Heritage Financial 10-Q 2014 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

______________________________________________________________

FORM 10-Q

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

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 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  ☑  No  ☐  

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

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 ☐   Accelerated filer ☑   Non-accelerated filer ☐   Smaller reporting company ☐ 

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

Indicate the number of shares outstanding of each issuer’s classes of common equity, as of the latest practicable date:  At November 6, 2014, there were 9,188,164 shares of issuer’s common stock outstanding.

HERITAGE FINANCIAL GROUP, INC.

INDEX

		Page
		Number
PART I – FINANCIAL INFORMATION
ITEM 1.	Financial Statements
	Consolidated Balance Sheets as of sEPTEMBER 31, 2014 and December 31, 2013	3
	Consolidated Statements of Income For the THREE and NINE Months Ended SEPTEMBER 30, 2014 AND 2013	4
	Consolidated Statements of Comprehensive Income For the three AND NINE Months Ended SEPTEMBER 30, 2014 and 2013	5
	Consolidated Statements of Stockholders’ Equity For the NINE MONThs Ended SEPTEMBER 30, 2014 and the year ended december 31, 2013	6
	Consolidated Statements of Cash Flows For the nINE MONThs Ended SEPTEMBER 30, 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	83
ITEM 4.	Controls and Procedures	87
PART II – OTHER INFORMATION
ITEM 1.	LEGAL PROCEEDINGS	88
ITEM 1A.	RISK FACTORS	88
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	88
ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	88
ITEM 4.	MINE SAFETY DISCLOSURES	88
ITEM 5.	OTHER INFORMATION	88
ITEM 6.	EXHIBITS	89

2

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands)

	Unaudited
	September  30,		December 31,
	2014		2013
Assets
Cash and due from banks	$	26,793	$	34,804
Interest-bearing deposits in banks		10,945		3,249
Federal funds sold		1,434		130
Total cash and cash equivalents		39,172		38,183
Securities available for sale, at fair value		339,189		294,299
Federal Home Loan Bank stock, at cost		9,950		7,342
Other equity securities, at cost		1,010		1,010
Loans held for sale		147,867		110,669
Loans:
Non-acquired loans		774,108		684,544
Acquired non-credit impaired loans		160,502		-
Acquired credit impaired loans non-covered		92,051		63,318
Acquired credit impaired loans covered		42,447		50,891
Less allowance for loan losses		9,916		8,955
Loans, net		1,059,192		789,798
Non-acquired other real estate owned		648		1,789
Acquired non-covered other real estate owned		3,296		1,693
Acquired covered other real estate owned		5,281		7,053
Total other real estate owned		9,225		10,535
FDIC loss-share receivable		27,929		41,306
Premises and equipment, net		49,922		37,978
Goodwill and intangible assets, net		16,702		4,253
Cash surrender value of bank owned life insurance		24,749		24,183
Other assets		30,627		21,369
	$	1,755,534	$	1,380,925
Liabilities and Stockholders' Equity
Noninterest bearing deposits	$	199,336		148,253
Interest bearing deposits		1,141,925		928,168
Total deposits		1,341,261		1,076,421
Federal funds purchased and securities sold under repurchase agreements		42,815		37,648
Other borrowings		190,440		131,394
Other liabilities		21,070		10,399
Total liabilities		1,595,586		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;
9,183,574 and  7,834,537 shares issued and outstanding, respectively		92		78
Capital surplus		106,510		78,566
Retained earnings		61,262		57,614
Accumulated other comprehensive loss, net of tax benefit of $3,292 and  $5,175, respectively		(4,937)		(7,762)
Unearned employee stock ownership plan (ESOP) shares, 292,559 and 332,535 shares, respectively		(2,979)		(3,433)
Total stockholders' equity		159,948		125,063
	$	1,755,534	$	1,380,925

See Notes to Consolidated Financial Statements

3

HERITAGE FINANCIAL GROUP, INC AND SUBSIDIARY

Consolidated Statements of Income (Unaudited)

For the Three and Nine Months Ended September 30, 2014 and 2013

(Dollars in Thousands except per share data)

	For the Three Months				For the Nine Months
	Ended September 30,				Ended September 30,
	2014		2013		2014		2013
Interest income
Interest and fees on loans	$	14,901	$	13,452	$	42,981	$	42,523
Interest on loans held for sale		1,493		434		3,984		839
Interest on taxable securities		1,180		1,155		3,600		3,116
Interest on nontaxable securities		381		318		1,103		911
Interest on federal funds sold		2		4		4		7
Interest on deposits in other banks		20		30		69		140
		17,977		15,393		51,741		47,536
Interest expense
Interest on deposits		1,192		982		3,508		3,077
Interest on other borrowings		856		853		2,560		2,446
		2,048		1,835		6,068		5,523
Net interest income		15,929		13,558		45,673		42,013
Provision for loan losses		640		350		1,284		1,503
Net interest income after provision		15,289		13,208		44,389		40,510
Noninterest income
Service charges on deposit accounts		1,612		1,577		4,558		4,028
Bankcard services income		919		852		2,749		2,445
Other service charges, commissions and fees		178		126		494		370
Brokerage fees		644		561		1,825		1,578
Mortgage banking activities		6,723		1,963		13,915		7,582
Bank-owned life insurance		190		200		566		603
Gain on sales of securities		628		-		766		-
Gain on acquisitions		-		-		-		4,188
Accretion of FDIC loss share receivable		(2,669)		(1,499)		(8,077)		(7,275)
Other		49		138		251		356
		8,274		3,918		17,047		13,875
Noninterest expense
Salaries and employee benefits		11,382		8,108		30,272		22,723
Equipment and occupancy		2,234		1,932		6,382		5,436
Advertising and marketing		288		335		737		871
Professional fees		446		340		1,420		857
Information services expenses		1,080		1,335		3,430		3,824
Net loss (gain) on sales and write-downs of
other real estate owned		8		335		433		368
Net (gain) loss on sales and write-downs of
acquired other real estate owned		(37)		(206)		(128)		(433)
Foreclosed asset expenses		77		337		246		779
Foreclosed acquired asset expenses		217		366		835		1,087
FDIC insurance and other regulatory fees		274		293		817		827
Acquisition related expenses		2,543		280		2,696		1,220
Deposit intangible expenses		186		204		574		609
FDIC loss-share clawback expenses		(35)		286		1,390		978
Other operating expenses		1,934		1,389		5,084		4,096
		20,597		15,334		54,188		43,242
Income before income taxes		2,966		1,792		7,248		11,143
Applicable income tax		1,007		470		2,174		3,233
Net income	$	1,959	$	1,322	$	5,074	$	7,910
Earnings per common share:
Basic earnings per share	$	0.26	$	0.18	$	0.68	$	1.07
Diluted earnings per share	$	0.26	$	0.18	$	0.67	$	1.05
Weighted average-common shares outstanding:
Basic		7,485,528		7,371,804		7,448,329		7,425,940
Diluted		7,676,233		7,483,812		7,622,378		7,519,664

See Notes to Consolidated Financial Statements.

4

HERITAGE FINANCIAL GROUP, INC AND SUBSIDIARY

Consolidated Statements of Comprehensive Income (Unaudited)

For the Three and Nine Months Ended September 30, 2014 and 2013

(Dollars in Thousands)

	For the Three Months				For the Nine Months
	Ended September 30,				Ended September 30,
	2014		2013		2014		2013
Net income	$	1,959	$	1,322	$	5,074	$	7,910
Other comprehensive income (loss):
Unrealized (losses) gains on cash flow hedge, net of tax (benefit) of $(131) and $41 for the quarter and $(1,293) and $1,363 for year to date, respectively		(197)		62		(1,939)		2,044
Unrealized holding (losses) gains on securities arising during the period, net of tax (benefit) of $(12) and $(197) for the quarter and $3,482 and $(4,417) for year to date, respectively		(18)		(295)		5,223		(6,626)
Reclassification adjustment for securities gains included in net income, net of tax benefit of $251 and $- for the quarter and $306 and $- for the year to date, respectively		(376)		-		(459)		-
Total other comprehensive income  (loss)		(591)		(233)		2,825		(4,582)
Comprehensive income	$	1,368	$	1,089	$	7,899	$	3,328

See Notes to Consolidated Financial Statements.

5

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

For the Nine Months Ended September 30, 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 expense 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 Nine Months Ended September 30, 2014 (Unaudited)

And The Year Ended December 31, 2013

(Dollars in Thousands, except per share data)

										Accumulated
										Other
										Compre-
	Common Stock			Capital		Retained		Unearned ESOP		hensive Income/
	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	-		-		-		5,074		-		-		5,074
Cash dividend declared,
$0.21 per share	-		-		-		(1,426)		-		-		(1,426)
Issuance of 1,336,414 shares
of common stock	1,336,414		14		26,968		-		-		-		26,982
Issuance of 14,000
restricted common stock	14,000		-		-		-		-		-		-
Exercise of 3,380
common stock options	3,380		-		30		-		-		-		30
Forfeiture of  461  shares of
restricted common stock	(461)		-		-		-		-		-		-
Repurchase of 4,296 shares
of common stock	(4,296)		-		(85)		-		-		-		(85)
Stock-based compensation expense	-		-		723		-		-		-		723
Other comprehensive income	-		-		-		-		-		2,825		2,825
Tax expense from stock-
based compensation plans	-		-		69		-		-		-		69
ESOP shares earned, 39,976  shares	-		-		321		-		454		-		775
Tax benefit on ESOP expense	-		-		(82)		-		-		-		(82)
Balance,  September 30, 2014	9,183,574	$	92	$	106,510	$	61,262	$	(2,979)	$	(4,937)	$	159,948

See Notes to Consolidated Financial Statements.

7

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 (Dollars in thousands)

	Nine Months Ended September 30,
	2014		2013
OPERATING ACTIVITIES	$	5,074	$	7,910
Net income
Adjustments to reconcile net income
to net cash (used in) provided by operating activities:
Depreciation and amortization		2,099		1,912
Amortization of intangibles		720		609
Provision for loan losses		1,284		1,503
Provision (benefit) for deferred taxes		(2,765)		64
Net gain on acquisitions		-		(4,188)
Gain on sales of securities		(766)		-
Net loss on sales and
write-downs of other real estate owned		433		368
Net gain on sales and write-downs of acquired other real estate owned		(128)		(433)
Amortization of available for sale discounts and premiums, net		1,552		1,947
Accretion of FDIC loss-share receivable		8,077		7,275
Increase in bank-owned life insurance		(566)		(604)
ESOP compensation expense		775		614
Stock-based compensation expense		723		686
Excess benefit related to stock-based compensation plans		(69)		(27)
Excess tax related to ESOP		82		10
Net change in:
Increase in loans held for sale		(30,254)		(22,434)
Increase in mortgage servicing rights		(3,850)		-
Increase in interest receivable		(225)		(843)
Increase in interest payable		214		118
Decrease in FDIC loss-share receivable		5,301		8,928
Net other operating activities		(489)		902
Total adjustments		(17,852)		(3,593)
Net cash (used in) provided by operating activities		(12,778)		4,317
INVESTING ACTIVITIES
Proceeds from sales of securities available for sale		11,708		32,022
Proceeds from maturities and calls of securities available for sale		24,337		12,005
Purchases of securities available for sale		(34,411)		(117,006)
(Increase) decrease in interest-bearing deposits in banks		(7,696)		1,401
(Increase) decrease in Federal Home Loan Bank stock		(1,682)		235
Increase in federal funds sold		(874)		(2,594)
Increase in loans, net		(74,869)		(52,405)
Net cash received from acquisition activity		4,195		153,179
Purchases of premises and equipment		(2,835)		(7,235)
Proceeds from sale of premises and equipment		13		-
Proceeds from sales of other real estate owned		6,324		8,288
Net cash (used in) provided by investing activities		(75,790)		27,890

See Notes to Consolidated Financial Statements.

8

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(Unaudited)

 (Dollars in thousands)

	Nine Months Ended September 30,
	2014		2013
FINANCING ACTIVITIES
Increase (decrease) in deposits	$	34,174	$	(29,158)
Increase in federal funds purchased and securities sold under repurchase agreements		1,944		1,563
Net proceeds from other borrowings		45,932		5,000
Excess tax related to stock-based compensation plans		69		27
Excess tax benefit related to ESOP		(82)		(10)
Proceeds from exercise of stock option		31		503
Repurchase of common stock		(85)		(5,263)
Dividends paid to stockholders		(1,426)		-
Net cash provided by (used in) financing activities		80,557		(27,338)
Net (decrease) increase in cash and due from banks		(8,011)		4,869
Cash and due from banks at beginning of period		34,804		23,993
Cash and due from banks at end of period	$	26,793	$	28,862
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest	$	5,854	$	5,405
Income taxes	$	4,935	$	3,136
NONCASH TRANSACTIONS
Principal balances of loans transferred to other real estate owned	$	3,362	$	4,972

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. 

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 September 30, 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 and nine months ended September 30, 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, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“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.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, (Topic 606). ASU 2014-09 states a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. In doing so, companies will need to use more judgment and make more estimates than under existing guidance. These may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. ASU 2014-09 is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. The amendments can be applied retrospectively to each prior reporting period or retrospectively with the cumulative effect of initially applying this update recognized at the date of initial application. The Company is currently evaluating the impact of adopting the new guidance on the consolidated financial statements, but the Company does not expect it to have a material impact.

In June 2014, the FASB issued ASU 2014-11, Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures (“ASU 2014-11”). ASU 2014-11 aligns the accounting for repurchase to maturity transactions and repurchase agreements executed as a repurchase financing with the accounting for other typical repurchase agreements. Going forward, these transactions would all be accounted for as secured borrowings. ASU 2014-11 is effective for the first interim or annual period beginning after December 15, 2014. In addition, the disclosure of certain transactions accounted for as a sale is effective for the first interim or annual period beginning after December 15, 2014, and the disclosure for transactions accounted for as secured borrowings is required for annual periods beginning after December 15, 2014 and interim periods beginning after March 15, 2015. Early adoption is prohibited. The Company is currently evaluating the impact of adopting the new guidance on the consolidated financial statements, but does not expect it to have a material impact.

In June 2014, the FASB issued ASU 2014-12,  Compensation—Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period, a consensus of the FASB Emerging Issues Task Force. ASU 2014-12 requires that a performance target that affects vesting and that could be achieved after the requisite service period will be treated as a performance condition. ASU 2014-12 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. An entity may apply the standards (1) prospectively to all share-based payment awards that are granted or modified on or after the effective date, or (2) retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented in the financial statements and to all new or modified awards thereafter. Earlier application is permitted. The adoption of ASU 2014-12 is not expected to have a material impact on the Company’s financial statements.

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 three and nine month periods ended September 30, 2014, potential common shares of 24,200 and 16,272, 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:

	For the Three Months				For the Nine Months
	Ended September 30,				Ended September 30,
	2014		2013		2014		2013
	(dollars in thousands, expect per share data
Basic earnings and shares:
Net income	$	1,959	$	1,322	$	5,074	$	7,910
Weighted-average basic shares outstanding		7,485,528		7,371,804		7,448,329		7,425,940
Basic earnings per share	$	0.26	$	0.18	$	0.68	$	1.07
Diluted earnings and shares:
Net income	$	1,959	$	1,322	$	5,074	$	7,910
Weighted-average basic shares outstanding		7,485,528		7,371,804		7,448,329		7,425,940
Add:  Stock options and nonvested shares		190,705		112,008		174,049		93,724
Weighted-average diluted shares outstanding		7,676,233		7,483,812		7,622,378		7,519,664
Diluted earnings per share	$	0.26	$	0.18	$	0.67	$	1.05

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.  There were no grants awarded from this plan and 3,000 stock options were exercised during the nine months ended September 30, 2014.  As of September 30, 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.   Additionally, on April 1, 2014, the Company granted 14,000 restricted stock awards and 24,200 stock options from this plan. There were 380 options exercised from this plan during the nine months ended September 30, 2014.  As of September 30, 2014, there were approximately 17,843 restricted stock awards and 26,684 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 September 30, 2014, there was approximately $880,000 of unrecognized compensation associated with these awards.  For the three months ended September 30, 2014 and 2013, we recognized compensation expense associated with these awards of approximately $99,000 and  $84,000, respectively.  For the nine months ended September 30, 2014 and 2013, we recognized compensation expense associated with these awards of approximately $274,000 and $249,000, respectively.    

The Company recognized compensation expense related to stock options of approximately $157,000 and $146,000, respectively, for the three months ended September 30, 2014 and 2013, and approximately $449,000 and $437,000       respectively, for the nine month periods ended September 30, 2014 and 2013.  At September 30, 2014, there was approximately $1.2 million of unrecognized compensation related to stock options.

13

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 4.     SECURITIES

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

			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
September 30, 2014:	(dollars in thousands)
U.S. Government sponsored agencies (GSEs)	$	55,617	$	68	$	(1,529)	$	54,156
State and municipal securities		73,964		1,285		(606)		74,643
GSE residential mortgage-backed securities		213,845		427		(3,882)		210,390
Total securities	$	343,426	$	1,780	$	(6,017)	$	339,189
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.

	September 30, 2014				December 31, 2013
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
	(dollars in thousands)
One year or less	$	-	$	-	$	-	$	-
One to five years		21,539		21,268		12,087		11,843
Five to ten years		53,548		52,689		58,328		55,333
Over ten years		54,494		54,842		40,297		37,854
Mortgage-backed securities		213,845		210,390		195,764		189,269
	$	343,426	$	339,189	$	306,476	$	294,299

Securities with a carrying value of approximately $203.0 million and $133.0 million at September 30, 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 $93.9 million and $30.9 million at September 30, 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				For the Nine Months
	Ended September 30,				Ended September 30,
	2014		2013		2014		2013
	(dollars in thousands)
Gross gains recognized on sales of securities	$	630	$	-	$	769	$	-
Gross losses recognized on sales of securities		(2)		-		(3)		-
Net realized gains on sales of securities available for sale	$	628	$	-	$	766	$	-

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
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
Description of Securities	Value		Losses		Value		Losses		Value		Losses
	(dollars in thousands)
September 30, 2014:
U.S. Government sponsored agencies
(GSEs)	$	4,280	$	(33)	$	41,429		(1,496)	$	45,709	$	(1,529)
State and municipal securities		3,198		(30)		20,227		(576)		23,425		(606)
GSE residential mortgage-backed
securities		26,577		(150)		120,828		(3,732)		147,405		(3,882)
Total temporarily impaired securities	$	34,055	$	(213)	$	182,484	$	(5,804)	$	216,539	$	(6,017)
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 September 30, 2014, total unrealized losses decreased to $6.0 million, or 2.8% 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 September 30, 2014 relate to 45 agencies, 57 state and municipal obligations and 116 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 September 30, 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 September 30, 2014, the Company held certain investment securities having continuous unrealized loss positions for more than 12 months.  All of these losses were in 40 agencies, 93 mortgage-backed securities and 50 municipal securities. The unrealized losses arose from changes in interest rates and market conditions as of September 30, 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.    As of September 30, 2014, management did not consider any of the investments in its investment portfolio to have OTTI.

The Company held 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 was reduced to a nominal book value for tracking purposes, and,  as a result, 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.  On July 24, 2014, the Company made the decision to sell the security for $584,000 and reported a gain in the amount of $584,000 for the third quarter.   The decision to the sell the security was based on the expectation that future gains would slow or even reverse given the current environment for this security.

The Company held 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.  On July 24, 2014, the Company made the decision to sell the security for $237,000 and reported a gain in the amount of $30,000 during the third quarter of 2014.  The decision to the sell the security was based on the expectation that future gains would slow or even reverse given the current environment for this security.

16

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 4.     SECURITIES (Continued)

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. 

	September 30,		December 31,
	2014		2013
	(dollars in thousands)
Beginning balance of credit losses	$	1,543	$	1,543
Other-than-temporary impairment credit losses		-		-
Reduction for securities sold during the period		(1,543)		-
Ending balance of cumulative credit losses recognized in earnings	$	-	$	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 September 30, 2014 and December 31, 2013, was $10.0 million and $7.3 million, respectively.   The estimated fair value of this investment is $10.0 million as of September 30, 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 September 30, 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 September 30, 2014.

17

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

note 5.     Loans and Allowance for Loan Losses

(EXCLUDING ACQUIRED LOANS)

The composition of loans is summarized as follows:

	September 30,		December 31,
	2014		2013
Commercial real estate:	(dollars in thousands)
Nonresidential	$	284,218	$	256,567
Multifamily		28,742		22,650
Farmland		29,441		23,420
Total commercial real estate loans		342,401		302,637
Construction and land		73,137		50,167
Residential real estate:
Mortgage loans, 1-4 family		179,131		177,456
Home equity		36,754		29,147
Total residential real estate loans		215,885		206,603
Consumer and other:
Indirect auto loans		45		247
Direct auto loans		6,093		6,640
Other		15,474		17,089
Total consumer and other loans		21,612		23,976
Commercial and industrial loans		121,073		101,161
Total non-acquired loans		774,108		684,544
Acquired non-credit impaired loans		160,502		-
Acquired credit impaired loans:
Non-covered		92,051		63,318
Covered		42,447		50,891
Total loans		1,069,108		798,753
Total allowance for loan losses		(9,916)		(8,955)
Loans, net	$	1,059,192	$	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 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 ACQUIRED LOANS) (Continued)

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

	Commercial		Residential		Construction		Commercial
	Real		Real		and		and		Consumer
	Estate		Estate		Land		Industrial		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		-		(82)		(31)		(42)		(176)		(331)
Recoveries		-		78		1		-		63		142
Provision for loan losses		344		173		285		264		84		1,150
Balance,  September 30, 2014	$	2,424	$	3,340	$	1,484	$	2,391	$	277	$	9,916
Allowance:
Ending balance: specific	$	352	$	772	$	84	$	91	$	41	$	1,340
Ending balance: collective	$	2,072	$	2,568	$	1,400	$	2,300	$	236	$	8,576
Loans:
Ending balance: individually
evaluated for impairment	$	4,675	$	2,968	$	3,765	$	111	$	60	$	11,579
Ending balance: collectively
evaluated for impairment	$	337,726	$	212,917	$	69,372	$	120,962	$	21,552	$	762,529

20

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

note 5.     Loans and Allowance for Loan Losses

(EXCLUDING ACQUIRED LOANS) (Continued)

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

	Commercial		Residential		Construction		Commercial
	Real		Real		and		and		Consumer
	Estate		Estate		Land		Industrial		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 ACQUIRED LOANS) (Continued)

Impaired loans by class are presented below for September 30, 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	$	591	$	609	$	-	$	591	$	-
Multifamily		-		-		-		-		-
Farmland		-		-		-		-		-
Construction and land		1,704		1,704		-		1,704		-
Residential real estate:
Mortgage loans, 1-4 family		140		146		-		142		2
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	$	4,084	$	4,150	$	352	$	4,152	$	6
Multifamily		-		-		-		-		-
Farmland		-		-		-		-		-
Construction and land		2,061		2,157		84		2,105		-
Residential real estate:
Mortgage loans, 1-4 family		2,526		3,321		494		2,634		7
Home equity		302		307		278		312		7
Consumer and other:
Indirect auto loans		6		9		-		7		-
Direct auto loans		18		31		10		24		-
Other		36		49		31		42		1
Commercial and industrial loans		111		263		91		169		-
Total
Commercial real estate	$	4,675	$	4,759	$	352	$	4,743	$	6
Construction and land		3,765		3,861		84		3,809		-
Residential real estate		2,968		3,774		772		3,088		16
Consumer and other		60		89		41		73		1
Commercial and industrial loans		111		263		91		169		-
Total	$	11,579	$	12,746	$	1,340	$	11,882	$	23

22

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

note 5.     Loans and Allowance for Loan Losses

                ��   (EXCLUDING ACQUIRED LOANS) (Continued)

Impaired loans by class are presented below for December 31, 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 ACQUIRED LOANS) (Continued)

Below is an analysis of the age of recorded investment in loans that are past due as of September 30, 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	$	-	$	-	$	2,245	$	2,245	$	281,973	$	284,218
Multifamily		-		-		-		-		28,742		28,742
Farmland		166		-		-		166		29,275		29,441
Total commercial real estate loans		166		-		2,245		2,411		339,990		342,401
Construction and land		23		-		1,823		1,846		71,291		73,137
Residential real estate:
Mortgage loans, 1-4 family		551		44		2,355		2,950		176,181		179,131
Home equity		28		-		302		330		36,424		36,754
Total residential real estate loans		579		44		2,657		3,280		212,605		215,885
Consumer and other:
Indirect auto loans		-		-		6		6		39		45
Direct auto loans		3		-		18		21		6,072		6,093
Other		36		-		36		72		15,402		15,474
Total consumer and other loans		39		-		60		99		21,513		21,612
Commercial and industrial loans		58		20		111		189		120,884		121,073
Total	$	865	$	64	$	6,896	$	7,825	$	766,283	$	774,108

*There were no accruing loans that were greater than 90 or more days past due at September 30, 2014.

24

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

note 5.     Loans and Allowance for Loan Losses

(EXCLUDING 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 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 September 30, 2014, the Company had troubled debt restructurings totaling $7.8 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 September 30, 2014, are troubled debt restructurings of $3.1 million.  In addition, at that date the Company had troubled debt restructurings totaling $4.7 million that were performing in accordance with their modified terms and are not included in nonaccruing loans.

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

Troubled debt restructurings for the periods ended:

	September 30, 2014
		Recorded
	Number	Investment
	of	Prior to		Recorded
	Modifications	Modifications		Investment
	(dollars in thousands)
Commercial real estate	2	$	3,036	$	3,021
Residential real estate	4		7,248		1,417
Construction and land	2		3,574		3,342
Commercial and industrial loans	-		-		-
Consumer and other	-		-		-
Total	8	$	13,858	$	7,780

26

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

note 5.     Loans and Allowance for Loan Losses

(EXCLUDING ACQUIRED LOANS) (Continued)

	December 31, 2013
		Recorded
	Number	Investment
	of	Prior to		Recorded
	Modifications	Modifications		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:

	September 30, 2014
	Number
	of	Recorded
	Modifications	Investment
	(dollars in thousands)
Commercial real estate	1	$	590
Residential real estate	3		1,106
Construction and land	1		1,400
Commercial and industrial loans	-		-
Consumer and other	-		-
Total	5	$	3,096

	December 31, 2013
	Number
	of	Recorded
	Modifications	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 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 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:

	Numerical		Regulatory
Risk Rating	Rating	Description	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 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 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 September 30, 2014 and December 31, 2013.

	September 30, 2014
							Construction
	Non-						and
	Residential		Multifamily		Farmland		Land
	(dollars in thousands)
Commercial Real Estate Credit Exposure
Pass 1	$	-	$	-	$	-	$	-
Pass 2		-		-		-		53
Pass 3		52,853		1,009		4,631		1,913
Pass 4		179,464		24,746		17,702		23,961
Pass 5		43,383		2,887		7,108		42,773
Special Mention 6		787		65		-		-
Special Mention Elevated 7		127		-		-		-
Substandard 8		5,359		35		-		2,614
Impaired Loans 9		2,245		-		-		1,823
Doubtful 10		-		-		-		-
Loss 11		-		-		-		-
Total	$	284,218	$	28,742	$	29,441	$	73,137

31

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

note 5.     Loans and Allowance for Loan Losses

(EXCLUDING 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

	September 30, 2014
	Commercial
	and Industrial
	(dollars in thousands)
Commercial and Industrial Credit Exposure
Pass 1	$	1,998
Pass 2		34
Pass 3		25,205
Pass 4		68,484
Pass 5		22,353
Special Mention 6		2,519
Special Mention Elevated 7		193
Substandard 8		176
Impaired Loans 9		111
Doubtful 10		-
Loss 11		-
Total	$	121,073

32

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

note 5.     Loans and Allowance for Loan Losses

(EXCLUDING 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 September 30, 2014
	Mortgage		Home Equity
	(dollars in thousands)
Residential Real Estate Credit Exposure
Pass 1-5	$	172,771	$	36,425
Special Mention 6		481		-
Special Mention Elevated 7		286		-
Substandard 8		3,238		27
Impaired Loans 9		2,355		302
Doubtful 10		-		-
Loss 11		-		-
Total	$	179,131	$	36,754

33

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

note 5.     Loans and Allowance for Loan Losses

(EXCLUDING 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 September 30, 2014
	Indirect		Direct
	Auto		Auto		Other
	(dollars in thousands)
Consumer and Other Credit Exposure
Pass 1-5	$	39	$	6,075	$	15,433
Special Mention 6		-		-		-
Special Mention Elevated 7		-		-		-
Substandard 8		-		-		5
Impaired Loans 9		6		18		36
Doubtful 10		-		-		-
Loss 11		-		-		-
Total	$	45	$	6,093	$	15,474

34

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

note 5.     Loans and Allowance for Loan Losses

(EXCLUDING 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.     ACQUIRED LOANS AND ALLOWANCE FOR LOAN LOSSES

Acquired Non-credit Impaired Loans

The Company elected to account for non-credit impaired loans acquired in the Alarion Bank (“Alarion”) acquisition under ASC 310–20.  ASC 310-20, Receivables: Nonrefundable Fees and Other Costs,  applies to the discount which is accreted through earnings based on estimated cash flows over the estimated life of the loan. 

Acquired Credit Impaired Loans

The Company elected to account for loans acquired in the Tattnall Bank, Citizens Bank of Effingham (“Citizens”), First Southern National Bank (“First Southern”), Frontier Bank (“Frontier”) acquisitions, and credit impaired loans acquired with the Alarion acquisition, under ASC 310–30.  ASC 310-30, Receivables: 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 and accounted for under ASC 310-30.

	September 30,		December 31,
Loans not covered by loss-sharing agreements:	2014		2013
	(dollars in thousands)
Commercial real estate	$	47,409	$	22,268
Residential real estate		30,446		30,134
Construction and land		5,309		5,156
Commercial and industrial		5,796		2,604
Consumer and other		3,091		3,156
	$	92,051	$	63,318

	September 30,		December 31,
Loans covered by loss-sharing agreements:	2014		2013
	(dollars in thousands)
Commercial real estate	$	12,344	$	14,161
Residential real estate		19,219		23,886
Construction and land		10,126		11,642
Commercial and industrial		680		864
Consumer and other		78		338
	$	42,447	$	50,891

The Company 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. 

36

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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

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

The following table represents the credit impaired loans receivable as of September 30, 2014, and reflects reclassifications from the balances reported at December 31, 2013:

	Acquired Loans		Acquired Loans
	Without Specific		With Specific
	Evidence of		Evidence of
	Deterioration in		Deterioration in		Total Loans
	Credit Quality		Credit Quality		Acquired
	(dollars in thousands)
Contractually required principal and interest	$	179,440	$	34,259	$	213,699
Nonaccretable difference		(13,659)		(9,069)		(22,728)
Cash flows expected to be collected		165,781		25,190		190,971
Accretable yield		(51,781)		(4,692)		(56,473)
Basis in acquired loans	$	114,000	$	20,498	$	134,498

The following table is a summary of changes in the accretable yields of acquired credit impaired loans since December 31, 2012 and reflects 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		44
Reclassification from nonaccretable difference		12,926
Accretion included in interest income		(18,463)
Adjustments to estimates of expected cash flows		9,225
Balance at September 30, 2014	$	56,473

37

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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

The following is a summary of the allowance for loan losses for the acquired credit impaired loans for 2014:

	Commercial		Residential		Construction		Commercial		Consumer
	Real		Real		and		and		and
	Estate		Estate		Land		Industrial		Other		Total
	(dollars in thousands)
Balance, January 1, 2014	$	-	$	-	$	-	$	-	$	-	$	-
Add (deduct):												-
Charge-offs		(25)		(15)		(66)		(28)		-		(134)
Recoveries		-		-		-		-		-		-
Provision for loan losses –												-
noncovered		-		-		16		28		-		44
Provision for loan losses - covered		25		15		50		-		-		90
Balance,  September 30, 2014	$	-	$	-	$	-	$	-	$	-	$	-
Allowance:
Ending balance: specific	$	-	$	-	$	-	$	-	$	-	$	-
Ending balance: collective	$	-	$	-	$	-	$	-	$	-	$	-
Loans:
Ending balance: individually
evaluated for impairment	$	41,122	$	11,133	$	6,016	$	4,121	$	2,036	$	64,428
Ending balance: collectively
evaluated for impairment	$	18,745	$	38,531	$	9,421	$	2,356	$	1,017	$	70,070

38

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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

The following is a summary of the allowance for loan losses for the acquired credit impaired loans for 2013:

	Commercial		Residential		Construction		Commercial		Consumer
	Real		Real		and		and		and
	Estate		Estate		Land		Industrial		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 September 30, 2014:
	(dollars in thousands)
Balance, December 31, 2013	$	41,306
Decrease in expected losses on covered assets		(349)
Accretion included in noninterest income		(8,077)
Reimbursements from the FDIC		(4,951)
Balance, September 30, 2014	$	27,929

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 September 30, 2014 and December 31, 2013. 

			Acquired		Acquired
	Non-acquired		Non-Covered		Covered
	OREO		OREO		OREO		Total
	(dollars in thousands)
Balance, December 31, 2013	$	1,789	$	1,693	$	7,053	$	10,535
Acquired in Alarion acquisition		-		1,991		-		1,991
Additions		473		87		2,767		3,327
Sales		(1,101)		(503)		(4,337)		(5,941)
Writedowns		(513)		28		(202)		(687)
Balance, September 30, 2014	$	648	$	3,296	$	5,281	$	9,225

			Acquired		Acquired
	Non-acquired		Non-Covered		Covered
	OREO		OREO		OREO		Total
	(dollars in thousands)
Balance, December 31, 2012	$	2,637	$	605	$	9,467	$	12,709
Acquired in Frontier acquisition		-		786		-		786
Additions		1,283		1,147		4,873		7,303
Sales		(1,776)		(835)		(6,571)		(9,182)
Writedowns		(355)		(10)		(716)		(1,081)
Balance, December 31, 2013	$	1,789	$	1,693	$	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 nine months ended September 30, 2014 or the twelve months ended December 31, 2013.

The following tables present financial assets and liabilities measured at fair value at September 30, 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
	September 30, 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)	$	54,156	$	-	$	54,156	$	-
State and municipal securities		74,643		-		74,643		-
GSE residential mortgage-backed securities		210,390		-		210,390		-
Total available for sale investment securities		339,189		-		339,189		-
Mortgage loans held for sale		147,867		-		147,867		-
Other assets(1)		1,845		-		-		1,845
Total assets at fair value	$	488,901	$	-	$	487,056	$	1,845
Liabilities
Interest rate swap – cash flow hedge	$	882	$	-	$	882	$	-
Total liabilities at fair value	$	882	$	-	$	882	$	-

(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 nine months ending September 30, 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.

	Other
Nine months September 30, 2014:	Assets(1)
	(dollars in thousands)
Beginning balance, December 31, 2013	$	1,762
Total gains (losses) included in earnings:(2)
Mortgage IRLCs		1,962
Mortgage securities forward commitments		(1,879)
Ending balance, September 30, 2014(3)	$	1,845

	Other
Year ended  December 31, 2013:	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 83% as of September 30, 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)

NOTE 9.     FAIR VALUE MEASUREMENTS (Continued)

	For Items Measured at Fair Value Pursuant to
	Election of the Fair Value Option:  Fair Value
	Gain (Loss) related to Mortgage Banking Activities
	Three Months Ended
	September 30, 2014		September 30, 2013
	(dollars in thousands)
Mortgage loans held for sale	$	1,246	$	573
	For Items Measured at Fair Value Pursuant to
	Election of the Fair Value Option:  Fair Value
	Gain (Loss) related to Mortgage Banking Activities
	Nine Months Ended
	September 30, 2014		September 30, 2013
	(dollars in thousands)
Mortgage loans held for sale	$	3,208	$	558

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 September 30, 2014 and December 31, 2013.

	September 30, 2014
			Aggregate Unpaid
			Principal Balance		Fair Value Over
	Aggregate Fair		with Escrow		Unpaid
	Value		Under FVO		Principal
Loans held for sale	$	147,867	$	142,921	$	4,946

	December 31, 2013
			Aggregate Unpaid
			Principal Balance		Fair Value Over
	Aggregate Fair		with Escrow		Unpaid
	Value		Under FVO		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
	September 30, 2014
	Total Carrying
	Value		Level 1		Level 2		Level 3
	(dollars in thousands)
Assets
Impaired Loans(1)	$	11,579	$	-	$	-	$	11,579
Non-acquired OREO		648		-		-		648
Acquired OREO non-covered		3,296		-		-		3,296
Acquired OREO covered		5,281		-		-		5,281
Mortgage servicing rights (MSR)		3,906		-		-		3,906
Total	$	24,710	$	-	$	-	$	24,710

	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:

	Fair Value at			Unobservable	Range
(dollars in thousands)	September 30, 2014		Valuation Technique	Input	(Weighted Average)
Impaired loans	$	11,579	Discounted appraisals (1)	Appraisal adjustments (2)	0% to 100% (56%) (3)
Non-acquired OREO		648	Discounted appraisals (1)	Appraisal adjustments (2)	0% to 100% (81%) (3)
Acquired OREO non-covered		3,296	Discounted appraisals (1)	Appraisal adjustments (2)	0% to 100% (72%) (3)
Acquired OREO covered		5,281	Discounted appraisals (1)	Appraisal adjustments (2)	0% to 100% (74%) (3)
MSR		3,906	Discounted cash flows	Discount rate	10%
				Prepayment Speeds	8-10%

(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.

(3) Ranges presented as a percentage of the non-discounted appraisals.

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.

Non-acquired and Acquired Non-credit Impaired 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.

Acquired Covered and Non-covered Credit Impaired Loans:    These loans carry large credit discounts which generally cover a majority of losses and the covered loans have loss-sharing agreements with the FDIC where a majority of those losses are reimbursed.  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.

			Fair Value Measurements at
			September 30, 2014
	Carrying
	Value		Total Fair Value		Level 1		Level 2		Level 3
			(dollars in thousands)
Assets
Cash and short-term investments	$	39,172	$	39,172	$	39,172	$	-	$	-
Other investments		9,950		9,950		-		-		9,950
Non-acquired loans		774,108		785,367		-		-		785,367
Acquired non-credit impaired loans		160,502		160,502		-		-		160,502
Acquired credit impaired loans:
Non-covered		92,051		92,051		-		-		92,051
Covered		42,447		42,447		-		-		42,447
FDIC loss-share receivable		27,929		27,929		-		-		27,929
Total assets at fair value	$	1,146,159	$	1,157,418	$	39,172	$	-	$	1,118,246
Liabilities
Deposits	$	1,341,261	$	1,331,354	$	-	$	-	$	1,331,354
Federal funds purchased and securities
sold under repurchase agreements		42,815		41,644		41,644		-		-
Other borrowings		190,440		182,028		-		-		182,028
Total liabilities at fair value	$	1,574,516	$	1,555,026	$	41,644	$	-	$	1,513,382

			Fair Value Measurements at
			December 31, 2013
	Carrying
	Value		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
Non-acquired loans		684,544		696,350		-		-		696,350
Acquired non-credit impaired loans		-		-		-		-		-
Acquired credit impaired loans:
Non-covered		63,318		63,318						63,318
Covered		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 loss on its cash flow hedge in other comprehensive income of $529,000 as of September 30, 2014.

The Company recognized a $882,000 cash flow hedge liability in other liabilities on the Consolidated  Balance Sheet at September 30, 2014.  There was no ineffectiveness in the cash flow hedge during the nine month period ended September 30, 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 September 30, 2014, the Company was required to provide collateral of $894,000 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. As of September 30, 2014, the Company recognized a net derivative asset related to mortgage lending activities of $1.8 million, and a net realized gain of $1.2 million and $3.2 million for the three and nine months ended September 30, 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
	September 30,		December 31,
	2014		2013
	(dollars in thousands)
Mortgage-backed securities forward
commitments	$	160,000	$	128,000
Best efforts sale commitments		60,178		19,418
Total commitments	$	220,178	$	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.

			Mortgage		Holding
Three months ended September 30, 2014	Bank		Banking		Company		Totals
	(dollars in thousands)
Net interest income	$	15,213	$	716	$	-	$	15,929
Provision for loan losses		640		-		-		640
Noninterest income		1,376		6,892		6		8,274
Noninterest expense		13,274		7,103		220		20,597
Income tax expense (benefit)		899		157		(49)		1,007
Segment profit (loss)	$	1,776	$	348	$	(165)	$	1,959
Segment assets at September 30, 2014	$	1,583,259	$	158,277	$	13,998	$	1,755,534
			Mortgage		Holding
Three months ended September 30, 2013	Bank		Banking		Company		Totals
	(dollars in thousands)
Net interest income	$	13,340	$	218	$	-	$	13,558
Provision for loan losses		350		-		-		350
Noninterest income		1,955		1,952		11		3,918
Noninterest expense		12,165		2,968		201		15,334
Income tax expense (benefit)		798		(247)		(81)		470
Segment profit (loss)	$	1,982	$	(551)	$	(109)	$	1,322
Segment assets at September 30, 2013	$	1,267,375	$	44,588	$	10,346	$	1,322,309

			Mortgage		Holding
Nine months ended September 30, 2014	Bank		Banking		Company		Totals
	(dollars in thousands)
Net interest income	$	43,208	$	2,465	$	-	$	45,673
Provision for loan losses		1,284		-		-		1,284
Noninterest income		1,592		15,437		18		17,047
Noninterest expense		36,410		17,096		682		54,188
Income tax expense (benefit)		2,143		250		(219)		2,174
Segment profit (loss)	$	4,963	$	556	$	(445)	$	5,074
Segment assets at September 30, 2014	$	1,583,259	$	158,277	$	13,998	$	1,755,534
			Mortgage		Holding
Nine months ended September 30, 2013	Bank		Banking		Company		Totals
	(dollars in thousands)
Net interest income	$	41,664	$	349	$	-	$	42,013
Provision for loan losses		1,503		-		-		1,503
Noninterest income		6,294		7,558		23		13,875
Noninterest expense		34,192		8,414		636		43,242
Income tax expense (benefit)		3,619		(157)		(229)		3,233
Segment profit (loss)	$	8,644	$	(350)	$	(384)	$	7,910
Segment assets at September 30, 2013	$	1,267,375	$	44,588	$	10,346	$	1,322,309

55

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 12.     ACQUISITION ACTIVITY

Alarion Bank

On September 30, 2014, the Company completed the merger of Alarion Financial Services, Inc. and its subsidiary Alarion Bank with and into Heritage Financial Group, Inc. and its subsidiary HeritageBank of the South.  In connection with the merger, the Company issued 1,158,147 shares for exchange of Alarion's shares and recorded $6.8 million in goodwill.  The Company acquired $160.5 million in non-credit impaired loans, $38.7 million in credit impaired loans, $2.0 million in other real estate owned, and $230.7 million in total deposits.  Immediately following the merger, the Company redeemed all of Alarion's preferred stock in exchange for $4.5 million in cash and 178,267 shares of the Company's common stock.  The Company expects to complete Alarion's system conversion during the fourth quarter of 2014.

The Company elected to account for the non-credit impaired loans, acquired in the Alarion acquisition under ASC 310–20.  ASC 310-20, Nonrefundable Fees and Other Costs,  requires the discount to be accreted through earnings based on estimated cash flows over the estimated life of the loan.  The Company elected to account for the credit impaired loans acquired in the Alarion 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 Alarion merger was accounted for using the acquisition method of accounting and the assets acquired, liabilities assumed and consideration exchanged were recorded at estimated fair value as of the acquisition date.  Fair values are preliminary and subject to refinement for up to a year after the closing date of the acquisition and are detailed in the following table:

56

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 12.     ACQUISITION ACTIVITY (continued)

			Initial
			Fair Value			As Recorded
	Acquired		Adjustments			by the Company
Assets	(dollars in thousands)
Cash and cash equivalents	$	4,195	$	-		$	4,195
Fed funds sold		430					430
Securities available to sale		39,372		-			39,372
FHLB and other bank stock		926		-			926
Loans held for sale		6,753		191	(a)		6,944
Non-credit impaired loans		161,343		(841)	(b)		160,502
Credit impaired loans		45,751		(7,082)	(c)		38,669
Premises and equipment		13,944		(2,721)	(d)		11,223
Other real estate owned		2,549		(558)	(e)		1,991
Core deposit intangible		-		2,499	(f)		2,499
Deferred tax asset		3,665		4,971	(g)		8,636
Other assets		1,066		154	(h)		1,220
Total assets	$	279,994	$	(3,387)		$	276,607
Liabilities
Noninterest-bearing deposits	$	1,650	$	-		$	1,650
Interest-bearing deposits		228,354		662	(i)		229,016
Federal funds purchased and sold under agreements to
repurchase		3,224		-			3,224
Other borrowings		13,000		921	(j)		13,921
Preferred dividends payable		1,194		(27)	(k)		1,167
Preferred stock		6,840					6,840
Other liabilities		4,216					4,216
Total liabilities	$	258,478	$	1,556		$	260,034
Net identifiable assets acquired over (under) liabilities assumed		21,516		(4,943)			16,573
Goodwill				6,819			6,819
Net assets acquired over liabilities assumed	$	21,516	$	1,876		$	23,392
Consideration:
Common shares issued		1,158,147
Purchase price per share of the Company's common stock	$	20.19
Total share consideration	$	23,383
Company common stock issued and cash exchanged for
fractional shares and stock appraisal rights	$	9
Fair value of total consideration transferred	$	23,392

57

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 12.     ACQUISITION ACTIVITY (continued)

Explanations

(a) The amount represents the fair value adjustments based on the evaluation of the acquired loans held for sale portfolio.

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

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

(d) The amount represents the fair value adjustments based on the evaluation of the acquired premises and equipment.

(e) The amount represents the fair value adjustments based on the evaluation of the acquired OREO.

(f) The amount 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.

(g) Adjustment represents the net deferred tax asset resulting from the mark down in Alarion assets through fair value adjustments and the mark up of liabilities through fair value adjustments.

(h) The amount represents fair value adjustments based on the evaluation of the acquired mortgage related IRLCs.

(i) The amount represents the fair value adjustments based on the evaluation of the acquired interest-bearing deposits, which held a higher interest rate than similar deposits as of the acquisition date.  The fair value adjustment will be amortized to reduce interest expense on a declining basis over the average life of the portfolio.

(j) The adjustment represents the prepayment penalty of the acquired borrowings as of the acquisition date, and immediately following the acquisition the borrowings were repaid.

(k) The amount represents the fair value adjustment to the acquired preferred stock dividends payable, and immediately following the acquisition the Alarion preferred stock was redeemed.

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:

58

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 12.     ACQUISITION ACTIVITY (continued)

			Fair Value
			and Other			As Recorded
	Acquired		Adjustments			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

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.

59

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 13.     SUBSEQUENT EVENTS

Subsequent events and transactions that occurred after September 30, 2014 but prior to November 10, 2014, the date these financial statements were available to be issued, have been evaluated for potential recognition or disclosure in these financial statements.  

On October 8, 2014, the Bank signed a definitive agreement (“Agreement”) to purchase a branch in Norcross, Georgia, from The PrivateBank and Trust Company, a wholly owned subsidiary of Chicago-based PrivateBancorp, Inc.  The branch is located at 3169 Holcomb Bridge Road, which is in the northeast area of metro Atlanta, approximately four miles north of the perimeter (I-285).  The transaction, which is expected to close in the fourth quarter of 2014, subject to regulatory approval and other customary conditions, is expected to result in the transfer of approximately $40 million in fully performing loans, at 99% of the outstanding balance at closing, and approximately $129 million in deposits, with a deposit premium of 3.8%.

60

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.

61

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

General.  Heritage is a $1.8 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 September 30, 2014, HeritageBank operated in Georgia, Florida and Alabama through 36 banking locations, 20 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.  In August 2014 we opened two additional mortgage offices in Greenwood Village and Denver, Colorado, and in September 2014 we opened a second full service branch in Macon, Georgia.

In September 2014, we completed the merger of Alarion Financial Services, Inc. and its subsidiary Alarion Bank with and into Heritage Financial Group, Inc. and its subsidiary HeritageBank of the South.  Alarion was a six branch full service bank based in Ocala, Florida with $160.5 million in non-credit impaired loans, $38.7 million in credit impaired loans, $2.0 million in OREO, and $230.7 million in total deposits.  In October 2014, we signed a definitive agreement to purchase a branch in Norcross, Georgia, from The PrivateBank and Trust Company which is expected to close during the fourth quarter of 2014.  The branch purchase is expected to result in the transfer of approximately $40 million in non-credit impaired loans and $129 million in deposits. 

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.

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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 $22.7 million at September 30, 2014.

	September 30, 2014
	Less than		One through		Four through		After Five
	One Year		Three Years		Five Years		Years		Total
	(In thousands)
Contractual obligations:
FHLB advances	$	91,000	$	62,990	$	25,759	$	10,691	$	190,440
Fed funds purchased and securities sold under  repurchase agreement		12,815		15,000		15,000		-		42,815
Operating leases (premises)		1,197		2,488		2,111		2,612		8,408
Total advances and operating leases	$	105,012	$	80,478	$	42,870	$	13,303	$	241,663
Off-balance sheet loan commitments:
Undisbursed portions of loans closed	$	29,273	$	19,281	$	895	$	-	$	49,449
Commitments to originate loans		161,966		-		-		-		161,966
Unused lines of credit		82,255		17,565		5,208		24,293		129,321
Total loan commitments		273,494		36,846		6,103		24,293		340,736
Total contractual obligations and loan commitments	$	378,506	$	117,324	$	48,973	$	37,596	$	582,399

63

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

Comparison of Financial Condition at September 30, 2014 and December 31, 2013

General.  Total assets increased by $374.6 million, or 27.1%, to $1.756 billion at September 30, 2014, from $1.381 billion at December 31, 2013.  Total interest-earning assets increased $361.4 million, or 29.9%, to $1.568 billion at September 30, 2014, from $1.207 billion at December 31, 2013.  The increase in total and interest-earning assets was driven by the Alarion acquisition, which added $276.6 million in total assets and $253.6 million in interest-earning assets, coupled with increases in loans, excluding loans acquired from Alarion, of $71.2 million, loans held for sale, excluding loans held for sale acquired from Alarion, of $30.3 million, interest bearing deposits in banks of $7.7 million, and securities available for sale, excluding securities acquired from Alarion, of $5.5 million.  At the same time, interest-bearing deposits increased $213.8 million driven primarily by the Alarion acquisition, other borrowings increased $59.0 million, and federal funds purchased and securities sold under repurchase agreements increased $5.2 million.

Cash and Securities.  Cash and due from banks decreased $8.0 million, or 23.0%, to $26.8 million at September 30, 2014, from $34.8 million at December 31, 2013.  Cash and securities (including bank deposits and federal funds sold) increased in the aggregate $45.9 million, or 13.8%, to $378.4 million, or 21.6% of total assets, at September 30, 2014, from $332.5 million, or 24.1% of total assets, at December 31, 2013.  At September 30, 2014, our liquidity position as a percentage of total assets improved as a result of growth in the balance of interest-bearing deposits in banks, securities available for sale and federal funds sold offset in part by the decline in cash and due from banks primarily driven by the Alarion acquisition.

	At September 30,		At December 31,		Amount		Percent
	2014		2013		Change		Change
	(Dollars in thousands)
Cash and due from banks	$	26,793	$	34,804	$	(8,011)	(23.0)	%
Interest-bearing deposits in banks		10,945		3,249		7,696	NM
Federal funds sold		1,434		130		1,304	NM
Securities available for sale, at fair value		339,189		294,299		44,890	15.3
Total	$	378,361	$	332,482	$	45,879	13.8	%

At September 30, 2014, our securities portfolio consisted of $54.2 million in GSE securities, $210.4 million in GSE residential mortgage-backed securities, and $74.6 million in state and municipal 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 September 30, 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 $270.4 million, or 33.8%, to $1.069 billion at September 30, 2014, from $798.8 million at December 31, 2013.  Overall, the change in the loan portfolio was driven primarily by the Alarion acquisition, which added $199.2 million, and organic loan growth of $89.6 million offset in part by principal pay downs and resolutions of $9.9 million for non-covered loans and $8.4 million for covered loans.  We continue to emphasize a diversified lending strategy as we noted balance growth in all of our major loan categories for the period. 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.

64

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 September 30, 2014, as compared to the end of 2013.

	Loans by Type as of
	September 30,		December 31,		Amount		Percentage
	2014		2013		Change		Change
	(dollars in thousands)
Non-acquired loans:
Nonresidential	$	284,218	$	256,567	$	27,651	10.8	%
Multifamily		28,742		22,650		6,092	26.9
Farmland		29,441		23,420		6,021	25.7
Construction and land		73,137		50,167		22,970	45.8
Mortgage loans, 1-4 family		179,131		177,456		1,675	0.9
Home equity		36,754		29,147		7,607	26.1
Consumer and other		21,612		23,976		(2,364)	(9.9)
Commercial and industrial		121,073		101,161		19,912	19.7
		774,108		684,544		89,564	13.1
Acquired non-credit impaired loans		160,502		-		160,502	NM
Acquired credit impaired loans:
Non-covered loans		92,051		63,318		28,733	45.4
Covered loans		42,447		50,891		(8,444)	(16.6)
		134,498		114,209		20,289	17.8
Total loans	$	1,069,108	$	798,753	$	270,355	33.8	%

Loans Held for Sale.  At September 30, 2014, we had approximately $147.9 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 loan production outpacing sales during 2014 coupled with an increase of $6.9 million in loans acquired from Alarion.  For the nine months ended September 30, 2014, we generated $678.0 million in mortgage loan originations and held a pipeline of end of period locks of $136.0 million.  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 $6.5 million of mortgage loans held for sale that have been held longer than ninety days as of September 30, 2014, and we held a mortgage repurchase reserve, used in the event a loan is repurchased from an investor, of $77,000 as of September 30, 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 September 30, 2014, our total loans delinquent for 30 to 89 days, excluding acquired loans, was $929,000, or 0.12% of total loans, excluding acquired loans, compared to $1.0 million, or 0.15% of total loans, excluding acquired loans, at December 31, 2013.  At September 30, 2014, our nonperforming assets, excluding acquired assets, totaled $7.5 million, or 0.43% of total assets, compared to $11.2 million, or 0.81% of total assets, at December 31, 2013. This $3.7 million, or 32.8%, decrease was primarily driven by a $2.4 million owner occupied, nonresidential loan secured by a convenience store and fast food restaurant that emerged from bankruptcy and was placed back on accrual status during the second quarter of 2014.  Our policy is to place bankruptcies on nonaccrual status until they are resolved, and this customer never missed an interest payment while in bankruptcy.  As a result, and due to other factors, we are expecting this customer to pay all contractually obligated principal and interest.  Separately, OREO write downs of $513,000 and OREO sales (net of additions) of $628,000 were recorded for the nine months ended September 30, 2014, which also reduced the balance of nonperforming assets, excluding acquired assets.  Included in nonaccruing loans at September 30, 2014, are troubled debt restructurings of $3.1 million, which involve forgiving a portion of interest or principal on loans or making loans at a rate materially below market. See Note  5 to the Consolidated Financial Statements in this Form 10-Q for additional information.

65

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

Our loan portfolio includes acquired credit impaired loans, which are generally recorded at a deep discount from the contractual principal value and accounted for under ASC 310-30 and acquired non-credit impaired loans, which are accounted for under ASC 310-20.  Acquired loans are excluded from the delinquent loan tables below.  See Note 6 to the Consolidated Financial Statements in this Form 10-Q for additional information about acquired loans.   

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

	Nonperforming Assets
	September 30,		December 31,		Amount		Percent
	2014		2013		Change		Change
	(Dollars in thousands)
Nonperforming loans	$	6,896	$	9,434	$	(2,538)	(26.9)	%
Foreclosed assets		648		1,789		(1,141)	(63.8)
Total nonperforming assets	$	7,544	$	11,223	$	(3,679)	(32.8)	%

Nonperforming loans, excluding acquired loans, decreased to 0.89% of total loans, excluding acquired loans, at September 30, 2014, from 1.38% at December 31, 2013, primarily driven by the $2.4 million owner occupied, nonresidential loan secured by a convenience store and fast food restaurant that emerged from bankruptcy and was placed back on accrual status during the second quarter of 2014.  We are cautiously optimistic that the positive trend of nonperforming loans, excluding acquired loans, will continue to improve as a percentage of total loans, excluding acquired loans, throughout 2014. 

OREO, excluding acquired assets, was $648,000 at September 30, 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 in excess of additions for the nine months ended September 30, 2014.  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 nine months ended September 30, 2014, we had gross proceeds on sales of OREO, excluding acquired assets, of $1.2 million and recorded a net gain of approximately $84,000 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 assets, 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 acquired loans and OREO, at the dates indicated.

	September 30,			December 31,
	2014			2013
	(Dollars in thousands)
Total criticized assets	$	23,737		$	22,741
Total classified assets		19,280			19,582
Total criticized assets to total non-acquired loans		3.07	%		3.32	%
Total classified assets to total non-acquired loans		2.49	%		2.86	%

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.

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

Allowance for Loan Losses.  Our allowance for loan losses at September 30, 2014, increased to $9.9 million compared to $8.9 million at December 31, 2013, primarily as a result of increased loans.   Excluding acquired loans, the allowance for loan losses to total loans was 1.28% at September 30, 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 acquired loans for the periods indicated:

	September 30,			December 31,			September 30,
	2014			2013			2013
	(dollars in thousands)
Allowance for loan losses to total non-acquired loans		1.28	%		1.31	%		1.34	%
Allowance for loan losses to average non-acquired loans		1.30	%		1.33	%		1.37	%
Allowance for loan losses to nonperforming loans		143.81	%		94.91	%		80.96	%
Accruing loans past due 30-89 days	$	929		$	1,001		$	669
Nonaccrual loans		6,895			9,434			10,986
Loans - 90 days past due & still accruing		-			-			-
Total nonperforming loans		6,895			9,434			10,986
OREO and repossessed assets		648			1,789			2,654
Total nonperforming assets	$	7,543		$	11,223		$	13,640
Nonperforming loans to total non-acquired loans		0.89	%		1.38	%		1.65	%
Nonperforming assets to total assets		0.43	%		0.81	%		1.03	%
Net charge-offs QTD to average non-acquired loans (annualized)		0.06	%		0.10	%		0.31	%
Net charge-offs QTD	$	117		$	160		$	503

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.

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

Premises and Equipment. Premises and equipment increased $11.9 million, or 31.4%, to $49.9 million at September 30, 2014, compared to December 31, 2013, primarily driven by the $11.2 million of premises and equipment acquired from Alarion and 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, offset in part by depreciation expense for premises and equipment for the nine months ended September 30, 2014.

Goodwill, Intangible Assets and Other Assets. Goodwill and intangible assets increased $12.4 million, or 292.7%, to $16.7 million at September 30, 2014, compared to $4.3 million at December 31, 2013.  The increase was driven by the Alarion acquisition which added $6.8 million in goodwill and $2.5 million in core deposit intangible coupled with growth in the MSRs net of amortization of $3.7 million, partially offset by the amortization expense of $574,000 related to core deposit intangibles for the nine months ended September 30, 2014. 

Cash surrender value of bank owned life insurance (“BOLI”) increased $566,000 to $24.7 million at September 30, 2014, from December 31, 2013, driven by the earnings of the BOLI policies for the nine months ended September 30, 2014.  Other assets increased $9.3 million to $30.6 million at September 30, 2014, compared to December 31, 2013, primarily driven by the Alarion acquisition which added a net deferred tax asset of $8.6 million and other assets of $1.2 million. See Note 12 to the Consolidated Financial Statements in this Form 10-Q for more information.

Deposits.  Total deposits increased $264.8 million, or 24.6%, to $1.341 billion at September 30, 2014, compared with $1.076 billion at December 31, 2013, primarily driven by the Alarion acquisition which added $230.7 million coupled with core deposit growth of $50.7 million offset in part by reductions in wholesale deposits of $12.9 million and time deposits of $3.7 million.

Borrowings and Other Liabilities.  The total amount of other borrowings increased $59.0 million to $190.4 million at September 30, 2014, from $131.4 million at December 31, 2013.  The increase in other borrowings was driven by the Alarion acquisition which added $13 million in FHLB borrowings along with a fair value rate adjustment of $921,000 coupled with an increase of short-term FHLB borrowings of $46.0 million offset in part by the amortization of the fair market value rate adjustment for purchased FHLB borrowings reflected as a reduction to interest expense of $807,000 for the nine months ended September 30, 2014.  The acquired Alarion borrowings were repaid in October 2014 with the fair value mark fully offsetting the prepayment penalty.  The weighted average rate on these other borrowings was 1.72% for the nine months ended September 30, 2014, compared to 2.15% for the same period in 2013.  Federal funds purchased and securities sold under repurchase agreements increased $5.2 million to $42.8 million at September 30, 2014, compared to $37.7 million at December 31, 2013, primarily driven by the Alarion acquisition which added $3.2 million coupled with growth in the customer repurchase agreements of $3.9 million offset in part by a reduction in the federal funds purchased from Chattahoochee Bank of Georgia of $2.0 million.

Equity.  Total equity increased $34.9 million to $159.9 million at September 30, 2014, compared with $125.1 million at December 31, 2013, primarily driven by the Alarion acquisition which added $27.0 million in common equity as a result of the issuance of 1,336,414 shares in new common shares in order to close the acquisition and redeem the Alarion preferred stock.  Total equity was also positively impacted by net income of $5.1 million, other comprehensive income of $2.8 million, the allocation of $775,000 in ESOP shares, and stock-based compensation of $723,000, offset in part by cash dividend payments of $1.4 million.

Accounting for Acquired Assets

General.  We perform ongoing assessments of the estimated cash flows of our acquired credit impaired loan portfolios accounted under ASC 310-30.  At September 30, 2014, the fair value of the acquired credit impaired loan portfolios consisted of $92.1 million in non-covered and $42.4 million in covered loans, compared with $63.3 million in non-covered and $50.9 million in covered loans at December 31, 2013.  The principal balance of the acquired credit impaired loan portfolios totaled $188.8 million at September 30, 2014, compared with $177.8 million at December 31, 2013.  The increase was driven by the $38.7 million of non-covered credit impaired loans acquired from Alarion offset in part by portfolio paydowns and resolutions.

The factors considered in the allowance for loan losses for acquired credit impaired 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 acquired credit impaired loan pools and compare the present value of expected cash flows to the carrying value

68

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

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, acquired credit impaired 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. 

At September 30, 2014, the acquired credit impaired loans individually assessed experienced charge-offs of $133,000 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 $63,000 at September 30, 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 September 30, 2014, the FDIC loss-share receivable associated with covered FDIC-acquired assets decreased $13.4 million to $27.9 million, or 33.8% of the principal balance of covered acquired credit impaired assets, compared to $41.3 million, or 37.8% of the principal balance of covered acquired credit impaired assets, at December 31, 2013. The principal balance of the covered acquired credit impaired assets totaled $82.8 million at September 30, 2014, compared with $109.2 million at December 31, 2013.  The reduction in the FDIC loss-share receivable as of September 30, 2014 compared to December 31, 2013 was primarily driven by $8.1 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 $5.0 million of reimbursements received from the FDIC. 

As of September 30, 2014, we have recorded an FDIC clawback liability of $3.3 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.

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

	September 30,			December 31,
	2014			2013
	(dollars in thousands)
FDIC loss-share receivable:
Single family estimated credit losses	$	6,524		$	8,995
Nonsingle family estimated credit losses		19,133			30,077
Pending reimbursements and other		2,272			2,234
Total	$	27,929		$	41,306
FDIC clawback liability	$	3,332		$	1,941
Total covered discount impacting FDIC loss-share receivable		32,071			39,071
FDIC receivable as % of gross balance of covered assets		33.8	%		37.8	%
Covered discount as % of FDIC loss-share receivable		91.9	%		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 September 30,
	2014						2013
	(Dollars in Thousands)
	Average		Interest				Average		Interest
	Outstanding		Earned/		Yield/		Outstanding		Earned/		Yield/
	Balance		Paid		Rate		Balance		Paid		Rate
Interest-Earning Assets:
Loans	$	999,848	$	16,399	6.51	%	$	817,366	$	13,891	6.74	%
Investment securities		301,646		1,691	2.22			303,349		1,582	2.07
Other short-term investments		27,367		22	0.32			26,862		34	0.50
Total interest-earning assets		1,328,861		18,112	5.41			1,147,577		15,507	5.36
Noninterest earning assets		155,007						179,188
Total assets		1,483,868						1,326,765
Interest-Bearing Liabilities:
Interest checking, money market, savings		659,883		377	0.23	%		549,561		306	0.22	%
Time deposits		366,918		815	0.88			359,631		676	0.75
Total interest-bearing deposits		1,026,801		1,192	0.46			909,192		982	0.43
Federal funds purchased and securities
sold under repurchase agreements		37,480		339	3.59			33,965		335	3.91
Other borrowings		111,829		517	1.83			101,814		518	2.02
Total interest bearing liabilities		1,176,110		2,048	0.69			1,044,971		1,835	0.70
Noninterest Bearing Liabilities:
Demand deposits		162,917						150,840
Other liabilities		11,353						12,120
Total noninterest bearing liabilities		174,270						162,960
Total liabilities		1,350,380						1,207,931
Stockholder’s equity		133,488						118,834
Total liabilities and stockholder’s equity		1,483,868						1,326,765
Net interest income			$	16,064					$	13,672
Net interest rate spread					4.72	%					4.66	%
Net earning assets	$	152,751					$	102,606
Net interest margin					4.80	%					4.73	%
Average interest-earning assets to average
interest-bearing liabilities		1.13X						1.1X
Core net interest margin (non-GAAP):
Loans(1)(2)	$	999,848	$	16,399	6.51	%	$	817,366	$	13,891	6.74	%
Acquired credit impaired loan discount adjustments(3)		50,607		4,621	36.23			75,023		3,718	19.66
Adjusted loans		1,050,455		11,778	4.45			892,389		10,173	4.52
Adjusted total interest-earning assets		1,379,468		13,491	3.88			1,222,600		11,789	3.83
Total interest bearing liabilities	$	1,176,110		2,048	0.69		$	1,044,971		1,835	0.70
Core net interest income			$	11,443					$	9,954
Core net interest rate spread					3.19	%					3.13	%
Core net interest margin					3.29	%					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) Acquired credit impaired loan discount adjustments include the reduction of interest income for discount accretion excluding contractual interest payments and the increase of core loans for the total balance of acquired credit impaired loan discounts.

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

	Nine Months Ended September 30,
	2014						2013
	(Dollars in Thousands)
	Average		Interest				Average		Interest
	Outstanding		Earned/		Yield/		Outstanding		Earned/		Yield/
	Balance		Paid		Rate		Balance		Paid		Rate
Interest-Earning Assets:
Loans	$	953,249	$	46,977	6.59	%	$	770,383	$	43,371	7.53	%
Investment securities		301,729		5,078	2.25			278,438		4,337	2.08
Other short-term investments		29,195		73	0.33			50,941		147	0.39
Total interest-earning assets		1,284,173		52,128	5.43			1,099,762		47,855	5.82
Noninterest earning assets		159,311						177,064
Total assets		1,443,484						1,276,826
Interest-Bearing Liabilities:
Interest checking, money market, savings		608,483	$	1,062	0.23	%		532,053		918	0.23	%
Time deposits		376,457		2,446	0.87			348,095		2,159	0.83
Total interest-bearing deposits		984,940		3,508	0.48			880,148		3,077	0.47
Federal funds purchased and securities
sold under repurchase agreements		35,967		999	3.71			33,846		995	3.93
Other borrowings		121,204		1,561	1.72			90,096		1,451	2.15
Total interest bearing liabilities		1,142,111		6,068	0.71			1,004,090		5,523	0.74
Noninterest Bearing Liabilities:
Demand deposits		161,326						139,208
Other liabilities		9,243						13,091
Total noninterest bearing liabilities		170,569						152,299
Total liabilities		1,312,680						1,156,389
Stockholder’s equity		130,804						120,437
Total liabilities and stockholder’s equity		1,443,484						1,276,826
Net interest income			$	46,060					$	42,332
Net interest rate spread					4.72	%					5.08	%
Net earning assets	$	142,062					$	95,672
Net interest margin					4.80	%					5.15	%
Average interest-earning assets to average
interest-bearing liabilities		1.12X						1.1X
Core net interest margin (non-GAAP):
Loans(1)(2)	$	953,249	$	46,977	6.59	%	$	770,383	$	43,371	7.53	%
Acquired credit impaired loan discount adjustments(3)		55,998		13,115	31.31			75,118		14,450	25.72
Adjusted loans		1,009,247		33,862	4.49			845,501		28,921	4.57
Adjusted total interest-earning assets		1,340,171		39,013	3.89			1,174,880		33,405	3.80
Total interest bearing liabilities	$	1,142,111		6,068	0.71		$	1,004,090		5,523	0.74
Core net interest income			$	32,945					$	27,882
Core net interest rate spread					3.18	%					3.07	%
Core net interest margin					3.29	%					3.17	%

(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) Acquired credit impaired loan discount adjustments include the reduction of interest income for discount accretion excluding contractual interest payments and the increase of core loans for the total balance of acquired credit impaired loan discounts. 71

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 September 30,
	2014 vs. 2013
	Increase (Decrease)				Total
	Due to				Increase
	Volume		Rate		(Decrease)
	(Dollars in Thousands)
Interest-earning assets:
Loans	$	3,101	$	(593)	$	2,508
Investment securities		(9)		118		109
Other short-term investments		1		(13)		(12)
Total interest-earning assets	$	3,093	$	(488)	$	2,605
Interest-bearing liabilities:
Interest checking, money market, savings	$	62	$	9	$	71
Time deposits		14		125		139
Federal funds purchased and securities sold under
repurchase agreements		35		(31)		4
Other borrowings		51		(52)		(1)
Total interest-bearing liabilities	$	162	$	51	$	213
Increase in net interest income					$	2,392

	Nine Months Ended September 30,
	2014 vs. 2013
	Increase (Decrease)				Total
	Due to				Increase
	Volume		Rate		(Decrease)
	(Dollars in Thousands)
Interest-earning assets:
Loans	$	10,295	$	(6,689)	$	3,606
Investment securities		363		378		741
Other short-term investments		(63)		(11)		(74)
Total interest-earning assets	$	10,595	$	(6,322)	$	4,273
Interest-bearing liabilities:
Interest checking, money market, savings	$	132	$	12	$	144
Time deposits		176		111		287
Federal funds purchased and securities sold under
repurchase agreements		62		(58)		4
Other borrowings		501		(391)		110
Total interest-bearing liabilities	$	871	$	(326)	$	545
Increase in net interest income					$	3,728

72

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

Comparison of Operating Results for the Three and Nine Month Periods Ended September 30, 2014 and 2013

General.  During the three and nine months ended September 30, 2014, we recorded net income of $1.9 million and $5.1 million, respectively, compared to net income of $1.3 million and $7.9 million, respectively, for the same periods in 2013.  Basic earnings per share for the three and nine months ended September 30, 2014, were $0.26 and $0.68, respectively, compared to $0.18 and $1.07, respectively, for the same periods in 2013.  Diluted earnings per share for the three and nine months ended September 30, 2014, were $0.26 and $0.67, respectively, compared to $0.18 and $1.05, respectively, for the same periods in 2013.  The improvement in operating results for the three months ended September 30, 2014 compared to the same period in 2013 was primarily driven by increases in revenue from mortgage banking activities, net interest income, and gain on sales of securities offset by increases in salaries and employee benefits, acquisition-related expenses, and increased negative accretion of the FDIC loss-share receivable.  The reduction in operating results for the nine months ended September 30, 2014 compared to the same period in 2013 was primarily driven by increases in salaries and employee benefits, acquisition-related expenses, and negative accretion of the FDIC loss-share receivable coupled with a one-time gain on acquisitions recorded in 2013, partially offset by improved revenue from mortgage banking activities, net interest income and gain on sales of securities. 

Interest Income. Total interest income for the three and nine months ended September 30, 2014, increased $2.6 million and $4.2 million, respectively, or 16.8% and 8.8%, respectively, compared to the same periods in 2013.  The increase was due to growth in average interest-earning assets for the three and nine months ended September 30, 2014 of $181.3 million and $184.4 million, respectively, compared to the same periods in 2013 primarily driven by the Frontier FDIC-assisted acquisition during the first quarter of 2013 and 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.  The increase in the average balance of earning assets for the three months ended September 30, 2014 was coupled with an increase of five basis points in the yield on average-earning assets to 5.41% as compared to the same period in 2013.  However, the increase in the average interest-earning assets for the nine months ended September 30, 2014 was in part offset by a reduction in the yield on interest-earning assets of 39 basis points compared to the same periods in 2013.

Interest income, on a fully taxable equivalent basis, on loans for the three and nine months ended September 30, 2014, increased $2.5 million and $3.6 million, respectively, to $16.4 million and $47.0 million, respectively, compared to $13.9 million and $43.4 million, respectively, for the same periods in 2013.  The increase in interest income on loans was driven by growth in the average loan balances for the three and nine months ended September 30, 2014, by $182.5 million and $182.9 million, respectively, as compared to the same periods in 2013 as a result of the 2013 Frontier acquisition and the organic loan growth experienced throughout all our markets.   However, the increase in interest income was negatively impacted for the three and nine months ended September 30, 2014, by a decline in the weighted average yield on loans of 24 basis points and 94 basis points, respectively, compared to the same periods in 2013 driven by reduced accretion on acquired credit impaired loans compared to the prior year. 

Interest income, on a fully taxable equivalent basis, on investment securities for the three and nine months ended September 30, 2014, was $1.7 million and $5.1 million, respectively, compared to $1.6 million and $4.3 million, respectively, for the same periods in 2013.  The weighted average yield on investments for the three and nine months ended September 30, 2014, improved 16 basis points and 17 basis points, respectively, which positively impacted the interest income on investment securities compared to the same periods in 2013.  The improvement in the weighted average yield on investments for the three months ended September 30, 2014 was partially offset by a reduction in the balance of investment securities of $1.7 million which negatively impacted the interest income on investments compared to the same period in 2013 as the balance was reduced as a percentage of interest earning assets.  However, favorable growth was recorded in the average balance of investment securities for the nine months ended September 30, 2014, of $23.3 million which positively impacted the interest income on investments compared to the same period in 2013 as excess liquidity was placed into investment securities.  We anticipate the yield on our investment portfolio to improve during the remainder of 2014 as we anticipate reducing the balance of our lower yielding investments as a percentage of our holdings. 

73

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

Interest income on other short-term investments for the three and nine months ended September 30, 2014 decreased to $22,000 and $73,000, respectively, compared to $34,000 and $147,000, respectively, for the same periods in 2013.  The decline for the nine months ended September 30, 2014 was driven by a reduction in the average balance of other short-term investments of $21.7 million compared to the same period in 2013 as excess liquidity was used to fund organic loan growth.  Also, the average yield on other short-term investments declined for the three and nine months ended September 30, 2014 by 18 basis points and five basis points, respectively, compared to the same periods in 2013.

Interest Expense.  Total interest expense for the three and nine months ended September 30, 2014, increased $213,000 and $545,000, respectively, or 11.6% and 9.9%, respectively, compared to the same periods in 2013.  The increase in interest expense was primarily the result of growth in the average balance of interest-bearing liabilities for the three and nine months ended September 30, 2014 of $131.1 million and $138.0 million, respectively, compared to the same periods 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 three and nine months ended September 30, 2014 of one basis point and three basis points, respectively, as compared to the same period in 2013.  We anticipate the change in the cost of interest-bearing liabilities to be minimal for the remainder of 2014 unless market interest rates either increase or decrease significantly.  

Interest expense on deposits for the three and nine months ended September 30, 2014, increased $210,000 and $431,000, respectively, compared to the same periods in 2013.  The increase in interest expense on deposits for the three and nine months ended September 30, 2014 was driven by growth in average interest-bearing deposits of $117.6 million and $104.8 million, respectively, compared to the same periods in 2013.  The increase in interest expense for the three and nine months ended September 30, 2014 was also impacted by an increase in the weighted average cost on deposits of three basis point and one basis points, respectively, compared to the same periods in 2013. 

Interest expense on federal funds purchased and securities sold under repurchase remained relatively unchanged for the three and nine months ended September 30, 2014 compared to the same periods in 2013.  Interest expense on other borrowings, consisting of FHLB advances, for the three months ended September 30, 2014 declined $1,000 compared to the same period in 2013 while the interest expense on other borrowings for the nine months ended September 30, 2014 increased $110,000 compared to the same period in 2013.  The increase in the interest expense on other borrowings for the nine months ended September 30, 2014, was primarily driven by an increase in the average balance of other borrowings of $31.1 million compared to the same period in 2013 driven by our strategy to take advantage of historically low interest rates to fund loan growth.  However, the increase in interest expense for the nine months ended September 30, 2014 was offset in part by a reduction in the weighted average rate paid on these borrowings of 43 basis points compared to the same period in 2013. 

Net Interest Income.    Net interest income, on a fully taxable equivalent basis, for the three and nine months ended September 30, 2014, increased $2.4 million and $3.7 million, respectively, or 17.5% and 8.8%, respectively, compared to the same periods in 2013.  The overall increase was primarily driven by an increase in the balance of interest-earning assets 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 three months ended September 30, 2014 increased five basis points compared to the same period in 2013 while the net interest margin for the three months ended September 30, 2014, increased seven basis points compared to the same period in 2013.  However, the net interest spread for the nine months ended September 30, 2014 decreased 37 basis points compared to the same period in 2013 while the net interest margin for the nine months ended September 30, 2014 declined 35 basis points compared to the same period in 2013.  We also expect loan accretion for FDIC-acquired loans to vary from quarter to quarter but continue to positively impact the net interest margin for the remainder of 2014.

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.

74

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

Provision for Loan Losses.  During the three months ended September 30, 2014, provision for loan losses expense increased by $290,000 compared to the same period in 2013 while the provision for loan losses expense for the nine months ended September 30, 2014 decreased $219,000 as compared to the same period in 2013.  The increase in provision expense for the three months ended September 30, 2014 was primarily driven by growth in the non-acquired loan portfolio as compared to the same period in 2013 while the decrease in provision expense for the nine months ended September 30, 2014 was primarily driven by improving credit quality for our non-acquired loan portfolio as compared to the same period in 2013.    We include five years of historical losses in our allowance calculation for all periods.  The use of this timeframe has recently resulted in an overall increase in historical losses.  However, offsetting the upward trend in losses is a change in the portfolio mix where loan growth has occurred.  Specifically, positive growth occurred in nonresidential loans as a percentage of the loan portfolio, which carries a lower historical loss rate compared to other loan categories.  In addition, criticized and classified loans have decreased as a percentage of the overall loan portfolio. 

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

	For the Three Months				For the Nine Months
	Ended September 30,				Ended September 30,
	2014		2013		2014		2013
	(Dollars in thousands)
Provision for loan losses – non-acquired	$	575	$	350	$	1,150	$	1,440
Provision for loan losses – acquired  non-credit impaired	$	-	$	-	$	-	$	-
Acquired credit impaired:
Non-covered	$	-	$	-	$	44	$	-
Covered		65		-		90		63
Provision for loan losses acquired credit impaired loans	$	65	$	-	$	134	$	63
Provision for loan losses	$	640	$	350	$	1,284	$	1,503

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 to the Consolidated Financial Statements in this Form 10-Q.

75

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

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

	Three Months Ended
	September 30,
	2014			2013			$ Chg		% Chg
	(Dollars in thousands)
Service charges on deposit accounts	$	1,612		$	1,577		$	35	2.2	%
Bankcard services income		919			852			67	7.9
Other service charges, commissions and fees		178			126			52	41.3
Brokerage fees		644			561			83	14.8
Mortgage banking activities		6,723			1,963			4,760	242.5
Bank-owned life insurance		190			200			(10)	(5.0)
Other		49			138			(89)	(64.5)
Total noninterest income	$	10,315		$	5,417		$	4,898	90.4	%
Noninterest income as a percentage of
average assets (annualized)		2.86	%		1.70	%

The increase in mortgage banking activities was primarily driven by increased volume resulting from our focus of expanding our mortgage banking business compared to the prior year.  We anticipate this positive trend in mortgage banking activities to continue to grow throughout 2014. 

	Nine Months Ended
	September 30,
	2014			2013			$ Chg		% Chg
	(Dollars in thousands)
Service charges on deposit accounts	$	4,558		$	4,028		$	530	13.2	%
Bankcard services income		2,749			2,445			304	12.4
Other service charges, commissions and fees		494			370			124	33.5
Brokerage fees		1,825			1,578			247	15.7
Mortgage banking activities		13,915			7,582			6,333	83.5
Bank-owned life insurance		566			603			(37)	(6.1)
Other		251			356			(105)	(29.5)
Total noninterest income	$	24,358		$	16,962		$	7,396	43.6	%
Noninterest income as a percentage of
average assets (annualized)		2.25	%		1.77	%

The increase in mortgage banking activities was primarily driven by increased volume resulting in our focus of expanding our mortgage banking business compared to the prior year.  We anticipate this positive trend in mortgage banking activities to continue to grow throughout 2014.  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 increase in bankcard services income was also primarily driven by growth in our overall customer base.      

76

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 acquired OREO, foreclosed acquired asset expenses and FDIC loss-share clawback expense, is presented in the tables below.

	Three Months Ended
	September 30,
	2014			2013			$ Chg		% Chg
	(Dollars in thousands)
Salaries and employee benefits	$	11,382		$	8,108		$	3,274	40.4	%
Equipment		1,171			1,029			142	13.8
Occupancy		1,063			903			160	17.7
Advertising and marketing		288			335			(47)	(14.0)
Legal and accounting		182			207			(25)	(12.1)
Consulting & other professional fees		264			133			131	98.5
Directors fees and retirement		160			157			3	1.9
Telecommunications		252			340			(88)	(25.9)
Supplies		133			140			(7)	(5.0)
Data processing fees		828			995			(167)	(16.8)
Loss (gain) on sales and write-downs of OREO		8			335			(327)	(97.6)
Foreclosed asset expenses		77			337			(260)	(77.2)
FDIC insurance and other regulatory fees		274			293			(19)	(6.5)
Deposit intangible expenses		186			204			(18)	(8.8)
Other operating		1,641			1,092			549	50.3
Total noninterest expenses	$	17,909		$	14,608		$	3,301	22.6	%
Noninterest expenses as a percentage of
average assets (annualized)		4.96	%		4.58	%

The increase in salaries and employee benefits was primarily due to the net hiring of 85 full-time equivalent employees (“FTEs”), excluding Alarion FTEs, a 20.6% increase from the prior year, primarily related to the hiring 83 FTEs for our mortgage banking expansion and an increase of three FTEs for our banking area offset by a reduction in our investments area of one FTE.

77

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

	Nine Months Ended
	September 30,
	2014			2013			$ Chg		% Chg
	(Dollars in thousands)
Salaries and employee benefits	$	30,272		$	22,723		$	7,549	33.2	%
Equipment		4,352			3,679			673	18.3
Occupancy		2,030			1,757			273	15.5
Advertising and marketing		737			871			(134)	(15.4)
Legal and accounting		886			628			258	41.1
Consulting & other professional fees		534			229			305	133.2
Directors fees and retirement		318			314			4	1.3
Telecommunications		1,692			1,878			(186)	(9.9)
Supplies		258			274			(16)	(5.8)
Data processing fees		1,738			1,946			(208)	(10.7)
Loss (gain) on sales and write-downs of OREO		433			368			65	17.7
Foreclosed asset expenses		246			779			(533)	(68.4)
FDIC insurance and other regulatory fees		817			827			(10)	(1.2)
Deposit intangible expenses		574			609			(35)	(5.7)
Other operating		4,508			3,508			1,000	28.5
Total noninterest expenses	$	49,395		$	40,390		$	9,005	22.3	%
Noninterest expenses as a percentage of
average assets (annualized)		4.56	%		4.22	%

The increase in salaries and employee benefits was primarily due to the net hiring of 85 full-time equivalent employees (“FTEs”), excluding Alarion FTEs, a 20.6% increase from the prior year, primarily related to the hiring 83 FTEs for our mortgage banking expansion and an increase of three FTEs for our banking area offset by a reduction in our investments area of one FTE.  The increases in equipment, occupancy, consulting & other professional fees, and other operating expenses were primarily due to the mortgage banking expansion.

78

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

Income Tax Expense.  Income tax expense for the three months ended September 30, 2014 increased $537,000 compared to the same period in 2013 while the income tax expense for the nine months ended September 30, 2014 declined $1.1 million compared to the same period in 2013.  The effective tax rate for the three and nine months ended September 30, 2014 was 34.0% and 30.0%, respectively, compared to 26.2% and 29.0%, respectively, for the same periods in 2013.

Accounting for Acquired Assets

Noninterest Income. The negative accretion for the FDIC loss-share receivable for the three and nine months ended September 30, 2014, increased $1.2 million and $802,000, respectively, compared to the same periods in 2013.  The negative accretion for the FDIC loss-share receivable is expected to decline as a percentage of noninterest income throughout 2014 but still remain elevated as a large portion of our FDIC loss-share receivable will be cleared with negative accretion.

Noninterest Expense. Foreclosed acquired asset expense for the three and nine months ended September 30, 2014, decreased $149,000 and $252,000, respectively, compared to the same periods in 2013.   The FDIC clawback expense for the three months ended September 30, 2014 decreased $321,000 compared to the same period in 2013 while the FDIC clawback expense for the nine months ended September 30, 2014 increased $412,000 compared to the same period in 2013.  We anticipate the FDIC clawback expense to remain elevated for the remainder of 2014 and then decline on a percentage of noninterest expense throughout 2015.  The net gain on sales and write-downs of acquired OREO for the three and nine months ended September 30, 2014, declined $169,000 and $305,000, respectively, compared to the same periods 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 September 30, 2014, the Bank had total federal funds credit lines with ten correspondent banks of $82.5 million, with no outstanding advances.  The Bank also maintains a credit facility with the FHLB of $204.0 million with total outstanding advances of $186.0 million at September 30, 2014.

At September 30, 2014, total deposits increased $264.8 million, or 24.6%, to $1.341 billion compared to $1.076 billion at December 31, 2013, primarily driven by growth from the Alarion acquisition of $231.1 million and core deposit growth of $43.3 million offset in part by reductions in wholesale deposits of $5.9 million and time deposits of $3.7 million.  Federal funds purchased and securities sold under agreements to repurchase increased $5.1 million, or 13.7%, to $42.8 million at September 30, 2014, compared to $37.7 million at December 31, 2013, primarily driven by growth from Alarion acquisition of $3.2 million.  Also, FHLB advances increased $59.0 million, or 44.9%, to $190.4 million at September 30, 2014, compared to $131.4 million at December 31, 2013 of which $13.0 million resulted from the Alarion acquisition. The increase in FHLB advances resulted from funding of non-acquired loan growth and loans held for sale.

79

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 September 30, 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 nine months ended September 30, 2014, detail cash flows from operating, investing and financing activities.  At September 30, 2014, net cash used in investing activities and operating activities was $75.8 million and $12.8 million, respectively, offset in part by net cash provided by financing activities of $80.6 million resulting in a net decline in cash and due from banks of $8.0 million to $26.8 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.

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

Regulatory Capital Ratios for the Company and the Bank at September 30, 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 September 30, 2014, with regulatory capital requirements.  These calculations are based on total risk weighted assets of $1.264 billion for the Company and $1.250 billion for the Bank as of September 30, 2014, and average total assets of $1.5 billion for the Company and $1.5 billion for the Bank for the three months ended September 30, 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.

									Minimum Required to
									Be Well Capitalized
					For Capital				Under Prompt
					Adequacy				Corrective Action
	Actual				Purposes				Provisions
	Amount		Ratio		Amount		Ratio		Amount		Ratio
	(Dollars in thousands)
Total Capital to Risk Weighted Assets
Consolidated	$	161,691	12.8	%	$	101,114	8.0	%		N/A
HeritageBank of the South		152,245	12.2	%		99,994	8.0	%	$	124,993	10.0	%
Tier I Capital to Risk Weighted Assets
Consolidated		151,698	12.0	%		50,557	4.0	%		N/A
HeritageBank of the South		142,252	11.4	%		49,997	4.0	%		74,996	6.0	%
Tier I Capital to Average Total Assets
Consolidated		151,698	10.3	%		58,833	4.0	%		N/A
HeritageBank of the South		142,252	9.7	%		58,648	4.0	%		73,310	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 September 30, 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	20.5	%
+300	15.7	%
+200	12.2	%
+100	7.3	%
(100)	(9.7)	%

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Quarterly Financial Summary - Unaudited

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

	For the Three Months Ended
	September		June		March		December		September
	30, 2014		30, 2014		31, 2014		31, 2013		30, 2013
	(dollars in thousands expect per share data)
Results of Operations:
Net interest income	$	15,929	$	15,774	$	13,971	$	16,253	$	13,558
Provision for loan losses		640		474		170		232		350
Net interest income after provision for
loan losses		15,289		15,300		13,801		16,021		13,208
Total noninterest income		8,274		5,286		3,487		4,536		3,918
Total noninterest expense		20,597		18,116		15,476		15,706		15,334
Income before income taxes		2,966		2,470		1,812		4,851		1,792
Applicable income tax		1,007		698		469		1,446		470
Net income	$	1,959	$	1,772	$	1,343	$	3,405	$	1,322
Per Share Data:
Weighted average shares – basic		7,485,528		7,436,717		7,422,044		7,407,722		7,371,804
Weighted average shares – diluted		7,676,233		7,607,501		7,581,775		7,530,606		7,483,812
Basic earnings per share	$	0.26	$	0.24	$	0.18	$	0.46	$	0.18
Diluted earnings per share		0.26		0.23		0.18		0.45		0.18

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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 September 30, 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 September 30, 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 September 30, 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 September 30, 2014.

				Number of	Maximum
	Total			Shares Purchased	Number of Shares
	Number			as Part of	that may yet be
	of Shares	Average Price		Publicly Announced	Purchased Under the
	Purchased	Paid Per Share		Plans or Programs	Plans or Programs
January	-	$	-	-	344,179
February	-		-	-	344,179
March	-		-	-	344,179
April	-		-	-	344,179
June	-		-	-	344,179
July	4,296		19.85	4,296	339,883
August	-		-	-	339,883
September	-		-	-	339,883
Total	4,296	$	19.85	4,296	339,883

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
2.2	Branch Sale Agreement dated October 7, 2014, between HeritageBank of the South and The PrivateBank and Trust Company	b
3.1	Articles Supplementary to the Articles of Incorporation	c
10.1	Employment agreement between Brian D. Schmitt and HeritageBank  of the South	d
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.
b	Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc. with the SEC on October 8, 2014.
c	Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc. with the SEC on October 2, 2014.
d	Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc. with the SEC on October 16, 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:   November 10, 2014	By:	/s/ O. Leonard Dorminey
		O. Leonard Dorminey
		President and Chief Executive Officer
		(Principal Executive Officer)
Date:   November 10, 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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