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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2009
Commission File Number 000-51305
 
(HERITAGE FINANCIAL GROUP LOGO)
HERITAGE FINANCIAL GROUP
(A United States Corporation)
IRS Employer Identification Number 45-0479535
721 N. Westover Blvd., Albany, GA 31707
229-420-0000
Securities registered pursuant to Section 12(b) of the Act:
     
Title of Each Class   Name of Each Exchange on which registered
     
Common Stock, Par Value $0.01 per share   NASDAQ Stock Market, LLC
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. o Yes þ No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. o Yes þ No
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes o No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). o Yes o No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a small reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
             
o Large accelerated filer   o Accelerated filer   o Non-accelerated filer   þ Smaller reporting company
        (Do not check if a smaller reporting company)    
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). o Yes þ No
As of March 31, 2010, there were 10,399,260 shares of the registrant’s common stock outstanding. The aggregate market value of the voting stock held by non-affiliates of the registrant on this date was approximately $21.1 million, computed by reference to the last sales price on NASDAQ Global Market on that date of $12.08 per share on 1,746,932 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Part III of Form 10-K — Portions of the Proxy Statement for the 2010 Annual Meeting of Stockholders.
 
 

 


 

PART I
Item 1. Business
General
Heritage Financial Group (the “Company”) was formed in February 2002, and operates through our wholly owned subsidiary, HeritageBank of the South (the “Bank”). We neither own nor lease any business property, but we use the premises, equipment and furniture of the Bank. We employ only persons who are executive officers of the Bank as our executive officers, and we also use the support staff of the Bank. We currently do not separately compensate any employees, although, in the future, we may hire additional employees if we expand our business at the holding company level.
The Company completed an initial public offering on June 29, 2005. It sold 3,372,375 shares of common stock in that offering for $10.00 per share. The Company’s employee stock ownership plan (the “ESOP”) purchased 440,700 shares with the proceeds of a loan from the Company. The Company received net proceeds of $32.4 million in the public offering, 50% of which was contributed to the Bank and $4.4 million of which was lent to the ESOP for its purchase of shares in the offering. The Company also issued 7,868,875 shares of common stock to Heritage, MHC (“MHC’). As of December 31, 2009, MHC owns approximately 76% of the Company.
The Bank was originally chartered in 1955 as a federal credit union, serving the Marine Corps Logistic Base in Albany, Georgia. Over the years, it evolved into a full-service, multi-branch community credit union in Dougherty, Lee, Mitchell and Worth counties. It was converted from a federal credit union charter to a federal mutual savings bank charter in July 2001. The objective of that charter conversion was to better serve customers and the local community though the broader lending ability of a savings bank and to expand our customer base beyond the limited field of membership permitted for credit unions. In February 2002, the Company was formed as part of a reorganization into a two-tier mutual holding company structure. On January 1, 2005, the Bank converted to a Georgia state-chartered stock savings bank.
The principal business of the Bank consists of attracting retail and commercial deposits from the general public and investing those funds primarily in permanent loans secured by first mortgages on owner-occupied, one- to four-family residences, multi-family residences and commercial property and a variety of consumer and commercial business loans. Revenues from this business are derived principally from interest on loans and securities and fee income.
The Bank offers a variety of deposit accounts having a wide range of interest rates and terms, which generally include savings accounts, money market deposit and term certificate accounts and checking accounts. It solicits deposits in our market areas and, to a lesser extent, from brokered deposits.
Forward Looking Statements
This document, including information incorporated by reference, contains forward-looking statements about the Company and its subsidiaries which we believe are within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, without limitation, statements with respect to anticipated future operating and financial performance, growth opportunities, interest rates, cost savings and funding advantages expected or anticipated to be realized by management. Words such as “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan” and similar expressions are intended to identify these forward-looking statements. Forward-looking statements by the Company and its management are based on beliefs, plans, objectives, goals, expectations, anticipations, estimates and the intentions of management and are not guarantees of future performance. The Company disclaims any obligation to update or revise any forward-looking statements based on the occurrence of future events, the receipt of new information, or otherwise. The important factors we discuss below, as well as other factors discussed under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and identified in our filings with the Securities and Exchange Commission (“the SEC”) and those presented elsewhere by our management from time to time, could cause actual results to differ materially from those indicated by the forward-looking statements made in this document:
    further developments in the Company’s ongoing review of and efforts to resolve any problem credit relationships described in this report, which could result in, among other things, further downgrades of aforementioned loans, additional provisions to the loan loss reserve and the incurrence of other material non-cash and cash charges;
 
    the strength of the United States economy in general and the strength of the local economies in which we conduct operations;
 
    the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve Board;
 
    inflation, interest rate, market and monetary fluctuations;

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    the timely development of and acceptance of new products and services and the perceived overall value of these products and services by users, including the features, pricing and quality compared to competitors’ products and services;
 
    the willingness of users to substitute our products and services for products and services of our competitors;
 
    the impact of changes in financial services’ laws and regulations (including laws concerning taxes, banking, securities and insurance);
 
    the impact of technological changes;
 
    acquisitions;
 
    growth into new markets;
 
    changes in consumer spending and saving habits; and
 
    our success at managing the risks involved in the foregoing.
The Company disclaims any obligation to update or revise any forward-looking statements based on the occurrence of future events, the receipt of new information, or otherwise.
Market Area
We intend to continue to be a community-oriented financial institution offering a variety of financial services to meet the needs of the communities we serve. We are headquartered in Albany, Georgia, and primarily serve Southwest Georgia through offices in Albany — Dougherty, Lee, and Worth Counties, Southeast Georgia through offices in Tattnall County (Reidsville and Collins), and North Central Florida through offices in Ocala — Marion County, and Lake City — Columbia County. We occasionally make loans beyond our market area to meet customer’s needs and to develop new business. The following table sets forth our market share as of June 30, 2009, the latest date for which information is available, in the major markets that we serve:
                         
            Market    
    Market   Share   Institutions in
Market Area   Share   Rank   Markets
 
Albany Georgia MSA
    13.1 %     3       16  
Ocala Florida MSA
    0.7 %     19       22  
Tattnall County Georgia
    15.6 %     4       5  
Lake City Florida
    6.3 %     6       7  
Southwest Georgia Market — Albany Metropolitan Statistic Area
The Southwest Georgia economy is historically based on manufacturing and agriculture, but it has become more service-oriented in the last two decades. Median household income and per capita income are below the state and national averages, reflecting the rural nature of the market and limited availability of high paying white collar and technical jobs. As of January 2010, the market area reported an unemployment rate of 11.8%, compared with the national average of 9.7%. Major employers in our market area include the Marine Corps Logistic Base, Phoebe Putney Memorial Hospital, Procter & Gamble, Teleperformance USA, Albany State University, Darton College, Palmyra Medical Centers, and Miller Brewing Company. During 2008, the area lost a major employer when Cooper Tire and Rubber Company announced they were closing their plant in Albany, eliminating 1,400 jobs. This market has a population of approximately 166,000. Population growth in this area has remained relatively flat, with a 5.2% growth from 2000 to 2009. Over the next five years, the population is expected to grow 2.6%.
Southeast Georgia Market — Tattnall County
The Tattnall County, Georgia market is largely based on agriculture. Median and household income are below the state and national averages. As of January 2010, the unemployment rate for the county was 11.1%. Major employers in the market include Fries Farms and Tattnall State Prison. This market has a population of approximately 24,000. Population growth in this area has remained relatively flat, with a 5.7% growth from 2000 to 2009. Over the next five years, the population is expected to grow 3.3%.

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North Central Florida Market — Ocala Metropolitan Statistic Area
The Ocala market economy is a service based economy. The area is known for its world-class equestrian training facilities and its booming retirement communities. Median household income and per capita income are below the state and national averages. However, due to the large retirement populations, much more of the income is disposable in nature compared to other markets. Top employers in the area include Monroe Regional Medical Centers, Wal-Mart Stores, AT&T, Publix Supermarkets, Emergency One, Lockheed Martin, ClosetMaid and Central Florida Community College. During 2009, Taylor, Bean & Whitaker, a national mortgage company, closed, eliminating over 1,200 jobs. The unemployment rate was 15.4% as of January 2010. This market has a population of approximately 342,000, and has experienced growth of 32.0% from 2000 to 2009. Over the next five years, the population is expected to grow 12.9%.
North Central Florida Market — Lake City Metropolitan Statistic Area
The Lake City Florida market economy is service based. Median household income and per capita income are below the state and national averages. Top employers in the area include the Veterans Administration Medical Center, TIMCO and Sitel. The unemployment rate was 11.6% as of January 2010. This market has a population of approximately 69,000, and has experience growth of 22.4% from 2000 to 2009. Over the next five years, the population is expected to grow 9.2%
Expansion
In 2008, we invested approximately $1.0 million for 4.9% of the outstanding shares in Chattahoochee Bank of Georgia (“Chattahoochee”), a de novo bank in Gainesville, Georgia. This investment provides us with the opportunity to further expand outside of Southwest Georgia. In addition to our investment in Chattahoochee, we have participated in loans generated by Chattahoochee that exceed their legal lending limits. This structure has allowed us to generate loan volume and exposure to Northeast Georgia without incurring building and personnel costs. Our Chief Executive Officer, O. Leonard Dorminey, serves on Chattahoochee’s Board of Directors, Executive Committee and Loan Committee. As of December 31, 2009, we had $4.8 million in loans purchased from Chattahoochee. As of that date, we also had $2.5 million in fed funds purchased from Chattahoochee.
On December 4, 2009, we acquired substantially all of the assets and assumed substantially all of the liabilities of The Tattnall Bank (“Tattnall”) in a federally-assisted acquisition from the Federal Deposit Insurance Corporation (the “FDIC”). Tattnall operated two branch offices in the Southeast Georgia markets of Reidsville and Collins, in Tattnall County. We did not enter into a loss-sharing agreement with the FDIC on this transaction; however, our bid to acquire Tattnall included a discount payment from the FDIC totaling $15.0 million.
On December 31, 2009, we acquired certain assets and assumed certain liabilities of the Lake City, Florida, branch of Atlantic Coast Bank. We purchased only performing loans that met underwriting standards of the Company, after a due diligence review of the loans at this branch. We assumed substantially all the deposits of this branch.
On February 25, 2010, we announced that the Bank signed a definitive agreement to purchase five bank branches from The Park Avenue Bank (“PAB”). These branches are located in the Southeast Georgia markets of Statesboro (2), Hazlehurst and Baxley, and the Southwest Georgia market of Adel. We expect this transaction to be completed in the second quarter of 2010, subject to regulatory approval. Following is information on the four markets in which we are acquiring branches from PAB.
Southeast Georgia Market — Statesboro MSA
The Statesboro market is a service based economy. Median and household income are below the state and national averages. As of January 2010, the unemployment rate was 10.3%. Major employers in the area include Georgia Southern University, Briggs & Stratton Corp., East Georgia Regional Medical Center and Viracon Georgia, Inc. Statesboro is a regional retail hub for many small communities in Southeast Georgia. This market has a population of approximately 67,000. Population growth has been steady, growing 20.1% from 2000 — 2009, and is expected to grow by 8.5% over the next five years. A major driver of growth for this area has been Georgia Southern University, which has approximately 18,000 full-time students.
Southeast Georgia Market — Baxley — Appling County
The Baxley — Appling County market is a service based economy, with strong roots in manufacturing and agriculture. Median and household income are below the state and national averages. As of January 2010, the unemployment rate was 11.0%. Major employers in the area include Southern Nuclear Operating Co., Altamaha Homecare and Rayonier Wood Products. The market has a population of approximately 18,000. Population growth has been relatively flat, with a 3.2% growth rate from 2000 to 2009. The population is expected to grow 1.6% over the next five years.

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Southeast Georgia Market — Hazlehurst — Jeff Davis County
The Hazlehurst — Jeff Davis County market is a service based economy, with strong roots in manufacturing and agriculture. Median and household income are below that state and national averages. As of January 2010, the unemployment rate was 14.9%. Major employers in the area include Propex Inc., McPherson Manufacturing Corp. and Beasley Forest Products. The market has a population of approximately 13,000. Population growth has been relatively flat, with growth of 4.3% from 2000 to 2009. The population is expected to grow 2.3% over the next five years.
Southwest Georgia Market — Adel — Cook County
The Adel — Cook County market is based primarily on agriculture and manufacturing. Median and household income are below the state and national averages. As of January 2010, the unemployment rate was 14.5%. Major employers in the area include BASF Sparks LLC, Jimmy Bullard and Sons, and J-M Manufacturing Co. The market has a population of approximately 17,000. Population growth has been relatively flat, with growth of 5.7% from 2000 to 2009. The population is expected to grow 2.2% over the next five years.
The following table sets forth PAB’s market share for the four markets in which we are acquiring their branches:
                         
            Market    
    Market   Share   Institutions in
Market Area   Share   Rank   Markets
 
Statesboro Georgia MSA
    4.9 %     6       9  
Adel, GA
    28.7 %     2       5  
Baxley, GA
    15.4 %     5       5  
Hazlehurst, GA
    29.1 %     2       5  
On March 17, 2010, the Company adopted a plan to reorganize from a two-tier mutual holding company to a full stock holding company and will undertake a “second-step” offering of shares of the holding company’s common stock. The conversion and offering is expected to be completed in the third quarter of 2010, subject to regulatory, stockholder and depositor approvals.
As part of the reorganization, HeritageBank of the South will become a wholly owned subsidiary of a to-be-formed stock corporation, Heritage Financial Group, Inc. Shares of the common stock of the Company, other than those held by Heritage, MHC, will be converted into shares of common stock in Heritage Financial Group, Inc., using an exchange ratio designed to preserve current percentage ownership interests. Shares owned by Heritage, MHC will be retired, and new shares representing that ownership will be offered and sold to the Bank’s eligible depositors, the Bank’s tax-qualified employee benefit plans and to members of the general public as set forth in the Plan of Conversion and Reorganization of Heritage, MHC.
The Plan of Conversion and Reorganization of Heritage MHC will be submitted to the Office of Thrift Supervision and the Georgia Department of Banking and Finance for regulatory approval. Upon receipt of regulatory approvals, the Company will seek approval from its stockholders and HeritageBank of the South depositors.
Competition
We face strong competition in originating commercial, real estate and other loans and in attracting deposits. Competition in originating real estate loans comes primarily from other banks, credit unions and mortgage bankers. Other banks, credit unions and finance companies also provide vigorous competition in consumer and commercial lending.
We attract deposits through our branch office system. Competition for those deposits is principally from other banks and credit unions located in the same community, as well as mutual funds and other alternative investments. We compete for these deposits by offering superior service and a variety of deposit accounts at competitive rates.
On-line Presence
The Company maintains a website at www.eheritagebank.com. The information contained on that website is not included as part of, or incorporated by reference into, this Annual Report on Form 10-K. The Company currently makes available on or through its website its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to these reports, and all other Securities and Exchange Commission filings. These materials are also available free of charge on the Securities and Exchange Commission’s website at www.sec.gov.

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Lending Activities
The following table presents information concerning the composition of the Bank’s loan portfolio in dollar amounts and in percentages (before deductions for allowances for losses) as of the dates indicated. Purchased loans have been excluded from the individual loan categories below because fair market value adjustment discounts of $7.2 million related to this pool of loans would distort the individual categories.
                                                                                 
    December 31,  
    2009     2008     2007     2006     2005  
    Amount     Percent     Amount     Percent     Amount     Percent     Amount     Percent     Amount     Percent  
                    (Dollars in Thousands)                  
Real Estate
                                                                               
One- to four-family
  $ 81,255       24.32 %   $ 79,727       26.36 %   $ 74,752       24.54 %   $ 73,681       26.62 %   $ 74,121       29.17 %
Multi-family
    11,650       3.49       10,719       3.54       12,297       4.04       16,913       6.11       15,918       6.26  
Commercial
    71,013       21.25       52,477       17.35       41,630       13.66       44,496       16.08       37,985       14.95  
Farmland
    9,013       2.70       5,744       1.90       4,818       1.58       2,642       0.95              
Construction and Development
    28,002       8.38       43,297       14.31       51,308       16.84       32,822       11.86       16,505       6.50  
 
                                                           
Total real estate loans
    200,933       60.14       191,964       63.46       184,805       60.66       170,554       61.62       144,529       56.88  
 
                                                           
Other loans
                                                                               
Consumer loans:
                                                                               
Student
    596       0.18       552       0.18       594       0.20       703       0.25       1,110       0.44  
Automobile
    26,698       7.99       39,753       13.14       47,718       15.66       46,331       16.74       50,137       19.73  
Home equity
    17,313       5.18       18,344       6.06       17,257       5.66       16,368       5.91       15,591       6.14  
Other
    7,687       2.30       9,037       2.99       9,377       3.08       8,812       3.19       9,058       3.56  
 
                                                           
Total consumer loans
    52,294       15.65       67,686       22.37       74,946       24.60       72,214       26.09       75,896       29.87  
Commercial business loans
    45,785       13.70       42,838       14.17       44,922       14.74       34,008       12.29       33,686       13.26  
 
                                                           
Total other loans
    98,079       29.35       110,524       36.54       119,868       39.34       106,222       38.38       109,582       43.12  
 
                                                           
 
    299,012       89.49       302,488       100.00       304,673       100.00       276,776       100.00       254,111       100.00  
Purchased loans, net of fair market value adjustments
    35,126       10.51                                                  
 
                                                           
Total loans
    334,138       100.00 %     302,488       100.00 %     304,673       100.00 %     276,776       100.00 %     254,111       100.00 %
 
                                                                     
Less allowance for loan losses
    6,060               4,951               4,416               4,076               3,618          
 
                                                                     
 
  $ 328,078             $ 297,537             $ 300,257             $ 272,700             $ 250,493          
 
                                                                     

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The following table shows the composition of the Bank’s loan portfolio by fixed- and adjustable-rate at the dates indicated. Purchased loans have been excluded from the individual loan categories below because fair market value adjustment discounts of $7.2 million related to this pool of loans would distort the individual categories.
                                                 
    December 31,  
    2009     2008     2007  
    Amount     Percent     Amount     Percent     Amount     Percent  
    (Dollars in Thousands)  
Fixed Rate Loans:
                                               
Real Estate
                                               
One- to four-family
  $ 75,301       22.53 %   $ 72,353       23.92 %   $ 69,841       22.92 %
Multi-family
    6,197       1.86       5,210       1.72       7,178       2.36  
Commercial
    58,300       17.45       42,084       13.91       32,634       10.71  
Farmland
    4,789       1.44       2,174       0.72       3,337       1.10  
Construction and development
    8,634       2.58       8,426       2.79       13,903       4.56  
 
                                   
Total real estate loans
    153,221       45.86       130,247       43.06       126,893       41.65  
Consumer
    31,130       9.32       45,168       14.93       53,618       17.60  
Commercial business
    18,975       5.68       14,218       4.70       16,482       5.41  
 
                                   
Total fixed-rate loans
    203,326       60.86       189,633       62.69       196,993       64.66  
 
                                   
 
                                               
Adjustable Rate Loans:
                                               
Real Estate
                                               
One- to four-family
    5,954       1.79       7,374       2.44       4,911       1.61  
Multi-family
    5,453       1.63       5,509       1.82       5,119       1.68  
Commercial
    12,713       3.80       10,393       3.44       8,996       2.95  
Farmland
    4,224       1.26       3,569       1.18       1,481       0.49  
Construction and development
    19,368       5.80       34,871       11.53       37,405       12.28  
 
                                   
Total real estate loans
    47,712       14.28       61,716       20.41       57,912       19.01  
Consumer
    21,164       6.33       22,518       7.44       21,328       7.00  
Commercial business
    26,810       8.02       28,621       9.46       28,440       9.33  
 
                                   
Total adjustable rate loans
    95,686       28.63       112,855       37.31       107,680       35.34  
 
                                   
 
    299,012       89.49       302,488       100.00       304,673       100.00  
Purchased loans, net of fair market value adjustments
    35,126       10.51                          
 
                                   
Total loans
    334,138       100.00 %     302,488       100.00 %     304,673       100.00 %
 
                                         
 
                                               
Less allowance for loan losses
    6,060               4,951               4,416          
 
                                         
 
                                               
Total loans, net
  $ 328,078             $ 297,537             $ 300,257          
 
                                         

7


 

The following schedule illustrates the contractual maturity of the Bank’s loan portfolio at December 31, 2009. Mortgages that have adjustable or renegotiable interest rates are shown as maturing in the period during which the contract is due. The schedule does not reflect the effects of possible prepayments or enforcement of due-on-sale clauses. Tax exempt loans are shown at actual rates, not at tax-equivalent rates. This table excludes $35.1 million in purchased loans because fair market value adjustment discounts of $7.2 million related to this pool of loans would distort the individual categories.
                                                                                                                         
Real Estate            
One- to Four Family   Multi-family   Commercial   Farmland   Construction   Consumer   Commercial Business   Total
    Weighted           Weighted           Weighted           Weighted           Weighted           Weighted           Weighted           Weighted
    Average           Average           Average           Average           Average           Average           Average           Average
Amount   Rate   Amount   Rate   Amount   Rate   Amount   Rate   Amount   Rate   Amount   Rate   Amount   Rate   Amount   Rate
(Dollars in Thousands)
One year or less: (1)                                                                                                        
$14,952  
    6.64 %   $ 3,270       6.43 %   $ 14,216       6.49 %   $ 4,536       5.62 %   $ 20,471       4.77 %   $ 4,057       8.23 %   $ 17,819       5.82 %   $ 79,321       5.88 %
 
                                                                                                                       
 
                                                                                                                       
One year through 5 years:
                                                                                           
$39,606  
    6.62 %   $ 8,380       5.28 %   $ 47,835       6.07 %   $ 4,477       5.39 %   $ 5,942       5.99 %   $ 30,351       7.80 %   $ 23,174       5.88 %   $ 159,765       6.45 %
 
                                                                                                                       
 
                                                                                                                       
Five years and over:
                                                                                                     
$26,697  
    5.58 %   $       %   $ 8,962       5.80 %   $       %   $ 1,589       6.17 %   $ 17,886       3.88 %   $ 4,792       3.59 %   $ 59,926       4.96 %
 
                                                                                                                       
 
                                                                                                                       
Total:
                                                                                                                       
$81,255  
          $ 11,650             $ 71,013             $ 9,013             $ 28,002             $ 52,294             $ 45,785             $ 299,012          
 
                                                                                                                       
 
(1)    Includes demand loans, loans having no stated maturity and overdraft loans.

8


 

Lending authority. The Bank has established lending limits for its officers. Lenders may make loans up to $250,000, based on the experience of the lender. The commercial managers may make and approve loans up to $500,000. The Chief Executive Officer of the Bank may approve loans up to $2.0 million, and the Senior Credit Officer may approve loans up to $2.0 million in conjunction with the commercial managers. The Chief Executive Officer and the Senior Credit Officer may jointly approve loans up to $3.0 million and the Executive Loan Committee may approve loans up to $5.0 million. Loans over these amounts or outside our general underwriting guidelines must be approved by the board of directors.
We are subject to the lending limit established under Georgia law for loans to one borrower and the borrower’s related entities. See “How We Are Regulated – HeritageBank of the South – Georgia Regulation.” Based on our capital level at December 31, 2009, the maximum amount under Georgia law that we could loan to any one borrower and the borrower’s related entities was $11.8 million for fully secured loans (including loans secured by real estate for which we have an independent appraisal) and $7.1 million for all other loans. Internally, we have set limits of $5.0 million for fully secured loans and $4.5 million for all other loans to any one borrower and the borrower’s related entities. These internal limits may be exceeded by approval of the board of directors.
Major loan customers. Our ten largest lending relationships are with commercial borrowers and total $53.6 million in the aggregate, or 16.0% of our $334.1 million loan portfolio at December 31, 2009. These relationships consist of $7.6 million for a finance company secured by accounts receivable and real estate in Southwest Georgia; $6.9 million to a specialty chemical business in Southwest Georgia; $6.6 million secured by real estate in North Central Florida; $5.7 million for the permanent financing of a hotel in North Central Florida; $5.3 million to a retail pharmacy business secured by inventory and real estate located primarily in Southwest Georgia; $5.0 million to a franchise restaurant chain with multiple locations in North Central Florida; $4.4 million to a franchise restaurant chain with multiple locations in North Central Florida; $4.1 million secured by residential rental property in Southwest Georgia; $4.0 million, of which $2.6 million is secured by multifamily property in Southwest Georgia and $1.4 million is secured primarily by residential rental real estate in Southwest Georgia; $4.0 million, of which $2.5 million is secured by residential real estate in Southwest Georgia and $1.5 million is secured by a mini-warehouse facility in Southwest Georgia.
As of December 31, 2009, all of these loans were performing as agreed and none were listed as classified assets.
For further information on credit quality, see the discussion under the headings “- Classified Assets” and “- Loan Delinquencies and Defaults” below and see also Management’s Discussion and Analysis contained in Item 7 of this 10-K.
One- to Four-Family Residential Real Estate Lending. We originate loans secured by first mortgages on one- to four-family residences in our lending area, and on occasion, outside our lending area for customers whose primary residences are within our lending area. The majority of these loans are originated by us and funded by other lenders. During 2002 and 2003, this type of lending increased because of increased demand for refinancing and our decision, in 2003, to originate more fixed-rate residential loans for our portfolio. In 2004, this loan demand decreased, primarily due to a decrease in refinancing activity, and we reduced the amount of mortgage loans originated for our portfolio, though we continued to originate loans for funding by another lender. In 2005, we ceased originating 15- and 30- year one- to four-family residential loans for our own portfolio. At December 31, 2009, we had $81.3 million, or 24.3% of our loan portfolio in one- to four-family residential loans. Of these, $75.3 million were fixed-rate loans and $6.0 million were adjustable rate loans.
We generally underwrite our one- to four-family owner-occupied loans based on the applicant’s employment and credit history and the appraised value of the subject property. Presently, we lend up to 90% of the lesser of the appraised value or purchase price for one- to four-family residential loans. For loans with a loan-to-value ratio in excess of 80%, we generally require private mortgage insurance in order to reduce our exposure below 80%. Properties securing our one- to four-family loans are appraised by independent fee appraisers approved by the board of directors. We require our borrowers to obtain title insurance and hazard insurance, and flood insurance, if necessary.
We currently originate one- to four-family mortgage loans on either a fixed- or adjustable-rate basis, as consumer demand dictates. Our pricing strategy for mortgage loans includes setting interest rates that are competitive with other local financial institutions and consistent with our internal needs. Fixed-rate loans generally have a five-year term, with a balloon payment and a 15- to 30-year amortization calculation.
Adjustable-rate mortgage, or ARM, loans are generally offered with annual repricing with a maximum annual rate change of 1% and maximum overall rate change of 4%. We use a variety of indices to reprice our ARM loans. Our ARM loans generally provide for specified minimum and maximum interest rates, with a lifetime cap and floor, and a periodic adjustment of the interest rate over the rate in effect on the date of origination. As a consequence of using caps, the interest rates on these loans may not be as rate sensitive as is our cost of funds. Our ARM loans are written using generally accepted underwriting guidelines. ARM loans generally pose different credit risks than fixed-rate loans, primarily because as interest rates rise, the borrower’s payment rises, increasing the potential for default. We do not offer teaser rates on adjustable-rate mortgage loans.

9


 

We no longer originate one- to four-family loans that are assumable. However, our portfolio does contain one- to four-family loans that are assumable, subject to our approval, and may contain prepayment penalties. Due to current market conditions and rapidly changing underwriting criteria required by investors, including the Federal Home Loan Bank, Fannie Mae and Freddie Mac, these loans may not be readily sellable to Freddie Mac, Fannie Mae, or other private investors. Our real estate loans contain a “due on sale” clause allowing us to declare the unpaid principal balance due and payable upon the sale of the collateral.
We generally underwrite our non- owner-occupied, one- to four-family loans primarily based on a 1.25 times debt service coverage, though we also consider the applicant’s creditworthiness and the appraised value of the property. Presently, we lend up to 85% of the lesser of the appraised value or purchase price for the residence. These loans are offered with a fixed rate or an adjustable rate using the prime rate as the index. These loans have terms of up to 15 years and are not assumable. We generally obtain title opinions from our counsel regarding these properties.
Commercial and Multi-Family Real Estate Lending. We offer a variety of multi-family and commercial real estate loans. These loans are secured primarily by multi-family dwellings, retail establishments, hotels, motels, warehouses and small office buildings located in our market areas. At December 31, 2009, commercial real estate and multi-family loans totaled $71.0 million and $11.7 million or 21.3% and 3.5%, respectively, of our gross loan portfolio.
Our loans secured by multi-family and commercial real estate are originated with either a fixed or adjustable interest rate over a three-or five-year term with a balloon payment generally based on a 15 year amortization. The interest rate on adjustable-rate loans is based on a variety of indices, generally determined through negotiation with the borrower. Loan-to-value ratios on our multi-family and commercial real estate loans typically do not exceed 80% of the appraised value of the property securing the loan.
Loans secured by multi-family and commercial real estate are underwritten based on the income producing potential of the property and the financial strength of the borrower. The net operating income, which is the income derived from the operation of the property less all operating expenses, must be sufficient to cover the payments related to the outstanding debt. We generally require personal guarantees of the borrowers and an assignment of rents or leases in order to be assured that the cash flow from the project will be used to repay the debt. Appraisals on properties securing multi-family and commercial real estate loans are performed by independent state certified or licensed fee appraisers approved by the board of directors, with a second independent appraisal review performed if the loan exceeds $500,000.
We generally do not maintain a tax or insurance escrow account for loans secured by multi-family and commercial real estate. In order to monitor the adequacy of cash flows on income-producing properties, the borrower is generally required to provide periodic financial information.
Loans secured by multi-family and commercial real estate properties generally involve a greater degree of credit risk than one- to four-family residential mortgage loans. These loans typically involve large balances to single borrowers or groups of related borrowers. Because payments on loans secured by multi-family and commercial real estate properties are often dependent on the successful operation or management of the properties, repayment of these loans may be subject to adverse conditions in the real estate market or the economy. If the cash flow from the project is reduced, or if leases are not obtained or renewed, the borrower’s ability to repay the loan may be impaired.
Construction and Development Lending. Our construction loan portfolio consists of loans for the construction of one- to four-family residences, multi-family residences and commercial properties. Construction lending generally affords us an opportunity to receive interest at rates higher than those obtainable from residential lending and to receive higher origination and other loan fees. In addition, construction loans are generally made with adjustable rates of interest for six- to nine-month terms, with interest-only payments due during the construction period. At December 31, 2009, we had $28.0 million in construction loans outstanding, representing 8.4% of our gross loan portfolio and consisting of $2.4 million in construction loans for one- to four-family residences, $3.5 million for commercial properties being constructed and $22.1 million in acquisition and development loans to builders, developers and individuals, for the development of lots for future residential and commercial construction.
Construction loans also involve additional risks because funds are advanced upon the security of the project under construction, which is of uncertain value prior to the completion of construction. Moreover, because of the uncertainties inherent in estimating construction costs, delays arising from labor problems, material shortages, and other unpredictable contingencies, it is relatively difficult to evaluate accurately the total loan funds required to complete a project, and the related loan-to-value ratios. We fund our construction loans based on percentage of completion as determined by physical property inspections. Acquisition and development loans are required to be paid down as lots are sold, though on an accelerated basis so that we are repaid before all the lots are sold. See also the discussion under the headings “- Classified Assets” and “- Loan Delinquencies and Defaults”.

10


 

Commercial Business Lending. At December 31, 2009, commercial business loans totaled $45.8 million or 13.7% of our gross loan portfolio. Our commercial business lending activities encompass loans with a variety of purposes and security, including loans to finance accounts receivable, inventory and equipment. Our commercial business lending policy includes credit file documentation and analysis of the borrower’s background, capacity to repay the loan, the adequacy of the borrower’s capital and collateral as well as an evaluation of other conditions affecting the borrower. Analysis of the borrower’s past, present and future cash flows is also an important aspect of our credit analysis. We generally obtain personal guarantees on our commercial business loans. Nonetheless, these loans are believed to carry higher credit risk than traditional single family loans.
Unlike residential mortgage loans, commercial business loans are typically made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business and, therefore, are of higher risk. Commercial business loans are generally secured by business assets, such as accounts receivable, equipment and inventory. This collateral may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself (which, in turn, is often dependent in part upon general economic conditions).
Our management recognizes the generally increased risks associated with our commercial business lending. Our commercial lending policy emphasizes complete credit file documentation and analysis of the borrower’s character, capacity to repay the loan, the adequacy of the borrower’s capital and collateral as well as an evaluation of the industry conditions affecting the borrower. Review of the borrower’s past, present and future cash flows is also an important aspect of our credit analysis. In addition, we generally obtain personal guarantees from the borrowers on these types of loans. The majority of the Bank’s commercial loans have been to borrowers in Southwest Georgia and North Central Florida. We intend to continue our commercial lending in this geographic area.
Consumer Lending. We offer a variety of secured consumer loans, including home equity lines of credit, new and used auto loans, boat and recreational vehicle loans, and loans secured by deposit accounts. We also offer a limited amount of unsecured loans. We originate our consumer loans primarily in our market areas. At December 31, 2009, our consumer loan portfolio totaled $52.3 million, or 15.7% of our gross loan portfolio.
Our home equity lines of credit totaled $17.3 million, and accounted for 5.2% of our gross loan portfolio at December 31, 2009. These loans may be originated in amounts, together with the amount of the existing first mortgage, of up to 100% of the value of the property securing the loan. Home equity lines of credit generally have a 15-year draw period and require the payment of 1.5% of the outstanding loan balance per month during the draw period, which may be reborrowed at any time during the draw period. We also offer a 15-year home equity line of credit that requires interest-only payments for the first five years, then fully amortizing payments over the remaining 10 years of the loan. At December 31, 2009, unfunded commitments on home equity lines of credit totaled $12.3 million. Other consumer loan terms vary according to the type of collateral, length of contract and creditworthiness of the borrower.
We originate auto loans on a direct basis and very limited on an indirect basis. Prior to 2008, we were very active in indirect auto lending. However, as we tightened our lending standards on indirect auto loans, we saw dramatic decreases in indirect auto loan production. Going forward, we do not expect indirect lending to be a significant part of our business, and we expect this portfolio to continue to decline as loans pay off. Auto loans totaled $26.7 million at December 31, 2009, or 8.0% of our gross loan portfolio, of which $10.2 million was direct loans and $16.5 million was indirect loans. Auto loans may be written for up to six years and usually have fixed rates of interest. Loan-to-value ratios are up to 100% of the sales price for new autos and 100% of retail value on autos, based on valuation from official used car guides.
Consumer loans generally have shorter terms to maturity, which reduces our exposure to changes in interest rates, and carry higher rates of interest than do one- to four-family residential mortgage loans. In addition, management believes that offering consumer loan products helps to expand and create stronger ties to our existing customer base by increasing the number of customer relationships and providing cross-marketing opportunities.
Consumer loans may entail greater risk than do one- to four-family residential mortgage loans, particularly in the case of consumer loans that are secured by rapidly depreciable assets, such as automobiles and recreational vehicles. In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance. As a result, consumer loan collections are dependent on the borrower’s continuing financial stability and, thus, are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.

11


 

Loan Originations, Purchases, Sales, Repayments and Servicing
We originate one- to four-family residential mortgage loans primarily through referrals from real estate agents, builders and from existing customers. Walk-in customers and referrals from existing customers are also important sources of loan originations. Since our conversion to a federal thrift in 2001, we have been able to expand our target market to include individuals who were not members of the credit union and have increased the number and amount of commercial real estate and commercial business loan originations. Loan origination fees earned totaled $557,000, $746,000 and $695,000 for the years ended December 31, 2009, 2008 and 2007, respectively.
While we originate both adjustable-rate and fixed-rate loans, our ability to originate loans is dependent upon customer demand for loans in our market areas. Demand is affected by competition and the interest rate environment. Loans and participations purchased must conform to our underwriting guidelines. Furthermore, during the past few years, we, like many other financial institutions, experienced significant prepayments on loans due to the low interest rate environment prevailing in the United States. In periods of economic uncertainty, the ability of financial institutions, including ours, to originate or purchase large dollar volumes of real estate loans may be substantially reduced or restricted, with a resultant decrease in interest income.
We have agreements with mortgage lenders, pursuant to which we originate residential mortgage loans for these lenders in accordance with their policies, terms and conditions and forward the loan package to those lenders for funding. We charge the borrower an origination fee for processing the borrower’s application in accordance with the lender’s specifications. We also may earn a premium on these loans based on the difference between the rate on the loan and the lock-in rate accepted by the lender. During 2009, we originated $28.5 million of mortgage loans for these lenders and generated approximately $345,000 of loan origination fees on these loans.
In addition to interest earned on loans and loan origination fees, we receive fees for loan commitments, late payments and other miscellaneous services. The fees vary from time to time, generally depending on the supply of funds and other competitive conditions in the market. Fees for late payments totaled $283,000, $288,000 and $264,000 for the years ended December 31, 2009, 2008 and 2007, respectively.
Asset Quality
When a borrower fails to make a required payment on a loan, we attempt to cure the delinquency by contacting the borrower. In the case of loans secured by residential real estate, a late notice is sent 15 and 30 days after the due date, and the borrower is contacted by phone beginning 16 days after the due date. When the loan is 31 days past due, a delinquency letter is mailed to the borrower. All delinquent accounts are reviewed by a collector, who attempts to cure the delinquency by contacting the borrower once the loan is 30 days past due. If the account becomes 60 days delinquent and an acceptable repayment plan has not been agreed upon, a collection officer will generally refer the account to legal counsel, with instructions to prepare a notice of intent to foreclose. The notice of intent to foreclose allows the borrower up to 30 days to bring the account current. If foreclosed, we take title to the property and sell it directly through a real estate broker.
Delinquent consumer loans are handled in a similar manner, except that appropriate action may be taken to collect any loan payment that is delinquent for more than 15 days. Follow-up contacts are generally on an accelerated basis compared to the mortgage loan procedure. Our procedures for repossession and sale of consumer collateral are subject to various requirements under the applicable consumer protection laws as well as other applicable laws and the determination by us that it would be beneficial from a cost basis.
Delinquent commercial business loans and loans secured by multi-family, farmland and commercial real estate are initially handled by the loan officer in charge of the loan, who is responsible for contacting the borrower. The collection department also works with the commercial loan officers to see that necessary steps are taken to collect delinquent loans. In addition, we have an officer loan committee that meets at least twice a month and reviews past due and criticized loans, as well as other loans that management feels may present possible collection problems. If an acceptable workout of a delinquent commercial loan cannot be agreed upon, we generally initiate foreclosure or repossession proceedings on any collateral securing the loan.

12


 

Delinquent Loans. The table below sets forth the amounts and categories of delinquent loans that were still accruing interest at December 31, 2009:
                         
    Thirty to     Sixty to     Total thirty days  
    fifty-nine days     ninety days     or more delinquent  
     
Delinquent Loans:
                       
One- to four-family
  $ 921     $ 374     $ 1,295  
Multi-family
                 
Commercial real estate
    118             118  
Farmland
    6             6  
Construction and development
    834             834  
Consumer
    450       92       542  
Commercial business
    350       102       452  
 
                 
Total
  $ 2,679     $ 568     $ 3,247  
 
                 
 
                       
Total as a percentage of total loans
    0.80 %     0.17 %     0.97 %
Nonperforming Assets. The table below sets forth the amounts and categories of nonperforming assets in our loan portfolio. Loans are placed on non-accrual status when the collection of principal and/or interest becomes doubtful. At all dates presented, we had no accruing loans more than 90 days delinquent. At December 31, 2009, we had troubled debt restructurings totaling $5.4 million, which involve forgiving a portion of interest or principal on any loans or making loans at a rate materially less than that of market rates. Included below in nonaccruing loans at December 31, 2009, are troubled debt restructurings of $2.1 million. In addition, at that date we had troubled debt restructurings totaling $3.2 million which were performing in accordance with their modified terms, and are not included in nonaccruing loans. For all other dates presented, we had no troubled debt restructurings. Foreclosed assets owned include assets acquired in settlement of loans.
                                         
    December 31,  
    2009     2008     2007     2006     2005  
    (Dollars in Thousands)  
Nonaccruing Loans:
                                       
One- to four-family
  $ 1,505     $ 689     $ 373     $     $ 102  
Multi-family
    122                          
Commercial real estate
    236       988       35             241  
Construction and development
    2,863       4,882       2,357       61        
Consumer
    489       575       447       197       524  
Commercial business
    3,248       147                    
 
                             
Total
    8,463       7,281       3,212       258       867  
 
                             
 
                                       
Foreclosed Assets:
                                       
One- to four-family
    583       115                   44  
Multi-family
                             
Commercial real estate
    362       284       287       306        
Construction and development
    794       1,666                    
Consumer
    56       55       78       16       15  
Commercial business
                             
 
                             
Total
    1,795       2,120       365       322       59  
 
                             
 
                                       
Total nonperforming assets
  $ 10,258     $ 9,401     $ 3,577     $ 580     $ 929  
 
                             
 
                                       
Total as a percentage of total assets
    1.79 %     1.87 %     0.76 %     0.14 %     0.25 %

13


 

As of December 31, 2009, the increased level of nonperforming assets is attributable primarily to our commercial lending activities. Commercial and consumer loans generally involve significantly greater credit risks than single-family residential lending. For a discussion of significant nonperforming assets, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of this 10-K.
For the year ended December 31, 2009, there was approximately $610,000 of gross interest income that would have been recorded had the non-accruing loans been current in accordance with their original terms. No significant amount was included in interest income on these loans for this period.
Other Loans of Concern. In addition to the nonperforming assets set forth in the table above, as of December 31, 2009, there was also an aggregate of $22.5 million of loans with respect to which known information about the possible credit problems of the borrowers have caused management to have doubts as to the ability of the borrowers to comply with present loan repayment terms and which may result in the future inclusion of such items in the non-performing asset categories. These loans have been considered in management’s determination of the adequacy of our allowance for loan losses.
Classified Assets. Federal regulations provide for the classification of loans and other assets, such as debt and equity securities considered to be of lesser quality, as “substandard,” “doubtful” or “loss.” An asset is considered “substandard” if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. “Substandard” assets include those characterized by the “distinct possibility” that the insured institution will sustain “some loss” if the deficiencies are not corrected. Assets classified as “doubtful” have all of the weaknesses inherent in those classified “substandard,” with the added characteristic that the weaknesses present make “collection or liquidation in full,” on the basis of currently existing facts, conditions, and values, “highly questionable and improbable.” Assets classified as “loss” are those considered “uncollectible” and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted.
When an institution classifies problem assets as either substandard or doubtful, it may establish specific allowances for these loans in an amount deemed prudent by management and approved by the board of directors. In addition, an institution is also required to develop general allowances. General allowances represent loss allowances that have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When an institution classifies problem assets as “loss,” it is required either to establish a specific allowance for losses equal to 100% of that portion of the asset so classified or to charge off such amount. The Bank’s determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the Federal Deposit Insurance Corporation (the “FDIC”) and the Georgia Department of Banking and Finance, which may order the establishment of additional general or specific loss allowances.
We regularly review the problem assets in our portfolio to determine whether any assets require classification in accordance with applicable regulations. On the basis of management’s review of our assets, at December 31, 2009, we had $25.8 million of our assets internally classified, of which $24.0 million is classified as substandard, none is classified as doubtful or loss, and $1.8 million is in other real estate and repossessions. The total amount classified represented 46.6% of our equity capital and 5.1% of our assets at December 31, 2009.
Provision for Loan Losses. We recorded a provision for loan losses for the year ended December 31, 2009 of $7.5 million, compared to $3.4 million for the year ended December 31, 2008. The provision for loan losses is charged to income to provide adequate allowance for loan losses to reflect probable incurred losses based on the factors discussed below under “— Allowance for Loan Losses.” The provision for loan losses for the year ended December 31, 2009 was based on management’s review of such factors which indicated that the allowance for loan losses reflected probable incurred losses in the loan portfolio as of the year ended December 31, 2009. For a more detailed analysis of the increased provision for loan losses in 2009, see “Provision for Loan Losses” included in Item 7 of this 10-K.
Allowance for Loan Losses. We maintain an allowance for loan losses to absorb probable incurred losses in the loan portfolio. The allowance is based on ongoing, monthly assessments of the estimated probable incurred losses in the loan portfolio. In evaluating the level of the allowance for loan losses, management considers the types of loans and the amount of loans in the loan portfolio, peer group information, historical loss experience, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. Large groups of smaller balance homogeneous loans, such as residential real estate, small commercial real estate, home equity and consumer loans, are evaluated in the aggregate using historical loss factors and peer group data adjusted for current economic conditions. Geographic peer group data is obtained by general loan type and adjusted to reflect known differences between peers and the Bank, such as loan seasoning, underwriting experience, local economic conditions and customer characteristics. More complex loans, such as multi-family and commercial real estate loans and commercial business loans, are evaluated individually for impairment, primarily through the evaluation of collateral values.

14


 

At December 31, 2009, our allowance for loan losses was $6.1 million or 1.81% of the total loan portfolio. Assessing the allowance for loan losses is inherently subjective as it requires making material estimates, including the amount and timing of future cash flows expected to be received on impaired loans, that may be susceptible to significant change. In the opinion of management, the allowance, when taken as a whole, reflects estimated probable loan losses in our loan portfolios. The allowance is discussed further in Notes 1 and 4 of the Notes to Consolidated Financial Statements and “Management’s Discussion and Analysis of Financial Condition and Results of Operation” in Item 7 of this 10-K.
The following table sets forth an analysis of our allowance for loan losses.
                                         
    December 31,  
    2009     2008     2007     2006     2005  
    (Dollars in Thousands)  
Balance at beginning of period
  $ 4,951     $ 4,416     $ 4,076     $ 3,618     $ 2,965  
 
                             
 
                                       
Charge-offs:
                                       
One- to four-family
    494       81       55             27  
Multi-family
                             
Commercial real estate
    25       773       29              
Construction and development
    3,100       1,414       435       31        
Consumer
    664       687       398       368       567  
Commercial business
    2,338       47       116              
 
                             
 
    6,621       3,002       1,033       399       594  
 
                             
 
                                       
Recoveries:
                                       
One- to four-family
                            8  
Multi-family
                             
Commercial real estate
          4                    
Construction and development
          2                    
Consumer
    180       161       195       162       224  
Commercial business
    50       20                    
 
                             
 
    230       187       195       162       232  
 
                             
 
                                       
Net charge-offs
    6,391       2,815       838       237       362  
 
                                       
Provision charged to operations
    7,500       3,350       1,178       695       1,015  
 
                             
 
                                       
Balance at end of period
  $ 6,060     $ 4,951     $ 4,416     $ 4,076     $ 3,618  
 
                             
 
                                       
Ratio of net charge-offs during the period to average loans outstanding during period
    2.13 %     1.58 %     0.29 %     0.09 %     0.24 %
 
                                       
Ratio of net charge-offs during the period to average nonperforming assets
    65.54 %     58.51 %     36.12 %     29.28 %     43.46 %
 
                                       
Allowance as a percentage of nonperforming loans
    71.61 %     67.99 %     137.49 %     1,582.00 %     473.18 %
 
                                       
Allowance as a percentage of total loans (end of period)
    1.81 %     1.64 %     1.45 %     1.47 %     1.42 %

15


 

The distribution of our allowance for losses on loans at the dates indicated is summarized as follows:
                                                                                                 
    December 31,  
    2009     2008     2007     2006  
    (Dollars in Thousands)  
                    Percent                     Percent                     Percent                     Percent  
                    of Loans                     of Loans                     of Loans                     of Loans  
            Loan     in Each             Loan     in Each             Loan     in Each             Loan     in Each  
    Amount of     Amounts     Category     Amount of     Amounts     Category     Amount of     Amounts     Category     Amount of     Amounts     Category  
    Loan Loss     By     to Total     Loan Loss     By     to Total     Loan Loss     By     to Total     Loan Loss     By     to Total  
    Allowance     Category     Loans     Allowance     Category     Loans     Allowance     Category     Loans     Allowance     Category     Loans  
Secured by one-to four- family residential real estate
  $ 1,422       81,255       24.32 %   $ 637     $ 79,727       26.36 %   $ 553     $ 74,752       24.54 %   $ 875     $ 73,681       26.62 %
 
                                                                                               
Secured by multi- family residential real estate
    75       11,650       3.49       69       10,719       3.54       123       12,297       4.04       177       16,913       6.11  
 
                                                                                               
Secured by commercial real estate
    979       71,013       21.25       874       52,477       17.35       847       41,630       13.66       925       44,496       16.08  
 
                                                                                               
Construction and development
    1,419       28,002       8.38       1,275       43,297       14.31       1,616       51,308       16.84       471       32,822       11.86  
 
                                                                                               
Farmland
    122       9,013       2.70       72       5,744       1.90       42       4,818       1.58       32       2,642       0.95  
 
                                                                                               
Consumer
    850       52,294       15.65       890       67,686       22.37       740       74,946       24.60       791       72,214       26.09  
 
                                                                                               
Commercial business
    1,193       45,785       13.70       1,134       42,838       14.17       495       44,922       14.74       805       34,008       12.29  
 
                                                                                               
Unallocated
                                                                         
 
                                                                                               
Purchased loans net of fair market value adjustments
          35,126       10.51                                                        
 
                                                                                               
 
                                                                       
Total
  $ 6,060       334,138       100.00 %   $ 4,951     $ 302,488       100.00 %   $ 4,416     $ 304,673       100.00 %   $ 4,076     $ 276,776       100.00 %
 
                                                                       
Investment Activities
Georgia savings banks have the authority to invest in various types of liquid assets, including United States Treasury obligations, securities of various federal, state and local agencies and jurisdictions, including callable agency securities, certain certificates of deposit of insured banks and savings institutions, certain bankers’ acceptances, repurchase agreements and federal funds. Subject to various restrictions, Georgia savings banks also may invest their assets in investment grade commercial paper and corporate debt securities and mutual funds whose assets conform to the investments that a Georgia savings banks is otherwise authorized to make directly. See “How We Are Regulated — HeritageBank of the South — Georgia Regulation” for a discussion of additional restrictions on our investment activities.
The Chief Financial Officer and Treasurer have the basic responsibility for the management of our investment portfolio. They consider various factors when making decisions, including the marketability, maturity and tax consequences of the proposed investment. The maturity structure of investments will be affected by various market conditions, including the current and anticipated slope of the yield curve, the level of interest rates, the trend of new deposit inflows, and the anticipated demand for funds via deposit withdrawals and loan originations and purchases.

16


 

The general objectives of our investment portfolio are to provide liquidity when loan demand is high, to assist in maintaining earnings when loan demand is low and to maximize earnings while satisfactorily managing risk, including credit risk, reinvestment risk, liquidity risk and interest rate risk. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Asset and Liability Management and Market Risk” in Item 7 of this 10-K.
Our investment securities currently consist of mortgage-backed securities, federal agency securities, preferred stocks, state and local government securities and corporate debt securities. See Note 3 of the Notes to Consolidated Financial Statements.
As a member of the Federal Home Loan Bank of Atlanta, we had $3.2 million in stock of the Federal Home Loan Bank of Atlanta at December 31, 2009. We maintain the minimum amount of stock the Federal Home Loan Bank of Atlanta allows based on our level of borrowings. For the year ended December 31, 2009, we received $10,000 in dividends from the Federal Home Loan Bank of Atlanta.
The following table sets forth the composition of our securities portfolio and other investments at the dates indicated. Our securities portfolio at December 31, 2009, did not contain securities of any single issuer with an aggregate book value in excess of 10% of our equity capital, excluding those issued by the United States Government or its agencies.
                                                 
    December 31,  
    2009     2008     2007  
    Carrying     % of     Carrying     % of     Carrying     % of  
    Value     Total     Value     Total     Value     Total  
                    (Dollars in Thousands)                  
Securities available for sale:
                                               
U. S. Government sponsored agency securities (GSE’s)
  $ 30,462       25.27 %   $ 21,165       18.22 %   $ 14,996       13.90 %
Corporate debt securities
    1,910       1.58       1,789       1.54       3,854       3.57  
GSE residential mortgage-backed securities
    54,537       45.26       60,927       52.46       55,354       51.32  
Private label residential mortgage-backed securities
    3,874       3.21       4,481       3.86       245       0.23  
State and municipal securities
    29,123       24.16       27,511       23.69       31,878       29.55  
Equity and other
    621       0.52       268       0.23       1,540       1.43  
 
                                   
 
  $ 120,527       100.00 %   $ 116,141       100.00 %   $ 107,867       100.00 %
 
                                   
 
                                               
Other earning assets:
                                               
Interest-bearing deposits with banks
  $ 43,236       74.76 %     746       2.18 %   $ 380       2.13 %
Federal funds sold
    11,340       19.61       30,254       88.50       14,505       81.24  
FHLB stock
    3,253       5.63       3,186       9.32       2,970       16.63  
 
                                   
 
  $ 57,829       100.00 %   $ 34,186       100.00 %   $ 17,855       100.00 %
 
                                   
For further information on the ratings of these securities, see Note 3 of the Notes to Consolidated Financial Statements and “Management’s Discussion and Analysis of Financial Condition and Results of Operation” in Item 7 of this 10-K.

17


 

The composition and maturities of the securities portfolio, excluding Federal Home Loan Bank stock, as of December 31, 2009 are indicated in the following table. Yields on tax exempt obligations have been computed on a tax equivalent basis.
                                                                                         
    Less than One Year     One to Five Years     Over Five to Ten Years     Over Ten Years     Total Securities  
            Weighted             Weighted             Weighted             Weighted             Weighted        
    Amortized     Average     Amortized     Average     Amortized     Average     Amortized     Average     Amortized     Average     Fair  
    Cost     Yield     Cost     Yield     Cost     Yield     Cost     Yield     Cost     Yield     Value  
                                    (Dollars in Thousands)                                          
Securities Available for Sale:
                                                                                       
U.S. government and agency securities
  $       %   $       %   $ 27,960       4.54 %   $ 2,611       4.12 %   $ 30,571       4.50 %   $ 30,462  
Corporate debt securities
                2,179       6.55                               2,179       6.55       1,910  
GSE mortgage- backed securities
                            15,988       3.96       38,103       3.23       54,091       3.45       54,537  
Private label mortgage-backed securities
                                        3,859       5.01       3,859       5.01       3,874  
State and municipal
                2,759       5.20       15,484       5.50       11,900       5.94       30,143       5.67       29,123  
Equity and other
    317       3.50                               435       5.84       752       4.86       621  
 
                                                                 
Total investment securities
  $ 317       3.50 %   $ 4,938       5.80 %   $ 59,432       4.65 %   $ 56,908       3.98 %   $ 121,595       4.38 %   $ 120,527  
 
                                                                 
Sources of Funds
General. Our sources of funds are deposits, borrowings, payment of principal and interest on loans, interest earned on or maturation of other investment securities and funds provided from operations.
Deposits. We offer a variety of deposit accounts to both consumers and businesses having a wide range of interest rates and terms. Our deposits consist of savings and checking accounts, money market deposit accounts, NOW and demand accounts and certificates of deposit. We solicit deposits primarily in our market areas and rely on competitive pricing policies, marketing and customer service to attract and retain these deposits. In addition, we solicit brokered deposits when terms and rates are more favorable than those in the markets we serve. At December 31, 2009, we had $25.0 million in brokered deposits, of which $11.6 million were money market deposits from a broker/dealer, and $13.4 million were in certificates of deposit in the Certificate of Deposit Account Registry Service (“CDARS”).
The flow of deposits is influenced significantly by general economic conditions, changes prevailing interest rates and competition. The variety of deposit accounts we offer has allowed us to be competitive in obtaining funds and to respond with flexibility to changes in consumer demand. We have become more susceptible to short-term fluctuations in deposit flows, as customers have become more interest rate conscious. We try to manage the pricing of our deposits in keeping with our asset and liability management, liquidity and profitability objectives, subject to competitive factors. Based on our experience, we believe that our deposits are relatively stable sources of funds. Despite this stability, our ability to attract and maintain these deposits and the rates paid on them has been and will continue to be significantly affected by market conditions.
Under regulations of the Board of Governors of the Federal Reserve System, we are required to maintain noninterest bearing reserves at specified levels against our transaction accounts, primarily checking and NOW accounts. At December 31, 2009, the Bank was in compliance with these Federal Reserve requirements and, as a result, would have been deemed to be in compliance with a similar reserve requirement under Georgia law.

18


 

The following tables set forth the average dollar amount of deposits in the various types of interest-bearing deposit programs we offered during the years indicated and the average rate paid on these accounts.
                                                 
    December 31,  
    2009     2008     2007  
    Average     Average     Average     Average     Average     Average  
    Balance     Rate     Balance     Rate     Balance     Rate  
                    (Dollars in Thousands)                  
Interest bearing deposits:
                                               
 
                                               
Interest bearing demand
  $ 50,679       1.05 %   $ 43,102       1.12 %   $ 37,217       0.99 %
Savings and money market accounts
    122,453       1.27       95,822       1.45       119,544       2.85  
Retail time deposits
    122,332       3.10       126,120       4.18       128,162       4.92  
Wholesale time deposits
    17,981       3.32       43,215       4.35       14,466       5.37  
 
                                   
Total interest bearing deposits
  $ 303,445       2.09 %   $ 308,259       2.93 %   $ 299,389       3.63 %
 
                                   
Time deposits:
                                         
    Maturity as of December 31, 2009  
    3-Months     Over 3-6     Over 6-12     Over 12        
    or Less     Months     Months     Months     Total  
                (In Thousands)                  
Time deposits of less than $100,000
  $ 32,626     $ 18,114     $ 24,148     $ 21,268     $ 96,156  
Time deposits of $100,000 or more
    27,227       10,014       23,327       18,225       78,793  
 
                             
Total time deposits
  $ 59,854     $ 28,128     $ 47,475     $ 39,493     $ 174,949  
 
                             
Borrowings. Although deposits are our primary source of funds, we may utilize borrowings when they are a less costly source of funds and can be invested at a positive interest rate spread, when we desire additional capacity to fund loan demand or when they meet our asset/liability management goals. Since converting from a credit union in 2001, our borrowings have consisted of advances from the Federal Home Loan Bank of Atlanta, federal funds purchased and securities sold under repurchase agreements. See Note 11 and Note 12 of the Notes to Consolidated Financial Statements.
We may obtain advances from the Federal Home Loan Bank of Atlanta upon the security of certain of our mortgage loans and mortgage-backed and other securities. These advances may be made pursuant to several different credit programs, each of which has its own interest rate, range of maturities and call features, and all long-term advances are required to provide funds for residential home financing. At December 31, 2009, we had $42.5 million in Federal Home Loan Bank advances outstanding and the ability to borrow an additional $27.6 million from the Federal Home Loan Bank of Atlanta.
We have the ability to borrow from securities broker-dealers and customers by pledging investments. These arrangements are known as securities sold under repurchase agreements. These borrowings can be done on an overnight, short-term or long-term basis. As of December 31, 2009, we had $30.0 million borrowed under long-term agreements with broker-dealers and $310,000 borrowed under overnight agreements with customers.
We also have the ability to borrow up to $20.0 million from correspondent banks, pursuant to renewable lines of credit. In addition, we also borrow from Chattahoochee Bank of Georgia (“Chattahoochee”) on an overnight basis, depending on their liquidity needs. At December 31, 2009, we had federal funds purchased from Chattahoochee of $2.5 million.
The Bank is authorized to borrow from the Federal Reserve Bank of Atlanta’s “discount window” after it has exhausted other reasonable alternative sources of funds, including Federal Home Loan Bank borrowings.

19


 

The following table sets forth the maximum month-end balance and average balance of Federal Home Loan Bank advances for the periods indicated.
                         
    Year Ended December 31,  
    2009     2008     2007  
    (Dollars In Thousands)  
Maximum Balance
                       
Federal Home Loan Bank advances
  $ 52,500     $ 88,000     $ 50,000  
 
                 
 
                       
Average Balance
                       
Federal Home Loan Bank advances
  $ 47,268     $ 60,800     $ 44,521  
 
                 
 
                       
Average interest rate paid during the year
    3.87 %     4.09 %     4.56 %
 
                 
 
                       
End of Year Balance
                       
Federal Home Loan Bank advances
  $ 42,500     $ 52,500     $ 50,000  
 
                 
 
                       
Weighted average interest rate of Federal Home
                       
Loan Bank advances
    3.68 %     3.96 %     4.67 %
 
                 
The following table sets forth the maximum month-end balance and average balance of federal funds purchased and securities sold under repurchase agreements for the periods indicated.
                         
    Year Ended December 31,  
    2009     2008     2007  
    (Dollars In Thousands)  
Maximum Balance
                       
Federal funds purchased and securities sold under repurchase agreements
  $ 53,279     $ 41,497     $ 17,823  
 
                 
 
                       
Average Balance
                       
Federal funds purchased and securities sold under repurchase agreements
  $ 40,112     $ 32,504     $ 11,525  
 
                 
 
                       
Average interest rate paid during the year
    1.23 %     2.95 %     4.96 %
 
                 
 
                       
End of Year Balance
                       
Federal funds purchased and securities sold under repurchase agreements
  $ 32,843     $ 41,497     $ 15,288  
 
                 
 
                       
Weighted average interest rate of Federal funds purchased and securities sold under repurchase agreements
    1.08 %     1.91 %     4.67 %
 
                 
Subsidiary and Other Activities
The Bank is engaged in the sale of securities and insurance products to customers through an agreement with a third-party broker-dealer, at a location separate from any of our deposit-taking facilities. During the year ended December 31, 2009, we earned $914,000 in gross fees and commissions from this activity. This activity is conducted in accordance with applicable provisions of federal and state insurance and securities laws.
The Bank does not currently have any active subsidiaries.

20


 

How We Are Regulated
Set forth below is a brief description of certain laws and regulations that are applicable to the Company, the Bank and MHC. The description of these laws and regulations, as well as descriptions of laws and regulations contained elsewhere herein, does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.
Legislation is introduced from time to time in the United States Congress and Georgia General Assembly that may affect our operations. In addition, the regulations governing the Company, the Bank and MHC may be amended from time to time by the Georgia Department of Banking and Finance, the FDIC, the Office of Thrift Supervision or the SEC, as appropriate. Any such legislative or regulatory changes in the future could adversely affect our operations and financial condition. No assurance can be given as to whether or in what form any such changes may occur.
The Georgia Department of Banking and Finance, the FDIC, and the Office of Thrift Supervision, as appropriate, have extensive enforcement authority over the Company, the Bank and MHC. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with the FDIC. Except under certain circumstances, public disclosure of formal enforcement actions by the FDIC and Office of Thrift Supervision is required by law.
HeritageBank of the South. The Bank, as a Georgia savings bank is subject to regulation and periodic examination by the Georgia Department of Banking and Finance and the FDIC. This regulation extends to all aspects of its operations. The Bank is required to maintain minimum levels of regulatory capital and is subject to some limitations on the payment of dividends to the Company. See “- Regulatory Capital Requirements” and “- Limitations on Dividends and Other Capital Distributions.” State and federal laws and regulations prescribe the investment and lending authority and activities of Georgia savings banks. The FDIC also insures the deposits of the Bank to the maximum extent permitted by law. This regulation of the Bank is intended for the protection of depositors and the insurance of accounts fund and not for the purpose of protecting stockholders.
    Georgia Regulation. The Bank is subject to extensive regulation and supervision by the Georgia Department of Banking and Finance. The Georgia Department of Banking and Finance regularly examines the Bank, often jointly with the FDIC. As a Georgia savings bank, we are required to have no more than 50% of our assets in commercial real estate and business loans. We are in compliance with this requirement. Our lending and investment authority and other activities are governed by Georgia law and regulations and policies of the Georgia Department of Banking and Finance. We are subject to a statutory lending limit for aggregate loans to one person or a group of persons combined because of certain common interests. That limit is 15% of our statutory capital base, except for loans fully secured by good collateral or ample security, which includes real estate with an independent appraisal, in which case that limit is increased to 25%. Our statutory capital base consists of our stock, paid-in-capital and surplus, capital debt and appropriated retained earnings, which is that portion of our retained earnings designated by the board of directors as not available for dividends, reduced by intangible assets. We have not appropriated any retained earnings. Our lending limit to a single borrower under Georgia law as of December 31, 2009 was $11.8 million secured and $7.2 million unsecured. We have no loans in excess of our lending limit. Georgia law also limits our ability to invest in real estate, including a limit on fixed assets of 60% of our statutory capital base, except for temporary grants of authority to exceed that limit granted by the Department of Banking and Finance. We are in compliance with limitations on our fixed assets as of December 31, 2009.
 
    Insurance of Accounts and Regulation by the FDIC. The FDIC regularly examines the Bank and prepares reports for the consideration of the Bank’s board of directors on any deficiencies that it may find in the Bank’s operations. The Bank generally must notify or obtain the approval of the FDIC if it or any of its subsidiaries intend to engage in activities not authorized for national banks. The FDIC has adopted guidelines establishing safety and soundness standards on such matters as loan underwriting and documentation, asset quality, earnings standards, internal controls and audit systems, interest rate risk exposure and compensation and other employee benefits. Any institution that fails to comply with these standards must submit a compliance plan. The FDIC also has the authority to initiate enforcement actions against the Bank.
 
    The Bank’s deposits are insured up to the applicable limits by the FDIC, and such insurance is backed by the full faith and credit of the Unites States Government. Through December 31, 2013, the basic deposit insurance is $250,000 instead of the $100,000 limit that had been in effect prior to October 31, 2008.
 
    As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC-insured institutions. Our deposit insurance premiums for the year ended December 31, 2009 were $820,000. Those premiums are expected to increase in 2010 due to recent strains of the FDIC deposit insurance fund due to the cost of large bank failures and the increase in the number of troubled banks.

21


 

    The FDIC also provides unlimited deposit insurance for noninterest-bearing transaction accounts (typically business checking accounts), NOW accounts bearing interest at 0.5% or less, and certain funds swept into noninterest-bearing savings accounts at institutions that opt into this enhanced deposit insurance coverage. Due to the low level of balances we had that qualified for this enhanced coverage, we opted out of this coverage, and therefore, effective January 1, 2010, our customers no longer qualified for this coverage.
 
    The FDIC assesses deposit insurance premiums quarterly on each FDIC-insured institution base on annualized rates for one of four risk categories applied to its deposits subject to certain adjustments. Each institution is assigned to one of four risk categories based on its capital, supervisory ratings and other factors. Well capitalized institutions that are financially sound with only a few minor weaknesses are assigned to Risk Category I. Risk Categories II, III and IV present progressively greater risks to the deposit insurance fund. Under the FDIC’s risk-based assessment rules, effective April 1, 2009, the initial base assessment rates prior to adjustments range from 12 to 16 basis points for Risk Category I, and are 22 basis points for Risk Category II, 32 basis points for Risk Category III, and 45 basis points for Risk Category IV. Initial base assessments rates are subject to adjustments based on an institution’s unsecured debt, secured liabilities and brokered deposits, such that the total base assessment rates after adjustments range from 7 to 24 basis points for Risk Category I, 17 to 43 basis points for Risk Category II, 27 to 58 basis points for Risk Category III, and 40 to 77.5 basis points for Risk Category IV. Rates increase uniformly by 3 basis points effective January 1, 2011.
 
    In addition to the regular quarterly assessments, due to losses and projected losses attributed to failed institutions, the FDIC imposes a special assessment of 5 basis points on the amount each depository institution’s assets reduced by the amount of its Tier 1 capital (no to exceed 10 basis points of its assessment base for regular quarterly premiums) as of June 30, 2009, which was collected on September 30, 2009.
 
    As a result of the decline in the reserve ratio (the ratio of the net worth of the deposit insurance fund to estimated insured deposits) and concerns about the expected failure costs and available liquid assets in the deposit insurance fund, the FDIC required each insured institution to prepay on December 30, 2009, the estimated amount of its quarterly assessment for the fourth quarter of 2009 and all quarters through the end of 2012 (in addition to the regular quarterly assessment for the third quarter which is due on December 30, 2009). The prepaid amount is recorded as an asset with a zero risk weight and the institution will continue to record quarterly expenses for deposit insurance. For purposes of calculation the prepaid amount, assessments are measured at the institution’s assessment rate as of September 30, 2009, with a uniform increase of 3 basis points effective January 1, 2011, and are base on the institution’s assessment base for the third quarter of 2009, with growth assumed quarterly at an annual rate of 5%. If events cause actual assessments during the prepayment period to vary from the prepaid amount, institutions will pay excess assessments in cash, or receive a rebate of prepaid amounts not exhausted after collection of assessments due on January 13, 2013, as applicable. Collection of the prepayment does not preclude the FDIC from changing assessment rates or revising the risk-based assessment in the future. The rule includes a process for exemption from the prepayment for institutions whose safety and soundness would be affected adversely.
 
    The FDIC estimates that the reserve ratio will reach the designated reserve ratio of 1.15% by 2017 as required by statute.
 
    The FDIC also may prohibit any FDIC-insured institution from engaging in any activity that it determines by regulation or order to pose a serious risk to the deposit insurance fund. The FDIC also has the authority to initiate enforcement actions against the Bank and may terminate our deposit insurance it if determines we have engaged in unsafe or unsound practices or is in an unsafe or unsound condition.
Heritage Financial Group and Heritage, MHC. As the holding companies of a Georgia savings bank, the Company and MHC are subject to regulation and examination by the Georgia Department of Banking and Finance. This state regulation includes the imposition of capital requirements and limits on dividend payments. See “- Regulatory Capital Requirements” and “- Limitations on Dividends and Other Capital Distributions.” As savings association holding companies, the Company and MHC also are subject to regulation and examination by the Office of Thrift Supervision. The terms of the Company’s charter is prescribed by the Office of Thrift Supervision and requires us to only pursue any or all of the lawful objectives and powers of the subsidiary of a mutual holding company.
    Regulation by the Office of Thrift Supervision. The Company and MHC are subject to regulation, supervision and examination by the Office of Thrift Supervision. Under regulations of the Office of Thrift Supervision, MHC must own a majority of outstanding shares of the Company. Applicable federal law and regulations limit the activities of the Company and MHC and require the approval of the Office of Thrift Supervision for any acquisition or divestiture of a subsidiary, including another financial institution or holding company thereof.

22


 

    Generally, transactions between the Bank and its affiliates are required to be on terms as favorable to the institution as transactions with non-affiliates, and certain of these transactions, such as loans to an affiliate, are restricted to a percentage of the Bank’s capital. In addition, the Bank may not lend to any affiliate engaged in activities not permissible for a bank holding company or acquire the securities of most affiliates. The Company and MHC are affiliates of the Bank.
 
    Under federal law, if the Bank fails the qualified thrift lender test, the Company and MHC must obtain the approval of the Office of Thrift Supervision prior to continuing, directly or through other subsidiaries, any business activity other than those approved for multiple savings association holding companies or their subsidiaries. In addition, within one year of such failure, MHC and the Company must register as, and will become subject to, the restrictions applicable to bank holding companies. The qualified thrift lender test requires a savings institution to have at least 65% of its portfolio assets, as defined by regulation, in qualified thrift investments on a monthly average for nine out of every 12 months on a rolling basis. As an alternative, the savings institution may maintain 60% of its assets in those assets specified in Section 7701(a)(19) of the Internal Revenue Code. Under either test, such assets primarily consist of residential housing related loans and investments. At December 31, 2009, the Bank met the test.
 
    Under regulations of the Office of Thrift Supervision, MHC, may convert to the stock form of ownership, though it has no current intention to do so. In a stock conversion, the members of MHC would have a right to subscribe for shares of stock in a new company that would own MHC’s shares in the Company. In addition, each share of stock in the Company not owned by MHC, would be converted into shares in that new company in an amount that preserves the holders percentage ownership.
 
    Georgia Regulation. The Georgia Department of Banking and Finance has supervisory and examination authority over the Company and MHC. Under this authority, there are limits on the amount of debt that can be incurred by the holding companies, and they must file periodic reports and annual registration forms.
Regulatory Capital Requirements for the Bank. The Bank is required to maintain minimum levels of regulatory capital under regulations of the FDIC. It became subject to these capital requirements on January 1, 2005, when it became a Georgia savings bank. These regulations established two capital standards, a leverage capital requirement and a risk-based capital requirement.
The capital standards require Tier 1 capital equal to at least 3.0% of total assets for the strongest institutions with the highest examination rating and 4.0% of total assets for all other institutions, unless the FDIC requires a higher level based on the particular circumstances or risk profile of the institution. Tier 1 capital generally consists of equity capital, with certain adjustments, including deducting most intangibles. At December 31, 2009, the Bank had $1.6 million in intangibles included in Tier 1 capital. At December 31, 2009, the Bank had Tier 1 capital equal to $55.1 million, or 11.2% of total average assets, which is $35.4 million above the minimum requirement of 4.0%.
The FDIC also requires the Bank to have Tier 1 capital of at least 4.0% of risk weighted-assets and total capital of at least 8.0% of risk-weighted assets. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet items, will be multiplied by a risk weight, ranging from 0% to 100%, based on the risk inherent in the type of asset. Total capital consists of Tier 1 capital, as defined above, and Tier 2 capital, which consists of certain permanent and maturing capital instruments that do not qualify as Tier 1 capital and of the allowance for possible loan and lease losses up to a maximum of 1.25% of risk-weighted assets. Tier 2 capital may be used to satisfy these risk-based requirements only to the extent of Tier 1 capital. At December 31, 2009, the Bank had $388.3 million in risk-weighted assets, $60.0 million in Tier 2 capital and $55.1 million in total capital. The FDIC is authorized to require the Bank to maintain an additional amount of total capital to account for concentration of credit risk, level of interest rate risk, equity investments in non-financial companies and the risk of non-traditional activities. On December 31, 2009, the Bank had Tier 1 capital of 14.2% of risk-weighted assets and Tier 2 capital of 15.5% of risk-weighted assets. These amounts were $39.6 million and $28.9 million, respectively, above the 4.0% and 8.0% requirement.
The FDIC is authorized and, under certain circumstances, required to take certain actions against savings banks that fail to meet their capital requirements. The FDIC is generally required to take action to restrict the activities of an “undercapitalized institution,” which is an institution with less than either a 4% leverage capital ratio, a 4% Tier 1 risked-based capital ratio or an 8% total risk-based capital ratio. Any such institution must submit a capital restoration plan and until such plan is approved by the FDIC may not increase its assets, acquire another institution, establish a branch or engage in any new activities, and generally may not make capital distributions. The FDIC is authorized to impose the additional restrictions.

23


 

Any institution that fails to comply with its capital plan or has Tier 1 risk-based or leverage capital ratios of less than 3% or a total risk-based capital ratio of less than 6.0% is considered “significantly undercapitalized” and must be made subject to one or more additional specified actions and operating restrictions that may cover all aspects of its operations and may include a forced merger or acquisition of the institution. An institution with tangible equity to total assets of less than 2% is “critically undercapitalized” and becomes subject to further mandatory restrictions on its. The FDIC generally is authorized to reclassify an institution into a lower capital category and impose the restrictions applicable to such category if the institution is engaged in unsafe or unsound practices or is in an unsafe or unsound condition. The imposition by the FDIC of any of these measures on the Bank may have a substantial adverse effect on its operations and profitability.
Institutions with at least a 4% leverage capital ratio, a 4% Tier 1 risked-based capital ratio and an 8.0% total risk-based capital ratio are considered “adequately-capitalized.” An institution is deemed “well-capitalized” institution if it has at least a 5% leverage capital ratio, a 6% Tier 1 risked-based capital ratio and an 10.0% total risk-based capital ratio. At December 31, 2009, the Bank was considered a “well-capitalized” institution.
Georgia imposes a capital requirement based on the leverage capital requirement of the FDIC. A Georgia savings bank must have at least a 4.5% leverage capital ratio, though the department of banking and Finance can impose a higher requirement for the specific circumstances and risks of the institution. Many banks are required to have a 5.5% ratio to address these specific circumstances and risks, and any bank with a less than 5.5% leverage capital ratio must submit a two-year capital plan with the Georgia Department of Banking and Finance.
Regulatory Capital Requirements for Heritage Financial Group. The Company is required to maintain a certain level of capital under a policy of the Georgia Department of Banking and Finance. That policy imposes a Tier 1 capital to total assets capital ratio of 4%, or higher for holding companies engaged in more risky, non-financial businesses. This level is based on the capital requirement imposed on bank holding companies by the Board of Governors of the Federal Reserve Systems and is similar to the Tier 1 leverage ratio imposed on the Bank. If either the Company or MHC fails to meet this requirement, it must file a capital plan and focus on reducing its more risky operations, and it may be subject to an enforcement action, including a capital directive.
Limitations on Dividends and Other Capital Distributions. Unless it meets certain financial criteria, the Bank must obtain the prior written approval of the Georgia Department of Banking and Finance before paying any dividend to the Company. Those financial criteria are having: (1) classified assets of no more than 80% of Tier 1 capital plus an allowance for loan losses at the time of its last examination; (2) paid no more than 50% of last calendar year’s net income in dividends in the current calendar year, and (3) a Tier 1 leverage capital ratio of at least 6%. Georgia prohibits the Company from paying a dividend if its debt to equity ratio is 30% or more or if it is not meeting its capital requirement.
In 2008 and 2009, the Bank requested and received approval from the Georgia Department of Banking and Finance to pay dividends in excess of 50% of last calendar year’s net income. Dividends paid by the Bank to the Company were $1.6 million in 2008 and $1.0 million in 2009.
In addition, MHC may elect to waive its pro rata portion of a dividend declared and paid by the Company after filing a notice with and receiving no objection from the Office of Thrift Supervision. During 2009, MHC waived its dividends. We anticipate that MHC, subject to its own need for capital and funds, will waive dividends paid by the Company. The interests of other stockholders of the Company who receive dividends are not diluted by any waiver of dividends by MHC in the event of a full stock conversion.
Federal Taxation
The Company and the Bank are subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below. The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to the Company or the Bank. The Bank’s federal income tax returns have never been audited. Prior to June 2001, the Bank was a federal credit union and was not generally subject to corporate income tax.
The Company files a consolidated federal income tax return with the Bank commencing with the first taxable year after completion of the offering. Accordingly, it is anticipated that any cash distributions made by the Company to its stockholders would be considered to be taxable dividends and not as a nontaxable return of capital to stockholders for federal and state tax purposes.
    Method of Accounting. For federal income tax purposes, the Bank currently reports its income and expenses on the accrual method of accounting and uses a fiscal year ending on December 31, for filing its federal income tax return.

24


 

    Minimum Tax. The Internal Revenue Code imposes an alternative minimum tax at a rate of 20% on a base of regular taxable income plus certain tax preferences, called alternative minimum taxable income. The alternative minimum tax is payable to the extent such alternative minimum taxable income is in excess of an exemption amount. Net operating losses can offset no more than 90% of alternative minimum taxable income. Certain payments of alternative minimum tax may be used as credits against regular tax liabilities in future years. The Bank has not been subject to the alternative minimum tax, nor do we have any such amounts available as credits for carryover.
 
    Net Operating Loss Carryovers. A financial institution may carryback net operating losses to the preceding two taxable years and forward to the succeeding 20 taxable years. This provision applies to losses incurred in taxable years beginning after August 6, 1997. At December 31, 2009, the Bank had no net operating loss carryforwards for federal income tax purposes.
 
    Corporate Dividends-Received Deduction. Because it files a consolidated return with its wholly owned subsidiary, the Bank, dividends from the Bank are not included as income to the Company. The corporate dividends-received deduction is 100% or 80%, in the case of dividends received from corporations with which a corporate recipient does not file a consolidated tax return, depending on the level of stock ownership of the payor of the dividend. Corporations that own less than 20% of the stock of a corporation distributing a dividend may deduct 70% of dividends received or accrued on their behalf.
State Taxation
The Company and the Bank are subject to Georgia and Florida corporate income tax, which is assessed at the rate of 6%. For this purpose, taxable income generally means federal taxable income subject to certain modifications provided for in Georgia and Florida law.
The Company and the Bank also are subject to Georgia business occupation taxes computed on gross receipts after deducting exempt income and interest paid on deposits and other liabilities. The tax rates assessed vary from one municipality to another. The total occupation taxes paid in 2009 amounted to $131,000.
Employees
At December 31, 2009, we had a total of 134 full-time equivalent employees. Our employees are not represented by any collective bargaining group. Management considers its employee relations to be good.

25


 

Item 1A. Risk Factors
Not required.
Item 1B. Unresolved Staff Comments
None.
Item 2. Description of Properties
At December 31, 2009, we had eight full-service offices owned by the Bank. In addition, we operate 2 full-service offices in Reidsville and Collins, Georgia, that we acquired in our FDIC assisted purchase of the Tattnall Bank in December of 2009. During the first quarter of 2010, we purchased those two branch buildings from the FDIC. We also own a piece of commercial property in Lee County, Georgia, on which we plan to construct a branch office in 2010. We have one leased facility in the North Central Florida market that served as our first office in that market. We no longer operate a full-service branch in this location, but still maintain an automated teller machine at the location. At December 31, 2009, one of our branch locations was held for sale. We operate a full service branch at this location; however, we have excess office space at this location that we no longer use. When this location is sold, we plan to leaseback the portion of the building needed for our branch, or relocate by purchasing or leasing in the area. For more information on our fixed assets, see Note 6 to the Notes to Consolidated Financial Statements.
Item 3. Legal Proceedings
In the opinion of management, the Company is not a party to any pending claims or lawsuits that are expected to have a material effect on the Company’s financial condition or results of operations. Periodically, there have been various claims and lawsuits involving the Company mainly as a defendant, such as claims to enforce liens, condemnation proceedings on properties in which the Bank holds security interests, claims involving the making and servicing of real property loans and other issues incident to the Bank’s business. Aside from such pending claims and lawsuits, which are incident to the conduct of the Company’s ordinary business, the Company is not a party to any material pending legal proceedings that would have a material effect on the financial condition or operations of the Company.
Item 4. (Removed and Reserved)

26


 

PART II
Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Small Business Issuer Purchases of Equity Securities
Market and Dividend Information
Our common stock is traded on the NASDAQ Global Market under the symbol HBOS. As of March 26, 2010, the Company estimates that it had approximately 1,500 stockholders, including approximately 700 beneficial owners holding shares in nominee or “street” name. The following table sets forth the high and low common stock prices in 2009 and 2008 based on the daily closing price for the time period indicated as quoted on the NASDAQ Global Market.
                         
                    Dividends  
                    Paid  
    High     Low     Per Share  
2009
                       
First quarter (01/01/2009 — 03/31/2009)
  $ 9.00     $ 5.08     $ 0.08  
Second quarter (04/01/2009 — 06/30/2009)
    10.03       6.25       0.08  
Third quarter (07/01/2009 — 09/30/2009)
    10.79       7.77       0.08  
Fourth quarter (10/1/2009 — 12/31/2009)
    8.84       6.63       0.08  
2008
                       
First quarter (01/01/2008 — 03/31/2008)
  $ 12.99     $ 10.86     $ 0.07  
Second quarter (04/01/2008 — 06/30/2008)
    12.50       11.00       0.07  
Third quarter (07/01/2008 — 09/30/2008)
    12.00       8.15       0.07  
Fourth quarter (10/01/2008 — 12/31/2008)
    11.00       8.25       0.07  
The Board of Directors of the Company commenced cash dividend payments to stockholders on October 24, 2005. The initial quarterly dividend rate was set at $0.05 per common share. Starting in 2007, the Company has raised its quarterly dividend $0.01 per common share each year. In January 2010, the Company raised its quarterly dividend to $0.09 per share. MHC, which owns 76% of the Company’s common shares, waived its right to receive cash dividends in 2005, 2006, 2008 and 2009. During 2007, MHC waived dividends on all but $42,900, which it needed for regulatory fees and operating expenses. Our cash dividend policy is continually reviewed by management and the Board of Directors. The Company intends to continue its policy of paying quarterly dividends; however, these payments will depend upon a number of factors, including capital requirements, regulatory limitations, the Company’s financial condition, results of operations and the Bank’s ability to pay dividends to the Company. The Company relies significantly upon such dividends from the Bank for payment of cash dividends to the stockholders. For information regarding restrictions on the payment of dividends by the Bank to the Company, see “Management’s Discussion and Analysis of Financial Condition and Results of Operation — Liquidity and Capital Resources” in this Annual Report. See also Note 19 of Notes to Consolidated Financial Statements.

27


 

The Company adopted an equity incentive plan providing for the issuance of stock options, restricted stock and stock appreciation rights. This plan was approved and became effective on May 17, 2006. The following table includes certain information with respect to awards under this equity incentive plan as of December 31, 2009:
                         
    Number of             Number of  
    securities             securities  
    to be issued     Weighted     remaining  
    upon     average     available for  
    exercise of     exercise price     future  
    outstanding     of outstanding     issuance  
    options,     options,     under equity  
    warrants     warrants and     compensation  
    and rights     rights     plans  
Equity compensation plans approved by security holders
    497,555     $ 12.48       43,506  
Equity compensation plans not approved by security holders
                 
 
                 
 
                       
Total
    497,555     $ 12.48       43,506  
 
                 
Information on the shares purchased during the fourth quarter of 2009 is as follows:
                                 
                    Number of     Maximum  
                    Shares     Number of  
                    Purchased as     Shares That  
                    Part of     May Yet be  
    Total             Publicly     Purchased  
    Number             Announced     Under the  
    of Shares     Average Price     Plans or     Plans or  
    Purchased     Paid Per Share     Programs     Programs  
October
        $             186,974  
November
    13,000       7.03       13,000       173,974  
December
                      173,974  
 
                       
 
                               
Total
    13,000     $ 7.03       13,000       173,974  
 
                       
On December 16, 2008, the Company announced that its Board of Directors had authorized the repurchase of up to 250,000 shares, or approximately 10% of its then outstanding publicly held shares of common stock. This program was set to expire in December 2009. On December 19, 2009, the Company extended this repurchase authorization until December 2010. As of March 31, 2010, the Company has purchased 76,026 shares at a weighted average price of $8.33 per share for a total of $633,000 under this plan. As of March 31, 2010, the Company had 173,974 remaining shares that may be purchased under the current authorization. The repurchases may be made from time to time in open-market or negotiated transactions as deemed appropriate by the Company and will depend on market conditions.

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Item 6. Selected Financial Data
Selected Consolidated Financial Information
                                         
    At December 31,  
    2009     2008     2007     2006     2005  
    (In thousands)  
Selected Financial Condition Data:
                                       
 
                                       
Total assets
  $ 571,948     $ 502,058     $ 468,672     $ 413,330     $ 363,797  
Loans, net
    328,079       297,537       300,257       272,700       250,493  
Securities available for sale, at fair value:
                                       
U.S. government and agency securities
    30,462       21,165       14,996       29,439       14,044  
Corporate debt securities
    1,910       1,789       3,854       4,106       3,786  
Mortgage-backed securities
    58,411       65,408       55,598       28,044       31,098  
State and municipal
    29,123       27,511       31,878       16,316       6,869  
Equity and other investments
    621       268       1,540       6,667       9,069  
Federal Home Loan Bank stock, at cost
    3,253       3,186       2,970       2,499       2,927  
Other equity securities, at cost
    1,010       1,010                    
Deposits
    426,607       338,546       330,629       299,189       238,640  
Federal Home Loan Bank advances
    42,500       52,500       50,000       40,000       50,000  
Federal funds purchased and securities sold under repurchase agreements
    32,843       41,497       15,288       5,531       237  
Total equity
    60,817       62,213       65,592       62,808       68,983  
 
                                       
Selected Operations Data:
                                       
 
                                       
Total interest income
  $ 23,401     $ 27,195     $ 27,997     $ 22,609     $ 19,243  
Total interest expense
    8,794       12,494       13,462       8,377       5,935  
 
                             
Net interest income
    14,607       14,701       14,535       14,232       13,308  
Provision for loan losses
    7,500       3,350       1,178       695       1,014  
 
                             
Net interest income after provision for loan losses
    7,107       11,351       13,357       13,537       12,294  
 
                             
Fees and service charges
    4,953       5,245       5,129       4,121       3,836  
Impairment loss on securities
          (3,119 )                  
Gain (loss) on sales of investment securities
    909       235       (355 )     (59 )     (5 )
Other noninterest income
    1,925       2,227       1,916       1,548       1,504  
 
                             
Total noninterest income
    7,787       4,588       6,690       5,610       5,335  
Total noninterest expense
    18,271       17,429       17,976       16,060       13,584  
 
                             
Income before tax (benefit) and extraordinary items
    (3,377 )     (1,490 )     2,071       3,086       4,045  
Income tax provision (benefit)
    (1,724 )     (1,228 )     (850 )     732       1,095  
 
                             
Net income (loss)
  $ (1,653 )   $ (262 )   $ 2,921     $ 2,354     $ 2,950  
 
                             

29


 

                                         
    Year Ended December 31,  
    2009     2008     2007     2006     2005  
Selected Financial Ratios and Other Data:
                                       
 
                                       
Performance Ratios:
                                       
Return on average assets
    (0.34 %)     (0.05 %)     0.66 %     0.63 %     0.83 %
Return on average equity
    (2.62 %)     (0.41 %)     4.55 %     3.44 %     5.18 %
Dividend payout ratio
    (43.62 %)     (299.94 %)     26.12 %     28.64 %     16.13 %
Net interest spread
    3.31 %     3.16 %     3.22 %     3.50 %     3.86 %
Net interest margin
    3.49 %     3.45 %     3.70 %     4.19 %     4.15 %
Operating expense to average total assets
    3.72 %     3.55 %     4.05 %     4.29 %     3.81 %
Average interest-earning assets to average interest-bearing liabilities
    108.97 %     110.34 %     114.66 %     116.64 %     115.95 %
Efficiency ratio
    81.59 %     90.36 %     84.69 %     80.94 %     72.86 %
 
                                       
Asset Quality Ratios:
                                       
Nonperforming assets to total assets at end of period
    1.81 %     1.87 %     0.76 %     0.14 %     0.25 %
Nonperforming loans to total loans
    2.53 %     2.41 %     1.05 %     0.09 %     0.33 %
Allowance for loan losses to nonperforming loans
    71.61 %     67.99 %     137.49 %     1,582.00 %     473.18 %
Allowance for loans losses to net loans
    1.81 %     1.64 %     1.45 %     1.47 %     1.44 %
Net charge offs to average loans outstanding
    2.13 %     1.58 %     0.29 %     0.09 %     0.15 %
 
                                       
Capital Ratios:
                                       
Equity to total assets at end of period
    10.63 %     12.39 %     14.00 %     15.22 %     18.96 %
Average equity to average assets
    12.84 %     13.05 %     14.47 %     18.29 %     15.98 %
 
                                       
Common Share Data and Other Ratios:
                                       
Gross shares outstanding at year end
    11,454,344       11,452,344       11,443,723       11,449,155       11,241,250  
Less treasury stock
    1,055,084       993,498       615,934       555,138        
 
                             
Net shares outstanding at year end
    10,399,260       10,458,846       10,827,789       10,894,017       11,241,250  
Shares owned by Heritage, MHC
    7,868,875       7,868,875       7,868,875       7,868,875       7,868,875  
Public shares outstanding
    2,530,385       2,589,971       2,958,914       3,025,142       3,372,375  
 
                                       
Unearned ESOP shares
    242,385       286,455       330,525       374,595       418,665  
 
                                       
MHC Ownership
    76 %     75 %     73 %     72 %     70 %
Public Ownership
    24 %     25 %     27 %     28 %     30 %
 
                                       
Book value per share
    5.99       6.12       6.25       5.97       6.37  
Tangible book value per share
    5.83       6.02       6.15       5.88       6.37  
 
                                       
Other Data:
                                       
Number of full-service offices
    10       8       7       7       6  

30


 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
Heritage Financial Group is the parent holding company of HeritageBank of the South. The Company is in a mutual holding company structure and 76% of its outstanding common stock is owned by Heritage, MHC, a federal mutual holding company.
The principal business of the Company is operating our wholly owned subsidiary, the Bank. Our results of operations depend primarily on our net interest income. Net interest income is the difference between the interest income we earn on our interest-earning assets, consisting primarily of loans and investment and mortgage-backed securities, and the interest we pay on our interest-bearing liabilities, consisting of savings and checking accounts, money market accounts, time deposits, federal funds purchased and securities sold under agreements to repurchase and borrowings. Our results of operations also are affected by our provisions for loan losses, noninterest income and noninterest expense. Noninterest income consists primarily of service charges on deposit accounts, mortgage origination fees, transaction fees, bank-owned life insurance, and commissions from investment services. Noninterest expense consists primarily of salaries and employee benefits, occupancy, equipment and data processing, advertising, professional fees and other costs. Our results of operations also may be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities.
Evolution of Business Strategy
We originally were chartered as a federal credit union in 1955. In 1998, we became a community chartered credit union. We accepted deposits and made loans to members who lived, worked or worshiped in the approved counties for the credit union charter. In 2001, we converted to a mutual thrift charter in order to better serve our customers and communities through a broader lending ability and an expanded customer base beyond the field of membership permitted for our credit union. The mutual holding company structure was established in 2002, and we converted from a thrift charter to a state savings bank charter in 2005. We feel this structure best suits our continued efforts to grow and expand our commercial business.
The Company completed an initial public stock offering on June 29, 2005. We sold 3,372,375 shares of common stock in that offering at $10.00 per share. The Company’s employee stock ownership plan (the “ESOP”) purchased 440,700 shares in the offering with the proceeds of a loan from the Company. The Company received net proceeds of $32.4 million in the public offering, 50% of which was contributed to the Bank and $4.4 million of which was loaned to the ESOP for its purchase of shares in the offering. The Company also issued an additional 7,867,875 shares of common stock to MHC, so that MHC would own 70% of the outstanding common stock at the closing of the offering.
Our current business strategy is to operate a well-capitalized and profitable commercial and retail financial institution dedicated to serving the needs of our customers. We strive to be the primary financial institution in the market areas we serve. We offer a broad range of products and services while stressing personalized and efficient customer service and convenient access to these products and services. We intend to continue to operate as a commercial and consumer lender. We have structured operations around a branch system that is staffed with knowledgeable and well-trained employees. Subject to capital requirements and our ability to grow in a reasonable and prudent manner, we may open or acquire additional branches as opportunities arise. In addition to our branch system, we continue to expand electronic services for our customers. We attempt to differentiate ourselves from our competitors by providing a higher level of customer service.

31


 

Our core business is composed of the following:
     1. Commercial Banking and Small Business Lending: We focus on the commercial real estate and business needs of individuals and small- to medium-sized businesses in our market area. In addition, we focus on high net worth individuals and small business owners. The commercial banking department is composed of seasoned commercial lenders and a support staff with years of combined experience in the industry. We expect this department to continue to be the fastest growing component of our business.
     2. Retail Banking: We operate a network of seven branch offices located in Dougherty, Lee, Worth and Tattnall counties in Georgia, two branches located in Ocala, Florida, and one branch located in Lake City, Florida. In addition, we have announced expansion plans to add five branches in four additional markets in 2010. Each office is staffed with knowledgeable banking professionals who strive to deliver quality service.
     3. Brokerage/Investment Services: We offer investment products, life, health, disability and long-term care insurance through our brokerage department. Our licensed personnel have over 50 years of experience in the financial services industry.
     4. Mortgage Lending: Staffed with experienced mortgage originators and processors, our mortgage lending department originates residential mortgage loans that are primarily funded by third-party mortgage lenders. We collect a fee on the origination of these loans.
We continue to implement this business strategy. A critical component of this strategy includes increasing our non-consumer based lending. At the end of 2009, our commercial real estate, nonresidential, business, multifamily, farmland, and construction loans totaled $165.5 million, or 49.5% of the total loan portfolio. Our ability to continue to grow our commercial loan portfolio is an important element of our long term business strategy. These non-consumer based loans are considered to entail greater risks than one- to four-family residential loans.
Another key component of our business strategy is the expansion of our operations beyond the Southwest Georgia market. On August 8, 2006, we commenced operating a branch in Ocala, Florida. On December 4, 2009, we acquired substantially all of the assets and assumed substantially all of the liabilities of the Tattnall Bank in Reidsville and Collins, Georgia, through an FDIC-assisted transaction. On December 31, 2009, we acquired the Lake City, Florida branch of Atlantic Coast Bank. As of December 31, 2009, we had approximately $88.7 million or 26.3% of our loans and $128.9 million or 30.2% of our deposits generated outside of our Southwest Georgia market. Operating a branch outside of the Southwest Georgia market subjects us to additional risk factors. These risk factors include, but are not limited to the following: management of employees from a distance, lack of knowledge of the local market, additional credit risks, logistical operational issues, and time constraints of management. These risk factors, as well as others we have not specifically identified, may affect our ability to successfully operate outside of our current market area.
On February 25, 2010, we announced that the Bank signed a definitive agreement to purchase five bank branches from The Park Avenue Bank. These branches are located in the Southeast Georgia markets of Statesboro (2), Hazlehurst and Baxley, and the Southwest Georgia market of Adel. We expect this transaction to close in the second quarter of 2010, subject to regulatory approval.
On March 17, 2010, the Company adopted a plan to reorganize from a two-tier mutual holding company to a full stock holding company and will undertake a “second-step” offering of shares of the holding company’s common stock. The conversion and offering is expected to be completed in the third quarter of 2010, subject to regulatory, stockholder and depositor approvals.
As part of the reorganization, HeritageBank of the South will become a wholly owned subsidiary of a to-be-formed stock corporation, Heritage Financial Group, Inc. Shares of the common stock of the Company, other than those held by Heritage, MHC, will be converted into shares of common stock in Heritage Financial Group, Inc., using an exchange ratio designed to preserve current percentage ownership interests. Shares owned by Heritage, MHC will be retired, and new shares representing that ownership will be offered and sold to the Bank’s eligible depositors, the Bank’s tax-qualified employee benefit plans and to members of the general public as set forth in the Plan of Conversion and Reorganization of Heritage, MHC.
The Plan of Conversion and Reorganization of Heritage, MHC will be submitted to the Office of Thrift Supervision and the Georgia Department of Banking and Finance for regulatory approval. Upon receipt of regulatory approvals, the Company will seek approval from its stockholders and members of Heritage, MHC.

32


 

Comparison of Financial Condition at December 31, 2009 and December 31, 2008
Total assets increased $69.9 million, a 13.9% increase from December 31, 2008, to $571.9 million at December 31, 2009. The increase was due primarily to our acquisition activity in the fourth quarter of 2009, which provided us with $61.5 million in cash, $35.2 million in loans and $97.7 million in deposits.
Total interest earning assets increased $59.6 million or 13.3% to $509.2 million at December 31, 2009, from $449.6 million at December 31, 2008. Gross loans increased $31.7 million or 10.5% to $334.1 million at December 31, 2009, compared with $302.5 million at December 31, 2008, due primarily to the previously mentioned acquisition activity. Investment securities increased $4.4 million or 3.8% to $120.5 million at December 31, 2009. Federal funds purchased decreased $18.9 million or 62.5% to $11.3 million at December 31, 2009. The decrease was primarily due to our efforts to reduce the amounts we maintain at correspondent banks by shifting more liquid assets to our interest-bearing account at the Federal Reserve. Interest-bearing deposits in banks increased $42.5 million to $43.2 at December 31, 2009. This was due primarily to funds obtained through our acquisition activity in the fourth quarter of 2009. We have maintained excess liquidity for three purposes. First, we believe it is prudent to maintain higher liquidity during uncertain economic times. Second, we believe this excess liquidity gives us additional flexibility in our acquisition strategy. Third, we believe this excess liquidity will provide us flexibility for funding loans or other investments if we see a dramatic rise in interest rates. Maintaining excess liquidity does cause net interest margin to decrease in the short term, however, we feel the benefits of maintaining excess liquidity outweighs the cost to net interest margin. We expect to continue to maintain excess liquidity during 2010.
Foreclosed assets decreased $324,000 to $1.8 million at December 31, 2009. Other real estate owned (“OREO”) comprised the majority of the decrease. During the year, approximately $732,000 of OREO was transferred in from the loan portfolio, and approximately $585,000 was acquired in our FDIC-assisted acquisition in the fourth quarter of 2009. We sold $1.2 million of OREO in 2009, and we wrote down $422,000 on OREO properties. The largest single balance in our OREO portfolio was $220,000 at December 31, 2009. Approximately $539,000 of our OREO portfolio at December 31, 2009, consisted of undeveloped lots or vacant land. Repossessed personal property remained relatively level at $56,000.
Intangible assets increased $571,000 due to our acquisition activity in the fourth quarter of 2009. Cash surrender value of bank owned life insurance (“BOLI”) increased by $621,000 due to the earnings on BOLI policies in place. Other assets increased $5.2 million. $800,000 of which was due to an increase in deferred tax assets stemming from the nature of our net loss in 2009. $2.0 million of the increase was due to our required prepayment of FDIC assessments in the fourth quarter of 2009. $1.1 million of the increase was due to the establishment of a receivable from the FDIC in connection with our FDIC-assisted acquisition in the fourth quarter of 2009.
Total liabilities increased $71.3 million or 16.2% to $511.1 million at December 31, 2009, compared with $439.8 million at December 31, 2008. This increase was due primarily to the increase in interest bearing liabilities, which increased $59.7 million or 14.4%, to $473.1 million at December 31, 2009, from $413.4 million at December 31, 2008. Deposits ended the year at $426.7 million, up 26.0% or $88.1 million from $338.6 million from December 31, 2008. This increase was attributable to our acquisition activity. Total Federal Home Loan Bank advances amounted to $42.5 million at December 31, 2009, a decrease of $10.0 million or 19.0% from December 31, 2008. We paid these advances down as maturities occurred in 2009 with funds received from our deposit growth. Federal funds purchased and securities sold under agreements to repurchase decreased $8.7 million during 2009, primarily due to a decrease in fed funds purchased from the Chattahoochee Bank of Georgia (“Chattahoochee”).
Total equity decreased by $1.4 million or 2.2% to $60.8 million at December 31, 2009. A net loss of $1.7 million, dividends of $721,000 and the purchase of $516,000 of treasury stock decreased equity. Compensation expense related to the allocation of ESOP shares of $367,000, stock-based compensation expense of $807,000, and other comprehensive income of $298,000 partially offset the decrease in equity.

33


 

Average Balances, Net Interest Income, Yields Earned and Rates Paid
The following table presents for the periods indicated the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. Yields on tax-exempt obligations have been computed on a tax equivalent basis. Nonaccruing loans have been included in the table as loans carrying a zero yield. Prior year balances have been adjusted in order to compute yields on a tax equivalent basis.
                                                                         
    Year Ended December 31,  
    2009     2008     2007  
    (Dollars in Thousands)  
    Average     Interest             Average     Interest             Average     Interest        
    Outstanding     Earned/     Yield/     Outstanding     Earned/     Yield/     Outstanding     Earned/     Yield/  
    Balance     Paid     Rate     Balance     Paid     Rate     Balance     Paid     Rate  
Interest-Earning Assets:
                                                                       
Loans
  $ 299,399     $ 18,555       6.21 %   $ 310,985     $ 20,882       6.70 %   $ 291,438     $ 22,160       7.61 %
Taxable investment securities
    84,455       3,604       4.27       88,896       4,890       5.50       79,205       4,220       5.33  
Tax exempt investment securities
    29,883       1,174       5.95       28,255       1,176       6.30       25,798       1,044       6.13  
Federal funds sold
    21,102       54       0.25       14,316       232       1.62       10,456       544       5.20  
Interest bearing deposits with banks
    1,931       14       0.72       630       15       2.44       652       29       4.39  
 
                                                           
Total interest-earning Assets
    436,770       23,401       5.50       443,082       27,195       6.26       407,549       27,997       7.01  
 
                                                           
 
                                                                       
Interest-Bearing Liabilities:
                                                                       
Interest bearing demand
    50,679       534       1.05       43,102       486       1.12       37,217       368       0.99  
Savings and money market
    122,453       1,553       1.27       95,822       1,390       1.46       119,544       3,407       2.85  
Retail time deposits
    122,332       3,788       3.10       126,120       5,283       4.18       128,162       6,307       4.92  
Wholesale time deposits
    17,981       597       3.32       43,215       1,884       4.35       14,466       776       5.37  
Borrowings
    87,380       2,322       2.66       93,304       3,451       3.69       56,014       2,604       4.65  
 
                                                           
Total interest-bearing liabilities
    400,825       8,794       2.19       401,563       12,494       3.10       355,403       13,462       3.79  
 
                                                           
 
                                                                       
Net interest income
          $ 14,607                     $ 14,701                     $ 14,535          
 
                                                                 
Net interest rate spread
                    3.31 %                     3.16 %                     3.22 %
 
                                                                 
Net earning assets
  $ 35,945                     $ 41,519                     $ 52,146                  
 
                                                                 
Net interest margin
                    3.49 %                     3.45 %                     3.70 %
 
                                                                 
 
                                                                       
Average interest-earning assets to average interest-bearing liabilities
    1.09x                       1.10x                       1.15x                  
 
                                                                 

34


 

Rate/Volume Analysis
The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between the changes related to outstanding balances and that due to the changes in interest rates. The change in interest attributable to rate has been determined by applying the change in rate between years to average balances outstanding in the later year. The change in interest due to volume has been determined by applying the rate from the earlier year to the change in average balances outstanding between years. Changes that are not solely due to volume have been consistently attributed to rate.
                                                 
    Year Ended December 31,  
    2009 vs. 2008     2008 vs. 2007  
    Increase (Decrease)     Total     Increase (Decrease)     Total  
    Due to     Increase     Due to     Increase  
    Volume     Rate     (Decrease)     Volume     Rate     (Decrease)  
    (Dollars in Thousands)  
Interest-earning assets:
                                               
Loans
  $ (592 )   $ (1,735 )   $ (2,327 )   $ 1,687     $ (2,965 )   $ (1,278 )
Taxable investment securities
    (266 )     (1,020 )     (1,286 )     245       425       670  
Tax exempt investment securities
    6       (8 )     (2 )     102       30       132  
Federal funds sold
    77       (255 )     (178 )     152       (464 )     (312 )
Interest bearing deposits with banks
    15       (16 )     (1 )     (931 )     917       (14 )
 
                                   
 
                                               
Total interest-earning assets
  $ (760 )   $ (3,034 )     (3,794 )   $ 1,255     $ (2,057 )     (802 )
 
                                   
 
                                               
Interest-bearing liabilities:
                                               
Interest bearing demand
  $ 81     $ (33 )     48     $ 63     $ 55       118  
Savings and money market
    509       (346 )     163       (805 )     (1,212 )     (2,017 )
Retail time deposits
    (148 )     (1,347 )     (1,495 )     (97 )     (927 )     (1,024 )
Wholesale time deposits
    (877 )     (410 )     (1,287 )     (1,289 )     2,397       1,108  
Borrowings
    (432 )     (697 )     (1,129 )     1,372       (525 )     847  
 
                                   
 
                                               
Total interest-bearing liabilities
  $ (867 )   $ (2,833 )     (3,700 )   $ (756 )   $ (212 )     (968 )
 
                                   
 
                                               
Net interest income
                  $ (94 )                   $ 166  
 
                                           

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Comparison of Operating Results for the Years Ended December 31, 2009 and December 31, 2008
General
Our net loss increased by $1.4 million to a loss of $1.7 million compared to a loss of $262,000 for the year ended December 31, 2008. Basic and diluted loss per share decreased to $0.16 per share for the year ended December 31, 2009 compared with $0.03 per share for the year ended December 31, 2008. A $4.2 million increase in loan loss provision expense, along with increases in noninterest expenses offset the improvement in noninterest income. Further explanations of these changes are discussed in more detail in the following sections.
Interest Income
Interest income decreased $3.8 million or 14.0% to $23.4 million at December 31, 2009 from $27.2 million at December 31, 2008. A 76 basis point decrease on yield in earnings assets, primarily due to a decrease in market interest rates, accounted for $3.0 million of the decrease, while a decrease in average balances during the year of $6.3 million accounted for $760,000 of the decrease. The decrease in average earning assets was due to a decrease in loan demand during the year. In the fourth quarter, our acquisition activity led to an increase in earning assets by year end. However, these additions of earning assets late in the year did not make up for the decline in average balances that had occurred earlier in the year.
Interest Expense
Interest expense decreased $3.7 million or 29.6% to $8.8 million at December 31, 2009 from $12.5 million at December 31, 2008. A 91 basis point decrease in the cost of interest bearing liabilities accounted for $2.8 million of the decrease, while a decrease in average balances, primarily wholesale deposits, accounted for $867,000 of the decrease.
Net Interest Income
Net interest income decreased $94,000 or 0.6% to $14.6 million compared with $14.7 million for the twelve months ending 2008. Our net interest spread increased 15 basis points to 3.31% compared with 3.16% during the year earlier period. The net interest margin increased 4 basis points to 3.49% versus 3.45% during the same period in 2008. Average interest earning assets decreased $6.3 million or 1.4% to $436.8 million at December 31, 2009, compared with $443.1 million at December 31, 2008. Average interest bearing liabilities decreased $738,000 or 0.2% to $400.8 million compared with $401.6 million at December 31, 2008.
The Federal Reserve Board has made extreme moves in interest rates, dropping the federal funds rate from a high of 5.25% in mid 2007 down to its current level of a targeted range of zero to 0.25%. These decreases in the federal funds rate caused our net interest margin to decline during 2008 and the first half of 2009. During the second half of 2009, we saw our net interest margin improve. The primary driver of this improvement was a decrease in our cost of interest bearing liabilities. This occurred as we were able to lower our deposit rates, and as our structured repurchase agreements priced lower during the year. We also reduced our wholesale time deposits from $27.8 million at December 31, 2008 to $14.1 million at December 31, 2009. During 2009, we also reduced our other borrowings by $10.0 million. For more information on interest rate changes, and the effects those changes may have on earnings, please see Item 7.a. in this Form 10-K.
Provision for Loan Losses
We recorded a provision for loans losses of $7.5 million in 2009 compared with $3.4 million for the prior-year period. Net charge-offs of $6.4 million were part of the reason for the increase in loan loss provision expense for 2009. Non-performing loans increased $1.2 million to $8.5 million at December 31, 2009, compared with $7.3 million at December 31, 2008. The ratio of non-performing loans to total loans increased to 2.53% compared with 2.41% at December 31, 2008. The allowance for loan losses as a percentage of total loans increased by 17 basis points to 1.81% compared with 1.64% at December 31, 2008.
The largest non-performing loan in our portfolio at December 31, 2009 was a $1.9 million loan on raw land in Atlanta, Georgia. This land was originally purchased for commercial and residential development. However, due to the economic environment in the area, this is no longer a viable alternative. The original amount of this loan was $5.0 million, and in 2009 we charged off $3.1 million on this loan. In March of 2010, we foreclosed on this property, and we currently have this property under contract for $1.9 million.
The next largest non-performing loan at December 31, 2009 was $1.3 million and is secured by various airplanes. In the fourth quarter of 2009, we charged this relationship down by $2.1 million. In February of 2010, the collateral securing this loan was liquidated and the proceeds were applied to the balance of the loan. We then charged off an additional $51,000 to cover the shortfall of the collateral sale.

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The next largest non-performing loan at December 31, 2009 was a real estate loan for $971,000 secured by a restaurant building in Ocala, Florida. Our next largest non-performing loan at December 31, 2009 was a real estate loan for $659,000 secured by various residential rental properties in Southwest Georgia. The remainder of our non-performing loans consist of various consumer and commercial loans, none exceeding $500,000. Current appraisals on real estate loans, expected costs of potential foreclosure or other disposition, and other potential losses on these loans are considered in our analysis of the allowance for loan losses.
Loans past due 30 or more days and still accruing totaled $3.2 million, or 0.96% of total loans at December 31, 2009. This compares to $4.5 million at December 31, 2008, or 1.47% of loans. We had no loans past due 90 or more days and still accruing at December 31, 2009 or 2008.
Our internally criticized and classified assets totaled $35.8 million at December 31, 2009, compared to $27.0 million at December 31, 2008. These balances include the aforementioned nonperforming loans, other real estate, and repossessed assets. Our internal loan review processes strive to identify weaknesses in loans prior to performance issues. However, our processes do not always provide sufficient time to work out plans with borrowers that would avoid foreclosure and/or losses.
We continue to see weakness in our loan portfolio, and as economic conditions remain difficult, we expect this trend to continue until we see improvement in the overall economy. We have taken actions to prevent losses in our current portfolio, including the appointment of a loan officer as a full time special assets manager, who is responsible for working out credits with identified weaknesses. We have also taken steps to better evaluate the capital and liquidity positions of our commercial loan guarantors, particularly those involved in commercial real estate construction and development. This includes further analysis of our guarantors’ financial position, liquidity, cash flow and contingent liabilities.
We establish provisions for loan losses, which are charged to operations, at a level we believe will reflect probable credit losses based on historical loss trends and an evaluation of specific credits in the loan portfolio. In evaluating the level of the allowance for loan losses, we consider the types of loans and the amount of loans in the loan portfolio, historical loss experience, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions, and past due status and trends.
We assess the allowance for loan losses on a quarterly basis and make provisions for loan losses as necessary in order to maintain the proper level of allowance. While we use available information to recognize losses on loans, future loan loss provisions may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses and may require us to recognize additional provisions based on their judgment of information available to them at the time of their examination. The allowance for loan losses is maintained at a level that represents management’s best estimate of inherent losses in the loan portfolio, and such losses were both probable and reasonably estimable. The level of the allowance is based on estimates and the ultimate losses may vary from the estimates.
Noninterest Income
A summary of noninterest income, excluding securities transactions, follows:
                                 
    For the Years Ended              
    2009     2008     $ Chg     % Chg  
            (Dollars in Thousands)          
Service charges on deposit accounts
  $ 3,547     $ 3,958     $ (411 )     -10.4 %
Other service charges, commissions and fees
    1,406       1,288       118       9.2 %
Brokerage fees
    914       1,030       (116 )     -11.3 %
Mortgage origination fees
    345       400       (55 )     -13.8 %
Bank owned life insurance
    621       495       126       25.5 %
Other
    45       301       (256 )     -85.1 %
 
                       
Total noninterest income
  $ 6,878     $ 7,472     $ (594 )     -7.9 %
 
                       
Noninterest income as a percentage of average assets
    1.4 %     1.5 %                
 
                           
The decrease in service charges on deposit accounts was due to a decrease in overdraft fees. During the year, we saw a decrease in the amount of depositors who overdrew their accounts. This was specifically true of our overdraft privilege program, which allows customers who meet certain standards to have their overdrafts covered up to $750, including checks, drafts, ACH, debit card and ATM transactions. We expect to continue to see decreased revenue in this area. In addition, recent regulatory changes to the offering of overdraft privilege on ATM and debit card may cause significant decreases in our overdraft fees. At this time,

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we are unable to accurately estimate the effect this legislation, and other potential legislation, may have on our overdraft income. We are currently analyzing our options to replace this income stream if it is significantly affected by legislation or by a significant change in consumer behavior. These options will most likely result in a major change in the fees we charge to our deposit customers.
The increase in other service charges, commissions and fees was due primarily to an increase in debit and ATM transaction fees. Our customers continue to increase debit card usage instead of using cash or checks. We expect this trend to continue, despite a decrease in consumer spending.
The decrease in our brokerage fees was due primarily to a decrease in assets under management, and thus a reduction in our asset management fees. This decrease was caused by market conditions and not by a decrease in the number of clients we serve in this business. In addition, as market conditions worsened in late 2008 and early 2009, we saw a decrease in commissions earned as our clients became less active in the equity markets.
Mortgage fees decreased due to a slowdown in the real estate market for new sales and a slowdown in refinance activity. In addition, stricter underwriting standards required by our investors and regulatory changes have caused an increase in the amount of time it takes to process each loan, which could cause a decrease in revenue. We expect this trend to continue throughout 2010, unless we see significant improvement in the economy.
Earnings on bank owned life insurance policies increased due to the purchase of an additional $5.0 million of cash surrender value of bank owned life insurance policies in the middle of 2008. 2009 was the first full year of earnings on this addition.
Other noninterest income decreased by $129,000 due to a decrease in FHLB stock dividends. We received $10,000 of FHLB dividends in 2009; however, we are uncertain about the level of dividends we may receive in the future. $119,000 of the decrease was due to a gain on the sale of a real estate partnership we recorded in 2008 with no similar gain in 2009.
Noninterest Expense
A summary of noninterest expense follows:
                                 
    For the years ended              
    December 31,              
    2009     2008     $ Chg     % Chg  
            (Dollars in Thousands)          
Salaries and employee benefits
  $ 8,899     $ 8,987     $ (88 )     -1.0 %
Equipment
    985       1,217       (232 )     -19.1 %
Occupancy
    1,198       1,204       (6 )     -0.5 %
Advertising and marketing
    439       496       (57 )     -11.5 %
Legal and accounting
    493       528       (35 )     -6.6 %
Directors fees and retirement
    553       552       1       0.2 %
Consulting and other professional fees
    297       318       (21 )     -6.6 %
Telecommunications
    239       258       (19 )     -7.4 %
Supplies
    177       177              
Data processing fees
    1,606       1,300       306       23.5 %
Loss on sale and write-downs of other real estate owned
    422       386       36       9.3 %
Foreclosed asset expenses
    257       229       28       12.2 %
FDIC insurance and other regulatory fees
    872       267       605       226.6 %
Impairment loss on premises held for sale
    502             (502 )   NM
Other operating
    1,332       1,510       (178 )     -11.8 %
 
                       
Total noninterest expenses
  $ 18,271     $ 17,429     $ 842       4.8 %
 
                       
Noninterest expenses as a percentage of average assets
    3.7 %     3.6 %                
 
                           
The decrease in salaries was due primarily to efforts to keep staffing levels in line with the lack of demand in our lines of business. However, with our acquisition activity in the fourth quarter of 2009, we have increased our full-time equivalent employees from 120 at December 31, 2008, to 134 at December 31, 2009. In addition, we may hire additional staff in our finance, operations and credit areas to assist with our acquisition activity in 2010.
Equipment and occupancy expenses decreased primarily because due to cost reduction measures we implemented to offset declines in revenue. However, we expect equipment and occupancy to increase in 2010 due to the addition of three new branches in the fourth quarter of 2009, and the planned addition of five branches in 2010.

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Advertising and marketing decreased due to our efforts to cut expenses in 2009. Due to our acquisition activity, we expect advertising and marketing expenses to increase in 2010.
The decrease in legal and accounting fees was due to a decrease in legal fees associated with collection efforts. However, these fees remain at historically high levels due to the elevated level of problem assets. We expect these costs to remain elevated until we see decreases in problem assets.
Directors fees remained level in 2009. We expect these fees to increase in 2010 due to the addition of local advisory boards related to our acquisition activity.
Consulting and other professional fees decreased primarily due to our efforts to reduce expenses in 2009. In 2010, these fees may increase as we use consultants and other professionals to assist with our analysis of acquisition opportunities, and with the subsequent integration of any such acquisitions.
Telecommunication expenses decreased due to our efforts to cut expenses in 2009. As we increase our branch network, we expect these fees to increase.
Supply expenses remained level in 2009, however, we expect those expenses to increase due to our acquisition activity.
Data processing expenses increased due to the increased amount of debit card transactions in 2009 and increases in other data processing fees. In 2010, our core processing contract terminates. We are currently negotiating this contract, and expect to receive a reduction in rates. However, our acquisition activity may cause this total expense to increase despite the reduction we expect to receive in per account charges under the new contract.
The loss on sale and write-down of other real estate owned increased due to the increased amount of other real estate owned and efforts to dispose of these properties. We expect that these expenses will remain elevated until levels of other real estate owned are reduced.
Foreclosed asset expenses also increased significantly due to the increased level of foreclosed assets. We expect that these expenses will also remain elevated until levels of other real estate and repossessions are reduced.
The increase in FDIC insurance and other regulatory fees was due to an increase in FDIC insurance during 2009, as well as a special assessment of $202,000. We expect FDIC insurance and other regulatory fees to remain high based on the increased level of deposits, and the amount of bank failure expenses that the FDIC is incurring.
The decrease in other operating expenses was due primarily to our efforts to cut expenses in 2009.
Income Tax Expense
Income tax benefits were $496,000 more for the year ended December 31, 2009 as compared with 2008. The increase in tax benefits was partially due to an increase in the loss before taxes of $1,886,000, along with other factors. Due to the losses incurred in 2009 and 2008, a comparison of effective tax rates is not meaningful.
Due to the losses we have incurred in 2009 and 2008, we have increased our deferred tax assets to $6.7 million at December 31, 2009, compared to $5.2 million at December 31, 2008, and $4.0 million at December 31, 2007. We analyze our deferred tax assets for potential impairment, and have determined that there is no impairment as of December 31, 2009.
Liquidity and Capital Resources
We are required to have enough cash and investments that qualify as liquid assets in order to maintain sufficient liquidity to ensure a safe and sound operation. Liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to the return on loans. Historically, we have maintained liquid assets above levels believed to be adequate to meet the requirements of normal operations, including potential deposit outflows. Cash flow projections are regularly reviewed and updated to assure that adequate liquidity is maintained.
Our liquidity, represented by cash and cash equivalents, is a product of our operating, investing and financing activities. The Company had $69.5 million in cash, federal funds sold and interest bearing deposits in banks generally available for its cash needs as of December 31, 2009. The Bank’s primary sources of funds are deposits, amortization, prepayments and maturities of outstanding loans and mortgage-backed securities, maturities of investment securities and other short-term investments and funds provided by operations. While scheduled payments from the amortization of loans and maturing short-term investments are relatively predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates,

39


 

economic conditions and competition. In addition, the Bank invests excess funds in short-term interest-earning assets, which provide liquidity to meet lending requirements. The Bank also generates cash through borrowings, primarily from Federal Home Loan Bank advances, to leverage its capital base, provide funds for its lending and investment activities and enhance its interest rate risk management.
Liquidity management is both a daily and long-term function of business management. Excess liquidity is generally invested in short-term investments, such as overnight deposits and federal funds. On a longer term basis, we maintain a strategy of investing in various lending products and investment securities, including mortgage-backed securities. The Bank uses its sources of funds primarily to meet its ongoing commitments, pay maturing deposits, fund withdrawals and fund loan commitments. At December 31, 2009, the total approved loan commitments and unused lines of credit outstanding amounted to $37.6 million, and outstanding letters of credit were $834,000. Certificates of deposit scheduled to mature in one year or less at December 31, 2009, totaled $131.4 million. It is management’s policy to manage deposit rates that are competitive with other local financial institutions, based on our needs and potential uses of the funds. Based on this management strategy, we believe that a majority of maturing deposits will remain with the Bank. In addition, the Bank had the ability, at December 31, 2009, to borrow an additional $27.5 million from the Federal Home Loan Bank of Atlanta and $20.0 million from other lenders as a funding source to meet commitments and for liquidity purposes.
The consolidated statement of cash flows for the years ended December 31, 2009 and 2008, details cash flows from operating, investing and financing activities. For the year ended December 31, 2009, net cash provided by operating activities was $2.4 million, while investing activities provided $33.1 million, primarily from acquisition activity, and financing activities used $30.8 million primarily to reduce non-core deposits and other borrowings, resulting in a net increase in cash during the twelve month period of $4.8 million.
In March 2008, we purchased a lot in the Southwest Georgia market for $743,000 for potential future expansion. We are currently planning to build a branch on this site, and will start construction later in 2010, but have not determined the cost of such an expansion.
Off-Balance-Sheet Liabilities
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. A summary of the Company’s commitments as of December 31, 2009 is as follows:
         
    (In Thousands)  
Commitments to extend credit
  $ 37,570  
Financial stand-by letters of credit
    834  
 
     
 
  $ 38,404  
 
     
Capital
Effective January 1, 2005, the Company and the Bank became subject to minimum capital requirements imposed by the Georgia Department of Banking and Finance. As of that same date, the Bank also became subject to minimum capital requirements and capital categories established by the FDIC. Based on their capital levels at December 31, 2009, the Company and the Bank exceeded these state and federal requirements. Consistent with our goals to operate a sound and profitable organization, our policy is for the Bank to maintain a “well-capitalized” status under the capital categories of the FDIC. Based on capital levels at December 31, 2009, the Bank was considered to be well-capitalized.
At December 31, 2009, the Company had total equity of $60.8 million or 10.6% of total assets. Under Georgia capital requirements for holding companies, the Company had Tier 1 leverage capital of $61.6 million or 12.4%, which is $41.7 million above the 4.0% requirement.
At December 31, 2009, the Bank had Tier 1 leverage capital of $55.1 million or 11.2%, which is $35.4 million above the 4.0% requirement. In addition, it had a Tier 1 risked-based capital ratio of 14.2% and total risked-based capital ratio of 15.5%.

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As reflected below, the Company and the Bank exceeded the minimum capital ratios at December 31, 2009:
                                                 
                                    Minimum Required to  
                                    Be Well Capitalized  
                    For Capital     Under Prompt  
                    Adequacy     Corrective Action  
    Actual     Purposes     Provisions  
    Amount     Ratio     Amount     Ratio     Amount     Ratio  
    (Dollars in Thousands)
Total Capital to Risk Weighted Assets
                                               
Consolidated
  $ 66,476       16.8 %   $ 31,735       8.0 %     N/A       N/A  
HeritageBank of the South
  $ 60,004       15.5 %   $ 31,067       8.0 %   $ 38,834       10.0 %
 
                                               
Tier I Capital to Risk Weighted Assets
                                               
Consolidated
  $ 61,586       15.5 %   $ 15,867       4.0 %     N/A       N/A  
HeritageBank of the South
  $ 55,114       14.2 %   $ 15,534       4.0 %   $ 23,301       6.0 %
 
                                               
Tier I Capital to Average Total Assets
                                               
Consolidated
  $ 61,586       12.4 %   $ 19,803       4.0 %     N/A       N/A  
HeritageBank of the South
  $ 55,114       11.2 %   $ 19,724       4.0 %   $ 24,655       5.0 %
Critical Accounting Policies
We have established certain accounting and financial reporting policies to govern the application of accounting principles generally accepted in the United States of America in the preparation of our financial statements. Our significant accounting policies are described in the Notes to Consolidated Financial Statements. Certain accounting policies involve significant judgments and assumptions by management which have a material impact on the carrying value of certain assets and liabilities. The judgments and assumptions used by management are based on historical experience and other factors that are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from the judgments and estimates adopted by management, which could have a material impact on the carrying values of assets and liabilities and the results of our operations. We believe the following accounting policies applied by us represent critical accounting policies.
Allowance for Loan Losses. We believe the allowance for loan losses is a critical accounting policy that requires the most significant judgments and estimates used in the preparation of our consolidated financial statements. The allowance for loan losses represents management’s estimate of probable loan losses in the loan portfolio. Calculation of the allowance for loan losses represents a critical accounting estimate due to the significant judgment, assumptions and estimates related to the amount and timing of estimated losses, consideration of current and historical trends and the amount and timing of cash flows related to impaired loans.
Management believes that the allowance for loan losses is maintained at a level that represents our best estimate of probable losses in the loan portfolio. While management uses available information to recognize losses on loans, future additions to the allowance for loan losses may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review our allowance for loan losses. These agencies may require us to recognize additions to the allowance for loan losses based on their judgments about information available to them at the time of their examination.
Management evaluates current information and events regarding a borrower’s ability to repay its obligations and considers a loan to be impaired when the ultimate collectibility of amounts due, according to the contractual terms of the loan agreement, is in doubt. If the loan is collateral-dependent, the fair value of the collateral is used to determine the amount of impairment. Impairment losses are included in the allowance for loan losses through a charge to the provision for losses on loans.
Subsequent recoveries are credited to the allowance for loan losses. Cash receipts for accruing loans are applied to principal and interest under the contractual terms of the loan agreement. Cash receipts on impaired loans for which the accrual of interest has been discontinued are applied first to principal and then to interest income.

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Income Taxes. Accounting for income taxes requires the asset and liability approach for financial accounting and reporting for deferred income taxes. We use the asset and liability method of accounting for deferred income taxes and provide deferred income taxes for all significant income tax temporary differences. See Note 13 of the Notes to Consolidated Financial Statements for additional details.
As part of the process of preparing our consolidated financial statements we are required to estimate our income taxes in the jurisdiction in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as depreciation and the provision for loan losses, for tax and financial reporting purposes. These differences result in deferred tax assets and liabilities that are included in our consolidated balance sheet.
After converting to a federally chartered savings association, the Bank became a taxable organization. Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary difference between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. The Internal Revenue Code and applicable regulations are subject to interpretation with respect to the determination of the tax basis of assets and liabilities for credit unions that convert charters and become a taxable organization. Since the Bank’s transition to a federally chartered thrift, the Bank has recorded income tax expense based upon management’s interpretation of the applicable tax regulations. Positions taken by the Company in preparing our federal and state tax returns are subject to the review of taxing authorities, and the review of the positions we have taken by taxing authorities could result in adjustments to our financial statements.
Estimates of Fair Value
The estimation of fair value is significant to a number of the Company’s assets, including, but not limited to, investment securities, goodwill, other real estate owned, and other repossessed assets. These are all recorded at either fair value or at the lower of cost or fair value. Fair values are volatile and may be influenced by a number of factors. Circumstances that could cause estimates of the fair value of certain assets and liabilities to change include a change in prepayment speeds, discount rates, or market interest rates. Our estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to be necessary.
Fair values for most investment securities are based on quoted market prices. If quoted market prices are not available, fair values are based on the quoted prices of similar instruments. The fair values of other real estate owned are typically determined based on appraisals by third parties, less estimated costs to sell.
Estimates of fair value are also required in performing an impairment analysis of goodwill. The Company reviews goodwill for impairment on at least an annual basis and whenever events or circumstances indicate the carrying value may not be recoverable. An impairment would be indicated if the carrying value exceeds the fair value of a reporting unit.
For more information on the Company’s accounting policies see Note 1 of the Notes to Consolidated Financial Statements.
Item 7a. Quantitative and Qualitative Disclosures about Market Risk
Asset and Liability Management and Market Risk
Our Risk When Interest Rates Change. The rates of interest we earn on assets and pay on liabilities generally are established contractually for a period of time. Market rates change over time. Like other financial institutions, our results of operations are impacted by changes in interest rates and the interest rate sensitivity of our assets and liabilities. The risk associated with changes in interest rates and our ability to adapt to these changes is known as interest rate risk and is our most significant market risk.
How We Measure Our Risk of Interest Rate Changes. As part of our attempt to manage our exposure to changes in interest rates and comply with applicable regulations, we monitor our interest rate risk. In doing so, we analyze and manage assets and liabilities based on their interest rates and payment streams, timing of maturities, repricing opportunities, and sensitivity to actual or potential changes in market interest rates.
To manage the potential for adverse effects of material and prolonged increases in interest rates on our results of operations, we adopted asset and liability management policies to understand, measure, monitor, and control the risk. These policies are designed to allow us to implement strategies to minimize the effects of interest rate changes to net income and capital position by properly matching the maturities and repricing terms of our interest earning assets and interest bearing liabilities. These

42


 

policies are implemented by the risk management committee, which is composed of senior management and board members. The risk management committee establishes guidelines for and monitors the volume and mix of assets and funding sources, taking into account relative costs and spreads, interest rate sensitivity and liquidity requirements. The objectives are to manage assets and funding sources to produce results that limit negative changes in net income and capital while supporting liquidity, capital adequacy, growth, risk and profitability goals. Senior managers oversee the process on a daily basis. The risk management committee meets quarterly to review, among other things, economic conditions and interest rate outlook, current and projected needs and capital position, anticipated changes in the volume and mix of assets and liabilities, interest rate risk exposure, liquidity position and net portfolio present value. The committee also recommends strategy changes, as appropriate, based on their review. The committee is responsible for reviewing and reporting the effects of the policy implementations and strategies to the board of directors on a quarterly basis.
In order to manage our assets and liabilities and achieve the desired liquidity, credit quality, interest rate risk, profitability and capital targets, we have focused our strategies on:
    Limiting the percentage of long-term fixed-rate loans within our portfolio;
 
    Originating a mix of variable-rate and shorter term fixed-rate loans;
 
    Originating prime-based home equity lines of credit;
 
    Managing deposit relationships for stability and a lower cost of funds position;
 
    Using Federal Home Loan Bank advances and other funding sources to align maturities and repricing terms of funding sources with loans; and
 
    Continuing the origination of consumer loans.
The risk management committee has oversight over the asset-liability management of the Company. This committee regularly reviews interest rate risk by forecasting the impact of alternative interest rate environments on net income and the market value of portfolio equity. Market value of portfolio equity is a measurement of the value of the balance sheet at a fixed point in time. It is summarized as the fair value of assets less the fair value of liabilities. The committee reviews computations of the value of capital at current interest rates and alternative interest rates. The variance in the net portfolio value between current interest rate computations and alternative rate computations represents the potential impact on capital if rates were to change.
The Company is exposed only to U.S. dollar interest rate changes, and, accordingly, the Company manages exposure by considering the possible changes in the net interest margin. The Company does not have any trading instruments nor does it classify any portion of the investment portfolio as held for trading. The Company monitors its sensitivity to changes in interest rates and may use derivative instruments to hedge this risk. The Company does not enter into derivatives or other financial instruments for trading or speculative purposes. Finally, the Company has no exposure to foreign currency exchange rate risk and commodity price risk.
Interest rates play a major part in the net interest income of a financial institution. The sensitivity to rate changes is known as “interest rate risk”. The repricing of interest-earning assets and interest-bearing liabilities can influence the changes in net interest income.
The Company uses simulation analysis to monitor changes in net interest income due to changes in market interest rates. The simulation of rising, declining and flat interest rate scenarios allows management to monitor and adjust interest rate sensitivity to minimize the impact of market interest rate swings. The analysis of the impact on net interest income over a twelve-month period is subjected to a shock in interest rates of 100, 200, 300 and 400 basis point increase or decrease in market rates on net interest income and is monitored on a quarterly basis. We also monitor regulatory required interest rate risk analysis which simulates more dramatic changes to rates.
The Company’s strategy is to mitigate interest risk to the greatest extent possible. Based on our analysis of the Company’s overall risk to changes in interest rates, we structure investment and funding transactions to reduce this risk. These strategies aim to achieve neutrality to interest rate risk. Although we strive to have our net interest income neutral to changes in rates, due to the inherent nature of our business, we will never be completely neutral to changes in rates. As of December 31, 2009, a drop in interest rates would increase our net interest income and an increase in rates would increase our net interest income, also known as liability sensitive. During 2008 and 2009, we put minimum interest rate requirements, also known as floors, in our prime-based floating rate loans. These floors are generally 200 to 300 basis points above their current index rate. These floors allowed us to earn a higher rate of interest than we would have otherwise earned during 2008 and 2009. However, due to these floors, many of our loans will not reprice when rates rise, until the increase in rates exceeds the loan floor. This lag in repricing is part of the reason we are liability sensitive over the next year in a rising rate environment. We feel that the level of interest rate risk is at an acceptable level, and is within our internal policy limits.

43


 

The Company maintains a risk management committee which monitors and analyzes interest rate risk. This committee is comprised of members of senior management and outside directors. This committee meets on a monthly basis and reviews the simulations listed above, as well as other interest rate risk reports.
The following table sets forth the distribution of the repricing of our earning assets and interest-bearing liabilities as of December 31, 2009, the interest rate sensitivity gap (i.e., interest rate sensitive assets divided by interest rate sensitivity liabilities), the cumulative interest rate sensitivity gap ratio (i.e., interest rate sensitive assets divided by interest rate sensitive liabilities) and the cumulative sensitivity gap ratio. The table also sets forth the time periods in which earning assets and liabilities will mature or may reprice in accordance with their contractual terms. However, the table does not necessarily indicate the impact of general interest rate movements on the net interest margin since the repricing of various categories of assets and liabilities is subject to competitive pressures and the needs of our customers. In addition, various assets and liabilities indicated as repricing within the same period may in fact reprice at different times within such period and at different rates.
                                         
    At December 31, 2009  
    Maturing or Repricing Within  
    Zero to     Three                    
    Three     Months to     One to Five     Over Five        
    Months     One Year     Years     Years     Total  
Earning assets:
                                       
Short-term assets
  $ 54,576     $     $     $     $ 54,576  
Investment Securities
    16,555       24,319       53,172       26,481       120,527  
Loans
    103,447       41,099       147,637       35,895       328,078  
 
                             
 
    174,578       65,418       200,809       62,376       503,181  
 
                             
Interest-bearing liabilities:
                                     
Interest-bearing demand deposits
    67,446                           67,446  
Savings and money market
    155,329                           155,329  
Time Deposits
    59,854       75,603       36,622       2,871       174,950  
Other Borrowings
    32,843                           32,843  
FHLB Advances
                17,500       25,000       42,500  
 
                             
 
    315,472       75,603       54,122       27,871       473,068  
 
                             
Interest rate sensitivity gap
  $ (140,894 )   $ (10,185 )   $ 146,687     $ 34,505     $ 30,113  
 
                             
Cumulative interest rate sensitivity gap
  $ (140,894 )   $ (151,079 )   $ (4,392 )   $ 30,113          
 
                               
Interest rate sensitivity gap ratio
    0.55       0.87       3.71       2.24          
 
                               
Cumulative interest rate sensitivity gap ratio
    0.55       0.61       0.99       1.06          
 
                               
The following table shows the results of our projections for net interest income expressed as a percentage change over net interest income in a flat rate scenario for an immediate change or “shock” in market interest rates over a twelve month period. Due to the historically low level of interest rates, we do not believe downward shocks greater than 50 basis points are relevant. In addition, due to the historically low interest rate environment, there is concern that we may say dramatic increases in interest rates when they begin to rise. To address this concern, we increased our upward interest rates shocks to include a shock of 400 basis points.
         
    Effect
Market   on Net
Rate   Interest
Change   Income
+400
    -10.0 %
+300
    -12.6 %
+200
    -12.9 %
+100
    -6.4 %
-50
    2.8 %

44


 

Item 8. Financial Statements
The following documents are filed as part of this report on Pages F-1 through F-48 and are hereby incorporated by reference into this Item 8:
  (a)   Report from Independent Registered Public Accounting Firm;
 
  (b)   Consolidated Balance Sheets as of December 31, 2009 and 2008;
 
  (c)   Consolidated Statements of Operations for the Years Ended December 31, 2009 and 2008;
 
  (d)   Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2009 and 2008;
 
  (e)   Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2009 and 2008;
 
  (f)   Consolidated Statements of Cash Flows for the Years Ended December 31, 2009 and 2008;
 
  (g)   Notes to Consolidated Financial Statements.

45


 

Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
None.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
We maintain a system of disclosure controls and procedures (as defined in Rule 13(a)-15(e) under the Securities Exchange Act (the “Exchange Act”)) that is designed to provide reasonable assurance that information required to be disclosed by us in the reports that we file under the Exchange act is recorder, processed, summarize and reported accurately and within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate. An evaluation of our disclosure controls and procedures was carried out as of December 31, 2009, under the supervision and with the participation of our principal executive officer, and other members of senior management.
Our principal executive officer and principal financial officer concluded that, as of December 31, 2009, our disclosure controls and procedures were effective in ensuring that the information we are required to disclose in the reports we file or submit under the Exchange Act is (i) accumulated and communicated to our management (including the principal executive officer and principal financial officer) to allow timely decisions regarding required disclosure, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
We intend to continually review and evaluate the design and effectiveness of the Company’s disclosure controls and procedures and to improve the Company’s controls and procedures over time and to correct any deficiencies that we may discover in the future. The goal is to ensure that senior management has timely access to all material financial and non-financial information concerning the Company’s business. While we believe the present design of the disclosure controls and procedures is effective to achieve its goal, future events affecting its business may cause the Company to modify its disclosure controls and procedures.
We do not expect that our controls and procedures over financial reporting will prevent all errors and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns in controls or procedures can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any control procedure also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of change in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.
Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Act) that occurred during the quarter ended December 31, 2009, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. The annual report of management on the effectiveness of internal control reporting is set forth below under “Management’s Annual Report on Internal Control Over Financial Reporting.”
Management’s Annual Report on Internal Control Over Financial Reporting
The management of Heritage Financial Group is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles accepted in the United States of America.

46


 

The Company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2009. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on this assessment and those criteria, management concluded that the Company maintained effective internal control over financial reporting as of December 31, 2009.
This annual report does not include an attestation of our independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our independent registered public accounting firm pursuant to temporary rules of the SEC that permit the Company to provide only management’s report in this annual report.
Item 9B. Other Information
None.

47


 

PART III
Item 10. Directors and Executive Officers and Corporate Governance
Directors
Information concerning the Directors of the Company is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 19, 2010, a copy of which will be filed not later than 120 days after the close of the fiscal year.
Executive Officers
Information concerning the Executive Officers of the Company is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 19, 2010.
Audit Committee Matters and Audit Committee Financial Expert
The Board of Directors of the Company has a standing Audit Committee, which has been established in accordance with Section 3(a)(58)(A) of the Exchange Act. The members of that committee are Directors Burger (chair), McGinley and Stanley, all of whom are considered independent under Nasdaq listing standards. The Board of Directors has determined that Director Burger is an “audit committee financial expert” as defined in applicable SEC rules. Additional information concerning the Audit Committee is incorporated herein by reference from the Company’s definitive proxy statement for its Annual Meeting of Stockholders to be held May 19, 2010, except for information contained under the heading “Report of the Audit Committee,” a copy of which will be filed not later than 120 days after the close of the fiscal year.
Nomination Procedures
There have been no material changes to the procedures by which stockholders may recommend nominees to the Company’s Board of Directors.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934 requires that the Company’s directors and executive officers, and persons who own more than 10% of the Company’s Common Stock, file with the SEC initial reports of ownership and reports of changes in ownership of the Company’s Common Stock. Officers, directors and greater than 10% stockholders are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms they file. To the Company’s knowledge, no late reports occurred during the fiscal year ended December 31, 2009. All other Section 16(a) filing requirements applicable to our executive officers, directors and greater than 10% beneficial owners were complied with.
Code of Ethics
In March 2005, the Company adopted a written Code of Business Conduct and Ethics based upon the standards set forth under Item 406 of Regulation S-B of the Securities and Exchange Commission. The Code of Business Conduct and Ethics applies to all of the Company’s directors, officers and employees. This code is available to all interested parties on the Company’s website at www.eheritagebank.com, under Governance Documents in the Investor Relations section.
Item 11. Executive Compensation
Information concerning executive compensation required by this item is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 19, 2010, except for information contained under the heading “Report of the Audit Committee,” a copy of which will be filed not later than 120 days after the close of the fiscal year.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information concerning security ownership of certain beneficial owners and management required by this item is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 19, 2010.
See Item 5 for information regarding shares available under the Company’s equity incentive compensation plan.

48


 

Item 13. Certain Relationships and Related Transactions and Director Independence
Information concerning certain relationships and related transactions required by this item is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 19, 2010, a copy of which will be filed not later than 120 days after the close of the fiscal year. This incorporation by reference excludes the information contained under the heading “Report of Audit Committee.”
Information concerning the independence of our directors required by this item is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 19, 2010, a copy of which will be filed not later than 120 days after the close of the fiscal year. This incorporation by reference excludes the information contained under the heading “Report of Audit Committee.”
Item 14. Principal Accountant Fees and Services
Information concerning fees and services by our principal accountants required by this item is incorporated herein by reference from our definitive proxy statement for the annual meeting of stockholders to be held on May 19, 2010, a copy of which will be filed not later than 120 days after the close of the fiscal year.

49


 

PART IV
Item 15. Exhibits and Financial Statement Schedules
(a)(1) List of Financial Statements
The following are contained in Item 8 of this Form 10-K:
(a)(2) List of Financial Statement Schedules:
All financial statement schedules have been omitted as the information is not required under the related instructions or is not applicable.

50


 

(a)(3) List of Exhibits:
         
        Reference to Prior
        Filing or Exhibit
        Number Attached
Exhibit Number   Document   Hereto
2.0  
Plan of acquisition, reorganization, arrangement, liquidation, or succession
  None
3.1  
Charter of the Registrant
  ***
3.2  
Bylaws of the Registrant
  *
4  
Instruments defining the rights of security holders, including indentures:
   
   
Form of Heritage Financial Group Common Stock Certificate
  **
9  
Voting Trust Agreement
  None
10  
Material contracts:
   
   
(1) Employment Agreements:
   
   
(a) (i) O. Leonard Dorminey — Bank
  *
   
(a) (ii) O. Leonard Dorminey — Holding Company
  *
   
(c) Carol W. Slappey
  *
   
(2) Deferred Compensation and Excess/Matching Contribution Plans
  *
   
(3) Supplemental Executive Retirement Plan
  *
   
(4) Directors’ Retirement Plan
  *
   
(5) 401(k) Savings Plan
  **
   
(6) Employee Stock Ownership Plan
  *
   
(7) Purchase and Assumption Agreement dated September 1, 2009, between HeritageBank
   
   
of the South and Atlantic Coast Federal Bank
  +
   
(8) Definitive Whole-bank Purchase and Assumption Agreement dated December 4, 2009,
   
   
between HeritageBank of the South and the Federal Deposit Insurance Corporation
  ++
   
(9) Purchase and Assumption Agreement dated February 23, 2010, between HeritageBank
   
   
of the South and The Park Avenue Bank
  +++
11  
Statement re: computation of per share earnings
  None
12  
Statement re: computation of ratios
  None
13  
Annual report to security holders, Form 10-Q or quarterly reports to security holders
  None
14  
Code of Business Conduct and Ethics
  ****
16  
Letter re: change in certifying accountant
  None
18  
Letter re: change in accounting principles
  None
21  
Subsidiaries of the Company
  21
22  
Published report regarding matters submitted to vote of security holders
  None
23  
Consent of Accountants
  23
24  
Power of Attorney
  ++++
31  
Rule 13a-14(a)/15d-14(a) Certifications
  31
32  
Section 1350 Certifications
  32
 
*   Filed as an exhibit to the Registrant’s Registration Statement on Form SB-2 (File No. 333-123581), declared effective by the SEC on May 16, 2005.
 
**   Filed as an exhibit to Pre-Effective Amendment No. 1 to the Registrant’s Registration Statement on Form SB-2. (File No. 333-123581) declared effective by the SEC on May 16, 2005.
 
***   Filed as an exhibit to the Filer’s Form 10-KSB for the year ended December 31, 2005, filed with the SEC on March 30, 2006.
 
****   Filed as an exhibit to the Filer’s Form 10-QSB for the quarter ended June 30, 2005, filed with the SEC on August 15, 2005.
 
+   Included as an exhibit to the Form 8-K filed with the SEC on September 2, 2009.
 
++   Included as an exhibit to the Form 8-K filed with the SEC on December 8, 2009.
 
+++   Included as an exhibit to the Form 8-K filed with the SEC on February 25, 2010.
 
++++   Included on signature page of this annual report.

51


 

SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
         
 

HERITAGE FINANCIAL GROUP
 
 
Date: April 9, 2010  By:   /s/ O. Leonard Dorminey    
    O. Leonard Dorminey, President and   
    Chief Executive Officer
(Duly Authorized Representative
 
 
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints O. Leonard Dorminey his true and lawful attorney-in-fact and agent, with full power of substitution and re-substitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K and all instruments necessary or advisable in connection therewith, and to file the same, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all said attorney-in-fact and agent or his substitute or substitutes may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
         
Date:
  April 9, 2010   /s/ O. Leonard Dorminey
 
       
 
      O. Leonard Dorminey
 
      President, Chief Executive Officer and Director (Principal Executive Officer)
 
       
Date:
  April 9, 2010   /s/ Antone D. Lehr
 
       
 
      Antone D. Lehr, Chairman of the Board
 
       
Date:
  April 9, 2010   /s/ Joseph C. Burger
 
       
 
      Joseph C. Burger, Vice Chairman of the Board
 
       
Date:
  April 9, 2010   /s/ Douglas J. McGinley
 
       
 
      Douglas J. McGinley, Director
 
       
Date:
  April 9, 2010   /s/ Carol W. Slappey
 
       
 
      Carol W. Slappey, Director
 
       
Date:
  April 9, 2010   /s/ J. Keith Land
 
       
 
      J. Keith Land, Director
 
       
Date:
  April 9, 2010   /s/ J. Lee Stanley
 
       
 
      J. Lee Stanley, Director
 
       
Date:
  April 9, 2010   /s/ T. Heath Fountain
 
       
 
      T. Heath Fountain
 
      Senior Vice President and Chief Financial Officer
 
      (Principal Financial and Accounting Officer)

52


 

Index to Exhibits
     
21
  Subsidiaries of the Company
 
   
23
  Consent of Accountants
 
   
31.1
  Rule 13a-14(a)/15d-14(a) Certifications of President and Chief Executive Officer
 
   
31.2
  Rule 13a-14(a)/15d-14(a) Certifications of Chief Financial Officer
 
   
32
  Section 1350 Certifications


 

(MAULDIN & JENKINS LOGO)
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
Heritage Financial Group
     and Subsidiary
Albany, Georgia
          We have audited the accompanying consolidated balance sheets of Heritage Financial Group and Subsidiary as of December 31, 2009 and 2008, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
          We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
          In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heritage Financial Group and Subsidiary as of December 31, 2009 and 2008, and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
(SIGNATURE)
Albany, Georgia
April 7, 2010

F-1


 

HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2009 AND 2008
                 
    2009     2008  
Assets
               
Cash and due from banks
  $ 14,921,517     $ 10,159,602  
Interest-bearing deposits in banks
    43,236,287       745,758  
Federal funds sold
    11,340,000       30,254,000  
Securities available for sale, at fair value
    120,526,900       116,140,525  
Federal Home Loan Bank Stock, at cost
    3,253,400       3,185,800  
Other equity securities, at cost
    1,010,000       1,010,000  
 
               
Loans
    334,138,932       302,487,892  
Less allowance for loan losses
    6,060,460       4,950,722  
 
           
Loans, net
    328,078,472       297,537,170  
 
               
Premises and equipment, net
    15,590,120       16,801,183  
Premises held for sale
    1,080,000        
Accrued interest receivable
    2,799,375       2,155,327  
Foreclosed assets
    1,795,544       2,119,818  
Intangible assets
    1,570,832       1,000,000  
Cash surrender value of bank owned life insurance
    14,756,771       14,136,119  
Other assets
    11,988,301       6,812,425  
 
           
 
               
 
  $ 571,947,519     $ 502,057,727  
 
           
 
               
Liabilities and Stockholders’ Equity
               
 
               
Deposits
               
Noninterest-bearing
  $ 28,881,905     $ 19,100,197  
Interest-bearing
    397,724,617       319,445,797  
 
           
Total deposits
    426,606,522       338,545,994  
Federal funds purchased and securities sold under repurchase agreements
    32,843,465       41,497,491  
Other borrowings
    42,500,000       52,500,000  
Accrued interest payable
    706,321       1,045,042  
Other liabilities
    8,474,370       6,256,227  
 
           
Total liabilities
    511,130,678       439,844,754  
 
           
 
               
Commitments and contingencies
               
 
               
Stockholders’ equity
               
Preferred stock, par value $0.01; 1,000,000 shares authorized; no shares issued
           
Common stock, par value $0.01; 25,000,000 shares authorized; 11,454,344 and 11,452,344 issued and outstanding
    114,543       114,523  
Capital surplus
    40,609,551       39,861,237  
Retained earnings
    38,984,165       41,357,209  
Accumulated other comprehensive loss
    (2,387,234 )     (2,685,633 )
Unearned employee stock ownership plan (ESOP) shares, 242,385 and 286,455 shares
    (2,423,850 )     (2,864,550 )
 
           
 
    74,897,175       75,782,786  
Treasury stock, at cost, 1,055,084 and 993,498 shares
    (14,080,334 )     (13,569,813 )
 
           
Total stockholders’ equity
    60,816,841       62,212,973  
 
           
 
               
 
  $ 571,947,519     $ 502,057,727  
 
           
See Notes to Consolidated Financial Statements.

F-2


 

HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2009 AND 2008
                 
    2009     2008  
Interest income
               
Interest and fees on loans
  $ 18,555,397     $ 20,881,600  
Interest on taxable securities
    3,603,871       4,890,165  
Interest on nontaxable securities
    1,174,043       1,175,720  
Interest on federal funds sold
    53,629       232,456  
Interest on deposits in other banks
    13,870       15,424  
 
           
 
    23,400,810       27,195,365  
 
           
 
               
Interest expense
               
Interest on deposits
    6,471,521       9,042,782  
Interest on other borrowings
    2,321,842       3,451,560  
 
           
 
    8,793,363       12,494,342  
 
           
 
               
Net interest income
    14,607,447       14,701,023  
Provision for loan losses
    7,500,000       3,350,000  
 
           
Net interest income after provision for loan losses
    7,107,447       11,351,023  
 
           
 
               
Noninterest income
               
Service charges on deposit accounts
    3,546,681       3,957,589  
Other service charges, commissions and fees
    1,405,938       1,287,591  
Brokerage fees
    914,041       1,029,980  
Mortgage origination fees
    344,576       400,044  
Bank owned life insurance
    620,652       495,492  
Impairment loss on securities available for sale
          (3,119,181 )
Gains on sale of securities
    908,877       234,676  
Other
    45,885       301,308  
 
           
 
    7,786,650       4,587,499  
 
           
 
               
Noninterest expense
               
Salaries and employee benefits
    8,898,984       8,987,913  
Equipment
    984,985       1,217,142  
Occupancy
    1,197,823       1,204,156  
Data processing fees
    1,605,510       1,299,963  
Directors fees and retirement
    553,428       552,289  
Consulting and other professional fees
    296,975       317,957  
Advertising and marketing
    439,032       496,124  
Legal and accounting
    493,118       528,085  
Telecommunications
    239,073       257,617  
Supplies
    176,521       176,973  
FDIC insurance and other regulatory fees
    871,622       267,475  
Losses on sales and write-downs of other real estate owned
    422,100       386,317  
Foreclosed asset expenses
    256,671       229,039  
Impairment loss on premises held for sale
    502,469        
Other operating
    1,332,431       1,507,808  
 
           
 
    18,270,742       17,428,858  
 
           
 
               
Loss before income tax benefit
    (3,376,645 )     (1,490,336 )
 
               
Applicable income tax benefit
    (1,724,326 )     (1,227,976 )
 
           
 
               
Net loss
  $ (1,652,319 )   $ (262,360 )
 
           
 
               
Basic loss per share
  $ (0.16 )   $ (0.03 )
 
           
 
               
Diluted loss per share
  $ (0.16 )   $ (0.03 )
 
           
See Notes to Consolidated Financial Statements.

F-3


 

HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
YEARS ENDED DECEMBER 31, 2009 AND 2008
                 
    2009     2008  
Net loss
  $ (1,652,319 )   $ (262,360 )
 
           
 
               
Other comprehensive income (loss):
               
Net realized gain on termination of cash flow hedge during the period, net of tax of $510,078
          765,117  
Elimination of unrealized gain on cash flow hedge terminated during the period, net of tax of $156,558
          (234,838 )
Accretion of realized gain on terminated cash flow hedge, net of tax of $140,747 and $64,018
    (211,120 )     (96,027 )
Net unrealized holding gains (losses) arising during period, net of tax (benefit) of $671,983 and ($994,469)
    1,007,973       (1,491,704 )
Reclassification adjustment for (gains) losses and securities impairment included in net income (loss), net of tax (benefit) of $363,551 and ($1,153,802)
    (545,326 )     1,730,703  
Adjustment to recognize funded status of pension plan, net of tax (benefit) of $31,248 and ($37,028)
    46,872       (55,542 )
 
           
 
               
Total other comprehensive income
    298,399       617,709  
 
           
 
               
Comprehensive income (loss)
  $ (1,353,920 )   $ 335,349  
 
           
See Notes to Consolidated Financial Statements.

F-4


 

HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
YEARS ENDED DECEMBER 31, 2009 AND 2008
                                                                 
                                                    Accumulated        
                                                    Other        
                                                    Compre-        
                                    Unearned             hensive        
    Common Stock     Capital     Retained     ESOP     Treasury     Income        
    Shares     Par Value     Surplus     Earnings     Shares     Stock     (Loss)     Total  
Balance, December 31, 2007
    11,443,723     $ 114,437     $ 39,009,323     $ 42,406,483     $ (3,305,250 )   $ (9,329,501 )   $ (3,303,342 )   $ 65,592,150  
Net loss
                      (262,360 )                       (262,360 )
Cash dividend declared, $0.28 per share
                      (786,914 )                       (786,914 )
Stock-based compensation expense
                809,086                               809,086  
Repurchase of 377,894 shares of stock for the treasury
                                  (4,244,715 )           (4,244,715 )
Issuance of 330 shares of common stock from the treasury
                (836 )                 4,403             3,567  
Forfeiture of restricted shares of common stock
    (884 )     (9 )     9                                
Issuance of restricted shares of common stock
    9,505       95       (95 )                              
Other comprehensive income
                                        617,709       617,709  
Tax benefit shortfall from stock- based compensation plans
                (3,432 )                             (3,432 )
ESOP shares earned, 44,070 shares
                47,182             440,700                   487,882  
 
                                               
Balance, December 31, 2008
    11,452,344       114,523       39,861,237       41,357,209       (2,864,550 )     (13,569,813 )     (2,685,633 )     62,212,973  
Net loss
                      (1,652,319 )                       (1,652,319 )
Cash dividend declared, $0.32 per share
                      (720,725 )                       (720,725 )
Stock-based compensation expense
                807,402                               807,402  
Repurchase of 62,026 shares of stock for the treasury
                                  (516,426 )           (516,426 )
Issuance of 440 shares of common stock from the treasury
                (2,602 )                 5,905             3,303  
Issuance of restricted shares of common stock
    2,000       20       (20 )                              
Other comprehensive income
                                        298,399       298,399  
Tax benefit shortfall from stock- based compensation plans
                (58,494 )                             (58,494 )
ESOP shares earned, 44,070 shares
                (73,946 )           440,700                   366,754  
Tax benefit on ESOP expense
                75,974                               75,974  
 
                                               
Balance, December 31, 2009
    11,454,344     $ 114,543     $ 40,609,551     $ 38,984,165     $ (2,423,850 )   $ (14,080,334 )   $ (2,387,234 )   $ 60,816,841  
 
                                               
See Notes to Consolidated Financial Statements.

F-5


 

HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2009 AND 2008
                 
    2009     2008  
OPERATING ACTIVITIES
               
Net loss
  $ (1,652,319 )   $ (262,360 )
 
           
 
               
Adjustments to reconcile net loss to net cash provided by operating activities:
               
Depreciation and amortization
    911,587       964,205  
Impairment loss on premises held for sale
    502,469        
Provision for loan losses
    7,500,000       3,350,000  
ESOP compensation expense
    366,754       487,882  
Provision for deferred taxes
    (699,010 )     (1,926,940 )
Stock-based compensation expense
    807,402       809,086  
Net gain on termination of cash flow hedge
          1,275,195  
Accretion of gain on termination of cash flow hedge
    (351,867 )     (160,045 )
Impairment losses on securities available for sale
          3,119,181  
Gains on sale of securities available for sale
    (908,877 )     (234,676 )
Loss on sale and write-downs of other real estate owned
    422,100       386,317  
Net (gains) losses on sale or disposal of premises and equipment
    (12,064 )     865  
Increase in bank owned life insurance
    (620,652 )     (495,472 )
Excess tax shortfall related to stock-based compensation plans
    58,494       3,432  
Excess tax expense related to ESOP
    (75,974 )      
(Increase) decrease in interest receivable
    (44,055 )     431,030  
Increase (decrease) in interest payable
    (501,498 )     97,690  
(Increase) decrease in taxes receivable
    (878,411 )     695,099  
Increase in prepaid FDIC assessment
    (2,020,181 )      
Net other operating activities
    (367,301 )     (83,939 )
 
           
Total adjustments
    4,088,916       8,718,910  
 
           
Net cash provided by operating activities
    2,436,597       8,456,550  
 
           
 
               
INVESTING ACTIVITIES
               
Increase in interest-bearing deposits in banks
    (42,490,529 )     (365,797 )
Purchases of securities available for sale
    (97,885,273 )     (64,161,362 )
Proceeds from maturities of securities available for sale
    31,400,213       15,985,014  
Proceeds from sale of securities available for sale
    64,814,421       37,416,842  
Purchase of bank owned life insurance
          (5,000,000 )
Increase in Federal Home Loan Bank stock
    (67,600 )     (216,100 )
Purchase of other equity securities
          (1,010,000 )
Increase (decrease) in federal funds sold
    18,914,000       (15,749,000 )
Increase in loans, net
    (3,548,886 )     (3,906,118 )
Purchases of premises and equipment
    (691,749 )     (2,950,733 )
Net cash received from acquisition activity
    61,446,617        
Proceeds from sales of premises and equipment
    12,745        
Proceeds from sales of other real estate owned
    1,220,206       1,112,341  
 
           
Net cash provided by (used in) investing activities
    33,124,165       (38,844,913 )
 
           

F-6


 

HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2009 AND 2008
                 
    2009     2008  
FINANCING ACTIVITIES
               
Increase (decrease) in deposits
  $ (9,634,666 )   $ 7,916,584  
Increase (decrease) in federal funds purchased and securities sold under repurchase agreements
    (8,654,026 )     26,209,039  
Proceeds from other borrowings
          46,000,000  
Repayment of other borrowings
    (11,293,787 )     (43,500,000 )
Excess tax benefit related to stock-based compensation plans
    (58,494 )     (3,432 )
Excess tax related to ESOP
    75,974        
Purchase of treasury shares, net
    (513,123 )     (4,241,148 )
Dividends paid to stockholders
    (720,725 )     (786,914 )
 
           
 
               
Net cash provided by (used in) financing activities
    (30,798,847 )     31,594,129  
 
           
 
               
Net increase in cash and due from banks
    4,761,915       1,205,766  
 
               
Cash and due from banks at beginning of year
    10,159,602       8,953,836  
 
           
 
               
Cash and due from banks at end of year
  $ 14,921,517     $ 10,159,602  
 
           
 
               
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
               
Cash paid during the year for:
               
Interest
  $ 9,132,084     $ 12,396,652  
Income taxes
  $ 64,821     $ 7,300  
 
               
NONCASH TRANSACTIONS
               
Decrease in unrealized losses on securities available for sale
  $ 771,078     $ 398,332  
Decrease in unrealized gain on terminated cash flow hedges
  $     $ 391,396  
Principal balances of loans transferred to other real estate owned
  $ 716,084     $ 3,276,417  
Pension liability increase (decrease)
  $ (78,120 )   $ 92,570  
See Notes to Consolidated Financial Statements.

F-7


 

HERITAGE FINANCIAL GROUP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Business
Heritage Financial Group (the “Company”) is a mid-tier holding company whose business is primarily conducted by its wholly-owned subsidiary, HeritageBank of the South (the “Bank”). The Company is a 76% owned subsidiary of Heritage, MHC, a federally chartered mutual holding company. The other 24% of the Company is owned by the public who acquired shares of the Company through a stock offering completed on June 29, 2005. Through the Bank, the Company operates a full service banking business and offers a broad range of retail and commercial banking services to its customers located in a market area which includes South Georgia and North Central Florida. The Company and the Bank are subject to the regulations of certain federal and state agencies and are periodically examined by those regulatory agencies.
Minority Stock Offering
The Company completed an initial public stock offering on June 29, 2005. It sold 3,372,375 shares of common stock in that offering for $10.00 per share. The Company’s employee stock ownership plan (the “ESOP”) purchased 440,700 shares with the proceeds of a loan from the Company. The Company received net proceeds of $32.4 million in the public offering, of which 50% was contributed to the Bank and $4.4 million was lent to the ESOP for its purchase of shares in the offering. The Company also issued an additional 7,867,875 shares of common stock to Heritage, MHC, so that Heritage, MHC would own 70% of the outstanding common stock at the closing of that offering.
Basis of Presentation and Accounting Estimates
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary. Significant intercompany transactions and balances have been eliminated in consolidation.
In preparing the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses, the valuation of foreclosed real estate, contingent assets and liabilities, deferred tax assets, other-than-temporary impairments of securities, and the fair value of financial instruments.
Cash Due from Banks and Cash Flows
For purposes of reporting cash flows, cash and due from banks includes cash on hand, cash items in process of collection and amounts due from banks. Cash flows from loans, federal funds sold, interest-bearing deposits, interest receivable, deposits, federal funds purchased and securities sold under repurchase agreements and interest payable in banks are reported net.
The Bank is required to maintain reserve balances in cash or on deposit with the Federal Reserve Bank. The total of those reserve balance requirements was approximately $2,787,000 and $2,141,000 at December 31, 2009 and 2008, respectively.

F-8


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Securities
Debt securities that management has the positive intent and ability to hold to maturity are classified as held to maturity and recorded at amortized cost. Management has not classified any of its debt securities as held to maturity. Securities not classified as held to maturity, including equity securities with readily determinable fair values, are classified as available for sale and recorded at fair value with unrealized gains and losses excluded from earnings and reported in accumulated other comprehensive income, net of the related deferred tax effect. Equity securities, including other equity securities, without a readily determinable fair value are classified as available for sale and recorded at cost. Restricted equity securities are recorded at cost.
The amortization of premiums and accretion of discounts are recognized in interest income using methods approximating the interest method over the life of the securities. Realized gains and losses, determined on the basis of the cost of specific securities sold, are included in earnings on the settlement date.
The Financial Accounting Standards Board (“FASB”) recently issued accounting guidance related to the recognition and presentation of other-than-temporary impairment (FASB Accounting Standards Codification (“ASC”) 320-10). See the “Recent Accounting Standards” section for additional information.
Prior to the adoption of the recent accounting guidance on April 1, 2009, management considered, in determining whether other-than-temporary impairment exists, (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
Securities purchased under resale agreements and securities sold under repurchase agreements are generally accounted for as collateralized financial transactions as more fully disclosed in Note 11. They are recorded at the amount at which the securities were acquired or sold plus accrued interest. It is the Company’s policy to take possession of securities purchased under resale agreements, which are primarily U.S. Government and Government agency securities. The market value of these securities is monitored, and additional securities are obtained when deemed appropriate to ensure such transactions are adequately collateralized. The Company also monitors its exposure with respect to securities sold under repurchase agreements, and a request for the return of excess securities held by the counterparty is made when deemed appropriate.
Originated Loans
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal balances less unearned income, net deferred fees and costs on originated loans and the allowance for loan losses. Interest income is accrued on the outstanding principal balance. Loan origination fees, net of certain direct origination costs of consumer and installment loans, are recognized at the time the loan is placed on the books. Loan origination fees for all other loans are deferred and recognized as an adjustment of the yield over the life of the loan using the straight-line method.
The accrual of interest on loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due, unless the loan is well-secured. Past due status is based on contractual terms of the loan. Generally, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued, but not collected for loans that are placed on nonaccrual or charged off, is reversed against interest income, unless management believes that the accrued interest is recoverable through the liquidation of collateral. Interest income on nonaccrual loans is subsequently recognized only to the extent cash payments are received until the loans are returned to accrual status. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

F-9


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Originated Loans (Continued)
A loan is considered impaired when it is probable, based on current information and events, the Company will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Impaired loans are measured by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price or the fair value of the collateral if the loan is collateral dependent. Interest on accruing impaired loans is recognized as long as such loans do not meet the criteria for nonaccrual status. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment.
Purchased Loans
Loans acquired in business acquisitions are recorded at the fair value at the acquisition date. Credit discounts are included in the determination of fair value; therefore, an allowance for loan losses is not recorded at the acquisition date.
In determining the acquisition date fair value of purchased loans, and in subsequent accounting, the Company generally aggregates purchased loans into pools of loans with common risk characteristics. Expected cash flows at the acquisition date in excess of the fair value of loans are recorded as interest income over the life of the loans using a level yield method if the timing and amount of the future cash flows of the pool is reasonably estimable. Subsequent to the acquisition date, increases in cash flows over those expected at the acquisition date are recognized as interest income prospectively. Decreases in expected cash flows after the acquisition date are recognized by recording an allowance for loan losses.
Allowance for Loan Losses
The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to expense. Loan losses are charged against the allowance when management believes the collectibility of the principal is unlikely. Subsequent recoveries, if any, are credited to the allowance.
The allowance is an amount that management believes will absorb estimated losses relating to specifically identified loans, as well as probable credit losses inherent in the balance of the loan portfolio. The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of loans in light of historical experience, the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, current economic conditions that may affect the borrower’s ability to pay and estimated value of any underlying collateral. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
This evaluation does not include the effects of expected losses on specific loans or groups of loans that are related to future events or expected changes in economic conditions. While management uses the best information available to make its evaluation, future adjustments to the allowance may be necessary if there are significant changes in economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses and may require the Company to make additions to the allowance based on their judgment about information available to them at the time of their examinations.

F-10


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Allowance for Loan Losses (Continued)
The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as impaired. For impaired loans, an allowance is established when the discounted cash flows, collateral value or observable market price of the impaired loan is lower than the carrying value of that loan. The general component covers non-impaired loans and is based on historical loss experience adjusted for other qualitative factors. Other adjustments may be made to the allowance for pools of loans after an assessment of internal or external influences on credit quality that are not fully reflected in the historical loss or risk rating data. An unallocated component may be maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
Mortgage Origination Fees
The Company originates first mortgage loans for other investors. These loans are not funded by the Company but, upon closing, the Company receives a fee from the investor. Generally, the Company receives fees equivalent to a stated percentage of the loan amount.
Premises and Equipment
Land is carried at cost. Premises and equipment are carried at cost, less accumulated depreciation computed on the straight-line method over the estimated useful lives:
         
    Years
Buildings
    40  
Furniture and equipment
    3-7  
Intangible Assets
Intangible assets consist of a payment made to complete a series of transactions which allowed the Company to acquire the right to branch into Florida in 2006. This indefinite lived intangible asset is required to be tested at least annually for impairment or whenever events occur that may indicate the recoverability of the carrying amount is not probable. In the event of impairment, the amount by which the carrying amount exceeds the fair value is charged to earnings. The Company performed its annual test of impairment in the fourth quarter and determined that there was no impairment in the carrying value of this intangible asset. The carrying amount of this asset at December 31, 2009 was $1,000,000.
Intangible assets also consist of core deposit premiums acquired in connection with business combinations. The core deposit premium is initially recognized based on a valuation performed as of the consummation date. The core deposit premium is amortized over the average remaining life of the acquired customer deposits, or approximately 7 years. Amortization periods are reviewed annually for impairment. Intangible assets were evaluated for impairment as of December 31, 2009, and based on that evaluation it was determined that there was no impairment. The carrying amount of the core deposit premium at December 31, 2009 was $570,832. These core deposit premiums were acquired were acquired in December 2009, and therefore, no amortization expense or related accumulated amortization has been recorded as of December 31, 2009.

F-11


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Foreclosed Assets
Foreclosed assets acquired through or in lieu of loan foreclosure are held for sale and are initially recorded at the lower of cost or fair value less estimated costs to sell. Any write-down to fair value at the time of transfer to foreclosed assets is charged to the allowance for loan losses. (Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell.) Costs of improvements are capitalized, whereas costs relating to holding foreclosed assets and subsequent adjustments to the value are expensed.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company — put presumptively beyond the reach of the transferor and its creditors even in bankruptcy or other receivership, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.
Pension Plan
The compensation cost of an employee’s pension benefit is recognized on the projected unit credit method over the employee’s approximate service period. The Company’s funding policy is to contribute annually an amount that satisfies the funding standard account requirements of ERISA.
Employee Stock Ownership Plan (“ESOP”)
The cost of shares issued to the ESOP, but not yet allocated to participants, is shown as a reduction of stockholders’ equity. Compensation expense is based on the market price of shares as they are committed to be released to participant accounts. Dividends on allocated ESOP shares reduce retained earnings; dividends on unearned ESOP shares reduce debt and accrued interest.
The Company accounts for its ESOP in accordance with Statement of Position 93-6. Accordingly, since the Company sponsors the ESOP with an employer loan, neither the ESOP’s loan payable or the Company’s loan receivable are reported in the Company’s consolidated balance sheet. Likewise, the Company does not recognize interest income or interest cost on the loan. Unallocated shares held by the ESOP are recorded as unearned ESOP shares in the consolidated statement of changes in stockholders’ equity. As shares are released for allocation, the Company recognizes compensation expense equal to the average market price of the shares for the period.
Treasury Stock
The Company’s repurchases of shares of its common stock are recorded at cost as treasury stock and result in a reduction of stockholders’ equity. When treasury shares are reissued, the Company uses an average cost method and any difference in repurchase cost and reissuance price is recorded as an increase or reduction in capital surplus.

F-12


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Income Taxes
The Company accounts for income taxes in accordance with income tax accounting guidance (FASB ASC 740, Income Taxes). On January 1, 2009, the Company adopted the recent accounting guidance related to accounting for uncertainty in income taxes, which sets out a consistent framework to determine the appropriate level of tax reserves to maintain for uncertain tax positions.
The income tax accounting guidance results in two components of income tax expense: current and deferred. Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues. The Company determines deferred income taxes using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and enacted changes in tax rates and laws are recognized in the period in which they occur.
Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. Deferred tax assets are recognized if it is more-likely-than-not, based on the technical merits, that the tax position will be realized or sustained upon examination. The term more-likely-than-not means a likelihood of more than 50 percent; the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any. A tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that has a greater than 50 percent likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold considers the facts, circumstances, and information available at the reporting date and is subject to management’s judgment. Deferred tax assets may be reduced by deferred tax liabilities and a valuation allowance if, based on the weight of evidence available, it is more-likely-than-not that some portion or all of a deferred tax asset will not be realized.
Loss Per Share
Basic loss per share represent net loss available to common shareholders divided by the weighted-average number of common shares outstanding during the period, excluding unearned shares of the Employee Stock Ownership Plan and unvested shares of stock. Diluted loss per share are computed by dividing net loss by the sum of the weighted-average number of shares of common stock outstanding and dilutive potential common shares. Potential common shares consist only of stock options and unvested restricted shares.
Comprehensive Income (Loss)
Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net loss. Although certain changes in assets and liabilities, such as unrealized gains and losses on securities available for sale, 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 (loss).
Advertising Costs
Advertising costs are expensed as incurred.
Reclassification
Certain amounts in the 2008 consolidated financial statements have been reclassed to conform to the 2009 presentation.

F-13


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Recent Accounting Standards
Effective July 1, 2009, the Company adopted new accounting guidance related to U.S. GAAP (FASB ASC 105, Generally Accepted Accounting Principles). This guidance establishes FASB ASC as the source of authoritative U.S. GAAP recognized by FASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative U.S. GAAP for SEC registrants. FASB ASC supersedes all existing non-SEC accounting and reporting standards. All other nongrandfathered, non-SEC accounting literature not included in FASB ASC has become nonauthoritative. FASB will no longer issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standards Updates (ASUs), which will serve to update FASB ASC, provide background information about the guidance, and provide the basis for conclusions on the changes to FASB ASC. FASB ASC is not intended to change U.S. GAAP or any requirements of the SEC. This guidance is effective for the Company as of December 31, 2009.
Effective April 1, 2009, the Company adopted new accounting guidance related to recognition and presentation of other-than-temporary impairment (FASB ASC 320-10). This recent accounting guidance amends the recognition guidance for other-than-temporary impairments of debt securities and expands the financial statement disclosures for other-than-temporary impairment losses on debt and equity securities. The recent guidance replaced the “intent and ability” indication in current guidance by specifying that (a) if a company does not have the intent to sell a debt security prior to recovery and (b) it is more-likely-than-not that it will not have to sell the debt security prior to recovery, the security would not be considered other-than-temporarily impaired unless there is a credit loss. When an entity does not intend to sell the security, and it is more-likely-than-not, the entity will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income. For held-to-maturity debt securities, the amount of an other-than-temporary impairment recorded in other comprehensive income for the noncredit portion of a previous other-than-temporary impairment should be amortized prospectively over the remaining life of the security on the basis of the timing of future estimated cash flows of the security.
The Company adopted accounting guidance related to fair value measurements and disclosures (FASB ASC 820, Fair Value Measurements and Disclosures). This guidance defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This guidance establishes a fair value hierarchy about the assumptions used to measure fair value and clarifies assumptions about risk and the effect of a restriction on the sale or use of an asset. The effect of adoption was not material.
FASB issued ASU 2009-05 (FASB ASC 820) which describes the valuation techniques companies should use to measure the fair value of liabilities for which there is limited observable market data. If a quoted price in an active market is not available for an identical liability, an entity should use one of the following approaches: (1) the quoted price of the identical liability when traded as an asset, (2) quoted prices for similar liabilities or similar liabilities when traded as an asset, or (3) another valuation technique that is consistent with the accounting guidance in FASB ASC for fair value measurements and disclosures. When measuring the fair value of liabilities, this guidance reiterates that companies should apply valuation techniques that maximize the use of relevant observable inputs, which is consistent with existing accounting provisions for fair value measurements. In addition, this guidance clarifies when an entity should adjust quoted prices of identical or similar assets that are used to estimate the fair value of liabilities. This guidance is effective for the Company as of December 31, 2009.

F-14


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Recent Accounting Standards (Continued)
In addition, the following accounting pronouncements were issued by FASB, but are not yet effective:
In June 2009, the FASB issued Statement of Financial Accounting Standards No. 166, “Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140”, codified in the “Consolidation” Topic of the ASC as ASU 2009-16, which eliminates the concept of a “Qualified Special Purpose Entity” from FAS 140, changes the requirements for derecognizing financial assets, and requires additional disclosures. ASU 2009-16 is effective for fiscal years beginning after November 15, 2009. The Company is in the process of reviewing the potential impact of these provisions; however, their adoption is not expected to have a material impact to the consolidated financial statements.
In June 2009, the FASB issued Statement of Financial Accounting Standards No. 167, “Amendments to FASB Interpretation No. 46(R)”, codified in the “Consolidation” Topic of the ASC as ASU 2009-17, which modifies how a company determines when a Variable Interest Entity (“VIE”) should be consolidated. It also requires a qualitative assessment of an entity’s determination of the primary beneficiary of a VIE based on whether the entity (1) has the power to direct the activities of a VIE that most significantly impact the entity’s economic performance, and (2) has the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE. An ongoing reassessment is also required to determine whether a company is the primary beneficiary of a VIE as well as additional disclosures about a company’s involvement in VIEs. ASU 2009-17 is effective for fiscal years beginning after November 15, 2009. The Company is in the process of reviewing the potential impact of these provisions; however, their adoption is not expected to have a material impact to the consolidated financial statements.
In January 2010, the FASB issued the ASU 2010-06, “Improving Disclosures about Fair Value Measurements”, which requires additional disclosures related to the transfers in and out of fair value hierarchy and the activity of Level 3 financial instruments. This ASU also provides clarification for the classification of financial instruments and the discussion of inputs and valuation techniques. The new disclosures and clarification are effective for interim and annual reporting periods ending after December 15, 2009, except for the disclosures related to the activity of Level 3 financial instruments. Those disclosures are effective for periods after December 15, 2010 and for interim periods within those years. The Company is in the process of reviewing the potential impact of ASU 2010-06; however, the adoption of this ASU is not expected to have a material impact to the consolidated financial statements.
NOTE 2. ACQUISITION ACTIVITY
The Tattnall Bank
On December 4, 2009, the Company participated in a federally-assisted acquisition of substantially all of the assets and substantially all of the liabilities of the Tattnall Bank (“Tattnall”) from the FDIC. Tattnall operated two branch offices in the Southeast Georgia markets of Reidsville and Collins. The Company’s bid included a discount payment from the FDIC totaling $15.0 million. The Company did not enter into a loss-sharing agreement with the FDIC.

F-15


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2. ACQUISITION ACTIVITY (Continued)
The Tattnall Bank (Continued)
The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of the acquisition:
                         
                    As Recorded  
    Acquired     Fair Value     by Heritage  
    from the     and Other     Financial  
(dollars in thousands)   FDIC     Adjustments     Group  
Assets
                       
Cash and cash equivalents
  $ 19,204     $ 12,700 (a)   $ 31,904  
Investment securities
    1,036             1,036  
Loans
    32,472       (7,598) (b)     24,874  
Foreclosed assets
    5,470       (4,869) (c)     601  
Core deposit intangibles
          159 (d)     159  
Due from the FDIC
          1,108 (e)     1,108  
Other assets
    600             600  
 
                 
Total Assets
  $ 58,782       1,500     $ 60,282  
 
                 
 
                       
Liabilities
                       
Noninterest-bearing deposits
  $ 4,661     $     $ 4,661  
Interest-bearing deposits
    51,507       369 (f)     51,876  
Borrowings
    1,294             1,294  
Accrual for expenses associated with the disposition of problem assets
          2,315 (g)     2,315  
Other liabilities
    136             136  
 
                 
Total Liabilities
  $ 57,598     $ 2,684     $ 60,282  
 
                 
Explanations
 
(a)   The adjustment represents the cash received from the FDIC immediately subsequent to the closing.
 
(b)   The adjustment represents the write down of the book value of Tattnall’s loans to their estimated fair value based on expected cash flows which includes an estimate of expected future loan losses.
 
(c)   The adjustment represents the write down of the book value of Tattnall’s OREO and repossessed assets to their estimated fair value at the acquisition date based on their estimated disposition costs.
 
(d)   The adjustment represents the value of the core deposit base assumed in the acquisition. The core deposit asset was recorded as an identifiable intangible asset and will be amortized on an accelerated basis over the average life of the deposit base, estimated to be seven years.
 
(e)   The adjustment represents the amount receivable from the FDIC, as adjustments were made from the date of the initial payment from the FDIC. This receivable, when added to the $12.7 million payment received from the FDIC, and the $1.2 million in net assets acquired, total the $15.0 million discount price from the FDIC for the acquisition.
 
(f)   The adjustment is necessary because the weighted average interest rate of Tattnall’s CD’s exceeded the cost of similar funding at the time of acquisition. The fair value adjustment will be amortized to reduce interest expense on a declining basis over the average life of the portfolio, which is estimated to be ten months.
 
(g)   The adjustment represents management’s estimates of the costs to work through and dispose of problem assets in Tattnall’s portfolio, including OREO and loans. This estimate is management’s best estimate at the time of acquisition. Any additional expenses above the amount accrued will be expensed as incurred.

F-16


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2. ACQUISITION ACTIVITY (Continued)
The Tattnall Bank (Continued)
The Company recognizes that the determination of the initial fair value of loans at the acquisition date involves a high degree of judgment and complexity. The carrying value of the acquired loans reflect management’s best estimate of the fair value of these assets as of the acquisition date. However, the amount the Company ultimately recognizes on these assets could differ materially from the value reflected in these financial statements, based upon the timing and amount of collections on the acquired loans in future periods. To the extent the actual values recognized for the acquired loans are less than the Company’s estimate, additional losses will be incurred. These fair value estimates are considered preliminary, and are subject to change for up to one year after the closing date of the acquisition as additional information relative to the closing date fair values becomes available.
Due to the significant fair value adjustments recorded, as well as the discount price received from the FDIC, Tattnall’s historical results are not believed to be relevant to the Company’s results, and thus no pro forma information is presented.
The Company did not immediately acquire the real estate, banking facilities, furniture or equipment of Tattnall as part of the purchase and assumption agreement. However, the purchase and assumption agreement gave the Company the option to purchase these assets. On March 4, 2010, the Company exercised its option with the FDIC and agreed to purchase these assets for approximately $1.3 million.
Lake City Branch of Atlantic Coast Bank
On December 31, 2009, we acquired certain assets and assumed certain liabilities of the Lake City, Florida, branch of Atlantic Coast Bank. The Company purchased only performing loans that met underwriting standards of the Company. After a due diligence review at this branch, the Company assumed substantially all the deposits of this branch.
The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition:
                         
    Acquired                
    from Lake             As Recorded  
    City Branch     Fair Value     by Heritage  
    of Atlantic     and Other     Financial  
(dollars in thousands)   Coast Bank     Adjustments     Group  
Assets
                       
Cash and cash equivalents
  $ 392     $ 29,150 (a)   $ 29,542  
Premises and equipment
    592             592  
Loans
    10,336       370 (b)     10,706  
Core deposit intangibles
          411 (c)     411  
Other assets
    292             292  
 
                 
Total Assets
  $ 11,612     $ 29,931     $ 41,543  
 
                 
 
                       
Liabilities
                       
Noninterest-bearing deposits
  $ 1,074     $     $ 1,074  
Interest-bearing deposits
    40,084       343 (d)     40,427  
Other liabilities
    16       26 (e)     42  
 
                 
Total Liabilities
  $ 41,174     $ 369     $ 41,543  
 
                 

F-17


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2. ACQUISITION ACTIVITY (Continued)
Lake City Branch of Atlantic Coast Bank (Continued)
Explanations
 
(a)   The adjustment represents the cash received from Atlantic Coast Bank to reflect the acquisition of excess liabilities assumed over assets purchased.
 
(b)   The adjustment represents the adjustment to fair market value of the loans assumed in the transaction.
 
(c)   The adjustment represents the consideration paid for the value of the core deposit base assumed in the acquisition. The core deposit asset was recorded as an identifiable intangible asset and will be amortized on an accelerated basis over the average life of the deposit base, estimated to be seven years.
 
(d)   The adjustment is necessary because the weighted average interest rate of the Lake City Branch CD’s exceeded the cost of similar funding at the time of acquisition. The fair value adjustment will be amortized to reduce interest expense on a declining basis over the average life of the portfolio, which is estimated to be twelve months.
 
(e)   The adjustment represents the accrual of certain expenses expected to be incurred as part of the acquisition.
NOTE 3. SECURITIES
The amortized cost and fair value of securities available for sale with gross unrealized gains and losses are summarized as follows:
                                 
            Gross     Gross        
    Amortized     Unrealized     Unrealized     Fair  
    Cost     Gains     Losses     Value  
December 31, 2009:
                               
U. S. Government sponsored agency securities (GSEs)*
  $ 30,571,605     $ 190,036     $ (299,664 )   $ 30,461,977  
State and municipal securities
    30,142,545       196,013       (1,215,694 )     29,122,864  
Corporate debt securities
    2,178,999       44,976       (313,757 )     1,910,218  
GSE residential mortgage-backed securities
    54,091,124       449,796       (4,682 )     54,536,238  
Private label residential mortgage-backed securities
    3,859,494       15,015       (30 )     3,874,479  
 
                       
Total debt securities
    120,843,767       895,836       (1,833,827 )     119,905,776  
Equity securities
    751,521       47,999       (178,396 )     621,124  
 
                       
Total securities**
  $ 121,595,288     $ 943,835     $ (2,012,223 )   $ 120,526,900  
 
                       
 
*   Such as Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and Federal Home Loan Banks.
 
**   At December 31, 2009, we held no securities of any single issuer (excluding the U.S. Government and federal agencies) with a book value that exceeded 10% of stockholders’ equity.

F-18


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3. SECURITIES (Continued)
                                 
            Gross     Gross        
    Amortized     Unrealized     Unrealized     Fair  
    Cost     Gains     Losses     Value  
December 31, 2008:
                               
U. S. Government sponsored agency securities (GSEs)
  $ 20,923,967     $ 248,091     $ (7,077 )   $ 21,164,981  
State and municipal securities
    30,052,558       60,677       (2,602,013 )     27,511,222  
Corporate debt securities
    2,187,686             (398,303 )     1,789,383  
GSE residential mortgage-backed securities
    59,519,328       1,469,043       (61,699 )     60,926,672  
Private label residential mortgage-backed securities
    4,861,651             (380,925 )     4,480,726  
 
                       
Total debt securities
    117,545,190       1,777,811       (3,450,017 )     115,872,984  
Equity securities
    434,801       20,999       (188,259 )     267,541  
 
                       
Total securities
  $ 117,979,991     $ 1,798,810     $ (3,638,276 )   $ 116,140,525  
 
                       
The amortized cost and fair value of debt securities available for sale as of December 31, 2009 by contractual maturity are shown below. Maturities may differ from contractual maturities in mortgage-backed securities because the mortgages underlying the securities may be called or repaid without penalty. Therefore, these securities are not included in the maturity categories in the following maturity summary.
                 
    Amortized     Fair  
    Cost     Value  
Due from one year to five years
  $ 3,700,300     $ 3,487,707  
Due from five to ten years
    11,384,865       11,493,407  
Due after ten years
    47,807,984       46,513,945  
Mortgage-backed securities
    57,950,618       58,410,717  
 
           
 
  $ 120,843,767     $ 119,905,776  
 
           
Securities with a carrying value of approximately $46,814,000 and $64,931,946 at December 31, 2009 and 2008, respectively, were pledged to secure public deposits, repurchase agreements and for other purposes required or permitted by law.
Gains and losses on sales of securities available for sale consist of the following:
                 
    December 31,
    2009   2008
Gross gains on sales of securities
  $ 964,793     $ 361,701  
Gross losses on sales of securities
    (55,916 )     (127,025 )
 
               
Net realized gains on sales of securities available for sale
  $ 908,877     $ 234,676  
 
               

F-19


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3. SECURITIES (Continued)
The following table shows the gross unrealized losses and fair value of securities aggregated by category and length of time that securities have been in a continuous unrealized loss position at December 31, 2009 and 2008.
                                                 
    Less Than 12 Months     12 Months or More     Total  
    Fair     Unrealized     Fair     Unrealized     Fair     Unrealized  
Description of Securities   Value     Losses     Value     Losses     Value     Losses  
December 31, 2009:
                                               
U.S. Government sponsored agency securities (GSEs)
  $ 14,295,966     $ (299,664 )   $     $     $ 14,295,966     $ (299,664 )
State and municipal securities
    8,125,696       (311,298 )     10,722,375       (904,396 )     18,848,071       (1,215,694 )
Corporate debt securities
                845,308       (313,757 )     845,308       (313,757 )
GSE residential mortgage-backed securities
    2,883,976       (4,682 )                 2,883,976       (4,682 )
Private label residential mortgage-backed securities
    24,344       (30 )                 24,344       (30 )
 
                                   
Subtotal, debt securities
    25,329,982       (615,674 )     11,567,683       (1,218,153 )     36,897,665       (1,833,827 )
Equity securities
                256,404       (178,396 )     256,404       (178,396 )
 
                                   
Total temporarily impaired securities
  $ 25,329,982     $ (615,674 )   $ 11,824,087     $ (1,396,549 )   $ 37,154,069     $ (2,012,223 )
 
                                   
                                                 
    Less Than 12 Months     12 Months or More     Total  
    Fair     Unrealized     Fair     Unrealized     Fair     Unrealized  
Description of Securities   Value     Losses     Value     Losses     Value     Losses  
December 31, 2008:
                                               
U.S. Government sponsored agency securities (GSEs)
  $ 1,992,923     $ (7,077 )   $     $     $ 1,992,923     $ (7,077 )
State and municipal securities
    12,567,698       (889,679 )     10,383,740       (1,712,334 )     22,951,438       (2,602,013 )
Corporate debt securities
                763,444       (398,303 )     763,444       (398,303 )
GSE residential mortgage-backed securities
                                   
Private label residential mortgage-backed securities
    4,366,655       (378,461 )     4,772,176       (64,163 )     9,138,831       (442,624 )
 
                                   
Subtotal, debt securities
    18,927,276       (1,275,217 )     15,919,360       (2,174,800 )     34,846,636       (3,450,017 )
Equity securities
                246,541       (188,259 )     246,541       (188,259 )
 
                                   
Total temporarily impaired securities
  $ 18,927,276     $ (1,275,217 )   $ 16,165,901     $ (2,363,059 )   $ 35,093,177     $ (3,638,276 )
 
                                   
GSE debt securities. The unrealized losses on the nine investments in GSEs were caused by interest rate increases. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost bases of the investments. Because the Company does not intend to sell the investments and it is not more-likely-than-not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at December 31, 2009.

F-20


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3. SECURITIES (Continued)
Corporate bonds. The Company’s unrealized losses on investments in two corporate bonds relates are primarily caused by recent decreases in profitability and profit forecasts by financial industry analysts resulting from the sub-prime mortgage market and a recent sector downgrade by several industry analysts. The Company currently does not believe it is probable that it will be unable to collect all amounts due according to the contractual terms of the investments. Because the Company does not intend to sell the investment and it is not more-likely-than-not that the Company will be required to sell the investments before recovery of its par value, which may be maturity, it does not consider these investments to be other-than-temporarily impaired at December 31, 2009.
GSE residential mortgage-backed securities. The unrealized losses on the Company’s investment in two GSE mortgage-backed securities were caused by interest rate increases. The Company purchased those investments at a discount relative to their face amount, and the contractual cash flows of those investments are guaranteed by an agency of the U.S. Government. Accordingly, it is expected that the securities would not be settled at a price less than the amortized cost bases of the Company’s investments. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company does not intend to sell the investments and it is not more-likely-than-not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at December 31, 2009.
Private-label residential mortgage-backed securities. The unrealized losses associated with one private residential mortgage-backed securities are primarily driven by higher projected collateral losses, wider credit spreads, and changes in interest rates. We assess for credit impairment using a cash flow model. Based upon our assessment of the expected credit losses of the security given the performance of the underlying collateral compared to our credit enhancement, we expect to recover the entire amortized cost basis of these securities.
Marketable equity securities. The Company’s investments in two marketable equity securities consist primarily of investments in preferred stock of entities in the financial services industry. The Company evaluated the prospects of the issuer in relation to the severity and duration of the impairment. Based on that evaluation and the Company’s ability and intent to hold those investments for a reasonable period of time sufficient for a forecasted recovery of fair value, the Company does not consider those investments to be other-than-temporarily impaired at December 31, 2009.
Other-Than-Temporary Impairment
Upon acquisition of a security, the Company decides whether it is within the scope of the accounting guidance for beneficial interests in securitized financial assets or will be evaluated for impairment under the accounting guidance for investments in debt and equity securities.
The accounting guidance for beneficial interests in securitized financial assets provides incremental impairment guidance for a subset of the debt securities within the scope of the guidance for investments in debt and equity securities. For securities where the security is a beneficial interest in securitized financial assets, the Company uses the beneficial interests in securitized financial asset impairment model. For securities where the security is not a beneficial interest in securitized financial assets, the Company uses debt and equity securities impairment model.

F-21


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3. SECURITIES (Continued)
Other-Than-Temporary Impairment (Continued)
Management routinely conducts periodic reviews to identify and evaluate each investment security to determine whether an other-than-temporary impairment has occurred. Economic models are used to determine whether an other-than-temporary impairment has occurred on these securities. While all securities are considered, the securities primarily impacted by other-than-temporary impairment testing are private-label mortgage-backed securities. For each private-label mortgage-backed security in the investment portfolio (including but not limited to those whose fair value is less than their amortized cost basis), an extensive, regular review is conducted to determine if an other-than-temporary impairment has occurred. Various inputs to the economic models are used to determine if an unrealized loss is other-than-temporary. The most significant inputs are the following:
    Default rate
 
    Severity
Other inputs may include the actual collateral attributes, which include geographic concentrations, credit ratings, and other performance indicators of the underlying asset.
During 2008, the Company recorded an other than temporary impairment charges on securities of three issuers whose securities were held in our available for sale portfolio. An other than temporary impairment charge of $1.5 million was recorded on its investment in Freddie Mac preferred stock. The value of these securities declined significantly after the U.S. Government placed both companies into conservatorship in September 2008. The securities have a new cost basis of approximately $1. In addition, the Company impaired the corporate bonds of General Motors, in which we had an investment of $1.2 million that was written down to $220,000, and the corporate bonds of Ford Motor Credit, in which the Company held an investment of $1 million that was written down to $400,000. Subsequent to the write down, the Company saw a significant increase in the value of the corporate bonds. Based on the change in value, the Company sold the investments in General Motors and Ford Motor Credit for an approximate gain of $172,000. The Company still holds the investment in the preferred stock of Freddie Mac at December 31, 2009.
Restricted Equity Securities
The investment in the common stock of the Federal Home Loan Bank of Atlanta is accounted for by the cost method, which also represents par value, and is made for long-term business affiliation reasons. In addition, this investment is subject to restrictions relating to sale, transfer or other disposition. Dividends are recognized in income when declared. The carrying value of this investment at December 31, 2009 is $3,253,400. The estimated fair value of this investment is $3,253,400 as of December 31, 2009 and therefore is not considered impaired.
Other equity securities represent an investment in the common stock of the Chattahoochee Bank of Georgia (“Chattahoochee”), a de novo bank in Gainesville, Georgia. The Company accounts for this investment by the cost method. This investment represents approximately 4.9% of the outstanding shares of Chattahoochee. Since its initial capital raise, Chattahoochee has not had any stock transactions, and therefore, no fair market value is readily available. The carrying value of this investment at December 31, 2009 is $1,010,000. The Company plans to hold this investment for the foreseeable future, and does not consider it impaired as of December 31, 2009.

F-22


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES
The composition of loans is summarized as follows:
                 
    December 31,  
    2009     2008  
Commercial real estate
  $ 71,013,650     $ 52,477,396  
Commercial and industrial loans
    45,784,735       42,838,238  
Multifamily
    11,650,057       10,719,282  
Construction and land
    28,002,622       43,296,696  
Farmland
    9,012,642       5,743,563  
Mortgage loans, 1-4 families
    81,255,214       79,727,032  
Home equity
    17,312,606       18,343,923  
Indirect auto loans
    16,546,425       26,577,958  
Direct auto loans
    10,151,213       13,175,286  
Student loans
    596,494       552,174  
Other
    7,687,048       9,036,344  
 
           
Total originated loans
    299,012,706       302,487,892  
Purchased loans, net of fair market value adjustments
    35,126,226        
 
           
Total loans
    334,138,932       302,487,892  
Total allowance for loan losses
    (6,060,460 )     (4,950,722 )
 
           
Loans, net
  $ 328,078,472     $ 297,537,170  
 
           
A loan is considered impaired, in accordance with the impairment accounting guidance (FASB ASC 310-10-35-16), when based on current information and events, it is probable that the Company will be unable to collect all amounts due from the borrower in accordance with the contractual term of the loan. Impaired loans include loans modified in troubled debt restructuring where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection.
Included in certain loan categories in the originated impaired loans are troubled debt restructurings that were classified as impaired. At December 31, 2009, the Company had $1,420,000 in commercial loans and $657,799 in commercial real estate loans that were modified in troubled debt restructuring and impaired. In addition to these amounts, the Company had troubled debt restructurings that were performing in accordance with their modified terms of $18,274 in residential mortgage loans, $1,454,452 in commercial real estate loans and $1,700,000 in development loans at December 31, 2009.
The following is a summary of information pertaining to impaired loans (excluding purchased loans and performing troubled debt restructurings):
                 
    As of and For the Years  
    Ended December 31,  
    2009     2008  
Impaired loans without a valuation allowance
  $     $  
Impaired loans with a valuation allowance
    7,236,764       7,281,226  
 
           
Total impaired loans
  $ 7,236,764     $ 7,281,226  
 
           
Valuation allowance related to impaired loans
  $ 1,175,081     $ 666,193  
 
           
Average investment in impaired loans
  $ 9,505,953     $ 4,811,203  
 
           
Forgone interest income on impaired loans
  $ 610,371     $ 202,843  
 
           

F-23


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)
Loans on nonaccrual status in the originated portfolio amounted to $7,236,764 and $7,281,226 at December 31, 2009 and 2008, respectively. Loans on nonaccrual status in the purchased portfolio totaled $1,226,112 at December 31, 2009. There were no loans past due ninety days or more and still accruing interest at December 31, 2009 and 2008, respectively. There were no significant amounts of interest income recognized on impaired loans on the cash basis for the years ended December 31, 2009 and 2008.
At December 31, 2009, the contractual amount of purchased loans totaled $42,354,492 less fair market value adjustments of $7,228,266 for a carrying value of $35,126,226. Management’s preliminary allocations estimate approximately $2,000,000 in accretable yield related to these purchased loans. No accretion was recognized in income during 2009 related to these purchased loans.
Changes in the allowance for loan losses are as follows:
                 
    Years Ended December 31,  
    2009     2008  
Balance, beginning of year
  $ 4,950,722     $ 4,415,669  
Provision for loan losses
    7,500,000       3,350,000  
Loans charged off
    (6,620,779 )     (3,001,570 )
Recoveries of loans previously charged off
    230,517       186,623  
 
           
Balance, end of year
  $ 6,060,460     $ 4,950,722  
 
           
    In the ordinary course of business, the Company has granted loans to certain directors, executive officers and their affiliates. Changes in related party loans at December 31, 2009 are summarized as follows:
         
Balance, beginning of year
  $ 10,075,860  
Advances
    9,699,433  
Repayments
    (11,053,483 )
 
     
Balance, end of year
  $ 8,721,810  
 
     
NOTE 5. OTHER REAL ESTATE OWNED
A summary of other real estate owned is presented as follows:
                 
    Years Ended December 31,  
    2009     2008  
Balance, beginning of year
  $ 2,064,789     $ 287,030  
Additions
    716,084       3,276,417  
Purchased other real estate, net of fair market value adjustments
    600,870        
Disposals
    (1,220,206 )     (1,112,341 )
Losses on sales and write downs of other real estate owned
    (422,100 )     (386,317 )
 
           
Balance, end of year
  $ 1,739,437     $ 2,064,789  
 
           

F-24


 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6. PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
                 
    December 31,