**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

**FORM 10-Q**

** **

**QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

** **

**FOR THE QUARTERLY PERIODENDED MARCH 31, 2007**

** **

**Commission File Number000-50921**

** **

**SOUTHERN HERITAGE BANCSHARES, INC.**

(Exact Name of RegistrantAs Specified in Its Charter)

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

 

**3020Keith Street, NWCleveland, Tennessee  37312**(Address of Principal Executive Offices and Zip Code)

**(423)473-7980** (Registrant’s Telephone Number, Including Area Code)

**NotApplicable**(Former name, former address and former fiscal year ifchanges since last report)

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for thepast 90 days.

| Yes x |   | No o |
|-------|--------|------|

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act. (Check one): 

| Large Accelerated Filer o |   | Accelerated  Filer o |   | Non-accelerated  Filer x |
|---------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

| Yes o |   | No x |
|-------|--------|------|

 

As of April 30,2007 there were 1,164,996 shares of common stock issued and outstanding.

 

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**SouthernHeritage Bancshares, Inc.**

**Table of Contents**
| **PART I:**  | ** ** | **FINANCIAL INFORMATION**                                                                   | ** ** | ** ** |
|--------------|------------|---------------------------------------------------------------------------------------------|------------|------------|
| ** **   | ** ** | ** **                                                                                  | ** ** | ** ** |
| ITEM 1:      |       | FINANCIAL STATEMENTS                                                                        |       |       |
|         |       |                                                                                        |       |       |
| ITEM 2:      |       | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |       |       |
|         |       |                                                                                        |       |       |
| ITEM 3:      |       | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                 |       |       |
|         |       |                                                                                        |       |       |
| ITEM 4:      |       | CONTROLS AND  PROCEDURES                                                                    |       |       |
|         |       |                                                                                        |       |       |
| **PART II:** | ** ** | **OTHER INFORMATION**                                                                       | ** ** | ** ** |
| ** **   | ** ** | ** **                                                                                  | ** ** | ** ** |
| ITEM 1:      |       | LEGAL PROCEEDINGS                                                                           |       |       |
|         |       |                                                                                        |       |       |
| ITEM  1A:    |       | RISK  FACTORS                                                                               |       |       |
|         |       |                                                                                        |       |       |
| ITEM 2:      |       | UNREGISTERED  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                |       |       |
|         |       |                                                                                        |       |       |
| ITEM 3:      |       | DEFAULTS UPON  SENIOR SECURITIES                                                            |       |       |
|         |       |                                                                                        |       |       |
| ITEM 4:      |       | SUBMISSION OF  MATTERS TO A VOTE OF SECURITY OLDERS20                                       |       |       |
|         |       |                                                                                        |       |       |
| ITEM  5:     |       | OTHER  INFORMATION                                                                          |       |       |
|         |       |                                                                                        |       |       |
| ITEM  6:     |       | EXHIBITS                                                                                    |       |       |
|         |       |                                                                                        |       |       |
| SIGNATURES   |       |                                                                                        |

 

 

 

 

 

2

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**ITEM 1. FINANCIAL STATEMENTS**

**SOUTHERNHERITAGE BANCSHARES, INC.Consolidated Balance SheetsMarch 31, 2007**

($ amounts in thousands except share and earnings per share)
| ** **                                                                                                           | ** ** | **March 31,  2007** | ** ** | **December 31,   2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------------|------------|
| ***Assets***                                                                                                         |       |                     |       |                              |       |
| Cash and due from banks                                                                                              | ** ** | $                        | 3,997      |                              | 5,165      |   |
| Federal funds sold                                                                                                   |       | 16,654                   |       | 12,288                            |       |
| ***Cash and cash equivalents***                                                                                      |       | 20,651                   |       | 17,453                            |       |
| Securities available-for-sale, at fair value                                                                         |       | 36,456                   |       | 28,746                            |       |
| Mortgage loans held for sale                                                                                         |       | 1,074                    |       | 2,538                             |       |
| Loans                                                                                                                |       | 155,437                  |       | 162,114                           |       |
| Allowance for loan losses                                                                                            |       | (1,995                   | )          | (1,971                            | )          |
| ***Loans, net***                                                                                                     |       | 153,442                  |       | 160,143                           |       |
| Premises and equipment                                                                                               |       | 5,194                    |       | 5,177                             |       |
| Restricted stock                                                                                                     |       | 830                      |       | 830                               |       |
| Accrued income receivable                                                                                            |       | 1,061                    |       | 1,043                             |       |
| Other assets                                                                                                         |       | 2,141                    |       | 2,254                             |       |
|                                                                                                                 | ** ** | $                        | 220,849    |                              | 218,184    |   |
|                                                                                                                 |       |                     |       |                              |       |
| ***Liabilities and Shareholders’ Equity***                                                                      |       |                     |       |                              |       |
| **Liabilities:**                                                                                                     |       |                     |       |                              |       |
| **Deposits:**                                                                                                        |       |                     |       |                              |       |
| Noninterest-bearing                                                                                                  | ** ** | $                        | 25,883     |                              | 26,265     |   |
| Interest-bearing                                                                                                     |       | 170,112                  |       | 164,758                           |       |
| ***Total deposits***                                                                                                 |       | 195,995                  |       | 191,023                           |       |
| Repurchase agreements                                                                                                |       | 494                      |       | 332                               |       |
| FHLB advance                                                                                                         |       | 0                        |       | 3,000                             |       |
| Accrued interest payable                                                                                             |       | 1,590                    |       | 1,494                             |       |
| Subordinated debentures                                                                                              |       | 5,155                    |       | 5,155                             |       |
| Other liabilities                                                                                                    |       | 260                      |       | 270                               |       |
| ***Total liabilities***                                                                                              |       | 203,494                  |       | 201,274                           |       |
| **Shareholders’  equity:**                                                                                      |       |                     |       |                              |       |
| Preferred stock, no par value. Authorized 1,000,000 shares; none issued                                              |       | —                   |       | —                            |       |
| Common stock, $1 par value. Authorized 2,000,000 shares; 1,164,996 shares  issued at March 31, 2007 and Dec 31, 2006 |       | 1,164                    |       | 1,164                             |       |
| Additional paid-in-capital                                                                                           |       | 13,086                   |       | 13,074                            |       |
| Retained earnings                                                                                                    |       | 3,312                    |       | 2,885                             |       |
| Accumulated other comprehensive loss                                                                                 |       | (207                     | )          | (213                              | )          |
| ***Total shareholders’ equity***                                                                                |       | 17,355                   |       | 16,910                            |       |
|                                                                                                                 | ** ** | $                        | 220,849    |                              | 218,184    |   |

 

Seeaccompanying notes to consolidated financial statements.

3

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**SOUTHERNHERITAGE BANCHARES, INC.Consolidated Statements of OperationsThree Months Ended March 31**

($ amounts in thousands except share and earnings per share)
| ** **                                                | ** ** | **Three Months Ended March 31** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| **Interest  income:**                                     |       |                                                |       |   |   |
| Loans, including fees                                     |       | $                                                   | 3,121      |   | 2,646 |   |
| Securities                                                |       | 340                                                 |       | 242 |   |
| Federal funds sold                                        |       | 205                                                 |       | 80 |   |
| ***Total interest income***                               |       | 3,666                                               |       | 2,968 |   |
| **Interest  expense:**                                    |       |                                                |       |   |   |
| Deposits                                                  |       | 1,785                                               |       | 1,116 |   |
| Other borrowed funds                                      |       | 112                                                 |       | 87 |   |
| ***Total interest expense***                              |       | 1,897                                               |       | 1,206 |   |
| ***Net interest income***                                 |       | 1,769                                               |       | 1,765 |   |
| **Provision  for loan losses**                            |       | 26                                                  |       | 51 |   |
| ***Net interest income after provision for loan losses*** |       | 1,743                                               |       | 1,714 |   |
| **Noninterest  income:**                                  |       |                                                |       |   |   |
| Service charges on deposit accounts                       |       | 203                                                 |       | 279 |   |
| Mortgage banking activities                               |       | 140                                                 |       | 143 |   |
| Gain (loss) on sale of securities                         |       | 4                                                   |       | 10 |   |
| Other service charges, commissions and fees               |       | 106                                                 |       | 80 |   |
| ***Total noninterest income***                            |       | 453                                                 |       | 512 |   |
| **Noninterest  expenses:**                                |       |                                                |       |   |   |
| Salaries and employee benefits                            |       | 817                                                 |       | 716 |   |
| Occupancy expense                                         |       | 96                                                  |       | 94 |   |
| Other operating expenses                                  |       | 680                                                 |       | 542 |   |
| ***Total noninterest expenses***                          |       | 1,593                                               |       | 1,352 |   |
| ***Income before income taxes***                          |       | 603                                                 |       | 874 |   |
| **Income  taxes**                                         |       | 176                                                 |       | 298 |   |
| ***Net income***                                          |       | 427                                                 |       | 576 |   |
|                                                      |       |                                                |       |   |   |
| **Other  comprehensive income (loss):**                   |       |                                                |       |   |   |
| Change in unrealized gains/losses on securities           |       | 6                                                   |       | 12 |   |
|                                                      |       |                                                |       |   |   |
| **Comprehensive  income (loss)**                          |       | 433                                                 |       | 588 |   |
|                                                      |       |                                                |       |   |   |
| Basic earnings per share                                  |       | $                                                   | 0.37       |   | $ | 0.51 |   |
| Diluted earnings per share                                |       | $                                                   | 0.34       |   | $ | 0.47 |   |
|                                                      |       |                                                |       |   |   |
| Shares used in computation of earnings per share          |       |                                                |       |   |   |
| Basic                                                     |       | 1,164,996                                           |       | 1,138,444 |   |
| Diluted                                                   |       | 1,243,677                                           |       | 1,230,515 |   |

 

Seeaccompanying notes to consolidated financial statements.

4

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**SOUTHERN HERITAGE BANCSHARES, INC.Consolidated Statements of Cash FlowsThree Months Ended March 31**

($ amounts in thousands)
| ** **                                                                 | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Cash flows from  operating activities                                      |       |     |       |     |       |
| Net income                                                                 |       | $        | 427        |     | $          | 576 |   |
| Adjustments to  reconcile net income to net cash from operating activities |       |     |       |     |       |
| Provision for  loan losses                                                 |       | 26       |       | 51       |       |
| Depreciation and  amortization                                             |       | 130      |       | 99       |       |
| Investment  securities (gains) losses                                      |       | (4       | )          | (10      | )          |
| Mortgage loans  originated for sale                                        |       | (5,272   | )          | (7,346   | )          |
| Proceeds from  sale of mortgage loans                                      |       | 6,876    |       | 6,685    |       |
| Gains on sales  of mortgage loans                                          |       | (140     | )          | (143     | )          |
| Loss on sale of  other real estate                                         |       | 42       |       | 13       |       |
| Stock  compensation expense                                                |       | 12       |       | 12       |       |
| Changes in  operating assets and liabilities:                              |       |     |       |     |       |
| (Increase)  decrease in accrued interest receivable                        |       | (18      | )          | 82       |       |
| Increase  (decrease) in accrued interest payable                           |       | 96       |       | (28      | )          |
| Other, net                                                                 |       | 90       |       | (24      | )          |
| Net cash  provided by (used in) operating activities                       |       | 2,085    |       | (33      | )          |
|                                                                       |       |     |       |     |       |
| Cash flows from  investing activities                                      |       |     |       |     |       |
| Proceeds from  maturities and redemptions of securities available for sale |       | 265      |       | 205      |       |
| Proceeds from  sales of securities available for sale                      |       | —   |       | 3,171    |       |
| Purchases of  securities available for sale                                |       | (7,978   | )          | (2,670   | )          |
| Purchases of  restricted equity securities                                 |       | —   |       | (4       | )          |
| Net decrease in  loans                                                     |       | 6,117    |       | 4,850    |       |
| Proceeds from  sale of other real estate                                   |       | 707      |       | —   |       |
| Net purchases of  premises and equipment                                   |       | (132     | )          | (73      | )          |
| Net cash (used  in) provided by investing activities                       |       | (1,021   | )          | 5,479    |       |
|                                                                       |       |     |       |     |       |
| Cash flows from  financing activities                                      |       |     |       |     |       |
| Increase in  repurchase agreements and federal funds purchased             |       | 162      |       | 33       |       |
| Decrease in  Federal Home Loan Bank Advances                               |       | (3,000   | )          | —   |       |
| Proceeds from  exercise of stock options                                   |       | —   |       | 22       |       |
| Net increase in  deposits                                                  |       | 4,972    |       | 3,614    |       |
| Net cash  provided by financing activities                                 |       | 2,134    |       | 3,669    |       |
|                                                                       |       |     |       |     |       |
| Net increase in cash  and cash equivalents                                 |       | 3,198    |       | 9,115    |       |
|                                                                       |       |     |       |     |       |
| Cash and cash  equivalents at beginning of period                          |       | 17,453   |       | 7,078    |       |
|                                                                       |       |     |       |     |       |
| Cash and cash  equivalents at end of period                                |       | $        | 20,651     |     | $          | 16,193 |   |
|                                                                       |       |     |       |     |       |
| Supplemental  disclosures of cash flow information                         |       |     |       |     |       |
| Cash paid during period  for:                                              |       |     |       |     |       |
| Interest                                                                   |       | $        | 1,801      |     | $          | 1,231 |   |
| Income taxes                                                               |       | 61       |       | 381      |       |
| Loans transferred to other real estate acquired through foreclosure        |       | 540      |       | 558      |       |

 

Seeaccompanying notes to consolidated financial statements.

5

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**SOUTHERN HERITAGE BANCSHARES, INC.Notes to Consolidated Financial StatementsMarch 31, 2007(Unaudited)**

*Basis of Presentation*

The accompanying financialstatements have been prepared in accordance with generally accepted accountingprinciples for interim financial information and with the instructions toForm 10-Q. Accordingly they do not include all information and footnotesrequired by generally accepted accounting principles for complete financialstatements.

The consolidated financialstatements include Southern Heritage Bancshares, Inc. and its wholly ownedsubsidiary, Southern Heritage Bank, together referred to as “the Company”.Intercompany transactions and balances are eliminated in consolidation.

Southern HeritageBancshares, Inc. is a one bank holding company that owns 100% of SouthernHeritage Bank (the Bank). Substantially all of the consolidated operations arethat of the Bank.

In the opinion of management,the financial statements contain all adjustments necessary to summarize fairlythe financial position of the Bank as of March 31, 2007, the results ofoperations for the three months ended March 31, 2007, and cash flows for thethree months ended March 31, 2007. The interim financial statements should beread in conjunction with the notes to the financial statements presented in theBank’s December 31, 2006, financial statements. The results for theinterim periods are not necessary indicative of the results to be expected forthe complete year.

*Allowance for Loan Losses*

Transactionsin the allowance for loan losses were as follows:
| ** **                       | ** ** | **Three Months  Ended  March 31, 2007** | ** ** | **Three Months  Ended  March 31, 2006** | ** ** |
|----------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                       | ** ** | **(In Thousands)**                                | ** ** | **(In Thousands)**                                | ** ** |
|                             |       |                                                   |       |                                                   |       |
| Balance January 1           |       | $                                                      | 1,971      |                                                   | $          | 2,036 |   |
|                             |       |                                                   |       |                                                   |       |
| Add (deduct):                    |       |                                                   |       |                                                   |       |
| Losses charged to allowance      |       | (23                                                    | )          | (218                                                   | )          |
| Recoveries credited to allowance |       | 21                                                     |       | 11                                                     |       |
| Provision for loan losses        |       | 26                                                     |       | 51                                                     |       |
|                             |       |                                                   |       |                                                   |       |
| Balance March 31            |       | $                                                      | 1,995      |                                                   | $          | 1,880 |   |

 

6

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The following table presentsvarious categories of loans contained in the Company’s loan portfolio for theperiods indicated and the total amount of all loans for such period:
| ** **                             | ** ** | **As of**                 | ** ** |
|----------------------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **March 31,** 2007   | ** ** | **December 31,  2006** | ** ** |
| ** **                             | ** ** | **($ in thousands)** | ** ** |
| Domestic:                              |       |                           |       |   |   |
|                                   |       |                           |       |   |   |
| Commercial, financial and agricultural |       | $                              | 48,013     |   | $ | 53,953 |   |
| Real estate - construction             |       | 29,875                         |       | 28,464 |   |
| Real estate - family residential       |       | 24,431                         |       | 24,835 |   |
| Real estate - commercial               |       | 47,652                         |       | 49,996 |   |
| Consumer                               |       | 5,466                          |       | 4,866 |   |
| Total loans                            |       | 155,437                        |       | 162,114 |   |
| Allowance for loan losses              |       | (1,995                         | )          | (1,971 | ) |
|                                   |       |                           |       |   |   |
| Total (net of allowance)               |       | $                              | 153,442    |   | $ | 160,143 |   |

 

The following table presentsinformation regarding nonaccrual, past due, restructured loans and internallyclassified substandard or doubtful loans at the dates indicated:
| ** **                                                                                                                         | ** ** | **As of**                 | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                         | ** ** | **March 31,** 2007   | ** ** | **December 31,  2006** | ** ** |
| ** **                                                                                                                         | ** ** | **($ in thousands)** | ** ** |
| Loans accounted for on a non-accrual basis:                                                                                        |       |                           |       |   |   |
| Number                                                                                                                             |       | 4                              |       | 3 |   |
| Amount                                                                                                                             |       | $                              | 583        |   | 250 |   |
|                                                                                                                               |       |                           |       |   |   |
| Accruing loans (including consumer loans) which are contractually past  due 90 days or more as to principal and interest payments: |       |                           |       |   |   |
| Number                                                                                                                             |       | 4                              |       | 6 |   |
| Amount                                                                                                                             |       | $                              | 21         |   | 293 |   |
|                                                                                                                               |       |                           |       |   |   |
| Loans internally classified as substandard or doubtful                                                                             |       |                           |       |   |   |
| Number                                                                                                                             |       | 25                             |       | 25 |   |
| Amount                                                                                                                             |       | $                              | 5,944      |   | 6,376 |   |
|                                                                                                                               |       |                           |       |   |   |

 

Management’s determination ofthe appropriate level of the provision for loan losses and the adequacy of theallowance for loan losses is based, in part on an evaluation of specific loans,as well as other factors considered by management, including the composition ofthe loan portfolio, current economic conditions, and the creditworthiness ofthe Bank’s borrowers and other related factors.

7

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As of March 31, 2007, thereare no loans classified for regulatory purposes as doubtful or substandard thathave not been disclosed in the above table, which (i) represent or result fromtrends or uncertainties which management reasonably expects will materially impactfuture operating results, liquidity, or capital resources, or (ii) representmaterial credits about which management is aware of any information whichcauses management to have series doubts as to the ability of such borrowers tocomply with the loan repayment terms.

*Stock Compensation*

The Company established anIncentive Stock Option Plan (ISO) for officers and employees and a Non-EmployeeDirectors’ Non-Qualified Stock Option Plan (NQO), which was shareholderapproved, effective August 8, 2000, allowing for the granting of shareoptions and shares to its employees and directors up to 153,543 shares ofcommon stock. The Company believes that such awards better align the interestsof its employees and directors with those of its shareholders. Option awardsare generally granted with an exercise price equal to the market price of theCompany’s stock at the date of grant; those option awards generally vest 20%every two years based on 10 years of continuous service. Certain option andshare awards provide for accelerated vesting if there is a change in control(as defined in the Plan).

The fair value of each optiongrant is estimated on the date of grant using the Black-Scholes option-pricingmodel. Expected volatilities are based on historical exercise patterns,employee terminations and historical stock prices. The expected life of optionsgranted represents the period of time that options granted are expected to beoutstanding. The U.S. Treasury 10 year constant maturity rate in effect at thedate of the grant is used to derive the risk-free interest rate for thecontractual period of the options.There were no options granted in 2007.

8

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A summary of option activityunder the Plan as of March 31, 2007, and changes during the three months thenended is presented below:

 
| **Options**                         | ** ** | ** ** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Weighted  Average  Intrinsic  Value** | ** ** |
|-------------------------------------|------------|------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                             | ** ** | ** **                                          | ** ** | **(In thousands)**                 | ** ** |
| Outstanding at January 1, 2007 |       | 125,556    |       | $          | 11.89      |                                   |       |                                                |       |                                    |
|                                |       |       |       |       |       |                                   |       |                                                |       |
| Granted                             |       | —     |       | —     |       |                                   |       |                                                |       |
|                                |       |       |       |       |       |                                   |       |                                                |       |
| Exercised                           |       | —     |       | —     |       |                                   |       |                                                |       |
|                                |       |       |       |       |       |                                   |       |                                                |       |
|  Forfeited                     |       | —     |       | —     |       |                                   |       |                                                |       |
|                                |       |       |       |       |       |                                   |       |                                                |       |
| Outstanding at March 31, 2007       |       | 125,556    |       | $          | 11.89      |                                   | 5.35       |                                                | $          | 3,529                                   |       |
|                                |       |       |       |       |       |                                   |       |                                                |       |
| Exercisable at March 31, 2007       |       | 41,679     |       | $          | 10.69      |                                   | 3.10       |                                                | $          | 1,222                                   |       |

 

9

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As of March 31, 2007, therewas $253,000 of total unrecognized compensation cost related to nonvestedshare-based compensation arrangements granted under the Plan. That cost isexpected to be recognized over a weighted-average period of approximately 5years. The options under the Plan vest every other year and no shares havevested in 2007. However, the compensation cost is recorded on a prorata basisover the entire vesting period resulting in total compensation cost of $12,000for the three months ended March 31, 2007 and 2006, based on the fair value ofthe options.

There were no optionsexercised for the three months ended March 31, 2007.

 

|                                                 | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
|                                            |       |     |       |     |       |
| Intrinsic value  of options exercised           |       | $        | —     |     | $          | 41,292 |   |
| Cash received  from option exercises            |       | —   |       | 21,708   |       |
| Tax benefit  realized from option exercises     |       | —   |       | 6,763    |       |
| Weighted average fair  value of options granted |       | —   |       | —   |       |
|                                                 |            |          |            |          |            |  |  |

 

10

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Earnings Per Share Amounts:  Basic earnings per share is computedusing the weighted average number of common shares outstanding during theperiod and excludes any dilutive effects of options. Diluted earnings per shareis computed 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 78,681 and 92,071 in 2007 and 2006 and decrease earnings pershare by $.03 and $.04. No shares were antidilutive at March 31, 2007 and2006.

Recently Issued AccountingStandards on the Financial Statements:  In July 2006, the FASB releasedInterpretation No. 48, “Accounting for Uncertainty in Income Taxes.”  This Interpretation revises the recognitiontests for tax positions taken in tax returns such that a tax benefit isrecorded only when it is more likely than not that the tax position will beallowed upon examination by taxing authorities. The amount of such a tax benefit to record is the largest amount that ismore likely than not to be allowed.   Anyreduction in deferred tax assets or increase in tax liabilities upon adoptionwill correspondingly reduce retained earnings.

The Company adopted theprovisions of FASB Interpretation No. 48, Accounting for Uncertainty in IncomeTaxes (“FIN 48”), on January 1, 2007, and determined there was no need to makean adjustment to retained earnings due to adoption of this Interpretation.  The Company has no unrecognized tax benefitsand does not anticipate any increase in unrecognized benefits during 2007relative to any tax positions taken prior to January 1, 2007.  Should the accrual of any interest orpenalties relative to unrecognized tax benefits to be necessary, it is the Company’spolicy to record such accruals in its income taxes accounts; no such accrualsexist as of January 1, 2007.  TheCompany and its subsidiary file a consolidated U.S. federal income tax returnand a combined unitary return in the state of Tennessee.  These returns are subject to examination bytaxing authorities for all years after 2002.

In September 2006, the FASBissued Statement No. 157*, Fair Value Measurements*.  This statement defines fair value,establishes a framework for measuring fair value and expands disclosures aboutfair value measurements.  This Statementestablishes a fair value hierarchy about the assumptions used to measure fairvalue and clarifies assumptions about risk and the effect of a restriction onthe sale or use of an asset.  Thestandard is effective for fiscal years beginning after November 15, 2007.  The company has not completed its evaluationof the impact of the adoption of this standard.

In February 2007 the FASBissued Statement of Financial Accounting Standard (“SFAS”) No. 159, “The FairValue Option for Financial Assets and Financial Liabilities.” SFAS No. 159permits entities to choose to measure many financial instruments and certainother items at fair value with an objective of improving financial reporting byproviding entities with the opportunity to mitigate volatility in reportedearnings caused by measuring related assets and liabilities differently withouthaving to apply complex hedge accounting provisions.  The provisions of SFAS No. 159 are effectiveas of the beginnings of an entity’s first fiscal year that begins afterNovember 15, 2007.

In addition, recently issuedaccounting standards that revise the accounting for derivatives embedded inother financial instruments and revise the recognitions and accounting forservicing of financial assets are effective for 2007 but did not have amaterial effect on the financial statements as of and for the three monthsended March 31, 2007.

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**ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

**FORWARD-LOOKINGSTATEMENTS**

Management’s discussion about us and management’sanalysis of our operations and prospects, and other matters, may includeforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995 and other provisions of federal and statesecurities laws.  Although we believe that the assumptions underlying suchforward-looking statements contained in this report 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 comparableterms should be understood by the reader to indicate that the statement is “forward-looking”and thus subject to change in a manner that can be unpredictable.  Factorsthat could cause actual results to differ materially from the resultsanticipated, but not guaranteed, in this report, include (without limitation)economic and social conditions, competition for loans, mortgages, and otherfinancial services and products, changes in interest rates, unforeseen changesin liquidity, results of operations, and financial conditions affecting ourcustomers, as well as other risks that cannot be accurately quantified orcompletely identified.  Many factors affecting our financial condition andprofitability, including changes in economic conditions, the volatility ofinterest rates, political events and competition from other providers offinancial services simply cannot be predicted.  Because these factors areunpredictable and beyond our control, earnings may fluctuate from period toperiod.  The purpose of this type of information is to provide readerswith information relevant to understanding and assessing our financialcondition and results of operations, and not to predict the future or toguarantee results.  We are unable to predict the types of circumstances,conditions, and factors that can cause anticipated results to change.  Weundertake no obligation to publish revised forward-looking statements toreflect the occurrence of changes or unanticipated events, circumstances, orresults.

**FINANCIAL CONDITION**

Total assets as of March 31,2007 increased 1.22%, or $2,665,000 to $220,849,000 compared with $218,184,000at December 31, 2006. The increase in total assets was funded by an increase intotal deposits of $4,972,000. Cash and cash equivalents increased $3,198,000 to$20,651,000 at March 31, 2007 from $17,453,000 at December 31, 2006. Securitiesincreased $7,710,000 to $36,456,000 at March 31, 2007 compared to $28,746,000at December 31, 2006.  Thedecrease in loans is primarily a result of pay downs in commercial loans anddeclining loan demand.  Combined with theincrease in deposits, $4,972,000; the excess funds were used to increase thesecurities portfolio and improve the company’s liquidity position, thruincreases in cash and federal funds sold.

Loans are the principalcomponent of the Company’s assets and the primary source of income. Total loansat March 31, 2007, were $155,437,000 compared to $162,114,000 at December 31,2006, a decrease of $6,677,000. The decrease in loans in the first three monthsof 2007 was as follows: construction real estate loans increased $1,411,000,commercial loans secured by real estate decreased $2,344,000, commercial loanswhich decreased $5,940,000; and consumer loans increased $600,000, and loanssecured by family residential real estate decreased $404,000.  As of March31, 2007, $47,652,000 or 30.7% of total loans were commercial loans secured byreal estate. Commercial loans were $48,013,000 or 30.9% of total loans. Loanssecured by family residential real estate were $24,431,000 or 15.7% of totalloans. Construction loans secured by real estate were $29,875,000 or 19.2% oftotal loans. Consumer loans were $5,466,000 or 3.5% of total loans.  Of the total loans, $98,798,000 or 63.6%mature or reprice within 12 months. Only $4,381,000 or 2.8% mature or repriceover five years.

There was $1,074,000 inmortgage loans held for sale at March 31, 2007, compared with $2,538,000 atDecember 31, 2006. The decrease in mortgage loans held for sale was primarilydue to timing issues related to secondary market investor funding.

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Management anticipates thatloan demand will be moderate in the near future. Including mortgage loans heldfor sale; the loan-to-deposit ratio as of March 31, 2007, was 79.3%, comparedto 84.9% at December 31, 2006, and the loan-to-assets ratio  was 70.4% at March 31, 2007, compared to74.3% at December 31, 2006. Management expects that the loan-to-deposit ratiofor the remainder of 2007 will remain in the range of approximately 80% - 85%and the loans-to-assets ratio will be between 70% - 75%.

The securities portfolioprovides a balance to interest rate and credit risk while providing a vehiclefor investing available funds, furnishing liquidity, and supplying securitiesto pledge as required for certain deposits and borrowed funds. All securitiesare classified as “available for sale”. We have no plans to liquidate asignificant amount of the securities portfolio.  As of March 31, 2007, theCompany owned $36,456,000 of securities available-for-sale, an increase of$7,710,000 or 26.8% compared to $28,746,000 at December 31, 2006.

Deposits which are the Company’sprimary source of funds, totaled $195,995,000 at March 31, 2007, for anincrease of $4,972,000, or 2.6%, compared to $191,023,000 at December 31, 2006.Deposits at March 31, 2007 consisted of $25,883,000 or 13.2% in non-interestbearing demand deposits, $40,169,000 or 20.5% in interest-bearing demanddeposits, $122,604,000 or 62.6% in time certificates of deposit and $7,339,000or 3.7% in savings accounts. There was $16,461,000 in brokered CDs at March 31,2007 compared to $21,526,000 at December 31, 2006. The Company has targetedlocal consumers, 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 factors such asliquidity needs and market conditions. The Company believes it has a competitiveadvantage by being a locally owned financial institution which will contributeto increased market share. However, no assurance of market growth can be given.

The majority of the depositscontinue to be CDs, which increased $5,052,000 in the first three months of2007. At March 31, 2007, the weighted average rate on CDs was 5.0% compared to3.9% for the three months ended March 31, 2006. The Company has time depositsmaturing within one year of $111,835,000 or 91.2% of total time deposits. Timedeposits maturing greater than one year were $10,768,000 or 8.8% of total timedeposits. Interest-bearing accounts, other than CDs, increased $300,000 in thefirst three months of 2007. Noninterest bearing deposits decreased $382,000 forthe three months ended March 31, 2007. The weighted average cost of all depositaccounts during the first three months of 2007 was 3.82% compared to 2.79% forthe same period in 2006.

Total shareholders’ equityincreased $445,000, to $17,355,000 at March 31, 2007, from $16,910,000 atDecember 31, 2006. This increase was due to the Company’s net income of$427,000 for the first three months of 2007 along with a net decrease inunrealized losses on securities available for sale of $6,000 net of tax.  There was a $12,000 increase in additionalpaid in capital related to stock option compensation according to FASB 123R.

As of March 31, 2007 the Bankis categorized as well capitalized under the regulatory framework for promptcorrective action. The total capital to risk-weighted assets ratio was 13.85%.Tier-1 to risk-weighted assets ratio was 12.72% and Tier-1 to average assetratio was 10.22%.

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**RESULTS OF OPERATIONS**

For the first three months of2007, net income after tax was 427,000, compared to $576,000 for the sameperiod in 2006, a decrease of 25.9%. The decrease in earnings over the previousyear was a result of a lower loan-to-deposit ratio, 79.3% at March 31, 2007compared to 84.9% at March 31, 2006 along with the decrease in interest margin,and an increase in personnel and operating expenses.  Net interest income before the provision forloan losses for the first three months of 2007 was $1,769,000, an increase of$4,000 from $1,765,000 for the first three months of 2006. The net interestmargin for March 31, 2007 was 3.62%, compared to March 31, 2006 at 3.95%.

Interest and fee income onloans for the first three months of 2007 was $3,121,000, an increase of$475,000 or 18% from $2,646,000 for the three months ended March 31, 2006. Theincrease in interest and fee income on loans is primarily due to increasedvolume in commercial loans as well as construction and commercial real estateloans along with the increase in rates following the Federal Reserve’s effortsto increase short term rates. The yield on all loans increased 78 basis pointsto 7.92% for the three months ended March 31, 2007 compared to 7.14% for thethree months ended March 31, 2006. Total loans outstanding at March 31, 2007were $155,437,000 compared to $146,281,000 at March 31, 2006.

Interest income from securitiesand short-term funds totaled $545,000 for the first three months of 2007, anincrease of $223,000 over the same period of 2006. The increase in 2007 was dueto an increase in the average dollar amount of securities and short-term fundsoutstanding; $48,796,000 at March 31, 2007 compared to $30,505,000 at March 31,2006 and the increase in short term rates. The yield on securities andshort-term funds increased to 5.30% at March 31, 2007 compared to 4.41% atMarch 31, 2006.

Interest expense totaled $1,897,000in the first three months of 2007, compared to $1,206,000 for the same periodof 2006. The increase in interest expense in 2006 was due to the significantgrowth of deposits and an increase in short term rates. The Company’s cost offunds increased to 4.28% at March 31, 2007 compared to 3.17% at March 31, 2006.Total deposits outstanding at March 31, 2007 were $195,995,000 compared to$171,729,000 at March 31, 2006.

The Company’s yield on earningassets has increased to 7.31%, for the first three months of 2007 compared to6.65% for the same period of 2006. The cost of interest-bearing funds hasfollowed the same trend, increasing to 4.38% for the first three months of2007, up from 3.29% for the three months ended March 31, 2006.  The Company’s net interest margin for thefirst three months of 2007 was 3.62% as compared to March 31, 2006 at3.95%.  See interest rate sensitivity forfurther discussion.

The allowance for loan lossesis maintained by management at a level considered adequate to cover probableincurred losses in the Company’s loan portfolio.  Management estimates the allowance balancerequired using past loan loss experience, the nature and volume of theportfolio, information about specific borrower situations and estimatedcollateral values, economic conditions, and other factors.   The Company provided $26,000 for loan lossesin the three months ended March 31, 2007, compared to $51,000 for the sameperiod of 2006.  The net charge-offs forthe first three months of 2007 were $23,000 compared to $218,000 for the sameperiod in 2006. This compares to net charge offs of $822,000 and $61,000 forthe years ended December 31, 2006 and 2005.  At March 31, 2007, theCompany had four loans totaling $583,000 in nonaccrual status.  Thiscompares with December 31, 2006, where there were three loans totaling $250,000in nonaccrual. At March 31, 2007, the allowance for loan losses was 1.28%compared to 1.22% at December 31, 2006.

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Total noninterest income forthe first three months of 2007 was $453,000 compared to $512,000 for the sameperiod in 2006. The largest single source of noninterest income is servicecharges on deposit accounts. Service charges on deposits totaled $203,000 in2007 compared to $279,000 in 2006. The decrease is due primarily to lower NSFand overdraft protection fee income realized during the period. Mortgagebanking income was $140,000 for the three months ended March 31, 2007 comparedto $143,000 for the same period in 2006. For the three months ended March 31,2007, the Company originated for subsequent sale, 41 loans for $5,272,000compared to 46 loans for $7,346,000 for the same period in 2006. The averageloan closed decreased $31,000 to $128,000 from $159,000 in the previous year.Net securities gains or losses reflected a gain of $4,000 in 2007 compared to again of $10,000 in 2006. Other service charges, commissions and fees were$106,000 as of March 31, 2007 as compared to $80,000 for the same period in2006. This includes safe deposit box rent, ATM interchange and surcharges,credit card interchange income, and the sale of checks to depositors.

Noninterest expenses were$1,593,000 for the first three months of 2007 compared with $1,352,000 for thesame period of 2006; an increase of $241,000 or 17.8%. The increase in noninterestexpenses in the first three months of 2007 is attributable primarily to theincrease in salaries and benefits expense; an increase of $101,000 or 14.1%compared to 2006.  This increaseprimarily resulted from the hiring of additional personel to cover the growthof the company.  As of March 31, 2007,the Company had 55 full-time equivalent employees compared to 51 for the sameperiod of 2006.

Other operating expenses hadan increase of $138,000 in the first three months of 2007 as compared to the sameperiod in 2006.  With the growth of the Company there were increases insome areas such as marketing $41,000, data processing $24,000, loss on ORE$21,000, loan expense $12,000, ATM $10,000, supplies $8,000, consultingservices $8,000, postage $6,000, audit $6,000, and telephone $4,000. Theincreases were offset with decreases in other areas such as human resources,and dues and subscriptions totaling $2,000.

The Company recorded incometax expense of $176,000 for the period ended March 31, 2007 compared to$298,000 for the same period in 2006. The effective tax rate for the threemonths ended March 31, 2007 is 29.2% compared to 34.1% for the same periodended 2006.  The decrease in theeffective tax rate is due to a larger percentage of pretax income being taxfree, 34.8% at March 31, 2007, compared to 16.0% at March 31, 2006.

**LIQUIDITY AND CAPITALRESOURCES**

Liquidity refers to theCompany’s ability to fund loan demand, meet deposit customers’ withdrawal needsand provide for operating expenses. As summarized in the Statement of CashFlows, the Company’s main source of cash flow is from receiving deposits fromits customers, and to a lesser extent, repayment of loan principal and interestincome on loans and investments. The primary uses of cash are lending to theCompany’s borrowers, and investing in securities and short-terminterest-earning assets.

In the first three months of2007, deposit growth has exceeded loan growth; however, this is more of atiming issue and is not expected to continue. Other potential sources ofliquidity include the sale of available-for-sale securities from the Company’sportfolio, the sale of loans, the purchase of federal funds, or repurchaseagreements. The Company currently has $16,461,000 in brokered certificates ofdeposit, compared to $21,526,000 at December 31, 2006.

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At March 31, 2007 and December 31, 2006, the Bank’s risk-based capitalratios and the minimums to be considered well-capitalized under the FederalReserve Board’s prompt corrective action guidelines were as follows:
| ** **                             | ** ** | **March 31, 2007** | ** ** | **Dec. 31, 2006** | ** ** | **Well-capitalized** | ** ** |
|----------------------------------------|------------|------------------------------|------------|-----------------------------|------------|----------------------|------------|
|                                   |       |                         |       |                        |       |                 |       |
| Tier 1 capital to risk-weighted assets |       | 12.72                        | %          | 12.26                       | %          | 6.0                  | %          |
| Total capital to risk-weighted assets  |       | 13.85                        | %          | 13.35                       | %          | 10.0                 | %          |
| Tier 1 leverage ratio                  |       | 10.22                        | %          | 10.82                       | %          | 5.0                  | %          |

 

As discussed above, totalshareholders’ equity increased $445,000, to $17,355,000 at March 31, 2007 from$16,910,000 at December 31, 2006. This increase was due to the Company’s netincome of $427,000 for the first three months of 2007 along with a net decreasein unrealized losses on securities available for sale of $6,000, net oftax.  There was $12,000 allocated toadditional paid in capital related to stock option compensation according toFASB 123R.

The payment of dividends bythe Company depends to a great extent on the ability of the Bank to paydividends to the Company. The Company is subject to the Tennessee Banking Act,which provides that the Bank may not declare dividends in any calendar yearthat exceeds the total of its net income of that year combined with itsretained net income of the preceding two years without the approval of theTennessee Department of Financial Institutions. Thereafter, 10% of net profitsmust be transferred to capital surplus prior to payment of dividends untilcapital surplus equals capital stock. The Bank is also subject to the minimumcapital requirements of the FDIC which impact the Bank’s ability to paydividends. If the Bank fails to meet these standards, it may not be able to paydividends or to accept additional deposits because of regulatory requirements.

If, in the opinion of theapplicable federal bank regulatory authority, a depository institution isengaged in or is about to engage in an unsafe or unsound practice (which,depending on the financial condition of the depository institution, couldinclude the payment of dividends), such authority may require that suchinstitution cease and desist from such practice. The federal banking agencieshave indicated that paying dividends that deplete a depository institution’scapital base to an inadequate level would be such an unsafe and unsound bankingpractice. Moreover, the Federal Reserve Board, the Comptroller of the Currencyand the FDIC have issued policy statements which provide that bank holdingcompanies and insured depository institutions generally should only paydividends out of current earnings.

**ITEM 3:  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

Like all financial institutions, we are subject tomarket risk from changes in interest rates. Interest rate risk is inherent inthe balance sheet due to the mismatch between the maturities of rate sensitiveassets and rate sensitive liabilities. If rates are rising, and the level ofrate sensitive liabilities exceeds the level of rate sensitive assets, the netinterest margin will be negatively impacted. Conversely, if rates are falling,and the level of rate sensitive liabilities is greater than the level of ratesensitive assets, the impact on the net interest margin will be favorable.Managing interest rate risk is further complicated by the fact that all ratesdo not change at the same pace, in other words, short term rates may be risingwhile longer term rates remain stable. In addition, different types of ratesensitive assets and rate sensitive liabilities react differently to changes inrates.

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To manage interest rate risk, we must take a positionon the expected future trend of interest rates. Rates may rise, fall, or remainthe same. Our asset liability committee develops its view of future rate trendsand strives to manage rate risk within a targeted range by monitoring economicindicators, examining the views of economists and other experts, andunderstanding the current status of our balance sheet. Our annual budgetreflects the anticipated rate environment for the next twelve months. The assetliability committee conducts a quarterly analysis of the rate sensitivityposition and reports its results to our board of directors.

The asset liability committee uses a computer model toanalyze the maturities of rate sensitive assets and liabilities. The modelmeasures the “gap” which is defined as the difference between the dollar amountof rate sensitive assets repricing during a period and the volume of ratesensitive liabilities repricing during the same period. Gap is also expressedas the ratio of rate sensitive assets divided by rate sensitive liabilities. Ifthe ratio is greater than “one”, the dollar value of assets exceeds the dollarvalue of liabilities, and the balance sheet is “asset sensitive”. Conversely,if the value of liabilities exceeds the value of assets, the ratio is less thanone and the balance sheet is “liability sensitive”. Our internal policyrequires management to maintain the gap within a range of 0.75 to 1.25.

The model measures scheduled maturities in periods ofthree months, four to twelve months, one to five years and over five years. Thechart below illustrates our rate sensitive position at March 31, 2007.Management uses the one year gap as the appropriate time period for settingstrategy.

**INTEREST RATE SENSITIVITY**

Financial institutions aresubject to interest rate risk to the degree that their interest-bearingliabilities (consisting principally of customer deposits) mature or repricemore or less frequently than their interest-earning assets (generallyconsisting of loans and investment securities). The match between the scheduledrepricing and maturities of earning assets and liabilities within defined timeperiods is referred to as “gap” analysis. At March 31, 2007 the cumulativeone-year gap was a negative (or liability sensitive) $47,960,000 or 22.9% ofearning assets compared to a negative gap of $25,298,000 or 12.3% of earningassets at December 31, 2006.

One of management’s objectivesin managing the Company’s balance sheet for interest rate sensitivity is toreduce volatility in the net interest margin by matching, as closely aspossible, the timing of the repricing of its interest rate sensitive assetswith interest rate sensitive liabilities. During the first three months of 2007rates remained constant compared to four rate increases in the first six monthsof 2006. Management believes that interest rates will level off and possiblydecline within the next two years. The Company’s strategy of being in anegative one year gap position should result in stable net interest margin asrates decline. The Company maintained a negative position during the fourthquarter of 2006. This position into the first quarter of 2007 has caused thenet interest margin to decline from 3.90% compared to 3.62% at March 31, 2007.Many of the Company’s loans are commercial real estate loans with rates thatare tied to New York Prime or that are fixed for up to three years, and thisstrategy allows the Company to match longer-term funding with these loans, thusminimizing volatility in the net interest margin.

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**Interest Rate 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 available  for sale, at fair value          |       | $                                                    | 504        |   | $ | — |   | $ | 504 |   | $ | 1,891 |   | $ | 34,061 |   | $ | 36,456 |   |
| Federal funds sold                                     |       | 16,654                                               |       | — |   | 16,654 |   | — |   | — |   | 16,654 |   |
| Mortgage loans held for  sale                          |       | 1,074                                                |       |   |   | 1,074 |   |   |   |   |   | 1,074 |   |
| Loans                                                  |       | 72,802                                               |       | 25,996 |   | 98,798 |   | 52,258 |   | 4,381 |   | 155,437 |   |
|                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total Earning  Assets                                  |       | $                                                    | 91,035     |   | $ | 25,996 |   | 117,031 |   | $ | 54,147 |   | $ | 38,443 |   | 209,621 |   |
|                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES                                            |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
|                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits                             |       | $                                                    | 80,699     |   | $ | 78,643 |   | 159,342 |   | $ | 10,770 |   | $ | — |   | 170,112 |   |
| Subordinated debentures                                |       | 5,155                                                |       |   |   | 5,155 |   |   |   |   |   | 5,155 |   |
| Other borrowings                                       |       | 494                                                  |       | — |   | 494 |   | — |   | — |   | 494 |   |
| Total  interest-bearing liabilities                    |       | $                                                    | 86,348     |   | $ | 78,643 |   | 164,991 |   | $ | 10,770 |   | $ | — |   | 175,761 |   |
|                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Asset (liability) GAP                                  |       | 4,687                                                |       | (52,647 | ) | (47,960 | ) | 43,377 |   | 38,443 |   | 33,862 |   |
|                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Cumulative asset  (liability) GAP                      |       | 4,687                                                |       | (47,960 | ) | (47,960 | ) | (4,581 | ) | 33,862 |   | 33,862 |   |
|                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Cumulative as a  percentage of interest-earning assets |       | 2.2                                                  | %          | (22.9 | )% | (22.9 | )% | (2.2 | )% | 16.2 | % | 16.2 | % |
|                                                   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
|                                                        |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**OFF-BALANCE SHEET ARRANGEMENTS**

We are a party to financialinstruments with off-balance sheet risk in the normal course of business tomeet the financing needs of its consumers.  At March 31, 2007, we hadunfunded loan commitments outstanding of $47.4 million and standby letters ofcredit of $2.5million.  These financial instruments include commitments toextend credit and standby letters of credit.  Those instruments involve,to varying degrees, elements of credit risk in excess of the amount recognizedin the balance sheet.  The contract or notional amounts of those instrumentsreflect the extent of our involvement in those particular financialinstruments.  We use the same credit policies in making commitments andconditional obligations as it does for on-balance sheet instruments.

Because these commitmentsgenerally have fixed expiration dates and many will expire without being drawnupon, the total commitment level does not necessarily represent future cashrequirements.  If needed, we can liquidate Federal funds sold orsecurities available for sale or borrow and purchase Federal funds from otherfinancial institutions where we have available federal funds lines totaling $14million.

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## **ITEM4:  CONTROLS AND PROCEDURES**

**DISCLOSURE CONTROLS**

The Company maintains disclosure controls andprocedures, as defined in Rule 13a-15(a) promulgated under the SecuritiesExchange Act of 1934 (the “Exchange Act”), that are designed to ensure thatinformation required to be disclosed by the Company in the reports that itfiles or submits under the Exchange Act is recorded, processed, summarized andreported within the time period specified in the SEC’s rules and forms and thatsuch information is accumulated and communicated to the management of theCompany , including its Chief Executive Officer and Chief Financial Officer (“Management”),as appropriate, to allow timely decisions regarding required disclosure.

Under the supervision and with the participation ofManagement, the Company evaluated the effectiveness of the design and operationof its disclosure controls and procedures as of the end of the period coveredby this report. Based on the evaluation of these disclosure controls andprocedures, the Chief Executive Officer and Chief Financial Officer concludedthat the Company’s disclosure controls and procedures were effective, subjectto the effectiveness of the Company’s internal control over financialreporting.

**INTERNAL CONTROLS**

Management is responsible for establishing andmaintaining adequate internal control over financial reporting.  The Company’s internal control system wasdesigned to provide reasonable assurance to Management and the board ofdirectors regarding the fair and reliable preparation and presentation of theconsolidated financial statements.

Crowe Chizek and Company LLC (“Crowe”) is theindependent registered public accounting firm responsible for auditing theCompany’s consolidated financial statements. In connection with Crowe’s audit of the Company’s consolidated financialstatements, Crowe submitted a draft report to Management and the AuditCommittee on April 12, 2007 stating that a combination of control deficienciesand financial reporting errors amounted to a material weakness in internalcontrols over financial reporting.  Crowesubmitted its final report on April 20, 2007 (the “Report”).  Management has thoroughly reviewed the draftand final reports and its findings and does not concur that a material weaknessexists.  Nonetheless, Management hasagreed to review the matters presented by Crowe in the Report and to respond tothe deficiencies raised in the Report.

**Changes in Internal Controls and Procedures **

Management has evaluated changes in the Company’sinternal controls over financial reporting during the Company’s fiscal quarterended March 31, 2007.  In connection withsuch evaluation, as noted above, Crowe informed Management that a materialweakness in internal controls over financial reporting existed due to theaggregation of certain control deficiencies that were detected during the 2006audit.  According to Crowe, the controldeficiencies involve, the issuance of new, complex accounting standards, thelack of measurement of the departure from generally accepted accountingprinciples associated with loan fee accounting and adjustments that wererequired to the Company’s financial statements after they were presented to theauditors.

There have been no changes to the Company’s internalcontrols over financial reporting that occurred since the beginning of thequarter ended March 31, 2007 that have materially affected, or are reasonablylikely to materially affect, the Company’s internal control over financialreporting.

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**PART II - OTHER INFORMATION**

**ITEM 1. LEGAL PROCEEDINGS**

There are no material pendinglegal proceedings to which the Company is a party of which any of their propertyis the subject.

**ITEM 1A. RISK FACTORS**

Investing in our common stock involves various riskswhich are particular to us, our bank, our industry and our market area. Severalrisk factors regarding investing in our common stock are discussed below. Thislisting should not be considered as all-inclusive. If any of the followingrisks were to occur, we may not be able to conduct our business as currentlyplanned and our financial condition or operating results could be negativelyimpacted. These matters could cause the trading price of our common stock todecline in future periods.

*We aregeographically concentrated in the Cleveland, Tennessee, and changes in localeconomic conditions impact our profitability.*

We operate primarily in Cleveland, Tennessee, andsubstantially all of our loan customers and most of our deposit and othercustomers live or have operations in Cleveland. Accordingly, our successsignificantly depends upon the growth in population, income levels, depositsand housing starts in Cleveland, along with the continued attraction ofbusiness ventures to the area. Our profitability is impacted by the changes ingeneral economic conditions in this market. Additionally, unfavorable local ornational economic conditions could reduce our growth rate, affect the abilityof our customers to repay their loans to us and generally affect our financialcondition and results of operations.

We are less able than a larger institution to spreadthe risks of unfavorable local economic conditions across a large number ofdiversified economies. Moreover, we cannot give any assurance that we willbenefit from any market growth or favorable economic conditions in our primarymarket areas if they do occur.

Our continued growth may require the need foradditional capital and further regulatory approvals which, if not obtained,could adversely impact our profitability and implementation of our currentbusiness plan.

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To continue to grow, we will need to providesufficient capital to the Company through earnings generation, additionalequity offerings or borrowed funds or any combination of these sources offunds. Should we incur indebtedness, we are required to obtain certainregulatory approvals beforehand. Should our growth exceed our expectations, wemay need to raise additional capital over our projected capital needs. However,our ability to raise additional capital, if needed, will depend on conditionsin the capital markets at that time, which are outside our control, and on ourfinancial performance. Accordingly, we cannot assure our ability to raiseadditional capital if needed on terms acceptable to us. If we cannot raiseadditional capital when needed, our ability to further expand and grow ouroperations could be materially impaired. Additionally, our current planinvolves increasing our branch network, which will require capitalexpenditures. Our expansion efforts may also require certain regulatoryapprovals. Should we not be able to obtain such approvals or otherwise not beable to grow our asset base, our ability to attain our long-term profitabilitygoals will be more difficult.

*If our allowancefor loan losses is not sufficient to cover actual loan losses, our earningswill decrease.*

If loan customers with significant loan balances failto repay their loans according to the terms of these loans, our earnings wouldsuffer. We make various assumptions and judgments about the collectibility ofour loan portfolio, including the creditworthiness of our borrowers and thevalue of any collateral securing the repayment of our loans. We maintain anallowance for loan losses in an attempt to cover the inherent risks associatedwith lending. In determining the size of this allowance, we rely on an analysisof our loan portfolio based on volume and types of loans, internal loanclassifications, trends in classifications, volume and trends in delinquencies,nonaccruals and charge-offs, national and local economic conditions, otherfactors and other pertinent information. Because we are a relatively youngorganization, our allowance estimation may be less reflective of our historicalloss experience than a more mature organization. If our assumptions areinaccurate, our current allowance may not be sufficient to cover potential loanlosses, and additional provisions may be necessary which would decrease ourearnings.

In addition, federal and state regulators periodicallyreview our loan portfolio and may require us to increase our allowance for loanlosses or recognize loan charge-offs. Their conclusions about the quality ofour loan portfolio may be different than ours. Any increase in our allowancefor loan losses or loan charge-offs as required by these regulatory agenciescould have a negative effect on our operating results.

*Fluctuations ininterest rates could reduce our profitability.*

Changes in interest rates may affect our level ofinterest income, the primary component of our gross revenue, as well as thelevel of our interest expense. Interest rate fluctuations are caused by manyfactors which, for the most part, are not under our direct control. Forexample, national monetary policy plays a significant role in the determinationof interest rates. Additionally, competitor pricing and the resultingnegotiations that occur with our customers also impact the rates we collect onloans and the rates we pay on deposits.

As interest rates change, we expect that we willperiodically experience “gaps” in the interest rate sensitivities of our assetsand liabilities, meaning that either our interest-bearing liabilities will bemore sensitive to changes in market interest rates than our interest-earningassets, or vice versa. In either event, if market interest rates should movecontrary to our position, this “gap” may work against us, and our earnings maybe negatively affected.

Changes in the level of interest rates also maynegatively affect our ability to originate real estate loans, the value of ourassets and our ability to realize gains from the sale of our assets, all ofwhich ultimately affect our earnings. A decline in the market value of ourassets may limit our ability to borrow additional funds. As a result, we couldbe required to sell some of our loans and investments under adverse marketconditions, upon terms that are not favorable to us, in order to maintain ourliquidity. If those sales are made at prices lower than the amortized costs ofthe investments, we will incur losses.

*The Company couldsustain losses if its asset quality declines.*

The Company’s earnings are affected by the Bank’sability to properly originate, underwrite and service loans. The Company couldsustain losses if it incorrectly assesses the creditworthiness of its borrowersor fails to detect or respond to deterioration in asset quality in a timelymanner. Problems with asset quality could cause the Bank’s interest income andnet interest margin to decrease and its provisions for loan losses to increase,which could adversely affect the Company’s results of operations and financialcondition.

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*Loss of our seniorexecutive officers or other key employees could impair our relationship withour customers and adversely affect our business.*

We have assembled a senior management team which has asubstantial background and experience in banking and financial services in theCleveland market. Loss of these key personnel could negatively impact ourearnings because of their skills, customer relationships and/or the potentialdifficulty of promptly replacing them.

*Competition withother banking institutions could adversely affect our profitability.*

A number of banking institutions in the Clevelandmarket have higher lending limits, more banking offices, and a larger marketshare. In addition, our asset management division competes with numerousbrokerage firms and mutual fund companies which are also much larger. In somerespects, this may place these competitors in a competitive advantage, althoughmany of our customers have selected us because of service quality concerns atthe larger enterprises. This competition may limit or reduce our profitability,reduce our growth and adversely affect our results of operations and financialcondition.

*The Company’scommon stock is currently traded on a local basis, the trading volume in itscommon stock has been thin and the sale of substantial amounts of the Company’scommon stock could depress the price of its common stock.*

The Company cannot say with any certainty when a moreactive and liquid trading market for its common stock will develop or besustained. Because of this, the Company’s shareholders may not be able tosell their shares at the volumes, prices, or times that they desire.

The Company cannot predict the effect, if any, thatfuture sales of its common stock, or availability of shares of its common stockfor sale, will have on the price of the Company’s common stock. The Company,therefore, can give no assurance that sales of substantial amounts of itscommon stock, or the potential for large amounts of sales, would not cause theprice of its common stock to decline or impair its ability to raise capitalthrough sales of its common stock.

*The price of the Company’s common stockmay fluctuate in the future, and these fluctuations may be unrelatedto its performance.*

*The Company may issue additional common stock or otherequity securities in the future which could dilute the ownership interest ofexisting shareholders.*

In order to maintain its capital at desired levels orrequired regulatory levels, or to fund future growth, the Company’s board ofdirectors may decide from time to time to issue additional shares of commonstock, or securities convertible into, exchangeable for or representing rightsto acquire shares of its common stock. The sale of these shares maysignificantly dilute the Company’s shareholders ownership interest as ashareholder and the per share book value of its common stock. New investors inthe future may also have rights, preferences and privileges senior to itscurrent shareholders which may adversely impact its current shareholders.

*The Company’sability to declare and pay dividends is limited by law and it may beunable to pay future dividends.*

The Company’s ability to pay dividends is derived fromthe income of the Bank. The Bank’s ability to declare and pay dividends islimited by its obligations to maintain sufficient capital and by other generalrestrictions on its dividends that are applicable to banks that are regulatedby the FDIC and the Department of Financial Institutions. In addition, the FRBmay impose restrictions on the Company’s ability to pay dividends on itscommon stock. As a result, the Company cannot assure its shareholders that itwill declare or pay dividends on shares of its common stock in the future.

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*Liquidity needscould adversely affect the Company’s results of operations and financialcondition.*

The Company relies on dividends from the Bank as itsprimary source of funds. The primary source of funds of the Bank are customerdeposits and loan repayments. While scheduled loan repayments are a relativelystable source of funds, they are subject to the ability of borrowers to repaythe loans. The ability of borrowers to repay loans can be adversely affected bya number of factors, including changes in economic conditions, adverse trendsor events affecting business industry groups, reductions in real estate valuesor markets, business closings or lay-offs, inclement weather, natural disastersand international instability. Additionally, deposit levels may beaffected by a number of factors, including rates paid by competitors, generalinterest rate levels, returns available to customers on alternative investmentsand general economic conditions. Accordingly, the Bank may be requiredfrom time to time to rely on secondary sources of liquidity to meet withdrawaldemands or otherwise fund operations. Such sources include Federal Home LoanBank advances and federal funds lines of credit from correspondent banks. Whilethe Bank believes that these sources are currently adequate, there can be noassurance they will be sufficient to meet future liquidity demands. The Bank may berequired to slow or discontinue loan growth, capital expenditures or otherinvestments or liquidate assets should such sources not be adequate.

*Our business isdependent on technology, and an inability to invest in technologicalimprovements may adversely affect our results of operations and financialcondition.*

The financial services industry is undergoing rapidtechnological changes with frequent introductions of new technology-drivenproducts and services. In addition to better serving customers, the effectiveuse of technology increases efficiency and enables financial institutions toreduce costs. We have made significant investments in data processing,management information systems and internet banking accessibility. Our futuresuccess will depend in part upon our ability to create additional efficienciesin our operations through the use of technology, particularly in light of ourpast and projected growth strategy. Many of our competitors have substantiallygreater resources to invest in technological improvements. We cannot makeassurances that our technological improvements will increase our operationalefficiency or that we will be able to effectively implement newtechnology-driven products and services or be successful in marketing these productsand services to our customers.

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**ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OFPROCEEDS**

(a)           Not applicable.

(b)           Not applicable.

(c)           None

Our ability to declare and pay dividends on our commonstock is limited by law and we may be unable to pay future dividends. We deriveour income solely from dividends on the shares of common stock of the bank. Thebank’s ability to declare and pay dividends to us is limited by its obligationsto maintain sufficient capital and by other general restrictions on itsdividends that are applicable to banks that are regulated by the FDIC and theTDFI. In addition, the Federal Reserve Board may impose restrictions on ourability to pay dividends on our common stock. As a result, we cannot assure ourshareholders that we will declare or pay dividends on shares of our commonstock in the future.

**ITEM3:  DEFAULTS UPON SENIOR SECURITIES**

(a)                                  None

(b)                                 None

**ITEM4:  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

None

**ITEM5:  OTHER INFORMATION**

(a)                                  None

(b)                                 None

**ITEM6:  EXHIBITS**
| 2.1*   |   | Articles of Share Exchange of Southern Heritage Bank and Southern  Heritage Bancshares, Inc. as filed on August 31, 2004. |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                      |
| 2.2*   |   | Plan of Share Exchange dated as of August 23, 2004 between Southern Heritage  Bank and Southern Heritage Bancshares, Inc. |
|   |   |                                                                                                                      |
| 3.1*   |   | Charter of Southern Heritage  Bancshares, Inc.                                                                            |
|   |   |                                                                                                                      |
| 3.2*   |   | By-laws of Southern Heritage  Bancshares, Inc.                                                                            |
|   |   |                                                                                                                      |
| 31.1   |   | Rule 13a-14(a)/15d-15(e)  Certification of the President.                                                                 |
|   |   |                                                                                                                      |
| 31.2   |   | Rule 13a-14(a)/15d-15(e)  Certification of the Chief Financial Officer.                                                   |
|   |   |                                                                                                                      |
| 32.1   |   | Section 1350 Certification  of the President.                                                                             |
|   |   |                                                                                                                      |
| 32.2   |   | Section 1350 Certification  of the Chief Financial Officer.                                                               |

 

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*      Previouslyfiled as an Exhibit to Southern Heritage Bancshares, Inc.’sForm 8-K as filed with the Securities Exchange Commission on August 31,2004 and incorporated by reference herein.

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**SOUTHERNHERITAGE BANCSHARES, INC.**

**FORM 10-Q**

Quarter ended March 31, 2007

**SIGNATURES**

In accordance with the requirements of the ExchangeAct, the Registrant caused this report to be signed on its behalf by theundersigned thereunto duly authorized.
|              |   | Southern Heritage  Bancshares, Inc. |
|--------------|--------|-------------------------------------|
|         |   | (Registrant)                        |
|         |   |                                |
|         |   |                                |
| May 15, 2007 |   | /s/ J. Lee Stewart                  |
| (Date)       |   | J. Lee Stewart                      |
|         |   | Chief Executive Officer             |
|         |   |                                |
|         |   |                                |
| May 15, 2007 |   | /s/ Steven W. Ledbetter             |
| (Date)       |   | Steven W. Ledbetter,                |
|         |   | Chief Financial Officer             |

 

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