Heritage Financial 10-Q 2012 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2012

Commission File Number 001-34902

HERITAGE FINANCIAL GROUP, INC.

(A Maryland Corporation)

IRS Employer Identification Number 38-3814230

721 N. Westover Blvd., Albany, GA 31707

229-420-0000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 and 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x   No  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  Large accelerated filer  o  Accelerated filer  x  Non-accelerated filer  o  Smaller reporting company  o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the exchange Act).  Yes o   No  x

Indicate the number of shares outstanding of each issuer’s classes of common equity, as of the latest practicable date:  At November 9, 2012, there were 8,245,555 shares of issuer’s common stock outstanding.

HERITAGE FINANCIAL GROUP, INC.

INDEX

			Page
			Number
PART I – FINANCIAL INFORMATION
	ITEM 1.	FINANCIAL STATEMENTS
		CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 30, 2012 AND DECEMBER 31, 2011	3
		CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011	4
		CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME  FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011	5
		CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2012 AND THE YEAR ENDED DECEMBER 31, 2011	6
		CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011	8
		CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS	10
	ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	54
	ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	74
	ITEM 4.	CONTROLS AND PROCEDURES	76
PART II – OTHER INFORMATION
	ITEM 1	LEGAL PROCEEDINGS	77
	ITEM 1A	RISK FACTORS	77
	ITEM 2	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	77
	ITEM 3	DEFAULTS UPON SENIOR SECURITIES	77
	ITEM 5	OTHER INFORMATION	77
	ITEM 6	EXHIBITS	78

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands)

	Unaudited September 30, 2012			Audited December 31, 2011
Assets
Cash and due from banks	$	22,016		$	34,521
Interest-bearing deposits in banks		17,026			43,101
Federal funds sold		11,046			21,753
Securities available for sale, at fair value		209,287			259,017
Federal Home Loan Bank Stock, at cost		3,205			4,067
Other equity securities, at cost		1,010			1,010
Loans held for sale		7,236			7,471
Loans		556,175			453,163
Covered loans		78,757			107,457
Less allowance for loan losses		8,530			7,494
Loans, net		626,402			553,126
Other real estate owned		2,001			3,362
Covered other real estate owned		9,457			10,047
Total other real estate owned		11,458			13,409
FDIC loss-share receivable		67,698			83,901
Premises and equipment, net		32,868			29,532
Premises held for sale		1,080			1,080
Accrued interest receivable		3,860			4,689
Goodwill and intangible assets		4,426			4,848
Cash surrender value of bank-owned life insurance		23,172			15,611
Other assets		13,109			12,716
	$	1,054,899		$	1,089,852
Liabilities and Stockholders' Equity
Deposits
Noninterest-bearing	$	108,767		$	78,823
Interest-bearing		736,312			805,364
Total deposits		845,079			884,187
Federal funds purchased and securities sold under repurchase agreements		35,833			35,049
Other borrowings		35,000			35,000
Accrued interest payable		695			972
Other liabilities		16,499			10,508
Total liabilities		933,106			965,716
Stockholders' equity
Preferred stock, par value; $0.01; 5,000,000 shares authorized; none issued
Common stock, par value $0.01; 45,000,000 shares authorized; 8,229,955 and 8,712,031  shares issued, respectively		82			87
Capital surplus		82,890			88,393
Retained earnings		45,677			42,374
Accumulated other comprehensive loss, net of tax benefit of $1,779 and $1,384		(2,669	)		(2,076	)
Unearned employee stock ownership plan (ESOP) shares, 399,162  and 439,138 shares		(4,187	)		(4,642	)
Total stockholders' equity		121,793			124,136
	$	1,054,899		$	1,089,852

See Notes to Consolidated Financial Statements.

3

HERITAGE FINANCIAL GROUP, INC AND SUBSIDIARY

Consolidated Statements of Operations (Unaudited)

For the Three and Nine Months Ended September 30, 2012 and 2011

(Dollars in Thousands)

	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2012			2011			2012			2011
Interest income
Interest and fees on loans	$	13,067		$	8,774		$	33,747		$	23,483
Interest on loans held for sale		342			45			729			99
Interest on taxable securities		924			1,013			2,919			3,441
Interest on nontaxable securities		298			207			891			629
Interest on federal funds sold		3			16			21			45
Interest on deposits in other banks		17			93			80			184
		14,651			10,148			38,387			27,881
Interest expense
Interest on deposits		1,257			2,048			3,766			5,879
Interest on other borrowings		681			687			2,025			2,114
		1,938			2,735			5,791			7,993
Net interest income		12,713			7,413			32,596			19,888
Provision for loan losses		1,934			1,000			3,425			2,300
Net interest income after provision		10,779			6,413			29,171			17,588
Noninterest income
Service charges on deposit accounts		1,285			1,267			3,441			3,540
Bankcard services income		783			685			2,437			1,946
Other service charges, commissions and fees		80			61			238			205
Brokerage fees		467			328			1,375			1,088
Mortgage banking activities		1,689			719			3,316			1,611
Bank-owned life insurance		210			146			561			440
Gain on sales of securities		1,484			213			1,554			666
Gain (loss) on acquisitions		(90	)		2,000			(56	)		4,217
Accretion FDIC loss share receivable		(1,606	)		448			(2,236	)		453
Other		59			25			194			128
		4,361			5,892			10,824			14,294
Noninterest expense
Salaries and employee benefits		6,380			5,384			17,375			14,635
Equipment and occupancy		1,317			1,201			4,035			2,961
Advertising and marketing		114			167			509			551
Professional fees		354			326			932			1,079
Information services expenses		1,240			1,063			3,456			2,546
(Gain) loss on sales and write-downs of
other real estate owned		90			(139	)		(58	)		798
Gain on sales and write-downs of FDIC
acquired other real estate owned		(33	)		(246	)		(108	)		(291	)
Foreclosed asset expenses		177			288			617			703
Foreclosed FDIC acquired asset expenses		563			-			1,191			-
FDIC insurance and other regulatory fees		276			128			785			775
Acquisition related expenses		14			299			414			1,056
Deposit intangible expenses		194			183			590			485
Other operating expenses		1,292			1,125			3,715			2,920
		11,978			9,779			33,453			28,218
Income before income taxes		3,162			2,526			6,542			3,664
Applicable income tax		1,164			786			2,213			1,190
Net income	$	1,998		$	1,740		$	4,329		$	2,474
Earnings per common share:
Basic earnings per share	$	0.25		$	0.21		$	0.54		$	0.30
Diluted earnings per share	$	0.25		$	0.21		$	0.54		$	0.30
Weighted average-common shares outstanding:
Basic		7,942,852			8,305,615			8,052,462			8,205,305
Diluted		7,944,983			8,307,010			8,054,183			8,206,906

See Notes to Consolidated Financial Statements.

4

HERITAGE FINANCIAL GROUP, INC AND SUBSIDIARY

Consolidated Statements of Comprehensive Income (Unaudited)

For the Three and Nine Months Ended September 30, 2012 and 2011

(Dollars in Thousands)

	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2012			2011			2012			2011
Net income	$	1,998		$	1,740		$	4,329		$	2,474
Other comprehensive income (loss):
Accretion of realized gain on terminated cash flow hedge, net of tax of $20 and $20 for the quarter and $59 and $80 for the year to date, respectively		(29	)		(29	)		(88	)		(119	)
Unrealized loss on cash flow hedge, net of tax benefit  of $9 and $0 for the quarter and $993and $0 for the year to date, respectively		(13	)		-			(1,489	)		-
Unrealized holding gains on investments arising during the period, net of tax of  $591  and $885 for the quarter and $1,278 and $2,308 for the year to date, respectively		886			1,328			1,916			3,462
Reclassification adjustment for investment gains included in net income, net of tax of $593 and $85 for the quarter and $621 and $266 for the year to date, respectively		(890	)		(128	)		(932	)		(399	)
Total other comprehensive income  (loss)		(46	)		1,171			(593	)		2,944
Comprehensive income	$	1,952		$	2,911		$	3,736		$	5,418

See Notes to Consolidated Financial Statements.

5

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

For the Nine Months Ended September 30, 2012 (Unaudited)

And The Year Ended December 31, 2011

(Dollars in Thousands, except per share data)

																Accumulated
																Other
													Unearned			Compre-
	Common Stock						Capital			Retained			ESOP			hensive
	Shares			Par Value			Surplus			Earnings			Shares			Loss			Total
Balance, December 31, 2010		8,710,511		$	87		$	88,876		$	39,536		$	(5,245	)	$	(3,914	)	$	119,340
Net income		-			-			-			3,825			-			-			3,825
Cash dividend declared, $0.12 per share		-			-			-			(987	)		-			-			(987	)
Issuance of  121,530  shares of restricted common stock		121,530			1			(1	)		-			-			-			-
Forfeiture of  3,068  of restricted common stock		(3,068	)		-			-			-			-			-			-
Repurchase of  116,942 shares of  common stock		(116,942	)		(1	)		(1,309	)		-			-			-			(1,310	)
Stock-based compensation expense		-			-			728			-			-						728
Other comprehensive income		-			-			-			-			-			1,838			1,838
Tax benefit shortfall from stock-based compensation plans		-			-			(8	)		-			-			-			(8	)
ESOP shares earned, 53,182 shares		-			-			17			-			603			-			620
Tax benefit on ESOP expense		-			-			90			-			-			-			90
Balance, December 31, 2011		8,712,031		$	87		$	88,393		$	42,374		$	(4,642	)	$	(2,076	)	$	124,136

See Notes to Consolidated Financial Statements.

6

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Continued)

For the Nine Months Ended September 30, 2012 (Unaudited)

And The Year Ended December 31, 2011

(Dollars in Thousands, except per share data)

																Accumulated
																Other
													Unearned			Compre-
	Common Stock						Capital			Retained			ESOP			hensive
	Shares			Par Value			Surplus			Earnings			Shares			Loss			Total
Balance, December 31, 2011		8,712,031		$	87		$	88,393		$	42,374		$	(4,642	)	$	(2,076	)	$	124,136
Net income		-			-			-			4,329			-			-			4,329
Cash dividend declared, $0.12  per share		-			-			-			(1,026	)		-			-			(1,026	)
Forfeiture of  166 shares of restricted common stock		(166	)		-			-			-			-			-			-
Repurchase of  481,910  shares of common stock		(481,910	)		(5	)		(6,232	)		-			-			-			(6,237	)
Stock-based compensation expense		-			-			626			-			-						626
Other comprehensive loss		-			-			-			-			-			(593	)		(593	)
Excess tax benefit  from stock- based compensation plans		-			-			6			-			-			-			6
ESOP shares earned, 39,976  shares		-			-			41			-			455			-			496
Excess tax benefit on ESOP  expense		-			-			56			-			-			-			56
Balance, September 30, 2012		8,229,955		$	82		$	82,890		$	45,677		$	(4,187	)	$	(2,669	)	$	121,793

See Notes to Consolidated Financial Statements.

7

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 (Dollars in thousands)

	Nine Months Ended September 30,
	2012			2011
OPERATING ACTIVITIES	$	4,329		$	2,474
Net income
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		1,552			1,008
Deposit premium amortization		590			485
Provision for loan losses		3,425			2,300
ESOP compensation expense		496			476
Provision (benefit) for deferred taxes		(449	)		2,142
Stock-based compensation expense		626			523
Accretion of gain on termination of cash flow hedge		(147	)		(199	)
Amortization of available for sale discounts and premiums, net		3,022			1,601
Gain on sales of securities available for sale		(1,554	)		(666	)
(Gain) loss on sales and write-downs of other real estate owned		(58	)		798
Gain on sales and write-downs of FDIC acquired other real estate owned		(108	)		-
Increase in bank-owned life insurance		(561	)		(439	)
Excess (tax) benefit related to stock-based compensation plans		(6	)		8
Excess (tax) benefit related to ESOP		(56	)		18
Decrease in FDIC loss share receivable		13,968			666
Accretion  of FDIC loss share receivable		2,236			(453	)
Decrease (increase) in interest receivable		871			(1,523	)
(Decrease) increase in interest payable		(302	)		308
Decrease (increase) in loans held for sale		235			(5,314	)
Decrease in prepaid FDIC assessment		344			693
Gain on acquisitions		(34	)		(4,217	)
Net other operating activities		3,643			668
Total adjustments		27,733			(1,117	)
Net cash provided by operating activities		32,062			1,357
INVESTING ACTIVITIES
Decrease (increase) in interest-bearing deposits in banks		26,075			(88,300	)
Purchases of securities available for sale		(82,682	)		(68,856	)
Proceeds from sales of securities available for sale		54,400			72,162
Proceeds from maturities and calls of securities available for sale		78,185			56,526
Purchase of bank owned life insurance		(7,000	)		-
Decrease in Federal Home Loan Bank stock		862			715
Decrease (increase) in federal funds sold		10,707			(28,992	)
Increase in loans, net		(72,954	)		(5,499	)
Purchases of premises and equipment		(3,148	)		(8,762	)
Net cash received from acquisition activity		5,831			67,704
Proceeds from sales of premises and equipment		-			27
Proceeds from sales of other real estate owned		9,177			5,201
Net cash provided by investing activities		19,453			1,926

See Notes to Consolidated Financial Statements.

8

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(Unaudited)

 (Dollars in thousands)

	Nine Months Ended September 30
	2012			2011
FINANCING ACTIVITIES
(Decrease) increase  in deposits	$	(57,605	)	$	22,373
Increase in federal funds purchased and securities sold under repurchase agreements		784			3,697
Repayment of other borrowings		-			(32,744	)
Excess tax (benefit) related to stock-based compensation plans		6			(8	)
Excess tax (benefit) related to ESOP		56			(18	)
Repurchase of common stock		(6,235	)		(1,309	)
Dividends paid to stockholders		(1,026	)		(785	)
Net cash used in financing activities		(64,020	)		(8,794	)
Net decrease in cash and due from banks		(12,505	)		(5,511	)
Cash and due from banks at beginning of period		34,521			28,803
Cash and due from banks at end of period	$	22,016		$	23,292
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the year for:
Interest	$	6,069		$	7,685
Income taxes	$	2,612		$	-
NONCASH TRANSACTIONS
Principal balances of loans transferred to other real estate owned	$	7,028		$	894

See Notes to Consolidated Financial Statements

9

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1. BASIS OF PRESENTATION AND ACCOUNTING ESTIMATES

Heritage Financial Group, Inc.  (the “Company”), a Maryland corporation, was incorporated in May 2010 and organized by Heritage MHC (the “MHC”), Heritage Financial Group and HeritageBank of the South ( the “Bank”) to facilitate the second-step conversion  from the mutual holding company structure to the stock holding company structure (the “Conversion”).  Upon consummation of the Conversion, which occurred on November 30, 2010, the Company became the holding company for the Bank and a 100% publicly owned stock holding company.  As a result of the Conversion, each share of Heritage Financial Group’s common stock owned by public shareholders was exchanged for 0.8377 shares of the Company’s common stock, with cash being paid in lieu of issuing fractional shares.  All shares and per share information for periods prior to the Conversion have been adjusted to reflect the 0.8377:1 exchange ratio on publicly traded shares.  All references to the Company refer to Heritage Financial Group for periods prior to the completion of the Conversion.

The accompanying consolidated financial information of the Company is unaudited; however, such information reflects all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations. The results of operations for the three and nine months ended September 30, 2012, are not necessarily indicative of the results that may be expected for the full year. These statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

The consolidated financial statements include the accounts of the Company and its subsidiary.  Significant intercompany transactions and balances have been eliminated in consolidation.

In preparing the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, 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 the reported amounts of revenues and expenses 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, the valuation of foreclosed real estate, deferred tax assets, other-than-temporary impairments of securities and the fair value of financial instruments.

The accompanying consolidated financial information of the Company as of September 30, 2012 and for the three and nine months ended September 30, 2012 and 2011 is unaudited; however, such information reflects all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations.

10

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1. BASIS OF PRESENTATION AND ACCOUNTING ESTIMATES (continued)

Recently Adopted Accounting Pronouncements

In May 2011, the FASB issued Accounting Standards Update (ASU) No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs to amend the Fair Value Measurement topic of the Accounting Standards Codification by clarifying the application of existing fair value measurement and disclosure requirements and by changing particular principles or requirements for measuring fair value or for disclosing information about fair value measurements. The amendments were effective for the Company beginning January 1, 2012 and did not have a material impact on the Company’s financial position, results of operations or cash flows.

In June 2011, the FASB issued ASUNo. 2011-05, Presentation of Comprehensive Income.  ASU 2011-05 requires entities to present net income and other comprehensive income in either a single continuous statement or in two separate, but consecutive statements of net income and other comprehensive income. The option to present items of other comprehensive income in the statement of changes in equity is eliminated. The guidance is effective for the Company for the first quarter of 2012, and did not have a material impact on the Company’s results of operations or financial position. It did not result in a change of disclosure, as the Company currently presents other comprehensive income in the separate statement following the Consolidated Statements of Income.

In September 2011, the FASB issued ASU No. 2011-08, Intangibles—Goodwill and Other (Topic 350): Testing Goodwill Impairment. The new guidance provides an entity the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity determines that this is the case, it is required to perform the currently prescribed two-step goodwill impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized for that reporting unit (if any). Based on the qualitative assessment, if an entity determines that the fair value of a reporting unit is more than its carrying amount, the two-step goodwill impairment test is not required. The new guidance is effective for the Company beginning January 1, 2012, and did not have a material impact on the Company’s results of operations or financial position.

In December 2011, the FASB issued ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities which is intended to enhance disclosures resulting in improved information being available to users of financial information about financial instruments and derivative instruments that are subject to offsetting (“netting”) in statements of financial position whether the statements are prepared using U.S. GAAP or International Financial Reporting Standards. ASU 2011-11 requires disclosure of both gross information and net information about instruments and transactions eligible for offset or subject to an agreement similar to a master netting agreement. In addition to the quantitative disclosures, reporting entities also are required to provide a description of rights of setoff associated with recognized assets and recognized liabilities subject to enforceable master netting arrangements or similar agreements. ASU 2011-11 is effective for annual reporting periods beginning on or after January 1, 2013 and interim periods within those annual periods. The required disclosures should be provided retrospectively for all comparative periods presented. The Company is evaluating the impact that the adoption of ASU 2011-11 will have on its financial position, results of operations and cash flows.

11

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 2. EARNINGS PER SHARE

Basic earnings per share represent income available attributable to common shareholders divided by the weighted-average number of common shares outstanding during the period, excluding unallocated shares of the Employee Stock Ownership Plan and unvested shares of issued restricted stock. For the three and nine months ended September 30, 2012, potential common shares of 542,816 and 542,816, respectively, were not included in the calculation of diluted earnings per share because the assumed exercise of such shares would be anti-dilutive.

 The table below sets forth our earnings per share:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
	(dollars in thousands, except per share amounts)
Basic earnings per share:
Net income	$	1,998	$	1,740	$	4,329	$	2,474
Weighted average common shares outstanding		7,942,852		8,305,615		8,052,462		8,205,305
Basic earnings  per common share	$	0.25	$	0.21	$	0.54	$	0.30
Diluted earnings  per share:
Net income	$	1,998	$	1,740	$	4,329	$	2,474
Weighted average common shares outstanding		7,942,852		8,305,615		8,052,462		8,205,305
Effect of dilutive stock options and restricted stock		2,131		1,395		1,721		1,601
Weighted average dilutive common shares outstanding		7,944,983		8,307,010		8,054,183		8,206,906
Diluted earnings  per common share	$	0.25	$	0.21	$	0.54	$	0.30

12

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 3. SHARE BASED COMPENSATION

On May 17, 2006, the Company’s stockholders approved the 2006 Equity Incentive Plan (the “Plan”).  The purpose of the Plan is to promote the long-term growth and profitability of Heritage Financial Group, Inc, to provide directors, advisory directors, officers and employees of Heritage Financial Group, Inc. and its affiliates with an incentive to achieve corporate objectives, to attract and retain individuals of outstanding competence, and to provide such individuals with an equity interest in Heritage Financial Group, Inc.  Under the Plan, the Compensation Committee of the Board of Directors has discretion to award up to 645,990 shares, of which 461,422 were available as stock options or stock appreciation rights and 184,568 shares were available as restricted stock awards.  As of September 30, 2012, there were approximately 12,800 restricted stock awards and 43,351 options available to be granted from the 2006 Plan.

On June 22, 2011, the Company’s stockholders approved the 2011 Equity Incentive Plan (the “2011 Plan”).  Under the 2011 Plan, the Compensation Committee has the discretion to award up to 573,481 shares, of which 409,429 were available as stock options or stock appreciation rights and 163,852 were available as restricted stock awards.  On July 1, 2011, the Company granted 117,530 restricted stock awards and 334,870 stock options from this plan.  There were no awards granted from this plan during the nine months ended September 30, 2012.

The Company granted restricted awards that may not be sold or otherwise transferred until certain restrictions have lapsed.  The unearned compensation related to these awards is being amortized to compensation expense over the period the restrictions lapse (generally one to five years).  The share-based expense for these awards was determined based on the market price of the Company's stock at the date of grant applied to the total number of shares that were anticipated to fully vest, amortized over the vesting period.  As of September 30, 2012, there was approximately $1.1 million of unrecognized compensation associated with these awards.  For the three months ended September 30, 2012 and 2011, we recognized compensation expense associated with these awards of approximately $75,000 and $18,000, respectively.  For the nine months ended September 30, 2012 and 2011, we recognized compensation expense associated with these awards of approximately $225,000 and $266,000, respectively.

The Company recognized compensation expense related to stock options of approximately $135,000 and $94,000 for each of the three months ended September 30, 2012 and 2011, and approximately $400,000 and $257,000 for the nine months ended September 30, 2012 and 2011, respectively.  At September 30, 2012, there was approximately $2.0 million of unrecognized compensation related to stock options.

13

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 4. SECURITIES

The amortized cost and fair value of securities available for sale with gross unrealized gains and losses are summarized as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
September 30, 2012 (unaudited):	(dollars in thousands)
U. S. Government sponsored agencies (GSEs)	$	22,683	$	434	$	(3	)	$	23,114
State and municipal securities		32,011		1,725		(115	)		33,621
Corporate debt securities		2,152		-		(64	)		2,088
GSE residential mortgage-backed securities		148,205		2,328		(260	)		150,273
Total debt securities		205,051		4,487		(442	)		209,096
Equity securities		207		15		(31	)		191
Total securities	$	205,258	$	4,502	$	(473	)	$	209,287

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
December 31, 2011:	(dollars in thousands)
U. S. Government sponsored agencies (GSEs)	$	45,141	$	598	$	(2	)	$	45,737
State and municipal securities		47,167		1,494		(457	)		48,204
Corporate debt securities		2,160		-		(204	)		1,956
GSE residential mortgage-backed securities		161,954		1,461		(452	)		162,963
Total debt securities		256,422		3,553		(1,115	)		258,860
Equity securities		207		66		(116	)		157
Total securities	$	256,629	$	3,619	$	(1,231	)	$	259,017

* At September 30, 2012 and December 31, 2011, the Company held no securities of any single issuer (excluding the U.S. Government and federal agencies) with a book value that exceeded 10% of stockholders’ equity.

The amortized cost and fair value of debt securities available for sale as of September 30, 2012 by contractual maturity are shown below.  Actual maturities may differ from contractual maturities in mortgage-backed securities because the mortgages underlying the securities may be called or repaid without penalty.  Therefore, these securities are not included in the maturity categories in the following maturity summary.

	Amortized Cost		Fair Value
	(dollars in thousands)
Due in one year or less	$	1,152	$	1,139
Due from one to five years		1,851		1,803
Due from five to ten years		12,422		12,982
Due after ten years		41,628		43,090
Mortgage-backed securities		148,205		150,273
	$	205,258	$	209,287

14

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 4. SECURITIES (Continued)

Securities with a carrying value of $103.8 million and $96.3 million at September 30, 2012 and December 31, 2011, respectively, were pledged to secure public deposits, repurchase agreements and for other purposes required or permitted by law.  The balance of pledged securities in excess of the pledging requirements was $30.5 million and $26.0 million at September 30, 2012 and December 31, 2011, respectively.

Recognized gains and losses on sales of securities available for sale consist of the following:

	For the three months ended September 30,
	2012		2011
	(dollars in thousands)
Gross gains recognized on sales of securities	$	1,484	$	213
Gross losses recognized on sales of securities		-		-
Net realized gains on sales of securities available for sale	$	1,484	$	213

	For the nine months ended September 30,
	2012			2011
	(dollars in thousands)
Gross gains recognized on sales of securities	$	1,761		$	666
Gross losses recognized on sales of securities		(207	)		-
Net realized gains on sales of securities available for sale	$	1,554		$	666

15

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 4. SECURITIES (Continued)

The following table shows the gross unrealized losses and fair value of securities aggregated by category and length of time that securities have been in a continuous unrealized loss position at September 30, 2012 and December 31, 2011.

	Less Than 12 Months					12 Months or More					Total
Description of Securities	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(dollars in thousands)
September 30, 2012 (unaudited):
U.S. Government sponsored agencies
(GSEs)	$	1,530	$	(3	)	$	-	$	-		$	1,530	$	(3	)
State and municipal securities		2,026		(15	)		1,612		(100	)		3,638		(115	)
Corporate debt securities		950		(50	)		1,140		(14	)		2,090		(64	)
GSE residential mortgage-backed Securities		26,979		(195	)		5,662		(65	)		32,641		(260	)
Subtotal, debt securities		31,485		(263	)		8,414		(179	)		39,899		(442	)
Equity securities		-		-			176		(31	)		176		(31	)
Total temporarily impaired securities	$	31,485	$	(263	)	$	8,590	$	(210	)	$	40,075	$	(473	)

	Less Than 12 Months					12 Months or More					Total
Description of Securities	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(dollars in thousands)
December 31, 2011 :
U.S. Government sponsored agencies
(GSEs)	$	2,498	$	(2	)	$	-	$	-		$	2,498	$	(2	)
State and municipal securities		2,976		(64	)		2,047		(393	)		5,023		(457	)
Corporate debt securities		920		(80	)		1,036		(124	)		1,956		(204	)
GSE residential mortgage-backed securities		58,883		(452	)		-		-			58,883		(452	)
Subtotal, debt securities		65,277		(598	)		3,083		(517	)		68,360		(1,115	)
Equity securities		-		-			91		(116	)		91		(116	)
Total temporarily impaired securities	$	65,277	$	(598	)	$	3,174	$	(633	)	$	68,451	$	(1,231	)

16

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 4. SECURITIES (Continued)

Other-Than-Temporary Impairment

The Company reviews its investment portfolio on a quarterly basis judging each investment for other-than-temporary impairment (“OTTI”).  Management does not have the intent to sell any of the temporarily impaired investments and believes it is more likely than not that the Company will not have to sell any such securities before a recovery of cost. The OTTI analysis focuses on the duration and amount a security is below book value and assesses a calculation for both a credit loss and a non credit loss for each measured security considering the security’s type, performance, underlying collateral, and any current or potential debt rating changes.  The OTTI calculation for credit loss is reflected in the income statement while the non credit loss is reflected in other comprehensive income (loss).

The Company holds Freddie Mac (“FHLMC”) preferred stock, and OTTI was recorded in the amount of the investment after the U.S. Government placed the company into conservatorship in September 2008.  The preferred stock has been reduced to a nominal book value for tracking purposes.  The investment is currently valued at $15,000.  During the twelve months ended December 30, 2008 the Company recognized a write-down of $1.5 million through non-interest income representing other-than-temporary impairment on the investment.

The Company holds a single issue trust preferred security issued by Royal Bank of Scotland (“RBS”).  The security suspended payments under the EU agreement for 24 months beginning April 1, 2011.  The Company valued the security by projecting estimated cash flows using the Moody’s Ba2 marginal default rate.  The difference in the present value and the carrying value of the security was the OTTI credit portion.  The security is currently carried at a fair value of $176,000 at September 30, 2012 and during the twelve months ended December 30, 2011, the Company recognized a write-down of $43,000 through non-interest income representing other-than-temporary impairment on the security.

The following table presents more detail on selective Company security holdings as September 30, 2012.  These details are listed separately due to the inherent level of risk for OTTI on these securities.

			Current Credit		Book		Fair		Unrealized			Present Value Discounted
Description	Cusip#		Rating		Value		Value		Loss			Cash Flow
Marketable equity securities
FHLMC Preferred Stock		313400657	Ca		$	-	$	15	$	-		$	15
Trust preferred securities
RBS Capital Fund		74928K208		B3	$	207	$	176	$	(31	)	$	207

The following table presents a roll-forward of the cumulative amount of credit losses on the Company’s investment securities that have been recognized through earnings as of September 30, 2012 and December 31, 2011.

	September 30, 2012		December 31, 2011
Beginning balance of credit losses	$	1,543	$	1,500
Other-than-temporary impairment credit losses		-		43
Ending balance of cumulative credit losses recognized in earnings	$	1,543	$	1,543

17

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES

The composition of loans is summarized as follows:

	September 30,			December 31
	2012			2011
Commercial real estate:
Nonresidential	$	193,392		$	138,970
Multifamily		19,805			15,797
Farmland		20,298			17,921
Total commercial real estate loans		233,495			172,688
Construction and land		30,010			26,804
Consumer real estate:
Mortgage loans, 1-4 families		157,551			129,745
Home equity		25,507			26,154
Total consumer real estate loans		183,058			155,899
Consumer and other:
Indirect auto loans		1,735			3,741
Direct auto loans		6,865			6,430
Other		17,921			13,701
Total consumer loans		26,521			23,872
Commercial and industrial loans		68,800			55,179
		541,884			434,442
Loans acquired through FDIC-assisted acquisitions
Non-Covered		14,291			18,721
Covered		78,757			107,457
Total FDIC acquired loans		93,048			126,178
Total loans	$	634,932		$	560,620
Total allowance for loan losses		(8,530	)		(7,494	)
Loans, net	$	626,402		$	553,126

18

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Commercial Real Estate

Commercial real estate lending includes real estate loans secured primarily by multifamily dwellings, retail establishments, hotels, motels, warehouses, small office buildings, farmland, and other nonresidential properties located in our market areas.

These loans typically involve large balances to single borrowers or groups of related borrowers.  Because payments on loans secured by nonresidential and multifamily real estate properties are often dependent on the successful operation or management of the properties, repayment of these loans may be subject to adverse conditions in the real estate market or the economy.  If the cash flow from the project is reduced, or if leases are not obtained or renewed, the borrower's ability to repay the loan may be impaired.

Loans secured by farmland typically involve large balances, and repayments are often dependent on the successful operation of the farm, making them subject to adverse weather and economic conditions.  If the cash flow from the farm operations declines, the borrower’s ability to repay the loan may be impaired.

Construction and Land

Construction and land lending consist of loans for the construction of one- to four-family residences, multifamily residences and commercial properties.  Construction loans also involve additional risks because funds are advanced upon the security of the project under construction, which is of uncertain value prior to the completion of construction.  Moreover, because of the uncertainties inherent in estimating construction costs, delays arising from labor problems, material shortages, and other unpredictable contingencies, it is relatively difficult to evaluate accurately the total loan funds required to complete a project, and the related loan-to-value ratios.

Consumer Real Estate

Consumer real estate lending consist of loans secured by first mortgages on one- to four-family residences, including home equity lines of credit, in our lending area, and on occasion, outside our lending area for customers whose primary residences are within the Company’s lending area.

Consumer and Other Lending

Consumer and other lending includes a variety of secured consumer loans, new and used auto loans, boat and recreational vehicle loans, and loans secured by deposit accounts. Consumer loans may entail greater risk, particularly in the case of consumer loans that are secured by rapidly depreciable assets, such as automobiles and recreational vehicles.  In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance.  As a result, consumer loan collections are dependent on the borrower's continuing financial stability and, thus, are more likely to be adversely affected by job loss, divorce, illness, or personal bankruptcy.

Commercial and Industrial Lending

Commercial and industrial lending activities encompass loans with a variety of purposes and security, including loans to finance accounts receivable, inventory and equipment.  Commercial business loans are generally secured by business assets, such as accounts receivable, equipment and inventory.  This collateral may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.

19

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Activity in the allowance for loan losses and recorded investment in loans, excluding FDIC acquired, by segment:

	Commercial Real Estate			Consumer Real Estate			Construction and Land			Commercial and Industrial			Consumer  and Other			Total
	(dollars in thousands)
Balance, January 1, 2012	$	1,878		$	2,440		$	1,270		$	1,551		$	355		$	7,494
Add (deduct):
Charge-offs		(166	)		(449	)		(72	)		(177	)		(163	)		(1,027	)
Recoveries		-			53			-			35			75			163
Provision*		846			1,140			(221	)		32			103			1,900
Balance, September  30, 2012	$	2,558		$	3,184		$	977		$	1,441		$	370		$	8,530
Allowance:
Ending balance: specific	$	356		$	523		$	-		$	-		$	-			879
Ending balance: collective	$	2,202		$	2,661		$	977		$	1,441		$	370		$	7,651
Loans:
Ending balance: individually evaluated for impairment	$	7,731		$	7,956		$	3,511		$	1.262		$	-		$	20,460
Ending balance: collectively evaluated for impairment	$	225,764		$	175,102		$	26,499		$	67,538		$	26,521		$	521,424

*Refer to FDIC-assisted transactions section of this footnote for details on provision expense related to the covered and noncovered FDIC acquired loan portfolio.

20

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

	Commercial Real Estate			Consumer Real Estate			Construction and Land			Commercial and Industrial			Consumer  and Other			Total
	(dollars in thousands)
Balance, January 1, 2011	$	1,721		$	2,197		$	1,977		$	1,601		$	605		$	8,101
Add (deduct):
Charge-offs		(573	)		(3,177	)		(18	)		(330	)		(264	)		(4,362	)
Recoveries		495			18			2			-			148			663
Credit mark transfer in		197			-			-			-			-			197
Provision		38			3,402			(691	)		280			(134	)		2,895
Balance, December 31, 2011	$	1,878		$	2,440		$	1,270		$	1,551		$	355		$	7,494
Allowance:
Ending balance: specific	$	8		$	352		$	341		$	-		$	-		$	701
Ending balance: collective	$	1,870		$	2,088		$	929			1,551		$	355		$	6,793
Loans:
Ending balance: individually evaluated for impairment	$	1,938		$	9,035		$	4,326		$	1,368		$	-		$	16,667
Ending balance: collectively evaluated for impairment	$	170,750		$	146,864		$	22,478		$	53,811		$	23,872		$	417,775

Impaired Loans

A loan is considered impaired, in accordance with the impairment accounting guidance (Accounting Standards Codification “ASC” 310-10-35-16), when based on current information and events, it is probable that the Company will be unable to collect all amounts due from the borrower in accordance with the contractual term of the loan.  Impaired loans include loans modified in troubled debt restructuring where concessions have been granted to borrowers experiencing financial difficulties.  These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection.

21

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Impaired loans, excluding FDIC acquired, by class are presented below as of September 30, 2012:

										Interest
				Unpaid				Average		Income
	Recorded			Principal		Related		Recorded		Recognized
		Investment		Balance		Allowance		Investment		YTD 2012
	(dollars in thousands)
Commercial real estate:
Nonresidential		$	4,551	$	4,753	$	398	$	4,516	$	73
Multifamily			-		-		-		-		-
Farmland			97		114		24		108		-
Total commercial real estate loans			4,648		4,867		422		4,624		73
Construction and land			3,921		3,977		295		3,976		133
Consumer real estate:
Mortgage loans, 1-4 families			6,339		8,649		1,106		6,380		35
Home equity			224		261		210		233		5
Total consumer real estate loans			6,563		8,910		1,316		6,613		40
Consumer and other:
Indirect auto loans			43		56		-		49		1
Direct auto loans			24		37		18		29		-
Other			41		82		37		84		4
Total consumer and other loans			108		175		55		162		5
Commercial and industrial loans			1,126		1,132		205		995		21
Total		$	16,366	$	19,061	$	2,293	$	16,370	$	272

22

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Impaired loans, excluding FDIC acquired, by class are presented below as of December 31, 2011:

										Interest
				Unpaid				Average		Income
	Recorded			Principal		Related		Recorded		Recognized
		Investment		Balance		Allowance		Investment		YTD 2011
	(dollars in thousands)
Commercial real estate:
Nonresidential		$	981	$	993	$	99	$	985	$	34
Multifamily			2		4		1		89		6
Farmland			111		114		-		112		-
Total commercial real estate loans			1,094		1,111		100		1,186		40
Construction and land			3,961		3,961		525		3,984		167
Consumer real estate:
Mortgage loans, 1-4 families			6,759		8,937		710		7,534		130
Home equity			105		138		101		112		4
Total consumer real estate loans			6,864		9,075		811		7,646		134
Consumer and other:
Indirect auto loans			83		98		-		103		4
Direct auto loans			55		67		41		65		2
Other			39		40		38		42		2
Total consumer and other loans			177		205		79		210		8
Commercial and industrial loans			1,179		1,323		389		1,301		20
Total		$	13,275	$	15,675	$	1,904	$	14,327	$	369

23

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Below is an analysis of the age of recorded investment in loans, excluding FDIC acquired, that are past due as of September 30, 2012.

	30-59		60-89		Greater		Total
	Days		Days		Than		Past				Total
	Past Due		Past Due		90 Days		Due		Current		Loans
	(dollars in thousands)
Commercial real estate:
Nonresidential	$	460	$	-	$	4,551	$	5,011	$	188,381	$	193,392
Multifamily		-		-		-		-		19,805		19,805
Farmland		409		-		97		506		19,792		20,298
Total commercial real estate loans		869		-		4,648		5,517		227,978		233,495
Construction and land		-		-		3,921		3,921		26,089		30,010
Consumer real estate:
Mortgage loans, 1-4 families		18		-		6,331		6,349		151,202		157,551
Home equity		45		-		224		269		25,238		25,507
Total consumer real estate loans		63		-		6,555		6,618		176,440		183,058
Consumer and other:
Indirect auto loans		8		-		43		51		1,684		1,735
Direct auto loans		6		-		24		30		6,835		6,865
Other		42		3		40		85		17,836		17,921
Total consumer and other loans		56		3		107		166		26,355		26,521
Commercial and industrial loans		17		30		1,126		1,173		67,627		68,800
Total	$	1,005	$	33	$	16,357	$	17,395	$	524,489	$	541,884

24

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Below is an analysis of the age of recorded investment in loans, excluding FDIC acquired, that are past due as of December 31, 2011.

	30-59		60-89		Greater		Total
	Days		Days		Than		Past				Total
	Past Due		Past Due		90 Days		Due		Current		Loans
	(dollars in thousands)
Commercial real estate:
Nonresidential	$	111	$	-	$	361	$	472	$	138,498	$	138,970
Multifamily		-		-		2		2		15,795		15,797
Farmland		-		-		111		111		17,810		17,921
Total commercial real estate loans		111		-		474		585		172,103		172,688
Construction and land		-				442		442		26,362		26,804
Consumer real estate:
Mortgage loans, 1-4 families		93		-		4,667		4,760		124,985		129,745
Home equity		54		24		105		183		25,971		26,154
Total consumer real estate loans		147		24		4,772		4,943		150,956		155,899
Consumer and other:
Indirect auto loans		23		-		83		106		3,635		3,741
Direct auto loans		-		-		55		55		6,375		6,430
Other		6		-		38		44		13,657		13,701
Total consumer and other loans		29		-		176		205		23,667		23,872
Commercial and industrial loans		60				1,179		1,239		53,940		55,179
Total	$	347	$	24	$	7,043	$	7,414	$	427,028	$	434,442

There were no accruing loans that were greater than 90 days past due at September 30, 2012 and December 31, 2011.

25

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Troubled Debt Restructuring (TDR) Modifications

Impaired loans include loans modified in troubled debt restructuring where concessions have been granted to borrowers experiencing financial difficulties.  These concessions are a part of the Company’s loss mitigation activities and could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection.  Certain TDR’s are classified as nonperforming at the time of restructure and may only be returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period, typically considered six to twelve months.

Included in certain loan categories are troubled debt restructurings that were classified as impaired.  At September 30, 2012, the Company had troubled debt restructurings totaling $9.0 million, which involved forgiving a portion of interest or principal on any loans or making loans at a rate materially less than that of market rates.  Included in nonaccruing loans at September 30, 2012 are troubled debt restructurings of $9.0 million.  In addition, at that date the Company had a troubled debt restructuring of $8,000 that was performing in accordance with the modified terms and is not included in nonaccruing loans.

At December 31, 2011, the Company had troubled debt restructurings totaling $10.4 million, which involve forgiving a portion of interest or principal on any loans or making loans at a rate materially less than that of market rates.  Included in nonaccruing loans at December 31, 2011, are troubled debt restructurings of $4.2 million.  In addition, at that date the Company had troubled debt restructurings totaling $6.2 million that were performing in accordance with their modified terms and are not included in nonaccruing loans.

The following tables include the recorded investment and number of modifications for modified loans.  The Company reports the recorded investment in the loans prior to a modification and also the recorded investment in the loans after the loans were restructured.  Management has also disclosed the recorded investment and number of modifications for troubled debt restructurings within the last year where a concession has been made that then defaulted in the current reporting period.

Troubled Debt Restructurings for the periods ended:

		September 30, 2012
				Recorded
		Number		Investment
		of Modifications		Prior to Modifications		Recorded Investment
	(dollars in thousands)
Commercial real estate			3	$	1,071	$	1,006
Consumer real estate			5		7,268		4,494
Construction and land			1		3,574		3,473
Commercial and industrial loans			1		17		16
Consumer and other			-		-		-
Total			10	$	11,930	$	8,989

26

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

		December 31, 2011
				Recorded
		Number		Investment
		of Modifications		Prior to Modifications		Recorded Investment
	(dollars in thousands)
Commercial real estate			2	$	852	$	843
Consumer real estate			5		7,268		5,206
Construction and land			1		3,574		3,519
Commercial and industrial loans			1		920		839
Consumer and other			-		-		-
Total			9	$	12,614	$	10,407

Troubled Debt Restructuring Modifications that Subsequently Defaulted for the periods ended:

	September 30, 2012
	Number
	of Modifications		Recorded Investment
	(dollars in thousands)
Commercial real estate		3	$	1,006
Consumer real estate		4		4,486
Construction and land		1		3,473
Commercial and industrial loans		1		16
Consumer and other		-		-
Total		9	$	8,981

		December 31, 2011
		Number
		of Modifications		Recorded Investment
	(dollars in thousands)
Commercial real estate			1	$	223
Consumer real estate			3		3,114
Construction and land			-		-
Commercial and industrial loans			1		839
Consumer and other			-		-
Total			5	$	4,176

27

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Allowance for Loan and Lease Losses (ALLL)

The Company establishes provisions for loan losses, which are charged to operations, at a level the Company believes will reflect probable credit losses based on historical loss trends and an evaluation of specific credits in the loan portfolio.

In evaluating the level of the allowance for loan losses, the Company considers the types of loans and the amount of loans in the loan portfolio, historical loss experience, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions, and past due status and trends.

The Company analyzes the non-FDIC acquired loan portfolios through the use of pools of homogenous loan types and through a specific quarterly review of larger problem loans. It is expected that a certain percentage of loans will move through the asset quality grades from pass, to classified and ultimately loss.  The Company evaluates the non-FDIC loan portfolio through review of four loan pool categories.

1. Pass credits with risk ratings 1-5

2. Other assets especially mentioned with risk rating 6-7

3. Substandard with risk rating 8 and still accruing

4. Impaired Loans 8-11 – Nonaccrual and troubled debt restructurings

Asset quality grades are described in detail subsequently.

The allowance consists of two components:

1. A general amount – The Company analyzes the historical migration of loans through each risk rating category and analyzes the history of losses as it relates to the various loan types and collateral types in order to evaluate and estimate the volume, magnitude and direction these events. These risk factors and other factors are applied to our review of the loan Pass credits with risk ratings 1-5 pool and other assets especially mentioned with risk rating 6 & 7 pool. These factors are applied to the substandard pool; however, in addition to reviewing the pool, a select group of individual loans are reviewed.  The results of the individual review are factored in with the historical loss analysis and applied to the pool.

2. A specific amount – Impaired loans, in addition to the general amount and review described above, are reviewed individually for specific amounts that are representative of identified credit exposures that are readily predictable by the current performance of the borrower and underlying collateral;

Even though the ALLL is composed of two components, the entire ALLL is available to absorb any credit losses.

The Company assesses the allowance for loan losses on a quarterly basis and makes provisions for loan losses as necessary in order to maintain the proper level of allowance.  While the Company uses available information to recognize losses on loans, future loan loss provisions may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses and may require the Company to recognize additional provisions based on their judgment of information available to them at the time of their examination.  The allowance for loan losses is maintained at a level that represents management's best estimate of inherent losses in the loan portfolio, and such losses were both probable and reasonably estimable.  The level of the allowance is based on estimates and the ultimate losses may vary from the estimates.

28

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Credit Quality

In September 2012, the Company modified its asset quality grading system by dividing it into eleven categories instead of eight.  This modification added one new pass level, an additional criticized level and a new classified level. The new grading system did not cause a material change to the allowance for loan losses and was created to help the Company better manage credit quality.

A summary of the asset grading system is as follows:

Risk Rating	Numerical Rating	Description	Regulatory Classification
Pass	1	Exceptional/Highest Quality	N/A
Pass	2	Excellent/High Quality	N/A
Pass	3	Strong/Above Average	N/A
Pass	4	Good/Average	N/A
Pass	5	Acceptable with more than average risk	N/A
Special Mention	6	Special Mention Loans	Criticized
Special Mention -  Elevated risk	7	Special Mention Loans with added risk exposure	Criticized
Substandard	8	Substandard/Inadequately Protected	Classified
Impaired Loans	9	Non Accrual Loans	Classified
Doubtful	10	Doubtful	Classified
Loss	11	Loss	Classified

Pass-1-Exceptional/Highest Quality – Loans in this category are secured by certificates of deposit.  There is no credit risk exposure in this category.

Pass-2-Excellent/High Quality – Loans in this category have excellent balance sheet and income statement and improving trends, including net worth, liquidity, working capital, leverage, cash flow and profitability. Financial ratios are superior within industry when industry comparison is available.

Pass-3-Strong/Above Average – Loans in this category have current and complete financial statements; Solid balance sheet and income statement with stable to improving trends  in areas such as net worth, liquidity, working capital, leverage, cash flow  and profitability; Leverage and ratios are better than industry standards when industry comparison is available; Debt service coverage, both historically and proposed, is more than adequate based on financial analysis; The borrower’s industry is stable to improving; Loans are properly structured and documented, and require only normal supervision and monitoring; Consistently meets debt obligations in a timely manner; Individual borrower or guarantor, with above average liquid net worth and minimal contingent liabilities.

29

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Pass-4-Good/Average - Loans in this category have sound risk profiles, good net worth and debt service coverage ratios; Financial statements are current and complete; Satisfactory balance sheet and income statement reflecting  adequate profitability, net worth, working capital, cash flow and leverage position; Financial analysis demonstrates adequate debt service coverage; Leverage and ratios are in line with industry averages when industry comparison is available; Debt service coverage, both historically and proposed, is adequate based on financial analysis; Loans are properly structured and documented and require only minimal supervision; Contingent Liabilities have been thoroughly analyzed and repayment sources are adequate to cover existing debt service; Individual borrower or guarantor with acceptable net worth and liquidity.

Pass-5-Acceptable with more than average risk - Loans in this category are those which are acceptable with more than average risk due to one or more factors, which could lead to financial difficulty if not closely managed. This rating may include those credits from higher categories that have declining trends in financial performance or credit quality. This category may also include credits that have previously been criticized or classified, but have improved in credit quality.

Special Mention 6-Special Mention Loans - Loans in this category are not currently adequate.  These loans are considered weaker due to less than adequate repayment history, and/or their collateral may not adequately protect the Bank from loss in the event of liquidation or foreclosure.  If left uncorrected, these weaknesses may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date. As a general rule, credits in this category will be delinquent less than 30 days and will not be chronically past due.  Loans in this category are not intended to remain in category 6 permanently as it should become evident fairly quickly whether or not the weaknesses can be cured and the loan upgraded.  If the weakness cannot be corrected, the relationship will more than likely need to be downgraded to a 7 or 8.

 Special Mention elevated Risk 7-Special Mention Loans with added risk exposure – Loans in this category have one or more potential weaknesses discussed in asset quality grade 6, but the borrower is still cooperative, satisfactory repayment plans are in place, and file documentation reflects the ability of the borrower to repay the debt as currently structured

Substandard 8-Substandard/Inadequately Protected – Loans in this category are inadequately protected by the current sound net worth and repayment capacity of the borrower or of the collateral pledged, if any.  Credit analysis has proven well defined weaknesses in debt service coverage, net worth and or poor loan structure.  There is a distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.  A reserve allocation of the estimated amount of loss or collateral shortfall has been made to the ALLL.  These loans are considered to be impaired loans and the chance of a loss is reasonably probable.

Impaired Loans 9-Non-Accrual Loans – Loans in this category are impaired with a loss potential of either principal or interest that is probable or likely to occur.  Once a loan enters this category, the estimated loss will be charged off.

30

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Doubtful 10-Doubtful - Loans in this category have all of the weaknesses inherent in those classified as Substandard, with the additional characteristic that the weaknesses make collection or liquidation in full highly questionable and improbable.  This assessment should be made on current facts, conditions and values.  The probability of some loss is extremely high, but because of certain important and reasonably specific pending factors (i.e., merger/liquidation, capital injection, refinancing plans, and/or perfection of liens), the amount of loss cannot yet be determined, but may total 50% of the outstanding balance.  Determination of the pending factors should generally be resolved within six months and the asset partially, or fully, charged-off or moved to substandard.  All doubtful assets must be placed on non-accrual.  A reserve allocation or charge off of at least 50% is normally recommended for such loans.

Loss 11-Loss - Loans in this category are considered uncollectible and of such little value that their continuance as active assets of the Bank is not warranted.  This classification does not mean that the loss has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing it off.  Once the loan is placed in this category, any determined loss will be charged-off within 30 days

Credit quality indicators for loans, excluding FDIC acquired, by class are presented below for September 30, 2012 and December 31, 2011.

December 31, 2011 credit quality numbers have been presented using the eleven scale credit quality for comparison purposes.

	As of September 30, 2012
							Construction
	Non-						and
	Residential		Multifamily		Farmland		Land
	(dollars in thousands)
Commercial Real Estate Credit Exposure
Pass 1	$	-	$	-	$	-	$	-
Pass 2		-		-		-		70
Pass 3		61,787		6,630		6,573		2,235
Pass 4		118,619		10,889		11,390		19,558
Pass 5		5,056		42		1,282		4,061
Special Mention 6		414		-		-		-
Special Mention elevated 7		-		1,720		-		-
Substandard 8		2,965		524		956		165
Impaired Loans 9		4,551		-		97		3,921
Doubtful 10		-		-		-		-
Loss 11		-		-		-		-
Total	$	193,392	$	19,805	$	20,298	$	30,010

31

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

	As of December 31, 2011
							Construction
	Non-						and
	Residential		Multifamily		Farmland		Land
	(dollars in thousands)
Commercial Real Estate Credit Exposure
Pass 1	$	-	$	-	$	-	$	-
Pass 2		-		-		-		76
Pass 3		39,543		479		6,032		6,432
Pass 4		85,425		12,996		9,049		11,707
Pass 5		7,262		2,183		2,163		3,927
Special Mention 6		4,564		-		161		465
Special Mention elevated 7		-		-		-		-
Substandard 8		1,923		139		405		3,756
Impaired Loans 9		253		-		111		441
Doubtful 10		-		-		-		-
Loss 11		-		-		-		-
Total	$	138,970	$	15,797	$	17,921	$	26,804

32

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

	As of September 30, 2012
	Commercial
	(dollars in thousands)
Commercial Credit Exposure
Pass 1	$	1,712
Pass 2		320
Pass 3		22,187
Pass 4		38,655
Pass 5		3,788
Special Mention 6		96
Special Mention elevated 7		6
Substandard 8		910
Impaired Loans 9		1,126
Doubtful 10		-
Loss 11		-
Total	$	68,800

	As of December 31, 2011
	Commercial
	(dollars in thousands)
Commercial Credit Exposure
Pass 1	$	1,095
Pass 2		299
Pass 3		17,902
Pass 4		29,056
Pass 5		4,440
Special Mention 6		802
Special Mention elevated 7		47
Substandard 8		637
Impaired Loans 9		901
Doubtful 10		-
Loss 11		-
Total	$	55,179

33

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

	As of September 30, 2012
	Mortgage		Home Equity
	(dollars in thousands)
Consumer Real Estate Credit Exposure
Pass 1-5	$	147,662	$	25,093
Special Mention 6		300		50
Special Mention elevated 7		-		-
Substandard 8		3,258		140
Impaired Loans 9		6,331		224
Doubtful 10		-		-
Loss 11		-		-
Total	$	157,551	$	25,507

	As of December 31, 2011
	Mortgage		Home Equity
	(dollars in thousands)
Consumer Real Estate Credit Exposure
Pass 1-5	$	119,809	$	25,682
Special Mention 6		154		262
Special Mention elevated 7		-		-
Substandard 8		5,716		90
Impaired Loans 9		4,066		120
Doubtful 10		-		-
Loss 11		-		-
Total	$	129,745	$	26,154

34

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

	As of September 30, 2012
	Indirect		Direct
	Auto		Auto		Other
	(dollars in thousands)
Consumer and Other Credit Exposure
Pass 1-5	$	1,666	$	6,841	$	17,829
Special Mention 6		-		-		-
Special Mention elevated 7		-		-		2
Substandard 8		26		-		50
Impaired Loans 9		43		24		36
Doubtful 10		-		-
Loss 11		-		-		4
Total	$	1,735	$	6,865	$	17,921

	As of December 31, 2011
	Indirect		Direct
	Auto		Auto		Other
	(dollars in thousands)
Consumer and Other Credit Exposure
Pass 1-5	$	3,610	$	6,385	$	13,624
Special Mention 6		18		-		20
Special Mention elevated 7		-		-		-
Substandard 8		49		1		49
Impaired Loans 9		64		44		8
Doubtful 10		-		-		-
Loss 11		-		-		-
Total	$	3,741	$	6,430	$	13,701

35

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

FDIC-Assisted Transactions

The Company elected to account for loans acquired in Tattnall Bank, Citizens Bank of Effingham (“Citizens”) and First Southern National Bank (“First Southern”) acquisitions under ASC 310–30.  ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, applies to a loan with evidence of deterioration of credit quality since origination, acquired by completion of a transfer for which it is probable, at acquisition, that the investor will be unable to collect all contractually required payments receivable.  ASC 310 prohibits carrying over or creating an allowance for loan losses upon initial recognition for loans which fall under the scope of this statement. Loans with specific evidence of deterioration in credit quality were accounted for under ASC 310.  In addition, the Company determined it would not be able to collect all the contractually required principal and interest payments on other loans in the portfolio which did not have specific evidence of credit quality due to multiple factors, including the deterioration of the economy since origination of these loans, the decline in real estate values in the market areas of the loans, and the poor underwriting standards under which these loans were originated.  These loans are accounted for by analogy to ASC 310. The following tables detail the fair value of loans covered and not covered under loss share agreements accounted under ASC 310-30.

Loans not covered by loss -sharing agreements:	September 30,
(dollars in thousands)	2012
Commercial real estate	$	7,321
Consumer real estate		2,328
Construction and land		550
Commercial and industrial		2,270
Consumer and other		1,822
	$	14,291

Loans covered by loss-sharing agreements:	September 30,
(dollars in thousands)	2012
Commercial real estate	$	23,565
Consumer real estate		35.399
Construction and land		14,293
Commercial and industrial		4,252
Consumer and other		1,248
	$	78,757

The Bank entered into loss-sharing agreements as part of the acquisitions of Citizens and First Southern.  The covered loans above are covered pursuant to the FDIC loss-share agreements.  Those agreements provide for the FDIC to reimburse the Company for 80% of covered losses associated with these loans, pursuant to the terms of the agreements.

36

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

FDIC-Assisted Transactions (continued)

The following table represents the loans receivable as of September 30, 2012 and reflects reclassifications from the balances reported at December 31, 2011:

	Acquired Loans Without Specific Evidence of Deterioration in Credit Quality			Acquired Loans With Specific Evidence of Deterioration in Credit Quality			Total Loans Acquired
	(dollars in thousands)
Contractually required principal and interest	$	146,627		$	35,645		$	182,272
Non-accretable difference		(34,538	)		(19,666	)		(54,204	)
Cash flows expected to be collected		112,089			15,979			128,068
Accretable yield		(33,422	)		(1,597	)		(35,019	)
Basis in acquired loans	$	78,667		$	14,382		$	93,049

The following table is a summary of changes in the accretable yields of acquired loans since the acquisition date and reflect refinements to the Company's initial estimate:

	Acquired Loans Without Specific Evidence of Deterioration in Credit Quality		Acquired Loans With Specific Evidence of Deterioration in Credit Quality				Total Loans Acquired
	(dollars in thousands)
Balance, December 31, 2011	$	29,146		$	1,950			$	31,096
Net Accretion		4,276			(353	)			3,923
Balance, September  30, 2012	$	33,422		$	1,597			$	35,019

The following is a summary of the allowance for loan and lease losses for the FDIC acquired loans for the period ended September 30, 2012:

	Commercial Real Estate			Consumer Real Estate			Construction and Land			Commercial and Industrial			Consumer  and  Other			Total
	(dollars in thousands)
		-			-
Balance, January 1, 2012	$	-		$	-		$	-		$	-		$	-		$	-
Add (deduct):
Charge-offs		(965	)		(121	)		(194	)		(233	)		(12	)		(1,525	)
Recoveries		-			-			-			-			-			-
Provision for loan losses - noncovered		-			-			-			-			12			12
Provision for loan losses - covered		965			121			194			233			-			1,513
Balance, September  30, 2012	$	-		$	-		$	-		$	-		$	-		$	-

37

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE 6. FDIC LOSS SHARE RECEIVABLE

A significant portion of the Company’s loan and other real estate assets are covered under loss share agreements with the FDIC in which the FDIC has agreed to reimburse us 80% of all covered losses as well as certain expenses incurred in connection with those assets. The Company estimated the amount that will be received from the FDIC under the loss share agreements that will result from losses incurred as the Company dispose of covered assets, and the Company’s recorded the estimate as a receivable from the FDIC. The Company discounted the receivable for the expected timing and receipt of those cash flows using a risk free rate plus a premium for risk. The accretion of the FDIC receivable discount is recorded into noninterest income using the level yield method over the estimated life of the receivable.

The FDIC receivable for loss share agreements is measured separately from the related covered assets because it is not contractually embedded in the assets and is not transferable if we sell the assets. The Company reviews and updates the fair value of the FDIC receivable at each reporting date in conjunction with the re-estimation of cash flows. The FDIC receivable fluctuates as loss estimates and expected cash flows related to covered loans and other real estate owned change.

The following tables provide changes in the loss-share receivable from the FDIC for the periods indicated.

For the nine  months ended September 30, 2012:
	(dollars in thousands)
Balance, December 31, 2011	$	83,901
Claimable losses on covered  assets under agreement		(1,485	)
Reimbursable expense claimed		1,754
Accretion of discounts and premiums, net		(2,904	)
Accrual for FDIC true up liability		(484	)
Reimbursements from FDIC		(13,084	)
Balance, September  30, 2012	$	67,698

For the twelve months ended December 31, 2011:
	(dollars in thousands)
Balance, December 31, 2010	$	-
FDIC Loss share receivable recorded for Citizens		58,164
FDIC Loss share receivable recorded for First Southern		30,464
Claimable losses on covered assets under agreement		(3,140	)
Reimbursable expense claimed		1,208
Accretion of discounts and premiums, net		381
Reimbursements from FDIC		(3,176	)
Balance, December 31, 2011	$	83,901

38

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE 7. OTHER REAL ESTATE OWNED (OREO)

The following table provides a summary of information pertaining to OREO for periods ended September 30, 2012 and December 31, 2011.

	OREO			Covered  OREO			Total
	(dollars in thousands)
Balance, December 31, 2011	$	3,362		$	10,047		$	13,409
Additions		951			6,081			7,032
Sales		(2,169	)		(6,216	)		(8,385	)
Writedowns		(143	)		(455	)		(598	)
Balance, September 30, 2012	$	2,001		$	9,457		$	11,458

	OREO			Covered  OREO			Total
	(dollars in thousands)
Balance, December 31, 2010	$	3,689		$	-		$	3,689
Acquired in Citizens acquisition		-			7,540			7,540
Acquired in First Southern acquisition		-			4,644			4,644
Additions		2,230			1,610			3,840
Sales		(1,699	)		(3,747	)		(5,446	)
Writedowns		(858	)		-			(858	)
Balance, December 31, 2011	$	3,362		$	10,047		$	13,409

39

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE 8. FAIR VALUE MEASUREMENTS

Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Current accounting guidance establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements).

The three levels of the fair value hierarchy are described below:

Level 1 – Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

Level 2 – Quoted prices in markets that are not active, or inputs that are observable, either directly, for substantially the full term of the asset or liability. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates and yield curves that are observable at commonly quoted intervals;

Level 3 – Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).

In instances where the determination of the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety.  The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

Fair Value Option

Fair Value Measurements and Disclosures (ASC 820) allow companies to report selected financial assets and liabilities at fair value.  The changes in fair value are recognized in earnings and the assets and liabilities measured under this methodology are required to be displayed separately on the balance sheet.   In certain circumstances, fair value enables a company to more accurately align its financial performance with the economic value of hedged assets. Fair value enables a company to mitigate the non-economic earnings volatility caused from financial assets and financial liabilities being carried at different bases of accounting, as well as to more accurately portray the active and dynamic management of a company’s balance sheet.

The Company has elected to record mortgage loans held-for-sale at fair value as of September 30, 2012.   The following is a description of mortgage loans held for sale including the specific reasons for electing fair value and the strategies for managing these assets on a fair value basis.

Mortgage Loans Held-for-Sale

The Company records mortgage loans held-for-sale at fair value in order to eliminate the complexities and inherent difficulties of achieving hedge accounting and to better align reported results with the underlying economic changes in value of the loans and related hedge instruments. This election impacts the timing and recognition of origination fees and costs, as well as servicing value, which are now recognized in earnings at the time of origination. Interest income on mortgage loans held-for-sale is recorded on an accrual basis in the consolidated statement of income under the heading “Interest income – loans, including fees”. The mark to market adjustments related to loans held-for-sale and the associated economic hedges are captured in mortgage banking activities.

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HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE 8. FAIR VALUE MEASUREMENTS (Continued)

Assets Measured at Fair Value on a Recurring Basis

The primary financial instruments that the Company carries at fair value include investment securities, derivative instruments, and mortgage loans held-for-sale.

The Company used the following methods and significant assumptions to estimate fair value for assets and liabilities measured on a recurring basis.

Securities:  Securities in an active market where quoted prices are available are classified within Level 1 of the valuation hierarchy.  Level 1 securities include highly liquid government securities and certain other financial products.  If quoted market prices are not available, then fair values are estimated by using pricing models that use observable inputs or quoted prices of securities with similar characteristics and are classified within Level 2 of the valuation hierarchy. In certain cases where there is limited activity or less transparency around inputs to the valuation and more complex pricing models or discounted cash flows are used.

Mortgage loans held-for-sale:  The fair value of mortgage loans held-for-sale is based on what secondary markets are currently offering for portfolios with similar characteristics predominantly consisting of those conforming to government sponsored entity or agency standards. The fair value measurements consider observable data that may include market trade pricing from brokers and the mortgage-backed security markets.

The Company classifies Interest Rate Lock Commitments (“IRLC”) on residential mortgage loans held-for-sale on a gross basis within other liabilities or other assets. The fair value of these commitments, while based on interest rates observable in the market, is highly dependent on the ultimate closing of the loans. Projected “pull-through” rates are determined quarterly by the Mortgage Division, using the Company’s historical data and the current interest rate environment to reflect the Company’s best estimate of the likelihood that a commitment will ultimately result in a closed loan. The loan servicing value is also included in the fair value of IRLCs.

Derivative assets and liabilities:The Companyuses derivatives to manage various financial risks. The fair values of derivative financial instruments are determined based on quoted market prices, dealer quotes and internal pricing models that are primarily sensitive to market observable data. The fair value of interest rate lock commitments, which are related to mortgage loan commitments, is based on quoted market prices adjusted for commitments that the Company does not expect to fund.

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HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE 8. FAIR VALUE MEASUREMENTS (Continued)

The credit risk associated with the underlying cash flows of an instrument carried at fair value was a consideration in estimating the fair value of certain financial instruments. Credit risk was considered in the valuation through a variety of inputs, as applicable, including, the actual default and loss severity of the collateral, and level of subordination. The assumptions used to estimate credit risk applied relevant information that a market participant would likely use in valuing an instrument. Because mortgage loans held-for-sale are sold within a few weeks of origination, it is unlikely to demonstrate any of the credit weaknesses discussed above and as a result, there were no credit related adjustments to fair value during the nine month periods ended September 30, 2012.

The following tables present financial assets measured at fair value at September 30, 2012 and December 31, 2011, on a recurring basis and the change in fair value for those specific financial instruments in which fair value has been elected at September 30, 2012.  The changes in the fair value of economic hedges were also recorded in mortgage banking activities and are designed to partially offset the change in fair value of the mortgage loans held-for-sale and interest rate lock commitments referenced in the tables below.

	Recurring Fair Value Measurements at September 30, 2012
	Total Carrying Value		Level 1		Level 2		Level 3
	(dollars in thousands)
Assets
Available for sale investment securities:
U.S. Government sponsored agencies (GSEs)	$	23,114	$		$	23,114	$	-
State and municipal securities		33,621				33,621		-
Corporate debt securities		2,088				2,088		-
GSE residential mortgage-backed securities		150,273						-
Equity securities		191		15		176		-
Total available for sale investment securities		209,287		15		209,272		-
Mortgage loans held for sale		7,236		-		7,236		-
Other assets (1)		150		-				150
Total assets at fair value	$	216,673	$	15	$	216,508	$	150
Liabilities
Interest rate swap – cash flow hedge	$	2,483	$	-	$	2,483	$	-
Other liabilities (1)		-		-		-		-
Total liabilities at fair value	$	2,483	$	-	$	2,483	$	-

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HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE 8. FAIR VALUE MEASUREMENTS (Continued)

	Recurring Fair Value Measurements at December 31, 2011
	Total Carrying Value		Level 1		Level 2		Level 3
	(dollars in thousands)
Assets
Available for sale investment securities:
U.S. Government sponsored agencies (GSEs)	$	45,737	$		$	45,737	$	-
State and municipal securities		48,204				48,204		-
Corporate debt securities		1,956				1,956		-
GSE residential mortgage-backed securities		162,963				162,963		-
Equity securities		157		66		91		-
Total available for sale investment securities		259,017		66		258,951		-
Total assets at fair value	$	259,017	$	66	$	258,951	$	-
Liabilities
Interest rate swap – cash flow hedge	$	-	$	-	$	-	$	-
Total liabilities at fair value	$	-	$	-	$	-	$	-

(1) This amount includes mortgage related interest rate lock commitments and derivative financial instruments to hedge interest rate risk. Interest rate lock commitments were recorded on a gross basis.

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HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE 8. FAIR VALUE MEASUREMENTS (Continued)

The following tables present a reconciliation of all assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (level 3) during the three and nine months ended September 30, 2012.  There were no transfers into or out of Level 3. There were no transfers between Level 1, and Level 2 during the three and nine months ended September 30, 2012.

Three months ended September 30, 2012:		Other Assets (1)		Other Liabilities (1)
	(dollars in thousands)
Beginning Balance June 30, 2012		$	-	$	-
Total gains (losses) included in earnings: (2)
Issuances			150		-
Settlements and closed loans			-		-
Expirations			-		-
Total gains (losses) included in Other comprehensive income			-		-
Ending Balance September 30, 2012 (3)		$	150	$	-

Nine  months ended September 30, 2012:		Other Assets (1)		Other Liabilities (1)
	(dollars in thousands)
Beginning Balance December 31, 2011		$	-	$	-
Total gains (losses) included in earnings: (2)
Issuances			150		-
Settlements and closed loans			-		-
Expirations			-		-
Total gains (losses) included in Other comprehensive income			-		-
Ending Balance September 30, 2012 (3)		$	150	$	-

(1) Includes mortgage related IRLCs and derivative financial instruments entered into to hedge interest rate risk.

(2) Amounts included in earnings are recorded in mortgage banking activities.

(3) Represents the amount included in earnings attributable to the changes in unrealized gains/losses relating to IRLCs and derivatives still held at period end.

There were no assets or liabilities measured at fair value on a recurring basis using significant unobservable inputs (level 3) during the three and nine months ended September 30, 2011.

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HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 8. FAIR VALUE MEASUREMENTS (Continued)

The unobservable input utilized in the determination of fair value of other assets and liabilities was a pull through rate, which was 65% as of September 30, 2012. A pull through rate is management’s assumption as to the percentage of loans in the pipeline that will close and eventually fund. It is based on the Company’s historical fall-out activity. Significant increases in this input in isolation would result in a significantly higher fair value measurement and significant decreases would result in a significantly lower fair value measurement. In addition, IRLCs’ fair value includes mortgage servicing rights that do not trade in an active market with readily observable prices. Accordingly, the fair value is estimated based on a valuation model which calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates, and other ancillary income, including late fees.

	For Items Measured at Fair Value Pursuant to Election of the Fair Value Option: Fair Value Gain related to Mortgage Banking Activities
	Three Months Ended
	September 30, 2012		September 30, 2011
	(dollars in thousands)
Mortgage loans held for sale	$	336	$	-

	For Items Measured at Fair Value Pursuant to Election of the Fair Value Option: Fair Value Gain related to Mortgage Banking Activities
	Nine Months Ended
	September 30, 2012		September 30, 2011
	(dollars in thousands)
Mortgage loans held for sale	$	336	$	-

The following tables present the difference between the aggregate fair value and the aggregate unpaid principal balance of loans held-for-sale for which the fair value option has been elected as of September 30, 2012 and December 31, 2011.

	September 30, 2012
	Aggregate Fair Value		Aggregate Unpaid  Principal Balance Under FVO		Fair Value Over Unpaid Principal
Loans held for sale	$	7,236	$	7,050	$	186

	December 31, 2011
	Aggregate Fair Value		Aggregate Unpaid  Principal Balance Under FVO		Fair Value Over Unpaid Principal
Loans held for sale	$	7,471	$	7,471	$	-

45

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 8. FAIR VALUE MEASUREMENTS (Continued)

Assets Measured at Fair Value on a Nonrecurring Basis

Certain financial assets and liabilities are measured at fair value on a nonrecurring basis. Adjustments to the fair market value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

The following is a description of the valuation methodologies used for instruments measured at fair value on a non-recurring basis and recognized in the accompanying balance sheet, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Impaired Loans:  Loan impairment is reported when full payment under the loan terms is not expected.  In accordance with the provisions of the loan impairment guidance (ASC 310-10-35), individual loans were written down to their fair value. Loans applicable to write downs of impaired loans are estimated using the present value of expected cash flows or the appraised value of the underlying collateral discounted as necessary due to management’s estimates of changes in economic conditions.  A portion of the allowance for loan losses is allocated to impaired loans if the value of such loans is deemed to be less than the unpaid balance. If these allocations cause the allowance for loan losses to require an increase, such increase is reported as a component of the provision for loan losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan is confirmed.  When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the loan impairment as non-recurring Level 2.  When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the loan impairment as non-recurring Level 3.

OREO (including covered):   Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value.  Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral.  When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed assets as nonrecurring Level 2.  When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as nonrecurring Level 3.

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HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 8. FAIR VALUE MEASUREMENTS (Continued)

The following table summarizes financial assets and liabilities measured at fair value on a nonrecurring basis:

	Non Recurring Fair Value Measurements at September 30, 2012
		Total Carrying Value		Level 1			Level 2			Level 3
	(dollars in thousands)
Assets
Impaired Loans(1)		$	14,073		$	-		$	-		$	14,073
OREO			2,001			-			-			2,001
Covered OREO			9,457			-			-			9,457
Total		$	25,531		$	-		$	-		$	25,531

	Non Recurring Fair Value Measurements at December 31, 2011
	Total Carrying Value		Level 1		Level 2		Level 3
	(dollars in thousands)
Assets
Impaired Loans(1)	$	11,371	$	-	$	-	$	11,371
OREO		3,362		-		-		3,362
Covered OREO		10,047		-		-		10,047
Other foreclosed assets		32		-		-		32
Total	$	24,812	$	-	$	-	$	24,812

(1) Amounts represent the fair value of collateral for impaired loans allocated to the allowance for loan and lease losses. Fair values are determined using actual market prices (Level 1), independent third party valuations and borrower records, discounted as appropriate (Level 3).

Assets Not Measured at Fair Value on a Recurring or Nonrecurring Basis

The following is a description of the valuation methodologies used for instruments  not measured at fair value on a recurring or non-recurring basis and recognized in the accompanying balance sheet, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Cash and short-term investments: The carrying amounts reported in the Consolidated Balance Sheets for cash and short-term investments, such as federal funds sold, approximated the fair value of those instruments. The Company classifies cash and short-term investments in Level 1 of the fair value hierarchy.

Other Investments:  The carrying amount of Federal Home Loan Bank Stock and other equity securities approximates fair value.  The Company classifies Federal Home Loan Bank stock and other equity securities in Level 1 of the fair value hierarchy.

FDIC Loss-Share Receivable:  Because the FDIC will reimburse the Company for certain acquired loans, should the Company experience a loss, an indemnification asset is recorded at fair value at the acquisition date.  The indemnification asset is recognized at the same time as the indemnified loans and measured on the same basis, subject to collectability or contractual limitations. The shared- loss agreements on the acquisition date reflect the reimbursements expected to be received from the FDIC, using an appropriate discount rate, which reflects counterparty credit risk and other uncertainties.  The shared-loss agreements continue to be measured on the same basis as the related indemnified loans, and the loss share receivable is impacted by changes in estimated cash flows associated with these loans.

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HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 8. FAIR VALUE MEASUREMENTS (Continued)

Loans:  The carrying amount of variable-rate loans that reprice frequently and have no significant change in credit risk approximates fair value.  The fair value of fixed-rate loans is estimated based on discounted contractual cash flows, using interest rates currently being offered for loans with similar terms to borrowers with similar credit quality.  The fair value of impaired loans is estimated based on discounted contractual cash flows or underlying collateral values, where applicable.

Covered Loans:  Covered loans include loans on which the majority of losses would be covered by loss-sharing agreements with the FDIC.  Management initially valued these assets at fair value using mostly unobservable inputs and, as such, has classified these assets as Level 3.

Deposits:  The carrying amount of demand deposits, savings deposits and variable-rate certificates of deposit approximates fair value.  The fair value of fixed-rate certificates of deposit is estimated based on discounted contractual cash flows using interest rates currently being offered for certificates of similar maturities.

Federal Funds Purchased and Securities Sold Under Repurchase Agreements:  The fair value of fixed rate federal funds purchased and securities sold under repurchase agreements is estimated based on discounted contractual cash flows using the current incremental borrowing rates for similar type borrowing arrangements.

Other Borrowings:  The carrying amount of variable rate advances approximates fair value.  The fair value of fixed rate advances is estimated based on discounted contractual cash flows using the current incremental borrowing rates for similar type borrowing arrangements.

The following tables present the assets that are measured at fair value on a non-recurring basis by level within the fair value hierarchy as reported on the consolidated statements of financial position at September 30, 2012 and December 31, 2011.

	Carrying		Fair Value Measurements at September 30, 2012
	Value		Total Fair Value		Level 1		Level 2		Level 3
			(dollars in thousands)
Assets
Cash and short-term investments	$	50,088	$	50,088	$	50,088	$	-	$	-
Other investments		4,215		4,215		-		-		4,215
Loans, net, excluding covered loans		547,645		533,593		-		-		533,593
Covered loans		78,757		78,757		-		-		78,757
FDIC loss-share receivable		67,698		67,698				-		67,698
Total assets at fair value	$	748,403	$	734,351	$	50,088	$	-	$	684,263
Liabilities
Deposits	$	845,079		839,143	$	-	$	-	$	839,143
Federal funds purchased and securities
Sold under repurchase agreements		35,833		35,843		35,843		-		-
Other borrowings		35,000		39,296				-		39,296
Total liabilities at fair value	$	915,912	$	914,282	$	35,843	$	878,439	$	878,439

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HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

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(Unaudited)

NOTE 8. FAIR VALUE MEASUREMENTS (Continued)

	Carrying		Fair Value Measurements at December 31, 2011
	Value		Total Fair Value		Level 1		Level 2		Level 3
			(dollars in thousands)
Assets
Cash and short-term investments	$	99,375	$	99,375	$	99,375	$	-	$	-
Other investments		5,077		5,077		-		-		5,077
Loans, net, excluding covered loans		453,163		437,737		-		-		437,737
Covered loans		107,457		107,457		-		-		107,457
FDIC loss-share receivable		83,901		83,901				-		83,901
Total assets at fair value	$	748,973-	$	733,547	$	99,375	$	-	$	634,172
Liabilities
Deposits	$	884,187	$	875,317	$	-	$	-	$	875,317
Federal funds purchased and securities
Sold under repurchase agreements		35,049		35,049		35,049		-		-
Other borrowings		35,000		35,000		-		-		35,000
Total liabilities at fair value	$	954,236	$	945,366	$	35,049	$	-	$	910,317

Current accounting guidance requires interim disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on settlements 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. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets, and, in many cases, could not be realized in immediate settlement of the instrument. Current accounting guidance excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

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HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. DERIVATIVE FINANCIAL INSTRUMENTS

Derivative Instruments – Interest Rate Swap Agreement

The Company is exposed to interest rate risk in the course of its business operations and manages a portion of this risk through the use of a derivative financial instrument, in the form of an interest rate swap (cash flow hedge). The Company accounts for its interest rate swap in accordance with ASC 815, Derivatives and Hedging, which requires that all derivatives be recognized as assets or liabilities in the balance sheet at fair value.

The Company utilizes the interest rate swap agreement to essentially convert a portion of its variable-rate debt to a fixed rate (cash flow hedge). For derivatives designated as hedging exposure to variable cash flows of a forecasted transaction (cash flow hedge), the effective portion of the derivative’s gain or loss is initially reported as a component of other comprehensive income and subsequently reclassified into earnings when the forecasted transaction affects earnings or when the hedge is terminated. The ineffective portion of the gain or loss is reported in earnings immediately. For derivatives that are not designated as hedging instruments, changes in the fair value of the derivatives are recognized in earnings immediately. In applying hedge accounting for derivatives, the Company establishes a method for assessing the effectiveness of the hedging derivative and a measurement approach for determining any ineffective aspect of the hedge upon the inception of the hedge.

Cash Flow Hedge of Interest Rate Risk

During the first quarter 2012, the Company entered into a forward starting interest rate swap agreement with a notional amount of $50.0 million to protect against variability in the expected future cash flows attributed to changes in the benchmark interest rate Libor beginning February 1, 2016 and ending February 1, 2024 on the designated notional amount of variable rate bank debt.

The Company recognized an after-tax unrealized loss on its cash flow hedge in other comprehensive income of $1.5 million for the nine months ended September 30, 2012.

The Company recognized a $2.5 million cash flow hedge liability in other liabilities on the balance sheet at September 30, 2012.  There was no ineffectiveness in the cash flow hedge during the nine months ended September 30, 2012.

Credit risk related to the derivative arises when amounts receivable from the counterparty (derivative dealer) exceed those payable. The Company controls the risk of loss by only transacting with derivative dealers that are national market makers whose credit ratings are strong. Each party to the interest rate swap is required to provide collateral in the form of cash or securities to the counterparty when the counterparty’s exposure to a mark-to-market replacement value exceeds certain negotiated limits. These limits are typically based on current credit ratings and vary with ratings changes.  As of September 30, 2012, the Company was required to provide collateral of $2.5 million for the derivative.  Also, the Company has a netting agreement with the counterparty.

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HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. DERIVATIVE FINANCIAL INSTRUMENTS (continued)

Derivative Instruments – Mortgage Lending Activities

The Company maintains a risk management program to manage interest rate risk and pricing risk associated with its mortgage lending activities. The risk management program includes the use of forward contracts and other derivatives that are recorded in the financial statements at fair value and are used to offset changes in value of the mortgage inventory due to changes in market interest rates. As a normal part of its operations, the Company enters into derivative contracts to economically hedge risks associated with overall price risk related to IRLCs and mortgage loans held-for-sale for which the fair value option has been elected. Fair value changes occur as a result of interest rate movements as well as changes in the value of the associated servicing rights. Derivative instruments used include forward commitments, mandatory commitments and best effort commitments. All derivatives are carried at fair value in the Consolidated Balance Sheets in other assets or other liabilities. A net gain of $150,000 was recorded for all related commitments as of September 30, 2012, which is the first period fair value was adopted by the Company.

The Company’s risk management derivatives are based on underlying risks primarily related to interest rates and forward sales commitments. Forwards are contracts for the delayed delivery or net settlement of an underlying instrument, such as a mortgage loan, in which the seller agrees to deliver on a specified future date, either a specified instrument at a specified price or yield or the net cash equivalent of an underlying instrument. These hedges are used to preserve the Company’s position relative to future sales of loans to third parties in an effort to minimize the volatility of the expected gain on sale from changes in interest rate and the associated pricing changes.

Credit and Market Risk Associated with Derivatives

Derivatives expose the Company to credit risk. If the counterparty fails to perform, the credit risk at that time would be equal to the net derivative asset position, if any, for that counterparty. The Company minimizes the credit or repayment risk in derivative instruments by entering into transactions with high quality counterparties that are reviewed periodically by the Company’s Risk Management area. The Company’s derivative positions as of September 30, 2012 were as follows

	Contract Amount
	September 30, 2012		December 31,  2011
	(dollars in thousands)
Fannie Mae mortgage-backed securities Forward commitments	$	-	$	-
Mandatory loan sale commitments		-		-
Best efforts sale commitments		14,995		7,471
Total commitments	$	14,995	$	7,471

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HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 10. ACQUISITION ACTIVITY

Single Branch of AB&T National Bank

On June 30, 2012, the Company completed an acquisition of a single branch of AB&T National Bank located in Auburn, Alabama.  The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition:

	Acquired		Fair Value and Other Adjustments			As Recorded by Heritage Financial Group
Assets	(dollars in thousands)
Cash and cash equivalents	$	146	$	5,685	(a)	$	5,831
Premises and equipment		1,741		-			1,741
Loans		10,890		(117	(b)		10,773
Core deposit intangibles		-		168	(c)		168
Other assets		43		-			43
Total Assets	$	12,820	$	5,736	(e)	$	18,556
Liabilities
Noninterest-bearing deposits	$	1,636	$			$	1,636
Interest-bearing deposits		16,810		50	(d)		16,860
Other liabilities		26					26
Total Liabilities	$	18,472	$	50	(e)	$	18,522

Explanations

(a) The adjustment represents the cash received from AB&T to reflect the acquisition of excess liabilities assumed over assets purchased.

(b) The adjustment represents the adjustment to fair market value of the loans assumed in the transaction.

(c) The adjustment represents the consideration paid for the value of the core deposit base assumed in the acquisition.  The core deposit asset was recorded as an identifiable intangible asset and will be amortized on an accelerated basis over the average life of the deposit base, estimated to be ten years.

(d) The adjustment is necessary because the weighted average interest rate of the CD's acquired exceeded the cost of similar funding at the time of acquisition.  The fair value adjustment will be amortized to reduce interest expense on a declining basis over the average life of the portfolio.

(e) The difference in total assumed assets and liabilities represents the $34,000 bargain purchase gain recognized in the second quarter 2012.

The Company did not acquire any loans with deteriorated credit quality as of the acquisition date this transaction.  Accordingly, the Company accounts for the loans acquired in this transaction under FASB ASC 805, Business Combinations.

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HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 11. SUBSEQUENT EVENTS

The Company filed a shelf offering on Form S-3 with the Securities and Exchange Commission (the “SEC”) on October 25, 2012. Under the shelf registration statement, which was declared effective by the SEC on November 7, 2012, the Company may offer and sell from time to time in the future, in one or more offerings, common stock, preferred stock, debt securities, warrants, depository shares, or units consisting of any combination of the foregoing.

Subsequent events and transactions that occurred after September 30, 2012 but prior to November 9, 2012, the date these financial statements were available to be issued, have been evaluated for potential recognition or disclosure in these financial statements.  There were no other subsequent events that require disclosure in the financial statements.

53

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements.When used in this Quarterly Report on Form 10-Q and in other filings by the Company with the Securities and Exchange Commission (the  “SEC”), in the Company's press releases or other public or shareholder communications, and in oral statements made with the approval of an authorized executive officer, the words or phrases “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimate,” “project,” “intends” or similar expressions are intended to identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.  Such statements are subject to certain risks and uncertainties, including, among other things, (i) expected cost savings, synergies and other benefits from the Company’s merger and acquisition activities might not be realized within the anticipated time frames or at all, and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, might be greater than expected; (ii) changes in economic conditions, either nationally or in the Company’s market areas; (iii) fluctuations in interest rates; (iv) the risks of lending and investing activities, including changes in the level and direction of loan delinquencies and write-offs and changes in estimates of the adequacy of the allowance for loan losses; (v) the possibility of other-than-temporary impairments of securities held in the Company’s securities portfolio; (vi) the Company’s ability to access cost-effective funding; (vii) fluctuations in real estate values and both residential and commercial real estate market conditions; (viii) demand for loans and deposits in the Company’s market areas; (ix) legislative or regulatory changes that adversely affect the Company’s business, including, without limitation, the Dodd-Frank Wall Street Reform and Consumer Protection Act and its implementing regulations, and the new overdraft protection regulations and customers’ responses thereto; (x) monetary and fiscal policies of the Federal Reserve Board and the U.S. Government and other governmental initiatives affecting the financial services industry; (xi) results of examinations of the Company and the Bank by their regulators, including the possibility that the regulators may, among other things, require the Company to increase its allowance for loan losses or to write-down assets; (xii) costs and effects of litigation, including settlements and judgments; (xiii) compliance risk with the FDIC loss-share agreements; (xiv) competition; and (xv) performance risk of mortgage loans sold on the secondary market.  The Company wishes to advise readers that the factors listed above could affect the Company's financial performance and could cause the Company's actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements.

The Company does not undertake, and specifically declines, any obligation-to publicly release the result of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

General.  Heritage Financial Group, Inc. (“Heritage” or the “Company”) is a $1.1 billion bank holding company headquartered in Albany, Georgia.  The principal business of Heritage is operating its wholly owned subsidiary, HeritageBank of the South (“HeritageBank” or the “Bank”).  Heritage primarily conducts commercial banking, retail banking and wealth management activities through its bank subsidiary.  As of September 30, 2012, HeritageBank operated in south Georgia, north central Florida and eastern Alabama through 23 full-service branch locations, 11 mortgage offices and 4 investment offices.HeritageBank provides credit based products, deposit accounts, corporate cash management, investment support and other services to commercial and retail clients.

Evolution of Business Strategy.  Our current business strategy is to operate a well-capitalized and profitable financial institution dedicated to serving the needs of our customers.  We strive to be the primary financial institution in the market areas we serve.  We offer a broad range of products and services while stressing personalized and efficient customer service and convenient access to these products and services.  We intend to continue to operate as a commercial and consumer lender.  We have structured operations around a branch system that is staffed with knowledgeable and well-trained employees.  Subject to capital requirements and our ability to grow in a reasonable and prudent manner, we may open or acquire additional branches as opportunities arise.  In addition to our branch system, we continue to expand electronic services for our customers.  We attempt to differentiate ourselves from our competitors by providing a higher level of customer service.

54

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Expansion Efforts.  A key element of our business strategy is increasing our presence and growing the “Heritage” brand in the markets we currently serve and expanding our operations beyond our original southwest Georgia market by entering new markets in other parts of southern Georgia, north central Florida, eastern Alabama and other adjacent communities that present attractive opportunities for expansion consistent with our capital availability.  This expansion of our market beyond southwest Georgia began in 2006, when we commenced operating a branch in Ocala, Florida.

We have pursued this expansion program through both prudent, disciplined internal growth and strategic acquisitions.  Many troubled financial institutions throughout our market footprint have closed or curtailed their lending activities, decreased their assets or sold branches to improve their capital which has given us the opportunity to expand through organic loan demand and attractive branch acquisitions.  We have also hired highly regarded and experienced lending officers and commercial bankers and expanded into new market areas that are contiguous to our existing market areas.  These recent activities reflect our ability to take advantage of these expansion opportunities.

2011 marked a milestone in our expansion activity with the purchase and assumption of two FDIC-assisted acquisitions near Savannah, Georgia and in Statesboro, Georgia.   In April 2012, we opened a commercial banking office in Macon, Georgia, and in June 2012, we completed the purchase of a single branch in Auburn, Alabama.  The Auburn, Alabama branch purchase resulted in the transfer of $12 million in loans and $19 million in deposits.  In August 2012, we hired a new management team to operate our mortgage division which is expected to lead significant growth in our mortgage business, particularly in the Atlanta, Georgia market.

Critical Accounting Policies

The accounting principles we follow and our methods of applying these principles conform with U.S. generally accepted accounting principles and with general practices within the banking industry. There have been no significant changes to our Critical Accounting Policies as described in our Annual Report on Form 10-K for the year ended December 31, 2011 with the exception of fair value accounting for residential mortgages held for sale.

Fair Value Accounting for Residential Mortgages Held for Sale.The primary financial instruments the Company carries at fair value for residential mortgage loans include interest rate lock commitments (“IRLCs”) and residential mortgage loans held-for-sale. The Company classifies IRLCs on residential mortgage loans, which are derivatives under ASC 815-10-15, on a gross basis within other liabilities or other assets. The fair value of these commitments, while based on interest rates observable in the market, is highly dependent on the ultimate closing of the loans. These “pullthrough” rates are based on both the Company’s historical data and the current interest rate environment and reflect the Company’s best estimate of the likelihood that a commitment will ultimately result in a closed loan. As a result of the adoption of SAB No. 109, the loan servicing value is also included in the fair value of IRLCs.    For further information on the fair value accounting for residential mortgages held for sale, see Note 8 of the Condensed Notes to Consolidated Financial Statements contained in this Form 10-Q.

55

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Off-Balance Sheet Arrangements, Contractual Obligations and Commitments.  The following table presents our longer term, non-deposit related, contractual obligations and commitments to extend credit to our borrowers, in aggregate and by payment due dates.  In addition to the commitments below, we had overdraft protection available in the amounts of $12.3 million at September 30, 2012.

	September 30,2012
	Less than One Year		One through Three Years		Four through Five Years		After Five Years		Total
	(In thousands)
Contractual obligations:
Federal Home Loan Bank advances	$	-	$	5,000	$	20,000	$	10,000	$	35,000
Repurchase agreement		-		-		15,000		15,000		30,000
Other borrowings		5,833		-		-		-		5,833
Operating leases (premises)		329		856		547		1,849		3,581
Total advances and operating leases	$	6,162	$	5,856	$	35,547	$	26,849	$	74,414
Off-balance sheet loan commitments:
Undisbursed portions of loans closed	$	-	$	-	$	-	$	-	$	-
Commitments to originate loans		43,831		-		-		-		43,831
Unused lines of credit		60,785		7,401		3,299		16,071		87,556
Total loan commitments		104,616		7,401		3,299		16,071		131,387
Total contractual obligations and loan commitments	$	110,778	$	13,257	$	38,846	$	42,920	$	205,801

56

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Comparison of Financial Condition at September 30, 2012 and December 31, 2011

General.  Total assets decreased by $34.9 million or -3.2% to $1.055 billion at September 30, 2012, from $1.090 billion at December 31, 2011.  Cash and due from banks, interest-bearing deposits and federal funds sold decreased $12.5 million, $26.1 million and $10.7 million, respectively from December 31, 2011 to September 30, 2012.  Securities available for sale declined $49.7 million or -19.2% from December 31, 2011 to September 30, 2012. Total loans, including loans held for sale increased by $74.1 million from December 31, 2011 to September 30, 2012, which included organic loan growth of $90.8 million and acquired loans of $12.2 million from the Auburn branch acquisition in part offset by a decrease in covered loans of $28.7 million and a decline in loans held for sale by $235,000.

Cash and Securities.The Company decreased the liquidity position, which includes bank deposits and federal funds sold, by $99.0 million or -27.6% to $259.4 million at September 30, 2012, from $358.4 million at December 31, 2011.

At September 30, 2012, our $209.3 million securities portfolio included $23.1 million in US government agency securities, $33.6 million in state and municipal securities, $2.1 million in corporate debt securities and $150.3 million in GSE residential mortgage-backed securities.  Although securities classified as available for sale may be sold from time to time to meet liquidity or other needs, it is not our normal practice to trade this segment of the investment securities portfolio. While management generally holds these assets on a long-term basis or until maturity, any short-term investments or securities available for sale could be converted at an earlier point, depending partly on changes in interestrates and alternative investment opportunities.  Based on our quarterly impairment analysis of these securities and their issues, we believe it is probable that we will be able to collect all amounts due under their contracts, net of previously recorded impairments.  The aggregate decrease in cash and due from banks, interest-bearing deposits and fed funds sold was primarily due to the use of excess liquidity to fund organic loans.

For the remainder of 2012, we expect to maintain cash, funds due from banks, federal funds sold and securities at elevated levels but do expect the declining trend for liquidity to continue in order to fund organic loan growth.  Maintaining excess liquidity does impact the net interest margin in a negative way in the short-term; however, the funding of organic loan growth with excess liquidity is expected to benefit the net interest margin going forward.  We also continue to anticipate additional organic loan growth for the remainder 2012 and plan to fund the growth with investment balance runoff gradually reducing liquid assets and liquidity at the same time we increase loans.  Future investment runoff will likely occur as a result of pay-downs, maturities, sales or calls.

Loans.Our net loan portfolio increased $74.3 million, or 13.3%, to $634.9 million at September 30, 2012, from $560.6 million at December 31, 2011.  The increase was caused by $90.8 million of organic growth and acquired loans of $12.2 million from the Auburn branch acquisition, partially offset by a decrease in covered loans of $28.7 million.  We expect the loan portfolio to continue to grow as planned organic loan growth is expected to exceed pay downs in the portfolio.

57

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Delinquencies and Non-performing Assets.As of September 30, 2012, loans past due for 30 to 89 days, excluding loans acquired in FDIC-assisted transactions, was $1.0 million or 0.19%, of non-FDIC acquired loans, compared to $371,000 or 0.09%, of non-FDIC acquired loans, at December 31, 2011.

The table below sets forth the amounts and categories of non-performing assets, excluding loans and OREO acquired in FDIC-assisted transactions at the dates indicated:

	September 30, 2012		December 31, 2011		Amount Change			Percent Change
	(Dollars in thousands)
Non-accruing loans	$	16,358	$	7,043	$	9,315			132.2	%
Foreclosed assets		1,403		3,356		(1,953	)		-58.2	%
Total	$	17,761	$	10,399	$	7,362			70.1	%

At September 30, 2012, our largest non-performing loan was $3.5 million classified as a troubled debt restructure and secured by commercial and undeveloped properties.  This loan was previously identified as a criticized asset and is adequately secured by the collateral.  Our second largest non-performing loan was $2.5 million, currently in bankruptcy, and secured by commercial properties.  This loan was previously identified as a criticized asset and is adequately secured based on the current appraisal.  Out third largest non-performing loan was $2.1 million secured by various residential and commercial properties.  Our fourth largest non-performing loan was $1.9 million secured by various residential and commercial properties.  This loan amount decreased from the balance of $3.9 million at December 31, 2010 due to a $2.0 million charge off during the first quarter of 2011.  The remainder of our non-performing loans consists of various consumer and commercial loans, none exceeding $1.0 million.  Current appraisals on real estate loans, expected cost of foreclosure or other disposition, and other probable losses on these loans are considered in our analysis of the allowance for loan losses.

Foreclosed assets decreased to $1.4 million at September 30, 2012, from $3.4 million at December 31, 2011.  Our largest foreclosed asset at September 30, 2012 was $1.1 million of undeveloped property.  The remainder of our foreclosed assets consists of various properties with no single property having a book value over $1.0 million.  All of these properties are being marketed actively for disposition.

Our internally criticized (watch list) and classified assets, excluding FDIC-assisted transactions, decreased $3.9 million and totaled $29.3 million at September 30, 2012, compared to $33.2 million at December 31, 2011.  This includes loans with respect to which known information about the possible credit problems of the borrowers have caused management to have doubts as to the ability of the borrowers to comply with present loan repayment terms and which may result in the future inclusion of such items in the non-performing asset categories.  These balances include the aforementioned nonperforming loans, but do not include other real estate or repossessed assets.  These loans have been considered in management's determination of the adequacy of our allowance for loan losses.  Our internal loan review processes strive to identify weaknesses in loans prior to performance issues.  However, our processes do not always provide sufficient time to work out plans with borrowers that would avoid foreclosure and/or losses.

Non-performing assets for the current quarter increased $7.4 million and totaled $17.8 million at September 30, 2012, compared to $10.4 million at December 31, 2011.  We remain cautiously optimistic this increase in nonperforming assets was driven by already identified and classified assets moving through the resolution process as we aggressively identify and resolve problem assets.  We have taken actions to prevent losses in our current portfolio by actively managing problem assets through a special assets committee.  We have also taken steps to better evaluate the capital and liquidity positions of our commercial loan guarantors, particularly those involved in commercial real estate construction and development.

58

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Allowance for Loan Losses.  The allowance for loan and lease losses, net of FDIC acquired loans, was $8.5 million as of September 30, 2012 compared to $7.5 million as of December 31, 2011.  As a percentage of period-end loans excluding FDIC acquired, the allowance for loan and lease losses was 1.57% as of September 30, 2012 compared to 1.72% as of December 31, 2011.  The FDIC acquired loans did not have an allowance for loan and lease losses as of September 30, 2012 or December 31, 2011.

Third quarter 2012 provision expense for loans and leases was $1.9 million as compared to $1.1 million during the linked quarter and $1.0 million during the comparable year-over-year quarter.  Third quarter 2012 provision expense included $1.18 million of expense for FDIC acquired loans with $1.17 million related to the covered loans as compared to $341,000 of expense for FDIC acquired loans with $338,000 related to covered loans for the linked quarter and no provision expense for the comparable year-over-year quarter.  The provision expense for loans and leases, excluding FDIC acquired loans, remained stable at $750,000 for the current quarter compared to the linked quarter primarily driven by lower net charge-offs offset by organic loan growth during the quarter.  The increase in provision expense for FDIC acquired loans relative to the linked quarter was driven primarily by charge-offs in excess of loan discounts during the quarter.

The following tables present information related to loan type and asset quality as of the periods indicated.

	Loans by Type as of
	September 30, 2012		December 31, 2011		September 30, 2011
	(dollars in thousands)
Non-FDIC acquired loans:
Nonresidential	$	193,392	$	138,970	$	129,730
Multifamily		19,805		15,797		13,754
Farmland		20,298		17,921		18,272
Construction and land		30,010		26,804		28,115
Mortgage loans, 1-4 families		157,551		129,745		134,269
Home equity		25,507		26,154		26,071
Consumer and other		26,521		23,872		21,955
Commercial and industrial		68,800		55,179		47,854
		541,884		434,442		420,020
Loans acquired through FDIC-assisted acquisitions:
Non-covered loans		14,291		18,721		24,714
Covered loans		78,757		107,457		116,206
		93,048		126,178		140,920
	$	634,932	$	560,620	$	560,940

59

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

	Asset Quality Data (Excluding loans acquired through FDIC-Assisted acquisitions) as of
	September 30, 2012			December 31, 2011			September 30, 2011
	(dollars in thousands)
Allowance for loan losses to total loans		1.57	%		1.72	%		1.65	%
Allowance for loan losses to average loans		1.61	%		1.32	%		1.29	%
Allowance for loan losses to non-performing loans		52.15	%		106.40	%		86.78	%
Accruing loans past due 30-89 days	$	1,038		$	371		$	1,487
Nonaccrual loans		16,358			7,043			7,994
Loans - 90 days past due & still accruing		-			-			-
Total non-performing loans		16,358			7,043			7,994
OREO and repossessed assets		1,403			3,356			1,841
Total non-performing assets	$	17,761		$	10,399		$	9,835
Non-performing loans to total loans		3.02	%		1.62	%		1.90	%
Non-performing assets to total assets		1.68	%		0.95	%		0.89	%
Net charge-offs QTD to average loans (annualized)		0.24	%		0.04	%		0.73	%
Net charge-offs QTD	$	320		$	37		$	650

For further information on the loan portfolio and allowance for loan losses, see Note 5 of the Condensed Notes to Consolidated Financial Statements contained in this Form 10-Q.

Premises and Equipment.  Premises and equipment increased approximately $3.3 million or 11.3% at September 30, 2012 to $32.9 million compared to December 31, 2011.  A large part of the increase was related to the Auburn, Alabama branch purchase of $1.7 million.  In addition, we completed the construction of the Macon, Georgia branch for $733,000 and currently have the Valdosta, Georgia branch under construction at $464,000.

Intangible Assets and Goodwill.   Intangible assets and goodwill decreased $422,000 or -8.7% to $4.4 million compared to December 31, 2011 resulting from the amortization of the intangible assets in part offset by the addition of a deposit intangible of $168,000 related to the June 2012 Auburn branch acquisition.

FDIC Loss-share Receivable.  FDIC loss-share receivable decreased $16.2 million or -19.3% to $67.7 million compared to December 31, 2011 primarily driven by reimbursements collected from the FDIC at $13 million and net negative accretion of $2.9 million.  For further information on the FDIC loss-share receivable, see Note 6 of the Condensed Notes to Consolidated Financial Statements contained in this Form 10-Q.

Cash Surrender Value of Bank-owned Life Insurance.   Cash surrender value of bank-owned life insurance increased $7.6 million or 48.4% to $23.2 million compared to December 31, 2011 resulting from the 2012 purchases of life insurance.

Deposits.  Total deposits decreased $39.1 million or -4.4% to $845.1 million at September 30, 2012 compared with $884.2 million at December 31, 2011.  The decrease was primarily driven by planned deposit runoff of $57.8 million in part offset by acquired deposits of $18.7 million related to the Auburn branch acquisition.

60

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Federal Home Loan Bank Advances and Other Borrowings.  The total amount of Federal Home Loan Bank advances remained the same at $35.0 million at September 30, 2012 and December 31, 2011.  Federal funds purchased and securities sold under agreements to repurchase increased to $35.8 million at September 30, 2012 compared with $35.0 million at December 31, 2011.

Equity.  Total equity decreased $2.3 million or -1.9% to $121.8 million at September 30, 2012, compared with $124.1 million at December 31, 2011, primarily the result of the repurchase of stock of $6.2 million, the payment of dividends of $1.0 million and other comprehensive loss of $593,000, partially offset by net income of $4.3 million for the nine months ended September 30, 2012, stock-based compensation of $626,000, and the allocation of $496,000 in ESOP shares which increased equity.

61

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Average Balances, Net Interest Income, Yields Earned and Rates Paid

The following table presents for the periods indicated the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates.  Yields and interest income on tax-exempt obligations have been computed on a tax equivalent basis using an assumed tax rate of 34%.  Nonaccruing loans have been included in the table as loans carrying a zero yield.

	Three Months Ended September 30,
	2012								2011
	(Dollars in Thousands)
	Average Outstanding Balance			Interest Earned/ Paid		Yield/ Rate			Average Outstanding Balance			Interest Earned/ Paid		Yield/ Rate
Interest-Earning Assets:
Loans	$	622,643		$	13,411		8.57	%	$	537,822		$	8,819		6.51	%
Investment Securities		235,862			1,322		2.23			201,763			1,220		2.40
Other short-term investments		24,814			20		0.32			129,658			109		0.33
Total interest-earning assets		883,319			14,753		6.64			869,243			10,148		4.69
Non-interest earning assets		186,811								170,435
Total assets		1,070,130								1,039,678
Interest-Bearing Liabilities:
Interest checking, money market, savings		475,975			313		0.26	%		453,752			871		0.76	%
Time deposits		292,272			944		1.28			307,592			1,177		1.52
Total interest-bearing deposits		768,247			1,257		0.65			761,344			2,048		1.07
Securities sold under repurchase agreements and short-term borrowings		69,242			681		3.91			68,678			687		3.97
Total interest bearing liabilities		837,489			1,938		0.92			830,022			2,735		1.31
Non-interest bearing liabilities:
Demand deposits
Other liabilities		94,453								77,107
Total non-interest bearing liabilities		13,304							��	8,713
Total liabilities		107,757								85,820
Shareholder’s equity		124,884								123,836
Total liabilities and shareholder’s equity		1,070,130								1,065,701
Net interest income				$	12,815							$	7,413
Net interest rate spread							5.72	%							3.38	%
Net earning assets	$	45,830							$	39,221
Net interest margin							5.77	%							3.44	%
Average interest-earning assets to average interest-bearing Liabilities		1.05	x							1.05	x

62

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

	Nine Months Ended September 30,
	2012								2011
	(Dollars in Thousands)
	Average Outstanding Balance			Interest Earned/ Paid		Yield/ Rate			Average Outstanding Balance			Interest Earned/ Paid		Yield/ Rate
Interest-Earning Assets:
Loans	$	592,060		$	34,482		7.78	%	$	500,406		$	23,582		6.30	%
Investment Securities		249,826			4,113		2.20			213,518			4,070		2.55
Other short-term investments		37,613			102		0.36			78,296			229		0.39
Total interest-earning assets		879,499			38,697		5.88			792,220			27,881		4.76
Non-interest earning assets		186,202								164,402
Total assets		1,065,701								956,622
Interest-Bearing Liabilities:
Interest checking, money market, savings		470,557			1,070		0.30	%		404,213			2,545		0.84	%
Time deposits		300,657			2,695		1.20			271,213			3,334		1.64
Total interest-bearing deposits		771,214			3,765		0.65			675,966			5,879		1.16
Securities sold under repurchase agreements and short-term borrowings		68,368			2,026		3.96			82,601			2,114		3.42
Total interest bearing liabilities		839,582			5,791		0.92			758,567			7,993		1.41
Non-interest bearing liabilities:
Demand deposits		89,719								68,396
Other liabilities		11,248								7,449
Total non-interest bearing liabilities		100,967								75,845
Total liabilities		940,549								834,412
Shareholder’s equity		125,152								122,210
Total liabilities and shareholder’s equity		1,065,701								956,622
Net interest income				$	32,906							$	19,888
Net interest rate spread							4.96	%							3.35	%
Net earning assets	$	39,917							$	33,653
Net interest margin							5.00	%							3.41	%
Average interest-earning assets to average interest-bearing Liabilities		1.05	x							1.04	x

63

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Rate/Volume Analysis

The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities.  It distinguishes between the changes related to outstanding balances and that due to the changes in interest rates.  The change in interest attributable to rate has been determined by applying the change in rate between years to average balances outstanding in the later year.  The change in interest due to volume has been determined by applying the rate from the earlier year to the change in average balances outstanding between years.  Changes that are not solely due to volume have been consistently attributed to rate.

	Three Months Ended September 30,
	2012 vs. 2011
	Increase (Decrease)						Total
	Due to						Increase
	Volume			Rate			(Decrease)
	(Dollars in Thousands)
Interest-earning assets:
Loans	$	5,518		$	(926	)	$	4,592
Investment Securities		818			(716	)		102
Other short-term investments		(350	)		261			(89	)
Total interest-earning assets	$	5,986		$	1,381		$	4,605
Interest-bearing liabilities:
Interest checking, money market, savings		169			(727	)		(558	)
Time deposits		(233	)		-			(233	)
Securities sold under repurchase agreements and short-term borrowings		22			(28	)		(6	)
Total interest bearing liabilities	$	(42	)	$	(755	)	$	(797	)
Net interest income							$	5,402

64

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

	Nine Months Ended September 30,
	2012 vs. 2011
	Increase (Decrease)						Total
	Due to						Increase
	Volume			Rate			(Decrease)
	(Dollars in Thousands)
Interest-earning assets:
Loans	$	5,775		$	5,125		$	10,900
Investment Securities		925			(882	)		43
Other short-term investments		(159	)		32			(127	)
Total interest-earning assets	$	6,541		$	(4,275	)	$	10,816
Interest-bearing liabilities:
Interest checking, money market, savings		558			(2,033	)		(1,475	)
Time deposits		474			(1,113	)		(639	)
Securities sold under repurchase agreements and short-term borrowings		(487	)		399			(88	)
Total interest-bearing liabilities	$	545		$	(2,747	)	$	(2,202	)
Net interest income							$	13,018

65

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Comparison of Operating Results for the Three and Nine Month Periods Ended September 30, 2012 and 2011

General.  During the three and nine months ended September 30, 2012, we recorded net income of $2.0 million and $4.3 million, respectively, compared to net income of $1.7 million and $2.5 million, respectively, for the same periods in 2011.  Basic and diluted earnings per share for the three and nine months ended September 30, 2012 were $0.25 and $0.54, respectively, compared to basic and diluted earnings per share of $0.21 and $0.30, respectively, for the same periods in 2011.  The improvement in operating results for the three and nine months ended September 30, 2012 was primarily driven by growth in net interest income partially offset by increased noninterest expense and a reduction in noninterest income driven by increased negative net accretion for the FDIC loss-share receivable.

Interest Income.  Total interest income for the three and nine months ended September 30, 2012, increased $4.5 million and $10.5 million, respectively, or 44.4% and 37.7%, respectively, compared to the same periods in 2011.  The increase was due to growth in average interest-earning assets for the three and nine months ended September 30, 2012 of $14.1 million and $87.3 million, respectively, or 1.6% and 11.0%, respectively, compared to the same periods in 2011.  These increases in the average balance of earning assets for the three and nine months ended September 30, 2012 were coupled with an increase of 195 basis points and 112 basis points, respectively, in the yield on average-earning assets to 6.64% and 5.88%, respectively, as compared to 4.69% and 4.76%, respectively, for the same periods in 2011.

The increase in average interest-earning assets was due primarily to organic and FDIC-assisted loan growth as compared to the prior year.  Our overall yield on average interest-earning assets increased in 2012 primarily driven by the increase in yield on loans acquired in FDIC-assisted acquisitions compared to the prior year which carry a higher interest rate as compared to traditional loans.

Interest income on loans, including loans held for sale, for the three and nine months ended September 30, 2012 was $13.4 million and $34.5 million, respectively, compared to $8.8 million and $23.6 million, respectively, for the same periods in 2011.  The increase in interest income on loans was primarily the result of the loans acquired in our FDIC-assisted transactions and our expansion into the Valdosta, Statesboro, Macon and Auburn markets, which was reflected in the increase of average loans for the three and nine months ended September 30, 2012 of $84.8 million and $91.7 million, respectively.  Also, positively impacting the increase in interest income on loans was a solid increase in the weighted average yield on loans for the three and nine months ended September 30, 2012 of 206 basis points and 148 basis points, respectively, to 8.57% and 7.78%, respectively.  The improvement in the loan yields was primarily driven by improved accretion on the FDIC-acquired loans for the periods presented.

Interest income on investment securities for the three and nine months ended September 30, 2012 was $1.3 million and $4.1 million, respectively, compared to $1.2 million and $4.1 million, respectively, for the same periods in 2011.  The weighted average yield on investments for the three and nine months ended September 30, 2012 declined 17 basis points and 35 basis points, respectively, to 2.23% and 2.20%, respectively.  However, growth in the average balance of investment securities for the three and nine months ended September 30, 2012 of $34.1 million and $36.3 million, respectively, to $235.9 million and $249.8 million, respectively, positively impacted the interest income on investment securities as we invest excess liquidity.  We continue to anticipate the yield on our investment portfolio to decline during this low interest rate environment as maturing investments are replaced with lower yielding investments.

66

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Interest Expense.  Total interest expense for the three and nine months ended September 30, 2012 decreased $797,000 and $2.2 million, respectively, or 29.1% and 27.6%, respectively, compared to the same periods in 2011.  The decrease in interest expense was primarily the result of a decline in the weighted average cost of interest-bearing liabilities for the three and nine months ended September 30, 2012 of 39 basis points and 49 basis points, respectively, to 0.92% and 0.92%, respectively.  The decrease in interest expense was in part offset by growth in the average balance of interest-bearing liabilities for the three and nine months ended September 30, 2012 of $7.5 million and $81.0 million, respectively, or 0.9% and 10.7%, respectively, compared to the same periods in 2011.  We expect the decline in the cost of interest-bearing liabilities to be minimal going forward unless market interest rates either increase or decrease significantly.

Interest expense on deposits for the three and nine months ended September 30, 2012 was $1.3 million and $3.8 million, respectively, compared to $2.0 million and $5.9 million, respectively, compared to the same periods in 2011.  The decrease in interest expense on deposits for the three and nine months ended September 30, 2012 was driven by a decline in the weighted average cost on deposits of 42 basis points and 51 basis points, respectively, compared to the same periods in 2011, due to a decrease in market rates of interest.  The decrease in interest expense was in part offset by growth in interest-bearing deposits primarily the result of the deposits acquired in our FDIC-assisted transactions and our expansion into the Valdosta, Statesboro, Macon and Auburn markets, which was reflected in the increase in the average balance of the interest-bearing deposits portfolio for the three and nine months ended September 30, 2012 of $6.9 million and $95.2 million, respectively.

Interest expense on other borrowings, consisting of Federal Home Loan Bank advances, federal funds purchased and securities sold under agreement to repurchase, for the three and nine months ended September 30, 2012 decreased $6,000 and $89,000, respectively, compared to the same periods in 2011.  The decrease in the interest expense on other borrowings for the three months ended September 30, 2012 was primarily driven by a reduction in the weighted average rate paid on these borrowings of 6 basis points compared to the same period in 2011.  The decrease in the interest expense on other borrowings for the nine months ended September 30, 2012 was primarily driven by a reduction in the average balance of other borrowings of $14.2 million compared to the same period in 2011.  The decrease in interest expense for the nine months ended September 30, 2012 was offset in part by an increase in the weighted average rate paid on these borrowings 54 basis points compared to the same period in 2011.

Net Interest Income.  Net interest income for the three and nine months ended September 30, 2012 increased $5.3 million and $12.7 million, respectively, or 71.5% and 63.9%, respectively, compared to the same periods in 2011.  The overall increase was primarily driven by an increase in the yield and balance of interest-earning assets on top of a decline in the cost of interest-bearing liabilities partially offset by balance growth in interest-bearing liabilities.  The net interest spread for the three and nine months ended September 30, 2012 increased 234 basis points and 160 basis points, respectively, to 5.72% and 4.96%, respectively, as compared to the same periods in 2011.  The net interest margin for the three and nine months ended September 30, 2012 improved 233 basis points and 159 basis points, respectively, to 5.77% and 5.00%, respectively, from the same periods in 2011.  The primary reason the net interest margin for the three and nine months ended September 30, 2012 increased significantly was the result of increased loan accretion for FDIC acquired loans increasing the weighted average yield on loans 206 basis points and 148 basis points, respectively, as compared to the same periods in 2011.  We also expect loan accretion for FDIC acquired loans to continue to positively impact the net interest margin for the remainder of 2012.

Our asset-liability management policy seeks to mitigate interest rate risk by making our balance sheet as neutral as possible to changes in interest rates.  Although our goal is to be neutral to changes in rates, we will not take undue risk to achieve this goal.  Therefore, we remain exposed to fluctuation in interest rates. For more information on the effect of changes in interest rates, see Item 3. - Quantitative and Qualitative Disclosures About Market Risk.

67

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Provision for Loan Losses.  During the three and nine months ended September 30, 2012, we recorded provision for loan losses expense of $1.9 million and $3.4 million, respectively, which was an increase compared to $1.0 million and $2.3 million, respectively, for the same periods in 2011.  The increase in provision expense was primarily driven by FDIC acquired provision expense for the three and nine months ended September 30, 2012 of $1.2 million and $1.5 million, respectively, where 80% of the expense related to covered loans is reimbursable from the FDIC.  The remaining provision expense for noncovered loan losses, excluding FDIC-acquired, trended lower for the three and nine months ended September 30, 2012 primarily driven by a reduction in annualized net charge-offs offset in part by organic loan growth as compared to the same periods in 2011. The following table presents the provision for loan expense in more detail for the periods indicated.

	For the Three Months Ended September 30,					For the Nine Months Ended September 30,
	2012			2011		2012			2011
			(Dollars in thousands)
Provision for loan losses – noncovered(1)	$	750		$	1,000		$	1,900	$	2,300
Provision for loan losses – FDIC acquired noncovered		12			-			12		-
Provision for loan losses – noncovered		762			1,000			1,912		2,300
Provision for loan losses- FDIC acquired covered		1,172			-			1,513		-
Provision for loan losses	$	1,934		$	1,000		$	3,425	$	2,300

(1) The amounts exclude the impact of provision expense for noncovered FDIC acquired loans.

  For further information on the loan portfolio and allowance for loan losses, see the Delinquencies and Non-performing Assets and Allowance for Loan Losses of this section and  see Note 5 of the Condensed Notes to Consolidated Financial Statements contained in this Form 10-Q.

Noninterest Income.  Noninterest income for the three months ended September 30, 2012 decreased $1.5 million or 26.0% compared to the same period in 2011. However, after excluding securities transactions, gain on acquisitions and accretion FDIC loss-share receivable, noninterest income increased $1.3 million, or 41.5%, to $4.6 million for the three months ended September 30, 2012 compared to the same period in 2011.

A summary of noninterest income, excluding the gain on securities, gain on acquisitions and accretion FDIC loss-share receivable, is as follows for the periods indicated:

	Three Months Ended September 30,
	2012			2011			$ Chg		% Chg
	(Dollars in thousands)
Service charges on deposit accounts	$	1,285		$	1,267		$	18		1.4	%
Bankcard services income		783			685			98		14.3
Other service charges, commissions and fees		80			61			19		31.2
Brokerage fees		467			328			139		42.4
Mortgage banking activities		1,689			719			970		134.9
Bank owned life insurance		210			146			64		43.8
Other		59			25			34		136.0
Total noninterest income	$	4,573		$	3,231		$	1,342		41.5	%
Noninterest income as a percentage of average assets (annualized)		1.71	%		1.24	%

The increase in service charges on deposit accounts was primarily driven by increased fees for services per account and an overall increase in the customer base offset in part by a reduction in overdraft fees.

The increase bankcard services income was primarily driven by our increased customer base and usage.

The improvement in brokerage fees was primarily driven by our expansion of brokerage offices.

68

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The increase in mortgage banking activities was primarily driven by increased volume resulting in an increase of $634,000 and the fair value election on mortgage loans held for sale resulting in an increase of $336,000 for 2012.

Noninterest income decreased $3.5 million, or 24.3%, to $10.8 million for the nine months ended September 30, 2012 compared to $14.3 million for the same period in 2011.  However, after excluding securities transactions, gain on acquisitions and accretion FDIC loss-share receivable from noninterest income, noninterest income increased $2.6 million, or 29.5%, to $11.6 million for the nine months ended September 30, 2012 compared to $8.9 million for the same period in 2011.

A summary of noninterest income, excluding the gain on securities, gain on acquisitions, gain on bank owned life insurance and accretion FDIC loss-share receivable, is as follows for the periods indicated:

	Nine Months Ended September 30,
	2012			2011			$ Chg			% Chg
	(Dollars in thousands)
Service charges on deposit accounts	$	3,441		$	3,540		$	(99	)		-2.8	%
Bankcard services income		2,437			1,946			491			25.2
Other service charges, commissions and fees		238			205			33			16.1
Brokerage fees		1,375			1,088			287			26.4
Mortgage banking activities		3,316			1,611			1,705			105.8
Bank owned life insurance		561			440			121			27.5
Other		194			96			98			102.1
Total noninterest income	$	11,562		$	8,926		$	2,636			29.5	%
Noninterest income as a percentage of average assets (annualized)		1.08	%		0.93	%

The decrease in service charges on deposit accounts was primarily driven by a per account reduction in overdraft fees offset in part by an increase in fees for services per account and an overall increase in the customer base.

The bankcard services income was primarily driven by our increased customer base and usage.

The improvement in brokerage fees was primarily driven by our expansion of brokerage offices.

The increase in mortgage banking activities was primarily driven by increased volume resulting in an increase of $1.4 million and the fair value election on mortgage loans held for sale resulting in an increase of $336,000 for 2012.

Accretion for FDIC loss-share receivable for the three and nine months ended September 30, 2012 turned negative $1.6 million and $2.2 million, respectively, compared to positive accretion of $448,000 and $453,000, respectively for the three and nine months ended for the same periods in 2011.  The accretion turned negative as a result of improvement in the expected cash flows of the loss-share performing portfolios and the FDIC true-up liability accrual of $484,000 for both the three and nine months ended September 30, 2012 in part offset by increased provision expense on covered loans of $1.2 million and $1.5 million, respectively, for the three and nine months ended September 30, 2012 compared to no provision expense for covered loans for the same periods in 2011.

69

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Noninterest Expense.  Noninterest expense increased $2.2 million, or 22.5%, to $12.0 million for the three months ended September 30, 2012 compared to $9.8 million for the same period in 2011.

A summary of noninterest expense is as follows for the periods indicated:

	Three Months Ended  September 30,
	2012			2011			$ Chg			% Chg
	(Dollars in thousands)
Salaries and employee benefits	$	6,380		$	5,384		$	996			18.5	%
Equipment		609			516			93			18.0
Occupancy		707			685			22			3.2
Advertising and marketing		114			167			(53	)		-31.7
Legal and accounting		204			118			86			72.9
Consulting & other professional fees		149			207			(58	)		-28.0
Directors fees and retirement		245			160			85			53.1
Telecommunications		236			206			30			14.6
Supplies		163			156			7			4.5
Data processing fees		1,004			857			147			17.2
(Gain) loss on sales and write-downs of other real estate owned		90			(139	)		229			-164.7
Gain on sales and write-downs of FDIC acquired other real estate owned		(33	)		(246	)		213			-86.6
Foreclosed asset expenses		177			288			(111	)		-38.5
Foreclosed FDIC acquired asset expenses		563			-			563		NM		(1)
FDIC insurance and other regulatory fees		276			128			148			-115.6
Acquisition related expenses		14			299			(285	)		-95.3
Deposit intangible expenses		194			183			11			6.0
Other operating		886			810			76			9.4
Total noninterest expenses	$	11,978		$	9,779		$	2,199			22.5	%
Noninterest expenses as a percentage of average assets (annualized)		4.48	%		3.76	%

(1) NM – The percentage change is not considered meaningful.

The increase in salaries and employee benefits was primarily due the one-time, early retirement charge for 2012 of $641,000 and an increase of 3 full-time equivalent employees (“FTE’s”), or 1.0%, from the prior year related to our market expansion activity.

The increase in equipment, occupancy, data processing, and other operating expenses was due to the expanded branch network.

The decrease in acquisition related expenses was result of elevated expenses experienced in the same period for 2011 related to the First Southern FDIC-assisted acquisition.

During 2012, we recorded a modest loss on the sale of OREO, excluding FDIC-acquired, compared to a gain recorded in 2011.  During 2012, we recorded gains on the sale of FDIC-acquired OREO assets lower than the same period in 2011.

Foreclosed asset expense for FDIC acquired assets was up from the prior year related to the improved resolution process for these assets.

70

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

A summary of noninterest expense is as follows for the periods indicated:

	Nine Months Ended September 30,
	2012			2011			$ Chg			% Chg
	(Dollars in thousands)
Salaries and employee benefits	$	17,375		$	14,635		$	2,740			18.7	%
Equipment		1,983			1,295			688			53.1
Occupancy		2,051			1,666			385			23.1
Advertising and marketing		509			551			(42	)		-7.6
Legal and accounting		546			495			51			10.3
Consulting & other professional fees		386			584			(198	)		-33.9
Directors fees and retirement		535			548			(13	)		-2.4
Telecommunications		756			556			200			36.2
Supplies		463			396			67			16.9
Data processing fees		2,700			1,990			710			35.7
(Gain) loss on sales and write-downs of other real estate owned		(58	)		798			(856	)		-107.3
Gain on sales and write-downs of FDIC acquired other real estate owned		(108	)		(291	)		183			62.9
Foreclosed asset expenses		617			703			(86	)		-12.2
Foreclosed FDIC acquired asset expenses		1,191			-			1,191		NM
FDIC insurance and other regulatory fees		785			775			10			1.3
Acquisition related expenses		414			1,056			(642	)		-60.8
Deposit intangible expenses		590			485			105			21.6
Other operating		2,718			1,976			742			37.5
Total noninterest expenses	$	33,453		$	28,218		$	5,235			18.6	%
Noninterest expenses as a percentage of average assets (annualized)		3.14	%		2.95	%

(1) NM – The percentage change is not considered meaningful.

The increase in salaries and employee benefits was primarily due to the increase of 26 FTE’s, or 8.8%, from the prior year related to our acquisition activity and a one-time, early retirement charge for 2012 of $641,000.

The increase in equipment, occupancy, data processing, and other operating expenses is due to the expanded branch network.

The decrease in acquisition related expenses is the result of elevated expenses experienced in the same period for 2011 related to the Citizens and First Southern FDIC-assisted acquisitions.

During 2012, we recorded a modest gain on the sale of OREO, excluding FDIC-acquired, compared to losses recorded in 2011.  During 2012, we recorded gains on the sale of FDIC-acquired OREO assets lower than the same period in 2011.

Foreclosed asset expense for FDIC acquired assets was up from the prior year related to the improved resolution process for these assets.

71

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Income Tax Expense.  Income tax expense for the three and nine months ended September 30, 2012 was $1.2 million and $2.2 million, respectively, compared to income tax expense of $786,000 and $1.2 million, respectively, for the same periods in 2011.  Our effective tax rate for the three and nine months ended September 30, 2012 was 36.8% and 33.8%, respectively, compared to 31.1% and 32.5%, respectively, for the same periods in 2011.

Liquidity and Capital Resources

We are required to have enough cash and investments that qualify as liquid assets in order to maintain sufficient liquidity to ensure a safe and sound operation.  Liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to the return on loans.  Historically, we have maintained liquid assets above levels believed to be adequate to meet the requirements of normal operations, including potential deposit outflows.  Cash flow projections are regularly reviewed and updated to assure that adequate liquidity is maintained.

Liquidity management involves the matching of cash flow requirements of customers, who may be either depositors desiring to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs and the ability of the Company to manage those requirements.  The Company strives to maintain an adequate liquidity position by managing the balances and maturities of interest earning assets and interest bearing liabilities so that the balance it has in short-term investments at any given time will adequately cover any reasonably anticipated immediate need for funds. Our liquidity, represented by cash and cash equivalents, is a product of our operating, investing and financing activities.  Liquidity management is both a daily and long-term function of business management.  Excess liquidity is generally invested in short-term investments, such as overnight deposits and federal funds.  On a longer term basis, we maintain a strategy of investing in various lending products and investment securities, including mortgage-backed securities.

If additional liquidity were needed, the Bank would turn to short-term borrowings as an alternative immediate funding source and would consider other appropriate actions such as promotions to increase core deposits or the sale of a portion of our unpledged investment portfolio.  In addition, we could draw on additional alternative immediate funding sources from lines of credit extended to us from our correspondent banks and/or the FHLB.  At September 30, 2012, the Bank had total federal funds credit lines with six correspondent banks of $74.0 million, with no outstanding advances.  The Bank also maintains a credit facility with the FHLB of $121.9 million with total outstanding advances of $35.0 million at September 30, 2012.

At September 30, 2012, total deposits decreased $15.2 million, or 1.8%, to $845.1 million for the third quarter of 2012 compared to $860.3 million for the linked quarter primarily driven by planned runoff of time deposit customers.  Total deposits decreased $39.1 million, or 4.4%, from $884.2 million for the same period in 2011 primarily driven by planned runoff of time and acquired deposits.  Federal funds purchased and securities sold under agreements to repurchase increased $4.1 million, or 12.9%, to $35.8 million for the third quarter of 2012 as compared to $31.7 million for the linked quarter and increased $800,000 from $35.0 million for the same period in 2011.  Also, FHLB advances were unchanged at $35 million for the third quarter of 2012 compared to the linked quarter and the same period in 2011.

The liquidity and capital resources of the Company are monitored continuously by the Company’s Board-authorized Risk Management Committee with day to day responsibility delegated to the Asset/ Liability Management Committee (“ALCO”) and on a periodic basis by state and federal regulatory authorities.  As determined under guidelines established by these regulatory authorities, the Company’s and the Bank’s liquidity ratios at September 30, 2012, were considered satisfactory.  At that date, the Bank’s short-term investments were adequate to cover any reasonably immediate need for funds.  The Company is aware of no events or trends likely to result in a negative material change in liquidity.

72

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The consolidated statements of cash flows for the nine months ended September 30, 2012 and 2011 detail cash flows from operating, investing and financing activities.  For the nine months ended September 30, 2012, net cash used for financing activities was $64.0 million offset in part by net cash provided from operating and investing activities of $32.1 million and $19.5 million, respectively, resulting in a net decrease in cash to $22.0 million as compared to the same period in 2011.

The Company filed a shelf offering on Form S-3 with the Securities and Exchange Commission (the “SEC”) on October 25, 2012. Under the shelf registration statement, which was declared effective by the SEC on November 7, 2012, the Company may offer and sell from time to time in the future, in one or more offerings, common stock, preferred stock, debt securities, warrants, depository shares, or units consisting of any combination of the foregoing.

The aggregate offering price of all securities that may be sold under the registration statement will not exceed $60 million. This shelf offering will give the Company flexibility to take advantage of acquisition opportunities that may arise in the future by accessing the capital markets on a timely and cost-effective basis. The specifics of any future offering, along with the prices and terms of any such securities offered by the Company, will be determined at the time of any such offering and will be described in detail in a prospectus supplement filed in connection with such offering. At this present time, the Company has no specific plans for an offering.

Regulatory Capital Ratios for the Company and HeritageBank of the South at September  30, 2012

The Company’s and the Bank’s regulatory capital levels exceed the minimums required by state and federal authorities.  The following table reflects the Company’s and the Bank’s compliance at September 30, 2012 with regulatory capital requirements.  These calculations are based on total risk weighted assets of $646.8 million consolidated and $629.2 million for the Bank as of September 30, 2012, and average total assets of $1.07 billion consolidated and $1.06 billion for the Bank for the three months ended September 30, 2012.  These consolidated capital ratios are based on the capital requirements for bank holding companies issued by the Board of Governors of the Federal Reserve System.  The Georgia Department of Banking and Finance, by policy, requires the Bank to maintain 4% of Tier 1 capital to average total assets of the Federal Reserve Requirements included in the table.

	Actual					For Capital Adequacy Purposes					Minimum Required to Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
	(Dollars in thousands)
Total Capital to Risk Weighted Assets
Consolidated	$	124,092		19.2	%	$	51,746		8.0	%		N/A
HeritageBank of the South		106,904		17.0	%		50,337		8.0	%	$	62,922		10.0	%
Tier I Capital to Risk Weighted Assets
Consolidated		116,213		18.0	%		25,873		4.0	%		N/A
HeritageBank of the South		99,024		15.7	%		25,169		4.0	%		37,753		6.0	%
Tier I Capital to Average Total Assets
Consolidated		116,213		10.9	%		42,836		4.0	%		N/A
HeritageBank of the South		99,024		9.3	%		42,374		4.0	%		52,968		5.0	%

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Asset and Liability Management and Market Risk

Our Risk When Interest Rates Change.  The rates of interest we earn on assets and pay on liabilities generally are established contractually for a period of time.  Market rates change over time.  Like other financial institutions, our results of operations are impacted by changes in interest rates and the interest rate sensitivity of our assets and liabilities.  The risk associated with changes in interest rates and our ability to adapt to these changes is known as interest rate risk and is our most significant market risk.

How We Measure Our Risk of Interest Rate Changes.  As part of our attempt to manage our exposure to changes in interest rates and comply with applicable regulations, we monitor our interest rate risk.  In doing so, we analyze and manage assets and liabilities based on their interest rates and payment streams, timing of maturities, repricing opportunities, and sensitivity to actual or potential changes in market interest rates.

To manage the potential for adverse effects of material and prolonged increases in interest rates on our results of operations, we adopted asset and liability management policies to understand, measure, monitor, and control the risk.  These policies are designed to allow us to implement strategies to minimize the effects of interest rate changes to net income and capital position by properly matching the maturities and repricing terms of our interest earning assets and interest bearing liabilities.  These policies are implemented by the ALCO, which is composed of senior management members.  The ALCO establishes guidelines for and monitors the volume and mix of assets and funding sources, taking into account relative costs and spreads, interest rate sensitivity and liquidity requirements.  The objectives are to manage assets and funding sources to produce results that limit negative changes in net income and capital while supporting liquidity, capital adequacy, growth, risk and profitability goals.  Senior managers oversee the process on a daily basis.  The ALCO meets monthly to review, among other things, economic conditions and interest rate outlook, current and projected needs and capital position, anticipated changes in the volume and mix of assets and liabilities, interest rate risk exposure, liquidity position and net portfolio present value.  The committee also recommends strategy changes, as appropriate, based on their review.  The committee is responsible for reviewing and reporting the effects of the policy implementations and strategies to the board of directors on a quarterly basis.

In order to manage our assets and liabilities and achieve the desired liquidity, credit quality, interest rate risk, profitability and capital targets, we have focused our strategies on:

· Limiting the percentage of long-term fixed-rate loans within our portfolio;

· Originating a mix of variable-rate and shorter term fixed-rate loans;

· Originating prime-based home equity lines of credit;

· Managing deposit relationships for stability and a lower cost of funds position;

· Continuing the origination of consumer loans.

74

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Asset and Liability Management and Market Risk (Continued)

The Risk Management Committee has oversight over the asset-liability management of the Company.  This committee regularly reviews interest rate risk by forecasting the impact of alternative interest rate environments on net income and the market value of portfolio equity.  Market value of portfolio equity is a measurement of the value of the balance sheet at a fixed point in time.  It is summarized as the fair value of assets less the fair value of liabilities.  The committee reviews computations of the value of capital at current interest rates and alternative interest rates.  The variance in the net portfolio value between current interest rate computations and alternative rate computations represents the potential impact on capital if rates were to change.

The Company is exposed only to U.S. dollar interest rate changes, and, accordingly, the Company manages exposure by considering the possible changes in the net interest margin.  The Company does not have any trading instruments nor does it classify any portion of the investment portfolio as held for trading.  The Company monitors its sensitivity to changes in interest rates and may use derivative instruments to hedge this risk.  The Company does not enter into derivatives or other financial instruments for trading or speculative purposes. Finally, the Company has no exposure to foreign currency exchange rate risk and commodity price risk.

Interest rates play a major part in the net interest income of a financial institution.  The sensitivity to rate changes is known as “interest rate risk”.  The repricing of interest-earning assets and interest-bearing liabilities can influence the changes in net interest income.

The Company uses simulation analysis to monitor changes in net interest income due to changes in market interest rates.  The simulation of rising, declining and flat interest rate scenarios allows management to monitor and adjust interest rate sensitivity to minimize the impact of market interest rate swings.  The analysis of the impact on net interest income over a twelve-month period is subjected to a shock in interest rates of 100, 200, 300,  and 400 basis point increase or decrease in market rates on net interest income and is monitored on a quarterly basis.  We also monitor regulatory required interest rate risk analysis which simulates more dramatic changes to rates.

The Company’s strategy is to mitigate interest risk to the greatest extent possible. Based on our analysis of the Company’s overall risk to changes in interest rates, we structure investment and funding transactions to reduce this risk.  These strategies aim to achieve neutrality to interest rate risk.  Although we strive to have our net interest income neutral to changes in rates, due to the inherent nature of our business, we will never be completely neutral to changes in rates.  As of September 30, 2012, a drop in interest rates would increase our net interest income and an increase in rates would decrease our net interest income, also known as being “liability sensitive.”  The modest liability sensitivity position was in part driven by our decision to use excess cash for investments and allow time deposits to rolloff.  We plan to mitigate the liability sensitivity position by focusing our efforts to extend liabilities and increase variable rate assets.  We feel the level of interest rate risk is at an acceptable level, and is within our internal policy limits.

The ALCO monitors and analyzes interest rate risk.  This committee is comprised of members of senior management and meets on a monthly basis and reviews the simulations listed above, as well as other interest rate risk reports.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following table shows the results of our projections for net interest income expressed as a percentage change over net interest income in a flat rate scenario for an immediate change or “shock” in market interest rates over a twelve month period.  Due to the historically low level of interest rates, we do not believe downward shocks greater than 100 basis points are relevant.  In addition, due to the historically low interest rate environment, there is concern that we may see a dramatic increase in interest rates at some point.  To address this concern, we increased our upward interest rate shocks to include a shock of 400 basis points.

	Effect
Market	on Net
Rate	Interest
Change	Income
+400	-3.3%
+300	-3.0%
+200	-2.4%
+100	0.1%
-100	1.6%

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

An evaluation of our disclosure controls and procedures (as defined in Rule 13(a)-14(c) under the Securities Exchange Act (the “Exchange Act”)) as of September 30, 2012, was carried out under the supervision and with the participation of our Chief Executive Officer, Chief Financial Officer and several other members of our senior management within the 40-day period preceding the filing date of this quarterly report.  Our Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2012, the Company’s disclosure controls and procedures were effective in ensuring that the information required to disclosed by the Company in the reports it files or submits under the Exchange Act is: (i) accumulated and communicated to the Company’s management (including its Chief Executive Officer and Chief Financial Officer) in a timely manner; and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

The Company does not expect that its disclosure controls and procedures over financial reporting will prevent all errors and all fraud.  A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met.  Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.  These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns in controls or procedures can occur because of simple error or mistake.  Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control.  The design of any control procedure also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of change in conditions, or the degree of compliance with the policies or procedures may deteriorate.  Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.

b) Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Act) that occurred during the quarter ended September 30, 2012, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In the normal course of business, the Company occasionally becomes involved in various legal proceedings.  In our opinion, any liability from such proceedings would not have a material adverse effect on the business or financial condition of the Company.

ITEM 1A. RISK FACTORS

There have been no material changes to the risk factors disclosed in Item 1A. of Part 1 in our Annual Report on Form 10-K for the year ended December 31, 2011.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

There were no unregistered sales of equity securities during the quarter ended September 30, 2012.

On July 25, 2011, the Company announced that in connection with the 2011 Equity Incentive Plan that a new stock repurchase program was authorized where the Company may repurchase during the coming year up to 163,852 shares, or 2% of its currently outstanding publicly held shares of common stock.  As of September 30, 2012, the Company had purchased all 163,852 shares at a weighted average price of $11.43 per share under the plan for a total of $1.9 million.

In December 2011, the Company’s Board of Directors authorized another stock repurchase program.  The program authorizes the Company to repurchase up to 435,000 shares.  As of September 30, 2012, the Company had purchased all 435,000 shares at a weighted average price of $13.04 per share under the plan for a total of $5.7 million.

In October 2012, the Company's Board of Directors approved another stock repurchase program expiring in October 2013, which authorizes the repurchase of 397,000 shares of common stock, or approximately 5% of the shares currently outstanding.

The repurchases may be made from time to time in open-market or negotiated transactions as deemed appropriate by the Company and will depend on market conditions.

	Total Number of Shares Purchased		Average Price Paid Per Share		Number of Shares Purchased as Part of Publicly Announced Plans or Programs		Maximum Number of Shares that may yet be Purchased Under the Plans or Programs
July		-	$	-		-		260,126
August		10,197	$	13.35		10,197		249,929
September		249,929	$	13.55		249,929		-
Total		260,126	$	$13.54		260,126		-

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. MINE SAFETY DISCLOSURES

None.

ITEM 5. OTHER INFORMATION

None.

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ITEM 6. EXHIBITS

Exhibit  Number	Document	Reference to Prior Filing or Exhibit Number Attached Hereto
2.7	Purchase and Assumption Agreement dated April 6, 2012, between HeritageBank of the South and AB&T National Bank	a
3.0	Form S-3	b
12.1	Ratio of Earnings to Fixed Charges	12.1
31.1	Rule 13a-14(a)/15d-14(a) Certifications of Chief Executive Officer	31.1
31.2	Rule 13a-14(a)/15d-14(a) Certifications of Chief Financial Officer	31.2
32	Section 1350 Certifications	32
101.INS	XBRL Instance Document
101.SCH	XBRL Taxonomy Extension Schema Document
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document
101.LAB	XBRL Taxonomy Extension Labels Linkbase Document
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document

a Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc.  with the SEC on April 11, 2012.

b Form S-3 was filed by Heritage Financial Group, Inc.  with the SEC on October 25, 2012.

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SIGNATURES

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

		HERITAGE FINANCIAL GROUP, INC.
Date:	November 9, 2012	By:	/s/ O. Leonard Dorminey
			O. Leonard Dorminey
			President and Chief Executive Officer
Date:	November 9, 2012	By:	/s/ T. Heath Fountain
			T. Heath Fountain
			Executive Vice President,
			Chief Administrative Officer and
			Chief Financial Officer
			(Principal Financial and Accounting Officer)

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