**UNITED STATES SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON,D.C.  20549**

**FORM 10-KSB**

**(MARKONE)**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe Fiscal Year Ended December 31, 2006**

**o**                                 TRANSITIONREPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT OF 1934

**Forthe Transition Period from             to              **

**CommissionFile No. 00050921**

**SOUTHERN HERITAGE BANCSHARES, INC**

(Exact Name of SmallBusiness Issuer as Specified in its Charter)

| **Tennessee**                    |   | **42-1627829**                     |
|----------------------------------|--------|------------------------------------|
| (State or Other  Jurisdiction of |   | (IRS Employer  Identification No.) |
| Incorporation or  Organization)  |   |                               |

 

**3020Keith Street, N.W., Cleveland, Tennessee 37320**

(Address ofPrincipal Executive Offices and Zip Code)

**(423)473-7980**

(Issuer’sTelephone Number)

Securitiesregistered pursuant to Section 12(b) of the Act: **None**

Securitiesregistered pursuant to Section 12(g) of the Act: **Common Stock, $1.00 par value per share.**

Check whether theissuer (1) filed all reports required to be filed by section 13 or 15(d) of theExchange Act during the past 12 months (or for such shorter period that theregistrant was required to file such Reports) and (2) has been subject to suchfiling requirements for the past 90 days.  Yes   x       No  o

Check if there isno disclosure of delinquent filers in response to Item 405 of the RegulationS-B contained in this form, and no disclosure will be contained, to the best ofthe registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of the Form 10-KSB or any amendment tothis Form 10-KSB.o

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act) Yes   oNo  x

The issuer’srevenues for the year ended December 31, 2006 were $15,508,000.

The aggregatemarket value of the issuer’s voting common stock held by non-affiliates of theregistrant at March 31, 2007 was $36,403,960, based upon 910,099 shares at anestimated $40.00 per share.

The number ofshares of the issuer’s common stock issued and outstanding on March 31, 2007was 1,164,996.

DOCUMENTSINCORPORATED BY REFERENCE: Certain Portions of the Issuer’s Proxy Statementrelating to its annual meeting of shareholders to be held May 17, 2007 areincorporated herein by reference in response to Part III.

Transitional SmallBusiness Disclosure Format (check one): Yes  o   No  x

 

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TABLE OF CONTENTS

 
| PART I   |   |      |   |                                                                                                             |
|----------|--------|-----------|--------|------------------------------------------------------------------------------------------------------------------|
|     |   | ITEM  1.  |   | DESCRIPTION  OF BUSINESS                                                                                         |
|     |   | ITEM  2.  |   | DESCRIPTION  OF PROPERTY                                                                                         |
|     |   | ITEM 3.   |   | LEGAL  PROCEEDINGS                                                                                               |
|     |   | ITEM  4.  |   | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                             |
|     |   |      |   |                                                                                                             |
| PART II  |   |      |   |                                                                                                             |
|     |   | ITEM  5.  |   | MARKET FOR COMMON EQUITY,  RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUER PURCHASES OF EQUITY  SECURITIES |
|     |   | ITEM 6.   |   | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                      |
|     |   | ITEM 7.   |   | FINANCIAL STATEMENTS                                                                                             |
|     |   | ITEM 8.   |   | CHANGES IN AND DISAGREEMENTS WITH  ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                            |
|     |   | ITEM 8A.  |   | CONTROLS AND  PROCEDURES                                                                                         |
|     |   | ITEM 8B.  |   | OTHER INFORMATION                                                                                                |
|     |   |      |   |                                                                                                             |
| PART III |   |      |   |                                                                                                             |
|     |   | ITEM 9.   |   | DIRECTORS AND  EXECUTIVE OFFICERS OF REGISTRANT                                                                  |
|     |   | ITEM 10.  |   | EXECUTIVE  COMPENSATION.                                                                                         |
|     |   | ITEM 11.  |   | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL  OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.                 |
|     |   | ITEM 12.  |   | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS                                                                  |
|     |   | ITEM  13. |   | EXHIBITS                                                                                                         |
|     |   | ITEM 14.  |   | PRINCIPAL  ACCOUNTANT FEES AND SERVICES                                                                          |

 

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**PART I**

**ITEM 1.  DESCRIPTION OF BUSINESS**

General

SouthernHeritage Bancshares, Inc. (the “Company”) was formed in 2004 under the laws ofthe State of Tennessee as a bank holding company for the purpose of acquiring100% of Southern Heritage Bank (the “Bank”) by means of a share exchange. On August 31, 2004, shareholders of the Bank received one share of the Companyfor every share of the Bank they owned.  Since the transaction involvedentities under common control, financial information for the prior periods ofthe Bank is shown as if the transactions occurred as of the beginning of theearliest period presented.  Substantially all of the consolidatedoperations are that of the Bank.

TheCompany commenced operations as a state chartered bank on April 12, 1999. The Company has total assets of approximately $218 million at December 31,2006.  The Company’s deposit accounts are insured under the FederalDeposit Insurance Corporation (the “FDIC”), up to the maximum applicable limitsthereof.  The Company is not a member of the Federal Reserve System.

TheCompany’s customer base consists primarily of small to medium-sized businessretailers, manufacturers, distributors, contractors, professionals, servicebusinesses and local residents. The Company offers a full range of competitiveretail and commercial banking services.  The deposit services offeredinclude various types of checking accounts, savings accounts, money marketinvestment accounts, certificates of deposits, automated teller machines, andretirement accounts.  Lending services include consumer installment loans,various types of mortgage loans, personal lines of credit, home equity loans,credit cards, real estate construction loans, commercial loans to small andmedium size businesses and professionals, and letters of credit.  TheCompany also offers safe deposit boxes of various sizes.  The Companyissues VISA and MasterCard credit cards and is a merchant depository forcardholder drafts under both types of credit cards.  The Company offersits customers drive-through banking services at all of its locations**.** The Company has trust powers and iscurrently in the early stages of implementing a trust and investment servicesdepartment.

TheCompany is subject to the regulatory authority of the Board of Governors of theFederal Reserve System, the Department of Financial Institutions of the Stateof Tennessee (“TDFI”) and the FDIC.

TheCompany’s principal executive offices are located at the Bank, at 3020 KeithStreet, N.W., Cleveland, Tennessee 37320, and its telephone number is (423)473-7980.

Market Area andCompetition

TheCompany’s primary service area is Bradley County.  The Company competeswith other commercial banks, savings and loan associations, credit unions andfinance companies operating in Bradley County and elsewhere. Nine otherfinancial institutions are doing business in Bradley County.  The Companyis subject to substantial competition in all aspects of its business. Intense competition for loans and deposits comes from other financial institutionsin the Company’s market area.  In certain aspects of its business, theCompany also competes with credit unions, small loan companies, insurancecompanies, mortgage companies, finance companies, brokerage houses and otherfinancial institutions, some of which are not subject to the same degree ofregulation and restriction as the Company and some of which have financialresources greater than those of the Company.  The future success of theCompany will depend primarily upon the difference between the cost of itsborrowing (primarily interest paid on deposits) and income from operations(primarily interest or fees earned on loans, sales of loans and investments).The Company competes for funds with other institutions, which, in most cases,are significantly larger and are able to provide a greater variety of servicesthan the Company and thus may obtain deposits at lower rates of interest.

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Employees

At December 31,2006, the Company employed 52 persons on a full-time basis and 13 persons on apart-time basis.  The Company’s employees are not represented by any unionor other collective bargaining agreement and the Company believes its employeerelations are satisfactory.

Supervision andRegulation

*Bank Holding Company Regulation.*TheCompany is a bank holding company within the meaning of the Bank HoldingCompany Act of 1956, as amended (the “Holding Company Act”), and is registeredwith the Federal Reserve Board. Its banking subsidiary, the Bank, is subject torestrictions under federal law which limit the transfer of funds by it to theCompany and nonbanking subsidiaries, whether in the form of loans, extensionsof credit, investments, or asset purchases.  Such transfers by anysubsidiary bank to its holding company or any non-banking subsidiary arelimited in amount to 10% of the subsidiary bank’s capital and surplus and, withrespect to the Company and all such nonbanking subsidiaries, to an aggregate of20% of such bank’s capital and surplus.  Furthermore, such loans andextensions of credit are required to be secured in specified amounts.  TheHolding Company Act also prohibits, subject to certain exceptions, a bankholding company from engaging in or acquiring direct or indirect control ofmore than 5% of the voting stock of any company engaged in non bankingactivities.  An exception to this prohibition is for activities expresslyfound by the Federal Reserve Board to be so closely related to banking ormanaging or controlling banks as to be a proper incident thereto or financialin nature.

As abank holding company, the Company is required to file with the Federal ReserveBoard semi-annual reports and such additional information as the FederalReserve Board may require.  The Federal Reserve Board also makesexaminations of the Company.

Accordingto Federal Reserve Board policy, bank holding companies are expected to act asa source of financial strength to each subsidiary bank and to commit resourcesto support each such subsidiary.  This support may be required at timeswhen a bank holding company may not be able to provide such support.

Abank holding company and its subsidiaries are also prohibited from acquiringany voting shares of, or interest in, any banks located outside of the state inwhich the operations of the bank holding company’s subsidiaries are located,unless the acquisition is specifically authorized by the statutes of the statein which the target is located.  Further, a bank holding company and itssubsidiaries are prohibited from engaging in certain tie-in arrangements inconnection with the extension of credit or provision of any property orservice.  Thus, an affiliate of a bank holding company may not extendcredit, lease or sell property, or furnish any services or fix or vary theconsideration for these on the condition that (i) the customer must obtain orprovide some additional credit, property or services from or to its bankholding company or subsidiaries thereof or (ii) the customer may not obtainsome other credit, property, or services from a competitor, except to theextent reasonable conditions are imposed to assure the soundness of the creditextended.

Inapproving acquisitions by bank holding companies of banks and companies engagedin the banking-related activities described above, the Federal Reserve Boardconsiders a number of factors, including the expected benefits to the publicsuch as greater convenience, increased competition, or gains in efficiency, asweighed against the risks of possible adverse effects such as undueconcentration of resources, decreased or unfair competition, conflicts ofinterest, or unsound banking practices.  The Federal Reserve Board is alsoempowered to differentiate between new activities and activities commencedthrough the acquisition of a going concern.

The Attorney General of theUnited States may, within 30 days after approval by the Federal Reserve Boardof an acquisition, bring an action challenging such acquisition under thefederal antitrust laws, in which case the effectiveness of such approval isstayed pending a final ruling by the courts.  Failure of the AttorneyGeneral to challenge an acquisition does not, however, exempt the holdingcompany from complying with both state and federal antitrust laws after theacquisition is consummated or immunize the acquisition from future challengeunder the anti-monopolization provisions of the Sherman Act.

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*Sarbanes-Oxley Act of 2002*. On July 30,2002, President Bush signed into law the Sarbanes-Oxley Act of 2002.  Thislegislation represents a comprehensive revision of laws affecting corporategovernance, accounting obligations and corporate reporting. The Sarbanes-OxleyAct is applicable to all companies with equity securities registered, or thatfile reports under, the Securities Exchange Act of 1934.  In particular,the Sarbanes-Oxley Act establishes (i) new requirements for audit committees,including independence, expertise and responsibilities; (ii) additionalresponsibilities regarding financial statements for the chief executive officerand chief financial officer of the reporting company and new requirements forthem to certify the accuracy of periodic reports; (iii) new standards forauditors and regulation of audits; (iv) increased disclosure and reportingobligations for the reporting company and its directors and executive officers,including an accelerated time frame for reporting of insider transactions; and(v) new and increased civil and criminal penalties for violations of thefederal securities laws. The legislation also established a new accountingoversight board to enforce auditing standards and restrict the scope ofservices that accounting firms may provide to their public company auditclients.  Because the Company’s common stock is registered with the SEC,it is subject to the requirements of this legislation.

*Tennessee Banking Act; Federal Deposit Insurance Act*.The Bank is a Tennessee state-chartered bank and is subject to the regulationsof and supervision by the FDIC as well as the TDFI, Tennessee’s state bankingauthority.  The Bank is also subject to various requirements andrestrictions under federal and state law, including requirements to maintainreserves against deposits, restrictions on the types and amounts of loans thatmay be granted and the interest that may be charged thereon and limitations on thetypes of investments that may be made and the types of services that may beoffered.  Various consumer laws and regulations also affect the operationsof the Bank.  In addition to the impact of regulation, commercial banksare affected significantly by the actions of the Federal Reserve Board as itattempts to control the money supply and credit availability in order toinfluence the economy.

Fromtime to time, legislation is enacted which has the effect of increasing thecost of doing business, limiting or expanding permissible activities oraffecting the competitive balance between banks and other financialinstitutions.  Proposals to change the laws and regulations governing theoperations and taxation of banks, bank holding companies and other financialinstitutions are frequently made in Congress, in the Tennessee legislature andbefore various bank regulatory and other professional agencies.  Thelikelihood of any major legislative changes and the impact such changes mighthave on the Bank are impossible to predict.

TheBank, as a Tennessee state chartered bank, is subject to primary supervision,periodic examination and regulation by the Commissioner of the TDFI (“Commissioner”)and the FDIC.  If, as a result of an examination of a bank, the FDIC shoulddetermine that the financial condition, capital resources, asset quality,earnings prospects, management, liquidity or other aspects of the Bank’soperations are unsatisfactory or that the Bank or its management is violatingor has violated any law or regulation, various remedies are available to theFDIC.  Such remedies include the power to enjoin “unsafe or unsound”practices, to require affirmative action to correct any conditions resultingfrom any violation or practice, to issue an administrative order that can bejudicially enforced, to direct an increase in capital, to restrict the growthof the Bank, to assess civil monetary penalties, to remove officers anddirectors and ultimately to terminate the Bank’s deposit insurance.  TheCommissioner has many of the same remedial powers, including the power to takepossession of a bank whose capital becomes impaired.  As of April 1, 2007,the Bank is not the subject of any such action by the FDIC or the Commissioner.

Thedeposits of the Bank are insured by the FDIC in the manner and to the extentprovided by law.  For this protection, the Bank pays a semiannualstatutory assessment.  Although the Bank is not a member of the FederalReserve System, it is nevertheless subject to certain regulations of the FederalReserve Board.

Variousrequirements and restrictions under the laws of the State of Tennessee and theUnited States affect the operations of the Bank.  State and federalstatutes and regulations relate to many aspects of the Bank’s operations, includingreserves against deposits, interest rates payable on deposits, loans,investments, mergers and acquisitions, borrowings, dividends, locations ofbranch offices and capital requirements.  Further, the Bank is required tomaintain certain levels of capital.

Tennesseelaw contains limitations on the interest rates that may be charged on varioustypes of loans and restrictions on the nature and amount of loans that may begranted and on the types of investments which may be made.  The operationsof banks are also affected by various consumer laws and regulations, includingthose relating to equal credit opportunity and regulation of consumer lendingpractices.  All Tennessee banks must become and remain insured banks underthe FDIA. (See 12 U.S.C. §1811, et seq.).

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*FIRREA.*Congress enacted the FinancialInstitutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”) on August9, 1989.  FIRREA provides that a depository institution insured by theFDIC can be held liable for any loss incurred by, or reasonable expected to beincurred by, the FDIC in connection with (i) the default of a commonlycontrolled FDIC insured depository institution or (ii) any assistance providedby the FDIC to a commonly controlled FDIC insured depository institution indanger of default.  FIRREA provides that certain types of personsaffiliated with financial institutions can be fined by the federal regulatoryagency having jurisdiction over a depository institution with federal depositinsurance (such as the Bank) up to $1 million per day for each violation ofcertain regulations related (primarily) to lending to and transactions withexecutive officers, directors, principal shareholders and the interests ofthese individuals.  Other violations may result in civil money penaltiesof $5,000 to $30,000 per day or in criminal fines and penalties.  Inaddition, the FDIC has been granted enhanced authority to withdraw or tosuspend deposit insurance in certain cases.

*FDICIA.*The Federal Deposit InsuranceCorporation Improvement Act of 1991 (“FDICIA”) which was enacted on December19, 1991, substantially revised the depository institution regulatory andfunding provisions of the FDIA and made revisions to several other federalbanking statutes.  Among other things, FDICIA requires the federal bankingregulators to take “prompt corrective action” in respect of FDIC-insureddepository institutions that do not meet minimum capital requirements. FDICIAestablishes five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,”“significantly undercapitalized” and “critically undercapitalized.”  Underapplicable regulations, a FDIC-insured depository institution is defined to bewell capitalized if it maintains a Leverage Ratio of at least 5%, a riskadjusted Tier 1 Capital Ratio of at least 6% and a Total Capital Ratio of atleast 10% and is not subject to a directive, order or written agreement to meetand maintain specific capital levels.  An insured depository institutionis defined to be adequately capitalized if it meets all of its minimum capitalrequirements as described above.  In addition, an insured depositoryinstitution will be considered undercapitalized if it fails to meet any minimumrequired measure, significantly undercapitalized if it is significantly belowsuch measure and critically undercapitalized if it fails to maintain a level oftangible equity equal to not less than 2% of total assets.  An insureddepository institution may be deemed to be in a capitalization category that islower than is indicated by its actual capital position if it receives anunsatisfactory examination rating.

Thecapital-based prompt corrective action provision of FDICIA and theirimplementing regulations apply to FDIC-insured depository institutions and arenot directly applicable to holding companies which control suchinstitutions.  However, the Federal Reserve Board has indicated that, inregulating bank holding companies, it will take appropriate action at theholding company level based on an assessment of the effectiveness ofsupervisory actions imposed upon subsidiary depository institutions pursuant tosuch provisions and regulations.

FDICIAgenerally prohibits an FDIC-insured depository institution from making anycapital distribution (including payment of dividends) or paying any managementfee to its holding company if the depository institution would thereafter beundercapitalized.  Undercapitalized depository institutions are subject torestrictions on borrowing from the Federal Reserve System.  In addition,undercapitalized depository institutions are subject to growth limitations andare required to submit capital restoration plans.  A depositoryinstitution’s holding company must guarantee the capital plan, up to an amountequal to the lesser of 5% of the depository institution’s assets at the time itbecomes undercapitalized or the amount of the capital deficiency when theinstitution fails to comply with the plan.  The federal banking agenciesmay not accept a capital plan without determining, among other things, that theplan is based on realistic assumptions and is likely to succeed in restoringthe depository institution’s capital.  If a depository institution failsto submit an acceptable plan, it is treated as if it is significantlyundercapitalized.

Significantlyundercapitalized depository institutions may be subject to a number ofrequirements and restrictions, including orders to sell sufficient voting stockto become adequately capitalized, requirements to reduce total assets andcessation of receipt of deposits from correspondent banks.  Criticallyundercapitalized depository institutions are subject to appointment of areceiver or conservator generally within 90 days of the date on which theybecame critically undercapitalized.

TheBank believes that at April 1, 2007, the Bank was well capitalized under thecriteria discussed above.

FDICIA contains numerousother provisions, including accounting, audit and reporting requirements,termination of the “too big to fail” doctrine except in special cases, limitationson the FDIC’s payment of deposits at foreign branches, new regulatory standardsin such areas as asset quality, earnings and compensation and revisedregulatory standards for, among other things, powers of state banks, realestate lending and capital adequacy.  FDICIA also requires that adepository institution provide 90 days prior notice of the closing of anybranches.

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Variousother legislation, including proposals to revise the bank regulatory system andto limit the investments that a depository institution may make with insuredfunds, is from time to time introduced in Congress.  The TDFI and FDICwill examine the Bank periodically for compliance with various regulatoryrequirements.  Such examinations, however, are for the protection of theBank Insurance Fund (“BIF”) and for depositors, and not for the protection ofinvestors and shareholders.

*Interstate Act*. The Riegle-Neal InterstateBanking and Branching Efficiency Act of 1994 (“Interstate Act”), which wasenacted on September 29, 1994, among other things and subject to certainconditions and exceptions, permits on an interstate basis (i) bank holdingcompany acquisitions commencing one year after enactment of banks of a minimumage of up to five years as established by state law in any state, (ii) mergersof national and state banks after May 31, 1997 unless the home state of eitherbank has opted out of the interstate bank merger provision, (iii) branching denovo by national and state banks if the host state has opted-in to thisprovision of the Interstate Act, and (iv) certain bank agency activities afterone year after enactment.  The Interstate Act contains a 30% intrastatedeposit cap, except for the initial acquisition in the state, restriction thatapplies to certain interstate acquisitions unless a different intrastate caphas been adopted by the applicable state pursuant to the provisions of theInterstate Act and a 10% national deposit cap restriction.  Tennessee hasopted-in to the Interstate Act.  Management cannot predict the extent towhich the business of the Bank may be affected.  Tennessee has alsoadopted legislation allowing banks to acquire branches across state linessubject to certain conditions, including the availability of similarlegislation in the other state.

*Brokered Deposits and Pass-Through Insurance*.The FDIC has adopted regulations under FDICIA governing the receipt of brokereddeposits and pass-through insurance.  Under the regulations, a bank cannotaccept or rollover or renew brokered deposits unless (i) it is well capitalizedor (ii) it is adequately capitalized and receives a waiver from the FDIC. A bank that cannot receive brokered deposits also cannot offer “pass-through”insurance on certain employee benefit accounts.  Whether or not it hasobtained such a waiver, an adequately capitalized bank may not pay an interestrate on any deposits in excess of 75 basis points over certain index prevailingmarket rates specified by regulation.  There are no such restrictions on abank that is well capitalized.  Because it believes that the Bank was wellcapitalized as of April 1, 2007, the Bank believes the brokered depositsregulation will have no material effect on the funding or liquidity of theBank.

*FDIC Insurance Premiums*. The Bank isrequired to pay semiannual FDIC deposit insurance assessments.  Asrequired by FDICIA, the FDIC adopted a risk-based premium schedule whichincreased the assessment rates for most FDIC-insured depositoryinstitutions.  Under the schedule, the premiums initially range from $.00to $.27 for every $100 of deposits.  Each financial institution isassigned to one of three capital groups - well capitalized, adequatelycapitalized or undercapitalized - and further assigned to one of threesubgroups within a capital group, on the basis of supervisory evaluations bythe institution’s primary federal and, if applicable, state supervisors andother information relevant to the institution’s financial condition and therisk posed to the applicable FDIC deposit insurance fund.  The actualassessment rate applicable to a particular institution will, therefore, dependin part upon the risk assessment classification so assigned to the institutionby the FDIC.  Recently the FDIC has passed a resolution to lower premiums.

Underthe FDIA, insurance of deposits may be terminated by the FDIC upon a findingthat the institution has engaged in unsafe and unsound practices, is in anunsafe or unsound condition to continue operations or has violated anyapplicable law, regulation, rule, order or condition imposed by a federal bankregulatory agency.

*Gramm-Leach-BlileyAct*. The Gramm-Leach-Bliley Act adopted in November 1999 hasbeen referred to as the most important banking bill in over 60 years.  Themost significant provisions ratify new powers for banks and bank holdingcompanies, especially in the areas of securities and insurance.  The Actalso includes requirements regarding the privacy and protection of customerinformation held by financial institutions, as well as many other providers offinancial services.  There are provisions providing for functionalregulation of the various services provided by institutions among differentregulators.  There are other provisions which limit the future expansionof unitary thrift holding companies which now prevent companies like Wal-Martfrom owning a thrift institution.  Finally, among many other sections ofthe Act, there is some relief for small banks from the regulatory burden of theCommunity Reinvestment Act.  The regulatory agencies have been adoptingmany new regulations to implement the Act.

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*USA Patriot Act*. On October 26, 2001,President Bush signed the USA PATRIOT Act of 2001 into law.  This actcontains the International Money Laundering Abatement and FinancialAnti-Terrorism Act of 2001 (the “IMLAFA”).  The IMLAFA substantiallybroadens existing anti-money laundering legislation and the extraterritorialjurisdiction of the United States, imposes new compliance and due diligenceobligations, creates new crimes and penalties, compels the production of documentslocated both inside and outside the United States, including those of foreigninstitutions that have a correspondent relationship in the United States, andclarifies the safe harbor from civil liability to customers.  The U.S.Treasury Department has issued a number of regulations implementing the USAPATRIOT Act that apply certain of its requirements to financial institutionssuch as our banking and broker-dealer subsidiaries.  The regulationsimpose new obligations on financial institutions to maintain appropriatepolicies, procedures and controls to detect, prevent and report moneylaundering and terrorist financing.  The Treasury Department is expectedto issue a number of additional regulations which will further clarify the USAPATRIOT Act’s requirements.

TheIMLAFA requires all “financial institutions,” as defined, to establishanti-money laundering compliance and due diligence programs no later than April2003.  Such programs must include, among other things, adequate policies,the designation of a compliance officer, employee training programs, and anindependent audit function to review and test the program.  The Bank hasestablished anti-money laundering compliance and due diligence programs tocomply with IMLAFA.

Payment ofDividends

Thepayment of dividends by the Company depends to a great extent on the ability ofthe Bank to pay dividends to the Company.  The Bank is subject to theTennessee Banking Act, which provides that the Bank may not declare dividendsin any calendar year that exceeds the total of its net income of that yearcombined with its retained net income of the preceding two years without theapproval of the TDFI.  Thereafter, 10% of net profits must be transferredto capital surplus prior to payment of dividends until capital surplus equalscapital stock.  The Bank is also subject to the minimum capitalrequirements of the FDIC which impact the Bank’s ability to paydividends.  If the Bank fails to meet these standards, it may not be ableto pay dividends or to accept additional deposits because of regulatoryrequirements.  On May 18, 2006 the Company paid a stock dividend equal to1 share for each 20 shares owned of its outstanding shares of common stock.

Investment Policy

Theobjective of the Company’s investment policy is to invest funds not otherwiseneeded to meet the loan demand of its market area to earn the maximum returnfor the Company, yet still maintain sufficient liquidity to meet fluctuationsin the Company’s loan demand and deposit structure.  In doing so, the Companybalances the market and credit risks against the potential investment return,makes investments compatible with the pledge requirements of the Bank’sdeposits of public funds, maintains compliance with regulatory investmentrequirements, and assists the various public entities with their financingneeds.  The funds management committee of the Company has full authorityover the investment portfolio and makes decisions on purchases and sales ofsecurities.  The entire portfolio, along with all investment transactionsoccurring since the previous board of director’s meeting, is reviewed by theboard at its next monthly meeting.  The investment policy allows portfolioholdings to include short-term securities purchased to provide the Company’sneeded liquidity and longer term securities purchased to generate level incomefor the Company over periods of interest rate fluctuations.  The Company’sinvestment securities portfolio at December 31, 2006, consisted of securitiesavailable for sale.

Loan Policy

All lending activities ofthe Company are under the direct supervision and control of the loan committee,which consists of seven directors, Len Graham, C.A. Kyle, Steve Ledbetter, JimWorkman, Lester Simerville, Lee Stewart and James Williams.  The loancommittee enforces loan authorizations for each officer, decides on loansexceeding such limits, services all requests for officer credits to the extentallowable under current laws and regulations, administers all problem credits,and determines the allocation of funds for each lending division.  TheCompany’s established maximum loan ratio of deposits is 95%.  The loanportfolio consists primarily of real estate, commercial, farming andinstallment loans.  Commercial loans consist of either real estate loans orterm loans.  Maturity of term loans is normally limited to a maximum ofseven years.  Conventional real estate loans may be made up to 85% of theappraised value or purchase cost of the real estate for no more than athirty-year term.  Installment loans are based on the earning capacity andvocational stability of the borrower.

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Theloan committee makes after-the-fact reviews of all loans in excess of $150,000secured and $50,000 unsecured.  The loan committee makes a monthly reviewof loans which are 30 days or more past due and the full board of directorsmakes a monthly review of loans which are 45 days or more past due.

Managementof the Company periodically reviews the loan portfolio, particularly nonaccrualand renegotiated loans.  The review may result in a determination that aloan should be placed on a nonaccrual status for income recognition.  Inaddition, to the extent that management identifies potential losses in the loanportfolio, it reduces the book value of such loans, through charge-offs, totheir estimated collectible value.  The Company’s policy is that accrualof interest is discontinued on a loan when management of the Company determinesupon consideration of economic and business factors affecting collectionefforts that collection of interest is doubtful.  The Company currentlyhas no loans where known information about possible credit problems ofborrowers causes management to have serious doubts as to the ability of suchborrowers to comply with the present loan repayment terms.

Whena loan is classified as nonaccrual, any unpaid interest is reversed againstcurrent income.  Interest is included in income thereafter only to theextent received in cash.  The loan remains in a nonaccrual classificationuntil such time as the loan is brought current, when it may be returned toaccrual classification.  When principal or interest on a nonaccrual loanis brought current, if in management’s opinion future payments arequestionable, the loan would remain classified as nonaccrual.  After a nonaccrualor renegotiated loan is charged off, any subsequent payments of either interestor principal are applied first to any remaining balance outstanding, then torecoveries and lastly to income.

TheCompany had no loans outstanding to foreign borrowers at December 31, 2006.

TheCompany’s underwriting guidelines are applied to four major categories ofloans:  commercial and industrial, consumer, agricultural and real estate,which includes residential, construction and development and certain other realestate loans.  The Company requires its loan officers and loan committeeto consider the borrower’s character, the borrower’s financial condition asreflected in current financial statements, the borrower’s managementcapability, the borrower’s industry and the economic environment in which theloan will be repaid.  Before approving a loan, the loan officer orcommittee must determine that the borrower is basically honest andcreditworthy, determine that the borrower is a capable manager, understand thespecific purpose of the loan, understand the source and plan of repayment,determine that the purpose, plan and source of repayment as well as collateralare acceptable, reasonable and practical given the normal framework withinwhich the borrower operates.

Credit RiskManagement and Allowance for Loan Losses

Creditrisk and exposure to loss are inherent parts of the banking business. Management seeks to manage and minimize these risks through its loan andinvestment policies and loan review procedures.  Management establishesand continually reviews lending and investment criteria and approval proceduresthat it believes reflect the risk sensitive nature of the Company.  Theloan review procedures are set to monitor adherence to the established criteriaand to ensure that on a continuing basis such standards are enforced andmaintained.  Management’s objective in establishing lending and investmentstandards is to manage the risk of loss and provide for income generationthrough pricing policies.

The loan portfolio isregularly reviewed and management determines the amount of loans to becharged-off.  In addition, such factors as the Company’s previous loanloss experience, prevailing and anticipated economic conditions, industryconcentrations and the overall quality of the loan portfolio areconsidered.  While management uses available information to recognizelosses on loans and real estate owned, future additions to the allowance may benecessary based on changes in economic conditions.  In addition, various regulatoryagencies, as an integral part of their examination process, periodically reviewthe allowances for losses on loans and real estate owned.  Such agenciesmay require the Company to recognize additions to the allowances based on theirjudgments about information available at the time of their examinations. In addition, any loan or portion thereof which is classified as a “loss” byregulatory examiners is charged-off.

9

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CapitalResources/Liquidity

*Liquidity.*  Of primary importance todepositors, creditors and regulators is the ability to have readily availablefunds sufficient to repay fully maturing liabilities.  The Company’sliquidity, represented by cash and cash due from banks, is a result of itsoperating, investing and financing activities.  In order to insure fundsare available at all times, the Company devotes resources to projecting on amonthly basis the amount of funds which will be required and maintainsrelationships with a diversified customer base so funds are accessible. Liquidity requirements can also be met through short-term borrowings or thedisposition of short-term assets which are generally matched to correspond tothe maturity of liabilities.

TheBank is subject to general FDIC guidelines which do not require a minimum levelof liquidity.  Management believes its liquidity ratios meet or exceedthese guidelines.  Management does not know of any trends or demands whichare reasonably likely to result in liquidity increasing or decreasing in anymaterial manner.

*Impact of Inflation and Changing Prices. *Theconsolidated financial statements and related consolidated financial datapresented herein have been prepared in accordance with generally acceptedaccounting principles which require the measurement of financial position andoperating results in terms of historical dollars without considering thechanges in the relative purchasing power of money over time and due toinflation.  The impact of inflation on operations of the Company isreflected in increased operating costs.  Unlike most industrial companies,virtually all of the assets and liabilities of the Company are monetary innature.  As a result, interest rates have a more significant impact on theCompany’s performance than the effects of general levels of inflation.  Interestrates do not necessarily move in the same direction or in the same magnitude asthe price of goods and services.

Capital Adequacy

Capitaladequacy refers to the level of capital required to sustain asset growth overtime and to absorb losses.  The objective of the Company’s management isto maintain a level of capitalization that is sufficient to take advantage ofprofitable growth opportunities while meeting regulatory requirements. This is achieved by improving profitability through effectively allocatingresources to more profitable businesses, improving asset quality, strengtheningservice quality, and streamlining costs.  The primary measures used bymanagement to monitor the results of these efforts are the ratios of averageequity to average assets, average tangible equity to average tangible assets,and average equity to net loans.

TheFederal Reserve Board has adopted capital guidelines governing the activitiesof bank holding companies.  These guidelines require the maintenance of anamount of capital based on risk-adjusted assets so that categories of assetswith potentially higher credit risk will require more capital backing thanassets with lower risk.  In addition, banks and bank holding companies arerequired to maintain capital to support, on a risk-adjusted basis, certainoff-balance sheet activities such as loan commitments.

Thecapital guidelines classify capital into two tiers, referred to as Tier I andTier II.  Under risk-based capital requirements, total capital consists ofTier I capital which is generally common stockholders’ equity less goodwill andTier II capital which is primarily a portion of the allowance for loan lossesand certain qualifying debt instruments.  In determining risk-basedcapital requirements, assets are assigned risk-weights of 0% to 100%, dependingprimarily on the regulatory assigned levels of credit risk associated with suchassets.  Off-balance sheet items are considered in the calculation ofrisk-adjusted assets through conversion factors established by theregulators.  The framework for calculating risk-based capital requiresbanks and bank holding companies to meet the regulatory minimums of 4%Tier I and 8% total risk-based capital.  In 1990 regulators added aleveraged computation to the capital requirements, comparing Tier Icapital to total average assets less goodwill.

The Federal DepositInsurance Corporation Improvement Act of 1991 (“FDICIA”) established fivecapital categories for banks and bank holding companies.  The bankregulators adopted regulations defining these five capital categories inSeptember 1992.  Under these new regulations each bank is classified intoone of the five categories based on its level of risk-based capital as measuredby Tier I capital, total risk-based capital, and Tier I leverageratios and its supervisory ratings.

10

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Thefollowing table lists the five categories of capital and each of the minimumrequirements for the three risk-based capital ratios.
| ** **                      | ** ** | **Total Risk-Based  Capital Ratio** | ** ** | **Tier I Risk-Based  Capital Ratio** | ** ** | **Leverage Ratio** | ** ** |
|---------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------------|------------|-------------------------|------------|
|                            |       |                                          |       |                                                |       |                    |       |
| Well-capitalized                |       | 10%  or above                                 |       | 6%  or above                                        |       | 5%  or above            |       |
|                            |       |                                          |       |                                                |       |                    |       |
| Adequately  capitalized         |       | 8%  or above                                  |       | 4%  or above                                        |       | 4%  or above            |       |
|                            |       |                                          |       |                                                |       |                    |       |
| Undercapitalized                |       | Less  than 8%                                 |       | Less  than 4%                                       |       | Less  than 4%           |       |
|                            |       |                                          |       |                                                |       |                    |       |
| Significantly  undercapitalized |       | Less  than 6%                                 |       | Less  than 3%                                       |       | Less  than 3%           |       |
|                            |       |                                          |       |                                                |       |                    |       |
| Critically  undercapitalized    |       | —                                        |       | —                                              |       | 2% or less              |       |

 

Asof December 31, 2006 the Bank had a Tier I capital ratio of 12.26%, a totalrisk-based capital ratio of 13.35% and a leverage ratio of 10.82%.

**ITEM 2.  DESCRIPTION OF PROPERTY**

Allof the Company’s properties are located in Cleveland, Tennessee. The Company’smain office is located at 3020 Keith Street, NW.  This facility isapproximately 17,000 square feet, two stories and was opened in December2002.  The Company has two branch offices, approximately 2,400 square feeteach.  The branch located at 2530 Dalton Pike opened in May 2000 and thebranch located at 3795 Georgetown Road opened in March 2001.

**ITEM 3.  LEGAL PROCEEDINGS**

Tothe best of the Company’s knowledge, there are no pending legal proceedings,other than routine litigation incidental to the business, to which the Companyor the Company is a party or of which any of the Company’s or the Company’sproperty is the subject.

**ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

Nomatters were submitted to a vote of security holders during the Company’s lastquarter of 2006.

**PART II**

**ITEM 5.  MARKET FOR COMMON EQUITY, RELATED STOCKHOLDERMATTERS AND SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES**

**Marketfor Common Stock**

As of December 31, 2006,the number of holders of common stock, the only class of equity security of theCompany issued and outstanding, was 824.  The common stock of the Companyis not traded through an organized exchange nor is there a known active publictrading market.  All of the purchases and sales of the common stock, ofwhich management is aware within the last two fiscal years, for the Company’scommon stock and the Company’s common stock, as applicable, have occurred in aprice range of $33-$40 per share.  This sale price represents transactionswhich management is aware of, but does not necessarily represent all tradingtransactions for the period. There are outstanding options to purchase 125,556shares of common stock, 41,679 of which are currently exercisable.

11

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**Dividends**

Thepayment of dividends is subject to the discretion of the Company’s board ofdirectors. The Company’s ability to pay dividends is dependent on cashdividends paid to it by the Company.  The ability of the Company to paydividends to the Company is restricted by applicable regulatory requirements.For more information on these restrictions, please see PART I, ITEM 1 “DESCRIPTIONOF BUSINESS — Payment of Dividends.” The Company’s board of directors in 2006declared a stock dividend of one share for each 20 shares owned forshareholders of record as of May 18, 2006 and in 2005 declared the samedividend (one share for each 20 shares owned) for shareholders of record as ofMay 19, 2005.  The effects of this stock dividend have been reflected inearnings per share and shares used in the computation of earnings per share forall periods presented.

**SecuritiesAuthorized for Issuance Under Equity Compensation Plans**

OnAugust 8, 2000, the board of directors of the Company approved the SouthernHeritage Company 2000 Stock Option Plan for Employees (the “Plan for Employees”). On August 8, 2000, the board of directors of the Company approved the 2000Non-Employee Directors’ Stock Option Plan (the “Non-Employee Director Plan”). The Company’s stockholders have also approved the Plan for Employees and theNon-Employee Director Plan.  The Company exchanged its options with theholders of the Company stock options under the Plan for Employees and the Non-EmployeeDirector Plan on an option-for-option basis. Thus, options that wereoutstanding under these Plans have been exchanged for options under the Company’sStock Option Plans.

Thefollowing table reflects the number of shares to be issued upon the exercise ofoptions granted under the Non-Employee Director Plan and the Plan forEmployees, the weighted-average exercise price of all such options, and thetotal number of shares of common stock reserved for issuance upon the exerciseof authorized, not-yet-granted options as of December 31, 2006:
| **Plan Category**                                          | ** ** | ** ** | ** ** | **# of Securities to be  Issued Upon Exercise of  Outstanding Options,  Warrants and Rights** | ** ** | **Weighted-average  Exercise Price of  Outstanding Options,  Warrants, and Rights** | ** ** | **# of Equity Securities  Remaining Available for  Future Issuance Under  Equity Compensation  Plans** | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Equity Compensation Plans  Approved by Security Holders**     |       |       |       |                                                                                                                                            |       |                                                                                                         |       |
| ** **                                                      | ** ** | ** ** | ** ** | ** **                                                                                                                                      | ** ** | ** **                                                                                                   | ** ** |
| **2000 Non-Employee Director Plan**                             |       | 9,696      |       | $                                                                                                                                               | 9.07       | ** **                                                                                                   | **—** | ** **                                                                                                                                     |
| ** **                                                      | ** ** | ** ** | ** ** | ** **                                                                                                                                      | ** ** | ** **                                                                                                   | ** ** |
| **2000 Plan for Employees**                                     |       | 115,860    |       | $                                                                                                                                               | 12.12      |                                                                                                         | 7,030      |                                                                                                                                           |
| ** **                                                      | ** ** | ** ** | ** ** | ** **                                                                                                                                      | ** ** | ** **                                                                                                   | ** ** |
| **Equity Compensation Plans Not  Approved by Security Holders** | ** ** | **—** | ** ** | **—**                                                                                                                                      | ** ** | **—**                                                                                                   | ** ** |
| ** **                                                      | ** ** | ** ** | ** ** | ** **                                                                                                                                      | ** ** | ** **                                                                                                   | ** ** |
| ** TOTAL**                                                 |       | 125,556    |       | $                                                                                                                                               | 11.89      |                                                                                                         | 7,030      |                                                                                                                                           |

 

**RecentSales of Unregistered Securities**

From January 1, 2003through December 31, 2006, the only securities issued without registration underthe Securities Act of 1933 were shares of the Company’s common stock which wereissued to two director and six employees pursuant to the Company’s Stock OptionPlans.  There were 35,052 shares purchased at an average price of $9.42per share for total proceeds of $330,041.  The Company relied on theexemption provided by Section 4(2) of the Securities Act of 1933 with respectto these issuances.

**Purchasesof Equity Securities by the Company**

TheCompany did not make any purchases of its common stock during the fourthquarter of 2006.

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**Purchasesof Equity Securities by the Company**

**The Company did not make anypurchases of its common stock during the fourth quarter of 2006.**

**ITEM6.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

**Forward-LookingStatements**

Management’sdiscussion of the Company and management’s analysis of the Company’s operationsand prospects, and other matters, may include forward-looking statements withinthe meaning of the Private Securities Litigation Reform Act of 1995 and otherprovisions of federal and state securities laws.  Although the Companybelieves that the assumptions underlying such forward-looking statementscontained in this Annual Report on Form 10-KSB are reasonable, any of theassumptions could be inaccurate and, accordingly, there can be no assurancethat the forward-looking statements included herein will prove to beaccurate.  The use of such words as “expect,” “anticipate,” “forecast,”and comparable terms should be understood by the reader to indicate that thestatement is “forward-looking” and thus subject to change in a manner that canbe unpredictable.  Factors that could cause actual results to differ fromthe results anticipated, but not guaranteed, in this Annual Report, include(without limitation) economic and social conditions, competition for loans,mortgages, and other financial services and products, changes in interestrates, unforeseen changes in liquidity, results of operations, and financialconditions affecting the Company’s customers, and other risks that cannot beaccurately quantified or completely identified.  Many factors affectingthe Company’s financial condition and profitability, including changes ineconomic conditions, the volatility of interest rates, political events andcompetition from other providers of financial services simply cannot bepredicted.  Because these factors are unpredictable and beyond the Company’scontrol, earnings may fluctuate from period to period.  The purpose ofthis type of information is to provide readers with information relevant tounderstanding and assessing the financial condition and results of operationsof the Company, and not to predict the future or to guarantee results. The Company is unable to predict the types of circumstances, conditions and factorsthat can cause anticipated results to change.  The Company undertakes noobligation to publish revised forward-looking statements to reflect theoccurrence of changes or unanticipated events, circumstances, or results.

**Overview**

Thefollowing discussion and financial information are presented to provideshareholders with a more comprehensive review of the financial condition andresults of operations of the Company than could be obtained from an examinationof the financial statements alone.  The review should be read inconjunction with the financial statements and accompanying notes set forth onpages 1 through 22 of this Annual Report.

**Resultsof Operations**

Netincome, after tax for 2006 was $2,022,000 compared to $1,957,000 in 2005, anincrease of 3.32%.  Basic and diluted income per common share were $1.76and $1.65 respectively, in 2006, compared to $1.73 and $1.61 in2005.   The Company declared stock dividend of one share for each twenty shares owned forshareholders of record as of May 18, 2006 and May 19, 2005.  The effect ofthe stock dividends have been reflected in earnings per share and shares usedin the computation of earnings per share for all periods presented.

Net InterestIncome

Netinterest income for 2006 was $7,450,000 compared with $6,457,000 in 2005. This was due primarily to continued growth in the Company’s loan portfolio in2006, which was funded by deposit growth.  Net interest margin during 2006was 3.90%, compared to 3.89% in 2005.   In 2006, the average yield oninterest earning assets was 7.02%, compared with 6.10% in 2005.  During2006, loans yielded 7.60%, compared with 6.60% in 2005.  The average ratepaid on interest-bearing deposits was 3.64% during 2006, compared to 2.60%during 2005.  Management expects that the cost of funds will continue toincrease in 2007.  This is due to theFederal Reserve increasing the discount rate four times in six months, during2006, for a total of 100 basis points. The rate increased from 4.25% to 5.25%. This followed eight increases in 2005, for a total, of 200 basispoints.  The company’s net interestmargin remained stable at 3.90% for 2006 and at 3.89% for 2005.  Increased competition for customers depositswill result in continued pressure on the net interest margin.

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Noninterest Income

Totalnoninterest income was $2,081,000 in 2006, compared with $1,992,000 in2005.  The largest single source of noninterest income is service chargeson deposit accounts.  Service charges on deposits totaled $1,028,000 in2006 and $1,285,000 in 2005.  The decrease is due mainly to lower NSFand overdraft protection fee income realized during the period.  Mortgage banking income was $568,000 in 2006,versus $442,000 in 2005.  In 2006, we originated for subsequent sale, 181loans for $27,482,000 compared to 181 loans for $26,860,000 in 2005.  Theaverage loan closed increased $3,400 to $151,800 compared to $148,400 in2005.  Net securities gains or lossesreflected a gain of $191,000 in 2006 compared to a loss of $5,000 in2005.   Other income was $294,000 as of December 31, 2006 as comparedto $270,000 for the same period in 2005. This includes Safe Deposit box rent, ATM interchange and surcharges,credit card interchange income, and the sale of checks to depositors.  Management expects that other fee income willcontinue to increase as the Company increases in size.

NoninterestExpense

Totalnoninterest expense was $5,737,000 in 2006, an increase of $618,000, or 12%over the $5,119,000 in 2005.  Major components of this increase includesalaries and employee benefits (which increased $373,000 in 2006 when comparedto 2005), the cost of premises and equipment (an increase of $60,000 over theprior year), Data Processing (increased $40,000), advertising and publicrelations (increased $95,000), supplies (increased $25,000), and other expenses(increased $25,000). Other expenses include items such as postage, outside feesand assessments, dues and subscriptions, loan expense, telephone, and loss ondisposition of foreclosed property.

Asof December 31, 2006, the Company had 52 full-time equivalent employees ascompared to 43 at December 31, 2005.   The company’s 401(k) profitsharing retirement plan implemented in 2004, resulted in a $70,000 match in2006 compared to $65,000 in 2005.  The Company’s salary incentive plantotaled $172,500 in 2006 compared to $165,000 in 2005, an increase of$7,500.  An addional $48,000 charge forstock option compensation as required by FASB Statement No. 123(R) in 2006compared to no charge in 2005.  Theincreased staff expense includes two highly compensated positions added during2005, a senior commercial lender (May) and human resources director (August)along with 3 new positions added in 2006 represents $117,000 of the increase.

Managementexpects that the cost of compliance with the internal control requirements ofSection 404 of the Sarbanes-Oxley Act of 2002 will have an adverse effect onnoninterest expense in future years.  Overhead costs as a percentage ofboth interest income and total assets should continue to decrease as theCompany continues to grow.

Provision For LoanLosses

Theallowance for loan losses is maintained by management at a level consideredadequate to cover probable incurred losses in the Company’s loanportfolio.  Management estimates the allowance balance required using pastloan loss experience, the nature and volume of the portfolio, information aboutspecific borrower situations and estimated collateral values, economicconditions, and other factors.  Prior to2006 the company’s net charge off experience has historically been low. In 2006, the company charged off $847,000 compared to $83,000 in 2005.  The increase in 2006 is primarily due tocharge offs related to two loan relationships of approximately $700,000.  The provision for loan losses was $756,000 in2006, compared with $374,000 in 2005, an increase of $382,000.  This increase was necessary primarily due tothe previously mentioned charge offs. Management had classified those loans that were associated with themajority of the charge offs in 2006 as substandard at December 31, 2005.  As a result , these loans were in ahomogeneous pool that required a significant allowance allocation in 2005, andtherefore the resulting provision in 2006 was less than the amount chargedoff.   At December 31, 2006, the allowance for loan losses was 1.22%of total loans, compared to 1.35% at year-end 2005.  Management allocatedapproximately 55% of the total allowance to commercial loans, 20% toresidential mortgage and home equity loans and 25% to consumer and credit cardloans to individuals.  At December 31, 2006 $257,000 of the allowance forloan losses was allocated to impaired loan balances.  At December 31,2006, there were three loans totaling $250,000 in nonaccrual status compared toone loan totaling $27,000 at December 31, 2005.  Management believes theallowance for loan losses at December 31, 2006, is adequate to absorb probableincurred losses in the loan portfolio.

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Income Taxes

TheCompany recorded income tax expense of $1,016,000 in 2006 compared to $999,000in 2005.  The effective tax rates for 2006 and 2005 are just under34%.  The Company’s tax free securities at December 31, 2006 were$18,527,000 or 64.5% of the portfolio compared to $16,886,000 or 68.3% in theprior year.  Tax free income for the year was $612,000 compared to$511,000 in the prior year.  Subject to legislative tax changes, it isanticipated the effective tax rate will remain stable in 2007.

**FinancialCondition**

Totalassets as of December 31, 2006 increased $29,038,000 or 15.4% to $218,184,000compared with $189,146,000 at December 31, 2005.  The increase in totalassets was funded primarily by an increase in total deposits of $22,908,000 andan increase in FHLB advances of $3,000,000.  Cash and cash equivalents increased$10,375,000 over the prior year to $17,453,000 at December 31, 2006. Securities increased $4,010,000 or 16.2% to $28,746,000 at December 31, 2006.

Loans

Loansare the principal component of the Company’s assets and the primary source ofincome.  Total loans grew from $151,131,000 in 2005, to $162,114,000 in2006, an increase of $10,983,000, or 7.3%.  Most of the net loan growth in2006 was in commercial which increased $10,454,000; commercial loans secured byreal estate increased $3,382,000; construction loans secured by real estateincreased $1,252,000; 1-4 family residential real estate loans decreased$857,000; and consumer loans decreased $3,248,000.  As of December 31,2006, $49,996,000 or 30.8% of total loans were commercial loans secured by realestate.  Commercial loans were $53,953,000 or 33.3% of total loans. Construction loans were $28,464,000 or 17.6% of total loans.  Loanssecured by 1-4 family residential real estate were $24,835,000 or 15.3% oftotal loans Consumer and other loans were $4,866,000 or 3.0% of totalloans.  Of the total loans, $110,514,000 or 68.2% mature or reprice withintwelve months.  Only $49,401,000 or 30.5% mature or reprice over fiveyears.

Therewere $2,538,000 in mortgage loans held for sale at December 31, 2006, comparedto $245,000 at December 31, 2005.  Theincrease in mortgage loans held for sale was primarily due to timing issuesrelated to secondary market investor funding.

Loanquality declined somewhat as delinquent and nonaccrual loan levels were higherat the end of 2006.  Their were six loans that were 90 days or more pastdue totaling $293,000 at December 31, 2006 compared to no delinquencies at yearend  2005.  There were three loanstotaling $250,000 on non-accrual at yearend compared to one loan for $27,000 onnonaccrual at yearend 2005.  The Company’sallowance for loan losses ratio to total loans (including mortgage loans) was1.20% at December 31, 2006 compared to 1.35% in 2005.  On December 31,2006 the Company’s loan to deposit ratio (including mortgage loans held forsale) was 84.9%, compared to 89.9% in 2005.  The loan to asset ratio(including mortgage loans held for sale) was 74.3% for 2006, compared to 79.9%in 2005.

Managementexpects loan demand to remain strong, especially in commercial loans. Management anticipates the loan-to-deposit ratio to remain in the range ofapproximately 85%-90% during the coming year.  Funding of future loangrowth may be restricted by our ability to raise core deposits, although wewill use alternative funding sources if necessary and cost effective. Loan growth may also be restricted by the necessity for us to maintainappropriate capital levels, as well as adequate liquidity.

Securities

Thecomposition of our securities portfolio reflects our investment strategy ofmaintaining an appropriate level of liquidity while providing a relativelystable source of income.  Our securities portfolio also provides a balanceto interest rate and credit risk while providing a vehicle for investingavailable funds, furnishing liquidity, and supplying securities to pledge asrequired for certain deposits and borrowed funds.  All securities areclassified as “available for sale”.  We have no plans to liquidate asignificant amount of the securities portfolio.

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AtDecember 31, 2006, the Company owned $28,746,000 in securities, compared to$24,736,000 in 2005.  Total securities increased in 2006 by $4,010,000 or16.2% over the prior year.  The Company’s investment portfolio is used toprovide yield, liquidity and provide pledging to secure public fund deposits.

Premises andEquipment

TheCompany’s fixed asset purchases were $344,000 in 2006.  Additions includeddata processing equipment ($292,000); building improvements ($2,000); andfurniture and fixtures ($50,000).

Deposits

Deposits,which are the Company’s primary source of funds, totaled $191,023,000 atDecember 31, 2006, an increase of $22,908,000 or 13.6% compared to $168,115,000at December 31, 2005.  At year-end 2006, $26,265,000, or 13.7% of theCompany’s total deposits are in noninterest-bearing demand accounts. Interest-bearing demand accounts were $164,758,000 or 86.3% of totaldeposits.   Savings accounts total $7,316,000, or 3.8% of totaldeposits.  The majority of the deposits continue to be in timedeposits.  Time deposits (certificate of deposits) total $117,551,000, or61.5% of total deposits.  CDs greater than $100,000 were $65,177,000compared to CDs less than $100,000 totaling $52,374,000 at December 31, 2006.There was $21,526,000 in brokered CDs at December 31, 2006 compared to$19,263,000 at December 31, 2005.  The Company has targeted localconsumers, professionals, and small businesses as its central clientele. These customers are being offered various deposit instruments such as demanddeposits, savings accounts, money market accounts, certificates of deposit andIRAs.  Rates paid on such instruments are set based on various factorssuch as liquidity needs and market conditions.  The Company believes ithas a competitive advantage by being a locally owned financial institutionwhich will contribute to increased market share.  However, no assurance ofmarket growth can be given.

Themajority of the deposits continue to be CDs, which increased $21,591,000 over2006.  At December 31, 2006, the weighted average rate on CDs was 4.37%compared to 3.33% at December 31, 2005.  The Company has time depositsmaturing within one year of $95,767,000 or 81.5% of total time deposits. Time deposits maturing greater than one year is $21,784,000 or 18.5% of totaltime deposits.  Interest-bearing deposits, other than CDs, increased$1,848,000 at December 31, 2006 compared to 2005. Non interest-bearing depositsdecreased $523,000 in 2006 compared to 2005.  The weighted average cost ofall interest bearing deposit accounts at December 31, 2006 was 3.64% comparedto 2.60% at December 31, 2005.

Liquidity

Liquidityrefers to the Company’s ability to fund loan demand, meet deposit customers’withdrawal needs and provide for operating expenses.  As summarized in theStatement of Cash Flows, the Company’s main sources of cash flow are fromreceiving deposits from its customers, and to a lesser extent, repayment ofloan principal and interest income on loans and securities.

Theprimary uses of cash are lending to the Company’s borrowers, and investing insecurities and short-term interest-earning assets.  In 2006, depositgrowth exceeded loan demand by $11,925,000.  The excess was primarily usedto increase the securities portfolio and federal funds sold.  Otherpotential sources of liquidity include the sale of securities available forsale from the Company’s securities portfolio, the sale of loans held for sale,Federal Home Loan Company advances, purchase of federal funds, repurchaseagreements or brokered deposits.

Capital Resources

TheCompany’s total shareholders’ equity at December 31, 2006 was $16,910,000,compared to $14,171,000 in December 31, 2005.  The increase of $2,739,000was the result of 2006 net income of $2,022,000 along with a net decrease inunrealized losses on securities available for sale of $161,000 net oftax.  Stock options totaling $266,000 were exercised during the year andthe company recorded a tax benefit of $178,000. There was a $48,000 increase in additional paid in capital related tostock option compensation according to FASB No. 123(R). The company eliminatedan overstatement of tax expense in prior years by recording a cumulative catchup adjustment in accordance with SAB 108 of $74,000.

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TheCompany declared a stock dividend of one share for each 20 shares owned forshareholders of record as of May 18, 2006 resulted in $9,000 paid forfractional shares.  The effects of the stock dividend have been reflectedin earnings per share and shares used in the computation of earnings per sharefor all periods presented.

Asof December 31, 2006 and 2005, the most recent regulatory notificationscategorized the Company as well capitalized under the regulatory framework forprompt corrective action.  The total capital to risk-weighted assets ratiofor the Company was 13.35%.  Tier-1 to risk weighted assets ratio was12.26%.  Tier 1 to average asset ratio was 10.82%.

Interest RateSensitivity

Financialinstitutions are subject to interest rate risk to the degree that theirinterest-bearing liabilities (consisting principally of customer deposits)mature or reprice more or less frequently than their interest-earning assets(generally consisting of loans and investment securities.  The matchbetween the scheduled repricing and maturities of earning assets and liabilitieswithin defined time periods is referred to as “gap” analysis.  At December31, 2006 the cumulative one-year gap was only $25,289,000 negative, orliability sensitive.

Oneof management’s objectives in managing the Company’s balance sheet for interestrate sensitivity is to reduce volatility in the net interest margin bymatching, as closely as possible, the timing of the repricing of its interestrate sensitive assets with interest rate sensitive liabilities.  During2006 the Company experienced four increases in the prime rate after eightincreases in 2005.  The result was an increase in the net interest marginto 3.90% in 2006 compared to 3.89% in 2005.   Management believesthat, as of year-end 2006, interest rates will stabilize and possibly declineover the next two years.

**InterestRate Gap Analysis**
| ** **                                             | ** ** | **Reprice’s or Maturing Within** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                             | ** ** | **(Dollars in Thousands)**                 | ** ** |
| ** **                                             | ** ** | **0-3  Months**                                      | ** ** | **3-12  Months** | ** ** | **Total  1 Year** | ** ** | **1-5  Years** | ** ** | **Over  5 Years** | ** ** | **Total** | ** ** |
| ASSETS                                                 |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
|                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Securities                                             |       | $                                                    | 504        |   | $ | — |   | $ | 504 |   | $ | 1,131 |   | $ | 27,111 |   | $ | 28,746 |   |
| Fed Funds Sold                                         |       | 12,288                                               |       | — |   | 12,288 |   | — |   | — |   | 12,288 |   |
| Mortgage Loans                                         |       | 2,537                                                |       |   |   | 2,537 |   |   |   | 2,537 |   |   |   |
| Loans                                                  |       | 88,663                                               |       | 21,851 |   | 110,514 |   | 48,270 |   | 3,331 |   | 162,115 |   |
|                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total Earning Assets                                   |       | $                                                    | 103,992    |   | $ | 21,851 |   | 125,843 |   | $ | 49,401 |   | $ | 30,442 |   | 205,686 |   |
|                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES                                            |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
|                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits                             |       | $                                                    | 76,410     |   | $ | 66,390 |   | 142,800 |   | $ | 21,958 |   | $ | — |   | 164,758 |   |
| Holding Company  Debt                                  |       | 5,000                                                |       |   |   | 5,000 |   |   |   | 5,000 |   |   |   |
| Other borrowings                                       |       | 3,332                                                |       | — |   | 3,332 |   | — |   | — |   | 3,332 |   |
| Total interest-bearing liabilities                     |       | $                                                    | 84,742     |   | $ | 66,390 |   | 151,132,1511 |   | $ | 21,958 |   | $ | — |   | 173,090 |   |
|                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Asset (liability)  GAP                                 |       | 19,250                                               |       | (44,539 | ) | (25,289 | ) | 27,443 |   | 30,442 |   | 32,596 |   |
|                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Cumulative asset  (liability) GAP                      |       | 19,250                                               |       | (25,289 | ) | (25,289 | ) | 2,154 |   | 32,596 |   | 32,596 |   |
|                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Cumulative as a  percentage of interest-earning assets |       | 9.4                                                  | %          | (12.3 | )% | (12.3 | )% | 1.0 | % | 15.8 | % | 15.8 | % |
|                                                        |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

17

----

**I.  Distribution of Assets, Liabilities andShareholders’ Equity; Interest Rates and Interest Differential**

**SOUTHERN HERITAGEBANKAverage Balance Sheets, Net Interest Revenue andChanges in Interest Income and Interest Expense**

The followingtable shows the average daily balances of each principal category of assets,liabilities and stockholders’ equity of the Bank, and an analysis of netinterest revenue, and the change in interest income and interest expensesegregated into amounts attributable to changes in volume and changes in rates.
| ** **                                       | ** ** | **In Thousands of dollars** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                       | ** ** | **December 31, 2006**            | ** ** | **December 31, 2005** | ** ** | **Change** | ** ** |
| ** **                                       | ** ** | **Average  Balance**                       | ** ** | **Interest  Rate** | ** ** | **Revenue/  Expense** | ** ** | **Average  Balance** | ** ** | **Interest  Rate** | ** ** | **Revenue/  Expense** | ** ** | **Due to  Volume** | ** ** | **Due to  Rate (1)** | ** ** | **Total** | ** ** |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Gross loans (2  and 3)                           |       | $                                          | 156,523    |   | 7.60 | % | $ | 11,896 |   | $ | 137,252 |   | 6.60 | % | $ | 9,052 |   | $ | 1,271 |   | 1,573 |   | 2,844 |   |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Securities  available for sale (5)               |       | 25,870                                     |       | 4.17 | % | 1,079 |   | 21,078 |   | 3.91 | % | 824 |   | 187 |   | 68 |   | 255 |   |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds  sold                              |       | 8,853                                      |       | 5.11 | % | 452 |   | 7,244 |   | 3.20 | % | 232 |   | 52 |   | 168 |   | 220 |   |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-earning assets                   |       | 191,246                                    |       | 7.02 | % | $ | 13,427 |   | 165,574 |   | 6.10 | % | $ | 10,108 |   | $ | 1,510 |   | 1,809 |   | 3,319 |   |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from  banks                         |       | 5,072                                      |       |   |   |   |   | 4,506 |   |   |   |   |   |   |   |   |   |   |   |
| Other nonearning  assets                         |       | 7,326                                      |       |   |   |   |   | 6,964 |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for  loan losses                       |       | (2,016                                     | )          |   |   |   |   | (1,875 | ) |   |   |   |   |   |   |   |   |   |   |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total assets                                     |       | $                                          | 201,628    |   |   |   |   |   | $ | 175,169 |   |   |   |   |   |   |   |   |   |   |   |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                        |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| NOW and money  market investments                |       | $                                          | 37,529     |   | 2.06 | % | $ | 774 |   | $ | 41,692 |   | 1.42 | % | $ | 590 |   | $ | (59 | ) | 243 |   | 184 |   |
| Savings                                          |       | 7,102                                      |       | 0.96 | % | 68 |   | 6,414 |   | 0.95 | % | 61 |   | 7 | ** ** | **—** |   | 7 |   |
| Time deposits $100,000  and over                 |       | 60,845                                     |       | 4.30 | % | 2,619 |   | 43,807 |   | 3.27 | % | 1,433 |   | 557 |   | 629 |   | 1,186 |   |
| Other time  deposits                             |       | 45,868                                     |       | 4.46 | % | 2,044 |   | 37,753 |   | 3.42 | % | 1,292 |   | 278 |   | 474 |   | 752 |   |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest-bearing  deposits                 |       | 151,344                                    |       | 3.64 | % | 5,505 |   | 129,666 |   | 2.60 | % | 3,376 |   | 783 |   | 1,346 |   | 2,129 |   |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Borrowings                                       |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|  FFP &Repos                             |       | 374                                        |       | 3.48 | % | 13 |   | 336 |   | 2.68 | % | 9 |   | 1 |   | 3 |   | 4 |   |
|  FHLB Adv                                   |       | 1,545                                      |       | 5.70 | % | 88 | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** | **—** |   | 88 |   | 88 |   |
| Subordinated Debt                                |       | 5,155                                      |       | 7.18 | % | 370 |   | 5,155 |   | 5.32 | % | 274 | ** ** | **—** |   | 96 |   | 96 |   |
| Total Borrowings                                 |       | 7,074                                      |       | 6.66 | % | 471 |   | 5,491 |   | 5.15 | % | 283 |   | 1 |   | 187 |   | 188 |   |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total Interest  bearing liabilities              |       | 158,418                                    |       | 3.77 | % | 5,976 |   | 135,157 |   | 2.71 | % | 3,659 |   | 784 |   | 1,533 |   | 2,317 |   |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities                 |       | 26,104                                     |       | — |   | — |   | 25,592 |   | — |   | — |   | — |   | — |   | — |   |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total Deposits  & Int Bearing Liab           |       | 184,522                                    |       | 3.24 | % | 5,976 |   | 160,749 |   | 2.28 | % | 3,659 |   | 785 |   | 1,533 |   | 2,317 |   |
| Noninterst  bearing liabilities                  |       | 1,878                                      |       |   |   |   |   | 1,092 |   |   |   |   |   |   |   |   |   |   |   |
| Total liabilities                                |       | 186,400                                    |       |   |   |   |   | 161,841 |   |   |   |   |   |   |   |   |   |   |   |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’  equity                       |       | 15,228                                     |       |   |   |   |   | 13,328 |   |   |   |   |   |   |   |   |   |   |   |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total liabilities  and shareholders’ equity |       | $                                          | 201,628    |   |   |   |   |   | $ | 175,169 |   |   |   |   |   |   |   |   |   |   |   |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest  income                             |       |                                       |       |   |   | $ | 7,451 |   |   |   |   |   | $ | 6,449 |   | $ | 725 |   | 276 |   | 1,190 |   |
|                                             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest margin (4)                          |       |                                       |       | 3.90 | % |   |   |   |   | 3.89 | % |   |   |   |   |   |   |   |   |

----

(1)             Changesin interest income and expense not due solely to balance or rate changes areincluded in the rate category.

(2)             Interestincome includes fees on loans of $711,000 in 2006 and $625,000 in 2005.

(3)             Nonaccrualloans are included in average loan balances and the associated income(recognized on a cash basis is included in interest.)

(4)             Netinterest income to average interest-earning assets.

(5)             Interestrates on tax-exempt securities are not adjusted to a tax-equivalent basis.

18

----

The following table shows the average daily balancesof each principal category of assets, liabilities and stockholders’ equity ofthe Bank, and an analysis of net interest revenue, and the change in interestincome and interest expense segregated into amounts attributable to changes involume and changes in rates.
| ** **                                       | ** ** | **In Thousands of dollars** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|
| ** **                                       | ** ** | **December 31, 2005**       | ** ** | **December 31, 2004** | ** ** | **Change** | ** ** |
| ** **                                       | ** ** | **Average  Balance**        | ** ** | **Interest  Rate** | ** ** | **Revenue/  Expense** | ** ** | **Average  Balance** | ** ** | **Interest  Rate** | ** ** | **Revenue/  Expense** | ** ** | **Due to  Volume** | ** ** | **Due to  Rate (1)** | ** ** | **Total** | ** ** |
| Gross loans (2  and 3)                           |       | $                           | 137,252    |   | 6.60 | % | $ | 9,052 |   | $ | 116,267 |   | 5.98 | % | $ | 6,957 |   | $ | 1,256 |   | 839 |   | 2,095 |   |
|                                             |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Securities  available for sale (5)               |       | 21,078                      |       | 3.91 | % | 824 |   | 15,781 |   | 3.82 | % | 603 |   | 202 |   | 19 |   | 221 |   |
|                                             |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds  sold                              |       | 7,244                       |       | 3.20 | % | 232 |   | 4,244 |   | 1.30 | % | 55 |   | 39 |   | 138 |   | 177 |   |
|                                             |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-earning assets                   |       | 165,574                     |       | 6.10 | % | $ | 10,108 |   | 136,292 |   | 5.59 | % | $ | 7,615 |   | $ | 1,497 |   | 996 |   | 2,493 |   |
|                                             |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from  banks                         |       | 4,506                       |       |   |   |   |   | 4,260 |   |   |   |   |   |   |   |   |   |   |   |
| Other nonearning  assets                         |       | 6,964                       |       |   |   |   |   | 6,719 |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for  loan losses                       |       | (1,875                      | )          |   |   |   |   | (1,549 | ) |   |   |   |   |   |   |   |   |   |   |
|                                             |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total assets                                     |       | $                           | 175,169    |   |   |   |   |   | $ | 145,722 |   |   |   |   |   |   |   |   |   |   |   |
|                                             |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                        |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| NOW and money  market investments                |       | $                           | 41,692     |   | 1.42 | % | $ | 590 |   | $ | 38,196 |   | 1.23 | % | $ | 468 |   | $ | 43 |   | 79 |   | 122 |   |
| Savings                                          |       | 6,414                       |       | 0.95 | % | 61 |   | 5,391 |   | 0.96 | % | 52 |   | 10 |   | (1 | ) | 9 |   |
| Time deposits $100,000  and over                 |       | 43,807                      |       | 3.27 | % | 1,433 |   | 35,520 |   | 2.67 | % | 947 |   | 221 |   | 265 |   | 486 |   |
| Other time  deposits                             |       | 37,753                      |       | 3.42 | % | 1,292 |   | 31,628 |   | 2.83 | % | 896 |   | 174 |   | 222 |   | 396 |   |
|                                             |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-bearing deposits                 |       | 129,666                     |       | 2.60 | % | 3,376 |   | 110,735 |   | 2.13 | % | 2,363 |   | 448 |   | 565 |   | 1,013 |   |
|                                             |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Borrowings                                       |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| FFP & Repos                                  |       | 336                         |       | 2.68 | % | 9 |   | 257 |   | 0.39 | % | 1 | ** ** | **—** |   | 8 |   | 8 |   |
| FHLB Adv                                         | ** ** | **—**                  | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| Subordinated Debt                                |       | 5,155                       |       | 5.32 | % | 274 |   | 210 | ** ** | **—** | ** ** | **—** | ** ** | **—** |   | 274 |   | 274 |   |
| Total Borrowings                                 |       | 5,491                       |       | 5.15 | % | 283 |   | 467 |   | 0.21 | % | 1 | ** ** | **—** |   | 282 |   | 282 |   |
|                                             |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total Interest  bearings liabilities             |       | 135,157                     |       | 2.71 | % | 3,659 |   | 111,202 |   | 2.13 | % | 2,364 |   | 448 |   | 847 |   | 1,295 |   |
|                                             |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities                 |       | 25,592                      |       | — |   | — |   | 21,951 |   | — |   | — |   | — |   | — |   | — |   |
|                                             |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total Deposits  & IntBearings Liab           |       | 160,749                     |       | 2.28 | % | 3,659 |   | 133,153 |   | 1.78 | % | 2,364 |   | 448 |   | 847 |   | 1,295 |   |
| Noninterst  bearings liabilities                 |       | 1,092                       |       |   |   |   |   | 768 |   |   |   |   |   |   |   |   |   |   |   |
| Total liabilities                                |       | 161,841                     |       |   |   |   |   | 133,921 |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’  equity                       |       | 13,328                      |       |   |   |   |   | 11,801 |   |   |   |   |   |   |   |   |   |   |   |
|                                             |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total liabilities  and shareholders’ equity |       | $                           | 175,169    |   |   |   |   |   | $ | 145,722 |   |   |   |   |   |   |   |   |   |   |   |
|                                             |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest  income                             |       |                        |       |   |   | $ | 6,449 |   |   |   |   |   | $ | 5,251 |   | $ | 1,049 |   | 149 |   | 1,480 |   |
|                                             |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest margin (4)                          |       |                        |       | 3.89 | % |   |   |   |   | 3.85 | % |   |   |   |   |   |   |   |   |

----

(1)             Changesin interest income and expense not due solely to balance or rate changes areincluded in the rate category.

(2)             Interestincome includes fees on loans of $625,000 in 2005 and $730,000 in 2004.

(3)             Nonaccrualloans are included in average loan balances and the associated income(recognized on a cash basis is included in interest.)

(4)             Netinterest income to average interest-earning assets

(5)             Interestrates on tax-exempt securities are not adjusted to a tax-equivalent basis.

19

----

**II.  INVESTMENT PORTFOLIO**

Thecarrying value of securities at December 31 is summarized as follows:

Category

|                             | ** ** | **December 31**           | ** ** |
|-----------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| ** **                  | ** ** | **($ in thousands)** | ** ** |
| Available for  sale:        |       |                           |       |   |   |   |
|                        |       |                           |       |   |   |
| U.S. Government  securities |       | $                              | 1,872      |   | $ | 1,900 |   |
| State and  municipal        |       | 18,527                         |       | 16,886 |   |
| Mortgage-backed             |       | 7,843                          |       | 5,449 |   |
| Corporate notes             |       | 504                            |       | 501 |   |
|                        |       |                           |       |   |   |
| Total                       |       | $                              | 28,746     |   | $ | 24,736 |   |
|                             |            |                                |            |  |  |  |  |  |

 

Thefollowing table presents the carrying value by maturity distribution of theinvestment portfolio along with weighted average yields thereon as of December31, 2006:

| ($ in thousands)              | ** ** | **Within  1 Year** | ** ** | **1-5  Years** | ** ** | **Beyond  5 Years** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|----------------|------------|--------------------------|------------|-----------|------------|
| U.S. Government securities              |       | $                       | —     |           | 496        |                     | $          | 1,376     |       | $ | 1,872 |   |
| State and municipal                     |       |                    |       |           |       | 18,527                   |       | 18,527    |       |
| Corporate notes                         |       |                    |       |           |       | 504                      |       | 504       |       |
| Weighted average yield (tax equivalent) |       |                    |       |           |       | 5.47                     | %          | 5.41      | %          |
|                                    |       |                    |       |           |       |                     |       |      |       |
| Mortgage-backed                         |       |                    |       |           |       |                     |       | $         | 7,843      |   |
|                                    |       |                    |       |           |       |                     |       |      |       |
| Weighted average yield                  |       |                    |       |           |       |                     |       | 4.75      | %          |
|                                         |            |                         |            |                |            |                          |            |           |            |  |  |  |

 

**III.  LOAN PORTFOLIO**

Thefollowing table presents various categories of loans contained in the Company’sloan portfolio for the periods indicated and the total amount of all loans forsuch period:

| Domestic:                                | ** ** | **2006**                       | ** ** | **2005** | ** ** |
|------------------------------------------|------------|--------------------------------|------------|----------|------------|
| ** **                               | ** ** | **($ in thousands)** | ** ** |
|                                     |       |                           |       |     |       |
| Commercial, financial  and agricultural  |       | $                              | 53,953     |     | $          | 43,499 |   |
| Real estate -  construction              |       | 28,464                         |       | 27,212   |       |
| Real estate - 1 to 4  family residential |       | 24,835                         |       | 25,692   |       |
| Real estate -  commercial                |       | 49,996                         |       | 46,614   |       |
| Consumer                                 |       | 4,866                          |       | 8,114    |       |
| Total loans                              |       | 162,114                        |       | 151,131  |       |
| Allowance for possible  loan losses      |       | (1,971                         | )          | (2,036   | )          |
|                                     |       |                           |       |     |       |
| Total (net of  allowance)                |       | $                              | 160,143    |     | $          | 149,095 |   |

 

20

----

Thefollowing is a presentation of an analysis of maturities of loans as ofDecember 31, 2006:

| Type of Loan                  | ** ** | **Due in 1  Year or  Less** | ** ** | **Due in 1  to 5 Years** | ** ** | **Due After  5 Years** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|--------------------------------------------|------------|----------------------------------------------|------------|----------------------------------|------------|-----------|------------|
| ** **                              | ** ** | **($ in thousands)**             | ** ** |
| Commercial, financial  and agricultural |       | $                                          | 43,583     |                                         | $          | 10,126                           |       | $         | 244        |   | $ | 53,953 |   |
| Real estate -  construction             |       | 19,352                                     |       | 7,928                                        |       | 1,184                            |       | 28,464    |       |
|                                    |       |                                       |       |                                         |       |                             |       |      |       |
| Total                                   |       | $                                          | 62,935     |                                         | $          | 18,054                           |       | $         | 1,428      |   | $ | 82,417 |   |

 

Thefollowing is a presentation of an analysis of sensitivities of such loans tochanges in interest rates as of December 31, 2006 (in thousands):

| Loans due after 1 year with  fixed interest rates   |   | $      | 14,795 |   |
|-----------------------------------------------------|--------|--------|--------|--------|
|                                                |   |   |   |
| Loans due after 1 year with variable interest rates |   | $      | 4,687  |   |

 

Thefollowing table presents information regarding nonaccrual, past due,restructured loans and internally classified substandard or doubtful loans atthe dates indicated:

|                                                                                                                                     | ** ** | **December 31,**          | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                          | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| ** **                                                                                                                          | ** ** | **($ in thousands)** | ** ** |
| Loans accounted for on  a non-accrual basis:                                                                                        |       |                           |       |   |   |
| Number                                                                                                                              |       | 3                              |       | 1 |   |
| Amount                                                                                                                              |       | $                              | 250        |   | $ | 27 |   |
|                                                                                                                                |       |                           |       |   |   |
| Accruing loans  (including consumer loans) which are contractually past due 90 days or more  as to principal and interest payments: |       |                           |       |   |   |
| Number                                                                                                                              |       | 6                              |       | — |   |
| Amount                                                                                                                              |       | 293                            |       | $ | — |   |
|                                                                                                                                |       |                           |       |   |   |
| Loans defined as  “troubled debt restructurings”                                                                          |       |                           |       |   |   |
| Number                                                                                                                              |       | —                         |       | — |   |
| Amount                                                                                                                              |       | $                              | —     |   | $ | — |   |
|                                                                                                                                |       |                           |       |   |   |
| Loans internally  classified as substandard or doubtful                                                                             |       |                           |       |   |   |
| Number                                                                                                                              |       | 25                             |       | 18 |   |
| Amount                                                                                                                              |       | $                              | 6,376      |   | $ | 5,324 |   |

 

Asof December 31, 2006, there are no loans classified for regulatory purposes asdoubtful or substandard that have not been disclosed in the above table, which(i) represent or result from trends or uncertainties which managementreasonably expects will materially impact future operating results, liquidity,or capital resources, or (ii) represent material credits about which managementis aware of any information which causes management to have serious doubts asto the ability of such borrowers to comply with the loan repayment terms.

Accrualof interest is discontinued on a loan when management of the Company determinesupon consideration of economic and business factors affecting collectionefforts that collection of interest is doubtful.

Thereare no other loans which are not disclosed above, but where known informationabout possible credit problems of borrowers causes management to have seriousdoubts as to the ability of such borrowers to comply with the present loanrepayment terms.

21

----

**IV.  SUMMARY OF LOAN LOSS EXPERIENCE**

Ananalysis of the Company’s loss experience is furnished in the following tablefor the periods indicated, as well as a breakdown of the allowance for possibleloan losses (in thousands):

|                                                                                            | ** **  | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|-------------|--------------------------------------------|------------|
| ** **                                                                                 | ** **  | **2006**                                   | ** ** | **2005** | ** ** |
|                                                                                       |        |                                       |       |   |   |
| Balance at beginning of  period                                                            |        | $                                          | 2,036      |   | $ | 1,723 |   |
|                                                                                       |        |                                       |       |   |   |
| Charge-offs:                                                                               | Commercial  |                                       | (721       | ) | (11 | ) |
|                                                                                       | Real Estate |                                       | (20        | ) | **—** | ** ** |
|                                                                                       | Consumer    |                                       | (106       | ) | (72 | ) |
|                                                                                       |        | (847                                       | )          | (83 | ) |
| Recoveries:                                                                                | Commercial  | ** **                                 | **—** |   | 1 |   |
|                                                                                       | Real Estate | ** **                                 | **—** | ** ** | **—** | ** ** |
|                                                                                       | Consumer    |                                       | 26         |   | 21 |   |
|                                                                                       |        |                                       |       |   |   |
| Net Charge-offs                                                                            |        | (821                                       | )          | (61 | ) |
|                                                                                       |        |                                       |       |   |   |
| Additions charged to  operations                                                           |        | 756                                        |       | 374 |   |
|                                                                                       |        |                                       |       |   |   |
| Balance at end of  period                                                                  |        | $                                          | 1,971      |   | $ | 2,036 |   |
|                                                                                       |        |                                       |       |   |   |
| Ratio of net charge-offs during the period to average loans  outstanding during the period |        | .53                                        | %          | .04 | % |

 

AtDecember 31, 2006 and 2005 the allowance was allocated as follows ($ inthousands):

|                                         | ** ** | **2006**   | ** ** | **2005**                                                                            | ** ** |
|-----------------------------------------|------------|------------|------------|-------------------------------------------------------------------------------------|------------|
| ** **                              | ** ** | **Amount** | ** ** | **Percentage of  loans in each  category to  total loans** | ** ** | **Amount** | ** ** | **Percentage of  loans in each  category to  total loans** | ** ** |
| Commercial, financial  and agricultural |       | $          | 788        |                                                                                | 33         | % | $ | 814 |   | 29 | % |
| Real  estate-construction               |       | 197        |       | 18                                                                                  | %          | 204 |   | 18 | % |
| Real estate-1 to 4  family residential  |       | 197        |       | 15                                                                                  | %          | 172 |   | 17 | % |
| Real estate-commercial                  |       | 296        |       | 31                                                                                  | %          | 305 |   | 31 | % |
| Consumer loans                          |       | 493        |       | 3                                                                                   | %          | 509 |   | 5 | % |
|                                    |       |       |       |                                                                                |       |   |   |   |   |
| Total                                   |       | $          | 1,971      |                                                                                | 100        | % | $ | 2,036 |   | 100 | % |

 

Allowance For LoanLosses

Inconsidering the adequacy of the Company’s allowance for loan losses, managementhas focused on the fact that as of December 31, 2006, 64% of outstanding loansare secured by real estate.

TheCompany’s consumer loan portfolio is also well secured, and as such, does not,in management’s opinion involve more than normal credit risk.  The same istrue for the Company’s real estate mortgage portfolio, approximately 15% ofwhich is secured by first mortgage on 1-4 family residential properties.

Althoughthe Company’s loan portfolio is concentrated in East Tennessee, management doesnot believe this geographic concentration presents an abnormally high risk.

22

----

**V.  DEPOSITS**

Thefollowing tables present, for the periods indicated, the average amount of andaverage rate paid on each of the following deposit categories ($ in thousands):

|                             | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------|------------|---------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| **Deposit Category**   | ** ** | **Average  Amount**                         | ** ** | **Average Rate  Paid** | ** ** | **Average  Amount** | ** ** | **Average Rate  Paid** | ** ** |
|                        |       |                                        |       |   |   |   |   |   |   |
| Noninterest-bearing  demand |       | $                                           | 26,104     |   | Not applicable |   | $ | 25,592 |   | Not applicable |   |
| NOW deposits                |       | 37,529                                      |       | 2.06 | % | 41,692 |   | 1.44 | % |
| Savings deposits            |       | 7,102                                       |       | 0.96 | % | 6,414 |   | .95 | % |
| Time deposits               |       | 106,713                                     |       | 4.37 | % | 81,560 |   | 3.33 | % |
|                             |            |                                             |            |  |  |  |  |  |  |  |  |

 

Thefollowing table indicates amount outstanding of time certificates of deposit of$100,000 or more and respective maturities for the year ended December 31, 2006(in thousands):

|                             | ** ** | **Certificates of Deposit** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|
|                        |       |                                  |       |
| 3 months or less            |       | $                                     | 16,912     |   |
| Over 3 to 6 months          |       | 19,765                                |       |
| Over 6 months to 12  months |       | 14,630                                |       |
| Over 12 months              |       | 13,870                                |       |
|                        |       |                                  |       |
| Total                       |       | $                                     | 65,177     |   |

 

**VI.  RETURN ON EQUITY AND ASSETS**

Returnson average consolidated assets and average consolidated equity for the periodsindicated are as follows:

|                                         | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------|------------|--------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
|                                    |       |                                       |       |   |   |
| Return on average  assets               |       | 1.00                                       | %          | 1.09 | % |
| Return on average  equity               |       | 13.28                                      | %          | 14.47 | % |
| Average equity to  average assets ratio |       | 7.55                                       | %          | 7.54 | % |
| Dividend payout ratio                   |       | —                                     | %          | — | % |

 

**VII.  SHORT-TERM BORROWINGS**

Informationconcerning securities sold under agreements to repurchase is summarized asfollows ($ in thousands):

|                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
|                                       |       |     |       |     |       |
| Average daily balance  during the year     |       | $        | 372        |     | $          | 257 |   |
| Average interest rate  during the year     |       | 3.44     | %          | 1.95     | %          |
| Maximum month-end  balance during the year |       | $        | 315        |     | $          | 327 |   |
| Balance at year-end                        |       | $        | 332        |     | $          | 300 |   |
| Weighted average interest rate at year-end |       | 3.64     | %          | 2.56     | %          |

 

23

----

**VIII.  OTHER BORROWINGS**

Atrust formed by the Company issued $5,000,000 of floating rate (3 month LIBORplus 2.05%) trust preferred securities in December 2006 as part of a pooledoffering of such securities.  The Company issued subordinated debenturesin the amount of $5,155,000 to the trust in exchange for the proceeds of theoffering; the debentures represent the sole asset of the trust.  TheCompany may redeem the subordinated debentures, in whole or in part, afterDecember 2009.  The subordinated debentures must be redeemed no later thanDecember 2034.

**ITEM7.  FINANCIAL STATEMENTS**

TheReport of Independent Registered Public Accounting Firm, Consolidated FinancialStatements and supplementary data required by Item 7 are set forth on pages 1through 21 of this Annual Report and are incorporated herein by reference.

**ITEM8.  CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

None.

**ITEM 8A.  CONTROLS AND PROCEDURES**

**DISCLOSURE CONTROLS**

The Companymaintains disclosure controls and procedures, as defined in Rule 13a-15(a)promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”),that are designed to ensure that information required to be disclosed by theCompany in the reports that it files or submits under the Exchange Act isrecorded, processed, summarized and reported within the time period specifiedin the SEC’s rules and forms and that such information is accumulated andcommunicated to the management of the Company , including its Chief ExecutiveOfficer and Chief Financial Officer (“Management”), as appropriate, to allowtimely decisions regarding required disclosure.

Under thesupervision and with the participation of Management, the Company evaluated theeffectiveness of the design and operation of its disclosure controls andprocedures as of the end of the period covered by this report. Based on theevaluation of these disclosure controls and procedures, the Chief ExecutiveOfficer and Chief Financial Officer concluded that the Company’s disclosure controlsand procedures were effective, subject to the effectiveness of the Company’sinternal control over financial reporting.

**INTERNAL CONTROLS**

Management isresponsible for establishing and maintaining adequate internal control overfinancial reporting.  The Company’sinternal control system was designed to provide reasonable assurance toManagement and the board of directors regarding the fair and reliablepreparation and presentation of the consolidated financial statements.

Crowe Chizek andCompany LLC (“Crowe”) is the independent registered public accounting firmresponsible for auditing the Company’s consolidated financial statements.  In connection with Crowe’s audit of theCompany’s consolidated financial statements, Crowe submitted a draft report toManagement and the Audit Committee on April 12, 2007 stating that a combinationof control deficiencies and financial reporting errors amounted to a materialweakness in internal controls over financial reporting.  Crowe submitted its final report on April 20,2007 (the “Report”).  Management hasthoroughly reviewed the draft and final reports and its findings and does notconcur that a material weakness exists. Nonetheless, Management has agreed to review the matters presented byCrowe in the Report and to respond to the deficiencies raised in the Report inorder to ensure that no material weakness does eventually present itself goingforward.

24

----

**Changes in Internal Controls andProcedures**

Management hasevaluated changes in the Company’s internal controls over financial reportingduring the Company’s fiscal quarter ended December 31, 2006.  In connection with such evaluation, as notedabove, Crowe informed Management that a material weakness in internal controlsover financial reporting existed due to the aggregation of certain controldeficiencies that were detected during the 2006 audit.  According to Crowe, the control deficienciesinvolve, the issuance of new, complex accounting standards, the lack ofmeasurement of the departure from generally accepted accounting principlesassociated with loan fee accounting and adjustments that were required to theCompany’s financial statements after they were presented to the auditors.

Subject to the above discussion, there have been nochanges to the Company’s internal controls over financial reporting thatoccurred since the beginning of the quarter ended December 31, 2006 that havematerially affected, or are reasonably likely to materially affect, the Company’sinternal control over financial reporting.

**ITEM8B.  OTHER INFORMATION**

None.

**PART III**

**ITEM9.  DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT**

Informationrelating to our directors and executive officers is contained in a definitiveProxy Statement involving the election of directors at the annual meeting of shareholdersto be held May 17, 2007, and such information is incorporated herein byreference.

**ITEM10.  EXECUTIVE COMPENSATION.**

Informationrelating to executive compensation is contained in the Proxy Statement referredto above in Item 9, and such information is incorporated herein by reference.

**ITEM11.  SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.**

Informationrelating to security ownership of certain beneficial owners and management iscontained in the Proxy Statement referred to above in Item 9, and suchinformation is incorporated herein by reference.

**ITEM12.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

Informationrelating to certain relationships and related transactions is contained in theProxy Statement referred to above in Item 9, and such information isincorporated herein by reference.

25

----

**ITEM13.  EXHIBITS**

| Exhibit No. | ** ** | **Description**                                                                                                                            |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                       |
| 3.1*             |       | Charter of Southern  Heritage Bancshares, Inc.                                                                                             |
| 3.2*             |       | Bylaws of Southern  Heritage Bancshares, Inc.                                                                                              |
| 4*               |       | Specimen Stock  Certificate for Southern Heritage Bancshares, Inc.                                                                         |
| 10.1**           |       | 2000 Stock Option Plan  for Employees for Southern Heritage Bancshares, Inc., as  successor-in-interest to Southern Heritage Bank          |
| 10.2**           |       | 2000 Non-Employee  Directors Stock Option Plan for Southern Heritage Bancshares, Inc., as  successor-in-interest to Southern Heritage Bank |
| 21**             |       | Subsidiaries of  Registrant                                                                                                                |
| 31.1             |       | Certification pursuant  to Rule 13a-14a/15d-14(a)                                                                                          |
| 31.2             |       | Certification pursuant  to Rule 13a-14a/15d-14(a)                                                                                          |
| 32.1             |       | Certification pursuant  to Rule 18 USC Section 1350-Sarbanes-Oxley Act of 2002                                                             |
| 33.2             |       | Certification pursuant  to Rule 18 USC Section 1350-Sarbanes-Oxley Act of 2002                                                             |

----

*Previouslyfiled as an exhibit to the Company’s Registration Statement on Form 8-KSB, asfiled with the Securities and Exchange Commission on August 31, 2005.

**Previouslyfiled as an exhibit to the Company’s Registration Statement on Form 10-KSB, asfiled with the Securities and Exchange Commission on April 14, 2005.

**ITEM14.  PRINCIPAL ACCOUNTANT FEES AND SERVICES**

Informationrelating to certain relationships and related transactions is contained in theProxy Statement referred to above in Item 9, and such information isincorporated herein by reference.

26

----

Inaccordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant caused this registration statement to be signed on its behalf by theundersigned, thereunto duly authorized.
|        |   | **SOUTHERN HERITAGE BANCSHARES, INC.** |
|--------|--------|----------------------------------------|
|   |   |                                   |   |
|   |   | By:                                    |   | /s/ Steven W. Ledbetter |
|   |   |                                   | Steven W. Ledbetter, Executive Vice |
|   |   |                                   | President and Chief Financial Officer |
|        |        |                                        |  |  |

 

Inaccordance with the Exchange Act, this report has been signed below by thefollowing persons on behalf of the registrant in their capacities as directors.
| By:    | /s/ R. Danny Hays       |   | By:    | /s/ Larry S. McDaniel         |
|--------|-------------------------|--------|--------|-------------------------------|
|   | R. Danny Hays, M.D.     |   |   | Larry S. McDaniel             |
| Date:  | April 23, 2007          |   | Date:  | April 23, 2007                |
|   |                    |   |   |                          |
| By:    | /s/ Steven W. Ledbetter |   | By:    | /s/ J. Lee Stewart            |
|   | Steven W. Ledbetter     |   |   | J. Lee Stewart                |
| Date:  | April 23, 2007          |   | Date:  | April 23, 2007                |
|   |                    |   |   |                          |
| By:    | /s/ Henry F. Smith      |   | By:    | /s/ Len D. Graham             |
|   | Henry F. Smith          |   |   | Len D. Graham                 |
| Date:  | April 23, 2007          |   | Date:  | April 23, 2007                |
|   |                    |   |   |                          |
| By:    | /s/ Jim A. Workman      |   | By:    | /s/ Clyde A. Kyle, Jr.        |
|   | Jim A. Workman          |   |   | Clyde A. Kyle, Jr., M.D.      |
| Date:  | April 23, 2007          |   | Date:  | April 23, 2007                |
|   |                    |   |   |                          |
| By:    | /s/ Eddie N. Duncan     |   | By:    | /s/ Lester T. Simerville, Sr. |
|   | Eddie N. Duncan, M.D.   |   |   | Lester T. Simerville, Sr.     |
| Date:  | April 23, 2007          |   | Date:  | April 23, 2007                |
|   |                    |   |   |                          |
| By:    | /s/ Roger E. Jenne      |   | By:    | /s/ James F. Williams, Jr.    |
|   | Roger E. Jenne, Esq.    |   |   | James F. Williams, Jr.        |
| Date:  | April 23, 2007          |   | Date:  | April 23, 2007                |
|        |                         |        |        |                               |  |  |

 

27

----

**SOUTHERN HERITAGEBANCSHARES, INC.CLEVELAND, TENNESSEE**

**CONSOLIDATEDFINANCIAL STATEMENTSDECEMBER 31, 2006 AND 2005**

**CONTENTS**
|                                                                  | ** ** | ** ** |
|------------------------------------------------------------------|------------|------------|
| REPORT OF  INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM         |       |       |
|                                                             |       |       |
| CONSOLIDATED FINANCIAL  STATEMENTS                               |       |       |
|                                                             |       |       |
| CONSOLIDATED BALANCE  SHEETS                                     |       |       |
|                                                             |       |       |
| CONSOLIDATED  STATEMENTS OF OPERATIONS                           |       |       |
|                                                             |       |       |
| CONSOLIDATED  STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY |       |       |
|                                                             |       |       |
| CONSOLIDATED  STATEMENTS OF CASH FLOWS                           |       |       |
|                                                             |       |       |
| NOTES TO  CONSOLIDATED FINANCIAL STATEMENTS                      |       |       |

 

----

**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

Shareholders and Board ofDirectors

Southern HeritageBancshares, Inc.

Cleveland,Tennessee

We have auditedthe accompanying consolidated balance sheets of Southern HeritageBancshares, Inc. as of December 31, 2006 and 2005, and the relatedconsolidated statements of operations, changes in shareholders’ equity and cashflows for the years then ended. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits.

We conducted ouraudits in accordance with auditing standards of the Public Company AccountingOversight Board (United States). Those standards require that we plan andperform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

In our opinion,the consolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Southern HeritageBancshares, Inc. as of December 31, 2006 and 2005, and the results of itsoperations and its cash flows for the years then ended in conformity with U. S.generally accepted accounting principles.

As discussed inNote 1, the Company adopted Staff Accounting Bulleting 108 *Consideringthe Effect of Prior Year Misstatements when Quantifying Misstatements in theCurrent Year Financial Statements* and accordingly adjusted assetsand liabilities at the beginning of 2006 with an offsetting adjustment to theopening balance of retained earnings. Also discussed in Note 1, the Companyadopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), *Share-based Payment*, using the modified prospectivetransition method as of January 1, 2006 and accordingly has recordedstock-based employee compensation cost using the fair value method.

Crowe Chizek andCompany LLC

Brentwood, Tennessee

April 20, 2007

F-1

----

**SOUTHERNHERITAGE BANCSHARES, INC.**

**CONSOLIDATED BALANCE SHEETS**

**December31, 2006 and 2005**

(Dollar amounts inthousands except per share data)
| ** **                                                                                                                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **ASSETS**                                                                                                                                   |       |     |       |     |       |
| Cash and due from  financial institutions                                                                                                    |       | $        | 5,165      |     | $          | 5,250 |   |
| Federal funds sold                                                                                                                           |       | 12,288   |       | 1,828    |       |
| Cash and cash  equivalents                                                                                                                   |       | 17,453   |       | 7,078    |       |
|                                                                                                                                         |       |     |       |     |       |
| Securities available  for sale                                                                                                               |       | 28,746   |       | 24,736   |       |
| Mortgage loans held for  sale                                                                                                                |       | 2,538    |       | 245      |       |
| Loans                                                                                                                                        |       | 162,114  |       | 151,131  |       |
| Allowance for loan  losses                                                                                                                   |       | (1,971   | )          | (2,036   | )          |
| Net loans                                                                                                                                    |       | 160,143  |       | 149,095  |       |
|                                                                                                                                         |       |     |       |     |       |
| Premises and equipment                                                                                                                       |       | 5,177    |       | 5,366    |       |
| Restricted equity  securities                                                                                                                |       | 830      |       | 515      |       |
| Accrued interest  receivable                                                                                                                 |       | 1,043    |       | 819      |       |
| Other assets                                                                                                                                 |       | 2,254    |       | 1,292    |       |
|                                                                                                                                         |       |     |       |     |       |
| Total assets                                                                                                                                 |       | $        | 218,184    |     | $          | 189,146 |   |
|                                                                                                                                         |       |     |       |     |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                               |       |     |       |     |       |
| Liabilities                                                                                                                                  |       |     |       |     |       |
| Deposits                                                                                                                                     |       |     |       |     |       |
| Non-interest  bearing                                                                                                                        |       | $        | 26,265     |     | $          | 26,788 |   |
| Interest bearing                                                                                                                             |       | 164,758  |       | 141,327  |       |
| Total deposits                                                                                                                               |       | 191,023  |       | 168,115  |       |
|                                                                                                                                         |       |     |       |     |       |
| Repurchase  agreements and federal funds purchased                                                                                           |       | 332      |       | 300      |       |
| Federal Home  Loan Bank advances                                                                                                             |       | 3,000    |       | —   |       |
| Accrued interest  payable                                                                                                                    |       | 1,494    |       | 904      |       |
| Subordinated  debentures                                                                                                                     |       | 5,155    |       | 5,155    |       |
| Other  liabilities                                                                                                                           |       | 270      |       | 501      |       |
| Total  liabilities                                                                                                                           |       | 201,274  |       | 174,975  |       |
|                                                                                                                                         |       |     |       |     |       |
| Shareholders’ equity                                                                                                                    |       |     |       |     |       |
| Preferred stock,  no par value; 1,000,000 shares authorized; none issued                                                                     |       | —   |       | —   |       |
| Common stock, $1  par value; 2,000,000 shares authorized; 1,164,996 shares issued at  Dec. 31, 2006 and 1,082,675 at Dec. 31, 2005 |       | 1,164    |       | 1,082    |       |
| Additional  paid-in capital                                                                                                                  |       | 13,074   |       | 10,766   |       |
| Retained  earnings                                                                                                                           |       | 2,885    |       | 2,696    |       |
| Accumulated  other comprehensive income (loss)                                                                                               |       | (213     | )          | (373     | )          |
|                                                                                                                                         |       |     |       |     |       |
| Total  shareholders’ equity                                                                                                             |       | 16,910   |       | 14,171   |       |
| Total liabilities and  shareholders’ equity                                                                                             |       | $        | 218,184    |     | $          | 189,146 |   |

 

See accompanyingnotes to consolidated financial statements.

F-2

----

**SOUTHERNHERITAGE BANCSHARES, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**YearsEnded December 31, 2006 and 2005**

(Dollar amounts inthousands except per share data)
| ** **                                                                            | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| Interest income                                                                       |       |      |       |      |       |
| Loans, including fees                                                                 |       | $         | 11,896     |      | $          | 9,052 |   |
| Securities                                                                            |       | 1,079     |       | 832       |       |
| Federal funds sold                                                                    |       | 452       |       | 232       |       |
|                                                                                  |       | 13,427    |       | 10,116    |       |
| Interest expense                                                                      |       |      |       |      |       |
| Deposits                                                                              |       | 5,505     |       | 3,376     |       |
| Other                                                                                 |       | 472       |       | 283       |       |
|                                                                                  |       | 5,977     |       | 3,659     |       |
|                                                                                  |       |      |       |      |       |
| **Net  interest income**                                                              |       | 7,450     |       | 6,457     |       |
|                                                                                  |       |      |       |      |       |
| Provision for  loan losses                                                            |       | 756       |       | 374       |       |
|                                                                                  |       |      |       |      |       |
| **Net  interest income after provision for loan losses**                              |       | 6,694     |       | 6,083     |       |
|                                                                                  |       |      |       |      |       |
| Noninterest  income                                                                   |       |      |       |      |       |
| Service charges on deposit accounts                                                   |       | 1,028     |       | 1,285     |       |
| Gain on sale of loans                                                                 |       | 568       |       | 442       |       |
| Net gains (losses) on available for sale securities  and restricted equity securities |       | 191       |       | (5        | )          |
| Other                                                                                 |       | 294       |       | 270       |       |
|                                                                                  |       | 2,081     |       | 1,992     |       |
| Noninterest  expense                                                                  |       |      |       |      |       |
| Salaries and employee benefits                                                        |       | 2,997     |       | 2,624     |       |
| Occupancy                                                                             |       | 410       |       | 360       |       |
| Furniture and equipment                                                               |       | 151       |       | 141       |       |
| Data processing                                                                       |       | 531       |       | 491       |       |
| Advertising and public relations                                                      |       | 345       |       | 250       |       |
| Operating supplies                                                                    |       | 117       |       | 92        |       |
| Other                                                                                 |       | 1,186     |       | 1,161     |       |
|                                                                                  |       | 5,737     |       | 5,119     |       |
|                                                                                  |       |      |       |      |       |
| **Income  before income taxes**                                                       |       | 3,038     |       | 2,956     |       |
|                                                                                  |       |      |       |      |       |
| Income taxes                                                                          |       | 1,016     |       | 999       |       |
|                                                                                  |       |      |       |      |       |
| **Net  income**                                                                       |       | $         | 2,022      |      | $          | 1,957 |   |
|                                                                                  |       |      |       |      |       |
| Earnings per  share:                                                                  |       |      |       |      |       |
| Basic                                                                                 |       | $         | 1.76       |      | $          | 1.73 |   |
| Diluted                                                                               |       | $         | 1.65       |      | $          | 1.61 |   |
|                                                                                  |       |      |       |      |       |
| Shares used in  computation of earnings per share:                                    |       |      |       |      |       |
| Basic                                                                                 |       | 1,150,713 |       | 1,132,136 |       |
| Diluted                                                                               |       | 1,225,189 |       | 1,218,072 |       |

 

See accompanyingnotes to consolidated financial statements.

F-3

----

**SOUTHERNHERITAGE BANCSHARES, INC.**

**CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**

**YearsEnded December 31, 2006 and 2005**

(Dollar amounts inthousands except per share data)
| ** **                                                                    | ** ** | **Common  Shares** | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Total  Shareholders’  Equity** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|----------------------------------|------------|------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------|------------|
|                                                                          |       |               |       |              |       |                             |       |                   |       |                                                      |       |                                  |       |
| Balance at  January 1, 2005                                              |       | 1,025              |       | $                 | 1,025      |                             | $          | 9,222                  |       | $                                                         | 2,277      |                                  | $          | 3 |   | $ | 12,527 |   |
|                                                                          |       |               |       |              |       |                             |       |                   |       |                                                      |       |                                  |       |
| Comprehensive  income:                                                        |       |               |       |              |       |                             |       |                   |       |                                                      |       |                                  |       |
| Net income                                                                    |       | —             |       | —            |       | —                           |       | 1,957                  |       | —                                                    |       | 1,957                                 |       |
| Change in unrealized gain on securities available  for sale, net of tax $196  |       | —             |       | —            |       | —                           |       | —                 |       | (379                                                      | )          | (379                                  | )          |
| Reclassification adjustment for losses included in  net income, net of tax $2 |       | —             |       | —            |       | —                           |       | —                 |       | 3                                                         |       | 3                                     |       |
|                                                                          |       |               |       |              |       |                             |       |                   |       |                                                      |       |                                  |       |
| Total  comprehensive income                                                   |       |               |       |              |       |                             |       |                   |       |                                                      |       | 1,581                                 |       |
|                                                                          |       |               |       |              |       |                             |       |                   |       |                                                      |       |                                  |       |
| Stock dividend  (5%) declared                                                 |       | 51                 |       | 51                |       | 1,487                            |       | (1,538                 | )          | —                                                    |       | —                                |       |
| Cash paid for  fractional shares                                              |       | (1                 | )          | (1                | )          | —                           |       | —                 |       | —                                                    |       | (1                                    | )          |
| Common Stock  Transactions:                                                   |       |               |       |              |       |                             |       |                   |       |                                                      |       |                                  |       |
| Non- employee directors’ stock plan                                      |       | 1                  |       | 1                 |       | 10                               |       | —                 |       | —                                                    |       | 11                                    |       |
| Employee stock plan                                                           |       | 6                  |       | 6                 |       | 47                               |       | —                 |       | —                                                    |       | 53                                    |       |
|                                                                          |       |               |       |              |       |                             |       |                   |       |                                                      |       |                                  |       |
| Balance at  December 31, 2005                                                 |       | 1,082              |       | 1,082             |       | 10,766                           |       | 2,696                  |       | (373                                                      | )          | 14,171                                |       |
|                                                                          |       |               |       |              |       |                             |       |                   |       |                                                      |       |                                  |       |
| Cumulative catch  up adjustment in accordance with SAB108                     |       |               |       |              |       |                             |       | 74                     |       |                                                      |       | 74                                    |       |
| Comprehensive  income:                                                        |       |               |       |              |       |                             |       |                   |       |                                                      |       |                                  |       |
| Net income                                                                    |       | —             |       | —            |       | —                           |       | 2,022                  |       | —                                                    |       | 2,022                                 |       |
| Change in unrealized loss on securities available  for sale, net of tax $83   |       | —             |       | —            |       | —                           |       | —                 |       | 161                                                       |       | 161                                   |       |
| Reclassification adjustment for gains included in  net income, net of tax $1  |       | —             |       | —            |       | —                           |       | —                 |       | (1                                                        | )          | (1                                    | )          |
| Total  comprehensive income                                                   |       |               |       |              |       |                             |       |                   |       |                                                      |       | 2,182                                 |       |
|                                                                          |       |               |       |              |       |                             |       |                   |       |                                                      |       |                                  |       |
| Stock based  compensation expense                                             |       |               |       |              |       | 48                               |       |                   |       |                                                      |       | 48                                    |       |
| Stock dividend  (5%) declared                                                 |       | 54                 |       | 54                |       | 1,844                            |       | (1,898                 | )          | —                                                    |       | —                                |       |
| Tax benefit from  exercise of stock options                                   |       |               |       |              |       | 178                              |       |                   |       |                                                      |       | 178                                   |       |
| Cash paid for  fractional shares                                              |       | —             |       | —            |       |                             |       | (9                     | )          | —                                                    |       | (9                                    | )          |
| Common Stock  Transactions:                                                   |       |               |       |              |       |                             |       |                   |       |                                                      |       |                                  |       |
| Non- employee directors’ stock plan                                      |       | 1                  |       | 1                 |       | 10                               |       | —                 |       | —                                                    |       | 11                                    |       |
| Employee stock plan                                                           |       | 27                 |       | 27                |       | 228                              |       | —                 |       | —                                                    |       | 255                                   |       |
|                                                                          |       |               |       |              |       |                             |       |                   |       |                                                      |       |                                  |       |
| Balance at December 31,  2006                                                 |       | 1,164              |       | $                 | 1,164      |                             | $          | 13,074                 |       | $                                                         | 2,885      |                                  | $          | (213 | ) | $ | 16,910 |   |

 

See accompanyingnotes to consolidated financial statements.

F-4

----

**SOUTHERNHERITAGE BANCSHARES, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**YearsEnded December 31, 2006 and 2005**

(Dollar amounts inthousands except per share data)
| ** **                                                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **Cash  flows from operating activities**                                  |       |     |       |     |       |
| Net income                                                                 |       | $        | 2,022      |     | $          | 1,957 |   |
| Adjustments to reconcile net income to net cash from  operating activities |       |     |       |     |       |
| Provision for loan losses                                                  |       | 756      |       | 374      |       |
| Depreciation and amortization                                              |       | 454      |       | 412      |       |
| Investment securities (gains) losses                                       |       | (191     | )          | 5        |       |
| Mortgage loans originated for sale                                         |       | (27,481  | )          | (26,856  | )          |
| Proceeds from sale of mortgage loans                                       |       | 25,756   |       | 27,736   |       |
| Gains on sales of mortgage loans                                           |       | (568     | )          | (442     | )          |
| Loss on sale of other real estate                                          |       | 13       |       | 23       |       |
| Tax benefit from exercise of stock options                                 |       | (178     | )          | —   |       |
| Stock compensation expense                                                 |       | 48       |       | —   |       |
| Deferred income tax expense (benefit)                                      |       | 145      |       | (128     | )          |
| Changes in operating assets and liabilities:                               |       |     |       |     |       |
| Increase in accrued interest receivable                                    |       | (224     | )          | (290     | )          |
| Decrease in accrued interest payable                                       |       | 590      |       | 475      |       |
| Other, net                                                                 |       | (846     | )          | 24       |       |
| Net cash provided by operating activities                                  |       | 296      |       | 3,290    |       |
|                                                                       |       |     |       |     |       |
| **Cash  flows from investing activities**                                  |       |     |       |     |       |
| Proceeds from maturities and redemptions of  securities available for sale |       | 1,054    |       | 1,379    |       |
| Proceeds from sales of securities available for sale                       |       | 7,671    |       | 5,294    |       |
| Purchases of securities available for sale                                 |       | (12,527  | )          | (12,317  | )          |
| Proceeds from sales of restricted equity securities                        |       | 275      |       |     |       |
| Purchases of restricted equity securities                                  |       | (400     | )          | (60      | )          |
| Net increase in loans                                                      |       | (12,344  | )          | (25,480  | )          |
| Proceeds from sale of other real estate                                    |       | 203      |       | 11       |       |
| Proceeds from sale of premises and equipment                               |       | —   |       | 32       |       |
| Net purchases of premises and equipment                                    |       | (228     | )          | (232     | )          |
| Net used in investing activities                                           |       | (16,296  | )          | (31,373  | )          |
|                                                                       |       |     |       |     |       |
| **Cash  flows from financing activities**                                  |       |     |       |     |       |
| Increase (decrease) in repurchase agreements and  federal funds purchased  |       | 32       |       | (752     | )          |
| Increase in Federal Home Loan Bank Advances                                |       | 3,000    |       | —   |       |
| Proceeds from exercise of stock options                                    |       | 266      |       | 64       |       |
| Dividends paid                                                             |       | (9       | )          | —   |       |
| Tax benefit from the exercise of stock options                             |       | 178      |       | —   |       |
| Net increase in deposits                                                   |       | 22,908   |       | 30,756   |       |
| Net cash provided by financing activities                                  |       | 26,375   |       | 30,068   |       |
|                                                                       |       |     |       |     |       |
| Net increase in  cash and cash equivalents                                 |       | 10,375   |       | 1,985    |       |
|                                                                       |       |     |       |     |       |
| Cash and cash  equivalents at beginning of year                            |       | 7,078    |       | 5,093    |       |
|                                                                       |       |     |       |     |       |
| Cash and cash  equivalents at end of year                                  |       | $        | 17,453     |     | $          | 7,078 |   |
|                                                                       |       |     |       |     |       |
| **Supplemental  disclosures of cash flow information**                     |       |     |       |     |       |
| Cash paid during  year for:                                                |       |     |       |     |       |
| Interest                                                                   |       | $        | 5,387      |     | $          | 3,184 |   |
| Income taxes                                                               |       | 1,297    |       | 1,061    |       |
| Loans transferred to  other real estate acquired through foreclosure       |       | 540      |       | 213      |       |

 

See accompanyingnotes to consolidated financial statements.

F-5

----

 **NOTE 1 — NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

The accountingprinciples followed and the methods of applying those principlesconform with accounting principles generally accepted in the United Statesof America and to general practices in the banking industry. The significantpolicies are summarized as follows:

Basis ofPresentation: The consolidated financial statements includeSouthern Heritage Bancshares, Inc. and its wholly owned subsidiary,Southern Heritage Bank, together referred to as “the Company”. Inter companytransactions and balances are eliminated in consolidation.

Nature ofOperations:  Southern Heritage Bancshares, Inc. wasformed in 2004 as a one bank holding company that owns 100% of SouthernHeritage Bank (the Bank).  Substantiallyall of the consolidated operations are that of the Bank.

Southern HeritageBank received its charter as a state bank and began operations onApril 12, 1999. The Company provides a variety of banking services toindividuals and businesses in Bradley County, Tennessee. Its primary depositproducts are demand and savings deposits and certificates of deposit, and itsprimary lending products are commercial, real estate mortgage and installmentloans.

Use of Estimates: To prepare financial statements in conformity with accounting principlesgenerally accepted in the United States of America, management makes estimatesand assumptions based on available information. These estimates and assumptionsaffect the amounts reported in the financial statements and the disclosuresprovided, and future results could differ. The allowance for loan losses andfair values of financial instruments are particularly subject to change.

Cash Flows: Cash and cash equivalents include cash, deposits with other financialinstitutions under 90 days, and federal funds sold. Net cash flows are reportedfor customer loan and deposit transactions, federal funds purchased andrepurchase agreements.

Securities: Securities are classified as held to maturity and carried at amortized costwhen management has the positive intent and ability to hold them to maturity.Securities are classified as available for sale when they might be sold beforematurity. Securities available for sale are carried at fair value, withunrealized holding gains and losses reported in other comprehensive income.Restricted equity securities such as Federal Home Loan Bank stock are carriedat cost.

Interest incomeincludes amortization of purchase premium or discount. Premiums and discountson securities are amortized on the level-yield method without anticipatingprepayments. Gains and losses on sales are recorded on the trade date anddetermined using the specific identification method.

Declines in thefair value of securities below their cost that are other than temporary arereflected as realized losses. In estimating other-than-temporary losses,management considers: (1) the length of time and extent that fair valuehas been less than cost, (2) the financial condition and near termprospects of the issuer, and (3) the Company’s ability and intent to holdthe security for a period sufficient to allow for any anticipated recovery infair value.

Loans: Loans that management has the intent and ability to hold for the foreseeablefuture or until maturity or payoff are reported at the principal balanceoutstanding, net of unearned interest and an allowance for loan losses.

Interest income isreported on the interest method and includes amortization of net deferred loanfees over the loan term using the level-yield method without anticipatingprepayments. Interest income on mortgage and commercial loans is discontinuedat the time the loan is 90 days delinquent unless the credit is well-securedand in process of collection. In all cases, loans are placed on nonaccrual orcharged-off at an earlier date if collection of principal or interest isconsidered doubtful.

All interestaccrued, but not received, for loans placed on nonaccrual is reversed againstinterest income. Interest received on such loans is accounted for on the cash-basisor cost-recovery method, until qualifying for return to accrual. Loans arereturned to accrual status when all the principal and interest amountscontractually due are brought current and future payments are reasonablyassured.

F-6

----

Mortgage LoansHeld for Sale:  Mortgage loans originated and intendedfor sale in the secondary market are carried at the lower of aggregate cost ormarket, as determined by outstanding commitments from investors. Net unrealizedlosses, if any, are recorded as a valuation allowance and charged to earnings.The related servicing rights are generally sold with the loans. At December 31,2006 and 2005, cost approximates the market value of such loans.

ForeclosedAssets:  Assets acquired through or instead of loanforeclosure are initially recorded at fair value when acquired, establishing anew cost basis. If fair value declines, subsequent to foreclosure, a valuationallowance is recorded through expense. Operating costs after acquisition areexpensed.

Allowance for LoanLosses:  The allowance for loan losses is a valuationallowance for probable incurred credit losses, increased by the provision forloan losses and decreased by charge-offs less recoveries. Management estimatesthe allowance balance required using past loan loss experience, the nature andvolume of the portfolio, information about specific borrower situations andestimated collateral values, economic conditions, and other factors.Allocations of the allowance may be made for specific loans, but theentire allowance is available for any loan that, in management’s judgment,should be charged-off. Loan losses are charged against the allowance whenmanagement believes the uncollectibility of a loan balance is confirmed.

The allowanceconsists of specific and general components. The specific component relates toloans that are individually classified as impaired or loans otherwiseclassified as substandard or doubtful. The general component coversnon-classified loans and is based on historical loss experience adjusted forcurrent factors.

A loan is impairedwhen full payment under the loan terms is not expected. Commercial andcommercial real estate loans meeting certain size and performancecharacteristics are individually evaluated for impairment. If a loan isimpaired, a portion of the allowance is allocated so that the loan is reported,net, at the present value of estimated future cash flows using the loan’sexisting rate or at the fair value of collateral if repayment is expectedsolely from the collateral. Large groups of smaller balance homogeneous loans,such as consumer and residential real estate loans, are collectively evaluatedfor impairment, and accordingly, they are not separately identified forimpairment disclosures.

Premises andEquipment:  Land is carried at cost. Premises andequipment are stated at cost less accumulated depreciation. Buildings andrelated components are depreciated using the straight-line method with usefullives ranging from 5 to 33 years. Furniture, fixtures and equipment are depreciatedusing the straight-line method with useful lives ranging from 3 to 5 years.

Long-term Assets:** **Premises and equipment and otherlong-term assets are reviewed for impairment when events indicate theircarrying amount may not be recoverable from future undiscounted cashflows. If impaired, the assets are recorded at fair value

Income Taxes: Income tax expense is the total of the current year income tax due orrefundable and the change in deferred tax assets and liabilities. Deferred taxassets and liabilities are the expected future tax amounts for the temporarydifferences between carrying amounts and tax bases of assets and liabilities,computed using enacted tax rates. A valuation allowance, if needed, reducesdeferred tax assets to the amount expected to be realized.

Repurchase Agreements: Substantially all repurchase agreement liabilities represent amounts advancedby various customers. Securities are pledged to cover these liabilities, whichare not covered by federal deposit insurance.

Earnings Per ShareAmounts:  Basic earnings per share is computed using theweighted average number of common shares outstanding during the period andexcludes any dilutive effects of options. Diluted earnings per share iscomputed using the weighted average number of common and common stockequivalent shares outstanding during the period; common stock equivalent sharesare excluded from the computation if their effect is antidilutive. The effectof these options on earnings per common share was to increase average sharesoutstanding by 74,000 and 86,000 in 2006 and 2005 and decrease earnings pershare by $.11 and $.12. No shares were antidilutive at December 31, 2006 and2005.

ComprehensiveIncome:  Comprehensive income consists of net income andother comprehensive income (loss). Other comprehensive income (loss) includesunrealized gains and losses on securities available for sale which is alsorecognized as a separate component of equity.

F-7

----

Fair Value of Financial Instruments:  Fair values of financial instrumentsare estimated using relevant market information and other assumptions, as morefully disclosed in a separate note. Fair value estimates involve uncertaintiesand matters of significant judgment regarding interest rates, credit risk,prepayments, and other factors, especially in the absence of broad markets forparticular items. Changes in assumptions or in market conditions couldsignificantly affect the estimates**.**

Off Balance SheetFinancial Instruments:  Financial instruments includeoff-balance sheet credit instruments, such as commitments to make loans andstandby letters of credit, issued to meet customer financing needs. The faceamount for these items represents the exposure to loss, before consideringcustomer collateral or ability to repay. Such financial instruments arerecorded when they are funded.

Operating Segments: While the chief decision-makers monitor the revenue streams of the variousproducts and services, the identifiable segments are not material andoperations are managed and financial performance is evaluated on a Company-widebasis. Accordingly, all of the financial service operations are considered bymanagement to be aggregated in one reportable operating segment.

Reclassifications: Some items in the prior year financial statements were reclassified toconform to the current presentation.

Loss Contingencies: Loss contingencies, including claims and legal actions arising in the ordinarycourse of business, are recorded as liabilities when the likelihood of loss isprobable and an amount or range of loss can be reasonably estimated. Managementdoes not believe there now are such matters that will have a material effect onthe financial statements.

Restrictions onCash:  Cash on hand or on deposit with the FederalReserve Bank was required to meet regulatory reserve and clearing requirements.These balances do not earn interest.

Equity: Stock dividends in excess of 20% are reported by transferring the par value ofthe stock issued from retained earnings to common stock. Stock dividends for20% or less are reported by transferring the fair value, as of the ex-dividenddate, of the stock issued from retained earnings to common stock and additionalpaid-in capital. Fractional share amounts are paid in cash with a reduction inretained earnings. The Company declared a stock dividend of one share for each20 shares owned for shareholders of record as of May 18, 2006. The effectsof this stock dividend have been reflected in earnings per share and sharesused in the computation of earnings per share for all periods presented.

Adoption of New Accounting Standards:

Effective January 1,2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”)No. 123(R), *Share-based Payment*,using the modified prospective transition method. Accordingly, the Company hasrecorded stock-based employee compensation cost using the fair value methodstarting in 2006.  For 2006, adoptingthis standard resulted in a reduction of income before and after income taxesof $48 and a decrease in basic and diluted earnings per share of $0.04 each.

Prior to January 1, 2006, employee compensation expense under stockoptions was reported using the intrinsic value method; therefore, nostock-based compensation cost is reflected in net income for the year endingDecember 31, 2005, as all options granted had an exercise price equal tothe market price of the underlying common stock at date of grant.

F-8

----

Thefollowing table illustrates the effect on net income and earnings per share ifexpense was measured using the fair value recognition provisions of FASBStatement No. 123, *Accounting forStock-Based Compensation*.
| ** **                                                                         | ** ** | **2005** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|
| Net income as  reported                                                            |       | $        | 1,957      |   |
| Deduct:  Stock-based compensation expense determined under fair value based method |       | 48       |       |
|                                                                               |       |     |       |
| Pro forma net  income                                                              |       | $        | 1,909      |   |
|                                                                               |       |     |       |
| Basic earnings  per share as reported                                              |       | $        | 1.73       |   |
| Pro forma basic  earnings per share                                                |       | 1.69     |       |
|                                                                               |       |     |       |
| Diluted earnings  per share as reported                                            |       | 1.61     |       |
| Pro forma diluted  earnings per share                                              |       | 1.57     |       |

 

There were noshares granted in 2006.

In September 2006, the Securities and Exchange Commission (SEC) releasedStaff Accounting Bulletin No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements (SAB 108),*which is effective for fiscal yearsending on or after November 15, 2006. SAB 108 provides guidance on how the effects of prior-year uncorrectedfinancial statement misstatements should be considered in quantifying a currentyear misstatement.  SAB 108 requirespublic companies to quantify misstatements using both an income statement(rollover) and balance sheet (iron curtain) approach and evaluate whethereither approach results in a misstatement that, when all relevant quantitativeand qualitative factors are considered, is material.  If prior year errors that had been previouslyconsidered immaterial now are considered material based on either approach, norestatement is required so long as management properly applied its previousapproach and all relevant facts and circumstances were considered.  Adjustments considered immaterial in prioryears under the method previously used, but now considered material under thedual approach required by SAB 108, are to be recorded upon initial adoption ofSAB 108.  The amount so recorded is shownas a cumulative effect adjustment and is recorded in opening retained earningsas of January 1, 2006.  This cumulativeeffect adjustment eliminates an overstatement of tax expense and related taxliability that arose in 2004.  Thereduction in accrued income taxes resulted in an increase in retained earningsof $74.  Management determined that theuncorrected amounts were immaterial in the prior years.

**NOTE 2 -SECURITIES**

Thefair value of available for sale debt securities and the related grossunrealized gains and losses recognized in accumulated other comprehensiveincome were as follows:
| ** **          | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** |
|---------------------|------------|-----------------|------------|------------------------------|------------|-------------------------------|------------|
| **2006**            | ** ** | ** **      | ** ** | ** **                   | ** ** | ** **                    | ** ** |
| Agencies            |       | $               | 1,872      |                         | $          | —                        |       | $ | (26 | ) |
| State and municipal |       | 18,527          |       | 16                           |       | (149                          | )          |
| Mortgage-backed     |       | 7,843           |       | 9                            |       | (177                          | )          |
| Corporate           |       | 504             |       | 4                            |       | —                        |       |
|                |       |            |       |                         |       |                          |       |
| Total               |       | $               | 28,746     |                         | $          | 29                            |       | $ | (352 | ) |
|                |       |            |       |                         |       |                          |       |
| **2005**            | ** ** | ** **      | ** ** | ** **                   | ** ** | ** **                    | ** ** |
| Agencies            |       | $               | 1,900      |                         | $          | —                        |       | $ | (49 | ) |
| State and municipal |       | 16,886          |       | 11                           |       | (343                          | )          |
| Mortgage-backed     |       | 5,449           |       | —                       |       | (186                          | )          |
| Corporate           |       | 501             |       | 2                            |       | —                        |       |
|                |       |            |       |                         |       |                          |       |
| Total               |       | $               | 24,736     |                         | $          | 13                            |       | $ | (578 | ) |

 

F-9

----

Proceeds fromsales, gross gains and gross losses of available for sale securities were asfollows:

|                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------|------------|----------|------------|----------|------------|
|                 |       |     |       |     |       |
| Proceeds from  sales |       | $        | 7,671      |     | $          | 5,294 |   |
| Gross gains          |       | 23       |       | 20       |       |
| Gross losses         |       | 22       |       | 25       |       |
|                 |       |     |       |     |       |
|                      |            |          |            |          |            |  |  |

 

Thefair value of debt securities at year end 2006 by contractual maturity were asfollows. Securities not due at a single maturity date, primarilymortgage-backed securities, are shown separately.

|                             | ** ** | **Fair Value** | ** ** |
|-----------------------------|------------|---------------------|------------|
|                        |       |                |       |
| Due from one to  five years |       | $                   | 496        |   |
| Due from five to  ten years |       | 2,578               |       |
| Due after ten  years        |       | 17,829              |       |
| Mortgage-backed  securities |       | 7,843               |       |
|                        |       | $                   | 28,746     |   |

 

Securities pledgedat year end 2006 and 2005 had a carrying amount of $1,640 and $1,569 and werepledged to secure public deposits and repurchase agreements.

At year end 2006and 2005, there were no holdings of securities of any one issuer, other thanthe U.S. Government and its agencies, in an amount greater than 10% ofshareholders’ equity.

The followingtable shows securities with unrealized losses and their fair value, aggregatedby investment category and length of time that individual securities have beenin a continuous unrealized loss position:

**2006**

|                                         | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total**       | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------------|------------|
| **Description of Securities** | ** ** | **Fair  Value**                        | ** ** | **Unrealized  Loss**                 | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** |
|                                    |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Agencies                                |       | $                                      | —     |                                 | $          | —          |       | $ | 1,872 |   | $ | 26 |   | $ | 1,872 |   | $ | 26 |   |
| State and  municipal                    |       | 6,181                                  |       | 51                                   |       | 6,779           |       | 98 |   | 12,960 |   | 149 |   |
| Mortgage-backed                         |       | 998                                    |       | 3                                    |       | 4,781           |       | 174 |   | 5,779 |   | 177 |   |
|                                    |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Total temporarily  impaired             |       | $                                      | 7,179      |                                 | $          | 54              |       | $ | 13,432 |   | $ | 298 |   | $ | 20,611 |   | $ | 352 |   |

 

**2005**

|                                         | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total**       | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------------|------------|
| **Description of Securities** | ** ** | **Fair  Value**                        | ** ** | **Unrealized  Loss**                 | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** |
| ** **                              | ** ** | ** **                             | ** ** | ** **                           | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Agencies                                |       | $                                      | 434        |                                 | $          | 16              |       | $ | 1,466 |   | $ | 33 |   | $ | 1,900 |   | $ | 49 |   |
| State and  municipal                    |       | 15,246                                 |       | 324                                  |       | 552             |       | 19 |   | 15,798 |   | 343 |   |
| Mortgage-backed                         |       | 2,537                                  |       | 51                                   |       | 2,905           |       | 135 |   | 5,442 |   | 186 |   |
|                                    |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Total temporarily  impaired             |       | $                                      | 18,217     |                                 | $          | 391             |       | $ | 4,923 |   | $ | 187 |   | $ | 23,140 |   | $ | 578 |   |

 

Unrealized losseson securities have not been recognized into income because the issuers are ofhigh credit quality, management has the intent and ability to hold for theforeseeable future, and the decline in fair value is largely due to changes inmarket interest rates. The fair value is expected to recover as the securitiesapproach their maturity date and/or market rates decline.

F-10

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**NOTE 3 -LOANS**

Loans at year-end were asfollows:
| ** **                       | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|
|                             |       |     |       |     |       |
| Commercial                       |       | $        | 53,953     |     | $          | 43,499 |   |
| Real estate:                     |       |     |       |     |       |
| Residential                      |       | 24,835   |       | 25,692   |       |
| Commercial                       |       | 49,996   |       | 46,614   |       |
| Construction                     |       | 28,464   |       | 27,212   |       |
| Consumer                         |       | 4,866    |       | 8,114    |       |
| Subtotal                         |       | 162,114  |       | 151,131  |       |
| Less: Allowance  for loan losses |       | (1,971   | )          | (2,036   | )          |
|                             |       |     |       |     |       |
| Loans, net                       |       | $        | 160,143    |     | $          | 149,095 |   |

 

**NOTE 4 -ALLOWANCE FOR LOAN LOSSES**

Activity in theallowance for loan losses was as follows:

|                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|
|                                        |       |     |       |     |       |
| Balance at  beginning of year               |       | $        | 2,036      |     | $          | 1,723 |   |
| Provision  charged to operating expenses    |       | 756      |       | 374      |       |
| Loans charged  off                          |       | (847     | )          | (83      | )          |
| Recoveries on  previously charged-off loans |       | 26       |       | 22       |       |
|                                        |       |     |       |     |       |
| Ending balance                              |       | $        | 1,971      |     | $          | 2,036 |   |

 

The Company hadsix impaired loans totaling $1,636 at year-end 2006 with interest incomerecognized on these loans of $98.  TheCompany did not have any loans impaired at year-end 2005.  The amount of the allowance for loan lossesallocated for the impaired loans was $257. The average of the impaired loans during the year was $1,372

Nonperforming loans wereas follows:

|                                               | ** ** | **2006** | ** ** | **2005**   | ** ** |
|-----------------------------------------------|------------|----------|------------|------------|------------|
|                                          |       |     |       |       |       |
| Loans past due  over 90 days still on accrual |       | $        | 293        | ** ** | $          | — |   |
| Nonaccrual loans                              |       | 250      |       | 27         |       |
|                                               |            |          |            |            |            |  |  |

 

Nonperformingloans and impaired loans are defined differently. Some loans may beincluded in both categories, whereas other loans may only be included inone category.

F-11

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**NOTE5 - PREMISES AND EQUIPMENT**

Year-endpremises and equipment were as follows:

|                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| Land                               |       | $        | 1,456      |     | $          | 1,456 |   |
| Buildings                          |       | 2,939    |       | 2,939    |       |
| Leasehold improvements             |       | 747      |       | 744      |       |
| Furniture, fixtures and  equipment |       | 1,880    |       | 1,802    |       |
|                               |       | 7,022    |       | 6,941    |       |
| Less: Accumulated  depreciation    |       | 1,845    |       | 1,575    |       |
|                               |       |     |       |     |       |
|                               |       | $        | 5,177      |     | $          | 5,366 |   |

 

Depreciationexpense was $352 and $365 for 2006 and 2005.

**NOTE6 - DEPOSITS**

Time deposits of$100 or more were $65,177 and $54,481 at year end 2006 and 2005.

Scheduledmaturities of time deposits for the next five years and thereafter were asfollows at year-end 2006:

| 2007       |       | $          | 95,767     |   |
|------------|------------|------------|------------|--------|
| 2008       |       | 15,330     |       |
| 2009       |       | 5,421      |       |
| 2010       |       | 928        |       |
| 2011       |       | 105        |       |
| Thereafter | ** ** | **—** | ** ** |
|       |       | $          | 117,551    |   |

 

**NOTE7 — REPURCHASE AGREEMENTS**

Repurchaseagreements are secured by securities available for sale with a carrying amountof $666 and $705 at year-end 2006 and 2005. Information concerning repurchaseagreements is summarized as follows:

|                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|
| Average daily balance  during the year      |       | $        | 372        |     | $          | 257 |   |
| Average interest rate  during the year      |       | 3.44     | %          | 1.95     | %          |
| Maximum month-end  balance during the year  |       | 415      |       | 327      |       |
| Weighted average  interest rate at year-end |       | 3.64     | %          | 2.56     | %          |
| Balance at year end                         |       | 332      |       | 300      |       |
|                                             |            |          |            |          |            |  |  |

 

**NOTE8 - FEDERAL HOME LOAN BANK ADVANCE**

At December 31, 2006, the company had one advance fromthe Federal Home Loan Bank in the amount of $3,000.  The advance matured January 2007 and bears afixed rate of 5.69%.  The advance ispayable at its maturity date, with a prepayment penalty for fixed rateadvances.  The advance was collateralizedby $34,134 of first mortgage loans under a blanket lien arrangement at year-end2006.  Based on this collateral and theCompany’s holdings of FHLB stock, the Company is eligible to borrow anadditional $719 at year-end 2006.

F-12

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**NOTE9 - SUBORDINATED DEBENTURES**

A trust formed bythe Company issued $5,000 of floating rate trust preferred securities in 2004as part of a pooled offering of such securities. The Company issued subordinateddebentures in the amount of $155 to the trust in exchange for the proceeds ofthe offering; the debentures represent the sole assets of the trust. The ratevaries quarterly at 3-month LIBOR, plus 2.05% and was 7.41% at December 31,2006. The Company may redeem the subordinated debentures, in whole or inpart, after December 2009 at face value. The subordinated debentures mustbe redeemed no later than December 2034.

**NOTE10 - INCOME TAXES**

Thecomponents of income tax expense (benefit) are summarized as follows:

|                    | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------|------------|----------|------------|----------|------------|
| Current federal    |       | $        | 716        |     | $          | 904 |   |
| Current state      |       | 155      |       | 223      |       |
| Deferred federal   |       | 98       |       | (118     | )          |
| Deferred state     |       | 47       |       | (10      | )          |
|               |       |     |       |     |       |
| Actual tax expense |       | $        | 1,016      |     | $          | 999 |   |

 

Temporarydifferences between tax and financial reporting that result in net deferred taxassets (liabilities) are as follows at December 31, 2006 and 2005:

|                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  assets:           |       |     |       |     |       |
| Allowance for loan losses       |       | $        | 644        |     | $          | 740 |   |
| Unrealized loss on securities   |       | 108      |       | 192      |       |
| Total deferred  tax assets      |       | 752      |       | 602      |       |
|                            |       |     |       |     |       |
| Deferred tax  liabilities:      |       |     |       |     |       |
| Depreciation                    |       | (339     | )          | (335     | )          |
| Unrealized gains on securities  |       | —   |       | (2       | )          |
| Other                           |       | (66      | )          | (42      | )          |
| Total deferred  tax liabilities |       | (405     | )          | (356     | )          |
|                            |       |     |       |     |       |
| Net deferred tax asset          |       | $        | 347        |     | $          | 576 |   |

 

Areconciliation of actual income tax expense in the financial statements to the “expected”tax expense (computed by applying the statutory Federal income tax rate of 34%to income or loss before income taxes) is as follows:

|                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Computed “expected”  tax expense |       | $        | 1,033      |     | $          | 1,005 |   |
| Tax exempt  interest                       |       | (208     | )          | (174     | )          |
| State income  taxes, net of effect of      |       |     |       |     |       |
| Federal income taxes                       |       | 134      |       | 140      |       |
| Expenses not allowed as tax deductions     |       | 57       |       | 26       |       |
| Other, net                                 |       | —   |       | 2        |       |
|                                       |       |     |       |     |       |
| Income tax  expense                        |       | $        | 1,016      |     | $          | 999 |   |

 

F-13

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**NOTE11 — RELATED PARTY TRANSACTIONS**

Loansto principal officers, directors, and their affiliates in 2006 were as follows:

| Beginning balance |   | $      | 9,845  |   |
|-------------------|--------|--------|--------|--------|
| New loans         |   | 1,015  |   |
| Repayments        |   | (541   | )      |
|              |   |   |   |
| Ending balance    |   | $      | 10,319 |   |

 

Deposits fromprincipal officers, directors, and their affiliates at year-end 2006 and 2005were $5,949 and $4,433.

**NOTE 12— CAPITAL REQUIREMENTS AND RESTRICTIONS ON RETAINED EARNINGS**

Banks are subjectto regulatory capital requirements administered by federal banking agencies.Capital adequacy guidelines and prompt corrective action regulations involvequantitative measures of assets, liabilities, and certain off-balance-sheetitems calculated under regulatory accounting practices. Capital amounts andclassifications are also subject to qualitative judgments by regulators.Failure to meet capital requirements can initiate regulatory action.

Prompt correctiveaction regulations provide five classifications:  well capitalized,adequately capitalized, undercapitalized, significantly undercapitalized, andcritically undercapitalized, although these terms are not used to representoverall financial condition. If adequately capitalized, regulatory approval isrequired to accept brokered deposits. If undercapitalized, capitaldistributions are limited, as is asset growth and expansion, and capitalrestoration plans are required. As of December 31, 2006 and 2005, the mostrecent regulatory notifications categorized the Bank as well capitalized underthe regulatory framework for prompt corrective action. There are no conditionsor events since that notification that management believes have changed theBank’s category.

Actualand required capital amounts (in thousands) and ratios for the Bank arepresented below at year-end.
| ** **                                     | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|------------------------------------------------|------------|------------|------------|----------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                                     | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                                       | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| December 31,  2006                             |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
|                                           |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| Total Capital to  risk weighted assets         |       | $          | 24,095     |                                         | 13.35      | %                                                                                                | $          | 14,438 |   | 8 | % | $ | 18,048 |   | 10 | % |
|                                           |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| Tier 1 (Core)  Capital to risk weighted assets |       | 22,124     |       | 12.26                                        | %          | 7,219                                                                                            |       | 4 | % | 10,829 |   | 6 | % |
|                                           |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| Tier 1 (Core)  Capital to average assets       |       | 22,124     |       | 10.82                                        | %          | 8,181                                                                                            |       | 4 | % | 10,226 |   | 5 | % |
|                                           |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| December 31,  2005                             |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
|                                           |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| Total Capital to  risk weighted assets         |       | $          | 21,580     |                                         | 13.14      | %                                                                                                | $          | 13,141 |   | 8.00 | % | $ | 16,426 |   | 10.00 | % |
|                                           |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| Tier 1 (Core)  Capital to risk weighted assets |       | 19,392     |       | 11.81                                        | %          | 6,570                                                                                            |       | 4.00 | % | 9,856 |   | 6.00 | % |
|                                           |       |       |       |                                         |       |                                                                                             |       |   |   |   |   |   |   |
| Tier 1 (Core) Capital  to average assets       |       | 19,392     |       | 10.39                                        | %          | 7,466                                                                                            |       | 4.00 | % | 9,332 |   | 5.00 | % |

 

F-14

----

The Bank is alsosubject to state regulations restricting the amount of dividends that can bepaid. At year end 2006, the Bank could pay approximately $2,811 in dividendsunder these regulations.

**NOTE13 — OFF-BALANCE-SHEET ACTIVITIES**

Some financialinstruments, such as loan commitments, credit lines, letters of credit, andoverdraft protection, are issued to meet customer financing needs. These areagreements to provide credit or to support the credit of others, as long asconditions established in the contract are met, and usually have expirationdates. Commitments may expire without being used. Off-balance-sheet riskto credit loss exists up to the face amount of these instruments, althoughmaterial losses are not anticipated. The same credit policies are used to makesuch commitments as are used for loans, including obtaining collateral atexercise of the commitment. The majority of the Company’s commitments to extendcredit has maturities less than one year and reflects the prevailing marketinterest rates at the time of the commitment.

Thecontractual amount of financial instruments with off-balance-sheet risk was asfollows at year end.

|                               | ** ** | **2006**            | ** ** | **2005**               | ** ** |
|-------------------------------|------------|---------------------|------------|------------------------|------------|
| ** **                    | ** ** | **Fixed Rate** | ** ** | **Variable Rate** | ** ** | **Fixed Rate** | ** ** | **Variable Rate** | ** ** |
| Commitments to  extend credit |       | $                   | 12,206     |                   | $          | 27,525 |   | $ | 12,323 |   | $ | 25,135 |   |
| Letters of credit             |       | 345                 |       | 2,422                  |       | 7 |   | 2,177 |   |
|                               |            |                     |            |                        |            |  |  |  |  |  |  |  |  |

 

The fixed ratecommitments have interest rates ranging from 4.20 % to 10.25 % at year end2006.

**NOTE14 - STOCK BASED COMPENSATION**

The Companyestablished an Incentive Stock Option Plan for certain officers and employeesand a Non-Employee Directors’ Non-Qualified Stock Option Plan effectiveAugust 8, 2000. The plans grant options to key employees and directors atfair value at date of grant. The director options vest 100% after six monthsfrom the grant date, and the employee options vest 20% every two years. AtDecember 31, 2006, there were options to purchase 9,696 shares pursuant to theNon-Employee Directors’ Plan and options to purchase 115,860 shares pursuant tothe Employees Plan. All options expire within ten years from the date of grant.

Asummary of the status of the Company’s stock option plans in actual share anddollar amounts is presented below  Allinformation has been adjusted for stock dividends.

|                                           | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|-------------------------------------------|------------|------------|------------|--------------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------|------------|
| Options  outstanding at December 31, 2005 |       | 157,435    |       | $                                          | 12.14      |                                                |       |                                |       |   |
|                                      |       |       |       |                                       |       |                                                |       |                                |       |
| Granted                                   |       | —     |       | —                                     |       |                                                |       |                                |       |
| Exercised                                 |       | (28,352    | )          | 9.37                                       |       |                                                |       |                                |       |
| Forfeited or  expired                     |       | (3,527     | )          | 17.80                                      |       |                                                |       |                                |       |
| Outstanding at end of year                |       | 125,556    |       | 11.89                                      |       | 5.35                                                |       | $                                   | 3,529,379  |   |
|                                      |       |       |       |                                       |       |                                                |       |                                |       |
| Exercisable at December  31, 2006         |       | 41,679     |       | $                                          | 10.69      |                                                | 3.1        |                                | $          | 1,221,611 |   |

 

Informationrelated to the stock option plan during each year follows:

|                                                 | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
|                                            |       |       |       |       |       |
| Intrinsic value  of options exercised           |       | $          | 799,087    |       | $          | 150,238 |   |
| Cash received  from option exercises            |       | 265,729    |       | 64,312     |       |
| Tax benefit  realized from option exercises     |       | 177,963    | ** ** | **—** | ** ** |
| Weighted average fair  value of options granted | ** ** | **—** | ** ** | **—** | ** ** |
|                                                 |            |            |            |            |            |  |  |

 

As of December 31,2006, there was $265 of total unrecognized compensation cost related tononvested stock options granted under the Plan. The cost is expected to be recognized over a weighted average period of6.02 years.

F-15

----

**NOTE15 — RETIREMENT PLAN**

The Company,effective September 1, 2004, has a 401(k) profit sharing plan coveringemployees meeting certain age and service requirements. Employeesmay contribute up to a certain dollar amount which is set by law. TheCompany makes matching contributions equal to 75% of the employee’scontribution up to 6% of the employee’s compensation. Participants are vestedimmediately in their contributions plus the actual earnings thereon. Companycontributions are vested 20% per year over 5 years. Expense for 2006 was $70and $65 for 2005.

**NOTE16 — FAIR VALUES OF FINANCIAL INSTRUMENTS**

The methods andassumptions used to estimate fair value are described as follows:

Carrying amount isthe estimated fair value for cash and cash equivalents, Federal Home Loan Bankand Bankers Bank stock, accrued interest receivable and payable, demanddeposits, repurchase agreements, and variable rate loans, deposits, andsubordinated debentures that reprice frequently and fully. Security fair valuesare based on market prices or dealer quotes, and if no such information isavailable, on the rate and term of the security and information about theissuer. For fixed rate loans or deposits and for variable rate loans ordeposits with infrequent repricing or repricing limits, fair value is based ondiscounted cash flows using current market rates applied to the estimated life andcredit risk. Fair value of loans held for sale is based on market quotes. Thefair value of FHLB advances is obtained from the FHLB and is calculated bydiscounting cash flows using an estimated interest rate based on the currentrates available to the Company for debt of similar remaining maturities andcollateral values.

Carryingamount and estimated fair values of financial instruments at December 31, 2006and 2005 were as follows:
| ** **                                        | ** ** | **2006**             | ** ** | **2005**        | ** ** |
|---------------------------------------------------|------------|----------------------|------------|-----------------|------------|
| ** **                                        | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** |
| Financial assets                                  |       |                 |       |            |       |   |   |   |   |
| Cash and cash equivalents                         |       | $                    | 17,453     |            | $          | 17,453 |   | $ | 7,078 |   | $ | 7,078 |   |
| Securities available for sale                     |       | 28,746               |       | 28,746          |       | 24,736 |   | 24,736 |   |
| Loans held for sale                               |       | 2,538                |       | 2,538           |       | 245 |   | 245 |   |
| Loans, net of allowance                           |       | 160,143              |       | 156,289         |       | 149,095 |   | 144,479 |   |
| FHLB and Bankers Bank stock                       |       | 830                  |       | 830             |       | 515 |   | 515 |   |
| Accrued interest receivable                       |       | 1,043                |       | 1,043           |       | 819 |   | 819 |   |
|                                              |       |                 |       |            |       |   |   |   |   |
| Financial  liabilities                            |       |                 |       |            |       |   |   |   |   |
| Deposits                                          |       | $                    | 191,023    |            | $          | 190,863 |   | $ | 168,115 |   | $ | 167,347 |   |
| Federal Home Loan Bank advances                   |       | 3,000                |       | 3,000           |       |   |   |   |   |
| Repurchase agreements and federal funds purchased |       | 332                  |       | 332             |       | 300 |   | 300 |   |
| Accrued interest payable                          |       | 1,494                |       | 1,494           |       | 904 |   | 904 |   |
| Subordinated  Debentures                          |       | 5,155                |       | 5,185           |       | 5,155 |   | 5,155 |   |

 

F-16

----

**PART I NOTE 17 — EARNINGS PER SHARE**

The factors used in the earnings per share computationfollow:

 
| ** **                                                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Basic                                                                           |       |     |       |     |       |
| Net income                                                                      |       | $        | 2,022      |     | $          | 1,957 |   |
|                                                                            |       |     |       |     |       |
| Weighted average common shares outstanding                                      |       | 1,151    |       | 1,132    |       |
|                                                                            |       |     |       |     |       |
| Basic earnings per common share                                                 |       | $        | 1.76       |     | $          | 1.73 |   |
|                                                                            |       |     |       |     |       |
| Diluted                                                                         |       |     |       |     |       |
| Net income                                                                      |       | $        | 2,022      |     | $          | 1,957 |   |
|                                                                            |       |     |       |     |       |
| Weighted average common shares outstanding for basic  earnings per common share |       | 1,151    |       | 1,132    |       |
| Add: Dilutive effects of assumed exercises of stock  options                    |       | 74       |       | 86       |       |
|                                                                            |       |     |       |     |       |
| Average shares and dilutive potential common shares                             |       | 1,225    |       | 1,218    |       |
|                                                                            |       |     |       |     |       |
| Diluted earnings  per common share                                              |       | $        | 1.65       |     | $          | 1.61 |   |

 

**Therewere no anti-dilutive options in the above computations of diluted earnings pershare.**

** **

F-17

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