1
EXHIBIT 13.1

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(Mark One)
/x/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 [FEE REQUIRED]

For the fiscal year ended June 30, 1995

/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

For the transition period from to
--- ---
Commission File No. 0-20000

HERITAGE FEDERAL BANCSHARES, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

TENNESSEE 62-1485034
(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER
OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)

110 EAST CENTER STREET, KINGSPORT, TENNESSEE 37660
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (615) 378-8000

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

None

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $1.00 per share
(Title of Class)

Indicate by check mark whether the registrant (1) has filed all reports required
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or 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 if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. /X/

As of August 11, 1995, the aggregate market value of the 3,189,506 shares of
Common Stock of the registrant issued and outstanding held by non-affiliates on
such date was approximately $82.9 million based on the closing sales price of
$26.00 per share of the registrant's Common Stock on August 9, 1995. For
purposes of this calculation, it is assumed that directors, officers and
beneficial owners of more than 5% of the registrant's outstanding voting stock
are not affiliates.

DOCUMENTS INCORPORATED BY REFERENCE

None.

Page 1 of ___ sequentially numbered pages
Exhibit Index at Sequentially Numbered Page ___

PART I

ITEM 1. BUSINESS

GENERAL

THE COMPANY. Heritage Federal Bancshares, Inc. (the "Company") was
incorporated in December 1991 under the laws of the State of Tennessee to become
a savings institution holding company with Heritage Federal Bank for Savings
("Heritage Federal" or the "Bank") as its subsidiary. On March 30, 1992, the
Bank converted from mutual to stock form as a wholly owned subsidiary of the
Company. In conjunction with the conversion and reorganization, the Company
issued 1,495,000 shares of its common stock, par value $1.00 per share (the
"Common Stock"), to the public and registered its Common Stock with the
Securities and Exchange Commission under the Securities Exchange Act of 1934. In
August 1993, the Company's Board of Directors approved a three-for-two stock
split, which was effected as a 50% stock dividend and in August 1994 the Board
approved a four-for-three stock split, effected as a 33% stock dividend.

The Company is classified as a unitary savings and loan holding company
subject to regulation by the Office of Thrift Supervision ("OTS") of the
Department of the Treasury. Prior to its acquisition of the Bank, the Company
had no assets and no liabilities and engaged in no business activities. Since
the acquisition, the Company has not engaged in any significant activity other
than holding the stock of the Bank and operating the business of a savings bank
through the Bank. Accordingly, the information set forth in this report,
including financial statements and related data, relates primarily to the Bank
and its subsidiary.

The executive offices of the Company are located at 110 East Center
Street, Kingsport, Tennessee 37660, and its main telephone number is (615)
378-8000.

THE BANK. Heritage Federal is a federally-chartered stock savings bank.
The Bank was incorporated in 1930 as a Tennessee-chartered building and loan
association under the name "Kingsport Savings and Loan Association." The Bank
converted to a federally chartered savings and loan association in 1935 and
later adopted the name "Heritage Federal Savings and Loan Association." In 1989,
the Bank converted to a federally chartered mutual savings bank, adopting its
current name. At June 30, 1995, the Bank operated through 13 full-service
offices located in six counties in east Tennessee. As discussed below, the Bank
sold five branches located in middle Tennessee in fiscal year 1993.

The principal business of Heritage Federal consists of accepting
deposits from the general public through its branch offices and investing these
funds in loans secured by one- to four-family residential properties located in
the Bank's market areas. The Bank also maintains a substantial investment
portfolio and originates a limited amount of consumer, commercial and commercial
real estate loans secured by properties in its market areas. The Bank also
offers trust services, and sells title insurance through its wholly-owned
subsidiary.

As a federally chartered savings bank, the Bank's deposits are insured
by the Savings Association Insurance Fund ("SAIF"), which is administered by the
Federal Deposit Insurance Corporation ("FDIC"), up to applicable limits for each
depositor. The Bank is a member of the Federal Home Loan Bank ("FHLB") of
Cincinnati, which is one of the 12 district banks comprising the FHLB System.
The Bank is subject to comprehensive examination, supervision and regulation by
the OTS and the FDIC. Such regulation is intended primarily for the protection
of depositors.

On August 7, 1992, the Bank sold its five branch offices in the middle
Tennessee area to Trans Financial Federal Savings Bank of Tennessee. Branches
included in the sale were located in Lebanon, Murfreesboro, Franklin,
McMinnville, and Cookeville, Tennessee. The Bank received a cash payment in the
transaction equivalent to the book value of the assets transferred plus $1
million. No loans were transferred as part of the sale, other than a small
amount secured by deposit accounts. Trans Financial Federal Savings Bank assumed
approximately $55 million in

deposits and purchased all premises and equipment related to the branches. The
branch sale was pursuant to the Bank's plan to dispose of its less profitable
branches and to concentrate on increasing its market share in its primary
markets in East Tennessee. In conjunction with this sale, the Bank also wrote
off in fiscal year 1993 an additional $637,000 in excess of cost over fair value
of net assets acquired. An environmental assessment conducted in connection with
the sale of the branches revealed that one location has been contaminated by a
release of gasoline from an underground storage tank the Company believes is
located on an adjacent property. The Company believes the responsible parties
are financially capable of remediating the underground storage tank site and
affected adjacent properties, if required, under the oversight of the State of
Tennessee, Division of Underground Storage Tanks, in accordance with the
Division's clean-up standards. Based on all known information, Heritage Federal
expects no third-party liability in this matter and has agreed to indemnify
Trans Financial from such liability.

In August 1993, the Bank, through its wholly-owned subsidiary, Citizens
Financial Corporation ("Citizens Financial") entered into an agreement with
third-party vendors to sell annuities and securities. The arrangement is one in
which the third-party vendors provide all personnel and other resources to sell
the annuities and securities and Citizens Financial leases space to the
third-party vendors. Citizens Financial received a percentage of the commissions
related to the sale of those products and did not assume any risk or any expense
other than as to certain supplies and office equipment. This arrangement
continued throughout most of fiscal year 1995.

The Bank's executive offices are located at 110 East Center Street,
Kingsport, Tennessee 37660 and its main telephone number is (615) 378-8000.

MERGER WITH FIRST AMERICAN CORPORATION

On February 21, 1995, the Bank entered into an Agreement and Plan of
Merger ("the Agreement") to merge with First American Corporation ("First
American"), a Tennessee bank holding company. Under the terms of the Agreement,
First American will acquire all of the outstanding shares of the Common Stock
and the Company's shareholders will receive $28.00 in value of shares of First
American common stock, such value to be based upon the average closing price of
the First American common stock for the 20 trading days ending on and including
the third day immediately preceding the effective time of the merger. The number
of shares of First American common stock to be exchanged in the merger cannot
exceed 1.098 shares or be less than 0.8116 shares. The Company has the
unilateral right to terminate the Agreement if First American's market price
drops below $23.50 and First American has the unilateral right to terminate the
Agreement if its market price exceeds $36.50. The Company is also permitted
under the Agreement to continue paying its quarterly cash dividend in the amount
of $0.095 per share but dividends in the last quarter prior to closing must be
coordinated with First American's dividend policy to avoid receipt by the
Company's shareholders of either two dividends or no dividends in any calendar
quarter. The Agreement also provides for the payment by the Company of a $4.5
million termination fee to First American under certain circumstances as well as
other lesser payments between the parties if the merger is not consummated for
other reasons.

LENDING ACTIVITIES

General. Heritage Federal originates loans through its offices located
in Sullivan, Washington, Carter, Hawkins, Anderson, Roane and, prior to their
sale on August 7, 1992, also originated loans through its now-sold branches
located in Wilson, Rutherford, Williamson, Warren and Putnam counties, all of
which are in Tennessee. The principal lending activity of the Bank is the
origination of conventional mortgage loans for the purpose of purchasing or
refinancing owner-occupied, one- to four-family residential properties in each
of its primary market areas. Conventional mortgage loans are fixed-rate or
adjustable-rate mortgage loans which are not insured or guaranteed by federal
agencies. At June 30, 1995, such loans totaled $241.8 million, or 79.4% of the
Bank's gross loan portfolio. The Bank also makes conventional mortgage loans for
the purpose of constructing one- to four-family residences and loans to
construct commercial and multi-family real estate. At June 30, 1995,
conventional one- to four-family construction loans totaled $5.2 million,
commercial construction loans totaled $1.6 million and multi-

family real estate construction loans totaled $0.2 million. In addition to
conventional loans, the Bank has originated limited amounts of residential
mortgage loans insured by the Federal Housing Administration ("FHA") or
guaranteed by the Veterans Administration ("VA"). At June 30, 1995, such loans
totaled $0.8 million. The Bank also originates consumer loans on a direct basis
and some small commercial loans.

The Bank has sought to reduce its exposure to changes in interest rates
by matching more closely the effective maturities or repricings of its
interest-sensitive assets and liabilities. In accordance with the Bank's
interest rate risk policy, management has emphasized the origination and/or
purchase of adjustable-rate mortgages and mortgage-backed securities,
intermediate-term fixed-rate mortgages, and short-term consumer loans. However,
because of generally declining interest rate levels during the past four fiscal
years, there has been increased consumer interest in fixed-rate loans. In order
to maintain market share under these changing conditions, the Bank began to
originate fixed-rate loans for potential resale to secondary market investors
and for its portfolio. In all cases, originations of long-term fixed-rate
mortgages are underwritten according to guidelines of the Federal Home Loan
Mortgage Corporation and the Federal National Mortgage Association. Since
February 1994, higher interest rates have slowed the trend toward fixed-rate
lending and have created renewed interest in adjustable-rate loan balances.
However, because of the moderate rise in mortgage rates during most of the
Bank's fiscal year ended June 30, 1995, the adjustable-rate component of the
Bank's portfolio of mortgage loans and mortgage-backed securities increased only
marginally to 68%, with fixed-rate loans comprising 32% as compared to the
portfolio mix at June 30, 1994, of 67% and 33%, respectively. The portfolio mix
at June 30, 1992 was 53% and 47%, respectively.

5
Set forth below is selected data relating to the composition of the
Bank's loan portfolio by type of loan on the dates indicated. As of June 30,
1995, the Bank had no concentrations of loans exceeding 10% of total loans other
than as disclosed below.

At June 30,
----------------------------------------------------------------------
1995 1994 1993
------------------ --------------------- --------------------
Amount % Amount % Amount %
-------- ------ -------- ------ -------- -----
(Dollars in thousands)

Real estate loans:
Construction (1)........................ $ 7,045 2.3% $ 11,220 3.5% $ 11,175 3.3%
One- to four-family residential (1)..... 241,756 79.4 253,790 79.9 281,796 83.2
Multi-family residential................ 8,552 2.8 7,714 2.4 6,237 1.9
Non-residential and other............... 24,101 7.9 24,563 7.7 19,633 5.8
-------- ----- -------- ----- -------- -----
Total............................... 281,454 92.4 297,287 93.5 318,841 94.2
-------- ----- -------- ----- -------- -----

Consumer loans:
Loans on deposits....................... 2,224 0.7 2,430 0.8 2,508 0.7
Home improvement loans (2).............. 994 0.3 1,541 0.5 1,925 0.6
Education loans......................... 6 -- 10 -- 14 --
Automobile.............................. 906 0.3 768 0.2 803 0.2
Other (2)............................... 9,259 3.0 8,114 2.6 8,290 2.5
-------- ----- -------- ----- -------- -----
Total............................... 13,389 4.3 12,863 4.1 13,540 4.0
-------- ----- -------- ----- -------- -----
Commercial................................ 10,093 3.3 7,597 2.4 6,224 1.8
-------- ----- -------- ----- -------- -----
Total loans......................... 304,936 100.0% 317,747 100.0% 338,605 100.0%
===== ===== =====

Less:
Loans in process........................ (3,169) (3,849) (5,598)
Discounts and other..................... (1,907) (2,919) (3,524)
Loan loss allowances.................... (2,327) (2,279) (2,388)
------ -------- --------
Total............................... $297,533 $308,700 $327,095
======== ======== ========

At June 30,
-------------------------------------------
1992 1991
------------------ --------------------
Amount % Amount %
--------- ------ -------- -----

Real estate loans:
Construction (1)........................ $ 10,609 2.9% $ 7,731 2.1%
One- to four-family residential (1)..... 302,409 81.9 299,572 80.0
Multi-family residential................ 9,838 2.7 12,338 3.3
Non-residential and other............... 23,338 6.2 28,266 7.5
-------- ----- -------- -----
Total............................... 346,194 93.7 347,907 92.9
-------- ----- -------- -----

Consumer loans:
Loans on deposits....................... 3,608 1.0 3,973 1.1
Home improvement loans (2).............. 2,628 0.7 4,160 1.1
Education loans......................... 26 -- 129 --
Automobile.............................. 1,168 0.3 1,623 0.4
Other (2)............................... 9,270 2.5 10,029 2.7
-------- ----- -------- -----
Total............................... 16,700 4.5 19,914 5.3
-------- ----- -------- -----
Commercial................................ 6,487 1.8 6,823 1.8
-------- ----- -------- -----
Total loans......................... 369,381 100.0% 374,644 100.0%
===== =====

Less:
Loans in process........................ (4,880) (3,628)
Discounts and other..................... (4,248) (5,111)
Loan loss allowances.................... (2,338) (1,926)
-------- --------
Total............................... $357,915 $363,979
======== ========

- ----------------------------
(1) Includes loans held for sale.
(2) Restated for current and prior years due to reclassification.

The following table sets forth certain information as of June 30, 1995
regarding the dollar amount of loans maturing in the Bank's portfolio, including
scheduled repayments of principal, based on contractual terms to maturity.
Demand loans, loans having no schedule of repayments and no stated maturity, and
overdrafts are reported as due in one year or less. The table below does not
include any estimate of prepayments, which significantly shorten the average
life of all mortgage loans and may cause the Bank's actual repayment experience
to differ from that shown below.

Due after
Due in One Year Total
One Year Through Due after Outstanding
or Less Five Years Five Years June 30, 1995
-------- ---------- ---------- -------------
(In thousands)

Real estate mortgage . . . . . $34,462 $121,827 $118,120 $274,409
Real estate-construction . . . 7,045 -- -- 7,045
Consumer . . . . . . . . . . . 10,318 2,774 297 13,389
Commercial . . . . . . . . . . 5,938 2,139 2,016 10,093
------- -------- -------- --------
Total . . . . . . . . . . $57,763 $126,740 $120,433 $304,936
======= ======== ======== ========

The following table sets forth as of June 30, 1995 the dollar amount of
the loans maturing subsequent to the year ending June 30, 1996 between those
with predetermined interest rates and those with adjustable interest rates.

Predetermined Floating or
Rate Adjustable Rates Total
------------- ---------------- --------
(In thousands)

Real estate mortgage . . . . . . . . . . $67,204 $172,743 $239,947
Consumer . . . . . . . . . . . . . . . . 2,000 1,071 3,071
Commercial . . . . . . . . . . . . . . . 2,274 1,881 4,155
------- -------- --------
Total . . . . . . . . . . . . . . . $71,478 $175,695 $247,173
======= ======== ========

One- to Four-Family Real Estate Lending. The Bank's primary lending
activity is the origination of conventional loans secured by owner-occupied,
one- to four-family residential properties. To a lesser extent, the Bank
originates FHA-insured and VA- guaranteed loans secured by such properties. The
purchase price for most such properties has been between $50,000 and $250,000.
At June 30, 1995, approximately $241.8 million, or 79.4% of the Bank's gross
loan portfolio consisted of loans secured by one- to four-family residential
real properties which were primarily owner-occupied, detached single-family
residences located in the Bank's primary market area.

The Bank's conventional mortgage loan originations are generally for
terms of 15 to 30 years, amortized on a monthly basis, with principal and
interest due each month. Residential real estate loans often remain outstanding
for significantly shorter periods than their contractual terms. Borrowers may
refinance or prepay loans at their option without penalty. Conventional
residential mortgage loans granted by the Bank customarily contain "due-on-sale"
clauses which permit the Bank to accelerate the indebtedness upon transfer of
ownership of the mortgaged property. Additionally, loans insured by the FHA
after December 1989 or guaranteed by the VA after March 1988 contain due-on-sale
clauses. Due-on-sale clauses are an important means of imposing assumption fees
and increasing the rate on existing mortgage loans during periods of rising
interest rates and increasing the turnover of mortgage loans in the Bank's
portfolio.

The Bank's lending policies generally limit the maximum loan-to-value
ratio on mortgage loans secured by owner-occupied properties to 95% of the
lesser of the appraised value or purchase price, with the condition that private
mortgage insurance is required on loans with loan-to-value ratios in excess of
80%. The maximum loan-to-value ratios on mortgage loans secured by non-
owner-occupied properties and/or used for refinancing purposes are from 75% to
80%.

Heritage Federal began originating conventional adjustable-rate
residential mortgage loans in the early 1980s and principally originates
five-year fixed/one-year adjustable-rate mortgage loans with rate adjustments
indexed to the weekly average rate of U.S. Treasury securities adjusted to a
constant one-year maturity (the "One-Year Treasury Index"). Following the first
five-year, fixed-rate term, the rates at which interest accrues on these
mortgages are adjustable once a year with limitations on adjustments of two
percentage points per adjustment period and 5.00 percentage points over the life
of the loan. The Bank's loan portfolio also includes a limited amount of loans
with variable rates tied to other indices and loans which have both longer and
shorter adjustment periods. The Bank has a small amount of loans which provide
for negative amortization, in which the loan payments may at times be
insufficient to pay the interest then due and the unpaid interest is added to
the outstanding loan balance so the principal increases rather than decreases as
payments are made. Heritage Federal originated $23.5 million of adjustable-rate,
one- to four-family mortgage loans during the year ended June 30, 1995.

There are unquantifiable credit risks resulting from potential
increased costs to the borrower as a result of repricing of adjustable-rate
mortgage loans. It is possible that during periods of rising interest rates, the
risk of default on adjustable-rate mortgage loans may increase due to the upward
adjustment of interest cost to the borrower. Further, the adjustable-rate
mortgages originated by the Bank generally provide for initial rates of interest
below the rates which would apply were the index used for pricing applied
initially. These discounted loans may be subject to increased risk of
delinquency or default when the higher, fully-indexed rate of interest
subsequently comes into effect, replacing the lower initial rate. In addition,
although adjustable-rate mortgage loans allow the Bank to increase the
sensitivity of its asset base to changes in interest rates, the extent of this
interest sensitivity is limited by the periodic and lifetime interest rate
adjustment limitations. Accordingly, there can be no assurance that yields on
the Bank's adjustable-rate mortgages will adjust sufficiently to compensate for
increases in the Bank's cost of funds.

Heritage Federal also originates conventional fixed-rate mortgage loans
on one- to four-family residential properties. All fixed-rate loans are
underwritten according to either FHLMC and FNMA guidelines, utilizing their
approved documents, so that the loans qualify for sale in the secondary mortgage
market, or pursuant to FHA or VA requirements, so that such loans will either be
insured by the FHA or partially guaranteed by the VA. Heritage Federal
originated $5.2 million in fixed-rate, one- to four-family mortgage loans during
the year ended June 30, 1995 and such loans amounted to $70.9 million or 23.2%,
of the Bank's loan portfolio at June 30, 1995.

Construction Lending. Heritage Federal engages in construction lending,
involving loans to qualified borrowers for construction of one- to four-family
residential properties and, on a limited basis, involving commercial and
multi-family properties. These properties are primarily located in the Bank's
market area. At June 30, 1995, the Bank's loan portfolio included $7.0 million
of loans secured by properties under construction (including $0.2 million in
commercial real estate construction loans and $1.6 million in multi-family real
estate construction loans), most of which were construction/permanent loans
structured to become permanent loans upon the completion of construction. All
construction loans are secured by a first lien on the property under
construction. Loan proceeds are disbursed in increments as construction
progresses and as inspections warrant. Construction/permanent loans have either
fixed- or adjustable-rates and are underwritten in accordance with the same
terms and requirements as the Bank's permanent mortgages, except the loans
generally provide for disbursement in stages during a construction period of up
to twelve months, during which period the borrower is required to make monthly
payments of accrued interest on the outstanding loan balance. Interim
construction loans generally have fixed interest rates, terms of up to twelve
months and a maximum loan-to-value ratio of 80%. Borrowers must satisfy all
credit requirements which

would apply to the Bank's permanent mortgage loan financing for the subject
property. If the borrower obtains mortgage insurance for the portion of the loan
in excess of 80% of collateral value, construction/permanent loans may be made
up to a maximum loan-to-value ratio of 90%.

Loans involving construction financing present a greater level of risk
than loans for the purchase of existing homes because loan funds are advanced
upon the security of the project under construction, which is of uncertain value
prior to the completion of construction. The Bank's risk of loss on a
construction loan is dependent primarily upon the accuracy of the initial
estimate of the property's value at completion of construction or development
and the estimated cost (including interest) of completion. If the estimate of
completed cost proves to be inaccurate, the borrower may be required to
contribute additional equity to the project. If the borrower is unable to do so,
the Bank may be required to advance funds beyond the amount originally
committed. If the estimate of value proves to be inaccurate, the Bank may be
confronted, at or prior to the maturity of the loan, with a project having a
value that is insufficient to ensure full repayment of the loan.

Commercial and Multi-Family Real Estate Lending. Heritage Federal has
historically engaged in a limited amount of commercial and multi-family real
estate lending. This lending has involved loans principally secured by apartment
buildings, churches and healthcare facilities. At June 30, 1995, the Bank's
commercial and multi-family real estate loan portfolio totaled $32.7 million and
included $3.7 million in loans secured by churches, $8.6 million in loans
secured by multi-family property and $20.4 million in loans secured by office
and retail buildings and other non-residential property. Generally, these loans
are made on an adjustable-rate basis for a period of 25 years or less on a
loan-to-value ratio of 80% or less, indexed to the One Year Treasury Index and
secured by properties located within the market area of the Bank.

The largest single commercial real estate loan at June 30, 1995, was a
$4.2 million loan secured by a medical office building in Kingsport, Tennessee
and guaranteed by a major hospital. The next three largest loans at June 30,
1995 are secured by a shopping center in the amount of $2.3 million, an
apartment complex in the amount of $2.1 million and a church with a balance of
$1.8 million.. All properties securing the Bank's commercial and multi-family
real estate loans are inspected by the Bank's lending personnel prior to the
loan's inception. The Bank also obtains appraisals on each such property in
accordance with applicable regulations.

Loans secured by commercial and multi-family real estate generally are
larger and involve greater risks than one- to four-family residential mortgage
loans. Because payments on loans secured by such properties are often dependent
on successful operation or management of the properties, repayment of such loans
may be subject, to a greater extent, to adverse conditions in the real estate
market or the economy. The Bank seeks to minimize these risks in a variety of
ways, including limiting the loans to one borrower in conformity with OTS
regulations and strictly scrutinizing the financial condition of the borrower,
the quality of the collateral and the management of the property securing the
loan. The Bank also obtains loan guarantees from financially capable parties.

Consumer Lending. The Bank's consumer loans generally have shorter
terms to maturity or repricing and higher interest rates than the long-term,
fixed-rate mortgage loans that constitute a substantial part of the Bank's loan
portfolio. The Bank's consumer loans primarily comprise automobile loans, loans
secured by second mortgages on residences, savings account loans, unsecured term
notes and installment loans. At June 30, 1995, the Bank's consumer loans totaled
approximately $13.4 million or 4.3% of the Bank's gross loan portfolio.

Automobile loans are secured by both new and used cars and are
generally limited to 80% of this "sticker price" or purchase price, whichever is
lower, or the loan value as published by the National Automobile Dealers
Association. Automobile loans are only made to the borrower-owners on a direct
basis. New cars are financed for a period of up to 60 months while used cars are
financed for 42 months or less. Collision insurance and vendor single interest
coverage, which insures the title to the Bank, are required on all automobile
loans.

Home equity loans, also referred to as second mortgage loans, are
generally made on the security of residences on which the Bank has a first
mortgage, normally do not exceed 89% of the appraised value of the residence
less the outstanding principal of the first mortgage, and generally have terms
of up to five years. Second mortgage loans for five or fewer years may have
fixed interest rates, and loans for more than five years have annually
adjustable interest rates indexed to the One-Year Treasury Index with a
limitation on adjustment of five percentage points above the initial interest
rate over the life of the loan. The maximum term of a second mortgage loan
generally does not exceed 15 years. At June 30, 1995, total outstanding second
mortgage loans amounted to $7.9 million, or 2.6% of the Bank's gross loan
portfolio. Home equity lines of credit which require no monthly repayment of
principal are restricted to a five year maturity. Because the borrower can
borrow up to the entire amount of the credit line at any time during its term,
annual financial statements are required and reviewed to determine the continued
creditworthiness of the borrower. Longer-term second mortgages require monthly
payments of principal and interest.

The Bank makes savings account loans for up to 90% of the depositor's
savings account balance. The interest rate is normally 2% above the rate paid on
the savings account, and the account must be pledged as collateral to secure the
loan. Savings account loans are payable on demand. At June 30, 1995, total loans
on savings accounts were $2.2 million, or 0.7% of the Bank's gross loan
portfolio. The Bank also offers credit cards.

Consumer loans entail a greater risk to the Bank than do residential
mortgage loans, particularly in the case of consumer loans which are unsecured
or secured by rapidly depreciable assets such as automobiles. In such cases, any
repossessed collateral for a defaulted consumer loan may not provide an adequate
source of repayment of the outstanding loan balance because of the greater
likelihood of damage, loss or depreciation. Any remaining deficiency often does
not warrant further substantial collection efforts against the borrower. In
addition, 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. Furthermore, the application of
various federal and state laws, including federal and state bankruptcy and
insolvency laws, may limit the amount which can be recovered on such loans. Such
loans may also give rise to claims and defenses by a consumer loan borrower
against an assignee of such loans such as the Bank, and a borrower may be able
to assert against such assignee claims and defenses which it has against the
seller of the underlying collateral. At June 30, 1995, $47,000, or 0.4% of the
consumer loan portfolio was past due 90 days or more.

Commercial Lending. As a federally chartered savings institution, the
Bank is authorized to invest up to 10% of its assets in commercial loans not
secured by real property. Heritage Federal offers a variety of business loans,
including farm loans, equipment loans, inventory loans and occasionally letters
of credit. At June 30, 1995, the total commercial loan portfolio was $10.1
million, or 3.3% of the Bank's gross loan portfolio. The largest commercial
non-real estate loan is secured by the inventory and accounts receivable of a
retail business, in the amount of $643,000. Commercial loans are primarily
offered as an accommodation to existing customers and are only offered on a
secured basis. Unlike residential mortgage loans, which generally are made on
the basis of the borrower's ability to make repayment from employment and other
income and which are secured by real property whose value tends to be easily
ascertainable, commercial loans typically are made based upon the cash flow of
his or her business and are generally secured by business assets, such as
accounts receivable, equipment and inventory. As a result, the availability of
funds for the payment of commercial loans may be substantially dependent on the
success of the business itself. Further, the collateral securing the loan may
depreciate over time, occasionally cannot be appraised with as much precision as
residential real estate, and may fluctuate in value based on the success of the
business.

Loan Solicitation and Processing. Loan originations are derived from a
number of sources. Residential mortgage loan originations primarily come from
walk-in customers and referrals by realtors and previous and present borrowers.
Consumer loan applicants are primarily present depositors or mortgage borrowers.
Mortgage loans are originated in all of the Bank's offices and are processed and
serviced at the Bank's main office in Kingsport. Applications for fixed-rate,
one- to four-family real estate loans are underwritten and closed based on FHLMC
and

FNMA standards, and other loan applications are underwritten and closed based on
the Bank's own loan guidelines. Residential and commercial mortgage loans are
required to have title searches, title insurance, and fire and extended coverage
insurance.

Upon receipt of a loan application from a prospective borrower, a
credit report and verifications are ordered to verify specific information
relating to the loan applicant's employment, income and credit standing. An
appraisal of the real estate intended to secure the proposed loan is undertaken
by a fee appraiser approved by the Bank.

The Board of Directors of the Bank has the responsibility and authority
for general supervision over the loan policies of the Bank. Under the Bank's
lending policies, Vice Presidents currently have the authority to approve
residential mortgages in amounts up to $203,150, secured consumer loans up to
$100,000, and unsecured consumer loans for up to $25,000. The Senior Vice
President for Branch Administration is authorized to approve secured loans in
amounts up to $200,000 and unsecured loans up to $100,000. The President and the
Executive Vice President may approve secured loans up to $300,000 and unsecured
loans up to $200,000. All other loans must be considered for approval by the
Loan Committee of the Board of Directors. Branch managers and loan officers may
approve loans in amounts up to $25,000 for secured loans and $10,000 for
unsecured loans.

Loan applicants are promptly notified of the decision of the Bank.
Interest rates on approved loans are subject to change if the loan is not funded
within 60 days after approval. If an approved loan is not funded within the 60
days, management contacts the applicant to determine the loan's status. It has
been management's experience that substantially all approved loans are funded.

Loan Originations, Purchases and Sales. Loan originations decreased
37.1% during fiscal year 1995 to $51,536,000 compared with $81,902,000 in fiscal
year 1994 due to: a declining consumer demand for adjustable-rate mortgage
loans, which are the Bank's principal source of loan originations; increased
competition in the mortgage origination business; a general slowdown in new home
construction; and a general decline in the volume of residential loan
refinancings. Net loans receivable declined 3.6% to $297,533,000 at June 30,
1995, compared with $308,700,000 at June 30, 1994. This change reflected the net
repayment of loans, which slowed significantly during fiscal 1995 from the
year-earlier period due to higher market rates and moderating refinancing
activity, in excess of new loan originations. As a matter of policy, the Bank is
not active in the secondary markets with respect to both purchasing and/or
selling loans; however, loans may be sold in order to better manage the Bank's
interest rate risk or for other specific business purposes. In such cases, loans
are generally sold with servicing rights retained in order to maintain the
Bank's customer relationships. At June 30, 1995, the Bank was servicing $7.8
million in loans for others.

The Financial Institutions Reform, Recovery, and Enforcement Act of
1989 ("FIRREA") provides that the loans-to-one-borrower limits applicable to
national banks apply to savings associations in the same manner and to the same
extent. Previously, the Bank was generally authorized to make loans to one
borrower, including related entities, in an amount equal to the lesser of 10% of
deposits or 100% of regulatory capital. Under the new limits, with certain
limited exceptions, loans and extensions of credit to a person outstanding at
one time generally shall not exceed 15% of the unimpaired capital and surplus of
the savings association. Loans and extensions of credit fully secured by readily
marketable collateral may comprise an additional 10% of unimpaired capital and
surplus. At June 30, 1995, the Bank had no lending relationship in excess of the
new loans-to-one borrower limits.

Under OTS regulations which became effective March 19, 1993, savings
associations must adopt and maintain written policies that establish appropriate
limits and standards for extensions of credit that are secured by liens or
interests in real estate or are made for the purpose of financing permanent
improvements to real estate. These policies must establish loan portfolio
diversification standards, prudent underwriting standards, including
loan-to-value limits that are clear and measurable, loan administration
procedures and documentation, approval and reporting requirements. The real
estate lending policies must reflect consideration of the Interagency Guidelines
for Real Estate Lending Policies (the "Interagency Guidelines") that have been
adopted by the federal bank regulators.

The Interagency Guidelines, among other things, call upon depository
institutions to establish internal loan-to-value limits for real estate loans
that are not in excess of the following supervisory limits: (i) for loans
secured by raw land, the supervisory loan-to-value limit is 65% of the value of
the collateral; (ii) for land development loans (i.e., loans for the purpose of
improving unimproved property prior to the erection of structures), the
supervisory limit is 75%; (iii) for loans for the construction of commercial,
multi-family or other nonresidential property, the supervisory limit is 80%;
(iv) for loans for the construction of one-to-four family properties, the
supervisory limit is 85%; and (v) for loans secured by other improved property
(e.g., farmland, completed commercial property and other income-producing
property including non-owner-occupied, one-to-four family property), the limit
is 85%. Although no supervisory loan-to-value limit has been established for
owner-occupied, one-to-four family and home equity loans, the Interagency
Guidelines state that for any such loan with a loan-to-value ratio that equals
or exceeds 90% at origination, an institution should require appropriate credit
enhancement in the form of either mortgage insurance or readily marketable
collateral.

The Interagency Guidelines state that it may be appropriate in
individual cases to originate or purchase loans with loan-to-value ratios in
excess of the supervisory loan-to-value limits, based on the support provided by
other credit factors. The aggregate amount of loans in excess of the supervisory
loan-to-value limits, however, should not exceed 100% of total capital and the
total of such loans secured by commercial, agricultural, multi-family and other
non-one-to-four family residential properties should not exceed 30% of total
capital. The supervisory loan-to-value limits do not apply to certain categories
of loans including loans insured or guaranteed by the U.S. government and its
agencies or by financially capable state, local or municipal governments or
agencies, loans backed by the full faith and credit of a state government, loans
that are to be sold promptly after origination without recourse to a financially
responsible party, loans that are renewed, refinanced or restructured without
the advancement of new funds, loans that are renewed, refinanced or restructured
in connection with a workout, loans to facilitate sales of real estate acquired
by the institution in the ordinary course of collecting a debt previously
contracted and loans where the real estate is not the primary collateral.

The following table sets forth certain information with respect to the
loan origination and sale activity of the Bank during the periods indicated.
There were no loans purchased during fiscal years 1995, 1994, or 1993.

Years Ended June 30,
-------------------------------------------
1995 1994 1993
-------- ------- --------
(In thousands)

Loans originated:
Real estate loans:
Construction loans:
One- to four-family . . . . . . . . . . . . . . . $ 9,906 $ 10,305 $ 16,640
Multi-family . . . . . . . . . . . . . . . . . . -- 1,763 --
Non-residential and other . . . . . . . . . . . . 220 877 1,224
Permanent loans:
One- to four-family . . . . . . . . . . . . . . . 18,845 40,829 31,007
Multi-family . . . . . . . . . . . . . . . . . . 104 1,559 --
Non-residential and other . . . . . . . . . . . . 1,184 8,489 900
Consumer loans . . . . . . . . . . . . . . . . . . 16,384 15,270 12,841
Commercial loans . . . . . . . . . . . . . . . . . 4,893 2,810 1,724
-------- -------- --------
Total loans originated . . . . . . . . . . . . . $ 51,536 $ 81,902 $ 64,336
======== ======== ========
Loan repayments . . . . . . . . . . . . . . . . . . . . $ 64,347 $102,760 $ 95,112
======== ======== ========
Net increase (decrease) in gross loan portfolio . . . . $(12,811) $(20,858) $(30,776)
======== ======== ========

Interest Rates and Loan Fees. Interest rates charged by the Bank on
mortgage loans are primarily determined by competitive loan rates offered in its
market area. Mortgage loan rates reflect factors such as general interest rate
levels, the supply of money available to the savings industry and the demand for
such loans. These factors are in turn affected by general economic conditions,
the monetary policies of the Federal government, including the Board of
Governors of the Federal Reserve System (the "Federal Reserve Board"), the
general supply of money in the economy, tax policies and governmental budget
matters.

In addition to interest earned on loans, Heritage Federal receives fees
for servicing loans for others. Loan servicing fees usually are charged as a
percentage (between 0.25% and 0.65%) of the balance of the loans being serviced.
During the year ended June 30, 1995, the Bank reported loan servicing fee income
of $47,840 and at June 30, 1995 the Bank was servicing $7.8 million in loans for
others. In addition to loan servicing fees, the Bank receives fees in connection
with loan commitments and originations, loan modifications, late payments,
changes of property ownership and for miscellaneous services related to its
loans. Income from these activities varies from period to period with the volume
and type of loans originated, sold and purchased, which in turn are dependent
upon the prevailing mortgage interest rates and their effect on the demand for
loans in the markets served by the Bank.

To the extent that loans are originated or acquired for the portfolio,
Statement of Financial Accounting Standards ("SFAS") No. 91 limits immediate
recognition of loan origination or acquisition fees as revenues and requires
that such income (net of certain deferred loan origination or acquisition costs)
be recognized over the estimated lives of the related loans as an adjustment to
yield. SFAS No. 91 thus limits the amount of revenue that may be recognized by
Heritage Federal at the time it originates or acquires loans. At June 30, 1995,
the Bank had $0.9 million of net loan fees that had been deferred and were being
recognized as income over the estimated lives of the related loans.

Non-Performing Loans and Other Problem Assets. Management reviews the
Bank's loans on a monthly basis. After residential mortgage loans become past
due more than 90 days, the Bank generally establishes an allowance in the amount
of uncollected interest. Commercial and multi-family real estate loans generally
are placed on non-accrual status if the loan becomes past due more than 90 days,
or management concludes that payment in full is not likely. Consumer loans are
charged off, or a reserve for any expected loss is established, after they
become more than 120 days past due. Loans are charged off when management
concludes that they are uncollectible.

The Bank's collection procedures provide that when a loan becomes past
due 30 days, the borrower is contacted either by telephone or by letter, and
payment is requested. If payment is not promptly received, the borrower is
contacted again, and efforts are made to formulate an affirmative plan to cure
the delinquency. After a loan becomes past due 90 days, the Bank generally
initiates legal proceedings.

Real estate acquired by the Bank as a result of foreclosure is
classified as real estate owned until such time as it is sold. When such
property is acquired, it is recorded at the lower of the unpaid loan balance or
its fair market value. Any required write-down of the loan to its fair market
value upon foreclosure is charged against the allowance for loan losses.

The following table sets forth information with respect to the Bank's
non-performing loans and other problem assets at the dates indicated. At the
dates indicated, there were no accruing loans which were contractually past due
90 days or more as to principal or interest payments.

At June 30
-------------------------------------------------------------
1995 1994 1993 1992 1991
----- ---- ------ ----- ------
(Dollars in thousands)

Loans accounted for on a
non-accrual basis: (1)

Residential . . . . . . . . . . . . . $ 178 $375 $ 506 $ 519 $1,277
Non-residential and other . . . . . . -- 42 675 -- 90
Consumer and commercial . . . . . . . 47 48 97 672 613
----- ---- ------ ------ ------
Total . . . . . . . . . . . . . . 225 465 1,278 1,191 1,980

Other non-performing assets (2) . . . . 643 531 625 1,500 1,789
----- ---- ------ ------ ------
Total non-performing assets . . . $ 868 $996 $1,903 $2,691 $3,769
===== ==== ====== ====== ======
Non-performing loans as a
percentage of total loans . . . . . . 0.08% 0.15% 0.38% 0.32% 0.54%
===== ==== ====== ====== ======
Non-performing assets as a
percentage of total assets . . . . . 0.16% 0.19% 0.37% 0.50% 0.74%
===== ==== ====== ====== ======

- ---------------
(1) Non-accrual status denotes loans on which, in the opinion of
management, the collection of additional interest is unlikely. The Bank
has generally established an allowance for uncollectible interest,
which is netted with the accrued interest receivable, for those
mortgage loans that are 90 days past due. The allowance for
uncollectible interest is established in an amount equal to all
interest previously accrued. The allowance for uncollectible interest
on past due loans amounted to $28,611, $26,863, $43,112, $92,328 and
$179,675 at June 30, 1995, 1994, 1993, 1992 and 1991, respectively.

(2) Other non-performing assets represents property acquired by the Bank
through foreclosure or repossession, in-substance foreclosure, and
other repossessed collateral as well as restructured loans.. Real
estate properties acquired through loan foreclosure and loans
foreclosed in substance are initially recorded at the lower of the
related loan balance, less any specific allowance for loss, or fair
value at the date of foreclosure. Real estate acquired in settlement of
loans is carried at the lower of cost or net realizable value. At June
30, 1995, the Bank's only real estate acquired in settlement of loans
was fully reserved.

Asset Classification and Allowance for Loan Losses. Federal regulations
require savings associations to review their assets on a regular basis and to
classify them as "substandard," "doubtful" or "loss," if warranted. Assets
classified as "substandard" or "doubtful" require the institution to establish
general allowances for loan losses. If an asset or portion thereof is classified
as "loss," the insured institution must either establish specific allowances for
loan losses in the amount of 100% of the portion of the asset classified as
"loss," or charge off such amount. An asset which does not currently warrant
classification but which possesses weaknesses or deficiencies deserving close
attention is required to be designated as "special mention." Currently, general
loss allowances established to cover possible losses related to assets
classified "substandard" or "doubtful" may be included in determining an
institution's regulatory capital, while specific valuation allowances for loan
losses do not qualify as regulatory capital. See "Regulation of the Bank --
Regulatory Capital Requirements." OTS examiners may disagree with the insured
institution's classifications and amounts reserved. If an institution does not
agree with an examiner's classification of an asset, it may appeal this
determination to the OTS. The Bank has determined that at June 30, 1995 it had
$2.0 million in assets classified as "substandard," no assets classified as
"doubtful" and $0.3 million in assets classified as "loss." The Bank did not
have any assets designated as "special mention" at June 30, 1995.

In originating loans, the Bank recognizes that credit losses will be
experienced and that the risk of loss will vary with, among other things, the
type of loan being made, the creditworthiness of the borrower over the term of
the loan, general economic conditions and, in the case of a secured loan, the
quality of the security for the loan. The allowance for loan losses is based on,
among other things, the Bank's and the industry's historical loan loss
experience, management's evaluation of economic conditions and management's
regular reviews of delinquencies and loan portfolio quality. The Bank increases
its allowance for loan losses by charging provisions for possible loan losses
against the Bank's income.

General allowances are made pursuant to management's assessment of risk
in the Bank's loan portfolio as a whole. Specific allowances are provided for
individual loans when ultimate collection is considered questionable by
management after reviewing the current status of loans which are contractually
past due and considering the net realizable value of the security for the loan.

The OTS, along with the other federal banking regulators, has adopted a
joint policy statement on the adequacy of general valuation allowances
applicable to all federally-insured depository institutions. The policy
statement provides that the primary responsibility for judging the adequacy of
general valuation allowances lies with management. Examiners will evaluate the
methodology and process used by management to establish such allowances. In
addition, examiners will judge the adequacy of the allowance by calculating
whether the allowance is at least equal to the following percentages of assets:
(i) the amount of estimated credit losses estimated to result over the next
twelve months from unclassified and Special Mention assets based on annual net
charge-offs experienced during the previous two or three years; (ii) 15% of
Substandard assets; and (iii) 50% of Doubtful assets.

As a result of the declines in regional real estate market values and
the significant losses experienced by many financial institutions, there has
been a greater level of scrutiny by regulatory authorities of the loan
portfolios of financial institutions undertaken as part of the examination of
the institution by the FDIC, OTS or other federal or state regulators. Results
of recent examinations indicate that these regulators may be applying more
conservative criteria in evaluating real estate market values, requiring
significantly increased provisions for potential loan losses. While the Bank
believes it has established its existing allowances for loan losses in
accordance with generally accepted accounting principles, there can be no
assurance that regulators, in reviewing the Bank's loan portfolio, will not
request the Bank to significantly increase its allowance for loan losses,
thereby adversely affecting the Bank's financial condition and earnings.

Because of the wide market area served by the Bank and the strong
employment base in its two major markets, the general economic problems facing
the country are generally much less pronounced in the areas served by the Bank.
Moreover, the sale during fiscal year 1993 of the middle Tennessee branches,
which were located in an area characterized by real estate values which had
declined after significant appreciation in the 1980s and a rise in personal
bankruptcies, has allowed the Bank to focus its efforts on its more profitable
branches located in its two remaining service areas. While the Bank did retain
the loans associated with the middle Tennessee branches, management believes
that appropriate reserves have been established against these loans, and
originations in that area have ceased.

For fiscal years 1995, 1994 and 1993, the Bank provided approximately
$82,000, $487,300 and $595,000, respectively, for loan losses. Total charge-offs
decreased to $39,800 during fiscal year 1995 from $600,058 during fiscal year
1994 and $558,300 during fiscal year 1993. At June 30, 1995, the allowance for
possible loan losses represented 1,034.22 % of total non-accrual loans and loans
past due more than 90 days compared to 490.03% and 186.9% at June 30, 1994 and
1993, respectively.

The following table sets forth an analysis of the Bank's allowance for
loan losses for the periods indicated.

Year Ended June 30,
-------------------------------------------------------------
1995 1994 1993 1992 1991
------ ------ ------ ------ ------
(Dollars in thousands)

Balance at beginning of period . . . . $2,279 $2,388 $2,338 $1,926 $ 532
Loans charge-off: ------ ------ ------ ------ ------
Real estate mortgage
One- to four-family . . . . . . . . (6) (9) -- (15) (2)
Commercial (1) . . . . . . . . . . -- (495) -- (99) --
Consumer . . . . . . . . . . . . . . (28) (64) (143) (130) (13)
Commercial . . . . . . . . . . . . . (6) (32) (415) (100) (90)
------ ------ ------ ------ ------
Total charge-offs . . . . . . . . (40) (600) (558) (344) (105)
------ ------ ------ ------ ------
Recoveries:
One- to four-family . . . . . . . . . -- -- 8 -- --
Consumer . . . . . . . . . . . . . . 6 4 5 7 3
------ ------ ------ ------ ------
Total recoveries . . . . . . . . 6 4 13 7 3
------ ------ ------ ------ ------

Net loans charged-off . . . . . . . . . (34) (596) (545) (337) (102)
------ ------ ------ ------ ------

Provision for possible loan losses . . 82 487 595 749 1,496
------ ------ ------ ------ ------
Balance at end of period . . . . . . . $2,327 $2,279 $2,388 $2,338 $1,926
====== ====== ====== ====== ======

Ratio of allowance for loan
losses to gross loans (2) . . . . . . 0.76% 0.72% 0.71% 0.63% 0.51%
====== ====== ====== ====== ======

Ratio of net charge-offs to average
loans outstanding during period . . . 0.01% 0.19% 0.16% 0.09% 0.03%
====== ====== ====== ====== ======

- --------------------
(1) Includes multi-family, non-residential and other real estate.

(2) Before deductions for loans in process, unamortized discount and loan
loss allowances.

The following table sets forth the breakdown of the allowance for loan
losses by loan category at the dates indicated. The allocation of the allowance
to each category is not necessarily indicative of future losses and does not
restrict the use of the allowance to absorb losses in any category.

At June 30,
------------------------------------------------------------------------------------------
1995 1994 1993
--------------------------- ---------------------------- -----------------------------
% of % of % of
Loans Loans Loans
in Each % of in Each % of in Each % of
Category Allowance Category Allowance Category Allowance
to Total to Total to Total to Total to Total to Total
Amount Loans(1) Loans(1) Amount Loans(1) Loans(1) Amount Loans(1) Loans(1)
------ -------- --------- ------ -------- -------- ------ -------- ---------
(Dollars in thousands)
Real estate mortgage:

One- to four-family (2) . . . . . . . $1,224 79.33% 0.39% $1,224 79.87% 0.39% $1,117 83.22% 0.33%
Commercial (3) . . . . . . . . . . . -- 10.71 -- -- 10.16 -- 146 7.64 0.04
Construction (4) . . . . . . . . . . -- 2.31 -- -- 3.53 -- -- 3.30 --
Consumer . . . . . . . . . . . . . . 1,087 4.34 0.36 1,030 4.05 0.32 933 4.00 0.28
Commercial . . . . . . . . . . . . . 16 3.31 0.01 25 2.39 0.01 192 1.84 0.06
------ ------ ---- ------ ------ ---- ------ ------ ----
Total allowance for loan losses . . $2,327 100.00% 0.76% $2,279 100.00% 0.72% $2,388 100.00% 0.71%
====== ====== ==== ====== ====== ==== ====== ====== ====

At June 30,
----------------------------------------------------------
1992 1991
--------------------------- ---------------------------
% of % of
Loans Loans
in Each % of in Each % of
Category Allowance Category Allowance
to Total to Total to Total to Total
Amount Loans(1) Loans(1) Amount Loans(1) Loans(1)
------ -------- -------- ------ -------- --------
(Dollars in thousands)
Real estate mortgage:

One- to four-family (2) . . . . . . . $ 901 81.87% 0.24% $ 719 79.96% 0.19%
Commercial (3) . . . . . . . . . . . -- 8.98 -- -- 10.84 --
Construction (4) . . . . . . . . . . -- 2.87 -- -- 2.06 --
Consumer . . . . . . . . . . . . . . 1,225 4.52 0.33 830 5.32 0.22
Commercial . . . . . . . . . . . . . 212 1.76 0.06 377 1.82 0.10
------ ------ ---- ------ ------ ----
Total allowance for loan losses . . $2,338 100.00% 0.63% $1,926 100.00% 0.51%
====== ====== ==== ====== ====== ====

- --------------------
(1) Before deductions for loans in process, unamortized discount and loan
loss allowances.
(2) Includes loans held for sale.
(3) Includes multi-family, non-residential and other real estate.
(4) Includes residential and commercial construction loans.

INVESTMENT ACTIVITIES

Heritage Federal is required under federal regulations to maintain a
minimum amount of liquid assets, which can be invested in specified short-term
securities, and is also permitted to make certain other investments. See
"Regulation of the Bank -- Liquidity Requirements." It has generally been
Heritage Federal's policy to maintain a liquidity portfolio in excess of the
amount required to satisfy regulatory requirements and the Bank's average daily
liquidity ratio of 19.25% for the month of June 1995 exceeded the 5% regulatory
requirement. Liquidity levels may be increased or decreased depending upon the
yields on investment alternatives, management's judgment as to the
attractiveness of the yields then available in relation to other opportunities,
its expectations of the level of yield that will be available in the future and
its projections as to the short-term demand for funds to be used in the Bank's
loan origination and other activities.

The general objectives of Heritage Federal's investment policy are to
(1) protect Heritage Federal's depositor resources, (2) maintain liquidity
levels to meet the operational needs of the Bank and applicable regulatory
requirements, (3) reduce credit risk by investing in high quality, diverse
investments, (4) serve as a hedge against significant interest rate shifts, (5)
contribute to earnings in a stable and dependable manner without compromising
the goals of liquidity and safety, and (6) provide collateral for pledging
needs. The Bank's investment activities are conducted by the investment officer
and senior management and supervised by the Board of Directors. An investment
policy has been adopted by the Board which provides for maintenance of the
investment portfolio for the purpose of providing earnings and ensuring a
minimum liquidity reserve. In accordance with the investment policy, management
has primarily invested in U.S. Treasury debt securities backed by the full faith
and credit of the United States, debt obligations issued by U.S.
government-sponsored enterprises ("GSE's") such as the Federal National Mortgage
Association ("FNMA") or Federal Home Loan Mortgage Corporation ("FHLMC"),
mortgage-backed securities issued by FNMA, FMLMC, or guaranteed by the
Government National Mortgage Association ("GNMA"), federal funds sold, and
interest-bearing deposits in other banks. General obligation and bank-qualified
bonds of municipalities within the market areas served by the Bank and which are
considered to possess acceptable credit and limited default risk are also
considered for investment. In addition, the Bank also invests in collateralized
mortgage obligations ("CMOs") when management determines that such obligations
represent appropriate investment vehicles. At June 30, 1995, the Bank had CMO
balances of approximately $14.9 million, representing approximately 7.2% of the
total investment portfolio. At June 30, 1995, fixed-rate CMOs amounted to
approximately $4.0 million, consisting principally of such types meeting the
regulatory definition of non-high risk mortgage derivatives. Adjustable-rate
CMOs totaled approximately $10.9 million at June 30, 1995, funded principally by
a floating-rate advance from the FHLB of Cincinnati.

Although mortgage-backed securities yield from 60 to 100 basis points
less than whole loans, they present substantially lower credit risk and are more
liquid than individual mortgage loans and may be used to collateralize
obligations of the Bank. Because the Bank receives regular payments of principal
and interest from its mortgage-backed securities, these investments provide more
consistent cash-flows than investments in other debt securities which generally
only pay principal at maturity. Mortgage- backed securities also help the Bank
meet certain definitional tests for favorable treatment under federal banking
and tax laws. See "Regulation of the Bank -- Qualified Thrift Lender Test" and
"Taxation."

Mortgage-backed securities, however, expose the Bank to certain unique
risks. In a declining rate environment, accelerated prepayments of loans
underlying these securities expose the Bank to the risk that it will be unable
to obtain comparable yields upon reinvestment of the proceeds. In the event the
mortgage-backed security has been funded with an interest-bearing liability with
a maturity comparable to the original estimated life of the mortgage-backed
security, the Bank's interest rate spread could be adversely affected.
Conversely, in a rising interest rate environment, the Bank may experience a
lower than estimated rate of repayment on the underlying mortgages, effectively
extending the estimated life of the mortgage-backed security and exposing the
Bank to the risk that it may be required to fund the asset with a liability
bearing a higher rate of interest. The Bank seeks to minimize the effect of
extension risk by focusing on investments in adjustable-rate and/or relatively
short-term (five to seven year maturity) balloon types of mortgage-backed
securities.

18
During 1992, the Federal Financial Institutions Examination Council
("FFIEC") issued a policy, which has since been adopted by all principal
regulatory authorities, regarding the suitability of investment in certain
mortgage derivative securities, including CMOs. This policy establishes a three
part risk measurement test for fixed-rate, and a one part test for
floating-rate, derivative instruments. Securities failing any one of the tests
are deemed to be "unsuitable" investments and must be transferred into a
"trading" portfolio reported at market value. At June 30, 1995, all of the
Bank's securities included in its investment portfolio met the criteria
established by the policy for continued classification as suitable investments.

The Board of Directors of the Bank has authorized a trading account in
an amount not to exceed $8,000,000 for the purpose of taking advantage of
favorable short-term market conditions. The Bank's investment policy specifies
that securities traded within this account must be U.S. Treasury or agency
obligations, and losses may not exceed the lesser of $10,000 per trade or
$25,000 per month. The trading account is administered by the Chief Financial
Officer and the Investment Manager. Securities positions in the trading account
are reported to the Board of Directors on a monthly basis. During the year ended
June 30, 1995, no securities were traded. At June 30, 1995, there were no
securities held in the trading account. It is anticipated that any future
activity in the trading account will involve medium-term U.S. Treasury Notes or
GNMA mortgage-backed securities.

The Bank adopted on a prospective basis SFAS No. 115 at the beginning
of fiscal year 1995, and in doing so, designated a portion of its investment
portfolio as available for sale. Securities designated as available for sale
consist of U. S. Treasury notes with laddered maturities, amounting to
approximately $20,000,000 in principal face value at June 30, 1995. The fair
value of these securities at June 30, 1995, with unrealized gains or losses, net
of taxes, of approximately $84,000 reflected as a separate component of
stockholders' equity, totaled $20,213,000. At that date, available for sale
securities had a weighted average life of approximately 1.1 years. The Bank
anticipates the available for sale portion of its investment portfolio will be
maintained as necessary in order to satisfy its liquidity needs. In the event
funds are needed for deposit account withdrawals, loan demand or other liquidity
purposes, these securities could be liquidated. For additional information, see
Note 3 of Notes to Consolidated Financial Statements.

The following table sets forth the book value of the Bank's investment
portfolio at the dates indicated. At June 30, 1995, the market value of the
Bank's investment portfolio was $206.1 million.

Years Ended June 30,
----------------------------------
1995 1994 1993
-------- -------- --------
(In thousands)

Investment and mortgage-backed securities:

Available for sale *
U.S. government obligations . . . . . . . . . . . . $ 20,213 $ -- $ --

Held to maturity
U.S. government and agency securities . . . . . . . 71,686 75,182 72,322
Collateralized mortgage obligations . . . . . . . . 14,942 5,615 8,851
Mortgage-backed securities . . . . . . . . . . . . . 83,995 92,558 60,089

Other investments:
Federal funds sold . . . . . . . . . . . . . . . . . 7,000 3,000 9,075
Equity securities . . . . . . . . . . . . . . . . . -- -- 8,000
Interest-earning deposits . . . . . . . . . . . . . 5,593 2,295 4,022
FHLB stock . . . . . . . . . . . . . . . . . . . . . 4,057 3,808 3,628
-------- -------- --------
Total investments . . . . . . . . . . . . . . . $207,486 $182,458 $165,987
======== ======== ========

- ---------------
* The Bank implemented SFAS No. 115 during the first quarter of fiscal
year 1995. Available-for-sale securities are shown at estimated market
value at June 30, 1995. All investments in fiscal years 1994 and 1993
were classified in accordance with management's positive intent to hold
such investments to maturity.

The following table sets forth the scheduled maturities, carrying
values, market values and average yields for the Bank's investment portfolio at
June 30, 1995.

At June 30,
--------------------------------------------------------------------------------------
After One Through After Five Through
One Year or Less Five Years Ten Years After Ten Years
------------------- ------------------- ------------------- ------------------
Weighted Weighted Weighted Weighted
Carrying Average Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield Value Yield
-------- -------- -------- -------- -------- -------- -------- --------
(Dollars in thousands)

Investment and mortgage-backed securities:

Available for sale (1)
U.S. government
obligations.......................... $ 7,072 6.20% $13,141 6.47% $ -- -- % $ -- -- %

Held to maturity
Collateralized mortgage
obligations........................... -- -- 748 6.85 2,032 6.33 12,162 7.68
U.S. government and
agency securities (2)................. 5,048 6.64 40,391 5.98 24,247 6.76 2,000 7.88
Mortgage-backed securities.............. 919 8.07 15,137 6.02 5,716 6.40 62,223 6.13

Other investments:
Federal funds sold...................... 7,000 6.05 -- -- -- -- -- --
Interest-earning deposits
and certificates of
deposit............................... 5,593 5.95 -- -- -- -- -- --
FHLB stock.............................. -- -- -- -- -- -- 4,057 6.63
------- ------- ------- --------
Total............................... $25,632 6.26% $69,417 6.09% $31,995 6.67% $ 80,442 6.43%
======= ======= ======= ========

At June 30,
-------------------------------
Total Investment Portfolio
-------------------------------
Weighted
Carrying Market Average
Value Value Yield
-------- -------- --------
(Dollars in thousands)

Investment and mortgage-backed securities:

Available for sale (1)
U.S. government
obligations.......................... $ 20,213 $ 20,213 6.38%

Held to maturity
Collateralized mortgage
obligations........................... 14,942 15,333 7.45
U.S. government and
agency securities (2)................. 71,686 70,925 6.34
Mortgage-backed securities.............. 83,995 83,012 6.15

Other investments:
Federal funds sold...................... 7,000 7,000 6.05
Interest-earning deposits
and certificates of
deposit............................... 5,593 5,593 5.95
FHLB stock.............................. 4,057 4,057 6.63
-------- --------
Total............................... $207,486 $206,133 6.33%
======== ========

- ---------------------
(1) All values shown for available for sale securities are estimated
market values at June 30, 1995.
(2) Yields on tax-exempt obligations have been computed on a
tax-equivalent basis.

DEPOSIT ACTIVITY AND OTHER SOURCES OF FUNDS

GENERAL. Deposits are the primary source of the Bank's funds for
lending, investment activities and general operational purposes. In addition to
deposits, Heritage Federal derives funds from loan principal and interest
repayments, maturities of investment securities and interest payments thereon.
Although loan repayments are a relatively stable source of funds, deposit
inflows and outflows are significantly influenced by general interest rates and
money market conditions. Borrowings may be used on a short-term basis to
compensate for reductions in the availability of funds, or on a longer term
basis for general operational purposes.

DEPOSITS. The Bank attracts deposits principally from within its
primary market areas by offering a variety of deposit instruments, including
checking accounts, money market accounts, regular savings accounts, retirement
savings plans, and certificates of deposit which range in maturity from seven
days to four years. Deposit terms vary according to the minimum balance
required, the length of time the funds must remain on deposit and the interest
rate. Maturities, terms, service fees and withdrawal penalties for its deposit
accounts are established by the Bank on a periodic basis. Heritage Federal
generally reviews its deposit mix and pricing on a weekly basis. In determining
the characteristics of its deposit accounts, Heritage Federal considers the
rates offered by competing institutions, funds acquisition and liquidity
requirements, growth goals, and federal regulations. The Bank does not accept
brokered deposits due to the volatility and rate sensitivity of such deposits.

Heritage Federal competes for deposits with other institutions in its
market areas by offering deposit instruments that are competitively priced and
providing customer service through convenient and attractive offices,
knowledgeable and efficient staff, and hours of service that meet customers'
needs. To provide additional convenience, Heritage Federal maintains Automatic
Teller Machines at branches through which customers can gain access to their
accounts at any time.

Heritage Federal began offering commercial demand deposit accounts in
1981 in order to attract local businesses to the Bank. Commercial account
customers are encouraged to use the Bank for all of their banking activities.
Such accounts totaled $25.7 million, or 5.7% of total deposits, at June 30,
1995.

Deposits in the Bank as of June 30, 1995 were represented by the
various programs described below.

Interest Minimum Minimum Balances Percentage of
Rate Term Category Amount (in thousands) Total Savings
- -------- ------- -------- ------- -------------- -------------

2.25% None NOW and Demand Accounts (1) $ 100 $ 66,983 14.91%
2.75% None Passbook Savings 10 68,433 15.23%
3.31% None Money Market Deposit Accounts 2,500 17,845 3.97%
2.50% None Super NOW Accounts 2,500 7,514 1.67%
-------- ------
Total $160,775 35.78%
-------- ------
Certificates of Deposit

2.34% 7-31 Day Fixed-Term, Fixed-Rate $ 2,500 $ 574 0.13%
2.51% 31-92 Day Fixed-Term, Fixed-Rate 2,500 340 0.08%
3.10% 92-181 Day Fixed-Term, Fixed-Rate 2,500 661 0.15%
4.06% 6 Month Fixed-Term, Fixed-Rate 2,500 31,789 7.07%
5.96% 7 Month Fixed-Term, Fixed-Rate 2,500 28,625 6.37%
4.91% 12 Month Fixed-Term, Fixed-Rate 1,000 28,687 6.38%
5.89% 13 Month Fixed-Term, Fixed-Rate 1,000 61,729 13.74%
5.27% 18 Month Fixed-Term, Fixed-Rate 1,000 9,548 2.12%
5.54% 24 Month Fixed-Term, Fixed-Rate 1,000 12,963 2.88%
5.35% 30 Month Fixed-Term, Fixed-Rate 1,000 27,254 6.07%
5.39% 36 Month Fixed-Term, Fixed-Rate 1,000 9,013 2.01%
5.89% 48 Month Fixed-Term, Fixed-Rate 1,000 23,852 5.31%
4.52% 12 Month IRA Fixed-Term (Variable) 25 6,698 1.49%
5.80% Jumbo (2) Fixed-Term, Fixed-Rate 100,000 17,251 3.84%
5.91% Other Fixed-Term, Fixed-Rate 10,000 29,559 6.58%
-------- ------
Total certificates $288,543 64.22%
-------- ------
Total deposits $449,318 100.00%
======== ======

- --------------------
(1) Includes non-interest-bearing demand accounts.
(2) Reflects certificates of deposits greater than $100,000.

The following table sets forth the change in dollar amount of deposits in
the various types of accounts offered by the Bank between the dates indicated.

At June 30, 1995 At June 30, 1994 At June 30, 1993
----------------------------- ------------------------------- --------------------
Increase Increase
(Decrease) (Decrease)
% of from Prior % of from Prior % of
Balance Deposits Year Balance Deposits Year Balance Deposits
------- -------- ---------- ------- -------- ---------- ------- --------
(Dollars in thousands)

Now and demand accounts (1) . . . . . $ 66,983 14.91% $ (6,084) $ 73,067 16.21% $ 4,998 $ 68,069 14.80%
Jumbo certificates (2) . . . . . . . 17,251 3.84 7,986 9,265 2.06 1,298 7,967 1.73
Super NOW and Money Market Deposit
Accounts . . . . . . . . . . . . . 25,359 5.64 (9,693) 35,052 7.78 (1,362) 36,414 7.92
Passbook and regular savings . . . . 68,433 15.23 (23,008) 91,441 20.28 4,874 86,567 18.82
7-181 day certificates . . . . . . . 1,575 0.36 (1,265) 2,840 .63 (373) 3,213 0.70
6 month certificates . . . . . . . . 31,789 7.07 (30,690) 62,479 13.85 (8,214) 70,693 15.36
7 month certificates . . . . . . . . 28,625 6.37 28,625 -- -- -- -- --
12 month certificates . . . . . . . . 28,687 6.38 (21,652) 50,339 11.17 (3,826) 54,165 11.78
13 month certificates . . . . . . . . 61,729 13.74 61,729 -- -- -- -- --
18 month certificates . . . . . . . . 9,548 2.12 (2,253) 11,801 2.62 302 11,499 2.50
30 month certificates . . . . . . . . 27,254 6.07 (6,706) 33,960 7.52 (5,005) 38,965 8.47
Negotiable . . . . . . . . . . . . . 29,559 6.58 (1,539) 31,098 6.90 322 30,776 6.69
Other . . . . . . . . . . . . . . . . 52,526 11.69 3,049 49,477 10.98 (2,188) 51,665 11.23
-------- ------ -------- -------- ------ ------- -------- ------
Total . . . . . . . . . . . . . . $449,318 100.00% $ (1,501) $450,819 100.00% $(9,174) $459,993 100.00%
======== ====== ======== ======== ====== ======= ======== ======

- --------------------
(1) Includes non-interest-bearing demand accounts.

(2) Reflects certificates of deposits greater than $100,000.

The following tables set forth the average balances and interest rates
based on month-end balances for interest-bearing demand deposits and time
deposits as of the dates indicated.

Year Ended June 30,
---------------------------------------------------------------------------------------------------
1995 1994 1993
------------------------ -------------------------- ----------------------------
Interest- Interest- Interest-
Bearing Bearing Bearing
Demand Savings Time Demand Savings Time Demand Savings Time
Deposits Deposits Deposits Deposits Deposits Deposits Deposits Deposits Deposits
---------------------------------------------------------------------------------------------------
(Dollars in thousands)

Average balance . . . . . $92,440 $79,116 $262,357 $100,423 $91,075 $262,928 $90,336 $82,091 $280,539
Average rate . . . . . . 2.53% 2.75% 4.69% 2.35% 2.80% 4.16% 2.79% 3.35% 4.85%

The following table sets forth the time deposits in the Bank classified
by rates as of the dates indicated.

At June 30,
------------------------------------
Rate 1995 1994 1993
---------- ---- ---- ----
(In thousands)

4.00% and under . . . . . . . . . . . . . . . . $ 15,415 $145,247 $151,753
4.01% - 6.00% . . . . . . . . . . . . . . . . 178,065 99,393 89,517
6.01% - 8.00% . . . . . . . . . . . . . . . . 94,592 6,171 25,515
8.01% - 9.50% . . . . . . . . . . . . . . . . 471 448 2,043
9.51% - 11.50% . . . . . . . . . . . . . . . . -- -- --
11.51% and above . . . . . . . . . . . . . . . -- -- 115
-------- -------- --------
$288,543 $251,259 $268,943
======== ======== ========

The following table indicates the amount of the Bank's certificates of
deposit of $100,000 or more by time remaining until maturity as of June 30,
1995.

Certificates
Maturity Period of Deposit
--------------- ------------
(In thousands)

Three months or less . . . . . . . . . . $13,970
Over three through six months . . . . . 8,965
Over six through twelve months . . . . . 17,226
Over twelve months . . . . . . . . . . . 7,690
-------
Total . . . . . . . . . . . . . . . $47,851
=======

The following table sets forth the Bank's deposit activities for the
periods indicated.

Years Ended June 30,
------------------------------------------
1995 1994 1993
---- ---- ----

Deposits . . . . . . . . . . . . . . . . . . . . . . . $1,359,160 $1,394,825 $1,407,913
Withdrawals . . . . . . . . . . . . . . . . . . . . . . 1,374,786 1,417,582 1,460,702
---------- ---------- ----------
Net decrease before interest credited . . . . . . . . (15,626) (22,757) (52,789)
Interest credited . . . . . . . . . . . . . . . . . . . 14,125 13,583 15,853
---------- ---------- ----------
Net increase (decrease) in savings deposits . . . . . $ (1,501) $ (9,174) $ (36,936)
========== ========== ==========

The net decrease in deposits before and after interest credited for
the year ended June 30, 1993 primarily reflects the Bank's sale, on August 7,
1992, of its five branch offices in the middle Tennessee area. The buyer, Trans
Financial Federal Savings Bank, assumed approximately $55 million in deposits.
The Bank's deposits in its other thirteen remaining branches increased
approximately 4.0% during fiscal year 1993. During fiscal year 1994, the Bank's
deposits declined 2.0%. Management believes the decline in deposits during
fiscal year 1994 was primarily attributable to the disintermediation behavior of
retail customers in a period of relatively low market interest rates. With
savings rates being the lowest offered by banks in many years, some depositors
sought higher yields. Alternative investment vehicles such as annuities and
mutual funds assumed a greater prominence in the marketplace, with investments
in such vehicles rising significantly during the period in spite of an upward
trend in interest rates during the second half of fiscal year 1994. During
fiscal year 1995, deposits declined $1.5 million, or .3%. Monetary policy
restraint by the Federal Reserve caused interest rates to move higher throughout
most of the fiscal year. With higher market interest rates prevailing, interest
rate differentials between transaction accounts

(such as NOW accounts and regular savings) and certificates of deposit reached
greater levels than those seen in the previous two years. This prompted a
considerable movement of depositor funds from lower interest-bearing accounts to
higher-yielding deposit products. This environment created increased competition
among financial institutions as many interest-rate-sensitive deposit customers
sought the best yields available in the marketplace. In response to
high-yielding alternative investment vehicles offered by the Bank's competition,
the Bank began offering seven- and 13-month certificates of deposit accounts in
July, 1994. Rates offered on these products were very competitive in relation to
other comparable investments available to deposit customers. This pricing
strategy allowed the Bank to retain the majority of its maturing
interest-sensitive deposits during the fiscal year, as well as minimizing its
marginal interest expense.

BORROWINGS. Savings deposits historically have been the primary source
of funds for the Bank's lending, investment, and general operating activities.
The Bank is authorized, however, to use advances from the FHLB of Cincinnati to
supplement its supply of lendable funds and to meet deposit withdrawal
requirements. The FHLB of Cincinnati functions as a central reserve bank
providing credit for savings institutions and certain other member financial
institutions. As a member of the FHLB System, Heritage Federal is required to
own stock in the FHLB of Cincinnati and is authorized to apply for advances.
Advances are pursuant to several different programs, each of which has its own
interest rate and range of maturities. Heritage Federal may obtain advances from
the FHLB of Cincinnati subject to underwriting approval. The Bank currently has
approval for a cash management advance in the amount of $25.0 million, which can
be accessed immediately should the need arise. The Bank has executed a blanket
pledge of its mortgage loan portfolio as collateral for all outstanding advances
from the FHLB. The Bank had approximately $18.1 million of advances outstanding
at June 30, 1995, and these advances were obtained for the purpose of increasing
the Bank's net interest income through the funding of additional purchases of
mortgage-backed securities and CMO's.

TRUST ACTIVITIES

The Bank has offered personal trust services since 1985. The Bank acts
as trustee for discretionary and non-discretionary accounts. The Bank's trust
activities include the administration of estates and testamentary trusts, acting
as trustee for profit-sharing plans and self-directed individual retirement
accounts, and acting in a variety of other fiduciary and custodial capacities.
At June 30, 1995, the Bank's Trust Department had $26.2 million in assets under
management.

SUBSIDIARY ACTIVITIES

As a federally chartered savings bank, Heritage Federal is permitted to
invest an amount equal to 2% of its assets in subsidiaries with an additional
investment of 1% of assets where such investment serves primarily community,
inner-city and community development purposes. Under such limitations, as of
June 30, 1995 Heritage Federal was authorized to invest up to approximately
$15.5 million in the stock of or loans to subsidiaries, including the additional
1% investment for community inner-city and community development purposes.
Heritage Federal may currently invest up to 50% of its regulatory capital in
conforming first mortgage loans to subsidiaries in which it owns 10% or more of
the capital stock.

The Bank's only service corporation is Citizens Financial, in which its
investment was $1.8 million at June 30, 1995. The activities of Citizens
Financial are currently not significant. Citizens Financial's principal activity
is that of a title insurance agency. Approximately 80% of its policies are
generated by the Bank's lending activity, with the remainder related to local
attorneys' activities and national referrals. Citizens Financial is an agent of
Ticor Title Insurance Company and Old Republic National Title Insurance Company.
In August 1993, Citizens Financial entered into a three-year agreement with
third-party vendors under which the vendors sold annuities and securities in the
thirteen branch offices of the Bank and Citizens Financial will leased space to
the vendors. Citizens Financial received a percentage of the commissions related
to the sale of those products and did not assume any related risk or expense,
except as to certain supplies and office equipment. The sales operations
commenced at the end of September 1993. This arrangement continued throughout
most of fiscal year 1995.

SAIF-insured savings institutions such as Heritage Federal must give
the FDIC and the Director of the OTS 30 days prior notice before establishing or
acquiring a new subsidiary, or commencing any new activity through an existing
subsidiary. Both the FDIC and the Director of the OTS have authority to order
termination of subsidiary activities determined to pose a risk to the safety or
soundness of the institution. In addition, recently adopted capital requirements
require savings institutions to deduct the amount of their investments in and
extensions of credit to subsidiaries engaged in activities not permissible to
national banks from capital in determining regulatory capital compliance. The
activities of Citizens Financial are permissible for national banks.

EMPLOYEES

As of June 30, 1995, the Company and its subsidiary had 159 full-time
and 17 part-time employees, none of whom was represented by a collective
bargaining agreement.

COMPETITION

The Bank faces strong competition both in originating real estate and
other loans and in attracting deposits. The Bank competes for real estate and
other loans principally on the basis of interest rates and the loan fees it
charges, the types of loans it originates and the quality of services it
provides to borrowers. Its primary competition in originating real estate loans
comes from other savings institutions, credit unions and mortgage bankers making
loans secured by real estate located in the Bank's market areas. Commercial
banks, credit unions, and finance companies provide vigorous competition in
consumer lending.

The Bank attracts all its deposits through its branch offices primarily
from the communities in which those branch offices are located. Consequently,
competition for deposits is principally from other savings institutions,
commercial banks, credit unions and brokers in these communities. Heritage
Federal competes for deposits and loans by offering a variety of deposit
accounts at competitive rates, a wide array of loan products, convenient
business hours and branch locations, a commitment to outstanding customer
service and a well-trained staff. In addition, the Bank believes it has
developed strong relationships with local businesses, realtors, and the public
in general giving it an excellent image in the community.

Management believes its primary market to be the city of Kingsport and
the immediately surrounding area. Management believes that the Bank is the
fourth largest depository institution in this market with approximately 13.2% of
the aggregate deposits. In Oak Ridge, the Bank's second leading market, the Bank
holds approximately 7.2% of the deposits, making it the seventh largest
depository institution, fourth largest non-credit union depository institution,
and the largest savings institution in this market.

REGULATION OF THE BANK

GENERAL. As a savings association, Heritage Federal is subject to
extensive regulation by the OTS. The lending activities and other investments of
the Bank must comply with various federal regulatory requirements. The OTS will
periodically examine the Bank for compliance with various regulatory
requirements. The FDIC also has the authority to conduct examinations of SAIF
members. The Bank must file reports with OTS describing its activities and
financial condition. The Bank is also subject to certain reserve requirements
promulgated by the Federal Reserve Board. This supervision and regulation is
intended primarily for the protection of depositors. Certain of these regulatory
requirements are referred to below or appear elsewhere herein.

FEDERAL HOME LOAN BANK SYSTEM. The Bank is a member of the FHLB System,
which consists of twelve district Federal Home Loan Banks subject to supervision
and regulation by the Federal Housing Finance Board ("FHFB"). The Federal Home
Loan Banks provide a central credit facility primarily for member institutions.
As a member of the FHLB of Cincinnati, the Bank is required to acquire and hold
shares of capital stock in the FHLB of Cincinnati in an amount at least equal to
1% of the aggregate unpaid principal of its home mortgage loans, home purchase
contracts, and similar obligations at the beginning of each year, or 1/20 of its
advances (borrowings) from the FHLB of Cincinnati, whichever is greater. The
FHLB of Cincinnati serves as a reserve or central bank for its

member institutions within its assigned district. It is funded primarily from
proceeds derived from the sale of consolidated obligations of the FHLB System.
It makes advances to members in accordance with policies and procedures
established by the FHFB and the Board of Directors of the FHLB of Cincinnati.
Long-term advances may only be made for the purpose of providing funds for
residential housing finance. See "Sources of Funds -- Borrowings."

LIQUIDITY REQUIREMENTS. The Bank is required to maintain average daily
balances of liquid assets (cash, certain time deposits, bankers' acceptances,
highly rated corporate debt and commercial paper, securities of certain mutual
funds, and specified United States government, state or federal agency
obligations) equal to the monthly average of not less than a specified
percentage (currently 5%) of its net withdrawable savings deposits plus
short-term borrowings. The Bank is also required to maintain average daily
balances of short-term liquid assets at a specified percentage (currently 1%) of
the total of its net withdrawable savings accounts and borrowings payable in one
year or less. Monetary penalties may be imposed for failure to meet liquidity
requirements. The average daily liquidity and short-term ratios of the Bank for
the month ended June 30, 1995 were 19.25% and 5.07%, respectively.

QUALIFIED THRIFT LENDER TEST. A savings association that does not meet
the Qualified Thrift Lender test ("QTL Test") must either convert to a bank
charter or comply with the following restrictions on its operations: (i) the
institution may not engage in any new activity or make any new investment,
directly or indirectly, unless such activity or investment is permissible for a
national bank; (ii) the branching powers of the institution shall be restricted
to those of a national bank; (iii) the institution shall not be eligible to
obtain any advances from its FHLB; and (iv) payment of dividends by the
institution shall be subject to the rules regarding payment of dividends by a
national bank. Upon the expiration of three years from the date the institution
ceases to be a Qualified Thrift Lender, it must cease any activity, and not
retain any investment not permissible for a national bank and immediately repay
any outstanding FHLB advances (subject to safety and soundness considerations).

Effective January 1, 1992, the QTL Test was amended to require that
Qualified Thrift Investments represent 65% of portfolio assets rather than 70%
as required after July 1, 1992. Under OTS implementing regulations, portfolio
assets are defined as total assets less intangibles, the value of property used
by a savings association in its business and liquidity investments in an amount
not exceeding 20% of assets. OTS regulations define Qualified Thrift Investments
to include, among other things, loans that were made to purchase, refinance,
construct, improve or repair domestic residential housing, home equity loans,
mortgage-backed securities, FHLB, FHLMC or FNMA stock and, subject to a 5% of
assets limitation, loans for personal, family. household or education purposes.
Qualified Thrift Investments do not include any intangible asset. Subject to a
20% of portfolio assets limit, savings associations are able to treat as
Qualified Thrift Investments 200% of their investments in loans to finance
"starter homes" and loans for construction, development or improvement of
housing and community service facilities or for financing small businesses in
"credit-needy" areas.

A savings association that was not subject to penalties for failure to
maintain Qualified Thrift Lender status as of June 30, 1991 shall be deemed a
Qualified Thrift Lender so long as its percentage of Qualified Thrift
Investments continues to equal or exceed 65% in at least nine out of each 12
months. For the period from January 1, 1992 until December 31, 1992, a savings
association ceased to be a Qualified Thrift Lender if its percentage of
Qualified Thrift Investments as measured by monthly averages fell below 65% for
four or more months. Beginning January 1, 1993, a savings association will cease
to be a Qualified Thrift Lender when its percentage of Qualified Thrift
Investments as measured by monthly averages over the immediately preceding
12-month period falls below 65% for four or more months. A savings association
that fails to maintain Qualified Thrift Lender status will be permitted to
requalify once, and if it fails the QTL Test a second time, it will become
immediately subject to all penalties as if all time limits on such penalties had
expired.

Since the Bank was not subject to sanctions for failure to comply with
the QTL Test as of June 30, 1991, it will remain in compliance until its monthly
average percentage of Qualified Thrift Investments to portfolio assets falls
below 65% for four or more months as measured by monthly averages over the
preceding 12-month period. At June 30, 1995, the Bank's QTL ratio was 84.84 %.

26
27

DIVIDEND LIMITATIONS. Under OTS regulations, the Bank may not pay
dividends on its capital stock if its regulatory capital would thereby be
reduced below the amount then required for the liquidation account established
for the benefit of certain depositors of the Bank at the time of its conversion
to stock form. In addition, savings association subsidiaries of savings and loan
holding companies are required to give the OTS 30 days prior notice of any
proposed declaration of dividends to the holding company.

Federal regulations impose additional limitations on the payment of
dividends and other capital distributions (including stock repurchases and cash
mergers) by the Bank. Under these regulations, a savings association that,
immediately prior to, and on a pro forma basis after giving effect to, a
proposed capital distribution, has total capital (as defined by OTS regulation)
that is equal to or greater than the amount of its fully phased-in capital
requirements (a "Tier 1 Association") is generally permitted without OTS
approval to make capital distributions during a calendar year in the amount
equal to the higher of (i) 75% of its net income over the most recent
four-quarter period or (ii) up to 100% of its net income to date during the
calendar year plus an amount that would reduce by one-half the amount by which
its total capital to assets ratio exceeded its fully phased-in capital
requirement to assets ratio at the beginning of the calendar year. A savings
association with total capital in excess of current minimum capital requirements
but not in excess of the fully phased-in requirements (a "Tier 2 Association")
is permitted to make capital distributions without OTS approval of up to 75% of
its net income for the previous four quarters, less dividends already paid for
such period depending on the savings association's level of risk-based capital.
A savings association that fails to meet current minimum capital requirements (a
"Tier 3 Association") is prohibited from making any capital contributions
without the prior approval of the OTS. Tier 1 Associations that have been
notified by the OTS that they are in need of more than normal supervision will
be treated as either a Tier 2 or Tier 3 Association. At June 30, 1995, the Bank
was a Tier 1 Association.

The Bank is prohibited from making any capital distributions if after
making the distribution, it would be undercapitalized as defined in the OTS'
prompt corrective action regulations. After consultation with the FDIC, the OTS
may permit a savings association to repurchase, redeem, retire or otherwise
acquire shares or ownership interests if the repurchase, redemption, retirement
or other acquisition: (i) is made in connection with the issuance of additional
shares or other obligations of the institution in at least an equivalent amount;
and (ii) will reduce the institution's financial obligations or otherwise
improve the institution's financial condition.

In addition to the foregoing, earnings of the Bank appropriated to bad
debt reserves and deducted for federal income tax purposes are not available for
payment of cash dividends or other distributions to the Company without payment
of taxes at the then current tax rate by the Bank on the amount of earnings
removed from the reserves for such distributions. See "Taxation." The Company
intends to make full use of this favorable tax treatment afforded to the Bank
and the Company and does not contemplate use of any earnings of the Bank in a
manner which would limit the Bank's bad debt deduction or create federal tax
liabilities.

REGULATORY CAPITAL REQUIREMENTS. Under OTS regulations, savings
associations must maintain "tangible" capital equal to 1.5% of adjusted total
assets, "core" capital equal to 3.0% of adjusted total assets and a combination
of core and "supplementary" capital equal to 8.0% of "risk-weighted" assets. In
addition, the OTS has recently adopted regulations which impose certain
restrictions on savings associations that have a total risk-based capital ratio
that is less than 8.0%, a ratio of Tier 1 capital to risk-weighted assets of
less than 4.0% or a ratio of Tier 1 capital to adjusted total assets of less
than 4.0% (or 3.0% if the institution is rated composite 1 under the OTS
examination rating system). For purposes of these regulations, Tier 1 capital
has the same definitions as core capital. See "-- Prompt Corrective Regulatory
Action." Core capital is defined as common stockholders' equity (including
retained earnings), noncumulative perpetual preferred stock and related surplus,
minority interests in the equity accounts of fully consolidated subsidiaries,
certain nonwithdrawable accounts and pledged deposits and "qualifying
supervisory goodwill."

Qualifying supervisory goodwill is defined generally as goodwill
resulting from the acquisition, merger, consolidation, purchase of assets or
other business combination (if such transaction occurred on or before April 12,
1989) with or of: (i) a savings association the fair market value of the assets
of which were less than the fair market value of its liabilities at the date of
acquisition; (ii) a problem institution which includes savings associations that

failed to meet their regulatory capital requirements or otherwise posed
supervisory concerns; or (iii) a savings association which was subject to
regulatory controls. Qualifying supervisory goodwill must be amortized on a
straight-line basis over the shorter of 20 years or the amortization period
previously in effect. Only eligible savings associations are permitted to
include qualifying supervisory goodwill in their capital calculations. An
eligible savings association is an association determined by the Director of OTS
to have competent management, to be in substantial compliance, as certified by
its board of directors, with all applicable statutes, regulations, orders, and
written agreements and directives, and to have management that has not engaged
in insider dealing, speculative practices or other activities that have
jeopardized or may jeopardize the savings association's safety capital. Unless
otherwise determined or notified by the Director of OTS, savings associations
will be deemed to be eligible savings associations for purposes of including
qualifying supervisory goodwill in core capital. Prior to January 1, 1992, the
maximum amount of qualifying supervisory goodwill included in core capital could
not exceed 1.5% of adjusted total assets with the applicable percentage
declining to 0% after December 31, 1994. The excess of cost over fair value of
net assets acquired resulting from the Bank's acquisitions in the early 1980s is
treated as qualifying supervisory goodwill.

Tangible capital is given the same definition as core capital but does
not include qualifying supervisory goodwill and is reduced by the amount of all
the savings association's intangible assets with only a limited exception for
purchased mortgage servicing rights and purchased credit card relationships.
Both core and tangible capital are further reduced by an amount equal to savings
association's debt and equity investments in subsidiaries engaged in activities
not permissible to national banks other than subsidiaries engaged in activities
undertaken as agent for customers or in mortgage banking activities and
subsidiary depository institutions or their holding companies. Investments in
and extensions of credit to such subsidiaries as of April 12, 1989, to the
extent still outstanding, however, were not required to be deducted from core
and tangible capital until July 1, 1990. Thereafter, an increasing percentage of
such investments will be deducted from core and tangible capital until June 30,
1995 when such investments must be fully netted. As of June 30, 1995, the Bank
had no investments in or extensions of credit to subsidiaries engaged in
activities not permitted to national banks.

"Adjusted total assets" are a savings association's total assets as
determined under generally accepted accounting principles ("GAAP"), increased by
certain goodwill amounts and by a pro-rated portion of the assets of
subsidiaries in which the savings association holds a minority interest and
which are not engaged in activities for which the capital rules require the
savings association to net its debt and equity investments in such subsidiaries
against capital, as well as a pro-rated portion of the assets of other
subsidiaries for which deduction is not fully required under phase-in rules.
Adjusted total assets are reduced by the amount of assets that have been
deducted from capital, the portion of savings association's investments in
subsidiaries that must be deducted from capital under the capital rules and, for
purposes of the core capital requirement, qualifying supervisory goodwill.

In determining compliance with the risk-based capital requirement, a
savings association is allowed to use both core capital and supplementary
capital provided the amount of supplementary capital used does not exceed the
savings association's core capital. Supplementary capital is defined to include
certain preferred stock issues, nonwithdrawable accounts and pledged deposits
that do not qualify as core capital, certain approved subordinated debt, certain
other capital instruments and a portion of the savings association's general
loss allowances. Total core and supplementary capital are reduced by the amount
of capital instruments held by other depository institutions pursuant to
reciprocal arrangements and, after July 1, 1990, by an increasing percentage of
the savings association's high loan-to-value ratio land loans and
non-residential construction loans, and certain equity investments not otherwise
deducted from core and tangible capital.

The risk-based capital requirement is measured against risk-weighted
assets, which equals the sum of each asset and the credit-equivalent amount of
each off-balance sheet item after being multiplied by an assigned risk weight.
Under the OTS risk- weighting system, one- to four-family first mortgages not
more than 90 days past due with loan-to-value ratios under 80% are assigned a
risk weight of 50%. Consumer and residential construction loans are assigned a
risk weight of 100%. Mortgage-backed securities and other debt securities
issued, or fully guaranteed as to principal and interest, by U.S. Government
agencies are assigned a 20% risk weight. Cash and U.S. Government securities
backed by the full faith and credit of the U.S. Government are given a 0% risk
weight.

The table below presents the Bank's capital position at June 30, 1995,
relative to its various minimum regulatory capital requirements.

Percent
of
Amount Assets *
------- --------
(Dollars in thousands)

Tangible capital ........................ $51,514 9.77%
Tangible capital requirement ............ 7,909 1.50
------- -----
Excess ................................ $43,605 8.27%
======= =====

Core capital ............................ $51,961 9.85%
Core capital requirement ................ 15,832 3.00
------- -----
Excess ................................ $36,129 6.85%
======= =====

Risk-based capital ...................... $54,208 25.00%
Risk-based capital requirement .......... 17,345 8.00
------- -----
Excess ................................ $36,863 17.00%
======= =====

- --------------------
* Based upon adjusted total assets of $527.3 million for purposes of the
tangible capital requirement, $527.7 million for purposes of the core
capital requirement, and risk-weighted assets of $217.0 million for
purposes of the risk-based capital requirement.

The Director of OTS must restrict the asset growth of savings
associations not in regulatory capital compliance, subject to a limited
exception for growth not exceeding interest credited. In addition, savings
associations not in full compliance with capital standards then applicable would
be subject to a capital directive which may include such restrictions, including
restrictions on the payment of dividends and on compensation, as deemed
appropriate by the Director of OTS. Institutions not in capital compliance must,
within 60 days thereafter, submit a capital plan to the OTS District Director
for approval explaining in detail its proposed strategies for raising capital
and for accomplishing its overall objective, and the institution may
concurrently apply for an exemption from a capital directive. The Director of
OTS is directed to treat as an unsafe and unsound practice any material failure
by a savings association to comply with a capital plan or capital directive. The
sanctions and penalties that could be imposed range from restrictions on
branching or on the activities of the institution, to restrictions on the
ability to obtain FHLB advances, to termination of insurance of accounts
following appropriate proceedings, to the appointment of a conservator or
receiver. A savings association not in full compliance with the capital
standards could apply for a limited exemption from sanctions. If the exemption
is granted, the savings association would still remain subject to restrictions
on growth.

OTS staff policies specify that savings associations failing any one of
their minimum regulatory capital requirements may not increase their total
assets during any quarter in excess of an amount equal to net interest credited
during the quarter. Under these policies, associations that have submitted
capital plans that are rejected by the District Director or that have had
capital plans approved but do not meet the targets or requirements of the
capital plan may not make any new loans or investments except with the prior
written approval of the District Director. Such approval will only be granted
when the proposed loan or investment is reasonable in the context of the
association's operations and does not significantly increase the risk profile of
the savings association.

In addition to requiring generally applicable capital standards for
savings associations, the Director of OTS may establish the minimum level of
capital for a savings association at such amount or at such ratio of
capital-to-assets as the Director determines to be necessary or appropriate for
such association in light of the particular circumstances of the association.
The Director of OTS may treat the failure of any savings association to maintain
capital at or above such level as an unsafe or unsound practice and may issue a
directive requiring any savings association which fails to maintain capital at
or above the minimum level required by the Director to submit and adhere to a
plan for increasing capital. Such an order may be enforced in the same manner as
an order issued by the FDIC.

Under FIRREA, the capital standards applicable to savings associations
must be no less than those applicable to national banks. On September 17, 1990,
the Office of the Comptroller of the Currency ("OCC") announced the adoption,
effective December 31, 1990, of regulations implementing more stringent core
capital requirements for national banks. The OCC regulations establish a new
minimum core capital ratio of 3% for the most highly rated banks, with at least
an additional 100 to 200 basis point "cushion" amount of additional capital
required on a case-by-case basis, considering the quality of risk management
systems and the overall risk in individual banks.

The OTS has recently adopted an amendment to its risk-based capital
requirements that, effective September 30, 1994, required savings institutions
with more than a "normal" level of interest rate risk to maintain additional
total capital. A savings institution's interest rate risk will be measured in
terms of the sensitivity of its "net portfolio value" to changes in interest
rates. Net portfolio value is defined, generally, as the present value of
expected cash inflows from existing assets and off-balance sheet contracts less
the present value of expected cash outflows from existing liabilities. A savings
institution will be considered to have a "normal" level of interest rate risk
exposure if the decline in its net portfolio value after an immediate 200 basis
point increase or decrease in market interest rates (whichever results in the
greater decline) is less than two percent of the current estimated economic
value of its assets. A savings institution with a greater than normal interest
rate risk will be required to deduct from total capital, for purposes of
calculating its risk-based capital requirement, an amount (the "interest rate
risk component") equal to one-half the difference between the institution's
measured interest rate risk and the normal level of interest rate risk,
multiplied by the economic value of its total assets.

The OTS will calculate the sensitivity of a savings institution's net
portfolio value based on data submitted by the institution in a schedule to its
quarterly Thrift Financial Report and using the interest rate risk measurement
model adopted by the OTS. The amount of the interest rate risk component, if
any, to be deducted from a savings institution's total capital will be based on
the institution's Thrift Financial Report filed three quarters earlier. The Bank
does not expect that this regulation will require it to reduce its capital
materially for purposes of determining compliance with its risk-based capital
requirement.

PROMPT CORRECTIVE REGULATORY ACTION. Under the Federal Deposit
Insurance Corporation Improvement Act ("FDICIA"), the federal banking regulators
are required to take prompt corrective action if an insured depository
institution fails to satisfy certain minimum capital requirements. All
institutions, regardless of their capital levels, are restricted from making any
capital distribution or paying any management fees if the institution would
thereafter fail to satisfy the minimum levels for any of its capital
requirements. An institution that fails to meet the minimum level for any
relevant capital measure (an "undercapitalized institution") may be: (i) subject
to increased monitoring by the appropriate federal banking regulator; (ii)
required to submit an acceptable capital restoration plan within 45 days; (iii)
subject to asset growth limits; and (iv) required to obtain prior regulatory
approval for acquisitions, branching and new lines of businesses. The capital
restoration plan must include a guarantee by the institution's holding company
that the institution will comply with the plan until it has been adequately
capitalized on average for four consecutive quarters, under which the holding
company would be liable up to the lesser of 5% of the institution's total assets
or the amount necessary to bring the institution into capital compliance as of
the date it failed to comply with its capital restoration plan. A "significantly
undercapitalized" institution, as well as any undercapitalized institution that
did not submit an acceptable capital restoration plan, may be subject to
regulatory

demands for recapitalization, broader application of restrictions on
transactions with affiliates, limitations on interest rates paid on deposits,
asset growth and other activities, possible replacement of directors and
officers, and restrictions on capital distributions by any bank holding company
controlling the institution. Any company controlling the institution could also
be required to divest the institution or the institution could be required to
divest subsidiaries. The senior executive officers of a significantly
undercapitalized institution may not receive bonuses or increases in
compensation without prior approval and the institution is prohibited from
making payments of principal or interest on its subordinated debt. In their
discretion, the federal banking regulators may also impose the foregoing
sanctions on an undercapitalized institution if the regulators determine that
such actions are necessary to carry out the purposes of the prompt corrective
action provisions. If an institution's ratio of tangible capital to total assets
falls below a "critical capital level," the institution will be subject to
conservatorship or receivership within 90 days unless periodic determinations
are made that forbearance from such action would better protect the deposit
insurance fund. Unless appropriate findings and certifications are made by the
appropriate federal bank regulatory agencies, a critically undercapitalized
institution must be placed in receivership if it remains critically
undercapitalized on average during the calendar quarter beginning 270 days after
the date it became critically undercapitalized. If a savings association is in
compliance with an approved capital plan on the date of enactment of FDICIA,
however, it will not be required to submit a capital restoration plan if it is
undercapitalized or become subject to the statutory prompt corrective action
provisions applicable to significantly and critically undercapitalized
institutions prior to July 1, 1994.

Effective December 19, 1992, the federal banking regulators, including
the OTS, adopted regulations implementing the prompt corrective action
provisions of FDICIA. Under such regulations, the federal banking regulators
will measure a depository institution's capital adequacy on the basis of the
institution's total risk-based capital ratio (the ratio of its total capital to
risk-weighted assets), Tier 1 risk-based capital ratio (the ratio of its core
capital to risk-weighted assets) and leverage ratio (the ratio of its core
capital to adjusted total assets). Under the regulations, a savings association
that is not subject to an order or written directive to meet or maintain a
specific capital level will be deemed "well capitalized" if it also has: (i) a
total risk-based capital ratio of 10% or greater; (ii) a Tier 1 risk-based
capital ratio of 6.0% or greater; and (iii) a leverage ratio of 5.0% or greater.
An "adequately capitalized" savings association is a savings association that
does not meet the definition of well capitalized and has: (i) a total risk-based
capital ratio of 8.0% or greater; (ii) a Tier 1 capital risk-based ratio of 4.0%
or greater; and (iii) a leverage ratio of 4.0% or greater (or 3.0% or greater if
the savings association has a composite 1 CAMEL rating). An "undercapitalized
institution" is a savings association that has (i) a total risk-based capital
ratio less than 8.0%; or (ii) a Tier 1 risk-based capital ratio of less than
4.0%; or (iii) a leverage ratio of less than 4.0% (or 3.0% if the association
has a composite 1 CAMEL rating). A "significantly undercapitalized" institution
is defined as a savings association that has: (i) a total risk-based capital
ratio of less than 6.0%; or (ii) a Tier 1 risk-based capital ratio of less than
3.0%; or (iii) a leverage ratio of less than 3.0%. A "critically
undercapitalized" savings association is defined as a savings association that
has a ratio of "tangible equity" to total assets of less than 2.0%. Tangible
equity is defined as core capital plus cumulative perpetual preferred stock (and
related surplus) less all intangibles other than qualifying supervisory goodwill
and certain purchased mortgage servicing rights. The OTS may reclassify a well
capitalized savings association as adequately capitalized and may require an
adequately capitalized or undercapitalized association to comply with the
supervisory actions applicable to associations in the next lower capital
category if the OTS determines, after notice and an opportunity for a hearing,
that the savings association is in an unsafe or unsound condition or that the
association has received and not corrected a less-than- satisfactory rating for
any CAMEL rating category. The Bank is classified as "well-capitalized" under
the new regulations.

The table below presents the Bank's capital position at June 30, 1995,
relative to its various minimum regulatory capital requirements under the prompt
corrective regulations.

Percent
of
Amount Assets *
------- --------
(Dollars in thousands)

Tangible equity . . . . . . . . . . . . . . . . . . . . $51,514 9.77%
Tangible equity requirement . . . . . . . . . . . . . . 10,546 2.00
------- -----
Excess . . . . . . . . . . . . . . . . . . . . . . . $40,968 7.77%
======= =====

Tier 1 or leverage capital . . . . . . . . . . . . . . $51,961 9.85%
Tier 1 or leverage capital requirement . . . . . . . . 21,109 4.00
------- -----
Excess . . . . . . . . . . . . . . . . . . . . . . . $30,852 5.85%
======= =====

Tier 1 risk-based capital . . . . . . . . . . . . . . . $51,961 23.97%
Tier 1 risk-based capital requirement . . . . . . . . . 8,673 4.00
------- -----
Excess . . . . . . . . . . . . . . . . . . . . . . . $43,288 19.97%
======= =====

Risk-based capital . . . . . . . . . . . . . . . . . . $54,208 25.00%
Risk-based capital requirement . . . . . . . . . . . . 17,345 8.00
------- -----
Excess . . . . . . . . . . . . . . . . . . . . . . . $36,863 17.00%
======= =====

- --------------------

* Based upon adjusted total assets for purposes of the tangible equity and
Tier 1 or leverage capital requirements, and risk-weighted assets for
purposes of the Tier 1 risk-based and risk- based capital requirements.

SAFETY AND SOUNDNESS GUIDELINES. Under FDICIA, as amended by the Riegle
Community Development and Regulatory Improvement Act of 1994 (the "CDRI Act"),
each Federal banking agency is required to establish safety and soundness
standards for institutions under its authority. On July 10, 1995, the Federal
banking agencies, including the OTS, released Interagency Guidelines
Establishing Standards for Safety and Soundness and published a final rule
establishing deadlines for submission and review of safety and soundness
compliance plans. The final rule and the guidelines went into effect on August
9, 1995. The guidelines require savings institutions to maintain internal
controls and information systems and internal audit systems that are appropriate
for the size, nature and scope of the institution's business. The guidelines
also establish certain basic standards for loan documentation, credit
underwriting, interest rate risk exposure, and asset growth. The guidelines
further provide that savings institutions should maintain safeguards to prevent
the payment of compensation, fees and benefits that are excessive or that could
lead to material financial loss, and should take into account factors such as
comparable compensation practices at comparable institutions. If the OTS
determines that a savings institution is not in compliance with the safety and
soundness guidelines, it may require the institution to submit an acceptable
plan to achieve compliance with the guidelines. A savings institution must
submit an acceptable compliance plan to the OTS within 30 days of receipt of a
request for such a plan. Failure to submit or implement a compliance plan may
subject the institution to regulatory sanctions. Management believes that the
Bank already meets substantially all the standards adopted in the interagency
guidelines, and therefore does not believe that implementation of these
regulatory standards will materially affect the Bank's operations.

Additionally under FDICIA, as amended by the CDRI Act, the Federal
banking agencies are required to establish standards relating to the asset
quality and earnings that the agencies determine to be appropriate. On July 10,
1995, the Federal banking agencies, including the OTS, issued proposed
guidelines relating to asset quality and

earnings. Under the proposed guidelines a savings institution should maintain
systems, commensurate with its size and the nature and scope of its operations,
to identify problem assets and prevent deterioration in those assets as well as
to evaluate and monitor earnings and ensure that earnings are sufficient to
maintain adequate capital and reserves. Management believes that the asset
quality and earnings standards, in the form proposed by the banking agencies,
would not have a material effect on the Bank's operations.

DEPOSIT INSURANCE. The Bank is required to pay assessments based on a
percent of its insured deposits to the FDIC for insurance of its deposits by the
SAIF. Under the Federal Deposit Insurance Act, the FDIC is required to set
semi-annual assessments for SAIF-insured institutions to achieve the designated
reserve ratio of the SAIF at 1.25% of estimated insured deposits or at a higher
percentage of estimated insured deposits that the FDIC determines to be
justified for that year by circumstances raising a significant risk of
substantial future losses to the SAIF.

Under the risk-based deposit insurance assessment system adopted by the
FDIC, the assessment rate for an insured depository institution depends on the
assessment risk classification assigned to the institution by the FDIC, which is
determined by the institution's capital level and supervisory evaluations. Based
on the data reported to regulators for the date closest to the last day of the
seventh month preceding the semi-annual assessment period, institutions are
assigned to one of three capital groups -- well capitalized, adequately
capitalized or undercapitalized -- using the same percentage criteria as under
the prompt corrective action regulations. See " -- Prompt Corrective Regulatory
Action." Within each capital group, institutions are assigned to one of three
subgroups on the basis of supervisory evaluations by the institution's primary
supervisory authority and such other information as the FDIC determines to be
relevant to the institution's financial condition and the risk posed to the
deposit insurance fund. Subgroup A consists of financially sound institutions
with only a few minor weaknesses. Subgroup B consists of institutions that
demonstrate weaknesses which, if not corrected, could result in significant
deterioration of the institution and increased risk of loss to the deposit
insurance fund. Subgroup C consists of institutions that pose a substantial
probability of loss to the deposit insurance fund unless effective corrective
action is taken. The assessment rate for SAIF-insured institutions ranges from
0.23% of deposits for well capitalized institutions in Subgroup A to 0.31% of
deposits for undercapitalized institutions in Subgroup C.

The FDIC has recently amended the risk-based assessment schedule to
significantly lower the deposit insurance assessment rate for most commercial
banks and other depository institutions with deposits insured by the Bank
Insurance Fund ("BIF") effective during the semi-annual period after the BIF
achieves its designated reserve ratio of 1.25% of BIF-insured deposits. Under
the new BIF assessment schedule, the assessment rates of BIF-insured
institutions will range from 0.31% of insured deposits for undercapitalized
BIF-institutions in supervisory Subgroup C to 0.04% of deposits for
well-capitalized institutions in supervisory Subgroup A, which constitute over
90% of BIF-insured institutions. The FDIC has indicated that it believes that
the BIF achieved the statutorily-designated reserve ratio during the quarter
ended June 30, 1995 and will refund any excess premiums paid by BIF-insured
institutions as soon as the reserve ratio is confirmed. The FDIC does not
anticipate that the assessment rate for SAIF-insured institutions in even the
lowest risk-based premium category will fall below the current 0.23% of insured
deposits before the year 2002 absent a recapitalization of the SAIF. The new BIF
assessment schedule would result in a substantial disparity in the deposit
insurance premiums paid by BIF and SAIF members and could place SAIF-insured
savings associations such as the Bank at a significant competitive disadvantage
to BIF-insured institutions.

Congress and the Administration are currently discussing various
proposals for the recapitalization of the SAIF. These proposals include the
payment of a one-time special assessment by SAIF-insured institutions in an
amount equal to at least 0.85% of their insured deposits. Based on the Bank's
total deposits at June 30, 1995, such a payment could be $3.8 million or higher.
No prediction can be made as to what action, if any, will be taken to
recapitalize the SAIF or as to the final form or timing of any such action.

SAIF members are generally prohibited from converting to the status of
BIF members, or merging with or transferring assets to a BIF member before the
date on which the SAIF first meets or exceeds the designated reserve ratio. The
FDIC, however, may approve such a transaction in the case of a SAIF member in
default or if the

transaction involves an insubstantial portion of the deposits of each
participant. In addition, mergers, transfers of assets and assumptions of
liabilities may be approved by the appropriate bank regulator so long as deposit
insurance premiums continue to be paid to the SAIF for deposits attributable to
the SAIF members plus an adjustment for the annual rate of growth of deposits in
the surviving bank without regard to subsequent acquisitions. Each depository
institution participating in a SAIF-to-BIF conversion transaction is required to
pay an exit fee to SAIF and an entrance fee to BIF. A savings association that
adopts a commercial bank or savings bank charter prior to the date on which the
SAIF first meets or exceeds the designated reserve ratio must remain a SAIF
member.

The FDIC has adopted a regulation which provides that any insured
depository institution with a ratio of Tier 1 capital to total assets of less
than 2% will be deemed to be operating in an unsafe or unsound condition, which
would constitute grounds for the initiation of termination of deposit insurance
proceedings. The FDIC, however, would not initiate termination of insurance
proceedings if the depository institution has entered into and is in compliance
with a written agreement with its primary regulator, and the FDIC is a party to
the agreement, to increase its Tier 1 capital to such level as the FDIC deems
appropriate. Tier 1 capital is defined as the sum of common stockholders'
equity, noncumulative perpetual preferred stock (including any related surplus)
and minority interests in consolidated subsidiaries, minus all intangible assets
other than mortgage servicing rights and qualifying supervisory goodwill
eligible for inclusion in core capital under OTS regulations and minus
identified losses and investments in certain securities subsidiaries. Insured
depository institutions with Tier 1 capital equal to or greater than 2% of total
assets may also be deemed to be operating in an unsafe or unsound condition
notwithstanding such capital level. The regulation further provides that in
considering applications that must be submitted to it by savings associations,
the FDIC will take into account whether the savings association is meeting with
the Tier 1 capital requirement for state non-member banks of 4% of total assets
for all but the most highly rated state non-member banks.

FEDERAL RESERVE SYSTEM. Pursuant to regulations of the Federal Reserve
Board, a thrift institution must maintain average daily reserves in a manner
sufficient to satisfy its reserve requirements on reservable liabilities. For
reservable liabilities exceeding $4.2 million, the institution must maintain
reserves of 3% on balances up to $54.0 million. On balances exceeding $54.0
million, the reserve requirement increases to 10%. Because required reserves are
maintained in the form of vault cash or in a non-interest bearing account at a
Federal Reserve Bank, the effect of the reserve requirement is to reduce the
amount of the institution's interest-earning assets. As of June 30, 1995, the
Bank met its reserve requirements.

TRANSACTIONS WITH AFFILIATES. Transactions between savings associations
and any affiliate are governed by Sections 23A and 23B of the Federal Reserve
Act. An affiliate of a savings association is any company or entity which
controls, is controlled by or is under common control with the savings
association. In a holding company context, the parent holding company of a
savings association (such as the Company) and any companies which are controlled
by such parent holding company are affiliates of the savings association.
Generally, Sections 23A and 23B (i) limit the extent to which the savings
institution or its subsidiaries may engage in "covered transactions" with any
one affiliate to an amount equal to 10% of such institution's capital stock and
surplus, and contain an aggregate limit on all such transactions with all
affiliates to an amount equal to 20% of such capital stock and surplus and (ii)
require that all such transactions be on terms substantially the same, or at
least as favorable, to the institution or subsidiary as those provided to a
non-affiliate. The term "covered transaction" includes the making of loans,
purchase of assets, issuance of a guarantee and similar other types of
transactions. In addition to the restrictions imposed by Sections 23A and 23B,
no savings association may (i) loan or otherwise extend credit to an affiliate,
except for any affiliate which engages only in activities which are permissible
for bank holding companies, or (ii) purchase or invest in any stocks, bonds,
debentures, notes or similar obligations of any affiliate, except for affiliates
which are subsidiaries of the savings association.

Savings associations are also subject to the restrictions contained in
Section 22(h) of the Federal Reserve Act on loans to executive officers,
directors and principal stockholders. Under Section 22(h), loans to a director,
executive officer or greater than 10% stockholder of a savings association and
certain affiliated interests of the foregoing, may not exceed, together with all
other outstanding loans to such person and affiliated interests, the

association's loans to one borrower limit (generally equal to 15% of the
institution's unimpaired capital and surplus) and all loans to such persons may
not exceed the institution's unimpaired capital and unimpaired surplus. Section
22(h) also prohibits loans, above amounts prescribed by the appropriate federal
banking agency, to directors, executive officers and greater than 10%
stockholders of a savings association, and their respective affiliates, unless
such loan is approved in advance by a majority of the board of directors of the
association with any "interested" director not participating in the voting. The
Federal Reserve Board has prescribed the loan amount (which includes all other
outstanding loans to such person), as to which such prior board of director
approval if required, as being the greater of $25,000 or 5% of capital and
surplus (up to $500,000). Further, the Federal Reserve Board pursuant to Section
22(h) requires that loans to directors, executive officers and principal
stockholders be made on terms substantially the same as offered in comparable
transactions to other persons. Section 22(h) also prohibits a depository
institution from paying the overdrafts of any of its executive officers or
directors.

Savings associations are further subject to the requirements and
restrictions of Section 22(g) of the Federal Reserve Act on loans to executive
officers and the restrictions of 12 U.S.C. Section 1972 on certain tying
arrangements and extensions of credit by correspondent banks. Section 22(g) of
the Federal Reserve Act requires that loans to executive officers of depository
institutions not be made on terms more favorable than those afforded to other
borrowers, requires approval for such extensions of credit by the board of
directors of the institution, and imposes reporting requirements for and
additional restrictions on the type, amount and terms of credits to such
officers. Section 1972 (i) prohibits a depository institution from extending
credit to or offering any other services, or fixing or varying the consideration
for such extension of credit or service, on the condition that the customer
obtain some additional service from the institution or certain of its affiliates
or not obtain services of a competitor of the institution, subject to certain
exceptions, and (ii) prohibits extensions of credit to executive officers,
directors, and greater than 10% stockholders of a depository institution by any
other institution which has a correspondent banking relationship with the
institution, unless such extension of credit is on substantially the same terms
as those prevailing at the time for comparable transactions with other persons
and does not involve more than the normal risk of repayment or present other
unfavorable features.

REGULATION OF THE COMPANY

GENERAL. The Company is a unitary savings and loan holding company
within the meaning of the Home Owners' Loan Act. As such, the Company is
registered with the OTS and subject to OTS regulations, examinations,
supervision and reporting requirements.

ACTIVITIES RESTRICTIONS. The Board of Directors of the Company
presently intends to operate the Company as a unitary savings and loan holding
company. There are generally no restrictions on the activities of a unitary
savings and loan holding company. However, if the director of OTS determines
that there is reasonable cause to believe that the continuation by a savings and
loan holding company of an activity constitutes a serious risk to the financial
safety, soundness, or stability of its subsidiary savings association, the
Director of OTS may impose such restrictions as deemed necessary to address such
risk and limiting (i) payment of dividends by the savings association, (ii)
transactions between the savings association and its affiliates, and (iii) any
activities of the savings association that might create a serious risk that the
liabilities of the holding company and its affiliates may be imposed on the
savings association. Notwithstanding the above rules as to permissible business
activities of unitary savings and loan holding companies, if the savings
association subsidiary of such a holding company fails to meet the QTL Test,
then such unitary holding company shall also presently become subject to the
activities restrictions applicable to multiple holding companies and unless the
savings association requalifies as a Qualified Thrift Lender within one year
thereafter, register as, and become subject to, the restrictions applicable to a
bank holding company.

If the Company were to acquire control of another savings association,
other than through merger or other business combination with the Bank, the
Company would thereupon become a multiple savings and loan holding company.
Except where such acquisition is pursuant to the authority to approve emergency
thrift acquisitions and where each subsidiary savings association meets the QTL
Test, the activities of the Company and any of its subsidiaries (other than the
Bank or other subsidiary savings institutions) would thereafter be subject to
further restrictions.

36
The Home Owners' Loan Act, as amended by FIRREA, provides that, among other
things, no multiple savings and loan holding company or subsidiary thereof which
is not a savings association shall commence or continue for a limited period of
time after becoming a multiple savings and loan holding company or subsidiary
thereof, any business activity, upon prior notice to, and no objection by the
OTS, other than (i) furnishing or performing management services for a
subsidiary savings association, (ii) conducting an insurance agency or escrow
business, (iii) holding, managing, or liquidating assets owned by or acquired
from a subsidiary savings institution, (iv) holding or managing properties used
or occupied by a subsidiary savings institution, (v) acting as trustee under
deeds of trust, (vi) those activities previously directly authorized by the
Federal Savings and Loan Insurance Corporation by regulation as of March 5, 1987
to be engaged in by multiple holding companies or (vii) those activities
authorized by the Federal Reserve Board as permissible for bank holding
companies, unless the Director of OTS by regulation prohibits or limits such
activities for savings and loan holding companies. Those activities described in
(vii) above must also be approved by the Director of OTS prior to being engaged
in by a multiple holding company.

RESTRICTIONS ON ACQUISITIONS. Savings and loan holding companies are
prohibited from acquiring, without prior approval of the Director of OTS, (i)
control of any other savings association or savings and loan holding company or
substantially all the assets thereof or (ii) more than 5% of the voting shares
of a savings association or holding company thereof which is not a subsidiary.
Under certain circumstances, a registered savings and loan holding company is
permitted to acquire, with the approval of the Director of OTS, up to 15% of the
voting shares of an under-capitalized savings association pursuant to a
"qualified stock issuance" without that savings association being deemed
controlled by the holding company. In order for the shares acquired to
constitute a "qualified stock issuance," the shares must consist of previously
unissued stock or treasury shares, the shares must be acquired for cash, the
savings and loan holding company's other subsidiaries must have tangible capital
of at least 6-1/2% of total assets, there must not be more than one common
director or officer between the savings and loan holding company and the issuing
savings association and transactions between the savings association and the
savings and loan holding company and any of its affiliates must conform to
Sections 23A and 23B of the Federal Reserve Act. Except with the prior approval
of the Director of OTS, no director or officer of a savings and loan holding
company or person owning or controlling by proxy or otherwise more than 25% of
such company's stock, may also acquire control of any savings association, other
than a subsidiary savings association, or of any other savings and loan holding
company.

The Director of OTS may only approve acquisitions resulting in the
formation of a multiple savings and loan holding company which controls savings
associations in more than one state if: (i) the multiple savings and loan
holding company involved controls a savings institution which operated a home or
branch office in the state of the association to be acquired as of March 5,
1987; (ii) the acquiror is authorized to acquire control of the savings
association pursuant to the emergency acquisition provisions of the Federal
Deposit Insurance Act; or (iii) the statutes of the state in which the
association to be acquired is located specifically permit institutions to be
acquired by state-chartered associations or savings and loan holding companies
located in the state where the acquiring entity is located (or by a holding
company that controls such state-chartered savings institutions).

Tennessee law authorizes the acquisition of a savings association with
its principal place of business in Tennessee, or a savings and loan holding
company with its principal place of business in Tennessee and which is not
controlled by any other savings and loan holding company, by an out-of-state
savings and loan holding company or out-of-state savings association, subject to
approval of the Tennessee Commissioner of Financial Institutions. An
"out-of-state savings and loan holding company" is a savings and loan holding
company with its principal place of business in a state other than Tennessee and
which is not controlled by any other savings and loan holding company. The
Tennessee Commissioner may only approve such an acquisition if the laws of the
state in which the out-of-state savings and loan holding company or out-of-state
savings association has its principal place of business both (i) allow Tennessee
savings associations and Tennessee savings and loan holding companies to acquire
savings associations and savings and loan holding companies in that state and
(ii) allow the Tennessee savings association or Tennessee savings and loan
holding company which is being acquired to acquire the out-of-state savings
association or out-of-state savings and loan holding company seeking to make the
acquisition.

The OTS has recently amended its regulations to permit federal
associations to branch in any state or states of the United States and its
territories. Except in supervisory cases or when interstate branching is
otherwise permitted by state law or other statutory provision, a federal
association may not establish an out-of-state branch unless (i) the federal
association qualifies as a "domestic building and loan association" under
Section 7701(a)(19) of the Internal Revenue Code and the total assets
attributable to all branches of the association in the state would qualify such
branches taken as a whole for treatment as a domestic building and loan
association and (ii) such branch would not result in (a) formation of a
prohibited multi-state multiple savings and loan holding company or (b) a
violation of certain statutory restrictions on branching by savings association
subsidiaries of banking holding companies. Federal associations generally may
not establish new branches unless the association meets or exceeds minimum
regulatory capital requirements. The OTS will also consider the association's
record of compliance with the Community Reinvestment Act of 1977 in connection
with any branch application.

The Bank Holding Company Act of 1956 authorizes the Federal Reserve
Board to approve an application by a bank holding company to acquire control of
any savings association. Pursuant to rules promulgated by the Federal Reserve
Board, owning, controlling or operating a savings association is a permissible
activity for bank holding companies if the savings association engages only in
deposit-taking activities and lending and other activities that are permissible
for bank holding companies. In approving such an application, the Federal
Reserve Board may not impose any restriction on transactions between the savings
association and its holding company affiliates except as required by Sections
23A and 23B of the Federal Reserve Act.

A bank holding company that controls a savings association may merge or
consolidate the assets and liabilities of the savings association with, or
transfer assets and liabilities to, any subsidiary bank which is a member of the
BIF with the approval of the appropriate federal banking agency and the Federal
Reserve Board. The resulting bank will be required to continue to pay
assessments to the SAIF at the rates prescribed for SAIF members on the deposits
attributable to the merged savings association plus an annual deposit growth
increment. In addition, the transaction must comply with the restrictions on
interstate acquisitions of commercial banks under the Bank Holding Company Act.

TAXATION

GENERAL. The Company files a consolidated federal income tax return
with the Bank and the Bank's subsidiary based upon a fiscal year ending June 30.
Consolidated returns have the effect of eliminating intercompany distributions,
including dividends, from the computation of consolidated taxable income for the
taxable year in which the distributions occur.

FEDERAL AND STATE INCOME TAXATION. Savings institutions are subject to
the provisions of the Internal Revenue Code of 1986, as amended (the "Code") in
the same general manner as other corporations. However, institutions such as the
Bank which meet certain definitional tests and other conditions prescribed by
the Code may benefit from certain favorable provisions regarding their
deductions from taxable income for annual additions to their bad debt reserve.
For purposes of the bad debt reserve deduction, loans are separated into
"qualifying real property loans," which generally are loans secured by interests
in certain real property, and nonqualifying loans, which are all other loans.
The bad debt reserve deduction with respect to nonqualifying loans must be based
on actual loss experience. The amount of the bad debt reserve deduction with
respect to qualifying real property loans may be based upon actual loss
experience (the "experience method") or a percentage of taxable income
determined without regard to such deduction (the "percentage of taxable income
method").

The Bank has generally elected to use the method which has resulted in
the greatest deductions for federal income tax purposes. Under the experience
method, the bad debt deduction for an addition to the reserve for qualifying
real property loans is an amount determined under a formula based generally on
the bad debts actually sustained by a savings institution over a period of
years. Under the percentage of taxable income method, the bad debt reserve
deduction for qualifying real property loans is computed as a percentage, which
Congress has reduced from as much as 60% in prior years to 8% of taxable income,
with certain adjustments, effective for taxable years

beginning after 1986. The allowable deduction under the percentage of taxable
income method (the "percentage bad debt deduction") for taxable years beginning
before 1987 was scaled downward in the event that less than 82% of the total
dollar amount of the assets of an institution were within certain designated
categories. When the percentage method bad debt deduction was lowered to 8%, the
82% qualifying assets requirement was lowered to 60%. For all taxable years,
there is no deduction in the event that less than 60% of the total dollar amount
of the assets of an institution falls within such categories. Moreover, in such
case, the Bank could be required to recapture, generally over a period of up to
four years, its existing bad debt reserve. As of June 30, 1995, more than the
required amount of the Bank's total assets fell within such category.

The bad debt deduction under the percentage of taxable income method is
subject to certain limitations. First, the amount added to the reserve for
losses on qualifying real property loans may not exceed the amount necessary to
increase the balance of such reserve at the close of the taxable year to 6% of
such loans outstanding at the end of the taxable year. Further, the addition to
the reserve for losses on qualifying real property loans cannot exceed the
amount which, when added to that year's addition to the bad debt reserve for
losses on nonqualifying loans, equals the amount by which 12% of total deposits
or withdrawable accounts of depositors at year-end exceeds the sum of surplus,
undivided profits and reserves at the beginning of the year. Finally, the
percentage bad debt deduction under the percentage of taxable income method is
reduced by the deduction for losses on nonqualifying loans.

To the extent (i) a savings bank's reserve for losses on qualifying
real property loans under the percentage of income method exceeds the amount
that would have been allowed under the experience method and (ii) a savings bank
makes distributions to stockholders (including distributions in redemption,
dissolution or liquidation) that are considered to result in withdrawals from
that excess bad debt reserve, then the amounts considered withdrawn will be
included in the savings bank's taxable income. The amount that would be deemed
withdrawn from such reserves upon such distribution and which would be subject
to taxation at the savings bank level at the normal corporate tax rate would be
an amount that, when reduced by taxes on such amount, would equal the amount
actually distributed. Dividends paid out of a savings bank's current or
accumulated earnings and profits as calculated for federal income tax purposes,
however, will not be considered to result in withdrawals from its bad debt
reserves to the extent of such earnings and profits. Dividends in excess of a
savings bank's current and accumulated earnings and profits, distributions in
redemption of stock, and distributions in partial or complete liquidation of a
savings bank will be considered to come from its loss reserve. The Bank
qualifies under provisions of the Internal Revenue Code which permit it to
deduct from income an allowance for bad debts based on approximately 8% of
taxable income before such deduction, or actual chargeoffs. As of June 30, 1995,
the Company has taken aggregate bad debt deductions of approximately $4,647,000
for income tax purposes under the percentage of taxable income method for which
no provisions for federal income tax have been made in the financial statements.
This amount may be used only for absorbing losses for tax purposes. It is not
related to amounts of losses actually anticipated and the additions thereto have
not been charged against income.

Earnings appropriated to the Bank's bad debt reserve and claimed as a
tax deduction are not available for the payment of cash dividends or for
distribution to stockholders (including distributions made on dissolution or
liquidation) unless the Bank includes the amount in taxable income, together
with the amount deemed necessary to pay the resulting federal income tax.

For taxable years beginning after December 31, 1986, the Code imposes
an alternative minimum tax at a rate of 20%. The alternative minimum tax
generally applies to a base of regular taxable income plus certain tax
preferences ("alternative minimum taxable income" or "AMTI") and is payable to
the extent such AMTI exceeds an exemption amount. The Code provides that an item
of tax preference is the excess of the bad debt deduction allowable for a
taxable year pursuant to the percentage of taxable income method over the amount
allowable under the experience method. The other items of tax preference that
constitute AMTI include (a) tax-exempt interest on newly-issued (generally,
issued on or after August 8, 1986) private activity bonds other than certain
qualified bonds and (b) for taxable years including 1987 through 1989, 50% of
the excess of (i) the taxpayer's pre-tax adjusted net book income over (ii) AMTI
(determined without regard to this latter preference and prior to reduction by
net

operating losses). For taxable years beginning after 1989, this latter
preference has been replaced by 75% of the excess (if any) of (i) adjusted
current earnings as defined in the Code, over (ii) AMTI (determined without
regard to this preference and prior to reduction by net operating losses). For
any taxable year beginning after 1986, net operating losses can offset no more
than 90% of AMTI. Certain payments of alternative minimum taxes may be used as
credits against regular tax liabilities in future years.

In addition to the Bank's federal income tax liability, the State of
Tennessee imposes an excise tax on savings institutions at the rate of 6% of net
taxable income, which is computed based on federal taxable income subject to
certain adjustments. The State of Tennessee also imposes franchise and privilege
taxes on savings institutions which, in the case of the Bank, have not
constituted significant expense items.

For additional information regarding taxation, see Note 11 to the Notes
to Consolidated Financial Statements.

NEW ACCOUNTING STANDARDS

Accounting for Income Taxes. Through June 30, 1993, the Company
followed SFAS No. 96, "Accounting for Income Taxes." SFAS 96 requires the asset
and liability method of accounting for income taxes. Under the asset and
liability method, deferred income taxes are recognized for the tax consequences
of "temporary differences" by applying enacted statutory tax rates applicable to
future years to differences between the financial carrying amounts and the tax
bases of existing assets and liabilities. Under SFAS No. 96, the effect on
deferred taxes of a change in tax rates is recognized in income in the period
that includes the enactment date.

In February 1992, the FASB issued SFAS No. 109, "Accounting for Income
Taxes." This statement supersedes both Accounting Principles Board ("APB")
Opinion No. 11 and SFAS No. 96, the previous authoritative literature on income
tax accounting. It also supersedes the guidance of APB No. 23 on the tax
treatment of savings institution bad debt reserves. SFAS No. 109 calculates
taxes on the asset and liability method; thus requiring recognition of deferred
tax liabilities and assets for the expected future tax consequences of events
that have been recognized in the financial statements or tax return. This
statement's emphasis on the balance sheet is consistent with SFAS No. 96, but is
a change from APB Opinion No. 11's emphasis on the expense calculation. Under
SFAS No. 109, the tax expense or benefit in the statement of income will be the
current tax liability plus the change in the deferred tax liabilities and assets
occurring during the year. SFAS No. 109 changes the treatment of loan loss
provisions in the calculation of taxes. Tax bad debt reserves that arose prior
to 1988 require recognition of deferred tax liabilities only if it becomes
apparent that those temporary differences will reverse in the foreseeable
future. Other differences between financial and tax reserves will create
temporary differences for which deferred tax assets or liabilities will be
computed. SFAS No. 109 is effective for fiscal years beginning after December
15, 1992. The Company adopted SFAS No. 109 in the quarter ended September 30,
1993. The adoption resulted in the recognition of a deferred tax asset, recorded
as a cumulative effect increase to net income of $764,000. See Note 1 of the
Notes to Consolidated Financial Statements.

Accounting for Impaired Loans. The FASB issued SFAS No. 114,
"Accounting by Creditors for Impairment of a Loan," which amended SFAS No. 5,
"Accounting for Contingencies," and SFAS No. 15, "Accounting by Debtors and
Creditors for Troubled Debt Restructurings." SFAS No. 114, as amended by SFAS
No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition
and Disclosure," requires the use of the discounted cash flow method for
measuring impairment of loans when it is probable that a creditor will be unable
to collect all amounts due according to the contractual terms of the loan
agreement. If expedient, the creditor may use a loan's observable market price
or the fair value of any collateral. The Bank adopted SFAS No.114 on a
prospective basis as of July 1, 1993 for the fiscal year ending June 30, 1994.
The adoption of SFAS No. 114 did not have a material effect on the Bank's
financial position or results of operations.

Accounting for Investments. In June 1993, the FASB also issued SFAS No.
115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS
No. 115 requires debt and equity securities to be classified into one of three
categories: (i) held to maturity, (ii) available for sale or (iii) trading.
Securities held to maturity are limited to debt securities that the holder has
the positive intent and the ability to hold to maturity; these securities are
reported at amortized cost. Securities held for trading are limited to debt and
equity securities that are held principally to be sold in the near term; these
securities are reported at fair value, and unrealized gains and losses are
reflected in earnings. Securities held as available for sale consist of all
other securities; these securities are reported at fair value, and unrealized
gains and losses are not reflected in earnings but are reflected as a separate
component of stockholders' equity. Under SFAS No. 115, securities that could be
sold in the future because of changes in interest rates or other factors may not
be classified as held to maturity. SFAS No. 115 is effective for years beginning
after December 15, 1993. At June 30, 1995 the carrying value of the Bank's held
to maturity portfolio of investment and mortgage-backed securities exceeded the
market value by approximately $1.35 million. Gross unrealized gains on
securities available for sale were approximately $136,000. The Company adopted
SFAS 115 during the fiscal year ended June 30, 1995. The Company designated its
entire laddered maturity portfolio of U.S. Treasury Notes as available for sale.
At June 30, 1995, these securities had a weighted average life of approximately
1.1 years with a face amount of $20 million. The Company maintains the available
for sale portion of the investment portfolio as necessary in order to satisfy
its liquidity needs. In the event funding is needed for loan originations,
deposit account withdrawals, or other liquidity purposes, these securities could
be liquidated.

ITEM 2. PROPERTIES

The following table sets forth the location and certain additional
information regarding the Bank's offices at June 30, 1995. The Bank owns all of
its offices except as indicated.

Total
Year Deposits
Opened/ at June Total Net Book Value at Approximate
Acquired 30, 1995 Investment June 30, 1995 Square Footage
-------- -------- ---------- ----------------- --------------
(Dollars in thousands)

MAIN OFFICE:

110 East Center Street
Kingsport 1930 $128,595 $3,310 $757 26,432

BRANCH OFFICES:

Colonial Heights Office
4105 Fort Henry Drive
Kingsport 1972 36,394 1,730 834 27,000

Fort Henry Drive Office
2060 Fort Henry Drive
Kingsport 1974 49,399 776 331 7,813

Mount Carmel Office
130 West Main Street
Mount Carmel 1975 22,657 346 169 2,912

Kings-Giant Office (1)
199 West Stone Drive
Kingsport 1975 23,299 269 75 1,920

Johnson City Office
1907 North Roan Street
Johnson City 1978 38,516 2,394 1,293 36,000

Elizabethton Office (1)
301 Broad Street
Elizabethton 1980 11,081 654 351 3,920

East Stone Drive Office
2240 East Stone Drive
Kingsport 1987 11,815 646 429 3,290

Boones Creek Office
4718 Kingsport Highway
Gray 1984 14,947 281 156 2,900

(Table continues on following page)

Oak Ridge Office
101 N. Rutgers Avenue
Oak Ridge 1981 63,110 2,250 1,081 15,984

Clinton Office
134 W. Broad Street
Clinton 1981 20,739 354 142 2,600

Harriman Office
South Roan Street
Harriman 1981 21,663 471 208 2,200

West Oak Ridge Office
21 Jefferson Avenue
Oak Ridge 1988 7,103 557 403 3,290

OTHER PROPERTY:

Administrative Offices
Heritage Plaza
220 Broad Street

Kingsport 1985 N/A 738 436 34,584
Old Loan Processing Building (2)
2098 Fort Henry Drive

Kingsport 1975 N/A 66 33 1,500
Original Colonial Heights
Branch Office
109 Colonial Heights
Kingsport 1972 N/A 151 88 3,700

- --------------------
(1) Leased property.

(2) Owned by Citizens Financial, the Bank's wholly-owned subsidiary, and
leased to the Bank.

In January 1980, Heritage Federal leased a parcel of land from an
unrelated third party on which the Bank constructed its Elizabethton branch
office. The lease agreement requires payments of $1,100 per month beginning
January, 1980 and ending on December 31, 1999. The original principal balance of
this lease was approximately $129,000. The balance remaining on June 30, 1995
was $119,173.

The Elizabethton property noted above is accounted for as a capital
lease. The lease on the Johnson City office through the Industrial Revenue Board
of Johnson City expired in August 1993 and the Bank exercised the purchase
option for the building. The lease on the Elizabethton office expires in
December 1999, and also includes an option to purchase the leased property for
$110,000 at maturity.

The Bank also owns a mainframe computer system with an original cost of
approximately $824,700 and a zero net book value at June 30, 1995. Additionally,
the Bank owns an identical computer system which it was given by its supplier
and which it uses as an emergency back-up system. The backup computer system was
obtained by the Bank to comply with OTS regulatory requirements for disaster
recovery plans. Other than for the preparation of its quarterly interest rate
risk estimates, certain asset and liability valuations pursuant to SFAS No. 107,
and monthly investment portfolio accounting, the Bank does not utilize the
services of any outside data processing center. At June 30, 1995, the net book
value of the Bank's premises, furniture, fixtures and equipment was
approximately $6.8 million. See Note 8 of Notes to Consolidated Financial
Statements for further information.

ITEM 3. LEGAL PROCEEDINGS

From time to time, the Bank is a party to various legal proceedings
incident to its business. Except as set forth below, there are no material legal
proceedings to which the Company, the Bank or its subsidiary is a party or to
which any of their property is subject.

The Bank is a defendant in a lawsuit brought by an employee on June 29,
1994 in a Tennessee state court alleging unlawful discrimination in connection
with a reduction in the employee's duties and change in title as part of the
Bank's restructuring of senior management positions during 1991 and 1992. The
lawsuit seeks total damages of $6 million plus attorney's fees and costs. The
Bank is vigorously contesting this claim. Based on the advice of counsel,
Heritage Federal believes that the possibility of the Bank's sustaining a
material adverse judgment related to such claims is remote.

ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the
fourth quarter of the fiscal year ended June 30, 1995.

PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDERS'
MATTERS

The Common Stock trades on The Nasdaq Stock Market under the symbol
"HFBS." As of August 11, 1995, there were 3,189,506 shares of the Common Stock
outstanding, held by approximately 1,040 stockholders of record, excluding
beneficial owners in nominee or street name. The table below sets forth the
quarterly high and low stock prices as quoted on The Nasdaq Stock Market for
fiscal years 1995 and 1994, adjusted for stock splits. Stock price data on The
Nasdaq Stock Market reflect interdealer prices, without retail mark-up,
mark-down or commission, and may not necessarily represent actual transactions.

1995 1994
----------------- ---------------------
Quarter Ended: High Low High Low
-------------- ---- --- ---- ---

September 30 . . . . . . . . . . $23 $16 11/16 $15 1/2 $13

December 31 . . . . . . . . . . . $23 1/2 $16 1/2 $15 3/4 $14 1/4

March 31 . . . . . . . . . . . . $27 $17 $17 1/4 $14 5/8

June 30 . . . . . . . . . . . . . $27 $24 $18 1/4 $16 1/8

Under the Agreement with First American, the Company cannot pay a
dividend on its Common Stock other than regular quarterly cash dividends not in
excess of $0.095 per share, but dividends in the last quarter prior to closing
must be coordinated with First American's dividend policy to avoid the receipt
of either no dividends or two dividends during such quarter. The following table
sets forth the cash dividends per share declared by the Company on the Common
Stock during fiscal years 1995 and 1994, adjusted for stock splits.

Quarter Ended: 1995 1994
-------------- ------- -------

September 30 . . . . . . . . $0.0950 $ --

December 31 . . . . . . . . . 0.0950 0.0825

March 31 . . . . . . . . . . 0.0950 0.0825

June 30 . . . . . . . . . . . 0.0950 0.0825

The declaration and payment of dividends is at the sole discretion of
the Company's Board of Directors and the amount, if any, depends upon the
earnings, financial condition and capital needs of the Company and the Bank as
well as certain federal banking laws and regulations to which the Company and
the Bank are subject. The ability of the Bank to pay cash dividends to the
Company on its capital stock is subject to, among other matters, the
restrictions set forth in federal statutes and regulations. See "Item 1.
Business -- Regulation of the Bank." In September 1993, the Company effected a
three-for-two stock split. In October 1993, the Company's Board of Directors
approved the payment of regular quarterly cash dividends on the Common Stock.
The initial quarterly rate was set at $.0825 per share, adjusted for the
Company's four-for-three stock split declared on July 20, 1994. Concurrent with
the declaration of that stock split, the Board of Directors also increased the
quarterly dividend rate to $.095 per share, payable on both old and new shares.

ITEM 6. SELECTED FINANCIAL DATA

The following summary of selected condensed consolidated financial
information and other data of the Company is qualified in its entirety by
reference to the detailed information and consolidated financial statements
thereto.

//
1995 1994 1993 1992 1991
-------- -------- -------- -------- --------
(Dollars in thousands, except per share amounts)
FINANCIAL POSITION AT JUNE 30,

Assets ................................................ $528,169 $515,888 $519,459 $540,478 $506,706
Cash and investment securities (1) .................... 128,719 95,702 113,251 117,638 113,138
Loans receivable, net (2) ............................. 297,533 308,700 327,095 357,915 363,979
Mortgage-backed securities ............................ 83,995 92,558 60,089 41,174 4,107
Excess cost over fair value of net assets
acquired and other intangibles, net (3) ............ 780 1,270 1,863 3,231 4,132
Deposits .............................................. 449,318 450,819 459,993 496,929 484,395
Other borrowed funds (4) .............................. 18,122 10,468 10,887 1,259 89
Obligations under capital leases ...................... 119 120 221 322 423
Stockholders' equity (5) .............................. 53,774 48,503 41,853 35,578 16,337

OPERATING RESULTS FOR YEAR ENDED JUNE 30,

Interest income ....................................... $ 35,979 $ 35,550 $ 39,066 $ 44,291 $ 46,932
Interest expense ...................................... 17,798 16,487 19,305 27,782 33,412
Provision for loan losses ............................. 82 487 595 749 1,496
-------- -------- -------- -------- --------
Net interest income after provision for loan losses ... 18,099 18,576 19,166 15,760 12,024
Gain (loss) on sales of interest-earning assets ....... -- -- -- 364 35
Gain on sale of branches .............................. -- -- 1,000 -- --
Other noninterest income .............................. 2,755 2,484 2,110 2,270 2,386
Amortization of excess of cost over
fair value of net assets acquired (6) ............... 423 525 1,302 853 990
Other noninterest expense ............................. 11,818 10,829 11,510 10,820 10,099
-------- -------- -------- -------- --------
Income before income tax expense ...................... 8,613 9,706 9,464 6,721 3,356
Income tax expense (7) ................................ 3,146 3,502 3,952 2,540 2,244
-------- -------- -------- -------- --------
Income before cumulative effect of
change in accounting principle ...................... 5,467 6,204 5,512 4,181 1,112
Cumulative effect at July 1, 1993 of
change in accounting for income taxes (8) ........... -- 764 -- -- --
-------- -------- -------- -------- --------
Net income ............................................ $ 5,467 $ 6,968 $ 5,512 $ 4,181 $ 1,112
======== ======== ======== ======== ========
Net income per share (9) .............................. $ 1.58 $ 2.07 $ 1.67 $ 1.36 N/A
Dividends per share ................................... $ .38 $ .25 -- -- --
Average common shares and common stock
equivalents outstanding (9) ......................... 3,464 3,372 3,309 3,071 --

OTHER DATA AS OF AND FOR YEAR ENDED JUNE 30,
Average interest rate spread .......................... 3.32% 3.54% 3.79% 3.23% 2.88%
Net yield on average interest-earning assets .......... 3.67% 3.79% 4.03% 3.36% 2.86%
Return on average total assets ........................ 1.05% 1.32% 1.07% 0.80% 0.22%
Return on average equity .............................. 10.70% 15.33% 14.23% 17.72% 6.76%
Equity as a percent of year-end total assets .......... 10.18% 9.40% 8.06% 6.58% 3.22%
Dividend payout ratio (10) ............................ 22.11% 12.65% -- -- --
Tangible equity as a percent of year-end total assets . 10.03% 9.16% 7.70% 5.98% 2.41%
Other noninterest expense (excluding amortization of
intangibles) as a percent of average total assets ... 2.28% 2.05% 2.23% 2.08% 1.99%
Ratio of non-performing 11 assets to total assets ..... 0.16% 0.19% 0.37% 0.50% 0.74%
Ratio of allowance for loan losses to gross loans ..... 0.76% 0.72% 0.71% 0.63% 0.51%
Ratio of allowance for loan losses to non-accrual loans
and loans past due more than 90 days ................ 1034.07% 490.03% 186.86% 196.33% 97.26%
Ratio of allowance for loan losses to non-performing
assets .............................................. 268.18% 228.72% 125.49% 86.89% 51.10%
Number of (at end of period):
Real estate loans outstanding ....................... 5,870 6,322 7,132 7,992 8,301
Savings accounts .................................... 52,614 54,026 55,531 63,744 65,545
Banking offices (12) ................................ 13 13 13 18 18

(1) Cash and investment securities consists of cash, interest-earning
deposits in other banks, federal funds sold, certificates of deposit,
and investment securities.

(2) Includes loans held for sale.

(3) Excess of cost over fair value of net assets acquired has been restated
in accordance with SFAS No. 72 for each period presented.

(4) Other borrowed funds includes advances from the FHLB of Cincinnati.
Also includes obligation of the Employee Stock Ownership Plan ("ESOP")
of Heritage Federal until its refinancing in January 1995.

(5) Represents retained earnings only prior to fiscal year 1992.

(6) Excess of cost over fair value of net assets acquired and the related
amortization expense have been restated in accordance with SFAS No. 72
for each period presented.

(7) During 1992, Heritage Federal entered into transactions involving its
portfolio of FHLB stock. These resulted in the realization of capital
gains for income tax purposes that were offset by capital loss
carryforwards from prior years. As a result, in accordance with SFAS
No. 96, deferred tax liabilities were reduced by $469,000 during the
year ended June 30, 1992. The Bank's effective tax rates for fiscal
years 1995, 1994, 1993, 1992 and 1991 were 36.5%, 36.1%, 41.8%, 37.8%
and 66.9%, respectively. See Note 11 of Notes to Consolidated Financial
Statements.

(8) During the first quarter of fiscal year 1994, Heritage adopted SFAS No.
109, "Accounting for Income Taxes". The cumulative effect of this
change in accounting principle on prior periods added $764,000 or $.22
per share to net income for that fiscal year.

(9) Pro forma primary earnings per share for fiscal year 1992 are
calculated by dividing net earnings by 3,071,000 shares of the Common
Stock issued at conversion and common stock equivalents, which include
certain stock options.

(10) Based on net income before cumulative change in accounting principle.

(11) Non-performing assets are composed of loans over 90 days delinquent,
restructured loans and real estate owned.

(12) All of Heritage Federal's offices are full-service offices. The lower
number of banking offices since 1992 reflects the August 1992 sale of
five branches.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

GENERAL. On March 30, 1992, Heritage Federal converted from mutual to
stock form and became a wholly owned subsidiary of Heritage. The sole operations
of Heritage consist of those of Heritage Federal and its subsidiary, Citizens
Financial Corporation ("Citizens Financial").

The principal business of Heritage Federal consists of accepting
deposits from the general public through its branches and investing these funds
in loans secured by one- to four-family residential properties located in its
market areas. Heritage Federal also maintains a substantial investment portfolio
and originates consumer loans and limited amounts of commercial and commercial
real estate loans secured by properties in its market areas. Additionally,
Heritage Federal offers trust services and through Citizens Financial sells
title insurance. In August 1993, Citizens Financial began to sell annuities and
securities from Heritage Federal's locations via an arrangement with a
third-party vendor, and this arrangement continued throughout most of fiscal
year 1995.

Heritage Federal's net income is dependent primarily on its net
interest income, which is the difference between interest earned on its loans
and investments and the interest paid on interest-bearing liabilities. The net
income of Heritage Federal also is affected by the generation of noninterest
income such as commissions, income from trust activities, service charges and
other fees, rental income, and gains or losses on the sale of loans and
investment securities. In addition, net income is affected by the level of
operating expenses, the amount of loan loss reserves set aside each year, and
the amount of income tax expense.

Heritage Federal's operations, as with those of the entire thrift
industry, are significantly affected by prevailing economic conditions,
competition, and the monetary and fiscal policies of governmental agencies.
Lending activities are influenced by the demand for and supply of housing,
competition among lenders, the level of interest rates, and the availability of
funds. Deposit flows and costs of funds are influenced by prevailing market
rates of interest, primarily on competing investments, account maturities, and
the levels of personal income and savings in the market area.

ASSET/LIABILITY MANAGEMENT. Net interest income, the primary component
of Heritage Federal's net income, arises from both the difference between the
yield on interest-earning assets and the cost of interest-bearing liabilities,
and the relative amounts of such assets and liabilities. In the early 1980s,
Heritage Federal's primary interest-earning assets, like those of most thrift
institutions at the time, consisted of long-term, fixed-rate mortgages.
Conversely, its liabilities were principally short-term deposits that were
highly sensitive to interest rate changes. Consequently, during the early 1980s,
as general interest rate levels rose, the interest rates on Heritage Federal's
loans and securities did not reprice as quickly to higher levels as did the
rates on its deposits. As a result, Heritage Federal's interest rate spread was
adversely affected during that time.

Heritage Federal has sought to reduce its exposure to changes in
interest rates by matching more closely the effective maturities or repricings
of its interest-sensitive assets and liabilities. In accordance with Heritage
Federal's interest rate risk policy, management has emphasized the origination
and/or purchase of adjustable-rate mortgages and mortgage-backed securities,
intermediate-term fixed-rate mortgages, medium-term U.S. agency and
government-sponsored enterprise ("GSE") notes, and short-term consumer loans.
Because of generally moderate interest rate levels during the past three years,
however, there has been increased consumer interest in fixed-rate loans. In
order to maintain market share under these changing conditions, Heritage Federal
began to originate fixed-rate loans for potential resale to secondary market
investors and for its portfolio. In all cases, originations of long-term,
fixed-rate mortgages are underwritten according to guidelines of the Federal
Home Loan Mortgage Corporation ("the FHLMC") and the Federal National Mortgage
Association ("the FNMA"). Since February 1994, higher interest rates have slowed
the trend toward fixed-rate lending and have created renewed interest in
adjustable-rate loans, enabling Heritage Federal to again increase the mix of
adjustable-rate loans in its overall loan balances as compared with the fiscal
year ended June 30, 1992. However, because of the moderate rise in mortgage
rates during most of Heritage Federal's fiscal year ended June 30, 1995, the
adjustable-rate component of Heritage Federal's portfolio of mortgage loans and
mortgage-backed securities increased only marginally to 68%, with fixed-rate
loans comprising 32% as compared to the portfolio mix at June 30, 1994, of 67%
and 33%, respectively. The portfolio mix at June 30, 1992, was 53% and 47%,
respectively.

In addition, Heritage Federal manages its interest rate risk in part by
maintaining a substantial portfolio of short-term investments. The weighted
average life of its investment portfolio at June 30, 1995, was approximately 3.9
years.

INTEREST RATE SENSITIVITY ANALYSIS. As a result of Heritage Federal's
interest rate risk management policy and management's strategy emphasizing the
origination of short-term and/or adjustable-rate mortgages, Heritage Federal's
excess of interest-bearing liabilities over interest-earning assets maturing or
repricing within one year (i.e., its "one-year gap") at June 30, 1995, was
estimated to be $49,523,000 or a negative 9.38% of total assets versus
$47,844,000 or a negative 9.27% at June 30, 1994. This marginal increase in
negative gap position primarily reflected the moderate increase in market
interest rates during most of fiscal year 1995 that resulted in the shifting
behavioral pattern of deposit customers' preference for higher-yielding,
longer-term certificate of deposit accounts, versus lower-yielding,
transaction-type accounts such as demand and passbook savings accounts. The
changing composition of liability accounts resulted in a lower amount of
liability sensitivity to short-term interest rate fluctuations at June 30, 1995,
compared with the previous fiscal year. This was functionally mirrored by a
similar reduction of short-term loans receivable/mortgage-backed securities
balances, thereby resulting in a minimal change in Heritage Federal's one-year
gap position. The increase in market interest rates during fiscal year 1995 also
continued the slowdown in the rate of loan prepayments, extending the duration
of Heritage Federal's loans and mortgage-backed securities. Management considers
its one-year gap to represent an acceptable balance between reducing Heritage
Federal's interest rate risk and enhancing its interest rate spread. However, as
a result of Heritage Federal's negative one-year gap, Heritage Federal's net
interest income would be adversely affected by increases in prevailing interest
rates.

The following table sets forth the interest sensitivity gap between
interest-earning assets and interest-bearing liabilities at June 30, 1995, which
are expected to mature or reprice in each of the time periods shown.

Over
Three Three Months Over One Over Five Over Ten Over
Months Through Through Through Through Twenty
or Less One Year Five Years Ten Years Twenty Years Years Total
-------- ------------ ---------- --------- ------------ ------- --------
(Dollars in thousands)

INTEREST-EARNING ASSETS:
Loans receivable, net .................. $ 54,628 $ 86,410 $ 130,374 $21,408 $ 4,713 $ 0 $297,533
Mortgage-backed securities ............. 23,153 33,045 18,089 5,054 3,008 1,646 83,995
Investment securities .................. 14,276 11,768 55,209 25,157 431 0 106,841
Federal funds sold ..................... 7,000 0 0 0 0 0 7,000
Interest-earning deposits .............. 5,593 0 0 0 0 0 5,593
FHLB stock ............................. 0 0 0 0 0 4,057 4,057
-------- --------- --------- ------- ------- ------- --------
Total ................................ 104,650 131,223 203,672 51,619 8,152 5,703 505,019
-------- --------- --------- ------- ------- ------- --------

INTEREST-BEARING LIABILITIES:
Total NDA deposits ..................... 9,434 23,605 48,728 0 0 0 81,767
Passbook savings ....................... 5,132 14,955 48,346 0 0 0 68,433
Certificates of deposit ................ 72,823 148,158 67,463 99 0 0 288,543
Other borrowed money ................... 10,687 602 3,683 3,150 119 0 18,241
-------- --------- --------- ------- ------- ------- --------
Total ................................ 98,076 187,320 168,220 3,249 119 0 456,984
-------- --------- --------- ------- ------- ------- --------

INTEREST SENSITIVITY GAP ............... $ 6,574 $ (56,097) $ 35,452 $48,370 $ 8,033 $ 5,703 $ 48,035
======== ========= ========= ======= ======= ======= ========

CUMULATIVE INTEREST SENSITIVITY
GAP .................................. $ 6,574 $ (49,523) $ (14,071) $34,299 $42,332 $48,035 $ 48,035
======== ========= ========= ======= ======= ======= ========

RATIO OF INTEREST-EARNING ASSETS TO
INTEREST-BEARING LIABILITIES ......... 106.70% 70.05% 121.07% 1588.77% 6850.42% 0.00% 110.51%
======== ========= ========= ======= ======= ======= ========

RATIO OF CUMULATIVE INTEREST SENSITIVITY
GAP TO TOTAL ASSETS .................. 1.24% -9.38% -2.66% 6.49% 8.01% 9.09% 9.09%
======== ========= ========= ======= ======= ======= ========

The table is based on a number of assumptions regarding the future
annual prepayment rate for Heritage Federal's various categories of loans and
mortgage-backed securities and the attrition rate of certain deposits.

Certain shortcomings are inherent in the method of analysis presented
in the table above. The data provided to Heritage Federal by its independent
consultant are derived from information reported by savings institutions in
urban areas in Tennessee. Use of other data derived from non-urban or
non-Tennessee savings institutions could lead to materially different results.
Although certain assets and liabilities may have similar maturities or periods
of repricing, they may react in different degrees to changes in market interest
rates. The interest rates on certain types of assets and liabilities may
fluctuate in advance of changes in market interest rates, while interest rates
on other types of assets and liabilities may lag behind changes in market
interest rates. Certain assets, such as adjustable-rate mortgages, have features
which restrict changes in interest rates on a short-term basis and over the life
of the asset. In the event of a change in interest rates, prepayment and early
withdrawal levels would likely deviate significantly from those assumed in
calculating the table. The ability of borrowers to service their debt may
decrease in the event of an interest rate increase.

AVERAGE BALANCES, INTEREST AND AVERAGE YIELDS AND RATES. The following
table sets forth information regarding average balances of interest-earning
assets and interest-bearing liabilities, as well as the weighted average yields
earned on Heritage Federal's assets and the weighted average interest rates paid
on Heritage Federal's liabilities, together with the net yield on
interest-earning assets for the past three fiscal years. Non-accrual loans have
been included in the average balances of loans receivable.

Years Ended June 30,
--------------------------------------------------------------------------------------------
1995 1994 1993
------------------------------ ------- ------------------- -----------------------------
Average Average Average
Average Yield/ Average Yield/ Average Yield/
Balance Interest Cost Balance Interest Cost Balance Interest Cost
------- -------- ------- ------- -------- ------- ------- -------- -------
(Dollars in thousands)

INTEREST-EARNING ASSETS:
Loans receivable, net ........... $305,124 $ 24,771 8.12% $314,336 $25,449 8.10% $342,583 $30,221 8.82%
Investment securities ........... 90,970 5,561 6.11% 87,649 5,042 5.75% 79,995 5,152 6.44%
Mortgage-backed securities ...... 87,805 5,034 5.73% 86,056 4,539 5.27% 48,977 3,075 6.28%
Federal funds sold .............. 3,256 172 5.28% 6,708 203 3.03% 8,409 302 3.59%
Interest-earning deposits ....... 3,767 192 5.10% 4,721 135 2.86% 6,266 160 2.55%
FHLB stock ...................... 3,919 249 6.35% 3,705 182 4.91% 3,540 156 4.41%
-------- -------- ---- -------- ------- ---- -------- ------- ----
Total interest-earning assets . 94,841 35,979 7.27% 503,175 35,550 7.07% 489,770 39,066 7.97%
Non-interest-earning assets ..... 23,538 23,993 26,022
-------- -------- --------
Total assets .................. $518,379 $527,168 $515,792
======== ======== ========

INTEREST-BEARING LIABILITIES:
Demand accounts ................. $ 92,440 $ 2,339 2.53% $100,423 $ 2,361 2.35% $ 90,336 $ 2,517 2.79%
Passbook savings ................ 79,116 2,176 2.75% 91,075 2,551 2.80% 82,091 2,747 3.35%
Certificates of deposit ......... 262,357 12,315 4.69% 262,928 10,934 4.16% 280,539 13,610 4.85%
Other borrowed money ............ 16,651 968 5.81% 12,255 641 5.23% 8,631 431 4.99%
-------- -------- ---- -------- ------- ---- -------- ------- ----
Total interest-bearing
liabilities ................ 450,564 17,798 3.95% 466,681 16,487 3.53% 461,597 19,305 4.18%
Non-interest-bearing liabilities* 16,719 15,034 15,454
-------- -------- --------
Total liabilities ............. 467,283 481,715 477,051
Stockholders' Equity ............ 51,096 45,453 38,741
-------- -------- --------
Total liabilities and
stockholders' equity ....... $518,379 $527,168 $515,792
======== ======== ========

NET INTEREST INCOME ............. $ 18,181 $19,063 $19,761
======== ======= =======

INTEREST RATE SPREAD ............ 3.32% 3.54% 3.79%
====== ====== ======

NET YIELD ON INTEREST-EARNING
ASSETS ....................... 3.67% 3.79% 4.03%
====== ====== ======

RATIO OF INTEREST-EARNING ASSETS
TO INTEREST-BEARING LIABILITIES 109.83% 107.82% 106.10%
====== ====== ======

* Includes average non-interest-bearing demand deposits of $9,060,000,
$10,940,000 and $8,609,000 during fiscal years 1995, 1994 and 1993,
respectively.

RATE/VOLUME ANALYSIS. The table below sets forth certain information
regarding changes in interest income and interest expense of Heritage Federal
for the periods indicated. For each category of interest-earning asset and
interest-bearing liability, information is provided on changes attributable to:
(1) changes in volume (changes in volume multiplied by old rate); and (2)
changes in rate (change in rate multiplied by old volume). Changes in
rate-volume (changes in rate multiplied by changes in volume) are allocated
between changes in volume and changes in rate on a proportional basis. Average
balances are derived from daily balances.

1995 vs. 1994 1994 vs. 1993
------------------------------ -------------------------------
Increase (Decrease) Increase (Decrease)

Due to Due to
------------------------------ -------------------------------
Volume Rate Total Volume Rate Total
------ ------ ----- ------ ------ -----
(Dollars in thousands)

INTEREST INCOME:
Loans receivable, net ............... $(748) $ 70 $ (678) $(2,389) $(2,383) $(4,772)
Investment securities ............... 196 323 519 468 (578) (110)
Mortgage-backed securities .......... 94 401 495 2,021 (557) 1,464
Federal funds sold .................. (136) 105 (31) (56) (43) (99)
Interest-earning deposits ........... (32) 89 57 (43) 18 (25)
FHLB stock .......................... 11 56 67 8 18 26
===== ======= ======= ======= ======= =======
Total interest-earning assets .... $(615) $ 1,044 $ 429 $ 9 $(3,525) $(3,516)
===== ======= ======= ======= ======= =======

INTEREST EXPENSE:
Total NDA deposits .................. $(195) $ 173 $ (22) $ 263 $ (419) $ (156)
Passbook savings .................... (330) (45) (375) 281 (477) (196)
Certificates of deposit ............. (24) 1,405 1,381 (817) (1,859) (2,676)
----- ------- ------- ------- ------- -------
Total deposits ................... (549) 1,533 984 (273) (2,755) (3,028)
Other borrowed money ................ 249 78 327 189 21 210
----- ------- ------- ------- ------- -------
Total interest-bearing liabilities (300) 1,611 1,311 (84) (2,734) (2,818)
===== ======= ======= ======= ======= =======
Change in net interest income ......... $(315) $ (567) $ (882) $ 93 $ (791) $ (698)
===== ======= ======= ======= ======= =======

FINANCIAL CONDITION. Heritage Federal's total assets increased 2.4% to
$528,169,000 at June 30, 1995, compared with $515,888,000 at June 30, 1994. This
change primarily reflected an increase in investment securities and cash and
cash equivalents from year to year, offset in part by a decline in loans
receivable and mortgage-backed securities.

Heritage Federal adopted on a prospective basis Statement of Financial
Accounting Standard ("SFAS") No. 115 at the beginning of fiscal year 1995, and
in doing so, designated a portion of its investment portfolio as available for
sale. Securities designated as available for sale consist of U. S. Treasury
notes with laddered maturities, amounting to approximately $20,000,000 in
principal face value at June 30, 1995. The fair value of these securities at
June 30, 1995, with unrealized gains or losses, net of taxes, of approximately
$84,000 reflected as a separate component of stockholders' equity, totaled
$20,213,000. At that date, available for sale securities had a weighted average
life of approximately 1.1 years. Heritage Federal anticipates the available for
sale portion of its investment portfolio will be maintained as necessary in
order to satisfy its liquidity needs. In the event funds are needed for deposit
account withdrawals, loan demand or other liquidity purposes, these securities
could be liquidated.

Cash and cash equivalents increased 46.8% to $21,878,000 or 4.1% of
total assets at June 30, 1995, from $14,906,000 or 2.9% of total assets at June
30, 1994.

Net loans receivable declined 3.6% to $297,533,000 at June 30, 1995,
compared with $308,700,000 at June 30, 1994. This change reflected the net
repayment of loans, which slowed significantly during fiscal 1995 from the
year-earlier period due to higher market rates and moderating refinancing
activity, in excess of new loan originations, which declined to $51,536,000 in
fiscal year 1995 compared with $81,902,000 in fiscal year 1994 due

to a declining consumer demand for adjustable-rate mortgage loans, which are
Heritage Federal's principal source of loan originations; increased competition
in the mortgage origination business; a general slowdown in new home
construction; and a general decline in the volume of residential loan
refinancings.

The cash inflow from the net repayment of loans during fiscal year 1995
together with the proceeds of matured and called investment securities were
invested primarily in GSE debt obligations issued by the FHLMC, the FNMA, and
the FHLB System. Terms of these securities were more favorable than investments
in mortgage-backed securities, because of shorter terms and competitive yields
and had risk characteristics consistent with Heritage Federal's philosophy on
interest rate risk. During fiscal year 1994, investable cash flows were deployed
primarily toward purchases of adjustable-rate mortgage-backed securities as part
of Heritage Federal's interest rate risk management in a lower rate environment.
By investing in mortgage-backed securities, Heritage Federal was able to obtain
higher yields than those available on other government and agency securities
with similar repricing characteristics at the time. Because borrowers on the
mortgages underlying such securities generally have the right to prepay their
loans without penalty, however, mortgage-backed securities expose Heritage
Federal to the risk that the security will prepay at a faster-than-anticipated
rate in a declining rate environment. Conversely, in a rising rate environment,
borrowers may prepay at a slower rate, effectively extending the maturity of
these securities and also compressing Heritage Federal's net interest spread as
its cost of funds rises. Heritage Federal seeks to avoid these risks by
investing in adjustable-rate, mortgage-backed securities. Heritage Federal
invests solely in mortgage-backed securities issued by the government-sponsored
enterprises such as the FNMA and the FHLMC, or guaranteed by the Government
National Mortgage Association ("GNMA"). These securities include fixed- and
adjustable-rate collateralized mortgage obligations, sometimes included in the
definition of mortgage derivatives, but which do not meet the regulatory
definition of high risk derivatives.

Investments and mortgage-backed securities increased 10.1% to
$190,835,000 at June 30, 1995, from $173,354,000 as of June 30, 1994.
Investments totaled $106,841,000 at the end of fiscal year 1995, or
approximately 20.2% of Heritage Federal's total assets at June 30, 1995,
compared with $80,796,000 or 15.7% of total assets at June 30, 1994. Heritage
Federal's investment in mortgage-backed securities declined to $83,995,000 at
June 30, 1995, from $92,558,000 as of June 30, 1994. Adjustable-rate products
comprised 60.4% and 59.4% of total mortgage-backed securities as of the end of
fiscal years 1995 and 1994, respectively. Collateralized mortgage obligations
("CMOs") at June 30, 1995, and 1994 totaled $14,942,000 and $5,615,000,
respectively. The increase in CMO balances was funded primarily by the proceeds
of an advance obtained from the FHLB of Cincinnati. These securities offered a
favorable yield differential over the cost of the advance, thereby generating
additional net interest income for Heritage Federal during the fiscal year.

Heritage Federal's deposits declined 0.3% during fiscal year 1995 to
$449,318,000 from $450,819,000 as of June 30, 1994. Heritage Federal relied both
upon advances from the FHLB of Cincinnati and internally generated earnings
during fiscal year 1995 to help fund its increase in interest-earning assets.
Advances from the FHLB totaled $18,122,000 at June 30, 1995, compared with
$9,587,000 at June 30, 1994. The increase in borrowings from the FHLB of
Cincinnati during fiscal year 1995 was used toward the purchase of CMOs.

RESULTS OF OPERATIONS. Net income for fiscal year 1995 decreased 21.5%
to $5,467,000 or $1.58 per share from $6,968,000 or $2.07 per share in fiscal
year 1994. All per share amounts have been adjusted for a four-for-three stock
split declared in July 1994 and a three-for-two stock split declared in August
1993. Heritage's earnings for fiscal year 1994 included $764,000 in
non-recurring income attributable to the adoption of the new standard for
accounting for income taxes. Net income before adoption of the new accounting
standard declined $737,000, or 11.9%, from fiscal year 1994. Heritage's lower
earnings for fiscal year 1995 reflected primarily a decline in net interest
income before provision for loan losses and an increase in noninterest expense,
which more than offset a lower provision for loan losses in fiscal year 1995 and
slightly higher noninterest income.

Net income for fiscal year 1994, excluding the impact of the adoption of
a new accounting standard for income taxes, increased 12.6% from the $5,512,000
or $1.67 per share reported in fiscal year 1993. In general, the increase in
fiscal year 1994 compared with fiscal year 1993 reflected a reduction in the
provision for loan losses and lower noninterest expense, which more than offset
a decline in net interest income and total non-interest income.

Net Interest Income. Net interest income declined 4.6% to $18,181,000 in
fiscal year 1995 from $19,063,000 in fiscal year 1994. Net interest income for
fiscal year 1994 declined 3.5% from $19,761,000 in fiscal year 1993.

The three-year period ended June 30, 1995, reflected a generally
favorable interest rate environment, although a number of rate increases
implemented by the Federal Reserve beginning in February 1994 resulted in higher
rate levels in the last half of fiscal year 1994 and much of fiscal year 1995.
Reflecting this increase midway through fiscal year 1994, Heritage Federal's
average interest rate spread in fiscal year 1995 declined to 3.32% from 3.54% in
fiscal year 1994 and 3.79% in fiscal year 1993.

Heritage Federal's net yield on average interest-earning assets declined
to 3.67% in fiscal 1995 from 3.79% in fiscal year 1994, again reflecting
increases in interest rates throughout most of fiscal year 1995. Heritage
Federal's net yield declined in fiscal year 1994 from 4.03% in fiscal year 1993.

Heritage Federal's average interest-earning assets decreased 1.7% to
$494,841,000 in fiscal year 1995 from $503,175,000 in fiscal year 1994,
reflecting primarily a decline in net loans receivable. Interest-earning assets
in fiscal year 1994 increased 2.7% from $489,770,000 during fiscal year 1993,
due in general to an increase during the year in investment and mortgage-backed
securities.

During the three-year period ended June 30, 1995, however, Heritage
Federal steadily increased its ratio of interest-earning assets to
interest-bearing liabilities to 109.8% during fiscal year 1995 from 107.8% in
fiscal year 1994 and 106.1% in fiscal year 1993. Heritage Federal achieved this
increase primarily by increasingly funding its activities with its net earnings
rather than liabilities. Likewise, the average yields on interest-earning assets
for fiscal years 1995, 1994 and 1993 were 7.27%, 7.07% and 7.97%, respectively.
The increase in average yields during the most recent fiscal year reflects
increases in yields on mortgage-backed securities and adjustable-rate mortgage
loans.

Because of the increase in Heritage Federal's average yield on its
interest-earning assets from fiscal year 1994 to fiscal year 1995, and the
increasing ratio of interest-earning assets to interest-bearing liabilities,
interest income increased to $35,979,000 in fiscal year 1995 from $35,550,000 in
fiscal year 1994. Interest income in fiscal year 1993 totaled $39,066,000.

Reflecting the same interest rate trends, interest expense increased to
$17,797,000 in fiscal year 1995 from $16,487,000 in fiscal year 1994. Interest
expense in fiscal year 1993 totaled $19,305,000. The increase during fiscal year
1995 reflects the increase in the average cost of interest-bearing liabilities
as a result of the general rise in market rates as well as Heritage Federal's
continued reliance on higher-costing FHLB advances and certificates of deposit
as funding sources. As with the yields on interest-earning assets, costs on
interest-bearing liabilities fell in fiscal year 1994 and increased in fiscal
year 1995. The average cost of interest-bearing liabilities over the past three
years was 3.95% in fiscal year 1995, 3.53% in fiscal year 1994 and 4.18% in
fiscal year 1993.

Average interest-bearing liabilities declined to $450,564,000 in fiscal
year 1995 compared with $466,681,000 in fiscal year 1994, reflecting primarily a
decrease in lower-costing demand and passbook savings accounts due to greater
competition from other investment vehicles. Average interest-bearing liabilities
for fiscal year 1994, however, increased from $461,597,000 during fiscal year
1993 as funds flowed into passbook accounts during a period of lower interest
rates.

Provision for Loan Losses. For fiscal years 1995, 1994, and 1993,
Heritage Federal provided $82,000, $487,000 and $595,000, respectively, for loan
losses. The allowance for loan losses is increased by charges against income and
decreased by charge-offs (net of recoveries). Management's periodic evaluation
of the adequacy of the allowance is based on Heritage Federal's past loan loss
experience, known and inherent risks in the portfolio, adverse situations that
may affect the borrowers' ability to repay, estimated value of any underlying
collateral, and current economic conditions. While management believes that it
has established the allowance in accordance with generally accepted accounting
principles and has taken into account the views of its regulators and the
current economic environment, there can be no assurance that in the future
Heritage Federal's regulators or its economic environment will not require
further increases in the allowance.

The decline in the amount provided for loan losses in fiscal year 1995
reflected a significant improvement in Heritage Federal's non-performing assets.
At June 30, 1995, the allowance for possible loan losses represented 1034.07% of
total non-accrual loans and loans past due more than 90 days. This compared with
490.03% at June 30, 1994, and 186.86% as of June 30, 1993. At June 30, 1995,
1994 and 1993, Heritage Federal's ratio of allowance for loan losses to
non-performing assets, including real estate owned, was 268.18%, 228.72% and
125.49%, respectively.

Noninterest Income. Noninterest income totaled $2,755,000 in fiscal year
1995, $2,484,000 in fiscal year 1994, and $3,110,000 in fiscal 1993. The higher
amount in fiscal year 1993 reflected a gain of $1,000,000 on the sale of five
branches during the year. Noninterest income, other than gains or losses on the
sale of the branches and interest-earning assets, increased moderately over the
three-year period ended June 30, 1995, aggregating $2,755,000, $2,484,000 and
$2,110,000 in fiscal years 1995, 1994 and 1993, respectively, reflecting
primarily an increase in other ancillary services such as checking fee income
and fee income from the sale of securities and annuities.

Noninterest Expense. Noninterest expense totaled $12,242,000 in fiscal
1995, $11,354,000 in fiscal year 1994, $12,813,000 in fiscal year 1993. The
increase in noninterest expense in fiscal year 1995 reflected higher
compensation and benefits expense, due to normal salary increases for personnel
and greater benefit costs, and because of the revision to certain compensation
plans in fiscal year 1994 which became effective during fiscal year 1995. The
decline in noninterest expense during fiscal year 1994 was due primarily to the
decrease in amortization expense associated with the excess of cost over fair
value of net assets acquired (i.e., goodwill) compared with fiscal year 1993,
during which a portion of the goodwill was written off because of Heritage
Federal's sale of the related assets. The decline also reflected lower
compensation-related expenses, due to revisions in certain compensation plans
during the year, along with lower communications and other office expense and
real estate owned expense and provisions.

Income Taxes. The effective income tax rates for fiscal years 1995, 1994
and 1993 were 36.5%, 36.1% and 41.8%, respectively, compared with the maximum
statutory corporate income tax rate of 38.0% during those periods. The higher
effective tax rate in fiscal year 1993 reflected tax on the gain on the sale of
five branches during the first quarter; the write-off of goodwill associated
with those branches was not tax deductible. Effective at the beginning of fiscal
year 1994, Heritage adopted SFAS No. 109, Accounting for Income Taxes, on a
prospective basis. The cumulative effect of this new accounting standard on
prior periods added $764,000 or $.22 per share to net income for fiscal year
1994.

IMPACT OF NEW ACCOUNTING STANDARDS. In December 1991, the Financial
Accounting Standards Board ("the FASB") issued SFAS No. 107, Disclosures about
Fair Value of Financial Instruments. SFAS No. 107 requires disclosures of
information about the fair value of all financial instruments. Such disclosure
is effective for fiscal years ending after December 15, 1992. Heritage adopted
SFAS No. 107 for the fiscal year ended June 30, 1993.

Heritage adopted SFAS No. 109, Accounting for Income Taxes, on a
prospective basis during the first quarter of fiscal year 1994. The cumulative
effect of this new accounting standard on prior periods added $764,000 or $.22
per share to net income for fiscal year 1994.

The FASB issued SFAS No. 114, Accounting by Creditors for Impairment of
a Loan, which amended SFAS No. 5, Accounting for Contingencies, and SFAS No. 15,
Accounting by Debtors and Creditors for Troubled Debt Restructurings. SFAS No.
114, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a
Loan - Income Recognition and Disclosure, requires the use of the discounted
cash flow method for measuring impairment of loans when it is probable that a
creditor will be unable to collect all amounts due according to the contractual
terms of the loan agreement. If expedient, the creditor may use a loan's
observable market price or the fair value of any collateral.

Heritage adopted SFAS No. 114 on a prospective basis as of July 1, 1993
for the fiscal year ending June 30, 1994. The adoption of SFAS No. 114 did not
have a material effect on Heritage's financial position or results of
operations.

The FASB issued SFAS No. 115, Accounting for Certain Investments in Debt
and Equity Securities, which supersedes SFAS No. 12, Accounting for Certain
Marketable Securities and amends SFAS No. 65, Accounting for Certain Mortgage
Banking Activities. SFAS No. 115 became effective for fiscal years beginning
after December 15, 1993. SFAS No. 115 requires investments in certain debt and
equity securities to be classified into three categories -- held to maturity,
available for sale, or trading. Securities classified into the held to maturity
category will be accounted for at cost, adjusted for amortization of premiums
and discounts. Securities in the remaining two categories will be carried at
market value, with changes in the market value of securities available for sale
being accounted for as changes in stockholders' equity and changes in the market
value of trading account securities being recognized in income.

Heritage adopted SFAS No. 115 on a prospective basis in the first
quarter of fiscal year 1995. The adoption of SFAS No. 115 did not have a
material effect on Heritage's financial position.

LIQUIDITY AND CAPITAL RESOURCES. Heritage Federal's principal sources of
funds for operations are deposits from its primary market areas, principal and
interest payments on loans and mortgage-backed securities, and proceeds from
maturing investment securities. Additionally, Heritage Federal may borrow funds
from the FHLB of Cincinnati or sell loans in order to increase liquidity.
Heritage Federal's deposits declined 0.3% during fiscal year 1995 to
$449,318,000 from $450,819,000 as of June 30, 1994. During fiscal year 1995,
Heritage Federal increased its advances from the FHLB of Cincinnati for the
purpose of increasing its net interest income through the purchase of additional
CMOs. Advances from the FHLB of Cincinnati totaled $18,122,000 at June 30, 1995,
compared with $9,587,000 at June 30, 1994.

Heritage Federal must satisfy three capital standards, as set by the
Office of Thrift Supervision (the "OTS"). These standards include a ratio of
core capital to adjusted total assets of 3.0%, a tangible capital standard
expressed as 1.5% of total adjusted assets, and a combination of core and
"supplementary" capital equal to 8.0% of risk-weighted assets. The OTS recently
finalized regulations that add an interest rate risk component to capital
requirements under certain circumstances. Heritage Federal does not expect that
this regulation will require it to reduce its capital materially for purposes of
determining compliance with its risk-based capital requirement. In addition, the
OTS has recently adopted regulations that impose certain restrictions on savings
associations that have a total risk-based capital ratio that is less than 8.0%,
a ratio of Tier 1 capital (or core capital) to risk-weighted assets of less than
4.0%, or a ratio of Tier 1 capital to adjusted total assets of less than 4.0%
(or 3.0% if the institution receives the highest rating under the OTS
examination rating system).

Heritage Federal presently exceeds all capital requirements as currently
promulgated. At June 30, 1995, Heritage Federal had tangible, core, Tier 1 to
risk-weighted assets, and risk-based capital ratios of 9.77%, 9.85%, 23.97%, and
25.00%, respectively.

The following table reconciles Heritage Federal's net worth at June 30,
1995, under generally accepted accounting principles to regulatory capital
requirements:

REGULATORY CAPITAL REQUIREMENTS (UNAUDITED)
-----------------------------------------------------------------------------------------
GAAP TANGIBLE TIER 1/CORE RISK-BASED
CAPITAL CAPITAL CAPITAL CAPITAL
----------- ----------- ----------- ----------

$52,378,000 $52,378,000 9.93% $52,378,000 9.92% $52,378,000 24.16%
===========

Add:
General valuation
allowances -- -- -- -- 2,247,000 1.03%

Deduct:
Goodwill 780,000 -0.15% 333,000 -0.06% 333,000 -0.15%
Unrealized gains on
Available for sale
securities 84,000 -0.01% 84,000 -0.01% 84,000 -0.04%
----------- ---- ----------- ---- ----------- -----

Regulatory
capital--computed 51,514,000 9.77% 51,961,000 9.85% 54,208,000 25.00%
Minimum capital
requirement 7,909,000 1.50% 15,832,000 3.00% 17,345,000 8.00%
----------- ---- ----------- ---- ----------- -----
Regulatory capital--excess $43,605,000 8.27% $36,129,000 6.85% $36,863,000 17.00%
=========== ==== =========== ==== =========== =====

Heritage Federal must maintain liquidity ratios at certain regulatory
levels. Regulations specify the types of assets that qualify for liquidity,
which generally include cash, federal funds sold, certificates of deposit and
qualifying types of U.S. Treasury and agency securities, and other investments
having maturities of five years or less. Such investments serve as a source of
funds upon which Heritage Federal may rely to meet deposit withdrawals and for
other short-term needs. The required levels of such liquidity are calculated on
a "liquidity base" consisting of net withdrawable accounts plus borrowings due
in one year or less. Presently, Heritage Federal is required to maintain total
liquid assets as described above of at least 5% of its liquidity base.
Short-term liquid assets (maturing in one year or less) may not be less than 1%
of Heritage Federal's liquidity base.

In recent years, Heritage Federal has maintained higher levels of
liquid assets than required by regulation. Management believes that the
liquidity levels maintained are adequate to meet potential deposit outflows,
loan demand and normal operations. Its short-term ratios were 5.07%, 3.30% and
5.36% at June 30, 1995, 1994 and 1993, respectively. Total liquidity ratios were
19.25%, 16.24% and 20.59%, respectively, for the same periods.

At June 30, 1995, Heritage Federal had outstanding commitments to
originate loans totaling $1,733,000, excluding $3,492,000 in approved but unused
home equity lines of credit. Management believes that Heritage Federal's sources
of funds are sufficient to fund all of its outstanding commitments.

IMPACT OF INFLATION AND CHANGING PRICES The consolidated financial
statements and notes thereto, presented herein, have been prepared in accordance
with generally accepted accounting principles, which require the measurement of
financial position and operating results in terms of historical dollars without
consideration of the changes in the relative purchasing power of money over time
due to inflation. The impact of inflation is reflected in the increased cost of
Heritage Federal's operations. Unlike most industrial companies, however, nearly
all the assets and liabilities of Heritage Federal are monetary. As a result,
interest rates have a greater impact on Heritage Federal's performance than do
the effects of general levels of inflation. Interest rates do not necessarily
move in the same direction or to the same extent as the price of goods and
services.
//

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEPENDENT ACCOUNTANTS' REPORT

The Board of Directors
Heritage Federal Bancshares, Inc.

We have audited the accompanying consolidated statements of financial condition
of Heritage Federal Bancshares, Inc. and Subsidiary as of June 30, 1995 and
1994, and the related consolidated statements of income, stockholders' equity,
and cash flows for each of the three years in the period ended June 30, 1995.
These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion of these financial statements based
on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Heritage Federal
Bancshares, Inc. and Subsidiary at June 30, 1995 and 1994, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended June 30, 1995, in conformity with generally accepted accounting
principles.

As discussed in Note 1 to the consolidated financial statements, the Company
changed its methods of accounting for securities and income taxes in 1995 and
1994, respectively.

COOPERS & LYBRAND L.L.P.

Knoxville, Tennessee
August 1, 1995

57
58

HERITAGE FEDERAL BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

June 30, 1995 and 1994

1995 1994
---- ----

ASSETS

Cash and due from banks $ 9,285,434 $ 9,610,848
Interest-earning deposits in financial institutions 5,592,680 2,295,206
Federal funds sold 7,000,000 3,000,000
------------ ------------

Total cash and cash equivalents 21,878,114 14,906,054

Securities available-for-sale 20,213,195 -
Securities held-to-maturity:
U.S. government and agencies and collateralized mortgage
obligations - approximate market value of $86,258,000 86,627,642 -
Mortgage-backed securities - approximate market value of
$83,012,000 83,994,659 -

Investment securities - approximate market value of
$78,754,000 - 80,796,409
Mortgage-backed securities - approximate market
value of $88,397,000 - 92,557,813
Loans receivable, net 297,533,313 308,699,625
Interest receivable 3,666,307 3,446,516
Real estate owned, net of allowance for losses of $211,771
and $262,322 at June 30, 1995 and 1994, respectively - 531,275
Premises and equipment, net 6,785,895 6,676,464
Investment in Federal Home Loan Bank stock, at cost 4,057,300 3,807,700
Excess of cost over fair value of net assets acquired and
other intangibles, net 780,132 1,270,127
Deferred income taxes 897,514 1,457,138
Other assets 1,735,008 1,738,951
------------ ------------
$528,169,079 $515,888,072
============ ============

The accompanying notes are an integral part
of these consolidated financial statements.

58
59

1995 1994
---- ----

LIABILITIES AND STOCKHOLDERS' EQUITY

Deposits $449,317,977 $450,818,608
Advances from Federal Home Loan Bank 18,121,921 9,587,083
Advances from borrowers for taxes and insurance 4,027,987 3,990,598
Accrued expenses and other liabilities 2,927,221 2,107,869
Employee Stock Ownership Plan obligation - 880,885
------------ ------------

474,395,106 467,385,043

Commitments and contingencies (Notes 2, 3, 5, 12, 15, 16, 18 and 21)

Stockholders' equity:
Preferred stock of $1.00 par value, authorized 2,000,000
shares; none issued or outstanding - -
Common stock of $1.00 par value, 8,000,000 shares
authorized; issued and outstanding - 3,186,158 at June 30,
1995 and 3,172,826 at June 30, 1994 (Note 19) 3,186,158 3,172,826
Additional paid-in capital 16,509,491 16,108,095
Retained earnings-substantially restricted 35,070,071 30,813,111
Unrealized appreciation on available-for-sale securities,
net of tax of $51,530 in 1995 84,079 -
Employee Stock Ownership Plan obligation (720,765) (880,885)
Unearned compensation of Management Recognition Plan (355,061) (710,118)
------------ ------------
53,773,973 48,503,029
------------ ------------
$528,169,079 $515,888,072
============ ============

HERITAGE FEDERAL BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

Years ended June 30, 1995, 1994 and 1993

1995 1994 1993
---- ----

Interest income:
Loans $24,770,777 $25,448,506 $30,220,709
Securities available-for-sale 1,361,695 - -
Securities held-to-maturity:
U.S. government and agencies and collateralized
mortgage obligations 4,199,355 - -
Mortgage backed securities 5,034,437 - -
Investments - 5,041,697 5,151,660
Mortgage-backed securities - 4,539,140 3,074,851
Other interest-earning assets 612,630 521,327 619,111
----------- ----------- -----------

Total interest income 35,978,894 35,550,670 39,066,331
----------- ----------- -----------
Interest expense:
Deposits 16,829,466 15,846,768 18,873,962
Other borrowed money 968,030 640,513 431,042
----------- ----------- -----------

Total interest expense 17,797,496 16,487,281 19,305,004
----------- ----------- -----------

Net interest income 18,181,398 19,063,389 19,761,327
Provision for loan losses 82,247 487,346 595,140
----------- ----------- -----------
Net interest income after provision
for loan losses 18,099,151 18,576,043 19,166,187
----------- ----------- -----------
Noninterest income:
Loan fees and service charges 1,826,140 1,574,221 1,426,069
Other operating income 928,831 909,600 684,393
Gain on sale of branches - - 1,000,000
----------- ----------- -----------

Total noninterest income 2,754,971 2,483,821 3,110,462
----------- ----------- -----------
Noninterest expense:
Compensation and benefits 6,198,938 5,306,228 5,713,579
Occupancy and equipment 1,124,528 1,089,392 1,130,840
Communications and other office expenses 1,510,758 1,371,648 1,543,704
Regulatory and other insurance premiums 1,180,955 1,196,911 1,090,247
Computer processing 636,232 597,360 570,524
Real estate owned expenses, including provision
for loss (87,398) 55,744 270,340
Other operating costs 1,254,716 1,211,057 1,191,916
Amortization of excess of cost over fair value of
net assets acquired 422,873 525,336 1,301,646
----------- ----------- -----------

Total noninterest expense $12,241,602 $11,353,676 $12,812,796
=========== =========== ===========

(continued)

60
61

HERITAGE FEDERAL BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME, CONTINUED

Years ended June 30, 1995, 1994 and 1993

1995 1994 1993
---- ---- ----

Income before income tax expense and
change in method of accounting for
income taxes $8,612,520 $9,706,188 $9,463,853
Income tax expense 3,145,666 3,501,963 3,951,634
---------- ---------- ----------

Net income before change in method
of accounting for income taxes 5,466,854 6,204,225 5,512,219

Cumulative effect of change in method
of accounting for income taxes - 764,255 -
---------- ---------- ----------

Net income $5,466,854 $6,968,480 $5,512,219
========== ========== ==========

Earnings per share:
Net income before change in method of
accounting for income taxes $1.58 $1.85 $1.67
Cumulative effect of change in method of
accounting for income taxes - .22 -
----- ----- -----
Earnings per share (Note 19) $1.58 $2.07 $1.67
===== ===== =====

The accompanying notes are an integral part of these
consolidated financial statements.

61
62

HERITAGE FEDERAL BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

Years ended June 30, 1995, 1994 and 1993

Net
unrealized
depreciation
Retained on certain
Common stock Additional earnings- marketable
------------ paid-in substantially equity
Shares Amount capital restricted securities
------ ------ ------- ---------- ----------

Balances at June 30, 1992 1,495,000 $1,495,000 $14,553,290 $ 20,703,246 -

Net income - - - 5,512,219 -

Proceeds from issuance of common
stock 42,468 42,468 445,915 - -

Implementation of Management
Recognition Plan, including
issuance of common stock 44,850 44,850 880,181 - -

Three for two stock split 791,159 791,159 - (791,159) -

Increases in fair value of shares held by
Management Recognition Plan
through award date - - 140,156 - -

Amortization of unearned compensation
of Management Recognition Plan - - - - -

Reduction of Employee Stock
Ownership Plan obligation - - - - -
--------- ---------- ----------- ----------- -----
Balances at June 30, 1993 2,373,477 $2,373,477 $16,019,542 $25,424,306 -
========= ========== =========== =========== =====

Employee Unearned
Stock compensation of
Ownership Management
Plan Recognition
obligation Plan Total
---------- ---- -----

Balances at June 30, 1992 $(1,173,388) - $35,578,148

Net income - - 5,512,219

Proceeds from issuance of common
stock - - 488,383

Implementation of Management
Recognition Plan, including
issuance of common stock - (925,031) -

Three for two stock split - - -

Increases in fair value of shares held by
Management Recognition Plan
through award date - (140,156) -

Amortization of unearned compensation
of Management Recognition Plan - 154,009 154,009

Reduction of Employee Stock
Ownership Plan obligation 120,348 - 120,348
----------- --------- -----------
Balances at June 30, 1993 $(1,053,040) $(911,178) $41,853,107
=========== ========= ===========

(continued)

HERITAGE FEDERAL BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY, CONTINUED

Years ended June 30, 1995, 1994 and 1993

Net
unrealized
depreciation
Retained on certain
Additional earnings- marketable
Common stock paid-in substantially equity
Shares Amount capital restricted securities
------ ------ ------- ---------- ----------

Balances at June 30, 1993 2,373,477 $2,373,477 $16,019,542 $25,424,306 -

Net income - - - 6,968,480 -

Proceeds from issuance of common
stock, including effect of three
for two stock split 6,143 6,143 88,553 (1,419) -

Cash dividend paid on common
stock at $.25 per share - - - (785,050) -

Four for three stock split 793,206 793,206 - (793,206) -

Amortization of unearned compensation
of Management Recognition Plan - - - - -

Reduction of Employee Stock
Ownership Plan obligation - - - - -
--------- ---------- ----------- ----------- -----

Balances at June 30, 1994 3,172,826 $3,172,826 $16,108,095 $30,813,111 -
========= ========== =========== =========== =====

Employee Unearned
Stock compensation of
Ownership Management
Plan Recognition
obligation Plan Total
---------- ---- -----

Balances at June 30, 1993 $(1,053,040) $(911,178) $41,853,107

Net income - - 6,968,480

Proceeds from issuance of common
stock, including effect of three
for two stock split - - 93,277

Cash dividend paid on common
stock at $.25 per share - - (785,050)

Four for three stock split - - -

Amortization of unearned compensation
of Management Recognition Plan - 201,060 201,060

Reduction of Employee Stock
Ownership Plan obligation 172,155 - 172,155
----------- --------- -----------

Balances at June 30, 1994 $ (880,885) $(710,118) $48,503,029
=========== ========= ===========

(continued)

63
64

HERITAGE FEDERAL BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY, CONTINUED

Years ended June 30, 1995, 1994 and 1993

Net
unrealized
Retained appreciation
Additional earnings- on available-
Common stock paid-in substantially for-sale
Shares Amount capital restricted securities
------ ------ ------- ---------- ----------

Balances at June 30, 1994 3,172,826 $3,172,826 $16,108,095 $30,813,111 -

Net income - - - 5,466,854 -
Adoption of change in accounting
for securities, net of tax - - - - (44,843)

Proceeds from issuance of common
stock, including effect of four
for three stock split 13,332 13,332 122,226 (1,269) -

Cash dividend paid on common
stock at $.38 per share - - - (1,208,625) -

Tax benefit from exercise of stock
options - - 67,800 - -

Tax benefit from Management
Recognition Plan - - 211,370 - -

Change in unrealized appreciation,
net of tax - - - - 128,922

Amortization of unearned compensation
of Management Recognition Plan - - - - -

Reduction of Employee Stock
Ownership Plan obligation - - - - -
--------- ---------- ----------- ----------- --------

Balances at June 30, 1995 3,186,158 $3,186,158 $16,509,491 $35,070,071 $ 84,079
========= ========== =========== =========== ========

Employee Unearned
Stock compensation of
Ownership Management
Plan Recognition
obligation Plan Total
---------- ---- -----

Balances at June 30, 1994 $(880,885) $(710,118) $48,503,029

Net income - - 5,466,854
Adoption of change in accounting
for securities, net of tax - - (44,843)

Proceeds from issuance of common
stock, including effect of four
for three stock split - - 134,289

Cash dividend paid on common
stock at $.38 per share - - (1,208,625)

Tax benefit from exercise of stock
options - - 67,800

Tax benefit from Management
Recognition Plan - - 211,370

Change in unrealized appreciation,
net of tax - - 128,922

Amortization of unearned compensation
of Management Recognition Plan - 355,057 355,057

Reduction of Employee Stock
Ownership Plan obligation 160,120 - 160,120
--------- --------- -----------

Balances at June 30, 1995 $(720,765) $(355,061) $53,773,973
========= ========= ===========

The accompanying notes are an integral part of these
consolidated financial statements.

HERITAGE FEDERAL BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years ended June 30, 1995, 1994 and 1993

1995 1994 1993
---- ---- ----

Cash flows from operating activities:
Net income $ 5,466,854 $ 6,968,480 $ 5,512,219
Adjustments to reconcile net income to net cash
provided by operating activities:
Cumulative effect of change in method of
accounting for income taxes - (764,255) -
Amortization of:
Excess of cost over fair value of net assets acquired 422,873 525,336 1,301,646
Discounts and premiums on securities 536,232 952,346 534,952
Deferred loan origination fees (505,384) (381,771) (60,562)
Loan discounts (753,527) (900,468) (1,056,576)
Provision for loan losses and losses on real estate 83,298 560,337 846,965
Gain on sale of branches - - (1,000,000)
Recognition of Management Recognition Plan expense 355,057 201,060 154,009
Recognition of ESOP expense 160,120 172,155 120,348
Dividends received in stock of Federal Home Loan Bank (249,600) (179,900) (156,100)
Deferred income taxes and charge in-lieu of taxes 787,264 16,554 260,000
Depreciation and amortization of premises and equipment 534,605 505,748 558,126
Increase in unearned compensation of Management
Recognition Plan - - (925,031)
Decrease (increase) in:
Other assets 71,065 28,116 4,851
Accrued interest receivable (219,791) 329,588 265,059
Increase (decrease) in:
Accrued expenses and other liabilities 820,568 (496,008) 650,624
------------ ------------ ------------

Total adjustments 2,042,780 568,838 1,498,311
------------ ------------ ------------

Net cash provided by operating activities 7,509,634 7,537,318 7,010,530
------------ ------------ ------------

Cash flows from investing activities:
Net repayments of loans 12,298,111 19,119,421 30,619,553
Principal receipts on mortgage-backed securities 8,289,568 15,847,363 9,069,390
Purchases of available-for-sale securities (3,984,063) - -
Proceeds from maturities of available-for-sale securities 6,035,681 - -
Purchases of securities held-to-maturity (64,990,375) - -
Proceeds from maturities of securities held-to-maturity 36,767,292 - -
Purchases of mortgage-backed securities - (48,754,748) (28,186,079)
Purchases of investment securities, certificates of deposit
and term federal funds sold - (49,295,935) (65,860,242)
Proceeds from maturities of investment securities and
certificates of deposit - 57,157,839 44,279,779
Proceeds from sales of foreclosed real estate 575,089 91,281 795,102
Purchases of Federal Home Loan Bank stock - - (3,400)
Cash and cash equivalents transferred in sale of branches - - (51,318,038)
Purchases of premises and equipment, net (644,036) (458,083) (501,176)
------------ ------------ ------------

Net cash used by investing activities $ (5,652,733) $ (6,292,862) $(61,105,111)
============ ============ ============

(continued)

HERITAGE FEDERAL BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS, Continued

Years ended June 30, 1995, 1994 and 1993

1995 1994 1993
---- ---- ----

Cash flows from financing activities:
Net increase (decrease) in deposits $(1,500,631) $ (9,174,309) $ 17,878,579
Net increase (decrease) in mortgage escrow funds 37,389 (30,602) (358,953)
Lease payments for obligations under capital leases (1,216) (101,100) (100,996)
Repayment of ESOP obligation (880,885) (172,155) (120,348)
Advances (repayments) from the Federal Home Loan Bank 8,534,838 (246,605) 9,748,028
Net proceeds from issuance of common stock 134,289 93,277 1,413,414
Dividends paid (1,208,625) (785,050) -
----------- ------------ ------------

Net cash provided (used) by financing activities 5,115,159 (10,416,544) 28,459,724
----------- ------------ ------------

Net increase (decrease) in cash and cash equivalents 6,972,060 (9,172,088) (25,634,857)

Cash and cash equivalents at beginning of year 14,906,054 24,078,142 49,712,999
----------- ------------ ------------

Cash and cash equivalents at end of year $21,878,114 $ 14,906,054 $ 24,078,142
=========== ============ ============

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:

Payments made during the period for:
Interest $17,666,029 $ 16,503,090 $ 19,262,868
Income taxes $ 2,389,500 $ 3,289,871 $ 3,967,122
=========== ============ ============

SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING ACTIVITIES:

Real estate foreclosures and related transfers $44,865 $70,627 $172,183
======= ======= ========

The Company sold certain branches during 1993. In conjunction with that
transaction, assets sold, liabilities transferred and gain recognized were as
follows:

Deposits transferred $54,814,922
Premises and equipment sold, net (2,122,622)
Share loans sold (550,468)
Accrued interest and other liabilities transferred 176,206
Gain on sale (1,000,000)
-----------
Cash and cash equivalents transferred $51,318,038
===========

The accompanying notes are an integral part of these
consolidated financial statements.

HERITAGE FEDERAL BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

PRINCIPLES OF CONSOLIDATION - The consolidated financial statements
include the accounts of Heritage Federal Bancshares, Inc. (the Company)
and its wholly-owned subsidiary, Heritage Federal Bank for Savings (the
Bank) and the Bank's wholly-owned subsidiary, Citizens Financial
Corporation. All significant intercompany balances and transactions are
eliminated in consolidation.

CASH AND CASH EQUIVALENTS - For purposes of reporting cash flows, cash and
cash equivalents consist of federal funds sold, cash on hand, and due from
banks. Cash and due from banks includes interest-bearing deposits of
$5,592,680 and $2,295,206 at June 30, 1995 and 1994, respectively. Federal
funds sold included in cash equivalents have maturities ranging from one
to 14 days. The Bank maintained cash reserves required by the Federal
Reserve Bank amounting to $3,168,000 and $4,720,000 as of June 30, 1995
and 1994, respectively.

INVESTMENT SECURITIES - Effective July 1, 1994, the Company adopted the
provisions of Financial Accounting Standards Board ("FASB") Statement of
Financial Accounting Standards No. 115 (SFAS 115), Accounting for Certain
Investments in Debt and Equity Securities. Investments in certain debt and
equity securities are classified as either Held-to-Maturity (reported at
amortized cost), Trading (reported at fair value with unrealized gains and
losses included in earnings), or Available-for-Sale (reported at fair
value with unrealized gains and losses excluded from earnings and reported
as a separate component of shareholders' equity).

Premiums and discounts on debt securities are recognized in interest
income on the level interest yield method over the period to maturity.

Prior to the adoption of SFAS 115, investment securities were those
securities held for investment purposes which management determined they
had the ability and intent to hold to maturity. Investment securities were
stated at cost adjusted for amortization of premiums and accretion of
discounts.

Mortgage-backed securities represent participating interests in pools of
long-term first mortgage loans originated and serviced by the issuers of
the securities. These securities, which have been classified as
held-to-maturity in 1995, are carried at unpaid principal balances,
adjusted for unamortized premiums and unearned discounts. Premiums and
discounts are amortized using the interest method over the remaining
period to contractual maturity, adjusted for anticipated prepayments.

Gains and losses on the sale of securities are determined using the
specific identification method.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, continued

LOANS RECEIVABLE - Loans receivable are stated at unpaid principal
balances, net of discounts, deferred loan origination fees, and the
allowance for loan losses.

Unearned discounts on mortgage loans purchased are amortized to interest
income using the interest method over the estimated average lives of the
loans.

The allowance for loan losses is increased by charges against income and
decreased by chargeoffs (net of recoveries). Management's periodic
evaluation of the adequacy of the allowance is based on the Bank's past
loan loss experience, known and inherent risks in the portfolio, adverse
situations that may affect the borrowers' ability to repay, estimated
value of any underlying collateral, and current economic conditions. While
management believes that it has established the allowance in accordance
with generally accepted accounting principles and has taken into account
the views of its regulators and the current economic environment, there
can be no assurance that in the future the Bank's regulators or its
economic environment will not require further increases in the allowance.

Uncollectible interest on loans that are contractually 90 days or more
past due or where management has determined that such amounts may be
uncollectible is charged off or an allowance is established. The allowance
is established by a charge against interest income equal to all interest
previously accrued, and income is subsequently recognized only to the
extent cash payments are received until, in management's judgment, the
borrower's ability to make periodic interest and principal payments
returns to normal, in which case the loan is returned to accrual status.

The Financial Accounting Standards Board issued Statement of Financial
Accounting Standards No. 114 (Statement 114), Accounting by Creditors for
Impairment of a Loan, which amended Statement 5, Accounting for
Contingencies, and Statement 15, Accounting by Debtors and Creditors for
Troubled Debt Restructurings.

Statement 114, as amended by Statement of Financial Accounting Standards
No. 118 (Statement 118), Accounting by Creditors for Impairment of a Loan
- Income Recognition and Disclosure, requires the use of the discounted
cash flow method for measuring impairment of loans when it is probable
that a creditor will be unable to collect all amounts due according to the
contractual terms of the loan agreement. If expedient, the creditor may
use a loan's observable market price or the fair value of any collateral.

The Company adopted Statement 114 on a prospective basis as of July 1,
1993 for the fiscal year ending June 30, 1994. The adoption of Statement
114 did not have a material affect on the Company's financial position or
results of operations.

DISCOUNTS ON LOANS ACQUIRED THROUGH MERGERS - Discounts on loans acquired
through mergers are accreted into income principally on the interest
method over the remaining contractual terms of the respective loans,
adjusted for expected prepayments.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, continued

LOAN ORIGINATION AND COMMITMENT FEES AND RELATED COSTS - Loan fees are
accounted for in accordance with Statement of Financial Accounting
Standards (SFAS) No. 91. Loan fees and certain direct loan origination
costs are deferred, and the net fee or cost is recognized in the statement
of income using the interest method over the contractual life of the
loans, adjusted for estimated prepayments based on the Bank's historical
prepayment experience. Commitment fees and costs relating to commitments
whose likelihood of exercise is remote are recognized over the commitment
period on a straight-line basis. If the commitment is subsequently
exercised during the commitment period, the remaining unamortized
commitment fee at the time of exercise is recognized over the life of the
loan as an adjustment of yield. The Bank ceases amortization of net
deferred fees on loans which are contractually 90 days or more past due or
where management has determined that such amounts may be uncollectible.

REAL ESTATE OWNED - Real estate properties acquired through loan
foreclosure or deed in lieu of foreclosure and properties classified as in
substance foreclosures are initially recorded at the lower of the related
loan balance, less any specific allowance for loss, or fair value at the
date of foreclosure. Costs subsequently incurred relating to development
and improvement of property are capitalized, whereas costs relating to
holding property are expensed. In substance foreclosed properties are
those properties where the borrower retains title but has little or no
remaining equity in the property considering its fair value; where
repayment can only be expected to come from the operation or sale of the
property; and where the borrower has effectively abandoned control of the
property or it is doubtful that the borrower will be able to rebuild
equity in the property. Property acquired by deed in lieu of foreclosure
results when a borrower voluntarily transfers title to the Bank in full
settlement of the related debt in an attempt to avoid foreclosure.

Valuations are periodically performed by management and an allowance for
losses is established by a charge to operations if the carrying value of a
property exceeds its estimated fair value.

PREMISES AND EQUIPMENT - Premises and equipment are stated at cost less
accumulated depreciation and amortization. Depreciation is computed using
the straight-line method over the estimated useful lives of the related
assets. Amortization is computed on the straight-line method over the term
of the lease or the life of the assets, whichever is shorter.

EXCESS OF COST OVER FAIR VALUE OF NET ASSETS ACQUIRED AND OTHER
INTANGIBLES - The Bank is amortizing the excess of cost over fair value of
net assets acquired (goodwill) through business combinations at a constant
rate when applied to the interest-earning assets, through June 1996, which
is the estimated remaining life of the long-term interest-earning assets.
During 1993, $637,000 of goodwill relating to the branches sold was
written-off. Other intangibles amounting to $447,482 and $514,604 at June
30, 1995 and 1994, respectively, consist of value related to a branch
network acquired in 1981, which is being amortized straight line through
2001; value assigned to the management in place in the 1981 acquisition,
which is being amortized straight line over the remaining service life of
the managers through 2001; and value assigned to core deposits acquired in
1986, which is being amortized straight line through 1996.

TRUST ASSETS - Assets held by the Bank in trust capacities are not
included in the accompanying consolidated statements of financial
condition, because such items are not assets of the Bank.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, continued

INCOME TAXES - Effective July 1, 1993, the Company adopted the provisions
of the Financial Accounting Standards Board Statement No. 109 (Statement
109), Accounting for Income Taxes, on a prospective basis for the fiscal
year ending June 30, 1994. The adoption of Statement 109 resulted in an
increase of the Company's deferred income tax asset of $764,255. Prior to
that date, the Company followed Statement of Financial Accounting
Standards No. 96, Accounting for Income Taxes (Statement 96). Statements
109 and 96 require the asset and liability method of accounting for income
taxes. Under the asset and liability method, deferred income taxes are
recognized for the tax consequences of "temporary differences" by applying
enacted statutory tax rates applicable to future years to differences
between the financial carrying amounts and the tax bases of existing
assets and liabilities. The effect on deferred taxes of a change in tax
rates is recognized in income in the period that includes the enactment
date.

2. CONVERSION TO STOCK SAVINGS BANK, FORMATION OF HOLDING COMPANY, SALE OF
COMMON STOCK AND MERGER

On March 30, 1992, the Bank converted from a mutual savings bank to a
capital stock savings bank. The Bank issued all of its outstanding capital
stock to Heritage Federal Bancshares, Inc., a holding company for Heritage
Federal Bank for Savings. Heritage Federal Bancshares, Inc. consummated a
public offering of 2,990,000 shares of common stock (after giving effect
to stock splits) which generated net proceeds of $16,048,290 after
conversion costs totaling $1,144,210. The Bank received 99% of the net
proceeds in exchange for the stock it issued to the holding company.

At the time of conversion, the Bank established a liquidation account in
an amount equal to the Bank's net worth for the benefit of eligible
account holders at the time of conversion. The liquidation account will be
reduced annually to the extent that eligible account holders have reduced
their eligible deposits, and shall cease upon the closing of the accounts,
and shall never be increased. In the event of liquidation of the Bank,
such person shall be entitled, after all payments to creditors, to a
distribution from the liquidation account before any distribution to
stockholders.

Federal regulations adopted by the Office of Thrift Supervision (OTS)
impose certain limitations on the payment of dividends and other capital
distributions, including stock repurchases, by the Bank. Based upon
current OTS regulations and its capital structure at June 30, 1995, the
Bank may make capital distributions during a year up to the greater of (i)
100% of its net earnings to date during the calendar year plus an amount
equal to one-half of the amount by which its total capital-to-assets ratio
exceeded its fully phased-in capital-to-assets ratio at the beginning of
the calendar year or (ii) 75% of its net income during the most recent
four-quarter period. At June 30, 1995, approximately $19,850,000 was
available for payment of dividends from the Bank to the Company under the
above mentioned OTS restrictions. Capital distributions by the Bank are
further subject to 30-day advance written notice to the OTS.

The Company's charter authorizes 2,000,000 shares of preferred stock of
the Company, of $1.00 par value. The Company's charter expressly vests in
the Board of Directors of the Company the authority to issue the preferred
stock in one or more series and to determine, to the extent permitted by
law prior to the issuance of the preferred stock (or any series of the
preferred stock), the relative rights, limitations, and preferences of the
preferred stock or any such series.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

2. CONVERSION TO STOCK SAVINGS BANK, FORMATION OF HOLDING COMPANY, SALE OF
COMMON STOCK AND MERGER, continued

In February 1995, the Company entered into a merger agreement with First
American Corporation (FAC). All of the outstanding shares of the Company
stock will be exchanged for common shares of FAC in a transaction that
will be accounted for as a pooling of interest. The transaction is
expected to be consummated during the Company's second fiscal quarter.

3. SECURITIES

At June 30, 1995, securities have been classified in the consolidated
financial statements according to management's intent. The carrying amount
of securities and their approximate market values at June 30, 1995 were as
follows:

Gross Gross Approximate
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
---- ----- ------ -----

Available-for-sale:
U.S. government obligations $ 20,077,586 $ 139,223 $ 3,614 $ 20,213,195
============ ========== ========== ============
Held-to-maturity:
U.S. government and agencies $ 71,685,619 $ 307,843 $1,068,462 $ 70,925,000
Collateralized mortgage
obligations 14,942,023 484,692 93,715 15,333,000
------------ ---------- ---------- ------------

86,627,642 792,535 1,162,177 86,258,000
------------ ---------- ---------- ------------

Mortgage-backed securities:
GNMA Certificates 49,076,676 189,729 623,405 48,643,000
FNMA Certificates 12,826,298 14,157 205,455 12,635,000
FHLMC Certificates 22,091,685 71,897 429,582 21,734,000
------------ ---------- ---------- ------------

83,994,659 275,783 1,258,442 83,012,000
------------ ---------- ---------- ------------

$170,622,301 $1,068,318 $2,420,619 $169,270,000
============ ========== ========== ============

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

3. SECURITIES, continued

Investment securities and mortgage-backed securities at June 30, 1994 were
summarized as follows:

Gross Gross Approximate
Book Unrealized Unrealized Market
Value Gains Losses Value
----- ----- ------ -----

U.S. government and agencies $ 75,181,904 $270,072 $2,102,976 $ 73,349,000

Collateralized mortgage
obligations 5,614,505 7,370 216,875 5,405,000
------------ -------- ---------- ------------
80,796,409 277,442 2,319,851 78,754,000
------------ -------- ---------- ------------

Mortgage-backed securities:
GNMA Certificates 52,390,756 10,508 2,866,264 49,535,000
FHLMC Certificates 25,810,401 58,079 823,480 25,045,000
FNMA Certificates 14,356,656 4,520 544,176 13,817,000
------------ -------- ---------- ------------

92,557,813 73,107 4,233,920 88,397,000
------------ -------- ---------- ------------

$173,354,222 $350,549 $6,553,771 $167,151,000
============ ======== ========== ============

Debt securities at June 30, 1995 will mature on the following schedule:

Available-for-sale Held-to-maturity
------------------ ----------------
Approximate Approximate
Amortized Market Amortized Market
Cost Value Cost Value
---- ----- ---- -----

Due in one year or less $ 7,048,291 $ 7,072,000 $ 5,966,753 $ 6,017,000
Due after one year through
five years 13,029,295 13,141,195 56,275,626 55,467,000
Due after five years through
ten years - - 31,994,678 31,742,000
Due after ten years - - 76,385,244 76,044,000
----------- ----------- ------------ ------------
$20,077,586 $20,213,195 $170,622,301 $169,270,000
=========== =========== ============ ============

The amortized cost and approximate market value of mortgage-backed
securities at June 30, 1995, by contractual maturities are shown in the
above table. Expected maturities will differ from contractual maturities
because borrowers may have the right to call or prepay obligations with or
without call or prepayment penalties.

The weighted average interest yield for all securities was approximately
6.35% at June 30, 1995 and 5.69% at June 30, 1994.

Investment securities carried in the consolidated statements of financial
condition at $23,850,000 and $19,760,000 as of June 30, 1995 and 1994,
respectively, were pledged to secure public deposits.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

4. LOANS RECEIVABLE

Loans receivable are summarized as follows:

1995 1994
---- ----

Loans secured by first mortgages on real estate:
Principal balances:
One to four single family residential $239,624,145 $251,144,767
Construction loans, gross commitment 7,044,838 11,219,927
Partially guaranteed by VA or insured by FHA 804,254 998,812
Other conventional 32,549,777 32,177,760
Other 1,431,052 1,746,064
------------ ------------

281,454,066 297,287,330

Less:
Discounts on loans acquired through mergers 1,013,821 1,767,348
Allowance for loan losses 1,222,676 1,222,676
Undisbursed portion of construction loans 2,436,442 3,732,820
Net deferred loan origination fees 871,853 1,192,445
------------ ------------

Total first mortgage loans 275,909,274 289,372,041
------------ ------------

Consumer and other loans:
Principal balances:
Secured by deposits 2,224,023 2,429,921
Education 6,216 10,213
Home equity and second mortgage 13,050,389 10,600,812
Credit card 535,134 595,452
Other consumer and commercial 7,666,405 6,823,118
------------ ------------

23,482,167 20,459,516

Less:
Net deferred loan origination fees (costs) 21,894 (39,945)
Allowance for loan losses 1,103,992 1,055,962
Loans-in-process 732,242 115,915
------------ ------------

Total consumer and other loans 21,624,039 19,327,584
------------ ------------

Loans receivable, net $297,533,313 $308,699,625
============ ============

Weighted average contractual yield 8.18% 7.38%
==== ====

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

4. LOANS RECEIVABLE, continued

Activity in the allowance for loan losses is summarized as follows:

1995 1994 1993
---- ---- ----

Balance at beginning of year $2,278,638 $2,387,673 $2,338,314
Provisions charged against income 82,247 487,346 595,140
Chargeoffs, net of recoveries (34,217) (596,381) (545,781)
---------- ---------- ----------

Balance at end of year $2,326,668 $2,278,638 $2,387,673
========== ========== ==========

The following is a summary of the principal balances of loans on
nonaccrual status and loans past due ninety days or more:

1995 1994
---- ----

Loans contractually past due 90 days or more
and/or on nonaccrual status:
Residential $178,000 $271,000
Consumer and commercial 47,000 194,000
-------- --------

$225,000 $465,000
======== ========

During the years ended June 30, 1995, 1994, and 1993, interest income of
approximately $17,000, $22,000, and $106,000, respectively, was not
recorded related to loans accounted for on a nonaccrual basis.

In the ordinary course of business, the Bank makes loans to directors and
officers and their related interests. Loans to directors and officers and
their related interests are as follows:

Balance at June 30, 1993 $1,640,199
Advances 702,860
Repayments (346,402)
----------
Separation of officer with loans (43,363)

Balance at June 30, 1994 1,953,294
Advances 381,926
Repayments (545,673)
----------

Balance at June 30, 1995 $1,789,547
==========

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

4. LOANS RECEIVABLE, continued

The Bank offers an unsecured $100,000 line of credit to each of its seven
non-employee directors. Amounts outstanding against line of credit
agreements with the two directors who have accepted the credit line were
$99,878 and $99,971 at June 30, 1995 and 1994, respectively. The directors
may retain their lines of credit after they leave the board, so long as
they continue to meet the normal credit requirements of the Bank.

As of June 30, 1995, the Company had impaired loans, as defined by SFAS
Statement No. 114, aggregating $2,111,000, on which specific reserves of
$70,000 had been recorded.

5. LOAN SERVICING

Mortgage loans serviced for others are not included in the accompanying
consolidated statements of financial condition. The approximate unpaid
principal balances of these loans were $7,821,000 and $9,905,000 at June
30, 1995 and 1994, respectively.

6. INTEREST RECEIVABLE

Interest receivable is summarized as follows:

1995 1994
---- ----

Securities available-for-sale $ 352,072 $ -
Securities held-to-maturity 1,533,030 -
Investment securities - 1,255,288
Mortgage-backed securities - 488,815
Loans receivable 1,781,205 1,702,413
---------- ----------

$3,666,307 $3,446,516
========== ==========

7. REAL ESTATE OWNED

Activity in the allowance for losses on real estate owned is summarized as
follows:

1995 1994 1993
---- ---- ----

Balance at beginning of year $262,322 $284,947 $ 201,330
Provision charged against income 1,051 72,991 251,825
Chargeoffs (51,602) (95,616) (168,208)
-------- -------- ---------

Balance at end of year $211,771 $262,322 $ 284,947
======== ======== =========

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

8. PREMISES AND EQUIPMENT

Premises and equipment are summarized as follows:

1995 1994
---- ----

Land $ 1,587,801 $ 1,540,381
Office buildings and leasehold improvements 8,935,532 8,831,100
Furniture, fixtures, and equipment 4,363,695 5,526,720
Automobiles 105,765 93,017
----------- -----------
14,992,793 15,991,218

Less accumulated depreciation and amortization 8,206,898 9,314,754
----------- -----------

Premises and equipment, net $ 6,785,895 $ 6,676,464
=========== ===========

9. DEPOSITS

Deposits are summarized as follows:

1995 1994
---- ----
Amount % Amount %
------ - ------ -

Noninterest-bearing demand deposits $ 10,574,976 2.4% $ 8,395,930 1.9%
Demand and NOW accounts at 2.25% 56,407,635 12.5 64,671,094 14.3
SuperNow at 2.50% 7,514,508 1.7 10,916,498 2.4
Money market at 3.31% 17,844,834 4.0 24,135,360 5.4
Passbook savings at 2.75% 68,433,425 15.2 91,440,876 20.3
------------ ----- ------------ -----

160,775,378 35.8 199,559,758 44.3
------------ ----- ------------ -----

Certificates of deposit:

2.00 to 2.50% $ 1,016,523 .2 $ 1,466,043 .3
2.51 to 3.00% 701,623 .2 2,367,612 .5
3.01 to 3.50% 2,850 .0 85,027,440 18.9
3.51 to 4.00% 13,693,624 3.0 56,385,354 12.5
4.01 to 4.50% 53,029,316 11.8 38,661,139 8.6
4.51 to 5.00% 56,907,063 12.7 27,079,048 6.0
5.01 to 5.50% 33,348,110 7.4 18,379,993 4.1
5.51 to 6.00% 34,780,123 7.8 15,273,215 3.4
6.01 to 6.50% 52,314,919 11.6 1,246,910 .3
6.51 to 7.00% 39,678,704 8.8 2,320,911 .5
7.01 to 7.50% 2,376,130 .5 1,123,279 .2
7.51 to 8.00% 222,920 .1 1,480,020 .3
8.01 to 8.50% 296,088 .1 286,531 .1
8.51 to 9.00% 99,110 .0 92,491 .0
9.01 to 9.50% 75,496 .0 68,864 .0
------------ ----- ------------ -----

288,542,599 64.2 251,258,850 55.7
------------ ----- ------------ -----

$449,317,977 100.0% $450,818,608 100.0%
============ ===== ============ =====

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

9. DEPOSITS, continued

The aggregate amount of jumbo certificates of deposit with a minimum
denomination greater than $100,000 was $17,250,670 and $9,264,566 at June
30, 1995 and 1994, respectively.

At June 30, 1995, scheduled maturities of certificates of deposit are as
follows:

Year ending June 30

1996 $221,752,925
1997 41,336,160
1998 16,498,383
Later 8,955,131
------------

$288,542,599
============

Interest expense on deposits for the years ended June 30, 1995, 1994 and
1993 is summarized as follows:

1995 1994 1993
---- ---- ----

Demand, Money Market, NOW, and SuperNOW $ 2,338,807 $ 2,361,347 $ 2,517,330
Passbook savings 2,175,733 2,550,798 2,746,998
Time deposits 12,314,926 10,934,623 13,609,634
----------- ----------- -----------

$16,829,466 $15,846,768 $18,873,962
=========== =========== ===========

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

10. ADVANCES FROM FEDERAL HOME LOAN BANK

Federal Home Loan Bank advances consist of the following:

1995 1994
---- ----

Variable rate advance which reprices monthly based on the
one month London Interbank Offering Rate (LIBOR) plus 5
basis points (6.1203% at June 30, 1995), with interest
only due monthly, and principal due on October 14, 2004 $10,000,000 $ -

8.1% fixed rate advance payable in monthly principal and
interest payments of $865 through February, 2006 74,005 78,207

6.0% fixed rate advance payable in monthly principal and
interest payments of $45,830, due through November 1,
2002

3,256,279 4,265,337

Variable rate advance which reprices monthly based on the
one month London Interbank Offering Rate (LIBOR) (6.0625%
at June 30, 1995), with interest only due monthly, and
principal due on November 14, 1997 492,000 536,000

5.15% fixed rate advance payable in monthly principal and
interest payments of $53,400, due through October 1, 2003 4,299,637 4,707,539
----------- ----------

$18,121,921 $9,587,083
=========== ==========

These advances are collateralized by a blanket pledge of qualifying
mortgage loans totaling $27,279,181 at June 30, 1995.

11. INCOME TAXES

Income tax expense (benefit) is summarized as follows:

1995 1994 1993
---- ---- ----

Current $2,358,402 $3,485,409 $3,691,634
Deferred 654,476 (47,280) (268,381)
Charge-in-lieu of taxes 262,227 248,529 528,381
Change in effective tax rate on
temporary differences (129,439) (184,695) -
---------- ---------- ----------

$3,145,666 $3,501,963 $3,951,634
========== ========== ==========

Included in the above are state income taxes of $393,037, $457,561, and
$473,310 in 1995, 1994, and 1993, respectively.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

11. INCOME TAXES, continued

The differences between income tax expense and the expected amounts
computed by applying the federal income tax rate to income before income
tax expense are as follows:

1995 1994 1993
Amount % Amount % Amount %
------ - ------ - ------ -

Income tax expense
at statutory rate $2,928,257 34.0% $3,300,104 34.0% $3,217,710 34.0%
Increases (decreases) in
tax resulting from:
Interest on tax-free
investments (25,442) (.3) (23,708) (.2) (34,565) (.4)
Purchase method of
accounting in
conjunction with
mergers 143,777 1.7 178,614 1.8 435,221 4.6
Change in effective rate on
temporary differences (129,439) (1.5) (184,695) (1.9) - -
Other, net (30,891) .1 (44,053) (.5) 20,883 .2
State income taxes, net
of Federal benefit 259,404 2.5 275,701 2.9 312,385 3.4
---------- ---- ---------- ---- ---------- ----

Actual income tax expense $3,145,666 36.5% $3,501,963 36.1% $3,951,634 41.8%
========== ==== ========== ==== ========== ====

Deferred income taxes reflect the impact of temporary differences between
the amount of assets and liabilities for financial reporting purposes and
as measured by tax laws and regulations. The sources of these temporary
differences are as follows:

1995 1994
---- ----

Excess of book over tax basis of equipment $(288,614) $ (221,276)
Discounts on loans acquired through mergers 385,252 616,765
Allowance for loan losses 450,075 783,880
Federal Home Loan Bank stock (288,221) (177,595)
Deferred loan fees (125,159) 187,354
Deferred compensation 833,322 290,202
Unrealized appreciation on available-for-sale securities (51,530) -
Other (17,611) (22,192)
--------- ----------

$ 897,514 $1,457,138
========= ==========

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

11. INCOME TAXES, continued

The Bank qualifies under provisions of the Internal Revenue Code which
permit it to deduct from income an allowance for bad debts based on
approximately 8% of taxable income before such deduction, or actual
chargeoffs. As of June 30, 1995, the Company has taken aggregate bad debt
deductions of approximately $4,647,000 for income tax purposes under the
percentage of taxable income method for which no provisions for federal
income tax have been made in the financial statements. This amount may be
used only for absorbing losses for tax purposes. It is not related to
amounts of losses actually anticipated and the additions thereto have not
been charged against income.

12. COMPENSATION AND BENEFITS

PENSION PLAN

Substantially all employees of the Bank and its subsidiary are covered by
a noncontributory defined benefit pension plan. The plan calls for
benefits to be paid to all eligible employees at retirement based
primarily upon years of service with the Bank and compensation paid in the
five consecutive years when earnings were the greatest within the ten year
period preceding retirement. Plan assets consist primarily of fixed income
and equity securities and money market instruments.

The following sets forth the funded status of the plan as of June 30, 1995
and 1994:

1995 1994
---- ----

Actuarial present value of benefit obligations:
Vested benefits $2,112,692 $1,981,368
Nonvested benefits 57,092 60,645
---------- ----------

Accumulated benefit obligations $2,169,784 $2,042,013
========== ==========

Projected benefit obligations $3,167,095 $3,110,004
Fair value of assets held in the plan 2,697,472 2,631,386
---------- ----------

Fair value of plan assets under projected
benefit obligations (469,623) (478,618)
Net unrecognized loss from past experience
different than assumed 817,537 960,278
Unrecognized prior service cost (119,620) 43,730
Unrecognized net asset as of July 1, 1987 (253,209) (274,309)
---------- ----------

Prepaid (accrued) pension cost $ (24,915) $ 251,081
========== ==========

The change in projected benefit obligations resulted from additions for
such factors as interest on the beginning balance and current year service
cost, less distributions to participants.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

12. COMPENSATION AND BENEFITS, continued

Pension expense for the years ended June 30, 1995, 1994, and 1993,
includes the following components:

1995 1994 1993
---- ---- ----

Service cost of the current period $ 128,817 $ 110,807 $ 116,232
Interest cost on the projected benefit obligations 230,242 202,372 179,720
Actual return on assets held in the plan (192,957) 36,410 (34,726)
Net amortization and deferral (48,877) (307,182) (251,987)
--------- --------- ---------

$ 117,225 $ 42,407 $ 9,239
========= ========= =========

The weighted average discount rate used to measure the projected benefit
obligations is 8.0%, the assumed rate of increase in future compensation
levels is 5.0%, and the expected long-term rate of return on assets is
9.5%. The Bank uses the straight-line method of amortization of
unrecognized gains and losses.

THRIFT AND PROFIT SHARING PLAN

The Bank has a thrift and profit sharing plan for substantially all
employees who have completed at least one year of service. The plan has
been amended to comply with the regulations of the Tax Equity and Fiscal
Responsibility Act, Code Section 401(k), the Retirement Equity Act of
1984, the Deficit Reduction Act of 1984, the Tax Reform Act of 1986, and
the Revenue Reconciliation Act of 1993.

Under these regulations, the Bank agrees to match an employee's
contribution equal to 5% of the employee's salary, although the employee
may contribute up to 10%. The expense for this plan for the years ended
June 30, 1995, 1994, and 1993 was approximately $154,000, $128,000 and
$116,000, respectively.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

13. PARENT COMPANY FINANCIAL INFORMATION

Condensed financial information for Heritage Federal Bancshares, Inc.
(parent company only) as of June 30, 1995 and 1994, was as follows:

1995 1994
---- ----

Condensed Balance Sheets

Assets

Cash $ 724,287 $ 1,044,132
Investment in subsidiary 33,841,080 29,147,192
Other assets 56,321 7,796
----------- -----------

Total assets $34,621,688 $30,199,120
=========== ===========

Liabilities

Accounts payable $ 105,591 $ 73,082
Employee Stock Ownership Plan obligation - 880,885
----------- -----------

Total liabilities 105,591 953,967
----------- -----------

Stockholders' Equity

Common stock 3,186,158 3,172,826
Additional paid-in capital 16,509,491 16,108,095
Retained earnings 15,812,195 11,555,235
Net unrealized appreciation on available-for-sale securities 84,079 -
Employee Stock Ownership Plan obligation (720,765) (880,885)
Unearned compensation of Management Recognition Plan (355,061) (710,118)
----------- -----------

Total stockholders' equity 34,516,097 29,245,153
----------- -----------

Total liabilities and stockholders' equity $34,621,688 $30,199,120
=========== ===========

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

13. PARENT COMPANY FINANCIAL INFORMATION, continued

Condensed Statements of Income

1995 1994
---- ----

Revenue:
Equity in earnings of subsidiary $ 6,043,382 $ 7,484,815
Loan interest income 30,837 -
----------- -----------
Total revenue 6,074,219 7,484,815
----------- -----------

Expenses
Management fees 572,340 636,442
Legal fees 237,039 143,167
Other 154,339 80,949
----------- -----------
Total expenses 963,718 860,558
----------- -----------
Income before income taxes 5,110,501 6,624,257

Income tax benefit (356,353) (344,223)
----------- -----------
Net income $5,466,854 $ 6,968,480
=========== ===========

Condensed Statements of Cash Flows

Cash flows from operating activities:
Net income $ 5,466,854 $ 6,968,480
Adjustments to reconcile net income to net cash provided
by operating activities:
Equity in earnings of subsidiary (6,043,382) (7,484,815)
Increase (decrease) in other liabilities 32,507 (77,337)
----------- -----------
Net cash used by operating activities (544,021) (593,672)
----------- -----------

Cash flows from investing activities:
Dividends from subsidiary 2,000,000 2,000,000
Advances to ESOP (720,765) -
Decrease in other assets 19,277 43,246
----------- -----------
Net cash provided by investing activities 1,298,512 2,043,246
----------- -----------

Cash flows from financing activities:

Proceeds from issuance of common stock 134,289 93,277
Dividend payments (1,208,625) (785,050)
----------- -----------
Net cash used by financing activities (1,074,336) (691,773)
----------- -----------

Net increase (decrease) in cash (319,845) 757,801

Cash at beginning of year 1,044,132 286,331
----------- -----------
Cash at end of year $ 724,287 $ 1,044,132
=========== ===========

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

14. CITIZENS FINANCIAL CORPORATION

Summarized financial information of the Bank's wholly-owned service
corporation, Citizens Financial Corporation, is as follows:

June 30,
--------
1995 1994
---- ----

Balance Sheets

Assets $1,842,612 $1,758,357
========== ==========

Accrued expenses and other liabilities $ 54,175 $ 117,204
Capital stock, paid-in capital and retained earnings 1,788,437 1,641,153
---------- ----------

$1,842,612 $1,758,357
========== ==========

Statements of Earnings

Years ended June 30,
--------------------
1995 1994 1993
---- ---- ----

Income $301,775 $310,776 $181,202
Expenses 154,491 155,956 100,573
-------- -------- --------
Net earnings $147,284 $154,820 $ 80,629
======== ======== ========

15. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND SIGNIFICANT GROUP
CONCENTRATION OF CREDIT RISK

The Bank is a party to financial instruments with off-balance-sheet risk
in the normal course of business to meet the financing needs of its
customers and to reduce its own exposure to fluctuations in interest
rates. These financial instruments include commitments to extend credit
and standby letters of credit. These instruments involve, to varying
degrees, elements of credit and interest rate risk in excess of the
amounts recognized in the statements of financial condition. The contract
or notional amounts of these instruments reflect the extent of involvement
the Bank has in particular classes of financial instruments.

The Bank's exposure to credit loss in the event of nonperformance by the
other party to the financial instrument for commitments to extend credit
and standby letters of credit is represented by the contractual notional
amount of those instruments. The Bank uses the same credit policies in
making these commitments and conditional obligations as it does for
on-balance-sheet instruments.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

15. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND SIGNIFICANT GROUP
CONCENTRATION OF CREDIT RISK, continued

Outstanding lines of credit balances were $1,682,944 and $1,685,212 at
June 30, 1995 and 1994, respectively. Commitments to originate or purchase
loans were approximately $1,733,000 and $5,195,000 at June 30, 1995 and
1994, respectively. The commitments exclude approved, but unused, home
equity lines of credit of $3,492,558 and $3,523,810 in 1995 and 1994,
respectively. The commitments to originate or purchase loans at June 30,
1995, were composed of variable rate loans of $1,204,000 and fixed rate
loans of $529,000. The fixed rate loans had interest rates ranging from
6.5% to 9.25%.

Commitments to extend credit are agreements to lend to a customer as long
as there is no violation of any condition established in the contract.
Commitments generally have fixed expiration dates or other termination
clauses and may require payment of a fee. Since many of the commitments
are expected to expire without being drawn upon, the total commitment
amounts do not necessarily represent future cash requirements. The Bank
evaluates each customer's credit worthiness on a case-by-case basis. The
amount of collateral obtained if deemed necessary by the Bank upon
extension of credit is based on management's credit evaluation of the
borrower. Collateral held varies but may include trade accounts
receivable; property, plant, and equipment; and income-producing
commercial properties.

Standby letters of credit are conditional commitments issued by the Bank
to guarantee the performance of a customer to a third party. The credit
risk involved in issuing letters of credit is essentially the same as that
involved in extending loan facilities to customers. At June 30, 1995, the
unused amount of letters of credit issued totaled $212,602.

Most of the Bank's business activity is with customers located within the
state of Tennessee. A majority of the loans are collateralized by
residential or commercial real estate or other personal property. The
loans are expected to be repaid from cash flow or proceeds from the sale
of selected assets of the borrowers. The Bank grants residential,
consumer, and commercial loans to customers throughout the eastern portion
of the state of Tennessee.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

16. EMPLOYEE STOCK OWNERSHIP PLAN OBLIGATION

In conjunction with converting to a stock ownership form, the Company and
the Bank established an Employee Stock Ownership Plan (ESOP), under which
the Bank makes annual contributions to a trust for the benefit of eligible
employees. To be eligible, an employee must be 21 years of age and have
completed at least one year of service. The contributions may be in the
form of cash, other property, or common shares of the Company. The amount
of the annual contribution is at the discretion of the Board of Directors
of the Bank. Initially, the ESOP acquired 209,300 shares of the Company's
common stock financed by $1,203,475 in borrowings by the ESOP. The Board
of Directors intends to contribute to the Plan an amount equal to the
required principal and interest payments related to the ESOP loan.

During 1995, the ESOP refinanced its notes payable with borrowings from
the Company. The new loan, which has essentially the same terms as the
prior borrowing, is payable in quarterly principal payments of $30,087
plus interest at the lender's base rate through March 30, 2002. At June
30, 1995, the loan bore interest at 9.00%. The plan is noncontributory and
there is no past service liability. The principal balance of the ESOP loan
was $720,765 at June 30, 1995 and $880,885 at June 30, 1994. The Company
is using the dividends paid on unallocated shares held by the ESOP to
reduce the outstanding debt. The financial statements for the years ended
June 30, 1995, 1994 and 1993 include compensation expense of $91,241,
$120,348 and $120,348 and interest expense of $37,592, $63,613 and
$74,407, respectively, related to the ESOP.

The ESOP debt agreement contains certain affirmative financial covenants
related to the Bank's operations and financial position. The Bank is in
compliance with all such covenants.

In prior years, the Company had guaranteed the repayment of the ESOP debt
to the outside lender and, accordingly, recorded the debt on its balance
sheet with a corresponding contra-equity account.

Future minimum principal payments due to the Company related to the
Employee Stock Ownership Plan obligation are as follows:

Year ended June 30,
-------------------

1996 $120,348
1997 120,348
1998 120,348
1999 120,348
2000 120,348
Thereafter 119,025
--------

$720,765
========

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

17. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)

The following is a summary of quarterly results of operations for the
years ended June 30, 1995 and 1994:

First Second Third Fourth
----- ------ ----- ------

1995:
Interest income $8,640,565 $8,959,429 $9,074,420 $9,304,480
Interest expense 4,049,674 4,338,990 4,468,926 4,939,906
---------- ---------- ---------- ----------
Net interest income 4,590,891 4,620,439 4,605,494 4,364,574

Provision for loan losses 20,591 2,501 30,920 28,235
---------- ---------- ---------- ----------

Net interest income after
provision for loan losses 4,570,300 4,617,938 4,574,574 4,336,339
---------- ---------- ---------- ----------

Other income 719,009 682,585 701,777 651,600
General and administrative expenses 3,112,009 3,143,617 3,104,945 2,881,031
---------- ---------- ---------- ----------

Income before income taxes 2,177,300 2,156,906 2,171,406 2,106,908
Income tax expense 769,853 689,759 798,920 887,134
---------- ---------- ---------- ----------

Net income $1,407,447 $1,467,147 $1,372,486 $1,219,774
========== ========== ========== ==========

Net income per share $0.41 $0.43 $0.39 $0.35
===== ===== ===== =====

1994:
Interest income $9,181,104 $8,986,173 $8,679,829 $8,703,564
Interest expense 4,309,713 4,198,871 3,997,124 3,981,573
---------- ---------- ---------- ----------

Net interest income 4,871,391 4,787,302 4,682,705 4,721,991

Provision for loan losses 216,652 212,519 45,295 12,880
---------- ---------- ---------- ----------

Net interest income after
provision for loan losses 4,654,739 4,574,783 4,637,410 4,709,111
---------- ---------- ---------- ----------

Other income 556,673 586,449 702,434 638,265
General and administrative expenses 3,049,639 3,021,942 2,415,619 2,866,476
---------- ---------- ---------- ----------

Income before income taxes 2,161,773 2,139,290 2,924,225 2,480,900
Income tax expense 863,870 828,453 969,150 840,490
---------- ---------- ---------- ----------

Net income before accounting change 1,297,903 1,310,837 1,955,075 1,640,410
Accounting change 764,255 - - -
---------- ---------- ---------- ----------

Net income after accounting change $2,062,158 $1,310,837 $1,955,075 $1,640,410
========== ========== ========== ==========

Net income per share $.61 $.39 $.58 $.49
==== ==== ==== ====

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

18. STOCK OPTION AND AWARD PLANS

1992 STOCK OPTION PLAN

The Company has adopted a stock option plan for the benefit of employees of
the Bank and nonemployee directors of the Company. The number of shares of
common stock authorized and awarded under the 1992 stock option plan was
299,000, equal to 10% of the total number of shares issued in the Company's
public offering. The option exercise price of $5.75 per share is equal to
100% of the fair market value of the common stock on the date of grant. The
option term is ten years. Options issued to employees of the Bank in
connection with the conversion became exercisable over a three year period
ending in March 1995. Options issued to nonemployee directors of the
Company are immediately exercisable. During 1993, a former director
exercised options for 14,950 shares at an exercise price of $5.75 per
share. During 1994, 2,728 options were exercised at an exercise price of
$5.75 per share. During 1995, 8,377 options were exercised at an exercise
price of $5.75 per share.

MANAGEMENT RECOGNITION PLAN (MRP)

The Bank issued 89,700 shares of common stock to a MRP Trust created during
1993. All of these shares, with a market value of $1,065,187 on the date of
award, have been awarded to certain executive officers as restricted stock
which will vest over the three year period ending March 1996. Compensation
expense in the amount of $355,057, $201,060 and $154,009 was recognized
during 1995, 1994 and 1993, respectively, related to these awards. The plan
contains provisions providing for forfeiture of unvested shares in the
event of termination, and vesting in the event of death, disability,
retirement or a change in control.

The shares issued to the MRP Trust have been recorded as outstanding
shares, and the unvested portion has been recorded as unearned compensation
through a contra-equity account.

INCENTIVE COMPENSATION PLANS

The Company has established an incentive compensation plan for certain
officers. The plan provides for annual cash bonuses, restricted stock
awards and stock options based upon base annual compensation and certain
operating results. For the year ended June 30, 1995, compensation in the
aggregate amount of $510,228 was recorded, including awards of 3,348 shares
of common stock which will vest over three years and options on 14,350
shares of common stock exercisable at $13.00 related to discounted option
plans. In 1994, the compensation recorded under these plans aggregated
$442,464, including awards of 5,073 shares of common stock which will vest
over three years and 30,735 options on shares of common stock exercisable
at $8.72 related to discounted option plans. In 1993, the compensation
recorded under these plans aggregated $404,463 including awards of 5,672
shares of common stock. In addition, in 1995, 1994 and 1993 participants
were granted stock options for 6,696 shares exercisable at $26.00 per
share, 10,149 shares exercisable at $17.44 per share, and 11,352 shares
exercisable at $14.25 per share, respectively.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

18. STOCK OPTION AND AWARD PLANS, continued

The Company has established an incentive compensation plan for nonemployee
directors. This unfunded plan provides benefits in the form of performance
stock options for shares of common stock. The number of shares received,
exercisable at 50% of the fair market value on the date of the grant, is
determined based on the amount of director fees deferred during the year by
each director. Director compensation recorded for 1995 related to this plan
amounted to $177,250, representing 13,635 shares at an exercise price of
$13.00 per share. Director compensation recorded for 1994 related to this
plan amounted to $134,650, representing 15,446 shares at an exercise price
of $8.72 per share.

In 1994, the Company adopted a new Director Option Plan that was approved
by the shareholders at the Annual Meeting in October. The plan provides for
automatic grants to each director of options to purchase 4,000 shares of
common stock annually at the fair market value on the date of the grant. At
June 30, 1995, no options had been exercised and 28,000 options are
exercisable at $20.25 per share and 28,000 options are exercisable at
$15.19 per share.

19. EARNINGS PER SHARE

On July 20, 1994, Heritage Federal Bancshares, Inc. declared a four for
three stock split for all shares outstanding as of August 5, 1994, to be
paid on August 26, 1994, to be effected as a stock dividend. On August 18,
1993, Heritage Federal Bancshares, Inc. declared a three for two stock
split for all shares outstanding as of September 8, 1993 to be effected as
a stock dividend. This stock split was paid September 30, 1993. All
references to the outstanding number of shares and earnings per share
amounts have been restated to reflect the splits.

Stock options are regarded as common stock equivalents. Common stock
equivalents are computed using the treasury stock method.

Following are weighted average shares outstanding for computation of
earnings per share for 1995, 1994, and 1993 after adjusting for stock
splits:

1995 1994 1993
---- ---- ----

Shares issued and outstanding 3,179,737 3,171,216 3,099,422
Common stock equivalents computed by
the treasury stock method-options 284,079 200,856 209,633
--------- --------- ---------

3,463,816 3,372,072 3,309,055
========= ========= =========

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

20. FAIR VALUES OF FINANCIAL INSTRUMENTS

Financial Accounting Standards Board Statement No. 107 (Statement 107)
requires disclosures of the estimated fair value of an entity's financial
instrument assets and liabilities. For the Company, as for most financial
institutions, the great bulk of its assets and liabilities are considered
financial instruments as defined in Statement 107. However, many of such
instruments lack an available trading market, as characterized by a
willing buyer and seller engaging in an exchange transaction. Also, it is
the Company's general practice and intent to hold its financial
instruments to maturity and not to engage in trading or sales activities.
Therefore, the Company used estimations and present value calculations to
prepare this disclosure.

Changes in the assumptions or methodologies used to estimate fair values
may materially affect the estimated amounts. Also, management is concerned
that there may not be reasonable comparability between institutions due to
the wide range of permitted assumptions and methodologies in the absence
of active markets. This lack of uniformity gives rise to a high degree of
subjectivity in estimating financial instrument fair values.

Fair values have been estimated using data which management considered the
best available, and estimation methodologies deemed suitable for the
pertinent category of financial instrument. The estimation methodologies
and resulting fair values, and recorded carrying amounts at June 30, 1995
and 1994, were as follows:

Cash and cash equivalents are by definition short-term and do not
present any unanticipated credit issues. Therefore, the carrying
amount is a reasonable estimate of fair value. The estimated fair
values of securities are provided in Note 3 to the financial
statements. These are based on quoted market prices, when available.
If a quoted market price is not available, fair value is estimated
using quoted market prices for similar securities.

The fair value of the net loan portfolio has been estimated using
present value cash flow discounted at an interest rate adjusted for
servicing costs and giving consideration to estimated prepayment risk
and credit loss factors.

1995 1994
------------------------------- ------------------------------
Estimated Fair Carrying Estimated Fair Carrying
Value Amount Value Amount
----- ------ ----- ------

1 - 4 family mortgages $247,984,000 $247,238,858 $259,692,000 $261,813,285
Consumer 23,226,000 23,482,167 20,214,000 20,459,516
Non-Residential 33,969,000 34,215,208 33,906,000 35,474,045
------------ ------------ ------------ ------------

$305,179,000 $304,936,233 $313,812,000 $317,746,846
============ ============ ============ ============

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

20. FAIR VALUES OF FINANCIAL INSTRUMENTS, continued

Fair value of deposit liabilities with no stated maturities has been
estimated to equal the carrying amount (the amount payable on demand),
totaling $160,775,378 and $199,559,758 in 1995 and 1994, respectively.
Under Statement 107, the fair value of deposits with no stated
maturity is equal to the amount payable on demand. Therefore, the fair
value estimates for these products do not reflect the benefits that
the Bank receives from the low-cost, long-term funding they provide.
These benefits are significant. There is no material difference
between the carrying amount of deposit liabilities with stated
maturities and their estimated fair value since the majority of the
liabilities mature within one year.

The fair value of certificates of deposits and advances from the
Federal Home Loan Bank is estimated by discounting the future cash
flows using the current rates offered for similar deposits and
advances with the same remaining maturities. The carrying value and
estimated fair values of certificates of deposit and Federal Home Loan
Bank advances at June 30, 1995 and 1994 are as follows:

1995 1994
---- ----

Certificates of deposits:
Carrying amount $288,542,599 $251,258,850
Estimated fair value $290,144,000 $252,205,000

Advances from Federal Home Loan Bank:
Carrying amount $18,121,921 $9,587,083
Estimated fair value $17,852,000 $8,992,000

In 1994, there was no material difference between the carrying amount and
estimated fair value of the obligation to the Employee Stock Ownership
Plan because it bore interest at a variable rate equivalent to a current
market rate.

There is no material difference between the carrying amount and estimated
fair value of off-balance sheet items totaling $3,415,944 in 1995 and
$6,880,212 in 1994, which are primarily comprised of unfunded loan
commitments which are generally priced at market at the time of funding.

The Company's remaining assets and liabilities are not considered
financial instruments.

21. FINANCIAL INSTITUTIONS REFORM, RECOVERY, AND ENFORCEMENT ACT

The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA),
which was signed into law in 1989, imposed stringent capital requirements
upon savings institutions. In addition, FIRREA included provisions for
changes in the federal regulatory structure for savings institutions
including a new deposit insurance system, increased deposit premiums and
restricted investment activities with respect to noninvestment grade
corporate debt and certain other investments. FIRREA also increased the
required ratio of housing-related assets in order to qualify as a
qualified thrift lender under federal regulations.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued

21. FINANCIAL INSTITUTIONS REFORM, RECOVERY, AND ENFORCEMENT ACT, continued

The Bank must satisfy three capital standards, as set by the Office of
Thrift Supervision ("the OTS"). These standards include a ratio of core
capital to adjusted total assets of 3.0%, a tangible capital standard
expressed as 1.5% of total adjusted assets, and a combination of core and
"supplementary" capital equal to 8.0% of risk-weighted assets. The OTS
recently finalized regulations that add an interest rate risk component to
capital requirements under certain circumstances. The Bank does not expect
that this regulation will require it to reduce its capital materially for
purposes of determining compliance with its risk-based capital
requirement. In addition, the OTS has recently adopted regulations that
impose certain restrictions on savings associations that have a total
risk-based capital ratio that is less than 8.0%, a ratio of Tier 1 capital
(or core capital) to risk-weighted assets of less than 4.0%, or a ratio of
Tier 1 capital to adjusted total assets of less than 4.0% (or 3.0% if the
institution receives the highest rating under the OTS examination rating
system).

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

Not applicable.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

DIRECTORS

The following table sets forth each director of the Company, his name,
age as of June 30, 1995, the year he first became a director of the Company's
principal subsidiary, Heritage Federal, and the expiration of his current term
as a director of the Company. All such persons were initially appointed as
directors in 1992 in connection with the incorporation and organization of the
Company. Each director of the Company is also a member of the Board of Directors
of the Bank.

YEAR FIRST
ELECTED CURRENT
AGE AS DIRECTOR TERM
OF JUNE OF THE TO
NAME 30, 1995 BANK EXPIRE
---- -------- ---- ------

Sam H. Anderson, Jr. 67 1991 1997

John C. Bracy 61 1986 1997

Clyde W. Craven 60 1989 1995

Robert C. Fox 73 1982 1996

William E. Kreis 48 1991 1996

Thomas E. LaGuardia, Jr. 67 1973 1996

Richard A. Manahan 56 1990 1997

C. Mack Patton 53 1984 1995

The principal occupation of each director of the Company for the last
five years is set forth below.

SAM H. ANDERSON, JR. is Chairman of the Board. He is also Chairman of
the Board of Anderson Ford, Inc., an automobile and truck dealership located in
Kingsport, Tennessee. He is also president or chairman of the board of four
other automobile dealerships located in east Tennessee and southwest Virginia.
Mr. Anderson is also president of a real estate concern, an insurance agency, a
vehicle leasing corporation, and an advertising firm. He served as chairman of
the boards of the Holston Valley Hospital Foundation and the Greater Kingsport
Chamber of Commerce Foundation and is currently a member of the board of
directors of the Holston Valley Life Insurance Co., Inc., a director and member
of the executive committee of the Holston Valley Hospital and Medical Center,
and for 24 years served as Commissioner of the Tennessee Motor Vehicle
Commission. He also served as chairman of the Kingsport Chamber of Commerce
Railroad Property Revitalization Project, and as director of the YMCA.

JOHN C. BRACY is currently Vice President, Secretary and General
Counsel of Eastman Chemical Company. Mr. Bracy is also Secretary of Eastman
Chemical Canada, Inc.; Eastman Chemical Espana S.A.; Eastman Chemical Europe,
Middle East, and Africa, Ltd.; Eastman Chemical Ltd; Eastman Chemical Mexicana,
S.A. de C.V.; Eastman International Management Company; Mustang Pipeline
Company; Petmex Mexicana, S.A. de C.V.; and Pinto Pipeline Company of Texas. In
addition, he is a Director of Eastman Chemical Foreign Sales Corporation. He is
past president and a past board member of the Ridgefields Country Club, Inc. and
Ridgefields Properties, Inc., and is currently a member of First Baptist Church,
Kingsport, Tennessee. He is a member of the Kingsport Bar Association, American
Bar Association, American Corporate Counsel Association, American Society of
Corporate Secretaries, Chemical Manufacturers Association, and The Conference
Board. He is a member of the Georgia Bar, Florida Bar, New York Bar, and
Tennessee Bar.

CLYDE W. CRAVEN is chairman of the board and chief executive officer of
ICS, a computer, environmental and engineering services company located in Oak
Ridge, Tennessee, a position he has held since 1988. Prior to assuming this
position, he was chairman of the board and chief executive officer of ISI, an
engineering and computer services company, from 1985 to 1988. Dr. Craven is also
president of Polaris Travel, a travel agency, a position he has held since 1978.
He is a member of the Oak Ridge Rotary Club, the board of directors of the Oak
Ridge Chamber of Commerce, the East Tennessee Economic Development Council,
Technology 2020, and the Oak Ridge Industrial Development Board, and is a deacon
of Central Baptist Church.

ROBERT C. FOX is a self-employed contractor, home builder and land
developer, and has been involved with such activities since 1953. Mr. Fox is a
member of the Board of Trustees of Carson-Newman College and has previously
served as the Vice Chairman of the Board of Trustees and as chairman of its
Athletic Committee and its Pension Fund Committee. He is also a member of the
Melton Hill Regional Industrial Development Association and has served on the
advisory committee of the East Tennessee Development Boards for Housing. Also,
Mr. Fox has served on the University of Tennessee Development Council.

WILLIAM E. KREIS is President and Chief Executive Officer of the Bank,
positions he assumed in 1991, and President and Chief Executive Officer of the
Company, positions he assumed in 1992. Prior to assuming his current positions,
he was Senior Vice President of the Bank from 1984 to 1991. Mr. Kreis is
currently a director of Holston Valley Health Care, Inc., Holston Valley Health
Care Foundation, East Tennessee State University Foundation, and the Kingsport
Area Chamber of Commerce Foundation. He is a member of the Advisory Board to the
Chair of Banking at East Tennessee State University and serves as a member of
the University of Tennessee, Knoxville Chancellor's Associates. He is also a
past director of the Kingsport Center of Opportunity, the Downtown Kingsport
Association, Northeast State Technical Community College Foundation, the United
Way of Kingsport, the Kingsport Chamber of Commerce, Junior Achievement of
Kingsport, and Central Appalachia Services.

THOMAS E. LAGUARDIA, JR., is currently retired and formerly was
chairman of a family owned grocery chain. He has served as president of Holston
Valley Health Care, Inc., and president of Holston Valley Hospital Medical
Center. He is a member of the Holston Valley Foundation Assessment Committee,
St. Dominic's Finance Board and the Duke Medical Center Cancer Advisory Board.

RICHARD A. MANAHAN is currently Vice President for University
Advancement at East Tennessee State University. Since 1981 he served as Vice
President for Administration and Development, Vice President for Finance and
Administration and Executive Assistant to the President. He is also Executive
Director of the University Foundation and a tenured Professor of Accountancy, as
well as a Professor of Educational Leadership and Policy Analysis at East
Tennessee State. Dr. Manahan has authored several articles and presentations at
national meetings. He is past Chairman of the Board of Directors of the Johnson
City/Washington County Area Chamber of Commerce and has served as its Treasurer
and Chairman-elect. Dr. Manahan also sits on the boards of various
organizations, including the Johnson City Area United Way, Inc., the Dawn of
Hope Development Center, the Tennessee Board of Nursing, and serves as Vice
Chairman of the Johnson City Development Authority. He is also a member of the
Executive Board of the Boy Scouts of America - Sequoyah Council, the
Secretary-Treasurer of the Health, Education and Housing Facilities Board of
Johnson City, a member of Munsey Memorial United Methodist Church, Johnson

City, Tennessee, and a past member of the Illinois State University Alumni
Association and the National Center for Quality - Tri- Cities. He is a member of
the Appalachian Chapter of the Tennessee Society of Certified Public
Accountants, the American Institute of Certified Public Accountants, and the
Tennessee, Virginia and Illinois Societies of Certified Public Accountants. He
has also been associated with Illinois State University, Illinois Board of
Regents, Radford University, Alexander Grant and Company (a national accounting
firm), and Springfield Marine Bank.

C. MACK PATTON is a physician practicing since 1974 in Kingsport with
Urology Associates of Kingsport. Dr. Patton has served on the board of directors
of the Ridgefields Country Club, Heritage National Health Plan of Tennessee,
Holston Valley Hospital and the Kingsport Independent Practice Association. He
is also a member of First Baptist Church where has served as a deacon and as a
member and Chairman of the Finance Committee.

EXECUTIVE OFFICERS WHO ARE NOT DIRECTORS

The following information is supplied with respect to executive
officers of the Company who are not directors. There are no arrangements or
understandings pursuant to which any of the executive officers were selected as
an officer, and no executive officer is related to any other director or officer
of the Company by blood, marriage or adoption.

Name and Age* Position
- ------------- --------

Richard D. Brumfield, 52 Executive Vice President and Secretary

Don R. Osborne, 48 Senior Vice President and Assistant Secretary

William F. Richmond, 46 Senior Vice President, Chief Financial Officer and Treasurer

- --------------------
* Age as of June 30, 1995.

The principal occupation of each such executive officer is set forth
below.

RICHARD D. BRUMFIELD is Executive Vice President and Secretary of the
Company and the Bank. He has been employed by the Bank in various capacities
since 1970 and has served in his current position with the Bank since 1986 and
with the Company since 1991. Mr. Brumfield is also a past member of the Board of
Directors of the Holston Valley Hospital and Medical Center and has served on
its audit and nominating committees. He is also a past director of the Greater
Kingsport United Way. He presently serves on the Business and Management
Technologies Committee of Northeast State Technical Community College and on the
Credit Committee of the Tennessee Bankers Association.

DON R. OSBORNE is Senior Vice President and Assistant Secretary of the
Company and the Bank. Mr. Osborne has been employed by the Bank in various
capacities since 1982 and has held his current position since 1991 with the
Company and the Bank. He is active in the Kingsport Chamber of Commerce, the
Finance Committee of the Colonial Heights Presbyterian Church, the Masonic
Lodge, the Greater Kingsport United Way, and the MIS Advisory Board of Northeast
State Community College. He also served with the Kingsport Center of
Opportunity, Kingsport Mental Health Center and Parent Teachers Association of
Sullivan County Schools.

WILLIAM F. RICHMOND is Senior Vice President, Chief Financial Officer
and Treasurer of the Company and is Senior Vice President and Chief Financial
Officer of the Bank. Mr. Richmond joined the Bank as its Controller in April
1985, became its Senior Vice President/Finance in June 1991, and also was
elected Treasurer in October 1991. He has held his position with the Company
since its formation in 1991. He is a member of the Rotary Club of
Kingsport-Downtown and served as campaign chairman of the Commercial Firms
Division for the 1993-1994 Greater Kingsport United Way Campaign. Mr. Richmond
is a past member of the Greater Kingsport United Way Allocation and Admission
Committee, and the boards of directors of the Boys Club of Greater Kingsport,
the Kingsport Center of Opportunity, and the Greater Kingsport YMCA. He is a
licensed Certified Public Accountant in Virginia and Tennessee and is also a
Certified Financial Planner.

STATEMENTS OF BENEFICIAL OWNERSHIP

Based solely on the Company's review of the copies of initial
statements of beneficial ownership and reports of changes in beneficial
ownership, which it has received in the past fiscal year or with respect to the
past fiscal year or written representations from such persons that no annual
report of changes in beneficial ownership was required, the Company believes
that all persons subject to such reporting requirements during the 1995 fiscal
year have complied with such reporting requirements.

ITEM 11. EXECUTIVE COMPENSATION

SUMMARY COMPENSATION TABLE

The following table sets forth the cash and noncash compensation for
each of the last three fiscal years awarded to or earned by (i) the Chief
Executive Officer, and (ii) the four highest paid executive officers of the
Company other than the Chief Executive Officer whose respective salary and bonus
earned in fiscal year 1995 exceeded $100,000 for services rendered in all
capacities to the Company and its subsidiary.

LONG-TERM COMPENSATION
-----------------------
ANNUAL COMPENSATION AWARDS(1)
------------------- -----------------------
OTHER RESTRICTED SECURITIES ALL OTHER
NAME AND PRINCIPAL ANNUAL STOCK UNDERLYING COMPENS-
POSITION YEAR SALARY BONUS(2) COMPENSATION(3) AWARDS(4) OPTIONS(5) ATION (6)
- ------------------ ---- ------ -------- --------------- --------- ---------- ---------

WILLIAM E. KREIS 1995 $177,300 107,876 $ -- $ 26,962 2,074 $ 22,650 (7)
PRESIDENT AND CHIEF 1994 154,000 -- -- 29,830 17,106 17,817
EXECUTIVE OFFICER 1993 131,800 104,500 -- 292,444 3,668 16,718

RICHARD D. BRUMFIELD 1995 116,100 30,508 -- 15,262 3,521 17,690 (8)
EXECUTIVE VICE PRESIDENT 1994 110,250 59,052 -- 18,454 3,810 14,080
AND SECRETARY 1993 104,600 70,490 -- 239,177 2,472 14,118

DON R. OSBORNE 1995 112,700 -- -- 15,002 5,767 15,879 (9)
SENIOR VICE PRESIDENT 1994 98,450 -- -- 16,625 9,534 11,571
AND ASSISTANT SECRETARY 1993 89,300 59,850 -- 148,105 2,100 11,079

WILLIAM F. RICHMOND 1995 87,750 23,207 -- 11,596 2,677 11,802(10)
SENIOR VICE PRESIDENT, 1994 80,250 26,933 -- 13,466 4,633 9,255
CHIEF FINANCIAL OFFICER 1993 73,650 50,540 -- 190,513 1,772 9,110
AND TREASURER

(Footnotes on following page)

- --------------------
(1) Awards under the Officer Incentive Plan are allocated to the year for
which award was earned, although effective dates for such awards were
after the end of the fiscal year.
(2) Bonus amounts in fiscal years 1995 and 1994 have been reduced by the
amounts foregone at the election of the named executive officers in
accordance with the Officer Incentive Plan. Such bonus amounts were
instead paid in the form of discounted stock options which are
reflected in the table as Long-Term Compensation.
(3) Does not include certain fringe benefits, the value of which did not
exceed $50,000 or 10% of salary for any named executive officer.
(4) Reflects fair market value at date of grant of shares of restricted
stock awarded pursuant to the Company's MRP and Officer Incentive Plan.
For fiscal year 1995, 1,037, 587, 577, and 446 restricted shares of
Common Stock were earned by Messrs. Kreis, Brumfield, Osborne and
Richmond, respectively, under the Officer Incentive Plan which were
awarded effective July 11, 1995. For fiscal year 1994, 1,710, 1,058,
953, and 772 restricted shares of Common Stock were earned by Messrs.
Kreis, Brumfield, Osborne and Richmond, respectively, under the Officer
Incentive Plan which were awarded effective July 20, 1994. For fiscal
year 1993, 1,833, 1,236, 1,049 and 885 restricted shares of Common
Stock were earned as restricted stock awards under the Officer
Incentive Plan by Messrs. Kreis, Brumfield, Osborne and Richmond,
respectively. Such shares of restricted stock were awarded effective
July 20, 1993 and vest ratably over a period of three years from the
date of grant. During fiscal year 1993, 22,425, 18,657, 11,212, and
14,980 shares of Common Stock were also granted as restricted stock
awards under the MRP to Messrs. Kreis, Brumfield, Osborne and Richmond,
respectively. The shares granted under the MRP vest through March 30,
1996, assuming continued employment with the Company. At June 30, 1995,
44,846 of such shares were vested. Dividends will be payable on all the
foregoing shares of restricted stock if and to the extent paid on the
Common Stock generally. As of June 30, 1995, Messrs. Kreis, Brumfield,
Osborne and Richmond had been awarded a total of 25,968, 20,951, 13,214
and 16,637 shares of restricted stock under the MRP and the Officer
Incentive Plan (not including fiscal year 1995 awards whose effective
date of grant was after June 30, 1995). Based on the fair market value
of the Common Stock on such date, the aggregate values of such shares
of restricted stock were $688,152, $555,202, $350,171 and $440,881,
respectively.
(5) Award amounts in each case have been adjusted for the three-for-two
stock split effected through a stock dividend paid September 30, 1993
and the four-for-three stock split effected through a stock dividend
paid August 26, 1994. Includes options for 2,074, 1,174, 1,154 and 892
shares of the Common Stock granted at an exercise price of $26.00 under
the Officer Incentive Plan in July 1995 to Messrs. Kreis, Brumfield,
Osborne and Richmond, respectively, based on the Company's performance
during fiscal year 1995. Also includes options to acquire -0-, 2,347,
4,613 and 1,785 shares granted in July 1995 at an exercise price of
$13.00 per share to Messrs. Kreis, Brumfield, Osborne and Richmond at
their election in lieu of a cash bonus under the Officer Incentive
Plan. The aggregate exercise price of such options was reduced by the
amount of cash bonus foregone. Includes options for 3,421, 2,117, 1,907
and 1,544 shares of the Common Stock granted at an exercise price of
$17.44 under the Officer Incentive Plan in July 1994 to Messrs. Kreis,
Brumfield, Osborne and Richmond, respectively, based on the Company's
performance during fiscal year 1994. Also includes options to acquire
13,685, 1,693, 7,627 and 3,089 shares granted in July 1994 at an
exercise price of $8.72 per share to Messrs. Kreis, Brumfield, Osborne
and Richmond at their election in lieu of a cash bonus under the
Officer Incentive Plan. The aggregate exercise price of such options
was reduced by the amount of cash bonus foregone. For fiscal year 1993,
reflects options to acquire 3,668, 2,472, 2,100 and 1,772 shares
granted with an exercise price of $14.25 per share to Messrs. Kreis,
Brumfield, Osborne and Richmond, respectively, in July 1993 pursuant to
the Officer Incentive Plan.
(6) Reflects the Company's contributions to the employee's account in the
401(k) Plan and in the ESOP, and the dollar value of premiums paid by
the Company for the term life insurance equivalent of split-dollar life
insurance for the benefit of the employee.
(7) Includes $8,817 in 401(k) Plan contributions by the Company, $12,147 in
ESOP contributions by the Company, and $1,686 of term life insurance
premium-equivalent payments.
(8) Includes $5,100 in 401(k) Plan contributions by the Company, $9,375 in
ESOP contributions by the Company, and $3,215 of term life insurance
premium-equivalent payments.
(9) Includes $4,990 in 401(k) Plan contributions by the Company, $9,027 in
ESOP contributions by the Company, and $1,862 of term life insurance
premium-equivalent payments.
(10) Includes $4,373 in 401(k) Plan contributions by the Company, $7,055 in
ESOP contributions by the Company, and $374 of term life insurance
premium-equivalent payments.

OPTION GRANTS IN LAST FISCAL YEAR

The following table contains information concerning the grants of
stock options under the Officer Incentive Plan to the Company's Chief Executive
Officer and each other executive officer of the Company whose salary and bonus
in fiscal year 1995 exceeded $100,000 for services rendered in all capacities to
the Company and its subsidiaries. The table shows options earned or elected in
lieu of cash bonuses under the Officer Incentive Plan during fiscal year 1995
and awarded effective July 11, 1995.

Grant Date
Individual Grants Value
------------------------------------------------------- ----------
% of Total
Number of Options
Securities Granted to Market
Underlying Employees Price on Grant Date
Options in Fiscal Exercise Date of Expiration Present
Name Granted (1) Year Price Grant Date Value
----------- --------- -------- --------- ---------- ----------

WILLIAM E. KREIS 2,074 9.85% $26.00 $ 26.00 7/05 $ 24,390 (2)

RICHARD D. BRUMFIELD 1,174 5.58 26.00 26.00 7/05 13,806 (2)
2,347 11.15 13.00 26.00 7/05 38,138 (2)

DON R. OSBORNE 1,154 5.48 26.00 26.00 7/05 13,571 (2)
4,613 21.92 13.00 26.00 7/05 74,961 (2)

WILLIAM F. RICHMOND 892 4.24 26.00 26.00 7/05 10,489 (2)
1,785 8.48 13.00 26.00 7/05 29,006 (2)

- --------------------

(1) All options were vested as of date of grant. To the extent not already
exercisable, the options generally will become immediately exercisable
in the event of a change in control of the Company, generally defined
as the acquisition of beneficial ownership of 25% or more of the
Company's voting securities by any person or group of persons.

(2) Represents the present value of the option at the date of grant, as
determined using the Black-Scholes option pricing model. In calculating
the present value of the option grant, the following assumptions were
utilized: (i) the current market price of the underlying Common Stock
at the date of grant was $26.00; (ii) the continuously compounded
risk-free rate of return expressed on an annual basis was 6.25%; (iii)
the risk of the underlying Common Stock, measured by the standard
deviation of the continuously compounded annual rate of return of the
Common Stock, was 30%; and (iv) dividends on the underlying Common
Stock increase at an annual rate of 5%. The foregoing assumptions are
used for illustrative purposes only. No assurance can be given that
actual experience will correspond to the assumptions utilized.

AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION
VALUES

The following table sets forth each exercise of stock options during
fiscal year 1995 by each of the named executive officers and the fiscal year-end
value of unexercised in-the-money options. The table does not reflect options
earned during fiscal year 1995 pursuant to the Officer Incentive Plan but
granted after the fiscal year end.

VALUE OF SECURITIES
NUMBER OF SECURITIES UNDERLYING UNEXERCISED
SHARES UNDERLYING UNEXERCISED IN-THE-MONEY
ACQUIRED ON VALUE OPTIONS AT FY-END (#)(1) OPTIONS AT FY-END ($)(2)
EXERCISE REALIZED ----------------------------- ----------------------------
NAME (#) ($) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
---- ----------- -------- ----------- ------------- ----------- -------------

William E. Kreis . . . . . -- -- 74,594 -- $1,436,011 --
Richard D. Brumfield . . . -- -- 43,598 -- 853,870 --
Don R. Osborne . . . . . . -- -- 34,060 -- 643,950 --
William F. Richmond . . . . -- -- 34,972 -- 683,383 --

- -----------------------
(1) Consists of options granted under the Option Plan and Officer Incentive
Plan.

(2) Based on the aggregate fair market value of the shares of Common Stock
underlying the options at June 30, 1995 less the aggregate exercise
price. For purposes of this calculation, the fair market value per
share of the Common Stock at fiscal year end is assumed to be equal to
the average of the high and low price on June 30, 1995 as reported on
The Nasdaq Stock Market ($26.50 per share). Unexercised options are
considered "in-the-money" if the exercise price is less than fair
market value of the underlying Common Stock. All options granted to the
named executive officers are currently in the money.

PENSION PLAN

The following table illustrates the maximum estimated annual benefits
payable upon retirement pursuant to the Bank's defined benefit pension plan (the
"Pension Plan") based upon the pension plan formula for specified average final
compensation and specified years of service.

YEARS OF SERVICE
AVERAGE FINAL ------------------------------------------------------------------------
COMPENSATION 15 20 25 30 35

$100,000 . . . . . . . $20,290 $27,053 $33,816 $40,579 $47,342
$125,000 . . . . . . . 25,465 33,953 42,441 50,929 59,417
$150,000 . . . . . . . 30,640 40,853 51,066 61,279 71,492
$175,000 . . . . . . . 30,640 40,853 51,066 61,279 71,492
$200,000 . . . . . . . 30,640 40,853 51,066 61,279 71,492
$225,000 . . . . . . . 30,640 40,853 51,066 61,279 71,492
$250,000 . . . . . . . 30,640 40,853 51,066 61,279 71,492
$275,000 . . . . . . . 30,640 40,853 51,066 61,279 71,492

Benefits are hypothetical amounts only. Currently, the maximum annual
benefit payable under the Pension Plan is $118,800. Also, average final
compensation in excess of $150,000 is not covered under the Pension Plan.
"Average final compensation," which is based upon the average annual salary (as
defined) for the five consecutive years of highest salary during the final ten
years of employment, is based upon compensation that would appear under the
"Salary" and "Bonus" columns of the Summary Compensation Table. As of June 30,
1995, Messrs. Kreis, Brumfield, Osborne and Richmond had 23, 25, 13 and 11 years
of credited service, respectively, under the Pension Plan. Benefits set forth in
the preceding table are computed as a ten-year-certain life annuity and are not
subject to any deduction for Social Security or other offset amounts.

EMPLOYMENT AGREEMENTS

The Bank entered into employment agreements on August 26, 1992, with
Messrs. Kreis, Brumfield, Osborne and Richmond, which replaced their severance
agreements earlier commenced on March 31, 1992. The employment agreements have a
term of thirty-six months. On each anniversary date from the date of
commencement of the agreements, the terms of employment may be extended for an
additional one-year period beyond the then effective expiration date upon a
determination by the Board of Directors that performance of the employee has met
the required standards and that such agreements should be extended. Each
agreement will be terminated upon death. The agreements provide that the Bank's
obligations under such agreements shall terminate if the employee is removed
from his position or permanently prohibited from participating in the Bank's
affairs by regulatory order; if the Bank is placed in conservatorship,
receivership or other custodianship by regulatory authorities; if the Bank
enters into an agreement to receive federal financial assistance; or if the Bank
is the subject of an approved supervisory merger. Termination of such
obligations shall not, however, affect any vested rights of the Bank or the
employees. No payments shall be made under the agreements, in any case, if the
employee's employment terminates for "just cause" as defined in the agreements,
or if the Bank is not in compliance with its fully phased-in capital
requirements at the time of the employee's termination or would not be in
compliance after making such payments. The employment agreements also provide
that the Bank's obligations thereunder will be suspended if the employee is
suspended and/or temporarily prohibited by federal regulatory authorities from
participating in the Bank's affairs. Further, if the charges against such
employee giving rise to such suspension or prohibition are subsequently
dismissed, the Bank's Board of Directors may, in its discretion, pay the
employee all or part of the compensation otherwise payable while the employment
agreement was suspended and reinstate any or all of its obligations under the
employment agreement.

The employment agreements contain provisions stating that in the event
of the involuntary termination of employment not for cause, as defined, in
connection with, or within 12 months after, any change in control of the Bank or
the Company, the employee will be paid an amount equal to the sum of the
employee's base salary in effect on the date of the change in control and the
base salary the employee would have received over the remainder of the term of
the agreement. In no event will such payments exceed the difference between (i)
2.99 times the average

100

annual compensation he received during the five-year period immediately prior to
the date of change in control and (ii) the sum of all other severance payments
received by the employee on account of the change in control. An employee's
severance benefits will be paid, at the employee's option, either within 30 days
of termination or over the lesser of 36 months or the remaining term of the
agreement. "Control" generally refers to the acquisition by any person or entity
of the ownership or power to vote more than 25% of the Bank's or Company's
voting stock, or the control of the election of a majority of the Bank's or
Company's Directors, or the exercise of a controlling influence over the
management or policies of the Bank or Company. The employment agreements also
provide for a similar lump sum payment to be made to the employees in the event
of voluntary termination of employment upon the occurrence, or within 90 days
thereafter, of certain specified events following any change in control, unless
consented to in advance by the employee in writing, including (i) requiring the
employee to perform his principal executive functions more than 35 miles from
the Bank's current primary office, (ii) the failure of the Bank or the Company
to maintain existing employee benefit plans, including material fringe benefits,
stock option and retirement plans, (iii) assigning duties and responsibilities
to the employee which are other than those normally associated with his position
with the Bank; or (iv) a material diminution of the employee's authority and
responsibility with the Bank. In addition to such events, Mr. Kreis' agreement
provides for lump sum payments upon the occurrence of the following events (or
within 90 days thereafter) after a change in control: (i) requiring that he
report to a person or persons other than the Bank's Board of Directors; or (ii)
a failure to elect or re-elect him to the Board of Directors of the Bank or the
Company. If the employee is terminated at any time with or without cause, except
for the reasons set forth above, the employee shall not be entitled to any
severance benefits under the employment agreement. The aggregate payments that
would be made to Messrs. Kreis, Brumfield, Osborne and Richmond, assuming the
termination of employment under the foregoing circumstances at June 30, 1995 and
without regard to other severance payments would have been approximately
$523,600, $369,300, $340,600 and $280,900, respectively.

DIRECTORS' COMPENSATION

Each non-employee member of the Board of Directors of the Company
receives a $6,000 annual retainer. Each non-employee member of the Board of
Directors of the Bank receives a fee of $1,000 for each Board meeting, provided
that a member will not be paid for more than two meetings not attended. The
Chairman of the Board receives a fee of $1,350 for each Board meeting attended.
Non-employee directors also receive a fee of $350 for each committee meeting
attended.

INCENTIVE COMPENSATION PLAN FOR NON-EMPLOYEE DIRECTORS. Non-employee
directors of the Company also participate in the Incentive Compensation Plan for
Non-Employee Directors (the "Director Incentive Plan"), the purposes of which
are to attract and retain the best available non-employee directors for the
Company, to compensate non-employee directors for the increased responsibility
associated with the Bank's conversion to stock form, and to provide additional
equity incentives. Executive officers and other employees of the Company may not
participate in the Director Incentive Plan.

The Director Incentive Plan is administered by a committee (the
"Director Incentive Plan Committee") consisting of all the members of the Bank's
Compensation Committee. The Director Incentive Plan is unfunded and benefits are
payable only in the form of discounted non-incentive options to acquire the
Common Stock. Under the Director Incentive Plan, non-employee directors may
elect to forego all or a portion of their director fees for the coming fiscal
year and instead receive options having an exercise price equal to 50% of the
fair market value of the Common Stock on the date of grant. The number of
options granted to a director is determined such that the aggregate discount on
options granted is equal to the amount of director fees foregone. For fiscal
year 1995, Directors Anderson, Bracy, Craven, Fox, LaGuardia, Manahan and Patton
received discounted options to acquire 2,069, 1,758, 1,958, 1,781, 2,042, 1,881
and 2,146 shares of the Common Stock, respectively, in lieu of director fees
under the Director Incentive Plan. For fiscal year 1996, each non-employee
director will receive cash instead of discounted options and thus will not defer
their director fees beginning in July 1995.

100

101

DIRECTOR OPTION PLAN. The Board of Directors has reserved 160,000
authorized but unissued shares of the Common Stock for issuance pursuant to
options issued under Heritage Federal Bancshares, Inc. 1994 Stock Option Plan
for Non-Employee Directors (the "Director Option Plan"). Under the Director
Option Plan, non-employee directors of the Company and its affiliates will
receive automatic annual grants of options to purchase 4,000 shares of the
Common Stock each. On February 16, 1994, each non-employee director was granted
options for 4,000 shares of the Common Stock at an exercise price of $15.19 per
share with respect to fiscal year 1994 and on August 17, 1994, each nonemployee
director was granted options to acquire 4,000 shares of the Common Stock at an
exercise price of $20.25 per share with respect to fiscal year 1995 and received
a grant of options for 4,000 shares of the Common Stock at an exercise price of
$27.50 on July 1, 1995 with respect to fiscal year 1996. Each nonemployee
director will receive an automatic grant of options for 4,000 shares on the
first day of each fiscal year thereafter. In each case, the exercise price was
equal to the fair market value of the Common Stock on the date of grant. Each of
the Options has a term of ten years. All such grants were immediately vested and
exercisable.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth, as of August 11, 1995, the most recent
practicable date, certain information as to the Common Stock beneficially owned
by (i) any person or group of persons who is known to Heritage to be the
beneficial owner of more than 5% of the Common Stock, and (ii) each of
Heritage's directors, each of Heritage's executive officers who are not
directors and by all of Heritage's directors and by all of Heritage's directors
and executive officers as a group.

AMOUNT AND PERCENT OF
NATURE OF SHARES OF
BENEFICIAL COMMON STOCK
BENEFICIAL OWNER OWNERSHIP(1) OUTSTANDING(2)
---------------- -------------- --------------

Heritage Federal Bank for Savings
Employee Stock Ownership Plan and
Trust
110 East Center Street
Kingsport, Tennessee 37660 209,300 (3) 6.56%

Heritage Federal Bank for Savings
Profit Sharing Plan
110 East Center Street
Kingsport, Tennessee 37660 288,713 (4) 9.10%

Directors:
Sam H. Anderson, Jr. 88,159 2.74%
John C. Bracy 58,333 1.81%
Clyde W. Craven 63,245 (5) 1.96%
Robert C. Fox 74,780 (6) 2.32%
William E. Kreis 138,707 (7) 4.25%
Thomas E. LaGuardia, Jr. 51,003 1.58%
Richard A. Manahan 47,770 (8) 1.48%
C. Mack Patton 73,260 (9) 2.27%

Named Executive Officers
who are not Directors:
Richard D. Brumfield 122,003 (10) 3.77%
Don R. Osborne 118,320 (11) 3.66%
William F. Richmond 66,159 (12) 2.05%

All Directors and Executive Officers
as a Group (11 persons) 901,739 (13) 24.86%

(Footnotes on following page)

101

102

- ---------------
(1) In accordance with Rule 13d-3 under the Securities Exchange Act of
1934, a person is deemed to be the beneficial owner, for purposes of
this table, of any shares of the Common Stock over which he or she has
or shares voting or investment power with respect to such security or
has a right to acquire beneficial ownership at any time within 60 days
from August 11, 1995. As used herein, "voting power" is the power to
vote or direct the voting of shares and "investment power" is the power
to dispose or direct the disposition of shares. Except as otherwise
noted, ownership is direct and the named beneficial owners exercise
sole voting and investment power over the indicated shares of the
Common Stock. Includes 33,455, 33,345, 34,227, 33,198, 76,668, 33,614,
33,792, 34,260, 47,119, 39,827 and 37,649 shares which Messrs.
Anderson, Bracy, Craven, Fox, Kreis, LaGuardia, Manahan, Patton,
Brumfield, Osborne and Richmond have the right to acquire within 60
days of August 11, 1995 pursuant to stock options.

(2) In calculating the percentage of shares outstanding for a named person
or group, the number of shares outstanding includes any shares of
Common Stock which the person or group has the right to acquire within
60 days of August 11, 1995.

(3) Consists of allocated and unallocated shares of the Common Stock held
in trust for the benefit of participating employees over which the ESOP
may be deemed to have shared voting and dispositive power. The ESOP is
administered by a committee consisting of Directors Robert C. Fox and
William E. Kreis and Vice President Jeffrey S. Little (the "ESOP
Trustees") The ESOP Trustees must vote all allocated shares held in the
ESOP in accordance with the instructions of the participating
employees. Unallocated shares and allocated shares for which no timely
direction is received must be voted as directed by the ESOP Trustees,
as directed by the Board of Directors. The ESOP Trustees and Heritage
Federal disclaim beneficial ownership over the shares of the Common
Stock held by the ESOP.

(4) Consists of shares of the Common Stock held in trust for the benefit of
participating employees over which the Heritage Federal Bank for
Savings Profit Sharing Plan (the "401(k) Plan") may be deemed to have
shared voting and dispositive power. The Plan Trustee votes shares as
directed by participants, and otherwise as directed by Heritage Federal
in its capacity as Plan Administrator and over which the Bank disclaims
beneficial ownership.

(5) Includes 7,588 shares held in a defined benefit pension plan of which
Dr. Craven serves as trustee and thereby exercises voting power over
such shares, and 3,676 shares held in spouse's IRA.

(6) Includes 5,265 shares held in individual retirement account ("IRA") and
2,649 shares held in spouse's IRA. Does not include shares held by the
ESOP of which he is a trustee and over which he disclaims beneficial
ownership.

(7) Includes 20,491 shares in Mr. Kreis' account in the Bank's 401(k)
Profit Sharing Plan (the "401(k) Plan"); 4,484 shares allocated to his
account in the Heritage Federal Bank for Savings ESOP, and 10,263
shares of restricted shares of the Common Stock ("restricted stock")
granted to Mr. Kreis pursuant to the Heritage Federal Bank for Savings
Management Recognition Plan and Trust (the "MRP") and the Officer
Incentive Plan over which Mr. Kreis exercises voting power. Does not
include shares held by the ESOP of which he is a trustee and over which
he disclaims beneficial ownership.

(8) Includes 12,773 shares held in IRA and 509 shares held in spouse's IRA.

(9) Includes 3,800 shares held in IRA.

(10) Includes 40,930 shares in Mr. Brumfield's account in the 401(k) Plan;
3,426 shares allocated to his account in the ESOP; and 7,923 shares
granted to Mr. Brumfield as restricted stock awards pursuant to the MRP
and the Officer Incentive Plan, over which Mr. Brumfield exercises
voting power.

(11) Includes 17,026 shares in Mr. Osborne's account in the 401(k) Plan;
3,073 shares allocated to his account in the ESOP; and 5,299 shares
granted to Mr. Osborne as restricted stock awards pursuant to the MRP
and the Officer Incentive Plan, over which Mr. Osborne exercises voting
power.

(12) Includes 5,546 shares in Mr. Richmond's account in the 401(k) Plan;
2,481 shares allocated to his account in the ESOP; and 6,249 shares
granted to Mr. Richmond as restricted stock awards pursuant to the MRP
and the Officer Incentive Plan, over which Mr. Richmond exercises
voting power.

(13) Includes shares held by certain directors and officers as custodians
under Uniform Transfer to Minors Acts, by their spouses and children,
and for the benefit of certain directors and officers under IRAs as set
forth above. Includes 83,993 shares held in the 401(k) Plan and 13,464
shares allocated to the accounts of executive officers in the ESOP, the
voting of which shares such officers have the power to direct. Also
includes 29,734 shares of restricted stock granted to the executive
officers pursuant to the MRP and the Officer Incentive Plan. Does not
include 125,350 unallocated shares held by the ESOP, the voting of
which is directed by the ESOP Trustees as directed by the Board of
Directors. Includes 104,650 shares, 47,241 shares and 84,000 shares
which directors have the right to purchase pursuant to stock options
granted under the Option Plan, Director Incentive Plan, and 1994 Stock
Option Plan for Non-Employee Directors, respectively. Also includes
142,129 shares and 59,134 shares which executive officers have the
right to purchase pursuant to stock options granted under the Option
Plan and the Officer Incentive Plan, respectively.

102

103

Information regarding arrangements, the operation of which may at
a subsequent date result in a change in control of the Company, is
contained in the section captioned "Merger with First American
National Corporation" under Part I hereof and is incorporated by
reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Under the Financial Institutions Reform, Recovery, and Enforcement Act
of 1989, the Bank's loans to directors and executive officers must be made on
substantially the same terms, including interest rates, as those prevailing for
comparable transactions and must not involve more than the normal risk of
repayment or present other unfavorable features. Furthermore, loans above the
greater of $25,000 or 5% of the Bank's capital and surplus (i.e., up to
$2,618,910 at June 30, 1995) to such persons must be approved in advance by a
disinterested majority of the Board of Directors. The Bank has a policy of
offering loans to officers and directors and employees in the ordinary course of
business, on substantially the same terms, including interest rates and
collateral, as those prevailing at the time for comparable transactions with
other persons. These loans do not involve more than the normal risk of
collectibility or present other unfavorable features. In addition, it has been
the practice to approve a $100,000 personal line of credit for each director.
Beyond that, officers and directors may only borrow for housing, personal
consumer loans, education or loans secured by savings accounts. Directors, from
the time of their election, and officers have not been permitted to borrow from
the institution for outside business purposes. Loans outstanding to directors
and executive officers during fiscal year 1995 were made at the prevailing
interest rates and on terms available to other customers of the Bank.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a) List of Documents Filed as Part of this Report

(1) Financial Statements. The following financial statements are
included under Item 8 hereof.

Independent Accountants' Report

Consolidated Statements of Financial Condition as of June 30, 1995
and 1994

Consolidated Statements of Income for the Years Ended June 30,
1995, 1994 and 1993

Consolidated Statements of Stockholders' Equity for the Years
Ended June 30, 1995, 1994 and 1993

Consolidated Statements of Cash Flows for the Years Ended June 30,
1995, 1994 and 1993

Notes to Consolidated Financial Statements.

(2) Financial Statement Schedules. The following financial statement
schedules are filed herewith:

None.

103

104

(3) Exhibits. The following is a list of exhibits filed as part of
this Annual Report on Form 10-K and is also the Exhibit Index.

Page in
Sequentially
No. Exhibits Numbered Copy
---- -------- -------------

2(a) Agreement and Plan of Merger, dated as of February 21, 1995
between First American Corporation and Heritage Federal
Bancshares, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . *
(b) Amendment dated May 17, 1995 to Agreement and Plan of Merger dated
February 21, 1995 between First American Corporation and Heritage
Federal Bancshares, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3(a) Certificate of Incorporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . **
(b) Bylaws . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . **
10(a) Management Recognition Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ***
(b) Stock Option Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ***
(c) Form of Employment Agreements between Heritage Federal Bank for Savings
and William E. Kreis, Richard D. Brumfield, Don R. Osborne and
William F. Richmond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ***
(d) Revised Form of Agreement for Split Dollar Insurance Program . . . . . . . . . . . . . . . . . . . .
(e) Heritage Federal Bancshares, Inc. Incentive Compensation Plan for Senior
Officers, as amended . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ****
(f) Heritage Federal Bancshares, Inc. Incentive Compensation Plan for
Non-Employee Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ****
(g) Heritage Federal Bancshares, Inc. 1994 Stock Option Plan for
Non-Employee Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ****
21 Subsidiaries of the Registrant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
23 Consent of Coopers & Lybrand L.L.P. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

- ---------------
* Incorporated by reference to Exhibit 2 to the Company's Current Report
on Form 8-K filed February 23, 1995

** Incorporated by reference to the Company's Registration Statement on
Form S-1 (File No. 33-44674).

*** Incorporated by reference to the Company's Annual Report on Form 10-K
for the year ended June 30, 1992.

**** Incorporated by reference to the Company's Annual Report on Form 10-K
for the year ended June 30, 1994.

(b) Reports on Form 8-K. No reports on Form 8-K were filed by the
Company during the last quarter of the fiscal year covered by this report on
Form 10-K.

(c) Exhibits. The exhibits required by Item 601 of Regulation S-K are
either filed as part of this Annual Report on Form 10-K or incorporated herein
by reference.

(d) Financial Statements and Financial Statement Schedules Excluded
From Annual Report. There are no other financial statements and financial
statement schedules which were excluded from the Annual Report to stockholders
pursuant to Rule 14a- 3(b)(1) which are required to be included herein.

104

105

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

HERITAGE FEDERAL BANCSHARES, INC.

August 18, 1995 By: /s/ William E. Kreis
--------------------------------------
William E. Kreis
President and Chief Executive Officer
(Duly Authorized Representative)

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

/s/ William E. Kreis August 18, 1995
- -----------------------------------------------
William E. Kreis
President, Chief Executive Officer and Director
(Principal Executive Officer)

/s/ William F. Richmond August 18, 1995
- -----------------------------------------------
William F. Richmond
Senior Vice President, Chief Financial
Officer and Treasurer
(Principal Financial and Accounting Officer)

/s/ Sam H. Anderson August 18, 1995
- -----------------------------------------------
Sam H. Anderson, Jr.
Chairman of the Board
(Director)

/s/ John C. Bracy August 18, 1995
- -----------------------------------------------
John C. Bracy
(Director)

/s/ Clyde W. Craven August 18, 1995
- -----------------------------------------------
Clyde W. Craven
(Director)

/s/ Robert C. Fox August 18, 1995
- -----------------------------------------------
Robert C. Fox
(Director)

/s/ Thomas E. LaGuardia, Jr. August 18, 1995
- -----------------------------------------------
Thomas E. LaGuardia, Jr.
(Director)

/s/ Richard A. Manahan August 18, 1995
- -----------------------------------------------
Richard A. Manahan
(Director)

/s/ C. Mack Patton August 18, 1995
- -----------------------------------------------
C. Mack Patton
(Director)

106

EXHIBIT 2(b)

107
AMENDMENT TO
AGREEMENT AND PLAN OF MERGER

This AMENDMENT (the "Amendment") to the AGREEMENT AND PLAN OF MERGER
dated as of February 21, 1995 (the "Agreement"), between First American
Corporation, a Tennessee corporation ("FAC") and Heritage Federal Bancshares,
Inc., a Tennessee corporation ("HFB") is made and entered as of May 17, 1995.

W I T N E S S E T H :

WHEREAS, the parties hereto have heretofore entered into the
Agreement which contemplated that the Merger of HFB with and into FAC would be
accounted for as a purchase; and

WHEREAS, FAC now desires to account for the Merger as a pooling and
the parties hereto desire to amend the Agreement as hereinafter set forth in
order to facilitate such accounting treatment.

NOW, THEREFORE, in consideration of the foregoing and the respective
representations, warranties, covenants and agreements set forth herein, the
parties hereto agree as follows:

1. Section 4.2(i) is hereby amended to delete the following:

"except with respect to the 1992 Plan and the 1994 Plan and the
Director Incentive Plan (A) to permit transfer of non-qualified
options to family members or non-profit charitable organizations or
(B) to permit exercise of such non-qualified options at any time
during the term thereof irrespective of service with HFB (or any
Subsidiary thereof) or any successor thereto"

so that Section 4.2(i) shall read in its entirety as follows:

(i) adopt any new employee benefit plan or program or make any
material change in or to any existing employee benefit plans or
programs of any HFB or any Subsidiary except as contemplated by
Section 5.9 herein or except as required by law; or make any
discretionary matching contributions or discretionary contributions
to any employee benefit plan of HFB or any Subsidiary thereof; or

2. Section 3.2(j) is hereby amended to delete the following:

108

"however, it is FAC's current intention to repurchase up to 80% of
such number of shares prior to or substantially concurrent with the
consummation of the Merger pursuant to Rule 10b-18 of the SEC and in
a manner which does not prohibit FAC from entering into pooling
transactions within two years from such repurchases"

so that Section 3.2(j) shall read in its entirety as follows:

(j) Consideration. FAC has reserved or will reserve for issuance
sufficient shares of FAC Common Stock for issuance in the Merger.

3. Section 5.9(a) is hereby amended by deleting its contents in
its entirety and adding the following:

FAC and HFB acknowledge that the Heritage Federal Bank for Savings
Employee Stock Ownership Plan and Trust (the "ESOP") has unallocated
assets with a fair market value exceeding the outstanding balance of
the loan secured by those assets. Without changing the existing
vesting and allocation provisions in the ESOP (or in any of FAC's
qualified plans), the parties intend that current employees of HFB
will benefit from this investment. Therefore, after the Effective
Time and until all unallocated shares now held by the ESOP are
released from collateral pledge and allocated to current HFB
employees (the "100% Allocation Date"), the ESOP will be continued as
a separate plan for the benefit of current employees of HFB eligible
to participate therein in accordance with ESOP's terms for so long as
a separate plan is legally permissible under the Internal Revenue
Code and the rules promulgated thereunder without causing
disqualification of the ESOP. If before the 100% Allocation Date, it
becomes legally impermissible under the Internal Revenue Code and the
rules promulgated thereunder to maintain the ESOP as a separate plan,
to the extent legally permissible under Internal Revenue Code
qualification requirements, the assets now held by the ESOP shall
continue to be allocated only to current employees of HFB, until the
100% Allocation Date.

4. HFB agrees that no holder of any options to purchase HFB Common
Stock shall be entitled to receive cash in lieu thereof.

5. Capitalized terms, not specifically defined herein shall have
the meanings ascribed to them in the Agreement.

6. This Amendment shall become effective retroactively to the
execution of the Agreement. Except as expressly provided above, all of the
terms and conditions of the Agreement shall remain unchanged and in full force
and effect.

IN WITNESS WHEREOF, FAC and HFB have caused this Amendment to be

109

signed by their respective officers thereunto duly authorized, all as of May 17,
1995.

[FIRST AMERICAN CORPORATION CORPORATE SEAL]

FIRST AMERICAN CORPORATION

BY: /s/ Dennis C. Bottorff
------------------------
Dennis C. Bottorff
Chairman and Chief Executive Officer

Attest:

Mary C.
- ----------------------------

Title: Assistant Secretary
----------------------

HERITAGE FEDERAL BANCSHARES, INC.

BY:
-------------------------
William E. Kreis
President and Chief Executive Officer

Attest:

- ----------------------------

Title:
----------------------

110

EXHIBIT 10(d)

111
SPLIT DOLLAR AGREEMENT

THIS AGREEMENT, made and entered into this ________ day of ________
1994, between HERITAGE FEDERAL BANK FOR SAVINGS, a Corporation chartered under
the laws of the United States, with its principal office located in the State of
Tennessee (hereinafter referred to as the "Employer", and _____________________,
an individual residing in the State of Tennessee (hereinafter referred to as the
"Employee").

WHEREAS, the Employee is a valuable employee of the Employer; and

WHEREAS, the Employee wishes to provide life insurance protection for
his/her family in the event of his/her death, under a life insurance policy
insuring his/her life (hereinafter referred to as the "Policy"); and

WHEREAS, the Employer is willing to assist in the payment of the
Policy premiums; and

WHEREAS, the Employer will retain the ownership of the Policy in
order to secure the payment of the cash value of the Policy to it as
reimbursement for premiums advanced by it;

NOW, THEREFORE, the parties hereto mutually agree:

PURCHASE OF POLICY

The Employer has purchased or will purchase the Policy from the Canada Life
Assurance Company or Canada Life Insurance Company of New York (the applicable
company to be hereinafter called "Insurer") in the total face amount of
$____________, ________________, such Policy being more fully described in
Exhibit "A" attached hereto and made a part hereof.

The parties agree that, as between them, the policy shall be subject to the
terms of this agreement and to the terms of the endorsement to such Policy
filed or to be filed with the Insurer (hereinafter referred to as the
"Endorsement").

POLICY OWNERSHIP

The Employer shall be the owner of the Policy, and may exercise all rights
granted to the owner by the terms of the Policy, except as otherwise provided
herein and in the Endorsement.

RIGHT TO DESIGNATE BENEFICIARY

The Employee shall have the right to designate a beneficiary or beneficiaries to
receive Policy death proceeds as well as the right to elect and change a
payment option for such beneficiaries, but subject always to any right or
interest which the Employer may have in such proceeds as provided in this
Agreement or in the Endorsement.

PREMIUM PAYMENTS

The Employer shall pay the entire policy premium billed by the insurer on or
before the due date for each premium due date on the policy.

112

DISABILITY WAIVER OF PREMIUMS

Notwithstanding any other provision in this agreement to the contrary, if the
Policy contains a disability waiver of premium provision, the Employee shall pay
all premiums attributable to such provision, and any premium waived shall be
considered as having been paid by the Employee.

DEATH PROCEEDS

Upon the death of the Employee, the Employer shall make prompt arrangements to
obtain the Policy death proceeds. The Employer shall retain a portion of such
death proceeds equal to the Premiums Paid by it under this agreement or, if
greater, the Cash Surrender Value of the Policy. For purposes of this section
entitled "Death Proceeds" and the section entitled "Termination of Agreement",
"Cash Surrender Value" shall refer to the amount of cash surrender value
existing within the Policy immediately prior to the death of the Policy insured,
net of any Policy surrender charges. For purposes of computing the Employer's
share under this section entitled, "Death Proceeds" and under the section
entitled "Termination of Agreement", the term "Premiums Paid" shall mean total
premiums paid by the Employer less any outstanding Policy indebtedness incurred
by the Employer, including any interest due on such indebtedness, and by other
amounts taken from the Policy by the Employer, including amounts received in the
form of withdrawals, partial surrenders or dividend payments. The balance of
the death proceeds, if any, shall be paid to the beneficiary or beneficiaries
designated by the Employee in accordance with the Endorsement.

TERMINATION OF AGREEMENT

This agreement shall terminate immediately upon the termination of the
Employee's employment (other than by reason of his/her death). The Employer may
terminate this agreement by written notice to the Employee with such termination
to be effective as of the date of such notice; provided, however, that in the
event of a change in control of Heritage Federal Bancshares, Inc. the parent
corporation of the Employer, the Employer may not elect to terminate this
agreement except upon termination of the Employee's employment for a just cause.
"Just Cause" shall mean termination because of the Employee's personal
dishonesty, incompetency, willful misconduct, breach of fiduciary duty
involving personal profit, intentional failure to perform stated duties, willful
violation of any law, rule or regulation, other than traffic violations or
similar offenses, or final cease-and-desist order. The term "control" shall
refer to the ownership, holding, or power to vote more than 25% of the Bank's or
Parent's voting stock, the control of the election of a majority of the Bank's
or Parent's directors, or the exercise of a controlling influence over the
management or policies of Heritage Federal Bancshares, Inc. by any person or by
persons acting as a group within the meaning of Section 13(d) of the Securities
Exchange Act of 1934. The term "person" means an individual other than the
Employee or a corporation, partnership, trust, association, joint venture, pool,
syndicate, sole proprietorship, unincorporated organization or any other form of
entity not specifically listed herein.

No termination of this agreement shall affect or impair any party's right to
Policy proceeds as such rights exist immediately prior to such termination.
Upon termination of this agreement for any reason specified in this section
entitled "TERMINATION OF AGREEMENT", the Employee shall have a thirty (30) day
option to receive from the Employer an absolute assignment of the Policy in
exchange for

113

a dollar amount equal to: (i) the Cash Surrender Value of the Policy or (ii)
the aggregate of Premiums Paid by the Employer, whichever is greater. Should
the Employee fail to exercise such option within the allowable period, the
Employer shall become the sole owner of all rights in the Policy and may deal
with the Policy as it, in its sole discretion, deems appropriate. The Employee
shall timely take all necessary measures to enable the Employer to enforce any
such right.

LIMITATION OF INSURER LIABILITY

In the event of the death of the insured under the Policy, the Insurer shall be
fully discharged from its obligations under the Policy by payment of the Policy
death proceeds to the Employer, to the beneficiary or beneficiaries named in the
Endorsement, or to any or all such persons or parties by joint check.

In the event that the Policy lapses or is surrendered during the life of the
insured under the Policy, the Insurer shall be fully discharged from its
obligation under the Policy by payment of the entire cash surrender value to the
employer.

The Insurer shall not be obligated to inquire as to the division or distribution
of any monies payable under this agreement. In no event shall the Insurer be
considered a party to this Agreement. No provision of this agreement shall in
any way be construed as affecting the obligations of the Insurer as provided in
the Policy or the Endorsement.

The following procedures shall govern benefit claims by the Employee or his/her
beneficiary(ies). For purposes of the split dollar life insurance plan
established by this agreement, the Claims Manager shall be Heritage Federal Bank
For Savings.

The Employee or his/her beneficiary(ies) shall make a claim for benefits by
giving written notice of such claim to the Claims Manager, who shall promptly
file the appropriate claim information with the Insurer.

If for any reason a claim for benefits is denied in whole or part, written
notice of such decision shall be furnished to the claimant within ninety (90)
days after receipt of the claim by the Claims Manager. Such notice shall
provide the following information:

(1) The specified reason or reasons for the denial;
(2) Specific reference to pertinent plan provisions on which the
denial is based;
(3) A description of any additional material or information
necessary for the claimant to perfect the claim and an explanation of why such
material or information is necessary; and
(4) An explanation of the plan's Review Procedure described below.

If notice of the claim denial is not furnished within ninety (90) days of the
date a claim is made, the claim shall be deemed denied and the claimant shall
proceed to the Review Procedure described below.

This procedure is established to provide the claimant a reasonable opportunity
to appeal a denied claim and obtain a full and fair review.

114

Upon denial of a claim, the claimant or his/her duly authorized representative
may:

(1) Request a review upon written application to the Claims
Manager;
(2) Review pertinent documents; and
(3) Submit issues and comments in writing.

A request for review must be made in writing by the claimant or his/her duly
authorized representative within sixty (60) days after receipt by the claimant
of written notification of denial of a claim.

A decision on review of a denied claim shall be made promptly by the Claims
Manager. Ordinarily this will be within sixty (60) days after the Claims
Manager's receipt of a request for review. Special circumstances may require an
extension of the time for processing, in which case a decision shall be rendered
as soon as possible, but not later than ninety (90) days after receipt of a
request for review. The Claims manager, in his/her discretion, may conduct a
hearing on the denied claim.

The decision on review shall be in writing and shall include specific reasons
for the decision, written in a manner calculated to be understood by the
claimant, as well as specific references to the pertinent plan provisions on
which the decision is based.

For purposes of the Employee Retirement Income Security Act of 1974 (ERISA), the
Employer will be the Named Fiduciary and Plan Administrator of the split dollar
insurance plan for which this agreement is hereby designated the written plan
instrument. The Employer may authorize a person or group of persons to fulfill
the responsibilities of the Employer as Plan Administrator.

The Named Fiduciary and/or the Plan Administrator may employ others to render
advice with regard to its responsibilities under this plan.

The Named Fiduciary may allocate fiduciary responsibilities to others and may
exercise any other powers necessary for the discharge of its duties to the
extent that the exercise of such powers does not conflict with the employee
Retirement Income Security Act of 1974 (ERISA).

PARTIES BOUND

This agreement shall be binding upon and inure to the benefit of the Employer
and its successors and assigns, and the Employee, his/her successors, assigns,
heirs, executors, administrators and beneficiaries.

NOTICES, CONSENTS AND DEMANDS

Any notice, consent or demand under this agreement shall be in writing, and
shall be signed by the party giving or making same. Such notice, consent or
demand shall be sent by United States certified mail, postage prepaid and
addressed to such party's last known address as shown on the records of the
Employer. The date of such mailing shall be deemed the date of such notice,
consent or demand.

FUNDING POLICY

The Funding Policy for this Split Dollar arrangement shall be:

115

(a) To maintain the policy in force by paying the premiums when due as
billed by the insurer.

(b) Dividends declared by the Insurer on the policy will be applied to
purchase additional paid-up insurance on the life of the Employee.

(c) The Employer has established and funded a separate fund for payment
of future premiums on the Employee's policy until termination of this agreement.
If the Employee's employment is terminated prior to any change in control as
defined herein, then the Employee's allocated share from this separate fund
shall belong to the Employer. In the event of a change in control and
termination of Employee's employment for any reason other than just cause then
the Employer agrees that the Employee's allocated portion of the separate fund
shall be paid to the Employee. In the event of a change in control and
termination of the Employee for just cause then the Employee's allocated share
of the separate fund shall belong to the Employer. Subject to the terms of this
agreement the Employer agrees that this separate fund shall be used solely to
pay future premiums on the Employee's policies included in the Employers Split
Dollar Life Insurance arrangement.

(d) Notwithstanding any of the provisions herein provided, if an
Employee is terminated for just cause then all rights in the Employee's policy
included in this Split Dollar Life Insurance Arrangement shall be forfeited by
the Employee and the policy of such terminated Employee shall belong to the
Employer.

INTERPRETATION

When appropriate in this agreement, words used in the singular shall include the
plural (and vice versa) and words used in the masculine shall include the
feminine (and vice versa). The section captions used in this agreement are for
organizational purposes only and shall have no determinative effect upon the
rights and duties created hereunder.

GOVERNING LAW

This agreement shall be governed by and construed in accordance with the laws of
the State of Tennessee.

IN WITNESS WHEREOF, the parties hereto have executed this agreement as of the
day and year first above written.

HERITAGE FEDERAL BANK FOR SAVINGS

BY
-------------------------------
TITLE
--------------------------
"EMPLOYER"

- ---------------------------------
"EMPLOYEE"

5
116

EXHIBIT A

Life Insurance Life Insurance Policy Identification Face
Company Name Plan Name Number Amount
- -------------- -------------- --------------------- -----

The Canada Life Heritage Federal Bank 2638 290 $130,000
Assurance Co. Split dollar Plan

117
EXHIBIT 21

SUBSIDIARIES OF THE REGISTRANT

PARENT

Heritage Federal Bancshares, Inc.

State or Other
Jurisdiction of Percentage
Subsidiaries (1) Incorporation Ownership
- ---------------- --------------- ----------

Heritage Federal Bank for Savings United States 100%

Subsidiary of Heritage Federal Bank for Savings (1)
- ---------------------------------------------------

Citizens Financial Corporation Tennessee 100%

- ------------------
(1) The assets, liabilities, and operations of the subsidiaries are included in
the consolidated financial statements contained in Item 8 of this Form
10-K.

118

EXHIBIT 23

119
[COOPERS & LYBRAND LETTERHEAD]

CONSENT OF INDEPENDENT ACCOUNTANTS

The Board of Directors
Heritage Federal Bancshares, Inc.:

We consent to the incorporation by reference in the registration statements of
Heritage Federal Bancshares, Inc. on Forms S-8 (File No. 33-46285, File No.
33-56160 and File No. 33-85482) of our report dated August 1, 1995, on our
audits of the consolidated financial statements of Heritage Federal Bancshares,
Inc. as of June 30, 1995 and 1994, and for the years ended June 30, 1995, 1994,
and 1993, which report is included in this Annual Report on Form 10-K.

/s/ Coopers & Lybrand L.L.P
---------------------------

Knoxville, Tennessee
August 17, 1995