**SECURITIES AND EXCHANGE COMMISSION**
 **Washington, D.C. 20549**
 **FORM 10-QSB**
 **[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF**
 **THE SECURITIES EXCHANGE ACT OF 1934**
 **For the quarterly period ended September 30, 2004**
 
 **[    ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**
 **For the Transition Period from _____** **to _____**
 
 **Commission File No.** **0-25020**
 
 **HERITAGE OAKS BANCORP** ****
 **(Exact name of registrant as specified in charter)**
 
 **STATE OF CALIFORNIA**  ****
 **(State or other jurisdiction of incorporation or organization)**
 
 **77-0388249**
 **(I.R.S. Employer Identification Code)**
 
 **545 12th STREET, PASO ROBLES, CA 93446**
 **(Address of principal office)**
 
 **(805) 239-5200**
 **(Registrant's telephone number, including area code)**
 
 **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 twelve (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 ninety (90) days.**
 **YES [X]** **NO [_]**
 **Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:**
 
 **No par value Common Stock - 3,815,970 shares outstanding at October 18, 2004.**
 
 
 
 
 **TABLE OF CONTENTS**
 
 
 Part 1.

Financial Information  Item 1.
Financial StatementsConsolidated Balance SheetsConsolidated Statements of Operations (Un-audited)Consolidated Statements of Cash Flows (Un-audited)Consolidated Statement of Changes in Stockholders Equity (Un-audited)Notes to Consolidated Financial Statements (Un-audited)Item 2.
Managements Discussion and Analysis of Financial Condition and Results of OperationsItem 3.
Controls and ProceduresPart 2.

Other InformationItem 6.
ExhibitsSignaturesCertificationsExhibits
 2   **PART 1.  FINANCIAL INFORMATION****Item 1.**

**Financial Statements**
 ****
 
 **HERITAGE OAKS BANCORP****CONSOLIDATED BALANCE SHEETS****(in thousands)****31-Dec-03**

**30-Sep-04**ASSETS


**(1)**
****

**(Unaudited)**
****Cash and due from banks

$
40,374

$
29,418Federal funds sold


36,740


25,020Total cash and cash equivalents


77,114


54,438Interest bearing deposits other banks


498


4,598Securities Available for sale


54,956


59,846Federal Home Loan Bank Stock, at cost


1,959


1,579Loans Held For Sale


4,402


2,489Loans, net


274,051


308,886Property, premises and equipment, net


9,874


9,902Cash surrender value life insurance


6,859


7,065Deferred Tax Assets


1,971


1,837Goodwill


4,905


4,905Core Deposit Intangible


2,442


2,126Other assets


2,917


2,923TOTAL ASSETS

$
441,948

$
460,594LIABILITIES AND STOCKHOLDERS' EQUITYLIABILITIESDeposits:Demand, non-interest bearing

$
137,859

$
157,283Savings, NOW, and money market deposits


153,413


161,277Time deposits of $100 or more


23,694


19,953Time deposits under $100


51,473


46,360Total deposits


366,439


384,873FHLB advances and other borrowed money


28,500


28,500Securities Sold under Agreement to Repurchase


460


566Notes Payable


3,500


Junior subordinated debentures


8,248


8,248Other liabilities


2,513


2,506Total liabilities


409,660


424,693COMMITMENTS AND CONTINGENCIES





Stockholders' equityCommon stock, no par value;20,000,000 shares authorized; issued and outstanding3,784,722 and 3,815,970 for December 31, 2003and September 30, 2004, respectively.


20,649


23,901Retained earnings


11,541


11,701Accumulated other comprehensive income


98


299Total stockholders' equity


32,288


35,901TOTAL LIABILITIES & STOCKHOLDERS' EQUITY

$
441,948

$
460,594
 (1)
These numbers have been derived from the audited financial statements.See notes to condensed financial statements.


3    **HERITAGE OAKS BANCORP****CONSOLIDATED STATEMENTS OF INCOME****For the Three Months Ended**

**For the Nine Months Ended****(in thousands except per share date)**

**September 30,**

**September 30,****2003**

**2004**

**2003**

**2004****(Unaudited)**

**(Unaudited)**

**(Unaudited)**

**(Unaudited)**Interest Income:Interest and fees on loans

$
3,869


5,136

$
11,401

$
15,002Investment securities


412


634


1,493


1,786Federal funds sold and commercial paper


73


74


180


228Time certificates of deposit


3


4


9


9Total interest income


4,357


5,848


13,083


17,025Interest Expense:Now accounts


4


10


73


21MMDA accounts


105


137


380


386Savings accounts


10


21


33


68Time deposits of $100 or more


34


61


117


180Other time deposits


216


197


671


655Other borrowed funds


407


371


1,280


1,211Total interest expense


776


797


2,554


2,521Net Int. Income Before Prov. for Possible Ln. Losses


3,581


5,051


10,529


14,504Provision for loan losses


75


75


325


280Net interest income after provision for loan losses


3,506


4,976


10,204


14,224Non-interest Income:Service charges on deposit accounts


404


546


1,206


1,644Gain of Sale of Securities


2


0


60


28Other income


574


525


1,543


1,621Total Non-interest Income


980


1,071


2,809


3,293Non-interest Expense:Salaries and employee benefits


1,593


2,068


4,615


6,242Occupancy and equipment


408


644


1,227


1,907Other expenses


1,012


1,412


3,020


4,210Total Noninterest Expenses


3,013


4,124


8,862


12,359Income before provision for income taxes


1,473


1,923


4,151


5,158Provision for applicable income taxes


557


730


1,531


1,927Net Income

$
916

$
1,193

$
2,620

$
3,231Earnings per share: See Note #4Basic

$
0.29

$
0.31

$
0.85

$
0.85Fully Diluted

$
0.28

$
0.29

$
0.79

$
0.79See notes to condensed financial statements
 4   **HERITAGE OAKS BANCORP****CONSOLIDATED STATEMENTS OF CASHFLOWS****(in thousands)**

**Periods ended September 30,****2003**

**2004****(Unaudited)**

**(Unaudited)****Cash Flows from Operating Activities**Net income

$
2,620

$
3,231Adjustments to reconcile net income tonet cash provided by operating activitiesNet cash provided by operating activitiesDepreciation and amortization


379


709Provision for possible loan losses


325


280Provision for possible unfunded loan losses


50


25Realized gain on sales of available-for-salesecurities, net


(60
)

(28
)Amortization of premiums/discounts oninvestment securities, net


375


307FHLB Stock dividends


(68
)

(55
)Amortization of intangible assets


30


316(Increase)/decrease in loans held for sale


(412
)

1,913(Increase)/decrease in deferred tax assets


(135
)

0Net increase in cash surrender value of life insurance


(195
)

(206
)(Increase)/decrease in other assets


(145
)

1Decrease in other liabilities


(4,777
)

(32
)**NET CASH PROVIDED BY/(USED IN) OPERATING ACTIVITIES**


(2,013
)

6,461**Cash Flows From Investing Activities**Purchase of securities available-for-sale


(1,633
)

(1,455
)Purchase of mortgage backed securities available-for-sale


(10,394
)

(17,295
)Proceeds from sales of securities available-for-sale


12,365


1,534Proceeds from principal reductions and maturitiesof securities available-for-sale


757


1,315Proceeds from principal reductions and maturitiesof mortgage backed securities available-for-sale


23,845


11,060Increase in Interest Bearing Deposits with other banks


0


(4,100
)Net change in FHLB and FRB stock


339


435Purchase of life insurance policies


(830
)

0Increase in loans, net


(28,091
)

(35,117
)ALLL Recoveries


233


2Purchase of property, premises and equipment, net


(2,521
)

(737
)**NET CASH USED IN INVESTING ACTIVITIES**


(5,930
)

(44,358
)**Cash Flows From Financing Activities**Increase in deposits, net

$
6,110

$
18,434Net increase/(decrease) in other borrowings


(9,403
)

(3,394
)Proceeds from exercise of stock options


395


187Cash paid in lieu of fractional shares


(3
)

(6
)**NET CASH PROVIDED BY FINANCING ACTIVITIES**


(2,901
)

15,221**Net Increase/(Decrease) in Cash and Cash Equivalents**


(10,844
)

(22,676
)**Cash and Cash Equivalents**, Beginning of year


60,554


77,114**Cash and Cash Equivalents**, End of year

$
49,710

$
54,438**Supplemental Disclosures of Cash Flow Information**Interest paid

$
2,388

$
2,277Income taxes paid

$
1,580

$
1,775**Supplemental Disclosures of Non-Cash Flow Information**Change in other comprehensive income

$
(445
)
$
201**See notes to condensed financial statements**    5   **HERITAGE OAKS BANCORP****CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY****September 30, 2003 and September 30, 2004****(Unaudited)****( in thousands except shares outstanding)****Accumulated**

********







**Other**

**Total****Shares**

**Common**

**Retained**

**Comprehensive**

**Stockholders'****Outstanding**

**Stock**

**Earnings**

**Income**

**Equity****(in thousands)****Balance January 1, 2003**


2,785,533

$
9,703

$
9,548

$
562

$
19,813Exercise of Stock Options


60,562


329


0





329Stock dividend- 5%


139,008


1,599


(1,599
)




0Cash paid to Shareholders' in Lieu offractional shares on 5% Stock Dividend








(3
)




(3
)Sale of Common Stock


5,000


67








67Comprehensive IncomeNet Income








2,620





2,620Unrealized Security Holding Gains(net of $321 tax )











(409
)

(409
)Less reclasification adjustment for gain(net of $24 tax)











(36
)

(36
)Total other comprehensive Income














2,211**Balance September 30, 2003**


**2,990,103**

**$**
**11,698**

**$**
**10,566**

**$**
**117**

**$**
**22,381****Other**


**Total******


**Shares**


**Common**


**Retained**


**Comprehensive**


**Stockholders'****Outstanding**


**Stock**


**Earnings**


**Income**


**Equity****(in thousands)****Balance January 1, 2004**


3,604,497

$
20,649

$
11,541

$
98

$
32,288Exercise of Stock Options


31,172


187








1875% Stock Dividend to be distributed


180,301


3,065


(3,065
)




0April 23, 2004Cash Paid in lieu of fractional shares








(6
)




(6
)Comprehensive IncomeNet Income








3,231





3,231Unrealized Security Holding Losses(net of $285 tax )











218


218Less reclasification adjustment for gain(net of $11 tax)











(17
)

(17
)Total other comprehensive Income














3,449**Balance September 30, 2004**


**3,815,970**

**$**
**23,901**

**$**
**11,701**

**$**
**299**

**$**
**35,901**
 
 **Note 1.**
**CONSOLIDATED FINANCIAL STATEMENTS**
 ****
 In the opinion of Management, the un-audited consolidated condensed financial statements contain all (consisting of only normal recurring adjustments) adjustments necessary to present fairly Heritage Oaks Bancorps (the Company) consolidated financial position at September 30, 2004 and results of cash flows for the nine months ended September 30, 2003 and 2004 and the results of operation for the three and nine months ended September 30, 2003 and 2004.
 
 Certain information and footnote disclosures normally presented in financial statements prepared in accordance with generally accepted accounting principles have been omitted. These interim consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Companys 2003 Annual Report to shareholders. The results for the three and nine months ended September 30, 2004 may not necessarily be indicative of the operating results for the full year.
 
 
 6
 **Note 2.**
**INVESTMENT SECURITIES**   In accordance with SFAS No. 115 Accounting for Certain Investments in Debt and Equity Securities, which addresses the accounting for investments in equity securities that have a readily determinable fair values and for investments in all debt securities, securities are classified in three categories and accounted for as follows: debit and equity securities that the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity and are measured at amortized cost; debt and equity securities bought and held principally for the purpose of selling in the near term are classified as trading securities and are measured at fair value, with the unrealized gains and losses included in
earnings; debt and equity securities not classified as either held-to-maturity or trading securities are deemed as available-for-sale and are measured at fair value, with the unrealized gains and losses, net of applicable taxes, reported in a separate component of stockholders equity. Any gains and losses on sales of investments are computed on a specific identification basis.
 
 The amortized cost and fair values of investment securities available for sale at December 31, 2003 andSeptember 30, 2004 :**December 31, 2003**



**Gross**

**Gross****(in thousands)**

**Amortized**

**Unrealized**

**Unrealized**

**Fair****Cost**

**Gains**

**Losses**

**Value**Obligations of U.S. government agencies and corporations

$
2,484

$
22

$
(24
)
$
2,482Mortgage-backed securities


41,980


197


(308
)

41,869Obligations of State and Political Subdivisions


10,320


365


(89
)

10,596Other Securities


9


0


0


9**TOTAL**

**$**
**54,793**

**$**
**584**

**$**
**(421**
**)**
**$**
**54,956****September 30, 2004**





**Gross**


**Gross****(in thousands)**


**Amortized**


**Unrealized**


**Unrealized**


**Fair****Cost**


**Gains**


**Losses**


**Value**Obligations of U.S. government agencies and corporations

$
1,878

$
9

$
(20
)
$
1,867Mortgage-backed securities


46,402


293


(190
)

46,505Obligations of State and Political Subdivisions


11,059


486


(80
)

11,465Other Securities


9








9**TOTAL**

**$**
**59,348**

**$**
**788**

**$**
**(290**
**)**
**$**
**59,846**
 **Note 3.**
**LOANS AND ALLOWANCE FOR LOAN LOSSES**
 
 Major classifications of loans were:**December 31,**

**September 30,****(in thousands)**

**2003**

**2004**Commercial, financial, and agricultural

$
49,024

$
46,151Real estate-construction


47,720


59,383Real estate-mortgage


175,880


202,475Installment loans to individuals


5,173


5,228All other loans (including overdrafts)


338


248278,135


313,485Less - deferred loan fees, net


(1,014
)

(1,465
)Less - reserve for possible loan losses


(3,070
)

(3,134
)Total loans

$
274,051

$
308,886Loans Held For Sale

$
4,402

$
2,489
 Concentration of Credit Risk
 At September 30, 2004, approximately $261.8 million of the Banks loan portfolio was collateralized by various forms of real estate. Such loans are generally made to borrowers located in San Luis Obispo and Santa Barbara Counties. The Bank attempts to reduce its concentration of credit risk by making loans which are diversified by project type. While Management believes that the collateral presently securing this portfolio is adequate, there can be no assurances that significant deterioration in the California real estate market would not expose the Bank to significantly greater credit risk.
 
 At September 30, 2004, the Bank was contingently liable for letters of credit accommodations made to its customer totaling approximately $16.7 million and un-disbursed loan commitments in the approximate amount of $127 million. The Bank makes commitments to extend credit in the normal course of business to meet the financing needs of its customers. Commitments to extend credit are agreement to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total outstanding commitment amount does not necessarily represent future cash requirements. Standby letters of credit written are conditional commitments issued by
the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as those involved in extending loan facilities to customers. The Bank anticipates no losses as a result of such transactions.
 
 7
 
 Allowance for Loan Losses
 An allowance for loan losses has been established by management to provide for those loans that may not be repaid in their entirety for a variety of reasons. The allowance is maintained at a level considered by management to be adequate to provide for probable incurred losses. The allowance is increased by provisions charged to earnings and is reduced by charge-offs, net of recoveries. The provision for loan losses is based upon past loan loss experience and managements evaluation of the loan portfolio under current economic conditions. Loans are charged to the allowance for loan losses when, and to the extent, they are deemed by management to be un-collectible. The allowance for loan losses is composed of allocations for specific loans and a historical portion for all other loans.
 
 An analysis of the changes in the reserve for possible loan losses is as follows:**(in thousands)**

**December 31,**

**September 30,****2003**

**2004**Balance at beginning of year

$
2,933

$
3,070Additions charged to operating expense


370


280Loans charged off


(466
)

(218
)Recoveries of loans previously charged off


233


2Balance at end of year

$
3,070

$
3,134
 The Bank recognized that credit losses will be experienced and the risk of loss will vary with, among other things, general economic conditions; the type of loan being made; the creditworthiness of the borrower over the term of the loan and in the case of a collateralized loan, the quality of the collateral for such loan. The allowance for loan loss represents the Banks estimate of the allowance necessary to provide for probable incurred losses in the portfolio. In making this determination, the Bank analyzes the ultimate collectibility of the loans in its portfolio by incorporating feedback provided by internal loan staff, an independent loan review function, and information provided by examinations performed by regulatory agencies. The Bank makes monthly evaluations as to the adequacy of the allowance for loan losses.
 
 The analysis of the allowance for loan losses is comprised of three components; specific credit allocation; general portfolio allocation; and subjectively by determined allocation. Effective January 1, 1995, the Bank adopted Statement of Financial Accounting Standards No.114, Accounting by Creditors for Impairment of a Loan (SFAS 114), as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures. These pronouncements provide that when it is probable that a creditor will be unable to collect all amounts due in accordance with the terms of the loan that such loan is deemed impaired. Impaired loans are accounted for differently in that the amount of the impairment is measured and reflected in the records of the creditor. The allowance for credit losses related to loans that are identified for
evaluation in accordance with Statement 114 is based on discounted cash flows using the loans initial effect interest rate or the fair value of the collateral for certain collateral dependent loans. The general portfolio allocation consists of an assigned reserve percentage based on the credit rating of the loan. The subjective portion is determined based on loan history and the Banks evaluation of various factors including current economic conditions and trends in the portfolio including delinquencies and impairment, as well as changes in the composition of the portfolio.
 
 The allowance for loan losses is based on estimate, and ultimate losses will vary from current estimates. These estimates are reviewed monthly, and as adjustments, either positive or negative, become necessary, a corresponding increase or decrease is made in the provision for loan losses. The methodology used to determine the adequacy of the allowance for possible loan losses for the third quarter of 2004 is consistent with prior periods.
 
 The allowance for loan losses as a percentage of total net loans was 1.01% as of September 30, 2004 and 1.12% as of December 31, 2003. Management believes that the allowance for credit losses at September 30, 2004 is prudent and warranted, based on information currently available.
  **Note 4.**
**EARNINGS PER SHARE**
 
 Basic earnings per share are based on the weighted average number of shares outstanding before any dilution from common stock equivalents. Diluted earnings per share reflects the potential dilution that could occur if securities or other contract to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shares in the earnings of the entity.
 8
 On October 31, 2003, the Company finalized the acquisition of Hacienda Bank and issued 602,485 shares of Company stock to shareholders of Hacienda Bank.
 
 On March 26, 2004, the Company announced that the Board of Directors of the Company approved a 5% stock dividend. The record date for the stock dividend was April 9, 2004 and the pay date was April 23, 2004.
 
 Share information has been retroactively adjusted for the 5% stock dividend announced in March 2004.
 
 The following table shows the number of shares used to calculate and the earnings per share for the three and nine months ending September 30, 2003 and 2004:
 **EPS**

**EPS****For the Three Months Ending**

**For the Nine Months Ending****30-Sep-03**

**30-Sep-04**

**30-Sep-03**

**30-Sep-04**Basic

$
0.29

$
0.31

$
0.85

$
0.85Diluted

$
0.28

$
0.29

$
0.79

$
0.79Shares:Basic


3,117,100


3,808,948


3,092,007


3,799,128Diluted


3,316,727


4,069,971


3,302,368


4,074,690
 
 The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provision of SFAS 123, Accounting for Stock Based Compensation, to stock based employee compensation:
 
 **Three Months Ended**

**Nine Months Ended****30-Sep-03**

**30-Sep-04**

**30-Sep-03**

**30-Sep-04**Net income:

**(in thousands except per share data)**As reported

$
916

$
1,194

$
2,620

$
3,231Stock-based compensation using the intrinsic value method











Stock-based compensation that would have been reported











using the fair value method of SFAS 123


(9
)

(8
)

(70
)

(52
)Pro forma net income

$
907

$
1,186

$
2,550

$
3,179Weighted Average Shares Outstanding - Basic


3,117


3,809


3,092


3,799Weighted Average Shares Outstanding - Diluted


3,317


4,070


3,302


4,075Basic Earnings per shareAs reported

$
0.29

$
0.31

$
0.85

$
0.85Pro forma

$
0.29

$
0.31

$
0.82

$
0.84Earnings per share - assuming dilutionAs reported

$
0.28

$
0.29

$
0.79

$
0.79Pro forma

$
0.27

$
0.29

$
0.77

$
0.78
 **Note 5.**
**RECENT ACCOUNTING PRONOUNCEMENTS**
 
 In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 03-03, *Accounting for Certain Loans or Debt Securities Acquired in a Transfer* (SOP 03-03). This SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investors initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. It includes such loans acquired in purchase business combinations and applies to all nongovernmental entities, including not-for-profit
organizations. This SOP does not apply to loans originated by the entity. This SOP limits the yield that may be accreted (accretable yield) to the excess of the investors estimate of undiscounted expected principal, interest, and other cash flows (cash flows expected at acquisition to be collected) over the investors initial investment in the loan.
 
 This SOP requires that the excess of contractual cash flows over cash flows expected to be collected (non-accretable difference) not be recognized as an adjustment of yield, loss accrual, or valuation allowance. This SOP prohibits investors from displaying accretable yield and non-accretable difference in the balance sheet. Subsequent increases in cash flows expected to be collected generally should be recognized prospectively through adjustment of the loans yield over its remaining life. Decreases in cash flows expected to be collected should be recognized as impairment, thereby retaining the accretable yield on the loan as adjusted. This SOP prohibits carrying over or creation of valuation allowances in the initial accounting of all loans acquired in a transfer that are within the scope of this SOP. The prohibition of the
valuation allowance carryover applies to the purchase of an individual loan, a pool of loans, a group of loans, and loans acquired in a purchase business combination. This SOP is effective for loans acquired in fiscal years beginning after December 15, 2004. Management has not completed its evaluation of the impact this pronouncement may have on the Companys consolidated financial position or results of operations.
 9  In March 2004, the Financial Accounting Standards Board (FASB) issued an exposure draft entitled "Share-Based Payment, an Amendment of FASB Statements No. 123 and 95." This proposed statement would eliminate the ability to account for stock-based compensation using APB 25 and require such transactions be recognized as compensation expense in the income statement based on their fair values at the date of grant. Companies transitioning to fair value based accounting for stock-based compensation will be required to use the "modified prospective" method whereby companies must recognize equity compensation cost from the beginning of the year in which the recognition provisions are first applied as if the fair value method had been used to account for all equity compensation awards granted, modified, or settled in fiscal years beginning after December 31, 1994. As
proposed, this statement would be effective for the Corporation on January 1, 2005. A final statement is expected to be issued in the fourth quarter of 2004.
 
 In January 2003, the FASB issued the Emerging Information Task Force Issue 03-1, *The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investors* (EITF 03-1), and in March 2004, FASB issued an update. EITF 03-1 addresses the meaning of other-than-temporary impairment and its application to certain debt and equity securities. EITF 03-1 aids in the determination of impairment of an investment and gives guidance as to the measurement of impairment loss and the recognition and disclosures of other-than-temporary investments. EITF 03-1 also provides a model to determine other-than-temporary impairment using evidence-based judgment about the
recovery of the fair value up to the cost of the investment by considering the severity and duration of the impairment in relation to the forecasted recovery of the fair value. The March 2004 update to EITF 03-1 includes application guidance as to the determination of impairment, disclosures required by an impairment, and guidance for the transition period and effective dates of disclosure requirements. In March 2004, the FASB also issued two proposed FASB Staff Positions (FSP): FSP EITF Issue 03-1-a, which gives additional guidance on the determination of impairment for debt securities impaired because of interest rate and/or sector spread increases, and FSP EITF Issue 03-1-b, which delays the disclosure effective date for debt securities impaired because of interest rate and/or sector spread increases. The comment deadline for the proposed FSPs was October 29, 2004, and the application and effective dates of portions of EITF 03-1 are deferred until the issuance of FSP EITF Issue 03-1-a
and FSP EITF Issue 03-1-b, which could be as early as November 2004.The adoption of EITF 03-1 and FSP EITF Issues 03-1-a and 03-1-b are not expected to have a material impact on the financial condition or operating results of the Company.
 
 
 **Note 9.**
**Reclassifications**
 Certain amounts in the 2003 financial statements have been reclassified to conform to the 2004 presentation.
 
 On October 31, 2003, the Company acquired Hacienda Bank. At the time of the transaction, Hacienda Bank had approximately $90 million in assets. On June 28, 2004, Hacienda Bank was merged with and into Heritage Oaks Bank.
 
 **Certain statements contained in this Quarterly Report on Form 10-QSB (Quarterly Report), including, without limitation, statements containing the words believes, anticipates, intends, expects, and words of similar impact, constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: general economic and business
conditions in those areas in which the Company operates, demographic changes, competition, fluctuations in interest rates, changes in business strategy or development plans, changes in governmental regulation, credit quality, the availability of capital to fund the expansion of the Companys business, as well as economic, political and global changes arising from the war on terrorism. (Refer to the Companys December 31, 2003 10-KSB, ITEM 1. Description of Business-Factors that May Affect Future Results of Operations.) The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future events or developments.**
 10
 **ITEM 2.**
**MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**
 The following is an analysis of the results of operations and financial condition of the Company for the periods ending September 30, 2004 and 2003. The analysis should be read in connection with the consolidated financial statements and notes thereto appearing elsewhere in this report.
 
 **THE COMPANY**
 
 Heritage Oaks Bancorp (the "Company") is a California corporation organized in 1994 to act as a holding company of Heritage Oaks Bank ("Bank"). In 1994, the Company acquired all of the outstanding common stock of the Bank in a holding company formation transaction.
 
 In April 2002, the Company formed Heritage Oaks Capital Trust I (the Trust). The Trust is a statutory business trust formed under the laws of the State of Delaware. The Trust is a wholly-owned, non-financial, non-consolidated subsidiary of the Company.
 
 On June 11, 2003, the Company entered into an Agreement to Merge and Plan of Reorganization (the Agreement) with Hacienda Bank (Hacienda), as amended on August 8, 2003, pursuant to which, among other things, (i) Heritage Oaks Merger Corp would merge with and into Hacienda, and (ii) Hacienda would become a wholly-owned subsidiary of the Company. In accordance with the terms of the Agreement, as amended, the merger was completed on October 31, 2003. Hacienda shareholders elected, after application of applicable pro ration provisions, to receive 75% of the consideration in stock and 25% in cash. The Company issued approximately 602,485 shares to the former Hacienda shareholders and approximately $2.6 million in cash.
 
 After the merger, the Company became a two-bank holding company owning all of the shares of both the Bank and Hacienda. In connection with the Agreement and the merger, Messrs. Mark Fugate and Alex Simas, previous members of Haciendas board of directors, were added to the board of directors of the Company.
 
 On March 26, 2004, the Company announced plans to merge Hacienda into the Bank and operate Hacienda as a Division of the Bank. The merger was finalized on June 28, 2004. The merger is expected to simplify and streamline the Companys regulatory reporting requirements. The goal was to accomplish the transition in a manner that will be transparent to the customers and employees and will not affect the day-to-day operations of the Bank. Immediate cost savings will be realized through eliminating duplicative organization memberships and Board and Committee Meeting fees. These initial hard dollar cost savings are not material to the Company, However, the savings in staff time from eliminating the duplicate preparation of Policies, Procedures, and Board and Committee monthly packages will be considerable and will
allow the Company to grow organically without the addition of administrative staff.
 
 Other than holding the shares of the Bank, the Company conducts no significant activities, although it is authorized, with the prior approval of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), the Company's principal regulator, to engage in a variety of activities which are deemed closely related to the business of banking. The Company has also caused to be incorporated a subsidiary, CCMS Systems, Inc. which is currently inactive and has not been capitalized. The Company has no present plans to activate the proposed subsidiary.
 
 Where You Can Find More Information
 
 Under the Securities Exchange Act of 1934 Sections 13 and 15(d), periodic and current reports must be filed with the SEC. The Company electronically files the following reports with the SEC: Form 10-KSB (Annual Report), Form 10-QSB (Quarterly Report), Form 8-K (Report of Unscheduled Material Events), and Form DEF 14A (Proxy Statement). The Company may file additional forms. The SEC maintains an Internet site, www.sec.gov, in which all forms filed electronically may be accessed. Additionally, all forms filed with the SEC and additional shareholder information is available free of charge on the Companys website: www.heritageoaksbancorp.com
 
 The Company posts these reports to its website as soon as reasonably practicable after filing them with the SEC. None of the information on or hyperlinked from the Companys website is incorporated into this Quarterly Report on Form 10-QSB.
 11  Executive Summary and Recent Developments
 
 The table below provides selected financial data that highlights the Companys quarterly performance results:
 
 SELECTED FINANCIAL DATAFor the Quarter Ended,Sep-03

Dec-03

Mar-04

Jun-04

Sep-04Return on Average Assets


1.13
%

1.14
%

0.82
%

1.05
%

1.06
%Return on Average Equity


17.18
%

16.83
%

10.60
%

13.90
%

13.62
%Average Equity to Average Assets


6.55
%

6.76
%

7.69
%

7.58
%

7.78
%Net Interest Margin


4.81
%

4.82
%

4.91
%

4.91
%

5.15
%Efficiency Ratio*


66.05
%

68.94
%

72.66
%

68.55
%

67.36
%Average Loans to Average Deposits


81.64
%

81.74
%

80.10
%

80.63
%

80.88
%Net Income

$
916

$
975

$
876

$
1,162

$
1,193Earnings Per Share:Basic

$
0.29

$
0.27

$
0.23

$
0.31

$
0.31Diluted

$
0.28

$
0.25

$
0.21

$
0.29

$
0.29Outstanding Shares:Basic


3,117,100


3,565,008


3,791,244


3,797,874


3,808,948Diluted


3,316,727


3,841,465


4,079,308


4,068,597


4,069,971
 *The efficiency ratio is defined as total non-interest expense as a percent of the combined net interest income plus non-interest income.
 
 Certainly, one of the Companys most notable recent events was the acquisition of Hacienda Bank that took place on October 31, 2003. Hacienda had approximately $82 million in assets at September 30, 2004. This acquisition was the culmination of many years effort to have a greater presence in the city of Santa Maria. In reviewing market share data (provided by the FDIC as of June every year) within the Companys primary service area of San Luis Obispo and Northern Santa Barbara counties, it was very clear that the city of Santa Maria with 28% of the total deposit base provided opportunity for growth. In order to obtain more market share, the Company needed a greater presence than the existing one branch office that was opened in 1999. The Company views this acquisition as a positive step to enhancing
market share and shareholder return. Initially, the Company anticipated that the acquisition would be accretive to earnings in the fourth quarter of 2004. However, the acquisition became accretive to diluted earnings per share for both of the three months ending June 30, and September 30, 2004.
 
 In 1999, Heritage put into action a Corporate Culture Survey that allows employee to respond anonymously to nearly 100 questions regarding communication, training, management effectiveness and many other pertinent areas. This survey is conducted annually during the fourth quarter. The results of the survey provide Senior Management and the Board with information that assists in future endeavors to address areas where there is an opportunity to improve. During the past five years, the overall rating has shown measured improvement. Senior Management and the Board of Directors consider this to be one of the most important achievements for the Company. This program was implemented for Hacienda in February 2004.
 
 The Company continues to focus on increased market share in each city within its primary market area. In 2002, marketing plans were initiated to reach the long term goal of at least a pro rata share of deposits in each market. Measured calling programs for both lending and operational staff have been implemented utilizing among other resources a Customer Relationship Management (CRM) system. While competition remains robust in the Central Coast with numerous independent banks headquartered here and the typical plethora of major financial institutions, the Company believes that our unique corporate culture that concentrates on our staff will ultimately be our best tool to accomplish our market share goals. From June 1998 to June 2003, the Companys market share in San Luis Obispo County grew from 5.9% to
7.5%. This growth represented a move from the eighth position among fifteen other commercial banks to fourth among fourteen commercial banks. The Compound Annual Growth Rate (CAGR) for the company over a ten year period (1994 through 2003) was 21.9% compared to a CAGR of 6.2% for total deposits in San Luis Obispo County.
 12   On February 17, 2004, the Bank relocated its Woodland Branch Office from the existing storefront location to the newly constructed 5,000 square foot stand alone facility. This building has been under construction for approximately one year and offers four drive through lanes, one drive through ATM and one through the wall ATM. The hours of operation include Sunday drive through from 10am to 2pm. The previous Woodland facility now houses administrative offices for the Bank and the lease expires in June 2005.
 
 In July 2003, the Bank purchased a property immediately adjacent to its Headquarters facility. It is the intention to build approximately 20,000 square feet of office space to house all administrative functions of the Company. Architectural plans are currently being submitted to local city departments. Completion of the project is anticipated to be sometime during the fourth quarter of 2005.
 
 On September 27, 2004, the Company commenced trading under the symbol HEOP on the Nasdaq SmallCap Market.
 
 In early October 2004, the Bank began the process of converting Hacienda Bank computer systems and changing the name from Hacienda Bank, a Division of Heritage Oaks Bank to the Bank's. The actual computer conversion date is set for March 4, 2005.
 
 Local Economy
 
 The economy in the Companys service area is based primarily on agriculture, tourism, light industry, oil and retail trade. Services supporting these industries have also developed in the areas of medical, financial and educational. The population in the two county areas comprising the Companys service area, according to the U.S. Bureau of the Census, was estimated at July 2001 to be approximately 655,600. San Luis Obispo County represents about 38% of this total with Santa Barbara County accounting for the remaining approximately 62%. The moderate climate allows a year round growing season for numerous vegetable and fruits. Vineyards and cattle ranches also contribute largely to the local economy. Vineyards in production have grown significantly over the past several years throughout the
Companys service area. Access to numerous recreational activities, including lakes, mountains and beaches, provide a relatively stable tourist industry from many areas including the Los Angeles/Orange County basin, the San Francisco Bay area and the San Joaquin Valley. Principally due to the diversity of the various industries in the Companys service area, the area, while not immune from economic fluctuations, does tend to enjoy a more stable level of economic activity from many other areas of California.
 
 The Central Coasts leading industry is the production of wine grapes and production of premium quality wines. Over the past two years, production of new vineyard land has led to an over capacity of wine grapes. Excess production of wine grapes has led to a decrease in prices of grapes sold and in some cases, the inability of farmers to sell grapes at any price. Wineries on the other hand are purchasing grapes at existing contract prices and in some cases, below contract prices. Wineries are becoming select in the quality of grapes purchases, asking farmers to thin crops to produce a higher quality fruit.
 
 The Bank recognized in 2000 that there would be over capacity in the production of wine grapes in our market area. As a result, efforts were made to move a significant portion of the vineyard development loan portfolio out of the Bank and into the government sponsored Farmer Mac program. Because of these actions on the part of the Bank, it is the opinion of Management that there would not be any negative impact from the current state of the wine grape industry.
 
 On December 22, 2003, a 6.5 magnitude earthquake rocked the Central Coast. The earthquake was centered in San Simeon, an area approximately 20 miles west of Paso Robles where the Company is headquartered. There was the tragic loss of two lives in Paso Robles. The greatest amount of property damage was centered in downtown Paso Robles. The Company did not sustain any structural damage to its facilities and there were no injuries to any employees or their families. City officials reacted quickly and obtained disaster status from state and federal agencies. Business in the downtown area experienced a moderate decline in activity, however, the area has already begun to rebuild and things are getting back to normal. Within days after the earthquake, the Company performed an assessment as to any financial impact
it could expect regarding effect to customers and their ability to repay any outstanding debt. The assessment revealed that there was no material impact to the Company.
 
 Critical Accounting Policies
 
 The Companys significant accounting policies are set forth in note 1 of the consolidated financial statements as of December 31, 2003 which was filed on Form 10-KSB. Of these significant accounting policies, the Company considers its policy regarding the allowance for loan losses to be its most critical accounting policy, because it requires management's most subjective and complex judgments. In addition, changes in economic conditions can have a significant impact on the allowance for loan losses and therefore the provision for loan losses and results of operations. The Company has developed appropriate policies and procedures for assessing the adequacy of the allowance for loan losses, recognizing that this process requires a number of assumptions and estimates with respect to its loan portfolio. The
Company's assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers, which is not known to management at the time of the issuance of the consolidated financial statements.
 13  The following is a brief description of our current accounting policies involving significant management valuation judgments.
 
 Allowance for Loan and Lease Losses
 The allowance for loan and lease losses represents managements best estimate of losses inherent in the existing loan portfolio. The allowance for loan and lease losses is increased by the provision for loan and lease losses charged to expense and reduced by loans charged-off, net of recoveries. The allowance for loan and lease losses is determined based on managements assessment of several factors: reviews and evaluation of individual loans, changes in the nature and volume of the loan portfolio, current economic conditions and the related impact on specific borrowers and industry groups, historical loan loss experiences and the level of classified and nonperforming loans.
 
 Loans are considered impaired if, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate stipulated in the loan agreement, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral. In measuring the fair value of the collateral, management uses assumptions and methodologies consistent with those that would be utilized by unrelated third parties.
 
 Changes in the financial condition of individual borrowers, economic conditions, historical loss experience and the condition of the various markets in which collateral may be sold may all affect the required level of the allowance for loan and lease losses and the associated provision for loan and lease losses.
 
 Securities Available for Sale
 The fair value of most securities that are designated available for sale are based on quoted market prices. If quoted market prices are not available, fair values are extrapolated from the quoted prices of similar instruments.
 
 Goodwill and Other Intangible Assets
 As discussed in the 2003 Annual Report, Note 6 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, we assess goodwill and other intangible assets each year for impairment. This assessment involves estimating cash flows for future periods. If the future cash flows were materially less than the recorded goodwill and other intangible assets balances, we would be required to take a charge against earnings to write down the assets to the lower value.
 
 **RESULTS OF OPERATIONS**
 
 Earnings Overview
 
 The Company reported net income for the three months ended September 30, 2004 of $1.2 million compared to $916 thousand during the same period in 2003. This represents an increase of 30.2%. Basic earnings per share for the three months ended September 30, 2004 and September 30, 2003, were $.31 and $.29, respectively. Diluted earnings per share for the three months ended September 30, 2004 and September 30, 2003, were $.29 and $.28, respectively. The Company reported net income for the nine months ended September 30, 2004 of $3.2 million compared to $2.6 million during the same period in 2003. This represents an increase of 23.3%. Basic earnings per share for the nine months ended September 30, 2004 and September 30, 2003
were the same at $.85. Diluted earnings per share for the nine months ended September 30, 2004 and September 30, 2003 were the same at $.79.
 
 When viewing data for the three and nine months ending September 30, 2004, it is important to keep in mind that Hacienda was acquired by the Company on October 31, 2003. Therefore, income and expense for Hacienda is included in the Companys consolidated results for the three and nine months ending September 30, 2004 but is not included in the Companys consolidated results for the three and nine months ending September 30, 2003. There were 602,485 shares of Company common stock issued in connection with the Hacienda acquisition. ****
 14   Net Interest Income and Interest Margin
 
 Net interest income, the primary component of the net earnings of a financial institution, refers to the difference between the interest paid on deposits and borrowings, and the interest earned on loans and investments. The net interest margin is the amount of net interest income expressed as a percentage of average earning assets. Factors considered in the analysis of net interest income are the composition and volume of earning assets and interest-bearing liabilities, the amount of non-interest bearing liabilities and non-accrual loans, and changes in market interest rates.
 
 The tables below sets forth changes from September 30, 2003 to September 30, 2004 for average interest earning assets and their respective average yields. Due to the declining yields on loans, the Company had to increase average earning assets to augment net interest income. The Company was able to grow the loan portfolio with continued market penetration by a team of seasoned loan officers who are compensated for production. The growth in the loan portfolio was achieved under the Companys established Loan Policy.
 
 The tax-exempt portion of the investment portfolio also increased, however, it experienced a 9 basis point decrease in average yield. At September 30, 2004, the tax equivalent yield was 7.03% compared to 7.02% for the same period in 2003. The Company has significant room to grow in tax-exempts before bumping up against the Alternative Minimum Tax issue with the IRS. The taxable investment portfolio gained in average yield due to extension caused by rising rates.
 
 **Average Balance****for nine months ending****(in thousands)**



**September 30,**Interest Earning Assets:

**2003**


**2004**

**$**
**Variance**

**%**
**Variance**Time deposits with other banks




$
595

$
1,514

$
919


154.45
%Investment securities taxable





44,118


49,373


5,255


11.91
%Investment securities non-taxable





10,035


11,206


1,171


11.67
%Federal funds sold





21,413


27,614


6,201


28.96
%Loans (1) (2)





215,368


297,545


82,177


38.16
%Total interest earning assets




$
291,529

$
387,252

$
95,723


32.83
%**Average Yield******




**for nine months ending****September 30,**Interest Earning Assets:

**2003**


**2004**


**Variance**Time deposits with other banks





2.02
%

1.41
%

-0.61
%Investment securities taxable





3.53
%

3.81
%

0.28
%Investment securities non-taxable





4.52
%

4.43
%

-0.09
%Federal funds sold





1.06
%

1.10
%

0.05
%Loans(1) (2)





7.08
%

6.74
%

-0.34
%Total interest earning assets





6.00
%

5.88
%

-0.12
%
 15
 The tables below sets forth changes from September 30, 2003 to September 30, 2004 for average interest bearing liabilities and their respective average rates paid. The Company continues to enjoy a low cost of funds, specifically in regard to interest bearing deposits. The ability to attract low cost deposits is part of the Companys marketing plans that have been in place for numerous years.
  **Average Balance****for nine months ending****(dollars in thousands)**



**September 30,**Interest -bearing liabilities:

**2003**

**2004**

**$ Variance**

**% Variance**Savings/NOW/money market




$
110,340

$
155,275

$
44,935


40.72
%Time deposits





46,140


71,710


25,570


55.42
%Other borrowings





31,062


31,762


700


2.25
%Long Term Debt





8,248


8,248


-


0.00
%Total interest-bearing liabilities




$
195,790

$
266,995

$
71,205


36.37
%**Average Yield****for nine months ending****September 30,**Interest -bearing liabilities:

**2003**


**2004**


**Variance**Savings/NOW/money market





0.59
%

0.41
%

-0.18
%Time deposits





2.28
%

1.56
%

-0.73
%Other borrowings





4.13
%

3.78
%

-0.36
%Long Term Debt





5.19
%

5.09
%

-0.10
%Total interest-bearing liabilities





1.74
%

1.26
%

-0.48
%
 The Company was able to increase the Net Interest Margin as the result of decreased costs for Interest Bearing Liabilities, primarily Time Deposits.
 
 In June, August and September 2004, the Federal Reserve Bank increased rates by a total of 75 basis points. Due to the asset sensitive nature of the Companys balance sheet, management believes that these increases, coupled with the Companys substantial volume of non-interest bearing deposits and low average rates on interest bearing deposits, will favorably impact the net interest margin.
 16
 The table below sets forth the average balance sheet information, interest income and expense, average yields and rates and net interest income and margin for the nine months ending September 30, 2003 and 2004.
  
 **AVERAGE BALANCE SHEET INFORMATION FOR THE NINE MONTHS ENDED SEPTEMBER 30,****(in thousands)****2003**





**2004****Average**

**Average Yield**

**Amount**

**Average**

**Average Yield**

**Amount**Interest Earning Assets:

**Balance**

**Rate Paid**

**Interest**

**Balance**

**Rate Paid**

**Interest**Interest Bearing Dep with other Banks

$
595


2.02
%
$
9

$
1,514


1.41
%
$
16Investment securities taxable


44,118


3.53
%

1,165


49,373


3.81
%

1,408Investment securities non-taxable


10,035


4.52
%

339


11,206


4.43
%

371Federal funds sold


21,413


1.06
%

169


27,614


1.10
%

228Loans (1) (2)


215,368


7.08
%

11,401


297,545


6.74
%

15,002Total interest earning assets


291,529


6.00
%

13,083


387,252


5.88
%

17,025Allowance for possible loan losses


(2,530
)







(3,150
)Non-earning assets:Cash and due from banks


21,057








29,792Property, premises and equipment


5,086








10,086Other assets


10,458








20,290TOTAL ASSETS

$
325,600







$
444,270Interest -bearing liabilities:Savings/NOW/money market


110,340


0.59
%

486


155,275


0.41
%

475Time deposits


46,140


2.28
%

788


71,710


1.56
%

835Other borrowings


31,062


4.13
%

960


31,762


3.78
%

897Long Term Debt


8,248


5.19
%

320


8,248


5.09
%

314Total interest-bearing liabilities


195,790


1.74
%

2,554


266,995


1.26
%

2,521Non-interest bearing liabilities:Demand deposits


105,335








140,879Other liabilities


3,152








2,418Total liabilities


304,277








410,292Stockholders' equityCommon stock


11,083








22,792Retained earnings


9,770








11,185Valuation Allowance Investments


470








1Total stockholders' equity


21,323








33,978TOTAL LIABILITIES ANDSTOCKHOLDERS' EQUITY

$
325,600







$
444,270Net Interest Income







$
10,529







$
14,504Net Interest Margin (3)





4.81
%







4.99
%
 (1)
Nonaccrual loans have been included in total loans.(2)
Loan fees of $532 and $735 for 2003 and 2004, respectively, have been included in the interest income computation.(3)
Net interest income has been calculated by dividing the net interest income by total average earning assets.
 The hypothetical impacts of sudden interest rate movements applied to the Companys asset and liability balances are modeled monthly. The results of this movement indicate how much of the Companys net interest income is at risk from various rate changes over a one year horizon. This exercise is valuable in identifying risk exposures. The results for the Companys September 30, 2004 balances indicate that the net interest income at risk over a one year time horizon for a 1% and 2% rate increase and 1% rate decrease are within the Companys policy guidelines for such changes. The 2% rate decrease is outside Company policy by 165bp, however, in the current low rate environment, a 200bp decrease is unlikely. Floors on loans are recognized in the models used.
 
 Rates Down 2%


Rates Down 1%


Rates Up 1%


Rates Up 2%Change in Net Interest Income


(11.65
%)

(5.69
%)

6.27
%

13.25
%
 It is important to note that the above table is a summary of several forecasts and actual results may vary. The forecasts are based on estimates and assumptions of management that may turn out to be different and may change over time. Factors affecting these estimates and assumptions include, but are not limited to 1) competitor behavior, 2) economic conditions both locally and nationally, 3) actions taken by the Federal Reserve Board, 4) customer behavior and 5) managements responses. Changes that vary significantly from the assumptions and estimates may have significant effects on the Companys net interest income. Therefore, the results of this analysis should not be relied upon as indicative of actual future results.
 17  Non-Interest Income
 
 The table below sets forth changes for the three months ending September 30, 2003 to September 30, 2004 for non-interest income excluding $2 thousand Gain on Securities Sold in 2003.
 Non-Interest Income Components**For Three Months Ended****September 30,****( in thousands)**


**2003**


**2004**

**$**
**Variance**


**% Variance**Service Charges on Deposit Accounts

$
404

$
546

$
142


35.15
%ATM/Debit Card Transaction/Interchange Fees


104


150


46


44.23
%Bancard


30


28


(2
)

-6.67
%Mortgage Origination Fees


280


151


(129
)

-46.07
%Earnings on Cash Surrender Value Life Ins


80


78


(2
)

-2.50
%Other


81


118


37


45.68
%**TOTAL**

**$**
**979**

**$**
**1,071**

**$**
**92**


**9.40**
**%** The table below sets forth changes for the nine months ending September 30, 2003 to September 30, 2004 for non-interest income excluding $60 thousand and $28 thousand Gain on Securities Sold in 2003 and 2004, respectively.
 ****

**For Nine Months Ended****September 30,****(in thousands)**


**2003**


**2004**

**$**
**Variance**


**% Variance**Service Charges on Deposit Accounts

$
1,206

$
1,644

$
438


36.32
%ATM/Debit Card Transaction/Interchange Fees


304


428


124


40.79
%Bancard


73


86


13


17.81
%Mortgage Origination Fees


709


528


(181
)

-25.53
%Earnings on Cash Surrender Value Life Ins


220


238


18


8.18
%Other


237


341


104


43.88
%**TOTAL**

**$**
**2,749**

**$**
**3,265**

**$**
**516**


**18.77**
**%**
   Increases in Service Charges on Deposit Accounts and ATM/Debit Card related transactions were favorably impacted by the 40.6% growth in Demand Deposits over a one year period that includes the addition of the three Hacienda branch offices. Mortgage origination fees have been impacted negatively by the decrease in re-finance activity due to rising rates.
 18
 Non-Interest Expenses
 
 The tables below set forth changes for the three and nine months ending September 30, 2003 to September 30, 2004 for non-interest expense.
 Non-Interest Expense Components**For Three Months Ended****September 30,****( in thousands)**

**2003**

**2004**

**$ Variance**

**% Variance**Salaries and Employee Benefits

$
1,593

$
2,068

$
475


29.82
%Occupany and Equipment


408


644


236


57.84
%Data Processing


385


511


126


32.73
%Advertising and promotional


90


143


53


58.89
%Regulatory fees


22


25


3


13.64
%Other professional fees and outside services


86


163


77


89.53
%Legal fees and other litigation expense


(20
)

24


44


-220.00
%Loan Department Costs


73


52


(21
)

-28.77
%Stationery and supplies


70


103


33


47.14
%Director fees


36


46


10


27.78
%Core Deposit Intangible Amortization


10


105


95


950.00
%Other


260


240


(20
)

-7.69
%**$**
**3,013**

**$**
**4,124**

**$**
**1,111**


**36.87**
**%****For Nine Months Ended****September 30,****( in thousands)**


**2003**


**2004**

**$**
**Variance**


**% Variance**Salaries and Employee Benefits

$
4,615

$
6,242

$
1,627


35.25
%Occupany and Equipment


1,227


1,907


680


55.42
%Data Processing


1,136


1,478


342


30.11
%Advertising and promotional


261


435


174


66.67
%Regulatory fees


59


88


29


49.15
%Other professional fees and outside services


276


432


156


56.52
%Legal fees and other litigation expense


42


71


29


69.05
%Loan Department Costs


202


130


(72
)

-35.64
%Stationery and supplies


185


289


104


56.22
%Director fees


113


161


48


42.48
%Core Deposit Intangible Amortization


30


316


286


953.33
%Other


716


810


94


13.13
%**$**
**8,862**

**$**
**12,359**

**$**
**3,497**


**39.46**
**%**
 
 Salary/Related Expense
 Salaries and employee related expense incurred the greatest dollar increase of any non-interest expense category for the three and nine months ending September 30, 2003 and 2004. Full time equivalent (FTE) employees increased from 127 at September 30, 2003 to 168 at September 30, 2004. The acquisition of Hacienda accounted for 24 FTE while the Bank increased by 17 FTE. Of the 17 that were added for the Bank, 6 were in the Mortgage Origination Department (5 of whom are commission based employees), 6 for the newly expanded Woodland Branch Office facility and the remaining 5 were due to general growth. Approximately $860 thousand of the increase in the first nine months of 2004 is the result of salary/related cost for Hacienda.
 
 There has been much media attention related to the cost of doing business in the State of California. Workers Compensation Insurance costs for the Company tripled on the renewal date in July 2003 from approximately $75 thousand per year to $220 thousand per year. Some of the increase was due to an expanding payroll, however, not to the extent that the premium increased. California legislators have recently enacted changes that have resulted in a 7% decrease to the Companys worker compensation insurance.
 
 Group health benefit costs increased by approximately $100 thousand in the nine months of 2004 compared to the same period in 2003.
 
 Occupancy and Equipment
 The increase in occupancy and equipment expense is due in part to the inclusion of Haciendas expense of $531 thousand for the first nine months of 2004. The remaining increase is due to the opening of the new Woodland branch office for the Bank.
 
 19
 
 Data Processing Expense
 The increase in data processing expense is due to the inclusion of Haciendas data processing expense of $427 thousand for the first nine months of 2004. In May 2003 and August 2003, the Company was able to re-negotiate their ATM processing and Data/Item Processing agreements, respectively, to lower costs.
 
 Provision for Income Taxes
 The provision for income taxes was 37.4% and 36.9% of net pre-tax income for the nine months ending September 30, 2004 and 2003, respectively.
 **FINANCIAL CONDITION ANALYSIS**
 
 Total assets of the Company were $441.9 million at December 31, 2003 compared to $460.6 million at September 30, 2004. This represents an increase of $18.6 million or 4.2%.
 
 Loans
 
 A significant portion of total assets is the Companys gross loans that were $278.1 million and $313.5 million at December 31, 2003 and September 30, 2004, respectively.
 
 The table below sets forth changes from December 31, 2003 to September 30, 2004 for the composition of the loan portfolio.
 **December 31,**

**September 30,****2003**

**2004**

**$Variance**

**%Variance****(in thousands)**Commercial, financial, and agricultural

$
49,024

$
46,151


(2,873
)

-5.86
%Real estate-construction


47,720


59,383


11,663


24.44
%Real estate-mortgage


175,880


202,475


26,595


15.12
%Installment loans to individuals


5,173


5,228


55


1.06
%All other loans (including overdrafts)


338


248


(90
)

-26.63
%278,135


313,485


35,350


12.71
%Less - deferred loan fees, net


(1,014
)

(1,465
)

(451
)

44.48
%Less - reserve for possible loan losses


(3,070
)

(3,134
)

(64
)

2.08
%Total loans

$
274,051

$
308,886


34,835


12.71
%Loans Held For Sale

$
4,402

$
2,489


(1,913
)

-43.46
%
 
 The small decrease in commercial, financial and agricultural loans is attributed to decreased activity on existing credit lines and to the payoff of a $1.5 million credit line by another lender.
 
 The increase in real estate-construction loans can be attributed to funding of existing construction projects and to several new construction loans made. The new construction loans include a residential tract development for $2.5 million, an addition to a strip center for $4.4 million, an apartment complex for $4.8 million, a retail/office complex for $3.5 million, a RV park for $1.5 million, a mini storage for $1.4 million, a warehouse for $1.4 million, a retail center for $1.4 million, a water park for $1.3 million and numerous other smaller projects. Construction loans are typically granted for a one year period and then, with income properties, are amortized over not more than 25 years with 10 to 15 year maturities.
 
 The large increase in real estate-mortgage loans  is attributed to several of the construction loans moving into amortizing loans, numerous new commercial property loans including an office/light industrial building for $8 million, 3 office/warehouse buildings for $3.3 million, a retail building for $2.1 million, an office complex for $2.5 million, an apartment for $1.2 million, an office building for $1 million, an apartment for $1 million and a RV storage for $1 million.
 
 The Bank presently has a concentration of loans in construction/land in the amount of $59.4 million which represents 157% of Total Risked Based capital. The construction/land loans are spread throughout our market area and have consistently performed in a satisfactory manner. Hotel loans were previously a concentration, however, with increased capital and loan payoffs, this is no longer the case. Hotel loans presently total $ 34 million which represents 91% of Total Risk Based capital. Hotel loans are also made to clients throughout our market. These loans have also typically paid as agreed. The Bank had one out of the area hotel participation loan that was in default. This loan, in the original amount of $1 million, was paid down by $900 thousand in April 2004 with the remaining $95 thousand charged off.
 20   In September 2004, the Bank issued an $11.7 million irrevocable standby letter of credit to guarantee the payment of Taxable Variable Rate Demand Bonds. The primary purpose of the bond issue was to refinance existing debt and provide funds for the expansion of an assisted living facility in San Luis Obispo. Approximately $6.6 million of the funds have been deposited at the Bank to be used for capital improvements to the assisted living facility. The letter of credit will expire in September 2007.
 
 Loans held for sale consist of mortgage originations that have already been sold pursuant to Correspondent Mortgage Loan Agreements. There is no interest rate risk associated with these loans as the commitments are in place at the time that the Bank funds them. Settlement from the correspondents is typically within 30 to 45 days.
 
 At September 30, 2004, the Bank had no foreign loans outstanding. The Bank did not have any concentrations of loans except as disclosed above.
 
 The Banks management is responsible for monitoring loan performance that is done through various methods, including a review of loan delinquencies and personal knowledge of customers. Additionally, the Bank maintains both a watch list of loans that, for a variety of reasons, management believes requires regular review as well as an internal loan classification process. Annually, the loan portfolio is also reviewed by an experienced, outside loan reviewer not affiliated with the Bank. A list of delinquencies, the watch list, loan grades and the outside loan review are reviewed regularly by the Banks Board of Directors.
 
 The Banks provision for loan losses was $75,000 for the third quarter of both 2003 and 2004. For the nine months ending September 30, 2003, the provision for losses was $325,000 compared to $280,000 for the same period in 2004. **** The provision amount is based on the Banks monthly allowance for loan losses calculation including current plans for recovery collection.
 
 The Bank has a non-accrual policy that requires a loan greater than 90 days past due to be placed on non-accrual status unless such loan is well-collateralized and in the process of collection. When loans are placed on non-accrual status, all uncollected interest accrued is reversed from earnings. Once on non-accrual status, interest on a loan is only recognized on a cash basis. Payments that are received may also be applied to reduce the principal balance. Loans may be returned to accrual status if management believes that all remaining principal and interest is fully collectible and there has been at least six months of sustained repayment performance since the loan was placed on non-accrual.
 
 If a loans credit quality deteriorates to the point that collection of principal is believed by management to be doubtful and the value of collateral securing the obligation is sufficient the Bank generally takes steps to protect and liquidate the collateral. Any loss resulting from the difference between the loan balance and the fair market value of the property is recognized by a charge to the reserve for loan losses. When the property is held for sale after foreclosure, it is subject to a periodic appraisal. If the appraisal indicates that the property will sell for less than its recorded value, the Bank recognizes the loss by a charge to non-interest expense.
 Loans on non-accrual status totaled $1.5 million and $.9 million at December 31, 2003 and September 30, 2004, respectively. Typically, these loans have adequate collateral protection and/or personal guaranties to provide a source of repayment to the Bank. Most of the loans on non-accrual are related to several commercial loans that are being addressed by specific workout plans at this time. Interest income that would have been recognized on non-accrual loans if they had performed in accordance with the terms of the loans was approximately $132 thousand and $89 thousand **** for the period ended December 31,
2003 and September 30, 2004, respectively.
 
 Non-performing loans include non-accrual loans, restructured loans and accruing loans that are 90 days or more delinquent. Non-performing loans totaled $1.6 million at December 31, 2003 and $.9 million at September 30, 2004.
 
 Non-performing loans were .36% and .20% of total assets as of December 31, 2003 and September 30, 2004, respectively. The allowance for loan loss to non-performing loans was 1.92x and 3.34x at December 31, 2003 and September 30, 2004, respectively.
 21   Total Cash and Due from Banks
 
 Total cash and due from banks were $40.4 million and $29.4 million at December 31, 2003 and September 30, 2004, respectively. This line item will vary depending on cash letters from the previous night and actual cash on hand in the branches.
 
 Investment Securities and Other Earning Assets
 
 Other earning assets are comprised of Federal Home Loan Bank, Federal Funds sold (funds lent on a short-term basis to other banks), investments in securities and short-term interest bearing deposits at other financial institutions. These assets are maintained for liquidity needs of the Bank, collateralization of public deposits, and diversification of the earning asset mix.
 
 The table below sets forth changes from December 31, 2003 to September 30, 2004 for the composition of other earning assets. Interest bearing deposits with other financial institutions increased by $4 million due to the placement of these funds in a short term (14 days) pool of money market accounts. The funds are FDIC insured and yield approximately 40 basis points more than over night Fed Funds. This re-direction of funds, along with increases in the Loan and Investment Portfolio have created a decrease in Fed Funds Sold.
 **COMPOSITION OF OTHER EARNING ASSETS****December 31,**

**September 30,****2003**

**2004**

**$ Variance**

**% Variance****(in thousands)**Federal Home Loan Bank, FRB and other stock

$
1,959

$
1,579

$
(380
)

-19.40
%Available-for-Sale Investments


54,956


59,846


4,890


8.90
%Federal Funds Sold


36,740


25,020


(11,720
)

-31.90
%Interest Bearing Deposits other fin inst.


498


4,598


4,100


823.29
%Total Other Earning Assets

$
94,153

$
91,043

$
(3,110
)

-3.30
%    The Company manages its securities portfolio to provide a source of both liquidity and earnings. The Bank has an asset/liability committee that develops current investment policies based upon its operating needs and market circumstance. The Banks investment policy is formally reviewed and approved annually by the board of directors. The asset/liability committee of the Bank is responsible for reporting and monitoring compliance with the investment policy. Reports are provided to Banks boards of directors on a regular basis.
 
 Securities available-for-sale are carried at fair value, with related unrealized net gains or losses, net of deferred income taxes, recorded as an adjustment to equity capital. As of December 31, 2003, net unrealized gains in the portfolio were $98 thousand compared to a net unrealized gains of $299 thousand at September 30, 2004. The portfolio increased in size due to additional security purchases of approximately $18.6 million off-set by $11 million and $1.5 million in principle reductions and the sale of three small securities, respectively.
 
 At September 30, 2004, available-for-sale securities in the portfolio included obligations of state and political subdivisions, obligations of US government agencies and corporations and mortgaged backed securities issued by various agencies.
 
 All fixed and adjustable rate mortgage pools contain a certain amount of risk related to the uncertainty of prepayments of the underlying mortgages. Interest rate changes have a direct impact upon prepayment rates. Heritage uses computer simulation models to test the average life, duration, market volatility and yield volatility of adjustable rate mortgage pools under various interest rate assumptions to monitor volatility. Stress tests are performed quarterly.
 22
 Deposits and Borrowed Funds
 
 The table below sets forth changes from December 31, 2003 to September 30, 2004 for the composition of deposit categories.
 **December 31,**

**September 30,****(in thousands)**

**2003**

**2004**

**$Variance**

**%Variance**Deposits:Demand, non-interest bearing

$
137,859

$
157,283


19,424


14.09
%Savings, NOW, and money market deposits


153,413


161,277


7,864


5.13
%Time deposits of $100 or more


23,694


19,953


(3,741
)

-15.79
%Time deposits under $100


51,473


46,360


(5,113
)

-9.93
%Total deposits

$
366,439

$
384,873

$
18,434


5.03
%   The Company has been able to increase deposits due to a well planned marketing strategy and incentive based compensation that has been in place for several years. Like all good strategies, this one is fluid and is subject to the changing dynamics within the Companys balance sheet and staffing along with changes in its primary market area. Friendly competition between the branch offices to increase deposit totals has been in place for two years. The branch offices are all given goals for each deposit category type and results are measured monthly. Lending and Operational staff work together to meet or beat their goals. This program has generated a significant amount of pride for the entire staff and resulted in growth for the Company.
 
 For the Company, at September 30, 2004, non-interest bearing demand deposits provide 40.9% of total deposits compared to 37.6% at December 31, 2003. The Bank has three deposit relationships that it considers to be volatile. These deposits are held by three, long time customers of the Bank that engage in mortgage related activities. The volatile nature of these relationships was evidenced by an increase of $7.9 million in account balances from December 31, 2003 to September 30, 2004. As a percentage of total deposits, these accounts represented 14.4% at December 31, 2003 compared to 15.8% at September 30, 2004. These volatile account relationships are included in the volatile liability dependency report that the Bank produces on a monthly basis. Management and the Board of Directors of the Bank are keenly aware
that as the mortgage market conditions change, these relationships will be impacted.
 
 Core deposits (time deposits less than $100,000, demand, and savings) gathered in the local communities served by the Company continue to be the primary source of funds for loans and investments. Core deposits of $364.9 million represented 94.8% of total deposits at September 30, 2004. The Company does not purchase funds through deposit brokers.
 
 In October 2003, the Company executed a Promissory Note with Pacific Coast Bankers Bank (PCBB) for a revolving line of credit in the amount of $3.5 million. As discussed in the paragraph below, at September 30, 2004, the Company had a zero balance outstanding on this loan.The note was obtained to assist with the cash and capital needs for the acquisition of Hacienda. The Company pledged 646,598 shares (51%) of the Banks stock as collateral for the loan. The note is revolving in nature for the first two years. The terms of the note call for quarterly interest only payments for the first two years with subsequent principal and interest payments for eight years on a fully amortized basis. The interest rate on the note is 4.75% and is variable and moves with prime. Under the terms of the agreement, the Company
will not incur any additional debt over $2 million exclusive of inter-company debt and existing debt without the prior written consent of PCBB. In addition, the Bank must be well capitalized on an on-going basis as defined by bank Regulators.
 
 One of the benefits of merging Hacienda Bank with and into the Bank on June 28, 2004 was the enhanced capital position of the resultant bank. On July 22, 2004, the Banks Board of Directors declared a dividend of $3.5 million to the Company to enable the Company to pay the PCBB line of credit down to zero. This was done on July 23, 2004. The line of credit in the amount of $3.5 million is still available to the Company until September 2005.
 
 The Bank has established borrowing lines with the Federal Home Loan Bank (FHLB). At September 30, 2004, the Bank had borrowings with the FHLB of $9.5 million and $19 million collateralized by loans and securities, respectively. The $28.5 million in borrowing matures in April 2005. On September 17, 2004, the Bank issued a Letter of Credit in the amount of approximately $11.7 million to a customer in regard to a senior care facility. The Letter of Credit was issued pursuant to a Letter of Credit Reimbursement Agreement between the Bank and the FHLB. It is collateralized by a blanket lien with the FHLB that includes all qualifying loans on the Banks balance sheet.
 23  At September 30, 2004, the Bank has a remaining borrowing capacity with existing collateral of approximately $62.7 million and $5.8 million secured by loans and securities, respectively.
 
 The Bank utilizes securities sold under repurchase agreements as a source of funds. The Bank had $460 thousand in securities sold under repurchase agreements at December 31, 2003 compared to $566 thousand at September 30, 2004.
 
 Capital
 
 The Company's total stockholders equity was $32.3 million at December 31, 2003 compared to $35.9 million at September 30, 2004. The increase in capital was due to net income of $3,231 thousand, stock options exercised in the amount of $187 thousand, and an increase in accumulated other comprehensive income of $201 thousand and $6 thousand cash paid in lieu of fractional shares.
 
 On March 26, 2004 the Board of Directors of the Company announced a 5% stock dividend to shareholders of record on April 9, 2004 that was distributed on April 23, 2004. The Consolidated Statements of Stockholders Equity found under Item 1.in this document reflects the 5% stock dividend.
 
 On April 10, 2002, the Company issued $8,248,000 of Floating Rate Junior Subordinated Deferrable Interest Debentures (the debt securities) to Heritage Oaks Capital Trust I, a statutory trust created under the laws of the State of Delaware. These debt securities are subordinated to effectively all borrowings of the Company and are due and payable on April 22, 2032. Interest is payable semi-annually on these debt securities at 6-Month LIBOR plus 3.7% for an effective rate of 5.07% as of September 30, 2004. The debt securities can be called at any time commencing on April 22, 2007, at par. The debt securities can also be redeemed at par if certain events occur that impact the tax treatment, regulatory treatment or the capital treatment of the issuance. The Company also purchased a 3% minority interest
totaling $248,000 in Heritage Oaks Capital Trust I. The balance of the equity of Heritage Oaks Capital Trust I is comprised of mandatorily redeemable preferred securities and is included in other assets.
 
 Under FASB Interpretation (FIN) No. 46, *Consolidation of Variable Interest Entities, an interpretation of ARB No. 51,* the Company is not allowed to consolidate Heritage Oaks Capital Trust I into the Companys financial statements. Prior to the issuance of FIN No. 46, bank holding companies typically consolidated these entities. The Federal Reserve Board had ruled that certain mandatorily redeemable preferred securities of a consolidated entity qualified as Tier 1 Capital. At September 30, 2004, the Company has included the net junior subordinated debt in its Tier1 Capital for regulatory capital purposes.
 
 If the Company elects to defer interest payments pursuant to terms of the agreement, then the Company may not (i) declare or pay any dividends or distributions on, or redeem, purchase, acquire or make a liquidation payment with respect to any of the Companys capital stock, or (ii) make any payment of principal of or premium, if any, or interest on or repay, repurchase or redeem any debt securities of the Company that rank pari passu with or junior in interest to the Debt Securities, other than, among other items, a dividend in the form of stock, warrants, options or other rights in the same stock as that on which the dividend is being paid or ranks pari passu with or junior to such stock. The prohibition on payment of dividends and payments on pari passu or junior debt also applies in the case of an event
of default under the agreements.
 
 The Company used the proceeds from the sale of the securities for general corporate purposes, including the repayment of outstanding indebtedness of $1.9 million on April 11, 2002 and capital contributions to the Bank for future growth.
 
 On May 6, 2004, the Federal Reserve Board released a notice of proposed rulemaking (NPR) pertaining to the continued inclusion of trust preferred securities in the Tier 1 capital of bank holding companies (BHCs). This
 NPR is subject to public comment prior to July 11, 2004 and therefore may be revised.
 
 This NPR proposes three substantive changes in the capital treatment of trust preferred securities:
 (i) subtraction of goodwill from core capital elements before calculating permitted trust preferred,(ii) amortization of tier 1 capital credit of trust preferred securities in the 5 years prior to maturity, and (iii) limitation of trust preferred securities to 15% of tier 1 capital, net of goodwill for internationally active BHCs. If this NPR is finally adopted, the Company will still be considered well capitalized under current regulatory guidelines.
 24   Management believes that organic growth in 2004 for the Company can be accomplished without further borrowing for capital or cash flow purposes. At September 30, 2004, the Company had sufficient cash to service the $8.2 million in junior subordinated debenture interest payments for approximately six quarters without dividends from subsidiaries. The Banks capacity to provide cash to the Company, while remaining well-capitalized, was $1.2 million at September 30, 2004.
 
 Capital ratios for commercial banks in the United States are generally calculated using three different formulas. These calculations are referred to as the Leverage Ratio and two risk based calculations known as: Tier One Risk Based Capital Ratio and the Total Risk Based Capital Ratio. These standards were developed through joint efforts of banking authorities from 12 different countries around the world. The standards essentially take into account the fact that different types of assets have different levels of risk associated with them. Furthermore, they take into account the off-balance sheet exposures of banks when assessing capital adequacy.
 
 The Leverage Ratio calculation simply divides common stockholders equity (reduced by any goodwill a bank may have) by the total assets. In the Tier One Risk Based Capital Ratio, the numerator is the same as the leverage ratio, but the denominator is the total risk-weighted assets. Risk weighted assets are determined by segregating all the assets and off balance sheet exposures into different risk categories and weighting them by a percentage ranging from 0% (lowest risk) to 100% (highest risk). The Total Risk Based Capital Ratio again uses risk-weighted assets in the denominator, but expands the numerator to include other capital items besides equity such as a limited amount of the loan loss reserve, long-term capital debt, preferred stock and other instruments.
 
 Summarized below are the Bank's and Company's capital ratios at September 30, 2004:Regulatory StandardAdequately

Well

Heritage Oaks

Heritage OaksCapitalized

Capitalized

Bancorp

BankLeverage Ratio


4.00
%

5.00
%

7.92
%

7.84
%Tier One Risk Based Captial Ratio


4.00
%

6.00
%

9.53
%

9.43
%Total Risk Based Captial Ratio


8.00
%

10.00
%

10.41
%

10.32
%
 For the Company, all $8 million of the trust preferred securities are accounted for as Tier I and Tier II Capital, respectively, for purposes of calculating Regulatory Capital.

Liquidity
The objective of liquidity management is to ensure the continuous availability of funds to meet the demands of depositors, investors and borrowers. Asset liquidity is primarily derived from loan payments and the maturity of other earning assets. Liquidity from liabilities is obtained primarily from the receipt of new deposits. The Banks Asset Liability Committee (ALCO) is responsible for managing the on-and off-balance sheet commitments to meet the needs of customers while achieving the Banks financial objectives. ALCO meets regularly to assess the projected funding requirements by reviewing historical funding patterns, current and forecasted economic conditions and individual customer funding needs. Deposits generated from Bank customers serve as the primary source of liquidity. The Bank has credit arrangements with correspondent
banks that serve as a secondary liquidity source in the amount of $7 million. At September 30, 2004, the Bank had no borrowings against credit arrangements with these correspondent banks. The Bank is a member of the FHLB and has a collateralized borrowing capacity remaining of approximately $68.5 million.

The Bank manages liquidity by maintaining a majority of the investment portfolio in federal funds sold and other liquid investments. At December 31, 2003, the ratio of liquid assets not pledged for collateral and other purposes to deposits and other liabilities was 28.1% compared to 22.5% at September 30, 2004. The ratio of net loans to deposits, another key liquidity ratio, was 76.0% at December 31, 2003 compared to 80.3% at September 30, 2004.

Inflation

  The
    assets and liabilities of a financial institution are primarily monetary in
    nature. As such they represent obligations to pay or receive fixed and determinable
    amounts of money that are not affected by future changes in prices. Generally,
    the impact of inflation on a financial institution is reflected by fluctuations
    in interest rates, the ability of customers to repay debt and upward pressure
    on operating expenses. The effect of inflation during the three-year period
    ended September 30, 2004 has been significant to the Companys financial
    position and results of operations in regard to fluctuation in interest rates
    creating narrowing net interest margins. However, inflation has not been a
    factor in the customers ability to repay debt or in upward pressure
    on operation expenses.
25Off-Balance Sheet Arrangements

Off-balance sheet arrangements are any contractual arrangement to which an unconsolidated entity is a party, under which the Company has: (1) any obligation under a guarantee contract; (2) a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to that entity for such assets; (3) any obligation under certain derivative instruments; or (4) any obligation under a material variable interest held by the Company in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to the Company, or engages in leasing, hedging or research and development services with the Company.

In the ordinary course of business, the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit, commercial letter of credit, and standby letter of credit. Such financial instruments are recorded in the financial statement when they are funded or related fees are incurred or received. For a fuller discussion of these financial instruments, refer to Note 10 of the Companys consolidated financial statements contained in Item 7 of Part II of the Companys December 31, 2003 10-KSB.

In the ordinary course of business, the Bank is a party to various operating leases. For a fuller discussion of these financial instruments, refer to Note 5 of the Companys consolidated financial statements contained in Item 7 of Part II of the Companys December 31, 2003 10-KSB.

In connection with the $8.2 million in debt securities discussed in Capital, the Company issued the full and unconditional payment guarantee of certain accrued distributions.

26

**Item 3.**
**Controls and Procedures**
Evaluation of disclosure controls and procedures
As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of its management, including the Companys Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Companys disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Companys disclosure controls and procedures are effective to provide reasonable assurances that information required to be disclosed in the reports the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SECs rules and
forms.

There was no change in the Companys internal controls over financial reporting during the quarter ended September 30, 2004 that has materially affected, or is reasonably likely to materially affect, the Companys internal controls over financial reporting.

In designing and evaluating disclosure controls and procedures, the Companys management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable, not absolute, assurances of achieving the desired control objectives and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.


**PART 2. OTHER INFORMATION**
ITEM 6.
EXHIBITS
(a)
Exhibits:
Exhibit (31.1)
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002Exhibit (31.2)
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002Exhibit (32.1)
Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002Exhibit (32.2)
Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
27

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

**HERITAGE OAKS BANCORP**Date: November 3, 2004
By:
/s/ Lawrence P. WardLawrence P. WardPresidentChief Executive Officer
******By:
/s/ Margaret A. TorresMargaret A. TorresChief Financial OfficerExecutive Vice President**


28

**EXHIBIT INDEX**
****
Exhibit (31.1)
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002Exhibit (31.2)
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002Exhibit (32.1)
Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002Exhibit (32.2)
Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
29