# UNITED STATES SECURITIES AND
EXCHANGE COMMISSIONWashington, D.C. 20549

# FORM 10-K

/X/ Annual report pursuant to
Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December
31, 2005; or

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

Commission file number
000-29829

PACIFIC FINANCIAL
CORPORATION (Exact Name of
Registrant as specified in its Charter)

|                                |                                  
|------------------------------- | ---------------------------------
|Washington                      | 91-1815009                       
|(State or Other Jurisdiction of | (IRS Employer Identification No.)
|Incorporation or Organization)  |                                  
|                                |                                  

1101 S. Boone Street Aberdeen, Washington
98520-5244(Address of Principal
Executive Offices) (Zip Code)

Registrants
telephone number, including area code: (360) 533-8870

Securities Registered
Pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant
to Section 12(g) of the Act:Common Stock, par value $1.00 per share

Indicate
by check mark whether the registrant is a well known seasoned issuer, as defined in Rule
405 of the Securities Act.                                Yes_____ NoX

Indicate
by check mark if the registrant is not required to file reports pursuant to Section 13 or
Section 14(d) of the Exchange Act.                   Yes_____ NoX

Indicate
by check mark whether the Registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months
(or for such shorter periods that the Registrant was required to file such reports), and
(2) has been subject to such requirements for the past 90 days. YesX No______

Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K
is not contained herein, and will not be contained, to the best of the registrants
knowledge, in definitive proxy or information statements incorporated by reference in
Part III of this Form 10-K or any amendment to this Form 10-K. [ X]

Indicate
by check mark whether the Registrant is a large accelerated filer, an accelerated filer
or a non-accelerateed filer.

Large accelerated filer
[ ]     Accelerated filer [ X ]     Non-accelerated
filer [ ]

Indicate
by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act).   Yes [ ] No [ X ]

The
aggregate market value of the common stock held by non-affiliates of the registrant at
June 30, 2005, was $84,632,440

The
number of shares outstanding of the registrants common stock, $1.00 par value, as of
February 28, 2006, was 6,479,462 shares.

# DOCUMENTS INCORPORATED
BY REFERENCE

Portions
of the registrants Proxy Statement filed in connection with its annual meeting of
shareholders to be held April 19, 2006 are incorporated by reference into Part III of
this Form 10-K.

---

# PACIFIC FINANCIAL
CORPORATION ANNUAL REPORT ON FORM
10-K FOR THE FISCAL YEARENDED DECEMBER 31, 2005

# TABLE OF CONTENTS

|           |                                                                                                                                          |     
|---------- | ---------------------------------------------------------------------------------------------------------------------------------------- | ----
|PART I     |                                                                                                                                          | Page
|           | Forward Looking Information                                                                                                              | 3   
|           | Item 1.      Business                                                                                                                    | 4   
|           | Item 1A. Risk Factors                                                                                                                    | 12  
|           | Item 1B. Unresolved Staff Comments                                                                                                       | 13  
|           | Item 2.      Properties                                                                                                                  | 14  
|           | Item 3.      Legal Proceedings                                                                                                           | 14  
|           | Item 4.      Submission of Matters to a Vote of Security Holders                                                                         | 14  
|PART  II   |                                                                                                                                          |     
|           | Item 5.      Market for Registrant's Common Equity, Related Stockholder Matters                and Issuer Purchases of Equity Securities | 15  
|           | Item 6.      Selected Financial Data                                                                                                     | 16  
|           | Item 7.      Management's Discussion and Analysis of Financial               Condition and Results of Operations                         | 18  
|           | Item 7A. Quantitative and Qualitative Disclosures About Market Risk                                                                      | 34  
|           | Item 8.      Financial Statements and Supplementary Data                                                                                 | 37  
|           | Item 9.      Changes in and Disagreements with Accountants on Accounting                and Financial Disclosure                         | 37  
|           | Item 9A.   Controls and Procedures                                                                                                       | 37  
|           | Item 9B.   Other Information                                                                                                             | 38  
|PART  III  |                                                                                                                                          |     
|           | Item 10.  Directors and Executive Officers of the Registrant                                                                             | 38  
|           | Item 11.  Executive Compensation                                                                                                         | 38  
|           | Item 12.  Security Ownership of Certain Beneficial Owners and Management               and Related Stockholder Matters                   | 39  
|           | Item 13.  Certain Relationships and Related Transactions                                                                                 | 39  
|           | Item 14.  Principal Accountant Fees and Services                                                                                         | 39  
|PART IV    |                                                                                                                                          |     
|           | Item 15.  Exhibits and Financial Statement Schedules                                                                                     | 40  
|SIGNATURES |                                                                                                                                          | 74  

2

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PART I

Forward Looking Information

This document contains
 forward-looking  statements that are subject to risks and  uncertainties.  These
statements are based on the beliefs and  assumptions  of our  management,  and on
 information  currently  available  to them. Forward-looking  statements include the
information  concerning our possible future results of operations set forth under
 "Management's  Discussion  and Analysis of Financial  Condition and Results of
 Operations"  and  statements preceded by,  followed by or that  include the words
 "believes,"  "expects,"  "anticipates,"  "intends,"  "plans," "estimates" or similar
expressions.

Any
 forward-looking  statements  in this  document are subject to risks  relating to, among
other things, the factors described under the heading "Risk Factors" below, as well as
the following:

| | 1.
      competitive  pressures  among  depository  and  other  financial  institutions
 that may          impede our  ability to  attract  and retain  borrowers,  depositors
 and other  customers,  retain our key          employees, and/or maintain our interest
margins and fee income;
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2.
      our growth strategy,  particularly if accomplished through  acquisitions,  which
may not          be successful if we fail to  accurately  assess market  opportunities,
 asset  quality,  anticipated  cost          savings, and transaction costs, or
experience  significant  difficulty  integrating acquired businesses or          assets
or opening new branches or lending offices;
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3.
      expenses  and  dedication  of  management  resources in  connection  with our
efforts to          comply with changing laws,  regulations,  and standards arising
primarily out of the Sarbanes-Oxley Act of          2002, including as a result of
internal control requirements  thereunder,  that may significantly increase          our
costs and ongoing  compliance  expenditures  and place  additional  burdens on our
limited  management          resources;
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 4.
      general economic or business  conditions,  either  nationally or in the state or
regions          in which we do business,  that may be less favorable than  expected,
 resulting in, among other things,  a          deterioration in credit quality, and/or a
reduced demand for credit;
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 5.
      any failure to comply with developing and changing standards of corporate
governance          and disclosure and internal control that could result in negative
publicity, leading to declines in our          stock price;
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 6.
      decreases in real estate prices, whether or not due to changes in economic
conditions,          that may reduce the value of our security for many of our loans; and
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 7.
      a lack of liquidity in the market for our common stock that may make it difficult
or          impossible for you to liquidate your investment in our stock or lead to
distortions in the market price          of our stock.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Our
management believes the forward-looking statements are reasonable; however, you should
not place undue reliance on them.  Forward-looking statements are not guarantees of
performance.  They involve risks, uncertainties and assumptions.  Many of the factors
that will determine our future results and share value are beyond our ability to control
or predict.  We undertake no obligation to update forward-looking statements.

3

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ITEM 1. Business

Pacific  Financial  Corporation
 (the  Company or Pacific) is a bank  holding  company  headquartered  in Aberdeen,
Washington.  The Company owns one bank, Bank of the Pacific  (sometimes  referred to as
the "Bank"),  which is also located in Washington.  The Company was  incorporated in the
State of Washington on February 12, 1997,  pursuant to a holding company reorganization
of the Bank.

During December 2005, the Company
 completed a placement of subordinated  debentures  through PFC Statutory Trust I (the
Trust), a Connecticut  trust formed for the exclusive purpose of issuing trust preferred
 securities.  Because the Trust is not consolidated with the Company,  pursuant to FASB
 Interpretation  No. 46, the Company's  financial statements  reflect the subordinated
 debt issued by the Company to the Trust.  For more information  regarding the Company's
 issuance  of trust  preferred  securities,  see  Footnote  8  "Junior  Subordinated
 Debentures"  to the Company's audited consolidated financial statements included in this
report.

The Company  conducts its banking
 business  through 16 branches  located in  communities  throughout  Grays Harbor County,
 Pacific  County,  and  Wahkiakum  County  in  Southwest  Washington,   and  Whatcom
 County  in  Northwest Washington.  The  Company  also  operates a loan  production
 office in  Gearhart,  Oregon.  The six  locations  in Whatcom  County,  which  includes
 Bellingham,  Washington,  were acquired as part of Pacific's  acquisition of BNW
Bancorp, Inc. (BNW) completed on February 27, 2004.

Pacific  Financial  Corporation is a
reporting  company with the Securities and Exchange  Commission (SEC), and the Company's
 common stock is listed on the OTC  Bulletin  Board(TM)under the symbol  "PFLC.OB".  At
December 31, 2005, the Company had total  consolidated  assets of $489.4  million,  total
 loans,  including  loans held for sale,  of $409.0 million, total deposits of $399.7
million, and total shareholders' equity of $46.6 million.

Pacific's  filings  with the SEC,
 including  its  annual  report on Form  10-K,  quarterly  reports  on Form 10-Q,
periodic  current  reports on Form 8-K and amendments to these reports,  are available
free of charge through links from  our  website  at  http://www.thebankofpacific.com  to
the  SEC's  site  at  http://www.sec.gov,  as  soon  as reasonably  practicable  after
filing with the SEC. You may also access our filings with the SEC directly  from the
Edgar  database  found on the SEC's  website.  By making  reference  to our  website
 above and  elsewhere  in this report, we do not intend to incorporate any information
from our site into this report.

The Bank

Bank of the  Pacific  was  organized
 in 1978 and  opened  for  business  in 1979 to meet  the need for a  regional community
bank with local interests to serve the small to medium-sized  local  businesses and
 professionals in the coastal region of Western  Washington.  Services offered by the
Bank include  commercial loans,  agriculture loans, installment loans, real estate loans,
residential mortgage loans and personal and business deposit products.

The Bank originates  loans primarily
in its local markets.  Its  underwriting  policies focus on assessment of each borrower's
 ability to service and repay the debt, and the  availability  of collateral  that can be
used to secure the loan.  Depending  on the nature of the  borrower  and the purpose and
amount of the loan,  the Bank's loans may be secured by a variety of collateral,
including business assets, real estate, and personal assets.

The Bank's commercial and
agricultural  loans consist primarily of secured revolving  operating lines of credit and
business term loans,  some of which may be partially  guaranteed by the Small Business
 Administration  or the U.S. Department  of  Agriculture.  Consumer  installment  loans
and other loans  represent a small  percentage  of total outstanding loans and include
home equity loans, auto loans, boat loans, and personal lines of credit.

4

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The Bank's  primary  sources of
deposits are from  individuals  and  businesses in its local  markets.  A concerted
effort has been made to attract  deposits in the local market  areas  through
 competitive  pricing and delivery of quality products.  These products include demand
accounts,  negotiable order of withdrawal  accounts,  money market investment  accounts,
 savings accounts and time deposits.  The Bank may also utilize  brokered  deposits from
time to time.

The Bank  provides  24 hour  online
 banking to its  customers  with  access to account  balances  and  transaction
histories,  plus an electronic  check register to make account  management and
 reconciliation  simple.  The online banking system is compatible with budgeting
 software like Intuit's  Quicken(R)or Microsoft's  Money(R).  In addition, the online
banking system includes the ability to transfer funds, make loan payments,  reorder
checks,  and request statement  reprints,  provides loan calculators and allows for
e-mail exchanges with  representatives  of the Bank. Also for a nominal fee,  customers
 can request stop payments and pay an unlimited  number of bills  online.  These services
 along  with rate  information  and other  information  can be  accessed  through  the
 Bank's  website at http://www.thebankofpacific.com.

The Bank's deposits are insured by
the Federal Deposit Insurance  Corporation  (FDIC) up to applicable legal limits under
the Bank  Insurance  Fund.  The Bank is a member of the Federal Home Loan Bank (FHLB) and
is regulated by the Washington Department of Financial Institutions, Division of Banks
(Division), and the FDIC.

Competition

Competition in the banking  industry
is significant  and has  intensified as the regulatory  environment  has grown more
 permissive.  Banks face a growing  number of competitors  and greater  degree of
competition  with respect to the provision of banking  services and the attracting of
deposits.  Non-bank and  non-depository  institutions  can be expected to increase
 competition  further as they offer bank-type  products in the more  permissive
 regulatory climate of today.

The Bank competes in Grays Harbor
County with  well-established  thrifts which are  headquartered in the area along with
branches of large banks with  headquarters  outside the area.  The Bank also competes with
 well-established  small community  banks,  branches of large  banks,  thrifts and credit
 unions in Pacific and  Wahkiakum  Counties in the state of  Washington  and Clatsop
 County in the state of Oregon.  In the Bank's  newest  market,  Whatcom  County,
Washington,  the Bank competes with large regional and  super-regional  financial
 institutions  that do not have a significant  presence  in the  Company's  historical
 market  areas.  The  Company  believes  its newest  territory provides  opportunities
for expansion,  but in pursuing that expansion it faces greater competitive challenges
than it faces in its historical market areas.

The adoption of the
 Gramm-Leach-Bliley  Act of 1999 (the Financial Services  Modernization Act) eliminated
many of the  barriers to  affiliation  among  providers  of  financial  services  and
 further  opened the door to business combinations  involving banks,  insurance
 companies,  securities or brokerage  firms, and others.  This regulatory change  has led
to  further  consolidation  in the  financial  services  industry  and the  creation  of
 financial conglomerates  which  frequently offer multiple  financial  services,
 including  deposit  services,  brokerage and others.  When combined with  technological
 developments  such as the Internet that have reduced  barriers to entry faced by
companies  physically  located outside the Company's  market area,  changes in the market
have resulted in increased competition and can be expected to result in further increases
in competition in the future.

5

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Although it cannot  guarantee  that
it will  continue to do so, the Company has been able to maintain a competitive advantage
 in its  historical  markets  as a result of its status as a local  institution,
 offering  products  and services  tailored to the needs of the  community.  Further,
 because of the extensive  experience of management in its market area and the business
 contacts of  management  and the  Company's  directors,  management  believes the
Company can continue to compete effectively.

According to the Market Share Report
 compiled by the FDIC, as of June 30, 2005,  the Company held a deposit market share of
30.1% in Pacific  County,  44.2% in Wahkiakum  County,  18.3% in Grays Harbor County,
 and 3.7% in Whatcom County.

Employees

As of December 31, 2005,  the Bank
 employed 181 full time  equivalent  employees.  Management  believes  relations with its
employees are good.

Supervision and Regulation

The  following is a general
 description  of certain  significant  statutes and  regulations  affecting the banking
industry.  This  regulation is intended  primarily for the  protection of depositors and
not for the benefit of the Company's  shareholders.  The following  discussion is
intended to provide a brief summary and,  therefore,  is not complete and is qualified by
the statutes and  regulations  referenced.  Changes in applicable  laws or regulations
may have a material effect on the business and prospects of the Company.

The  operations  of the Company may
also be  affected  by changes in the  policies of banking and other  government
regulators.  The  Company  cannot  accurately  predict  the  nature or extent of the
 effects on its  business  and earnings that fiscal or monetary policies, or new federal
or state laws or regulations, may have in the future.

The Company

General

As a bank holding  company,  the
Company is subject to the Bank  Holding  Company Act of 1956,  as amended  (BHCA), which
 places the Company  under the  supervision  of the Board of  Governors  of the Federal
 Reserve  System (the Federal  Reserve).  The Company  must file annual  reports  with
the Federal  Reserve and must provide it with such additional  information as it may
require. In addition,  the Federal Reserve periodically  examines the Company and the
Bank.

Bank Holding Company Regulation

In  general,  the BHCA  limits a
bank  holding  company  to  owning or  controlling  banks  and  engaging  in other
banking-related  activities.  Bank holding  companies must obtain  approval of the
Federal Reserve before they: (1) acquire  direct or indirect  ownership or control of any
voting shares of any bank that results in total  ownership or control,  directly or
 indirectly,  of more than 5% of the voting shares of such bank;  (2) merge or
consolidate with another bank holding company;  or (3) acquire  substantially all of the
assets of another bank or bank holding company.

Control of Nonbanks.With certain
exceptions, the BHCA prohibits bank holding companies from acquiring direct or indirect
ownership or control of more than 5% of the voting shares in any company that is not
a bank or a bank holding company unless the Federal Reserve determines that the
activities of such company are incidental or closely related to the business of
banking. If a bank holding company is well-capitalized and meets certain criteria
specified by the Federal Reserve, it may engage de novo in certain permissible
nonbanking activities without prior Federal Reserve approval.

6

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Control Transactions. The Change
in Bank Control Act of 1978, as amended, requires a person (or group of persons acting
in concert) acquiring control of a bank holding company to provide the Federal Reserve
with 60 days' prior written notice of the proposed acquisition. Following receipt of
this notice, the Federal Reserve has 60 days within which to issue a notice
disapproving the proposed acquisition, but the Federal Reserve may extend this time
period for up to another 30 days. An acquisition may be completed before expiration
of the disapproval period if the Federal Reserve issues written notice of its
intent not to disapprove the transaction. In addition, any company must obtain
approval of the Federal Reserve before acquiring 25% (5% if the company is a bank
holding company) or more of the outstanding shares or otherwise obtaining control over
the Company.

Source of Strength Requirements.
Under Federal Reserve policy, the Company is expected to act as a source of
financial and managerial strength to the Bank. This means that the Company is required
to commit, as necessary, resources to support the Bank. Any capital loans made by
the Company to the Bank would be subordinate in priority to deposits and to certain
other indebtedness of the Bank.

Financial Services Modernization Act

On November  12,  1999,  the
 Financial  Services  Modernization  Act (the  "FSMA")  was signed into law.  The FSMA
repeals the two affiliation  provisions of the  Glass-Steagall  Act:  Section 20, which
 restricted the affiliation of Federal Reserve member banks with firms "engaged
 principally" in specified securities  activities;  and Section 32, which  restricts
 officer,  director,  or employee  interlocks  between a member bank and any company or
person "primarily engaged" in specified securities  activities.  In addition,  the FSMA
contains provisions that expressly preempt any state law restricting the  establishment
 of financial  affiliations,  primarily  related to insurance. The general effect of the
law is to establish a comprehensive  framework to permit  affiliations  among  commercial
banks,  insurance companies,  securities firms, and other financial service providers by
revising and expanding the bank  holding  company  framework  to permit a holding
 company  system  to  engage  in a full  range of  financial activities through a new
entity known as a financial holding company.

Financial  holding  companies  may
affiliate  with  securities  firms and  insurance  companies and engage in other
activities  that are financial in nature or are  incidental or  complementary  to
activities  that are financial in nature.   "Financial  in  nature"  activities  include
 securities  underwriting,   dealing,  and  market  making, sponsoring mutual funds and
investment companies,  insurance  underwriting and agency,  merchant banking, and other
activities  approved by the Federal Reserve.  The Company received  approval to become a
financial  holding company during 2000,  but having never  utilized the  increased
 flexibility  enjoyed by financial  holding  companies,  it elected to de-certify as a
financial holding company in December 2005.

The FSMA and related regulations
also:

| |  | broadened
 the  activities  that may be conducted by national  banks and by banking  subsidiaries
 of bank          holding companies, and their financial subsidiaries;
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | provided
an enhanced framework for protecting the privacy of consumer information; and
|- |  | --------------------------------------------------------------------------------------

| |  | modified
the laws governing the implementation of the Community Reinvestment Act.
|- |  | ---------------------------------------------------------------------------------

The Company  does not believe that
the FSMA has had a material  effect on its  operations.  However,  to the extent that the
 legislation  permits  banks,  securities  firms,  and  insurance  companies to
 affiliate,  the financial services industry may experience further  consolidation.  The
Financial  Services  Modernization Act is intended to grant to community  banks certain
powers as a matter of right that larger  institutions  have  accumulated on an ad hoc
basis.  Nevertheless,  this  legislation  may have the result of increasing the amount of
competition  that the Company faces from larger  institutions and other types of
companies with substantially  greater resources than the Company and offering a wider
variety of financial products than the Bank currently offers.

7

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Pursuant to the  requirements  of
the FSMA,  federal  banking  regulators  adopted  certain privacy and information
security requirements for financial  institutions,  together with certain consumer
protection rules for the sale of insurance  products.  Privacy and security rules
 require,  among other things,  disclosure of privacy  policies to consumers and
 implementation  of information  security programs designed to identify and assess the
risks that may threaten customer  information.  Insurance related rules require that
certain oral and written  disclosures be made before the  completion of the sale of an
insurance  product.  The Company  believes  that it is in compliance  with these rules
and that they do not adversely affect its operations.

USA Patriot Act of 2001

On October 26, 2001,  President Bush
signed the Uniting and  Strengthening  America by Providing  Appropriate Tools Required
to Intercept and Obstruct  Terrorism  (USA Patriot Act) of 2001.  Among other things,
 the USA Patriot Act (1)  prohibits  banks from  providing  correspondent  accounts
 directly to foreign  shell  banks;  (2) imposes due diligence  requirements on banks
opening or holding accounts for foreign financial  institutions or wealthy foreign
individuals;  (3) requires financial  institutions to establish an  anti-money-laundering
 compliance program,  and (4)  eliminates  civil  liability  for  persons  who file
 suspicious  activity  reports.  The USA Patriot Act also increases  governmental powers
to investigate  terrorism,  including expanded government access to account records. The
 Department of the Treasury is empowered to  administer  and make rules to implement the
act. We do not believe that compliance with the USA Patriot Act has had a material effect
on our business and operations.

Sarbanes-Oxley Act of 2002

The  Sarbanes-Oxley Act of 2002 was
adopted in response to public concerns  regarding  corporate  accountability in
connection  with the recent  accounting  scandals at various large publicly traded
 companies.  The stated goals of the act are to increase  corporate  responsibility,  to
provide for enhanced  penalties for accounting and auditing improprieties at publicly
traded  companies,  and to protect investors by improving the accuracy and reliability of
corporate  disclosures  pursuant to the securities laws. The  Sarbanes-Oxley Act
generally applies to all companies such as the Company that file periodic  reports with
the SEC under the Securities  Exchange Act of 1934, as amended (Exchange Act).

The  Sarbanes-Oxley Act includes
 additional  disclosure  requirements and new corporate  governance rules, and has
resulted in  significant  rulemaking  by the SEC and the  securities  exchanges  relating
to corporate  governance, independence  of board  members,  internal  control  over
 financial  reporting,  disclosure  controls,  and  other matters. Most rulemaking
 initiatives were completed by the close of 2003.  Sarbanes-Oxley  represents
 significant federal  involvement  in matters  traditionally  left to state  regulatory
 systems,  such as the regulation of the accounting  profession,  and to state  corporate
 law,  such as the  relationship  between a board of directors and management and between
a board of directors and its committees.

The Sarbanes-Oxley Act addresses,
 among other matters,  (1) board audit committees;  (2) certification of Exchange Act
reports by the chief  executive  officer and the chief  financial  officer;  (3) the
 forfeiture  of bonuses or other  incentive-based  compensation  and  securities  trading
 profits by directors and executive  officers in the twelve-month period following
initial publication of any financial statements that later require  restatement;  (4)
disclosure of off-balance  sheet  transactions;  (5) expedited  reporting of stock
 transactions  by insiders;  (6) disclosure  of whether an issuer has a code of ethics,
 and changes or waivers of such code;  (7) the  formation of a Public Company  Accounting
 Oversight Board; (8) auditor  independence;  and (9) increased criminal penalties for
violations of securities laws.

8

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The  Sarbanes-Oxley  Act has
resulted in  significantly  increased  reporting  expenses and audit and audit related
costs and greater demands on our senior management.

Transactions With Affiliates

The Company and the Bank are deemed
 affiliates  within the meaning of the Federal  Reserve Act,  and  transactions between
 affiliates  are subject to certain  restrictions.  Accordingly,  the Company and the
Bank must comply with Sections 23A and 23B of the Federal  Reserve Act.  Generally,
 Sections 23A and 23B (1) limit the extent to which a financial  institution or its
subsidiaries may engage in covered transactions with an affiliate,  as defined, to an
amount  equal to 10% of such  institution's  capital and surplus and an  aggregate  limit
on all such  transactions with all affiliates to an amount equal to 20% of such capital
and surplus,  and (2) require all  transactions  with an affiliate to be on terms
 substantially the same, or at least as favorable to the institution or subsidiary,  as
those provided to a  non-affiliate.  Regulation W, which collected many existing
 interpretations  of provisions of the Federal  Reserve Act,  became  effective in April
2003. The regulation  restricts  loans,  asset  purchases and other transactions between
a depository institution and its affiliated entities.

Regulation of Management

Federal law (1) sets forth the
 circumstances  under which officers or directors of a financial  institution may be
removed by the  institution's  federal  supervisory  agency;  (2) places restraints on
lending by an institution to its  executive  officers,  directors,  principal
 shareholders,  and their  related  interests;  and (3)  prohibits management  personnel
 from  serving  as a  director  or in  other  management  positions  with  another
 financial institution  which has assets  exceeding a specified  amount or which has an
office  within a specified  geographic area.

Tie-In Arrangements

The Company and the Bank cannot
engage in certain tie-in  arrangements  in connection with any extension of credit, sale
or lease of property or  furnishing of services.  For example,  with certain  exceptions,
 neither the Company nor the Bank may  condition  an  extension  of credit to a customer
on either (1) a  requirement  that the customer obtain  additional  services  provided by
it or (2) an agreement by the  customer to refrain from  obtaining  other services from a
competitor.

State Law Restrictions

As a  Washington  business
 corporation,  the Company may be subject to certain  limitations  and  restrictions  as
provided  under  applicable  Washington  corporate law. In addition,  Washington  banking
law restricts and governs certain activities of the Bank.

The Bank

General

The Bank, as an FDIC insured
 state-chartered  bank, is subject to regulation  and  examination by the FDIC and the
Department  of  Financial  Institutions  of the  State of  Washington.  The  federal
 laws  that  apply to the Bank regulate,  among other things,  the scope of its business,
 its  investments,  its reserves against  deposits,  the timing of the availability of
deposited funds and the nature and amount of and collateral for loans.

CRA. The Community Reinvestment
Act (the CRA) requires that, in connection with examinations of financial
institutions within their jurisdiction, the FDIC evaluate the record of the financial
institutions in meeting the credit needs of their local communities, including low and
moderate income neighborhoods, consistent with the safe and sound operation of those
banks. These factors are also considered in evaluating mergers, acquisitions, and
applications to open a branch or facility. In connection with the FDIC's
assessment of the record of financial institutions under the CRA, it assigns a
rating of either, "outstanding," "satisfactory," "needs to improve," or "substantial
noncompliance" following an examination. The Bank received a CRA rating of
"satisfactory" during its most recent examination.

9

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Insider Credit Transactions. Banks
are also subject to certain restrictions imposed by the Federal Reserve Act on
extensions of credit to executive officers, directors, principal shareholders, or
any related interests of such persons. Extensions of credit (i) must be made on
substantially the same terms, including interest rates and collateral, and follow
credit underwriting procedures that are not less stringent than those prevailing at
the time for comparable transactions with persons not covered above and who are not
employees and (ii) must not involve more than the normal risk of repayment or present
other unfavorable features. Banks are also subject to certain lending limits and
restrictions on overdrafts to such persons. A violation of these restrictions may
result in the assessment of substantial civil monetary penalties on the affected bank
or any officer, director, employee, agent, or other person participating in the
conduct of the affairs of that bank, the imposition of a cease and desist order, and
other regulatory sanctions.

FDICIA. Under the Federal Deposit
Insurance Corporation Improvement Act of 1991 (FDICIA), each federal banking agency
has prescribed, by regulation, noncapital safety and soundness standards for
institutions under its authority. These standards cover internal controls,
information systems, and internal audit systems, loan documentation, credit
underwriting, interest rate exposure, asset growth, compensation, fees and benefits,
such other operational and managerial standards as the agency determines to be
appropriate, and standards for asset quality, earnings and stock valuation. An
institution which fails to meet these standards must develop a plan acceptable to the
agency, specifying the steps that the institution will take to meet the standards.
Failure to submit or implement such a plan may subject the institution to regulatory
sanctions. Management believes that the Bank meets all such standards and,
therefore, does not believe that these regulatory standards will materially
affect the Company's business or operations.

Interstate Banking and Branching

The Riegle-Neal  Interstate  Banking
and Branching  Efficiency Act of 1994 (the Interstate Act) permits  nationwide interstate
banking and branching under certain  circumstances.  This legislation  generally
 authorizes  interstate branching  and relaxes  federal law  restrictions  on interstate
 banking.  Currently,  bank holding  companies may purchase  banks in any state,  and
states may not prohibit  such  purchases.  Additionally,  banks are permitted to merge
with banks in other states as long as the home state of neither  merging  bank has opted
out. The  Interstate Act requires  regulators to consult with community  organizations
 before  permitting an interstate  institution to close a branch in a low-income area.

With regard to interstate  bank
mergers,  Washington has opted in to the  Interstate Act and allows  in-state banks to
merge with out-of-state  banks subject to certain aging  requirements.  Washington law
generally  authorizes the acquisition  of an in-state bank by an  out-of-state  bank
through merger with a Washington  financial  institution that  has been in  existence
 for at least 5 years  prior  to the  acquisition.  With  regard  to  interstate  bank
branching,  out-of-state  banks  that do not  already  operate a branch in  Washington
 may not  establish  de novo branches  in  Washington  or  establish  and  operate a
branch by  acquiring  a branch in  Washington.  Under  FDIC regulations,  banks are
prohibited  from using their  interstate  branches  primarily for deposit  production.
 The FDIC has accordingly implemented a loan-to-deposit ratio screen to ensure compliance
with this prohibition.

10

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Deposit Insurance

The deposits of the Bank are
currently  insured to a maximum of $100,000 per depositor  through the Bank  Insurance
Fund  administered  by the FDIC.  All insured  banks are  required to pay  semi-annual
 deposit  insurance  premium assessments to the FDIC.

FDICIA  included  provisions  to
reform the Federal  deposit  insurance  system,  including the  implementation  of
risk-based  deposit  insurance  premiums.  FDICIA also  permits  the FDIC to make
 special  assessments  on insured depository  institutions in amounts  determined by the
FDIC to be necessary to give it adequate  assessment  income to repay  amounts  borrowed
 from the U.S.  Treasury  and other  sources,  or for any other  purpose the FDIC deems
necessary.  The FDIC has  implemented  a  risk-based  insurance  premium  system  under
 which  banks are  assessed insurance  premiums  based on how much risk they  present  to
the  insurance  fund.  Banks  with  higher  levels of capital and a low degree of
 supervisory  concern  are  assessed  lower  premiums  than banks with lower  levels of
capital or a higher degree of supervisory concern.  The Bank presently qualifies for the
lowest premium level.

Dividends

The  principal  source of the
 Company's  cash  revenues  is  dividends  received  from the Bank.  The  payment  of
dividends is subject to government  regulation,  in that regulatory authorities may
prohibit banks and bank holding companies  from paying  dividends  in a manner that would
 constitute  an unsafe or unsound  banking  practice.  In addition,  a bank may not pay
cash  dividends  if that payment  could  reduce the amount of its capital  below that
necessary to meet minimum  applicable  regulatory capital  requirements.  Other than the
laws and regulations noted above,  which  apply to all banks and bank  holding
 companies,  neither  the  Company  nor the Bank are  currently subject to any regulatory
 restrictions  on their  dividends.  Under  applicable  restrictions,  as of December 31,
2005, the Bank could declare dividends totaling $6,046,000 without obtaining prior
regulatory approval.

Capital Adequacy

Federal bank  regulatory  agencies
use capital  adequacy  guidelines  in the  examination  and  regulation  of bank holding
companies and banks. If capital falls below minimum  guideline  levels,  the holding
company or bank may be denied approval to acquire or establish additional banks or
non-bank businesses or to open new facilities.

The FDIC and Federal  Reserve use
risk-based  capital  guidelines for banks and bank holding  companies.  These are
designed to make such capital  requirements  more  sensitive to  differences  in risk
profiles among banks and bank holding  companies,  to account for  off-balance  sheet
exposure and to minimize  disincentives  for holding liquid assets.  Assets  and
 off-balance  sheet  items are  assigned  to broad  risk  categories,  each  with
 appropriate weights.  The  resulting  capital  ratios  represent  capital as a
 percentage  of total  risk-weighted  assets and off-balance  sheet  items.  The
 guidelines  are  minimums,  and the Federal  Reserve  has noted that bank  holding
companies  contemplating  significant  expansion  programs  should not allow  expansion
to diminish  their  capital ratios and should maintain ratios well in excess of the
minimum.  The current  guidelines  require all bank holding companies  and
 federally-regulated  banks to maintain a minimum  risk-based  total  capital  ratio
equal to 8%, of which at least 4% must be Tier I capital.  Tier I capital for bank
holding companies includes common  shareholders' equity,  certain  qualifying  perpetual
 preferred stock and minority  interests in equity accounts of consolidated subsidiaries,
less intangibles except as described above and accumulated other comprehensive income
(loss).

The Federal  Reserve also employs a
leverage  ratio,  which is Tier I capital as a percentage  of total assets less
intangibles,  to be used as a supplement to risk-based  guidelines.  The principal
 objective of the leverage ratio is to constrain  the maximum  degree to which a bank
holding  company may leverage  its equity  capital  base.  The Federal Reserve  requires
a minimum  leverage ratio of 3%. However,  for all but the most highly rated bank holding
companies and for bank holding  companies seeking to expand,  the Federal Reserve expects
an additional  cushion of at least 1% to 2%.

11

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FDICIA  created a  statutory
 framework  of  supervisory  actions  indexed to the capital  level of the  individual
institution.  Under regulations  adopted by the FDIC, an institution is assigned to one
of five capital  categories depending on its total risk-based  capital ratio,  Tier I
risk-based  capital ratio,  and leverage ratio,  together with certain subjective
 factors.  Institutions which are deemed to be  undercapitalized  depending on the
category to which they are assigned are subject to certain mandatory  supervisory
 corrective actions.  The Company does not believe that these regulations had a material
effect on its operations.

Effects of Government Monetary Policy

The  earnings  and growth of the
Company are  affected  not only by general  economic  conditions,  but also by the fiscal
and monetary  policies of the federal  government,  particularly  the Federal  Reserve.
 The Federal Reserve can and does implement  national  monetary policy for such purposes
as curbing  inflation and combating  recession, but its open  market  operations  in U.S.
 government  securities,  control  of the  discount  rate  applicable  to borrowings
 from the  Federal  Reserve,  and  establishment  of  reserve  requirements  against
 certain  deposits, influence the growth of bank loans,  investments  and deposits,  and
also affect interest rates charged on loans or paid on  deposits.  The nature and impact
of future  changes in monetary  policies  and their impact on the Company and the Bank
cannot be predicted with certainty.

ITEM 1A. Risk Factors

The following are certain risks that
management believes are specific to our business.  This should not be viewed as an all
inclusive list or in any particular order.

Future loan losses may exceed our
allowance for loan losses.

We are subject to credit risk, which
is the risk of losing principal or interest due to borrowers' failure to repay loans in
accordance with their terms.  A downturn in the economy or the real estate market in our
market areas or a rapid change in interest rates could have a negative effect on
collateral values and borrowers' ability to repay.  This deterioration in economic
conditions could result in losses to the Company in excess of loan loss allowances.  To
the extent loans are not paid timely by borrowers, the loans are placed on non-accrual,
thereby reducing interest income.  To the extent loan charge-offs exceed our financial
models, increased amounts charged to the provision for loan losses would reduce income.

Rapidly changing interest rate
environments could reduce our net interest margin, net interest income, fee income and
net income

Interest and fees on loans and
securities, net of interest paid on deposits and borrowings, are a large part of our net
income.  Interest rates are key drivers of our net interest margin and subject to many
factors beyond the control of management.  As interest rates change, net interest income
is affected.  Rapid increases in interest rates in the future could result in interest
expense increasing faster than interest income because of mismatches in financial
instrument maturities.  Further, substantially higher interest rates generally reduce
loan demand and may result in slower loan growth particularly in commercial real estate
lending, an important factor in the Company's revenue growth over the past two years.
 Decreases or increases in interest rates could have a negative effect on the spreads
between the interest rates earned on assets and the rates of interest paid on
liabilities, and therefore decrease net interest income.  See "Quantitative and
Qualitative Disclosures about Market Risk."

12

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Slower than anticipated growth in
new branches and new product and service offerings could result in reduced net income

We have placed a strategic emphasis
on expanding our branch network and product offerings.  Executing this strategy carries
risks of slower than anticipated growth both in new branches and new products.  New
branches and products require a significant investment of both financial and personnel
resources.  Lower than expected loan and deposit growth in new investments can decrease
anticipated revenues and net income generated by those investments, and opening new
branches and introducing new products could result in more additional expenses than
anticipated and divert resources from current core operations.

The financial services industry is
very competitive

We face competition in attracting
and retaining deposits, making loans, and providing other financial services throughout
our market area.  Our competitors include other community banks, larger banking
institutions, and a wide range of other financial institutions such as credit unions,
government-sponsored enterprises, mutual fund companies, insurance companies and other
non-bank businesses.  Many of these competitors have substantially greater resources than
us.  For a more complete discussion of our competitive environment, see
"Business-Competition" in Item 1 above.  If we are unable to compete effectively, we will
lose market share and income from deposits, loans, and other products may be reduced.

Decreased volumes and lower gains on
sales of mortgage loans sold could adversely impact net income

We originate and sell mortgage
loans.  Changes in interest rates affect demand for our loan products and the revenue
realized on the sale of loans.  A decrease in the volume of loans sold can decrease our
revenues and net income.

Inability to hire or retain certain
key professionals, management and staff could adversely affect our revenues and net income

We rely on key personnel to manage
and operate our business, including major revenue generating functions such as our loan
and deposit portfolios.  The loss of key staff may adversely affect our ability to
maintain and manage these portfolios effectively, which could negatively affect our
revenues.  In addition, loss of key personnel could result in increased recruiting and
hiring expenses, which could cause a decrease in our net income.

ITEM 1B. Unresolved Staff
Comments

None

ITEM 2. Properties

The  Company's  administrative
 offices are  located in  Aberdeen,  Washington.  The  building  located at 300 East
Market  Street is owned by the Bank and  houses the main  branch.  The  administrative
 offices of the Bank and the Company, which are leased from an unaffiliated third party, are located at 1101 S. Boone Street and is leased
space.  The Bank completed  construction and occupied the main branch building in
December of 1979.

Pacific owns the land and
 buildings  occupied  by its nine  branches  in  Grays  Harbor,  Pacific  and  Wahkiakum
Counties,  as well as its data processing operations in Long Beach,  Washington.  Three
of the six branches located in Whatcom  County  operate in leased  facilities, which are leased from an unaffiliated third party, and the
 Bellingham,  Everson,  and Lynden,  WA branch land and building is owned.  The aggregate
monthly lease payment for all leased space is approximately $24,000.

13

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In  addition  to the  land and
 buildings  owned by  Pacific,  it also  owns  all of its  furniture,  fixtures  and
equipment,  including  data  processing  equipment,  at  December  31,  2005.  The net
book value of the  Company's premises and equipment was $10.1 million at that date.

Management  believes  that  the
 facilities  are  of  sound  construction  and in  good  operating  condition,  are
appropriately insured and are adequately equipped for carrying on the business of the
Bank.

ITEM 3. Legal Proceedings

The Company and the Bank from time
to time are party to various legal  proceedings  arising in the ordinary  course of
business.  Management  believes that there are no threatened or pending  proceedings
 against the Company or the Bank which, if determined adversely, would have a material
effect on its business or financial condition.

ITEM 4. Submission of Matters to a
Vote of Security Holders

No matters were submitted to a vote
of security holders in the fourth quarter of 2005.

14

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PART II

ITEM 5. Market for Registrant's
Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities

The Company's common stock is
presently traded on the OTC Bulletin Board under the trading symbol "PFLC.OB". Prior to
March 2004, our common stock was not listed and was only traded in private transactions.
 Accordingly, the prices reported and listed below for the first quarter of 2004 reflect
only transactions known and reported to management.  Because only limited information is
available, the data may not accurately reflect all trades that occurred.  Historically,
trading in our stock has been very limited and the trades that have occurred cannot be
characterized as amounting to an established public trading market, even since March
2004.  As a result, the trading prices of our common stock may not reflect the price that
would result if our stock was actively traded at high volumes.

The following are high and low bid prices quoted on the OTC Bulletin Board
during the periods indicated.  The quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions:

|               | Shares Traded | 2005High | Low | Shares Traded (1) | 2004High (1) | Low (1)
|-------------- | ------------- | -------- | --- | ----------------- | ------------ | -------
|First Quarter  |               |          |     | 61,423            |              | $      
|Second Quarter |               |          |     | 188,900           |              | $      
|Third Quarter  |               |          |     | 74,500            |              | $      
|Fourth Quarter |               |          |     | 47,900            |              | $      

(1)    
          All prices and numbers of shares have been retroactively adjusted for a
          two-for-one stock split effective April 4, 2005.

As of December 31, 2005, there were
approximately 1,190 shareholders of record of the Companys common stock. Effective January 1, 2005, the Company appointed Mellon
Investor Services LLC to serve as the transfer agent for its  common stock.  Prior to that date, the Company served as its own
transfer agent.

The Companys Board of Directors
declared dividends on its common stock in December 2005 and 2004 in the amounts per share
of $.73 and $.72, respectively. The Board of Directors has adopted a dividend policy which
is reviewed annually. There can be no assurance the Company will continue to increase its
dividend or declare and pay dividends at historical rates.

Payment of dividends is subject to
regulatory limitations. Under federal banking law, the payment of dividends by the Company
and the Bank is subject to capital adequacy requirements established by the Federal
Reserve and the FDIC. Under Washington general corporate law as it applies to the Company,
no cash dividend may be declared or paid if, after giving effect to the dividend, the
Company is insolvent or its liabilities exceed its assets. Payment of dividends on the
Common Stock is also affected by statutory limitations, which restrict the ability of the
Bank to pay upstream dividends to the Company. Under Washington banking law as it applies
to the Bank, no dividend may be declared or paid in an amount greater than net profits
then available, and after a portion of such net profits have been added to the surplus
funds of the Bank. Under applicable restrictions, as of December 31, 2005, the Bank could
declare dividends totaling $6,046,000 without obtaining prior regulatory approval.

15

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# ITEM 6. Selected
Financial Data

On February 27, 2004, the Company
completed its acquisition of BNW. BNW, through its operating subsidiary Bank NorthWest,
operated five banking locations in Whatcom County, Washington, including its largest city,
Bellingham, Washington, and as of the date of acquisition had total assets of
approximately $120.0 million, total loans of approximately $110.7 million, total deposits
of approximately $87.8 million, and total shareholders equity of approximately $7.2
million.

The historical information in the
selected consolidated financial data below reflects major variances for the year 2004
compared to the prior year due to the inclusion of assets acquired in the BNW merger. For
instance, the loan portfolio acquired in the acquisition contributed approximately $7.5
million in interest income during the period February 27, 2004 through December 31, 2004,
while the increased interest expense associated with acquired deposits totaled
approximately $1.2 million during the perod, meaning approximately $6.3 million in 2004
net interest income can be attributed to the BNW acquisition. Noninterest income increased
approximately $1.2 million due to the acquisition, while noninterest expense
increased approximately $5.6 million.

The acquisition was accounted for
using the purchase method of accounting and, accordingly, the assets and liabilities of
BNW were recorded at their respective fair value. Goodwill, the excess of the purchase
price over the net fair value of the assets and liabilities acquired, was recorded at
$11.3 million and a core deposit identifiable intangible asset of $993,000 was recorded.

The following table sets forth
certain selected consolidated financial data of the Company at and for the years ended
December 31:

|                             | 2005 | 2004 | 2003 | 2002   | 2001
|---------------------------- | ---- | ---- | ---- | ------ | ----
|
|Operations Data              |      |      |      |        |     
|Net interest income          |      |      | $    | 22,284 |     
|Provision for credit losses  |      |      |      | 1,100  |     
|Noninterest income           |      |      |      | 4,081  |     
|Noninterest expense          |      |      |      | 16,566 |     
|Provision for income taxes   |      |      |      | 2,653  |     
|Net income                   |      |      |      | 6,046  |     
|Net income per share:        |      |     
|Basic                        |      |      |      | .94    |     
|Diluted                      |      |      |      | .92    |     
|                             |      |      |      |        |     
|Dividends declared           |      |      |      | 4,719  |     
|Dividends declared per share |      |      |      | .73    |     
|Dividends paid ratio         |      |      |      | 78     | %   
|                             |      |      |      |        |     
|Performance Ratios           |      |     
|Interest rate spread         |      |      |      | 5.34   | %   
|Net interest margin (2)      |      |      |      | 5.25   | %   
|Efficiency ratio (3)         |      |      |      | 62.83  | %   
|Return on average assets     |      |      |      | 1.31   | %   
|Return on average equity     |      |      |      | 12.70  | %   

16

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|Balance Sheet Data       |  |  |   |         |  
|------------------------ |  |  | - | ------- | -
|Total assets             |  |  | $ | 489,409 |  
|Loans, net               |  |  |   | 393,574 |  
|Total deposits           |  |  |   | 399,726 |  
|Other borrowings         |  |  |   | 35,790  |  
|Shareholders' equity     |  |  |   | 46,600  |  
|Book value per share (4) |  |  |   | 7.21    |  
|Equity to assets ratio   |  |  |   | 9.52    | %

|Asset Quality Ratios                   |  |  |  |       |  
|-------------------------------------- |  |  |  | ----- | -
|Nonperforming loans to total loans     |  |  |  | 1.67  | %
|Allowance for loan losses              |  | 
|to total loans                         |  |  |  | 1.33  | %
|Allowance for loan losses              |  | 
|to nonperforming loans                 |  |  |  | 79.64 | %
|Nonperforming assets to   total assets |  |  |  | 1.36  | %

(1)    
          Retroactively adjusted for a two-for-one stock split effective  April 4,
          2005.

(2)    
          Net interest income divided by average earning assets.

(3)    
          Non-interest expense divided by the sum of net interest income and non-interest
          income.

(4)     Shareholder
equity divided by shares outstanding.

17

---



ITEM 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations

The following discussion should be
read in conjunction with Pacifics audited consolidated financial statements and
related notes appearing elsewhere in this report. In addition, please refer to
Pacifics forward-looking statement disclosure included in Part I of this report.

# RESULTS OF OPERATIONS

Years ended December 31, 2005, 2004,
and 2003

General.    
          The Companys net income for 2005 was $6,046,000, a 5.9% increase compared
          to $5,707,000 in 2004, and an increase of 24.6% from $4,579,000 in 2003. Basic
          earnings per share were $.94, $.93, and $.91 for 2005, 2004, and 2003,
          respectively. Return on average assets was 1.31%, 1.41%, and 1.61% in 2005,
          2004, and 2003, respectively. Return on average equity was 12.70%, 14.21%, and
          17.10%, respectively, in 2005, 2004, and 2003. The increase in net income for
          the current year is primarily due to increased lending volume, interest rates
          and gains on sales of loans. Reductions in return on average assets and return
          on average equity can be attributed primarily to the addition of goodwill
          associated with the purchase accounting treatment of the BNW transaction.

The following table presents
condensed consolidated statements of income for the Company for each of the years in the
three-year period ended December 31, 2005.

|(Dollars in thousands)      | 2005 | Increase(Decrease)Amount | % | 2004   | Increase(Decrease)Amount | % | 2003 
|--------------------------- | ---- | ------------------------ | - | ------ | ------------------------ | - | -----
|Interest income             |      |                          | $ | 29,631 |                          | $ | 5,493
|Interest expense            |      |                          |   | 7,347  |                          |   | 2,729
|Net interest income         |      |                          |   | 22,284 |                          |   | 2,764
|Provision for credit losses |      |                          |   | 1,100  |                          |   | 130  
|Net interest income after   |      |                         
|provision for credit losses |      |                          |   | 21,184 |                          |   | 2,634
|Other operating income      |      |                          |   | 4,081  |                          |   | 919  
|Other operating expense     |      |                          |   | 16,566 |                          |   | 3,011
|Income before income taxes  |      |                          |   | 8,699  |                          |   | 542  
|Income taxes                |      |                          |   | 2,653  |                          |   | 203  
|Net income                  |      |                          |   | 6,046  |                          |   | 339  

Net Interest Income. The
Company derives the majority of its earnings from net interest income, which is the
difference between interest income earned on interest earning assets and interest expense
incurred on interest bearing liabilities. The following table sets forth information with
regard to average balances of the interest earning assets and interest bearing liabilities
and the resultant yields or cost, net interest income, and the net interest margin.

18

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|                                                                   | Year Ended December 31,
|------------------------------------------------------------------ | -----------------------
|
|Assets                                                             |                        
|Earning assets:                                                    |                        
|Loans                                                              |                        
|Investment Securities:                                             |                        
|Taxable                                                            |                        
|Tax-Exempt                                                         |                        
|Total investment                                                   |                        
|securities                                                         |                        
|Federal Home Loan Bank      Stock                                  |                        
|Federal funds sold and                                             |                        
|deposits in banks                                                  |                        
|Total earning assets/interest                                      |                        
|income                                                             |                        
|Cash and due from banks                                            |                        
|Bank premises and equipment                                        |                        
|(net)                                                              |                        
|Other assets                                                       |                        
|Allowance for credit losses                                        |                        
|Total assets                                                       |                        
|Liabilities and Shareholders' Equity                               |                        
|Interest bearing liabilities:                                      |                        
|Deposits:                                                          |                        
|Savings and interest-                                              |                        
|bearing demand                                                     |                        
|Time                                                               |                        
|Total deposits                                                     |                        
|Short-term  borrowings                                             |                        
|Long-term borrowings                                               |                        
|Secured borrowings                                                 |                        
|Junior subordinated debentures                                     |                        
|Total borrowings                                                   |                        
|Total interest-bearing liabilities/                                |                        
|Interest expense                                                   |                        
|Demand deposits                                                    |                        
|Other liabilities                                                  |                        
|Shareholders' equity                                               |                        
|Total liabilities and shareholders'                                |                        
|equity                                                             |                        
|Net interest income                                                |                        
|Net interest income as a percentage                                |                        
|of average earning assets                                          |                        
|Interest income                                                    |                        
|Interest expense                                                   |                        
|Net interest income                                                |                        
|Net interest margin (1)                                            |                        
|* Tax equivalent basis -          34% tax rate used                |                        
|(1) Net interest income divided by average interest earning assets |                        

Nonaccrual loans and loans held for
sale are included in loans.

Interest income on loans include loan
fees of $2,439,000, $1,573,000, and $1,003,000 in 2005, 2004, and 2003, respectively.

For purposes of computing the average yield,
the Company used historical cost balances which do not give effect to changes in fair
value that are reflected as a component of shareholders equity.

19

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Net interest income increased 14.2%
to $22,284,000 in 2005 compared to 2004. The increase is primarily the result of increased
lending volumes and higher interest rates. The Companys interest income increased
22.8% to $29,631,000 in 2005 from $24,138,000 in 2004. Interest expense increased to
$7,347,000 in 2005 or 59.1%, compared to $4,618,000 in 2004. This is due to the 200 basis
point increase in short-term interest rates during 2005. Net interest income increased
55.6% to $19,520,000 in 2004 compared to 2003. The Companys interest income
increased 51.3% to $24,138,000 in 2004 from $15,949,000 in 2003. The increases in 2004
were primarily the result of the BNW acquisition.

The Companys average loan
portfolio increased $56,245,000, or 17.8%, from year end 2004 to year end 2005, and
increased $127,097,000, or 67.5%, from 2003 to 2004. The growth in 2004 is primarily due
to the acquisition of BNW effective February 27, 2004. The increase in loans in 2005 is a
result of the Companys continued focus on commercial business and commercial and
construction real estate lending. The Company attributes the growth in commercial loans to
its strong local presence in the markets it serves and its ability to meet the needs of
its commercial customers through local decision making and rapid responses to customer
inquiries. Additionally, the Company continued to benefit from its expanded presence in
the vibrant Whatcom County market. Residential real estate demand continued to be strong
as low long-term interest rates continued to prevail in 2005. During 2005, residential
mortgage production sold into the secondary market increased $44,364,000 or 66.7%. A large
portion of the Companys loan portfolio rates are tied to variable rate indexes. As a
result, the Company was positioned well for the Federal Reserve rate increases which
occurred in 2005.

The Companys average investment
portfolio decreased $12,425,000 or 23.9% from 2004. The Companys average investment
portfolio increased $10,958,000, or 17.4%, during 2004 from 2003. The changes in 2005 and
2004 were due to maturing investments being utilized to fund loan production.

The Companys average deposits
increased $52,113,000 or 15.6% from 2004, and increased $69,161,000 or 34.8% in 2004 from
2003. The primary reason for the increase in 2004 is due to the acquisition of BNW and
continuation of its targeted marketing program after the acquisition. The Company
attributes the growth in 2005 to its experienced branch staff and a focused commitment on
improving customer service throughout its branch delivery system.

The Company decreased its average
borrowings during 2005 by $1,622,000 or 6.5%. These borrowings consist of advances from
the Federal Home Loan Bank of Seattle. Short-term borrowings in 2004 were converted to
long-term borrowings in 2005 in order to take advantage of low long-term interest rates.
The Company increased its average borrowings during 2004 by $10,754,000 or 76.4%. Secured
borrowings decreased to $2,150,000 compared to $3,733,000 in 2004. The secured borrowings
at December 31, 2005 represent borrowings collateralized by participation interests in
loans originated by the Company. These borrowings are repaid as payments are made on the
underlying loans, bearing interest rates ranging from 6.5% to 8.5%.

Net interest margins were 5.25%,
5.25%, and 4.75%, for the years ended December 31, 2005, 2004, and 2003, respectively.

20

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The following table presents changes
in net interest income attributable to changes in volume or rate. Changes not solely due
to volume or rate are allocated to volume and rate based on the absolute values of each.

|                                   | 2005 compared to 2004Increase (decrease) due to | 2004 compared to 2003Increase (decrease) due to
|---------------------------------- | ----------------------------------------------- | -----------------------------------------------
|
|Interest earned on:                |                                                 |                                                
|Loans                              |                                                 |                                                
|Securities:                        |                                                 |                                                
|Taxable                            |                                                 |                                                
|Tax-exempt                         |                                                 |                                                
|Total securities                   |                                                 |                                                
|Federal Home Loan Bank Stock       |                                                 |                                                
|Fed funds sold and interest        |                                                 |                                                
|bearing deposits in other banks    |                                                 |                                                
|Total interest earning assets      |                                                 |                                                
|Interest paid on:                  |                                                 |                                                
|Savings and interest bearing       |                                                 |                                                
|demand deposits                    |                                                 |                                                
|Time deposits                      |                                                 |                                                
|Total borrowings                   |                                                 |                                                
|Total interest bearing liabilities |                                                 |                                                
|Change in net interest income      |                                                 |                                                

Non-Interest Income.
Non-interest income was $4,081,000 for 2005, an increase of $919,000 or 29.1% from 2004
when it totaled $3,162,000. The 2004 amount was an increase of $1,316,000 or 71.3%
compared to the 2003 total of $1,846,000.

The following
table represents the principal categories of non-interest income for each of the years in
the three-year period ended December 31, 2005.

|(Dollars in thousands)                | 2005 | Increase(Decrease)Amount | % | 2004  | Increase(Decrease)Amount | % | 2003
|------------------------------------- | ---- | ------------------------ | - | ----- | ------------------------ | - | ----
|Service charges on                    |      |                          |   |       |                          |   |     
|deposit accounts                      |      |                          | $ | 1,470 |                          | $ | 173 
|Mortgage broker fees                  |      |                          |   |      |                          |   | (12 
|Income from and gains on sale of      |      |                         
|foreclosed real estate                |      |                          |   |      |                          |   | (77 
|Net gains from sales of loans         |      |                          |   | 1,809 |                          |   | 783 
|Net gain on sale of securities        |      |                          |   | 2     |                          |   | (1  
|Earnings on bank owned life insurance |      |                          |   | 393   |                          |   | 15  
|Other operating income                |      |                          |   | 407   |                          |   | 38  
|Total non-interest income             |      |                          |   | 4,081 |                          |   | 919 

Service charges on deposits increased
13.3% and 26.3% during 2005 and 2004, respectively. The Company continues to emphasize the
importance of exceptional customer service and believes this emphasis facilitated the
opening of a significant number of new demand deposit accounts during 2005. The increase
in 2004 is attributable primarily to the BNW acquisition.

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Income from sources other than
service charges on deposit accounts totaled $2,611,000 in 2005, an increase of $746,000
from 2004, or 40.0%. The primary reason for the increase was the acquisition of BNW and
gains on sale of loans, which totaled $1,026,000 and $1,809,000 during 2004 and 2005,
respectively. The market interest rate environment heavily influences revenue from
mortgage banking activities. Refinance activity continued to be strong in 2005, as
long-term interest rates remained stable. Management expects gains on sale of loans to
decline in 2006 as new home construction and refinancing activity slows. Other major
components of non-interest income were gains on sale of foreclosed real estate and bank
owned life insurance income.

Non-Interest Expense. Total
non-interest expense in 2005 was $16,566,000, an increase of $3,011,000 or 22.2% compared
to $13,555,000 in 2004. In 2004 non-interest expense increased $5,610,000 or 70.6%
compared to $7,945,000 in 2003. The Company expects that non-interest expense will
increase approximately 10% during 2006 as it continues to make infrastructure improvements
to support the future growth of the Company. Additionally, the Company plans to open two
new, full service banking facilities during the first quarter of 2006.

The following table represents the
principal categories of non-interest expense for each of the years in the three-year
period ended December 31, 2005.

|(Dollars in thousands)         | 2005 | Increase(Decrease)Amount | % | 2004   | Increase(Decrease)Amount | % | 2003 
|------------------------------ | ---- | ------------------------ | - | ------ | ------------------------ | - | -----
|Salaries and employee benefits |      |                          | $ | 10,073 |                          | $ | 1,939
|Occupancy and equipment        |      |                          |   | 2,037  |                          |   | 449  
|Marketing and advertising      |      |                          |   | 495    |                          |   | 229  
|State taxes                    |      |                          |   | 348    |                          |   | 42   
|Data processing                |      |                          |   | 479    |                          |   | (135 
|Other expense                  |      |                          |   | 3,134  |                          |   | 487  
|Total non-interest expense     |      |                          | $ | 16,566 |                          | $ | 3,011

Salary and employee benefits, the
largest component of non-interest expense, increased by $1,939,000, or 23.8%, in 2005 to
$10,073,000 and increased by $3,370,000, or 70.7%, in 2004 compared to 2003. The Company
increased its level of staffing to 181 full-time equivalent employees at December 31, 2005
from 157 full-time equivalent employees at December 31, 2004. In 2004, salary and benefits
increased primarily due to a larger employee base as the result of the BNW acquisition, in
addition to normal merit increases. At the time of acquisition, the Company had 96 full
time equivalent employees and BNW employed 52 full time equivalent employees.

Occupancy and equipment expenses
increased $449,000 to $2,037,000 in 2005 compared with $1,588,000 for 2004 due to
increased facilities expenses, primarily rent and increased depreciation expense related
to the acquisition of fixed assets needed to support the growth of the Company. Occupancy
and equipment expenses increased 64.6% for 2004 compared to 2003 as a direct result of the
BNW acquisition. BNW operated five locations in its market area. Three of the branches,
including the Barkley branch, Birch Bay branch and Lynden branch operated in leased
facilities. Two branches, the Bellingham branch and Everson branch, are owned by the
Company. During 2005, the Lynden branch moved from a leased location to a newly
constructed branch which is owned by the Company.

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Marketing and advertising expense
increased 86.1% to $495,000 in 2005 compared with $266,000 for 2004 due to expansion in
the marketing department undertaken to increase the Companys presence in its primary
market areas. Additionally, the Company increased promotional costs associated with the
grand opening of its Ferndale, Washington branch in May 2005, the relocation of the Lynden
branch into a new facility in August 2005, and a name change for all BNW branches.
Marketing and advertising expenses increased 43.8% for 2004 compared to 2003 as a direct
result of the BNW acquisition.

State taxes paid in 2005 totaled
$348,000, an increase of 13.7% compared with 2004 due to increased revenues. In 2004,
state taxes totaled $306,000, an increase of 343.5% over 2003 amounts as a result of a tax
refund pertaining to an application filed by the Company with the Washington State
Department of Revenue for overpayment of business and occupation tax which was received in
2003.

Data processing expense decreased
22.0% to $479,000 in 2005 compared with $614,000 for 2004 due to the costs savings
associated with consolidating the BNW processing operations into the Companys
existing in-house system. Data processing expense increased $309,000 or 101.3% in 2004
compared to 2003 due to the BNW acquisition. Although it was planned to consolidate BNW
data processing operations into the Companys systems during 2004, the conversion was
delayed into 2005.

Other operating expense increased
18.4% to $3,134,000 in 2005 compared with $2,647,000 for 2004 primarily due to increases
in director fees, donations, postage costs, and core deposit amortization expense, each of
which were up $158,000, $54,000, $48,000 and $35,000, respectively. The $990,000 or 59.8%
increase in other expense in 2004 was due primarily to the BNW acquisition, including
travel expense, core deposit intangible amortization expense, and loan expense. In
addition, during 2004 costs associated with implementing section 404 of the Sarbanes-Oxley
Act resulted in a direct increase in compliance expense of approximately $170,000.

CRITICAL ACCOUNTING
POLICIES

The Companys consolidated
financial statements are prepared in accordance with accounting principles generally
accepted in the United States of America. The financial information contained within these
statements is, to a significant extent, financial information that is based on approximate
measures of the financial effects of transactions and events that have already occurred.
Based on its evaluation of accounting policies that involve the most complex and
subjective decisions and assessments, management has identified its most critical
accounting policy as related to the allowance for credit losses. The Companys
allowance for credit loss methodology incorporates a variety of risk considerations, both
quantitative and qualitative, in establishing an allowance for credit losses that
management believes is appropriate at each reporting date. Quantitative factors include
the Companys historical loss experience, delinquency and charge-off trends,
collateral values, changes in nonperforming loans, and other factors. Quantitative factors
also incorporate known information about individual loans, including borrowers
sensitivity to interest rate movements. Qualitative factors include the general economic
environment in the Companys markets, including economic conditions and, in
particular, the state of certain industries. Size and complexity of individual credits in
relation to loan structure, existing loan policies and pace of portfolio growth are other
qualitative factors that are considered in the methodology. As the Company adds new
products and increases the complexity of its loan portfolio, it intends to enhance its
methodology accordingly. A materially different amount could be reported for the provision
for credit losses in the statement of operations to change the allowance for credit losses
if managements assessment of the above factors were different. This discussion and
analysis should be read in conjunction with the Companys financial statements and
the accompanying notes presented elsewhere herein, as well as the portion of this
Managements Discussion and Analysis section entitled LENDING  Allowance
and Provision for Credit Losses. Although management believes the levels of the
allowance as of both December 31, 2005 and 2004 were adequate to absorb losses
inherent in the loan portfolio, a decline in local economic conditions, or other factors,
could result in increasing losses that cannot reasonably be predicted at this time.

23

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Goodwill is initially recorded when
the purchase price paid for an acquisition exceeds the estimated fair value of the net
identified tangible and intangible assets acquired. Goodwill is presumed to have an
indefinite useful life and is tested, at least annually, for impairment at the reporting
unit level. The Company performs an annual review each year, or more frequently if
indicators of potential impairment exists, to determine if the recorded goodwill is
impaired. The Companys impairment review process compares the fair value of the
Company to its carrying value, including the goodwill related to the Company. If the fair
value exceeds the carrying value, goodwill of the Company is not considered impaired and
no additional analysis is necessary. As of December 31, 2005, there have been no events or
changes in circumstances that would indicate a potential impairment.

ASSET AND LIABILITY
MANAGEMENT

The largest component of the
Companys earnings is net interest income. Interest income and interest expense are
affected by general economic conditions, competition in the market place, market interest
rates and repricing and maturity characteristics of the Companys assets and
liabilities. Exposure to interest rate risk is primarily a function of differences between
the maturity and repricing schedules of assets (principally loans and investment
securities) and liabilities (principally deposits). Assets and liabilities are described
as interest sensitive for a given period of time when they mature or can reprice within
that period. The difference between the amount of interest sensitive assets and interest
sensitive liabilities is referred to as the interest sensitive GAP for any
given period. The GAP may be either positive or negative. If positive, more
assets reprice than liabilities. If negative, the reverse is true.

Certain shortcomings are inherent in
the interest sensitivity GAP method of analysis. Complexities such as
prepayment risk and customer responses to interest rate changes are not taken into account
in the GAP analysis. Accordingly, management also utilizes a net interest
income simulation model to measure interest rate sensitivity. Simulation modeling gives a
broader view of net interest income variability, by providing various rate shock exposure
estimates. Management regularly reviews the interest rate risk position and provides
measurement reports to the Board of Directors.

The following table shows the dollar
amount of interest sensitive assets and interest sensitive liabilities at December 31,
2005 and differences between them for the maturity or repricing periods indicated.

|(dollars in thousands)                   | Due in oneyear or less | Due afterone throughfive years | Due afterfive years | Total  
|---------------------------------------- | ---------------------- | ------------------------------ | ------------------- | -------
|Interest earning assets                  |                        |                                |                     |        
|Loans, including loans held for sale     |                        |                                | $                   | 240,741
|Investment securities                    |                        |                                |                     | 7,428  
|Fed Funds sold and interest              |                        |                               
|bearing balances with banks              |                        |                                |                     | 283    
|Federal Home Loan Bank Stock             |                        |                                |                     |       
|Total interest earning assets            |                        |                                | $                   | 248,452
|Interest bearing liabilities             |                        |                               
|Interest bearing demand deposits         |                        |                                | $                   | 49,140 
|Savings deposits                         |                        |                                |                     | 145,126
|Time deposits                            |                        |                                |                     | 63,755 
|Short term borrowings                    |                        |                                |                     | 3,985  
|Long term borrowings                     |                        |                                |                     | 5,000  
|Secured borrowings                       |                        |                                |                     |       
|Junior subordinated debentures           |                        |                                |                     |       
|Total interest bearing liabilities       |                        |                                | $                   | 280,475
|Net interest rate sensitivity GAP        |                        |                                | $                   | (32,023
|Cumulative interest rate sensitivity GAP |                        |                                |                     |        
|Cumulative interest rate sensitivity GAP |                        |                               
|as a % of earning assets                 |                        |                                |                     |        

24

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Effects of Changing Prices.
The results of operations and financial conditions presented in this report are based on
historical cost information, and are unadjusted for the effects of inflation. Since the
assets and liabilities of financial institutions are primarily monetary in nature, the
performance of the Company is affected more by changes in interest rates than by
inflation. Interest rates generally increase as the rate of inflation increases, but the
magnitude of the change in rates may not be the same.

The effects of inflation on financial
institutions is normally not as significant as its influence on businesses which have
investments in plants and inventories. During periods of high inflation there are normally
corresponding increases in the money supply, and financial institutions will normally
experience above-average growth in assets, loans and deposits. Inflation does increase the
price of goods and services, and therefore operating expenses increase during inflationary
periods.

INVESTMENT PORTFOLIO

The Companys investment
securities portfolio decreased $6,738,000, or 15.7% during 2005 to $36,252,000 compared to
year end 2004 as proceeds from maturities and principal payments were used to fund loans.
The Companys investment securities portfolio decreased $22,471,000, or 34.3% during
2004 to $42,990,000 at year end from $65,461,000 in 2003. The changes in 2004 were
primarily in other securities as the Company liquidated the majority of the mutual funds
it held in order to fund loan growth.

The Company regularly reviews its
investment portfolio to determine whether any of its securities are other than temporarily
impaired. In addition to accounting and regulatory guidance, in determining whether a
security is other than temporarily impaired, the Company considers duration and amount of
each unrealized loss, the financial condition of the issuer, and the prospects for a
change in market value and net asset value within a reasonable period of time. At December
31, 2005 and 2004, the Company did not have any other than temporarily impaired
securities.

The carrying values of investment
securities at December 31 in each of the last three years are as follows:

HELD TO MATURITY

|(dollars in thousands)                           | 2005 | 2004 | 2003
|------------------------------------------------ | ---- | ---- | ----
|U.S. Agencies securities                         |      |      | $   
|Obligations of states and political subdivisions |      |      |     
|Total                                            |      |      | $   
|AVAILABLE FOR SALE                               |      |     
|(dollars in thousands)                           |      |      |     
|U.S. Agencies securities                         |      |      | $   
|Obligations of states and political subdivisions |      |      |     
|Other securities                                 |      |      |     
|Total                                            |      |      | $   

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The following table presents the
maturities of investment securities at December 31, 2005. Taxable equivalent values are
used in calculating yields assuming a tax rate of 34%.

HELD TO MATURITY

|(dollars in thousands)              | Due in oneyear or less | Due after one throughfive years | Due afterfive throughten years | Due afterten years | Total
|----------------------------------- | ---------------------- | ------------------------------- | ------------------------------ | ------------------ | -----
|U.S. Agency securities              |                        |                                 | $                              |                   |      
|Weighted average yield              |                        |                                 |                                |                   |      
|Obligations of states and political |                        |                                
|subdivisions                        |                        |                                 | $                              |                   |      
|Weighted average yield              |                        |                                 |                                |                   |      
|Total                               |                        |                                 | $                              |                   |      

AVAILABLE FOR SALE

|(dollars in thousands)              | Due in oneyear or less | Due afterone throughfive years | Due afterfive throughten years | Due afterten years | Total
|----------------------------------- | ---------------------- | ------------------------------ | ------------------------------ | ------------------ | -----
|U.S. Agency securities              |                        |                                | $                              |                   |      
|Weighted average yield              |                        |                                |                                |                   |      
|Obligations of states and political |                        |                               
|subdivisions                        |                        |                                | $                              | 2,151              |      
|Weighted average yield              |                        |                                |                                | 6.39               | %    
|Other securities                    |                        |                                | $                              | 3,434              |      
|Weighted average yield              |                        |                                |                                | 3.84               | %    
|Total                               |                        |                                | $                              | 5,585              |      

LENDING

General.    
          The Companys policy is to originate loans primarily in its local markets.
          Depending on the purpose of the loan, the loans may be secured by a variety of
          collateral, including business assets, real estate, and personal assets.

The following table sets forth the
composition of the Companys loan portfolio (including loans held for sale) at
December 31 in each of the past five years.

|(dollars in thousands)      | 2005 | 2004 | 2003 | 2002    | 2001
|--------------------------- | ---- | ---- | ---- | ------- | ----
|Commercial                  |      |      | $    | 124,536 |     
|Real Estate Construction    |      |      |      | 87,621  |     
|Real Estate Mortgage        |      |      |      | 185,503 |     
|Installment                 |      |      |      | 9,945   |     
|Credit cards and overdrafts |      |      |      | 1,863   |     
|Less unearned income        |      |      |      | (487    | )   
|Total                       |      |      | $    | 408,981 |     

26

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Loan Maturities and Sensitivity in
Interest Rates. The following table presents information related to maturity
distribution and interest rate sensitivity of commercial and real estate construction
loans outstanding, based on scheduled repayments at December 31, 2005.

|(dollars in thousands)                   | Due in one  year or less | Due after one through  five years | Due afterfive years | Total  
|---------------------------------------- | ------------------------ | --------------------------------- | ------------------- | -------
|Commercial                               |                          |                                   | $                   | 46,682 
|Real estate construction                 |                          |                                   |                     | 56,458 
|Total                                    |                          |                                   | $                   | 103,140
|Total loans maturing after one year with |                          |                                  
|Predetermined interest rates (fixed)     |                          |                                   |                     |        
|Floating or adjustable rates (variable)  |                          |                                   |                     |        
|Total                                    |                          |                                   |                     |        

At December 31, 2005, 34.4% of the
total loan portfolio presented above was due in one year or less.

Risk Elements. Risk elements
include accruing loans past due ninety days or more, non-accrual loans, and loans which
have been restructured to provide reduction or deferral of interest or principal for
reasons related to the debtors financial difficulties. The Companys policy for
placing loans on non-accrual status is based upon managements evaluation of the
ability of the borrower to meet both principal and interest payments as they become due.
Generally, loans with interest or principal payments which are ninety or more days past
due are placed on non-accrual, unless they are well-secured and in the process of
collection, and the interest accrual is reversed against income.

27

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The following table presents
information related to the Companys non-accrual loans and other non-performing
assets at December 31 in each of the last five years.

|(dollars in thousands)       | 2005 | 2004 | 2003 | 2002  | 2001
|---------------------------- | ---- | ---- | ---- | ----- | ----
|Non-accrual loans            |      |      | $    | 6,650 |     
|Accruing loans past due      |      |     
|90 days or more              |      |      |      | 82    |     
|Restructured loans           |      |      |      |      |     
|Foreclosed real estate owned |      |      |      | 37    |     

Non-accrual loans totaled $6,650,000
at December 31, 2005. This represents 1.63% of total loans including loans held for sale,
compared to $470,000, or .14% at December 31, 2004. Non-accrual loans at year end 2005
relate primarily to one borrower involved in the forest products industry. Although the
borrower is making principal and interest payments as agreed and is continuing operations,
the deteriorating financial condition of the borrower creates the potential the Company
may not be able to collect all principal and interest according to the terms of the loan.
Of the non-accrual loans outstanding, $3,484,000 are guaranteed by the United State
Department of Agriculture representing 52.4% of non-accrual loans outstanding. Non-accrual
loans increased approximately $5,000 to $470,000 in 2004 from 2003. The totals are net of
charge-offs based on managements estimate of fair market value or the result of
appraisals. During 2004, sales of foreclosed real estate owned totaled $58,000. There were
no sales of foreclosed real estate in 2005.

Non-accrual loans decreased
$1,399,000 to $465,000 at year-end 2003 after increasing to $1,864,000 in 2002 from
$1,254,000 in 2001. Interest income on non-accrual loans that would have been recorded had
those loans performed in accordance with their initial terms, as of December 31, was
$76,000 for 2005, $8,000 for 2004, $37,000 for 2003, $118,000 for 2002, and $75,000 for
2001. Interest income recognized on impaired loans for 2005 was $569,000, for 2004 was
$16,000, for 2003 was $19,000, for 2002 was $13,000, and for 2001 was $2,000.

Loan Concentrations. The
Company has credit risk exposure related to real estate loans. The Company makes real
estate loans for construction and loans for other purposes which are secured by real
estate. At December 31, 2005, loans secured by real estate totaled $273,124,000, which
represents 66.8% of the total loan portfolio. Real estate construction loans comprised
$87,621,000 of that amount, while real estate loans secured by residential properties
totaled $50,546,000. As a result of these concentrations of loans, the loan portfolio is
susceptible to changes in economic and market conditions in the Companys market
areas. The Company generally requires collateral on all real estate exposures and
typically maintains loan-to-value ratios of no greater than 80%.

Allowance and Provision for Credit
Losses. The allowance for credit losses reflects managements current estimate of
the amount required to absorb losses on existing loans and commitments to extend
credit.  Loans deemed uncollectible are charged against and reduce the allowance.
Periodically, a provision for credit losses is charged to current expense. This provision
acts to replenish the allowance for credit losses and to maintain the allowance at a level
that management deems adequate. There is no precise method of predicting specific loan
losses or amounts that ultimately may be charged off on segments of the loan portfolio.
The determination that a loan may become uncollectible, in whole or in part, is a matter
of judgment. Similarly, the adequacy of the allowance for credit losses can be determined
only on a judgmental basis, after full review, including (a) consideration of economic
conditions and the effect on particular industries and specific borrowers; (b) a review of
borrowers financial data, together with industry data, the competitive situation,
the borrowers management capabilities and other factors; (c) a continuing evaluation
of the loan portfolio, including monitoring by lending officers and staff credit personnel
of all loans which are identified as being of less than acceptable quality; (d) an
in-depth appraisal, on a monthly basis, of all loans judged to present a possibility of
loss (if, as a result of such monthly appraisals, the loan is judged to be not fully
collectible, the carrying value of the loan is reduced to that portion considered
collectible); and (e) an evaluation of the underlying collateral for secured lending,
including the use of independent appraisals of real estate properties securing loans. A
formal analysis of the adequacy of the allowance is conducted quarterly and is reviewed by
the Board of Directors.  Based on this analysis, management considers the allowance
for credit losses to be adequate.

28

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Periodic provisions for loan losses
are made to maintain the allowance for credit losses at an appropriate level. The
provisions are based on an analysis of various factors including historical loss
experience based on volumes and types of loans, volumes and trends in delinquencies and
non-accrual loans, trends in portfolio volume, results of internal and independent
external credit reviews, and anticipated economic conditions.

Transactions in the allowance for
credit losses for the five years ended December 31, 2005 are as follows:

|(dollars in thousands)        | 2005 | 2004 | 2003 | 2002  | 2001
|----------------------------- | ---- | ---- | ---- | ----- | ----
|Balance at beginning of year  |      |      | $    | 4,236 |     
|Charge-offs:                  |      |     
|Commercial                    |      |      |      | 41    |     
|Real estate loans             |      |      |      |      |     
|Credit card                   |      |      |      | 7     |     
|Installment                   |      |      |      | 17    |     
|Total charge-offs             |      |      | $    | 65    |     
|Recoveries:                   |      |     
|Commercial                    |      |      | $    | 3     |     
|Real estate loans             |      |      |      | 19    |     
|Credit card                   |      |      |      | 1     |     
|Installment                   |      |      |      | 2     |     
|Total recoveries              |      |      | $    | 25    |     
|Net charge-offs               |      |      |      | 40    |     
|Provision for credit losses   |      |      |      | 1,100 |     
|BNW Bancorp, Inc. acquisition |      |      |      |      |     
|Balance at end of year        |      |      | $    | 5,296 |     
|Ratio of net charge-offs      |      |     
|to average loans outstanding  |      |      |      | .01   | %   

The allowance for credit losses was
$5,296,000 at year-end 2005, compared with $4,236,000 at year-end 2004, an increase of
$1,060,000 or 25.0%. The increased level of allowance for credit losses was primarily due
to the growth of the loan portfolio. Changes in the composition of the loan portfolio
included a 12.1% increase in commercial loans, while real estate construction and real
estate mortgage loans increased 21.2%. Estimated loss factors used in the allowance for
credit loss analysis are established based in part on historic charge-off data by loan
category and economic conditions. Based on the trends in historical charge-offs analysis,
the loss factors used in the allowance for credit loss analysis for commercial loans and
real estate loans were increased during the year ended December 31, 2005.

29

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Based on the methodology used for
credit loss analysis, management deemed the allowance for credit losses of $5,296,000 at
December 31, 2005 (1.29% of total loans outstanding and 79.64% of non-performing loans)
adequate to provide for probable losses based on an evaluation of known and inherent risks
in the loan portfolio at that date.

In May 1993, the Financial Accounting
Standards Board (FASB) issued SFAS No. 114, Accounting by Creditors for Impairment
of a Loan and in October 1996, issued SFAS No. 118, Accounting by Creditors
for Impairment of a LoanIncome Recognition Disclosures, an amendment to SFAS No.
114".  The Company measures impaired loans based on the present value of
expected future cash flows discounted at the loans effective interest rate or, as a
practical expedient, at the loans observable market price or the fair market value
of the collateral if the loan is collateral dependent.  The Company excludes loans
that are currently measured at fair value or at the lower of cost or fair value, and
certain large groups of smaller balance homogeneous loans that are collectively measured
for impairment.

The following table summarizes the
Banks impaired loans at December 31:

|(dollars in thousands)                        | 2005 | 2004 | 2003 | 2002  | 2001
|--------------------------------------------- | ---- | ---- | ---- | ----- | ----
|Total Impaired Loans                          |      |      | $    | 6,650 |     
|Total Impaired Loans with Valuation Allowance |      |      |      | 4,917 |     
|Valuation Allowance related to Impaired Loans |      |      |      | 924   |     

No allocation of the allowance for credit
losses was considered necessary for the remaining impaired loans. The balance of the
allowance for credit losses in excess of these specific reserves is available to absorb
losses from all loans.

It is the Companys policy to
charge-off any loan or portion of a loan that is deemed uncollectible in the ordinary
course of business.  The entire allowance for credit losses is available to absorb
such charge-offs.  The Company allocates its allowance for credit losses
primarily on the basis of historical data.  Based on certain characteristics of the
portfolio, losses can be anticipated for major loan categories.

The following table presents the
allocation of the allowance for credit losses among the major loan categories based
primarily on their historical net charge-off experience and other business considerations
at December 31 in each of the last five years.

|(Dollars in thousands)                        | 2005Reserve | % of TotalLoans | 2004Reserve | % of TotalLoans | 2003Reserve | % of TotalLoans | 2002Reserve | % of TotalLoans | 2001Reserve | % of TotalLoans
|--------------------------------------------- | ----------- | --------------- | ----------- | --------------- | ----------- | --------------- | ----------- | --------------- | ----------- | ---------------
|Commercial loans                              |             |                 | $           | 1,589           |             |                 | 30          | %               | $           | 1,680          
|Real estate loans                             |             |                 |             | 3,548           |             |                 | 67          | %               |             | 2,432          
|Consumer loans                                |             |                 |             | 159             |             |                 | 3           | %               |             | 124            
|Total allowance                               |             |                 | $           | 5,296           |             |                 | 100         | %               | $           | 4,236          
|                                              |             |                
|Ratio of allowance for credit losses to loans |             |                
|outstanding at end of year                    |             |                 |             | 1.29            | %           |                 |             |                 |             | 1.23           

The table indicates a decrease of
$91,000 in the allowance related to commercial loans from December 31, 2004 to December
31, 2005, an increase of $1,116,000 relating to real estate loans, and an increase of
$35,000 related to consumer loans. The primary reason for the increases and changes in
percentage allocations are due to changes in portfolio mix. There was an increase of
$916,000 from December 31, 2003 to December 31, 2004 in the allowance related to
commercial loans, with an additional increase of $1,033,000 and $49,000 in consumer loans
for the same period. There was a decrease of $203,000 from December 31, 2002 to December
31, 2003 in the allowance related to commercial loans, with additional decreases of $7,000
in real estate loans and $25,000 in consumer loans during the same period.

30

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DEPOSITS

The Companys primary source of
funds has historically been customer deposits. A variety of deposit products are offered
to attract customer deposits. The products include non-interest bearing demand accounts,
negotiable order of withdrawal (NOW) accounts, savings accounts, and time deposits.
Interest-bearing accounts earn interest at rates established by management, based on
competitive market factors and the need to increase or decrease certain types of
maturities of deposits. The Company has succeeded in growing its deposit base over the
last three years despite increasing competition for deposits in our markets. The Company
believes that it has benefited from its local identity and superior customer service.
Attracting deposits remains integral to the Companys business as it is the primary
source of funds for loans and a major decline in deposits or failure to attract deposits
in the future could have an adverse effect on operations. The Company relies primarily on
its branch staff and current customer relationships to attract and retain deposits. The
Companys strategic plan includes continuing to grow non-interest bearing accounts
which contribute to higher levels of non-interest income and net interest margin.

The following table sets forth the
average balances for each major category of deposits and the weighted average interest
rate paid for deposits for the periods indicated.

|(dollars in thousands)               | 2005 | RATE | 2004 | RATE    | 2003 | RATE
|------------------------------------ | ---- | ---- | ---- | ------- | ---- | ----
|Non-interest bearing demand deposits |      |      | $    | 79,866  |      |     
|Interest bearing demand deposits     |      |      |      | 56,615  |      |     
|Savings deposits                     |      |      |      | 138,425 |      |     
|Time deposits                        |      |      |      | 112,345 |      |     
|Total                                |      |      | $    | 387,251 |      |     

Maturities of time certificates of
deposit as of December 31, 2005 are summarized as follows:

|(dollars in thousands)   | Under$100,000 | Over$100,000 | Total
|------------------------ | ------------- | ------------ | -----
|3 months or less         |               |              | $    
|Over 3 through 6 months  |               |              |      
|Over 6 through 12 months |               |              |      
|Over 12 months           |               |              |      
|Total                    |               |              |      

Total deposits increased 15.9% to
$387.2 million at December 31, 2005 compared to $334.1 million at December 31, 2004,
primarily as a result of growth in money market accounts and non-interest bearing demand
deposits. Money market accounts increased 25.6% or $17.2 million and non-interest bearing
demand deposits increased 20.3% or $14.6 million during 2005. Management attributes the growth in transaction accounts to its experienced branch staff
and a focused commitment on improving customer service throughout its branch delivery
system

Deposit growth in 2004 was largely
attributable to the BNW acquisition. At acquisition, BNW demand deposits totaled $16.3
million, interest bearing demand deposits totaled $8.1 million, savings deposits totaled
$25.6 million and time deposits totaled $37.8 million for a total of $87.8 million. Since
the acquisition, demand deposits in the Whatcom market area have increased $5.6 million,
interest bearing demand deposits have increased $751,000, savings deposits have decreased
$3 million and time deposits have decreased $15.5 million. The decrease in time deposits
in 2004 is primarily due to the non-renewal of brokered time deposits acquired from BNW. Brokered deposits remaining at December 31, 2005 totaled
$5,762.000.

31

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SHORT-TERM BORROWINGS

The following is information
regarding the Companys short-term borrowings for the years ended December 31, 2005,
2004 and 2003.

|(dollars in thousands)                                    | 2005 | 2004 | 2003
|--------------------------------------------------------- | ---- | ---- | ----
|Amount outstanding at end of period                       |      |      | $   
|Weighted average interest rate thereon                    |      |      |     
|Maximum amount outstanding at any month end during period |      |      | $   
|Average amounts outstanding during the period             |      |      |     
|Weighted average interest rate during period              |      |      |     

CONTRACTUAL OBLIGATIONS

The following is information
regarding the Companys long-term obligations, which consist of borrowings from the
Federal Home Loan Bank of Seattle, Junior Subordinated Debentures and premises under
operating leases for the year ended December 31, 2005.

|                                  | Payments due by Period
|--------------------------------- | ----------------------
|
|Federal Home Loan Bank borrowings |                       
|Operating leases                  |                       
|Junior subordinated debentures    |                       
|Total long-term obligations       |                       

COMMITMENTS AND
CONTINGENCIES

The Bank is party to financial
instruments with off-balance-sheet risk in the normal course of business to meet the
financing needs of their customers. These financial instruments include commitments to
extend credit and standby letters of credit, and involve, to varying degrees, elements of
credit risk in excess of the amount recognized on the consolidated balance sheets.

The Banks exposure to credit
loss in the event of nonperformance by the other party to the financial instrument for
commitments to extend credit and standby letters of credit is represented by the
contractual amount of those instruments. The Bank uses the same credit policies in making
commitments and conditional obligations as they do for on-balance-sheet instruments. A
summary of the Banks commitments at December 31 is as follows:

|                             | 2005 | 2004
|---------------------------- | ---- | ----
|Commitments to extend credit |      |     
|Standby letters of credit    |      |     

32

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KEY FINANCIAL RATIOS

|Year ended December 31,                | 2005 | 2004 | 2003 | 2002  | 2001
|-------------------------------------- | ---- | ---- | ---- | ----- | ----
|Return on average assets               |      |      |      | 1.31  | %   
|Return on average equity               |      |      |      | 12.70 | %   
|Average equity to average assets ratio |      |      |      | 10.30 | %   
|Dividend payout ratio                  |      |      |      | 78    | %   

LIQUIDITY AND CAPITAL
RESOURCES

Liquidity.    
          The primary concern of depositors, creditors and regulators is the
          Companys ability to have sufficient funds readily available to repay
          liabilities as they mature. In order to ensure adequate funds are available at
          all times, the Company monitors and projects the amount of funds required on a
          daily basis. Through the Bank, the Company obtains funds from its customer base,
          which provides a stable source of core demand and consumer deposits.

Other sources are available with
borrowings from the Federal Home Loan Bank of Seattle and correspondent banks. Liquidity
requirements can also be met through disposition of short-term assets. In
managements opinion, the Company maintains an adequate level of liquid assets,
consisting of cash and due from banks, interest bearing deposits with banks, and federal
funds sold to support the daily cash flow requirements.

Management expects to continue to
rely on customer deposits as the primary source of liquidity, but may also obtain
liquidity from maturity of its investment securities, sale of securities currently
available for sale, loan sales, loan repayments, net income, and other borrowings. Although deposit balances have shown
historical growth, deposit habits of customers may be influenced by changes in the
financial services industry, interest rates available on other investments, general
economic conditions, consumer confidence, and competition. Borrowings may be used on a
short-term basis to compensate for reductions in deposits, but are generally not
considered a long term solution to liquidity issues. Therefore, reductions in deposits
could adversely affect the Companys results of operations.

The holding company specifically relies on
dividends from the Bank, proceeds from the exercise of stock option, and proceeds from the issuance of trust
preferred securities for its funds, which are used for various corporate purposes.  On July 2, 2003, the
Federal Reserve issued Supervisory Letter SR 03-13 clarifying that Bank Holding Companies should continue to report trust
preferred securities in accordance with current Federal Reserve Bank instructions which allows trust preferred securities in
to be counted in Tier 1 capital subject to certain limitations.  The Federal Reserve has indicated that it will review the implications of any accounting
treatment changes and, if necessary or warranted, will provide appropriate guidance.  For additional information regarding
trust preferred securities, this discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included
elsewhere in this report including Footnote 8 - "Junior Subordinated Debentures".

Capital.    
          The Company endeavors to maintain equity capital at an adequate level to support
          and promote investor confidence. The Company conducts its business through the
          Bank. Thus, the Company needs to be able to provide capital and financing to the
          Bank should the need arise. The primary sources for obtaining capital are
          additional stock sales and retained earnings. Total shareholders equity
          averaged $47,620,000 in 2005, which includes $11,282,000 of goodwill associated
          with the BNW acquisition. Shareholders equity averaged $40,154,000 in
          2004, compared to $26,786,000 in 2003.

33

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The Companys Board of Directors
considers financial results, growth plans, and anticipated capital needs in formulating
its dividend policy. The payment of dividends is subject to adequate financial results of
the Bank, and limitations imposed by law and governmental regulations.

The Federal Reserve has established
guidelines that mandate risk-based capital requirements for bank holding companies. Under
the guidelines, one of four risk weights is applied to balance sheet assets, each with
different capital requirements based on the credit risk of the asset. The Companys
capital ratios include the assets of the Bank on a consolidated basis in accordance with
the requirements of the Federal Reserve. The Companys capital ratios have exceeded
the minimum required to be classified well capitalized for each of the past
three year-end reporting dates.

The following
table sets forth the minimum required capital ratios and actual ratios for December 31,
2005 and 2004.

|                                         |  |  | CapitalRatioAdequacyPurposes
|---------------------------------------- |  |  | ----------------------------
|
|December 31, 2005                        |  |  |                             
|Tier 1 capital (to average assets)       |  | 
|Consolidated                             |  |  | $                           
|Bank                                     |  |  |                             
|Tier 1 capital (to risk-weighted assets) |  | 
|Consolidated                             |  |  |                             
|Bank                                     |  |  |                             
|Total capital (to risk-weighted assets)  |  | 
|Consolidated                             |  |  |                             
|Bank                                     |  |  |                             
|December 31, 2004                        |  | 
|Tier 1 capital (to average assets)       |  | 
|Consolidated                             |  |  | $                           
|Bank                                     |  |  |                             
|Tier 1 capital (to risk-weighted assets) |  | 
|Consolidated                             |  |  |                             
|Bank                                     |  |  |                             
|Total capital (to risk-weighted assets)  |  | 
|Consolidated                             |  |  |                             
|Bank                                     |  |  |                             

New Accounting Pronouncements.
For a discussion of new accounting pronouncements and their impact on the Company, see
Note 1 of the Notes to the Consolidated Financial Statements included in Item 8 of this
Form 10-K.

# ITEM 7A. Quantitative
and Qualitative Disclosures About Market Risk

The Companys results of
operations are largely dependent upon its ability to manage interest rate risk. Management
considers interest rate risk to be a significant market risk that could have a material
effect on the Companys financial condition and results of operations. The Company
does not currently use derivatives to manage market and interest rate risks. All of the
Companys transactions are denominated in U.S. dollars. Approximately 73% of the
Companys loans have interest rates that float with the Companys reference
rate. Fixed rate loans generally are made with a term of five years or less.

34

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In the Asset and Liability section of
the Managements Discussion and Analysis in Item 7 is a table presenting estimated
maturity or pricing information indicating the Companys exposure to interest rate
changes. The assumptions and description of the process used to manage interest rate risk
is further discussed in the Asset and Liability Management section. The following table
discloses the balances of financial instruments held by the Company, including the fair
value as of December 31, 2005.

The expected maturities are disclosed
based on contractual schedules. Principal repayments are not considered. The expected
maturities for financial liabilities with no stated maturity reflect estimated future
roll-off rates. The roll-off rates for non-interest bearing deposits, interest bearing
demand deposits, money market accounts, and savings deposits are 15%, 25%, 25% and 20%,
respectively. The interest rates disclosed are based on rates in effect at December 31,
2005. Fair values are estimated in accordance with generally accepted accounting
principles as disclosed in the financial statements.

35

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|Year ended December 31, 2005       | Expected Maturity |  |   |         |   |  
|---------------------------------- | ----------------- |  | - | ------- | - | -
|
|Financial Assets                   |                   |  |   |         |   |  
|Cash and cash equivalents          |                   | 
|Non-interest bearing               |                   |  | $ | 11,223  |   | $
|Interest bearing deposits in banks |                   |  |   | 283     |   |  
|Weighted average interest rate     |                   |  |   | 3.00    | % |  
|Securities available for sale      |                   | 
|Fixed rate                         |                   |  |   | 2,660   |   |  
|Weighted average interest rate     |                   |  |   | 3.91    | % |  
|Variable rate                      |                   |  |   | 2,925   |   |  
|Weighted average interest rate     |                   |  |   | 3.32    | % |  
|Securities held to maturity        |                   | 
|Fixed rate                         |                   |  |   |        |   |  
|Weighted average interest rate     |                   |  |   |        |   |  
|Loans receivable                   |                   | 
|Fixed rate                         |                   |  |   | 20,489  |   |  
|Weighted average interest rate     |                   |  |   | 6.73    | % |  
|Adjustable rate                    |                   |  |   | 225,645 |   |  
|Weighted average interest rate     |                   |  |   | 7.65    | % |  
|Federal Home Loan Bank stock       |                   |  |   |        |   |  
|Weighted average interest rate     |                   |  |   |        |   |  

|Year ended December 31, 2005       | Expected Maturity |  |   |        |  
|---------------------------------- | ----------------- |  | - | ------ | -
|
|Financial Liabilities              |                   |  |   |        |  
|Non-interest bearing deposits      |                   |  | $ | 12,940 |  
|Interest bearing checking accounts |                   |  |   | 12,285 |  
|Weighted average interest rate     |                   |  |   | .65    | %
|Money Market accounts              |                   |  |   | 21,155 |  
|Weighted average interest rate     |                   |  |   | 2.76   | %
|Savings accounts                   |                   |  |   | 12,101 |  
|Weighted average interest rate     |                   |  |   | 1.95   | %
|Certificates of deposit            |                   | 
|Fixed rate                         |                   |  |   | 61,472 |  
|Weighted average interest rate     |                   |  |   | 3.23   | %
|Variable rate                      |                   |  |   | 2,283  |  
|Weighted average interest rate     |                   |  |   | 2.36   | %
|Short Term Borrowings              |                   |  |   | 3,985  |  
|Weighted average interest rate     |                   |  |   | 5.13   | %
|Long Term Borrowings               |                   | 
|Fixed rate                         |                   |  |   | 5,000  |  
|Weighted average interest rate     |                   |  |   | 2.70   | %
|Secured borrowings                 |                   |  |   |       |  
|Weighted average interest rate     |                   |  |   |       |  
|Junior subordinated debentures     |                   |  |   |       |  
|Weighted average interest rate     |                   |  |   |       |  

As illustrated in the table above,
our balance sheet is currently sensitive to decreasing interest rates, meaning that more
interest bearing assets mature or re-price than interest earning liabilities. Therefore,
if our asset and liability mix were to remain unchanged, and there was a decrease in
market rates of interest, the Company would expect that its net income would be adversely
affected. In contrast, an increasing interest rate environment would positively affect
income. While the table presented above provides information about the Companys
interest sensitivity, it does not predict the trends of future earnings. For this reason,
financial modeling is used to forecast earnings under varying interest rate projections.
While this process assists in managing interest rate risk, it does require significant
assumptions for the projection of loan prepayments, loan origination volumes and liability
funding sources that may prove to be inaccurate.

36

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# ITEM 8. Financial
Statements and Supplementary Data

Information required for this item is
included in Item 15 of this report.

ITEM 9. Changes in and
disagreements with accountants on accounting and financial disclosure

Not applicable.

# ITEM 9A. Controls and
Procedures

Disclosure Controls and
Procedures.Pacifics disclosure controls and procedures are designed to ensure
that information the Company must disclose in its reports filed or submitted under the
Exchange Act is recorded, processed, summarized, and reported on a timely basis. Our
management has evaluated, with the participation and under the supervision of our chief
executive officer (CEO) and chief financial officer (CFO), the effectiveness of our
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the
Exchange Act) as of the end of the period covered by this report. Based on this
evaluation, our CEO and CFO have concluded that, as of such date, the Companys
disclosure controls and procedures are effective in ensuring that information relating to
the Company, including its consolidated subsidiaries, required to be disclosed in reports
that it files under the Exchange Act is (1) recorded, processed, summarized and reported
within the time periods specified in the SECs rules and forms, and (2) accumulated
and communicated to our management, including our CEO and CFO, as appropriate to allow
timely decisions regarding required disclosures.

Changes in Internal Control Over
Financial Reporting. There have not been any changes in the Companys internal
control over financial reporting, as such term is defined in Rules 13a-15(f) and
15d-15(f) under the Exchange Act, during the Companys fiscal quarter ended December
31, 2005 that have materially affected, or are reasonable likely to materially affect,
the Companys internal control over financial reporting.

Managements Report on
Internal Control Over Financial Reporting.The Companys management is
responsible for establishing and maintaining adequate internal control over financial
reporting. The Companys internal control system is designed to provide reasonable
assurance to our management and the board of directors regarding the preparation and fair
presentation of published financial statements. Nonetheless, all internal control systems,
no matter how well designed, have inherent limitations. Even systems determined to be
effective as of a particular date can provide only reasonable assurance with respect to
financial statement preparation and presentation and may not eliminate the need for
restatements.

The Companys management
assessed the effectiveness of the Companys internal control over financial reporting
as of December 31, 2005. In making this assessment, management used the criteria set forth
by the Committee of Sponsoring Organizations of the Treadway Commission in Internal
Control  Integrated Framework. Based on our assessment, we believe that, as
of December 31, 2005, the Companys internal control over financial reporting is
effective based on those criteria.

The Companys independent
registered public accounting firm has audited managements assessment of the
effectiveness of the Companys internal control over financial reporting as of
December 31, 2005, as stated in their report with the Company's Consolidated Financial Statements in Item 15 below.

37

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# ITEM 9B. Other
Information

None.

# Part III

# ITEM 10.  Directors and
Executive Officers of the Registrant

Information concerning directors and
executive officers requested by this item is contained in the Companys 2006 Proxy
Statement for its annual meeting of shareholders to be held on April 19, 2006 (2006
Proxy Statement), in the sections entitled MANAGEMENT-Certain Executive
Officers, Proposal No. 1  Election of Directors, and
Compliance with Section 16(a) of the Exchange Act and is incorporated into
this report by reference.

The Board of Directors adopted a Code
of Ethics for the Companys executive officers that requires the Companys
officers to maintain the highest standards of professional conduct. A copy of the
Executive Officer Code of Ethics is available on the Companys Web site
www.thebankofpacific.com under the link for Stockholder Info and CEOs Newsletter.

The Company has a separately
designated Audit Committee established in accordance with Section 3(a)(58)(A) of the
Exchange Act. The committee is composed of Directors Duane E. Hagstrom, Gary C. Forcum,
and G. Dennis Archer, each of whom is independent as that term is used in Item 7(d)(3)(iv)
of Schedule 14A under the Exchange Act. In determining independence of board members, the
Companys Board of Directors has applied the definition of independence found in the
Nasdaq listing standards.

The Companys Board of Directors
has determined that Duane E. Hagstrom, Gary C. Forcum and G. Dennis Archer are audit
committee financial experts as defined in Item 401(h) of the SECs Regulation S-K.
Directors Hagstrom, Forcum and Archer are independent as that term is used in Item
7(d)(3)(iv) of Schedule 14A.

# ITEM 11. Executive
Compensation

Information concerning executive
compensation requested by this item is contained in the registrants 2006 Proxy
Statement in the sections entitled DIRECTOR COMPENSATION and EXECUTIVE
COMPENSATION (not including Audit Committee Report, Report of the
Compensation Committee and Stock Performance Graph), and is incorporated
into this report by reference.

38

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# ITEM 12.  Security
Ownership of Certain Beneficial Owners and Management and Related
                   Stockholder Matters

Information concerning security
ownership of certain beneficial owners and management requested by this item is contained
in the registrants 2006 Proxy Statement in the section entitled MANAGEMENT
 Security Ownership of Certain Beneficial Owners and Management, and is
incorporated into this report by reference.

Equity Compensation Plan
Information. The following table summarizes share and exercise price information about
the Companys equity compensation plans as of December 31, 2005.

|Plan Category                          | (a)
Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights | (b)
Weighted-average
exercise price
of outstanding
options, warrants
and rights | (c)
Number remaining
available for future
issuance under equity
compensation plans
(excluding securities
reflected in column (a)
|-------------------------------------- | ----------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------
|Equity compensation plans approved     |                                                                                                 |                                                                                 |                                                                                                                                 
|by security holders:                   |                                                                                                 |                                                                                 |                                                                                                                                 
|Equity compensation plans not approved |                                                                                                 |                                                                                
|by security holders:                   |                                                                                                 |                                                                                 |                                                                                                                                 
|Total                                  |                                                                                                 |                                                                                 |                                                                                                                                 

(1)    
          Excludes 40,594 shares under outstanding options, with an aggregate exercise
          price of $6.16, granted by the Company pursuant to a merger agreement in
          substitution of BNW Bancorp, Inc. options.

# ITEM 13. Certain
Relationships and Related Transactions

Information concerning certain
relationships and related transactions requested by this item is contained in the
registrants 2006 Proxy Statement in the section entitled Compensation
Committee Interlocks and Insider Participation and is incorporated into this report
by reference.

# ITEM 14. Principal
Accountant Fees and Services

Information concerning fees paid to
our independent public accountants required by this item is included under the heading
AUDITORS  Fees Paid to Auditors in the registrants 2006 Proxy
Statement and is incorporated into this report by reference.

39

---



# Part IV

# ITEM 15. Exhibits and
Financial Statement Schedules

| | (a) (1) |  | The following financial statements are filed below:Report of Independent Registered Public Accounting FirmReport of Independent Registered Public Accounting Firm (Internal Control)Consolidated Financial StatementsConsolidated Balance SheetsConsolidated Statements of Income Consolidated Statements of Shareholders' Equity Consolidated Statements of Cash FlowsNotes to Consolidated Financial Statements
| | ------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (a) (2) |  | Schedules: None
| | ------- |  | ---------------

| | (a) (3) |  | Exhibits: See Exhibit Index immediately following the signature page.
| | ------- |  | ---------------------------------------------------------------------

40

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McGladrey & PullenCertified Public Accountants

# Report of Independent
Registered Public Accounting Firm

To the Board of Directors Pacific Financial
CorporationAberdeen, Washington

We have audited the consolidated
balance sheets of Pacific Financial Corporation and Subsidiary as of December 31,
2005, 2004 and 2003, and the related consolidated statements of income, shareholders
equity, and cash flows for each of the three years in the period ended December 31, 2005.
These consolidated financial statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these consolidated financial
statements based on our audits.

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

In our opinion, the consolidated
financial statements referred to above present fairly, in all material respects, the
financial position of Pacific Financial Corporation and Subsidiary as of December
31, 2005, 2004 and 2003, and the results of their operations and their cash flows for each
of the three years in the period ended December 31, 2005, in conformity with U.S.
generally accepted accounting principles.

We also have audited, in accordance
with the standards of the Public Company Accounting Oversight Board (United States), the
effectiveness of Pacific Financial Corporation and Subsidiary internal control over
financial reporting as of December 31, 2005, based on criteria established in Internal
ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission (COSO) and our report dated March 13, 2006 expressed an
unqualified opinion on managements assessment of the effectiveness of Pacific
Financial Corporations internal control over financial reporting and an
unqualified opinion on the effectiveness of Pacific Financial Corporations
internal control over financial reporting.

/s/ McGladrey & Pullen

Tacoma, WashingtonMarch
13, 2006

McGladrey & Pullen, LLP is a
member firm of RSM International  an affiliation of separate and independent legal
entities.

41

---



McGladrey & PullenCertified Public Accountants

# REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of DirectorsPacific Financial
CorporationAberdeen, Washington

We have audited managements
assessment, included in the accompanying Internal Control Assessment, that Pacific
Financial Corporation and Subsidiary maintained effective internal control over
financial reporting as of December 31, 2005, based on criteria established in Internal
ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission (COSO). Pacific Financial Corporation and Subsidiarys
management is responsible for maintaining effective internal control over financial
reporting and for its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express an opinion on managements assessment and
an opinion on the effectiveness of the Companys internal control over financial
reporting based on our audit.

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

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

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

In our opinion, managements
assessment that Pacific Financial Corporation and Subsidiary maintained effective
internal control over financial reporting as of December 31, 2005, is fairly stated, in
all material respects, based on criteria established in Internal ControlIntegrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO). Also in our opinion, Pacific Financial Corporation and Subsidiary
maintained, in all material respects, effective internal control over financial reporting
as of December 31, 2005, based on criteria established in Internal ControlIntegrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO).

We have also audited, in accordance
with the standards of the Public Company Accounting Oversight Board (United States), the
consolidated financial statements of Pacific Financial Corporation and Subsidiary
and our report dated March 13, 2006 expressed an unqualified opinion.

/s/ McGladrey & Pullen

Tacoma, WashingtonMarch
13, 2006

McGladrey & Pullen, LLP is a
member firm of RSM International  an affiliation of separate and independent legal
entities.

42

---



# Consolidated Balance
Sheets

(Dollars in Thousands)

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

|                                                                            | 2005 | 2004
|--------------------------------------------------------------------------- | ---- | ----
|Assets                                                                      |      |     
|Cash and due from banks                                                     |      |     
|Interest bearing deposits in banks                                          |      |     
|Federal funds sold                                                          |      |     
|Securities available for sale                                               |      |     
|Securities held to maturity (market value 2005 - $6,502; and 2004 - $7,312) |      |     
|Federal Home Loan Bank stock, at cost                                       |      |     
|Loans held for sale                                                         |      |     
|Loans                                                                       |      |     
|Allowance for credit losses                                                 |      |     
|Loans - net                                                                 |      |     
|Premises and equipment                                                      |      |     
|Foreclosed real estate                                                      |      |     
|Accrued interest receivable                                                 |      |     
|Cash surrender value of life insurance                                      |      |     
|Goodwill                                                                    |      |     
|Other intangible assets                                                     |      |     
|Other assets                                                                |      |     
|Total assets                                                                |      |     
|Liabilities and Shareholders' Equity                                        |      |     
|Liabilities                                                                 |      |     
|Deposits:                                                                   |      |     
|Demand, non-interest bearing                                                |      |     
|Savings and interest-bearing demand                                         |      |     
|Time, interest-bearing                                                      |      |     
|Total deposits                                                              |      |     
|Accrued interest payable                                                    |      |     
|Secured borrowings                                                          |      |     
|Short-term borrowings                                                       |      |     
|Long-term borrowings                                                        |      |     
|Junior subordinated debentures                                              |      |     
|Other liabilities                                                           |      |     
|Total liabilities                                                           |      |     
|Commitments and Contingencies                                               |      |     
|Shareholders' Equity                                                        |      |     
|Common stock (par value $1); authorized:  25,000,000 shares;                |      |     
|issued and outstanding:  2005 - 6,464,536 shares; 2004 - 6,421,396 shares   |      |     
|Additional paid-in capital                                                  |      |     
|Retained earnings                                                           |      |     
|Accumulated other comprehensive income (loss)                               |      |     
|Total shareholders' equity                                                  |      |     
|Total liabilities and shareholders' equity                                  |      |     

|See notes to consolidated financial
statements. | 43 | 
|----------------------------------------------- | -- | 

---



# Consolidated Statements
of Income

(Dollars in Thousands,
Except Per Share Amounts)

Pacific Financial
Corporation and Subsidiary Years Ended December 31, 2005, 2004 and 2003

|                                                        | 2005 | 2004 | 2003
|------------------------------------------------------- | ---- | ---- | ----
|Interest and Dividend Income                            |      |      |     
|Loans                                                   |      |      | $   
|Federal funds sold and deposits in banks                |      |      |     
|Securities available for sale:                          |      |     
|Taxable                                                 |      |      |     
|Tax-exempt                                              |      |      |     
|Securities held to maturity:                            |      |     
|Taxable                                                 |      |      |     
|Tax-exempt                                              |      |      |     
|Federal Home Loan Bank stock dividends                  |      |      |     
|Total interest and dividend income                      |      |      |     
|Interest Expense                                        |      |     
|Deposits                                                |      |      |     
|Short-term borrowings                                   |      |      |     
|Long-term borrowings                                    |      |      |     
|Secured borrowings                                      |      |      |     
|Total interest expense                                  |      |      |     
|Net interest income                                     |      |      |     
|Provision for Credit Losses                             |      |      |     
|Net interest income after provision for credit losses   |      |      |     
|Non-Interest Income                                     |      |     
|Service charges on deposit accounts                     |      |      |     
|Mortgage broker fees                                    |      |      |     
|Income from and gains on sale of foreclosed real estate |      |      |     
|Net gains from sales of loans                           |      |      |     
|Net gains on sales of securities available for sale     |      |      |     
|Earnings on bank owned life insurance                   |      |      |     
|Other operating income                                  |      |      |     
|Total non-interest income                               |      |      |     
|Non-Interest Expense                                    |      |     
|Salaries and employee benefits                          |      |      |     
|Occupancy                                               |      |      |     
|Equipment                                               |      |      |     
|State taxes                                             |      |      |     
|Data processing                                         |      |      |     
|Professional services                                   |      |      |     
|Other                                                   |      |      |     
|Total non-interest expense                              |      |      |     
|Income before income taxes                              |      |      |     
|Income Taxes                                            |      |      |     
|Net income                                              |      |      | $   
|Earnings Per Share                                      |      |     
|Basic                                                   |      |      | $   
|Diluted                                                 |      |      |     

|See notes to consolidated financial
statements. | 44 | 
|----------------------------------------------- | -- | 

---

# Consolidated Statements
of Shareholders Equity

(Dollars in Thousands)

Pacific Financial
Corporation and SubsidiaryYears Ended December 31, 2005, 2004 and 2003

|                              | Shares of Common Stock | Common Stock | Additional Paid-in Capital | Retained Earnings | Accumulated Other Comprehensive Income (Loss) | Total
|----------------------------- | ---------------------- | ------------ | -------------------------- | ----------------- | --------------------------------------------- | -----
|Balance at December 31, 2002  |                        |              |                            |                   |                                               |      
|Comprehensive income:         |                        |              |                            | 5,025,318         |                                               | $    
|Net income                    |                        |              |                            |                  |                                               |      
|Other comprehensive income,   |                        |             
|net of tax:                   |                        |             
|Change in fair value of       |                        |             
|securities available for sale |                        |              |                            |                  |                                               |      
|Comprehensive income          |                        |              |                            |                   |                                               |      
|                              |                        |              |                            |                   |                                               |      
|Stock options exercised       |                        |              |                            | 17,700            |                                               |      
|Issuance of common stock      |                        |              |                            | 60                |                                               |      
|Cash dividends declared       |                        |             
|($0.68 per share)             |                        |              |                            |                  |                                               |      
|Balance at December 31, 2003  |                        |              |                            | 5,043,078         |                                               |      
|                              |                       
|Comprehensive income:        
|Net income                    |                        |              |                            |                  |                                               |      
|Other comprehensive income,   |                        |             
|net of tax:                   |                        |             
|Change in fair value of       |                        |             
|securities available for sale |                        |              |                            |                  |                                               |      
|Comprehensive income          |                        |              |                            |                   |                                               |      
|Stock options exercised       |                        |              |                            | 106,414           |                                               |      
|Issuance of common stock      |                        |              |                            | 1,271,904         |                                               |      
|Stock compensation expense    |                        |              |                            |                  |                                               |      
|Cash dividends declared       |                        |             
|($0.72 per share)             |                        |              |                            |                  |                                               |      
|Tax benefit from exercise of  |                        |             
|stock options                 |                        |              |                            |                  |                                               |      
|Balance at December 31, 2004  |                        |              |                            | 6,421,396         |                                               |      
|Comprehensive income:         |                        |             
|Net income                    |                        |              |                            |                  |                                               |      
|Other comprehensive income,   |                        |             
|net of tax:                   |                        |             
|Change in fair value of       |                        |             
|securities available for sale |                        |              |                            |                  |                                               |      
|Comprehensive income          |                        |              |                            |                   |                                               |      
|Stock options exercised       |                        |              |                            | 42,620            |                                               |      
|Issuance of common stock      |                        |              |                            | 520               |                                               |      
|Stock compensation expense    |                        |              |                            |                  |                                               |      
|Cash dividends declared       |                        |             
|($0.73 per share)             |                        |              |                            |                  |                                               |      
|Tax benefit from exercise of  |                        |             
|stock options                 |                        |              |                            |                  |                                               |      
|Balance at December 31, 2005  |                        |              |                            | 6,464,536         |                                               | $    

|See notes to consolidated financial
statements. | 45 | 
|----------------------------------------------- | -- | 

---

---



# Consolidated Statements
of Cash Flows

(Dollars in Thousands)

Pacific Financial
Corporation and SubsidiaryYears Ended December 31, 2005, 2004 and 2003

|                                                                  | 2005 | 2004 | 2003
|----------------------------------------------------------------- | ---- | ---- | ----
|Cash Flows from Operating Activities                              |      |      |     
|Net income                                                        |      |      | $   
|Adjustments to reconcile net income to net cash                   |      |     
|provided by (used in) operating activities:                       |      |     
|Depreciation and amortization                                     |      |      |     
|Provision for credit losses                                       |      |      |     
|Deferred income tax (benefit)                                     |      |      |     
|Originations of loans held for sale                               |      |      |     
|Proceeds from sales of loans held for sale                        |      |      |     
|Gains on sales of loans                                           |      |      |     
|FHLB Stock dividends received                                     |      |      |     
|Gains on sale of securities available for sale                    |      |      |     
|Gains on sales of foreclosed real estate                          |      |      |     
|Loss on sale of premises and equipment                            |      |      |     
|Earnings on bank owned life insurance                             |      |      |     
|(Increase) decrease in accrued interest receivable                |      |      |     
|Increase (decrease) in accrued interest payable                   |      |      |     
|Write-down of foreclosed real estate                              |      |      |     
|Other - net                                                       |      |      |     
|Net cash provided by (used in) operating activities               |      |      |     
|Cash Flows from Investing Activities                              |      |     
|Net (increase) decrease in interest bearing deposits in banks     |      |      |     
|Net (increase) decrease in federal funds sold                     |      |      |     
|Activity in securities available for sale:                        |      |     
|Sales                                                             |      |      |     
|Maturities, prepayments and calls                                 |      |      |     
|Purchases                                                         |      |      |     
|Activity in securities held to maturity:                          |      |     
|Maturities                                                        |      |      |     
|Purchases                                                         |      |      |     
|Purchase of Investment in PFC Statutory Trust I                   |      |      |     
|Proceeds from sales of SBA loan pools                             |      |      |     
|Increase in loans made to customers, net of principal collections |      |      |     
|Purchases of premises and equipment                               |      |      |     
|Proceeds from sales of premises and equipment                     |      |      |     
|Additions to foreclosed real estate                               |      |      |     
|Proceeds from sales of foreclosed real estate                     |      |      |     
|Purchase of bank owned life insurance                             |      |      |     
|Cash paid for acquisition, net of cash acquired                   |      |      |     
|Net cash used in investing activities                             |      |      |     

(continued)

|See notes to consolidated financial
statements. | 46 | 
|----------------------------------------------- | -- | 

---



# Consolidated Statements
of Cash Flows

(concluded)    
          (Dollars in Thousands)

Pacific Financial
Corporation and SubsidiaryYears Ended December 31, 2005, 2004 and 2003

|                                                                   | 2005 | 2004 | 2003
|------------------------------------------------------------------ | ---- | ---- | ----
|Cash Flows from Financing Activities                               |      |      |     
|Net increase in deposits                                           |      |      | $   
|Net increase (decrease) in short-term borrowings                   |      |      |     
|Net increase (decrease) in secured borrowings                      |      |      |     
|Proceeds from issuance of long-term borrowings                     |      |      |     
|Repayments of long-term borrowings                                 |      |      |     
|Proceeds from junior subordinated debentures                       |      |      |     
|Common stock issued                                                |      |      |     
|Cash dividends paid                                                |      |      |     
|Net cash provided by (used in) financing activities                |      |      |     
|Net change in cash and due from banks                              |      |      |     
|Cash and Due from Banks                                            |      |     
|Beginning of year                                                  |      |      |     
|End of year                                                        |      |      | $   
|Supplemental Disclosures of Cash Flow Information                  |      |     
|Interest paid                                                      |      |      | $   
|Income taxes paid                                                  |      |      |     
|Supplemental Disclosures of Non-Cash Investing Activities          |      |     
|Fair value adjustment of securities available for sale, net of tax |      |      | $   
|Transfer of loans to foreclosed real estate                        |      |      |     
|Financed sales of foreclosed real estate                           |      |      |     
|Common stock issued upon business combination                      |      |      |     

|See notes to consolidated financial
statements. | 47 | 
|----------------------------------------------- | -- | 

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 1  Summary of
Significant Accounting Policies

# Principles of
Consolidation

The consolidated financial statements
include the accounts of Pacific Financial Corporation (the Company), and its wholly owned
subsidiary, The Bank of the Pacific (the Bank). The Company has another wholly owned
subsidiary, PFC Statutory Trust I (the Trust), which does not meet the criteria for
consolidation. All significant intercompany transactions and balances have been
eliminated.

# Nature of Operations

The Company is a holding company
which operates primarily through its subsidiary bank. The Bank operates sixteen branches
located in Grays Harbor, Pacific, Whatcom and Wahkiakum Counties in western Washington and
a loan production office in Clatsop County Oregon. The Bank provides loan and deposit
services to customers, who are predominately small- and middle-market businesses and
middle-income individuals in western Washington and Oregon. The Trust was formed in 2005
to issue $5,000,000 in trust preferred securities.

# Consolidated Financial
Statement Presentation

The consolidated financial statements
have been prepared in accordance with accounting principles generally accepted in the
United States of America and practices within the banking industry. The preparation of
consolidated financial statements requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities, and the disclosure of
contingent assets and liabilities, as of the date of the balance sheet, and the reported
amounts of revenues and expenses during the reporting period. Actual results could differ
from those estimates. Material estimates that are particularly susceptible to significant
change in the near term relate to the determination of the allowance for credit losses and
the valuation of deferred tax assets.

Certain prior year amounts have been
reclassified, with no change to net income or shareholders equity, to conform to the
2005 presentation. All dollar amounts, except per share information, are stated in
thousands.

# Securities Available for
Sale

Securities available for sale consist
of debt securities, marketable equity securities and mutual funds that the Company intends
to hold for an indefinite period, but not necessarily to maturity. Such securities may be
sold to implement the Companys asset/liability management strategies and in response
to changes in interest rates and similar factors. Securities available for sale are
reported at fair value. Unrealized gains and losses, net of the related deferred tax
effect, are reported as a net amount in a separate component of shareholders equity
entitled accumulated other comprehensive income (loss). Realized gains and
losses on securities available for sale, determined using the specific identification
method, are included in earnings. Amortization of premiums and accretion of discounts are
recognized in interest income over the period to maturity. For mortgage-backed securities,
actual maturity may differ from contractual maturity due to principal payments and
amortization of premiums and accretion of discounts may vary due to prepayment speed
assumptions.

(continued)

48

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 1  Summary of
Significant Accounting Policies (continued)

# Securities Held to
Maturity

Debt securities for which the Company
has the positive intent and ability to hold to maturity are reported at cost, adjusted for
amortization of premiums and accretion of discounts, which are recognized in interest
income over the period to maturity.

Declines in the fair value of
individual securities held to maturity and available for sale below their cost that are
other than temporary result in write-downs of the individual securities to their fair
value. Such write-downs are included in earnings as realized losses.

# Federal Home Loan Bank
Stock

The Company, as a member of the
Federal Home Loan Bank (FHLB) system, is required to maintain an investment in capital
stock of the FHLB in an amount equal to the greater of 1% of its outstanding home loans or
5% of advances from the FHLB.

The recorded amount of FHLB stock
equals its fair value because the shares can only be redeemed by the FHLB at the $100 per
share par value.

# Loans Held for Sale

Mortgage loans originated for sale in
the foreseeable future in the secondary market are carried at the lower of aggregatecost or estimated market value. Gains and losses on sales of loans are recognized at
settlement date and are determined by the difference between the sales proceeds and the
carrying value of the loans. All sales are made without recourse.Net unrealized
losses are recognized through a valuation allowance established by charges to income.

# Loans Receivable

Loans receivable that management has
the intent and ability to hold for the foreseeable future or until maturity or pay-off are
reported at their outstanding principal balances adjusted for any charge-offs, the
allowance for credit losses, and any deferred fees or costs on originated loans, and
unamortized premiums or discounts on purchased loans. Loan fees and certain direct loan
origination costs are deferred, and the net fee or cost is recognized as an adjustment to
interest income using the interest method.

Because some loans may not be repaid
in full, an allowance for credit losses is recorded. An allowance for credit losses is a
valuation allowance for probable incurred credit losses. The allowance for credit losses
is increased by a provision for credit losses charged to expense and decreased by
charge-offs (net of recoveries). The allowance is based on ongoing, quarterly assessments
of the probable and estimable losses inherent in the loan portfolio. The Companys
methodology for assessing the appropriateness of the allowance consists of several key
elements, which include the formula allowance and specific allowances.

(continued)

49

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 1  Summary of
Significant Accounting Policies (continued)

# Loans Receivable
(concluded)

The formula portion of the general
credit loss allowance is established by applying a loss percentage factor to the different
loan types. The allowances are provided based on Managements continuing evaluation
of the pertinent factors underlying the quality of the loan portfolio, including changes
in the size and composition of the loan portfolio, actual loan loss experience, current
economic conditions, geographic concentrations, seasoning of the loan portfolio, specific
industry concentrations, and the duration of the current business cycle. The recovery of
the carrying value of loans is susceptible to future market conditions beyond the
Companys control, which may result in losses or recoveries differing from those
provided. Specific allowances are established in cases where Management has identified
significant conditions or circumstances related to a loan that Management believes
indicate the probability that a loss has been incurred. Impaired loans consist of loans
receivable that are not expected to be repaid in accordance with their contractual terms
and are measured using the fair value of collateral. Smaller balance loans are excluded
from this analysis.

Interest income on loans is accrued
over the term of the loans based upon the principal outstanding. The accrual of interest
on loans is discontinued when, in Managements opinion, the borrower may be unable to
meet payments as they come due. When interest accrual is discontinued, all unpaid accrued
interest is reversed. Interest income is subsequently recognized only to the extent that
cash payments are received until, in Management judgment, the borrower has the
ability to make contractual interest and principal payments, in which case the loan is
returned to accrual status.

# Premises and Equipment

Premises and equipment are stated at
cost less accumulated depreciation, which is computed on the straight-line method over the
estimated useful lives of the assets. Asset lives range from 3 to 39 years. Leasehold
improvements are amortized over the terms of the respective leases or the estimated useful
lives of the improvements, whichever is less. Gains or losses on dispositions are
reflected in earnings.

# Foreclosed Real Estate

Real estate properties acquired
through, or in lieu of, foreclosure are to be sold and are initially recorded at the lower
of cost or fair value of the properties less estimated costs of disposal. Any write-down
to fair value at the time of transfer to other real estate owned is charged to the
allowance for credit losses. Properties are evaluated regularly to ensure that the
recorded amounts are supported by their current fair values, and that valuation allowances
to reduce the carrying amounts to fair value less estimated costs to dispose are recorded
as necessary. Any subsequent reductions in carrying values, and revenue and expense from
the operations of properties, are charged to operations.

(continued)

50

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 1  Summary of
Significant Accounting Policies (continued)

# Goodwill and other
intangible assets

Goodwill is initially recorded when
the purchase price paid for an acquisition exceeds the estimated fair value of the net
identified tangible and intangible assets acquired. Goodwill is presumed to have an
indefinite useful life and is tested, at least annually or more frequently if indicators
of potential impairment exist, for impairment. Our impairment review process compares the
fair value of the Bank to its carrying value. If the fair value exceeds the carrying
value, goodwill is not considered impaired and no additional analysis is necessary. As of
December 31, 2005, there have been no events or changes in circumstances that would
indicate a potential impairment. Other intangible assets consisting of core deposit
intangibles are amortized to non-interest expense using a straight line method over seven
years. Net unamortized core deposit intangible totaled $745,000 at December 31, 2005.
Amortization expense related to core deposit intangible during the year ended December 31,
2005 totaled $142,000. Amortization expense for the core deposit intangible is estimated
to be $142,000 for each of the five succeeding years.

# Impairment of long-lived
assets

Management periodically reviews the
carrying value of its long-lived assets to determine if an impairment has occurred or
whether changes in circumstances have occurred that would require a revision to the
remaining useful life. In making such determination, management evaluates the performance,
on an undiscounted basis, of the underlying operations or assets which give rise to such
amount.

# Transfers of Financial
Assets

Transfers of financial assets are
accounted for as sales when control over the assets has been surrendered. Control over
transferred assets is deemed to be surrendered when (1) the assets have been isolated from
the Bank, (2) the transferee obtains the right (free of conditions that constrain it from
taking advantage of that right) to pledge or exchange the transferred assets, and (3) the
Bank does not maintain effective control over the transferred assets through an agreement
to repurchase them before their maturity.

# Income Taxes

Deferred tax assets and liabilities
result from differences between the financial statement carrying amounts and the tax bases
of assets and liabilities, and are reflected at currently enacted income tax rates
applicable to the period in which the deferred tax assets or liabilities are expected to
be realized or settled. Deferred tax assets are reduced by a valuation allowance when
management determines that it is more likely than not that some portion or all of the
deferred tax assets will not be realized. As changes in tax laws or rates are enacted,
deferred tax assets and liabilities are adjusted through the provision for income taxes.

The Company files a consolidated
federal income tax return. The Bank provides for income taxes separately and remits to the
Company amounts currently due in accordance with a Tax Allocation Agreement between the
Company and the Bank.

(continued)

51

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 1  Summary of
Significant Accounting Policies (continued)

# Stock-Based Compensation

At December 31, 2005, the Company has
three stock-based employee compensation plans, which are described more fully in Note 14.
The Company accounts for those plans under the recognition and measurement principles of
APB No. 25, Accounting for Stock Issued to Employees, and related interpretations.
Accordingly, no stock-based compensation cost is reflected in net income, as all options
granted under those plans had an exercise price equal to the market value of the
underlying common stock on the date of grant. See recent accounting pronouncements section
which discusses future impacts of new accounting guidance. In July 2005, the Board of
Directors approved the accelerated vesting of out of the money options previously awarded
in light of new accounting regulations that will take effect in the Companys next
fiscal year. As a result of the vesting acceleration, options to purchase 257,600 shares
of Company common stock became exercisable immediately. All of these stock options were
considered out of the money since the options exercise price was greater than the
current market value of the stock. Stock-based compensation illustrated in the table below
increased by approximately $365,000 as a result of the vesting acceleration.

The following illustrates the effect
on net income and earnings per share if the Company had applied the fair value recognition
provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based
compensation awards for the effects of all options granted on or after January 1, 1995 for
the years ended December 31:

|                                                              | 2005 | 2004   | 2003
|------------------------------------------------------------- | ---- | ------ | ----
|Net income, as reported                                       |      | $6,046 |     
|Add stock compensation expensed                               |      | 12     |     
|Less total stock-based compensation expense determined        |     
|under fair value method for all qualifying awards, net of tax |      | 586    |     
|Pro forma net income                                          |      | $5,472 |     
|Earnings Per Share                                            |     
|Basic:                                                        |     
|As reported                                                   |      | $0.94  |     
|Pro forma                                                     |      | 0.85   |     
|Diluted:                                                      |     
|As reported                                                   |      | 0.92   |     
|Pro forma                                                     |      | 0.84   |     

# Fair Values of Financial
Instruments

The following methods and assumptions
were used by the Company in estimating the fair values of financial instruments disclosed
in these consolidated financial statements:

(continued)

52

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 1  Summary of
Significant Accounting Policies (continued)

# Fair Values of Financial Instruments
(concluded)

| | Cash,
Interest Bearing Deposits at Other Financial Institutions, and Federal Funds Sold The
carrying amounts of cash, interest bearing deposits at other financial institutions, and
federal funds sold approximate their fair value.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Securities
Available for Sale and Held to Maturity Fair values for securities are based on
quoted market prices.
| | ----------------------------------------------------------------------------------------------------------------

| | Federal
Home Loan Bank StockThe
carrying value of Federal Home Loan Bank stock approximates its fair value.
| | -----------------------------------------------------------------------------------------------------------

| | Investment
in PFC Statutory Trust IThe
carrying value of the Investment in PFC Statutory Trust I approximates its fair value.
| | -----------------------------------------------------------------------------------------------------------------------------

| | Loans
For
variable rate loans that reprice frequently and have no significant change in credit risk,
fair values are based on carrying values. Fair values for fixed rate loans are estimated
using discounted cash flow analysis, using interest rates currently being offered for
loans with similar terms to borrowers of similar credit quality. Fair values of loans held
for sale are based on their estimated market prices. Fair values for impaired loans are
estimated using discounted cash flow analyses or underlying collateral values, where
applicable.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Deposit
Liabilities The
fair value of deposits with no stated maturity date is included at the amount payable on
demand. Fair values for fixed rate certificates of deposit are estimated using a
discounted cash flow calculation based on interest rates currently offered on similar
certificates.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Secured
borrowingsFor variable rate secured borrowings that reprice frequently and have no
significant change in credit risk, fair values are based on carrying values.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Short-Term
Borrowings The
carrying amounts of short-term borrowings approximate their fair values.
| | --------------------------------------------------------------------------------------------------

| | Long-Term
Borrowings and Junior Subordinated Debentures
The
fair values of the Companys long-term borrowings and junior subordinated debentures
are estimated using discounted cash flow analyses based on the Companys incremental
borrowing rates for similar types of borrowing arrangements.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Accrued
Interest Receivable and Payable
The
carrying amounts of accrued interest receivable and payable approximate their fair values.
| | --------------------------------------------------------------------------------------------------------------------------------------

(continued)

53

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 1  Summary of
Significant Accounting Policies (continued)

| | Off-Balance-Sheet
Instruments
The fair value of commitments to
extend credit and standby letters of credit was estimated using the fees currently
charged to enter into similar agreements, taking into account the remaining terms of the
agreements and the present creditworthiness of the customers. Since the majority of the
Companys off-balance-sheet instruments consist of non-fee producing, variable-rate
commitments, the Company has determined they do not have a distinguishable fair value.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# Cash Equivalents and
Cash Flows

The Company considers all amounts
included in the balance sheet caption Cash and due from banks to be cash
equivalents. Cash flows from loans, interest bearing deposits in banks, federal funds
sold, short-term borrowings, secured borrowings and deposits are reported net.

The Company maintains balances in
depository institution accounts which, at times, may exceed federally insured limits. The
Company has not experienced any losses in such accounts.

# Earnings Per Share

Basic earnings per share excludes
dilution and is computed by dividing net income by the weighted average number of common
shares outstanding. Diluted earnings per share reflect the potential dilution that could
occur if common shares were issued pursuant to the exercise of options under the
Companys stock option plans. Stock options excluded from the calculation of diluted
earnings per share because they are antidilutive, represented 272,600, 103,600 and 20,000
in 2005, 2004 and 2003, respectively.

# Comprehensive Income

Accounting principles generally
require that recognized revenue, expenses, gains and losses be included in net income.
Certain changes in assets and liabilities, such as unrealized gains and losses on
securities available for sale, are reported as a separate component of the equity section
of the consolidated balance sheets, such items, along with net income, are components of
comprehensive income. Gains and losses on securities available for sale are reclassified
to net income as the gains or losses are realized upon sale of the securities.
Other-than-temporary impairment charges are reclassified to net income at the time of the
charge.

(continued)

54

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 1  Summary of
Significant Accounting Policies (concluded)

# Recent Accounting
Pronouncements

In May 2005, FASB issued SFAS No.
154, Accounting Changes for Error Corrections (SFAS No. 154). SFAS No. 154 provides
guidance on the accounting for and reporting of accounting changes and error corrections.
It established, unless impracticable, retrospective application as the required method for
reporting a change in accounting principle in the absence of explicit transaction
requirements specific to the newly adopted accounting principle. SFAS No. 154 is effective
for accounting changes and corrections of errors made in fiscal years beginning after
December 15, 2005. The adoption of SFAS No. 154 is not expected to have a material impact
on the Companys consolidated financial statements.

On December 16, 2004, the FASB issued
SFAS No. 123R, Share-Based Payment, a revision of SFAS No. 123. SFAS No. 123R
will require the Company to, among other things, measure all employee stock-based
compensation awards using a fair value method and record such expense in the
Companys consolidated financial statements. The provisions of SFAS 123R are
effective no later than the beginning of the first interim or annual reporting period that
begins after June 15, 2005. The Company will adopt the new requirements using the modified
prospective transition method. The adoption of SFAS 123R will increase the Companys
future compensation expense for unvested awards outstanding as of December 31, 2005 by the
following estimated amounts:

|Year ended December 31, | Estimated Additional Compensation Expense (in thousands)
|----------------------- | --------------------------------------------------------
|                        |                                                         
|2006                    | $21                                                     
|2007                    | 13                                                      
|2008                    | 2                                                       
|2009                    | 1                                                       
|                        | $37                                                     

# Note 2  Restricted
Assets

Federal Reserve Board regulations
require that the Bank maintain certain minimum reserve balances in cash on hand and on
deposit with the Federal Reserve Bank, based on a percentage of deposits. The average
amount of such balances for the years ended December 31, 2005 and 2004 were approximately
$765 and $675, respectively.

(continued)

55

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 3  Securities

Investment securities have been
classified according to managements intent. The amortized cost of securities and
their approximate fair value are as follows:

|                                                 | Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Fair Value
|------------------------------------------------ | -------------- | ---------------------- | ----------------------- | ----------
|Securities Available for Sale                    |                |                        |                         |           
|December 31, 2005                                |                |                       
|U.S. Government agency securities                |                |                        | $                       | 4,445     
|Obligations of states and political subdivisions |                |                        |                         | 12,251    
|Mortgage-backed securities                       |                |                        |                         | 8,432     
|Corporate bonds                                  |                |                        |                         | 2,071     
|Mutual funds                                     |                |                        |                         | 3,039     
|                                                 |                |                        | $                       | 30,238    
|December 31, 2004                                |                |                       
|U.S. Government agency securities                |                |                        | $                       | 4,567     
|Obligations of states and political subdivisions |                |                        |                         | 12,632    
|Mortgage-backed securities                       |                |                        |                         | 10,270    
|Corporate bonds                                  |                |                        |                         | 4,096     
|Mutual funds                                     |                |                        |                         | 4,014     
|                                                 |                |                        | $                       | 35,579    
|Securities Held to Maturity                      |                |                       
|December 31, 2005                                |                |                       
|State and municipal securities                   |                |                        | $                       | 5,315     
|Mortgage-backed securities                       |                |                        |                         | 1,189     
|                                                 |                |                        | $                       | 6,504     
|December 31, 2004                                |                |                       
|State and municipal securities                   |                |                        | $                       | 5,496     
|Mortgage-backed securities                       |                |                        |                         | 1,714     
|                                                 |                |                        | $                       | 7,210     

(continued)

56

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 3  Securities
(continued)

Unrealized losses and fair value,
aggregated by investment category and length of time that individual securities have been
in continuous unrealized loss position, as of December 31, 2005 and 2004 are summarized as
follows:

|December 31, 2005                 | Less than Fair    Value | 12 Months Unrealized Loss | More than Fair     Value | 12 Months Unrealized Loss | Total   Fair   Value | Unrealized Loss
|--------------------------------- | ----------------------- | ------------------------- | ------------------------ | ------------------------- | -------------------- | ---------------
|Available for Sale                |                         |                          
|U.S. Government agency securities |                         |                           | $                        | 999                       |                      | $              
|Obligations of states and         |                         |                          
|political subdivisions            |                         |                           |                          | 3,764                     |                      |                
|Mortgage-backed securities        |                         |                           |                          | 4,125                     |                      |                
|Corporate bonds                   |                         |                           |                          | 554                       |                      |                
|Mutual funds                      |                         |                           |                          |                          |                      |                
|Total                             |                         |                           | $                        | 9,442                     |                      | $              
|Held to Maturity                  |                         |                          
|State and municipal securities    |                         |                           | $                        | 1,443                     |                      | $              
|Mortgage-backed securities        |                         |                           |                          | 1,183                     |                      |                
|Total                             |                         |                           | $                        | 2,626                     |                      | $              
|December 31, 2004                 |                         |                          
|Available for Sale                |                         |                          
|U.S. Government agency securities |                         |                           | $                        | 4,081                     |                      | $              
|Obligations of states and         |                         |                          
|political subdivisions            |                         |                           |                          | 1,952                     |                      |                
|Mortgage-backed securities        |                         |                           |                          | 3,808                     |                      |                
|Corporate bonds                   |                         |                           |                          | 993                       |                      |                
|Mutual funds                      |                         |                           |                          | 3,912                     |                      |                
|Total                             |                         |                           | $                        | 14,746                    |                      | $              
|Held to Maturity                  |                         |                          
|State and municipal securities    |                         |                           | $                        | 338                       |                      | $              

For all the above investment
securities, the unrealized losses are generally due to changes in interest rates and, as
such, are considered to be temporary by the Company. The Company has evaluated the
securities shown above and anticipates full recovery of amortized cost with respect to
these securities at maturity or sooner in the event of a more favorable market interest
rate environment. The Company regularly reviews its investment portfolio to determine
whether any of its securities are other than temporarily impaired.  In addition to accounting and
regulatory guidance, in determining whether a security is other than temporarily impaired, the Company considers duration
and amount of each unrealized loss, the financial condition of the issuer, and the prospects for a change in market value
and net asset value within a reasonable period of time.  Additionally, the contractual cash flows of mortgage-backed securities
are guaranteed by an agency of the U.S. Government.

(continued)

57

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 3  Securities
(concluded)

The contractual maturities of
investment securities held to maturity and available for sale at December 31, 2005 are
shown below. Investment in mortgage-backed securities are shown separately because
maturities may differ from contractual maturities as borrowers have the right to call or
prepay obligations, with or without call or prepayment penalties. Investments in mutual
funds are shown separately due to the short-term nature of the investments and because
mutual funds do not have a stated maturity date.

|                                | Held to Maturity | Available for Sale
|------------------------------- | ---------------- | ------------------
|
|Due in one year or less         |                  |                   
|Due from one year to five years |                  |                   
|Due from five to ten years      |                  |                   
|Due after ten years             |                  |                   
|Mortgage-backed securities      |                  |                   
|Mutual funds                    |                  |                   
|Total                           |                  |                   

Gross gains realized on sales of
securities were $65, $30 and $9 and gross losses realized were $63, $27 and $5 in 2005,
2004, and 2003 respectively.

Securities carried at approximately
$27,483 at December 31, 2005 and $27,374 at December 31, 2004 were pledged to secure
public deposits, borrowings at the Federal Home Loan Bank of Seattle, for other purposes
required or permitted by law.

# Note 4  Loans

Loans (including loans held for sale)
at December 31 consist of the following:

|                            | 2005 | 2004
|--------------------------- | ---- | ----
|Commercial and agricultural |      |     
|Real estate:                |      |     
|Construction                |      |     
|Residential 1-4 family      |      |     
|Multi-family                |      |     
|Commercial                  |      |     
|Farmland                    |      |     
|Consumer                    |      |     
|                            |      |     
|Less unearned income        |      |     
|                            |      |     

(continued)

58

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

Note 4  Loans
(concluded)

Changes in the allowance for credit
losses for the years ended December 31 are as follows:

|                              | 2005 | 2004 | 2003
|----------------------------- | ---- | ---- | ----
|Balance at beginning of year  |      |      | $   
|BNW Bancorp, Inc. acquisition |      |      |     
|Provision for credit losses   |      |      |     
|Charge-offs                   |      |      |     
|Recoveries                    |      |      |     
|Net charge-offs               |      |      |     
|Balance at end of year        |      |      | $   

Following is a summary of
information pertaining to impaired loans:

|                                                             | 2005 | 2004 | 2003
|------------------------------------------------------------ | ---- | ---- | ----
|December 31                                                  |      |      |     
|Impaired loans without a valuation allowance                 |      |      | $   
|Impaired loans with a valuation allowance                    |      |      |     
|Total impaired loans                                         |      |      | $   
|Valuation allowance related to impaired loans                |      |      | $   
|Years Ended December 31                                      |      |     
|Average investment in impaired loans                         |      |      | $   
|Interest income recognized on a cash basis on impaired loans |      |      |     

At December 31, 2005, there were no commitments
to lend additional funds to borrowers whose loans have been modified. Loans 90 days and
over past due and still accruing interest at December 31, 2005 and 2004 were $82 and $0.

Certain related parties of the
Company, principally directors and their affiliates, were loan customers of the Bank in
the ordinary course of business during 2005 and 2004. Total loans outstanding at December
31, 2005 and 2004 to key officers and directors were $4,767 and $5,825, respectively.
During 2005, new loans of $6,101 were made, and repayments totaled $7,159. In
managements opinion, these loans and transactions were on the same terms as those
for comparable loans and transactions with non-related parties. No loans to related
parties were on non-accrual, past due or restructured at December 31, 2005.

(continued)

59

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 5  Premises
and Equipment

The components of premises and
equipment at December 31 are as follows:

|                                               | 2005 | 2004
|---------------------------------------------- | ---- | ----
|Land                                           |      |     
|Premises                                       |      |     
|Equipment, furniture and fixtures              |      |     
|                                               |      |     
|Less accumulated depreciation and amortization |      |     
|Total premises and equipment                   |      |     

The Bank leases premises under operating
leases. Rental expense of leased premises was $327, $191 and $7 for 2005, 2004 and 2003,
respectively, which is included in occupancy expense.

Minimum net rental commitments under
noncancelable leases having an original or remaining term of more than one year for future
years ending December 31 are as follows:

|                                | 
|------------------------------- | 
|2006                            | 
|2007                            | 
|2008                            | 
|2009                            | 
|2010                            | 
|Total minimum payments required | 

Certain leases contain renewal
options from five to ten years and escalation clauses based on increased in property taxes
and other costs.

# Note 6  Deposits

The composition of deposits at
December 31 is as follows:

|                                      | 2005 | 2004
|------------------------------------- | ---- | ----
|Demand deposits, non-interest bearing |      |     
|NOW and money market accounts         |      |     
|Savings deposits                      |      |     
|Time certificates, $100,000 or more   |      |     
|Other time certificates               |      |     
|Total                                 |      |     

(continued)

60

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 6  Deposits
(concluded)

Scheduled maturities of time
certificates of deposit are as follows for future years ending December 31:

|     | 
|---- | 
|2006 | 
|2007 | 
|2008 | 
|2009 | 
|2010 | 
|     | 

# Note 7  Borrowings

Short-term borrowings at December 31,
2005 mature in January 2006 and bear interest at 5.13%. Short-term borrowings generally
mature within one to four days from the transaction date.

Long-term borrowings at December 31,
2005 and 2004 represent advances from the Federal Home Loan Bank of Seattle. Advances at
December 31, 2005 bear interest at 1.81% to 4.27% and mature in various years as follows:
2006  $5,000; 2007  $2,000; 2008  $5,000; 2009  $11,000; and 2010
 $1,500. The Bank has pledged $32,372 of securities and loans as collateral for
these borrowings at December 31, 2005.

Secured borrowings at December 31,
2005 and 2004 represent borrowings collateralized by participation interests in loans
originated by the Bank. These borrowings are repaid as payments (normally monthly) are
made on the underlying loans, bearing interest ranging from 6.5% to 8.5%. Original
maturities range from May 2009 to February 2016.

# Note 8  Junior
Subordinated Debentures

In December 2005, the Company issued
$5,155,000 of junior subordinated debentures to PFC Statutory Trust I, a Connecticut trust
that was formed for the exclusive purpose of issuing trust preferred securities to provide
additional regulatory capital. This capital has a relatively low cost as interest payments
on the debentures are deductible for income tax purposes. The Trust purchased the
debentures with the proceeds of the sale of its common securities to the Company for
$155,000 and trust preferred securities for $5,000,000. The subordinated debentures and
trust preferred securities mature on March 15, 2036, and are redeemable at the
Companys option on or after March 15, 2011. The debentures bear interest, payable
quarterly, at a 6.39% fixed rate until March 15, 2011, at which time the interest rate
becomes a variable rate, adjusted quarterly, equal to 145 basis points over the three
month LIBOR rate. The Company has unconditionally guaranteed distributions on, and
payments on liquidation and redemption of, the trust preferred securities.

(continued)

61

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 9  Income
Taxes

Income taxes are comprised of the
following for the years ended December 31:

|                   | 2005 | 2004 | 2003
|------------------ | ---- | ---- | ----
|Current            |      |      | $   
|Deferred (benefit) |      |      |     
|Total income taxes |      |      | $   

The tax effects of temporary
differences that give rise to significant portions of deferred tax assets and liabilities
at December 31 are:

|                                                 | 2005 | 2004
|------------------------------------------------ | ---- | ----
|Deferred Tax Assets                              |      |     
|Allowance for credit losses                      |      |     
|Deferred compensation                            |      |     
|Unrealized loss on securities available for sale |      |     
|Other                                            |      |     
|Total deferred tax assets                        |      |     
|Deferred Tax Liabilities                         |      |     
|Unrealized gain on securities available for sale |      |     
|Depreciation                                     |      |     
|Deferred revenue                                 |      |     
|Core deposit intangible                          |      |     
|Total deferred tax liabilities                   |      |     
|Net deferred tax assets (liabilities)            |      |     

The following is a reconciliation
between the statutory and effective federal income tax rate for the years ended December
31:

|                               | 2005 |  | 2004 |       | 2003 | 
|------------------------------ | ---- |  | ---- | ----- | ---- | 
|
|Income tax at statutory rate   |      |  | $    | 3,031 |      | 
|Adjustments resulting from:    |      | 
|Tax-exempt income              |      |  |      | (244  | )    | 
|Net earnings on life insurance |      | 
|policies                       |      |  |      | (125  | )    | 
|Other                          |      |  |      | (9    | )    | 
|Total income tax expense       |      |  | $    | 2,653 |      | 

62

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 10  Employee
Benefits

# Incentive Compensation
Plan

The Bank has a plan that provides
incentive compensation to key employees if the Bank meets certain performance criteria
established by the Board of Directors. The cost of this plan was $1,023, $919, and $602 in
2005, 2004 and 2003, respectively.

# 401(k) Plans

The Bank has established a 401(k)
profit sharing plan for those employees who meet the eligibility requirements set forth in
the plan. Eligible employees may contribute up to 15% of their compensation. Matching
contributions by the Bank are at the discretion of the Board of Directors. Contributions
totaled $290, $234 and $129 for 2005, 2004 and 2003, respectively.

# Director and Employee
Deferred Compensation Plans

The Company has director and employee
deferred compensation plans. Under the terms of the plans, a director or employee may
participate upon approval by the Board. The participant may then elect to defer a portion
of his or her earnings (directors fees or salary) as designated at the beginning of
each plan year. Payments begin upon retirement, termination, death or permanent
disability, sale of the Company, the ten-year anniversary of the participants
participation date, or at the discretion of the Company. There are currently two
participants in the plans. Total deferrals plus earnings were $134, $113 and $105 at
December 31, 2005, 2004 and 2003, respectively. There is no expense to the Company for
this plan.

The directors of a bank acquired by
the Company in 1999 adopted two deferred compensation plans for directors  one plan
providing retirement income benefits for all directors and the other, a deferred
compensation plan, covering only those directors who have chosen to participate in the
plan. At the time of adopting these plans, the Bank purchased life insurance policies on
directors participating in both plans which may be used to fund payments to them under
these plans. Cash surrender values on these policies were $3,022 and $2,923 at December
31, 2005 and 2004, respectively. In 2005, 2004 and 2003, the net (benefit)/cost recorded
from these plans, including the cost of the related life insurance, was $(334), ($322) and
($271), respectively. Both of these plans were fully funded and frozen as of September 30,
2001. Plan participants were given the option to either remain in the plan until reaching
the age of 70 or to receive a lump-sum distribution. Participants electing to remain in
the plan will receive annual payments over a ten-year period upon reaching 70 years of
age. The liability associated with these plans totaled $354 and $360 at December 31, 2005
and 2004, respectively.

# Non-Qualified Deferred
Compensation Plan

The Company has a non-qualified
deferred compensation plan to cover selected employees. Its annual contributions to the
plan totaled $5, $5 and $6 in 2005, 2004 and 2003, respectively. Covered employees may
also contribute to the plan. The liability associated with this plan totaled $6 at
December 31, 2005 and 2004.

# Note 11  Dividend
Reinvestment Plan

In November 2005, the Company
instituted a dividend reinvestment plan which allows for all or partial of the cash
dividends to be reinvested in shares of Company common stock based upon shareholder
election. Under the plan, 1,000,000 shares are authorized for dividend reinvestment, of
which none have been issued through December 31, 2005.

63

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 12 
Commitments and Contingencies

The Bank is party to financial
instruments with off-balance-sheet risk in the normal course of business to meet the
financing needs of their customers. These financial instruments include commitments to
extend credit and standby letters of credit, and involve, to varying degrees, elements of
credit risk in excess of the amount recognized on the consolidated balance sheets.

The Banks exposure to credit
loss in the event of nonperformance by the other party to the financial instrument for
commitments to extend credit and standby letters of credit is represented by the
contractual amount of those instruments. The Bank uses the same credit policies in making
commitments and conditional obligations as they do for on-balance-sheet instruments. A
summary of the Banks commitments at December 31 is as follows:

|                             | 2005 | 2004
|---------------------------- | ---- | ----
|Commitments to extend credit |      |     
|Standby letters of credit    |      |     

Commitments to extend credit are
agreements to lend to a customer as long as there is no violation of any condition
established in the contract. Since many of the commitments are expected to expire without
being drawn upon, the total commitment amounts do not necessarily represent future cash
requirements. The Banks experience has been that approximately 67% of loan
commitments is drawn upon by customers. The Bank evaluates each customers
creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed
necessary by the Bank upon extension of credit, is based on managements credit
evaluation of the party. Collateral held varies, but may include accounts receivable,
inventory, property and equipment, residential real estate, and income-producing
commercial properties.

Standby letters of credit are
conditional commitments issued by the Bank to guarantee the performance of a customer to a
third party. Those guarantees are primarily issued to support public and private borrowing
arrangements. The credit risk involved in issuing letters of credit is essentially the
same as that involved in extending loan facilities to customers. Collateral held varies as
specified above, and is required in instances where the Bank deems necessary.

Certain executive officers have
entered into employment contracts with the Bank which provide for contingent payments
subject to future events.

The Bank has agreements with
commercial banks for lines of credit totaling $37,000, none of which was used at December
31, 2005. In addition, the Bank has a credit line with the Federal Home Loan Bank of
Seattle totaling 20% of assets, $24,500 of which was used at December 31, 2005. These
borrowings are collateralized under blanket pledge and custody agreements.

Because of the nature of its
activities, the Company is subject to various pending and threatened legal actions which
arise in the ordinary course of business. In the opinion of management, liabilities
arising from these claims, if any, will not have a material effect on the financial
position of the Company.

64

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 13 
Significant Concentrations of Credit Risk

Most of the Banks business
activity is with customers and governmental entities located in the state of Washington,
including investments in state and municipal securities. Loans are generally limited by
state banking regulations to 20% of the Banks shareholders equity, excluding
accumulated other comprehensive income (loss). As of December 31, 2005 the Banks
loans to borrowers in the hotel\motel industry totaled $47,875 or 11.77% of total loans.
The Bank did not experience any loan losses to borrowers in the hotel/motel industry in
2005. Standby letters of credit were granted primarily to commercial borrowers. The Bank,
as a matter of practice, generally does not extend credit to any single borrower or group
of borrowers in excess of $5.5 million.

# Note 14  Stock
Options

The Companys three stock
incentive plans provide for granting incentive stock options, as defined under current tax
laws, to key personnel and under the plan adopted in 2000, options not qualified for
favorable tax treatment and other types of stock based awards. Under the first plan,
options are exercisable 90 days from the date of grant. These options terminate if not
exercised within ten years from the date of grant. If after six years from the date of
grant fewer than 20% of the options have been exercised, they will expire at a rate of 20%
annually. Under the second plan, the options are exercisable one year from the date of
grant, at a rate of 10% annually. Options terminate if not exercised when they become
available, and no additional grants will be made under these two plans. The plan adopted
in 2000, authorizes the issuance of up to a total of 1,000,000 shares, (339,400 shares are
available for grant at December 31, 2005). Under the 2000 plan, options either become
exercisable ratably over five years or vest fully five years from the date of grant. Under
the 2000 plan, the Company may grant up to 150,000 options for its common stock to a
single individual in a calendar year.

The fair value of each option grant
is estimated on the date of grant, based on the Black-Scholes option pricing model and
using the following weighted-average assumptions:

|                        | 2005     | 2004     | 2003    
|----------------------- | -------- | -------- | --------
|Dividend yield          | 4.44%    | 4.07%    | 5.31%   
|Expected life           | 10 years | 10 years | 10 years
|Risk-free interest rate | 4.47%    | 4.71%    | 4.38%   
|Expected volatility     | 17.23%   | 16.97%   | 17.73%  

The weighted average fair value of
options granted during 2005 and 2004 was $4.37 and $2.77, respectively.

The Black-Scholes model used by the
Company to calculate option values, as well as other currently accepted option valuation
models, were developed to estimate the fair value of freely tradable, fully transferable
options without vesting restrictions, which significantly differ from the Companys
stock option awards. These models also require highly subjective assumptions, including
future stock price volatility and expected time until exercise, which greatly affect the
calculated values. Accordingly, management believes that this model does not necessarily
provide a reliable single measure of the fair value of the Companys option awards.

(continued)

65

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 14  Stock
Options (concluded)

A summary of the status of the
Companys stock option plans as of December 31, 2005, 2004 and 2003, and changes
during the years ending on those dates, is presented below:

|                                 | 2005 |  | 2004 |         | 2003 |  
|-------------------------------- | ---- |  | ---- | ------- | ---- | -
|
|Outstanding at beginning of year |      |  |      | 619,794 |      | $
|BNW Bancorp, Inc. acquisition    |      |  |      |        |      |  
|Granted                          |      |  |      | 122,500 |      |  
|Exercised                        |      |  |      | (42,620 | )    |  
|Forfeited                        |      |  |      | (12,000 | )    |  
|Outstanding at end of year       |      |  |      | 687,674 |      | $
|Exercisable at end of year       |      |  |      | 543,668 |      | $

The following information summarizes
information about stock options outstanding and exercisable at December 31, 2005:

|Range ofExercisePrices | NumberOutstanding | WeightedAverageRemainingContractualLife (Years) | WeightedAverageExercisePrice | NumberExercisable | WeightedAverageExercisePrice
|---------------------- | ----------------- | ----------------------------------------------- | ---------------------------- | ----------------- | ----------------------------
|$ 5.88 - $6.18         |                   |                                                 |                              | 40,594            |                             
|11.11 - 12.00          |                   |                                                 |                              | 291,680           |                             
|12.50                  |                   |                                                 |                              | 43,000            |                             
|13.50                  |                   |                                                 |                              | 37,800            |                             
|14.75                  |                   |                                                 |                              | 2,000             |                             
|15.50                  |                   |                                                 |                              | 20,000            |                             
|16.00                  |                   |                                                 |                              | 5,000             |                             
|16.05 - 17.50          |                   |                                                 |                              | 247,600           |                             
|                       |                   |                                                 |                              | 687,674           |                             

In July 2005, the Board of Directors approved
the acceleration of vesting of 257,600 out of the money options previously awarded under
the 2000 Stock Option Plan. All of these options were considered out of the money since the option's exercise price
was greater than the current market value; therefore no compensation expense was recorded.  As a result, the accelerated
stock options became exercisable
immediately.

66

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 15 
Regulatory Matters

The Company and the Bank are subject
to various regulatory capital requirements administered by the federal banking agencies.
Failure to meet minimum capital requirements can initiate certain mandatory and possibly
additional discretionary actions by regulators that, if undertaken, could have a direct
material effect on the Companys consolidated financial statements. Under capital
adequacy guidelines on the regulatory framework for prompt corrective action, the Bank
must meet specific capital adequacy guidelines that involve quantitative measures of the
Banks assets, liabilities and certain off-balance-sheet items as calculated under
regulatory accounting practices. The Banks capital classification is also subject to
qualitative judgments by the regulators about components, risk weightings and other
factors.

Quantitative measures established by
regulation to ensure capital adequacy require the Company and the Bank to maintain minimum
amounts and ratios (set forth in the table below) of Tier 1 capital (as defined in the
regulations) to total average assets (as defined), and minimum ratios of Tier 1 and total
capital (as defined) to risk-weighted assets (as defined).

As of December 31, 2005, the most
recent notification from the Banks regulator categorized the Bank as well
capitalized under the regulatory framework for prompt corrective action. To be categorized
as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based,
and Tier 1 leverage ratios as set forth in the table. There are no conditions or events
since that notification that management believes have changed the institutions
category.

The Company and the Banks
actual capital amounts and ratios are also presented in the table. Management believes, as
of December 31, 2005, the Company and the Bank meet all capital requirements to which they
are subject.

|                                          | ActualAmount | Ratio | Capital AdequacyPurposesAmount | Ratio  | To be Well CapitalizedUnder Prompt
Corrective ActionProvisionsAmount | Ratio
|----------------------------------------- | ------------ | ----- | ------------------------------ | ------ | -------------------------------------------------------------------- | -----
|December 31, 2005                         |              |       |                                |        |                                                                      |      
|Tier 1 capital (to average assets):       |              |      
|Company                                   |              |       | $                              | 39,692 |                                                                      |      
|Bank                                      |              |       |                                | 39,168 |                                                                      |      
|Tier 1 capital (to risk-weighted assets): |              |      
|Company                                   |              |       |                                | 39,692 |                                                                      |      
|Bank                                      |              |       |                                | 39,168 |                                                                      |      
|Total capital (to risk-weighted assets):  |              |      
|Company                                   |              |       |                                | 44,950 |                                                                      |      
|Bank                                      |              |       |                                | 44,421 |                                                                      |      

67

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 15 
Regulatory Matters (concluded)

|                                          | ActualAmount | Ratio | Capital AdequacyPurposesAmount | Ratio  | To be Well CapitalizedUnder Prompt
Corrective ActionProvisionsAmount | Ratio
|----------------------------------------- | ------------ | ----- | ------------------------------ | ------ | -------------------------------------------------------------------- | -----
|December 31, 2004                         |              |       |                                |        |                                                                      |      
|Tier 1 capital (to average assets):       |              |      
|Company                                   |              |       | $                              | 32,899 |                                                                      |      
|Bank                                      |              |       |                                | 32,197 |                                                                      |      
|Tier 1 capital (to risk-weighted assets): |              |      
|Company                                   |              |       |                                | 32,899 |                                                                      |      
|Bank                                      |              |       |                                | 32,197 |                                                                      |      
|Total capital (to risk-weighted assets):  |              |      
|Company                                   |              |       |                                | 37,135 |                                                                      |      
|Bank                                      |              |       |                                | 36,433 |                                                                      |      

# Note 16  Comprehensive
Income

Net unrealized gains and losses
include, net of tax, $455, $325 and $254 of unrealized losses arising during 2005, 2004
and 2003, respectively, less reclassification adjustments of $2, $3 and $4 for gains
included in net income in 2005, 2004 and 2003, respectively, as follows:

|                                                              | Before-TaxAmount | TaxBenefit(Expense) | Net-of-TaxAmount
|------------------------------------------------------------- | ---------------- | ------------------- | ----------------
|2005                                                          |                  |                     |                 
|Unrealized holding losses arising during the year             |                  |                     | $               
|Reclassification adjustments for gains realized in net income |                  |                     |                 
|Net unrealized losses                                         |                  |                     | $               
|2004                                                          |                  |                    
|Unrealized holding losses arising during the year             |                  |                     | $               
|Reclassification adjustments for gains realized in net income |                  |                     |                 
|Net unrealized losses                                         |                  |                     | $               
|2003                                                          |                  |                    
|Unrealized holding losses arising during the year             |                  |                     |                 
|Reclassification adjustments for gains realized in net income |                  |                     |                 
|Net unrealized losses                                         |                  |                     |                 

68

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 17  Fair
Value of Financial Instruments

The estimated fair value of the
Companys financial instruments at December 31 are as follows:

|                                    | 2005CarryingAmount | FairValue | 2004CarryingAmount | FairValue
|----------------------------------- | ------------------ | --------- | ------------------ | ---------
|Financial Assets                    |                    |           |                    |          
|Cash and due from banks,            |                    |          
|interest-bearing deposits with      |                    |          
|banks, and federal funds sold       |                    |           | $                  | 11,506   
|Securities available for sale       |                    |           |                    | 29,748   
|Securities held to maturity         |                    |           |                    | 6,504    
|Investment in PFC Statutory Trust I |                    |           |                    | 155      
|Federal Home Loan Bank stock        |                    |           |                    | 1,858    
|Loans receivable, net               |                    |           |                    | 393,574  
|Loans held for sale                 |                    |           |                    | 10,111   
|Accrued interest receivable         |                    |           |                    | 2,364    
|Financial Liabilities               |                    |          
|Deposits                            |                    |           | $                  | 399,726  
|Short-term borrowings               |                    |           |                    | 3,985    
|Long-term borrowings                |                    |           |                    | 24,500   
|Secured borrowings                  |                    |           |                    | 2,150    
|Junior subordinated debentures      |                    |           |                    | 5,155    
|Accrued interest payable            |                    |           |                    | 547      

The Bank assumes interest rate risk
(the risk that general interest rate levels will change) as a result of its normal
operations. As a result, the fair values of the Banks financial instruments will
change when interest rate levels change and that change may either be favorable or
unfavorable to the Bank. Management attempts to match maturities of assets and liabilities
to the extent believed necessary to minimize interest rate risk. However, borrowers with
fixed rate obligations are less likely to prepay in a rising rate environment and more
likely to prepay in a falling rate environment. Conversely, depositors who are receiving
fixed rates are more likely to withdraw funds before maturity in a rising rate environment
and less likely to do so in a falling rate environment. Management monitors rates and
maturities of assets and liabilities, and attempts to minimize interest rate risk by
adjusting terms of new loans, and deposits and by investing in securities with terms that
mitigate the Banks overall interest rate risk.

69

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 18  Earnings
Per Share Disclosures

Following is information regarding
the calculation of basic and diluted earnings per share for the years indicated.

|                               | Net Income(Numerator) | Shares (Denominator) | Per ShareAmount
|------------------------------ | --------------------- | -------------------- | ---------------
|Year Ended December 31, 2005   |                       |                      |                
|Basic earnings per share:      |                       |                      | $              
|Effect of dilutive securities: |                       |                      |                
|Diluted earnings per share:    |                       |                      | $              
|Year Ended December 31, 2004   |                       |                     
|Basic earnings per share:      |                       |                      | $              
|Effect of dilutive securities: |                       |                      |                
|Diluted earnings per share:    |                       |                      | $              
|Year Ended December 31, 2003   |                       |                     
|Basic earnings per share:      |                       |                      | $              
|Effect of dilutive securities: |                       |                      |                
|Diluted earnings per share:    |                       |                      | $              

The number of shares shown for
options is the number of incremental shares that would result from the
exercise of options and use of the proceeds to repurchase shares at the average market
price during the year.

70

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 19  Condensed
Financial Information  Parent Company Only

# Condensed Balance Sheets 
December 31

|                                           | 2005 | 2004
|------------------------------------------ | ---- | ----
|Assets                                     |      |     
|Cash                                       |      |     
|Investment in the Bank                     |      |     
|Due from the Bank                          |      |     
|Other assets                               |      |     
|Total assets                               |      |     
|Liabilities and Shareholders' Equity       |      |     
|Dividends payable                          |      |     
|Junior subordinated debentures             |      |     
|Shareholders' equity                       |      |     
|Total liabilities and shareholders' equity |      |     

# Condensed Statements of
Income  Years Ended December 31

|                                                         | 2005 | 2004 | 2003
|-------------------------------------------------------- | ---- | ---- | ----
|Dividend Income from the Bank                            |      |      | $   
|Expenses                                                 |      |      |     
|Income before income tax benefit                         |      |      |     
|Income Tax Benefit                                       |      |      |     
|Income before equity in undistributed income of the Bank |      |      |     
|Equity in Undistributed Income of the Bank               |      |      |     
|Net income                                               |      |      | $   

(continued)

71

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 19  Condensed
Financial Information  Parent Company Only (concluded)

# Condensed Statements of
Cash Flows  Years Ended December 31

|                                                    | 2005 | 2004 | 2003
|--------------------------------------------------- | ---- | ---- | ----
|Operating Activities                                |      |      |     
|Net income                                          |      |      | $   
|Adjustments to reconcile net income to              |      |     
|net cash provided by operating activities:          |      |     
|Equity in undistributed income of subsidiary        |      |      |     
|Net change in other assets                          |      |      |     
|Other - net                                         |      |      |     
|Net cash provided by operating activities           |      |      |     
|Investing Activities                                |      |     
|Dividend to subsidiary                              |      |      |     
|Purchase of trust common securities                 |      |      |     
|Net cash used in investing activities               |      |      |     
|Financing Activities                                |      |     
|Proceeds from junior subordinated debentures        |      |      |     
|Common stock issued                                 |      |      |     
|Dividends paid                                      |      |      |     
|Other, net                                          |      |      |     
|Net cash provided by (used in) financing activities |      |      |     
|Net increase (decrease) in cash                     |      |      |     
|Cash                                                |      |     
|Beginning of year                                   |      |      |     
|End of year                                         |      |      | $   

72

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 20  Quarterly
Data (Unaudited)

|                             | FirstQuarter | SecondQuarter | ThirdQuarter | FourthQuarter
|---------------------------- | ------------ | ------------- | ------------ | -------------
|Year Ended December 31, 2005 |              |               |              |              
|Interest income              |              |               | $            | 6,646        
|Interest expense             |              |               |              | 1,519        
|Net interest income          |              |               |              | 5,127        
|                             |             
|Provision for credit losses  |              |               |              | 300          
|                             |             
|Non-interest income          |              |               |              | 886          
|                             |             
|Non-interest expenses        |              |               |              | 3,879        
|                             |             
|Income before income taxes   |              |               |              | 1,834        
|                             |             
|Income taxes                 |              |               |              | 545          
|                             |             
|Net income                   |              |               | $            | 1,289        
|                             |             
|Earnings per common share:   |              |              
|Basic                        |              |               | $            | .20          
|Diluted                      |              |               |              | .20          

(continued)

73

---



# Notes to Consolidated
Financial Statements

Pacific Financial
Corporation and SubsidiaryDecember 31, 2005 and 2004

# Note 20  Quarterly
Data (Unaudited) (concluded)

|                             | FirstQuarter | SecondQuarter | ThirdQuarter | FourthQuarter
|---------------------------- | ------------ | ------------- | ------------ | -------------
|Year Ended December 31, 2004 |              |               |              |              
|Interest income              |              |               | $            | 4,837        
|Interest expense             |              |               |              | 879          
|Net interest income          |              |               |              | 3,958        
|                             |             
|Provision for credit losses  |              |               |              | 70           
|                             |             
|Non-interest income          |              |               |              | 571          
|                             |             
|Non-interest expenses        |              |               |              | 2,606        
|                             |             
|Income before income taxes   |              |               |              | 1,853        
|                             |             
|Income taxes                 |              |               |              | 479          
|                             |             
|Net income                   |              |               | $            | 1,374        
|                             |             
|Earnings per common share:   |              |              
|Basic                        |              |               | $            | .25          
|Diluted                      |              |               |              | .25          

74

---



# SIGNATURES

Pursuant to the requirements of
Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned, thereunto duly authorized, on
the 16th day of March, 2006.

|                                  | PACIFIC FINANCIAL CORPORATION
|--------------------------------- | -----------------------------
|                                  | (Registrant)                 
|                                  |                              
|/s/ Dennis A. Long                | /s/ Denise Portmann          
|Dennis A. Long, President and CEO | Denise Portmann, CFO         

Pursuant to the requirements of the
Securities Exchange Act of 1934, this report has been signed below by the following
persons on behalf of the registrant and in the capacities indicated, on the
16th day of March, 2006.

|                                                                                            |                                                                                   
|------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------
|Principal Executive Officer and Director                                                    | Principal Financial and Accounting Officer                                        
|/s/ Dennis A. LongDennis A. Long, President and CEO and DirectorPrincipal Executive Officer | /s/ Denise Portmann Denise Portmann, CFOPrincipal Financial and Accounting Officer
|Remaining Directors                                                                         |                                                                                   
|/s/ Joseph A. MalikJoseph A. Malik (Chairman of the Board)                                  | /s/ G. Dennis ArcherG. Dennis Archer                                              
|/s/ Gary C. ForcumGary C. Forcum                                                            | Duane E. Hagstrom                                                                 
|/s/ Steward L. ThomasSteward L. Thomas                                                      | /s/ John FerlinJohn Ferlin                                                        
|/s/ Douglas M. SchermerDouglas M. Schermer                                                  | /s/ Robert J. WorrellRobert J. Worrell                                            
|/s/ Susan C. FreeseSusan C. Freese                                                          | /s/ Randy W. Roglin Randy W. Rognlin                                              
|/s/ Randy RustRandy Rust                                                                    | /s/ Edwin Ketel Edwin Ketel                                                       

75

---



Exhibit Index

|EXHIBIT NO. | EXHIBIT                                                                         
|----------- | --------------------------------------------------------------------------------
|3.1         | Restated Articles of Incorporation (1)                                          
|3.2         | Bylaws (2)                                                                      
|10          | Executive Compensation Plans and Arrangements and Other Management Contracts    
|10.1        | Employment Agreement with Dennis A. Long dated July 1, 2005                     
|10.2        | Employment Agreement with John Van Dijk dated July 1, 2005                      
|10.3        | Employment Agreement with Bruce D. MacNaughton dated July 1, 2005               
|10.4        | Employment Agreement with Denise Portmann dated July 1, 2005                    
|10.5        | Bank of the Pacific Incentive Stock Option Plan (3)                             
|10.6        | The Bank of Grays Harbor Incentive Stock Option Plan (3)                        
|10.7        | 2000 Stock Incentive Compensation Plan (4)                                      
|10.8        | Bonus Program for Officers (4)                                                  
|10.9        | The Bank of Grays Harbor Employee Deferred Compensation Plan (5)                
|21          | Subsidiaries of Registrant - Bank of the Pacific, organized under Washington law
|23          | Consent of McGladrey & Pullen, LLP, Independent Auditors                        
|31.1        | Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)             
|31.2        | Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)             
|32          | Certification Pursuant to 18 U.S.C. 1350                                        
|99          | Description of common stock of the Company (6)                                  

(1)    
          Incorporated by reference to Exhibit 3.2 to the Companys Quarterly Report
          on Form 10-Q for the quarter ended June 30, 2000.

(2)    
          Incorporated by reference to Exhibit 2b to Form 8-A filed by the Company and
          declared effective on March 7, 2000 (Registration No. 000-29329)

(3)    
          Incorporated by reference to Exhibits 10.7 and 10.8 to the Companys Annual
          Report on Form 10-K for the year ended December 31, 1999.

(4)    
          Incorporated by reference to Exhibits 10.1 and 10.2 to the Companys
          Quarterly Report on Form 10-Q for the quarter ended March 31, 2000.

(5)    
          Incorporated by reference to Exhibit 10.10 to the Companys Annual Report
          on Form 10-K for the year ended December 31, 2000.

(6)    
          Incorporated by reference to Exhibit 99 to the Companys Quarterly Report
          on Form 10-Q for the quarter ended September 30, 2000.

76