UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, 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, 2004; 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)

                             300 East Market 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 (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. Yes X   No
                         ---    ---

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

Indicate  by check mark  whether  the  Registrant  is an  accelerated  filer (as
defined by Exchange Act Rule 12b-2). Yes [X] No [ ]

The  aggregate  market value of the common stock held by  non-affiliates  of the
registrant at June 30, 2004, was $109,163,732

The number of shares  outstanding of the  registrant's  common stock,  $1.00 par
value as of February 28, 2005, was 3,210,698 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 20, 2005 are incorporated by reference
into Part III of this Form 10-K.

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                          PACIFIC FINANCIAL CORPORATION
                 ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR
                             ENDED DECEMBER 31, 2004

                                TABLE OF CONTENTS
PART I                                                                      Page

            Forward Looking Information                                       3

            Stock Split                                                       4

            Item  1.    Business                                              4

            Item  2.    Properties                                            12

            Item  3.    Legal Proceedings                                     13

            Item  4.    Submission of Matters to a Vote of Security Holders   13

PART  II
            Item  5.    Market   for   Registrant's   Common   Equity,        14
                        Related Stockholder Matters and Issuer and
                        Purchases of Equity Securities

            Item  6.    Selected Financial Data                               15

            Item  7.    Management's   Discussion   and  Analysis  of         17
                        Financial Condition and Results of Operations

            Item  7A.   Quantitative  and Qualitative  Disclosures  About     33
                        Market Risk

            Item  8.    Financial Statements and Supplementary Data           35

            Item  9.    Changes  in  and   Disagreements   with  Accountants  35
                        on Accounting and Financial Disclosure

            Item 9A.    Controls and Procedures                               35

            Item 9B.    Other Information                                     36

PART  III
            Item  10.   Directors and Executive Officers of the Registrant    37

            Item  11.   Executive Compensation                                37

            Item  12.   Security  Ownership  of  Certain  Beneficial  Owners  38
                        and Management And Related Stockholder Matters

            Item  13.   Certain Relationships and Related Transactions        38

            Item  14.   Principal Accountant Fees and Services                38

PART  IV
            Item  15.   Exhibits and Financial Statement Schedules            39

SIGNATURES                                                                    74

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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 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.  changes in the  interest  rate  environment  that may reduce our
      margins,  decrease  demand for our products and  services,  and  adversely
      effect the value of our investment securities;

            3.  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;

            4.  our  acquisition  of BNW Bancorp  Inc.  which may be dilutive to
      earnings per share, or less beneficial than expected, if we do not realize
      expected  cost  savings or  successfully  integrate  BNW Bancorp  into the
      Company in a timely  manner and without  significant  customer or employee
      disruptions or losses;

            5.  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;

            6.  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;

            7.  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;

            8.  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

            9.  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.

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<PAGE>

      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.

Stock Split

      All per share  amounts and numbers of shares of our common stock  included
in this report (except on the cover page) have been retroactively adjusted for a
two-for-one  stock split  declared on February 16, 2005,  to be paid on April 4,
2005, to shareholders of record on March 15, 2005.

ITEM 1.  Business

Pacific  Financial  Corporation (the Company or Pacific) is a financial  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.

The  Company  conducts  its  banking  business  through 15  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  loan  production  offices in  Gearhart,  Oregon and  Burlington,
Washington.  The five 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.

The BNW acquisition was accomplished through a merger in which each share of BNW
common stock was converted  into 0.85 shares of Pacific common stock (before the
2005 split),  resulting in the  issuance of  1,271,904  shares of Pacific  stock
(post-split). Simultaneous with the merger of BNW into Pacific, BNW's subsidiary
Bank  NorthWest  was merged into Bank of the Pacific,  although  Whatcom  County
branches  continue  to conduct  business  under the name "Bank  Northwest."  The
merger was accounted for as a purchase transaction.

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, 2004, the Company
had total consolidated  assets of $441.8 million,  total loans,  including loans
held for sale, of $347.8 million,  total deposits of $363.5  million,  and total
shareholders'  equity of $45.3 million.  To give you a reference point as to the
effect  of the  BNW  acquisition  on  these  figures,  at the  time  of the  BNW
acquisition,  BNW 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  Company  has not made any  significant  changes in  products  and  services
offered to customers of Bank of the Pacific following the merger, but it is able
to offer higher  lending limits to its  customers,  particularly  those who were
formerly BNW customers.

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

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<PAGE>

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.

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
traditionally  has not sought brokered  deposits and does not intend to do so in
the future.

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 or Microsoft's  Money.
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.  The Company 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
Company competes with well-established  small community banks, branches of large
banks,  thrifts and credit unions in Pacific and

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<PAGE>

Wahkiakum Counties in the state of Washington and Clatsop County in the state of
Oregon.  Other  non-bank  and  non-depository  institutions  can be  expected to
increase competition further as they offer bank type products.

As a result of its  acquisition of BNW in February  2004, the Company  entered a
new market in Whatcom County,  Washington,  including the Bellingham  area. This
market is very  competitive  and  includes  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.

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, 2004,
the Company  held a deposit  market share of 28.1% in Pacific  County,  45.8% in
Wahkiakum County, 17.2% in Grays Harbor County, and 3.6% in Whatcom County.

Employees

As of December 31, 2004, the Bank employed 157 full time  equivalent  employees.
The Bank  acquired 52  employees  in the merger with BNW  completed  in February
2004. 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.

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                                   The Company
General

As a  financial  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.

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

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company system to engage in a full range of financial  activities  through a new
entity known as a financial holding company.

The Company received approval to become a financial holding company during 2000.
Bank  holding  companies  that elect to become a financial  holding  company 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 marking, sponsoring mutual
funds and investment  companies,  insurance  underwriting  and agency,  merchant
banking,  and activities  that the Federal  Reserve,  in  consultation  with the
Secretary of the Treasury, determines from time to time to be so closely related
to banking or managing or controlling banks as to be a proper incident thereto.

The law and related regulations also:

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

    o     provided an enhanced  framework for protecting the privacy of consumer
          information; and

    o     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.

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.

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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.

The  Sarbanes-Oxley  Act  has  resulted  in  significantly  increased  reporting
expenses and audit and audit related costs and 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.

                                       9

<PAGE>


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.

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,

                                       10

<PAGE>

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.

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, 2004,  the Bank
could declare dividends  totaling  $5,707,000 without obtaining prior regulatory
approval.

                                       11

<PAGE>


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%.

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 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 and the  administrative  and operations  offices of the Bank and the
Company.  The Bank completed  construction and occupied the building in December
of 1979.

                                       12

<PAGE>


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 five  branches  located in
Whatcom County operate in leased facilities,  and the Bellingham and Everson, WA
branch land and building is owned.

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, 2004.  The net book value of the  Company's  premises and equipment
was $6.8 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
2004.

                                       13

<PAGE>

                                     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 periods  prior to the second  quarter of the 2004
fiscal year 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.


Effective January 1, 2005, the Company appointed Mellon Investor Services LLC to
serve as the  transfer  agent for our  common  stock.  Prior to that  date,  the
Company served as its own transfer agent.

<TABLE>
<CAPTION>

                                    2004                                       2003

                Shares Traded(1)   High(1)       Low(1)   Shares Traded(1)    High(1)       Low(1)
<S>                <C>           <C>            <C>           <C>            <C>           <C>
First Quarter      23,970        $  17.25       $  17.00      11,774         $  13.50      $  12.38

Second Quarter     85,362        $  17.50       $  15.25      10,973         $  15.00      $  14.00

Third Quarter      79,510        $  17.50       $  16.25       8,220         $  15.50      $  15.00

Fourth Quarter      8,638        $  17.50       $  17.00       3,730         $  16.75      $  15.50

</TABLE>

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


As of December 31, 2004, there were  approximately  1,229 shareholders of record
of the Company's common stock.

The  Company's  Board of  Directors  declared  dividends  on its common stock in
December   2004  and  2003  in  the  amounts  per  share  of  $.72  and  $.70,
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, 2004, the Bank could declare dividends totaling
$5,707,000 without obtaining prior regulatory approval.

                                       14

<PAGE>

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 since the February 27th acquisition  date,  while the increased  interest
expense  associated  with  acquired  loans totaled  approximately  $1.2 million,
meaning approximately $6.3 million in 2004 net interest income can be attributed
to  loans  acquired  in  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. As part
of the  accounting  for the  acquisition,  the Company  recorded a core  deposit
identifiable  intangible asset of $993,000. The core deposit intangible recorded
as part of the  acquisition  has an  estimated  life of seven  years.  Estimated
amortization expense was approximately  $118,000 for the year ended December 31,
2004 and is estimated to total  $142,000  annually for the years ended  December
31, 2005 through 2010, and $23,000 for the year ended December 31, 2011.


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

<TABLE>
<CAPTION>

                                     2004       2003        2002        2001         2000
                                   ------------------------------------------------------
                                           ($ in thousands, except per share data)
<S>                             <C>        <C>         <C>         <C>          <C>
Operations Data

Net interest income             $  19,520  $  12,541   $  11,788   $  11,572    $  11,675
Provision for credit losses           970         --         954         580          635
Noninterest income                  3,162      1,846       2,059       1,529        1,217

Noninterest expense                13,555      7,945       7,414       7,193        7,530
Provision for income taxes          2,450      1,863       1,563       1,521        1,424
Net income                          5,707      4,579       3,916       3,807        3,303
Net income per share:
Basic                                 .93(1)     .91(1)      .79(1)      .77(1)       .67(1)
Diluted                               .91(1)     .90(1)      .78(1)      .76(1)       .66(1)

Dividends declared                  4,624      3,530       3,392       3,289        3,204
Dividends declared per share          .72(1)     .70(1)      .68(1)      .66(1)       .64(1)
Dividends paid ratio                   81%        77%         87%         86%          97%

(1) Retroactively adjusted for a two-for-stock split to be paid April 4, 2005.


                                       15

<PAGE>

Performance Ratios

Interest rate spread                 5.34%      4.89%       5.18%       5.28%        5.24%
Net interest margin (1)              5.25%      4.75%       5.05%       5.16%        5.14%
Efficiency ratio (2)                59.76%     55.22%      53.54%      54.90%       58.41%
Return on average assets             1.41%      1.61%       1.54%       1.55%        1.34%
Return on average equity            14.21%     17.10%      15.81%      15.57%       14.95%

Balance Sheet Data

Total assets                    $ 441,791    306,715     268,534     243,617      253,313
Loans, net                        341,671    197,500     183,031     174,495      175,142
Total deposits                    363,501    260,800     225,254     214,644      213,511
Other borrowings                   25,233     14,500      12,800          --       11,358
Shareholders' equity               45,303     25,650      24,683      23,514       22,743
Book value per share (3)             7.06(1)    5.09(1)     4.91(1)     4.72(1)      4.55(1)
Equity to assets ratio              10.25%      8.36%       9.19%       9.65%        8.98%

(1) Retroactively adjusted for a two-for-stock split to be paid April 4, 2005.

Asset Quality Ratios

Nonperforming loans to total loans    .15%       .27%       1.00%        .71%        1.93%
Allowance for loan losses
  to total loans                     1.23%      1.12%       1.33%       1.19%        1.14%
Allowance for loan losses
  to nonperforming loans           832.22%    411.40%     132.67%     168.18%       59.24%
Nonperforming assets to
  total assets                        .12%       .18%        .69%        .51%        1.35%

</TABLE>

(1)    Net interest income divided by average earning assets.
(2)    Non-interest  expense  divided  by the  sum of net  interest  income  and
       non-interest income.
(3)    Shareholder equity divided by shares outstanding.

                                       16

<PAGE>

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, 2004, 2003, and 2002

General.  The Company's  net income for 2004 was  $5,707,000,  a 24.6%  increase
compared to  $4,579,000  in 2003,  and an increase of 16.9% from  $3,916,000  in
2002.  Basic earnings per share were $.93,  $.91,  and $.79 for 2004,  2003, and
2002,  respectively.  Return on average  assets was 1.41%,  1.61%,  and 1.54% in
2004, 2003, and 2002, respectively. Return on average equity was 14.21%, 17.10%,
and 15.81%,  respectively,  in 2004,  2003, and 2002. The increase in net income
for the current year is primarily due to the  acquisition  of BNW Bancorp,  Inc.
effective February 27, 2004,  coupled with increased lending volume.  Reductions
in return on average  assets and return on average  equity can be  attributed to
the costs of the  acquisition,  as well as the  addition of goodwill  associated
with the purchase accounting treatment of the 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, 2004.

<TABLE>
<CAPTION>

                                        Increase                  Increase
                                       (Decrease)                (Decrease)
                                       ----------                ----------
(Dollars in thousands)           2004    Amount     %     2003      Amount      %       2002
---------------------------------------------------------------------------------------------
<S>                            <C>        <C>      <C>   <C>         <C>       <C>    <C>
Interest income                $24,138    $8,189   51.3  $15,949     $170      1.1    $15,779
Interest expense                 4,618     1,210   35.5    3,408     (583)   (14.6)     3,991
Net interest income             19,520     6,979   55.6   12,541      753      6.4     11,788
Provision for credit losses        970       970  100.0       --     (954)  (100.0)       954
Net interest income after
  provision for credit losses   18,550     6,009   47.9   12,541    1,707     15.8     10,834
Other operating income           3,162     1,316   71.3    1,846     (213)   (10.3)     2,059
Other operating expense         13,555     5,610   70.6    7,945      531      7.2      7,414
Income before income taxes       8,157     1,715   26.6    6,442      963     17.6      5,479
Income taxes                     2,450       587   31.5    1,863      300     19.2      1,563
Net income                       5,707     1,128   24.6    4,579      663     16.9      3,916

</TABLE>


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.


                                       17

<PAGE>

<TABLE>
<CAPTION>

                                                                           Year Ended December 31,
                                                                           -----------------------
                                                2004                                 2003                           2002
                                                ----                                 ----                           ----
                                               Interest                            Interest                       Interest
                                  Average      Income         Avg      Average      Income      Avg     Average    Income      Avg
                                  Balance     (Expense)      Rate       Balance    (Expense)   Rate     Balance   (Expense)    Rate

(dollars in thousands)
Assets
<S>                               <C>         <C>            <C>       <C>         <C>         <C>     <C>        <C>         <C>
  Earning assets:
     Loans                        $315,364    $  21,881*     6.94%     $188,267    $ 13,381*   7.11%   $178,765   $ 13,212*   7.39%*
     Investment Securities:
       Taxable                      34,174        1,415      4.14%       48,206       1,738    3.61%     32,991      1,541    4.67%
       Tax-Exempt                   17,795        1,165*     6.55%       14,721       1,050*   7.13%     14,510      1,165*   8.03%
     Total investment
       securities                   51,969        2,580      4.96%       62,927       2,788    4.43%     47,501      2,706    5.70%
     Federal Home Loan Bank Stock    1,114           60      5.39%          887          49    5.52%      3,102        186    6.01%
     Federal funds sold and
       deposits in banks             3,329           44      1.32%       11,855         118    1.00%      5,644        107    1.90%
Total earning assets/interest
  income                          $371,776    $  24,565      6.61%     $263,936    $ 16,336    6.18%   $235,013   $ 16,211    6.90%
  Cash and due from banks            9,866                                7,930                           8,331
  Bank premises and equipment
     (net)                           6,200                                3,780                           3,930
  Other assets                      21,087                               10,448                           9,552
  Allowance for credit losses       (3,555)                              (2,357)                         (2,515)
  Total assets                    $405,374                             $283,737                        $254,310


Liabilities and Shareholders' Equity
  Interest bearing liabilities:
     Deposits:
       Savings and interest-
         bearing demand           $155,846    $  (1,273)      .82%     $112,129    $   (827)    .74%   $104,111   $ (1,080)   1.04%
           Time                    112,078       (2,461)     2.20%       86,634      (2,096)   2.42%     79,664     (2,667)   3.35%
     Total deposits                267,924       (3,734)     1.39%      198,763      (2,923)   1.47%    183,775     (3,747)   2.04%
     Short-term  borrowings          7,825          (96)     1.23%           --          --      --         174         (4)   2.48%
     Long-term borrowings           17,000         (549)     3.23%       14,071        (485)   3.45%      6,548       (240)   3.67%
     Secured borrowings              4,078         (239)     5.86%           --          --      --          --         --      --
Total interest-bearing liabilities/
  Interest expense                $296,827    $  (4,618)     1.56%     $212,834    $ (3,408)   1.60%   $190,497   $ (3,991)   2.10%
Demand deposits                     66,135                               42,864                          36,180
Other liabilities                    2,258                                1,253                           2,867
Shareholders' equity                40,154                               26,786                          24,766
Total liabilities and shareholders'
  equity                          $405,374                             $283,737                        $254,310
Net interest income                           $  19,947*                           $ 12,928*                      $ 12,220*

Net interest income as a percentage of
  average earning assets
         Interest income                                     6.61%                             6.18%                          6.90%
         Interest expens                                     1.24%                             1.29%                          1.72%
         Net interest income                                 5.37%                             4.89%                          5.18%
         Net interest margin (1)                             5.25%                             4.75%                          5.05%

         * Tax equivalent basis - 34% tax rate used
           (1)  Net interest income divided by average interest earning assets

</TABLE>

Nonaccrual loans are included in "loans."

Interest  income on loans  include  loan  fees of  $1,572,500,  $1,003,182,  and
$778,605 in 2004, 2003, and 2002, 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.

Net interest income increased 55.6% to $19,520,000 in 2004 compared to 2003. The
increase  is  primarily  the result of the  acquisition  of BNW.  The  Company's
interest income increased 51.3% to $24,138,000 in

                                       18

<PAGE>


2004 from $15,949,000 in 2003. This increase is due to the increased balances in
loans.  The continued low interest rates for most of 2004 allowed the Company to
maintain a reasonable cost of funds ratio.  Although  interest expense increased
to $4,618,000  in 2004,  compared to $3,408,000 in 2003 due primarily to the BNW
acquisition,  the  cost of  funds  ratio  decreased  slightly  to  1.24% in 2004
compared to 1.29% in 2003. Net interest income  increased 6.4% to $12,541,000 in
2003 compared to 2002. The increase was primarily the result of no provision for
credit  losses  as a result  of an  improvement  in the  quality  of the  credit
portfolio.  The Company's  interest income increased 1.1% to $15,949,000 in 2003
from $15,779,000 in 2002. The increase was due to increased balances in interest
bearing deposits in banks, fed funds sold, securities and loans.

The Company's average loan portfolio increased $127,097,000, or 67.5%, from year
end 2003 to year end 2004, and increased $9,502,000, or 5.3%, from 2002 to 2003.
The growth in 2004 is primarily due to the acquisition of BNW effective February
27, 2004.  Growth during 2003 was primarily due to opening of a loan  production
office on August 1, 2003 in Gearhart,  Oregon.  A large portion of the Company's
loan portfolio rates are tied to variable rate indexes.  Given the unprecedented
low interest rate  environment  since 2002,  the Company is positioned  well for
rate increases the Federal Reserve has indicated will continue.

The Company's average investment  portfolio decreased  $10,958,000 or 17.4% from
2003. The decrease was due to maturing  investments  being utilized to fund loan
production. The Company's average investment portfolio increased $15,426,000, or
32.5%,  during  2003 from 2002.  The  changes in 2003 were  invested  in various
long-term investment products, resulting in an increase in earnings.

The Company's  average  deposits  increased  $69,161,000 or 34.8% from 2003, and
increased  $14,988,000  or 8.2% in 2003 from 2002.  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.  Deposit growth in Pacific's
historical markets during 2004 totaled $20.7 million, or 8%.

The Company  increased  its average  borrowings  during 2004 by  $10,754,000  or
76.4%.  These borrowings  consist of advances from the Federal Home Loan Bank of
Seattle.  The proceeds were used to fund loan growth.  The Company increased its
average  borrowings  during 2003 by  $7,523,000  or 114.9%.  Secured  borrowings
increased  to  $3,733,000  compared  to none  the  previous  year.  The  secured
borrowings  at  December  31,  2004  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 5.75% to 8.5%.

Net interest margins were 5.25%,  4.75%, and 5.05%, for the years ended December
31, 2004, 2003, and 2002, respectively.




                                       19

<PAGE>

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.


<TABLE>
<CAPTION>

                                       2004 compared to 2003          2003 compared to 2002
                                     --------------------------     --------------------------

                                     Increase (decrease) due to     Increase (decrease) due to
(dollars in thousands)               --------------------------     --------------------------
                                     Volume      Rate      Net      Volume     Rate        Net
                                     ------      ----      ---      ------     ----        ---
<S>                                  <C>        <C>     <C>           <C>     <C>         <C>
Interest earned on:
  Loans                              $8,798     $(298)  $8,500        $687    $(518)      $169
Securities:
   Taxable                             (582)      259     (323)        602     (405)       197
   Tax-exempt                           206       (91)     115          17     (132)      (115)
    Total securities                   (376)      168     (208)        619     (537)        82
Federal Home Loan Bank Stock             32       (21)      11        (123)     (14)      (137)
  Fed funds sold and
  interest bearing deposits
    in other banks                     (104)       30      (74)         79      (68)        11
Total interest earning assets         8,350      (121)   8,229       1,262   (1,137)       125

Interest paid on:
  Savings and interest bearing
 demand deposits                       (350)      (96)    (446)        (78)     331        253
  Time deposits                        (572)      207     (365)       (218)     789        571
  Other borrowings                     (299)      139     (160)       (254)      13       (241)
  Secured borrowings                   (239)       --     (239)         --       --         --
Total interest bearing liabilities   (1,221)      250   (1,210)       (550)   1,133        583
Change in net interest income         6,890       129    7,019         712       (4)       708

</TABLE>

Non-Interest Income. Non-interest income was $3,162,000 for 2004, an increase of
$1,316,000 or 71.3% from 2003 when it totaled $1,846,000.  The 2003 amount was a
decrease of $213,000 or 10.3% compared to the 2002 total of $2,059,000.

The following table represents the principal  categories of non-interest  income
for each of the years in the three-year period ended December 31, 2004.


<TABLE>
<CAPTION>


                                              Increase                   Increase
                                             (Decrease)                 (Decrease)
                                             ----------                 ----------
(Dollars in thousands)                  2004   Amount      %      2003    Amount       %       2002
-----------------------------------------------------------------------------------------------------
<S>                                    <C>       <C>      <C>     <C>       <C>       <C>      <C>
Service charges on
    deposit accounts                   $1,297    $270     26.3%   $1,027    $(42)     (3.9%)   $1,069
Mortgage broker fees                       12     (89)   (88.1%)     101      98     326.7%         3
Income from and gains on sale of
    foreclosed real estate                 77      51    196.2%       26    (266)    (91.1%)      292
Net gains from sales of loans           1,026     992   2917.7%       34      34     100.0%        --
Net gain on sale of securities              3      (1)   (25.0%)       4       4     100.0%        --
Earnings on bank owned life insurance     378      50     15.2%      328     (22)     (6.3%)      350
Other operating income                    369      45     13.2%      326     (19)     (5.5%)      345

Total non-interest income               3,162   1,316     71.3%    1,846    (213)    (10.3%)    2,059

</TABLE>

                                       20

<PAGE>


In 2004,  service charges on deposit accounts  increased  $270,000 or 26.3% to a
total of  $1,297,000  compared to  $1,027,000  in 2003.  The 2003 total was down
$42,000 or 3.9% compared to the 2002 total of  $1,069,000.  The increase in 2004
was attributable primarily to the BNW acquisition.

Income from  sources  other than  service  charges on deposit  accounts  totaled
$1,865,000 in 2004, an increase of $1,046,000 from 2003, or 127.7%.  The primary
reason for the increase was the  acquisition  of BNW and gains on sale of loans,
which totaled  $1,026,000  during 2004.  Other major  components of non-interest
income  were  gains  on sale of  foreclosed  real  estate  and bank  owned  life
insurance income. Income from other sources for 2003 was $819,000, a decrease of
$171,000 or 17.3% compared to 2002,  primarily due to a decrease from foreclosed
real estate income and gain on sale of foreclosed real estate.

Non-Interest  Expense.  Total non-interest  expense in 2004 was $13,555,000,  an
increase  of  $5,610,000  or 70.6%  compared  to  $7,945,000  in  2003.  In 2003
non-interest expense increased $531,000 or 7.2% compared to $7,414,000 in 2002.


The following table represents the principal  categories of non-interest expense
for each of the years in the three-year period ended December 31, 2004.

<TABLE>
<CAPTION>


                                          Increase                   Increase
                                         (Decrease)                 (Decrease)
                                         ----------                 ----------
(Dollars in thousands)             2004    Amount      %       2003   Amount      %       2002
-----------------------------------------------------------------------------------------------
<S>                             <C>       <C>        <C>    <C>       <C>        <C>    <C>
Salaries and employee benefits  $ 8,134   $ 3,370    70.7%  $ 4,764   $  568     13.5%  $ 4,196
Occupancy and equipment           1,588       623    64.6%      965      (19)    (1.9%)     984
State taxes                         306       237   343.5%       69     (137)   (66.5%)     206
Data processing                     614       309   101.3%      305       37     13.8%      268
Other expense                     2,913     1,071    58.1%    1,842       82      4.7%    1,760

Total non-interest expense      $13,555   $ 5,610    70.6%  $ 7,945   $  531      7.2   $ 7,414

</TABLE>

Salary and employee  benefits  increased  by  $3,370,000,  or 70.7%,  in 2004 to
$8,134,000 and increased by $568,000, or 13.5%, in 2003 compared to 2002. Salary
and benefits  increased  primarily due to a larger  employee  base in 2004,  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.  At year end, the Bank had 157 full
time equivalent employees.

Occupancy  and  equipment  expense  increased  $623,000  or  64.6%  in 2004  and
decreased  $19,000 or 1.9% in 2003. The increase in 2004 relates directly to 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
operate in leased  facilities.  Two branches,  the Bellingham branch and Everson
branch,  are  owned by the  Company.  The  decrease  in 2003 was due to  reduced
equipment depreciation expenses.

State taxes paid in 2004 totaled $306,000, an increase of $237,000 or 343.5% due
to  increased  revenues.  State taxes paid in 2003  decreased  $137,000 or 66.5%
compared  to  2002.  This  was  the  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.

Data  processing  expense  increased  $309,000  or 101.3% in 2004 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.  Accordingly,  the  Company  was not  able to  realize  the  savings
associated with the conversion during 2004.

                                       21

<PAGE>


The  $1,071,000 or 58.1%  increase in other expense in 2004 was due primarily to
the  BNW  acquisition,   including  travel  expense,   core  deposit  intangible
amortization  expense,  loan expense and marketing expense.  In addition,  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, 2004 and 2003 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.

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, 2004, 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

                                       22

<PAGE>


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, 2004 and differences between them
for the maturity or repricing periods indicated.

<TABLE>
<CAPTION>

                                                           Due after
                                           Due in one     one through     Due after
(dollars in thousands)                    year or less     five years     five years      Total
-------------------------------------------------------------------------------------------------
<S>                                         <C>            <C>           <C>            <C>
Interest earning assets

Loans, including loans held for sale        $ 165,783      $  96,443     $  85,533      $ 347,759
Investment securities                           9,329         18,935        14,726         42,990
Fed Funds and interest
  bearing balances with banks                  11,494             --            --         11,494
Federal Home Loan Bank Stock                       --             --         1,850          1,850
Total interest earning assets               $ 186,606      $ 115,378     $ 102,109      $ 404,093


Interest bearing liabilities

Interest bearing demand deposits            $  55,650      $      --     $      --      $  55,650
Savings deposits                              123,784             --            --        123,784
Time deposits                                  84,076         28,280            --        112,356
Long term borrowings                            5,000         16,500            --         21,500
Secured borrowings                                 --             --         3,733          3,733
Total interest bearing liabilities          $ 268,510      $  44,780     $   3,733      $ 317,023



Net interest rate sensitivity GAP           $ (81,904)     $  70,598     $  98,376      $  87,070

Cumulative interest rate sensitivity GAP                   $ (11,306)    $  87,070      $  87,070
Cumulative interest rate sensitivity GAP
as a % of earning assets                                        (2.8%)        21.5%          21.5%


</TABLE>

The  following  table shows the dollar amount of interest  sensitive  assets and
interest sensitive  liabilities at December 31, 2003 and difference between them
for the maturity or repricing periods indicated.

<TABLE>
<CAPTION>

                                                           Due after
                                           Due in one      one through   Due after
(dollars in thousands)                    year or less     five years    five years       Total
-------------------------------------------------------------------------------------------------
<S>                                         <C>            <C>           <C>            <C>
Loans                                       $  78,261      $  43,407     $  78,070      $ 199,738
Investment securities                          27,136         21,652        16,673         65,461
Fed Funds and interest
  bearing balances with banks                  20,392             --            --         20,392
Federal Home Loan Bank Stock                       --             --           915            915
Total interest earning assets               $ 125,789      $  65,059     $  95,658      $ 286,506




                                       23

<PAGE>


Interest bearing liabilities

Interest bearing demand deposits            $  47,388      $      --     $      --      $  47,388
Savings deposits                               84,105             --            --         84,105
Time deposits                                  59,040         26,405            --         85,445
Long term borrowings                            2,000          6,500         6,000         14,500
Total interest bearing liabilities          $ 192,533      $  32,905     $   6,000      $ 231,438


Net interest rate sensitivity GAP           $ (66,744)     $  32,154     $  89,658      $  55,068
Cumulative interest rate sensitivity GAP                   $ (34,590)    $  55,068      $  55,068
Cumulative interest rate sensitivity GAP
  as a % of earning assets                                     (12.1%)        19.2%          19.2%

</TABLE>


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  $22,471,000,  or 34.3%
during 2004 to  $42,990,000 at year end from  $65,461,000  in 2003,  which was a
$2,869,000  increase  over 2002.  The  changes in 2004 were  primarily  in other
securities as the Company  liquidated  the majority of the mutual funds it held.
Proceeds from sales were used to fund loans.  The changes in 2003 were primarily
in U.S. Government agency mortgaged backed 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)                             2004      2003        2002
--------------------------------------------------------------------------------
U.S. Agencies securities                          $1,714    $2,944     $ 6,611
Obligations of states and political subdivisions   5,496     5,044       3,751

     Total                                        $7,210    $7,988     $10,362


AVAILABLE FOR SALE

(dollars in thousands)                             2004      2003        2002
--------------------------------------------------------------------------------
U.S. Agencies securities                         $14,778   $18,030     $19,164
Obligations of states and political subdivisions  12,942    14,751      12,098
Other securities                                   8,060    24,692      20,968
     Total                                       $35,780   $57,473     $52,230





                                       24

<PAGE>

The following table presents the maturities of investment securities at December
31, 2004.  Taxable  equivalent values are used in calculating  yields assuming a
tax rate of 34%.

HELD TO MATURITY

<TABLE>
<CAPTION>

                                                  Due after     Due after
                                   Due in one     one through  five through  Due after
(dollars in thousands)            year or less    five years    ten years    ten years   Total
-----------------------------------------------------------------------------------------------
<S>                                   <C>           <C>          <C>          <C>        <C>
U.S. Agency securities              $   --         $    --       $   --       $1,714    $ 1,714
  Weighted average yield                --              --           --         4.82%
Obligations of states and political
  subdivisions                      $   --         $ 2,371       $1,205       $1,920    $ 5,496
  Weighted average yield                --            4.41%        6.91%        6.89%

     Total                          $   --         $ 2,371       $1,205       $3,634    $ 7,210


AVAILABLE FOR SALE
                                                  Due after     Due after
                                  Due in one     one through   five through  Due after
(dollars in thousands)           year or less     five years    ten years    ten years   Total
-----------------------------------------------------------------------------------------------
U.S. Agency securities              $1,606         $ 5,033       $3,289       $4,850    $14,778
  Weighted average yield              3.05%           3.16%        4.75%        4.66%
Obligations of states and political
  subdivisions                      $1,773         $ 5,662       $3,361       $2,146    $12,942
  Weighted average yield              7.08%           7.75%        8.99%        8.34%
Other securities                    $5,950         $ 2,111           --           --    $ 8,060
  Weighted average yield              4.43%           4.54%          --           --

     Total                          $9,329         $12,806       $6,650       $6,995    $35,780


</TABLE>


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
at December 31 in each of the past five years.

<TABLE>
<CAPTION>

(dollars in thousands)          2004       2003        2002        2001        2000
------------------------------------------------------------------------------------

<S>                          <C>         <C>         <C>         <C>         <C>
Commercial                   $111,050    $ 64,344    $ 69,794    $ 72,427    $ 68,827
Real Estate Construction       49,347      11,894       9,697       6,554       6,118
Real Estate Mortgage          176,011     117,940     101,151      91,714      96,334
Installment                     9,653       4,625       4,114       4,941       4,612
Credit cards and overdrafts     1,979         935       1,034         968       1,277
Less unearned income             (281)         --          --          --          --
     Total                   $347,759    $199,738    $185,790    $176,604    $177,168

</TABLE>




                                       25

<PAGE>

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, 2004.

                                          Due after
                            Due in one   one through   Due after
(dollars in thousands)     year or less  five years    five years       Total
-------------------------------------------------------------------------------

Commercial                   $ 33,132     $ 35,966     $ 41,952        $111,050
Real estate construction       29,612       10,016        9,719          49,347
     Total                   $ 62,744     $ 45,982     $ 51,671        $160,397


Total loans maturing after one year with
  Predetermined interest rates (fixed)    $ 31,903     $ 73,355        $105,258
  Floating or adjustable rates (variable)   64,784        5,446          70,230
     Total                                $ 96,687     $ 78,801        $175,488

At December 31, 2004, 22.1% 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.


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)       2004      2003       2002      2001     2000
-------------------------------------------------------------------------------

Non-accrual loans           $ 470     $ 465    $ 1,864   $ 1,254    $3,128
Accruing loans past due
  90 days or more              --        --          2        79       292
Restructured loans             --        --         --        --        --
Foreclosed real estate owned   40        98        686     1,040        --

Non-accrual loans increased  approximately $5,000 to $470,000 in 2004 from 2003.
The total is net of charge-offs  based on  management's  estimate of fair market
value or the result of  appraisals.  The  balance  consists of real estate and a
commercial  loan  guaranteed by the SBA.  During 2004,  sales of foreclosed real
estate owned totaled $58,000.

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. The non-accrual  loans
in 2000 were attributable to the decline in the regional and national  economies
and the local  agriculture  economy.  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 $8,000  for 2004,  $37,000  for 2003,
$118,000 for 2002,  $75,000 for 2001,  and $168,000  for 2000.  Interest  income
recognized  on impaired  loans for 2004 was $16,000,  for 2003 was $19,000,  for
2002 was $13,000, for 2001 was $2,000, and for 2000 was $31,000.

                                       26

<PAGE>


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, 2004,  loans secured
by real estate totaled  $225,358,000,  which  represents 64.8% of the total loan
portfolio.  Real estate construction loans comprised $49,347,000 of that amount,
while real estate loans secured by residential  properties totaled  $52,339,000.
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.

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, 2004 are as follows:

<TABLE>
<CAPTION>

(dollars in thousands)                     2004        2003        2002        2001        2000
------------------------------------------------------------------------------------------------

<S>                                       <C>         <C>         <C>         <C>         <C>
Balance at beginning of year              $2,238      $2,473      $2,109      $2,026      $1,930
Charge-offs:
  Commercial                                 235          17         131         170         554
  Real estate loans                           18         239         461         366          --
  Credit card                                 11           6          16          13           6
  Installment                                 11           3          24          15           8
    Total charge-offs                     $  275      $  265      $  632      $  564      $  568




                                       27

<PAGE>


Recoveries:
  Commercial                              $    7      $    5      $   11      $   54      $   15
  Real estate loans                          123          23          28          12          11
  Credit card                                  1           1           2          --          --
  Installment                                 --           1           1           1           3
    Total recoveries                      $  131      $   30      $   42      $   67      $   29

Net charge-offs (recoveries)                 144         235         590         497         539
Provision for credit losses                  970          --         954         580         635
BNW Bancorp, Inc. acquisition              1,172          --          --          --          --
Balance at end of year                    $4,236      $2,238      $2,473      $2,109      $2,026
Ratio of net charge-offs (recoveries)
  to average loans outstanding               .05%        .12%        .33%        .29%        .33%


</TABLE>

The allowance for credit losses was $4,236,000 at year-end  2004,  compared with
$2,238,000 at year-end  2003, an increase of $1,998,000 or 89.3%.  The aggregate
increase  resulted from the BNW acquisition and a provision of $970,000 in 2004.
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 72.6% increase in commercial  loans,  while real estate  construction
and real estate mortgage loans increased  73.7%.  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, 2004.

Based on the methodology  used for credit loss analysis,  management  deemed the
allowance  for credit  losses of $4,236,000 at December 31, 2004 (1.23% of total
loans outstanding and 832.22% 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:

<TABLE>
<CAPTION>

(dollars in thousands)                           2004         2003        2002       2001     2000
---------------------------------------------------------------------------------------------------
<S>                                             <C>          <C>     <C>           <C>      <C>
Total Impaired Loans                            $7,934       $  588  $    2,314    $ 1,662  $ 3,128
Total Impaired Loans with Valuation Allowance    7,464          123          18      1,180    1,114
Valuation Allowance related to Impaired Loans      200           23           2        143      412

</TABLE>

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.

                                       28

<PAGE>


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.

<TABLE>
<CAPTION>

                                % of            % of            % of            % of             % of
                        2004    Total    2003   Total   2002    Total   2001    Total   2000     Total
(Dollars in thousands) Reserve  Loans  Reserve  Loans  Reserve  Loans  Reserve  Loans  Reserve   Loans
------------------------------------------------------------------------------------------------------
<S>                   <C>         <C>     <C>    <C>    <C>      <C> <C>        <C>   <C>         <C>
Commercial loans      $1,680      32%     764    32%  $  967     37%  $  548    41%   $  689      39%
Real estate loans      2,432      65%   1,399    65%   1,406     60%   1,413    56%    1,256      58%
Consumer loans           124       3%      75     3%     100      3%     148     3%       81       3%

Total allowance       $4,236     100%   2,238   100%  $2,473    100%  $2,109   100%   $2,026     100%


Ratio of allowance for credit
  losses to loans outstanding
  at end of year        1.23%            1.12%          1.33%           1.19%          1.14%

</TABLE>

The table  indicates  an  increase  of  $916,000  in the  allowance  related  to
commercial  loans from  December 31, 2003 to December  31, 2004,  an increase of
$1,033,000  relating to real estate loans, and an increase of $49,000 related to
consumer  loans.  The primary reason for the increases and changes in percentage
allocations  are due to the  acquisition  of BNW and the  resulting  changes  in
portfolio  mix.  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.

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.

                                       29

<PAGE>

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.

<TABLE>
<CAPTION>

(dollars in thousands)              2004     RATE     2003    RATE     2002     RATE
--------------------------------------------------------------------------------------

<S>                              <C>         <C>   <C>        <C>    <C>         <C>
Demand deposits                  $ 66,135    0.00% $ 42,864   0.00%  $ 36,180    0.00%
Interest bearing demand deposits   49,547     .42%   33,251    .42%    29,137     .76%
Savings deposits                  106,299     .87%   78,878    .87%    74,974    1.15%
Time deposits                     112,078    2.20%   86,634   2.42%    79,664    3.35%

     Total                       $334,059    1.39% $241,627   1.20%  $219,955    1.70%

</TABLE>

Maturities  of  time  certificates  of  deposit  as of  December  31,  2004  are
summarized as follows:

                                       Under             Over
(dollars in thousands)               $100,000          $100,000            Total
                                     --------          --------            -----
3 months or less                     $26,928           $30,655           $57,583
Over 3 through 6 months               11,940             8,365            20,305
Over 6 through 12 months               5,185             1,003             6,188
Over 12 months                        13,309            14,971            28,280
     Total                            57,362            54,994           112,356


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 is primarily due to the  non-renewal  of
brokered time deposits  acquired from BNW, as the Company  traditionally has not
sought brokered deposits.


SHORT-TERM BORROWINGS

The following is information  regarding the Company's short-term  borrowings for
the years ended December 31, 2004, 2003 and 2002.

<TABLE>
<CAPTION>

(dollars in thousands)                                      2004       2003       2002
---------------------------------------------------------------------------------------

<S>                                                        <C>          <C>      <C>
Amount outstanding at end of period                        $    --      $--      $1,800
Weighted average interest rate thereon                           0%       0%       1.35%
Maximum amount outstanding at any month end during period  $22,313      $--      $2,790
Average amounts outstanding during the period                7,825       --         174
Weighted average interest rate during period                  1.23%       0%       2.48%

</TABLE>


                                       30

<PAGE>


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, premises
under operating leases and construction  contract to build a branch for the year
ended December 31, 2004.

                                                 Payments due by Period
                                     -------------------------------------------
                                            Less than    1-3     3-5   More than
                                     Total   1 year     years   years   5 years
Contractual obligations
--------------------------------------------------------------------------------
Federal Home Loan Bank borrowings  $21,500   $5,000    $7,000   $9,500     $--
Operating leases                       648       --       462      186      --
Construction contract                1,086       --     1,086       --      --

Total long-term obligations        $23,234   $5,000    $8,548   $9,686     $--


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:

                                                             2004          2003

Commitments to extend credit                                $75,188      $44,044
Standby letters of credit                                     3,997        2,715

KEY FINANCIAL RATIOS

<TABLE>
<CAPTION>

Year ended December 31,                 2004        2003        2002        2001         2000
---------------------------------------------------------------------------------------------

<S>                                     <C>         <C>         <C>         <C>         <C>
Return on average assets                1.41%       1.61%       1.54%       1.55%       1.34%
Return on average equity               14.21%      17.10%      15.81%      15.57%      14.95%
Average equity to average assets ratio  9.91%       9.44%       9.74%       9.96%       8.96%
Dividend payout ratio                     81%         77%         87%         86%         97%

</TABLE>

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

                                       31

<PAGE>


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,  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.

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  $40,154,000 in 2004,  which  includes  $11,282,000 of goodwill
associated with the BNW acquisition.  Shareholders'  equity averaged $26,786,000
in 2003, compared to $24,766,000 in 2002, an increase of 8.2%.

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 years.

The following  table sets forth the minimum  required  capital ratios and actual
ratios for December 31, 2004 and 2003.

                                                                   Capital
                                                                   Adequacy
                                          Actual                   Purposes
(dollars in  thousands)                   Amount     Ratio     Amount     Ratio
--------------------------------------------------------------------------------
December 31, 2004
Tier 1 capital (to average  assets)
     Consolidated                        $32,899      7.83%    $16,790     4.00%
     Bank                                 32,197      7.76%     16.601     4.00%
Tier 1 capital (to risk-weighted  assets)
     Consolidated                         32,899      9.00%     14,636     4.00%
     Bank                                 32,197      8.81%     14,624     4.00%
Total  capital (to  risk-weighted assets)
     Consolidated                         37,135     10.15%     29,273     8.00%
     Bank                                 36,433      9.97%     29,247     8.00%


                                       32

<PAGE>


December 31, 2003
Tier 1 capital (to average assets)
     Consolidated                        $25,190      8.49%    $11,864     4.00%
     Bank                                 24,651      8.31%     11.864     4.00%
Tier 1 capital (to risk-weighted assets)
     Consolidated                         25,190     11.62%      8,675     4.00%
     Bank                                 24,651     11.37%      8,675     4.00%
Total capital (to risk-weighted assets)
     Consolidated                         27,428     12.65%     17,350     8.00%
     Bank                                 26,889     12.40%     17,350     8.00%

OTHER EVENTS

On February 16, 2005, the Board of Directors  approved a two-for-one stock split
for  shareholders  of  record  as of March  15,  2005,  payable  April 4,  2005.
Additionally,  in February 2005 the Company entered into a construction contract
to build a new branch facility in Lynden,  Washington, a town in Whatcom County.
Construction costs are estimated at $1 million.


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 62% 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.

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, 2004.

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, 2004.
Fair values are  estimated in  accordance  with  generally  accepted  accounting
principles as disclosed in the financial statements.


                                       33

<PAGE>


<TABLE>
<CAPTION>


                                              Expected Maturity
Year ended December 31, 2004                                                                           there                 Fair
(dollars in thousands)                       2005         2006        2007       2008        2009      after      Total      Value
------------------------------------------------------------------------------------------------------------------------------------
<S>                                        <C>          <C>         <C>         <C>        <C>        <C>        <C>        <C>
Financial Assets
  Cash and cash equivalents
      Non-interest bearing                 $ 10,213          --          --         --          --         --    $ 10,213   $ 10,213
      Interest bearing deposits in banks   $  5,460          --          --         --          --         --    $  5,460   $  5,460
      Weighted average interest rate           2.14%
  Federal funds sold
      Fixed rate                           $  6,034          --          --         --          --         --    $  6,034   $  6,034
      Weighted average interest rate           2.01%
  Securities available for sale
      Fixed rate                           $  9,329     $ 3,431     $ 3,399     $1,088     $ 4,863    $13,670    $ 35,780   $ 35,780
      Weighted average interest rate           5.82%       4.30%       2.91%      4.06%       4.56%      4.43%
  Securities held to maturity
      Fixed rate                                 --          --     $   619     $1,047     $   420    $ 5,124    $  7,210   $  7,312
      Weighted average interest rate             --          --        2.50%      2.99%       3.45%      3.71%
  Loans receivable
      Fixed rate                           $ 34,904     $ 4,973     $ 6,598     $4,950     $ 8,194    $68,876    $128,495   $131,056
      Weighted average interest rate           6.49%       6.89%       7.17%      6.88%       6.24%      6.92%
      Adjustable rate                      $149,033     $ 4,883     $39,257     $4,917     $15,727    $ 5,447    $219,264   $219,264
      Weighted average interest rate           6.39%       6.03%       6.23%      5.35%       6.38%      5.25%
  Federal Home Loan Bank stock                   --          --          --         --          --    $ 1,850    $  1,850   $  1,850
      Weighted average interest rate                                                                     2.96%


                                              Expected Maturity
Year ended December 31, 2004                                                                           there                  Fair
(dollars in thousands)                        2005        2006        2007       2008        2009      after      Total       Value
------------------------------------------------------------------------------------------------------------------------------------
Financial Liabilities
  Non-interest bearing deposits            $ 10,756     $15,238     $11,429     $8,915     $ 7,132    $18,241    $ 71,711   $ 71,711
  Interest bearing checking accounts       $  8,291     $11,747     $ 8,810     $5,286     $ 4,228    $16,915    $ 55,277   $ 55,277
      Weighted average interest rate            .35%        .35%        .35%       .35%        .35%       .35%
  Money Market accounts                    $ 10,109     $14,321     $10,740     $6,445     $ 5,156    $20,621    $ 67,392   $ 67,392
      Weighted average interest rate           1.67%       1.67%       1.67%      1.67%       1.67%      1.67%
  Savings accounts                         $  8,515     $11,312     $ 8,485     $5,090     $ 4,072    $19,290    $ 56,765   $ 56,765
      Weighted average interest rate            .35%      .35%     .35%    .35%     .35%      .35%
  Certificates of deposit
      Fixed rate                           $ 39,956     $ 9,486     $25,189     $7,550     $ 1,451         --    $ 83,632   $ 83,671
      Weighted average interest rate           1.72%       2.59%       3.47%      3.92%       3.64%
      Variable rate                        $ 24,752       3,972          --         --          --         --    $ 28,724   $ 28,724
      Weighted average interest rate           3.33%       3.23%
  Borrowings
      Fixed rate                           $  5,000     $ 5,000     $ 2,000     $3,500     $ 6,000         --    $ 21,500   $ 21,370
      Weighted average interest rate           3.21%       2.69%       3.57%      2.97%       3.49%
  Secured borrowings                             --          --          --         --          --    $ 3,733    $  3,733   $  3,733
  Weighted average interest rate                                                                         5.86%


</TABLE>

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

                                       34

<PAGE>


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.

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.

Management's  Report on Internal Control Over Financial  Reporting.  Pursuant to
Securities and Exchange  Commission  Release No. 34-50754 (the  "Release"),  the
Company  is not at this time  filing  management's  annual  report  on  internal
control over financial  reporting required by Item 308(a) of Regulation S-K, and
the related  attestation report of the independent  registered public accounting
firm, as required by Item 308(b) of Regulation  S-K. Under the conditions of the
Release,  we have up to 45 additional days beyond the due date of this Form 10-K
(March 16, 2005) for the filing of management's  report on internal control over
financial  reporting  and the  associated  report on the  audit of  management's
assessment of the effectiveness of the Company's internal control over financial
reporting  as of December  31,  2004.  We expect to file our  assessment  of our
internal control and the associated report by our independent  auditors no later
than May 2, 2005.

The  Company's  management  is  responsible  for  establishing  and  maintaining
adequate internal control over financial  reporting,  as that term is defined in
Exchange Act Rules  13a-15(f) and 15d-15(f).  Under the supervision and with the
participation  of the Company's  management,  including the principal  executive
officer  and  principal  financial  officer,  the  Company is in the  process of
conducting an assessment of its internal control over financial  reporting using
the  criteria  set forth by the  Committee of  Sponsoring  Organizations  of the
Treadway Commission in Internal Control--Integrated Framework.

At  this  time,  no  material  weaknesses  in our  internal  control  have  been
identified.  There is no assurance that as a result of the ongoing evaluation of
our internal control over financial reporting,  we will not identify significant
deficiencies  that  either  alone or in  combination  with  others,  amount to a
material weakness in our internal control.

                                       35

<PAGE>


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, 2004 that have materially  affected,
or are reasonable likely to materially  affect,  the Company's  internal control
over financial reporting.

ITEM 9B.  Other Information

None.









                                       36


<PAGE>

                                    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  2005 Proxy  Statement  for its annual  meeting of
shareholders  to be held on April 20,  2005  ("2005  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,  G. Dennis  Archer,
Walter Westling and David Woodland,  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  2005 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.

                                       37

<PAGE>


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  2005 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, 2004.

<TABLE>
<CAPTION>

                                                (a)                      (b)                   (c)
                                       Number of securities        Weighted-average     Number remaining
                                         to be issued upon           exercise price    available for future
                                           exercise of              of outstanding    issuance under equity
                                        outstanding options,        options, warrants     compensation plans
                                        warrants and rights            and rights      (excluding securities
                                                                                      reflected in column (a))
        Plan Category
        -------------
<S>                                            <C>                    <C>                    <C>
Equity compensation plans approved
by security holders:                          619,794(1)               $12.51(1)             449,900(1)

Equity compensation plans not approved
by security holders:                               --                      --                     --
                                              -------                                        -------
Total                                         619,794                                        449,900

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

</TABLE>


ITEM 13.  Certain Relationships and Related Transactions

Information  concerning certain relationships and related transactions requested
by this item is  contained  in the  registrant's  2005  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  accountants  required by this item is
included  under  the  heading   "AUDITORS  -  Fees  Paid  to  Auditors"  in  the
registrant's  2004  Proxy  Statement  and is  incorporated  into this  report by
reference.

                                       38

<PAGE>

                                     Part IV

ITEM 15.  Exhibits and Financial Statement Schedules

     (a) (1)  The following financial statements are filed below:
                   Independent Auditor's Report
                   Consolidated Balance Sheets
                   Consolidated Statements of Income
                   Consolidated Statements of Shareholders' Equity
                   Consolidated Statements of Cash Flows
                   Notes to Consolidated Financial Statements

     (a) (2) Schedules: None

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

                                       39

<PAGE>

McGladrey & Pullen
Certified Public Accountants


            Report of Independent Registered Public Accounting Firm




Board of Directors
Pacific Financial Corporation
Aberdeen, Washington


We  have  audited  the  accompanying  consolidated  balance  sheets  of  PACIFIC
FINANCIAL CORPORATION AND SUBSIDIARY as of December 31, 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,  2004.  These
financial  statements are the  responsibility of the Company's  management.  Our
responsibility  is to express an opinion on these financial  statements based on
our audits.

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

In our opinion, the consolidated  financial statements referred to above present
fairly, in all material  respects,  the financial  position of PACIFIC FINANCIAL
CORPORATION AND SUBSIDIARY as of December 31, 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, 2004, in conformity  with  accounting  principles  generally
accepted in the United States of America.


/s/ McGladrey & Pullen, LLP

Tacoma, Washington
February 9, 2005



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

                                       40

<PAGE>



Consolidated Balance Sheets
--------------------------------------------------------------------------------
(Dollars in Thousands)

Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003

<TABLE>
<CAPTION>
                                                                2004         2003

Assets
<S>                                                          <C>          <C>
   Cash and due from banks                                   $ 10,213     $  9,280
   Interest bearing deposits in banks                           5,460       15,392
   Federal funds sold                                           6,034        5,000
   Securities available for sale                               35,780       57,473
   Securities held to maturity (market value 2004
   - $7,312; and 2003 - $8,097)                                 7,210        7,988
   Federal Home Loan Bank stock, at cost                        1,850          915
   Loans held for sale                                          1,852           --

   Loans                                                      345,907      199,738
   Allowance for credit losses                                  4,236        2,238
   Loans - net                                                341,671      197,500

   Premises and equipment                                       6,833        3,967
   Foreclosed real estate                                          40           98
   Accrued interest receivable                                  1,873        1,275
   Cash surrender value of life insurance                       9,037        6,193
   Goodwill                                                    11,282           --
   Other intangible assets                                        887           --
   Other assets                                                 1,769        1,634

   Total assets                                              $441,791     $306,715


Liabilities and Shareholders' Equity

Liabilities
   Deposits:
     Demand, non-interest bearing                            $ 71,711     $ 43,862
     Savings and interest-bearing demand                      179,434      131,493
     Time, interest-bearing                                   112,356       85,445
   Total deposits                                             363,501      260,800

   Accrued interest payable                                       385          234
   Secured borrowings                                           3,733           --
   Long-term borrowings                                        21,500       14,500
   Other liabilities                                            7,369        5,531

   Total liabilities                                          396,488      281,065

Commitments and Contingencies                                      --           --

Shareholders' Equity
   Common stock (par value $1); authorized:  25,000,000
     shares; issued and outstanding:  2004 - 6,421,396
     shares; 2003 - 5,043,078 shares                            6,421        2,522
   Additional paid-in capital                                  25,003       10,005
   Retained earnings                                           13,746       12,663
   Accumulated other comprehensive income                         133          460
   Total shareholders' equity                                  45,303       25,650

   Total liabilities and shareholders' equity                $441,791     $306,715

</TABLE>

See notes to consolidated financial statements.

                                       41
<PAGE>


Consolidated Statements of Income
--------------------------------------------------------------------------------
(Dollars in Thousands, Except Per Share Amounts)

Pacific Financial Corporation and Subsidiary
Years Ended December 31, 2004, 2003 and 2002

<TABLE>
<CAPTION>

                                                              2004          2003        2002


Interest and Dividend Income
<S>                                                         <C>           <C>          <C>
   Loans                                                    $21,850       $13,350      $13,175
   Federal funds sold and deposits in banks                      44           118          107
   Securities available for sale:
     Taxable                                                  1,318         1,570        1,401
     Tax-exempt                                                 526           484          501
   Securities held to maturity:
     Taxable                                                     97           168          139
     Tax-exempt                                                 243           210          270
   Federal Home Loan Bank stock dividends                        60            49          186
   Total interest and dividend income                        24,138        15,949       15,779

Interest Expense
   Deposits                                                   3,734         2,923        3,747
   Short-term borrowings                                         97            --            4
   Long-term borrowings                                         548           485          240
   Secured borrowings                                           239            --           --
   Total interest expense                                     4,618         3,408        3,991

   Net interest income                                       19,520        12,541       11,788

Provision for Credit Losses                                     970            --          954

   Net interest income after provision for credit losses     18,550        12,541       10,834

Non-Interest Income
   Service charges on deposit accounts                        1,297         1,027        1,069
   Mortgage broker fees                                          12           101            3
   Income from and gains on sale of foreclosed real estate       77           26           292
   Net gains from sales of loans                              1,026            34          --
   Net gains on sales of securities available for sale            3             4          --
   Earnings on bank owned life insurance                        378           328          350
   Other operating income                                       369           326          345
   Total non-interest income                                  3,162         1,846        2,059

Non-Interest Expense
   Salaries and employee benefits                             8,134         4,764        4,196
   Occupancy                                                    763           433          419
   Equipment                                                    825           532          565
   State taxes                                                  306            69          206
   Data processing                                              614           305          268
   Professional services                                        307           137          158
   Other                                                      2,606         1,705        1,602
   Total non-interest expense                                13,555         7,945        7,414

   Income before income taxes                                 8,157         6,442        5,479

Income Taxes                                                  2,450         1,863        1,563

   Net income                                               $ 5,707       $ 4,579      $ 3,916


Earnings Per Share
   Basic                                                    $  0.93       $  0.91      $  0.79
   Diluted                                                     0.91          0.90         0.78

</TABLE>


See notes to consolidated financial statements.

                                       42

<PAGE>


Consolidated Statements of Shareholders' Equity
--------------------------------------------------------------------------------
(Dollars in Thousands)

Pacific Financial Corporation and Subsidiary
Years Ended December 31, 2004, 2003 and 2002
<TABLE>
<CAPTION>

                                                                                           Accumulated
                                      Shares of                Additional                    Other
                                       Common       Common     Paid-in      Retained      Comprehensive
                                        Stock        Stock      Capital     Earnings        Income (Loss)      Total


<S>                                   <C>           <C>         <C>         <C>                 <C>           <C>
Balance at December 31, 2001          4,983,258     $4,983      $ 7,033     $11,090             $408          $23,514

Comprehensive income:
   Net income                                --         --           --       3,916               --            3,916
   Other comprehensive income,
     net of tax:
       Change in fair value of
         securities available for sale       --         --           --          --              309              309
   Comprehensive income                                                                                         4,225

Stock options exercised                  42,000         42          254          --               --              296
Issuance of common stock                     60         --            1          --               --                1
Cash dividends declared
   ($0.68 per share)                         --         --           --      (3,392)              --           (3,392)
Tax benefit from exercise of
   stock options                             --         --           39          --               --               39

   Balance at December 31, 2002       5,025,318      5,025        7,327      11,614              717           24,683

Comprehensive income:
   Net income                                --         --           --       4,579               --            4,579
   Other comprehensive income,
     net of tax:
       Change in fair value of
         securities available for sale       --         --           --          --             (257)            (257)
   Comprehensive income                                                                                         4,322

Stock options exercised                  17,700         18          156          --               --              174
Issuance of common stock                     60         --            1          --               --                1
Cash dividends declared
   ($0.70 per share)                         --         --           --      (3,530)              --           (3,530)

   Balance at December 31, 2003       5,043,078      5,043        7,484      12,663              460           25,650

Comprehensive income:
   Net income                                --         --           --       5,707               --            5,707
   Other comprehensive income,
     net of tax:
       Change in fair value of
         securities available for sale       --         --           --          --             (327)            (327)
   Comprehensive income                                                                                         5,380

Stock options exercised                 106,414        106          676          --               --              782
Issuance of common stock              1,271,904      1,272       16,641          --               --           17,913
Stock compensation expense                   --         --           60          --               --               60
Cash dividends declared
   ($0.72 per share)                         --         --           --      (4,624)              --           (4,624)
Tax benefit from exercise of
   stock options                             --         --          142          --               --              142

   Balance at December 31, 2004       6,421,396     $6,421      $25,003     $13,746             $133          $45,303

See notes to consolidated financial statements.

</TABLE>

                                       43

<PAGE>


Consolidated Statements of Cash Flows
--------------------------------------------------------------------------------
(Dollars in Thousands)

Pacific Financial Corporation and Subsidiary
Years Ended December 31, 2004, 2003 and 2002

<TABLE>
<CAPTION>

                                                                       2004          2003        2002

Cash Flows from Operating Activities
<S>                                                                   <C>         <C>         <C>
   Net income                                                         $ 5,707     $  4,579    $  3,916
   Adjustments to reconcile net income to net cash
     provided by operating activities:
       Depreciation and amortization                                      655          404         433
       Provision for credit losses                                        970          --         954
       Deferred income tax (benefit)                                      (97)        (144)        (82)
       Originations of loans held for sale                            (66,639)         - -        (548)
       Proceeds from sales of loans held for sale                      66,550          286         262
       FHLB Stock dividends received                                      (60)         (49)       (186)
       Gains on sales of loans                                         (1,026)         (34)        --
       Gains on sale of securities available for sale                      (3)          (4)        --
       Gains on sales of foreclosed real estate                           (71)         (10)       (178)
       Loss on sale of premises and equipment                              35           11         --
       Earnings on bank owned life insurance                             (378)        (328)       (350)
       (Increase) decrease in accrued interest receivable                (192)         218         (88)
       increase (decrease) in accrued interest payable                     81          (84)       (123)
       Write-down of foreclosed real estate                                --          173         420
       Other - net                                                        524          (49)        929
   Net cash provided by operating activities                            6,056        4,969       5,359

Cash Flows from Investing Activities
   Net (increase) decrease in interest bearing deposits in banks       10,124      (15,019)      1,095
   Net (increase) decrease in federal funds sold                       (1,034)      (5,000)      3,505
   Activity in securities available for sale:
     Sales                                                             19,055        2,994          --
     Maturities, prepayments and calls                                  9,651       12,343      14,109
     Purchases                                                         (3,090)     (21,275)    (34,338)
   Activity in securities held to maturity:
     Maturities                                                         1,910        3,919       3,481
     Purchases                                                         (1,169)      (1,654)     (8,920)
   Federal Home Loan Bank stock redemption                                 --           --       3,133
   Proceeds from sales of SBA loan pools                                5,735        2,006          --
   Increase in loans made to customers, net of principal collections  (42,313)     (16,709)    (10,046)
   Purchases of premises and equipment                                 (2,379)        (511)       (261)
   Proceeds from sales of premises and equipment                           --            2          --
   Additions to foreclosed real estate                                     --          (21)         --
   Proceeds from sales of foreclosed real estate                          478          734         707
   Purchase of bank owned life insurance                               (2,500)          --          --
   Cash paid for acquisition, net of cash acquired                      3,146           --          --
   Net cash used in investing activities                               (2,386)     (38,191)    (27,535)

</TABLE>

(continued)

See notes to consolidated financial statements.

                                       44

<PAGE>

Consolidated Statements of Cash Flows
--------------------------------------------------------------------------------
(concluded) (Dollars in Thousands)

Pacific Financial Corporation and Subsidiary
Years Ended December 31, 2004, 2003 and 2002

<TABLE>
<CAPTION>

                                                                       2004          2003       2002


Cash Flows from Financing Activities
<S>                                                                   <C>          <C>         <C>
   Net increase in deposits                                           $14,611      $35,546     $10,610
   Net increase (decrease) in short-term borrowings                   (25,333)      (1,800)      1,800
   Net increase in secured borrowings                                   3,733           --          --
   Proceeds from issuance of long-term borrowings                       9,000        3,500      11,000
   Repayments of long-term borrowings                                  (2,000)          --          --
   Common stock issued                                                    782          175         297
   Cash dividends paid                                                 (3,530)      (3,392)     (3,289)
   Net cash provided by (used in) financing activities                 (2,737)      34,029      20,418

   Net change in cash and due from banks                                  933          807      (1,758)

Cash and Due from Banks
   Beginning of year                                                    9,280        8,473      10,231

   End of year                                                        $10,213      $ 9,280     $ 8,473


Supplemental Disclosures of Cash Flow Information
   Interest paid                                                      $ 4,467      $ 3,492     $ 4,114
   Income taxes paid                                                    2,113        2,087       1,260

Supplemental Disclosures of Non-Cash Investing Activities
   Fair value adjustment of securities available for sale, net of tax $  (327)     $  (257)    $   309
   Transfer of loans to foreclosed real estate                            349        1,127       1,198
   Financed sales of foreclosed real estate                                --          839         629
   Common stock issued upon business combination                       17,913           --          --

</TABLE>










See notes to consolidated financial statements.

                                       45

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


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). 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  fifteen  branches  located in Grays  Harbor,  Pacific,
Whatcom and Wahkiakum  Counties in western  Washington  and two loan  production
offices in Burlington,  Washington and 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.

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 foreclosed  real estate
and deferred tax assets.

Certain prior year amounts have been reclassified,  with no change to net income
or  shareholders'  equity,  to  conform  to the 2004  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.



(continued)

                                       46

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


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  aggregate  cost 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

Loans are stated at the amount of unpaid  principal,  reduced by  deferred  loan
fees and an  allowance  for credit  losses.  Interest on loans is accrued  daily
based on the principal amount outstanding.

Generally,   the  accrual  of  interest  on  loans  is  discontinued   when,  in
management's opinion, the borrower may be unable to meet payments as they become
due or when they are past due 90 days as to either principal or interest, unless
they are well secured and in the process of collection. When interest accrual is
discontinued, all unpaid accrued interest is reversed against current income. If
management determines that the ultimate collectibility of principal is in doubt,
cash receipts on nonaccrual loans are applied to reduce the principal balance on
a cash-basis method, until the loans qualify for return to accrual status. Loans
are  returned  to  accrual  status  when  all  principal  and  interest  amounts
contractually  due are  brought  current  and  future  payments  are  reasonably
assured.  The interest on these loans is accounted for on the cash-basis method,
until qualifying for return to accrual.




(continued)

                                       47

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 1 - Summary of Significant Accounting Policies (continued)

Allowance for Credit Losses

The allowance  for credit losses is maintained at a level  sufficient to provide
for probable  credit losses based on evaluating  known and inherent risks in the
loan  portfolio.  The allowance is provided based upon  management's  continuing
analysis of the pertinent factors  underlying the quality of the loan portfolio.
These factors include changes in the size and composition of the loan portfolio,
delinquency levels,  actual loan loss experience,  current economic  conditions,
and detailed analysis of individual loans for which full  collectibility may not
be assured. The detailed analysis includes techniques to estimate the fair value
of loan  collateral  and the  existence  of  potential  alternative  sources  of
repayment.   The  allowance  consists  of  specific,   general  and  unallocated
components.  The  specific  component  relates to loans that are  classified  as
either doubtful,  substandard or special  mention.  For such loans that are also
classified as impaired,  an allowance is established  when the  discounted  cash
flows (or collateral  value or observable  market price) of the impaired loan is
lower  than the  carrying  value of that  loan.  The  general  component  covers
non-classified  loans and is based on historical  loss  experience  adjusted for
qualitative   factors.   An   unallocated   component  is  maintained  to  cover
uncertainties  that could affect  management's  estimate of probable losses. The
unallocated  component  of the  allowance  reflects  the  margin of  imprecision
inherent in the underlying  assumptions used in the methodologies for estimating
specific  and  general  losses  in the  portfolio.  The  appropriateness  of the
allowance  for losses on loans is estimated  based upon these factors and trends
identified by  management  at the time  consolidated  financial  statements  are
prepared.

When available  information confirms that specific loans or portions thereof are
uncollectible,  identified  amounts are charged against the allowance for credit
losses.  The existence of some or all of the following  criteria will  generally
confirm that a loss has been incurred: the loan is significantly  delinquent and
the  borrower  has not  demonstrated  the  ability  or  intent to bring the loan
current;  the Bank has no recourse to the borrower,  or if it does, the borrower
has  insufficient  assets to pay the debt;  the estimated fair value of the loan
collateral is significantly below the current loan balance,  and there is little
or no near-term prospect for improvement.

A loan is considered impaired when it is probable that a creditor will be unable
to collect all amounts (principal and interest) due according to the contractual
terms  of  the  loan  agreement.  Smaller  balance  homogenous  loans,  such  as
residential  mortgage loans and consumer loans, are  collectively  evaluated for
potential loss. When a loan has been identified as being impaired, the amount of
the  impairment is measured by using  discounted  cash flows,  except when, as a
practical expedient, the current fair value of the collateral,  reduced by costs
to sell,  is used.  When the  measurement  of the impaired loan is less than the
recorded investment in the loan including accrued interest and net deferred loan
fees,  an impairment is recognized by creating or adjusting an allocation of the
allowance for credit losses.

A  provision  for credit  losses is charged  against  income and is added to the
allowance  for  credit  losses  based  on  quarterly  assessments  of  the  loan
portfolio.  The  allowance  for  credit  losses is  allocated  to  certain  loan
categories based on the relative risk characteristics, asset classifications and
actual loss experience of the loan portfolio. While management has allocated the
allowance for credit losses to various loan portfolio segments, the allowance is
general in nature and is available for the loan portfolio in its entirety.

The  ultimate  recovery of all loans is  susceptible  to future  market  factors
beyond the Bank's  control.  These  factors  may result in losses or  recoveries
differing  significantly  from  those  provided  in the  consolidated  financial
statements.  In  addition,  regulatory  agencies,  as an integral  part of their
examination process, periodically review the Bank's allowance for credit losses,
and may  require  the Bank to make  additions  to the  allowance  based on their
judgment about information available to them at the time of their examinations.




(continued)

                                       48

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 1 - Summary of Significant Accounting Policies (continued)

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.

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 at the reporting  unit level.  Our impairment
review  process  compares  the fair  value of the  Bank to its  carrying  value,
including  the  goodwill  related  to the Bank.  If the fair value  exceeds  the
carrying  value,  goodwill of the Bank unit is not  considered  impaired  and no
additional  analysis is necessary.  As of December 31, 2004,  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.

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.

(continued)

                                       49

<PAGE>


Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 1 - Summary of Significant Accounting Policies (continued)

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 Bank provides for income taxes  separately and remits to the Company amounts
currently due.

Stock-Based Compensation

At December 31, 2004, the Company has three  stock-based  employee  compensation
plans, which are described more fully in Note 13. 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 account  pronouncements
section which discuss future impacts of new accounting  guidance.  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:


<TABLE>
<CAPTION>
                                                                 2004         2003         2002

<S>                                                             <C>          <C>          <C>
Net income, as reported                                         $5,707       $4,579       $3,916
Add stock compensation expensed                                     36           --          --
Less total stock-based compensation expense determined
   under fair value method for all qualifying awards, net of tax   157           86           93


   Pro forma net income                                         $5,586       $4,493       $3,823

Earnings Per Share
   Basic:
     As reported                                                $ 0.93      $  0.91       $ 0.79
     Pro forma                                                    0.91         0.90         0.77
   Diluted:
     As reported                                                  0.91         0.90         0.78
     Pro forma                                                    0.89         0.88         0.77

</TABLE>



(continued)

                                       50

<PAGE>


Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 1 - Summary of Significant Accounting Policies (continued)

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:

      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 Stock
      The carrying value of Federal Home Loan Bank stock  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 borrowings
      For variable rate secured  borrowings that reprice  frequently and have no
      significant  change in credit  risk,  fair  values  are based on  carrying
      values.

      Long-Term Borrowings
      The fair values of the Company's long-term  borrowings 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)

                                       51

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 1 - Summary of Significant Accounting Policies (continued)

Fair Values of Financial Instruments (concluded)

      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,  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.

All per share amounts and numbers of shares have been retroactively adjusted for
a two-for-one stock split to be paid on April 4, 2005, to shareholders of record
on March 15, 2005.

Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, gains
and losses be  included in net income.  Although  certain  changes in assets and
liabilities,  such as unrealized  gains and losses on  securities  available for
sale,  are  reported  as a  separate  component  of the  equity  section  of the
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.

Recent Accounting Pronouncements

In  December  2003,  the FASB  issued  a  revision  to  Interpretation  No.  46,
"Consolidation  of Variable  Interest  Entities,"  ("FIN 46") which  established
guidance for determining when an entity should consolidated  another entity that
meets the definition of a variable  interest entity.  FIN 46 requires a variable
interest  entity to be  consolidated  by a company if that company will absorb a
majority  of the  expected  losses,  will  receive a  majority  of the  expected
residual return, or both. FASB deferred the effective date of FIN 46 to no later
than the end of the first  reporting  period that ends after March 15, 2004. The
Interpretation  and  the  revision  had no  material  effect  on  the  Company's
consolidated financial statements.

(continued)

                                       52

<PAGE>


Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 1 - Summary of Significant Accounting Policies (continued)

Recent Accounting Pronouncements (continued)

In December  2003,  the Accounting  Standards  Executive  Committee of the AICPA
issued Statement of Position No. 03-3 ("SOP 03-3"), Accounting for Certain Loans
or Debt Securities Acquired in a Transfer. SOP 03-3 addresses the accounting for
differences  between  contractual  cash flows and the cash flows  expected to be
collected  from  purchased  loans or debt  securities if those  differences  are
attributable,  in part, to credit quality.  SOP 03-3 requires purchased loans or
debt  securities  to be  recorded  initially  at fair value based on the present
value of the cash  flows  expected  to be  collected  with no  carryover  of any
valuation allowance previously recognized by the seller.  Interest income should
be recognized  based on the effective  yield from the cash flows  expected to be
collected.  To the extent that the purchased loans or debt securities experience
subsequent  deterioration  in credit  quality,  a valuation  allowance  would be
established  for any additional cash flows that are not expected to be received.
However,  if more cash flows  subsequently  are  expected  to be  received  than
originally  estimated,  the  effective  yield would be adjusted on a prospective
basis.  SOP 03-3 will be effective for loans and debt securities  acquired after
December 31, 2004.  Management does not expect the adoption of this statement 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",
which is an amendment of FASB  Statement Nos. 123 and 95. SFAS No. 123R changes,
among other things, the manner in which share-based compensation,  such as stock
options,  will be accounting  for by both public and non-public  companies,  and
will be effective as of the beginning of the first  interim or annual  reporting
period  that  begins  after June 15,  2005.  For public  companies,  the cost of
employee services received in exchange for equity instruments  including options
and  restricted  stock  awards  generally  will be measured at fair value at the
grant date.  The grant date fair value will be  estimated  using  option-pricing
models adjusted for the unique characteristics of those options and instruments,
unless  observable  market prices for the same or similar options are available.
The cost will be recognized over the requisite service period, often the vesting
period,  and will be  remeasured  subsequently  at each  reporting  date through
settlement date.

The changes in accounting will replace existing requirements under SFAS No. 123,
"Accounting  for  Stock-Based  Compensation,"  and will eliminate the ability to
account  for  share-based  compensation  transactions  using APB Opinion No. 25,
"Accounting for Stock Issued to Employees,"  which does not require companies to
expense  options if the exercise price is equal to the trading price at the date
of grant. The accounting for similar  transactions  involving parties other than
employees or the accounting for employee stock  ownership plans that are subject
to AICPA Statement of Position 93-6,  "Employers'  Accounting for Employee Stock
Ownership Plans," would remain unchanged.

In March 2004,  the  Securities  and Exchange  Commission  ("SEC")  issued Staff
Accounting  Bulletin  ("SAB") No. 105,  Application of Accounting  Principles to
Loan Commitments,  which provides  guidance  regarding loan commitments that are
accounting for as derivative  instruments.  In this SAB, the SEC determined that
an  interest  rate  lock  commitment  should  generally  be  valued  at  zero at
inception.  The rate locks will  continue  to be  adjusted  for changes in value
resulting  form  changes  in  market  interest  rates.  This  SAB did not have a
material effect on the Company's financial position or results of operations.



(continued)

                                      53

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 1 - Summary of Significant Accounting Policies (concluded)

Recent Accounting Pronouncements (concluded)

On September 30, 2004, the Financial  Accounting Standards Board ("FASB") issued
FASB Staff Position ("FSP") Emerging Issues Task Force ("EITF") Issue No. 03-1-1
delaying the effective  date of paragraphs  10-20 of EITF 03-1,  "The Meaning of
Other-Than-Temporary  Impairment and Its  Application  to Certain  Investments",
which provides  guidance for  determining  the meaning of  "other-than-temporary
impaired" and its  application  to certain debt  securities  within the scope of
SFAS  No.  115,   "Accounting  for  Certain   Investments  in  Debt  and  Equity
Securities",  and investments  accounted for under the cost method. The guidance
requires that investments which have declined in value due to credit concerns or
solely due to changes in interest rates must be recorded as other-than-temporary
impaired unless the Company can assert and demonstrate its intention to hold the
security for a period of time  sufficient  to allow for a recovery of fair value
up to or beyond the cost of the investment which might mean maturity.  The delay
of the effective date of EITF 03-1 will be superseded  concurrent with the final
issuance of proposed FSP Issue 03-1-a.  Proposed FSP Issue 03-1-a is intended to
provide  implementation  guidance  with respect to all  securities  analyzed for
impairment under paragraphs 10-20 of EITF 03-1.  Management continues to closely
monitor and  evaluate  how the  provisions  of ETIF 03-1 and  proposed FSP Issue
03-1-a will affect the Company.


Note 2 - Business Combination

On February  27,  2004,  the Company  effected a business  combination  with BNW
Bancorp,  Inc.  Each share of BNW Bancorp,  Inc.  stock was  exchanged  for 0.85
shares of Pacific Financial Corporation's common stock resulting in the issuance
of 1,271,904  new shares.  Total stock and cash  consideration  for BNW Bancorp,
Inc. was $18.2  million.  The  acquisition  was accounted for using the purchase
method of  accounting  and,  accordingly,  the  assets  and  liabilities  of BNW
Bancorp, Inc. 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  $11,282.  As  part  of  the  accounting  for  the
acquisition,  the Company  recorded an  identifiable  intangible  asset.  A core
deposit  intangible  of $993 was  recorded  and is  being  amortized  using  the
straight-line  method  over seven  years.  The  goodwill  is not tax  deductible
because  this was a nontaxable  transaction.  The  purchased  assets and assumed
liabilities were recorded as follows:

Assets
     Cash                                       $  3,465
     Investments                                   5,507
     Premises and equipment                        1,102
     Loans                                       109,635
     Core deposit intangible                         993
     Goodwill                                     11,282
     Other, net                                      850
     Total Assets                               $132,834

Liabilities
     Deposits                                   $ 88,281
     Borrowings                                   25,333
     Other, net                                      988
     Total Liabilities                          $114,602

     Assets acquired less liabilities assumed   $ 18,232
     Stock consideration                          17,913
     Cash consideration                         $    319

(continued)

                                       54

<PAGE>


Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 2 - Business Combination (concluded)

The  following  unaudited  pro forma  financials  for the  twelve  months  ended
December  31,  2004 and 2003  assumes  that the BNW  acquisition  occurred as of
January of each fiscal year, after giving effect to certain adjustments. The pro
forma  results have been  prepared  for  comparative  purposes  only and are not
necessarily  indicative  of the  results  of  operations  which may occur in the
future or that would have occurred had the BNW acquisition  been  consummated on
the date indicated.


                                                  2004        2003

      Net interest income                       $20,404      $17,638
      Non-interest income                         3,275        3,106
      Non-interest expense                       15,120       13,166
      Net income                                $ 5,246      $ 5,009

      Earings per share:
            Basic                               $  0.80      $  0.80
            Diluted                                0.78         0.78


Note 3 - 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,  2004 and 2003  were  approximately  $675 and  $650,
respectively.


Note 4 - Securities

Investment securities have been classified according to management's intent. The
carrying amounts of securities and their approximate fair values are as follows:

<TABLE>
<CAPTION>


                                                                   Gross       Gross
                                                     Amortized   Unrealized  Unrealized   Fair
                                                       Cost        Gains      Losses      Value

Securities Available for Sale

December 31, 2004
<S>                                                   <C>          <C>        <C>       <C>
   U.S. Government agency securities                  $ 4,567       $ 42      $ 65      $ 4,544
   Obligations of states and political subdivisions    12,632        346        36       12,942
   Mortgage-backed securities                          10,270         64       100       10,234
   Corporate bonds                                      4,096         59         7        4,148
   Mutual funds                                         4,014         --       102        3,912

                                                      $35,579       $511      $310      $35,780
</TABLE>







(continued)

                                       55

<PAGE>


Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 4 - Securities (continued)

<TABLE>
<CAPTION>

                                                                   Gross      Gross
                                                     Amortized   Unrealized  Unrealized   Fair
                                                        Cost       Gains      Losses      Value

December 31, 2003
<S>                                                   <C>          <C>        <C>       <C>
   U.S. Government agency securities                  $ 1,738      $  81      $ --      $ 1,819
   Obligations of states and political subdivisions    14,239        600        88       14,751
   Mortgage-backed securities                          16,121        181        91       16,211
   Corporate bonds                                      4,122        122        11        4,233
   Mutual funds                                        20,556         --        97       20,459

                                                      $56,776      $ 984      $287      $57,473

Securities Held to Maturity

December 31, 2004
   State and municipal securities                     $ 5,496      $  84      $ 13      $ 5,567
   Mortgage-backed securities                           1,714         31        --        1,745

                                                      $ 7,210      $ 115      $ 13      $ 7,312

December 31, 2003
   State and municipal securities                     $ 5,044      $  75      $ 20      $ 5,099
   Mortgage-backed securities                           2,944         54        --        2,998

                                                      $ 7,988      $ 129      $ 20      $ 8,097

</TABLE>

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, 2004 and 2003 are summarized as follows:

<TABLE>
<CAPTION>

                                        Less than 12 Months         More than 12 Months         Total

                                       Fair       Unrealized        Fair     Unrealized    Fair    Unrealized
                                       Value         Loss           Value      Loss        Value     Loss
December 31, 2004

Available for Sale
<S>                                   <C>            <C>                        <C>      <C>         <C>
   U.S. Government agency securities  $ 4,081        $ 65         $   --        $--      $ 4,081     $ 65
   Obligations of states and
     political subdivisions             1,952          20          1,104         16        3,056       36
   Mortgage-backed securities           3,808          23          1,390         77        5,198      100
   Corporate bonds                        993           7             --         --          993        7
   Mutual funds                         3,912         102             --         --        3,912      102

   Total                              $14,746        $217         $2,494        $93      $17,240     $310

Held to Maturity
   State and municipal securities     $   338        $  6         $  383        $ 7      $   721     $ 13

</TABLE>


(continued)

                                       56

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 4 - Securities (concluded)

<TABLE>
<CAPTION>

                                        Less than 12 Months         More than 12 Months          Total

                                       Fair       Unrealized        Fair     Unrealized    Fair    Unrealized
                                       Value         Loss           Value      Loss        Value     Loss

December 31, 2003

Available for Sale
<S>                                   <C>            <C>         <C>            <C>      <C>         <C>
   Obligations of states and
     political subdivisions           $ 1,546        $ 88        $    --        $--      $ 1,546     $ 88
   Mortgage-backed securities           3,375          67          2,942         24        6,317       91
   Corporate bonds                      1,094          11             --         --        1,094       11
   Mutual funds                         3,855          44         16,604         53       20,459       97

   Total                              $ 9,870        $210        $19,546        $77      $29,416     $287

Held to Maturity
   State and municipal securities     $   374        $ 16        $   912        $ 4      $ 1,286     $ 20

</TABLE>

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.
Additionally,  the  contractual  cash flows of  mortgage-backed  securities  are
guaranteed by an agency of the U.S. Government.

The  contractual  maturities  of  investment  securities  held to  maturity  and
available for sale at December 31, 2004 are shown below.  Maturities  may differ
from contractual  maturities  because 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.


<TABLE>
<CAPTION>

                                     Held to Maturity           Available for Sale

                                  Amortized       Fair        Amortized     Fair
                                    Cost          Value         Cost        Value

<S>                                <C>           <C>          <C>          <C>
Due in one year or less            $   --        $   --       $ 3,738      $ 3,810
Due from one year to five years     2,371         2,392        11,718       11,833
Due from five to ten years          1,205         1,241         3,213        3,339
Due after ten years                 1,920         1,934         2,626        2,652
Mortgage-backed securities          1,714         1,745        10,270       10,234
Mutual funds                           --            --         4,014        3,912

    Total                          $7,210        $7,312       $35,579      $35,780
</TABLE>

Gross gains  realized on sales of  securities  were $30 and $9 and gross  losses
realized were $27 and $5 in 2004 and 2003, respectively.  There were no sales of
securities in 2002.

Securities carried at approximately  $27,374 at December 31, 2004 and $18,691 at
December  31, 2003 were pledged to secure  public  deposits,  borrowings  at the
Federal Home Loan Bank of Seattle,  for other purposes  required or permitted by
law.

(continued)

                                       57

<PAGE>


Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 5 - Loans

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

<TABLE>
<CAPTION>

                                                               2004         2003

<S>                                              <C>           <C>          <C>
Commercial and agricultural                                  $111,050     $ 64,344
Real estate:
  Construction                                                 49,347       11,894
  Residential 1-4 family                                       43,183       24,418
  Multi-family                                                  9,156        2,197
  Commercial                                                  112,743       85,933
  Farmland                                                     10,929        5,268
Consumer                                                       11,632        5,684
                                                              348,040      199,738
Less unearned income                                             (281)          --

                                                             $347,759     $199,738

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

                                                   2004         2003         2002

Balance at beginning of year                     $2,238        $2,473       $2,109
BNW Bancorp, Inc. acquisition                     1,172            --           --
Provision for credit losses                         970            --          954

Charge-offs                                        (275)         (265)        (632)
Recoveries                                          131            30           42
   Net charge-offs                                 (144)         (235)        (590)

   Balance at end of year                        $4,236        $2,238       $2,473


Following is a summary of information pertaining to impaired loans:

                                                   2004         2003         2002

December 31
   Impaired loans without a valuation allowance    $470        $  342       $2,296
   Impaired loans with a valuation allowance         --           123           18

   Total impaired loans                            $470        $  465       $2,314

   Valuation allowance related to impaired loans   $ --        $   23       $    2

Years Ended December 31
   Average investment in impaired loans            $255        $1,412       $2,390
   Interest income recognized on a cash basis on     16            12           13
     impaired loans

</TABLE>

                                       58

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 5 - Loans

At December 31, 2004,  there were no  commitments  to lend  additional  funds to
borrowers  whose loans have been modified.  There were no loans 90 days and over
past due and still accruing interest at December 31, 2004 and 2003.

Certain  related  parties  of  the  Company,  principally  directors  and  their
affiliates,  were loan customers of the Bank in the ordinary  course of business
during 2004 and 2003.  Total loans  outstanding at December 31, 2004 and 2003 to
key officers and directors  were $9,796 and $6,857,  respectively.  During 2004,
new loans of $17,084 were made, and repayments totaled $14,145.  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, 2004.


Note 6 - Premises and Equipment

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

                                                 2004         2003

Land                                            $2,825       $1,125
Premises                                         5,412        4,309
Equipment, furniture and fixtures                5,668        4,122
                                                13,905        9,556
Less accumulated depreciation and amortization   7,072        5,589

   Total premises and equipment                 $6,833       $3,967

The Bank  leases  premises  under  operating  leases.  Rental  expense of leased
premises was $191,  $7 and $3 for 2004,  2003 and 2002,  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:

   2005                                                        $182
   2006                                                         140
   2007                                                         140
   2008                                                          98
   2009                                                          88

   Total minimum payments required                             $648

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

                                       59

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 7 - Deposits

The composition of deposits at December 31 is as follows:

                                                  2004          2003

Demand deposits, non-interest bearing           $ 71,711     $ 43,862
NOW and money market accounts                    123,042       79,185
Savings deposits                                  56,392       52,308
Time certificates, $100,000 or more               54,994       43,608
Other time certificates                           57,362       41,837

   Total                                        $363,501     $260,800

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

   2005                                                      $ 84,076
   2006                                                        11,551
   2007                                                         7,837
   2008                                                         7,496
   2009                                                         1,396

                                                             $112,356
Note 8 - Borrowings

Long-term  borrowings at December 31, 2004  represent  advances from the Federal
Home Loan Bank of Seattle  bearing  interest  at 1.81% to 4.41% and  maturing in
various years as follows:  2005 - $5,000;  2006 - $5,000;  2007 - $2,000; 2008 -
$3,500;  and 2009 - $6,000. The Bank has pledged $53,156 of securities and loans
as collateral for these borrowings at December 31, 2004.

Secured borrowings at December 31, 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 5.75% to 8.5%. Original maturities range from June 2005 to
November 2018.


Note 9 - Income Taxes

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

                                                2004          2003        2002

Current                                        $2,547        $1,719      $1,645
Deferred (benefit)                                (97)          144         (82)

   Total income taxes                          $2,450        $1,863      $1,563

(continued)

                                       60

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 9 - Income Taxes (concluded)

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

                                                      2004         2003
Deferred Tax Assets
   Allowance for credit losses                       $1,287       $  634
   Deferred compensation                                161          159
   Other                                                 54           12
   Total deferred tax assets                          1,502          805

Deferred Tax Liabilities
   Unrealized gain on securities available for sale  $   68       $  237
   Depreciation                                         202          167
   Deferred revenue                                   1,150          886
   Core deposit intangible                              301           --
   Total deferred tax liabilities                     1,721        1,290

   Net deferred tax liabilities                      $ (219)      $ (485)

Net  deferred  tax  liabilities  are  included  in  other   liabilities  on  the
consolidated balance sheets.

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

<TABLE>
<CAPTION>

                                            2004                2003                   2002

                                                Percent             Percent                 Percent
                                               of Pre-tax          of Pre-tax             of Pre-tax
                                     Amount     Income     Amount    Income      Amount     Income

<S>                                  <C>          <C>     <C>        <C>        <C>         <C>
Income tax at statutory rate         $2,855       35.0%   $2,255     35.0%      $1,918      35.0%
Adjustments resulting from:
   Tax-exempt income                   (276)      (3.4)     (232)    (3.6)        (276)     (5.0)
   Net earnings on life insurance
     policies                          (121)      (1.5)     (103)    (1.6)        (111)     (2.0)
   Other                                 (8)       (.1)      (57)     (.9)          32        .5

   Total income tax expense          $2,450       30.0%   $1,863     28.9%      $1,563      28.5%

</TABLE>



                                       61

<PAGE>


Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


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  $919,  $602,  and  $435 in  2004,  2003  and  2002,
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 $234,
$129 and $126 for 2004, 2003 and 2002, 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 $113, $105 and $110 at December
31, 2004,  2003 and 2002,  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 $2,923 and $2,819 at
December  31,  2004 and 2003,  respectively.  In 2004,  2003 and  2002,  the net
(benefit)/cost recorded from these plans, including the cost of the related life
insurance, was $(322), ($271) and ($315), 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.

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, $6 and $6 in 2004,
2003 and 2002, respectively. Covered employees may also contribute to the plan.





                                       62

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 11 - 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:

                                                            2004          2003

Commitments to extend credit                               $75,188      $44,044
Standby letters of credit                                    3,997        2,715

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
$21,000, none of which was used at December 31, 2004. In addition,  the Bank has
a credit line with the Federal Home Loan Bank of Seattle totaling 20% of assets,
$21,500  of  which  was  used  at  December  31,  2004.   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.

                                       63

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 12 - 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, 2004 the Bank's  loans to  borrowers in the
hotel\motel  industry totaled $36,209 or 10.53% of total loans. The Bank did not
experience  any loan losses to  borrowers in the  hotel/motel  industry in 2004.
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 13 - 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, (449,900 shares are available for grant at December 31, 2004).
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:

                                             2004           2003          2002

Dividend yield                               4.07%          5.31%          5.67%
Expected life                            10 years       10 years      10  years
Risk-free interest rate                      4.71%          4.38%         5.49%
Expected volatility                         16.97%         17.73%        18.99%


The  weighted  average  fair value of options  granted  during 2004 and 2003 was
$2.77 and $1.43, 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)

                                       64

<PAGE>


Notes to Consolidated Financial Statements
------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 13 - Stock Options (concluded)

A summary of the status of the Company's stock option plans as of December 31,
2004, 2003 and 2002, and changes during the years ending on those dates, is
presented below:

<TABLE>
<CAPTION>

                                            2004                   2003                  2002

                                                 Weighted               Weighted              Weighted
                                                 Average                Average               Average
                                                 Exercise               Exercise              Exercise
                                    Shares        Price      Shares      Price     Shares      Price

<S>                                 <C>          <C>        <C>         <C>        <C>        <C>
Outstanding at beginning of year    465,900      $11.63     359,592     $11.13     368,600    $10.60
BNW Bancorp, Inc. acquisition       117,208        5.83         --          --          --        --
Granted                             143,100       17.03    124,008       12.81      47,992     11.67
Exercised                          (106,414)      11.09    (17,700)       9.83     (42,000)     7.05
Forfeited                                --          --         --          --     (15,000)    11.11

   Outstanding at end of year       619,794      $12.51    465,900      $11.63     359,592    $11.13

Exercisable at end of year          257,690      $10.50    153,998      $11.03     106,600    $10.54

The following information summarizes information about stock options outstanding
and exercisable at December 31, 2004:
</TABLE>

<TABLE>
<CAPTION>

                                        Weighted
                                        Average          Weighted                      Weighted
        Range of                        Remaining        Average                       Average
        Exercise            Number      Contractual      Exercise         Number       Exercise
        Prices           Outstanding    Life (Years)      Price        Exercisable      Price

<S>    <C>      <C>         <C>             <C>            <C>            <C>           <C>
       $ 5.88 - $6.18       44,594          6              $ 6.17         44,594        $ 6.17
         7.65               20,000          2                7.65         20,000          7.65
        11.11 - 12.00      297,600          6               11.28        145,596         11.20
        12.50               54,000          8               12.50          3,000         12.50
        13.50               40,500          5               13.50         40,500         13.50
        15.50               20,000          8               15.50          4,000         15.50
        16.05 - 17.50      143,100          9               17.03             --         17.03

                           619,794                                       257,690

</TABLE>

                                       65

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 14 - 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, 2004, 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, 2004, the Company and the
Bank meet all capital requirements to which they are subject.

<TABLE>
<CAPTION>

                                                                                              To be Well Capitalized
                                                                                              Under Prompt
                                                                 Capital Adequacy             Corrective Action
                                               Actual            Purposes                     Provisions
                                               Amount   Ratio    Amount            Ratio      Amount                  Ratio

December 31, 2004
<S>                                            <C>       <C>      <C>               <C>       <C>                      <C>
   Tier 1 capital (to average assets):
     Company                                  $32,899    7.83%   $16,790            4.00%         NA                     NA
     Bank                                      32,197    7.76     16,601            4.00     $20,751                   5.00%
   Tier 1 capital (to risk-weighted assets):
     Company                                   32,899    9.00     14,636            4.00          NA                     NA
     Bank                                      32,197    8.81     14,624            4.00      21,935                   6.00
   Total capital (to risk-weighted assets):
     Company                                   37,135   10.15     29,273            8.00          NA                     NA
     Bank                                      36,433    9.97     29,247            8.00      36,559                  10.00

</TABLE>




(continued)

                                       66

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 14 - Regulatory Matters (concluded)

<TABLE>
<CAPTION>

                                                                                              To be Well Capitalized
                                                                                              Under Prompt
                                                                 Capital Adequacy             Corrective Action
                                               Actual            Purposes                     Provisions
                                               Amount   Ratio    Amount            Ratio      Amount                  Ratio

December 31, 2003
<S>                                            <C>      <C>        <C>              <C>       <C>                      <C>
   Tier 1 capital (to average assets):
     Company                                  $25,190    8.49%   $11,864            4.00%        N/A                    N/A
     Bank                                      24,651    8.31     11,864            4.00     $14,830                   5.00%
   Tier 1 capital (to risk-weighted assets):
     Company                                   25,190   11.62      8,675            4.00         N/A                    N/A
     Bank                                      24,651   11.37      8,675            4.00      13,012                   6.00
   Total capital (to risk-weighted assets):
     Company                                   27,428   12.65     17,350            8.00         N/A                    N/A
     Bank                                      26,889   12.40     17,350            8.00      21,687                  10.00

</TABLE>

Note 15 - Comprehensive Income

Net unrealized gains and losses include,  net of tax, $325 of unrealized  losses
arising  during 2004,  $254 of unrealized  gains arising during 2003 and $309 of
unrealized gains arising during 2002, less  reclassification  adjustments of $3,
$4 and $0 for gains included in net income in 2004, 2003 and 2002, respectively,
as follows:

<TABLE>
<CAPTION>


                                                                    Before-    Tax
                                                                      Tax     Benefit    Net-of-Tax
                                                                     Amount  (Expense)     Amount

<S>                                                                  <C>       <C>         <C>
2004
   Unrealized holding losses arising during the year                 $(492)    $ 167       $(325)
   Reclassification adjustments for gains realized in net income        (3)        1          (2)

   Net unrealized losses                                             $(495)    $ 168       $(327)

2003
   Unrealized holding losses arising during the year                 ($384)    $ 130       $(254)
   Reclassification adjustments for gains realized in net income        (4)        1          (3)

   Net unrealized losses                                             $(388)    $ 131       ($257)

2002
   Unrealized holding losses arising during the year                 $ 467     $(158)      $ 309
   Reclassification adjustments for gains realized in net income        --        --          --

   Net unrealized gains                                              $ 467     $(158)      $ 309

</TABLE>

                                       67

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 16 - Fair Values of Financial Instruments

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

<TABLE>
<CAPTION>

                                                 2004                       2003

                                       Carrying        Fair        Carrying       Fair
                                        Amount         Value        Amount        Value

<S>                                    <C>           <C>           <C>          <C>
Financial Assets
   Cash and due from banks,
     interest-bearing deposits with
     banks, and federal funds sold     $ 21,707      $ 21,707      $ 29,672     $ 29,672
   Securities available for sale         35,780        35,780        57,473       57,473
   Securities held to maturity            7,210         7,312         7,988        8,097
   Federal Home Loan Bank stock           1,850         1,850           915          915
   Loans receivable, net                341,671       344,234       197,500      200,449
   Loans held for sale                    1,852         1,852            --           --
   Accrued interest receivable            1,873         1,873         1,275        1,275

Financial Liabilities
   Deposits                            $363,501      $363,540      $260,800     $261,516
   Long-term borrowings                  21,500        21,370        14,500       14,319
   Secured borrowings                     3,733         3,733            --           --
   Accrued interest payable                 385           385           234          234


</TABLE>

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.







                                       68

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 17 - Earnings Per Share Disclosures

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


                                  Net Income       Shares           Per Share
                                 (Numerator)    (Denominator)        Amount

Year Ended December 31, 2004
   Basic earnings per share:
     Net income                     $5,707        6,140,482           $0.93
   Effect of dilutive securities:
     Options                            --          166,542            (.02)
   Diluted earnings per share:
     Net income                     $5,707        6,307,024           $0.91

Year Ended December 31, 2003
   Basic earnings per share:
     Net income                     $4,579        5,025,688           $0.91
   Effect of dilutive securities:
     Options                            --           94,006            (.01)
   Diluted earnings per share:
     Net income                     $4,579        5,119,694           $0.90

Year Ended December 31, 2002
   Basic earnings per share:
     Net income                     $3,916        4,985,052           $0.79
   Effect of dilutive securities:
     Options                            --           35,738            (.01)
   Diluted earnings per share:
     Net income                     $3,916        5,020,790           $0.78


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.








                                       69

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 18 - Condensed Financial Information - Parent Company Only

Condensed Balance Sheets - December 31


<TABLE>
<CAPTION>

                                                                             2004         2003

<S>                                                          <C>           <C>          <C>
Assets
   Cash                                                                    $ 5,011      $ 3,699
   Investment in the Bank                                                   44,600       25,208
   Due from the Bank                                                           316           89
   Other assets                                                                 --          184
   Total assets                                                            $49,927      $29,180

Liabilities and Shareholders' Equity
   Dividends payable                                                       $ 4,624      $ 3,530
   Shareholders' equity                                                     45,303       25,650

   Total liabilities and shareholders' equity                              $49,927      $29,180


Condensed Statements of Income - Years Ended December 31

                                                               2004          2003         2002

Dividend Income from the Bank                                $ 4,200       $ 3,729      $ 3,200

Expenses                                                        (255)          (96)         (59)

   Income before income tax benefit                            3,945         3,633        3,141

Income Tax Benefit                                                85            30           20

   Income before equity in undistributed income of the Bank    4,030         3,663        3,161


Equity in Undistributed Income of the Bank                     1,677           916          755

   Net income                                                $ 5,707       $ 4,579      $ 3,916

</TABLE>

(continued)


                                       70

<PAGE>

Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 18 - Condensed Financial Information - Parent Company Only (concluded)

Condensed Statements of Cash Flows - Years Ended December 31

<TABLE>
<CAPTION>

                                                               2004          2003         2002

<S>                                                          <C>           <C>          <C>
Operating Activities
   Net income                                                $ 5,707       $ 4,579      $ 3,916
   Adjustments to reconcile net income to
     net cash provided by operating activities:
       Equity in undistributed income of subsidiary           (1,677)         (916)        (755)
       Net change in other assets                               (218)           --           --
       Other - net                                                60          (214)         (19)
   Net cash provided by operating activities                   3,872         3,449        3,142

Investing Activities
   Increase in amounts due from the Bank                          --            --           --

Financing Activities
   Common stock issued                                           782           175          297
   Dividends paid                                             (3,530)       (3,392)      (3,289)
   Other, net                                                    188            --           --
   Net cash used in financing activities                      (2,560)       (3,217)      (2,992)

   Net increase in cash                                        1,312           232          150


Cash
   Beginning of year                                           3,699         3,467        3,317

   End of year                                               $ 5,011       $ 3,699      $ 3,467


</TABLE>






                                       71

<PAGE>


Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 19 - Subsequent Events

In February 2005, the Board of Directors  approved a two-for-one  stock split to
be paid April 4, 2005, to  shareholders  of record on March 15, 2005. The impact
of this event has been retroactively reflected in the accompanying  consolidated
financial  statements  as of December  31, 2001,  which is the  earliest  period
presented.   Additionally,   in  February  2005  the  Company   entered  into  a
construction  contract  to  build  a  branch  facility  in  Lynden,  Washington.
Construction costs are estimated at $1,000,000.


Note 20 - Quarterly Data (Unaudited)

                                    First       Second        Third       Fourth
                                   Quarter      Quarter      Quarter     Quarter

Year Ended December 31, 2004

Interest income                    $4,837       $6,180       $6,251      $6,631
Interest expense                      879        1,077        1,150       1,273
   Net interest income              3,958        5,103        5,101       5,358

Provision for credit losses            70          300          300         300

Non-interest income                   571          903          892         796

Non-interest expenses               2,606        3,599        3,642       3,708

   Income before income taxes       1,853        2,107        2,051       2,146

Income taxes                          479          680          616         675

   Net income                      $1,374       $1,427       $1,435      $1,471

Earnings per common share:
  Basic                            $  .25       $  .23       $  .23      $  .22
  Diluted                             .25          .22          .22         .22









(continued)

                                       72

<PAGE>

--------------------------------------------------------------------------------
Notes to Consolidated Financial Statements


Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003


Note 20 - Quarterly Data (Unaudited) (concluded)

                                    First       Second        Third       Fourth
                                   Quarter      Quarter      Quarter     Quarter

Year Ended December 31, 2003

Interest income                    $3,922       $3,991       $3,982      $4,054
Interest expense                      899          896          824         789
   Net interest income              3,023        3,095        3,158       3,265

Provision for credit losses            --           --           --          --

Non-interest income                   444          457          539         406

Non-interest expenses               1,910        1,931        2,003       2,101

   Income before income taxes       1,557        1,621        1,694       1,570

Income taxes                          445          470          500         448

   Net income                      $1,112       $1,151       $1,194      $1,122

Earnings per common share:
  Basic                            $  .22       $  .23       $  .24      $  .22
  Diluted                             .22          .23          .24         .21


                                       73

<PAGE>


                                   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,
2005.


                                        PACIFIC FINANCIAL CORPORATION
                                             (Registrant)


/s/ Dennis A. Long                      /s/ John Van Dijk
---------------------------------       ------------------------------------
Dennis A. Long, President and CEO       John Van Dijk, CFO and Secretary

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, 2005.

Principal Executive Officer and Director      Principal Financial and Accounting
                                              Officer


/s/ Dennis A. Long                            /s/ John Van Dijk
-----------------------------------           ----------------------------------
Dennis A. Long, President and CEO             John Van Dijk, Treasurer (CFO)
and Director                                  Principal Financial and Accounting
Principal Executive Officer                   Officer

Remaining Directors

/s/ Joseph A. Malik                           /s/ G. Dennis Archer
---------------------------                   ----------------------------------
Joseph A. Malik (Chairman of the Board)       G. Dennis Archer


--------------------------                    ----------------------------------
Gary C. Forcum                                Duane E. Hagstrom


--------------------------                    ----------------------------------
Walter L. Westling                            John Ferlin


/s/ David L. Woodland                         /s/ Robert J. Worrell
--------------------------                    ----------------------------------
David L. Woodland                             Robert J. Worrell


/s/ Susan C. Freese                           /s/ Randy W. Rognlin
--------------------------                    ----------------------------------
Susan C. Freese                               Randy W. Rognlin


/s/ Randy Rust
--------------------------                    ----------------------------------
Randy Rust                                    Edwin Ketel


/s/ Douglas M. Schermer                       /s/ Stewart L. Thomas
--------------------------                    ----------------------------------
Douglas M. Schermer                           Stewart L. Thomas


                                       74

<PAGE>


                                  Exhibit Index

EXHIBIT NO.          EXHIBIT
-----------          -------

2.1                  Agreement  and Plan of Merger  between  the Company and BNW
                     Bancorp, Inc. dated as of October 22, 2003 (1)
3.1                  Restated Articles of Incorporation (2)
3.2                  Bylaws (3)
10                   Executive  Compensation  Plans and  Arrangements  and Other
                     Management Contracts
10.1                 Employment  Agreement with Dennis A. Long dated January 27,
                     2004 (4)
10.2                 Employment  Agreement  with John Van Dijk dated  January 2,
                     2003 (5)
10.3                 Employment   Agreement  with  Bruce  D.  MacNaughton  dated
                     January 2, 2003 (5)
10.4                 Bank of the Pacific Incentive Stock Option Plan (6)
10.5                 The Bank of Grays Harbor Incentive Stock Option Plan (6)
10.6                 2000 Stock Incentive Compensation Plan (7)
10.7                 Bonus Program for Officers (7)
10.8                 The Bank of Grays  Harbor  Employee  Deferred  Compensation
                     Plan (8)
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 (9)

(1) Incorporated by reference to Exhibit 99.1 to the Company's current report on
Form 8-K dated October 22, 2003.

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

(3) 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)

(4) Incorporated by reference to Exhibit 10.1  to the Company's Annual Report on
Form 10-K for the year ended December 31, 2003.

(5) Incorporated by reference to Exhibits 10.2, and 10.3 to the Company's Annual
Report on Form 10-K for the year ended December 31, 2002.

(6)  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.

(7) 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.


<PAGE>


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

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