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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-KSB



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|x | ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------

For the fiscal year ended December 31, 2005



| ̈ | TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------

For the transition period from  to

Commission File Number: 0-11255



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HERITAGE BANKSHARES, INC.

(Name of Small Business Issuer in its Charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Virginia                                                       |  | 54-1234322                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|200 East Plume Street Norfolk, Virginia                        |  | 23510                               
|(Address of Principal Executive Offices)                       |  | (Zip Code)                          

Issuers telephone number (757) 523-2600



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Securities registered pursuant
to Section 12(b) of the Exchange Act: None

Securities registered pursuant to Section 12(g) of the Exchange Act: Common
Stock, $5 par value



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

Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment
to this Form 10-KSB. ̈

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

State issuers revenues for its most recent fiscal year:
$11,703,373.

The aggregate market value of the registrants stock held by non-affiliates of the registrant as of October 20, 2006:
$23,374,711.*

As of October 20, 2006, 1,927,652 shares of common stock were issued and outstanding.



|* | In calculating the aggregate market value, we have used $16.90 per share, which is the sales price of the Common Stock of the Company on October 20, 2006, and 1,383,119 shares
of voting stock held by non-affiliates of the Company on October 20, 2006.
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

TABLE OF CONTENTS



|         |  |                                                                                                                 |  |     
|-------- |  | --------------------------------------------------------------------------------------------------------------- |  | ----
|         |  |                                                                                                                 |  | Page
|Part I   |  |                                                                                                                
|         |  |                                                                                                                
|Item 1.  |  | Description of Business                                                                                         |  | 4   
|         |  |                                                                                                                
|Item 1A. |  | Risk Factors                                                                                                    |  | 9   
|         |  |                                                                                                                
|Item 2.  |  | Description of Property                                                                                         |  | 12  
|         |  |                                                                                                                
|Item 3.  |  | Legal Proceedings                                                                                               |  | 13  
|         |  |                                                                                                                
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                                             |  | 13  
|         | 
|Part II  |  |                                                                                                                
|         |  |                                                                                                                
|Item 5.  |  | Market for Common Equity and Related Stockholder Matters                                                        |  | 14  
|         |  |                                                                                                                
|Item 6.  |  | Managements Discussion and Analysis or Plan of Operations                                                      |  | 15  
|         |  |                                                                                                                
|Item 7.  |  | Financial Statements                                                                                            |  | 40  
|         |  |                                                                                                                
|Item 8.  |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.                           |  | 67  
|         |  |                                                                                                                
|Item 8A. |  | Controls and Procedures                                                                                         |  | 67  
|         |  |                                                                                                                
|Item 8B. |  | Other Matters                                                                                                   |  | 69  
|         | 
|Part III |  |                                                                                                                
|         |  |                                                                                                                
|Item 9.  |  | Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act |  | 70  
|         |  |                                                                                                                
|Item 10. |  | Executive Compensation                                                                                          |  | 73  
|         |  |                                                                                                                
|Item 11. |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters                  |  | 77  
|         |  |                                                                                                                
|Item 12. |  | Certain Relationships and Related Transactions                                                                  |  | 79  
|         |  |                                                                                                                
|Item 13. |  | Exhibits                                                                                                        |  | 80  
|         |  |                                                                                                                
|Item 14. |  | Principal Accountant Fees and Services                                                                          |  | 81  



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Part I

As used in this annual report on Form 10-KSB, the Company, we,
our and us refer to Heritage Bankshares, Inc. and its subsidiaries, unless the context requires otherwise.

Late Filing

As further described below in Item 6, Managements Discussion and Analysis or Plan of Operations  Restatement
of Prior Financial Statements, the Company has previously restated its financial statements for the years ended December 31, 2003, and 2002, as well as unaudited financial information previously released for 2004, to correct accounting
errors identified by the Company in 2005. The restatement was complicated by several factors and was not completed until, on June 9, 2006, the Company filed its annual report on Form 10-KSB for the year ended December 31, 2004. (For
detailed discussion of the restatement, see Item 6, Managements Discussion and Analysis of Financial Condition and Results of Operations  Restatement of Consolidated Financial Statements, Item 8A, Controls and
Procedures and Note 2 of the Notes to Consolidated Financial Statements in the Companys annual report on Form 10-KSB for 2004.) The restatement process necessarily delayed managements efforts in connection with the Companys
financial statements for the year ended December 31, 2005 and, therefore, the preparation and filing of this annual report on Form 10-KSB for 2005.

Forward-Looking Statements

Statements contained in this annual report on Form 10-KSB which are not historical facts are
forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may be identified by the use of such words as may, will, believe,
expect, anticipate, should, planned, estimated, and potential. These forward-looking statements relate to, among other things, expectations regarding the business environment in
which we operate, projections of future performance and perceived opportunities in the market, and they are based on managements current beliefs, assumptions and expectations. Such forward-looking statements are subject to risks and
uncertainties which could cause actual results to differ materially from the expectations of future results, performance or financial condition we express or imply in any forward-looking statements. For a detailed discussion of the factors that
might cause such a difference, see Item 1A, Risk Factors.

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



| |  |  | the demand for our products and services;
| | - |  | -----------------------------------------



| |  |  | actions taken by our competitors;
| | - |  | ---------------------------------



| |  |  | changes in the prevailing interest rates;
| | - |  | -----------------------------------------



| |  |  | changes in delinquencies and defaults by our borrowers;
| | - |  | -------------------------------------------------------



| |  |  | changes in loan quality and performance;
| | - |  | ----------------------------------------



| |  |  | changes in FDIC insurance premiums;
| | - |  | -----------------------------------



| |  |  | legislative or regulatory changes or actions that affect our business;
| | - |  | ----------------------------------------------------------------------



| |  |  | our ability to achieve financial goals and strategic plans;
| | - |  | -----------------------------------------------------------



| |  |  | litigation;
| | - |  | -----------



| |  |  | weaknesses in our internal control over financial reporting; and
| | - |  | ----------------------------------------------------------------



| |  |  | credit and other risks of lending activities.
| | - |  | ---------------------------------------------

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



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ITEM 1. DESCRIPTION OF BUSINESS

General

Heritage Bankshares, Inc. (the Company) is a bank holding company incorporated under the laws of the Commonwealth of Virginia in 1983, and
serves as the holding company for its wholly-owned subsidiaries: Heritage Bank (the corporate name was changed from Heritage Bank & Trust effective October 11, 2005), IBV Real Estate Holdings, Inc., and Sentinel Trust Services, LLC.
Since 1992, the Company has operated as a one bank holding company. The principal executive office of the Company is located at 200 East Plume Street, Norfolk, Virginia. Currently, the Company does not transact any material business other than
through Heritage Bank. Information concerning the Company and Heritage Bank may be found at www.heritagebankva.com.

Heritage Bank (the
Bank) is a wholly-owned subsidiary of the Company and is a state banking corporation engaged in the general commercial and retail banking business. The Bank was incorporated in Virginia on September 19, 1975 and commenced business
at 841 North Military Highway in Norfolk, Virginia on February 7, 1977. On December 31, 2005, the Bank had assets of $204.4 million, with total loans held for investment of $130.4 million and deposits of $173.0 million.

The Bank has one wholly-owned subsidiary, Sentinel Financial Group, Inc. (Sentinel Financial). At December 31, 2005, Sentinel Financial
owned an interest in each of Bankers Investment Group, LLC, and Bankers Insurance, LLC, each of which offer various insurance and investment services. Our ownership interest in these companies, through Sentinel Financial, allows the Bank to provide
these investment and insurance services to its customers. (In December of 2005, Sentinel Financial sold its entire interest in Bankers Title of Hampton Roads, LLC, another company that provides various banking and insurance services.)

IBV Real Estate Holdings, Inc. (IBV) is a wholly-owned subsidiary of the Company and was formed for the sole purpose of owning additional
real estate assets acquired by the Company or the Bank. IBV owns a 1% interest in and is the sole general partner of IBV Partners, LP, a Virginia limited partnership formed in December 1986 (IBV Partners). The sole asset of IBV Partners
is a 17,200 square-foot office building located at 1450 South Military Highway, Chesapeake, Virginia. The Bank is a tenant in the property, as described below in Item 2, Description of Properties.

Sentinel Trust Services, LLC (Sentinel Trust) is a wholly-owned subsidiary of the Company that was originally formed to own an interest in
Old Dominion Trust Company, a provider of trust services. In 2004, Old Dominion Trust Company merged with AMG Guaranty Trust, a privately held provider of investment services. At December 31, 2005, Sentinel Trust owned 2,560 shares, or less
than 1%, of the common stock of AMG Guaranty Trust.

Principal Products or Services

The Company, through the Bank, engages in a general community and commercial banking business, targeting the banking needs of individuals and small to
medium sized businesses in its primary service area which includes Chesapeake, Norfolk, and Virginia Beach, Virginia. The principal business of the Company is to attract deposits and to lend or invest those deposits on profitable terms. These
deposits are in varied forms of both demand and time accounts including checking accounts, interest checking, money market accounts, savings accounts, certificates of deposit, and IRA accounts.

The Company is involved in the construction and real estate lending market and actively extends both consumer and commercial credit. Loans consist of
varying terms and may be secured or unsecured. Loans to individuals are for personal, household, and family purposes. Loans to businesses are made for purposes such as working capital, plant expansion, and equipment purchases. See Item 6,
Managements Discussion and Analysis or Plans of Operations, for a breakdown of loans by classification.

Market Area

The Company is located in the Norfolk-Virginia Beach-Newport News Metropolitan Statistical Area (MSA), which extends approximately 65 miles
from Williamsburg, Virginia, to Virginia Beach, Virginia, and Currituck County, North Carolina. This MSA is the 31stlargest Metropolitan Statistical Area in the United States with a population in 2004 of approximately 1.6 million persons. The Companys principal market within this MSA is the Hampton Roads area, which comprises the cities of Norfolk,
Portsmouth, Virginia Beach, Chesapeake, Suffolk, Hampton, and Newport News. The Company maintains its corporate headquarters in Norfolk, Virginia, and as of September 30, 2006, the Bank has a total of five retail offices located in the cities
of Norfolk and Virginia Beach, Virginia. One of the Companys Norfolk retail offices also includes a mortgage loan origination office.

Although the Hampton Roads area supports a wide range of industrial and commercial activities, the areas principal employer is the United States Navy and other branches of the Armed Forces of the United States. Significant cutbacks in
defense spending and consolidations of domestic military installations could affect the general economy of the Companys market area. Depending on whether the Hampton Roads area experiences an overall increase or decrease in military and
federal wages and salaries, the potential future impact of any such cutbacks or consolidations could be either favorable or unfavorable.



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Competition

The banking business in the MSA, and the Companys principal market area, is highly competitive, and the Company faces significant competition both in making loans and in attracting deposits. At June 30, 2006, the Companys
deposit market share as a percentage of FDIC-insured institutions deposits in the MSA was 1.01%. The Companys competition for loans comes from commercial banks, savings banks, mortgage banking subsidiaries of regional commercial banks,
national mortgage bankers, insurance companies, and other institutional lenders. The Companys most direct competition for deposits has historically come from savings banks, commercial banks, credit unions and other financial institutions. The
Company may face an increase in competition as a result of the continuing reduction in the restrictions on the interstate operations of financial institutions. The Company also faces competition for deposits from short-term money market mutual funds
and other corporate and government securities funds. (For additional discussion regarding competition facing the Company, see Item 1A, Risk Factors, below.)

Employees

At December 31, 2005, we employed 82 full-time equivalent employees. At
September 30, 2006, we employed 78 full-time equivalent employees. Management considers its employee relations to be excellent.

Supervision and
Regulation

Bank holding companies and banks are extensively regulated under both federal and state law. The following summary briefly
describes certain significant provisions of applicable federal and state laws and applicable regulations and the potential impact of such provisions on the Company and the Bank. This summary is not complete, and we refer you to the particular
statutory or regulatory provisions or proposals for more information. Because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal regulation of financial
institutions may change in the future and impact the operations of the Company and the Bank.

The Company

General. The Company is registered with the Federal Reserve Bank (Federal Reserve) as a financial holding company under the Bank
Holding Company Act of 1956 (the BHCA), as amended by the Gramm-Leach-Bliley Act, and is subject to ongoing regulation, supervision and examination by the Federal Reserve. The Company is required to file with the Federal Reserve periodic
and annual reports and other information concerning its own business operations and those of its subsidiaries. The Federal Reserve also supervises the Companys operations and major transactions affecting its capital structure, including
mergers, acquisitions and share redemptions.

Capital Adequacy. The Federal Reserve has promulgated capital adequacy regulations for
all bank holding companies with assets in excess of $150 million. The Federal Reserves capital adequacy regulations are based upon a risk-based capital determination, whereby a bank holding companys capital adequacy is determined in
light of the risk, both on- and off-balance sheet, contained in the companys assets. Different categories of assets are assigned risk weightings and are counted at a percentage of their book value.

The regulations divide capital between Tier 1 capital (core capital) and Tier 2 capital. For a bank holding company, Tier 1 capital consists
primarily of common stock, related surplus, noncumulative perpetual preferred stock, minority interests in consolidated subsidiaries and a limited amount of qualifying cumulative preferred securities. Goodwill and certain other intangibles are
excluded from Tier 1 capital. Tier 2 capital consists of an amount equal to the allowance for loan and lease losses up to a maximum of 1.25% of risk-weighted assets, limited other types of preferred stock not included in Tier 1
capital, hybrid capital instruments and term subordinated debt. Investments in and loans to unconsolidated banking and finance subsidiaries that constitute capital of those subsidiaries are excluded from capital. The sum of Tier 1 and
Tier 2 capital constitutes qualifying total capital. The Tier 1 component must comprise at least 50% of qualifying total capital.

Every bank holding company has to achieve and maintain a minimum Tier 1 capital ratio (Tier 1 capital to risk-weighted assets) of at least 4.0% and a minimum total capital ratio of at least 8.0%. In addition, banks and bank holding
companies are required to maintain a minimum leverage ratio of Tier 1 capital to average total consolidated assets (leverage capital ratio) of at least 3.0% for the most highly-rated, financially sound banks and bank holding companies, and a
minimum leverage ratio of at least 4.0% for all other banks. The Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve define Tier 1 capital for banks in the same manner for both the leverage ratio and the risk-based
capital ratio. However, the Federal Reserve defines Tier 1 capital for bank holding companies in a slightly different manner.



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The guidelines also provide that banking organizations experiencing internal growth or making
acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory level, without significant reliance on intangible assets. The guidelines also indicate that the Federal Reserve will continue to consider
a Tangible Tier 1 Leverage Ratio in evaluating proposals for expansion or new activities. The Tangible Tier 1 Leverage Ratio is the ratio of Tier 1 capital, less intangibles not deducted from Tier 1 capital, to quarterly average total
assets.

Source of Strength for Subsidiary.Bank holding companies are required to serve as a source of financial strength for their
depository institution subsidiaries, and, if their depository institution subsidiaries become undercapitalized, bank holding companies may be required to guarantee the subsidiaries compliance with capital restoration plans filed with their
bank regulators, subject to certain limits.

Dividends.As a holding company that does not, as an entity, currently engage in
separate business activities of a material nature, the Companys ability to pay cash dividends to its shareholders depends upon the cash dividends it receives from the Bank. The Company must pay operating expenses from funds it receives from
the Bank. Therefore, shareholders may receive cash dividends from the Company only to the extent that funds are available after payment of operating expenses. In addition, the Federal Reserve generally prohibits bank holding companies from paying
cash dividends except out of operating earnings, and permits dividends only if the prospective rate of earnings retention appears consistent with the bank holding companys capital needs, asset quality and overall financial condition. As a
Virginia corporation, our payment of cash dividends also is subject to the restrictions under Virginia law on the declaration of cash dividends. Under such provisions, cash dividends may not be paid if a corporation will not be able to pay its debts
as they become due in the usual course of business after paying such a cash dividend or if the corporations total assets would be less than the sum of its total liabilities plus the amount that would be needed to satisfy certain preferential
liquidation rights. (See below for discussion regarding regulatory considerations for dividends payable by the Bank.)

Change of
Control.State and federal banking law restricts the amount of voting stock of a bank that a person may acquire without the prior approval of banking regulators. The BHCA requires that a bank holding company obtain the approval of the Federal
Reserve before it may merge with a bank holding company, acquire a subsidiary bank, acquire substantially all of the assets of any bank, or before it may acquire ownership or control of any voting shares of any bank or bank holding company if, after
such acquisition, it would own or control, directly or indirectly, more than 5% of the voting shares of that bank or bank holding company. The overall effect of such laws is to make it more difficult to acquire the Company by tender offer or similar
means than it might be to acquire control of another type of corporation. Consequently, the Companys shareholders may be less likely to benefit from rapid increases in stock prices that often result from tender offers or similar efforts to
acquire control of other types of companies.

In addition, under certain amendments to the Virginia Financial Institutions Holding Company
Act that became effective July 1, 1983, no corporation, partnership or other business entity may acquire, or make any public offer to acquire, more than 5% of the stock of any Virginia financial institution, or any Virginia financial
institution holding company, unless it first files an application with the Virginia State Corporation Commission (the SCC). The SCC is directed by the statute to solicit the views of the affected financial institution, or financial
institution holding company, with respect to such stock acquisition, and is empowered to conduct an investigation during the 60 days following receipt of such an application. If the SCC takes no action within the prescribed period, or if during the
prescribed period it issues notice of its intent not to disapprove an application, the acquisition may be completed.

Legislation

Sarbanes-Oxley Act.On July 30, 2002, the Sarbanes-Oxley Act (SOX) was enacted. SOX is not a banking law, but applies to all
public companies, including the Company. The stated goals of SOX are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and to protect investors by
improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. Given the extensive role of the Securities and Exchange Commission (the SEC) in implementing and interpreting the rules relating to many of
SOXs new requirements, the potential impact on the Company of these requirements may not be determined for some time.

SOX includes
additional disclosure requirements and new corporate governance rules for public companies, requires the SEC to adopt extensive additional disclosure, corporate governance and other related rules for public companies, increases criminal penalties
for violations of the securities laws, and mandates further studies of specified issues by the SEC and other federal government agencies. SOX also provides for the federal regulation of accounting firms that provide services to public companies and
mandates additional listing standards for the securities exchanges.

The SEC has adopted rules implementing the provisions of SOX, but some
of these rules do not presently apply to the Company because certain of the rules have delayed effective dates and/or do not apply to companies, like us, whose securities are quoted on over-the counter securities markets (see Item 5,
Market for Common Equity and Related Stockholder Matters below). The SEC has also extended the effective dates of certain rules after their adoption.



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Bank Secrecy Act; USA PATRIOT Act.Under the Bank Secrecy Act (BSA), a financial
institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction. Financial institutions are generally required to report to the United States Treasury cash transactions involving more
than $10,000. In addition, financial institutions are required to file suspicious activity reports for any transaction that involves more than $5,000 and which the financial institution knows, suspects or otherwise has reason to suspect involves
illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose. The USA PATRIOT Act of 2001 (the Patriot Act), enacted in response to the September 11, 2001, terrorist attacks, strengthens the anti-money
laundering provisions of the BSA. Many of the new provisions added by the Patriot Act apply to accounts at or held by foreign banks, or accounts of or transactions with foreign entities, and thus do not apply to the Bank because it does not have
significant foreign business. However, the Patriot Act does require federal banking regulators to consider a banks record of compliance under the BSA in acting on any application filed with such federal regulators. In January of 2005, the Bank
entered into a confidential Memorandum of Understanding (MOU) with the Federal Reserve with respect to deficiencies in its compliance with certain provisions of BSA. The deficiencies were discovered in the Federal Reserves annual
review of the Banks policies and procedures in late 2004, and the Bank entered into the MOU to remedy the deficiencies on a going-forward basis. The Bank took corrective measures outlined in the MOU and, accordingly, the MOU was terminated in
October 2006. The Federal Reserve undertook a limited scope BSA examination of the Bank in 2005 and, subsequent to that examination, approved the Banks application to open its branch in Virginia Beach. The Banks record of compliance with
the BSA will be an additional factor in any applications filed with federal regulators in the future.

The Bank

General. The Bank operates as a state bank subject to supervision and regulation by the Bureau of Financial Institutions of the SCC. The Bureau of
Financial Institutions regulates all areas of a Virginia state banks commercial banking operations, including reserves, loans, mergers, payment of dividends, establishment of branches and other aspects of operations.

Transactions with Affiliates. The Bank may not engage in specified transactions (including, for example, loans) with its affiliates unless the
terms and conditions of those transactions are substantially the same or at least as favorable to the Bank as those prevailing at the time for comparable transactions with or involving other nonaffiliated entities. In the absence of comparable
transactions, any transaction between the Bank and its affiliates must be on terms and under circumstances, including credit standards, which in good faith would be offered or would apply to nonaffiliated companies. In addition, transactions
referred to as covered transactions between the Bank and its affiliates may not exceed 10% of the Banks capital and surplus per affiliate and an aggregate of 20% of its capital and surplus for covered transactions with all
affiliates. Certain transactions with affiliates, such as loans, also must be secured by collateral of specific types and amounts. The Bank also is prohibited from purchasing low-quality assets from an affiliate. Every company under common control
with the Bank, including the Company, is deemed to be an affiliate of the Bank.

Loans to Insiders. Federal law also constrains the
types and amounts of loans that the Bank may make to its executive officers, directors and principal shareholders. Among other things, these loans are limited in amount, must be approved by the Banks board of directors in advance, and must be
on terms and conditions as favorable to the Bank as those available to an unrelated person.

Regulation of Lending Activities. Loans
made by the Bank are also subject to numerous federal and state laws and regulations, including the Truth-In-Lending Act, the Federal Consumer Credit Protection Act, the Equal Credit Opportunity Act, the Real Estate Settlement Procedures Act and
adjustable rate mortgage disclosure requirements. Remedies are available to the borrower or consumer and the Bank is subject to penalties if the Bank fails to comply with these laws and regulations. The scope and requirements of these laws and
regulations have expanded significantly in recent years.

Branch Banking. All banks located in Virginia are authorized to branch
statewide. Accordingly, a bank located anywhere in Virginia has the ability, subject to regulatory approval, to establish branch facilities near any of our facilities and within the Banks our market area. Federal law provides for nationwide
interstate banking and branching, subject to certain aging and deposit concentration limits that may be imposed under applicable state laws. Applicable Virginia statutes permit regulatory authorities to approve de novo branching in Virginia by
institutions located in states that would permit Virginia institutions to branch on a de novo basis into those states. Federal regulations prohibit an out-of-state bank from using interstate branching authority primarily for the purpose of deposit
production. These regulations include guidelines to ensure that interstate branches operated by an out-of-state bank in a host state are reasonably helping to meet the credit needs of the host state communities served by the out-of-state bank.

Reserve Requirements.Pursuant to regulations of the Federal Reserve, the Bank must maintain average daily reserves against its
transaction accounts. No reserves are required to be maintained on the first $6.6 million of transaction accounts, but reserves equal to 3.0% must be maintained on the aggregate balances of those accounts between $6.6 million and
$45.4 million, and reserves equal to 10.0% plus $1.2 million must be maintained on aggregate balances in excess of $45.4 million. These percentages are subject to adjustment by the Federal Reserve. Because required reserves must be
maintained in the form of vault cash or in a noninterest-bearing account at a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the institutions interest-earning assets. As of December 31, 2005, the
Bank met its reserve requirements.



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Community Reinvestment.Under the Community Reinvestment Act (CRA), as implemented by
regulations of the federal bank regulatory agencies, an insured bank has a continuing and affirmative obligation, consistent with its safe and sound operation, to help meet the credit needs of its entire community, including low and moderate income
neighborhoods. The CRA does not establish specific lending requirements or programs for banks, nor does it limit a banks discretion to develop the types of products and services that it believes are best suited to its particular community,
consistent with the CRA. The CRA requires the federal bank regulatory agencies, in connection with their examination of insured banks, to assess the banks records of meeting the credit needs of their communities, using the ratings of
outstanding, satisfactory, needs to improve, or substantial noncompliance, and to take that record into account in its evaluation of certain applications by those banks. All banks are required to make
public disclosure of their CRA performance ratings. The Banks current CRA performance rating is satisfactory.

Governmental Monetary Policies. The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve. Changes in the discount rate on member bank borrowings,
control of borrowings, open market transactions in United States government securities, the imposition of and changes in reserve requirements against member banks and deposits and assets of foreign bank branches, and the imposition of and changes in
reserve requirements against certain borrowings by banks and their affiliates are some of the monetary policies available to the Federal Reserve. Those monetary policies influence to a significant extent the overall growth of all bank loans,
investments and deposits and the interest rates charged on loans or paid on time and savings deposits in order to mitigate recessionary and inflationary pressures. These techniques are used in varying combinations to influence overall growth and
distribution of bank loans, investments and deposits, and their use may also affect interest rates charged on loans or paid for deposits.

The monetary policies of the Federal Reserve have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. In view of changing conditions in the national economy
and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of the Bank.

Dividends. All dividends paid by the Bank are paid to the Company, the sole shareholder of the Bank. The general dividend policy of the Bank is to
pay dividends at levels consistent with maintaining liquidity and preserving applicable capital ratios and servicing obligations. The dividend policy of the Bank is subject to the discretion of the board of directors of the Bank and will depend upon
such factors as future earnings, financial condition, cash needs, capital adequacy, compliance with applicable statutory and regulatory requirements and general business conditions.

The ability of the Bank to pay dividends is restricted under applicable law and regulations. Under Virginia banking law, dividends must be paid out of
retained earnings and no cash dividends may be paid if the Banks surplus is less than 50% of its paid-in capital. Also, under federal banking law, no cash dividend may be paid if the Bank is undercapitalized or insolvent or if payment of the
cash dividend would render the Bank undercapitalized or insolvent, and no cash dividend may be paid by the Bank if it is in default of any deposit insurance assessment due to the FDIC.

Capital Adequacy. The capital adequacy regulations which apply to state banks, such as the Bank, are similar to the Federal Reserve requirements
promulgated with respect to bank holding companies discussed above.

Enforcement Authority. The federal banking laws also contain
civil and criminal penalties available for use by the appropriate regulatory agency against certain institution-affiliated parties, primarily including management, employees and agents of a financial institution, as well as independent
contractors such as attorneys and accountants and others who participate in the conduct of the financial institutions affairs and who caused or are likely to cause more than minimum financial loss to or a significant adverse effect on the
institution, in each case who knowingly or recklessly violate a law or regulation, breach a fiduciary duty or engage in unsafe or unsound practices. These practices can include the failure of an institution to timely file required reports or the
submission of inaccurate reports. These laws authorize the appropriate banking agency to issue cease and desist orders that may, among other things, require affirmative action to correct any harm resulting from a violation or practice, including
restitution, reimbursement, indemnification or guarantees against loss. A financial institution may also be ordered to restrict its growth, dispose of certain assets or take other action as determined by the primary federal banking agency to be
appropriate. The Bank is current in its quarterly filings with the Federal Reserve.

Prompt Corrective Action. Banks are subject to
restrictions on their activities depending on their level of capital. Federal prompt corrective action regulations divide banks into five different categories, depending on their level of capital:



| |  |  | A bank is deemed to be well-capitalized if it has a total risk-based capital ratio of 10% or more, a core capital ratio of 6% or more and a leverage ratio of five
percent or more, and if the bank is not subject to an order or capital directive to meet and maintain a certain capital level.
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| |  |  | A bank is deemed to be adequately capitalized if it has a total risk-based capital ratio of 8% or more, a core capital ratio of 4% or more and a leverage ratio of 4% or
more (unless it receives the highest composite rating at its most recent examination and is not experiencing or anticipating significant growth, in which instance it must maintain a leverage ratio of 3% or more).
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | A bank is deemed to be undercapitalized if it has a total risk-based capital ratio of less than 8%, a core capital ratio of less than 4% or a leverage ratio of less than
3%.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | A bank is deemed to be significantly undercapitalized if it has a risk-based capital ratio of less than 6%, a core capital ratio of less than 3% and a leverage ratio of
less than 3%.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | A bank is deemed to be critically undercapitalized if it has a leverage ratio of less than or equal to 2%. In addition, the applicable federal banking agency has the
ability to downgrade a banks classification (but not to critically undercapitalized) based on other considerations even if the bank meets the otherwise applicable capital guidelines.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

If a state member bank, such as the Bank, is classified as undercapitalized, the bank is required to submit a capital restoration plan to the
Federal Reserve. An undercapitalized bank is prohibited from increasing its assets, engaging in a new line of business, acquiring any interest in any company or insured depository institution, or opening or acquiring a new branch office, except
under certain circumstances, including the acceptance by the Federal Reserve of a capital restoration plan for that bank. In addition, if a state member bank is classified as undercapitalized, the Federal Reserve may take certain actions to correct
the capital position of the bank.

If a state member bank is classified as significantly undercapitalized, the Federal Reserve
would be required to take one or more prompt corrective actions. These actions would include, among other things, requiring sales of new securities to bolster capital, changes in management, limits on interest rates paid, prohibitions on
transactions with affiliates, termination of certain risky activities and restrictions on compensation paid to executive officers. Moreover, if a bank is classified as critically undercapitalized, the bank must be placed into
conservatorship or receivership within 90 days, unless the FDIC determines otherwise.

The capital classification of a bank affects
the frequency of examinations of the bank and impacts the ability of the bank to engage in certain activities and affects the deposit insurance premiums paid by the bank.

Banks also may be restricted in their ability to accept brokered deposits, depending on their capital classification. Well-capitalized banks are permitted to accept brokered deposits, but all banks that
are not well-capitalized are not permitted to accept such deposits. The Federal Reserve may, on a case-by-case basis, permit member banks that are adequately capitalized to accept brokered deposits if the Federal Reserve determines that acceptance
of such deposits would not constitute an unsafe or unsound banking practice with respect to the bank. At December 31, 2005, the Bank was classified as well-capitalized.

Deposit Insurance.The Banks deposits are insured up to $100,000 per insured account by the Bank Insurance Fund of the FDIC. The FDIC
assesses insurance premiums on a banks deposits at a variable rate depending on the probability that the deposit insurance fund will incur a loss with respect to the bank. The FDIC determines the deposit insurance assessment rates on the basis
of the banks capital classification and supervisory evaluations. Each of these categories has three subcategories, resulting in nine assessment risk classifications. The three subcategories with respect to capital are
well-capitalized, adequately capitalized and less than adequately capitalized (that would include undercapitalized, significantly undercapitalized and critically
undercapitalized banks). The three subcategories with respect to supervisory concerns are healthy, supervisory concern and substantial supervisory concern. A bank is deemed healthy if it is
financially sound with only a few minor weaknesses. A bank is deemed subject to supervisory concern if it has weaknesses that, if not corrected, could result in significant deterioration of the bank and increased risk to the Bank
Insurance Fund of the FDIC. A bank is deemed subject to substantial supervisory concern if it poses a substantial probability of loss to the Bank Insurance Fund. The Banks deposit insurance assessments may increase depending upon
the risk category and subcategory, if any, to which the Bank is assigned. Any increase in insurance assessments could have an adverse effect on the Banks earnings.

ITEM 1A. RISK FACTORS

Our business, operations and financial condition are subject to various risks. In
addition to the other information contained in this Form 10-KSB, you should carefully consider the risks, uncertainties and other factors described below because they could materially and adversely affect our business, financial condition,
operating results, cash flow and prospects, and/or the market price of our common stock. This section does not describe all risks that may be applicable to us, our business or our industry, and is included solely as a summary of certain material
risk factors.



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| |  |  | We have identified material weaknesses and significant deficiencies in our internal control over financial reporting.Our management has identified numerous material
weaknesses in our internal control over financial reporting and concluded that our internal controls over financial reporting were not effective as of December 31, 2005. (Additional information on these issues, and our ongoing efforts to
improve internal controls, is included in Item 8A, Controls and Procedures, found later in this report and in our annual report on Form 10-KSB for the year ended December 31, 2004, filed on June 9, 2006.)
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | No system of internal control can be relied upon to discover or prevent all discrepancies. However, our risk is significantly greater because material weaknesses and significant
deficiencies existed in our internal controls in prior periods. We can give you no assurance that we have discovered all material errors in our financial reporting.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Although we believe that our efforts to date have strengthened some of our internal controls and addressed some of the concerns that gave rise to the material weakness, we have much
work ahead of us to bring our internal controls over financial reporting to a satisfactory level. While we believe that our efforts to improve internal controls will be successful and that we will be able to maintain adequate controls over our
financial processes and reporting in the future, we cannot be certain of the outcome of our efforts or when we will be able to achieve our goal. Any failure to implement or maintain effective internal controls could harm our operating results, cause
us to fail to meet our reporting obligations in a timely manner, and/or permit material errors in our financial reporting.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Any of the matters described above could cause a decline in the value of our shares or cause trading in our stock to be restricted.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our need to comply with extensive and complex government regulation could have an adverse effect on our business. The banking industry is subject to extensive regulation by
state and federal authorities to protect depositors, the public or the insurance funds maintained by the FDIC. Banking regulations affect our lending practices, capital structure, investment practices, dividend policy and many other aspects of our
business. These requirements may constrain our rate of growth and changes in regulations could adversely affect us. The burden imposed by these federal and state regulations may place banks, including the Bank, at a competitive disadvantage compared
to less regulated competitors. In addition, the cost of compliance with regulatory requirements could adversely affect our ability to operate profitably. See Item 1, Description of Business  Supervision and Regulation above,
for more information about applicable banking laws and regulations. In addition, because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal regulation of
financial institutions may change in the future nor the impact those changes may have on our operations. Although Congress in recent years has sought to reduce the regulatory burden on financial institutions in certain respects, we fully expect that
the financial institution industry will remain heavily regulated in the near future and that additional laws or regulations may be adopted further regulating specific banking practices.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We rely heavily on our management team and on our ability to attract and retain key personnel.We are a customer-focused and relationship-driven organization. We expect our
future growth to be driven in a large part by the relationships maintained with our customers by our Chief Executive Officer, and our other executive and senior lending officers. We also rely heavily on our management team to maintain and improve
our internal controls, accounting and reporting systems. We need to increase the depth of our management team in order to meet our existing challenges, and to meet our growth and profitability objectives. We have entered into employment agreements
with our Chief Executive Officer and certain other key executives. The existence of such agreements, however, does not necessarily ensure that we will be able to continue to retain their services. The failure to expand our management team or the
loss of our Chief Executive Officer, Chief Financial Officer or other key employees for any reason could have a material adverse effect on our business and possibly result in reduced revenues and earnings.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We depend on the profitability of the Bank. We are a single bank holding company and our business is owning all of the outstanding stock of the Bank. As a result, our
operating results and financial position depend on the operating results and financial position of the Bank. Many factors could adversely affect our short and long term operating performance, including those described below.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We may incur losses if we are unable to successfully manage interest rate risk.Our profitability will depend in substantial part upon the spread between the interest rates
earned on investments and loans and interest rates paid on
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

deposits and other interest-bearing liabilities. We occasionally engage in marketing and promotions that
offer above-market rates to attract deposits. Changes in interest rates will affect our operating performance and financial condition in diverse ways, including the pricing of loans and deposits, the volume of loan originations in our mortgage
banking business and the value we can recognize on the sale of mortgage loans in the secondary market. We attempt to minimize our exposure to interest rate risk, but we will be unable to eliminate it. Our net interest spread will depend on many
factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and economic conditions generally.



| |  |  | We may be adversely affected by economic conditions in our market area.We are headquartered in Norfolk, Virginia, and our market includes the greater Hampton Roads
metropolitan area. Because our lending is concentrated in this market, we will be affected by the general economic conditions in the greater southeast Virginia area. Changes in the economy may influence the growth rate of our loans and deposits, and
the quality of our loan portfolio and loan and deposit pricing. A significant decline in general economic conditions caused by inflation, recession, unemployment or other factors beyond our control would impact these local economic conditions and
the demand for banking products and services generally, which could negatively affect our financial condition and performance.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our loans secured by real estate may increase our credit losses, which would adversely affect our financial results.We offer a variety of secured loans, including commercial
lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Many of our loans are secured by real estate (both residential and commercial) in our market area. A major downturn in the real estate market
could adversely affect the value of our collateral for real estate loans and our customers ability to pay these loans, which in turn could impact us. Risk of loan defaults and foreclosures are unavoidable in the banking industry, and we try to
limit our exposure to this risk by monitoring our extensions of credit carefully. We cannot fully eliminate credit risk, however, and as a result credit losses may occur in the future.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | If our allowance for loan losses becomes inadequate, our results of operations may be adversely affected.We maintain an allowance for loan losses that we believe is a
reasonable estimate of known and inherent losses in our loan portfolio. Through a periodic review and consideration of the loan portfolio, management determines the amount of the allowance for loan losses by considering general market conditions,
credit quality of the loan portfolio, the collateral supporting the loans and performance of our customers relative to their financial obligations with us. The amount of future losses is susceptible to changes in economic, operating and other
conditions, including changes in interest rates, that may be beyond our control, and these losses may exceed our current estimates. Although we believe our allowance for loan losses is a reasonable estimate of known and inherent losses in our loan
portfolio, we cannot fully predict such losses or that our loan loss allowance will be adequate in the future. Excessive loan losses could have a material impact on our financial performance. Federal and state regulators periodically review our
allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in the amount of our loan loss provision or loans
charged-off as required by these regulatory agencies could have a negative effect on our operating results.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We may suffer losses in the Banks loan portfolio despite its underwriting practices.We seek to mitigate the risks inherent in our loan portfolio by adhering to
specific underwriting practices. These practices include analysis of a borrowers prior credit history, financial statements, tax returns and cash flow projections, valuation of collateral based on reports of independent appraisers, and
verification of liquid assets. Although we believe that our underwriting criteria are appropriate for our loans, the Bank may incur losses on loans that meet these criteria.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our future success is dependent on our ability to compete effectively in the highly competitive banking industry.We face vigorous competition from other banks and other
financial institutions, including savings and loan associations, savings banks, finance companies and credit unions, for deposits, loans and other financial services in our market area. Most of these banks and other financial institutions are
significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services. We also compete with other providers of
financial services, such as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations, which may be able to offer financing on more favorable terms than we can. Many of our non-bank
competitors are not subject to the same extensive regulations that govern us. As a result, these non-bank competitors have advantages over us in providing certain services. This competition may reduce or limit our margins and our market share and
may adversely affect our results of operations and financial condition.
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| |  |  | The costs of being a public bank holding company are proportionately higher for small companies like us. The U.S. Patriot Act, the Bank Secrecy Act and the Sarbanes-Oxley Act
of 2002 and related regulations of the Securities and Exchange Commission have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices. Many of these regulations are or will become applicable to our
company. As a result, we have experienced and expect to continue to incur increased compliance costs, including costs related to implementing and maintaining internal controls and the requirement that our auditors attest to and report on
managements assessment of our internal controls. These necessary compliance costs are proportionately higher for a company of our size and will affect our profitability more than that of some of our larger competitors.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our ability to operate profitably may be affected by our ability to implement technologies into our operations.The market for financial services, including banking services
and consumer finance services, is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, Internet-based banking and telebanking. Our ability to compete successfully in
our market may be affected by the extent to which we are able to utilize technological changes. If we are not able to implement new technologies at a cost that is reasonable and appropriate for a bank of our size, properly or timely anticipate them,
or properly train our staff to use them, our business, financial condition or operating results could be adversely affected.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | There is a limited trading market for our common stock; it may be difficult to sell our shares after you have purchased them.The trading in the shares of our common stock
has historically been limited. On July 7, 2005, our common stock was removed from quotation on the Over the Counter Bulletin Board (OTCBB) as a result of our failure to remain current in our reporting requirements under
Section 13 of the Securities Act of 1934, as amended. Since that time, our shares have been quoted only on the Pink Sheets over-the-counter market, which is less well-known than the OTCBB and may have caused trading in our shares to be even
more limited. Once we are current in our reporting requirements, we intend to seek to have our shares quoted once again on the OTCBB. Even in that event, trading on the OTCBB is more limited than on the national exchanges such as the New York Stock
Exchange or NASDAQ, so there will continue to be a limited trading market for our stock. Even if a more active market for our stock develops, there can be no assurance that it will continue, or that you will be able to sell your shares at the
desired price.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

ITEM 2. DESCRIPTION OF PROPERTIES

At December 31, 2005, the Bank operated from seven locations:



|                                                        |  |                                                                             |  |               |  |                           
|------------------------------------------------------- |  | --------------------------------------------------------------------------- |  | ------------- |  | --------------------------
|Office Location                                         |  | Type of Facility                                                            |  | Owned/ Leased |  | Approximate Square Footage
|                                                        |  |                                                                             | 
|200 East Plume Street, Norfolk, Virginia                |  | Retail Banking Office, Corporate
Headquarters                               |  | Owned         |  | 4,400 sq. ft.             
|                                                        |  |                                                                             | 
|841 North Military Highway, Norfolk, Virginia           |  | Retail Banking Office, Real Estate Finance,
and Mortgage Lending Department |  | Owned         |  | 6,250 sq. ft.             
|                                                        |  |                                                                             | 
|815 Colley Avenue, Norfolk, Virginia                    |  | Retail Banking Office                                                       |  | Owned         |  | 3,000 sq. ft.             
|                                                        |  |                                                                             | 
|735 East Ocean View Avenue, Norfolk, Virginia           |  | Retail Banking Office                                                       |  | Owned         |  | 3,000 sq. ft.             
|                                                        |  |                                                                             | 
|1450 South Military Highway, Chesapeake, Virginia       |  | Retail Banking Office                                                       |  | Leased        |  | 2,440 sq. ft.             
|                                                        |  |                                                                             | 
|1450 South Military Highway, Chesapeake, Virginia       |  | Operations Center                                                           |  | Leased        |  | 10,133 sq. ft.            
|                                                        |  |                                                                             | 
|3500 Virginia Beach Boulevard, Virginia Beach, Virginia |  | Retail Banking Office                                                       |  | Leased        |  | 3,800 sq. ft.             
|                                                        |  |                                                                             | 
|225 East City Hall Avenue, Norfolk, Virginia            |  | Commercial Loan Office                                                      |  | Leased        |  | 2,186 sq. ft.             



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As described above, the facility located at South Military Highway, Chesapeake, Virginia, is owned by IBV Partners, an
affiliate of the Company, which leases to the Company certain space in the facility on a month-to-month basis. The Bank consolidated the Retail Banking operations at the South Military Highway office into the North Military Highway office in May
2006.

The Virginia Beach Boulevard Retail Banking office lease expires in May 2010 with an option to renew for an additional 5-year term. The East City
Hall Avenue Commercial Loan office lease expires in March 2007 with an option to renew on a month-to-month basis for up to 6 months.

During 2005, the Bank
acquired, or entered into agreements for the purpose of acquiring, the following sites with the intention of opening future Retail Banking offices:



|                                                |  |                               
|----------------------------------------------- |  | ------------------------------
|1756 Laskin Road, Virginia Beach, Virginia      |  | Site purchased in October 2005
|                                                | 
|601 Lynnhaven Parkway, Virginia Beach, Virginia |  | Site purchased in June 2006   

In addition, in September 2005, the Bank entered into an agreement to lease, through April 2017, approximately
6,665 sq. ft. in a new facility located in downtown Norfolk, Virginia, for the purpose of opening a Retail Banking, Commercial Lending and Executive office currently planned for 2007. The Bank is also currently negotiating to lease an additional
3,464 sq. ft. in this facility. The Bank currently intends to consolidate its Plume Street and East City Hall Avenue offices and staff into this new facility upon occupancy; as a result, the Bank currently does not intend to renew its lease for the
East City Hall Avenue facility.

We believe that all of our properties are adequately covered by insurance, are in good operating condition (ordinary wear
and tear excepted) and are adequate and suitable for the ordinary and regular conduct of our business.

ITEM 3. LEGAL PROCEEDINGS

At the date of this Form 10-KSB, the Company is not a party to any legal
proceedings, the adverse outcome of which, in managements opinion, individually or in the aggregate, would have a material effect on the Companys results of operations or financial position.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of
securities holders during the fourth quarter of (or at any other time during) the fiscal year ended December 31, 2005. Due to the need to restate its financial statements for the years ended December 31, 2003 and 2002, and the delayed
filing of the 2004 annual report on Form 10-KSB, the Company deferred its 2005 annual meeting and will conduct all necessary business in conjunction with the Companys 2006 annual meeting, currently planned for late December 2006.



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Part II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Market Information

The Companys common stock is currently quoted in the Pink Sheets over-the-counter securities market under the symbol HBKS.PK. The
Companys common stock was quoted on the OTCBB through July 6, 2005. The following table sets forth the high and low closing sales price for the common stock by calendar quarters for 2005 and 2004.



|               |  |      |       |     |   |      
|-------------- |  | ---- | ----- | --- | - | -----
|               |  | HIGH |       | LOW
|2005           |  |      |       |     |   |      
|               |  |     
|Fourth Quarter |  | $    | 16.75 |     | $ | 14.40
|Third Quarter  |  |      | 18.50 |     |   | 15.45
|Second Quarter |  |      | 17.95 |     |   | 16.30
|First Quarter  |  |      | 20.16 |     |   | 16.30
|               |  |     
|2004           |  |      |       |     |   |      
|               |  |     
|Fourth Quarter |  | $    | 20.00 |     | $ | 16.60
|Third Quarter  |  |      | 17.50 |     |   | 14.50
|Second Quarter |  |      | 16.25 |     |   | 14.28
|First Quarter  |  |      | 16.50 |     |   | 15.08

At December 31, 2005, there were 926 record holders of the 1,714,668 outstanding shares of
the Companys common stock. At September 30, 2006, there were 905 record holders of the 1,927,652 outstanding shares of the Companys common stock.

In July 2005, the Company engaged Registrar and Transfer Company as the Companys transfer agent. Prior to that time, the Company acted as its own transfer agent.

On July 28, 2004, the Companys Board of Directors declared a 2-for-1 stock split, effected in the form of a stock dividend, which was
distributed on September 30, 2004 to shareholders of record on September 15, 2004. All references in this annual report on Form 10-KSB to per share results and weighted average common and common equivalent shares outstanding have been
adjusted to reflect the effects of this stock split.

There were no repurchases of the Companys common stock during the fourth
quarter of (or at any other time during) the fiscal year ended December 31, 2005.

Dividends

The Companys Board of Directors determines whether to declare dividends and the amount of such dividends. Determinations by the Board take into
account the Companys financial condition, results of operations, capital requirements, general business conditions and other relevant factors, and the Companys dividend policy may change from time to time at the discretion of the Board
of Directors depending on such factors. The Companys principal source of funds for cash dividends are the dividends paid to the Company by the Bank. The Company declared cash dividends of $0.24 and $0.22 per share, in aggregate, in 2005 and
2004, respectively. Regulatory restrictions on the payment of dividends by both the Bank to the Company and the Company to its shareholders are discussed above in Item 1, Description of Business - Supervision and Regulation, and
described in Note 17 to the Consolidated Financial Statements under Financial Statements.

Recent Sales of Unregistered Securities

Pursuant to a 2006 private placement of up to 200,000 shares of common stock, offered only to its directors and executive officers (the
Private Placement), the Company sold a total of 185,584 shares of its common stock at a price of $15.50 per share and received total proceeds of approximately $2.9 million. (The Private Placement was effected through two separate
closings, an initial closing that occurred on June 30, 2006 and a second closing that occurred on July 31, 2006. Please see the Companys current reports on Form 8-K filed on July 5, 2006 and August 1, 2006.)No fee was paid to any underwriter, placement agent or finder in connection with the Private Placement. The Private Placement was offered only to directors and executive officers of the Company, all of whom are accredited
investors under the Securities Act of 1933, as amended (the Securities Act). The Company relied on the exemption from the registration requirements of the Securities Act by virtue of Section 4(2) thereof and Rule 506 of
Regulation D promulgated



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thereunder, which exempts certain transactions by an issuer not involving any public offering. The Company did not engage
in any public advertising or general solicitation in connection with the Private Placement. The Company provided the offerees with a confidential private placement memorandum, including certain reports filed with the Securities and Exchange
Commission and other financial and business information. In addition, as noted above, all of the offerees in the Private Placement were directors and/or executive officers of the Company.

ITEM 6. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS

Managements discussion
and analysis is intended to assist readers in the understanding and evaluation of the financial condition and results of operations of Heritage Bankshares, Inc. It should be read in conjunction with the audited consolidated financial statements and
accompanying notes included in this annual report on Form 10-KSB and the supplemental financial data appearing throughout this discussion and analysis. On July 28, 2004, the Companys Board of Directors declared a 2-for-1 stock split,
to be effected in the form of a stock dividend, distributed September 30, 2004 to shareholders of record on September 15, 2004. All references in this discussion and analysis to per share results and weighted average shares outstanding
have been adjusted to reflect the effects of this stock split.

Overview

The Company, through the Bank, engages in a general community and commercial banking business, targeting the banking needs of individuals and small to
medium sized businesses in its primary service area which includes Chesapeake, Norfolk, and Virginia Beach, Virginia. The principal business of the Company is to attract deposits and to lend or invest those deposits on profitable terms. These
deposits are in varied forms of both demand and time accounts including checking accounts, interest checking, money market accounts, savings accounts, certificates of deposit, and IRA accounts.

The Company is involved in the construction and real estate lending market and actively extends both personal and commercial credit. Loans consist of
varying terms and can be secured or unsecured. Loans to individuals are for personal, household, and family purposes. Loans to businesses are for such purposes as working capital, plant expansion, and equipment purchases.

Restatement of Prior Financial Statements

On
March 28, 2005, management concluded that the Companys financial statements and data for 2004, including the quarterly reports on Form 10-QSB and the quarterly and year-end results of operations announced by press release on
January 31, 2005, should no longer be relied upon due to prior accounting errors. Management then concluded on November 3, 2005 that the Companys financial statements for the years ended December 31, 2003 and December 31,
2002, should be restated and no longer be relied upon, again as a result of previous accounting errors. Specifically, errors were identified in the Companys accounting for deferral of loan origination fees and direct loan origination costs,
its deferred compensation plan, its treatment of certain stock options, and various other matters. Accordingly, the financial statements and notes as of and for the years ended December 31, 2003 and 2002, as well as (unaudited) financial
information previously released for 2004, were restated to correct these accounting errors. (For detailed discussion on the restatement, see Item 6, Managements Discussion and Analysis of Financial Condition and Results of
Operations  Restatement of Consolidated Financial Statements, Item 8A, Controls and Procedures and Note 2 of the Notes to Consolidated Financial Statements, in the Companys annual report on Form 10-KSB
for the year ended December 31, 2004, filed on June 9, 2006.) All financial data for 2004, 2003 and 2002 contained in this annual report on Form 10-KSB reflects the restated financial statements.

Critical Accounting Policies

The preparation of the
Companys consolidated financial statements and accompanying notes are governed by accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to use judgments,
estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. While we believe our judgments, estimates and assumptions are reasonable under the
circumstances, actual results may differ materially under different conditions, or using different assumptions.

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

Allowance for Loan
Losses. The allowance for loan losses is maintained at a level which, in managements judgment, is adequate to absorb estimated credit losses on existing loans which may be uncollectible. If judgments and assumptions were to significantly
differ from those used by management to estimate the allowance, the allowance for loan losses and the provision for loan losses on the income statement could be impacted materially. In addition, the allowance for loan losses is subject to review by
various regulators who conduct examinations of the allowance for loan losses, and may require adjustments to the allowance based upon their assessment regarding its adequacy and the methodology used. (For further discussion of the allowance for loan
losses, see Lending Activities  Allowance for Loan Losses located in Managements Discussion and Analysis below.)



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Impairment of Loans. A loan is considered impaired when it is probable that the Company will be
unable to collect all interest and principal payments due according to the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loans effective interest
rate, or the fair value of the collateral if the loan is collateral dependent. A valuation allowance is maintained to the extent that the measure of the impaired loan is less than the recorded investment.

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

Deferral of Loan Fees and Origination Costs. SFAS No. 91, Accounting for
Non-Refundable Fees and Costs Associated with Originating or Acquiring Loans and Indirect Costs of Leases, generally requires that loan fees and direct loan origination costs be deferred and recognized as an adjustment to the loans
yield. While the amount of fees to be deferred is generally apparent in the origination of a loan, the Company utilizes estimates to determine the amount of deferred direct origination costs, especially payroll costs, that are attributable to the
loan origination process. Managements estimates of the amount of costs associated with successful loan origination activities are reviewed and updated annually.

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

Selected Financial Ratios

The information presented below is derived in part from the audited consolidated financial statements and notes thereto of the Company. This information
presented should be read in conjunction with the Companys consolidated financial statements appearing elsewhere in this annual report on Form 10-KSB.



|                                     |  |                                |   |  |       |   |  |       |  
|------------------------------------ |  | ------------------------------ | - |  | ----- | - |  | ----- | -
|                                     |  | FOR THE YEARS ENDEDDECEMBER 31 |  
|                                     |  | 2005                           |   |  | 2004  |   |  | 2003  |  
|Return on average assets (1)         |  | 0.44                           | % |  | 1.11  | % |  | 1.26  | %
|Return on average equity (2)         |  | 5.03                           | % |  | 11.47 | % |  | 13.33 | %
|Average equity to average assets (3) |  | 8.71                           | % |  | 9.71  | % |  | 9.49  | %
|Dividend payment ratio (4)           |  | 51.06                          | % |  | 22.22 | % |  | 8.41  | %

---

|(1) | Net income divided by average total assets.
|--- | -------------------------------------------

|(2) | Net income divided by average equity.
|--- | -------------------------------------

|(3) | Average equity divided by average total assets.
|--- | -----------------------------------------------

|(4) | Represents dividends declared per share divided by basic net income per share.
|--- | ------------------------------------------------------------------------------

Financial Condition of the Company

Total Assets. At December 31, 2005, the Companys total assets
increased by $50.9 million, or 33.1%, compared to total assets at the end of 2004. The increase in assets resulted primarily from an increase in the balance of federal funds sold, loans held for investment, and premises and equipment, offset by a
reduction in the balance of investment securities.

Investment Securities. Investment securities decreased by $5.5 million, or
35.6%, as compared to December 31, 2004, due to portfolio maturities.

Loans. Loans held for investment at December 31,
2005 were $130.4 million, which represents an increase of $6.9 million, or 5.6%, from the balance of $123.5 million at December 31, 2004.

Asset Quality. The Companys total nonperforming assets decreased to $230,400, or 0.11% of assets, at December 31, 2005, compared to $960,600, or 0.62% of assets, at December 31, 2004. The aggregate decrease of
$730,200 resulted from a $432,900 reduction in nonperforming loans and the sale of $297,300 in REO during 2005. At December 31, 2005, there was no REO, compared to $297,000 of REO at the end of 2004.



16



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##### Table of Contents

Deposits. Deposits increased by $39.7 million, or 29.8%, from $133.1 million at December 31,
2004 to $172.8 million at December 31, 2005, due to growth in noninterest bearing and money market deposits.

Borrowed Funds.
At December 31, 2005, the Companys borrowed funds consisted of advances from the FHLB of Atlanta and securities sold to customers under agreements to repurchase (repos). FHLB advances increased by $10.0 million as a result of
a five year fixed-rate loan made to the Company during 2005. The balance of customer repos increased by $2.2 million, from $2.0 million at December 31, 2004 to $4.2 million at December 31, 2005. These increases were partially offset by a
$1.7 million decrease in other short-term borrowings.

Capital. Stockholders equity increased by $425,000, or 2.7%, from $15.6
million at December 31, 2004 to $16.1 million at December 31, 2005. Stockholders equity increased primarily as a result of a $768,000 increase in the Companys comprehensive income, reduced by the payment of cash dividends of
$410,000 to stockholders.

Net Interest Income

Like most financial institutions, the primary component of earnings for the Company is net interest income. Net interest income is the difference between interest income, primarily from loan and investment securities portfolios, and
interest expense, primarily on customer deposits and borrowings. Changes in net interest income result from changes in volume, spread and margin. For purposes of determining such changes in net interest income, volume refers to the average dollar
level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income
divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as levels of noninterest-bearing liabilities. During the years ended December 31,
2005 and 2004, average interest-earning assets were $170.1 million and $137.9 million, respectively. During these same years, the Companys net interest margins were 3.70% and 3.99%, respectively.



17



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##### Table of Contents

Average Balances and Average Rates Earned and Paid. The following table sets forth, for the
periods indicated, information with regard to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest-earning assets and interest expense on interest-bearing liabilities, resultant yields or
costs, net interest income, net interest spread, net interest margin and ratio of average interest-earning assets to average interest-bearing liabilities. In preparing the table, nonaccrual loans are included in the average loan balance.



|                                                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|-------------------------------------------------------------------------------- |  | ---------------------------- | ------- | - | ---------------------------- | - | ---------- | ---------------------------- | ---- | ------------------ |  | - | -------- | - | ---------- | - | ----- | ------------------ | ---- | - | -------- | - | ---------- | - |  | - | ----- |  | ---- | -
|                                                                                 |  | YEAR ENDED DECEMBER 31, 2005 |         |   | YEAR ENDED DECEMBER 31, 2004 |   |            | YEAR ENDED DECEMBER 31, 2003 |     
|                                                                                 |  | AverageBalance (1)           |         |   | Interest                     |   | Yield/Cost |                              |      | AverageBalance (1) |  |   | Interest |   | Yield/Cost |   |       | AverageBalance (1) |      |   | Interest |   | Yield/Cost |  
|                                                                                 |  | (Dollars in Thousands)       |        
|Interest-earning assets (2)                                                      |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Loans (2) (3)                                                                    |  | $                            | 126,428 |   |                              | $ | 8,466      |                              | 6.70 | %                  |  | $ | 114,387  |   |            | $ | 7,021 |                    | 6.14 | % |          | $ | 93,792     |   |  | $ | 5,959 |  | 6.35 | %
|Investment securities-taxable                                                    |  |                              | 12,292  |   |                              |   | 362        |                              | 2.94 | %                  |  |   | 17,121   |   |            |   | 525   |                    | 3.07 | % |          |   | 16,654     |   |  |   | 636   |  | 3.82 | %
|Investment securities-non-taxable (2)                                            |  |                              | 1,114   |   |                              |   | 48         |                              | 4.30 | %                  |  |   | 1,090    |   |            |   | 47    |                    | 4.30 | % |          |   | 913        |   |  |   | 40    |  | 4.44 | %
|FHLB and Federal Reserve Stock                                                   |  |                              | 758     |   |                              |   | 33         |                              | 4.42 | %                  |  |   | 417      |   |            |   | 16    |                    | 3.77 | % |          |   | 360        |   |  |   | 16    |  | 4.48 | %
|Federal funds sold                                                               |  |                              | 29,487  |   |                              |   | 1,135      |                              | 3.87 | %                  |  |   | 4,889    |   |            |   | 50    |                    | 1.03 | % |          |   | 11,037     |   |  |   | 115   |  | 1.04 | %
|                                                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Total interest-earning assets                                                    |  |                              | 170,079 |   |                              |   | 10,044     |                              | 5.91 | %                  |  |   | 137,904  |   |            |   | 7,659 |                    | 5.55 | % |          |   | 122,756    |   |  |   | 6,766 |  | 5.51 | %
|Non-interest earning assets                                                      |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Other assets                                                                     |  |                              | 14,666  |   |                              |   |            |                              |      |                    |  |   | 11,829   |   |            |   |       |                    |      |   |          |   | 10,396     |   |  |   |       |  |      |  
|                                                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Total assets                                                                     |  | $                            | 184,745 |   |                              |   |            |                              |      |                    |  | $ | 149,733  |   |            |   |       |                    |      |   |          | $ | 133,152    |   |  |   |       |  |      |  
|                                                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Interest-bearing liabilities                                                     |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Money market, NOW accounts                                                       |  | $                            | 42,662  |   |                              | $ | 677        |                              | 1.59 | %                  |  | $ | 31,008   |   |            | $ | 146   |                    | 0.47 | % |          | $ | 22,040     |   |  | $ | 93    |  | 0.42 | %
|Savings deposits                                                                 |  |                              | 5,748   |   |                              |   | 49         |                              | .85  | %                  |  |   | 5,750    |   |            |   | 37    |                    | 0.65 | % |          |   | 5,216      |   |  |   | 42    |  | 0.81 | %
|Certificates of deposit                                                          |  |                              | 71,632  |   |                              |   | 2,518      |                              | 3.52 | %                  |  |   | 65,197   |   |            |   | 1,933 |                    | 2.96 | % |          |   | 63,097     |   |  |   | 2,041 |  | 3.23 | %
|                                                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Total deposits                                                                   |  |                              | 120,042 |   |                              |   | 3,244      |                              | 2.70 | %                  |  |   | 101,955  |   |            |   | 2,116 |                    | 2.08 | % |          |   | 90,353     |   |  |   | 2,176 |  | 2.41 | %
|                                                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Other borrowings                                                                 |  |                              | 11,926  |   |                              |   | 501        |                              | 4.20 | %                  |  |   | 4,541    |   |            |   | 36    |                    | 0.79 | % |          |   | 5,381      |   |  |   | 40    |  | 0.73 | %
|                                                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Total interest-bearing liabilities                                               |  |                              | 131,968 |   |                              |   | 3,745      |                              | 2.84 | %                  |  |   | 106,496  |   |            |   | 2,152 |                    | 2.02 | % |          |   | 95,734     |   |  |   | 2,216 |  | 2.32 | %
|                                                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Non interest-bearing liabilities                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Demand deposits                                                                  |  |                              | 35,054  |   |                              |   |            |                              |      |                    |  |   | 27,763   |   |            |   |       |                    |      |   |          |   | 23,745     |   |  |   |       |  |      |  
|Other liabilities                                                                |  |                              | 1,640   |   |                              |   |            |                              |      |                    |  |   | 941      |   |            |   |       |                    |      |   |          |   | 1,038      |   |  |   |       |  |      |  
|                                                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Total liabilities                                                                |  |                              | 168,662 |   |                              |   |            |                              |      |                    |  |   | 135,200  |   |            |   |       |                    |      |   |          |   | 120,517    |   |  |   |       |  |      |  
|                                                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Stockholders equity                                                             |  | $                            | 16,083  |   |                              |   |            |                              |      |                    |  |   | 14,533   |   |            |   |       |                    |      |   |          |   | 12,635     |   |  |   |       |  |      |  
|                                                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Total liabilities and stockholders equity                                        |  | $                            | 184,745 |   |                              |   |            |                              |      |                    |  | $ | 149,733  |   |            |   |       |                    |      |   |          | $ | 133,152    |   |  |   |       |  |      |  
|                                                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Net interest income and interest rate spread                                     |  |                              |         |   |                              | $ | 6,299      |                              | 3.07 | %                  |  |   |          |   |            | $ | 5,507 |                    | 3.53 | % |          |   |            |   |  | $ | 4,550 |  | 3.19 | %
|                                                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Net interest margin                                                              |  |                              |         |   |                              |   |            |                              | 3.70 | %                  |  |   |          |   |            |   |       |                    | 3.99 | % |          |   |            |   |  |   |       |  | 3.71 | %
|                                                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  
|Ratio of average interest-earning assets to average interest-bearing liabilities |  |                              | 128.88  | % |                              |   |            |                              |      |                    |  |   | 129.49   | % |            |   |       |                    |      |   |          |   | 128.23     | % |  |   |       |  |      |  
|                                                                                 |  |                              |         |   |                              |   |            |                              |      |                    |  |   |          |   |            |   |       |                    |      |   |          |   |            |   |  |   |       |  |      |  

---

|(1) | For the years ended December 31, 2003 and 2004, daily average balances are calculated using the daily average balances for the Bank and an average of month-end balances for the
parent only. These calculations do not necessarily include adjustments to accounts other than as of month end. For the year ended December 31, 2005, average balances are computed by averaging month-end balances. Average balances for all periods
have been adjusted by certain restatement related items.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Yields on tax-free loans and investments have not been adjusted for tax equivalency.
|--- | ------------------------------------------------------------------------------------

|(3) | For the purposes of these computations, nonaccruing loans are included in the daily average loan amounts outstanding.
|--- | ---------------------------------------------------------------------------------------------------------------------



18



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##### Table of Contents

Rate/Volume Analysis

The following table analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The table distinguishes between
(i) changes attributable to volume (changes in volume multiplied by the prior periods rate), (ii) changes attributable to rate (changes in rate multiplied by the prior periods volume), and (iii) net change (the sum of the
previous columns). The change attributable to both rate and volume (changes in rate multiplied by changes in volume) has been allocated equally to both the changes attributable to volume and the changes attributable to rate.



|                                        |  |                                                                  |       |   |                                                                  |   |       |       |  |   |        |   |  |      |       |   |       |   |      |   |  |   |       |  
|--------------------------------------- |  | ---------------------------------------------------------------- | ----- | - | ---------------------------------------------------------------- | - | ----- | ----- |  | - | ------ | - |  | ---- | ----- | - | ----- | - | ---- | - |  | - | ----- | -
|                                        |  | Year Ended December 31, 2005 vs. 2004 Increase (Decrease) Due to |       |   | Year Ended December 31, 2004 vs. 2003 Increase (Decrease) Due to |  
|                                        |  | Volume                                                           |       |   | Rate                                                             |   |       | Total |  |   | Volume |   |  | Rate |       |   | Total |  
|                                        |  | (Dollars in Thousands)                                           |      
|Interest income                         |  |                                                                  |       |   |                                                                  |   |       |       |  |   |        |   |  |      |       |   |       |   |      |   |  |   |       |  
|Loans                                   |  | $                                                                | 775   |   |                                                                  | $ | 670   |       |  | $ | 1,445  |   |  | $    | 1,270 |   |       | $ | (209 | ) |  | $ | 1,061 |  
|Investment securities taxable           |  |                                                                  | (143  | ) |                                                                  |   | (21   | )     |  |   | (164   | ) |  |      | 17    |   |       |   | (128 | ) |  |   | (111  | )
|Investment securities non-taxable       |  |                                                                  | 1     |   |                                                                  |   |      |       |  |   | 1      |   |  |      | 8     |   |       |   | (1   | ) |  |   | 7     |  
|FHLB & FRB stock                        |  |                                                                  | 15    |   |                                                                  |   | 3     |       |  |   | 18     |   |  |      | 2     |   |       |   | (3   | ) |  |   | (1    | )
|Fed funds sold                          |  |                                                                  | 702   |   |                                                                  |   | 383   |       |  |   | 1,085  |   |  |      | (64   | ) |       |   | 1    |   |  |   | (63   | )
|                                        |  |                                                                  |       |   |                                                                  |   |       |       |  |   |        |   |  |      |       |   |       |   |      |   |  |   |       |  
|Total interest income                   |  |                                                                  | 1,350 |   |                                                                  |   | 1,035 |       |  |   | 2,385  |   |  |      | 1,233 |   |       |   | (340 | ) |  |   | 893   |  
|                                        |  |                                                                  |       |   |                                                                  |   |       |       |  |   |        |   |  |      |       |   |       |   |      |   |  |   |       |  
|Interest expense                        |  |                                                                  |       |   |                                                                  |   |       |       |  |   |        |   |  |      |       |   |       |   |      |   |  |   |       |  
|Deposits:                               |  |                                                                  |       |   |                                                                  |   |       |       |  |   |        |   |  |      |       |   |       |   |      |   |  |   |       |  
|Money Market/NOW accounts               |  |                                                                  | 72    |   |                                                                  |   | 459   |       |  |   | 531    |   |  |      | 41    |   |       |   | 11   |   |  |   | 52    |  
|Savings deposits                        |  |                                                                  |      |   |                                                                  |   | 12    |       |  |   | 12     |   |  |      | 4     |   |       |   | (9   | ) |  |   | (5    | )
|Certificates of deposit                 |  |                                                                  | 203   |   |                                                                  |   | 382   |       |  |   | 585    |   |  |      | 66    |   |       |   | (174 | ) |  |   | (108  | )
|Borrowings                              |  |                                                                  | 367   |   |                                                                  |   | 98    |       |  |   | 465    |   |  |      | (5    | ) |       |   | 2    |   |  |   | (3    | )
|                                        |  |                                                                  |       |   |                                                                  |   |       |       |  |   |        |   |  |      |       |   |       |   |      |   |  |   |       |  
|Total interest expense                  |  |                                                                  | 642   |   |                                                                  |   | 951   |       |  |   | 1,593  |   |  |      | 106   |   |       |   | (170 | ) |  |   | (64   | )
|                                        |  |                                                                  |       |   |                                                                  |   |       |       |  |   |        |   |  |      |       |   |       |   |      |   |  |   |       |  
|Net interest income Increase (decrease) |  | $                                                                | 708   |   |                                                                  | $ | 84    |       |  | $ | 792    |   |  | $    | 1,127 |   |       | $ | (170 | ) |  | $ | 957   |  
|                                        |  |                                                                  |       |   |                                                                  |   |       |       |  |   |        |   |  |      |       |   |       |   |      |   |  |   |       |  

Comparison of Operating Results for the Years Ended December 31, 2005 and 2004

Overview. The Companys pre-tax income was $1.2 million for the year ended December 31, 2005 compared to $2.3 million in 2004, a decrease
of $1.1 million. During 2005, net interest income increased by $792,000, the provision for loan losses decreased by $420,000, other noninterest income increased by $262,000, and other noninterest expenses increased by $2.6 million. Net income, after
tax, in 2005 was $809,000, a decrease of $858,000 from $1.7 million in 2004. Diluted earnings per share decreased by $0.50, from $0.96 per share in 2004 to $0.46 per share in 2005.

Net Interest Income. The Companys net interest income before provision for loan losses increased by $792,000 in 2005. This increase resulted
from a $2.4 million increase in interest income offset by a $1.6 million increase in interest expense, as compared to 2004.

Interest on
loans increased by $1.4 million, or 20.6%, from $7.0 million in 2004 to $8.4 million in 2005. This increase was attributable to a $12.0 million increase in the average balance of loans, and an increase in the yield on the Companys loan
portfolio from 6.14% in 2004 to 6.70% in 2005.

Interest on investment securities decreased by $163,000 in 2005 compared to 2004. This
decrease resulted primarily from a decrease in the average balance of the portfolio from $18.2 million in 2004 to $13.4 million in 2005. Interest on federal funds sold increased by $1.1 million, due to the average balance increasing from $4.9
million in 2004 to $29.5 million in 2005 and an increase in the average rate from 1.03% in 2004 to 3.87% in 2005. The growth in the balance of federal funds sold was primarily related to a $18.1 million growth in the average balance of deposits and
a $7.4 million increase in the average balances of borrowings from December 31, 2004 to December 31, 2005. During a rising interest rate environment with a flat yield curve, management elected to invest in federal funds sold until more
attractive investment or lending opportunities arose.



19



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##### Table of Contents

The Companys interest expense increased by $1.6 million compared to 2004, as a result of an
increase in interest paid on both deposits and borrowings. Interest paid on deposits increased by $1.1 million, resulting from an increase in the average balance of interest-bearing deposits from $102.0 million in 2004 to $120.0 million in 2005 and
from an increase in the average cost of interest-bearing deposits from 2.08% in 2004 to 2.70% in 2005. Interest paid on borrowed funds increased by $465,000, from $36,000 in 2004 to $501,000 in 2005, primarily as a result of the Company borrowing
$10.0 million in 2005 from the FHLB of Atlanta at a fixed rate of 4.54% with a maturity in 2010.

The Companys net interest margin
decreased from 3.99% for the year ended December 31, 2004 to 3.70% for the year ended December 31, 2005. The interest rate spread decreased from 3.53% to 3.07% for the same periods. The decrease in the Companys interest rate spread
occurred because the cost of its interest-bearing liabilities increased 82 basis points, from 2.02% in 2004 to 2.84% in 2005, which more than offset the 36 basis point increase in yield on interest-earning assets, which increased from 5.55% in 2004
to 5.91% in 2005.

Provision for Loan Losses. The Companys provision for loan losses decreased by $420,000, from $453,000 in
2004 to $33,000 in 2005. This decrease in the provision for loan losses resulted primarily from the nonrecurrence in 2005 of a $353,000 impairment provision in 2004 related to a lending relationship with one borrower.

Other Noninterest Income. Total other income in 2005 was $1.7 million, an increase of $262,000 over 2004:



| |  |  | Gains on the sale of real estate owned (REO) were $427,000 in 2005 compared to no gains or losses on the sale of REO in 2004. At December 31, 2004, the Company
reclassified as REO four properties that had been previously and improperly classified as investment property. All of the properties were sold during the first three quarters of 2005.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Service charges on deposit accounts increased by $95,000, from $300,000 in 2004 to $395,000 in 2005, due to an increase in transaction accounts as well as a more systematic
application of appropriate account fees.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Late charges and other loan fees increased by $98,000, from $90,000 in 2004 to $188,000 in 2005, primarily due to an increase in prepayment penalties collected on loans paid before
maturity.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | These increases in noninterest income were offset by the nonrecurrence in 2005 of $373,000 in bank-owned life insurance income, a significant item of non-recurring noninterest
income recorded in 2004.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Other Noninterest Expense. Total other expenses increased by $2.6 million, from $4.2 million
in 2004 to $6.8 million in 2005:



| |  |  | Compensation increased by $938,000, from $2.2 million in 2004 to $3.2 million in 2005, related primarily to a $1.3 million increase in salary and various benefit costs, partially
offset by a $286,000 decrease in deferred compensation expense. The Companys number of full-time equivalent employees increased from 51 at December 31, 2004 to 82 at December 31, 2005. In addition to opening a new retail banking
office in Virginia Beach, the Bank has also recruited a number of additional lending, retail banking, accounting and administrative personnel intended to provide a foundation for future growth of the Bank. The decrease in deferred compensation
expense resulted from the nonrecurrence in 2005 of expenses incurred in 2004 to adjust the liability in connection with the death of a plan participant in 2004, and to also adjust the deferred compensation liability, at December 31, 2004, to
reflect a change in estimates to the discount rates used to calculate that liability.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Professional fees increased by $428,000, from $106,000 in 2004 to $534,000 in 2005, primarily as a result of an $81,000 increase in accounting and audit fees, and a $333,000
increase in legal fees due to various corporate legal matters, including expense associated with the restatement of the Companys financial statements for prior periods, updating the Companys stock option plan, and branch development.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Contract employee services increased by $283,000, from $10,000 in 2004 to $293,000 in 2005, primarily related to $277,000 in expenses for consultants and contract accounting staff
utilized in the Companys restatement process.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Marketing expenses increased by $248,000, from $49,000 in 2004 to $297,000 in 2005, as a result of approximately $38,000 in expenses associated with the Banks name and logo
change, a $101,000 increase in advertising and other general marketing expense, and a related $109,000 expense for advisory board incentive campaigns initiated in 2005. The Bank formed Advisory Boards in 2005 and has implemented an Advisory Board
Incentive Campaign through a model developed by the Banks staff.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

| |  |  | The Companys expenditures for furniture and fixtures increased by $241,000, from $211,000 in 2004 to $452,000 in 2005, due to the impact of the Banks infrastructure and
expansion initiatives. From 2004 to 2005, expenses increased related to service contracts, software maintenance, general office equipment and supplies, and depreciation on furniture, equipment and software.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The Bank also incurred a $124,700 impairment charge related to its investment in Bankers Investment Group, LLC, a retail stock brokerage firm sponsored by the Virginia Bankers
Association.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Occupancy, stationery and supplies, and data processing expense increased by $94,000, $73,000 and $53,000, respectively, from 2004 to 2005, due to the Banks expansion.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Income Taxes. The Companys income tax expense for the year ended December 31, 2005 was $373,000 compared
to $610,000 for 2004, which represented effective tax rates of 31.5% and 26.8%, respectively. The primary reason for the increased effective tax rate in 2005 was related to the non-taxable life insurance proceeds recorded in 2004.



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##### Table of Contents

The following tables set forth, for the periods indicated, components of noninterest income and
noninterest expense:



|                                           |  |                         |           |      |   |          
|------------------------------------------ |  | ----------------------- | --------- | ---- | - | ---------
|                                           |  | Years Ended December 31
|                                           |  | 2005                    |           | 2004
|Noninterest income                         |  |                         |           |      |   |          
|Service charges on deposit accounts        |  | $                       | 395,520   |      | $ | 300,478  
|Gains on sale of other real estate owned   |  |                         | 427,066   |      |   |         
|Gains on sale of loans, net                |  |                         | 260,353   |      |   | 234,093  
|Income from bank-owned life insurance, net |  |                         | 20,356    |      |   | 393,421  
|Late charges and other fees on loans       |  |                         | 187,687   |      |   | 89,890   
|Consumer credit card fees                  |  |                         | 80,603    |      |   | 79,878   
|ATM fees                                   |  |                         | 85,932    |      |   | 76,282   
|Merchant discount fees                     |  |                         | 51,624    |      |   | 49,820   
|Other                                      |  |                         | 149,970   |      |   | 173,087  
|                                           |  |                         |           |      |   |          
|Total noninterest income                   |  | $                       | 1,659,111 |      | $ | 1,396,949
|                                           |  |                         |           |      |   |          
|                                           | 
|                                           |  | Years Ended December 31
|                                           |  | 2005                    |           | 2004
|Noninterest expense                        |  |                         |           |      |   |          
|Compensation                               |  | $                       | 3,159,118 |      | $ | 2,221,244
|Data Processing                            |  |                         | 366,161   |      |   | 312,970  
|Occupancy expenses                         |  |                         | 371,721   |      |   | 278,070  
|Furniture and equipment expense            |  |                         | 452,141   |      |   | 211,138  
|Contract employee services                 |  |                         | 292,577   |      |   | 9,637    
|Taxes and licenses                         |  |                         | 152,551   |      |   | 123,046  
|Professional fees                          |  |                         | 534,195   |      |   | 105,531  
|ATM transaction expense                    |  |                         | 103,240   |      |   | 76,211   
|Credit card expense                        |  |                         | 81,989    |      |   | 72,371   
|Stationery and supplies                    |  |                         | 144,671   |      |   | 72,043   
|Telephone expense                          |  |                         | 67,043    |      |   | 63,970   
|Postage                                    |  |                         | 55,544    |      |   | 59,163   
|Courier                                    |  |                         | 59,563    |      |   | 52,515   
|Marketing expense                          |  |                         | 297,260   |      |   | 49,419   
|Service bureau expense                     |  |                         | 60,017    |      |   | 49,530   
|Insurance expense                          |  |                         | 54,234    |      |   | 39,266   
|Travel                                     |  |                         | 47,977    |      |   | 33,836   
|Shareholder expense                        |  |                         | 35,092    |      |   | 30,292   
|Training expense                           |  |                         | 46,237    |      |   | 27,821   
|Loan servicing expense                     |  |                         | 61,305    |      |   | 27,011   
|FDIC insurance                             |  |                         | 18,238    |      |   | 18,159   
|Impairment  Bankers Investment            |  |                         | 124,685   |      |   |         
|Other miscellaneous                        |  |                         | 157,758   |      |   | 240,687  
|                                           |  |                         |           |      |   |          
|Total noninterest expense                  |  | $                       | 6,743,317 |      | $ | 4,173,930
|                                           |  |                         |           |      |   |          



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##### Table of Contents

Other Matters

Pursuant to a 2006 private placement of up to 200,000 shares of common stock, offered only to its directors and executive officers (the Private Placement), the Company sold a total of 185,584 shares of its common stock at a
price of $15.50 per share and received total proceeds of approximately $2.9 million. (The Private Placement was effected through two separate closings, an initial closing that occurred on June 30, 2006 and a second closing that occurred on
July 31, 2006. Please see the Companys current reports on Form 8-K filed on July 5, 2006 and August 1, 2006.) See Part II, Item 5, Recent Sale of Unregistered Securities for further detail.

On September 28, 2006, the Company entered into a Loan Agreement (the Loan Agreement) with Cardinal Bank (Cardinal).
Pursuant to the Loan Agreement and a Promissory Note dated September 28, 2006 made by the Company to Cardinal (the Note), Cardinal agreed to loan to the Company a total of Five Million Dollars ($5,000,000) (the Loan).
(The Loan was funded in its entirety on September 29, 2006.) The Loan bears interest at an annual rate equal to the 30-day LIBOR rate plus 2.4%, with interest paid on a monthly basis and, if not sooner paid, the Loan is payable in full on
September 30, 2011. The Loan is not guaranteed by any third party and is not secured. The Company contributed the proceeds of the Loan to the Banks capital. The Loan Agreement requires the Company to comply with a regulatory
leverage capital ratio and a non-performing assets ratio. The Loan Agreement contains other affirmative covenants, including reporting requirements, covenants regarding conduct of business, payment of obligations (including taxes),
inspection rights, compliance with laws and the obligation to maintain a meaningful deposit relationship with Cardinal. The events of default under the Loan Agreement (and the Note) include payment defaults, misrepresentations, breaches of
covenants, bankruptcy events, judgments and changes of control. See the Form 8-K filed by the Company on October 3, 2006 for further detail.

The Company also plans in the future to consider raising additional capital through the issuance of both common stock and preferred trust securities.

Effective January 1, 2006, the Company adopted SFAS No. 123(R), Accounting for Stock-Based Compensation (SFAS 123(R)). SFAS 123(R) requires that the fair value of equity instruments, such
as stock options, be recognized as an expense in the financial statements as services are performed. Accordingly, subsequent to January 1, 2006, any grants of stock options by the Company will result in a charge to earnings on the later of
(1) the grant date, or (2) upon shareholder approval of any proposed incentive plan related to the grants. The effect of results on operations will depend on the number of options granted, the calculation of the fair value of the options
granted, the service period and other terms provided in the grants, and the estimate of forfeitures.

On July 26, 2006, the
Companys Board of Directors approved the Heritage 2006 Equity Incentive Plan (2006 Incentive Plan), which authorizes the grant of stock options, stock appreciation rights, restricted stock and certain other equity awards with
respect to not more than 200,000 shares of the Companys common stock. The Board of Directors also granted 70,000 stock options to Mr. Ives at an exercise price of $15.56, and a total of 24,000 stock options to certain of its nonemployee
directors at an exercise price of $18.67, pursuant to the 2006 Incentive Plan. The 2006 Incentive Plan and the outstanding option grants thereunder are subject to the approval of the shareholders of the Company within twelve (12) months after
July 26, 2006. Concurrently with its approval of the 2006 Incentive Plan, the Board of Directors terminated the Companys ability to issue new awards under the 1987 Stock Option Plan and 1999 Stock Option Plan, pending the approval by the
Companys shareholders of the 2006 Incentive Plan. On October 25, 2006, the Board of Directors increased to 250,000 the number of shares of the Companys common stock that are available under the 2006 Incentive Plan, and granted, at
an exercise price of $16.65, 74,000 additional options thereunder, all subject to shareholder approval of the plan.

As the Company is
currently reviewing option valuation methodologies, we cannot at this time predict the effect on results of operations related to the 2006 grants.

Lending Activities

Loans held for investment, net of unearned fees and costs, at December 31, 2005 were $130.4 million
compared with $123.5 million at December 31, 2004, an increase of $6.9 million or 5.6%. As a percentage of average earning assets, average loans were 74.3% at December 31, 2005, and 83.0% at December 31, 2004. Loans secured by real
estate increased by $9.3 million in 2005.

General. The Bank engages in a wide range of lending activities, which include the
origination, primarily in the Banks market area, of (1) commercial business loans, (2) commercial real estate loans, (3) construction loans, (4) land acquisition and development loans, and (5) home equity, consumer and
residential mortgage loans. At December 31, 2005, the Banks loans held for investment, net of allowance for loan losses and unearned fees/costs, in all categories totaled $130.4 million.

Commencing in early 2005, the Bank has taken a number of steps, such as the recruitment of highly knowledgeable and experienced lending officers, the
introduction of centralized loan processing, the implementation of new underwriting and documentation requirements, and the regular utilization of the loan committee process, to improve the underwriting, documentation, and administration of the
Banks loan portfolio. The discussion in this section relates to the lending practices adopted by the Bank since early 2005.



23



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##### Table of Contents

Loan Policy. The Banks Loan Policy provides general guidance on underwriting of loans, risk
management, credit approval, loan administration and problem asset management. The Policy is designed to help ensure that loan growth is accompanied by acceptable asset quality with uniform and consistently applied approval, administration, and
documentation practices and standards.

Commercial Business Lending. The Bank actively solicits commercial business loans of all
types. Commercial business loans include revolving lines of credit to provide working capital, term loans to finance the purchase of vehicles and equipment, letters of credit to guarantee payment and performance, and other loans to assist businesses
in cash management or growth opportunities.

Revolving lines of credit are typically secured by various assets of the borrower, provide for
the acceleration of repayment upon any event of default, are monitored monthly or quarterly to ensure compliance with loan covenants, when appropriate, and are re-underwritten annually before renewal. Interest rates on revolving lines of credit
generally are variable. Term loans are generally advanced for the purchase of, and are secured by, vehicles and equipment and are normally fully amortized over a term of two to five years, on either a fixed or variable rate basis. In general, these
credit facilities carry the unconditional guarantees of the owners and/or stockholders.

Commercial Real Estate Lending. The
Banks commercial real estate loans are primarily secured by the value of real property and the income arising from such property. The proceeds of commercial real estate loans are generally used by the borrower to finance or refinance the cost
of acquiring and/or improving a commercial property. The properties that typically secure these loans are office and warehouse facilities, retail facilities, and other commercial properties. In addition, the Bank will on a more limited basis make
loans secured by special purpose facilities such as hotels, mini-storage warehouses and manufacturing facilities. The Bank actively seeks to make commercial real estate loans to borrowers who will occupy or use the financed property in connection
with their normal business operations. The Bank also makes commercial real estate loans for other purposes if the borrower is in strong financial condition and presents a substantial business opportunity for the Bank or if the borrower is
creditworthy and has substantially leased or pre-leased the improvements to tenants acceptable to the Bank.

The Banks commercial
real estate loans are usually amortized over a period of time ranging from 15 years to 25 years and usually have a term to maturity ranging from five years to 15 years. These loans normally include provisions for interest rate adjustments after the
loan is three to five years old. The Banks maximum loan-to-value ratio for a commercial real estate loan is 85%; however, this maximum can be waived for particularly strong borrowers on an exception basis. Most commercial real estate loans are
further secured by one or more unconditional personal guarantees.

The Bank structures some of its commercial real estate loans as
mini-permanent loans. The amortization period, term and interest rates for these loans vary based on borrower preferences and the Banks assessment of the loan and the degree of risk involved. If the borrower prefers a fixed rate of interest,
the Bank usually offers a loan with a fixed rate of interest for a term of three to five years with an amortization period of up to 25 years and the remaining balance of the loan due and payable in a single balloon payment at the end of the initial
term. If the borrower prefers a variable or floating rate of interest, the Bank usually offers a loan with a variable interest rate tied to a readily recognizable index, such as the Banks prime rate, for a term of three to five years with an
amortization period of up to 25 years and the remaining balance of the loan due and payable in a single balloon payment at the end of the initial term.

Loans secured by commercial real estate are generally larger and involve a greater degree of risk than residential mortgage loans. Because payments on loans secured by commercial real estate are usually dependent on
successful operation or management of the properties securing such loans, repayment of such loans is subject to changes in both general and local economic conditions and the borrowers business and income. As a result, events beyond the control
of the Bank, such as a downturn in the local economy, could adversely affect the performance of the Banks commercial real estate loan portfolio. The Bank seeks to minimize these risks by lending to established customers or experienced real
estate developers and generally restricting its commercial real estate loans to its primary market area. Emphasis is placed on the income producing characteristics and repayment capacity of the collateral.

Construction Lending. The Bank has an active construction lending program. The Bank makes loans primarily for the construction of one-to-four
family residences and, to a lesser extent, multi-family dwellings. The Bank also makes construction loans for office and warehouse facilities and other nonresidential projects, generally limited to borrowers who are owner-occupants or who present
other business opportunities for the Bank.

The amounts, interest rates and terms for construction loans vary, depending upon market
conditions, the size and complexity of the project, and the financial strength of the borrower and any guarantors of the loan. The term for the Banks typical construction loan ranges from nine months to 15 months for the construction of an
individual residence and from 15 months to a maximum of three



24



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##### Table of Contents

years for larger residential or commercial projects. The Bank does not typically amortize its construction loans, and the
borrower pays interest monthly on the outstanding principal balance of the loan. The Banks construction loans generally have a floating or variable rate of interest but occasionally have a fixed interest rate. The Bank does not generally
finance the construction of commercial real estate projects built on a purely speculative basis. For residential builder loans, the Bank limits the number of models and/or speculative units allowed depending on market conditions, the builders
financial strength and track record and other factors. Generally, the maximum loan-to-value ratio for one-to-four family residential construction loans is 80% of the propertys fair market value, or 85% of the propertys fair market value
if the property will be the borrowers primary residence. The fair market value of a project is determined on the basis of an appraisal of the project usually conducted by an independent, outside appraiser acceptable to the Bank or an internal
evaluation when permitted under the Banks policies and regulatory guidelines. For larger projects, where unit absorption or leasing is a concern, the Bank may also obtain a feasibility study or other acceptable information from the borrower or
other sources about the likely disposition of the property following the completion of construction.

Construction loans for nonresidential
projects and multi-unit residential projects are generally larger and involve a greater degree of risk to the Bank than residential mortgage loans. The Bank attempts to minimize such risks (1) by making construction loans in accordance with the
Banks underwriting standards to established customers or experienced real estate developers in its primary market area and (2) by monitoring the quality, progress and cost of construction. The maximum loan-to-value ratio established by
the Bank for non-residential construction projects and multi-unit residential construction projects is 80 percent; however, this maximum can be waived for particularly strong borrowers on an exception basis.

Land Acquisition and Development Lending. Land acquisition and development loans are made to builders and developers for the purpose of acquiring
unimproved land to be developed for residential building sites, residential housing subdivisions, multi-family dwellings and a variety of commercial uses. The Bank generally does not make land acquisition and development loans for commercial
developments but does make such loans for borrowers seeking to build owner-occupied facilities on the subject land.

The Bank underwrites
and processes land acquisition and development loans in much the same manner as commercial construction loans and commercial real estate loans. For residential land acquisition and development loans, the Bank uses a lower loan-to-value ratio, which
is a maximum of 65% for unimproved land and 75% of the appraised value of the developed lots as determined in accordance with the Banks appraisal policies for developed lots for single-family or townhouse construction and discounted, when
appropriate, to reflect absorption periods in excess of one year. The Bank can waive the maximum loan-to-value ratio for particularly strong borrowers on an exception basis. The term of land acquisition and development loans ranges from a maximum of
two years for loans relating to the acquisition of unimproved land to, generally, a maximum of three years for other types of projects. All land acquisition and development loans generally are further secured by one or more unconditional personal
guarantees. Because these loans are usually larger in amount and involve more risk than individual lot loans, the Bank carefully evaluates the borrowers assumptions and projections about market conditions and absorption rates in the community
in which the property is located and the borrowers ability to carry the loan if the borrowers assumptions prove inaccurate.

Home Equity and Consumer Lending and Residential Mortgage Lending. The Bank offers its customers home equity lines of credit and home equity loans that enable customers to borrow funds secured by the equity in their homes. Home
equity lines of credit are offered with adjustable rates of interest on an open-end revolving basis. Home equity loans are offered with fixed rates for a fixed period of time, usually between five and 15 years. Home equity lines of credit and home
equity loans are secured by liens on personal residences and generally do not present as much risk to the Bank as other types of consumer loans.

The Bank offers a variety of consumer loans, including automobile loans, personal secured and unsecured loans, credit card loans, loans secured by savings accounts or certificates of deposit, and loans to purchase residential lots for the
later construction of owner-occupied residences. The shorter terms and generally higher interest rates on consumer loans help the Bank maintain a profitable spread between its average loan yield and its cost of funds. Consumer loans secured by
collateral other than a personal residence generally involve more credit risk than residential mortgage loans because of the type and nature of the collateral or, in certain cases, the absence of collateral. However, the Bank believes the higher
yields generally earned on such loans compensate for the increased credit risk associated with such loans.

The Bank originates residential
mortgage loans secured by properties located in its primary market area in Hampton Roads, Virginia. The Bank offers various types of residential mortgage loans in addition to traditional long-term, fixed-rate or adjustable rate mortgage loans. The
Bank generally underwrites loans to be retained by the Bank on terms consistent with secondary mortgage market standards. The Bank underwrites loans to be sold to secondary market investors after closing on terms specified by the investors. Most of
the Banks residential mortgage loans are sold to secondary market investors promptly after closing.



25



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##### Table of Contents

The following table sets forth, at the dates indicated, the Companys loan portfolio composition by
type of loan:



|                           |  |                |             |   |      |   |             |      |  |   |             |   |  |      |            |   |  |   |            |  
|-------------------------- |  | -------------- | ----------- | - | ---- | - | ----------- | ---- |  | - | ----------- | - |  | ---- | ---------- | - |  | - | ---------- | -
|                           |  | At December 31 |            
|                           |  | 2005           |             |   | 2004 |   |             | 2003 |  |   | 2002        |   |  | 2001 |           
|Commercial                 |  | $              | 17,927,074  |   |      | $ | 19,582,518  |      |  | $ | 19,803,180  |   |  | $    | 13,920,806 |   |  | $ | 13,767,525 |  
|Real estate - mortgage     |  |                | 98,801,013  |   |      |   | 90,513,054  |      |  |   | 71,422,680  |   |  |      | 58,077,032 |   |  |   | 53,416,568 |  
|Real estate - construction |  |                | 10,013,033  |   |      |   | 9,042,071   |      |  |   | 3,551,281   |   |  |      | 4,170,760  |   |  |   | 6,110,906  |  
|Installment and consumer   |  |                | 4,665,853   |   |      |   | 5,595,735   |      |  |   | 6,844,998   |   |  |      | 6,413,711  |   |  |   | 6,517,187  |  
|                           |  |                |             |   |      |   |             |      |  |   |             |   |  |      |            |   |  |   |            |  
|Total gross loans          |  |                | 131,406,973 |   |      |   | 124,733,378 |      |  |   | 101,622,139 |   |  |      | 82,582,309 |   |  |   | 79,812,186 |  
|                           |  |                |             |   |     
|Allowance for loan losses  |  |                | (1,335,001  | ) |      |   | (1,264,000  | )    |  |   | (1,186,854  | ) |  |      | (1,087,840 | ) |  |   | (1,085,148 | )
|Unearned loan costs (fees) |  |                | 348,354     |   |      |   | 59,245      |      |  |   | 126,825     |   |  |      | 114,436    |   |  |   | (37,792    | )
|                           |  |                |             |   |      |   |             |      |  |   |             |   |  |      |            |   |  |   |            |  
|Loans, net                 |  | $              | 130,420,326 |   |      | $ | 123,528,623 |      |  | $ | 100,562,110 |   |  | $    | 81,608,905 |   |  | $ | 78,689,246 |  
|                           |  |                |             |   |      |   |             |      |  |   |             |   |  |      |            |   |  |   |            |  

The following table presents (i) the aggregate maturities of loans in the named categories of
the Companys loan portfolio and (ii) the aggregate amounts of such loans maturing after one year by fixed and variable rates:

Loan Portfolio Composition and Maturities at December 31, 2005



|                         |  |               |            |                               |   |               |  |       |            |                                 |   |             |  |        |  
|------------------------ |  | ------------- | ---------- | ----------------------------- | - | ------------- |  | ----- | ---------- | ------------------------------- | - | ----------- |  | ------ | -
|                         |  | Within 1 Year |            | After 1 Yearbut Within 5Years |   | After 5 Years |  | Total |            | Percentageof TotalLoanPortfolio |  
|Commercial               |  | $             | 8,410,477  |                               | $ | 5,896,039     |  | $     | 3,620,559  |                                 | $ | 17,927,075  |  | 13.64  | %
|Real Estate-Mortgage     |  |               | 21,084,372 |                               |   | 15,382,047    |  |       | 62,334,593 |                                 |   | 98,801,012  |  | 75.19  | %
|Real Estate-Construction |  |               | 10,013,033 |                               |   |              |  |       |           |                                 |   | 10,013,033  |  | 7.62   | %
|Consumer                 |  |               | 1,133,947  |                               |   | 3,389,097     |  |       | 142,809    |                                 |   | 4,665,853   |  | 3.55   | %
|                         |  |               |            |                               |   |               |  |       |            |                                 |   |             |  |        |  
|                         |  | $             | 40,641,829 |                               | $ | 24,667,183    |  | $     | 66,097,961 |                                 | $ | 131,406,973 |  | 100.00 | %
|                         |  |               |            |                               |   |               |  |       |            |                                 |   |             |  |        |  



|                                                     |  |       |           
|---------------------------------------------------- |  | ----- | ----------
|Loans Maturing After 1 Year                          |  | Total
|Fixed rate loans                                     |  | $     | 24,762,181
|Variable rate loans (includes loans subject to call) |  |       | 66,002,963
|                                                     |  |       |           
|                                                     |  | $     | 90,765,144
|                                                     |  |       |           

Allowance For Loan Losses

The Company maintains the allowance for loan losses at a level which, in managements judgment, is adequate to absorb estimated credit losses on existing loans which may become uncollectible. The amount of the
allowance is affected by: (1) loan charge offs, which decrease the allowance, (2) recoveries on loans previously charged off, which increase the allowance, and (3) the provision for loan losses charged to income, which increases the
allowance.

The Company continuously reviews its loan portfolio by reviewing its credit quality through ongoing credit review processes and
constructs a comprehensive allowance analysis for its loan portfolio at least quarterly. This analysis includes two basic elements: (1) specific allowances for individual loans, and (2) general allowances for loan portfolio segments which
factor in historical loan loss experience and delinquency rates for the Company and the banking industry, as well as loan portfolio mix, growth and trends, and economic conditions.

The Bank evaluates various loans individually for impairment as required by Financial Accounting Standard (SFAS) No. 114,
Accounting by Creditors for Impairment of a Loan. Evaluations are based upon either discounted cash flows or collateral evaluations. If the evaluation shows that a loan is individually impaired, then a specific reserve is established for
the amount of the impairment.



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##### Table of Contents

For loans without individual measures of impairment, the Bank makes estimates of losses for groups of
loans as required by SFAS No. 5, Accounting for Contingencies. As part of the loan loss reserve methodology, loans are categorized into one of five major categories or segments of loans: (1) commercial and industrial loans,
(2) consumer loans, (3) 1-4 family residential real estate secured loans (including home equity loans and lines), (4) commercial real estate loans, and (5) acquisition development and/or construction loans.

These categories are further subdivided by assigned asset quality. Loss factors are calculated using the above mentioned quantitative and qualitative
data and are then applied to each of the loan segments to determine a reserve level for each of the five segments of loans. In addition, an unallocated reserve is calculated to allow for the imprecision inherent in estimating losses on the segmented
portions of the loan portfolio primarily using historical data.

The allowance for loan losses was $1.3 million, or 1.01% of total loans
held for investment, net of unearned fees and costs, at December 31, 2005. This compares to an allowance of $1.3 million, or 1.01% of such loans, at year-end 2004 as reflected in the table below.

At present, management believes that the allowance for loan losses is adequate. However, the allowance is subject to regulatory examinations and
determination as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance in comparison to peer banks identified by regulatory agencies. Such agencies may require the
Company to recognize additions to the allowance for loan losses based on their judgments about information available at the time of their examinations.

The following table sets forth, for the periods indicated, a summary of activity in the Companys allowance for loan losses:



|                                                                                                                           |  |                                      |           |    |      |   |           |      |  |   |           |    |  |      |           |   |  |   |           |  
|-------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------ | --------- | -- | ---- | - | --------- | ---- |  | - | --------- | -- |  | ---- | --------- | - |  | - | --------- | -
|                                                                                                                           |  | At or for the Year Ended December 31 |          
|                                                                                                                           |  | 2005                                 |           |    | 2004 |   |           | 2003 |  |   | 2002      |    |  | 2001 |          
|Balance at beginning of year                                                                                               |  | $                                    | 1,264,000 |    |      | $ | 1,186,854 |      |  | $ | 1,087,840 |    |  | $    | 1,085,148 |   |  | $ | 1,055,216 |  
|                                                                                                                           |  |                                      |           |    |      |   |           |      |  |   |           |    |  |      |           |   |  |   |           |  
|Charge-offs:                                                                                                               |  |                                      |           |    |      |   |           |      |  |   |           |    |  |      |           |   |  |   |           |  
|Commercial                                                                                                                 |  |                                      | 14,963    |    |      |   | 353,697   |      |  |   |          |    |  |      | 39,544    |   |  |   |          |  
|Real estate                                                                                                                |  |                                      | 4,093     |    |      |   |          |      |  |   |          |    |  |      |          |   |  |   |          |  
|Consumer                                                                                                                   |  |                                      | 31,572    |    |      |   | 32,616    |      |  |   | 32,800    |    |  |      | 59,227    |   |  |   | 45,882    |  
|                                                                                                                           |  |                                      |           |    |      |   |           |      |  |   |           |    |  |      |           |   |  |   |           |  
|Total charge-offs                                                                                                          |  |                                      | 50,628    |    |      |   | 386,313   |      |  |   | 32,800    |    |  |      | 98,771    |   |  |   | 45,882    |  
|                                                                                                                           |  |                                      |           |    |      |   |           |      |  |   |           |    |  |      |           |   |  |   |           |  
|Recoveries                                                                                                                 |  |                                      |           |    |      |   |           |      |  |   |           |    |  |      |           |   |  |   |           |  
|Commercial                                                                                                                 |  |                                      | 80,000    |    |      |   |          |      |  |   |          |    |  |      |          |   |  |   |          |  
|Real estate                                                                                                                |  |                                      |          |    |      |   |          |      |  |   | 55,855    |    |  |      |          |   |  |   | 24,746    |  
|Consumer                                                                                                                   |  |                                      | 8,619     |    |      |   | 10,459    |      |  |   | 35,959    |    |  |      | 2,463     |   |  |   | 17,568    |  
|                                                                                                                           |  |                                      |           |    |      |   |           |      |  |   |           |    |  |      |           |   |  |   |           |  
|Total recoveries                                                                                                           |  |                                      | 88,619    |    |      |   | 10,459    |      |  |   | 91,814    |    |  |      | 2,463     |   |  |   | 42,314    |  
|                                                                                                                           |  |                                      |           |    |      |   |           |      |  |   |           |    |  |      |           |   |  |   |           |  
|Net (recoveries) charge-offs                                                                                               |  |                                      | (37,991   | )  |      |   | 375,854   |      |  |   | (59,014   | )  |  |      | 96,308    |   |  |   | 3,568     |  
|                                                                                                                           |  |                                      |           |    |      |   |           |      |  |   |           |    |  |      |           |   |  |   |           |  
|Provision for loan losses                                                                                                  |  |                                      | 33,010    |    |      |   | 453,000   |      |  |   | 40,000    |    |  |      | 99,000    |   |  |   | 33,500    |  
|                                                                                                                           |  |                                      |           |    |      |   |           |      |  |   |           |    |  |      |           |   |  |   |           |  
|Balance at end of period:                                                                                                  |  | $                                    | 1,335,001 |    |      | $ | 1,264,000 |      |  | $ | 1,186,854 |    |  | $    | 1,087,840 |   |  | $ | 1,085,148 |  
|                                                                                                                           |  |                                      |           |    |      |   |           |      |  |   |           |    |  |      |           |   |  |   |           |  
|Ratio of net charge-offs to average loans outstanding                                                                      |  |                                      | (0.03     | )% |      |   | 0.33      | %    |  |   | (0.06     | )% |  |      | 0.11      | % |  |   |          | %
|                                                                                                                           |  |                                      |           |    |     
|Ratio of allowance for loan losses to outstanding loans held for investment, net of unearned fees and costs at end of year |  |                                      | 1.01      | %  |      |   | 1.01      | %    |  |   | 1.17      | %  |  |      | 1.32      | % |  |   | 1.36      | %



27



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##### Table of Contents

Breakdown of Allowance for Loan Losses by Category

The following table presents an allocation of the Companys allowance for loan losses and the percentage of loans in each category to the total
amount of loans at December 31, 2005, 2004, 2003, 2002, and 2001. The allocation presented for 2005 and 2004 reflects a revised allocation methodology recommended by new management and adopted by the Company effective for the year ended
December 31, 2004. Previous managements allocations of the allowance for loan losses for the periods ended December 31, 2003, December 31, 2002, and December 31, 2001 have not been reclassified to reflect the new
methodology.



|                           |  |                        |       |                          |        |   |        |      |                          |  |        |        |  |                          |       |  |        |   |                          |   |       |        |        |                          |  |   |       |  |        |  
|-------------------------- |  | ---------------------- | ----- | ------------------------ | ------ | - | ------ | ---- | ------------------------ |  | ------ | ------ |  | ------------------------ | ----- |  | ------ | - | ------------------------ | - | ----- | ------ | ------ | ------------------------ |  | - | ----- |  | ------ | -
|                           |  | At December 31         |      
|                           |  | 2005                   |       |                          | 2004   |   |        | 2003 |                          |  | 2002   |        |  | 2001                     |      
|                           |  | Amount                 |       | Percentof TotalLoans (1) |        |   | Amount |      | Percentof TotalLoans (1) |  |        | Amount |  | Percentof TotalLoans (1) |       |  | Amount |   | Percentof TotalLoans (1) |   |       | Amount |        | Percentof TotalLoans (1) | 
|                           |  | (Dollars in Thousands) |      
|Loan Type Allocation       |  |                        |       |                          |        |   |        |      |                          |  |        |        |  |                          |       |  |        |   |                          |   |       |        |        |                          |  |   |       |  |        |  
|Real estate  mortgage     |  | $                      | 654   |                          | 75.19  | % |        | $    | 551                      |  | 72.56  | %      |  | $                        | 415   |  | 72.70  | % |                          | $ | 76    |        | 70.35  | %                        |  | $ | 175   |  | 66.96  | %
|Real estate  construction |  |                        | 15    |                          | 7.62   | % |        |      | 4                        |  | 7.25   | %      |  |                          |      |  | 3.50   | % |                          |   |      |        | 5.05   | %                        |  |   |      |  | 7.66   | %
|Commercial                 |  |                        | 450   |                          | 13.64  | % |        |      | 450                      |  | 15.70  | %      |  |                          | 25    |  | 18.93  | % |                          |   | 319   |        | 16.83  | %                        |  |   | 143   |  | 17.20  | %
|Consumer                   |  |                        | 121   |                          | 3.55   | % |        |      | 164                      |  | 4.49   | %      |  |                          | 94    |  | 4.87   | % |                          |   | 39    |        | 7.77   | %                        |  |   | 96    |  | 8.18   | %
|                           |  |                        |       |                          |        |   |        |      |                          |  |        |        |  |                          |       |  |        |   |                          |   |       |        |        |                          |  |   |       |  |        |  
|                           |  |                        | 1,240 |                          | 100.00 | % |        |      | 1,169                    |  | 100.00 | %      |  |                          | 534   |  | 100.00 | % |                          |   | 434   |        | 100.00 | %                        |  |   | 414   |  | 100.00 | %
|                           |  |                        |       |                          |        |   |        |      |                          |  |        |        |  |                          |       |  |        |   |                          |   |       |        |        |                          |  |   |       |  |        |  
|Specific problem loans     |  |                        |      |                          |        |   |        |      |                         |  |        |        |  |                          | 50    |  |        |   |                          |   | 123   |        |        |                          |  |   | 69    |  |        |  
|Unallocated                |  |                        | 95    |                          |        |   |        |      | 95                       |  |        |        |  |                          | 603   |  |        |   |                          |   | 531   |        |        |                          |  |   | 602   |  |        |  
|                           |  |                        |       |                          |        |   |        |      |                          |  |        |        |  |                          |       |  |        |   |                          |   |       |        |        |                          |  |   |       |  |        |  
|                           |  | $                      | 1,335 |                          |        |   |        | $    | 1,264                    |  |        |        |  | $                        | 1,187 |  |        |   |                          | $ | 1,088 |        |        |                          |  | $ | 1,085 |  |        |  
|                           |  |                        |       |                          |        |   |        |      |                          |  |        |        |  |                          |       |  |        |   |                          |   |       |        |        |                          |  |   |       |  |        |  

---

|(1) | Represents total of all outstanding loans in each category as a percent of total loans outstanding.
|--- | ---------------------------------------------------------------------------------------------------

Nonperforming Assets

The Companys nonperforming assets include nonperforming loans (nonaccrual
and restructured loans) and REO. The Company does not generally accrue interest on loans that are 90 days or more past due and reverses all previously accrued, but uncollected, interest on loans that are placed in nonaccrual status (with the
exception of credit card loans on which the Company does not accrue interest over 120 days).

REO is recorded at the lower of cost or
estimated fair value as determined generally by appraisals. If the fair value of REO is less than the book value of the loan formerly secured by such REO, the fair value becomes the new cost basis of the REO, and the difference is charged against
the allowance for loan losses on the date of foreclosure or completion of the appraisal. Subsequent valuations are periodically performed and valuation allowances are established if the carrying value of the real estate exceeds estimated fair value
less estimated costs of sales. Other repossessed assets are carried at the lower of cost or estimated fair value as determined by independent surveys or appraisals at the time of repossession. If the fair value of the repossessed asset is less than
the book value of the loan formerly secured by such repossessed asset, the difference between the book value and the fair value is charged to the allowance for loan losses on the date of repossession.



28



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##### Table of Contents

The following table sets forth, for the period indicated, information with respect to the Companys
nonaccrual loans, restructured loans, total nonperforming loans (nonaccrual loans plus restructured loans), and total nonperforming assets:



|                                           |  |                |         |   |      |   |         |      |  |   |        |   |  |      |        |   |  |   |         |  
|------------------------------------------ |  | -------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------ | - |  | ---- | ------ | - |  | - | ------- | -
|                                           |  | At December 31 |        
|                                           |  | 2005           |         |   | 2004 |   |         | 2003 |  |   | 2002   |   |  | 2001 |       
|Nonaccrual loans (1)                       |  | $              | 225,934 |   |      | $ | 648,658 |      |  | $ | 10,969 |   |  | $    | 13,306 |   |  | $ | 33,463  |  
|Accruing loans past due 90 days or more    |  |                | 4,476   |   |      |   | 14,629  |      |  |   | 22,323 |   |  |      | 42,760 |   |  |   | 159,764 |  
|                                           |  |                |         |   |      |   |         |      |  |   |        |   |  |      |        |   |  |   |         |  
|Total nonperforming loans                  |  |                | 230,410 |   |      |   | 663,287 |      |  |   | 33,292 |   |  |      | 56,066 |   |  |   | 193,227 |  
|                                           |  |                |         |   |     
|Real estate owned, net                     |  |                |        |   |      |   | 297,295 |      |  |   |       |   |  |      |       |   |  |   | 433,340 |  
|                                           |  |                |         |   |      |   |         |      |  |   |        |   |  |      |        |   |  |   |         |  
|Total nonperforming assets                 |  | $              | 230,410 |   |      | $ | 960,582 |      |  | $ | 33,292 |   |  | $    | 56,066 |   |  |   | 626,567 |  
|                                           |  |                |         |   |      |   |         |      |  |   |        |   |  |      |        |   |  |   |         |  
|Total nonperforming assets to total assets |  |                | 0.11    | % |      |   | 0.62    | %    |  |   | 0.02   | % |  |      | 0.04   | % |  |   | 0.54    | %

---

|(1) | At December 31, 2005, includes $224,799 of restructured loans.
|--- | --------------------------------------------------------------

At December 31, 2005, the Company had approximately $2,500,203 in loans that are not currently classified as nonaccrual or 90 days or more past due or otherwise restructured loans, but which cause management to
have concerns as to the ability of the borrowers to comply with the present loan repayment terms. These loans may result later in being included in nonaccrual, past due or restructured loans.

Loans Held for Sale

Loans held for sale at
December 31, 2005 were $1.4 million compared to $1.5 December 31, 2004. These loans were pre-committed for sale to investors.

Investment
Securities

The Companys investment portfolio is a source of liquidity and is the second largest category of earning assets. The
portfolio includes U.S. Government and agency securities, obligations of states and political subdivisions, mortgage-backed securities, preferred trust securities, marketable equity securities, and other debt securities. In addition to the
investment securities, the Company also invests in federal funds sold. Securities available for sale were $9.3 million at December 31, 2005, compared with $14.3 million at December 31, 2004. Securities held to maturity were $681,000 at
December 31, 2005, compared to $1.2 million at December 31, 2004.



29



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##### Table of Contents

The following table summarizes the amortized cost, gross unrealized gains and losses and the estimated fair value of
securities available for sale and held to maturity:



|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|------------------------------------------------ |  | -------------- | ---------- | -------------------- | - | --------------------- |  | ---------- | ------- |  | - | ----------
|                                                 |  | Amortized Cost |            | GrossUnrealizedGains |   | GrossUnrealizedLosses |  | Fair Value
|Year ended December 31, 2005                     |  |                |            |                      |   |                       |  |            |         |  |   |           
|                                                 |  |                |            |                     
|Securities available for sale                    |  |                |            |                      |   |                       |  |            |         |  |   |           
|                                                 |  |                |            |                     
|U.S. Treasury Securities                         |  | $              | 500,084    |                      | $ |                      |  | $          | 864     |  | $ | 499,220   
|Other U.S. government agency securities          |  |                | 7,975,571  |                      |   |                      |  |            | 115,840 |  |   | 7,859,731 
|Mortgage-backed securities                       |  |                | 170,902    |                      |   | 2,073                 |  |            |        |  |   | 172,975   
|Obligations of states and political subdivisions |  |                | 634,115    |                      |   | 13,122                |  |            |        |  |   | 647,237   
|Marketable equity securities                     |  |                | 80,475     |                      |   | 22,251                |  |            | 8,580   |  |   | 94,146    
|Other convertible debt security                  |  |                | 5,000      |                      |   | 6,369                 |  |            |        |  |   | 11,369    
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Total securities available for sale              |  |                | 9,366,147  |                      |   | 43,815                |  |            | 125,284 |  |   | 9,284,678 
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Securities held to maturity                      |  |                |            |                      |   |                       |  |            |         |  |   |           
|Mortgage-backed securities                       |  |                | 11,748     |                      |   | 74                    |  |            |        |  |   | 11,822    
|Obligations of states and political subdivisions |  |                | 469,488    |                      |   | 7,546                 |  |            |        |  |   | 477,034   
|Preferred trust securities                       |  |                | 200,000    |                      |   | 12,000                |  |            |        |  |   | 212,000   
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Total securities held to maturity                |  |                | 681,236    |                      |   | 19,620                |  |            |        |  |   | 700,856   
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Total securities                                 |  | $              | 10,047,383 |                      | $ | 63,435                |  | $          | 125,284 |  | $ | 9,985,534 
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Year ended December 31, 2004                     |  |                |            |                      |   |                       |  |            |         |  |   |           
|                                                 |  |                |            |                     
|Securities available for sale                    |  |                |            |                      |   |                       |  |            |         |  |   |           
|                                                 |  |                |            |                     
|U.S. Treasury securities                         |  | $              | 501,135    |                      | $ |                      |  | $          | 5,940   |  | $ | 495,195   
|Other U. S. government agency securities         |  |                | 12,878,809 |                      |   | 14,921                |  |            | 89,858  |  |   | 12,803,872
|Mortgage-backed securities                       |  |                | 229,278    |                      |   | 8,682                 |  |            |        |  |   | 237,960   
|Obligations of states and political subdivisions |  |                | 607,968    |                      |   | 26,845                |  |            |        |  |   | 634,813   
|Marketable equity securities                     |  |                | 80,475     |                      |   | 23,569                |  |            | 3,910   |  |   | 100,134   
|Other convertible debt security                  |  |                | 5,000      |                      |   | 7,540                 |  |            |        |  |   | 12,540    
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Total securities available for sale              |  |                | 14,302,665 |                      |   | 81,557                |  |            | 99,708  |  |   | 14,284,514
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Securities held to maturity                      |  |                |            |                      |   |                       |  |            |         |  |   |           
|Mortgage backed securities                       |  |                | 16,509     |                      |   | 236                   |  |            |        |  |   | 16,745    
|Obligations of state and political subdivisions  |  |                | 469,367    |                      |   | 11,263                |  |            |        |  |   | 480,630   
|Preferred trust securities                       |  |                | 200,000    |                      |   | 40,000                |  |            |        |  |   | 240,000   
|Other corporate debt securities                  |  |                | 505,538    |                      |   | 8,107                 |  |            |        |  |   | 513,645   
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Total securities held to maturity                |  |                | 1,191,414  |                      |   | 59,606                |  |            |        |  |   | 1,251,020 
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Total securities                                 |  | $              | 15,494,079 |                      | $ | 141,163               |  | $          | 99,708  |  | $ | 15,535,534
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           



30



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##### Table of Contents

|                                                 |  |               |            |                      |   |                        |  |            |        |  |   |           
|------------------------------------------------ |  | ------------- | ---------- | -------------------- | - | ---------------------- |  | ---------- | ------ |  | - | ----------
|                                                 |  | AmortizedCost |            | GrossUnrealizedGains |   | Gross UnrealizedLosses |  | Fair Value
|Year ended December 31, 2003                     |  |               |            |                      |   |                        |  |            |        |  |   |           
|                                                 |  |               |            |                     
|Securities available for sale                    |  |               |            |                      |   |                        |  |            |        |  |   |           
|                                                 |  |               |            |                     
|U.S. Treasury securities                         |  | $             | 500,131    |                      | $ | 2,839                  |  | $          |       |  | $ | 502,970   
|Other U. S. government agency securities         |  |               | 16,926,157 |                      |   | 163,477                |  |            | 12,839 |  |   | 17,076,795
|Mortgage-backed securities                       |  |               | 358,906    |                      |   | 14,493                 |  |            |       |  |   | 373,399   
|Obligations of states and political subdivisions |  |               | 582,829    |                      |   | 26,395                 |  |            |       |  |   | 609,224   
|Marketable equity securities                     |  |               | 17,455     |                      |   | 12,506                 |  |            |       |  |   | 29,961    
|Other convertible debt security                  |  |               | 5,000      |                      |   | 4,310                  |  |            |       |  |   | 9,310     
|                                                 |  |               |            |                      |   |                        |  |            |        |  |   |           
|Total securities available for sale              |  |               | 18,390,478 |                      |   | 224,020                |  |            | 12,839 |  |   | 18,601,659
|                                                 |  |               |            |                      |   |                        |  |            |        |  |   |           
|Securities held to maturity                      |  |               |            |                      |   |                        |  |            |        |  |   |           
|Mortgage backed securities                       |  |               | 25,315     |                      |   | 370                    |  |            |       |  |   | 25,685    
|Obligations of state and political subdivisions  |  |               | 469,234    |                      |   | 13,187                 |  |            |       |  |   | 482,421   
|Preferred trust securities                       |  |               | 300,000    |                      |   | 19,000                 |  |            |       |  |   | 319,000   
|Other corporate debt securities                  |  |               | 511,598    |                      |   | 31,522                 |  |            |       |  |   | 543,120   
|                                                 |  |               |            |                      |   |                        |  |            |        |  |   |           
|Total securities held to maturity                |  |               | 1,306,147  |                      |   | 64,079                 |  |            |       |  |   | 1,370,226 
|                                                 |  |               |            |                      |   |                        |  |            |        |  |   |           
|Total securities                                 |  | $             | 19,696,625 |                      | $ | 288,099                |  | $          | 12,839 |  | $ | 19,971,885
|                                                 |  |               |            |                      |   |                        |  |            |        |  |   |           

The following table presents the contractual maturity distribution and weighted average yields,
based on amortized cost, of the Companys investment securities portfolio at December 31, 2005. Actual maturities will differ from contractual maturities because some securities may be called or prepaid prior to their contractual maturity.



|                                                 |  |                |           |       |                                 |   |                |                                   |           |  |                |                |  |       |         |  |                |   |       |   |         |                |      |       |  |   |            |  |      |  
|------------------------------------------------ |  | -------------- | --------- | ----- | ------------------------------- | - | -------------- | --------------------------------- | --------- |  | -------------- | -------------- |  | ----- | ------- |  | -------------- | - | ----- | - | ------- | -------------- | ---- | ----- |  | - | ---------- |  | ---- | -
|                                                 |  | 1 Year or Less |           |       | After 1 Year butthrough 5 Years |   |                | After 5 Years butthrough 10 Years |           |  | After 10 Years |                |  | Total |        
|                                                 |  | Amortized Cost |           | Yield |                                 |   | Amortized Cost |                                   | Yield     |  |                | Amortized Cost |  | Yield |         |  | Amortized Cost |   | Yield |   |         | Amortized Cost |      | Yield | 
|U.S. Treasury Securities                         |  | $              | 500,084   |       | 1.66                            | % |                | $                                 |          |  |               |                |  | $     |        |  |               |   |       | $ |        |                |     |       |  | $ | 500,084    |  | 1.66 | %
|Other U.S. government agency securities          |  |                | 5,429,844 |       | 2.42                            | % |                |                                   | 2,545,727 |  | 2.98           | %              |  |       |        |  |               |   |       |   |        |                |     |       |  |   | 7,975,571  |  | 2.60 | %
|Mortgage-backed securities                       |  |                |          |       |                                |   |                |                                   |          |  |               |                |  |       |        |  |               |   |       |   | 182,650 |                | 5.30 | %     |  |   | 182,650    |  | 5.30 | %
|Obligations of states and political subdivisions |  |                |          |       |                                |   |                |                                   | 194,488   |  | 5.08           | %              |  |       | 634,115 |  | 4.26           | % |       |   | 275,000 |                | 4.30 | %     |  |   | 1,103,603  |  | 4.41 | %
|Corporate debt securities                        |  |                |          |       |                                |   |                |                                   |          |  |               |                |  |       |        |  |               |   |       |   | 5,000   |                | 6.00 | %     |  |   | 5,000      |  | 6.00 | %
|Preferred trust securities                       |  |                |          |       |                                |   |                |                                   |          |  |               |                |  |       |        |  |               |   |       |   | 200,000 |                | 9.25 | %     |  |   | 200,000    |  | 9.25 | %
|Marketable equity securities                     |  |                |          |       |                                |   |                |                                   |          |  |               |                |  |       |        |  |               |   |       |   | 80,475  |                | 2.98 | %     |  |   | 80,475     |  | 2.98 | %
|                                                 |  |                |           |       |                                 |   |                |                                   |           |  |                |                |  |       |         |  |                |   |       |   |         |                |      |       |  |   |            |  |      |  
|Total                                            |  | $              | 5,929,928 |       | 2.36                            | % |                | $                                 | 2,740,215 |  | 3.13           | %              |  | $     | 634,115 |  | 4.26           | % |       | $ | 743,125 |                | 5.75 | %     |  | $ | 10,047,383 |  | 2.94 | %
|                                                 |  |                |           |       |                                 |   |                |                                   |           |  |                |                |  |       |         |  |                |   |       |   |         |                |      |       |  |   |            |  |      |  

Yields on tax exempt obligations have not been computed on a tax equivalent basis.

At December 31, 2005, there were no securities of any issuer (other than U.S. government agencies) that exceeded 10% of the Companys
stockholders equity.



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##### Table of Contents

SOURCES OF FUNDS

Deposit Activities

The Company provides a range of deposit services, including noninterest-bearing checking accounts,
interest-bearing checking and savings accounts, money market accounts and certificates of deposit. These accounts generally earn interest at rates established by management based on competitive market factors and managements desire to increase
or decrease certain types or maturities of deposits. The Company strives to establish customer relationships to attract core deposits in noninterest-bearing and other transactional accounts and thus to reduce its costs of funds.

The Banks deposit base includes large denomination certificates of deposit of $100,000 or more. These deposits represented approximately 8.9% and
19.3% of total deposits at December 31, 2005 and 2004, respectively.

The following table sets forth, for the periods indicated, the
average balance outstanding and average interest rates for each major category of deposits:



|                                                        |  |                 |             |             |      |   |                |      |             |  |      |                |  |             |             |  |      |  
|------------------------------------------------------- |  | --------------- | ----------- | ----------- | ---- | - | -------------- | ---- | ----------- |  | ---- | -------------- |  | ----------- | ----------- |  | ---- | -
|                                                        |  | At December 31  |            
|                                                        |  | 2005            |             |             | 2004 |   |                | 2003 |            
|                                                        |  | Average Balance |             | AverageRate |      |   | AverageBalance |      | AverageRate |  |      | AverageBalance |  | AverageRate |            
|Interest-bearing NOW, money market and savings accounts |  | $               | 48,410,155  |             | 1.50 | % |                | $    | 36,758,002  |  | 0.50 | %              |  | $           | 27,255,652  |  | 0.50 | %
|Time deposits                                           |  |                 | 71,631,693  |             | 3.52 | % |                |      | 65,197,372  |  | 2.96 | %              |  |             | 63,096,818  |  | 3.23 | %
|                                                        |  |                 |             |             |      |   |                |      |             |  |      |                |  |             |             |  |      |  
|Total interest-bearing deposits                         |  |                 | 120,041,848 |             | 2.70 | % |                |      | 101,955,374 |  | 2.08 | %              |  |             | 90,352,470  |  | 2.41 | %
|Demand and other noninterest-bearing deposits           |  |                 | 35,053,947  |             |     |   |                |      | 27,763,303  |  |     |                |  |             | 23,745,336  |  |     |  
|                                                        |  |                 |             |             |      |   |                |      |             |  |      |                |  |             |             |  |      |  
|Total average deposits                                  |  | $               | 155,095,795 |             | 2.09 | % |                | $    | 129,718,677 |  | 1.63 | %              |  | $           | 114,097,806 |  | 1.91 | %
|                                                        |  |                 |             |             |      |   |                |      |             |  |      |                |  |             |             |  |      |  

The following table sets forth the amounts and maturities of certificates of deposit with balances
of $100,000 or more at December 31, 2005:

Remaining maturity



|                                     |  |   |           
|------------------------------------ |  | - | ----------
|Less than three months               |  | $ | 1,599,584 
|Over three months through six months |  |   | 2,790,473 
|Over six months through one year     |  |   | 1,531,395 
|Over twelve months                   |  |   | 9,478,495 
|                                     |  |   |           
|Total                                |  | $ | 15,399,947
|                                     |  |   |           

Borrowings

As additional sources of funding, the Company utilizes unsecured credit lines from correspondent banks, advances from the Federal Home Loan Bank of Atlanta (FHLB) under a secured line of credit, and
securities sold under agreements to repurchase which are secured transactions with customers and generally mature the day following the day sold. At December 31, 2005, borrowings included $10.0 million from the FHLB at a fixed rate of 4.54%,
maturing in March 2010, and included $4.2 million in securities sold under agreements to repurchase. In October 2006, the Company repaid, without penalty, this FHLB advance to reduce the level of liquidity.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity

Liquidity refers to the availability of sufficient funds to meet the needs of depositors, borrowers, creditors,
investors and to fund operations. The Companys primary sources of funds are customer deposits, cash, investment securities available for sale, loan repayments and borrowings. These funds are used to make loans, purchase investment securities,
meet depositor withdrawals and fund operations. For the year ended December 31, 2005, cash and cash equivalents increased by $46.3 million, to $54.2 million from $7.9 million at December 31, 2004.



32



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##### Table of Contents

In 2005, operating activities of the Company provided $1.5 million of cash flows primarily reflecting
$809,000 in net income, adjustments of $1.1 million for various items such as depreciation, provision for loan losses and option exercise tax benefits, and a $425,000 increase in cash resulting from the proceeds of loans held for sale of $17.6
million, offset by cash used to originate loans held for sale of $17.1 million.

Investing activities used $5.0 million of cash flow in
2005, primarily reflecting cash used to fund an increase of $6.9 million in loans held for investment and $3.5 million used for purchases of premises and equipment. This increase in funds used was primarily offset by $5.3 million in net proceeds
received from principal repayments of securities in excess of securities purchased.

Net additional cash flows of $49.8 million were
provided by financing activities primarily attributable to a net increase in deposits of $39.7 million, an $8.3 million net increase in other borrowings and an increase of $2.2 million in securities sold under agreements to repurchase, offset by
dividend payments to stockholders of $410,000.

Liquid assets, which include cash and due from banks, fed funds sold and nonpledged
securities available for sale, totaled $54.7 million at December 31, 2005. In addition, the Banks funding sources at December 31, 2005 consisted of established borrowing capacity, subject to qualifying collateral availability, with
the FHLB of 20% of the Banks total assets, or $40.9 million, and established federal funds lines of $10.0 million with correspondent banks.

Certificates of deposit that are scheduled to mature within one year totaled $38.7 million at December 31, 2005. These deposits are generally considered to be rate sensitive. While the Companys liquidity could be impacted by a
decrease in the renewals of deposits or general deposit runoff, the Company has the ability to raise deposits by conducting deposit promotions. In the event the Company requires funds beyond its ability to generate them internally, the Company could
borrow from its established lines or obtain funds through the sale of investment securities from its available for sale portfolio.

Capital Resources

The Companys capital is reflected in its stockholders equity, which was $16.1 million, or 7.9% of assets, at
December 31, 2005 compared to $15.6 million, or 10.2% of assets, at December 31, 2004. The Company paid aggregate dividends of $0.24 per share in 2005, compared to aggregate dividends of $0.22 per share in 2004. The dividend payout ratio
was 51.1% in 2005, compared to 22.2% in 2004.

The Companys capital continues to exceed regulatory requirements for total capital to
risk weighted assets, Tier 1 capital to risk weighted assets, and Tier 1 capital to tangible assets (leverage ratio). The Companys total capital ratio was 10.88% at December 31, 2005 compared to 12.10% at December 31, 2004. The Tier
1 capital ratio was 10.05% at December 31, 2005 compared to 11.20% at December 31, 2004. The leverage ratio was 7.81% at December 31, 2005 compared to 10.20% at December 31, 2004. These ratios all are in excess of the mandated
minimum requirements.

The Company will consider additional sources of capital, through the issuance of stock, debt or otherwise, as needs
arise.



33



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##### Table of Contents

The following table presents information on the Companys and the Banks capital amounts and
ratios as of December 31, 2005 and 2004. For purposes of the risk-based capital ratios, loans held for investment have been risk-weighted 100%.



|                                         |  |        |        |       |                             |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|---------------------------------------- |  | ------ | ------ | ----- | --------------------------- | - | ------ | --------------------------------------------------------------------- | ------ |  | --- | ------ |  | ----- | ------ |  | ---- | -
|(Dollars in thousands)                   |  | Actual |        |       | For CapitalAdequacyPurposes |   |        | Minimum To Be WellCapitalized
UnderPrompt Corrective ActionProvisions |       
|                                         |  | Amount |        | Ratio |                             |   | Amount |                                                                       | Ratio  |  |     | Amount |  | Ratio |       
|At December 31, 2005                     |  |        |        |       |                             |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Total Capital (to Risk-Weighted Assets)  |  |        |        |       |                             |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 17,461 |       | 10.88                       | % |        | $                                                                     | 12,836 |  | 8.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 16,609 |       | 10.36                       | % |        | $                                                                     | 12,822 |  | 8.0 | %      |  | $     | 16,027 |  | 10.0 | %
|Tier 1 Capital (to Risk-Weighted Assets) |  |        |        |       |                             |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 16,126 |       | 10.05                       | % |        | $                                                                     | 6,418  |  | 4.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 15,274 |       | 9.53                        | % |        | $                                                                     | 6,411  |  | 4.0 | %      |  | $     | 9,616  |  | 6.0  | %
|Tier 1 Capital (to Average Assets)       |  |        |        |       |                             |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 16,126 |       | 7.81                        | % |        | $                                                                     | 8,258  |  | 4.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 15,274 |       | 7.45                        | % |        | $                                                                     | 8,205  |  | 4.0 | %      |  | $     | 10,257 |  | 5.0  | %
|                                         |  |        |        |       |                             |  
|At December 31, 2004                     |  |        |        |       |                             |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Total Capital (to Risk-Weighted Assets)  |  |        |        |       |                             |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 16,923 |       | 12.10                       | % |        | $                                                                     | 11,185 |  | 8.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 15,423 |       | 11.04                       | % |        | $                                                                     | 11,173 |  | 8.0 | %      |  | $     | 13,967 |  | 10.0 | %
|Tier 1 Capital (to Risk-Weighted Assets) |  |        |        |       |                             |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 15,659 |       | 11.20                       | % |        | $                                                                     | 5,593  |  | 4.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 14,159 |       | 10.14                       | % |        | $                                                                     | 5,587  |  | 4.0 | %      |  | $     | 8,380  |  | 6.0  | %
|Tier 1 Capital (to Average Assets)       |  |        |        |       |                             |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 15,659 |       | 10.20                       | % |        | $                                                                     | 6,144  |  | 4.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 14,159 |       | 9.29                        | % |        | $                                                                     | 6,093  |  | 4.0 | %      |  | $     | 7,617  |  | 5.0  | %

Federal and state banking regulations place certain restrictions on dividends paid and loans or
advances made by the Bank to the Company. The amount of dividends the Bank may pay to the Company, without prior approval, is limited to current year earnings plus retained net profits for the two preceding years. Loans or advances are limited to
10% of the Banks stockholders equity.

Contractual Obligations and Commitments

In the normal course of business there are various outstanding contractual obligations of the Company that will require future cash outflows. In addition,
there are commitments and contingent liabilities, such as commitments to extend credit, that may or may not require future cash outflows. The following table reflects contractual obligations of the Company outstanding as of December 31, 2005.



|                                               |  |                        |         |                           |   |           |  |           |        |                  |   |        |  |   |      
|---------------------------------------------- |  | ---------------------- | ------- | ------------------------- | - | --------- |  | --------- | ------ | ---------------- | - | ------ |  | - | -----
|                                               |  | Payments Due by Period
|Contractual Obligations                        |  | Total                  |         | On DemandOr Within 1 Year |   | 1-3 Years |  | 3-5 Years |        | More than5 Years
|                                               |  | (Dollars In Thousands)
|Securities sold under agreements to repurchase |  | $                      | 4,235   |                           | $ | 4,235     |  | $         |       |                  | $ |       |  | $ |     
|Other short-term borrowings                    |  |                        | 50      |                           |   | 50        |  |           |       |                  |   |       |  |   |     
|FHLB Advance                                   |  |                        | 10,000  |                           |   |          |  |           |       |                  |   | 10,000 |  |   |     
|Operating lease obligations                    |  |                        | 1,615   |                           |   | 216       |  |           | 297    |                  |   | 251    |  |   | 851  
|Deposits                                       |  |                        | 172,765 |                           |   | 140,378   |  |           | 20,392 |                  |   | 11,995 |  |   |     
|Deferred compensation                          |  |                        | 1,227   |                           |   | 69        |  |           | 135    |                  |   | 135    |  |   | 888  
|Purchase obligations                           |  |                        | 1,300   |                           |   | 573       |  |           | 647    |                  |   | 80     |  |   |     
|                                               |  |                        |         |                           |   |           |  |           |        |                  |   |        |  |   |      
|Total contractual cash obligations             |  | $                      | 191,192 |                           | $ | 145,521   |  | $         | 21,471 |                  | $ | 22,461 |  | $ | 1,739
|                                               |  |                        |         |                           |   |           |  |           |        |                  |   |        |  |   |      



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##### Table of Contents

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

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

The Company uses the same credit policies in making
commitments and conditional obligations as it does for on-balance-sheet instruments. Unless otherwise noted, the Company requires collateral or other security to support financial instruments with credit risk.

The following table reflects other commitments of the Company outstanding as of December 31, 2005:



|                             |  |      |           
|---------------------------- |  | ---- | ----------
|                             |  | 2005
|Commitments to extend credit |  | $    | 32,523,919
|Standby letters of credit    |  |      | 338,244   
|Commitments to sell loans    |  |      | 1,491,000 
|                             |  |      |           
|                             |  | $    | 34,353,163
|                             |  |      |           

Asset/Liability Management

The Companys primary market risk exposure is interest rate risk. Fluctuations in interest rates will impact both the level of interest income and interest expense and the market value of the Companys
interest-earning assets and interest-bearing liabilities.

The primary goal of the Companys asset/liability management strategy is to
maximize its net interest income over time while limiting exposure to interest rate fluctuations. The Companys ability to manage its interest rate risk depends generally on the Companys ability to match the maturities and repricing
characteristics of its assets and liabilities while taking into account the separate goals of maintaining asset quality and liquidity and achieving the desired level of net interest income. The principal variables that affect the Companys
management of its interest rate risk include the Companys existing interest rate gap position, managements assessment of future interest rates, the need for the Company to replace assets that may prepay before their scheduled maturities,
and the withdrawal of liabilities over time.

One technique used by the Company in managing its interest rate risk exposure is the
management of the Companys interest sensitivity gap. The interest sensitivity gap is defined as the difference between the amount of interest-earning assets anticipated, based upon certain assumptions, to mature or reprice within a specific
time period and the amount of interest-bearing liabilities anticipated, based upon certain assumptions, to mature or reprice within that same time period. At December 31, 2005, the Companys one year positive gap
(interest-earning assets maturing or repricing within a period in excess of interest-bearing liabilities repricing within the same period) was 8.9% of total assets. Thus, during periods of rising interest rates, this implies that the Companys
net interest income would be positively affected because the yield of the Companys interest-earning assets is likely to rise faster than the cost on its interest-bearing liabilities. In periods of falling interest rates, the opposite effect on
net interest income is likely to occur. The interest sensitivity gap position of the Company is a static analysis at December 31, 2005. Because many factors affect the composition of the Companys assets and liabilities, a change in
prevailing interest rates will not necessarily result in a corresponding change in net interest income that would be projected using only the interest sensitivity gap table for the Company at December 31, 2005.

The Company manages its interest rate risk by influencing the adjustable and fixed rate mix of its loans, securities, deposits and borrowings. The
Company can add loans or securities with adjustable, balloon or call features, as well as fixed rate loans and mortgage securities, if the yield on such loans and securities is consistent with the Companys asset/liability management strategy.
Also, the Company can manage its interest rate risk by extending the maturity of its borrowings or selling certain assets and repaying borrowings.

Certain shortcomings are inherent in any method of analysis used to estimate a financial institutions interest rate gap. The analysis is based at a given point in time and does not take into consideration that changes in interest
rates do not affect all assets and liabilities equally. For example, although certain assets and liabilities may have similar maturities or repricing, they may react differently to changes in market interest rates. The interest rates on certain
types of assets and liabilities also may fluctuate in advance



35



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##### Table of Contents

of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. The
interest rates on loans with balloon or call features may or may not change depending upon their interest rates relative to market interest rates. Additionally, certain assets, such as adjustable-rate mortgages, have features that may restrict
changes in interest rates on a short-term basis and over the life of the asset.

The Company is also subject to prepayment risk,
particularly in falling interest rate environments or in environments where the slope of the yield curve is relatively flat or negative. Such changes in the interest rate environment can cause substantial changes in the level of prepayments of loans
and mortgage-backed securities, which may also affect the Companys interest rate gap position.



36



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##### Table of Contents

The following table sets forth the amounts of interest-earning assets and interest-bearing liabilities
outstanding at December 31, 2005, that are subject to repricing or that mature in each of the future time periods shown. Money market, NOW, and savings deposits are assumed to be subject to immediate pricing and depositor availability and have
been placed in the shortest repricing period. In making the gap table computations, none of the assumptions sometimes made regarding loan prepayment rates and deposit decay rates have been used. In addition, the table does not reflect scheduled loan
principal payments. The interest rate sensitivity of the Companys assets and liabilities illustrated in the Interest Sensitivity Analysis below would vary substantially if different assumptions were used or if actual experience differs from
that indicated by the assumption used. Loans and securities with balloon provisions, or that are subject to a call provision, are included in the period in which they balloon or may first be called. Except as stated above, the amount of assets and
liabilities shown that reprice or mature during a particular period were determined in accordance with the contractual terms of the asset or liability.

Interest Sensitivity Analysis

December 31, 2005



|                                                                    |  |                      |             |   |                                      |   |             |                              |  |   |                               |   |  |                                |            |   |       |   |            |   |  |   |            
|------------------------------------------------------------------- |  | -------------------- | ----------- | - | ------------------------------------ | - | ----------- | ---------------------------- |  | - | ----------------------------- | - |  | ------------------------------ | ---------- | - | ----- | - | ---------- | - |  | - | -----------
|                                                                    |  | Three Months or Less |             |   | Over ThreeMonthsthroughTwelve Months |   |             | Over One Year to Three Years |  |   | Over Three Years to FiveYears |   |  | Over FiveYears orNon-Sensitive |            |   | Total
|Assets                                                              |  |                      |             |   |                                      |   |             |                              |  |   |                               |   |  |                                |            |   |       |   |            |   |  |   |            
|Interest-earning assets:                                            |  |                      |             |   |                                      |   |             |                              |  |   |                               |   |  |                                |            |   |       |   |            |   |  |   |            
|Loans (1)                                                           |  | $                    | 62,038,862  |   |                                      | $ | 10,888,448  |                              |  | $ | 18,036,725                    |   |  | $                              | 24,595,792 |   |       | $ | 17,320,566 |   |  | $ | 132,880,393
|Investment securities                                               |  |                      | 1,905,863   |   |                                      |   | 4,206,060   |                              |  |   | 2,690,005                     |   |  |                                | 136,234    |   |       |   | 1,027,752  |   |  |   | 9,965,914  
|Federal funds sold                                                  |  |                      | 45,831,070  |   |                                      |   |            |                              |  |   |                              |   |  |                                |           |   |       |   |           |   |  |   | 45,831,070 
|Federal Home Loan, Federal Reserve stock                            |  |                      |            |   |                                      |   |            |                              |  |   |                              |   |  |                                |           |   |       |   | 822,700    |   |  |   | 822,700    
|                                                                    |  |                      |             |   |                                      |   |             |                              |  |   |                               |   |  |                                |            |   |       |   |            |   |  |   |            
|Total interest-earning assets                                       |  | $                    | 109,775,795 |   |                                      | $ | 15,094,508  |                              |  | $ | 20,726,730                    |   |  | $                              | 24,732,026 |   |       | $ | 19,171,018 |   |  | $ | 189,500,077
|                                                                    |  |                      |             |   |                                      |   |             |                              |  |   |                               |   |  |                                |            |   |       |   |            |   |  |   |            
|Liabilities                                                         |  |                      |             |   |                                      |   |             |                              |  |   |                               |   |  |                                |            |   |       |   |            |   |  |   |            
|Interest-bearing liabilities:                                       |  |                      |             |   |                                      |   |             |                              |  |   |                               |   |  |                                |            |   |       |   |            |   |  |   |            
|                                                                    |  |                      |             |   |                                      |  
|Interest-bearing deposits:                                          |  |                      |             |   |                                      |   |             |                              |  |   |                               |   |  |                                |            |   |       |   |            |   |  |   |            
|Savings accounts                                                    |  | $                    | 4,664,622   |   |                                      |   |            |                              |  |   |                              |   |  |                                |           |   |       | $ |           |   |  | $ | 4,664,622  
|Checking accounts (2)                                               |  |                      | 18,935,129  |   |                                      |   |            |                              |  |   |                              |   |  |                                |           |   |       |   |           |   |  |   | 18,935,129 
|Money Market deposits                                               |  |                      | 40,137,978  |   |                                      |   |            |                              |  |   |                              |   |  |                                |           |   |       |   |           |   |  |   | 40,137,978 
|Certificates of Deposit                                             |  |                      | 6,934,426   |   |                                      |   | 31,750,747  |                              |  |   | 20,392,490                    |   |  |                                | 11,994,635 |   |       |   |           |   |  |   | 71,072,298 
|                                                                    |  |                      |             |   |                                      |   |             |                              |  |   |                               |   |  |                                |            |   |       |   |            |   |  |   |            
|Total interest-bearing deposits                                     |  |                      | 70,672,155  |   |                                      |   | 31,750,747  |                              |  |   | 20,392,490                    |   |  |                                | 11,994,635 |   |       |   |           |   |  |   | 134,810,027
|                                                                    |  |                      |             |   |                                      |   |             |                              |  |   |                               |   |  |                                |            |   |       |   |            |   |  |   |            
|Federal Home Loan Bank Advance                                      |  |                      |            |   |                                      |   |            |                              |  |   |                              |   |  |                                | 10,000,000 |   |       |   |           |   |  |   | 10,000,000 
|Securities sold under agreements to repurchase                      |  | $                    | 4,235,393   |   |                                      |   |            |                              |  |   |                              |   |  |                                |           |   |       |   |           |   |  | $ | 4,235,393  
|Other short term borrowings                                         |  |                      | 50,000      |   |                                      |   |            |                              |  |   |                              |   |  |                                |           |   |       |   |           |   |  |   | 50,000     
|                                                                    |  |                      |             |   |                                      |   |             |                              |  |   |                               |   |  |                                |            |   |       |   |            |   |  |   |            
|Total interest-bearing liabilities                                  |  | $                    | 74,957,548  |   |                                      | $ | 31,750,747  |                              |  | $ | 20,392,490                    |   |  | $                              | 21,994,635 |   |       | $ |           |   |  | $ | 149,095,420
|                                                                    |  |                      |             |   |                                      |   |             |                              |  |   |                               |   |  |                                |            |   |       |   |            |   |  |   |            
|Interest sensitivity gap                                            |  | $                    | 34,818,247  |   |                                      | $ | (16,656,239 | )                            |  | $ | 334,240                       |   |  | $                              | 2,737,391  |   |       | $ | 19,171,018 |   |  | $ | 40,404,657 
|Cumulative interest sensitivity gap                                 |  | $                    | 34,818,247  |   |                                      | $ | 18,162,007  |                              |  | $ | 18,496,247                    |   |  | $                              | 21,233,639 |   |       | $ | 40,404,657 |   |  |   |            
|Cumulative interest sensitivity gap as a percentage of total assets |  |                      | 17.0        | % |                                      |   | 8.9         | %                            |  |   | 9.0                           | % |  |                                | 10.4       | % |       |   | 19.7       | % |  |   |            
|                                                                    |  |                      |             |   |                                      |   |             |                              |  |   |                               |   |  |                                |            |   |       |   |            |   |  |   |            

---

|(1) | Excludes non-accrual loans of $225,934.
|--- | ---------------------------------------

|(2) | Excludes $37,954,601 of noninterest-bearing deposits.
|--- | -----------------------------------------------------

Recent
Accounting Pronouncements

In May 2005, the Financial Accounting Standards Board issued SFAS No. 154, Accounting Changes and
Error Corrections  A Replacement of APB Opinion No. 20 and FASB Statement No. 3.The new standard changes the requirements for the accounting for and reporting of a change in accounting principle. Among other changes, SFAS
No. 154 requires that a voluntary change in



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accounting principle be applied retrospectively with all prior period financial statements presented on the new
accounting principle, unless it is impracticable to do so. SFAS No. 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that
was effected by a change in accounting principle and (2) correction of errors in previously issued financial statements should be termed a restatement. The new standard is effective for accounting changes and corrections of errors
made in fiscal years beginning after December 15, 2005. The adoption of this standard did not have a material effect on the Companys consolidated financial statements contained in this annual report on Form 10-KSB.

In November 2005, the FASB issued FASB Staff Position (FSP) FAS 115-1 and 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to
Certain Investments.The FSP addresses the determination of when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. The FSP also includes accounting considerations
subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The FSP is required to be applied to reporting periods
beginning after December 15, 2005. The adoption of the FSP did not have a material impact on the Companys consolidated financial statements contained in this annual report on Form 10-KSB.

In December 2004, the FAS issued SFAS No. 153, Exchanges of Productive Assets,an Amendment of Accounting Principles Board (APB) Opinion
No. 29, Accounting for Nonmonetary Exchanges. Under SFAS No. 153, nonmonetary exchanges are required to be accounted for at fair value, recognizing any gains or losses, if the fair value is determinable within reasonable limits and
the transaction has commercial substance. SFAS No. 153 is effective for fiscal periods beginning after June 15, 2005. The adoption of this standard did not have a material effect on the Companys consolidated financial statements
contained in this annual report on Form 10-KSB.

In December 2004, the FASB issued SFAS No. 123(R), Accounting for Stock-Based
Compensation(SFAS No. 123(R)). SFAS No. 123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. SFAS No. 123(R) focuses primarily on
accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123(R) requires that the fair value of such equity instruments be recognized as an expense in the historical financial
statements as services are performed. Prior to SFAS No. 123(R), only certain pro forma disclosures of fair value were required. The provisions of this Statement are effective for the first interim reporting period that begins after
December 15, 2005, for small business filers. The Company adopted SFAS No. 123(R) effective as of January 1, 2006.

The
Company had no existing awards of stock options that were unvested as of January 1, 2006. Accordingly, no additional stock-based compensation expense related to awards granted prior to January 1, 2006, will be recognized subsequent to the
adoption of SFAS No. 123(R). Stock-based compensation expense under SFAS No. 123(R) for grants of awards after January 1, 2006, will depend on the number of options granted, the calculation of the fair value of the options granted,
the service period and other terms provided in the grants, and the estimate of forfeitures (see Other Matters, above, and Note 10 to the Companys consolidated financial statements).

Off Balance Sheet Arrangements

In the normal course
of business, the Company is a party to financial instruments with off-balance-sheet risk. Those financial instruments, designed to meet the financing needs of customers, include commitments to sell loans, issue standby letters of credit, and
otherwise extend credit. Those instruments involve both credit and interest rate risk in addition to the amount recognized on the balance sheet. The contractual amounts of these financial instruments reflect the extent of involvement in the event of
nonperformance by the other party to the financial instrument. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. We obtain collateral based on our credit
assessment of the customer in each circumstance.

The Company historically sells substantially all of the residential mortgage loans it
originates to third-party investors, some of whom require the repurchase of loans in the event of early default or faulty documentation. Mortgage loans and their related servicing rights are sold under agreements that define certain eligibility
criteria for the mortgage loans. Recourse periods vary from 30 days up to 1 year and conditions for repurchase vary with the investor. Mortgages subject to recourse are collateralized by single-family residences and generally either have
loan-to-value ratios of 80% or less or have private mortgage insurance or are insured or guaranteed by an agency of the U.S. Government. We consider recourse considerations in our calculation of the Companys capital adequacy. We did not make
any payments under these recourse provisions in 2005 or 2004. Risks also arise from the possible inability of counterparties to meet the terms of their contracts. The Company has procedures in place to evaluate the credit risk of investors and does
not expect any counterparty to fail to meet its obligations.

At December 31, 2005, the Company had rate lock commitments to originate
mortgage loans amounting to $140,000 and had entered into corresponding mandatory commitments, on a best-efforts basis, to sell those loans. These commitments to sell loans are designed to eliminate the Companys exposure to fluctuations in
interest rates in connection with rate lock commitments and loans held for sale.



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Additional information related to the Companys off-balance-sheet risk exposure is detailed in Note
16 to the accompanying consolidated financial statements.

Effects of Inflation

The effect of changing prices is typically different for financial institutions than for other entities because a financial institutions assets and
liabilities are monetary in nature. Interest rates are significantly impacted by inflation, but neither the timing nor the magnitude of the changes is directly related to price-level indices. The consolidated financial statements reflect the impacts
of inflation on interest rates, loan demands and deposits.



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ITEM 7. FINANCIAL STATEMENTS

Report of Independent Registered Public Accounting Firm

The Shareholders and Board of Directors

Heritage Bankshares, Inc.

Norfolk, Virginia

We have audited the accompanying consolidated balance sheets of Heritage Bankshares, Inc. and its subsidiaries as of December 31, 2005
and 2004 and the related consolidated statements of income, stockholders equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to
express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the
standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The
Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining,
on a test basis, evidence supporting the amounts and disclosures in the financial statements assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to
above present fairly, in all material respects, the consolidated financial position of Heritage Bankshares, Inc. and its subsidiaries as of December 31, 2005 and 2004 and the consolidated results of their operations and their cash
flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

/s/PKF Witt Mares, PLC

Norfolk, Virginia

September 8, 2006



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HERITAGE BANKSHARES, INC.

CONSOLIDATED BALANCE SHEETS

At December 31, 2005 and 2004



|                                                                                                                                   |  |      |             |   |      |   |             |  
|---------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | -
|                                                                                                                                   |  | 2005 |             |   | 2004 |  
|ASSETS                                                                                                                             |  |      |             |   |      |   |             |  
|Cash and due from banks                                                                                                            |  | $    | 8,348,895   |   |      | $ | 6,470,690   |  
|Federal funds sold                                                                                                                 |  |      | 45,831,070  |   |      |   | 1,406,667   |  
|Securities available for sale, at fair value (adjusted cost of $9,366,147 and $14,302,665, respectively)                           |  |      | 9,284,678   |   |      |   | 14,284,514  |  
|Securities held to maturity, at cost (fair value approximates $700,856 and $1,251,020, respectively)                               |  |      | 681,236     |   |      |   | 1,191,414   |  
|Loans, net                                                                                                                         |  |      |             |   |      |   |             |  
|Held for investment, net of allowance for loan losses of $1,335,001 and $1,264,000, respectively                                   |  |      | 130,420,326 |   |      |   | 123,528,623 |  
|Held for sale                                                                                                                      |  |      | 1,351,000   |   |      |   | 1,515,700   |  
|Accrued interest receivable                                                                                                        |  |      | 683,610     |   |      |   | 593,219     |  
|Stock in Federal Reserve Bank, at cost                                                                                             |  |      | 64,900      |   |      |   | 64,900      |  
|Stock in Federal Home Loan Bank of Atlanta, at cost                                                                                |  |      | 757,800     |   |      |   | 289,700     |  
|Other real estate owned                                                                                                            |  |      |            |   |      |   | 297,295     |  
|Premises and equipment, net                                                                                                        |  |      | 5,743,532   |   |      |   | 2,525,799   |  
|Other assets                                                                                                                       |  |      | 1,469,191   |   |      |   | 1,606,273   |  
|                                                                                                                                   |  |      |             |   |      |   |             |  
|Total assets                                                                                                                       |  | $    | 204,636,238 |   |      | $ | 153,774,794 |  
|                                                                                                                                   |  |      |             |   |      |   |             |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                               |  |      |             |   |      |   |             |  
|Liabilities                                                                                                                        |  |      |             |   |      |   |             |  
|Deposits                                                                                                                           |  |      |             |   |      |   |             |  
|Noninterest bearing                                                                                                                |  | $    | 37,954,601  |   |      | $ | 26,026,268  |  
|Interest-bearing                                                                                                                   |  |      | 134,810,027 |   |      |   | 107,052,436 |  
|                                                                                                                                   |  |      |             |   |      |   |             |  
|Total deposits                                                                                                                     |  |      | 172,764,628 |   |      |   | 133,078,704 |  
|                                                                                                                                   |  |      |             |   |      |   |             |  
|Federal Home Loan Bank Advance                                                                                                     |  |      | 10,000,000  |   |      |   |            |  
|Securities sold under agreements to repurchase                                                                                     |  |      | 4,235,393   |   |      |   | 2,030,021   |  
|Other borrowings                                                                                                                   |  |      | 50,000      |   |      |   | 1,791,000   |  
|Accrued interest payable                                                                                                           |  |      | 378,399     |   |      |   | 231,905     |  
|Other liabilities                                                                                                                  |  |      | 1,135,661   |   |      |   | 995,663     |  
|                                                                                                                                   |  |      |             |   |      |   |             |  
|Total liabilities                                                                                                                  |  |      | 188,564,081 |   |      |   | 138,127,293 |  
|                                                                                                                                   |  |      |             |   |      |   |             |  
|Commitments and contingent liabilities (Note 10, 14, and 16)                                                                       |  |      |            |   |      |   |            |  
|Stockholders equity                                                                                                               |  |      |             |   |      |   |             |  
|Common stock, $5 par value - authorized 3,000,000 shares; issued and outstanding: 2005  1,714,668 shares; 2004  1,707,182
shares |  |      | 8,573,340   |   |      |   | 8,535,910   |  
|Additional paid-in capital                                                                                                         |  |      | 314,838     |   |      |   | 285,097     |  
|Retained earnings                                                                                                                  |  |      | 7,237,748   |   |      |   | 6,838,473   |  
|Accumulated other comprehensive income (loss), net                                                                                 |  |      | (53,769     | ) |      |   | (11,979     | )
|                                                                                                                                   |  |      |             |   |      |   |             |  
|Total stockholders equity                                                                                                         |  |      | 16,072,157  |   |      |   | 15,647,501  |  
|                                                                                                                                   |  |      |             |   |      |   |             |  
|Total liabilities and stockholders equity                                                                                         |  | $    | 204,636,238 |   |      | $ | 153,774,794 |  
|                                                                                                                                   |  |      |             |   |      |   |             |  

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



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HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31, 2005 and 2004



|                                                    |  |      |            |      |   |          
|--------------------------------------------------- |  | ---- | ---------- | ---- | - | ---------
|                                                    |  | 2005 |            | 2004
|Interest income                                     |  |      |            |      |   |          
|Loans and fees on loans                             |  | $    | 8,465,942  |      | $ | 7,020,713
|Taxable investment securities                       |  |      | 361,722    |      |   | 525,495  
|Nontaxable investment securities                    |  |      | 47,843     |      |   | 46,848   
|Dividends on FRB and FHLB stock                     |  |      | 33,496     |      |   | 15,720   
|Interest on federal funds sold                      |  |      | 1,135,259  |      |   | 50,572   
|                                                    |  |      |            |      |   |          
|Total interest income                               |  |      | 10,044,262 |      |   | 7,659,348
|                                                    |  |      |            |      |   |          
|Interest expense                                    |  |      |            |      |   |          
|Deposits                                            |  |      | 3,244,403  |      |   | 2,115,947
|Borrowings                                          |  |      | 500,468    |      |   | 35,897   
|                                                    |  |      |            |      |   |          
|Total interest expense                              |  |      | 3,744,871  |      |   | 2,151,844
|                                                    |  |      |            |      |   |          
|Net interest income                                 |  |      | 6,299,391  |      |   | 5,507,504
|                                                    |  |     
|Provision for loan losses                           |  |      | 33,010     |      |   | 453,000  
|                                                    |  |      |            |      |   |          
|Net interest income after provision for loan losses |  |      | 6,266,381  |      |   | 5,054,504
|                                                    |  |      |            |      |   |          
|Noninterest income                                  |  |      |            |      |   |          
|Service charges on deposit accounts                 |  |      | 395,520    |      |   | 300,478  
|Gains on sale of other real estate owned            |  |      | 427,066    |      |   |         
|Gains on sale of loans held for sale, net           |  |      | 260,353    |      |   | 234,093  
|Income from bank-owned life insurance               |  |      | 20,356     |      |   | 393,421  
|Late charges and other fees on loans                |  |      | 187,687    |      |   | 89,890   
|Other                                               |  |      | 368,129    |      |   | 379,067  
|                                                    |  |      |            |      |   |          
|Total noninterest income                            |  |      | 1,659,111  |      |   | 1,396,949
|                                                    |  |      |            |      |   |          
|Noninterest expense                                 |  |      |            |      |   |          
|Compensation                                        |  |      | 3,159,118  |      |   | 2,221,244
|Data processing                                     |  |      | 366,161    |      |   | 312,970  
|Occupancy                                           |  |      | 371,721    |      |   | 278,070  
|Furniture and equipment                             |  |      | 452,141    |      |   | 211,138  
|Taxes and licenses                                  |  |      | 152,551    |      |   | 123,046  
|Professional fees                                   |  |      | 534,195    |      |   | 105,531  
|Contract employee services                          |  |      | 292,577    |      |   | 9,637    
|Marketing                                           |  |      | 297,260    |      |   | 49,419   
|Other                                               |  |      | 1,117,593  |      |   | 862,875  
|                                                    |  |      |            |      |   |          
|Total noninterest expense                           |  |      | 6,743,317  |      |   | 4,173,930
|                                                    |  |      |            |      |   |          
|Income before provision for income taxes            |  |      | 1,182,175  |      |   | 2,277,523
|                                                    |  |     
|Provision for income taxes                          |  |      | 372,759    |      |   | 610,144  
|                                                    |  |      |            |      |   |          
|Net income                                          |  | $    | 809,416    |      | $ | 1,667,379
|                                                    |  |      |            |      |   |          
|Earnings per share                                  |  |      |            |      |   |          
|Basic                                               |  | $    | 0.47       |      | $ | 0.99     
|                                                    |  |      |            |      |   |          
|Diluted                                             |  | $    | 0.46       |      | $ | 0.96     
|                                                    |  |      |            |      |   |          

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



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HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

Years ended December 31, 2005 and 2004



|                                                                                                 |  |              |  |                           |           |  |                   |          |   |                                              |   |           |       |  |   |          |   |  |   |            |  
|------------------------------------------------------------------------------------------------ |  | ------------ |  | ------------------------- | --------- |  | ----------------- | -------- | - | -------------------------------------------- | - | --------- | ----- |  | - | -------- | - |  | - | ---------- | -
|                                                                                                 |  | Common Stock |  | AdditionalPaid-in Capital |           |  | Retained Earnings |          |   | Accumulated OtherComprehensive Income
(Loss) |   |           | Total | 
|                                                                                                 |  | Shares       |  | Amount                    |           |  |                   |         
|Balance, December 31, 2003                                                                       |  | 1,583,800    |  | $                         | 7,919,000 |  | $                 | (146,295 | ) |                                              | $ | 5,533,121 |       |  | $ | 139,380  |   |  | $ | 13,445,206 |  
|                                                                                                 |  |              |  |                           |           |  |                   |          |   |                                              |   |           |       |  |   |          |   |  |   |            |  
|Comprehensive income:                                                                            |  |              |  |                           |           |  |                   |          |   |                                              |   |           |       |  |   |          |   |  |   |            |  
|                                                                                                 |  |              |  |                           |           | 
|Net income for 2004                                                                              |  |             |  |                           |          |  |                   |         |   |                                              |   | 1,667,379 |       |  |   |         |   |  |   | 1,667,379  |  
|Change in unrealized gain (loss) on securities available-for-sale, net of tax benefit of $77,973 |  |             |  |                           |          |  |                   |         |   |                                              |   |          |       |  |   | (151,359 | ) |  |   | (151,359   | )
|                                                                                                 |  |              |  |                           |           |  |                   |          |   |                                              |   |           |       |  |   |          |   |  |   |            |  
|Total comprehensive income                                                                       |  |             |  |                           |          |  |                   |         |   |                                              |   |          |       |  |   |         |   |  |   | 1,516,020  |  
|                                                                                                 |  |              |  |                           |           | 
|Exercise of stock options and related tax benefits                                               |  | 123,382      |  |                           | 616,910   |  |                   | 431,267  |   |                                              |   |          |       |  |   |         |   |  |   | 1,048,177  |  
|Other                                                                                            |  |             |  |                           |          |  |                   | 125      |   |                                              |   |          |       |  |   |         |   |  |   | 125        |  
|Cash dividends ($0.22 per share)                                                                 |  |             |  |                           |          |  |                   |         |   |                                              |   | (362,027  | )     |  |   |         |   |  |   | (362,027   | )
|                                                                                                 |  |              |  |                           |           |  |                   |          |   |                                              |   |           |       |  |   |          |   |  |   |            |  
|Balance, December 31, 2004                                                                       |  | 1,707,182    |  | $                         | 8,535,910 |  | $                 | 285,097  |   |                                              | $ | 6,838,473 |       |  | $ | (11,979  | ) |  | $ | 15,647,501 |  
|                                                                                                 |  |              |  |                           |           |  |                   |          |   |                                              |   |           |       |  |   |          |   |  |   |            |  
|Comprehensive income:                                                                            |  |              |  |                           |           |  |                   |          |   |                                              |   |           |       |  |   |          |   |  |   |            |  
|Net income for 2005                                                                              |  |             |  |                           |          |  |                   |         |   |                                              |   | 809,416   |       |  |   |         |   |  |   | 809,416    |  
|Change in unrealized gain (loss) on securities available-for-sale, net of tax benefit of $21,528 |  |             |  |                           |          |  |                   |         |   |                                              |   |          |       |  |   | (41,790  | ) |  |   | (41,790    | )
|                                                                                                 |  |              |  |                           |           |  |                   |          |   |                                              |   |           |       |  |   |          |   |  |   |            |  
|Total comprehensive income                                                                       |  |             |  |                           |          |  |                   |         |   |                                              |   |          |       |  |   |         |   |  |   | 767,626    |  
|                                                                                                 |  |              |  |                           |           | 
|Exercise of stock options and related tax benefits                                               |  | 7,486        |  |                           | 37,430    |  |                   | 29,733   |   |                                              |   |          |       |  |   |         |   |  |   | 67,163     |  
|Other                                                                                            |  |             |  |                           |          |  |                   | 8        |   |                                              |   |          |       |  |   |         |   |  |   | 8          |  
|Cash dividends ($0.24 per share)                                                                 |  |             |  |                           |          |  |                   |         |   |                                              |   | (410,141  | )     |  |   |         |   |  |   | (410,141   | )
|                                                                                                 |  |              |  |                           |           |  |                   |          |   |                                              |   |           |       |  |   |          |   |  |   |            |  
|Balance, December 31, 2005                                                                       |  | 1,714,668    |  | $                         | 8,573,340 |  | $                 | 314,838  |   |                                              | $ | 7,237,748 |       |  | $ | (53,769  | ) |  | $ | 16,072,157 |  
|                                                                                                 |  |              |  |                           |           |  |                   |          |   |                                              |   |           |       |  |   |          |   |  |   |            |  

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



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HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years ended December 31, 2005 and 2004



|                                                                                  |  |      |             |   |      |   |             |  
|--------------------------------------------------------------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | -
|                                                                                  |  | 2005 |             |   | 2004 |  
|Cash flows from operating activities:                                             |  |      |             |   |      |   |             |  
|Net income                                                                        |  | $    | 809,416     |   |      | $ | 1,667,379   |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |      |             |   |      |   |             |  
|Provision for loan losses                                                         |  |      | 33,010      |   |      |   | 453,000     |  
|Amortization (accretion) of loan yield adjustments, net                           |  |      | 160,599     |   |      |   | 203,473     |  
|Depreciation, amortization and accretion, net                                     |  |      | 377,134     |   |      |   | 428,110     |  
|Exercise of stock options tax benefit                                             |  |      | 29,624      |   |      |   | 452,521     |  
|Net gains on sale of:                                                             |  |      |             |   |      |   |             |  
|Loans                                                                             |  |      | (260,352    | ) |      |   | (234,093    | )
|Real estate                                                                       |  |      | (443,683    | ) |      |   |            |  
|Loss on sale, disposal or impairment of long-lived assets                         |  |      | 10,657      |   |      |   | 55,870      |  
|(Gain) Loss on sale of investment                                                 |  |      | (3,111      | ) |      |   | 29,440      |  
|Proceeds from sales of loans held for sale                                        |  |      | 17,552,540  |   |      |   | 14,745,036  |  
|Origination of loans held for sale                                                |  |      | (17,127,488 | ) |      |   | (15,855,168 | )
|Changes in assets/liabilities, net                                                |  |      |             |   |      |   |             |  
|Decrease (increase) in interest receivable and other assets                       |  |      | 65,643      |   |      |   | (207,373    | )
|Increase (decrease) in other liabilities                                          |  |      | 286,492     |   |      |   | 260,634     |  
|                                                                                  |  |      |             |   |      |   |             |  
|Net cash provided by operating activities                                         |  |      | 1,490,481   |   |      |   | 1,998,829   |  
|                                                                                  |  |      |             |   |      |   |             |  
|Cash flows from investing activities:                                             |  |      |             |   |      |   |             |  
|Purchases of securities available for sale                                        |  |      |            |   |      |   | (565,050    | )
|Proceeds from maturities of securities available for sale                         |  |      | 4,740,000   |   |      |   | 4,275,000   |  
|Principal repayments on securities available for sale                             |  |      | 58,617      |   |      |   | 130,268     |  
|Proceeds from maturities of securities held to maturity                           |  |      | 500,000     |   |      |   | 100,000     |  
|Principal repayments on securities held to maturity                               |  |      | 4,746       |   |      |   | 8,778       |  
|Proceeds from sale of investment                                                  |  |      | 22,304      |   |      |   | 55,040      |  
|Net increase in loans held for investment                                         |  |      | (6,921,312  | ) |      |   | (23,622,986 | )
|Purchases of Federal Home Loan Bank stock                                         |  |      | (765,100    | ) |      |   | (67,600     | )
|Redemption of Federal Home Loan Bank stock                                        |  |      | 297,000     |   |      |   | 81,200      |  
|Purchases of premises and equipment                                               |  |      | (3,482,090  | ) |      |   | (429,599    | )
|Proceeds from sale of real estate owned                                           |  |      | 560,361     |   |      |   |            |  
|Proceeds from sales of premises and equipment                                     |  |      | 19,907      |   |      |   |            |  
|                                                                                  |  |      |             |   |      |   |             |  
|Net cash used for investing activities                                            |  |      | (4,965,567  | ) |      |   | (20,034,949 | )
|                                                                                  |  |      |             |   |      |   |             |  
|Cash flows from financing activities:                                             |  |      |             |   |      |   |             |  
|Proceeds from exercise of stock options                                           |  |      | 37,539      |   |      |   | 595,656     |  
|Net increase in deposits                                                          |  |      | 39,685,924  |   |      |   | 8,337,897   |  
|Proceeds from Federal Home Loan Bank advances                                     |  |      | 17,175,000  |   |      |   |            |  
|Repayments of Federal Home Loan Bank advances                                     |  |      | (7,175,000  | ) |      |   |            |  
|Proceeds from federal funds purchased                                             |  |      | 13,972,000  |   |      |   | 44,065,000  |  
|Repayment of federal funds purchased                                              |  |      | (15,713,000 | ) |      |   | (42,324,000 | )
|Net increase (decrease) in securities sold under agreements to repurchase         |  |      | 2,205,372   |   |      |   | (3,929,320  | )
|Cash dividends paid                                                               |  |      | (410,141    | ) |      |   | (362,027    | )
|                                                                                  |  |      |             |   |      |   |             |  
|Net cash provided by financing activities                                         |  |      | 49,777,694  |   |      |   | 6,383,206   |  
|                                                                                  |  |      |             |   |      |   |             |  
|Increase (decrease) in cash and cash equivalents                                  |  |      | 46,302,608  |   |      |   | (11,652,914 | )
|                                                                                  |  |     
|Cash and cash equivalents, beginning of year                                      |  |      | 7,877,357   |   |      |   | 19,530,271  |  
|                                                                                  |  |      |             |   |      |   |             |  
|Cash and cash equivalents, end of year                                            |  | $    | 54,179,965  |   |      | $ | 7,877,357   |  
|                                                                                  |  |      |             |   |      |   |             |  
|Supplemental disclosure:                                                          |  |      |             |   |      |   |             |  
|                                                                                  |  |     
|Interest paid                                                                     |  | $    | 3,598,377   |   |      | $ | 2,121,881   |  
|Income taxes paid                                                                 |  | $    | 520,000     |   |      | $ | 483,766     |  

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



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HERITAGE BANKSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2004, 2003 AND 2002

NOTE 1  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of Heritage Bankshares,
Inc. and its wholly-owned subsidiaries, Heritage Bank, IBV Real Estate Holdings, Inc., and Sentinel Trust Services, LLC. All significant intercompany balances and transactions have been eliminated in consolidation.

Nature of Operations

Heritage Bankshares, Inc. (the
Company) is a bank holding company incorporated under the laws of the Commonwealth of Virginia in 1983, and at December 31, 2005, serves as the holding company for its wholly-owned subsidiaries: Heritage Bank (name changed from
Heritage Bank & Trust in October 2005), IBV Real Estate Holdings, Inc., and Sentinel Trust Services, LLC.

Heritage Bank (the
Bank) is a wholly-owned subsidiary of the Company and is a state banking corporation engaged in the general commercial and retail banking business. The Bank is a full-service bank conducting a general commercial and consumer banking
business with its customers located throughout the Hampton Roads area of Virginia. The Bank has one wholly-owned subsidiary, Sentinel Financial Group, Inc. (Sentinel Financial). At December 31, 2005, Sentinel Financial owned an
interest in each of Bankers Investment Group, LLC, and Bankers Insurance, LLC, providers of various insurance and investment products. The financial activities pertaining to these interests are recorded on the cost method of accounting for
investments.

IBV Real Estate Holdings, Inc. (IBV) is a wholly-owned subsidiary of the Company and was formed for the sole
purpose of owning additional real estate assets acquired by the Company or the Bank. IBV owns a 1% interest in IBV Partners, LP, a Virginia limited partnership formed in December 1986. IBV serves as the general partner of the partnership. The
partnerships sole asset is a 17,200 square-foot office building located at 1450 South Military Highway, Chesapeake, Virginia. The Bank is a tenant in the property.

Sentinel Trust Services, LLC (Sentinel) is a wholly-owned subsidiary of the Company and was originally formed to own an interest in Old Dominion Trust Company, a provider of trust services. In 2004, Old
Dominion Trust merged with AMG Guaranty Trust, a privately held provider of investment services. At December 31, 2005, Sentinel owned 2,560 shares, or less than 1%, of the common stock of AMG Guaranty.

Use of Estimates

The preparation of financial
statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results could differ from those estimates. Material estimates that are particularly susceptible to
significant change relate to the determination of the allowance for losses on loans, the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans, and the valuation of deferred tax assets.

Significant Group Concentrations of Credit Risk

Substantially all of the Companys lending activities are with customers located in southeastern Virginia. Note 6 presents the Companys lending activities. The Company invests in a variety of securities, principally obligations
of U.S. government agencies and obligations of states and political subdivisions. Note 4 presents the Companys investment activities. The Company does not have any significant concentrations of loans in any one industry or customer, other than
the local hospitality industry.

Cash and Cash Equivalents

For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, and federal funds sold.



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Investment Securities

Investment securities are classified in three categories and accounted for as follows:



| |  | Debt securities that the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value,
with unrealized gains and losses included in earnings.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Debt and equity securities not classified as either held-to-maturity or trading securities are classified as available-for-sale securities and reported at fair value, with
unrealized gains and losses excluded from earnings and reported as other comprehensive income, a separate component of stockholders equity.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Gains and losses on sales of securities are computed based on specific identification of the adjusted cost of each security and included in other income. Amortization of premiums and accretion of discounts are
computed by the effective yield method and recognized in interest income.

Declines in the fair value of individual held-to-maturity and
available-for-sale securities below their cost that are other than temporary would result in write-downs of the individual securities to fair value. These write-downs would be included in earnings as realized losses.

Loans

Loans are reported at their principal
outstanding balance net of charge-offs, deferred loan fees and costs on originated loans, unearned income, and unamortized premiums or discounts, if any, on purchased loans. Interest income is generally recognized when income is earned using the
interest method. Loan origination fees and certain direct loan origination costs are deferred and the net amounts are amortized as an adjustment to yield on the respective loans.

Loans Held For Sale

Mortgage loans originated and intended for sale in the secondary market are
carried at cost. Loans held for sale are pre-committed to secondary market investors and, subsequent to being closed, are held for short holding periods pending receipt of loan documents.

Allowance For Loan Losses

The Company maintains an
allowance for loan losses at a level which, in managements judgment, is adequate to absorb estimated credit losses on existing loans which may become uncollectible. The amount of the allowance is affected by: (1) loan charge offs, which
decrease the allowance, (2) recoveries on loans previously charged off, which increase the allowance, and (3) the provision for loan losses charged to income, which increases the allowance.

The Company continuously reviews its loan portfolio by reviewing its credit quality through ongoing credit review processes and prepares a comprehensive
allowance analysis for its loan portfolio at least quarterly. This analysis includes two basic elements: specific allowances for individual loans, and general allowances for loan portfolio segments which factor in historical loan loss experience and
delinquency rates for the Company and the banking industry, as well as loan portfolio mix, growth and trends, and economic conditions.

The
Bank evaluates various loans individually for impairment as required by Statement of Financial Accounting Standard (SFAS) No. 114, Accounting by Creditors for Impairment of a Loan. Evaluations are based upon either discounted
cash flows or collateral evaluations. If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of the impairment.

For loans without individual measures of impairment, the Company makes estimates of losses for groups of loans as required by SFAS No. 5,
Accounting for Contingencies. As part of the loan loss reserve methodology, loans are categorized into one of five major categories or segments of loans: (1) commercial and industrial loans, (2) consumer loans, (3) 1-4 family
residential real estate secured loans (including home equity loans and lines), (4) commercial real estate loans, and (5) acquisition development and/or construction loans.

These categories are further subdivided by assigned asset quality. Loss factors are calculated using the above mentioned quantitative and qualitative
data and are then applied to each of the loan segments to determine a reserve level for each of the five segments of loans. In addition, an unallocated reserve is calculated to account for the imprecision inherent in estimating losses on the
segmented portions of the loan portfolio primarily using historical data.



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Income Recognition on Nonaccrual Loans

Loans are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days,
unless such loans are well-secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful, or is partially charged off, the loan is generally classified as nonaccrual. Loans that are on a current payment status
or past due less than 90 days may also be classified as nonaccrual, if repayment in full of principal and/or interest is in doubt.

Loans
may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance by
the borrower.

While a loan is classified as nonaccrual, and the future collectibility of the recorded loan balance is doubtful,
collections of interest and principal are generally applied as a reduction to principal outstanding. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis.

Other Real Estate Owned

Other real estate owned is
comprised of real estate acquired through foreclosure, acceptance of a deed in lieu of foreclosure, or loans in which the Company receives physical possession of the debtors real estate. Other real estate owned is carried at the lower of the
recorded investment in the loan or the fair value of the real estate less estimated costs to sell. Net operating income of such properties, exclusive of depreciation, is included in other income and related depreciation expense is included in other
expense.

Restructured Loans

Loans are
considered troubled debt restructurings if, for economic or legal reasons, a concession has been granted to the borrower related to the borrowers financial difficulties that the Company would not have otherwise considered. The Company
restructures certain loans in instances where a determination is made that greater economic value will be realized under new terms than through foreclosure, liquidation, or other disposition. The terms of the renegotiation generally involve some or
all of the following characteristics: a reduction in the interest pay rate to reflect actual operating income, an extension of the loan maturity date to allow time for stabilization of operating income, and partial forgiveness of principal and
interest.

The carrying value of a restructured loan is reduced by the fair value of assets or equity interest received from the borrower,
if any. Prior to demonstrating performance, the Bank generally classifies restructured loans as nonaccrual. The accrual of interest resumes when such loans can demonstrate performance, generally evidenced by six months of pre- or post-restructuring
payment performance in accordance with the restructured terms, or by the presence of other significant factors. In addition, at the time of restructuring, loans are generally classified as impaired. A restructured loan that is not impaired, based on
the restructured terms, and has a stated interest rate greater than or equal to a market interest rate at the date of the restructuring, is reclassified as unimpaired in the year immediately following the year it was disclosed as restructured.

Off Balance Sheet Credit Related Financial Instruments

In the ordinary course of business, the Company has entered into commitments to extend credit and issue standby letters of credit. Such financial instruments are recorded when they are funded.

Rate Lock Commitments

The Company enters into
commitments to originate residential mortgage loans whereby the interest rate on the loan is determined prior to funding (i.e., rate lock commitments). Such rate lock commitments on mortgage loans to be sold in the secondary market are considered to
be derivatives. The period of time between issuance of a loan commitment and closing and sale of the loan generally ranges from 15 to 90 days. The Company protects itself from changes in interest rates through the use of best efforts forward
delivery commitments, whereby the Company commits to sell a loan at the time the borrower commits to an interest rate with the intent that the buyer has assumed interest rate risk on the loan. In such instances, the Company is not exposed to losses
nor will it realize gains related to its rate lock commitments due to changes in interest rates.

The market values of rate lock
commitments and best efforts contracts are not readily ascertainable with precision because rate lock commitments and best efforts contracts are not actively traded. Because of the high correlation between rate lock commitments and best efforts
contracts, no gain or loss occurs on the rate lock commitments.



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Sale of Loans

Transfers of loans are accounted for as sales when control over the loans has been surrendered. Control over transferred loans is deemed to be surrendered when (1) the loans have been isolated from the Company, (2) the transferee
obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred loans, and (3) the Company does not maintain effective control over the transferred loans through an agreement to
repurchase them before their maturity.

Premises and Equipment

Land is carried at cost. Buildings and equipment are carried at cost, less accumulated depreciation computed on the straight-line method over the estimated useful lives of the assets.

Federal Reserve Bank Stock and Federal Home Loan Bank Stock

As a member of the Federal Reserve Bank (FRB), the Company is required to hold shares of FRB capital stock, $100 par value, in an amount equal to 6% of the Banks total common stock and capital surplus.

As a member of the Federal Home Loan Bank (FHLB) of Atlanta, the Company is required to hold shares of capital stock in the FHLB in an amount
equal to 0.20% of total assets plus 4.50% of borrowings from the FHLB.

FRB stock and FHLB stock are carried at cost.

Income Taxes

The Company files a consolidated tax
return. Provisions for income taxes reflect tax expense incurred as a consolidated group. Tax expense is allocated among the members of the consolidated group in accordance with an intercompany agreement for tax expense. Income taxes are provided
for the tax effects of the transactions reported in the financial statements and consist of taxes currently due plus deferred taxes related primarily to differences between the basis of investment securities, deferred loan fees, allowance for loan
losses, allowance for losses on foreclosed real estate, premises and equipment and deferred compensation for financial and income tax reporting. The deferred tax assets and liabilities represent the future tax return consequences of those
differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. An allowance is provided if it is more likely than not that the Company will not realize the benefits of a deferred tax asset. Through
December 31, 2005, a valuation allowance has not been provided against the deferred tax asset.

Deferred Compensation Plans

The Company maintains deferred compensation agreements with certain current and former directors and the beneficiary of its former chief executive
officer. The Companys policy is to accrue the present value of estimated amounts to be paid under the contracts over the required service period to the date the participant is fully eligible to receive the benefits. At December 31, 2005,
the discount rate the Company utilized to determine the deferred compensation liability was determined by computing the average of the last three year-end periods AA corporate bond yield, whose approximate maturity corresponded to the
approximate time remaining to pay out the expected benefits for each participant.

Bank-Owned Life Insurance

The Company has purchased life insurance policies on certain current and former directors. Company-owned life insurance is recorded at its cash surrender
value, or the amount that can be realized.

Stock Compensation Plans

SFAS No. 123, Accounting for Stock-Based Compensation, encourages all entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured
at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value
based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB Opinion No. 25), whereby compensation cost is the excess, if any, of the market price of
the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock. Stock options issued under the Companys stock option plan generally have no intrinsic value at the grant date and, under APB
Opinion No. 25, no compensation cost is recognized for them. The Company has elected to continue with the accounting methodology in APB Opinion No. 25 and, as a result, has provided pro forma disclosures of net income and earnings per
share and other disclosures as if the fair value based method of accounting had been applied.



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Effective January 1, 2006, the Company adopted SFAS No. 123(R), Accounting for Stock-Based
Compensation (SFAS 123(R)). SFAS 123(R) requires that the fair value of equity instruments, such as stock options, be recognized as an expense in the financial statements as services are performed.



|                                                                                                                                      |  |      |          |   |      |   |           |  
|------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | -------- | - | ---- | - | --------- | -
|                                                                                                                                      |  | 2005 |          |   | 2004 |  
|Net income as reported                                                                                                                |  | $    | 809,416  |   |      | $ | 1,667,379 |  
|Add: Stock-based employee compensation expense included in net income, net of related tax                                             |  |      | 5        |   |      |   | 83        |  
|Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of related tax
effects |  |      | (106,289 | ) |      |   | (2,235    | )
|                                                                                                                                      |  |      |          |   |      |   |           |  
|Pro forma net income                                                                                                                  |  | $    | 703,132  |   |      | $ | 1,665,227 |  
|                                                                                                                                      |  |      |          |   |      |   |           |  
|Basic net income per share                                                                                                            |  |      |          |   |      |   |           |  
|As reported                                                                                                                           |  | $    | 0.47     |   |      | $ | 0.99      |  
|                                                                                                                                      |  |      |          |   |      |   |           |  
|Pro forma                                                                                                                             |  | $    | 0.41     |   |      | $ | 0.99      |  
|                                                                                                                                      |  |      |          |   |      |   |           |  
|Diluted net income per share                                                                                                          |  |      |          |   |      |   |           |  
|As reported                                                                                                                           |  | $    | 0.46     |   |      | $ | 0.96      |  
|                                                                                                                                      |  |      |          |   |      |   |           |  
|Pro forma                                                                                                                             |  | $    | 0.40     |   |      | $ | 0.96      |  
|                                                                                                                                      |  |      |          |   |      |   |           |  

Earnings Per Common Share

Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflect additional common
shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by the Company relate to outstanding stock options and are determined using the treasury stock method. Earnings
per share calculations are presented in Note 9.

Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, and realized gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and
losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. Components of other comprehensive income are
presented in Note 2.

Business Segments

The Company currently reports its activities as a single business segment. In determining appropriate segment definition and reporting, the Company considers components of the business about which financial information relating to
performance and resource allocation is available and regularly evaluated by management. Management determines components for which it will implement performance and resource measurement procedures based upon criteria of relative importance and
materiality to the organization.

Reclassifications

Certain reclassifications have been made to prior year financial statements to conform them to the current year presentation.



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NOTE 2  OTHER COMPREHENSIVE INCOME

The components of other comprehensive income and related tax effects are as follows:



|                                                                   |  |                         |         |   |      |   |          |  
|------------------------------------------------------------------ |  | ----------------------- | ------- | - | ---- | - | -------- | -
|                                                                   |  | Years Ended December 31 |        
|                                                                   |  | 2005                    |         |   | 2004 |  
|Unrealized holding gains (losses) on available-for-sale securities |  | $                       | (63,318 | ) |      | $ | (229,332 | )
|Tax Effect                                                         |  |                         | 21,528  |   |      |   | 77,973   |  
|                                                                   |  |                         |         |   |      |   |          |  
|Net of tax amount                                                  |  | $                       | (41,790 | ) |      | $ | (151,359 | )
|                                                                   |  |                         |         |   |      |   |          |  

NOTE 3  RESTRICTIONS ON CASH AND DUE FROM BANKS

The Bank is required to maintain average balances on hand or with the FRB. At December 31, 2005 and 2004, these reserve balances amounted to
$2,811,000 and $1,693,000, respectively.



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NOTE 4  SECURITIES



|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|------------------------------------------------ |  | -------------- | ---------- | -------------------- | - | --------------------- |  | ---------- | ------- |  | - | ----------
|                                                 |  | Amortized Cost |            | GrossUnrealizedGains |   | GrossUnrealizedLosses |  | Fair Value
|At December 31, 2005                             |  |                |            |                      |   |                       |  |            |         |  |   |           
|Securities available for sale                    |  |                |            |                      |   |                       |  |            |         |  |   |           
|U.S. Treasury securities                         |  | $              | 500,084    |                      | $ |                      |  | $          | 864     |  | $ | 499,220   
|Other U.S. government agency securities          |  |                | 7,975,571  |                      |   |                      |  |            | 115,840 |  |   | 7,859,731 
|Mortgage-backed securities                       |  |                | 170,902    |                      |   | 2,073                 |  |            |        |  |   | 172,975   
|Obligations of states and political subdivisions |  |                | 634,115    |                      |   | 13,122                |  |            |        |  |   | 647,237   
|Marketable equity securities                     |  |                | 80,475     |                      |   | 22,251                |  |            | 8,580   |  |   | 94,146    
|Other convertible debt security                  |  |                | 5,000      |                      |   | 6,369                 |  |            |        |  |   | 11,369    
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Total securities available for sale              |  |                | 9,366,147  |                      |   | 43,815                |  |            | 125,284 |  |   | 9,284,678 
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Securities held to maturity                      |  |                |            |                      |   |                       |  |            |         |  |   |           
|Mortgage-backed securities                       |  |                | 11,748     |                      |   | 74                    |  |            |        |  |   | 11,822    
|Obligations of states and political subdivisions |  |                | 469,488    |                      |   | 7,546                 |  |            |        |  |   | 477,034   
|Preferred trust securities                       |  |                | 200,000    |                      |   | 12,000                |  |            |        |  |   | 212,000   
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Total securities held to maturity                |  |                | 681,236    |                      |   | 19,620                |  |            |        |  |   | 700,856   
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Total securities                                 |  | $              | 10,047,383 |                      | $ | 63,435                |  |            | 125,284 |  | $ | 9,985,534 
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|At December 31, 2004                             |  |                |            |                      |   |                       |  |            |         |  |   |           
|Securities available for sale                    |  |                |            |                      |   |                       |  |            |         |  |   |           
|U.S. Treasury securities                         |  | $              | 501,135    |                      | $ |                      |  | $          | 5,940   |  | $ | 495,195   
|Other U. S. government agency securities         |  |                | 12,878,809 |                      |   | 14,921                |  |            | 89,858  |  |   | 12,803,872
|Mortgage-backed securities                       |  |                | 229,278    |                      |   | 8,682                 |  |            |        |  |   | 237,960   
|Obligations of states and political subdivisions |  |                | 607,968    |                      |   | 26,845                |  |            |        |  |   | 634,813   
|Marketable equity securities                     |  |                | 80,475     |                      |   | 23,569                |  |            | 3,910   |  |   | 100,134   
|Other convertible debt security                  |  |                | 5,000      |                      |   | 7,540                 |  |            |        |  |   | 12,540    
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Total securities available for sale              |  |                | 14,302,665 |                      |   | 81,557                |  |            | 99,708  |  |   | 14,284,514
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Securities held to maturity                      |  |                |            |                      |   |                       |  |            |         |  |   |           
|Mortgage backed securities                       |  |                | 16,509     |                      |   | 236                   |  |            |        |  |   | 16,745    
|Obligations of states and political subdivisions |  |                | 469,367    |                      |   | 11,263                |  |            |        |  |   | 480,630   
|Preferred trust securities                       |  |                | 200,000    |                      |   | 40,000                |  |            |        |  |   | 240,000   
|Other corporate debt securities                  |  |                | 505,538    |                      |   | 8,107                 |  |            |        |  |   | 513,645   
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Total securities held to maturity                |  |                | 1,191,414  |                      |   | 59,606                |  |            |        |  |   | 1,251,020 
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Total securities                                 |  | $              | 15,494,079 |                      | $ | 141,163               |  | $          | 99,708  |  | $ | 15,535,534
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           

Investment securities having carrying values of $4,660,312 and $8,483,520 at December 31,
2005 and 2004, respectively, were pledged to secure deposits of the U.S. government and the Commonwealth of Virginia. The fair values of these securities were $4,635,521 and $8,437,456 at December 31, 2005 and 2004, respectively.

Investment securities having carrying values of $4,577,797 and $4,488,904 at December 31, 2005 and 2004, respectively, are pledged for retail
repurchase agreements. The estimated fair values of these securities were $4,516,900 and $4,460,010 at December 31, 2005 and 2004, respectively.



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The following tables show gross unrealized losses and fair value on investment securities, aggregated by
investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2005 and 2004. The current year unrealized losses on investment securities are a result of changes in interest
rates during the periods. All unrealized losses on investment securities are considered by management to be temporary given the credit ratings on these investment securities and the short duration of the unrealized loss.



|                                        |  |                      |           |                   |   |            |  |                  |           |            |   |                  |  |   |            |  |   |        
|--------------------------------------- |  | -------------------- | --------- | ----------------- | - | ---------- |  | ---------------- | --------- | ---------- | - | ---------------- |  | - | ---------- |  | - | -------
|                                        |  | At December 31, 2005
|                                        |  | Less Than 12 Months  |           | 12 Months or More |   | Total     
|                                        |  | Fair Value           |           | UnrealizedLosses  |   | Fair Value |  | UnrealizedLosses |           | Fair Value |   | UnrealizedLosses
|U.S. Treasury securities                |  | $                    |          |                   | $ |           |  | $                | 499,220   |            | $ | 864              |  | $ | 499,220    |  | $ | 864    
|Other U.S. government agency securities |  |                      |          |                   |   |           |  |                  | 7,859,731 |            |   | 115,840          |  |   | 7,859,731  |  |   | 115,840
|Marketable equity securities            |  |                      |          |                   |   |           |  |                  | 38,440    |            |   | 8,580            |  |   | 38,440     |  |   | 8,580  
|                                        |  |                      |           |                   |   |            |  |                  |           |            |   |                  |  |   |            |  |   |        
|Total temporarily impaired securities   |  | $                    |          |                   | $ |           |  | $                | 8,397,391 |            | $ | 125,284          |  | $ | 8,397,391  |  | $ | 125,284
|                                        |  |                      |           |                   |   |            |  |                  |           |            |   |                  |  |   |            |  |   |        
|                                        | 
|                                        |  | At December 31, 2004
|                                        |  | Less Than 12 Months  |           | 12 Months or More |   | Total     
|                                        |  | Fair Value           |           | UnrealizedLosses  |   | Fair Value |  | UnrealizedLosses |           | Fair Value |   | UnrealizedLosses
|U.S. Treasury securities                |  | $                    | 495,195   |                   | $ | 5,940      |  | $                |          |            | $ |                 |  | $ | 495,195    |  | $ | 5,940  
|Other U.S. government agency securities |  |                      | 8,047,316 |                   |   | 56,311     |  |                  | 2,477,815 |            |   | 33,547           |  |   | 10,525,131 |  |   | 89,858 
|Marketable equity securities            |  |                      | 43,110    |                   |   | 3,910      |  |                  |          |            |   |                 |  |   | 43,110     |  |   | 3,910  
|                                        |  |                      |           |                   |   |            |  |                  |           |            |   |                  |  |   |            |  |   |        
|Total temporarily impaired securities   |  | $                    | 8,585,621 |                   | $ | 66,161     |  | $                | 2,477,815 |            | $ | 33,547           |  | $ | 11,063,436 |  | $ | 99,708 
|                                        |  |                      |           |                   |   |            |  |                  |           |            |   |                  |  |   |            |  |   |        

The amortized cost and fair value of investment securities at December 31, 2005, by
contractual maturity, are shown below. Actual maturities will differ from contractual maturities since some securities may be called or prepaid prior to their contractual maturity:



|                                       |  |                               |           |                             |   |               |  |            |         |  |   |        
|-------------------------------------- |  | ----------------------------- | --------- | --------------------------- | - | ------------- |  | ---------- | ------- |  | - | -------
|                                       |  | Securities Available for Sale |           | Securities Held to Maturity
|                                       |  | AmortizedCost                 |           | Fair Value                  |   | AmortizedCost |  | Fair Value
|Due in one year or less                |  | $                             | 5,929,928 |                             | $ | 5,868,946     |  | $          |        |  | $ |       
|Due after one year through five years  |  |                               | 2,545,727 |                             |   | 2,490,005     |  |            | 194,488 |  |   | 197,116
|Due after five years through ten years |  |                               | 634,115   |                             |   | 647,237       |  |            |        |  |   |       
|Due after ten years                    |  |                               | 256,377   |                             |   | 278,490       |  |            | 486,748 |  |   | 503,740
|                                       |  |                               |           |                             |   |               |  |            |         |  |   |        
|Total                                  |  | $                             | 9,366,147 |                             | $ | 9,284,678     |  | $          | 681,236 |  | $ | 700,856
|                                       |  |                               |           |                             |   |               |  |            |         |  |   |        



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NOTE 5  LOANS

Loans consist of the following:



|                           |  |                |             |   |      |   |             |  
|-------------------------- |  | -------------- | ----------- | - | ---- | - | ----------- | -
|                           |  | At December 31 |            
|                           |  | 2005           |             |   | 2004 |  
|Commercial                 |  | $              | 17,927,074  |   |      | $ | 19,582,518  |  
|Real estate - mortgage     |  |                | 98,801,013  |   |      |   | 90,513,054  |  
|Real estate - construction |  |                | 10,013,033  |   |      |   | 9,042,071   |  
|Installment and consumer   |  |                | 4,665,853   |   |      |   | 5,595,735   |  
|                           |  |                |             |   |      |   |             |  
|Total loans:               |  |                | 131,406,973 |   |      |   | 124,733,378 |  
|                           |  |               
|Allowance for loan losses  |  |                | (1,335,001  | ) |      |   | (1,264,000  | )
|Unearned loan fees/costs   |  |                | 348,354     |   |      |   | 59,245      |  
|                           |  |                |             |   |      |   |             |  
|Loans net                  |  | $              | 130,420,326 |   |      | $ | 123,528,623 |  
|                           |  |                |             |   |      |   |             |  

Nonperforming assets were:



|                                        |  |                |         |      |   |        
|--------------------------------------- |  | -------------- | ------- | ---- | - | -------
|                                        |  | At December 31
|                                        |  | 2005           |         | 2004
|Nonaccrual loans (1)                    |  | $              | 225,934 |      | $ | 648,658
|Accruing loans past due 90 days or more |  |                | 4,476   |      |   | 14,629 
|                                        |  |                |         |      |   |        
|Total nonperforming loans               |  |                | 230,410 |      |   | 663,287
|                                        |  |               
|Real estate owned, net                  |  |                |        |      |   | 297,295
|                                        |  |                |         |      |   |        
|Total nonperforming assets              |  | $              | 230,410 |      | $ | 960,582
|                                        |  |                |         |      |   |        

---

|(1) | At December 31, 2005, includes $224,799 of restructured loans.
|--- | --------------------------------------------------------------

If interest on nonaccrual loans had been accrued, such income would have approximated $57,106 and $19,670 in 2005 and 2004, respectively, none of which was recognized in income.

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



|                           |  |                |           |   |      |   |           |  
|-------------------------- |  | -------------- | --------- | - | ---- | - | --------- | -
|                           |  | At December 31 |          
|                           |  | 2005           |           |   | 2004 |  
|Balance, beginning of year |  | $              | 1,264,000 |   |      | $ | 1,186,854 |  
|Provision for loan losses  |  |                | 33,010    |   |      |   | 453,000   |  
|Loans charged-off          |  |                | (50,628   | ) |      |   | (386,313  | )
|Recoveries                 |  |                | 88,619    |   |      |   | 10,459    |  
|                           |  |                |           |   |      |   |           |  
|Balance, end of year       |  | $              | 1,335,001 |   |      | $ | 1,264,000 |  
|                           |  |                |           |   |      |   |           |  



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The following is a summary of information pertaining to impaired loans:



|                                                      |  |                         |         |      |   |        
|----------------------------------------------------- |  | ----------------------- | ------- | ---- | - | -------
|                                                      |  | At December 31         
|                                                      |  | 2005                    |         | 2004
|Impaired loans without a valuation allowance          |  | $                       | 225,934 |      | $ | 651,391
|Impaired loans with a valuation allowance             |  |                         |        |      |   |       
|                                                      |  |                         |         |      |   |        
|Total impaired loans:                                 |  | $                       | 225,934 |      | $ | 651,391
|                                                      |  |                         |         |      |   |        
|Valuation allowance related to impaired loans         |  | $                       |        |      | $ |       
|                                                      |  |                         |         |      |   |        
|                                                      | 
|                                                      |  | Years Ended December 31
|                                                      |  | 2005                    |         | 2004
|Average investment in impaired loans (while impaired) |  | $                       | 532,005 |      | $ | 255,037
|Interest income recognized on impaired loans          |  | $                       |        |      | $ | 201    

NOTE 6  PREMISES AND EQUIPMENT

Premises and equipment consist of the following:



|                                  |  |                |            |   |      |   |            |  
|--------------------------------- |  | -------------- | ---------- | - | ---- | - | ---------- | -
|                                  |  | At December 31 |           
|                                  |  | 2005           |            |   | 2004 |  
|Land and improvements             |  | $              | 3,008,206  |   |      | $ | 873,839    |  
|Buildings and improvements        |  |                | 1,999,737  |   |      |   | 1,998,309  |  
|Leasehold improvements            |  |                | 209,463    |   |      |   | 7,951      |  
|Equipment, furniture and fixtures |  |                | 2,452,205  |   |      |   | 1,597,945  |  
|Fixed assets not in service       |  |                | 155,888    |   |      |   |           |  
|                                  |  |                |            |   |      |   |            |  
|                                  |  |                | 7,825,499  |   |      |   | 4,478,044  |  
|Less - accumulated depreciation   |  |                | (2,081,967 | ) |      |   | (1,952,245 | )
|                                  |  |                |            |   |      |   |            |  
|                                  |  | $              | 5,743,532  |   |      | $ | 2,525,799  |  
|                                  |  |                |            |   |      |   |            |  

Depreciation expense for the years ended December 31, 2005 and 2004 was $233,793 and
$152,812, respectively.

Total rent expense for the years ended December 31, 2005 and 2004 amounted to $153,834 and $75,810,
respectively.

In 2005, the Company incurred a $6,195 impairment charge related to equipment.

Future minimum lease payments, by year and in the aggregate, under noncancelable leases with remaining terms of one year or more at December 31,
2005 were as follows:



|           |  |   |          
|---------- |  | - | ---------
|2006       |  | $ | 96,322   
|2007       |  |   | 175,724  
|2008       |  |   | 121,770  
|2009       |  |   | 124,204  
|2010       |  |   | 126,688  
|2011- 2017 |  |   | 850,992  
|           |  |   |          
|           |  | $ | 1,495,700
|           |  |   |          



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NOTE 7  DEPOSITS

Interest-bearing deposits consist of the following:



|                                          |  |             |             |      |   |            
|----------------------------------------- |  | ----------- | ----------- | ---- | - | -----------
|                                          |  | December 31
|                                          |  | 2005        |             | 2004
|Money Market and NOWs                     |  | $           | 59,073,107  |      | $ | 33,987,021 
|Savings                                   |  |             | 4,664,622   |      |   | 6,628,114  
|Certificates of deposit $100,000 and over |  |             | 15,399,947  |      |   | 26,223,143 
|Other time deposits                       |  |             | 55,672,351  |      |   | 40,214,158 
|                                          |  |             |             |      |   |            
|                                          |  | $           | 134,810,027 |      | $ | 107,052,436
|                                          |  |             |             |      |   |            

At December 31, 2005 the scheduled maturities of time deposits are as follows:



|                    |  |   |           
|------------------- |  | - | ----------
|2006                |  | $ | 38,685,173
|2007                |  |   | 12,451,901
|2008                |  |   | 7,940,589 
|2009                |  |   | 8,910,968 
|2010 and thereafter |  |   | 3,083,667 
|                    |  |   |           
|                    |  | $ | 71,072,298
|                    |  |   |           

NOTE 8  SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE AND OTHER BORROWINGS

Securities sold under agreements to repurchase had carrying values of $4,577,979 and $4,488,902 and market values of $4,516,900 and $4,460,009 at
December 31, 2005 and 2004, respectively. Information concerning securities sold under agreements to repurchase is summarized as follows:



|                                               |  |             |           |   |      |   |           |  
|---------------------------------------------- |  | ----------- | --------- | - | ---- | - | --------- | -
|                                               |  | December 31 |          
|                                               |  | 2005        |           |   | 2004 |  
|Balance at end of year                         |  | $           | 4,235,393 |   |      | $ | 2,030,021 |  
|Average balance during the year                |  | $           | 3,005,359 |   |      | $ | 4,270,691 |  
|                                               |  |            
|Weighted average interest rate during the year |  |             | 2.91      | % |      |   | 0.75      | %
|Interest expense during the year               |  | $           | 87,532    |   |      | $ | 32,114    |  
|Maximum month-end balance during the year      |  | $           | 4,235,393 |   |      | $ | 7,352,608 |  

The Bank is a member of the FHLB of Atlanta, which had established, at December 31, 2005, a
credit availability for the Bank at 20.0% of total assets. At December 31, 2005, the Bank had outstanding an advance of $10.0 million at a fixed rate of 4.54%, maturing in March 2010.

At December 31, 2005, the Bank had a total of $10.0 million in approved lines of credit with correspondent banks with no outstanding balance.

At December 31, 2005, other short-term borrowings consisted of $50,000 of U.S. Treasury tax and loan deposit notes.



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NOTE 9  EARNINGS PER SHARE RECONCILIATION

The Company calculates its basic and diluted earnings per share (EPS) in accordance with SFAS No. 128  Earnings Per Share.
The components of the Companys EPS calculations are as follows:



|                                                  |  |                         |           |      |   |          
|------------------------------------------------- |  | ----------------------- | --------- | ---- | - | ---------
|                                                  |  | Years Ended December 31
|                                                  |  | 2005                    |           | 2004
|Net income (numerator, basic and diluted)         |  | $                       | 809,416   |      | $ | 1,667,379
|Weighted average shares outstanding (denominator) |  |                         | 1,709,405 |      |   | 1,682,637
|Earnings per common share - basic                 |  | $                       | 0.47      |      | $ | 0.99     
|                                                  |  |                        
|Effect of dilutive securities                     |  |                         |           |      |   |          
|                                                  |  |                        
|Weighted average shares outstanding               |  |                         | 1,709,405 |      |   | 1,682,637
|Effect of stock options                           |  |                         | 43,128    |      |   | 54,033   
|                                                  |  |                         |           |      |   |          
|Diluted average shares outstanding (denominator)  |  |                         | 1,752,533 |      |   | 1,736,670
|                                                  |  |                         |           |      |   |          
|Earnings per common share  assuming dilution     |  | $                       | 0.46      |      | $ | 0.96     

The difference in the number of shares used for basic earnings per share and diluted earnings per
share for each of the two years results solely from the dilutive effect of stock options. Options on 30,000 shares were not included in computing diluted earnings per share for the year ended December 31, 2005, because the effects of the
options were antidilutive.

NOTE 10  EMPLOYEE AND DIRECTOR BENEFIT PLANS

Stock Compensation Plans

At December 31, 2005, the Company had fixed stock compensation plans
for its employees and nonemployee directors. The Company applies Accounting Principles Board Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees, and related interpretations in accounting for its plans. For those companies
applying APB 25, FASB Statement No. 123, Accounting for Stock-Based Compensation,requires certain pro-forma disclosures of net income and earnings per share.

The Company maintains the Heritage Bankshares, Inc. 1987 and 1999 Stock Option Plans (Stock Option Plans) for the benefit of employees and nonemployee directors. Of the 480,000 shares authorized for option
grants under the Stock Option Plans, 440,000 shares were authorized for grants to employees and 40,000 shares were authorized for grants to nonemployee directors. At December 31, 2005, 108,400 shares remained available for future option grants
to employees and 1,332 shares remained available for future option grants to nonemployee directors.

The Board of Directors has general
discretionary authority to establish the terms of option grants made to employees under the Stock Option Plans. Under the 1999 Stock Option Plan, the option price for each employee grant may not be less than the fair market value of the
Companys shares on the date of the grant, and no option may be exercised more than ten years after the date of the grant. Nonemployee directors receive automatic option grants following the first annual meeting of the Companys
shareholders that is held after the directors are elected. The Board of Directors, in its sole discretion, determines the number of shares to be covered by each nonemployee director grant, the option price is 120% of the fair market value of the
Companys shares on the date of the grant, and no option may be exercised more than ten years after the date of the grant. The Board of Directors has general discretionary authority to determine the other terms of option grants to nonemployee
directors.

In 2006, the Companys Board of Directors approved the Heritage 2006 Equity Incentive Plan (2006 Incentive
Plan), which authorizes the grant of stock options, stock appreciation rights, restricted stock and certain other equity awards with respect to not more than 250,000 shares of the Companys common stock. The Board of Directors also
granted stock options to certain of its executives and nonemployee directors. The 2006 Incentive Plan and the outstanding option grants thereunder are subject to the approval of the shareholders of the Company within twelve (12) months after
July 26, 2006. Concurrently with its approval of the 2006 Incentive Plan, the Board of Directors terminated the Companys ability to issue new awards under the 1987 Stock Option Plan and 1999 Stock Option Plan, pending the approval by the
Companys shareholders of the 2006 Incentive Plan.



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A summary of the Companys stock option activity and related information is as follows:



|                                 |  |                         |   |      |                                |       |        |          |   |                               |   |     
|-------------------------------- |  | ----------------------- | - | ---- | ------------------------------ | ----- | ------ | -------- | - | ----------------------------- | - | ----
|                                 |  | Years Ended December 31
|                                 |  | 2005                    |   | 2004
|                                 |  | Shares                  |   |      | WeightedAverage Exercise Price |       | Shares |          |   | WeightedAverageExercise Price
|Outstanding at beginning of year |  | 104,786                 |   |      | $                              | 6.07  |        | 228,168  |   |                               | $ | 5.40
|Granted                          |  | 30,000                  |   |      |                                | 19.79 |        |         |   |                               |   |    
|Exercised                        |  | (7,486                  | ) |      |                                | 5.01  |        | (123,382 | ) |                               |   | 4.83
|Forfeited                        |  | (900                    | ) |      |                                | 3.25  |        |         |   |                               |   |    
|                                 |  |                         |   |      |                                |       |        |          |   |                               |   |     
|Outstanding at end of year       |  | 126,400                 |   |      |                                | 9.41  |        | 104,786  |   |                               |   | 6.07
|                                 |  |                         |   |      |                                |       |        |          |   |                               |   |     
|Options exercisable at year end  |  | 126,400                 |   |      |                                | 9.41  |        | 102,454  |   |                               |   | 6.01
|                                 |  |                         |   |      |                                |       |        |          |   |                               |   |     

The Company did not grant any options in 2004. The weighted average fair value of options granted
in 2005 was $5.34 and was determined as of the grant date using the Black-Scholes option pricing model, assuming the following weighted average factors: risk-free interest rate of 3.93%; volatility of 25.14%; dividend yield of 1.80%; and expected
life of 7.5 years.

SFAS No. 123 encourages all entities to adopt a fair value based method of accounting for employee stock
compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. However, it also allows an entity to continue to measure
compensation cost for those plans using the intrinsic value based method of accounting prescribed by APB Opinion No. 25 whereby compensation cost is the excess, if any, of the market price of the stock at the grant date (or other measurement
date) over the amount an employee must pay to acquire the stock. Stock options issued under the Companys stock option plan generally have no intrinsic value at the grant date and, under APB Opinion No. 25, no compensation cost is
recognized for them. The Company has elected to continue with the accounting methodology in APB Opinion No. 25 and, as a result, has provided pro forma disclosures of net income and earnings per share and other disclosures as if the fair value
based method of accounting had been applied.

Effective January 1, 2006, the Company adopted SFAS No. 123(R), Accounting for
Stock-Based Compensation (SFAS. 123(R)). SFAS 123(R) requires that the fair value of equity instruments, such as stock options, be recognized as an expense in the financial statements as services are performed.



|                                                                                                                                      |  |                         |          |   |      |   |           |  
|------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | -------- | - | ---- | - | --------- | -
|                                                                                                                                      |  | Years Ended December 31 |         
|                                                                                                                                      |  | 2005                    |          |   | 2004 |  
|Net income as reported                                                                                                                |  | $                       | 809,416  |   |      | $ | 1,667,379 |  
|Add: Stock-based employee compensation expense included in net income, net of related tax                                             |  |                         | 5        |   |      |   | 83        |  
|Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of related tax
effects |  |                         | (106,289 | ) |      |   | (2,235    | )
|                                                                                                                                      |  |                         |          |   |      |   |           |  
|Pro forma net income                                                                                                                  |  | $                       | 703,132  |   |      | $ | 1,665,227 |  
|                                                                                                                                      |  |                         |          |   |      |   |           |  
|Basic net income per share                                                                                                            |  |                         |          |   |      |   |           |  
|As reported                                                                                                                           |  | $                       | 0.47     |   |      | $ | 0.99      |  
|                                                                                                                                      |  |                         |          |   |      |   |           |  
|Pro forma                                                                                                                             |  | $                       | 0.41     |   |      | $ | 0.99      |  
|                                                                                                                                      |  |                         |          |   |      |   |           |  
|Diluted net income per share                                                                                                          |  |                         |          |   |      |   |           |  
|As reported                                                                                                                           |  | $                       | 0.46     |   |      | $ | 0.96      |  
|                                                                                                                                      |  |                         |          |   |      |   |           |  
|Pro forma                                                                                                                             |  | $                       | 0.40     |   |      | $ | 0.96      |  
|                                                                                                                                      |  |                         |          |   |      |   |           |  



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##### Table of Contents

Exercise prices for options outstanding and exercisable as of December 31, 2005, were as follows:



|                |                   |                     |         |                                                 |     |                               |   |                   |  |                               |  |   |      
|--------------- | ----------------- | ------------------- | ------- | ----------------------------------------------- | --- | ----------------------------- | - | ----------------- |  | ----------------------------- |  | - | -----
|                |                   | Options Outstanding |         | Options Exercisable                            
|Exercise Prices |                   | NumberOutstanding   |         | WeightedAverageRemainingContractualLife (Years) |     | WeightedAverageExercise Price |   | NumberExercisable |  | WeightedAverageExercise Price
|                | $            4.25 |                     | 9,600   |                                                 | 0.7 |                               | $ | 4.25              |  | 9,600                         |  | $ | 4.25 
|                | 4.75              |                     | 12,200  |                                                 | 0.7 |                               |   | 4.75              |  | 12,200                        |  |   | 4.75 
|                | 5.13              |                     | 14,000  |                                                 | 4.6 |                               |   | 5.13              |  | 14,000                        |  |   | 5.13 
|                | 6.15              |                     | 22,000  |                                                 | 4.4 |                               |   | 6.15              |  | 22,000                        |  |   | 6.15 
|                | 6.82              |                     | 1,000   |                                                 | 4.0 |                               |   | 6.82              |  | 1,000                         |  |   | 6.82 
|                | 7.25              |                     | 32,600  |                                                 | 3.6 |                               |   | 7.25              |  | 32,600                        |  |   | 7.25 
|                | 7.50              |                     | 3,000   |                                                 | 6.1 |                               |   | 7.50              |  | 3,000                         |  |   | 7.50 
|                | 12.03             |                     | 2,000   |                                                 | 6.9 |                               |   | 12.03             |  | 2,000                         |  |   | 12.03
|                | 19.79             |                     | 30,000  |                                                 | 9.1 |                               |   | 19.79             |  | 30,000                        |  |   | 19.79
|                |                   |                     |         |                                                 |     |                               |   |                   |  |                               |  |   |      
|                |                   |                     | 126,400 |                                                 | 4.8 |                               | $ | 9.41              |  | 126,400                       |  | $ | 9.41 
|                |                   |                     |         |                                                 |     |                               |   |                   |  |                               |  |   |      

Deferred Compensation Plan

In 1985, the Company entered into a deferred compensation and retirement arrangement with certain directors and subsequently with one officer. The Companys policy is to accrue the present value of estimated
amounts to be paid under the contracts over the required service period to the date the participant is fully eligible to receive the benefit. At December 31, 2005, and 2004, other liabilities included $771,390 and $793,967, respectively,
related to the deferred compensation plans. Compensation expense related to this plan was $50,834 and $336,942, for the years ended December 31, 2005 and 2004, respectively.

Employee Stock Ownership Plan

The Board of Directors adopted an Employees Stock Ownership Plan
(the ESOP) effective January 1, 1998. The ESOP covers substantially all employees after they have met eligibility requirements, and funds contributed to the plan are used to purchase outstanding common stock.

The Company recognized compensation expense related to the ESOP of $45,804 and $44,472 for the years ended December 31, 2005 and 2004, respectively.
Dividends received by the ESOP are used for administrative expenses of the plan. At December 31, 2005, the ESOP owns 20,732 shares. Stock purchases for the year ended December 31, 2005 totaled 1,649 shares, while 7,385 shares were
distributed to terminated employees. At December 31, 2005, the fair market value of the total shares held by the ESOP totaled $303,724.

401k
Retirement Program

Effective January 1, 1993, the Board of Directors adopted a Retirement Program (the 401K). Eligible
employees who have completed the required months of service are eligible to participate and make contributions. The Company makes employer matching contributions. The Company expensed $52,887 and $46,218 for the years ended December 31, 2005
and 2004, respectively.

NOTE 11  OTHER REAL ESTATE OWNED

The Company foreclosed on four properties in 1990 and 1991 and subsequently utilized the properties for investment income. Pursuant to a bank examination in 2004, the Company reclassified the properties to other real
estate owned at December 31, 2004, in the amount of $297,295. These properties were sold during 2005 and, at December 31, 2005, the Company had no other real estate owned.



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NOTE 12  OTHER INCOME AND OTHER EXPENSE

The components of other noninterest income are as follows:



|                               |  |                         |         |      |   |        
|------------------------------ |  | ----------------------- | ------- | ---- | - | -------
|                               |  | Years Ended December 31
|                               |  | 2005                    |         | 2004
|Consumer credit card fees      |  | $                       | 80,603  |      | $ | 79,878 
|ATM fees                       |  |                         | 85,932  |      |   | 76,282 
|Merchant discount fees         |  |                         | 51,624  |      |   | 49,820 
|Other                          |  |                         | 149,970 |      |   | 173,087
|                               |  |                         |         |      |   |        
|Total other noninterest income |  | $                       | 368,129 |      | $ | 379,067
|                               |  |                         |         |      |   |        

The components of other noninterest expense are as follows:



|                                |  |                         |           |      |   |        
|------------------------------- |  | ----------------------- | --------- | ---- | - | -------
|                                |  | Years Ended December 31
|                                |  | 2005                    |           | 2004
|ATM transaction                 |  | $                       | 103,240   |      | $ | 76,211 
|Credit card                     |  |                         | 81,989    |      |   | 72,371 
|Stationery and supplies         |  |                         | 144,671   |      |   | 72,043 
|Telephone                       |  |                         | 67,043    |      |   | 63,970 
|Postage                         |  |                         | 55,544    |      |   | 59,163 
|Courier                         |  |                         | 59,563    |      |   | 52,515 
|Service bureau expense          |  |                         | 60,017    |      |   | 49,530 
|Insurance expense               |  |                         | 54,234    |      |   | 39,266 
|Travel                          |  |                         | 47,977    |      |   | 33,836 
|Shareholder                     |  |                         | 35,092    |      |   | 30,292 
|Training                        |  |                         | 46,237    |      |   | 27,821 
|Loan servicing                  |  |                         | 61,305    |      |   | 27,011 
|FDIC insurance                  |  |                         | 18,238    |      |   | 18,159 
|Impairment  Bankers Investment |  |                         | 124,685   |      |   |       
|Other miscellaneous             |  |                         | 157,758   |      |   | 240,687
|                                |  |                         |           |      |   |        
|Total other noninterest expense |  | $                       | 1,117,593 |      | $ | 862,875
|                                |  |                         |           |      |   |        

NOTE 13  INCOME TAXES

The principal components of income tax expense are as follows:



|                                      |  |                         |         |      |   |          |  
|------------------------------------- |  | ----------------------- | ------- | ---- | - | -------- | -
|                                      |  | Years Ended December 31 |        
|                                      |  | 2005                    |         | 2004 |  
|Federal Income Tax Expense-Current    |  | $                       | 218,723 |      | $ | 786,930  |  
|Deferred Federal Income Tax (Benefit) |  |                         | 154,036 |      |   | (176,786 | )
|                                      |  |                         |         |      |   |          |  
|Income Tax Expense                    |  | $                       | 372,759 |      | $ | 610,144  |  
|                                      |  |                         |         |      |   |          |  



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A reconciliation of income tax expense calculated at the federal statutory rate and that shown in the
statements of income is summarized as follows:



|                                                                         |  |                         |         |   |      |   |          |  
|------------------------------------------------------------------------ |  | ----------------------- | ------- | - | ---- | - | -------- | -
|                                                                         |  | Years Ended December 31 |        
|                                                                         |  | 2005                    |         |   | 2004 |  
|Federal income tax expense - at 34% statutory rate                       |  | $                       | 401,939 |   |      | $ | 774,358  |  
|Effect of tax-exempt interest                                            |  |                         | (35,920 | ) |      |   | (35,001  | )
|Effect of Life insurance proceeds, premiums, and increases in value, net |  |                         | (5,133  | ) |      |   | (133,764 | )
|Other                                                                    |  |                         | 11,873  |   |      |   | 4,551    |  
|                                                                         |  |                         |         |   |      |   |          |  
|                                                                         |  | $                       | 372,759 |   |      | $ | 610,144  |  
|                                                                         |  |                         |         |   |      |   |          |  

A cumulative net deferred tax asset is included in other assets at December 31, 2005 and
2004. The components of the asset are as follows:



|                                                  |  |                |         |   |      |   |        
|------------------------------------------------- |  | -------------- | ------- | - | ---- | - | -------
|                                                  |  | At December 31
|                                                  |  | 2005           |         |   | 2004
|Deferred Tax Assets                               |  |                |         |   |      |   |        
|                                                  |  |               
|Deferred compensation                             |  | $              | 262,272 |   |      | $ | 269,949
|Allowance for loan losses                         |  |                | 370,238 |   |      |   | 359,015
|Valuation allowance on certain assets             |  |                |        |   |      |   | 98,478 
|Net depreciation on available-for-sale securities |  |                | 27,699  |   |      |   | 6,171  
|Other                                             |  |                | 33,310  |   |      |   | 14,754 
|                                                  |  |                |         |   |      |   |        
|Total Deferred Tax Assets                         |  |                | 693,519 |   |      |   | 748,367
|                                                  |  |                |         |   |      |   |        
|Deferred Tax Liabilities                          |  |                |         |   |      |   |        
|                                                  |  |               
|Deferred loan costs, net                          |  |                | 118,440 |   |      |   | 20,143 
|Investments in partnerships                       |  |                | (9,531  | ) |      |   | 23,185 
|Premises and equipment                            |  |                | 100,295 |   |      |   | 88,227 
|Other                                             |  |                | 645     |   |      |   | 634    
|                                                  |  |                |         |   |      |   |        
|Total Deferred Tax Liabilities                    |  |                | 209,849 |   |      |   | 132,189
|                                                  |  |                |         |   |      |   |        
|Net Deferred Tax Assets                           |  | $              | 483,670 |   |      | $ | 616,178
|                                                  |  |                |         |   |      |   |        

NOTE 14  COMMITMENTS AND CONTINGENCIES - RELATED PARTY

The Company entered into a lease with a related party to provide space for one retail banking office and the Banks operations center. This lease has
been classified as an operating lease for financial reporting purposes and expired December 31, 2004, at which time the lease was continued on a month-to-month basis. Total annual rent expense was $92,450 and $75,810 for the years 2005 and
2004, respectively.

The Bank also has a loan receivable from this related party, which is secured by the building and improvements that
include the retail banking office and the Banks operation center. The balance of this loan was $510,148 and $525,777 at December 31, 2005 and 2004, respectively.

NOTE 15  OTHER RELATED PARTY TRANSACTIONS

The Bank has loan and deposit transactions with
certain of its executive officers and directors, and with companies in which the officers and directors have a financial interest. Related party deposits amounted to $8,955,292 and $4,498,954 at December 31, 2005 and 2004, respectively. In
addition to related party deposits, securities sold under agreements to repurchase with related parties amounted to approximately $400,273 and $429,751 at December 31, 2005 and 2004, respectively.



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A summary of related party loan activity for the Bank is as follows during 2005:



|                           |  |   |          
|-------------------------- |  | - | ---------
|Balance, December 31, 2004 |  | $ | 6,675,533
|Originations 2005          |  |   | 6,277,058
|Repayments  2005          |  |   | 3,001,305
|                           |  |   |          
|Balance, December 31, 2005 |  | $ | 9,951,286
|                           |  |   |          

In the opinion of management, such related party loans are made in the ordinary course of business
at normal credit terms, including interest rate and collateral requirements and do not represent more than normal credit risk.

In the
ordinary course of business, the Company has engaged in transactions with certain of its directors companies for legal services, property management services and insurance.

Commitments to extend credit and letters of credit to related parties amounted to $3,894,014 and $3,117,495 at December 31, 2005 and 2004,
respectively.

NOTE 16  COMMITMENTS AND FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET CREDIT RISK

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

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

The Company uses the same credit policies in making commitments and conditional obligations as it does for
on-balance-sheet instruments. Unless otherwise noted, the Company requires collateral or other security to support financial instruments with credit risk. Contractual amounts for financial instruments whose contract amounts represent credit risk at
December 31, 2005 and 2004 were as follows:



|                             |  |      |            |      |   |           
|---------------------------- |  | ---- | ---------- | ---- | - | ----------
|                             |  | 2005 |            | 2004
|Commitments to extend credit |  | $    | 32,523,919 |      | $ | 28,655,169
|Standby letters of credit    |  |      | 338,244    |      |   | 621,753   
|Commitments to sell loans    |  |      | 1,491,000  |      |   | 1,269,350 
|                             |  |      |            |      |   |           
|                             |  | $    | 34,353,163 |      | $ | 30,546,272
|                             |  |      |            |      |   |           

As of December 31, 2005, the Company had $45,648,601 in deposits in financial institutions in
excess of amounts insured by the FDIC, the majority of which was on deposit at Bank of America.

NOTE 17  REGULATORY MATTERS

The Bank is subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital
requirements may result in certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Banks financial statements. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Banks assets, liabilities, and certain off-balance-sheet items as calculated under regulatory
accounting practices. The Banks capital amounts and classification are also subject to qualitative judgments by the regulators about components (such as interest rate risk), risk weighting, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the
table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes that, as of December 31, 2005, the Bank meets
all capital adequacy requirements to which it is subject.



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The Bank is well capitalized under the applicable regulatory framework. To be categorized as
well capitalized, the Bank must maintain the minimum total risk-based, Tier I risk-based, and Tier I leverage ratios set forth in the table below. There are no conditions or events that management believes have changed the Banks
categorization. Additionally, management believes that, as of December 31, 2005, the Company meets all capital adequacy requirements to which it is subject. At December 31, 2005, the Companys total risk-based capital, Tier 1
risk-based capital, and Tier 1 capital (leverage) ratios were 10.88%, 10.05% and 7.81%, respectively. For purposes of the risk-based capital calculations presented in the following table, loans held for investment have been risk-weighted 100%.

The capital amounts and ratios for the Company and the Bank as of December 31, 2005 and 2004 are presented in the following table:



|                                         |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|---------------------------------------- |  | ------ | ------ | ----- | ---------------------------- | - | ------ | --------------------------------------------------------------------- | ------ |  | --- | ------ |  | ----- | ------ |  | ---- | -
|(Dollars in thousands)                   |  | Actual |        |       | For Capital AdequacyPurposes |   |        | Minimum To Be WellCapitalized
UnderPrompt Corrective ActionProvisions |       
|                                         |  | Amount |        | Ratio |                              |   | Amount |                                                                       | Ratio  |  |     | Amount |  | Ratio |       
|At December 31, 2005                     |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Total Capital (to Risk-Weighted Assets)  |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 17,461 |       | 10.88                        | % |        | $                                                                     | 12,836 |  | 8.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 16,609 |       | 10.36                        | % |        | $                                                                     | 12,822 |  | 8.0 | %      |  | $     | 16,027 |  | 10.0 | %
|Tier 1 Capital (to Risk-Weighted Assets) |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 16,126 |       | 10.05                        | % |        | $                                                                     | 6,418  |  | 4.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 15,274 |       | 9.53                         | % |        | $                                                                     | 6,411  |  | 4.0 | %      |  | $     | 9,616  |  | 6.0  | %
|Tier 1 Capital (to Average Assets)       |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 16,126 |       | 7.81                         | % |        | $                                                                     | 8,258  |  | 4.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 15,274 |       | 7.45                         | % |        | $                                                                     | 8,205  |  | 4.0 | %      |  | $     | 10,257 |  | 5.0  | %
|                                         |  |        |        |       |                              |  
|At December 31, 2004                     |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Total Capital (to Risk-Weighted Assets)  |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 16,923 |       | 12.10                        | % |        | $                                                                     | 11,185 |  | 8.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 15,423 |       | 11.04                        | % |        | $                                                                     | 11,173 |  | 8.0 | %      |  | $     | 13,967 |  | 10.0 | %
|Tier 1 Capital (to Risk-Weighted Assets) |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 15,659 |       | 11.20                        | % |        | $                                                                     | 5,593  |  | 4.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 14,159 |       | 10.14                        | % |        | $                                                                     | 5,587  |  | 4.0 | %      |  | $     | 8,380  |  | 6.0  | %
|Tier 1 Capital (to Average Assets)       |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 15,659 |       | 10.20                        | % |        | $                                                                     | 6,144  |  | 4.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 14,159 |       | 9.29                         | % |        | $                                                                     | 6,093  |  | 4.0 | %      |  | $     | 7,617  |  | 5.0  | %

Federal and state banking regulations place certain restrictions on dividends paid and loans or
advances made by the Bank to the Company. The amount of dividends the Bank may pay to the Company, without prior approval, is limited to current year earnings plus retained net profits for the two preceding years. Loans or advances are limited to
10.0% of the Banks shareholders equity.

NOTE 18  DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

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

Cash, Due From Banks and Federal Funds Sold

For cash due from banks and federal funds sold, the
carrying amount is a reasonable estimate of fair value.



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Investment Securities

Fair values are based on quoted market prices. For unquoted securities, the fair value is estimated by the Company on the basis of financial and other information. Securities available for sale are recorded at fair
value.

Loans

The fair value of loans
is estimated by discounting the future estimated scheduled cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings.

The fair value of loans does not include the value of the customer relationship or the right to fees generated by the account.

Accrued Interest Receivable

The carrying amount of
accrued interest approximates fair value.

Stock in Federal Reserve Bank and Federal Home Loan Bank

The carrying value for FRB and FHLB stock approximates fair value.

Bank-Owned Life Insurance

The carrying value of life insurance approximates fair value, as this investment is carried at
cash surrender value.

Deposit Liabilities

The fair value of deposits with no stated maturities (which includes demand deposits, savings accounts, and money market deposits) is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of
deposit is estimated using a discounted cash flow model based on the rates currently offered for deposits of similar remaining maturities.

Deposit liabilities with no stated maturity are reported at the amount payable on demand without regard for the inherent funding value of these instruments. The Company believes that significant value exists in this funding source. The fair
value of deposits does not include the value of the customer relationship or the rights to fees generated by the account.

Federal Home Loan Bank
Advances

The fair value of FHLB advances is estimated using discounted cash flow analysis based on rates offered at the reporting date
for borrowings of similar remaining maturities.

Short-term Borrowings and Securities Sold Under Agreements to Repurchase

For short-term borrowings (which include securities sold under agreements to repurchase), the carrying amount is a reasonable estimate of fair value.

Accrued Interest Payable

The carrying
value of accrued interest payable is a reasonable estimate of fair value.

Loan Commitments and Standby Letters of Credit

The carrying value of notional principal amounts of loan commitments and standby letters of credit are reasonable estimates of fair value.



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The following table presents the carrying amounts and fair value of the Companys financial
instruments at December 31, 2005 and 2004.



|                                                                        |  |                        |         |            |   |                |  |            |         |  |   |        
|----------------------------------------------------------------------- |  | ---------------------- | ------- | ---------- | - | -------------- |  | ---------- | ------- |  | - | -------
|                                                                        |  | 2005                   |         | 2004      
|                                                                        |  | CarryingAmount         |         | Fair Value |   | CarryingAmount |  | Fair Value
|                                                                        |  | (Dollars in Thousands)
|Financial assets:                                                       |  |                        |         |            |   |                |  |            |         |  |   |        
|Cash and due from banks                                                 |  | $                      | 8,349   |            | $ | 8,349          |  | $          | 6,471   |  | $ | 6,471  
|Federal funds sold                                                      |  |                        | 45,831  |            |   | 45,831         |  |            | 1,407   |  |   | 1,407  
|Securities available for sale                                           |  |                        | 9,285   |            |   | 9,285          |  |            | 14,285  |  |   | 14,285 
|Securities held to maturity                                             |  |                        | 681     |            |   | 701            |  |            | 1,191   |  |   | 1,251  
|Loans held for investment                                               |  |                        | 130,420 |            |   | 130,339        |  |            | 123,529 |  |   | 123,473
|Loans held for sale                                                     |  |                        | 1,351   |            |   | 1,351          |  |            | 1,516   |  |   | 1,516  
|Accrued interest receivable                                             |  |                        | 684     |            |   | 684            |  |            | 593     |  |   | 593    
|Stock in FRB and FHLB                                                   |  |                        | 823     |            |   | 823            |  |            | 355     |  |   | 355    
|Bank-owned life insurance                                               |  |                        | 512     |            |   | 512            |  |            | 476     |  |   | 476    
|                                                                        |  |                        |         |           
|Financial Liabilities:                                                  |  |                        |         |            |   |                |  |            |         |  |   |        
|Deposits                                                                |  |                        | 172,765 |            |   | 173,640        |  |            | 133,079 |  |   | 133,998
|Federal Home Loan Bank Advance                                          |  |                        | 10,000  |            |   | 9,836          |  |            |        |  |   |       
|Short-term borrowing and securities sold under agreements to repurchase |  |                        | 4,285   |            |   | 4,285          |  |            | 3,821   |  |   | 3,821  
|Accrued interest payable                                                |  |                        | 378     |            |   | 378            |  |            | 232     |  |   | 232    



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NOTE 19  CONDENSED FINANCIAL INFORMATION OF HERITAGE BANKSHARES, INC.

(Parent Company Only)

The following condensed
financial statements of Heritage Bankshares, Inc. are presented below on a parent company only basis for the years indicated.



|                                                           |  |                         |            |   |      |   |            |  
|---------------------------------------------------------- |  | ----------------------- | ---------- | - | ---- | - | ---------- | -
|                                                           |  | At December 31          |           
|                                                           |  | 2005                    |            |   | 2004 |  
|Condensed Balance Sheets                                   |  |                         |            |   |      |   |            |  
|Assets                                                     |  |                         |            |   |      |   |            |  
|Cash                                                       |  | $                       | 128,337    |   |      | $ | 623,431    |  
|Investment in Heritage Bank                                |  |                         | 15,207,498 |   |      |   | 14,129,363 |  
|Investment in non-bank subsidiaries                        |  |                         | 161,069    |   |      |   | 161,069    |  
|Investment in securities available for sale, at fair value |  |                         | 105,515    |   |      |   | 112,674    |  
|Other assets                                               |  |                         | 639,408    |   |      |   | 734,031    |  
|                                                           |  |                         |            |   |      |   |            |  
|Total Assets:                                              |  | $                       | 16,241,827 |   |      | $ | 15,760,568 |  
|                                                           |  |                         |            |   |      |   |            |  
|Liabilities and Stockholders Equity                       |  |                         |            |   |      |   |            |  
|Other liabilities                                          |  | $                       | 169,670    |   |      | $ | 113,067    |  
|                                                           |  |                         |            |   |      |   |            |  
|Common stock                                               |  |                         | 8,573,340  |   |      |   | 8,535,910  |  
|Additional paid-in capital                                 |  |                         | 314,838    |   |      |   | 285,097    |  
|Retained earnings                                          |  |                         | 7,237,748  |   |      |   | 6,838,473  |  
|Accumulated other comprehensive income (loss)              |  |                         | (53,769    | ) |      |   | (11,979    | )
|                                                           |  |                         |            |   |      |   |            |  
|Stockholders equity                                       |  | $                       | 16,072,157 |   |      | $ | 15,647,501 |  
|                                                           |  |                         |            |   |      |   |            |  
|Total Liabilities and Stockholders Equity                 |  | $                       | 16,241,827 |   |      | $ | 15,760,568 |  
|                                                           |  |                         |            |   |      |   |            |  
|                                                           | 
|                                                           |  | Years Ended December 31 |           
|                                                           |  | 2005                    |            |   | 2004 |  
|Condensed Statements of Operations                         |  |                         |            |   |      |   |            |  
|Dividends from subsidiary bank                             |  | $                       | 410,141    |   |      | $ | 167,150    |  
|Equity in undistributed net income of subsidiaries         |  |                         | 622,758    |   |      |   | 1,554,977  |  
|Interest and dividend income                               |  |                         | 4,247      |   |      |   | 1,858      |  
|Other expenses                                             |  |                         | (338,356   | ) |      |   | (84,810    | )
|                                                           |  |                         |            |   |      |   |            |  
|Income before income taxes                                 |  |                         | 698,790    |   |      |   | 1,639,175  |  
|Benefit from income taxes                                  |  |                         | 110,626    |   |      |   | 28,204     |  
|                                                           |  |                         |            |   |      |   |            |  
|Net Income                                                 |  | $                       | 809,416    |   |      | $ | 1,667,379  |  
|                                                           |  |                         |            |   |      |   |            |  

Certain restrictions exist regarding the ability of the Bank to transfer funds to the Company in
the form of cash dividends, loans or advances. Pursuant to federal regulations, dividends are generally restricted to net profits, as defined, for the current year, plus retained net profits for the previous two years. The maximum amount available
for transfer from the Bank to the Company in the form of loans and advances is 10.0% of the Banks stockholders equity.



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Heritage Bankshares, Inc.

Statements of Cash Flows



|                                                      |  |                         |          |   |      |   |            |  
|----------------------------------------------------- |  | ----------------------- | -------- | - | ---- | - | ---------- | -
|                                                      |  | Years Ended December 31 |         
|                                                      |  | 2005                    |          |   | 2004 |  
|Cash flows from operating activities                  |  |                         |          |   |      |   |            |  
|Net income                                            |  | $                       | 809,416  |   |      | $ | 1,667,379  |  
|Undistributed net income of subsidiaries              |  |                         | (622,758 | ) |      |   | (1,554,977 | )
|Add (deduct) items not affecting cash during the year |  |                         |          |   |      |   |            |  
|Depreciation, amortization and accretion, net         |  |                         | 8        |   |      |   | 125        |  
|Exercise of stock options tax benefit                 |  |                         | 29,624   |   |      |   | 452,521    |  
|Loss on sale of investment                            |  |                         |         |   |      |   | 29,440     |  
|Changes in assets/liabilities, net                    |  |                         |          |   |      |   |            |  
|(Increase) decrease in other assets                   |  |                         | (395,385 | ) |      |   | (613,719   | )
|(Increase) decrease in other liabilities              |  |                         | 56,603   |   |      |   | (86,976    | )
|                                                      |  |                         |          |   |      |   |            |  
|Net cash provided by (used for) operating activities  |  |                         | (122,492 | ) |      |   | (106,207   | )
|                                                      |  |                         |          |   |      |   |            |  
|Cash flows from investing activities                  |  |                         |          |   |      |   |            |  
|Purchases of securities available for sale            |  |                         |         |   |      |   | (63,020    | )
|Purchase of investment                                |  |                         |         |   |      |   |           |  
|Proceeds from sale of investment                      |  |                         |         |   |      |   | 55,040     |  
|                                                      |  |                         |          |   |      |   |            |  
|Net cash used for investing activities                |  |                         |         |   |      |   | (7,980     | )
|                                                      |  |                         |          |   |      |   |            |  
|Cash flows from financing activities                  |  |                         |          |   |      |   |            |  
|Proceeds from exercise of stock options               |  |                         | 37,539   |   |      |   | 595,656    |  
|Cash dividends paid                                   |  |                         | (410,141 | ) |      |   | (362,027   | )
|                                                      |  |                         |          |   |      |   |            |  
|Net cash provided by (used for) financing activities  |  |                         | (372,602 | ) |      |   | 233,629    |  
|                                                      |  |                         |          |   |      |   |            |  
|Increase (decrease) in cash and cash equivalents      |  |                         | (495,094 | ) |      |   | 119,442    |  
|                                                      |  |                        
|Cash and cash equivalents at beginning of year        |  |                         | 623,431  |   |      |   | 503,989    |  
|                                                      |  |                         |          |   |      |   |            |  
|Cash and cash equivalents at end of year              |  | $                       | 128,337  |   |      | $ | 623,431    |  
|                                                      |  |                         |          |   |      |   |            |  

*    *    *    *    *



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ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.

On
December 22, 2005, PKF Witt Mares, PLC (Witt Mares) notified the President & CEO and the Chairman of the Audit Committee of the Company that it would decline to stand for reappointment as the Companys independent
registered public accounting firm for the year ending December 31, 2006. Witt Mares indicated that it was declining to stand for reappointment due to the fact that it will not have an SEC engagement partner available for the Companys 2006
audit when, pursuant to Rule 2.01(c)(6) of Regulation S-X, Witt Mares SEC engagement partner currently assigned to the Companys account will be required to rotate off the account.

At that time Witt Mares agreed to continue to serve, and did serve, as the Companys independent registered public accounting firm relative to the
restatement of its annual financial statements for the years ended December 31, 2003, and December 31, 2002, as well as the Companys financial statements for 2004, as reported in the Companys annual report on Form 10-KSB
for the year ended December 31, 2004, filed on June 9, 2006. Witt Mares also offered to serve, and the Audit Committee of the Company retained Witt Mares to serve, as the Companys independent registered accounting firm relative to
the Companys financial statements for the fiscal year ending December 31, 2005, as reported in this annual report on Form 10-KSB. Witt Mares also agreed to assist in facilitating a transition to a successor firm of independent
accountants.

Witt Mares performed audits on the Companys financial statements for the fiscal years ended December 31, 2005,
December 31, 2004 and December 31, 2003. Witt Mares reports did not contain an adverse opinion or a disclaimer of opinion, and were not modified as to uncertainty, audit scope or accounting principles.

In addition, during the fiscal years ended December 31, 2005, 2004 and 2003, and up to the date of this annual report on Form 10-KSB,



| |  | there have been no disagreements with Witt Mares on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which
disagreement(s), if not resolved to the satisfaction of Witt Mares, would have caused Witt Mares to make reference to the subject matter of the disagreement(s) in connection with its reports for such years, and
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | there were no reportable events as identified in Item 304(a)(1)(iv)(B) of Regulation S-B.
| | - | -------------------------------------------------------------------------------------------

ITEM 8A. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

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

In 2005, as further described in our annual report on Form 10-KSB for the year ended December 31, 2004 filed on June 9, 2006 (the
2004 Form 10-KSB), we conducted an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of December 31, 2005 and 2004. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer determined that our
disclosure controls and procedures were not effective to ensure that material information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported as and when
required. These ineffective disclosure controls and procedures, together with the material weaknesses in internal control over financial reporting described below, resulted in numerous accounting errors that required the Company to restate our
financial statements for 2003 and 2002, as well as unaudited financial information previously released for 2004, as described in detail in the 2004 Form 10-KSB. While we have taken steps to improve our controls and procedures, as further
described below, management once again concluded that the Companys internal controls and procedures with respect to financial reporting were not effective as of December 31, 2005.



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Internal Control Over Financial Reporting

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

In connection with the restatement effected in the 2004 Form 10-KSB,
and as part of our continuing assessment of internal control over financial reporting for the year ended December 31, 2005, we identified material weaknesses and significant deficiencies in internal control over financial reporting which are
described below. A material weakness in internal control over financial reporting is a control deficiency, or combination of control deficiencies, that result in there being more than a remote likelihood that a material misstatement of the annual or
interim financial statements will not be prevented or detected.

Our management identified significant deficiencies or material weaknesses
primarily in the Companys control environment, control activity, and information components of its internal controls. The Companys control environment was deficient because applicable personnel did not possess adequate knowledge and
expertise to prepare financial reports in accordance with all applicable requirements, did not properly assign authority and responsibility, and did not adequately organize, train, and develop its associates. The Company mistakenly believed that it
was permitted to disregard those generally accepted accounting principles that it believed to be immaterial, a position that is in contravention of Staff Accounting Bulletin 99. Control activities were deficient because of inadequate approval
procedures, the lack of sufficient reconciliations, inadequate segregation of duties, and the assignment of incompatible functions. Moreover, certain pertinent information was not identified, captured or retained in a form and pursuant to a
timetable that enabled our personnel to carry out their responsibilities. This latter weakness, in particular, caused the task of restating the Companys financial statements in the 2004 Form 10-KSB to be much more difficult and time consuming
than originally anticipated.

The material weaknesses and significant deficiencies in internal control over financial reporting resulted in
the following numerous errors in our financial statements for prior periods:



| |  | The Companys methods of accounting and record generation and maintenance for loan origination costs and for amortizing fees were inadequate. In misapplying Statement of
Financial Accounting Standards No. 91, Accounting for Non-Refundable Fees and Costs Associated with Originating or Acquiring Loans and Indirect Costs of Leases (FAS 91), the Company both miscalculated direct origination costs and
applied an incorrect amortization method.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The Companys practices and procedures for accounting for deferred compensation plans and associated life insurance and the maintenance of related rewards were inadequate
because management did not accrue the employers obligation according to the terms of the individual contracts over the required service period to the date the participants are fully eligible to receive the benefits. As a result, the Company
understated the required liability. It also incorrectly credited life insurance proceeds to the deferred compensation liability, failed to report certain insurance proceeds as income, and did not record an increase in cash surrender value of life
insurance contracts in the correct year.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The Company misapplied Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and the calculation of diluted earnings per
share thereunder. Because its accounting practices and procedures relating to the exercise of stock options were inadequate, a tax benefit from option exercises was incorrectly reflected as an income tax expense reduction instead of solely as an
increase in the Companys additional paid-in capital, erroneously increasing the Companys net income and earnings per share.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The Companys accounting practices and procedures in a variety of other areas were also inadequate, requiring adjustments to correct several other errors relating to the
impairment of certain loans, the failure to record depreciation expense for certain properties, the incorrect recording of employer 401(k) matching contributions, the failure to record an impairment of certain long-lived assets as a charge to
earnings, errors in income tax expenses, and additional miscellaneous accounting errors.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The above errors are described in additional detail in Item 6, Managements Discussion and Analysis and Analysis of Financial Condition and Results of Operations
 Restatement of Consolidated Financial Statements in the 2004 Form 10-KSB.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Although many of the weaknesses and deficiencies have not been fully remediated, we have adopted and
implemented numerous measures in connection with our ongoing efforts to improve our internal control processes, some of which were enhanced further or implemented in connection with the restatement process. These measures include the following:



| |  | We have recruited new personnel to our finance organization who have expertise in financial controls and reporting, including a new chief financial officer and a corporate
controller, made other changes in finance personnel, and retained outside experts to improve the overall quality and level of experience of our finance organization globally.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We have reorganized our finance and general and administrative organizations to create a single global organization to improve financial oversight.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We have made changes in our organizational structure to provide a clearer segregation of responsibilities in connection with account reconciliations, manual journal entries, and the
preparation and review of documentation to support our quarterly and annual financial statements.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We have implemented a global account reconciliation policy which requires the monthly reconciliation of all balance sheet accounts and the use of standard methodology and templates
for account reconciliations.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

We continue to implement remedial measures in response to specific accounting and reporting
issues identified during the restatement. However, much work remains and, given our small size, we have limited resources to devote to this significant task. Future remedial measures will include adding personnel and systems as well as making
additional organizational changes to improve supervision and increased training for finance and accounting personnel. We will continue to develop new policies and procedures and educate and train our employees on our existing policies and procedures
in our effort to constantly improve our internal controls and control environment.

Managements evaluation of the Companys
internal control over financial reporting is not complete. In connection with its ongoing evaluation, management may identify additional control deficiencies and once management has completed its evaluation of all control deficiencies, management
may determine that these deficiencies, either alone or in combination with others, constitute one or more material weaknesses. Furthermore, our controls and procedures are not capable of preventing all instances of error or fraud. A control system,
no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system will be attained. Our controls and procedures can be circumvented by the individual acts of some persons, by
collusion of two or more people or by management override of the control. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected on a timely basis.

As a part of the Companys preparation for compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, the Company will
continue to evaluate the effectiveness of its internal controls and procedures on an ongoing basis, and will take further action as appropriate. Section 404 requires the Companys management to report on, and the auditors to attest to, the
effectiveness of the Companys internal control structure and procedures for financial reporting as of our fiscal year ended December 31, 2007. While the efforts needed to completely remediate the internal control material weakness as
described above will be challenging, and there can be no guarantees, the Company is planning to remediate these deficiencies by such date. In the event the Company has one or more material weaknesses in internal controls at December 31, 2007,
the Companys management will disclose such weakness in its report and will not be able to conclude that the Companys internal control over financial reporting was effective at such date. Similarly, the Company believes any such material
weakness would be referenced in an adverse attestation report from the auditors.

Other than as described above, there were no changes in
the Companys internal control over financial reporting in the quarter ended December 31, 2005 that materially affected, or are reasonably likely to materially affect, the Companys internal control over financial reporting.

ITEM 8B. OTHER MATTERS

None.



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Part III

ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT

Directors and Executive Officers

The following table sets forth the names and ages of our directors and executive officers,
together with their principal offices with the Company, as of the date of this Form 10-KSB.



|                       |  |     |  |                                                 |  |               |  
|---------------------- |  | --- |  | ----------------------------------------------- |  | ------------- | -
|Name                   |  | Age |  | Position                                        |  | DirectorSince |  
|Lisa F. Chandler       |  | 52  |  | Director                                        |  | 1998          |  
|                       |  |     | 
|James A. Cummings      |  | 64  |  | Director                                        |  | 1992          |  
|                       |  |     | 
|Wendell C. Franklin    |  | 61  |  | Director                                        |  | 2005          | *
|                       |  |     | 
|F. Dudley Fulton       |  | 57  |  | Director                                        |  | 1988          |  
|                       |  |     | 
|John O. Guthrie        |  | 57  |  | Chief Financial Officer                         |  |              |  
|                       |  |     | 
|Michael S. Ives        |  | 54  |  | Director, President and Chief Executive Officer |  | 2005          | *
|                       |  |     | 
|Stephen A. Johnsen     |  | 61  |  | Director and Secretary of the Board             |  | 1984          |  
|                       |  |     | 
|Thomas G. Johnson, III |  | 37  |  | Director                                        |  | 2002          |  
|                       |  |     | 
|David L. Kaufman       |  | 50  |  | Director                                        |  | 2005          | *
|                       |  |     | 
|Charles R. Malbon, Jr. |  | 56  |  | Director                                        |  | 2005          | *
|                       |  |     | 
|Peter M. Meredith, Jr. |  | 54  |  | Director and Chairman of the Board              |  | 1992          |  
|                       |  |     | 
|L. Allan Parrott, Jr.  |  | 40  |  | Director                                        |  | 2002          |  
|                       |  |     | 
|Ross C. Reeves         |  | 58  |  | Director                                        |  | 1994          |  
|                       |  |     | 
|Harvey W. Roberts, III |  | 61  |  | Director and Vice-Chairman of the Board         |  | 1993          |  
|                       |  |     | 
|Howard M. Webb         |  | 69  |  | Director                                        |  | 2005          | *
|                       |  |     | 
|Barbara Zoby           |  | 54  |  | Director                                        |  | 2005          | *

---

|* | The Board of Directors appointed these individuals as directors on April 27, 2005 (other than Mr. Ives, who was appointed on February 7, 2005), subject to re-election
by the Companys shareholders at their next annual meeting, in accordance with applicable Virginia law.
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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The following is a brief description of the business experience of the Companys directors and
executive officers during the past five years.

Ms. Chandler is the Executive Vice President of Nancy Chandler Associates, a
residential real estate brokerage company, in Norfolk, Virginia.

Mr. Cummings is the President of Southern Atlantic Label Company,
Inc., a manufacturer, in Chesapeake, Virginia.

Mr. Franklin is a Senior Vice President and a Partner of S.L. Nusbaum Realty Company, a
commercial real estate, leasing and brokerage firm, in Norfolk, Virginia.

Mr. Fulton is the President and Chief Executive Officer of
USI/Henderson & Phillips, an insurance brokerage and financial services company, in Norfolk, Virginia.

Mr. Guthrie is the
Chief Financial Officer of Heritage Bankshares, Inc. and Heritage Bank and joined the Company in February 2005. Prior to joining the Company, Mr. Guthrie was the Chief Financial Officer of CENIT Bancorp, Inc., in Norfolk, Virginia, for nearly
eighteen years.

Mr. Ives is the President and Chief Executive Officer of Heritage Bankshares, Inc. and Heritage Bank. Prior to joining
the Company in February 2005, Mr. Ives was the Chief Executive Officer of the Hampton Roads Market of SouthTrust Bank; before that, Mr. Ives served as President and Chief Executive Officer of CENIT Bancorp, Inc. for nearly fifteen years.

Mr. Johnsen is the Executive Vice President of Flagship Group, Ltd., an insurance and financial services company, in Norfolk,
Virginia.

Mr. Johnson is a Senior Vice President and Partner of S.L. Nusbaum Realty Company, a commercial real estate, leasing and
brokerage firm, in Norfolk, Virginia.

Mr. Kaufman is the Senior Managing Director of Envest Holdings LLC, a venture capital company,
in Norfolk, Virginia.

Mr. Malbon is the President of Tank Lines, Inc., an oil distributor, in Virginia Beach, Virginia.

Mr. Meredith is the Chairman and Chief Executive Officer of Meredith Construction Co., Inc., a general contractor, in Norfolk, Virginia.
Mr. Meredith also has served as Chairman of the Board and a Director of Waterside Capital Corporation, a reporting company located in Norfolk, Virginia, since 1994.

Mr. Parrott is the President of Tidewater Fleet Supply, LLC, a wholesale auto parts distributor, in Chesapeake, Virginia.

Mr. Reeves is an attorney with Willcox & Savage, P.C., a law firm, in Norfolk, Virginia.

Mr. Roberts is a retired Certified Public Accountant. Prior to his retirement, Mr. Roberts was a principal in the accounting firm McPhillips, Roberts & Deans, PLC, in Norfolk, Virginia.

Mr. Webb is a Director of ColonialWebb Contractors Co., a mechanical contractor, in Norfolk, Virginia. Mr. Webb was Chief Executive Officer of
Webb Technologies, Inc. from 1999 through 2004.

Ms. Zoby is the President and Chief Executive Officer of Yukon Lumber Co., a specialty
lumber firm, in Norfolk, Virginia.

The Companys Board of Directors currently consists of 15 members and is divided into three
classes serving staggered three-year terms. Directors for each class will be elected at the annual meeting of shareholders held in the year in which the term for that class expires and will serve for three years.

Family Relationships

The Company is not aware of any
family relationships between any director, executive officer or person nominated or selected by the Company to become a director or executive officer.



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Certain Legal Proceedings

The Company is not aware of the involvement during the past five years of any director, executive officer or person nominated or selected by the Company to become a director or executive officer in any of the
following legal proceedings that is material to an evaluation of the ability or integrity of any such person:



| |  |  | Any bankruptcy petition filed by or against any business of which such person was a general partner or executive officer either at the time of the bankruptcy or within two years
prior to that time;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Any conviction in a criminal proceeding or being subject to a pending criminal proceeding (excluding traffic violations and other minor offenses);
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Being subject to any order, judgment, or decree, not subsequently reversed, suspended or vacated, of any court of competent jurisdiction, permanently or temporarily enjoining,
barring, suspending or otherwise limiting such persons involvement in any type of business, securities or banking activities; or
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Being found by a court of competent jurisdiction (in a civil action), the SEC or the Commodity Futures Trading Commission to have violated a federal or state securities or
commodities law, and the judgment has not been reversed, suspended, or vacated.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Audit Committee Financial Expert

The Audit Committee of the Companys Board of Directors has not designated an audit committee financial expert, as defined under
Item 401(e) of Regulation S-B. While the Audit Committee does not currently have an audit committee financial expert, the committee (as currently comprised) provides a blend of business backgrounds, all of which include significant experience
with financial matters; the Board of Directors further believes that the committee members, taken as a whole, have the attributes identified in Item 401(e)(2) of Regulation S-B and thus it is not necessary to designate one person as an expert.

Compliance with Section 16(a) of the Exchange Act

Section 16(a) of the Exchange Act requires the Companys directors, executive officers and persons who beneficially own greater than ten percent (10%) of the Companys common stock (the
Reporting Persons) to file reports relating to their ownership and changes in ownership of Company common stock with the Securities and Exchange Commission (the SEC). Reporting Persons are required by SEC regulations to
furnish to the Company copies of all Section 16(a) reports.

Based solely on its review of copies of such reports, the Company
believes that all required reports were filed on a timely basis during the year ended December 31, 2005, except as follows:



| |  |  | Mr. Ives filed one late Form 4 related to one transaction that was not timely reported.
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | Mr. Parrott filed one late Form 4 related to one transaction that was not timely reported.
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | Ms. Zoby filed one late Form 4 related to one transaction that was not timely reported.
| | - |  | ---------------------------------------------------------------------------------------

In addition, based solely on its review of copies of such reports, the Company believes that all reports required to have been filed through
September 30, 2006 have been filed on a timely basis, except as follows:



| |  |  | Mr. Johnsen filed one late Form 4 related to one transaction that was not timely reported.
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | Ms. Chandler filed one late Form 4 related to one transaction that was not timely reported.
| | - |  | -------------------------------------------------------------------------------------------

Code of Ethics

The Company has adopted a Code of Ethics that applies to its Chief Executive Officer
and Chief Financial Officer. The Code of Ethics summarizes the legal, ethical and regulatory standards that such individuals must follow and is a reminder to all of the Companys directors and executive officers of the seriousness of that
commitment. As adopted, the Code of Ethics sets forth written standards that are designed, among other things, to deter wrongdoing and to promote:



| |  |  | honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | compliance with applicable governmental laws, rules and regulations;
| | - |  | --------------------------------------------------------------------



| |  |  | the prompt internal reporting of violations of the Code of Ethics to an appropriate person or persons identified in the Code of Ethics; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | accountability for adherence to the Code of Ethics.
| | - |  | ---------------------------------------------------



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A copy of the Companys Code of Ethics may be obtained by any person, without charge, by accessing
the Companys web site at: http://www.heritagebankva.com/CorporateNews/CodeOfEthics.aspx.

ITEM 10. EXECUTIVE COMPENSATION

Summary Compensation Table

The summary compensation table below sets forth the particulars of compensation paid or earned to (in each case as applicable) the following individuals
(named executive officers) during the fiscal years ended December 31, 2005, 2004 and 2003:



| |  |  | our companys Chief Executive Officer;
| | - |  | --------------------------------------



| |  |  | each of our companys four most highly compensated executive officers who were serving as executive officers, and whose total salary and bonus exceeded $100,000 per year; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | up to two additional individuals for whom disclosure would have been provided above but for the fact that the individual was not serving as an executive officer of the Company at
the end of the applicable fiscal years.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Please also see the additional disclosures regarding certain named
executive officers set forth below.

Summary Compensation Table



|                                                                     |  |              |  |                     |                      |                                                                 |   |                            |  |          |  |   |                
|-------------------------------------------------------------------- |  | ------------ |  | ------------------- | -------------------- | --------------------------------------------------------------- | - | -------------------------- |  | -------- |  | - | ---------------
|                                                                     |  |              |  | Annual Compensation |                      | Long-Term Compensation Awards Securities Underlying
Options (#) |   | All Other Compensation (1)
|Name and Principal Position                                          |  | Year         |  | Salary              |                      | Bonus                                                           |   |                           
|Michael S. Ives President and Chief Executive Officer                |  | 200520042003 |  | $                   | 154,500            |                                                                 | $ | 70,000                   |  | 30,000 |  | $ | 4,936        
|                                                                     |  |              |  |                     |                     
|John O. Guthrie Executive Vice President and Chief Financial Officer |  | 200520042003 |  | $                   | 99,167             |                                                                 | $ | 50,000                   |  |       |  | $ | 3,226        
|                                                                     |  |              |  |                     |                     
|Donald F. Price, President (2) First Executive Vice President        |  | 200520042003 |  | $                   | 32,878115,350101,113 |                                                                 | $ | 30,00015,27131,818         |  |       |  | $ | 1,3075,2164,606
|                                                                     |  |              |  |                     |                     
|Peter M. Meredith, Jr. (3) Chief Executive Officer                   |  | 200520042003 |  | $                   |                   |                                                                 | $ |                         |  |       |  | $ |             

---

|(1) | Includes, in the case of Mr. Ives, $4,626 contributed to the Banks 401(k) Plan by the Bank in 2005; and $310 representing taxable compensation related to group life
insurance in 2005.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Includes, in the case of Mr. Guthrie, $2,940 contributed to the Banks 401(k) Plan by the Bank
in 2005; and $286 representing taxable compensation related to group life insurance in 2005.

Includes, in the case of Mr. Price,
$1,221, $5,072 and $4,492 contributed to the Banks 401(k) Plan by the Bank in 2005, 2004 and 2003, respectively; and $86, $144 and $114 representing taxable compensation related to group term life insurance in 2005, 2004 and 2003,
respectively.

|(2) | Includes, in salary, $3,354, $9,683 and $7,363 related to incentive based commission compensation paid in 2005, 2004 and 2003, respectively; and $4,606, $2,167 and $2,083 paid in
2005, 2004 and 2003, respectively, for unused vacation.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Mr. Meredith served between November 2004 and February 2005 without compensation as further described below.
|--- | ------------------------------------------------------------------------------------------------------------

Robert J. Keogh, the Companys former Chief Executive Officer, passed away in November 2004. Following Mr. Keoghs death, Peter M.
Meredith, Jr., then serving as Chairman of the Board of Directors, was appointed Chief Executive Officer of the Company and Mr. Price was appointed President of the Company.



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On February 7, 2005, Michael S. Ives was elected President and Chief Executive Officer of the
Company and the Bank. Contemporaneously with Mr. Ives election, Mr. Meredith resigned as Chief Executive Officer of the Company and Mr. Price resigned as President of the Company. (Mr. Meredith continued as Chairman of the Board
of Directors of the Company, and Mr. Price assumed the new role of President of the Norfolk Region of the Company.) Mr. Price resigned as President of the Norfolk Region of the Company later in February 2005.

The Company and Mr. Ives entered into an Employment Agreement dated February 7, 2005 (please see the Companys current report on Form 8-K
filed on February 9, 2005). The Employment Agreement provided for (i) an initial term that began on February 7, 2005 and ends on December 31, 2009; (ii) an initial annual salary of $200,000, subject to annual review, plus
the opportunity to earn annual incentive bonuses; (iii) an employment inducement grant of a fully-vested option to purchase 30,000 shares of Company common stock; (iv) a commitment to grant to Mr. Ives the option to acquire 50,000
additional shares of Company common stock under a future amended stock option plan; (v) severance payments by the Company to Mr. Ives if his employment is terminated in certain circumstances, including severance payments upon the
termination of his employment in connection with a change of control of the Company, all as further described below; and (vi) a $500 monthly automobile allowance and payment of certain club membership dues.

Effective as of June 30, 2006, the Company and Mr. Ives amended his Employment Agreement (please see the Companys current report on
Form 8-K filed on July 7, 2006). Pursuant to the Amendment, (i) Mr. Ives annual salary was continued at the 2005 level of $200,000 per year, eliminating certain incentive bonuses and the potential repricing of
Mr. Ives option for 30,000 shares of Company stock provided for in the original Employment Agreement; (ii) the Company committed to grant Mr. Ives the option to acquire 70,000 shares of Company common stock under an amended
stock option plan (the Option Plan) the Company anticipates will be adopted in 2006, with such options generally vesting in equal installments over five years commencing on December 31, 2006 (assuming adoption of the Option Plan in
2006), subject to accelerated vesting in certain circumstances and continued vesting if Mr. Ives retires after attaining age 55 (the Companys commitment for the 70,000 options to be granted under the Option Plan pursuant to the Amendment
superseded the Companys commitment under the original Employment Agreement to grant Mr. Ives 50,000 incentive options, as those options were never granted); and (iii) the Company committed to grant to Mr. Ives a limited
alternative stock appreciation right (the LASAR) for the appreciation of 70,000 shares of Company common stock. Pursuant to a Limited Alternative Stock Appreciation Right Agreement dated August 23, 2006 (please see the
Companys current report on Form 8-K filed on August 28, 2006), the Company granted the LASAR to Mr. Ives; the LASAR is exercisable only upon the change of control of the Company, and the LASAR is void upon the approval of the
Option Plan by the Companys shareholders.

The Company and Mr. Guthrie entered into an Employment Agreement dated June 9,
2006 (please see the Companys annual report on Form 10-KSB for the year ended December 31, 2004, filed on June 9, 2006). The Employment Agreement (i) has an initial term that began on May 1, 2005 and ends on
April 30, 2007; (ii) provides for an initial annual salary of $120,000, which is subject to at least annual review and was increased to $123,600 as of January 1, 2006; and (iii) provides in certain events for severance payments
by the Company to Mr. Guthrie if his employment is terminated, including severance payments upon the termination of his employment in connection with a change of control of the Company, all as further described below.



74



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The table below shows the present value of severance amounts that would be payable to Mr. Ives and
Mr. Guthrie under the employment agreements described above upon certain events resulting in termination of their employment with the Company. For purposes of calculating these amounts, we have assumed that the date of termination is
November 1, 2006 and that the value of a share of the Companys common stock on such date is $16.75. All amounts include accrued vacation and sick leave.



|                                           |  |      |           |         |   |        
|------------------------------------------ |  | ---- | --------- | ------- | - | -------
|                                           |  | Ives |           | Guthrie
|Resignation for Good Reason                |  | $    | 604,319   |         | $ | 124,098
|Resignation without Good Reason            |  | $    | 26,923    |         | $ | 4,435  
|Termination without Cause                  |  | $    | 604,319   |         | $ | 124,098
|Termination with Cause                     |  | $    | 26,923    |         | $ | 4,435  
|Death                                      |  | $    | 43,590    |         | $ | 14,735 
|Disability                                 |  | $    | 35,256    |         | $ | 9,585  
|Retirement                                 |  | $    | 26,923    |         | $ | 4,435  
|Company payment upon Change of Control (1) |  | $    | 1,038,257 |         | $ | 181,287

---

|(1) | Payable if employment is terminated without cause or the executive resigns for good reason within twelve (12) months after a change of control of the Company. Includes, in the
case of Mr. Ives, $83,300 payable upon acceleration and exercise of the LASAR and $294,700 for reimbursement of excise taxes.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Option/SAR Grants Table

The following table provides information concerning stock options granted to the Companys
named executive officers in 2005:

Option/SAR Grants in Last Fiscal Year*

Individual Grants



|                |  |                                                  |  |                                                        |   |  |                               |       |                 |         
|--------------- |  | ------------------------------------------------ |  | ------------------------------------------------------ | - |  | ----------------------------- | ----- | --------------- | --------
|Name            |  | Number
ofSecuritiesUnderlyingOptions Granted (#) |  | % of Total Options Granted to Employees In Fiscal
Year |   |  | Exercise Or Base Price ($/Sh) |       | Expiration Date
|Michael S. Ives |  | 30,000                                           |  | 100                                                    | % |  | $                             | 19.79 |                 | 2/8/2015

---

|* | As noted above, pursuant to a Limited Alternative Stock Appreciation Agreement dated August 23, 2006, the Company granted to Mr. Ives a LASAR for the appreciation of
70,000 shares of the Companys common stock.
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



75



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Aggregate Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values

The following table provides certain information concerning each exercise of stock options during the fiscal year ended
December 31, 2005 by named executive officers and the fiscal year-end holdings and value of unexercised options:

Aggregate Option Exercises in
Last Fiscal Year and FY-End Option Values



|                |  |                           |  |               |        |                                                                                                         |          |                                                                             |   |           |    
|--------------- |  | ------------------------- |  | ------------- | ------ | ------------------------------------------------------------------------------------------------------- | -------- | --------------------------------------------------------------------------- | - | --------- | ---
|Name            |  | SharesAcquired onExercise |  | ValueRealized |        | Number of Shares ofCommon Stock UnderlyingUnexercised Options at FY- End
2005 Exercisable/Unexercisable |          | Value of UnexercisedIn-the-Money Options atFY-End Exercisable/Unexercisable |  
|Michael S. Ives |  |                          |  |               |       |                                                                                                         | 30,000/ |                                                                             |   | /       |    
|Donald F. Price |  | 4,000                     |  | $             | 53,000 |                                                                                                         | 17,000/ |                                                                             | $ | 154,160/ | (1)

---

|(1) | The market value of the Companys common stock at December 31, 2005, was $14.65 per share, and the exercise price for in-the-money-options was $4.25 on 4,000 shares, $4.75
on 4,000 shares, $5.13 on 3,000 shares, and $7.25 on 6,000 shares.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Compensation of Directors

Directors of the Company and directors of the Bank receive $500 for each Board of Directors meeting attended and $150 for each committee meeting
attended. Committee Chairs receive $200 for each committee meeting chaired.

Under the terms of the 1999 Stock Option Plan,
non-employee directors are also entitled to receive an automatic award of stock options following the first annual meeting of the shareholders of the Company that is held after such director is elected to be a member of the Board of
Directors. The amount of shares covered by each automatic award of stock options is determined in the sole discretion of the Board of Directors.

Stephen A. Johnsen, a member of the Board of Directors, and the Bank entered into a deferred compensation arrangement in 1985 pursuant to which Mr. Johnsen deferred $12,000 of his directors fees. The
agreement provides for the Bank to pay Mr. Johnsen a retirement benefit of $3,355 per month for 120 months beginning on April 1 following his attainment of age 70. The agreement further provides that if Mr. Johnsen dies before his
retirement benefit begins, the Bank will pay his designated beneficiary $1,976 per month for 120 months thereafter. Similar arrangements were made for the other outside directors of the Bank serving in 1985 and for a number of years thereafter. Over
the years, all of the participants in the arrangement except Mr. Johnsen have retired from Board service. The Bank is the owner and beneficiary of an insurance policy on the life of Mr. Johnsen with a total death benefit of $177,097 at
December 31, 2005.



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ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The following table contains information about the beneficial ownership of the Companys common stock as of September 30, 2006, by each director, by each of the Companys named executive officers, by each person known by the
Company to be the holder of 5% or more of the Companys outstanding common stock, and all of the Companys directors and named executive officers as a group. As of September 30, 2006, 1,927,852 shares of the Companys common
stock were issued and outstanding. In calculating the number of shares of common stock which are beneficially owned (and thus the percentage of common stock beneficially owned) a person is deemed to own common stock if that person has the right
to acquire beneficial ownership of common stock within sixty (60) days through the exercise of any option, warrant or right, or through the conversion of any security. Except as otherwise noted below, solely for purposes of this Form 10-KSB,
the address for each person listed above is 1450 S. Military Highway, Chesapeake, Virginia 23320.



|                                                                                                                     |  |                                     |          |  |                  |  
|-------------------------------------------------------------------------------------------------------------------- |  | ----------------------------------- | -------- |  | ---------------- | -
|Name and Address of Beneficial Owner                                                                                 |  | Number of Shares Beneficially Owned |          |  | Percent of Class |  
|Lisa F. Chandler                                                                                                     |  | 8,509                               | (1)      |  | *                |  
|James A. Cummings                                                                                                    |  | 29,256                              | (2)      |  | 1.52             | %
|Wendell C. Franklin                                                                                                  |  | 35,595                              |          |  | 1.85             | %
|F. Dudley Fulton                                                                                                     |  | 15,300                              |          |  | *                |  
|John O. Guthrie                                                                                                      |  | 6,500                               |          |  | *                |  
|Michael S. Ives                                                                                                      |  | 80,000                              | (3)      |  | 4.09             | %
|David L. Kaufman                                                                                                     |  | 11,000                              |          |  | *                |  
|Stephen A. Johnsen                                                                                                   |  | 30,590                              | (4)      |  | 1.59             | %
|Thomas G. Johnson, III                                                                                               |  | 12,400                              | (5)      |  | *                |  
|Peter M. Meredith, Jr. Chairman & CEO Meredith Construction Company, Inc. 1014 W. 24thStreet Norfolk,
Virginia 23517 |  | 114,882                             | (6)      |  | 5.95             | %
|Charles R. Malbon, Jr.                                                                                               |  | 7,900                               |          |  | *                |  
|L. Allan Parrott, Jr.                                                                                                |  | 16,000                              | (7)      |  | *                |  
|Ross C. Reeves                                                                                                       |  | 11,100                              | (8)      |  | *                |  
|Harvey W. Roberts, III                                                                                               |  | 60,184                              | (9)      |  | 3.12             | %
|Howard M. Webb                                                                                                       |  | 4,225                               |          |  | *                |  
|Barbara Zoby                                                                                                         |  | 8,350                               |          |  | *                |  
|Philip W. Wyne 348 Gamage Drive Norfolk, Virginia 23518                                                              |  | 93,630                              | (10)(13) |  | 4.86             | %
|Banc Fund V L.P. 208 South LaSalle Street Chicago, Illinois 60604                                                    |  | 138,742                             | (11)     |  | 7.20             | %
|Mrs. Robert J. Keogh c/o Virginia Investment Counselors 999 Waterside Drive, Suite 1925 Norfolk, Virginia 23510      |  | 84,994                              | (12)(13) |  | 4.41             | %
|All Named Executive Officers and Directors as a Group                                                                |  | 451,791                             | (12)     |  | 22.89            | %

---

|* | Indicates less than one percent.
|- | --------------------------------

|(1) | Includes (a) 6,509 shares held in the name of the Lisa F Chandler Trust U/A dated 03/19/2001, and (b) 2,000 shares issuable upon exercise of options to purchase shares
pursuant to the Companys 1999 Stock Option Plan (1999 Stock Option Plan).
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Includes 11,000 shares owned jointly with Mr. Cummings wife.
|--- | -------------------------------------------------------------



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|(3) | Includes 30,000 options issued pursuant to Mr. Ives Employment Agreement dated February 7, 2005. (Does not include a LASAR for the appreciation of 70,000 shares
granted on August 23, 2006 pursuant to a Limited Alternative Stock Appreciation Right Agreement, as the LASAR is exercisable only upon a change of control of the Company.)
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Includes 3,300 shares owned jointly with Mr. Johnsens wife.
|--- | ------------------------------------------------------------

|(5) | Includes 2,000 shares issuable upon exercise of options to purchase shares pursuant to the 1999 Stock Option Plan.
|--- | ------------------------------------------------------------------------------------------------------------------

|(6) | Includes (a) 21,920 shares held as Meredith Realty Company, L.L.C., (b) 27,616 shares held as Pomar Holding, L.L.C., (c) 6,000 shares held as Meredith Realty
Associates and (d) 4,000 shares issuable upon exercise of options to purchase shares pursuant to the 1999 Stock Option Plan.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) | Includes 800 shares held in trust for the benefit of Mr. Parrotts children.
|--- | ----------------------------------------------------------------------------

|(8) | Includes (a) 750 shares owned by Mr. Reeves wife and (b) 4,000 shares issuable upon exercise of options to purchase shares pursuant to the 1999 Stock Option
Plan.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(9) | Includes (a) 34,560 shares owned by Mr. Roberts wife, (b) 6,000 shares owned jointly with Mr. Roberts wife and (c) 4,000 shares issuable upon
exercise of options to purchase shares pursuant to the 1999 Stock Option Plan.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(10) | Based on information provided by Mr. Wyne on February 21, 2006. Includes (a) 23,830 shares owned jointly with Mr. Wynes wife, (b) 8,000 shares owned
by Mr. Wynes wife, (c) 1,000 shares owned by Mr. William R. Reid, over which Mr. Wyne shares voting power, and (d) 60,800 shares held in the name of the Philip Wirth Wyne Trust.
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(11) | Based on a Schedule 13G/A filed by Banc Fund V L.P. on January 27, 2006. Includes (a) 112,242 shares beneficially owned by Banc Fund V L.P., (b) 22,500 shares
beneficially owned by Banc Fund VI L.P., and (c) 4,000 shares beneficially owned by Banc Fund VII L.P.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(12) | Includes 46,000 shares issuable to all named executive officers and directors as a group upon exercise of options to purchase shares pursuant to the 1999 Stock Option Plan.
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(13) | Indicates shareholders that as of December 31, 2005 owned more than five percent (5%) of the outstanding Common Stock of the Company but that, as a result of an increase
in the number of outstanding shares in connection with a private placement of Common Stock completed by the Company in the summer of 2006, no longer satisfy the 5% threshold.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Securities Authorized for Issuance under Equity Compensation Plans

The following table summarizes information, as of December 31, 2005, relating to the equity compensation plans of the Company pursuant to which grants of options to acquire shares of common stock may be granted
from time to time.



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Equity Compensation Plan Information



|                                                               |  |                                                                         |  |                                                         |       |                                                                                                                                            |        
|-------------------------------------------------------------- |  | ----------------------------------------------------------------------- |  | ------------------------------------------------------- | ----- | ------------------------------------------------------------------------------------------------------------------------------------------ | -------
|Plan Category                                                  |  | Number of Securitiesto be Issued UponExercise
ofOutstanding Options (a) |  | Weighted-AverageExercise Price
ofOutstandingOptions (b) |       | Number of SecuritiesRemaining Available forFuture Issuance UnderEquity CompensationPlans (Excluding SecuritiesReflected in Column (a)) (c)
|Equity Compensation Plans Approved by Security Holders         |  | 126,400                                                                 |  | $                                                       | 9.41  |                                                                                                                                            | 109,732
|Equity Compensation Plans Not Approved by Security Holders (1) |  | 168,000                                                                 |  | $                                                       | 16.48 |                                                                                                                                            | 82,000 
|Total                                                          |  | 294,400                                                                 |  | $                                                       | 13.44 |                                                                                                                                            | 191,732

---

|(1) | On July 26, 2006, the Companys Board of Directors approved the Heritage 2006 Equity Incentive Plan (2006 Incentive Plan), which authorizes the grant of stock
options, stock appreciation rights, restricted stock and certain other equity awards with respect to not more than 200,000 shares of the Companys common stock. The Board of Directors also granted 70,000 stock options to Mr. Ives at an
exercise price of $15.56, and a total of 24,000 stock options to certain of its nonemployee directors at an exercise price of $18.67, pursuant to the 2006 Incentive Plan. The 2006 Incentive Plan and the outstanding option grants thereunder are
subject to the approval of the shareholders of the Company within twelve (12) months after July 26, 2006. Concurrently with its approval of the 2006 Incentive Plan, the Board of Directors terminated the Companys ability to issue new
awards under the 1987 Stock Option Plan and 1999 Stock Option Plan, pending the approval by the Companys shareholders of the 2006 Incentive Plan. On October 25, 2006, the Board of Directors increased to 250,000 the number of shares of the
Companys common stock that are available under the 2006 Incentive Plan, and granted, at an exercise price of $16.65, 74,000 additional options thereunder, all subject to shareholder approval of the plan.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Many directors of the Company and the Bank and
their associates, including business concerns in which they are officers or directors or in which they and/or their immediate families have a substantial interest, are customers of the Bank. As such, the directors have had transactions with the
Bank, including loans made in the ordinary course of business on substantially the same terms, including interest rates, collateral and repayment terms, as those prevailing at the time for comparable loans to other parties. Such loans have not
involved more than the normal risk of collectibility or other unfavorable features. See related party loan and deposit disclosures in Note 15 of the Consolidated Financial Statements included in this Form 10-KSB.

The Bank currently occupies 10,133 square feet of a building located at 1450 South Military Highway in Chesapeake, Virginia. The building is owned by IBV
Partners, L.P., a Virginia limited partnership (IBV Partners), which has as its sole general partner IBV Real Estate Holdings, Inc., a wholly-owned subsidiary of the Company. Former and current directors of the Company and the Bank own,
in the aggregate, approximately 12.6% of the limited partnership interests in IBV Partners. IBV Partners and the Bank entered into a lease in December 1986, which has subsequently been modified, pursuant to which the Bank leases certain facilities
used for retail banking and operations purposes; the lease is currently month-to-month. See disclosures regarding the lease commitment in Note 14 of the Consolidated Financial Statements included in this Form 10-KSB.

The Company and the Bank purchase various types of business insurance through the Flagship Group, LTD (Flagship), of which Stephen A. Johnsen
is Executive Vice President. Mr. Johnsen is a director and Secretary of the Board of Directors of the Company. Insurance premiums paid to Flagship as agent for commercial insurance providers amounted to $47,300 during 2004.

The Company retained the law firm of Willcox & Savage, P.C. in 2005 and 2004 in connection with certain legal matters, and expects to continue
to do so in the future. Ross C. Reeves, a director of the Company, is a member of Willcox & Savage, P.C. The Company paid fees to the firm of $294,309 in 2005 and $18,891 in 2004.

The Company contracted in 2005 and 2004 with Meredith Construction Company, Inc. (Meredith Construction), of which Peter M. Meredith, Jr., is
Chairman and Chief Executive Officer, for various construction, repair, and property maintenance and management services. Mr. Meredith is Chairman of the Board of the Company. The Company paid Meredith Construction $206,296



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in 2005 for construction, repairs and property maintenance, and management services, and $27,324 in 2004 for property
maintenance and management services. Payments for maintenance and management services exclude out-of-pocket payments to third parties for which there were dollar-for-dollar reimbursements by the Company to Meredith Construction. The Company also has
sold securities to Meredith Construction under agreements to repurchase, which constitute 3.95% of the securities sold by the Company under agreements to repurchase at December 31, 2005. See Note 8 of the Consolidated Financial Statements
included in the Companys annual report for additional information.

The Company contracts for various heating and air conditioning
repair services through ColonialWebb Contractors (Colonial), of which Howard M. Webb is a director. Mr. Webb is a director of the Company. In 2005, the Company paid $1,398 to Colonial for heating and air conditioning services. Also,
in 2005, Colonial was a subcontractor for Meredith Construction in connection with construction work related to one of the Companys new retail banking offices. Meredith Construction paid Colonial $24,448 in 2005 related to this subcontract.

The Company paid a real estate commission in 2005 to S. L. Nusbaum Realty Company (Nusbaum), of which Wendell C. Franklin and
Thomas G. Johnson III are senior vice presidents and partners. Messrs. Franklin and Johnson are directors of the Company. In 2005, the Company paid $42,000 to Nusbaum for representing the Company in the purchase of a future banking office site.

The Company has sold securities to Tidewater Fleet Supply, LLC (Tidewater Fleet Supply) under agreements to repurchase, which
constitute 5.50% of the securities sold by the Company under agreements to repurchase at December 31, 2005. L. Allan Parrott, Jr., is President of Tidewater Fleet Supply and is a director of the Company.

ITEM 13. EXHIBITS

Exhibits:



|      |  |                                                                                                                                                                                                                                                                                                                              
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1   |  | Articles of Incorporation. (Incorporated herein by reference to the Companys Form 10-K for 1983 filed March 29, 1984.)                                                                                                                                                                                                      
|      | 
|3.2   |  | Articles of Amendment to Articles of Incorporation filed on December 31, 1985. (Incorporated herein by reference to the Companys form S-8 filed January 26, 2004)                                                                                                                                                           
|      | 
|3.3   |  | Articles of Amendment to Articles of Incorporation filed on August 9, 1990. (Incorporated herein by reference to the Companys form S-8 filed January 26, 2004)                                                                                                                                                              
|      | 
|3.4   |  | Articles of Amendment to Articles of Incorporation filed on August 12, 1992. (Incorporated herein by reference to the Companys form S-8 filed January 26, 2004)                                                                                                                                                             
|      | 
|3.5   |  | Bylaws as amended (Incorporated herein by reference to the Companys Form 10-K for 1983 filed March 29, 1984.)                                                                                                                                                                                                               
|      | 
|*10.1 |  | 1987 Stock Option Plan. (Incorporated herein by reference to the Companys Form S-8 filed January 26, 2004.)                                                                                                                                                                                                                 
|      | 
|10.2  |  | Lease dated December 29, 1996, between IBV Partners, L.P. as landlord, and Heritage Bank & Trust, as Tenant, for the lease of 7,581 square feet of space in a building located at 1450 South
Military Highway, Chesapeake, Virginia. (Incorporated herein by reference to the Companys Form 10-K for 1986 filed March 1987.)
|      | 
|*10.3 |  | Amendment to 1987 Employees Stock Ownership Plan, which provided for certain changes required by IRS regulations including changes in participant vesting schedules. (Incorporated
herein by reference to the Companys Form 10-K for 1990 filed March 30, 1991.)                                                           
|      | 
|*10.4 |  | Employees Stock Ownership Plan. (Incorporated herein by reference to the Companys Form 10-KSB for 1997 filed March 30, 1998.)                                                                                                                                                                                               
|      | 
|*10.5 |  | 1999 Stock Option Plan for Employees. (Incorporated herein by reference to the Companys Form S-8 filed January 26, 2004.)                                                                                                                                                                                                   



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Exhibits:



|       |  |                                                                                                                                                                                           
|------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*10.6  |  | Amendment to the 1999 Stock Option Plan. (Incorporated herein by reference to the Companys Form S-8 filed January 26, 2004.)                                                             
|       | 
|*10.7  |  | Employment Agreement of Michael S. Ives. (Incorporated herein by reference to the Companys Form 8-K filed on February 9, 2005.)                                                          
|       | 
|10.8   |  | Amended and Restated Bylaws of Heritage Bankshares, Inc. (Incorporated herein by reference to the Companys Form 8-K filed on May 3, 2005.)                                               
|       | 
|*10.9  |  | Employment Agreement of John O. Guthrie. (Incorporated herein by reference to the Companys Form 10-KSB filed on June 9, 2006.)                                                           
|       | 
|*10.10 |  | Amendment to Employment Agreement of Michael S. Ives. (Incorporated herein by reference to the Companys Form 8-K filed on July 5, 2006.)                                                 
|       | 
|10.11  |  | Amendment to Bylaws of Heritage Bankshares, Inc. (Incorporated herein by reference to the Companys Form 8-K filed on August 1, 2006.)                                                    
|       | 
|*10.12 |  | Limited Alternative Stock Appreciation Right Agreement of Michael S. Ives. (Incorporated herein by reference to the Companys Form 8-K filed on August 28, 2006.)                         
|       | 
|10.13  |  | Loan Agreement between Heritage Bankshares, Inc. and Cardinal Bank dated September 28, 2006. (Incorporated herein by reference to the Companys Form 8-K filed on October 3,
2006.)       
|       | 
|10.14  |  | Note made by Heritage Bankshares, Inc. to Cardinal Bank dated September 28, 2006. (Incorporated herein by reference to the Companys Form 8-K filed on October 3, 2006.)                  
|       | 
|16.1   |  | Letter from PKF Witt Mares, PLC to the Securities & Exchange Commission, dated December 29, 2005. (Incorporated herein by reference to the Companys Form 8-K filed on
December 29, 2005.)
|       | 
|21.1   |  | Subsidiaries of the Registrant                                                                                                                                                            
|       | 
|23.1   |  | Consent of PKF Witt Mares, PLC                                                                                                                                                            
|       | 
|31.1   |  | Certification of principal executive officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                   
|       | 
|31.2   |  | Certification of principal financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                   
|       | 
|32.1   |  | Certification of principal executive officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                    
|       | 
|32.2   |  | Certification of principal financial officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                    

---

|* | Indicates management contract or compensatory plan or arrangement.
|- | ------------------------------------------------------------------

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The Company retained Witt Mares, PLC (Witt
Mares), independent public accountants, to audit the books and records of the Company for the years ended December 31, 2005 and 2004.



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Audit Fees

The aggregate fees billed by Witt Mares for professional services for the fiscal years ended December 31, 2005 and 2004, including fees associated with the annual audit and reviews of quarterly reports on Form 10-QSB and for services
that are normally provided by accountants in connection with statutory and regulatory filings or engagements for those years, were $36,500 and $46,700, respectively.

Audit-Related Fees

The aggregate fees billed by Witt Mares for assurance and related services that
were reasonably related to the performance of the audit or review of the Companys financial statements were $21,475 for the fiscal year ended December 31, 2005 and $0 for the fiscal year ended December 31, 2004.

Tax Fees

The aggregate fees billed by Witt Mares in
our fiscal years ended December 31, 2005 and December 31, 2004 for professional services rendered by the principal accountants for tax compliance, tax advice, and tax planning were $1,125 and $6,800, respectively. The nature of the
services comprising those fees was the review of the Companys consolidated tax return.

All Other Fees

There were no aggregate fees billed by Witt Mares in our fiscal years ended December 31, 2005 and December 31, 2004 for products and services
provided by Witt Mares, other than the services reported above in this Item 14.

Audit Committee Administration of Engagement of Principal
Accountants

The Audit Committee pre-approves audit engagement terms and fees prior to the commencement of any audit work, other than
that which may be necessary for the independent auditor to prepare the proposed audit approach, scope and fee estimates. The independent auditors annually submit a written proposal that details all audit and audit related services. Audit fees are
fixed and contained in the proposal, and the Audit Committee reviews the nature and dollar value of services provided under such proposal. Any revisions to such proposal after the engagement has begun are reviewed and pre-approved by the Audit
Committee.

All of the services described above under the captions Audit Fees, Audit Related Fees, Tax
Fees and All Other Fees were approved by the Audit Committee pursuant to SEC Regulation S-X, Rule 2-01(c)(7)(i)(C).



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SIGNATURES

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



|                       |  |                                      
|---------------------- |  | -------------------------------------
|                       |  | HERITAGE BANKSHARES, INC.            
|                       |  | (Registrant)                         
|                       | 
|Date: November 9, 2006 |  | /s/ Michael S. Ives                  
|                       |  | Michael S. Ives,                     
|                       |  | President and Chief Executive Officer

In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.



|                 |  |                                             
|---------------- |  | --------------------------------------------
|November 9, 2006 |  | /s/ Michael S. Ives                         
|                 |  | Michael S. Ives,                            
|                 |  | President and Chief Executive Officer       
|                 |  | (Principal Executive Officer) and Director  
|                 | 
|November 9, 2006 |  | /s/ John O. Guthrie                         
|                 |  | John O. Guthrie,                            
|                 |  | Chief Financial Officer                     
|                 |  | (Principal Financial and Accounting Officer)
|                 | 
|November 9, 2006 |  | /s/ Peter M. Meredith, Jr.                  
|                 |  | Peter M. Meredith, Jr.,                     
|                 |  | Chairman of the Board of Directors and      
|                 |  | Director                                    
|                 | 
|November 9, 2006 |  | /s/ Stephen A. Johnsen                      
|                 |  | Stephen A. Johnsen,                         
|                 |  | Secretary of the Board of Directors and     
|                 |  | Director                                    
|                 | 
|November 9, 2006 |  | /s/ Lisa F. Chandler                        
|                 |  | Lisa F. Chandler,                           
|                 |  | Director                                    
|                 | 
|November 9, 2006 |  | /s/ James A. Cummings                       
|                 |  | James A. Cummings,                          
|                 |  | Director                                    



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|                 |  |                           
|---------------- |  | --------------------------
|November 9, 2006 |  | /s/ Wendell C. Franklin   
|                 |  | Wendell C. Franklin,      
|                 |  | Director                  
|                 | 
|November 9, 2006 |  | /s/ F. Dudley Fulton      
|                 |  | F. Dudley Fulton,         
|                 |  | Director                  
|                 | 
|November 9, 2006 |  | /s/ Thomas G. Johnson, III
|                 |  | Thomas G. Johnson, III,   
|                 |  | Director                  
|                 | 
|November 9, 2006 |  | /s/ David L. Kaufman      
|                 |  | David L. Kaufman,         
|                 |  | Director                  
|                 | 
|November 9, 2006 |  | /s/ Charles R. Malbon, Jr.
|                 |  | Charles R. Malbon, Jr.,   
|                 |  | Director                  
|                 | 
|November 9, 2006 |  | /s/ L. Allan Parrott      
|                 |  | L. Allan Parrott,         
|                 |  | Director                  
|                 | 
|November 9, 2006 |  | /s/ Ross C. Reeves        
|                 |  | Ross C. Reeves,           
|                 |  | Director                  
|                 | 
|November 9, 2006 |  | /s/ Harvey W. Roberts, III
|                 |  | Harvey W. Roberts, III,   
|                 |  | Director                  
|                 | 
|November 9, 2006 |  | /s/ Howard M. Webb        
|                 |  | Howard M. Webb,           
|                 |  | Director                  
|                 | 
|November 9, 2006 |  | /s/ Barbara Zoby          
|                 |  | Barbara Zoby,             
|                 |  | Director                  



84