Heritage Financial 10-K 2012 FY Annual report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2012

Commission File Number 000-51305

Heritage Financial Group, Inc.

(Exact name of registrant as specified in its charter)

Maryland	38-3814230
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
721 N. Westover Blvd., Albany, GA	31707
(Address of principal executive officers)	(Zip Code)

Registrant’s telephone number, including area code: 229-420-0000

Securities registered pursuant to Section 12(b) of the Act:

Title of each class:	Name of each exchange on which registered
Common Stock, Par Value $0.01 per share	Nasdaq Global Market

Securities registered pursuant to Section 12(g) of the Act:

None

(Title of each class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.       oYes    x No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    oYes    x No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the 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.    xYes    o No

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).    x Yes   o No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

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

o Large accelerated filer	x Accelerated filer
o Non-accelerated filer (Do not check if a smaller reporting company)	o Smaller reporting company

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

The aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2012 was approximately $98.2 million, based on the closing sale price of $12.87 per share for the registrant’s common stock on Nasdaq Global Market on that date.

As of March 15, 2013, there were 7,881,260 shares of the registrant’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Part III of Form 10-K – Portions of the Proxy Statement for the 2013 Annual Meeting of Stockholders.

Table of Contents

	Part I
Item 1.	Business	3
Item 1A.	Risk Factors	34
Item 1B.	Unresolved Staff Comments	44
Item 2.	Description of Properties	44
Item 3.	Legal Proceedings	44
Item 4.	Mine Safety Disclosures	44
	Part II
Item 5.	Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	44
Item 6.	Selected Financial Data	47
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	50
Item 7A.	Quantitative and Qualitative Disclosures about Market Risk	72
Item 8.	Financial Statements and Supplemental Data	76
Item 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure	77
Item 9A.	Controls and Procedures	77
Item 9B.	Other Information	78
	Part III
Item 10.	Directors and Executive Officers and Corporate Governance	78
Item 11.	Executive Compensation	80
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	80
Item 13.	Certain Relationships and Related Transactions and Director Independence	80
Item 14.	Principal Accountant Fees and Services	80
	Part IV
Item 15.	Exhibits and Financial Statement Schedules	80

2

PART I

Item 1. Business

General

Heritage Financial Group, Inc. (“Heritage” or the “Company”) is a $1.1 billion holding company headquartered in Albany, Georgia.  Heritage primarily conducts commercial banking, retail banking and wealth management activities through its wholly owned subsidiary, HeritageBank of the South (“HeritageBank” or the “Bank”).  As of December 31, 2012, HeritageBank operated in south Georgia, north central Florida and eastern Alabama through 20 full-service branch locations, 13 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.

The Company was formed by its federally chartered predecessor, Heritage Financial Group (the “Predecessor”) in connection with a second-step conversion and public offering conducted in the latter half of 2010, in which the Predecessor merged into the Company and converted from a mutual holding company structure to a stock holding company structure (“Conversion”). In that merger, each public share of common stock of the Predecessor was exchanged for 0.8377 shares of the Company’s common stock. Prior period shares and per share data, including dividends per share, included in the Form 10-K have been adjusted to reflect the 0.8377 exchange ratio. The words “we,” “our” and “us” in this Form 10-K refer to Heritage and HeritageBank on a consolidated basis and for periods prior to the closing of the second-step conversion on November 30, 2010, to the Predecessor and HeritageBank on a consolidated basis, unless indicated otherwise herein.

At December 31, 2012, we had total assets of $1.1 billion, loans of $670.0 million, deposits of $869.6 million and stockholders’ equity of $120.6 million. Our executive offices are located at 721 N. Westover Boulevard, Albany, Georgia 31707. Our common stock is traded on the Nasdaq Global Market under the symbol “HBOS.” For more information about our business, see Item 7. - Management’s Discussion and Analysis of Financial Condition and Results of Operation – General.

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.

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.

3

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 $11 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.  In March 2013, we completed the FDIC-assisted whole-bank purchase of Frontier Bank, a nine branch full service bank based in LaGrange, Georgia with approximately $111.0 million in loans and $224.0 million in deposits.

Forward-Looking Statements

This Form 10-K contains statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements are based on many assumptions and estimates and are not guarantees of future performance. Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control. The words “may,” “would,” “could,” “will,” “expect,” “anticipate,” “believe,” “intend,” “plan,” “predict,” “should,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements. Potential risks and uncertainties include, but are not limited to those described below under “Risk Factors.”

Market Area

We intend to continue to be a community-oriented financial institution offering a variety of financial services to meet the needs of the communities we serve.  We are headquartered in Albany, Georgia.  At December 31, 2012, we primarily served our markets in southern Georgia through offices in Albany, Macon, Savannah, Statesboro, and Valdosta, north central Florida through offices in Ocala and Lake City and eastern Alabama through an office in Auburn-Opelika.  We occasionally make loans beyond our market area to meet customer needs and to develop new business.

The following table sets forth our deposit market share by market area, including acquisitions, as of June 30, 2012, based on the most recent data available from the Federal Deposit Insurance Corporation (“FDIC”).  Most of our market areas fall within Metropolitan Statistical Areas (“MSA”) and were selected based on the market area’s significance to our operations.

Market Area	Market Share		Market  Share Rank		Institutions  in Market
Albany, Georgia MSA		15.9%		1		16
Macon, Georgia MSA		0.0		17		18
Statesboro, Georgia		14.9		4		8
Savannah, Georgia MSA		2.3		10		24
Valdosta, Georgia MSA		1.0		16		21
Ocala, Florida MSA		1.2		16		22
Lake City, Florida		4.9		6		7
Auburn-Opelika, Alabama MSA		0.9		13		17

Information regarding the local economy, major employers, unemployment levels and recent and projected population growth in our eight market areas is provided below.  (The unemployment and demographic (population) data was obtained from the website of SNL Financial at www.snl.com.  SNL Financial is a provider of news, financial data and analysis on the banking business.)  Overall, these eight market areas are experiencing higher unemployment levels than the nation or their respective states.  As of December 2012, the national unemployment rate was 7.8%, and the rates in Georgia, Florida and Alabama were 8.8%, 7.9% and 6.5%, respectively.

4

Southwest Georgia Market - Albany MSA.  The Albany MSA was historically based on manufacturing and agriculture, but it has become more service-oriented.  Median household income and per capita income are below the state and national averages, reflecting the rural nature of the market and limited availability of high paying white collar and technical jobs.  As of December 2012, the market area reported an unemployment rate of 9.7%, compared with 9.9% for the same period in the prior year and 7.8% for the national average.  Major employers in the MSA include the Marine Corps Logistic Base, Phoebe Putney Memorial Hospital, Procter & Gamble, Teleperformance USA, Albany State University, Darton College, and MillerCoors Brewing Company.  This MSA has a population of approximately 157,000, and the population growth in this MSA is projected to remain relatively flat with a negative growth rate of 0.1% through 2016.

South Middle Georgia Market - Macon MSA.  The Macon MSA is centrally located in Georgia and offers extensive access to rail, road and air supply lines which make the MSA excellent for warehousing and distribution.  Median household income and per capita income are below the state and national averages, reflecting the limited availability of high paying white collar and technical jobs.  As of December 2012, the market area reported an unemployment rate of 9.2%, compared with 13.7% for the same period in the prior year and 7.8% for the national average.  Major employers in the MSA include the Robins Air Force Base, Medical Center Interventional, Pavilion, and Mercer University.  This MSA has a population of approximately 233,000, and the population growth in this MSA is projected to increase at a rate of 1.0% through 2016.

South Georgia Market – Valdosta MSA.  The Valdosta MSA is a traditional manufacturing and agriculture economy that has become more service-oriented.  Median household income levels are below the state and national averages, reflecting the rural economy and limited availability of higher paying white collar and technology jobs.  As of December 2012, the market area reported an unemployment rate of 8.5%, compared with 8.6% for the same period in the prior year and 7.8% for the national average.  Major employers in the area include Moody Air Force Base, with approximately 6,000 personnel.  Other major employers include South Georgia Medical Center, Lowe’s Home Centers, Conversys Corporation, and Valdosta State University.  Valdosta is a regional hub for communities in south Georgia.  This market has a population of approximately 142,000, and the population growth in this MSA is projected to increase at a rate of 7.8% through 2016.

Southeast Georgia Market – Statesboro.  The Statesboro market is a service-based economy.  Median and household income levels are below the state and national averages.  As of December 2012, the market area reported an unemployment rate of 10.0%, compared with 10.0% for the same period in the prior year and 7.8% for the national average.  Major employers in the area include Georgia Southern University, Briggs & Stratton Corp., East Georgia Regional Medical Center and Viracon Georgia, Inc.  Statesboro is a regional retail hub for many small communities in southeast Georgia.  This market has a population of approximately 71,000, and the population growth in this market area is projected to increase at a rate of 8.4% through 2016.

Southeast Georgia Market – Savannah MSA.  The Savannah MSA is a five-tiered economy consisting of manufacturing, the port and transportation, tourism, the military, and miscellaneous and other businesses such as health care.  Median and household income levels are below the state and national averages.  As of December 2012, the market area reported an unemployment rate of 8.2%, compared with 8.8% for the same period in the prior year and 7.8% for the national average.  Major employers in the area include Gulfstream Aerospace, International Paper, Georgia Pacific Savannah River Site, Memorial Health, and Fort Stewart Hunter Army Airfield.  The transportation industry, centered on the Port of Savannah, is a vital element of the economy and is the fifth largest container port in the country, handling more than 2.1 million container units in 2010 and shipping to more than 150 countries around the world.  This MSA has a population of approximately 353,000, and the population growth in this MSA is projected to increase at a rate of 6.3% through 2016.

North Central Florida Market - Ocala MSA.  The Ocala MSA is a service based economy.  The area is known for its world-class equestrian training facilities and its booming retirement communities.  Median household income and per capita income are below the state and national averages.  However, due to the large retirement population, much more of the income is disposable in nature compared to other markets.  As of December 2012, the market area reported an unemployment rate of 8.9%, compared with 11.6% for the same period in the prior year and 7.8% for the national average.  Major employers in the area include Monroe Regional Medical Centers, Wal-Mart Stores, AT&T, Publix Supermarkets, Emergency One, Lockheed Martin, ClosetMaid, and Central Florida Community College.  This MSA has a population of approximately 334,000, and the population growth in this MSA is projected to increase at a rate of 2.3% through 2016.

5

North Central Florida Market - Lake City.  The Lake City market area is service-based.  Median household income and per capita income are below the state and national averages.  As of December 2012, the market area reported an unemployment rate of 7.3%, compared with 9.9% for the same period in the prior year and 7.8% for the national average.  Major employers in the area include the Veterans Administration Medical Center, TIMCO and Sitel.  This MSA has a population of approximately 69,000, and the population growth in this market area is projected to increase at a rate of 6.9% through 2016.

Eastern Alabama Market – Auburn-Opelika MSA.  The Auburn-Opelika MSA is one of the fastest growing in the nation and has shifted away from traditional manufacturing with a focus on commercial, residential and industrial activity.  Median household income and per capita income are below the state and national averages.  As of December 2012, the market area reported an unemployment rate of 5.7%, compared with 6.4% for the same period in the prior year and 7.8% for the national average.  Major employers in the area include Briggs and Stratton, Wal-Mart distribution center, Mando America Corporation, East Alabama Medical Center and Auburn University.  This MSA has a population of approximately 143,000, and the population growth in this MSA is projected to increase at a rate of 9.5% through 2016.

Competition

We face strong competition in originating commercial, real estate and other loans and in attracting deposits.  Competition in originating real estate loans comes primarily from other banks, credit unions and mortgage bankers.  Other banks, credit unions and finance companies also provide vigorous competition in consumer and commercial lending.

We attract deposits through our branch office system.  Competition for those deposits is principally from other banks and credit unions located in the same community, as well as mutual funds and other alternative investments.  We compete for these deposits by offering superior service and a variety of deposit accounts at competitive rates.

Available Information

Heritage maintains a website at www.eheritagebank.com.  The Company currently makes available on or through its website its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, amendments to these reports, and all other Securities and Exchange Commission (“SEC”) filings. These materials are also available free of charge on the Securities and Exchange Commission's website at www.sec.gov.

6

Lending Activities

The following table presents information concerning the composition of HeritageBank’s loan portfolio in dollar amounts and in percentages (before deductions for allowances for losses) as of the dates indicated.

	December 31,
	2012					2011					2010					2009					2008
	Amount		Percent			Amount		Percent			Amount		Percent			Amount		Percent			Amount		Percent
	(Dollars in thousands)
Commercial Real Estate
Nonresidential	$	212,570		31.73	%	$	138,970		24.79	%	$	110,079		26.27	%	$	71,158		21.30	%	$	52,477		17.35	%
Multifamily		21,293		3.18			15,797		2.82			13,598		3.25			12,135		3.63			10,719		3.54
Farmland		20,141		3.01			17,921		3.20			12,339		2.94			9,013		2.70			5,744		1.90
Total		254,004		37.92			172,688		30.80			136,016		32.46			92,306		27.63			68,940		22.79
Construction and land		33,340		4.98			26,804		4.78			24,522		5.85			28,385		8.49			43,297		14.31
Residential real estate
Mortgage loans, 1-4 families		161,883		24.16			129,745		23.14			131,293		31.34			87,469		26.18			79,727		26.36
Home equity		27,345		4.08			26,154		4.67			26,091		6.23			18,778		5.62			18,344		6.06
Total		189,228		28.24			155,899		27.81			157,384		37.57			106,247		31.80			98,071		32.42
Commercial and industrial loans		83,659		12.49			55,179		9.84			52,589		12.55			45,837		13.72			42,838		14.17
Consumer and other loans		25,498		3.80			23,872		4.26			27,115		6.47			36,943		11.06			49,342		16.31
Loans acquired through FDIC-assisted transactions
Non-Covered		11,850		1.76			18,721		3.34			21,371		5.10			24,420		7.30			-		-
Covered		72,425		10.81			107,457		19.17			-		-			-		-			-		-
Total		84,275		12.57			126,178		22.51			21,371		5.10			24,420		7.30			-		-
Total loans		670,004		100.00	%		560,620		100.00	%		418,997		100.00	%		334,138		100.00	%		302,488		100.00	%
Less allowance for loan losses		9,061					7,494					8,101					6,060					4,951
Total loans, net	$	660,943				$	553,126				$	410,896				$	328,078				$	297,537

7

The following table shows the composition of HeritageBank's loan portfolio by fixed- and adjustable-rates at the dates indicated.

	December 31,
	2012					2011					2010					2009					2008
	Amount		Percent			Amount		Percent			Amount		Percent			Amount		Percent			Amount		Percent
	(Dollars in thousands)
Fixed-Rate Loans:
Real Estate
Residential real estate	$	145,496		21.72	%	$	117,336		20.93	%	$	102,626		24.49	%	$	98,462		29.47	%	$	72,353		23.92	%
Multi-family		16,605		2.48			12,340		2.20			10,190		2.43			6,455		1.93			5,210		1.72
Nonresidential		187,708		28.02			113,761		20.29			77,033		18.39			58,419		17.48			42,084		13.91
Farmland		13,339		1.99			14,534		2.59			8,086		1.93			4,789		1.43			2,174		0.72
Construction and land		18,522		2.76			20,799		3.71			12,966		3.09			8,752		2.62			8,426		2.79
Total real estate loans		381,670		56.97			278,770		49.73			210,901		50.33			176,877		52.93			130,247		43.06
Consumer and other loans		21,574		3.22			19,953		3.56			20,021		4.78			21,992		6.58			45,168		14.93
Commercial and industrial loans		52,830		7.89			28,523		5.09			21,964		5.24			18,997		5.69			14,218		4.70
Total fixed-rate loans		456,074		68.08			327,246		58.37			252,886		60.35			217,866		65.20			189,633		62.69
Adjustable-Rate Loans:
Real Estate
Residential real estate		43,732		6.52			38,563		6.88			8,335		1.99			7,785		2.33			7,374		2.44
Multifamily		4,688		0.70			3,457		0.62			580		0.14			5,680		1.70			5,509		1.82
Nonresidential		24,862		3.71			25,209		4.50			20,449		4.88			12,739		3.81			10,393		3.44
Farmland		6,802		1.02			3,387		0.60			3,689		0.88			4,224		1.27			3,569		1.18
Construction and land		14,818		2.22			6,005		1.07			9,460		2.26			19,633		5.88			34,871		11.53
Total real estate loans		94,902		14.17			76,621		13.67			45,513		10.15			50,061		14.99			61,716		20.41
Consumer and other loans		3,924		0.58			3,919		0.70			21,892		5.22			14,951		4.48			22,518		7.44
Commercial and industrial loans		30,829		4.60			26,656		4.75			28,231		6.74			26,840		8.03			28,621		9.46
Total adjustable-rate loans		129,655		19.35			107,196		19.12			92,636		22.11			91,852		27.50			112,855		37.31
		585,729		87.43			434,442		77.49			345,522		82.46			309,718		92.70			302,488		100.00
Loans acquired through FDIC-assisted transactions(1)
Non-Covered		11,850		1.76			18,721		3.34			21,371		5.10			24,420		7.30			-		-
Covered		72,425		10.81			107,457		19.17			-		-			-		-			-		-
Total		84,275		12.57			126,178		22.51			21,371		5.10			24,420		7.30			-		-
Total loans		670,004		100.00	%		560,620		100.00	%		418,997		100.00	%		334,138		100.00	%		302,488		100.00	%
Less allowance for loan losses		9,061					7,494					8,101					6,060					4,951
Total loans, net	$	660,943				$	553,126				$	410,896				$	328,078				$	297,537

(1) Loans acquired through FDIC-assisted transactions are accounted for under ASC 310-30 and are therefore are not considered either fixed or variable.

8

The following schedule illustrates the contractual maturity of HeritageBank's loan portfolio at December 31, 2012, excluding FDIC acquired loans.  Mortgages that have adjustable or renegotiable interest rates are shown as maturing in the period during which the contract is due.  The schedule does not reflect the effects of possible prepayments or enforcement of due-on-sale clauses.

	Consumer and Commercial Real Estate					Construction and land					Consumer and Other					Commercial and Industrial					Total
Due During Years Ending December 31,	Amount		Weighted Average Rate			Amount		Weighted Average Rate			Amount		Weighted Average Rate			Amount		Weighted Average Rate			Amount		Weighted Average Rate
	(Dollars in thousands)
2013(1)	$	57,546		5.33	%	$	16,896		4.62	%	$	11,272		6.86	%	$	36,847		4.17	%	$	122,561		4.91	%
2014		31,377		5.56			2,575		4.61			3,948		7.60			4,738		4.54			42,638		5.57
2015		44,897		4.87			4,943		3.13			3,021		6.83			9,240		4.30			62,101		4.74
2016 to 2017		83,120		5.12			2,665		5.17			4,668		5.58			21,818		4.25			112,271		4.97
2018 to 2022		127,566		4.63			2,512		4.71			2,435		5.49			11,016		4.45			143,529		4.63
2023 to 2027		44,567		4.25			2,043		4.02			97		7.90			-		-			46,707		4.25
2028 and following		54,159		4.76			1,706		5.25			57		8.99			-		-			55,922		4.78
Total	$	443,232		4.88		$	33,340		4.44		$	25,498		6.52		$	83,659		4.26		$	585,729		4.82

(1) Includes demand loans, loans having no stated maturity and overdraft loans

Lending authority.  The Board of Directors has established lending authorities for its officers.   Based on individual experience, Market Presidents and Commercial Lenders have established lending authorities up to $500,000, and Consumer and Mortgage Lenders have lending authorities up to $100,000.   Regional Managers and Regional Presidents may make and approve secured loans up to $1.0 million.  Regional Credit Officers may approve secured loans up to $1.5 million.  The Chief Banking Officer’s lending authority covers loans and relationships up to $2.0 million.  The Chief Executive Officer and the Chief Credit Officer may approve loans and relationships up to $5.0 million.  These higher lending authorities are granted in conjunction with the written recommendations and analysis of the commercial managers, regional presidents and regional credit officers.   Relationships and exposures that exceed $5.0 million must be approved by the Board of Directors.

We are subject to lending limits established under Georgia law for loans to one borrower and the borrower's related entities.  See “How We Are Regulated - HeritageBank - Georgia Regulation.”  Based on our capital level at December 31, 2012, the maximum amount under Georgia law that we could loan to any one borrower and the borrower's related entities was $21.0 million for fully secured loans (including loans secured by real estate for which we have an independent appraisal) and $12.6 million for all other loans.  Internally, we have set a limit of $5.0 million for all loans to any one borrower and the borrower’s related entities.  This internal limit may be exceeded with the approval of the Board of Directors.

Major loan customers.  Our ten largest lending relationships, excluding loans acquired through FDIC-assisted transactions, are with commercial borrowers and total $64.8 million in the aggregate, or 9.7% of our $670.0 million loan portfolio at December 31, 2012.  These relationships consist of $7.9 million  to a nursing home secured by real estate located in southwest Georgia; $7.9 million to a specialty chemical business and their related interests in southwest Georgia; $7.3 million secured primarily by multifamily and residential rental real estate in southeast Georgia; $6.6 million to a retail pharmacy business secured by inventory and real estate located primarily in southwest Georgia; $6.5 million for the permanent financing of a hotel in north central Florida; $6.4 million secured primarily by a finance company secured by accounts receivable and real estate in southwest Georgia; $6.3 million to a nursing home and assisted living secured by real estate located in central Georgia; $5.4 million for the permanent financing of a hotel in north central Florida; $5.4 million secured primarily by multifamily and residential rental real estate in south Georgia; and $5.1 million secured primarily by multifamily and residential rental real estate in south Georgia.  As of the date of this filing, these major customer relationships were performing and rated as pass credits.

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For further information on credit quality, see the discussion under the headings Item 1 - Asset Quality -- Delinquent Loans and -- Classified Assets and see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 Residential Real Estate Lending.  We originate 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 our lending area.  The majority of these loans are originated by us and sold to other lenders.  At December 31, 2012, we had $189.2 million, or 28.2% of gross loans, in residential real estate loans including home equity lines of credit, of which $145.5 million were fixed-rate loans and $43.7 million were adjustable rate loans.

Our home equity lines of credit totaled $27.3 million and accounted for 4.1% of gross loans at December 31, 2012.  These loans may be originated in amounts, together with the amount of the existing first mortgage, of up to 100% of the value of the property securing the loan.  Home equity lines of credit generally have a 3-year to 15-year draw period and require the payment of 1.5% of the outstanding loan balance per month during the draw period, which may be reborrowed at any time during the draw period.  We also offer a 3-year to 15-year home equity line of credit that requires interest-only payments for the first five years, then fully amortizing payments over the remaining 10 years of the loan.  At December 31, 2012, unfunded commitments on home equity lines of credit totaled $21.8 million.  Other consumer loan terms vary according to the type of collateral, length of contract and creditworthiness of the borrower.

We generally underwrite our one- to four-family owner-occupied loans based on the applicant's employment and credit history and the appraised value of the subject property.  Presently, we lend up to 90% of the lesser of the appraised value or purchase price for one- to four-family residential loans.  Properties securing our one- to four-family loans are appraised by independent fee appraisers approved by the Board of Directors.  We require our borrowers to obtain title insurance, hazard insurance and, if necessary, flood insurance.  We currently originate one- to four-family mortgage loans on either a fixed- or adjustable-rate basis, as consumer demand dictates.  Our pricing strategy for mortgage loans includes setting interest rates that are competitive with other local financial institutions and consistent with our internal needs.  Fixed-rate loans generally have a 15- to 30-year term.

Adjustable-rate mortgage, or ARM, loans are generally offered with annual repricing with a maximum annual rate change of 1% and maximum overall rate change of 4%.  We use a variety of indices to reprice our ARM loans.  Our ARM loans generally provide for specified minimum and maximum interest rates, with a lifetime cap and floor, and a periodic adjustment of the interest rate over the rate in effect on the date of origination.  As a consequence of using caps, the interest rates on these loans may not be as rate sensitive as is our cost of funds.  Our ARM loans are written using generally accepted underwriting guidelines.  ARM loans generally pose different credit risks than fixed-rate loans, primarily because as interest rates rise, the borrower's payment rise, increasing the potential for default.  We do not offer initial discounted rates or “teaser” rates on adjustable-rate mortgage loans.  Our real estate loans contain a “due on sale” clause allowing us to declare the unpaid principal balance due and payable upon the sale of the collateral.

We generally underwrite our non-owner-occupied, one- to four-family loans primarily based on a 1.25 times debt service coverage, though we also consider the applicant's creditworthiness and the appraised value of the property.  Presently, we lend up to 85% of the lesser of the appraised value or purchase price for the residence.  These loans are offered with a fixed rate or an adjustable rate using The Wall Street Journal prime rate as the index.  These loans have terms of up to 15 years and are not assumable.  We generally obtain title opinions from our counsel regarding these properties.

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Commercial Real Estate Lending.  We offer a variety of multifamily, nonresidential, and farmland real estate loans.  These loans are secured primarily by multifamily dwellings, retail establishments, hotels, motels, warehouses, small office buildings, farmland, and other properties located in our market areas.  At December 31, 2012, commercial real estate totaled $254.0 million, or 37.9% of gross loans. Nonresidential real estate totaled $212.6 million, or 31.7% of gross loans, and multifamily real estate totaled $21.3 million, or 3.2% of gross loans as December 31, 2012.

Nonresidential and multifamily loans are originated with either a fixed or adjustable interest rate over various terms and structures.  The interest rate on adjustable-rate loans is based on a variety of indices, generally determined through negotiation with the borrower.  Loan-to-value ratios on our nonresidential and multifamily real estate loans typically do not exceed 80% of the appraised value of the property securing the loan.  Loans secured by nonresidential and multifamily real estate are underwritten based on the income producing potential of the property and the financial strength of the borrower.  The net operating income, which is the income derived from the operation of the property less all operating expenses, must be sufficient to cover the payments related to the outstanding debt.  We generally require personal guarantees of the borrowers and an assignment of rents or leases in order to be assured that the cash flow from the project will be used to repay the debt.  Appraisals on properties securing nonresidential and multifamily real estate loans are performed by independent state certified or licensed fee appraisers approved by the board of directors, with a second independent appraisal review performed if the loan exceeds $500,000.

We generally do not maintain a tax or insurance escrow account for loans secured by nonresidential and multifamily real estate.  In order to monitor the adequacy of cash flows on income-producing properties, the borrower is generally required to provide periodic financial information.

Loans secured by nonresidential and multifamily real estate properties generally involve a greater degree of credit risk than single family residential mortgage loans.  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.

Our loans secured by farmland totaled $20.1 million, or 3.0% of gross loans, and are originated with either a fixed or adjustable interest rate over a three-or five-year term with a balloon payment generally based on a 15-year amortization.  The interest rate on adjustable-rate loans is based on a variety of indices, generally determined through negotiation with the borrower.  Loan-to-value ratios on our farmland loans typically do not exceed 80% of the appraised value of the property securing the loan.  Farmland loans are underwritten based on the income-producing potential of the property and the financial strength of the borrower.  In order to monitor the adequacy of cash flows from farm operations, the borrower is required to provide periodic financial information.

Loans secured by farmland generally involve a greater degree of credit risk than one- to four-family residential loans.  These loans 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 is impaired.

Construction and Land Lending.  Our construction loan portfolio consists of loans for the construction of one- to four-family residences, multifamily residences and commercial properties.  Construction lending generally affords us an opportunity to receive interest at rates higher than those obtainable from residential lending and to receive higher origination and other loan fees.  In addition, construction loans are generally made with adjustable rates of interest for six- to nine-month terms, with interest-only payments due during the construction period.  At December 31, 2012, we had $33.3 million in construction loans outstanding, representing 5.0% of gross loans.

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.  We fund our construction loans based on percentage of completion as determined by physical property inspections.  Acquisition and development loans are required to be paid down as lots are sold, though on an accelerated basis so that we are repaid before all the lots are sold.  See also the discussion under the headings “Classified Assets” and “Loan Delinquencies and Defaults.”

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Commercial and Industrial Lending.  At December 31, 2012, commercial business loans totaled $83.7 million or 12.5% of gross loans.  Our commercial business lending activities encompass loans with a variety of purposes and security, including loans to finance accounts receivable, agricultural production, inventory and equipment.  Our commercial business lending policy includes credit file documentation and analysis of the borrower's background, capacity to repay the loan, the adequacy of the borrower's capital and collateral as well as an evaluation of other conditions affecting the borrower.  Analysis of the borrower's past, present and future cash flows is also an important aspect of our credit analysis.

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.  As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself (which, in turn, is often dependent in part upon general economic conditions).  We generally obtain personal guarantees on our commercial business loans.  Nonetheless, these loans are believed to carry higher credit risk than traditional single family loans.

Consumer and Other Lending.  We offer a variety of secured consumer loans, new and used auto loans, boat and recreational vehicle loans, and loans secured by deposit accounts. We also offer a limited amount of low dollar, unsecured loans and consumer credit cards.  We originate our consumer and other loans primarily in our market areas.  At December 31, 2012, our consumer and other loan portfolio totaled $25.5 million, or 3.8% of gross loans.

We originate auto loans on a direct basis and, in very limited circumstances, on an indirect basis.  Auto loans may be written for up to six years and usually have fixed rates of interest.  Loan-to-value ratios are up to 100% of the sales price for new autos and 100% of retail value on used autos, based on valuation from official used car guides.  Consumer loans generally have shorter terms to maturity, which reduces our exposure to changes in interest rates, and carry higher rates of interest than do one- to four-family residential mortgage loans.

Management believes that offering consumer loan products helps to expand and create stronger ties to our existing customer base by increasing the number of customer relationships and providing cross-market selling opportunities.  Consumer loans may entail greater risk than do single family residential mortgage loans, 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.

Loan Originations, Purchases, Sales, Repayments and Servicing

We originate one- to four-family residential mortgage loans primarily through referrals from real estate agents, builders and from existing customers.  Loan origination fees earned totaled $1.3 million, $814,000 and $824,000 for the years ended December 31, 2012, 2011 and 2010, respectively.

While we originate both adjustable-rate and fixed-rate loans, our ability to originate loans is dependent upon customer demand for loans in our market areas.  Demand is affected by competition and the interest rate environment.  Loans and participations purchased must conform to our underwriting guidelines.  In periods of economic uncertainty, the ability of financial institutions, including ours, to originate or purchase large dollar volumes of real estate loans may be substantially reduced or restricted, which in turn lowers our interest income.

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In addition to the categories of loans originated by us and described above, as of December 31, 2012, $84.3 million, or 12.6% of gross loans, consisted of loans acquired through FDIC-assisted acquisitions, with $72.4 million covered under loss-sharing agreements with the FDIC. Due diligence performed on these loans was limited due to the quick timing required for these transactions; however, the loss-sharing agreements with the FDIC provides coverage for 80% of the covered loan balance, which significantly mitigates the credit risk exposure for these loans.  See Item 8 - Note 5 of the Consolidated Financial Statements for additional information about these loans acquired through FDIC-assisted acquisitions.

We have agreements with mortgage lenders, pursuant to which we originate and fund residential mortgage loans for these lenders in accordance with their policies, terms, and conditions.  We charge the borrower an origination fee for processing the application in accordance with the lender's specifications.  We also may earn a premium on these loans based on the difference between the rate on the loan and the lock-in rate accepted by the lender.  During 2012, we originated $137.4 million of mortgage loans for these lenders, generating approximately $5.7 million in mortgage banking income on these loans.  During 2011, we originated $94.0 million of mortgage loans for these lenders, generating approximately $2.7 million in mortgage banking income on those loans.

In addition to interest earned on loans and loan origination fees, we receive fees for loan commitments, late payments and other miscellaneous services.  The fees vary from time to time, generally depending on the supply of funds and other competitive conditions in the market.  Fees for late payments totaled $214,000, $246,000 and $267,000 for the years ended December 31, 2012, 2011 and 2010, respectively.

Asset Quality

When a borrower fails to make a required payment on a loan, we attempt to cure the delinquency by contacting the borrower.  Delinquent consumer loan customers are contacted by the lender and a centralized collections department.  Delinquent commercial loan customers are contacted by the lender and are turned over to our special assets division if collection efforts by the lender are not successful.  If the borrower does not cure the delinquency, we undertake an analysis of the best means to maximize our return through collection efforts, which may include litigation, taking a deed-in-lieu of foreclosure, agreeing to a short sale, and/or initiating foreclosure proceedings.  In the event we take title to underlying collateral, we generally seek to sell the asset as soon as practicable.

Delinquent Loans.  The table below sets forth the contractual principal balances by category of loans, excluding loans acquired through FDIC-assisted acquisitions, that were 30 to 89 days past due and still accruing interest at December 31, 2012:

	Thirty to fifty-nine days			Sixty to eighty-nine days			Total thirty to eighty-nine days
	(Dollars in thousands)
Delinquent Loans:
Residential real estate	$	1,283		$	-		$	1,283
Multifamily		-			-			-
Nonresidential		-			744			744
Farmland		-			-			-
Construction and land		-			-			-
Consumer and other		79			11			90
Commercial and industrial		14			-			14
Total	$	1,376		$	755		$	2,131
Total as a percentage of total loans		0.2	%		0.1	%		0.3	%

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Nonperforming Assets.  The following table sets forth the amounts and categories of nonperforming assets in our loan portfolio.  Loans are placed on non-accrual status when the collection of principal and/or interest becomes doubtful.  Our loans acquired through FDIC-assisted acquisitions are excluded from the nonperforming loan table below because they are accounted for under ASC Topic 310-30.  See Item 8 - Note 4 to the Consolidated Financial Statements.  At all dates presented, we had no accruing loans 90 days or more delinquent.  Included in nonaccruing loans at December 31, 2012, are troubled debt restructurings of $6.9 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.  In addition, at that date we had troubled debt restructurings totaling $7,000 that were performing in accordance with their modified terms and are not included in nonaccruing loans.  Foreclosed assets owned include assets acquired in settlement of loans.

	December 31,
	2012			2011			2010			2009			2008
	(Dollars in thousands)
Nonaccruing Loans:
Residential real estate	$	4,589		$	4,772		$	4,873		$	1,505		$	689
Multifamily		-			2			1,770			122			-
Nonresidential		4,938			361			1,586			236			988
Farmland		-			111			-			-			-
Construction and development		3,881			442			1,423			2,863			4,882
Commercial and industrial		1,149			1,179			88			3,248			147
Consumer and other		120			176			165			489			575
Total nonaccruing loans		14,677			7,043			9,905			8,463			7,281
Foreclosed Assets:
Residential real estate		1,739			498			468			583			115
Multifamily		-			-			-			-			-
Nonresidential		-			45			1,095			362			284
Farmland		97			-			-			-			-
Construction and development		784			2,806			2,126			794			1,666
Commercial and industrial		-			-			-			-			-
Consumer and other		-			7			-			56			55
Total foreclosed assets		2,620			3,356			3,689			1,795			2,120
Total nonperforming assets	$	17,297		$	10,399		$	13,594		$	10,258		$	9,401
Total as a percentage of total assets		1.58	%		0.95	%		1.80	%		1.79	%		1.87	%

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For the year ended December 31, 2012, approximately $315,000 of gross interest income would have been recorded had the non-accruing loans been current in accordance with their original terms.  No significant amount was included in interest income on these loans for this period.

See Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Comparison of Financial Condition at December 31, 2012 and December 31, 2011 --- Delinquencies and Non-performing Assets for more information on our non-performing assets.

Other Loans of Concern.  In addition to the nonperforming assets set forth in the table above, as of December 31, 2012, there was also an aggregate of $10.9 million of 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 fully with present loan repayment terms and that may result in the future inclusion of those loans in the non-performing asset categories.  These loans include all criticized and classified loans and certain other past due loans that are not in a non-performing loan category.  These loans have been considered in management's determination of the adequacy of our allowance for loan losses.

At December 31, 2012, we had three other loans of concern of over $1.0 million totaling approximately $3.8 million.  The largest was a $1.7 million loan secured by a multifamily property in Statesboro, Georgia.  The remaining loans of concern at December 31, 2012 consisted of a $1.1 million loan secured by various residential properties in southwest Georgia and a $1.0 million loan secured by a nonresidential property in Ocala, Florida.

Classified Assets.  Federal regulations provide for the classification of loans and other assets, such as debt and equity securities considered to be of lesser quality, as "substandard," "doubtful" or "loss."  An asset is considered "substandard" if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any.  "Substandard" assets include those characterized by the "distinct possibility" that the insured institution will sustain "some loss" if the deficiencies are not corrected.  Assets classified as "doubtful" have all of the weaknesses inherent in those classified "substandard," with the added characteristic that the weaknesses present make "collection or liquidation in full," on the basis of currently existing facts, conditions, and values, "highly questionable and improbable."  Assets classified as "loss" are those considered "uncollectible" and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted.

When HeritageBank classifies problem assets as either substandard, doubtful, or loss, the loans are charged down to appraised value less selling costs while specific allowances are used for loans that do not qualify for a charge-off but the loss can be reasonably estimated.  In addition, we establish general allowances based on historical loss history and migration analysis.  General allowances represent loss allowances that have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets.  Our determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the FDIC and the Georgia Department of Banking and Finance (“GDBF”), which may order the establishment of additional general or specific loss allowances.

We regularly review the problem assets in our portfolio to determine whether any assets require classification in accordance with applicable regulations.  On the basis of management's review of our assets, at December 31, 2012, we had $25.1 million of our assets internally classified, of which $22.4 million consisted of loans and $2.6 million of other real estate and repossessions.  All of these assets were classified as substandard.  We had no assets classified as doubtful or loss at December 31, 2012.  The total amount classified represented 20.8% of our equity capital and 2.3% of our assets at December 31, 2012.  All of our $14.7 million in nonperforming loans at December 31, 2012, were included in our classified assets at that date, and the allowance for loan losses related to those nonperforming loans at that date was $2.3 million.

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Allowance for Loan Losses.  We maintain an allowance for loan losses to absorb probable incurred losses in the loan portfolio.  In evaluating the level of the allowance for loan losses, management considers the types of loans and the amount of loans in the loan portfolio, historical loss experience, migration analysis, probability of default, 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.  We analyze the historical migration of loans through each risk rating category and analyze 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 pass credit loan pools and other assets especially mentioned loan pools. These factors are applied to the substandard loan 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.  Impaired loans 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 while impaired loans with balances less than $500,000 typically use a historical loss analysis.  See Item 8 - Note 4 to the Consolidated Financial Statements for additional information about our allowance methodology.

At December 31, 2012, our allowance for loan losses was $9.1 million or 1.4% of the total loan portfoliocompared with a balance of $7.5 million, or 1.3% of total loans at December 31, 2011.   Total criticized and classified loans decreased by $4.4 million during the period to $25.5 million at December 31, 2012 from $29.9 million at December 31, 2011.  Nonaccrual loans increased $7.7 million during the period to $14.7 million at December 31, 2012 compared with $7.0 million at December 31, 2011.  The primary reason for the increase in nonaccrual loans from 2011 was the migration of two loan relationships totaling $6.0 million, previously identified as criticized assets, to nonaccrual status during 2012.  One of the relationships, totaling $3.5 million, was classified a troubled-debt restructuring and additional collateral of $6.1 million has been secured.  The other relationship was a Chapter 11 bankruptcy where the collateral deficiency is fully reserved as of December 31, 2012.  Loans past due thirty days and still accruing increased by $1.8 million to $2.1 million at December 31, 2012 compared with $371,000 at December 31, 2011.

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The allowance for loan losses is maintained at a level which management believes is adequate to absorb all probable losses on loans then present in the loan portfolio.  The amount of the allowance is affected by:  (1) loan charge-offs, which decrease the allowance; (2) recoveries on loans previously charged-off, which increase the allowance; (3) the provision for possible loan losses charged against income, which increases the allowance; and (4) credit mark transfers as a result of acquired loan pools experiencing credit losses in excess of the fair value discounts established, which increase the allowance.  The allowance is discussed further in Item 8 - Notes 1 and 4 to the Consolidated Financial Statements and Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operation Critical Accounting Policies -Allowance for Loan Losses.  The following table sets forth an analysis of our allowance for loan losses.

	December 31,
	2012			2011			2010			2009			2008
	(Dollars in thousands)
Balance at beginning of period	$	7,494		$	8,101		$	6,060		$	4,951		$	4,416
Charge-offs:
Residential real estate		(498	)		(3,177	)		(1,278	)		(494	)		(81	)
Commercial real estate		(166	)		(573	)		(412	)		(25	)		(773	)
Construction and land		(81	)		(18	)		(704	)		(3,100	)		(1,414	)
Commercial and industrial		(208	)		(330	)		(804	)		(2,338	)		(47	)
Consumer and other		(188	)		(264	)		(488	)		(664	)		(687	)
		(1,141	)		(4,362	)		(3,686	)		(6,621	)		(3,002	)
Recoveries:
Residential real estate		75			18			10			-			-
Commercial real estate		-			495			-			-			4
Construction and land		1			2			-			-			2
Commercial and industrial		35			-			-			50			20
Consumer and other		97			148			217			180			161
		208			663			227			230			187
Net charge-offs		(933	)		(3,699	)		(3,459	)		(6,391	)		(2,815	)
Credit mark transfer in		-			197			-			-			-
Provision charged to operations		2,500			2,895			5,500			7,500			3,350
Balance at end of period	$	9,061		$	7,494		$	8,101		$	6,060		$	4,951
Ratio of net charge-offs during the period to average loans outstanding during period		0.19	%		0.91	%		0.87	%		2.13	%		1.58	%
Ratio of net charge-offs during the period to average nonperforming assets		6.60	%		31.90	%		36.23	%		65.54	%		58.51	%
Allowance as a percentage of nonperforming loans		61.73	%		106.40	%		81.79	%		71.61	%		67.99	%
Allowance as a percentage of total loans (end of period)		1.55	%		1.72	%		2.04	%		1.81	%		1.64	%

(1) Ratios are on an annualized basis and exclude loans acquired through FDIC-assisted acquisitions.

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The distribution of our allowance for losses on loans at the dates indicated is summarized as follows:

	December 31,
	2012					2011					2010					2009					2008
	Amount of Loan Loss Allowance		Percent of Loans in Each Category to Total Loans			Amount of Loan Loss Allowance		Percent of Loans in Each Category to Total Loans			Amount of Loan Loss Allowance		Percent of Loans in Each Category to Total Loans			Amount of Loan Loss Allowance		Percent of Loans in Each Category to Total Loans			Amount of Loan Loss Allowance		Percent of Loans in Each Category to Total Loans
	(Dollars in thousands)
Residential real estate	$	3,251		28.24	%	$	2,440		27.81	%	$	2,197		37.57	%	$	1,422		31.80	%	$	637		32.42	%
Commercial real estate		2,744		37.92			1,878		30.80			1,721		32.46			1,176		27.63			1,015		22.79
Construction and land		978		4.98			1,270		4.78			1,977		5.85			1,419		8.49			1,275		14.31
Consumer and other		364		3.80			355		4.26			605		6.47			850		11.06			890		16.31
Commercial and Industrial		1,724		12.49			1,551		9.84			1,601		12.55			1,193		13.72			1,134		14.17
Loans acquired through FDIC-assisted transactions		-		12.57			-		22.51			-		5.10			-		7.30			-		-
Total	$	9,061		100.00	%	$	7,494		100.00	%	$	8,101		100.00	%	$	6,060		100.00	%	$	4,951		100.00	%

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Accounting for FDIC Acquired Loans

We perform ongoing assessments of the estimated cash flows of our FDIC acquired loan portfolios accounted under ASC 310-30.  At December 31, 2012, the fair value of the FDIC acquired loan portfolios consisted of $72.4 million in covered and $11.9 million in non-covered loans compared with $107.5 million in covered and $18.7 million in non-covered loans at December 31, 2011.  The principal balance of the FDIC-assisted loan portfolios totaled $152.1 million at December 31, 2012 compared with $228.4 million at December 31, 2011.

The factors considered in the allowance for loan losses for FDIC acquired loans are driven by a regular assessment of the expected cash flows of the loans.  We perform periodic valuation procedures to re-estimate the expected cash flows on FDIC acquired loan pools and compare the present value of expected cash flows to the carrying value of the loans at the pool level.  In order to estimate expected cash flows, we specifically review these loans each period to assist in the determination of appropriate probability of default and loss given default assumptions to be applied to the remainder of the portfolio. The estimate of expected cash flows may also be adjusted for management's estimate of probable losses on specific loan types dependent upon trends in observable market and industry data, such as prepayment speeds and collateral values. These cash flow evaluations are inherently subjective as they require material estimates, all of which may be susceptible to significant change. Separately, FDIC acquired loans individually assessed, or not pooled, go through the same re-estimate of expected cash flows calculation, and when a shortfall of discount is considered likely an allowance is recorded and a corresponding charge-off is recorded immediately, which results in an immediate use of the allowance.

During 2012, the FDIC acquired loan pools did not experience any charge-offs or record any increase in allowance for loan losses and experienced improvement in cash flows, which positively impacted the FDIC acquired loan accretion related to the pooled loans.  At December 31, 2012, the FDIC acquired loans individually assessed experienced charge-offs for the year of $3.4 million related to inadequate discounts as a result of the re-estimation of cash flows for such loans.  The charge-offs for FDIC acquired loans individually assessed did not increase the allowance for loan losses at December 31, 2012.

At December 31, 2012, the FDIC loss-share receivable associated with covered FDIC acquired loans decreased $23.2 million to $60.7 million, or 39.9% of the principal balance of FDIC acquired loans, compared to $83.9 million, or 36.7% of the principal balance of FDIC acquired loans, at December 31, 2011. The reduction in the FDIC loss-share receivable for 2012 was primarily driven by $17.1 million of reimbursements received from the FDIC and $5.0 million of negative accretion, resulting from the improvement in cash flows for the FDIC acquired loan pools, included in noninterest income of the consolidated statements of operations.  We have also recorded an FDIC true-up (“claw back”) liability of $703,000 for all FDIC loss share agreements as of December 31, 2012.  This FDIC claw back liability was driven by an improvement in estimates of expected cash flows for the FDIC acquired loan pools covered under loss-sharing agreements.

See Item 8 - Notes 5 and 6 to the Consolidated Financial Statements for additional information about the accounting for FDIC acquired loans and FDIC loss-share receivable.

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Investment Activities

Georgia savings banks have the authority to invest in various types of liquid assets, including United States Treasury obligations, securities of various federal, state and local agencies and jurisdictions, including callable agency securities, certain certificates of deposit of insured banks and savings institutions, certain bankers' acceptances, repurchase agreements, federal funds, and other investments.  Subject to various restrictions, Georgia savings banks also may invest their assets in investment grade commercial paper and corporate debt securities and mutual funds whose assets conform to the investments that a Georgia savings bank is otherwise authorized to make directly.  See "How We Are Regulated - HeritageBank of the South - Georgia Regulation" for a discussion of additional restrictions on our investment activities.

The Chief Financial Officer and Chief Accounting Officer have the basic responsibility for the management of our investment portfolio. They consider various factors when making decisions, including the marketability, maturity, and tax consequences of the proposed investment.  The maturity structure of investments will be affected by various market conditions, including the current and anticipated slope of the yield curve, the level of interest rates, the trend of new deposit inflows, and the anticipated demand for funds via deposit withdrawals and loan originations and purchases.  The general objectives of our investment portfolio are to provide liquidity when loan demand is high, to assist in maintaining earnings when loan demand is low and to maximize earnings while satisfactorily managing risk, including credit risk, reinvestment risk, liquidity risk and interest rate risk.  See Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management and Market Risk.

Our investment securities currently consist of mortgage-backed securities, federal agency securities, preferred stocks, state and local government securities, and corporate debt securities.  See Item 8 - Note 3 to the Consolidated Financial Statements.  As a member of the Federal Home Loan Bank of Atlanta (“FHLB”), we had $4.3 million in stock of the Federal Home Loan Bank of Atlanta valued at cost at December 31, 2012.  We maintain the minimum amount of stock the Federal Home Loan Bank of Atlanta allows based on our level of borrowings.  During the year ended December 31, 2012, we received $67,000 in dividends from the Federal Home Loan Bank of Atlanta.

The following table sets forth the composition of our securities portfolio and other investments at the dates indicated.  Our securities portfolio at December 31, 2012, did not contain securities of any single issuer with an aggregate book value in excess of 10% of our equity capital, excluding those issued by the United States Government or its sponsored entities.

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	December 31,
	2012					2011					2010
	Carrying Value		% of Total			Carrying Value		% of Total			Carrying Value		% of Total
	(Dollars in thousands)
Securities available for sale:
U. S. Government sponsored agencies (GSE) securities and U.S. Treasury Securities	$	21,019		9.49	%	$	45,737		17.65	%	$	89,032		37.35	%
Corporate debt securities		1,020		0.46			1,956		0.76			1,700		0.71
GSE residential mortgage- backed securities		157,497		71.13			162,963		62.92			125,336		52.58
Private label residential mortgage-backed securities		-		0.00			-		0.00			2,807		1.18
State and municipal securities		41,573		18.78			48,204		18.61			19,160		8.04
Equity and other		297		0.14			157		0.06			342		0.14
		221,406		100.00	%		259,017		100.00	%		238,377		100.00	%
Other earning assets:
Interest-bearing deposits with banks	$	15,393		64.06	%	$	43,101		62.54	%	$	10,911		63.02	%
Federal funds sold		4,306		17.92			21,753		31.56			2,700		15.59
Federal Home Loan Bank stock		4,330		18.02			4,067		5.90			3,703		21.39
	$	24,029		100.00	%	$	68,921		100.00	%	$	17,314		100.00	%

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The composition and maturities of the securities portfolio, excluding Federal Home Loan Bank stock, as of December 31, 2012 are indicated in the following table.  Yields on tax exempt obligations have been computed on a tax equivalent basis.  For further information on the ratings of these securities, see Item 8 - Note 3 to the Consolidated Financial Statements and Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operation - Critical Accounting Policies -- Estimates of Fair Value and - Comparison of Financial Condition at December 31, 2012 and December 31, 2011.

	Less than One Year					One to Five Years					Over Five to Ten Years					Over Ten Years					Total Securities
	Amortized Cost		Weighted Average Yield			Amortized Cost		Weighted Average Yield			Amortized Cost		Weighted Average Yield			Amortized Cost		Weighted Average Yield			Amortized Cost		Weighted Average Yield			Fair Value
	(Dollars in Thousands)
Securities Available for Sale:
U. S. Government sponsored agencies (GSE) securities	$	-		-	%	$	-		-	%	$	13,004		2.01	%	$	7,992		4.27	%	$	20,996		2.87	%	$	21,019
State and municipal		-		-			786		4.55			7,916		3.76			31,807		3.62			40,509		3.67			41,573
Corporate debt securities		150		7.50			1,000		6.25			-		-			-		-			1,150		6.41			1,020
GSE mortgage-backed securities		-		-			-		-			34,869		3.12			121,600		3.17			156,469		3.16			157,497
Equity and other		-		-			-		-			-		-			207		5.90			207		5.90			297
Total investment securities	$	150		7.50	%	$	1,786		5.50	%	$	55,789		2.95	%	$	161,606		3.32	%	$	219,331		3.24	%	$	221,406

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Sources of Funds

General.  Our sources of funds are deposits, borrowings, payment of principal and interest on loans, interest earned on or maturation of other investment securities and funds provided from operations.

Deposits.  We offer a variety of deposit accounts to both consumers and businesses having a wide range of interest rates and terms.  Our deposits consist of savings and checking accounts, money market deposit accounts, NOW accounts, demand accounts, and certificates of deposit.  We solicit deposits primarily in our market areas and rely on competitive pricing policies, marketing and customer service to attract and retain these deposits.  In addition, we solicit brokered deposits when terms and rates are more favorable than those in the markets we serve.  At December 31, 2012, we had $56.2 million in brokered deposits, of which $46.0 million were one-way purchases of Certificate of Deposit Account Registry Service® or CDARS®, and $10.2 million were customer balances placed in the reciprocal CDARS® product.

The flow of deposits is influenced significantly by general economic conditions, changes in prevailing interest rates and competition.  The variety of deposit accounts we offer has allowed us to be competitive in obtaining funds and to respond with flexibility to changes in consumer demand.  We have become more susceptible to short-term fluctuations in deposit flows, as customers have become more interest rate conscious.  We try to manage the pricing of our deposits in keeping with our asset and liability management, liquidity and profitability objectives, subject to competitive factors.  Based on our experience, we believe that our deposits are relatively stable sources of funds.  Despite this stability, our ability to attract and maintain these deposits and the rates paid on them has been and will continue to be significantly affected by market conditions.

Under regulations of the Board of Governors of the Federal Reserve System (“FRB”), we are required to maintain noninterest-bearing reserves at specified levels against our transaction accounts, primarily checking and NOW accounts.  At December 31, 2012, we were in compliance with these federal requirements and, as a result, would have been deemed to be in compliance with a similar reserve requirement under Georgia law.

The following table sets forth our deposit flows during the periods indicated.

	Year Ended December 31,
	2012			2011			2010
	(Dollars in thousands)
Opening balance	$	884,187		$	534,243		$	426,607
Net deposits and withdrawals		(19,049	)		341,588			103,031
Interest credited		4,416			8,356			4,605
Ending balance	$	869,554		$	884,187		$	534,243
Net increase/(decrease)	$	(14,633	)	$	349,944		$	107,636
Percent increase/(decrease)		(16.5	)%		65.5	%		25.23	%

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The following table indicates the amount of our certificates of deposit and other deposits by time remaining until maturity as of December 31, 2012.

	Maturity as of December 31, 2012
	Three Months or Less		Over Three to Six Months		Over Six to Twelve Months		Over Twelve Months		Total
	(Dollars in thousands)
Time deposits of less than $100,000	$	28,500	$	28,062	$	37,587	$	39,853	$	134,002
Time deposits of $100,000 or more		38,680		24,718		58,378		38,922		160,698
Total time deposits	$	67,180	$	52,780	$	95,965	$	78,775	$	294,700

The following tables set forth the average dollar amount of deposits in the various types of non-interest bearing and interest-bearing deposit programs we offered during the periods indicated and the average rate paid on the interest-bearing accounts.

	For the twelve months ended December 31,
	2012					2011					2010
	Average Balance		Average Rate			Average Balance		Average Rate			Average Balance		Average Rate
	(Dollars in thousands)
Non-interest bearing deposits	$	96,077		N/A		$	70,120		N/A		$	41,446		N/A
Interest-bearing deposits:
Interest-bearing demand	$	149,732		0.18	%	$	135,608		0.60	%	$	92,147		1.00	%
Savings and money market accounts		316,222		0.34			288,378		0.82			186,870		1.09
Retail time deposits		262,703		1.27			271,634		1.54			159,366		1.60
Wholesale time deposits		36,630		0.49			11,666		1.60			11,293		2.29
Total interest-bearing deposits	$	765,287		0.64	%	$	707,286		1.07	%	$	449,676		1.28	%

The following table sets forth the dollar amount of deposits in the various types of deposit programs offered at the dates indicated.

	December 31,
	2012					2011					2010
	Amount		Percent of Total			Amount		Percent of Total			Amount		Percent of Total
	(Dollars in thousands)
Transaction and Savings Deposits:
Non-interest bearing demand	$	116,272		13.37	%	$	78,823		8.91	%	$	44,769		8.38	%
Interest bearing demand		144,954		16.67			151,765		17.16			109,329		20.46
Savings and money market		313,628		36.07			344,820		39.01			211,105		39.52
Total transaction and savings		574,854		66.11			575,408		65.08			365,203		68.36
Certificates:
0.00-1.99%		235,839		27.12			221,786		25.08			85,326		15.97
2.00-3.99%		51,628		5.94			73,587		8.32			70,743		13.24
4.00-5.99%		7,233		0.83			13,406		1.52			12,586		2.36
6.00% and over		-		-			-		-			385		0.07
Total certificates		294,700		33.89			308,779		34.92			169,040		31.64
Total deposits	$	869,554		100.00	%	$	884,187		100.00	%	$	534,243		100.00	%

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The following table shows rate and maturity information for our certificates of deposit at December 31, 2012.

	0.00- 1.99%			2.00- 3.99%			4.00- 5.99%			6.00% and over			Total			Percent of Total
	(Dollars in thousands)
Certificates maturing in quarter ending:
March 31, 2013	$	63,068		$	3,574		$	538		$	-		$	67,180			22.80	%
June 30, 2013		48,281			3,500			999			-			52,780			17.91
September 30, 2013		40,887			5,475			3,516			-			49,878			16.93
December 31, 2013		39,952			5,219			916			-			46,087			15.64
March 31, 2014		5,328			4,090			112			-			9,530			3.23
June 30, 2014		6,174			1,938			376			-			8,488			2.88
September 30, 2014		4,967			2,103			-			-			7,070			2.40
December 31, 2014		3,843			2,767			-			-			6,610			2.24
March 31, 2015		1,153			3,534			677			-			5,364			1.82
June 30, 2015		628			3,753			-			-			4,381			1.49
September 30, 2015		3,702			3,668			-			-			7,370			2.50
December 31, 2015		2,804			3,179			-			-			5,983			2.03
Thereafter		15,052			8,828			-			-			23,979			8.14
Total	$	235,839		$	51,628		$	7,233		$	-		$	294,700			100.00	%
Percent of Total		80.03	%		17.52	%		2.45	%		0.00	%		100.00	%

Borrowings.  Although deposits are our primary source of funds, we may utilize borrowings when they are a less costly source of funds, when we desire additional capacity to fund loan demand, or when they meet our asset/liability management goals.  Our borrowings consist of advances from the FHLB, federal funds purchased, and securities sold under repurchase agreements.  See Item 8 - Notes 14 and Note 15 to the Consolidated Financial Statements.

Advances from the FHLB require borrowing capacity supported by the pledging of certain loans or securities.  These advances may be made pursuant to several different credit programs, each of which has its own interest rate, range of maturities, and call features.  At December 31, 2012, we had $60.0 million in FHLB advances outstanding and the ability to borrow an additional $63.4 million.

We have the ability to borrow from securities broker-dealers and customers by pledging investments.  These arrangements are known as securities sold under repurchase agreements.  These borrowings can be done on an overnight, short-term or long-term basis.  As of December 31, 2012, we had $30.0 million borrowed under long-term agreements with broker-dealers and $2.8 million borrowed under overnight agreements with customers.

We also have the ability to borrow up to $74.0 million from correspondent banks, pursuant to renewable lines of credit.  In addition, we also borrow from Chattahoochee Bank of Georgia on an overnight basis, depending on their liquidity needs.  At December 31, 2012, we had approximately $417,000 in federal funds purchased from that bank compared with $1.6 million at December 31, 2011.

We are authorized to borrow from the Federal Reserve Bank of Atlanta's “discount window" after we have exhausted other reasonable alternative sources of funds, including FHLB advances.

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The following table sets forth the average and weighted average rate paid, period-end balance, maximum month-end balance and average balance of FHLB advances for the periods indicated.

	At or For the Year Ended December 31,
	2012			2011			2010
	(Dollars in thousands)
Maximum Balance:
FHLB advances	$	60,000		$	62,500		$	62,500
Average Balance:
FHLB advances	$	38,975		$	46,473		$	42,983
Average interest rate paid during the period		3.61	%		3.19	%		3.70	%
End of Period Balance:
FHLB advances	$	60,000		$	35,000		$	62,500
Weighted average interest rate of FHLB advances		2.58	%		3.68	%		2.65	%

The following table sets forth the maximum month-end balance and average balance of federal funds purchased and securities sold under repurchase agreements for the periods indicated.

	At or For the Year Ended December 31,
	2012			2011			2010
	(Dollars in thousands)
Maximum Balance:
Federal funds purchased and securities sold under repurchase agreements	$	37,227		$	36,750			$	35,446
Average Balance:
Federal funds purchased and securities sold under repurchase agreements	$	33,528		$	33,383			$	34,097
Average interest rate paid during the period		3.98	%		3.94	%			2.71	%
End of Period Balance:
Federal funds purchased and securities sold under repurchase agreements	$	33,219		$	35,049			$	32,421
Weighted average interest rate of Federal funds purchased and securities sold under repurchase agreements		3.97	%		3.77	%			2.98	%

Subsidiary and Other Activities

We are engaged in the sale of securities and insurance products to customers through an agreement with a third-party broker-dealer.  During the years ended December 31, 2012 and 2011, we earned $1.8 million and $1.4 million, respectively, in gross fees and commissions from this activity.  This activity is conducted in accordance with applicable provisions of federal and state insurance and securities laws.

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In 2008, we acquired 4.9% of the outstanding shares of Chattahoochee Bank of Georgia, a de novo bank in Gainesville, Georgia, for approximately $1.0 million.  This investment provides us with the opportunity to further expand outside of southwest Georgia.  We also participate in loans generated by Chattahoochee Bank of Georgia that exceed its legal lending limits, allowing us to generate loan volume and exposure to the northeast Georgia market without incurring building and personnel costs.  O. Leonard Dorminey, our President and Chief Executive Officer, serves on the board of directors, executive committee and loan committee of Chattahoochee Bank of Georgia.  As of December 31, 2012, we had $4.7 million in loan participations with and $417,000 in federal funds purchased from Chattahoochee Bank of Georgia.

Other than HeritageBank, we currently do not have any active subsidiaries.

Employees

At December 31, 2012, we had a total of 321 full-time equivalent employees.  Our employees are not represented by any collective bargaining group.  Management considers its employee relations to be good.

How We Are Regulated

Set forth below is a brief description of material information regarding certain laws and regulations that are and will be applicable to Heritage and HeritageBank.

Heritage is a savings and loan holding company subject to regulation and supervision by the FRB.  The FRB requires that Heritage serve as a source of financial and managerial strength for HeritageBank, particularly when HeritageBank is in financial distress.  HeritageBank is a Georgia savings bank subject to regulation and supervision by the GDFB and the FDIC, which also insures our deposits.  The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) created the Consumer Financial Protection Bureau (“CFPB”) that has authority to promulgate regulations intended to protect consumers with respect to financial products and services, including those provided by HeritageBank, and to restrict unfair, deceptive or abusive conduct by providers of consumer financial products and services.  These regulations had previously been enacted by HeritageBank’s primary federal regulator.  As a public company, Heritage is subject to the regulation and reporting requirements of the SEC.

Legislation is introduced from time to time in the United States Congress and Georgia General Assembly that may affect our operations.  In addition, the regulations governing Heritage and HeritageBank may be amended from time to time by the GDBF, the FDIC, the FRB, the CFPB or the SEC, as appropriate.  Any legislative or regulatory changes, including those resulting from the Dodd-Frank Act, in the future could adversely affect our operations and financial condition.  This includes the authority from the Dodd-Frank Act effective July 21, 2011, for financial institutions to pay interest on demand deposits, which could increase our interest expense.  See “- The Dodd-Frank Act” below for additional information on its provisions.

The GDBF, the FDIC and the FRB, as appropriate, have extensive enforcement authority over Heritage and HeritageBank.  This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions.  In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices.  Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with the FDIC.  Except under certain circumstances, public disclosure of formal enforcement actions by the FDIC and FRB is required by law.

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HeritageBank of the South

HeritageBank, as a Georgia savings bank, is subject to regulation and periodic examination by the GDBF and the FDIC.  This regulation extends to all aspects of its operations.  HeritageBank is required to maintain minimum levels of regulatory capital and is subject to some limitations on the payment of dividends to Heritage.  See “Regulatory Capital Requirements for HeritageBank” and “Limitations on Dividends and Other Capital Distributions” below.  State and federal laws and regulations prescribe the investment and lending authority and activities of Georgia savings banks.  The FDIC also insures the deposits of HeritageBank to the maximum extent permitted by law.  This regulation of HeritageBank is generally intended for the protection of depositors and the insurance of accounts fund and not for the purpose of protecting stockholders.

Georgia Regulation.  HeritageBank is subject to extensive regulation and supervision by the GDBF.  The GDBF regularly examines HeritageBank, often jointly with the FDIC.  As a Georgia savings bank, HeritageBank is required to have no more than 50% of its assets in commercial real estate and business loans.  HeritageBank is in compliance with this requirement.  Our lending and investment authority and other activities are governed by Georgia law and regulations and policies of the GDBF.  We are subject to a statutory lending limit for aggregate loans to one person or a group of persons combined because of certain common interests.  That limit is 15% of our statutory capital base, except for loans fully secured by good collateral or ample security, which includes real estate with an independent appraisal, in which case that limit is increased to 25%.  Our statutory capital base consists of our stock, paid-in-capital and surplus, capital debt and appropriated retained earnings, which is that portion of our retained earnings designated by the board of directors as not available for dividends, reduced by intangible assets.  We have not appropriated any retained earnings.  Georgia law limits our ability to invest in real estate, including a limit on fixed assets of 60% of our statutory capital base, except for temporary grants of authority to exceed that limit granted by the GDBF.  We are in compliance with limitations on our fixed assets as of December 31, 2012.

Insurance of Accounts and Regulation by the FDIC.  The FDIC regularly examines HeritageBank and prepares reports for the consideration of its board of directors on any deficiencies that it may find in operations.  HeritageBank generally must notify or obtain the approval of the FDIC if it or any of its subsidiaries intend to engage in activities not authorized for national banks.  During examinations, the FDIC may require the Bank to establish additional reserves for loan losses, which decreases the Company’s net income.  The FDIC has adopted guidelines establishing safety and soundness standards on such matters as loan underwriting and documentation, asset quality, earnings standards, internal controls and audit systems, interest rate risk exposure, and compensation and other employee benefits.  Any institution that fails to comply with these standards must submit a compliance plan.

HeritageBank’s deposits are insured up to the applicable limits by the FDIC, and such insurance is backed by the full faith and credit of the United States Government.  The basic deposit insurance is $250,000 per each separately insured depositor, as defined in FDIC regulations.  As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by insured institutions.  Our deposit insurance premiums for the year ended December 31, 2012 were approximately $915,000.  Those premiums have increased in recent years and may continue to increase in the future.  Also, if the Bank experiences financial distress or operates in an unsafe or unsound manner, these deposit premiums will increase based on the formula established by the FDIC.

On February 7, 2011, pursuant to the Dodd-Frank Act, the FDIC adopted new regulations, which became effective April 1, 2011, that redefined the “assessment base” used for calculating deposit insurance assessments. Unlike the previous system, in which the assessment base was calculated by using an insured depository institution’s domestic deposits less a few allowable exclusions, the new assessment base is calculated using the average consolidated total assets of an insured depository institution less the average tangible equity (Tier 1 capital) of such institution. The FDIC continues to utilize a risk-based assessment system in which institutions will be subject to assessment rates ranging from 2.5 to 45 basis points, subject to adjustments for unsecured debt and, in certain cases, brokered deposits. The new rules eliminated adjustments for secured liabilities.

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The new rules retain the FDIC’s flexibility to, without further notice-and-comment rulemaking, adopt rates that are higher or lower than the stated base assessment rates, provided that the FDIC cannot (i) increase or decrease the total rates from one quarter to the next by more than two basis points, or (ii) deviate by more than two basis points from the stated base assessment rates. Although the Dodd-Frank Act makes the FDIC’s payment of a dividend to depository institutions discretionary, as opposed to mandatory, when the reserve ratio exceeds a certain threshold, the FDIC’s new rule establishes a decreasing schedule of assessment rates that would take effect when the DIF reserve ratio first meets or exceeds 1.15%. If the DIF reserve ratio meets or exceeds 1.15%, base assessment rates would range from 1.5 to 40 basis points; if the DIF reserve ratio meets or exceeds 2%, base assessment rates would range from 1 to 38 basis points; and if the DIF reserve ratio meets or exceeds 2.5%, base assessment rates would range from 0.5 to 35 basis points. All base assessment rates would continue to be subject to adjustments for unsecured debt and brokered deposits.

The FDIC also collects a deposit-based assessment from insured financial institutions on behalf of The Financing Corporation (“FICO”). The funds from these assessments are used to service debt issued by FICO in its capacity as a financial vehicle for the Federal Savings & Loan Insurance Corporation. The FICO assessment rate is set quarterly and in 2012 it averaged 0.66 cents per $100 of average total assets less average tangible equity. These assessments will continue until the debt matures between 2017 and 2019.

The FDIC also may prohibit any insured institution from engaging in any activity that it determines by regulation or order to pose a serious risk to the deposit insurance fund and may terminate our deposit insurance if it determines we have engaged in unsafe or unsound practices or are in an unsafe or unsound condition.

Heritage

 As the holding company of a Georgia savings bank, Heritage is subject to regulation and periodic examination by the GDBF and the FRB.  This regulation extends to all aspects of its operations.  Our federal and state regulators impose minimum capital requirements on us and the other holding companies and financial institutions they regulate.  They also may impose higher capital requirements on an individualized basis if they believe the financial institution or holding company is subject to excessive risk.  See “Regulatory Capital Requirements for HeritageBank” and “Limitations on Dividends and Other Capital Distributions” below.

Heritage is subject to regulation, supervision and examination by the FRB.  Applicable federal law and regulations limit the activities of Heritage and require the approval of the FRB for any acquisition or divestiture of a subsidiary, including another financial institution or holding company thereof.  The Bank is required to file reports with the FRB and is subject to regulation and examination by the FRB, including regulations requiring that the Company serve as a source of financial and managerial strength for the Bank, particularly when the Bank is in financial distress.

Under federal law, if HeritageBank fails the qualified thrift lender test, Heritage must obtain the approval of the FRB prior to continuing, directly or through other subsidiaries, any business activity other than those approved for multiple savings association holding companies or their subsidiaries.  In addition, within one year of such failure, Heritage must register as, and will become subject to, the restrictions applicable to bank holding companies.  The qualified thrift lender test requires a savings institution to have at least 65% of its portfolio assets, as defined by regulation, in qualified thrift investments on a monthly average for nine out of every 12 months on a rolling basis.  As an alternative, the savings institution may maintain 60% of its assets in those assets specified in Section 7701(a)(19) of the Internal Revenue Code.  Under either test, such assets primarily consist of residential housing related loans and investments.  At December 31, 2012, HeritageBank met the test.

The GDBF also has supervisory and examination authority over Heritage.  Under this authority, there are limits on the amount of debt that can be incurred by Heritage, and Heritage must file periodic reports and annual registration forms.

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Regulatory Capital Requirements for HeritageBank.

HeritageBank is required to maintain minimum levels of regulatory capital under regulations of the FDIC and polices of the GDBF.  These regulations established two capital standards, a leverage capital requirement and a risk-based capital requirement.  The FDIC also may impose capital requirements in excess of these standards on individual institutions on a case-by-case basis based on the particular circumstances or risk profile of the institution.  See Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operation – Capital Resources for information on the Bank’s compliance with these capital requirements.

The capital standards generally require Tier 1 capital equal to at least 4.0% of adjusted total assets, deducting most intangibles.  The FDIC also requires HeritageBank to have Tier 1 capital of at least 4.0% of risk weighted-assets and total capital of at least 8.0% of risk-weighted assets.  In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet items, will be multiplied by a risk weight, ranging from 0% to 100%, based on the risk inherent in the type of asset.   Total capital consists of Tier 1 capital, as defined above, and Tier 2 capital, which consists of certain permanent and maturing capital instruments that do not qualify as Tier 1 capital and of the allowance for possible loan and lease losses up to a maximum of 1.25% of risk-weighted assets.  Tier 2 capital may be used to satisfy these risk-based requirements only to the extent of Tier 1 capital.  The FDIC is authorized to require HeritageBank to maintain an additional amount of total capital to account for concentration of credit risk, level of interest rate risk, equity investments in non-financial companies and the risk of non-traditional activities.

The FDIC is authorized and, under certain circumstances, required to take certain actions against banks that fail to meet their capital requirements.  The FDIC is generally required to take action to restrict the activities of an “undercapitalized institution," which is an institution with less than either a 4% leverage capital ratio, a 4% Tier 1 risked-based capital ratio or an 8% total risk-based capital ratio.  Any such institution must submit a capital restoration plan and until such plan is approved by the FDIC may not increase its assets, acquire another institution, establish a branch or engage in any new activities, and generally may not make capital distributions.  The FDIC is authorized to impose the additional restrictions.

Any institution that fails to comply with its capital plan or has Tier 1 risk-based or leverage capital ratios of less than 3% or a total risk-based capital ratio of less than 6% is considered "significantly undercapitalized" and must be made subject to one or more additional specified actions and operating restrictions that may cover all aspects of its operations and may include a forced merger or acquisition of the institution.  An institution with tangible equity to total assets of less than 2% is "critically undercapitalized" and becomes subject to further mandatory restrictions on it.  The FDIC generally is authorized to reclassify an institution into a lower capital category and impose the restrictions applicable to such category if the institution is engaged in unsafe or unsound practices or is in an unsafe or unsound condition.

The imposition by the FDICof any of these measures on HeritageBank may have a substantial adverse effect on our operations and profitability.

Georgia imposes a capital requirement based on the leverage capital requirement of the FDIC.  A Georgia savings bank must have at least a 4.5% leverage capital ratio, though the GDBF can impose a higher requirement for the specific circumstances and risks of the institution.  Many banks are required to have a 5.5% ratio to address these specific circumstances and risks, and any bank with a less than 5.5% leverage capital ratio must submit a two-year capital plan with the GDBF.

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Regulatory Capital Requirements for Heritage.  Heritage is required to maintain a certain level of capital under a policy of the GDBF that imposes a Tier 1 capital to total assets capital ratio of 4%, or higher for holding companies engaged in more risky, non-financial businesses.  This level is based on the capital requirement imposed on bank holding companies by the FRB and is similar to the Tier 1 leverage ratio imposed on HeritageBank.  If Heritage fails to meet this requirement, it must file a capital plan and focus on reducing its more risky operations, and it may be subject to an enforcement action, including a capital directive.

Limitations on Dividends and Other Capital Distributions

The ability of the Bank to pay dividends depends on its earnings and capital levels and may be limited by FDIC or GDBF directives or orders.  Unless it meets certain financial criteria, HeritageBank must obtain the prior written approval of the GDBF before paying any dividend to Heritage.  Those financial criteria are having: (1) classified assets of no more than 80% of Tier 1 capital plus an allowance for loan losses at the time of its last examination; (2) paid no more than 50% of last calendar year's net income in dividends in the current calendar year, and (3) a Tier 1 leverage capital ratio of at least 6%.  Georgia law prohibits HeritageBank from paying a dividend if its debt to equity ratio is 30% or more or if it is not meeting its capital requirement.   HeritageBank paid $2.2 million in dividends in 2012 and no dividends in 2011.

As a subsidiary financial institution of a savings association holding company, any distributions of capital by Heritage, including dividends and stock redemptions or repurchases, are subject to regulation by the FRB.  Heritage must file a notice with the FRB before declaring any dividend.  The FRB will consult the FDIC about the appropriateness of the proposed dividend, and the FRB may object to any proposed dividend.

Restrictions on Transactions with Affiliates

Heritage and HeritageBank are subject to the provisions of Section 23A of the Federal Reserve Act. Section 23A places limits on the amount of:

· a bank’s loans or extensions of credit to affiliates;

· a bank’s investment in affiliates;

· assets a bank may purchase from affiliates, except for real and personal property exempted by the FRB;

· loans or extensions of credit made by a bank to third parties collateralized by the securities or obligations of affiliates; and

· a bank’s guarantee, acceptance or letter of credit issued on behalf of an affiliate.

The total amount of the above transactions is limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank’s capital and surplus.  In addition to the limitation on the amount of these transactions, each of the above transactions must also meet specified collateral requirements.  HeritageBank must also comply with other provisions designed to avoid taking low-quality assets.

Heritage and HeritageBank are also subject to the provisions of Section 23B of the Federal Reserve Act, which, among other things, prohibit an institution from engaging in the above transactions with affiliates unless the transactions are on terms substantially the same, or at least as favorable to the institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

The Dodd-Frank Act enhances the requirements for certain transactions with affiliates under Section 23A and 23B, including an expansion of the definition of “covered transactions” and increasing the amount of time for which collateral requirements regarding covered transactions must be maintained.

HeritageBank is also subject to restrictions on extensions of credit to its executive officers, directors, principal shareholders and their related interests.  These extensions of credit (1) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with third parties, and (2) must not involve more than the normal risk of repayment or present other unfavorable features. Effective July 21, 2011, an insured depository institution is prohibited from engaging in asset purchases or sales transactions with its officers, directors or principal shareholders unless on market terms and, if the transaction represents greater than 10% of the capital and surplus of the bank, it has been approved by a majority of the disinterested directors.

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The Dodd-Frank Act

The Dodd-Frank Act, which was enacted in July 2010, has had a broad impact on the financial services industry.  Its provisions include significant regulatory and compliance changes that are designed to improve the supervision, oversight, safety and soundness of the financial services sector.  Additionally, the Dodd-Frank Act establishes a new framework for systemic risk oversight within the financial system to be distributed among new and existing federal regulatory agencies, including the Financial Stability Oversight Council, the FRB, the Office of the Comptroller of the Currency and the FDIC.

Some of the Dodd-Frank Act’s most far-reaching provisions, such as those regulating derivatives and proprietary trading activity and hedge funds, providing for enhanced supervision of “systemically significant” institutions,  and phasing out Tier 1 capital treatment for trust preferred securities, apply only to institutions with over $10 billion in assets or to business lines in which we do not engage.  Certain provisions do, however, apply to or affect us, including provisions that:

· Change the assessment base for federal deposit insurance from a deposit-based to an asset-based calculation as described in “—Insurance of Accounts and Regulation by the FDIC” above;

· Make permanent the $250,000 limit for federal deposit insurance;

· Repeal the federal prohibition on payment of interest on demand deposits;

· Impose new mortgage lending requirements, including minimum underwriting standards, originator compensation restrictions, consumer protections for certain types of loans, and disclosure to borrowers;

· Apply to bank holding companies the same leverage and risk-based capital requirements that apply to insured depository institutions;

· Permit de novo and interstate branching; and

· Impose new limits on affiliate transactions as described in “—Restrictions on Transactions with Affiliates” above.

Basel III

In June 2012, federal regulators issued proposed rules to implement the capital adequacy recommendations of the Basel Committee on Banking Supervision first proposed in December 2010.  The proposed rules, known as “Basel III,” propose significant changes to the minimum capital levels and asset risk-weights for all depository institutions and depository institution holding companies (collectively, “banking organizations”) with total consolidated assets of $500 million or more.   Among the many changes in these proposed rules, banking organizations would be required to hold higher levels of capital, a significantly higher portion of which would be required to be Tier 1 capital.

Further, beginning in 2016, the ability of banking organizations to declare and pay dividends or pay discretionary bonuses to certain executive officers would become limited should the banking organization fail to maintain a “capital conservation buffer” composed of Tier 1 common equity that is 2.5% greater than applicable minimum capital requirements.  The proposed Basel III rules would also impose significant changes on the risk-weighting of many assets, including home mortgages with high loan to value ratios, certain acquisition, development and construction loans, and certain past due assets.  Finally, the proposed rules would also prevent trust preferred securities from counting as Tier 1 capital for the issuer following a ten-year phase out ending in 2022.   The final rule was expected to become effective on January 1, 2013; however, due to the volume and content of public comments received, the federal regulators announced on November 9, 2012 that the final rule would not be in effect on January 1, 2013.

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Federal Taxation

Heritage and HeritageBank are subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below.  The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to Heritage or HeritageBank.

Heritage will file a consolidated federal income tax return with HeritageBank.  Accordingly, it is anticipated that any cash distributions made by Heritage to its stockholders would be considered to be taxable dividends and not as a nontaxable return of capital to stockholders for federal and state tax purposes.

Method of Accounting.  For federal income tax purposes, HeritageBank currently reports its income and expenses on the accrual method of accounting and uses a fiscal year ending on December 31 for filing its federal income tax return.

Minimum Tax.  The Internal Revenue Code imposes an alternative minimum tax at a rate of 20% on a base of regular taxable income plus certain tax preferences, called alternative minimum taxable income.  The alternative minimum tax is payable to the extent such alternative minimum taxable income is in excess of an exemption amount.  Net operating losses can offset no more than 90% of alternative minimum taxable income.  Certain payments of alternative minimum tax may be used as credits against regular tax liabilities in future years.

Net Operating Loss Carryforwards.  A financial institution may carryback net operating losses to the preceding two taxable years and forward to the succeeding 20 taxable years.  This provision applies to losses incurred in taxable years beginning after August 6, 1997.  At December 31, 2012, Heritage had no net operating loss carryforwards for federal income tax purposes.

Corporate Dividends-Received Deduction.  Because it files a consolidated return with its wholly owned subsidiary, HeritageBank, dividends from HeritageBank are not included as income to Heritage.  The corporate dividends-received deduction is 100%, or 80% in the case of dividends received from corporations with which a corporate recipient does not file a consolidated tax return, depending on the level of stock ownership of the payor of the dividend.  Corporations that own less than 20% of the stock of a corporation distributing a dividend may deduct 70% of dividends received or accrued on their behalf.

State Taxation

Heritage and HeritageBank are subject to Georgia, Florida, and Alabama corporate income tax, which is assessed at the rate of 6% for Georgia and Florida and 6.5% for Alabama.  For this purpose, taxable income generally means federal taxable income subject to certain modifications provided for in Georgia, Florida, and Alabama law.  Heritage and HeritageBank also are subject to Georgia business occupation taxes computed on gross receipts after deducting exempt income and interest paid on deposits and other liabilities.  The tax rates assessed vary from one municipality to another.  The total occupation taxes expensed in 2012 was $292,000.

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Item 1A.   Risk Factors

The following are certain risk factors that could impact our business, financial results, and results of operations.  Investing in our common stock involves risks, including those described below.  These risk factors should be considered by prospective and current investors in our common stock when evaluating the disclosures in this Annual Report on Form 10-K (particularly the forward-looking statements).  These risk factors could cause actual results and conditions to differ materially from those projected in forward-looking statements.  If any of the events in the following risks actually occur, or if additional risks and uncertainties not presently known to us or that we believe are immaterial do materialize, then our business, financial condition or results of operations could be materially adversely impacted.  In addition, the trading price of our common stock could decline due to any of the events described in these risks.

The United States economy has been gradually improving but unemployment is still elevated, and another economic downturn impacting our geographic market areas would adversely affect our business and financial results.

The United States experienced a severe economic recession beginning in 2008 and many of the effects of that recession are expected to continue in 2013.  While economic growth has resumed recently, the rate of growth has been slow and unemployment remains at very high levels and is not expected to improve greatly in the near future.  Furthermore, our primary market areas in southern Georgia and northern and central Florida have experienced unemployment rates higher than the national average.  Loan portfolio quality has deteriorated at many financial institutions reflecting, in part, the weak U.S. economy and high unemployment.  In addition, the values of real estate collateral supporting many commercial loans and home mortgages have declined and may continue to decline.  The continuing real estate downturn also has resulted in reduced demand for the construction of new housing and increased delinquencies in construction, residential and commercial mortgage loans for many lenders.  Stock prices for financial institutions and their holding companies have declined substantially, and it is significantly more difficult for those entities to raise capital or borrow in the debt markets.

Continued negative developments in the financial services industry and the domestic and international credit markets may significantly affect the markets in which we do business, the market for and value of our loans and investments, and our ongoing operations, costs and profitability.  Moreover, continued declines in the stock market in general, or in stock values of financial institutions and their holding companies specifically, could adversely affect our stock performance.

Our expansion efforts, particularly through new and acquired branches, may not be successful if we fail to manage our growth effectively.

A key component of our strategy to grow and improve profitability is to expand our branch network into communities within or adjacent to Georgia, Florida and Alabama markets in which we currently conduct business.  In June 2012, we acquired a branch in Auburn, Alabama from AB&T National Bank.  We intend to continue to pursue a growth strategy for our business.  Operating branches outside of our original southwest Georgia market and beyond our current market areas may subject us to additional risk, including the local risks related to the new market areas, management of employees from a distance, additional credit risks, logistical operational issues and management time constraints.

We regularly evaluate potential acquisitions and expansion opportunities, and, if appropriate opportunities present themselves, we expect to engage in selected acquisitions of financial institutions in the future, including FDIC-assisted transactions, branch acquisitions, or other business growth initiatives or undertakings.  There can be no assurance that we will successfully identify appropriate opportunities, that we will be able to negotiate or finance such activities or that such activities, if undertaken, will be successful.  We can provide no assurance that we will be able to manage the costs and implementation risks associated with this strategy so that expansion of our branch network will be profitable.  In addition, if we were to conclude that the value of an acquired business had decreased and that the related goodwill had been impaired, that conclusion would result in an impairment of goodwill charge to us, which would adversely affect our results of operations.

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We have engaged in three FDIC-assisted transactions with two subject to loss-sharing agreements and may engage in more such transactions in the future, which could present additional risks to our financial condition and earnings.

We have engaged in three FDIC-assisted acquisitions with two subject to loss-sharing agreements.  These acquisitions involve risks similar to acquiring existing banks, even though the FDIC might provide assistance to mitigate certain risks, such as sharing in exposure to loan losses and providing indemnification against certain liabilities of the failed institution.  As is typical in the acquisition of a failed financial institution, many of the loans acquired in these acquisitions were non-performing and had poor documentation, including a lack of current financial information on borrowers and of current evidence of collateral value.

 In December 2009, we acquired a failed bank in southeast Georgia in an FDIC-assisted transaction, including $37.5 million in loans.  This FDIC-assisted transaction did not involve a loss-share agreement pursuant to which the FDIC covers portions of the losses incurred or the assets acquired.  We did, however, receive a $15.0 million purchase discount paid by the FDIC.   These loans are carried on our books at fair value, based on an estimate of future cash flows, which we review and evaluate quarterly and, under GAAP.  Because of the condition and terms of these loans, the actual amount recognized by us on these assets could differ materially from this fair value, and we also anticipate incurring foreclosure and collection expenses on certain of these loans over the next five years, which will increase our non-interest expense.  Therefore, we may incur losses on this acquired loan portfolio.

In February 2011, we acquired a failed bank in east Georgia with $131.3 million in loans, and in August 2011, we acquired a failed bank in southeast Georgia with $99.2 million in loans.  In each of these transactions, we entered into a loss-share agreement under which the FDIC will reimburse us for 80% of the losses on covered loans and other real estate owned.  These loss-share agreements require us to follow specific servicing and reporting procedures.  Failure to properly follow these procedures or other breach of the loss-share agreements by us could result in the loss of the FDIC reimbursement of losses on covered loans and other real estate owned, which could have a material negative effect on our financial condition and results of operations.

At December 31, 2012, we had an FDIC loss-share receivable of $60.7 million associated with our loss-sharing agreements with the FDIC.  This receivable is periodically adjusted to reflect the present value of our expected losses related to FDIC-assisted acquisitions plus reimbursable expenses less recoveries.  The receivable is adjusted for improvements in cash flow by reducing the receivable through negative accretion.  Conversely, if losses are greater than anticipated, the receivable would be increased.

In the current economic environment, we expect to be presented with more opportunities to acquire the assets and liabilities of failed banks through FDIC-assisted transactions.  However, these acquisitions are structured in a manner that does not allow us the time normally associated with preparing for and evaluating an acquisition, including preparing for integration of an acquired institution.  Therefore, we may face additional risks, including the loss of customers, strain on management resources related to collection and management of problem loans and problems related to integration of personnel and operating systems.  We cannot assure that we will be successful in overcoming these risks or any other problems encountered in connection with FDIC-assisted transactions.  Our inability to overcome these risks could have an adverse effect on our ability to achieve our business strategy and maintain our market value and profitability.  Moreover, even though we are inclined to participate in an FDIC-assisted transaction, we can offer no assurances that we would be successful in acquiring the financial institution or assets that we are seeking.

Changes in national and local economic conditions could lead to higher than anticipated loan charge-offs on assets acquired in FDIC-assisted transactions.

The fluctuations in national, regional and local economic conditions, including those related to local residential, commercial real estate and construction markets, may increase the level of charge-offs that we make to our loan portfolio, and, consequently, reduce our net income, and may also increase the level of charge-offs on the loan portfolios that we have acquired in FDIC-assisted acquisitions and correspondingly reduce our net income. These fluctuations are not predictable, cannot be controlled and may have a material adverse impact on our operations and financial condition even if other favorable events occur.

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Although we have entered into two loss-share agreements with the FDIC providing a significant portion of losses related to specified loan portfolios that we acquired in connection with our two 2011 FDIC-assisted transactions will be borne by the FDIC, we are not protected for all losses resulting from charge-offs with respect to those specified loan portfolios. Additionally, the loss-share agreements have limited terms; therefore, any charge-off of related losses that we experience after the term of the loss-sharing agreements will not be reimbursable by the FDIC and will negatively impact our net income.

Our business may be affected adversely by credit risk associated with residential real estate.

As of December 31, 2012, residential real estate, including home equity loans and lines of credit, totaled $189.2 million, or 28.2%, of total loans.  This type of lending is generally sensitive to regional and local economic conditions that may significantly affect the ability of borrowers to meet their loan payment obligations, making loss levels difficult to predict.  The decline in residential real estate values resulting from the downturn in local housing markets has reduced the value of the real estate collateral securing the majority of our loans and has increased the risk that we would incur losses if borrowers default on their loans.  In addition, borrowers seeking to sell their homes may find that they cannot sell their properties for an amount equal to or greater than the unpaid principal balance of their loans.  Continued declines in both the volume of real estate sales and sales prices, coupled with high levels of unemployment, may result in higher loan delinquencies or problem assets, a decline in demand for our products and services or a decrease in our deposits.  These potential negative events may cause us to incur losses, which would adversely affect our capital and liquidity and could damage our financial condition and business operations.  These declines may have a greater impact on our earnings and capital than on the earnings and capital of financial institutions that have more diversified loan portfolios.

We are subject to credit risks in connection with the concentration of adjustable rate loans in our portfolio.

Adjustable rate loans totaled $129.7 million, or 19.4%, of our loan portfolio at December 31, 2012.  Borrowers with adjustable rate loans are exposed to increased monthly payments when the related interest rate adjusts upward under the terms of the loan to the rate computed in accordance with the applicable index and margin.  Any rise in prevailing market interest rates may result in increased payments for borrowers who have adjustable-rate loans, increasing the possibility of default.  Borrowers seeking to avoid these increased monthly payments by refinancing their loans may no longer be able to find available replacement loans at comparably lower interest rates.  In addition, declining housing prices may prevent refinancing or a sale of the home because borrowers may then have insufficient equity in their homes.  These events, alone or in combination, may contribute to higher delinquency rates and negatively impact our earnings.

If our nonperforming assets increase, our earnings will be negatively impacted.

At December 31, 2012, our nonperforming assets (which consist of non-accrual loans, loans 90 days or more delinquent, nonperforming troubled debt restructurings and foreclosed real estate assets) totaled $17.3 million, which was an increase of $6.9 million or 66.3% over nonperforming assets at December 31, 2011.  Our nonperforming assets adversely affect our net income in various ways.  We do not record interest income on non-accrual loans or real estate owned.  We must reserve for estimated credit losses, which are established through a current period charge to the provision for loan losses, and from time to time, if appropriate, we must write down the value of properties in our other real estate owned portfolio to reflect changing market values.  Additionally, there are legal fees associated with the resolution of problem assets as well as carrying costs including taxes, insurance and maintenance related to our other real estate owned.  Further, the resolution of nonperforming assets requires the active involvement of management, potentially distracting them from the overall supervision of our operations and other income-producing activities.

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If our allowance for loan losses is not sufficient to cover actual loan losses, our earnings could decrease.

We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans.  In determining the amount of the allowance for loan losses, we review our loans and our loss and delinquency experience, and we evaluate economic conditions.  Management recognizes that significant new growth in loan portfolios, new loan products, and the refinancing of existing loans can result in portfolios comprised of unseasoned loans that may not perform in a historical or projected manner.  If our assumptions are incorrect, our allowance for loan losses may not be sufficient to cover actual losses, resulting in additions to our allowance.  Additions to our allowance decrease our net income.  Our allowance for loan losses, excluding loans acquired through FDIC-assisted acquisitions, was 1.55% of gross loans, excluding loans acquired through FDIC-assisted acquisitions, and 61.7% of non-performing loans at December 31, 2012, compared to 1.72% of gross loans, excluding loans acquired through FDIC-assisted acquisitions, and 106.4% of nonperforming loans at December 31, 2011.

 Our emphasis on originating commercial and residential real estate and commercial and industrial loans is one of the more significant factors in evaluating the allowance for loan losses.  As we continue to increase our originations of these loans, increased provisions for loan losses may be necessary, resulting in decreased earnings.

Our regulators and external auditor periodically review our allowance for loan losses and may require us to recognize additions to the allowance based on their judgments about information available to them at the time of their review.  These increases in our allowance for loan losses or loan charge-offs may have a material adverse effect on our financial condition and results of operations.

If our investments in real estate are not properly valued or sufficiently reserved to cover actual losses, or if we are required to increase our valuation reserves, our earnings could be reduced.

We obtain updated valuations in the form of appraisals and broker price opinions when a loan has been foreclosed and the property taken in as other real estate owned (“OREO”), and at certain other times during the asset’s holding period.  Our net book value (“NBV”) in the loan at the time of foreclosure and thereafter is compared to the updated market value of the foreclosed property less estimated selling costs (fair value).  A charge-off is recorded for any excess in the asset’s NBV over its fair value.  If our valuation process is incorrect, the fair value of our investments in real estate may not be sufficient to recover our NBV in such assets, resulting in the need for additional charge-offs.  Additional material charge-offs to our investments in real estate could have a material adverse effect on our financial condition and results of operations.  Our bank regulator periodically reviews our REO and may require us to recognize further charge-offs.  Any increase in our charge-offs, as required by our regulator, may have a material adverse effect on our financial condition and results of operations.

Our securities portfolio may be negatively impacted by fluctuations in market value and interest rates, which may have an adverse effect on our financial condition.

Our securities portfolio may be impacted by fluctuations in market value, potentially reducing accumulated other comprehensive income and/or earnings.  Fluctuations in market value may be caused by decreases in interest rates, lower market prices for securities and limited investor demand.  Our securities portfolio is evaluated for other-than-temporary impairment on at least a quarterly basis.  If this evaluation shows impairment to the actual or projected cash flows associated with one or more securities, a potential loss to earnings may occur.  Changes in interest rates can have an adverse effect on our financial condition, as our available-for-sale securities are reported at their estimated fair value, and therefore are impacted by fluctuations in interest rates.  We increase or decrease our stockholders’ equity by the amount of change in the estimated fair value of the available-for-sale securities, net of taxes.  At December 31, 2012, the net unrealized gain on securities available for sale was $2.1 million compared to a net unrealized gain of $2.4 million at December 31, 2011.

Changes in interest rates could adversely affect our results of operations and financial condition.

Our results of operations and financial condition are affected significantly by changes in interest rates.  Our results of operations depend substantially on our net interest income, which is the difference between the interest income we earn on our interest-earning assets, such as loans and securities, and the interest expense we pay on our interest-bearing liabilities, such as deposits and borrowings.  Because interest-bearing liabilities generally reprice or mature more quickly than interest-earning assets, an increase in interest rates generally would tend to result in a decrease in net interest income.

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Changes in interest rates may affect the average life of loans and mortgage-related securities.  Decreases in interest rates can result in increased prepayments of loans and mortgage-related securities, as borrowers refinance to reduce their borrowing costs.  Under these circumstances, we are subject to reinvestment risk to the extent that we are unable to reinvest the cash received from such prepayments at rates that are comparable to the rates on existing loans and securities.  Additionally, increases in interest rates may decrease loan demand and make it more difficult for borrowers to repay adjustable-rate loans.  Also, increases in interest rates may extend the life of fixed-rate assets, which would limit the funds we have available to reinvest in higher-yielding alternatives, and may result in customers withdrawing certificates of deposit early so long as the early withdrawal penalty is less than the interest they could receive as a result of the higher interest rates.

Changes in interest rates also affect the current fair value of our interest-earning securities portfolio.  Generally, the value of securities moves inversely with changes in interest rates.  At December 31, 2012, the fair value of our portfolio of available-for-sale securities totaled $221.4 million.  Gross unrealized gains on these securities totaled $2.9 million, while gross unrealized losses on these securities totaled $864,000, resulting in a net unrealized gain of $2.1 million at December 31, 2012.

At December 31, 2012, the Company’s internal simulation model indicated that our net portfolio value would decrease by 5.5% if there was an instantaneous parallel 200 basis point increase in market interest rates.  See the Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management and Market Risk.

Our strategies to modify our interest rate risk profile may be difficult to implement.

Our asset/liability management strategies are designed to decrease our interest rate risk sensitivity.  One such strategy is increasing the amount of adjustable rate and/or short-term assets.  We offer adjustable rate loan products as a means to achieve this strategy.  The availability of lower rates on fixed-rate loans would generally create a decrease in borrower demand for adjustable rate assets.  Additionally, these adjustable-rate assets may prepay.  At December 31, 2012, 19.4% of our loan portfolio consisted of adjustable-rate loans, compared to 19.1% at December 31, 2011.

We also are managing our liabilities to moderate our interest rate risk sensitivity.  Customer demand is primarily for short-term certificates of deposit.  Using short-term liabilities to fund long-term, fixed-rate assets will increase the interest rate sensitivity of any financial institution.  We are utilizing FHLB advances and repurchase agreements to mitigate the impact of customer demand by lengthening the maturities of these advances or entering into longer term repurchase agreements, depending on liquidity or investment opportunities.

FHLB advances and repurchase agreements are entered into as liquidity is needed or to fund assets that provide for a spread considered sufficient by management.  If we are unable to originate adjustable rate assets at favorable rates or fund loan originations or securities purchases with long-term advances or structured borrowings, we may have difficulty executing this asset/liability management strategy and/or it may result in a reduction in profitability.

We face risks related to covenants in our loan sales to investors and secondary mortgage market conditions.

Our agreements with investors to sell our loans generally contain covenants that require us to repurchase loans under certain circumstances, including some delinquencies, or to return premiums paid by those investors if the loans are paid off early.  If we are required to repurchase sold loans under these covenants, they may be deemed troubled loans, with the potential for charge-offs and/or loss provision changes, which could impact our earnings and asset quality ratios adversely.  We did not incur any losses in conjunction with these agreements in 2012.

Our ability to sell loans on the secondary mortgage market is impacted by interest rate changes and investor demand or expected return.  If this market becomes less liquid, we may not be able to rely as much on loan sales to reduce our interest rate and credit risk.

We face significant operational risks.

We operate in many different financial service businesses and rely on the ability of our employees and systems to process a significant number of transactions.  Operational risk is the risk of loss from operations, including fraud by employees or outside persons, employees’ execution of incorrect or unauthorized transactions, data processing and technology errors or hacking and breaches of internal control systems.

38

A tightening of credit markets and liquidity risk could impair our ability to fund operations and jeopardize our financial condition.

Liquidity is essential to our business.  A tightening of the credit markets and the inability to obtain adequate funding to replace deposits and fund continued loan growth may affect asset growth, our earnings capability and capital levels negatively.We rely on a number of different sources in order to meet our potential liquidity demands.  Our primary sources of liquidity are increases in deposit accounts, including brokered deposits, as well as cash flows from loan payments and our securities portfolio.  The expiration of unlimited insurance coverage for noninterest bearing demand transaction accounts on December 31, 2012 may result in a run-off in such accounts to the extent that such accounts contain in excess of the $250,000 per depositor insurance coverage limit.  Borrowings, especially from the FHLB and repurchase agreements, also provide us with a source of funds to meet liquidity demands.  An inability to raise funds through deposits, borrowings, the sale of loans, and other sources could have a substantial negative effect on our liquidity.

Our access to funding sources in amounts adequate to finance our activities or on terms that are acceptable to us could be impaired by factors that affect us specifically, or the financial services industry or economy in general.  Factors that could detrimentally impact our access to liquidity sources include adverse regulatory action against us or a decrease in the level of our business activity as a result of a downturn in the markets in which our loans are concentrated.  Our ability to borrow also could be impaired by factors that are not specific to us, such as a disruption in the financial markets, negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations, or continued deterioration in credit markets.

We may elect or be compelled to seek additional capital in the future, but that capital may not be available when it is needed.

We are required by federal regulatory authorities to maintain adequate levels of capital to support our operations.  Should we be required by regulatory authorities to raise additional capital, we may seek to do so through the issuance of, among other things, our common stock or preferred stock.  The issuance of additional shares of common stock or convertible securities to new stockholders would be dilutive to our current stockholders.

Our ability to raise additional capital, if needed, will depend on conditions in the capital markets, economic conditions, our financial performance, and a number of other factors, many of which are outside our control.  Accordingly, we cannot assure our ability to raise additional capital if needed or on terms acceptable to us. If we cannot raise additional capital when needed, it may have a material adverse effect on our financial condition, results of operations and prospects.

There may be future sales of additional common stock or preferred stock or other dilution of our equity, which may adversely affect the market price of our common stock.

We are not restricted from issuing additional common stock or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities.  The market value of our common stock could decline as a result of sales by us of a large number of shares of common stock or preferred stock or similar securities in the market or the perception that such sales could occur.

Our Board of Directors is authorized to issue additional common stock, as well as classes or series of preferred stock, generally without any action on the part of the stockholders.  In addition, the board has the power, generally without stockholder approval, to set the terms of any such classes or series of preferred stock that may be issued, including voting rights, dividend rights, and preferences over the common stock with respect to dividends or upon the liquidation, dissolution, or winding-up of our business and other terms.  If we issue preferred stock in the future that has a preference over the common stock with respect to the payment of dividends or upon liquidation, dissolution or winding-up, or if we issue preferred stock with voting rights that dilute the voting power of the common stock, the rights of holders of the common stock or the market value of the common stock could be adversely affected.

39

Anti-takeover provisions could negatively impact our stockholders.

Provisions in our charter and bylaws, the corporate law of the State of Maryland and federal regulations could delay, defer or prevent a third party from acquiring us, despite the possible benefit to our stockholders, or otherwise adversely affect the market price of any class of our equity securities, including our common stock.  These provisions include: a prohibition on voting shares of common stock beneficially owned in excess of 10% of total shares outstanding, supermajority voting requirements for certain business combinations with any person who beneficially owns more than 10% of our outstanding common stock; the election of directors to staggered terms of three years; advance notice requirements for nominations for election to our Board of Directors; and for proposing matters that stockholders may act on at stockholder meetings, a requirement that only directors may fill a vacancy in our Board of Directors, supermajority voting requirements to remove any of our directors and the other provisions of our charter.  Our charter also authorizes our Board of Directors to issue preferred stock, and preferred stock could be issued as a defensive measure in response to a takeover proposal.  In addition, pursuant to federal and state laws and regulations, as a general matter, no person or company, acting individually or in concert with others, may acquire more than 10% of our common stock without prior approval from our regulators.

These provisions may discourage potential takeover attempts, discourage bids for our common stock at a premium over market price or adversely affect the market price of, and the voting and other rights of the holders of, our common stock.  These provisions could also discourage proxy contests and make it more difficult for holders of our common stock to elect directors other than the candidates nominated by our Board of Directors.

The voting limitation provision in our charter could limit your voting rights as a holder of our common stock.

Our charter provides that any person or group who acquires beneficial ownership of our common stock in excess of 10% of the outstanding shares may not vote the excess shares.  Accordingly, if you acquire beneficial ownership of more than 10% of the outstanding shares of our common stock, your voting rights with respect to the common stock will not be commensurate with your economic interest in our company.

We currently hold a significant amount of bank-owned life insurance.

At December 31, 2012, we held $62.5 million of bank-owned life insurance (“BOLI”) on key employees and executives, with a cash surrender value of $23.4 million.  The policies are maintained to fund amounts owed under executive supplemental retirement plans.  The eventual repayment of the cash surrender value is subject to the ability of the various insurance companies to pay death benefits or to return the cash surrender value to us if needed for liquidity purposes.  We continually monitor the financial strength of the various companies with whom we carry these policies.  However, any one of these companies could experience a decline in financial strength, which could impair its ability to pay benefits or return our cash surrender value.  If we need to liquidate these policies for liquidity purposes, we would be subject to taxation on the increase in cash surrender value and penalties for early termination, both of which would adversely impact earnings.

If our investment in the FHLB becomes impaired, our earnings and stockholders’ equity could decrease.

At December 31, 2012, we owned $4.3 million in FHLB stock.  We are required to own this stock to be a member of and to obtain advances from our FHLB.  This stock is not marketable and can only be redeemed by our FHLB.  Our FHLB’s financial condition is linked, in part, to the eleven other members of the FHLB System and to accounting rules and asset quality risks that could materially lower their capital, which would cause our FHLB stock to be deemed impaired, resulting in a decrease in our earnings and assets.

40

Changes in laws and regulations and the cost of regulatory compliance with new laws and regulations may adversely affect our operations and our income.

The Bank and the Company are subject to extensive regulation, supervision, and examination by federal and state regulators, which have extensive discretion in connection with its supervisory and enforcement activities, including the ability to impose restrictions on a bank’s operations, reclassify assets, determine the adequacy of a bank’s allowance for loan losses and determine the level of deposit insurance premiums assessed.  Because our business is highly regulated, the laws and applicable regulations are subject to frequent change.  Any change in these regulations and oversight, whether in the form of regulatory policy, new regulations, or legislation or additional deposit insurance premiums could have a material impact on our operations.

In response to the recent financial crisis, Congress took actions that are intended to strengthen confidence and encourage liquidity in financial institutions, and the FDIC has taken actions to increase insurance coverage on deposit accounts.  The recently enacted Dodd-Frank Act provides for the creation of the CFPB, which has broad authority to issue regulations governing the services and products we provide consumers.  This additional regulation could increase our compliance costs and otherwise adversely impact our operations.  That legislation also contains provisions that, over time, could result in higher regulatory capital requirements and loan loss provisions for the Company and the Bank and may increase interest expense due to the ability to pay interest on all demand deposits.  The potential exists for additional federal or state laws and regulations, or changes in policy, affecting lending and funding practices and liquidity standards.  See “How We Are Regulated.”

In this recent economic downturn, federal and state banking regulators have been active in responding to concerns and trends identified in examinations and have issued many formal enforcement orders requiring capital ratios in excess of regulatory requirements.  The FDIC and GDBF govern the activities in which the Bank may engage, primarily for the protection of depositors and not for the protection or benefit of stockholders.  In addition, new laws and regulations may increase our costs of regulatory compliance and of doing business and otherwise affect our operations.  New laws and regulations may significantly affect the markets in which we do business, the markets for and value of our loans and investments, the fees we can charge and our ongoing operations, costs, and profitability.

Increases in deposit insurance premiums and special FDIC assessments could negatively impact our earnings.

Our deposits are insured up to applicable limits by the Deposit Insurance Fund of the FDIC and are subject to deposit insurance assessments to maintain deposit insurance.  As an FDIC-insured institution, we are required to pay quarterly deposit insurance premium assessments to the FDIC. Although we cannot predict what the insurance assessment rates will be in the future, either deterioration in our risk-based capital ratios or adjustments to the base assessment rates could have a material adverse impact on our business, financial condition, results of operations, and cash flows.  See “How we are Regulated” and “HeritageBank of the South - Insurance of Accounts and Regulation by the FDIC.”

Strong competition within our market areas may limit our growth and profitability.

Competition in the banking and financial services industry is intense.  We compete with numerous commercial banks, savings institutions, mortgage brokerage firms, credit unions, finance companies, mutual funds, insurance companies, securities brokers, and investment banking firms operating locally and elsewhere.  Many of our competitors have substantially greater resources and lending limits than we have, have greater name recognition and market presence that benefit them in attracting business, and offer certain services that we do not or cannot provide.  In addition, larger competitors may be able to price loans and deposits more aggressively than we do.  Our profitability depends upon our continued ability to successfully compete in our market area.  The greater resources and deposit and loan products offered by some of our competitors may limit our ability to increase our core deposits and interest earning assets.

Our accounting policies and methods impact how we report our financial condition and results of operations. Application of these policies and methods may require management to make estimates about matters that are uncertain.

Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations.  Our management must exercise judgment in selecting and applying many of these accounting policies and methods so they comply with generally accepted accounting principles and reflect management’s judgment of the most appropriate manner to report our financial condition and results of operations.  In some cases, management must select the accounting policy or method to apply from two or more alternatives, any of which might be reasonable under the circumstances yet might result in our reporting materially different amounts than would have been reported under a different alternative.   These accounting policies are critical to presenting our financial condition and results of operations.  They may require management to make difficult, subjective or complex judgments about matters that are uncertain.  Materially different amounts could be reported under different conditions or using different assumptions.

41

Our controls and procedures may be ineffective.

We regularly review and update our internal controls, disclosure controls, and procedures and corporate governance policies and procedures.  As a result, we may incur increased costs to maintain and improve our controls and procedures.  Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met.  Any failure or circumvention of our controls or procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations or financial condition.

System failure or breaches of our network security could subject us to increased operating costs as well as litigation and other liabilities.

The computer systems and network infrastructure we use could be vulnerable to unforeseen problems.  Our operations are dependent upon our ability to protect our computer equipment against damage from physical theft, fire, power loss, telecommunications failure, or a similar catastrophic event, as well as from security breaches, denial of service attacks, viruses, worms, and other disruptive problems caused by hackers.  Any damage or failure that causes an interruption in our operations could have a material adverse effect on our financial condition and results of operations.  Computer break-ins, phishing and other disruptions could jeopardize the security of information stored in and transmitted through our computer systems and network infrastructure, which may result in significant liability to us and cause existing and potential customers to refrain from doing business with us.

Although we, with the help of third-party service providers, intend to continue to implement security technology and establish operational procedures to prevent such damage, there can be no assurance that these security measures will be successful.  In addition, advances in computer capabilities, new discoveries in the field of cryptography or other developments could result in a compromise or breach of the algorithms we and our third-party service providers use to encrypt and protect customer transaction data.  A failure of such security measures could have a material adverse effect on our reputation, financial condition and results of operations.

We rely on other companies to provide key components of our business infrastructure.

Our business operations rely on third party vendors, which provide services such as data processing, recording and monitoring transactions, online banking interfaces and services, Internet connections and network access. While we have selected these third party vendors carefully, we do not control their actions. Any problems caused by these third parties, including those resulting from disruptions in communication services provided by a vendor, failure of a vendor to handle current or higher volumes, cyber-attacks and security breaches at a vendor, failure of a vendor to provide services for any reason or poor performance of services, could adversely affect our ability to deliver products and services to our customers and otherwise conduct our business. Financial or operational difficulties of a third party vendor could also hurt our operations if those difficulties interfere with the vendor's ability to serve us. Furthermore, our vendors could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints. Replacing these third party vendors could also create significant delay and expense. Accordingly, use of such third parties creates an unavoidable inherent risk to our business operations.

Implementation of our stock-based incentive plan may dilute stockholders’ ownership interests.

As of December 31, 2012, there were approximately 43,882 restricted shares and 98,012 stock options reserved for future awards under our two equity incentive plans.  These stock-based incentive plans may be funded either through open market purchases or from the issuance of authorized but unissued shares of Heritage common stock.  While our intention is to fund this plan through open market purchases, stockholders would experience approximately a 1.7% reduction in ownership interest in the event 141,894 newly issued shares of our common stock are issued upon exercise of stock options or issued as restricted stock under these plans.

42

Additional compensation and benefit expenses associated with the implementation of our stock-based incentive benefit plans will affect our profitability adversely.

As awards are granted under our two equity incentive plans, our non-interest expenses are likely to increase as we will recognize additional annual employee compensation and benefit expenses related to the shares granted to employees, executives and directors under these plans.  We cannot predict the actual amount of these new stock-related compensation and benefit expenses because applicable accounting practices require that expenses be based on the fair market value of the shares of common stock at specific points in the future; however, we expect them to be material.  In addition, we will recognize expense for our employee stock ownership plan when shares are committed to be released to participants’ accounts (i.e., as the loan used to acquire these shares is repaid), and we will recognize expense for restricted stock awards and stock options over the vesting period of awards made to recipients.

Our common stock trading volume may not provide adequate liquidity for investors.

Our common stock is listed on the Nasdaq Global Market.  However, the average daily trading volume in our common stock is less than that of many larger financial services companies.  A public trading market having the desired depth, liquidity, and orderliness depends on the presence of a sufficient number of willing buyers and sellers for our common stock at any given time.  This presence is impacted by general economic and market conditions and investors’ views of our Company.  Because our trading volume is limited, any significant sale of our shares is subject to significant volatility in the price of our common stock.

The ownership interest of management and employees could enable insiders to prevent a merger that may provide stockholders a premium for their shares.

Our directors and executive officers own 455,234 shares, or 5.6%, of the Company’s common stock and options for an additional 606,695 shares.  In addition, our employee stock ownership plan owns 7.8% of the outstanding shares of Heritage common stock.   This may result in management, directors, and employees controlling a significant percentage of shares of Heritage common stock.  If these individuals were to act together, they could have significant influence over the outcome of any stockholder vote.  This voting power may discourage a potential sale of Heritage that its public stockholders may desire.

Various factors may make takeover attempts more difficult to achieve.

Provisions of our articles of incorporation and bylaws, federal regulations, Georgia and Maryland law, and various other factors may make it more difficult for companies or persons to acquire control of Heritage without the consent of our Board of Directors.  Stockholders may want a takeover attempt to succeed because, for example, a potential acquiror could offer a premium over the then-prevailing market price of our common stock.

We may be adversely affected by the lack of soundness of other financial institutions.

Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by Heritage cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to Heritage. Any such losses could have a material adverse effect on our financial condition and results of operations.

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Item 1B. Unresolved Staff Comments

None.

Item 2. Description of Properties

At December 31, 2012, our corporate headquarters are located at 721 N. Westover Boulevard, Albany, Georgia.  In addition to our corporate headquarters, we had 20 full-service branch locations, 13 mortgage offices, and 4 investment offices.  19 of the full-service branch locations were owned and six mortgage offices and three investment offices were located in existing full-service branch locations.  One full-service branch location, 7 mortgage offices, and one investment office were leased.  A complete list of all branch and ATM locations can be found on the Heritage’s website at www.eheritagebank.com.  For more information on our fixed assets, see Item 8 - Note 9 to the Consolidated Financial Statements.

Item 3.   Legal Proceedings

The Company is not a party to any pending claims or lawsuits that management believes would have a material effect on the Company's financial condition or results of operations.

Item 4.   Mine Safety Disclosures

Not applicable.

PART II

Item 5.  Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The Company’s common stock is traded on the Nasdaq Global Market under the symbol “HBOS.”  The shares began trading on November 30, 2010.  Prior to that date, the shares of common stock of the Predecessor also traded on that market under the same symbol.  As of December 31, 2012, the Company estimates that it had approximately 2,135 stockholders, including approximately 1,017 beneficial owners holding shares in nominee or “street” name.

The following table sets forth the high and low sales prices of the shares of common stock of the Company and cash dividends paid to public stockholders.

	High		Low		Dividends Paid Per Share
2012
Fourth quarter (10/01/2012 through 12/31/2012)	$	13.97	$	11.83	$	0.24
Third quarter (07/01/2012 through 09/30/2012)		14.03		12.42		0.04
Second quarter (04/01/2012 through 06/30/2012)		13.00		11.25		0.04
First quarter (01/01/2012 through 03/31/2012)		12.50		11.05		0.04
2011
Fourth quarter (10/01/2011 through 12/31/2011)	$	11.93	$	10.01	$	0.03
Third quarter (07/01/2011 through 09/30/2011)		12.18		10.07		0.03
Second quarter (04/01/2011 through 06/30/2011)		12.97		11.00		0.03
First quarter (01/01/2011 through 03/31/2011)		13.52		11.15		0.03

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During the fourth quarter of 2012, the Company paid a special one-time dividend of $0.20 in lieu of regular quarterly dividends that would have been anticipated to be paid in 2013.The Companyintends to resume paying cash dividends on a quarterly basis in 2014.  The continued payment of dividends also will depend on a number of factors, including our capital requirements, our financial condition and results of operations, tax considerations, statutory and regulatory limitations, and general economic conditions.  No assurance can be given that we will continue to pay dividends or that they will not be reduced or eliminated in the future.

The Company’s ability to pay dividends depends on the Company’s unconsolidated available funds and earnings thereon, as well as dividends from HeritageBank.  Under the rules of the FRB, the Company is not permitted to pay dividends on its common stock if its stockholders’ equity would be reduced below the amount of the liquidation account established in connection with the conversion.  Similarly, HeritageBank will not be permitted to pay dividends to the Company, its sole stockholder, if HeritageBank’s stockholder’s equity would be reduced below the amount of the liquidation account established in connection with the conversion.  In addition, HeritageBank will not be permitted to make a capital distribution if, after making such distribution, capital would be below regulatory capital guidelines or if it does not receive FRB authorization to pay the dividend.  Georgia law and regulations imposes limits on dividend payments by HeritageBank and certain levels of dividends require the prior approval of the GDBF.  See Item 1 – Business – Limitations on Dividends and other Capital Distributions.

Maryland law generally limits dividends by Heritage to an amount equal to the excess of our capital surplus over payments that would be owed upon dissolution to stockholders whose preferential rights upon dissolution are superior to those receiving the dividend, and to an amount that would not make us insolvent.  Finally, pursuant to FRB regulations, during the three-year period following the second-step conversion, which closed on November 30, 2010, we may not take any action to declare an extraordinary dividend to stockholders that would be treated by recipients as a tax-free return of capital for federal income tax purposes.

The Company has two equity incentive plans providing for the issuance of stock options, restricted stock, restricted share units and stock appreciation rights.  The first is a plan that originally was adopted by the Predecessor in May 2006 and became the Company’s plan in the second-step conversion, when awards and available shares under the plan were adjusted to reflect the 0.8377 exchange ratio.  In June 2011, the Company’s stockholders approved the second equity incentive plan, which reserved an additional 573,481 shares of common stock for the issuance of stock options, restricted stock, restricted share units and stock appreciation rights.  The following table includes certain information with respect to certain awards and remaining shares available for awards under these equity incentive plans as of December 31, 2012:

	Number of securities to be issued upon exercise of outstanding options, warrants and rights		Weighted average exercise price of outstanding options, warrants and rights		Number of securities remaining available for future issuance under equity compensation plans
Equity compensation plans approved by security holders		765,132	$	13.51		98,012
Equity compensation plans not approved by security holders		-		-		-
Total		765,132	$	13.51		98,012

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During 2012, the Company completed the repurchase of 481,910 shares authorized by the stock repurchase programs announced in 2011.  In October 2012, the Company’s Board of Directors authorized another stock repurchase program to acquire up to 397,000 shares.  Under this program 72,909 shares were repurchased during 2012 at a cost of $986,000.  The program will expire in October 2013 unless completed sooner or otherwise extended.

Information on the shares purchased during 2012 is a follows:

	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
January		-	$	-		-		481,910
February		18,279		11.95		18,279		463,631
March		25,000		12.05		25,000		438,631
April		-		-		-		438,631
May		70,000		12.20		70,000		368,631
June		108,505		12.35		108,505		260,126
July		-		-		-		260,126
August		10,197		13.35		10,197		249,929
September		249,929		13.55		249,929		-
October		-		-		-		397,000
November		-		-		-		397,000
December		72,909		13.50		72,909		324,091
Total		671,761	$	12.70		671,761		324,091

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Item 6.  Selected Financial Data

SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA OF

HERITAGE FINANCIAL GROUP, INC. AND ITS SUBSIDIARY

The summary financial information presented below is derived in part from the consolidated financial statements of Heritage and its subsidiary.  The information at December 31, 2012 and 2011 and for the years ended December 31, 2012, 2011, and 2010 is derived in part from the audited consolidated financial statements of Heritage that are included in Item 8.  The information at December 31, 2009 and 2008, and for the years ended December 31, 2008 and 2007, is derived in part from audited consolidated financial statements that are not included in this Form 10-K.  However, in the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the results of the operations for the unaudited periods have been made.  The following information is only a summary, and you should read it in conjunction with Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 8 - Consolidated Financial Statements.

	December 31,
	2012		2011		2010		2009		2008
	(In thousands)
Selected Financial Condition Data:
Total assets	$	1,097,506	$	1,089,852	$	755,436	$	571,948	$	502,058
Loans, net		660,943		553,126		410,896		328,078		297,537
Securities available for sale, at fair value:
U.S. government and agency securities and U.S Treasury Securities		21,019		45,737		89,032		30,462		21,165
Corporate debt securities		1,020		1,956		1,700		1,910		1,789
Mortgage-backed securities		157,497		162,963		128,143		58,410		65,408
State and municipal		41,573		48,204		19,160		29,122		27,511
Equity and other investments		297		157		342		621		268
Federal Home Loan Bank stock, at cost		4,330		4,067		3,703		3,253		3,186
Other equity securities, at cost		1,010		1,010		1,010		1,010		1,010
Deposits		869,554		884,187		534,243		426,607		338,546
Federal Home Loan Bank advances		60,000		35,000		62,500		42,500		52,500
Federal funds purchased and securities sold under repurchase agreements		33,219		35,049		32,421		32,843		41,497
Stockholders’ equity		120,649		124,136		119,340		60,817		62,213

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	Year Ended December 31,
	2012			2011			2010			2009			2008
	(In thousands)
Selected Operations Data:
Total interest income	$	54,738		$	39,449		$	28,439		$	23,401		$	27,195
Total interest expense		7,613			10,350			8,274			8,793			12,494
Net interest income		47,125			29,099			20,165			14,608			14,701
Provision for loan losses		5,930			2,800			5,500			7,500			3,350
Net interest income after provision for loan losses		41,195			26,204			14,665			7,108			11,351
Fees and service charges		8,305			7,719			6,177			4,953			5,245
Mortgage banking activities		4,768			2,377			-			-			-
Impairment loss on securities		-			(43	)		-			-			(3,119	)
Gain on sales of investment securities		2,838			684			294			909			235
Life insurance proceeds		-			32			916			-			-
Bargain purchase gain		(56	)		4,217			2,722			-			-
Accretion  of FDIC Loss Share Receivable		(5,028	)		381			-			-			-
Other noninterest income		2,869			2,100			2,375			1,925			2,227
Total noninterest income		13,696			17,467			12,484			7,787			4,588
Total noninterest expense		45,549			38,746			26,049			18,271			17,429
Income before tax expense (benefit)		9,342			4,925			1,099			(3,376	)		(1,490	)
Income tax expense (benefit)		2,585			1,100			(307	)		(1,724	)		(1,228	)
Net income (loss)	$	6,757		$	3,825		$	1,406		$	(1,652	)	$	(262	)

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	Year Ended December 31,
	2012			2011			2010			2009			2008
Selected Financial Ratios and Other Data:
Performance Ratios:
Return on average assets		0.63	%		0.39	%		0.22	%		(0.34	%)		(0.05	%)
Return on average equity		5.42	%		3.12	%		2.09	%		(2.62	%)		(0.41	%)
Dividend payout ratio		41.91	%		25.80	%		49.08	%	NM			NM
Net interest spread		5.30	%		3.58	%		3.55	%		3.31	%		3.16	%
Net interest margin		5.35	%		3.62	%		3.66	%		3.49	%		3.45	%
Operating expense to average total assets(1)		4.25	%		3.92	%		4.04	%		3.72	%		3.55	%
Average interest-earning assets to average interest-bearing liabilities		105.96	%		103.63	%		107.36	%		108.97	%		110.34	%
Efficiency ratio		74.89	%		83.21	%		79.79	%		81.59	%		90.36	%
Total loans to total deposits		77.05	%		63.41	%		78.43	%		78.32	%		89.35	%
Asset Quality Ratios (excluding Loans acquired through FDIC-assisted acquisitions) (1) :
Nonperforming assets to total assets at end of period		1.58	%		0.95	%		1.80	%		1.81	%		1.87	%
Nonperforming assets and troubled debt restructurings to total assets at  end of period		1.58	%		1.53	%		2.67	%		2.35	%		1.87	%
Nonperforming loans to total loans		2.51	%		1.62	%		2.49	%		2.53	%		2.41	%
Nonperforming loans and troubled debt restructurings to total loans		2.51	%		3.06	%		4.14	%		3.48	%		2.41	%
Allowance for loan losses to non-performing loans		61.73	%		106.40	%		81.79	%		71.61	%		67.99	%
Allowance for loan losses to total loans		1.55	%		1.72	%		2.04	%		1.81	%		1.64	%
Net charge offs to average loans outstanding(1)		0.19	%		0.91	%		0.87	%		2.13	%		1.58	%
Capital Ratios:
Tangible equity to total assets at end of period		10.61	%		10.95	%		15.41	%		10.36	%		12.19	%
Equity to total assets at end of period		10.99	%		11.39	%		15.80	%		10.63	%		12.39	%
Average equity to average assets		12.63	%		12.42	%		10.46	%		12.84	%		13.05	%
Common Share Data and Other Ratios:
Gross shares outstanding  at year-end(3)		8,172,486			8,712,031			8,710,511			9,595,303			9,593,628
Less treasury stock(3)		-			-			-			883,843			832,253
Net shares outstanding at year-end(3)		8,172,486			8,712,031			8,710,511			8,711,460			8,761,375
Shares owned by Heritage, MHC(2) (3)		-			-			-			6,591,756			6,591,756
Public shares outstanding(3)		8,172,486			8,712,031			8,710,511			2,119,704			2,169,619
Unearned ESOP shares(3)		385,836			439,138			492,320			203,045			239,963
Book value per share(3)	$	15.49		$	15.01		$	14.52		$	7.14		$	7.30
Tangible book value per share(3)	$	14.95		$	14.42		$	14.17		$	6.96		$	7.18
Basic income (loss) per share(3)	$	0.85		$	0.47		$	0.17		$	(0.20	)	$	(0.03	)
Diluted income (loss) per share(3)	$	0.85		$	0.47		$	0.17		$	(0.20	)	$	(0.03	)
Cash dividends paid on public shares outstanding	$	2,832,185		$	986,434		$	690,125		$	720,775		$	786,914
Cash dividends paid to Heritage MHC(2)		-			-			30,600			-			-
Cash dividends waived by Heritage MHC		-			-			2,802,195			2,518,040			2,203,285
Pro forma cash dividends that would have been paid  without waiver(2)(3)	$	2,832,185		$	986,434		$	3,522,920		$	3,238,765		$	2,990,199
Cash dividends per share (excluding shares held by  Heritage MHC)(2)(3)	$	0.36		$	0.12		$	0.43		$	0.32		$	0.33
Pro forma cash dividends per share (on all outstanding shares with no waiver by Heritage MHC) (3)	$	0.36		$	0.12		$	0.08		$	0.08		$	0.07
Other Data:
Number of full-service offices		20			22			16			10			8
Mortgage loan production offices		13			11			1			-			-

1.  Loans acquired through FDIC-assisted acquisitions are recorded in our assets at a discount from the contractual principal value.  See Item 8 – Notes 2 and 5 to the Consolidated Financial Statements.

2.  Effective November 30, 2010, Heritage MHC was eliminated in the second-step conversion, and all dividends declared from that date are paid to all stockholders.

3. All prior year common share  data  and per share calculations have been adjusted to reflect the 0.8377 share exchange.

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Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

MANAGEMENT'S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

General.  Heritage Financial Group, Inc. (“Heritage” or the “Company”) is a $1.1 billion holding company headquartered in Albany, Georgia.  Heritage primarily conducts commercial banking, retail banking and wealth management activities through its wholly owned subsidiary, HeritageBank of the South (“HeritageBank” or the “Bank”).  As of December 31, 2012, HeritageBank operated in south Georgia, north central Florida and eastern Alabama through 20 full-service branch locations, 13 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.

Core Business.  Our core business is composed of the following:

Commercial Banking and Small Business Lending.  We focus on the commercial real estate and business needs of individuals and small to medium-sized businesses in our market area.  In addition, we focus on high net worth individuals and small business owners.  The commercial banking department is composed of seasoned commercial lenders and a support staff with extensive commercial banking experience.

Retail Banking.  We currently operate a branch network with each office staffed with knowledgeable banking professionals who strive to deliver quality service.

Mortgage Lending.  Staffed with experienced mortgage originators and processors, our mortgage lending department originates residential mortgage loans that are primarily sold in the secondary market through 13 production offices throughout central and southern Georgia, north central Florida and east Alabama.  We collect a fee on the origination of these loans.

Brokerage/Investment Services.  We offer investment products, life, health, disability and long-term care insurance through our brokerage department.

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.

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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.  In March 2013, we completed the FDIC-assisted whole-bank purchase of Frontier Bank, a nine branch full service bank based in LaGrange, Georgia with approximately $111.0 million in loans and $224.0 million in deposits.

Critical Accounting Policies

We have established certain accounting and financial reporting policies to govern the application of accounting principles generally accepted in the United States of America (“GAAP”) in the preparation of our financial statements.  Our significant accounting policies are described in Item 8 - Notes to the Consolidated Financial Statements.  Certain accounting policies involve significant judgments and assumptions by management which has a material impact on the carrying value of certain assets and liabilities.  The judgments and assumptions used by management are based on historical experience and other factors that are believed to be reasonable under the circumstances.  Because of the nature of the judgments and assumptions made by management, actual results could differ from the judgments and estimates adopted by management, which could have a material impact on the carrying values of assets and liabilities and the results of our operations.  We believe the following accounting policies applied by us represent critical accounting policies.  For more information on our accounting policies, see Item 8 - Note 1 to the Consolidated Financial Statements.

Acquisition Accounting.  GAAP require the use of fair value accounting in determining the carrying values of certain assets and liabilities acquired in business combinations and accordingly we recorded assets purchased and liabilities assumed in our FDIC-assisted acquisitions at their fair values. The fair value of the loan portfolios acquired in these transactions was recorded and is being accounted for under the principles prescribed by ASC 310.

On the date of acquisition all loans acquired are assigned a fair value based on the present value of projected future cash flows. An accretable discount is determined based on the timing of the projected cash flows and is taken into income over the projected life of the loans. Such accretion is included in interest income. Expected cash flows are re-estimated at each reporting date. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses.

Subsequent increases in cash flows result in a reversal of the provision for loan losses to the extent of prior charges and adjusted the accretable discount, which will have a positive effect on interest income. Because we record loans acquired in connection with FDIC-assisted acquisitions at fair value, we record no allowance for loan losses related to the acquired covered loans on the acquisition date, given that the fair value of the loans acquired incorporates assumptions regarding credit risk.

Acquisitions are accounted for under the purchase method of accounting. Purchased assets and assumed liabilities are recorded at their estimated fair values as of the purchase date.  Any identifiable intangible assets are also recorded at fair value.  When the fair value of the assets purchased exceed the fair value of liabilities assumed, a "bargain purchase gain" results.  If the consideration given exceeds the fair value of the net assets received, goodwill is recognized. Fair values are subject to refinement for up to one year after the closing date of an acquisition as information relative to closing date fair values becomes available.

FDIC Receivable for Loss-Share Agreements.  A significant portion of our acquired loan and other real estate assets are covered under loss share agreements with the FDIC in which the FDIC has agreed to reimburse the Company 80% of all losses as well as certain expenses incurred in connection with those assets.  We estimate the amount that we will receive from the FDIC under the loss share agreements that will result from losses incurred as covered loans and other real estate assets are disposed, and an estimate of the receivable from the FDIC is recorded. We discount 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.

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The loss share agreements also include a provision whereby if losses do not exceed a calculated threshold, we are obligated to compensate the FDIC. This is referred to as a clawback liability and, if applicable, is paid at the end of ten years. The formula for the clawback liability varies from transaction-to-transaction and will be calculated using the formula provided in the individual loss share agreements and will not be consolidated into one calculation.  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 the assets are sold. We will review and update the fair value of the FDIC receivable at each reporting date in conjunction with the re-estimation of cash flows. The FDIC receivable will fluctuate as loss estimates and expected cash flows related to covered loans and other real estate owned change.

Loans Held for Sale.  Loans held for sale consist of one-to-four family residential loans originated for sale in the secondary market and are carried at fair value  under ASC 825-10-25.  For residential mortgage loans, fair value is determined by outstanding commitments from investors for committed loans and on the basis of current delivery prices in the secondary mortgage market for uncommitted loans, if any.   Adjustments to reflect unrealized gains and losses resulting from changes in fair value of residential mortgage loans held-for-sale and realized gains and losses upon ultimate sale of the loans are classified as noninterest income in the Consolidated Statements of Operations.

We enter into interest rate lock commitments (“IRLCs”) with customers on mortgage loans with the intention to sell the loan in the secondary market. 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 derivatives arising from the IRLCs are recorded at fair value in other assets and liabilities and changes in that fair value are included in mortgage banking activities.

The fair value of the IRLC derivatives are determined by reference to quoted prices for loans with similar coupon rates and terms. 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 historical data and the current interest rate environment and reflect the best estimate of the likelihood that a commitment will ultimately result in a closed loan.  Gains and losses on the sale of those loans are included in mortgage banking activities.

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 Item 8 - Note 23 to the Consolidated Financial Statements.

Allowance for Loan Losses (ALLL).  We established provisions for loan losses, which are charged to operations, at a level believed to 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, we consider the types and amount of loans in the loan portfolio, five year historical loss experience, migration analysis, probability of default, 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.

We analyze 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.  We evaluate the non-FDIC loan portfolio through review of four loan pool categories.

1. Pass credits with risk ratings 1-5

2. Special mention with risk ratings 6-7

3. Substandard with risk rating 8 and still accruing

4. Impaired loans with risk ratings 9-11 – Nonaccrual and troubled debt restructurings

Asset quality grades are described in Item 8 – Note 4 to the Consolidated Financial Statements.

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The allowance consists of two components:

1. A general amount –  We analyze the historical migration of loans through each risk rating category and analyze 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 Pass credits with risk ratings 1-5 pool and other assets specially 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 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. Impaired loans with balances lower than $500,000 are not typically reviewed on an individual basis due to their small size.  Instead, a historical loss analysis is used for these loans, which assumes the loan migration to default is likely, and the assumed loss is recorded as a specific amount.

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

The allowance for loan losses is assessed on a quarterly basis and we make provisions for loan losses as necessary in order to maintain the proper level of allowance.  While we use 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 us 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, where 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.  See Item 8 - Note 1 to the Consolidated Financial Statementsfor further information.

Income Taxes.  The income tax accounting guidance results in two components of income tax expense: current and deferred.  Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues.  We determine deferred income taxes using the liability (or balance sheet) method.  Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and enacted changes in tax rates and laws are recognized in the period in which they occur.

Deferred income tax expense results from changes in deferred tax assets and liabilities between periods.  Deferred tax assets are recognized if it is more-likely-than-not, based on the technical merits, that the tax position will be realized or sustained upon examination.  A tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that has a greater than 50 percent likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information.  The determination of whether or not a tax position has met the more-likely-than-not recognition threshold considers the facts, circumstances, and information available at the reporting date and is subject to management’s judgment.  Deferred tax assets may be reduced by deferred tax liabilities and a valuation allowance if, based on the weight of evidence available, it is more-likely-than-not that some portion or all of a deferred tax asset will not be realized.

Estimates of Fair Value.  The estimation of fair value is significant to a number of our assets, including, but not limited to, investment securities, goodwill, other real estate owned and other repossessed assets.  These are all recorded at either fair value or at the lower of cost or fair value.  Fair values are volatile and may be influenced by a number of factors.  Circumstances that could cause estimates of the fair value of certain assets and liabilities to change include a change in prepayment speeds, discount rates, or market interest rates.  Our estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the consolidated financial statements in the period in which they are determined to be necessary.

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Fair values for most investment securities are based on quoted market prices.  If quoted market prices are not available, fair values are based on the quoted prices of similar instruments.  The fair values of other real estate owned typically are determined based on appraisals by third parties, less estimated costs to sell.  Estimates of fair value also are required in performing an impairment analysis of goodwill.  Heritage reviews goodwill for impairment on at least an annual basis and whenever events or circumstances indicate the carrying value may not be recoverable.  Impairment would be applicable if the carrying value exceeds the fair value of a reporting unit.

Recent Accounting Standards

For discussion of Recent Accounting Standards, please see Item 8 - Note 1 to the Consolidated Financial Statements.

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

General.  Total assets increased by $7.7 million, or 0.7%, to $1.098 billion at December 31, 2012, from $1.090 billion at December 31, 2011.  Cash and due from banks decreased $10.5 million, or 30.5%, to $24.0 million at December 31, 2012 from $34.5 million at December 31, 2011.  Total interest-earning assets increased $34.8 million, or 3.9%, to $926.7 million at December 31, 2012, from $891.9 million at December 31, 2011.  Loans, including loans held for sale, increased $109.4 million, securities available for sale decreased $37.6 million, federal funds decreased $17.4 million, and interest-bearing deposits in banks decreased $27.7 million.  At the same time, deposits decreased by $14.6 million, federal funds purchased and securities sold under repurchase agreements decreased by $1.8 million, other borrowings increased by $25.0 million, and stockholders’ equity decreased by $3.5 million.

Cash and Securities.  We decreased our liquidity position as a percentage of total assets to utilize excess liquidity to grow interest earning assets primarily through organic loan growth in 2012.  Cash and securities (including bank deposits and federal funds sold) decreased in the aggregate $93.3 million, or 26.0%, to $265.1 million, or 24.2% of total assets, at December 31, 2012, from $358.4 million, or 32.9% of total assets, at December 31, 2011.

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	At December 31,				Amount			Percent
	2012		2011		Change			Change
	(Dollars in thousands)
Cash and due from banks	$	23,993	$	34,521	$	(10,528	)		(30.50	)%
Interest-bearing deposits in banks		15,393		43,101		(27,708	)		(64.29	)
Federal funds sold		4,306		21,753		(17,447	)		(80.21	)
Securities available for sale, at fair value		221,406		259,017		(37,611	)		(14.52	)
Total	$	265,098	$	358,392	$	(93,294	)		(26.03	)%

At December 31, 2012, our securities portfolio consisted of $21.0 million in U.S. Government agency sponsored securities, $157.5 million U.S. government agency mortgage-backed securities, $41.6 million in state and municipal securities, and $1.3 million in corporate debt and equity securities.  These corporate debt and equity securities had a net unrealized loss based on fair value of $40,000.  We currently intend on holding these securities to maturity.  We believe it is probable that we will be able to collect the amounts due under the contractual terms of the securities portfolio.  Therefore we do not believe any securities experienced other than temporary impairment at December 31, 2012.  See Item 8 - Note 3 to the Consolidated Financial Statements for additional information.

We expect to continue lowering our excess liquidity balance on a percent of total assets basis in cash, funds due from banks, federal funds sold, and securities in 2013, but at a much slower pace than 2012.  We believe that utilizing some of our excess liquidity to increase our loan portfolio is a prudent strategy to maintain through 2013.

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Loans.  Our loan portfolio increased $109.4 million, or 19.5%, to $670.0 million at December 31, 2012, from $560.6 million at December 31, 2011.  Overall, this increase reflects increases in organic loan growth across our market footprint of $140.3 million and $11.0 million in loans acquired in connection with our Auburn branch acquisition, offset in part by a reduction in FDIC acquired loans of $41.9 million.

The following table reflects the changes in the types of loans in our portfolio at the end of 2012 as compared to the end of 2011.

	December 31,				Amount			Percentage
	2012		2011		Change			Change
Commercial real estate:
Nonresidential	$	212,570	$	138,970	$	73,600			52.96	%
Multifamily		21,293		15,797		5,496			34.79
Farmland		20,141		17,921		2,220			12.39
Total commercial real estate loans		254,004		172,688		81,316			47.09
Construction and land		33,340		26,804		6,536			24.38
Residential real estate:
Mortgage loans, 1-4 families		161,883		129,745		32,138			24.77
Home equity		27,345		26,154		1,191			4.55
Total  residential real estate loans		189,228		155,899		33,329			21.38
Consumer and other:
Indirect auto loans		1,304		3,741		(2,437	)		(65.14	)
Direct auto loans		6,801		6,430		371			5.77
Other		17,393		13,701		3,692			26.95
Total consumer loans		25,498		23,872		1,626			6.81
Commercial and industrial loans		83,659		55,179		28,480			51.61
		585,729		434,442		151,287			34.82
Loans acquired through FDIC-assisted acquisitions
Non-Covered		11,850		18,721		(6,781	)		(36.70	)
Covered		72,425		107,457		(35,032	)		(32.60	)
Total loans	$	670,004	$	560,620	$	109,384			19.51	%

Overall, the change in the loan portfolio is consistent with our strategy to grow our loans organically through our nonresidential, commercial and industrial, and residential lending and to work through our FDIC acquired loan portfolio. We continue to emphasize commercial lending as noted with the growth in nonresidential and commercial and industrial loans coupled with an emphasis on residential real estate lending for mortgage loans, 1-4 families.  Outside of FDIC acquired loans, the only loan category to report a reduction was indirect auto loans driven by our strategic decision to exit that line of business.

Due to our renewed focus on finding new lending relationships from high-quality borrowers in 2012, we expanded our core loan portfolio by $140.3 million.  We also see more opportunities to take market share from the regional and community banks competing within our market footprint.  We continue to seek opportunities to grow our loan portfolio through organic growth, branch acquisitions, loan purchases, FDIC-assisted opportunities, and whole bank acquisitions.

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At December 31, 2012, we had approximately $15.6 million in loans held for sale, which are mortgage loans generated to be sold to investors, as compared to $7.5 million at the end of 2011.  The increase was driven by our continued focus on this product and our election, during the third quarter of 2012, to account for these loans under ASC 825-10-25.  We typically hold these loans for less than ninety days and earn the stated rate on the note until they are purchased by the investor.  See Item 8 – Notes 1 and 23 of the Consolidated Financial Statements for additional information.

Delinquencies and Nonperforming Assets.  As of December 31, 2012, our total loans delinquent for 30 to 89 days was $2.1 million or 0.32% of total loans, excluding FDIC acquired loans.  See Item 1 - Asset Quality - Delinquent Loans and - Classified Assets for additional information.

At December 31, 2012, our nonperforming assets totaled $17.9 million, or 1.58% of total assets, compared to $10.4 million, or 0.95% of total assets at December 31, 2011.  This $7.5 million, or 72.3%, increase was primarily driven by the migration of two relationships totaling $6.0 million to non-performing status during the third quarter of 2012.  One of the relationships totaling $3.5 million was classified a troubled-debt restructuring and additional collateral of $6.1 million has been secured.  The other relationship was a Chapter 11 bankruptcy where the collateral deficiency is fully reserved as of year-end.  Both of these relationships were previously identified as criticized assets.

Our loan portfolio has included FDIC acquired loans since December 2009, which are generally recorded at a deep discount from the contractual principal value and accounted for under ASC 310-30.  These loans acquired through FDIC-assisted acquisitions are excluded from the delinquent loan tables below because they are accounted for in a different manner.  See Item 8 - Note 5 to the Consolidated Financial Statements for more information concerning our FDIC acquired loans.    Included in non-accruing loans at December 31, 2012, are troubled debt restructurings of $6.9 million, which involve forgiving a portion of interest or principal on loans or making loans at a rate materially below market.

The table below sets forth the amounts and categories of non-performing assets in our loan portfolio, excluding loans and foreclosed assets acquired through FDIC-assisted acquisitions, at the dates indicated.

	Non-Performing Assets at December 31,
	2012		2011		Amount Change			Percent Change
	(Dollars in thousands)
Non-accruing loans	$	14,677	$	7,043	$	7,634			108.4	%
Foreclosed assets		2,620		3,356		(736	)		(21.9	)
Total non-performing assets	$	17,297	$	10,399	$	(6,898	)		66.3	%

Non-performing loans increased to 2.5% of total loans at the end of 2012 from 1.6% at the end of 2011 primarily driven by the migration of $6.0 million of criticized assets to nonaccrual, as discussed above.  Foreclosed assets, excluding assets acquired through FDIC-assisted acquisitions, decreased from $3.4 million at December 31, 2011 to $2.6 million at December 31, 2012.  We continue to aggressively confront credit quality issues in our loan portfolio.  Foreclosed assets, which consist almost entirely of OREO, experienced a slight reduction driven by a combination of sales and write downs in excess of additions for 2012.  We believe the current value of each foreclosed asset represents our estimated disposition value based on current appraisals and market data, and all of these properties are being marketed actively for disposition.  During 2012, we had gross proceeds on sales of OREO, excluding assets acquired through FDIC-assisted acquisitions, of approximately $2.4 million and recorded net losses of approximately $219,000 on those sales.  See Item 1 - Asset Quality - Delinquent Loans and - Classified Assets for additional information.

Our internally criticized (watch list) and classified assets, excluding FDIC acquired loans, totaled $28.2 million at December 31, 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 nonperforming asset categories.  These balances include the aforementioned nonperforming loans, OREO, and repossessed assets.  These loans have been considered in management's determination of the adequacy of our allowance for loan losses.

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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.  We have taken actions to prevent losses in our current portfolio with our 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.

Allowance for Loan Losses.  Our allowance for loan losses at December 31, 2012 was $9.1 million compared to $7.5 million at December 31, 2011.  Excluding FDIC acquired loans, the allowance for loan losses to total loans was 1.55% at December 31, 2012 and 1.72% at December 31, 2011.  This decrease reflects improving credit trends in our loan portfolio; however, we are cautiously optimistic the improvement will continue into 2013.

The following table sets forth asset quality information, excluding FDIC acquired loans for the periods indicated:

	At and For the Year Ended
	December 31, 2012			December 31, 2011
	(Dollars in thousands)
Allowance for loan losses to total loans		1.55	%		1.72	%
Allowance for loan losses to average loans		1.62			1.32
Allowance for loan losses to non-performing loans		61.73			106.40
Loans 30 to 89 days past due and still accruing	$	2,131		$	371
Nonaccrual loans	$	14,677		$	7,043
Loans 90 days past due and still accruing		-			-
Total non-performing loans		14,677			7,043
Other real estate owned and repossessed assets		2,620			3,356
Total non-performing assets	$	17,297		$	10,399
Non-performing loans to total loans		2.51	%		1.62	%
Non-performing assets to total assets		1.58			0.95
Net charge-offs to average loans (annualized)		0.19			0.91
Net charge-offs	$	933		$	3,502

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We assess the allowance for loan losses on a quarterly basis and make provisions for loan losses as necessary in order to maintain the proper level of allowance.  While we use 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 us 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.  See Item 8 – Note 4 to the Consolidated Financial Statements for additional information.

Premises and Equipment. Premises and equipment increased $3.5 million, or 11.8%, at December 31, 2012, primarily driven by an Auburn, Alabama branch purchase and completed construction on a Valdosta, Georgia branch and a Macon, Georgia branch at $1.7 million, $2.4 million and $733,000, respectively, during 2012. Additionally, we closed branches in Guyton, Georgia and Collins, Georgia and transferred $458,000 to premises held for sale.  See Item 8 – Note 9 to the Consolidated Financial Statements for additional information.

FDIC Loss-Share Receivable. The FDIC loss-share receivable was $60.7 million at December 31, 2012 and represents the present value of 80% of our expected losses and reimbursable expenses associated with the covered assets acquired through FDIC-assisted acquisitions.  During 2012, $17.1 million in reimbursements from the FDIC had been recorded and net negative accretion totaled $5.0 million.  See Item 8 – Note 6 to the Consolidated Financial Statements for additional information.

Intangible Assets, Goodwill and Other Assets.  Intangible assets and goodwill decreased from $4.8 million by $613,000 to $4.2 million, primarily related to the amortization expense of $781,000 related to core deposit intangibles in 2012.

Cash surrender value of bank owned life insurance (“BOLI”) increased from $15.6 million at December 31, 2011 to $23.4 million at December 31, 2012 primarily resulting from 2012 purchases of life insurance to cover additional key members of the Company that were not previously covered under the program.  Other assets decreased $1.4 million during 2012, primarily due to a reduction in receivables from an OREO settlement and from the FDIC related to our 2011 FDIC-assisted transactions.

Deposits.  Total deposits decreased $14.6 million, or 1.7%, to $869.6 million at December 31, 2012 compared with $884.2 million at December 31, 2011, primarily driven by planned deposit runoff of $33.3 million in part offset by acquired deposits of $18.7 million related to the Auburn branch acquisition.  A summary of deposit accounts with the corresponding weighted average cost of funds is presented below (in thousands).

	As of December 31, 2012					As of December 31, 2011
	Amount		Wtd. Avg. Rate			Amount		Wtd. Avg. Rate
Checking (noninterest)	$	116,272		0.00	%	$	78,823		0.00	%
NOW (interest)		144,954		0.10			151,765		0.28
Savings		67,391		0.05			60,552		0.16
Money Market		246,237		0.36			284,268		0.56
Certificates		294,700		1.17			308,779		1.67
Total	$	869,554		0.52	%	$	884,187		0.89	%

Borrowings and Other Liabilities.  The total amount of other borrowings increased $25.0 million from $35.0 million at the end of 2011 to $60.0 million at the end of 2012, as we took advantage of low borrowings rates to fund loan growth.  The weighted average rate on these advances was 3.61% in 2012 compared to 3.68% in 2011.  Federal funds purchased decreased by $1.1 million and securities sold under agreements to repurchase decreased by $692,000 for a net decrease of $1.8 million, or 5.2%, as a result of a decrease in our federal funds purchased from Chattahoochee Bank of Georgia and due to the reduced commercial accounts with corresponding repurchase agreements.  See Item 8 – Note 15 to the Consolidated Financial Statements for additional information.

Equity.  Total equity decreased $3.5 million to $120.6 million at December 31, 2012, compared with $124.1 million at December 31, 2011, primarily driven by the repurchase of common shares of $7.2 million, dividends of $2.8 million paid during the year, and other comprehensive loss of $1.8 million, offset in part by net income of $6.8 million, stock-based compensation of $858,000, and the allocation of $669,000 in ESOP shares.

59

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 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.

	Year Ended December 31,
	2012								2011								2010
	Average Outstanding Balance			Interest Earned/ Paid		Yield/ Rate			Average Outstanding Balance			Interest Earned/ Paid		Yield/ Rate			Average Outstanding Balance			Interest Earned/ Paid		Yield/ Rate
	(Dollars in thousands)
Interest-Earning Assets:
Loans	$	608,722		$	49,807		8.18	%	$	517,093		$	33,725		6.52	%	$	379,696		$	23,810		6.28	%
Investment securities		240,198			5,186		2.16			220,163			5,416		2.46			142,301			4,455		3.35
Other short term investments		38,782			137		0.35			78,430			308		0.39			43,547			174		0.40
Total interest-earning assets		887,702			55,130		6.21			815,686			39,449		4.89			565,544			28,439		5.03
Non-interest earning  assets		183,373								172,810								78,853
Total assets		1,071,075								988,496								644,397
Interest-Bearing Liabilities:
Interest checking, money    market and savings		465,954			1,347		0.29			423,986			3,185		0.75			279,017			2,947		1.06
Time deposits		299,333			3,528		1.18			283,300			4,365		1.54			170,659			2,812		1.65
Total interest bearing-deposits		765,287			4,875		0.64			707,286			7,550		1.07			449,676			5,759		1.28
Securities sold under repurchase and borrowings		72,503			2,739		3.78			79,856			2,800		3.51			77,081			2,515		3.26
Total interest- bearing liabilities		837,790			7,614		0.91			787,142			10,350		1.31			526,757			8,274		1.57
Noninterest Bearing Liabilities:
Demand deposits		96,077								71,852								41,503
Other liabilities		12,615								6,775								8,659
Total non-interest bearing liabilities		108,692								78,627								50,162
Total liabilities		946,482								865,769								576,919
Shareholder’s equity		124,593								122,727								67,478
Total liabilities and shareholder’s equity		1,071,075								988,496								644,397
Net interest income				$	47,516							$	29,099							$	20,165
Net interest rate spread							5.30	%							3.58	%							3.55	%
Net earning assets	$	49,912							$	28,544							$	38,787
Net interest margin							5.35	%							3.62	%							3.66	%
Average interest-  earning assets to average interest-bearing liabilities		1.06	x							1.04	x							1.07	x

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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 those 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.

	Year Ended December 31,									Year Ended December 31,							Year Ended December 31,
	2012 vs. 2011									2011 vs. 2010							2010 vs. 2009
	Increase (Decrease) Due to						Total Increase			Increase (Decrease) Due to					Total Increase		Increase (Decrease) Due to						Total Increase
	Volume			Rate			(Decrease)			Volume		Rate			(Decrease)		Volume			Rate			(Decrease)
	(Dollars in thousands)
Interest-earning assets:
Loans	$	5,976		$	10,106		$	16,082		$	7,867	$	2,048		$	9,915	$	4,837		$	417		$	5,254
Investment securities		493			(723	)		(230	)		1,734		(773	)		961		767			(1,090	)		(323	)
Other short-term investments		(156	)		(15	)		(171	)		117		17			134		111			(4	)		107
Total interest-earning assets	$	6,313		$	(9,368	)	$	15,681		$	9,718	$	1,292		$	11,010	$	5,715		$	(677	)		5,038
Interest-bearing liabilities:
Interest checking, money market and savings		315			(2,153	)		(1,838	)		1,336		(1,098	)		238		1,378			(517	)		861
Wholesale time deposits		247			(1,084	)		(837	)		2,509		(956	)		1,553		(349	)		(1,226	)		(1,575	)
Total interest-bearing deposits		562			(3,237	)		(2,675	)		3,845		(2,054	)		1,791		1,029			(1,743	)		(714	)
Borrowings		(258	)		197			(61	)		135		150			285		(146	)		340			194
Total interest-bearing liabilities	$	304			(3,040	)		(2,736	)	$	3,980		(1,904	)	$	2,076	$	883			(1,403	)		(520	)
Net interest income							$	18,417							$	8,934							$	5,558

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Comparison of Operating Results for the Year Ended December 31, 2012 and December 31, 2011

General.  During the year ended December 31, 2012, we recorded net income of $6.8 million, or $0.85 basic and diluted earnings per share, compared to a net income of $3.8 million, or $0.47 basic and diluted earnings per share, for the year ended December 31, 2011.  This $3.0 million improvement in operating results reflects an increase in net interest income and a decrease in loan loss provision expense, excluding FDIC acquired loans, partially offset by an increase in FDIC acquired loan loss provision expense, a decrease in noninterest income, and  an increase in noninterest expense.

Interest Income.  Total interest income for 2012 increased $15.3 million, or 38.8%, to $54.7 million, compared to $39.4 million during 2011.  The increase was due to a $72.0 million, or 8.8%, increase in average interest-earning assets during 2012 primarily driven by organic loan growth to $887.7 million, compared to $815.7 million during 2011.  Also positively impacting interest income was the balance sheet structural shift from lower yielding short-term investments to higher yielding loans as a percentage of interest-earning assets.  Moreover, the yield on interest-earning assets improved by 132 basis points to 6.21% during 2012 as compared to 4.89% in 2011.

Interest income on loans for 2012 was $49.8 million compared to $33.7 million for 2011.  The $16.1 million increase in interest income on loans was primarily driven by the increase in yield compared to the prior year on FDIC acquired loans, which carry a higher interest rate as compared to traditional loans.  Also benefiting our increased interest income on loans was organic loan growth driven by our expansion into the Valdosta, Statesboro, Macon and Auburn markets during 2012.   Our expansion into these new markets helped increase our average loan portfolio balance by $91.6 million while the 166 basis point increase in the weighted average yield on loans to 8.18% for 2012 compared to 6.52% in 2011 was driven by improved accretion on FDIC acquired loans for 2012.

Interest income on investment securities for 2012 was $5.2 million compared to $5.4 million in 2011.  The weighted average yield on investments for 2012 declined 30 basis points to 2.16% compared to 2.46% for 2011.  However, growth in the average balance of investment securities of $20.0 million for 2012 positively impacted the interest income on investment securities as excess liquidity was invested.  We continue to anticipate the yield on our investment portfolio to decline during 2013 as a result of this low interest rate environment as maturing investments are replaced with lower yielding investments.

Interest income on other short-term investments for 2012 decreased to $137,000 compared to $308,000 in 2011.  The decline was driven by a reduction in the average balance of other short-term investments of $39.6 million as excess liquidity was used to fund organic loan growth.  The average yield on other short-term investments modestly declined 4 basis points to 0.35% for 2012 compared to 0.39% for 2011.

Interest Expense.  Total interest expense for 2012 decreased $2.7 million, or 26.4%, to $7.6 million compared to $10.3 million for 2011.  The decrease in interest expense was primarily the result of a decline in the weighted average cost of interest-bearing liabilities for 2012 of 40 basis points to 0.91% compared to 1.31% for 2011.  The decrease in interest expense was in part offset by growth in the average balance of interest-bearing liabilities for 2012 of $50.6 million, or 6.4%, compared to 2011.  We anticipate the change in the cost of interest-bearing liabilities to be minimal in 2013 unless market interest rates either increase or decrease significantly.

Interest expense on deposits for 2012 was $4.9 million compared to $7.6 million for 2011.  The decrease in interest expense on deposits for 2012 was driven by a decline in the weighted average cost on deposits of 43 basis points to 0.64% compared to 1.07% for 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 2012 of $58.0 million compared to 2011.

Interest expense on other borrowings, consisting of FHLB advances, federal funds purchased and securities sold under agreement to repurchase, decreased $61,000 compared to 2011.  The decrease in the interest expense on other borrowings for 2012 was primarily driven by a reduction in the average balance of other borrowings of $7.4 million compared to 2011.  The decrease in interest expense for 2012 was offset in part by an increase in the weighted average rate paid on these borrowings 27 basis points to 3.78% compared to 3.51% for 2011.

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Net Interest Income.  Net interest income for 2012 increased $18.0 million, or 62.0%, to $47.1 million compared to $29.1 million for 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 2012 increased 172 basis points to 5.30% compared to 3.58% for 2011.  The net interest margin for 2012 improved 173 basis points to 5.35% from 3.62% for 2011.  The primary reason the net interest margin increased significantly for 2012 was the result of increased loan accretion for FDIC acquired loans increasing the weighted average yield on loans 166 basis points compared to 2011.  We also expect loan accretion for FDIC acquired loans to continue to positively impact the net interest margin for 2013.

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.  See Item 7a.  -Quantitative and Qualitative Disclosures about Market Risk

Provision for Loan Losses.  During 2012, we recorded provision for loan losses expense of $5.9 million compared to $2.9 million for 2011.  The increase in provision expense was primarily driven by FDIC acquired provision expense for 2012 of $3.4 million 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 2012 compared to 2011 primarily driven by a reduction in annualized net charge-offs offset in part by organic loan growth. We include five years of historical losses in our allowance calculation for all periods.  The use of this timeframe has recently resulted in an overall increase in historical losses.  However, offsetting the upward trend in losses is a change in the portfolio mix where loan growth has occurred.  Specifically, positive growth occurred in nonresidential loans as a percentage of the loan portfolio which carries a lower historical loss rate compared to other loan categories.  In addition, criticized and classified loans have decreased as a percentage of the overall loan portfolio.The following table presents the provision for loan expense in more detail for the periods indicated.

	For the Year Ended December 31,
	2012		2011
Provision for loan losses – noncovered	$	2,500	$	2,895
Provision for loan losses – FDIC acquired noncovered		12		-
Provision for loan losses – noncovered		2,512		2,895
Provision for loan losses- FDIC acquired covered		3,418		-
Provision for loan losses	$	5,930	$	2,895

For further information on the loan portfolio and allowance for loan losses, see Item 8 – Notes 4 and 5 to the Consolidated Financial Statements.

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Noninterest Income.  A summary of noninterest income, excluding securities transactions, bargain purchase gains, and gain on BOLI life insurance proceeds, follows:

	Year Ended December 30,
	2012			2011			$ Chg			% Chg
	(Dollars in thousands)
Service charges on deposit accounts	$	4,748		$	4,777		$	(29	)		(0.6	)  %
Bankcard services income		3,231			2,637			594			22.5
Other service charges, commissions and fees		326			305			21			6.9
Brokerage fees		1,838			1,386			452			32.6
Mortgage banking activities		4,768			2,377			2,391			100.0
Bank-owned life insurance		771			588			183			31.1
Accretion of FDIC loss-share receivable		(5,028	)		381			(5,409	)		(100.0	)
Other		260			126			134			100.0
Total noninterest income	$	10,914		$	12,577		$	(1,663	)		(13.22	)  %
Noninterest income as a percentage of average assets		1.02	%		1.27	%

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 $2.1 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 in 2012 turned negative $5.0 million compared to positive accretion of $381,000 for 2011.  The accretion turned negative as a result of improvement in the expected cash flows of the FDIC acquired performing loan pools and the FDIC true-up liability accrual of $703,000 for 2012 in part offset by increased provision expense on individually assessed covered loans of $3.4 million compared to no provision expense for individually assessed covered loans for the same period in 2011.  See Item 1 - Accounting for FDIC Acquired Loans.

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Noninterest Expense.A summary of noninterest expense follows:

	Year Ended
	December 31,
	2012			2011			$ Chg			% Chg
	(Dollars in thousands)
Salaries and employee benefits	$	23,543		$	20,393		$	3,150			15.4	%
Equipment		2,700			1,996			704			35.3
Occupancy		2,932			2,279			653			28.7
Advertising and marketing		656			785			(129	)		(16.4	)
Legal and accounting		804			588			216			36.7
Directors fees and retirement		713			699			14			2.0
Consulting and other professional fees		515			716			(201	)		(28.1	)
Telecommunications		976			829			147			17.7
Supplies		562			547			15			2.7
Data processing fees		3,665			2,846			819			28.8
Loss on sales and write-downs of other real estate owned		219			771			(552	)		(71.6	)
Gain on sales and write-downs of FDIC other real estate owned		(313	)		(383	)		70			(18.3	)
Foreclosed asset expenses		970			725			245			33.8
Foreclosed FDIC acquired asset expenses		1,767			118			1,649			100.0
FDIC insurance and other regulatory fees		1,037			954			83			8.7
Acquisition related expenses		418			1,309			(891	)		(68.1	)
Deposit intangible expenses		781			692			89			12.9
Other operating expense		3,604			2,882			722			25.1
Total noninterest expenses	$	45,549		$	38,746		$	6,803			17.6	%
Noninterest expenses as a percentage of average assets		4.25	%		3.92	%
Efficiency ratio		74.89	%		83.21	%

The increase in salaries and employee benefits was primarily due to the increase, on average, of 18 FTE’s, or 6.0%, 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 2011 related to the Citizens and First Southern FDIC-assisted acquisitions.  During 2012, we recorded a loss on the sale of OREO, excluding FDIC acquired, lower than in 2011.  During 2012, we recorded gains on the sale of FDIC acquired OREO assets lower than in 2011.  Foreclosed asset expense for FDIC acquired assets increased from the prior year related to the improved resolution process for these assets.

Income Tax Expense.  For 2012, we recorded an income tax expense of $2.6 million, compared to $1.1 million during 2011.  Our effective tax rate 2012 was 27.7% compared to 22.3% for 2011.  See Item 8 – Note 16 to the Consolidated Financial Statements for additional information.

65

Comparison of Operating Results for the Year Ended December 31, 2011 and December 31, 2010

General.  During the year ended December 31, 2011, we recorded net income of $3.8 million, or $0.47 basic and diluted earnings per share, compared to a net income of $1.4 million, or $0.17 basic and diluted earnings per share, for the year ended December 31, 2010.  This $2.4 million improvement in operating results reflected an increase in net interest income, a decrease in loan loss provision expense, and an increase in noninterest income, which were partially offset by an increase in noninterest expense.

Interest Income.  Total interest income for 2011 increased $11.0 million, or 38.7%, to $39.4 million, compared to $28.4 million during 2010.  The increase was due to a $250.1 million, or 44.2%, increase in average interest-earning assets during 2011 to $815.7 million, compared to $565.5 million during 2010.  This increase in average interest-earning assets was due primarily to the two FDIC-assisted acquisitions completed in 2011 and, to a lesser extent, organic loan growth.  This increase in the average balance of earning assets was offset by a 23 basis point decrease in yield on interest-earning assets to 4.89% during 2011 as compared to 5.12% in 2010, as a result of the effects of the rate cuts by the FRB since 2007.

Interest income on loans for 2011 was $33.4 million compared to $23.8 million for 2010.  The $9.6 million increase in interest income on loans was primarily a result of the loans acquired in our FDIC-assisted transactions and our expansion in new markets, which is reflected in an $133.5 million increase in the average loan portfolio balance in addition to a 25 basis point increase in the weighted average yield on loans to 6.53% for 2011 compared to 6.28% in 2010.

Interest income on investment securities for 2011 was $5.4 million compared to $4.4 million in 2010.  Our average investment securities increased by $77.9 million to $220.2 million for 2011 as a result of increased purchases and $35.7 million in securities acquired through FDIC-assisted acquisitions.  The weighted average yield on investments for 2011 declined 89 basis points to 2.46% compared to 3.35% for 2010.

Interest income on short-term investments for 2011 was $308,000 compared to $174,000 in 2010.  Our average short-term investments increased $34.9 million to $78.4 million as a result of the growth in liquid assets from our FDIC-assisted acquisitions.  The average yield on short-term investments decreased 1 basis point for 2011.

Interest Expense.  Total interest expense increased $2.1 million or 25.3% to $10.4 million for 2011, compared to $8.3 million during 2010.  The cost of interest-bearing liabilities decreased 26 basis points to 1.31% during 2011 compared with 1.57% during 2010, as a result of the continued downward trends in the rate cycle.  This decrease in costs was offset by an increase in the average balance of interest-bearing liabilities during 2011 to $787.1 million, an increase of $260.3 million compared to $526.8 million during 2010 primarily driven by the deposits acquired through two FDIC-assisted acquisitions occurring in 2011.

Interest expense on deposits for 2011 was $7.6 million compared to $5.8 million for 2010.  The $1.2 million increase in interest expense on deposits was due to the deposits acquired through two FDIC-assisted acquisitions occurring in 2011 partially offset by a reduction in average deposit rates as deposits are repriced to lower market rates. The average rate paid on the deposit portfolio decreased 20 basis points from 1.28% for 2010 to 1.08% for 2011.  This decrease in the rate paid on deposits was offset by a $257.6 million increase in the average balance of interest-bearing deposits portfolio, primarily driven by two FDIC-assisted acquisitions occurring in 2011.

Interest expense on other borrowings, consisting of FHLB advances, federal funds purchased, and securities sold under agreement to repurchase, for 2011 was $2.8 million compared to $2.5 million for 2010.  This reflects a $2.8 increase in average other borrowings to $79.9 million for 2011 and an increased yield paid on these borrowings, from an average rate paid of 3.26% for 2010 compared to 3.51% for 2011.  The increase in expense was the result of variable rates on the structured repurchase agreements adjusting to higher fixed rates in accordance with their contractual terms.

Net Interest Income.  Net interest income for 2011 increased $8.9 million or 44.3% to $29.1 million from $20.2 million for 2010, primarily due to the increase in acquired interest earning assets and interest-bearing liabilities at a net positive spread through two FDIC-assisted acquisitions occurring in 2011.  The net interest spread increased 3 basis points to 3.58% for 2011 compared with 3.55% during 2010.  The net interest margin decreased 4 basis points for 2011 to 3.62% compared with 3.66% for 2010.

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Provision for Loan Losses.  During 2011, we recorded a $2.9 million provision for loan losses, which is a decrease of $2.6 million, or 47.3%, compared to the $5.5 million provision recorded during 2010.  The primary difference in provision expense was due to improvement in the underlying credit trends in the loan portfolio.

Our loan portfolio includes $126.2 million of loans acquired through FDIC-assisted acquisitions, which are generally recorded at a deep discount and subject to accounting under ASC 310-30.  These FDIC acquired loans were not subject to provision expense for 2011.

Our internally criticized and classified assets totaled $33.2 million at December 31, 2011, compared to $37.8 million at December 31, 2010.  These balances include nonperforming loans, other real estate, and repossessed assets.  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.

Noninterest Income.  A summary of noninterest income, excluding securities transactions, bargain purchase gains, and gain on BOLI life insurance proceeds, follows:

	Year Ended December 30,
	2011			2010			$ Chg			% Chg
	(Dollars in thousands)
Service charges on deposit accounts	$	4,777		$	4,113		$	664			16.1	%
Other service charges, commissions and fees		3,034			2,064			970			47.0	%
Brokerage fees		1,386			1,070			316			29.5	%
Mortgage banking fees		2,285			606			1,679			277.1	%
Bank-owned life insurance		588			610			(22	)		(3.6	)%
Accretion of FDIC loss-share receivable		381			-			381			100.0	%
Other		126			88			38			43.2	%
Total noninterest income	$	12,577		$	8,551		$	4,026			47.1	%
Noninterest income as a percentage of average assets (annualized)		1.27	%		1.33	%

The increase in service charges on deposit accounts, other service charges, commissions and fees is due primarily to the increase in new deposits accounts and new market activity from our FDIC-assisted acquisitions.  The increase in brokerage fees during the year was due to an increase in assets under management during the year, due primarily to the increases seen in the equity markets.  Mortgage banking fees increased due to our rapid expansion of opening 10 mortgage production offices in 2011 throughout our central and southern Georgia and north central Florida markets.

Accretion of FDIC loss-share receivable resulted in $381,000 in noninterest income in 2011, which consisted of $903,000 in present value adjustments partially offset by $522,000 of negative accretion associated with improvement in expected cash flows associated with the performing loan pools acquired through FDIC-assisted transactions.

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Noninterest Expense.A summary of noninterest expense follows:

	Year Ended
	December 31,
	2011			2010			$ Chg			% Chg
	(Dollars in thousands)
Salaries and employee benefits	$	20,393		$	12,676		$	7,717			60.9	%
Equipment		1,996			1,131			865			76.5	%
Occupancy		2,279			1,512			767			50.7	%
Advertising and marketing		785			593			192			32.4	%
Legal and accounting		588			616			(28	)		(4.5	)%
Directors fees and retirement		699			563			136			24.2	%
Consulting and other professional fees		716			364			352			96.7	%
Telecommunications		829			517			312			60.3	%
Supplies		547			350			197			56.3	%
Data processing fees		2,846			2,190			656			30.0	%
Loss (gain) on sales and write-downs of other real estate owned		388			(18	)		406			2255.6	%
Foreclosed asset expenses		725			1,013			(288	)		(28.4	)%
FDIC insurance and other regulatory fees		954			924			30			3.3	%
Acquisition related expenses		1,309			627			682			108.8	%
Deposit intangible expenses		692			276			416			150.7	%
Other operating expense		3,000			1,715			1,285			74.9	%
Total noninterest expenses	$	38,746		$	25,049		$	13,697			54.7	%
Noninterest expenses as a percentage of average assets		3.92	%		3.89	%
Efficiency ratio		83.21	%		79.79	%

The increase in salaries and employee benefits was due to an increase in the number of full-time equivalent employees to 327 for 2011, compared to 217 for 2010, primarily related to our FDIC-assisted acquisitions and our mortgage banking expansion.  We added approximately 57 employees associated with the two FDIC-assisted acquisitions and added approximately 20 employees associated with our mortgage banking expansion.  Equipment and occupancy expenses increased primarily due to the two FDIC-assisted acquisitions occurring in 2011.  Consulting and other professional fees increased in 2011, because we hired outside advisors to assist us in evaluating expansion and acquisition opportunities and in integrating our recently acquired branches. The increase in telecommunications expenses and supplies is related to our acquisition and expansion activity.  The increase in data processing fees reflects our expanded operations and the increased use of debit and ATM cards; however, this cost was more than offset by the income we received on these transactions.

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The increase in loss on sale of OREO was driven by our increased resolution activity related to our FDIC-assisted portfolio.  Foreclosed asset and collection expenses decreased primarily due to the FDIC sharing in the costs for the FDIC-assisted portfolios we acquired in 2011.  Other operating expenses increased primarily due to the amortization of core deposit intangibles associated with our 2011 FDIC-assisted acquisition activity.  In addition, we recorded acquisition expenses of approximately $1.3 million in 2011 related to the cost associated with our acquisitions and conversion of the operating systems in these branches to our existing operating system.

Income Tax Expense.  For 2011, we recorded an income tax expense of $1.1 million, compared to a tax benefit of $307,000 during 2010.

Liquidity

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 to manage those requirements.  We strive 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, we 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 December 31, 2012, HeritageBank 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 $123.4 million with total outstanding advances of $60.0 million at December 31, 2012.

At December 31, 2012, total deposits decreased $14.6 million, or 1.7%, to $869.6 million compared to $884.2 million for 2011 primarily driven by planned runoff of time deposit customers.  Federal funds purchased and securities sold under agreements to repurchase decreased $1.8 million, or 5.2%, to $33.2 million for 2012 compared to $35.0 million for 2011.  Also, FHLB advances increased $25.0 million to $60.0 million for 2012 compared to $35.0 million for 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 December 31, 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.

The consolidated statements of cash flows for 2012 detail cash flows from operating, investing and financing activities.  For 2012, net cash used in investing activities and financing activities were $26.4 million and $20.0 million, respectively, offset in part by net cash provided by operating activities of $35.8 million, resulting in a net decrease in cash of $10.5 million as compared to 2011.

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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.

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 December 31, 2012.

	December 31, 2012
	Less than One Year		One through Three Years		Four through Five Years		After Five Years		Total
	(In thousands)
Contractual obligations:
FHLB advances	$	-	$	20,000	$	25,000	$	15,000	$	60,000
Repurchase agreement		417		-		15,000		15,000		30,417
Other borrowings		2,802		-		-		-		2,802
Operating leases (premises)		416		890		582		1,778		3,666
Total advances and operating Leases		3,635		20,890		40,582		31,778		96,885
Off-balance sheet loan commitments:
Undisbursed portions of loans closed		-		-		-		-		-
Commitments to originate loans		36,887		-		-		-		36,887
Unused lines of credit		57,180		8,482		3,441		18,492		87,595
Total loan commitments	$	94,067	$	8,482	$	3,441	$	18,492	$	124,482
Total contractual obligations and loan commitments									$	221,367

Capital Resources

Heritage and HeritageBank are subject to minimum capital requirements imposed by the GDBF, FDIC and FRB.  Based on their capital levels at December 31, 2012, Heritage and HeritageBank exceeded these state and federal requirements.  Consistent with our goals to operate a sound and profitable organization, our policy is for HeritageBank to maintain a "well-capitalized" status under the capital categories of the FDIC.  Based on capital levels at December 31, 2012, HeritageBank was considered to be well-capitalized.

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As reflected in the following table, Heritage and HeritageBank exceeded the minimum capital ratios at December 31, 2012:

	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:
Heritage Consolidated	$	128,381		18.4	%	$	55,697		8.0	%		N/A		-
HeritageBank	$	111,762		16.4	%	$	54,359		8.0	%	$	67,949		10.0	%
Tier I Capital to Risk-Weighted Assets:
Heritage Consolidated	$	119,881		17.2	%	$	27,849		4.0	%		N/A		-
HeritageBank	$	103,248		15.2	%	$	27,180		4.0	%	$	40,769		6.0	%
Tier I Capital to Average Total Assets:
Heritage Consolidated	$	119,881		11.0	%	$	43,498		4.0	%		N/A		-
HeritageBank	$	103,248		9.6	%	$	43,186		4.0	%	$	53,982		5.0	%

Impact of Inflation

The effects of price changes and inflation can vary substantially for most financial institutions.  While management believes that inflation affects the economic value of total assets, it believes that it is difficult to assess the overall impact.  Management believes this to be the case due to the fact that generally neither the timing nor the magnitude of changes in the consumer price index coincides with changes in interest rates or asset values.  For example, the price of one or more of the components of the consumer price index may fluctuate considerably, influencing composite consumer price index, without having a corresponding effect on interest rates, asset values, or the cost of those goods and services normally purchased by us.  In years of high inflation and high interest rates, intermediate and long-term interest rates tend to increase, adversely impacting the market values of investment securities, mortgage loans and other long-term fixed rate loans.  In addition, higher short-term interest rates tend to increase the cost of funds.  In other years, the opposite may occur.

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Item 7a.  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 Asset/Liability Committee (“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;

· Extending time deposit and other borrowings duration; and

· Managing loan and deposit pricing to optimize ALCO strategies.

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.

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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 such as the interest rate swap derivative executed in 2012.  See Item 8 – Note 19 in the Consolidated Financial Statements.  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 December 31, 2012, a drop in interest rates would decrease our net interest income and an increase in rates would increase our net interest income, also known as being “asset sensitive.”  The asset sensitivity position was in part driven by our strategic decision to extend other borrowings and continue improving the balance sheet mix.  We plan to improve the asset 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.

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The following table sets forth the distribution of the repricing of our earning assets and interest-bearing liabilities as of December 31, 2012, the interest rate sensitivity gap (i.e., interest rate sensitive assets divided by interest rate sensitivity liabilities), the cumulative interest rate sensitivity gap ratio (i.e., interest rate sensitive assets divided by interest rate sensitive liabilities) and the cumulative sensitivity gap ratio. The table also sets forth the time periods in which earning assets and liabilities will mature or may reprice in accordance with their contractual terms. However, the table does not necessarily indicate the impact of general interest rate movements on the net interest margin since the repricing of various categories of assets and liabilities is subject to competitive pressures and the needs of our customers. In addition, various assets and liabilities indicated as repricing within the same period may in fact reprice at different times within such period and at different rates.

	December 31, 2012
	Maturing or Repricing Within
	Zero to Three Months			Three Months to One Year			One to Five Years			Over Five Years			Total
	(Dollars in thousands)
Earning assets:
Short-term assets	$	19,699		$	-		$	-		$	-		$	19,699
Investment securities		19,259			40,065			96,082			66,000			221,406
Loans held for sale		15,608			-			-			-			15,608
Loans		102,003			131,553			345,363			82,024			660,943
		156,569			171,618			441,445			148,024			917,656
Interest-bearing liabilities:
Interest-bearing demand deposits		(144,954	)		-			-			-			(144,954	)
Savings and money market		(313,628	)		-			-			-			(313,628	)
Time deposits		(65,466	)		(150,993	)		(78,241	)		-			(294,700	)
Other borrowings		(33,219	)		-			-			-			(33,219	)
Federal Home Loan Bank advances		-			-			(45,000	)		(15,000	)		(60,000	)
		(557,267	)		(150,993	)		(123,241	)		(15,000	)		(846,501	)
Interest rate sensitivity gap	$	(400,698	)	$	20,625		$	318,204		$	133,024		$	73,957
Cumulative interest rate sensitivity gap	$	(400,698	)	$	(380,073	)	$	(61,869	)	$	71,155
Interest rate sensitivity gap ratio		0.28			1.14			3.58			9.87
Cumulative interest rate sensitivity gap ratio		0.28			0.46			0.93			1.08

The following table shows the results of our projections for net interest income expressed as a percentage change over our net interest income projection 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 dramatic increases in interest rates when they begin to rise.  To address this concern, we increased our upward interest rates shocks to include a shock of 400 basis points.

Market Rate Change	Effect on Net Interest Income
+400	6.4%
+300	6.1%
+200	5.5%
+100	4.4%
-100	-2.3%

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Quarterly Financial Summary - Unaudited

The following table presents condensed information relating to quarterly periods presented.

	For the Three Months Ended
	December  31, 2012		September  30, 2012		June 30, 2012		March 31, 2012		December 31, 2011
	(dollars in thousands expect per share data)
Results of Operations:
Net interest income	$	14,530	$	12,713	$	10,159	$	9,724	$	9,211
Provision for loan losses		2,507		1,934		1,091		400		595
Net interest income after provision for credit losses		12,023		10,779		9,068		9,324		8,616
Total noninterest income		2,873		4,361		3,679		2,783		3,173
Total noninterest expense		12,095		11,978		10,674		10,801		10,528
Income before provision (benefit) for income taxes		2,801		3,162		2,073		1,306		1,261
Provision (benefit) for income taxes		373		1,164		713		335		(90	)
Net income	$	2,428	$	1,998	$	1,360	$	971	$	1,351
Per Share Data:
Weighted average shares – basic		7,720,839		7,942,852		8,071,354		8,144,382		8,229,293
Weighted average shares – diluted		7,722,867		7,944,983		8,702,935		8,145,730		8,230,206
Basic earnings per share	$	0.31	$	0.25	$	0.17	$	0.12	$	0.17
Diluted earnings per share		0.31		0.25		0.17		0.12		0.17
Cash dividend declared per share		0.24		0.04		0.04		0.04		0.03

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Item 8.  Financial Statements and Supplementary Data

See page 75 for our unaudited quarterly results of operations and the pages beginning with F-1 for our audited consolidated financial statements.

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Item 9.  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A.  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 December 31, 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 preceding the filing date of this annual report.  Our Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 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 December 31, 2012, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Management’s Annual Report on Internal Control Over Financial Reporting

The management of Heritage is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) under the Securities Exchange Act of 1934.  The Company’s internal control over financial reporting is a process designed to provide reasonable assurance to the Company’s management and board of directors regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles accepted in the United States of America.

The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of  records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.

77

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  All internal control systems, no matter how well designed, have inherent limitations, including the possibility of human error and the circumvention of overriding controls.  Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation.  Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.

Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2012.  In making the assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.  Based on this assessment and those criteria, management concluded that the Company maintained effective internal control over financial reporting as of December 31, 2012.

The Company’s independent registered public accounting firm has issued an audit report on Heritage’s internal control over financial reporting.  This report can be found in Item 8 – Report of Independent Registered Public Accounting Firm.

Item 9B.  Other Information

None.

PART III

Item 10.  Directors and Executive Officers and Corporate Governance

Directors

Information concerning the Directors of the Company is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 22, 2013, a copy of which will be filed not later than 120 days after the close of the 2012 fiscal year.

Executive Officers

Information concerning the Executive Officers of the Company is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 22, 2013, a copy of which will be filed not later than 120 days after the close of the 2012 fiscal year.

Audit Committee Matters and Audit Committee Financial Expert

The Board of Directors of the Company has a standing Audit Committee, which has been established in accordance with Section 3(a)(58)(A) of the Exchange Act.  The members of that committee are Directors Burger (chair), McGinley and Stanley, all of whom are considered independent under Nasdaq listing standards.  The Board of Directors has determined that Director Burger is an “audit committee financial expert” as defined in applicable SEC rules.  Additional information concerning the Audit Committee is incorporated herein by reference from the Company’s definitive proxy statement for its annual meeting of stockholders to be held May 22, 2013 (except for information contained under the heading “Report of the Audit Committee”), a copy of which will be filed not later than 120 days after the close of the 2012 fiscal year.

78

Nomination Procedures

Under the Nominating Committee Charter, the Nominating Committee is required to review nominations for election as a director submitted by stockholders addressed to the Company's Secretary in compliance with the Company's charter and bylaws using the same criteria as all other nominations.  Those criteria are business experience, education, integrity and reputation, independence, conflicts of interest, diversity, age, number of other directorships and commitments (including charitable organizations), tenure on the Board, attendance at Board and committee meetings, stock ownership, specialized knowledge (such as an understanding of banking, accounting, marketing, finance, regulation and public policy) and a commitment to the Company's communities and shared values, as well as overall experience in the context of the needs of the Board as a whole.

Under the Bylaws of the Company, in order for a stockholder nominee to be eligible for election a director of the Company, the nomination (i) must have been agreed to by the Board of Directors or Nominating Committee -or (ii) must have been made by a stockholder who (1) is a stockholder of record on the date of giving the public notice of the date of the meeting as noted below and on the record date for the determination of stockholders entitled to vote at the meeting, and (2) complies with the notice procedures below.  Stockholder nominations must be made by timely notice in writing to the Secretary of the Company.  To be timely, a stockholder's notice shall be delivered or mailed to and received by the Secretary at the principal executive offices of the Company not less than 90 days or more than 120 days prior to the date of the meeting; provided, however, that in the event that less than 100 days' notice or public announcement of the date of the meeting is given or made to stockholders, notice by the stockholder to be timely must be so received not later than the close of business on the tenth day following the day on which such notice of the date of the meeting was mailed or otherwise transmitted or the day on which public announcement of the date of the meeting was first made by the Company, whichever shall first occur.  A stockholder's notice must be in writing and set forth (a) as to each person whom the stockholder proposes to nominate for election as a director, all information relating to such person that is required to be disclosed in connection with solicitations of proxies for election of directors, or is otherwise required, in each case pursuant to Regulation 14A under the Exchange Act or any successor rule or regulation; and (b) as to the stockholder giving the notice: (i) the name and address of such stockholder as they appear on the Company 's books and of the beneficial owner, if any, on whose behalf the nomination is made; (ii) the class or series and number of shares of capital stock of the Company that are owned beneficially or of record by such stockholder and such beneficial owner; (iii) a description of all arrangements or understandings between such stockholder and each proposed nominee and any other person or persons (including their names) pursuant to which the nomination(s) are to be made by such stockholder; (iv) a representation that such stockholder intends to appear in person or by proxy at the meeting to nominate the persons named in its notice; and (v) any other information relating to such stockholder that would be required to be disclosed in a proxy statement or other filings required to be made in connection with solicitations of proxies for election of directors pursuant to Regulation 14A under the Exchange Act or any successor rule or regulation.   Such stockholder notice must be accompanied by a written consent of each proposed nominee to be named as a nominee and to serve as a director if elected.  No person shall be eligible for election as a director of the Company unless nominated in accordance with these requirements.  The officer of the Company or other person presiding at the meeting shall, if the facts so warrant, determine that a nomination was not made in accordance with such provisions and, if he or she should so determine, he or she shall so declare to the meeting and the defective nomination shall be disregarded.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Securities Exchange Act of 1934 requires that the Company's directors and executive officers, and persons who own more than 10% of the Company's common stock, file with the SEC initial reports of ownership and reports of changes in ownership of the Company's common stock.  Officers, directors and greater than 10% stockholders are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms they file.  To the Company's knowledge, no late reports occurred during the fiscal year ended December 31, 2012, and all other Section 16(a) filing requirements applicable to our executive officers, directors and greater than 10% beneficial owners were complied with.

Code of Ethics

In November 2010, the Company adopted a written Code of Business Conduct and Ethics based upon the standards set forth under Item 406 of Regulation S-B of the Securities and Exchange Commission.  The Code of Business Conduct and Ethics applies to all of the Company's directors, officers and employees.  This code is available to all interested parties on the Company’s website at www.eheritagebank.com, under Governance Documents in the Investor Relations section.

79

Item 11.  Executive Compensation

Information concerning executive compensation required by this item is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 22, 2013, a copy of which will be filed not later than 120 days after the close of the 2012 fiscal year.

Item 12.  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Information concerning security ownership of certain beneficial owners and management required by this item is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 22, 2013, a copy of which will be filed not later than 120 days after the close of the 2012 fiscal year.

See Item 5 for information regarding shares available under the Company’s equity incentive compensation plans.

Item 13.  Certain Relationships and Related Transactions and Director Independence

Information concerning certain relationships and related transactions required by this item is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 22, 2013, a copy of which will be filed not later than 120 days after the close of the 2012 fiscal year.

Information concerning the independence of our directors required by this item is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 22, 2013, a copy of which will be filed not later than 120 days after the close of the 2012 fiscal year.

Item 14.  Principal Accountant Fees and Services

Information concerning fees and services by our principal accountants required by this item is incorporated herein by reference from our definitive proxy statement for the annual meeting of stockholders to be held on May 22, 2013, a copy of which will be filed not later than 120 days after the close of the 2012 fiscal year.

PART IV

Item 15.  Exhibits and Financial Statement Schedules

(a)(1) List of Financial Statements

The following are contained in Item 8 of this Form 10-K:

Reports of Independent Registered Public Accounting Firm

Consolidated Balances Sheets as of December 31, 2012 and 2011

Consolidated Statements of Operations for the Years Ended December 31, 2012, 2011 and 2010

Consolidated Statements of Other Comprehensive Income (Loss) for the Years Ended December 31, 2012, 2011, and 2010

Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2012, 2011, and 2010

Consolidated Statements of Cash Flows for the Years Ended December 31, 2012, 2011 and 2010

Notes to Consolidated Financial Statements

80

(a)(2) List of Financial Statement Schedules:

All financial statement schedules have been omitted as the information is not required under the related instructions or is not applicable.

(a)(3) List of Exhibits:

Exhibit Number	Document	Reference to Prior Filing or Exhibit Number Attached Hereto
2.1	Plan of Conversion and Reorganization of Heritage MHC	a
2.2	Form of Agreement and Plan of Merger by and among Heritage Financial Group, Heritage MHC and Heritage Financial Group, Inc.	a
2.3	Purchase and Assumption Agreement dated as of December 4, 2009 by and among the FDIC, receiver of The Tattnall Bank, Reidsville, Georgia; HeritageBank of the South; and the FDIC in its corporate capacity.	d
2.4	Purchase and Assumption Agreement dated as of February 18, 2011 by and among the FDIC, receiver of Citizens Bank of Effingham, Springfield, Georgia; HeritageBank of the South; and the FDIC in its corporate capacity.	g
2.5	Purchase and Assumption Agreement dated as of August 19, 2011 by and among the FDIC, receiver of First Southern National Bank, Statesboro, Georgia; HeritageBank of the South; and the FDIC in its corporate capacity.	h
2.6	Purchase and Assumption Agreement dated February 23, 2010, between HeritageBank of the South and The Park Avenue Bank	e
2.7	Purchase and Assumption Agreement dated April 6, 2012, between HeritageBank of the South and AB&T National Bank	l
2.8	Purchase and Assumption Agreement dated as of March 8, 2013 by and among the FDIC, receiver of Frontier Bank, LaGrange, Georgia; HeritageBank of the South; and the FDIC in its corporate capacity.	n
3.0	Form S-3	m
3.1	Articles of Incorporation of Heritage Financial Group, Inc.	a
3.2	Bylaws of Heritage Financial Group, Inc.	a
4	Form of Heritage Financial Group, Inc. Common Stock Certificate	a
10.1	Employment Agreement between O. Leonard Dorminey and HeritageBank	b*
10.2	Employment Agreement between O. Leonard Dorminey and Heritage Financial Group	b*
10.3	Employment Agreement between Carol W. Slappey and HeritageBank	b*
10.4	Deferred Compensation and Excess/Matching Contribution Plans	b
10.5	Supplemental Executive Retirement Plan	b
10.6	Directors’ Retirement Plan	b
10.7	Employee Stock Ownership Plan	b
10.8	Heritage Financial Group 2006 Equity Incentive Plan	c
10.9	Awards made to directors and executive officers under the Heritage Financial Group 2006 Equity Incentive Plan on July 1, 2006 and the forms and agreement in Exhibit 10.10.	c
10.10	Forms of agreements for stock options (including incentive stock options), stock appreciation rights, restricted stock and restricted share units under the Heritage Financial Group 2006 Equity Incentive Plan.	c
10.11	Employment Agreement between T. Heath Fountain and HeritageBank	f*
10.12	Employment Agreement between O. Mitchell Smith and HeritageBank	f*
10.13	Employment Agreement between David Durland and HeritageBank	i*
10.14	Heritage Financial Group, Inc. 2011 Equity Incentive Plan	j

81

10.15	Awards made to directors and executive officers under the Heritage Financial Group, Inc. 2011 Equity Incentive Plan on July 1, 2011 and the forms and agreement in Exhibit 10.16.	j
10.16	Forms of agreements for stock options (including incentive stock options), stock appreciation rights, restricted stock and restricted share units under the Heritage Financial Group, Inc. 2011 Equity Incentive Plan.	j
12.1	Ratio of Earnings to Fixed Charges	12.1
14	Code of Business Conduct and Ethics	k
21	Subsidiaries of the Company	k
23	Consent of Accountants	23
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	Filed as an exhibit to the Heritage Financial Group, Inc. Registration Statement on Form S-1 (File No. 333-123581) filed on May 23, 2010.
b	Filed as an exhibit to the Registration Statement of Heritage Financial Group (the Predecessor) on Form SB-2 (File No. 333-123581) filed on March 25, 2005.
c	Included as Exhibit 10.11 to the Form 10-KSB for the year ended December 31, 2006, filed by Heritage Financial Group (the Predecessor) with the SEC on March 27, 2007.
d	Included as an exhibit to the Form 8-K filed by Heritage Financial Group (the Predecessor) with the SEC on December 8, 2009.
e	Included as an exhibit to the Form 8-K filed by Heritage Financial Group (the Predecessor) with the SEC on February 25, 2010.
f	Filed as an exhibit to Pre-Effective Amendment No. 1 to the Heritage Financial Group, Inc. Registration Statement on Form S-1 (File No. 333-123581) filed on August 9, 2010.
g	Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc. with the SEC on February 24, 2011.
h	Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc. with the SEC on August 22, 2011.
i	Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc. with the SEC on April 21, 2011.
j	Included as an exhibit to the Form 10-Q filed by Heritage Financial Group, Inc. with the SEC on August 15, 2011.
k	Included as an exhibit to the Form 10-K filed by Heritage Financial Group, Inc.  with the SEC on March 31, 2011.
l	Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc.  with the SEC on April 11, 2012.
m	Form S-3 was filed by Heritage Financial Group, Inc.  with the SEC on October 25, 2012.
n	Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc. with the SEC on March 12, 2013.
*	Represents a management contract or compensatory plan or arrangement.

82

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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:	March 15, 2013	By:	/s/ O. Leonard Dorminey
			O. Leonard Dorminey, President and Chief Executive Officer
			(Duly Authorized Representative)

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Date:	March 15, 2013	/s/ O. Leonard Dorminey
		O. Leonard Dorminey
		President, Chief Executive Officer and Director (Principal Executive Officer)
Date:	March 15, 2013	/s/ Antone D. Lehr
		Antone D. Lehr, Chairman of the Board
Date:	March 15, 2013	/s/ Joseph C. Burger
		Joseph C. Burger, Vice Chairman of the Board
Date:	March 15, 2013	/s/ Douglas J. McGinley
		Douglas J. McGinley, Director
Date:	March 15, 2013	/s/ Carol W. Slappey
		Carol W. Slappey, Director
Date:	March 15, 2013	/s/ J. Keith Land
		J. Keith Land, Director
Date:	March 15, 2013	/s/ J. Lee Stanley
		J. Lee Stanley, Director
Date:	March 15, 2013	/s/ T. Heath Fountain
		T. Heath Fountain, Executive Vice President
		Chief Administrative Officer and Chief Financial Officer
		(Principal Financial and Accounting Officer)

83

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS OF

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

Reports of Independent Registered Public Accounting Firm	F-1
Consolidated Balance Sheets at December 31, 2012 and 2011	F-3
Consolidated Statements of Income for the Years Ended December 31, 2012, 2011 and 2010	F-4
Consolidated Statements of Comprehensive Income (Loss) for the Years ended December 31, 2012, 2011 and 2010	F-5
Consolidated Statements of Stockholders' Equity for the Years ended December 31, 2012, 2011 and 2010	F-6
Consolidated Statements of Cash Flows for the Years ended December 31, 2012, 2011 and 2010	F-8
Notes to Consolidated Financial Statements	F-10

***

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors

Heritage Financial Group, Inc.

and Subsidiary

Albany, Georgia

We have audited the accompanying consolidated balance sheets of Heritage Financial Group, Inc. and Subsidiary as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income (loss), stockholders' equity and cash flows for each of the three years in the period ended December 31, 2012.  These financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Heritage Financial Group, Inc. and Subsidiary as of December 31, 2012 and 2011, and the results of their income and their cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 15, 2013 expressed an unqualified opinion on the Company’s internal control over financial reporting

/s/ Mauldin & Jenkins, LLC

Albany, Georgia

March 15, 2013

F-1

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors

Heritage Financial Group, Inc.

and Subsidiary

Albany, Georgia

We have audited the internal control over financial reporting of Heritage Financial Group, Inc. and subsidiary (the “Company”) as of December 31, 2012, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2012 of the Company and our report dated March 15, 2013 expressed an unqualified opinion on those consolidated financial statements.

/s/ Mauldin & Jenkins, LLC

Albany, Georgia

March 15, 2013

F-2

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands)

	December 31,
	2012			2011
Assets
Cash and due from banks	$	23,993		$	34,521
Interest-bearing deposits in banks		15,393			43,101
Federal funds sold		4,306			21,753
Total cash and cash equivalents		43,692			99,375
Securities available for sale, at fair value		221,406			259,017
Federal Home Loan Bank Stock, at cost		4,330			4,067
Other equity securities, at cost		1,010			1,010
Loans held for sale		15,608			7,471
Loans		597,579			453,163
Covered loans		72,425			107,457
Less allowance for loan losses		9,061			7,494
Loans, net		660,943			553,126
Other real estate owned		3,242			3,362
Covered other real estate owned		9,467			10,047
Total other real estate owned		12,709			13,409
FDIC loss-share receivable		60,731			83,901
Premises and equipment, net		33,015			29,532
Goodwill and intangible assets		4,235			4,848
Cash surrender value of bank owned life insurance		23,382			15,611
Other assets		16,445			18,485
	$	1,097,506		$	1,089,852
Liabilities and Stockholders' Equity
Deposits
Noninterest-bearing	$	116,272		$	78,823
Interest-bearing		753,282			805,364
Total deposits		869,554			884,187
Federal funds purchased and securities sold under repurchase agreements		33,219			35,049
Other borrowings		60,000			35,000
Other liabilities		14,084			11,480
Total liabilities		976,857			965,716
Commitment and Contingencies (Note 20)
Stockholders' equity
Preferred stock, par value; $0.01; 5,000,000  shares authorized;none issued, respectively		-			-
Common stock, par value $0.01; 45,000,000 shares authorized;8,172,486 and  8,712,031 shares issued, respectively		82			87
Capital surplus		82,154			88,393
Retained earnings		46,299			42,374
Accumulated other comprehensive loss, net of tax of $2,566 and  $1,384		(3,849	)		(2,076	)
Unearned employee stock ownership plan (ESOP) shares,385,836 and 439,138 shares		(4,037	)		(4,642	)
Total stockholders' equity		120,649			124,136
	$	1,097,506		$	1,089,852

See Notes to Consolidated Financial Statements.

F-3

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in Thousands, except per share data)

	Years Ended December 31,
	2012			2011			2010
Interest income
Interest and fees on loans	$	49,798		$	33,725		$	23,810
Interest on taxable securities		3,681			4,536			3,495
Interest on nontaxable securities		1,123			880			960
Interest on federal funds sold		30			60			45
Interest on deposits in other banks		106			248			129
		54,738			39,449			28,439
Interest expense
Interest on deposits		4,874			7,550			5,759
Interest on other borrowings		2,739			2,800			2,515
		7,613			10,350			8,274
Net interest income		47,125			29,099			20,165
Provision for loan losses		5,930			2,895			5,500
Net interest income after provision for loan losses		41,195			26,204			14,665
Noninterest income
Service charges on deposit accounts		4,748			4,777			4,113
Bankcard services income		3,231			2,637			1,709
Other service charges, commissions and fees		326			305			355
Brokerage fees		1,838			1,386			1,070
Mortgage banking activities		4,768			2,377			606
Bank owned life insurance		771			588			610
Gain on bank owned life insurance		-			32			916
Other-than-temporary impairment losses		-			(159	)		-
Portion of impairment loss recognized in other comprehensive income		-			(116	)		-
Net impairment losses recognized in earnings		-			(43	)		-
Gain on sales of securities		2,838			684			294
Gain (loss) on acquisitions		(56	)		4,217			2,722
Accretion of FDIC loss share receivable		(5,028	)		381			-
Other income		260			126			88
		13,696			17,467			12,484
Noninterest expense
Salaries and employee benefits		23,543			20,393			12,676
Equipment  and occupancy		5,632			4,275			2,643
Advertising and marketing		656			785			593
Professional fees		1,319			1,304			980
Information services expenses		4,641			3,675			2,707
(Gain) loss on sales and write-downs of other real estate owned		219			771			(18	)
Gain on sales and write-downs of  FDIC acquired other real estate owned		(313	)		(383	)		-
Foreclosed asset expenses		970			725			1,013
Foreclosed FDIC acquired asset expenses		1,767			118			-
FDIC insurance and other regulatory fees		1,037			954			924
Impairment loss on intangible asset		-			-			1,000
Acquisition  related expenses		418			1,309			627
Deposit intangible expenses		781			692			276
Other operating		4,879			4,128			2,627
		45,549			38,746			26,049
Income before income taxes (benefit)	$	9,342		$	4,925		$	1,099
Applicable income tax expense (benefit)		2,585			1,100			(307	)
Net income	$	6,757		$	3,825		$	1,406
Earnings  per common share:
Basic earnings per share	$	0.85		$	0.47		$	0.17
Diluted earnings per share	$	0.85		$	0.47		$	0.17
Weighted average-common shares outstanding
Basic		7,969,104			8,188,843			8,424,394
Diluted		7,970,903			8,190,062			8,432,282

See Notes to Consolidated Financial Statements.

F-4

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Dollars in Thousands)

	Years Ended December 31,
	2012			2011			2010
Net income	$	6,757		$	3,825		$	1,406
Other comprehensive income (loss):
Accretion of realized gain on terminated cash flow hedge, net of tax of $65 , $99,and $141		(98	)		(149	)		(211	)
Unrealized loss on cash flow hedge, net of tax benefit of $863, $- and $-		(1,295	)		-			-
Net unrealized holding gains (losses) arising during period, net of tax (benefit) of $1,514,  $2,474 and $695		1,514			3,710			(1,043	)
Reclassification adjustment for gains and securities impairment included in net income, net of tax $1,135, $273 and $118		(1,703	)		(410	)		(176	)
Adjustment to recognize funded status of pension plan, net of tax of $127, $875 and $65		(191	)		(1,313	)		(97	)
Total other comprehensive income (loss)		(1,773	)		1,838			(1,527	)
Comprehensive income (loss)	$	4,984		$	5,663		$	(121	)

See Notes to Consolidated Financial Statements.

F-5

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

(Dollars in Thousands, except per share data)

																			Other
													Unearned						Compre-
	Common Stock						Capital			Retained			ESOP			Treasury			hensive
	Shares			Par Value			Surplus			Earnings			Shares			Stock			Income (Loss)			Total
Balance, December 31, 2009		11,454,344		$	115		$	40,610		$	38,984		$	(2,424	)	$	(14,080	)	$	(2,387	)	$	60,818
Net income		-			-			-			1,406			-			-			-			1,406
Cash dividend declared,$0.36 per share		-			-			-			(854	)		-			-			-			(854	)
Stock-based compensation expense		-			-			810			-			-			-			-			810
Repurchase of 1,578 shares of stock for the treasury		-			-			-			-			-			(19	)		-			(19	)
Issuance of 1,075 shares of common stock from the treasury		-			-			(4	)		-			-			14			-			10
Items relating to conversion and stock offering:
Merger of Heritage MHC		(7,868,875	)		(79	)		102			-			-			-			-			23
Treasury stock retired		(1,055,587	)		(11	)		(14,074	)		-			-			14,085			-			-
Common stock exchanged for cash in lieu of issuing fractional shares		(411,127	)		(4	)		4			-			-			-			-			-
Proceeds from stock offering, net offering expenses ($4,459)		6,591,756			66			61,393			-			-			-			-			61,459
Purchase of ESOP shares (327,677)		-			-			-			-			(3,277	)		-			-			(3,277	)
Other comprehensive loss		-			-			-			-			-			-			(1,527	)		(1,527	)
Tax benefit from stock-based compensation plans		-			-			(14	)		-			-			-			-			(14	)
ESOP shares earned, 38,403 shares		-			-			3			-			456			-			-			459
Tax benefit on ESOP expense		-			-			46			-			-			-			-			46
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 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

F-6

(Continued)

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Continued)

(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		-			-			-			6,757			-			-			6,757
Cash dividend declared, $0.36 per share		-			-			-			(2,832	)		-			-			(2,832	)
Issuance of  15,600 shares of restricted common stock		15,600			-			-			-			-			-			-
Forfeiture of  326  shares of restricted common stock		(326	)		-			-			-			-			-			-
Repurchase of  554,819  shares of common stock		(554,819	)		(5	)		(7,215	)		-			-			-			(7,220	)
Stock-based compensation expense		-			-			858			-			-			-			858
Other comprehensive loss		-			-			-			-			-			(1,773	)		(1,773	)
Tax benefit from stock-based compensation plans		-			-			7			-			-			-			7
ESOP shares earned 53,302  shares		-			-			64			-			605			-			669
Tax benefit on ESOP expense		-			-			47			-			-			-			47
Balance, December 31, 2012		8,172,486		$	82		$	82,154		$	46,299		$	(4,037	)	$	(3,849	)	$	120,649

See Notes to Consolidated Financial Statements.

F-7

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)

	Years Ended December 31,
	2012			2011			2010
OPERATING ACTIVITIES
Net income	$	6,757		$	3,825		$	1,406
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		2,110			1,522			946
Amortization of deposit intangibles		781			692			276
Impairment loss on intangible assets		-			-			1,000
Provision for loan losses		5,930			2,895			5,500
ESOP compensation expense		669			620			459
Provision for deferred (taxes) benefit		(384	)		(270	)		955
Stock-based compensation expense		858			728			810
Accretion of gain on termination of cash flow hedge		(163	)		(248	)		(352	)
Amortization of available for sale discounts and premiums, net		3,761			2,533			1,904
Impairment on securities available for sale		-			43			-
Gain on sales of securities available for sale, net		(2,838	)		(684	)		(294	)
(Gain) loss on sales and write-downs of  other real estate owned		219			771			(18	)
(Gain) on sales and write-downs of  FDIC acquired other real estate owned		(313	)		(383	)		-
Net gain on sales or disposal of premises and equipment		-			(4	)		(4	)
Increase in bank owned life insurance		(771	)		(587	)		(267	)
Excess tax benefit related to  stock-based compensation plans		(7	)		8			14
Excess tax expense related to ESOP		(47	)		(90	)		(46	)
Decrease in FDIC loss share receivable		18,143			3,494			-
Accretion of FDIC loss share receivable		5,028			(381	)		-
(Increase) decrease in interest receivable		1,131			(1,782	)		116
Increase (decrease) in interest payable		(291	)		270			(43	)
Increase in loans held for sale		(8,137	)		(7,246	)		(225	)
Decrease in prepaid FDIC assessment		344			840			837
Gain on bank owned life insurance		-			(32	)		(916	)
Bargain purchase (gain) loss		56			(4,217	)		(2,722	)
Net other operating activities		2,964			2,547			(2,010	)
Total adjustments		29,043			1,039			5,920
Net cash provided by operating activities		35,800			4,864			7,326
INVESTING ACTIVITIES
(Increase) decrease in interest-bearing deposits in banks		27,708			(32,190	)		32,325
Purchases of securities available for sale		(170,043	)		(135,484	)		(256,281	)
Proceeds from maturities of securities available for sale		94,697			98,185			98,224
Proceeds from sales of securities available for sale		111,720			55,935			36,566
Purchase of bank owned life insurance		(7,000	)		-			-
Increase (decrease) in Federal Home Loan Bank stock		(263	)		1,202			(450	)
(Increase) decrease in federal funds sold		17,447			(19,053	)		8,640
Increase in loans, net		(113,821	)		(8,876	)		(39,858	)
Purchases of premises and equipment		(4,311	)		(9,562	)		(3,334	)
Net cash received from acquisition activity		5,831			67,704			40,553
Proceeds from sales of premises and equipment		-			19			17
Proceeds from sales of other real estate owned		11,665			8,851			2,628
Net cash provided by (used in) investing activities		(26,370	)		26,731			(80,970	)

(Continued)

F-8

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)

	Years Ended December 31,
	2012			2011			2010
FINANCING ACTIVITIES
Increase (decrease) in deposits	$	(33,130	)	$	6,454		$	10,573
Increase (decrease) in federal funds purchased and securities sold under repurchase agreements		(1,830	)		2,628			(422	)
Proceeds from other borrowings		25,000			-			20,000
Repayment of other borrowings		-			(32,744	)		-
Excess tax benefit related to   stock-based compensation plans		7			(8	)		(14	)
Excess tax related to ESOP		47			90			46
Purchase of shares, net		(7,220	)		(1,310	)		(8	)
Net proceeds from common stock offering and reorganization		-			-			61,482
Purchase of common shares for ESOP		-			-			(3,277	)
Dividends paid to stockholders		(2,832	)		(987	)		(854	)
Net cash provided by (used in)  financing activities		(19,958	)		(25,877	)		87,526
Net increase (decrease) in cash and due from banks		(10,528	)		5,718			13,882
Cash and due from banks at beginning of year		34,521			28,803			14,921
Cash and due from banks at end of year	$	23,993		$	34,521		$	28,803
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid (received) during the year for:
Interest	$	7,879		$	10,080		$	8,278
Income taxes paid (received)	$	2,925		$	-		$	(807	)
NONCASH TRANSACTIONS
Principal balances of loans transferred to other real estate owned	$	10,847		$	4,557		$	4,560
Pension liability increase (decrease)	$	(191	)	$	1,313		$	97

See Notes to Consolidated Financial Statements.

F-9

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business

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 Heritage Bank of the South ( the “Bank”) to facilitate the second-step conversion of the Company 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.

Through the Bank, the Company operates a full service banking business and offers a broad range of retail and commercial banking services to its customers located primarily in central and southern Georgia and north central Florida.  The Company and the Bank are subject to the regulations of certain federal and state agencies and are periodically examined by those regulatory agencies.

Basis of Presentation and Accounting Estimates

The consolidated financial statements include the accounts of the Company and its wholly-owned 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 (“GAAP”), 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.

Acquisition Accounting

Generally accepted accounting principles require the use of fair value accounting in determining the carrying values of certain assets and liabilities acquired in business combinations and accordingly the Company recorded assets purchased and liabilities assumed in our FDIC-assisted acquisitions at their fair values. The fair value of the loan portfolios acquired in these transactions was recorded and is being accounted for under the principles prescribed by ASC 310.

On the date of acquisition all loans acquired are assigned a fair value based on the present value of projected future cash flows. An accretable discount is determined based on the timing of the projected cash flows and is taken into income over the projected life of the loans. Such accretion is included in interest income. Expected cash flows are re-estimated at each reporting date. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses.

Subsequent increases in cash flows result in a reversal of the provision for loan losses to the extent of prior charges and adjusted the accretable discount, which will have a positive effect on interest income. Because the Company records loans acquired in connection with FDIC-assisted acquisitions at fair value, the Company records no allowance for loan losses related to the acquired covered loans on the acquisition date, given that the fair value of the loans acquired incorporates assumptions regarding credit risk.

F-10

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Acquisition Accounting (Continued)

Acquisitions are accounted for under the purchase method of accounting. Purchased assets and assumed liabilities are recorded at their estimated fair values as of the purchase date. Any identifiable intangible assets are also recorded at fair value.  When the fair value of the assets purchased exceed the fair value of liabilities assumed, a "bargain purchase gain" results.  If the consideration given exceeds the fair value of the net assets received, goodwill is recognized. Fair values are subject to refinement for up to one year after the closing date of an acquisition as information relative to closing date fair values becomes available.

FDIC Receivable for Loss-Share Agreements

A significant portion of the Company’s acquired loan and other real estate assets are covered under loss share agreements with the FDIC in which the FDIC has agreed to reimburse the Company 80% of all losses as well as certain expenses incurred in connection with those assets. The Company estimated the amount that it will receive from the FDIC under the loss share agreements that will result from losses incurred as the Company disposes of covered loans and other real estate assets, and the Company 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 loss share agreements also include a provision whereby if losses do not exceed a calculated threshold, the Company is obligated to compensate the FDIC. This is referred to as a clawback liability and, if applicable, is paid at the end of ten years. The formula for the clawback liability varies from transaction-to-transaction and will be calculated using the formula provided in the individual loss share agreements and will not be consolidated into one calculation.  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 the Company sells the assets. The Company will review and update the fair value of the FDIC receivable at each reporting date in conjunction with the re-estimation of cash flows. The FDIC receivable will fluctuate as loss estimates and expected cash flows related to covered loans and other real estate owned change.

Cash Due from Banks and Cash Flows

For purposes of reporting cash flows, cash and due from banks includes cash on hand, cash items in process of collection, and amounts due from banks.  Cash flows from loans, federal funds sold, interest-bearing deposits, interest receivable, deposits, federal funds purchased and securities sold under repurchase agreements, and interest payable in banks are reported net.

The Bank is required to maintain reserve balances in cash or on deposit with the Federal Reserve Bank.  The total of those reserve balance requirements was approximately $1.2 million and $18.7 million at December 31, 2012 and 2011, respectively.

Securities

Debt securities that management has the positive intent and ability to hold to maturity are classified as held to maturity and recorded at amortized cost.  Management has not classified any of its debt securities as held to maturity.  Securities not classified as held to maturity, including equity securities with readily determinable fair values, are classified as available for sale and recorded at fair value with unrealized gains and losses excluded from earnings and reported in accumulated other comprehensive income (loss), net of the related deferred tax effect.  Equity securities, including other equity securities, without a readily determinable fair value are classified as available for sale and recorded at cost.  Restricted equity securities are recorded at cost.

F-11

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Securities (Continued)

The amortization of premiums and accretion of discounts are recognized in interest income using the interest method over the life of the securities.  Realized gains and losses, determined on the basis of the cost of specific securities sold, are included in earnings on the settlement date.

The Company evaluates investment securities for other-than-temporary impairment using relevant accounting guidance specifying that (a) if a company does not have the intent to sell a debt security prior to recovery and (b) it is more likely than not that it will not have to sell the debt security prior to recovery, the security would not be considered other-than-temporarily impaired unless there is a credit loss.  When the Company does not intend to sell the security, and it is more likely than not, the Company will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income.

Securities purchased under resale agreements and securities sold under repurchase agreements are generally accounted for as collateralized financial transactions as more fully disclosed in Note 12.  They are recorded at the amount at which the securities were acquired or sold plus accrued interest.  It is the Company’s policy to take possession of securities purchased under resale agreements, which are primarily U.S. Government and Government agency securities.  The market value of these securities is monitored, and additional securities are obtained when deemed appropriate to ensure such transactions are adequately collateralized.  The Company also monitors its exposure with respect to securities sold under repurchase agreements, and a request for the return of excess securities held by the counterparty is made when deemed appropriate.

Loans Held for Sale

Loans held for sale consist of one-to-four family residential loans originated for sale in the secondary market and are carried at fair value under ASC 825-10-25. For residential mortgage loans, fair value is determined by outstanding commitments from investors for committed loans and on the basis of current delivery prices in the secondary mortgage market for uncommitted loans, if any.  Adjustments to reflect unrealized gains and losses resulting from changes in fair value of residential mortgage loans held-for-sale and realized gains and losses upon ultimate sale of the loans are classified as noninterest income in the Consolidated Statements of Income.

The Company enters into interest rate lock commitments (“IRLCs”) with customers on mortgage loans with the intention to sell the loan in the secondary market. 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 derivatives arising from the IRLCs are recorded at fair value in other assets and liabilities and changes in that fair value are included in mortgage banking activities.

The fair value of the IRLC derivatives are determined by reference to quoted prices for loans with similar coupon rates and terms. 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.  Gains and losses on the sale of those loans are included in mortgage banking activities.

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 23.

F-12

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Loans

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal balances less unearned income, net deferred fees and costs on originated loans and the allowance for loan losses.  Interest income is accrued on the outstanding principal balance.  Loan origination fees, net of certain direct origination costs of consumer loans not secured by real estate, are recognized at the time the loan is placed on the books.  Loan origination fees and costs for all other loans are deferred and recognized as an adjustment of the yield over the life of the loan using the level yield method without anticipating prepayments.

The accrual of interest on loans is discontinued when, in management's opinion, the borrower may be unable to meet payments as they become due, unless the loan is well-secured.  Past due status is based on contractual terms of the loan.  Generally, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful.  All interest accrued, but not collected for loans that are placed on nonaccrual or charged off, is reversed against interest income, unless management believes that the accrued interest is recoverable through the liquidation of collateral.  Interest income on nonaccrual loans is subsequently recognized only to the extent cash payments are received until the loans are returned to accrual status.  Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and the loan has been performing to contractual terms for a period of not less than 6 months.

A loan is considered impaired when it is probable, based on current information and events, the Company will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement.  Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due.  Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.  Impaired loans are measured by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price or the fair value of the collateral if the loan is collateral dependent.  Interest on accruing impaired loans is recognized as long as such loans do not meet the criteria for nonaccrual status.

Purchased loans acquired in business acquisitions are recorded at the fair value at the acquisition date.  Credit discounts are included in the determination of fair value; therefore, an allowance for loan losses is not recorded at the acquisition date.

In determining the acquisition date fair value of purchased loans, and in subsequent accounting, the Company generally aggregates purchased loans into pools of loans with common risk characteristics. Expected cash flows at the acquisition date in excess of the fair value of loans are recorded as interest income over the life of the loans using a level yield method if the timing and amount of the future cash flows of the pool is reasonably estimable. Subsequent to the acquisition date, increases in cash flows over those expected at the acquisition date are recognized as interest income prospectively. Decreases in expected cash flows after the acquisition date are recognized by recording an allowance for loan losses.

Covered Loans

The portion of the Company’s loan portfolio covered under loss share agreements with the FDIC in which the FDIC has agreed to reimburse the Company 80% of all losses as well as certain expenses incurred in connection with those assets. For further information of accounting for covered loans refer to the Acquisition Accounting and FDIC receivable for Loss Share Agreements sections within this Note 1.

Allowance for Loan Losses

The Company establishes provisions for loan losses, which are charged to income, at a level Management believes will reflect probable credit losses based on historical loss trends and an evaluation of specific credits in the loan portfolio.  For further information on the accounting for Allowance for Loan Losses, see Note 4 for further information.

F-13

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Premises and Equipment

Land is carried at cost.  Premises and equipment are carried at cost, less accumulated depreciation computed on the straight-line method over the estimated useful lives:

	Years
Buildings		40
Furniture and equipment		3-7

Intangible Assets

Intangible assets consist of core deposit intangibles acquired in connection with business acquisitions.  The core deposit intangibles are initially recognized based on a valuation performed as of the consummation date.  The core deposit intangibles are amortized over the average remaining life of the acquired customer deposits, or approximately 7 years.  Intangible assets were evaluated for impairment as of December 31, 2012 and based on that evaluation there was no impairment.

Goodwill

Goodwill recorded represents the excess of the purchase price over the fair value of the net assets acquired in acquisitions. Goodwill acquired in a business acquisition is determined to have an indefinite useful life and is not amortized, but tested for impairment at least annually.

Goodwill is tested for impairment on an annual basis and between annual tests if events occur, or if circumstances change, that would more likely than not reduce the fair value below its carrying amount. The annual impairment test is based on discounted cash flow models that incorporate variables including growth in net income, discount rates, and terminal values. If the carrying amount of goodwill exceeds its fair value, an impairment loss is recognized as a non-cash charge.  Goodwill was evaluated for impairment during the fourth quarter of 2012, and based on that evaluation there was no impairment.

Other Real Estate Owned (“OREO”)

OREO, consisting of properties obtained through foreclosure or through a deed in lieu of foreclosure in satisfaction of loans, is reported at the lower of cost or fair value, determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources, adjusted for estimated selling costs. Management also considers other factors, including changes in absorption rates, length of time the property has been on the market and anticipated sales values, which have resulted in adjustments to the collateral value estimates indicated in certain appraisals.  At the time of foreclosure or initial possession of collateral, any excess of the loan balance over the fair value of the real estate held as collateral is treated as a charge against the allowance for loan losses.

Subsequent declines in the fair value of OREO below the new cost basis are recorded through valuation adjustments. Significant judgments and complex estimates are required in estimating the fair value of other real estate, and the period of time within which such estimates can be considered current is significantly shortened during periods of market volatility. In response to market conditions and other economic factors, management may utilize liquidation sales as part of its problem asset disposition strategy. As a result of the significant judgments required in estimating fair value and the variables involved in different methods of disposition, the net proceeds realized from sales transactions could differ significantly from appraisals, comparable sales, and other estimates used to determine the fair value of other real estate.  Management reviews the value of other real estate periodically and adjusts the values as appropriate. Revenue and expenses from OREO operations as well as gains or losses on sales and any subsequent adjustments to the value are recorded as a component of non-interest expense.

F-14

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Covered OREO

The portion of OREO covered under loss share agreements with the FDIC in which the FDIC has agreed to reimburse the Company 80% of all losses as well as certain expenses incurred in connection with those assets.   For further information of accounting for covered loans refer to the Acquisition Accounting and FDIC receivable for Loss Share Agreements sections within this Note 1.

Transfers of Financial Assets

Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered.  Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company - put presumptively beyond the reach of the transferor and its creditors even in bankruptcy or other receivership, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.

Pension Plan

The compensation cost of an employee’s pension benefit is recognized on the projected unit credit method over the employee’s approximate service period.  The Company’s funding policy is to contribute annually an amount that satisfies the funding standard account requirements of ERISA.

Employee Stock Ownership Plan ("ESOP")

The cost of shares issued to the ESOP, but not yet allocated to participants, is shown as a reduction of stockholders’ equity.  Compensation expense is based on the market price of shares as they are committed to be released to participant accounts.  Dividends on allocated ESOP shares reduce retained earnings; dividends on unearned ESOP shares reduce debt and accrued interest.

The Company accounts for its ESOP in accordance with ASC 718-40.  Accordingly, since the Company sponsors the ESOP with an employer loan, neither the ESOP’s loan payable or the Company’s loan receivable are reported in the Company’s consolidated balance sheet.  Likewise, the Company does not recognize interest income or interest cost on the loan.  Unallocated shares held by the ESOP are recorded as unearned ESOP shares in the consolidated statement of changes in stockholders’ equity.  As shares are released for allocation, the Company recognizes compensation expense equal to the average market price of the shares for the period.

Income Taxes

The income tax accounting guidance results in two components of income tax expense: current and deferred.  Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues.  The Company determines deferred income taxes using the liability (or balance sheet) method.  Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and enacted changes in tax rates and laws are recognized in the period in which they occur.  The Company and Bank file consolidated income tax returns but maintain a tax allocation agreement, whereby the Company and Bank calculate their respective amounts of income and expenses and are only responsible for their share of the consolidated income taxes as if they were to file on an unconsolidated basis.

F-15

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Income Taxes (continued)

Deferred income tax expense results from changes in deferred tax assets and liabilities between periods.  Deferred tax assets are recognized if it is more-likely-than-not, based on the technical merits, that the tax position will be realized or sustained upon examination.  A tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that has a greater than 50 percent likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information.  The determination of whether or not a tax position has met the more-likely-than-not recognition threshold considers the facts, circumstances, and information available at the reporting date and is subject to management’s judgment.  Deferred tax assets may be reduced by deferred tax liabilities and a valuation allowance if, based on the weight of evidence available, it is more-likely-than-not that some portion or all of a deferred tax asset will not be realized.

The Company recognizes interest and penalties accrued relative to unrecognized tax benefits in its respective federal or state income taxes accounts. As of December 31, 2012, there were no accruals for uncertain tax positions and no accruals for interest and penalties. The Company and its subsidiary file a consolidated United States federal income tax return, as well as income tax returns  in Georgia, Florida, Alabama and Maryland.  The Company's filed income tax returns are no longer subject to examination by taxing authorities for years prior to 2009.

Earnings Per Share

Basic earnings per share represent net income available to common shareholders divided by the weighted-average number of common shares outstanding during the period, excluding unearned shares of the Employee Stock Ownership Plan and unvested shares of stock.  Diluted earnings per share are computed by dividing net income by the sum of the weighted-average number of shares of common stock outstanding and dilutive potential common shares. Potential common shares consist only of stock options and unvested restricted shares.

Comprehensive Income (Loss)

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income (loss).  Although certain changes in assets and liabilities, such as unrealized gains and losses on securities available for sale, are reported as a separate component of the equity section of the balance sheet, such items, along with net income (loss), are components of comprehensive income (loss).

Advertising Costs

Advertising costs are expensed as incurred.

Derivative Instruments

The Company enters into derivative transactions principally to protect against the risk of adverse price or interest rate movements on the value of certain assets and liabilities and on future cash flows. In addition, certain contracts and commitments are defined as derivatives under generally accepted accounting principles.

All derivative instruments are carried at fair value on the balance sheet. Special hedge accounting provisions are provided, which permit the change in the fair value of the hedged item related to the risk being hedged to be recognized in earnings in the same period and in the same income statement line as the change in the fair value of the derivative, see Note 19 for additional information.

F-16

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Derivative Instruments (continued)

Derivative instruments designated in a hedge relationship to mitigate exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivative instruments designated in a hedge relationship to mitigate exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking each hedged transaction.

Reclassification

Certain amounts in the consolidated financial statements presented in the year ended December 31, 2011 have been reclassed to conform to the December 31, 2012 presentation, with no effect on total assets or net income.

Recent Accounting Standards

The following are summaries of recently issued accounting pronouncements that impact the accounting and reporting practices of the Company:

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 income 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 income 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 income or financial position.

F-17

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Recent Accounting Standards (continued)

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 income and cash flows.

In October 2012, ASU 2012-06, “Business Combinations (Topic 805) - Subsequent Accounting for an Indemnification Asset Recognized at the Acquisition Date as a Result of a Government-Assisted Acquisition of a Financial Institution (a consensus of the FASB Emerging Issues Task Force).” ASU 2012-06 clarifies the applicable guidance for subsequently measuring an indemnification asset recognized as a result of a government-assisted acquisition of a financial institution. Under ASU 2012-06, when a reporting entity recognizes an indemnification asset as a result of a government-assisted acquisition of a financial institution and, subsequently, a change in the cash flows expected to be collected on the indemnification asset occurs (as a result of a change in cash flows expected to be collected on the assets subject to indemnification), the reporting entity should subsequently account for the change in the measurement of the indemnification asset on the same basis as the change in the assets subject to indemnification. Any amortization of changes in value should be limited to the contractual term of the indemnification agreement (that is, the lesser of the term of the indemnification agreement and the remaining life of the indemnified assets). The amendments are effective for fiscal years beginning on or after December 15, 2012 and early adoption is permitted. The amendments are to be applied prospectively to any new indemnification assets acquired after the date of adoption and to indemnification assets existing as of the date of adoption arising from a government-assisted acquisition of a financial institution. The Company adopted this standard on October 1, 2012. The effect of adopting this standard did not have a material effect on the consolidated financial statements.

F-18

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2. 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.

F-19

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2. ACQUISITION ACTIVITY (Continued)

Citizens Bank of Effingham

On February 18, 2011 (the “Closing Date”), HeritageBank of the South entered into a Purchase and Assumption Agreement by and among the Federal Deposit Insurance Corporation as receiver of Citizens Bank of Effingham (“Citizens”), Springfield, Georgia, the Bank and the FDIC acting in its corporate capacity, pursuant to which the Bank acquired a majority of all assets and assumed substantially all of the liabilities of Citizens (the “Acquisition”). In connection with the Acquisition, the Bank also acquired other real estate owned (“OREO”) as of the Closing Date.

Pursuant to that agreement, the Bank agreed to pay a premium on deposits totaling $1.4 million and to acquire the specified assets, net of liabilities, at a discount to book value of $25.1 million. The Bank also received a cash payment from the FDIC in the amount of $24.0 million.

The Bank and the FDIC also entered into loss-sharing agreements that provide the Bank with significant protection against credit losses on Citizens’ loans and related assets acquired in the Acquisition. Under these agreements, discussed in more detail below, the FDIC will, for a specified number of years, reimburse the Bank for 80% of all losses and related expenses on covered assets, primarily acquired loans and OREO.

The fair values of the assets acquired and liabilities assumed in conjunction with the Acquisition as of the Closing Date are detailed in the following table (dollars in thousands):

	February 18, 2011		Average Maturity (Years)		Effective Yield / Cost
Assets Acquired:
Cash and due from banks	$	33,900
Securities available for sale		13,386		4.20		1.49	%
Loans		72,720		1.34		4.53	%
Other real estate owned		7,540
Estimated reimbursement from the FDIC		58,164
Core deposit intangible		1,895
Other assets		2,245
Total assets acquired		189,850
Cash paid to settle the acquisition		24,000
Fair value of assets acquired		213,850
Liabilities Assumed:
Deposits		206,276		1.26		1.58	%
Other liabilities		6,174
Fair value of liabilities assumed		212,450
Net Assets Acquired / Gained from Acquisition	$	1,400

F-20

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2. ACQUISITION ACTIVITY (Continued)

The following table summarizes the assets covered by the loss-sharing agreements, under the Single Family “SF” and Non-Single Family “Non-SF” certificates, and the amount covered by the FDIC and the estimated fair values (dollars in thousands):

	Amounts Covered		Fair Value		SF Certificate (10 Years for Losses)		Non-SF Certificate (5 Years for Losses)
Loans	$	131,256	$	66,671	$	22,744	$	108,512
OREO		21,663		7,540		-		21,663
Total	$	152,919	$	74,211	$	22,744	$	130,175

The Company elected to account for loans acquired in the Citizens acquisition under ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. Topic 310-30 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. Topic 310-30 prohibits carrying over or creating an allowance for loan losses upon initial recognition for loans that fall under its scope.

The following table presents information regarding the loan portfolio acquired on February 18, 2011 at fair value (dollars in thousands):

	Loans With Deterioration of Credit Quality		Loans Without A Deterioration of Credit Quality		Total Loans, at Fair Value
Construction and land	$	5,641	$	7,454	$	13,095
Farmland		1,272		2,362		3,634
Residential real estate		3,804		14,936		18,740
Commercial real estate		4,635		15,551		20,186
Commercial and industrial		1,787		11,643		13,430
Consumer		31		3,604		3,635
	$	17,170	$	55,550	$	72,720

The following table presents purchased loans accounted for under ASC Topic 310-30 as of the Closing Date:

February 18, 2011

(dollars in thousands)

Contractually-required principal and interest	$	172,568
Non-accretable difference		(63,694	)
Cash flows expected to be collected		108,874
Accretable yield		(36,154	)
Fair value of loans accounted for under ASC 310-30	$	72,720

The Company did not immediately acquire the real estate, banking facilities, furniture or equipment of Citizens as part of the purchase and assumption agreement.  However, the Company subsequently purchased the real estate, banking facilities, furniture or equipment of Citizens from the FDIC at fair value in the amount of $3.2 million during the second quarter of 2011.

F-21

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2. ACQUISITION ACTIVITY (Continued)

First Southern National Bank

On August 19, 2011 (the “Closing Date”), HeritageBank of the South entered into a Purchase and Assumption Agreement by and among the FDIC as receiver of First Southern National Bank (“First Southern”), Statesboro, Georgia, the Bank and the FDIC acting in its corporate capacity, pursuant to which the Bank acquired a majority of all assets and assumed a majority of all liabilities of First Southern (the “First Southern Acquisition”). In connection with the First Southern Acquisition, the Bank also acquired other real estate owned (“OREO”) as of the Closing Date.

Pursuant to the Agreement, the Bank agreed to pay a premium on deposits totaling $1.2 million and to acquire the specified assets, net of liabilities, at a discount to book value of $16.3 million. The Bank also received a cash payment from the FDIC in the amount of $3.4 million.

The Bank and the FDIC also have entered into loss-sharing agreements that provide the Bank with significant protection against credit losses on First Southern’s loans and related assets acquired in the First Southern Acquisition. Under these agreements, discussed in more detail below, the FDIC will, for a specified number of years, reimburse the Bank for 80% of all losses and related expenses on covered assets, primarily acquired loans and OREO.

The fair values of the assets acquired and liabilities assumed in conjunction with the First Southern Acquisition as of the Closing Date are detailed in the following table (dollars in thousands):

	August 19, 2011		Average maturity (years)		Effective Yield / Cost
Assets Acquired:
Cash and due from banks	$	6,264
Securities available for sale		22,295		9.32		3.29	%
Loans		68,084		6.25		5.38	%
Other real estate owned and foreclosed assets		4,669
Estimated reimbursement from the FDIC		30,464
Core deposit intangible		850
Other assets		3,694
Total assets acquired		136,320
Cash paid to settle the acquisition		3,540
Fair value of assets acquired		139,860
Liabilities Assumed:
Deposits		137,212		0.70		1.08	%
Other liabilities		1,448
Fair value of liabilities assumed		138,660
Net Assets Acquired / Gained from Acquisition	$	1,200

The following table summarizes the assets covered by the loss-sharing agreements, under the Single Family “SF” and Non-Single Family “Non-SF” certificates, and the amount covered by the FDIC and the estimated fair values (dollars in thousands).

	Amounts Covered		Fair Value		SF Certificate (10 Years for Losses)		Non-SF Certificate (5 Years for Losses)
Loans	$	99,197	$	68,084	$	20,651	$	78,546
OREO		8,645		4,669		7,080		1,565
Total	$	107,842	$	72,753	$	27,731	$	80,111

F-22

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2. ACQUISITION ACTIVITY (Continued)

The Company elected to account for loans acquired in the First Southern Acquisition under ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. Topic 310-30 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. Topic 310-30 prohibits carrying over or creating an allowance for loan losses upon initial recognition for loans that fall under its scope

The following table presents information regarding the loan portfolio acquired on August 19, 2011 at fair value (dollars in thousands):

	Loans with deterioration of credit quality		Loans without deterioration of credit quality		Total loans,  at fair value
Construction and land	$	4,888	$	3,604	$	8,492
Farmland		-		4,709		4,709
Residential  real estate		2,058		26,302		28,360
Commercial real estate		2,517		9,814		12,331
Commercial and industrial		76		8,897		8,973
Consumer		44		5,175		5,219
	$	9,583	$	58,501	$	68,084

The following table presents purchased loans accounted for under ASC Topic 310-30 as of the Closing Date:

August 19, 2011

(dollars in thousands)

Contractually-required principal and interest	$	127,042
Non-accretable difference		(36,994	)
Cash flows expected to be collected	$	90,048
Accretable yield		(21,964	)
Fair value of loans accounted for under ASC 310-30	$	68,084

The Company did not immediately acquire the real estate, banking facilities, or furniture of First Southern but did purchase some of the equipment as part of the purchase and assumption agreement.

The Company recognizes that the determination of the initial fair value of loans at the acquisition date involves a high degree of judgment and complexity.  The carrying value of the acquired loans reflect management’s best estimate of the fair value of these assets as of the acquisition date.  However, the amount the Company ultimately recognizes on these assets could differ materially from the value reflected in these financial statements, based upon the timing and amount of collections on the acquired loans in future periods.  To the extent the actual values recognized for the acquired loans are less than the Company’s estimate, additional losses will be incurred.  These fair value estimates are considered preliminary, and are subject to change for up to one year after the closing date of the acquisition as additional information relative to the closing date fair values becomes available.

F-23

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2. ACQUISITION ACTIVITY (Continued)

Five Branches of The Park Avenue Bank

On May 24, 2010, the Company completed an acquisition of five branches of The Park Avenue Bank (“PAB”), two in Statesboro and one each in Baxley, Hazlehurst and Adel, Georgia.

The table below represents the refinements to the Company’s initial fair value adjustments allowed by ASC 820, recorded subsequent to the date of acquisition, as of December 31, 2010:

(dollars in thousands)	As Recorded by Heritage Financial Group		Adjusted Fair Value				As Recorded by Heritage Financial Group
Assets
Cash and cash equivalents	$	40,562	$	-			$	40,562
Premises and equipment		3,448		-				3,448
Loans		51,792		(749	)	(a)		51,043
Core deposit intangibles		1,130		781		(b)		1,911
Other assets		245		(63	)			182
Total Assets	$	97,177	$	(31	)		$	97,146
Liabilities
Noninterest-bearing deposits	$	15,564	$	-			$	15,564
Interest-bearing deposits		81,557		(31	)	(c)		81,526
Other liabilities		56		-				56
Total Liabilities		97,177	$	(31	)		$	97,146

Explanations

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

(b)  The adjustment represents a refinement to the value of the core deposit intangible assumed in the acquisition. The core deposit intangible was recorded as an identifiable intangible asset and will be amortized over the average life of the related deposit portfolio, estimated to be seven years.

(c) The adjustment represents a refinement to fair value of the CD's acquired and will be amortized to reduce interest expense over the average life of the portfolio.

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

F-24

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 3. 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
December 31, 2012:	(dollars in thousands)
U. S. Government sponsored agencies (GSEs)	$	20,996	$	50	$	(27	)	$	21,019
State and municipal securities		40,509		1,362		(298	)		41,573
Corporate debt securities		1,150		-		(130	)		1,020
GSE residential mortgage-backed securities		156,469		1,434		(406	)		157,497
Total debt securities		219,124		2,846		(861	)		221,109
Equity securities		207		93		(3	)		297
Total securities	$	219,331	$	2,939	$	(864	)	$	221,406
December 31, 2011:
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

The amortized cost and fair value of debt securities available for sale by contractual maturity are shown below.  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.

	December 31, 2012				December 31, 2011
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(dollars in thousands)
One year or less	$	150	$	150	$	1,007	$	890
One to five years		1,786		1,661		5,361		5,322
Five to ten years		20,920		21,264		11,501		11,812
Over ten years		40,006		40,834		76,599		77,873
Mortgage-backed securities		156,469		157,497		161,954		162,963
	$	219,331	$	221,406	$	256,422	$	258,860

Securities with a carrying value of approximately $94.6 million and $96.3 million at December 31, 2012 and 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 $18.0 million and $26.0 million at December 31, 2012 and 2011, respectively.

F-25

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 3. SECURITIES (Continued)

The gross realized gains and losses recognized in income are reflected in the following table:

	Years Ended December 31,
	2012			2011		2010
	(dollars in thousands)
Gross gains	$	3,068		$	684	$	324
Gross losses		(230	)		-		(30	)
Net realized gains	$	2,838		$	684	$	294

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.

	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, 2012 :
U.S. Government sponsored agencies (GSEs)	$	5,481	$	(27	)	$	-	$	-		$	5,481	$	(27	)
State and municipal securities		10,981		(226	)		1,377		(72	)		12,358		(298	)
Corporate debt securities		-		-			1,020		(130	)		1,020		(130	)
GSE residential mortgage-backed securities		62,235		(337	)		4,634		(69	)		66,869		(406	)
Subtotal, debt securities		78,697		(590	)		7,031		(271	)		85,728		(861	)
Equity securities		-		-			204		(3	)		204		(3	)
Total temporarily impaired securities	$	78,697	$	(590	)	$	7,235	$	(274	)	$	85,932	$	(864	)
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	)

F-26

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 3. SECURITIES (Continued)

At December 31, 2012, total securities with unrealized losses improved to $864,000, or 1.0% of the securities, compared to $1.2 million, or 1.8% of the securities, at December 31, 2011.  The unrealized losses in 2012 relate principally to five agencies, 33 state and municipal obligations, three corporate debt securities and 50 mortgage-backed securities.  In analyzing an issuer's financial condition, management considers whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, the results of reviews of the issuer's financial condition, and the issuer's anticipated ability to pay the contractual cash flows of the investments.

The Company does not currently intend to sell the securities within the portfolio and it is not more-likely-than-not that the Company will be required to sell the debt securities; therefore, management does not consider these investments to be other-than-temporarily impaired at December 31, 2012. Management continues to monitor all of these securities with a high degree of scrutiny. There can be no assurance that the Company will not conclude in future periods that conditions existing at that time indicate some or all of these securities may be sold or are other than temporarily impaired, which would require a charge to earnings in such periods.  At December 31, 2012, the Company held certain investment securities having continuous unrealized loss positions for more than 12 months.  All of these losses were in two corporate securities, one single issue trust preferred, nine mortgage-backed securities, and five municipal securities. The unrealized loss arose from changes in interest rates and market conditions as of December 31, 2012.

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 $93,000. 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.  During the twelve months ended December 31, 2011 the Company recognized a write-down of $43,000 through non-interest income representing OTTI on the security.  At December 31, 2012, the book value of the security was recorded at $207,000 which agrees to the present value of the security and therefore no OTTI was recorded in 2012.  At December 31, 2012, the fair value of the security was $203,000 with $4,000 of an unrealized loss recorded in other comprehensive

F-27

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 3. SECURITIES (Continued)

The following table presents more detail on selective Company security holdings as of year-end 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	$	-	$	93	$	-		$	93
Trust preferred securities
RBS Capital Fund		74928K208	B3		207		203		(4	)		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.

	December 31, 2012		December 31, 2011		December 31, 2010
Beginning balance of credit losses	$	1,543	$	1,500	$	1,500
Other-than-temporary impairment credit losses		-		43		-
Ending balance of cumulative credit losses recognized in earnings	$	1,543	$	1,543	$	1,500

Restricted Equity Securities

The investment in the common stock of the Federal Home Loan Bank of Atlanta is accounted for by the cost method, which also represents par value, and is made for long-term business affiliation reasons.  In addition, this investment is subject to restrictions relating to sale, transfer or other disposition.  Dividends are recognized in income when declared.  The carrying value of this investment at December 31, 2012 and 2011 is $4.3 million and $4.1 million, respectively.   The estimated fair value of this investment is $4.3 million as of December 31, 2012, and therefore is not considered impaired.

Other equity securities represent an investment in the common stock of the Chattahoochee Bank of Georgia (“Chattahoochee”), a de novo bank in Gainesville, Georgia.  The Company accounts for this investment by the cost method.  This investment represents approximately 4.9% of the outstanding shares of Chattahoochee.  Since its initial capital raise, Chattahoochee has not had any stock transactions, and therefore, no fair market value is readily available.  The carrying value of this investment at December 31, 2012 is $1.0 million.  The Company plans to hold this investment for the foreseeable future, and did not consider it impaired as of December 31, 2012.

F-28

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC ACQUIRED LOANS)

The composition of loans is summarized as follows:

	December 31,
	2012			2011
Commercial real estate:
Nonresidential	$	212,570		$	138,970
Multifamily		21,293			15,797
Farmland		20,141			17,921
Total commercial real estate loans		254,004			172,688
Construction and land		33,340			26,804
Residential real estate:
Mortgage loans, 1-4 families		161,883			129,745
Home equity		27,345			26,154
Total Residential real estate loans		189,228			155,899
Consumer and other:
Indirect auto loans		1,304			3,741
Direct auto loans		6,801			6,430
Other		17,393			13,701
Total consumer loans		25,498			23,872
Commercial and industrial loans		83,659			55,179
		585,729			434,442
Loans acquired through FDIC-assisted acquisitions
Non-Covered		11,850			18,721
Covered		72,425			107,457
Total loans		670,004			560,620
Total allowance for loan losses		(9,061	)		(7,494	)
Loans, net	$	660,943		$	553,126

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.

F-29

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (Continued)

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.

Residential real estate

Residential 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.

In the ordinary course of business, the Company has granted loans to certain directors, executive officers and their affiliates.  Changes in related party loans are summarized as follows:

	As of December 31
	2012			2011
	(dollars in thousands)
Balance, beginning of year	$	9,316		$	9,121
Advances		13,929			15,951
Repayments		(12,295	)		(15,738	)
Changes in related parties		-			(18	)
Balance, end of year	$	10,950		$	9,316

F-30

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (Continued)

Activity in the allowance for loan losses and recorded investment in loans by segment:

	Commercial Real Estate			Residential 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	)		(498	)		(81	)		(208	)		(188	)		(1,141	)
Recoveries		-			75			1			35			97			208
Provision*		1,032			1,234			(212	)		346			100			2,500
Balance, December  31, 2012	$	2,744		$	3,251		$	978		$	1,724		$	364		$	9,061
Allowance:
Ending balance: specific	$	429		$	1,294		$	304		$	206		$	68		$	2,301
Ending balance: collective	$	2,315		$	1,957		$	674		$	1,518		$	296		$	6,760
Loans:
Ending balance: individually evaluated for impairment	$	4,938		$	4,596		$	3,881		$	1,149		$	120		$	14,684
Ending balance: collectively evaluated for impairment	$	249,066		$	184,632		$	29,459		$	82,510		$	25,378		$	571,045

*Refer to Note 5 for the FDIC acquired loan provision expense details.

F-31

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (Continued)

Activity in the allowance for loan losses and recorded investment in loans by segment:

	Commercial Real Estate			Residential 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	$	100		$	811		$	525		$	389		$	79		$	1,904
Ending balance: collective	$	1,778		$	1,629		$	745		$	1,162		$	276		$	5,590
Loans:
Ending balance: individually evaluated for impairment	$	1,094		$	6,864		$	3,961		$	1,179		$	177		$	13,275
Ending balance: collectively evaluated for impairment	$	171,594		$	149,035		$	22,843		$	54,000		$	23,695		$	421,167

Impaired Loans

A loan is considered impaired, in accordance with the impairment accounting guidance (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.

F-32

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (Continued)

Impaired loans by class are presented below for 2012:

									Interest
			Unpaid				Average		Income
	Recorded		Principal		Related		Recorded		Recognized
	Investment		Balance		Allowance		Investment		YTD 2012
	(dollars in thousands)
Loans with no related allowance recorded
Commercial real estate:
Nonresidential	$	-	$	-	$	-	$	-	$	-
Multifamily		-		-		-		-		-
Farmland		-		-		-		-		-
Construction and land		3,443		3,469		-		4,606		134
Residential real estate:
Mortgage loans, 1-4 families		535		553		-		324		19
Home equity		-		-		-		-		-
Consumer and other:
Indirect auto loans		-		-		-		-		-
Direct auto loans		-		-		-		-		-
Other		-		-		-		-		-
Commercial and industrial loans		877		878		-		769		11
Loans with related allowance recorded
Commercial real estate:
Nonresidential	$	4,938	$	5,195	$	429	$	4,975	$	101
Multifamily		-		-		-		-		-
Farmland		-		-		-		-		-
Construction and land		438		504		304		472		-
Residential real estate:
Mortgage loans, 1-4 families		3,782		4,061		1,054		4,414		52
Home equity		279		321		240		290	��	8
Consumer and other:
Indirect auto loans		30		43		-		35		1
Direct auto loans		23		36		16		28		0
Other		67		77		52		75		4
Commercial and industrial loans		272		278		206		282		13
Total
Commercial real estate	$	4,938	$	5,195	$	429	$	4,975	$	101
Construction and land		3,881		3,973		304		5,078		134
Residential real estate		4,596		4,935		1,294		5,028		60
Consumer and other		120		156		68		138		5
Commercial and industrial loans		1,149		1,156		206		1,051		24
Total	$	14,684	$	15,415	$	2,301	$	16,270	$	324

F-33

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (Continued)

Impaired loans by class are presented below for 2011:

									Interest
			Unpaid				Average		Income
	Recorded		Principal		Related		Recorded		Recognized
	Investment		Balance		Allowance		Investment		YTD 2011
	(dollars in thousands)
Loans with no related allowance recorded
Commercial real estate:
Nonresidential	$	620	$	620	$	-	$	623	$	30
Multifamily		-		-		-		-		-
Farmland		-		-		-		-		-
Construction and land		-		-		-		-		-
Residential real estate:
Mortgage loans, 1-4 families						-				-
Home equity		11		11		-		13		1
Consumer and other:
Indirect auto loans		-		-		-		-		-
Direct auto loans		-		-		-		-		-
Other		-		-		-		-		-
Commercial and industrial loans		839		886		-		876		5
Loans with related allowance recorded
Commercial real estate:
Nonresidential	$	361	$	373	$	99	$	362	$	4
Multifamily		2		4		1		89		6
Farmland		111		114		-		112		-
Construction and land		3,961		3,961		525		3,984		167
Residential real estate:
Mortgage loans, 1-4 families		6,781		8,989		710		7,557		129
Home equity		72		75		101		76		4
Consumer and other:
Indirect auto loans		83		98		-		103		4
Direct auto loans		55		67		41		65		2
Other		39		40		38		42		2
Commercial and industrial loans		340		437		389		425		15
Total
Commercial real estate	$	1,094	$	1,111	$	100	$	1,186	$	40
Construction and land		3,961		3,961		525		3,984		167
Residential real estate		6,864		9,075		811		7,646		134
Consumer and other		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

F-34

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (Continued)

Below is an analysis of the age of recorded investment in loans that are past due as of December 31, 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	$	-	$	744	$	4,938	$	5,682	$	206,888	$	212,570
Multifamily		-		-		-		-		21,293		21,293
Farmland		-		-		-		-		20,141		20,141
Total commercial real estate loans		-		744		4,938		5,682		248,322		254,004
Construction and land		-		-		3,881		3,881		29,459		33,340
Residential real estate:
Mortgage loans, 1-4 families		1,233		-		4,475		5,708		156,175		161,883
Home equity		50		-		114		164		27,181		27,345
Total residential real estate loans		1,283		-		4,589		5,872		183,356		189,228
Consumer and other:
Indirect auto loans		5		5		30		40		1,264		1,304
Direct auto loans		2		6		23		31		6,770		6,801
Other		72		-		67		139		17,254		17,393
Total consumer and other loans		79		11		120		210		25,288		25,498
Commercial and industrial loans		14		-		1,149		1,164		82,495		83,659
Total	$	1,376	$	755	$	14,677	$	16,809	$	568,920	$	585,729

F-35

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (Continued)

Below is an analysis of the age of recorded investment in loans that are past due as of the year ended 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
Residential 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 residential 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 December 31, 2012 and 2011.

F-36

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (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.

At December 31, 2012, the Company had troubled debt restructurings totaling $6.9 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, 2012, are troubled debt restructurings of $6.9 million.  In addition, at that date the Company had troubled debt restructurings totaling $7,000 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:

	December 31, 2012
			Recorded
	Number		Investment
	of Modifications		Prior to Modifications			Recorded Investment
	(dollars in thousands)
Commercial real estate		3		$	1,071		$	997
Residential real estate		5			7,268			2,409
Construction and land		1			3,574			3,443
Commercial and industrial loans		1			17			14
Consumer and other		-			-			-
Total		10		$	11,930		$	6,863

F-37

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (Continued)

	As of December 31, 2011
			Recorded
	Number		Investment
	of Modifications		Prior to Modifications			Recorded Investment
Commercial real estate		2		$	852		$	843
Residential 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:

	December 31, 2012
	Number
	of		Recorded Investment
	Modifications
	(dollars in thousands)
Commercial real estate		3		$	997
Residential real estate		4			2,402
Construction and land		1			3,443
Commercial and industrial loans		1			14
Consumer and other		-			-
Total		9		$	6,856

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

F-38

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (Continued)

Allowance for Loan and Lease Losses (ALLL)

The Company establishes provisions for loan losses, which are charged to income, 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, five year historical loss experience, migration analysis, probability of default, 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. Special mention with risk ratings 6-7

3. Substandard with risk rating 8 and still accruing

4. Impaired Loans 9-11 – 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 of these events. These risk factors and other factors are applied to our review of the Pass credits with risk ratings 1-5 pool and other assets specially 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 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. Impaired loans with balances lower than $500,000 are not typically reviewed on an individual basis due to their small size.  Instead, a historical loss analysis is used for these loans, which assumes the loan migration to default is likely, and the assumed loss is recorded as a specific amount.

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 we make 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, where 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.

F-39

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (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 change to the allowance methodology 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.

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.

F-40

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (Continued)

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.

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 by class are presented below for December 31, 2012 and 2011.

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

F-41

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (Continued)

	As of December 31, 2012
							Construction
	Non-						and
	Residential		Multifamily		Farmland		Land
	(dollars in thousands)
Commercial Real Estate Credit Exposure
Pass 1	$	-	$	-	$	-	$	-
Pass 2		-		-		-		68
Pass 3		63,944		3,820		6,459		7,202
Pass 4		135,189		15,214		12,258		16,732
Pass 5		4,711		41		1,275		5,332
Special Mention 6		907		-		-		-
Special Mention elevated 7		-		1,707		-		-
Substandard 8		2,881		511		149		125
Impaired Loans 9		4,938		-		-		3,881
Doubtful 10		-		-		-		-
Loss 11		-		-		-		-
Total	$	212,570	$	21,293	$	20,141	$	33,340

	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

F-42

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (Continued)

	As of December 31, 2012
	Commercial
	(dollars in thousands)
Commercial Credit Exposure
Pass 1	$	1,194
Pass 2		366
Pass 3		29,447
Pass 4		46,916
Pass 5		3,781
Special Mention 6		86
Special Mention elevated 7		6
Substandard 8		713
Impaired Loans 9		1,150
Doubtful 10		-
Loss 11		-
Total	$	83,659

	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

F-43

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (Continued)

	As of December 31, 2012
	Mortgage		Home Equity
	(dollars in thousands)
Residential real estate Credit Exposure
Pass 1-5	$	154,067	$	26,922
Special Mention 6		357		-
Special Mention elevated 7		-		-
Substandard 8		3,202		144
Impaired Loans 9		4,257		279
Doubtful 10		-		-
Loss 11		-		-
Total	$	161,883	$	27,345

	As of December 31, 2011
	Mortgage		Home Equity
	(dollars in thousands)
Residential 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

F-44

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES(EXCLUDING FDIC ACQUIRED LOANS) (Continued)

	As of December 31, 2012
	Indirect		Direct
	Auto		Auto		Other
	(dollars in thousands)
Consumer and Other Credit Exposure
Pass 1-5	$	1,252	$	6,778	$	17,280
Special Mention 6		-		-		-
Special Mention elevated 7		-		-		1
Substandard 8		22		-		45
Impaired Loans 9		30		23		67
Doubtful 10		-		-		-
Loss 11		-		-		-
Total	$	1,304	$	6,801	$	17,393

	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

F-45

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5. FDIC ACQUIRED LOANS AND ALLOWANCE FOR LOAN LOSSES

The Company elected to account for loans acquired in Tattnall Bank, Citizens and 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:	December 31,
	2012		2011
	(dollars in thousands)
Commercial real estate	$	6,359	$	7,632
Residential real estate		2,110		2,304
Construction and land		494		1,512
Commercial and industrial		1,574		3,320
Consumer and other		1,313		3,953
		11,850		18,721

Loans covered by loss-sharing agreements:	December 31,
	2012		2011
	(dollars in thousands)
Commercial real estate	$	21,820	$	31,951
Residential real estate		32,846		44,189
Construction and land		14,248		19,789
Commercial and industrial		2,670		9,515
Consumer and other		841		2,013
		72,425		107,457

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.

F-46

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5. FDIC ACQUIRED LOANS AND ALLOWANCE FOR LOAN LOSSES (CONTINUED)

The following table represents the loans receivable as of December 31, 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	$	132,934		$	26,223		$	159,157
Non-accretable difference		(32,867	)		(13,133	)		(46,000	)
Cash flows expected to be collected		100,067			13,090			113,157
Accretable yield		(27,335	)		(1,547	)		(28,882	)
Basis in acquired loans	$	72,732		$	11,543		$	84,275

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:

(dollars in thousands)	Accretable Yield
Balance at December 31, 2010		4,598
Additions		58,118
Reclassification from non-accretable difference		8,016
Accretion included in interest income		(7,985	)
Adjustments to estimates of expected cash flows		(31,651	)
Balance at December 31, 2011	$	31,096
Additions		-
Reclassification from non-accretable difference		22,349
Accretion included in interest income		(23,251	)
Adjustments to estimates of expected cash flows		(1,312	)
Balance at December 31, 2012	$	28,882

F-47

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5. FDIC ACQUIRED LOANS AND ALLOWANCE FOR LOAN LOSSES (CONTINUED)

The following is a summary of the allowance for loan losses for the FDIC acquired loans for 2012:

	Commercial Real Estate			Residential Real Estate			Construction and Land			Commercial and Industrial			Consumer  and  Other			Total
	(dollars in thousands)
		-			-
Balance, January 1, 2012	$	-		$	-		$	-		$	-		$	-		$	-
Add (deduct):
Charge-offs		(1,114	)		(951	)		(907	)		(433	)		(26	)		(3,431	)
Recoveries		-			-			-			-			-			-
Provision for loan losses - noncovered		-			-			-			-			12			12
Provision for loan losses - covered		1,114			951			907			433			14			3,419
Balance, December  31, 2012	$	-		$	-		$	-		$	-		$	-		$	-
Allowance:
Ending balance: specific	$	-		$	-		$	-		$	-		$	-		$	-
Ending balance: collective	$	-		$	-		$	-		$	-		$	-		$	-
Loans:
Ending balance: individually evaluated for impairment	$	8,149		$	3,562		$	6,573		$	153		$	46		$	18,483
Ending balance: collectively evaluated for impairment	$	20,030		$	31,394		$	8,169		$	4,091		$	2,108		$	65,792

F-48

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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 the Company 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 disposes 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 the Company sells 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. Increases in expected cash flows on covered FDIC acquired loans impact the FDIC loss share receivable by reducing the receivable over the shorter of the estimated life of the loan or the expected life of the indemnification asset.  Conversely, decreases in expected cash flows first impact accretable discounts to the extent available and then impact the allowance for loan losses while also increasing the FDIC loss share receivable.  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 year ended December 31, 2012:
	(dollars in thousands)
Balance, December 31, 2011	$	83,901
Decrease in expected losses on covered assets		(1,042	)
Accretion included in noninterest income		(5,028	)
Reimbursements from FDIC		(17,100	)
Balance, December 31, 2012	$	60,731

For the year 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
Decrease in expected losses on covered assets		(1,932	)
Accretion included in noninterest income		381
Reimbursements from FDIC		(3,176	)
Balance, December  31, 2011	$	83,901

F-49

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 7. ACCRUED INTEREST RECEIVABLE

Accrued interest receivable consists of the following for the periods indicated:

	December 31,
	2012		2011
Loans	$	2,599	$	3,047
Other interest earning assets		2		22
GSE residential mortgage-backed securities		500		666
Other investment securities		500		954
Subtotal, securities		1,000		1,620
	$	3,601	$	4,689

F-50

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8.  OTHER REAL ESTATE OWNED

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

	OREO			Covered  OREO			Total
	(dollars in thousands)
Balance, December 31, 2011	$	3,362		$	10,047		$	13,409
Additions		2,695			8,152			10,847
Sales		(2,366	)		(7,969	)		(10,335	)
Writedowns		(449	)		(763	)		(1,212	)
Balance, December 31, 2012	$	3,242		$	9,467		$	12,709

	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

The covered OREO above is covered pursuant to the FDIC loss-share agreements which are discussed in Note 2 Acquisition Activity, and is presented net of the related fair value discount.

F-51

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 9. PREMISES AND EQUIPMENT

Premises and equipment are summarized as follows:

	December 31,
	2012			2011
Land and improvements	$	10,970		$	9,895
Buildings		21,667			18,131
Furniture and equipment		14,978			13,453
Construction in progress		-			573
		47,615			40,052
Accumulated depreciation		(14,600	)		(12,520	)
	$	33,015		$	29,532
Premises held for sale	$	1,538		$	1,080

The Company completed the acquisition of the Auburn, Alabama branch purchase during the second quarter of 2012 at $1.7 million.  The Company also completed the construction of new branches in Valdosta, Georgia and Macon, Georgia during 2012.  The construction of the Valdosta and Macon branches was completed and placed in service at approximately $2.4 million and $733,000, respectively.  Additionally, during the fourth quarter, the Company closed branches in Guyton, Georgia and Collins, Georgia. As of December 31, 2012, these premises, approximately $458,000, were held for sale.   Depreciation and amortization expense was $2.1 million, $1.5 million, and $946,000 for the years ended December 31, 2012, 2011 and 2010, respectively.

F-52

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 9.  PREMISES AND EQUIPMENT (Continued)

Leases

In 2012, the Company entered into a 9 year lease agreement for a location in Atlanta, Georgia as part of the mortgage loan production expansion.  Additionally, the Company had 5 leases agreements, with remaining lease terms between 4 to 33 months, for mortgage loan productions office locations as of December 31, 2012.

In 2012, the Company entered into a 3 year ATM branding leasing agreement for an ATM in Albany, Georgia.

The Company entered into various operating agreements for office equipment, primarily printers, as a result of the increase in operation locations in 2012 and 2011. The average term of these agreements is 36 months.

The Company has a lease agreement for its investment division operations located in Albany, Georgia on a month to month lease.

The Company also has an assignment of a 99 year land lease associated with a branch office in Ocala, Florida with a remaining life of approximately 60 years.

Rental expense under all operating leases amounted to approximately $986,000, $543,000 and $121,000 for the years ended December 31, 2012, 2011 and 2010, respectively.

Future minimum lease commitments on noncancelable operating leases, excluding any renewal options, are summarized as follows:

	(dollars in thousands)
2013	$	416
2014		515
2015		375
2016		303
2017		278
Thereafter		1,779
	$	3,666

F-53

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 10. GOODWILL AND INTANGIBLE ASSETS

During 2010, the Company recorded goodwill associated with the Lake City branch acquisition.  As of December 31, 2012 and 2011, the goodwill was carried at $552,000.  The fair value was greater than the carrying amount of goodwill based on the discounted cash flow model, and, as such, resulted in no impairment of the goodwill in 2012.  See Note 1 for additional information.

Intangible assets consist of core deposit intangibles acquired in connection with business acquisitions.

In February 2011, the Company recorded $1.8 million core deposit intangible with the FDIC-assisted acquisition of Citizens.  Additionally, the Company recorded $850,000 core deposit intangible with the FDIC-assisted acquisition of First Southern Bank in August 2011.

In June 2012, the Company recorded $169,000 core deposit intangible with the acquisition of the Auburn branch.

Following is a summary of information related to the intangible assets associated with these acquisitions based on the Company's allocations:

	As of December 31, 2012				As of December 31, 2011
	Gross Carrying Amount		Accumulated Amortization		Gross Carrying Amount		Accumulated Amortization
	(dollars in thousands)
The Tattnall Bank	$	263	$	133	$	263	$	73
Lake City, Florida, branch		460		146		460		128
PAB branches		1,912		651		1,912		429
Citizens Bank of Effingham		1,778		590		1,778		283
First Southern National Bank		850		211		850		55
Auburn, Alabama, branch		169		18		-		-
Core deposit intangibles	$	5,432	$	1,749	$	5,263	$	968

The estimated amortization expense for each of the next five years as of December 31, 2012 is as follows:

	(dollars in thousands)
2013	$	709
2014		649
2015		593
2016		538
2017		482
2018 and beyond		712
	$	3,683

There was $781,000, $692,000 and $276,000 of amortization expense recorded during the year ended December 31, 2012, 2011 and 2010.

F-54

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 11. DEPOSITS

The aggregate amount of time deposits in denominations of $100,000 or more at December 31, 2012 and 2011 was $160.1 million and $154.7 million, respectively.

The scheduled maturities of time deposits at December31, 2012 are as follows:

2013	$	215,925
2014		31,699
2015		23,097
2016		12,504
2017 and beyond		11,475
	$	294,700

Overdraft deposit accounts reclassified to loans totaled $316,000 and $586,000 at December 31, 2012 and 2011, respectively.

The Company had $56.2 million and $45.2 million in brokered deposits as of December 31, 2012 and 2011, respectively.  The increase in brokered deposited resulted from the Company’s purchase of CDARS One Way Buy deposits of approximately $49.0 million during the third and fourth quarters of 2012; offset by a decline due to the Company’s cancelation of the 2006 brokered MMA agreement which resulted in a decline of brokered MMA accounts of $34.8 million as of December 31, 2011 to $0 as of December 31, 2012.

The depositors of the Bank are insured by the FDIC.  This insurance coverage generally insures each depositor up to $250,000.  Amounts in excess of $250,000 are generally not insured.

The following table presents the interest expense for each major category of deposits for periods indicated:

	Years Ended December 31,
	2012		2011		2010
Interest Expense
Interest bearing demand	$	270	$	818	$	917
Savings and money market		1,139		2,367		2,030
Retail time deposits		3,349		4,178		2,554
Wholesale time deposits		116		187		258
	$	4,874	$	7,550	$	5,759

F-55

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 12. EMPLOYEE BENEFIT PLANS

Pension Plan

The Company provides pension benefits for eligible employees through a defined benefit pension plan.  Effective January 1, 2009, the Board of Directors voted to freeze the plan to new entrants.  Participants of the plan prior to January 1, 2009 that meet certain age and service requirements participate in the retirement plan on a noncontributing basis.  Information pertaining to the activity in the plan is as follows:

	December 31,
	(dollars in thousands)
	2012			2011			2010
Changes in benefit obligations:
Obligations at beginning of year	$	11,776		$	9,851		$	8,327
Service cost		818			709			702
Interest cost		522			507			489
Benefits paid		(1,192	)		(1,076	)		(530	)
Actuarial loss		1,267			1,785			863
Obligations at end of year	$	13,191		$	11,776		$	9,851
Changes in plan assets:
Fair value of assets at beginning of year	$	8,097		$	8,184		$	6,233
Actual return on assets		960			(95	)		861
Company contributions		1,000			1,085			1,620
Benefits paid		(1,192	)		(1,076	)		(530	)
Fair value of assets at end of year	$	8,865		$	8,098		$	8,184
Funded status at end of year, included in other liabilities	$	4,326		$	3,678		$	(1,667	)
Pretax amounts recognized in accumulated other comprehensive income consist of:
Net loss	$	6,191		$	5,863		$	3,666
Prior service cost		139			149			158
	$	6,330		$	6,012		$	3,824
Accumulated benefit obligation	$	10,895		$	9,736		$	8,265
Net periodic benefit cost:
Service cost	$	819		$	709		$	702
Interest cost		521			507			489
Expected return on plan assets		(585	)		(636	)		(475	)
Amortization of prior losses		565			319			306
Amortization of service costs		9			9			9
Net periodic benefit cost	$	1,329		$	908		$	1,031

F-56

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 12.  EMPLOYEE BENEFIT PLANS (Continued)

Pension Plan (Continued)

Other changes in plan assets and benefit obligations recognized in other comprehensive income (loss):

	December 31,
	2012			2011				2010
	(dollars in thousands)
Current year actuarial loss	$	892			$	2,516			$	477
Amortization of prior losses		(565	)			(319	)			(306	)
Amortization of prior service cost		(9	)			(9	)			(9	)
Total recognized in other comprehensive income (loss)	$	318			$	2,188			$	162

	December 31,
	2012			2011
Assumptions used in computations:
In computing ending obligations:
Discount rate		4.25	%		4.75	%
Rate of compensation increase		3.00	%		3.00	%
In computing expected return on plan assets		7.50	%		7.50	%

To determine the expected rate of return on plan assets, the Company considers the current and expected asset allocations, as well as historical and expected returns on various categories of plan assets.  The approximate allocation of plan assets as of December 31, 2012 and 2011 is as follows:

	2012			2011
Fixed income		21.3	%		35.6	%
Equities		37.7	%		54.6	%
Balanced		26.1	%		-
Cash and cash equivalents		13.1	%		6.1	%
Other		1.8	%		3.7	%

Plan fiduciaries set investment policies and strategies for the plan assets.  Long-term strategic investment objectives include capital appreciation through balancing risk and return.

The Company expects to contribute $1.0 million to the plan during 2013.

The amounts in accumulated other comprehensive income (loss) that are expected to be recognized as components of net periodic benefit cost during 2013 are as follows:

Prior service cost	$	9
Net loss		580
	$	589

F-57

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 12.  EMPLOYEE BENEFIT PLANS (Continued)

Pension Plan (Continued)

Estimated future benefit payments, which reflect expected future service, as appropriate, are as follows:

Fiscal Year	Amount
	(dollars in thousands)
2013	$	484
2014		454
2015		426
2016		727
2017		604
2018-2022		9,565

401(K) Plan

The Company has also established a salary deferral plan under Section 401(k) of the Internal Revenue Code.  The plan allows eligible employees to defer a portion of their compensation up to 25%, subject to certain limits based on federal tax laws.  Such deferrals accumulate on a tax deferred basis until the employee withdraws the funds.  The Company matches 50% of employee’s contributions up to 4% of their salary.  Total expense recorded for the Company’s match was approximately $205,000, $157,000 and $123,000 for the fiscal years ended December 31, 2012, 2011 and 2010, respectively.

Employee Stock Ownership Plan (ESOP)

In connection with the minority stock offering, the Company established an Employee Stock Ownership Plan (“ESOP”) for the benefit of its employees with an effective date of June 29, 2005.  The ESOP purchased 440,700 (369,174 after conversion) shares of common stock from the minority stock offering with proceeds from a ten-year note in the amount of $4.4 million from the Company.  After the 2010 Conversion and stock offering, the unearned shares held by the ESOP were adjusted to reflect the 0.8377:1 exchange ratio on publicly traded shares.  Additionally, in connection with the 2010 Conversion the stock offering, the ESOP purchased 327,677 shares of common stock with proceeds from a twenty-year note in the amount of $3.3 million.

The Company’s Board of Directors determines the amount of contribution to the ESOP annually, but it is required to make contributions sufficient to service the ESOP’s debt.  Shares are released for allocation to employees as the ESOP debt is repaid.  Eligible employees receive an allocation of released shares at the end of the calendar year on a relative compensation basis.  An employee becomes eligible on January 1st or July 1st immediately following the date they complete one year of service.  Company dividends on allocated shares will be paid to employee accounts.  Dividends on unallocated shares held by the ESOP will be applied to the ESOP note payable.

Contributions to the ESOP during 2012, 2011 and 2010 amounted to $1.0 million, $726,000 and $488,000,  respectively.

Compensation expense for shares committed to be released under the Company’s ESOP for the fiscal years ended December 31, 2012, 2011 and 2010 were $669,000, $620,000 and $459,000, respectively.  Shares held by the ESOP were as follows:

	Years Ended December 31,
	2012		2011		2010
Shares released for allocation		311,014		257,713		204,531
Unearned		385,837		439,138		492,320
Total ESOP shares		696,851		696,851		696,851
Fair value of unearned shares	$	5,320,688	$	5,181,828	$	6,114,617

F-58

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 13. DEFERRED COMPENSATION PLANS

The Company has entered into separate deferred compensation arrangements with certain executive officers and directors.  The plans call for certain amounts payable at retirement, death or disability.  The estimated present value of the deferred compensation is being accrued over the remaining expected service period.  The Company has purchased life insurance policies which they intend to use to finance this liability.  Cash surrender value of life insurance of $23.4 million and $15.6 million December31, 2012 and 2011, respectively, is separately stated on the consolidated balance sheets.  The Bank is generally limited by regulatory guidance to an investment in cash surrender value of Bank owned life insurance (“BOLI”) of no more than 25% of Tier I capital at the time of purchase.  The Bank was in compliance with this regulatory guidance at the time of purchase.   In September of 2007, the Company accelerated vesting under its deferred compensation agreements with each of its currently serving covered directors and executives.  Under this acceleration, each covered director and executive is fully vested in their plan balance.

Accrued deferred compensation $3.1 million at December 31, 2012 and 2011, respectively, is included in other liabilities.

The Company has also entered into deferred salary agreements with certain officers electing to defer a portion of their salary.  These amounts are expensed and the plan accumulates the deferred salary plus earnings.  At December 31, 2012 and 2011, the liability for these agreements was $814,000 and $707,000 respectively, and is included in other liabilities.

Aggregate compensation expense under the plans was $49,000, $42,000 and $58,000 for the years ended December 31, 2012, 2011 and 2010, respectively.

F-59

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 14. FEDERAL FUNDS PURCHASED AND SECURITIES SOLD UNDER REPURCHASE AGREEMENTS

Federal funds purchased represent unsecured borrowings from other banks and generally mature daily.  Securities sold under repurchase agreements are secured borrowings and are reflected at the amount of cash received in connection with the transactions.  The Company may be required to provide additional collateral based on the fair value of the underlying securities.  The Company monitors the fair value of the underlying securities on a daily basis.  Federal funds purchased and securities sold under repurchase agreements at were as follows:

	December 31,
	2012		2011
	(dollars in thousands)
Federal funds purchased from Chattahoochee Bank of Georgia with interest at 0.15% maturing daily.	$	417	$	1,555
Sold in overnight agreements maturing in one to four days.		2,802		3,494
Sold in a structured agreement due January 25, 2018 with a rate of 3.78% fixed until maturity.		5,000		5,000
Sold in a structured agreement due March 3, 2018 with a rate of 3.45% fixed until maturity.		5,000		5,000
Sold in a structured agreement due March 3, 2018 with a variable rate, that resets quarterly, of 4.37% at December 31, 2012.		5,000		5,000
Sold in a structured agreement due March 8, 2017 with a fixed rate of 4.85% until maturity.		10,000		10,000
Sold in a structured agreement due August 21, 2017 with a fixed rate of 4.75% until maturity.		5,000		5,000
	$	33,219	$	35,049

The federal funds purchased from Chattahoochee are under similar terms and conditions as would be available with other third parties.

F-60

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 15.  OTHER BORROWINGS

Other borrowings consist of the following:

	December 31,
	2012		2011
	(dollars in thousands)
Advance from Federal Home Loan Bank with interest at a fixed rate of 3.71%, due September 17, 2014	$	5,000	$	5,000
Advance from Federal Home Loan Bank with interest at a fixed rate of 4.23%, due August 17, 2015		5,000		5,000
Advance from Federal Home Loan Bank with interest at a fixed rate of 2.74%, due July 23, 2018		10,000		10,000
Advance from Federal Home Loan Bank with interest at a fixed rate of 4.54%, due October 31, 2016		15,000		15,000
Advance from Federal Home Loan Bank with interest at a fixed rate of 0.41%, November 5, 2014		5,000		-
Advance from Federal Home Loan Bank with interest at a fixed rate of 0.57%, November 5, 2015		5,000		-
Advance from Federal Home Loan Bank with interest at a fixed rate of 0.76%, November 7, 2016		5,000		-
Advance from Federal Home Loan Bank with interest at a fixed rate of 1.00%, November 6, 2017		5,000		-
Advance from Federal Home Loan Bank with interest at a fixed rate of 1.21%, November 5, 2018		5,000		-
	$	60,000	$	35,000

Net eligible loans of the Company pledged via a blanket lien to the FHLB for advances and letters of credit at December 31, 2012, were approximately $262.9 million which allows the Company a total borrowing capacity at FHLB of approximately $123.4 million. After accounting for advances totaling $60.0 million, the Company had unused net credit available with the FHLB in the amount of approximately $63.4 million at December 31, 2012.

The other borrowings at December 31, 2012 have maturities in future years as follows:

2013	$	-
2014		10,000
2015		10,000
2016		20,000
2017		5,000
Later years		15,000
	$	60,000

The Company and the Bank have available unused lines of credit with various financial institutions, including the FHLB, totaling approximately $137.4 million and $114.8 million December 31, 2012 and 2011, respectively.

F-61

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 16. INCOME TAXES

The income tax expense (benefit) in the consolidated statements of income consists of the following:

	Years Ended December 31,
	2012		2011			2010
	(dollars in thousands)
Current	$	1,705	$	1,983		$	346
Deferred		880		(883	)		(653	)
	$	2,585	$	1,100		$	(307	)

The Company's income tax expense (benefit) differs from the amounts computed by applying the federal income tax statutory rates to income before income taxes.  A reconciliation of the differences is as follows:

	Years Ended December 31,
	2012					2011					2010
	(dollars in thousands)
Tax at federal income tax rate	$	3,176		34.00	%	$	1,674		34.00	%	$	374		34.00	%
Increase (decrease)resulting from:
Tax-exempt interest		(368	)	(3.95	)%		(283	)	(5.75	)%		(323	)	(29.38	)%
Gain on bank owned life insurance death benefit		-		-			(11	)	(0.22	)%		(312	)	(28.33	)%
Bank owned life insurance		(262	)	(2.81	)%		(200	)	(4.06	)%		(208	)	(18.88	)%
Employee Stock Ownership Plan		(39	)	(0.42	)%		(76	)	(1.55	)%		(39	)	(3.59	)%
Other		78		0.83	%		(4	)	(0.08	)%		201		18.28	%
Provision for income tax expense (benefits)		2,585		27.65	%		1,100		22.34	%		(307	)	(27.90	)%
Pre-tax income for each period	$	9,342				$	4,925				$	1,099

For the year ended December 31, 2010, the Company recorded an income a tax benefit despite having recorded net income.  The sources of nontaxable income, primarily from tax-exempt interest and bank owned life insurance and benefit exceeded the total taxable income for the period, and therefore caused an income tax benefit to be recorded.

F-62

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 16. INCOME TAXES (Continued)

The components of deferred taxes are summarized as follows:

	December 31,
	2012		2011
	(dollars in thousands)
Deferred tax assets:
Loan loss reserves	$	3,624	$	2,800
Deferred compensation		1,581		1,522
Pension liability		2,531		2,404
Unrealized loss on derivative		863		-
Impairment loss on securities available for sale		556		556
Stock-based compensation		593		494
Nonaccrual loans		126		139
Premises held for sale		201		201
Other real estate owned		665		452
Core deposit intangible		391		351
Deferred loans costs		41		(111	)
Other		13		238
		11,185		9,046
Deferred tax liabilities:
Bargain gain purchase		1,506		-
Depreciation and amortization		923		278
Realized gains on terminated cash flow hedges		-		65
Deferred pension costs		200		337
Goodwill		44		30
Unrealized gains on securities available for sale		829		955
		3,502		1,665
Net deferred tax assets	$	7,683	$	7,381

Management performed an analysis related to the Company’s deferred tax assets for the year ended December 31, 2012 and 2011. In its analysis, the Company considered all available evidence, both positive and negative, to determine whether estimated future taxable income will be sufficient to realize these assets. The tax operating losses have been carried back against prior years’ taxable income, resulting in the tax benefits from the losses being fully realized. Based on current tax laws, there are no more income taxes that may be recovered from prior years. As a result, the realization of the deferred tax assets is solely dependent upon future taxable income.  The primary positive evidence considered was sustained taxable income for both  2012 and 2011, internal projections, economic and industry trends, historical and projected loan loss trends, the impact of regulatory reform and demographic data for the Company’s markets.  Based upon this analysis, the Company believes that future taxable income will more likely than not be sufficient to realize these assets, and thus, no valuation allowances were deemed necessary for the periods indicated above.

F-63

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 17. 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.  Stock options, where the exercise price was greater than the average market price of the common shares, were not included in the computation of net income per diluted share as they would have been anti-dilutive.  These out-of-the-money options were 387,744, 557,613 and 379,726 at December 31, 2012, 2011 and 2010.

The components used to calculate basic and diluted earnings per share follows:

	Years Ended December 31,
	2012		2011		2010
	(dollars in thousands, except per share data)
Basic earnings and shares:
Net income	$	6,757	$	3,825	$	1,406
Weighted-average basic shares outstanding		7,969,104		8,188,843		8,424,394
Basic earnings per share	$	0.85	$	0.47	$	0.17
Diluted earnings and shares:
Net income	$	6,757	$	3,825	$	1,406
Weighted-average basic shares outstanding		7,969,104		8,188,843		8,424,394
Add:  Effect of dilutive outstanding equity-based shares		1,799		1,219		7,888
Weighted-average diluted shares outstanding		7,970,903		8,190,062		8,432,282
Diluted earnings per share	$	0.85	$	0.47	$	0.17

NOTE 18. STOCK PLANS AND STOCK-BASED COMPENSATION

EQUITY INCENTIVE PLANS

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 December 31, 2012, there were approximately 12,800 restricted stock awards and 49,593 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.  As of December 31, 2012, there were approximately 31,082 restricted stock awards and 48,419 options available to be granted from the 2011 Plan.

F-64

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 18. STOCK PLANS AND STOCK-BASED COMPENSATION (Continued)

EQUITY INCENTIVE PLANS (continued)

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.

 STOCK OPTIONS

A summary of the status of the two plans, along with changes during the periods then ended, follows:

	December 31,
	2012				2011					2010
	(dollars in thousands, except per share data)
			Weighted-					Weighted-				Weighted-
			Average					Average				Average
			Exercise					Exercise				Exercise
	Number		Price		Number			Price		Number		Price
Under option, beginning of period		738,560	$	13.51		416,791		$	14.90		416,791	$	14.90
Granted		31,900		13.25		346,870			11.95		-		-
Exercised		-		-		-			-		-		-
Forfeited		5,326		11.99		(7,219	)		14.55		-		-
Expired		-		-		(17,882	)		15.44		-		-
Under option, end of period		765,132	$	13.51		738,560		$	13.51		416,791	$	14.90
Exercisable at end of period		456,940	$	14.48		386,091		$	14.94		323,787	$	14.99
Weighted average fair value per option of options granted during period			$	282				$	2,692			$	-
Total grant date fair value of options vested during the period			$	535				$	300			$	305
Total intrinsic value of options exercised during the period			$	-				$	-			$	-
Shares available for grant				98,012					117,673				36,446

F-65

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 18. STOCK PLANS AND STOCK-BASED COMPENSATION (Continued)

STOCK OPTIONS (continued)

The following table presents information on stock options outstanding for the period shown, less estimated forfeitures:

	Years Ended December 31,
	2012		2011		2010
Stock options vested and expected to vest:
Number		765,132		738,560		416,791
Weighted Average Exercise Price	$	13.51	$	13.51	$	14.90
Aggregate Intrinsic Value		-		-		-
Weighted Average Contractual Term of Options	5.9 years		6.8 years		5.5 years
Stock options vested and currently exercisable:
Number		456,940		386,091		323,787
Weighted Average Exercise Price	$	14.48	$	14.94	$	14.99
Aggregate Intrinsic Value		-		-		-
Weighted Average Contractual Term of Options	4.1 years		4.4 years		5.4 years

A further summary of the options outstanding at December 31, 2012 follows:

	Options Outstanding						Options Exercisable
Range of Exercise Prices	Number		Weighted- Average Contractual Life in Years		Weighted- Average Exercise Price		Number		Weighted- Average Exercise Price
$14.97		377,214		3.6	$	14.97		377,214	$	14.97
$19.85		2,094		4.1	$	19.85		2,094	$	19.85
$13.43		7,788		5.2	$	13.43		6,363	$	13.43
$8.32		5,026		7.1	$	8.32		3,015	$	8.32
$12.35		12,000		8.2	$	12.35		2,400	$	12.35
$11.94		329,110		8.7	$	11.94		65,854	$	11.94
$13.26		31,900		9.8	$	13.26		-	$	13.26
		765,132		5.9	$	13.51		456,940	$	14.48

F-66

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 18. STOCK PLANS AND STOCK-BASED COMPENSATION (Continued)

STOCK OPTIONS (continued)

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model.  Expected volatilities are based on historical volatility of the Company’s stock.  Expected dividends are based on expected dividend trends and the expected market price of the Company’s stock price at grant.  Historical data is used to estimate option exercises and employee terminations within the valuation model.  The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

The Company granted 31,900 options on October 1, 2012 from the 2011 Equity Incentive Plan.  In 2011, the Company granted 12,000 options on January 1, 2011 from the 2006 Equity Incentive Plan, and, on July 1, 2011, the Company granted 334,870 options from the new 2011 Equity Incentive Plan. There were no options granted during the year ended December 31, 2010.  The assumptions listed in the table below were used for the options granted in the period indicated.

	Years Ended December 31,
	2012			2011			2010
Weighted-average risk-free interest rate		1.25	%		2.55	%		-
Weighted average expected life of the options	7.5 years			7.5 years				-
Weighted average expected dividends (as a percent of the fair value of the stock)		1.82	%		1.64	%		-
Weighted-average expected volatility		87.71	%		80.46	%		-

For the years ended December 31, 2012, 2011, and 2010 the Company recognized pre-tax compensation expense related to stock options of approximately $549,000, $392,000, and $312,000, respectively.   At December 31, 2012, there was approximately $2.1 million of unrecognized compensation related to stock options.

RESTRICTED STOCK

The Company also grants restricted stock periodically for the benefit of employees and directors.  The 2006 plan reserved 184,568 shares of common stock for restricted stock grants and, under the 2011 plan, 163,852 shares of common stock are reserved for restricted stock grants.

At December 31, 2012, restricted stock grants covering 171,934 shares of common stock had been issued less 166 shares forfeited in 2012 leaving 12,800 shares available for grant from the 2006 Equity Incentive Plan.  Additionally, at December 31, 2012, restricted stock grants covering 132,930 shares of common stock had been issued, 160 had been forfeited and 31,082shares were available for grant from the 2011 Equity Incentive Plan

F-67

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 18. STOCK PLANS AND STOCK-BASED COMPENSATION (Continued)

RESTRICTED STOCK (continued)

Restricted stock grants are made at the discretion of the Board of Directors. Compensation expense for restricted stock is based on the market price of the Company stock at the time of the grant and amortized on a straight-line basis over the vesting period which is currently five years for all grants issued.  Recipients of restricted stock do not pay any cash consideration to the Company for the shares, have the right to vote all shares subject to such grant and receive all dividends with respect to such shares, whether or not the shares have vested.  The restriction is based upon continuous service. The Company awarded 15,600 shares of restricted stock on October 1, 2012 from the 2011 Equity Incentive Plan.   In 2011, the Company awarded 4,000 shares of restricted stock on January 1, 2011 from the 2006 Equity Incentive Plan and 117,530 shares of restricted stock from the 2011 Equity Incentive Plan on July 1, 2011.  Restricted stock consists of the following:

	December 31, 2012						December 31, 2011						December 31, 2010
				Weighted						Weighted						Weighted
				Average						Average						Average
				Market						Market						Market
	Restricted			Price			Restricted			Price			Restricted			Price
	Shares			at Grant			Shares			at Grant			Shares			at Grant
Balance, beginning of period		123,910			$	11.94		37,705			$	14.60		71,213			$	14.74
Granted		15,600				13.26		121,530				11.95		-				-
Vested		(25,389	)			11.95		(32,256	)			14.85		(33,508	)			14.90
Forfeited		(326	)			12.70		(3,069	)			14.50		-				-
Balance, end of period		113,795			$	12.12		123,910			$	11.94		37,705			$	14.60

The balance of unearned compensation related to these restricted shares as of December 31, 2012 is $1.2 million which is expected to be recognized over a weighted-average of 3.69 years.  Total compensation expense recognized for the restricted shares granted to employees and directors for the year ended December 31, 2012, 2011, and 2010 was approximately $309,000, $336,000 and $497,000, respectively.

F-68

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 19. DERIVATIVE FINANCIAL INSTRUMENTS

The Company’s asset-liability management policy allows the use of certain derivative financial instruments for hedging purposes in managing the Company’s interest rate risk.  The Company does not enter into derivatives or other financial instruments for trading or speculative purposes.  A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate.  The most common derivative instruments include interest rate swaps, caps, floors and collars.

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

In 2007, the Company entered into three, 5-year interest rate swap agreements totaling a $20 million notional amount to hedge against interest rate risk in a declining rate environment.  As a cash flow hedge, the portion of the change in the fair value of the derivative that has been deemed highly effective is recognized in other comprehensive income until the related cash flows from the hedged item are recognized in earnings.  At December 31, 2007, the Company reported a $234,838 gain, net of a $156,558 tax effect, in other comprehensive income related to cash flow hedges.

In March 2008, the Company terminated these swap agreements for a cash payment from its counterparty in the amount of $898,725.  This gain, net of tax, is reported as a component of other comprehensive income, and will be accreted to interest income over the remaining life of the swap agreements.  As of December 31, 2012 and 2011 the Company had a balance of $- and $163,000, respectively, of unaccreted gain related to these swap agreements.

For the year ended December 31, 2012, 2011 and 2010, the Company recorded interest income of $163,000, $248,000, $352,000, respectively, on the accretion of terminated cash flow hedges.

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 $1.3 million for the year ended December 31, 2012.

The Company recognized a $2.2 million cash flow hedge liability in other liabilities on the balance sheet at December 31, 2012.  There was no ineffectiveness in the cash flow hedge during the year ended December 31, 2012.

F-69

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 19. DERIVATIVE FINANCIAL INSTRUMENTS (continued)

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 December 31, 2012, the Company was required to provide collateral of $2.3 million for the derivative.  Also, the Company has a netting agreement with the counterparty.

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 Interest Rate Lock Commitments (“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 $287,000 was recorded for all related commitments as of December 31, 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, see Note 23 Fair Value for further information.

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 were as follows

	Contract Amount
	December 31, 2012		December 31,  2011
	(dollars in thousands)
Fannie Mae mortgage-backed securities Forward commitments	$	13,500	$	-
Mandatory loan sale commitments		17,241		-
Best efforts sale commitments		18,366		7,471
Total commitments	$	49,107	$	7,471

F-70

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 20. COMMITMENTS AND CONTINGENCIES

Loan Commitments

The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit and standby letters of credit.  They involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amount recognized in the balance sheets.

The Company's exposure to credit loss is represented by the contractual amount of those instruments.  The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.  A summary of the Company's commitments is as follows:

	December 31,
	2012		2011
	(dollars in thousands)
Commitments to extend credit	$	98,492	$	82,165
Commitments to originate loans		36,887		-
Standby letters of credit		1,371		501
	$	136,750	$	82,666

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the customer.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party.  Those guarantees are primarily issued to support public and private borrowing arrangements.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers.  Collateral is required in instances which the Company deems necessary.

At December 31, 2012 and 2011, the carrying amount of liabilities related to the Company’s obligation to perform under financial standby letters of credit was insignificant.  The Company has not been required to perform on any financial standby letters of credit and the Company has not incurred any losses on financial standby letters of credit for the year ended December 31, 2012 and 2011.

Contingencies

In the normal course of business, the Company is involved in various legal proceedings.  In the opinion of management, any liability resulting from such proceedings would not have a material effect on the Company's financial statements at December 31, 2012.

F-71

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 21. CONCENTRATIONS OF CREDIT

The Company makes commercial, residential, construction, agricultural, agribusiness and consumer loans to customers primarily in counties in south and central Georgia and north central Florida.  A majority of the Company's customers' abilities to honor their contracts is dependent on the business economy in the geographical areas served by the Bank.

A substantial portion of the Company's loans are secured by real estate in the Company's primary market areas.  In addition, a substantial portion of the other real estate owned is located in those same markets.  Accordingly, the ultimate collectability of a substantial portion of the Company's loan portfolio and the recovery of a substantial portion of the carrying amount of other real estate owned are susceptible to changes in real estate conditions in the Company's primary market area.

Based on the capital level at December 31, 2012, the maximum amount under Georgia law that the Bank could loan to any one borrower and the borrower's related entities was $21.0 million for fully secured loans and $12.6 million for all other loans.  Internally, management has set a limit of $5.0 million.  These internal limits may be exceeded by approval of the Board of Directors.

NOTE 22. REGULATORY MATTERS

The Bank is subject to certain restrictions on the amount of dividends that may be declared without prior regulatory approval.  At December 31, 2012, there was approximately $3.7 million available for  dividend declaration without regulatory approval.

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's and Bank's financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices.  Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios of total and Tier I capital, as defined by the regulations, to risk-weighted assets, as defined, and of Tier I capital to average assets, as defined.  Management believes, as of December 31, 2012 and 2011, the Company and the Bank met all capital adequacy requirements to which they are subject.

F-72

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 22. REGULATORY MATTERS (Continued)

As of December 31, 2012 and 2011, the most recent notification from the regulatory authorities categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the following table.  There are no conditions or events since that notification that management believes have changed the Bank’s category.  Prompt corrective action provisions are not applicable to bank holding companies.

The Company and the Bank’s actual capital amounts and ratios are presented in the following table.

						For Capital					To Be Well Capitalized
						Adequacy					Under Prompt Corrective
	Actual					Purposes					Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
	(Dollars in thousands)
December 31, 2012
Total Capital to Risk Weighted Assets
Consolidated	$	128,381		18.4	%	$	55,697		8.0	%	$	N/A		-
Heritage Bank of the South		111,762		16.4	%		54,359		8.0	%		67,949		10	%
Tier I Capital to Risk Weighted Assets
Consolidated	$	119,881		17.2	%	$	27,849		4.0	%	$	N/A		-
Heritage Bank of the South		103,248		15.2	%		27,180		4.0	%		40,769		6.0	%
Tier I Capital to Average Assets:
Consolidated	$	119,881		11.0	%	$	43,498		4.0	%	$	N/A		-
Heritage Bank of the South		103,248		9.6	%		43,186		4.0	%		53,982		5.0	%
As of December 31, 2011
Total Capital to Risk Weighted Assets
Consolidated	$	127,854		22.4	%	$	45,570		8.0	%	$	N/A		-
Heritage Bank of the South		102,208		18.8	%		43,603		8.0	%		54,504		10.0	%
Tier I Capital to Risk Weighted Assets
Consolidated	$	121,033		21.2	%	$	22,785		4.0	%	$	N/A		-
Heritage Bank of the South		95,357		17.5	%		21,802		4.0	%		32,703		6.0	%
Tier I Capital to Average Assets:
Consolidated	$	121,033		11.2	%	$	43,407		4.0	%	$	N/A		-
Heritage Bank of the South		95,357		8.9	%		43,017		4.0	%		53,722		5.0	%

Heritage Financial Group, Inc. is subject to Georgia capital requirements for holding companies.

At December 31, 2012, Heritage Financial Group, Inc. had total equity of $120.6 million or 11.0% of total assets as of that date.  Under Georgia capital requirements for holding companies, Heritage Financial Group, Inc. had Tier I leverage capital of $119.9 million or 11.0%, which was $76.4 million above the 4.0% requirement.

F-73

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 22. REGULATORY MATTERS (Continued)

Under federal law, the Bank is subject to the qualified thrift lender test.  The qualified thrift lender test requires a savings institution to have at least 65% of its portfolio assets in housing related to finance and other specified areas.  If this test is not met, limits are placed on growth, branching, new investments, FHLB advances and dividends, or the Bank must convert to a commercial bank charter.  Management believes that this test is met.

As a Georgia savings bank, the Bank is subject to less restrictive regulations.  Under Georgia regulations, the Bank is required to have no more than 50% of its assets in commercial real estate and business loans.

A reconciliation of the Bank's capital included in its balance sheets and the regulatory capital amounts follows:

	December 31,
	2012			2011
	(dollars in thousands)
Total capital per balance sheet	$	104,016		$	99,893
Regulatory capital adjustments:
Net unrealized losses on available for sale securities		(1,245	)		(1,433	)
Accumulated net gains on cash flow hedges		5,093			3,509
Disallowed goodwill and other disallowed intangible assets		(4,234	)		(4,848	)
Disallowed deferred tax assets		(382	)		(1,764	)
Total Tier 1 Capital		103,248			95,357
Allowance for loan and lease losses includible in  Tier 2 capital		8,500			6,821
Unrealized gains on available for sale equity securities includible in Tier 2 capital		14			30
Total Tier 1 and 2 Capital	$	111,762		$	102,208

F-74

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 23. FAIR VALUE MEASUREMENTS

Determination of Fair Value

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).

Fair Value Hierarchy

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 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.

F-75

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 23. FAIR VALUE MEASUREMENTS (Continued)

Assets and Liabilities 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 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.

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 twelve month periods ended December 31, 2012.

The following tables present financial assets measured at fair value at December 31, 2012 and 2011, on a recurring basis and the change in fair value for those specific financial instruments in which fair value has been elected.  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 following tables.

F-76

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 23. FAIR VALUE MEASUREMENTS (Continued)

	Recurring Fair Value Measurements at December 31, 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)	$	21,019	$	-	$	21,019	$	-
State and municipal securities		41,573		-		41,573		-
Corporate debt securities		1,020		-		1,020		-
GSE residential mortgage-backed securities		157,497		-		157,497		-
Equity securities		297		93		204		-
Total available for sale investment securities		221,406		93		221,313		-
Mortgage loans held for sale		15,608		-		15,608		-
Other assets (1)		287		-		-		287
Total assets at fair value	$	237,301	$	93	$	236,921	$	287
Liabilities
Interest rate swap – cash flow hedge	$	2,158	$	-	$	2,158	$	-
Total liabilities at fair value	$	2,158	$	-	$	2,158	$	-

	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.

F-77

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 23. 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 year ended December 31, 2012.  There were no transfers into or out of Level 3. There were no transfers between Level 1, and Level 2 during the year ended December 31, 2012.

The year ended December 31, 2012:	Other Assets (1)
	(dollars in thousands)
Beginning Balance December 31, 2011	$	-
Total gains (losses) included in earnings: (2)
Issuances		437
Settlements and closed loans		(150	)
Expirations		-
Total gains (losses) included in other comprehensive income		-
Ending Balance December 31, 2012 (3)	$	287

(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 year ended December 31, 2011.

A significant unobservable input utilized in the determination of fair value of other assets and liabilities was a pull through rate, which was 77% as of December 31, 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.

F-78

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 23. FAIR VALUE MEASUREMENTS (Continued)

	For Items Measured at Fair Value Pursuant to Election of the Fair Value Option: Fair Value Gain related to Mortgage Banking Activities
	Twelve Months Ended
	December 31, 2012		December 31, 2011
	(dollars in thousands)
Mortgage loans held for sale	$	618	$	-

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

	December 31, 2012
	Aggregate Fair Value		Aggregate Unpaid  Principal Balance with Escrow Under FVO		Fair Value Over Unpaid Principal
Loans held for sale	$	15,608	$	15,277	$	331

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

Assets Measured at Fair Value on a Nonrecurring Basis

Certain financial assets 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.

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HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 23. FAIR VALUE MEASUREMENTS (Continued)

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 are carried at their fair value. 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 availableor 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.

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

	Non Recurring Fair Value Measurements at December 31, 2012
	Total Carrying Value		Level 1		Level 2		Level 3
	(dollars in thousands)
Assets
Impaired Loans(1)	$	14,684	$	-	$	-	$	14,684
OREO		3,242		-		-		3,242
Covered OREO		9,467		-		-		9,467
Total	$	27,393	$	-	$	-	$	27,393
	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).

F-80

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 23. FAIR VALUE MEASUREMENTS (Continued)

The following table presents quantitative information about financial and nonfinancial assets measured at fair value on a nonrecurring basis using Level 3 valuation inputs:

Quantitative Information about Level 3 Fair Value Measurements:

(dollars in thousands)	Fair Value at December 31, 2012		Valuation Technique	Unobservable Input	Range (Weighted Average)
Impaired loans	$	14,684	Discounted appraisals (1)	Appraisal adjustments (2)	0% to 97% (71%)
OREO		3,242	Discounted appraisals (1)	Appraisal adjustments (2)	10% to 100% (34%)
Covered OREO		9,467	Discounted appraisals (1)	Appraisal adjustments (2)	0% to 100% (74%)

(1) Fair value is generally based on appraisals of the underlying collateral.

(2) Appraisals may be adjusted by management for customized discounting criteria, estimated sales costs, and proprietary qualitative adjustments such as historical loss experience on the type of collateral.

Assets and Liabilities 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 3 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.

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.

F-81

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 23. FAIR VALUE MEASUREMENTS (Continued)

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.

	Carrying		Fair Value Measurements at December 31, 2012
	Value		Total Fair Value		Level 1		Level 2		Level 3
			(dollars in thousands)
Assets
Cash and short-term investments	$	43,692	$	43,692	$	43,692	$	-	$	-
Other investments		5,340		5,340		-		-		5,340
Loans, net, excluding covered loans		597,579		607,018		-		-		607,018
Covered loans		72,425		72,425		-		-		72,425
FDIC loss-share receivable		60,731		60,731				-		60,731
Total assets at fair value	$	779,767	$	789,206	$	43,692	$	-	$	745,514
Liabilities
Deposits	$	869,554		862,726	$	-	$	-	$	862,726
Federal funds purchased and securities Sold under repurchase agreements		33,219		32,812		32,812		-		-
Other borrowings		60,000		63,985				-		63,985
Total liabilities at fair value	$	962,773	$	959,523	$	32,812	$	-	$	926,711

	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		38,161		-		-		38,161
Total liabilities at fair value	$	954,236	$	948,527	$	35,049	$	-	$	913,478

F-82

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 23. FAIR VALUE MEASUREMENTS (Continued)

Current accounting guidance requires 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.

F-83

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 24. CONDENSED FINANCIAL INFORMATION OF HERITAGE FINANCIAL GROUP, INC. (PARENT COMPANY ONLY)

CONDENSED BALANCE SHEETS

(Dollars in thousands)

	December 31,
	2012		2011
Assets
Cash and due from banks	$	13,901	$	21,686
Other equity securities, at cost		1,010		1,010
Investment in subsidiary		104,015		99,893
Premises and equipment, net		439		450
Other assets		1,381		1,475
Total assets	$	120,746	$	124,514
Liabilities
Other liabilities	$	97	$	378
Stockholders' equity		120,649		124,136
Total liabilities and stockholders' equity	$	120,746	$	124,514

F-84

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 24. CONDENSED FINANCIAL INFORMATION OF HERITAGE FINANCIAL GROUP, INC. (PARENT COMPANY ONLY) (Continued)

CONDENSED STATEMENTS OF INCOME

(Dollars in thousands)

	Years Ended December 31,
	2012		2011			2010
Income
Dividends from subsidiary	$	2,186	$	-		$	-
Interest		-		15			39
Other noninterest income		11		-			-
Total income		2,197		15			39
Expense
Depreciation		14		14			13
Other expense		1,016		903			771
Total expense		1,030		917			784
Income (loss) before income tax benefits and equity in undistributed earnings of subsidiary		1,167		(902	)		(745	)
Income tax benefits		356		356			248
Income (loss) before equity in undistributed earnings of subsidiary		1,523		(546	)		(497	)
Equity in undistributed earnings of subsidiary		5,234		4,371			1,903
Net income	$	6,757	$	3,825		$	1,406

F-85

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 24. CONDENSED FINANCIAL INFORMATION OF HERITAGE FINANCIAL GROUP, INC. (PARENT COMPANY ONLY) (Continued)

CONDENSED STATEMENTS OF CASH FLOWS

	Years Ended December 31,
	2012			2011			2010
OPERATING ACTIVITIES
Net income	$	6,757		$	3,825		$	1,406
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		14			14			13
Excess tax shortfall related to stock-based compensation plans		8			2			14
Stock-based compensation expense		259			216			229
Equity in undistributed earnings of subsidiary		(5,234	)		(4,371	)		(1,903	)
Other operating activities		(195	)		(1,079	)		99
Total adjustments		(5,148	)		(5,218	)		(1,548	)
Net cash provided by (used in) operating activities		1,609			(1,393	)		(142	)
INVESTING ACTIVITIES
Contribution of 50% of proceeds of stock offering to subsidiary		-			(16	)		(30,730	)
Fund ESOP note receivable from conversion and stock offering		-			-			(3,277	)
Contribution to subsidiary		-			(7,000	)		-
Purchase of premises and equipment		(3	)		-			(2	)
Purchases of securities available for sale					-			(79,994	)
Proceeds from maturities of securities available for sale		-			25,000			54,998
Proceeds from sale of securities available for sale		-			-			-
Proceeds from fair value transfer of securities to bank		-			590			-
Net cash provided by (used in) investing activities		(3	)		18,574			(59,005	)
FINANCING ACTIVITIES
Net proceeds from common stock offering		-			-			61,482
Shares released to employee stock ownership plan		669			620			468
Excess tax benefit related to stock-based compensation plans		(8	)		(2	)		(14	)
Purchase of shares, net		(7,220	)		(1,310	)		(16	)
Dividends paid to stockholders		(2,832	)		(987	)		(854	)
Net cash provided by (used in) financing activities		(9,391	)		(1,679	)		61,066
Net increase (decrease) in cash and due from banks		(7,785	)		15,502			1,919
Cash and due from banks at beginning of period		21,686			6,184			4,265
Cash and due from banks at end of period	$	13,901		$	21,686		$	6,184

F-86

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 25. STOCK REPURCHASE PLAN

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.  As of December 31, 2012 the Company had purchased 72,909 shares at a weighted average price of $13.50 per share for a total of $984,000.

NOTE 26. SUBSEQUENT EVENTS

On March 8, 2013, the Company entered into a definitive whole-bank purchase and assumption agreement with the Federal Deposit Insurance Corporation ("FDIC") to acquire Frontier Bank ("Frontier"), a full-service bank based in LaGrange, Georgia, with total assets of approximately $259.0 million.  The Georgia Department of Banking and Finance closed Frontier and appointed the FDIC as receiver.

As a result of this acquisition, the Company assumed approximately $224.0 million in deposits and acquired $111.0 million in loans.  In addition to assuming all of the deposits of Frontier, the Company purchased approximately $262.0 million of its assets.  The Company did not enter into a loss-share agreement with the FDIC.

F-87