Highlands Bankshares 10-K 2014 FY Annual report

Exhbit 13.1

HIGHLANDS BANKSHARES, INC.  AND SUBSIDIARY

CONSOLIDATED FINANCIAL REPORT

DECEMBER 31, 2014

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 Finanical Reporting		3
FINANCIAL STATEMENTS
	Consolidated Balance Sheets	4
	Consolidated Statement of Income	5
	Consolidated Statements of Comprehensive Income	6
	Consolidated Statements of Stockholders Equity	7
	Consolidated Statements of Cash Flows	8
	Notes to Consolidated Financial Statements	9-51

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, 2014 and 2013, and the related consolidated statements of income, comprehensive income, stockholders' equity, and cash flows for each of the years in the two-year period ended December 31, 2014. The Company’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, 2014 and 2013, and the consolidated results of its operations and its cash flows for each of the years in the two-year period ended December 31, 2014, in conformity with accounting principles generally accepted in the United States of America.

  CERTIFIED PUBLIC ACCOUNTANTS

Bristol, Virginia

March 30, 2015

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, 2014 based on the framework set forth in "Internal Control - Integrated Framework - 1992" issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Based on its evaluation, management concluded that, as of December 31, 2014, Highlands Bankshares, Inc.’s internal control over financial reporting was effective.

3

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

December 31, 2014 and 2013

(Amounts in thousands)

	2014	2013
ASSETS
Cash and due from banks	$       15,018	$       16,965
Federal funds sold	40,792	67,030
Total Cash and Cash Equivalents	55,810	83,995
Investment securities available-for-sale (Note 3)	84,335	55,318
Other Investments, at cost (Note 4)	6,767	4,710
Loans, net of allowance for loan losses of  $5,477 and $6,825 in 2014 and 2013, respectively (Note 5)	401,520	396,961
Premises and equipment, net (Note 6)	20,236	20,188
Deferred Tax Assets, net (Note 8)	10,744	10,444
Interest receivable	2,235	2,171
Bank Owned Life Insurance	14,183	14,132
Other Real Estate Owned, net	6,685	7,834
Other assets	2,599	2,559
Total Assets	$     605,114	$     598,312
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits (Note 9)
Noninterest bearing	$      118,557	$      107,328
Interest bearing	364,940	380,946
Total Deposits	483,497	488,274
Interest, taxes and other liabilities	1,014	2,595
Short term borrowings (Note 10)	20,051	23,500
Long-term debt (Note 11)	47,750	47,802
Capital securities (Note 12)	-	3,150
Total Other Liabilities	68,815	77,047
Total Liabilities	552,312	565,321
STOCKHOLDERS' EQUITY
Common stock, 7,851 shares  and 5,011 shares  issued in 2014 and 2013, respectively,  authorized 40,000 shares, par  value  $0.625 per share  (Note 15)	4,907	3,132
Preferred stock,  2,092 shares issued and authorized  10,000 shares, par value $2.00 per share	4,184	-
Additional paid-in capital	18,180	7,783
Retained Earnings	25,436	22,910
Accumulated other comprehensive income (loss)	95	(834)
Total Stockholders' Equity	52,802	32,991
Total Liabilities and Stockholders' Equity	$     605,114	$     598,312

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, 2014 and 2013

(Amounts in thousands, except per share data)

	2014	2013
INTEREST INCOME
Loans receivable and fees on loans	$     21,332	$     21,599
Securities available for sale:
Taxable	1,005	735
Tax-exempt	483	551
Other investment income	215	155
Federal funds sold	136	146
Total Interest Income	23,171	23,186
INTEREST EXPENSE
Deposits	2,539	2,951
Other borrowed funds	2,685	3,143
Total interest expense	5,224	6,094
Net interest income	17,947	17,092
PROVISION FOR LOAN LOSSES (Note 5)	1,324	1,320
Net interest income after provision for loan losses	16,623	15,772
NON-INTEREST INCOME
Securities gains (losses)	1	(758)
Service charges on deposit accounts	1,915	2,088
Other service charges, commissions and fees	1,649	1,714
Other operating income	710	1,054
Total Non-Interest Income	4,275	4,098
NON-INTEREST EXPENSE
Salaries and employee benefits (Note 14)	10,025	9,578
Occupancy expense of bank premises	1,069	1,185
Furniture and equipment expense	1,166	1,193
Other operating expenses (Note 23)	5,356	5,326
Foreclosed Assets –Write-down and operating expenses	1,533	3,785
Total Non-Interest Expenses	19,149	21,067
Income (Loss) before Income Taxes	1,749	(1,197)
Income Tax Benefit  (Note 8)	(777)	(2,679)
Net Income	$                   2,526	$           1,482
Earnings Per Common Share (Note 13)	$                       0.36	$             0.30
Diluted Earnings Per Common Share (Note 13)	$                       0.28	$             0.30

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

5

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

Years Ended December 31, 2014 and 2013

(Amounts in thousands, except per share data)

	2014			2013
Net Income		$ 2,526			$1,482
Other Comprehensive Income
Unrealized gains on securities during the period		1,,408			813
Less: reclassification adjustment for (gains) losses included
in securities gains (losses) in the Consolidated Statement of Inc income		(1	)		758
Income
Other Comprehensive Income  before tax		1,407			1,571
Income tax expense related to other		478			534
comprehensive Income
Other Comprehensive Income		929			1,037
COMPREHENSIVE INCOME		$3,455			$2,519

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

6

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

Years Ended December 31, 2014 and 2013

(Amounts in thousands)

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

	Common Stock Shares	Par Value	Preferred Stock Shares	Preferred Stock Par Value	Additional Paid In Capital	Retained Earnings	Accumulated Other Comprehensive Income (Loss)	Stockholders’ Equity
Balance December 31, 2012	5,011	$ 3,132	-	-	$   7,783	$  21,428	$    (1,871)	$  30,472
Net Income						$   1,482		$ 1,482
Other Comprehensive Income							$ 1,037	$ 1,037
Balance, December 31, 2013	5,011	$ 3,132	-	-	$   7,783	$22,910	$  (834)	$   32,991
Net Income						$ 2,526		$    2,526
Issuance of Common Stock	2,840	$ 1,775			$  7,643			$    9,418
Issuance of Preferred Stock			2,092	$ 4,184	$ 2,754			$    6,938
Other Comprehensive Income							$  929	$      929
Balance December 31, 2014	7,851	$4,907	2,092	$ 4,184	$ 18,180	$ 25,436	$    95	$ 52,802

7

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2014 and 2013

(Amount in thousands)

	2014		2013
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	2,526	$	1,482
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision for loan losses		1,324		1,320
Provision for deferred income taxes		517		56
Depreciation and amortization		883		896
Valuation adjustment of deferred tax assets		(1,000)		(2,000)
Net realized (gains) losses on available-for-sale securities		(1)		758
Net amortization on securities		732		756
Amortization of capital issue costs		29		5
Valuation adjustment of other real estate owned		486		1,299
(Increase) decrease in interest receivable		(64)		143
(Increase) decrease in other assets		(399)		2,744
Increase (decrease) in interest, taxes and other
liabilities		(1,581)		529
Net Cash provided by operating activities		3,452		7,988
CASH FLOWS FROM INVESTING ACTIVITIES:
Securities available for sale:
Proceeds from sale of debt and equity securities		-		4,367
Proceeds from maturities of debt and equity securities		11,094		11,330
Purchase of debt and equity securities		(39,434)		(13,559)
(Purchase) redemption of other investments		(2,057)		220
Net (increase) decrease in loans		(9,188)		(15,729)
Proceeds from sales of other real estate owned		3,547		6,399
Proceeds from cash surrender value of life insurance		360		-
Premises and equipment expenditures		(88)7		(997)
Net Cash used in investing activities		(36,565)		(7,969)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net decrease in certificates of deposit		(15,531)		(20,308)
Net increase in demand, savings and other deposits		10,754		23,242
Net increase (decrease) in short term borrowings		(3,449)		3,330
Net decrease in long-term debt		(52)		(3,496)
Net decrease in capital securities		(3,150)		-
Issuance of common stock		9,418		-
Issuance of preferred stock		6,938		-
Net Cash provided by financing activities		4,928		2,768
Net increase (decrease) in cash and cash equivalents		(28,185)		2,787
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR		83,995		81,208
CASH AND CASH EQUIVALENTS AT END OF YEAR	$	55,810	$	83,995
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for:
Interest	$	6,630	$	5,882
Income taxes	$	-	$	-
SUPPLEMENTAL DISCLOSURES OF NONCASH TRANSACTIONS
Transfer of loans to other real estate owned	$	3,304	$	3,737
Loans originated from sales of other real estate owned	$	1,748	$	3,240

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

8

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(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., Highlands Union Financial Services, Inc., and Blue Ridge Hospitality, LLC, which are wholly owned subsidiaries of the Bank. Blue Ridge Hospitality, LLC, was formed in June 2014 to hold and manage certain properties acquired by the Bank through foreclosure or deed in lieu of foreclosure.  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 standard 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 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.  Highlands Capital Trust I became effective January 14, 1998.  The nature of the trust is described more fully in Note 12.

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 by a charge in the Statement of Income.

Loans

The Company makes mortgage, commercial and consumer loans to customers.  Included in mortgage lending are loans secured by real estate such as single family and multifamily dwelling units as well as  commercial properties both owner occupied and held for lease to others.  Commercial loans include those primarily secured by business assets or land or may be unsecured. Consumer loans include second mortgages and equity lines of credit and other personal loans which may be secured or unsecured. The Company also makes farmland loans and other agricultural type loans such as financing farming activities.

9

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(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 a loan 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. Payments on non-accrual loans are applied to principal or applied on a cash basis. All interest accrued but not collected for loans that are placed on non-accrual or charged off status 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 Financial Accounting Standards Board ASC 310, Receivables –Subsequent Measurement.  Loans evaluated individually for impairment include classified loans, non-performing loans, 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.   For loans that are not individually evaluated, the Company makes estimates of losses for groups of loans as required by ASC 450-20, Accounting for Contingencies.  Loans are grouped by similar characteristics, including the type of loan, the assigned loan grade and the general collateral type.  Assigned loan grades include Quality, Satisfactory, Acceptable, Special Mention, Substandard and Doubtful, each with an increasing risk of potential loss. 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 is 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 is 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

10

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(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.

Other Real Estate Owned

Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management using updated appraisals and other information and the assets are carried at the lower of carrying amount or fair value less cost to sell.  Generally, appraisals are updated every 24 months for all individually significant properties or when current events indicate that a property may have suffered a material decrease in value.  Revenue and expenses from operations and gains and losses on disposals are included in Non-interest expense captioned “Foreclosed Assets-Write-down and operating expenses”.

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 (2011 through 2013).

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 2014 or 2013.

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.

11

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

Amounts in thousands)

Note 1. Summary of Significant Accounting Policies (Continued)

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.

Recent Accounting Pronouncements

In February 2013, ASU No. 2013-02 - Comprehensive Income was issued to improve the reporting of reclassifications out of accumulated other comprehensive income by requiring an entity to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts.  The amendment was effective for the current reporting period.

In July 2013, the FASB issued ASU 2013-11, Income Taxes (Topic 740) - Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss or a Tax Credit Carryforward Exists. ASU 2013-11 is intended to clarify the presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss or a tax credit carryforward exists. This presentation had not been addressed in Topic 740 and there was diversity in reporting practices in those instances. ASU 2013-11 requires an unrecognized tax benefit to be presented as a liability and not netted against a deferred tax asset.  The amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2014. Early adoption is permitted.  Adoption by the Company is not expected to have an impact on the consolidated financial statements and related disclosures.

Accounting Standards Update (ASU) No. 2014-04, Receivables - Troubled Debt Restructurings by Creditors - Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure was issued by the FASB on January 20, 2014.  The amendments are intended to clarify when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan should be derecognized and the real estate recognized.  These amendments clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either: (a) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure; or (b) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additional disclosures are required. The amendments are effective for interim periods within annual periods beginning after December 15, 2014.

On May 28, 2014, the FASB issued ASU 2014-09 – Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective.  The core principle of the new guidance is that entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  To achieve the core principle, an entity should apply the following steps: (1) identify the contract with the customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract, and (5) recognize revenue when the performance obligation is satisfied.  The new guidance is effective for the Company for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period, early application is not permitted.The Company is evaluating the effect that ASU 2014-09 will have on its consolidated financial statements and related disclosures; however, the Company does not currently expect the new guidance to have a material effect on its financial statements.

12

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

Amounts in thousands)

Note 1. Summary of Significant Accounting Policies (Continued)

In June 2014, the FASB issued ASU 2014-11 – Transfers and Servicing: Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures, which changes the accounting for repurchase-to-maturity transactions to secured borrowing accounting. Additionally, for repurchase financing arrangements, the amendments of this ASU require separate accounting for a transfer of a financial asset executed contemporaneously with a repurchase agreement with the same counterparty, which will result in secured borrowing accounting for the repurchase agreement. The ASU is effective for the first interim or annual period beginning after December 15, 2014. Earlier application is not permitted.  The Company does not expect the adoption of this guidance to have a material impact on the consolidated financial statements.

In August 2014, the FASB issued ASU 2014-14 –Receivables – Troubled Debt Restructurings by Creditors: Classification of Certain Government-Guaranteed Mortgage Loans upon Foreclosure which requires de-recognition of mortgage loan and recognition of other receivable if the loan has a government guarantee (e.g. FHA/VA) and upon foreclosure if the following is met: 1) the loan has a government guarantee that is not separable from the loan before foreclosure; 2) at the time of foreclosure, the creditor has the intent to convey the real estate property to the guarantor and make a claim on the guarantee, and the creditor has the ability to recover under that claim; and, 3) at the time of foreclosure, any amount of the claim that is determined on the basis of the fair value of the real estate is fixed.The other receivable should be measured based on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor.The guidance is effective for annual periods and interim periods within those annual periods, beginning after December 15, 2014.  The Company does not expect the adoption of this guidance to have a material impact on the consolidated financial statements.

Other accounting standards have been issued by the FASB that are not currently applicable to the Company or are not expected to have a material impact on the Company’s financial statements.

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 written strategic and capital plan;

·   establish a revised investment policy;

·   improve the Bank’s earnings and overall condition;

·   revise the Bank’s information technology program;

·   establish a disaster recovery and business continuity program; and,

·   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.

13

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note  3.                      Investment Securities Available-For-Sale

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

	2014
	Amortized Cost	Gross Unrealized Gains	Gross Unrealized Losses	Fair Value
State and political subdivisions	$   9,546	$      163	$         8	$      9,701
Mortgage backed securities	61,476	395	148	61,723
Single Issue Trust Preferred	500	-	12	488
SBA Pools	12,669	29	275	12,423
	$    84,191	$       587	$     443	$    84,335

	2013
	Amortized Cost	Gross Unrealized Gains	Gross Unrealized Losses	Fair Value
State and political subdivisions	$   9,795	$       51	$       309	$      9,537
Mortgage backed securities	30,984	190	434	30,740
Single Issue Trust Preferred	907	-	24	883
SBA Pools	14,396	30	767	13,659
SLMA	500	-	1	499
	$   56,582	$       271	$     1,535	$    55,318

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

	December 31, 2014
	Less Than 12 months		12 Months or More		Total
	Fair Value	Unrealized Losses	Fair Value	Unrealized Losses	Fair Value	Unrealized Losses
State and political subdivisions	$         -	$         -	$   1,002	$    8	$   1,002	$         8
Mortgage-backed securities	5,244	19	7,586	129	12,830	148
Single Issue Trust Preferred	-	-	488	12	488	12
SBA Pools	-	-	11,239	275	11,239	275
Total	$  5,244	$     19	$  20,315	$    424	$25,559	$     443

The total number of investment securities in a loss position at December 31, 2014 was 34.

14

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

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

	December 31, 2013
	Less Than 12 months		12 Months or More		Total
	Fair Value	Unrealized Losses	Fair Value	Unrealized Losses	Fair Value	Unrealized Losses
State and political subdivisions	$    4,812	$     144	$   849	$      165	$   5,661	$      309
Mortgage-backed securities	16,586	308	1,733	126	18,319	434
Pooled Trust Preferred Securities	-	-	-	-	-	-
Single Issue Trust Preferred	-	-	883	24	883	24
SBA Pools	7,273	482	4,802	285	12,075	767
SLMA	499	1	-	-	499	1
Total	$  29,170	$     935	$  8,267	$    600	$37,437	$  1,535

The total number of investment securities in a loss position at December 31, 2013 was 52.

The Company assesses securities for OTTI quarterly by reviewing credit ratings, financial and regulatory reports as well as other pertinent financial indicators published. As of December 31, 2014 and 2013, the Company's assessment revealed no impairment other than that deemed temporary.

Investment securities available-for-sale with a book value (amortized cost) of $39,298 and $40,077 at December 31, 2014 and 2013 respectively, and a market value of $39,325 and $39,889 at December 31, 2014 and 2013, respectively, were pledged as collateral on public deposits, FHLB advances, secured correspondent credit lines and for other purposes as required or permitted by law.

15

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(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, 2014 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	1,529	1,554
Due after five years through ten years	2,088	2,119
Due after ten years	19,098	18,939
	22,715	22,612
Mortgage-backed securities	61,476	61,723
	$     84,191	$     84,335

For the years ended December 31, 2014 and 2013, proceeds from sales of securities were $0 and $4,367 respectively.  Gross realized gains and losses on investment securities available for sale were as follows:

	2014	2013
Realized gains from sales and calls of securities	$       1	$       575
Realized losses	-	(1,333)
Net gains (losses)	$       1	$    (758)

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 $4,525 and $4,460 at December 31, 2014 and 2013, 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 Deposit purchased from other FDIC - insured institutions.  The balances of these CDs were $2,242 and $250 at December 31, 2014 and 2013, respectively.

16

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 5.  Loans and Allowance for Loan Losses

The composition of net loans is as follows:

	2014	2013
Real Estate Secured:
Residential 1-4 family	$   186,829	$   175,860
Multifamily	21,131	20,592
Construction and Land Loans	18,518	18,509
Commercial, Owner Occupied	70,748	71,459
Commercial, Non-owner occupied	32,173	37,117
Second mortgages	8,075	7,934
Equity lines of credit	6,499	7,884
Farmland	8,246	9,322
	352,219	348,677
Secured (other) and unsecured
Personal	20,901	20,472
Commercial	31,586	31,575
Agricultural	2,683	3,376
	55,170	55,423
Overdrafts	285	304
	407,674	404,404
Less:
Allowance for loan losses	5,477	6,825
Net deferred fees	677	618
	6,154	7,443
Loans, net	$    401,520	$    396,961

Loans are considered delinquent when payments have not been made according to the terms of the contract. 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.

17

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(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, 2014:

	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	$    4,521	$    3,001	$    2,884	$    10,406	$  176,423	$  186,829	$          -
Equity lines of credit	45	-	-	45	6,454	6,499	-
Multifamily	1,252	-	-	1,252	19,879	21,131	-
Farmland	208	-	477	685	7,561	8,246	-
Construction,  Land Development, Other Land Loans	417	31	168	616	17,902	18,518	-
Commercial Real Estate- Owner Occupied	2,193	790	2,344	5,327	65,421	70,748	-
Commercial Real Estate- Non Owner Occupied	225	85	1,547	1,857	30,316	32,173	-
Second Mortgages	107	51	134	292	7,783	8,075	-
Non Real Estate Secured
Personal	404	105	233	742	20,444	21,186	22
Commercial	720	49	447	1,216	30,370	31,586	-
Agricultural	3	-	-	3	2,680	2,683	-
Total	$    10,095	$    4,112	$   8,234	$   22,441	$  385,233	$  407,674	$          22

The following is a summary of non-accrual loans at December 31, 2014:

	Amount
Real Estate Secured
Residential 1-4 Family	$       3,401
Multifamily	-
Construction and Land Loans	168
Commercial-Owner Occupied	5,259
Commercial- Non Owner Occupied	1,547
Second Mortgages	134
Equity Lines of Credit	-
Farmland	477
Secured (other) and Unsecured
Personal	211
Commercial	447
Agricultural	-
Total	$     11,644

18

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(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, 2013:

	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	$    3,219	$    1,805	$    2,699	$    7,723	$  168,137	$  175,860	$          -
Equity lines of credit	-	-	318	318	7,566	7,884	-
Multifamily	-	97	-	97	20,495	20,592	-
Farmland	38	-	129	167	9,155	9,322	-
Construction,  Land Development, Other Land Loans	303	117	1,615	2,035	16,474	18,509	-
Commercial Real Estate- Owner Occupied	665	26	1,610	2,301	69,158	71,459	-
Commercial Real Estate- Non Owner Occupied	234	2,257	637	3,128	33,989	37,117	-
Second Mortgages	341	3	56	400	7,534	7,934	-
Non Real Estate Secured
Personal	357	177	146	680	20,096	20,776	2
Commercial	1,344	121	266	1,731	29,844	31,575	-
Agricultural	29	-	-	29	3,347	3,376	-
Total	$    6,530	$    4,603	$   7,476	$   18,609	$  385,795	$  404,404	$          2

The following is a summary of non-accrual loans at December 31, 2013:

	Amount
Real Estate Secured
Residential 1-4 Family	$       2,890
Multifamily	-
Construction and Land Loans	1,694
Commercial-Owner Occupied	3,005
Commercial- Non Owner Occupied	2,429
Second Mortgages	92
Equity Lines of Credit	318
Farmland	146
Secured (other) and Unsecured
Personal	144
Commercial	266
Agricultural	-
Total	$     10,984

19

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(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, 2014 and December 31, 2013. 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 –December 31, 2014

Grade (1)	Residential 1-4 Family	Multifamily	Farmland	Construction, Land Loans	Commercial Real Estate- Owner Occupied	Commercial Real Estate Non-Owner Occupied
Quality	29,494	6	37	3,278	4,159	874
Satisfactory	100,767	16,326	3,090	8,091	31,018	15,052
Acceptable	44,021	2,719	4,080	4,745	20,987	12,223
Special Mention	2,640	828	198	2,231	3,994	2,108
Substandard	9,907	1,252	841	173	10,590	1,916
Doubtful	-	-	-	-	-	-
Total	$   186,829	$     21,131	$     8,246	$        18,518	$     70,748	$      32,173

Credit Risk Profile by Internally Assigned Grade –December 31, 2013

Grade (1)	Residential 1-4 Family	Multifamily	Farmland	Construction, Land Loans	Commercial Real Estate- Owner Occupied	Commercial Real Estate Non-Owner Occupied
Quality	33,137	-	823	3,425	5,831	1,495
Satisfactory	90,569	15,419	4,128	8,123	27,712	15,153
Acceptable	38,958	3,049	3,699	3,733	22,007	11,148
Special Mention	4,678	2,124	6	1,652	6,823	2,507
Substandard	8,518	-	666	1,576	8,620	6,814
Doubtful	-	-	-	-	466	-
Total	$   175,860	$     20,592	$     9,322	$        18,509	$     71,459	$      37,117

(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.

20

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

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

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:

·   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 historical) 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 Bank will sustain some loss if the deficiencies are not corrected.

21

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

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

 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

·   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.

Credit Risk Profile based on payment activity – December 31, 2014

	Consumer - Non Real Estate	Equity Line of Credit /Jr. liens	Commercial - Non Real Estate	Agricultural - Non Real Estate
Performing	$       20,953	$          14,440	$            31,139	$           2,683
Nonperforming (>90 days past due)	233	134	447	-
Total	$       21,186	$         14,574	$              31,586	$           2,683

Credit Risk Profile based on payment activity - December 31, 2013

	Consumer - Non Real Estate	Equity Line of Credit / Jr. liens	Commercial - Non Real Estate	Agricultural - Non Real Estate
Performing	$       20,630	$          15,444	$               31,309	$            3,376
Nonperforming (>90 days past due)	146	374	266	-
Total	$       20,776	$         15,818	$              31,575	$           3,376

22

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

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

The following tables reflect the Bank’s impaired loans at December 31, 2014 and December 31, 2013:

December 31, 2014	Recorded Investment	Unpaid Principal Balance	Related Allowance	Average Recorded Investment	Interest Income Recognized
With no Related Allowance
Real Estate Secured
Residential 1-4 family	$     7,988	$     7,988	$          -	$     7,015	$       256
Equity lines of credit	24	24	-	194	1
Multifamily	1,252	1,252	-	626	21
Farmland	842	842	-	663	32
Construction, Land Development, Other Land Loans	1,738	1,738	-	1,716	64
Commercial Real Estate- Owner Occupied	9,188	9,392	-	7,291	262
Commercial Real Estate- Non Owner Occupied	-	-	-	3,227	-
Second Mortgages	618	618	-	340	20
Non Real Estate Secured
Personal	54	54	-	53	3
Commercial	361	361	-	229	20
Agricultural	-	-	-	-	-
Total	$    22,065	$    22,269	$          -	$   21,354	$       679

December 31, 2014	Recorded Investment	Unpaid Principal Balance	Related Allowance	Average Recorded Investment	Interest Income Recognized
With an Allowance Recorded
Real Estate Secured
Residential 1-4 family	$     3,148	$     3,148	$       586	$     3,087	$       125
Equity lines of credit	-	-	-	19	-
Multifamily	-	-	-	-	-
Farmland	-	-	-	100	-
Construction, Land Development, Other Land Loans	366	366	20	183	13
Commercial Real Estate- Owner Occupied	1,403	1,403	143	2,466	56
Commercial Real Estate- Non Owner Occupied	1,916	1,916	322	3,249	31
Second Mortgages	-	-	-	28	-
Non Real Estate Secured
Personal	253	253	188	193	7
Commercial	802	802	540	863	28
Agricultural	7	7	7	94	1
Total	$    7,895	$    7,895	$     1,806	$    10,282	$       261

23

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

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

December 31, 2013	Recorded Investment	Unpaid Principal Balance	Related Allowance	Average Recorded Investment	Interest Income Recognized
With no Related Allowance
Real Estate Secured
Residential 1-4 family	$     6,042	$     6,042	$          -	$     6,300	$       198
Equity lines of credit	364	364	-	182	6
Multifamily	-	-	-	-	-
Farmland	483	483	-	391	11
Construction, Land Development, Other Land Loans	1,694	1,694	-	1,677	1
Commercial Real Estate- Owner Occupied	5,393	5,393	-	5,201	173
Commercial Real Estate- Non Owner Occupied	6,454	6,454	-	4,943	250
Second Mortgages	62	62	-	191	3
Non Real Estate Secured
Personal	53	53	-	31	3
Commercial	96	96	-	82	5
Agricultural	-	-	-	10	-
Total	$    20,641	$    20,641	$          -	$   19,008	$       650

December 31, 2013	Recorded Investment	Unpaid Principal Balance	Related Allowance	Average Recorded Investment	Interest Income Recognized
With an Allowance Recorded
Real Estate Secured
Residential 1-4 family	$     3,026	$     3,026	$       394	$     3,756	$       145
Equity lines of credit	38	38	38	19	1
Multifamily	-	-	-	202	-
Farmland	200	200	25	201	8
Construction, Land Development, Other Land Loans	-	-	-	-	-
Commercial Real Estate- Owner Occupied	3,528	3,528	630	3,113	72
Commercial Real Estate- Non Owner Occupied	4,581	4,581	1,230	3,788	93
Second Mortgages	56	56	45	28	1
Non Real Estate Secured
Personal	133	133	84	77	6
Commercial	924	924	695	791	34
Agricultural	181	181	56	448	4
Total	$    12,667	$    12,667	$     3,197	$    12,423	$       364

24

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

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

 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, 2014 and 2013, 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 troubled debt restructuring 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 $12,060 and $17,810 of loans categorized as troubled debt restructurings as of December 31, 2014 and 2013, respectively. Interest is accrued on troubled debt restructurings if the loan is otherwise not impaired and the full collection of principal and interest under the modified terms is still deemed probable.

In the determination of the allowance for loan losses, management considers troubled debt restructurings and subsequent defaults in these restructurings by adjusting the loan grades of such loans. Defaults resulting in charge-offs affect the historical loss experience ratios which are a component of the allowance calculation. Additionally, specific reserves may be established on restructured loans evaluated individually.

25

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENT

 December 31, 2014

(Amounts in thousands)

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

The following is a summary of troubled debt restructurings occurring during the twelve months ended December 31, 2014.

Troubled Debt Restructurings Interest only	Number of Contracts	Pre- Modification  Outstanding Recorded Investment	Post- Modification Recorded Investment
Residential 1-4 family
Equity lines of credit
Multifamily	1	1,252	1,252
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied	1	1,395	1,395
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Business Commercial
Agricultural
Total	2	2,647	2,647

Troubled Debt Restructurings Below Market Rate	Number of Contracts	Pre- Modification  Outstanding Recorded Investment	Post- Modification Recorded Investment
Residential 1-4 family	1	879	879
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied	1	707	707
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Business Commercial
Agricultural
Total	2	1,586	1,586

26

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

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

Troubled Debt Restructurings Loan term extension		Number of Contracts	Pre- Modification  Outstanding Recorded Investment	Post- Modification Recorded Investment
Residential 1-4 family		6	1,217	1,217
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied		1	2,114	2,114
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Business Commercial
Agricultural		1	129	129
Total		8	3,460	3,460
Troubled Debt Restructurings All	Number of Contracts		Pre- Modification  Outstanding Recorded Investment	Post- Modification Recorded Investment
Total Restructurings	12		7,693	7,693

Troubled Debt Restructurings That subsequently defaulted	Number of Contracts	Pre- Modification  Outstanding Recorded Investment	Post- Modification Recorded Investment
Residential 1-4 family
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Business Commercial
Agricultural
Total

27

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 December 31, 2014

(Amounts in thousands)

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

The following is a summary of troubled debt restructurings occurring during the twelve months ended December 31, 2013.

Troubled Debt Restructurings Interest only	Number of Contracts	Pre- Modification  Outstanding Recorded Investment	Post- Modification Recorded Investment
Residential 1-4 family
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied	1	1,395	1,395
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Business Commercial
Agricultural
Total	1	1,395	1,395

Troubled Debt Restructurings Below Market Rate	Number of Contracts	Pre- Modification  Outstanding Recorded Investment	Post- Modification Recorded Investment
Residential 1-4 family	2	1,264	1,264
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied
Commercial Real Estate-  Non Owner Occupied	5	8,687	8,687
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Business Commercial
Agricultural
Total	7	9,951	9,951

28

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

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

Troubled Debt Restructurings Loan term extension		Number of Contracts	Pre- Modification  Outstanding Recorded Investment	Post- Modification Recorded Investment
Residential 1-4 family		3	500	500
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans		1	55	55
Commercial Real Estate-  Owner Occupied		1	552	552
Commercial Real Estate-  Non Owner Occupied
Second Mortgages		1	36	36
Non Real Estate Secured
Personal / Consumer
Business Commercial		1	71	71
Agricultural		3	755	755
Total		10	1,969	1,969
Troubled Debt Restructurings All	Number of Contracts		Pre- Modification  Outstanding Recorded Investment	Post- Modification Recorded Investment
Total Restructurings	18		13,315	13,315

Troubled Debt Restructurings That subsequently defaulted	Number of Contracts	Pre- Modification  Outstanding Recorded Investment	Post- Modification Recorded Investment
Residential 1-4 family
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate-  Owner Occupied
Commercial Real Estate-  Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer
Business Commercial
Agricultural
Total

29

IGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

          (Amounts in thousands)

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

The following tables present the balance in the allowance for loan losses and the recorded investment in loans by loan category and is segregated by impairment evaluation method as of  December 31, 2014 and December 31, 2013.

Twelve months ended December 31, 2014	Residential 1-4 Family	Multifamily	Construction and Land Loans	Commercial Owner Occupied	Commercial Non-Owner Occupied	Second Mortgages	Equity Line of Credit	Farmland	Personal and  Overdrafts	Commercial and Agricultural	Unallocated	Total
Allowance for Credit Losses:
Beginning Balance December 31,  2013	975	143	230	1,029	1,415	153	50	65	483	1,264	1,018	6,825
Provision for Credit Losses	277	(123)	(142)	(407)	886	(61)	140	(53)	636	86	85	1,324
Charge-offs	258	-	18	345	1,239	25	116	-	544	407	-	2,952
Recoveries	(1)	-	(17)	(132)	(1)	-	-	-	(90)	(39)	-	(280)
Net Charge-offs	257	-	1	213	1,238	25	116	-	454	368	-	2,672
Ending Balance  December 31, 2014	995	20	87	409	1,063	67	74	12	665	982	1,103	5,477
Ending Balance: Individually evaluated for impairment	586	-	20	143	322	-	-	-	188	547	-	1,806
Ending Balance:  Collectively Evaluated for Impairment	409	20	67	266	741	67	74	12	477	435	1,103	3,671
Loans:
Ending Balance: Individually Evaluated for Impairment	11,136	1,252	2,104	10,591	1,916	618	24	842	592	1,170	-	30,245
Ending Balance: Collectively Evaluated for Impairment	175,693	19,879	16,414	60,157	30,257	7,457	6,475	7,404	20,594	33,099	-	377,429
Ending Balance: December 31, 2014	$186,829	$21,131	$18,518	$70,748	$32,173	$8,075	$6,499	$8,246	$21,186	$34,269	-	$407,674

30

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

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

Twelve months ended December 31, 2013	Residential 1-4 Family	Multifamily	Construction and Land Loans	Commercial Owner Occupied	Commercial Non-Owner Occupied	Second Mortgages	Equity Line of Credit	Farmland	Personal and  Overdrafts	Commercial and Agricultural	Unallocated	Total
Allowance for Credit Losses:
Beginning Balance December 31,  2012	1,242	280	823	1,039	1,075	161	30	97	486	1,530	686	7,449
Provision for Credit Losses	166	(137)	(471)	42	748	126	23	8	366	117	332	1,320
Charge-offs	452	-	127	52	408	134	3	40	444	420	-	2,080
Recoveries	(19)	-	(5)	-	-	-	-	-	(75)	(37)	-	(136)
Net Charge-offs	433	-	122	52	408	134	3	40	369	383	-	1,944
Ending Balance  December 31, 2013	975	143	230	1,029	1,415	153	50	65	483	1,264	1,018	6,825
Ending Balance: Individually evaluated for impairment	394	-	-	630	1,230	45	38	25	84	751	-	3,197
Ending Balance:  Collectively Evaluated for Impairment	581	143	230	399	185	108	12	40	399	513	1,018	3,628
Loans:
Ending Balance: Individually Evaluated for Impairment	9,068	-	1,694	8,921	11,035	118	402	683	490	1,201	-	33,612
Ending Balance: Collectively Evaluated for Impairment	166,792	20,592	16,815	62,538	26,082	7,816	7,482	8,639	20,286	33,750	-	370,792
Ending Balance: December 31, 2013	$175,860	$20,592	$18,509	$71,459	$37,117	$7,934	$7,884	$9,322	$20,776	$34,951	-	$404,404

31

HIGHLANDSBANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

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

 Overview of Loan Review and ALLL Processes

The loan review function performs various tasks that are utilized to discover weaknesses within the loan portfolio.  These include annual reviews on loan relationships that are greater than $500,000.  The relationship review includes a discussion on the collateral, repayment history, guarantor(s) financial position, and debt service coverage on an individual and global level.  These reviews are based primarily upon federal tax returns for cash flow determination, internally prepared interim statements and personal financial statements.  Debt service coverage (DSC) is calculated on each individual customer, or guarantor, as well as the aggregate or global DSC.  The DSC is discounted to determine a “stressed” DSC.  Collateral evaluation includes an inspection of the collateral file to determine if the Bank is indeed properly securitized.  Collateral is discounted, when appropriate, to determine a “stressed” loan to value ratio (LTV).   In addition to annual loan relationship reviews, quarterly reviews on all loan relationships over $100,000 that are graded Substandard, Doubtful and Loss are also completed.  This quarterly review process is comprised of a shortened version of the full relationship review.  These quarterly reviews include a discussion on personal credit management, DSC and LTV.  In addition to these quarterly reviews of all non-pass watch list relationships, a semi-annual review is conducted on all Special Mention loan relationships that are on the watch list.  These reviews are prepared in the same manner as the quarterly non-pass relationship reviews.  The appropriateness of the risk rating of each relationship is assessed, with changes to the risk rating being made by the Senior Credit Review Officer, when deemed appropriate. Other measures taken to determine potential problem relationships include the monthly preparation of the watch list.  During that process, past due loan reports are reviewed, as well as any other information that might be presented by loan officers, regarding a particular loan relationship that is exhibiting stress.  To be considered as a watch list relationship, distinct characteristics must be exhibited.  These include, but are not limited to late payments greater than 60 days, a low DSC calculation, bankruptcy filings, casualty losses, or other issues that would cause a perceived increase in the risk of loss to the Bank. The final segment of the loan review process involves special reviews.  These reviews target specific segments of the loan portfolio, i.e. credit cards, equity lines, consumer loans, construction loans, and other specific segments of the loan portfolio that management wishes to have reviewed.  However, currently, the primary emphasis of the loan review function is loan relationship review work, and watch list management.

The segments of the Company’s loan portfolio are disaggregated to a level that allows management to monitor risk and performance. In reviewing risk, management has determined there to be several different risk categories within the loan portfolio. The allowance for loan losses consists of amounts applicable to: (i) the commercial loan portfolio; (ii) the commercial real estate loan portfolio; (iii) the construction loan portfolio; (iv) the consumer loan portfolio; and, (v) the residential loan portfolio. The commercial real estate (“CRE”) loan segment is further disaggregated into two classes. Non-owner occupied CRE loans, which include loans secured by non-owner occupied nonfarm nonresidential properties, generally have a greater risk profile than all other CRE loans, which include multifamily structures and owner-occupied commercial structures. The construction loan segment is further disaggregated into two classes. One-to-four family residential construction loans are generally made to individuals for the acquisition of and/or construction on a lot or lots on which a residential dwelling is to be built. Commercial construction loans are generally made to developers or investors for the purpose of acquiring, developing and constructing residential or commercial structures. Construction lending is generally considered to involve a higher degree of credit risk than long-term permanent financing.

The following describes the Company’s basic methodology for computing its ALLL for the twelve months ending December 31, 2014 and 2013.

On a quarterly basis, the ALLL methodology begins with the identification of loans subject to ASC 310.  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 under ASC 310. All loans that are rated “5” (Special Mention) are presumed not to be impaired. However, “5” rated loans, together with any troubled debt restructured loans, may warrant further analysis before completing an assessment of impairment.  For ASC 310 loans that are individually evaluated and found to be impaired (primarily those designated as Substandard and Doubtful), the associated ALLL will be based upon one of the three impairment measurement methods specified within ASC 310:

(1)   Present value of expected future cash flows discounted at the loan’s effective interest rate;

(2)   Loan’s observable market price; or,

(3)   Fair value of the collateral.

32

HIGHLANDSBANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

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

To determine the amount of loan loss exposure for the impaired ASC 310 loans, the value of collateral for secured loans is evaluated to determine the current value and potential exposure.  The collateral value is adjusted for its age and condition, and, for real estate, adjusted for condition, location, and age of the most current appraisal.  If the adjusted value of the collateral is less than the current principal balance, the difference is designated as direct exposure for loan loss calculations.  The total balance of unsecured loans is considered as direct exposure.

ASC 450 Loan Loss:

For all other loans, including individual loans determined not to be impaired under ASC 310, the associated ALLL is calculated in accordance with ASC 450 that provides for estimated credit losses likely to be realized on groups of loans with similar risk characteristics. The Bank uses standard call report categories to segregate loans into groups with similar risk characteristics. Estimated credit losses reflect significant factors that affect the collectability of the portfolio as of the evaluation date. Key factors that influence risk within the Bank’s loan portfolio are divided into three major categories:

(1) Historical Loss Factor: To calculate the anticipated loan loss in each call report category for ASC 450 loans, the Bank begins with the net loss in each category for each of the last twelve quarters. The Bank uses a rolling twelve quarter weighted historical loss average where the most recent quarters are weighted heavier than the earlier quarters so that the calculation reflects current risk trends within the portfolio.  The weighting used by the Bank is similar to the Rule of 78’s with the net losses of the most recent quarter weighted at 12/78ths and those in the first quarter in the twelve quarter period weighted at 1/78th.   Therefore, the net losses of the most recent year represent approximately 54% of the calculation compared with 33% if a simple average of losses over the three-year period was used. The total of weighted factors for each call report category is applied to the current outstanding loan balance in each category to calculate expected loss based on historical data for a group of loans with similar risk characteristics.  The same weighting is applied to all loan types.

(2)External economic factors:  Economic conditions have a significant impact on the Bank’s loan portfolio because deteriorating conditions can adversely impact both collateral values and the customer’s ability to service debt.  Management has selected the following external factors as indicators of economic conditions:

a.   National GDP Growth Rate

b.   Local Unemployment Rates

c.   The Prime Rate

The values for external factors are updated on a quarterly basis based on current economic data.

(3)Internal process factors:  Internal factors that influence loss rates as a result of risk management and control practices include the following:

d.   Past-Due Loans

e.   Non-Accrual Loans

f.   CRE Concentrations

g.   Loan Volume Level

h.   Level and Trend of Classified Loans

  The values for internal factors are updated on a quarterly basis based on current portfolio metrics.

Once the quarterly ALLL is computed, the calculations are reviewed by the Company’s credit administration committee which is comprised of the CEO, CFO, and Senior Lending Officers, including Credit Review personnel.  The Company’s controller also performs a detailed review of the computations, estimates, etc. included in the ALLL calculation. The ALLL is then reviewed and approved by the Board of Directors.

33

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 6.  Premises and Equipment

Premises and equipment are comprised of the following:

	2014	2013
Land	$        9,150	$        9,150
Bank Premises	14,071	14,061
Equipment	14,201	13,355
	37,422	36,566
Less: accumulated depreciation	17,200	16,378
Construction in progress	14	-
	$        20,236	$       20,188

Depreciation expense was $863 and $876 for 2014 and 2013, 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, 2014 and 2013 was $14,183 and $14,132, respectively.

34

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 8.  Income Taxes

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

	2014		2013
Deferred tax assets:
Allowance for loan loss	$	1,862	$	2,321
Previous Years AMT		802		802
Loss on Other Equity Investments		51		51
NOL carry-forwards  (20 year carry-forward period)		9,420		9,125
Net unrealized loss on securities available-for-sale		-		430
		12,135		12,729
Deferred tax liability:
Depreciation		(342)		(285)
Net unrealized gain on securities available for sale		(49)		-
		(391		(285)
Deferred Tax Asset Valuation Allowance		(1,000)		(2,000)
Net deferred tax assets:	$	10,744	$	10,444

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

	2014		2013
Federal:
Current	$	(295)	$	(735)
Deferred		(482)		(1,944)
Total	$	(777)	$	(2,679)

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

	2014		2013
Statutory rate applied to earnings (losses) before income taxes	$	595	$	(406)
Tax exempt interest		(164)		(187)
Life Insurance proceeds		(78)
Deferred Tax Valuation allowance		(1,000)		(2,000)
Other, net		(130)		(86)
Total	$	(777)	$	(2,679)

Deferred tax assets represent the future tax benefit of deductible differences and, if it is more likely than not that a tax asset will not be realized, a valuation allowance is required to reduce the recorded deferred tax assets to net realizable value. As of December 31, 2011, in consideration of uncertainties regarding the timing of improvements in current economic conditions and management’s estimate of future tax liabilities, management provided an allowance of $4,170.  As of December 31, 2014, management maintained an allowance of $1,000 to reflect its estimate of net realizable value at that date. The expiration date range related to the utilization of the net operating losses (20 year period) is 2030 thru 2034.

35

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 9. Deposits

The composition of deposits is as follows:

	2014	2013
Non-interest bearing demand	$       118,557	$       107,328
Interest bearing demand	111,527	116,052
Savings deposits	83,608	79,558
Time deposits, in amounts of $100,000 or more	52,812	57,369
Other time deposits	116,993	127,967
Total deposits	$      483,497	$      488,274

The scheduled maturities of time deposits at December 31, 2014 are as follows:

2015	$    84,035
2016	23,131
2017	14,996
2018	12,169
2019	13,467
Thereafter	22,007
	$      169,805

Note 10. Short-Term Borrowings

Short-term borrowings totaling $20,051 at December 31, 2014 as shown on the balance sheet consist primarily of two Federal Home Loan Bank advances that are secured by a lien on a specific class of residential and commercial mortgage loans of the Bank. The advances are also secured by a specific group of available for sale securities held in safekeeping by the FHLB. The Federal Home Loan Bank has the option to convert these advances which total $20,000 to a three month LIBOR-based floating rate advance.  These two notes have interest rates that range from 3.84% to 4.34% at December 31, 2014. The average rate paid on these two borrowings was 3.97% during 2013 and 2014. Also included in other short-term borrowings are the contractual principal payments due over the next 12 months on an FHLB advance granted through the FHLB’s Affordable Housing Program. The contractual payments due on the FHLB Affordable Housing program loan total $51 and have a zero interest rate.  As discussed in Note 25, the Company paid off a Holding Company Loan from Community Bankers Bank in the amount of $3,440 with funds received in the private placement capital raise. This loan was included in short-term borrowings as of December 31, 2013.

36

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 11. Long-Term Debt

At December 31, Highlands Bankshares, Inc. and its Subsidiary had the following long-term debt agreements:

	2014		2013
Note payable FHLB dated 08/23/05 for $750 with an annual interest rate of 0%, due 08/24/2020. The note requires monthly principal payments and was granted as part of the FHLB’s Affordable Housing Program.	$	250		302

Note payable FHLB dated 08/29/12 for $12,500 with an annual interest rate of 3.53%, due 08/29/19. The note requires quarterly interest payments.		12,500		12,500
Note payable FHLB dated 08/29/12 for $12,500 with an annual interest rate of 3.70%, due 08/29/19. The note requires quarterly interest payments.		12,500		12,500
Note payable FHLB dated 08/29/12 for $5,000 with an annual interest rate of 2.73%, due 08/29/18. The note requires quarterly interest payments		5,000		5,000
Note payable FHLB dated 08/29/12 for $5,000 with an annual interest rate of 3.74%, due 08/29/19. The note requires quarterly interest payments.		5,000		5,000
Note payable FHLB dated 08/29/12 for $7,500 with an annual interest rate of 2.43%, due 08/29/17. The note requires quarterly interest payments.		7,500		7,500
Note payable FHLB dated 08/29/12 for $5,000 with an annual interest rate of 2.86%, due 08/29/18. The note requires quarterly interest payments.		5,000		5,000
Total	$	47,750	$	47,802

37

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 11. Long-Term Debt (continued)

A specific class of commercial and residential mortgage loans, with a balance of $151,033 at December 31, 2014 and a specific group of securities available for sale with a lendable collateral value of $3,620 at December 31, 2014 were pledged to the FHLB as collateral for the above advances and to secure additional available lines of credit.

Contractual principal maturities of long-term debt at December 31, 2014 are as follows:

2015	$               -
2016	51
2017	7,552
2018	10,053
2019	30,054
Thereafter	40
	$      47,750

38

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 12. Capital Securities

The Company completed a $7.5 million capital issue of 9.25% Preferred Securities (the “Trust Preferred Securities”) on January 23, 1998.  These Trust Preferred Securities were issued by Highlands Capital Trust I, a wholly owned subsidiary of the Company.

On July 15, 2014, the Company redeemed in full the Trust Preferred Securities and paid all the deferred interest payments with proceeds received from the April 2014 private placement capital raise that is further discussed in Note 25.

Note 13.  Stock and Earnings Per Share

Earnings per common share is computed using the weighted average outstanding shares for the years ended December 31.  Outstanding stock options (Note 15) impact on earnings per share is determined using the treasury stock method. For 2014 and 2013, the impact of conversions of outstanding stock options was anti-dilutive. During 2014, the Company issued a total of 2,092,287 shares of Series A preferred stock (See Note 25). These preferred shares are non-voting mandatorily convertible non-cumulative preferred shares which are entitled to receive dividends equal to dividends paid on the Company’s common shares. The Series A preferred shares will rank pari passu with the common stock with respect to all terms (other than voting), including, the payment of dividends or distributions, and payments and rights upon liquidation and dissolution. The following is a reconciliation of the numerators and the denominators of the basic and diluted earnings per common share computation:

	2014	2013
Income available to common stockholders	$       2,526	$       1,482
Weighted average shares outstanding	6,964	5,011
Shares outstanding including assumed conversion	9,056	5,011
Basic earnings per common share	$        0.36	$        0.30
Fully diluted earnings per share (including convertible preferred shares oustanding)	$        0.28	$        0.30

Note 14. Profit Sharing and Retirement Savings Plan

The Bank has a 401(K) savings plan available to substantially all employees meeting minimum eligibility requirements.  The Bank makes a discretionary 1.5% profit sharing contribution to all employees exclusive of employee contributions and employer matching.    Employees may elect to make voluntary contributions to the plan up to the maximum allowed by law.  In addition to the 1.5% profit sharing contribution, the Bank matches 100% of the employee’s initial 1% contribution and 50% of the next 5%. The cost of Bank contributions under the savings plan was $300 and $290 in 2014 and 2013, respectively.

39

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 15. Stock Option Plan and Equity Compensation Plan

The Company sponsors an equity compensation plan, adopted by the Board of Directors in 2006, which provides for the granting of nonqualified stock options, stock appreciation rights, stock awards and stock units. Under the plan, the Company may grant options to its directors, officers and employees for up to 200,000 shares of common stock. The Company did not grant any equity compensation in 2014 or 2013.

A summary of the status of the Company’s stock option plan is presented below:

	2014		2013
	Weighted Average Exercise Price	Number of Shares	Weighted Average Exercise Price	Number of Shares
Options outstanding at January 1	$    14.76	106,900	$    14.24	151,600
Granted	-	-	-	-
Exercised	-	-	-	-
Expired	14.50	(51,300)	13.00	(44,700)
Options outstanding and exercisable at December 31	$   15.00	55,600	$   14.76	106,900

    Information pertaining to options outstanding at December 31, 2014 is as follows:

Options Outstanding and Exercisable
Number Outstanding	Weighted Average Remaining Contractual Life	Exercise Price
55,600	0.44 years	$      15.00

40

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 16. Off-Balance Sheet Activities

The Bank is party to various financial instruments with off-balance sheet risk arising in the normal course of business to meet the financing needs of their customers.  Those financial instruments include commitments to extend credit and commercial letters of credit of approximately $324 and $524, unfunded commitments under lines of credit of $41,738 and $39,572 and commitments to grant new loans of $2,862 and $2,830 for the years ended December 31, 2014 and 2013, respectively.  These instruments contain various elements of credit and interest rate risk in excess of the amount recognized in the statements of financial condition. The Bank's exposure to credit loss, in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit, is the contractual amount of those instruments.  The Bank uses the same credit policies in making commitments and conditional obligations that they do for on-balance sheet instruments. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  The commitments for equity lines of credit may expire without being drawn upon.  Therefore, the total commitment amounts do not necessarily represent future cash requirements.  The amount of collateral obtained, if it is deemed necessary by the Company, is based on management’s credit evaluation of the customer.

Unfunded commitments under lines of credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers.  These lines of credit usually do not contain a specified maturity date and may not be drawn upon to the total extent to which the Company is committed.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party.  Those letters of credit are primarily issued to support public and private borrowing arrangements.  Essentially all letters of credit issued have expiration dates within one year.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  The Company holds collateral supporting those commitments if deemed necessary.

Note 17.                        Commitments and Contingencies

The Bank has made arrangements with and has available from corresponding banks certain lines of credit to fund any necessary cash requirements. The Bank has $67,801 of Federal Home Loan Bank advances outstanding against its corresponding line of credit as of December 31, 2014. A specific class of commercial and residential mortgage loans, with a balance of $151,033 at December 31, 2014 and a specific group of securities available for sale with a lendable collateral value of $3,620 at December 31, 2014 were pledged to the FHLB as collateral. At December 31, 2014, the Bank had approximately $49,000 of available credit at the FHLB and $6,000 of secured lines of available credit granted from one of its correspondent banks.

In 2010, Edith Moser (“Moser”) filed two complaints in the Circuit Court of Washington County, VA, claiming that Highlands Union Bank (the “Bank”) improperly handled the repossession and disposition of collateral from a warehouse in June/July 2008.  Moser also claims that the Bank acted as her business advisor and breached fiduciary duties owed to her in this capacity.  One complaint seeks $700 in damages for conversion based solely on the repossession/disposition of collateral.  The second complaint seeks $7,850 in damages for breach of fiduciary duty, violation of UCC Article 9, actual fraud, unjust enrichment, and business conspiracy.  In response, the Bank filed demurrers to both complaints, both of which were granted in part and denied in part with leave granted to amend. Moser chose not to amend either complaint, opting instead to consolidate her remaining claims into one action.  Moser’s remaining claims against the Bank were for violation of UCC Article 9, fraud, unjust enrichment of personal property, and conversion of personal property.  This proceeding concluded in February 2015, following a jury trial at which the court struck the UCC and fraud claims and the jury returned a verdict in favor of Moser with respect to the remaining claims, awarding her $4 in compensatory damages and no punitive damages.

41

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 17.                        Commitments and Contingencies (Continued)

On January 27, 2014, Angela Welch, as Chapter 7 Trustee for the bankruptcy estate of Frank Michael Mongelluzzi, named the Bank as a defendant in a lawsuit filed in the U.S. District Court for the Middle District of Florida, Tampa Division, No. 8:14cv00189-JDW-TBM, M.D. Fla.  The case was transferred to the U.S. District Court for the Western District of Virginia, and is styled Welch v. Highlands Union Bank, 1:14-cv-00063-JPJ-PMS, W.D. Va.  The  complaint states three counts: the first for avoidance and recovery of fraudulent transfers pursuant to 11 U.S.C. § 544(b) and Florida Statutes §§ 726.105(1)(a) and 726.108, and/or otherwise applicable law; the second for  avoidance and recovery of fraudulent transfers pursuant to 11

U.S.C. § 544(b) and Florida Statutes §§ 726.105(1)(b) and 726.108, and/or otherwise applicable law; and the third for avoidance and recovery of fraudulent transfers pursuant to 11 U.S.C. § 544(b) and Florida Statutes §§ 726.106(1) and 726.108, and/or otherwise applicable law.  Each count seeks the recovery of $1,246 in overdraft repayments made by the debtor to the Bank, prejudgment interest, and costs.  The matter is in the discovery stage. The Bank intends to vigorously defend itself. We are unable to evaluate the likelihood of an unfavorable outcome or estimate the amount or range of potential loss.

Note 18.                        Fair Value Disclosures

The Company utilizes fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures.  Securities available-for-sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Fair Value Hierarchy

Under ASC Topic 820 on Fair Value Measurements and Disclosures, the Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

·   Level 1 - Valuation is based upon quoted prices for identical instruments traded in active markets.

·   Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

·   Level 3 - Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

A description of valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon third party models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality, the Company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

Recurring --Investment Securities Available for Sale

Securities classified as available for sale are reported at fair value utilizing Level 2.  For Level 2 securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, and the bond’s terms and conditions, among other things.

42

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 18.                        Fair Value Disclosures (Continued)

The following summarizes the Company’s available for sale securities portfolio measured at fair value on a recurring basis as of December 31, 2014 and December 31, 2013, segregated by the level of the valuation inputs within the fair value hierarchy.

2014
	Level 1	Level 2	Level 3	Total Fair Value
Available for Sale Securities
State and Political Subdivisions	$          -	$     9,701	$          -	$     9,701
Mortgage Backed Securities	$          -	61,723	$          -	61,723
Single Issue Trust Preferred	$          -	488	$          -	488
SBA Pools	$          -	12,423	$          -	12,423
SLMA	$          -	-	$          -	-
Total AFS Securities	$          -	$   84,335	$         -	$   84,335

2013
	Level 1	Level 2	Level 3	Total Fair Value
Available for Sale Securities
State and Political Subdivisions	$          -	$     9,537	$          -	$    9,537
Mortgage Backed Securities	$          -	30,740	$          -	30,740
Single Issue Trust Preferred	$          -	883	$          -	883
SBA Pools	$          -	13,659	$          -	13,659
SLMA	$          -	499	$          -	499
Total AFS Securities	$          -	$  55,318	$          -	$  55,318

Pursuant to ASC Topic 820, the following table shows a reconciliation of the beginning and ending balance at December 31, 2013 for Level 3 assets measured on a recurring basis using significant unobservable inputs.

Investment Securities Available for Sale	2013
Beginning Balance, January 1	$       294
Total gains (losses) included in net income	(754)
Included in Other Comprehensive Income	460
Transfers in or out of Level 3	-
Ending Balance, December 31	$           -

Non Recurring - Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value, recent appraisal value and /or tax assessed value, liquidation value and 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, 2014 and December 31, 2013, all of the total impaired loans were evaluated based on the fair value of the collateral.  The Company frequently obtains appraisals prepared by external professional appraisers and applies discounts ranging from 8% to 40% depending on type of property, condition, location, etc.; therefore, the Company records impaired loans in Level 3. The Company also in certain instances prepares internally generated valuations from on-site inspections, third-party valuation models or other information.

43

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 18.                        Fair Value Disclosures (Continued)

Non Recurring -Foreclosed Assets / Repossessions

Foreclosed assets and repossessions are adjusted to fair value upon transfer of the loans to foreclosed assets and repossessions. Subsequently, foreclosed assets and repossessions are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices or recent appraised values of the collateral which the Company considers as nonrecurring Level 2.  When the current appraised value is not available and /or further discounted below the most recent appraised value less selling costs due to such things as absorption rates and market conditions, the Company records the foreclosed assets within Level 3 of the fair value hierarchy.

The following table summarizes the Company’s assets at fair value on a non - recurring basis as of December 31, 2014 and December 31, 2013 segregated by the level of the valuation inputs within the fair value hierarchy. The tables disclose the recorded investment of impaired loans requiring a specific allowance.

December 31, 2014	Level 1	Level 2	Level 3	Total Fair Value
Impaired Loans	$           -	$             -	$   7,895	$   7,895
Repossessions/OREO, net	$           -	$             -	$     6,704	$   6,704

December 31, 2013	Level 1	Level 2	Level 3	Total Fair Value
Impaired Loans	$           -	$               -	$  12,667	$   12,667
Repossessions/OREO, net	$           -	$       1,218	$ 6,618	$     7,836

The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis for which the Company uses Level 3 inputs to determine fair value (dollars in thousands):

			Quantitative Information about Level 3 Fair Value Measurements
					Valuation	Unobservable	Range
December 31,	2014		2013		Techniques	Input (2)	(Weighted Average)
OREO	$	6,704	$	6,618	Appraisal of collateral (1)	Appraisal adjustments	0% to 45% (13%)
						Liquidation expenses	0% to 10% (9%)
Impaired loans	$	7,895	$	12,667	Fair value of collateral –real estate  (1), (3)	Appraisal adjustments	0% to 10% (9%)
					FFair value of collateral –equipment, inventory, other  (1), (3)	Appraisal adjustments	25% to 50% (33%)
						Liquidation expenses	0% to 10% (9%)

44

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 18.                        Fair Value Disclosures (Continued)

Valuation adjustments and liquidation cost adjustments represent unobservable inputs for OREO and impaired loans.  The ranges of discounts applied are based on age of independent appraisals, type and condition of collateral, current market conditions, and experience with the local market.

(1)Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various level 3 inputs which are not identifiable.

(2)Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses.  The range and weighted average of liquidation expenses and other appraisal adjustments are presented as a percent of the appraisal.

(3)Includes qualitative adjustments by management.

General

The Company has no liabilities carried at fair value or measured at fair value on a non-recurring basis.

Fair Value of Financial Instruments

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices.  However, in many instances, there are no quoted market prices for the Company’s various financial instruments.  In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.  Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of   the   instrument.  Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

Cash and Cash Equivalents

The carrying amount reported in the balance sheets for cash, short-term investments and federal funds sold approximates fair value.

Securities Available for Sale

Fair values are determined in the manner as described above.

Other Investments

Other investments include Federal Home Loan Bank stock, Federal Reserve Bank stock, Community Bankers Bank stock and Pacific Coast Bankers Bank stock.  The carrying value of those securities approximates fair value based on the redemption provisions of those Banks. Also included in other investments are certificates of deposit purchased from other FDIC banks in which the carrying amount approximates fair value.

Loans

The fair value of loans represent estimates at which the loans of the Bank could be exchanged on the open market, based upon the current lending rate for similar types of lending arrangements discounted over the remaining life of the loans.

Deposits

The fair value of deposits represent estimates at which the deposit liabilities of the Bank could be exchanged on the open market, based upon the current deposit rates for similar types of deposit arrangements discounted over the remaining life of the deposits.

Other Short-Term Borrowings

45

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 18.                        Fair Value Disclosures (Continued)

Fair values of other short-term borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements. Estimated maturity dates are also included in the calculation of fair value for these borrowings.

Long-term Debt and Capital Securities

Rates currently available to the Company for debt with similar terms and remaining maturities or established call prices are used to estimate fair value of existing debt.

Off-Balance Sheet Instruments

The amount of off-balance sheet commitments to extend credit, standby letters of credit, and financial guarantees, is considered equal to fair value.  Because of the uncertainty involved in attempting to assess the likelihood and timing of commitments being drawn upon, coupled with the lack of an established market and the wide diversity of fee structures, the Company does not believe it is meaningful to provide an estimate of fair value that differs from the given value of the commitment

The carrying amounts and fair values of the Company's financial instruments at December 31, 2014 and December 31, 2013 were as follows:

	December  31, 2014		December 31, 2013
	Carrying Amount	Fair Value	Carrying Amount	Fair Value
Cash and cash equivalents	$    55,810	$    55,810	$    83,995	$    83,995
Securities available for sale	84,335	84,335	55,318	55,318
Other investments	6,767	6,767	4,710	4,710
Loans, net	401,520	398,019	396,961	390,401
Deposits	(483,497))	(464,335))	(488,274)	(466,120))
Other short-term borrowings	(20,051))	(21,495))	(23,500)	(25,538))
Long-term debt	(47,750))	(50,799))	(47,802)	(50,892))
Capital Securities	-	-	(3,150)	(3,175))

Note 19.                        Related Party Transactions

In the normal course of business, the Bank has made loans to its directors and officers and their affiliates.  All loans and commitments made to such officers and directors and to companies in which they are officers or have significant ownership interest have been made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons, and did not, in the opinion of management, involve more than normal credit risk or present other unfavorable features.  The activity in such loans is as follows:

	2014	2013
Balance, beginning	$    7,723	$    10,952
Additions	2,549	3,546
Reductions	(2,498))	(6,775))
Balance, ending	$    7,774	$    7,723
Unused commitments	$      720	$      574

Deposits from related parties held by the Bank at December 31, 2014 and 2013 were $4,029 and $3,531, respectively.

46

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 20.                        Restrictions on Cash

The Federal Reserve Bank requires the Bank to maintain reserve balances.  The total of those reserve balances including available vault cash at December 31, 2014 and 2013 was $9,455 and $10,311 respectively.

Note 21.                        Minimum Regulatory Capital Requirements

The Company and the Bank are subject to various regulatory capital requirements administered by their primary regulator, the Federal Reserve Bank of Richmond.  Failure to meet the minimum regulatory capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators, that if undertaken, could have a direct material effect on the Company and Bank and the consolidated financial statements.  Under the regulatory capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines involving quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification under the prompt corrective action guidelines are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.  Prompt corrective action provisions are not applicable to bank holding companies.

47

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 21.  Minimum Regulatory Capital Requirements (continued)

Existing quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of total risk-based capital and Tier I capital to risk-weighted assets (as defined in the regulations), and Tier I capital to adjusted total assets (as defined).

As of December 31, 2014, the most recent notification from the Federal Reserve Bank of Richmond categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.

The Company’s actual and required capital amounts and ratios are as follows:

	Actual		For Capital Adequacy Purposes
	Amount	Ratio	Amount	Ratio
As of December 31, 2014:
Total Risk-Based Capital (to Risk-Weighted Assets)	$   51,688	14.32%	$ 28,875	=,> 8%
Tier 1 Capital (to Risk-Weighted Assets)	47,167	13.07%	14,437	=,> 4%
Tier 1 Capital (to Adjusted Total Assets)	47,167	7.78%	24,239	=,> 4%
As of December 31, 2013:
Total Risk-Based Capital (to Risk-Weighted Assets)	$   35,129	9.81%	$ 28,650	=,> 8%
Tier 1 Capital (to Risk-Weighted Assets)	30,627	8.55%	14,325	=,> 4%
Tier 1 Capital (to Adjusted Total Assets)	30,627	5.22%	23,451	=,> 4%

The Bank’s actual and required capital amounts and ratios are as follows:

	Actual		For Capital Adequacy Purposes		To be Well Capitalized under the Prompt Corrective Action Provisions
	Amount	Ratio	Amount	Ratio	Amount	Ratio
As of December 31, 2014:
Total Risk-Based Capital (to Risk-Weighted  Assets)	$   51,184	14.19%	$  28,861	=,> 8%	$ 36,076	=,> 10%
Tier 1 Capital (to Risk-Weighted Assets)	46,663	12.93%	14,430	=,> 4%	21,645	=,> 6%
Tier 1 Capital (to Adjusted Total Assets)	46,663	7.71%	24,196	=,> 4%	30,245	=,> 5%
As of December 31, 2013:
Total Risk-Based Capital (to Risk-Weighted  Assets)	$   39,477	11.03%	$  28,626	=,> 8%	$ 35,783	=,> 10%
Tier 1 Capital (to Risk-Weighted Assets)	34,975	9.77%	14,313	=,> 4%	21,470	=,> 6%
Tier 1 Capital (to Adjusted Total Assets)	34,975	5.98%	23,402	=,> 4%	29,253	=,> 5%

On July 7, 2013 the Federal Reserve Board approved Basel III Final Rule to begin implementation January 1, 2015. The desired overall objective of Basel III is to improve the banking sector’s ability to absorb shocks arising from financial and economic stress.  The Final Rule changes minimum capital ratios and raises the Tier 1 Risk Weighted Assets to 6% from 4%.  In addition, the new rules require a bank to maintain a capital conservation buffer of between 2 and 2 ½ % beginning in 2016.  The new rules will be phased in beginning in 2015 with complete compliance required by 2019.  Generally, the Basel III Final Rule will require banks to maintain higher levels of common equity and regulatory capital.

48

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 22.                        Restrictions on Dividends

The Parent Company’s principal asset is its investment in the Bank, its wholly-owned consolidated subsidiary.  The primary source of income for the Parent Company historically has been dividends from the Bank.  Regulatory agencies limit the amount of funds that may be transferred from the Bank to the Parent Company in the form of dividends, loans or advances.

Under applicable laws and without prior regulatory approval, the total dividend payments of the Bank in any calendar year are restricted to the net profits of that year, as defined, combined with the retained net profits for the two preceding years. The Company and Bank currently are prohibited from paying dividends unless regulatory approval is obtained.  (See Note 2 Formal Written Agreement).

Note 23.                        Other Operating Income and Expenses

Other operating income and expenses that exceed 1% of the total of interest income and other income presented separately consist of the following:

	2014	2013
BOLI income	$      410	$      445
Sale of Fixed Assets	$          6	$      382
Other Contracted Services	$      614	$      615
Bank Franchise Taxes	$      260	$      300
FDIC Insurance Costs	$   1,203	$   1,320
Software Licensing / Maintenance	$      642	$      656
Postage and Freight	$      293	$      342
Legal	$      336	$      389
Other Loan Expense	$      332	$      173

Note 24.  Condensed Parent Company Financial Statements

The condensed financial statements below relate to Highlands Bankshares, Inc., as of December 31, 2014 and 2013 and for the years then ended.  Equity in undistributed earnings of subsidiary includes the change in unrealized gains or losses on securities, net of tax.

CONDENSED BALANCE SHEETS
	2014	2013
ASSETS
Cash	$     331	$     178
Capital securities repurchased	-	600
Other investments	102	102
Equity in subsidiary	52,295	40,487
Other assets	74	460
Total Assets	$   52,802	$   41,827
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest, taxes and other liabilities	$              -	$    1,636
Other short term borrowings	-	3,450
Long Term Debt	-	-
Capital securities	-	3,750
Total Liabilities	-	8,836
STOCKHOLDERS’ EQUITY	52,802	32,991
Total Liabilities and Stockholders’ Equity	$   52,802	$     41,827

49

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 24.  Condensed Parent Company Financial Statements (Continued)

CONDENSED STATEMENTS OF INCOME
	2014	2013
Dividends from subsidiary	$          -	$          -
Interest and dividend income	48	100
Other income	11	-
Interest expense	(356)	(850)
Operating expense	(155)	(8)
	(452)	(758)
Income tax benefit	154	257
Equity in undistributed earnings of subsidiary	2,824	1,983
Net income	$   2,526	$   1,482

50

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2014

(Amounts in thousands)

Note 24.  Condensed Parent Company Financial Statements (Continued)

CONDENSED STATEMENTS OF CASH FLOWS
	2014	2013
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$  2,526	$  1,482
Adjustments to reconcile net income to net cash   Provided by operating activities:
Depreciation and amortization	24	5
Equity in undistributed earnings of subsidiary	(2,824)	(1,983)
(Increase) decrease in other assets	207	(12)
Increase (decrease)  in other liabilities	(1,636)	608
Net cash provided by (used in) operating activities	(1,703)	100
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital contributed to subsidiary bank	(7,900)	-
Net cash (used in) investing   activities	(7,900)	-
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase (decrease) in Short Term Borrowings	(3,450)	3,347
Issuance of Common Stock	9,418
Issuance of Preferred Stock	6,938
Decrease in Long Term Debt	-	(3,447)
Redemption of capital securities	(3,150)	-
Net cash provided by (used in) financing activities	9,756	(100)
Net increase in cash and cash equivalents	153	-
CASH AND CASH EQUIVALENTS AT   BEGINNING OF YEAR	178	178
CASH AND CASH EQUIVALENTS AT END OF   YEAR	$   331	$178

Note 25. Private Placement Capital Raise / Rights Offering

On April 16, 2014, the management and board of directors of Highlands Bankshares, Inc. announced the completion of a $16,525 private placement capital raise. Purchasers in the private placement included outside investors, as well as certain directors and executive officers of the Company. The Company sold 2,673,249 newly issued shares of the Company’s common stock at $3.50 per share, and 2,048,179 shares of Series-A convertible perpetual preferred stock at $3.50 per share. The private placement was disclosed on Form 8-K on April 16, 2014. The Company immediately paid off a Holding Company Loan in the amount of $3,440 to Community Bankers Bank on April 16, 2014 with the funds received from the capital raise. The Company also paid off the remaining $3,150 of its trust preferred securities including accrued interest. The payoff totaling $4,802 was completed on July 15, 2014. The Company down-streamed to the subsidiary Bank in June 2014 $7,500 of funds received from the capital raise. During the third quarter of 2014, the Company also conducted a rights offering to its existing shareholders other than directors and executive officers. The Company raised a total of $556 as a result of the offering. The Company immediately down-streamed $400 of the $556 to the Bank in September of 2014. In October 2014, one of the private placement purchasers, TNH Financial Fund, LP, purchased another $183 of common and preferred stock which allowed them to maintain the same ownership percentage that was held immediately prior to the rights offering. Net proceeds received from the private placement issues and rights offering totaled $16,356.

51