HERITAGE FINANCIAL CORP /WA/ - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-K

Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2003

Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

Commission File No. 0-29480

HERITAGE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Washington

91-1857900

(State or other jurisdiction of

incorporation or organization)

(IRS Employer

Identification No.)

201 Fifth Avenue SW, Olympia, Washington 98501

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code: (360) 943-1500

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

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, no par value per share

(Title of class)

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the 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. ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨

The aggregate market value of the voting stock held by non-affiliates of the registrant is $111,671,212 and is based upon the last sales price as quoted on the NASDAQ Stock Market for February 6, 2004.

The Registrant had 6,149,751 shares of common stock outstanding as of February 6, 2004.

DOCUMENTS TO BE INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement dated March 22, 2004 for the 2004 Annual Meeting of Stockholders will be incorporated by reference into Part III of this Form 10-K.

HERITAGE FINANCIAL CORPORATION

FORM 10-K

December 31, 2003

TABLE OF CONTENTS


		Page
	PART I

ITEM 1.	BUSINESS	3

	LENDING ACTIVITIES	3

	INVESTMENT ACTIVITIES	11

	DEPOSIT ACTIVITIES AND OTHER SOURCES OF FUNDS	13

	SUPERVISION AND REGULATION	15

	COMPETITION	20

ITEM 2.	PROPERTIES	20

ITEM 3.	LEGAL PROCEEDINGS	20

ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	20

	PART II

ITEM 5.	MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS	21

ITEM 6.	SELECTED FINANCIAL DATA	23

ITEM 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	24

ITEM 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	33

ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA	34

ITEM 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES	34

ITEM 9A.	CONTROLS AND PROCEDURES	34

	PART III

ITEM 10.	DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT	35

ITEM 11.	EXECUTIVE COMPENSATION	35

ITEM 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT	35

ITEM 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS	35

ITEM 14.	PRINCIPAL ACCOUNTING FEES AND SERVICES	35

	PART IV

ITEM 15.	EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K	36

PART I

ITEM 1. BUSINESS

General

Heritage Financial Corporation is a bank holding company incorporated in the State of Washington in August 1997. We were organized for the purpose of acquiring all of the capital stock of Heritage Savings Bank upon our reorganization from a mutual holding company form of organization to a stock holding company form of organization (“Conversion”).

We are primarily engaged in the business of planning, directing and coordinating the business activities of our wholly owned subsidiaries: Heritage Savings Bank (“Heritage Bank”) and Central Valley Bank, N.A. Heritage Bank is a Washington state-chartered savings bank whose deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”) under the Savings Association Insurance Fund (“SAIF”). Heritage Bank conducts business from its main office in Olympia, Washington and its eleven branch offices located in Thurston, Pierce, and Mason Counties. Central Valley Bank is a national bank whose deposits are insured by the FDIC under the Bank Insurance Fund (“BIF”). Central Valley Bank conducts business from its main office in Toppenish, Washington, and its five branch offices located in Yakima and Kittitas Counties.

Our business consists primarily of lending and deposit relationships with small businesses including agribusiness and their owners in our market area, attracting deposits from the general public and originating for sale or investment purposes first mortgage loans on residential properties located in western and central Washington State. We also make residential construction, income property, and consumer loans.

On March 5, 1999, we merged with Washington Independent Bancshares, Inc. whose wholly owned subsidiary was Central Valley Bank. This merger was accounted for as a pooling of interests, and accordingly, our financial information has been restated to include the accounts and results of operations of Washington Independent Bancshares, Inc. for all periods presented. Effective June 12, 1998, we acquired North Pacific Bancorporation, whose wholly owned subsidiary was North Pacific Bank, in a transaction accounted for under purchase accounting rules. North Pacific Bank was a Washington state-chartered commercial bank, which was merged into Heritage Bank effective November 20, 1998.

Market Areas

We offer financial services to meet the needs of the communities we serve through community-oriented financial institutions. Headquartered in Olympia, Thurston County, Washington, we conduct business through Heritage Bank and Central Valley Bank. Heritage Bank has twelve full service offices, with six in Pierce County, five in Thurston County, and one in Mason County. Heritage Bank has mortgage origination offices in Thurston County, Mason County and Pierce County, which all operate within banking offices. The mortgage loan operations are performed in one office located in Thurston County. Central Valley Bank operates six full service offices, with five in Yakima County and one in Kittitas County.

Lending Activities

General. Our lending activities are conducted through Heritage Bank and Central Valley Bank. We offer commercial, real estate, income property, agricultural, and consumer loans. We have focused on commercial lending in recent years, which reflects our efforts to broaden our products and services to those more closely related to commercial banking. As a result of our efforts to expand in Pierce County, commercial loans increased in the recent year to $266.3 million, or 51.1% of total loans, as of December 31, 2003 from $243.9 million, or 51.9% of total loans, as of December 31, 2002. We continue to provide real estate mortgages, both single and multifamily residential and commercial. Real estate mortgages increased to $207.1 million, or 39.7% of total

loans, at December 31, 2003, from $187.6 million, or 39.9% of total loans, at December 31, 2002. As we pursue our strategy to focus on commercial lending within a flat economy, management continues to emphasize strong asset quality.

Our overall lending operations are guided by loan policies, which are reviewed and approved annually by our board of directors. These policies outline the basic policies and procedures by which lending operations are conducted. The policies address the types of loans, underwriting and collateral requirements, terms, interest rate and yield considerations, compliance with laws and regulations, and compliance with internal lending limits. We supplement our own supervision of the loan underwriting and approval process with periodic loan audits by experienced external loan specialists who review credit quality, loan documentation, and compliance with laws and regulations.

The following table provides information about our loan portfolio by type of loan for the dates indicated. These balances are net of deferred loan fees and prior to deduction for the allowance for loan losses.


	At December 31,
	2003					2002					2001					2000					1999
	Balance			% of Tota		Balance			% of Total		Balance			% of Total		Balance			% of Total		Balance			% of Total
	(Dollars in thousands)
Commercial	$	266,252		51.06	%	$	243,872		51.86	%	$	263,063		52.75	%	$	234,166		48.55	%	$	192,088		45.98	%
Real Estate Mortgages
One-four family residential(1)		57,377		11.00			72,846		15.49			91,189		18.28			107,501		22.28			97,907		23.44
Five or more family residential and commercial properties		149,728		28.72			114,750		24.40			107,450		21.55			109,560		22.71			94,242		22.56

Total real estate mortgages		207,105		39.72			187,596		39.89			198,639		39.83			217,061		44.99			192,149		46.00
Real estate construction
One-four family residential		19,881		3.81			29,201		6.21			32,494		6.51			27,412		5.68			23,293		5.58
Five or more family residential and commercial properties		19,570		3.75			3,169		0.67			83		0.02			—		—			7,537		1.80

Total real estate construction(2)		39,451		7.56			32,370		6.88			32,577		6.53			27,412		5.68			30,830		7.38
Consumer		10,043		1.93			7,616		1.62			5,794		1.16			5,466		1.13			4,273		1.02

Gross loans		522,851		100.27	%		471,454		100.25	%		500,073		100.27	%		484,105		100.35	%		419,340		100.38	%
Less deferred loan fees and other		(1,438	)	(0.27	)		(1,190	)	(0.25	)		(1,368	)	(0.27	)		(1,670	)	(0.35	)		(1,578	)	(0.38	)

Total loans receivable and loans held for sale	$	521,413		100.00	%	$	470,264		100.00	%	$	498,705		100.00	%	$	482,435		100.00	%	$	417,762		100.00	%

(1)

Includes loans held for sale of $1,018, $8,113, $6,275, $1,931 and $589 respectively.

(2)

Balances are net of undisbursed loan proceeds.

The following table presents at December 31, 2003 (i) the aggregate maturities of loans in the named categories of our loan portfolio and (ii) the aggregate amounts of fixed rate and variable or adjustable rate loans in the named categories that mature after one year.


	Maturing
	Within 1 year		1-5 years		After 5 years		Total
	(Dollars in thousands)
Commercial	$	79,547	$	66,470	$	120,235	$	266,252
Real estate construction		28,697		7,595		3,159		39,451

Total	$	108,244	$	74,065	$	123,394	$	305,703

Fixed rate loans			$	46,162	$	50,822	$	96,984
Variable or adjustable rate loans				27,903		72,572		100,475

Total			$	74,065	$	123,394	$	197,459

Real Estate Lending

One- to Four- Family Residential Real Estate Lending. The majority of our residential loans are secured by one- to four- family residences located in our primary market areas. Our underwriting standards require that one- to four-family portfolio loans generally are owner-occupied and do not exceed 80% (90% with private mortgage insurance) of the current appraised value or cost, whichever is lower, of the underlying collateral. Terms typically range from 15 to 30 years. We offer both fixed rate mortgages and adjustable rate mortgages (“ARMs”) with repricing based on a Treasury Bill or other index. However, our ability to generate volume in ARMs is largely a function of consumer preference and the interest rate environment. Our current policy is not to make ARMs with discounted initial interest rates (i.e., “teasers”). We generally sell all government guaranteed mortgages, both fixed rate and adjustable rate. Management determines to what extent we will retain or sell other ARMs and other fixed rate mortgages in their strategy to control our interest rate sensitivity position. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Asset/Liability Management”.

Multifamily and Commercial Real Estate Lending. We have made, and anticipate continuing to make, on a selective basis, multifamily and commercial real estate loans in our primary market areas. Commercial real estate loans are made for small shopping centers, warehouses, and professional offices. Cash flow coverage to debt servicing requirements is generally 1.2 times or more. Our underwriting standards generally require that the loan-to-value ratio for multifamily and commercial real estate loans not exceed 80% of appraised value or cost, whichever is lower.

Multifamily and commercial real estate mortgage lending affords our banks an opportunity to receive interest at rates higher than those generally available from one- to four- family residential lending. However, loans secured by such properties usually are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than one- to four-family residential mortgage loans. Because payments on loans secured by multifamily and commercial real estate properties are often dependent on the successful operation and management of the properties, repayment of these loans may be affected by adverse conditions in the real estate market or the economy. We seek to minimize these risks by strictly scrutinizing the financial condition of the borrower, the quality of the collateral, and the management of the property securing the loan. We also generally obtain personal guarantees from financially capable borrowers based on a review of personal financial statements.

Construction Loans. We originate one- to four-family residential construction loans for the construction of custom homes (where the home buyer is the borrower) and provide financing to builders for the construction of pre-sold homes and speculative residential construction (i.e. built before a buyer is identified). We lend to builders who have demonstrated a favorable record of performance and profitable operations and who are building in markets that management understands and is comfortable with existing economic conditions. We further endeavor to limit our construction lending risk through adherence to strict underwriting procedures. Loans to one builder are generally limited on a case-by-case basis with unsold home limits based on builder strengths. Our underwriting standards require that the loan-to-value ratio for pre-sold homes and speculative residential construction generally not exceed 80% of appraised value or builder’s cost, whichever is less. Speculative construction and land development loans are generally short term in nature and priced with a variable rate of interest using the prime rate as the index. We generally require builders to have some tangible form of equity in each construction project. Also, we generally require prompt and thorough documentation of all draw requests and we inspect the project prior to paying any draw requests from builders.

Construction lending affords us the opportunity to achieve higher interest rates and fees with shorter terms to maturity than does our single-family permanent mortgage lending. However, construction lending is generally considered to involve a higher degree of risk than single-family permanent mortgage lending because of the inherent difficulty in estimating both a property’s value at completion of the project and the estimated costs of the project. As a result, these loans are generally more difficult to evaluate and monitor. If the estimate of

construction cost proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the project. If the estimate of value upon completion proves to be inaccurate, we may be confronted with a project whose value is insufficient to ensure full repayment. Projects may also be jeopardized by disagreements between borrowers and builders, and the failure of builders to pay subcontractors. Loans to builders to construct homes for which no purchaser has been identified carry more risk because the liquidation of the loan depends on the builder’s ability to sell the property.

Commercial Business Lending

We offer commercial loans to sole proprietorships, partnerships, and corporations with an emphasis on real estate related industries and businesses in agricultural, health care, legal, and other professions. The types of commercial loans offered are business lines of credit secured primarily by real estate, accounts receivable and inventory financing, business term loans secured by real estate for either working capital or lot acquisition, Small Business Administration (“SBA”) loans, and unsecured business loans.

Commercial business lending generally involves greater risk than residential mortgage lending and these risks differ from those associated with residential and commercial real estate lending. Commercial real estate lending is generally considered to be collateral based lending with loan amounts based on predetermined loan to collateral values, where liquidation of the underlying real estate collateral is viewed as the primary source of repayment if the borrower defaults. Although our commercial business loans are often collateralized by real estate, the decision to grant a commercial business loan depends primarily on the creditworthiness and cash flow of the borrower (and any guarantors), while liquidation of collateral is a secondary source of repayment.

As of December 31, 2003, we had $266.3 million, or 51.1% of our total loans receivable, in commercial loans. The average loan size is approximately $225,000 with loans generally in amounts of $1,000,000 or less.

Origination and Sales of Loans

We originate real estate and other loans with approximately two-thirds of the residential mortgage volumes generated from our mortgage loan origination offices. Walk-in customers and referrals from real estate brokers are important sources of loan originations.

Consistent with our asset/liability management strategy, we sell a majority of our fixed rate and ARM residential mortgage loans to the secondary market. Commitments to sell mortgage loans generally are made during the period between the taking of the loan application and the closing of the mortgage loan. The timing for making these sale commitments is dependent upon the timing of the borrower’s election to lock-in the mortgage interest rate and fees prior to loan closing. Most of these sale commitments are made on a “best efforts” basis whereby we are only obligated to sell the mortgage if the mortgage loan is approved and closed. As a result, management believes that market risk is minimal. In addition, we have a small amount of mortgage loan production, which is brokered to other lenders prior to funding.

When we sell mortgage loans, we typically sell the servicing of the loans (i.e., collection of principal and interest payments). However, we serviced $2.0 million, $3.9 million, and $6.3 million in mortgage loans for others as of December 31, 2003, 2002, and 2001, respectively. We received fee income for servicing activities on mortgage loans of $14,000, $19,000, and $22,000 for the years ended December 31, 2003, 2002, and 2001, respectively.

The following table presents summary information concerning our origination and sale of residential mortgage loans and the gains achieved on such activities.


	Years ended December 31,
	2003		2002		2001		2000		1999
	(Dollars in thousands)
One- to four-family residential mortgage loans:
Originated	$	125,438	$	91,614	$	103,634	$	55,630	$	78,248
Sold		105,790		74,318		97,807		35,876		58,266
Gains on sales of loans, net	$	1,907	$	1,404	$	1,669	$	684	$	1,079

Commitments and Contingent Liabilities

In the ordinary course of business, we enter into various types of transactions that include commitments to extend credit that are not included in our consolidated financial statements. We apply the same credit standards to these commitments as we use in all our lending activities and have included these commitments in our lending risk evaluations. Our exposure to credit loss under commitments to extend credit is represented by the amount of these commitments. At December 31, 2003, we had outstanding commitments to extend credit, including letters of credit, in the amount of $106.5 million.

Delinquencies and Nonperforming Assets

Delinquency Procedures. We send a borrower a delinquency notice 15 days after the due date when the borrower fails to make a required payment on a loan. If the delinquency is not brought current, additional delinquency notices are mailed at 30 and 45 days for commercial loans. Additional written and oral contacts are made with the borrower between 60 and 90 days after the due date.

If a real estate loan payment is past due for 45 days or more, the Collection Manager may perform a review of the condition of the property if suspect. We may negotiate and accept a repayment program with the borrower, accept a voluntary deed in lieu of foreclosure or, when considered necessary, begin foreclosure proceedings. If foreclosed on, real property is sold at a public sale and we bid on the property to protect our interest. A decision as to whether and when to begin foreclosure proceedings is based on such factors as the amount of the outstanding loan in relation to the value of the property securing the original indebtedness, the extent of the delinquency, and the borrower’s ability and willingness to cooperate in resolving the delinquency.

Real estate acquired by us is classified as real estate owned until it is sold. When property is acquired, it is recorded at the lower of cost or estimated fair value at the date of acquisition, not to exceed net realizable value, and any resulting write-down is charged to the allowance for loan losses. Upon acquisition, all costs incurred in maintaining the property are expensed. Costs relating to the development and improvement of the property, however, are capitalized to the extent of the property’s net realizable value.

We consider loans as an in-substance foreclosure if the borrower has little or no equity in the property based upon its estimated fair value, repayment can be expected only from operation or sale of the collateral, the borrower has effectively abandoned control of the collateral, or it is doubtful the borrower will be able to repay the loan in the foreseeable future because of the borrower’s current financial status. In substance foreclosures are accounted for as if the properties were held as other real estate.

Delinquencies in the commercial business loan portfolio are handled on a case-by-case basis. Generally, notices are sent and personal contact is made with the borrower when the loan is 15 days past due. Loan officers are responsible for collecting loans they originate or which are assigned to them. Depending on the nature of the loan and the type of collateral securing the loan, we may negotiate and accept a modified payment program or take other actions as circumstances warrant.

Classification of Assets. Federal regulations require that our banks periodically evaluate the risk inherent in their loan portfolio. In addition, the Division of Banks of the Washington State Department of Financial Institutions (“Division”), the Office of the Comptroller of the Currency (“OCC”), and the FDIC have authority to identify problem assets and, if appropriate, require them to be classified by risk. There are three classifications for problem assets: Substandard, Doubtful, and Loss. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of Substandard assets, with the additional characteristics that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values questionable. There is a high possibility of loss in assets classified as Doubtful. An asset classified as Loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. If an asset or a portion of the asset is classified as Loss, the institution must charge off this amount. We also have assets we classify as watch and other assets especially mentioned (OAEM). Assets classified as watch are performing assets but have elements of risk that require more monitoring than other performing assets. Assets classified as OAEM are assets that continue to perform but have shown deterioration in credit quality and require close monitoring.

Nonperforming Assets. Nonperforming assets consist of nonaccrual loans, restructured loans, and real estate owned. The following table provides information about our nonaccrual loans, restructured loans, and real estate owned for the indicated dates.


	At December 31,
	2003			2002			2001			2000			1999
	(Dollars in thousands)
Nonaccrual loans	$	297		$	1,987		$	1,962		$	1,607		$	1,804
Restructured loans		—			—			—			—			—

Total nonperforming loans		297			1,987			1,962			1,607			1,804
Real estate and other assets owned		389			296			1,053			—			—

Total nonperforming assets	$	686		$	2,283		$	3,015		$	1,607		$	1,804

Accruing loans past due 90 days or more	$	19		$	19		$	306		$	1,086		$	—
Potential problem loans		10,502			11,261			4,631			2,422			2,826
Allowance for loan losses		7,748			6,874			5,751			5,063			4,264
Nonperforming loans to loans		0.06	%		0.42	%		0.39	%		0.33	%		0.43	%
Allowance for loan losses to loans		1.49	%		1.46	%		1.15	%		1.05	%		1.02	%
Allowance for loan losses to nonperforming loans		2,611.97	%		346.05	%		293.12	%		315.02	%		236.27	%
Nonperforming assets to total assets		0.11	%		0.38	%		0.49	%		0.28	%		0.35	%

Nonaccrual Loans. Our financial statements are prepared on the accrual basis of accounting, including the recognition of interest income on our loan portfolio, unless a loan is placed on nonaccrual. Loans are considered to be impaired and are placed on nonaccrual when there are serious doubts about the collectibility of principal or interest. Our policy is to place a loan on nonaccrual when the loan becomes past due for 90 days or more, is less than fully collateralized, and is not in the process of collection. Amounts received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected.

Interest foregone (recovered) on nonaccrual loans was $37,233, $(29,986) and $173,371 for the years ended December 31, 2003, 2002, and 2001, respectively.

Real estate and other assets owned at December 31, 2003 was $559,662. However, only $388,888 of this balance was reported as a nonperforming asset with the difference guaranteed by the Small Business Administration.

Potential Problem Loans. Potential problem loans are those loans that are currently accruing interest, but which are considered possible credit problems because financial information of the borrowers causes us concerns

as to their ability to comply with the present repayment program and may result in placing the loan on nonaccrual. As of December 31, 2003 potential problem loans decreased by $759,000 to $10.5 million from $11.3 million at December 31, 2002.

Analysis of Allowance for Loan Losses

Management maintains an allowance for loan losses to absorb estimated credit losses associated with the loan portfolio, including all binding commitments to lend. We determine an adequate allowance through our ongoing quarterly loan quality assessments.

We assess the estimated credit losses inherent in our non-classified loan portfolio by considering a number of elements including:

• Levels and trends in delinquencies and nonaccruals;

• Trends in loan demand and structure including terms and interest rates;

• National and local economic trends;

• Specific industry conditions such as commercial and residential construction;

• Concentrations of credits in specific industries;

• Bank regulatory examination results and our own credit examinations; and

• Recent loss experience in the portfolio.

We calculate an adequate allowance for the non-classified portion of our loan portfolio based on an appropriate percentage risk factor that is calculated based on the above-noted elements and trends. We add specific provisions for each classified loan after a careful analysis of that loan’s credit and collateral factors. Our analysis of an adequate allowance combines the provisions made for both our non-classified loans and the specific provisions made for each classified loan.

We determine our provision expense for the next quarter by applying the same percentage risk factor applied to the non-classified loan portfolio to our expected loan growth. We determine our monthly provision expense by dividing our estimate of provision expense for the quarter by three.

The allowance for loan losses has increased over the past several years reflecting a period of strong loan growth and changes in our loan portfolio composition. Our commercial loan portfolio now makes up approximately half of our loan portfolio, while other less risky categories, such as the residential mortgage portfolio, have declined as a percentage of the total portfolio. We expect our allowance for loan losses to continue to increase commensurate with the growth in our loan portfolio and changes in composition.

While we believe we use the best information available to determine the allowance for loan losses, net income could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance, unforeseen market conditions arise or if we are directed to make adjustments to the allowance for loan losses by our regulators.

The following table provides information regarding changes in our allowance for loan losses for the indicated periods:


	Years Ended December 31,
	2003			2002			2001			2000			1999
	(Dollars in thousands)
Total loans outstanding at end of period(1)	$	521,413		$	470,264		$	498,705		$	482,435		$	417,762

Average loans outstanding during period	$	481,404		$	472,785		$	494,379		$	445,813		$	361,116

Allowance balance at beginning of period	$	6,874		$	5,751		$	5,063		$	4,264		$	3,957
Provision for loan losses		1,125			1,835			1,193			787			408
Charge-offs:
Real estate(2)		(138	)		(69	)		(407	)		(4	)		(120	)
Commercial		(102	)		(657	)		(88	)		(34	)		(117	)
Consumer		(19	)		(7	)		(12	)		(2	)		(10	)

Total charge-offs		(259	)		(733	)		(507	)		(40	)		(247	)

Recoveries:
Real estate(2)		3			1			1			22			113
Commercial		4			20			—			29			32
Consumer		1			—			1			1			1

Total recoveries		8			21			2			52			146

Net (charge-offs) recoveries		(251	)		(712	)		(505	)		12			(101	)

Allowance balance at end of period	$	7,748		$	6,874		$	5,751		$	5,063		$	4,264

Ratio of net (charge-offs) recoveries during period to average loans outstanding		(0.05	)%		(0.15	)%		(0.10	)%		—	%		(0.03	)%

(1)

Includes loans held for sale

(2)

During the periods shown, the charge-offs and recoveries shown under the Real Estate category relate to real estate mortgages and in some periods real estate construction loans were included in this category.

The following table shows the allocation of the allowance for loan losses for the indicated periods. The allocation is based upon an evaluation of defined loan problems, historical loan loss ratios, and industry wide and other factors that may affect future loan losses in the categories shown below:


	At December 31,
	2003				2002				2001				2000				1999
	Amount		% of Total Loans (1)		Amount		% of Total Loans (1)		Amount		% of Total Loans (1)		Amount		% of Total Loans (1)		Amount		% of Total Loans (1)
	(Dollars in thousands)
Commercial	$	5,578	51.0	%	$	4,949	51.8	%	$	4,141	52.7	%	$	3,644	45.8	%	$	3,070	39.2	%
Real Estate Mortgage
One-four family residential		305	11.0	%		271	15.4	%		227	18.1	%		200	23.3	%		168	29.6	%
Five or more family residential and commercial properties		1,310	28.7	%		1,162	24.4	%		972	21.5	%		856	22.5	%		721	21.3	%
Real Estate Construction:
One-four family residential		419	3.7	%		370	6.2	%		310	6.5	%		274	5.6	%		145	8.1	%
Five or more family residential and commercial properties		31	3.8	%		28	0.6	%		23	—			20	1.8	%		17	0.6	%
Consumer		105	1.8	%		94	1.6	%		78	1.2	%		69	1.0	%		58	1.2	%
Unallocated		—				—				—				—				85

Net loans	$	7,748	100.0	%	$	6,874	100.0	%	$	5,751	100.0	%	$	5,063	100.0	%	$	4,264	100.0	%

(1)

Represents the total of all outstanding loans in each category as a percent of total loans outstanding.

Investment Activities

At December 31, 2003, our investment securities portfolio totaled $57.8 million, which consisted of $55.6 million of securities available for sale and $2.2 million of securities held to maturity. This compares with a total portfolio of $51.0 million at December 31, 2002, which was comprised of $48.2 million of securities available for sale and $2.8 million of securities held to maturity. The composition of the two investment portfolios by type of security, at each respective date, is presented in financial statement Notes 4 and 5.

Our investment policy is established by the board of directors and monitored by the Audit and Finance Committee of the Board of Directors. It is designed primarily to provide and maintain liquidity, generate a favorable return on investments without incurring undue interest rate and credit risk, and compliments our bank’s lending activities. The policy dictates the criteria for classifying securities as either available for sale or held for investment. The policy permits investment in various types of liquid assets permissible under applicable regulations, which include U.S. Treasury obligations, U.S. Government agency obligations, some certificates of deposit of insured banks, mortgage backed and mortgage related securities, some corporate notes, municipal bonds, FHLB stock, and federal funds. Investment in non-investment grade bonds, structured notes, and stripped mortgage backed securities are not permitted under the policy.

The following table provides information regarding our investment securities available for sale at December 31, 2003.


	Book Value		Fair Value		Weighted Average Yield (1)
	(Dollars in thousands)
Obligations of US Government agencies
Due within one year	$	20,916	$	20,924	3.52	%
Due after 1 year but within 5 years		4,885		4,885	3.55
Due after 5 years but within 10 years		1,368		1,549	5.08

		27,169		27,358

Mortgage backed securities
Due within one year		10,000		9,946	2.19
Due after 5 years but within 10 years		1,084		1,093	3.22
Due after 10 years		2,351		2,420	5.38

		13,435		13,459

Collateralized mortgage obligations
Due after 5 years but within 10 years		453		456	3.55
Due after 10 years		14,481		14,328	4.09

		14,934		14,784

Total all investments available for sale	$	55,538	$	55,601

The following table provides information regarding our investment securities held to maturity at December 31, 2003.


	Book Value		Fair Value		Weighted Average Yield (1)
	(Dollars in thousands)
Municipal bonds
Due within one year	$	505	$	520	6.56	%
Due after 1 year but within 5 years		1,025		1,094	6.28
Due after 5 years but within 10 years		—		—	—

		1,530		1,614

Mortgage backed securities
Due within one year		30		30	3.32
Due after 1 year but within 5 years		65		69	8.26
Due after 5 years but within 10 years		9		9	8.74
Due after 10 years		517		567	8.16

		621		675

Total all investments held to maturity	$	2,151	$	2,289

(1)

Taxable equivalent weighted average yield.

We held $2.9 million of FHLB stock at December 31, 2003. The stock has no contractual maturity and amounts in excess of the required minimum for FHLB membership may be redeemed at par. At December 31, 2003, we were required to maintain an investment in the stock of the FHLB of Seattle of at least $2.0 million.

Deposit Activities and Other Sources of Funds

General. Our primary sources of funds are deposits, loan repayments and borrowings. Scheduled loan repayments are a relatively stable source of funds, while deposits and unscheduled loan prepayments, which are influenced significantly by general interest rate levels, interest rates available on other investments, competition, economic conditions, and other factors are not. Our deposit balances increased by $24.7 million in 2003 over the prior year, with the deposit mix shifting from certificate of deposits to non-interest and low interest bearing accounts. Customer deposits remain an important source of funding, but these balances have been influenced in the past by adverse market changes in the industry and may be affected by future developments such as interest rate fluctuations and new competitive pressures. Borrowings may be used on a short-term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels). Borrowings may also be used on a longer-term basis to support expanded lending activities and match the maturity of repricing intervals of assets.

Deposit Activities. We offer a variety of deposit accounts designed to attract both short-term and long-term deposits. These accounts include certificates of deposit (“CDs”), regular savings accounts, money market accounts, checking and negotiable order of withdrawal (“NOW”) accounts, and individual retirement accounts (“IRAs”). These accounts generally earn interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. At December 31, 2003, we had no brokered deposits. The more significant deposit accounts are described below.

Certificates of Deposit. We offer several types of CDs with maturities ranging from one to five years, which require a minimum deposit of $100. In addition, we offer a CD that has a maturity of three to eleven months and a minimum deposit of $2,500, and permits additional deposits at the initial rate throughout the CD term. Interest is compounded daily and credited quarterly or at maturity. Finally, negotiable CDs are offered in amounts of $100,000 or more for terms of 30 days to 12 months. The negotiable CDs pay simple interest credited at maturity.

Regular Savings Accounts. We offer savings accounts that allow for unlimited deposits and withdrawals, provided that a $100 minimum balance is maintained. Interest is compounded daily and credited quarterly.

Money Market Accounts. Money market accounts pay a variable interest rate that is tiered depending on the balance maintained in the account. Minimum opening balances vary. Interest is compounded daily and paid monthly.

Checking and NOW Accounts. Checking and NOW accounts are non-interest and interest bearing, and may be charged service fees based on activity and balances. NOW accounts pay interest, but require a higher minimum balance to avoid service charges.

Individual Retirement Accounts. IRAs permit annual contributions regulated by law and pay interest at fixed rates. Maturities are available from one to five years, and interest is compounded daily and credited quarterly.

Sources of Funds

Deposit Activities. The following table provides the average balances outstanding and the weighted average interest rates for each major category of deposits for the years ended December 31,:


	2003				2002				2001
	Average Balance		Average Rate Paid		Average Balance		Average Rate Paid		Average Balance		Average Rate Paid
	(Dollars in Thousands)
Interest bearing demand and money market accounts	$	154,420	0.82	%	$	143,617	1.20	%	$	126,302	2.07	%
Savings		97,352	1.17			88,775	1.72			61,190	3.50
Certificates of deposit		202,141	2.36			222,997	3.07			244,369	5.24

Total interest bearing deposits		453,913	1.58			455,389	2.22			431,861	4.06
Demand and other noninterest bearing deposits		63,890	—			55,712	—			47,455	—

Total deposits	$	517,803	1.38	%	$	511,101	1.98	%	$	479,316	3.66	%

The following table provides the change in the balances of deposits during the year and the impact of credited interest on those deposits for the years ended December 31,:


	2003			2002			2001
	(Dollars in thousands)
Net increase in deposits	$	24,716		$	2,036		$	54,846
Less: Interest credited		(7,166	)		(10,146	)		(18,126	)

Net increase (decrease) before interest credited.	$	17,550		$	(8,110	)	$	36,720

The following table shows the amount and maturity of certificates of deposits of $100,000 or more as of December 31, 2003:


	(Dollars in thousands)
Remaining maturity:
Three months or less	$	2,196
Over three months through six months		2,822
Over six months through twelve months		47,588
Over twelve months		36,236

Total	$	88,842

Borrowings. Deposits are the primary source of funds for our lending and investment activities, and our general business purposes. We rely upon advances from the FHLB of Seattle to supplement our supply of lendable funds and meet deposit withdrawal requirements. The FHLB of Seattle has served as one of our secondary sources of liquidity. Advances from the FHLB of Seattle are typically secured by our first mortgage loans and stock issued by the FHLB of Seattle, which is owned by us. Our subsidiary banks also have lines to purchase federal funds up to $29.7 million. In addition, Heritage Bank maintains a $5.0 million line to support letters of credit. We also maintain a line of credit of $5.0 million with Key Bank to supplement any cash needs not covered by dividends from the banks or earnings from investments.

The FHLB functions as a central reserve bank providing credit for member financial institutions. As members, we are required to own capital stock in the FHLB and are authorized to apply for advances on the

security of such stock and certain of our mortgage loans and other assets (principally securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met. Advances are made pursuant to several different programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based either on a fixed percentage of an institution’s net worth or on the FHLB’s assessment of the institution’s creditworthiness. Under its current credit policies, the FHLB of Seattle limits advances to 20% of assets for Heritage Bank and 10% of assets for Central Valley Bank.

The following table is a summary of FHLB advances for the years ended December 31,:


	2003			2002			2001
	(Dollars in thousands)
Balance at period end	$	31,100		$	—		$	8,000
Average balance during the period		7,306			1,167			17,924
Maximum amount outstanding at any month end		31,100			6,000			33,300
Average interest rate:
During the period		1.21	%		4.83	%		5.33	%
At period end		1.10	%		0	%		5.01	%

We maintain a line of credit with Key Bank for short-term corporate funding needs. The following table is a summary of usage on the Key Bank line of credit for the years ended December 31,:


	2003			2002			2001
	(Dollars in thousands)
Balance at period end	$	—		$	—		$	—
Average balance during the period		735			827			118
Maximum amount outstanding at any month end		4,127			3,607			168
Average interest rate:
During the period		4.10	%		4.58	%		7.12	%
At period end		0	%		0	%		0	%

The following table is a summary of fed funds purchased for the years ended December 31,:


	2003			2002			2001
	(Dollars in thousands)
Balance at period end	$	—		$	—		$	—
Average balance during the period		—			—			82
Maximum amount outstanding at any month end		—			—			175
Average interest rate:
During the period		—	%		—	%		6.52	%
At period end		—	%		—	%		0	%

Supervision and Regulation

We are subject to extensive federal and Washington state legislation, regulation, and supervision. These laws and regulations are primarily intended to protect depositors and the FDIC rather than stockholders. The laws and regulations affecting banks and bank holding companies have changed significantly over recent years, and it is reasonable to expect that similar changes will continue in the future. Any change in applicable laws, regulations, or regulatory policies may have a material effect on our business, operations, and prospects. We cannot predict the nature or the extent of the effects on our business and earnings that any fiscal or monetary policies or new federal or state legislation may have in the future.

The following information is qualified in its entirety by reference to the particular statutory and regulatory provisions described.

Heritage Financial. We are subject to regulation as a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended, and are supervised by the Federal Reserve. The Federal Reserve has the authority to order bank holding companies to cease and desist from unsound practices and violations of conditions imposed on it. The Federal Reserve is also empowered to assess civil money penalties against companies and individuals who violate the Bank Holding Company Act or orders or regulations there under in amounts up to $1.0 million per day. The Federal Reserve may order termination of non-banking activities by non-banking subsidiaries of bank holding companies, or divestiture of ownership and control of a non-banking subsidiary by a bank holding company. Some violations may also result in criminal penalties. The FDIC and OCC are authorized to exercise comparable authority under the Federal Deposit Insurance Act, the National Bank Act, and other statutes for state nonmember banks such as Heritage Bank or national banks such as Central Valley Bank.

The Federal Reserve has a policy that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, the Federal Reserve provides that bank holding companies should serve as a source of strength to its subsidiary banks by being prepared to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity, and should maintain the financial flexibility and capital raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company’s failure to meet its obligation to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve’s regulations or both. The Federal Deposit Insurance Act requires an undercapitalized institution to send to the Federal Reserve a capital restoration plan with a guaranty by each company having control of the bank’s compliance with the plan.

We are required to file an annual report and periodic reports with the Federal Reserve and provide additional information as the Federal Reserve may require. The Federal Reserve may examine us, and any of our subsidiaries, and charge us for the cost of the examination.

We, and any subsidiaries which we may control, are considered “affiliates” within the meaning of the Federal Reserve Act, and transactions between our bank subsidiaries and affiliates are subject to numerous restrictions. With some exceptions, we, and our subsidiaries are prohibited from tying the provision of various services, such as extensions of credit, to other services offered by us, or our affiliates.

Bank regulations require bank holding companies and banks to maintain a minimum “leverage” ratio of core capital to adjusted quarterly average total assets of at least 3%. In addition, banking regulators have adopted risk-based capital guidelines under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Tier I capital generally consists of common stockholders’ equity (which does not include unrealized gains and losses on securities), less goodwill and certain identifiable intangible assets. Tier II capital includes Tier I capital plus the allowance for loan losses and subordinated debt, both subject to some limitations. Regulatory risk-based capital guidelines require Tier I capital of 4% of risk-adjusted assets and minimum total capital ratio (combined Tier I and Tier II) of 8% of risk-adjusted assets.

Subsidiaries. Heritage Bank is a Washington state-chartered savings bank, the deposits of which are insured by the FDIC. Heritage Bank is subject to regulation by the FDIC and the Division of Banks of the Washington Department of Financial Institutions (“Division”). Central Valley Bank is a national bank chartered by the Office of the Comptroller of the Currency (“OCC”) and insured by the FDIC. In addition, Central Valley Bank is a member of the Federal Reserve System. Although Heritage Bank is not a member of the Federal Reserve System, the Federal Reserve has supervisory authority over us and our subsidiary banks.

Among other things, applicable federal and state statutes and regulations which govern a bank’s operations relate to minimum capital requirements, required reserves against deposits, investments, loans, legal lending limits, mergers and consolidation, borrowings, issuance of securities, payment of dividends, establishment of branches, and other aspects of its operations. The Division, the OCC, and the FDIC also have authority to prohibit banks under their supervision from engaging in what they consider to be unsafe and unsound practices.

The banks are required to file periodic reports with the FDIC, the Division, and the OCC, and are subject to periodic examinations and evaluations by those regulatory authorities. Based upon these evaluations, the regulators may revalue the assets of an institution and require that it establish specific reserves to compensate for the differences between the regulator-determined value and the book value of such assets. These examinations must be conducted every 12 months, except that well-capitalized banks may be examined every 18 months. The FDIC and the Division may each accept the results of an examination by the other in lieu of conducting an independent examination.

As subsidiaries of a bank holding company, our banks are subject to various restrictions in their dealings with us and other companies that may become affiliated with us.

Dividends paid by our subsidiaries provide substantially all of our cash flow. Applicable federal and Washington state regulations restrict capital distributions by our banks, including dividends. Such restrictions are tied to the institution’s capital levels after giving effect to such distributions. The FDIC and OCC have established the qualifications necessary for a “well-capitalized” bank, which affects FDIC risk-based insurance premium rates. To qualify as “well-capitalized”, banks must have a Tier I risk-adjusted capital ratio of at least 6%, a total risk-adjusted capital ratio of at least 10%, and a leverage ratio of at least 5%. Both Heritage Bank and Central Valley Bank were “well-capitalized” at December 31, 2003.

Federal laws generally bar institutions, which are not well capitalized, from accepting brokered deposits. The FDIC has issued rules, which prohibit under-capitalized institutions from soliciting or accepting brokered deposits. Adequately capitalized institutions are allowed to solicit brokered deposits, but only to accept them if a waiver is obtained from the FDIC.

Deposit Insurance. Heritage Bank’s deposit accounts are insured by the FDIC under the SAIF to the maximum extent permitted by law. Central Valley Bank is insured by the FDIC under the BIF to the maximum extent permitted by law. Each bank pays deposit insurance premiums to the FDIC based on a risk-based assessment system established by the FDIC for all member institutions. Under applicable regulations, institutions are assigned to one of three capital groups that are based solely on the level of an institution’s capital (“well capitalized”, “adequately capitalized” or “undercapitalized”), which are defined in the same manner as the regulations establishing the prompt corrective action system under the FDIC as described above. The matrix so created results in nine assessment risk classifications.

Pursuant to recent changes in federal law, the FDIC imposed a special assessment on each depository institution with SAIF-assessable deposits, which resulted in the SAIF achieving its designated reserve ratio. In addition, the FDIC reduced the assessment schedule for SAIF members, effective January 1, 1997, to a range of 0% to 0.27%, with most institutions, including Heritage Bank, paying 0%. This assessment schedule is the same as that for the BIF, which reached its designated reserve ratio in 1995. In addition, since January 1, 1997, SAIF members are charged an assessment of approximately 0.06% of SAIF-assessable deposits for the purpose of paying interest on the bonds issued by the Financing Corporation in the 1980s to help fund the thrift industry cleanup. BIF-assessable deposits will be charged an assessment to help pay interest on the bonds at a rate of approximately ..013% until the earlier of December 31, 1999 or the date upon which the last savings association ceases to exist, after which time the assessment will be the same for all insured deposits. Recent legislative changes provided for the merger of the BIF and SAIF into the Deposit Insurance Fund on January 1, 1999, but only if no insured depository institutions were savings associations on that date. This merger did not occur.

Other Regulatory Developments. Congress has enacted significant federal banking legislation in recent years. The following summarizes some of the recent significant federal banking legislation.

Financial Services Reform Legislation. On November 12, 1999, the Gramm-Leach-Bliley Act (“GLBA”) was enacted into law. The GLBA removes various barriers imposed by the Glass-Steagall Act of 1933, specifically those prohibiting banks and bank holding companies from engaging in the securities and insurance business. The GLBA also expands the bank holding company act framework to permit bank holding companies with subsidiary banks meeting certain capital and management requirements to elect to become a “financial holding company”.

Beginning March 2000, financial holding companies may engage in a full range of financial activities, including not only banking, insurance, and securities activities, but also merchant banking and additional activities determined to be “financial in nature” or “complementary” to an activity that is financial in nature. The GLBA also provides that the list of permissible financial activities will be expanded as necessary for a financial holding company to keep abreast of competitive and technological changes.

The GLBA also expands the activities in which insured state banks may engage. Under the GLBA, insured state banks are given the ability to engage in financial activities through a subsidiary, as long as the bank and its bank affiliates meet and comply with certain requirements. First, the state bank and each of its bank affiliates must be “well capitalized”. Second, the bank must comply with certain capital deduction and financial statement requirements provided under the GLBA. Third, the bank must comply with certain financial and operational safeguards provided under the GLBA. Fourth, the bank must comply with the limits imposed by the GLBA on transactions with affiliates.

Although the GLBA preserves the Federal Reserve as the umbrella supervisor of financial holding companies, it adopts an administrative approach to regulation that defers to the action and paperwork requirements of the “functional” regulators of insurers, broker-dealers, investment companies, and banks. Thus, the various state and federal regulators of a financial holding company’s operating subsidiaries would retain their jurisdiction and authority over those operating entities. As the umbrella supervisor, however, the Federal Reserve has the potential to affect the operations and activities of a financial holding company’s subsidiaries through its power over the financial holding company parent. In addition, the GLBA contains numerous trigger points related to legal non-compliance and other serious problems affecting bank affiliates that could lead to direct Federal Reserve involvement and the possible exercise of remedial authority affecting both financial holding companies and their affiliated operating companies.

USA Patriot Act. On October 26, 2001, President George W. Bush signed into law the USA Patriot Act (“Patriot Act”). Title III of the Patriot Act concerns money laundering provisions that may affect many community banks. These provisions include:

•

The Secretary of the Treasury is authorized to impose special measures, such as recordkeeping or reporting, on domestic financial institutions that are a primary concern;

•

Financial institutions with private or correspondent accounts with non-U.S. citizens must establish policies and procedures to detect money laundering through those accounts;

•

Financial institutions are barred from maintaining correspondent accounts for foreign shell banks (that is a bank that does not have a physical presence in any county);

•

The Secretary of the Treasury is required to prescribe regulations to further encourage cooperation among financial institutions, regulators, and law enforcement agencies and officials to share information about terrorist acts and money laundering activities;

•

The Secretary of the Treasury is required to issue regulations to establish minimum procedures for financial institutions to use in verifying customer identity during the account-opening process;

•

Depository institutions are permitted to provide information to other institutions concerning the possible involvement in potentially unlawful activity by a current or former employee;

•

The Secretary of the Treasury is required to establish a secure website to receive suspicious activity reports and currency transaction reports, and provide institutions with alerts and other information regarding suspicious activity that warrant immediate attention; and

•

The federal bank regulators are required to consider the anti-money laundering record of each depository institution in evaluating applications under the Bank Merger Act.

Sarbanes-Oxley Act. On July 31, 2002, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act implements a broad range of corporate governance and accounting measures for public companies designed to promote honesty and transparency in corporate America and better protect investors from the type of corporate wrongdoing that occurred in Enron, WorldCom, and similar companies. The Sarbanes-Oxley Act’s principal legislation includes:

•

The creation of an independent accounting oversight board;

•

Auditor independence provisions that restrict non-audit services accountants may provide to their audit clients;

•

Additional corporate governance and responsibility measures, including the requirement that the chief executive officer and the chief financial officer certify financial statements and the expansion of powers of audit committees;

•

Expanded disclosure requirements, including accelerated reporting of stock transactions by insiders;

•

Mandatory disclosure by analysts of potential conflicts of interest; and

•

A range of enhanced penalties for fraud and other violations.

Website Access to Company Reports

We post publicly available reports required to be filed with the SEC on our website, www.HF-WA.com, as soon as reasonably practicable after filing such reports with the SEC. The required reports are available free of charge through our website.

Executive Officers

During 2003, we adopted a code of ethics that applies to our principal executive officer, principal financial officer, controller and assistant controller. We intend to post the text of our code of ethics at www.HF-WA.com in the section titled Investor Relations. Any waivers of the code of the ethics will be publicly disclosed to shareholders.

Audit Committee of the Board of Directors

The audit committee of our board of directors retains our independent auditors, reviews and approves the scope and results of the audits with the auditors and management, monitors the adequacy of our system of internal controls and reviews the annual report, auditors’ fees and non-audit services to be provided by the independent auditors. The members of our audit committee are Daryl D. Jensen, chair of the committee, Philip S. Weigand, Brian Charneski, Jeffrey Lyon and Peter Fleutsch. Our board of directors has determined that Mr. Jensen meets the definition of an audit committee financial expert, as determined by the requirements of the SEC.

Competition

We compete for loans and deposits with other thrifts, commercial banks, credit unions, mortgage bankers, and other institutions in the scope and type of services offered, interest rates paid on deposits, pricing of loans, and number and locations of branches, among other things. Many of our competitors have substantially greater resources than we do. Particularly in times of high or rising interest rates, we also face significant competition for investors’ funds from short-term money market securities and other corporate and government securities.

We compete for loans principally through the range and quality of the services we provide, interest rates and loan fees, and the locations of our banks’ branches. We actively solicit deposit-related clients and compete for deposits by offering depositors a variety of savings accounts, checking accounts, cash management and other services.

Employees

At December 31, 2003, we had 206 full-time equivalent employees. We believe that employees play a vital role in the success of a service company. Employees are provided with a variety of benefits such as medical, vision, dental and life insurance, a generous retirement plan, and paid vacations and sick leave. None of our employees are covered by a collective bargaining agreement.

ITEM 2. PROPERTIES

Our executive offices and the main office of Heritage Bank are located in approximately 22,000 square feet of the headquarters building and adjacent office space which are owned and located in downtown Olympia. At December 31, 2003, Heritage Bank had six offices located in Tacoma and surrounding areas of Pierce County, (all but one of which are owned) five offices located in Thurston County (all of which are owned with one office located on leased land), and one office in Shelton, Mason County (which is owned). Central Valley Bank had six offices, five located in Yakima County and one in Kittitas County (all of which are owned with two on leased land).

ITEM 3. LEGAL PROCEEDINGS

We, and our banks, are not a party to any material pending legal proceedings other than ordinary routine litigation incidental to the business of the Bank.

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

No matters were submitted to a vote of security holders in the fourth quarter of 2003.

PART II

ITEM 5.

MARKET FOR THE REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock is traded on the NASDAQ National Market System^{^®} under the symbol HFWA. At December 31, 2003, we had approximately 1,300 stockholders of record (not including the number of persons or entities holding stock in nominee or street name through various brokerage firms) and 6,192,996 outstanding shares of common stock. The last reported sales price on February 6, 2004 was $21.96 per share. The following table provides bid information per share of our common stock as reported on the NASDAQ National Market System^{^®} for the indicated quarters.


	2003 Quarter ended:
	March 31		June 30		September 30		December 31
High	$	22.98	$	24.47	$	22.26	$	23.00
Low	$	17.41	$	21.16	$	20.74	$	21.10


	2002 Quarter ended:
	March 31		June 30		September 30		December 31
High	$	14.15	$	15.95	$	16.39	$	17.57
Low	$	11.65	$	13.20	$	14.45	$	16.01

Since our stock offering in January 1998, we have declared the following quarterly cash dividends:


Declared	Cash Dividend per share		Record Date	Paid
March 24, 1998	$	0.035	April 6, 1998	April 15, 1998
June 23, 1998	$	0.040	July 6, 1998	July 15, 1998
September 18, 1998	$	0.045	October 6, 1998	October 15, 1998
December 17, 1998	$	0.050	January 15, 1999	January 25, 1999
March 25, 1999	$	0.055	April 15, 1999	April 26, 1999
June 18, 1999	$	0.060	July 15, 1999	July 27, 1999
September 17, 1999	$	0.065	October 15, 1999	October 27, 1999
December 16, 1999	$	0.070	January 14, 2000	January 27, 2000
March 17, 2000	$	0.075	April 14, 2000	April 28, 2000
June 16, 2000	$	0.080	July 14, 2000	July 28, 2000
September 21, 2000	$	0.085	October 16, 2000	October 27, 2000
December 22, 2000	$	0.090	January 19, 2001	January 31, 2001
March 27, 2001	$	0.095	April 16, 2001	April 27, 2001
June 26, 2001	$	0.100	July 16, 2001	July 25, 2001
September 28, 2001	$	0.105	October 15, 2001	October 29, 2001
December 19, 2001	$	0.110	January 15, 2003	January 30, 2003
March 19, 2002	$	0.115	April 15, 2003	April 29, 2003
June 25, 2002	$	0.120	July 15, 2003	July 26, 2003
September 23, 2002	$	0.125	October 15, 2003	October 29, 2003
December 19, 2002	$	0.130	January 15, 2003	January 30, 2003
March 20, 2003	$	0.135	April 15, 2003	April 29, 2003
June 25, 2003	$	0.140	July 15, 2003	July 28, 2003
September 24, 2003	$	0.145	October 15, 2003	October 27, 2003
December 19, 2003	$	0.150	January 15, 2004	January 30, 2004

Dividends to shareholders depend primarily upon the receipt of dividends from our subsidiary banks. The FDIC and the Division have the authority under their supervisory powers to prohibit the payment of dividends by

Heritage Bank to us. For a period of ten years after the conversion from mutual to stock ownership, Heritage Bank may not, without prior approval of the Division, declare or pay a cash dividend in excess of one-half of the greater of the Bank’s net income for the current fiscal year or the average of the Bank’s net income for the current fiscal year, and the retained earnings of the two prior fiscal years. In addition, Heritage Bank may not declare or pay a cash dividend on its common stock if the effect of the dividend would be to reduce the Bank’s net worth below the amount required for the liquidation account. For Central Valley Bank, the approval of the OCC is required if the total of all dividends declared by Central Valley Bank in any calendar year exceeds the total of its net income of that year combined with its retained net income of the preceding two years, less any required transfer of surplus or fund for the retirement of any preferred stock. Other than the specific restrictions mentioned above, current regulations allow us, and our subsidiary banks to pay dividends on our common stock if our or our banks’ regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve, the OCC, and the FDIC.

The Company measures its employee stock-based compensation arrangements using the provisions outlined in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, which is an intrinsic value-based method of recognizing compensation costs. The Company has adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-based Compensation. Most of the Company’s stock options do not have any intrinsic value at grant date, therefore no compensation cost has been recognized for its stock option plan activity. However, during 2003 compensation expense was recognized for restricted stock awards and some incentive stock options. See the consolidated financial statement Notes 1(o) and 14 for further discussion and disclosures on stock options. See the following table for the consolidated activity within stock option plans 1994, 1997, 1998 and 2002 as of December 31, 2003, all of which were approved by stockholders:


Number of securities to be issued upon exercise of outstanding options and awards		597,707
Weighted average exercise price of outstanding options	$	13.11
Number of securities remaining available for future issuance		362,382

ITEM 6.

SELECTED FINANCIAL DATA


	For the years ended December 31,
	2003			2002			2001			2000			1999
	(Dollars in thousands, except per share data)
Operations Data:
Net interest income	$	29,817		$	30,203		$	26,632		$	24,841		$	23,458
Provision for loan losses		1,125			1,835			1,193			787			408
Noninterest income		7,164			6,181			5,925			4,190			4,038
Noninterest expense		22,223			20,254			20,624			19,323			18,773
Federal income tax expense		4,729			4,871			3,778			2,947			2,958
Net income		8,904			9,424			6,962			5,974			5,357
Earnings per share
Basic		1.37			1.31			0.87			0.66			0.50
Diluted		1.32			1.27			0.86			0.65			0.49
Dividend payout ratio(1)		41.6	%		37.4	%		46.9	%		50.2	%		50.1	%

Performance Ratios:
Net interest spread		5.16	%		5.17	%		4.33	%		4.12	%		4.56	%
Net interest margin(2)		5.42	%		5.53	%		4.98	%		5.04	%		5.49	%
Efficiency ratio(3)		60.09	%		55.67	%		63.35	%		66.56	%		68.27	%
Return on average assets		1.49	%		1.58	%		1.19	%		1.11	%		1.14	%
Return on average equity		13.03	%		12.18	%		8.52	%		6.66	%		5.32	%


	At December 31,
	2003			2002			2001			2000			1999
Balance Sheet Data:
Total assets	$	640,920		$	594,587		$	609,643		$	573,530		$	510,958
Loans receivable, net		512,647			455,277			486,679			475,441			412,909
Loans held for sale		1,018			8,113			6,275			1,931			589
Deposits		541,832			517,116			515,080			460,234			405,068
Federal Home Loan Bank advances		31,100			—			8,000			23,125			2,800
Other borrowings		—			—			—			1,000			8
Stockholders’ equity		62,232			72,397			78,528			83,005			95,264
Book value per share	$	10.05		$	10.63		$	10.42		$	10.09		$	9.50
Equity to assets ratio		9.71	%		12.18	%		12.88	%		14.47	%		18.68	%
Asset Quality Ratios:
Nonperforming loans to loans		0.06	%		0.42	%		0.39	%		0.33	%		0.43	%
Allowance for loan losses to loans		1.49	%		1.46	%		1.15	%		1.05	%		1.02	%
Allowance for loan losses to nonperforming loans		2,611.97	%		346.05	%		293.12	%		315.02	%		236.27	%
Nonperforming assets to total assets		0.11	%		0.38	%		0.49	%		0.28	%		0.35	%
Other Data:
Number of banking offices		18			18			18			18			17
Number of full-time equivalent employees		206			195			198			211			222

(1)

Dividend payout ratio is declared dividends per share divided by basic earnings per share.

(2)

Net interest margin is net interest income divided by average interest earning assets.

(3)

The efficiency ratio is recurring noninterest expense divided by the sum of net interest income and noninterest income.

ITEM 7.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is intended to assist in understanding the financial condition and results of operations of the Company. The information contained in this section should be read with the December 31, 2003 audited consolidated financial statements and notes to those financial statements included in this Form 10-K.

Statements concerning future performance, developments or events, expectations for growth and market forecasts, and any other guidance on future periods, constitute forward-looking statements and are subject to a number of risks and uncertainties, which might cause actual results to differ materially from stated expectations. Specific factors include, but are not limited to, the effect of interest rate changes, risks associated with acquisition of other banks and opening new branches, the ability to control costs and expenses, and general economic conditions. Additional information on these and other factors, which could affect our financial results are included in our filings with the Securities and Exchange Commission.

Critical Accounting Policies

The Company’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Companies may apply certain critical accounting policies requiring management to make subjective or complex judgments, often as a result of the need to estimate the effect of matters that are inherently uncertain.

The Company considers its most critical accounting policy to be the allowance for loan losses. The allowance for loan losses is established through a provision for loan losses charged against earnings. The balance of the allowance for loan losses is maintained at the amount management believes will be adequate to absorb known and inherent losses in the loan portfolio. The appropriate balance of allowance for loan losses is determined by applying estimated loss factors to the credit exposure from outstanding loans. Estimated loss factors are based on subjective measurements including management’s assessment of the internal risk classifications, changes in the nature of the loan portfolio, industry concentrations and the impact of current local, regional and national economic factors on the quality of the loan portfolio. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Company’s consolidated financial statements, results of operation or liquidity.

For additional information regarding the allowance for loan losses, its relation to the provision for loans losses, risk related to asset quality and lending activity, see Part I, Item 1 as well as the Management’s Discussion and Analysis of Financial Condition and Results of Operation—Provision for Loan Losses.

Overview

Heritage Financial Corporation is a bank holding company, which primarily engages in the business activities of our wholly owned subsidiaries: Heritage Savings Bank and Central Valley Bank. We provide financial services to our local communities with an ongoing strategic focus in expanding our commercial lending relationships, market expansion and a continual focus on asset quality. During the five-year period from 1999 thru 2003 our total assets have grown $130.0 million, or 25.4%, with net loans making up $99.7 million of this increase. Our emphasis in growing our commercial loan portfolio resulted in an increase in commercial loans of $74.2 million, or 38.6%, since 1999. In addition, the overall loan increases were enhanced by our emphasis in growing our Pierce county market.

Deposits have increased $136.8 million, or 33.8%, for the period from 1999 thru 2003 with a change in deposit mix from certificates of deposits to non-interest and low interest bearing demand deposits. These deposit increases are due to our focus on growing our customer base as well as the ongoing market conditions causing investors to invest in deposit accounts instead of the stock market. As a whole, our customers are investing in

short term deposit products. In turn, equity has declined by $33.0 million since December 31, 1999 as a result of our stock repurchase programs. Since 1999, we have repurchased 5,262,137 shares totaling $62.2 million. During the five-year period from 1999 thru 2003, our net income has increased by 66.2% or $3.5 million. The result of these five-year trends have provided our company with an increase in return on average equity from 5.32% for the year ended December 31, 1999 to 13.03% for year ended December 31, 2003. Our short-term goal is to reach a return on average equity of 15.0% for the year ended 2005.

Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment portfolios, and our cost of funds, which consists of interest paid on deposits and borrowed funds. Like most financial institutions, our interest income and cost of funds are affected significantly by general economic conditions, particularly changes in market interest rates and government policies.

Changes in net interest income result from changes in volume, net interest spread, and net interest margin. Volume refers to the average dollar amounts of interest earning assets and interest bearing liabilities. Net interest spread refers to the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities. Net interest margin refers to net interest income divided by average interest earning assets and is influenced by the level and relative mix of interest earning assets and interest bearing and non-interest bearing liabilities.

The following table provides relevant net interest income information for selected time periods. The average loan balances presented in the table are net of allowances for loan losses. Nonaccrual loans have been included in the tables as loans carrying a zero yield.


	Years Ended December 31,
	2003						2002						2001
	Average Balance		Interest Earned/ Paid		Average Rate		Average Balance		Interest Earned/ Paid		Average Rate		Average Balance		Interest Earned/ Paid		Average Rate
	(Dollars in thousands)
Interest Earning Assets:
Loans	$	481,404	$	35,059	7.28	%	$	472,785	$	37,930	8.02	%	$	494,379	$	43,111	8.72	%
Mortgage Backed Securities		5,568		330	5.94			7,589		482	6.35			4,069		301	7.40
Investment securities and FHLB Stock		47,711		1,574	3.30			35,363		1,546	4.37			25,622		1,406	5.49
Interest earning deposits		15,860		188	1.18			30,106		469	1.56			11,019		372	3.38

Total interest earning assets	$	550,543	$	37,151	6.75	%	$	545,843	$	40,427	7.41	%	$	535,089	$	45,190	8.45	%
Noninterest earning assets		47,694						50,035						50,582

Total assets	$	598,237					$	595,878					$	585,671

Interest Bearing Liabilities:
Certificates of deposit	$	202,141	$	4,767	2.36	%	$	222,997	$	6,857	3.07	%	$	244,369	$	12,797	5.24	%
Savings accounts		97,352		1,139	1.17			88,775		1,528	1.72			61,190		2,140	3.50
Interest bearing demand and money market accounts		154,420		1,273	0.82			143,617		1,719	1.20			126,302		2,618	2.07

Total interest bearing deposits		453,913		7,179	1.58			455,389		10,104	2.22			431,861		17,555	4.06
FHLB advances		7,241		87	1.20			1,189		56	4.74			18,002		961	5.34
Other borrowed funds		730		68	9.33			826		64	7.68			202		42	20.85

Total interest bearing liabilities	$	461,884	$	7,334	1.59	%	$	457,404	$	10,224	2.24	%	$	450,065	$	18,558	4.12	%
Demand and other noninterest bearing deposits		63,890						55,712						47,455
Other noninterest bearing liabilities		4,120						5,378						6,479
Stockholders’ equity		68,343						77,384						81,672

Total liabilities and stockholders’ equity	$	598,237					$	595,878					$	585,671

Net interest income			$	29,817					$	30,203					$	26,632
Net interest spread					5.16	%					5.17	%					4.33	%
Net interest margin					5.42	%					5.53	%					4.98	%
Average interest earning assets to average interest bearing liabilities					119.19	%					119.33	%					118.89	%

The following table provides the amount of change in our net interest income attributable to changes in volume and changes in interest rates. Changes attributable to the combined effect of volume and interest rates have been allocated proportionately for changes due to volume and interest rates.


	Years Ended December 31,
	2003 Compared to 2002 Increase (Decrease) Due to									2002 Compared to 2001 Increase (Decrease) Due to
	Volume			Rate			Total			Volume			Rate			Total
	(Dollars in thousands)
Interest Earning Assets:
Loans	$	692		$	(3,563	)	$	(2,871	)	$	(1,882	)	$	(3,299	)	$	(5,181	)
Mortgage backed securities		(128	)		(23	)		(151	)		261			(80	)		181
Investment securities and FHLB stock		540			(512	)		28			534			(394	)		140
Interest earning deposits		(222	)		(60	)		(282	)		647			(550	)		97

Total interest income	$	882		$	(4,158	)	$	(3,276	)	$	(440	)	$	(4,323	)	$	(4,763	)

Interest bearing liabilities:
Certificates of deposit	$	(641	)	$	(1,450	)	$	(2,091	)	$	(1,119	)	$	(4,821	)	$	(5,940	)
Savings accounts		148			(536	)		(388	)		965			(1,577	)		(612	)
Interest bearing demand and money market accounts		129			(576	)		(447	)		359			(1,257	)		(898	)

Total interest bearing deposits		(364	)		(2,562	)		(2,926	)		205			(7,655	)		(7,450	)
FHLB advances		287			(257	)		30			(898	)		(7	)		(905	)
Other borrowings		(6	)		12			6			131			(110	)		21

Total interest bearing liabilities	$	(83	)	$	(2,807	)	$	(2,890	)	$	(562	)	$	(7,772	)	$	(8,334	)

Results of Operations for the Years Ended December 31, 2003 and 2002

Net Income. Our net income was $8.9 million or $1.32 per diluted share for the year ended December 31, 2003 compared to $9.4 million or $1.27 per diluted share for the previous year. The 5.5% decline in income was a result of a lower net interest margin and the costs related to our Pierce County expansion. The net interest margin declined 11 basis points with average earning assets increasing $4.7 million, ending the year at $550.5 million compared to the previous year end of $545.8 million. The Pierce County expansion involved the addition of commercial lenders and a newly leased commercial lending office.

Net Interest Income. Net interest income decreased $386,000 to 29.8 million for the year ended December 31, 2003 compared with the previous year of $30.2 million. The decline in net interest income resulted primarily from the tightening of the net interest margin in a declining interest-rate environment.

Net interest income as a percentage of average earning assets (net interest margin) for the year ended December 31, 2003 decreased to 5.42% from 5.53% for the previous year. Our net interest spread for the year ended December 31, 2003 decreased to 5.16% from 5.17% for the prior year. This corresponded with the decrease in the average cost of funds to 1.59% for the year ended December 31, 2003 from 2.24% for the same period last year as well as the decrease in the average rate of interest earning assets to 6.75% for the year ended December 31, 2003 from 7.41% for the same period last year. The low rate environment is a result of a continued weak economy and an effort by the Federal Reserve to stimulate the economy. Overall, our net interest margin is very strong at 5.42% in comparison to the median for West Coast publicly traded thrifts of 4.09% and West Coast publicly traded commercial banks of 4.60% as reported by D.A. Davidson and Companies.

Provision for Loan Losses. During the year ended December 31, 2003, we provided $1.1 million through operations to maintain our allowance at an adequate level compared to $1.8 million for the year ended

December 31, 2002. For the year ended December 31, 2003, we experienced net charge-offs of $251,000 versus net charge-offs of $712,000 for the year ended December 31, 2002. The provision and corresponding net charge-offs increased our allowance for loan loss as a percentage of total loans to 1.49% at December 31, 2003 from 1.46% at the end of 2002. Our asset quality has remained solid as demonstrated by the nonperforming assets to total assets ratio of 0.11% at December 31, 2003 compared to 0.38% at December 31, 2002.

We consider the allowance for loan losses at December 31, 2003 to adequately cover known and reasonably foreseeable loan losses based on our assessment of various factors affecting the loan portfolio, including the level of problem loans, business conditions, estimated collateral values, loss experience, and credit concentrations. See the previous discussion on the allowance for loan losses in Item 1 for further information about these factors.

Noninterest Income. Total noninterest income increased $983,000, or 15.9%, for the year ended December 31, 2003 compared with the prior year. Mortgage banking income increased $503,000, or 35.8%, over the prior year. Mortgage loans sold during 2003 were $105.8 million versus $74.3 million sold during 2002, an increase of 4.2%. Merchant visa income increased $357,000, or 29.0%, due to increased business volumes. Service charges on deposits also increased by $105,000 due to our focus on growing our deposit relationships.

Noninterest Expense. Total noninterest expense increased $2.0 million, or 9.7%, for the year ended 2003 compared to the 2002 period. Salaries and employee benefits increased by $1.1 million primarily due to the increase in full time equivalents of 11 (206 at December 31, 2003 and 195 at December 31, 2002). Most of the increase in full time equivalents was related to the market expansion in Pierce County. Employee benefits are also a factor as health insurance costs continue to rise. Merchant Visa expenses increased by $300,000, or 30.1%. The increase was in line with the increase in business volumes as well as Merchant Visa income. Building occupancy increased by $325,000 over the prior year due to additional leased office space in Pierce county and the ongoing repairs and maintenance of buildings and grounds. Data processing increased by $150,000, or 14.1%, due to the costs associated with a major project initiated in 2003 to select one core processor for our subsidiary banks.

Results of Operations for the Years Ended December 31, 2002 and 2001

Net Income. Our net income was $9.4 million or $1.27 per diluted share for the year ended December 31, 2002 compared to $7.0 million or $0.86 per diluted share for the previous year. The growth in income primarily resulted from an improved net interest margin, improved levels of noninterest income, and continued expense control. Average earning assets increased $10.7 million, ending the year at $545.8 million compared to the previous year end of $535.1 million. The average rate on average earning assets declined by 104 basis points. Average costing liabilities grew $7.3 million with cost of funds declining by 188 basis points over the prior year.

Net Interest Income. Net interest income increased $3.6 million, or 13.4%, for the year ended December 31, 2002 compared with the previous year. The growth in net interest income resulted primarily from maintaining a strong net interest margin in a declining interest-rate environment. Average loans decreased by $21.6 million, or 4.4%, with a decline in the average rate of 70 basis points. Average deposits increased $31.8 million, or 6.6%, with a more significant decline in the average rate of 184 basis points.

Net interest income as a percentage of average earning assets (net interest margin) for the year ended December 31, 2002 increased to 5.53% from 4.98% for the previous year. Our net interest spread for the year ended December 31, 2001 increased to 5.17% from 4.33% for the prior year. This corresponded with the decrease in the average cost of funds to 2.24% for the year ended December 31, 2002 from 4.12% for the same period last year as well as the decrease in the average rate of interest earning assets to 7.41% for the year ended December 31, 2002 from 8.45% for the same period last year. The low rate environment is a result of a continued weak economy and an effort by the Federal Reserve to stimulate the economy.

Provision for Loan Losses. During the year ended December 31, 2002, we provided $1.8 million through operations to maintain our allowance at an adequate level because of a continuation of the weak economy. For

the year ended December 31, 2002, we experienced net charge-offs of $712,000 versus net charge-offs of $505,000 for the year ended December 31, 2001. The provision increased our allowance for loan loss as a percentage of total loans to 1.46% at December 31, 2002 from 1.15% at the end of 2001. Our asset quality has remained solid as demonstrated by the nonperforming assets to total assets ratio of 0.38% at December 31, 2002 compared to 0.49% at December 31, 2001.

We consider the allowance for loan losses at December 31, 2002 to adequately cover known and reasonably foreseeable loan losses based on our assessment of various factors affecting the loan portfolio, including the level of problem loans, business conditions, estimated collateral values, loss experience, and credit concentrations. See the previous discussion on the allowance for loan losses in Item 1 for further information about these factors.

Noninterest Income. Total noninterest income increased $256,000, or 4.3%, for the year ended December 31, 2002 compared with the prior year. Service charges on deposits increased $327,000, or 16.4%, resulting from increased service charges and increased demand for deposit products. Merchant visa income increased $335,000, or 37.4%, due to a continual increase in business volumes. Mortgage banking income decreased $265,000 from the prior year. Mortgage loans sold during 2002 were $74.3 million versus $97.8 million sold during 2001. Additionally, the decrease in other income of $158,000 was attributable to the 2001 sale of Heritage Bank’s ownership interest in Transalliance Corporation (a debit/credit card processor), which resulted in a gain on sale of investment of $157,000.

Noninterest Expense. Total noninterest expense decreased $370,000, or 1.8%, for the year ended 2002 compared to the 2001 period. The current year noninterest expense reflects the elimination of goodwill, totaling $577,000 in prior years, due to the adoption of Financial Accounting Standard (FAS) 142 effective January 1, 2002, which requires that goodwill no longer be amortized, but instead periodically tested for impairment. Merchant Visa expenses also increased by $268,000, or 36.8%, which was in line with the increase in Merchant Visa income. Personnel expenses increased $226,000, or 2.2%. Other expenses decreased $412,000, or 11.1%, due primarily to the costs associated with the Vision 2001 initiative of $589,000 during 2001. We incurred Vision 2001 expenses during 2001, which were primarily consulting fees paid to Alex Sheshunoff Management Services, L.P.

Liquidity and Capital Resources

Our primary sources of funds are deposits, loan repayments, loan sales, interest earned on and proceeds from investment securities, and advances from the FHLB of Seattle. These funds, together with retained earnings, equity and other borrowed funds, are used to make loans, acquire investment securities and other assets, and fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by the level of interest rates, economic conditions, and competition.

We must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, satisfy other financial commitments, and fund operations. We generally maintain sufficient cash and short-term investments to meet short-term liquidity needs. At December 31, 2003, cash and cash equivalents totaled $35.5 million, or 5.5% of total assets. At December 31, 2003, our banks maintained a credit facility with the FHLB of Seattle for $113.4 million of which we borrowed $31.1 million as of December 31, 2003.

During 2003 total assets grew $46.3 million with net loans increasing by $57.4 million over the prior year end and deposits increasing $24.7 million over the prior year end. As a result, we borrowed from the FHLB of Seattle and had an increase year over year of $31.1 million. Our strategy has been to acquire core deposits (which we define to include all deposits except public funds) from our retail accounts, acquire noninterest bearing demand deposits from our commercial customers, and use available credit lines to fund growth in assets. We anticipate that we will continue to rely on the same sources of funds in the future and use those funds primarily to make loans and purchase investment securities.

We, and our banks, are subject to various regulatory capital requirements. As of December 31, 2003, we, and our banks were classified as “well capitalized” institutions under the criteria established by the Federal Deposit Insurance Act. Our initial public offering in January of 1998 significantly increased our capital to levels well in excess of regulatory requirements and our internal needs. In 1999, we determined that buying our own shares with some of our excess capital was the best use of this capital and we began to buy back our Company’s outstanding shares. As of December 31, 2003, we have repurchased 5,176,554 shares of our stock representing 47.7% of the total outstanding as of March 31, 1999 at an average price of $12.01 reducing our capital levels by $62.2 million.

Our capital levels will also be modestly impacted by our 401(k) Employee Stock Ownership Plan and Trust (“KSOP”). The Employee Stock Ownership Plan (“ESOP”) purchased 2% of the common stock issued in the January 1998 stock offering and borrowed from the Company to fund the purchase of the Company’s common stock. The loan to the ESOP will be repaid principally from the Bank’s contributions to the ESOP. The Bank’s contributions will be sufficient to service the debt over the 15 year loan term at the interest rate of 8.5%. As the debt is repaid, shares are released, and allocated to plan participants based on the proportion of debt service paid during the year. As shares are released, compensation expense is recorded equal to the then current market price of the shares, our capital is increased, and the shares become outstanding for earnings per share calculations. For the year ended December 31, 2003, the Company has allocated or committed to be released to the ESOP 8,817 earned shares and has 80,084 unearned, restricted shares remaining to be released. The fair value of unearned, restricted shares held by the ESOP trust was $1,724,000 at December 31, 2003.

Asset/Liability Management

Our primary financial objective is to achieve long term profitability while controlling our exposure to fluctuations in market interest rates. To accomplish this objective, we have formulated an interest rate risk management policy that attempts to manage the mismatch between asset and liability maturities while maintaining an acceptable interest rate sensitivity position. The principal strategies which we employ to control our interest rate sensitivity are: selling most long term, fixed rate, one- to four-family residential mortgage loan originations; originating commercial loans and residential construction loans at variable interest rates for terms generally one year or less; and offering noninterest bearing demand deposit accounts to businesses and individuals. The longer-term objective is to increase the proportion of noninterest bearing demand deposits, low interest bearing demand deposits, money market accounts, and savings deposits relative to certificates of deposit to reduce our overall cost of funds.

Our asset and liability management strategies have resulted in a positive 0-3 month “gap” of 1.3% and a positive 4-12 month “gap” of 3.5% as of December 31, 2003. These “gaps” measure the difference between the dollar amount of our interest earning assets and interest bearing liabilities that mature or reprice within the designated period (three months and 4-12 months) as a percentage of total interest earning assets, based on certain estimates and assumptions as discussed below. We believe that the implementation of our operating strategies has reduced the potential effects of changes in market interest rates on our results of operations. The positive gap for the 0-3 month period indicates that decreases in market interest rates may adversely affect our results over that period.

The following table provides the estimated maturity or repricing and the resulting interest rate sensitivity gap of our interest earning assets and interest bearing liabilities at December 31, 2003 based upon estimates of expected mortgage prepayment rates and deposit run off rates consistent with national trends. We adjusted mortgage loan maturities for loans held for sale by reflecting these loans in three-month category, which is consistent with their sale in the secondary mortgage market. The amounts in the table are derived from our internal data. We used certain assumptions in presenting this data so the amounts may not be consistent with other financial information prepared in accordance with generally accepted accounting principles. The amounts in the tables also could be significantly affected by external factors, such as changes in prepayment assumptions, early withdrawal of deposits, and competition.


	Estimated Maturity or Repricing Within
	0-3 months			4-12 months			1-5 years			5-15 years			More than 15 years			Total
	(Dollars in thousands)
Interest Earnings Assets:
Loans	$	163,824		$	105,002		$	153,768		$	80,519		$	18,300		$	521,413
Investment securities		25,053			5,828			23,983			2,888			—			57,752
FHLB and Federal Reserve Stock		2,962			—			—			—			—			2,962
Fed funds sold		7,600			—			—			—			—			7,600
Interest earning deposits		9,981			—			—			—			—			9,981

Total interest earning assets	$	209,420		$	110,830		$	177,751		$	83,407		$	18,300		$	599,708

Interest Bearing Liabilities:
Total interest bearing deposits	$	170,643		$	97,510		$	194,826		$	—		$	—		$	462,979
FHLB advances and other borrowings		31,100			—			—			—			—			31,100

Total interest bearing liabilities	$	201,743		$	97,510		$	194,826		$	—		$	—		$	494,079

Rate sensitivity gap	$	7,677		$	13,220		$	(17,075	)	$	83,407		$	18,300		$	105,629
Cumulative rate sensitivity gap:
Amount		7,677			20,997			3,922			87,329			105,629
As a percentage of total interest earning assets		1.28	%		3.50	%		0.65	%		14.56	%		17.61	%

Certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on some types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market interest rates. Additionally, some assets, such as adjustable rate mortgages, have features, which restrict changes in the interest rates of those assets both on a short-term basis and over the lives of such assets. Further, if a change in market interest rates occurs, prepayment, and early withdrawal levels could deviate significantly from those assumed in calculating the tables. Finally, the ability of many borrowers to service their adjustable rate debt may decrease if market interest rates increase substantially.

Impact of Inflation and Changing Prices

Inflation affects our operations by increasing operating costs. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, changes in interest rates generally have a more significant impact on a financial institution’s performance than the effects of general levels of inflation. Although interest rates do not necessarily move in the same direction or the same extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates.

Recent Financial Accounting Pronouncements

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, addressing consolidation by business enterprises of certain variable interest entities. Under the provisions of

Interpretation No. 46, an enterprise must consolidate a variable interest entity if that enterprise will absorb a majority of the entity’s expected losses or receive a majority of the entity’s residual returns, or both, regardless of the enterprise’s direct or indirect ability to make decisions about the entity’s activities through voting or similar rights. Interpretation No. 46 applies immediately to interests in variable interest entities created or acquired after January 31, 2003 and to the first fiscal year or interim period beginning after June 15, 2003 for interests in variable interest entities acquired before February 1, 2003. Application of this Interpretation did not have a material effect on our financial statements.

In April 2003, the FASB issued Financial Accounting Standard (FAS) No. 149, Amendment of Statement 133 on Derivative instruments and Hedging Activities. The provisions of this Statement are effective for contracts entered into or modified after June 20, 2003 and hedging relationships designated after June 30, 2003. Except for the provisions related to FAS Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, all provisions of this Statement should be applied prospectively. The provisions of the Statement related to Statement 133 Implementation Issues that have been effective for fiscal quarters that begin prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates. Application of this Interpretation did not have a material effect on our financial statements.

In May 2003, the FASB issued FAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. The provisions of this Statement are effective for financial instruments entered into or modified after May 31, 2003, and otherwise are effective at the beginning of the first interim period beginning after June 15, 2003. It is to be implemented by reporting the cumulative effect of a change in accounting principle for financial instruments created before May 15, 2003 and still existing at the beginning of the interim period of adoption. Restatement is not permitted. Application of this Interpretation did not have an effect on our financial statements.

In December 2003, the FASB amended FAS No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits—an amendment of FASB Statements No. 87, 88, and 106. The provisions of this Statement are effective for financial statements with fiscal years ending after December 15, 2003. The Statement revises employers’ disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by FASB Statements No. 87, Employers’ Accounting for Pensions, No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, and No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions. This Statement retains the disclosure requirements contained in FASB Statement No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits, which it replaces. It requires additional disclosures to those in the original Statement 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. The required information should be provided separately for pension plans and for other postretirement benefit plans. Application of this Interpretation did not have an effect on our financial statements.

The Emerging Issues Task Force (EITF) Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” In connection with its discussion of EITF Issue No. 02-14, “Whether the Equity Method of Accounting Applies When an Investor Does Not Have an Investment in Voting Stock of an Investee but Exercises Significant Influence through Other Means,” at the November 21, 2002 meeting, the Task Force discussed the meaning of other-than-temporary impairment and its application to certain investments carried at cost. The Task Force requested that the FASB staff consider other impairment models within U.S. GAAP when developing its views. At the November 25, 2003 EITF meeting, the Board ratified a consensus that certain quantitative and qualitative disclosures for periods ending after December 15, 2003 should be required for securities accounted for under Statement 115 that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. Application of this Interpretation did not have a material effect on our financial statements.

ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to interest rate risk through our lending and deposit gathering activities. For a discussion of how this exposure is managed and the nature of changes in our interest rate risk profile during the past year, see “Asset/Liability Management” under Management’s Discussion and Analysis of Financial Condition and Results of Operation.

Neither we, nor our banks, maintain a trading account for any class of financial instrument, nor do we, or they, engage in hedging activities or purchase high risk derivative instruments. Moreover, neither we, nor our banks, are subject to foreign currency exchange rate risk or commodity price risk.

The table below provides information about our financial instruments that are sensitive to changes in interest rates as of December 31, 2003. The table presents principal cash flows and related weighted average interest rates by expected maturity dates. The data in this table may not be consistent with the amounts in the preceding table, which represents amounts by the repricing date or maturity date (whichever occurs sooner) adjusted by estimates such as mortgage prepayments and deposit reduction or early withdrawal rates.


	By Expected Maturity Date
	Year Ended December 31,
	2004			2005			2006			2007- 2008			After 2009			Total		Fair Value
	(Dollars in thousands)
Investment Securities
Amounts maturing:
Fixed rate	$	1,007		$	1,975		$	5,464		$	19,509		$	19,820		$	47,775
Weighted average interest rate		4.00	%		3.24	%		2.82	%		3.79	%		4.22	%
Adjustable Rate		—			—			—			—			9,977			9,977
Weighted average interest rate		—			—			—			—			2.20	%

Totals		1,007			1,975			5,464			19,509			29,797		$	57,752	$	57,890
Loans
Amounts maturing:
Fixed rate	$	93,482		$	10,229		$	20,106		$	36,042		$	157,741		$	317,600
Weighted average interest rate		6.41	%		5.74	%		7.60	%		6.85	%		6.56	%
Adjustable rate		86,198			24,377			14,777			77,061			1,400			203,813
Weighted average interest rate		5.84	%		6.08	%		6.60	%		6.45	%		7.31	%

Totals	$	179,680		$	34,606		$	34,883		$	113,103		$	159,141		$	521,413	$	530,285
Certificates of Deposit
Amounts maturing:
Fixed rate	$	156,999		$	35,431		$	3,399		$	9,066		$	—		$	204,985	$	204,120
Weighted average interest rate		1.77	%		2.24	%		2.89	%		3.95	%		—

The terrorist attacks that took place in the United States on September 11, 2001 were unprecedented events that have created many economic and political uncertainties. The long-term effects of the September 11, 2001 attacks on our business and revenues remain unknown. The potential for future terrorist attacks, the national and international responses to terrorist attacks, and other acts of war or hostility have created many economic and political uncertainties, which could adversely affect our business and revenues in the short or long-term in ways that can not presently be predicted.

ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

For financial statements, see the Index to Consolidated Financial Statements on page F-1.

ITEM 9.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

There were no changes in nor disagreements with our accountants on accounting and financial disclosure.

ITEM 9A.

CONTROLS AND PROCEDURES

Our Chief Executive Officer and Chief Financial Officer have evaluated our disclosure controls and procedures as of a date within 90 days of the filing of this Report. Based on their evaluation, they concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us and the reports filed are submitted by us under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported, within the time period specified in the applicable rules and forms. There have been no significant changes in our internal controls or in other factors that could significantly affect disclosure controls subsequent to the date of their evaluation.

PART III

ITEM 10.

DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Information concerning directors of the registrant is incorporated by reference to the section entitled “Election of Directors” of our definitive Proxy Statement dated March 22, 2004 (“Proxy Statement”) for the annual meeting of shareholders to be held April 29, 2004.

The required information with respect to our executive officers is incorporated by reference to the section entitled “Executive Officers” of the Proxy Statement.

The required information with respect to compliance with Section 16(a) of the Exchange Act is incorporated by reference to the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance” of the Proxy Statement.

ITEM 11.

EXECUTIVE COMPENSATION

For information concerning executive compensation see “Executive Compensation” of the Proxy Statement, which is incorporated as part of this document by reference. Neither the Report of the Personnel and Compensation Committee nor the Stock Performance Graph, both of which are contained in the Proxy Statement, are incorporated as part of this document by this reference.

ITEM 12.

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

For information concerning security ownership of certain beneficial owners and management, see “Stock Ownership” of the Proxy Statement, which is incorporated as part of this document by reference.

ITEM 13.

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

For information concerning certain relationships and related transactions, see “Interest of Management in Certain Transactions” of the Proxy Statement, which is incorporated as part of this document by reference.

ITEM 14.

PRINCIPAL ACCOUNTING FEES AND SERVICES

For information concerning principal accounting fees and services, see “Relationship with Independent Public Accountants” of the Proxy Statement, which is incorporated as part of this document by reference.

PART IV

ITEM 15.

EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a)(1) The consolidated financial statements are contained as listed on the “Index to Consolidated Financial Statements” on page F-1.

(2) All schedules are omitted because they are not required or applicable, or the required information is shown in the consolidated financial statements or notes.

(3) Exhibits


Exhibit No.
3.1		Articles of Incorporation(1)

3.2		Bylaws of the Company(1)

10.1		1998 Stock Option and Restricted Stock Award Plan(2)

10.5		Form of Severance Agreement entered into between the Company and seven additional executives, effective as of October 1, 1997(1)

10.6		1997 Stock Option and Restricted Stock Award Plan(3)

10.7		Employment Agreement between the Company and Michael Broadhead, effective September 28, 1998(4)

10.8		Employment Agreement between the Company and Brian L. Vance, effective June 1, 2001(5)

10.9		Employment Agreement between the Company and Donald V. Rhodes, effective June 1, 2001(5)

10.10		2002 Incentive Stock Option Plan, Director Nonqualified Stock Option Plan, and Restricted Stock Option Plan(6)

14.0		Code of Ethics

21.0		Subsidiaries of the Company

23.0		Consent of KPMG LLP

24.0		Power of Attorney

31.0		Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.0		Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1)

Incorporated by reference to the Registration Statement on Form S-1 (Reg. No. 333-35573) declared effective on November 12, 1997.

(2)

Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-71415).

(3)

Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-57513).

(4)

Incorporated by reference to the Registration Statement on Form S-4 dated January 20, 1999.

(5)

Incorporated by reference to the Annual Report on Form 10-K dated March 20, 2002.

(6)

Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-88980; 333-88982; 333-88976).

(b) Reports on Form 8-K. The Company filed four reports on Form 8-K during 2003 as follows:

(1) On March 24, 2003, the Company filed a Form 8-K announcing the Executive Management Promotion of Brian Vance to President and Chief Executive Officer of Heritage Bank.

(2) On May 1, 2003, the Company filed a Form 8-K announcing the first quarter of 2003 earnings.

(3) On July 23, 2003, the Company filed a Form 8-K announcing the second quarter of 2003 earnings.

(4) On October 22, 2003, the Company filed a Form 8-K announcing the third quarter of 2003 earnings.

SIGNATURES

Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned.

HERITAGE FINANCIAL CORPORATION

Principal Executive Officer:

/s/ DONALD V. RHODES

Donald V. Rhodes

Chairman, President and Chief Executive Officer

Principal Financial Officer:

/s/ EDWARD D. CAMERON

Edward D. Cameron

Senior Vice President, Corporate Secretary and Treasurer

Dated: March 8, 2004

Donald V. Rhodes, pursuant to powers of attorney, which are being filed with this Annual Report on Form 10-K, has signed this report on March 8, 2004, as attorney-in-fact for the following directors who constitute a majority of the board of directors.


Lynn M. Brunton	Brian Charneski	Jeffrey S. Lyon
Daryl D. Jensen	H. Edward Odegard	Brian L. Vance
James P. Senna	Peter Fluetsch
Philip S. Weigand	Melvin R. Lewis

/s/ DONALD V. RHODES

Donald V. Rhodes

Attorney in fact

March 8, 2004

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2003, 2002, and 2001

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS


		Page

Independent Auditors’ Report		F-2

Consolidated Statements of Financial Condition—December 31, 2003 and December 31, 2002		F-3

Consolidated Statements of Income—Years ended December 31, 2003, 2002, and 2001		F-4

Consolidated Statements of Stockholders’ Equity and Comprehensive Income—Years ended December 31, 2003, 2002, and 2001		F-5

Consolidated Statements of Cash Flows—Years ended December 31, 2003, 2002, and 2001		F-6

Notes to Consolidated Financial Statements		F-7

F-1

Independent Auditors’ Report

The Board of Directors

Heritage Financial Corporation:

We have audited the accompanying consolidated statements of financial condition of Heritage Financial Corporation and subsidiaries (Corporation) as of December 31, 2003 and 2002, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit 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 consolidated financial position of Heritage Financial Corporation and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America.

As discussed in Notes 1 and 7 to the consolidated financial statements, effective January 1, 2002, the Company adopted the provisions of Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets.

LOGO

Seattle, Washington

February 20, 2004

F-2

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

December 31, 2003 and 2002

(Dollars in thousands)


	2003			2002
ASSETS
Cash on hand and in banks	$	17,945		$	18,801
Interest earning deposits		9,981			19,192
Federal funds sold		7,600			7,950
Investment securities available for sale		55,601			48,177
Investment securities held to maturity		2,151			2,821
Loans held for sale		1,018			8,113
Loans receivable		520,395			462,151
Less: Allowance for loan losses		(7,748	)		(6,874	)

Loans receivable, net		512,647			455,277
Real estate owned		523			653
Premises and equipment, at cost, net		17,451			18,029
Federal Home Loan Bank and Federal Reserve stock, at cost		2,962			2,854
Accrued interest receivable		2,782			2,880
Prepaid expenses and other assets		3,205			3,200
Deferred Federal income taxes, net		414			—
Goodwill, net		6,640			6,640

	$	640,920		$	594,587

LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits	$	541,832		$	517,116
Advances from Federal Home Loan Bank		31,100			—
Accrued expenses and other liabilities		5,756			4,746
Deferred Federal income taxes, net		—			328

		578,688			522,190

Stockholders’ equity:
Common stock, no par, 15,000,000 shares authorized; 6,192,996 and 6,809,373 shares outstanding at December 31, 2003 and 2002, respectively		18,430			33,587
Unearned compensation—ESOP and restricted stock award		(1,087	)		(1,208	)
Retained earnings, substantially restricted		44,849			39,672
Accumulated other comprehensive income, net		40			346

Total stockholders’ equity		62,232			72,397
Commitments and Contingencies		—			—

	$	640,920		$	594,587

See accompanying notes to consolidated financial statements.

F-3

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

For the years ended December 31, 2003, 2002 and 2001

(Dollars in thousands, except per share amounts)


	2003		2002		2001
Interest income:
Loans	$	35,059	$	37,930	$	43,111
Mortgage backed securities		330		482		301
Investment securities and Federal Home Loan Bank dividends		1,574		1,546		1,406
Interest on federal funds sold and overnight deposits		188		469		372

Total interest income		37,151		40,427		45,190

Interest expense:
Deposits		7,179		10,104		17,555
Other borrowings		155		120		1,003

Total interest expense		7,334		10,224		18,558

Net interest income		29,817		30,203		26,632
Provision for loan losses		1,125		1,835		1,193

Net interest income after provision for loan losses		28,692		28,368		25,439

Noninterest income:
Gains on sales of loans, net		1,907		1,404		1,669
Service charges on deposits		2,421		2,316		1,989
Rental income		268		263		267
Merchant visa income		1,588		1,231		896
Other income		980		967		1,104

Total noninterest income		7,164		6,181		5,925

Noninterest expense:
Salaries and employee benefits		11,648		10,519		10,293
Building occupancy		3,759		3,434		3,346
FDIC premiums		81		88		90
Data processing		1,212		1,062		1,048
Marketing		415		439		392
Office supplies and printing		377		416		438
Goodwill amortization		—		—		577
Merchant visa		1,297		997		729
Other		3,434		3,299		3,711

Total noninterest expense		22,223		20,254		20,624

Income before Federal income tax expense		13,633		14,295		10,740
Federal income tax expense		4,729		4,871		3,778

Net income	$	8,904	$	9,424	$	6,962

Basic earnings per common share	$	1.37	$	1.31	$	0.87
Basic weighted average shares outstanding		6,494,343		7,209,356		7,964,521
Diluted earnings per common share	$	1.32	$	1.27	$	0.86
Diluted weighted average shares outstanding		6,734,987		7,420,654		8,135,341

See accompanying notes to consolidated financial statements.

F-4

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME

For the years ended December 31, 2003, 2002 and 2001

(Dollars and shares in thousands)


	Number of common shares		Common stock			Unearned compensation— ESOP and Restricted Stock Awards			Retained earnings			Accumulated other comprehensive income, net			Total stock- holders’ equity
Balance at December 31, 2000	8,223			54,080			(1,074	)		30,000			(1	)		83,005
Earned ESOP shares	9			5			99			—			—			104
Exercise of stock options	102			411			—			—			—			411
Stock repurchased	(800	)		(8,810	)		—			—			—			(8,810	)
Net income	—			—			—			6,962			—			6,962
Net increase in unrealized gain on securities available for sale, net of taxes	—			—			—			—			43			43
Cash dividends declared	—			—			—			(3,187	)		—			(3,187	)

Balance at December 31, 2001	7,534			45,686			(975	)		33,775			42			78,528
Restricted stock awards granted	—			429			(429	)		—			—			—
Earned ESOP and restricted stock shares	44			45			196			—			—			241
Exercise of stock options	61			479			—			—			—			479
Stock repurchased	(830	)		(13,052	)		—			—			—			(13,052	)
Net income	—			—			—			9,424			—			9,424
Net increase in unrealized gain on securities available for sale, net of taxes	—			—			—			—			304			304
Cash dividends declared	—			—			—			(3,527	)		—			(3,527	)

Balance at December 31, 2002	6,809		$	33,587		$	(1,208	)	$	39,672		$	346		$	72,397
Restricted stock awards granted	1			22			(22	)		—			—			—
Earned ESOP, incentive stock options and restricted stock shares	9			155			143			—			—			298
Exercise of stock options	147			1,172			—			—			—			1,172
Stock repurchased	(773	)		(16,506	)		—			—			—			(16,506	)
Net income	—			—			—			8,904			—			8,904
Net decrease in unrealized gain on securities available for sale, net of taxes	—			—			—			—			(306	)		(306	)
Cash dividends declared	—			—			—			(3,727	)		—			(3,727	)

Balance at December 31, 2003	6,193		$	18,430		$	(1,087	)	$	44,849		$	40		$	62,232


Comprehensive Income	2003			2002		2001
Net income	$	8,904		$	9,424	$	6,962
Increase (decrease) in unrealized gain on securities available for sale, net of tax of ($154), $164 and $22		(306	)		304		43

Comprehensive income	$	8,598		$	9,728	$	7,005

See accompanying notes to consolidated financial statements.

F-5

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the years ended December 31, 2003, 2002 and 2001

(Dollars in thousands)


	2003			2002			2001
Cash flows from operating activities:
Net income	$	8,904		$	9,424		$	6,962
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		1,863			1,774			2,303
Deferred loan fees, net of amortization		254			(42	)		28
Provision for loan losses		1,125			1,835			1,193
Federal Home Loan Bank stock dividends and Federal Reserve Stock		(124	)		57			(186	)
Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities		302			(3,074	)		2,575
Recognition of compensation related to ESOP, incentive stock options and restricted stock shares		298			241			104
Gain on sale of investment securities available for sale		—			—			(41	)
Gain on sale of other investments		—			(10	)		(157	)
Gain on sale of premises and equipment		(2	)		(12	)		—
Gain on sale of other real estate owned		(1	)		(26	)		—
Net (increase) decrease in loans held for sale		7,095			(1,838	)		(4,344	)
Deferred Federal income tax benefit		(580	)		(432	)		(192	)
Proceeds from Federal Home Loan Bank stock		16			238			—

Net cash provided by operating activities		19,150			8,135			8,245

Cash flows from investing activities:
Loans (originated) paid down, net of principal payments and loan sales		(59,264	)		29,125			(13,728	)
Proceeds from other real estate owned		645			1,126			—
Maturities of investment securities available for sale		52,091			40,149			48,649
Sales of investment securities available for sale		—			—			6,041
Maturities of investment securities held to maturity		670			882			1,679
Purchase of investment securities held to maturity		—			—			(325	)
Purchase of investment securities available for sale		(59,975	)		(61,379	)		(47,370	)
Proceeds from sale of other investments		—			10			157
Purchase of premises and equipment		(1,305	)		(833	)		(1,181	)
Proceeds from premises and equipment		22			26			—

Net cash (used in) provided by investing activities		(66,116	)		9,106			(6,078	)

Cash flows from financing activities:
Net increase in deposits		24,716			2,036			54,846
Net increase (decrease) in FHLB advances		31,100			(8,000	)		(15,125	)
Net decrease in other borrowed funds		—			—			(1,000	)
Cash dividends paid		(3,731	)		(3,537	)		(3,178	)
Exercise of stock options		970			479			411
Repurchase of common stock		(16,506	)		(13,052	)		(8,810	)

Net cash (used in) provided by financing activities		36,549			(22,074	)		27,144

Net increase (decrease) in cash and cash equivalents		(10,417	)		(4,833	)		29,311
Cash and cash equivalents at beginning of year		45,943			50,776			21,465

Cash and cash equivalents at end of year	$	35,526		$	45,943		$	50,776

Supplemental disclosures of cash flow information:
Cash payments for:
Interest expense	$	7,312		$	10,304		$	19,161
Federal income taxes		5,104			6,743			2,962
Supplemental disclosure of noncash activities:
Mortgage loans transferred to real estate owned	$	515		$	484		$	1,269
Net charge offs		251			712			505
Tax benefit from nonqualified stock options		202			46			—

See accompanying notes to consolidated financial statements.

F-6

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands)

(1) Summary of Significant Accounting Policies

(a) Description of Business

Heritage Financial Corporation (the Company) is a bank holding company incorporated in the State of Washington in August 1997. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly owned subsidiaries: Heritage Bank and Central Valley Bank. Heritage Bank is a Washington-chartered savings bank whose deposits are insured by the Federal Deposit Insurance Corporation (FDIC) under the Savings Association Insurance Fund (SAIF). Heritage Bank conducts business from its main office in Olympia, Washington and its eleven branch offices located in Thurston, Pierce and Mason Counties. Central Valley Bank is a National Bank whose deposits are insured by the Federal Deposit Insurance Corporation (FDIC) under the Bank Insurance Fund (BIF). Central Valley Bank conducts business from its main office in Toppenish, Washington, and its five branch offices located in Yakima and Kittitas Counties.

The Company’s business consists primarily of focusing on lending and deposit relationships with small businesses including agribusiness and their owners in its market area, attracting deposits from the general public and originating for sale or investment purposes first mortgage loans on residential properties located in western and central Washington. The Company also makes residential construction loans, income property loans and consumer loans.

(b) Basis of Presentation

The accounting and reporting policies of the Company and its subsidiaries conform to accounting principles generally accepted in the United States of America. In preparing the consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of income and expense during the reporting periods. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses. Actual results could differ from these estimates.

The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions among the Company and its subsidiaries have been eliminated in consolidation.

Certain amounts in the consolidated financial statements for prior years have been reclassified to conform to the current consolidated financial statement presentation.

For purposes of reporting cash flows, cash and cash equivalents includes cash on hand and in banks, interest bearing deposits, and federal funds sold.

The Company is required to maintain an average reserve balance with the Federal Reserve Bank in the form of cash. For the years ended December 31, 2003 and 2002 the Company maintained adequate levels of cash to meet the Federal Reserve Bank requirement.

F-7

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

(d) Investment Securities

The Company identifies investments as held to maturity or available for sale at the time of acquisition. Securities are classified as held to maturity when the Company has the ability and positive intent to hold them to maturity. Securities classified as available for sale are available for future liquidity requirements and may be sold prior to maturity.

Investment securities held to maturity are recorded at cost, adjusted for amortization of premiums or accretion of discounts using the interest method. Securities available for sale are carried at fair value. Unrealized gains and losses on securities available for sale are excluded from earnings and are reported in other comprehensive income. Realized gains and losses on sale are computed on the specific identification method.

A decline in the market value of any available for sale or held to maturity security below cost that is deemed to be other than temporary results in a reduction in carrying amount to fair value. The impairment is charged to earnings and a new cost basis for the security is established.

(e) Loans Receivable and Loans Held for Sale

Loans are generally recorded at their outstanding principal balance adjusted for charge-offs, the allowance for loan losses and deferred fees or any costs on originated loans. Interest on loans is calculated using the simple interest method based on the daily balance of the principal amount outstanding and is credited to income as earned.

The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well secured and in the process of collection. Credit card loans and other personal loans are typically charged-off no later than 180 days past due. In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is doubtful.

All interest accrued but not collected on loans that are placed on non-accrual or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Discounts and premiums on purchased loans are amortized using the effective interest method over the remaining contractual lives, adjusted for actual prepayments. Mortgage loans held for sale are carried at the lower of amortized cost or market value determined on an aggregate basis. Any loan that management determines will not be held to maturity is classified as held for sale at the time of origination, purchase or securitization, or when such decision is made. Unrealized losses on such loans are included in income.

(f) Loan Fees

Loan origination fees and certain direct origination costs are deferred and amortized as an adjustment of the yields of the loans over their contractual lives, adjusted for prepayment of the loans, using the effective interest method. In the event loans are sold, the deferred net loan origination fees or costs are recognized as a component of the gains or losses on the sales of loans.

F-8

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

(g) 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 earnings. Losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

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 the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. The evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.

While management uses available information to recognize losses on loans, future additions to the allowance 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 Bank’s allowance for loan losses. Such agencies may require the Bank to make additions to the allowance based on their judgments about information available to them at the time of their examinations.

(h) Impaired Loans

A loan is considered impaired when, based on current information and events, it is probable the Company will be unable to collect the scheduled payments of principal or interest when due according to 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. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrowers, including length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amounts of the shortfall in relation to the principal and interest owned. Impairment is measured on a loan by loan basis for commercial and construction loans 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.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures.

(i) Mortgage Banking Operations

The Company sells mortgage loans primarily on a servicing released basis and recognizes a cash gain or loss. A cash gain or loss is recognized to the extent that the sales proceeds of the mortgage loans sold exceed or are less than the net book value at the time of sale. In addition, there are some mortgage loans brokered to other lenders, which are recognized to income as incurred.

Commitments to sell mortgage loans are made primarily during the period between the taking of the loan application and the closing of the mortgage loan. The timing of making these sale commitments is dependent upon the timing of the borrower’s election to lock-in the mortgage interest rate and fees prior to loan closing.

F-9

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

Most of these sale commitments are made on a best-efforts basis whereby the Bank is only obligated to sell the mortgage if the mortgage loan is approved and closed by the Bank. As a result, management believes that market risk is minimal.

Loan servicing income is recorded when earned. Loan servicing costs are charged to expense as incurred.

(j) Real Estate and Other Assets Owned

Real estate and other assets acquired by the Company in satisfaction of debt is held for sale and recorded at fair value at time of foreclosure and is carried at the lower of the new cost basis or fair value less estimated costs to sell.

(k) Premises and Equipment

Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets. The estimated useful lives used to compute depreciation and amortization for buildings and building improvements is 15 to 30 years; and for furniture, fixtures and equipment is 3 to 7 years.

(l) Goodwill

Goodwill represents the costs in excess of net assets acquired arising from the purchase of North Pacific Bank and was being amortized on a straight-line basis over 15 years. Accumulated amortization of goodwill amounted to $2,020 as of December 31, 2001. Effective January 1, 2002 the Company adopted the provisions of Statement of Financial Accounting Standard (SFAS) No. 142—Goodwill and Other Intangible Assets, which resulted in goodwill no longer being amortized. Instead, goodwill is reviewed for impairment and written down and charged to income during the periods in which the recorded value is more than its implied value. The Company evaluates any potential impairment of goodwill on an annual basis at the Heritage Bank level.

(m) Federal Income Taxes

The Company files a consolidated federal income tax return. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the periods in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rate is recognized in income in the period that includes the enactment date.

(n) Employee Stock Ownership Plan

The Company sponsors an Employee Stock Ownership Plan (ESOP). The ESOP purchased 2% of the common stock issued in the January 1998 stock offering and borrowed from the Company in order to fund the purchase of the Company’s common stock. The loan to the ESOP will be repaid principally from the Bank’s contributions to the ESOP. The Bank’s contributions will be sufficient to service the debt over the 15 year loan term at the interest rate of 8.5%. As the debt is repaid, shares are released and allocated to plan participants based on the proportion of debt service paid during the year. As shares are released, compensation expense is recorded equal to the then current market price of the shares and the shares become outstanding for earnings per share

F-10

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

calculations. Cash dividends on allocated shares are recorded as a reduction of retained earnings and paid or distributed directly to participants’ accounts. Cash dividends on unallocated shares are recorded as a reduction of debt and accrued interest.

(o) Stock Based Compensation

The Company measures its employee stock-based compensation arrangements using the provisions outlined in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, which is an intrinsic value-based method of recognizing compensation costs. The Company has adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-based Compensation. As most of the Company’s stock options have no intrinsic value at grant date, compensation cost generally has not been recognized for its stock option plan activity. However, compensation expense was recognized during 2003 and 2002 resulting from restricted stock awards and certain incentive stock options.

If the Company had elected to recognize compensation cost on the fair value at the grant dates for awards under its plans, consistent with the method prescribed by SFAS No. 123, net income and earnings per share would have been changed to the pro forma amounts for the years ended December 31,:


	2003			2002			2001
Net income:
As reported	$	8,904		$	9,424		$	6,962
Plus compensation costs recognized under ABP No. 25, net of taxes		67			96			—
Less SFAS No. 123 compensation costs, net of taxes		(103	)		(285	)		(323	)

Pro forma	$	8,868		$	9,235		$	6,639

Basic earnings per share:
As reported	$	1.37		$	1.31		$	0.87
Plus compensation costs recognized under ABP No. 25, net of taxes		0.01			0.01			—
Less SFAS No. 123 compensation costs, net of taxes		(0.02	)		(0.04	)		(0.04	)

Pro forma	$	1.36		$	1.28		$	0.83

Diluted earnings per share:
As reported	$	1.32		$	1.27		$	0.86
Plus compensation costs recognized under ABP No. 25, net of taxes		0.01			0.01			—
Less SFAS No. 123 compensation costs, net of taxes		(0.02	)		(0.04	)		(0.04	)

Pro forma	$	1.31		$	1.24		$	0.82

The compensation expense included in the pro forma net income is not likely to be representative of the effect on reported net income for future years because options vest over several years and additional awards generally are made each year.

F-11

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

The fair value of options granted during the years ended December 31, 2003, 2002 and 2001 is estimated on the date of grant using the Black-Scholes options pricing model. The following assumptions were used to calculate the fair value of the options granted:


Grant period ended	Risk Free Interest Rate		Expected Life (in years)	Expected Volatility		Expected Dividend Yield		Weighted Average Fair Value
December 31, 2003	3.52	%	6	24	%	3.88	%	3.74
December 31, 2002	3.63	%	7	20	%	3.97	%	1.84
December 31, 2001	5.00	%	7	19	%	4.04	%	1.69

(2) Loans Receivable and Loans Held for Sale

Loans receivable and loans held for sale at December 31, 2003 and 2002 consist of the following:


	2003			2002
Commercial loans	$	266,252		$	243,872

Real estate mortgages:
One to four family residential		57,377			72,846
Five or more family residential and commercial real estate		149,728			114,750

Total real estate mortgage		207,105			187,596
Real estate construction:
One to four family residential		19,881			29,201
Five or more family residential and commercial real estate		19,570			3,169

Total real estate construction		39,451			32,370
Consumer		10,043			7,616

Subtotal		522,851			471,454
Deferred loan fees and other		(1,438	)		(1,190	)

Total loans receivable and loans held for sale	$	521,413		$	470,264

As of December 31, 2003 and 2002, the Company had loans to persons serving as Directors and Executive Officers, and entities related to such individuals, aggregating $15,961 and $7,385, respectively. All loans were made on essentially the same terms and conditions as comparable transactions with other persons, and did not involve more than the normal risk of collectibility. The Company did not have any borrowings from Directors or Executive Officers at December 31, 2003.

Accrued interest on loans receivable amounted to $2,436 and $2,584 as of December 31, 2003 and 2002, respectively. The weighted average interest rate on loans was 6.5% and 7.3% for December 31, 2003 and 2002, respectively. The Company had $297 and $1,987 of impaired loans, which were nonaccruing as of December 31, 2003 and 2002, respectively. The annual average balance of impaired loans for the years ended December 31, 2003 and 2002 were $1,022 and $3,271, respectively. The allowance for loan losses to impaired loans at December 31, 2003 and 2002 totaled $53 and $246, respectively. Interest recognized on impaired loans for the years ended December 31, 2003, 2002 and 2001 totaled $162, $146 and $26, respectively. Interest on impaired loans foregone (recovered) was $37, $(30), and $173 for the years ended December 31, 2003, 2002 and 2001,

F-12

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

respectively. The Company has no commitments to extend additional credit on loans that are impaired at December 31, 2003.

Details of certain mortgage banking activities at December 31, 2003 and 2002 are as follows:


	2003		2002
Loans held for sale at lower of cost or market	$	1,018	$	8,113
Loans serviced for others		2,010		3,852
Total Loans sold		105,790		74,318
Commitments to sell mortgage loans		3,657		10,608
Commitments to fund mortgage loans (at interest rates approximating market rates)
Fixed rate		3,814		3,839
Variable or adjustable rate		369		288

Servicing fee income from mortgage loans serviced for others amounted to $14, $19 and $22 for the years ended December 31, 2003, 2002 and 2001, respectively.

As of December 31, 2003, the Company had commitments of $39.7 million in other commercial lines of credit, $47.4 million in real estate commitments (both construction and lines of credit), and $19.4 million in other commitments (including consumer credit lines and letters of credit).

(3) Allowance for Loan Losses

Activity in the allowance for loan losses is summarized as follows for the years ended December 31,:


	2003			2002			2001
Balance at beginning of period	$	6,874		$	5,751		$	5,063
Provision		1,125			1,835			1,193
Recoveries		8			21			2
Charge offs		(259	)		(733	)		(507	)

Balance at end of period	$	7,748		$	6,874		$	5,751

F-13

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

(4) Investment Securities Available For Sale

The amortized cost and fair values of investment securities available for sale at the dates indicated are as follows:


	Amortized cost		Gross unrealized gains		Gross unrealized losses			Fair value
December 31, 2003
U.S. Government and its agencies	$	27,144	$	148	$	(107	)	$	27,185
Mortgage backed and related securities:
Collateralized mortgage obligations		14,934		52		(202	)		14,784
Other		13,460		247		(75	)		13,632

Totals	$	55,538	$	447	$	(384	)	$	55,601

December 31, 2002
U.S. Government and its agencies	$	22,733	$	282	$	(7	)	$	23,008
Mortgage backed and related securities:
Collateralized mortgage obligations		10,579		59		(29	)		10,609
Other		14,342		218		—			14,560

Totals	$	47,654	$	559	$	(36	)	$	48,177

The impairment of investments, as of December 31, 2003, were not other-than-temporary and therefore unrealized losses were not recognized. Due to the short-term nature of these investments we expect to receive full value of these investments. Investments with unrealized losses as of December 31, 2003 are reported as follows:


	Less than 12 months				12 months or longer				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
U.S. Government and its agencies	$	9,389	$	107	$	—	$	—	$	9,389	$	107
Mortgage backed and related securities		9,903		223		—		—		9,903		223

Total temporarily impaired securities	$	19,292	$	330	$	—	$	—	$	19,292	$	330

The amortized cost and fair value of securities available for sale, by contractual maturity, at December 31, 2003 are shown below:


	Amortized cost		Fair value
Due in one year or less	$	525	$	675
Due after one year through three years		6,705		6,755
Due after three through five years		19,276		19,232
Due after five years through ten years		3,761		3,761
Due after ten years		25,271		25,178

Totals	$	55,538	$	55,601

F-14

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

There were no sales of investment securities available for sale during the years ended December 31, 2003 and 2002. During the year ended December 31, 2001 there were sales of investment securities available for sale resulting in a $41 gain.

Accrued interest on investment securities available for sale amounted to $328 and $258 as of December 31, 2003 and 2002, respectively.

At December 31, 2003 and 2002, investment securities available for sale with fair values of $12,879 and $12,065, respectively, were pledged to secure public deposits and for other purposes as required or permitted by law.

We had no securities available for trading at December 31, 2003 or 2002.

(5) Investment Securities Held to Maturity

The amortized cost and fair values of investment securities held to maturity are as follows:


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair value
December 31, 2003
Mortgage backed securities:
FNMA certificates	$	68	$	4	$	—	$	72
FHLMC certificates		153		9		—		162
GNMA certificates		400		41		—		441
Municipal bonds		1,530		84		—		1,614

	$	2,151	$	138	$	—	$	2,289

December 31, 2002
Mortgage backed securities:
FNMA certificates	$	140	$	10	$	—	$	150
FHLMC certificates		273		17		—		290
GNMA certificates		688		65		—		753
Municipal bonds		1,720		108		—		1,828

	$	2,821	$	200	$	—	$	3,021

The amortized cost and fair value of investment securities held to maturity, by contractual maturity, at December 31, 2003 are shown below:


	Amortized cost		Fair value
Due in one year or less	$	505	$	520
Due after one year through three years		685		725
Due after three years through five years		277		300
Due after five years through ten years		137		147
Due after ten years		547		597

Totals	$	2,151	$	2,289

F-15

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

There were no sales of investment securities held to maturity during the years ended December 31, 2003, 2002 and 2001.

Accrued interest on investment securities held to maturity amounted to $13 and $17 as of December 31, 2003 and 2002, respectively.

At December 31, 2003 and 2002, investment securities held to maturity with amortized cost values of $1,924 and $6,439, respectively, were pledged to secure public deposits and for other purposes as required or permitted by law.

(6) Premises and Equipment

A summary of premises and equipment at December 31, 2003 and 2002 follows:


	2003		2002
Land	$	4,527	$	4,538
Buildings and building improvements		17,959		17,423
Furniture, fixtures and equipment		12,349		12,167

		34,835		34,128
Less accumulated depreciation		17,384		16,099

	$	17,451	$	18,029

(7) Goodwill and Other Intangible Assets —Adoption of Statement 142

In July 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141—Business Combinations and SFAS No. 142—Goodwill and Other Intangible Assets. SFAS No. 141 requires business combinations initiated after June 30, 2001 to be accounted for by using the purchase method of accounting and broadens the criteria for recording intangible assets separate from goodwill. Recorded goodwill and intangibles will be evaluated against this new criteria and may result in certain intangibles being included in goodwill. Alternatively, certain amounts initially recorded as goodwill may be separately identified and recognized apart from goodwill.

SFAS No. 142 requires the use of a nonamortization approach to account for purchased goodwill and certain intangibles. Under a nonamortization approach, goodwill and certain intangibles will not be amortized into results of operations. Rather, goodwill and certain intangibles are reviewed for impairment, written down, and charged to results of operations only in the periods in which the recorded value of goodwill and certain intangibles is more than its implied value. The provisions of each statement were adopted by us on January 1, 2002. Nonamortized goodwill in the amount of $6,640 was subject to the transition provisions of SFAS Nos. 141 and 142. Other than the discontinuation of monthly goodwill amortization, the adoption of this statement did not have a material impact on the results of our operations or financial position.

F-16

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

The following table illustrates the impact of adopting SFAS No. 141 and 142 at December 31,:


	2003		2002		2001
Net Income:
Reported net income	$	8,904	$	9,424	$	6,962
Add back: Goodwill amortization		—		—		577

Pro forma net income	$	8,904	$	9,424	$	7,539

Basic earnings per share:
As reported basic earnings per share	$	1.37	$	1.31	$	0.87
Add back: Goodwill amortization		—		—		0.07

Pro forma basic earnings per share	$	1.37	$	1.31	$	0.94

Diluted earnings per share:
As reported diluted earnings per share	$	1.32	$	1.27	$	0.86
Add back: Goodwill amortization		—		—		0.07

Pro forma diluted earnings per share	$	1.32	$	1.27	$	0.93

(8) Deposits

Deposits consist of the following at December 31,:


	2003				2002
	Amount		Percent		Amount		Percent
Non interest demand deposits	$	78,853	14.6	%	$	73,860	14.3	%
NOW accounts		79,721	14.7			64,881	12.5
Money market accounts		77,141	14.2			73,978	14.3
Savings accounts		101,132	18.7			93,477	18.1
Certificate of deposit accounts		204,985	37.8			210,920	40.8

	$	541,832	100.0	%	$	517,116	100.0	%

The combined weighted average interest rate of deposits was 1.12% and 1.57% at December 31, 2003 and 2002, respectively. Accrued interest payable on deposits was $290 and $277 at December 31, 2003 and 2002, respectively. Interest expense, by category are as follows for the years ended December 31,:


	2003		2002		2001
NOW accounts	$	601	$	779	$	1,045
Money market accounts		1,449		1,975		2,888
Savings accounts		363		493		825
Certificate of deposit accounts		4,766		6,857		12,797

	$	7,179	$	10,104	$	17,555

F-17

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

At December 31, 2003, the scheduled maturities of certificates of deposit are as follows:


Within one year	$	130,205
Between one and two years		62,041
Between two and three years		3,675
Between three and four years		5,723
Between four and five years		3,341

	$	204,985

Certificates of deposit issued in denominations equal to or in excess of $100,000 totaled $88,842 and $81,887 at December 31, 2003 and 2002, respectively.

(9) FHLB Advances and Stock

The Federal Home Loan Bank of Seattle (FHLB) functions as a central reserve bank providing credit for member financial institutions. Advances are made pursuant to several different programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based either on a fixed percentage of an institution’s net worth or on the FHLB’s assessment of the institution’s creditworthiness. At December 31, 2003, the Company maintained a credit facility with the FHLB of Seattle for $113.4 million with an outstanding balance of $31.1 million.

The Company is required to maintain an investment in the stock of FHLB in an amount equal to at least 1% of the unpaid principal balances of the Bank’s residential mortgage loans or 5% of its outstanding advances from the FHLB, whichever is greater. At December 31, 2003, the Company was required to maintain an investment in the stock of FHLB of Seattle of at least $2.0 million. The Company maintained $2.9 million in FHLB stock at December 31, 2003. Purchases and sales of stock are made directly with the FHLB at par value. During 2003 and 2002, the Company was required to redeem FHLB stock totaling $16 and $238, respectively, due to the new capital structure requirements issued by FHLB.

A summary of FHLB Advances is summarized as follows:


	2003			2002
Balance at period end, due less than 12 months	$	31,100		$	—
Average balance		7,306			1,167
Maximum amount outstanding at any month end		31,100			6,000
Average interest rate:
During the period		1.21	%		4.83	%
At period end		1.10	%		—	%

At December 31, 2003 and 2002, the Company had $31,100 and zero, respectively, in overnight advances from the FHLB.

Advances from the FHLB are collateralized by a blanket pledge on FHLB stock owned by the Company, deposits at the FHLB and all mortgages or deeds of trust securing such properties. In accordance with the pledge agreement, the Company must maintain unencumbered collateral in an amount equal to varying percentages ranging from 100% to 125% of outstanding advances depending on the type of collateral. At December 31, 2003, the Company was required to maintain $113,369 in collateral to meet the collateral requirements of FHLB.

F-18

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

(10) Federal Funds Purchased

Our subsidiary banks maintain advance lines to purchase federal funds totaling $29,700. The lines generally mature annually with the exception of a $2,000 line with U.S. Bank, which does not mature. The $23,700 line with KeyBank matures in July 2004 and the $4,000 line with Bank of America matured December 31, 2003 but automatically renews annually. As of December 31, 2003 there were no overnight federal funds purchased.

(11) Key Bank Line of Credit

The Company maintains a line of credit for $5 million with Key Bank, which is renewed annually, and currently matures in March 2004. The usage on the Key Bank line of credit is summarized as follows:


	2003			2002
Balance at period end	$	—		$	—
Average balance during the period		735			827
Maximum amount outstanding at any month end		4,127			3,607
Average interest rate:
During the period		4.10	%		4.58	%
At period end		0	%		0	%

(12) Federal Income Taxes

Federal income tax expense consists of the following for the years ended December 31,:


	2003			2002			2001
Current	$	5,309		$	5,303		$	3,970
Deferred		(580	)		(432	)		(192	)

	$	4,729		$	4,871		$	3,778

Federal income tax expense differs from that computed by applying the Federal statutory income tax rate of 34% and 35% for income in excess of $10 million for the years ended December 31,:


	2003			2002			2001
Income tax expense at Federal statutory rate	$	4,772		$	5,003		$	3,652
Goodwill		—			—			196
Other, net		(43	)		(132	)		(70	)

	$	4,729		$	4,871		$	3,778

F-19

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

The following table presents major components of the deferred Federal income tax asset (liability) resulting from differences between financial reporting and tax bases for the years ended December 31,:


	2003			2002
Deferred tax assets:
Allowance for loan losses	$	2,712		$	2,215
Management bonus		68			63
Vacation benefits		105			100
Other		144			98

Total deferred tax assets		3,029			2,476
Deferred tax liabilities:
Deferred loan fees		(766	)		(749	)
Premises and equipment		(1,068	)		(1,159	)
FHLB stock		(757	)		(710	)
Unrealized gain on sale of available for sale securities		(24	)		(186	)

Total deferred tax liabilities		(2,615	)		(2,804	)

Deferred Federal income tax asset (liability), net	$	414		$	(328	)

The Company has qualified under provisions of the Internal Revenue Code to compute federal income taxes after deductions of additions to the bad debt reserves. At December 31, 2003, the Company had a taxable temporary difference of approximately $2.8 million that arose before 1988 (base-year amount). In accordance with Statement of Financial Accounting Standards No. 109, a deferred tax liability has not been recognized for the temporary difference. Management does not expect this temporary difference to reverse in the foreseeable future.

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management expects to realize the benefits of these deductible differences.

(13) Stockholders’ Equity

(a) Stock Repurchase Program

On April 26, 1999 the board of directors of the Company authorized the repurchase in the open market of 100,000 of its outstanding common shares. This was accomplished in the second quarter of 1999 for $0.8 million, or $8.56 per share. In October of 1999, the Company began the first of six stock repurchase programs. The first totaling 1,082,389 shares, or 10% of the then outstanding shares was commenced in October 1999 and completed in February 2000. The second totaling 976,748 shares, or 10% of the then outstanding shares was commenced in February 2000 and completed in August 2000. The third program for a total of 890,000 shares representing 10% of the then outstanding shares was commenced in August 2000 and completed in May 2001. The fourth program for a total of 800,000 shares representing 10% of the then outstanding shares was commenced in May 2001 and completed in June 2002. The fifth program for a total of 750,000 shares was commenced in June 2002 and completed in March 2003, which represented 10% of the then outstanding shares. The sixth program, for a total

F-20

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

of 660,000 shares, commenced in March 2003, with 574,263 shares, or 87.0%, repurchased as of December 31, 2003. Collectively as of December 31, 2003, the Company repurchased 5,176,554 shares of our stock representing 47.7% of the total outstanding as of March 31, 1999 at an average price of $12.01. Stock repurchased for the years ended December 31, 2003 and 2002 were $16.5 million and $13.1 million, respectively.

(b) Earnings Per Common Share

The following table illustrates the reconciliation of weighted average shares used for earnings per share computations for the years ended December 31,:


	2003		2002		2001
Basic:
Basic weighted average shares outstanding	6,530,177		7,239,657		7,964,521
Less restricted stock awards	(35,834	)	(30,301	)	—

Total basic weighted average shares outstanding	6,494,343		7,209,356		7,964,521
Diluted:
Basic weighted average shares outstanding	6,494,343		7,209,356		7,964,521
Incremental shares from stock options and restricted stock awards	240,644		211,298		170,820

Weighted average shares outstanding	6,734,987		7,420,654		8,135,341

For purposes of calculating basic and diluted EPS, the numerator of net income is the same.

There were no anti-dilutive outstanding options to purchase common stock at December 31, 2003, 2002 or 2001.

On December 19, 2003, the Company announced a quarterly cash dividend of 15 cents per share payable on January 30, 2004, to shareholders of record on January 15, 2004.

(d) Restrictions on Dividends

Dividends from the Company depend, in part, upon receipt of dividends from its subsidiary banks because the Company currently has no source of income other than dividends from Heritage Bank, Central Valley Bank, and earnings from the investment of the net proceeds from the Conversion retained by the Company.

The FDIC and the Washington State Department of Financial Institutions (“DFI”) have the authority under their supervisory powers to prohibit the payment of dividends by Heritage Bank to the Company. For a period of ten years after the Conversion, Heritage Bank may not, without prior approval of the DFI, declare or pay a cash dividend in an amount in excess of one-half of (i) the greater of the Bank’s net income for the current fiscal year or (ii) the average of the Bank’s net income for the current fiscal year and not more than two of the immediately preceding fiscal years. In addition, Heritage Bank may not declare or pay a cash dividend on its common stock if the effect thereof would be to reduce the net worth of the Bank below the amount required for the liquidation account. Other than the specific restrictions mentioned above, current regulations allow the Company and its subsidiary banks to pay dividends on their common stock if the Company’s or Bank’s regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve and the FDIC.

F-21

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

At Central Valley Bank the approval of the Comptroller of the Currency is required if the total of all dividends declared by Central Valley Bank in any calendar year exceeds the total of its net income of that year combined with its retained net income of the preceding two years, less any required transfers to surplus or a fund for the retirement of any preferred stock.

(14) Stock Option and Award Plans

In September 1994, Heritage Bank’s stockholders approved the adoption of the 1994 stock option plan, providing for the award of a restricted stock award to a key officer, incentive stock options to employees and nonqualified stock options to directors of the Bank at the discretion of the Board of Directors. On September 24, 1996, Heritage Bank’s stockholders approved the adoption of the 1997 stock option plan, which is generally similar to the 1994 plan. On October 15, 1998, the Company’s stockholders approved the adoption of the 1998 stock option plan, which is similar to the 1994 and 1997 plans. The 1998 plan does not affect any options granted under the 1994 or 1997 plans. On April 25, 2002, The Company’s stockholders approved the adoption of the 2002 Incentive Stock Option Plan, the 2002 Director Nonqualified Stock Option Plan and the 2003 Restricted Stock Plan, which are generally similar to the 1994, 1997 and 1998 stock plans.

Under these stock option plans, on the date of grant, the exercise price of the option must at least equal the market value per share of the Company’s common stock. The 1994 plan provides for the grant of options and stock awards up to 344,996 shares. The 1997 plan provides for the granting of options and stock awards up to 257,460 common shares. The 1998 plan provides for the grant of stock options and stock awards for up to 461,125 shares. The 2002 Incentive Stock Option plan provides for the grant of stock options for up to 430,000 shares. The 2002 Director Nonqualified Stock Option plan provides for the grant of stock options for up to 70,000 shares. The 2002 Restricted Stock plan provides for the grant of stock awards for up to 50,000 shares. The number of shares remaining available for future issuance totaled 362,382 as of December 31, 2003.

Stock options generally vest ratably over three years and expire five years after they become exercisable which amounts to an average term of seven years. Restricted Stock awards issued under the 1998 plan have a five-year cliff vesting.

F-22

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

The following table summarizes stock option and award activity for the years ended December 31, 2003, 2002 and 2001.


	Outstanding Options and Awards				Exercisable Options and Awards
	Shares		Avg. Price		Shares		Avg. Price
Balance at December 31, 2000	570,176		$	6.87	333,077		$	5.40
Options granted	35,100			10.14	—			—
Became exercisable	—			—	106,250			9.43
Less: Exercised	(102,340	)		4.02	(102,340	)		4.02
Expired or canceled	(35,675	)		9.04	(35,675	)		6.85

Balance at December 31, 2001	467,261			7.57	301,312			6.85

Options and awards granted	184,100			12.25	—			—
Became exercisable	—			—	90,850			9.05
Less: Exercised	(61,611	)		6.52	(61,611	)		6.52
Expired or canceled	(3,550	)		10.47	(3,550	)		9.23

Balance at December 31, 2002	586,200			9.13	327,001			7.55

Options and awards granted	169,350			21.20	—			—
Became exercisable	—			—	123,599			10.53
Less: Exercised	(146,693	)		6.61	(146,693	)		6.61
Expired or canceled	(11,150	)		16.57	(10,650	)		16.29

Balance at December 31, 2003	597,707		$	13.11	293,257		$	8.96

Financial data pertaining to outstanding stock options and exercisable stock options at December 31, 2003 follows:


Exercise Price	Number of Outstanding Option Shares	Weighted Average Remaining Contractual Life (in years)	Weighted Average Exercise Price		Number of Exercisable Option Shares	Weighted Average Exercise Price
$ 3.58—$ 8.25	61,111	1.4	$	4.63	61,111	$	4.63
$ 8.44—$ 8.50	56,200	2.9	$	8.45	56,200	$	8.45
$ 8.75—$ 9.00	12,950	2.5	$	8.89	12,950	$	8.89
$9.75	64,500	3.9	$	9.75	64,500	$	9.75
$ 10.05—$10.15	25,300	4.4	$	10.15	14,500	$	10.15
$11.13	45,000	1.9	$	11.13	45,000	$	11.13
$12.25	132,096	5.2	$	12.25	38,996	$	12.25
$15.95	2,700	6.0	$	15.95	—		—
$19.05	9,000	6.1	$	19.05	—		—
$21.38	152,850	6.2	$	21.38	—		—

	561,707	4.3	$	13.10	293,257	$	8.96

The above table does not include the shares issued under the restricted stock award plan of 1998. There were 35,000 shares issued on February 19, 2002 at the fair market value of $12.25, which were approved by

F-23

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

shareholders on April 25, 2002. An additional 1,500 shares were issued on May 12, 2003 at the fair market value of $22.47, with 500 of these shares canceled during the third quarter of 2003. The compensation expense associated with theses awards is being booked over the vesting life of 5 years. For the years ended December 31, 2003 and 2002, $55 and $109 in compensation expense was booked, respectively. The unvested shares are not included for the calculation of basic earnings per share but are included in diluted earnings per share.

(15) Regulatory Capital Requirements

The Company is a bank holding company under the supervision of the Federal Reserve Bank. Bank holding companies are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve. Heritage Bank and Central Valley Bank are federally insured institutions and thereby subject to the capital requirements established by the Federal Deposit Insurance Corporation (FDIC). The Federal Reserve requirements generally parallel the FDIC requirements. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements.

F-24

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

Pursuant to minimum capital requirements of the FDIC, Heritage Bank and Central Valley Bank are required to maintain a leverage ratio (capital to assets ratio) of 3% and risk-based capital ratios of Tier 1 capital and total capital (to total risk-weighted assets) of 4% and 8%, respectively. As of December 31, 2003 and December 31, 2002, Heritage Bank and Central Valley Bank were both classified as “well capitalized” institutions under the criteria established by the FDIC Act. There are no conditions or events since that notification that management believes have changed the Bank’s classification as a well capitalized institution.


	Minimum Requirements				Well- capitalized Requirements				Actual
	$		%		$		%		$		%
As of December 31, 2003:
The Company consolidated
Tier 1 leverage capital to average assets	$	18,414	3	%	$	30,691	5	%	$	55,505	9.0	%
Tier 1 capital to risk-weighted assets		21,291	4			31,937	6			55,505	10.4
Total capital to risk-weighted assets		42,583	8			53,228	10			62,172	11.7
Heritage Bank
Tier leverage capital to average assets		15,526	3			25,877	5			43,876	8.5
Tier 1 capital to risk-weighted assets		18,818	4			28,227	6			43,876	9.3
Total capital to risk-weighted assets		37,635	8			47,044	10			49,771	10.6
Central Valley Bank
Tier leverage capital to average assets		2,903	3			4,838	5			7,388	7.6
Tier 1 capital to risk-weighted assets		2,505	4			3,758	6			7,388	11.8
Total capital to risk-weighted assets		5,010	8			6,263	10			8,116	13.0

As of December 31, 2002:
The Company consolidated
Tier 1 leverage capital to average assets	$	17,737	3	%	$	29,562	5	%	$	65,411	11.1	%
Tier 1 capital to risk-weighted assets		19,120	4			28,680	6			65,411	13.7
Total capital to risk-weighted assets		38,240	8			47,800	10			71,403	14.9
Heritage Bank
Tier leverage capital to average assets		14,938	3			24,897	5			55,201	11.1
Tier 1 capital to risk-weighted assets		16,650	4			24,976	6			55,201	13.3
Total capital to risk-weighted assets		33,301	8			41,626	10			60,421	14.5
Central Valley Bank
Tier leverage capital to average assets		2,803	3			4,672	5			6,777	7.3
Tier 1 capital to risk-weighted assets		2,450	4			3,674	6			6,777	11.1
Total capital to risk-weighted assets		4,899	8			6,124	10			7,443	12.2

(16) Employee Benefit Plans

Effective October 1, 1999 the Company combined three retirement plans, a money purchase pension plan, a 401k plan, and an employee stock ownership plan (ESOP) at Heritage Bank, and the 401k plan at Central Valley Bank into one plan (KSOP). Effective April 1, 2002 the Company added three investment funds to the plan as well as changed the eligibility requirements to the plan. At this same time the Company approved an amendment of the plan to reflect certain provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”).

F-25

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

The pension portion of the KSOP is a defined contribution retirement plan. The plan provides a contribution to all eligible participants upon completion of one year of service, the attainment of 21 years of age, and employment on the last day of the year. It is the Company’s policy to fund plan costs as accrued. Employee vesting occurs over a period of seven years, at which time they become fully vested. Charges of approximately $403, $426, and $316 are included in the consolidated statements of income for the years ended December 31, 2003, 2002 and 2001, respectively.

The KSOP also maintains the Company’s salary savings 401(k) plan for its employees. All persons employed as of July 1, 1984 automatically participate in the plan. All employees hired after that date who are at least 21 years of age and with three continuous months of service and at least 250 hours of service to the Company may participate in the plan. Employees who participate may contribute a portion of their salary, which is matched by the employer at 50% up to certain specified limits. Employee vesting in employer portions is similar to the retirement plan described above for the period prior to December 31, 2001. Employee vesting in employer portions occurs over a period of six years for those contributions made after January 1, 2003. Employer contributions for the years ended December 31, 2003, 2002 and 2001 were $209, $162, and $154, respectively.

The third portion of the KSOP is the employee stock ownership plan (ESOP). Heritage Bank established for eligible employees the ESOP and related trust effective July 1, 1994, which became active upon the former mutual holding company’s conversion to a stock-based holding company in January 1995. The plan provides a contribution to all eligible participants upon completion of one year of service, the attainment of 21 years of age, and employment on the last day of the year. The ESOP is funded by employer contributions in cash or common stock. Employee vesting occurs over a period of seven years.

In January 1998, the ESOP borrowed $1,323 from the Company to purchase additional common stock of the Company. The loan will be repaid principally from the subsidiary bank’s contributions to the ESOP over a period of fifteen years. The interest rate on the loan is 8.5% per annum. ESOP compensation expense was $183, $96 and $64 for the years ended December 31, 2003, 2002 and 2001, respectively.

For the year ended December 31, 2003, the Company has allocated or committed to be released to the ESOP 8,817 earned shares and has 80,084 unearned, restricted shares remaining to be released. The fair value of unearned, restricted shares held by the ESOP trust was $1,724 at December 31, 2003.

(a) Severance Agreements

The Company has entered into contracts with certain senior officers that provide benefits under certain conditions following termination without cause, following a change of control of the Company.

F-26

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

(17) Fair Value of Financial Instruments

Because broadly traded markets do not exist for most of the Company’s financial instruments, the fair value calculations attempt to incorporate the effect of current market conditions at a specific time. Fair valuations are management’s estimates of values. These determinations are subjective in nature, involve uncertainties and matters of significant judgment and do not include tax ramifications; therefore, the results cannot be determined with precision, substantiated by comparison to independent markets and may not be realized in an actual sale or immediate settlement of the instruments. There may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results. For all of these reasons, the aggregation of the fair value calculations presented herein do not represent, and should not be construed to represent, the underlying value of the Company.

(a) Financial Instruments With Book Value Equal to Fair Value

The fair value of financial instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value equal to book value.

(b) Investment Securities

The fair value of all investment securities excluding Federal Home Loan Bank (FHLB) stock was based upon quoted market prices. FHLB stock is not publicly traded, however it may be redeemed on a dollar-for-dollar basis, for any amount the Bank is not required to hold. The fair value is therefore equal to the book value.

For most loans, fair value is estimated using the Company’s lending rates that would have been quoted on December 31, 2003 for loans, which mirror the attributes of the loans with similar rate structures and average maturities. Commercial loans and construction loans, which are variable rate and short-term are reflected with fair values equal to book value.

(d) Deposits

For deposits with no contractual maturity, the fair value is equal to the book value. The fair value of fixed maturity deposits is based on discounted cash flows using the difference between the deposit rate and an alternative cost of funds rate.

(e) FHLB Advances

The fair value of FHLB advances are estimated based on discounting the future cash flows using the rate currently offered on similar borrowings with similar maturities.

(f) Other Borrowings

Other borrowings consist of overnight Federal Funds purchased and are considered at fair value.

F-27

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

(g) Commitments to Extend Credit and Standby Letters of Credit

The fair value of commitments to extend credit can be estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counter parties. It is not practicable to estimate fair value on these instruments.

The table below presents the book value amount of the Bank’s financial instruments and their corresponding fair values:


	December 31, 2003				December 31, 2002
	Book value		Fair value		Book value		Fair value
Financial Assets
Cash on hand and in banks	$	17,945	$	17,945	$	18,801	$	18,801
Interest bearing deposits		9,981		9,981		19,192		19,192
Federal funds sold		7,600		7,600		7,950		7,950
Investment securities available for sale		55,601		55,601		48,177		48,177
Investment securities held to maturity		2,151		2,289		2,821		3,021
FHLB and Federal Reserve stock		2,962		2,962		2,854		2,854
Loans receivable and loans held for sale		521,413		530,285		470,264		474,584

Financial Liabilities
Deposits:
Savings, money market and demand	$	336,847	$	336,847	$	306,196	$	306,196
Time certificates		204,985		204,120		210,920		213,361

Total deposits		514,832		540,967		517,116		519,557

FHLB advances		31,100		31,100		—		—

(18) Contingencies

The Company is involved in numerous business transactions, which, in some cases, depend on regulatory determination as to compliance with rules and regulations. Also, the Company has certain litigation and negotiations in progress. All such matters are attributable to activities arising from normal operations. In the opinion of management, after review with legal counsel, the eventual outcome of the aforementioned matters is unlikely to have a materially adverse effect on the Company’s consolidated financial statements or its financial position.

F-28

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

(19) Heritage Financial Corporation (Parent Company Only)

Following is the condensed financial statements of the Parent Company.

HERITAGE FINANCIAL CORPORATION

(PARENT COMPANY ONLY)

Condensed Statements of Financial Condition


	December 31,
	2003		2002
ASSETS
Cash and interest earning deposits	$	3,947	$	3,175
Loans receivable—ESOP		987		1,056
Investment in subsidiary banks		57,851		68,518
Other assets		443		743

	$	63,228	$	73,492

LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities	$	996	$	1,095
Total stockholders’ equity		62,232		72,397

	$	63,228	$	73,492

HERITAGE FINANCIAL CORPORATION

(PARENT COMPANY ONLY)

Condensed Statements of Income


	Years Ended December 31,
	2003			2002			2001
Interest income:
Interest income	$	18		$	16		$	26
ESOP loan		87			93			98
Other income:
Equity in undistributed income of subsidiaries		9,332			9,864			7,264

Total income		9,437			9,973			7,388
Interest expense		68			63			41
Other expenses		696			712			541

Total expense		764			775			582

Income before federal income taxes		8,673			9,198			6,806
Benefit for income taxes		(231	)		(226	)		(156	)

Net income	$	8,904		$	9,424		$	6,962

Basic earnings per common share	$	1.37		$	1.31		$	0.87
Diluted earnings per common share		1.32			1.27			0.86

F-29

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

HERITAGE FINANCIAL CORPORATION

(PARENT COMPANY ONLY)

Condensed Statements of Cash Flows


	Years Ended December 31,
	2003			2002			2001
Cash flows from operating activities:
Net income	$	8,904		$	9,424		$	6,962
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Undistributed income of subsidiaries		(9,332	)		(9,864	)		(7,264	)
Dividends from subsidiaries		20,000			16,950			12,400
Recognition of compensation related to ESOP and restricted stock shares		298			241			104
Net change in other assets and liabilities		100			476			(238	)
Gain on sale of premises and equipment		(1	)		—			—

Net cash provided by operating activities		19,969			17,227			11,964
Cash flows from investing activities:
ESOP loan principal repayments		69			63			58
Proceeds from sale of premise and equipment		1			—			—

Net cash provided by investing activities		70			63			58
Cash flows from financing activities:
Cash dividends paid		(3,731	)		(3,527	)		(3,178	)
Exercise of stock options		970			479			411
Stock repurchase		(16,506	)		(13,052	)		(8,810	)

Net cash used in financing activities		(19,267	)		(16,100	)		(11,577	)

Net increase in cash and cash equivalents		772			1,190			445
Cash and cash equivalents at beginning of period		3,175			1,985			1,540

Cash and cash equivalents at end of period	$	3,947		$	3,175		$	985

F-30

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands)

(20) Selected Quarterly Financial Data (Unaudited)

Results of operations on a quarterly basis were as follows (dollars in thousands, except for per share amounts):


	Year ended December 31, 2003
	First Quarter		Second Quarter		Third Quarter		Fourth Quarter
Interest income	$	9,277	$	9,196	$	9,275	$	9,377
Interest expense		2,000		1,873		1,746		1,690

Net interest income		7,277		7,323		7,529		7,687
Provision for loan losses		495		330		150		150

Net interest income after provision for loan losses		6,782		6,993		7,379		7,537
Non-interest income		1,627		1,991		1,929		1,509
Non-interest expense		5,250		5,608		5,607		5,649

Income before provision for income taxes		3,160		3,376		3,701		3,397
Provision for income taxes		1,099		1,170		1,288		1,173

Net income	$	2,061	$	2,206	$	2,413	$	2,224

Basic earnings per share	$	0.31	$	0.33	$	0.38	$	0.35
Diluted earnings per share		0.30		0.32		0.36		0.34
Cash dividends declared		0.135		0.140		0.145		0.150


	Year ended December 31, 2002
	First Quarter		Second Quarter		Third Quarter		Fourth Quarter
Interest income	$	10,304	$	10,221	$	10,007	$	9,894
Interest expense		2,943		2,610		2,398		2,273

Net interest income		7,361		7,611		7,609		7,621
Provision for loan losses		306		539		495		495

Net interest income after provision for loan losses		7,055		7,072		7,114		7,126
Non-interest income		1,393		1,484		1,552		1,753
Non-interest expense		4,986		5,147		4,944		5,177

Income before provision for income taxes		3,462		3,409		3,722		3,702
Provision for income taxes		1,169		1,152		1,262		1,289

Net income	$	2,293	$	2,257	$	2,460	$	2,413

Basic earnings per share	$	0.31	$	0.31	$	0.35	$	0.35
Diluted earnings per share		0.30		0.30		0.34		0.34
Cash dividends declared		0.115		0.120		0.125		0.130

F-31

INDEX TO EXHIBITS


Exhibit No.
3.1		Articles of Incorporation(1)
3.2		Bylaws of the Company(1)
10.1		1998 Stock Option and Restricted Stock Award Plan(2)
10.5		Form of Severance Agreement entered into between the Company and seven additional executives, effective as of October 1, 1997(1)
10.6		1997 Stock Option and Restricted Stock Award Plan(3)
10.7		Employment Agreement between the Company and Michael Broadhead, effective September 28, 1998(4)
10.8		Employment Agreement between the Company and Brian L. Vance, effective June 1, 2001(5)
10.9		Employment Agreement between the Company and Donald V. Rhodes, effective June 1, 2001(5)
10.10		2002 Incentive Stock Option Plan, Director Nonqualified Stock Option Plan, and Restricted Stock Option Plan(6)
14.0		Code of Ethics
21.0		Subsidiaries of the Company
23.0		Consent of KPMG LLP
24.0		Power of Attorney
31.0		Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.0		Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1)

Incorporated by reference to the Registration Statement on Form S-1 (Reg. No. 333-35573) declared effective on November 12, 1997.

(2)

Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-71415).

(3)

Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-57513).

(4)

Incorporated by reference to the Registration Statement on Form S-4 dated January 20, 1999.

(5)

Incorporated by reference to the Annual Report on Form 10-K dated March 20, 2002.

(6)

Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-88980; 333-88982; 333-88976).