requirements, product guidelines and underwriting standards.  Any exceptions that are identified during the underwriting and approval process have been adequately mitigated by other factors.
 
 
·  
Documented historical cash flow that meets or exceeds required minimum Bank guidelines, or that can be supplemented with verifiable cash flow from other sources.  
 
 
·  
Adequate secondary sources to liquidate the debt, including combinations of liquidity, liquidation of collateral, or liquidation value to the net worth of the borrower or guarantor
 
 
For existing loans, all of the requirements outlined above will apply, plus all payments have been made as agreed, current financial information on all borrowers and guarantors has been obtained and analyzed, and overall business operating trends are stable with any declines considered minor and temporary.
 
 
Acceptable-This grade is given to loans that show signs of weakness in either adequate sources of repayment or collateral, but have demonstrated mitigating factors that minimize the risk of delinquency or loss.  Loans assigned this rating may demonstrate some or all of the following characteristics:
 

 
19

 

 

 
HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
Note 5.  Loans and Allowance for Loan Losses (Continued)
 Acceptable (continued)
 
·  
Additional exceptions to the Bank's policy requirements, product guidelines or underwriting standards that present a higher degree of risk to the Bank.  Although the combination and/or severity of identified exceptions is greater, all exceptions have been properly mitigated by other factors.
 
 
·  
Unproved, insufficient or marginal primary sources of repayment that appear sufficient to service the debt at this time.  Repayment weaknesses may be due to minor operational issues, financial trends, or reliance on projected (not historic) performance.
 
 
·  
Marginal or unproven secondary sources to liquidate the debt, including combinations of liquidation of collateral and liquidation value to the net worth of the borrower or guarantor.
 
 
For existing loans, payments have generally been made as agreed with only minor and isolated delinquencies.
 
 
Special Mention -This grade is given to Watch List loans that include the following characteristics:
 
 
·  
Loans with underwriting guideline tolerances and/or exceptions with no identifiable mitigating factors.
 
 
·  
Extending loans that are currently performing satisfactorily but with potential weaknesses that may, if not corrected, weaken the asset or inadequately protect the Bank's position at some future date. Potential weaknesses are the result of deviations from prudent lending practices.
 
 
·  
Loans where adverse economic conditions that develop subsequent to the loan origination do not jeopardize liquidation of the debt, but do substantially increase the level of risk may also warrant this rating.
 
 
     Substandard-Loans in this category are characterized by deterioration in quality exhibited by any number of well-defined weaknesses requiring corrective action. A substandard loan is inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans classified as substandard must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt; they are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
 
 
 The weaknesses may include, but are not limited to:
 
 
·  
High debt to worth ratios and or declining or negative earnings trends
 
 
·  
Declining or inadequate liquidity
 
 
·  
Improper loan structure  or questionable repayment sources
 
 
·  
Lack of well-defined secondary repayment source, and
 
 
·  
Unfavorable competitive comparisons.
 
 
Such loans are no longer considered to be adequately protected due to the borrower's declining net worth, lack of earnings capacity, declining collateral margins and/or unperfected collateral positions. A possibility of loss of a portion of the loan balance cannot be ruled out. The repayment ability of the borrower is marginal or weak and the loan may have exhibited excessive overdue status or extensions and/or renewals.
 
 
Doubtful -Loans classified Doubtful have all the weaknesses inherent in loans classified Substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values highly questionable and improbable. The ability of the borrower to service the debt is extremely weak, overdue status is constant, the debt has been placed on non-accrual status, and no definite repayment schedule exists.
 
 
However, these loans are not yet rated as loss because certain events may occur which would salvage the debt. Among these events are:
 
 
·  
Injection of capital
 
 
·  
Alternative financing
 
 
·  
Liquidation of assets or the pledging of additional collateral.
 

 
20

 

 

 
HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)
Note 5.  Loans and Allowance for Loan Losses (Continued)

Credit Risk Profile based on payment activity
   
Consumer - Non Real Estate
   
Equity Line of Credit
   
Commercial - Non Real Estate
   
Agricultural - Non Real Estate
 
                         
Performing
  $ 26,699     $ 10,016     $ 39,015     $ 2,751  
Nonperforming (>90 days past due)
    74       -       1,456       97  
                                 
     Total
  $ 26,773     $ 10,016     $ 40,471     $ 2,848  
                                 

The following tables reflect the Bank’s impaired loans at December 31, 2010:

   
Recorded Investment
   
Unpaid Principal Balance
   
Related Allowance
   
Average Recorded Investment
   
Interest Income Recognized
 
2010 With no Related Allowance
                             
Real Estate Secured
                             
Residential 1-4 family
  $ 7,451     $ 7,772     $ -     $ 6,857     $ 191  
Equity lines of credit
    -       -       -       -       -  
Multifamily
    40       40       -       1,314       1  
Farmland
    774       1,300       -       924       -  
Construction, Land Development, Other Land Loans
    3,853       3,853       -       5,768       141  
Commercial Real Estate- Owner Occupied
    5,498       5,498       -       3,318       260  
Commercial Real Estate- Non Owner Occupied
    3,506       3,506       -       2,215       77  
Second Mortgages
    700       700       -       516       25  
Non Real Estate Secured
                                       
Personal /Consumer
    21       21       -       11       2  
Business Commercial
    1,266       1,266       -       1,162       55  
Agricultural
    -       -       -       -       -  
Credit Cards
    -       -       -       -       -  
                                         
          Total
  $ 23,109     $ 23,956     $ -     $ 22,085     $ 752  


 
21

 



HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)

Note 5.  Loans and Allowance for Loan Losses  (Continued)

   
Recorded Investment
   
Unpaid Principal Balance
   
Related Allowance
   
Average Recorded Investment
   
Interest Income Recognized
 
2010 With an Allowance Recorded
                             
Real Estate Secured
                             
Residential 1-4 family
  $ 4,515     $ 4,515     $ 644     $ 2,377     $ 262  
Equity lines of credit
    -       -       -       -       -  
Multifamily
    1,632       1,632       92       770       51  
Farmland
    312       312       34       191       21  
Construction, Land Development, Other Land Loans
    7,035       7,515       917       4,264       139  
Commercial Real Estate- Owner Occupied
    4,277       4,277       110       2,981       37  
Commercial Real Estate- Non Owner Occupied
    5,033       5,033       1,071       1,981       88  
Second Mortgages
    84       122       -       42       -  
Non Real Estate Secured
                                       
Personal /Consumer
    50       50       -       54       1  
Business Commercial
    2,132       2,132       1,250       956       58  
Agricultural
    28       28       12       8       -  
Credit Cards
    -       -       -       -       -  
                                         
          Total
  $ 25,098     $ 25,616     $ 4,130     $ 13,624     $ 657  

A loan is considered impaired and an allowance for loan losses is established on loans for which it is probable that the full collection of principal and interest is in doubt. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value based on recent appraisal  and /or tax assessment value, liquidation value and/or discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At December 31, 2010, all of the total impaired loans were evaluated based on the fair value of the collateral. On a quarterly basis, the ALLL methodology begins with the determination of individually impaired loans. All loans that are rated “7” (Doubtful) are assessed as impaired based on the expectation that the full collection of principal and interest is in doubt. All loans that are rated “6” (Substandard) or are expected to be downgraded to “6”, require additional analysis to determine whether they may be impaired. All loans that are rated “5” (Special Mention) are presumed not to be impaired. However, “5” rated loans with the following characteristics warrant further analysis before completing an assessment of impairment:

•  
A loan is 60 days or more delinquent on scheduled principal or interest;
•  
A loan is presently in an unapproved over advanced position;
•  
A loan is newly modified; or
•  
A loan is expected to be modified.

The Company’s credit administration personnel and senior financial officers are responsible for tracking, coding, and monitoring loans that become Troubled Debt Restructurings. Concessions are made to existing borrowers in the form of modified interest rates and / or payment terms. The loans are segregated for regulatory and external reporting. Each specific TDR is reviewed to determine if the accrual of interest should be discontinued and also reviewed for impairment. The Company’s senior credit administration officer performs this analysis on a quarterly basis in addition to determining any other loans that are impaired within the loan portfolio. The Company had a total of $13.98 million and $6.01 million of loans categorized as troubled debt restructurings as of December 31, 2010 and December 31, 2009, respectively. Interest is accrued on TDRs if the loan is otherwise not impaired and the full collection of principal and interest under the modified terms is still deemed likely to occur by management.

 
22

 


HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)



Note 6.  Premises and Equipment

Premises and equipment are comprised of the following:

   
2010
   
2009
 
             
Land
  $ 10,760     $ 10,723  
Bank Premises
    14,061       14,061  
Equipment
    12,195       12,015  
      37,016       36,799  
Less: accumulated depreciation
    13,507       12,237  
      23,509       24,562  
Construction in Progress
    -       51  
                 
    $ 23,509     $ 24,613  

Depreciation expense was $1,293 and $1,321 for 2010 and 2009, respectively.

Note 7.  Bank Owned Life Insurance

The Company maintains insurance on the lives of certain key directors and officers.  As beneficiary, the Company receives the cash surrender value if the policy is terminated, and upon death of the insured, receives all benefits payable.  The current value of the policies at December 31, 2010 and 2009 was $12,777 and $12,324, respectively.

 
23

 


HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)

Note 8.  Income Taxes

The components of the net deferred tax asset, included in other assets, are as follows:

   
2010
   
2009
 
             
Deferred tax assets:
           
    Allowance for loan loss
  $ 3,503     $ 3,971  
    Previous Years AMT
    802       293  
    Loss on Other Equity Investments
    51       51  
    NOL carry-forwards  (20 year carry-forward period)
    3,529          
    Other than temporary impairment charge on AFS securities
    2,340       3,947  
    Net unrealized loss on securities available-for-sale
    2,039       1,829  
      12,264       10,091  
                 
Deferred tax liability:
               
    Depreciation
    (377 )     (417 )
      (377 )     (417 )
                 
Net deferred tax asset
  $ 11,887     $ 9,674  

The components of income tax expense related to continuing operations are as follows:

   
2010
   
2009
 
             
Federal:
           
  Current
  $ (4,294 )   $ (1,024 )
  Deferred
    2,029       (4,210 )
                 
    Total
  $ (2,265 )   $ (5,234 )

The Company’s income tax expense differs from the expected tax expense at the statutory federal rate of 34% as follows:

   
2010
   
2009
 
             
Statutory rate applied to earnings before income taxes
  $ (1498 )   $ (3,949 )
Tax exempt interest
    (586 )     (807 )
Life Insurance benefits
    -       (223 )
Other, net
    (181 )     (255 )
                 
    Total
  $ (2,265 )   $ (5,234 )

Note 9. Deposits

The composition of deposits is as follows:

   
2010
   
2009
 
             
Non-interest bearing demand
  $ 85,923     $ 84,073  
Interest bearing demand
    94,084       75,560  
Savings deposits
    59,788       55,745  
Time deposits, in amounts of $100,000 or more
    99,766       111,637  
Other time deposits
    197,211       192,889  
                 
Total deposits
  $ 536,772     $ 519,904  


 
24

 

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010
(Amounts in thousands)
Note 9.  Deposits (Continued)

The scheduled maturities of time deposits at December 31, 2010 are as follows:

2011
  $ 146,653  
2012
    88,884  
2013
    20,749  
2014