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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, 2006



| ̈ | 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) 648-1700



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



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Check whether the issuer is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act. ̈

Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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

Check if there is no disclosure of delinquent files pursuant to Item 405 of Regulation S-B is not contained in this form, and no disclosure will 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: $13,778,036.

The aggregate market value of the registrants stock held by non-affiliates of the registrant as of
February 28, 2007: $30,157,560.In calculating the aggregate market value, we have used $16.41 per
share, which is the sales price of the Common Stock of the Company on February 28, 2007, and 1,837,755 shares of voting stock held by non-affiliates of the Company on February 28, 2007.

As of February 28, 2007, 2,278,652 shares of common stock were issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrants definitive Proxy Statement for the 2007
Annual Meeting of Shareholders, currently scheduled for June 21, 2007, are incorporated by reference into Part III hereof.

Transitional Small
Business Disclosure Format (check one):    Yes ̈No  x

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TABLE OF CONTENTS



|         |  |           |  |                                                                                                                 |  |     
|-------- |  | --------- |  | --------------------------------------------------------------------------------------------------------------- |  | ----
|         |  |           |  |                                                                                                                 |  | Page
|Part I   |  |           |  |                                                                                                                
|         |  | Item 1.   |  | Description Of Business                                                                                         |  | 3   
|         |  | Item 1A.  |  | Risk Factors                                                                                                    |  | 9   
|         |  | Item 2.   |  | Description Of Properties                                                                                       |  | 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                                                        |  | 15  
|         |  | Item 6.   |  | Managements Discussion and Analysis or Plan of Operations                                                      |  | 17  
|         |  | Item 7.   |  | Financial Statements                                                                                            |  | 41  
|         |  | Item 8.   |  | Changes In and Disagreements with Accountants on Accounting and Financial Disclosure.                           |  | 69  
|         |  | Item 8 A. |  | Controls and Procedures                                                                                         |  | 70  
|         |  | Item 8 B. |  | Other Matters                                                                                                   |  | 71  
|         |  |          
|Part III |  |           |  |                                                                                                                
|         |  | Item 9.   |  | Directors, Executive Officers, Promoters And Control Persons; Compliance With Section 16(a) Of The Exchange Act |  | 72  
|         |  | Item 10.  |  | Executive Compensation                                                                                          |  | 72  
|         |  | Item 11.  |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters                  |  | 72  
|         |  | Item 12.  |  | Certain Relationships and Related Transactions                                                                  |  | 72  
|         |  | Item 13.  |  | Exhibits                                                                                                        |  | 73  
|         |  | Item 14.  |  | Principal Accountant Fees and Services                                                                          |  | 74  



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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.

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; 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.



|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, 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, 2006, the Bank had assets of $222.9 million, with total loans held for investment, net, of $140.1 million and deposits of $194.0 million.



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The Bank has one wholly-owned subsidiary, Sentinel Financial Group, Inc. (Sentinel
Financial). At December 31, 2006, 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 various investment and insurance services to its customers.

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, 2006, 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 33rdlargest 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 December 31, 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.

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, 2006, we employed 74 full-time equivalent employees.



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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.

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



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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 requirements, and the continuing evolution of SOXs requirements, the impact on the Company of these
requirements may continue to change for some time.

SOX includes additional disclosure requirements and corporate governance rules for
public companies, extensive additional disclosure, corporate governance and other related rules adopted by the SEC 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.

Not all of the rules that the SEC has adopted implementing the provisions of SOX 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.

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 the corrective measures outlined in
the MOU and, accordingly, the MOU was terminated in October 2006. The Banks record of compliance with the BSA will be an additional factor in any applications filed with federal regulators in the future.



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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 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, 2006, the Bank met its reserve requirements.

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



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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.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 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.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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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, 2006, 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.

Available Information

We maintain an Internet
website at www.heritagebankva.com. Among other Company-related information, this website contains a link to our filings with the SEC on Form 10-KSB, Form 10-QSB, and Form 8-K, and amendments to those reports filed or furnished pursuant to
Section 13(a) or 15(d) of the Securities Exchange Act of 1934. The reports are made available on our website as soon as practicable following the filing of the reports with the SEC. The information is free of charge and may be reviewed,
downloaded and printed from our website at any time. You may also read and copy any material we file with the SEC at the SECs Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. You may obtain information on the operation of
the SECs Public Reference Room by calling the SEC at (202) 942-8090. Copies of these materials may be obtained at prescribed rates from the SEC at such address. These materials can also be inspected on the SECs web site at
www.sec.gov.



|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.



| |  |  | 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
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



9



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##### Table of Contents

| | 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 have entered into employment agreements with our Chief Executive Officer, Chief Financial 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 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 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
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



10



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##### Table of Contents

| | 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.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 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.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



11



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| |  |  | Material weaknesses and significant deficiencies in our internal control over financial reporting existed for prior periods. As further described in
Item 8A, Controls and Procedures, found later in this report, our management has concluded that our disclosure controls and procedures over financial reporting were effective as of December 31, 2006. However, as previously
reported in our annual reports on Form 10-KSB for the years ending December 31, 2004 and December 31, 2005, management identified numerous material weaknesses in our internal control over financial reporting for the years ended ending
December 31, 2004 and December 31, 2005 and concluded that internal controls over financial reporting were not effective as of those dates. While no system of internal control can be relied upon to discover or prevent all discrepancies, we
believe our risk for financial discrepancies is increased in light of the material weaknesses and significant deficiencies that existed in our internal controls for prior periods and we can give you no assurance that we have discovered all material
errors in our financial reporting for those periods. To the extent any undiscovered errors from prior periods impact our financial reports for later periods, or if we subsequently identify new weaknesses or deficiencies in our internal controls over
financial reporting, the value of our shares could decline and/or trading in our stock could be restricted.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|ITEM 2. | DESCRIPTION OF PROPERTIES
|------- | -------------------------

At December 31,
2006, 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       |  | Operations Center                                                           |  | Leased        |  | 11,119 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.             

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. In March 2007, a contract is being negotiated on behalf of IBV Partners to sell the South Military Highway facility to a third party. The contract is subject to the approval of the partners. The Bank intends to continue to lease
space from the buyer for a minimum of one year from the date of closing. Because the Bank has only a 1% interest in IBV Partners, once the transaction is consummated, any gain on sale to the Bank is expected to be immaterial.

The Virginia Beach Boulevard Retail Banking office lease expires in May 2010 with an option to renew for an additional 5-year term. The Bank has an option to terminate
this lease effective December 2007. 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    |  | 



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##### Table of Contents

Construction of the Retail Banking office on Lynnhaven Parkway is underway, and the Bank anticipates opening this office
in the first quarter of 2008. Construction plans for the Laskin Road Retail Banking office are still in development.

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 planned for 2007.
In November 2006, the Bank amended and restated this agreement to lease, through May 2017, 12,142 sq. ft. in this new facility, with rent to be paid beginning in May 2007. The Bank currently intends to consolidate its Plume Street and East City Hall
Avenue offices and staff, and its Loan Administration Department, into the new facility upon occupancy; as a result, the Bank will terminate its lease for the East City Hall Avenue facility. In addition, in March 2007, the Bank entered into a
contract to sell the Plume Street office. The sale is expected to close in the second quarter of 2007, but the Bank will lease the premises for a period of at least six months following closing. The Bank expects to record a gain on sale of the Plume
Street office once the sale is consummated.

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
|------- | ---------------------------------------------------

On December 28, 2006, the Company held its Combined 2005 and 2006 Annual Meeting of Shareholders (the Annual Meeting). At the Annual Meeting, the Companys shareholders (i) elected twelve nominated directors to
the Board of Directors of the Company, (ii) approved the Heritage 2006 Equity Incentive Plan and (iii) ratified the appointment of Elliot Davis LLC as the Companys independent auditors for the year ending December 31, 2006.

More specifically, at the Annual Meeting the shareholders elected the following individuals to the Board of Directors:



|                       |  |           |  |               |  |                             
|---------------------- |  | --------- |  | ------------- |  | ----------------------------
|Director               |  | Votes For |  | Votes Against |  | Broker Non-Votes/Abstentions
|Michael S. Ives        |  | 1,597,464 |  | 6,138         |  |                            
|David L. Kaufman       |  | 1,597,464 |  | 6,138         |  |                            
|Wendell C. Franklin    |  | 1,597,068 |  | 6,534         |  |                            
|F. Dudley Fulton       |  | 1,597,464 |  | 6,138         |  |                            
|Ross C. Reeves         |  | 1,475,810 |  | 127,792       |  |                            
|Howard M. Webb         |  | 1,597,464 |  | 6,138         |  |                            
|Barbara Zoby           |  | 1,597,464 |  | 6,138         |  |                            
|Lisa F. Chandler       |  | 1,597,464 |  | 6,138         |  |                            
|Stephen A. Johnsen     |  | 1,470,248 |  | 133,354       |  |                            
|Thomas G. Johnson, III |  | 1,597,464 |  | 6,138         |  |                            
|Charles R. Malbon, Jr. |  | 1,597,464 |  | 6,138         |  |                            
|L. Allan Parrott, Jr.  |  | 1,597,464 |  | 6,138         |  |                            

In addition, the term of office of the following directors continued after the Annual Meeting:
James A. Cummings, Peter M. Meredith, Jr., and Harvey W. Roberts, III.



13



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##### Table of Contents

The vote on the ratification of Elliott Davis LLC as the Companys independent auditors for the year
ending December 31, 2006 was as follows:



|          |  |               |  |                             
|--------- |  | ------------- |  | ----------------------------
|Votes For |  | Votes Against |  | Broker Non-Votes/Abstentions
|1,576,055 |  | 21,820        |  | 5,727                       

The vote on the Heritage 2006 Equity Incentive Plan was as follows:



|          |  |               |  |                             
|--------- |  | ------------- |  | ----------------------------
|Votes For |  | Votes Against |  | Broker Non-Votes/Abstentions
|1,091,346 |  | 182,366       |  | 329,890                     



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##### Table of Contents

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 2006 and 2005.



|               |  |        |  |     |      
|-------------- |  | ------ |  | --- | -----
|               |  | HIGH   |  | LOW
|2006           |  |        |  |     |      
|               |  |       
|Fourth Quarter |  | $17.00 |  | $   | 15.75
|Third Quarter  |  | 18.00  |  |     | 15.50
|Second Quarter |  | 17.00  |  |     | 15.25
|First Quarter  |  | 15.50  |  |     | 15.00
|               |  |       
|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

At December 31, 2006, there were 943 record holders of the 2,277,652 outstanding shares of
the Companys common stock.

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 per share, in aggregate, in each of 2006 and 2005, 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.



15



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##### Table of Contents

Equity Compensation Plan Information

The Company makes grants of options to purchase common stock of the Company pursuant to its stock option plans. Information regarding the Companys outstanding executive compensation plans as of December 31,
2006 is set forth in the following table:



|                                                           |  |                                                                          |  |                                                           |       |                                                                                                                                             |       
|---------------------------------------------------------- |  | ------------------------------------------------------------------------ |  | --------------------------------------------------------- | ----- | ------------------------------------------------------------------------------------------------------------------------------------------- | ------
|Plan Category                                              |  | Number of Securitiesto be Issued UponExercise
ofOutstanding Options  (a) |  | Weighted-AverageExercise Price of OutstandingOptions  (b) |       | Number of SecuritiesRemaining Available forFuture Issuance UnderEquity CompensationPlans  (Excluding SecuritiesReflected in Column (a)  (c)
|                                                           |  |                                                                         
|Equity Compensation Plans Approved by Security Holders (1) |  | 258,600                                                                  |  | $                                                         | 14.35 |                                                                                                                                             | 88,000
|Equity Compensation Plans Not Approved by Security Holders |  |                                                                         |  |                                                           |      |                                                                                                                                             |      
|                                                           |  |                                                                          |  |                                                           |       |                                                                                                                                             |       
|Total                                                      |  | 258,600                                                                  |  | $                                                         | 14.35 |                                                                                                                                             | 88,000
|                                                           |  |                                                                          |  |                                                           |       |                                                                                                                                             |       

---

|(1) | On December 28, 2006, at the Companys Combined 2005 and 2006 Annual Meeting of Shareholders, the Companys shareholders 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
Companys ability to issue new awards under the 1987 Stock Option Plan and 1999 Stock Option Plan was terminated concurrently with approval of the 2006 Incentive Plan.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Recent Sales of Unregistered Securities

Pursuant to a private placement in the summer of 2006 of up
to 200,000 shares of common stock, offered only to its directors and executive officers (the Initial 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 Initial 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 for additional information regarding the Initial Private Placement.)No fee was paid to any underwriter, placement agent or finder in
connection with the Initial Private Placement. The Initial 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). For purposes of the Initial Private Placement, 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 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 Initial 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
Initial Private Placement were directors and/or executive officers of the Company.

Pursuant to a private placement in December of 2006
(the Second Private Placement) of up to 350,000 shares of its common stock, offered only to accredited investors, the Company sold a total of 350,000 shares of its common stock at a price of $15.50 per share and received total proceeds
of approximately $5.425 million. The Second Private Placement closed on December 27, 2006. (Please see the Companys current report on Form 8-K filed on December 21, 2006 for additional information regarding the Second Private
Placement.) No fee was paid to any underwriter, placement agent or finder in connection with the Second Private Placement. The Second Private Placement was offered only to accredited investors under the Securities Act. For purposes of
the Second Private Placement, 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 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 Second Private



16



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##### Table of Contents

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 Second Private Placement were accredited investors.

The shares of common stock issued in connection with both the Initial Private Placement and the Second Private Placement were not registered under the
Securities Act or any state securities laws, and are subject to restrictions on transfer and may not be transferred except pursuant to registration under or exemptions from the registration requirements of the Securities Act and applicable state
securities laws.



|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. 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

As previously reported, in 2005 the Company determined that it was necessary to
restate our financial statements for the years ended December 31, 2003 and December 31, 2002, as well as unaudited information previously released for 2004, to correct various 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. (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, as well as 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, 2005, filed on November 9, 2006.) Managements attention to these matters also prevented the Company from
filing its annual reports on Form 10-KSB for 2004 and 2005 in a timely fashion. All financial data for 2003 and 2002 contained in this annual report on Form 10-KSB reflects the restated financial statements, and the financial data for 2004
reflects the financial statements that are included in the 2004 Form 10-KSB.

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



17



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##### Table of Contents

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 Companys allowance for loan losses,
see Lending Activities  Allowance for Loan Losses located in Managements Discussion and Analysis below.)

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 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 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 ENDED DECEMBER 31, |  
|                                     | 2006 |                                  |   | 2005 |       |   | 2004 |      
|Return on average assets (1)         |      | 0.09                             | % |      | 0.44  | % |      | 1.11  | %
|Return on average equity (2)         |      | 1.03                             | % |      | 5.03  | % |      | 11.47 | %
|Average equity to average assets (3) |      | 8.36                             | % |      | 8.71  | % |      | 9.71  | %
|Dividend payout ratio (4)            |      | 240.00                           | % |      | 51.06 | % |      | 22.22 | %

---

|(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. The Companys total assets increased by $18.3 million, or
8.9%, from $204.6 million at December 31, 2005 to $222.9 million at the end of 2006. The increase in assets resulted primarily from an increase in the ending balances of loans held for investment and securities available for sale, partially
offset by a decrease in the balance of federal funds sold.

Federal Funds Sold and Investment Securities. Total federal funds sold
and investment securities increased by $9.1 million, from $55.8 million at December 31, 2005 to $64.9 million at December 31, 2006.

Loans. Loans held for investment at December 31, 2006 were $140.1 million, which represents an increase of $9.7 million, or 7.4%, from the loan balance of $130.4 million at December 31, 2005.



18



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##### Table of Contents

Asset Quality. The Companys total nonperforming assets decreased to $178,000, or 0.08% of
assets, at December 31, 2006, compared to $230,000, or 0.11 % of assets, at December 31, 2005, attributable to a decrease in the balance of nonaccrual loans.

Deposits. Driven by growth in core deposits, total deposits increased by $15.6 million, or 9.0%, from $172.8 million at December 31, 2005 to
$188.4 million at December 31, 2006. Core deposits, which are comprised of noninterest-bearing, money market, NOW and savings deposits, increased by $20.4 million, or 20.1%, from $101.7 million at December 31, 2005 to $122.1 million at
December 31, 2006. This increase in core deposits was partially offset by a $4.8 million decrease in certificate of deposit balances.

Borrowed Funds. Borrowed funds decreased by $5.5 million, from $14.3 million at December 31, 2005 to $8.8 million at December 31, 2006, primarily due to the repayment of the Banks $10.0 million, 4.54% fixed rate FHLB
advance, partially offset by the $5.0 million unsecured 5-year term loan obtained by the Company in September 2006 (the Term Loan). At December 31, 2006, the Companys borrowed funds consisted primarily of the Term Loan and
$3.7 million of securities sold to customers under agreements to repurchase. In January 2007, the Company repaid the Term Loan, which during the fourth quarter of 2006 had an average borrowing cost to the Company of 7.8%.

Capital. Stockholders equity increased by $8.3 million, or 51.8%, from $16.1 million at December 31, 2005 to $24.4 million at
December 31, 2006. Stockholders equity increased primarily as a result of a total of $8.2 in net capital raised in connection with sales of the Companys common stock in private placements that closed in June, July and December 2006
(see Item 5, Market for Common Equity and Related Stockholder Matters  Recent Sales of Unregistered Securities).

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, 2006 and 2005, average interest-earning assets were $194.6 million and $170.9 million, respectively. During these same
years, the Companys net interest margins were 3.63% and 3.69%, respectively.



19



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##### Table of Contents

Average Balances and Average Rates Earned and Paid. The following table sets forth for the
Company, 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, 2006 |         |          | YEAR ENDED DECEMBER 31, 2005 |            |        | YEAR ENDED DECEMBER 31, 2004 |                   
|                                                                                 | 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)                                                                    |                        | $                            | 136,779 |          |                              | $          | 9,677  |                              | 7.08               | % |  | $        | 126,428 |            |  | $ | 8,466              |  | 6.70 | %        |  | $          | 114,387 |   |  | $ | 7,021 |  | 6.14 | %
|Investment securities-taxable                                                    |                        |                              | 15,022  |          |                              |            | 651    |                              | 4.33               | % |  |          | 12,292  |            |  |   | 362                |  | 2.94 | %        |  |            | 17,121  |   |  |   | 525   |  | 3.07 | %
|Investment securities-non-taxable (2)                                            |                        |                              | 1,128   |          |                              |            | 49     |                              | 4.34               | % |  |          | 1,114   |            |  |   | 48                 |  | 4.30 | %        |  |            | 1,090   |   |  |   | 47    |  | 4.30 | %
|FHLB and Federal Reserve Stock                                                   |                        |                              | 830     |          |                              |            | 48     |                              | 5.74               | % |  |          | 758     |            |  |   | 33                 |  | 4.42 | %        |  |            | 417     |   |  |   | 16    |  | 3.77 | %
|Federal funds sold                                                               |                        |                              | 40,876  |          |                              |            | 2,007  |                              | 4.91               | % |  |          | 30,279  |            |  |   | 1,135              |  | 3.75 | %        |  |            | 4,889   |   |  |   | 50    |  | 1.03 | %
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|Total interest-earning assets                                                    |                        |                              | 194,635 |          |                              |            | 12,432 |                              | 6.39               | % |  |          | 170,871 |            |  |   | 10,044             |  | 5.88 | %        |  |            | 137,904 |   |  |   | 7,659 |  | 5.55 | %
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                   
|Noninterest-earning assets                                                       |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|Other assets                                                                     |                        |                              | 14,843  |          |                              |            |        |                              |                    |   |  |          | 13,874  |            |  |   |                    |  |      |          |  |            | 11,829  |   |  |   |       |  |      |  
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|Total assets                                                                     |                        | $                            | 209,478 |          |                              |            |        |                              |                    |   |  | $        | 184,745 |            |  |   |                    |  |      |          |  | $          | 149,733 |   |  |   |       |  |      |  
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                   
|Interest-bearing liabilities                                                     |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|Money market, NOW accounts                                                       |                        | $                            | 66,475  |          |                              | $          | 2,033  |                              | 3.06               | % |  | $        | 42,662  |            |  | $ | 677                |  | 1.59 | %        |  | $          | 31,008  |   |  | $ | 146   |  | 0.47 | %
|Savings deposits                                                                 |                        |                              | 3,546   |          |                              |            | 35     |                              | 0.99               | % |  |          | 5,748   |            |  |   | 49                 |  | .85  | %        |  |            | 5,750   |   |  |   | 37    |  | 0.65 | %
|Certificates of deposit                                                          |                        |                              | 66,498  |          |                              |            | 2,745  |                              | 4.13               | % |  |          | 71,632  |            |  |   | 2,518              |  | 3.52 | %        |  |            | 65,197  |   |  |   | 1,933 |  | 2.96 | %
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|Total deposits                                                                   |                        |                              | 136,519 |          |                              |            | 4,813  |                              | 3.53               | % |  |          | 120,042 |            |  |   | 3,244              |  | 2.70 | %        |  |            | 101,955 |   |  |   | 2,116 |  | 2.08 | %
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|Other borrowings                                                                 |                        |                              | 11,600  |          |                              |            | 563    |                              | 4.85               | % |  |          | 11,926  |            |  |   | 501                |  | 4.20 | %        |  |            | 4,541   |   |  |   | 36    |  | 0.79 | %
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|Total interest-bearing liabilities                                               |                        |                              | 148,119 |          |                              |            | 5,376  |                              | 3.63               | % |  |          | 131,968 |            |  |   | 3,745              |  | 2.84 | %        |  |            | 106,496 |   |  |   | 2,152 |  | 2.02 | %
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                   
|Noninterest-bearing liabilities                                                  |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|Demand deposits                                                                  |                        |                              | 42,128  |          |                              |            |        |                              |                    |   |  |          | 35,054  |            |  |   |                    |  |      |          |  |            | 27,763  |   |  |   |       |  |      |  
|Other liabilities                                                                |                        |                              | 1,723   |          |                              |            |        |                              |                    |   |  |          | 1,640   |            |  |   |                    |  |      |          |  |            | 941     |   |  |   |       |  |      |  
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|Total liabilities                                                                |                        |                              | 191,970 |          |                              |            |        |                              |                    |   |  |          | 168,662 |            |  |   |                    |  |      |          |  |            | 135,200 |   |  |   |       |  |      |  
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|Stockholders equity                                                             |                        | $                            | 17,508  |          |                              |            |        |                              |                    |   |  | $        | 16,083  |            |  |   |                    |  |      |          |  | $          | 14,533  |   |  |   |       |  |      |  
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|Total liabilities and stockholders equity                                        |                        | $                            | 209,478 |          |                              |            |        |                              |                    |   |  | $        | 184,745 |            |  |   |                    |  |      |          |  | $          | 149,733 |   |  |   |       |  |      |  
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|Net interest income and interest rate spread                                     |                        |                              |         |          |                              | $          | 7,056  |                              | 2.76               | % |  |          |         |            |  | $ | 6,299              |  | 3.04 | %        |  |            |         |   |  | $ | 5,507 |  | 3.53 | %
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|Net interest margin                                                              |                        |                              |         |          |                              |            |        |                              | 3.63               | % |  |          |         |            |  |   |                    |  | 3.69 | %        |  |            |         |   |  |   |       |  | 3.99 | %
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  
|Ratio of average interest-earning assets to average interest-bearing liabilities |                        |                              | 131.40  | %        |                              |            |        |                              |                    |   |  |          | 129.48  | %          |  |   |                    |  |      |          |  |            | 129.49  | % |  |   |       |  |      |  
|                                                                                 |                        |                              |         |          |                              |            |        |                              |                    |   |  |          |         |            |  |   |                    |  |      |          |  |            |         |   |  |   |       |  |      |  

---

|(1) | For the year ended December 31, 2006, the calculations are based on daily average balances. For the year ended December 31, 2005, average balances are computed by
averaging month-end balances. For the year ended December 31, 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. Average balances for 2005 and 2004 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 average loan balances.
|--- | ----------------------------------------------------------------------------------------------------



20



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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, 2006 vs. 2005Increase (Decrease) Due to |       |      | Year Ended December 31, 2005 vs. 2004Increase (Decrease) Due to |  
|                                        | Volume                 |                                                                 |       | Rate |                                                                 |   | Total |   |  | Volume |       |   | Rate |   |       | Total | 
|                                        | (Dollars in Thousands) |                                                                
|Interest income                         |                        |                                                                 |       |      |                                                                 |   |       |   |  |        |       |   |      |   |       |       |  |   |       |   |  |   |       |  
|Loans                                   |                        | $                                                               | 716   |      |                                                                 | $ | 495   |   |  | $      | 1,211 |   |      | $ | 775   |       |  | $ | 670   |   |  | $ | 1,445 |  
|Investment securities taxable           |                        |                                                                 | 92    |      |                                                                 |   | 197   |   |  |        | 289   |   |      |   | (142  | )     |  |   | (21   | ) |  |   | (163  | )
|Investment securities non-taxable       |                        |                                                                 | 1     |      |                                                                 |   |      |   |  |        | 1     |   |      |   | 1     |       |  |   |      |   |  |   | 1     |  
|FHLB & FRB stock                        |                        |                                                                 | 4     |      |                                                                 |   | 11    |   |  |        | 15    |   |      |   | 14    |       |  |   | 3     |   |  |   | 17    |  
|Federal funds sold                      |                        |                                                                 | 463   |      |                                                                 |   | 409   |   |  |        | 872   |   |      |   | 702   |       |  |   | 383   |   |  |   | 1,085 |  
|                                        |                        |                                                                 |       |      |                                                                 |   |       |   |  |        |       |   |      |   |       |       |  |   |       |   |  |   |       |  
|Total interest income                   |                        |                                                                 | 1,276 |      |                                                                 |   | 1,112 |   |  |        | 2,388 |   |      |   | 1,350 |       |  |   | 1,035 |   |  |   | 2,385 |  
|                                        |                        |                                                                 |       |      |                                                                 |   |       |   |  |        |       |   |      |   |       |       |  |   |       |   |  |   |       |  
|                                        |                        |                                                                 |       |      |                                                                 |  
|Interest expense                        |                        |                                                                 |       |      |                                                                 |   |       |   |  |        |       |   |      |   |       |       |  |   |       |   |  |   |       |  
|Deposits:                               |                        |                                                                 |       |      |                                                                 |   |       |   |  |        |       |   |      |   |       |       |  |   |       |   |  |   |       |  
|Money Market/NOW accounts               |                        |                                                                 | 510   |      |                                                                 |   | 846   |   |  |        | 1,356 |   |      |   | 72    |       |  |   | 459   |   |  |   | 531   |  
|Savings deposits                        |                        |                                                                 | (21   | )    |                                                                 |   | 7     |   |  |        | (14   | ) |      |   |      |       |  |   | 12    |   |  |   | 12    |  
|Certificates of deposit                 |                        |                                                                 | (189  | )    |                                                                 |   | 416   |   |  |        | 227   |   |      |   | 203   |       |  |   | 382   |   |  |   | 585   |  
|Borrowings                              |                        |                                                                 | (16   | )    |                                                                 |   | 78    |   |  |        | 62    |   |      |   | 367   |       |  |   | 98    |   |  |   | 465   |  
|                                        |                        |                                                                 |       |      |                                                                 |   |       |   |  |        |       |   |      |   |       |       |  |   |       |   |  |   |       |  
|Total interest expense                  |                        |                                                                 | 284   |      |                                                                 |   | 1,347 |   |  |        | 1,631 |   |      |   | 642   |       |  |   | 951   |   |  |   | 1,593 |  
|                                        |                        |                                                                 |       |      |                                                                 |   |       |   |  |        |       |   |      |   |       |       |  |   |       |   |  |   |       |  
|Net interest income Increase (decrease) |                        | $                                                               | 992   |      |                                                                 | $ | (235  | ) |  | $      | 757   |   |      | $ | 708   |       |  | $ | 84    |   |  | $ | 792   |  
|                                        |                        |                                                                 |       |      |                                                                 |   |       |   |  |        |       |   |      |   |       |       |  |   |       |   |  |   |       |  

Comparison of Operating Results for the Years Ended December 31, 2006 and 2005

Overview. The Companys pre-tax income was $256,000 for the year ended December 31, 2006 as compared to $1.2 million in 2005, a decrease
of $926,000. During 2006, net interest income increased by $757,000, the provision for loan losses increased by $31,000, other noninterest income decreased by $313,000, and other noninterest expense increased by $1.3 million. Net income, after tax,
in 2006 was $180,000, a decrease of $629,000 from $809,000 in 2005. Diluted earnings per share decreased by $0.36, from $0.46 per share in 2005 to $0.10 per share in 2006.

Net Interest Income. The Companys net interest income before provision for loan losses increased by $757,000 in 2006. 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 2005.

Interest on
loans increased by $1.2 million, or 14.3%, from $8.5 million in 2005 to $9.7 million in 2006. This increase was attributable to a $10.4 million increase in the average balance of loans, and an increase in the yield on the Companys loan
portfolio from 6.70% in 2005 to 7.08% in 2006.

Interest on investment securities increased by $290,000 in 2006 compared to 2005. This
increase resulted primarily from an increase in the average balance of the Companys investment portfolio from $13.4 million in 2005 to $16.1 million in 2006, and an increase in year-over-year average yield from 3.06% to 4.33%. Interest on
federal funds sold increased by $872,000, due to the average balance increasing from $30.3 million in 2005 to $40.9 million in 2006 and an increase in the average rate from 3.75% in 2005 to 4.91% in 2006.



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The Companys interest expense increased by $1.6 million, from $3.7 million in 2005 to $5.3 million
in 2006. Interest paid on deposits increased by $1.6 million, resulting from an increase in the average balance of interest-bearing deposits from $120.0 million in 2005 to $136.5 million in 2006 and from an increase in the average cost of
interest-bearing deposits from 2.70% in 2005 to 3.53% in 2006. Interest paid on borrowed funds increased by $62,000, from $501,000 in 2005 to $563,000 in 2006. Interest expense on borrowed funds increased primarily as a result of (a) a $101,000
increase in interest expense attributable to a $5.0 million unsecured 5-year term loan obtained by the Company in September 2006 (the Company subsequently contributed the proceeds of the loan to the capital of the Bank), and (b) a $27,000
increase in interest expense due to an increase in the average cost of retail repurchase agreements from 3.42% in 2005 to 4.29% in 2006, partially offset by a $66,000 decrease in interest expense on other borrowed funds primarily due to the
repayment in October 2006 of the Banks $10.0 million FHLB advance.

The Companys net interest margin decreased by 6 basis
points, from 3.69% for the year ended December 31, 2005 to 3.63% for the year ended December 31, 2006, as the interest rate spread decreased by 28 basis points, from 3.04% to 2.76%, partially offset by the positive impact of the growth in
noninterest-bearing deposits. The decrease in the Companys interest rate spread occurred because the cost of its interest-bearing liabilities increased 79 basis points, from 2.84% in 2005 to 3.63% in 2006, which more than offset the 51 basis
point increase in yield on interest-earning assets, which increased from 5.88% in 2005 to 6.39% in 2006. Average noninterest-bearing deposits increased by $7.1 million, from $35.0 million in 2005 to $42.1 million in 2006.

Provision for Loan Losses.The Companys provision for loan losses increased by $31,000, from $33,000 in 2005 to $64,000 in 2006. This
increase in the provision for loan losses resulted primarily from additional provision expense necessary to support loan growth.

Noninterest Income. Total noninterest income decreased by $313,000, from $1.7 million in 2005 to $1.4 million in 2006:



| |  |  | There were no gains on the sale of real estate owned (REO) in 2006 compared to gains of $427,000 in 2005.
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | Late charges and other loan fees decreased by $96,000, from $188,000 in 2005 to $92,000 in 2006, primarily due to a decrease in prepayment penalties collected on
loans paid before maturity.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Gains on sale of mortgage loans held for sale decreased by $82,000, from $260,000 in 2005 to $178,000 in 2006, due to a decrease in mortgage origination volume.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Fees on credit cards declined by $33,000 in 2006 as compared to 2005 due to the sale in 2006 of the Banks retail credit card portfolio.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Service charges on deposit accounts increased by $232,000, from $396,000 in 2005 to $628,000 in 2006, due to an increase in transaction accounts as well as a more
systematic application of appropriate account fees.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Gains on the sale of the Banks retail credit card portfolio and equity securities held by the Company were $96,000 and $34,000, respectively, in 2006. The
Bank sold its credit card portfolio primarily to eliminate a significant diversion of the Banks retail banking team from the core strategy of serving business customers. There were no similar gains on sale in 2005.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Noninterest Expense. Total noninterest expense increased by $1.3 million, from $6.8 million in 2005 to $8.1
million in 2006:



| |  |  | Compensation expense increased by $1.0 million, from $3.2 million in 2005 to $4.2 million in 2006. This increase related primarily to the impact of employee growth
during 2005, which fully impacted 2006 costs. Also, as previously announced, during the summer of 2006 the Companys Board of Directors approved the Heritage 2006 Equity Incentive Plan (Incentive Plan) and granted stock options
under the Incentive Plan to certain employees and nonemployee directors, and both the Incentive Plan and option grants were approved by the Companys shareholders at the 2005 and 2006 Combined Annual Meeting held on December 28, 2006.
Statement of Financial Accounting Standard No.123(R), Accounting for Stock-Based Compensation, requires that the fair value of such stock options be recognized as an expense over the requisite service period. Accordingly, in December 2006,
the Bank expensed $72,000 for the 2006 portion of the total fair value expense related to the 2006 option grants under the Incentive Plan.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Data processing expense increased by $158,000 from 2005 to 2006, due to the addition of certain customer services and an increase in total transaction costs.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------



22



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##### Table of Contents

| |  |  | The Companys expenditures for furniture and fixtures increased by $141,000, from $452,000 in 2005 to $593,000 in 2006, as a result of the impact of
infrastructure and expansion initiatives.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Occupancy expense increased by $125,000, from $372,000 in 2005 to $497,000 in 2006, primarily due to additional operating expenses for the Banks Virginia
Beach retail banking office and City Center commercial loan office and increases in other maintenance and security expenses.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Loss on the write-down of fixed assets increased by $64,000, from $11,000 in 2005 to $75,000 in 2006, primarily attributable to the impairment of fixed assets
related to the planned 2007 consolidation of the Banks Plume Street and City Center offices into a new facility, and the replacement of the Banks antiquated telephone system in the fourth quarter of 2006.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Telephone expense increased by $39,000, attributable to higher operating costs associated with the new telephone system.
| | - |  | ------------------------------------------------------------------------------------------------------------------------



| |  |  | Taxes and license expense increased by $33,000, from $152,000 in 2005 to $185,000 in 2006, primarily due to increase in franchise tax and assessment expense related
to growth in the Banks deposits.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Impairment charges related to the Companys investment in Bankers Investment Group LLC, a retail stock brokerage firm sponsored by the Virginia Bankers
Association (Bankers Investment), decreased by $118,000, from $125,000 in 2005 to $7,000 in 2006.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Contract employee services decreased by $86,000, from $293,000 in 2005 to $207,000 in 2006, primarily related to a decrease in the second half of 2006 in expenses
for consultants and contract accounting staff utilized in the Companys restatement process.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Marketing expenses decreased by $80,000, from $297,000 in 2005 to $217,000 in 2006, primarily related to the non-recurrence in 2006 of approximately $38,000 in 2005
expenses associated with the Banks name and logo change, as well as lower advertising expenses.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Credit card expense decreased by $40,000, from $82,000 in 2005 to $42,000 in 2006, due to sale in 2006 of the Banks retail credit card portfolio.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------

Income Taxes. The Companys income tax expense for the year ended December 31, 2006 was $76,000
compared to $373,000 for 2005, which represented effective tax rates of 29.6% and 31.5%, respectively.



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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,
|                                           |  | 2006                     |           | 2005
|Noninterest income                         |  |                          |           |      |   |          
|Service charges on deposit accounts        |  | $                        | 627,473   |      | $ | 395,520  
|Gains on sale of other real estate owned   |  |                          |          |      |   | 427,066  
|Gains on sale of loans, net                |  |                          | 178,146   |      |   | 260,353  
|Income from bank-owned life insurance, net |  |                          | 20,407    |      |   | 20,356   
|Late charges and other fees on loans       |  |                          | 91,996    |      |   | 187,687  
|Consumer credit card fees                  |  |                          | 47,537    |      |   | 80,603   
|ATM fees                                   |  |                          | 105,022   |      |   | 85,932   
|Merchant discount fees                     |  |                          | 45,692    |      |   | 51,624   
|Gain on sale of credit cards               |  |                          | 95,565    |      |   |         
|Gain on sale of equity securities          |  |                          | 33,815    |      |   |         
|Other                                      |  |                          | 100,590   |      |   | 149,970  
|                                           |  |                          |           |      |   |          
|Total noninterest income                   |  | $                        | 1,346,243 |      | $ | 1,659,111
|                                           |  |                          |           |      |   |          
|                                           | 
|                                           |  | Years Ended December 31,
|                                           |  | 2006                     |           | 2005
|Noninterest expense                        |  |                          |           |      |   |          
|Compensation                               |  | $                        | 4,197,596 |      | $ | 3,159,118
|Data processing                            |  |                          | 524,305   |      |   | 366,161  
|Occupancy expenses                         |  |                          | 496,892   |      |   | 371,721  
|Furniture and equipment expense            |  |                          | 593,087   |      |   | 452,141  
|Contract employee services                 |  |                          | 206,672   |      |   | 292,577  
|Taxes and licenses                         |  |                          | 184,928   |      |   | 152,551  
|Professional fees                          |  |                          | 528,620   |      |   | 534,195  
|ATM transaction expense                    |  |                          | 115,878   |      |   | 103,240  
|Credit card expense                        |  |                          | 42,075    |      |   | 81,989   
|Stationery and supplies                    |  |                          | 143,657   |      |   | 144,671  
|Telephone expense                          |  |                          | 106,146   |      |   | 67,043   
|Postage                                    |  |                          | 68,773    |      |   | 55,544   
|Courier                                    |  |                          | 84,624    |      |   | 59,563   
|Marketing expense                          |  |                          | 217,107   |      |   | 297,260  
|Service bureau expense                     |  |                          | 64,135    |      |   | 60,017   
|Insurance expense                          |  |                          | 58,893    |      |   | 54,234   
|Travel                                     |  |                          | 40,685    |      |   | 47,977   
|Shareholder expense                        |  |                          | 47,532    |      |   | 35,092   
|Training expense                           |  |                          | 37,172    |      |   | 46,237   
|Loan servicing expense                     |  |                          | 43,984    |      |   | 61,305   
|FDIC insurance                             |  |                          | 21,285    |      |   | 18,238   
|Impairment  Bankers Investment            |  |                          | 7,009     |      |   | 124,685  
|Loss on sale of equity securities          |  |                          | 8,163     |      |   |         
|Other miscellaneous                        |  |                          | 243,034   |      |   | 157,758  
|                                           |  |                          |           |      |   |          
|Total noninterest expense                  |  | $                        | 8,082,252 |      | $ | 6,743,317
|                                           |  |                          |           |      |   |          

Lending Activities

Loans held for investment, net of allowance for loan losses and unearned fees and costs, at December 31, 2006 were $140.1 million compared with $130.4 million at December 31, 2005, an increase of $9.7
million or 7.4%, primarily attributable to a $7.5 million increase in loans secured by real estate. As a percentage of average earning assets, average loans were 70.3% at December 31, 2006, and 74.0% at December 31, 2005.



24



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##### Table of Contents

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.

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.

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



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##### Table of Contents

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 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



26



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##### Table of Contents

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.

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



|                           |  |                 |             |   |      |   |             |      |  |   |             |   |  |      |             |   |  |   |            |  
|-------------------------- |  | --------------- | ----------- | - | ---- | - | ----------- | ---- |  | - | ----------- | - |  | ---- | ----------- | - |  | - | ---------- | -
|                           |  | At December 31, |            
|                           |  | 2006            |             |   | 2005 |   |             | 2004 |  |   | 2003        |   |  | 2002 |            
|Commercial                 |  | $               | 19,752,244  |   |      | $ | 17,927,074  |      |  | $ | 19,582,518  |   |  | $    | 19,803,180  |   |  | $ | 13,920,806 |  
|                           |  |                 |             |   |     
|Real estate - mortgage     |  |                 | 92,513,346  |   |      |   | 98,801,013  |      |  |   | 90,513,054  |   |  |      | 71,422,680  |   |  |   | 58,077,032 |  
|                           |  |                 |             |   |     
|Real estate - construction |  |                 | 23,780,496  |   |      |   | 10,013,033  |      |  |   | 9,042,071   |   |  |      | 3,551,281   |   |  |   | 4,170,760  |  
|                           |  |                 |             |   |     
|Installment and consumer   |  |                 | 4,731,529   |   |      |   | 4,665,853   |      |  |   | 5,595,735   |   |  |      | 6,844,998   |   |  |   | 6,413,711  |  
|                           |  |                 |             |   |      |   |             |      |  |   |             |   |  |      |             |   |  |   |            |  
|Total gross loans          |  |                 | 140,777,615 |   |      |   | 131,406,973 |      |  |   | 124,733,378 |   |  |      | 101,622,139 |   |  |   | 82,582,309 |  
|                           |  |                 |             |   |     
|Allowance for loan losses  |  |                 | (1,373,000  | ) |      |   | (1,335,001  | )    |  |   | (1,264,000  | ) |  |      | (1,186,854  | ) |  |   | (1,087,840 | )
|Unearned loan costs (fees) |  |                 | 713,894     |   |      |   | 348,354     |      |  |   | 59,245      |   |  |      | 126,825     |   |  |   | 114,436    |  
|                           |  |                 |             |   |      |   |             |      |  |   |             |   |  |      |             |   |  |   |            |  
|Loans, net                 |  | $               | 140,118,509 |   |      | $ | 130,420,326 |      |  | $ | 123,528,623 |   |  | $    | 100,562,110 |   |  | $ | 81,608,905 |  
|                           |  |                 |             |   |      |   |             |      |  |   |             |   |  |      |             |   |  |   |            |  

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, 2006 | 
|                                                               |  |               |            |                               |  
|                                                               |  | Within 1 Year |            | After 1 Yearbut Within 5Years |   | After 5 Years |  | Total |            | Percentage ofTotal LoanPortfolio |  
|Commercial                                                     |  | $             | 5,387,682  |                               | $ | 7,309,186     |  | $     | 3,918,609  |                                  | $ | 16,615,477  |  | 11.80  | %
|Real Estate-Mortgage                                           |  |               | 6,443,839  |                               |   | 10,382,648    |  |       | 75,956,859 |                                  |   | 92,783,346  |  | 65.91  | %
|Real Estate-Construction                                       |  |               | 16,766,618 |                               |   | 6,743,878     |  |       |           |                                  |   | 23,510,496  |  | 16.70  | %
|Consumer                                                       |  |               | 1,651,922  |                               |   | 6,084,596     |  |       | 131,778    |                                  |   | 7,868,296   |  | 5.59   | %
|                                                               |  |               |            |                               |   |               |  |       |            |                                  |   |             |  |        |  
|                                                               |  | $             | 30,250,061 |                               | $ | 30,520,308    |  | $     | 80,007,246 |                                  | $ | 140,777,615 |  | 100.00 | %
|                                                               |  |               |            |                               |   |               |  |       |            |                                  |   |             |  |        |  



|                                                     |  |       |            
|---------------------------------------------------- |  | ----- | -----------
|Loans Maturing After 1 Year                          |  | Total
|Fixed rate loans                                     |  | $     | 34,100,932 
|                                                     | 
|Variable rate loans (includes loans subject to call) |  |       | 76,426,622 
|                                                     |  |       |            
|                                                     |  | $     | 110,527,554
|                                                     |  |       |            

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.



27



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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.

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 $1,373,000, or 0.97% of total loans held for investment, net of unearned fees and costs, at December 31, 2006. This compares to an allowance of $1,335,001, or 1.01% of such loans, at year-end 2005 as reflected in the table below.

Management currently 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, |          
|                                                                                                                           |  | 2006                                  |           |   | 2005 |   |           | 2004 |  |   | 2003      |   |  | 2002 |          
|Balance at beginning of year                                                                                               |  | $                                     | 1,335,001 |   |      | $ | 1,264,000 |      |  | $ | 1,186,854 |   |  | $    | 1,087,840 |    |  | $ | 1,085,148 |  
|                                                                                                                           |  |                                       |           |   |      |   |           |      |  |   |           |   |  |      |           |    |  |   |           |  
|Charge-offs:                                                                                                               |  |                                       |           |   |      |   |           |      |  |   |           |   |  |      |           |    |  |   |           |  
|Commercial                                                                                                                 |  |                                       | 28,623    |   |      |   | 14,963    |      |  |   | 353,697   |   |  |      |          |    |  |   | 39,544    |  
|Real estate                                                                                                                |  |                                       |          |   |      |   | 4,093     |      |  |   |          |   |  |      |          |    |  |   |          |  
|Consumer                                                                                                                   |  |                                       | 62,228    |   |      |   | 31,572    |      |  |   | 32,616    |   |  |      | 32,800    |    |  |   | 59,227    |  
|                                                                                                                           |  |                                       |           |   |      |   |           |      |  |   |           |   |  |      |           |    |  |   |           |  
|Total charge-offs                                                                                                          |  |                                       | 90,851    |   |      |   | 50,628    |      |  |   | 386,313   |   |  |      | 32,800    |    |  |   | 98,771    |  
|                                                                                                                           |  |                                       |           |   |      |   |           |      |  |   |           |   |  |      |           |    |  |   |           |  
|Recoveries                                                                                                                 |  |                                       |           |   |      |   |           |      |  |   |           |   |  |      |           |    |  |   |           |  
|Commercial                                                                                                                 |  |                                       | 42,606    |   |      |   | 80,000    |      |  |   |          |   |  |      |          |    |  |   |          |  
|Real estate                                                                                                                |  |                                       |          |   |      |   |          |      |  |   |          |   |  |      | 55,855    |    |  |   |          |  
|Consumer                                                                                                                   |  |                                       | 21,982    |   |      |   | 8,619     |      |  |   | 10,459    |   |  |      | 35,959    |    |  |   | 2,463     |  
|                                                                                                                           |  |                                       |           |   |      |   |           |      |  |   |           |   |  |      |           |    |  |   |           |  
|Total recoveries                                                                                                           |  |                                       | 64,588    |   |      |   | 88,619    |      |  |   | 10,459    |   |  |      | 91,814    |    |  |   | 2,463     |  
|                                                                                                                           |  |                                       |           |   |      |   |           |      |  |   |           |   |  |      |           |    |  |   |           |  
|Net (recoveries) charge-offs                                                                                               |  |                                       | 26,263    |   |      |   | (37,991   | )    |  |   | 375,854   |   |  |      | (59,014   | )  |  |   | 96,308    |  
|                                                                                                                           |  |                                       |           |   |      |   |           |      |  |   |           |   |  |      |           |    |  |   |           |  
|Provision for loan losses                                                                                                  |  |                                       | 64,262    |   |      |   | 33,010    |      |  |   | 453,000   |   |  |      | 40,000    |    |  |   | 99,000    |  
|                                                                                                                           |  |                                       |           |   |      |   |           |      |  |   |           |   |  |      |           |    |  |   |           |  
|Balance at end of period:                                                                                                  |  | $                                     | 1,373,000 |   |      | $ | 1,335,001 |      |  | $ | 1,264,000 |   |  | $    | 1,186,854 |    |  | $ | 1,087,840 |  
|                                                                                                                           |  |                                       |           |   |      |   |           |      |  |   |           |   |  |      |           |    |  |   |           |  
|Ratio of net charge-offs to average loans outstanding                                                                      |  |                                       | 0.02      | % |      |   | (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 |  |                                       | 0.97      | % |      |   | 1.01      | %    |  |   | 1.01      | % |  |      | 1.17      | %  |  |   | 1.32      | %



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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, 2006, 2005, 2004, 2003, and 2002. The allocation presented for 2006, 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 and December 31, 2002 have not been reclassified to reflect the new methodology.



|                           |  |                        |       |                          |        |   |        |      |                          |  |        |        |  |                          |       |  |        |   |                          |   |       |        |        |                          |  |   |       |  |        |  
|-------------------------- |  | ---------------------- | ----- | ------------------------ | ------ | - | ------ | ---- | ------------------------ |  | ------ | ------ |  | ------------------------ | ----- |  | ------ | - | ------------------------ | - | ----- | ------ | ------ | ------------------------ |  | - | ----- |  | ------ | -
|                           |  | At December 31         |      
|                           |  | 2006                   |       |                          | 2005   |   |        | 2004 |                          |  | 2003   |        |  | 2002                     |      
|                           |  | 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     |  | $                      | 812   |                          | 65.72  | % |        | $    | 654                      |  | 75.19  | %      |  | $                        | 551   |  | 72.56  | % |                          | $ | 415   |        | 72.70  | %                        |  | $ | 76    |  | 70.35  | %
|                           |  |                        |       |                          |        |   |        |      |                          | 
|Real estate  construction |  |                        | 18    |                          | 16.89  | % |        |      | 15                       |  | 7.62   | %      |  |                          | 4     |  | 7.25   | % |                          |   |      |        | 3.50   | %                        |  |   |      |  | 5.05   | %
|                           |  |                        |       |                          |        |   |        |      |                          | 
|Commercial                 |  |                        | 365   |                          | 14.03  | % |        |      | 450                      |  | 13.64  | %      |  |                          | 450   |  | 15.70  | % |                          |   | 25    |        | 18.93  | %                        |  |   | 319   |  | 16.83  | %
|                           |  |                        |       |                          |        |   |        |      |                          | 
|Consumer                   |  |                        | 75    |                          | 3.36   | % |        |      | 121                      |  | 3.55   | %      |  |                          | 164   |  | 4.49   | % |                          |   | 94    |        | 4.87   | %                        |  |   | 39    |  | 7.77   | %
|                           |  |                        |       |                          |        |   |        |      |                          |  |        |        |  |                          |       |  |        |   |                          |   |       |        |        |                          |  |   |       |  |        |  
|                           |  |                        | 1,270 |                          | 100.00 | % |        |      | 1,240                    |  | 100.00 | %      |  |                          | 1,169 |  | 100.00 | % |                          |   | 534   |        | 100.00 | %                        |  |   | 434   |  | 100.00 | %
|                           |  |                        |       |                          |        |   |        |      |                          |  |        |        |  |                          |       |  |        |   |                          |   |       |        |        |                          |  |   |       |  |        |  
|Specific problem loans     |  |                        |      |                          |        |   |        |      |                         |  |        |        |  |                          |      |  |        |   |                          |   | 50    |        |        |                          |  |   | 123   |  |        |  
|                           |  |                        |       |                          |        |   |        |      |                          | 
|Unallocated                |  |                        | 103   |                          |        |   |        |      | 95                       |  |        |        |  |                          | 95    |  |        |   |                          |   | 603   |        |        |                          |  |   | 531   |  |        |  
|                           |  |                        |       |                          |        |   |        |      |                          |  |        |        |  |                          |       |  |        |   |                          |   |       |        |        |                          |  |   |       |  |        |  
|                           |  | $                      | 1,373 |                          |        |   |        | $    | 1,335                    |  |        |        |  | $                        | 1,264 |  |        |   |                          | $ | 1,187 |        |        |                          |  | $ | 1,088 |  |        |  
|                           |  |                        |       |                          |        |   |        |      |                          |  |        |        |  |                          |       |  |        |   |                          |   |       |        |        |                          |  |   |       |  |        |  

---

|(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 generally does not 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.



29



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##### Table of Contents

The following table sets forth, for the date 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, |        
|                                           |  | 2006            |         |   | 2005 |   |         | 2004 |  |   | 2003    |   |  | 2002 |       
|Nonaccrual loans (1)                       |  | $               | 169,642 |   |      | $ | 225,934 |      |  | $ | 648,658 |   |  | $    | 10,969 |   |  | $ | 13,306 |  
|Accruing loans past due 90 days or more    |  |                 | 7,865   |   |      |   | 4,476   |      |  |   | 14,629  |   |  |      | 22,323 |   |  |   | 42,760 |  
|                                           |  |                 |         |   |      |   |         |      |  |   |         |   |  |      |        |   |  |   |        |  
|Total nonperforming loans                  |  |                 | 177,507 |   |      |   | 230,410 |      |  |   | 663,287 |   |  |      | 33,292 |   |  |   | 56,066 |  
|                                           |  |                 |         |   |     
|Real estate owned, net                     |  |                 |        |   |      |   |        |      |  |   | 297,295 |   |  |      |       |   |  |   |       |  
|                                           |  |                 |         |   |      |   |         |      |  |   |         |   |  |      |        |   |  |   |        |  
|Total nonperforming assets                 |  | $               | 177,507 |   |      | $ | 230,410 |      |  | $ | 960,582 |   |  | $    | 33,292 |   |  | $ | 56,066 |  
|                                           |  |                 |         |   |      |   |         |      |  |   |         |   |  |      |        |   |  |   |        |  
|Total nonperforming assets to total assets |  |                 | 0.08    | % |      |   | 0.11    | %    |  |   | 0.62    | % |  |      | 0.02   | % |  |   | 0.04   | %

---

|(1) | At December 31, 2006 and 2005, includes restructured loans of $169,642 and $224,799, respectively.
|--- | --------------------------------------------------------------------------------------------------

At December 31, 2006 the Company had approximately $1.1 million 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, 2006 were $520,000 compared to $1.4 million at December 31, 2005. These loans were pre-committed for sale to investors.

Investment Securities

The Companys investment portfolio is a source of liquidity and is its second largest category
of earning assets. At December 31, 2006, the portfolio included U.S. Government and agency securities, obligations of states and political subdivisions, mortgage-backed securities and preferred trust securities. In addition to the investment
securities, the Company also invests in federal funds sold. Securities available for sale were $44.9 million at December 31, 2006, compared with $9.3 million at December 31, 2005. Securities held to maturity were $679,000 at
December 31, 2006, compared to $681,000 at December 31, 2005.



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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 for the years ended December 31, 2006, 2005 and 2004:



|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|------------------------------------------------ |  | -------------- | ---------- | -------------------- | - | --------------------- |  | ---------- | ------- |  | - | ----------
|                                                 |  | Amortized Cost |            | GrossUnrealizedGains |   | GrossUnrealizedLosses |  | Fair Value
|At December 31, 2006                             |  |                |            |                      |   |                       |  |            |         |  |   |           
|                                                 |  |                |            |                     
|Securities available for sale                    |  |                |            |                      |   |                       |  |            |         |  |   |           
|                                                 |  |                |            |                     
|U.S. Treasury Securities                         |  | $              | 16,108,728 |                      | $ | 6,221                 |  | $          |        |  | $ | 16,114,949
|U.S. government sponsored enterprises            |  |                | 27,976,529 |                      |   | 11,239                |  |            | 15,578  |  |   | 27,972,190
|Mortgage-backed securities                       |  |                | 135,905    |                      |   | 631                   |  |            |        |  |   | 136,536   
|Obligations of states and political subdivisions |  |                | 661,387    |                      |   | 16,445                |  |            |        |  |   | 677,832   
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Total securities available for sale              |  |                | 44,882,549 |                      |   | 34,536                |  |            | 15,578  |  |   | 44,901,507
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Securities held to maturity                      |  |                |            |                      |   |                       |  |            |         |  |   |           
|                                                 |  |                |            |                     
|Mortgage-backed securities                       |  |                | 9,257      |                      |   | 106                   |  |            |        |  |   | 9,363     
|Obligations of states and political subdivisions |  |                | 469,615    |                      |   | 8,654                 |  |            |        |  |   | 478,269   
|Preferred trust securities                       |  |                | 200,000    |                      |   | 12,000                |  |            |        |  |   | 212,000   
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Total securities held to maturity                |  |                | 678,872    |                      |   | 20,760                |  |            |        |  |   | 699,632   
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|Total securities                                 |  | $              | 45,561,421 |                      | $ | 55,296                |  | $          | 15,578  |  | $ | 45,601,139
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           
|                                                 |  |                |            |                     
|At December 31, 2005                             |  |                |            |                      |   |                       |  |            |         |  |   |           
|                                                 |  |                |            |                     
|Securities available for sale                    |  |                |            |                      |   |                       |  |            |         |  |   |           
|                                                 |  |                |            |                     
|U.S. Treasury Securities                         |  | $              | 500,084    |                      | $ |                      |  | $          | 864     |  | $ | 499,220   
|U.S. government sponsored enterprises            |  |                | 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 
|                                                 |  |                |            |                      |   |                       |  |            |         |  |   |           



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|                                                 |  |                |            |                      |   |                       |  |            |        |  |   |           
|------------------------------------------------ |  | -------------- | ---------- | -------------------- | - | --------------------- |  | ---------- | ------ |  | - | ----------
|                                                 |  | Amortized Cost |            | GrossUnrealizedGains |   | GrossUnrealizedLosses |  | Fair Value
|At December 31, 2004                             |  |                |            |                      |   |                       |  |            |        |  |   |           
|                                                 |  |                |            |                     
|Securities available for sale                    |  |                |            |                      |   |                       |  |            |        |  |   |           
|                                                 |  |                |            |                     
|U.S. Treasury securities                         |  | $              | 501,135    |                      | $ |                      |  | $          | 5,940  |  | $ | 495,195   
|U. S. government sponsored enterprises           |  |                | 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
|                                                 |  |                |            |                      |   |                       |  |            |        |  |   |           

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, 2006. 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                         |                | $              | 16,108,728 |  | 5.08                            | %              |  | $                                 |        |  |               |   |       | $     |        |                |     |       |  | $ |               |  |      |   |  | $ | 16,108,728 |  | 5.08 | %
|U.S. government sponsored enterprises            |                |                | 27,976,529 |  | 5.01                            | %              |  |                                   |        |  |               |   |       |       |        |                |     |       |  |   |               |  |      |   |  |   | 27,976,529 |  | 5.01 | %
|Mortgage-backed securities                       |                |                |           |  |                                |                |  |                                   |        |  |               |   |       |       |        |                |     |       |  |   | 145,162        |  | 5.50  | % |  |   | 145,162    |  | 5.50 | %
|Obligations of states and political subdivisions |                |                |           |  |                                |                |  |                                   | 194,615 |  | 5.08           | % |       |       | 661,387 |                | 4.26 | %     |  |   | 275,000        |  | 4.30  | % |  |   | 1,131,002  |  | 4.41 | %
|Preferred trust securities                       |                |                |           |  |                                |                |  |                                   |        |  |               |   |       |       |        |                |     |       |  |   | 200,000        |  | 9.25  | % |  |   | 200,000    |  | 9.25 | %
|                                                 |                |                |            |  |                                 |                |  |                                   |         |  |                |   |       |       |         |                |      |       |  |   |                |  |       |   |  |   |            |  |      |  
|Total                                            |                | $              | 44,085,257 |  | 5.04                            | %              |  | $                                 | 194,615 |  | 5.08           | % |       | $     | 661,387 |                | 4.26 | %     |  | $ | 620,162        |  | 6.18  | % |  | $ | 45,561,421 |  | 5.04 | %
|                                                 |                |                |            |  |                                 |                |  |                                   |         |  |                |   |       |       |         |                |      |       |  |   |                |  |       |   |  |   |            |  |      |  

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

At December 31, 2006, there were no securities of any issuer (other than U.S. government sponsored enterprises) that exceeded 10% of the
Companys stockholders equity.



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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 8.4% and
8.9% of total deposits at December 31, 2006 and 2005, 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, |            
|                                                        |  | 2006            |             |             | 2005 |   |                | 2004 |            
|                                                        |  | Average Balance |             | AverageRate |      |   | AverageBalance |      | AverageRate |  |      | AverageBalance |  | AverageRate |            
|Interest-bearing NOW, money market and savings accounts |  | $               | 70,020,852  |             | 2.95 | % |                | $    | 48,410,155  |  | 1.50 | %              |  | $           | 36,758,002  |  | 0.50 | %
|Time deposits                                           |  |                 | 66,498,503  |             | 4.13 | % |                |      | 71,631,693  |  | 3.52 | %              |  |             | 65,197,372  |  | 2.96 | %
|                                                        |  |                 |             |             |      |   |                |      |             |  |      |                |  |             |             |  |      |  
|Total interest-bearing deposits                         |  |                 | 136,519,355 |             | 3.53 | % |                |      | 120,041,848 |  | 2.70 | %              |  |             | 101,955,374 |  | 2.08 | %
|Demand and other noninterest- bearing deposits          |  |                 | 42,128,134  |             |     |   |                |      | 35,053,947  |  |     |                |  |             | 27,763,303  |  |     |  
|                                                        |  |                 |             |             |      |   |                |      |             |  |      |                |  |             |             |  |      |  
|Total average deposits                                  |  | $               | 178,647,489 |             | 2.69 | % |                | $    | 155,095,795 |  | 2.09 | %              |  | $           | 129,718,677 |  | 1.63 | %
|                                                        |  |                 |             |             |      |   |                |      |             |  |      |                |  |             |             |  |      |  

The following table sets forth the amounts and maturities of certificates of deposit with balances
of $100,000 or more at December 31, 2006:

Remaining maturity



|                                     |  |             |           
|------------------------------------ |  | ----------- | ----------
|Less than three months               |  | $ 6,483,398
|Over three months through six months |  |             | 835,890   
|Over six months through one year     |  |             | 2,293,186 
|Over twelve months                   |  |             | 6,741,991 
|                                     |  |             |           
|Total                                |  | $           | 16,354,465
|                                     |  |             |           

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, 2006, borrowings included $3.7 million in securities sold under agreements to
repurchase, and a $5.0 million unsecured term loan obtained by the Company in September 2006. In October 2006, the Company repaid, without penalty, a $10.0 million FHLB advance at a fixed rate of 4.54% to reduce the Banks level of liquidity.
In January 2007, the Company repaid the $5.0 million unsecured term loan.

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.



33



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##### Table of Contents

Liquid assets, which include cash and due from banks, fed funds sold and nonpledged securities available
for sale, totaled $67.3 million at December 31, 2006. In addition, the Banks funding sources at December 31, 2006 consisted of established borrowing capacity, subject to qualifying collateral availability, with the FHLB of 20% of the
Banks total assets, or $44.5 million, and established federal funds lines of $10.0 million with correspondent banks. At December 31, 2006, there was no outstanding balance with the FHLB or under the federal funds lines.

Certificates of deposit that are scheduled to mature within one year totaled $47.4 million at December 31, 2006. 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. Management believes the
Companys liquidity sources are sufficient to satisfy the Companys current operational requirements and obligations.

Capital Resources

The Companys capital is reflected in its stockholders equity, which was $24.4 million, or 10.9% of assets, at
December 31, 2006 compared to $16.1 million, or 7.9% of assets, at December 31, 2005. The Company raised a total of $8.2 million in net capital in connection with sales of the Companys common stock in private placements that closed
in June, July and December 2006. (For details, see Item 5, Market For Common Equity and Related Stockholder Matters  Recent Sales of Unregistered Securities.) The Company paid aggregate dividends of $0.24 per share in each of
2006 and 2005. The dividend payout ratio was 240.0% in 2006, compared to 51.1% in 2005.

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 15.69% at December 31, 2006 compared
to 10.88% at December 31, 2005; the Tier 1 capital ratio was 14.85% at December 31, 2006 compared to 10.05% at December 31, 2005; and the leverage ratio was 11.35% at December 31, 2006 compared to 7.81% at December 31, 2005.
These ratios all exceed the mandated minimum requirements.

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



34



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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, 2006 and 2005. For purposes of the risk-based capital ratios, qualifying 1-4 family residential loans at December 31, 2006 have been risk-weighted 50%. All loans held for investment at December 31, 2005 have
been risk-weighted 100%.



|                                         |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|---------------------------------------- |  | ------ | ------ | ----- | ---------------------------- | - | ------ | --------------------------------------------------------------------- | ------ |  | --- | ------ |  | ----- | ------ |  | ---- | -
|(Dollars in thousands)                   |  | Actual |        |       | For Capital AdequacyPurposes |   |        | Minimum To Be WellCapitalized
UnderPrompt Corrective ActionProvisions |       
|                                         |  | Amount |        | Ratio |                              |   | Amount |                                                                       | Ratio  |  |     | Amount |  | Ratio |       
|At December 31, 2006                     |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |       
|                                         |  |        |        |       |                              |  
|Total Capital (to Risk-Weighted Assets)  |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 25,765 |       | 15.69                        | % |        | $                                                                     | 13,137 |  | 8.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 24,612 |       | 15.00                        | % |        | $                                                                     | 13,125 |  | 8.0 | %      |  | $     | 16,407 |  | 10.0 | %
|Tier 1 Capital (to Risk-Weighted Assets) |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 24,392 |       | 14.85                        | % |        | $                                                                     | 6,568  |  | 4.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 23,239 |       | 14.16                        | % |        | $                                                                     | 6,563  |  | 4.0 | %      |  | $     | 9,844  |  | 6.0  | %
|Tier 1 Capital (to Average Assets)       |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 24,392 |       | 11.35                        | % |        | $                                                                     | 8,600  |  | 4.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 23,239 |       | 10.83                        | % |        | $                                                                     | 8,582  |  | 4.0 | %      |  | $     | 10,727 |  | 5.0  | %
|                                         |  |        |        |       |                              |  
|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  | %

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. For additional detail, see Item 1, Description of Business  Supervision and Regulation above.

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, 2006.



|                                               |  |                        |         |                          |   |           |  |           |        |                  |   |       |  |   |      
|---------------------------------------------- |  | ---------------------- | ------- | ------------------------ | - | --------- |  | --------- | ------ | ---------------- | - | ----- |  | - | -----
|                                               |  | Payments Due by Period
|Contractual Obligations                        |  | Total                  |         | On DemandOr Within1 Year |   | 1-3 Years |  | 3-5 Years |        | More than5 Years
|                                               |  | (dollars in thousands)
|Securities sold under agreements to repurchase |  | $                      | 3,716   |                          | $ | 3,716     |  | $         |       |                  | $ |      |  | $ |     
|Other borrowings (1)                           |  |                        | 5,050   |                          |   | 50        |  |           |       |                  |   | 5,000 |  |   |     
|Operating lease obligations                    |  |                        | 2,865   |                          |   | 320       |  |           | 502    |                  |   | 494   |  |   | 1,549
|Deposits                                       |  |                        | 188,397 |                          |   | 169,504   |  |           | 16,234 |                  |   | 2,659 |  |   |     
|Deferred compensation                          |  |                        | 1,158   |                          |   | 68        |  |           | 135    |                  |   | 135   |  |   | 820  
|Purchase obligations                           |  |                        | 4,225   |                          |   | 3,915     |  |           | 208    |                  |   | 102   |  |   |     
|                                               |  |                        |         |                          |   |           |  |           |        |                  |   |       |  |   |      
|Total contractual cash obligations             |  | $                      | 205,411 |                          | $ | 177,573   |  | $         | 17,079 |                  | $ | 8,390 |  | $ | 2,369
|                                               |  |                        |         |                          |   |           |  |           |        |                  |   |       |  |   |      

---

|(1) | $5.0 million of other borrowings was repaid in January 2007.
|--- | ------------------------------------------------------------



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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, 2006:



|                             |  |      |           
|---------------------------- |  | ---- | ----------
|                             |  | 2006
|Commitments to extend credit |  | $    | 40,567,244
|Standby letters of credit    |  |      | 1,015,971 
|Commitments to sell loans    |  |      | 2,115,800 
|                             |  |      |           
|                             |  | $    | 43,699,015
|                             |  |      |           

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 to manage 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, 2006, 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 1.1% 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 because the yield of interest-earning assets likely would fall faster than the cost of interest-bearing liabilities. The interest sensitivity gap position of the Company is a static analysis at December 31, 2006. 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, 2006.

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



36



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##### Table of Contents

differently to changes in market interest rates. The interest rates on certain types of assets and liabilities also may fluctuate in advance 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 on 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.



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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, 2006, 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, 2006



|                                                                    |  |                      |             |   |                                      |   |            |                              |  |   |                               |   |  |                                  |            |   |       |   |            |   |  |   |            
|------------------------------------------------------------------- |  | -------------------- | ----------- | - | ------------------------------------ | - | ---------- | ---------------------------- |  | - | ----------------------------- | - |  | -------------------------------- | ---------- | - | ----- | - | ---------- | - |  | - | -----------
|                                                                    |  | Three Months or Less |             |   | Over ThreeMonthsthroughTwelve Months |   |            | Over One Year to Three Years |  |   | Over Three Years to FiveYears |   |  | Over Five Years or Non-Sensitive |            |   | Total
|Assets                                                              |  |                      |             |   |                                      |   |            |                              |  |   |                               |   |  |                                  |            |   |       |   |            |   |  |   |            
|Interest-earning assets:                                            |  |                      |             |   |                                      |   |            |                              |  |   |                               |   |  |                                  |            |   |       |   |            |   |  |   |            
|Loans (1)                                                           |  | $                    | 55,952,460  |   |                                      | $ | 13,535,259 |                              |  | $ | 20,364,929                    |   |  | $                                | 27,605,373 |   |       | $ | 24,383,846 |   |  | $ | 141,841,867
|Investment securities                                               |  |                      | 27,677,487  |   |                                      |   | 16,641,857 |                              |  |   | 200,000                       |   |  |                                  | 108,204    |   |       |   | 952,831    |   |  |   | 45,580,379 
|Federal funds sold                                                  |  |                      | 19,286,245  |   |                                      |   |           |                              |  |   |                              |   |  |                                  |           |   |       |   |           |   |  |   | 19,286,245 
|Federal Home Loan, Federal Reserve stock                            |  |                      |            |   |                                      |   |           |                              |  |   |                              |   |  |                                  |           |   |       |   | 722,200    |   |  |   | 722,200    
|                                                                    |  |                      |             |   |                                      |   |            |                              |  |   |                               |   |  |                                  |            |   |       |   |            |   |  |   |            
|Total interest-earning assets                                       |  | $                    | 102,916,192 |   |                                      | $ | 30,177,116 |                              |  | $ | 20,564,929                    |   |  | $                                | 27,713,577 |   |       | $ | 26,058,877 |   |  | $ | 207,430,691
|                                                                    |  |                      |             |   |                                      |   |            |                              |  |   |                               |   |  |                                  |            |   |       |   |            |   |  |   |            
|Liabilities                                                         |  |                      |             |   |                                      |   |            |                              |  |   |                               |   |  |                                  |            |   |       |   |            |   |  |   |            
|                                                                    |  |                      |             |   |                                      |  
|Interest-bearing deposits:                                          |  |                      |             |   |                                      |   |            |                              |  |   |                               |   |  |                                  |            |   |       |   |            |   |  |   |            
|Savings accounts                                                    |  | $                    | 2,641,294   |   |                                      | $ |           |                              |  | $ |                              |   |  | $                                |           |   |       | $ |           |   |  | $ | 2,641,294  
|Checking accounts (2)                                               |  |                      | 14,369,595  |   |                                      |   |           |                              |  |   |                              |   |  |                                  |           |   |       |   |           |   |  |   | 14,369,595 
|Money Market deposits                                               |  |                      | 57,382,851  |   |                                      |   |           |                              |  |   |                              |   |  |                                  |           |   |       |   |           |   |  |   | 57,382,851 
|Certificates of Deposit                                             |  |                      | 13,916,399  |   |                                      |   | 33,498,427 |                              |  |   | 16,234,685                    |   |  |                                  | 2,659,071  |   |       |   |           |   |  |   | 66,308,582 
|                                                                    |  |                      |             |   |                                      |   |            |                              |  |   |                               |   |  |                                  |            |   |       |   |            |   |  |   |            
|Total interest-bearing deposits                                     |  |                      | 88,310,139  |   |                                      |   | 33,498,427 |                              |  |   | 16,234,685                    |   |  |                                  | 2,659,071  |   |       |   |           |   |  |   | 140,702,322
|                                                                    |  |                      |             |   |                                      |   |            |                              |  |   |                               |   |  |                                  |            |   |       |   |            |   |  |   |            
|Securities sold under agreements to repurchase                      |  |                      | 3,715,992   |   |                                      |   |           |                              |  |   |                              |   |  |                                  |           |   |       |   |           |   |  |   | 3,715,992  
|Other borrowings                                                    |  |                      | 5,050,000   |   |                                      |   |           |                              |  |   |                              |   |  |                                  |           |   |       |   |           |   |  |   | 5,050,000  
|                                                                    |  |                      |             |   |                                      |   |            |                              |  |   |                               |   |  |                                  |            |   |       |   |            |   |  |   |            
|Total interest-bearing liabilities                                  |  | $                    | 97,076,131  |   |                                      | $ | 33,498,427 |                              |  | $ | 16,234,685                    |   |  | $                                | 2,659,071  |   |       | $ |           |   |  | $ | 149,468,314
|                                                                    |  |                      |             |   |                                      |   |            |                              |  |   |                               |   |  |                                  |            |   |       |   |            |   |  |   |            
|Interest sensitivity gap                                            |  | $                    | 5,840,061   |   |                                      | $ | (3,321,311 | )                            |  | $ | 4,330,244                     |   |  | $                                | 25,054,506 |   |       | $ | 26,058,877 |   |  | $ | 57,962,377 
|Cumulative interest sensitivity gap                                 |  | $                    | 5,840,061   |   |                                      | $ | 2,518,750  |                              |  | $ | 6,848,994                     |   |  | $                                | 31,903,500 |   |       | $ | 57,962,377 |   |  |   |            
|                                                                    |  |                      |             |   |                                      |  
|Cumulative interest sensitivity gap as a percentage of total assets |  |                      | 2.6         | % |                                      |   | 1.1        | %                            |  |   | 3.1                           | % |  |                                  | 14.3       | % |       |   | 26.0       | % |  |   |            
|                                                                    |  |                      |             |   |                                      |   |            |                              |  |   |                               |   |  |                                  |            |   |       |   |            |   |  |   |            

---

|(1) | Excludes non-accrual loans of $169,642
|--- | --------------------------------------

|(2) | Excludes $47,694,963 of noninterest-bearing deposits.
|--- | -----------------------------------------------------

Recent
Accounting Pronouncements

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



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December 15, 2005 for small business filers. The Company adopted SFAS No. 123(R) effective as of January 1, 2006 under the modified
prospective transition method. 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) 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 (see Note 2  Share Based Compensation).

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 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.

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.

In February 2006, the Financial Accounting Standards Board (FASB) issued
SFAS No. 155, Accounting for Certain Hybrid Financial Instruments,which amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities,and SFAS No. 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities. This statement resolves issues addressed in SFAS No. 133 related to beneficial interests in securitized financial assets and permits fair value remeasurement for any hybrid financial
instrument that contains an embedded derivative. SFAS No. 155 is effective for all financial instruments acquired or issued for fiscal years beginning after September 15, 2006. The adoption of this statement is not expected to have a
material effect the Companys consolidated financial statements.

In March 2006, the FASB issued SFAS No. 156, Accounting for
Servicing of Financial Assets, which amends SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. This statement requires all separately recognized servicing assets and servicing
liabilities be initially measured at fair value. SFAS No. 156 is effective for fiscal years beginning after September 15, 2006. The adoption of this statement is not expected to have a material effect on the Companys consolidated
financial statements.

In June 2006, the FASB issued Interpretation No. (FIN) 48, Accounting for Income Tax
Uncertainties. FIN 48 clarifies the criteria for recognizing tax benefits under SFAS No. 109, Accounting for Income Taxes. This interpretation defines the threshold for recognizing the benefits of tax return positions in the
financial statements as more-likely-than-not to be sustained by the taxing authority. FIN 48 is effective for fiscal years beginning after December 15, 2006, and is not expected to have a material effect on the Companys
consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This statement
defines fair value, established a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The adoption of this statement is
not expected to have a material effect on the Companys consolidated financial statements.

In September 2006, the FASB issued SFAS
No. 158, Accounting for Defined Benefit Pension and Other Postretirement Plans, which amends SFAS Nos. 87, 88, 106 and 132(R). This statement requires employers to recognize in the statement of financial position the over funded or under
funded status of a defined benefit postretirement plan measured as the difference between the fair value of plan assets and the benefit obligation. SFAS No. 158 is effective for fiscal years ending after December 15, 2006. The adoption of
this statement is not expected to have a material effect on the Companys consolidated financial statements.

In September 2006, the
SEC released Staff Accounting Bulletin (SAB) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, which requires registrants to consider the effect
of all carry over and reversing effects of prior year misstatements when quantifying errors in current year financial statements. The SEC allows registrants to record the effects of adopting this guidance as a cumulative-effect adjustment to
retained earnings. This adjustment must be reported as of the beginning of the first fiscal year ending November 2006. The adoption of this SAB is not



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expected to have a material effect on the Companys consolidated financial statements.

In September 2006, the Emerging Issues Task Force (EITF) released EITF Issue No. 06-4, Accounting for Deferred Compensation and
Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.The EITF reached a consensus that for an endorsement split-dollar life insurance arrangement, an employer should recognize a liability for future benefits
based on the substantive agreement with the employee. The consensus is effective for fiscal years beginning after December 15, 2007. The adoption of the EITF is not expected to have a material effect on the Companys consolidated financial
statements.

In September 2006, the EITF released EITF Issue No. 06-5, Accounting for Purchases of Life Insurance 
Determining the Amount that could be Realized in Accordance with FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance. The EITF reached a consensus that a policyholder should consider any additional amounts to be
received included in the contractual terms of the policy in determining the amount that could be realized. The adoption of the EITF is not expected to have a material effect on the Companys consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial LiabilitiesIncluding an
amendment of FASB Statement No. 115, (SFAS No. 159), which permits companies to choose to measure many financial instruments and certain other items at fair value. The objective of SFAS No. 159 is to improve
financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159
is effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating any effect that SFAS No. 159 may have on its 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, and we obtain collateral based on our credit
assessment of the customer in each instance.

The Company historically sells to third-party investors substantially all of the residential
mortgage loans it originates, 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 2006 or 2005. 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, 2006, the Company had rate lock commitments to originate mortgage loans
amounting to $1.6 million 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.

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 companies 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 Stockholders and Board of Directors

Heritage Bankshares, Inc.

Norfolk, Virginia

We have audited the accompanying consolidated balance sheet of Heritage Bankshares, Inc. and subsidiaries (the Company) as of December 31, 2006, and the related consolidated statements of income, stockholders equity
and cash flows for the year then ended. This consolidated financial statement is the responsibility of the Companys management. Our responsibility is to express an opinion on this consolidated financial statement based on our audit.

We conducted our audit 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 was not required to have, nor were we engaged to perform an audit of the Companys 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 audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statement referred to above presents fairly, in all material respects, the financial position of Heritage Bankshares, Inc. and
subsidiaries at December 31, 2006 and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.



|                      
|----------------------
|/s/ Elliott Davis, LLC
|                      
|                      
|Galax, Virginia       
|March 23, 2007        



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##### Table of Contents

Report of Independent Registered Public Accounting Firm

The Stockholders and Board of Directors

Heritage Bankshares, Inc.

Norfolk, Virginia

We have audited the
accompanying consolidated balance sheet of Heritage Bankshares, Inc. and its subsidiaries as of December 31, 2005, and the related consolidated statements of income, stockholders equity and cash flows for the year 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 audit.

We conducted our audit 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 audit provides 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 the consolidated results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in
the United States of America.



|                       
|-----------------------
|/s/ PKF Witt Mares, PLC
|                       
|                       
|Norfolk, Virginia      
|November 9, 2006       



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HERITAGE BANKSHARES, INC.

CONSOLIDATED BALANCE SHEETS

At December 31, 2006 and 2005



|                                                                                                                                   |  |      |             |      |   |             |  
|---------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ----------- | ---- | - | ----------- | -
|                                                                                                                                   |  | 2006 |             | 2005 |  
|ASSETS                                                                                                                             |  |      |             |      |   |             |  
|                                                                                                                                   |  |     
|Cash and due from banks                                                                                                            |  | $    | 7,902,980   |      | $ | 8,348,895   |  
|Federal funds sold                                                                                                                 |  |      | 19,286,245  |      |   | 45,831,070  |  
|Securities available for sale, at fair value                                                                                       |  |      | 44,901,507  |      |   | 9,284,678   |  
|Securities held to maturity, at cost                                                                                               |  |      | 678,872     |      |   | 681,236     |  
|Loans, net                                                                                                                         |  |      |             |      |   |             |  
|Held for investment, net of allowance for loan losses of $1,373,000 and $1,335,001, respectively                                   |  |      | 140,118,509 |      |   | 130,420,326 |  
|Held for sale                                                                                                                      |  |      | 520,000     |      |   | 1,351,000   |  
|Accrued interest receivable                                                                                                        |  |      | 736,021     |      |   | 683,610     |  
|Stock in Federal Reserve Bank, at cost                                                                                             |  |      | 312,900     |      |   | 64,900      |  
|Stock in Federal Home Loan Bank of Atlanta, at cost                                                                                |  |      | 409,300     |      |   | 757,800     |  
|Premises and equipment, net                                                                                                        |  |      | 6,765,603   |      |   | 5,743,532   |  
|Other assets                                                                                                                       |  |      | 1,256,454   |      |   | 1,469,191   |  
|                                                                                                                                   |  |      |             |      |   |             |  
|Total assets                                                                                                                       |  | $    | 222,888,391 |      | $ | 204,636,238 |  
|                                                                                                                                   |  |      |             |      |   |             |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                               |  |      |             |      |   |             |  
|                                                                                                                                   |  |     
|Liabilities                                                                                                                        |  |      |             |      |   |             |  
|Deposits                                                                                                                           |  |      |             |      |   |             |  
|Noninterest-bearing                                                                                                                |  | $    | 47,694,963  |      | $ | 37,954,601  |  
|Interest-bearing                                                                                                                   |  |      | 140,702,322 |      |   | 134,810,027 |  
|                                                                                                                                   |  |      |             |      |   |             |  
|Total deposits                                                                                                                     |  |      | 188,397,285 |      |   | 172,764,628 |  
|                                                                                                                                   |  |      |             |      |   |             |  
|Federal Home Loan Bank Advance                                                                                                     |  |      |            |      |   | 10,000,000  |  
|Securities sold under agreements to repurchase                                                                                     |  |      | 3,715,992   |      |   | 4,235,393   |  
|Other borrowings                                                                                                                   |  |      | 5,050,000   |      |   | 50,000      |  
|Accrued interest payable                                                                                                           |  |      | 376,480     |      |   | 378,399     |  
|Other liabilities                                                                                                                  |  |      | 944,456     |      |   | 1,135,661   |  
|                                                                                                                                   |  |      |             |      |   |             |  
|Total liabilities                                                                                                                  |  |      | 198,484,213 |      |   | 188,564,081 |  
|                                                                                                                                   |  |      |             |      |   |             |  
|Commitments and contingent liabilities (Note 10, 14, and 16)                                                                       |  |      |            |      |   |            |  
|                                                                                                                                   |  |     
|Stockholders equity                                                                                                               |  |      |             |      |   |             |  
|Common stock, $5 par value - authorized 3,000,000 shares; issued and outstanding: 2006  2,277,652 shares; 2005  1,714,668
shares |  |      | 11,388,260  |      |   | 8,573,340   |  
|Additional paid-in capital                                                                                                         |  |      | 6,031,549   |      |   | 314,838     |  
|Retained earnings                                                                                                                  |  |      | 6,971,856   |      |   | 7,237,748   |  
|Accumulated other comprehensive income (loss), net                                                                                 |  |      | 12,513      |      |   | (53,769     | )
|                                                                                                                                   |  |      |             |      |   |             |  
|Total stockholders equity                                                                                                         |  |      | 24,404,178  |      |   | 16,072,157  |  
|                                                                                                                                   |  |      |             |      |   |             |  
|Total liabilities and stockholders equity                                                                                         |  | $    | 222,888,391 |      | $ | 204,636,238 |  
|                                                                                                                                   |  |      |             |      |   |             |  

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, 2006 and 2005



|                                                    |  |      |            |      |   |           
|--------------------------------------------------- |  | ---- | ---------- | ---- | - | ----------
|                                                    |  | 2006 |            | 2005
|Interest income                                     |  |      |            |      |   |           
|Loans and fees on loans                             |  | $    | 9,677,303  |      | $ | 8,465,942 
|Taxable investment securities                       |  |      | 650,885    |      |   | 361,722   
|Nontaxable investment securities                    |  |      | 48,974     |      |   | 47,843    
|Dividends on FRB and FHLB stock                     |  |      | 47,614     |      |   | 33,496    
|Interest on federal funds sold                      |  |      | 2,007,017  |      |   | 1,135,259 
|                                                    |  |      |            |      |   |           
|Total interest income                               |  |      | 12,431,793 |      |   | 10,044,262
|                                                    |  |      |            |      |   |           
|Interest expense                                    |  |      |            |      |   |           
|Deposits                                            |  |      | 4,812,810  |      |   | 3,244,403 
|Borrowings                                          |  |      | 562,710    |      |   | 500,468   
|                                                    |  |      |            |      |   |           
|Total interest expense                              |  |      | 5,375,520  |      |   | 3,744,871 
|                                                    |  |      |            |      |   |           
|Net interest income                                 |  |      | 7,056,273  |      |   | 6,299,391 
|Provision for loan losses                           |  |      | 64,262     |      |   | 33,010    
|                                                    |  |      |            |      |   |           
|Net interest income after provision for loan losses |  |      | 6,992,011  |      |   | 6,266,381 
|                                                    |  |      |            |      |   |           
|Noninterest income                                  |  |      |            |      |   |           
|Service charges on deposit accounts                 |  |      | 627,473    |      |   | 395,520   
|Gains on sale of other real estate owned            |  |      |           |      |   | 427,066   
|Gains on sale of loans held for sale, net           |  |      | 178,146    |      |   | 260,353   
|Late charges and other fees on loans                |  |      | 91,996     |      |   | 187,687   
|Other                                               |  |      | 448,628    |      |   | 388,485   
|                                                    |  |      |            |      |   |           
|Total noninterest income                            |  |      | 1,346,243  |      |   | 1,659,111 
|                                                    |  |      |            |      |   |           
|Noninterest expense                                 |  |      |            |      |   |           
|Compensation                                        |  |      | 4,197,596  |      |   | 3,159,118 
|Data processing                                     |  |      | 524,305    |      |   | 366,161   
|Occupancy                                           |  |      | 496,892    |      |   | 371,721   
|Furniture and equipment                             |  |      | 593,087    |      |   | 452,141   
|Taxes and licenses                                  |  |      | 184,928    |      |   | 152,551   
|Professional fees                                   |  |      | 528,620    |      |   | 534,195   
|Contract employee services                          |  |      | 206,672    |      |   | 292,577   
|Marketing                                           |  |      | 217,107    |      |   | 297,260   
|Other                                               |  |      | 1,133,045  |      |   | 1,117,593 
|                                                    |  |      |            |      |   |           
|Total noninterest expense                           |  |      | 8,082,252  |      |   | 6,743,317 
|                                                    |  |      |            |      |   |           
|Income before provision for income taxes            |  |      | 256,002    |      |   | 1,182,175 
|Provision for income taxes                          |  |      | 75,882     |      |   | 372,759   
|                                                    |  |      |            |      |   |           
|Net income                                          |  | $    | 180,120    |      | $ | 809,416   
|                                                    |  |      |            |      |   |           
|Earnings per share                                  |  |      |            |      |   |           
|Basic                                               |  | $    | 0.10       |      | $ | 0.47      
|                                                    |  |      |            |      |   |           
|Diluted                                             |  | $    | 0.10       |      | $ | 0.46      
|                                                    |  |      |            |      |   |           
|Weighted average shares outstanding                 |  |      |            |      |   |           
|                                                    |  |      |            |      |   |           
|Basic                                               |  |      | 1,820,300  |      |   | 1,709,405 
|Diluted                                             |  |      | 1,853,634  |      |   | 1,752,533 

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, 2006 and 2005



|                                                                                                 |        |              |   |        |                           |            |   |                   |   |           |                                              |  |   |           |   |  |   |         |   |  |   |            |  
|------------------------------------------------------------------------------------------------ | ------ | ------------ | - | ------ | ------------------------- | ---------- | - | ----------------- | - | --------- | -------------------------------------------- |  | - | --------- | - |  | - | ------- | - |  | - | ---------- | -
|                                                                                                 |        | Common Stock |   |        | AdditionalPaid-in Capital |            |   | Retained Earnings |   |           | Accumulated OtherComprehensive Income
(Loss) |  |   | Total     |  
|                                                                                                 | Shares |              |   | Amount |                           |            |   |                   |  
|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 |  
|                                                                                                 |        |              |   |        |                           |            |   |                   |   |           |                                              |  |   |           |   |  |   |         |   |  |   |            |  
|Comprehensive income:                                                                            |        |              |   |        |                           |            |   |                   |   |           |                                              |  |   |           |   |  |   |         |   |  |   |            |  
|Net income for 2006                                                                              |        |             |   |        |                           |           |   |                   |   |          |                                              |  |   | 180,120   |   |  |   |        |   |  |   | 180,120    |  
|Change in unrealized gain (loss) on securities available-for-sale, net of tax of $34,145         |        |             |   |        |                           |           |   |                   |   |          |                                              |  |   |          |   |  |   | 66,282  |   |  |   | 66,282     |  
|                                                                                                 |        |              |   |        |                           |            |   |                   |   |           |                                              |  |   |           |   |  |   |         |   |  |   |            |  
|Total comprehensive income                                                                       |        |             |   |        |                           |           |   |                   |   |          |                                              |  |   |          |   |  |   |        |   |  |   | 246,402    |  
|                                                                                                 |        |              |   |        |                           |           
|Exercise of stock options and related tax benefits                                               |        | 29,800       |   |        |                           | 149,000    |   |                   |   | 112,127   |                                              |  |   |          |   |  |   |        |   |  |   | 261,127    |  
|Issuance of common stock                                                                         |        | 535,584      |   |        |                           | 2,677,920  |   |                   |   | 5,549,429 |                                              |  |   |          |   |  |   |        |   |  |   | 8,227,349  |  
|Repurchase of common stock                                                                       |        | (2,400       | ) |        |                           | (12,000    | ) |                   |   | (16,800   | )                                            |  |   |          |   |  |   |        |   |  |   | (28,800    | )
|Equity-based compensation expense                                                                |        |             |   |        |                           |           |   |                   |   | 71,955    |                                              |  |   |          |   |  |   |        |   |  |   | 71,955     |  
|Cash dividends ($0.24 per share)                                                                 |        |             |   |        |                           |           |   |                   |   |          |                                              |  |   | (446,012  | ) |  |   |        |   |  |   | (446,012   | )
|                                                                                                 |        |              |   |        |                           |            |   |                   |   |           |                                              |  |   |           |   |  |   |         |   |  |   |            |  
|Balance, December 31, 2006                                                                       |        | 2,277,652    |   |        | $                         | 11,388,260 |   |                   | $ | 6,031,549 |                                              |  | $ | 6,971,856 |   |  | $ | 12,513  |   |  | $ | 24,404,178 |  
|                                                                                                 |        |              |   |        |                           |            |   |                   |   |           |                                              |  |   |           |   |  |   |         |   |  |   |            |  

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, 2006 and 2005



|                                                                                  |  |      |             |   |      |   |             |  
|--------------------------------------------------------------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | -
|                                                                                  |  | 2006 |             |   | 2005 |  
|Cash flows from operating activities:                                             |  |      |             |   |      |   |             |  
|Net income                                                                        |  | $    | 180,120     |   |      | $ | 809,416     |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |      |             |   |      |   |             |  
|Provision for loan losses                                                         |  |      | 64,262      |   |      |   | 33,010      |  
|Amortization (accretion) of loan yield adjustments, net                           |  |      | 350,070     |   |      |   | 160,599     |  
|Depreciation, amortization and accretion, net                                     |  |      | (27,276     | ) |      |   | 377,134     |  
|Stock-based compensation                                                          |  |      | 71,955      |   |      |   |            |  
|Exercise of stock options tax benefit                                             |  |      | 110,157     |   |      |   | 29,624      |  
|Net gains on sale of:                                                             |  |      |             |   |      |   |             |  
|Securities                                                                        |  |      | (25,652     | ) |      |   |            |  
|Loans                                                                             |  |      | (178,145    | ) |      |   | (260,352    | )
|Real estate owned                                                                 |  |      |            |   |      |   | (443,683    | )
|Property, plant and equipment                                                     |  |      | (643        | ) |      |   |            |  
|Loss on sale, disposal or impairment of long-lived assets                         |  |      | 74,582      |   |      |   | 10,657      |  
|(Gain) on sale of investment                                                      |  |      |            |   |      |   | (3,111      | )
|Proceeds from sales of loans held for sale                                        |  |      | 10,590,145  |   |      |   | 17,552,540  |  
|Origination of loans held for sale                                                |  |      | (9,581,000  | ) |      |   | (17,127,488 | )
|Changes in assets/liabilities, net                                                |  |      |             |   |      |   |             |  
|Decrease (increase) in interest receivable and other assets                       |  |      | 126,183     |   |      |   | 65,643      |  
|Increase (decrease) in other liabilities                                          |  |      | (193,124    | ) |      |   | 286,492     |  
|                                                                                  |  |      |             |   |      |   |             |  
|Net cash provided by operating activities                                         |  |      | 1,561,634   |   |      |   | 1,490,481   |  
|                                                                                  |  |      |             |   |      |   |             |  
|Cash flows from investing activities:                                             |  |      |             |   |      |   |             |  
|Proceeds from sales of securities available for sale                              |  |      | 111,127     |   |      |   |            |  
|Purchases of securities available for sale                                        |  |      | (83,108,182 | ) |      |   |            |  
|Proceeds from maturities of securities available for sale                         |  |      | 47,900,000  |   |      |   | 4,740,000   |  
|Principal repayments on securities available for sale                             |  |      | 35,118      |   |      |   | 58,617      |  
|Proceeds from maturities of securities held to maturity                           |  |      |            |   |      |   | 500,000     |  
|Principal repayments on securities held to maturity                               |  |      | 2,482       |   |      |   | 4,746       |  
|Proceeds from sale of investment                                                  |  |      |            |   |      |   | 22,304      |  
|Net increase in loans held for investment                                         |  |      | (10,112,515 | ) |      |   | (6,921,312  | )
|Purchases of Federal Home Loan Bank stock and Federal Reserve Bank stock          |  |      | (349,500    | ) |      |   | (765,100    | )
|Redemption of Federal Home Loan Bank stock                                        |  |      | 450,000     |   |      |   | 297,000     |  
|Purchases of premises and equipment                                               |  |      | (1,497,667  | ) |      |   | (3,482,090  | )
|Proceeds from sale of real estate owned                                           |  |      |            |   |      |   | 560,361     |  
|Proceeds from sales of premises and equipment                                     |  |      |            |   |      |   | 19,907      |  
|                                                                                  |  |      |             |   |      |   |             |  
|Net cash used for investing activities                                            |  |      | (46,569,137 | ) |      |   | (4,965,567  | )
|                                                                                  |  |      |             |   |      |   |             |  
|Cash flows from financing activities:                                             |  |      |             |   |      |   |             |  
|Proceeds from exercise of stock options                                           |  |      | 150,970     |   |      |   | 37,539      |  
|Net increase in deposits                                                          |  |      | 15,632,657  |   |      |   | 39,685,924  |  
|Proceeds from Federal Home Loan Bank advances                                     |  |      |            |   |      |   | 17,175,000  |  
|Repayments of Federal Home Loan Bank advances                                     |  |      | (10,000,000 | ) |      |   | (7,175,000  | )
|Proceeds from federal funds purchased                                             |  |      |            |   |      |   | 13,972,000  |  
|Repayment of federal funds purchased                                              |  |      |            |   |      |   | (15,713,000 | )
|Net increase (decrease) in securities sold under agreements to repurchase         |  |      | (519,401    | ) |      |   | 2,205,372   |  
|Private Placement issuance of stock                                               |  |      | 8,227,349   |   |      |   |            |  
|Stock repurchase                                                                  |  |      | (28,800     | ) |      |   |            |  
|Proceeds from other borrowings                                                    |  |      | 5,000,000   |   |      |   |            |  
|Cash dividends paid                                                               |  |      | (446,012    | ) |      |   | (410,141    | )
|                                                                                  |  |      |             |   |      |   |             |  
|Net cash provided by financing activities                                         |  |      | 18,016,763  |   |      |   | 49,777,694  |  
|                                                                                  |  |      |             |   |      |   |             |  
|Increase (decrease) in cash and cash equivalents                                  |  |      | (26,990,740 | ) |      |   | 46,302,608  |  
|Cash and cash equivalents, beginning of year                                      |  |      | 54,179,965  |   |      |   | 7,877,357   |  
|                                                                                  |  |      |             |   |      |   |             |  
|Cash and cash equivalents, end of year                                            |  | $    | 27,189,225  |   |      | $ | 54,179,965  |  
|                                                                                  |  |      |             |   |      |   |             |  
|Supplemental disclosure:                                                          |  |      |             |   |      |   |             |  
|Interest paid                                                                     |  | $    | 5,377,438   |   |      | $ | 3,598,377   |  
|Income taxes paid                                                                 |  | $    | 150,000     |   |      | $ | 520,000     |  
|Additional cash flow information:                                                 |  |      |             |   |      |   |             |  
|Transfers from other real estate to loans                                         |  | $    |            |   |      | $ | 164,000     |  

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, 2006 AND 2005

---

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, 2006, serves as the holding company for its wholly-owned subsidiaries: Heritage Bank, 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, 2006, 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, 2006, 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 5 presents the Companys lending
activities. The Company invests in a variety of securities, principally obligations of the U.S., U.S. government sponsored enterprises, mortgage-backed securities 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.

Cash and Cash
Equivalents

For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, federal funds
sold and overnight investments with Federal Home Loan Bank.



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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: (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 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



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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.

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 Company 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 is recognized on the rate lock commitments.



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##### Table of Contents

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 0.18% (effective March 27, 2007) 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, 2006, no valuation allowance has been provided against the Companys 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, 2006, 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

At December 31, 2006, the Company has one stock-based compensation plan (the 2006 Incentive Plan). 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. The Company elected to follow the modified prospective transition method, under which compensation expense is recognized prospectively for all unvested options outstanding at January 1, 2006 and for all
awards modified or granted after that date. The Company had no existing stock options that remained unvested as of January 1, 2006. A description of the 2006 Incentive Plan and additional disclosures required by SFAS No. 123(R) are
included in Note 10.

Prior to January 1, 2006, the Company had elected to account for stock options pursuant to APB No. 25,
Accounting for Stock Issued to Employees. The information below for the year ended December 31, 2005 is disclosed in accordance with SFAS No. 123, Accounting for Stock-Based Compensation, which required pro forma disclosures
of net income and earnings per share as if the fair value based method of accounting had been applied. The weighted average fair value of options granted in 2005 was $5.34 and



50



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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.



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

Earnings Per Common Share

Basic earnings per share represent 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.

NOTE 2  OTHER COMPREHENSIVE INCOME

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



|                                                                   |  |                          |         |   |      |   |         |  
|------------------------------------------------------------------ |  | ------------------------ | ------- | - | ---- | - | ------- | -
|                                                                   |  | Years Ended December 31, |        
|                                                                   |  | 2006                     |         |   | 2005 |  
|Unrealized holding gains (losses) on available-for-sale securities |  | $                        | 100,427 |   |      | $ | (63,318 | )
|                                                                   |  |                         
|Tax Effect                                                         |  |                          | (34,145 | ) |      |   | 21,528  |  
|                                                                   |  |                          |         |   |      |   |         |  
|Net of tax amount                                                  |  | $                        | 66,282  |   |      | $ | (41,790 | )
|                                                                   |  |                          |         |   |      |   |         |  



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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, 2006 and 2005, these reserve balances amounted to
$1,063,000 and $2,811,000, respectively.

NOTE 4  SECURITIES



|                                                 |  |               |            |                      |   |                       |  |            |         |  |   |           
|------------------------------------------------ |  | ------------- | ---------- | -------------------- | - | --------------------- |  | ---------- | ------- |  | - | ----------
|                                                 |  | AmortizedCost |            | GrossUnrealizedGains |   | GrossUnrealizedLosses |  | Fair Value
|At December 31, 2006                             |  |               |            |                      |   |                       |  |            |         |  |   |           
|                                                 |  |               |            |                     
|Securities available for sale                    |  |               |            |                      |   |                       |  |            |         |  |   |           
|U.S. Treasury securities                         |  | $             | 16,108,728 |                      | $ | 6,221                 |  | $          |        |  | $ | 16,114,949
|U.S. government sponsored enterprises            |  |               | 27,976,529 |                      |   | 11,239                |  |            | 15,578  |  |   | 27,972,190
|Mortgage-backed securities                       |  |               | 135,905    |                      |   | 631                   |  |            |        |  |   | 136,536   
|Obligations of states and political subdivisions |  |               | 661,387    |                      |   | 16,445                |  |            |        |  |   | 677,832   
|                                                 |  |               |            |                      |   |                       |  |            |         |  |   |           
|Total securities available for sale              |  |               | 44,882,549 |                      |   | 34,536                |  |            | 15,578  |  |   | 44,901,507
|                                                 |  |               |            |                      |   |                       |  |            |         |  |   |           
|Securities held to maturity                      |  |               |            |                      |   |                       |  |            |         |  |   |           
|Mortgage-backed securities                       |  |               | 9,257      |                      |   | 106                   |  |            |        |  |   | 9,363     
|Obligations of states and political subdivisions |  |               | 469,615    |                      |   | 8,654                 |  |            |        |  |   | 478,269   
|Preferred trust securities                       |  |               | 200,000    |                      |   | 12,000                |  |            |        |  |   | 212,000   
|                                                 |  |               |            |                      |   |                       |  |            |         |  |   |           
|Total securities held to maturity                |  |               | 678,872    |                      |   | 20,760                |  |            |        |  |   | 699,632   
|                                                 |  |               |            |                      |   |                       |  |            |         |  |   |           
|Total securities                                 |  | $             | 45,561,421 |                      | $ | 55,296                |  | $          | 15,578  |  | $ | 45,601,139
|                                                 |  |               |            |                      |   |                       |  |            |         |  |   |           
|At December 31, 2005                             |  |               |            |                      |   |                       |  |            |         |  |   |           
|                                                 |  |               |            |                     
|Securities available for sale                    |  |               |            |                      |   |                       |  |            |         |  |   |           
|U.S. Treasury securities                         |  | $             | 500,084    |                      | $ |                      |  | $          | 864     |  | $ | 499,220   
|U.S. government sponsored enterprises            |  |               | 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 
|                                                 |  |               |            |                      |   |                       |  |            |         |  |   |           

Investment securities having carrying value of $983,120 and $4,660,312 at December 31, 2006
and 2005, respectively, were pledged to secure deposits of the U.S. government and the Commonwealth of Virginia. The fair values of these securities were $992,261 and $4,635,521 at December 31, 2006 and 2005, respectively.

Investment securities having carrying values of $3,762,354 and $4,577,797 at December 31, 2006 and 2005, respectively, are pledged for retail
repurchase agreements. The estimated fair values of these securities were $3,765,440 and $4,516,900 at December 31, 2006 and 2005, 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, 2006 and 2005. 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, 2006
|                                      |  | Less Than 12 Months  |   | 12 Months or More |   | Total     
|                                      |  | Fair Value           |   | UnrealizedLosses  |   | Fair Value |  | UnrealizedLosses |           | Fair Value |   | UnrealizedLosses
|U.S. government sponsored enterprises |  | $                    |  |                   | $ |           |  | $                | 2,492,190 |            | $ | 15,578           |  | $ | 2,492,190 |  | $ | 15,578 
|                                      |  |                      |   |                   |   |            |  |                  |           |            |   |                  |  |   |           |  |   |        
|Total temporarily impaired securities |  | $                    |  |                   | $ |           |  | $                | 2,492,190 |            | $ | 15,578           |  | $ | 2,492,190 |  | $ | 15,578 
|                                      |  |                      |   |                   |   |            |  |                  |           |            |   |                  |  |   |           |  |   |        
|                                      | 
|                                      |  | 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    
|U.S. government sponsored enterprises |  |                      |  |                   |   |           |  |                  | 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
|                                      |  |                      |   |                   |   |            |  |                  |           |            |   |                  |  |   |           |  |   |        

The amortized cost and fair value of investment securities at December 31, 2006, 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                |  | $                             | 44,085,257 |                             | $ | 44,087,140    |  | $          |        |  | $ |       
|Due after one year through five years  |  |                               |           |                             |   |              |  |            | 194,615 |  |   | 195,441
|Due after five years through ten years |  |                               | 661,387    |                             |   | 677,831       |  |            |        |  |   |       
|Due after ten years                    |  |                               | 135,905    |                             |   | 136,536       |  |            | 484,257 |  |   | 504,191
|                                       |  |                               |            |                             |   |               |  |            |         |  |   |        
|Total                                  |  | $                             | 44,882,549 |                             | $ | 44,901,507    |  | $          | 678,872 |  | $ | 699,632
|                                       |  |                               |            |                             |   |               |  |            |         |  |   |        



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NOTE 5  LOANS

Loans consist of the following:



|                           |  |                 |             |   |      |   |             |  
|-------------------------- |  | --------------- | ----------- | - | ---- | - | ----------- | -
|                           |  | At December 31, |            
|                           |  | 2006            |             |   | 2005 |  
|Commercial                 |  | $               | 19,752,244  |   |      | $ | 17,927,074  |  
|Real estate - mortgage     |  |                 | 92,513,346  |   |      |   | 98,801,013  |  
|Real estate - construction |  |                 | 23,780,496  |   |      |   | 10,013,033  |  
|Installment and consumer   |  |                 | 4,731,529   |   |      |   | 4,665,853   |  
|                           |  |                 |             |   |      |   |             |  
|Total loans:               |  |                 | 140,777,615 |   |      |   | 131,406,973 |  
|                           |  |                
|Allowance for loan losses  |  |                 | (1,373,000  | ) |      |   | (1,335,001  | )
|Unearned loan fees/costs   |  |                 | 713,894     |   |      |   | 348,354     |  
|                           |  |                 |             |   |      |   |             |  
|Loans net                  |  | $               | 140,118,509 |   |      | $ | 130,420,326 |  
|                           |  |                 |             |   |      |   |             |  

Nonperforming assets were:



|                                        |  |                 |         |      |   |        
|--------------------------------------- |  | --------------- | ------- | ---- | - | -------
|                                        |  | At December 31,
|                                        |  | 2006            |         | 2005
|Nonaccrual loans (1)                    |  | $               | 169,642 |      | $ | 225,934
|Accruing loans past due 90 days or more |  |                 | 7,865   |      |   | 4,476  
|                                        |  |                 |         |      |   |        
|Total nonperforming loans               |  |                 | 177,507 |      |   | 230,410
|                                        |  |                
|Real estate owned, net                  |  |                 |        |      |   |       
|                                        |  |                 |         |      |   |        
|Total nonperforming assets              |  | $               | 177,507 |      | $ | 230,410
|                                        |  |                 |         |      |   |        

---

|(1) | At December 31, 2006 and 2005, includes restructured loans of $169,642 and $224,799, respectively.
|--- | --------------------------------------------------------------------------------------------------

If interest on nonaccrual loans had been accrued, such income would have approximated $37,501 and $57,106 in 2006 and 2005, 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, |          
|                           |  | 2006            |           |   | 2005 |  
|Balance, beginning of year |  | $               | 1,335,001 |   |      | $ | 1,264,000 |  
|Provision for loan losses  |  |                 | 64,262    |   |      |   | 33,010    |  
|Loans charged-off          |  |                 | (90,851   | ) |      |   | (50,628   | )
|Recoveries                 |  |                 | 64,588    |   |      |   | 88,619    |  
|                           |  |                 |           |   |      |   |           |  
|Balance, end of year       |  | $               | 1,373,000 |   |      | $ | 1,335,001 |  
|                           |  |                 |           |   |      |   |           |  



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



|                                                      |  |                          |         |      |   |        
|----------------------------------------------------- |  | ------------------------ | ------- | ---- | - | -------
|                                                      |  | At December 31,         
|                                                      |  | 2006                     |         | 2005
|Impaired loans without a valuation allowance          |  | $                        | 169,642 |      | $ | 225,934
|Impaired loans with a valuation allowance             |  |                          |        |      |   |       
|                                                      |  |                          |         |      |   |        
|Total impaired loans:                                 |  | $                        | 169,642 |      | $ | 225,934
|                                                      |  |                          |         |      |   |        
|Valuation allowance related to impaired loans         |  | $                        |        |      | $ |       
|                                                      |  |                          |         |      |   |        
|                                                      | 
|                                                      |  | Years Ended December 31,
|                                                      |  | 2006                     |         | 2005
|Average investment in impaired loans (while impaired) |  | $                        | 198,932 |      | $ | 532,005
|Interest income recognized on impaired loans          |  | $                        |        |      | $ |       

NOTE 6  PREMISES AND EQUIPMENT

Premises and equipment consist of the following:



|                                  |  |                 |            |   |      |   |            |  
|--------------------------------- |  | --------------- | ---------- | - | ---- | - | ---------- | -
|                                  |  | At December 31, |           
|                                  |  | 2006            |            |   | 2005 |  
|Land and improvements             |  | $               | 3,941,076  |   |      | $ | 3,008,206  |  
|Buildings and improvements        |  |                 | 2,003,511  |   |      |   | 1,999,737  |  
|Leasehold improvements            |  |                 | 213,734    |   |      |   | 209,463    |  
|Equipment, furniture and fixtures |  |                 | 2,491,515  |   |      |   | 2,452,205  |  
|Fixed assets not in service       |  |                 | 227,748    |   |      |   | 155,888    |  
|                                  |  |                 |            |   |      |   |            |  
|                                  |  |                 | 8,877,584  |   |      |   | 7,825,499  |  
|Less - accumulated depreciation   |  |                 | (2,111,981 | ) |      |   | (2,081,967 | )
|                                  |  |                 |            |   |      |   |            |  
|                                  |  | $               | 6,765,603  |   |      | $ | 5,743,532  |  
|                                  |  |                 |            |   |      |   |            |  

Depreciation expense for the years ended December 31, 2006 and 2005 was $401,657 and
$233,793, respectively.

In 2006 and 2005, the Company incurred impairment charges related to equipment of $74,582 and $6,195,
respectively.

Total rent expense for the years ended December 31, 2006 and 2005 amounted to $222,111 and $153,834, respectively.

At December 31, 2006, the Company shortened the depreciated lives on certain ATM equipment with remaining book value of $69,823. The
estimated impact on 2006 was $4,924.

Future minimum lease payments, by year and in the aggregate, under noncancelable leases with
remaining terms of one year or more at December 31, 2006 were as follows:



|            |  |   |          
|----------- |  | - | ---------
|2007        |  | $ | 213,054  
|2008        |  |   | 224,020  
|2009        |  |   | 232,980  
|2010        |  |   | 242,300  
|2011        |  |   | 251,992  
|2012 - 2017 |  |   | 1,549,078
|            |  |   |          
|            |  | $ | 2,713,424
|            |  |   |          



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NOTE 7  DEPOSITS

Interest-bearing deposits consist of the following:



|                                          |  |              |             |      |   |            
|----------------------------------------- |  | ------------ | ----------- | ---- | - | -----------
|                                          |  | December 31,
|                                          |  | 2006         |             | 2005
|Money Market and NOWs                     |  | $            | 71,752,446  |      | $ | 59,073,107 
|Savings                                   |  |              | 2,641,294   |      |   | 4,664,622  
|Certificates of deposit $100,000 and over |  |              | 16,354,465  |      |   | 15,399,947 
|Other time deposits                       |  |              | 49,954,117  |      |   | 55,672,351 
|                                          |  |              |             |      |   |            
|                                          |  | $            | 140,702,322 |      | $ | 134,810,027
|                                          |  |              |             |      |   |            

At December 31, 2006 the scheduled maturities of time deposits are as follows:



|                    |  |   |           
|------------------- |  | - | ----------
|2007                |  | $ | 47,414,826
|2008                |  |   | 9,022,580 
|2009                |  |   | 7,212,105 
|2010                |  |   | 1,894,385 
|2011 and thereafter |  |   | 764,686   
|                    |  |   |           
|                    |  | $ | 66,308,582
|                    |  |   |           

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

Securities sold under agreements to repurchase had carrying values of $3,762,354 and $4,577,979 and market values of $3,765,440 and $4,516,900 at
December 31, 2006 and 2005, respectively. Information concerning securities sold under agreements to repurchase is summarized as follows:



|                                               |  |              |           |   |      |   |           |  
|---------------------------------------------- |  | ------------ | --------- | - | ---- | - | --------- | -
|                                               |  | December 31, |          
|                                               |  | 2006         |           |   | 2005 |  
|Balance at end of year                         |  | $            | 3,715,992 |   |      | $ | 4,235,393 |  
|Average balance during the year                |  | $            | 2,679,155 |   |      | $ | 3,005,359 |  
|                                               |  |             
|Weighted average interest rate during the year |  |              | 4.29      | % |      |   | 2.91      | %
|Interest expense during the year               |  | $            | 114,846   |   |      | $ | 87,532    |  
|Maximum month-end balance during the year      |  | $            | 3,715,992 |   |      | $ | 4,235,393 |  

The Bank is a member of the FHLB of Atlanta, which had established, at December 31, 2006, a
credit availability for the Bank at 20.0% of total assets. At December 31, 2006, the Bank had no outstanding advances. At December 31, 2006, the Bank had a total of $10.0 million in approved lines of credit with correspondent banks with no
outstanding balance.

At December 31, 2006, other short-term borrowings consisted of $50,000 of U.S. Treasury tax and loan deposit
notes. In addition, at December 31, 2006, the Company had outstanding a $5 million unsecured term loan, the proceeds of which were used to increase the Banks capital. In January 2007, the unsecured term loan was repaid with the proceeds of the
December 2006 private placement.



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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,
|                                                  |  | 2006                     |           | 2005
|Net income (numerator, basic and diluted)         |  | $                        | 180,120   |      | $ | 809,416  
|Weighted average shares outstanding (denominator) |  |                          | 1,820,300 |      |   | 1,709,405
|Earnings per common share  basic                 |  | $                        | 0.10      |      | $ | 0.47     
|                                                  |  |                         
|Effect of dilutive securities                     |  |                          |           |      |   |          
|                                                  |  |                         
|Weighted average shares outstanding               |  |                          | 1,820,300 |      |   | 1,709,405
|Effect of stock options                           |  |                          | 33,334    |      |   | 43,128   
|                                                  |  |                          |           |      |   |          
|Diluted average shares outstanding (denominator)  |  |                          | 1,853,634 |      |   | 1,752,533
|                                                  |  |                          |           |      |   |          
|Earnings per common share  assuming dilution     |  | $                        | 0.10      |      | $ | 0.46     

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 122,000 shares and 30,000 shares were not included in computing diluted earnings per share for the years ended December 31, 2006 and 2005,
respectively, because the effects of the options were antidilutive.

NOTE 10  EMPLOYEE AND DIRECTOR BENEFIT PLANS

Stock Compensation Plans

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. The Company elected to follow the modified prospective transition method, under which compensation expense is recognized prospectively for all unvested options outstanding at January 1, 2006 and
for all awards modified or granted after that date. The Company had no existing stock options that remained unvested as of January 1, 2006.

On July 26, 2006, the Companys Board of Directors approved the Heritage 2006 Equity Incentive Plan (2006 Incentive Plan), which authorizes the grant by the Board of Directors of stock options, stock appreciation
rights, restricted stock and certain other equity awards to officers and nonemployee directors of the Company and the Bank. The 2006 Incentive Plan was adopted subject to the approval of the shareholders of the Company, and contingent upon that
approval the Board of Directors terminated the Companys ability to issue new awards under both its 1987 Stock Option Plan and its 1999 Stock Option Plan. Pursuant to the 2006 Incentive Plan, on July 26, 2006, the Board of Directors
granted an option to Michael S. Ives, President and CEO of the Company and the Bank, with respect to 70,000 shares of the Companys common stock at an exercise price of $15.56, and options with respect to 24,000 shares to certain nonemployee
directors at an exercise price of $18.67. On October 25, 2006, the Board of Directors granted an option with respect to 20,000 shares to John O. Guthrie, Chief Financial Officer of the Company and the Bank, and options with respect to 54,000
shares to certain other officers at an exercise price of $16.65. On December 28, 2006, the Companys shareholders approved the 2006 Incentive Plan and, accordingly, that date became the measurement date for the stock options granted in
2006 under the 2006 Incentive Plan.

The maximum number of shares of the Companys common stock that may be issued under the 2006
Incentive Plan is 250,000. The shares issued may be authorized but unissued shares, treasury shares or shares purchased by the Company on the open market or from private sources for use under the Plan. The Board of Directors may approve the grant of
nonstatutory stock options and options qualifying as incentive stock options. The option price of either a nonstatutory stock option or an incentive stock option will be the fair market value of the Companys common stock on the date of grant.
Fair market value is defined generally as the weighted average (based on daily trading volume) during the thirty (30) day period next preceding the date of grant of the last sale prices of a share of the Companys
common stock on the five (5) days nearest preceding the date of grant on which at least 300 shares were traded.

The option granted to
Mr. Ives in 2006 becomes exercisable at the rate of 20% commencing on December 31, 2006 and continuing on each subsequent December 31. The options granted in 2006 to nonemployee directors become exercisable at the rate of 20% on each
anniversary of the date of grant. The options granted in 2006 to Mr. Guthrie and other officers become exercisable at the



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rate of 20% commencing on December 31, 2007 and continuing on each subsequent December 31. All options granted will become exercisable earlier upon
a change in control (as defined in the 2006 Incentive Plan) of the Company. The options may also become exercisable earlier upon the optionees retirement, disability or death, and in the case of an optionee who is an employee, the
optionees termination without cause or resignation for good reason. No option may be exercised after ten (10) years from the date of grant.

Previously, the Company had elected to account for stock options pursuant to APB No. 25, Accounting for Stock Issued to Employees. The information below for the year ended December 31, 2005 is
disclosed in accordance with SFAS No. 123, Accounting for Stock-Based Compensation, which required pro forma disclosures of net income and earnings per share as if the fair value based method of accounting had been applied. 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.



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

The fair value of each stock option award was estimated on the date of grant for the 2005 option
grant and on the measurement date (shareholder approval date of the 2006 Incentive Plan) for the 2006 option grants using a Black-Scholes valuation model that uses assumptions presented in the following table. Expected volatility is based on the
historical volatility of the Companys stock, using weekly price observations over the expected term of the stock options. The expected term represents the period of time that stock options granted are expected to be outstanding. With no
existing Company historical exercise information available for the majority of the members of the new management team and outside directors who received option grants, the expected life of the options was estimated based on managements new
business plan and provisions of the grant including the contractual term and vesting schedule. The expected dividend yield is based on recent dividend history. The risk-free interest rate is the U.S. Treasury zero coupon yield curve in effect at the
measurement date for the period corresponding to the expected life of the option.

The estimates of fair value derived from the
Black-Scholes option pricing model are theoretical values for stock options, and changes in assumptions used in the model could result in materially different fair value estimates. The actual value of the stock options will depend on the market
value of the Companys common stock when the options are exercised. The fair value of options granted during 2006 and 2005 were estimated with the following assumptions:



|                                                                 |  |                         |           |   |      |   |           |  
|---------------------------------------------------------------- |  | ----------------------- | --------- | - | ---- | - | --------- | -
|                                                                 |  | Year Ended December 31, |          
|                                                                 |  | 2006                    |           |   | 2005 |  
|Expected dividend yield                                          |  |                         | 1.5       | % |      |   | 1.80      | %
|Expected stock price volatility                                  |  |                         | 19.9      | % |      |   | 25.14     | %
|Risk-fee interest rate                                           |  |                         | 4.62      | % |      |   | 3.93      | %
|Expected life of options                                         |  |                         | 6.5 years |   |      |   | 7.5 years |  
|Weighted average fair value of options granted during the period |  | $                       | 3.86      |   |      | $ | 5.34      |  



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The following table presents a summary of stock option activity during 2006:



|                                 |  |         |  |                               |       |                                         |     |                           |   |    
|-------------------------------- |  | ------- |  | ----------------------------- | ----- | --------------------------------------- | --- | ------------------------- | - | ---
|                                 |  | Shares  |  | Weighted AverageExercisePrice |       | Weighted Average Remaining Term (Years) |     | Aggregate Intrinsic Value
|                                 |  |         |  |                               |       |                                         |     | (in thousands)           
|Outstanding at January 1, 2006   |  | 126,400 |  | $                             | 9.41  |                                         |    |                           |   |   
|Granted                          |  | 162,000 |  |                               | 16.48 |                                         |    |                           |   |   
|Exercised                        |  | 29,800  |  |                               | 4.96  |                                         |    |                           |   |   
|Forfeited/expired                |  |        |  |                               |      |                                         |    |                           |   |   
|                                 |  |         |  |                               |       |                                         |     |                           |   |    
|Outstanding at December 31, 2006 |  | 258,600 |  | $                             | 14.35 |                                         | 7.8 |                           | $ | 649
|                                 |  |         |  |                               |       |                                         |     |                           |   |    
|Exercisable at December 31, 2006 |  | 110,600 |  | $                             | 11.39 |                                         | 5.3 |                           | $ | 624
|                                 |  |         |  |                               |       |                                         |     |                           |   |    

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the
difference between the Companys closing stock price on the last trading day of 2006 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised
their options on December 31, 2006. The amount changes based on the fair market value of the Companys stock. The Companys current policy is to issue new shares to satisfy share option exercises.

The aggregate intrinsic value of options exercised for the twelve months ended December 31, 2006 and 2005 was $327,012 and $87,130, respectively.
Cash received from option exercises during 2006 and 2005 was $147,950 and $37,539, respectively. The total fair value of shares vested for the same periods was $59,080 and $166,167.

The amount charged against income, before income tax benefit of $15,102, in relation to the stock-based payment arrangement was $71,955 for the year
ended December 31, 2006. At December 31, 2006, unrecognized compensation expense related to nonvested stock option grants was $554,165 and is currently expected to be recognized over a weighted average period of 2.3 years as follows:



|                                |  |                                 |    
|------------------------------- |  | ------------------------------- | ---
|For the year ended December 31: |  | Stock-Based CompensationExpense
|                                |  | (in thousands)                 
|2007                            |  | $                               | 127
|2008                            |  |                                 | 123
|2009                            |  |                                 | 124
|2010                            |  |                                 | 123
|2011                            |  |                                 | 57 
|                                |  |                                 |    
|Total                           |  | $                               | 554
|                                |  |                                 |    

Stock option awards granted in 2006 under the 2006 Incentive Plan provide for accelerated vesting
under certain circumstances as defined in the Plan such as a change of control with respect to the Company, the optionees retirement, death, permanent disability, and if the optionee is an employee of the Company resignation for good reason or
termination without cause. Occurrence of these events may cause the requisite service period to be less than reflected in the schedule above, and unamortized stock-based compensation expense recognized at that time.

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, 2006, and 2005, other liabilities included $743,296 and $771,390, respectively, related to the deferred compensation plans. Compensation
expense related to this plan was $40,907 and $50,834, for the years ended December 31, 2006 and 2005, 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.



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The Company recognized compensation expense related to the ESOP of $0 and $45,804 for the years ended
December 31, 2006 and 2005, respectively. Dividends received by the ESOP are used for administrative expenses of the plan. At December 31, 2006, the ESOP owned 9,485 shares. Stock purchases for the year ended December 31, 2006 totaled
0 shares, while 11,247 shares were distributed to terminated employees. At December 31, 2006, the fair market value of the total shares held by the ESOP totaled $151,760.

401(k) Retirement Program

Effective January 1, 1993, the Board of Directors adopted a
Retirement Program (the 401(k)). 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 $168,583
and $52,887 for the years ended December 31, 2006 and 2005, respectively.

NOTE 11  OTHER REAL ESTATE OWNED

At December 31, 2006 and 2005, the Company had no other real estate owned. Other real estate owned was sold during 2005 at a gain of $427,066.

NOTE 12  OTHER NONINTEREST INCOME AND EXPENSE

The components of other noninterest income are as follows:



|                                           |  |                          |         |      |   |        
|------------------------------------------ |  | ------------------------ | ------- | ---- | - | -------
|                                           |  | Years Ended December 31,
|                                           |  | 2006                     |         | 2005
|Consumer credit card fees                  |  | $                        | 47,537  |      | $ | 80,603 
|ATM fees                                   |  |                          | 105,022 |      |   | 85,932 
|Merchant discount fees                     |  |                          | 45,692  |      |   | 51,624 
|Income from bank-owned life insurance, net |  |                          | 20,407  |      |   | 20,356 
|Gain on sale of credit cards               |  |                          | 95,565  |      |   |       
|Gain on sale of equity securities          |  |                          | 33,815  |      |   |       
|Other                                      |  |                          | 100,590 |      |   | 149,970
|                                           |  |                          |         |      |   |        
|Total other noninterest income             |  | $                        | 448,628 |      | $ | 388,485
|                                           |  |                          |         |      |   |        

The components of other noninterest expense are as follows:



|                                  |      |                          |           |  |   |          
|--------------------------------- | ---- | ------------------------ | --------- |  | - | ---------
|                                  |      | Years Ended December 31,
|                                  | 2006 |                          | 2005     
|ATM transaction                   |      | $                        | 115,878   |  | $ | 103,240  
|Credit card                       |      |                          | 42,075    |  |   | 81,989   
|Stationery and supplies           |      |                          | 143,657   |  |   | 144,671  
|Telephone                         |      |                          | 106,146   |  |   | 67,043   
|Postage                           |      |                          | 68,773    |  |   | 55,544   
|Courier                           |      |                          | 84,624    |  |   | 59,563   
|Service bureau expense            |      |                          | 64,135    |  |   | 60,017   
|Insurance expense                 |      |                          | 58,893    |  |   | 54,234   
|Travel                            |      |                          | 40,685    |  |   | 47,977   
|Shareholder                       |      |                          | 47,532    |  |   | 35,092   
|Training                          |      |                          | 37,172    |  |   | 46,237   
|Loan servicing                    |      |                          | 43,984    |  |   | 61,305   
|FDIC insurance                    |      |                          | 21,285    |  |   | 18,238   
|Impairment  Bankers Investment   |      |                          | 7,009     |  |   | 124,685  
|Loss on sale of equity securities |      |                          | 8,163     |  |   |         
|Other miscellaneous               |      |                          | 243,034   |  |   | 157,758  
|                                  |      |                          |           |  |   |          
|Total other noninterest expense   |      | $                        | 1,133,045 |  | $ | 1,117,593
|                                  |      |                          |           |  |   |          



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NOTE 13  INCOME TAXES

The principal components of income tax expense are as follows:



|                                      |  |                          |         |   |      |   |        
|------------------------------------- |  | ------------------------ | ------- | - | ---- | - | -------
|                                      |  | Years Ended December 31,
|                                      |  | 2006                     |         |   | 2005
|Federal Income Tax Expense-Current    |  | $                        | (18,007 | ) |      | $ | 218,723
|Deferred Federal Income Tax (Benefit) |  |                          | 93,889  |   |      |   | 154,036
|                                      |  |                          |         |   |      |   |        
|Income Tax Expense                    |  | $                        | 75,882  |   |      | $ | 372,759
|                                      |  |                          |         |   |      |   |        

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, |        
|                                                                         |  | 2006                     |         |   | 2005 |  
|Federal income tax expense - at 34% statutory rate                       |  | $                        | 87,041  |   |      | $ | 401,939 |  
|Effect of tax-exempt interest                                            |  |                          | (32,400 | ) |      |   | (35,920 | )
|Effect of Life insurance proceeds, premiums, and increases in value, net |  |                          | (4,504  | ) |      |   | (5,133  | )
|Other                                                                    |  |                          | 25,745  |   |      |   | 11,873  |  
|                                                                         |  |                          |         |   |      |   |         |  
|                                                                         |  | $                        | 75,882  |   |      | $ | 372,759 |  
|                                                                         |  |                          |         |   |      |   |         |  

A cumulative net deferred tax asset is included in other assets at December 31, 2006 and
2005. The components of the asset are as follows:



|                                                                 |  |                 |         |   |      |   |         |  
|---------------------------------------------------------------- |  | --------------- | ------- | - | ---- | - | ------- | -
|                                                                 |  | At December 31, |        
|                                                                 |  | 2006            |         |   | 2005 |  
|Deferred Tax Assets                                              |  |                 |         |   |      |   |         |  
|                                                                 |  |                
|Deferred compensation                                            |  | $               | 252,721 |   |      | $ | 262,272 |  
|Allowance for loan losses                                        |  |                 | 392,087 |   |      |   | 370,238 |  
|FAS 123(R) - non-qualifying options                              |  |                 | 15,102  |   |      |   |        |  
|Net depreciation (appreciation) on available-for-sale securities |  |                 | (6,446  | ) |      |   | 27,699  |  
|Other                                                            |  |                 | 46,026  |   |      |   | 33,310  |  
|                                                                 |  |                 |         |   |      |   |         |  
|Total Deferred Tax Assets                                        |  |                 | 699,490 |   |      |   | 693,519 |  
|                                                                 |  |                 |         |   |      |   |         |  
|                                                                 |  |                
|Deferred Tax Liabilities                                         |  |                 |         |   |      |   |         |  
|                                                                 |  |                
|Deferred loan costs, net                                         |  |                 | 242,724 |   |      |   | 118,440 |  
|Investments in partnerships                                      |  |                 | 3,337   |   |      |   | (9,531  | )
|Premises and equipment                                           |  |                 | 97,176  |   |      |   | 100,295 |  
|Other                                                            |  |                 | 617     |   |      |   | 645     |  
|                                                                 |  |                 |         |   |      |   |         |  
|Total Deferred Tax Liabilities                                   |  |                 | 343,854 |   |      |   | 209,849 |  
|                                                                 |  |                 |         |   |      |   |         |  
|Net Deferred Tax Assets                                          |  | $               | 355,636 |   |      | $ | 483,670 |  
|                                                                 |  |                 |         |   |      |   |         |  



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NOTE 14  COMMITMENTS AND CONTINGENCIES - RELATED PARTY

The Company is a party to a lease with a related party to provide space for 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 $125,606 and $92,450 for the years 2006 and 2005, respectively.

The Bank also has a loan receivable from this same related party, which is secured by the building and improvements that include the
Banks operations center. The balance of this loan was $493,289 and $510,148 at December 31, 2006 and 2005, respectively.

In
December 2006, the Bank contracted with Meredith Construction Company, Inc. (Meredith Construction), of which Peter M. Meredith, Jr. is Chairman and Chief Executive Officer, as general contractor to build, for a maximum price of $1.4
million (which includes a fee of approximately $127,000 to Meredith Construction), the Banks new retail banking office on its site on Lynnhaven Parkway in Virginia Beach. Mr. Meredith is Chairman of the Board of the Company. Meredith
Construction plans to utilize ColonialWebb Contractors Co., of which Howard M. Webb is a director, as the heating and air conditioning subcontractor related to construction of the Lynnhaven office. Mr. Webb is a director of the Company.

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.

A summary of related party loan activity for the Bank is as follows during 2006:



|                                     |  |   |            |  
|------------------------------------ |  | - | ---------- | -
|Balance, December 31, 2005 (revised) |  | $ | 11,301,287 |  
|Originations 2006                    |  |   | 3,595,378  |  
|Repayments 2006                      |  |   | (2,938,352 | )
|Other*                               |  |   | (400,842   | )
|                                     |  |   |            |  
|Balance, December 31, 2006           |  | $ | 11,557,471 |  
|                                     |  |   |            |  

---

|* | During 2006, certain Bank employees no longer qualified as related parties.
|- | ---------------------------------------------------------------------------

In the opinion of management, such related party loans are made in the ordinary course of business on substantially the same terms, including interest rate and collateral, as those prevailing at the same time for
comparable loans to unrelated persons and did not involve more than the normal risk of collectibility or present other unfavorable features.

Commitments to extend credit and letters of credit to related parties amounted to $4,008,966 and $3,894,014 at December 31, 2006 and 2005, respectively. (See Note 14 for additional commitments to related parties.)

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 a 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.



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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, 2006 and 2005 were as follows:



|                             |  |      |            |      |   |           
|---------------------------- |  | ---- | ---------- | ---- | - | ----------
|                             |  | 2006 |            | 2005
|Commitments to extend credit |  | $    | 40,567,244 |      | $ | 32,523,919
|Standby letters of credit    |  |      | 1,015,971  |      |   | 338,244   
|Commitments to sell loans    |  |      | 2,115,800  |      |   | 1,491,000 
|                             |  |      |            |      |   |           
|                             |  | $    | 43,699,015 |      | $ | 34,353,163
|                             |  |      |            |      |   |           

As of December 31, 2006, the Company had $19,311,892 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, 2006, the Bank meets
all capital adequacy requirements to which it is subject.

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, 2006, the Company meets all capital adequacy requirements to which it is subject. At December 31, 2006, the Companys total risk-based
capital, Tier 1 risk-based capital, and Tier 1 capital (leverage) ratios were 15.69%, 14.85% and 11.35%, respectively. For purposes of the risk-based capital calculations presented in the following table, qualifying 1-4 family residential loans at
December 31, 2006 have been risk-weighted 50%. All loans held for investment at December 31, 2005 have been risk-weighted 100%.



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The capital amounts and ratios for the Company (consolidated) and the Bank as of December 31, 2006
and 2005 are presented in the following table:



|                                         |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|---------------------------------------- |  | ------ | ------ | ----- | ---------------------------- | - | ------ | --------------------------------------------------------------------- | ------ |  | --- | ------ |  | ----- | ------ |  | ---- | -
|                                         |  | Actual |        |       | For Capital AdequacyPurposes |   |        | Minimum To Be WellCapitalized
UnderPrompt Corrective ActionProvisions |       
|(Dollars in thousands)                   |  | Amount |        | Ratio |                              |   | Amount |                                                                       | Ratio  |  |     | Amount |  | Ratio |       
|At December 31, 2006                     |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|                                         |  |        |        |       |                              |  
|Total Capital (to Risk-Weighted Assets)  |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 25,765 |       | 15.69                        | % |        | $                                                                     | 13,137 |  | 8.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 24,612 |       | 15.00                        | % |        | $                                                                     | 13,125 |  | 8.0 | %      |  | $     | 16,407 |  | 10.0 | %
|Tier 1 Capital (to Risk-Weighted Assets) |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 24,392 |       | 14.85                        | % |        | $                                                                     | 6,568  |  | 4.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 23,239 |       | 14.16                        | % |        | $                                                                     | 6,563  |  | 4.0 | %      |  | $     | 9,844  |  | 6.0  | %
|Tier 1 Capital (to Average Assets)       |  |        |        |       |                              |   |        |                                                                       |        |  |     |        |  |       |        |  |      |  
|Consolidated Company                     |  | $      | 24,392 |       | 11.35                        | % |        | $                                                                     | 8,600  |  | 4.0 | %      |  |       | N/A    |  | N/A  |  
|Bank                                     |  | $      | 23,239 |       | 10.83                        | % |        | $                                                                     | 8,582  |  | 4.0 | %      |  | $     | 10,727 |  | 5.0  | %
|                                         |  |        |        |       |                              |  
|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  | %

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.

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.



64



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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.

Other Borrowings and Securities Sold Under Agreements to Repurchase

The carrying amount for other borrowings and securities sold under agreements to repurchase 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.



65



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The following table presents the carrying amounts and fair value of the Companys financial
instruments at December 31, 2006 and 2005.



|                                                                   |  |                        |         |            |   |                |  |            |         |  |   |        
|------------------------------------------------------------------ |  | ---------------------- | ------- | ---------- | - | -------------- |  | ---------- | ------- |  | - | -------
|                                                                   |  | 2006                   |         | 2005      
|                                                                   |  | CarryingAmount         |         | Fair Value |   | CarryingAmount |  | Fair Value
|                                                                   |  | (Dollars in Thousands)
|Financial assets:                                                  |  |                        |         |            |   |                |  |            |         |  |   |        
|Cash and due from banks                                            |  | $                      | 7,903   |            | $ | 7,903          |  | $          | 8,349   |  | $ | 8,349  
|Federal funds sold                                                 |  |                        | 19,286  |            |   | 19,286         |  |            | 45,831  |  |   | 45,831 
|Securities available for sale                                      |  |                        | 44,902  |            |   | 44,902         |  |            | 9,285   |  |   | 9,285  
|Securities held to maturity                                        |  |                        | 679     |            |   | 700            |  |            | 681     |  |   | 701    
|Loans held for investment                                          |  |                        | 140,119 |            |   | 140,079        |  |            | 130,420 |  |   | 130,339
|Loans held for sale                                                |  |                        | 520     |            |   | 520            |  |            | 1,351   |  |   | 1,351  
|Accrued interest receivable                                        |  |                        | 736     |            |   | 736            |  |            | 684     |  |   | 684    
|Stock in FRB and FHLB                                              |  |                        | 722     |            |   | 722            |  |            | 823     |  |   | 823    
|Bank-owned life insurance                                          |  |                        | 547     |            |   | 547            |  |            | 512     |  |   | 512    
|                                                                   |  |                        |         |           
|Financial Liabilities:                                             |  |                        |         |            |   |                |  |            |         |  |   |        
|Deposits                                                           |  |                        | 188,397 |            |   | 189,111        |  |            | 172,765 |  |   | 173,640
|Federal Home Loan Bank Advance                                     |  |                        |        |            |   |               |  |            | 10,000  |  |   | 9,836  
|Other borrowing and securities sold under agreements to repurchase |  |                        | 8,766   |            |   | 8,766          |  |            | 4,285   |  |   | 4,285  
|Accrued interest payable                                           |  |                        | 376     |            |   | 376            |  |            | 378     |  |   | 378    



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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,          |           
|Condensed Balance Sheets                                   |  | 2006                     |            |   | 2005 |  
|Assets                                                     |  |                          |            |   |      |   |            |  
|Cash                                                       |  | $                        | 5,641,457  |   |      | $ | 128,337    |  
|Investment in Heritage Bank                                |  |                          | 23,251,379 |   |      |   | 15,207,498 |  
|Investment in non-bank subsidiaries                        |  |                          | 51,069     |   |      |   | 161,069    |  
|Investment in securities available for sale, at fair value |  |                          |           |   |      |   | 105,515    |  
|Other assets                                               |  |                          | 502,378    |   |      |   | 639,408    |  
|                                                           |  |                          |            |   |      |   |            |  
|Total Assets                                               |  | $                        | 29,446,283 |   |      | $ | 16,241,827 |  
|                                                           |  |                          |            |   |      |   |            |  
|Liabilities and Stockholders Equity                       |  |                          |            |   |      |   |            |  
|Note payable                                               |  | $                        | 5,000,000  |   |      | $ |           |  
|Other liabilities                                          |  |                          | 42,105     |   |      |   | 169,670    |  
|                                                           |  |                          |            |   |      |   |            |  
|Total Liabilities                                          |  | $                        | 5,042,105  |   |      | $ | 169,670    |  
|                                                           |  |                          |            |   |      |   |            |  
|Common stock                                               |  | $                        | 11,388,260 |   |      |   | 8,573,340  |  
|Additional paid-in capital                                 |  |                          | 6,031,549  |   |      |   | 314,838    |  
|Retained earnings                                          |  |                          | 6,971,856  |   |      |   | 7,237,748  |  
|Accumulated other comprehensive income (loss)              |  |                          | 12,513     |   |      |   | (53,769    | )
|                                                           |  |                          |            |   |      |   |            |  
|Stockholders equity                                       |  | $                        | 24,404,178 |   |      | $ | 16,072,157 |  
|                                                           |  |                          |            |   |      |   |            |  
|Total Liabilities and Stockholders Equity                 |  | $                        | 29,446,283 |   |      | $ | 16,241,827 |  
|                                                           |  |                          |            |   |      |   |            |  
|                                                           | 
|                                                           |  | Years Ended December 31, |           
|Condensed Statements of Operations                         |  | 2006                     |            |   | 2005 |  
|Dividends from subsidiary bank                             |  | $                        | 443,539    |   |      | $ | 410,141    |  
|Equity in undistributed net income of subsidiaries         |  |                          | 15,864     |   |      |   | 622,758    |  
|Other income                                               |  |                          | 35,571     |   |      |   |           |  
|Interest and dividend income                               |  |                          | 3,433      |   |      |   | 4,247      |  
|Interest expense                                           |  |                          | (100,937   | ) |      |   |           |  
|Other expenses                                             |  |                          | (360,048   | ) |      |   | (338,356   | )
|                                                           |  |                          |            |   |      |   |            |  
|Income before income taxes                                 |  |                          | 37,422     |   |      |   | 698,790    |  
|Benefit from income taxes                                  |  |                          | 142,698    |   |      |   | 110,626    |  
|                                                           |  |                          |            |   |      |   |            |  
|Net Income                                                 |  | $                        | 180,120    |   |      | $ | 809,416    |  
|                                                           |  |                          |            |   |      |   |            |  

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, |           
|                                                      |  | 2006                     |            |   | 2005 |  
|Cash flows from operating activities                  |  |                          |            |   |      |   |          |  
|                                                      |  |                         
|Net income                                            |  | $                        | 180,120    |   |      | $ | 809,416  |  
|Add (deduct) items not affecting cash during the year |  |                          |            |   |      |   |          |  
|Depreciation, amortization and accretion, net         |  |                          | 71,955     |   |      |   | 8        |  
|Undistributed net income of subsidiaries              |  |                          | (15,864    | ) |      |   | (622,758 | )
|Exercise of stock options tax benefit                 |  |                          | 110,157    |   |      |   | 29,624   |  
|Net gain on securities available for sale             |  |                          | (25,652    | ) |      |   |         |  
|Changes in assets/liabilities, net                    |  |                          |            |   |      |   |          |  
|(Increase) decrease in other assets                   |  |                          | (7,694,665 | ) |      |   | (395,385 | )
|(Increase) decrease in other liabilities              |  |                          | (127,565   | ) |      |   | 56,603   |  
|                                                      |  |                          |            |   |      |   |          |  
|Net cash provided by (used for) operating activities  |  |                          | (7,501,514 | ) |      |   | (122,492 | )
|                                                      |  |                          |            |   |      |   |          |  
|Cash flows from investing activities                  |  |                          |            |   |      |   |          |  
|Proceeds of securities available for sale             |  |                          | 111,127    |   |      |   |         |  
|                                                      |  |                          |            |   |      |   |          |  
|Net cash used for investing activities                |  |                          | 111,127    |   |      |   |         |  
|                                                      |  |                          |            |   |      |   |          |  
|Cash flows from financing activities                  |  |                          |            |   |      |   |          |  
|Proceeds from exercise of stock options               |  |                          | 150,970    |   |      |   | 37,539   |  
|Proceeds from other borrowings                        |  |                          | 5,000,000  |   |      |   |         |  
|Stock repurchases                                     |  |                          | (28,800    | ) |      |   |         |  
|Private placement issuance of stock, net of costs     |  |                          | 8,227,349  |   |      |   |         |  
|Cash dividends paid                                   |  |                          | (446,012   | ) |      |   | (410,141 | )
|                                                      |  |                          |            |   |      |   |          |  
|Net cash provided by (used for) financing activities  |  |                          | 12,903,507 |   |      |   | (372,602 | )
|                                                      |  |                          |            |   |      |   |          |  
|Increase (decrease) in cash and cash equivalents      |  |                          | 5,513,120  |   |      |   | (495,094 | )
|                                                      |  |                         
|Cash and cash equivalents at beginning of year        |  |                          | 128,337    |   |      |   | 623,431  |  
|                                                      |  |                          |            |   |      |   |          |  
|Cash and cash equivalents at end of year              |  | $                        | 5,641,457  |   |      | $ | 128,337  |  
|                                                      |  |                          |            |   |      |   |          |  

*    *    *    *    *



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

On November 29, 2006, the Company engaged Elliott Davis LLC (Elliott Davis) as the Companys independent registered public
accounting firm for the fiscal year ending December 31, 2006. The Audit Committee made the decision to engage Elliott Davis and that decision was approved, adopted, and ratified by the Companys Board of Directors, and on December 28,
2006 the Companys shareholders ratified the appointment of Elliot Davis at the Combined 2005 and 2006 Annual Meeting of Shareholders.

As previously reported, the Companys former accounting firm, PFK Witt Mares, PLC (Witt Mares), notified the Company on December 22, 2005 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 would 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 would be required to rotate off the account.

On November 17, 2006, Elliott Davis acquired Larrowe and Company, PLC (Larrowe). In September 2005, the Company had engaged Larrowe to
assist initially with computational issues related to amounts reported in its financial statements under Statement of Financial Accounting Standards No. (FAS) 91, Accounting for Nonrefundable Fees and Costs Associated with
Originating or Acquiring Loans and Initial Direct Costs of Leases (as Amended), for the years ended December 31, 2000 through 2005. In June 2006, the Company converted its loan application system to calculate FAS 91 deferred costs and
fees on an ongoing basis. Larrowe was consulted during the conversion process on the overall methodology of that process and evaluated the resulting output. In addition, during 2006, representatives of the Company consulted with Larrowe in
connection with the presentation and adequacy of disclosures in its annual report on Form 10-KSB for the year ended December 31, 2004, with respect to the following accounting matters:



| |  |  | Deferral of loan fees and costs under FAS 91
| | - |  | --------------------------------------------



| |  |  | Loans held for sale
| | - |  | -------------------



| |  |  | Reporting sale of assets
| | - |  | ------------------------



| |  |  | Reporting of ineffective internal controls
| | - |  | ------------------------------------------



| |  |  | Accounting for stock options
| | - |  | ----------------------------

With
respect to the financial results for 2005 (which were audited by Witt Mares), during 2006 Larrowe provided assistance to the Company on the following accounting and disclosure issues:



| |  |  | Deferral of loan fees and costs under FAS 91
| | - |  | --------------------------------------------



| |  |  | Impairment of an asset
| | - |  | ----------------------



| |  |  | Recognition of income on non-accrual loans
| | - |  | ------------------------------------------



| |  |  | Procedures for recognition of impaired loans
| | - |  | --------------------------------------------

During 2006, Larrowe provided general accounting consultation on the following issues related to the financial results of 2006.



| |  |  | Impairment of an asset under FAS 143 (Accounting for Asset Retirement Obligations )
| | - |  | -------------------------------------------------------------------------------------



| |  |  | Stock issuance costs
| | - |  | --------------------



| |  |  | Reporting sale of assets
| | - |  | ------------------------



| |  |  | Share based payments under FAS 123R (Share-Based Payment)
| | - |  | -----------------------------------------------------------



| |  |  | Deferral of loan fees and costs under FAS 91
| | - |  | --------------------------------------------

The Company sought Larrowes consultation to supplement the preparation of required financial disclosures by the Companys accounting staff. There were no disagreements between the Company, Larrowe, and Witt Mares concerning the
accounting or reporting of any of these matters for either of the 2004 or 2005 fiscal years.

No other independent registered public
accounting firm was consulted on any of the above matters.

The Company has not otherwise consulted with Elliot Davis or Larrowe during its
two most recent fiscal years or during any subsequent interim period prior to its appointment as auditor regarding either (i) the application of accounting principles to a specified transaction, either completed or contemplated, or the type of
audit opinion that might be rendered on the Companys financial statements or (ii) any matter that was the subject of a disagreement or event as defined in Item 304(a)(1)(iv) of Regulation S-B and the related instructions.



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|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 Companys 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. Furthermore, 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.

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, 2006. Based upon
that evaluation, as a result of the Companys undertakings with respect to its disclosure controls and procedures over the last two years (further described below), our Chief Executive Officer and Chief Financial Officer have determined that
our disclosure controls and procedures with respect to financial reporting were effective as of December 31, 2006 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.

Changes in Internal Control Over Financial Reporting

The Companys 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.

As described in our Form 10-KSB for the year ended December 31, 2005, during 2005 the Company
discovered accounting errors in its previously reported financial results and determined that financial information for 2004, 2003, and 2002 should be restated. In connection with this restatement, management identified material weaknesses and
significant deficiencies in internal control over financial reporting that created a more than remote likelihood that a material misstatement of the Companys annual or interim financial statements would not be prevented or detected.

Specifically, in our 2005 Form 10-KSB, we reported 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. 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.

These material weaknesses and significant deficiencies in internal control over financial reporting
resulted in errors in the following areas:



| |  |  | loan origination costs and amortization of fees;
| | - |  | ------------------------------------------------



| |  |  | deferred compensation plans, including associated life insurance and the maintenance of related records;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | stock option expensing; and
| | - |  | ---------------------------



| |  |  | a variety of other areas, including impairment of certain loans, depreciation expense, employer 401(k) matching contributions, impairment of certain long-lived
assets, and income tax expenses.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Beginning in 2005 and throughout 2006, 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. During 2006, we continued to implement remedial measures in response to specific accounting and
reporting issues related to the restatement. We have added personnel and systems, improved our organizational supervision, developed additional policies and procedures, as well as trained our employees on our existing policies and procedures, all in
an effort to constantly improve our internal controls and control environment.

As a result of the foregoing efforts and other similar undertakings by
Company management, the Company believes that as of December 31, 2006 it has eliminated the material weaknesses and deficiencies in its internal controls and procedures over financial reporting that existed in prior periods.

Further, as a part of the Companys preparation for compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, we will document and
test our internal controls and procedures and will take further action as appropriate. Section 404 requires the Companys management to issue formal reports on the effectiveness of the Companys internal control structure and
procedures for financial reporting as of our fiscal year ended December 31, 2007. In the event that, during our testing, we identify one or more material weaknesses in internal controls at December 31, 2007, the Companys management
will disclose such weakness in its formal report and will not be able to conclude that the Companys internal control over financial reporting is effective at such date. If such material weaknesses continue to exist at December 31, 2008,
the Company believes such material weaknesses would be referenced in an adverse attestation report from its auditors as of such date.

Other than as
described above, there were no changes in the Companys internal control over financial reporting in the quarter ended December 31, 2006 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

The Company will file a definitive proxy statement for its 2007 Annual Meeting of Shareholders
pursuant to Regulation 14A (the Proxy Statement) within 120 days after the end of the fiscal year covered by this annual report on Form 10-KSB (i.e., by April 30, 2007); accordingly, certain information that is required under
Part III of this annual report on Form 10-KSB is omitted from this report and will be included in the Proxy Statement, and is incorporated herein by reference to the Proxy Statement.



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

The information concerning our directors, additional information regarding certain executive officers and other information required by this Item 9
shall be included in the Proxy Statement and is hereby incorporated herein by reference.

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.
| | - |  | ---------------------------------------------------

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
|-------- | ----------------------

The information concerning
Executive Compensation required by this Item 10 shall be included in the Proxy Statement and is hereby incorporated herein by reference. (The information incorporated herein by this reference expressly excludes the Compensation Discussion and
Analysis and the Compensation Committee Report on Executive Compensation.)



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

The information concerning Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters required by this Item 11
shall be included in the Proxy Statement and is hereby incorporated herein by reference.



|ITEM 12. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
|-------- | ----------------------------------------------

The
information concerning Certain Relationships and Related Transactions required by this Item 12 shall be included in the Proxy Statement and is hereby incorporated herein by reference.



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|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.)                                                                                                                                                                                                   
|          | 
|*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.)                                                                                                                                                            



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|          |  |                                                                                                                                                                                           
|--------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibits: |  |                                                                                                                                                                                           
|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.)                  
|          | 
|*10.15    |  | Amendment to Employment Agreement of Michael S. Ives. (Incorporated herein by reference to the Companys Form 8-K filed on December 26, 2006.)                                            
|          | 
|*10.16    |  | Heritage 2006 Equity Incentive Plan. (Incorporated herein by reference to the Companys Form 8-K filed on December 29, 2006.)                                                             
|          | 
|10.17     |  | Amended and Restated Deed of Lease between Heritage Bank and Dominion Enterprises dated November 21, 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                                                                                                                                                            
|          | 
|23.2      |  | Consent of Elliott Davis LLC                                                                                                                                                              
|          | 
|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
information concerning Principal Accountant Fees and Services required by this Item 14 shall be included in the Proxy Statement and is hereby incorporated herein by reference.



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##### Table of Contents

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: March 28, 2007                                                                                                                                                          |  |  |  | /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.
|                                                                                                                                                                              |  | 
|March 28, 2007                                                                                                                                                                |  |  |  | /s/ Michael S. Ives                         
|                                                                                                                                                                              |  |  |  | Michael S. Ives,                            
|                                                                                                                                                                              |  |  |  | President and Chief Executive Officer       
|                                                                                                                                                                              |  |  |  | (Principal Executive Officer) and Director  
|                                                                                                                                                                              |  | 
|March 28, 2007                                                                                                                                                                |  |  |  | /s/ John O. Guthrie                         
|                                                                                                                                                                              |  |  |  | John O. Guthrie,                            
|                                                                                                                                                                              |  |  |  | Chief Financial Officer                     
|                                                                                                                                                                              |  |  |  | (Principal Financial and Accounting Officer)
|                                                                                                                                                                              |  | 
|March 28, 2007                                                                                                                                                                |  |  |  | /s/ Peter M. Meredith, Jr.                  
|                                                                                                                                                                              |  |  |  | Peter M. Meredith, Jr.,                     
|                                                                                                                                                                              |  |  |  | Chairman of the Board of Directors and      
|                                                                                                                                                                              |  |  |  | Director                                    
|                                                                                                                                                                              |  | 
|March 28, 2007                                                                                                                                                                |  |  |  | /s/ Stephen A. Johnsen                      
|                                                                                                                                                                              |  |  |  | Stephen A. Johnsen,                         
|                                                                                                                                                                              |  |  |  | Secretary of the Board of Directors and     
|                                                                                                                                                                              |  |  |  | Director                                    
|                                                                                                                                                                              |  | 
|March 28, 2007                                                                                                                                                                |  |  |  | /s/ Lisa F. Chandler                        
|                                                                                                                                                                              |  |  |  | Lisa F. Chandler,                           
|                                                                                                                                                                              |  |  |  | Director                                    
|                                                                                                                                                                              |  | 
|March 28, 2007                                                                                                                                                                |  |  |  | /s/ James A. Cummings                       
|                                                                                                                                                                              |  |  |  | James A. Cummings,                          
|                                                                                                                                                                              |  |  |  | Director                                    



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|               |  |  |  |                           
|-------------- |  |  |  | --------------------------
|March 28, 2007 |  |  |  | /s/ Wendell C. Franklin   
|               |  |  |  | Wendell C. Franklin,      
|               |  |  |  | Director                  
|               |  | 
|March 28, 2007 |  |  |  | /s/ F. Dudley Fulton      
|               |  |  |  | F. Dudley Fulton,         
|               |  |  |  | Director                  
|               |  | 
|March 28, 2007 |  |  |  | /s/ Thomas G. Johnson, III
|               |  |  |  | Thomas G. Johnson, III,   
|               |  |  |  | Director                  
|               |  | 
|March 28, 2007 |  |  |  | /s/ David L. Kaufman      
|               |  |  |  | David L. Kaufman,         
|               |  |  |  | Director                  
|               |  | 
|March 28, 2007 |  |  |  | /s/ Charles R. Malbon, Jr.
|               |  |  |  | Charles R. Malbon, Jr.,   
|               |  |  |  | Director                  
|               |  | 
|March 28, 2007 |  |  |  | /s/ L. Allan Parrott      
|               |  |  |  | L. Allan Parrott,         
|               |  |  |  | Director                  
|               |  | 
|March 28, 2007 |  |  |  | /s/ Ross C. Reeves        
|               |  |  |  | Ross C. Reeves,           
|               |  |  |  | Director                  
|               |  | 
|March 28, 2007 |  |  |  | /s/ Harvey W. Roberts, III
|               |  |  |  | Harvey W. Roberts, III,   
|               |  |  |  | Director                  
|               |  | 
|March 28, 2007 |  |  |  | /s/ Howard M. Webb        
|               |  |  |  | Howard M. Webb,           
|               |  |  |  | Director                  
|               |  | 
|March 28, 2007 |  |  |  | /s/ Barbara Zoby          
|               |  |  |  | Barbara Zoby,             
|               |  |  |  | Director                  



76