Heritage Financial 10-Q 2014 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2014

Commission File Number 001-34902

HERITAGE FINANCIAL GROUP, INC.

(A Maryland Corporation)

IRS Employer Identification Number 38-3814230

721 N. Westover Blvd., Albany, GA 31707

229-420-0000

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

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

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

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

Indicate the number of shares outstanding of each issuer’s classes of common equity, as of the latest practicable date:  At May 9, 2014, there were 7,848,517shares of issuer’s common stock outstanding.

HERITAGE FINANCIAL GROUP, INC.

INDEX

			Page
			Number
PART I – FINANCIAL INFORMATION
	ITEM 1.	FINANCIAL STATEMENTS
		CONSOLIDATED BALANCE SHEETS AS OF MARCH 31, 2014 AND DECEMBER 31, 2013	3
		CONSOLIDATED STATEMENTS OF INCOME FOR THE THREE ENDED MARCH 31, 2014 AND 2013	4
		CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME  FOR THE THREE ENDED MARCH 31, 2014 AND 2013	5
		CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY FOR THE THREE MONTHS ENDED MARCH 31, 2014 AND THE YEAR ENDED DECEMBER 31, 2013	6
		CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED MARCH 31, 2014 AND 2013	8
		CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.	10
	ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	61
	ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	79
	ITEM 4.	CONTROLS AND PROCEDURES	82
PART II – OTHER INFORMATION
	ITEM 1.	LEGAL PROCEEDINGS	83
	ITEM 1A.	RISK FACTORS	83
	ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	83
	ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	83
	ITEM 4.	MINE SAFETY DISCLOSURES	83
	ITEM 5.	OTHER INFORMATION	83
	ITEM 6.	EXHIBITS	84

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands)

	Unaudited March 31,			December 31,
	2014			2013
Assets
Cash and due from banks	$	27,703		$	34,804
Interest-bearing deposits in banks		10,495			3,249
Federal funds sold		1,215			130
Total cash and cash equivalents		39,413			38,183
Securities available for sale, at fair value		305,044			294,299
Federal Home Loan Bank stock, at cost		6,282			7,342
Other equity securities, at cost		1,010			1,010
Loans held for sale		126,436			110,669
Loans		762,344			747,862
Covered loans		47,684			50,891
Less allowance for loan losses		9,145			8,955
Loans, net		800,883			789,798
Other real estate owned		2,632			3,482
Covered other real estate owned		6,095			7,053
Total other real estate owned		8,727			10,535
FDIC loss-share receivable		37,637			41,306
Premises and equipment, net		38,603			37,978
Goodwill and intangible assets, net		4,757			4,253
Cash surrender value of bank owned life insurance		24,372			24,183
Other assets		20,376			21,369
	$	1,413,540		$	1,380,925
Liabilities and Stockholders' Equity
Noninterest bearing deposits	$	163,090		$	148,253
Interest bearing deposits		963,564			928,168
Total deposits		1,126,654			1,076,421
Federal funds purchased and securities sold under repurchase agreements		33,785			37,648
Other borrowings		116,127			131,394
Other liabilities		8,990			10,399
Total liabilities		1,285,556			1,255,862
Commitments and Contingencies
Stockholders' equity
Preferred stock, par value; $0.01; 5,000,000  shares authorized; no shares issued or outstanding		-			-
Common stock, par value $0.01; 45,000,000 shares authorized; 7,834,517 and 7,834,537 shares issued and outstanding, respectively		78			78
Capital surplus		78,871			78,566
Retained earnings		58,464			57,614
Accumulated other comprehensive loss, net of tax benefit of $4,098 and  $5,175, respectively		(6,147	)		(7,762	)
Unearned employee stock ownership plan (ESOP) shares, 319,210 and 332,535 shares, respectively		(3,282	)		(3,433	)
Total stockholders' equity		127,984			125,063
	$	1,413,540		$	1,380,925

See Notes to Consolidated Financial Statements.

3

HERITAGE FINANCIAL GROUP, INC AND SUBSIDIARY

Consolidated Statements of Income (Unaudited)

For the Three Months Ended March 31, 2014 and 2013

(Dollars in Thousands except per share data)

	For the Three Months Ended March 31,
	2014			2013
Interest income
Interest and fees on loans	$	13,350		$	13,369
Interest on loans held for sale		1,025			115
Interest on taxable securities		1,206			866
Interest on nontaxable securities		354			285
Interest on federal funds sold		1			1
Interest on deposits in other banks		19			22
		15,955			14,658
Interest expense
Interest on deposits		1,140			1,054
Interest on other borrowings		844			749
		1,984			1,803
Net interest income		13,971			12,855
Provision for loan losses		170			485
Net interest income after provision		13,801			12,370
Noninterest income
Service charges on deposit accounts		1,443			1,154
Bankcard services income		889			762
Other service charges, commissions and fees		162			99
Brokerage fees		566			481
Mortgage banking activities		2,166			2,182
Bank-owned life insurance		189			202
Gain on acquisitions		-			4,188
Accretion of FDIC loss share receivable		(2,031	)		(2,397	)
Other		103			94
		3,487			6,765
Noninterest expense
Salaries and employee benefits		8,580			6,430
Equipment and occupancy		1,995			1,666
Advertising and marketing		228			187
Professional fees		451			215
Information services expenses		1,200			1,182
Net loss (gain) on sales and write-downs of other real estate owned		318			(25	)
Net (gain) loss on sales and write-downs of FDIC acquired other real estate owned		(264	)		24
Foreclosed asset expenses		87			215
Foreclosed FDIC-acquired asset expenses		333			421
FDIC insurance and other regulatory fees		244	��		256
Acquisition related expenses		52			792
Deposit intangible expenses		196			194
FDIC loss-share clawback expenses		543			566
Other operating expenses		1,513			1,233
		15,476			13,356
Income before income taxes		1,812			5,779
Applicable income tax		469			1,851
Net income	$	1,343		$	3,928
Earnings per common share:
Basic earnings per share	$	0.18		$	0.52
Diluted earnings per share	$	0.18		$	0.52
Weighted average-common shares outstanding:
Basic		7,422,044			7,526,344
Diluted		7,581,775			7,528,522

See Notes to Consolidated Financial Statements.

4

HERITAGE FINANCIAL GROUP, INC AND SUBSIDIARY

Consolidated Statements of Comprehensive Income (Unaudited)

For the Three Months Ended March 31, 2014 and 2013

(Dollars in Thousands)

	For the Three Months Ended March 31,
	2014			2013
Net income	$	1,343		$	3,928
Other comprehensive income (loss):
Unrealized (loss) gain on cash flow hedge, net of tax (benefit) of $(636) and $198 for 2014 and 2013, respectively		(954	)		297
Unrealized holding gains (losses) on investments arising during the period, net of tax (benefit) of $1,713 and $(370) for 2014 and 2013, respectively		2,569			(554	)
Total other comprehensive income  (loss)		1,615			(257	)
Comprehensive income	$	2,958		$	3,671

See Notes to Consolidated Financial Statements.

5

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

For the Three Months Ended March 31, 2014 (Unaudited)

And The Year Ended December 31, 2013

(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, 2012		8,172,486		$	82		$	82,154		$	46,299	$	(4,037	)	$	(3,849	)	$	120,649
Net income		-			-			-			11,315		-			-			11,315
Exercise of 36,263 stock options		36,263			-			503			-		-			-			503
Forfeiture of 300 shares of restricted common stock		(300	)		-			-			-		-			-			-
Repurchase of  373,912  shares of common stock		(373,912	)		(4	)		(5,263	)		-		-			-			(5,267	)
Stock-based compensation expense		-			-			917			-		-			-			917
Other comprehensive loss		-			-			-			-		-			(3,913	)		(3,913	)
Tax benefit from stock-based compensation plans		-			-			34			-		-			-			34
ESOP shares earned 53,302  shares		-			-			249			-		604			-			853
Tax benefit on ESOP expense		-			-			(28	)		-		-			-			(28	)
Balance, December 31, 2013		7,834,537		$	78		$	78,566		$	57,614	$	(3,433	)	$	(7,762	)	$	125,063

See Notes to Consolidated Financial Statements.

6

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Continued)

For the Three Months Ended March 31, 2014 (Unaudited)

And The Year Ended December 31, 2013

(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, 2013		7,834,537		$	78	$	78,566		$	57,614		$	(3,433	)	$	(7,762	)	$	125,063
Net income		-			-		-			1,343			-			-			1,343
Cash dividend declared, $0.07 per share		-			-		-			(493	)		-			-			(493	)
Exercise of  120 stock options		120			-		2			-			-			-			2
Forfeiture of  140  shares of restricted common stock		(140	)		-		-			-			-			-			-
Stock-based compensation expense		-			-		224			-			-			-			224
Other comprehensive income		-			-		-			-			-			1,615			1,615
ESOP shares earned, 13,325  shares		-			-		101			-			151			-			252
Tax on ESOP  expense		-			-		(22	)		-			-			-			(22	)
Balance,  March 31, 2014		7,834,517		$	78	$	78,871		$	58,464		$	(3,282	)	$	(6,147	)	$	127,984

See Notes to Consolidated Financial Statements.

7

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(Dollars in thousands)

	Three Months Ended March 31,
	2014			2013
OPERATING ACTIVITIES	$	1,343		$	3,928
Net income
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		723			589
Amortization of intangibles		213			194
Provision for loan losses		170			485
Provision (benefit) for deferred taxes		(2,452	)		1,829
Net gain on acquisitions		-			(4,188	)
Net (gain) loss on sales and write-downs of other real estate owned		318			(25	)
Net (gain) loss on sales and write-downs of FDIC-acquired other real estate owned		(264	)		24
Amortization of available for sale discounts and premiums, net		561			545
Accretion of FDIC loss-share receivable		2,031			2,397
Increase in bank-owned life insurance		(189	)		(202	)
ESOP compensation expense		252			186
Stock-based compensation expense		224			230
Excess tax benefit related to stock-based compensation plans		-			1
Excess tax (benefit) related to ESOP		22			(4	)
Net change in:
Increase in loans held for sale		(15,767	)		(3,297	)
Increase in mortgage servicing rights		(717	)		-
Increase in interest receivable		(56	)		(302	)
Increase (decrease) in interest payable		(15	)		160
Decrease in FDIC loss-share receivable		1,639			6,322
Net other operating activities		(850	)		4,959
Total adjustments		(14,157	)		9,903
Net cash (used in) provided by operating activities		(12,814	)		13,831
INVESTING ACTIVITIES
Proceeds from sales of securities available for sale		168			10,125
Proceeds from maturities and calls of securities available for sale		7,926			6,500
Purchases of securities available for sale		(15,118	)		(41,754	)
Increase in interest-bearing deposits in banks		(7,246	)		(133,823	)
Decrease in Federal Home Loan Bank stock		1,060			235
(Increase) decrease in federal funds sold		(1,085	)		1,154
Increase in loans, net		(11,967	)		(11,423	)
Net cash received from acquisition activity		-			153,179
Purchases of premises and equipment		(1,349	)		(1,062	)
Proceeds from sales of other real estate owned		2,467			1,090
Net cash used in investing activities		(25,144	)		(15,779	)

See Notes to Consolidated Financial Statements.

8

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(Unaudited)

 (Dollars in thousands)

	Three Months Ended March 31,
	2014			2013
FINANCING ACTIVITIES
Increase in deposits	$	50,233		$	13,919
(Decrease) increase in federal funds purchased and securities sold under repurchase agreements		(3,863	)		1,033
(Repayment) proceeds from other borrowings		(15,000	)		5,000
Excess benefit related to stock-based compensation plans		-			(1	)
Excess (benefit) tax related to ESOP		(22	)		4
Proceeds from exercise of stock option		2			-
Repurchase of common stock		-			(4,084	)
Dividends paid to stockholders		(493	)		-
Net cash provided by financing activities		30,857			15,871
Net increase (decrease) in cash and due from banks		(7,101	)		13,923
Cash and due from banks at beginning of period		34,804			23,993
Cash and due from banks at end of period	$	27,703		$	37,916
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest	$	1,999		$	1,643
Income taxes	$	2,944		$	18
NONCASH TRANSACTIONS
Principal balances of loans transferred to other real estate owned	$	712		$	1,446

See Notes to Consolidated Financial Statements.

9

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1. BASIS OF PRESENTATION AND ACCOUNTING ESTIMATES

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

The consolidated financial statements include the accounts of the Company and its subsidiary, the Bank.  Significant intercompany transactions and balances have been eliminated in consolidation.  Certain amounts in the consolidated financial statements for the periods presented have been reclassified to conform to the current period’s presentation and had no effect on previously reported total assets or net income.

In preparing the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses, the valuation of foreclosed real estate, deferred tax assets, other-than-temporary impairments of securities and the fair value of financial instruments.

The accompanying consolidated financial information of the Company as of March 31, 2014 and 2013 is unaudited; however, such information reflects all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations.  The results of operations for the three months ended March 31, 2014, are not necessarily indicative of the results that may be expected for the full year. These statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

10

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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

Recently Adopted Accounting Pronouncements

In January 2014, FASB issued ASU 2014-04, “Receivables—Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure (a consensus of the FASB Emerging Issues Task Force).” ASU 2014-04 clarifies when an in-substance repossession or foreclosure occurs: a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. The amendments are effective for fiscal years and interim periods beginning on or after December 15, 2014. The Company is currently in the process of evaluating the ASU.

11

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 2. EARNINGS PER SHARE

Basic earnings per share represent income available attributable to common stockholders divided by the weighted-average number of common shares outstanding during the period, excluding unallocated shares of the Employee Stock Ownership Plan and unvested shares of issued restricted stock. For the period ended March 31, 2014, potential common shares of 31,053, respectively, were not included in the calculation of diluted earnings per share because the assumed exercise of such shares would be anti-dilutive.

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

	Three Months ended March 31,
	2014		2013
	(dollars in thousands, except per share data)
Basic earnings and shares:
Net income	$	1,343	$	3,928
Weighted-average basic shares outstanding		7,422,044		7,526,344
Basic earnings per share	$	0.18	$	0.52
Diluted earnings and shares:
Net income	$	1,343	$	3,928
Weighted-average basic shares outstanding		7,422,044		7,526,344
Add:  Stock options and nonvested shares		159,731		2,178
Weighted-average diluted shares outstanding		7,581,775		7,528,522
Diluted earnings per share	$	0.18	$	0.52

12

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 3. SHARE BASED COMPENSATION

On May 17, 2006, the Company’s stockholders approved the 2006 Equity Incentive Plan (the “2006 Plan”).  The purpose of the 2006 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 2006 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 March 31, 2014, there were approximately 12,800 restricted stock awards and 56,963 options available to be granted from the 2006 Plan.

On June 22, 2011, the Company’s stockholders approved the 2011 Equity Incentive Plan (the “2011 Plan”).  Under the 2011 Plan, the Compensation Committee has the discretion to award up to 573,481 shares, of which 409,429 were available as stock options or stock appreciation rights and 163,852 were available as restricted stock awards.  On July 1, 2011, the Company granted 117,530 restricted stock awards and 334,870 stock options from this plan. On October 1, 2012, the Company granted 15,600 restricted stock awards and 31,900 stock options from this plan.    There were no awards granted from this plan and 120 options exercised during the three months ended March 31, 2014.  As of March 31, 2014, there were approximately 31,522 restricted stock awards and 49,539 options available to be granted from the 2011 Plan.

The Company granted restricted awards that may not be sold or otherwise transferred until certain restrictions have lapsed.  The unearned compensation related to these awards is being amortized to compensation expense over the period the restrictions lapse (generally one to five years).  The share-based expense for these awards was determined based on the market price of the Company's stock at the date of grant applied to the total number of shares that were anticipated to fully vest, amortized over the vesting period.  As of March 31, 2014, there was approximately $794,000 of unrecognized compensation associated with these awards.  For the three months ended March 31, 2014 and 2013, we recognized compensation expense associated with these awards of approximately $81,000 and $84,000, respectively.

The Company recognized compensation expense related to stock options of approximately $143,000 and $146,000, respectively, for the three months ended March 31, 2014 and 2013.  At March 31, 2014, there was approximately $1.4 million of unrecognized compensation related to stock options.

13

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 4. SECURITIES

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

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
March 31, 2014:	(dollars in thousands)
U.S. Government sponsored agencies (GSEs)	$	55,643	$	48	$	(2,031	)	$	53,660
State and municipal securities		57,021		570		(1,946	)		55,645
GSE residential mortgage-backed securities		200,068		432		(5,541	)		194,959
Total debt securities		312,732		1,050		(9,518	)		304,264
Equity securities		207		573		-			780
Total securities	$	312,939	$	1,623	$	(9,518	)	$	305,044
December 31, 2013:
U.S. Government sponsored agencies (GSEs)	$	56,493	$	9	$	(2,930	)	$	53,572
State and municipal securities		54,012		222		(3,420	)		50,814
GSE residential mortgage-backed securities		195,764		394		(6,889	)		189,269
Total debt securities		306,269		625		(13,239	)		293,655
Equity securities		207		439		(2	)		644
Total securities	$	306,476	$	1,064	$	(13,241	)	$	294,299

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.

	March 31, 2014				December 31, 2013
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(dollars in thousands)
One year or less	$	-	$	-	$	-	$	-
One to five years		15,054		14,819		12,087		11,843
Five to ten years		57,075		55,310		58,328		55,333
Over ten years		40,742		39,956		40,297		37,854
Mortgage-backed securities		200,068		194,959		195,764		189,269
	$	312,939	$	305,044	$	306,476	$	294,299

Securities with a carrying value of approximately $134.2 million and $133.0 million at March 31, 2014 and December 31, 2013, 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 $33.5 million and $30.9 million at March 31, 2014 and December 31, 2013, respectively.

14

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 4. SECURITIES (Continued)

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

	For the three months ended March 31,
	2014			2013
	(dollars in thousands)
Gross gains recognized on sales of securities	$	1		$	-
Gross losses recognized on sales of securities		(1	)		-
Net realized gains on sales of securities available for sale	$	-		$	-

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)
March 31, 2014 :
U.S. Government sponsored agencies (GSEs)	$	43,973	$	(1,830	)	$	2,798	$	(201	)	$	46,771	$	(2,031	)
State and municipal securities		15,475		(659	)		14,437		(1,287	)		29,912		(1,946	)
GSE residential mortgage-backed securities		135,222		(4,313	)		27,153		(1,228	)		162,375		(5,541	)
Subtotal, debt securities		194,670		(6,802	)		44,388		(2,716	)		239,058		(9,518	)
Equity securities		-		-			-		-			-		-
Total temporarily impaired securities	$	194,670	$	(6,802	)	$	44,388	$	(2,716	)	$	239,058	$	(9,518	)
December 31, 2013 :
U.S. Government sponsored agencies (GSEs)	$	53,716	$	(2,930	)	$	-	$	-		$	53,716	$	(2,930	)
State and municipal securities		31,243		(2,321	)		7,566		(1,099	)		38,809		(3,420	)
GSE residential mortgage-backed securities		141,069		(5,917	)		20,747		(972	)		161,816		(6,889	)
Subtotal, debt securities		226,028		(11,168	)		28,313		(2,071	)		254,341		(13,239	)
Equity securities		205		(2	)		-		-			205		(2	)
Total temporarily impaired securities	$	226,233	$	(11,170	)	$	28,313	$	(2,071	)	$	254,546	$	(13,241	)

15

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 4. SECURITIES (Continued)

At March 31, 2014, total unrealized losses decreased to $9.5 million, or 4.0% of the temporarily impaired securities, compared to $13.2 million, or 5.2% of the temporarily impaired securities, at December 31, 2013.  The unrealized losses at March 31, 2014 relate to 46 agencies, 79 state and municipal obligations and 125 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 March 31, 2014. 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 March 31, 2014, the Company held certain investment securities having continuous unrealized loss positions for more than 12 months.  All of these losses were in 2 agencies, 23 mortgage-backed securities and 40 municipal securities. The unrealized losses arose from changes in interest rates and market conditions as of March 31, 2014.

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.

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 $558,000. During the twelve months ended December 31, 2008, the Company recognized a write-down of $1.5 million through noninterest 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 noninterest income representing OTTI on the security.  Subsequent to the recorded OTTI on this security, interest payments have resumed and this security is now considered performing.  At March 31, 2014, the book value of the security was recorded at $207,000 and the fair value of the security was $222,000 with $15,000 of unrealized gain recorded in other comprehensive income.

16

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 4. SECURITIES (Continued)

The following table presents more detail on selective Company security holdings as of March 31, 2014.  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
(dollars in thousands)
Marketable equity securities
FHLMC Preferred Stock		313400657	Ca	$	-	$	558	$	-	$	558
Trust preferred securities
RBS Capital Fund		74928K208	B3		207		222		-		222

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.

	March 31, 2014		December 31, 2013
	(dollars in thousands)
Beginning balance of credit losses	$	1,543	$	1,543
Other-than-temporary impairment credit losses		-		-
Ending balance of cumulative credit losses recognized in earnings	$	1,543	$	1,543

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 March 31, 2014 and December 31, 2013, was $6.3 million and $7.3 million, respectively.   The estimated fair value of this investment is $6.3 million as of March 31, 2014, and therefore it 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 had limited stock transactions, and therefore, no fair market value is readily available.  The carrying value of this investment at March 31, 2014 and December 31, 2013, was $1.0 million.  The Company plans to hold this investment for the foreseeable future, and did not consider it impaired as of March 31, 2014.

17

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES

(EXCLUDING FDIC-ACQUIRED LOANS)

The composition of loans is summarized as follows:

	March 31,			December 31,
	2014			2013
Commercial real estate:	(dollars in thousands)
Nonresidential	$	262,753		$	256,567
Multifamily		25,718			22,650
Farmland		30,116			23,420
Total commercial real estate loans		318,587			302,637
Construction and land		53,138			50,167
Residential real estate:
Mortgage loans, 1-4 family		176,344			177,456
Home equity		31,898			29,147
Total residential real estate loans		208,242			206,603
Consumer and other:
Indirect auto loans		135			247
Direct auto loans		6,097			6,640
Other		14,675			17,089
Total consumer and other loans		20,907			23,976
Commercial and industrial loans		101,696			101,161
		702,570			684,544
Loans acquired through FDIC-assisted acquisitions
Noncovered		59,774			63,318
Covered		47,684			50,891
Total loans		810,028			798,753
Total allowance for loan losses		(9,145	)		(8,955	)
Loans, net	$	800,883		$	789,798

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.

18

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES

(EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

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

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

Construction and Land

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

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.

19

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. 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, 2014	$	2,080	$	3,171		$	1,229	$	2,169	$	306		$	8,955
Add (deduct):
Charge-offs		-		(13	)		-		-		(37	)		(50	)
Recoveries		-		42			-		-		28			70
Provision for loan losses		81		(78	)		78		13		(29	)		65
Balance, March  31, 2014	$	2,161	$	3,122		$	1,307	$	2,182	$	268		$	9,040
Allowance:
Ending balance: specific	$	327	$	709		$	333	$	110	$	35		$	1,514
Ending balance: collective	$	1,834	$	2,413		$	974	$	2,072	$	233		$	7,526
Loans:
Ending balance: individually evaluated for impairment	$	4,379	$	2,833		$	3,815	$	135	$	52		$	11,214
Ending balance: collectively evaluated for impairment	$	314,208	$	205,409		$	49,323	$	101,561	$	20,855		$	691,356

20

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. 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, 2013	$	2,744		$	3,251		$	978	$	1,724		$	364		$	9,061
Add (deduct):
Charge-offs		(276	)		(735	)		-		(810	)		(154	)		(1,975	)
Recoveries		-			109			1		16			83			209
Provision for loan losses		(388	)		546			250		1,239			13			1,660
Balance, December 31, 2013	$	2,080		$	3,171		$	1,229	$	2,169		$	306		$	8,955
Allowance:
Ending balance: specific	$	343		$	696		$	305	$	104		$	47		$	1,495
Ending balance: collective	$	1,737		$	2,475		$	924	$	2,065		$	259		$	7,460
Loans:
Ending balance: individually evaluated for impairment	$	4,456		$	2,939		$	3,829	$	135		$	59		$	11,418
Ending balance: collectively evaluated for impairment	$	298,181		$	203,664		$	46,338	$	101,026		$	23,917		$	673,126

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.

21

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES

(EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

Impaired loans by class are presented below for 2014:

									Interest
			Unpaid				Average		Income
	Recorded		Principal		Related		Recorded		Recognized
	Investment		Balance		Allowance		Investment		YTD 2014
	(dollars in thousands)
Loans with no related allowance recorded
Commercial real estate:
Nonresidential	$	-	$	-	$	-	$	-	$	-
Multifamily		-		-		-		-		-
Farmland		-		-		-		-		-
Construction and land		3,367		3,367		-		3,392		-
Residential real estate:
Mortgage loans, 1-4 family		1,405		2,076		-		1,746		-
Home equity		-		-		-		-		-
Consumer and other:
Indirect auto loans		-		-		-		-		-
Direct auto loans		-		-		-		-		-
Other		-		-		-		-		-
Commercial and industrial loans		-		-		-		-		-
Loans with related allowance recorded
Commercial real estate:
Nonresidential	$	4,379	$	4,638	$	327	$	4,506	$	7
Multifamily		-		-		-		-		-
Farmland		-		-		-		-		-
Construction and land		448		517		333		451		1
Residential real estate:
Mortgage loans, 1-4 family		1,304		1,489		594		1,406		8
Home equity		124		124		115		127		-
Consumer and other:
Indirect auto loans		8		17		-		11		-
Direct auto loans		12		26		8		19		-
Other		32		44		27		37		-
Commercial and industrial loans		135		257		110		232		2
Total
Commercial real estate	$	4,379	$	4,638	$	327	$	4,506	$	7
Construction and land		3,815		3,884		333		3,843		1
Residential real estate		2,833		3,689		709		3,279		8
Consumer and other		52		87		35		67		-
Commercial and industrial loans		135		257		110		232		2
Total	$	11,214	$	12,555	$	1,514	$	11,927	$	18

22

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES

(EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

Impaired loans by class are presented below for 2013:

									Interest
			Unpaid				Average		Income
	Recorded		Principal		Related		Recorded		Recognized
	Investment		Balance		Allowance		Investment		YTD 2013
	(dollars in thousands)
Loans with no related allowance recorded
Commercial real estate:
Nonresidential	$	-	$	-	$	-	$	-	$	-
Multifamily		-		-		-		-		-
Farmland		-		-		-		-		-
Construction and land		3,380		3,380		-		3,407		-
Residential real estate:
Mortgage loans, 1-4 family		1,438		2,085		-		1,937		-
Home equity		-		-		-		-		-
Consumer and other:
Indirect auto loans		-		-		-		-		-
Direct auto loans		-		-		-		-		-
Other		-		-		-		-		-
Commercial and industrial loans		-		-		-		-		-
Loans with related allowance recorded
Commercial real estate:
Nonresidential	$	4,456	$	4,679	$	343	$	4,567	$	28
Multifamily		-		-		-		-		-
Farmland		-		-		-		-		-
Construction and land		449		517		305		452		-
Residential real estate:
Mortgage loans, 1-4 family		1,501		1,733		696		1,559		22
Home equity		-		-		-		-		-
Consumer and other:
Indirect auto loans		6		14		4		9		-
Direct auto loans		18		32		12		22		-
Other		35		46		31		40		1
Commercial and industrial loans		135		255		104		260		3
Total
Commercial real estate	$	4,456	$	4,679	$	343	$	4,567	$	28
Construction and land		3,829		3,897		305		3,859		-
Residential real estate		2,939		3,818		696		3,496		22
Consumer and other		59		92		47		71		1
Commercial and industrial loans		135		255		104		260		3
Total	$	11,418	$	12,741	$	1,495	$	12,253	$	54

23

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. 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 March 31, 2014.

	30-59		60-89				Total
	Days		Days		Non		Past				Total
	Past Due		Past Due		Accrual*		Due		Current		Loans
	(dollars in thousands)
Commercial real estate:
Nonresidential	$	180	$	-	$	4,379	$	4,559	$	258,194	$	262,753
Multifamily		-		-		-		-		25,718		25,718
Farmland		143		-		-		143		29,973		30,116
Total commercial real estate loans		323		-		4,379		4,702		313,885		318,587
Construction and land		49		67		1,848		1,964		51,174		53,138
Residential real estate:
Mortgage loans, 1-4 family		260		-		2,708		2,968		173,376		176,344
Home equity		34		-		124		158		31,740		31,898
Total residential real estate loans		294		-		2,832		3,126		205,116		208,242
Consumer and other:
Indirect auto loans		3		-		8		11		124		135
Direct auto loans		2		7		12		21		6,076		6,097
Other		2		-		31		33		14,642		14,675
Total consumer and other loans		7		7		51		65		20,842		20,907
Commercial and industrial loans		78		5		135		218		101,478		101,696
Total	$	751	$	79	$	9,245	$	10,075	$	692,495	$	702,570

*There were no accruing loans that were greater than 90 or more days past due at March 31, 2014.

24

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. 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, 2013.

	30-59		60-89				Total
	Days		Days		Non-		Past				Total
	Past Due		Past Due		Accrual*		Due		Current		Loans
	(dollars in thousands)
Commercial real estate:
Nonresidential	$	-	$	-	$	4,456	$	4,456	$	252,111	$	256,567
Multifamily		-		-		-		-		22,650		22,650
Farmland		-		-		-		-		23,420		23,420
Total commercial real estate loans		-		-		4,456		4,456		298,181		302,637
Construction and land		163		-		1,849		2,012		48,155		50,167
Residential real estate:
Mortgage loans, 1-4 family		600		88		2,936		3,624		173,832		177,456
Home equity		139		-		-		139		29,008		29,147
Total residential real estate loans		739		88		2,936		3,763		202,840		206,603
Consumer and other:
Indirect auto loans		2		3		6		11		236		247
Direct auto loans		2		-		18		20		6,620		6,640
Other		4		-		34		38		17,051		17,089
Total consumer and other loans		8		3		58		69		23,907		23,976
Commercial and industrial loans		-		-		135		135		101,026		101,161
Total	$	910	$	91	$	9,434	$	10,435	$	674,109	$	684,544

*There were no accruing loans that were greater than 90 or more days past due at December 31, 2013.

25

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. 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 March 31, 2014, the Company had troubled debt restructurings totaling $7.7 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 March 31, 2014, are troubled debt restructurings of $5.7 million.  In addition, at that date the Company had troubled debt restructurings totaling $2.0 million that were performing in accordance with their modified terms and are not included in nonaccruing loans.

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

Troubled debt restructurings for the periods ended:

	March 31, 2014
			Recorded
	Number		Investment
	of Modifications		Prior to Modifications		Recorded Investment
	(dollars in thousands)
Commercial real estate		3	$	3,036	$	2,844
Residential real estate		5		7,268		1,459
Construction and land		2		3,574		3,367
Commercial and industrial loans		-		-		-
Consumer and other		-		-		-
Total		10	$	13,878	$	7,670

26

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES

(EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

	December 31, 2013
			Recorded
	Number		Investment
	of Modifications		Prior to Modifications		Recorded Investment
	(dollars in thousands)
Commercial real estate		3	$	3,036	$	2,878
Residential real estate		5		7,268		1,488
Construction and land		2		3,574		3,380
Commercial and industrial loans		-		-		-
Consumer and other		-		-		-
Total		10	$	13,878	$	7,746

Troubled debt restructuring modifications that subsequently defaulted for the periods ended:

	March 31, 2014
	Number
	of Modifications		Recorded Investment
	(dollars in thousands)
Commercial real estate		3	$	2,844
Residential real estate		4		1,457
Construction and land		1		1,400
Commercial and industrial loans		-		-
Consumer and other		-		-
Total		8	$	5,701

	December 31, 2013
	Number
	of Modifications		Recorded Investment
	(dollars in thousands)
Commercial real estate		3		$	2,878
Residential real estate		4			1,485
Construction and land		1			1,400
Commercial and industrial loans		-			-
Consumer and other		-			-
Total		8		$	5,763

27

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. 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 also 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.

28

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES

(EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

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.

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	Nonaccrual 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 borrowers with an 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 borrowers with current and complete financial statements; solid balance sheet and income statement with stable to improving trends  in areas such as net worth, liquidity, working capital, leverage, cash flow  and profitability; leverage and ratios are better than industry standards when industry comparison is available; debt service coverage, both historically and proposed, is more than adequate based on financial analysis; the borrower’s industry is stable to improving; loans are properly structured and documented and require only normal supervision and monitoring; consistently meets debt obligations in a timely manner; individual borrower or guarantor, with above average liquid net worth and minimal contingent liabilities.

29

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES

(EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

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

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

Special Mention-6-Special Mention Loans - Loans in this category are not currently adequate.  These loans are considered weaker due to less than adequate repayment history, and/or their collateral may not adequately protect the Company 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 Company’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 Company 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-Nonaccrual Loans – Loans in this category are impaired with a loss potential of either principal or interest that is probable or likely to occur.  Once a loan enters this category, the estimated loss will be charged off.

30

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES

(EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

Doubtful 10-Doubtful - Loans in this category have all of the weaknesses inherent in those classified as Substandard, with the additional characteristic that the weaknesses make collection or liquidation in full highly questionable and improbable.  This assessment should be made on current facts, conditions and values.  The probability of some loss is extremely high, but because of certain important and reasonably specific pending factors (i.e., merger/liquidation, capital injection, refinancing plans, and/or perfection of liens), the amount of loss cannot yet be determined, but may total 50% of the outstanding balance.  Determination of the pending factors should generally be resolved within six months and the asset partially, or fully, charged-off or moved to substandard.  All doubtful assets must be placed on nonaccrual.  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 Company 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 March 31, 2014 and December 31, 2013.

	As of March 31, 2014
							Construction
	Non-						and
	Residential		Multifamily		Farmland		Land
	(dollars in thousands)
Commercial Real Estate Credit Exposure
Pass 1	$	-	$	-	$	-	$	-
Pass 2		-		-		-		58
Pass 3		55,122		498		5,279		2,409
Pass 4		172,789		24,037		21,320		22,030
Pass 5		26,144		1,146		3,157		24,071
Special Mention 6		1,055		37		156		-
Special Mention Elevated 7		130		-		143		688
Substandard 8		3,134		-		61		2,034
Impaired Loans 9		4,379		-		-		1,848
Doubtful 10		-		-		-		-
Loss 11		-		-		-		-
Total	$	262,753	$	25,718	$	30,116	$	53,138

31

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES

(EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

	As of December 31, 2013
							Construction
	Non-						and
	Residential		Multifamily		Farmland		Land
	(dollars in thousands)
Commercial Real Estate Credit Exposure
Pass 1	$	-	$	-	$	-	$	-
Pass 2		-		-		-		60
Pass 3		58,386		360		5,762		2,299
Pass 4		171,496		22,252		16,999		24,902
Pass 5		17,804		-		297		18,381
Special Mention 6		1,087		38		301		-
Special Mention Elevated 7		131		-		-		696
Substandard 8		3,207		-		61		1,980
Impaired Loans 9		4,456		-		-		1,849
Doubtful 10		-		-		-		-
Loss 11		-		-		-		-
Total	$	256,567	$	22,650	$	23,420	$	50,167

	As of March 31, 2014
	Commercial and Industrial
	(dollars in thousands)
Commercial and Industrial Credit Exposure
Pass 1	$	1,283
Pass 2		39
Pass 3		19,440
Pass 4		66,154
Pass 5		13,905
Special Mention 6		440
Special Mention Elevated 7		225
Substandard 8		75
Impaired Loans 9		135
Doubtful 10		-
Loss 11		-
Total	$	101,696

32

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES

(EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

	As of December 31, 2013
	Commercial and Industrial
	(dollars in thousands)
Commercial and Industrial Credit Exposure
Pass 1	$	1,325
Pass 2		432
Pass 3		24,344
Pass 4		64,653
Pass 5		9,757
Special Mention 6		208
Special Mention Elevated 7		239
Substandard 8		68
Impaired Loans 9		135
Doubtful 10		-
Loss 11		-
Total	$	101,161

	As of March 31, 2014
	Mortgage		Home Equity
	(dollars in thousands)
Residential Real Estate Credit Exposure
Pass 1-5	$	170,473	$	31,774
Special Mention 6		428		-
Special Mention Elevated 7		7		-
Substandard 8		2,728		-
Impaired Loans 9		2,708		124
Doubtful 10		-		-
Loss 11		-		-
Total	$	176,344	$	31,898

33

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES

(EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

	As of December 31, 2013
	Mortgage		Home Equity
	(dollars in thousands)
Residential Real Estate Credit Exposure
Pass 1-5	$	171,349	$	29,147
Special Mention 6		460		-
Special Mention Elevated 7		-		-
Substandard 8		2,711		-
Impaired Loans 9		2,936		-
Doubtful 10		-		-
Loss 11		-		-
Total	$	177,456	$	29,147

	As of March 31, 2014
	Indirect		Direct
	Auto		Auto		Other
	(dollars in thousands)
Consumer and Other Credit Exposure
Pass 1-5	$	127	$	6,085	$	14,634
Special Mention 6		-		-		-
Special Mention Elevated 7		-		-		-
Substandard 8		-		-		9
Impaired Loans 9		8		12		32
Doubtful 10		-		-		-
Loss 11		-		-		-
Total	$	135	$	6,097	$	14,675

34

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES

(EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

	As of December 31, 2013
	Indirect		Direct
	Auto		Auto		Other
	(dollars in thousands)
Consumer and Other Credit Exposure
Pass 1-5	$	241	$	6,622	$	17,042
Special Mention 6		-		-		-
Special Mention Elevated 7		-		-		-
Substandard 8		-		-		12
Impaired Loans 9		6		18		35
Doubtful 10		-		-		-
Loss 11		-		-		-
Total	$	247	$	6,640	$	17,089

35

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 6. FDIC-ACQUIRED LOANS AND ALLOWANCE FOR LOAN LOSSES

The Company elected to account for loans acquired in the Tattnall Bank, Citizens Bank of Effingham (“Citizens”), First Southern National Bank (“First Southern”) and Frontier Bank (“Frontier”) 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 310-30 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 310-30.  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 310-30. 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:	March 31,		December 31,
	2014		2013
	(dollars in thousands)
Commercial real estate	$	21,269	$	22,268
Residential real estate		28,115		30,134
Construction and land		5,573		5,156
Commercial and industrial		1,926		2,604
Consumer and other		2,891		3,156
	$	59,774	$	63,318

Loans covered by loss-sharing agreements:	March 31,		December 31,
	2014		2013
	(dollars in thousands)
Commercial real estate	$	14,044	$	14,161
Residential real estate		22,372		23,886
Construction and land		10,332		11,642
Commercial and industrial		801		864
Consumer and other		135		338
	$	47,684	$	50,891

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.  The FDIC agreements to reimburse are set to expire five years from the acquisition date for non-single family loans and ten years from the acquisition date for single family loans, while recoveries will be shared three years after the reimbursement expiration for the single family loans.

The following table presents the loss-sharing agreement expirations:

Acquisition	Non-single Family Expiration	Single Family Expiration
Citizens	March 2016	March 2021
First Southern	September 2016	September 2021

36

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 6. FDIC-ACQUIRED LOANS AND ALLOWANCE FOR LOAN LOSSES (CONTINUED)

The following table represents the loans receivable as of March 31, 2014, and reflects reclassifications from the balances reported at December 31, 2013:

	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	$	169,079		$	21,982		$	191,061
Nonaccretable difference		(22,636	)		(8,181	)		(30,817	)
Cash flows expected to be collected		146,443			13,801			160,244
Accretable yield		(48,289	)		(4,497	)		(52,786	)
Basis in acquired loans	$	98,154		$	9,304		$	107,458

The following table is a summary of changes in the accretable yields of acquired loans since December 31, 2012 and reflect refinements to the Company's initial estimate:

(dollars in thousands)	Accretable Yield
Balance at December 31, 2012	$	28,882
Additions		21,189
Reclassification from nonaccretable difference		12,620
Accretion included in interest income		(29,459	)
Adjustments to estimates of expected cash flows		19,509
Balance at December 31, 2013	$	52,741
Additions		-
Reclassification from nonaccretable difference		4,304
Accretion included in interest income		(5,712	)
Adjustments to estimates of expected cash flows		1,453
Balance at March 31, 2014	$	52,786

37

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 6. 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 2014:

	Commercial Real Estate		Residential Real Estate		Construction and Land		Commercial and Industrial		Consumer and Other		Total
	(dollars in thousands)
		-		-
Balance, January 1, 2014	$	-	$	-	$	-	$	-	$	-	$	-
Add (deduct):
Charge-offs		-		-		-		-		-		-
Recoveries		-		-		-		-		-		-
Provision for loan losses –noncovered		-		-		-		-		-		-
Provision for loan losses - covered		-		105		-		-		-		105
Balance, March  31, 2014	$	-	$	105	$	-	$	-	$	-	$	105
Allowance:
Ending balance: specific	$	-	$	-	$	-	$	-	$	-	$	-
Ending balance: collective	$	-	$	105	$	-	$	-	$	-	$	105
Loans:
Ending balance: individually evaluated for impairment	$	13,200	$	4,487	$	4,959	$	118	$	1,656	$	24,420
Ending balance: collectively evaluated for impairment	$	22,113	$	46,000	$	10,946	$	2,609	$	1,370	$	83,038

38

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 6. 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 2013:

	Commercial Real Estate		Residential Real Estate			Construction and Land			Commercial and Industrial			Consumer and Other		Total
	(dollars in thousands)
		-		-
Balance, January 1, 2013	$	-	$	-		$	-		$	-		$	-	$	-
Add (deduct):
Charge-offs		-		(2	)		(38	)		(35	)		-		(75	)
Recoveries		-		-			-			-			-		-
Provision for loan losses -noncovered		-		-			11			-			-		11
Provision for loan losses - covered		-		2			27			35			-		64
Balance, December 31, 2013	$	-	$	-		$	-		$	-		$	-	$	-
Allowance:
Ending balance: specific	$	-	$	-		$	-		$	-		$	-	$	-
Ending balance: collective	$	-	$	-		$	-		$	-		$	-	$	-
Loans:
Ending balance: individually evaluated for impairment	$	13,425	$	4,543		$	5,994		$	114		$	1,706	$	25,782
Ending balance: collectively evaluated for impairment	$	23,004	$	49,477		$	10,804		$	3,354		$	1,788	$	88,427

39

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 7. 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 has 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 details of changes in the loss-share receivable from the FDIC for the periods indicated.

For the period ended March 31, 2014:
	(dollars in thousands)
Balance, December 31, 2013	$	41,306
Decrease in expected losses on covered assets		(581	)
Accretion included in noninterest income		(2,031	)
Reimbursements from the FDIC		(1,057	)
Balance, March 31, 2014	$	37,637

For the period ended December 31, 2013:
	(dollars in thousands)
Balance, December 31, 2012	$	60,731
Clawback liability reclassified from asset		703
Decrease in expected losses on covered assets		(371	)
Accretion included in noninterest income		(9,293	)
Reimbursements from the FDIC		(10,464	)
Balance, December 31, 2013	$	41,306

40

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 8. OTHER REAL ESTATE OWNED (OREO)

The following table provides a summary of information pertaining to other real estate owned (“OREO”) for periods ended March 31, 2014 and December 31, 2013.

					Covered
		OREO			OREO			Total
	(dollars in thousands)
Balance, December 31, 2013		$	3,482		$	7,053		$	10,535
Additions			299			415			714
Sales			(699	)		(1,403	)		(2,102	)
Writedowns			(450	)		30			(420	)
Balance, March 31, 2014		$	2,632		$	6,095		$	8,727

	OREO			Covered OREO			Total
	(dollars in thousands)
Balance, December 31, 2012	$	3,242		$	9,467		$	12,709
Acquired in Frontier acquisition		786			-			786
Additions		2,430			4,873			7,303
Sales		(2,611	)		(6,571	)		(9,182	)
Writedowns		(365	)		(716	)		(1,081	)
Balance, December 31, 2013	$	3,482		$	7,053		$	10,535

41

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. 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).

The fair value hierarchy is based on the lowest level input that is significant to the fair value measurement of the asset and liability 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.

On September 30, 2012, the Company made the election to record mortgage loans held for sale at fair value.   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.

42

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

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.

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 interest rate lock commitments (“IRLCs”) 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.

43

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

The credit risk associated with the underlying cash flows of an instrument carried at fair value was a consideration in estimating the fair value of certain financial instruments. Credit risk was considered in the valuation through a variety of inputs, as applicable, including, the actual default and loss severity of the collateral, and level of subordination. The assumptions used to estimate credit risk applied relevant information that a market participant would likely use in valuing an instrument. Because mortgage loans held for sale are sold within a few weeks of origination, they are 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 three months ended March 31, 2014, and twelve months ended December 31, 2013.

The following tables present financial assets measured at fair value at March 31, 2014 and December 31, 2013, 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.

	Recurring Fair Value Measurements at March 31, 2014
	Total Carrying Value		Level 1		Level 2		Level 3
	(dollars in thousands)
Assets
Available for sale investment securities:
U.S. Government sponsored agencies (GSEs)	$	53,660	$	-	$	53,660	$	-
State and municipal securities		55,645		-		55,645		-
GSE residential mortgage-backed securities		194,959		-		194,959		-
Equity securities		780		558		222		-
Total available for sale investment securities		305,044		558		304,486		-
Mortgage loans held for sale		126,436		-		126,436		-
Interest rate swap – cash flow hedge		760		-		760
Other assets(1)		858		-		-		858
Total assets at fair value	$	433,098	$	558	$	431,682	$	858

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

44

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

	Recurring Fair Value Measurements at December 31, 2013
	Total Carrying Value		Level 1		Level 2		Level 3
	(dollars in thousands)
Assets
Available for sale investment securities:
U.S. Government sponsored agencies (GSEs)	$	53,572	$	-	$	53,572	$	-
State and municipal securities		50,814		-		50,814		-
GSE residential mortgage-backed securities		189,269		-		189,269		-
Equity securities		644		439		205		-
Total available for sale investment securities		294,299		439		293,860		-
Mortgage loans held for sale		110,669		-		110,669		-
Interest rate swap – cash flow hedge		2,350		-		2,350		-
Other assets(1)		1,762		-		-		1,762
Total assets at fair value	$	409,080	$	439	$	406,879	$	1,762

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

45

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

The following tables present a reconciliation of all assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (level 3) during the three months ending March 31, 2014, and the year ending December 31, 2013.  There were no transfers into or out of Level 3, nor were there any transfers between Level 1 and Level 2 during these periods.

Three months March 31, 2014:	Other Assets(1)
	(dollars in thousands)
Beginning balance, December 31, 2013	$	1,762
Total gains (losses) included in earnings:(2)
Mortgage IRLCs		379
Mortgage securities forward commitments		(1,283	)
Ending balance, March 31, 2014(3)	$	858

Year ended  December 31, 2013:	Other Assets(1)
	(dollars in thousands)
Beginning balance, December 31, 2012	$	287
Total gains (losses) included in earnings:(2)
Mortgage IRLCs		266
Mortgage securities forward commitments		1,209
Ending balance, December 31, 2013(3)	$	1,762

(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.

A significant unobservable input utilized in the determination of fair value of other assets was a pull through rate, which was 82% as of March 31, 2014. 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, the fair value of an IRLC 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.

46

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE9.  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
	Three Months Ended
	March 31, 2014		March 31, 2013
	(dollars in thousands)
Mortgage loans held for sale	$	2,063	$	841

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 (“FVO”) has been elected as of March 31, 2014 and December 31, 2013.

	March 31, 2014
	Aggregate Fair Value		Aggregate Unpaid Principal Balance with Escrow Under FVO		Fair Value Over Unpaid Principal
Loans held for sale	$	126,436	$	122,818	$	3,618

	December 31, 2013
	Aggregate Fair Value		Aggregate Unpaid Principal Balance with Escrow Under FVO		Fair Value Over Unpaid Principal
Loans held for sale	$	110,669	$	109,193	$	1,476

47

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

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 (“LOCOM”) 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 nonrecurring basis and recognized in the accompanying consolidated balance sheet, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Impaired Loans:  Loan impairment is reported when full payment under the loan terms is not expected.  In accordance with the provisions of the loan impairment guidance (ASC 310-10-35), individual loans 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 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 loan impairment as nonrecurring 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.

Mortgage Servicing Rights (MSR): Mortgage servicing rights are initially recorded at the current LOCOM value when mortgage loans are sold with servicing retained. These assets are then amortized in proportion to and over the period of estimated net servicing income. On a quarterly basis these servicing assets are assessed for impairment based on fair value. Management determines fair value by stratifying the servicing portfolio into homogeneous subsets with unique behavior characteristics, converting those characteristics into income and expense streams, adjusting those streams for prepayments, present valuing the adjusted streams, and combining the present values into a total. If the carrying value of any loan stratification tranche is higher than the present value of the tranche, an impairment is recorded.

48

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

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

	Nonrecurring Fair Value Measurements at March 31, 2014
	Total Carrying Value		Level 1		Level 2		Level 3
	(dollars in thousands)
Assets
Impaired Loans(1)	$	11,214	$	-	$	-	$	11,214
OREO		2,632		-		-		2,632
Covered OREO		6,095		-		-		6,095
Mortgage servicing rights (MSR)		902		-		-		902
Total	$	20,843	$	-	$	-	$	20,843

	Nonrecurring Fair Value Measurements at December 31, 2013
	Total Carrying Value		Level 1		Level 2		Level 3
	(dollars in thousands)
Assets
Impaired Loans(1)	$	11,418	$	-	$	-	$	11,418
OREO		3,482		-		-		3,482
Covered OREO		7,053		-		-		7,053
Mortgage servicing rights (MSR)		202		-		-		202
Total	$	22,155	$	-	$	-	$	22,155

(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 independent third party valuations and borrower records, discounted as appropriate (Level 3).

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 March 31, 2014		Valuation Technique	Unobservable Input	Range (Weighted Average)
Impaired loans	$	11,214	Discounted appraisals (1)	Appraisal adjustments (2)	0% to 100% (72%)
OREO		2,632	Discounted appraisals (1)	Appraisal adjustments (2)	0% to 100% (60%)
Covered OREO		6,095	Discounted appraisals (1)	Appraisal adjustments (2)	0% to 100% (69%)
MSR		902	Discounted cash flows	Discount rate	10%
				Prepayment Speeds	9%

(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.

49

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

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 nonrecurring basis and recognized in the accompanying consolidated 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.

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.

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.

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

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

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

50

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

The following tables present the assets that are measured at fair value on a nonrecurring basis by level within the fair value hierarchy as reported on the consolidated statements of financial position.

	Carrying Value		Fair Value Measurements at March 31, 2014
			Total Fair Value		Level 1		Level 2		Level 3
			(dollars in thousands)
Assets
Cash and short-term investments	$	39,413	$	39,413	$	39,413	$	-	$	-
Other investments		7,292		7,292		-		-		7,292
Loans, excluding covered loans		762,344		773,975		-		-		773,975
Covered loans		47,684		47,684		-		-		47,684
FDIC loss-share receivable		37,637		37,637				-		37,637
Total assets at fair value	$	894,370	$	906,001	$	39,413	$	-	$	866,588
Liabilities
Deposits	$	1,126,654	$	1,116,497	$	-	$	-	$	1,116,497
Federal funds purchased and securities sold under repurchase agreements		33,785		37,770		37,770		-		-
Other borrowings		116,127		108,207		-		-		108,207
Total liabilities at fair value	$	1,276,566	$	1,262,474	$	37,770	$	-	$	1,224,704

	Carrying Value		Fair Value Measurements at December 31, 2013
			Total Fair Value		Level 1		Level 2		Level 3
			(dollars in thousands)
Assets
Cash and short-term investments	$	38,183	$	38,183	$	38,183	$	-	$	-
Other investments		8,352		8,352		-		-		8,352
Loans, excluding covered loans		747,862		759,668		-		-		759,668
Covered loans		50,891		50,891		-		-		50,891
FDIC loss-share receivable		41,306		41,306				-		41,306
Total assets at fair value	$	886,594	$	898,400	$	38,183	$	-	$	860,217
Liabilities
Deposits	$	1,076,421	$	1,066,943	$	-	$	-	$	1,066,943
Federal funds purchased and securities sold under repurchase agreements		37,648		39,661		39,661		-		-
Other borrowings		131,394		122,937		-		-		122,937
Total liabilities at fair value	$	1,245,463	$	1,229,541	$	39,661	$	-	$	1,189,880

51

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. 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 nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

52

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 10. 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

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 gain on its cash flow hedge in other comprehensive income of $456,000 as of March 31, 2014.

The Company recognized a $760,000 cash flow hedge asset in other assets on the consolidated balance sheet at March 31, 2014.  There was no ineffectiveness in the cash flow hedge during the three month period ended March 31, 2014.

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 March 31, 2014, the Company was not required to provide collateral for the derivative.  Also, the Company has a netting agreement with the counterparty.

53

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 10. DERIVATIVE FINANCIAL INSTRUMENTS (continued)

Derivative Instruments – Mortgage Lending Activities

The Company maintains a risk management program to manage interest rate risk and pricing risk associated with its mortgage lending activities. The risk management program includes the use of forward contracts and other derivatives that are recorded in the financial statements at fair value and are used to offset changes in value of the mortgage inventory due to changes in market interest rates. As a normal part of its operations, the Company enters into derivative contracts to economically hedge risks associated with overall price risk related to IRLCs and mortgage loans held for sale for which the fair value option has been elected. Fair value changes occur as a result of interest rate movements as well as changes in the value of the associated servicing rights. Derivative instruments used include forward commitments, mandatory commitments and best effort commitments. All derivatives are carried at fair value in the Consolidated Balance Sheets in other assets or other liabilities. A net realized loss of $904,000 was recorded for all related commitments for the three months ended March 31, 2014.

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 9 Fair Value Measurements 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
	March 31, 2014		December 31, 2013
	(dollars in thousands)
Mortgage-backed securities forward commitments	$	157,500	$	128,000
Best efforts sale commitments		17,049		19,418
Total commitments	$	174,549	$	147,418

54

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 11. SEGMENT INFORMATION

The Company’s operating segments include banking and mortgage banking.  The reportable segments are determined by the products and services offered, and internal reporting.  Segment performance is evaluated using net interest income and noninterest income. Income taxes are allocated based on income before income taxes, and indirect expenses (includes management fees) are allocated based on various internal factors for each segment. Transactions among segments are made at fair value. Information reported internally for performance assessment follows.

Three months ended March 31, 2014	Bank		Mortgage Banking			Holding Company			Totals
	(dollars in thousands)
Net interest income	$	13,146	$	825		$	-		$	13,971
Provision for loan losses		170		-			-			170
Noninterest income		1,089		2,392			6			3,487
Noninterest expense		11,466		3,815			195			15,476
Income tax expense (benefit)		725		(185	)		(71	)		469
Segment profit (loss)	$	1,874	$	(413	)	$	(118	)	$	1,343
Segment assets at March 31, 2014	$	1,262,999	$	136,662		$	13,879		$	1,413,540

Three months ended March 31, 2013	Bank		Mortgage Banking			Holding Company			Totals
	(dollars in thousands)
Net interest income	$	12,836	$	19		$	-		$	12,855
Provision for loan losses		485		-			-			485
Noninterest income		4,577		2,182			6			6,765
Noninterest expense		10,964		2,206			186			13,356
Income tax expense (benefit)		1,921		(1	)		(69	)		1,851
Segment profit (loss)	$	4,043	$	(4	)	$	(111	)	$	3,928
Segment assets at March 31, 2013	$	1,338,071	$	20,849		$	11,630		$	1,370,550

55

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 12. ACQUISITION ACTIVITY

Frontier Bank

On March 8, 2013, HeritageBank of the South entered into a definitive whole-bank purchase and assumption agreement with the FDIC to acquire Frontier Bank, a full-service bank based in LaGrange, Georgia.  The Georgia Department of Banking and Finance closed Frontier Bank and, by Order of the Georgia Superior Court, appointed the FDIC as Receiver.  The Bank acquired a majority of the assets, with the exception of certain loans and all the OREO as of the bid valuation date of December 19, 2012, and assumed substantially all of the liabilities of Frontier.

The agreement with the FDIC did not involve a loss-sharing agreement but did include an asset purchase discount of $34.8 million. The Bank also received a cash payment from the FDIC in the amount of $97.5 million.

The Company elected to account for loans acquired in the Frontier 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 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:

	Acquired		Fair Value and Other Adjustments				As Recorded by the Company
Assets	(dollars in thousands)
Cash and cash equivalents	$	55,660	$	97,519		(a)	$	153,179
Securities available to sale		22,241		-				22,241
FHLB and other bank stock		1,897		-				1,897
Loans		98,041		(24,715	)	(b)		73,326
Other real estate owned		1,620		(834	)	(c)		786
Core deposit intangible		-		625		(d)		625
Other assets		1,788		-				1,788
Total assets	$	181,247	$	72,595			$	253,842
Liabilities
Noninterest-bearing deposits	$	23,683	$	-			$	23,683
Interest-bearing deposits		187,896		507		(e)		188,403
Other borrowings		32,068		5,210		(f)		37,278
Deferred tax liability		-		1,675		(g)		1,675
Other liabilities		289		-				289
Total Liabilities	$	243,936	$	7,392			$	251,328
Liabilities assumed over assets acquired	$	62,689
Aggregate fair value adjustments			$	65,203
Gain on acquisition, net of tax							$	2,514

56

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 12. ACQUISITION ACTIVITY (continued)

Explanations

(a) The adjustment represents the cash received from the FDIC to reflect the acquisition of excess liabilities assumed over assets acquired and the asset purchase discount.

(b) The adjustment reflects fair value adjustments based on the evaluation of the acquired loan portfolio. The fair value adjustment includes adjustments for estimated credit losses, liquidity and servicing costs.

(c) The adjustment represents the estimated credit losses in the acquired other real estate owned.

(d) 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.

(e) 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.

(f) The adjustment is necessary because the weighted average interest rate of the other borrowings assumed 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 borrowings.

(g) The amount represents the deferred tax liability recorded as a result of the recorded gain on acquisition.

The Company did not immediately acquire the real estate, banking facilities, furniture and equipment of Frontier as part of the purchase and assumption agreement.  However, the Company subsequently purchased the real estate, banking facilities, furniture and equipment of Frontier from the FDIC at fair value in the amount of $5.0 million during the second quarter of 2013.

NOTE 13. SUBSEQUENT EVENTS

On April 21, 2014, the Company entered into an Agreement of Plan of Merger to acquire all of the common stock of Alarion Financial Services, Inc. (“Alarion”), in a stock transaction valued at approximately $22.1 million.

Alarion, headquartered in Ocala, Florida, is the holding company for Alarion Bank, which operates six branches in Ocala, Gainesville and Alachua (suburban Gainesville). As of March 31, 2014, Alarion reported approximately $284 million in assets, $200 million in loans, $242 million in deposits and $18 million in tangible common equity. Upon completion of the transaction, Heritage is expected to have approximately $1.7 billion in assets, $1.0 billion in loans, and $1.4 billion in deposits. The transaction is expected to be immediately accretive to Heritage’s fully diluted earnings per share, excluding deal costs.

Under the terms of the agreement, which has been unanimously approved by the Boards of Directors of both companies, Alarion’s stockholders will receive 0.44 shares of Heritage’s common stock for each share of Alarion common stock owned, resulting in the issuance of a total of approximately 1,159,000 shares in the exchange. Additionally, in connection with the transaction, affiliates of Jacobs Asset Management, LLC that are investors in both Heritage and the preferred stock of Alarion will exchange approximately $4.5 million of Alarion preferred stock and accrued but unpaid dividends for approximately 178,000 shares of Heritage common stock and approximately $1.7 million in cash. These transactions, which are subject to regulatory approval, the approval of the stockholders of Alarion and other customary conditions, is expected to close in the third quarter of 2014.

57

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

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

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

58

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

General.  Heritage is a $1.4 billion bank holding company headquartered in Albany, Georgia.  The principal business of Heritage is operating its wholly owned subsidiary, HeritageBank.  Heritage primarily conducts commercial banking, retail banking, mortgage banking and wealth management activities through its bank subsidiary.  As of March 31, 2014, HeritageBank operated in Georgia, Florida and Alabama through 29 banking locations, 15 mortgage offices and 5 investment offices.HeritageBank provides credit based products, deposit accounts, corporate cash management, investment support and other services to commercial and retail clients.

Strategy.  Our business strategy is to operate a well-capitalized and profitable financial institution dedicated to serving the needs of our customers.  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 Georgia, Florida, and Alabama that present attractive opportunities for expansion consistent with our capital availability.  We have pursued this expansion program through both prudent, disciplined internal growth and strategic 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.

In March 2013, we completed an FDIC-assisted whole-bank purchase of Frontier Bank, a nine branch full service bank based in LaGrange, Georgia with approximately $98.0 million in loans and $212.0 million in deposits, and in November 2013, we opened a banking location and mortgage office in Columbus, Georgia.  In December 2013, we opened a banking location and mortgage office in Birmingham, Alabama, and in February 2014 we opened a mortgage office in Colorado Springs, Colorado.

Critical Accounting Policies

The accounting principles we follow and our methods of applying these principles conform with U.S. generally accepted accounting principles and with general practices within the banking industry. There have been no significant changes to our Critical Accounting Policies as described in our Annual Report on Form 10-K for the year ended December 31, 2013.

59

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

Off-Balance Sheet Arrangements, Contractual Obligations and Commitments.  The following table presents our longer term, non-deposit related, contractual obligations and commitments to extend credit to our customers, in aggregate and by payment due dates.  In addition to the commitments below, we had overdraft protection available in the amount of $23.1 million at March 31, 2014.

	March 31, 2014
	Less than One Year		One through Three Years		Four through Five Years		After Five Years		Total
	(In thousands)
Contractual obligations:
FHLB advances	$	25,068	$	37,591	$	36,878	$	16,590	$	116,127
Fed funds purchased and securities sold under  repurchase agreement		3,785		15,000		10,000		5,000		33,785
Operating leases (premises)		931		1,844		1,564		2,415		6,754
Total advances and operating leases	$	29,784	$	54,435	$	48,442	$	24,005	$	156,666
Off-balance sheet loan commitments:
Undisbursed portions of loans closed	$	19,573	$	3,214	$	1,231	$	-	$	24,018
Commitments to originate loans		97,927		-		-		-		97,927
Unused lines of credit		79,768		9,084		5,043		17,532		111,427
Total loan commitments		197,268		12,298		6,274		17,532		233,372
Total contractual obligations and loan commitments	$	227,052	$	66,733	$	54,716	$	41,537	$	390,038

60

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

Comparison of Financial Condition at March 31, 2014 and December 31, 2013

General.  Total assets increased by $32.6 million, or 2.4%, to $1.414 billion at March 31, 2014, from $1.381 billion at December 31, 2013.  Cash and due from banks decreased $7.1 million, or 20.4%, to $27.7 million at March 31, 2014, from $34.8 million at December 31, 2013.  Total interest-earning assets increased $46.1 million, or 3.8%, to $1.253 billion at March 31, 2014, from $1.207 billion at December 31, 2013.  The increase in interest-earning assets was driven by increases in loans of $11.3 million, loans held for sale of $15.8 million, securities available for sale of $10.7 million, interest bearing deposits in banks of $7.2 million and federal funds sold of $1.1 million.  At the same time, interest-bearing deposits increased $35.4 million, other borrowings decreased $15.3 million, and federal funds purchased and securities sold under repurchase agreements declined $3.9 million.

Cash and Securities.  Cash and securities (including bank deposits and federal funds sold) increased in the aggregate $12.0 million, or 3.6%, to $344.5 million, or 24.4% of total assets, at March 31, 2014, from $332.5 million, or 24.1% of total assets, at December 31, 2013. At March 31, 2014, our liquidity position as a percentage of total assets improved as a result of growth in the balance of securities available for sale coupled with improvement in the unrealized loss of the securities portfolio as compared to December 31, 2013.

	At March 31, 2014		At December 31, 2013		Amount Change			Percent Change
	(Dollars in thousands)
Cash and due from banks	$	27,703	$	34,804	$	(7,101	)		(20.4	)%
Interest-bearing deposits in banks		10,495		3,249		7,246			223.0
Federal funds sold		1,215		130		1,085			834.6
Securities available for sale, at fair value		305,044		294,299		10,745			3.7
Total	$	344,457	$	332,482	$	11,975			3.6	%

At March 31, 2014, our securities portfolio consisted of $53.7 million in GSE securities, $195.0 million in GSE residential mortgage-backed securities, $55.6 million in state and municipal securities, and $780,000 in corporate equity securities.  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 March 31, 2014.  See Note 4 to the Consolidated Financial Statements in this Form 10-Q for additional information.

We expect to lower our excess liquidity on the basis of cash, funds due from banks, federal funds sold, and securities as a percent of total assets throughout 2014.  We continue to believe that utilizing some of our excess liquidity to increase our loan portfolio as a percentage of total assets is a prudent strategy for us throughout 2014.

Loans.  Our loan portfolio increased $11.3 million, or 1.4%, to $810.0 million at March 31, 2014, from $798.8 million at December 31, 2013.  Overall, the change in the loan portfolio was primarily driven by organic loan growth of $18.0 million offset in part by principal pay downs and resolutions of $3.5 million for noncovered loans and $3.2 million for covered loans.  We continue to emphasize a diversified lending strategy as we noted balance growth in most of our major loan categories for the quarter. We also continue to 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, and whole bank acquisitions.

61

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

The following table reflects the changes in the types of loans in our portfolio at March 31, 2014, as compared to the end of 2013.

	Loans by Type as of
	March 31,		December 31		Amount			Percentage
	2014		2013		Change			Change
	(dollars in thousands)
Non-FDIC-acquired loans:
Nonresidential	$	262,753	$	256,567	$	6,186			2.4	%
Multifamily		25,718		22,650		3,068			13.5
Farmland		30,116		23,420		6,696			28.6
Construction and land		53,138		50,167		2,971			5.9
Mortgage loans, 1-4 family		176,344		177,456		(1,112	)		(0.6	)
Home equity		31,898		29,147		2,751			9.4
Consumer and other		20,907		23,976		(3,069	)		(12.8	)
Commercial and industrial		101,696		101,161		535			0.5
		702,570		684,544		18,026			2.6
Loans acquired through FDIC-assisted acquisitions:
Noncovered loans		59,774		63,318		(3,544	)		(5.6	)
Covered loans		47,684		50,891		(3,207	)		(6.3	)
		107,458		114,209		(6,751	)		(5.9	)
Total loans	$	810,028	$	798,753	$	11,275			1.4	%

Loans Held for Sale.  At March 31, 2014, we had approximately $126.4 million in loans held for sale, which are mortgage loans generated to be sold to investors, as compared to $110.7 million at December 31, 2013.  The increase was driven by our decision to slow loan sales to Fannie Mae during the quarter in order to sell to Freddie Mac for better execution.  The Company received approval to sell loans to Freddie Mac at the end of the first quarter of 2014, and expects to deliver loans during the second quarter of 2014.  During the first quarter of 2014 we generated $135.5 million in mortgage loan originations, and we anticipate this positive trend in mortgage loan originations held for sale to continue throughout 2014.  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.  We currently have $26.7 million of mortgage loans held for sale that have been held longer than ninety days as of March 31, 2014, and we held a mortgage repurchase reserve, used in the event a loan is repurchased from an investor, of $32,000 as of March 31, 2014.  We do not anticipate difficulty in selling the loans we have held greater than ninety days to an investor in the foreseeable future.  See Notes 1 and 9 to the Consolidated Financial Statements in this Form 10-Q for additional information.

Delinquencies and Nonperforming Assets.  As of March 31, 2014, our total loans delinquent for 30 to 89 days was $830,000, or 0.12% of total loans, excluding FDIC-acquired loans, compared to $1.0 million, or 0.15% of total loans, excluding FDIC-acquired loans, at December 31, 2013.  At March 31, 2014, our nonperforming assets, excluding FDIC-acquired, totaled $10.3 million, or 0.73% of total assets, compared to $11.2 million, or 0.81% of total assets, at December 31, 2013. This $874,000, or 7.8%, decrease was primarily driven by an OREO write down of $450,000 and OREO sales net of additions of $235,000 for the quarter.  Included in nonaccruing loans at March 31, 2014, are troubled debt restructurings of $5.7 million, which involve forgiving a portion of interest or principal on loans or making loans at a rate materially below market.

62

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

Our loan portfolio includes FDIC-acquired loans, 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.  See Accounting for FDIC-assisted Acquisitions and Note 6 to the Consolidated Financial Statements in this Form 10-Q for additional information about FDIC-acquired loans.

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

	Nonperforming Assets
	March 31, 2014		December 31, 2013		Amount Change			Percent Change
	(Dollars in thousands)
Nonaccruing loans	$	9,245	$	9,434	$	(189	)		(2.0	)%
Foreclosed assets		1,104		1,789		(685	)		(38.3	)
Total nonperforming assets	$	10,349	$	11,223	$	(874	)		(7.8	)%

Nonperforming loans, excluding FDIC-acquired loans, decreased to 1.32% of total loans, excluding FDIC-acquired loans, at March 31, 2014, from 1.38% at December 31, 2013, primarily driven by continued improvement in our loan portfolio trends.  We are cautiously optimistic that the positive trend of nonperforming loans, excluding FDIC-acquired loans, will continue to improve as a percentage of total loans, excluding FDIC-acquired loans, throughout 2014.

OREO, excluding FDIC-acquired assets, was $1.1 million at March 31, 2014, compared to $1.8 million at December 31, 2013.  We continue to aggressively confront credit quality issues in our loan portfolio.  OREO experienced a decrease primarily driven by write downs and sales for the first quarter of 2014 in excess of additions.  We believe the current value of each OREO property represents our estimated disposition value less estimated selling expenses based on current appraisals and market data.  All of these properties are being marketed actively for disposition.  For the quarter ended March 31, 2014, we had gross proceeds on sales of OREO, excluding covered FDIC-acquired assets, of $883,000 and recorded a net gain of approximately $184,000 on those sales.  See Note 8 to the Consolidated Financial Statements in this Form 10-Q for more information.

Our internally criticized (watch list) and classified assets, excluding FDIC-acquired loans, totaled $22.0million at March 31, 2014, compared to $22.7 million at December 31, 2013.  This includes loans with respect to which known information about the possible credit problems of the borrowers has 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.

The table below sets forth the amounts of criticized and classified assets in our portfolio, excluding FDIC-acquired loans and OREO, at the dates indicated.

	March 31,			December 31,
	2014			2013
	(Dollars in thousands)
Total criticized assets	$	22,026		$	22,741
Total classified assets		18,717			19,582
Total criticized assets to total loans		3.14	%		3.32	%
Total classified assets to total loans		2.66	%		2.86	%

63

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

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 March 31, 2014, was $9.1 million and at December 31, 2013, was $8.9 million.   Excluding FDIC-acquired loans, the allowance for loan losses to total loans was 1.30% at March 31, 2014, and 1.31% at December 31, 2013.  This slight decrease reflects improving credit trends in our loan portfolio, and we are cautiously optimistic the improvement will continue into 2014.

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

	March 31, 2014			December 31, 2013			March 31, 2013
	(dollars in thousands)
Allowance for loan losses to total loans		1.30	%		1.31	%		1.51	%
Allowance for loan losses to average loans		1.32	%		1.33	%		1.53	%
Allowance for loan losses to nonperforming loans		98.92	%		94.91	%		71.56	%
Accruing loans past due 30-89 days	$	830		$	1,001		$	1,316
Nonaccrual loans		9,245			9,434			12,723
Loans - 90 days past due & still accruing		-			-			-
Total nonperforming loans		9,245			9,434			12,723
OREO and repossessed assets		1,104			1,789			3,028
Total nonperforming assets	$	10,349		$	11,223		$	15,751
Nonperforming loans to total loans		1.32	%		1.38	%		2.11	%
Nonperforming assets to total assets		0.73	%		0.81	%		1.15	%
Net (recoveries) charge-offs QTD to average loans (annualized)		(0.01	)%		0.10	%		0.27	%
Net (recoveries) charge-offs QTD	$	(20	)	$	160		$	406

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 Note 5 to the Consolidated Financial Statements in this Form 10-Q for additional information.

64

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

Premises and Equipment. Premises and equipment increased $625,000, or 1.6%, to $38.6 million at March 31, 2014, compared to December 31, 2013, primarily driven by the purchase of a commercial building during the first quarter for $775,000 in Albany, Georgia, which is planned for general corporate expansion for our operations departments.

Goodwill, Intangible Assets and Other Assets. Goodwill and intangible assets increased $504,000, or 11.9%, to $4.8 million at March 31, 2014, compared to $4.3 million at December 31, 2013.  The increase was driven by growth in the MSRs net of amortization of $699,000, partially offset by the amortization expense of $195,000 related to core deposit intangibles for the first quarter of 2014.

Cash surrender value of bank owned life insurance (“BOLI”) increased $189,000 to $24.4 million at March 31, 2014, from December 31, 2013, driven by the earnings of the BOLI policies for the first quarter of 2014.  Other assets decreased $1.0 million to $20.4 million at March 31, 2014, compared to December 31, 2013, primarily due to reductions in the fair market value of the cash flow hedge of $1.6 million, the fair market value of mortgage related interest rate lock commitments and derivative financial instruments used to hedge interest rate risk of $903,000, offset in part by an increase in deferred tax assets of $1.4 million. See Note 10 to the Consolidated Financial Statements in this Form 10-Q for more information.

Deposits.  Total deposits increased $50.2 million, or 4.7%, to $1.127 billion at March 31, 2014, compared with $1.076 billion at December 31, 2013, primarily driven by core deposit growth of $46.2 million, wholesale deposit growth of $2.7 million, and time deposit growth of $1.3 million.

Borrowings and Other Liabilities.  The total amount of other borrowings decreased $15.3 million to $116.1 million at March 31, 2014, from $131.4 million at December 31, 2013.  The reduction in other borrowings was driven by the repayment of short-term FHLB borrowings of $15.0 million and the fair market value rate adjustment for the FHLB borrowings reflected as a reduction to interest expense of $267,000.  The weighted average rate on these other borrowings was 1.75% for the first quarter of 2014 compared to 2.59% for the same period in 2013.  Federal funds purchased and securities sold under repurchase agreements decreased $3.9 million to $33.8 million at March 31, 2014, compared to $37.7 million at December 31, 2013, primarily driven by reductions in the customer repurchase agreements of $2.0 million and the federal funds purchased from Chattahoochee Bank of Georgia of $1.9 million.

Equity.  Total equity increased $2.9 million to $128.0 million at March 31, 2014, compared with $125.1 million at December 31, 2013, primarily driven by other comprehensive income of $1.6 million, net income of $1.3 million, stock-based compensation of $224,000, and the allocation of $252,000 in ESOP shares, offset in part by cash dividend payments of $493,000.

Accounting for FDIC-Assisted Acquisitions

General.  We perform ongoing assessments of the estimated cash flows of our FDIC-acquired loan portfolios accounted under ASC 310-30.  At March 31, 2014, the fair value of the FDIC-acquired loan portfolios consisted of $47.7 million in covered and $59.8 million in noncovered loans, compared with $50.9 million in covered and $63.3 million in noncovered loans at December 31, 2013.  The principal balance of the FDIC-acquired loan portfolios totaled $165.8 million at March 31, 2014, compared with $177.8 million at December 31, 2013.  The decrease in FDIC-acquired loans was driven by the portfolio paydowns and resolutions.

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 and charge-off are recorded immediately, which results in an immediate use of the allowance.

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

During the first quarter of 2014, we recorded an allowance against the FDIC-acquired noncovered perm 1-4 loan pool for Frontier of $105,000 for a valuation adjustment needed to adjust the yield.  The remaining FDIC-acquired loan pools experienced improvement in cash flows, which positively impacted the FDIC-acquired loan accretion related to the pooled loans.  At March 31, 2014, the FDIC-acquired loans individually assessed did not experience any charge-offs related to inadequate discounts as a result of the re-estimation of cash flows for such loans compared to $75,000 at December 31, 2013, and $35,000 at March 31, 2013.  See Note 6 to the Consolidated Financial Statements in this Form 10-Q for additional information.

FDIC Loss-Share Receivable and Clawback Liability.  At March 31, 2014, the FDIC loss-share receivable associated with covered FDIC-acquired assets decreased $3.7 million to $37.6 million, or 37.5% of the principal balance of covered FDIC-acquired assets, compared to $41.3 million, or 37.8% of the principal balance of covered FDIC-acquired assets, at December 31, 2013. The principal balance of the covered FDIC-acquired assets totaled $100.5 million at March 31, 2014, compared with $109.2 million at December 31, 2013.  The reduction in the FDIC loss-share receivable during the first quarter of 2014 was primarily driven by $2.0 million of negative accretion, which resulted from the improvement in cash flows for the FDIC-acquired loan pools and was included in noninterest income, and $1.1 million of reimbursements received from the FDIC.

As of March 31, 2014, we have recorded an FDIC clawback liability of $2.5 million for all FDIC loss-share agreements, compared to $1.9 million at December 31, 2013.  This increase in FDIC clawback liability was driven by an improvement in estimates of expected cash flows for the FDIC-acquired assets covered under loss-sharing agreements. See Note 7 to the Consolidated Financial Statements in this Form 10-Q for additional information.

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

The following table presents the FDIC loss-share receivable and clawback liability in more detail for the periods indicated.

	March 31, 2014			December 31, 2013
	(dollars in thousands)
FDIC loss-share receivable:
Single family estimated credit losses	$	8,446		$	8,995
Nonsingle family estimated credit losses		27,459			30,077
Pending reimbursements and other		1,732			2,234
Total	$	37,637		$	41,306
FDIC clawback liability	$	2,484		$	1,941
Total covered discount impacting FDIC loss-share receivable		35,906			39,071
FDIC receivable as % of gross balance of covered assets		37.5	%		37.8	%
Covered discount as % of FDIC loss-share receivable		95.4	%		94.6	%

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

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

	Three Months Ended March 31,
	2014								2013
	(Dollars in Thousands)
	Average Outstanding Balance			Interest Earned/ Paid		Yield/ Rate			Average Outstanding Balance			Interest Earned/ Paid		Yield/ Rate
Interest-Earning Assets:
Loans	$	903,153		$	14,379		6.46	%	$	698,905		$	13,486		7.83	%
Investment securities		301,407			1,680		2.26			237,729			1,248		2.13
Other short-term investments		20,715			20		0.39			45,613			24		0.21
Total interest-earning assets		1,225,275			16,079		5.32			982,247			14,758		6.09
Noninterest earning assets		163,312								166,667
Total assets		1,388,587								1,148,914
Interest-Bearing Liabilities:
Interest checking, money market, savings		555,828			327		0.24	%		475,176			287		0.24	%
Time deposits		382,486			813		0.86			321,970			767		0.97
Total interest-bearing deposits		938,314			1,140		0.49			797,146			1,054		0.54
Federal funds purchased and securities sold under repurchase agreements		35,977			329		3.71			34,273			328		3.88
Other borrowings		119,413			515		1.75			65,965			421		2.59
Total interest bearing liabilities		1,093,704			1,984		0.74			897,384			1,803		0.81
Noninterest Bearing Liabilities:
Demand deposits		158,583								119,059
Other liabilities		8,475								11,671
Total noninterest bearing liabilities		167,058								130,730
Total liabilities		1,260,762								1,028,114
Stockholder’s equity		127,825								120,800
Total liabilities and stockholder’s equity		1,388,587								1,148,914
Net interest income				$	14,095							$	12,955
Net interest rate spread							4.59	%							5.28	%
Net earning assets	$	131,571							$	84,863
Net interest margin							4.66	%							5.35	%
Average interest-earning assets to average interest-bearing liabilities		1.12	x							1.09	x
Core net interest margin (non-GAAP):
Loans(1)(2)	$	903,153		$	14,379		6.46	%	$	698,905		$	13,486		7.83	%
FDIC-acquired loan discount adjustments(3)		61,056			3,850		25.57			67,744			4,588		27.47
Loans		964,209			10,529		4.43			766,649			8,898		4.71
Adjusted total interest-earning assets		1,286,331			12,229		3.86			1,049,991			10,170		3.93
Total interest bearing liabilities	$	1,093,704			1,985		0.74		$	897,384			1,803		0.81
Core net interest income				$	10,244							$	8,367
Core net interest rate spread							3.12	%							3.11	%
Core net interest margin							3.23	%							3.23	%

(1) Average loan balances includes nonaccrual loans for the periods presented.

(2) Fully Taxable Equivalent (“FTE”) at the rate of 34%. The FTE basis adjusts for the tax benefits of income on certain tax-exempt loans and investments using the federal statutory rate of 34% for each period presented. The Company believes this measure to be the preferred industry measurement of net interest income and provides relevant comparison between taxable and nontaxable amounts.

(3) FDIC-acquired loan discount adjustments include the reduction of interest income for FDIC-acquired loan discount accretion excluding contractual interest payments and the increase of core loans for the total balance of FDIC-acquired loan discounts.

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

Rate/Volume Analysis

The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities.  It distinguishes between the changes related to outstanding balances and 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.

	Three Months Ended March 31,
	2014 vs. 2013
	Increase (Decrease)						Total
	Due to						Increase
	Volume			Rate			(Decrease)
	(Dollars in Thousands)
Interest-earning assets:
Loans	$	3,941		$	(3,048	)	$	893
Investment securities		334			98			432
Other short-term investments		(13	)		9			(4	)
Total interest-earning assets	$	4,262		$	(2,941	)	$	1,321
Interest-bearing liabilities:
Interest checking, money market, savings	$	49		$	(9	)	$	40
Time deposits		144			(98	)		46
Federal funds purchased and securities sold under repurchase agreements		16			(15	)		1
Other borrowings		341			(247	)		94
Total interest-bearing liabilities	$	550		$	(369	)	$	181
Increase in net interest income							$	1,140

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

Comparison of Operating Results for the Three Month Periods Ended March 31, 2014 and 2013

General.  During the quarter ended March 31, 2014, we recorded net income of $1.3 million, or $0.18 basic and diluted earnings per share, compared to a net income of $3.9 million, or $0.52 basic and diluted earnings per share, for the quarter ended March 31, 2013.  This $2.6 million decline in operating results reflects a reduction in the gain on acquisitions and an increase in salaries and employee benefits partially offset by improved interest income on loans and securities.

Interest Income.  Total interest income for the first quarter of 2014 increased $1.3 million, or 8.8%, to $16.0 million, compared to $14.7 million for the same quarter in 2013.  The increase was due to a $243.0 million, or 24.7%, increase in average interest-earning assets to $1.225 billion for the first quarter of 2014 compared to $0.982 billion for the same quarter in 2013, with the increase driven by the Frontier FDIC-assisted acquisition during the first quarter of 2013 and, to a lesser extent, organic loan growth.  Also positively impacting interest income was the structural balance sheet shift from lower yielding short-term investments to higher yielding loans and investment securities.  However, the yield on interest-earning assets declined by 77 basis points to 5.32% during the first quarter of 2014 as compared to 6.09% for the same quarter in 2013.

Interest income, on a fully taxable equivalent basis, on loans for the first quarter of 2014 was $14.4 million compared to $13.5 million for the same quarter in 2013.  The $893,000 increase in interest income on loans was primarily driven by growth in average loan balances of $204.2 million offset in part by a reduction of 137 basis points in the weighted average yield on loans to 6.46% for the first quarter of 2014 compared to the prior year.  The growth in average loan balances for the first quarter of 2014 compared to the prior year was driven by the Frontier FDIC-assisted acquisition and organic loan growth for most of our markets.  The reduction in the weighted average loan yield was also driven by our Frontier FDIC-assisted acquisition where these FDIC-acquired loans are carrying a lower yield compared to our other FDIC-acquired loans coupled with a reduction in the yield on our core loan portfolio as maturing rates were replaced at lower yields for the first quarter of 2014 compared to the prior year.

Interest income, on a fully taxable equivalent basis, on investment securities for the first quarter of 2014 was $1.7 million compared to $1.2 million for the same quarter in 2013.  The weighted average yield on investments for the first quarter of 2014 improved 13 basis points to 2.26% compared to 2.13% for the first quarter of 2013.  Also, positive growth in the average balance of investment securities of $63.7 million for the first quarter of 2014 impacted the interest income on investment securities.  We anticipate the yield on our investment portfolio to improve during 2014 as a result of our ability to replace maturing investments with higher yielding investments.

Interest income on other short-term investments for the first quarter of 2014 decreased $4,000 to $20,000 compared to the same quarter in 2013.  The decline was driven by a reduction in the average balance of other short-term investments of $24.9 million as excess liquidity was used to fund organic loan growth.  However, the average yield on other short-term investments improved 18 basis points to 0.39% for the first quarter of 2014 compared to the same quarter in 2013, which partially offset the decline in volume.

Interest Expense.  Total interest expense for the first quarter of 2014 increased $181,000, or 10.0%, to $2.0 million compared to $1.8 million for the same quarter in 2013.  The increase in interest expense was primarily the result of growth in the average balance of interest-bearing liabilities for the first quarter of 2014 of $196.3 million, or 21.9%, compared to the same quarter in 2013.  The increase in interest expense was in part offset by a decline in the weighted average cost of interest-bearing liabilities for the first quarter of 2014 of 7 basis points to 0.74% compared to 0.81% for same quarter in 2013.  We anticipate the change in the cost of interest-bearing liabilities to be minimal in 2014 unless market interest rates either increase or decrease significantly.

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

Interest expense on deposits for the first quarter of 2014 increased $86,000 to $1.1 million compared to the same quarter in 2013.  The increase in interest expense on deposits for the first quarter of 2014 was driven by growth in interest-bearing deposits of $141.2 million, or 17.7%, for the first quarter of 2014 compared to the same quarter in 2013.  The decrease in interest expense was in part offset by a decline in the weighted average cost on deposits of 5 basis points to 0.49% compared to 0.54% for the same quarter in 2013.

Interest expense on federal funds purchased and securities sold under repurchase agreements slightly increased $1,000 to $329,000 for the first quarter of 2014 compared to the same quarter in 2013.  Interest expense on other borrowings, consisting of FHLB advances, increased $94,000 to $515,000 for the first quarter of 2014 compared to the same quarter in 2013.  The increase in the interest expense on other borrowings for the first quarter of 2014 was primarily driven by an increase in the average balance of other borrowings of $53.4 million compared to the same quarter in 2013.  The increase in interest expense for the first quarter of 2014 was offset in part by a significant reduction in the weighted average rate paid on these borrowings of 84 basis points to 1.75% compared to 2.59% for the same quarter in 2013.  The increase in other borrowings is part of our strategy to take advantage of historically low interest rates to fund future loan growth.

Net Interest Income.  Net interest income, on a fully taxable equivalent basis, for the first quarter of 2014 increased $1.1 million, or 8.8%, to $14.1 million compared to $13.0 million for the same quarter in 2013.  The overall increase was primarily driven by an increase in the balance of interest-earning assets on top of a decline in the cost of interest-bearing liabilities partially offset by a reduction in the yield on interest-earning assets and balance growth in interest-bearing liabilities.  The net interest spread for the first quarter of 2014 decreased 69 basis points to 4.59% compared to the same quarter in 2013, and the net interest margin for the first quarter of 2014 declined 68 basis points to 4.66% compared to the same quarter in 2013.  The primary reason the net interest margin decreased significantly for the first quarter of 2014 was the result of reduced loan accretion for FDIC-acquired loans, decreasing the weighted average yield on loans 109 basis points compared to the same quarter in 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 3. - Quantitative and Qualitative Disclosures About Market Risk.

Provision for Loan Losses.  During the first quarter of 2014, we recorded provision for loan losses expense of $170,000 compared to $485,000 for the same quarter in 2013.  The decrease in provision expense was primarily driven by a decrease of $385,000 related to noncovered loans driven by improving credit quality on our core loan portfolio coupled with a reduction of $35,000 related to individually assessed FDIC-acquired covered loans where 80% of the expense related to covered loans is reimbursable from the FDIC; offset in part by an increase in the provision expense of $105,000 related to the noncovered FDIC-acquired perm 1-4 loan pool for Frontier for a valuation adjustment needed to adjust the yield.  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.

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

The following table presents the provision for loan losses in more detail for the periods indicated.

	For the three months Ended March 31,
	2014		2013
	(Dollars in thousands)
Provision for loan losses – noncovered	$	65	$	450
Provision for loan losses – FDIC-acquired noncovered		105		-
Provision for loan losses – noncovered		170		450
Provision for loan losses – FDIC-acquired covered		-		35
Provision for loan losses	$	170	$	485

For further information on the loan portfolio and allowance for loan losses, see the Delinquencies and Nonperforming Assets and Allowance for Loan Losses of this section and  see Notes 5 and 6 of the Condensed Notes to Consolidated Financial Statements in this Form 10-Q.

Noninterest Income.  A summary of noninterest income, excluding securities transactions, gain on acquisitions and accretion of FDIC loss-share receivable, is presented in the table below.

	Three Months Ended March 31,
	2014			2013			$ Chg			% Chg
	(Dollars in thousands)
Service charges on deposit accounts	$	1,443		$	1,154		$	289			25.0	%
Bankcard services income		889			762			127			16.7
Other service charges, commissions and fees		162			99			63			63.4
Brokerage fees		566			481			85			17.7
Mortgage banking activities		2,166			2,182			(16	)		(0.7	)
Bank-owned life insurance		189			202			(13	)		(6.4	)
Other		103			94			9			9.6
Total noninterest income	$	5,518		$	4,974		$	544			10.9	%
Noninterest income as a percentage of average assets (annualized)		1.59	%		1.73	%

The increase in service charges on deposit accounts was primarily driven by an increase in fees for services per account and an increase in overdraft fees primarily driven by our overall customer base increase.   The improvement in 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.

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

Noninterest Expense.  A summary of noninterest expense, excluding acquisition related expenses, loss on sales and write-down of FDIC-acquired OREO and foreclosed FDIC-acquired asset expenses, is presented in the table below.

	Three Months Ended March 31,
	2014			2013			$ Chg			% Chg
	(Dollars in thousands)
Salaries and employee benefits	$	8,580		$	6,430		$	2,150			33.4	%
Equipment		1,027			812			215			26.5
Occupancy		967			854			113			13.2
Advertising and marketing		228			187			41			21.9
Legal and accounting		179			119			60			50.4
Consulting & other professional fees		271			97			174			179.4
Directors fees and retirement		158			157			1			0.6
Telecommunications		290			230			60			26.1
Supplies		125			134			(9	)		(6.7	)
Data processing fees		909			951			(42	)		(4.4	)
Loss (gain) on sales and write-downs of OREO		318			(25	)		343			1372.0
Foreclosed asset expenses		87			215			(128	)		(59.5	)
FDIC insurance and other regulatory fees		244			256			(12	)		(4.7	)
Deposit intangible expenses		196			194			2			1.0
Other operating		1,230			942			288			30.6
Total noninterest expenses	$	14,809		$	11,553		$	3,256			28.2	%
Noninterest expenses as a percentage of average assets (annualized)		4.27	%		4.02	%

The increase in salaries and employee benefits was primarily due the hiring of 100 full-time equivalent employees (“FTEs”), a 28.2% increase from the prior year, primarily related to the hiring 79 FTEs for our mortgage banking expansion and the hiring of 20 FTEs to support our increased branch footprint from the Frontier FDIC-assisted acquisition.

The increases in equipment, occupancy, data processing, and other operating expenses were primarily due to the mortgage banking expansion and the Frontier acquisition.

The increase in loss on sales and write-downs of OREO expense from the prior year related to one $410,000 write down of OREO.

73

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

Income Tax Expense.  Income tax expense for the first quarter of 2014 was $469,000 compared to income tax expense of $1.9 million for the same quarter in 2013.  Our effective tax rate for the first quarter of 2014 was 25.9% compared to 32.0% for the same quarter in 2013.

Accounting for FDIC-Assisted Acquisitions

Noninterest Income. The negative accretion for the FDIC loss-share receivable for the first quarter of 2014 decreased $366,000 to $2.0 million compared to the same quarter in 2013.  The decrease in negative accretion was primarily due to lower amortization needed as a result of the re-estimation of cash flows for the first quarter of 2014 compared to the same quarter in 2013.

Noninterest Expense. Foreclosed FDIC-acquired asset expense for the first quarter of 2014 decreased $88,000 to $333,000 compared to the same quarter in 2013, and the FDIC clawback expense for the first quarter of 2014 decreased $23,000 to $543,000 compared to the same quarter in 2013.  The gain on sales net of write-downs of FDIC-acquired OREO for the first quarter of 2014 improved to $264,000 compared to a loss on sales and write-downs of FDIC-acquired OREO of $24,000 for the same quarter in 2013 primarily driven by our ability to sell FDIC-acquired OREO closer to appraised value as compared to the previous year.

Liquidity and Capital Resources

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

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

If additional liquidity were needed, the Bank would turn to short-term borrowings as an alternative immediate funding source and would consider other appropriate actions such as promotions to increase core deposits or the sale of a portion of our unpledged investment portfolio.  In addition, we could draw on additional alternative immediate funding sources from lines of credit extended to us from our correspondent banks and/or the FHLB.  At March 31, 2014, the Bank had total federal funds credit lines with six correspondent banks of $74.0 million, with no outstanding advances.  The Bank also maintains a credit facility with the FHLB of $135.8 million with total outstanding advances of $112.1 million at March 31, 2014.

At March 31, 2014, total deposits increased $50.2 million, or 4.7%, to $1.127 billion compared to $1.076 billion at December 31, 2013, primarily driven by core deposit growth of $46.2 million, wholesale deposit growth of $2.7 million, and time deposit growth of $1.3 million.  Federal funds purchased and securities sold under agreements to repurchase decreased $3.9 million, or 10.3%, to $33.8 million at March 31, 2014, compared to $37.7 million at December 31, 2013.  Also, FHLB advances decreased $15.3 million, or 11.6%, to $116.1 million at March 31, 2014, compared to $131.4 million at December 31, 2013.

74

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

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 March 31, 2014, 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 the three months ended March 31, 2014, detail cash flows from operating, investing and financing activities.  At March 31, 2014, net cash used in investing activities and operating activities was $25.1 million and $12.8 million, respectively, offset in part by net cash provided by financing activities of $30.9 million resulting in a net decline in cash and due from banks of $7.1 million to $27.7 million.

The Company filed a shelf offering on Form S-3 with 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 under the shelf registration statement.

75

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

Regulatory Capital Ratios for the Company and the Bank at March 31, 2014

The Company’s and the Bank’s regulatory capital levels exceed the minimums required by state and federal authorities.  The following table reflects the Company’s and the Bank’s compliance at March 31, 2014, with regulatory capital requirements.  These calculations are based on total risk weighted assets of $978.9 million consolidated and $965.0 million for the Bank as of March 31, 2014, and average total assets of $1.4 billion consolidated and $1.4 billion for the Bank for the three months ended March 31, 2014.  These consolidated capital ratios are based on the capital requirements for bank holding companies issued by the Board of Governors of the Federal Reserve System.  The Georgia Department of Banking and Finance, by policy, requires the Bank to maintain 4% of Tier 1 capital to average total assets of the Federal Reserve requirements included in the table.

	Actual					For Capital Adequacy Purposes					Minimum Required to Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
	(Dollars in thousands)
Total Capital to Risk Weighted Assets
Consolidated	$	138,610		14.2	%	$	78,313		8.0	%		N/A
HeritageBank of the South		124,794		12.9	%		77,203		8.0	%	$	96,503		10.0	%
Tier I Capital to Risk Weighted Assets
Consolidated		129,465		13.2	%		39,156		4.0	%		N/A
HeritageBank of the South		115,649		12.0	%		38,601		4.0	%		57,902		6.0	%
Tier I Capital to Average Total Assets
Consolidated		129,465		9.3	%		55,563		4.0	%		N/A
HeritageBank of the South		115,649		8.4	%		55,208		4.0	%		69,010		5.0	%

On July 2, 2013, the Federal Reserve approved final rules that substantially amend the regulatory risk-based capital rules applicable to the Company and the Bank.  On July 9, 2013, the FDIC also approved, as an interim final rule, the regulatory capital requirements for U.S. banks, following the actions of the Federal Reserve.   The final rules implement the “Basel III” regulatory capital reforms, as well as certain changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).

The final rules include new or increased risk-based capital requirements that will be phased in from 2015 to 2019.   The rules add a new common equity Tier 1 capital to risk-weighted assets ratio minimum of 4.5%, increase the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0%, and decrease the Tier 2 capital that may be included in calculating total risk-based capital from 4.0% to 2.0%.  The final rules also introduce a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets, which is in addition to the Tier 1 and total risk-based capital requirements.   The required minimum ratio of total capital to risk-weighted assets will remain 8.0% and the minimum leverage ratio will remain 4.0%.  The new risk-based capital requirements (except for the capital conservation buffer) will become effective for the Company on January 1, 2015.  The capital conservation buffer will be phased in over four years beginning on January 1, 2016, with a maximum buffer of 0.625% of risk-weighted assets for 2016, 1.25% for 2017, 1.875% for 2018, and 2.5% for 2019 and thereafter.  Failure to maintain the required capital conservation buffer will result in limitations on capital distributions and on discretionary bonuses to executive officers.

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

The following chart compares the risk-based capital ratios required under existing Federal Reserve rules to those prescribed under the new final rules described above:

	Current Rules		Final Rules
Common Equity Tier 1:		-		4.5%
Tier 1:		4.0%		6.0%
Total Risk-based Capital:		8.0%		8.0%
Common Equity Tier 1
Capital Conservation Buffer:		-		2.5%

The final rules also implement revisions and clarifications consistent with Basel III regarding the various components of Tier 1 capital, including common equity, unrealized gains and losses and instruments that will no longer qualify as Tier 1 capital.The final rules also set forth certain changes for the calculation of risk-weighted assets that the Company will be required to implement beginning January 1, 2015.

In addition to the updated capital requirements, the final rules also contain revisions to the prompt corrective action framework.   Beginning January 1, 2015, the minimum ratios for the Bank to be considered well-capitalized will be updated as follows:

	Current Rules		Final Rules
Total Capital:		10.0%		10.0%
Tier 1 Capital:		6.0%		8.0%
Common Equity Tier 1 Capital:		-		6.5%
Leverage Ratio:		5.0%		5.0%

Management is currently evaluating the provisions of the final rules and their expected impact on the Company.  Based on the Company’s current capital composition and levels, management does not presently anticipate that the final rules present a material risk to the Company’s financial condition or results of operations.

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ITEM 3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Asset and Liability Management and Market Risk

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

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

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

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

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

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

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

· Increasing retail and wholesale time deposit duration; and

· Increasing the origination of mortgage loans to be sold to investors.

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ITEM 3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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 at 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 directly 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 direct exposure to foreign currency exchange rate risk or commodity price risk.

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

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

The Company’s strategy is to mitigate interest rate risk to the extent possible as part of the Company’s overall business strategy. Based on our analysis of the Company’s overall risk to changes in interest rates, we structure investment and funding transactions to reduce this risk.  These strategies aim to achieve neutrality to interest rate risk, and the ALCO is responsible for monitoring and analyzing interest rate risk on a regular basis.  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 March 31, 2014, 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 overall balance sheet structure designed to take advantage of rising interest rates.  The Company plans to maintain our asset sensitivity position by focusing our efforts to extend liabilities and increase variable rate assets.  The Company feels the level of interest rate risk is at an acceptable level, and it is within our internal policy limits.

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ITEM 3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following table shows the results of our projections for net interest income expressed as a percentage change over net interest income in a flat rate scenario for an immediate change or “shock” in market interest rates over a twelve month period.  Due to the historically low level of interest rates, the Company does not believe downward shocks greater than 100 basis points are relevant.

	Effect
Market	on Net
Rate	Interest
Change	Income
+400		15.7	%
+300		12.0	%
+200		9.4	%
+100		5.5	%
-100		-7.4	%

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Quarterly Financial Summary - Unaudited

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

	For the Three Months Ended
	March 31, 2014		December 31, 2013		September 30, 2013		June 30, 2013		March 31, 2013
	(dollars in thousands expect per share data)
Results of Operations:
Net interest income	$	13,971	$	16,253	$	13,558	$	15,600	$	12,855
Provision for loan losses		170		232		350		668		485
Net interest income after provision for loan losses		13,801		16,021		13,208		14,932		12,370
Total noninterest income		3,487		4,536		3,918		3,195		6,765
Total noninterest expense		15,476		15,706		15,334		14,555		13,356
Income before income taxes		1,812		4,851		1,792		3,572		5,779
Applicable income tax		469		1,446		470		912		1,851
Net income	$	1,343	$	3,405	$	1,322	$	2,660	$	3,928
Per Share Data:
Weighted average shares – basic		7,422,044		7,407,722		7,371,804		7,381,370		7,526,344
Weighted average shares – diluted		7,581,775		7,530,606		7,483,812		7,383,992		7,528,522
Basic earnings per share	$	0.18	$	0.46	$	0.18	$	0.36	$	0.52
Diluted earnings per share		0.18		0.45		0.18		0.36		0.52

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ITEM 4. CONTROLS AND PROCEDURES

(a)Evaluation of Disclosure Controls and Procedures

An evaluation of our disclosure controls and procedures (as defined in Rule 13(a)-14(c) under the Securities Exchange Act (the “Exchange Act”)) as of March 31, 2014, was carried out under the supervision and with the participation of our Chief Executive Officer, Chief Financial Officer and several other members of our senior management within the 40-day period preceding the filing date of this quarterly report.  Our Chief Executive Officer and Chief Financial Officer concluded that, as of March 31, 2014, 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 March 31, 2014, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

ITEM 1.   LEGAL PROCEEDINGS

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

ITEM 1A. RISK FACTORS

There have been no material changes to the risk factors disclosed in Item 1A. of Part 1 in our Annual Report on Form 10-K for the year ended December 31, 2013.

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

In April 2014, the Company’s Board of Directors extended its stock repurchase program for 344,179 shares, or 4% of the Company's currently outstanding common stock, which expires in April 2015, unless the program is extended or completed earlier.  There were no unregistered sales of equity securities during the quarter ended March 31, 2014.

	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		-	$	-		-		344,179
February		-		-		-		344,179
March		-		-		-		344,179
Total		-	$	-		-		344,179

ITEM 3.    DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4.    MINE SAFETY DISCLOSURES

None.

ITEM 5.    OTHER INFORMATION

None.

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ITEM 6.    EXHIBITS

Exhibit Number	Document	Reference to Prior Filing or Exhibit Number Attached Hereto
2.1	Agreement and Plan of Merger, dated April 21, 2014, by and between Heritage Financial Group, Inc. and Alarion Financial Services, Inc.	a
12.1	Ratio of Earnings to Fixed Charges	12.1
31.1	Rule 13a-14(a)/15d-14(a) Certifications of Chief Executive Officer	31.1
31.2	Rule 13a-14(a)/15d-14(a) Certifications of Chief Financial Officer	31.2
32	Section 1350 Certifications	32
101.INS	XBRL Instance Document
101.SCH	XBRL Taxonomy Extension Schema Document
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document
101.LAB	XBRL Taxonomy Extension Labels Linkbase Document
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document

a Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc. with the SEC on April 22, 2014.

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SIGNATURES

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

			HERITAGE FINANCIAL GROUP, INC.
Date:	May 9, 2014	By:	/s/ O. Leonard Dorminey
			O. Leonard Dorminey
			President and Chief Executive Officer
			(Principal Executive Officer)
Date:	May 9, 2014	By:	/s/ T. Heath Fountain
			T. Heath Fountain
			Executive Vice President,
			Chief Administrative Officer and
			Chief Financial Officer
			(Principal Financial and Accounting Officer)

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