##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 
 FORM 10-QSB
 QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2006  Commission File Number 000-51305
 
 
 HERITAGE FINANCIAL GROUP
 
 310 W. Oglethorpe Blvd., Albany, GA 31701
229-420-0000
 þ o
 o þ
 APPLICABLE ONLY TO CORPORATE ISSUERS
   o þ




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##### 



HERITAGE FINANCIAL GROUP
 INDEX
 PageNumberPART I  FINANCIAL INFORMATIONITEM 1. FINANCIAL STATEMENTSCONSOLIDATED BALANCE SHEETS AS OF
SEPTEMBER 30, 2006 AND DECEMBER 31, 2005
    
    
    3CONSOLIDATED STATEMENTS OF INCOME
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
    
    
    4CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
    
    
    5CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND THE YEAR ENDED
DECEMBER 31, 2005
    
    
    6CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
    
    
    7CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
    
    
    8ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS
    
    
    10ITEM 3. CONTROLS AND PROCEDURES
    
    
    19PART II  OTHER INFORMATION
    
    
    20ITEM 1. LEGAL PROCEEDINGS
    
    
    20ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
    
    
    20ITEM 6. EXHIBITS
    
    
    20SIGNATURES
    
    
    21EXHIBITSEx-31.1 Section 302 CertificationEx-31.2 Section 302 CertificationEx-32   Section 906 Certification
  31.1
    
    
    Rule 13a14(a) Certification of Chief Executive Officer31.2
    
    
    Rule 13a14(a) Certification of Chief Financial Officer32
    
    
    Section 1350 Certification
 2




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##### Table of Contents



HERITAGE FINANCIAL GROUP AND SUBSIDIARY
 
 Consolidated Balance Sheets
September 30, 2006 and December 31, 2005
 Unaudited
    
    
    AuditedSeptember 30,
    
    
    December 31,2006
    
    
    2005AssetsCash and due from banks
    
    $
    8,988,187
    
    
    $
    10,499,084Interest-bearing deposits in banks
    
    
    456,296
    
    
    
    1,387,046Federal funds sold
    
    
    4,039,000
    
    
    
    6,820,000Securities available for sale, at fair value
    
    
    58,155,977
    
    
    
    64,866,021Federal home loan bank stock, at cost
    
    
    2,949,400
    
    
    
    2,927,000Loans
    
    
    279,479,765
    
    
    
    254,110,534Less allowance for loan losses
    
    
    4,171,928
    
    
    
    3,617,678Loans, net
    
    
    275,307,837
    
    
    
    250,492,856Premises and equipment, net
    
    
    13,059,978
    
    
    
    12,004,468Accrued interest receivable
    
    
    1,899,116
    
    
    
    1,666,629Foreclosed assets
    
    
    448,550
    
    
    
    59,272Intangible assets
    
    
    1,000,000
    
    
    
    Cash surrender value of bank owned life insurance
    
    
    8,210,773
    
    
    
    7,987,442Other assets
    
    
    6,037,126
    
    
    
    5,086,968$
    380,552,240
    
    
    $
    363,796,786Liabilities and Stockholders EquityDepositsNoninterest-bearing
    
    $
    14,317,345
    
    
    $
    14,059,406Interest-bearing
    
    
    237,590,768
    
    
    
    224,580,863Total deposits
    
    
    251,908,113
    
    
    
    238,640,269Federal funds purchased and securities sold under
repurchase agreements
    
    
    4,040,834
    
    
    
    237,222Other borrowings
    
    
    50,000,000
    
    
    
    50,000,000Other liabilities
    
    
    6,520,949
    
    
    
    5,935,648Total liabilities
    
    
    312,469,896
    
    
    
    294,813,139Commitments and contingenciesStockholders equityPreferred stock, par value $0.01; 1,000,000 shares authorized;
no shares issued
    
    
    
    
    
    
    Common stock, par value $0.01; 25,000,000 shares authorized;
11,446,155 and 11,241,250 issued and outstanding
    
    
    114,462
    
    
    
    112,413Capital surplus
    
    
    39,935,822
    
    
    
    37,126,877Retained earnings
    
    
    39,704,340
    
    
    
    38,717,576Accumulated other comprehensive loss
    
    
    (2,512,293
    )
    
    
    (2,786,569
    )Unearned compensation
    
    
    (2,380,249
    )
    
    
    Unearned employee stock ownership plan (ESOP) shares,
385,613 and 418,665 shares
    
    
    (3,856,125
    )
    
    
    (4,186,650
    )71,005,957
    
    
    
    68,983,647Treasury stock, at cost, 220,258 shares
    
    
    (2,923,613
    )
    
    
    Total stockholders equity
    
    
    68,082,344
    
    
    
    68,983,647$
    380,552,240
    
    
    $
    363,796,786
 See Notes to Consolidated Financial Statements.
 3




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##### Table of Contents



HERITAGE FINANCIAL GROUP AND SUBSIDIARY
 
 Consolidated Statements of Income (Unaudited)
For the Three and Nine Months Ended September 30, 2006 and 2005
 Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Interest incomeInterest and fees on loans
    
    $
    4,998,436
    
    
    $
    4,217,212
    
    
    $
    13,916,955
    
    
    $
    11,888,545Interest on taxable securities
    
    
    640,647
    
    
    
    644,093
    
    
    
    1,950,192
    
    
    
    1,799,412Interest on nontaxable securities
    
    
    51,959
    
    
    
    56,749
    
    
    
    175,050
    
    
    
    217,724Interest on federal funds sold
    
    
    96,571
    
    
    
    63,261
    
    
    
    316,144
    
    
    
    206,503Interest on deposits in other banks
    
    
    5,895
    
    
    
    13,397
    
    
    
    32,761
    
    
    
    29,1865,793,508
    
    
    
    4,994,712
    
    
    
    16,391,102
    
    
    
    14,141,370Interest expenseInterest on deposits
    
    
    1,586,597
    
    
    
    1,002,725
    
    
    
    4,060,743
    
    
    
    2,963,269Interest on other borrowings
    
    
    611,249
    
    
    
    473,603
    
    
    
    1,677,922
    
    
    
    1,395,5022,197,846
    
    
    
    1,476,328
    
    
    
    5,738,665
    
    
    
    4,358,771Net interest income
    
    
    3,595,662
    
    
    
    3,518,384
    
    
    
    10,652,437
    
    
    
    9,782,599Provision for loan losses
    
    
    635,000
    
    
    
    250,000
    
    
    
    695,000
    
    
    
    714,555Net interest income after provision for
loan losses
    
    
    2,960,662
    
    
    
    3,268,384
    
    
    
    9,957,437
    
    
    
    9,068,044Noninterest incomeService charges on deposit accounts
    
    
    910,236
    
    
    
    859,058
    
    
    
    2,222,526
    
    
    
    2,331,651Other service charges, commissions and fees
    
    
    278,124
    
    
    
    121,330
    
    
    
    731,661
    
    
    
    559,870Brokerage fees
    
    
    125,789
    
    
    
    172,470
    
    
    
    392,365
    
    
    
    453,194Mortgage origination fees
    
    
    116,558
    
    
    
    122,927
    
    
    
    338,696
    
    
    
    299,001Bank owned life insurance
    
    
    76,429
    
    
    
    76,126
    
    
    
    223,331
    
    
    
    221,886Loss on sale of securities
    
    
    (11,239
    )
    
    
    
    
    
    
    (11,239
    )
    
    
    (4,653
    )Other
    
    
    25,087
    
    
    
    38,844
    
    
    
    178,265
    
    
    
    203,1521,520,984
    
    
    
    1,390,755
    
    
    
    4,075,605
    
    
    
    4,064,101Noninterest expenseSalaries and employee benefits
    
    
    2,325,747
    
    
    
    1,814,602
    
    
    
    6,538,907
    
    
    
    5,242,745Equipment
    
    
    285,499
    
    
    
    335,283
    
    
    
    913,140
    
    
    
    1,247,486Occupancy
    
    
    278,333
    
    
    
    267,327
    
    
    
    782,317
    
    
    
    738,985Advertising and marketing
    
    
    84,310
    
    
    
    48,666
    
    
    
    242,527
    
    
    
    182,488Legal and accounting
    
    
    205,766
    
    
    
    93,783
    
    
    
    546,088
    
    
    
    290,181Directors fees and retirement
    
    
    149,860
    
    
    
    73,644
    
    
    
    354,167
    
    
    
    218,332Telephone
    
    
    79,418
    
    
    
    63,509
    
    
    
    206,833
    
    
    
    187,171Supplies
    
    
    80,461
    
    
    
    61,398
    
    
    
    191,776
    
    
    
    173,687Data processing fees
    
    
    252,800
    
    
    
    161,161
    
    
    
    665,278
    
    
    
    353,761Other operating
    
    
    514,542
    
    
    
    281,196
    
    
    
    1,425,703
    
    
    
    958,7284,256,736
    
    
    
    3,200,569
    
    
    
    11,866,736
    
    
    
    9,593,564Income before income taxes
    
    
    224,910
    
    
    
    1,458,570
    
    
    
    2,166,306
    
    
    
    3,538,581Applicable income taxes
    
    
    63,141
    
    
    
    466,573
    
    
    
    673,457
    
    
    
    1,149,191Net income
    
    $
    161,769
    
    
    $
    991,997
    
    
    $
    1,492,849
    
    
    $
    2,389,390Basic earnings per share
    
    $
    .02
    
    
    $
    .09
    
    
    $
    .14
    
    
    $
    .27Diluted earnings per share
    
    $
    .02
    
    
    $
    .09
    
    
    $
    .14
    
    
    $
    .27
 See Notes to Consolidated Financial Statements.
 4




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##### Table of Contents



HERITAGE FINANCIAL GROUP AND SUBSIDIARY
 
 Consolidated Statements of Comprehensive Income (Unaudited)
For the Three and Nine Months Ended September 30, 2006 and 2005
 Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Net income
    
    $
    161,769
    
    
    $
    991,997
    
    
    $
    1,492,849
    
    
    $
    2,389,390Other comprehensive income (loss):Reclassification adjustment for losses
included in net income, net of tax benefit
of $4,457 and $- for the quarter and $4,457
and $1,861 for the year to date
    
    
    6,781
    
    
    
    
    
    
    
    6,781
    
    
    
    2,792Unrealized holding gains (losses) arising
during period, net of tax (benefit) of
$499,982 and $(141,420) for the
quarter and $175,820 and $(256,728)
for the year to date
    
    
    760,677
    
    
    
    (212,130
    )
    
    
    267,495
    
    
    
    (398,592
    )Total other comprehensive income (loss)
    
    
    767,458
    
    
    
    (212,130
    )
    
    
    274,276
    
    
    
    (395,800
    )Comprehensive income
    
    $
    929,227
    
    
    $
    779,867
    
    
    $
    1,767,125
    
    
    $
    1,993,590
 See Notes to Consolidated Financial Statements.
 5




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##### Table of Contents



HERITAGE FINANCIAL GROUP AND SUBSIDIARY
 
 Consolidated Statements of Stockholders Equity
For the Nine Months Ended September 30, 2006 (Unaudited) and the Year Ended December 31, 2005
 AccumulatedUnearned
    
    
    
    
    
    
    
    
    
    
    OtherCommon Stock
    
    
    Capital
    
    
    Retained
    
    
    ESOP
    
    
    Unearned
    
    
    Treasury
    
    
    ComprehensiveShares
    
    
    Par Value
    
    
    Surplus
    
    
    Earnings
    
    
    Shares
    
    
    Compensation
    
    
    Stock
    
    
    Income (Loss)
    
    
    TotalBalance, December 31, 2004
    
    
    1,000
    
    
    $
    10
    
    
    $
    4,799,990
    
    
    $
    35,935,700
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    (1,601,946
    )
    
    $
    39,133,754Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,950,495
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,950,495Cash dividends declared,
$.05 per share
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (168,619
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (168,619
    )Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,184,623
    )
    
    
    (1,184,623
    )Issuance of 7,867,875 shares
of common stock to
Heritage, MHC
    
    
    7,867,875
    
    
    
    78,679
    
    
    
    (78,679
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Sale of 3,372,375 shares of
common stock in an initial
public offering, net of
issuance costs
    
    
    3,372,375
    
    
    
    33,724
    
    
    
    32,384,337
    
    
    
    
    
    
    
    (4,407,000
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    28,011,061ESOP shares earned,
22,035 shares
    
    
    
    
    
    
    
    
    
    
    21,229
    
    
    
    
    
    
    
    220,350
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    241,579Balance, December 31, 2005
    
    
    11,241,250
    
    
    
    112,413
    
    
    
    37,126,877
    
    
    
    38,717,576
    
    
    
    (4,186,650
    )
    
    
    
    
    
    
    
    
    
    
    (2,786,569
    )
    
    
    68,983,647Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,492,849
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,492,849Cash dividends declared,
$0.15 per share
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (506,085
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (506,085
    )Issuance of restricted shares
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    of common stock
    
    
    204,905
    
    
    
    2,049
    
    
    
    2,567,460
    
    
    
    
    
    
    
    
    
    
    
    (2,569,509
    )
    
    
    
    
    
    
    
    
    
    
    Amortization of unearned
compensation, net of
forfeitures
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    189,260
    
    
    
    
    
    
    
    
    
    
    
    189,260Compensation expense related
to stock option plans
    
    
    
    
    
    
    
    
    
    
    149,661
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    149,661Repurchase of 220,328 shares
for the treasury
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,924,542
    )
    
    
    
    
    
    
    (2,924,542
    )Issuance of 70 shares of
common stock from the
treasury
    
    
    
    
    
    
    
    
    
    
    141
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    929
    
    
    
    
    
    
    
    1,070Other comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    274,276
    
    
    
    274,276ESOP shares earned,
33,053 shares
    
    
    
    
    
    
    
    
    
    
    91,683
    
    
    
    
    
    
    
    330,525
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    422,208Balance, September 30, 2006
    
    
    11,446,155
    
    
    $
    114,462
    
    
    $
    39,935,822
    
    
    $
    39,704,340
    
    
    $
    (3,856,125
    )
    
    $
    (2,380,249
    )
    
    $
    (2,923,613
    )
    
    $
    (2,512,293
    )
    
    $
    68,082,344
 See Notes to Consolidated Financial Statements.
 6




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##### Table of Contents



HERITAGE FINANCIAL GROUP AND SUBSIDIARY
 
 Consolidated Statements of Cash Flows (Unaudited)
For the Nine Months Ended September 30, 2006 and 2005
 Nine Months EndedSeptember 30,2006
    
    
    2005OPERATING ACTIVITIESNet income
    
    $
    1,492,849
    
    
    $
    2,389,390Adjustments to reconcile net income to net cash
provided by operating activities:Depreciation and amortization
    
    
    795,785
    
    
    
    982,354Provision for loan losses
    
    
    695,000
    
    
    
    714,555ESOP compensation expense
    
    
    422,208
    
    
    
    Stock option plan expenses
    
    
    149,661
    
    
    
    Amortization of unearned compensation
    
    
    189,260
    
    
    
    Net losses on sale of securities available for sale
    
    
    11,239
    
    
    
    4,653Net (increase) decrease in foreclosed assets
    
    
    (389,278
    )
    
    
    81,118Increase in bank owned life insurance
    
    
    (223,331
    )
    
    
    (221,885
    )Increase in interest receivable
    
    
    (232,487
    )
    
    
    (96,811
    )Increase (decrease) in interest payable
    
    
    53,898
    
    
    
    (2,095
    )Increase (decrease) in taxes payable
    
    
    (252,638
    )
    
    
    473,284Net other operating activities
    
    
    (346,395
    )
    
    
    382,120Total adjustments
    
    
    872,922
    
    
    
    2,317,293Net cash provided by operating activities
    
    
    2,365,771
    
    
    
    4,706,683INVESTING ACTIVITIES(Increase) decrease in interest-bearing deposits in banks
    
    
    930,750
    
    
    
    (864,330
    )Purchases of securities available for sale
    
    
    (3,495,155
    )
    
    
    (31,079,327
    )Proceeds from maturities of securities available for sale
    
    
    3,730,080
    
    
    
    22,066,425Proceeds from sale of securities available for sale
    
    
    6,918,434
    
    
    
    2,874,694Net change in Federal home loan bank stock
    
    
    (22,400
    )
    
    
    Redemption of corporate credit union membership shares
    
    
    
    
    
    
    809,135Increase in federal funds sold
    
    
    2,781,000
    
    
    
    3,995,000Purchase of intangible asset
    
    
    (1,000,000
    )
    
    
    Increase in loans, net
    
    
    (25,509,981
    )
    
    
    (12,327,910
    )Purchase of premises and equipment
    
    
    (1,851,295
    )
    
    
    (275,916
    )Net cash used in investing activities
    
    
    (17,518,567
    )
    
    
    (14,802,229
    )FINANCING ACTIVITIESIncrease (decrease) in deposits
    
    
    13,267,844
    
    
    
    (9,230,379
    )Increase in federal funds purchased and securities sold
under agreement to repurchase
    
    
    3,803,612
    
    
    
    Proceeds from other borrowings
    
    
    25,000,000
    
    
    
    550,000Repayment of other borrowings
    
    
    (25,000,000
    )
    
    
    (6,550,000
    )Proceed from sale of common stock, net of issuance costs
    
    
    
    
    
    
    28,097,480Purchase of treasury shares, net
    
    
    (2,923,472
    )
    
    
    Dividends paid to stockholders
    
    
    (506,085
    )
    
    
    Net cash provided by financing activities
    
    
    13,641,899
    
    
    
    12,867,101Net increase (decrease) in cash and due from banks
    
    
    (1,510,897
    )
    
    
    2,771,555Cash and due from banks at beginning of period
    
    
    10,499,084
    
    
    
    6,621,232Cash and due from banks at end of period
    
    $
    8,988,187
    
    
    $
    9,392,787
 See Notes to Consolidated Financial Statements.
 7




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##### Table of Contents



HERITAGE FINANCIAL GROUP AND SUBSIDIARY
 
 CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 NOTE 1
    
    
    
    BASIS OF PRESENTATION AND ACCOUNTING ESTIMATESThe accompanying consolidated financial information of the Company is unaudited;
however, such information reflects all adjustments (consisting of normal recurring
adjustments) which are, in the opinion of management, necessary for a fair presentation
of the financial position and results of operations. The results of operations for the
three and nine months ended September 30, 2006, are not necessarily indicative of the
results that may be expected for the full year. These statements should be read in
conjunction with the consolidated financial statements and related notes included in the
Companys Annual Report on Form 10-KSB for the year ended December 31, 2005.The consolidated financial statements include the accounts of the Company and its
subsidiary. Significant intercompany transactions and balances have been eliminated in
consolidation.In preparing the consolidated financial statements in conformity with accounting
principles generally accepted in the United States of America, management is required to
make estimates and assumptions that affect the reported amounts of assets and liabilities
as of the date of the balance sheet and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.Material estimates that are particularly susceptible to significant change in the
near-term relate to the determination of the allowance for loan losses, the valuation of
foreclosed real estate, contingent assets and liabilities and deferred tax assets.NOTE 2
    
    
    
    EARNINGS PER SHAREBasic earnings per share are computed by dividing net income by the weighted-average
number of shares of common stock outstanding during the period, excluding unallocated
shares of the Employee Stock Ownership Plan and restricted stock grants. Diluted earnings
per share are computed by dividing net income by the sum of the weighted-average number
of shares of common stock outstanding and dilutive potential common shares. Potential
common shares consist of stock options and restricted stock grants.Prior to June 29, 2005, the Company had 1,000 shares of common stock outstanding held by
its sole shareholder, Heritage, MHC. In connection with the issuance of 3,372,375 shares
of common stock in the public offering completed on June 29, 2005, the Company issued an
additional 7,867,875 shares to Heritage, MHC, so that it would own 70% of the Companys
outstanding shares after the public offering. All per share information has been adjusted
to give effect to the issuance of those 7,867,875 as if it had occurred on January 1,
2005.The components used to calculate basic and diluted earnings per share are summarized
below:
 Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Basic earnings per share:Net income
    
    $
    161,769
    
    
    $
    991,997
    
    
    $
    1,492,849
    
    
    $
    2,389,390Weighted average common shares outstanding
    
    
    10,636,323
    
    
    
    10,800,550
    
    
    
    10,755,262
    
    
    
    8,882,027Total basic earnings per common share
    
    $
    .02
    
    
    $
    .09
    
    
    $
    .14
    
    
    $
    .27Diluted earnings per share:Net income
    
    $
    161,769
    
    
    $
    991,997
    
    
    $
    1,492,849
    
    
    $
    2,389,390Weighted average common shares outstanding
    
    
    10,636,323
    
    
    
    10,800,550
    
    
    
    10,755,262
    
    
    
    8,882,027Effect of dilutive stock options and restricted stock
    
    
    20,280
    
    
    
    
    
    
    
    12,863
    
    
    
    Weighted average dilutive common shares outstanding
    
    
    10,656,603
    
    
    
    10,800,550
    
    
    
    10,768,125
    
    
    
    8,882,027Total diluted earnings per common share
    
    $
    .02
    
    
    $
    .09
    
    
    $
    .14
    
    
    $
    .27
 8




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##### Table of Contents



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 NOTE 3
    
    
    
    SHARE-BASED COMPENSATIONOn May 17, 2006, our stockholders approved the 2006 Equity Incentive Plan (the
Plan). The purpose of the Plan is to promote the long-term growth and profitability of
Heritage Financial Group, to provide directors, advisory directors, officers and
employees of Heritage Financial Group and its affiliates with an incentive to achieve
corporate objectives, to attract and retain individuals of outstanding competence, and to
provide such individuals with an equity interest in Heritage Financial Group. Under the
Plan, the Compensation Committee of the Board of Directors has discretion to award up to
771,149 shares, of which 550,821 were available as stock options or stock appreciation
rights and 220,328 shares were available as restricted stock awards. On May 19, 2006,
the Compensation Committee of the Board of Directors granted stock options and tandem
stock appreciation rights totaling 513,105 shares and granted restricted stock awards
totaling 204,905 shares. All stock options, stock appreciation rights and restricted
stock awards vest over a period of five years.The Company granted restricted awards that may not be sold or otherwise transferred until
certain restrictions have lapsed. The unearned compensation related to these awards is
being amortized to compensation expense over the period the restrictions lapse (generally
one to five years). The share-based expense for these awards was determined based on the
market price of our stock at the date of grant applied to the total number of shares that
were anticipated to fully vest, amortized over the vesting period. As of September 30,
2006, we have unearned compensation of $2,380,249 associated with these awards. We
recognized compensation expense of $128,475 and $189,260 respectively for the three and
nine months ended September 30, 2006.On May 19, 2006, the Company adopted Statement of Financial Accounting Standards No.
123R, Share-Based Payment(SFAS 123R). As a result of adopting SFAS 123R, we recognized
compensation expense related to stock options of $101,594 and $149,661 respectively for
the three and nine months ended September 30, 2006. At September 30, 2006, there was
approximately $1,882,235 of unrecognized compensation related to stock options, which is
expected to be recognized over a period of 4.85 years.The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the assumptions listed in the table below.
Expected volatilities are based on historical volatility of a peer group of the Companys
stock. Expected dividends are based on dividend trends and the market price of the
Companys stock price at grant. Historical data is used to estimate option exercises and
employee terminations within the valuation model. The risk-free rate for periods within
the contractual life of the option is based on the U.S. Treasury yield curve in effect at
the time of grant. Based on these assumptions, all options outstanding at September 30,
2006, had a fair value per option of $3.96 per share.
 For the Three Monthsand Nine MonthsEndedSeptember 30, 2006Risk-free interest rate
    
    
    4.5
    %Expected life of the options
    
    10 yearsExpected annual dividend rate
    
    
    2.0
    %Expected volatility
    
    
    24.0
    %
 As of September 30, 2006, all 513,105 stock options and tandem stock appreciation rights
outstanding had an exercise price of $12.54 per share. No stock options or stock
appreciations rights were exercisable nor had any been forfeited as of September 30,
2006.
 9




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##### Table of Contents



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS
 Forward-Looking Statements
  General
   Evolution of Business Strategy
   10




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##### Table of Contents



Evolution of Business Strategy (Continued)
    Critical Accounting Policies
 Share-Based Payment .
 Employers Accounting for Defined Benefit Pension and Other
Postretirement Plans
 Off-Balance-Sheet Liabilities
  (In thousands)Commitments to extend credit
    
    $
    34,010Financial stand-by letters of credit
    
    
    1,054$
    35,064
 11




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##### Table of Contents



Comparison of Financial Condition at September 30, 2006 and December 31, 2005
     Results of Operations
 For the three months ended September 30, 2006 and 2005
  For the nine months ended September 30, 2006 and 2005
   12




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##### Table of Contents



Net Interest Income
 For the three months ended September 30, 2006 and 2005
  For the nine months ended September 30, 2006 and 2005
  General comments on net interest income
  13




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##### Table of Contents



Provision for Loan Losses
 For the three months ended September 30, 2006 and 2005
   For the nine months ended September 30, 2006 and 2005
   General comments on the provision for loan losses
   14




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##### Table of Contents



Noninterest Income
  Three Months Ended
    
    
    
    
    
    
    
    
    
    
    Nine Months EndedSeptember 30,
    
    
    
    
    
    
    
    
    
    
    September 30,2006
    
    
    2005
    
    
    $ Chg
    
    
    % Chg
    
    
    2006
    
    
    2005
    
    
    $ Chg
    
    
    % ChgService charges on deposit accounts
    
    $
    910,236
    
    
    $
    859,058
    
    
    $
    51,178
    
    
    
    5.96
    %
    
    $
    2,222,526
    
    
    $
    2,331,651
    
    
    $
    (109,125
    )
    
    
    -4.68
    %Other service charges, commissions
and fees
    
    
    278,124
    
    
    
    121,330
    
    
    
    156,794
    
    
    
    129.23
    %
    
    
    731,661
    
    
    
    559,870
    
    
    
    171,791
    
    
    
    30.68
    %Brokerage fees
    
    
    125,789
    
    
    
    172,470
    
    
    
    (46,681
    )
    
    
    -27.07
    %
    
    
    392,365
    
    
    
    453,194
    
    
    
    (60,829
    )
    
    
    -13.42
    %Mortgage origination fees
    
    
    116,558
    
    
    
    122,927
    
    
    
    (6,369
    )
    
    
    -5.18
    %
    
    
    338,696
    
    
    
    299,001
    
    
    
    39,695
    
    
    
    13.28
    %Bank owned life insurance
    
    
    76,429
    
    
    
    76,126
    
    
    
    303
    
    
    
    .40
    %
    
    
    223,331
    
    
    
    221,886
    
    
    
    1,445
    
    
    
    0.65
    %Loss on sale of securities
    
    
    (11,239
    )
    
    
    
    
    
    
    (11,239
    )
    
    
    
    
    
    
    (11,239
    )
    
    
    (4,653
    )
    
    
    (6,586
    )
    
    
    141.54
    %Other
    
    
    25,087
    
    
    
    38,844
    
    
    
    (13,757
    )
    
    
    -35.42
    %
    
    
    178,265
    
    
    
    203,152
    
    
    
    (24,887
    )
    
    
    -12.25
    %Total noninterest income
    
    $
    1,520,984
    
    
    $
    1,390,755
    
    
    $
    130,229
    
    
    
    9.36
    %
    
    $
    4,075,605
    
    
    $
    4,064,101
    
    
    $
    11,504
    
    
    
    0.28
    %Noninterest income as a percentage of
average assets (annualized)
    
    
    1.63
    %
    
    
    1.57
    %
    
    
    
    
    
    
    
    
    
    
    1.48
    %
    
    
    1.53
    %
    15




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##### Table of Contents



Noninterest Expense
  Three Months Ended
    
    
    
    
    
    
    
    
    
    
    Nine Months EndedSeptember 30,
    
    
    
    
    
    
    
    
    
    
    September 30,2006
    
    
    2005
    
    
    $ Chg
    
    
    % Chg
    
    
    2006
    
    
    2005
    
    
    $ Chg
    
    
    % ChgSalaries and employee benefits
    
    $
    2,325,747
    
    
    $
    1,814,602
    
    
    $
    511,145
    
    
    
    28.17
    %
    
    $
    6,538,907
    
    
    $
    5,242,745
    
    
    $
    1,296,162
    
    
    
    24.72
    %Equipment
    
    
    285,499
    
    
    
    335,283
    
    
    
    (49,784
    )
    
    
    -14.85
    %
    
    
    913,140
    
    
    
    1,247,486
    
    
    
    (334,346
    )
    
    
    -26.80
    %Occupancy
    
    
    278,333
    
    
    
    267,327
    
    
    
    11,006
    
    
    
    4.12
    %
    
    
    782,317
    
    
    
    738,985
    
    
    
    43,332
    
    
    
    5.86
    %Advertising and marketing
    
    
    84,310
    
    
    
    48,666
    
    
    
    35,644
    
    
    
    73.24
    %
    
    
    242,527
    
    
    
    182,488
    
    
    
    60,039
    
    
    
    32.90
    %Legal and accounting
    
    
    205,766
    
    
    
    93,783
    
    
    
    111,983
    
    
    
    119.41
    %
    
    
    546,088
    
    
    
    290,181
    
    
    
    255,907
    
    
    
    88.19
    %Directors fees and retirement
    
    
    149,860
    
    
    
    73,644
    
    
    
    76,216
    
    
    
    103.49
    %
    
    
    354,167
    
    
    
    218,332
    
    
    
    135,835
    
    
    
    62.21
    %Telephone
    
    
    79,418
    
    
    
    63,509
    
    
    
    15,909
    
    
    
    25.05
    %
    
    
    206,833
    
    
    
    187,171
    
    
    
    19,662
    
    
    
    10.50
    %Supplies
    
    
    80,461
    
    
    
    61,398
    
    
    
    19,063
    
    
    
    31.05
    %
    
    
    191,776
    
    
    
    173,687
    
    
    
    18,089
    
    
    
    10.41
    %Data processing fees
    
    
    252,800
    
    
    
    161,161
    
    
    
    91,639
    
    
    
    56.86
    %
    
    
    665,278
    
    
    
    353,761
    
    
    
    311,517
    
    
    
    88.06
    %Other operating
    
    
    514,542
    
    
    
    281,196
    
    
    
    233,346
    
    
    
    82.98
    %
    
    
    1,425,703
    
    
    
    958,728
    
    
    
    466,975
    
    
    
    48.71
    %Total noninterest expenses
    
    $
    4,256,736
    
    
    $
    3,200,569
    
    
    $
    1,056,167
    
    
    
    33.0
    %
    
    $
    11,866,736
    
    
    $
    9,593,564
    
    
    $
    2,273,172
    
    
    
    23.69
    %Noninterest expenses as a percentage of
average assets (annualized)
    
    
    4.56
    %
    
    
    3.60
    %
    
    
    
    
    
    
    
    
    
    
    4.31
    %
    
    
    3.61
    %
 16




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##### Table of Contents



Noninterest Expense (Continued)
  For The
    
    
    For TheThree Month
    
    
    Nine MonthIncrease in:
    
    Period
    
    
    PeriodSalaries
    
    $
    92,000
    
    
    $
    295,000ESOP expense
    
    
    155,000
    
    
    
    422,000Stock based compensation
    
    
    168,000
    
    
    
    248,000Defined benefit pension plan
    
    
    30,000
    
    
    
    90,000Insurance and other benefits
    
    
    66,000
    
    
    
    245,000Total increase
    
    $
    511,000
    
    
    $
    1,300,000
  Income Tax Expense
  17




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##### Table of Contents



Liquidity and Capital Resources
    Regulatory Capital Ratios for HeritageBank of the South at September 30, 2006
  Minimum Required toBe Well CapitalizedFor Capital
    
    Under PromptAdequacy
    
    Corrective ActionActual
    
    Purposes
    
    ProvisionsAmount
    
    Ratio
    
    Amount
    
    Ratio
    
    Amount
    
    Ratio(Dollars in thousands)Total Capital to Risk Weighted Assets
    
    $
    58,380
    
    
    
    19.3
    %
    
    $
    24,144
    
    
    
    8.0
    %
    
    $
    30,180
    
    
    
    10.0
    %Tier I Capital to Risk Weighted Assets
    
    
    54,602
    
    
    
    18.1
    
    
    
    12,072
    
    
    
    4.0
    
    
    
    18,108
    
    
    
    6.0Tier I Capital to Average Assets
    
    
    54,602
    
    
    
    15.2
    
    
    
    14,452
    
    
    
    4.0
    
    
    
    18,065
    
    
    
    5.0
  18




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##### Table of Contents



ITEM 3. CONTROLS AND PROCEDURES
     19




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##### Table of Contents



PART II  OTHER INFORMATION
 
 ITEM 1. LEGAL PROCEEDINGS
  
 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
   Number of
    
    
    MaximumShares
    
    
    Number ofPurchased as
    
    
    Shares thatPart of
    
    
    may yet beTotal
    
    
    
    
    
    
    Publicly
    
    
    PurchasedNumber
    
    
    
    
    
    
    Announced
    
    
    Under theof Shares
    
    
    Average Price
    
    
    Plans or
    
    
    Plans orPurchased
    
    
    Paid Per Share
    
    
    Programs
    
    
    ProgramsJuly
    
    
    42,128
    
    
    $
    13.45
    
    
    
    42,128
    
    
    
    20,000August
    
    
    20,000
    
    
    
    13.57
    
    
    
    20,000
    
    
    
    September
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    
    62,128
    
    
    $
    13.49
    
    
    
    62,128
    
    
    
    
  
 ITEM 6 . EXHIBITS
 Reference toPrior FilingRegulation S-B
    
    
    
    or Exhibit NumberExhibit Number
    
    Document
    
    Attached Hereto31
    
    Rule 13a-14(a)/15d-14(a) Certifications
    
    
    3132
    
    Section 1350 Certifications
    
    
    32
 20




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##### Table of Contents



SIGNATURES
  HERITAGE FINANCIAL GROUPDate: November 9, 2006
    
    By:
    
    /s/ O. Leonard Dorminey

O. Leonard Dorminey
President and Chief Executive OfficerDate: November 9, 2006
    
    By:
    
    /s/ Tammy W. BurdetteTammy W. BurdetteExecutive Vice President and
Chief Financial Officer
 21