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, 2004

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. x

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 was $89,549,747 and was based upon the last sales price as quoted on the NASDAQ Stock Market for June 30, 2004.

The Registrant had 5,968,137 shares of common stock outstanding as of February 4, 2005.

DOCUMENTS TO BE INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement dated March 22, 2005 for the 2005 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, 2004

TABLE OF CONTENTS


		Page
	PART I

ITEM 1.	BUSINESS	3

	LENDING ACTIVITIES	3

	INVESTMENT ACTIVITIES	10

	DEPOSIT ACTIVITIES AND OTHER SOURCES OF FUNDS	12

	SUPERVISION AND REGULATION	14

	COMPETITION	18

ITEM 2.	PROPERTIES	18

ITEM 3.	LEGAL PROCEEDINGS	19

ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	19

	PART II

ITEM 5.	MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES	20

ITEM 6.	SELECTED FINANCIAL DATA	21

ITEM 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	22

ITEM 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	31

ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA	31

ITEM 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES	31

ITEM 9A.	CONTROLS AND PROCEDURES	32

ITEM 9B.	OTHER INFORMATION	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 AND FINANCIAL STATEMENT SCHEDULES	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 Bank and Central Valley Bank, N.A. Heritage Bank is a Washington state-chartered commercial bank whose deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”) under the Savings Association Insurance Fund (“SAIF”) and the Bank Insurance Fund (“BIF”). During 2004, Heritage Bank changed its charter from a savings bank to a commercial bank. 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. 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. 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 our 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 $336.2 million, or 56.1% of total loans, as of December 31, 2004 from $266.3 million, or 51.1% of total loans, as of December 31, 2003. We continue to provide real estate mortgages, both single and multifamily residential and commercial. Real estate mortgages increased to $211.9 million, or 35.3% of total loans, at December 31, 2004, from $207.1 million, or 39.7% of total loans, at December 31, 2003.

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 prior to deduction for the allowance for loan losses.


	At December 31,
	2004					2003					2002					2001					2000
	Balance			% of Total		Balance			% of Total		Balance			% of Total		Balance			% of Total		Balance			% of Total
	(Dollars in thousands)
Commercial	$	336,227		56.06	%	$	266,252		51.06	%	$	243,872		51.86	%	$	263,063		52.75	%	$	234,166		48.55	%
Real Estate Mortgages
One-four family residential(1)		58,903		9.82			57,377		11.00			72,846		15.49			91,189		18.28			107,501		22.28
Five or more family residential and commercial properties		152,958		25.50			149,728		28.72			114,750		24.40			107,450		21.55			109,560		22.71

Total real estate mortgages		211,861		35.32			207,105		39.72			187,596		39.89			198,639		39.83			217,061		44.99
Real estate construction
One-four family residential		23,266		3.88			19,881		3.81			29,201		6.21			32,494		6.51			27,412		5.68
Five or more family residential and commercial properties		17,121		2.85			19,570		3.75			3,169		0.67			83		0.02			—		—

Total real estate construction(2)		40,387		6.73			39,451		7.56			32,370		6.88			32,577		6.53			27,412		5.68
Consumer		13,045		2.18			10,043		1.93			7,616		1.62			5,794		1.16			5,466		1.13

Gross loans		601,520		100.29	%		522,851		100.27	%		471,454		100.25	%		500,073		100.27	%		484,105		100.35	%
Less deferred loan fees and other		(1,759	)	(0.29	)		(1,438	)	(0.27	)		(1,190	)	(0.25	)		(1,368	)	(0.27	)		(1,670	)	(0.35	)

Total loans receivable and loans held for sale	$	599,761		100.00	%	$	521,413		100.00	%	$	470,264		100.00	%	$	498,705		100.00	%	$	482,435		100.00	%

(1)

Includes loans held for sale of $381, $1,018, $8,113, $6,275 and $1,931 as of December 31, 2004, 2003, 2002, 2001 and 2000, respectively.

(2)

Balances are net of undisbursed loan proceeds.

The following table presents at December 31, 2004 (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	$	126,575	$	96,581	$	113,071	$	336,227
Real estate construction		29,580		6,085		4,722		40,387

Total	$	156,155	$	102,666	$	117,793	$	376,614

Fixed rate loans			$	42,240	$	43,240	$	85,480
Variable or adjustable rate loans				60,426		74,553		134,979

Total			$	102,666	$	117,793	$	220,459

Real Estate Lending

Single-Family Residential Real Estate Lending. The majority of our residential loans are secured by single-family residences located in our primary market areas. Our underwriting standards require that single-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 single-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 single-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 single-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 buyers 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, 2004, we had $336.2 million, or 56.1% of our total loans receivable, in commercial loans. The average loan size is approximately $300,000 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 $0.9 million, $2.0 million, and $3.9 million in mortgage loans for others as of December 31, 2004, 2003, and 2002, respectively. We received fee income for servicing activities on mortgage loans of $10,000, $14,000, and $19,000 for the years ended December 31, 2004, 2003, and 2002, 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,
	2004		2003		2002		2001		2000
	(Dollars in thousands)
Residential mortgage loans:
Originated	$	52,188	$	125,438	$	91,614	$	103,634	$	55,630
Sold		35,822		105,790		74,318		97,807		35,876
Gains on sales of loans, net	$	640	$	1,907	$	1,404	$	1,669	$	684

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, 2004, we had outstanding commitments to extend credit, including letters of credit, in the amount of $127.9 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,
	2004			2003			2002			2001			2000
	(Dollars in thousands)
Nonaccrual loans	$	319		$	297		$	1,987		$	1,962		$	1,607
Restructured loans		—			—			—			—			—

Total nonperforming loans		319			297			1,987			1,962			1,607
Real estate and other assets owned		—			389			296			1,053			—

Total nonperforming assets	$	319		$	686		$	2,283		$	3,015		$	1,607

Accruing loans past due 90 days or more	$	—		$	19		$	19		$	306		$	1,086
Potential problem loans	$	12,184		$	10,502		$	11,261		$	4,631		$	2,422
Allowance for loan losses	$	8,295		$	7,748		$	6,874		$	5,751		$	5,063
Nonperforming loans to loans		0.05	%		0.06	%		0.42	%		0.39	%		0.33	%
Allowance for loan losses to loans		1.38	%		1.49	%		1.46	%		1.15	%		1.05	%
Allowance for loan losses to nonperforming loans		2,603.60	%		2,611.97	%		346.05	%		293.12	%		315.02	%
Nonperforming assets to total assets		0.05	%		0.11	%		0.38	%		0.49	%		0.28	%

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 $4,397, $37,233 and $(29,986) for the years ended December 31, 2004, 2003, and 2002, respectively.

There were no real estate and other assets owned at December 31, 2004. As of December 31, 2003, there was $559,662 in real estate and other assets owned. 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 could result in placing the loan on nonaccrual. As of December 31, 2004, potential problem loans increased by $1.7 million to $12.2 million from $10.5 million at December 31, 2003.

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.

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,
	2004			2003			2002			2001			2000
	(Dollars in thousands)
Total loans outstanding at end of period(1)	$	599,761		$	521,413		$	470,264		$	498,705		$	482,435

Average loans outstanding during period	$	549,445		$	481,404		$	472,785		$	494,379		$	445,813

Allowance balance at beginning of period	$	7,748		$	6,874		$	5,751		$	5,063		$	4,264
Provision for loan losses		645			1,125			1,835			1,193			787
Charge-offs:
Real estate(2)		(41	)		(138	)		(69	)		(407	)		(4	)
Commercial		(55	)		(102	)		(657	)		(88	)		(34	)
Agriculture		(10	)		—			—			—			—
Consumer		(3	)		(19	)		(7	)		(12	)		(2	)

Total charge-offs		(109	)		(259	)		(733	)		(507	)		(40	)

Recoveries:
Real estate(2)		8			3			1			1			22
Commercial		—			4			20			—			29
Agriculture		3			—			—			—			—
Consumer		—			1			—			1			1

Total recoveries		11			8			21			2			52

Net (charge-offs) recoveries		(98	)		(251	)		(712	)		(505	)		12

Allowance balance at end of period	$	8,295		$	7,748		$	6,874		$	5,751		$	5,063

Ratio of net (charge-offs) recoveries during period to average loans outstanding		(0.02	)%		(0.05	)%		(0.15	)%		(0.10	)%		—	%

(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 affect loan losses in the categories shown below:


	At December 31,
	2004				2003				2002				2001				2000
	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	$	5,971	55.9	%	$	5,578	51.0	%	$	4,949	51.8	%	$	4,141	52.7	%	$	3,644	45.8	%
Real Estate Mortgage
One-four family residential		327	9.8	%		305	11.0	%		271	15.4	%		227	18.1	%		200	23.3	%
Five or more family residential and commercial properties		1,402	25.4	%		1,310	28.7	%		1,162	24.4	%		972	21.5	%		856	22.5	%
Real Estate Construction:
One-four family residential		449	3.9	%		419	3.7	%		370	6.2	%		310	6.5	%		274	5.6	%
Five or more family residential and commercial properties		34	2.8	%		31	3.8	%		28	0.6	%		23	—			20	1.8	%
Consumer		112	2.2	%		105	1.8	%		94	1.6	%		78	1.2	%		69	1.0	%

Net loans	$	8,295	100.0	%	$	7,748	100.0	%	$	6,874	100.0	%	$	5,751	100.0	%	$	5,063	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, 2004, our investment securities portfolio totaled $47.4 million, which consisted of $45.9 million of securities available for sale and $1.5 million of securities held to maturity. This compares with a total portfolio of $57.8 million at December 31, 2003, which was comprised of $55.6 million of securities available for sale and $2.2 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, 2004.


	Book Value		Fair Value		Weighted Average Yield(1)
	(Dollars in thousands)
Obligations of US Government agencies
Due within one year	$	16,493	$	16,299	3.32	%
Due after 1 year but within 5 years		2,531		2,550	3.93
Due after 5 years but within 10 years		1,771		1,806	5.23

		20,795		20,655

Mortgage backed securities
Due within one year		11,003		10,871	2.75
Due after 1 year but within 5 years		614		620	3.89
Due after 5 years but within 10 years		1,490		1,537	5.31

		13,107		13,028

Collateralized mortgage obligations
Due after 1 year but within 5 years		231		230	3.82
Due after 5 years but within 10 years		1,823		1,781	2.91
Due after 10 years		10,263		10,197	4.02

		12,317		12,208

Total all investments available for sale	$	46,219	$	45,891

The following table provides information regarding our investment securities held to maturity at December 31, 2004.


	Book Value		Fair Value		Weighted Average Yield(1)
	(Dollars in thousands)
Municipal bonds
Due within one year	$	460	$	469	6.07	%
Due after 1 year but within 5 years		565		595	6.51

		1,025		1,064

Mortgage backed securities
Due within one year		28		29	4.17
Due after 1 year but within 5 years		28		29	8.27
Due after 5 years		379		414	8.20

		435		472

Total all investments held to maturity	$	1,460	$	1,536

(1)

Taxable equivalent weighted average yield.

We held $3.0 million of FHLB stock at December 31, 2004. 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, 2004, we were required to maintain an investment in the stock of the FHLB of Seattle of at least $1.8 million. We held $86,400 in Federal Reserve Bank stock.

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 $45.5 million in 2004 over the prior year, with certificates of deposit accounts increasing slightly as a percentage of total deposits. Although, we continue to increase our non-interest and low interest bearing account balances we had larger increases in certificate of deposits due to our efforts to control rising cost of funds as well as fund loan growth. Customer deposits remain an important source of funding, but these balances have been influenced in the past by adverse market conditions 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, 2004, 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. At Heritage Bank, interest is compounded daily and credited quarterly or at maturity. At Central Valley Bank, interest is accrued daily and compounded 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. At Heritage Bank, interest is compounded daily and credited quarterly. At Central Valley Bank, interest is accrued daily and compounded 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. At Heritage Bank, interest is compounded daily and paid monthly. At Central Valley Bank, interest is accrued daily and compounded 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. At Heritage Bank, interest is compounded daily and credited quarterly. At Central Valley Bank, interest is accrued daily and compounded 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:


	2004				2003				2002
	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	$	165,486	0.73	%	$	154,420	0.82	%	$	143,617	1.20	%
Savings		104,271	1.00			97,352	1.17			88,775	1.72
Certificates of deposit		222,279	2.01			202,141	2.36			222,997	3.07

Total interest bearing deposits		492,036	1.37			453,913	1.58			455,389	2.22
Demand and other noninterest bearing deposits		76,994	—			63,890	—			55,712	—

Total deposits	$	569,030	1.18	%	$	517,803	1.38	%	$	511,101	1.98	%

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:


	2004			2003			2002
	(Dollars in thousands)
Net increase in deposits	$	45,446		$	24,716		$	2,036
Less: Interest credited		(6,458	)		(7,166	)		(10,146	)

Net increase (decrease) before interest credited.	$	38,988		$	17,550		$	(8,110	)

The following table shows the amount and maturity of certificates of deposits of $100,000 or more as of December 31, 2004:


	(Dollars in thousands)
Remaining maturity:
Three months or less	$	1,751
Over three months through six months		18,933
Over six months through twelve months		37,413
Over twelve months		59,277

Total	$	117,374

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 Federal Home Loan Bank of Seattle (“FHLB”) 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, which is owned by us. Our subsidiary banks also have lines to purchase federal funds up to $28.5 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. At December 31, 2004, we maintained a credit facility with the FHLB of Seattle for $122.6 million with an outstanding balance of $40.9 million.

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:


	2004			2003			2002
	(Dollars in thousands)
Balance at period end	$	40,900		$	31,100		$	—
Average balance during the period		30,352			7,241			1,189
Maximum amount outstanding at any month end		48,900			31,100			6,000
Average interest rate:
During the period		1.49	%		1.21	%		4.83	%
At period end		2.35	%		1.10	%		0	%

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:


	2004			2003			2002
	(Dollars in thousands)
Balance at period end	$	—		$	—		$	—
Average balance during the period		557			730			826
Maximum amount outstanding at any month end		2,194			4,127			3,607
Average interest rate:
During the period		4.38	%		4.10	%		4.58	%
At period end		0	%		0	%		0	%

There were no fed funds purchased for the years ended December 31, 2004, 2003 and 2002.

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, the FDIC and shareholders. 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 thereunder 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 the Office of the Comptroller of the currency (“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 annual 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 commercial 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 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, 2004.

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 and the BIF 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 1980’s 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 0.013% 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.

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.

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 country);

•

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 30, 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. We have also adopted a Code of Ethics applicable to all officers, directors, and employees, which is posted on 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 have posted the text of our code of ethics at www.HF-WA.com in the section titled Investor Information: Corporate Governance. 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, all of whom are considered “independent” as defined by the SEC. 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 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

We have 196 full-time equivalent employees. We saw a reduction of 10 full-time equivalents during 2004 predominately due to our staff reductions in the mortgage department. We still provide mortgage lending services but our staffing reductions were primarily due to declined volumes. 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 by Heritage Bank and located in

downtown Olympia. At December 31, 2004, 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 2004.

PART II

ITEM 5.

MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock is traded on the NASDAQ National Market System^{^®} under the symbol HFWA. At December 31, 2004, 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 5,946,990 outstanding shares of common stock. The last reported sales price on February 4, 2005 was $21.42 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.


	2004 Quarter ended:
	March 31		June 30		September 30		December 31
High	$	22.14	$	21.37	$	21.20	$	22.50
Low	$	20.26	$	18.17	$	18.40	$	19.67

	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

Since our stock offering in January 1998, we have declared quarterly cash dividends. The two most recent fiscal years quarterly cash dividends are listed below:


Declared	Cash Dividend per share		Record Date	Paid
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
March 18, 2004	$	0.155	April 15, 2004	April 29, 2004
June 17, 2004	$	0.160	July 15, 2004	July 29, 2004
September 23, 2004	$	0.165	October 15, 2004	October 29, 2004
December 21, 2004	$	0.170	January 14, 2005	January 28, 2005

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.

ITEM 6.

SELECTED FINANCIAL DATA


	For the years ended December 31,
	2004			2003			2002			2001			2000
	(Dollars in thousands, except per share data)
Operations Data:
Net interest income	$	31,727		$	29,817		$	30,203		$	26,632		$	24,841
Provision for loan losses		645			1,125			1,835			1,193			787
Noninterest income		6,498			7,164			6,181			5,925			4,190
Noninterest expense		23,270			22,223			20,254			20,624			19,323
Federal income tax expense		4,725			4,729			4,871			3,778			2,947
Net income		9,585			8,904			9,424			6,962			5,974
Earnings per share
Basic		1.61			1.37			1.31			0.87			0.66
Diluted		1.57			1.32			1.27			0.86			0.65
Dividend payout ratio(1)		40.4	%		41.6	%		37.4	%		46.9	%		50.2	%

Performance Ratios:
Net interest spread		4.91	%		5.16	%		5.17	%		4.33	%		4.12	%
Net interest margin(2)		5.13	%		5.42	%		5.53	%		4.98	%		5.04	%
Efficiency ratio(3)		60.88	%		60.09	%		55.67	%		63.35	%		66.56	%
Return on average assets		1.44	%		1.49	%		1.58	%		1.19	%		1.11	%
Return on average equity		15.80	%		13.03	%		12.18	%		8.52	%		6.66	%

	At December 31,
	2004			2003			2002			2001			2000
Balance Sheet Data:
Total assets	$	697,267		$	640,920		$	594,587		$	609,643		$	573,530
Loans receivable, net		591,085			512,647			455,277			486,679			475,441
Loans held for sale		381			1,018			8,113			6,275			1,931
Deposits		587,278			541,832			517,116			515,080			460,234
Federal Home Loan Bank advances		40,900			31,100			—			8,000			23,125
Other borrowings		—			—			—			—			1,000
Stockholders’ equity		60,944			62,232			72,397			78,528			83,005
Book value per share	$	10.25		$	10.05		$	10.63		$	10.42		$	10.09
Equity to assets ratio		8.74	%		9.71	%		12.18	%		12.88	%		14.47	%
Asset Quality Ratios:
Nonperforming loans to loans		0.05	%		0.06	%		0.42	%		0.39	%		0.33	%
Allowance for loan losses to loans		1.38	%		1.49	%		1.46	%		1.15	%		1.05	%
Allowance for loan losses to nonperforming loans		2,603.60	%		2,611.97	%		346.05	%		293.12	%		315.02	%
Nonperforming assets to total assets		0.05	%		0.11	%		0.38	%		0.49	%		0.28	%
Other Data:
Number of banking offices		18			18			18			18			18
Number of full-time equivalent employees		196			206			195			198			211

(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, 2004 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 estimate 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 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 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 2000 thru 2004 our total assets have grown $123.7 million, or 21.6%, with net loans making up $115.6 million of this increase. Our emphasis in growing our commercial loan portfolio resulted in an increase in commercial loans of $102.1 million, or 43.6%, since 2000. In addition, the overall loan increases were enhanced by our emphasis in growing our Pierce county market.

Deposits have increased $127.0 million, or 27.6%, for the period from 2000 thru 2004 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 $22.1 million since December 31, 2000 as a result of our stock repurchase programs. Since 1999, we have repurchased 5,579,191 shares totaling $70.5 million. During the five-year period from 2000 thru 2004, our annual net income has increased by 60.4% or $3.6 million. The result of these five-year trends have provided our company with an increase in return on average equity from 6.66% for the year ended December 31, 2000 to 15.80% for year ended December 31, 2004. We exceeded our previous five year strategic goal of a 15.00% return on average equity by the year ended December 31, 2005 one year early.

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,
	2004						2003						2002
	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	$	549,444	$	36,938	6.72	%	$	481,404	$	35,059	7.28	%	$	472,785	$	37,930	8.02	%
Mortgage Backed Securities		3,312		172	5.22			5,568		330	5.94			7,589		482	6.35
Investment securities and FHLB Stock		51,139		1,657	3.24			47,711		1,574	3.30			35,363		1,546	4.37
Interest earning deposits		14,945		177	1.18			15,860		188	1.18			30,106		469	1.56

Total interest earning assets	$	618,840	$	38,944	6.29	%	$	550,543	$	37,151	6.75	%	$	545,843	$	40,427	7.41	%
Noninterest earning assets		46,478						47,694						50,035

Total assets	$	665,318					$	598,237					$	595,878

Interest Bearing Liabilities:
Certificates of deposit	$	222,279	$	4,477	2.01	%	$	202,141	$	4,767	2.36	%	$	222,997	$	6,857	3.07	%
Savings accounts		104,271		1,043	1.00			97,352		1,139	1.17			88,775		1,528	1.72
Interest bearing demand and money market accounts		165,486		1,204	0.73			154,420		1,273	0.82			143,617		1,719	1.20

Total interest bearing deposits		492,036		6,724	1.37			453,913		7,179	1.58			455,389		10,104	2.22
FHLB advances		30,352		453	1.49			7,241		87	1.20			1,189		56	4.74
Other borrowed funds		557		40	7.18			730		68	9.33			826		64	7.68

Total interest bearing liabilities	$	522,945	$	7,217	1.38	%	$	461,884	$	7,334	1.59	%	$	457,404	$	10,224	2.24	%
Demand and other noninterest bearing deposits		76,994						63,890						55,712
Other noninterest bearing liabilities		4,708						4,120						5,378
Stockholders’ equity		60,671						68,343						77,384

Total liabilities and stockholders’ equity	$	665,318					$	598,237					$	595,878

Net interest income			$	31,727					$	29,817					$	30,203
Net interest spread					4.91	%					5.16	%					5.17	%
Net interest margin					5.13	%					5.42	%					5.53	%
Average interest earning assets to average interest bearing liabilities					118.34	%					119.19	%					119.33	%

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,
	2004 Compared to 2003 Increase (Decrease) Due to									2003 Compared to 2002 Increase (Decrease) Due to
	Volume			Rate			Total			Volume			Rate			Total
	(Dollars in thousands)
Interest Earning Assets:
Loans	$	4,941		$	(3,062	)	$	1,879		$	692		$	(3,563	)	$	(2,871	)
Mortgage backed securities		(134	)		(24	)		(158	)		(128	)		(23	)		(151	)
Investment securities and FHLB stock		114			(31	)		83			540			(512	)		28
Interest earning deposits		(28	)		17			(11	)		(222	)		(60	)		(282	)

Interest income	$	4,893		$	(3,100	)	$	1,793		$	882		$	(4,158	)	$	(3,276	)

Interest bearing liabilities:
Certificates of deposit	$	475		$	(765	)	$	(290	)	$	(641	)	$	(1,450	)	$	(2,091	)
Savings accounts		81			(177	)		(96	)		148			(536	)		(388	)
Interest bearing demand and money market accounts		91			(160	)		(69	)		129			(576	)		(447	)

Total interest bearing deposits		647			(1,102	)		(455	)		(364	)		(2,562	)		(2,926	)
FHLB advances		273			93			366			287			(257	)		30
Other borrowings		(16	)		(12	)		(28	)		(6	)		12			6

Interest expense	$	904		$	(1,021	)	$	(117	)	$	(83	)	$	(2,807	)	$	(2,890	)

Results of Operations for the Years Ended December 31, 2004 and 2003

Net Income. Our net income was $9.6 million or $1.57 per diluted share for the year ended December 31, 2004 compared to $8.9 million or $1.32 per diluted share for the previous year. The 7.9% increase in net income was a result of increased loan growth, maintaining a strong net interest margin and a decline in the loan loss provision by $480,000. The net interest margin declined 29 basis points with average earning assets increasing $68.3 million, ending the year at $618.8 million compared to the previous year end of $550.5 million. During 2004, there was a one-time gain on sale of an investment available for sale (HCB Bancorp shares) pre-tax of $218,000 and after-tax of $144,000. Excluding the gain on sale of the HCB Bancorp shares, net income would have been $9.4 million or $1.54 per diluted share.

Net Interest Income. Net interest income increased $1.9 million to $31.7 million for the year ended December 31, 2004 compared with the previous year of $29.8 million. The increase in net interest income resulted primarily from strong loan growth and our continuation of the net interest margin above 5.0%.

Net interest income as a percentage of average earning assets (net interest margin) for the year ended December 31, 2004 decreased to 5.13% from 5.42% for the previous year. Our net interest spread for the year ended December 31, 2004 decreased to 4.91% from 5.16% for the prior year. This corresponded with the decrease in the average rate of interest earning assets to 6.29% for the year ended December 31, 2004 from 6.75% for the same period last year as well as the decrease in the average cost of funds to 1.38% (only a 21 basis point decline) for the year ended December 31, 2004 from 1.59% for the same period last year. Overall, our net interest margin is very strong at 5.13% in comparison to the median for West Coast publicly traded commercial banks of 4.65% as reported by D.A. Davidson and Companies for the period ending September 30, 2004.

Provision for Loan Losses. During the year ended December 31, 2004, we provided $645,000 through operations to maintain our allowance at an adequate level compared to $1.1 million for the year ended December 31, 2003. For the year ended December 31, 2004, we experienced net charge-offs of $98,000 versus net charge-offs

of $251,000 for the year ended December 31, 2003. The provision and corresponding net charge-offs decreased our allowance for loan losses as a percentage of total loans to 1.38% at December 31, 2004 from 1.49% at the end of 2003. Our asset quality has remained solid as demonstrated by the nonperforming assets to total assets ratio of 0.05% at December 31, 2004 compared to 0.11% at December 31, 2003.

We consider the allowance for loan losses at December 31, 2004 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 decreased $666,000, or 9.3%, for the year ended December 31, 2004 compared with the prior year. Mortgage banking income decreased $1.3 million, or 66.4%, over the prior year. Mortgage loans sold during 2004 were $35.8 million versus $105.8 million sold during 2003, a decrease of 66.2%. Merchant visa income increased $327,000, or 20.6%, due to increased business volumes. Service charges on deposits also increased by $135,000 due to our focus on growing our deposit relationships.

Noninterest Expense. Total noninterest expense increased $1.1 million, or 4.7%, for the year ended 2004 compared to the 2003 period. Salaries and employee benefits increased by $574,000 primarily due to the unfavorable impact of lower deferred salary contra expense associated with decreased residential loan volumes. Although we experienced a decline in full time equivalent employees of 10 year over year related to our decreased mortgage department staff, we also experienced increases in health benefit costs. Merchant Visa expenses increased by $205,000, or 15.8%. The increase was in line with the increase in business volumes as well as Merchant Visa income. Other operating expenses increased by $215,000, or 6.3%, due to the increases in accounting and professional services related to the implementation of Sarbanes-Oxley Section 404—Internal Controls over Financial Reporting as well as various expenses associated with Central Valley Bank converting to a new service provider—Bisys.

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.

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 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, 2004, cash and cash equivalents totaled $25.3 million, or 3.6% of total assets. At December 31, 2004, our banks maintained a credit facility with the FHLB of Seattle for $122.6 million of which we borrowed $40.9 million as of December 31, 2004. In addition, we maintain a credit facility with KeyBank of $5.0 million as well as another $5.0 million line to support letters of credit. Our subsidiary banks also maintain advance lines to purchase federal funds totaling $28.5 million as of December 31, 2004.

During 2004 total assets grew $56.3 million with net loans increasing by $78.4 million over the prior year-end and deposits increasing $45.5 million over the prior year-end. As a result, borrowings increased by $9.8 million from the FHLB of Seattle. 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, 2004, 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, 2004, we have repurchased 5,579,191 shares of our stock representing 51.4% of the total outstanding as of March 31, 1999 at an average price of $12.64 reducing our capital levels by $70.5 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, 2004, the Company has allocated or committed to be released to the ESOP 8,817 earned shares and has 71,267 unearned, restricted shares remaining to be released. The fair value of unearned, restricted shares held by the ESOP trust was $1,576,426 at December 31, 2004.

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, single-family residential mortgage loan originations; originating commercial loans and residential construction loans at variable interest rates repricing 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 11.2% and a negative 4-12 month “gap” of 1.5% as of December 31, 2004. 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, 2004 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 the 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	$	181,760		$	56,502		$	256,356		$	77,177		$	27,966		$	599,761
Investment securities		25,684			1,974			3,993			5,621			10,079			47,351
FHLB and Federal Reserve Stock		3,038			—			—			—			—			3,038
Fed funds sold		6,000			—			—			—			—			6,000
Interest earning deposits		2,769			—			—			—			—			2,769

Total interest earning assets	$	219,251		$	58,476		$	260,349		$	82,798		$	38,045		$	658,919

Interest Bearing Liabilities:
Total interest bearing deposits	$	104,268		$	142,502		$	258,432		$	—		$	—		$	505,202
FHLB advances and other borrowings		40,900			—			—			—			—			40,900

Total interest bearing liabilities	$	145,168		$	142,502		$	258,432		$	—		$	—		$	546,102

Rate sensitivity gap	$	74,083		$	(84,026	)	$	1,917		$	82,798		$	38,045		$	112,817
Cumulative rate sensitivity gap:
Amount		74,083			(9,943	)		(8,026	)		74,772			112,817
As a percentage of total interest earning assets		11.24	%		(1.51	)%		(1.22	)%		11.35	%		17.12	%

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 December 2004, the FASB issued a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation (SFAS No. 123R). This Statement supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. This Statement does not change the accounting guidance for share-based payment transactions with parties other than employees provided in Statement 123 as originally issued and EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” This Statement does not address the accounting for employee share ownership plans, which are subject to AICPA Statement of Position 93-6, Employers’ Accounting for Employee Stock Ownership Plans. This Statement is effective for public entities that do not file as small business issuers—as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. The Company is evaluating the requirements of SFAS No. 123R and expects the adoption will have an impact on the consolidated results of operations and earnings per share. The Company has not determined the method of adoption or the effect of adopting SFAS No. 123R.

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. FASB has delayed the effective date of paragraph 10-20 of Issue 03-1. This delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. Application of this Interpretation did not have a material effect on our financial statements.

In December 2003, the FASB issued FASB Interpretation (FIN) No. 46 (revised December 2003), Consolidation of Variable Interest Entities, which addressed how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46, Consolidation of Variable Interest Entities, which was issued in January 2003. The Company will be required to apply FIN 46R to variable interests in variable interest entities (VIEs) created after December 31, 2003. For VIEs created before January 1, 2004, the Interpretation will be applied beginning on January 1, 2005. For any VIEs that must be consolidated under FIN 46R that were created before January 1, 2004, the assets, liabilities and noncontrolling interests of the VIE initially would be measured at their carrying amounts with any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an accounting change. If determining the carrying amounts is not practicable, fair value at the date FIN 46R first applies may be used to measure the assets, liabilities, and noncontrolling interests of the VIE. Application of this Interpretation did not have an 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, 2004. 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,
	2005			2006			2007			2008- 2009			After 2010			Total		Fair Value
	(Dollars in thousands)
Investment Securities
Amounts maturing:
Fixed rate	$	1,956		$	4,424		$	4,343		$	10,029		$	15,700		$	36,452
Weighted average interest rate		3.17	%		2.92	%		2.84	%		3.46	%		4.05	%
Adjustable Rate		—			—			—			—			10,899			10,899
Weighted average interest rate		—			—			—			—			2.78	%

Totals		1,956			4,424			4,343			10,029			26,599		$	47,351	$	47,427
Loans
Amounts maturing:
Fixed rate	$	40,176		$	20,325		$	13,460		$	29,246		$	100,647		$	203,854
Weighted average interest rate		7.03	%		7.73	%		7.16	%		6.60	%		5.90	%
Adjustable rate		137,464			30,573			17,360			41,928			168,582			395,907
Weighted average interest rate		6.35	%		6.18	%		6.32	%		6.48	%		6.15	%

Totals	$	177,640		$	50,898		$	30,820		$	71,174		$	269,229		$	599,761	$	595,441
Certificates of Deposit
Amounts maturing:
Fixed rate	$	189,831		$	31,603		$	7,546		$	6,694		$	—		$	235,674	$	234,766
Weighted average interest rate		2.07	%		2.84	%		4.11	%		3.47	%		—

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 accountants nor disagreements with our accountants on accounting and financial disclosure.

ITEM 9A.

CONTROLS AND PROCEDURES

(i) Disclosure Controls and Procedures.

As of December 31, 2004, our Chief Executive Officer and Chief Financial Officer have evaluated our disclosure controls and procedures. 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.

(ii) Internal Control Over Financial Reporting.

(a) Management’s report on internal control over financial reporting.

Management of Heritage Financial Corporation and subsidiaries is responsible for establishing and maintaining adequate internal control over financial reporting as required by the Sarbanes-Oxley Act of 2002 and as defined in the Securities Exchange Act of 1934 Rule 13a-15(f). A system of internal control can provide only reasonable, not absolute assurance, that the objectives of the controls system are met. Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

Based on this evaluation, our management concluded that as of December 31, 2004, our internal control over financial reporting was effective.

(b) Attestation report of the registered public accounting firm.

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Heritage Financial Corporation:

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting that Heritage Financial Corporation and subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial condition of Heritage Financial Corporation and

subsidiaries as of December 31, 2004 and 2003, 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, 2004, and our report dated March 15, 2005 expressed an unqualified opinion on those consolidated financial statements.

/s/ KPMG LLP

Seattle, Washington

March 15, 2005

(c) Changes in internal control over financial reporting.

There were no significant changes in the Company’s internal control over financial reporting during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

ITEM 9B.

OTHER INFORMATION.

None.

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, 2005 (“Proxy Statement”) for the annual meeting of shareholders to be held April 28, 2005.

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

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 and we have not yet adopted the latest revisions to SFAS No. 123. 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 2004 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, 2004, all of which were approved by stockholders.


Number of securities to be issued upon exercise of outstanding options and awards		595,070
Weighted average exercise price of outstanding options	$	15.83
Number of securities remaining available for future issuance		239,903

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 AND FINANCIAL STATEMENT SCHEDULES

(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)

10.11		Revised Employment Agreement between the Company and Donald V. Rhodes, effective January 1, 2005(8)

14.0		Code of Ethics(7)

21.0		Subsidiaries of the Company

23.0		Consent of Independent Registered Public Accounting Firm

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).

(7)

Incorporated by reference to the Annual Report on Form 10-K dated March 8, 2004.

(8)

Incorporated by reference to the Quarterly Report on Form 10Q dated November 2, 2004.

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 and Chief Executive Officer

Principal Financial Officer:

/s/ EDWARD D. CAMERON

Edward D. Cameron

Senior Vice President, Corporate Secretary and Treasurer

Dated: March 15, 2005

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 15, 2005, 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 15, 2005

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2004, 2003, and 2002

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS


		Page
Report of Independent Registered Public Accounting Firm		F-2

Consolidated Statements of Financial Condition—December 31, 2004 and December 31, 2003		F-3

Consolidated Statements of Income—Years ended December 31, 2004, 2003, and 2002		F-4

Consolidated Statements of Stockholders’ Equity and Comprehensive Income—Years ended December 31, 2004, 2003, and 2002		F-5

Consolidated Statements of Cash Flows—Years ended December 31, 2004, 2003, and 2002		F-6

Notes to Consolidated Financial Statements		F-7

F-1

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Heritage Financial Corporation:

We have audited the accompanying consolidated statements of financial condition of Heritage Financial Corporation and subsidiaries (the Company) as of December 31, 2004 and 2003, 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, 2004. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heritage Financial Corporation and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Heritage Financial Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 15, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

/s/ KPMG LLP

Seattle, Washington

March 15, 2005

F-2

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

December 31, 2004 and 2003

(Dollars in thousands)


	2004			2003
ASSETS
Cash on hand and in banks	$	16,570		$	17,945
Interest earning deposits		2,769			9,981
Federal funds sold		6,000			7,600
Investment securities available for sale		45,891			55,601
Investment securities held to maturity		1,460			2,151
Loans held for sale		381			1,018
Loans receivable		599,380			520,395
Less: Allowance for loan losses		(8,295	)		(7,748	)

Loans receivable, net		591,085			512,647
Real estate owned		—			523
Premises and equipment, at cost, net		16,883			17,451
Federal Home Loan Bank and Federal Reserve stock, at cost		3,038			2,962
Accrued interest receivable		2,946			2,782
Prepaid expenses and other assets		2,803			3,205
Deferred Federal income taxes, net		801			414
Goodwill, net		6,640			6,640

	$	697,267		$	640,920

LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits	$	587,278		$	541,832
Advances from Federal Home Loan Bank		40,900			31,100
Accrued expenses and other liabilities		8,145			5,756

		636,323			578,688

Stockholders’ equity:
Common stock, no par, 15,000,000 shares authorized; 5,946,990 and 6,192,996 shares outstanding at December 31, 2004 and 2003, respectively		11,883			18,430
Unearned compensation—ESOP and restricted stock award		(1,379	)		(1,087	)
Retained earnings, substantially restricted		50,657			44,849
Accumulated other comprehensive income (loss), net		(217	)		40

Total stockholders’ equity		60,944			62,232
Commitments and Contingencies		—			—

	$	697,267		$	640,920

See accompanying notes to consolidated financial statements.

F-3

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

For the years ended December 31, 2004, 2003 and 2002

(Dollars in thousands, except per share amounts)


	2004		2003		2002
Interest income:
Loans	$	36,938	$	35,059	$	37,930
Mortgage backed securities		172		330		482
Investment securities and Federal Home Loan Bank dividends		1,657		1,574		1,546
Interest on federal funds sold and overnight deposits		177		188		469

Total interest income		38,944		37,151		40,427

Interest expense:
Deposits		6,724		7,179		10,104
Other borrowings		493		155		120

Total interest expense		7,217		7,334		10,224

Net interest income		31,727		29,817		30,203
Provision for loan losses		645		1,125		1,835

Net interest income after provision for loan losses		31,082		28,692		28,368

Noninterest income:
Gains on sales of loans, net		640		1,907		1,404
Service charges on deposits		2,556		2,421		2,316
Rental income		294		268		263
Merchant visa income		1,915		1,588		1,231
Other income		1,093		980		967

Total noninterest income		6,498		7,164		6,181

Noninterest expense:
Salaries and employee benefits		12,222		11,648		10,519
Building occupancy		2,038		1,896		1,660
Depreciation		1,708		1,863		1,774
FDIC premiums		92		81		88
Data processing		1,252		1,212		1,062
Marketing		423		415		439
Office supplies and printing		384		377		416
Merchant visa		1,502		1,297		997
Other		3,649		3,434		3,299

Total noninterest expense		23,270		22,223		20,254

Income before Federal income tax expense		14,310		13,633		14,295
Federal income tax expense		4,725		4,729		4,871

Net income	$	9,585	$	8,904	$	9,424

Basic earnings per common share	$	1.61	$	1.37	$	1.31
Basic weighted average shares outstanding		5,950,874		6,494,343		7,209,356
Diluted earnings per common share	$	1.57	$	1.32	$	1.27
Diluted weighted average shares outstanding		6,123,364		6,734,987		7,420,654

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, 2004, 2003 and 2002

(Dollars and shares in thousands)


	Number of common shares		Common stock			Unearned compensation— ESOP and Restricted Stock Awards			Retained earnings			Accumulated other comprehensive income (loss), net			Total stock- holders’ equity
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
Restricted stock awards granted	25			598			(598	)		—			—			—
Earned ESOP, incentive stock options and restricted stock shares	9			93			306			—			—			399
Exercise of stock options	123			1,069			—			—			—			1,069
Stock repurchased	(403	)		(8,307	)		—			—			—			(8,307	)
Net income	—			—			—			9,585			—			9,585
Net decrease in unrealized gain (loss) on securities available for sale, net of taxes	—			—			—			—			(257	)		(257	)
Cash dividends declared	—			—			—			(3,777	)		—			(3,777	)

Balance at December 31, 2004	5,947		$	11,883		$	(1,379	)	$	50,657		$	(217	)	$	60,944


Comprehensive Income	2004			2003			2002
Net income	$	9,585		$	8,904		$	9,424
Increase (decrease) in unrealized gain (loss) on securities available for sale, net of tax of ($132), ($154), and $164		(257	)		(306	)		304

Comprehensive income	$	9,328		$	8,598		$	9,728

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, 2004, 2003 and 2002

(Dollars in thousands)


	2004			2003			2002
Cash flows from operating activities:
Net income	$	9,585		$	8,904		$	9,424
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		1,708			1,863			1,774
Deferred loan fees, net of amortization		324			254			(42	)
Provision for loan losses		645			1,125			1,835
Federal Home Loan Bank stock dividends and Federal Reserve Stock		(79	)		(124	)		57
Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities		2,705			302			(3,074	)
Recognition of compensation related to ESOP, incentive stock options and restricted stock shares		399			298			241
Gain on sale of investment securities available for sale		(218	)		—			—
Gain on sale of other investments		—			—			(10	)
Gain on sale of premises and equipment		(7	)		(2	)		(12	)
Gain on sale of other real estate owned		(73	)		(1	)		(26	)
Net (increase) decrease in loans held for sale		637			7,095			(1,838	)
Deferred Federal income tax benefit		(254	)		(580	)		(432	)
Proceeds from Federal Home Loan Bank stock		3			16			238

Net cash provided by operating activities		15,375			19,150			8,135

Cash flows from investing activities:
Loans (originated) paid down, net of principal payments and loan sales		(79,309	)		(58,498	)		29,125
Proceeds from other real estate owned		571			645			1,126
Maturities of investment securities available for sale		26,829			52,325			40,149
Sales of investment securities available for sale		243			—			—
Maturities of investment securities held to maturity		691			670			882
Purchase of investment securities available for sale		(17,643	)		(59,975	)		(61,379	)
Proceeds from sale of other investments		—			—			10
Purchase of premises and equipment		(1,158	)		(1,305	)		(833	)
Proceeds from premises and equipment		11			22			26

Net cash (used in) provided by investing activities		(69,765	)		(66,116	)		9,106

Cash flows from financing activities:
Net increase in deposits		45,446			24,716			2,036
Net increase (decrease) in FHLB advances		9,800			31,100			(8,000	)
Cash dividends paid		(3,744	)		(3,731	)		(3,537	)
Exercise of stock options		1,008			970			479
Repurchase of common stock		(8,307	)		(16,506	)		(13,052	)

Net cash (used in) provided by financing activities		44,203			36,549			(22,074	)

Net decrease in cash and cash equivalents		(10,187	)		(10,417	)		(4,833	)
Cash and cash equivalents at beginning of year		35,526			45,943			50,776

Cash and cash equivalents at end of year	$	25,339		$	35,526		$	45,943

Supplemental disclosures of cash flow information:
Cash payments for:
Interest expense	$	6,902		$	7,312		$	10,304
Federal income taxes		4,583			5,104			6,743
Supplemental disclosure of noncash investing and financing activities:
Mortgage loans transferred to real estate owned	$	39		$	515		$	484
Net charge offs		98			251			712
Tax benefit from nonqualified stock options		61			202			46

See accompanying notes to consolidated financial statements.

F-6

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share amounts)

(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 commercial 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, 2004 and 2003 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, except per share amounts)

(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.

(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.

F-8

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

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 adjustments 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 owed. 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. 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.

F-9

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

(j) Real Estate and Other Assets Owned

Real estate and other assets acquired by the Company in satisfaction of debt are held for sale and recorded at fair value at time of foreclosure and are 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 39 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 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

F-10

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

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 2004, 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:


	2004			2003			2002
Net income:
As reported	$	9,585		$	8,904		$	9,424
Plus compensation costs recognized under ABP No. 25, net of taxes		143			67			96
Less SFAS No. 123 compensation costs, net of taxes		(325	)		(103	)		(285	)

Pro forma	$	9,403		$	8,868		$	9,235

Basic earnings per share:
As reported	$	1.61		$	1.37		$	1.31
Plus compensation costs recognized under ABP No. 25, net of taxes		0.02			0.01			0.01
Less SFAS No. 123 compensation costs, net of taxes		(0.06	)		(0.02	)		(0.04	)

Pro forma	$	1.57		$	1.36		$	1.28

Diluted earnings per share:
As reported	$	1.57		$	1.32		$	1.27
Plus compensation costs recognized under ABP No. 25, net of taxes		0.02			0.01			0.01
Less SFAS No. 123 compensation costs, net of taxes		(0.05	)		(0.02	)		(0.04	)

Pro forma	$	1.54		$	1.31		$	1.24

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.

The fair value of options granted during the years ended December 31, 2004, 2003 and 2002 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, 2004	2.99	%	6	20	%	4.31	%	$	2.58
December 31, 2003	3.52	%	6	24	%	3.88	%	$	3.74
December 31, 2002	3.63	%	7	20	%	3.97	%	$	1.84

F-11

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

(2) Loans Receivable and Loans Held for Sale

Loans receivable and loans held for sale at December 31, 2004 and 2003 consist of the following:


	2004			2003
Commercial loans	$	336,227		$	266,252

Real estate mortgages:
One to four family residential		58,903			57,377
Five or more family residential and commercial real estate		152,958			149,728

Total real estate mortgage		211,861			207,105
Real estate construction:
One to four family residential		23,266			19,881
Five or more family residential and commercial real estate		17,121			19,570

Total real estate construction		40,387			39,451
Consumer		13,045			10,043

Subtotal		601,520			522,851
Deferred loan fees and other		(1,759	)		(1,438	)

Total loans receivable and loans held for sale	$	599,761		$	521,413

As of December 31, 2004 and 2003, the Company had loans to persons serving as Directors and Executive Officers, and entities related to such individuals, aggregating $16,033 and $15,961, 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, 2004.

Potential problem loans as of December 31, 2004 were $12,200, up from 10,500 at December 31, 2003. 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 could result in placing the loan on nonaccrual.

Accrued interest on loans receivable amounted to $2,721 and $2,436 as of December 31, 2004 and 2003, respectively. The weighted average interest rate on loans was 6.4% and 6.5% for December 31, 2004 and 2003, respectively. The Company had $319 and $297 of impaired loans, which were nonaccruing as of December 31, 2004 and 2003, respectively. The annual average balance of impaired loans for the years ended December 31, 2004 and 2003 were $433 and $1,022, respectively. The allowance for loan losses related to impaired loans at December 31, 2004 and 2003 totaled $52 and $53, respectively. Interest recognized on impaired loans for the years ended December 31, 2004, 2003 and 2002 totaled $23, $162 and $146, respectively. Interest on impaired loans foregone (recovered) was $4, $37, and $(30) for the years ended December 31, 2004, 2003 and 2002, respectively. The Company has no commitments to extend additional credit on loans that are impaired at December 31, 2004.

F-12

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Details of certain mortgage banking activities at December 31, 2004 and 2003 are as follows:


	2004		2003
Loans held for sale at lower of cost or market	$	381	$	1,018
Loans serviced for others		899		2,010
Total Loans sold		35,822		105,790
Commitments to sell mortgage loans		695		3,657
Commitments to fund mortgage loans (at interest rates approximating market rates)
Fixed rate		2,656		3,814
Variable or adjustable rate		189		369

Servicing fee income from mortgage loans serviced for others amounted to $10, $14 and $19 for the years ended December 31, 2004, 2003 and 2002, respectively.

As of December 31, 2004, the Company had commitments of $59,900 in other commercial lines of credit, $61,900 in real estate commitments (both construction and lines of credit), and $6,100 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:


	2004			2003			2002
Balance at beginning of period	$	7,748		$	6,874		$	5,751
Provision		645			1,125			1,835
Recoveries		11			8			21
Charge offs		(109	)		(259	)		(733	)

Balance at end of period	$	8,295		$	7,748		$	6,874

The allocation of the allowance for loan losses is summarized as follows for the years ended December 31:


	2004				2003				2002
	Amount		% of Total Loans (1)		Amount		% of Total Loans (1)		Amount		% of Total Loans (1)
	(Dollars in thousands)
Commercial	$	5,971	55.9	%	$	5,578	51.0	%	$	4,949	51.8	%
Real Estate Mortgage
One-four family residential		327	9.8	%		305	11.0	%		271	15.4	%
Five or more family residential and commercial properties		1,402	25.4	%		1,310	28.7	%		1,162	24.4	%
Real Estate Construction:
One-four family residential		449	3.9	%		419	3.7	%		370	6.2	%
Five or more family residential and commercial properties		34	2.8	%		31	3.8	%		28	0.6	%
Consumer		112	2.2	%		105	1.8	%		94	1.6	%

Net loans	$	8,295	100.0	%	$	7,748	100.0	%	$	6,874	100.0	%

(1)

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

F-13

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

(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, 2004
U.S. Government and its agencies	$	20,795	$	60	$	(200	)	$	20,655
Mortgage backed and related securities:
Collateralized mortgage obligations and mortgage backed securities		14,421		76		(132	)		14,365
Other related securities		11,003		—		(132	)		10,871

Totals	$	46,219	$	136	$	(464	)	$	45,891

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

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

The impairment of investments, as of December 31, 2004, are not considered to be other than temporary and therefore unrealized losses were not recognized. Due to the intent to hold these investments to maturity we expect to receive full value of these investments. Investments with unrealized losses as of December 31, 2004 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	$	12,003	$	89	$	4,889	$	111	$	16,892	$	200
Mortgage backed and related securities		6,884		49		14,625		215		21,509		264

Total temporarily impaired securities	$	18,887	$	138	$	19,514	$	326	$	38,401	$	464

The amortized cost and fair value of securities available for sale, by contractual maturity, at December 31, 2004 are shown below:


	Amortized cost		Fair value
Due in one year or less	$	12,503	$	12,367
Due after one year through three years		8,478		8,439
Due after three through five years		9,891		9,764
Due after five years through ten years		3,639		3,633
Due after ten years		11,708		11,688

Totals	$	46,219	$	45,891

F-14

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

During the year ended December 31, 2004 there were sales of investment securities (HCB Bancorp shares) available for sale resulting in a $218 gain. There were no sales of investment securities available for sale during the year ended December 31, 2003.

Accrued interest on investment securities available for sale amounted to $210 and $328 as of December 31, 2004 and 2003, respectively.

At December 31, 2004 and 2003, investment securities available for sale with fair values of $13,795 and $12,879, 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, 2004 or 2003.

(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, 2004
Mortgage backed securities:
FNMA certificates	$	30	$	1	$	—	$	31
FHLMC certificates		130		7		—		137
GNMA certificates		275		29		—		304
Municipal bonds		1,025		39		—		1,064

	$	1,460	$	76	$	—	$	1,536

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

The amortized cost and fair value of investment securities held to maturity, by contractual maturity, at December 31, 2004 are shown below:


	Amortized cost		Fair value
Due in one year or less	$	460	$	469
Due after one year through three years		327		343
Due after three years through five years		265		281
Due after five years		408		443

Totals	$	1,460	$	1,536

F-15

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

There were no sales of investment securities held to maturity during the years ended December 31, 2004, 2003 and 2002.

Accrued interest on investment securities held to maturity amounted to $9 and $13 as of December 31, 2004 and 2003, respectively.

At December 31, 2004 and 2003, investment securities held to maturity with amortized cost values of $1,391 and $1,924, 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, 2004 and 2003 follows:


	2004		2003
Land	$	4,527	$	4,527
Buildings and building improvements		18,049		17,959
Furniture, fixtures and equipment		11,576		12,349

		34,152		34,835
Less accumulated depreciation		17,269		17,384

	$	16,883	$	17,451

(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. Goodwill amortization has not been recognized since 2001 and the Company has evaluated the impairment of goodwill each year ended since December 31, 2002 and concluded there is no goodwill impairment.

F-16

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

(8) Deposits

Deposits consist of the following at December 31,:


	2004				2003
	Amount		Percent		Amount		Percent
Non interest demand deposits	$	82,076	14.0	%	$	78,853	14.6	%
NOW accounts		90,570	15.4			79,721	14.7
Money market accounts		79,017	13.5			77,141	14.2
Savings accounts		99,941	17.0			101,132	18.7
Certificate of deposit accounts		235,674	40.1			204,985	37.8

	$	587,278	100.0	%	$	541,832	100.0	%

The combined weighted average interest rate of deposits was 1.26% and 1.12% at December 31, 2004 and 2003, respectively. Accrued interest payable on deposits was $557 and $290 at December 31, 2004 and 2003, respectively. Interest expense, by category, is as follows for the years ended December 31:


	2004		2003		2002
NOW accounts	$	461	$	601	$	779
Money market accounts		1,454		1,449		1,975
Savings accounts		332		363		493
Certificate of deposit accounts		4,477		4,766		6,857

	$	6,724	$	7,179	$	10,104

At December 31, 2004, the scheduled maturities of certificates of deposit are as follows:


Within one year	$	189,834
Between one and two years		31,602
Between two and three years		7,546
Between three and four years		3,783
Between four and five years		2,909

	$	235,674

Certificates of deposit issued in denominations equal to or in excess of $100 totaled $117,374 and $88,842 at December 31, 2004 and 2003, 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, 2004, the Company maintained a credit facility with the FHLB of Seattle for $122,600 with an outstanding balance of $40,900.

F-17

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

The Company is required to maintain an investment in the stock of FHLB in an amount equal to at least the greater of $0.5 or 0.75% of residential mortgage loans and pass-through securities plus 3.5% of its outstanding advances from the FHLB and 5.0% of the outstanding balance of mortgage loans sold to the FHLB. At December 31, 2004, the Company was required to maintain an investment in the stock of FHLB of Seattle of at least $1,800. The Company maintained $3,000 in FHLB stock at December 31, 2004. Purchases and sales of stock are transacted directly with the FHLB at par value. During 2004 and 2003, the Company was required to redeem FHLB stock totaling $3 and $16, respectively, due to the new capital structure requirements issued by FHLB.

A summary of FHLB Advances is summarized as follows:


	2004			2003
Balance at period end, due less than 12 months	$	40,900		$	31,100
Average balance		30,352			7,241
Maximum amount outstanding at any month end		48,900			31,100
Average interest rate:
During the period		1.49	%		1.21	%
At period end		2.35	%		1.10	%

At December 31, 2004 and 2003, the Company had $40,900 and $31,100, 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, 2004, the Company was required to maintain $103,592 in collateral to meet the collateral requirements of FHLB.

(10) Federal Funds Purchased

Our subsidiary banks maintain advance lines to purchase federal funds totaling $28,500. The lines generally mature annually with the exception of a $2,000 line with U.S. Bank, which does not mature. The lines with Key Bank matures in July 2005, the lines with US Bank were originated in 2000 and 2001 and automatically renew. As of December 31, 2004 there were no overnight federal funds purchased.

(11) Borrowings

The Company maintains a line of credit for $5,000 with Key Bank, which is renewed annually, and currently matures in March 2005. The usage on the Key Bank line of credit is summarized as follows:


	2004			2003
Balance at period end	$	—		$	—
Average balance during the period		554			730
Maximum amount outstanding at any month end		2,194			4,127
Average interest rate:
During the period		4.38	%		4.10	%
At period end		0	%		0	%

The Company maintains a line to support letters of credit for $5,000 with Key Bank, which is renewed annually, and currently matures in July 2006. There has been no usage on the Key Bank line to support letters of credit

F-18

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

(12) Federal Income Taxes

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


	2004			2003			2002
Current	$	4,979		$	5,309		$	5,303
Deferred		(254	)		(580	)		(432	)

	$	4,725		$	4,729		$	4,871

Federal income tax expense differs from that computed by applying the Federal statutory income tax rate of 35% for the years ended December 31:


	2004			2003			2002
Income tax expense at Federal statutory rate	$	5,009		$	4,772		$	5,003
Tax exempt interest		(159	)		(42	)		(20	)
Other, net		(125	)		(1	)		(112	)

	$	4,725		$	4,729		$	4,871

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:


	2004			2003
Deferred tax assets:
Allowance for loan losses	$	2,903		$	2,712
Accrued compensation		180			173
Other		135			144
Unrealized loss on available for sale securities		109			—

Total deferred tax assets		3,327			3,029
Deferred tax liabilities:
Deferred loan fees		(745	)		(766	)
Premises and equipment		(1,001	)		(1,068	)
FHLB stock		(780	)		(757	)
Unrealized loss on available for sale securities		—			(24	)

Total deferred tax liabilities		(2,526	)		(2,615	)

Deferred Federal income tax asset, net	$	801		$	414

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, 2004, the Company had a taxable temporary difference of approximately $2,800 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

F-19

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

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 $800, or $8.56 per share. In October of 1999, the Company began the first of eight 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 979,846 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 890,056 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 of 660,000 shares was commenced in March 2003 and completed in February 2004, which represented 10% of the then outstanding shares. The seventh program, for a total of 307,200 shares commenced in March 2004 and completed in June 2004, which represented 5% of the then outstanding shares. The eighth program, for a total of 295,000 shares, commenced in July 2004, with 9,700 shares, or 3.3%, repurchased as of December 31, 2004. Collectively as of December 31, 2004, the Company repurchased 5,579,191 shares of our stock representing 51.4% of the total outstanding as of March 31, 1999 at an average price of $12.64. Stock repurchased for the years ended December 31, 2004 and 2003 were $8,300 and $16,500, 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:


	2004		2003		2002
Basic:
Basic weighted average shares outstanding	6,006,362		6,530,177		7,239,657
Less restricted stock awards	(55,488	)	(35,834	)	(30,301	)

Total basic weighted average shares outstanding	5,950,874		6,494,343		7,209,356
Diluted:
Basic weighted average shares outstanding	5,950,874		6,494,343		7,209,356
Incremental shares from stock options and restricted stock awards	172,490		240,644		211,298

Weighted average shares outstanding	6,123,364		6,734,987		7,420,654

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, 2004, 2003 or 2002.

On December 21, 2004, the Company announced a quarterly cash dividend of 17.0 cents per share payable on January 28, 2005, to shareholders of record on January 14, 2005.

F-20

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

(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 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 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.

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 239,903 as of December 31, 2004.

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-21

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

The following table summarizes stock option and award activity for the years ended December 31, 2004, 2003 and 2002.


	Outstanding Options and Awards				Exercisable Options and Awards
	Shares		Avg. Price		Shares		Avg. Price
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

Options and awards granted	157,730			21.11	—			—
Became exercisable	—			—	142,015			15.08
Less: Exercised	(122,814	)		8.21	(122,814	)		8.21
Expired or canceled	(37,553	)		18.46	(37,553	)		18.46

Balance at December 31, 2004	595,070		$	15.83	274,905		$	12.19

Financial data pertaining to outstanding stock options and exercisable stock options at December 31, 2004 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—$8.50	55,841	1.9	$	7.86	55,841	$	7.86
$8.75—$9.75	58,000	2.7		9.57	58,000		9.57
$10.05	800	4.3		10.05	800		10.05
$10.15	19,800	3.3		10.15	19,800		10.15
$11.13	17,937	1.5		11.13	17,937		11.13
$12.25	114,757	4.2		12.25	72,357		12.25
$15.95	1,770	5.2		15.95	420		15.95
$19.05	9,000	5.1		19.05	3,000		19.05
$21.11	117,315	6.2		21.11	—		—
$21.38	138,850	5.2		21.38	46,750		21.38

	534,070	4.4	$	15.83	274,905	$	12.19

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-22

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

shareholders on April 25, 2002. There were 1,500 shares 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. An additional 27,500 shares were issued on March 18, 2004 at the fair market value of $21.11 with 2,500 shares canceled during the second quarter of 2004. The compensation expense associated with theses awards is being booked over the vesting life of 5 years. For the years ended December 31, 2004, 2003, and 2002, $167, $55 and $109 in compensation expense were 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-23

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

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, 2004 and December 31, 2003, 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, 2004:
The Company consolidated
Tier 1 leverage capital to average assets	$	20,489	3	%	$	34,149	5	%	$	54,431	8.0	%
Tier 1 capital to risk-weighted assets		22,710	4			34,064	6			54,431	9.6
Total capital to risk-weighted assets		45,419	8			56,774	10			61,543	10.8
Heritage Bank
Tier 1 leverage capital to average assets		17,246	3			28,744	5			45,276	7.9
Tier 1 capital to risk-weighted assets		19,854	4			29,781	6			45,276	9.1
Total capital to risk-weighted assets		39,708	8			49,635	10			51,496	10.4
Central Valley Bank
Tier 1 leverage capital to average assets		3,230	3			5,383	5			8,052	7.5
Tier 1 capital to risk-weighted assets		2,892	4			4,339	6			8,052	11.1
Total capital to risk-weighted assets		5,785	8			7,231	10			8,874	12.3

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 1 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 1 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

(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-24

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

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 $355, $403, and $426 are included in the consolidated statements of income for the years ended December 31, 2004, 2003 and 2002, 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, 2004, 2003 and 2002 were $205, $209, and $162, 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 $198, $183 and $96 for the years ended December 31, 2004, 2003 and 2002, respectively.

For the year ended December 31, 2004, the Company has allocated or committed to be released to the ESOP 8,817 earned shares and has 71,267 unearned, restricted shares remaining to be released. The fair value of unearned, restricted shares held by the ESOP trust was $1,576 at December 31, 2004.

(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-25

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

(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 of Seattle (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, 2004 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.

(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.

F-26

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

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


	December 31, 2004				December 31, 2003
	Book value		Fair value		Book value		Fair value
Financial Assets
Cash on hand and in banks	$	16,570	$	16,570	$	17,945	$	17,945
Interest earning deposits		2,769		2,769		9,981		9,981
Federal funds sold		6,000		6,000		7,600		7,600
Investment securities available for sale		45,891		45,891		55,601		55,601
Investment securities held to maturity		1,460		1,536		2,151		2,289
FHLB and Federal Reserve stock		3,038		3,038		2,962		2,962
Loans receivable and loans held for sale		599,761		595,441		521,413		530,285

Financial Liabilities
Deposits:
Savings, money market and demand	$	351,604	$	351,604	$	336,847	$	336,847
Time certificates		235,674		185,999		204,985		204,120

Total deposits		587,278		537,603		541,832		540,967

FHLB advances		40,900		40,900		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-27

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

(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,
	2004		2003
ASSETS
Cash and interest earning deposits	$	962	$	3,947
Loans receivable—ESOP		911		987
Investment in subsidiary banks		59,965		57,851
Other assets		147		443

	$	61,985	$	63,228

LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities	$	1,041	$	996
Total stockholders’ equity		60,944		62,232

	$	61,985	$	63,228

HERITAGE FINANCIAL CORPORATION

(PARENT COMPANY ONLY)

Condensed Statements of Income


	Years Ended December 31,
	2004			2003			2002
Interest income:
Interest income	$	7		$	18		$	16
ESOP loan		81			87			93
Other income:
Gain on sale of investment		218			—			—
Equity in undistributed income of subsidiaries		10,008			9,332			9,864

Total income		10,314			9,437			9,973
Interest expense		40			68			63
Other expenses		906			696			712

Total expense		946			764			775

Income before federal income taxes		9,368			8,673			9,198
Benefit for income taxes		(217	)		(231	)		(226	)

Net income	$	9,585		$	8,904		$	9,424

Basic earnings per common share	$	1.61		$	1.37		$	1.31
Diluted earnings per common share		1.57			1.32			1.27

F-28

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

HERITAGE FINANCIAL CORPORATION

(PARENT COMPANY ONLY)

Condensed Statements of Cash Flows


	Years Ended December 31,
	2004			2003			2002
Cash flows from operating activities:
Net income	$	9,585		$	8,904		$	9,424
Adjustments to reconcile net income to net cash provided by operating activities:
Undistributed income of subsidiaries		(10,008	)		(9,332	)		(9,864	)
Dividends from subsidiaries		7,900			20,000			16,950
Recognition of compensation related to ESOP and restricted stock shares		181			298			241
Net change in other assets and liabilities		324			100			476
Gain on sale of premises and equipment		—			(1	)		—

Net cash provided by operating activities		7,982			19,969			17,227
Cash flows from investing activities:
ESOP loan principal repayments		76			69			63
Proceeds from sale of premise and equipment		—			1			—

Net cash provided by investing activities		76			70			63
Cash flows from financing activities:
Cash dividends paid		(3,744	)		(3,731	)		(3,527	)
Exercise of stock options		1,008			970			479
Stock repurchase		(8,307	)		(16,506	)		(13,052	)

Net cash used in financing activities		(11,043	)		(19,267	)		(16,100	)

Net increase (decrease) in cash and cash equivalents		(2,985	)		772			1,190
Cash and cash equivalents at beginning of period		3,947			3,175			1,985

Cash and cash equivalents at end of period	$	962		$	3,947		$	3,175

F-29

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

(20) Selected Quarterly Financial Data (Unaudited)

Results of operations on a quarterly basis were as follows:


	Year ended December 31, 2004
	First Quarter		Second Quarter		Third Quarter		Fourth Quarter
Interest income	$	9,375	$	9,456	$	9,855	$	10,258
Interest expense		1,668		1,667		1,839		2,043

Net interest income		7,707		7,789		8,016		8,215
Provision for loan losses		180		180		150		135

Net interest income after provision for loan losses		7,527		7,609		7,866		8,080
Non-interest income		1,563		1,703		1,530		1,702
Non-interest expense		5,764		5,903		5,742		5,861

Income before provision for income taxes		3,326		3,409		3,654		3,921
Provision for income taxes		1,107		1,119		1,211		1,288

Net income	$	2,219	$	2,290	$	2,443	$	2,633

Basic earnings per share	$	0.36	$	0.39	$	0.42	$	0.44
Diluted earnings per share		0.35		0.38		0.41		0.43
Cash dividends declared		0.155		0.160		0.165		0.170


	Year ended December 31, 2003
	First Quarter		Second Quarter		Third Quarter		Fourth Quarter
Interest income	$	9,277	$	9,196	$	9,301	$	9,377
Interest expense		2,000		1,873		1,771		1,690

Net interest income		7,277		7,323		7,530		7,687
Provision for loan losses		495		330		150		150

Net interest income after provision for loan losses		6,782		6,993		7,380		7,537
Non-interest income		1,627		1,991		2,038		1,508
Non-interest expense		5,249		5,608		5,718		5,648

Income before provision for income taxes		3,160		3,376		3,700		3,397
Provision for income taxes		1,099		1,170		1,287		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

F-30

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)
10.11		Revised Employment Agreement between the Company and Donald V. Rhodes, effective January 1, 2005(8)
14.0		Code of Ethics(7)
21.0		Subsidiaries of the Company
23.0		Consent of Independent Registered Public Accounting Firm
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).

(7)

Incorporated by reference to the Annual Report on Form 10-K dated March 8, 2004.

(8)

Incorporated by reference to the Quarterly Report on Form 10Q dated November 2, 2004.