UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

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

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

Commission file number 000-29829

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


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

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

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

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

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

Indicate by check mark whether the registrant is a well known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes_____ No X

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 14(d) of the Exchange Act. Yes_____ No X

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

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

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

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

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

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

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

DOCUMENTS INCORPORATED BY REFERENCE

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

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


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

PART I

Forward Looking Information

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

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

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

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

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

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

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

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

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

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

ITEM 1. Business

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

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

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

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

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

The Bank

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

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

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

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

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

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

Competition

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

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

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

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

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

Employees

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

Supervision and Regulation

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

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

The Company

General

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

Bank Holding Company Regulation

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

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

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

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

Financial Services Modernization Act

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

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

The FSMA and related regulations also:

•

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

•

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

•

modified the laws governing the implementation of the Community Reinvestment Act.

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

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

USA Patriot Act of 2001

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

Sarbanes-Oxley Act of 2002

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

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

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

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

Transactions With Affiliates

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

Regulation of Management

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

Tie-In Arrangements

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

State Law Restrictions

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

The Bank

General

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

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

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

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

Interstate Banking and Branching

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

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

Deposit Insurance

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

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

Dividends

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

Capital Adequacy

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

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

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

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

Effects of Government Monetary Policy

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

ITEM 1A. Risk Factors

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

Future loan losses may exceed our allowance for loan losses.

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

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

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

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

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

The financial services industry is very competitive

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

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

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

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

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

ITEM 1B. Unresolved Staff Comments

None

ITEM 2. Properties

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

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

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

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

ITEM 3. Legal Proceedings

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

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

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

PART II

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

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

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

		2005 High		Low			2004 High (1)		Low (1)
First Quarter	61,423	$	17.62	$	15.77	23,970	$	17.25	$	17.00
Second Quarter	188,900	$	16.00	$	13.60	85,362	$	17.50	$	15.25
Third Quarter	74,500	$	16.60	$	14.10	79,510	$	17.50	$	16.25
Fourth Quarter	47,900	$	16.00	$	13.84	8,638	$	17.50	$	17.00

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

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

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

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

ITEM 6. Selected Financial Data

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

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

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

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

	2005			2004			2003			2002			2001
	($ in thousands, except per share data)
Operations Data
Net interest income	$	22,284		$	19,520		$	12,541		$	11,788		$	11,572
Provision for credit losses		1,100			970			—			954			580
Noninterest income		4,081			3,162			1,846			2,059			1,529
Noninterest expense		16,566			13,555			7,945			7,414			7,193
Provision for income taxes		2,653			2,450			1,863			1,563			1,521
Net income		6,046			5,707			4,579			3,916			3,807
Net income per share:
Basic		.94			.93	(1)		.91	(1)		.79	(1)		.77	(1)
Diluted		.92			.91	(1)		.90	(1)		.78	(1)		.76	(1)

Dividends declared		4,719			4,624			3,530			3,392			3,289
Dividends declared per share		.73			.72	(1)		.70	(1)		.68	(1)		.66	(1)
Dividends paid ratio		78	%		81	%		77	%		87	%		86	%

Performance Ratios
Interest rate spread		5.34	%		5.37	%		4.89	%		5.18	%		5.28	%
Net interest margin (2)		5.25	%		5.25	%		4.75	%		5.05	%		5.16	%
Efficiency ratio (3)		62.83	%		59.76	%		55.22	%		53.54	%		54.90	%
Return on average assets		1.31	%		1.41	%		1.61	%		1.54	%		1.55	%
Return on average equity		12.70	%		14.21	%		17.10	%		15.81	%		15.57	%

Balance Sheet Data
Total assets	$	489,409		441,791		306,715		268,534		243,617
Loans, net		393,574		341,671		197,500		183,031		174,495
Total deposits		399,726		363,501		260,800		225,254		214,644
Other borrowings		35,790		25,233		14,500		12,800		—
Shareholders' equity		46,600		45,303		25,650		24,683		23,514
Book value per share (4)		7.21		7.06	(1)	5.09	(1)	4.91	(1)	4.72	(1)
Equity to assets ratio		9.52	%	10.25	%	8.36	%	9.19	%	9.65	%

Asset Quality Ratios
Nonperforming loans to total loans	1.67	%	.15	%	.27	%	1.00	%	.71	%
Allowance for loan losses
to total loans	1.33	%	1.23	%	1.12	%	1.33	%	1.19	%
Allowance for loan losses
to nonperforming loans	79.64	%	832.22	%	411.40	%	132.67	%	168.18	%
Nonperforming assets to total assets	1.36	%	.12	%	.18	%	.69	%	.51	%

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

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

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

(4) Shareholder equity divided by shares outstanding.

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

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

RESULTS OF OPERATIONS

Years ended December 31, 2005, 2004, and 2003

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

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

(Dollars in thousands)	2005		Increase (Decrease) Amount			2004		Increase (Decrease) Amount			2003
Interest income	$	29,631	$	5,493	22.8	$	24,138	$	8,189	51.3	$	15,949
Interest expense		7,347		2,729	59.1		4,618		1,210	35.5		3,408
Net interest income		22,284		2,764	14.2		19,520		6,979	55.6		12,541
Provision for credit losses		1,100		130	13.4		970		970	100.0		—
Net interest income after
provision for credit losses		21,184		2,634	14.2		18,550		6,009	47.9		12,541
Other operating income		4,081		919	29.1		3,162		1,316	71.3		1,846
Other operating expense		16,566		3,011	22.2		13,555		5,610	70.6		7,945
Income before income taxes		8,699		542	6.6		8,157		1,715	26.6		6,442
Income taxes		2,653		203	8.3		2,450		587	31.5		1,863
Net income		6,046		339	5.9		5,707		1,128	24.6		4,579

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

	Year Ended December 31,
(dollars in thousands)	Average Balance			2005 Interest Income (Expense)			Avg Rate			Average Balance			2004 Interest Income (Expense)			Avg Rate			Average Balance			2003 Interest Income (Expense)			Avg Rate
Assets
Earning assets:
Loans	$	371,609		$	27,652	*		7.44	%	$	315,364		$	21,881	*		6.94	%	$	188,267		$	13,381	*		7.11	%
Investment Securities:
Taxable		23,231			1,004			4.32	%		34,174			1,415			4.14	%		48,206			1,738			3.61	%
Tax-Exempt		16,313			1,018	*		6.24	%		17,795			1,165	*		6.55	%		14,721			1,050	*		7.13	%
Total investment
securities		39,544			2,022			5.11	%		51,969			2,580			4.96	%		62,927			2,788			4.43	%
Federal Home Loan Bank Stock		1,855			—			—			1,114			60			5.39	%		887			49			5.52	%
Federal funds sold and
deposits in banks		11,282			344			3.05	%		3,329			44			1.32	%		11,855			118			1.00	%
Total earning assets/interest
income	$	424,290		$	30,018			7.07	%	$	371,776		$	24,565			6.61	%	$	263,936		$	16,336			6.18	%
Cash and due from banks		10,009									9,866									7,930
Bank premises and equipment
(net)		8,180									6,200									3,780
Other assets		24,876									21,087									10,448
Allowance for credit losses		(4,818	)								(3,555	)								(2,357	)
Total assets	$	462,537								$	405,374								$	283,737
Liabilities and Shareholders' Equity
Interest bearing liabilities:
Deposits:
Savings and interest-
bearing demand	$	195,040		$	(3,089	)		1.58	%	$	155,846		$	(1,273	)		.82	%	$	112,129		$	(827	)		.74	%
Time		112,345			(3,323	)		2.96	%		112,078			(2,461	)		2.20	%		86,634			(2,096	)		2.42	%
Total deposits		307,385			(6,412	)		2.09	%		267,924			(3,734	)		1.39	%		198,763			(2,923	)		1.47	%
Short-term borrowings		69			(4	)		5.80	%		7,825			(96	)		1.23	%		—			—			—
Long-term borrowings		22,982			(768	)		3.34	%		17,000			(549	)		3.23	%		14,071			(485	)		3.45	%
Secured borrowings		2,942			(163	)		5.54	%		4,078			(239	)		5.86	%		—			—			—
Junior subordinated debentures		152			—			—			—			—			—			—			—			—
Total borrowings		26,145			(935	)		3.58	%		28,903			(884	)		3.06	%		14,071			(485	)		3.45	%
Total interest-bearing liabilities/
Interest expense	$	333,530		$	(7,347	)		2.20	%	$	296,827		$	(4,618	)		1.56	%	$	212,834		$	(3,408	)		1.60	%
Demand deposits		78,787									66,135									42,864
Other liabilities		2,600									2,258									1,253
Shareholders' equity		47,620									40,154									26,786
Total liabilities and shareholders'
equity	$	462,537								$	405,374								$	283,737
Net interest income				$	22,671*								$	19,947*								$	12,928*
Net interest income as a percentage
of average earning assets
Interest income								7.07	%								6.61	%								6.18	%
Interest expense								1.73	%								1.24	%								1.29	%
Net interest income								5.34	%								5.37	%								4.89	%
Net interest margin (1)								5.25	%								5.25	%								4.75	%
* Tax equivalent basis - 34% tax rate used
(1) Net interest income divided by average interest earning assets

Nonaccrual loans and loans held for sale are included in “loans.”

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

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

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

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

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

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

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

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

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

	2005 compared to 2004 Increase (decrease) due to									2004 compared to 2003 Increase (decrease) due to
(dollars in thousands)	Volume			Rate			Net			Volume			Rate			Net
Interest earned on:
Loans	$	4,104		$	1,667		$	5,771		$	8,798		$	(298	)	$	8,500
Securities:
Taxable		(471	)		60			(411	)		(582	)		259			(323	)
Tax-exempt		(94	)		(53	)		(147	)		206			(91	)		115
Total securities		(565	)		7			(558	)		(376	)		168			(208	)
Federal Home Loan Bank Stock		24			(84	)		(60	)		32			(21	)		11
Fed funds sold and interest
bearing deposits in other banks		194			106			300			(104	)		30			(74	)
Total interest earning assets		3,757			1,696			5,453			8,350			(121	)		8,229
Interest paid on:
Savings and interest bearing
demand deposits		(384	)		(1,432	)		(1,816	)		(350	)		(96	)		(446	)
Time deposits		(6	)		(856	)		(862	)		(572	)		207			(365	)
Total borrowings		95			(146	)		(51	)		(538	)		139			(399	)
Total interest bearing liabilities		(295	)		(2,434	)		(2,729	)		(1,460	)		250			(1,210	)
Change in net interest income		3,462			(738	)		2,724			6,890			129			7,019

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

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

(Dollars in thousands)	2005		Increase (Decrease) Amount					2004		Increase (Decrease) Amount					2003
Service charges on
deposit accounts	$	1,470	$	173		13.3	%	$	1,297	$	270		26.3	%	$	1,027
Mortgage broker fees		—		(12	)	(100.0	%)		12		(89	)	(88.1	%)		101
Income from and gains on sale of
foreclosed real estate		—		(77	)	(100.0	%)		77		51		196.2	%		26
Net gains from sales of loans		1,809		783		76.3	%		1,026		992		2917.7	%		34
Net gain on sale of securities		2		(1	)	(33.3	%)		3		(1	)	(25.0	%)		4
Earnings on bank owned life insurance		393		15		4.0	%		378		50		15.2	%		328
Other operating income		407		38		10.3	%		369		45		13.2	%		326
Total non-interest income		4,081		919		29.1	%		3,162		1,316		71.3	%		1,846

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

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

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

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

(Dollars in thousands)	2005		Increase (Decrease) Amount					2004		Increase (Decrease) Amount				2003
Salaries and employee benefits	$	10,073	$	1,939		23.8	%	$	8,134	$	3,370	70.7	%	$	4,764
Occupancy and equipment		2,037		449		28.3	%		1,588		623	64.6	%		965
Marketing and advertising		495		229		86.1	%		266		81	43.8	%		185
State taxes		348		42		13.7	%		306		237	343.5	%		69
Data processing		479		(135	)	(22.0	%)		614		309	101.3	%		305
Other expense		3,134		487		18.4	%		2,647		990	59.8	%		1,657
Total non-interest expense	$	16,566	$	3,011		22.2	%	$	13,555	$	5,610	70.6	%	$	7,945

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

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

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

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

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

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

CRITICAL ACCOUNTING POLICIES

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

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

ASSET AND LIABILITY MANAGEMENT

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

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

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

(dollars in thousands)	Due in one year or less			Due after one through five years			Due after five years			Total
Interest earning assets
Loans, including loans held for sale	$	240,741		$	100,112		$	68,128		$	408,981
Investment securities		7,428			17,217			11,607			36,252
Fed Funds sold and interest
bearing balances with banks		283			—			—			283
Federal Home Loan Bank Stock		—			—			1,858			1,858
Total interest earning assets	$	248,452		$	117,329		$	81,593		$	447,374
Interest bearing liabilities
Interest bearing demand deposits	$	49,140		$	—		$	—		$	49,140
Savings deposits		145,126			—			—			145,126
Time deposits		63,755			55,441			—			119,196
Short term borrowings		3,985			—			—			3,985
Long term borrowings		5,000			19,500			—			24,500
Secured borrowings		—			388			1,762			2,150
Junior subordinated debentures		—			—			5,155			5,155
Total interest bearing liabilities	$	280,475		$	61,860		$	6,917		$	349,252
Net interest rate sensitivity GAP	$	(32,023	)	$	55,469		$	74,676		$	98,122
Cumulative interest rate sensitivity GAP				$	23,446		$	98,122		$	98,122
Cumulative interest rate sensitivity GAP
as a % of earning assets					5.2	%		21.9	%		21.9	%

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

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

INVESTMENT PORTFOLIO

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

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

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

HELD TO MATURITY

(dollars in thousands)	2005		2004		2003
U.S. Agencies securities	$	1,189	$	1,714	$	2,944
Obligations of states and political subdivisions		5,315		5,496		5,044
Total	$	6,504	$	7,210	$	7,988
AVAILABLE FOR SALE
(dollars in thousands)		2005		2004		2003
U.S. Agencies securities	$	12,627	$	14,778	$	18,030
Obligations of states and political subdivisions		12,172		12,942		14,751
Other securities		4,949		8,060		24,692
Total	$	29,748	$	35,780	$	57,473

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

HELD TO MATURITY

(dollars in thousands)	Due in one year or less		Due after one through five years			Due after five through ten years			Due after ten years			Total
U.S. Agency securities	$	—	$	—		$	—		$	1,189		$	1,189
Weighted average yield		—		—			—			5.03	%
Obligations of states and political
subdivisions	$	—	$	3,060		$	855		$	1,400		$	5,315
Weighted average yield		—		5.53	%		6.90	%		7.34	%
Total	$	—	$	3,060		$	855		$	2,589		$	6,504

AVAILABLE FOR SALE

(dollars in thousands)	Due in one year or less			Due after one through five years			Due after five through ten years			Due after ten years			Total
U.S. Agency securities	$	—		$	4,522		$	1,465		$	6,640		$	12,627
Weighted average yield		—			3.52	%		4.52	%		4.70	%
Obligations of states and political
subdivisions	$	2,151		$	2,790		$	4,365		$	2,866		$	12,172
Weighted average yield		6.39	%		6.21	%		6.07	%		5.73	%
Other securities	$	3,434		$	1,515			—			—		$	4,949
Weighted average yield		3.84	%		4.05	%		—			—
Total	$	5,585		$	8,827		$	5,830		$	9,506		$	29,748

LENDING

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

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

(dollars in thousands)	2005			2004			2003		2002		2001
Commercial	$	124,536		$	111,050		$	64,344	$	69,794	$	72,427
Real Estate Construction		87,621			49,347			11,894		9,697		6,554
Real Estate Mortgage		185,503			176,011			117,940		101,151		91,714
Installment		9,945			9,653			4,625		4,114		4,941
Credit cards and overdrafts		1,863			1,979			935		1,034		968
Less unearned income		(487	)		(281	)		—		—		—
Total	$	408,981		$	347,759		$	199,738	$	185,790	$	176,604

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

(dollars in thousands)	Due in one year or less		Due after one through five years		Due after five years		Total
Commercial	$	46,682	$	39,935	$	37,919	$	124,536
Real estate construction		56,458		16,348		14,815		87,621
Total	$	103,140	$	56,283	$	52,734	$	212,157
Total loans maturing after one year with
Predetermined interest rates (fixed)			$	27,859	$	60,288	$	88,147
Floating or adjustable rates (variable)				71,041		1,333		72.374
Total			$	98,900	$	61,621	$	160,521

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

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

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

(dollars in thousands)	2005		2004		2003		2002		2001
Non-accrual loans	$	6,650	$	470	$	465	$	1,864	$	1,254
Accruing loans past due
90 days or more		82		—		—		2		79
Restructured loans		—		—		—		—		—
Foreclosed real estate owned		37		40		98		686		1,040

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

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

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

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

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

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

(dollars in thousands)	2005			2004			2003			2002			2001
Balance at beginning of year	$	4,236		$	2,238		$	2,473		$	2,109		$	2,026
Charge-offs:
Commercial		41			235			17			131			170
Real estate loans		—			18			239			461			366
Credit card		7			11			6			16			13
Installment		17			11			3			24			15
Total charge-offs	$	65		$	275		$	265		$	632		$	564
Recoveries:
Commercial	$	3		$	7		$	5		$	11		$	54
Real estate loans		19			123			23			28			12
Credit card		1			1			1			2			—
Installment		2			—			1			1			1
Total recoveries	$	25		$	131		$	30		$	42		$	67
Net charge-offs		40			144			235			590			497
Provision for credit losses		1,100			970			—			954			580
BNW Bancorp, Inc. acquisition		—			1,172			—			—			—
Balance at end of year	$	5,296		$	4,236		$	2,238		$	2,473		$	2,109
Ratio of net charge-offs
to average loans outstanding		.01	%		.05	%		.12	%		.33	%		.29	%

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

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

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

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

(dollars in thousands)	2005		2004		2003		2002		2001
Total Impaired Loans	$	6,650	$	7,934	$	588	$	2,314	$	1,662
Total Impaired Loans with Valuation Allowance		4,917		7,464		123		18		1,180
Valuation Allowance related to Impaired Loans		924		200		23		2		143

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

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

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

(Dollars in thousands)	2005 Reserve					2004 Reserve					2003 Reserve					2002 Reserve					2001 Reserve
Commercial loans	$	1,589		30	%	$	1,680		32	%	$	764		32	%	$	967		37	%	$	548		41	%
Real estate loans		3,548		67	%		2,432		65	%		1,399		65	%		1,406		60	%		1,413		56	%
Consumer loans		159		3	%		124		3	%		75		3	%		100		3	%		148		3	%
Total allowance	$	5,296		100	%	$	4,236		100	%	$	2,238		100	%	$	2,473		100	%	$	2,109		100	%

Ratio of allowance for credit losses to loans
outstanding at end of year		1.29	%				1.23	%				1.12	%				1.33	%				1.19	%

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

DEPOSITS

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

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

(dollars in thousands)	2005				2004				2003
Non-interest bearing demand deposits	$	79,866	0.00	%	$	66,135	0.00	%	$	42,864	0.00	%
Interest bearing demand deposits		56,615	.58	%		49,547	.42	%		33,251	.42	%
Savings deposits		138,425	1.99	%		106,299	.87	%		78,878	.87	%
Time deposits		112,345	2.96	%		112,078	2.20	%		86,634	2.42	%
Total	$	387,251	1.66	%	$	334,059	1.39	%	$	241,627	1.20	%

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

(dollars in thousands)	Under $100,000		Over $100,000		Total
3 months or less	$	8,186	$	15,652	$	23,838
Over 3 through 6 months		5,907		7,911		13,818
Over 6 through 12 months		14,853		11,246		26,099
Over 12 months		29,133		26,308		55,441
Total		58,079		61,117		119,196

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

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

SHORT-TERM BORROWINGS

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

(dollars in thousands)	2005			2004			2003
Amount outstanding at end of period	$	3,985		$	—		$	—
Weighted average interest rate thereon		5.13	%		—	%		—	%
Maximum amount outstanding at any month end during period	$	3,985		$	22,313		$	—
Average amounts outstanding during the period		69			7,825			—
Weighted average interest rate during period		5.80	%		1.23	%		—	%

CONTRACTUAL OBLIGATIONS

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

	Payments due by Period
Contractual obligations	Total		Less than 1 year		1-3 years		3-5 years		More than 5 years
Federal Home Loan Bank borrowings	$	24,500	$	5,000	$	7,000	$	12,500	$	—
Operating leases		987		278		443		266		—
Junior subordinated debentures		5,155		—		—		—	$	5,155
Total long-term obligations	$	30,642	$	5,278	$	7,443	$	12,766	$	5,155

COMMITMENTS AND CONTINGENCIES

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

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

			2005			2004
Commitments to extend credit			$	95,369		$	75,188
Standby letters of credit				3,907			3,997

KEY FINANCIAL RATIOS

Year ended December 31,
Return on average assets	1.31	%	1.41	%	1.61	%	1.54	%	1.55	%
Return on average equity	12.70	%	14.21	%	17.10	%	15.81	%	15.57	%
Average equity to average assets ratio	10.30	%	9.91	%	9.44	%	9.74	%	9.96	%
Dividend payout ratio	78	%	81	%	77	%	87	%	86	%

LIQUIDITY AND CAPITAL RESOURCES

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

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

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

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

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

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

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

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

						Capital Ratio Adequacy Purposes
(dollars in thousands)	Actual Amount		Ratio			Amount		Ratio
December 31, 2005
Tier 1 capital (to average assets)
Consolidated	$	39,692		8.38	%	$	18,947		4.00	%
Bank		39,168		8.28	%		18,922		4.00	%
Tier 1 capital (to risk-weighted assets)
Consolidated		39,692		9.44	%		16,825		4.00	%
Bank		39,168		9.32	%		16,809		4.00	%
Total capital (to risk-weighted assets)
Consolidated		44,950		10.69	%		33,650		8.00	%
Bank		44,421		10.57	%		33,618		8.00	%
December 31, 2004
Tier 1 capital (to average assets)
Consolidated	$	32,899		7.83	%	$	16,790		4.00	%
Bank		32,197		7.77	%		16,601		4.00	%
Tier 1 capital (to risk-weighted assets)
Consolidated		32,899		9.00	%		14,636		4.00	%
Bank		32,197		8.88	%		14,498		4.00	%
Total capital (to risk-weighted assets)
Consolidated		37,135		10.15	%		29,273		8.00	%
Bank		36,433		10.05	%		28,997		8.00	%

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

ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk

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

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

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

Year ended December 31, 2005	Expected Maturity
(dollars in thousands)	2006			2007			2008			2009			2010			there- after			Total		Fair Value
Financial Assets
Cash and cash equivalents
Non-interest bearing	$	11,223		$	—		$	—		$	—		$	—		$	—		$	11,223	$	11,223
Interest bearing deposits in banks		283			—			—			—			—			—			283		283
Weighted average interest rate		3.00	%		—			—			—			—			—
Securities available for sale
Fixed rate		2,660			3,479			751			4,346			230			15,357			26,823		26,823
Weighted average interest rate		3.91	%		3.36	%		3.97	%		4.61	%		4.65	%		3.76	%
Variable rate		2,925			—			—			—			—			—			2,925		2,925
Weighted average interest rate		3.32	%		—			—			—			—			—
Securities held to maturity
Fixed rate		—			725			1,072			484			778			3,445			6,504		6,502
Weighted average interest rate		—			2.94	%		3.02	%		3.81	%		5.09	%		4.84	%
Loans receivable
Fixed rate		20,489			7,736			6,741			6,565			7,204			62,106			110,841		109,296
Weighted average interest rate		6.73	%		7.27			6.98	%		6.79	%		6.78	%		6.97	%
Adjustable rate		225,645			20,588			38,214			7,187			5,155			1,351			298,140		298,140
Weighted average interest rate		7.65	%		6.54	%		7.03	%		7.11	%		7.82	%		6.35	%
Federal Home Loan Bank stock		—			—			—			—			—			1,858			1,858		1,858
Weighted average interest rate		—			—			—			—			—			—

Year ended December 31, 2005	Expected Maturity
(dollars in thousands)	2006			2007			2008			2009			2010			there after			Total		Fair Value
Financial Liabilities
Non-interest bearing deposits	$	12,940		$	10,999		$	9,349		$	7,947		$	6,755		$	38,274		$	86,264	$	86,264
Interest bearing checking accounts		12,285			9,214			6,910			5,183			3,887			11,661			49,140		49,140
Weighted average interest rate		.65	%		.65	%		.65	%		.65	%		.65	%		.65	%
Money Market accounts		21,155			15,866			11,900			8,925			6,694			20,081			84,621		84,621
Weighted average interest rate		2.76	%		2.76	%		2.76	%		2.76	%		2.76	%		2.76	%
Savings accounts		12,101			9,681			7,745			6,196			4,957			19,825			60,505		60,505
Weighted average interest rate		1.95	%		1.95	%		1.95	%		1.95	%		1.95	%		1.95	%
Certificates of deposit
Fixed rate		61,472			27,958			9,398			1,608			2,967			—			103,403		102,675
Weighted average interest rate		3.23	%		4.03	%		3.91	%		3.70	%		4.36	%		—
Variable rate		2,283			12,523			978			9			—			—			15,793		15,793
Weighted average interest rate		2.36	%		3.22	%		4.07	%		4.41	%		—			—
Short Term Borrowings		3,985			—			—			—			—			—			3,985		3,985
Weighted average interest rate		5.13	%		—			—			—			—			—
Long Term Borrowings
Fixed rate		5,000			2,000			5,000			11,000			1,500			—			24,500		22,585
Weighted average interest rate		2.70	%		3.57	%		3.25	%		3.84	%		4.12	%		—
Secured borrowings		—			—			—			—			388			1,762			2,150		2,150
Weighted average interest rate		—			—			—			—			6.81	%		7.59	%
Junior subordinated debentures		—			—			—			—			—			5,155			5,155		5,155
Weighted average interest rate		—			—			—			—			—			6.39	%

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

ITEM 8. Financial Statements and Supplementary Data

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

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

Not applicable.

ITEM 9A. Controls and Procedures

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

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

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

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

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

ITEM 9B. Other Information

None.

Part III

ITEM 10. Directors and Executive Officers of the Registrant

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

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

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

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

ITEM 11. Executive Compensation

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

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

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

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

Plan Category			(b) Weighted-average exercise price of outstanding options, warrants and rights
Equity compensation plans approved
by security holders:	647,080	(1)	$	13.73	339,400
Equity compensation plans not approved
by security holders:	—			—	—
Total	647,080	(1)			339,400

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

ITEM 13. Certain Relationships and Related Transactions

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

ITEM 14. Principal Accountant Fees and Services

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

Part IV

ITEM 15. Exhibits and Financial Statement Schedules

(a) (1)

The following financial statements are filed below:
Report of Independent Registered Public Accounting Firm
Report of Independent Registered Public Accounting Firm (Internal Control)
Consolidated Financial Statements
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Shareholders' Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements

(a) (2)

Schedules: None

(a) (3)

Exhibits: See Exhibit Index immediately following the signature page.

McGladrey & Pullen
Certified Public Accountants

Report of Independent Registered Public Accounting Firm

To the Board of Directors
Pacific Financial Corporation
Aberdeen, Washington

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

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

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

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

/s/ McGladrey & Pullen

Tacoma, Washington
March 13, 2006

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

McGladrey & Pullen
Certified Public Accountants

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors
Pacific Financial Corporation
Aberdeen, Washington

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

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

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

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

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

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

/s/ McGladrey & Pullen

Tacoma, Washington
March 13, 2006

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

Consolidated Balance Sheets

(Dollars in Thousands)

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

	2005			2004
Assets
Cash and due from banks	$	11,223		$	10,213
Interest bearing deposits in banks		283			5,460
Federal funds sold		—			6,034
Securities available for sale		29,748			35,780
Securities held to maturity (market value 2005 - $6,502; and 2004 - $7,312)		6,504			7,210
Federal Home Loan Bank stock, at cost		1,858			1,850
Loans held for sale		10,111			1,852
Loans		398,870			345,907
Allowance for credit losses		5,296			4,236
Loans - net		393,574			341,671
Premises and equipment		10,085			6,833
Foreclosed real estate		37			40
Accrued interest receivable		2,364			1,873
Cash surrender value of life insurance		9,394			9,037
Goodwill		11,282			11,282
Other intangible assets		745			887
Other assets		2,201			1,769
Total assets	$	489,409		$	441,791
Liabilities and Shareholders' Equity
Liabilities
Deposits:
Demand, non-interest bearing	$	86,264		$	71,711
Savings and interest-bearing demand		194,266			179,434
Time, interest-bearing		119,196			112,356
Total deposits		399,726			363,501
Accrued interest payable		547			385
Secured borrowings		2,150			3,733
Short-term borrowings		3,985			—
Long-term borrowings		24,500			21,500
Junior subordinated debentures		5,155			—
Other liabilities		6,746			7,369
Total liabilities		442,809			396,488
Commitments and Contingencies		—			—
Shareholders' Equity
Common stock (par value $1); authorized: 25,000,000 shares;
issued and outstanding: 2005 - 6,464,536 shares; 2004 - 6,421,396 shares		6,464			6,421
Additional paid-in capital		25,386			25,003
Retained earnings		15,073			13,746
Accumulated other comprehensive income (loss)		(323	)		133
Total shareholders' equity		46,600			45,303
Total liabilities and shareholders' equity	$	489,409		$	441,791

See notes to consolidated financial statements.

Consolidated Statements of Income

(Dollars in Thousands, Except Per Share Amounts)

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

	2005		2004		2003
Interest and Dividend Income
Loans	$	27,611	$	21,850	$	13,350
Federal funds sold and deposits in banks		344		44		118
Securities available for sale:
Taxable		933		1,318		1,570
Tax-exempt		446		526		484
Securities held to maturity:
Taxable		71		97		168
Tax-exempt		226		243		210
Federal Home Loan Bank stock dividends		—		60		49
Total interest and dividend income		29,631		24,138		15,949
Interest Expense
Deposits		6,412		3,734		2,923
Short-term borrowings		4		97		—
Long-term borrowings		768		548		485
Secured borrowings		163		239		—
Total interest expense		7,347		4,618		3,408
Net interest income		22,284		19,520		12,541
Provision for Credit Losses		1,100		970		—
Net interest income after provision for credit losses		21,184		18,550		12,541
Non-Interest Income
Service charges on deposit accounts		1,470		1,297		1,027
Mortgage broker fees		—		12		101
Income from and gains on sale of foreclosed real estate		—		77		26
Net gains from sales of loans		1,809		1,026		34
Net gains on sales of securities available for sale		2		3		4
Earnings on bank owned life insurance		393		378		328
Other operating income		407		369		326
Total non-interest income		4,081		3,162		1,846
Non-Interest Expense
Salaries and employee benefits		10,073		8,134		4,764
Occupancy		1,035		763		433
Equipment		1,002		825		532
State taxes		348		306		69
Data processing		479		614		305
Professional services		302		307		137
Other		3,327		2,606		1,705
Total non-interest expense		16,566		13,555		7,945
Income before income taxes		8,699		8,157		6,442
Income Taxes		2,653		2,450		1,863
Net income	$	6,046	$	5,707	$	4,579
Earnings Per Share
Basic	$	0.94	$	0.93	$	0.91
Diluted		0.92		0.91		0.90

See notes to consolidated financial statements.

Consolidated Statements of Shareholders’ Equity

(Dollars in Thousands)

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

		Common Stock		Additional Paid-in Capital		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total
Balance at December 31, 2002
Comprehensive income:	5,025,318	$	5,025	$	7,327	$	11,614		$	717		$	24,683
Net income	—		—		—		4,579			—			4,579
Other comprehensive income,
net of tax:
Change in fair value of
securities available for sale	—		—		—		—			(257	)		(257	)
Comprehensive income													4,322

Stock options exercised	17,700		18		156		—			—			174
Issuance of common stock	60		—		1		—			—			1
Cash dividends declared
($0.68 per share)	—		—		—		(3,530	)		—			(3,530	)
Balance at December 31, 2003	5,043,078		5,043		7,484		12,663			460			25,650

Comprehensive income:
Net income	—		—		—		5,707			—			5,707
Other comprehensive income,
net of tax:
Change in fair value of
securities available for sale	—		—		—		—			(327	)		(327	)
Comprehensive income													5,380
Stock options exercised	106,414		106		676		—			—			782
Issuance of common stock	1,271,904		1,272		16,641		—			—			17,913
Stock compensation expense	—		—		60		—			—			60
Cash dividends declared
($0.72 per share)	—		—		—		(4,624	)		—			(4,624	)
Tax benefit from exercise of
stock options	—		—		142		—			—			142
Balance at December 31, 2004	6,421,396		6,421		25,003		13,746			133			45,303
Comprehensive income:
Net income	—		—		—		6,046			—			6,046
Other comprehensive income,
net of tax:
Change in fair value of
securities available for sale	—		—		—		—			(456	)		(456	)
Comprehensive income													5,590
Stock options exercised	42,620		43		362		—			—			405
Issuance of common stock	520		—		—		—			—			—
Stock compensation expense	—		—		12		—			—			12
Cash dividends declared
($0.73 per share)	—		—		—		(4,719	)		—			(4,719	)
Tax benefit from exercise of
stock options	—		—		9		—			—			9
Balance at December 31, 2005	6,464,536	$	6,464	$	25,386	$	15,073		$	(323	)	$	46,600

See notes to consolidated financial statements.

Consolidated Statements of Cash Flows

(Dollars in Thousands)

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

	2005			2004			2003
Cash Flows from Operating Activities
Net income	$	6,046		$	5,707		$	4,579
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization		1,127			655			404
Provision for credit losses		1,100			970			—
Deferred income tax (benefit)		(24	)		(97	)		(144	)
Originations of loans held for sale		(117,364	)		(66,639	)		—
Proceeds from sales of loans held for sale		110,914			66,550			286
Gains on sales of loans		(1,809	)		(1,026	)		(34	)
FHLB Stock dividends received		—			(60	)		(49	)
Gains on sale of securities available for sale		(2	)		(3	)		(4	)
Gains on sales of foreclosed real estate		—			(71	)		(10	)
Loss on sale of premises and equipment		8			35			11
Earnings on bank owned life insurance		(393	)		(378	)		(328	)
(Increase) decrease in accrued interest receivable		(491	)		(192	)		218
Increase (decrease) in accrued interest payable		162			81			(84	)
Write-down of foreclosed real estate		3			—			173
Other - net		(291	)		524			(49	)
Net cash provided by (used in) operating activities		(1,014	)		6,056			4,969
Cash Flows from Investing Activities
Net (increase) decrease in interest bearing deposits in banks		5,177			10,124			(15,019	)
Net (increase) decrease in federal funds sold		6,034			(1,034	)		(5,000	)
Activity in securities available for sale:
Sales		3,645			19,055			2,994
Maturities, prepayments and calls		7,944			9,651			12,343
Purchases		(6,394	)		(3,090	)		(21,275	)
Activity in securities held to maturity:
Maturities		691			1,910			3,919
Purchases		—			(1,169	)		(1,654	)
Purchase of Investment in PFC Statutory Trust I		(155	)		—			—
Proceeds from sales of SBA loan pools		3,405			5,735			2,006
Increase in loans made to customers, net of principal collections		(56,633	)		(42,313	)		(16,709	)
Purchases of premises and equipment		(4,377	)		(2,379	)		(511	)
Proceeds from sales of premises and equipment		124			—			2
Additions to foreclosed real estate		—			—			(21	)
Proceeds from sales of foreclosed real estate		—			478			734
Purchase of bank owned life insurance		—			(2,500	)		—
Cash paid for acquisition, net of cash acquired		—			3,146			—
Net cash used in investing activities		(40,539	)		(2,386	)		(38,191	)

(continued)

See notes to consolidated financial statements.

Consolidated Statements of Cash Flows

(concluded) (Dollars in Thousands)

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

	2005			2004			2003
Cash Flows from Financing Activities
Net increase in deposits	$	36,225		$	14,611		$	35,546
Net increase (decrease) in short-term borrowings		3,985			(25,333	)		(1,800	)
Net increase (decrease) in secured borrowings		(1,583	)		3,733			—
Proceeds from issuance of long-term borrowings		8,000			9,000			3,500
Repayments of long-term borrowings		(5,000	)		(2,000	)		—
Proceeds from junior subordinated debentures		5,155			—			—
Common stock issued		405			782			175
Cash dividends paid		(4,624	)		(3,530	)		(3,392	)
Net cash provided by (used in) financing activities		42,563			(2,737	)		34,029
Net change in cash and due from banks		1,010			933			807
Cash and Due from Banks
Beginning of year		10,213			9,280			8,473
End of year	$	11,223		$	10,213		$	9,280
Supplemental Disclosures of Cash Flow Information
Interest paid	$	7,185		$	4,467		$	3,492
Income taxes paid		3,020			2,113			2,087
Supplemental Disclosures of Non-Cash Investing Activities
Fair value adjustment of securities available for sale, net of tax	$	(456	)	$	(327	)	$	(257	)
Transfer of loans to foreclosed real estate		—			349			1,127
Financed sales of foreclosed real estate		—			—			839
Common stock issued upon business combination		—			17,913			—

See notes to consolidated financial statements.

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 1 — Summary of Significant Accounting Policies

Principles of Consolidation

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

Nature of Operations

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

Consolidated Financial Statement Presentation

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

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

Securities Available for Sale

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

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 1 — Summary of Significant Accounting Policies (continued)

Securities Held to Maturity

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

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

Federal Home Loan Bank Stock

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

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

Loans Held for Sale

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

Loans Receivable

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

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

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 1 — Summary of Significant Accounting Policies (continued)

Loans Receivable (concluded)

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

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

Premises and Equipment

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

Foreclosed Real Estate

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

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 1 — Summary of Significant Accounting Policies (continued)

Goodwill and other intangible assets

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

Impairment of long-lived assets

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

Transfers of Financial Assets

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

Income Taxes

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

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

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 1 — Summary of Significant Accounting Policies (continued)

Stock-Based Compensation

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

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

	2005	2004	2003
Net income, as reported	$6,046	$5,707	$4,579
Add stock compensation expensed	12	36	—
Less total stock-based compensation expense determined
under fair value method for all qualifying awards, net of tax	586	157	86
Pro forma net income	$5,472	$5,586	$4,493
Earnings Per Share
Basic:
As reported	$0.94	$0.93	$0.91
Pro forma	0.85	0.91	0.90
Diluted:
As reported	0.92	0.91	0.90
Pro forma	0.84	0.89	0.88

Fair Values of Financial Instruments

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

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 1 — Summary of Significant Accounting Policies (continued)

Fair Values of Financial Instruments (concluded)

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

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

Federal Home Loan Bank Stock
The carrying value of Federal Home Loan Bank stock approximates its fair value.

Investment in PFC Statutory Trust I
The carrying value of the Investment in PFC Statutory Trust I approximates its fair value.

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

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

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

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

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

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

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 1 — Summary of Significant Accounting Policies (continued)

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

Cash Equivalents and Cash Flows

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

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

Earnings Per Share

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

Comprehensive Income

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

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 1 — Summary of Significant Accounting Policies (concluded)

Recent Accounting Pronouncements

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

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

Year ended December 31,	Estimated Additional Compensation Expense (in thousands)

2006	$21
2007	13
2008	2
2009	1
	$37

Note 2 — Restricted Assets

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

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 3 — Securities

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

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Securities Available for Sale
December 31, 2005
U.S. Government agency securities	$	4,445	$	23	$	98	$	4,370
Obligations of states and political subdivisions		12,251		104		183		12,172
Mortgage-backed securities		8,432		5		180		8,257
Corporate bonds		2,071		7		54		2,024
Mutual funds		3,039		—		114		2,925
	$	30,238	$	139	$	629	$	29,748
December 31, 2004
U.S. Government agency securities	$	4,567	$	42	$	65	$	4,544
Obligations of states and political subdivisions		12,632		346		36		12,942
Mortgage-backed securities		10,270		64		100		10,234
Corporate bonds		4,096		59		7		4,148
Mutual funds		4,014		—		102		3,912
	$	35,579	$	511	$	310	$	35,780
Securities Held to Maturity
December 31, 2005
State and municipal securities	$	5,315	$	46	$	42	$	5,319
Mortgage-backed securities		1,189		—		6		1,183
	$	6,504	$	46	$	48	$	6,502
December 31, 2004
State and municipal securities	$	5,496	$	84	$	13	$	5,567
Mortgage-backed securities		1,714		31		—		1,745
	$	7,210	$	115	$	13	$	7,312

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 3 — Securities (continued)

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

December 31, 2005	Less than Fair Value		12 Months Unrealized Loss		More than Fair Value		12 Months Unrealized Loss		Total Fair Value		Unrealized Loss
Available for Sale
U.S. Government agency securities	$	999	$	1	$	3,032	$	97	$	4,031	$	98
Obligations of states and
political subdivisions		3,764		154		1,273		29		5,037		183
Mortgage-backed securities		4,125		59		3,635		121		7,760		180
Corporate bonds		554		15		961		39		1,515		54
Mutual funds		—		—		2,925		114		2,925		114
Total	$	9,442	$	229	$	11,826	$	400	$	21,268	$	629
Held to Maturity
State and municipal securities	$	1,443	$	24	$	945	$	18	$	2,388	$	42
Mortgage-backed securities		1,183		6		—		—		1,183		6
Total	$	2,626	$	30	$	945	$	18	$	3,571	$	48
December 31, 2004
Available for Sale
U.S. Government agency securities	$	4,081	$	65	$	—	$	—	$	4,081	$	65
Obligations of states and
political subdivisions		1,952		20		1,104		16		3,056		36
Mortgage-backed securities		3,808		23		1,390		77		5,198		100
Corporate bonds		993		7		—		—		993		7
Mutual funds		3,912		102		—		—		3,912		102
Total	$	14,746	$	217	$	2,494	$	93	$	17,240	$	310
Held to Maturity
State and municipal securities	$	338	$	6	$	383	$	7	$	721	$	13

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

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 3 — Securities (concluded)

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

	Held to Maturity				Available for Sale
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Due in one year or less	$	—	$	—	$	2,638	$	2,660
Due from one year to five years		3,060		3,038		8,488		8,336
Due from five to ten years		855		854		4,358		4,377
Due after ten years		1,400		1,427		3,283		3,193
Mortgage-backed securities		1,189		1,183		8,432		8,257
Mutual funds		—		—		3,039		2,925
Total	$	6,504	$	6,502	$	30,238	$	29,748

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

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

Note 4 — Loans

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

	2005			2004
Commercial and agricultural	$	124,536		$	111,050
Real estate:
Construction		87,621			49,347
Residential 1-4 family		50,546			43,183
Multi-family		5,229			9,156
Commercial		117,645			112,743
Farmland		12,083			10,929
Consumer		11,808			11,632
		409,468			348,040
Less unearned income		(487	)		(281	)
	$	408,981		$	347,759

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 4 – Loans (concluded)

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

	2005			2004			2003
Balance at beginning of year	$	4,236		$	2,238		$	2,473
BNW Bancorp, Inc. acquisition		—			1,172			—
Provision for credit losses		1,100			970			—
Charge-offs		(65	)		(275	)		(265	)
Recoveries		25			131			30
Net charge-offs		(40	)		(144	)		(235	)
Balance at end of year	$	5,296		$	4,236		$	2,238

Following is a summary of information pertaining to impaired loans:

	2005		2004		2003
December 31
Impaired loans without a valuation allowance	$	1,733	$	470	$	342
Impaired loans with a valuation allowance		4,917		—		123
Total impaired loans	$	6,650	$	470	$	465
Valuation allowance related to impaired loans	$	924	$	—	$	23
Years Ended December 31
Average investment in impaired loans	$	6,925	$	255	$	1,412
Interest income recognized on a cash basis on impaired loans		569		16		12

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

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

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 5 — Premises and Equipment

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

	2005		2004
Land	$	3,830	$	2,825
Premises		6,819		5,412
Equipment, furniture and fixtures		7,102		5,668
		17,751		13,905
Less accumulated depreciation and amortization		7,666		7,072
Total premises and equipment	$	10,085	$	6,833

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

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


2006	$	278
2007		235
2008		208
2009		194
2010		72
Total minimum payments required	$	987

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

Note 6 — Deposits

The composition of deposits at December 31 is as follows:

	2005		2004
Demand deposits, non-interest bearing	$	86,264	$	71,711
NOW and money market accounts		133,761		123,042
Savings deposits		60,505		56,392
Time certificates, $100,000 or more		61,117		54,994
Other time certificates		58,079		57,362
Total	$	399,726	$	363,501

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 6 – Deposits (concluded)

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


2006				$ 63,755
2007				40,481
2008				10,376
2009				1,617
2010				2,967
				$ 119,196

Note 7 — Borrowings

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

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

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

Note 8 – Junior Subordinated Debentures

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

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 9 — Income Taxes

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

	2005			2004			2003
Current	$	2,677		$	2,547		$	1,719
Deferred (benefit)		(24	)		(97	)		144
Total income taxes	$	2,653		$	2,450		$	1,863

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

	2005		2004
Deferred Tax Assets
Allowance for credit losses	$	1,625	$	1,287
Deferred compensation		166		161
Unrealized loss on securities available for sale		167		—
Other		186		54
Total deferred tax assets		2,144		1,502
Deferred Tax Liabilities
Unrealized gain on securities available for sale	$	—	$	68
Depreciation		104		202
Deferred revenue		1,747		1,150
Core deposit intangible		253		301
Total deferred tax liabilities		2,104		1,721
Net deferred tax assets (liabilities)	$	40		($ 219	)

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

	2005						2004						2003
	Amount			Percent of Pre-tax Income			Amount			Percent of Pre-tax Income			Amount			Percent of Pre-tax Income
Income tax at statutory rate	$	3,031			35	.0%	$	2,855			35	.0%	$	2,255			35	.0%
Adjustments resulting from:
Tax-exempt income		(244	)		(2	.8)		(276	)		(3	.4)		(232	)		(3	.6)
Net earnings on life insurance
policies		(125	)		(1	.4)		(121	)		(1	.5)		(103	)		(1	.6)
Other		(9	)		(	.1)		(8	)		(	.1)		57			(	.9)
Total income tax expense	$	2,653			30	.7%	$	2,450			30	.0%	$	1,863			28	.9%

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 10 — Employee Benefits

Incentive Compensation Plan

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

401(k) Plans

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

Director and Employee Deferred Compensation Plans

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

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

Non-Qualified Deferred Compensation Plan

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

Note 11 – Dividend Reinvestment Plan

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

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 12 — Commitments and Contingencies

			2005			2004
Commitments to extend credit			$	95,369		$	75,188
Standby letters of credit				3,907			3,997

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

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

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

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

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

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 13 — Significant Concentrations of Credit Risk

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

Note 14 — Stock Options

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

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

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

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

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

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 14 — Stock Options (concluded)

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

	2005					2004				2003
	Shares			Weighted Average Exercise Price		Shares		Weighted Average Exercise Price		Shares			Weighted Average Exercise Price
Outstanding at beginning of year		619,794		$	12.51		465,900	$	11.63		359,592		$	11.13
BNW Bancorp, Inc. acquisition		—			—		117,208		5.83		—			—
Granted		122,500			16.22		143,100		17.03		124,008			12.81
Exercised		(42,620	)		9.50		106,414		11.09		(17,700	)		9.83
Forfeited		(12,000	)		16.77		—		—		—			—
Outstanding at end of year		687,674		$	13.28		619,794	$	12.51		465,900		$	11.63
Exercisable at end of year		543,668		$	14.15		257,690	$	10.50		153,998		$	11.03

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

Range of Exercise Prices
$ 5.88 - $6.18	40,594	5	$ 6.17	40,594	$ 6.17
11.11 - 12.00	291,680	5	11.28	199,674	11.22
12.50	43,000	7	12.50	9,000	12.50
13.50	37,800	4	13.50	37,800	13.50
14.75	2,000	10	14.75	—	—
15.50	20,000	7	15.50	20,000	15.50
16.00	5,000	10	16.00	—	—
16.05 - 17.50	247,600	8	17.03	236,600	16.68
	687,674			543,668

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

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 15 — Regulatory Matters

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

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

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

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

	Actual Amount			Capital Adequacy Purposes Amount
December 31, 2005
Tier 1 capital (to average assets):
Company	$	39,692	8.38	$	18,947	4.00	%	NA		NA
Bank		39,168	8.28		18,922	4.00		23,652	5	.00%
Tier 1 capital (to risk-weighted assets):
Company		39,692	9.44		16,825	4.00		NA		NA
Bank		39,168	9.32		16,809	4.00		25,214	6	.00
Total capital (to risk-weighted assets):
Company		44,950	10.69		33,650	8.00		NA		NA
Bank		44,421	10.57		33,618	8.00		42,023	10	.00

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 15 — Regulatory Matters (concluded)

	Actual Amount			Capital Adequacy Purposes Amount
December 31, 2004
Tier 1 capital (to average assets):
Company	$	32,899	7.83	$	16,790	4.00	%	NA		NA
Bank		32,197	7.77		16,601	4.00		20,751	5	.00%
Tier 1 capital (to risk-weighted assets):
Company		32,899	9.00		14,636	4.00		NA		NA
Bank		32,197	8.88		14,498	4.00		21,748	6	.00
Total capital (to risk-weighted assets):
Company		37,135	10.15		29,273	8.00		NA		NA
Bank		36,433	10.05		28,997	8.00		36,246	10	.00

Note 16 — Comprehensive Income

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

	Before- Tax Amount			Tax Benefit (Expense)		Net-of-Tax Amount
2005
Unrealized holding losses arising during the year	$	(689	)	$	234	$	(455	)
Reclassification adjustments for gains realized in net income		(2	)		1		(1	)
Net unrealized losses	$	(691	)	$	235	$	(456	)
2004
Unrealized holding losses arising during the year	$	(492	)	$	167	$	(325	)
Reclassification adjustments for gains realized in net income		(3	)		1		(2	)
Net unrealized losses	$	(495	)	$	168	$	(327	)
2003
Unrealized holding losses arising during the year		($384	)	$	130		($254	)
Reclassification adjustments for gains realized in net income		(4	)		1		(3	)
Net unrealized losses		($388	)	$	131		($257	)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 17 — Fair Value of Financial Instruments

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

	2005 Carrying Amount		Fair Value		2004 Carrying Amount		Fair Value
Financial Assets
Cash and due from banks,
interest-bearing deposits with
banks, and federal funds sold	$	11,506	$	11,506	$	21,707	$	21,707
Securities available for sale		29,748		29,748		35,780		35,780
Securities held to maturity		6,504		6,502		7,210		7,312
Investment in PFC Statutory Trust I		155		155		—		—
Federal Home Loan Bank stock		1,858		1,858		1,850		1,850
Loans receivable, net		393,574		392,029		341,671		344,234
Loans held for sale		10,111		9,981		1,852		1,852
Accrued interest receivable		2,364		2,364		1,873		1,873
Financial Liabilities
Deposits	$	399,726	$	398,998	$	363,501	$	363,540
Short-term borrowings		3,985		3,985		—		—
Long-term borrowings		24,500		22,585		21,500		21,370
Secured borrowings		2,150		2,150		3,733		3,733
Junior subordinated debentures		5,155		5,155		—		—
Accrued interest payable		547		547		385		385

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

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 18 — Earnings Per Share Disclosures

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

	Net Income (Numerator)			Per Share Amount
Year Ended December 31, 2005
Basic earnings per share:	$	6,046	6,425,615	$	0	.94
Effect of dilutive securities:		—	112,635		(	.02)
Diluted earnings per share:	$	6,046	6,538,250	$	0	.92
Year Ended December 31, 2004
Basic earnings per share:	$	5,707	6,140,482	$	0	.93
Effect of dilutive securities:		—	166,542		(	.02)
Diluted earnings per share:	$	5,707	6,307,024	$	0	.91
Year Ended December 31, 2003
Basic earnings per share:	$	4,579	5,025,688	$	0	.91
Effect of dilutive securities:		—	94,006		(	.01)
Diluted earnings per share:	$	4,579	5,119,694	$	0	.90

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

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 19 — Condensed Financial Information — Parent Company Only

Condensed Balance Sheets — December 31

	2005		2004
Assets
Cash	$	4,849	$	5,011
Investment in the Bank		51,076		44,600
Due from the Bank		394		316
Other assets		155		—
Total assets	$	56,474	$	49,927
Liabilities and Shareholders' Equity
Dividends payable	$	4,719	$	4,624
Junior subordinated debentures		5,155		—
Shareholders' equity		46,600		45,303
Total liabilities and shareholders' equity	$	56,474	$	49,927

Condensed Statements of Income — Years Ended December 31

	2005			2004			2003
Dividend Income from the Bank	$	4,250		$	4,200		$	3,729
Expenses		(205	)		(255	)		(96	)
Income before income tax benefit		4,045			3,945			3,633
Income Tax Benefit		69			85			30
Income before equity in undistributed income of the Bank		4,114			4,030			3,663
Equity in Undistributed Income of the Bank		1,932			1,677			916
Net income	$	6,046		$	5,707		$	4,579

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 19 — Condensed Financial Information — Parent Company Only (concluded)

Condensed Statements of Cash Flows — Years Ended December 31

	2005			2004			2003
Operating Activities
Net income	$	6,046		$	5,707		$	4,579
Adjustments to reconcile net income to
net cash provided by operating activities:
Equity in undistributed income of subsidiary		(1,932	)		(1,677	)		(916	)
Net change in other assets		(69	)		(218	)		—
Other - net		12			60			(214	)
Net cash provided by operating activities		4,057			3,872			3,449
Investing Activities
Dividend to subsidiary		(5,000	)		—			—
Purchase of trust common securities		(155	)		—			—
Net cash used in investing activities		(5,155	)		—			—
Financing Activities
Proceeds from junior subordinated debentures		5,155			—			—
Common stock issued		405			782			175
Dividends paid		(4,624	)		(3,530	)		(3,392	)
Other, net		—			188			—
Net cash provided by (used in) financing activities		936			(2,560	)		(3,217	)
Net increase (decrease) in cash		(162	)		1,312			232
Cash
Beginning of year		5,011			3,699			3,467
End of year	$	4,849		$	5,011		$	3,699

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 20 — Quarterly Data (Unaudited)

	First Quarter		Second Quarter		Third Quarter		Fourth Quarter
Year Ended December 31, 2005
Interest income	$	6,646	$	7,397	$	8,065	$	7,523
Interest expense		1,519		1,884		2,194		1,750
Net interest income		5,127		5,513		5,871		5,773

Provision for credit losses		300		300		300		200

Non-interest income		886		1,034		1,202		959

Non-interest expenses		3,879		4,101		4,360		4,226

Income before income taxes		1,834		2,146		2,413		2,306

Income taxes		545		650		752		706

Net income	$	1,289	$	1,496	$	1,661	$	1,600

Earnings per common share:
Basic	$	.20	$	.23	$	.26	$	.25
Diluted		.20		.23		.25		.24

(continued)

Notes to Consolidated Financial Statements

Pacific Financial Corporation and Subsidiary
December 31, 2005 and 2004

Note 20 — Quarterly Data (Unaudited) (concluded)

	First Quarter		Second Quarter		Third Quarter		Fourth Quarter
Year Ended December 31, 2004
Interest income	$	4,837	$	6,180	$	6,251	$	6,631
Interest expense		879		1,077		1,150		1,273
Net interest income		3,958		5,103		5,101		5,358

Provision for credit losses		70		300		300		300

Non-interest income		571		903		892		796

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

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

Income taxes		479		680		616		675

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

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

SIGNATURES

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

	PACIFIC FINANCIAL CORPORATION
	(Registrant)

/s/ Dennis A. Long	/s/ Denise Portmann
Dennis A. Long, President and CEO	Denise Portmann, CFO

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


Principal Executive Officer and Director	Principal Financial and Accounting Officer
/s/ Dennis A. Long Dennis A. Long, President and CEO and Director Principal Executive Officer	/s/ Denise Portmann Denise Portmann, CFO Principal Financial and Accounting Officer
Remaining Directors
/s/ Joseph A. Malik Joseph A. Malik (Chairman of the Board)	/s/ G. Dennis Archer G. Dennis Archer
/s/ Gary C. Forcum Gary C. Forcum	Duane E. Hagstrom
/s/ Steward L. Thomas Steward L. Thomas	/s/ John Ferlin John Ferlin
/s/ Douglas M. Schermer Douglas M. Schermer	/s/ Robert J. Worrell Robert J. Worrell
/s/ Susan C. Freese Susan C. Freese	/s/ Randy W. Roglin Randy W. Rognlin
/s/ Randy Rust Randy Rust	/s/ Edwin Ketel Edwin Ketel

Exhibit Index

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

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

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

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

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

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

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

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

FORM 10-K

DOCUMENTS INCORPORATED BY REFERENCE

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

TABLE OF CONTENTS

ITEM 6. Selected Financial Data

RESULTS OF OPERATIONS

ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk

ITEM 8. Financial Statements and Supplementary Data

ITEM 9A. Controls and Procedures

ITEM 9B. Other Information

Part III

ITEM 10. Directors and Executive Officers of the Registrant

ITEM 11. Executive Compensation

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

ITEM 13. Certain Relationships and Related Transactions

ITEM 14. Principal Accountant Fees and Services

Part IV

ITEM 15. Exhibits and Financial Statement Schedules

Report of Independent Registered Public Accounting Firm

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Consolidated Balance Sheets

Consolidated Statements of Income

Consolidated Statements of Shareholders’ Equity

Consolidated Statements of Cash Flows

Consolidated Statements of Cash Flows

Notes to Consolidated Financial Statements

Note 1 — Summary of Significant Accounting Policies

Principles of Consolidation

Nature of Operations

Consolidated Financial Statement Presentation

Securities Available for Sale

Notes to Consolidated Financial Statements

Note 1 — Summary of Significant Accounting Policies (continued)

Securities Held to Maturity

Federal Home Loan Bank Stock

Loans Held for Sale

Loans Receivable

Notes to Consolidated Financial Statements

Note 1 — Summary of Significant Accounting Policies (continued)

Loans Receivable (concluded)

Premises and Equipment

Foreclosed Real Estate

Notes to Consolidated Financial Statements

Note 1 — Summary of Significant Accounting Policies (continued)

Goodwill and other intangible assets

Impairment of long-lived assets

Transfers of Financial Assets

Income Taxes

Notes to Consolidated Financial Statements

Note 1 — Summary of Significant Accounting Policies (continued)

Stock-Based Compensation

Fair Values of Financial Instruments

Notes to Consolidated Financial Statements

Note 1 — Summary of Significant Accounting Policies (continued)

Fair Values of Financial Instruments (concluded)

Notes to Consolidated Financial Statements

Note 1 — Summary of Significant Accounting Policies (continued)

Cash Equivalents and Cash Flows

Earnings Per Share

Comprehensive Income

Notes to Consolidated Financial Statements

Note 1 — Summary of Significant Accounting Policies (concluded)

Recent Accounting Pronouncements

Note 2 — Restricted Assets

Notes to Consolidated Financial Statements

Note 3 — Securities

Notes to Consolidated Financial Statements

Note 3 — Securities (continued)

Notes to Consolidated Financial Statements

Note 3 — Securities (concluded)

Note 4 — Loans

Notes to Consolidated Financial Statements

Notes to Consolidated Financial Statements

Note 5 — Premises and Equipment

Note 6 — Deposits

Notes to Consolidated Financial Statements

Note 6 – Deposits (concluded)

Note 7 — Borrowings

Note 8 – Junior Subordinated Debentures

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

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