**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 Year ended
              December
                31, 2005




OR




o
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934 For the transition
              period
                from ________to _________




Commission
      file number 0-25020





**Heritage
      Oaks Bancorp**


(Exact
      name of registrant as specified in its charter)





State
                of California
            77-0388249(State
                or other jurisdiction of
            (I.R.S.
                Identification No.)employee
                incorporation or organization)545
                12th Street, Paso Robles, California 93446
            (805)
                239-5200(Address
                of principal executive offices) (Zip Code)
            (Registrant’s
                telephonenumber,
                including area code)Securities
                registered pursuant to Section 12(b) of the Act: NoneSecurities
                registered pursuant to Section 12(g) of the Act:Title
                of each class
            Name
                of each exchange on which registeredCommon
                Stock, (no par value)
            NASDAQ
                Capital Market





Indicate
      by check mark if the registrant is a well-known, seasoned issuer as defined
      in
      Rule 405 of the Securities Act. Yes o No x





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Act. Yes o No x





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





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 o.





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer or is a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (check
      one.)


Large
      Accelerated filer o Accelerated
      filer o Non-accelerated filer x.





Indicate
      by check mark whether the the registrant is a shell company (as defined in
      Rule
      12b-2 of the Act)


Yes
o
      No x





The
      aggregate market value of the voting and non-voting common equity held by
      non-affiliates of the Registrant at June 30, 2005 was $66.9 million. As of
      February 1, 2006, the Registrant had 6,234,780 shares of Common Stock
      outstanding.





**DOCUMENTS
      INCORPORATED BY REFERENCE**





The
      information required in Part III, Items 10 through 14 are incorporated by
      reference to the registrant’s definitive proxy statement for the 2006 annual
      meeting of shareholders.









**TABLE
      OF CONTENTS**





PART
                IItem
                1.
            Business.
            3Item
                1A.
            Risk
                Factors.
            12Item
                1B.
            Unresolved
                Staff Comments.
            17Item
                2.
            Properties.
            17Item
                3.
            Legal
                Proceedings.
            18Item
                4.
            Submission
                of Matters to a Vote of Security Holders.
            18PART
                IIItem
                5.
            Market
                for Registrant’s Common Equity, Related Stockholder Matters and Issuer
                Purchases of Equity Securities.
            19Item
                6.
            Selected
                Financial Data.
            22Item
                7.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations.
            22Item
                7A.
            Quantitative
                and Qualitative Disclosures about Market Risk.
            42Item
                8.
            Financial
                Statements and Supplementary Data.
            44Item
                9.
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosure.
            77Item
                9A.
            Controls
                and Procedures.
            77Item
                9B.
            Other
                Information.
            77PART
                IIIItem
                10.
            Directors
                and Executive Officers of the Registrant.
            78Item
                11.
            Executive
                Compensation.
            78Item
                12.
            Security
                Ownership of Certain Beneficial Owners and Management and Related
            78Stockholder
                Matters.Item
                13.
            Certain
                Relationships and Related Transactions.
            78Item
                14.
            Principal
                Accounting Fees and Services.
            78PART
                IVItem
                15.
            Exhibits
                and Financial Statement Schedules.
            79Signatures
            
            83




2





**PART
      I**





**Certain
      statements contained in this Annual Report on Form 10-K (“Annual Report”),
      including, without limitation, statements containing the words “believes”,
“anticipates”, “intends”, “expects”, and words of similar impact, constitute
“forward-looking statements” within the meaning of Section 27A of the Securities
      Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. Such
      forward-looking statements involve known and unknown risks, uncertainties and
      other factors that may cause the actual results, performance or achievements
      of
      the Company to be materially different from any future results, performance
      or
      achievements expressed or implied by such forward-looking statements. Such
      factors include, among others, the following: general economic and business
      conditions in those areas in which the Company operates, demographic changes,
      competition, fluctuations in interest rates, changes in business strategy or
      development plans, changes in governmental regulation, credit quality, the
      availability of capital to fund the expansion of the Company’s business,
      economic, political and global changes arising from the war on terrorism and
      other factors referenced in this report, including in “Item 1A. Risk Factors”
The Company disclaims any obligation to update any such factors or to publicly
      announce the results of any revisions to any of the forward-looking statements
      contained herein to reflect future events or developments.**





**ITEM
      1. DESCRIPTION OF BUSINESS.**





**General**





Heritage
      Oaks Bancorp (the "Company", “we” or “our”) is a California corporation
      organized in 1994 to act as a holding company of Heritage Oaks Bank (the
“Bank"). In 1994, the Company acquired all of the outstanding common stock of
      the Bank in a holding company formation transaction.





In
      April
      2002, the Company formed Heritage Oaks Capital Trust I (the “Trust”). The Trust
      is a statutory business trust formed under the laws of the State of Delaware.
      The Trust is a wholly-owned, non-financial, non-consolidated subsidiary of
      the
      Company.





Other
      than holding the shares of the Bank, the Company conducts no significant
      activities, although it is authorized, with the prior approval of the Board
      of
      Governors of the Federal Reserve System (the "Federal Reserve Board"), the
      Company's principal regulator, to engage in a variety of activities which are
      deemed closely related to the business of banking. The Company has also
      incorporated a subsidiary, CCMS Systems, Inc. which is currently inactive and
      has not been capitalized. The Company has no present plans to activate the
      proposed subsidiary.





**Banking
      Services**





The
      Bank
      was licensed by the California Department of Financial Institutions (“DFI”) and
      commenced operation in January 1983. As a California state bank, the Bank is
      subject to primary supervision, examination and regulation by the DFI and the
      Federal Deposit Insurance Corporation (“FDIC”). The Bank is also subject to
      certain other federal laws and regulations. The deposits of the Bank are insured
      by the FDIC up to the applicable limits thereof.





At
      December 31, 2005, the Company had approximately $489 million in consolidated
      assets, $363 million in net consolidated loans, $418 million in consolidated
      deposits, and $45 million in stockholders' equity.





The
      Bank
      is headquartered in Paso Robles, California with a branch office in Paso Robles,
      two branches in San Luis Obispo, one branch office in Cambria, one branch office
      in Arroyo Grande, three branch offices in Santa Maria, one branch office in
      Atascadero and one branch office in Morro Bay. The Bank conducts a commercial
      banking business in San Luis Obispo County and Northern Santa Barbara County,
      including accepting demand, savings and time deposits, and making commercial,
      real estate, SBA, agricultural, credit card, and consumer loans. It also offers
      installment note collection, issues cashier’s checks and money orders, sells
      travelers checks, and provides bank-by-mail, night depository, safe deposit
      boxes, and other customary banking services. The Bank does not offer trust
      services or international banking services and does not plan to do so in the
      near future.


3





The
      Bank’s operating policies since inception have emphasized small business,
      commercial and retail banking. Most of the Bank’s customers are retail
      customers, farmers and small to medium-sized businesses. The Bank takes real
      estate, listed and unlisted securities, savings and time deposits, automobiles,
      machinery and equipment as collateral for loans. The areas in which the Bank
      has
      directed virtually all of its lending activities are (i) commercial and
      agricultural loans, (ii) installment loans, (iii) construction loans, and (iv)
      other real estate loans or commercial loans secured by real estate. As of
      December 31, 2005, these four categories accounted for approximately 16.3%,
      1.5%, 20.9% and 61.2% respectively, of the Bank’s loan portfolio. As of December
      31, 2005, $302.1 million or 82.1% of the Bank’s $362.6 million in gross loans
      consisted of interim construction and other real estate secured loans, primarily
      for single family residences or for commercial development. Commercial and
      agricultural loans increased $10.5 million or 21.1% and other real estate loans
      or commercial loans secured by real estate increased $7.6 million or 3.4%
      between year-end 2004 and year-end 2005. See “Item 7. - Management’s Discussion
      and Analysis of Financial Condition and Results of Operations.”





Most
      of
      the Bank’s deposits are attracted by local promotional activities and
      advertising in the local media. A material portion of the Bank’s deposits have
      not been obtained from a single person or a few persons, the loss of any one
      or
      more of which would have a materially adverse effect on the business of the
      Bank. Management considers two account relationships with customers engaged
      in
      mortgage related businesses to be volatile deposit relationships. These deposit
      accounts, which are closely monitored by bank management, had combined balances
      of $65.6 million or 15.7% of total deposits at December 31, 2005 compared to
      $50.3 million or 13.6% of total deposits at December 31, 2004. Management and
      the Board of Directors of the Bank are aware that should mortgage market
      conditions change, these relationships may be impacted. As of December 31,
      2005,
      the Bank had approximately 21,858 deposit accounts consisting of non-interest
      bearing (“demand”), interest-bearing demand and money market accounts with
      balances totaling $305.4 million for an average balance per account of
      approximately $14.0 thousand; 8,502 savings accounts with balances totaling
      $29.4 million for an average balance per account of approximately $3.5 thousand;
      and 2,625 time certificate of deposit accounts with balances totaling $83.7
      million, for an average balance per account of approximately $31.9 thousand.





The
      principal sources of the Company’s consolidated revenues are (i) interest and
      fees on loans, (ii) interest on investments, (iii) service charges on deposit
      accounts and other charges and fees, (iv) mortgage origination fees and (v)
      miscellaneous income. For the year ended December 31, 2005, these sources
      comprised 77.9%, 7.9%, 6.9%, 2.6% and 4.7%, respectively, of the Company’s total
      operating income.





The
      Company has not engaged in any material research activities relating to the
      development of new services or the improvement of existing bank services, except
      as otherwise discussed herein. There has been no significant change in the
      types
      of services offered by the Bank since its inception. The Company has no present
      plans regarding "a new line of business" requiring the investment of a material
      amount of total assets. Most of the Company’s business originates from San Luis
      Obispo and Northern Santa Barbara Counties and there is no emphasis on foreign
      sources and application of funds. The Company’s business, based upon performance
      to date, does not appear to be seasonal. Management of the Company is unaware
      of
      any material effect upon the Company’s capital expenditures, earnings or
      competitive position as a result of federal, state or local environmental
      regulations.





The
      Bank
      holds service marks issued by the U.S. Patent and Trademark Office for the
      “Acorn” design, the “Oakley” design and “Deeply Rooted in Your
      Hometown”:





**Employees**





As
      of
      February 1, 2006, the Bank had 190 full-time equivalent employees. The Company
      has only two salaried employees. The Bank believes that its employee relations
      are positive.





**Local
      Economic Climate**




The
      economy in the Company’s service area is based primarily on agriculture,
      tourism, light industry, oil and retail trade. Services supporting these
      industries have also developed in the areas of medical, financial and
      educational services. The population of San Luis Obispo County and the City
      of
      Santa Maria (in Northern Santa Barbara County) totaled 260,000 and 92,000,
      respectively, according to economic data provided by local county and title
      company sources. The moderate climate allows a year round growing season for
      numerous vegetable and fruits. Vineyards and cattle ranches also contribute
      largely to the local economy. The Central Coast’s leading agricultural industry
      is the production of high quality wine grapes and production of premium quality
      wines. Vineyards in production have grown significantly over the past several
      years throughout the Company’s service area. Access to numerous recreational
      activities, including lakes, mountains and beaches, provide a relatively stable
      tourist industry from many areas including the Los Angeles/Orange County basin,
      the San Francisco Bay area and the San Joaquin Valley. Principally due to the
      diversity of the various industries in the Company’s service area, the area,
      while not immune from economic fluctuations, does tend to enjoy a more stable
      level of economic activity than many other areas of California.


4





**Competition**




Banking
      and the financial services business in California generally, and in the
      Company’s service area specifically, is highly competitive. The increasingly
      competitive environment is a result primarily of changes in regulation, changes
      in technology and product delivery systems, and the accelerating pace of
      consolidation among financial services providers and the appearance of new
      banking organizations. The flattening yield curve environment of 2005 further
      drove competition as borrowers have expanded choices of maturities within
      attractive ranges of offered interest rates resulting in various borrower
      strategies based upon interest rate expectations including choosing longer
      term
      fixed rate loans over variable Prime-based loans.





In
      order
      to compete with other financial institutions in its service area, the Bank
      relies principally upon local advertising programs; direct personal contact
      by
      officers, directors, employees, and shareholders; and specialized services
      such
      as courier pick-up and delivery of non-cash banking items. The Bank emphasizes
      to customers the advantages of dealing with a locally owned and community
      oriented institution. The Bank also seeks to provide special services and
      programs for individuals in its primary service area who are employed in the
      agricultural, professional and business fields, such as loans for equipment,
      furniture, tools of the trade or expansion of practices or businesses. Larger
      banks may have a competitive advantage because of higher lending limits and
      major advertising and marketing campaigns. They also perform services, such
      as
      trust services, international banking, discount brokerage and insurance services
      that the Bank is not authorized or prepared to offer currently. The Bank has
      made arrangements with correspondent banks and with others to provide such
      services for its customers. For borrowers requiring loans in excess of the
      Bank’s legal lending limits, the Bank has offered, and intends to offer in the
      future, such loans on a participating basis with correspondent banks and with
      other independent banks, retaining the portion of such loans which is within
      its
      lending limit. As of December 31, 2005, the Bank’s legal lending limits to a
      single borrower and such borrower's related parties was approximately $8.1
      million on an unsecured basis and approximately $13.6 million on a fully secured
      basis. These calculations are based on regulatory capital plus reserves of
      $54.2
      million for the Bank.





Commercial
      banks compete with savings and loan associations, credit unions, other financial
      institutions, securities brokerage firms, and other entities for funds. For
      instance, yields on corporate and government debt securities and other
      commercial paper affect the ability of commercial banks to attract and hold
      deposits. Commercial banks also compete for loans with savings and loan
      associations, credit unions, consumer finance companies, mortgage companies
      and
      other lending institutions.




The
      financial services industry is undergoing rapid technological changes involving
      frequent introductions of new technology-driven products and services that
      have
      further increased competition. There can also be no assurance that these
      technological improvements, if made, will increase the Company’s operational
      efficiency or that the Company will be able to effectively implement new
      technology-driven products and services or be successful in marketing these
      products and services to our customers.




**Effect
      of Government Policies and Recent Legislation**




Banking
      is a business that depends on rate differentials. In general, the difference
      between the interest rate paid by the Company on deposits and other borrowings
      and the interest rate received by the Company on loans extended to its customers
      and securities held in the portfolio comprise the major portion of the Company’s
      earnings. These rates are highly sensitive to many factors that are beyond
      the
      control of the Company. Accordingly, the earnings and growth of the Company
      are
      subject to the influence of domestic and foreign economic conditions, including
      inflation, recession and unemployment.





The
      commercial banking business is not only affected by general economic conditions
      but is also influenced by the monetary and fiscal policies of the federal
      government and the policies of regulatory agencies, particularly the Federal
      Reserve Board. The Federal Reserve Board implements national monetary policies
      (with objectives such as curbing inflation and combating recession) by its
      open-market operations in United States Government securities, by adjusting
      the
      required level of reserves for financial institutions subject to its reserve
      requirements and by varying the discount rates applicable to borrowings by
      depository institutions. The actions of the Federal Reserve Board in these
      areas
      influence the growth of bank loans, investments and deposits and also affect
      interest rates charged on loans and paid on deposits. The nature and impact
      on
      the Company of any future changes in monetary policies cannot be predicted.





From
      time
      to time, legislation is enacted which has the effect of increasing the cost
      of
      doing business, limiting or expanding permissible activities or affecting the
      competitive balance between banks and other financial institutions. Proposals
      to
      change the laws and regulations governing the operations and taxation of banks,
      bank holding companies and other financial institutions are frequently made
      in
      Congress, in the California legislature and before various bank regulatory
      and
      other professional agencies. See “Supervision and Regulation-Financial Services
      Modernization Legislation and Sarbanes - Oxley Act of 2002”.




5


**Supervision
      and Regulation**




General




The
      Company and the Bank are extensively regulated under both federal and state
      law.
      Set forth below is a summary description of certain laws that relate to the
      regulation of the Company and the Bank. The description does not purport to
      be
      complete and is qualified in its entirety by reference to the applicable laws
      and regulations.





The
      Company




The
      Company is a bank holding company within the meaning of the Bank Holding Company
      Act of 1956, as amended (the "Bank Holding Company Act"), and is registered
      as
      such with, and subject to the supervision of, the Federal Reserve Board. The
      Company is required to file with the Federal Reserve Board quarterly and annual
      reports and such additional information as the Federal Reserve Board may require
      pursuant to the Bank Holding Company Act. The Federal Reserve Board may conduct
      examinations of bank holding companies and their subsidiaries.





The
      Company is required to obtain the approval of the Federal Reserve Board before
      it may acquire all or substantially all of the assets of any bank, or ownership
      or control of the voting shares of any bank if, after giving effect to such
      acquisition of shares, the Company would own or control more than 5% of the
      voting shares of such bank. Prior approval of the Federal Reserve Board is
      also
      required for the merger or consolidation of the Company and another bank holding
      company.





The
      Company is prohibited by the Bank Holding Company Act, except in certain
      statutorily prescribed instances, from acquiring direct or indirect ownership
      or
      control of more than 5% of the outstanding voting shares of any company that
      is
      not a bank or bank holding company and from engaging, directly or indirectly,
      in
      activities other than those of banking, managing or controlling banks or
      furnishing services to its subsidiaries. However, the Company may, subject
      to
      the prior approval of the Federal Reserve Board, engage in any, or acquire
      shares of companies engaged in, activities that are deemed by the Federal
      Reserve Board to be so closely related to banking or managing or controlling
      banks as to be a proper incident thereto. See discussion under "Financial
      Modernization Act" below for additional information.





The
      Federal Reserve Board may require that the Company terminate an activity or
      terminate control of or liquidate or divest subsidiaries or affiliates when
      the
      Federal Reserve Board determines that the activity or the control or the
      subsidiary or affiliates constitutes a significant risk to the financial safety,
      soundness or stability of any of its banking subsidiaries. The Federal Reserve
      Board also has the authority to regulate provisions of certain bank holding
      company debt, including authority to impose interest ceilings and reserve
      requirements on such debt. Under certain circumstances, the Company must file
      written notice and obtain approval from the Federal Reserve Board prior to
      purchasing or redeeming its equity securities.





Under
      the
      Federal Reserve Board's regulations, a bank holding company is required to
      serve
      as a source of financial and managerial strength to its subsidiary banks and
      may
      not conduct its operations in an unsafe and unsound manner. In addition, it
      is
      the Federal Reserve Board's policy that in serving as a source of strength
      to
      its subsidiary banks, a bank holding company should stand ready to use available
      resources to provide adequate capital funds to its subsidiary banks during
      periods of financial stress or adversity and should maintain the financial
      flexibility and capital-raising capacity to obtain additional resources for
      assisting its subsidiary banks. A bank holding company's failure to meet its
      obligations to serve as a source of strength to its subsidiary banks will
      generally be considered by the Federal Reserve Board to be an unsafe and unsound
      banking practice or a violation of the Federal Reserve Board's regulations
      or
      both.





The
      Company and the Bank are prohibited from engaging 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 us or (2) an agreement by the customer to refrain from obtaining other
      services from a competitor.


6




The
      Company is subject to the periodic reporting requirements of the Securities
      Exchange Act of 1934, as amended, and files reports and proxy statements
      pursuant to such Act with the Securities and Exchange Commission (the
“SEC”).





The
      Bank




The
      Bank
      is chartered under the laws of the State of California and its deposits are
      insured by the FDIC to the extent provided by law. The Bank is subject to the
      supervision of, and is regularly examined by, the DFI and the FDIC. For the
      Bank, such supervision and regulation includes comprehensive reviews of all
      major aspects of the Bank’s business and condition. Various requirements and
      restrictions under the laws of the United States and the State of California
      affect the operations of the Bank. Federal and California statutes relate to
      many aspects of the Bank’s operations, including reserves against deposits,
      interest rates payable on deposits, loans, investments, mergers and
      acquisitions, borrowings, dividends and locations of branch offices. Further,
      the Bank is required to maintain certain levels of capital.





If,
      as a
      result of an examination of a bank, the FDIC or the DFI should determine that
      the financial condition, capital resources, asset quality, earnings prospects,
      management, liquidity, or other aspects of a bank’s operations are
      unsatisfactory or that a bank or its respective management is violating or
      has
      violated any law or regulation, various remedies are available to these
      regulatory agencies. Such remedies include the power to enjoin "unsafe or
      unsound" practices, to require affirmative action to correct any conditions
      resulting from any violation or practice, to issue an administrative order
      that
      can be judicially enforced, to direct an increase in capital, to restrict
      growth, to assess civil monetary penalties, to remove officers and directors,
      and ultimately to terminate deposit insurance, which for a California chartered
      bank would result in a revocation of the bank’s charter.





Capital
      Standards




The
      Federal Reserve Board and the FDIC have adopted risk-based minimum capital
      guidelines intended to provide a measure of capital that reflects the degree
      of
      risk associated with a banking organization's operations for both transactions
      reported on the balance sheet as assets and transactions, such as letters of
      credit and recourse arrangements, which are recorded as off balance sheet items.
      Under these guidelines, nominal dollar amounts of assets and credit equivalent
      amounts of off balance sheet items are multiplied by one of several risk
      adjustment percentages, which range from 0% for assets with low credit risk,
      such as certain U.S. Treasury securities, to 100% for assets with relatively
      high credit risk, such as business loans.





A
      banking
      organization's risk-based capital ratios are obtained by dividing its qualifying
      capital by its total risk adjusted assets. The regulators measure risk-adjusted
      assets, which includes off balance sheet items, against both total qualifying
      capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and
      Tier 1 capital. Tier 1 capital consists primarily of common stock, retained
      earnings, non-cumulative perpetual preferred stock (cumulative perpetual
      preferred stock for bank holding companies) and minority interests in certain
      subsidiaries, less most intangible assets. Tier 2 capital may consist of a
      limited amount of the allowance for possible loan and lease losses, cumulative
      preferred stock, long term preferred stock, eligible term subordinated debt
      and
      certain other instruments with some characteristics of equity. The inclusion
      of
      elements of Tier 2 capital is subject to certain other requirements and
      limitations of the federal banking agencies. The federal banking agencies
      require a minimum ratio of qualifying total capital to risk-adjusted assets
      of
      8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%.





In
      addition to the risked-based guidelines, federal banking regulators require
      banking organizations to maintain a minimum amount of Tier 1 capital to total
      assets, referred to as the leverage ratio. For a banking organization rated
      in
      the highest of the five categories used by regulators to rate banking
      organizations, the minimum leverage ratio of Tier 1 capital to total assets
      is
      3%. For all banking organizations not rated in the highest category, the minimum
      leverage ratio must be at least 4%. In addition to these uniform risk-based
      capital guidelines and leverage ratios that apply across the industry, the
      regulators have the discretion to set individual minimum capital requirements
      for specific institutions at rates significantly above the minimum guidelines
      and ratios. Future changes in regulations or practices could further reduce
      the
      amount of capital recognized for purposes of capital adequacy. Such a change
      could affect the ability of the Company to grow and could restrict the amount
      of
      profits, if any, available for the payment of dividends.





The
      following table presents the amount of the capital ratios for the Company and
      the Bank and the minimum regulatory capital requirements as of December 31,
      2005:


7




Minimum
                Regulatory
              Capital
                Requirements
            
            Heritage
              Oaks
                Bancorp
            
            Heritage
              Oaks
                BankLeverage
                Ratio
            
            4.00%
            
            9.61%
            
            9.11%Tier
                I Risk Weighted
            
            4.00%
            
            10.98%
            
            10.38%Total
                Risk Based
            
            8.00%
            
            11.93%
            
            11.33%




Under
      applicable regulatory guidelines, the Bank was considered "Well Capitalized"
      at
      December 31, 2005.





Under
      applicable regulatory guidelines, the Company’s trust preferred securities
      issued by our subsidiary capital trust qualify as Tier 1 capital up to a maximum
      limit of 25% of Tier 1 capital. Any additional portion of the trust preferred
      securities would qualify as Tier II capital. As of December 31, 2005, the
      subsidiary trust had $8 million in trust preferred securities outstanding,
      of
      which $8 million qualify as Tier 1 capital.





In
      addition, the DFI has authority to take possession of the business and
      properties of a bank in the event that the tangible shareholders' equity of
      a
      Bank is less than the greater of (i) 4% of the banks total assets or (ii)
      $1,000,000.




Prompt
      Corrective Action and Other Enforcement Mechanisms




Federal
      banking agencies possess broad powers to take corrective and other supervisory
      action to resolve the problems of insured depository institutions, including
      but
      not limited to those institutions that fall below one or more prescribed minimum
      capital ratios described above. An institution that, based upon its capital
      levels, is classified as well capitalized, adequately capitalized, or
      undercapitalized may be treated as though it were in the next lower capital
      category if the appropriate federal banking agency, after notice and opportunity
      for hearing, determines that an unsafe or unsound condition or an unsafe or
      unsound practice warrants such treatment. At each successive lower capital
      category, an insured depository institution is subject to more restrictions.
      The
      federal banking agencies, however, may not treat a significantly
      undercapitalized institution as critically undercapitalized unless its capital
      ratio actually warrants such treatment.





In
      addition to measures taken under the prompt corrective action provisions,
      commercial banking organizations may be subject to potential enforcement actions
      by the federal regulators for unsafe or unsound practices in conducting their
      businesses or for violations of any law, rule, regulation, or any condition
      imposed in writing by the agency or any written agreement with the agency.
      Enforcement actions may include:




·
            the
                imposition of a conservator or receiver or the issuance of a
                cease-and-desist order that can be judicially
                enforced;


·
            the
                termination of insurance of deposits (in the case of a depository
                institution);


·
            the
                imposition of civil money
                penalties;


·
            the
                issuance of directives to increase
                capital;


·
            the
                issuance of formal and informal
                agreements;


·
            the
                issuance of removal and prohibition orders against institution-affiliated
                parties; and,


·
            the
                enforcement of such actions through injunctions or restraining orders
                based upon a judicial determination that the agency would be harmed
                if
                such equitable relief was not
                granted.




Additionally,
      a holding company's inability to serve as a source of strength to its subsidiary
      banking organizations could serve as an additional basis for a regulatory action
      against the holding company.




Banks
      are
      also subject to certain Federal Reserve Board restrictions on extensions of
      credit to executive officers, directors, principal shareholders or any related
      interests of such persons (i.e., insiders). Extensions of credit (1) must be
      made on substantially the same terms and pursuant to the same credit
      underwriting procedures as those for comparable transactions with persons who
      are neither insiders nor employees, and (2) 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 insiders.
      A
      violation of these restrictions may result in regulatory sanctions on the bank
      or its insiders.


8




Safety
      and Soundness Standards





The
      Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) imposes certain
      specific restrictions on transactions and requires federal banking regulators
      to
      adopt overall safety and soundness standards for depository institutions related
      to internal control, loan underwriting and documentation and asset growth.
      Among
      other things, FDICIA limits the interest rates paid on deposits by
      undercapitalized institutions, restricts the use of brokered deposits, limits
      the aggregate extensions of credit by a depository institution to an executive
      officer, director, principal shareholder or related interest, and reduces
      deposit insurance coverage for deposits offered by undercapitalized institutions
      for deposits by certain employee benefits accounts. The federal banking agencies
      may require an institution to submit to an acceptable compliance plan as well
      as
      have the flexibility to pursue other more appropriate or effective courses
      of
      action given the specific circumstances and severity of an institution's
      noncompliance with one or more standards.




Premiums
      for Deposit Insurance




The
      Bank’s deposits are currently insured to a maximum of $100,000 per depositor
      through the Bank Insurance Fund administered by the FDIC. The Bank is required
      to pay deposit insurance premiums, which are assessed semiannually and paid
      quarterly. The premium amount is based upon a risk classification system
      established by the FDIC. 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
      FDIC
      is also empowered 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
      is authorized to terminate a depository institution's deposit insurance upon
      a
      finding by the FDIC that the institution's financial condition is unsafe or
      unsound or that the institution has engaged in unsafe or unsound practices
      or
      has violated any applicable rule, regulation, order or condition enacted or
      imposed by the institution's regulatory agency.




Sarbanes-Oxley
      Act of 2002




On
      July
      30, 2002, the Sarbanes-Oxley Act of 2002 (“SOX”), was signed into law to address
      corporate and accounting fraud. SOX establishes a new accounting oversight
      board
      that will enforce auditing standards and restricts the scope of services that
      accounting firms may provide to their public company audit clients. Among other
      things, SOX also (i) requires chief executive officers and chief financial
      officers to certify to the accuracy of periodic reports filed with the SEC;
      (ii)
      imposes new disclosure requirements regarding internal controls,
      off-balance-sheet transactions, and pro forma (non-GAAP) disclosures; (iii)
      accelerates the time frame for reporting of insider transactions and periodic
      disclosures by public companies; and (iv) requires companies to disclose whether
      or not they have adopted a code of ethics for senior financial officers and
      whether the audit committee includes at least one “audit committee financial
      expert.”





Under
      SOX, the SEC is required to regularly and systematically review corporate
      filings, based on certain enumerated factors. To deter wrongdoing, SOX: (i)
      subjects bonuses issued to top executives to disgorgement if a restatement
      of a
      company’s financial statements was due to corporate misconduct; (ii) prohibits
      an officer or director from misleading or coercing an auditor; (iii) prohibits
      insider trades during pension fund “blackout periods”; (iv) imposes new criminal
      penalties for fraud and other wrongful acts; and (v) extends the period during
      which certain securities fraud lawsuits can be brought against a company or
      its
      officers.





As
      a
      public reporting company, the Company is subject to the requirements of SOX
      and
      related rules and regulations issued by the SEC and Nasdaq. It is anticipated
      that the Company will incur additional expense as a result of the Act, but
      we do
      not expect that such compliance will have a material impact on our
      business.





Financial
      Services Modernization Legislation




On
      November 12, 1999, the Gramm- Leach-Bliley Act of 1999 (the "Financial Services
      Modernization Act") was signed into law. The Financial Services Modernization
      Act is intended to modernize the banking industry by removing barriers to
      affiliation among banks, insurance companies, the securities industry and other
      financial service providers. It provides financial organizations with the
      flexibility of structuring such affiliations through a holding company structure
      or through a financial subsidiary of a bank, subject to certain limitations.
      The
      Financial Services Modernization Act establishes a new type of bank holding
      company, known as a financial holding company, that may engage in an expanded
      list of activities that are "financial in nature," which include securities
      and
      insurance brokerage, securities underwriting, insurance underwriting and
      merchant banking. The Company has not sought “financial holding company” status
      and has no present plans to do so.




9


The
      Financial Services Modernization Act also sets forth a system of functional
      regulation that makes the Federal Reserve Board the "umbrella supervisor" for
      holding companies, while providing for the supervision of the holding company's
      subsidiaries by other federal and state agencies.





In
      addition, the Bank is subject to other provisions of the Financial Services
      Modernization Act, including those relating to CRA, privacy and safe-guarding
      confidential customer information, regardless of whether the Company elects
      to
      become a financial holding company or to conduct activities through a financial
      subsidiary of the Bank. The Company does not, however, currently intend to
      file
      notice with the Federal Reserve Board to become a financial holding company
      or
      to engage in expanded financial activities through a financial subsidiary of
      the
      Bank.





The
      Company and the Bank do not believe that the Financial Services Modernization
      Act will have a material adverse effect on their operations in the near-term.
      However, to the extent that it 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 act may have the result
      of increasing the amount of competition that the Company faces from larger
      institutions and other types of companies offering financial products, many
      of
      which may have substantially more financial resources than the Company.




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, or
      the
      Patriot Act, of 2001. Among other things, the Patriot Act (i) prohibits banks
      from providing correspondent accounts directly to foreign shell banks; (ii)
      imposes due diligence requirements on banks opening or holding accounts for
      foreign financial institutions or wealthy foreign individuals (iii) requires
      financial institutions to establish an anti-money-laundering compliance program,
      and (iv) eliminates civil liability for persons who file suspicious activity
      reports. The 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 Patriot Act. Various measures are currently pending before
      Congress to extend portions of the Patriot Act. While we believe the Patriot
      Act
      may, to some degree, affect our recordkeeping and reporting expenses, we do
      not
      believe that it will have a material adverse effect on our business and
      operations.




Transactions
      between Affiliates




Transactions
      between a bank and its "affiliates" are quantitatively and qualitatively
      restricted under the Federal Reserve Act. The Federal Reserve Board issued
      Regulation W on October 31, 2002, which comprehensively implements Sections
      23A and 23B of the Federal Reserve Act. Sections 23A and 23B and Regulation
      W
      restrict loans by a depository institution to its affiliates, asset purchases
      by
      a depository institution from its affiliates, and other transactions between
      a
      depository institution and its affiliates. Regulation W unifies in one public
      document the Federal Reserve Board’s interpretations of Section 23A and 23B.
      Regulation W had an effective date of April 1, 2003.




Community
      Reinvestment Act




The
      Bank
      is subject to certain fair lending requirements and reporting obligations
      involving home mortgage lending operations and Community Reinvestment Act
      ("CRA") activities. The CRA generally requires the federal banking agencies
      to
      evaluate the record of a financial institution in meeting the credit needs
      of
      their local communities, including low and moderate income neighborhoods. In
      addition to substantial penalties and corrective measures that may be required
      for a violation of certain fair lending laws, the federal banking agencies
      may
      take compliance with such laws and CRA into account when regulating and
      supervising other activities. When a bank holding company applies for approval
      to acquire a bank or other bank holding company, the Federal Reserve Board
      will
      review the assessment of each subsidiary bank of the applicant bank holding
      company, and such records may be the basis for denying the application. A bank's
      compliance with its CRA obligations is based on a performance-based evaluation
      system which bases CRA ratings on an institution's lending service and
      investment performance, resulting in a rating by the appropriate bank regulatory
      agency of "outstanding", "satisfactory", "needs to improve" or "substantial
      noncompliance.” At its last examination by the FDIC, the Bank received a CRA
      rating of "Satisfactory."




10


Privacy





Federal
      banking rules limit the ability of banks and other financial institutions to
      disclose non-public information about consumers to nonaffiliated third parties.
      Pursuant to these rules, financial institutions must provide:





·
            initial
                notices to customers about their privacy policies, describing the
                conditions under which they may disclose non-public information to
                nonaffiliated third parties and
                affiliates;





·
            annual
                notices of their privacy policies to current customers;
                and





·
            a
                reasonable method for customers to “opt out” of disclosures to
                nonaffiliated third parties.





These
      privacy provisions affect how consumer information is transmitted through
      diversified financial companies and conveyed to outside vendors. We have
      implemented our privacy policies in accordance with the law.





In
      recent
      years, a number of states have implemented their own versions of privacy laws.
      For example, in 2003, California adopted standards that are more restrictive
      than federal law, allowing bank customers the opportunity to bar financial
      companies from sharing information with their affiliates.





Predatory
      Lending





The
      term
      "predatory lending," much like the terms "safety and soundness" and "unfair
      and
      deceptive practices," is far-reaching and covers a potentially broad range
      of
      behavior. As such, it does not lend itself to a concise or a comprehensive
      definition. But typically predatory lending involves at least one, and perhaps
      all three, of the following elements:





·
            making
                unaffordable loans based on the assets of the borrower rather than
                on the
                borrower's ability to repay an obligation, or asset-based
                lending;





·
            inducing
                a borrower to refinance a loan repeatedly in order to charge high
                points
                and fees each time the loan is refinanced, or loan flipping;
                and





·
            engaging
                in fraud or deception to conceal the true nature of the loan obligation
                from an unsuspecting or unsophisticated
                borrower.





Federal
      Reserve Board regulations aimed at curbing such lending significantly widened
      the pool of high-cost home-secured loans covered by the Home Ownership and
      Equity Protection Act of 1994, a federal law that requires extra disclosures
      and
      consumer protections to borrowers. The following triggers coverage under the
      Home Ownership and Equity Protection Act of 1994:





·
            interest
                rates for first lien mortgage loans in excess of 8 percentage points
                above
                comparable Treasury securities,





·
            subordinate-lien
                loans of 10 percentage points above Treasury securities,
                and





·
            fees
                such as optional insurance and similar debt protection costs paid
                in
                connection with the credit transaction, when combined with points
                and fees
                if deemed excessive.





In
      addition, the regulation bars loan flipping by the same lender or loan servicer
      within a year. Lenders also will be presumed to have violated the law—which says
      loans shouldn't be made to people unable to repay them—unless they document that
      the borrower has the ability to repay. Lenders that violate the rules face
      cancellation of loans and penalties equal to the finance charges paid. Community
      Bancorp does not expect these rules and potential state action in this area
      to
      have a material impact on our financial condition or results of
      operations.




11


Bank
      Secrecy Act and Money Laundering Control Act





In
      1970,
      Congress passed the Currency and Foreign Transactions Reporting Act, otherwise
      known as the Bank Secrecy Act (the “BSA”), which established requirements for
      recordkeeping and reporting by banks and other financial institutions. The
      BSA
      was designed to help identify the source, volume and movement of currency and
      other monetary instruments into and out of the United States in order to help
      detect and prevent money laundering connected with drug trafficking, terrorism
      and other criminal activities. The primary tool used to implement BSA
      requirements is the filing of Suspicious Activity Reports. Today, the BSA
      requires that all banking institutions develop and provide for the continued
      administration of a program reasonably designed to assure and monitor compliance
      with certain recordkeeping and reporting requirements regarding both domestic
      and international currency transactions. These programs must, at a minimum,
      provide for a system of internal controls to assure ongoing compliance, provide
      for independent testing of such systems and compliance, designate individuals
      responsible for such compliance and provide appropriate personnel training.





**Where
      You Can Find More Information**





Under
      the
      Securities Exchange Act of 1934 Sections 13 and 15(d), periodic and current
      reports must be filed with the SEC. The Company electronically files the
      following reports with the SEC: Form 10-K (Annual Report), Form 10-Q (Quarterly
      Report), Form 8-K (Current Report), insider ownership reports and Form DEF
      14A
      (Proxy Statement). The Company may file additional forms. The SEC maintains
      an
      Internet site, www.sec.gov, in which all forms filed electronically may be
      accessed. Additionally, all forms filed with the SEC and additional shareholder
      information is available free of charge on the Company's website:
      www.heritageoaksbancorp.com





The
      Company posts these reports to its website as soon as reasonably practicable
      after filing them with the SEC. None of the information on or hyperlinked from
      the Company’s website is incorporated into this Annual Report on Form
      10-K.





The
      Company also posts its Committee Charters, Code of Ethics, Code of Conduct
      and
      Corporate Governance Guidelines on the Company website.





**ITEM
      1A.**  **RISK
      FACTORS**





***An
      investment in our common stock is subject to risks inherent to our business.
      The
      material risks and uncertainties that management believes may affect our
      business are described below. Before making an investment decision, you should
      carefully consider the risks and uncertainties described below together with
      all
      of the other information included or incorporated by reference in this Annual
      Report. The risks and uncertainties described below are not the only ones facing
      our business. Additional risks and uncertainties that management is not aware
      of
      or focused on or that management currently deems immaterial may also impair
      our
      business operations. This Annual Report is qualified in its entirety by these
      risk factors.***





***If
      any of the following risks actually occur, our financial condition and results
      of operations could be materially and adversely affected. If this were to
      happen, the value of our common stock could decline significantly, and you
      could
      lose all or part of your investment.***





**Risks
      Associated with our Business.**




**We
      are highly dependent on real estate and a downturn in the real estate market
      could hurt our business.**





A
      significant portion of our loan portfolio is dependent on real estate. At
      December 31, 2005, real estate served as the principal source of collateral
      with
      respect to approximately 82.1% of our loan portfolio. A decline in current
      economic conditions or rising interest rates could have an adverse effect on
      the
      demand for new loans, the ability of borrowers to repay outstanding loans,
      the
      value of real estate and other collateral securing loans and the value of real
      estate owned by us, as well as our financial condition and results of operations
      in general and the market value of our common stock.




Acts
      of
      nature, including earthquakes, floods and fires, which may cause uninsured
      damage and other loss of value to real estate that secures these loans, may
      also
      negatively impact our financial condition.




12


**We
      also have a concentration in higher risk commercial real estate
      loans.**





We
      also
      have a high concentration in commercial real estate or CRE loans. Approximately
      57.0% of our lending portfolio can be classified as CRE lending. CRE loans
      generally involve a higher degree of credit risk than residential mortgage
      lending due, among other things, to the large amounts loaned to individual
      borrowers. Losses incurred on loans to a small number of borrowers could have
      a
      material adverse impact on our income and financial condition. In addition,
      unlike residential mortgage loans, commercial real estate loans generally depend
      on the cash flow from the property to service the debt. Cash flow may be
      significantly affected by general economic conditions.




Banking
      regulators have recently issued proposed guidance regarding institutions that
      have particularly high concentrations of CRE within their lending portfolios.
      This guidance suggests that institutions that exceed certain levels of CRE
      lending may be required, in the future, to maintain higher capital ratios than
      institutions with lower concentrations in CRE lending *.* At
      December 31, 2005, the Bank’s CRE level exceeded the threshold for such
      concentrations. If and when this proposed guidance becomes final, we may be
      subject to enhanced regulatory scrutiny and subject to higher capital
      requirements.




**Our
      real estate lending also exposes us to the risk of environmental
      liabilities.**





In
      the
      course of our business, we may foreclose and take title to real estate, and
      could be subject to environmental liabilities with respect to these properties.
      We may be held liable to a governmental entity or to third persons for property
      damage, personal injury, investigation and clean-up costs incurred by these
      parties in connection with environmental contamination, or may be required
      to
      investigate or clean up hazardous or toxic substances, or chemical releases
      at a
      property. The costs associated with investigation or remediation activities
      could be substantial. In addition, as the owner or former owner of a
      contaminated site, we may be subject to common law claims by third parties
      based
      on damages and costs resulting from environmental contamination emanating from
      the property. If we ever become subject to significant environmental
      liabilities, our business, financial condition, liquidity and results of
      operations could be materially and adversely affected.




**Our
      business is subject to interest rate risk and changes in interest rates may
      adversely affect our performance and financial condition.**





Our
      earnings are impacted by changing interest rates. Changes in interest rates
      impact the demand for new loans, the credit profile of our borrowers, the rates
      received on loans and securities and rates paid on deposits and borrowings.
      The
      difference between the rates received on loans and securities and the rates
      paid
      on deposits and borrowings is known as interest rate spread. Given our current
      volume and mix of interest-bearing liabilities and interest-earning assets,
      we
      would expect our interest rate spread to increase if interest rates rise and,
      conversely, to decline if interest rates fall. Increasing levels of competition
      in the banking and financial services business may decrease our net interest
      margin by forcing us to offer lower lending interest rates and pay higher
      deposit interest rates. Although we believe our current level of interest rate
      sensitivity is reasonable, significant fluctuations in interest rates and
      increasing competition may have an adverse effect on our business, financial
      condition and results of operations.




A
      sustained decrease in market interest rates could adversely affect our earnings.
      When interest rates decline, borrowers tend to refinance higher-rate, fixed-rate
      loans at lower rates, prepaying their existing loans. Under those circumstances,
      we would not be able to reinvest those prepayments in assets earning interest
      rates as high as the rates on the prepaid loans. In addition, our commercial
      real estate and commercial loans, which carry interest rates that, in general,
      adjust in accordance with changes in the prime rate, will adjust to lower rates.
      We are also significantly affected by the level of loan demand available in
      our
      market. The inability to make sufficient loans directly affects the interest
      income we earn. Lower loan demand will generally result in lower interest income
      realized as we place funds in lower yielding investments.




**Failure
      to successfully execute our strategy could adversely affect our
      performance.**





Our
      financial performance and profitability depends on our ability to execute our
      corporate growth strategy. Continued growth, however, may present operating
      and
      other problems that could adversely affect our business, financial condition
      and
      results of operations. Accordingly, there can be no assurance that we will
      be
      able to execute our growth strategy or maintain the level of profitability
      that
      we have recently experienced. Factors that may adversely affect our ability
      to
      attain our long-term financial performance goals include those stated elsewhere
      in this section, as well as:




13




·
            Inability
                to control non-interest expense, including, but not limited to, rising
                employee and healthcare costs;




·
            Inability
                to increase non-interest income;
                and




·
            Continuing
                ability to expand, through de novo branching or finding acquisition
                targets at valuation levels we find
                attractive.




**Economic
      conditions in the Central Coast of California area could adversely affect our
      operations and/or cause us to sustain losses.**





Our
      retail and commercial banking operations are concentrated primarily in San
      Luis
      Obispo and Santa Barbara Counties. As a result of this geographic concentration,
      our results of operations depend largely upon economic conditions in this area.
      A significant source of risk arises from the possibility that losses will be
      sustained if a significant number of our borrowers, guarantors and related
      parties fail to perform in accordance with the terms of their loans. This risk
      increases when the economy is weak. We have adopted underwriting and credit
      monitoring procedures and credit policies, including the establishment and
      review of the allowance for credit losses, that management believes are
      appropriate to minimize this risk by assessing the likelihood of nonperformance,
      tracking loan performance and diversifying our credit portfolio. These policies
      and procedures, however, may not prevent unexpected losses that could materially
      adversely affect our results of operations in general and the market value
      of
      our stock.




Our
      primary market area is an increasingly competitive and overcrowded
      banking **** market. 
      Our ability to achieve the growth outlined in our corporate strategic
      goals may be dependent in part on an ability to grow through the successful
      addition of new branches or the identification and acquisition of potential
      targets at acceptable pricing levels either inside or outside of our primary
      market.  If we are unable to attract significant new business through
      strategic branching, or acquire new business through our acquisition of other
      banks, our growth in loans and deposits and, therefore, our earnings, may
      be adversely affected.




**We
      face strong competition from financial service companies and other companies
      that offer banking services that could hurt our business.**





The
      financial services business in our market areas is highly competitive. It is
      becoming increasingly competitive due to changes in regulation, technological
      advances, and the accelerating pace of consolidation among financial services
      providers. We face competition both in attracting quality assets and deposits
      and in making loans. We compete for loans principally through the interest
      rates
      and loan fees we charge and the efficiency and quality of services we provide.
      Increasing levels of competition in the banking and financial services business
      may reduce our market share, decrease loan demand, cause the prices we charge
      for our services to fall, or decrease our net interest margin by forcing us
      to
      offer lower lending interest rates and pay higher deposit interest rates.
      Therefore, our results may differ in future periods depending upon the nature
      or
      level of competition.




Technology
      and other changes are allowing parties to complete financial transactions that
      historically have involved banks through alternative methods. For example,
      consumers can now maintain funds that would have historically been held as
      bank
      deposits in brokerage accounts or mutual funds. Consumers can also complete
      transactions such as paying bills and/or transferring funds directly without
      the
      assistance of banks. The process of eliminating banks as intermediaries, known
      as “disintermediation,” could result in the loss of fee income, as well as the
      loss of customer deposits and the related income generated from those deposits.
      The loss of these revenue streams and the lower cost deposits as a source of
      funds could have a material adverse effect on our financial condition and
      results of operations.




**We
      may not be able to attract and retain skilled people** .




Our
      success depends, in large part, on our ability to attract and retain key people.
      Competition for the best people in most of our activities can be intense and
      we
      may not be able to hire people or to retain them. The unexpected loss of
      services of one or more of our key personnel could have a material adverse
      impact on our business because of their skills, knowledge of our market, years
      of industry experience and the difficulty of promptly finding qualified
      replacement personnel.




14





**Our
      internal operations are subject to a number of risks.**





We
      are
      subject to certain operations risks, including, but not limited to, data
      processing system failures and errors, customer or employee fraud and
      catastrophic failures resulting from terrorist acts or natural disasters. We
      maintain a system of internal controls to mitigate against such occurrences
      and
      maintain insurance coverage for such risks that are insurable, but should such
      an event occur that is not prevented or detected by our internal controls,
      uninsured or in excess of applicable insurance limits, it could have a
      significant adverse impact on our business, financial condition or results
      of
      operations.




*Information
      Systems* .
      We rely
      heavily on communications and information systems to conduct our business.
      Any
      failure, interruption or breach in security of these systems could result in
      failures or disruptions in our customer relationship management, general ledger,
      deposit, loan and other systems. While we have policies and procedures designed
      to prevent or limit the effect of the failure, interruption or security breach
      of our information systems, there can be no assurance that any such failures,
      interruptions or security breaches will not occur or, if they do occur, that
      they will be adequately addressed. The occurrence of any failures, interruptions
      or security breaches of our information systems could damage our reputation,
      result in a loss of customer business, subject us to additional regulatory
      scrutiny, or expose us to civil litigation and possible financial liability,
      any
      of which could have a material adverse effect on our financial condition and
      results of operations.




*Technological
      Advances* .
      The
      financial services industry is continually undergoing rapid technological change
      with frequent introductions of new technology-driven products and services.
      The
      effective use of technology increases efficiency and enables financial
      institutions to better serve customers and to reduce costs. Our future success
      depends, in part, upon our ability to address the needs of our customers by
      using technology to provide products and services that will satisfy customer
      demands, as well as to create additional efficiencies in our operations. Many
      of
      our competitors have substantially greater resources to invest in technological
      improvements. We may not be able to effectively implement new technology-driven
      products and services or be successful in marketing these products and services
      to our customers. Failure to successfully keep pace with technological change
      affecting the financial services industry could have a material adverse impact
      on our business and, in turn, our financial condition and results of operations.




*Severe
      Weather, Natural Disasters, Acts Of War Or Terrorism and Other External
      Events* .
      Severe
      weather, natural disasters, acts of war or terrorism and other adverse external
      events could have a significant impact on our ability to conduct business.
      Such
      events could affect the stability of our deposit base, impair the ability of
      borrowers to repay outstanding loans, impair the value of collateral securing
      loans, cause significant property damage, result in loss of revenue and/or
      cause
      us to incur additional expenses. For example, the Central Coast of California
      is
      subject to earthquakes and fires. Operations in our market could be disrupted
      by
      both the evacuation of large portions of the population as well as damage and
      or
      lack of access to our banking and operation facilities. While we have not
      experienced such an occurrence to date, other severe weather or natural
      disasters, acts of war or terrorism or other adverse external events may occur
      in the future. Although management has established disaster recovery policies
      and procedures, the occurrence of any such event could have a material adverse
      effect on our business, which, in turn, could have a material adverse effect
      on
      our financial condition and results of operations.




**We
      depend on cash dividends from our subsidiary bank to meet our cash
      obligations.**





As
      a
      holding company, dividends from our subsidiary bank provide a substantial
      portion of our cash flow used to service the interest payments on our trust
      preferred securities and our other obligations, including cash dividends. See
      “Item 5 - Market for Common Equity and Related Stockholder Matters.” Various
      statutory provisions restrict the amount of dividends our subsidiary bank can
      pay to us without regulatory approval.




15


**Risks
      Associated with our Industry.**





**We
      are subject to government regulation that could limit or restrict our
      activities, which in turn could adversely impact our
      operations.**





The
      financial services industry is regulated extensively. Federal and State
      regulation is designed primarily to protect the deposit insurance funds and
      consumers, and not to benefit our shareholders. These regulations can sometimes
      impose significant limitations on our operations.





New
      laws
      and regulations or changes in existing laws and regulations or repeal of
      existing laws and regulations may adversely impact our business. For example,
      operating expenses were impacted by the $151 thousand cost of compliance with
      the Sarbanes-Oxley Act provisions in the year ended December 31,
      2005.





Further,
      federal monetary policy, particularly as implemented through the Federal Reserve
      System, significantly affects economic conditions for us.





**New
      legislative and regulatory proposals may affect our operations and growth.**





Proposals
      to change the laws and regulations governing the operations and taxation of,
      and
      federal insurance premiums paid by, banks and other financial institutions
      and
      companies that control such institutions are frequently raised in the
      U.S. Congress, state legislatures and before bank regulatory authorities.
      The likelihood of any major changes in the future and the impact such changes
      might have on us or our subsidiaries are impossible to determine. Similarly,
      proposals to change the accounting treatment applicable to banks and other
      depository institutions are frequently raised by the SEC, the federal banking
      agencies, the IRS and other appropriate authorities. The likelihood and impact
      of any additional future changes in law or regulation and the impact such
      changes might have on us or our subsidiaries are impossible to determine at
      this
      time.





**Risks
      Associated with our Stock.**





**Our
      Stock Trades Less Frequently Than Others.**





Although
      our common stock is listed for trading on the Nasdaq Capital Market, the trading
      volume in our common stock is less than that of other larger financial services
      companies. A public trading market having the desired characteristics of depth,
      liquidity and orderliness depends on the presence in the marketplace of willing
      buyers and sellers of our common stock at any given time. This presence depends
      on the individual decisions of investors and general economic and market
      conditions over which we have no control. Given the lower trading volume of
      our
      common stock, significant sales of our common stock, or the expectation of
      these
      sales, could cause our stock price to fall.





**Our
      Stock Price Is Affected by a Variety of Factors.** **





Stock
      price volatility may make it more difficult for you to resell your common stock
      when you want and at prices you find attractive. Our stock price can fluctuate
      significantly in response to a variety of factors discussed in this section,
      including, among other things:





•
              Actual
                  or anticipated variations in quarterly results of
                  operations.
 
 •
              Recommendations
                  by securities analysts.


•
            Operating
                and stock price performance of other companies that investors deem
                comparable to our company.





•
            News
                reports relating to trends, concerns and other issues in the financial
                services industry.





•
            Perceptions
                in the marketplace regarding our company and/or its
                competitors.




**Our
        Common Stock Is Not An Insured Deposit** . **
 
 Our
        common stock is not a bank deposit and, therefore, is not insured against
        loss
        by the FDIC, any other deposit insurance fund or by any other public or private
        entity. Investment in our common stock is inherently risky for the reasons
        described in this “Risk Factors” section and elsewhere in this report and is
        subject to the same market forces that affect the price of common stock in
        any
        company. As a result, if you acquire our common stock, you may lose some
        or all
        of your investment.


16


**Our
      Articles Of Incorporation and By-Laws, As Well As Certain Banking Laws, May
      Have An Anti-Takeover Effect.**





Provisions
      of our articles of incorporation, bylaws and federal banking laws, including
      regulatory approval requirements, could make it more difficult for a third
      party
      to acquire us, even if doing so would be perceived to be beneficial to our
      shareholders. The combination of these provisions may hinder a non-negotiated
      merger or other business combination, which, in turn, could adversely affect
      the
      market price of our common stock.





**ITEM
      1B. UNRESOLVED STAFF COMMENTS.**





None





**ITEM
      2.**  **DESCRIPTION
      OF PROPERTIES.**





The
      Company and the Bank own and occupy a permanent headquarters facility that
      is
      located at 545 Twelfth Street, Paso Robles, CA.





On
      July
      3, 2003, the Bank closed escrow to purchase real property located at 500
      13 th Street,
      Paso Robles, Ca. This property is located directly adjacent to the Bank’s
      Headquarters. The Bank is nearing completion of new structure on the site to
      allow for the consolidation of all Administrative functions of the Bank within
      the new facility. The Bank anticipates that this project will be complete in
      of
      the second quarter of 2006.





The
      Bank
      occupies a non-banking office, located at 600 Twelfth Street, Paso Robles,
      Ca
      that was purchased by the Bank on December 23, 1986. On December 30, 2004,
      the
      Bank sold the facility for the appraised value to a non-affiliated party and
      subsequently entered into a 12 month lease which has since been extended to
      June
      30, 2006. The lease cost is fixed at $4,000 per month. As part of the sale,
      the
      Bank has a permanent easement right to 9 parking spaces and a 30 year easement
      for 17 parking spaces.





The
      Bank
      leases a non-banking facilitiy at 171 Niblick Rd., Paso Robles, Ca. for
      approximately $2,500 per month. The existing facility currently houses an ATM
      and administrative offices. The Bank has extended the current lease through
      April 30, 2006.





On
      June
      26, 1997 the Bank executed a lease for its branch office at 297 Madonna Road,
      San Luis Obispo, Ca. Heritage subleases approximately 58% of this office space
      to another firm and uses 42%. The tenant firm pays 58% of the rent and expenses
      and the Bank pays 42%. The rent under the lease for the entire space is
      approximately $8,345 a month and the lease expires on June 30, 2009.





The
      Bank
      opened a branch office at 1135 Santa Rosa Street in downtown San Luis Obispo,
      Ca
      in April 1996. The Bank is leasing the branch building for approximately $9,800
      per month. The lease expires on February 28, 2006 with options to
      renew.





On
      February 21, 1997, the Bank acquired the Cambria branch of Wells Fargo Bank
      located at 1276 Tamson Drive, Cambria. The Bank leases this branch for
      approximately $3,673 per month and the lease expires on July 1,
      2009.





On
      August
      26, 1998, the Company purchased property located at 9900 El Camino Real,
      Atascadero, Ca. The Company constructed a building and on April 1, 1999, the
      Company entered into a lease agreement with the Bank. In July 2005 the Company
      entered into a sale-leaseback transaction of this office with an un-affiliated
      third party with the Bank again as the lessee. The sale price was $900 thousand
      and resulted in a gain to the Company of approximately $283 thousand. The Bank’s
      new lease calls for payments of $5,026 per month and expires on August 13,
      2010.





On
      November 1, 1998, the Bank entered into a 10-year lease with an unaffiliated
      party to lease property known as 1660 South Broadway, Santa Maria, Ca. The
      current lease payment is $6,667 per month. In December 2004, the Bank received
      regulatory approval to relocate the banking operations of the branch to the
      Bank’s other branch office located less than one mile away. The Bank has entered
      into an agreement with an unaffiliated third party to sublease this location
      for
      $6,384 per month which will expire on October 31, 2008.




17


On
      November 9, 2001, the Bank acquired, through a Branch Purchase transaction
      from
      Westamerica Bank, the land and building located at 1255 Grand Avenue, Arroyo
      Grande, Ca. The Bank previously had a lease on another facility that housed
      its
      Arroyo Grande Branch and the Bank consolidated the branch into the newly
      acquired facility.





On
      November 9, 2001, the Bank also acquired from Westamerica Bank, a branch office
      located at 310 Morro Bay Blvd., Morro Bay, Ca. The seller conveyed title to
      the
      building at the closing. The building is on leased land. The seller assigned
      and
      Heritage assumed the lease that expires on April 1, 2012. The monthly lease
      payment is $2,400.





On
      July
      26, 2002, the Bank purchased land at the intersection of Niblick and South
      River
      Roads in Paso Robles, Ca. The purchase price was $900,000. In February 2003,
      the
      Bank began construction of a full service branch. The Bank relocated the
      existing branch office, located at 171 Niblick Road, Paso Robles, Ca, to the
      new
      facility on February 17, 2004.





The
      Bank
      leases the premises located 361 Town Center West Santa Maria, Ca. The lease
      expires July 31, 2012 in which the Bank currently makes lease payments of
      $17,063 per month. The Bank also subleases part of the 2 nd floor of
      the Town Center West office to two lessees. The sublease payments are $2,775
      and
      $2,450 per month and expire October 1, 2006 and February 28, 2008,
      respectively.





The
      Bank
      owns the premises located at 2239 South Broadway, Santa Maria, Ca., which is
      known as the South Broadway office. This office consists of approximately 3,700
      square feet which include drive-up facilities and parking. The branch was opened
      in July 2002.





The
      Bank
      also leases the premises located at 1125 East Clark Ave, Santa Maria, Ca. which
      is known as the Oak Knolls office. The Bank’s lease expires on June 30, 2008,
      and current lease payments are $6,385 per month.





The
      Company believes its present facilities are adequate for its present needs.
      The
      Company believes that the insurance coverage on all properties is
      adequate. Most of
      the leases contain multiple renewal options and provisions for rental increases,
      principally for changes in the cost of living index, property taxes and
      maintenance.





**ITEM
      3.**  **LEGAL
      PROCEEDINGS.**





The
      Bank
      is, from time to time, subject to various pending and threatened legal actions
      which arise out of the normal course of its business. Neither the Company nor
      the Bank is a party to any pending material legal or administrative proceedings
      (other than ordinary routine litigation incidental to the Company's or the
      Bank’s business).





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





None.


18





**PART
      II**





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





**Market
      Information**




The
      Company’s Common Stock trades on the Nasdaq Capital Market under the symbol
“HEOP.”




The
      following table summarizes those trades of the Company’s Common Stock on NASDAQ,
      setting forth the approximate high and low closing sales prices for each
      quarterly period ended since January 1, 2004.




Quarter
                  Ended 2005
              
              Closing
                  PricesHigh
              
              LowDecember
                  31,
              
              $
              21.40
              
              $
              16.67September
                  30,
              
              
              17.00
              
              
              14.33June
                  30,
              
              
              15.00
              
              
              13.08March
                  31,
              
              
              15.23
              
              
              12.79
 
 Quarter
                  Ended 2004
              
              Closing
                  PricesHigh
              
              LowDecember
                  31,
              
              $
              13.43
              
              $
              11.24September
                  30,
              
              
              12.22
              
              
              9.84June
                  30,
              
              
              11.21
              
              
              10.32March
                  31,
              
              
              11.19
              
              
              10.28




Prices
      listed above have been adjusted to reflect all stock dividend and split
      activity.





**Holders**





As
      of
      February 1, 2006, there were approximately 2,287 holders of the Company's Common
      Stock. There are no other classes of equity securities outstanding.





**Dividends**





The
      Company is a legal entity separate and distinct from the Bank. The Company's
      shareholders are entitled to receive dividends when and as declared by its
      Board
      of Directors, out of funds legally available therefore, subject to the
      restrictions set forth in the California General Corporation Law (the
      "Corporation Law"). The Corporation Law provides that a corporation may make
      a
      distribution to its shareholders if the corporation's retained earnings equal
      at
      least the amount of the proposed distribution. The Corporation Law also provides
      that, in the event that sufficient retained earnings are not available for
      the
      proposed distribution, a corporation may nevertheless make a distribution to
      its
      shareholders if it meets two conditions, which generally stated are as follows:
      (i) the corporation's assets equal at least 1-1/4 times its liabilities, and
      (ii) the corporation's current assets equal at least its current liabilities
      or,
      if the average of the corporation's earnings before taxes on income and before
      interest expenses for the two preceding fiscal years was less than the average
      of the corporation's interest expenses for such fiscal years, then the
      corporation's current assets must equal at least 1-1/4 times its current
      liabilities. Refer to “Item 7. Management’s Discussion and Analysis of Financial
      condition and Results of Operations” on junior subordinated debenture
      limitations on dividends.





The
      ability of the Company to pay a cash dividend and to service the debt on its
      junior subordinated debenture depends largely on the Bank’s ability to pay a
      cash dividend to the Company. The payment of cash dividends by the Bank is
      subject to restrictions set forth in the California Financial Code (the
      "Financial Code"). The Financial Code provides that a bank may not make a cash
      distribution to its shareholders in excess of the lesser of (a) bank’s retained
      earnings; or (b) bank’s net income for its last three fiscal years, less the
      amount of any distributions made by the bank or by any majority-owned subsidiary
      of the bank to the shareholders of the bank during such period. However, a
      bank
      may, with the approval of the DFI, make a distribution to its shareholders
      in an
      amount not exceeding the greatest of (x) its retained earnings; (y) its net
      income for its last fiscal year; or (z) its net income for its current fiscal
      year. In the event that the DFI determines that the shareholders' equity of
      a
      bank is inadequate or that the making of a distribution by the bank would be
      unsafe or unsound, the DFI may order the bank to refrain from making a proposed
      distribution.




19


The
      FDIC
      may also restrict the payment of dividends if such payment would be deemed
      unsafe or unsound or if after the payment of such dividends, the bank would
      be
      included in one of the "undercapitalized" categories for capital adequacy
      purposes pursuant to federal law. (See, "Item 1 - Description of Business -
      Prompt Corrective Action and Other Enforcement Mechanisms.") Additionally,
      while
      the Federal Reserve Board has no general restriction with respect to the payment
      of cash dividends by an adequately capitalized bank to its parent holding
      company, the Federal Reserve Board might, under certain circumstances, place
      restrictions on the ability of a particular bank to pay dividends based upon
      peer group averages and the performance and maturity of the particular bank,
      or
      object to management fees to be paid by a subsidiary bank to its holding company
      on the basis that such fees cannot be supported by the value of the services
      rendered or are not the result of an arm's length transaction.




Under
      these provisions, the amount available for distribution from the Bank to the
      Company was approximately $12.7 million at December 31, 2005.





The
      following table outlines stock dividend and stock spit activity since
      2000:




Stock
                Dividend Percentage
            Record
                Date5%
            April
                3, 20005%
            March
                16, 20015%
            March
                8, 20022
                for 1 Split
            August
                2, 20025%
            March
                14, 20035%
            April
                9, 20045%
            April
                8, 20053
                for 2 Split
            November,
                10 2005





The
      Company paid no cash dividends during the time period covered in the above
      table. Whether dividends will be paid in the future will be determined by the
      Board of Directors after consideration of various factors. The Company's
      profitability and regulatory capital ratios in addition to other financial
      conditions will be key factors considered by the Board of Directors in making
      such determinations regarding the payment of dividends by the Company.





**Securities
      Authorized for Issuance Under Equity Compensation Plans**





In
      May
      2005, stockholders approved the Company’s 2005 Equity Based Compensation Plan
      (the “2005 Plan”). The principal purpose of the 2005 Plan is to promote the
      success of the Company by providing an additional means to attract, motivate,
      retain and reward key employees and directors of the Company and its
      subsidiaries with stock options and other equity based incentives for high
      levels of individual performance and improved financial performance of the
      Company. The 2005 Plan provides no further grants may be made from the 1997
      Stock Option Plan.




The
      2005
      Plan authorizes the granting of: Incentive Stock Options; Non-Qualified Stock
      Options; Stock Appreciation Rights; Restricted Stock Awards; Restricted Stock
      Units; and Performance Share Cash Only Awards. Vesting restrictions on awards
      may be time based and/or performance based; Participation in the 2005 Plan
      is
      limited to officers at the level of Vice President or above and other officers
      who provide substantial services to the Company as well as the Company’s
      directors.




20


The
      following table summarizes information as of December 31, 2005 relating to
      equity compensation plans of the Company pursuant to which grants of options,
      restricted stock or other rights to acquire shares may be granted from time
      to
      time:




Plan
                Category
            Plan
              Year
            
            Number
                of securities to
              be
                issued upon
              exercise
                of outstanding
              options,
                warrants of
              rights
            
            Weighted
                average
              exercise
                price of
              outstanding
                options,
              warrants
                of rights
            
            Number
                of
              securities
              remaining
                available
              for
                future issuanceEquity
                compensation
              plans
                approved by
              security
                holders
            1990
              1997
              2005
            
            3,136
              522,556
              3,7502
            
            $2.55
              $5.20
              $0.00
            
            -0-
              -0-1
              611,697Equity
                compensation
              plans
                not approved by
              security
                holders
            
            
            N/A
            
            N/A
            
            N/ATotal
            
            
            529,442
            
            $5.15
            
            611,697





1 No
      further grants may be made from the 1997 Stock Option Plan.




2 The
      awards reflected in the table from the 2005 Plan were in the form of restricted
      stock grants. The restrictions lapse on the annual anniversary date at a rate
      of
      20% per year for 5 years.




21





**ITEM
      6.**  **SELECTED
      FINANCIAL DATA.**





The
      table
      below provides selected financial data that highlights the Company’s performance
      results for the five years ended December 31, 2005, 2004, 2003, 2002 and 2001.




**For
                the Year Ended December 31,****2005**
            
            **2004**
            
            **2003**
            
            **2002**
            
            **2001****Results
                of Operations**
            
            **(Dollars
                in thousands except per share and ratio data)**Total
                Interest Income
            
            $
            30,175
            
            $
            23,313
            
            $
            18,174
            
            $
            16,035
            
            $
            14,461Total
                Interest Expense
            
            
            5,016
            
            
            3,361
            
            
            3,463
            
            
            3,491
            
            
            3,430Net
                Interest Income
            
            
            25,159
            
            
            19,952
            
            
            14,711
            
            
            12,544
            
            
            11,031Provision
                for Possible Loan Losses
            
            
            710
            
            
            410
            
            
            370
            
            
            545
            
            
            600Net
                Interest Income after Provision for Possible
              Loan
                Losses
            
            
            24,449
            
            
            19,542
            
            
            14,341
            
            
            11,999
            
            
            10,431Total
                Non-Interest Income
            
            
            5,009
            
            
            4,999
            
            
            3,797
            
            
            3,463
            
            
            4,681Total
                Non-Interest Expenses
            
            
            18,718
            
            
            17,198
            
            
            12,425
            
            
            11,074
            
            
            11,387Income
                Before Income Tax Provision
            
            
            10,740
            
            
            7,343
            
            
            5,713
            
            
            4,388
            
            
            3,725Provision
                for Income Taxes
            
            
            4,103
            
            
            2,759
            
            
            2,117
            
            
            1,649
            
            
            1,379Net
                Income
            
            $
            6,637
            
            $
            4,584
            
            $
            3,596
            
            $
            2,739
            
            $
            2,346**Earnings
                Per Share**Basic:
            
            $
            1.08
            
            $
            0.77
            
            $
            0.71
            
            $
            0.57
            
            $
            0.50Diluted:
            
            $
            1.01
            
            $
            0.71
            
            $
            0.67
            
            $
            0.52
            
            $
            0.46**Financial
                Condition**Total
                Assets
            
            $
            488,501
            
            $
            448,012
            
            $
            441,948
            
            $
            337,511
            
            $
            214,885Net
                Loans
            
            $
            362,635
            
            $
            334,964
            
            $
            274,051
            
            $
            187,311
            
            $
            156,150Deposits
            
            $
            417,797
            
            $
            370,441
            
            $
            366,439
            
            $
            264,178
            
            $
            195,585Shareholder's
                Equity
            
            $
            44,845
            
            $
            37,250
            
            $
            32,288
            
            $
            19,813
            
            $
            15,877**Selected
                Financial Ratios**Return
                on Average Assets
            
            
            1.38
            %
            
            1.02
            %
            
            1.05
            %
            
            0.98
            %
            
            1.22
            %Return
                on Average Equity
            
            
            16.06
            %
            
            13.15
            %
            
            15.52
            %
            
            15.56
            %
            
            15.74
            %Return
                on Average Tangible Equity
            
            
            19.11
            %
            
            16.61
            %
            
            16.39
            %
            
            15.56
            %
            
            15.74
            %Average
                Equity to Average Assets
            
            
            8.61
            %
            
            7.79
            %
            
            6.76
            %
            
            6.33
            %
            
            7.74
            %Efficiency
                Ratio1
            
            
            62.04
            %
            
            68.93
            %
            
            67.13
            %
            
            69.18
            %
            
            72.47
            %Dividend
                Payout Ratio
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –




1 The
      efficiency ratio is defined as total non-interest expense as a percent of the
      combined net interest income plus non-interest income.





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





The
      following is an analysis of the financial condition and results of operations
      of
      the Company for the two years ended December 31, 2005. The analysis should
      be
      read in connection with the consolidated financial statements and notes thereto
      appearing elsewhere in this report.





**Executive
      Summary**





Both
      changes in short term interest rates as well as changes to the shape of the
      yield curve influence the Company and its markets. Generally, in 2005 increases
      in longer term interest rates were not commensurate with the rise in short
      term
      interest rates that has occurred since June 2004 resulting in smaller
      differentials between long and short term interest rates. This effect is known
      as a flattening yield curve. The affects of the flattening yield curve can
      be
      wide ranging, but generally, the flattening yield curve has been credited for
      supporting the strong housing market and recent economic stability in the face
      of actions by the FRB that under normal circumstances would slow both housing
      and the economy. The dual effects of expanding net interest margin at the
      Company due to higher short term rates and the active economy and credit markets
      due to the flattening yield curve resulted in overall positive performance
      of
      the bank in 2005.


22





The
      Company’s earnings are highly influenced by changes in short term interest
      rates. The nature of the Company’s balance sheet can be summarily described as
      of short duration and asset sensitive. The balance sheet is of short duration
      because a large percentage of its interest sensitive assets and liabilities
      reprice immediately with changes in the Federal Funds and Prime interest rates.
      The Company is asset sensitive, primarily due to its large volume of
      non-interest bearing demand deposit accounts which effectively never reprice.
      Therefore, an upward movement in short term interest rates will generally result
      in higher net interest margin and, conversely, a reduction in short term
      interest rates will result in reduced net interest margin.





Beginning
      in January 2001 and continuing through July 2003, actions by the Federal Reserve
      Bank (the “FRB”) to cut target interest rates resulted in the Prime Rate being
      reduced from 9.50% to 4.00% and beginning in June 2004 through December 2005,
      the FRB increased the Prime Rate from 4.00% to 7.25%.





Historically,
      the largest and most variable source of income for the Company is net interest
      income. The results of operations for the years 2005, 2004 and 2003 reflect
      the
      impact of changes in short term rates as well as growth in the volume of both
      interest earning assets and interest bearing liabilities during these periods.





During
      2005, the steady increases in the Prime Rate was the primary driver of the
      Company’s 68 basis point increase in net interest margin, from 5.10% to 5.78%
      compared to a 28 basis point increase during 2004 and a 22 basis point decrease
      for 2003. In 2005, earnings were also influenced by deposit and commercial
      loan
      growth, increasing both net interest income and service charges and fees. An
      active mortgage market also drove increases in fee income and cost containment
      which, combined with higher net interest margin (“NIM”), resulted in a lower
      efficiency ratio.





During
      2004, the Company was able to exceed prior year NIM and earnings per share
      (“EPS”) by growing average earning assets and stabilizing its efficiency ratio
      year over year. The increases to Prime in 2004 were done in 25bp increments
      for
      a total of 125bp. The Company began to experience the positive impact of these
      increases particularly when the combined increases exceeded 100bp, at which
      time
      the “floors” placed on many loans that moved with Prime were exceeded. The
      effect of these rate increases is reflected in the increase in the net interest
      margin from 4.82% for the year ended December 31, 2003 compared to 5.10% at
      December 31, 2004.





The
      Company acquired Hacienda Bank on October 31, 2003. The effects of the late-2003
      Merger were the primary factor in the year over year comparisons of 2004 versus
      2003. Hacienda had approximately $90 million in assets at December 31, 2003.
      The
      acquisition became accretive to earnings in 2004.





**Results
      of Operations**





The
      Company reported net income of $6.6 million for the year ended December 31,
      2005
      compared to $4.6 million and $3.6 million for the years 2004 and 2003
      respectively. This represents an increase of 45% for 2005 over 2004 and 27%
      for
      2004 over 2003. Basic earnings per share were $1.08, $0.77 and $0.71 at December
      31, 2005, 2004 and 2003, respectively. Diluted earnings per share were $1.01,
      $0.71 and $0.67 at December 31, 2005, 2004 and 2003, respectively. The earnings
      increase for 2005 was primarily attributable to a favorable interest rate
      environment, increases in and changes to the mix of average earning assets
      as
      well as an increase in non-interest bearing demand deposits. To fully understand
      and compare the information presented for the Company for the years 2004 and
      2003, it is important to consider the acquisition of Hacienda on October 31,
      2003. The results of operations of Hacienda for the months of November and
      December 2003 are included in the Company’s 2003 results of operations and
      Hacienda’s results for the full year ended December 31, 2004 were consolidated
      into the Company’s results of operations. The increase in earnings for 2004 over
      2003 was primarily attributable to the effects of the merger as well as
      increases in average earning assets and average deposits and to a lesser extent
      an interest rate environment favorable to the Company’s asset-sensitive balance
      sheet.




23


**Net
      Interest Income and Interest Margin**





Net
      interest income, the primary component of the net earnings of a financial
      institution, refers to the difference between the interest paid on deposits
      and
      borrowings, and the interest earned on loans and investments. The net interest
      margin is the amount of net interest income expressed as a percentage of average
      earning assets. Factors considered in the analysis of net interest income are
      the composition and volume of earning assets and interest-bearing liabilities,
      the amount of non-interest bearing liabilities and non-accrual loans, and
      changes in market interest rates.





The
      table
      below sets forth the average balance sheet information, interest income and
      expense, average yields and rates and net interest income and margin for the
      years ended December 31, 2005, 2004 and 2003. The average balance of
      non-accruing loans has been included in loan totals.




**AVERAGE
                BALANCE SHEET INFORMATION**


**(dollars
                  in thousands)**
              
              **For
                  the year ending December 31,****2005**
              
              
              
              
              
              **2004**
              
              
              
              
              
              **2003****Avg.**
              
              **Yield/**
              
              **Amt.**
              
              **Avg.**
              
              **Yield/**
              
              **Amt.**
              
              **Avg.**
              
              **Yield/**
              
              **Amt.**Interest
                  Earning Assets:
              
              **Balance**
              
              **Rate**
              
              **Interest**
              
              **Balance**
              
              **Rate**
              
              **Interest**
              
              **Balance**
              
              **Rate**
              
              **Interest**Interest
                  bearing deposits with other banks
              
              $
              1,149
              
              
              4.44
              %
              $
              51
              
              $
              2,154
              
              
              1.90
              %
              $
              41
              
              $
              661
              
              
              1.97
              %
              $
              13Investment
                  securities taxable
              
              
              38,499
              
              
              3.81
              %
              
              1,465
              
              
              49,178
              
              
              3.76
              %
              
              1,849
              
              
              42,353
              
              
              3.54
              %
              
              1,499Investment
                  securities non-taxable
              
              
              13,701
              
              
              4.33
              %
              
              593
              
              
              11,511
              
              
              4.40
              %
              
              506
              
              
              10,129
              
              
              4.48
              %
              
              454Federal
                  funds sold
              
              
              19,529
              
              
              3.42
              %
              
              667
              
              
              24,287
              
              
              1.24
              %
              
              302
              
              
              25,602
              
              
              1.09
              %
              
              278Loans
                  (1) (2)
              
              
              362,735
              
              
              7.55
              %
              
              27,399
              
              
              304,402
              
              
              6.77
              %
              
              20,615
              
              
              226,707
              
              
              7.03
              %
              
              15,930Total
                  interest earning assets
              
              
              435,613
              
              
              6.93
              %
              
              30,175
              
              
              391,532
              
              
              5.95
              %
              
              23,313
              
              
              305,452
              
              
              5.95
              %
              
              18,174Allowance
                  for possible loan losses
              
              
              (3,577
              )
              
              
              
              
              
              
              
              (3,158
              )
              
              
              
              
              
              
              
              (3,164
              )Other
                  assets
              
              
              48,168
              
              
              
              
              
              
              
              
              59,054
              
              
              
              
              
              
              
              
              40,883TOTAL
                  ASSETS
              
              $
              480,204
              
              
              
              
              
              
              
              $
              447,428
              
              
              
              
              
              
              
              $
              343,171Interest
                  -bearing liabilities:Savings/NOW/money
                  market
              
              
              167,223
              
              
              1.01
              %
              
              1,695
              
              
              158,291
              
              
              0.44
              %
              
              699
              
              
              116,965
              
              
              0.53
              %
              
              625Time
                  deposits
              
              
              65,128
              
              
              2.74
              %
              
              1,784
              
              
              69,715
              
              
              1.54
              %
              
              1,071
              
              
              51,049
              
              
              2.21
              %
              
              1,126Other
                  borrowings
              
              
              27,966
              
              
              3.41
              %
              
              954
              
              
              31,023
              
              
              3.72
              %
              
              1,155
              
              
              31,396
              
              
              4.10
              %
              
              1,287Long
                  Term Debt
              
              
              8,248
              
              
              7.07
              %
              
              583
              
              
              8,248
              
              
              5.29
              %
              
              436
              
              
              8,248
              
              
              5.15
              %
              
              425Total
                  interest-bearing liabilities
              
              
              268,565
              
              
              1.87
              %
              
              5,016
              
              
              267,277
              
              
              1.26
              %
              
              3,361
              
              
              207,658
              
              
              1.67
              %
              
              3,463Demand
                  deposits
              
              
              166,780
              
              
              
              
              
              
              
              
              142,796
              
              
              
              
              
              
              
              
              109,349Other
                  liabilities
              
              
              3,519
              
              
              
              
              
              
              
              
              2,501
              
              
              
              
              
              
              
              
              2,995Stockholders'
                  equityCommon
                  stock
              
              
              28,049
              
              
              
              
              
              
              
              
              23,071
              
              
              
              
              
              
              
              
              12,649Retained
                  earnings
              
              
              13,268
              
              
              
              
              
              
              
              
              11,510
              
              
              
              
              
              
              
              
              10,143Valuation
                  Allowance Investments
              
              
              23
              
              
              
              
              
              
              
              
              273
              
              
              
              
              
              
              
              
              377Total
                  stockholders' equity
              
              
              41,340
              
              
              
              
              
              
              
              
              34,854
              
              
              
              
              
              
              
              
              23,169TOTAL
                    LIABILITIES AND STOCKHOLDERS'
                  EQUITY
              
              $
              480,204
              
              
              
              
              
              
              
              $
              447,428
              
              
              
              
              
              
              
              $
              343,171Net
                  Interest Income
              
              
              
              
              
              
              
              $
              25,159
              
              
              
              
              
              
              
              $
              19,952
              
              
              
              
              
              
              
              $
              14,711Net
                  Interest Margin (3)
              
              
              
              
              
              5.78
              %
              
              
              
              
              
              
              
              5.10
              %
              
              
              
              
              
              
              
              4.82
              %




(1)
            Nonaccrual
                loans have been included in total loans.(2)
            Loan
                fees of $1,440, $1,021 and $754, for 2005, 2004 and 2003, respectively
                have been included in the interest income computation.(3)
            Net
                interest income has been calculated by dividing the net interest
                income by
                total average earning assets.




24


**RATE/VOLUME
                ANALYSIS**




2005
              
              2004
              
              2003Average
              
              Average
              
              
              
              Average
              
              Average
              
              
              
              Average
              
              AverageIncrease
                  (decrease) in:
              
              Bal/Vol
              
              Rate
              
              Total
              
              Bal/Vol
              
              Rate
              
              Total
              
              Bal/Vol
              
              Rate
              
              TotalInterest
                  income:Loans
                  (1)
              
              $
              5,104
              
              $
              1,680
              
              $
              6,784
              
              $
              5,293
              
              
              ($608
              )
              $
              4,685
              
              $
              3,794
              
              
              ($1,263
              )
              $
              2,531Investment
                  securities taxable
              
              
              (401
              )
              
              17
              
              
              (384
              )
              
              242
              
              
              108
              
              
              350
              
              
              (51
              )
              
              (381
              )
              
              (432
              )Investment
                  securities
                non-taxable
                  (2):
              
              
              147
              
              
              (15
              )
              
              132
              
              
              94
              
              
              (15
              )
              
              79
              
              
              270
              
              
              (36
              )
              
              234Taxable
                  equivalent adjustment (2):
              
              
              (50
              )
              
              5
              
              
              (45
              )
              
              (32
              )
              
              5
              
              
              (27
              )
              
              (92
              )
              
              12
              
              
              (80
              )Interest-bearing
                  deposits
              
              
              (19
              )
              
              29
              
              
              10
              
              
              29
              
              
              (1
              )
              
              28
              
              
              15
              
              
              (7
              )
              
              8Federal
                  funds sold
              
              
              (59
              )
              
              424
              
              
              365
              
              
              (14
              )
              
              38
              
              
              24
              
              
              13
              
              
              (135
              )
              
              (122
              )Total
              
              
              4,722
              
              
              2,140
              
              
              6,862
              
              
              5,612
              
              
              (473
              )
              
              5,139
              
              
              3,949
              
              
              (1,810
              )
              
              2,139Interest
                  expense:Savings,
                  now, money market
              
              
              39
              
              
              957
              
              
              996
              
              
              216
              
              
              (142
              )
              
              74
              
              
              203
              
              
              (357
              )
              
              (154
              )Time
                  deposits
              
              
              (70
              )
              
              783
              
              
              713
              
              
              414
              
              
              (469
              )
              
              (55
              )
              
              128
              
              
              (288
              )
              
              (160
              )Other
                  borrowings
              
              
              (3
              )
              
              (198
              )
              
              (201
              )
              
              (15
              )
              
              (117
              )
              
              (132
              )
              
              88
              
              
              128
              
              
              216Long
                  term borrowings
              
              
              –
              
              
              147
              
              
              147
              
              
              13
              
              
              (2
              )
              
              11
              
              
              119
              
              
              (49
              )
              
              70Total
              
              
              (34
              )
              
              1,689
              
              
              1,655
              
              
              628
              
              
              (730
              )
              
              (102
              )
              
              538
              
              
              (566
              )
              
              (28
              )Increase
                  (decrease) in netInterest
                  income
              
              
              4,756
              
              
              451
              
              
              5,207
              
              
              4,984
              
              
              257
              
              
              5,241
              
              
              3,411
              
              
              (1,244
              )
              
              2,167





(1) Loan
                fees of $754,
                $1,021 and $1,440, for 2005, 2004 and 2003, respectively have been
                included in the interest income computation.(2) Adjusted
                to a fully
                taxable equivalent basis using a tax rate of 34%.




Note
                A: Average balances of all categories in each period were included
                in the
                volume computations.Note
                B: Average yield rates in each period were used in rate computations.
                Change attributable to both volume and rate have been allocated in
                proportion to the relationship between their absolute dollar
                amounts.




During
      2005 there was a $6.9 million increase in interest income and a $1.7 million
      increase in interest expense compared to 2004. The resulting $5.2 million
      increase in net interest income was the result of a number of dynamics affecting
      both average balance and interest rate considerations. The Company experienced
      an increase in its average earning assets outstanding of $44.1 million. This
      increase was primarily attributable to the net increase in average loans, which
      were up by $58.3 million. The increase in loans was partially offset by
      decreases in average federal funds sold of $4.8 million and taxable investment
      securities of $10.7 million. Also, average interest bearing liabilities
      increased by $1.3 million, significantly less than the increase in earning
      assets. Non-interest bearing demand deposits increased by $23.9 million during
      this period and
      provided low-cost funding for the growth in earning assets .
      In
      addition, earning asset yields were approximately 100 basis points higher in
      2005 compared to 2004 while deposit costs excluding demand deposits increased
      61
      basis points.




During
      2004 there was a $5.1 million increase in interest income along with a decrease
      of $102 thousand in interest expense compared to 2003. The resulting $5.2
      million increase in net interest income for 2004 was also a result of a number
      of dynamics affecting both average balance and interest rate considerations.
      The
      Company experienced an increase in its average earning assets outstanding of
      $86.1 million. The increase was divided amongst a net increase in average loans
      of $77.7 million and an increase in average investments of $8.2 million. Also,
      average interest bearing liabilities increased by $59.6 million, less than
      the
      increase in earning assets. The increases in earning assets and interest bearing
      liabilities are primarily attributable to the acquisition of Hacienda which
      affected the averages of these balances in 2004 with little corresponding
      influence in 2003. Non-interest demand deposits increased by $33.4 million
      during this period and provided low-cost funding for the growth in earning
      assets. Average earning assets yield was unchanged in 2004 versus 2003 while
      liability costs dropped 41 basis points.




The
      hypothetical impacts of sudden interest rate movements applied to the Company’s
      asset and liability balances are modeled monthly. The results of this movement
      indicate how much of the Company’s net interest income is “at risk” from various
      rate changes over a one year horizon. This exercise is valuable in identifying
      risk exposures. The results for the Company’s December 31, 2005 balances
      indicate that the net interest income at risk over a one year time horizon
      from
      a 1.0% and 2.0% upward rate movement and a 1.0% downward movement are within
      the
      Company’s policy guidelines for such changes. See, “Item 7A - Quantitative and
      Qualitative Disclosures about Market Risk.”




25





The
      tables below set forth changes from 2004 to 2005 for average interest earning
      assets and their respective average yields.





Average
                Balance
            
            
            
            
            
            Average
                Yieldfor
                the year ending
            
            
            
            
            
            for
                the year ending(dollars
                in thousands)
            
            31-Dec
            
            $
            
            %
            
            31-DecInterest
                Earning Assets:
            
            2005
            
            2004
            
            Variance
            
            Variance
            
            2005
            
            2004
            
            VarianceTime
                deposits with other banks
            
            $
            1,149
            
            $
            2,154
            
            $
            (1,005
            )
            
            -46.66
            %
            
            4.44
            %
            
            1.90
            %
            
            2.54
            %Investment
                securities taxable
            
            
            38,499
            
            
            49,178
            
            
            (10,679
            )
            
            -21.71
            %
            
            3.81
            %
            
            3.76
            %
            
            0.05
            %Investment
                securities non-taxable
            
            
            13,701
            
            
            11,511
            
            
            2,190
            
            
            19.03
            %
            
            4.33
            %
            
            4.40
            %
            
            -0.07
            %Federal
                funds sold
            
            
            19,529
            
            
            24,287
            
            
            (4,758
            )
            
            -19.59
            %
            
            3.42
            %
            
            1.24
            %
            
            2.18
            %Loans
                (1) (2)
            
            
            362,735
            
            
            304,402
            
            
            58,333
            
            
            19.16
            %
            
            7.55
            %
            
            6.77
            %
            
            0.78
            %Total
                interest earning assets
            
            $
            435,613
            
            $
            391,532
            
            $
            44,081
            
            
            11.26
            %
            
            6.93
            %
            
            5.95
            %
            
            0.98
            %





(1)
            Nonaccrual
                loans have been included in total loans.(2)
            Loan
                fees of $1,440, $1,021 and $754, for 2005, 2004 and 2003, respectively
                have been included in the interest income computation.





The
      tables below sets forth changes from 2004 to 2005 for average interest bearing
      liabilities and their respective average rates paid.





Average
                Balance
            
            
            
            
            
            Average
                Ratefor
                the year ending
            
            
            
            
            
            for
                the year ending(dollars
                in thousands)
            
            31-Dec
            
            $
            
            %
            
            31-DecInterest
                bearing liabilities:
            
            2005
            
            2004
            
            Variance
            
            Variance
            
            2005
            
            2004
            
            VarianceSavings/NOW/money
                market
            
            $
            167,223
            
            $
            158,291
            
            $
            8,932
            
            
            5.64
            %
            
            1.01
            %
            
            0.44
            %
            
            0.57
            %Time
                deposits
            
            
            65,128
            
            
            69,715
            
            
            (4,587
            )
            
            -6.58
            %
            
            2.74
            %
            
            1.54
            %
            
            2.59
            %Other
                borrowings
            
            
            27,966
            
            
            31,023
            
            
            (3,057
            )
            
            -9.85
            %
            
            3.41
            %
            
            3.72
            %
            
            -0.31
            %Long
                Term Debt
            
            
            8,248
            
            
            8,248
            
            
            –
            
            
            0.00
            %
            
            7.07
            %
            
            5.29
            %
            
            1.78
            %Total
                interest-bearing liabilities
            
            $
            268,565
            
            $
            267,277
            
            $
            1,288
            
            
            0.48
            %
            
            1.87
            %
            
            1.26
            %
            
            0.61
            %




26





**Non-Interest
      Income**





The
      table
      below sets forth changes from 2004 to 2005 and 2003 to 2004 for non-interest
      income exclusive of gains on sale of securities, SBA loans and premises.





Non-Interest
                Income Components




**For
                the Year Ended****December
                31,****(dollars
                in thousands)**
            
            **2005**
            
            **2004**
            
            **$
                Variance**
            
            **%
                Variance**Service
                Charges on Deposit Accounts
            
            $
            2,430
            
            $
            2,173
            
            $
            257
            
            
            11.8
            %ATM/Debit
                Card Transaction/Interchange Fees
            
            
            629
            
            
            583
            
            
            46
            
            
            7.9
            %Bancard
            
            
            160
            
            
            116
            
            
            44
            
            
            37.9
            %Mortgage
                Origination Fees
            
            
            897
            
            
            602
            
            
            295
            
            
            49.0
            %Earnings
                on Cash Surrender Value Life Ins
            
            
            323
            
            
            294
            
            
            29
            
            
            9.9
            %Other
            
            
            482
            
            
            446
            
            
            36
            
            
            8.1
            %**TOTAL**
            
            **$**
            **4,921**
            
            **$**
            **4,214**
            
            **$**
            **707**
            
            
            **16.8**
            **%**






**For
                  the Year Ended****December
                  31,****(dollars
                  in thousands)**
              
              **2004**
              
              **2003**
              
              **$
                  Variance**
              
              **%
                  Variance**Service
                  Charges on Deposit Accounts
              
              $
              2,173
              
              $
              1,723
              
              $
              450
              
              
              26.1
              %ATM/Debit
                  Card Transaction/Interchange Fees
              
              
              583
              
              
              406
              
              
              177
              
              
              43.6
              %Bancard
              
              
              116
              
              
              100
              
              
              16
              
              
              16.0
              %Mortgage
                  Origination Fees
              
              
              602
              
              
              880
              
              
              (278
              )
              
              -31.6
              %Earnings
                  on Cash Surrender Value Life Ins
              
              
              294
              
              
              264
              
              
              30
              
              
              11.4
              %Other
              
              
              446
              
              
              364
              
              
              82
              
              
              22.5
              %**TOTAL**
              
              **$**
              **4,214**
              
              **$**
              **3,737**
              
              **$**
              **477**
              
              
              **12.8**
              **%**




For
      2005
      compared to 2004, increases in Service Charges on Deposit Accounts were
      generally commensurate with and primarily due to deposit growth.





Mortgage
      Origination Fees increased in 2005 in comparison to 2004 due primarily to
      increased mortgage volumes as a result of decreasing interest rates and the
      availability of credit to mortgage consumers. Management is very aware that
      the
      revenue generated by this line of business is impacted by rate volatility and
      that if rates continue to rise or the availability of credit is diminished
      that
      mortgage volumes at the Company could decline and impact the level of mortgage
      origination fee income. To mitigate material decreases in net revenue from
      this
      line of business, Management has taken steps to ensure that fixed costs are
      minimal due to commission based remuneration. In addition, the Company has
      increased mortgage sales representation in markets that it services in an effort
      to increase market share.





For
      2004
      compared to 2003, increases in Service Charges on Deposit Accounts and ATM/Debit
      Card Transactions are the direct effect of deposit growth and the full year
      impact in 2004 of the Hacienda acquisition.





Mortgage
      Origination Fees decreased in 2004 in comparison to 2003 due primarily to a
      slowdown in the re-finance market that was felt throughout the United States
      during the period. Though long term rates were not significantly impacted by
      the
      FRB rate increases during 2004, borrowers had already taken advantage of the
      lower rate environment of 2002 and 2003.




27





**Non-Interest
      Expenses**





The
      table
      below sets forth changes from 2005 to 2004 for non-interest expense.





Non-Interest
                Expense Components




**For
                the Year Ended****December
                31,****(dollars
                in thousands)**
            
            **2005**
            
            **2004**
            
            **$
                Variance**
            
            **%
                Variance**Salaries
                and Employee Benefits
            
            $
            9,746
            
            $
            8,457
            
            $
            1,289
            
            
            15.2
            %Occupany
                and Equipment
            
            
            2,491
            
            
            2,570
            
            
            (79
            )
            
            -3.1
            %Data
                Processing
            
            
            2,200
            
            
            2,570
            
            
            (370
            )
            
            -14.4
            %Advertising
                and promotional
            
            
            582
            
            
            515
            
            
            67
            
            
            13.0
            %Regulatory
                fees
            
            
            106
            
            
            114
            
            
            (8
            )
            
            -7.0
            %Other
                professional fees and outside services
            
            
            802
            
            
            530
            
            
            272
            
            
            51.3
            %Legal
                fees and other litigation expense
            
            
            122
            
            
            76
            
            
            46
            
            
            60.5
            %Loan
                Department Costs
            
            
            182
            
            
            181
            
            
            1
            
            
            0.6
            %Stationery
                and supplies
            
            
            311
            
            
            374
            
            
            (63
            )
            
            -16.8
            %Director
                fees
            
            
            247
            
            
            179
            
            
            68
            
            
            38.0
            %Core
                Deposit Intangible Amortization
            
            
            573
            
            
            421
            
            
            152
            
            
            36.1
            %Other
            
            
            1,356
            
            
            1,211
            
            
            145
            
            
            12.0
            %**$**
            **18,718**
            
            **$**
            **17,198**
            
            **$**
            **1,520**
            
            
            **8.8**
            **%**




**For
                the Year Ended****December
                31,****(dollars
                in thousands)**
            
            **2004**
            
            **2003**
            
            **$
                Variance**
            
            **%
                Variance**Salaries
                and Employee Benefits
            
            $
            8,457
            
            $
            6,498
            
            $
            1,959
            
            
            30.1
            %Occupany
                and Equipment
            
            
            2,570
            
            
            1,757
            
            
            813
            
            
            46.3
            %Data
                Processing
            
            
            2,570
            
            
            1,581
            
            
            989
            
            
            62.6
            %Advertising
                and promotional
            
            
            515
            
            
            361
            
            
            154
            
            
            42.7
            %Regulatory
                fees
            
            
            114
            
            
            86
            
            
            28
            
            
            32.6
            %Other
                professional fees and outside services
            
            
            530
            
            
            432
            
            
            98
            
            
            22.7
            %Legal
                fees and other litigation expense
            
            
            76
            
            
            52
            
            
            24
            
            
            46.2
            %Loan
                Department Costs
            
            
            181
            
            
            255
            
            
            (74
            )
            
            -29.0
            %Stationery
                and supplies
            
            
            374
            
            
            249
            
            
            125
            
            
            50.2
            %Director
                fees
            
            
            179
            
            
            152
            
            
            27
            
            
            17.8
            %Core
                Deposit Intangible Amortization
            
            
            421
            
            
            41
            
            
            380
            
            
            926.8
            %Other
            
            
            1,211
            
            
            961
            
            
            250
            
            
            26.0
            %**$**
            **17,198**
            
            **$**
            **12,425**
            
            **$**
            **4,773**
            
            
            **38.4**
            **%**





Salary/Related
      Expense




Salaries
      and employee related expense incurred the greatest dollar increase of any
      non-interest expense category during both 2005 and 2004. For the year ended
      December 31, 2005, the primary sources of the increase in this category were
      bonus expense, salaries and expenses under the Company’s salary continuation
      plans. Other factors included higher group insurance costs and 401k
      contributions. Most of these increases are a direct result of increases in
      the
      Company’s overall size and profitability. During 2004 approximately $710
      thousand or 41% of the dollar variance was due to the full year effect of the
      Hacienda acquisition versus only two months during 2003. Full time equivalent
      (FTE) employees increased from 164 at December 31, 2003 to 170 at December
      31,
      2004 and to 186 at December 31, 2005.




Bonus
      and
      commissions expense increases during 2004 and 2005 were influenced by the
      Company’s commitment to incentive based pay. Management believes that incentive
      based pay is a significant part of the Company’s corporate culture and has
      served to help provide above average return to shareholders. All employees
      participate either on a monthly, quarterly or annual basis.




Group
      insurance costs increased by approximately $160 thousand each of the past two
      years. During 2004, nearly $100 thousand of this increase is due to the full
      year impact of the Hacienda staff. In addition, rising group health costs have
      been an area of great concern nationally for nearly all businesses recently.
      The
      Company has made efforts to contain these costs while at the same time ensuring
      that employees receive appropriate and fair consideration.




28




Occupancy
      and Equipment




Occupancy
      and equipment expense decreased $78 thousand compared to 2004. In July 2005
      the
      Company entered into a sale-leaseback transaction of its branch office in the
      city of Atascadero. The sale price was $900 thousand and resulted in a gain
      to
      the Company of approximately $283 thousand which will be amortized into income
      over the term of the leaseback. While this transaction increases occupancy
      expense, the net income statement effect of the sale-leaseback will be a
      reduction in the net monthly cost of operating the branch. Occupancy and
      equipment expense increased $813 thousand in 2004 over that in 2003. The full
      year impact of the Hacienda acquisition on October 31, 2003 accounts for
      approximately $585 thousand of this variance. The other major contributing
      factor impacting this increase was the relocation of the Woodland Branch to
      a
      new facility in February 2004 that accounted for approximately $149 thousand
      additional expense over that of 2003.




Data
      Processing Expense




Data
      processing expense declined $370 thousand in 2005 compared to 2004. The primary
      cause of the decline was $540 thousand of non-recurring expenses in 2004 related
      to the March 2005 final conversion of Hacienda’s core and other ancillary
      processing services into the Bank’s systems. Nearly 83% of this conversion cost
      is being saved over 18 months via a credit from its current data processing
      vendor of $25 thousand per month. The Company will cease receiving this monthly
      credit in October 2006. In addition, the conversion allowed the Company to
      discontinue incurring Hacienda’s legacy data processing costs beginning in March
      2005. The increase in data processing expense in 2004 compared to 2003 of $989
      thousand was due to the one-time conversion expenses, bank-wide customer growth
      and the assumption Hacienda’s data processing costs post-merger. The impact of a
      full year of expense for Hacienda accounted for approximately $480 thousand
      in
      2004 compared to two month’s expense in 2003 of $103 thousand.




Other
      Professional Fees and Outside Services




The
      Company incurred $802 thousand in other professional fees and outside services
      during 2005. These expenses increased by $272 thousand and $98 thousand in
      2005
      and 2004 respectively. The increases during these periods were attributable
      to
      higher audit and tax accounting costs, attorney’s fees and consulting fees
      related to compliance with the Sarbanes-Oxley Act, Section 404.




Core
      Deposit Intangible Amortization




Following
      the acquisition of Hacienda in late 2003 the Company incurred significantly
      higher core deposit intangible amortization during 2004 and 2005 compared to
      2003. The Company chose to amortize the Hacienda-related intangibles by
      utilizing an amortization schedule in accordance with FAS 141 and FAS 142.
      In
      accordance with this schedule, the Company should incur less expense in 2006
      than in 2004 or 2005.




**Provision
      for Income Taxes**




The
      provision for income taxes was 38.2%, 37.6% and 37.1% of net pre-tax income
      for
      years ended December 31, 2005, 2004 and 2003, respectively.




**Provision
      and Allowance for Credit Losses**




An
      allowance for loan losses has been established by management to provide for
      those loans that may not be repaid in their entirety for a variety of reasons.
      The allowance is maintained at a level considered by management to be adequate
      to provide for probable incurred losses. The allowance is increased by
      provisions charged to earnings and is reduced by charge-offs, net of recoveries.
      The provision for loan losses is based upon past loan loss experience and
      management’s evaluation of the loan portfolio under current economic conditions.
      Loans are charged to the allowance for loan losses when, and to the extent,
      they
      are deemed by management to be un-collectible. The allowance for loan losses
      is
      composed of allocations for specific loans and a historical portion for all
      other loans.




The
      Bank
      recognizes that credit losses will be experienced and the risk of loss will
      vary
      with, among other things, general economic conditions; the type of loan being
      made; the creditworthiness of the borrower over the term of the loan and in
      the
      case of a collateralized loan, the quality of the collateral for such loan.
      The
      allowance for loan loss represents the Bank’s estimate of the allowance
      necessary to provide for probable incurred losses in the portfolio. In making
      this determination, the Bank analyzes the ultimate collectibility of the loans
      in the portfolios by incorporating feedback provided by internal loan staff,
      an
      independent loan review function, and information provided by examinations
      performed by regulatory agencies. The Bank makes monthly evaluations as to
      the
      adequacy of the allowance for loan losses.




29




The
      analysis of the allowance for loan losses is comprised of three components;
      specific credit allocation; general portfolio allocation; and subjectively
      by
      determined allocation. Effective January 1, 1995 the Bank adopted Statement
      of
      Financial Accounting Standards No.114, Accounting by Creditors for Impairment
      of
      a Loan (SFAS 114), as amended by SFAS No. 118, Accounting by Creditors for
      Impairment of a Loan - Income Recognition and Disclosures. These pronouncements
      provide that when it is probable that a creditor will be unable to collect
      all
      amounts due in accordance with the terms of the loan that such loan is deemed
      impaired. Impaired loans are accounted for differently in that the amount of
      the
      impairment is measured and reflected in the records of the creditor. The
      allowance for credit losses related to loans that are identified for evaluation
      in accordance with Statement 114 is based on discounted cash flows using the
      loan’s initial effective interest rate or the fair value of the collateral for
      certain collateral dependent loans. The general portfolio allocation consists
      of
      an assigned reserve percentage based on the credit rating of the loan. The
      subjective portion is determined based on loan history and the Banks’ evaluation
      of various factors including current economic conditions and trends in the
      portfolio including delinquencies and impairment, as well as changes in the
      composition of the portfolio.




The
      allowance for loan losses is based on estimate, and ultimate losses will vary
      from current estimates. These estimates are reviewed monthly by the Bank’s
      Director’s Loan Committee and full Board of Directors, and as adjustments,
      either positive or negative, become necessary, a corresponding increase or
      decrease is made in the provision for loan losses. The methodology used to
      determine the adequacy of the allowance for possible loan losses for the year
      2005 is consistent with prior periods.




The
      Bank’s provision for loan losses was $710 thousand, $410 thousand and $370
      thousand for 2005, 2004 and 2003 respectively. The increase in the loan loss
      provision represents coverage for general loan portfolio growth and real estate
      concentrations. Net loan charge-offs (loans charged off, net of loans recovered)
      were $76 thousand for 2005 and $233 thousand in both 2004 and 2003. Losses
      in
      2005 decreased through sound loan underwriting and stable economic conditions.
      The allowance for credit losses as a percent of total gross loans at year-end
      2005, 2004 and 2003 was 1.05, 0.96% and 1.10%, respectively.




Loans
      are
      placed on non-accrual when a loan is specifically determined to be impaired
      or
      when principal or interest is delinquent for 90 days or more. Any unpaid
      interest previously accrued on those loans is reversed from income. Interest
      income generally is not recognized on specific impaired loans unless the
      likelihood of further loss is remote. Interest payments received on such loans
      are applied as a reduction on the loan principal balance.




Loans
      on
      non-accrual status totaled $54 thousand, $872 thousand and $1.5 million at
      December 31, 2005, 2004 and 2003, respectively. The decrease in non-accrual
      totals was the result of resolving several loan situations. Typically, these
      loans have adequate collateral protection and/or personal guaranties to provide
      a source of repayment to the Bank. The loans on non-accrual are related to
      several commercial loans that are being addressed by specific workout plans
      at
      this time. Interest income that would have been recognized on non-accrual loans
      if they had performed in accordance with the terms of the loans was
      approximately $87 thousand, $126 thousand and $132 thousand for the period
      ended
      December 31, 2005, 2004 and 2003, respectively.




Non-performing
      loans include non-accrual loans, restructured loans and accruing loans that
      are
      90 days or more delinquent. The Bank had no loans that were 90 days or more
      delinquent and still accruing interest at December 31, 2005. Total
      non-performing loans were $54 thousand at December 31, 2005.




30





The
      following table summarizes the analysis of the allowance for loan losses as
      of
      December 31, 2005, 2004, 2003, 2002 and 2001:





**Analysis
                of Allowance for Loan Losses**(in
                thousands)




**2005**
            
            **2004**
            
            **2003**
            
            **2002**
            
            **2001**Balance
                at Beginning of Period
            
            $
            3,247
            
            $
            3,070
            
            $
            2,336
            
            $
            1,744
            
            $
            1,321Balance
                of Hacienda Bank atBeginning
                of Period
            
            
            –
            
            
            –
            
            
            597
            
            
            –
            
            
            –Charge-offs:Commercial,
                Fianacial and Agricultural
            
            
            86
            
            
            202
            
            
            463
            
            
            76
            
            
            156Real
                Estate- Construction
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –Commercial
                Real Estate
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –Installment
                Loans to Individuals:
            
            
            12
            
            
            29
            
            
            –
            
            
            –
            
            
            22Money Plus
            
            
            2
            
            
            5
            
            
            3
            
            
            5
            
            
            3Credit Cards
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –Other Installment
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –Total
                charge-offs
            
            
            100
            
            
            236
            
            
            466
            
            
            81
            
            
            181Recoveries:Commercial,
                Fianacial and Agricultural
            
            
            –
            
            
            1
            
            
            232
            
            
            127
            
            
            –Real
                Estate- Construction
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –Real
                Estate-Mortgage
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –Installment
                Loans to Individuals:
            
            
            24
            
            
            2
            
            
            1
            
            
            –
            
            
            2Money Plus
            
            
            –
            
            
            –
            
            
            –
            
            
            1
            
            
            2Credit Cards
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –Other Installment
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –Total
                recoveries
            
            
            24
            
            
            3
            
            
            233
            
            
            128
            
            
            4Net
                Charge-offs
            
            
            76
            
            
            233
            
            
            233
            
            
            (47
            )
            
            177Additions
                Charged to Operations
            
            
            710
            
            
            410
            
            
            370
            
            
            545
            
            
            600Balance
                at End of Period
            
            
            3,881
            
            
            3,247
            
            
            3,070
            
            
            2,336
            
            
            1,744Gross
                Loans at End of Period
            
            $
            368,133
            
            $
            339,693
            
            $
            278,135
            
            $
            190,469
            
            $
            158,472Ratio
                of Net Charge-offs During theYear
                to Average Loans outstanding
            
            
            0.02
            %
            
            0.08
            %
            
            0.10
            %
            
            -0.03
            %
            
            0.12
            %Ratio
                of Reserves to Gross Loans
            
            
            1.05
            %
            
            0.96
            %
            
            1.10
            %
            
            1.23
            %
            
            1.10
            %Ratio
                of Non-performing Loans tothe
                Allowance for Credit Losses
            
            
            1.39
            %
            
            28.77
            %
            
            50.20
            %
            
            57.62
            %
            
            85.70
            %




**Allocation
                of the Allowance for Loan
                Losses**




2005
            
            2004
            
            2003
            
            2002
            
            2001%
                Total
            
            
            
            %
                Total
            
            
            
            %
                Total
            
            
            
            %
                Total
            
            
            
            %
                TotalAmount
            
            Loans
            
            Amount
            
            Loans
            
            Amount
            
            Loans
            
            Amount
            
            Loans
            
            Amount
            
            LoansCommercial,
                Fianacial and
              Agricultural
            $
            633
            
            
            16
            %
            $
            475
            
            
            15
            %
            $
            541
            
            
            18
            %
            $
            494
            
            
            21
            %
            $
            447
            
            
            26
            %Real
                Estate- Construction
            
            812
            
            
            21
            %
            
            641
            
            
            20
            %
            
            527
            
            
            17
            %
            
            498
            
            
            21
            %
            
            258
            
            
            15
            %Commercial
                Real Estate
            
            2,221
            
            
            57
            %
            
            1,934
            
            
            60
            %
            
            1,793
            
            
            58
            %
            
            1,178
            
            
            50
            %
            
            909
            
            
            52
            %Home
                Equity Lines of Credit
            
            152
            
            
            4
            %
            
            141
            
            
            4
            %
            
            148
            
            
            5
            %
            
            116
            
            
            5
            %
            
            91
            
            
            5
            %Installment
                Loans to Individuals
            
            59
            
            
            2
            %
            
            53
            
            
            2
            %
            
            57
            
            
            2
            %
            
            47
            
            
            2
            %
            
            35
            
            
            2
            %All
                Other Loans (including
              overdrafts)
            
            4
            
            
            0
            %
            
            3
            
            
            0
            %
            
            4
            
            
            0
            %
            
            3
            
            
            0
            %
            
            5
            
            
            0
            %Total
            $
            3,881
            
            
            100
            %
            $
            3,247
            
            
            100
            %
            $
            3,070
            
            
            100
            %
            $
            2,336
            
            
            100
            %
            $
            1,744
            
            
            100
            %





**Financial
      Condition**





Total
      assets of the Company were $488.5 million at December 31, 2005 compared to
      $448.0 million at December 31, 2004, this represents an increase of $40.5
      million or 9.0%. A favorable lending environment allowed the Company to increase
      net loans by $27.7 million. Excess funds were invested primarily in Federal
      Funds Sold which ended the year $20.5 million higher than at year-end 2004.
      The
      investment portfolio trended downward during the year primarily due to
      prepayments on mortgage-backed securities. The portfolio ended 2005 with a
      book
      value $13.0 million less than at December 31, 2004.




31




The
      growth in assets was fueled by $20.6 million increases in both non-interest
      bearing demand deposits and money market balances as well as a $22.7 million
      increase in time deposits. These increases were offset by an $18.5 decrease
      in
      FHLB advances and other borrowings, primarily the result of an FHLB advance
      maturity which was not renewed in view of excess liquidity at the bank during
      the fourth quarter of 2005.




Earning
      assets as a percent of total assets was 93.6% at December 31, 2005 compared
      to
      91.6% and 85.2% at December 31, 2004 and 2003 respectively.





For
      2004,
      total assets increased by $6.0 million or 1.4%. The major contributing factor
      to
      this modest growth was a $14.2 million decrease in time deposits. This decrease
      was a factor of intended pricing instituted by Management as the result of
      the
      Hacienda acquisition in October 2003. At the time of the acquisition, one of
      the
      prime objectives was to bring the Hacienda cost of deposits, specifically time
      deposits, in line with those of the Bank. The Hacienda time deposit decrease
      represented approximately 87.0% of the total decrease in time deposits. The
      benefit of this action was very apparent in the favorable increase in net
      interest margin for the Company in 2004.




One
      other
      factor that contributed in a smaller way was the $3.5 million decrease in Notes
      Payable. The Company repaid, in full, the outstanding balance of a revolving
      line of credit. This was done in July 2004.




Earning
      assets as a percent of total assets was 91.6% at December 31, 2004 compared
      to
      85.2% at December 31, 2003. In addition to the increase in the percent of
      earning assets, the change in the mix was such that a large portion of low
      yielding Fed Funds Sold moved into higher yielding loans.





**Loans**





A
      significant portion of total assets is the Company’s gross loans that were
      $368.1 million and $339.7 million at December 31, 2005 and 2004, respectively.
      Approximately 59.0% of gross loans at December 31, 2005 re-price within one
      year. If interest rates change, the yield on the loans that renew or re-price
      according to their terms, will also change. The Company has an Asset/Liability
      Management system that models various interest rate environments for all rate
      sensitive assets and liabilities. In a 100 basis point increase action by the
      FRB, the model indicates that the net interest income would increase by
      approximately $1.6 million while a 100 basis point decline would decrease net
      interest income by $1.7 million.





The
      table
      below sets forth the composition of the loan portfolio as of December 31, 2005,
      2004, 2003, 2002 and 2001.




(in
                thousands)2005
            
            2004
            
            2003
            
            2002
            
            2001Amount
            
            Percent
            
            Amount
            
            Percent
            
            Amount
            
            Percent
            
            Amount
            
            Percent
            
            Amount
            
            PercentCommercial,
                Financial and Agricultural
            
            $
            60,050
            
            
            16
            %
            $
            49,584
            
            
            15
            %
            $
            49,024
            
            
            18
            %
            $
            40,373
            
            
            21
            %
            $
            40,608
            
            
            26
            %Real
                Estate- Construction
            
            
            76,981
            
            
            21
            %
            
            66,833
            
            
            20
            %
            
            47,720
            
            
            17
            %
            
            40,723
            
            
            21
            %
            
            23,449
            
            
            15
            %Commercial
                Real Estate
            
            
            210,690
            
            
            57
            %
            
            202,765
            
            
            60
            %
            
            162,463
            
            
            58
            %
            
            96,324
            
            
            50
            %
            
            82,581
            
            
            52
            %Home
                Equity Lines of Credit
            
            
            14,398
            
            
            4
            %
            
            14,708
            
            
            4
            %
            
            13,417
            
            
            5
            %
            
            10,486
            
            
            5
            %
            
            8,243
            
            
            5
            %Installment
                Loans to Individuals
            
            
            5,620
            
            
            2
            %
            
            5,538
            
            
            2
            %
            
            5,173
            
            
            2
            %
            
            2,291
            
            
            2
            %
            
            3,172
            
            
            2
            %All
                Other Loans (including overdrafts)
            
            
            394
            
            
            0
            %
            
            265
            
            
            0
            %
            
            338
            
            
            0
            %
            
            272
            
            
            0
            %
            
            419
            
            
            0
            %Total
                Loans, Gross
            
            
            368,133
            
            
            100
            %
            
            339,693
            
            
            100
            %
            
            278,135
            
            
            100
            %
            
            190,469
            
            
            100
            %
            
            158,472
            
            
            100
            %Deferred
                Loan Fees
            
            
            (1,617
            )
            
            
            
            
            (1,482
            )
            
            
            
            
            (1,014
            )
            
            
            
            
            (822
            )
            
            
            
            
            (578
            )Reserve
                for Possible Loan Losses
            
            
            (3,881
            )
            
            
            
            
            (3,247
            )
            
            
            
            
            (3,070
            )
            
            
            
            
            (2,336
            )
            
            
            
            
            (1,744
            )Total
                Loans, Net
            
            $
            362,635
            
            
            
            
            $
            334,964
            
            
            
            
            $
            274,051
            
            
            
            
            $
            187,311
            
            
            
            
            $
            156,150Loans
                Held For Sale
            
            $
            3,392
            
            
            
            
            $
            2,253
            
            
            
            
            $
            4,402
            
            
            
            
            $
            8,166
            
            
            
            
            $
            4,082




32





The
      following are the approximate maturities and sensitivity to change in interest
      rates for the loan portfolio at December 31, 2005.





(in
                thousands)
            
            Due
                    Within3 monthsor less
            
            Due
                    Over3 mos through12 months
            
            Due
                    Over12 mothrough 3 yrs
            
            Due
                    Over3 yrsthrough 5 yrs
            
            Due
                    Over5 yrsthrough 15 yrs
            
            Due
                  Over15 yrs
            
            TotalFixed
                Rate LoansCommercial,
                Fianacial and Agricultural
            
            $
            790
            
            $
            1,531
            
            $
            2,998
            
            $
            3,742
            
            $
            3,075
            
            $
            –
            
            $
            12,136Real
                Estate- Construction
            
            
            20,209
            
            
            4,407
            
            
            458
            
            
            –
            
            
            –
            
            
            –
            
            
            25,074Commercial
                Real Estate
            
            
            2,430
            
            
            841
            
            
            4,527
            
            
            4,700
            
            
            8,490
            
            
            –
            
            
            20,988Home
                Equity Lines of Credit
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –Installment
                Loans to Individuals
            
            
            60
            
            
            343
            
            
            466
            
            
            1,098
            
            
            2,426
            
            
            282
            
            
            4,675All
                Other Loans (including overdrafts)
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –Totals
            
            $
            23,489
            
            $
            7,122
            
            $
            8,449
            
            $
            9,540
            
            $
            13,991
            
            $
            282
            
            $
            62,873




(in
                thousands)
            
            Due
                    Within3 monthsor less
            
            Due
                    Over3 mos through12 months
            
            Due
                    Over12 mothrough 3 yrs
            
            Due
                    Over3 yrsthrough 5 yrs
            
            Due
                    Over5 yrsthrough 15 yrs
            
            Due
                  Over15 yrs
            
            TotalVariable
                Rate LoansCommercial,
                Fianacial and Agricultural
            
            $
            38,017
            
            $
            1,335
            
            $
            5,933
            
            $
            2,629
            
            $
            –
            
            $
            –
            
            $
            47,914Real
                Estate- Construction
            
            
            48,150
            
            
            449
            
            
            60
            
            
            3,248
            
            
            –
            
            
            –
            
            
            51,907Commercial
                Real Estate
            
            
            62,578
            
            
            21,742
            
            
            78,484
            
            
            26,898
            
            
            –
            
            
            –
            
            
            189,702Home
                Equity Lines of Credit
            
            
            14,398
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            14,398Installment
                Loans to Individuals
            
            
            945
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            945All
                Other Loans (including overdrafts)
            
            
            394
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            394Totals
            
            $
            164,482
            
            $
            23,526
            
            $
            84,477
            
            $
            32,775
            
            $
            –
            
            $
            –
            
            $
            305,260Totals
                All Loans
            
            $
            187,971
            
            $
            30,648
            
            $
            92,926
            
            $
            42,315
            
            $
            13,991
            
            $
            282
            
            $
            368,133





The
      following table sets forth changes from 2004 to 2005 for the loan portfolio
      categories.





(in
                thousands)
            
            2005
            
            2004
            
            $
                Variance
            
            %
                VarianceCommercial,
                Financial and Agricultural
            
            $
            60,050
            
            $
            49,584
            
            $
            10,466
            
            
            17.43
            %Real
                Estate- Construction
            
            
            76,981
            
            
            66,833
            
            
            10,148
            
            
            13.18
            %Commercial
                Real Estate
            
            
            210,690
            
            
            202,765
            
            
            7,925
            
            
            3.76
            %HELOC
            
            
            14,398
            
            
            14,708
            
            
            (310
            )
            
            -2.15
            %Installment
                Loans to Individuals
            
            
            5,620
            
            
            5,538
            
            
            82
            
            
            1.46
            %All
                Other Loans (including overdrafts)
            
            
            394
            
            
            265
            
            
            129
            
            
            32.74
            %Total
                Loans,Gross
            
            
            368,133
            
            
            339,693
            
            
            28,440
            
            
            7.73
            %Deferred
                Loan Fees
            
            
            (1,617
            )
            
            (1,482
            )
            
            (135
            )
            
            8.35
            %Reserve
                for Possible Loan Losses
            
            
            (3,881
            )
            
            (3,247
            )
            
            (634
            )
            
            16.34
            %Total
                Loans,Net
            
            $
            362,635
            
            $
            334,964
            
            $
            27,671
            
            
            7.63
            %Loans
                Held For Sale
            
            $
            3,392
            
            $
            2,253
            
            $
            1,139
            
            
            33.58
            %




The
      increase in commercial, financial and agricultural loans is attributed primarily
      to a $3.6 million oilfield equipment loan, several new $1.0 million lines of
      credit and a $1.4 million farm real estate loan.





The
      increase in real estate-construction loans can be attributed to several large
      new construction projects and the funding of existing construction projects.
      New
      loans include a residential tract development for $3.3 million, an addition
      to a
      strip center for $4.0 million, a medical office complex for $10.7 million,
      a
      medical office for $4.0 million, a retail/warehouse for $4.4 million, hotel
      loans to several clients for $6.3 million, $4.2 million, $3.8 million, $2.2
      million and $1.7 million, a retail/office complex for $4.2 million, an office
      complex for $3.1 million and numerous other smaller projects. Several
      construction loans paid off during 2005 as borrowers refinanced through mortgage
      brokers and out of the area lenders. Construction loans are typically granted
      for a one year period and then, with income properties, are amortized over
      not
      more than 25 years with 10 to 15 year maturities.





The
      increase in commercial real estate loans is attributed to several of the
      construction loans moving into amortizing loans and to new commercial property
      loans. New loans include a strip center for $4.9 million, 7 office buildings
      for
      $3.7 million, a warehouse building for $1.9 million, service stations for $3.2
      million, a resort hotel for $4.3 million, a hotel for $2.0 million, a bowling
      alley/restaurant for $1.5 million, a strip center for $2.7 million and an
      office/warehouse for $2.2 million.




33




The
      Bank
      presently has a concentration of loans in construction/land in the amount of
      $77.0 million which represents 165% of the Bank’s Total Risk Based capital.
      Un-disbursed commitments total $63.1 million which combined with disbursed
      represent 296% of the Bank’s Total Risk based Capital. At December 31, 2005
      there were 83 construction loans with outstanding balances and remaining
      commitments of approximately $58.9 million and $63.0 million, respectively.
      The
      single largest construction loan has a commitment amount of approximately $10.7
      million with a balance of approximately $2.5 million at December 31, 2005.
      This
      is an office complex in San Luis Obispo, Ca. At December 31, 2005, there were
      53
      land loans with balances of approximately $18.1 million. The single largest
      land
      loan accounts for approximately $1.6 million of the total and is for a mixed
      use
      development. The construction/land loans are spread throughout our market area
      and have consistently performed in a satisfactory manner.





Hotel
      loans disbursed are also considered to be a concentration with balances of
      $31.9
      million which represents 76.0% of the Bank’s Total Risk Based Capital. There are
      several hotel construction loans that increase total commitments to $54.2
      million which represents a concentration at 113% of the Bank’s Total Risk Based
      Capital. At December 31, 2005, there were 32 motel loans. The single largest
      loan had a balance of approximately $6.3 million, was made to a nationally
      known
      chain and is located in Paso Robles, Ca. The hotel loans are also made to
      clients throughout our market. These loans have also typically paid as agreed.
      The Bank had one out of area hotel participation loan that was in default.
      This
      loan, in the original amount of $1 million, was paid down by $900 thousand
      in
      April 2004 and the remaining $95 thousand charged off in 2004. A small recovery
      of $1 thousand was received with no further payment expected.





In
      September 2004, the Bank issued an $11.7 million irrevocable standby letter
      of
      credit to guarantee the payment of Taxable Variable Rate Demand Bonds. The
      primary purpose of the bond issue was to refinance existing debt and provide
      funds for capital improvements and expansion of an assisted living facility
      in
      San Luis Obispo. Approximately $6.6 million of the funds were deposited with
      the
      Bank with $3.5 million remaining at December 31, 2005. The project is
      approximately 50% complete and should be finished in mid 2006. The letter of
      credit will expire in September 2007.





Construction
      loan demand for both single family and commercial real estate was strong during
      the first half of 2005 and then softened during the second half of the year.
      Increased interest rates and construction costs impacted commercial real estate
      activity. Area home prices continue to increase however they remain considerably
      lower than the metropolitan areas to our North and South. Reasonable mortgage
      rates and a variety of financing options (interest only mortgages, 40 year
      loans, etc.) have kept many in the market. The continued availability of land
      for subdivision use also continued to drive the market in the North San Luis
      Obispo and Santa Maria markets.





Business
      properties are also in demand with low vacancies and competitive loan rates.
      Commercial property values and rental rates have increased substantially during
      the year. Investors, many seeking exchange properties, continue to seek
      properties in our market area. Capitalization rates have steadily decreased
      with
      increased demand. Capitalization rate ranges over the last three years are:
      2003
      - 7.0% to 8.0%, 2004- 6.5% to 7.5% and 2005- 5.5% to 6.5%. Low capitalization
      rate properties typically require larger down payments in order to satisfy
      bank
      debt coverage requirements. The Bank expects to experience continued growth
      in
      commercial real estate loans during 2006.




Loans
      held for sale consist of mortgage originations that have already been sold
      pursuant to correspondent mortgage loan agreements. There is no interest rate
      risk associated with these loans as the commitments are in place at the time
      that the Bank funds them. Settlement from the correspondents is typically within
      30 to 45 days.





At
      December 31, 2005, the Bank had no foreign loans outstanding. The Bank did
      not
      have any concentrations of loans except as disclosed above.





The
      Bank’s management is responsible for monitoring loan performance that is done
      through various methods, including a review of loan delinquencies and personal
      knowledge of customers. Additionally, the Bank maintains both a “watch” list of
      loans that, for a variety of reasons, management believes requires regular
      review as well as an internal loan classification process. Annually, the loan
      portfolio is also reviewed by an experienced, outside loan reviewer not
      affiliated with the Bank. A list of delinquencies, the watch list, loan grades
      and the outside loan review are reviewed regularly by the Bank’s Board of
      Directors.




34




The
      Bank
      has a non-accrual policy that requires a loan greater than 90 days past due
      to
      be placed on non-accrual status unless such loan is well-collateralized and
      in
      the process of collection. When loans are placed on non-accrual status, all
      uncollected interest accrued is reversed from earnings. Once on non-accrual
      status, interest on a loan is only recognized on a cash basis. Loans may be
      returned to accrual status if management believes that all remaining principal
      and interest is fully collectible and there has been at least six months of
      sustained repayment performance since the loan was placed on non-accrual. At
      December 31, 2005 non-accrual loans were $54 thousand.





If
      a
      loan’s credit quality deteriorates to the point that collection of principal is
      believed by management to be doubtful and the value of collateral securing
      the
      obligation is sufficient the Bank generally takes steps to protect and liquidate
      the collateral. Any loss resulting from the difference between the loan balance
      and the fair market value of the property is recognized by a charge to the
      reserve for loan losses. When the property is held for sale after foreclosure,
      it is subject to a periodic appraisal. If the appraisal indicates that the
      property will sell for less than its recorded value, the Bank recognizes the
      loss by a charge to non-interest expense.





**Total
      Cash and Due from Banks**





Total
      cash and due from banks were $18.3 million, $13.1million and $40.4 million
      at
      December 31, 2005, 2004 and 2003, respectively. This line item will vary
      depending on cash letters from the previous night and actual cash on hand in
      the
      branches. In December 2004, the Bank implemented a deposit re-classification
      program that enabled the Bank to reduce reserve requirements with the FRB by
      approximately $15 million.





Other
      earning assets are comprised of Federal Home Loan Bank stock, Federal Funds
      sold
      (funds lent on a short-term basis to other banks), investments in securities
      and
      short-term interest bearing deposits at other financial institutions. These
      assets are maintained for liquidity needs of the Bank, collateralization of
      public deposits, and diversification of the earning asset mix.




**COMPOSITION
                OF OTHER EARNING ASSETS**(in
                thousands)




2005
            
            2004
            
            2003Amount
            
            Percent
            
            Amount
            
            Percent
            
            Amount
            
            PercentFederal
                Home Loan Bank, FRBand other stock
            
            $
            1,885
            
            
            3
            %
            $
            1,809
            
            
            3
            %
            $
            1,959
            
            
            2
            %Available-for-Sale
                Investments
            
            
            44,402
            
            
            61
            %
            
            57,394
            
            
            84
            %
            
            54,956
            
            
            58
            %Federal
                Funds Sold
            
            
            26,280
            
            
            36
            %
            
            5,775
            
            
            8
            %
            
            36,740
            
            
            39
            %Interest
                Bearing Deposits other finanical institutions
            
            
            298
            
            
            0
            %
            
            3,498
            
            
            5
            %
            
            498
            
            
            1
            %Total
                Other Earning Assets
            
            $
            72,865
            
            
            100
            %
            $
            68,476
            
            
            100
            %
            $
            94,153
            
            
            100
            %





The
      Company manages its securities portfolio to provide a source of both liquidity
      and earnings. The Bank has an asset/liability committee that develops current
      investment policies based upon its operating needs and market circumstance.
      The
      Bank’s investment policy is formally reviewed and approved annually by the board
      of directors. The asset/liability committee of the Bank is responsible for
      reporting and monitoring compliance with the investment policy. Reports are
      provided to Bank’s board of directors on a regular basis.





Securities
      available-for-sale are carried at fair value, with related unrealized net gains
      or losses, net of deferred income taxes, recorded as an adjustment to equity
      capital. As of December 31, 2005, there were net unrealized losses in the
      portfolio of $158 thousand compared to net unrealized gains of $147 thousand
      at
      December 31, 2004. During 2005 the portfolio decreased in size due primarily
      to
      prepayments on mortgage-backed securities. The fair value decreased due
      generally to rising interest rates in 2005 as the FRB continued to raise the
      fed
      funds rate throughout 2005. During 2004, the portfolio increased in size due
      to
      available liquidity during the first three quarters of the year. The value
      increased due to long term rates remaining low in spite of FRB rate increases
      starting in June 2004 through December 2004.





All
      fixed
      and adjustable rate mortgage pools contain a certain amount of risk related
      to
      the uncertainty of prepayments of the underlying mortgages. Interest rate
      changes have a direct impact upon prepayment rates. The Bank uses computer
      simulation models to test the average life, duration, market volatility and
      yield volatility of adjustable rate mortgage pools under various interest rate
      assumptions to monitor volatility. Stress tests are performed quarterly.




35





The
      amortized cost and fair values of investment securities available for sale
      at
      December, 2005 and 2004:





December
                31, 2005
            
            
            
            Gross
            
            Gross(in
                thousands)
            
            Amortized
            
            Unrealized
            
            Unrealized
            
            FairCost
            
            Gains
            
            Losses
            
            ValueObligations
                of U.S. government agencies and corporations
            
            $
            826
            
            $
            –
            
            $
            (20
            )
            $
            806Mortgage-backed
                securities
            
            
            28,795
            
            
            13
            
            
            (518
            )
            
            28,290Obligations
                of State and Political Subdivisions
            
            
            15,036
            
            
            364
            
            
            (103
            )
            
            15,297Other
                Securities
            
            
            9
            
            
            –
            
            
            –
            
            
            9Total
            
            $
            44,666
            
            $
            377
            
            $
            (641
            )
            $
            44,402




December
                31, 2004
            
            
            
            Gross
            
            Gross(in
                thousands)
            
            Amortized
            
            Unrealized
            
            Unrealized
            
            FairCost
            
            Gains
            
            Losses
            
            ValueObligations
                of U.S. government agencies and corporations
            
            $
            1,868
            
            $
            5
            
            $
            (30
            )
            $
            1,843Mortgage-backed
                securities
            
            
            42,622
            
            
            181
            
            
            (239
            )
            
            42,564Obligations
                of State and Political Subdivisions
            
            
            12,651
            
            
            413
            
            
            (86
            )
            
            12,978Other
                Securities
            
            
            9
            
            
            –
            
            
            –
            
            
            9Total
            
            $
            57,150
            
            $
            599
            
            $
            (355
            )
            $
            57,394





The
                Amortized cost, fair value, and maturites at December 31, 2005 are
                as
                follows:(in
                thousands)




Securities
                Available-for-Sale
            
            WeightedAmortized
            
            Fair
            
            AverageCost
            
            Value
            
            YieldDue
                in One Year or Less
            
            $
            509
            
            $
            497
            
            
            2.20
            %Due
                after One Yearthrough
                Five Years
            
            
            2,217
            
            
            2,249
            
            
            4.08
            %Due
                after Five Yearsthrough
                TenYears
            
            
            6,522
            
            
            6,629
            
            
            4.49
            %Due
                after TenYears
            
            
            6,623
            
            
            6,737
            
            
            4.68
            %Mortgage-backedSecurities
            
            
            28,795
            
            
            28,290
            
            
            4.01
            %Total
            
            $
            44,666
            
            $
            44,402
            
            
            4.17
            %




36





**Deposits
      and Borrowed Funds**





The
      following table sets forth information for the last three fiscal years regarding
      the composition of deposits at December 31, and the average rates paid on each
      of these categories:





**COMPOSITION
                OF DEPOSITS**(in
                thousands)




**2005**
            
            **2004**
            
            **2003****Average**
            
            
            
            **Average**
            
            
            
            **Average****Balance**
            
            **Rate
                Paid**
            
            **Balance**
            
            **Rate
                Paid**
            
            **Balance**
            
            **Rate
                Paid**Non-Interest
                Bearing Demand
            
            $
            164,014
            
            
            0.00
            %
            $
            143,455
            
            
            0.00
            %
            $
            137,859
            
            
            0.00
            %Interest
                Bearing Demand
            
            
            50,598
            
            
            0.16
            %
            
            60,256
            
            
            0.05
            %
            
            63,479
            
            
            0.16
            %Savings
            
            
            29,386
            
            
            0.30
            %
            
            36,232
            
            
            0.25
            %
            
            32,315
            
            
            0.32
            %Money
                Market
            
            
            90,122
            
            
            0.91
            %
            
            69,527
            
            
            0.95
            %
            
            57,619
            
            
            1.02
            %Time
                Deposits
            
            
            83,677
            
            
            2.74
            %
            
            60,971
            
            
            1.54
            %
            
            75,167
            
            
            2.21
            %Total
                Deposits
            
            $
            417,797
            
            
            0.87
            %
            $
            370,441
            
            
            0.48
            %
            $
            366,439
            
            
            0.73
            %





Set
        forth
        is a maturity schedule of domestic time certificates of
        deposit of $100,000 and over at December 31, 2005:




**TIME
                DEPOSITS $100,000 AND OVER:**(dollars
                in thousands)




Less
                than 3 months
            
            $
            18,0743
                to 12 months
            
            
            32,221Over
                1 year
            
            
            15,968Total
            
            $
            66,263





The
      following table sets forth changes from 2004 to 2005 for deposit
      categories.




2005
            
            2004
            
            $
                Variance
            
            %
                VarianceNon-Interest
                Bearing Demand
            
            $
            164,014
            
            $
            143,455
            
            $
            20,559
            
            
            14.33
            %Interest
                Bearing Demand
            
            
            50,598
            
            
            60,256
            
            
            (9,658
            )
            
            -16.03
            %Savings
            
            
            29,386
            
            
            36,232
            
            
            (6,846
            )
            
            -18.89
            %Money
                Market
            
            
            90,122
            
            
            69,527
            
            
            20,595
            
            
            29.62
            %Time
                Deposits
            
            
            83,677
            
            
            60,971
            
            
            22,706
            
            
            37.24
            %Total
                Deposits
            
            $
            417,797
            
            $
            370,441
            
            $
            47,356
            
            
            12.78
            %





The
      Company has been able to increase non-interest bearing, savings and money market
      deposits due to a well planned marketing and promotional strategy and incentive
      based compensation that has been in place for several years. The strategy is
      subject to the changing dynamics within the Company’s balance sheet and staffing
      along with changes within its primary market area. Friendly competition between
      the branch offices to increase deposit totals has been in place for two years.
      The branch offices are all given goals for each deposit category type and
      results are measured monthly.




37




Non-interest
      bearing demand deposits were 39.3% of total deposits at December 31, 2005 and
      increased by approximately $20.6 million or 14.3% during 2005. The Bank has
      two
      large deposit relationships that it considers to be volatile. These deposits
      are
      held by, long time customers of the Bank that engage in mortgage related
      activities. During 2005, the balances carried by these relationships increased
      by approximately $15.3 million at December 31, 2005 compared to December 31,
      2004. The increased mortgage related activity during 2005 had a direct impact
      on
      the deposit balances held by these entities. These volatile account
      relationships are included in the volatile liability dependency report that
      the
      Bank produces on a monthly basis. Management and the Board of Directors of
      the
      Bank are aware that should mortgage market conditions change, these
      relationships may be impacted.





Savings,
      NOW and money market deposits were $170.1 million at December 31, 2005 compared
      to $166.0 million at December 31, 2004. This represents an increase of
      approximately $4.1 million or 2.5%.





During
      2005, time deposits increased by $22.7 million primarily a result of increasing
      offered rates related to promotional activities at the Bank. Management also
      believes that as depositors have become more sensitive to interest rate
      differentials between various deposit products as interest rates have risen
      since mid-2004.





During
      2004, time deposits decreased by $14.2 million. This decrease was a factor
      of
      intended pricing instituted by Management as the result of the Hacienda
      acquisition in October 2003. At the time of the acquisition, one of the prime
      objectives was to bring the Hacienda cost of deposits, specifically time
      deposits, in line with those of the Bank. The Hacienda time deposit decrease
      represented approximately 87% of the total decrease in time deposits. The
      benefit of this action was very apparent in the favorable increase in net
      interest margin for the Company in 2004.





Core
      deposits (time deposits less than $100,000, demand, and savings) gathered in
      the
      local communities served by the Company continue to be the primary source of
      funds for loans and investments. Core deposits of $400.4 million represented
      95.8% of total deposits at December 31, 2005 as compared to $352.4 million
      95.1%
      of total deposits at December 31, 2004. The Company does not purchase funds
      through deposit brokers.





In
      October 2005 the Company renewed a promissory note with Pacific Coast Bankers
      Bank (PCBB) for a revolving line of credit in the amount of $3.5 million. The
      note is revolving in nature for the first two years and the terms of the note
      call for quarterly interest only payments for the first two years with
      subsequent principal and interest payments for eight years on a fully amortized
      basis. At December 31, 2005, the Company had a zero balance outstanding on
      this
      loan. The Company pledged 646,598 shares (51%) of the Bank’s stock as collateral
      for the loan. At December 31, 2005, the interest rate on the note was 7.25%
      and
      is variable and moves with prime. Under the terms of the agreement, the Company
      will not incur any additional debt over $2 million exclusive of inter-company
      debt and existing debt without the prior written consent of PCBB. In addition,
      the Bank must be “well” capitalized on an on-going basis as defined by bank
      Regulators. The note was renewed as an additional financing option for the
      Company. The original 2 year note note was executed In October 2003 and was
      originally obtained to assist with the cash and capital needs for the
      acquisition of Hacienda.





The
      Bank
      has established borrowing lines with the Federal Home Loan Bank (FHLB). At
      December 31, 2005, the Bank had borrowings with the FHLB of $10 million that
      are
      collateralized by loans. In addition, the Bank has an $11.7 million letter
      of
      credit secured by loans. At December 31, 2005, the Bank, under the FHLB
      programs, has a remaining borrowing capacity with existing collateral of
      approximately $80.0 million and $13.4 million secured by loans and securities,
      respectively.





The
      Bank
      utilizes securities sold under repurchase agreements as a source of funds.
      The
      Bank had $3.8 million in securities sold under repurchase agreements at December
      31, 2005 compared to $766 thousand and $460 thousand at December 31, 2004 and
      2003 respectively.





**Capital**





The
      Company's total stockholders equity was$44.8, million at December 31, 2005
      compared to $37.3 million and $32.3 million at December 31, 2004 and 2003
      respectively. The increase in capital during 2005 was due to net income of
      $6.6
      million, $12 thousand cash paid to stockholders in lieu of fractional shares
      on
      a 5% stock dividend paid April 23, 2005 and the 3 for 2 stock split paid
      December 2, 2005, stock options exercised in the amount of $1.3 million, and
      a
      decrease in accumulated other comprehensive income of $305 thousand.




38




On
      April
      10, 2002, the Company issued $8,248,000 of Floating Rate Junior Subordinated
      Deferrable Interest Debentures (the “debt securities”) to Heritage Oaks Capital
      Trust I, a statutory trust created under the laws of the State of Delaware.
      These debt securities are subordinated to effectively all borrowings of the
      Company and are due and payable on April 22, 2032. Interest is payable quarterly
      on these debt securities at 6-Month LIBOR plus 3.7% for an effective rate of
      8.147% as of December 31, 2005. The debt securities can be called at any time
      commencing on April 22, 2007, at par. The debt securities can also be redeemed
      at par if certain events occur that impact the tax treatment, regulatory
      treatment or the capital treatment of the issuance. The Company also purchased
      a
      3% minority interest totaling $248,000 in Heritage Oaks Capital Trust I. The
      balance of the equity of Heritage Oaks Capital Trust I is comprised of
      mandatorily redeemable preferred securities and is included in other
      assets.





Under
      FASB Interpretation (FIN) No. 46, *“Consolidation
      of Variable Interest Entities, an interpretation of ARB No.
      51,”* the
      Company is not allowed to consolidate Heritage Oaks Capital Trust I into the
      Company’s financial statements. Prior to the issuance of FIN No. 46, bank
      holding companies typically consolidated these entities. The Federal Reserve
      Board had ruled that certain mandatorily redeemable preferred securities of
      a
      consolidated entity qualified as Tier 1 Capital. The Federal Reserve Board
      is
      evaluating the capital impact from FIN No. 46 but has not issued any final
      ruling. As of December 31, 2005, the Company has included the net junior
      subordinated debt in its Tier 1 Capital for regulatory capital purposes. See,
      “Item 1 - Business - Factors That May Affect Future Results of Operations -
      Trust Preferred Securities.”





If
      the
      Company elects to defer interest payments pursuant to terms of the agreement,
      then the Company may not (i) declare or pay any dividends or distributions
      on,
      or redeem, purchase, acquire or make a liquidation payment with respect to
      any
      of the Company’s capital stock, or (ii) make any payment of principal of or
      premium, if any, or interest on or repay, repurchase or redeem any debt
      securities of the Company that rank pari passu with or junior in interest to
      the
      Debt Securities, other than, among other items, a dividend in the form of stock,
      warrants, options or other rights in the same stock as that on which the
      dividend is being paid or ranks pari passu with or junior to such stock. The
      prohibition on payment of dividends and payments on pari passu or junior debt
      also applies in the case of an event of default under the
      agreements.





The
      Company used the proceeds from the sale of the securities for general corporate
      purposes, including the repayment of outstanding indebtedness of $1.9 million
      on
      April 11, 2002 and capital contributions to the Bank for future
      growth.





At
      December 31, 2005, the Company had sufficient cash to service the $8.2 million
      in junior subordinated debenture interest payments for approximately fifteen
      quarters without dividends from subsidiaries. The Bank’s capacity to provide
      cash to the Company, while remaining “well-capitalized”, was approximately $6
      million at December 31, 2005.





Capital
      ratios for commercial banks in the United States are generally calculated using
      three different formulas. These calculations are referred to as the "Leverage
      Ratio" and two "risk based" calculations known as: "Tier One Risk Based Capital
      Ratio" and the "Total Risk Based Capital Ratio." These standards were developed
      through joint efforts of banking authorities from 12 different countries around
      the world. The standards essentially take into account the fact that different
      types of assets have different levels of risk associated with them. Furthermore,
      they take into account the off-balance sheet exposures of banks when assessing
      capital adequacy.





The
      Leverage Ratio calculation simply divides common stockholders’ equity (reduced
      by any goodwill a bank may have) by the total assets of the Bank. In the Tier
      One Risk Based Capital Ratio, the numerator is the same as the leverage ratio,
      but the denominator is the total "risk-weighted assets" of the Bank. Risk
      weighted assets are determined by segregating all the assets and off balance
      sheet exposures into different risk categories and weighting them by a
      percentage ranging from 0% (lowest risk) to 100% (highest risk). The Total
      Risk
      Based Capital Ratio again uses "risk-weighted assets" in the denominator, but
      expands the numerator to include other capital items besides equity such as
      a
      limited amount of the loan loss reserve, long-term capital debt, preferred
      stock
      and other instruments.




39





Summarized
      below are the Company’s and the Bank’s capital ratios at December 31, 2005.





Minimum
                Regulatory
            
            Heritage
            
            HeritageCapital
                Requirements
            
            Oaks
                Bancorp
            
            Oaks
                BankLeverage
                Ratio
            
            4.00%
            
            9.61%
            
            9.11%Tier
                I Risk Weighted
            
            4.00%
            
            10.98%
            
            10.38%Total
                Risk Based
            
            8.00%
            
            11.93%
            
            11.33%





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





**Liquidity**





The
      objective of liquidity management is to ensure the continuous availability
      of
      funds to meet the demands of depositors, investors and borrowers. Asset
      liquidity is primarily derived from loan payments and the maturity of other
      earning assets. Liquidity from liabilities is obtained primarily from the
      receipt of new deposits. The Bank’s Asset Liability Committee (ALCO) is
      responsible for managing the on-and off-balance sheet commitments to meet the
      needs of customers while achieving the Bank’s financial objectives. ALCO meets
      regularly to assess the projected funding requirements by reviewing historical
      funding patterns, current and forecasted economic conditions and individual
      customer funding needs. Deposits generated from the Bank’s customers serve as
      the primary source of liquidity. The Bank has credit arrangements with
      correspondent banks that serve as a secondary liquidity source. At December
      31,
      2005, these credit lines totaled $13.4 million and the Bank had no borrowings
      against those lines. The Bank is a member of the FHLB and has collateralized
      borrowing capacities remaining of $93.4 million at December 31, 2005.





The
      Bank
      manages liquidity by maintaining a majority of the investment portfolio in
      federal funds sold and other liquid investments. At December 31, 2005, the
      ratio
      of liquid assets not pledged for collateral and other purposes to deposits
      and
      other liabilities was 16.05% compared to 12.7% in 2004. The ratio of net loans
      to deposits, another key liquidity ratio, was 86.8% at December 31, 2005
      compared to 90.4% at December 31, 2004.





**Inflation**





The
      assets and liabilities of a financial institution are primarily monetary in
      nature. As such they represent obligations to pay or receive fixed and
      determinable amounts of money that are not affected by future changes in prices.
      Generally, the impact of inflation on a financial institution is reflected
      by
      fluctuations in interest rates, the ability of customers to repay debt and
      upward pressure on operating expenses. The effect on inflation during the
      three-year period ended December 31, 2005 has been significant to the Company’s
      financial position or results of operations in regard to fluctuation in interest
      rates creating changing net interest margins. However, inflation has not been
      a
      factor in customers’ ability to repay debt or in upward pressure on operation
      expenses.





**Critical
      Accounting Policies and Estimates**





Our
      accounting policies are integral to understanding the results reported.
      Accounting policies are described in detail in Note 1 of the NOTES TO
      CONSOLIDATED FINANCIAL STATEMENTS. Our most complex accounting policies require
      management’s judgment to ascertain the valuation of assets, liabilities,
      commitments and contingencies. We have established detailed policies and control
      procedures that are intended to ensure valuation methods are well controlled
      and
      applied consistently from period to period. In addition, the policies and
      procedures are intended to ensure that the process for changing methodologies
      occurs in an appropriate manner. The following is a brief description of our
      current accounting policies involving significant management valuation
      judgments.




Allowance
      for Loan and Lease Losses




The
      allowance for loan and lease losses represents management’s best estimate of
      losses inherent in the existing loan portfolio. The allowance for loan and
      lease
      losses is increased by the provision for loan and lease losses charged to
      expense and reduced by loans charged-off, net of recoveries. The allowance
      for
      loan and lease losses is determined based on management’s assessment of several
      factors: reviews and evaluation of individual loans, changes in the nature
      and
      volume of the loan portfolio, current economic conditions and the related impact
      on specific borrowers and industry groups, historical loan loss experiences
      and
      the level of classified and nonperforming loans.




40




Loans
      are
      considered impaired if, based on current information and events, it is probable
      that we will be unable to collect the scheduled payments of principal or
      interest when due according to the contractual terms of the loan agreement.
      The
      measurement of impaired loans is generally based on the present value of
      expected future cash flows discounted at the historical effective interest
      rate
      stipulated in the loan agreement, except that all collateral-dependent loans
      are
      measured for impairment based on the fair value of the collateral. In measuring
      the fair value of the collateral, management uses assumptions and methodologies
      consistent with those that would be utilized by unrelated third parties.




Changes
      in the financial condition of individual borrowers, economic conditions,
      historical loss experience and the condition of the various markets in which
      collateral may be sold may all affect the required level of the allowance for
      loan and lease losses and the associated provision for loan and lease losses.




Securities
      Available for Sale




The
      fair
      value of most securities that are designated available for sale are based on
      quoted market prices. If quoted market prices are not available, fair values
      are
      extrapolated from the quoted prices of similar instruments.




Goodwill
      and Other Intangible Assets




As
      discussed in Note 6 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, we assess
      goodwill and other intangible assets each year for impairment. This assessment
      involves estimating cash flows for future periods. If the future cash flows
      were
      materially less than the recorded goodwill and other intangible assets balances,
      we would be required to take a charge against earnings to write down the assets
      to the lower value. The Company’s assessment at December 31, 2005 pursuant to
      its Goodwill Impairment Testing Policy resulted in no impairment.




Deferred
      Tax Assets




We
      use an
      estimate of future earnings to support our position that the benefit of our
      deferred tax assets will be realized. If future income should prove nonexistent
      or less than the amount of the deferred tax assets within the tax years to
      which
      they may be applied, the asset may not be realized and our net income will
      be
      reduced. Our deferred tax assets are described further in Note 9 of the NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS.




Supplemental
      Employee Compensation Benefits Agreements




As
      described in Note 12 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, we
      have
      entered into supplemental employee compensation benefits agreements with certain
      executive and senior officers. The measurement of the liability under these
      agreements includes estimates involving life expectancy, length of time before
      retirement, and expected benefit levels. Should these estimates prove materially
      wrong, we could incur additional or reduced expense to provide the benefits.




**Recent
      Accounting Developments**




In
      December 2004, the FASB issued SFAS No. 123 (revised 2004). Share-Based Payment,
      which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation.
      SFAS No. 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued
      to
      Employees and amends SFAS No. 95, Statement of Cash Flows. Generally, the
      approach in SFAS No. 123(R) is similar to the approach described in SFAS No.
      123. However, SFAS No. 123(R) requires all share-based payments to employees,
      including grants of employee stock options, to be recognized in the income
      statement based on their fair values. Pro forma disclosure is no longer an
      alternative. The new standard will be effective for the Company in the first
      interim or annual reporting period beginning after December 15, 2005. The
      Company has not determined if the adoption of this standard will have a material
      impact on its financial statements.




At
      the
      June 29, 2005 FASB Board meeting, the Board agreed to issue FSP FAS 115-1,
      The
      Meaning of Other-Than-Temporary Impairment and Its Application to Certain
      Investments which will replace the guidance previously set forth in EITF 03-1,
      The Meaning of Other-Than -Temporary Impairment and Its Application to Certain
      Investments. This FSP effectively eliminates the accounting guidance provided
      in
      EITF-03-1 in favor of existing impairment recognition guidance under SFAS No.
      115, SAB No. 59, APB No. 18, and EITF Topic D-44. The FSP is for periods
      beginning after September 15, 2005, but its adoption is not expected to have
      a
      material impact on the Company’s consolidated financial statements.




This
      discussion should be read in conjunction with the consolidated financial
      statements of the Company, including the notes thereto, appearing elsewhere
      in
      this report.




41




**Off-Balance
      sheet Arrangements, Contractual Obligations and Contingent
      Liabilities**




In
      the
      ordinary course of business, the Company may enter into off-balance sheet
      financial instruments consisting of commitments to extend credit, commercial
      letters of credit, and standby letters of credit. Such financial instruments
      are
      recorded in the financial statement when they are funded or related fees are
      incurred or received.




Less
                than
            
            One
                to Three
            
            Three
                to Five
            
            More
                than(in
                thousands)
            
            one
                year
            
            Years
            
            Years
            
            Five
                Years
            
            TotalLong
                Term Debt Obligations
            
            $
            –
            
            $
            –
            
            $
            –
            
            $
            8,248
            
            $
            8,248Operating
                Lease Obligations
            
            
            662
            
            
            1,113
            
            
            613
            
            
            350
            
            
            2,738Totals
            
            $
            662
            
            $
            1,113
            
            $
            613
            
            $
            8,598
            
            $
            10,986




As
      noted
      in Footnote 10 to the financial statements, the Company is contingently liable
      for letters of credit made to its customers in the ordinary course of business
      totaling $17.0 million at December 31, 2005, down from $17.6 million one year
      earlier. Additionally, the Company has undisbursed loan commitments, also made
      in the ordinary course of business, totaling $167.7 million, which was up from
      the $123.5 million outstanding one year earlier. The Company has an allowance
      for losses-unfunded commitments totaling $163 thousand at December 31, 2005,
      to
      cover losses inherent in its letter of credit accommodations and undisbursed
      loan commitments.





There
      are
      no Special Purpose Entity (“SPE”) trusts, corporations, or other legal entities
      established by the Company which reside off-balance sheet. There are no other
      off-balance sheet items other than the aforementioned items related to letter
      of
      credit accommodations and undisbursed loan commitments.





As
      noted
      in Footnote 15 to the financial statements, the Company does make loans to
      related parties (directors and officers) in the ordinary course of business
      at
      prevailing rates and terms. These loans totaled $14.6 million and $5.2 million
      at the end of 2005 and 2004, respectively.





**Item
      7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK.**





As
      a
      financial institution, the Company’s primary component of market risk is
      interest rate volatility. Fluctuations in interest rates will ultimately impact
      both the level of interest income and interest expense recorded on a large
      portion of the Company’s assets and liabilities, and the market value of all
      interest earning assets and interest bearing liabilities, other than those
      which
      possess a short term to maturity. Virtually all of the Company’s interest
      earning assets and interest bearing liabilities are located at the banking
      subsidiary level. Thus, virtually all of the Company’s interest rate risk
      exposure lies at the banking subsidiary level other than $8.2 million in
      subordinated debentures issued by the Company’s subsidiary grantor trust. As a
      result, all significant interest rate risk procedures are performed at the
      banking subsidiary level. The subsidiary bank’s real estate loan portfolio,
      concentrated primarily within Northern Santa Barbara County and San Luis Obispo
      County, California, are subject to risks associated with the local
      economy.




The
      fundamental objective of the Company’s management of its assets and liabilities
      is to maximize the Company’s economic value while maintaining adequate liquidity
      and an exposure to interest rate risk deemed by Management to be acceptable.
      Management believes an acceptable degree of exposure to interest rate risk
      results from the management of assets and liabilities through maturities,
      pricing and mix to attempt to neutralize the potential impact of changes in
      market interest rates. The Company’s profitability is dependent to a large
      extent upon its net interest income, which is the difference between its
      interest income on interest-earning assets, such as loans and investments,
      and
      its interest expense on interest-bearing liabilities, such as deposits and
      borrowings. The Company is subject to interest rate risk to the degree that
      its
      interest-earning assets re-price differently than its interest-bearing
      liabilities. The Company manages its mix of assets and liabilities with the
      goals of limiting its exposure to interest rate risk, ensuring adequate
      liquidity, and coordinating its sources and uses of funds.




The
      Company seeks to control interest rate risk exposure in a manner that will
      allow
      for adequate levels of earnings and capital over a range of possible interest
      rate environments. The Company has adopted formal policies and practices to
      monitor and manage interest rate risk exposure.  Management believes
      historically it has effectively managed the effect of changes in interest rates
      on its operating results.  Management believes that it can continue to
      manage the short-term effect of interest rate changes under various interest
      rate scenarios.




42




Management
      employs the use of an Asset and Liability Management software that is used
      to
      measure the Bank’s exposure to future changes in interest rates. This model
      measures the expected cash flows and re-pricing of each financial
      asset/liability separately in measuring the Bank’s interest sensitivity. Based
      on the results of this model, management believes the Bank’s balance sheet is
“asset sensitive”.  The Company generally expects expansion in its net
      interest income if rates rise and expects, conversely, contraction if rates
      fall.  The level of potential or expected contraction indicated by the
      tables below is considered acceptable by management and is compliant with the
      Bank’s ALCO policies.  Management will continue to perform this analysis
      each quarter to further validate the expected results against actual
      data.




The
      hypothetical impacts of sudden interest rate movements applied to the Company’s
      asset and liability balances are modeled monthly. The results of this movement
      indicate how much of the Company’s net interest income is “at risk” from various
      rate changes over a one year horizon. This exercise is valuable in identifying
      risk exposures. The results for the Company’s December 31, 2005 balances
      indicate that the net interest income at risk over a one year time horizon
      for a
      1%, 2% and 3% rate increase and 1% rate decrease are within the Company’s policy
      guidelines for such changes.




December
        31, 2005


(dollars
                in Thousands)
            
            Shock
                Rate Scenarios-100bp
            
            Base
            
            +100bp
            
            +200bp
            
            +300bpNet
                Interest Income (NII)
            
            $
            24,202
            
            $
            25,917
            
            $
            27,543
            
            $
            29,166
            
            $
            30,788$
                Change from Base
            
            $
            (1,715
            )
            $
            –
            
            $
            1,626
            
            $
            3,249
            
            $
            4,871%
                Change from Base
            
            
            -6.62
            %
            
            0.00
            %
            
            6.27
            %
            
            12.54
            %
            
            18.80
            %




It
      is
      important to note that the above table is a summary of several forecasts and
      actual results may vary. The forecasts are based on estimates and assumptions
      of
      management that may turn out to be different and may change over time. Factors
      affecting these estimates and assumptions include, but are not limited to 1)
      competitor behavior, 2) economic conditions both locally and nationally, 3)
      actions taken by the Federal Reserve Board, 4) customer behavior and 5)
      management’s responses. Changes that vary significantly from the assumptions and
      estimates may have significant effects on the Company’s net interest income,
      therefore, the results of this analysis should not be relied upon as indicative
      of actual future results.





The
      following tables show Management’s estimates of how the loan portfolio is broken
      out between variable-daily, variable at various time lines, fixed rate loans
      and
      estimates of re-pricing opportunities for the entire loan portfolio.





(dollars
                in Thousands)%
                ofGross
                Loans
            
            Balance
            
            TotalVariable-Daily
            
            $
            149,373
            
            
            41
            %Variable-Other
                than daily
            
            
            155,887
            
            
            42
            %Fixed
            
            
            62,873
            
            
            17
            %Total
                Gross Loans
            
            $
            368,133
            
            
            100
            %Gross
                Loans
            
            %
                ofRe-Pricing
            
            
            Balance
            
            
            Total<
                1 Year
            
            $
            218,619
            
            
            59
            %1-3
                Years
            
            
            92,926
            
            
            25
            %3-5
                Years
            
            
            42,315
            
            
            11
            %>
                5 Years
            
            
            14,273
            
            
            4
            %$
            368,133
            
            
            100
            %




The
      table
      above identifies approximately 40% of the loan portfolio that will re-price
      immediately in a changing rate environment.





The
      Company also attempts to quantify the impact of interest rate changes on
      borrowers’ ability to pay on loans and the impact of similar rate changes on the
      value of collateral held against loans. To this end, the Company, from time
      to
      time, will sample loans and analyze them under a rate shock scenario to
      specifically assess the impact of the rate shock on financial ratios such as
      interest rate coverage and loan-to-value. The results of the analysis have
      generally revealed that in the case of such a rate shock, a high percentage
      of
      loans tested would continue to express ratios within current underwriting
      guidelines. The results of these analyses are considered
      acceptable by management.





43





**ITEM
      8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.**





**HERITAGE
      OAKS BANCORP AND SUBSIDIARIES**


**DECEMBER
      31, 2005, 2004, AND 2003**





**Contents**





**Financial
                Statements**Report
                of Independent Registered Public Accounting Firm
            
            
            45Consolidated
                Balance Sheets
              December
                31, 2005 and 2004
            
            
            46Consolidated
                Statements of Income
              For
                the Years Ended December 31, 2005, 2004, and 2003
            
            
            47Consolidated
                Statement of Changes in Stockholders' Equity
              For
                the Years Ended December 31, 2005, 2004, and 2003
            
            
            48Consolidated
                Statements of Cash Flows
              For
                the Years Ended December 31, 2005, 2004, and 2003
            
            
            49**Notes
                to Consolidated Financial Statements**
            
            
            51




44




**Report
      of Independent Registered Public Accounting Firm**




Board
      of
      Directors


Heritage
      Oaks Bancorp


Paso
      Robles, California





We
      have
      audited the accompanying consolidated balance sheets of Heritage Oaks Bancorp
      and Subsidiaries (the “Company”) as of December 31, 2005 and 2004, and the
      related consolidated statements of income, changes in stockholders' equity
      and
      cash flows for each of the three years in the period ended December 31, 2005.
      These consolidated financial statements are the responsibility of the Company’s
      management. Our responsibility is to express an opinion on these consolidated
      financial statements based on our audits.





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





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of Heritage Oaks Bancorp and
      Subsidiaries as of December 31, 2005 and 2004, and the results of its
      operations, changes in its stockholders' equity, and its cash flows for each
      of
      the three years in the period ended December 31, 2005, in conformity with U.S.
      generally accepted accounting principles.








/s/
      Vavrinek, Trine, Day & Co., LLP





Rancho
      Cucamonga, California


January
      13, 2006





45




**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **CONSOLIDATED
        BALANCE SHEETS**
 **FOR
        YEARS ENDED DECEMBER 31, 2005 AND 2004**
 **(Amounts
        in thousands, except share data)**


**Assets**2005
            
            2004Cash
                and due from banks
            
            $
            18,279
            
            $
            13,092Federal
                funds sold
            
            
            26,280
            
            
            5,775Money
                market funds
            
            
            –
            
            
            3,000Total
                Cash and Cash Equivalents
            
            
            44,559
            
            
            21,867Interest-bearing
                deposits in other financial institutions
            
            
            298
            
            
            498Investment
                securities, available-for-sale
            
            
            44,402
            
            
            57,394Federal
                Home Loan Bank and Federal Reserve Bank Stock, at cost
            
            
            1,885
            
            
            1,809Loans
                held for sale
            
            
            3,392
            
            
            2,253Loans,
                net of deferred fees of $1,617 and $1,482 and allowance
                forloan
                loss of $3,881 and $3,247 at December 31, 2005and
                2004, respectively
            
            
            362,635
            
            
            334,964Property
                premises and equipment, net
            
            
            11,905
            
            
            10,383Net
                deferred tax asset
            
            
            2,358
            
            
            1,918Cash
                surrender value of life insurance
            
            
            7,706
            
            
            7,130Goodwill
            
            
            4,865
            
            
            4,865Intangible
                assets
            
            
            1,448
            
            
            2,021Other
                assets
            
            
            3,048
            
            
            2,910Total
                Assets
            
            $
            488,501
            
            $
            448,012**Liabilities
                and Stockholders' Equity**LiabilitiesDepositsDemand
                non-interest bearing
            
            $
            164,014
            
            $
            143,455Savings,
                NOW and money market deposits
            
            
            170,106
            
            
            166,015Time
                deposits of $100 or more
            
            
            17,414
            
            
            18,034Time
                deposits under $100
            
            
            66,263
            
            
            42,937Total
                Deposits
            
            
            417,797
            
            
            370,441FHLB
                advances and other borrowings
            
            
            10,000
            
            
            28,500Securities
                sold under agreement to repurchase
            
            
            3,847
            
            
            766Junior
                subordinated debentures
            
            
            8,248
            
            
            8,248Other
                liabilities
            
            
            3,764
            
            
            2,807Total
                Liabilities
            
            
            443,656
            
            
            410,762COMMITMENTS
                AND CONTINGENCIES (Notes #5 and #10)
            
            
            –
            
            
            –Stockholders'
                EquityCommon
                stock, no par value; 20,000,000 shares authorized;6,231,982
                and 6,013,260 shares issued andoutstanding for 2005 and 2004, respectively
            
            
            29,255
            
            
            24,050Retained
                earnings
            
            
            15,748
            
            
            13,053Accumulated
                other comprehensive income
            
            
            (158
            )
            
            147Total
                Stockholders' Equity
            
            
            44,845
            
            
            37,250Total
                Liabilities and Stockholders' Equity
            
            $
            488,501
            
            $
            448,012




The
        accompanying notes are an integral part of these financial
        statements.





46


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **CONSOLIDATED
        STATEMENTS OF INCOME**
 **FOR
        YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**
 **(Amounts
        in thousands, except share data)**





2005
            
            2004
            
            2003**Interest
                Income**Interest
                and fees on loans
            
            $
            27,399
            
            $
            20,615
            
            $
            15,930Interest
                on Investment SecuritiesObligations
                of U.S. Government Agencies
            
            
            1,389
            
            
            1,767
            
            
            1,408Obligations
                of State and Political Subdivisions
            
            
            593
            
            
            506
            
            
            454Interest
                on time deposits with other banks
            
            
            9
            
            
            11
            
            
            13Interest
                on Federal funds sold
            
            
            667
            
            
            302
            
            
            278Interest
                on other securities
            
            
            118
            
            
            112
            
            
            91Total
                Interest Income
            
            
            30,175
            
            
            23,313
            
            
            18,174**Interest
                Expense**Interest
                on savings, NOW and money market deposits
            
            
            1,695
            
            
            699
            
            
            625Interest
                on time deposits in denominations of$100 or more
            
            
            413
            
            
            118
            
            
            204Interest
                on time deposits under $100
            
            
            1,371
            
            
            953
            
            
            922Other
            
            
            1,537
            
            
            1,591
            
            
            1,712Total
                Interest Expense
            
            
            5,016
            
            
            3,361
            
            
            3,463Net
                interest income before provision forpossible
                loan losses
            
            
            25,159
            
            
            19,952
            
            
            14,711Provision
                for Possible Loan Losses
            
            
            710
            
            
            410
            
            
            37024,449
            
            
            19,542
            
            
            14,341**Noninterest
                Income**Fees
                and service charges
            
            
            2,430
            
            
            2,173
            
            
            1,723Investment
                securities gain/(loss), net
            
            
            –
            
            
            28
            
            
            60Gain
                on sale of SBA loans, net
            
            
            84
            
            
            45
            
            
            –Gain
                on sale of premise, net
            
            
            4
            
            
            712
            
            
            –Other
            
            
            2,491
            
            
            2,041
            
            
            2,014Total
                Noninterest Income
            
            
            5,009
            
            
            4,999
            
            
            3,797**Noninterest
                Expenses**Salaries
                and employee benefits
            
            
            9,746
            
            
            8,457
            
            
            6,498Equipment
                expenses
            
            
            824
            
            
            929
            
            
            675Occupancy
                expenses
            
            
            1,667
            
            
            1,640
            
            
            1,082Other
                expenses
            
            
            6,481
            
            
            6,172
            
            
            4,170Total
                Noninterest Expenses
            
            
            18,718
            
            
            17,198
            
            
            12,425Income
                Before Provision for Income Taxes
            
            
            10,740
            
            
            7,343
            
            
            5,713Provision
                for Income Taxes
            
            
            4,103
            
            
            2,759
            
            
            2,117Net
                Income
            
            $
            6,637
            
            $
            4,584
            
            $
            3,596Earnings
                Per ShareBasic
            
            $
            1.08
            
            $
            0.77
            
            $
            0.71Diluted
            
            $
            1.01
            
            $
            0.71
            
            $
            0.67




The
        accompanying notes are an integral part of these financial
        statements.





47


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **CONSOLIDATED
        STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**
 **FOR
        YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**
 **(Amounts
        in thousands, except share data)**





AccumulatedCommon
                Stock
            
            
            
            
            
            Other
            
            TotalNumber
                of
            
            
            
            Comprehensive
            
            Retained
            
            Comprehensive
            
            Stockholders'Shares
            
            Amount
            
            Income
            
            Earnings
            
            Income
            
            Equity**Balance,
                January 1, 2003**
            
            
            2,785,533
            
            
            9,703
            
            
            
            
            
            9,548
            
            
            562
            
            
            19,813Exercise
                of stock options(including
                $204 tax benefit from
                exercise
                  of stock options)
            
            
            72,471
            
            
            583
            
            
            
            
            
            
            
            
            
            
            
            583Stock
                issued in connection with
              purchase
                of Hacienda Bank
            
            
            602,485
            
            
            8,698
            
            
            
            
            
            
            
            
            
            
            
            8,698Sale
                of stock
            
            
            5,000
            
            
            66
            
            
            
            
            
            
            
            
            
            
            
            66Cash
                paid to stockholders in lieu
                of
                  fractional shares on
                5%
                  stock dividend
            
            
            
            
            
            
            
            
            
            
            
            (4
            )
            
            
            
            
            (4
            )5%
                stock dividend
            
            
            139,008
            
            
            1,599
            
            
            
            
            
            (1,599
            )
            
            
            
            
            –Comprehensive
                incomeNet
                income
            
            
            
            
            
            
            
            $
            3,596
            
            
            3,596
            
            
            
            
            
            3,596Unrealized
                security holding
              losses
                (net of $287 tax)
            
            
            
            
            
            
            
            
            (428
            )
            
            
            
            
            (428
            )
            
            (428
            )Less
                reclassification
              adjustmentsfor
              gains
                (net of $24 tax)
            
            
            
            
            
            
            
            
            (36
            )
            
            
            
            
            (36
            )
            
            (36
            )Total
                comprehensive
              income
            
            
            
            
            
            
            
            $
            3,132**Balance,
                December 31, 2003**
            
            
            3,604,497
            
            
            20,649
            
            
            
            
            
            11,541
            
            
            98
            
            
            32,288Exercise
                of stock options(including
                $136 tax benefit from
              exercise
                of stock options)
            
            
            33,625
            
            
            335
            
            
            
            
            
            
            
            
            
            
            
            335Cash
                paid to stockholders in lieu
              of
                fractional shares on
              5%
                stock dividend
            
            
            
            
            
            
            
            
            
            
            
            (6
            )
            
            
            
            
            (6
            )5%
                stock dividend
            
            
            179,821
            
            
            3,066
            
            
            
            
            
            (3,066
            )
            
            
            
            
            –Comprehensive
                incomeNet
                income
            
            
            
            
            
            
            
            $
            4,584
            
            
            4,584
            
            
            
            
            
            4,584Unrealized
                security holding
              losses
                (net of $44 tax)
            
            
            
            
            
            
            
            
            66
            
            
            
            
            
            66
            
            
            66Less
                reclassification
              adjustments
                for
              gains
                (net of $11 tax)
            
            
            
            
            
            
            
            
            (17
            )
            
            
            
            
            (17
            )
            
            (17
            )Total
                comprehensive
              income
            
            
            
            
            
            
            
            $
            4,633**Balance,
                December 31, 2004**
            
            
            3,817,943
            
            $
            24,050
            
            
            
            
            $
            13,053
            
            $
            147
            
            $
            37,250Exercise
                of stock options(including
                $588 tax benefit from
              exercise
                of stock options)
            
            
            144,674
            
            
            1,275
            
            
            
            
            
            
            
            
            
            
            
            1,275Cash
                paid to stockholders in lieu
              of
                fractional shares on
              5%
                stock dividend
            
            
            
            
            
            
            
            
            
            
            
            (7
            )
            
            
            
            
            (7
            )5%
                stock dividend
            
            
            195,013
            
            
            3,930
            
            
            
            
            
            (3,930
            )
            
            
            
            
            –3
                for 2 stock split
            
            
            2,074,352Cash
                paid to stockholders in lieu
              of
                fractionalshares
                on 3 for
              2
                stock split
            
            
            
            
            
            
            
            
            
            
            
            (5
            )
            
            
            
            
            (5
            )Comprehensive
                incomeNet
                income
            
            
            
            
            
            
            
            $
            6,637
            
            
            6,637
            
            
            
            
            
            6,637Unrealized
                security holding
              losses
                (net of $204 tax)
            
            
            
            
            
            
            
            
            (305
            )
            
            
            
            
            (305
            )
            
            (305
            )Total
                comprehensive
              income
            
            
            
            
            
            
            
            $
            6,332**Balance,
                December 31, 2005**
            
            
            6,231,982
            
            $
            29,255
            
            
            
            
            $
            15,748
            
            $
            (158
            )
            $
            44,845


The
        accompanying notes are an integral part of these financial
        statements.





48


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
 **FOR
        YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**
 **(Amounts
        in thousands, except share data)**


2005
            
            2004
            
            2003**Cash
                Flows from Operating Activities**Net
                income
            
            $
            6,637
            
            $
            4,584
            
            $
            3,596Adjustments
                to reconcile net income tonet
                cash provided by operating activitiesNet
                cash provided by operating activitiesDepreciation
                and amortization
            
            
            897
            
            
            949
            
            
            661Provision
                for possible loan losses
            
            
            710
            
            
            410
            
            
            370Provision
                for possible losses on unfundedloan
                commitments
            
            
            10
            
            
            25
            
            
            50Realized
                (gain)/loss on sales of available-for-salesecurities,
                net
            
            
            –
            
            
            (28
            )
            
            (60
            )Amortization
                of premiums/discounts oninvestment
                securities, net
            
            
            184
            
            
            407
            
            
            451Amortization
                of core deposit intangibles
            
            
            573
            
            
            421
            
            
            41Gain
                on sale of property, premises and equipment, net
            
            
            (4
            )
            
            (712
            )
            
            –Net
                change in loans held for sale
            
            
            (1,139
            )
            
            2,149
            
            
            3,764Net
                increase in cash surrender value of life insurance
            
            
            (276
            )
            
            (271
            )
            
            (264
            )FHLB
                Dividends received
            
            
            (76
            )
            
            (72
            )
            
            (87
            )Decrease/(Increase)
                in deferred tax asset
            
            
            (236
            )
            
            20
            
            
            (363
            )Decrease/(Increase)
                in other assets
            
            
            (119
            )
            
            183
            
            
            212Increase/(decrease)
                in other liabilities
            
            
            672
            
            
            269
            
            
            (5,195
            )**NET
                CASH PROVIDED BY OPERATING ACTIVITIES**
            
            
            7,833
            
            
            8,334
            
            
            3,176**Cash
                Flows From Investing Activities**Purchase
                of securities available-for-sale
            
            
            (2,588
            )
            
            (3,012
            )
            
            (1,633
            )Purchase
                of mortgage-backed securities available-for-sale
            
            
            –
            
            
            (17,295
            )
            
            (27,487
            )Net
                redemption (purchase) of Federal Home Loan Bank and
                FederalReserve
                Bank stock
            
            
            –
            
            
            222
            
            
            332Proceeds
                from sales of mortgage-backed securities
            
            
            –
            
            
            1,534
            
            
            12,365Proceeds
                from principal reductions and maturitiesof
                securities available-for-sale
            
            
            1,350
            
            
            1,315
            
            
            757Proceeds
                from principal reductions and maturities ofmortgage-backed securities
            
            
            13,537
            
            
            14,723
            
            
            27,387Net
                change in interest-bearing deposits inother
                financial institutions
            
            
            200
            
            
            –
            
            
            99Purchase
                of life insurance policies
            
            
            (300
            )
            
            –
            
            
            (1,180
            )Increase
                in cash due to acquisition
            
            
            –
            
            
            –
            
            
            22,703Recoveries
                on loans previously charged off
            
            
            25
            
            
            3
            
            
            233Increase
                in loans, net
            
            
            (28,406
            )
            
            (61,326
            )
            
            (35,465
            )Proceeds
                from sale of property, premises and equipment
            
            
            900
            
            
            900
            
            
            –Purchase
                of property, premises and equipment, net
            
            
            (3,059
            )
            
            (1,646
            )
            
            (3,158
            )**NET
                CASH USED IN INVESTING ACTIVITIES**
            
            
            (18,341
            )
            
            (64,582
            )
            
            (5,047
            )


The
        accompanying notes are an integral part of these financial
        statements.





49


**HERITAGE
        OAKS BANCORP AND SUBSIDIARIES**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS (Continued)**
 **FOR
        YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**
 **(Amounts
        in thousands, except share data)**


2005
            
            2004
            
            2003**Cash
                Flows From Financing Activities**Increase
                in deposits, net
            
            $
            47,356
            
            $
            4,002
            
            $
            23,788Net
                increase/(decrease) in FHLB borrowings
            
            
            (18,500
            )
            
            –
            
            
            (9,500
            )Net
                (decrease)/increase in notes payable
            
            
            –
            
            
            (3,500
            )
            
            3,500Net
                increase in securities sold under agreement to repurchase
            
            
            3,081
            
            
            306
            
            
            202Proceeds
                from exercise of stock options
            
            
            1,275
            
            
            199
            
            
            379Proceeds
                from sale of stock
            
            
            –
            
            
            –
            
            
            66Cash
                paid in lieu of fractional shares
            
            
            (12
            )
            
            (6
            )
            
            (4
            )**NET
                CASH PROVIDED BY FINANCING ACTIVITIES**
            
            
            33,200
            
            
            1,001
            
            
            18,431**Net
                Increase/(Decrease) in Cash and Cash Equivalents**
            
            
            22,692
            
            
            (55,247
            )
            
            16,560**Cash
                and Cash Equivalents**,
                Beginning of year
            
            
            21,867
            
            
            77,114
            
            
            60,554**Cash
                and Cash Equivalents**,
                End of year
            
            $
            44,559
            
            $
            21,867
            
            $
            77,114







2005
              
              2004
              
              2003**Supplemental
                  Disclosures of Cash Flow Information**Interest
                  paid
              
              $
              4,912
              
              $
              3,453
              
              $
              3,652Income
                  taxes paid
              
              $
              3,825
              
              $
              2,575
              
              $
              2,250**Supplemental
                  Disclosures of Non-Cash Flow Information**Change
                  in other valuation allowance for investment securities
              
              $
              (509
              )
              $
              82
              
              $
              (781
              )Tax
                  benefit of stock options exercised
              
              $
              588
              
              $
              136
              
              $
              204**Supplemental
                  Disclosures**Net
                  change in assets/liabilities due to acquisition of Hacienda
                  BankIncrease
                  in interest-bearing deposits in other financial
                  institutions
              
              $
              –
              
              $
              –
              
              $
              100Increase
                  in investments
              
              $
              –
              
              $
              –
              
              $
              2,121Increase
                  in net loans
              
              $
              –
              
              $
              –
              
              $
              51,878Increase
                  in FHLB stock
              
              $
              –
              
              $
              –
              
              $
              253Increase
                  in premises and equipment
              
              $
              –
              
              $
              –
              
              $
              2,834Increase
                  in goodwill and other intangible assets
              
              $
              –
              
              $
              –
              
              $
              7,029Increase
                  in other assets
              
              $
              –
              
              $
              –
              
              $
              901Increase
                  in demand, money market and savings deposits
              
              $
              –
              
              $
              –
              
              $
              48,678Increase
                  in time certificates of deposit
              
              $
              –
              
              $
              –
              
              $
              29,795Increase
                  in other liabilities
              
              $
              –
              
              $
              –
              
              $
              644


The
        accompanying notes are an integral part of these financial
        statements.




50




**HERITAGE
                OAKS BANCORP AND SUBSIDIARIES**
              **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
              **DECEMBER
                31, 2005, 2004, AND 2003**
              **(Dollars
                in thousands, except per share
                amounts)**




**Note
      #1 - Summary of Significant Accounting Policies**




The
      accounting and reporting policies of Heritage Oaks Bancorp (the Company) and
      subsidiaries conform to accounting principles generally accepted in the United
      States of America and to general practices within the banking industry. A
      summary of the Company's significant accounting and reporting policies
      consistently applied in the preparation of the accompanying financial statements
      follows:





Principles
      of Consolidation





The
      consolidated financial statements include the Company and its wholly owned
      subsidiaries, Heritage Oaks Bank, (the “Bank”) and CCMS Systems, Inc.
      Inter-company balances and transactions have been eliminated.




Nature
      of Operations




The
      Company has been organized as a single operating segment. The Bank operates
      eleven branches within San Luis Obispo and Northern Santa Barbara counties.
      The
      Bank offers traditional banking products such as checking, savings and
      certificates of deposit, as well as mortgage loans and commercial and consumer
      loans to customers who are predominately small to medium-sized businesses and
      individuals.





Investment
      in Non-Consolidated Subsidiary





The
      Company accounts for its investments in its wholly owned special purpose entity,
      Heritage Oaks Capital Trust I (the “Trust”), using the equity method under which
      the subsidiary’s net earnings are recognized in the Company’s statements of
      income. Prior to December 31, 2003, the accounts of the Trust were included
      in
      the consolidated financial statements of the Company. Pursuant to the Company’s
      adoption of the transition guidance of FASB Interpretations Number (“FIN”) 46R
      for investments in special purpose entities, the Company deconsolidated the
      Trust from its financial statements as of December 31, 2003.





Use
      of
      Estimates in the Preparation of Financial Statements





The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires management to make
      estimates and assumptions that affect the reported amounts of assets and
      liabilities and disclosure of contingent assets and liabilities at the date
      of
      the financial statements and the reported amounts of revenues and expenses
      during the reporting period. Actual results could differ from those
      estimates.





Estimates
      that are particularly susceptible to significant change relate to the
      determination of the allowance for loan losses on loans and the valuation of
      real estate acquired in connection with foreclosures or in satisfaction of
      loans. In connection with the determination of the allowances for losses on
      loans and foreclosed real estate, management obtains independent appraisals
      for
      significant properties.





While
      management uses available information to recognize losses on loans and
      foreclosed real estate, future additions to the allowances may be necessary
      based on changes in local economic conditions. In addition, regulatory agencies,
      as an integral part of their examination process, periodically review the
      Company’s allowances for losses on loans and foreclosed real estate. Such
      agencies may require the Company to recognize additions to the allowances based
      on their judgments about information available to them at the time of their
      examination. Because of these factors, it is reasonably possible that the
      allowances for losses on loans and foreclosed real estate may
      change.




51




**HERITAGE
                OAKS BANCORP AND SUBSIDIARIES**
              **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
              **DECEMBER
                31, 2005, 2004, AND 2003**
              **(Dollars
                in thousands, except per share
                amounts)**




Note
      #1 -
      Summary of Significant Accounting Policies, Continued




Cash
      and Due From Banks





Banking
      regulations require that all banks maintain a percentage of their deposits
      as
      reserves in cash or on deposit with the Federal Reserve Bank. The Banks complied
      with the reserve requirements as of December 31, 2005.





The
      Company maintains amounts due from banks that exceed federally insured limits.
      The Company has not experienced any losses in such accounts.





Cash
      and Cash Equivalents





For
      purposes of reporting cash flows, cash and cash equivalents include cash, due
      from banks, federal funds sold and money market funds. Generally, federal funds
      are sold for one-day periods.





Investment
      Securities





In
      accordance with Statement of Financial Accounting Standards (SFAS) No. 115,
      " *Accounting
      for Certain Investments in Debt and Equity Securities,* "
      which
      addresses the accounting for investments in equity securities that have readily
      determinable fair values and for investments in all debt securities. Securities
      are classified in three categories and accounted for as follows: debt, equity,
      and mortgage-backed securities that the Company has the positive intent and
      ability to hold to maturity are classified as held-to-maturity and are measured
      at amortized cost; debt and equity securities bought and held principally for
      the purpose of selling in the near term are classified as trading securities
      and
      are measured at fair value, with unrealized gains and losses included in
      earnings; debt and equity securities not classified as either held-to-maturity
      or trading securities are deemed as available-for-sale and are measured at
      fair
      value, with unrealized gains and losses, net of applicable taxes, reported
      in a
      separate component of stockholders' equity. Gains or losses on sales of
      investment securities are determined on the specific identification method.
      Premiums and discounts are amortized or accreted using the interest method
      over
      the expected lives of the related securities.





Declines
      in the fair values of individual held-to-maturity and available-for-sale
      securities below their cost that are other than temporary result in write-downs
      of individual securities to their fair value. The related write-downs are
      included in earnings as realized losses. In estimating other-than-temporary
      impairment losses, management considers (1) the length of time and the extent
      to
      which the fair value has been less than cost, (2) the financial condition and
      near-term prospects of the issuer, and (3) the intent and ability of the Company
      to retain its investment in the issuer for a period of time sufficient to allow
      for any anticipated recover in fair value.




Loans
      and Interest on Loans




Loans
      receivable that management has the intent and ability to hold for the
      foreseeable future or until maturity or payoff are reported at their outstanding
      unpaid principal balances reduced by any charge-offs of specific valuation
      accounts and net of any deferred fees or costs on originated loans, or
      unamortized premiums or discounts on purchased loans.





Loan
      origination fees and certain direct origination costs are capitalized and
      recognized as an adjustment of the yield of the related loan.





Loans
      on
      which the accrual of interest has been discontinued are designated as
      non-accrual loans. The accrual of interest on loans is discontinued when
      principal or interest is past due 90 days based on contractual terms of the
      loan
      or when, in the opinion of management, there is reasonable doubt as to
      collectibility. When loans are placed on non-accrual status, all interest
      previously accrued but not collected is reversed against current period interest
      income. Interest income generally is not recognized on specific impaired loans
      unless the likelihood of further loss is remote. Interest payments received
      on
      such loans are applied as a reduction to the loan principal balance. Interest
      accruals are resumed on such loans only when they are brought current with
      respect to interest and principal and when, in the judgment of management,
      the
      loans are estimated to be fully collectible as to all principal and
      interest.





52


**HERITAGE
                  OAKS BANCORP AND SUBSIDIARIES**
                **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
                **DECEMBER
                  31, 2005, 2004, AND 2003**
                **(Dollars
                  in thousands, except per share
                  amounts)**
  **Note
        #1 - Summary of Significant Accounting Policies,
        Continued**




The
      Company considers a loan to be impaired when it is probable that the Company
      will be unable to collect all amounts due (principal and interest) according
      to
      the contractual terms of the loan agreement. Measurement of impairment is based
      on the expected future cash flows of an impaired loan which are to be discounted
      at the loan’s effective interest rate, or measured by reference to an observable
      market value, if one exists, or the fair value of the collateral for a
      collateral-dependent loan. The Company selects the measurement method on a
      loan-by-loan basis except that collateral-dependent loans for which foreclosure
      is probable are measured at the fair value of the collateral. The Bank
      recognizes interest income on impaired loans based on its existing methods
      of
      recognizing interest income on non-accrual loans.





All
      loans
      are generally charged off at such time the loan is classified as a
      loss.




Loans
      Held for Sale




Loans
      held for sale are carried at the lower of aggregate cost or market value, which
      is determined by the specified value in the commitments. Net unrealized losses,
      if any, are recognized through a valuation allowance by charges to
      expense.





Allowance
      for Loan Losses





The
      allowance for loan losses is maintained at a level which, in management's
      judgment, is adequate to absorb credit losses inherent in the loan portfolio.
      The amount of the allowance is based on management's evaluation of the
      collectibility of the loan portfolio, including the nature of the portfolio,
      credit concentrations, trends in historical loss experience, specific impaired
      loans, and economic conditions. Allowances for impaired loans are generally
      determined based on collateral values or the present value of estimated cash
      flows. The allowance is increased by a provision for loan losses, which is
      charged to expense and reduced by charge-offs, net of recoveries. Changes in
      the
      allowance relating to impaired loans are charged or credited to the provision
      for loan losses. Because of uncertainties inherent in the estimation process,
      management’s estimate of credit losses inherent in the loan portfolio and the
      related allowance may change.





Property,
      Premises and Equipment





Land
      is
      carried at cost. Premises and equipment are carried at cost less accumulated
      depreciation and amortization. Depreciation is computed using the straight-line
      method over the estimated useful lives, which ranges from three to ten years
      for
      furniture and fixtures and forty years for buildings. Leasehold improvements
      are
      amortized using the straight-line method over the estimated useful lives of
      the
      improvements or the remaining lease term, whichever is shorter. Expenditures
      for
      betterments or major repairs are capitalized and those for ordinary repairs
      and
      maintenance are charged to operations as incurred. Total depreciation expenses
      for the reporting periods ending December 31, 2005, 2004, and 2003 were
      approximately $897, $949, and $661, respectively.





Goodwill
      and Intangible Assets





The
      Company has engaged in the acquisition of financial institutions and the
      assumption of deposits and purchase of assets from other financial institutions.
      The Company has paid premiums on these acquisitions, and such premiums are
      recorded as intangible assets, in the form of goodwill or core deposit
      intangible assets.





53


**HERITAGE
                  OAKS BANCORP AND SUBSIDIARIES**
                **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
                **DECEMBER
                  31, 2005, 2004, AND 2003**
                **(Dollars
                  in thousands, except per share
                  amounts)**
  **Note
        #1 - Summary of Significant Accounting Policies,
        Continued**





Goodwill
      represents the excess of the purchase price over the estimated fair value of
      the
      net assets acquired. In accordance with the provisions of Statement of Financial
      Accounting No. (“SFAS”) 142, goodwill is not being amortized whereas
      identifiable intangible assets with finite lives are amortized over their useful
      lives. On an annual


basis,
      the Company is required to test goodwill for impairment. The Company’s
      assessment at December 31, 2005 pursuant to its Goodwill Impairment Testing
      Policy resulted in no impairment.





Core
      deposit intangibles represent the intangible value of depositor relationships
      resulting from deposit liabilities assumed in acquisitions. Core deposit
      intangibles are being amortized over six and ten years. Intangibles are
      evaluated periodically for other than temporary impairment. Should such an
      assessment indicate that the undiscounted value of an intangible may be
      impaired, the net book value of the intangible would be written down to the
      net
      estimated recoverable value.





Income
      Taxes





Provisions
      for income taxes are based on amounts reported in the statements of income
      (after exclusion of non-taxable income such as interest on state and municipal
      securities) and include deferred taxes on temporary differences in the
      recognition of income and expense for tax and financial statement purposes.
      Deferred taxes are computed on the liability method as prescribed in SFAS No.
      109, "Accounting for Income Taxes."





Advertising
      Costs





The
      Company expenses the costs of advertising in the period incurred.





Disclosure
      about Fair Value of Financial Instruments





SFAS
      No.
      107 specifies the disclosure of the estimated fair value of financial
      instruments. The Company’s estimated fair value amounts have been determined by
      the Company using available market information and appropriate valuation
      methodologies.





However,
      considerable judgment is required to develop the estimates of fair value.
      Accordingly, the estimates are not necessarily indicative of the amounts the
      Company could have realized in a current market exchange. The use of different
      market assumptions and/or estimation methodologies may have a material effect
      on
      the estimated fair value amounts.





Although
      management is not aware of any factors that would significantly affect the
      estimated fair value amounts, such amounts have not been comprehensively
      revalued for purposes of these financial statements since the balance sheet
      date
      and, therefore, current estimates of fair value may differ significantly from
      the amounts presented in the accompanying notes.





Financial
      Instruments





In
      the
      ordinary course of business, the Company has entered into off-balance sheet
      financial instruments consisting of commitments to extend credit, commercial
      letters of credit, and standby letters of credit as described in Note #10.
      Such
      financial instruments are recorded in the financial statements when they are
      funded or related fees are incurred or received.





Comprehensive
      Income





Beginning
      in 1998, the Company adopted SFAS No. 130, “ *Reporting
      Comprehensive Income* , *”* which
      requires the disclosure of comprehensive income and its components. Changes
      in
      unrealized gain (loss) on available-for-sale securities
      net of income taxes is the only component of accumulated other comprehensive
      income for the Company.




54


**HERITAGE
                  OAKS BANCORP AND SUBSIDIARIES**
                **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
                **DECEMBER
                  31, 2005, 2004, AND 2003**
                **(Dollars
                  in thousands, except per share
                  amounts)**
  **Note
        #1 - Summary of Significant Accounting Policies, Continued**


Reclassifications





Certain
      amounts in the 2004 and 2003 financial statements have been reclassified to
      conform to the 2005 presentation.





Earnings
      Per Share (EPS)





Basic
      EPS
      excludes dilution and is computed by dividing income available to common
      stockholders by the weighted-average number of common shares outstanding for
      the
      period. Diluted EPS reflects the potential dilution that could occur if
      securities or other contracts to issue common stock were exercised or converted
      into common stock or resulted in the issuance of common stock that then shared
      in the earnings of the entity.





Stock-Based
      Compensation





SFAS
      No.
      123, *“Accounting
      for Stock-Based Compensation,”* encourages, but does not require, companies to record compensation cost for
      stock-based employee compensation plans at fair value. The Company has chosen
      to
      continue to account for stock-based compensation using the intrinsic value
      method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, *“Accounting
      for Stock Issued to Employees,”* and
      related Interpretations. Accordingly, compensation cost for stock options is
      measured as the excess, if any, of the quoted market price of the Company’s
      stock at the date of the grant over the amount an employee must pay to acquire
      the stock.





Had
      compensation cost for the Company’s stock option plans been determined based on
      the fair value at the grant dates for awards under those plans consistent with
      the method of SFAS No. 123, the Company’s net income and earnings per share
      would have been reduced to the pro forma amount indicated below:





2005
            
            2004
            
            2003Net
                income:As
                reported
            
            $
            6,637
            
            $
            4,584
            
            $
            3,596Stock-based
                compensation using the intrinsicvalue
                method
            
            
            –
            
            
            –
            
            
            –Stock-based
                compensation that would havebeen
                reported using the fair value methodof
                SFAS 123
            
            
            (89
            )
            
            (64
            )
            
            (75
            )Pro
                forma net income
            
            $
            6,548
            
            $
            4,520
            
            $
            3,521Basic
                earnings per share:As
                reported
            
            $
            1.08
            
            $
            0.77
            
            $
            0.71Pro
                forma
            
            
            1.06
            
            
            0.76
            
            
            0.70Diluted
                earnings per share:As
                reported
            
            $
            1.01
            
            $
            0.71
            
            $
            0.67Pro
                forma
            
            
            1.00
            
            
            0.70
            
            
            0.65




55


**HERITAGE
                  OAKS BANCORP AND SUBSIDIARIES**
                **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
                **DECEMBER
                  31, 2005, 2004, AND 2003**
                **(Dollars
                  in thousands, except per share
                  amounts)**
  **Note
        #1 - Summary of Significant Accounting Policies,
        Continued**





Current
      Accounting Pronouncements





In
      December 2004, the FASB issued SFAS No. 123 (revised 2004). *“Share-Based
      Payment”* ,
      which
      is a revision of SFAS No. 123, *“Accounting
      for Stock-Based Compensation”* .
      SFAS
      No. 123(R) supersedes Accounting Principles Board (“APB”) Opinion No. 25, *“Accounting
      for Stock Issued to Employees”* and
      amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS
      No.
      123(R) is similar to the approach described in SFAS No. 123. However, SFAS
      No.
      123(R) requires all share-based payments to employees, including grants of
      employee stock options, to be recognized in the income statement based on their
      fair values. Pro forma disclosure is no longer an alternative. The new standard
      will be effective for the Company in the first interim or annual reporting
      period beginning after December 15, 2005. The Company has not determined if
      the
      adoption of this standard will have a material impact on its financial
      statements.




**Note
      #2 - Investment Securities**




At
      December 31, 2005 and 2004, the investment securities portfolio was comprised
      of
      securities classified as available-for-sale, in accordance with SFAS No. 115,
      resulting in investment securities available-for-sale being carried at fair
      value adjusted for amortization of premiums and accretions of discounts, and
      fair market value adjustments for securities transferred from
      available-for-sale.





The
      amortized cost and fair values of investment securities available-for-sale
      at
      December 31, 2005, were:





Gross
            
            GrossAmortized
            
            Unrealized
            
            UnrealizedCost
            
            Gains
            
            Losses
            
            Fair
                ValueObligations
                of U.S. Governmentagencies
                and corporations
            
            $
            826
            
            $
            –
            
            $
            (20
            )
            $
            806Mortgage-backed
                securities
            
            
            28,795
            
            
            13
            
            
            (518
            )
            
            28,290Obligations
                of state and politicalsubdivisions
            
            
            15,036
            
            
            364
            
            
            (103
            )
            
            15,297Other
                securities
            
            
            9
            
            
            –
            
            
            –
            
            
            9Total
            
            $
            44,666
            
            $
            377
            
            $
            (641
            )
            $
            44,402




The
      amortized cost and fair values of investment securities available-for-sale
      at
      December 31, 2004, were:





Gross
            
            GrossAmortized
            
            Unrealized
            
            UnrealizedCost
            
            Gains
            
            Losses
            
            Fair
                ValueObligations
                of U.S. Governmentagencies
                and corporations
            
            $
            1,868
            
            $
            5
            
            $
            (30
            )
            $
            1,843Mortgage-backed
                securities
            
            
            42,622
            
            
            181
            
            
            (239
            )
            
            42,564Obligations
                of state and politicalsubdivisions
            
            
            12,651
            
            
            413
            
            
            (86
            )
            
            12,978Other
                securities
            
            
            9
            
            
            –
            
            
            –
            
            
            9Total
            
            $
            57,150
            
            $
            599
            
            $
            (355
            )
            $
            57,394




There
      were no investment securities held-to-maturity at December 31, 2005 and December
      31, 2004.





56


**HERITAGE
                  OAKS BANCORP AND SUBSIDIARIES**
                **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
                **DECEMBER
                  31, 2005, 2004, AND 2003**
                **(Dollars
                  in thousands, except per share
                  amounts)**
  **Note
        #2 - Investment Securities, Continued**





The
      amortized cost and fair values of investment securities available-for-sale
      at
      December 31, 2005, by contractual maturity are shown below. Actual maturities
      may differ from contractual maturities because borrowers may have the right
      to
      call or prepay obligations with or without call or prepayment
      penalties.





SecuritiesAvailable-for-SaleAmortizedCost
            
            Fair
                ValueDue
                in one year or less
            
            $
            509
            
            $
            497Due
                after one year through five years
            
            
            2,217
            
            
            2,249Due
                after five years through ten years
            
            
            6,522
            
            
            6,629Due
                after ten years
            
            
            6,623
            
            
            6,737Mortgage-backed
                securities
            
            
            28,795
            
            
            28,290Total
                Securities
            
            $
            44,666
            
            $
            44,402




Proceeds
      from sales, maturities and principal reductions of investment securities
      available-for-sale during 2005, 2004, and 2003, were $1,350, $1,315, and $757,
      respectively. There were no gross gains or losses reported during 2005 and
      2004.
      In 2003, gross gains and losses were $3 and $0, respectively.





Proceeds
      from sales and maturities and principal reductions of mortgage-backed securities
      in 2005, 2004, and 2003, were $13,537, $14,723, and $27,387, respectively.
      There
      were no gross gains or losses reported during 2005. In 2004, and 2003, gross
      gains on these sales were $28 and $60, respectively. Unrealized (losses)/gains
      on investment securities and mortgage-backed securities included in
      shareholders’ equity net of tax at December 31, 2005, 2004, and 2003 were
      ($158), $147, and $98, respectively.





Securities
      having a carrying value and a fair value of approximately $25,366 and $34,672
      at
      December 31, 2005 and 2004, respectively, were pledged to secure public deposits
      and for other purposes as required by law.





At
      the
      June 29, 2005 FASB Board meeting, the Board agreed to issue FSP FAS 115-1, *The
      Meaning of Other-Than-Temporary Impairment and Its Application to Certain
      Investments* which
      will replace the guidance previously set forth in EITF 03-1, *The
      Meaning of Other-Than -Temporary Impairment and Its Application to Certain
      Investments.* This FSP
      effectively eliminates the accounting guidance provided in EITF-03-1 in favor
      of
      existing impairment recognition guidance under SFAS No. 115, SAB No. 59, APB
      No.
      18, and EITF Topic D-44. The FSP is for periods beginning after September 15,
      2005, but its adoption is not expected to have a material impact on the
      Company’s consolidated financial statements.




57




**HERITAGE
                  OAKS BANCORP AND SUBSIDIARIES**
                **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
                **DECEMBER
                  31, 2005, 2004, AND 2003**
                **(Dollars
                  in thousands, except per share
                  amounts)**
  Note
      #2 -
      Investment Securities, Continued





Those
      investment securities available for sale which have an unrealized loss position
      at December 31, 2005 and 2004, are detailed below: (amounts in
      thousands)





Securities
                in a Loss
            
            Securities
                in a LossPosition
                for Less than
            
            Position
                for 12 Months12
                Months
            
            or
                Longer
            
            TotalFair
            
            Unrealized
            
            Fair
            
            Unrealized
            
            Fair
            
            UnrealizedDecember
                31, 2005
            
            Value
            
            Loss
            
            Value
            
            Loss
            
            Value
            
            LossObligations
                of U.S. Governmentagencies
                and corporations
            
            $
            –
            
            $
            –
            
            $
            806
            
            $
            (20
            )
            $
            806
            
            $
            (20
            )Mortgage-backed
                securities
            
            
            14,111
            
            
            (250
            )
            
            11,902
            
            
            (268
            )
            
            26,013
            
            
            (518
            )Obligations
                of state and politicalsubdivisions
            
            
            4,237
            
            
            (83
            )
            
            620
            
            
            (20
            )
            
            4,857
            
            
            (103
            )Other
                securities
            
            
            –
            
            
            –Total
            
            $
            18,348
            
            $
            (333
            )
            $
            13,328
            
            $
            (308
            )
            $
            31,676
            
            $
            (641
            )December
                31, 2004Obligations
                of U.S. Governmentagencies
                and corporations
            
            $
            497
            
            $
            (3
            )
            $
            841
            
            $
            (27
            )
            $
            1,338
            
            $
            (30
            )Mortgage-backed
                securities
            
            
            13,951
            
            
            (74
            )
            
            9,691
            
            
            (181
            )
            
            23,642
            
            
            (255
            )Obligations
                of state and politicalsubdivisions
            
            
            879
            
            
            (2
            )
            
            811
            
            
            (84
            )
            
            1,690
            
            
            (86
            )Other
                securities
            
            
            –
            
            
            –Total
            
            $
            15,327
            
            $
            (79
            )
            $
            11,343
            
            $
            (292
            )
            $
            26,670
            
            $
            (371
            )




There
      are
      seventeen securities that have been in a loss position for twelve months or
      longer. These securities are guaranteed by either the U.S. Government or other
      governments. These unrealized losses relate principally to current interest
      rates for similar types of securities. In analyzing an issuer’s financial
      condition, the Company considers whether the securities are issued by the
      federal government or its agencies, whether downgrades by bond rating agencies
      have occurred, and the results of reviews of the issuer’s financial condition.
      As the Company has the ability to hold these securities until maturity, or
      for
      the foreseeable future, if classified as available-for-sale, no declines are
      deemed to be other-than-temporary.





58


**HERITAGE
                  OAKS BANCORP AND SUBSIDIARIES**
                **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
                **DECEMBER
                  31, 2005, 2004, AND 2003**
                **(Dollars
                  in thousands, except per share
                  amounts)**


**Note
      #3 - Loans**




Major
      classifications of loans were:





2005
            
            2004Commercial,
                financial and agricultural
            
            $
            60,050
            
            $
            49,584Real
                Estate - construction
            
            
            76,981
            
            
            66,833Real
                Estate - other
            
            
            210,690
            
            
            202,765Home
                Equity lines of credit
            
            
            14,398
            
            
            14,708Installment
                loans to individuals
            
            
            5,620
            
            
            5,538All
                other loans (including overdrafts)
            
            
            394
            
            
            265368,133
            
            
            339,693Less:  Deferred
                loan fees
            
            
            (1,617
            )
            
            (1,482
            )Less:  Allowance
                for loan losses
            
            
            (3,881
            )
            
            (3,247
            )Total
                Loans
            
            $
            362,635
            
            $
            334,964Loans
                held for sale
            
            $
            3,392
            
            $
            2,253




Concentration
      of Credit Risk





At
      December 31, 2005 and 2004, approximately $302,069 and $284,306 of the Bank’s
      loan portfolio was collateralized by various forms of real estate. Such loans
      are generally made to borrowers located in San Luis Obispo County and Northern
      Santa Barbara County. The Bank attempts to reduce their concentration of credit
      risk by making loans which are diversified by project type. While management
      believes that the collateral presently securing this portfolio is adequate,
      there can be no assurances that significant deterioration in the California
      real
      estate market would not expose the Bank to significantly greater credit
      risk.




Loans
      serviced for others are not included in the accompanying balances sheets. The
      unpaid principal balance of loans serviced for others was $3.6 million, $3.5
      million and $6.9 million at December 31, 2005, 2004 and 2003, respectively.





The
      following is a summary of the investment in impaired loans, the related
      allowance for loan losses, and income recognized thereon as of December
      31:





2005
            
            2004
            
            2003Impaired
                loans with a valuation allowance
            
            $
            54
            
            $
            821
            
            $
            1,475Impaired
                loans without a valuation allowance
            
            
            –
            
            
            113
            
            
            158Total
                impaired loans
            
            $
            54
            
            $
            934
            
            $
            1,633Valuation
                allowance related to impaired loans
            
            $
            16
            
            $
            453
            
            $
            528Average
                recorded investment in impaired loans
            
            $
            374
            
            $
            1,076
            
            $
            1,100Cash
                receipts applied to reduce principal balance
            
            $
            8
            
            $
            110
            
            $
            132Interest
                income recognized for cash payments
            
            $
            –
            
            $
            48
            
            $
            25




The
      provisions of SFAS No. 114 and SFAS No. 118 permit the valuation allowance
      reported above to be determined on a loan-by-loan basis or by aggregating loans
      with similar risk characteristics. Because the loans currently identified as
      impaired have unique risk characteristics, the valuation allowance was
      determined on a loan-by-loan basis.





59


**HERITAGE
                  OAKS BANCORP AND SUBSIDIARIES**
                **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
                **DECEMBER
                  31, 2005, 2004, AND 2003**
                **(Dollars
                  in thousands, except per share
                  amounts)**


**Note
      #3 - Loans, Continued**




Non-accruing
      loans totaled approximately $54 and $934 at December 31, 2005 and 2004,
      respectively. As of December 31, 2005 and 2004, all loans on non-accrual were
      classified as impaired. If interest on non-accrual loans had been recognized
      at
      the original interest rates, interest income would have increased $87, $126,
      and
      $132, in 2005, 2004, and 2003, respectively. No additional funds are committed
      to be advanced in connection with impaired loans.





At
      December 31, 2005 and 2004, the Bank had no loans past due 90 days or more
      and
      still accruing interest.





At
      December 31, 2005, there were no loans classified as troubled debt
      restructurings.





The
      Bank
      also originates Small Business Administration (“SBA”) loans for sale to
      governmental agencies and institutional investors. At December 31, 2005 and
      2004, the unpaid principal balance of SBA loans serviced for others totaled
      $1,715 and $1,046, respectively. The gain on sale of SBA loans was $84, $45,
      and
      $0 for the years ended December 31, 2005, 2004, and 2003,
      respectively.




The
      balance of capitalized servicing rights included in “other assets” on the
      Company’s Consolidated Balance Sheets at December 31, 2005 and 2004, was $6 and
      approximately $1, respectively. The fair values of these rights approximate
      their book values respectively.





**Note
      #4 - Allowance for Loan Losses**





Transactions
      in the allowance for loan losses are summarized as follows:





2005
            
            2004
            
            2003Balance,
                Beginning of Year
            
            $
            3,247
            
            $
            3,070
            
            $
            2,336Additions
                charged to operating expense
            
            
            710
            
            
            410
            
            
            370Loans
                charged off
            
            
            (100
            )
            
            (236
            )
            
            (466
            )Recoveries
                of loans previously charged off
            
            
            24
            
            
            3
            
            
            233Credit
                from purchase of Hacienda Bank
            
            
            –
            
            
            –
            
            
            597Balance,
                End of Year
            
            $
            3,881
            
            $
            3,247
            
            $
            3,070




**Note
      #5 - Property, Premises and Equipment**




Property,
      premises and equipment consisted of the following:





2005
            
            2004Building
                and improvements
            
            $
            7,330
            
            $
            7,966Furniture
                and equipment
            
            
            4,641
            
            
            5,65411,971
            
            
            13,620Less: 
                Accumulated depreciation and amortization
            
            
            6,652
            
            
            7,6405,319
            
            
            5,980Land
            
            
            3,782
            
            
            4,051Construction
                in progress
            
            
            2,804
            
            
            352Total
            
            $
            11,905
            
            $
            10,383





During
      2003, the Bank purchased land for future development of a Paso Robles,
      California administrative facility for approximately $1,100. Total remaining
      construction commitments related to this project totaled approximately $2.1
      million, as of December 31, 2005.





In
      July
      2005 the Company entered into a sale-leaseback transaction, with a
      non-affiliated party, for the Atascadero Branch Office with the Bank as the
      lessee. The sale price was $900 and resulted in a gain to the Company of
      approximately $283 which will be amortized against rental expense over the
      first
      5 year term of the lease. The Bank’s new lease calls for payments of $5 per
      month for 5 years with 4 separate 5 year options to extend.




60


**HERITAGE
                  OAKS BANCORP AND SUBSIDIARIES**
                **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
                **DECEMBER
                  31, 2005, 2004, AND 2003**
                **(Dollars
                  in thousands, except per share
                  amounts)**


**Note
      #5 - Property, Premises and Equipment, Continued**





The
      Company leases land, buildings, and equipment under non-cancelable operating
      leases expiring at various dates through 2012. The following is a schedule
      of
      future minimum lease payments based upon obligations at year-end.





Year
                EndingDecember
                31,
            
            Amount2006
            
            $
            6622007
            
            
            5822008
            
            
            5312009
            
            
            3572010
            
            
            256More
                than 5 years
            
            
            350Total
            
            $
            2,738




The
      leases contain options to extend for periods from five to twenty years. Options
      to extend which have been exercised and the related lease costs are included
      above. Total expenditures charged for leases for the reporting periods ended
      December 31, 2005, 2004, and 2003, were approximately $663, $622, and $435,
      respectively.




**Note
      #6 - Intangible Assets**




Intangible
      assets consisted of core deposit intangibles subject to amortization with a
      net
      carrying value of $1,448 and $2,021, net of $1,083 and $510 accumulated
      amortization as of December 31, 2005 and 2004, respectively. Amortization
      expense for the periods ended December 31, 2005, 2004, and 2003 was $573, $421,
      and $41, respectively. The estimated future amortization expense for the next
      six years is $300 for 2006, $354 for 2007, $388 for 2008, $337 for 2009, $40
      for
      2010, and $29 for 2011.




**Note
      #7 - Time Deposit Liabilities**




At
      December 31, 2005, the Banks had time certificates of deposit with maturity
      distributions as follows:





Year
                EndingDecember
                31,2006
            
            $
            66,0962007
            
            
            16,7532008
            
            
            6302009
            
            
            198$
            83,677




**Note
      #8 - Borrowings**





The
      Bank
      has borrowing lines with correspondent banks totaling $13.5 million. At December
      31, 2005 there were no balances outstanding on these borrowing
      lines.





**Federal
      Home Loan Bank (FHLB) Advances**





The
      Bank
      has established borrowing lines with the Federal Home Loan Bank (FHLB). At
      December 31, 2004, the Bank had borrowings with the FHLB of $10 million that
      matures in July 2006 with a current interest rate of 4.15%. This borrowing
      is
      collateralized by loans. In addition, the Bank has an $11.7 million letter
      of
      credit secured by loans.




61


**HERITAGE
                  OAKS BANCORP AND SUBSIDIARIES**
                **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
                **DECEMBER
                  31, 2005, 2004, AND 2003**
                **(Dollars
                  in thousands, except per share
                  amounts)**


**Note
      #8 - Borrowings, Continued**





At
      December 31, 2005, the Bank has a remaining borrowing capacity with existing
      collateral of approximately $80 million and $13.4 million secured by loans
      and
      securities, respectively.





The
      Bank
      has pledged approximately $185.0 in loans to the FHLB.





Securities
      Sold Under Agreements to Repurchase





Securities
      sold under agreements to repurchase, which are classified as secured borrowings,
      generally mature within one to four days from the transaction date. Securities
      sold under agreements to repurchase are reflected at the amount of cash received
      in connection with the transaction. As of December 31, 2005 and 2004, the Bank
      had $3,847 and $766 in securities sold under agreements to repurchase. Interest
      expense recorded was $44, $8, and $2 for the years ended December 31, 2005,
      2004, and 2003, respectively. The carrying value of underlying securities
      provided as collateral for these transactions was $5,771 and $924 at December
      31, 2005 and 2004, respectively.





Notes
      Payable





On
      October 10, 2005, the Company renewed a revolving line of credit in the amount
      of $3,500 through Pacific Coast Bankers Bank (PCBB). The line is secured by
      51%
      of the outstanding shares of the Bank’s stock. The line bears interest at the
      Wall Street Journal prime rate. Interest payments are due quarterly. The line
      is
      scheduled to mature on October 10, 2007 at which time the line converts to
      an
      eight-year term loan maturing on October 10, 2015. Principal and interest
      payments are due quarterly. Under the terms of the agreement, the Company will
      not incur any additional debt over $2,000 exclusive of the inter-company debt
      and existing debt without prior written


consent
      of PCBB. In addition, the Bank must be “well” capitalized on an on-going basis
      as defined by the Regulators. At December 31, 2005, the outstanding balance
      owed
      was $0.





Junior
      Subordinated Debentures





On
      April
      10, 2002, the Company issued $8,248 of Floating Rate Junior Subordinated
      Deferrable Interest Debentures “ (the “debt securities”) to Heritage Oaks
      Capital Trust I, a statutory trust created under the laws of the State of
      Delaware. These debt securities are subordinated to effectively all borrowings
      of the Company and are due and payable on April 22, 2032. Interest is payable
      quarterly on these debt securities at 6-Month LIBOR plus 3.7% for an effective
      rate of 8.15% as of December 31, 2005. The debt securities can be called at
      any
      time commencing on April 22, 2007, at par. The debt securities can also be
      redeemed at par if certain events occur that impact the tax treatment or the
      capital treatment of the issuance. The Company also purchased a 3% minority
      interest totaling $248 in Heritage Oaks Capital Trust I. The balance of the
      equity of Heritage Oaks Capital Trust I is comprised of mandatorily redeemable
      preferred securities and is included in other assets.





Under
      FASB Interpretation (FIN) No. 46, *“Consolidation
      of Variable Interest Entities, an interpretation of ARB No.
      51,”* the
      Company is not allowed to consolidate Heritage Oaks Capital Trust I into the
      Company’s financial statements. Prior to the issuance of FIN No. 46, Bank
      holding companies typically consolidated these entities. On February 28, 2005,
      the Federal Reserve Board issued a new rule which provides that, notwithstanding
      the deconsolidation of such trusts, junior subordinated debentures, such as
      those issued by the Company, may continue to constitute up to 25% of a bank
      holding company's Tier 1 capital, subject to certain new limitations which
      will
      not become effective until March 31, 2009 and which, in any event, are not
      expected to affect the treatment of the Company's Junior Subordinated Debentures
      as Tier 1 capital for regulatory purposes. As of December 31, 2005, the Company
      has included the net junior subordinated debt in its Tier1 Capital for
      regulatory capital purposes.




62


**HERITAGE
                  OAKS BANCORP AND SUBSIDIARIES**
                **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
                **DECEMBER
                  31, 2005, 2004, AND 2003**
                **(Dollars
                  in thousands, except per share
                  amounts)**
  **Note
        #9 - Income Taxes**





The
      current and deferred amounts of the provision (benefit) for income taxes
      were:





Year
                Ending December 31,2005
            
            2004
            
            2003Federal
                Income TaxCurrent
            
            $
            3,045
            
            $
            2,031
            
            $
            1,611Deferred
            
            
            (134
            )
            
            16
            
            
            (82
            )Total
                Federal Taxes
            
            
            2,911
            
            
            2,047
            
            
            1,529State
                Franchise TaxCurrent
            
            
            1,291
            
            
            706
            
            
            630Deferred
            
            
            (99
            )
            
            6
            
            
            (42
            )Total
                State Franchise Tax
            
            
            1,192
            
            
            712
            
            
            588Total
                Income Taxes
            
            $
            4,103
            
            $
            2,759
            
            $
            2,117




The
      provision for taxes on income differed from the amounts computed using the
      federal statutory tax rate of 34 percent is as follows:





2005
            
            2004
            
            2003Amount
            
            Percent
            
            Amount
            
            Percent
            
            Amount
            
            PercentTax
                provision at federal statutory tax
              rate
            
            $
            3,652
            
            
            34.0
            
            $
            2,497
            
            
            34.0
            
            $
            1,942
            
            
            34.0State
                income taxes, net of federalincome
                tax benefit
            
            
            768
            
            
            7.2
            
            
            507
            
            
            6.9
            
            
            388
            
            
            6.8Tax
                exempt income and other, Net
            
            
            (317
            )
            
            (3.0
            )
            
            (245
            )
            
            (3.4
            )
            
            (213
            )
            
            (3.7
            )Total
                Tax Provision
            
            $
            4,103
            
            
            38.2
            
            $
            2,759
            
            
            37.5
            
            $
            2,117
            
            
            37.1





The
      net
      deferred tax asset is determined as follows:





2005
            
            2004Deferred
                Tax AssetsReserves
                for loan losses
            
            $
            1,414
            
            $
            1,152Fixed
                assets
            
            
            357
            
            
            280Accruals
            
            
            800
            
            
            667Investment
                securities valuation
            
            
            109
            
            
            –Deferred
                Fees
            
            
            231
            
            
            248Net
                operating loss carryforward
            
            
            506
            
            
            821Total
                Deferred tax assets arising from cumulativetiming
                differences
            
            
            3,417
            
            
            3,168Total
                Deferred Tax Assets
            
            $
            3,417
            
            $
            3,168Deferred
                Tax LiabilitiesFair
                value adjustment for purchased assets
            
            $
            480
            
            $
            718Investment
                securities valuation
            
            
            –
            
            
            98Deferred
                costs, prepaids and FHLB
            
            
            579
            
            
            434Total
                Deferred Tax Liabilities
            
            
            1,059
            
            
            1,250Net
                Deferred Tax Assets
            
            $
            2,358
            
            $
            1,918




As
      part
      of a transaction with Hacienda Bank, the Company has approximately $1.5 million
      of net operating losses (NOL) available for carry forward at December 31, 2005.
      The realization of the NOL is limited for federal tax purposes and for state
      tax
      purposes under current tax law. Any amount not utilized for federal tax purposes
      will expire on various years through 2014.





63


**HERITAGE
                  OAKS BANCORP AND SUBSIDIARIES**
                **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
                **DECEMBER
                  31, 2005, 2004, AND 2003**
                **(Dollars
                  in thousands, except per share
                  amounts)**


**Note
      #10 - Commitments and Contingencies**




The
      Company is involved in various litigation. In the opinion of management and
      the
      Company’s legal counsel, the disposition of all such litigation pending will not
      have a material effect on the Company’s financial statements.





In
      the
      normal course of business, the Bank enters into financial commitments to meet
      the financing needs of their customers. These financial commitments include
      commitments to extend credit and standby letters of credit. Those instruments
      involve, to varying degrees, elements of credit and interest rate risk not
      recognized in the statement of financial position.





The
      Bank’s exposure to loan loss in the event of nonperformance on 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 as they do for loans reflected in the consolidated financial
      statements.





As
      of
      December 31, 2005 and 2004, the Bank had the following outstanding financial
      commitments whose contractual amount represents credit risk:





2005
            
            2004Commitments
                to extend credit
            
            $
            167,698
            
            $
            123,470Standby
                letters of credit
            
            
            17,033
            
            
            17,599$
            184,731
            
            $
            141,069





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. Standby letters of
      credit are conditional commitments to guarantee the performance of a Bank
      customer to a third party. Since many of the commitments and standby letters
      of
      credit are expected to expire without being drawn upon, the total amounts do
      not
      necessarily represent future cash requirements. The Bank evaluates each
      customer's credit worthiness on a case-by-case basis. The amount of collateral
      obtained if deemed necessary by the Bank is based on management's credit
      evaluation of the customer.





**Note
      #11 - Regulatory Matters**





The
      Company (on a consolidated basis) and the Bank is subject to various regulatory
      capital requirements administered by 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 and the Bank’s financial statements.
      Under capital adequacy guidelines and the regulatory framework for prompt
      corrective action, the Company and the Bank must meet specific capital
      guidelines that involve quantitative measures of the Company’s and the Bank’s
      assets, liabilities and certain off-balance sheet items as calculated under
      regulatory accounting practices. The Company’s and the Bank’s capital amounts
      and classification are also subject to qualitative judgments by the regulators
      about components, risk weightings and other factors. Prompt corrective action
      provisions are not applicable to bank holding companies.





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 total and Tier 1 capital (as defined in the regulations) to
      risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average
      assets (as defined). Management believes, as of December 31, 2005, that the
      Company and the Bank meets all capital adequacy requirements to which it is
      subject.





As
      of the
      most recent notification, the Federal Deposit Insurance Corporation categorized
      the Bank as well-capitalized under the regulatory framework for prompt
      corrective action. There are no conditions or events since that notification
      that management believes have changed the Bank's category. To be categorized
      as
      well-capitalized, the Bank must maintain minimum capital ratios as set forth
      in
      the table below. The following table also sets forth the Company’s and the
      Bank’s actual regulatory capital amounts and ratios:





64


**HERITAGE
                  OAKS BANCORP AND SUBSIDIARIES**
                **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
                **DECEMBER
                  31, 2005, 2004, AND 2003**
                **(Dollars
                  in thousands, except per share
                  amounts)**
  **Note
        #11 - Regulatory Matters, Continued**





Capital
                NeededTo
                Be WellCapitalized
                UnderFor
                Capital
            
            Prompt
                CorrectiveActual
                Regulatory
            
            Adequacy
                Purposes
            
            Action
                ProvisionsCapital
            
            
            
            Capital
            
            
            
            CapitalAmount
            
            Ratio
            
            Amount
            
            Ratio
            
            Amount
            
            Ratio**As
                of December 31, 2005**Total
                capital to risk-weighted assets:Company
            
            $
            50,736
            
            
            11.93
            %
            $
            34,022
            
            
            8.0
            %
            
            N/A
            
            
            N/AHeritage
                Oaks Bank
            
            
            48,071
            
            
            11.33
            %
            
            33,942
            
            
            8.0
            %
            $
            42,428
            
            
            10.0
            %Tier
                1 capital to risk-weighted assets:Company
            
            
            46,692
            
            
            10.98
            %
            
            17,010
            
            
            4.0
            %
            
            N/A
            
            
            N/AHeritage
                Oaks Bank
            
            
            44,027
            
            
            10.38
            %
            
            16,966
            
            
            4.0
            %
            
            25,449
            
            
            6.0
            %Tier
                1 capital to average assets:Company
            
            
            46,692
            
            
            9.61
            %
            
            19,435
            
            
            4.0
            %
            
            N/A
            
            
            N/AHeritage
                Oaks Bank
            
            
            44,027
            
            
            9.11
            %
            
            19,331
            
            
            4.0
            %
            
            24,164
            
            
            5.0
            %**As
                of December 31, 2004**Total
                capital to risk-weighted assets:Company
            
            $
            41,482
            
            
            10.65
            %
            $
            31,160
            
            
            8.0
            %
            
            N/A
            
            
            N/AHeritage
                Oaks Bank
            
            
            39,653
            
            
            10.16
            %
            
            31,223
            
            
            8.0
            %
            $
            39,029
            
            
            10.0
            %Tier
                1 capital to risk-weighted assets:Company
            
            
            38,082
            
            
            9.78
            %
            
            15,575
            
            
            4.0
            %
            
            N/A
            
            
            N/AHeritage
                Oaks Bank
            
            
            36,253
            
            
            9.29
            %
            
            15,609
            
            
            4.0
            %
            
            23,414
            
            
            6.0
            %Tier
                1 capital to average assets:Company
            
            
            38,082
            
            
            8.34
            %
            
            18,265
            
            
            4.0
            %
            
            N/A
            
            
            N/AHeritage
                Oaks Bank
            
            
            36,253
            
            
            8.09
            %
            
            17,925
            
            
            4.0
            %
            
            22,406
            
            
            5.0
            %





As
      disclosed in Note #8, Borrowings - Junior Subordinated Debentures, subject
      to
      percentage limitations, the proceeds from the issuance of trust preferred
      securities are considered Tier 1 capital by the Company for regulatory purposes.
      However, as a result of the issuance of FIN 46 and FIN 46R, the trust subsidiary
      is not consolidated in these financial statements and therefore the proceeds
      received by the Company from the trust subsidiary is reported as subordinated
      debt. On February 28, 2005, the Federal Reserve Board issued a new rule which
      provides that, notwithstanding the deconsolidation of such trusts, junior
      subordinated debentures, such as those issued by the Company, may continue
      to
      constitute up to 25% of a bank holding company's Tier 1 capital, subject to
      certain new limitations which will not become effective until March 31, 2009
      and
      which, in any event, are not expected to affect the treatment of the Company's
      Junior Subordinated Debentures as Tier 1 capital for regulatory purposes.





**Note
      #12 - Salary Continuation Plan**





The
      Company established a salary continuation plan agreement with the President,
      Chief Financial Officer, Chief Lending Officer, Chief Administrative Officer
      and
      certain Senior Vice Presidents, as authorized by the Board of Directors. This
      agreement provides for annual cash payments for a period not to exceed 15 years,
      payable at age 60-65, depending on the agreement. In the event of death prior
      to
      retirement age, annual cash payments would be made to the beneficiaries for
      a
      determined number of years. The present values of the Company’s liability under
      this Agreement were approximately $1,250 and $913 at December 31, 2005 and
      2004,
      respectively, and are included in other liabilities in the Company’s
      Consolidated Financial Statements. The Company maintains lifeinsurance
      policies, which are intended to fund all costs of the plan. The cash surrender
      values of these life insurance policies totaled approximately $7,706 and $7,130,
      at December 31, 2005 and 2004, respectively.





65


**HERITAGE
                  OAKS BANCORP AND SUBSIDIARIES**
                **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
                **DECEMBER
                  31, 2005, 2004, AND 2003**
                **(Dollars
                  in thousands, except per share
                  amounts)**




**Note
      #13 - Employee Benefit Plans**





401(k)
      Pension Plan





During
      1994, the Company established a savings plan for employees that allow
      participants to make contributions by salary deduction equal to 15 percent
      or
      less of their salary pursuant to section 401(k) of the Internal Revenue Code.
      Employee contributions are matched up to 25 percent of the employee’s
      contribution. Employees vest immediately in their own contributions and they
      vest in the Company’s contribution based on years of service. Expenses of the
      savings plan were approximately $109, $93, and $74, for the years ended December
      31, 2005, 2004, and 2003, respectively.




**Employee
      Stock Ownership Plan**




The
      Company sponsors an employee stock ownership plan (ESOP) that covers all
      employees who have completed 12 consecutive months of service, are over 21
      years
      of age and work a minimum of 1,000 hours per year. The amount of the annual
      contribution to the ESOP is at the discretion of the Board of Directors. The
      contributions made to this plan were approximately $216 in 2005, $206 in 2004,
      and $162 in 2003.




**Note
      #14 - Equity Compensation Plans**




At
      December 31, 2005, the Company had two stock option plans, which are described
      below.





The
      Company adopted the Company’s 1990 stock option plan, which is a tandem stock
      option plan permitting options to be granted either as “Incentive Stock Options”
or as “Non-Qualified Stock Options” under the Internal Revenue Code. All
      outstanding options were granted at prices which equal the fair market value
      on
      the day of grant. Options granted vest at a rate of 25 percent per year for
      four
      years and expire no later than ten years from the date of grant. The plan
      provided for issuance of up to 350,075 shares of the Company’s un-issued common
      stock and is subject to the specific approval of the Board of Directors. The
      Company’s 1990 stock option plan expired in July 2000.





No
      options were granted during 2005, 2004, or 2003.





66


**HERITAGE
                  OAKS BANCORP AND SUBSIDIARIES**
                **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
                **DECEMBER
                  31, 2005, 2004, AND 2003**
                **(Dollars
                  in thousands, except per share
                  amounts)**


**Note
      #14 - Equity Compensation Plans, Continued**







The
      following tables summarize information about the 1990 stock option plan
      outstanding at December 31, 2005.





2005
            
            2004
            
            2003Weighted-
            
            
            
            Weighted-
            
            
            
            Weighted-Average
            
            
            
            Average
            
            
            
            AverageExercise
            
            
            
            Exercise
            
            
            
            ExerciseShares
            
            Price
            
            Shares
            
            Price
            
            Shares
            
            PriceOutstanding
                at beginning of year
            
            
            3,136
            
            $
            2.55
            
            
            3,530
            
            $
            2.55
            
            
            3,530
            
            $
            2.55GrantedCancelled
            
            
            –
            
            $
            –
            
            
            –
            
            $
            –
            
            
            –
            
            $
            –Exercised
            
            
            –
            
            $
            –
            
            
            (394
            )
            $
            2.55
            
            
            –
            
            $
            –Outstanding
                at end of year
            
            
            3,136
            
            $
            2.55
            
            
            3,136
            
            $
            2.55
            
            
            3,530
            
            $
            2.55Options
                available for granting atend
                of year
            
            
            –
            
            
            
            
            
            –
            
            
            
            
            
            –Options
                exercisable at year-end
            
            
            3,136
            
            $
            2.55
            
            
            3,136
            
            $
            2.55
            
            
            3,530
            
            $
            2.55Weighted-average
                fair value ofoptions
                granted during the year
            
            
            –
            
            
            
            
            
            –
            
            
            
            
            
            –





Options
                Outstanding
            
            Options
                ExercisableWeighted-
            
            Weighted-
            
            
            
            Weighted-Average
            
            Average
            
            
            
            AverageExercise
            
            Number
            
            Remaining
            
            Exercise
            
            Number
            
            ExercisePrice
            
            Outstanding
            
            Contractual
                Life
            
            Price
            
            Exercisable
            
            Price$
            2.55
            
            
            3,136
            
            
            1.58
            
            $
            2.55
            
            
            3,136
            
            $
            2.55




The
      Company adopted the Company’s 1997 stock option plan, which is a tandem stock
      option plan permitting options to be granted either as “Incentive Stock Options”
or as “Non-Qualified Stock Options” under the Internal Revenue Code. All
      outstanding options were granted at prices which equal the fair market value
      on
      the day of the grant. Options granted vest at a rate of 20 percent per year
      for
      five years, and expire no later than ten years from the date of grant. The
      plan
      provides for issuance of up to 427,531 shares of the Company’s unissued common
      stock and is subject to the specific approval of the Board of
      Directors.





During
      1999, the Board of Directors approved an amendment to the 1997 Stock Option
      Plan. Under this amendment, the plan provides for issuance of up to 241,288
      additional shares of the Company’s common stock. Upon approval by stockholders
      of the 2005 Equity Based Compensation Plan at the May 26, 2005 shareholder
      meeting, no further grants would be made from the 1997 Stock Option Plan.





The
      fair
      value of each option granted was estimated on the date of grant using the
      Black-Scholes option pricing model with the following assumptions for 2005,
      2004, and 2003, respectively: risk-free rates of 4.11 percent, 4.22 percent,
      and
      4.58 percent, dividend yields of 0 percent for all years presented, expected
      life of 7.5 years in 2005 and 10 years for 2004 and 2003; and volatility of
      24
      percent for all years presented.





67


**HERITAGE
                    OAKS BANCORP AND SUBSIDIARIES**
                  **NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS**
                  **DECEMBER
                    31, 2005, 2004, AND 2003**
                  **(Dollars
                    in thousands, except per share
                    amounts)**


**Note
      #14 - Equity Compensation Plans, Continued**




The
      following summarizes information about the 1997 stock option plan outstanding
      at
      December 31, 2005.





2005
            
            2004
            
            2003Weighted-
            
            
            
            Weighted-
            
            
            
            Weighted-Average
            
            
            
            Average
            
            
            
            AverageExercise
            
            
            
            Exercise
            
            
            
            ExerciseShares
            
            Price
            
            Shares
            
            Price
            
            Shares
            
            PriceOutstanding
                at beginning of year
            
            
            738,180
            
            $
            4.51
            
            
            740,255
            
            $
            3.89
            
            
            668,026
            
            $
            3.33Granted
            
            
            11,250
            
            $
            13.84
            
            
            87,058
            
            $
            10.83
            
            
            211,751
            
            $
            5.30Cancelled
            
            
            (7,079
            )
            $
            10.81
            
            
            (36,567
            )
            $
            8.15
            
            
            (19,673
            )
            $
            4.57Exercised
            
            
            (219,795
            )
            $
            3.13
            
            
            (52,566
            )
            $
            3.76
            
            
            (119,849
            )
            $
            3.16Outstanding
                at end of year
            
            
            522,556
            
            $
            5.20
            
            
            738,180
            
            $
            4.51
            
            
            740,255
            
            $
            3.89Options
                available for grant end of year
            
            
            –
            
            
            
            
            
            61,686
            
            
            
            
            
            112,177Options
                exercisable at year-end
            
            
            429,023
            
            $
            4.07
            
            
            618,777
            
            $
            3.57
            
            
            617,257
            
            $
            3.47Weighted-average
                fair value ofoptions
                granted during the year
            
            $
            5.24
            
            
            
            
            $
            4.89
            
            
            
            
            $
            3.92





Options
                Outstanding
            
            Options
                ExercisableWeighted-
            
            Weighted-
            
            
            
            Weighted-Average
            
            Average
            
            
            
            AverageExercise
            
            Number
            
            Remaining
            
            Exercise
            
            Number
            
            ExercisePrice
            
            Outstanding
            
            Contractual
                Life
            
            Price
            
            Exercisable
            
            Price$
                2.55-$ 5.74
            
            
            390,833
            
            3.37
                Years
            
            $
            3.64
            
            
            388,857
            
            $
            3.63$
                5.80-$10.27
            
            
            41,892
            
            6.60
                Years
            
            $
            6.91
            
            
            24,774
            
            $
            6.67$10.79-$13.84
            
            
            89,831
            
            8.36
                Years
            
            $
            11.22
            
            
            15,392
            
            $
            10.85522,556
            
            
            
            
            
            
            
            
            429,023




On
      May
      26, 2005, the stockholders of the Company approved the 2005 Equity Based
      Compensation Plan (the “2005 Plan”). Upon approval by stockholders, no further
      grants would be made from the 1997 Stock Option Plan. The 2005 Plan authorizes
      the granting of Incentive Stock Options, Non-Qualified Stock Options, Stock
      Appreciation Rights (“SARs”), Restricted Stock Awards, Restricted Stock Units
      and Performance Share Cash Only Awards. The 2005 Plan will provide for a maximum
      of ten percent (10%) of the Company’s issued and outstanding shares of common
      stock as of March 25, 2005 and adjusted on each anniversary thereafter to be
      ten
      percent (10%) of the then issued and outstanding number of shares. During 2005,
      3,750 shares of restricted stock were granted which vest at twenty percent
      (20%)
      per year for five years. All share amounts have been adjusted to reflect the
      3-for-2 stock split in December 2005. Compensation is based upon the fair market
      value for the stock on the grant date and is recognized evenly over the vesting
      period. Total expense recorded during 2005 was $3 and total expense for 2006
      will be $11 related to the restricted shares.




**Note
      #15 - Related Party Transactions**




The
      Bank
      has entered into loan and deposit transactions with certain directors and
      executive officers of the Bank and the Company. These loans were made and
      deposits were taken in the ordinary course of the Bank’s business and, in
      management’s opinion, were made at prevailing rates and terms.





68


**HERITAGE
                    OAKS BANCORP AND SUBSIDIARIES**
                  **NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS**
                  **DECEMBER
                    31, 2005, 2004, AND 2003**
                  **(Dollars
                    in thousands, except per share
                    amounts)**


**Note
      #15 - Related Party Transactions, Continued**




An
      analysis of loans to directors and executive officers is as
      follows:





2005
            
            2004Outstanding
                Balance, Beginning of Year
            
            $
            5,213
            
            $
            6,351Additional
                loans made
            
            
            10,181
            
            
            2,214Repayments
            
            
            (791
            )
            
            (3,352
            )Outstanding
                Balance, End of Year
            
            $
            14,603
            
            $
            5,213




Deposits
      from related parties held by the Bank at December 31, 2005 and 2004 amounted
      to
      approximately $3,619 and $3,280, respectively.




**Note
      #16 - Restriction on Transfers of Funds to Parent**




There
      are
      legal limitations on the ability of the Bank to provide funds to the Company.
      Dividends declared by the Bank may not exceed, in any calendar year, without
      approval of the California Department of Financial Institutions (DFI), its
      respective net income for the year and the retained net income for the preceding
      two years. Section 23A of the Federal Reserve Act restricts the Bank from
      extending credit to the Company and other affiliates amounting to more than
      20
      percent of its contributed capital and retained earnings.





**Note
      #17 - Fair Value of Financial Instruments**





The
      fair
      value of a financial instrument is the amount at which the asset or obligation
      could be exchanged in a current transaction between willing parties, other
      than
      a forced or liquidation sale. Fair value estimates are made at a specific point
      in time based on relevant market information and information about the financial
      instrument. These estimates do not reflect any premium or discount that could
      result from offering for sale at one time the entire holdings or a particular
      financial instrument. Because no market value exists for a significant portion
      of the financial instruments, fair value estimates are based on judgments
      regarding future expected loss experience, current economic conditions, risk
      characteristics of various financial instruments, and other factors. These
      estimates are subjective in nature, involve uncertainties and matters of
      judgment and, therefore, cannot be determined with precision. Changes in
      assumptions could significantly affect the estimates.





Fair
      value estimates are based on financial instruments both on and off the balance
      sheet without attempting to estimate the value of anticipated future business
      and the value of assets and liabilities that are not considered financial
      instruments. Additionally, tax consequences related to the realization of the
      unrealized gains and losses can have a potential effect on fair value estimates
      and have not been considered in many of the estimates.




69


**HERITAGE
                    OAKS BANCORP AND SUBSIDIARIES**
                  **NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS**
                  **DECEMBER
                    31, 2005, 2004, AND 2003**
                  **(Dollars
                    in thousands, except per share
                    amounts)**


**Note
      #17 - Fair Value of Financial Instruments, Continued**





The
      estimated fair value of financial instruments at December 31 is summarized
      as
      follows:





2005
            
            2004Carrying
            
            
            
            CarryingAmount
            
            Fair
                Value
            
            Amount
            
            Fair
                ValueAssetsCash
                and cash equivalents
            
            $
            44,559
            
            $
            44,559
            
            $
            21,867
            
            $
            21,867Interest-bearing
                deposits
            
            
            298
            
            
            298
            
            
            498
            
            
            498Investments
                and mortgage-backed securities
            
            
            44,402
            
            
            44,402
            
            
            57,394
            
            
            57,394FHLB
                stock
            
            
            1,885
            
            
            1,885
            
            
            1,809
            
            
            1,809Loans
                receivable, net
            
            
            366,516
            
            
            364,652
            
            
            338,211
            
            
            337,638Loans
                held for sale
            
            
            3,392
            
            
            3,392
            
            
            2,253
            
            
            2,253Accrued
                interest receivable
            
            
            1,977
            
            
            1,977
            
            
            1,654
            
            
            1,654LiabilitiesNoninterest-bearing
                deposits
            
            
            164,014
            
            
            164,014
            
            
            143,455
            
            
            143,455Interest-bearing
                deposits
            
            
            253,783
            
            
            253,958
            
            
            226,986
            
            
            227,039FHLB
                advances
            
            
            10,000
            
            
            10,071
            
            
            28,500
            
            
            28,950Securities
                sold under repurchase agreements
            
            
            3,847
            
            
            3,847
            
            
            766
            
            
            766Notes
                payable
            
            
            –
            
            
            –
            
            
            –
            
            
            –Junior
                Subordinated Debentures
            
            
            8,248
            
            
            8,248
            
            
            8,248
            
            
            8,248Accrued
                interest payable
            
            
            511
            
            
            511
            
            
            407
            
            
            407




Notional
            
            Cost
                to Cede
            
            Notional
            
            Cost
                to CedeAmount
            
            or
                Assume
            
            Amount
            
            or
                AssumeOff-Balance
                Sheet InstrumentsCommitments
                  to extend credit and
                standby
                  letters of credit
            
            $
            184,731
            
            $
            1,847
            
            $
            141,069
            
            $
            1,411




The
      following methods and assumptions were used by the Company in estimating fair
      value disclosures:





Cash
      and Cash Equivalents





The
      carrying amounts reported in the balance sheet for cash and cash equivalents
      approximate those assets' fair values due to the short-term nature of the
      assets.





Interest
      Bearing Deposits





Fair
      values for time deposits are estimated using a discounted cash flow analysis
      that applies interest rates currently being offered on certificates to a
      schedule of aggregated contractual maturities on such time
      deposits.





Investment
      and Mortgage-Backed Securities





Fair
      values are based upon quoted market prices, where available.





Loans
      and Loans Held for Sale





For
      variable-rate loans that re-price frequently and with no significant change
      in
      credit risk, fair values are based on carrying amounts. The fair values for
      other loans (for example, fixed rate commercial real estate and rental property
      mortgage loans and commercial and industrial loans) are estimated using
      discounted cash flow analysis, based on interest rates currently being offered
      for loans with similar terms to borrowers of similar credit quality.Loan
      fair
      value estimates include judgments regarding future expected loss experience
      and
      risk characteristics. The carrying amount of accrued interest receivable
      approximates its fair value.





70


**HERITAGE
                    OAKS BANCORP AND SUBSIDIARIES**
                  **NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS**
                  **DECEMBER
                    31, 2005, 2004, AND 2003**
                  **(Dollars
                    in thousands, except per share
                    amounts)**


**Note
      #17 - Fair Value of Financial Instruments, Continued**








Deposits





The
      fair
      values disclosed for demand deposits (for example, interest-bearing checking
      accounts and passbook accounts) are, by definition, equal to the amount payable
      on demand at the reporting date (that is, their carrying amounts). The fair
      values for certificates of deposit are estimated using a discounted cash flow
      calculation that applies interest rates currently being offered on certificates
      to a schedule of aggregated contractual maturities on such time deposits. The
      carrying amount of accrued interest payable approximates fair
      value.





FHLB
      Advances





The
      fair
      value disclosed for FHLB advances is determined by discounting contractual
      cash
      flows at current market interest rates for similar instruments.





Securities
      Sold Under Agreement to Repurchase




The
      carrying amounts reported in the balance sheets for securities sold under
      agreement to repurchase approximate those liabilities’ fair values due to the
      short-term nature of the liabilities.




Junior
      Subordinated Debentures





The
      fair
      value disclosed for junior subordinated debentures is based on carrying amounts.
      The debentures are variable-rated notes that re-price frequently.





Off-balance
      Sheet Instruments





Fair
      values of commitments to extend credit and standby letters of credit are based
      upon fees currently charged to enter into similar agreements, taking into
      account the remaining terms of the agreement and the counterparties' credit
      standing.





71


**HERITAGE
                    OAKS BANCORP AND SUBSIDIARIES**
                  **NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS**
                  **DECEMBER
                    31, 2005, 2004, AND 2003**
                  **(Dollars
                    in thousands, except per share
                    amounts)**


**Note
      #18 - Earnings Per Share (EPS)**





The
      following is a reconciliation of net income and shares outstanding to the income
      and number of shares used to compute EPS. Share information has been
      retroactively adjusted for the stock dividend as discussed in Note
      #20.





2005
            
            2004
            
            2003Net
            
            
            
            Net
            
            
            
            NetIncome
            
            Shares
            
            Income
            
            Shares
            
            Income
            
            SharesNet
                income as reported
            
            $
            6,637
            
            
            
            
            $
            4,584
            
            
            
            
            $
            3,596Shares
                outstanding at year-end
            
            
            
            
            
            6,231,982
            
            
            
            
            
            6,013,260
            
            
            
            
            
            5,960,301Impact
                of weighting sharespurchased
                during the year
            
            
            
            
            
            (64,045
            )
            
            
            
            
            (22,762
            )
            
            
            
            
            (860,238
            )Used
                in Basic EPS
            
            
            6,637
            
            
            6,167,937
            
            
            4,584
            
            
            5,990,498
            
            
            3,596
            
            
            5,100,063Dilutive
                effect of outstandingstock
                options
            
            
            
            
            
            383,452
            
            
            
            
            
            444,270
            
            
            
            
            
            332,919Used
                in Dilutive EPS
            
            $
            6,637
            
            
            6,551,389
            
            $
            4,584
            
            
            6,434,768
            
            $
            3,596
            
            
            5,432,981





**Note
      #19 - Other Income/Expense**





The
      following is a breakdown of fees and other income and expenses for the years
      ended December 31, 2005, 2004, and 2003:





2005
            
            2004
            
            2003Fees
                and Other IncomeATM/Debit
                Card Transaction/Interchange Fees
            
            $
            629
            
            $
            583
            
            $
            406Bankcard
                merchant fees
            
            
            160
            
            
            116
            
            
            100Mortgage
                origination fees
            
            
            897
            
            
            602
            
            
            880Earnings
                on cash surrender value oflife
                insurance policies
            
            
            323
            
            
            294
            
            
            264Other
            
            
            482
            
            
            446
            
            
            364$
            2,491
            
            $
            2,041
            
            $
            2,014Other
                ExpensesData
                processing
            
            $
            2,200
            
            $
            2,570
            
            $
            1,581Advertising
                and promotional
            
            
            582
            
            
            515
            
            
            361Regulatory
                fees
            
            
            106
            
            
            114
            
            
            86Other
                professional fees and outside services
            
            
            802
            
            
            530
            
            
            432Legal
                fees and other litigation expenses
            
            
            122
            
            
            76
            
            
            52Loan
                department costs
            
            
            182
            
            
            181
            
            
            255Stationery
                and supplies
            
            
            311
            
            
            374
            
            
            249Director
                fees
            
            
            247
            
            
            179
            
            
            152Core
                deposit amortization
            
            
            573
            
            
            421
            
            
            41Other
            
            
            1,356
            
            
            1,212
            
            
            961Total
            
            $
            6,481
            
            $
            6,172
            
            $
            4,170





72


**HERITAGE
                    OAKS BANCORP AND SUBSIDIARIES**
                  **NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS**
                  **DECEMBER
                    31, 2005, 2004, AND 2003**
                  **(Dollars
                    in thousands, except per share
                    amounts)**


**Note
      #20 - Stock Dividends and Stock Splits**




On
      March
      7, 2003, the Board of Directors declared a five percent stock dividend payable
      on March 28, 2003 to stockholders of record on March 14, 2003. Cash was paid
      in
      lieu of fractional shares at the rate of $11.50 per share and amounted to
      $4.





On
      March
      26, 2004, the Board of Directors declared a five percent stock dividend payable
      on April 23, 2004 to stockholders of record on April 9, 2004. Cash was paid
      in
      lieu of fractional shares at the rate of $17.00 per share and amounted to
      $6.





On
      March
      25, 2005, the Board of Directors declared a five percent stock dividend payable
      on April 22, 2005 to stockholders of record on April 8, 2005. Cash was paid
      in
      lieu of fractional shares at the rate of $20.15 per share and amounted to
      $8.





On
      October 21, 2005, the Board of Directors declared a 3-for-2 stock split payable
      on December 2, 2005 to stockholders of record on November 10, 2005. Cash was
      paid in lieu of fractional shares at the rate of $18.86 per share and amounted
      to $5.





All
      references in financial statements and notes to financial statements to number
      of shares, per share amounts, and market prices of the Company’s common stock
      have been restated to reflect the increased number of shares
      outstanding.





**Note
      #21 - Acquisition of Assets and Liabilities**





On
      October 31, 2003, the Company acquired of 100 percent of the outstanding common
      shares of Hacienda Bank. The results of Hacienda Bank’s operations have been
      included in the consolidated financial statements since that date. Hacienda
      Bank
      is a community bank that offers a full range of commercial banking services
      and
      operates three branches in Santa Maria, California. As a result of the
      acquisition, the combined organization is expected to be able to offer customers
      a broader array of services and products.




The
      aggregate purchase price was $11,301, including $2,603 of cash and common stock
      valued at $8,698. The value of the 602,485 common shares issued was determined
      by multiplying the number of outstanding common shares of Hacienda Bank by
      75%
      and the conversion ratio of .5208. The result of this calculation was added
      to
      the fair value of the outstanding stock options issued in connection with the
      acquisition.





73


**HERITAGE
                    OAKS BANCORP AND SUBSIDIARIES**
                  **NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS**
                  **DECEMBER
                    31, 2005, 2004, AND 2003**
                  **(Dollars
                    in thousands, except per share
                    amounts)**


**Note
      #21 - Acquisition of Assets and Liabilities, Continued**





The
      following table summarizes the estimated fair values of the assets acquired
      and
      liabilities assumed at the date of acquisition based upon third-party valuations
      of certain intangible assets:





At
                October 31,2003Cash
                and cash equivalents
            
            $
            22,703Interest-bearing
                deposits in other financial institutions
            
            
            100Investments
                and FHLB stock
            
            
            2,374Loans
            
            
            51,878Premises
                and equipment
            
            
            2,834Intangible
                assets
            
            
            2,124Goodwill
            
            
            4,905Other
                assets
            
            
            901Total
                Assets Acquired
            
            
            87,819Noninterest-bearing
                deposits
            
            
            (17,456
            )Interest-bearing
                deposits
            
            
            (61,017
            )Other
                liabilities
            
            
            (644
            )Net
                Assets Acquired
            
            $
            8,702




The
      $2,124 of acquired intangible assets was assigned to core deposit intangibles
      that are subject to amortization and has an estimated average useful life of
      six
      years.





During
      2004, the Company reduced the recorded goodwill by approximately $40 for the
      settlement of a contingent liability and the payment of additional merger
      expenses.





The
      following un-audited pro forma combined results of operations assumes that
      the
      acquisition occurred on January 1, 2002:





For
                the Year EndedDecember
                31,2003
            
            2002Revenues
            
            $
            26,563
            
            $
            24,907Net
                Income
            
            
            2,925
            
            
            3,550Earnings
                per Common ShareBasic
            
            $
            1.01
            
            $
            1.05Diluted
            
            $
            0.95
            
            $
            0.98





These
      pro
      forma amounts are based upon certain assumptions and estimates which the Company
      believes are reasonable. The pro forma consolidated results of operations do
      not
      purport to be indicative of the results which would actually have been obtained
      had the acquisition occurred on the dates indicated or which may be obtained
      in
      the future.





On
      June
      28, 2004, Hacienda Bank merged with and into the Bank.




74


**HERITAGE
                    OAKS BANCORP AND SUBSIDIARIES**
                  **NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS**
                  **DECEMBER
                    31, 2005, 2004, AND 2003**
                  **(Dollars
                    in thousands, except per share
                    amounts)**
  **Note
          #22 - Condensed Financial Information of Heritage Oaks Bancorp (Parent
          Company)**





**Balance
                Sheets**2005
            
            2004**Assets**Cash
            
            $
            487
            
            $
            293Federal
                funds sold
            
            
            2,150
            
            
            775Total cash and cash equivalents
            
            
            2,637
            
            
            1,068Prepaid
                and other assets
            
            
            443
            
            
            387Property
                and premises
            
            
            –
            
            
            625Investment
                in subsidiaries
            
            
            50,428
            
            
            43,533Total
                Assets
            
            $
            53,508
            
            $
            45,613**Liabilities
                and Stockholders' Equity**Notes
                payable
            
            $
            –
            
            $
            –Junior
                subordinated debentures
            
            
            8,248
            
            
            8,248Other
                liabilities
            
            
            415
            
            
            115Total
                Liabilities
            
            
            8,663
            
            
            8,363Stockholders'
                EquityCommon
                stock
            
            
            29,255
            
            
            24,050Retained
                earnings
            
            
            15,590
            
            
            13,200Total
                Stockholders' Equity
            
            
            44,845
            
            
            37,250Total
                Liabilities andStockholders'
                Equity
            
            $
            53,508
            
            $
            45,613




75


**HERITAGE
                    OAKS BANCORP AND SUBSIDIARIES**
                  **NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS**
                  **DECEMBER
                    31, 2005, 2004, AND 2003**
                  **(Dollars
                    in thousands, except per share
                    amounts)**


**Note
      #22 - Condensed Financial Information of Heritage Oaks Bancorp (Parent Company),** **Continued**





**Statements
                of Income**2005
            
            2004
            
            2003**Income**Equity
                in undisbursed income of subsidiaries
            
            $
            7,201
            
            $
            5,039
            
            $
            3,943Interest
                income
            
            
            65
            
            
            21
            
            
            21Other
            
            
            31
            
            
            57
            
            
            57Total
                Income
            
            
            7,297
            
            
            5,117
            
            
            4,021**Expense**Salary
                expense
            
            
            85
            
            
            75
            
            
            77Equipment
                expense
            
            
            (10
            )
            
            15
            
            
            15Other
                professional fees and outside services
            
            
            268
            
            
            130
            
            
            56Interest
                expense
            
            
            583
            
            
            517
            
            
            449Other
            
            
            126
            
            
            112
            
            
            69Total
                Expense
            
            
            1,052
            
            
            849
            
            
            666Total
                Operating Income
            
            
            6,245
            
            
            4,268
            
            
            3,355Income
                tax benefit
            
            
            (392
            )
            
            (316
            )
            
            (241
            )Net
                Income
            
            $
            6,637
            
            $
            4,584
            
            $
            3,596





76




**HERITAGE
                    OAKS BANCORP AND SUBSIDIARIES**
                  **NOTES
                    TO CONSOLIDATED FINANCIAL STATEMENTS**
                  **DECEMBER
                    31, 2005, 2004, AND 2003**
                  **(Dollars
                    in thousands, except per share
                    amounts)**
 Note
      #22
      - Condensed Financial Information of Heritage Oaks Bancorp (Parent Company),
      Continued


**Statements
                of Cash Flows**2005
            
            2004
            
            2003**Cash
                Flows From Operating Activities**Net
                income
            
            $
            6,637
            
            $
            4,584
            
            $
            3,596Adjustments
                to Reconcile Net Income to Net CashProvided
                By/(Used in) Operating ActivitiesDepreciation
            
            
            8
            
            
            15
            
            
            15Increase
                in other assets
            
            
            (56
            )
            
            229
            
            
            129Increase
                in other liabilities
            
            
            18
            
            
            10
            
            
            18Undistributed
                income of subsidiaries
            
            
            (7,201
            )
            
            (5,039
            )
            
            (3,943
            )Net
                Cash Used In Operating Activities
            
            
            (594
            )
            
            (201
            )
            
            (185
            )**Cash
                Flows From Investing Activities**Net
                Proceeds from sale of fixed assets
            
            
            900
            
            
            –
            
            
            –Contribution
                to subsidiaries
            
            
            –
            
            
            –
            
            
            (3,960
            )Net
                Cash Provided By/(Used In) Investing Activities
            
            
            900
            
            
            –
            
            
            (3,960
            )**Cash
                Flows From Financing Activities**Cash
                dividends received
            
            
            –
            
            
            3,500
            
            
            –Cash
                paid in lieu of fractional shares
            
            
            (12
            )
            
            (6
            )
            
            (4
            )Increase/(decrease)
                in notes payable
            
            
            –
            
            
            (3,500
            )
            
            3,500Proceeds
                from the sale of stock
            
            
            –
            
            
            –
            
            
            67Proceeds
                from the exercise of options
            
            
            1,275
            
            
            335
            
            
            379Net
                Cash Provided ByFinancing
                Activities
            
            
            1,263
            
            
            329
            
            
            3,942**Net
                Increase/(Decrease) in Cash****and
                Cash Equivalents**
            
            
            1,569
            
            
            128
            
            
            (203
            )**Cash
                and Cash Equivalents**,
                Beginning of Year
            
            
            1,068
            
            
            940
            
            
            1,143**Cash
                and Cash Equivalents**,
                End of Year
            
            $
            2,637
            
            $
            1,068
            
            $
            940




**ITEM
      9.**  **CHANGES
      WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.**




None.





**ITEM
      9A. CONTROLS AND PROCEDURES.**





Within
      90
      days prior to the date of this report, the Company carried out an evaluation,
      under the supervision and with the participation of its management, including
      the Company’s Chief Executive Officer and Chief Financial Officer, of the
      effectiveness of the design and operation of the Company’s disclosure controls
      and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation,
      the Chief Executive Officer and Chief Financial Officer concluded that the
      Company’s disclosure controls and procedures are effective.





During
      the quarter ended December 31, 2005, there have been no changes in our internal
      controls over financial reporting that has materially affected, or are
      reasonably likely to materially affect, these controls.




**ITEM
        9B. OTHER INFORMATION.**
 
 None.


77




**PART
      III**





**ITEM
      10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.**





**Code
      of Ethics**





We
      have
      adopted a Code of Conduct, which applies to all employees, officers and
      directors of the Company and Bank. Our Code of Conduct meets the requirements
      of
      a “code of ethics” as defined by Item 406 of Regulation S-K and applies to our
      Chief Executive Officer, Chief Financial Officer and Chief Accounting Officer,
      as well as all other employees, as indicated above. Our Code of Conduct is
      posted on our website at *www.heritageoaksbancorp.com* ** under
      the
      heading “Investor Relations - Governance Documents.” Any change to or waiver of
      the code of conduct (other than technical, administrative and other
      non-substantive changes) will be posted on the Company’s website or reported on
      a Form 8-K filed with the Securities and Exchange Commission. While the Board
      may consider a waiver for an executive officer or director, the Board does
      not
      expect to grant such waivers.





The
      balance of the information required by Item 10 of Form 10-K is incorporated
      by
      reference from the information contained in the Company’s Proxy Statement for
      the 2006 Annual Meeting of Shareholders which will be filed pursuant to
      Regulation 14-A





**ITEM
      11. EXECUTIVE COMPENSATION.**





The
      information required by Item 11 of Form 10-K is incorporated by reference from
      the information contained in the Company’s Proxy Statement for the 2006 Annual
      Meeting of Shareholders which will be filed pursuant to Regulation
      14-A.





**ITEM
      12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS.**





The
      information required by Item 12 of Form 10-K is incorporated by reference from
      the information contained in the Company’s Proxy Statement for the 2006 Annual
      Meeting of Shareholders which will be filed pursuant to Regulation
      14-A.





**ITEM
      13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.**





The
      information required by Item 13 of Form 10-K is incorporated by reference from
      the information contained in the Company’s Proxy Statement for the 2006 Annual
      Meeting of Shareholders which will be filed pursuant to Regulation
      14-A.





**ITEM
      14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.**





The
      information required by Item 14 of Form 10-K is incorporated by reference from
      the information contained in the Company’s Proxy Statement for the 2006 Annual
      Meeting of Shareholders which will be filed pursuant to Regulation
      14-A.




78




**PART
      IV**





**ITEM
      15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.**





(b)
      Exhibits:





(2.1a)
            Branch
                Purchase and Assumption Agreement and Real Property Purchase Agreement
                entered into between Westamerica Bank and Heritage Oaks Bank, dated
                July
                16, 2001 filed with the SEC in the Company’s 10-QSB for the period ending
                June 30, 2001.(2.1b)
            Agreement
                to Merge and Plan of Reorganization, dated June 11, 2003, filed with
                the
                SEC in the Company’s 8-K of June 12, 2003.(3.1a)
            Articles
                of Incorporation incorporated by reference from Exhibit 3.1a to
                Registration Statement on Form S-4 No. 33-77504 filed with the SEC
                on
                April, 1994.(3.1b)
            Amendment
                to the Articles of Incorporation filed with the Secretary of State
                on
                October 16, 1997 filed with the SEC in the Company’s 10-KSB for the year
                ending December 31, 1997.(3.2)
            The
                Company Bylaws as amended November 16, 2000 filed with the SEC in
                the
                Company’s 10-KSB for the year ended December 31, 2000.(4.1)
            Specimen
                form of The Company stock certificate incorporated by reference from
                Exhibit 4.1 to Registration Statement on Form S-4 No. 33-77504 filed
                with
                the SEC on April 8, 1994.(10.1)
            1990
                Stock Option Plan incorporated by reference from Exhibit 10.2 to
                Registration Statement on Form S-4 No. 33-77504, filed with the SEC
                on
                April 8, 1994.(10.2)
            Form
                of Stock Option Agreement incorporated by reference from Exhibit
                4.2 to
                Registration Statement on Form S-4 No. 33-77504, filed with the SEC
                on
                April 8, 1994.(10.3)
            Lawrence
                P. Ward Employment Letter Agreement, dated February 28, 2002,filed
                with the SEC in the Company’s 10-KSB Report for the year ended December
                31, 2001.(10.4)
            401(k)
                Pension and Profit Sharing Plan filed with the SEC in the Company’s 10K
                Report for the year ended December 31, 1994.(10.5)
            The
                Company 1995 Bonus Plan, filed with the SEC in the Company’s 10K Report
                for the year ended December 31, 1994.(10.6)
            Salary
                Continuation Agreement with Lawrence P. Ward, filed with the SEC
                in the
                Company’s 10-QSB Report for the quarter ended March 31,
                2001.(10.7)
            Salary
                Continuation Agreement with Gwen R. Pelfrey, filed with the SEC in
                the
                Company’s 10K Report for the year ended December 31,
                1994.(10.8)
            Woodland
                Shopping Center Lease, filed with the SEC in the Company’s 10K Report for
                the year ended December 31, 1994.




79




(10.9)
            1135
                Santa Rosa Street Lease, filed with the SEC in the Company’s 10KSB Report
                for the year ended December 31, 1995.(10.10)
            Lease
                Agreement for Cambria Branch Office dated February 21, 1997 filed
                with the
                SEC in the Company’s 10KSB reported for the year ended December
                31,1996.(10.11)
            1997
                Stock Option Plan incorporated by reference from Exhibit 4a to
                Registration Statement on Form S-8 No.333-31105 filed with the SEC
                on July
                11, 1997 as amended, incorporated by reference, from Registration
                Statement on Form S-8, File No. 333-83235 filed with the SEC on July
                20,
                1999.(10.12)
            Form
                of Stock Option Agreement incorporated by reference from Exhibit
                4b to
                Registration Statement on Form S-8 No. 333-31105 filed with the SEC
                on
                July 11, 1997.(10.13)
            Madonna
                Road Lease filed with the SEC in the Company’s 10KSB for the year ended
                December 31, 1997.(10.14)
            Santa
                Maria lease commencing November 1, 1998 filed with the SEC in the
                Company’s 10-KSB for the year ended December 31, 1998.(10.15)
            Master
                data processing agreement with Mid West payment Systems, Inc. commencing
                October 1, 1998 filed with the SEC in the Company’s 10-KSB for the year
                ended December 31, 1998.(10.16)
            Salary
                Continuation Agreement with Margaret A. Torres, filed with the SEC
                in the
                Company’s 10KSB Report for the year ended December 31,
                1999.(10.17)
            Salary
                Continuation Agreement with Paul Tognazzini, filed with the SEC in
                the
                Company’s 10-KSB Report for the year ended December 31,
                2001.(10.18)
            Atascadero
                Branch Lease entered into on March 31, 1999. filed with the SEC in
                the
                Company’s 10-KSB reported for the year ended December
                31,1999.(10.19)
            Service
                Bureau Processing Agreement entered into between Alltel Information
                Services, Inc. and Heritage Oaks Bank, dated August 1, 1999. Filed
                with
                the SEC in the Company’s 10-KSB reported for the year ended December 31,
                1999.(10.20)
            ASSET
                PURCHASE AGREEMENT entered into between Travelex America, Inc. and
                Heritage Oaks Bank, dated November 21 , 2000 filed with the SEC in
                the
                Company’s 10-KSB reported for the year ended December 31,
                2000.(10.21)
            Change
                in Terms Agreement and Business Loan Agreement entered into between
                the
                Company and Pacific Coast Banker’s Bank on November 8, 2000, filed with
                the SEC in the Company’s 10-KSB reported for the year ended December 31,
                2001.




80




(10.22)
            Executive
                Salary Continuation Agreement dated February 1, 2002 between Heritage
                Oaks
                Bank and Margaret A. Torres, filed with the SEC in the Company’s 10-QSB
                reported for March 31, 2002.(10.23)
            Executive
                Salary Continuation Agreement dated February 1, 2002 between Heritage
                Oaks
                Bank and Paul Tognazzini, filed with the SEC in the Company’s 10-QSB
                reported for March 31, 2002.(10.24)
            Executive
                Salary Continuation Agreement dated February 1, 2002 between Heritage
                Oaks
                Bank and Gwen R. Pelfrey, filed with the SEC in the Company’s 10-QSB
                reported for March 31, 2002.(10.25)
            Executive
                Salary Continuation Agreement dated February 1, 2002 between Heritage
                Oaks
                Bank and Gloria Brady, filed with the SEC in the Company’s 10-QSB reported
                for March 31, 2002.(10.26)
            Executive
                Salary Continuation Agreement dated February 1, 2002 between Heritage
                Oaks
                Bank and Joe Carnevali, filed with the SEC in the Company’s 10-QSB
                reported for March 31, 2002.(10.27)
            Executive
                Salary Continuation Agreement dated February 1, 2002 between Heritage
                Oaks
                Bank and Donna Breuer, filed with the SEC in the Company’s 10-QSB reported
                for March 31, 2002.(10.28)
            Executive
                Salary Continuation Agreement dated February 1, 2002 between Heritage
                Oaks
                Bank and Chris Sands, filed with the SEC in the Company’s 10-QSB reported
                for March 31, 2002.(10.29)
            Money
                Access Services Processing Agreement for ATM processing, signed on
                October
                3, 2002, filed with the SEC in the Company’s 10QSB reported for September
                30, 2002.(10.30)
            The
                Company Employee Stock Ownership Plan, Summary Plan Description,
                filed
                with the SEC in the Company’s 10-KSB reported for December 31,
                2002.(10.31)
            The
                Company Employee Stock Ownership Plan, Summary of Material Modifications
                to the Summary Plan Description dated July 2002, filed with the SEC
                in the
                Company’s 10-KSB reported for December 31, 2002.(10.32)
            A
                Construction Agreement dated February 12, 2003 between Heritage Oaks
                Bank
                and HBE financial Facilities, a Division of HBE Corporation, filed
                with
                the SEC in the Company’s 10-QSB for March 31, 2003.(10.33)
            Executive
                Salary Continuation Agreement dated July 1, 2003 between Heritage
                Oaks
                Bank and Mark Stasinis, filed with the SEC in the Company’s 10-QSB
                reported for June 30, 2003.(10.34)
            Executive
                Salary Continuation Agreement dated July 1, 2003 between Heritage
                Oaks
                Bank and Kelley Stolz, filed with the SEC in the Company’s 10-QSB reported
                for June 30, 2003.(10.35)
            Executive
                Salary Continuation Agreement dated July 1, 2003 between Heritage
                Oaks
                Bank and Paul Deline, filed with the SEC in the Company’s 10-QSB reported
                for June 30, 2003.




81




(10.36)
            Executive
                Salary Continuation Agreement dated July 1, 2003 between Heritage
                Oaks
                Bank and Mitch Massey, filed with the SEC in the Company’s 10-QSB reported
                for June 30, 2003.(10.37)
            Employment
                Agreement with David Duarte, President and Chief Operating Officer
                of
                Hacienda Bank, dated September 5, 2003 and filed with the SEC in
                the
                Company’s 10-QSB reported for September 30, 2003.(10.38)
            Promissory
                Note executed on October 3, 2003 for $3.5 million with Pacific Coast
                Bankers Bank, filed with the SEC in the Company’s 10-QSB reported for
                September 30, 2003.(10.39)
            Employment
                Agreement with Lawrence P. Ward, President and Chief Executive Officer
                of
                Heritage Oaks Bank, dated February 1, 2004 and filed with the SEC
                in the
                Company’s 10-KSB reported for December 31, 2003.(10.40)
            Executive
                Salary Continuation Agreement dated November 1, 2003 between Hacienda
                Bank
                and David Duarte, filed with the SEC in the Company’s 10-KSB reported for
                December 31, 2003.(10.41)
            Fifth
                Amendment to Service Bureau Processing Agreement dated June 19, 2004
                between Fidelity Information Services, Inc. and Heritage Oaks Bank,
                filed
                with the SEC in the Company’s 10QSB for June 30, 2004.(10.42)
            Atascadero
                Branch Lease entered into on July 15, 2005, filed with the SEC in
                the
                Company’s 10-Q for the quarter ended September 30, 2005(14)
            Code
                of Ethics, filed with the SEC in the Company’s 10-KSB for the year ended
                December 31, 2003.(21)
            Subsidiaries
                of the Company. Heritage Oaks Bank is the only financial subsidiaries
                of
                the Company.(23)
            Consent
                of Independent Registered Accounting Firm(31.1)
            Certification
                of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
                Act of 2002(31.2)
            Certification
                of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
                Act of 2002(32.1)
            Certification
                of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
                Act of 2002(32.2)
            Certification
                of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
                Act of 2002




82





SIGNATURES





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




THE
      COMPANY


/s/ Lawrence
              P. Ward
            
            
            /s/ Margaret
              A. TorresLAWRENCE
                P. WARDPresident
                  and Chief Executive OfficerDated:
                    March 1, 2006
            
            
            MARGARET
                A. TORRES
              Executive
                  Vice President and Chief Financial Officer
                Dated:
                    March 1, 2006




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 and on the dates
                indicated.





/s/
                B.R. Bryant
            
            Chairman
                of the Board
            March
                1, 2006B.R.
                BRYANT/s/
                Donald H. Campbell
            
            Vice
                Chairman
            March
                1, 2006DONALD
                H. CAMPBELL
            
            of
                the Board of Directors/s/
                Kenneth Dewar
            
            Director
            March
                1, 2006KENNETH
                DEWAR/s/
                Mark C. Fugate
            
            Director
            March
                1, 2006MARK
                C. FUGATE/s/
                Dolores T. Lacey
            
            Director
            March
                1, 2006DOLORES
                T. LACEY/s/
                Merle F. Miller
            
            Director
            March
                1, 2006MERLE
                F. MILLER/s/
                Michael Morris
            
            Director
            March
                1, 2006MICHAEL
                MORRIS/s/
                Daniel J. O’Hare
            
            Director
            March
                1, 2006DANIEL
                J. O’HARE/s/
                Alex Simas
            
            Director
            March
                1, 2006ALEX
                SIMAS/s/
                Ole K. Viborg
            
            Director
            March
                1, 2006OLE
                K. VIBORG/s/
                Lawrence P. Ward
            
            Director
            March
                1, 2006LAWRENCE
                P. WARD





83





EXHIBIT
      INDEX





Exhibit
              Sequential
              Number
            Description23
            Consent
                of Independent Accountants31.1
            Certification
                of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
                Act of 200231.2
            Certification
                of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
                Act of 200232.1
            Certification
                of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
                Act of 200232.2
            Certification
                of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
                Act of 2002




84