**SECURITIES
AND EXCHANGE COMMISSION**
 **WASHINGTON,
D.C. 20549**
 **FORM
10-KSB**
 
 |X|
 ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES
EXCHANGE ACT OF 1934 for the Year ended December
31, 2004
 
 OR
 
 |_| 
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 employee
      incorporation or organization)
    
    (I.R.S.
      Identification No.)545
      12th Street, Paso Robles, California 93446
    
    (805)
      239-5200(Address
      of principal executive offices) (Zip Code)
    
    Registrant’s
      telephone number,
      including area code
 Securities
registered pursuant to Section 12(b) of the Act: None
 
 Securities
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
      SmallCap
 Indicate
by check mark whether the registrant (1) has filed all reports required to be
riled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes | X| No |_|
 
 Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-B 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-KSB or any amendment to
this Form 10-KSB |X|.
 
 Indicate
by check mark whether the registrant is an accelerated filer (as defined in
Exchange Act Rule 12b-2).
 Yes
|_|  No |X|
 
 Registrant's
revenue for 2004 was $28.3 million. The aggregate market value of the voting
stock held by non-affiliates of the Registrant at February 1, 2005 was $60.9
million. As of February 1, 2005, the Registrant had 3,817,943 shares of Common
Stock outstanding.
 
 The
following documents are incorporated by reference in Part III: Items 9 through
12 and Item 14 of Registrant’s definitive proxy statement for the 2005 annual
meeting of shareholders.
 
 Transitional
Small Business Disclosure Format (check one) Yes
|_|  No |X|
 
  1
 
 **TABLE
OF CONTENTS**
 PART
      IItem
      1.
    Description
      of BusinessItem
      2.
    Description
      of PropertiesItem
      3.
    Legal
      ProceedingsItem
      4.
    Submission
      of Matters to a Vote of Security HoldersPART
      IIItem
      5.
    Market
      for Registrant’s Common Equity and Related Stockholder
    MattersItem
      6.
    Management’s
      Discussion and Analysis of Financial
      Condition and Results of OperationsItem
      7.
    Financial
      StatementsItem
      8A.
    Controls
      and ProceduresItem
      8B.
    Other
      InformationPART
      IIIItem
      9.
    Directors,
      Executive Officers, Promoters and Control Persons; Compliance With Section
      16(a) of the Exchange
      ActItem
      10.
    Executive
      CompensationItem
      11.
    Security
      Ownership of Certain Beneficial Owners and ManagementItem
      12.
    Certain
      Relationships and Related TransactionsItem
      13.
    Exhibits
      and Reports on Form 8-KItem
      14.
    Principal
      Accountant Fees and ServicesSignatures
 
 2
 PART
I
 
 **Certain
statements contained in this Annual Report on Form 10-KSB (“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 1.
Description of Business-Factors that May Affect Future Results of Operations”.
The Company disclaims any obligation to update any such factors or to publicly
announce the results of any revisions to any of the forward-looking statements
contained herein to reflect future events or developments.**
 
 ITEM 1.
DESCRIPTION OF BUSINESS
 
 Where You
Can Find More Information
 
 Under the
Securities Exchange Act of 1934 Sections 13 and 15(d), periodic and current
reports must be filed with the SEC. The Company electronically files the
following reports with the SEC: Form 10-KSB (Annual Report), Form 10-QSB
(Quarterly Report), Form 8-K (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-KSB.
 
 The
Company also posts its Committee Charters, Code of Ethics, Code of Conduct and
Corporate Governance Guidelines on the Company website.
 
 General
 
 Heritage
Oaks Bancorp (the "Company") 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.
 
 On
June 11, 2003, the Company entered into an Agreement to Merge and Plan of
Reorganization (the “Agreement”) with Hacienda Bank (“Hacienda”), as amended on
August 8, 2003, pursuant to which, among other things, (i) Heritage Oaks
Merger Corp would merge with and into Hacienda, and (ii) Hacienda would become a
wholly-owned subsidiary of the Company. In accordance with the terms of the
Agreement, as amended, the merger was completed on October 31, 2003. 
In connection with the Agreement and the merger, Messrs. Mark Fugate and Alex
Simas, previous members of Hacienda’s board of directors, were added to the
board of directors of the Company.
 
 On June
28, 2004, Hacienda Bank merged with and into the Bank.
 
 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.
 
 3
 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, 2004, the Company had approximately $448 million in consolidated
assets, $335 million in net consolidated loans, $370 million in consolidated
deposits, and $37.2 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, four 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 cashiers 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.
 
 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, 2004, these four categories accounted for approximately 14.6%,
1.7%, 19.7% and 64.0% respectively, of the Bank’s loan portfolio. As of December
31, 2004, $284.3 million or 83.7% of the Bank’s $339.7 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 $560 thousand or 1.14% and other real estate loans
or commercial loans secured by real estate increased $41.6 million or 23.7%
between year-end 2003 and year-end 2004. See “Item 6 - 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. The Bank has deposit relationships with three, long time customers that
engage in mortgage related business, however, these volatile account
relationships are included in the volatile liability dependency report that the
Bank produces on a monthly basis. These three deposit relationships had balances
of $50.3 million at December 31, 2004 compared to $52.8 million at December 31,
2003. Management and the Board of Directors of the Bank are keenly aware that as
the mortgage market conditions change, these relationships will be impacted. As
of December 31, 2004, the Bank had approximately 19,988 deposit accounts
consisting of non-interest bearing (demand), interest-bearing demand and money
market accounts with balances totaling $273.2 million for an average balance per
account of approximately $14 thousand; 3,917 savings accounts with balances
totaling $36.2 million for an average balance per account of approximately $9
thousand; and 2,005 time certificate of deposit accounts with balances totaling
$61 million, for an average balance per account of approximately $30 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, 2004, these sources
comprised 72.8%, 9.5%, 7.7%, 2.1% and 7.9%, 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.
 
 4
 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”:
 
 Developments
 
 On
September 24, 2004, the Company’s common stock was approved for listing on the
Nasdaq SmallCap Market. The Company commenced trading on Nasdaq SmallCap Market
on September 27, 2004 under the symbol “HEOP”.
 
 Facilities
Expansion
 
 On July
26, 2002, the Bank purchased a parcel of land (approximately 2 acres) on the
corner of Niblick and South River Roads in Paso Robles, Ca. The purchase price
was $900,000. In February 2003, Heritage entered into a Construction Agreement
with HBE Financials Facilities to construct a 5,000 square foot full service
branch. The “turn-key” price for the construction is $1.8 million. The Bank
relocated the existing “Woodland” branch office, that was located at 171 Niblick
Road, Paso Robles, Ca. The new facility opened on February 17, 2004.
 
 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 purchase price was $1.1 million. It is the Bank’s intention to
build a 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 late in the fourth quarter of
2005.
 
 Bank
Acquisition
 
 On
June 11, 2003, the Company entered into an Agreement with Hacienda, as
amended on August 8, 2003, pursuant to which, among other things, (i)
Heritage Oaks Merger Corp would merge with and into Hacienda, and (ii) Hacienda
would become a wholly-owned subsidiary of the Company. In accordance with the
terms of the Agreement, as amended, the merger was completed on October 31,
2003.
 
 The
shareholders of Hacienda who elected cash received cash for their shares based
on a value of $6.75 per share; those who elected stock received .5208
shares of the Company common stock for each share of Hacienda common stock, and
those that elected for a combination of the two received the appropriate
allocations of the elections made. The amount of cash and the Company common
stock was subject to certain allocation procedures designed to ensure that at
least 75% of the total consideration paid to holders of Hacienda common stock
was paid in Company common stock. Since elections were made for more than the
maximum stock amount, Hacienda shareholders who elected stock had a pro-rata
reduction in the amount of stock they received and received cash for the
difference. The amount of cash paid was approximately $2.6 million and there
were 602,485 shares of the Company’s common stock issued.
 
 In
connection with the Agreement and the merger, Messrs. Mark Fugate and Alex
Simas, previous directors of Hacienda’s board of directors, were added to the
board of directors of the Company.
 
 On June
28, 2004, Hacienda Bank was merged with and into the Bank.
 
 Earthquake
 
 On
December 22, 2003, a 6.5 magnitude earthquake rocked the California Central
Coast. The earthquake was centered in San Simeon, an area approximately 20 miles
west of Paso Robles where the Company is headquartered. There was the tragic
loss of two lives in Paso Robles. The greatest amount of property damage was
centered in downtown Paso Robles. The Company did not sustain any structural
damage to its facilities and there were no injuries to any employees or their
families. City officials reacted quickly and obtained disaster status from state
and federal agencies. Business’ in the downtown area experienced a moderate
decline in activity, however, the area has already begun to rebuild and things
are getting back to normal. Within days after the earthquake, the Company
performed an assessment as to any financial impact it could expect regarding
effect to customers and their ability to repay any outstanding debt. At that
time, the assessment revealed that there was no expected material impact to the
Company. There has been no change to this assessment.
 
 5
 Employees
 
 As of
February 1, 2005, the Bank had 170 full-time equivalent employees. The Company
has only two salaried employees (the internal auditor and assistant).
 
 The
Company believes that the work conditions, wages, and benefits it offers to its
employees are competitive with those offered by other employers in this area and
in this industry. If employees have concerns about work conditions or
compensation, they are strongly encouraged to voice these concerns openly and
directly to their supervisors.
 
 Our
experience has shown that when employees deal openly and directly with
supervisors, the work environment can be excellent, communications can be clear,
and attitudes can be positive. We believe that the Company amply demonstrates
its commitment to employees by responding effectively to any concerns. The Bank
conducts weekly “Staff Meetings” that include, but are not limited to, current
events within the Bank and community, training on products and services,
introduction of new employees and acknowledgement of staff members who have
performed in an exemplary manner.
 
 Our
intent is to have the most knowledgeable employees in our market
area.
 
 The
Company regularly updates and distributes its "Employee Handbook" that is
designed to acquaint employees with the Company and to provide information about
working conditions, employee benefits and the policies affecting their
employment. It describes many of the employee responsibilities and outlines
programs developed by the Company to benefit the employee. The main objective is
to provide a work environment that is conducive to both personal and
professional growth.
 
 The
Employee Handbook contains a section on “Reporting of Violations of Law” that
sets forth procedures for reporting Accounting/Auditing Irregularities. These
procedures provide a method for employees to confidentially and/or anonymously
report accounting, internal controls, and/or auditing problems within the
Company. A post office box in the name of the Audit Committee Chairman has been
established to submit any such concern.
 
 In 1999,
the Bank put into action a Corporate Culture Survey that allows employees to
respond anonymously to nearly 100 questions regarding communication, training,
management effectiveness and many other pertinent areas. This survey is
conducted annually during the fourth quarter. The results of the survey provide
Senior Management and the Board with information that assists in future
endeavors to address areas where there is an opportunity to improve. During the
past six years, the overall “rating” has shown measured improvement. Senior
Management and the Board of Directors consider this to be one of the most
important achievements for the Company.
 
 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. The population of San Luis Obispo County and the City of Santa
Maria (in Northern Santa Barbara County) totaled 258,200 and 85,000,
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. 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.
 
 The
Central Coast’s leading agricultural industry is the production of high quality
wine grapes and production of premium quality wines. Through the late 1990’s and
into the year 2000, production of new vineyard land led to an over capacity of
wine grapes. By the end of 2000, excess production of wine grapes led to a
decrease in the process of grapes sold and in some cases, the inability of
farmers to sell grapes at prices necessary to break even. Wineries, on the other
had, were able to purchase grapes at existing contract prices and in some cases,
below contract prices. In situation where wineries purchased grape inventories
at existing contract prices, wineries demanded that farmers thin crop level,
thereby producing a product of extremely high quality.
 
 6
 Over the
past two years, the number of premium wine producers in the Paso Robles
appellation has more than doubled. Paso Robles wines have continually achieved
high recognition for outstanding quality and in 2003 Forbes Magazine recognized
the area as the next “Napa Valley”.
 
 The Bank
recognized in 2000 that the farming end of the wine industry held the highest
level of risk and that the increased levels of grape production would negatively
impact commodity prices for the growers. At that time, the Bank strategically
moved its portfolio of vineyard development loans out of the Bank’s portfolio
and into the Farmer Mac government guaranteed program. As a result of this
strategy, the Bank now has a very small and manageable portfolio of vineyard
development loans amounting to approximately $1.2 million at December 31, 2004.
In the opinion of Management, another negative turn in the wine grape industry
is expected to have very little impact on the overall risk of the Bank’s loan
portfolio.
 
 Competition
  Banking
and 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
Company’s business is concentrated in its service area, which encompasses San
Luis Obispo County and Northern Santa Barbara County. 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, 2004, the Bank’s legal lending limits to a single borrower and such
borrower's related parties was approximately $7.0 million on an unsecured basis
and approximately $11.7 million on a fully secured basis. These calculations are
based on regulatory capital plus reserves of $46.7 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.
 
 7
 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”.
 
 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.
 
 8
 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.
 
 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.
 
 9
 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,
2004:
 
 Minimum
      Regulatory
    
    Heritage
    
    HeritageCapital
      Requirements
    
    Oaks
      Bancorp
    
    Oaks
      BankLeverage
      Ratio
    
    
    4.00
    %
    
    8.34
    %
    
    8.09
    %Tier
      I Risk Weighted
    
    
    4.00
    %
    
    9.78
    %
    
    9.29
    %Total
      Risk Based
    
    
    8.00
    %
    
    10.65
    %
    
    10.16
    %
  Under
applicable regulatory guidelines, the Bank was considered "Well Capitalized" at
December 31, 2004.
 
 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, 2004, the
subsidiary trust had $8 million in trust preferred securities outstanding, of
which $8 million qualify as Tier 1 capital. See “Factors That May Affect Future
Results of Operations - Trust Preferred Securities.”
 
 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.
 
 
 10
 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.
  11
 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.
 
 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. 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."
 
 12
  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.
 
 13
 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
operation.
 
 Factors
That May Affect Future Results of Operations
  In
addition to other information contained in this Annual Report, the following
risks may affect the Company and/or the Bank. If any of these risks occur, the
Company’s or Bank’s business, financial condition or operation results could be
adversely affected.
 
 
 Dependence
on Real Estate
 
 A
significant portion of the loan portfolio of the Bank is dependent on real
estate. At December 31, 2004, real estate served as the principal source of
collateral with respect to approximately 83.7% percent of the Bank’s 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 the Bank, as
well as the Company's financial condition and results of operations in general
and the market value of the Company's common stock. Acts of nature, including
earthquakes, floods and draughts, which may cause uninsured damage and other
loss of value to real estate and crops that secures these loans, may also
negatively impact the Company's financial condition. See, “Item 6. -Management’s
Discussion and Analysis- Financial Condition Analysis, Loans”.
 
 
 Interest
Rate Changes
 
 The
earnings of the Company are substantially affected by changes in prevailing
interest rates. Changes in interest rates affect the demand for new loans, the
credit profile of existing loans, the rates received on loans and securities and
the rates the Company must pay on deposits and borrowings. The difference
between the rates the Bank receives on loans and securities and the rates they
must pay on deposits and borrowings is known as the interest rate spread. Given
the Company’s current volume and mix of interest-bearing liabilities and
interest-earning assets, the Company’s interest rate spread can be expected to
increase when market interest rates are rising, and to decline when market
interest rates are declining. Our analysis indicates that the increases in the
target federal funds rate announced by the Federal Reserve Board in 2004
resulted in an increase of 28 basis points in the Company’s average interest
rate spread from that of 2003. Although the Company believes the current level
of interest rate sensitivity is reasonable, significant fluctuations in interest
rates may have an adverse impact on our business, financial condition and
results of operations.
 
 Competition
 
 Competition
may adversely affect our performance. The financial services business in our
market area is highly competitive and becoming more so due to changes in
regulation, technological advances and the accelerating pace of consolidation
among financial service providers. We face competition both in attracting
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 the
services we provide. Increasing levels of competition in banking and financial
services businesses may reduce our market share or cause the prices we charge
for our services to fall. Our results may differ in future periods depending on
the nature or level of competition.
 
 Regulation
 
 The
Company is subject to government regulation that could limit or restrict our
activities, adversely affecting our operations. The financial services industry
is heavily regulated. Federal and state regulation is designed to protect the
deposits of consumers, not to benefit our shareholders. The regulations impose
significant limitations on our operations, and may be changed at any time to
impose significant new limitations, possibly causing our results to vary
significantly from past results. Government policy and regulation, particularly
as implemented through the Federal Reserve System, significantly affects credit
conditions for us.
 
 14
 In
response to several well-publicized corporate and auditing scandals, the
President signed the Sarbanes-Oxley Act into law on July 29, 2002. This act
calls for increased federal regulation of the accounting profession and imposes
new requirements upon boards of directors, audit committees and executive
officers of public companies. These requirements will likely increase the
accounting and legal costs of the Company.
 
 Operating
Strategies
 
 From time
to time, the Company develops long-term financial performance goals to guide and
measure the success of our operating strategies. The Company can make no
assurance that we will be successful in achieving these long-term goals or that
our operating strategies will be successful. Achieving success in these areas is
dependent on a number of factors, many of which are beyond the Company’s direct
control. Factors that may adversely affect the Company’s ability to attain its
long-term financial performance goals include:
 
 ·
    Deterioration
      of asset quality;
 
 ·
    Inability
      to control non-interest expense, including, but not limited to, rising
      employee and healthcare costs;
 
 ·
    Inability
      to increase non-interest income
 
 ·
    Inability
      to decrease reliance on revenue generated from
assets;
 
 ·
    Ability
      to increase loan growth;
 
 ·
    Regulatory
      and other impediments associated with making
  acquisitions;
 
 ·
    Deterioration
      in general economic conditions, especially in the Company’s core
      markets;
 
 ·
    Decreases
      in the Company’s net interest margin;
 
 ·
    Increases
      in competition; and
 
 ·
    Adverse
      regulatory or legislative developments.
  Borrowers’
Failure to Perform
 
 A
significant number of our borrowers and guarantors may fail to perform their
obligations as required by the terms of their loans, resulting in losses for us.
This risk increases when the economy is weak. We have adopted underwriting and
credit policies, and loan monitoring procedures, including the establishment and
monitoring of allowances for credit losses. Management believes these provisions
are reasonable and adequate, and should keep credit losses within expected
limits by assessing the likelihood of nonperformance, tracking loan performance
and diversifying our credit portfolio. However, these policies and procedures
may not be adequate to prevent unexpected losses that could materially and
adversely affect our results of operations.
 
 Operations
Risks
 
 The Bank
is 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. The
Bank maintains a system of internal controls to mitigate against such
occurrences and maintains insurance coverage for such risks, but should such an
event occur that is not prevented or detected by the Bank’s internal controls,
uninsured or in excess of applicable insurance limits, it could have a
significant adverse impact on the Company's business, financial condition or
results of operations.
  Geographic
Concentration
 Our
operations are located almost entirely in the Central Coast region of
California. As a result of this geographic concentration, our results depend
largely upon economic and business conditions in this region. Deterioration in
economic and business conditions in our market area could have a material
adverse impact on the quality of our loan portfolio and the demand for our
products and services, which in turn may have a material adverse effect on our
results of operations.
  15
 War on
Terrorism
  The
terrorist attacks of September 11, 2001, the ensuing worldwide war on terrorism
and the war with Iraq may lead to unexpected shifts in cash flows, deposit
levels, and general economic activity. US banking agencies have warned of the
possible impact of such events on the capital ratios of banks.
 
 Company
Cash Flow
 
 As a
holding company, a substantial portion of the Company’s cash flow typically
comes from dividends from the Bank. Various statutory provisions restrict the
amount of dividends the Bank can pay to the Company without regulatory
approval.
 
 ITEM
2.  DESCRIPTION
OF PROPERTIES
 
 The Bank
and the Company occupy a permanent headquarters facility that is located at 545
Twelfth Street, Paso Robles, Ca. The purchase price for the headquarters office,
was approximately $1,000,000 for the building and land. This building has
approximately 9,000 square feet of space and off-street parking. The Bank has
remodeled this building at an approximate cost of $300,000.
 
 The Bank
has a non-banking office, located at 600 Twelfth Street, Paso Robles (directly
across from its present headquarters) that was purchased by the Bank on December
23, 1986, for approximately $400,000 from an unaffiliated party. 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. 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. This was done
to accommodate the occupancy of the new Administrative structure, currently
under construction. When completed, anticipated to be late in 2005, all staff
and operations at the non-banking office will be relocated to the new building.
 
 In June
of 1994, the Bank opened a branch at 171 Niblick Rd., Paso Robles, Ca. The Bank
leases this 1,800 square foot branch for approximately $2,500 per month. On
February 24, 2000, the Bank renewed the lease for an additional five-year term.
On February 17, 2004, the branch customer base was relocated to 1400 South River
Road and the existing facility currently houses an ATM and administrative
offices. The Bank is in the process of extending the current lease through
January 2006 to allow for the completion of the new Administrative structure
currently under construction. When completed, anticipated to be late in 2005,
all staff and operations at the Niblick facility will be relocated to the new
building.
 
 On June
26, 1997 the Bank executed a lease for its branch office at 297 Madonna Road,
San Luis Obispo. The branch was previously located in premises that were
acquired from La Cumbre Savings, which lease expired in 1997. The new branch
lease is for 6,200 square feet of which Heritage subleases approximately 58% to
another firm and uses 42%. The other firm pays 58% of the rent and expenses and
the Bank pays 42%. The rent under the lease for the entire space is
approximately $8,150 a month. In June, 2002, the rent re-priced to 95% of the
prevailing fair market value and increases each year thereafter at the greater
of the consumer price index or 2.5% until 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 a building containing approximately 5,618
square feet for approximately $9,800 per month. The original lease expired on
February 28, 2001 and Heritage executed its option to extend for a period of
five years. As of January 2003, the Bank has obtained two additional five year
options to extend.
 
 On
February 21, 1997, the Bank acquired the Cambria branch of Wells Fargo Bank
located at 1276 Tamson Drive, Cambria. The Bank leases this 2,916 square foot
branch for approximately $3,500 per month, subject to adjustments for cost of
living increases and certain pass-throughs. In December 2003, the Bank exercised
an option to extend the lease for an additional five years and there is one
additional five year option to extend remaining in the lease.
 
 On August
26, 1998, the Company purchased property located at 9900 El Camino Real,
Atascadero. The purchase price was $271,160. The Company constructed a building
with a total of 3,500 square feet of floor space. The total cost of improvements
was $440,765 plus furniture and fixtures. On April 1, 1999, the Company entered
into a five-year lease agreement, with three five-year options to renew, with
the Bank at the rate of $4,725 per month or $1.35 per square foot. Comparatives
were obtained to ensure that the lease amount was at fair market
value.
 
 16
 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 lease
calls for monthly payments based on a triple net price of $1.34 per square foot
or approximately $6,300 per month. The rent will adjust each November by the
Consumer Price Index or a maximum of 6%. The lease will expire on October 31,
2008, with the Bank having three five-year options to renew. In December 2004,
the Bank received regulatory approval to relocate the banking operations of the
branch to the Bank’s other branch office (Hacienda branch acquired in October
2003) located less than one mile away. This relocation will take place on March
4, 2005. The Bank has entered into a listing agreement to sublease this location
at the time of the relocation. .
 
 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 short term lease on a facility that housed
its Arroyo Grande Branch and the Bank consolidated the existing Bank branch into
the newly acquired facility. The appraised fair value at the time of acquisition
of the acquired location was $800,000.
 
 On
November 9, 2001, the Bank also acquired from Westamerica Bank (seller), a
branch office located at 310 Morro Bay Blvd., Morro Bay, Ca. The seller conveyed
title to the building at the closing. The appraised fair value of the acquired
building was $200,000. 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 a parcel of land (approximately 2 acres) on the
corner of Niblick and South River Roads in Paso Robles, Ca. The purchase price
was $900,000. In February 2003, the Bank entered into a Construction Agreement
with HBE Financials Facilities to construct a 5,000 square foot full service
branch. The “turn-key” price for the construction is $1.8 million. The Bank
relocated the existing “Woodland” branch office, located at 171 Niblick Road,
Paso Robles, Ca. to the new facility on February 17, 2004.
 
 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 purchase price was $1.1 million. It is the Bank’s intention to
build a 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 late in the fourth quarter of
2005.
 
 The Bank
leases the premises located 361 Town Center West Santa Maria, California 93458.
The Town Center West office is a two story design of approximately 14,000 square
feet. The lease expires July 31, 2012 in which the Bank makes lease payments of
$15,400 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 $2,475 and
$2,450 per month and expire October 1, 2006 and July 31, 2005, respectively.
 
 The Bank
owns the premises located at 2239 South Broadway, Santa Maria, California 93455,
which is known as the South Broadway office. The South Broadway office consists
of approximately 3,700 net square feet which include drive-up facilities and
parking for approximately 30 vehicles. The cost of the land and premises was
approximately $2.2 million and was opened in July 2002.
 
 The Bank
also leases the premises located at 1125 East Clark Ave, Santa Maria,
California, 93455 which is known as the Oak Knolls office. The Oak Knolls office
consists of approximately 4,600 square feet. The Bank’s lease expires on June
30, 2008, and current lease payments are $6,100 per month. The Bank also has an
option to extend the term for an additional five-year period and also two
additional two-year periods.
 
 The
Company believes its present facilities are adequate for its present needs. The
Company believes that the insurance coverage on all properties is
adequate.
 
 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).
 
 17
 ITEM
4.  SUBMISSION
OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
 NONE.
 
 PART
II
 
 ITEM
5.  MARKET
FOR COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
 
 Market
Information
 
 On
September 27, 2004, the Company’s stock was listed on the Nasdaq SmallCap
Market. Maguire Investments, Inc., Hoefer & Arnett, Inc., The Seidler
Companies, Sandler O’Neill & Partners and Wedbush Morgan Securities make a
market in the Company's Common Stock. Certain information concerning the Common
Stock is reported on NASDAQ under the symbol “HEOP”.
 
 The
information in the following table indicates the high and low bid prices of the
Company's Common Stock for each quarterly period during the last three years
based upon information provided by Maguire Investments, Inc., Hoefer &
Arnett, Inc., The Seidler Companies and Wedbush Morgan Securities. These prices
do not include retail mark-ups, mark-downs or commission.
 
 
 Quarter Ended
    
    Bid Prices2004
    
    Low
    
    HighMarch
      31
    
    $
    16.48
    
    $
    17.62June
      30
    
    
    16.25
    
    
    17.65September
      30
    
    
    15.50
    
    
    19.25
 
 
 December 31, 2004
    
    Closing Price
    $20.802003
    
    Low
    
    HighMarch
      31
    
    $
    10.60
    
    $
    13.00June
      30
    
    
    11.00
    
    
    13.25September
      30
    
    
    11.70
    
    
    13.95December
      31
    
    
    13.55
    
    
    18.00
 
 
 2002
    
    Low
    
    HighMarch
      31
    
    $
    12.85
    
    $
    12.85June
      30
    
    
    12.88
    
    
    13.00September
      30
    
    
    12.80
    
    
    13.20December
      31
    
    
    11.50
    
    
    11.65
 
 Prices
listed above have been adjusted to reflect all stock dividend and split
activity.
 
 Holders
 
 As of
February 1, 2005, there were approximately 1,434 holders of the Company's Common
Stock. There are no other classes of equity 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 6.
Management’s Discussion and Analysis of Financial condition and Results of
Operations” on junior subordinated debenture limitations on
dividends.
 
 18
 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. 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 $8.5 million at December 31, 2004.
 
 The
following table outlines stock dividend activity since 2000:
 
 Stock
Dividend Percentage  Record
Date
 
 5%    April 3,
2000
 
 5%    March 16,
2001
 
 5%    March 8,
2002
 
 2 for 1
Split  August 2,
2002
 
 5%    March 14,
2003
 
 5%    April 9,
2004
 
 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.
 
 The
following table summarizes information as of December 31, 2004 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 securitiesto be issued uponexercise of options
    
    Weighted
      averageexercise price ofoutstanding options
    
    Number
      of securitiesremaining availablefor future
issuanceEquity
      compensation plans approved by security holders
    
    
    1990
      1997
    
    
    1,991
      468,686
    
    $
      $
    4.02
      7.10
    
    
    -0-
      39,166Equity
      compensation plans not approved by security holders
    
    
    
    
    
    -0-
    
    
    -0-
    
    
    -0-Total
    
    
    
    
    
    470,677
    
    $
    7.09
    
    
    39,166
 
 19
 ITEM
6.  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, 2004. The analysis should be
read in connection with the consolidated financial statements and notes thereto
appearing elsewhere in this report.
 
 Executive
Summary
 
 The table
below provides selected financial data that highlights the Company’s performance
results for the three years ending December 31, 2002, 2003 and 2004.
 
 **SELECTED
      FINANCIAL DATA**December
      31,2002
    
    2003
    
    
    
    2004%
      Change2002 to 2003
    
    
    
    %
      Change2003 to 2004Return
      on Average Assets
    
    
    0.98
    %
    
    1.05
    %
    
    7.14
    %
    
    1.02
    %
    
    -2.86
    %Return
      on Average Equity
    
    
    15.56
    %
    
    15.52
    %
    
    -0.26
    %
    
    13.15
    %
    
    -15.27
    %Return
      on Average Tangible Equity
    
    
    15.56
    %
    
    16.39
    %
    
    5.33
    %
    
    16.61
    %
    
    1.34
    %Average
      Equity to Average Assets
    
    
    6.33
    %
    
    6.76
    %
    
    6.79
    %
    
    7.79
    %
    
    15.24
    %Net
      Interest Margin
    
    
    5.04
    %
    
    4.82
    %
    
    -4.37
    %
    
    5.10
    %
    
    5.81
    %Efficiency
      Ratio*
    
    
    69.18
    %
    
    67.13
    %
    
    -2.96
    %
    
    68.93
    %
    
    2.68
    %Average
      Loans to Average Deposits
    
    
    77.63
    %
    
    81.74
    %
    
    5.29
    %
    
    82.09
    %
    
    0.43
    %Net
      Income (in thousands)
    
    $
    2,739
    
    $
    3,596
    
    
    31.29
    %
    $
    4,584
    
    
    27.47
    %Average
      Assets (in thousands)
    
    $
    278,332
    
    $
    342,923
    
    
    23.21
    %
    $
    447,428
    
    
    30.47
    %Earnings
      Per Share:Basic
    
    $
    0.90
    
    $
    1.12
    
    
    24.44
    %
    $
    1.21
    
    
    8.04
    %Diluted
    
    $
    0.82
    
    $
    1.05
    
    
    28.05
    %
    $
    1.12
    
    
    6.67
    %
 
 *The
efficiency ratio is defined as total non-interest expense as a percent of the
combined net interest income plus non-interest income.
 
 In order
to understand our performance over the last three years, we must begin our
discussion with the Net Interest Margin (NIM). 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%. Beginning in June 2004 through December 2004, the FRB increased the Prime
Rate from 4.00% to 5.25%. Historically, the largest source of income for the
Company is that which is created by net interest income. This reduction in rates
prior to June 2004, specifically as it related to a) approximately 30% of the
Company’s gross loan portfolio at December 31, 2003 that adjusted with Prime and
other indices and b) securities in the Investment portfolio that react to rate
fluctuations, made it very difficult to maintain the level of the NIM for 2002
and 2003 that the Company had experienced in the past. Despite this interest
rate environment, the Company was able to exceed prior year earnings and EPS by
growing average earning assets and reducing the 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 once the increases exceeded 100bp, at which time the “floors”
placed on many loans that moved with Prime were exceeded. The effect of this can
be seen in the increase in the net interest margin from 4.91% at June 30, 2004
to 5.10% at December 31, 2004.
 
 20
 In 1999,
the Bank put into action a Corporate Culture Survey that allows employee to
respond anonymously to nearly 100 questions regarding communication, training,
management effectiveness and many other pertinent areas. This survey is
conducted annually during the fourth quarter. The results of the survey provide
Senior Management and the Board with information that assists in future
endeavors to address areas where there is an opportunity to improve. During the
past six years, the overall “rating” has shown measured improvement. Senior
Management and the Board of Directors consider this to be one of the most
important achievements for the Company.
 
 Certainly
one of the most notable recent events for the Company was the acquisition of
Hacienda Bank that took place on October 31, 2003. Hacienda had approximately
$90 million in assets at December 31, 2003. This acquisition was the culmination
of many years effort to have a greater presence in the city of Santa Maria. In
reviewing market share data (provided by the FDIC as of June every year) within
the Company’s primary service area of San Luis Obispo and Northern Santa Barbara
counties, it was very clear that the city of Santa Maria with 28% of the total
deposit base provided opportunity for growth. In order to obtain more market
share, the Company needed a greater presence than the existing one branch office
that was opened in 1999. The Company views this acquisition as a positive step
to enhancing market share and shareholder return. The acquisition became
accretive to earnings in 2004. In June 2004, Hacienda merged with and into the
Bank.
 
 The
Company continues to focus on increased market share in each city within its
primary market area. In 2002, marketing plans were initiated to reach the long
term goal of at least a pro rata share of deposits in each market. Measured
calling programs for both lending and operational staff have been implemented
utilizing among other resources a Customer Relationship Management (CRM) system.
While competition remains robust in the Central Coast with numerous independent
banks headquartered here and the typical plethora of major financial
institutions, the Company believes that our unique corporate culture that
concentrates on our staff will ultimately be our best tool to accomplish our
market share goals.
 
 Critical
Accounting Policies
 
 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.
 
 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.
 
 21
 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, 2004 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.
 
 Earnings
Overview
 
 When
viewing data for the year 2004, it is important to keep in mind that Hacienda
was acquired by the Company on October 31, 2003. Income and expense for Hacienda
that is included in the Company consolidation is for the months of November and
December 2003 compared to the entire year for 2004.
 
 The
Company reported net income for 2004 of $4.6 million compared to $3.6 million
for 2003. This represents an increase of 27% and was accomplished by increasing
average earning assets. Net income reported for 2003 represented an increase of
31% more than 2002 net income of $2.7 million. Basic earnings per share were
$1.21, $1.12 and $.90 at December 31, 2004, 2003 and 2002, respectively. Diluted
earnings per share were $1.12, $1.05 and $.82 at December 31, 2004, 2003 and
2002, respectively.
  Net
Interest Income and Interest Margin
 
 Net
interest income, the primary component of the net earnings of a financial
institution, refers to the difference between the interest paid on deposits and
borrowings, and the interest earned on loans and investments. The net interest
margin is the amount of net interest income expressed as a percentage of average
earning assets. Factors considered in the analysis of net interest income are
the composition and volume of earning assets and interest-bearing liabilities,
the amount of non-interest bearing liabilities and non-accrual loans, and
changes in market interest rates.
 
 The
tables below set forth changes from 2003 to 2004 for average interest earning
assets and their respective average yields. Due to the declining yields on loans
as the result of lower rates until June 2004, the Company had to increase the
portfolio for the year in order to augment net interest income. The Company was
able to grow the loan portfolio with continued market penetration by a team of
seasoned loan officers who are compensated for production. Loan underwriting
criteria was not compromised while accomplishing this. The tax-exempt portion of
the investment portfolio was also increased while giving up only 8 basis points
in the average yield. The Company has significant room to grow in tax-exempts
before bumping up against the Alternative Minimum Tax issue with the IRS. The
taxable investment portfolio increased during the year as the result of
available liquidity during the first half of 2004. The yield on average taxable
investments actually increased by 22 basis points for 2004 from 2003 due to the
flattening of the yield curve whereby long term rates did not increase at the
same rate as the shorter term rates. This non-parallel shifting of rates was a
positive impact to the majority of the investment portfolio that consists of
longer term Mortgage Backed Securities.
 
 22
 **(dollars
      in thousands)**
    
    **Average
      Balance YTD**Interest
      Earning Assets:
    
    **2003**
    
    **2004**
    
    **$
      Variance**
    
    **%
      Variance**Interest
      Bearing Dep with other Banks
    
    $
    661
    
    $
    2,154
    
    $
    1,493
    
    
    225.87
    %Investment
      securities taxable
    
    
    42,353
    
    
    49,178
    
    
    6,825
    
    
    16.11
    %Investment
      securities non-taxable
    
    
    10,129
    
    
    11,511
    
    
    1,382
    
    
    13.64
    %Federal
      funds sold
    
    
    25,602
    
    
    24,287
    
    
    (1,315
    )
    
    -5.14
    %Loans
    
    
    226,707
    
    
    304,402
    
    
    77,695
    
    
    34.27
    %Total
      interest earning assets
    
    
    305,452
    
    
    391,532
    
    
    86,080
    
    
    28.18
    %
 **Average
      Yield YTD**Interest
      Earning Assets:
    
    **2003**
    
    **2004**
    
    **Variance**Interest
      Bearing Dep with other Banks
    
    
    1.97
    %
    
    1.90
    %
    
    -0.07
    %Investment
      securities taxable
    
    
    3.54
    %
    
    3.76
    %
    
    0.22
    %Investment
      securities non-taxable
    
    
    4.48
    %
    
    4.40
    %
    
    -0.08
    %Federal
      funds sold
    
    
    1.09
    %
    
    1.24
    %
    
    0.15
    %Loans
    
    
    7.03
    %
    
    6.77
    %
    
    -0.26
    %Total
      interest earning assets
    
    
    5.95
    %
    
    5.95
    %
    
    0.00
    %
 
 The
tables below sets forth changes from 2003 to 2004 for average interest bearing
liabilities and their respective average rates paid. The Company continues to
enjoy a low cost of funds, specifically in regard to interest bearing deposits.
The ability to attract low cost deposits is part of the Company’s marketing
plans that have been in place for numerous years. The average rate paid on
“Other Borrowing” decreased in April 2004 due to the maturity and renewal for
borrowing related to the FHLB. In October 2003, the Company requested the full
disbursement of a $3.5 million line of credit with Pacific Coast Bankers Bank to
assist in the acquisition of Hacienda. This borrowing was paid down to $0 in
July 2004.
  **(dollars
      in thousands)**
    
    **Average
      Balance YTD**Interest
      -bearing liabilities:
    
    **2003**
    
    **2004**
    
    **$
      Variance**
    
    **%
      Variance**Savings/NOW/money
      market
    
    
    116,965
    
    
    158,291
    
    
    41,326
    
    
    35.33
    %Time
      deposits
    
    
    51,049
    
    
    69,715
    
    
    18,666
    
    
    36.56
    %Other
      Borrowings
    
    
    31,396
    
    
    31,023
    
    
    (373
    )
    
    -1.19
    %Long
      Term Debt
    
    
    8,248
    
    
    8,248
    
    
    0
    
    
    0.00
    %Total
      interest-bearing liabilities
    
    
    207,658
    
    
    267,277
    
    
    59,619
    
    
    28.71
    %Net
      Interest Income
    
    $
    14,711
    
    $
    19,952
    
    
    5,241
    
    
    35.63
    %Net
      Interest Margin (3)
    
    
    4.82
    %
    
    5.10
    %
    
    0.28
    %
    
    5.81
    %
 23
 
 **Average
      Rate Paid YTD**Interest
      -bearing liabilities:
    
    **2003**
    
    **2004**
    
    **Variance**Savings/NOW/money
      market
    
    
    0.53
    %
    
    0.44
    %
    
    -0.09
    %Time
      deposits
    
    
    2.21
    %
    
    1.54
    %
    
    -0.67
    %Other
      Borrowings
    
    
    4.10
    %
    
    3.72
    %
    
    -0.38
    %Long
      Term Debt
    
    
    5.15
    %
    
    5.29
    %
    
    0.14
    %Total
      interest-bearing liabilities
    
    
    1.67
    %
    
    1.26
    %
    
    -0.41
    %
 
 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, 2002, 2003 and 2004. The average balance of
non-accruing loans has been included in loan totals.
  **YTD****2002**
    
    
    
    
    
    **2003**
    
    
    
    
    
    **2004****(dollars
      in thousands)**
    
    **Average**
    
    **Avg
      Yield**
    
    **Amount**
    
    **Average**
    
    **Avg
      Yield**
    
    **Amount**
    
    **Average**
    
    **Avg
      Yield**
    
    **Amount**Interest
      Earning Assets:
    
    **Balance**
    
    **Rate
      Paid**
    
    **Interest**
    
    **Balance**
    
    **Rate
      Paid**
    
    **Interest**
    
    **Balance**
    
    **Rate
      Paid**
    
    **Interest**Interest
      Bearing Dep with other Banks
    
    $
    169
    
    
    2.96
    %
    $
    5
    
    $
    661
    
    
    1.97
    %
    $
    13
    
    $
    2,154
    
    
    1.90
    %
    $
    41Investment
      securities taxable
    
    
    43,502
    
    
    4.44
    %
    
    1,931
    
    
    42,353
    
    
    3.54
    %
    
    1,499
    
    
    49,178
    
    
    3.76
    %
    
    1,849Investment
      securities non-taxable
    
    
    6,358
    
    
    4.72
    %
    
    300
    
    
    10,129
    
    
    4.48
    %
    
    454
    
    
    11,511
    
    
    4.40
    %
    
    506Federal
      funds sold
    
    
    24,799
    
    
    1.61
    %
    
    400
    
    
    25,602
    
    
    1.09
    %
    
    278
    
    
    24,287
    
    
    1.24
    %
    
    302Loans
      (1) (2)
    
    
    173,861
    
    
    7.71
    %
    
    13,399
    
    
    226,707
    
    
    7.03
    %
    
    15,930
    
    
    304,402
    
    
    6.77
    %
    
    20,615Total
      interest earning assets
    
    
    248,689
    
    
    6.45
    %
    
    16,035
    
    
    305,452
    
    
    5.95
    %
    
    18,174
    
    
    391,532
    
    
    5.95
    %
    
    23,313Allowance
      for possible loan losses
    
    
    (2,088
    )
    
    
    
    
    
    
    
    (3,164
    )
    
    
    
    
    
    
    
    (3,158
    )Non-earning
      assets:Cash
      and due from banks
    
    
    18,588
    
    
    
    
    
    
    
    
    22,750
    
    
    
    
    
    
    
    
    28,777Property,
      premises and equipment
    
    
    3,953
    
    
    
    
    
    
    
    
    6,011
    
    
    
    
    
    
    
    
    10,082Other
      assets
    
    
    9,190
    
    
    
    
    
    
    
    
    12,122
    
    
    
    
    
    
    
    
    20,195TOTAL
      ASSETS
    
    $
    278,332
    
    
    
    
    
    
    
    $
    343,171
    
    
    
    
    
    
    
    $
    447,428Interest-bearing
      liabilities:Savings/NOW/money
      market
    
    
    92,800
    
    
    0.84
    %
    
    779
    
    
    116,965
    
    
    0.53
    %
    
    625
    
    
    158,291
    
    
    0.44
    %
    
    699Time
      deposits
    
    
    46,453
    
    
    2.77
    %
    
    1,286
    
    
    51,049
    
    
    2.21
    %
    
    1,126
    
    
    69,715
    
    
    1.54
    %
    
    1,071Other
      Borrowings
    
    
    28,967
    
    
    3.70
    %
    
    1,071
    
    
    31,396
    
    
    4.10
    %
    
    1,287
    
    
    31,023
    
    
    3.72
    %
    
    1,155Long
      Term Debt
    
    
    6,000
    
    
    5.92
    %
    
    355
    
    
    8,248
    
    
    5.15
    %
    
    425
    
    
    8,248
    
    
    5.29
    %
    
    436Total
      interest-bearing liabilities
    
    
    174,220
    
    
    2.00
    %
    
    3,491
    
    
    207,658
    
    
    1.67
    %
    
    3,463
    
    
    267,277
    
    
    1.26
    %
    
    3,361Interest
      bearing liabilities:Demand
      deposits
    
    
    84,702
    
    
    
    
    
    
    
    
    109,349
    
    
    
    
    
    
    
    
    142,796Other
      liabilities
    
    
    1,803
    
    
    
    
    
    
    
    
    2,995
    
    
    
    
    
    
    
    
    2,501Total
      liabilities
    
    
    260,725
    
    
    
    
    
    
    
    
    320,002
    
    
    
    
    
    
    
    
    412,574Shareholders'
      equityCommon
      stock
    
    
    9,037
    
    
    
    
    
    
    
    
    12,649
    
    
    
    
    
    
    
    
    23,071Retained
      earnings
    
    
    8,437
    
    
    
    
    
    
    
    
    10,143
    
    
    
    
    
    
    
    
    11,510Valuation
      Allowance Investments
    
    
    133
    
    
    
    
    
    
    
    
    377
    
    
    
    
    
    
    
    
    273Total
      stockholders' equity
    
    
    17,607
    
    
    
    
    
    
    
    
    23,169
    
    
    
    
    
    
    
    
    34,854TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
    
    $
    278,332
    
    
    
    
    
    
    
    $
    343,171
    
    
    
    
    
    
    
    $
    447,428Interest
      Income
    
    
    
    
    
    
    
    $
    12,544
    
    
    
    
    
    
    
    $
    14,711
    
    
    
    
    
    
    
    $
    19,952Interest
      Margin(3)
    
    
    
    
    
    5.04
    %
    
    
    
    
    
    
    
    4.82
    %
    
    
    
    
    
    
    
    5.10
    %Nonaccrual
      loans have been included in total loans.Loan
      fees of $753, $754 and $1,021 for 2002, 2003 and 2004, respectively, have
      been
      included in the interest income computation.Net
      interest income has been calculated by dividing the net interest income by
      total earning assets.Note:
      All average balances have been computed using daily
    balances.
 24
 
 **RATE/VOLUME
      ANALYSIS**2002
    
    2003
    
    2004Average
    
    Average
    
    
    
    Average
    
    Average
    
    
    
    Average
    
    AverageIncrease
      (decrease) in:
    
    Bal/Vol
    
    Rate
    
    Total
    
    Bal/Vol
    
    Rate
    
    Total
    
    Bal/Vol
    
    Rate
    
    TotalInterest
      income:Loans
      (1)
    
    $
    2,559
    
    
    ($2,441
    )
    $
    118
    
    $
    3,794
    
    
    ($1,263
    )
    $
    2,531
    
    $
    5,293
    
    
    ($608
    )
    $
    4,685Investment
      securities taxable
    
    
    1,898
    
    
    (492
    )
    
    1,406
    
    
    (51
    )
    
    (381
    )
    
    (432
    )
    
    242
    
    
    108
    
    
    350Investment
      securities non-taxable (2):
    
    
    (11
    )
    
    1
    
    
    (10
    )
    
    270
    
    
    (36
    )
    
    234
    
    
    94
    
    
    (15
    )
    
    79Taxable
      equivalent adjustment (2):
    
    
    31
    
    
    (2
    )
    
    29
    
    
    (92
    )
    
    12
    
    
    (80
    )
    
    (32
    )
    
    5
    
    
    (27
    )Interest-bearing
      deposits
    
    
    (5
    )
    
    (2
    )
    
    (7
    )
    
    15
    
    
    (7
    )
    
    8
    
    
    29
    
    
    (1
    )
    
    28Federal
      funds sold
    
    
    523
    
    
    (485
    )
    
    38
    
    
    13
    
    
    (135
    )
    
    (122
    )
    
    (14
    )
    
    38
    
    
    24Total
    
    
    4,995
    
    
    (3,421
    )
    
    1,574
    
    
    3,949
    
    
    (1,810
    )
    
    2,139
    
    
    5,612
    
    
    (473
    )
    
    5,139Interest
      expense:Savings,
      now, money market
    
    
    381
    
    
    (566
    )
    
    (185
    )
    
    203
    
    
    (357
    )
    
    (154
    )
    
    216
    
    
    (142
    )
    
    74Time
      deposits
    
    
    (125
    )
    
    (954
    )
    
    (1,079
    )
    
    128
    
    
    (288
    )
    
    (160
    )
    
    414
    
    
    (469
    )
    
    (55
    )Other
      borrowings
    
    
    1,854
    
    
    (884
    )
    
    970
    
    
    88
    
    
    128
    
    
    216
    
    
    (15
    )
    
    (117
    )
    
    (132
    )Long
      term borrowings
    
    
    -
    
    
    355
    
    
    355
    
    
    119
    
    
    (49
    )
    
    70
    
    
    13
    
    
    (2
    )
    
    11Total
    
    
    2,110
    
    
    (2,049
    )
    
    61
    
    
    538
    
    
    (566
    )
    
    (28
    )
    
    628
    
    
    (730
    )
    
    (102
    )Increase
      (decrease) in netInterest
      income
    
    $
    2,885
    
    
    ($1,372
    )
    $
    1,513
    
    $
    3,411
    
    
    ($1,244
    )
    $
    2,167
    
    $
    4,984
    
    $
    257
    
    $
    5,241(1)
      Loan fees of $753, $754 and $1,021 for 2002, 2003 and 2004, 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.
 
 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, 2004 balances
indicate that the net interest income at risk over a one year time horizon from
a 1% and 2% rate movement are within the Company’s policy guidelines for such
changes.
 
 Rates
      Down 2%
    
    Rates
      Down 1%
    
    Rates
      Up 1%
    
    Rates
      Up 2%Change
      in Net Interest Income
    
    
    (10.86
    %)
    
    (5.65
    %)
    
    6.22
    %
    
    12.66
    %
 
 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
effecting 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.
 
 
 25
 
 Non-Interest
Income
 
 The table
below sets forth changes from 2003 to 2004 for non-interest income exclusive of
gains on sale of 1)
securities; 2) SBA loans and; 3) premises.
 (amount
      in thousands)Fees
      and Other Income2003
    
    2004
    
    $
      Variance
    
    %
      VarianceService
      Charges on Deposit Accounts
    
    $
    1,723
    
    $
    2,173
    
    $
    450
    
    
    26.1
    %ATM/Debit
      Card Transaction/Interchange Fees
    
    
    406
    
    
    583
    
    
    177
    
    
    43.6
    %Bankcard
      Merchant Fees
    
    
    100
    
    
    116
    
    
    16
    
    
    16.0
    %Mortgage
      Broker Fees
    
    
    880
    
    
    602
    
    
    (278
    )
    
    -31.6
    %Earnings
      on Cash Surrender Value Life Ins
    
    
    264
    
    
    294
    
    
    30
    
    
    11.4
    %Other
    
    
    364
    
    
    446
    
    
    82
    
    
    22.5
    %Total
    
    $
    3,737
    
    $
    4,214
    
    $
    477
    
    
    12.8
    %
 
 Increases
in Service Charges on Deposit Accounts and ATM/Debit Card Transactions are the
direct effect of deposit growth and the full year impact of Hacienda in 2004.
 
 Mortgage
Origination Fees decreased in 2004 due primarily to a slowdown in the re-finance
market that was felt throughout the United States. This particular area of home
loan re-financing basically had been saturated during 2002 and 2003. Even though
long term rates were not significantly impacted by the FRB increase in rates in
2004 (as the yield curve flattened), borrowers had already taken advantage of
the low rate environment in 2002 and 2003. 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 in the future, the yield curve may not remain
flat and long term rates may be impacted. 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 been positioning itself throughout the past several years for future
market penetration with sales representation in all markets that it services. A
concerted marketing effort is in place to capture more of the mortgage
origination business in the Company’s primary market area even in a rising rate
environment.
 
 Non-Interest
Expenses
 
 The table
below sets forth changes from 2003 to 2004 for non-interest expense.
 
 (amount
      in thousands)Other
      Expenses
    
    2003
    
    2004
    
    $
      Variance
    
    %
      VarianceSalaries
      and Employee Benefits
    
    $
    6,498
    
    $
    8,457
    
    $
    1,959
    
    
    30.1
    %Occupany
      and Equipment
    
    
    1,757
    
    
    2,570
    
    
    813
    
    
    46.3
    %Data
      Processing
    
    
    1,581
    
    
    2,570
    
    
    989
    
    
    62.6
    %Advertising
      and promotional
    
    
    361
    
    
    515
    
    
    154
    
    
    42.7
    %Regulatory
      fees
    
    
    86
    
    
    114
    
    
    28
    
    
    32.6
    %Other
      professional fees and outside services
    
    
    432
    
    
    530
    
    
    98
    
    
    22.7
    %Legal
      fees and other litigation expense
    
    
    52
    
    
    76
    
    
    24
    
    
    46.2
    %Loan
      Department Costs
    
    
    255
    
    
    181
    
    
    (74
    )
    
    -29.0
    %Stationery
      and supplies
    
    
    249
    
    
    374
    
    
    125
    
    
    50.2
    %Director
      fees
    
    
    152
    
    
    179
    
    
    27
    
    
    17.8
    %Core
      Deposit Amortization
    
    
    41
    
    
    421
    
    
    380
    
    
    926.8
    %Other
    
    
    961
    
    
    1,211
    
    
    250
    
    
    26.0
    %Total
    
    $
    12,425
    
    $
    17,198
    
    $
    4,773
    
    
    38.4
    %
 
 Salary/Related
Expense
 Salaries
and employee related expense incurred the greatest dollar increase of any
non-interest expense category during 2004. Approximately $710 thousand or 41% of
the dollar variance is due to the full year effect of the Hacienda acquisition
versus only two months in 2003. Full time equivalent (FTE) employees increased
from 164 at December 31, 2003 to 170 at December 31, 2004.
 
 26
 Another
area that increased in 2004 was in regard to incentive based pay. “Pay for
performance” is a significant part of the Company’s Corporate Culture and has
served the Company well to provide above average return to the shareholders. All
employees participate either on a monthly, quarterly or annual basis. Expense
for all bonus based compensation increased by $113 thousand in 2004 compared to
2003.
 
 Group
health benefit costs increased by approximately $160 thousand in 2004 compared
to 2003. 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 over the past several years.
The Company has made efforts to “hold the line” on costs while at the same time
ensuring that employees receive appropriate and fair consideration. For 2004,
the average amount of cost per employee that the Company paid for group health
benefits was approximately $310 per month compared to approximately $285 per
month in 2003.
 
 Occupancy
and Equipment
 Occupancy
and equipment 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
 The
increase in data processing expense of $989 thousand was due to overall customer
growth and the inclusion of Hacienda’s data processing expense for the entire
year. The impact of a full year expense for Hacienda accounted for approximately
$480 thousand in 2004 compared to two month’s expense in 2003 of $103 thousand.
In addition, the Bank expensed approximately $540 thousand in 2004 for the March
4, 2005 conversion of Hacienda’s core and other ancillary processing services to
the Bank’s systems. Nearly 83% of this conversion cost will be saved in 18
months of future processing expenses.
 
 Provision
for Income Taxes
 
 The
provision for income taxes was 37.6% and 37.1% of net pre-tax income for years
ended December 31, 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.
 
 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.
 
 27
 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
2004 is consistent with prior periods.
 
 The
Bank’s provision for loan losses was $410 thousand for 2004 compared to $370
thousand for 2003. Net loan charge-offs (loans charged off, net of loans
recovered) were $233 thousand in both 2004 and 2003. The allowance for credit
losses as a percent of total gross loans at year-end 2004 and 2003 was .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 $872 thousand and $1.5 million at December 31, 2004
and 2003, respectively.
 Typically,
these loans have adequate collateral protection and/or personal guaranties to
provide a source of repayment to the Bank. Most of the loans on non-accrual are
related to several commercial loans that are being addressed by specific workout
plans at this time. Interest income that would have been recognized on
non-accrual loans if they had performed in accordance with the terms of the
loans was approximately $126 thousand and $132 thousand for the period ended
December 31, 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, 2004. Restructured loans
that were not on non-accrual totaled $62 thousand at December 31, 2004. Total
non-performing loans were $934 thousand at December 31, 2004.
 
 The
following table summarized the analysis of the allowance for loan losses as of
December 31, 2000, 2001, 2002, 2003 and 2004:
  **Analysis
of Allowance for Loan Losses**
 (in
      thousands)**2000**
    
    **2001**
    
    **2002**
    
    **2003**
    
    **2004**Balance
      at Beginning of Period
    
    $
    1,241
    
    $
    1,321
    
    $
    1,744
    
    $
    2,336
    
    $
    3,070Balance
      of Hacienda Bank atBeginning
      of Period
    
    
    
    
    
    -
    
    
    -
    
    
    597
    
    
    -Charge-offs:Commercial,
      Fianacial and Agricultural
    
    
    454
    
    
    156
    
    
    76
    
    
    463
    
    
    202Real
      Estate- Construction
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -Real
      Estate-Mortgage
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -Installment
      Loans to Individuals:
    
    
    4
    
    
    22
    
    
    -
    
    
    -
    
    
    29Money
      Plus
    
    
    1
    
    
    3
    
    
    5
    
    
    3
    
    
    5Credit
      Cards
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -Other
      Installment
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -Total
      charge-offs
    
    
    459
    
    
    181
    
    
    81
    
    
    466
    
    
    236Recoveries:Commercial,
      Fianacial and Agricultural
    
    
    17
    
    
    -
    
    
    127
    
    
    232
    
    
    1Real
      Estate- Construction
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -Real
      Estate-Mortgage
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -Installment
      Loans to Individuals:
    
    
    1
    
    
    2
    
    
    -
    
    
    1
    
    
    2Money
      Plus
    
    
    2
    
    
    2
    
    
    1
    
    
    -
    
    
    -Credit
      Cards
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -Other
      Installment
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -Total
      recoveries
    
    
    20
    
    
    4
    
    
    128
    
    
    233
    
    
    3Net
      Charge-offs
    
    
    439
    
    
    177
    
    
    (47
    )
    
    233
    
    
    233Additions
      Charged to Operations
    
    
    519
    
    
    600
    
    
    545
    
    
    370
    
    
    410Balance
      at End of Period
    
    
    1,321
    
    
    1,744
    
    
    2,336
    
    
    3,070
    
    
    3,247Gross
      Loans at End of Period
    
    $
    135,488
    
    $
    158,472
    
    $
    190,469
    
    $
    278,135
    
    $
    339,693Ratio
      of Net Charge-offs During theYear
      to Average Loans outstanding
    
    
    0.44
    %
    
    0.12
    %
    
    -0.03
    %
    
    0.10
    %
    
    0.08
    %Ratio
      of Reserves to Gross Loans
    
    
    0.97
    %
    
    1.10
    %
    
    1.23
    %
    
    1.10
    %
    
    0.96
    %Ratio
      of Non-performing Loans tothe
      Allowance for Credit Losses
    
    
    75.01
    %
    
    85.70
    %
    
    57.62
    %
    
    50.20
    %
    
    28.77
    %
  28
 
 **Allocation
of the Allowance for Loan Losses**
  2000
    
    2001
    
    2002
    
    2003
    
    2004%
      Total
    
    
    
    %
      Total
    
    
    
    %
      Total
    
    
    
    %
      Total
    
    
    
    %
      TotalAmount
    
    Loans
    
    Amount
    
    Loans
    
    Amount
    
    Loans
    
    Amount
    
    Loans
    
    Amount
    
    LoansCommercial,
      Fianacial and Agricultural
    
    $
    418
    
    
    32
    %
    $
    447
    
    
    26
    %
    $
    495
    
    
    21
    %
    $
    541
    
    
    18
    %
    $
    474
    
    
    15
    %Real
      Estate- Construction
    
    
    181
    
    
    14
    %
    
    258
    
    
    15
    %
    
    499
    
    
    21
    %
    
    527
    
    
    17
    %
    
    639
    
    
    20
    %Real
      Estate-Mortgage
    
    
    688
    
    
    52
    %
    
    1,000
    
    
    57
    %
    
    1,310
    
    
    56
    %
    
    1,941
    
    
    63
    %
    
    2,046
    
    
    63
    %Installment
      Loans to Individuals
    
    
    31
    
    
    2
    %
    
    35
    
    
    2
    %
    
    47
    
    
    2
    %
    
    57
    
    
    2
    %
    
    53
    
    
    2
    %All
      Other Loans (including overdrafts)
    
    
    3
    
    
    0
    %
    
    5
    
    
    0
    %
    
    3
    
    
    0
    %
    
    4
    
    
    0
    %
    
    3
    
    
    0
    %Total
    
    $
    1,321
    
    
    100
    %
    $
    1,744
    
    
    100
    %
    $
    2,355
    
    
    100
    %
    $
    3,070
    
    
    100
    %
    $
    3,214
    
    
    100
    %
 
 Local
Economy
 
 The
economy in the Company’s service area is based primarily on agriculture,
tourism, light industry, oil and retail trade. Services supporting these
industries have also developed in the areas of medical, financial and
educational. The population of San Luis Obispo County and the City of Santa
Maria (in Northern Santa Barbara County) totaled 258,200 and 85,000,
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. Vineyards in production have grown significantly
over the past several years throughout the Company’s service area. Access to
numerous recreational activities, including lakes, mountains and beaches,
provide a relatively stable tourist industry from many areas including the Los
Angeles/Orange County basin, the San Francisco Bay area and the San Joaquin
Valley. Principally due to the diversity of the various industries in the
Company’s service area, the area, while not immune from economic fluctuations,
does tend to enjoy a more stable level of economic activity from many other
areas of California.
 
 The
Central Coast’s leading agricultural industry is the production of high quality
wine grapes and production of premium quality wines. Through the late 1990’s and
into the year 2000, production of new vineyard land led to an over capacity of
wine grapes. By the end of 2000, excess production of wine grapes led to a
decrease in the process of grapes sold and income cases, the inability of
farmers to sell grapes at prices necessary to break even. Wineries, on the other
had, were able to purchase grapes at existing contract prices and in some cases,
below contract prices. In situation where wineries purchased grape inventories
purchased graoe inventories at existing contract prices, wineries demanded that
farmers thin crop level, thereby producing a product of extremely high
quality.
 
 Over the
past two years, the number of premium wine producers in the Paso Robles
appellation has more than doubled. Paso Robles wines have continually achieved
high recognition for outstanding quality and in 2003 Forbes Magazine recognized
the area as the next “Napa Valley”.
 
 The Bank
recognized in 2000 that the farming end of the wine industry held the highest
level of risk and that the increased levels of grape production would negatively
impact commodity prices for the growers. At that time, the Bank strategically
moved its portfolio of vineyard development loans out of the Bank’s portfolio
and into the Farmer Mac government guaranteed program. As a result of this
strategy, the Bank now has a very small and manageable portfolio of vineyard
development loans amounting to approximately $1.2 million at December 31, 2004.
In the opinion of Management, another negative turn in the wine grape industry
is expected to have very little impact on the overall risk of the Bank’s loan
portfolio.
 
 On
December 22, 2003, a 6.5 magnitude earthquake rocked the Central Coast. The
earthquake was centered in San Simeon, an area approximately 20 miles west of
Paso Robles where the Company is headquartered. There was the tragic loss of two
lives in Paso Robles. The greatest amount of property damage was centered in
downtown Paso Robles. The Company did not sustain any structural damage to its
facilities and there were no injuries to any employees or their families. City
officials reacted quickly and obtained disaster status from state and federal
agencies. Business’ in the downtown area experienced a moderate decline in
activity, however, the area has already begun to rebuild and things are getting
back to normal. Within days after the earthquake, the Company performed an
assessment as to any financial impact it could expect regarding effect to
customers and their ability to repay any outstanding debt. The assessment
revealed that there was no material impact to the Company.
 
 29
 
 FINANCIAL
CONDITION ANALYSIS
 
 Total
assets of the Company were $448 million at December 31, 2004 compared to $441.9
million at December 31, 2003. This represents an increase of $6 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% 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
$339.7 million and $278.1 million at December 31, 2004 and 2003, respectively.
Approximately 66% of gross loans at December 31, 2004 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 $1.4 million while a 100 basis point decline would decrease net
interest income by $1.2 million.
 
 The table
below sets forth the composition of the loan portfolio as of December 31, 2000,
2001, 2002, 2003 and 2004.
 
 **COMPOSITION
      OF LOAN PORTFOLIO**(in
      thousands)2000
    
    2001
    
    2002
    
    2003
    
    2004Amount
    
    Percent
    
    Amount
    
    Percent
    
    Amount
    
    Percent
    
    Amount
    
    Percent
    
    Amount
    
    PercentCommercial,
      Financial and Agricultural
    
    $
    42,931
    
    
    32
    %
    $
    40,608
    
    
    26
    %
    $
    40,373
    
    
    21
    %
    $
    49,024
    
    
    18
    %
    $
    49,584
    
    
    15
    %Real
      Estate- Construction
    
    
    18,599
    
    
    14
    %
    
    23,449
    
    
    15
    %
    
    40,723
    
    
    21
    %
    
    47,720
    
    
    17
    %
    
    66,833
    
    
    20
    %Real
      Estate-Mortgage
    
    
    70,551
    
    
    52
    %
    
    90,824
    
    
    57
    %
    
    106,810
    
    
    56
    %
    
    175,880
    
    
    63
    %
    
    217,473
    
    
    63
    %Installment
      Loans to Individuals
    
    
    3,246
    
    
    2
    %
    
    3,172
    
    
    2
    %
    
    2,291
    
    
    2
    %
    
    5,173
    
    
    2
    %
    
    5,538
    
    
    2
    %All
      Other Loans (including overdrafts)
    
    
    161
    
    
    0
    %
    
    419
    
    
    0
    %
    
    272
    
    
    0
    %
    
    338
    
    
    0
    %
    
    265
    
    
    0
    %Total
      Loans,Gross
    
    
    135,488
    
    
    100
    %
    
    158,472
    
    
    100
    %
    
    190,469
    
    
    100
    %
    
    278,135
    
    
    100
    %
    
    339,693
    
    
    100
    %Deferred
      Loan Fees
    
    
    (487
    )
    
    
    
    
    (578
    )
    
    
    
    
    (822
    )
    
    
    
    
    (1,014
    )
    
    
    
    
    (1,482
    )Reserve
      for Possible Loan Losses
    
    
    (1,321
    )
    
    
    
    
    (1,744
    )
    
    
    
    
    (2,336
    )
    
    
    
    
    (3,070
    )
    
    
    
    
    (3,247
    )Total
      Loans,Net
    
    $
    133,680
    
    
    
    
    $
    156,150
    
    
    
    
    $
    187,311
    
    
    
    
    $
    274,051
    
    
    
    
    $
    334,964Loans
      Held For Sale
    
    $
    2,475
    
    
    
    
    $
    4,082
    
    
    
    
    $
    8,166
    
    
    
    
    $
    4,402
    
    
    
    
    $
    2,253
 
 The
following table sets forth changes from 2003 to 2004 for the loan portfolio
categories.
  (in
      thousands)
    
    2003
    
    2004
    
    $
      Variance
    
    %
      VarianceCommercial,
      Financial and Agricultural
    
    $
    49,024
    
    $
    49,584
    
    $
    560
    
    
    1.14
    %Real
      Estate- Construction
    
    
    47,720
    
    
    66,833
    
    
    19,113
    
    
    40.05
    %Real
      Estate-Mortgage
    
    
    175,880
    
    
    217,473
    
    
    41,593
    
    
    23.65
    %Installment
      Loans to Individuals
    
    
    5,173
    
    
    5,538
    
    
    365
    
    
    7.06
    %All
      Other Loans (including overdrafts)
    
    
    338
    
    
    265
    
    
    (73
    )
    
    -21.60
    %Total
      Loans,Gross
    
    
    278,135
    
    
    339,693
    
    
    61,558
    
    
    22.13
    %Deferred
      Loan Fees
    
    
    (1,014
    )
    
    (1,482
    )
    
    (468
    )
    
    46.15
    %Reserve
      for Possible Loan Losses
    
    
    (3,070
    )
    
    (3,247
    )
    
    (177
    )
    
    5.77
    %Total
      Loans,Net
    
    $
    274,051
    
    $
    334,964
    
    $
    60,913
    
    
    22.23
    %Loans
      Held For Sale
    
    $
    4,402
    
    $
    2,253
    
    $
    (2,149
    )
    
    -48.82
    %
 30
 The small
increase in commercial, financial and agricultural loans is attributed primarily
to a $4.9 million ranch real estate loan made in December 2004. Several other
farm real estate loans and operating lines were paid off during the year by
other agricultural lenders.
 
 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 $2.5 million, an addition to a
strip center for $4.4 million, an apartment complex for $4.8 million, a
retail/office complex for $3.5 million, a RV park for $1.5 million, a
mini-storage for $1.4 million, a warehouse for $1.4 million, a retail center for
$1.4 million, a gas station for $1.4 million, a water park for $1.3 million and
numerous other smaller projects. Several construction loans paid off during 2004
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 large
increase in real estate-mortgage loans  is
attributed to several of the construction loans moving into amortizing loans and
numerous new commercial property loans including a office building for $8
million, 6 office/warehouse buildings for $7 million, a retail building for $2.1
million, an office complex for $2.5 million, a motel for $1.9 million, an
apartment for $1.2 million, a rural residence for $1.2 million, an office
building for $1 million and a RV storage for $1 million.
 
 The Bank
presently has a concentration of loans in construction/land in the amount of
$66.8 million which represents 166% of the Bank’s Total Risk Based capital. At
December 31, 2004 there were 63 construction loans with outstanding balances and
remaining commitments of approximately $43.3 million and $70 million,
respectively. The single largest construction loan has a commitment amount of
approximately $4.8 million with a balance of approximately $1 million at
December 31, 2004. This is an apartment complex on the outskirts of Santa Maria,
Ca. At December 31, 2004, there were 59 land loans with balances of
approximately $23.5 million. The single largest land loan accounts for
approximately $4.8 million of the total and is for a single family home tract
development. The construction/land loans are spread throughout our market area
and have consistently performed in a satisfactory manner.
 
 Hotel
loans were previously considered to be a concentration, however, with increased
capital at the Bank level, this is no longer the case. Hotel loans presently
total $36.6 million, up $2.6 million from 2003 year end, which represents 92% of
the Bank’s Total Risk Based capital. At December 31, 2004, there were 31 motel
loans. The single largest loan had a balance of approximately $3.9 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.
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 the expansion of an assisted living facility in San Luis Obispo.
Approximately $6.6 million of the funds have been deposited with the Bank. These
funds will be used for capital improvements to the assisted living facility. The
letter of credit will expire in September 2007.
 
 Construction
loan demand for both single family and commercial real estate was strong during
2004 and is expected to continue during 2005. Area home prices continue to
increase however they remain considerably lower than the metropolitan areas to
our North and South. Low mortgage rates and a multitude 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.
 
 Business
properties are also in demand with low vacancies and favorable 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. The Bank expects to experience continued growth
in commercial real estate loans during 2005.
 
 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.
 
 
 31
 
 At
December 31, 2004, the Bank had no foreign loans outstanding. The Bank did not
have any concentrations of loans except as disclosed above.
 
 The
Bank’s management is responsible for monitoring loan performance that is done
through various methods, including a review of loan delinquencies and personal
knowledge of customers. Additionally, the Bank maintains both a “watch” list of
loans that, for a variety of reasons, management believes requires regular
review as well as an internal loan classification process. Annually, the loan
portfolio is also reviewed by an experienced, outside loan reviewer not
affiliated with the Bank. A list of delinquencies, the watch list, loan grades
and the outside loan review are reviewed regularly by the Bank’s Board of
Directors. Except as set forth in the preceding table, there are no loans which
management has serious doubts as to the borrower’s ability to comply with
present loan repayment terms.
 
 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.
 
 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 $13.1million and $40.4 million at December 31, 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.
 
 Investment
Securities and Other Earning Assets
 
 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)2002
    
    2003
    
    2004Amount
    
    Percent
    
    Amount
    
    Percent
    
    Amount
    
    PercentFederal
      Home Loan Bank, FRB and other stock
    
    $
    1,951
    
    
    2
    %
    $
    1,959
    
    
    2
    %
    $
    1,809
    
    
    3
    %Available-for-Sale
      Investments
    
    
    65,396
    
    
    62
    %
    
    54,956
    
    
    58
    %
    
    57,394
    
    
    84
    %Federal
      Funds Sold
    
    
    37,040
    
    
    35
    %
    
    36,740
    
    
    39
    %
    
    5,775
    
    
    8
    %Interest
      Bearing Deposits other fin inst.
    
    
    497
    
    
    0
    %
    
    498
    
    
    1
    %
    
    3,498
    
    
    5
    %Total
      Other Earning Assets
    
    $
    104,884
    
    
    100
    %
    $
    94,153
    
    
    100
    %
    $
    68,476
    
    
    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, 2004, net unrealized gains in the portfolio were
$147 thousand compared to $98 thousand at December 31, 2003. The portfolio
increased in size due to available liquidity during the first three quarters of
2004. The value increased due to long term rates remaining low in spite of FRB
rate increases starting in June 2004 through December 2004.
 
 32
 
 At
December 31, 2004, available-for-sale securities in the portfolio included
obligations of state and political subdivisions, obligations of US government
agencies and corporations and mortgaged backed securities issued by various
agencies.
 
 All fixed
and adjustable rate mortgage pools contain a certain amount of risk related to
the uncertainty of prepayments of the underlying mortgages. Interest rate
changes have a direct impact upon prepayment rates. 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.
 
 The
Amortized cost, fair value, and maturites at December 31, 2004 are as
follows:
  (in
      thousands)Securities
      Available-for-SaleAmortized
    
    FairCost
    
    ValueDue
      in One Year or Less
    
    $
    1,888
    
    $
    1,854Due
      after One Year through Five Years
    
    
    2,249
    
    
    2,296Due
      after Five Years through Ten Years
    
    
    5,255
    
    
    5,368Due
      after TenYears
    
    
    5,165
    
    
    5,312Mortgage-backed
      Securities
    
    
    42,622
    
    
    42,564Total
    
    $
    57,179
    
    $
    57,394
 
 33
 
 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)2002
    
    2003
    
    2004Average
    
    
    
    Average
    
    
    
    AverageBalance
    
    Rate
      Paid
    
    Balance
    
    Rate
      Paid
    
    Balance
    
    Rate
      PaidNon-Interest
      Bearing Demand
    
    $
    106,556
    
    
    0.00
    %
    $
    137,859
    
    
    0.00
    %
    $
    143,455
    
    
    0.00
    %Interest
      Bearing Demand
    
    
    44,338
    
    
    0.46
    %
    
    63,479
    
    
    0.16
    %
    
    60,256
    
    
    0.05
    %Savings
    
    
    18,773
    
    
    0.24
    %
    
    32,315
    
    
    0.32
    %
    
    36,232
    
    
    0.25
    %Money
      Market
    
    
    49,457
    
    
    1.94
    %
    
    57,619
    
    
    1.02
    %
    
    69,527
    
    
    0.95
    %Time
      Deposits
    
    
    45,054
    
    
    2.77
    %
    
    75,167
    
    
    2.21
    %
    
    60,971
    
    
    1.54
    %Total
      Deposits
    
    $
    264,178
    
    
    0.92
    %
    $
    366,439
    
    
    0.73
    %
    $
    370,441
    
    
    0.48
    %Set
      forth is a maturity schedule of domestic time certificatesof
      deposit of $100,000 and over at December 31, 2004:**TIME
      DEPOSITS $100,000 AND OVER:**(dollars
      in thousands)Less
      than 3 months
    
    $
    5,2433
      to 12 months
    
    
    7,750Over
      1 year
    
    
    5,041Total
    
    $
    18,034
 
 The
following table sets forth changes from 2003 to 2004 for deposit
categories.
 
 2003
    
    2004
    
    $
      Variance
    
    %
      VarianceNon-Interest
      Bearing Demand
    
    $
    137,859
    
    $
    143,455
    
    $
    5,596
    
    
    4.06
    %Interest
      Bearing Demand
    
    
    63,479
    
    
    60,256
    
    
    (3,223
    )
    
    -5.08
    %Savings
    
    
    32,315
    
    
    36,232
    
    
    3,917
    
    
    12.12
    %Money
      Market
    
    
    57,619
    
    
    69,527
    
    
    11,908
    
    
    20.67
    %Time
      Deposits
    
    
    75,167
    
    
    60,971
    
    
    (14,196
    )
    
    -18.89
    %Total
      Deposits
    
    $
    366,439
    
    $
    370,441
    
    $
    4,002
    
    
    1.09
    %
 
 The
Company has been able to increase non-interest bearing, savings and money market
deposits due to a well planned marketing strategy and incentive based
compensation that has been in place for several years. Like all good strategies,
this one is fluid and is subject to the changing dynamics within the Company’s
balance sheet and staffing along with changes in its primary market area.
Friendly competition between the branch offices to increase deposit totals has
been in place for two years. The branch offices are all given goals for each
deposit category type and results are measured monthly. Lending and Operational
staff work together to meet or beat their goals. This program has generated a
significant amount of pride for the entire staff and resulted in growth for the
Company.
 
 34
 Non-interest
bearing demand deposits provide 38.7% of total deposits and grew by
approximately $5.6 million or 4.0% in 2004. The Bank has three deposit
relationships that it considers to be volatile. These deposits are held by
three, long time customers of the Bank that engage in mortgage related
activities. During 2004, the balances carried by these relationships decreased
by approximately $2.5 million at December 31, 2004 compared to December 31,
2003. The slowdown experienced in mortgage related activity 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 keenly aware that as the mortgage market conditions change, these
relationships will be impacted.
 
 Savings,
NOW and money market deposits were $166 million at December 31, 2004 compared to
$153.4 million at December 31, 2003. This represents an increase of
approximately $12.6 million or 8.2%.
 
 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 $352.4 million represented
95.1% of total deposits at December 31, 2004. The Company does not purchase
funds through deposit brokers.
 
 In
October 2003, the Company executed a Promissory Note with Pacific Coast Bankers
Bank (PCBB) with a term of 2 years for a revolving line of credit in the amount
of $3.5 million. At December 31, 2004, the Company had a zero balance
outstanding on this loan. The note was obtained to assist with the cash and
capital needs for the acquisition of Hacienda. The Company pledged 646,598
shares (51%) of the Bank’s stock as collateral for the loan. The note is
revolving in nature for the first two years. The terms of the note call for
quarterly interest only payments for the first two years with subsequent
principal and interest payments for eight years on a fully amortized basis. At
December 31, 2004, the interest rate on the note was 5.25% 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 Bank
has established borrowing lines with the Federal Home Loan Bank (FHLB). At
December 31, 2004, the Bank had borrowings with the FHLB of $9.5 million and $19
million that mature in April 2005. These are collateralized by loans and
securities, respectively. In addition, the Bank has an $11.7 million letter of
credit secured by loans. At December 31, 2004, the Bank has a remaining
borrowing capacity with existing collateral of approximately $66.1 million and
$3.8 million secured by loans and securities, respectively.
 
 The Bank
utilizes securities sold under repurchase agreements as a source of funds. The
Bank had $766 thousand in securities sold under repurchase agreements at
December 31, 2004 compared to $460 thousand at December 31, 2003.
 
 Capital
 
 The
Company's total stockholders equity was $37.3 million at December 31, 2004
compared to $32.3 million at December 31, 2003. The increase in capital during
2004 was due to net income of $4.6 million, $6 thousand cash paid to
stockholders in lieu of fractional shares on a 5% stock dividend paid April 23,
2004, stock options exercised in the amount of $335 thousand, and an increase in
accumulated other comprehensive income of $49 thousand.
 
 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 6.00% as of December 31, 2004. The debt securities can be called at any
time commencing on April 22, 2007, at par. The debt securities can also be
redeemed at par if certain events occur that impact the tax treatment,
regulatory treatment or the capital treatment of the issuance. The Company also
purchased a 3% minority interest totaling $248,000 in Heritage Oaks Capital
Trust I. The balance of the equity of Heritage Oaks Capital Trust I is comprised
of mandatorily redeemable preferred securities and is included in other
assets.
 
 35
 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, 2004, the Company has included the net junior
subordinated debt in its Tier1 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 Heritage for future
growth.
 
 Management
believes that organic growth in 2005 for the Company can be accomplished without
further borrowing for capital or cash flow purposes. At December 31, 2004, the
Company had sufficient cash to service the $8.2 million in junior subordinated
debenture interest payments for approximately seven quarters without dividends
from subsidiaries. The Bank’s capacity to provide cash to the Company, while
remaining “well-capitalized”, was approximately $700 thousand at December 31,
2004.
 
 Capital
ratios for commercial banks in the United States are generally calculated using
three different formulas. These calculations are referred to as the "Leverage
Ratio" and two "risk based" calculations known as: "Tier One Risk Based Capital
Ratio" and the "Total Risk Based Capital Ratio." These standards were developed
through joint efforts of banking authorities from 12 different countries around
the world. The standards essentially take into account the fact that different
types of assets have different levels of risk associated with them. Furthermore,
they take into account the off-balance sheet exposures of banks when assessing
capital adequacy.
 
 The
Leverage Ratio calculation simply divides common stockholders’ equity (reduced
by any goodwill a bank may have) by the total assets 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.
 
 Summarized
below are the Company’s and the Bank’s capital ratios at December 31, 2004.
 
 Minimum
      Regulatory
    
    Heritage
    
    HeritageCapital
      Requirements
    
    Oaks
      Bancorp
    
    Oaks
      BankLeverage
      Ratio
    
    
    4.00
    %
    
    8.34
    %
    
    8.09
    %Tier
      I Risk Weighted
    
    
    4.00
    %
    
    9.78
    %
    
    9.29
    %Total
      Risk Based
    
    
    8.00
    %
    
    10.65
    %
    
    10.16
    %
    36
 
 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,
2004, these credit lines totaled $7 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 $69.9 million at December 31, 2004.
 
 The Bank
manages liquidity by maintaining a majority of the investment portfolio in
federal funds sold and other liquid investments. At December 31, 2004, the ratio
of liquid assets not pledged for collateral and other purposes to deposits and
other liabilities was 12.7% compared to 28.1% in 2003. The ratio of net loans to
deposits, another key liquidity ratio, was 90% at December 31, 2003 compared to
76% at December 31, 2003. Declining liquidity became a factor during the fourth
quarter of 2004 due to extremely strong loan demand and deposit stabilization.
While liquidity calculations have decreased, the Bank has a number of funding
sources available including approximately $69 million in collateralized
borrowing with the FHLB. Management has already put into place a marketing
program that is geared to obtain additional deposits, specifically in money
market accounts. This was successful in August 2002 when the Bank increased
deposits by nearly $25 million with a special money market account promotion.
The promotion in 2002 did not significantly impact the Bank’s net interest
margin and management believes that the same results can be obtained again.
 
 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, 2004 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 the customers ability to repay debt or in upward pressure on operation
expenses.
 
 
 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.
 
 In
January 2003, the FASB issued the Emerging Information Task Force Issue 03-1,
The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investors (“EITF 03-1”), and in March 2004, FASB issued an update. EITF 03-1
addresses the meaning of other-than-temporary impairment and its application to
certain debt and equity securities. EITF 03-1 aids in the determination of
impairment of an investment and gives guidance as to the measurement of
impairment loss and the recognition and disclosures of other-than-temporary
investments. EITF 03-1 also provides a model to determine other-than-temporary
impairment using evidence-based judgment about the recovery of the fair value up
to the cost of the investment by considering the severity and duration of the
impairment in relation to the forecasted recovery of the fair value. The March
2004 update to EITF 03-1 includes application guidance as to the determination
of impairment, disclosures required by an impairment, and guidance for the
transition period and effective dates of disclosure requirements. In March 2004,
the FASB also issued two proposed FASB Staff Positions (“FSP”): FSP EITF Issue
03-1-a, which gives additional guidance on the determination of impairment for
debt securities impaired because of interest rate and/or sector spread
increases, and FSP EITF Issue 03-1-b, which delays the disclosure effective date
for debt securities impaired because of interest rate and/or sector spread
increases. The comment deadline for the proposed FSPs was October 29, 2004, and
the application and effective dates of portions of EITF 03-1 are deferred until
the issuance of FSP EITF Issue 03-1-a and FSP EITF Issue 03-1-b, which could be
as early as November 2004.The adoption of EITF 03-1 and FSP EITF Issues 03-1-a
and 03-1-b are not expected to have a material impact on the financial condition
or operating results of the Company.
 
 37
 
 This
discussion should be read in conjunction with the consolidated financial
statements of the Company, including the notes thereto, appearing elsewhere in
this report.
 
 Off-Balance
sheet Arrangements
 
 In the
ordinary course of business, the Company has entered into off-balance sheet
financial instruments consisting of commitments to extend credit, commercial
letter of credit, and standby letter of credit. Such financial instruments are
recorded in the financial statement when they are funded or related fees are
incurred or received.
 
 38
   ITEM 7.
FINANCIAL STATEMENTS
  **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 
 **DECEMBER
31, 2004, 2003, AND 2002**
 
 **Contents**
 
 **Financial
Statements**
 
 Report
      of Independent Registered Public Accounting Firm
    F-1Consolidated
      Balance SheetsDecember
      31, 2004 and 2003
    F-2Consolidated
      Statements of IncomeFor
      the Years Ended December 31, 2004, 2003, and 2002
    F-3Consolidated
      Statement of Changes in Stockholders' EquityFor
      the Years Ended December 31, 2004, 2003, and 2002
    F-4Consolidated
      Statements of Cash FlowsFor
      the Years Ended December 31, 2004, 2003, and 2002
    F-5**Notes
      to Consolidated Financial Statements**
    F-7
 
 
   
   **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **CONSOLIDATED
BALANCE SHEETS**
 **DECEMBER
31, 2004 AND 2003**
 **(Amounts
in thousands, except share data)**
  **Assets**2004
    
    2003Cash
      and due from banks
    
    $
    13,092
    
    $
    40,374Federal
      funds sold
    
    
    5,775
    
    
    36,740Money
      market funds
    
    
    3,000
    
    
    -Total
      Cash and Cash Equivalents
    
    
    21,867
    
    
    77,114Interest-bearing
      deposits in other financial institutions
    
    
    498
    
    
    498Investment
      securities, available-for-sale
    
    
    57,394
    
    
    54,956Federal
      Home Loan Bank and Federal Reserve Bank Stock, at cost
    
    
    1,809
    
    
    1,959Loans
      held for sale
    
    
    2,253
    
    
    4,402Loans,
      net of deferred fees and allowance for loan lossesof
      $3,247 and $3,070 at December 31, 2004and
      2003, respectively
    
    
    334,964
    
    
    274,051Property
      premises and equipment, net
    
    
    10,383
    
    
    9,874Net
      deferred tax asset
    
    
    1,918
    
    
    1,971Cash
      surrender value of life insurance
    
    
    7,130
    
    
    6,859Goodwill
    
    
    4,865
    
    
    4,905Intangible
      assets
    
    
    2,021
    
    
    2,442Other
      assets
    
    
    2,910
    
    
    2,917Total
      Assets
    
    $
    448,012
    
    $
    441,948**Liabilities
      and Stockholders' Equity**LiabilitiesDepositsDemand
      non-interest bearing
    
    $
    143,455
    
    $
    137,859Savings,
      NOW and money market deposits
    
    
    166,015
    
    
    153,413Time
      deposits of $100 or more
    
    
    18,034
    
    
    23,694Time
      deposits under $100
    
    
    42,937
    
    
    51,473Total
      Deposits
    
    
    370,441
    
    
    366,439FHLB
      advances and other borrowings
    
    
    28,500
    
    
    28,500Securities
      sold under agreement to repurchase
    
    
    766
    
    
    460Notes
      payable
    
    
    -
    
    
    3,500Junior
      subordinated debentures
    
    
    8,248
    
    
    8,248Other
      liabilities
    
    
    2,807
    
    
    2,513Total
      Liabilities
    
    
    410,762
    
    
    409,660COMMITMENTS
      AND CONTINGENCIES (Notes #5 and #10)
    
    
    -
    
    
    -Stockholders'
      EquityCommon
      stock, no par value; 20,000,000 shares authorized;3,817,943
      and 3,784,318 shares issued andoutstanding
      for 2004 and 2003, respectively
    
    
    24,050
    
    
    20,649Retained
      earnings
    
    
    13,053
    
    
    11,541Accumulated
      other comprehensive income
    
    
    147
    
    
    98Total
      Stockholders' Equity
    
    
    37,250
    
    
    32,288Total
      Liabilities and Stockholders' Equity
    
    $
    448,012
    
    $
    441,948
 
 The accompanying notes are an integral part of these financial
statements.
  F-2
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF INCOME**
 **FOR
THE YEARS ENDED DECEMBER 31, 2004, 2003, AND 2002**
 **(Dollars
in thousands, except per share amounts)**
 
 2004
    
    2003
    
    2002**Interest
      Income**Interest
      and fees on loans
    
    $
    20,615
    
    $
    15,930
    
    $
    13,399Interest
      on Investment SecuritiesObligations
      of U.S. Government Agencies
    
    
    1,767
    
    
    1,408
    
    
    1,872Obligations
      of State and Political Subdivisions
    
    
    506
    
    
    454
    
    
    300Interest
      on time deposits with other banks
    
    
    11
    
    
    13
    
    
    5Interest
      on Federal funds sold
    
    
    302
    
    
    278
    
    
    400Interest
      on other securities
    
    
    112
    
    
    91
    
    
    59Total
      Interest Income
    
    
    23,313
    
    
    18,174
    
    
    16,035**Interest
      Expense**Interest
      on savings, NOW and money market deposits
    
    
    699
    
    
    625
    
    
    779Interest
      on time deposits in denominations of$100
      or more
    
    
    118
    
    
    204
    
    
    183Interest
      on time deposits under $100
    
    
    953
    
    
    922
    
    
    1,103Other
    
    
    1,591
    
    
    1,712
    
    
    1,426Total
      Interest Expense
    
    
    3,361
    
    
    3,463
    
    
    3,491Net
      interest income before provision forpossible
      loan losses
    
    
    19,952
    
    
    14,711
    
    
    12,544Provision
      for Possible Loan Losses
    
    
    410
    
    
    370
    
    
    54519,542
    
    
    14,341
    
    
    11,999**Noninterest
      Income**Fees
      and service charges
    
    
    2,173
    
    
    1,723
    
    
    1,433Investment
      securities gain/(loss), net
    
    
    28
    
    
    60
    
    
    (19
    )Gain
      on sale of premise, net
    
    
    712
    
    
    -
    
    
    -Other
    
    
    2,086
    
    
    2,014
    
    
    2,049Total
      Noninterest Income
    
    
    4,999
    
    
    3,797
    
    
    3,463**Noninterest
      Expenses**Salaries
      and employee benefits
    
    
    8,457
    
    
    6,498
    
    
    5,386Equipment
      expenses
    
    
    929
    
    
    675
    
    
    711Occupancy
      expenses
    
    
    1,640
    
    
    1,082
    
    
    955Other
      expenses
    
    
    6,172
    
    
    4,170
    
    
    4,022Total
      Noninterest Expenses
    
    
    17,198
    
    
    12,425
    
    
    11,074Income
      Before Provision for Income Taxes
    
    
    7,343
    
    
    5,713
    
    
    4,388Provision
      for Income Taxes
    
    
    2,759
    
    
    2,117
    
    
    1,649Net
      Income
    
    $
    4,584
    
    $
    3,596
    
    $
    2,739Earnings
      Per ShareBasic
    
    $
    1.21
    
    $
    1.12
    
    $
    0.90Diluted
    
    $
    1.12
    
    $
    1.05
    
    $
    0.82
 The accompanying notes are an integral part of these
financial statements.
 
 F-3
 
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY**
 **FOR
THE YEARS ENDED DECEMBER 31, 2004, 2003, AND 2002**
 **(Amounts
in thousands, except share data)**
  AccumulatedCommon
      Stock
    
    
    
    
    
    Other
    
    TotalNumber
      of
    
    
    
    Comprehensive
    
    Retained
    
    Comprehensive
    
    Stockholders'Shares
    
    Amount
    
    Income
    
    Earnings
    
    Income
    
    Equity**Balance,
      January 1, 2002**
    
    
    1,297,880
    
    $
    7,536
    
    
    
    
    $
    8,496
    
    $
    (155
    )
    $
    15,877Exercise
      of stock options
    
    
    60,477
    
    
    486
    
    
    
    
    
    
    
    
    
    
    
    486(including
      $300 tax benefit from exerciseof
      stock options)Stock
      dividends paid - 5%
    
    
    64,648
    
    
    1,681
    
    
    
    
    
    (1,681
    )
    
    
    
    
    -Cash
      paid to stockholders in lieu offractional
      shares on 5% stock dividend
    
    
    
    
    
    
    
    
    
    
    
    (6
    )
    
    
    
    
    (6
    )Two-for-one
      stock split
    
    
    1,362,528Comprehensive
      incomeNet
      income
    
    
    
    
    
    
    
    $
    2,739
    
    
    2,739
    
    
    
    
    
    2,739Unrealized
      security holding gains(net
      of $471 tax)
    
    
    
    
    
    
    
    
    706
    
    
    
    
    
    706
    
    
    706Less
      reclassification adjustmentsfor
      losses (net of $8 tax)
    
    
    
    
    
    
    
    
    11
    
    
    
    
    
    11
    
    
    11Total
      comprehensive income
    
    
    
    
    
    
    
    $
    3,456**Balance,
      December 31, 2002**
    
    
    2,785,533
    
    
    9,703
    
    
    
    
    
    9,548
    
    
    562
    
    
    19,813Exercise
      of stock options
    
    
    72,471
    
    
    583
    
    
    
    
    
    
    
    
    
    
    
    583(including
      $204 tax benefit from exerciseof
      stock options)Stock
      issued in connection withpurchase
      of Hacienda Bank
    
    
    602,485
    
    
    8,698
    
    
    
    
    
    
    
    
    
    
    
    8,698Sale
      of stock
    
    
    5,000
    
    
    66
    
    
    
    
    
    
    
    
    
    
    
    66Cash
      paid to stockholders in lieu offractional
      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
    
    
    33,625
    
    
    335
    
    
    
    
    
    
    
    
    
    
    
    335(including
      $136 tax benefit from exerciseof
      stock options)Cash
      paid to stockholders in lieu offractional
      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 adjustmentsfor
      gains (net of $11tax)
    
    
    
    
    
    
    
    
    (17
    )
    
    
    
    
    (17
    )
    
    (17
    )Total
      comprehensive income
    
    
    
    
    
    
    
    $
    4,633**Balance,
      December 31, 2004**
    
    
    3,817,943
    
    $
    24,050
    
    
    
    
    $
    13,053
    
    $
    147
    
    $
    37,250
 The accompanying notes are an integral part of these
financial statements.
 
 F-4
 
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF CASH FLOWS**
 **FOR
THE YEARS ENDED DECEMBER 31, 2004, 2003, AND 2002**
 **(Dollars
in thousands)**
 
 2004
    
    2003
    
    2002**Cash
      Flows from Operating Activities**Net
      income
    
    $
    4,584
    
    $
    3,596
    
    $
    2,739Adjustments
      to reconcile net income tonet
      cash provided by operating activitiesNet
      cash provided by operating activitiesDepreciation
      and amortization
    
    
    949
    
    
    661
    
    
    652Provision
      for possible loan losses
    
    
    410
    
    
    370
    
    
    545Provision
      for possible losses on unfundedloan
      commitments
    
    
    25
    
    
    50
    
    
    40Realized
      (gain)/loss on sales of available-for-salesecurities,
      net
    
    
    (28
    )
    
    (60
    )
    
    19Amortization
      of premiums/discounts oninvestment
      securities, net
    
    
    407
    
    
    451
    
    
    239Amortization
      of core deposit intangibles
    
    
    421
    
    
    41
    
    
    43Gain
      on sale of property, premises and equipment, net
    
    
    (712
    )
    
    -
    
    
    -Net
      change in loans held for sale
    
    
    2,149
    
    
    3,764
    
    
    (4,084
    )Net
      increase in cash surrender value of life insurance
    
    
    (271
    )
    
    (264
    )
    
    (272
    )FHLB
      Dividends received
    
    
    (72
    )
    
    (87
    )
    
    (54
    )Decrease/(Increase)
      in deferred tax asset
    
    
    20
    
    
    (363
    )
    
    (391
    )Decrease/(Increase)
      in other assets
    
    
    183
    
    
    212
    
    
    (82
    )Increase/(decrease)
      in other liabilities
    
    
    269
    
    
    (5,195
    )
    
    5,539**NET
      CASH PROVIDED BY OPERATING ACTIVITIES**
    
    
    8,334
    
    
    3,176
    
    
    4,933**Cash
      Flows From Investing Activities**Purchase
      of securities available-for-sale
    
    
    (3,012
    )
    
    (1,633
    )
    
    (3,337
    )Purchase
      of mortgage-backed securities available-for-sale
    
    
    (17,295
    )
    
    (27,487
    )
    
    (59,757
    )Net
      redemption (purchase) of Federal Home Loan Bank and
FederalReserve
      Bank stock
    
    
    222
    
    
    332
    
    
    (1,668
    )Proceeds
      from sales of mortgage-backed securities
    
    
    1,534
    
    
    12,365
    
    
    5,406Proceeds
      from principal reductions and maturitiesof
      securities available-for-sale
    
    
    1,315
    
    
    757
    
    
    26Proceeds
      from principal reductions and maturities ofmortgage-backed
      securities
    
    
    14,723
    
    
    27,387
    
    
    15,231Net
      change in interest-bearing deposits inother
      financial institutions
    
    
    -
    
    
    99
    
    
    (398
    )Purchase
      of life insurance policies
    
    
    -
    
    
    (1,180
    )
    
    -Increase
      in cash due to acquisition
    
    
    -
    
    
    22,703
    
    
    -Recoveries
      on loans previously written off
    
    
    3
    
    
    233
    
    
    128Increase
      in loans, net
    
    
    (61,326
    )
    
    (35,465
    )
    
    (31,834
    )Proceeds
      from sale of property, premises and equipment
    
    
    900
    
    
    -
    
    
    7Purchase
      of property, premises and equipment, net
    
    
    (1,646
    )
    
    (3,158
    )
    
    (1,580
    )**NET
      CASH USED IN INVESTING ACTIVITIES**
    
    
    (64,582
    )
    
    (5,047
    )
    
    (77,776
    )
  The accompanying notes are an integral part of these
financial statements.
 F-5
 
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF CASH FLOWS (Continued)**
 **FOR
THE YEARS ENDED DECEMBER 31, 2004, 2003, AND 2002**
 **(Dollars
in thousands)**
 2004
    
    
    2003
    
    
    2002**Cash
      Flows From Financing Activities**Increase
      in deposits, net
    
    $
    4,002
    
    $
    23,788
    
    $
    68,594Net
      increase/(decrease) in FHLB borrowings
    
    
    -
    
    
    (9,500
    )
    
    38,000Proceeds
      from issuance of trust preferred securities
    
    
    -
    
    
    -
    
    
    8,000Net
      (decrease)/increase in notes payable
    
    
    (3,500
    )
    
    3,500
    
    
    (1,895
    )Net
      increase in securities sold under agreementto
      repurchase
    
    
    306
    
    
    202
    
    
    120Proceeds
      from exercise of stock options
    
    
    199
    
    
    379
    
    
    186Proceeds
      from sale of stock
    
    
    -
    
    
    66
    
    
    -Cash
      paid in lieu of fractional shares
    
    
    (6
    )
    
    (4
    )
    
    (6
    )**NET
      CASH PROVIDED BY FINANCING ACTIVITIES**
    
    
    1,001
    
    
    18,431
    
    
    112,999**Net
      (Decrease)/Increase in Cash and Cash Equivalents**
    
    
    (55,247
    )
    
    16,560
    
    
    40,156**Cash
      and Cash Equivalents**,
      Beginning of year
    
    
    77,114
    
    
    60,554
    
    
    20,398**Cash
      and Cash Equivalents**,
      End of year
    
    $
    21,867
    
    $
    77,114
    
    $
    60,554**Supplemental
      Disclosures of Cash Flow Information**Interest
      paid
    
    $
    3,453
    
    $
    3,652
    
    $
    3,280Income
      taxes paid
    
    $
    2,575
    
    $
    2,250
    
    $
    1,960**Supplemental
      Disclosures of Non-Cash Flow Information**Change
      in other valuation allowance for investment securities
    
    $
    82
    
    $
    (781
    )
    $
    1,195Tax
      benefit of stock options exercised
    
    $
    136
    
    $
    204
    
    $
    300**Supplemental
      Disclosures**Net
      change in assets/liabilities due to acquisition of Hacienda
      BankIncrease
      in interest-bearing deposits in other financial
    institutions
    
    $
    -
    
    $
    100
    
    $
    -Increase
      in investments
    
    $
    -
    
    $
    2,121
    
    $
    -Increase
      in net loans
    
    $
    -
    
    $
    51,878
    
    $
    -Increase
      in FHLB stock
    
    $
    -
    
    $
    253
    
    $
    -Increase
      in premises and equipment
    
    $
    -
    
    $
    2,834
    
    $
    -Increase
      in goodwill and other intangible assets
    
    $
    -
    
    $
    7,029
    
    $
    -Increase
      in other assets
    
    $
    -
    
    $
    901
    
    $
    -Increase
      in demand, money market and savings deposits
    
    $
    -
    
    $
    48,678
    
    $
    -Increase
      in time certificates of deposit
    
    $
    -
    
    $
    29,795
    
    $
    -Increase
      in other liabilities
    
    $
    -
    
    $
    644
    
    $
    -
  The accompanying notes are an integral part of
these financial statements.  F-6
  **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
31, 2004, 2003, AND 2002**
 **(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
twelve 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 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.
 
 F-7
 ****HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share
amounts)****
 ****
 **Note
#1 - Summary of Significant Accounting Policies** , **Continued**
 
 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.
 
 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, 2004.
 
 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.
 
 F-8
 ****HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share
amounts)****
 ****
 **Note
#1 - Summary of Significant Accounting Policies, Continued**
 
 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.
 
 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.
 
 F-9
 ****HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share
amounts)****
 ****
 **Note
#1 - Summary of Significant Accounting Policies, Continued**
 
 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, 2004, 2003, and 2002 were
approximately $949, $661, and $652, 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.
 
 Goodwill
represents the excess of the purchase price over the estimated fair value of the
net assets acquired. In accordance with the provisions of 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.
 
 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.
 
 F-10
 ****HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share
amounts)****
 ****
 **Note
#1 - Summary of Significant Accounting Policies, Continued**
 
 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.
 
 Reclassifications
 
 Certain
amounts in the 2003 and 2002 financial statements have been reclassified to
conform to the 2004 presentation.
 ****
 F-11
 ****
 ****HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share
amounts)****
 ****
 **Note
#1 - Summary of Significant Accounting Policies, Continued**
 
 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:
 
 2004
    
    2003
    
    2002Net
      income:As
      reported
    
    $
    4,584
    
    $
    3,596
    
    $
    2,739Stock-based
      compensation using the intrinsicvalue
      method
    
    
    -
    
    
    -
    
    
    -Stock-based
      compensation that would havebeen
      reported using the fair value methodof
      SFAS 123
    
    
    (55
    )
    
    (75
    )
    
    (111
    )Pro
      forma net income
    
    $
    4,529
    
    $
    3,521
    
    $
    2,628Basic
      earnings per share:As
      reported
    
    $
    1.21
    
    $
    1.12
    
    $
    0.90Pro
      forma
    
    
    1.19
    
    
    1.10
    
    
    0.86Diluted
      earnings per share:As
      reported
    
    $
    1.12
    
    $
    1.05
    
    $
    0.82Pro
      forma
    
    
    1.11
    
    
    1.03
    
    
    0.79
 F-12
 ****HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(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 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.
 
 F-13
 ******HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share
amounts)******
 ****
 **Note
#2 - Investment Securities**
 
 At
December 31, 2004 and 2003, 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, 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
 The
amortized cost and fair values of investment securities available-for-sale at
December 31, 2003, were:
 Gross
    
    GrossAmortized
    
    Unrealized
    
    UnrealizedCost
    
    Gains
    
    Losses
    
    Fair
      ValueObligations
      of U.S. Governmentagencies
      and corporations
    
    $
    2,484
    
    $
    22
    
    $
    (24
    )
    $
    2,482Mortgage-backed
      securities
    
    
    41,980
    
    
    197
    
    
    (308
    )
    
    41,869Obligations
      of state and politicalsubdivisions
    
    
    10,320
    
    
    365
    
    
    (89
    )
    
    10,596Other
      securities
    
    
    9
    
    
    -
    
    
    -
    
    
    9Total
    
    $
    54,793
    
    $
    584
    
    $
    (421
    )
    $
    54,956
 There
were no investment securities held-to-maturity at December 31, 2004 and December
31, 2003.
 ****
 F-14
 ******HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(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, 2004, 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.
 
 Securities Available-for-SaleAmortizedCost
    
    Fair
      ValueDue
      in one year or less
    
    $
    1,859
    
    $
    1,854Due
      after one year through five years
    
    
    2,249
    
    
    2,296Due
      after five years through ten years
    
    
    5,255
    
    
    5,368Due
      after ten years
    
    
    5,165
    
    
    5,312Mortgage-backed
      securities
    
    
    42,622
    
    
    42,564Total
      Securities
    
    $
    57,150
    
    $
    57,394
 Proceeds
from sales, maturities and principal reductions of investment securities
available-for-sale during 2004, 2003, and 2002, were $1,315, $757, and $26,
respectively. In 2004, gross gains and losses were $0 and $0, respectively. In
2003, gross gains and losses were $3 and $0, respectively. There were no gross
gains or losses reported during 2002.
 
 Proceeds
from sales and maturities and principal reductions of mortgage-backed securities
in 2004, 2003, and 2002, were $16,257, $39,752, and $20,637, respectively. In
2004, 2003, and 2002, gross gains and losses on these sales were $28 and $0, $57
and $0, and $1 and $20, respectively. Unrealized gains on investment securities
and mortgage-backed securities included in shareholders’ equity net of tax at
December 31, 2004, 2003, and 2002 were $147, $98, and $562,
respectively.
 
 Securities
having a carrying value and a fair value of approximately $34,672 and $44,101 at
December 31, 2004 and 2003, respectively, were pledged to secure public deposits
and for other purposes as required by law.
 
  F-15
 ******HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share
amounts)******
 ****
 **Note
#2 - Investment Securities, Continued**
 
 In January 2003, the FASB issued the Emerging
Information Task Force Issue 03-1, *“The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investors”*(“EITF
03-1”), and in March 2004, FASB issued an update. EITF 03-1 addresses the
meaning of other-than-temporary impairment and its application to certain debt
and equity securities. EITF 03-1 aids in the determination of impairment of an
investment and gives guidance as to the measurement of impairment loss and the
recognition and disclosures of other-than-temporary investments. EITF 03-1 also
provides a model to determine other-than-temporary impairment using
evidence-based judgment about the recovery of the fair value up to the cost of
the investment by considering the severity and duration of the impairment in
relation to the forecasted recovery of the fair value. The March 2004 update to
EITF 03-1 includes application guidance as to the determination of impairment,
disclosures required by an impairment, and guidance for the transition period
and effective dates of disclosure requirements. In March 2004, the FASB also
issued two proposed FASB Staff Positions (“FSP”): FSP EITF Issue 03-1-a, which
gives additional guidance on the determination of impairment for debt securities
impaired because of interest rate and/or sector spread increases, and FSP EITF
Issue03-1-b,which delays the disclosure effective date for debt securities impaired
because of interest rate and/or sector spread increases. The comment deadline
for the proposed FSPs was October 29, 2004, and the application and effective
dates of portions of EITF 03-1 are deferred until the issuance of FSP EITF Issue
03-1-a and FSP EITF Issue 03-1-b, which could be as early as November 2004.The
adoption of EITF 03-1 and FSP EITF Issues 03-1-a and 03-1-b are not expected to
have a material impact on the financial condition or operating results of the
Company.
  Those
investment securities available for sale which have an unrealized loss position
at December 31, 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
    
    UnrealizedValue
    
    Loss
    
    Value
    
    Loss
    
    Value
    
    LossObligations
      of U.S. Governmentagencies
      and corporations
    
    $
    497
    
    $
    3
    
    $
    841
    
    $
    27
    
    $
    1,338
    
    $
    30Mortgage-backed
      securities
    
    
    13,951
    
    
    74
    
    
    9,691
    
    
    181
    
    
    23,642
    
    
    255Obligations
      of state and politicalsubdivisions
    
    
    879
    
    
    2
    
    
    811
    
    
    84
    
    
    1,690
    
    
    86Other
      securities
    
    
    -
    
    
    -Total
    
    $
    15,327
    
    $
    79
    
    $
    11,343
    
    $
    292
    
    $
    26,670
    
    $
    371
 Management
does not believe that any individual unrealized loss as of December 31, 2004
represents an other-than-temporary impairment. The unrealized losses reported
for mortgage-backed securities relate primarily to securities issued by FNMA,
FHLMC and GNMA. These unrealized losses are primarily attributable to changes in
interest rates and were individually not significant to their respective
amortized cost.
 ****
 F-16
 ******HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share
amounts)******
 ****
 **Note
#3 - Loans**
 
 Major
classifications of loans were:
 
 2004
    
    2003Commercial,
      financial and agricultural
    
    $
    49,584
    
    $
    49,024Real
      Estate - construction
    
    
    66,833
    
    
    47,720Real
      Estate - other
    
    
    217,473
    
    
    175,880Installment
      loans to individuals
    
    
    5,538
    
    
    5,173All
      other loans (including overdrafts)
    
    
    265
    
    
    338339,693
    
    
    278,135Less:
      Deferred loan fees
    
    
    (1,482
    )
    
    (1,014
    )Less:
      Allowance for loan losses
    
    
    (3,247
    )
    
    (3,070
    )Total
      Loans
    
    $
    334,964
    
    $
    274,051Loans
      held for sale
    
    $
    2,253
    
    $
    4,402
 Concentration
of Credit Risk
 
 At
December 31, 2004 and 2003, approximately $284,306 and $223,600 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 $3.5 million, $6.9
million and $2.8 million at December 31, 2004, 2003 and 2002, respectively.
 
 F-17
 ****HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share
amounts)****
 
 **Note
#3 - Loans, Continued**
 
 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:
 2004
    
    2003
    
    2002Impaired
      loans with a valuation allowance
    
    $
    821
    
    $
    1,475
    
    $
    1,326Impaired
      loans without a valuation allowance
    
    
    113
    
    
    158
    
    
    20Total
      impaired loans
    
    $
    934
    
    $
    1,633
    
    $
    1,346Valuation
      allowance related to impaired loans
    
    $
    453
    
    $
    528
    
    $
    725Average
      recorded investment in impaired loans
    
    $
    1,076
    
    $
    1,100
    
    $
    1,526Cash
      receipts applied to reduce principal balance
    
    $
    110
    
    $
    132
    
    $
    520Interest
      income recognized for cash payments
    
    $
    48
    
    $
    25
    
    $
    313
 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.
 
 Non-accruing
loans totaled approximately $872 and $1,586 at December 31, 2004 and 2003,
respectively. As of December 31, 2004 and 2003, 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 $126, $132,
and $135, in 2004, 2003, and 2002, respectively. No additional funds are
committed to be advanced in connection with impaired loans.
 
 At
December 31, 2004 and 2003, the Bank had $0 and $21, respectively, in loans past
due 90 days or more and still accruing interest.
 
 At
December 31, 2004, loans totaling approximately $62 of which $39 are included in
non-accrual loans, were classified as troubled debt restructurings.
 
 **Note
#4 - Allowance for Loan Losses**
 
 Transactions
in the allowance for loan losses are summarized as follows:
 
 2004
    
    2003
    
    2002Balance,
      Beginning of Year
    
    $
    3,070
    
    $
    2,336
    
    $
    1,744Additions
      charged to operating expense
    
    
    410
    
    
    370
    
    
    545Loans
      charged off
    
    
    (236
    )
    
    (466
    )
    
    (81
    )Recoveries
      of loans previously charged off
    
    
    3
    
    
    233
    
    
    128Credit
      from purchase of Hacienda Bank
    
    
    -
    
    
    597
    
    
    -Balance,
      End of Year
    
    $
    3,247
    
    $
    3,070
    
    $
    2,336
  **Note
#5 - Property, Premises and Equipment**
 
 Property,
premises and equipment consisted of the following:
 2004
    
    2003Land
    
    $
    4,051
    
    $
    2,598Building
      and improvements
    
    
    7,966
    
    
    7,455Furniture
      and equipment
    
    
    5,654
    
    
    5,031Construction
      in progress
    
    
    352
    
    
    2,05118,023
    
    
    17,135Less:
      Accumulated depreciation and amortization
    
    
    7,640
    
    
    7,261Total
    
    $
    10,383
    
    $
    9,874
 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 $3,000,
as of December 31, 2004.
  F-18
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
31, 2004, 2003, AND 2002**
 **(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,
    
    Amount2005
    
    $
    7122006
    
    
    6062007
    
    
    5642008
    
    
    5142009
    
    
    302More
      than 5 years
    
    
    555Total
    
    $
    3,253
  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, 2004, 2003, and 2002, were approximately $622, $435, and $423,
respectively.
 
 **Note
#6 - Intangible Assets**
 
 Intangible
assets consisted of core deposit intangibles subject to amortization with a net
carrying value of $2,021 and $2,442, net of $510 and $89 accumulated
amortization as of December 31, 2004 and 2003, respectively. Amortization
expense for the periods ended December 31, 2004, 2003, and 2002 was $421, $41,
and $43, respectively. The estimated future amortization expense for the next
seven years is $573 for 2005, $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, 2004, the Banks had time certificates of deposit with maturity
distributions as follows:
 
 Year
      EndingDecember
      31,2005
    
    $
    40,7602006
    
    
    17,2872006
    
    
    1,5112007
    
    
    1,413$
    60,971
 
 F-19
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
31, 2004, 2003, AND 2002**
 **(Dollars
in thousands, except per share amounts)**  ****
 **Note
#8 - Borrowings**
 
 The Bank
has borrowing lines with correspondent banks totaling $7 million.
 
 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 $28.5 million that
matures in April 2005 with a weighted average interest rate of 3.47%. These are
collateralized by loans and securities, respectively. In addition, the Bank has
an $11.7 million letter of credit secured by loans. At December 31, 2004, the
Bank has a remaining borrowing capacity with existing collateral of
approximately $66.1 million and $3.8 million secured by loans and securities,
respectively.
 
 The Bank
has pledged approximately $191.7 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, 2004 and 2003, the Bank
had $766 and $460 in securities sold under agreements to repurchase. Interest
expense recorded was $8, $2, and $7 for the years ended December 31, 2004, 2003,
and 2002, respectively. The carrying value of underlying securities provided as
collateral for these transactions was $924 and $852 at December 31, 2004 and
2003, respectively.
 
 Notes
Payable
 
 On
October 10, 2003, the Company obtained 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, 2005 at which time the line converts to an
eight-year term loan maturing on October 10, 2013. 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. A
principal reduction of $3,500 was made in July 2004 and at December 31, 2004,
the outstanding balance owed was $0.
 
 F-20
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
31, 2004, 2003, AND 2002**
 **(Dollars
in thousands, except per share amounts)**
 **Note
#8 - Borrowings, Continued**
 
 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 6.00% as of December 31, 2004. The debt securities can be called at any
time commencing on April 22, 2007, at par. The debt securities can also be
redeemed at par if certain events occur that impact the tax treatment 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, 2004, the Company
has included the net junior subordinated debt in its Tier1 Capital for
regulatory capital purposes.
 ****
 **Note
#9 - Income Taxes**
 
 The
current and deferred amounts of the provision (benefit) for income taxes
were:
 
 Year
      Ending December 31,2004
    
    2003
    
    2002Federal
      Income TaxCurrent
    
    $
    2,031
    
    $
    1,611
    
    $
    1,390Deferred
    
    
    16
    
    
    (82
    )
    
    (247
    )Total
      Federal Taxes
    
    
    2,047
    
    
    1,529
    
    
    1,143State
      Franchise TaxCurrent
    
    
    706
    
    
    630
    
    
    651Deferred
    
    
    6
    
    
    (42
    )
    
    (145
    )Total
      State Franchise Tax
    
    
    712
    
    
    588
    
    
    506Total
      Income Taxes
    
    $
    2,759
    
    $
    2,117
    
    $
    1,649
 
 F-21
 ****HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share
amounts)****
 **Note
#9 - Income Taxes, Continued**
 
 The
provision for taxes on income differed from the amounts computed using the
federal statutory tax rate of 34 percent is as follows:
 
 2004
    
    2003
    
    2002Amount
    
    Percent
    
    Amount
    
    Percent
    
    Amount
    
    PercentTax
      provision at federal statutory tax rate
    
    $
    2,497
    
    
    34.0
    
    $
    1,942
    
    
    34.0
    
    $
    1,492
    
    
    34.0State
      income taxes, net of federalincome
      tax benefit
    
    
    507
    
    
    6.9
    
    
    388
    
    
    6.8
    
    
    333
    
    
    7.6Tax
      exempt income and other, Net
    
    
    (245
    )
    
    (3.4
    )
    
    (213
    )
    
    (3.7
    )
    
    (176
    )
    
    (4.0
    )Total
      Tax Provision
    
    $
    2,759
    
    
    37.5
    
    $
    2,117
    
    
    37.1
    
    $
    1,649
    
    
    37.6
 The net
deferred tax asset is determined as follows:
 2004
    
    2003Deferred
      Tax AssetsReserves
      for loan losses
    
    $
    1,152
    
    $
    1,050Fixed
      assets
    
    
    280
    
    
    250Accruals
    
    
    667
    
    
    709Investment
      securities valuation
    
    
    -
    
    
    67Deferred
      Fees
    
    
    248
    
    
    -Net
      operating loss carryforward
    
    
    821
    
    
    590Total
      Deferred tax assets arising from cumulativetiming
      differences
    
    
    3,168
    
    
    2,666Total
      Deferred Tax Assets
    
    $
    3,168
    
    $
    2,666Deferred
      Tax LiabilitiesFair
      value adjustment for purchased assets
    
    $
    718
    
    $
    695Investment
      securities valuation
    
    
    98
    
    
    -Deferred
      costs, prepaids and FHLB
    
    
    434
    
    
    -Total
      Deferred Tax Liabilities
    
    
    1,250
    
    
    695Net
      Deferred Tax Assets
    
    $
    1,918
    
    $
    1,971
 As part
of a transaction with Hacienda Bank, the Company has approximately $1,996,000 of
net operating losses (NOL) available for carry forward at December 31, 2004. 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.
 
 F-22
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
31, 2004, 2003, AND 2002**
 **(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, 2004 and 2003, the Bank had the following outstanding financial
commitments whose contractual amount represents credit risk:
 2004
    
    2003Commitments
      to extend credit
    
    $
    123,470
    
    $
    93,127Standby
      letters of credit
    
    
    17,599
    
    
    3,372$
    141,069
    
    $
    96,499
 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.
 
 F-23
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
31, 2004, 2003, AND 2002**
 **(Dollars
in thousands, except per share amounts)**
 **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, 2004, 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:
 
 F-24
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
31, 2004, 2003, AND 2002**
 **(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, 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
      of December 31, 2003**Total
      capital to risk-weighted assets:Company
    
    $
    36,042
    
    
    11.14
    %
    $
    25,886
    
    
    8.0
    %
    
    N/A
    
    
    N/AHeritage
      Oaks Bank
    
    
    31,061
    
    
    11.78
    %
    
    21,088
    
    
    8.0
    %
    $
    26,360
    
    
    10.0
    %Hacienda
      Bank
    
    
    6,389
    
    
    10.65
    %
    
    4,798
    
    
    8.0
    %
    $
    5,998
    
    
    10.0
    %Tier
      1 capital to risk-weighted assets:Company
    
    
    32,845
    
    
    10.15
    %
    
    12,943
    
    
    4.0
    %
    
    N/A
    
    
    N/AHeritage
      Oaks Bank
    
    
    28,516
    
    
    10.82
    %
    
    10,544
    
    
    4.0
    %
    
    15,816
    
    
    6.0
    %Hacienda
      Bank
    
    
    5,737
    
    
    9.57
    %
    
    2,399
    
    
    4.0
    %
    
    3,599
    
    
    6.0
    %Tier
      1 capital to average assets:Company
    
    
    32,845
    
    
    8.30
    %
    
    15,823
    
    
    4.0
    %
    
    N/A
    
    
    N/AHeritage
      Oaks Bank
    
    
    28,516
    
    
    8.61
    %
    
    13,242
    
    
    4.0
    %
    
    16,552
    
    
    5.0
    %Hacienda
      Bank
    
    
    5,737
    
    
    7.21
    %
    
    3,183
    
    
    4.0
    %
    
    3,979
    
    
    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.
 
 F-25
 ****HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share amounts)******
**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 $913 and $695 at December 31, 2004 and 2003,
respectively, and are included in other liabilities in the Company’s
Consolidated Financial Statements. The Company maintains life insurance
policies, which are intended to fund all costs of the plan. The cash surrender
values of these life insurance policies totaled approximately $7,130 and $6,859,
at December 31, 2004 and 2003, respectively.
 
 **Note
#13 - Employee Benefit Plans**
 
 401(k)
Pension Plan
 
 During
1994, the Company established a savings plan for employees that allows
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 $93, $74, and $64, for the years ended December
31, 2004, 2003, and 2002, 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 $206 in 2004, $162 in 2003,
and $125 in 2002.
 
 
 F-26
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
31, 2004, 2003, AND 2002**
 **(Dollars
in thousands, except per share amounts)**
 **Note
#14 - Stock Option Plans**
 
 At
December 31, 2004, 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 2002, 2003, or 2004.
 
 The
following tables summarize information about the 1990 stock option plan
outstanding at December 31, 2004.
 
 2004
    
    2003
    
    2002Weighted-
    
    
    
    Weighted-
    
    
    
    Weighted-Average
    
    
    
    Average
    
    
    
    AverageExercise
    
    
    
    Exercise
    
    
    
    ExerciseShares
    
    Price
    
    Shares
    
    Price
    
    Shares
    
    PriceOutstanding
      at beginning of year
    
    
    2,241
    
    $
    4.02
    
    
    2,241
    
    $
    4.02
    
    
    37,563
    
    $
    1.59GrantedCancelled
    
    
    -
    
    $
    -
    
    
    -
    
    $
    -
    
    
    -
    
    $
    -Exercised
    
    
    (250
    )
    $
    4.02
    
    
    -
    
    $
    -
    
    
    (35,322
    )
    $
    1.44Outstanding
      at end of year
    
    
    1,991
    
    $
    4.02
    
    
    2,241
    
    $
    4.02
    
    
    2,241
    
    $
    4.02Options
      available for granting atend
      of year
    
    
    -
    
    
    
    
    
    -
    
    
    
    
    
    -Options
      exercisable at year-end
    
    
    1,991
    
    $
    4.02
    
    
    2,241
    
    $
    4.02
    
    
    2,241
    
    $
    4.02Weighted-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$
      4.02
    
    
    1,991
    
    
    2.53
    
    $4.02
    
    1,991
    
    $4.02
  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.
 
 F-27
 ****HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share
amounts)****
 **Note
#14 - Stock Option Plans, Continued**
 
 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.
 
 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 2004,
2003, and 2002, respectively: risk-free rates of 4.22 percent, 4.58 percent, and
3.73 percent, dividend yields of 0 percent for all years presented, expected
life of 10 years, 10 years, and 8 years; and volatility of 24 percent, 24
percent, and 26 percent.
 
 The
following summarizes information about the 1997 stock option plan outstanding at
December 31, 2004.
 
 2004
    
    2003
    
    2002Weighted-
    
    
    
    Weighted-
    
    
    
    Weighted-Average
    
    
    
    Average
    
    
    
    AverageExercise
    
    
    
    Exercise
    
    
    
    ExerciseShares
    
    Price
    
    Shares
    
    Price
    
    Shares
    
    PriceOutstanding
      at beginning of year
    
    
    470,003
    
    $
    6.13
    
    
    424,143
    
    $
    5.24
    
    
    458,484
    
    $
    4.91Granted
    
    
    55,275
    
    $
    17.06
    
    
    134,445
    
    $
    8.35
    
    
    19,294
    
    $
    10.69Cancelled
    
    
    (23,217
    )
    $
    12.84
    
    
    (12,491
    )
    $
    7.19
    
    
    (22,280
    )
    $
    4.27Exercised
    
    
    (33,375
    )
    $
    5.92
    
    
    (76,095
    )
    $
    4.98
    
    
    (31,354
    )
    $
    4.33Outstanding
      at end of year
    
    
    468,686
    
    $
    7.10
    
    
    470,003
    
    $
    6.13
    
    
    424,143
    
    $
    5.24Options
      available for grant end of year
    
    
    39,166
    
    
    
    
    
    71,224
    
    
    
    
    
    193,178Options
      exercisable at year-end
    
    
    392,874
    
    $
    5.62
    
    
    391,909
    
    $
    5.46
    
    
    321,878
    
    $
    4.62Weighted-average
      fair value ofoptions
      granted during the year
    
    $
    7.70
    
    
    
    
    $
    6.17
    
    
    
    
    $
    4.25
 
 Options
      Outstanding
    
    Options
      ExercisableWeighted-
    
    Weighted-
    
    
    
    Weighted-Average
    
    Average
    
    
    
    AverageExercise
    
    Number
    
    Remaining
    
    Exercise
    
    Number
    
    ExercisePrice
    
    Outstanding
    
    Contractual
      Life
    
    Price
    
    Exercisable
    
    Price$
      4.02-$ 6.86
    
    
    313,888
    
    
    3.57
      Years
    
    $
    4.96
    
    
    308,535
    
    $
    4.94$
      7.04-$ 9.23
    
    
    73,263
    
    
    5.47
      Years
    
    $
    7.34
    
    
    69,130
    
    $
    7.35$10.20-$13.29
    
    
    26,785
    
    
    7.56
      Years
    
    $
    11.22
    
    
    15,209
    
    $
    11.62$16.19-$19.20
    
    
    54,750
    
    
    9.20
      Years
    
    $
    17.07
    
    
    -
    
    $
    -468,686
    
    
    
    
    
    
    
    
    392,874
  F-28
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
31, 2004, 2003, AND 2002**
 **(Dollars
in thousands, except per share amounts)**
 ****
 **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.
 
 An
analysis of loans to directors and executive officers is as
follows:
  2004
    
    2003Outstanding
      Balance, Beginning of Year
    
    $
    6,351
    
    $
    1,472Additional
      loans made
    
    
    2,214
    
    
    3,348Acquisition
      of Hacienda Bank
    
    
    -
    
    
    4,380Repayments
    
    
    (3,352
    )
    
    (2,849
    )Outstanding
      Balance, End of Year
    
    $
    5,213
    
    $
    6,351
 Deposits
from related parties held by the Bank at December 31, 2004 and 2003 amounted to
approximately $3,280 and $5,276, 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.
 
 F-29
 ****HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share
amounts)****
 ****
 **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.
 
 The
estimated fair value of financial instruments at December 31 is summarized as
follows:
 
 **2004
    
    2003Carrying
    
    
    
    CarryingAmount
    
    Fair
      Value
    
    Amount
    
    Fair
      ValueAssetsCash
      and cash equivalents
    
    $
    21,867
    
    $
    21,867
    
    $
    77,114
    
    $
    77,114Interest-bearing
      deposits
    
    
    498
    
    
    498
    
    
    498
    
    
    498Investments
      and mortgage-backed securities
    
    
    57,394
    
    
    57,394
    
    
    54,956
    
    
    54,956FHLB
      stock
    
    
    1,809
    
    
    1,809
    
    
    1,959
    
    
    1,959Loans
      receivable, net
    
    
    338,211
    
    
    337,638
    
    
    277,121
    
    
    278,131Loans
      held for sale
    
    
    2,253
    
    
    2,253
    
    
    4,402
    
    
    4,402Accrued
      interest receivable
    
    
    1,654
    
    
    1,654
    
    
    1,485
    
    
    1,485LiabilitiesNoninterest-bearing
      deposits
    
    
    143,455
    
    
    143,455
    
    
    137,859
    
    
    137,859Interest-bearing
      deposits
    
    
    226,986
    
    
    227,039
    
    
    228,580
    
    
    228,914FHLB
      advances
    
    
    28,500
    
    
    28,950
    
    
    28,500
    
    
    28,560Securities
      sold under repurchase agreements
    
    
    766
    
    
    766
    
    
    460
    
    
    460Notes
      payable
    
    
    -
    
    
    -
    
    
    3,500
    
    
    3,500Junior
      Subordinated Debentures
    
    
    8,248
    
    
    8,248
    
    
    8,248
    
    
    8,248Accrued
      interest payable
    
    
    407
    
    
    407
    
    
    506
    
    
    506Notional
    
    
    Cost
      to Cede
    
    
    Notional
    
    
    Cost
      to CedeAmount
    
    
    or
      Assume
    
    
    Amount
    
    
    or
      AssumeOff-Balance
      Sheet InstrumentsCommitments
      to extend credit andstandby
      letters of credit
    
    $
    141,069
    
    $
    1,411
    
    $
    96,499
    
    $
    965

F-30**
 ****HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share
amounts)****
 ****
 **Note
#17 - Fair Value of Financial Instruments, Continued**
 
 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.
 
 ·
    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.
 ****
 F-31
 ****HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share
amounts)****
 ****
 **Note
#17 - Fair Value of Financial Instruments, Continued**
 
 ·
    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.
 
 ·
    Notes
      Payable and Junior Subordinated
Debentures
 
 The fair
value disclosed for notes payable and junior subordinated debentures is based on
carrying amounts. The notes 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.
 
 **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.
 
 2004
    
    2003
    
    2002Net
    
    
    
    Net
    
    
    
    NetIncome
    
    Shares
    
    Income
    
    Shares
    
    Income
    
    SharesNet
      income as reported
    
    $
    4,584
    
    
    
    
    $
    3,596
    
    
    
    
    $
    2,739Shares
      outstanding at year-end
    
    
    
    
    
    3,817,943
    
    
    
    
    
    3,784,318
    
    
    
    
    
    3,070,768Impact
      of weighting sharespurchased
      during the year
    
    
    
    
    
    (14,452
    )
    
    
    
    
    (573,492
    )
    
    
    
    
    (11,872
    )Used
      in Basic EPS
    
    
    4,584
    
    
    3,803,491
    
    
    3,596
    
    
    3,210,826
    
    
    2,739
    
    
    3,058,896Dilutive
      effect of outstandingstock
      options
    
    
    
    
    
    282,076
    
    
    
    
    
    221,946
    
    
    
    
    
    271,146Used
      in Dilutive EPS
    
    $
    4,584
    
    
    4,085,567
    
    $
    3,596
    
    
    3,432,772
    
    $
    2,739
    
    
    3,330,041
 ****
 F-32
 ****HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
**DECEMBER
31, 2004, 2003, AND 2002**
**(Dollars
in thousands, except per share
amounts)****
 ****
 **Note
#19 - Other Income/Expense**
 
 The
following is a breakdown of fees and other income and expenses for the years
ended December 31, 2004, 2003, and 2002:
 
 2004
    
    2003
    
    2002Fees
      and Other IncomeATM/Debit
      Card Transaction/Interchange Fees
    
    $
    583
    
    $
    406
    
    $
    494Bankcard
      merchant fees
    
    
    116
    
    
    100
    
    
    123Mortgage
      origination fees
    
    
    602
    
    
    880
    
    
    767Earnings
      on cash surrender value oflife
      insurance policies
    
    
    294
    
    
    264
    
    
    304Other
    
    
    491
    
    
    364
    
    
    361$
    2,086
    
    $
    2,014
    
    $
    2,049Other
      ExpensesData
      processing
    
    $
    2,570
    
    $
    1,581
    
    $
    1,416Advertising
      and promotional
    
    
    515
    
    
    361
    
    
    380Regulatory
      fees
    
    
    114
    
    
    86
    
    
    62Other
      professional fees and outside services
    
    
    530
    
    
    432
    
    
    416Legal
      fees and other litigation expenses
    
    
    76
    
    
    52
    
    
    106Loan
      department costs
    
    
    181
    
    
    255
    
    
    204Stationery
      and supplies
    
    
    374
    
    
    249
    
    
    231Director
      fees
    
    
    179
    
    
    152
    
    
    165Core
      deposit amortization
    
    
    421
    
    
    41
    
    
    41Other
    
    
    1,212
    
    
    961
    
    
    1,001Total
    
    $
    6,172
    
    $
    4,170
    
    $
    4,022
 
 
 F-33
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
31, 2004, 2003, AND 2002**
 **(Dollars
in thousands, except per share amounts)**
 
 **Note
#20 - Stock Dividends and Stock Splits**
 
 On
February 22, 2002, the Board of Directors declared a five percent stock dividend
payable on March 29, 2002 to stockholders of record on March 8, 2002. Cash was
paid in lieu of fractional shares at the rate of $26.00 per share and amounted
to $6.
 
 On July
19, 2002, the Board of Directors declared a two-for-one stock split payable on
August 15, 2002 to stockholders of record on August 2, 2002.
 
 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.
 
 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.
 
 
 F-34
 
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
31, 2004, 2003, AND 2002**
 **(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.
  F-35
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
31, 2004, 2003, AND 2002**
 **(Dollars
in thousands, except per share amounts)**
 **Note
#22 - Condensed Financial Information of Heritage Oaks Bancorp (Parent
Company)**
 
 **Balance
      Sheets**2004
    
    2003**Assets**Cash
    
    $
    293
    
    $
    290Federal
      funds sold
    
    
    775
    
    
    650Total
      cash and cash equivalents
    
    
    1,068
    
    
    940Prepaid
      and other assets
    
    
    387
    
    
    639Property
      and premises
    
    
    625
    
    
    618Investment
      in subsidiaries
    
    
    43,533
    
    
    41,944Total
      Assets
    
    $
    45,613
    
    $
    44,141**Liabilities
      and Stockholders' Equity**Notes
      payable
    
    $
    -
    
    $
    3,500Junior
      subordinated debentures
    
    
    8,248
    
    
    8,248Other
      liabilities
    
    
    115
    
    
    105Total
      Liabilities
    
    
    8,363
    
    
    11,853Stockholders'
      EquityCommon
      stock
    
    
    24,050
    
    
    20,649Retained
      earnings
    
    
    13,200
    
    
    11,639Total
      Stockholders' Equity
    
    
    37,250
    
    
    32,288Total
      Liabilities andStockholders'
      Equity
    
    $
    45,613
    
    $
    44,141
 
   F-36
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
31, 2004, 2003, AND 2002**
 **(Dollars
in thousands, except per share amounts)**
  **Note
#22 - Condensed Financial Information of Heritage Oaks Bancorp (Parent Company),** **Continued**
 
 **Statements
      of Income**2004
    
    2003
    
    2002**Income**Equity
      in undisbursed income of subsidiaries
    
    $
    5,039
    
    $
    3,943
    
    $
    3,032Interest
      income
    
    
    21
    
    
    21
    
    
    16Other
    
    
    57
    
    
    57
    
    
    57Total
      Income
    
    
    5,117
    
    
    4,021
    
    
    3,105**Expense**Salary
      expense
    
    
    75
    
    
    77
    
    
    71Equipment
      expense
    
    
    15
    
    
    15
    
    
    15Other
      professional fees and outside services
    
    
    130
    
    
    56
    
    
    28Interest
      expense
    
    
    517
    
    
    449
    
    
    384Other
    
    
    112
    
    
    69
    
    
    72Total
      Expense
    
    
    849
    
    
    666
    
    
    570Total
      Operating Income
    
    
    4,268
    
    
    3,355
    
    
    2,535Income
      tax benefit
    
    
    (316
    )
    
    (241
    )
    
    (204
    )Net
      Income
    
    $
    4,584
    
    $
    3,596
    
    $
    2,739
  F-37
 **HERITAGE
OAKS BANCORP AND SUBSIDIARIES**
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
31, 2004, 2003, AND 2002**
 **(Dollars
in thousands, except per share amounts)**
  **Note
#22 - Condensed Financial Information of Heritage Oaks Bancorp (Parent Company),** **Continued**
 
 **Statements
      of Cash Flows**2004
    
    2003
    
    2002**Cash
      Flows From Operating Activities**Net
      income
    
    $
    4,584
    
    $
    3,596
    
    $
    2,739Adjustments
      to Reconcile Net Income to Net CashProvided
      By/(Used in) Operating ActivitiesDepreciation
    
    
    15
    
    
    15
    
    
    15Increase
      in other assets
    
    
    229
    
    
    129
    
    
    (48
    )Increase
      in other liabilities
    
    
    10
    
    
    18
    
    
    72Undistributed
      income of subsidiaries
    
    
    (5,039
    )
    
    (3,943
    )
    
    (3,032
    )Net
      Cash Used In Operating Activities
    
    
    (201
    )
    
    (185
    )
    
    (254
    )**Cash
      Flows From Investing Activities**Contribution
      to subsidiaries
    
    
    -
    
    
    (3,960
    )
    
    (5,448
    )Net
      Cash Used In Investing Activities
    
    
    -
    
    
    (3,960
    )
    
    (5,448
    )**Cash
      Flows From Financing Activities**Cash
      dividends received
    
    
    3,500
    
    
    -
    
    
    -Cash
      paid in lieu of fractional shares
    
    
    (6
    )
    
    (4
    )
    
    (6
    )Increase/(decrease)
      in notes payable
    
    
    (3,500
    )
    
    3,500
    
    
    (1,895
    )Issuance
      of junior subordinated debentures
    
    
    -
    
    
    -
    
    
    8,248Proceeds
      from the sale of stock
    
    
    -
    
    
    67
    
    
    -Proceeds
      from the exercise of options
    
    
    335
    
    
    379
    
    
    487Net
      Cash Provided ByFinancing
      Activities
    
    
    329
    
    
    3,942
    
    
    6,834**Net
      Increase/(Decrease) in Cash****and
      Cash Equivalents**
    
    
    128
    
    
    (203
    )
    
    1,132**Cash
      and Cash Equivalents**,
      Beginning of Year
    
    
    940
    
    
    1,143
    
    
    11**Cash
      and Cash Equivalents**,
      End of Year
    
    $
    1,068
    
    $
    940
    
    $
    1,143
 
 F-38
 
 I TEM 8.  CHANGES
WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
 
 None
 
 ITEM
8A.  CONTROLS
AND PROCEDURES
 
 (a)
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.
 
 (b)
During the quarter ended December 31, 2004, 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
8B.  OTHER
INFORMATION
  NONE
 PART
III
 
 ITEM
9.  DIRECTORS,
EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
 
 The
information required by Item 9 of Form 10-KSB is incorporated by reference from
the information contained in the Company’s Proxy Statement for the 2004 Annual
Meeting of Shareholders which will be filed pursuant to Regulation 14A.
 
 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-B 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.
 
 ITEM
10.  EXECUTIVE
COMPENSATION
 
 The
information required by Item 10 of Form 10-KSB is incorporated by reference from
the information contained in the Company’s Proxy Statement for the 2004 Annual
Meeting of Shareholders which will be filed pursuant to Regulation 14A.
 
 ITEM
11.  SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
 The
information required by Item 11 of Form 10-KSB is incorporated by reference from
the information contained in the Company’s Proxy Statement for the 2004 Annual
Meeting of Shareholders which will be filed pursuant to Regulation 14A.
 
 39
 
 ITEM
12.  CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS
 
 The
information required by Item 12 of Form 10-KSB is incorporated by reference from
the information contained in the Company’s Proxy Statement for the 2004 Annual
Meeting of Shareholders which will be filed pursuant to Regulation 14A.
 
 ITEM
13.  EXHIBITS
AND REPORTS ON FORM 8-K
 
 (a)
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.
  
 40
  (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.
   (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.
   41
 (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.
   (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.
  
 42
  (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.
   (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.
   (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
   ITEM
14.  PRINCIPAL
ACCOUNTANT FEES AND SERVICES
 
 The
information required by Item 14 of Form 10-KSB is incorporated by reference from
the information contained in the Company’s Proxy Statement for the 2004 Annual
Meeting of Shareholders which will be filed pursuant to Regulation
14A.
 43
 
 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. WARD
      President and Chief Executive OfficerDated:March
      23, 2005
    
    
    MARGARET A.
      TORRESExecutive Vice Pres and Chief Financial OfficerDated:March
      23, 2005
 
 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
      23, 2005B.R.
      BRYANT/s/
      Donald H. Campbell
    Vice
      Chairman
    March
      23, 2005DONALD
      H. CAMPBELL
    of
      the Board of Directors/s/
      Kenneth Dewar
    Director
    March
      23, 2005KENNETH
      DEWAR/s/
      Mark C. Fugate
    Director
    March
      23, 2005MARK
      C. FUGATE/s/
      Dolores T. Lacey
    Director
    March
      23, 2005DOLORES
      T. LACEY/s/
      Merle F. Miller
    Director
    March
      23, 2005MERLE
      F. MILLER/s/
      Michael Morris
    Director
    March
      23, 2005MICHAEL
      MORRIS/s/
      Daniel J. O’Hare
    Director
    March
      23, 2005DANIEL
      J. O’HARE/s/
      Alex Simas
    Director
    March
      23, 2005ALEX
      SIMAS/s/
      Ole K. Viborg
    Director
    March
      23, 2005OLE
      K. VIBORG/s/
      Lawrence P. Ward
    Director
    March
      23, 2005LAWRENCE
      P. WARD
 
 44
 
 EXHIBIT
INDEX
 
 ExhibitSequentialNumber
    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