Heritage Bankshares (HBKS) 10-Q 2012 Q3 Quarterly report

U. S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

FORM 10-Q

x Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2012

¨ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from             to             

Commission File Number 0-11255

HERITAGE BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

Virginia	54-1234322
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification Number)

150 Granby Street, Suite 150, Norfolk, Virginia 23510

(Address of principal executive office)

(757) 648-1700

(Issuer’s telephone number)

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

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

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. (Check one):

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

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

A total of 2,275,891 shares of the registrant’s common stock were outstanding as of October 31, 2012.

TABLE OF CONTENTS

	Page No.
Part I. FINANCIAL INFORMATION
Item 1 - Financial Statements (Unaudited)
Consolidated Balance Sheets September 30, 2012 and December 31, 2011		3
Consolidated Statements of Income Three and Nine Months Ended September 30, 2012 and 2011		4
Consolidated Statements of Cash Flows Nine Months Ended September 30, 2012 and 2011		5
Consolidated Statements of Comprehensive Income Three and Nine Months Ended September  30, 2012 and 2011		6
Notes to Consolidated Financial Statements		7
Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operation		22
Item 3 - Quantitative and Qualitative Disclosures About Market Risk		26
Item 4 - Controls and Procedures		26
Part II. OTHER INFORMATION
Item 1 - Legal Proceedings		26
Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds		26
Item 3 - Defaults Upon Senior Securities		26
Item 4 - Mine Safety Disclosures		26
Item 5 - Other Information		27
Item 6 - Exhibits		27
Signatures		28

2

Part I. FINANCIAL INFORMATION

Item 1 Financial Statements

HERITAGE BANKSHARES, INC.

CONSOLIDATED BALANCE SHEETS

	At September 2012 (unaudited)		At December  31, 2011 (audited)
	(in thousands except share data)
ASSETS
Cash and due from banks	$	5,693	$	5,335
Interest-bearing deposits in other banks		33,502		8,646
Federal funds sold		28		33
Total cash and cash equivalents		39,223		14,014
Certificates of deposit in other banks		13,695		—
Securities available for sale, at fair value		26,188		45,310
Loans, net
Held for investment, net of allowance for loan losses		213,082		213,183
Accrued interest receivable		588		694
Stock in Federal Reserve Bank, at cost		594		591
Stock in Federal Home Loan Bank of Atlanta, at cost		440		834
Premises and equipment, net		10,743		11,029
Other real estate owned		591		1,719
Bank-owned life insurance		5,648		5,616
Other assets		1,904		1,594
Total assets	$	312,696	$	294,584
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities
Deposits
Noninterest-bearing	$	100,960	$	92,839
Interest-bearing		171,664		157,139
Total deposits		272,624		249,978
Federal Home Loan Bank Advances		—		4,000
Securities sold under agreements to repurchase		212		1,502
Other borrowings		545		782
Accrued interest payable		36		83
Other liabilities		2,074		1,802
Total liabilities		275,491		258,147
Commitments and contingencies		—		—
Stockholders’ equity
Preferred stock, no par value - 1,000,000 shares authorized:
Senior non-cumulative perpetual preferred stock, Series C, 7,800 shares issued and outstanding at both September 30, 2012 and December 31, 2011		7,800		7,800
Common stock, $5 par value - 6,000,000 shares authorized;
2,275,891 shares and 2,304,965 shares issued and outstanding at September 30, 2012 and December 31, 2011, respectively		11,379		11,525
Additional paid-in capital		6,732		6,704
Retained earnings		11,169		9,967
Accumulated other comprehensive income, net		125		441
Total stockholders’ equity		37,205		36,437
Total liabilities and stockholders’ equity	$	312,696	$	294,584

See accompanying notes to consolidated financial statements.

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HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	(in thousands except share and per share data)
Interest income
Interest income and fees on loans	$	2,485		$	2,833		$	7,740		$	8,543
Interest on taxable investment securities		174			193			716			514
Other interest and dividend income		61			37			106			112
Total interest income		2,720			3,063			8,562			9,169
Interest expense
Deposits		228			309			702			923
Borrowings		6			10			23			36
Total interest expense		234			319			725			959
Net interest income		2,486			2,744			7,837			8,210
Provision for loan losses		—			33			35			44
Net interest income after provision for loan losses		2,486			2,711			7,802			8,166
Noninterest income
Service charges on deposit accounts		67			87			195			259
Late charges and other fees on loans		11			25			77			57
Gain on sale of investment securities		284			—			284			87
Income from bank-owned life insurance		43			—			161			—
Other		87			85			241			224
Total noninterest income		492			197			958			627
Noninterest expense
Compensation		1,008			1,090			3,179			3,283
Data processing		160			148			471			435
Occupancy		221			234			668			622
Furniture and equipment		161			142			446			438
Taxes and licenses		79			86			239			252
Professional fees		57			74			243			292
FDIC assessment		39			37			116			137
(Gain)loss on sale or impairment of other real estate owned		(10	)		—			41			1
Other		282			250			743			773
Total noninterest expense		1,997			2,061			6,146			6,233
Income before provision for income taxes		981			847			2,614			2,560
Provision for income taxes		288			299			749			861
Net income	$	693		$	548		$	1,865		$	1,699
Preferred stock dividend and accretion of discount		(20	)		(252	)		(86	)		(562	)
Net income available to common stockholders	$	673		$	296		$	1,779		$	1,137
Earnings per common share
Basic	$	0.30		$	0.13		$	0.77		$	0.49
Diluted	$	0.29		$	0.13		$	0.76		$	0.49
Dividends per share	$	0.06		$	0.06		$	0.18		$	0.18
Weighted average shares outstanding - basic		2,275,891			2,303,107			2,295,413			2,305,652
Effect of dilutive equity awards		54,362			13,441			49,385			11,246
Weighted average shares outstanding - diluted		2,330,253			2,316,548			2,344,798			2,316,898

See accompanying notes to consolidated financial statements.

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HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

	Nine Months Ended September 30,
	2012			2011
	(in thousands)
Cash flows from operating activities:
Net income	$	1,865		$	1,699
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan loss		35			44
Amortization of loan yield adjustments, net		209			242
Depreciation, amortization and accretion, net		462			451
Stock based compensation		79			68
Deferred compensation		45			28
Exercise of stock options tax benefit		1			—
Net (gains) losses on:
Sale of securities		(284	)		(87	)
Sale or impairment of other real estate owned		41			—
Net income on bank owned life insurance		(161	)		—
Changes in assets/liabilities, net:
Increase in interest receivable and other assets		(43	)		(3	)
Increase (decrease) in interest payable and other liabilities		(154	)		3
Net cash provided by operating activities		2,095			2,445
Cash flows from investing activities:
Proceeds from maturities and principal repayments of securities available for sale		23,200			6,487
Purchases of securities available for sale		(18,996	)		(36,921	)
Proceeds from sales of securities available for sale		14,696			6,005
Proceeds from sale of other real estate owned		1,535			—
Net decrease (increase) in certificates of deposit in other banks		(13,695	)		2,011
Net increase in loans held for investment		(239	)		(311	)
Purchases of Federal Home Loan Bank stock and Federal Reserve Bank stock		(59	)		(4	)
Redemption of FHLB stock and Federal Reserve Bank stock		450			679
Purchases of premises and equipment		(166	)		(292	)
Purchases of and premiums paid for bank-owned life insurance		(12	)		(13	)
Proceeds from bank-owned life insurance		141			—
Net cash provided by/(used for) investing activities		6,855			(22,359	)
Cash flows from financing activities:
Proceeds from exercise of stock options		8			—
Net increase in deposits		22,646			33,494
Net decrease in Federal Home Loan Bank advances		(4,000	)		—
Net decrease in securities sold under agreements to repurchase		(1,290	)		(833	)
Repayments of other borrowings		(237	)		(228	)
Proceeds from issuance of preferred stock		—			7,788
Redemption of preferred stock		—			(10,406	)
Retirement of common stock		(368	)		(55	)
Cash dividends paid		(500	)		(810	)
Net cash provided by financing activities		16,259			28,950
Increase in cash and cash equivalents		25,209			9,036
Cash and cash equivalents, beginning of period		14,014			16,380
Cash and cash equivalents, end of period	$	39,223		$	25,416
Supplemental disclosure:
Interest paid	$	773		$	965
Income taxes paid	$	813		$	1,079
Noncash financing activities:
Transfer of loans to other real estate owned	$	96		$	25

See accompanying notes to consolidated financial statements.

5

HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	(in thousands)						(in thousands)
Net income for period ended September 30	$	693		$	548		$	1,865		$	1,699
Unrealized holding (gains)losses on securities available for sale		(66	)		191			(196	)		69
Tax effect on unrealized (gains)losses		22			(65	)		67			(23	)
Realized gains on sales of available for sale securities		(284	)		—			(284	)		(87	)
Tax effect on realized gains		97			—			97			29
Total comprehensive income	$	462		$	674		$	1,549		$	1,687

See accompanying notes to consolidated financial statements.

6

HERITAGE BANKSHARES, INC.

Notes to Consolidated Financial Statements

Note 1 – Principles of Consolidation and Basis of Presentation

The accompanying unaudited consolidated financial statements include the accounts of Heritage Bankshares, Inc. and its wholly-owned subsidiary, Heritage Bank. All significant intercompany balances and transactions have been eliminated in consolidation.

Heritage Bankshares, Inc. (the “Company”) is a bank holding company incorporated under the laws of the Commonwealth of Virginia in 1983, and the Company serves as the holding company for its wholly-owned subsidiaries. The Company’s only subsidiary, Heritage Bank (the “Bank”), is a state banking corporation engaged in the general commercial and retail banking business. The Bank is a full-service bank conducting a general commercial and consumer banking business with its customers located throughout the Hampton Roads area of Virginia.

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial reporting and with the instructions for Form 10-Q. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. These unaudited consolidated financial statements should be read in conjunction with and with reference to the audited consolidated financial statements and accompanying footnotes included in the Company’s annual report on Form 10-K for the year ended December 31, 2011. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results could differ from those estimates. Certain reclassifications have been made to prior year financial statements to conform to current period presentation.

The Company believes its critical accounting policies are those that are particularly sensitive in terms of judgments and the extent to which estimates are used, and such policies include (a) the valuation of the allowance for loan losses and the impairment of loans, (b) the impairment of financial investments and other accounts, (c) the deferral of loan fees and direct loan origination costs, and (d) accounting for income taxes.

Allowance for Loan Losses; Impairment of Loans.The Bank maintains an allowance for loan losses at a level that, in management’s judgment, is adequate to absorb estimated credit losses on existing loans. The amount of the allowance is affected by: (1) loan charge-offs, which decrease the allowance, (2) recoveries on loans previously charged-off, which increase the allowance, and (3) the provision for loan losses charged to income, which increases the allowance.

The Bank analyzes its loan portfolio through ongoing credit review processes and constructs a comprehensive allowance analysis for its loan portfolio at least quarterly. This analysis includes two basic elements: (1) specific allowances for individual loans, and (2) general allowances for loan portfolio segments, which factor in historical loan loss experience and delinquency rates for the Bank and the banking industry and numerous other environmental factors.

The Bank evaluates various loans individually for impairment based on guidance for receivables. The evaluation is based upon either discounted cash flows or collateral evaluations. If the evaluation shows that a particular loan is impaired, then a specific reserve is established, or a charge-off is made, for the amount of any impairment.

For loans without an individual measure of impairment, the Bank makes estimates of losses for groups of loans in accordance with guidance for contingencies. As part of the loan loss reserve methodology, loans are placed into one of four major categories or segments of loans: (1) commercial and industrial loans, (2) consumer loans, (3) 1-4 family residential loans (including home equity loans and lines), and (4) multi-family and other commercial real estate loans.

7

The Bank then considers the impact of various bank, industry, economic and other environmental factors and documents, which are further used in the analysis.

The Bank’s allowance for loan losses is divided into four distinct portions: (1) Historical – an amount based on the Bank’s actual net charge-offs; (2) Impaired Loans – an amount for specific allocations on significant individual credits as prescribed by guidance for receivables; (3) Loan Segments – an amount to adjust the historical allocation for the four loan segments based on environmental factors as provided by guidance for contingencies; and (4) Unallocated – an amount to reflect the imprecision inherent in these calculations.

Impairment of Financial Investments and Other Accounts. Impairment of investment securities, other equity investments and other asset accounts results in a write-down that must be included in net income when the fair value of the asset declines below cost and the decline is other-than-temporary. The fair values of these investments and other assets are subject to change, as they are influenced by market conditions and management decisions.

Deferral of Loan Fees and Direct Loan Origination Costs. Generally accepted accounting principles relating to accounts receivable require that loan fees and direct loan origination costs be deferred and recognized as an adjustment to the loan’s yield. While the amount of fees to be deferred is generally apparent in the origination of a loan, the Company utilizes estimates to determine the amount of deferred direct origination costs, especially payroll costs, that are attributable to the loan origination process. Management’s estimates of the amount of costs associated with successful loan origination activities are reviewed and updated annually.

Accounting for Income Taxes. The determination of the Company’s effective tax rate requires judgment. In the ordinary course of business, there are transactions and calculations for which the ultimate tax outcomes are uncertain. In addition, the Company’s tax returns are subject to audit by various tax authorities. Although we believe that our estimates are reasonable, there can be no assurance that the final tax outcome will not be materially different than that which is reflected in the income tax provision and accrual.

Subsequent Events. In accordance with accounting guidance, the Company has evaluated events and transactions for potential recognition or disclosure in these financial statements through the date the financial statements were issued.

Recent Accounting Pronouncements

There were no authoritative pronouncements that would have a material impact on the Company during the quarter ending September 30, 2012.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

Note 2 – Share-Based Compensation

The following table presents a summary of stock option activity for the period of January 1, 2012 through September 30, 2012.

	Shares			Weighted Average Exercise Price			Weighted Average Remaining Term(years)		Aggregate Intrinsic Value
									(in thousands)
Outstanding at January 1, 2012		235,800		$	12.65
Granted		—			—
Exercised		(1,000	)		(7.50	)
Forfeited/expired		(800	)		(12.12	)
Outstanding at September 30, 2012		234,000		$	12.67			4.0	$	133
Exercisable at September 30, 2012		226,400		$	12.75			3.9	$	121

8

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the quarter and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on September 30, 2012. The amount changes based on the fair market value of the Company’s common stock, as reflected by stock market prices. The Company’s current policy is to issue new shares of common stock to satisfy option exercises. The aggregate intrinsic value of options exercised during the nine months ended September 30, 2012 was $3,700. Cash received from exercises of options during the first nine months of 2012 was $7,500. There were no options exercised during the nine months ended September 30, 2011.

On January 25, 2012, the Company’s Board of Directors granted, effective February 1, 2012, 43,600 shares of restricted stock to certain executives under the Heritage 2006 Equity Incentive Plan, as amended (“2006 Incentive Plan”). The shares vest at a rate of 20% over a five year period beginning on February 1, 2013 and on each February 1 thereafter. Upon the death or permanent disability of the executive or a change of control of the Company, any remaining unvested shares will vest immediately.

As defined in the 2006 Incentive Plan, fair value of the shares was measured by the closing price of a share of the Company’s common stock on the OTC Markets Group, Inc. reporting system on the grant date of the applicable award or, if the Company’s shares were not traded on the grant-date, then the closing price of a share of common stock on the OTC Markets Group, Inc. reporting system on the next preceding date on which a trade occurred. In addition, because the share-recipients are not entitled to dividends until the shares vest, the grant date fair value of the award was reduced by the present value of the dividends expected to be paid on the underlying shares during the service period, discounted at the appropriate risk-free interest rate.

The following table presents a summary of restricted stock award activity for the period of January 1, 2012 to September 30, 2012.

	Shares		Fair Value at Grant Date
Outstanding at January 1, 2012		—		—
Granted		43,600	$	11.28
Vested		—		—
Forfeited/expired		—		—
Outstanding at September 30, 2012		43,600	$	11.28

The amount charged against income, before income tax benefit of $22,295, in relation to stock-based payment arrangements was $79,059 for the nine months ended September 30, 2012. The amount charged against income, before income tax benefit of $1,423, in relation to stock-based payment arrangements was $67,642 for the nine months ended September 30, 2011. At September 30, 2012, unrecognized compensation expense, net of estimated forfeitures, related to unvested stock option and restricted stock grants was $433,754 and is currently expected to be recognized over a weighted average period of 2.2 years as follows:

	Stock-Based Compensation Expense
	(in thousands)
At September 30, 2012:
2012	$	28
2013		102
2014		98
2015		99
2016		99
2017		8
Total	$	434

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Note 3 – Disclosure About Fair Value of Financial Instruments

The following summary presents an estimate of the fair value of the Company’s financial instruments. Because no active market readily exists for a portion of the Company’s financial instruments, fair values of some financial instruments are based on estimates using present value and other valuation techniques. Much of the information used to determine fair value is highly subjective in nature and therefore the results may not be precise. The subjective factors include, among other things, estimates of cash flows, risk characteristics, credit quality and interest rates, all of which are subject to change. Accordingly, the amounts that will actually be realized or paid upon settlement or maturity of the various instruments could be significantly different.

The following table presents the carrying amounts, fair value and level of input of those financial instruments whose fair value differs from carrying amount at September 30, 2012 and December 31, 2011.

	At September 30, 2012
	Carrying Amount		Fair Value		Level 1		Level 2		Level 3
	(in thousands)
Financial Assets:
Loans held for investment	$	213,082	$	216,733	$	—	$	1,494	$	215,239
Financial liabilities:
Deposits	$	272,624	$	272,691	$	—	$	272,691	$	—
Other borrowings		545		573		—		—		573

	At December 31, 2011
	Carrying Amount		Fair Value		Level 1		Level 2		Level 3
	(in thousands)
Financial Assets:
Loans held for investment	$	213,183	$	219,056	$	—	$	—	$	219,056
Financial liabilities:
Deposits	$	249,978	$	250,167	$	—	$	250,167	$	—
Other borrowings		782		823		—		—		823

Fair Value Hierarchy

“Fair Value Measurements and Disclosures” establishes three levels of inputs that may be used to measure fair value:

Level 1: Valuation is based on quoted prices in active markets for identical assets or liabilities.

Level 2: Valuation is based on observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.

Level 3: Valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

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Investment Securities Available for Sale

Investment securities available for sale are recorded at fair value on a recurring basis. Fair value is measured by quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 2 securities include Treasury notes and bills, mortgage-backed securities issued by government sponsored entities, municipal bonds and other securities issued by government sponsored agencies.

Loans

The Company does not record loans at fair value on a recurring basis. Fair value is measured using modeling software that incorporates various assumptions based on observable market data such as interest rate fluctuations and cash flow data. From time to time, a loan is considered impaired. Loans that are deemed to be impaired are valued in accordance with guidance related to receivables. The fair value of impaired loans is estimated using one of several methods, including collateral value, liquidation value and discounted cash flows.

When the fair value of collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as Level 2. If the fair value of the loan is based on criteria other than observable market prices or current appraised value, the loan is recorded as Level 3.

Other Real Estate Owned

Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Foreclosed assets are carried at the lower of the carrying value or fair value. Once management’s intentions change regarding the utilization of its own property, that property is transferred to other real estate owned at fair value. Fair value is based upon independent observable market prices or appraised values of the collateral, which the Company considers to be Level 2 inputs. The Company may, from time to time, revise its evaluation of the fair value of a property and provide an allowance based on subjective criteria such as declines in assessed value, which the Company considers to be Level 3 inputs.

Other Financial Assets

Other financial assets are recorded at fair value on a recurring basis. Fair value is based on quoted market prices which are considered to be Level 2 inputs.

General

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

Assets Recorded at Fair Value on a Recurring Basis

	At September 30, 2012
	Total		Level 1		Level 2		Level 3
	(in thousands)
Investment in securities available for sale:
U.S. Treasury notes	$	2,031	$	—	$	2,031	$	—
U.S. government sponsored enterprises		24,157		—		24,157		—
Other financial assets		284		—		284		—
Total assets at fair value	$	26,472	$	—	$	26,472	$	—

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Assets Recorded at Fair Value on a Recurring Basis

	At December 31, 2011
	Total		Level 1		Level 2		Level 3
	(in thousands)
Investment in securities available for sale:
U.S. Treasury notes	$	2,043	$	—	$	2,043	$	—
U.S. government sponsored enterprises		34,188		—		34,188		—
Mortgage-backed securities		9,079		—		9,079		—
Other financial assets		245		—		245		—
Total assets at fair value	$	45,555	$	—	$	45,555	$	—

Assets Recorded at Fair Value on a Non-Recurring Basis

	At September 30, 2012
	Total		Level 1		Level 2		Level 3
	(in thousands)
Impaired loans
Real estate-commercial	$	794	$	—	$	794	$	—
Real estate-construction		791		—		791		—
Other real estate owned		591		—		591		—
Total assets at fair value	$	2,176	$	—	$	2,176	$	—

	At December 31, 2011
	Total		Level 1		Level 2		Level 3
	(in thousands)
Other real estate owned	$	1,719	$	—	$	1,719	$	—
Total assets at fair value	$	1,719	$	—	$	1,719	$	—

Note 4 – Securities

The tables below present amortized cost, unrealized gains and losses, and fair value of the Company’s investments in securities available for sale at September 30, 2012 and December 31, 2011.

	At September 30, 2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(in thousands)
Securities Available for Sale
U.S Treasury notes	$	2,003	$	28	$	—	$	2,031
U.S. government sponsored enterprises		23,996		161		—		24,157
Total securities available for sale	$	25,999	$	189	$	—	$	26,188
Total securities (1)	$	25,999	$	189	$	—	$	26,188

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	At December 31, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(in thousands)
Securities Available for Sale
U.S Treasury Notes	$	2,004	$	39	$	—	$	2,043
U.S. government sponsored enterprises		34,000		188		—		34,188
Mortgage-backed securities		8,637		442		—		9,079
Total securities available for sale	$	44,641	$	669	$	—	$	45,310
Total securities (1)	$	44,641	$	669	$	—	$	45,310

(1) At September 30, 2012 and December 31, 2011, the Company held no securities classified as held to maturity.

There were no investment securities with unrealized losses at either September 30, 2012 or December 31, 2011. Current year unrealized losses on investment securities, if any, are a result of changes in interest rates during the periods. Unrealized losses on investment securities, if any, are considered by management to be temporary given the credit ratings on these investment securities and the short duration of any unrealized loss due to credit quality.

The amortized cost and fair value of investment securities at September 30, 2012, by contractual maturity, are reflected below. Actual maturities will differ from contractual maturities because some securities may be called or prepaid prior to their contractual maturity.

	Securities Available for Sale
	Amortized Cost		Fair Value
	(in thousands)
Due in one year or less	$	—	$	—
Due after one year through five years		2,003		2,031
Due after five years through ten years		23,996		24,157
Due after ten years		—		—
Total	$	25,999	$	26,188

Gross proceeds from sales of securities available for sale were $4,696,000 for the third quarter of 2012 accumulating to $14,696,000 for the first nine months of 2012. Gross realized gains associated with these 2012 sales were $284,000 for both the third quarter and first nine months of 2012. There were no sales of securities available for sale in the third quarter of 2011, and gross proceeds from sales of securities available for sale were $6,005,000 for the nine month period ended September 30, 2011. Gross realized gains associated with these 2011 sales were $87,000. There were no gross losses associated with the sale of securities available for sale during either 2012 or 2011. Gains and losses on the sale of investment securities are recorded as of the trade date and are determined using the specific identification method.

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Note 5 – Loans held for investment, net

Loans at the dates indicated consisted of the following:

	At September 30, 2012			At December 31, 2011
	(in thousands)
Commercial	$	36,268		$	39,212
Real estate-commercial		123,600			110,350
Real estate-construction and land		6,650			14,075
Real estate-residential 1-4		46,778			49,894
Consumer		1,861			1,743
Total loans		215,157			215,274
Allowance for loan losses		(2,075	)		(2,091	)
Total loans, net	$	213,082		$	213,183

All loan amounts are presented net of unearned fees and costs for September 30, 2012 and December 31, 2011.

Nonperforming assets at the dates indicated were:

	At September 30, 2012		At December 31, 2011
	(in thousands)
Nonperforming loans	$	—	$	—
Real estate owned		591		1,719
Total nonperforming assets	$	591	$	1,719

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A summary of the activity in the allowance for loan losses account for the periods indicated is as follows:

	At September 30,
	2012			2011
	(in thousands)
Balance, beginning of year	$	2,091		$	2,090
Provision for loan losses		35			44
Loans charged-off
Commercial		(7	)		(1	)
Real estate-commercial		—			—
Real estate-construction and land		—			(29	)
Real estate-residential 1-4		(63	)		—
Consumer		(1	)		(1	)
Total loans charged-off		(71	)		(31	)
Loans recovered
Commercial		—			2
Real estate-commercial		—			—
Real estate-construction and land		20			—
Real estate-residential 1-4		—			48
Consumer		—			—
Total loans recovered		20			50
Net recoveries (charge-offs)		(51	)		19
Balance, end of period	$	2,075		$	2,153

The following table presents the aging analysis of the Company’s loan portfolio at September 30, 2012:

	30-59 days past due		60-89 days past due		90 days or more past due		Total past due		Current		Total loans outstanding		Loans 90 days past due and accruing
	(in thousands)
Commercial	$	—	$	13	$	—	$	13	$	36,255	$	36,268	$	—
Real estate-commercial		—		—		—		—		123,600		123,600		—
Real estate-construction and land		—		—		—		—		6,650		6,650		—
Real estate-residential 1-4		490		—		—		490		46,288		46,778		—
Consumer		—		—		—		—		1,861		1,861		—
Total loans	$	490	$	13	$	—	$	503	$	214,654	$	215,157	$	—

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The following table presents the aging analysis of the Company’s loan portfolio at December 31, 2011:

	30-59 days past due		60-89 days past due		90 days or more past due		Total past due		Current		Total loans outstanding		Loans 90 days past due and accruing
	(in thousands)
Commercial	$	—	$	—	$	—	$	—	$	39,212	$	39,212	$	—
Real estate-commercial		—		—		—		—		110,350		110,350		—
Real estate-construction and land		—		—		—		—		14,075		14,075		—
Real estate-residential 1-4		33		—		—		33		49,861		49,894		—
Consumer		—		—		—		—		1,743		1,743		—
Total loans	$	33	$	—	$	—	$	33	$	215,241	$	215,274	$	—

The Bank utilizes an internal system based on payment history as its primary credit indicator on its commercial and commercial real estate loan portfolios. Loans that consistently meet an established historical payment schedule are not given further scrutiny other than that given in the ordinary course of business. Any loan that misses its normal payment date falls into a category of heightened scrutiny to determine whether a potential weakness exists. Based upon the collection and analysis of certain data, if there is a determination that no weakness exists, the loan will be given no further heightened scrutiny. If, however, current financial information indicates a potential weakness, aggressive investigation will begin into collateral values and borrower ability to pay to determine loss potential to the Bank. If loss potential is small, the loan is placed into a category of continued monitoring. If loss potential is high, the process of collateral realization may begin.

The following table is a summary of credit quality indicators related to the Bank’s commercial, commercial real estate and construction real estate loans at September 30, 2012:

	Commercial		Real Estate Commercial		Real Estate Construction and Land		Total
	(in thousands)
Category:
Normal review	$	36,268	$	122,806	$	5,950	$	165,024
Closely monitored		—		794		700		1,494
In collection		—		—		—		—
Total	$	36,268	$	123,600	$	6,650	$	166,518

The following table is a summary of credit quality indicators related to the Bank’s commercial, commercial real estate and construction real estate loans at December 31, 2011.

	Commercial		Real Estate Commercial		Real Estate Construction and Land		Total
	(in thousands)
Category:
Normal review	$	39,212	$	109,788	$	12,948	$	161,948
Closely monitored		—		562		1,127		1,689
In collection		—		—		—		—
Total	$	39,212	$	110,350	$	14,075	$	163,637

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For regulatory purposes, the Bank utilizes an internal credit classification system to manage the credit quality of its commercial and real estate loan portfolios. Loans classified as “substandard” have well-defined weaknesses and typically have experienced a degradation in either the current value of the pledged collateral or of the paying capacity of the borrower; these loans carry a distinct possibility that the Bank could sustain some loss unless the weakness is corrected. Loans classified as “doubtful” have uncorrected weaknesses that have a high possibility of loss; a loan may reside in this classification temporarily until a currently unquantifiable expected loss can be determined with a greater degree of accuracy. Any loan classified in the “loss” risk class is considered uncollectible and is to be charged-off within 30 days or less.

The following table presents a summary of commercial, commercial real estate, and construction real estate loans classified by this internal credit classification at September 30, 2012:

	Commercial		Real Estate Commercial		Real Estate Construction and Land		Total
	(in thousands)
Category:
Not classified	$	35,941	$	122,806	$	4,490	$	163,237
Substandard		327		794		2,160		3,281
Doubtful		—		—		—		—
Total	$	36,268	$	123,600	$	6,650	$	166,518

The following table presents a summary of commercial, commercial real estate, and construction real estate loans classified by this internal credit classification at December 31, 2011:

	Commercial		Real Estate Commercial		Real Estate Construction and Land		Total
	(in thousands)
Category:
Not classified	$	39,200	$	109,219	$	12,778	$	161,197
Substandard		12		1,131		1,297		2,440
Doubtful		—		—		—		—
Total	$	39,212	$	110,350	$	14,075	$	163,637

The Bank utilizes delinquency status in its evaluation of credit exposure for residential 1-4 and consumer loans, which include both revolving and closed-end mortgages as well as installment and personal loans. These loans are considered to be nonperforming when severely delinquent, defined as 90 days or more past due.

The following table represents the credit risk profile for the consumer portfolio at September 30, 2012:

	Real Estate Residential 1-4		Consumer		Total
	(in thousands)
Category:
Performing	$	46,778	$	1,861	$	48,639
Nonperforming		—		—		—
Total	$	46,778	$	1,861	$	48,639

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The following table represents the credit risk profile for the consumer portfolio at December 31, 2011:

	Real Estate Residential 1-4		Consumer		Total
	(in thousands)
Category:
Performing	$	49,894	$	1,743	$	51,637
Nonperforming		—		—		—
Total	$	49,894	$	1,743	$	51,637

The following tables present an allocation of the Company’s allowance for loan losses and the respective loans evaluated based on its allowance methodology at September 30, 2012:

	Commercial		Real Estate Commercial		Real Estate Construction and Land		Real Estate Residential 1-4		Consumer		Unallocated		Total
	(in thousands)
Allowance for loan losses:
Ending balance:
Individually evaluated for impairment (1)	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Ending balance:
Collectively evaluated for impairment		308		1,045		51		416		16		239		2,075
Total Ending Balance	$	308	$	1,045	$	51	$	416	$	16	$	239	$	2,075
	Commercial		Real Estate Commercial		Real Estate Construction and Land		Real Estate Residential 1-4		Consumer				Total
	(in thousands)
Total loans:
Ending balance:
Individually evaluated for impairment	$	—	$	794	$	700	$	—	$	—			$	1,494
Ending balance:
Collectively evaluated for impairment		36,268		122,806		5,950		46,778		1,861				213,663
Total Ending Balance	$	36,268	$	123,600	$	6,650	$	46,778	$	1,861			$	215,157

(1) Certain loans were evaluated for impairment at September 30, 2012. Based on this evaluation process, it was determined that no specific allowance was required.

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The following tables present an allocation of the Company’s allowance for loan losses and the respective loans evaluated based on its allowance methodology at December 31, 2011:

	Commercial		Real Estate Commercial		Real Estate Construction and Land		Real Estate Residential 1-4		Consumer		Unallocated		Total
	(in thousands)
Allowance for loan losses:
Ending balance:
Individually evaluated for impairment (1)	$	—	$	5	$	10	$	—	$	—	$	—	$	15
Ending balance:
Collectively evaluated for impairment		343		961		113		455		15		189		2,076
Total Ending Balance	$	343	$	966	$	123	$	455	$	15	$	189	$	2,091
														��
	Commercial		Real Estate Commercial		Real Estate Construction and Land		Real Estate Residential 1-4		Consumer				Total
	(in thousands)
Total loans:
Ending balance:
Individually evaluated for impairment	$	—	$	562	$	1,127	$	—	$	—			$	1,689
Ending balance:
Collectively evaluated for impairment		39,212		109,788		12,948		49,894		1,743				213,585
Total Ending Balance	$	39,212	$	110,350	$	14,075	$	49,894	$	1,743			$	215,274

(1) Certain loans were evaluated for impairment at December 31, 2011. Based on this evaluation process, it was determined that no specific allowance was required.

19

The following table reflects the average daily recorded investment in impaired loans as of September 30, 2012 and interest income recognized on those loans for the nine month period ending September 30, 2012:

	Recorded Investment		Unpaid Principal Balance		Specific Related Allowance		Average Daily Recorded Investment		Interest Income Recognized
	(in thousands)
With no allowance recorded:
Commercial	$	—	$	—	$	—	$	—	$	—
Real estate - commercial		794		792		—		759		22
Real estate - construction and land		791		789		—		935		24
Real estate - residential 1-4		—		—		—		43		—
Consumer		—		—		—		—		—
Total	$	1,585	$	1,581	$	—	$	1,737	$	46
With an allowance recorded:
Commercial	$	—	$	—	$	—	$	—	$	—
Real estate - commercial		—		—		—		—		—
Real estate - construction and land		—		—		—		—		—
Real estate - residential 1-4		—		—		—		—		—
Consumer		—		—		—		—		—
Total	$	—	$	—	$	—	$	—	$	—
Total
Commercial	$	—	$	—	$	—	$	—	$	—
Real estate - commercial		794		792		—		759		22
Real estate - construction and land		791		789		—		935		24
Real estate - residential 1-4		—		—		—		43		—
Consumer		—		—		—		—		—
Total	$	1,585	$	1,581	$	—	$	1,737	$	46

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The following table reflects the average daily recorded investment in impaired loans as of December 31, 2011 and interest income on those loans for the year ending December 31, 2011.

	Recorded Investment		Unpaid Principal Balance		Specific Related Allowance		Average Daily Recorded Investment		Interest Income Recognized
	(in thousands)
With no allowance recorded:
Commercial	$	—	$	—	$	—	$	—	$	—
Real estate - commercial		562		559		—		488		—
Real estate - construction and land		1,127		1,124		—		17		—
Real estate - residential 1-4		—		—		—		—		—
Consumer		—		—		—		—		—
Total	$	1,689	$	1,683	$	—	$	505	$	—
With an allowance recorded:
Commercial	$	—	$	—	$	—	$	—	$	—
Real estate - commercial		—		—		—		—		—
Real estate - construction and land		—		—		—		—		—
Real estate - residential 1-4		—		—		—		—		—
Consumer		—		—		—		—		—
Total	$	—	$	—	$	—	$	—	$	—
Total
Commercial	$	—	$	—	$	—	$	—	$	—
Real estate - commercial		562		559		—		488		—
Real estate - construction and land		1,127		1,124		—		17		—
Real estate - residential 1-4		—		—		—		—		—
Consumer		—		—		—		—		—
Total	$	1,689	$	1,683	$	—	$	505	$	—

No loans were restructured during the quarter ending September 30, 2012. During the quarter ending March 31, 2012, two loans to one borrower were restructured in which both concessions on interest rate and extensions of payment terms were granted. The pre-modification recorded investment was $1,118,000 for the real estate construction loan and $560,000 for the commercial real estate loan. Post-modification recorded investments in these two loans were $879,000 for the real estate construction loan and $805,000 for the commercial real estate loan.

During the nine month period ended September 30, 2012, no loans that had been restructured during the prior twelve months went into default.

At the time of restructuring, loans that are considered troubled are evaluated for impairment allowances based on collateral value, expected cash flows and/or financial strength of the borrower. Any such loan deemed impaired may be assigned a specific allowance in the calculation of allowance for loan losses. If there are subsequent payment defaults on troubled debt restructured loans, additional evaluations are conducted to determine impairment levels. No impairment allowance was deemed necessary at September 30, 2012.

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Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations

As used in this Quarterly Report on Form 10-Q, the “Company,” “we,” “our” and “us” refer to Heritage Bankshares, Inc. and its subsidiaries, unless the context requires otherwise.

Forward-Looking Statements

Statements contained in this Quarterly Report on Form 10-Q that are not historical facts are forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may be identified by the use of such words as “may,” “will,” “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated” and “potential”, among others, though these words are not the exclusive means of identifying such forward-looking statements. These forward-looking statements relate to, among other things, expectations regarding the business environment in which we operate, projections of future performance and perceived opportunities in the market, and they are based on management’s current beliefs, assumptions and expectations. Such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from the expectations of future results, performance or financial condition we express or imply in any forward-looking statements. For a detailed discussion of the factors that might cause such a difference, see Item 1A, “Risk Factors,” in our Annual Report on Form 10-K for the year ended December 31, 2011, filed with the Securities and Exchange Commission on March 29, 2012.

Factors that might affect forward-looking statements include, among other things:

• the demand for our products and services;

• actions taken by our competitors;

• changes in prevailing interest rates;

• changes in delinquencies and defaults by our borrowers;

• changes in loan quality and performance;

• changes in FDIC insurance assessments;

• legislative or regulatory changes or actions that affect our business, including new regulations imposed by the Dodd-Frank Act;

• our ability to achieve financial goals and strategic plans;

• our participation in the Small Business Lending Fund Program;

• litigation; and

• credit and other risks of lending activities.

As a result, we cannot assure you that our future results of operations, financial condition or other matters will be consistent with those expressed or implied in any forward-looking statements. You should not place undue reliance on these forward-looking statements, as they all are based only on information available at this time, and we assume no obligation to update any of these statements.

Financial Condition of the Company

Total Assets. The Company’s total assets increased by $14.9 million, or 5.0%, from $297.8 million at September 30, 2011 to $312.7 million at September 30, 2012. The increase in assets resulted primarily from an $11.6 million increase in our aggregate cash, securities available for sale, interest-bearing deposits in other banks and federal funds sold, together with a $5.0 million increase in bank-owned life insurance. Compared to December 31, 2011 total assets increased $18.1 million, primarily from a $38.5 million increase in our interest-bearing deposits in other banks, federal funds sold and certificates of deposits in other banks, offset by a $19.1 million decrease in securities available for sale.

Investments.Securities available for sale decreased by $15.6 million, from $41.8 million at September 30, 2011 to $26.2 million at September 30, 2012. Overnight funds increased by $20.4 million and certificates of

22

deposit, interest-bearing deposits in other banks (excluding overnight funds), and federal funds sold increased by a total of $6.9 million, with a resulting aggregate increase in such investment balances from $19.9 million at September 30, 2011 to $47.2 million at September 30, 2012. Compared to December 31, 2011 securities available for sale decreased by $19.1 million from $45.3 million. Other interest-earning assets (excluding loans) increased $38.5 million from $8.7 million at December 31, 2011. Overnight funds contributed $25.2 million to this overall increase in other interest-bearing assets.

Loans. Loans held for investment, net, were $213.1 million at September 30, 2012, a decrease of $1.2 million from our loan balance of $214.3 million at September 30, 2011. At December 31, 2011, loans held for investment were $213.2 million.

Asset Quality. Nonperforming assets were $591,000, or 0.19% of total assets, at September 30, 2012, compared to $1,753,000 in nonperforming assets, or 0.59% of total assets, at September 30, 2011 and $1,719,000, or 0.58% of total assets, at December 31, 2011. Other real estate owned consisted of a bank branch site that we no longer plan to utilize and one additional single family home obtained through foreclosure proceedings against one borrower during the third quarter of 2012.

Deposits. Total deposits at September 30, 2012 were $272.6 million compared to $257.6 million at September 30, 2011, an increase of $15.0 million, or 5.8%. Core deposits, which are comprised of noninterest-bearing, money market, NOW and savings deposits, increased by $39.4 million, or 18.9%, from $208.2 million at September 30, 2011 to $247.6 million at September 30, 2012. Noninterest-bearing deposits increased by $8.6 million to $101.0 million at September 30, 2012 and, as a percentage of total deposits, increased from 35.8% at September 30, 2011 to 37.0% at September 30, 2012. Total deposits increased by $22.6 million, or 9.1%, compared to $250.0 million at December 31, 2011, attributable to a $41.9 million increase in core deposits offset by a $19.3 million decrease in certificates of deposit.

Average total deposits increased by $27.9 million, or 11.8%, from $237.4 million for the nine-month period ended September 30, 2011 to $265.4 million for the nine-month period ended September 30, 2012. Average core deposits increased by $44.3 million, or 23.5%, over the comparable nine-month periods. Average noninterest-bearing deposits increased by $11.4 million, from $86.3 million in the nine-month period ending September 30, 2011 to $97.7 million in the comparable period ending September 30, 2012. As a percentage of total average deposits, average noninterest-bearing deposits increased slightly from 36.3% at September 30, 2011 to 36.8% at September 30, 2012.

Borrowed Funds. Borrowed funds decreased by $1,647,000, from $2,404,000 at September 30, 2011 to $757,000 at September 30, 2012. Compared to $5.9 million at December 31, 2011, borrowed funds decreased $5.5 million at September 30, 2012, primarily due to a $4.0 million decrease in FHLB advances.

Capital. Stockholders’ equity increased by $1.3 million, or 3.8%, from $35.9 million at September 30, 2011 to $37.2 million at September 30, 2012, primarily due to an increase in earnings. Stockholders’ equity was $36.4 million at December 31, 2011.

Comparison of Operating Results for the Three Months Ended September 30, 2012 and 2011

Overview. The Company’s pretax income was $981,000 for the third quarter of 2012, compared to pretax income of $847,000 for the third quarter of 2011, an increase of $134,000. A $284,000 gain on the sale of investment securities more than offset a decrease of $258,000 in net interest income. Our effective tax rate decreased from 35.3% in the third quarter of 2011 to 29.4% in the third quarter of 2012.

Net Interest Income. The Company’s net interest income before provision for loan losses decreased by $258,000, comparing the third quarters of 2012 and 2011. Our average loan portfolio decreased by $2.3 million from $214.3 million in the third quarter of 2011 to $212.0 million in the third quarter of 2012, while our average overnight funds increased by $18.1 million and our average investment in securities available for sale and other interest-earning assets (excluding loans and overnight funds) increased by $6.5 million, for a net increase in interest-earning assets of $22.3 million comparing the two quarters. Average interest-bearing liabilities increased by $15.9 million from the third quarter of 2011 to $176.5 million in the third quarter of 2012, resulting primarily from a $16.9 million increase in average interest-bearing deposits. The average yield on our interest-earning assets was adversely impacted by lower yields on loans and an increase in the average balance of investment securities and other interest-earning assets, which was only partially offset by a decrease in the average cost of interest-bearing liabilities. As a result, our interest rate spread decreased 52 basis points from 3.74% in the third quarter of 2011 to 3.22% in the third quarter of 2012, and our net interest margin decreased 63 basis points from 4.06% in the third quarter of 2011 to 3.43% in the third quarter of 2012.

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Provision for Loan Losses. There was no provision for loan losses in the quarter ending September 30, 2012 compared to a provision for loan losses of $33,000 in the quarter ending September 30, 2011.

Noninterest Income. Total noninterest income increased by $295,000, from $197,000 in the third quarter of 2011 to $492,000 in the third quarter of 2012. This increase is primarily attributable to a $284,000 gain on sale of investment securities and $43,000 in income from bank-owned life insurance in the third quarter of 2012 that did not occur in the third quarter of 2011.

Noninterest Expense. Total noninterest expense was $1.997 million for the third quarter of 2012, a $64,000 decrease from the third quarter of 2011, primarily due to an $82,000 decrease in compensation expense in the third quarter of 2012.

Income Taxes.The Company’s income tax expense for the third quarter of 2012 was $288,000, reflecting an effective tax rate of 29.4%, compared to income tax expense of $299,000 for the third quarter of 2011, reflecting an effective tax rate of 35.3%. This reduction in effective tax rate was attributable to increases in tax-exempt interest income and other non-taxable income.

Net Income Available to Common Stockholders. Because of qualified loan growth, the dividend rate on our SBLF program preferred stock was 1.00% for the third quarter of 2012, resulting in dividends on preferred stock of $20,000, a savings of $232,000 compared to $252,000 of TARP preferred stock dividends and dividend accretion for the third quarter of 2011. Net income available to common stockholders was $673,000 for the third quarter of 2012, compared to $296,000 for the third quarter of 2011, an increase of $377,000, or $0.16 per weighted average diluted common share.

Comparison of Operating Results for the Nine Months Ended September 30, 2012 and 2011

Overview. The Company’s pretax income was $2,614,000 for the first nine months of 2012, compared to pretax income of $2,560,000 for the first nine months of 2011, an increase of $54,000. This increase resulted primarily from a $331,000 increase in noninterest income and an $87,000 decrease in noninterest expense, partially offset by a $373,000 decrease in net interest income between the two nine-month periods. The Company’s effective tax rate for the first nine months of 2012 was 28.6% compared to an effective tax rate of 33.6% for the first nine months of 2011.

Net Interest Income. The Company’s net interest income before provision for loan losses decreased by $373,000, comparing the first-nine month periods of 2012 and 2011. Our average loan portfolio decreased by $900,000 from $215.9 million in the first nine months of 2011 to $215.0 million in the first nine months of 2012, while our average investment in overnight funds increased by $9.7 million and our average investment in securities available for sale and other interest-earning assets (excluding loans and overnight funds) increased by $12.5 million, for a net increase in interest-earning assets of $21.3 million comparing the two nine-month periods. Average interest-bearing liabilities increased by $15.7 million from the first nine months of 2011 to $171.6 million in the first nine months of 2012, resulting primarily from a $16.6 million increase in average interest-bearing deposits. The average yield on our interest-earning assets was adversely impacted by lower yields on loans and an increase in the average balance of investment securities and other interest-earning assets, which was only partially offset by a decrease in the average cost of interest-bearing liabilities. As a result, our interest rate spread decreased 36 basis points from 3.88% in the first nine months of 2011 to 3.52% in the first nine months of 2012, and our net interest margin decreased 47 basis points from 4.22% in the first nine months of 2011 to 3.75% in the first nine months of 2012.

Provision for Loan Losses. Provision for loan losses was $35,000 and $44,000 for the nine months ending September 30, 2012 and 2011, respectively.

Noninterest Income. Total noninterest income increased by $331,000, from $627,000 in the first nine months of 2011 to $958,000 in the first nine months of 2012. The primary factors in this increase were a $197,000 increase in gains on sale of investment securities and a $161,000 increase in income from bank-owned life insurance in the first nine months of 2012.

Noninterest Expense. Total noninterest expense decreased by $87,000, from $6.233 million in the first nine months of 2011 to $6.146 million in the first nine months of 2012, primarily attributable to decreased compensation expense of $104,000.

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Income Taxes. The Company’s income tax expense for the first nine months of 2012 was $749,000, reflecting an effective tax rate of 28.6%, compared to income tax expense of $861,000 for the first nine months of 2011, reflecting an effective tax rate of 33.6%. This reduction in effective tax rate was primarily attributable to an increase in tax-exempt interest income and other non-taxable income.

Net Income Available to Common Stockholders. After the impact of dividends on our preferred stock, net income available to common shareholders was $1.779 million for the first nine months of 2012, or earnings per diluted common share of $0.76, compared to net income available to common stockholders of $1.137 million for the first nine months of 2011, or earnings per diluted common share of $0.49, an increase of $642,000, or $0.27 per diluted common share. This increase in earnings available to common stockholders is primarily attributable to qualified loan growth which resulted in a 1.47% dividend rate on our SBLF program preferred stock in the first nine months of 2012, compared to accelerated accretion of the discount on outstanding TARP preferred stock and the associated dividend rate of 8.96% in the first nine months of 2011.

Commitments

We are a party to financial instruments with off-balance sheet credit risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit in the form of loans or loans approved but not yet funded, standby letters of credit, and commitments to sell loans. These instruments involve, to varying degrees, elements of risk which have not been recognized in our consolidated balance sheets.

Loan commitments are agreements to extend credit to a customer so long as there are no violations of the applicable contract terms prior to the funding. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee by the customer. Because certain of the commitments are expected to be withdrawn or expire unused, the total commitment amount does not necessarily represent future cash requirements. Standby letters of credit are written unconditional commitments to guarantee the performance of a Bank customer to a third party.

We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments. Unless otherwise noted, we require collateral or other security to support financial instruments with credit risk.

The following table reflects our other loan commitments outstanding at the dates indicated:

	At September 30,
	2012		2011
	(in thousands)
Commitments to extend credit	$	35,453	$	31,524
Standby letters of credit		189		76
Total Commitments	$	35,642	$	31,600

Liquidity

Liquidity refers to the availability of sufficient funds to meet the needs of depositors, borrowers, creditors and investors and to fund operations. Our primary sources of funds are customer deposits, cash and cash equivalents, certificates of deposit in other banks, unpledged investment securities available for sale, loan repayments and borrowings. These funds are used to make loans, purchase investment securities, meet depositor withdrawals and fund operations. At September 30, 2012, liquid assets, which include cash and due from banks, interest-bearing deposits in other banks, federal funds sold, certificates of deposit in other banks and nonpledged securities available for sale, were $78.9 million, an increase of $21.1 million from $57.8 million at December 31, 2011.

We also are able to obtain funds through approved borrowing lines with the Federal Home Loan Bank of Atlanta and other financial institutions. At September 30, 2012, there were no outstanding balances with these institutions.

Management believes our existing liquidity sources are sufficient to satisfy the Company’s operational requirements and obligations. We maintain a high level of liquidity due to a concentration in some customer deposits, which can fluctuate significantly as depositor needs change.

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Capital Resources

The Company’s capital is reflected in its stockholders’ equity, which was $37.2 million at September 30, 2012, up from $36.4 million at December 31, 2011, primarily attributable to an increase in retained earnings. At September 30, 2012, the Company and the Bank were considered “well-capitalized” as defined by the Federal Reserve Bank. We monitor the current and projected capital levels of the Bank and the Company and will consider additional sources of capital, through the issuance of stock, debt or otherwise, as needs arise.

Item 3 Quantitative and Qualitative Disclosures About Market Risk

The Company is a smaller reporting company and thus is not required to provide the information required by this Item 3.

Item 4 Controls and Procedures

The Company is required to maintain disclosure controls and procedures that are designed to provide reasonable assurance that information required to be disclosed in reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), such as this quarterly report on Form 10-Q, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and that such information is accumulated and communicated to Company management, including its principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, the Company recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

We conducted an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2012. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have determined that our disclosure controls and procedures with respect to financial reporting were effective as of September 30, 2012 to ensure that material information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported as and when required.

Changes in Internal Control Over Financial Reporting

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

There were no changes in the Company’s internal control over financial reporting in the quarter ended September 30, 2012 that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

Part II. OTHER INFORMATION

Item 1 Legal Proceedings

The Company is a party to routine litigation incidental to our business, none of which is considered likely to have a material effect on the Company.

Item 2 Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3 Defaults Upon Senior Securities

None

Item 4 Mine Safety Disclosures

Not Applicable

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Item 5 Other Information

None

Item 6 Exhibits

See Index to Exhibits

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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 BANKSHARES, INC.
	(Registrant)
November 9, 2012	/s/ Michael S. Ives
	Michael S. Ives,
	President & Chief Executive Officer (Principal Executive Officer)
November 9, 2012	/s/ John O. Guthrie
	John O. Guthrie,
	Chief Financial Officer
	(Principal Financial and Accounting Officer)

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Index to Exhibits

Exhibit No.	Description
3.1	Amended and Restated Articles of Incorporation of Heritage Bankshares, Inc. (Incorporated herein by reference to the Company’s Form 10-Q filed on August 11, 2009.)
3.2	Articles of Amendment to the Articles of Incorporation of Heritage Bankshares, Inc. Establishing the Terms of the SBLF Preferred Shares. (Incorporated herein by reference to the Company’s Form 8-K filed on August 11, 2011.)
3.3	Amendment to Bylaws of Heritage Bankshares, Inc. (Incorporated herein by reference to the Company’s Form 8-K filed on April 2, 2012.)
10.8	Amended and Restated Bylaws of Heritage Bankshares, Inc. (Incorporated herein by reference to the Company’s Form 8-K filed on May 3, 2005.)
10.11	Amendment to Bylaws of Heritage Bankshares, Inc. (Incorporated herein by reference to the Company’s Form 8-K filed on August 1, 2006.)
*10.16	Heritage 2006 Equity Incentive Plan (As Amended and Restated Effective January 28, 2009). (Incorporated herein by reference to the Company’s Form S-8 filed on July 27, 2009.)
*10.17	January 2012 Amendments to Heritage 2006 Equity Incentive Plan (As Amended and Restated Effective January 28, 2009). (Incorporated herein by reference to the Company’s Form 10-K filed on March 29, 2012.)
*10.18	August 2012 Amendment to Heritage 2006 Equity Incentive Plan (As Amended and Restated Effective January 28, 2009). (Originally reported in the Company’s Form 8-K filed on August 24, 2012.)**
10.22	SBLF Securities Purchase Agreement, dated August 11, 2011, between Heritage Bankshares, Inc. and the Secretary of the Treasury. (Incorporated herein by reference to the Company’s Form 8-K filed on August 11, 2011.)
10.23	TARP Repurchase Document, dated August 11, 2011, between Heritage Bankshares, Inc. and the United States Department of the Treasury. (Incorporated herein by reference to the Company’s Form 8-K filed on August 11, 2011.)
31.1	Certification of principal executive officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.**
31.2	Certification of principal financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.**
32.1	Certification of principal executive officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**
32.2	Certification of principal financial officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**
101	Interactive Data File#

* Indicates management contract or compensatory plan or arrangement.

** Indicates filed herewith.

# Indicates furnished herewith. In accordance with Rule 406T of Regulation S-T, the information in these exhibits shall not be deemed to be “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to liability under that section, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, except as expressly set forth by specific reference in such filing.

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