Pacific Financial Corporation
Annual Report 2016

Plain-text annual report

2016 Annual Report Cover-Proof1.ai 1 3/20/2017 2:32:11 PM C M Y CM MY CY CMY K 2016 SH HAREHOLDE ERS’ LETTE ER Denise Portmann President & CEO Dear Fell low Sharehol lders: In 2016, w the history 18% from capital an we achieved o y of our bank m 2015. Drivi d excellent cr our seventh co k. We generat ing our solid r redit quality. onsecutive ye ted earnings o results were s ear of profitab of $6.6 millio strong loan gr bility and pos on for the full rowth, acceler ted the most p year, or $0.6 rated deposit profitable yea 63 per share, u growth, stron ar in up ng As we stre market po presence i consecutiv The divid an annual eamlined our osition in Nor in Vancouver ve year by 5% dend was paid yield of 2.4% operations du rthwestern Wa r, Portland an % to $0.23 per d on January 9 %, at recent m uring the year ashington and d Salem. In a r share, demo 9, 2017, to sha market levels. r, we expande d Coastal Wa addition, we r onstrating our areholders of ed our client r shington and raised our ann r commitment f record as of relationships, Oregon, whi nual cash divi t to building s December 31 , deepening o ile expanding idend for the shareholder v 1, 2016, provi our third value. iding our Our total state of W deposits r 2016. We our mortg they buy o deposit growt Washington at remained high e expect loan gage lending t or build in the th rate was 9. 5.6%* and th h at 84% of to and deposit g team is expec e coming year .1% for the ye he national m otal deposits. growth to con cted to be very rs. ear, outpacing edian growth In addition, w ntinue to be ro y active in he g the median h rate at 4.6% we increased obust in the n lping homeow deposit grow *. Our core t our loan port next few years wners finance e wth rate for the transaction tfolio by 5.1% s. In particula e the next hom % for ar, me Regarding performan g the effective nce, highlight eness of our b ts from 2016 business strate are detailed a egy and conti as follows: inuing the mo omentum of o our strong fina ancial  W We delivered r  O Our net interes  O Our credit qua million, or 0.20 m  A Although our c cl lassification o .65% at year- 2  W We remained w lo oans. In n 2016, we str einvesting in p re  llion for 2016 d to 4.11%. 6. record earning st margin (NIM lity continued 0% of total as classified asse of one comme -end compare well reserved gs of $6.6 mi M) improved d to improve, ssets - the low ets increased ercial property d to 3.62% la at year end, w with nonperf west level sinc slightly to $1 y, the ratio of ast year. with our allow forming asset ce 2007. 17.5 million, d f classified as ts declining 6 5% to $1.8 due primarily ssets to gross y to the advers loans was se wance for loa an losses at 1. 39% of total reamlined our people and te r operating fo echnology thro ootprint by clo oughout the f osing two und franchise. derperforming g branches an nd   2016 SHAREHOLDERS’ LETTER  All capital levels exceeded regulatory requirements for a “well-capitalized” financial institution, ending the year with a total risk-based capital ratio of 12.56%, a Tier 1 risk-based ratio of 11.31% and a leverage ratio of 9.25%. Our objectives for 2017 include expansion of treasury management services in growth markets, enhancing the digital banking experience and increasing branch productivity, resulting in impressive and memorable customer service. We believe these initiatives will result in commercial deposit and fee income growth, broaden access to digital application processing, and increase digital transactions with greater customer adoption of mobile banking and person-to-person payments. We also expect our business banking team to grow as they gain momentum from an integrated calling effort with commercial and branch relationship managers.  We continue to build an outstanding franchise. We have a strong team of highly- experienced bankers, and every day they deliver the distinct level of service our customers deserve. We are ideally positioned to serve our communities in 2017 and beyond. We are also proud of the strong financial and service commitment we have to our local community organizations. It’s a commitment that goes beyond offering financial products, services and expertise. In 2016, we invested over $100,000 back into our communities, and our loyal employees volunteered over 800 hours to local non-profit groups, like local food banks and student food programs, financial literacy programs, medical services and community foundations. As a community bank, we are keenly aware that reinvesting in our communities empowers our neighborhoods, stimulates economic development, helps our small businesses grow, and generates long-lasting customer loyalty. As we look forward to 2017, we are striving to deliver another strong performance to benefit our shareholders, customers, communities and employees. Please join us for our annual Shareholders’ meeting on Wednesday, April 26, 2017, at 4:00 pm at 1216 Skyview Drive, Aberdeen, WA 98520. Sincerely, Randy Rognlin Chairman of the Board Pacific Financial Corporation * Source: SNL Financial. Denise Portmann President and Chief Executive Officer Pacific Financial Corporation   Pacific Financial Corporation Selected Financial Data The following selected consolidated five year financial data should be read in conjunction with the Company's audited consolidated financial statements and the accompanying notes presented in this report. Operations Data Net interest income Loan loss provision (recapture) Noninterest income Noninterest expense Provision for income taxes Net income Net income per share: Basic Diluted Dividends declared Dividends declared per share Dividends payout ratio Performance Ratios Interest rate spread Net interest margin⁽¹⁾ Efficiency ratio⁽²⁾ Return on average assets Return on average equity Balance S heet Data Total assets Loans, net Total deposits Total borrowings Shareholders' equity Book value per share⁽³⁾ Tangible book value per share⁽⁴⁾ Equity to assets ratio $ $ $ $ $ $ $ $ 2016 31,663 $ 998 11,225 32,840 2,460 6,590 $ For the Year Ended December 31, 2014 2015 2013 (in thousands) 27,033 $ 300 8,079 28,155 1,730 4,927 $ 29,139 $ 582 9,799 30,859 1,921 5,576 $ 23,800 $ (450) 9,955 29,502 972 3,731 $ 2016 For the Year Ended December 31, 2015 2013 2014 (dollars in thousands, except per share data) $ 0.63 0.62 2,398 $ 0.23 $ 36% $ 0.54 0.53 $ 0.48 0.48 $ 0.37 0.37 2,287 $ 0.22 $ 41% 2,178 $ 0.21 $ 44% 2,036 $ 0.20 $ 55% 3.99% 4.11% 76.62% 0.77% 8.16% 3.99% 4.10% 79.25% 0.71% 7.35% 4.06% 4.17% 80.19% 0.68% 6.92% 3.87% 4.00% 87.40% 0.55% 5.48% 891,383 $ 648,611 779,731 22,056 80,005 7.67 6.38 8.98% $ $ 824,613 $ 617,019 714,499 24,706 76,285 7.34 6.03 9.25% $ $ 744,807 $ 554,746 639,054 24,856 72,483 6.99 5.68 9.73% $ $ 705,039 $ 496,307 607,347 23,403 67,137 6.59 5.25 9.52% $ $ Asset Quality Ratios Nonperforming loans to total loans Allowance for loan losses to total loans Allowance for loan losses to nonperforming loans Nonperforming assets to total assets 0.19% 1.39% 0.24% 1.33% 1.62% 1.48% 1.98% 1.66% 747.93% 0.20% 547.89% 0.62% 91.54% 1.36% 115.41% 1.42% ⁽¹⁾ Net interest income divided by average earning assets ⁽²⁾ Noninterest expense divided by the sum of net interest income and noninterest income ⁽³⁾ Shareholder equity divided by shares outstanding ⁽⁴⁾ Shareholder equity less intangibles divided by shares outstanding 2012 24,011 (1,100) 9,391 28,417 1,300 4,785 2012 0.47 0.47 2,024 0.20 0.42 4.20% 4.34% 85.08% 0.75% 7.28% 643,594 438,838 548,243 23,903 66,721 6.59 5.35 10.37% 3.37% 2.09% 61.92% 3.08% Tel: 509-747-8095 Fax: 509-747-8415 www.bdo.com 601 West Riverside Avenue Suite 900 Spokane, WA 99201 Independent Auditor’s Report Board of Directors Pacific Financial Corporation Aberdeen, Washington Report on the Financial Statements We have audited the accompanying consolidated financial statements of Pacific Financial Corporation (which includes its wholly owned subsidiary, Bank of the Pacific) (the “Company”), which comprise the consolidated balance sheets as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for the years then ended, and the related notes to the consolidated financial statements. Management’s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditor’s Responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America and the standards applicable to financial audits contained in Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the company’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms. Opinion In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pacific Financial Corporation as of December 31, 2016 and 2015, and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America. Spokane, Washington March 24, 2017 Pacific Financial Corporation Consolidated Statements of Financial Condition (Dollars in thousands, except per share data) See accompanying Notes to Consolidated Financial Statements. December 31,December 31,ASSETS20162015Cash on hand and in banks$15,707$17,680Interest bearing deposits43,5919,846Cash and cash equivalents59,29827,526Other interest earning deposits2,2312,727Investment securities available for sale, at fair value111,296100,024Investment securities held to maturity (fair value of $863 and $1,713, respectively)8591,697Loans held for sale6,57312,333Loans, net657,803625,336Allowance for loan losses(9,192)(8,317)Total Loans, net648,611617,019Federal Home Loan Bank stock, at cost1,3351,346Pacific Coast Bankers' Bank stock, at cost1,0001,000Premises and equipment, net16,32615,749Other real estate owned and foreclosed assets4053,610Accrued interest receivable 2,8852,674Cash surrender value of life insurance19,34619,231Goodwill12,16812,168Other intangible assets1,3771,404Other assets7,6736,105Total assets$891,383$824,613LIABILITIES AND SHAREHOLDERS' EQUITYDepositsDemand$233,631$185,001Interest bearing demand and savings416,925389,723Time deposits129,175139,775Total deposits779,731714,499Federal Home Loan Bank advances8,65311,303Junior subordinated debentures13,40313,403Accrued interest payable and other liabilities9,5919,123Total liabilities811,378748,328Shareholders' Equity:Preferred Stock, no par value; 5,000,000 shares authorized; no shares issuedor outstanding at December 31, 2016 and December 31, 2015--Common Stock, $1 par value; 25,000,000 shares authorized, 10,424,541 and 10,394,828 shares issued and outstanding at December 31, 2016 and 2015, respectively10,42510,395Additional paid-in-capital43,53443,245Retained earnings26,73722,545Accumulated other comprehensive (loss) income, net(691)100Total shareholders' equity80,00576,285Total liabilities and shareholders' equity$891,383$824,613 Pacific Financial Corporation Consolidated Statements of Income (Dollars in thousands, except per share data) See accompanying Notes to Consolidated Financial Statements. 2 20162015INTEREST AND DIVIDEND INCOMELoans, including fees$31,828$29,294Deposits in banks and Federal Funds sold16392Taxable interest on investment securities1,1221,094Tax-exempt interest on investment securities922792FHLB & PCBB dividends10068Total interest and dividend income34,13531,340INTEREST EXPENSEDeposits1,9281,715Federal Funds purchased102Federal Home Loan Bank advances230236Junior subordinated debentures304248Total interest expense2,4722,201Net interest income31,66329,139Loan loss provision998582Net interest income after loan loss provision30,66528,557NONINTEREST INCOMEService charges on deposits1,8761,764Gain on sale of loans, net6,3034,961Gain on sales of securities available for sale, net653Earnings on bank owned life insurance467490Other noninterest income2,5732,403Total noninterest income11,2259,671NONINTEREST EXPENSECompensation and employee benefits20,88419,070Occupancy2,0641,965Equipment1,0521,061Data processing2,0471,872Professional services516599Marketing585638Other real estate owned, net438160State and local taxes459815Federal deposit insurance premium456512Other noninterest expense4,3394,039Total noninterest expense32,84030,731Income before income taxes9,0507,497Income tax expense2,4601,921Net income$6,590$5,576Basic earnings per common share$0.63 $0.54 Diluted earnings per common share$0.62 $0.53 Twelve Months Ended December 31, Pacific Financial Corporation Consolidated Statements of Comprehensive Income (Dollars in thousands) See accompanying Notes to Consolidated Financial Statements. 3 20162015Net Income$6,590$5,576Change in fair value of securities available for sale(856)4Defined benefit pension plan65231Other comprehensive (loss) income, net of tax(791)235Comprehensive income$5,799$5,811Twelve Months Ended December 31, Pacific Financial Corporation Consolidated Statements of Shareholders’ Equity (Dollars in thousands, except share amounts) See accompanying Notes to Consolidated Financial Statements. Pacific Financial Corporation 4 Number of Common Shares Common Stock Additional Paid-in Capital Retained Earnings Accumulated Other Comprehensive Income (Loss) Total Shareholders' Equity Balance at December 31, 201410,371,460 $10,371$42,991$19,256$(135)$72,483Net income- --5,576-5,576Other comprehensive income, net of taxUnrealized holding gain on securities less reclassification-adjustments for net gains included in net income- ---44Amortization of unrecognized prior service costs andnet gains- ---231231Issuance of common stock23,368 2441--65Cash dividends declared ($0.22 per share)- --(2,287)-(2,287)Stock-based compensation expense- -213--213Balance at December 31, 201510,394,828 $10,395$43,245$22,545$100$76,285Net income- --6,590-6,590Other comprehensive (loss) income, net of taxUnrealized loss on securities less reclassification-adjustments for net losses included in net income- ---(856)(856)Amortization of unrecognized prior service costs andnet gains- ---6565Issuance of common stock29,713 30(36)--(6)Cash dividends declared ($0.23 per share)- --(2,398)-(2,398)Stock-based compensation expense- -325--325Balance at December 31, 201610,424,541 $10,425$43,534$26,737$(691)$80,005 Consolidated Statements of Cash Flow (Dollars in thousands) See accompanying Notes to Consolidated Financial Statements. 5 20162015Cash flows from operating activities:Net Income$6,590$5,576Adjustments to reconcile net income to net cash from operating activitiesProvision for loan losses998582Depreciation and amortization2,7222,861Deferred income taxes(101)29Originations of loans held for sale(233,610)(206,986)Proceeds from sales of loans held for sale245,496205,400Gain on sale of loans, net(6,126)(4,961)Gain on sale of securities available for sale, net(6)(53)Gain on sale of other real estate owned, net(97)(128)Gain on sale of premises and equipment(4)(30)Earnings on bank owned life insurance(467)(490)Increase in accrued interest receivable(211)(326)(Decrease) increase in accrued interest payable(3)7Other real estate owned write-downs71104Decrease (increase) in prepaid expenses78(376)Other operating activities1,043644Net cash provided by operating activities16,3731,853Cash flows from investing activitiesLoans originated, net of principal payments(31,344)(66,952)Net (decrease) increase in interest bearing balances with banks(33,249)6,409Maturities of investment securities held to maturity838131Maturities of investment securities available for sale12,78210,262Purchase of investment securities available for sale(29,156)(28,268)Purchases of FHLB Stock(3,215)(972)Purchases of premises and equipment(3,013)(844)Proceeds from sales of investment securities available for sale2,5644,287Proceeds from redemption of FHLB Stock3,2262,521Proceeds from sales of other real estate owned1,9321,289Net cash used in investing activities(78,635)(72,137)Cash flows from financing activitiesNet increase in deposits65,23275,445Repayments of FHLB Advances(2,650)(150)Issuance of common stock(6)65Cash dividends paid(2,287)(2,178)Net cash provided by financing activities60,28973,182Net (decrease) increase in cash and cash equivalents(1,973)2,898Cash and cash equivalents at beginning of year17,68014,782Cash and cash equivalents at end of year$15,707$17,680Supplemental disclosures of cash flow information:Cash paid for interest$2,475$2,194Cash paid for taxes$2,199$2,306Supplemental non-cash disclosures of cash flow information:Other real estate owned acquired in settlement of loans$(219)$(3,876)Financed sale of other real estate owned$1,518$448Assets transferred to assets held for sale$838$-Twelve Months Ended December 31, Pacific Financial Corporation and Subsidiary Notes to Consolidated Financial Statements For the Years Ended December 31, 2016 and December 31, 2015 NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization – Pacific Financial Corporation (the “Company”) is a bank holding company headquartered in Aberdeen, Washington. The Company owns one banking subsidiary, Bank of the Pacific (the “Bank”), which is also headquartered in Aberdeen, Washington. The Company was incorporated in the State of Washington in February, 1997, pursuant to a holding company reorganization of the Bank. The Company has two wholly owned subsidiaries, PFC Statutory Trust I and II (the “Trusts”), which do not meet the criteria for consolidation, and therefore, are not consolidated in the Company’s financial statements. The Company conducts its banking business through the Bank, which operates fifteen branches located in communities in Grays Harbor, Pacific, Whatcom, Clark, Skagit and Wahkiakum counties in the state of Washington and three branches in Clatsop County, Oregon. In addition, the Bank operates three loan production offices in Burlington and DuPont, Washington and Salem Oregon and has a residential real estate mortgage department. Basis of presentation – The consolidated financial statements include the accounts of Pacific Financial Corporation and its wholly- owned subsidiary. All intercompany accounts and transactions have been eliminated in consolidation. The interim consolidated financial statements are not audited, but include all adjustments that Management considers necessary for a fair presentation of consolidated financial condition and results of operations for the interim periods presented. Certain prior year amounts have been reclassified to conform with the 2016 presentation. None of these reclassifications have an effect on net income or net cash flows. Method of accounting and use of estimates – The Company prepares its consolidated financial statements in conformity with accounting principles generally accepted in the United States of America and prevailing practices within the banking industry. This requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of income and expenses during the reporting periods. Actual results could differ from those estimates. Significant estimates made by Management involve the calculation of the allowance for loan losses, impaired loans, the fair value of available for sale investment securities, deferred tax assets, and the value of other real estate owned and foreclosed assets. The Company utilizes the accrual method of accounting, which recognizes income when earned and expenses when incurred. Subsequent events –The Company performed an evaluation of subsequent events through March 24, 2017, the date these financial statements were available to be issued. There were no significant subsequent events identified. Securities available for sale – Securities available for sale consist of debt securities that the Company intends to hold for an indefinite period, but not necessarily to maturity. Securities available for sale are reported at fair value. Unrealized gains and losses, net of the related deferred tax effect, are reported net as 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. 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 that are deemed to be other than temporary are reflected in earnings when identified. Management evaluates individual securities for other than temporary impairment (“OTTI”) on a quarterly basis. OTTI is separated into a credit and noncredit component. Noncredit component losses are recorded in other comprehensive income (loss) when the fair value of the debt security is below the carrying value primarily due to changes in interest rates, there has not been significant deterioration in the financial condition of the issuer, and it is not more likely than not that the Company will be required to, nor does it have the intent to sell the security before the anticipated recovery of its remaining carrying value. Credit component losses are reported in noninterest income. Federal Home Loan Bank stock – The Company’s investment in Federal Home Loan Bank (“FHLB”) stock is carried at cost. The Company is required to maintain a minimum level of investment in FHLB stock based on specific percentages of its outstanding 6 mortgages, total assets, or FHLB advances. At December 31, 2016 and December 31, 2015 the stock was that of FHLB of Des Moines. Pacific Coast Bankers Bank stock – The Company’s investment in Pacific Coast Bankers Bank (“PCBB”) stock is carried at cost. 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 fair 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. Net unrealized losses are recognized through a valuation allowance established by charges to income. Loans held for sale that are unable to be sold in the secondary market are transferred to loans receivable when identified. Loans receivable – Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at their outstanding principal balances adjusted for any charge-offs, the allowance for loan losses, 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 of yield over the contractual life of the related loans using the effective interest method. 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 against interest income. Interest income is subsequently recognized only to the extent that cash payments are received until, in management’s judgment, the borrower has the ability to make contractual interest and principal payments, in which case the loan is returned to accrual status. Allowance for loan losses – The allowance for loan losses is established through a provision that is charged to earnings as probable losses are incurred. Losses are charged against the allowance when management believes the collectability of a loan balance is unlikely. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of underlying collateral and prevailing economic conditions. The evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available. The Company’s methodology for assessing the appropriateness of the allowance consists of several key elements, which includes a general formulaic allowance and a specific allowance on impaired loans. The formulaic portion of the general credit loss allowance is established by applying a loss percentage factor to the different loan types based on historical loss experience adjusted for qualitative factors. A loan is considered impaired when, based on current information and events, it is probable the Company will be unable to collect principal and interest when due according to the contractual terms of the original loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls are generally not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrowers, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial, construction and real estate loans by either the present value of the expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral less estimated selling costs if the loan is collateral dependent. When the net realizable value of an impaired loan is less than the book value of the loan, impairment is recognized by adjusting the allowance for loan losses. Uncollected accrued interest is reversed against interest income. If ultimate collection of principal is in doubt, all subsequent cash receipts including interest payments on impaired loans are applied to reduce the principal balance. For all portfolio segments, a restructuring of a debt constitutes a troubled debt restructuring (“TDR”) if the Company grants a concession to the borrower for economic or legal reasons related to the borrower’s financial difficulties that it would not otherwise consider. TDRs typically present an elevated level of credit risk as the borrowers are not able to perform according to the original contractual terms. Loans or leases that are reported as TDRs are considered impaired and measured for impairment as described above. 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. 7 Other real estate owned – Real estate properties acquired through, or in lieu of, foreclosure are to be sold and are initially recorded at the 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 (“OREO”) is charged to the allowance for loan losses. Properties are evaluated regularly to ensure that the recorded amounts are supported by their current fair values, and that write-downs to reduce the carrying amounts to fair value less estimated costs to dispose are recorded as necessary. Any subsequent reductions in carrying values, and revenue and expense from the operations of properties, are charged to operations. Goodwill and other intangible assets – At December 31, 2016 the Company had $13.5 million in 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 reviewed for potential impairment during the second quarter on an annual basis or more frequently if events or circumstances indicate a potential impairment, at the reporting unit level. The Company has one reporting unit, the Bank, for purposes of computing goodwill. The analysis of potential impairment of goodwill requires a two-step process. The first step is a comparison of the reporting unit’s fair value to its carrying value. If the reporting unit’s fair value is less than its carrying value, the Company would be required to progress to the second step. In the second step the Company calculates the implied fair value of its reporting unit. The Company compares the implied fair value of goodwill to the carrying amount of goodwill on the Company’s balance sheet. If the carrying amount of the goodwill is greater than the implied fair value of that goodwill, an impairment loss must be recognized in an amount equal to that excess. The implied fair value of goodwill is determined in the same manner as goodwill recognized in a business combination. The estimated fair value of the Company is allocated to all of the Company’s individual assets and liabilities, including any unrecognized identifiable intangible assets, as if the Company had been acquired in a business combination and the estimated fair value of the Company is the price paid to acquire it. The allocation process is performed only for purposes of determining the amount of goodwill impairment, as no assets or liabilities are written up or down, nor are any additional unrecognized identifiable intangible assets recorded as a part of this process. The results of the Company’s annual impairment test determined the reporting unit’s fair value exceeded its carrying value and no goodwill impairment existed. As of December 31, 2016 management determined there were no events or circumstances which would more likely than not reduce the fair value of its reporting unit below its carrying value. No assurance can be given that the Company will not record an impairment loss on goodwill in the future. Core deposit intangibles are amortized to noninterest expenses using an accelerated method over ten years. Net unamortized core deposit intangible totaled $110,000 and $137,000 at December 31, 2016 and 2015, respectively. Amortization expense related to core deposit intangible totaled $27,000 and $34,000 during the years ended December 31, 2016 and 2015, respectively. In 2006, the Bank completed a deposit transfer and assumption transaction with an Oregon-based bank for a $1.3 million premium. In connection with completion of the transaction, the Oregon Department of Consumer and Business Services issued a Certificate of Authority to the Bank authorizing it to conduct a banking business in the State of Oregon. The premium, and the resultant right to conduct business in Oregon, is recorded as an indefinite-lived intangible asset. Impairment of long-lived assets – Management periodically reviews the carrying value of its long-lived assets to determine if impairment has occurred or whether changes in circumstances have occurred that would require a revision to the remaining useful life, of which there have been none. 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, including cash, investment securities, loans and loans held for sale, 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 Company, (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 Company does not maintain effective control over the transferred assets through either an agreement to repurchase them before their maturity, or the ability to cause the buyer to return specific assets. 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. 8 As of December 31, 2016, the Company had no unrecognized tax benefits. The Company’s policy is to recognize interest and penalties on unrecognized tax benefits in “Income Taxes” in the consolidated statements of income. There were no amounts related to interest and penalties recognized for the year ended December 31, 2016. The tax years that remain subject to examination by federal and state taxing authorities are the years ended December 31, 2015, 2014 and 2013. Stock-based compensation – Accounting guidance requires measurement of compensation cost for all stock based awards based on the grant date fair value and recognition of compensation cost over the service period of stock based awards. The fair value of stock options is determined using the Black-Scholes valuation model. The Company’s stock compensation plans are described more fully in Note 15. 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 and cash equivalents have a maturity of 90 days or less at the time of purchase. 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. Certificates of deposit held for investment – Certificates of deposit held for investments include amounts invested with financial institutions for a stated interest rate and maturity date. Early withdraw penalties apply, however the Company plans to hold these investments to maturity. 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, were 291,034 and 260,350 in 2016 and 2015, respectively. Comprehensive (loss) income – Recognized revenue, expenses, gains and losses are included in net income. Certain changes in assets and liabilities, such as prior service costs and amortization of prior service costs related to defined benefit plans and unrealized gains and losses on securities available for sale, are reported within equity in other accumulated comprehensive (loss) income in the consolidated balance sheet. Such items, along with net income, are components of comprehensive (loss) 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. Business segment – The Company operates a single business segment. The financial information that is used by the chief operating decision maker in allocating resources and assessing performance is only provided for one reportable segment as of December 31, 2016 and 2015. Recent accounting pronouncements Financial Accounting Standards Board (“FASB”) Accounting Standards update (“ASU” or “Update”) ASU 2014-09, Revenue from Contracts with Customers, was issued in May 2014, Under this Update, FASB created a new Topic 606 which is in response to a joint initiative of FASB and the International Accounting Standards Board to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and international financial reporting standards that would: 1. Remove inconsistencies and weaknesses in revenue requirements. 2. Provide a more robust framework for addressing revenue issues. 3. Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets. 4. Provide more useful information to users of financial statements through improved disclosure requirements. 5. Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer. The original effective date for this Update was deferred in FASB ASU 2015-14 below. The Company is currently evaluating the impact that the Update will have on its Consolidated Financial Statements. FASB ASU 2015-14, Revenue from Contracts with Customers, was issued in August 2015 and defers the effective date of the above- mentioned FASB ASU 2014-09 for certain entities. Public business entities, certain not-for-profit entities, and certain employee benefit plans should apply the guidance in Update 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Earlier application is now permitted, but only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company is a public business entity and will not early adopt the guidance in Update 2014-09 as permitted in this Update. The Company is currently evaluating the impact that Update 2014-09 will have on its Consolidated Financial Statements upon adoption. 9 FASB ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities (Subtopic 825-10), was issued in January 2016, to enhance the reporting model for financial instruments to provide users of financial statements with more decision- useful information. This Update contains several provisions, including but not limited to 1) requiring equity investments, with certain exceptions, to be measured at fair value with changes in fair value recognized in net income; 2) simplifying the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; 3) eliminating the requirement to disclose the method(s) and significant assumptions used to estimate fair value; and 4) requiring separate presentation of financial assets and liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements. The Update also changes certain financial statement disclosure requirements, including requiring disclosures of the fair value of financial instruments be made on the basis of exit price. The Update is effective for public entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company is currently evaluating the impact that the Update will have on its Consolidated Financial Statements. FASB ASU 2016-02, Leases (Topic 842), was issued in February 2016, to increase transparency and comparability of leases among organizations and to disclose key information about leasing arrangements. The Update sets out the principles for the recognition, measurement, presentation and disclosure of leases for both lessees and lessors. The Update requires lessees to apply a dual approach, classifying leases as either a finance or operating lease. This classification will determine whether the lease expense is recognized based on an effective interest method or on a straight-line basis over the term of the lease. A lessee is also required to record a right- of-use asset and a lease liability for all leases with a term greater than 12 months regardless of their classification. All cash payments will be classified within operating activities in the statement of cash flows. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The Update is effective for public entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company is currently evaluating the impact that the Update will have on its Consolidated Financial Statements. FASB ASU 2016-08, Revenue from Contracts with Customers: Principal versus Agent Considerations, was issued in March 2016 and it clarifies the implementation guidance of the above-mentioned FASB ASU 2014-09 as it relates to principal versus agent considerations. The Update addresses identifying the unit of account and nature of the goods or services as well as applying the control principle and interactions with the control principle. The amendments to the Update do not change the core principle of the guidance. The effective date and transition requirements for this Update are the same as FASB ASU 2014-09. The Company is currently evaluating the impact that the Update will have on its Consolidated Financial Statements. FASB ASU 2016-09, Stock Compensation (Topic 718), issued in March 2016, is intended to simplify several aspects of the accounting for share-based payment award transactions. For public business entities, the guidance is effective for annual periods after December 15, 2016, including interim periods within those annual periods with early adoption permitted. Certain amendments will be applied using a modified retrospective transition method by means of a cumulative-effect adjustment to equity as of the beginning of the period in which the guidance is adopted. Other amendments will be applied retroactively (such as presentation of employee taxes paid on the statement of cash flows) or prospectively (such as recognition of excess tax benefits on the income statement). The Company is currently evaluating the impact that this Update will have on its Consolidated Financial Statements. FASB ASU 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing, was issued in April 2016 which clarifies the implementation guidance of the above-mentioned FASB ASU 2014-09 as it relates to identifying performance obligations and licensing. The effective date and transition requirements for this Update are the same as FASB ASU 2014-09. The Company is currently evaluating the impact that this Update will have on its Consolidated Financial Statements. FASB ASU 2016-13, Financial Instruments: Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, was issued in June 2016. Commonly referred to as the current expected credit loss model ("CECL"), this Update requires financial assets measured at amortized cost basis to be presented at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset to present the net carrying value at the amount expected to be collected on the financial asset. The measurement of expected credit losses is based on relevant information about past events including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. The amendment affects loans, debt securities, trade receivables, net investments in leases, off balance-sheet credit exposures, reinsurance receivables, and any other financial asset not excluded from the scope that have the contractual right to receive cash. The Update replaces the incurred loss impairment methodology, which generally only considered past events and current conditions, with a methodology that reflects the expected credit losses and required consideration of a broader range of reasonable and supportable information to estimate all expected credit losses. For public business entities that are not U.S. Securities and Exchange Commission filers, the Update is effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years with early adoption permitted for fiscal years after December 15, 2018. An entity will apply the amendments through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. A prospective transition approach is required for debt securities. The Company is currently evaluating the impact that this Update will have on its Consolidated Financial Statements. 10 FASB ASU 2016-15, Statement of Cash Flows (Topic 213): Classification of Certain Cash Receipts and Cash Payments, was issued in August 2016. The Update addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. For public business entities, the guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted and must be applied using a retrospective transitional method to each period presented. The Company is currently evaluating the impact that this Update will have on its Consolidated Financial Statements. FASB ASU 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, was issued in January 2017. The Update simplifies how an entity is required to test goodwill for impairment by eliminating a step from the goodwill impairment test. The amendments in this update provide that an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. Additionally, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. This Update is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. As we approach the adoption date, we will consult the updated goodwill impairment test steps to determine if an impairment charge should be recognized. 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 required reserve balance at December 31, 2016 and 2015 was met by holding cash. NOTE 3 – SECURITIES Investment securities consist principally of short and intermediate term debt instruments issued by the U.S. Treasury, other U.S. government agencies, state and local governments, other corporations, and mortgaged backed securities (“MBS”). Investment securities have been classified according to management’s intent. The amortized cost of securities and their approximate fair value were as follows: 11 GrossGrossAmortizedUnrealizedUnrealizedFair Cost GainsLossesValueAvailable for SaleCollateralized mortgage obligations: agency issued$35,840$63$388$35,515Collateralized mortgage obligations: non-agency336-5331Mortgage backed securities: agency issued15,2664811515,199U.S. Government and agency securities7,5677247,635State and municipal securities53,0475761,00752,616Total available for sale$112,056$759$1,519$111,296Held to maturityMortgage backed securities: agency issued$49$4$-$53State and municipal securities810--810Total held to maturity$859$4$-$863December 31, 2016(in thousands) 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, 2016 and December 31, 2015, were as follows: At December 31, 2016, there were 105 investment securities in an unrealized loss position. The unrealized losses on these securities were caused by changes in interest rates, widening pricing spreads and market illiquidity, leading to a decline in the fair value subsequent to their purchase. 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 environment. Based on management’s evaluation, and because the Company does not have the intent to sell these securities and it is not more likely than not that it will have to sell the securities before recovery of cost basis, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2016. For collateralized mortgage obligations (“CMOs”) the Company estimates expected future cash flows of the underlying collateral, together with any credit enhancements. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which considers current delinquencies, future expected default rates and collateral value by vintage) and prepayments. The expected cash flows of the security are then discounted to arrive at a present value amount. For the years ended December 31, 2016 and 2015, no CMO was determined to be other-than-temporarily- impaired. The Company has not recorded impairments related to credit losses through earnings for the years ended December 31, 2016 and 2015. 12 GrossGrossAmortizedUnrealizedUnrealizedFair Cost GainsLossesValueAvailable for SaleCollateralized mortgage obligations: agency issued$39,445$129$529$39,045Collateralized mortgage obligations: non agency434-12422Mortgage backed securities: agency issued12,2565012812,178U.S. Government agency securities8,58881238,646State and municipal securities38,7659993139,733Total available for sale$99,488$1,259$723$100,024Held to maturityMortgage backed securities: agency issued$65$5$-$70State and municipal securities1,63211-1,643Total held to maturity$1,697$16$-$1,713December 31, 2015(in thousands)UnrealizedUnrealizedUnrealizedFair ValueLossesFair ValueLossesFair ValueLossesAvailable for saleCollateralized mortgage obligations: agency issued$23,601$279$5,630$109$29,231$388Collateralized mortgage obligations: non agency--33153315Mortgage backed securities: agency issued9,9051012,8251412,730115U.S. Government agency securities2,5864--2,5864State and municipal securities30,4611,007--30,4611,007Total$66,553$1,391$8,786$128$75,339$1,519UnrealizedUnrealizedUnrealizedFair ValueLossesFair ValueLossesFair ValueLossesAvailable for saleCollateralized mortgage obligations: agency issued$25,029$325$7,987$204$33,016$529Collateralized mortgage obligations: non agency--4221242212Mortgage backed securities: agency issued6,240643,273649,513128U.S. Government agency securities5,59523--5,59523State and municipal securities5,13331--5,13331Total$41,997$443$11,682$280$53,679$723(in thousands)December 31, 2016Less Than 12 Months12 Months or More TotalLess Than 12 Months12 Months or More Total(in thousands)December 31, 2015 Proceeds from sales of securities available-for-sale were $2.6 million and $4.3 million for the years ended December 31, 2016 and December 31, 2015, respectively. The following table provides the gross realized gains and losses on the sales of securities for the periods indicated: The Company did not engage in originating subprime mortgage loans, and it does not believe that it has material exposure to subprime mortgage loans or subprime mortgage backed securities. Additionally, the Company does not own any sovereign debt of Eurozone nations or structured financial products, such as collateralized debt obligations or structured investment vehicles, which are known by the Company to have elevated risk characteristics. The amortized cost and fair value of collateralized mortgage obligations and mortgage backed securities are presented by expected average life, rather than contractual maturity. Expected maturities may differ from contractual maturities because borrowers may have the right to prepay underlying loans without prepayment penalties. The amortized cost and estimated fair value of investment securities at December 31, 2016, by maturity were as follows: At December 31, 2016 and December 31, 2015, investment securities with an estimated fair value of $72.4 million and $84.4 million, respectively, were pledged to secure public deposits, certain nonpublic deposits and borrowings. As required of all members of the FHLB system, the Company maintains an investment in the capital stock of the FHLB in an amount equal to the greater of $500,000 or 0.5% of home mortgage loans and pass-through securities plus 5.0% of the outstanding balance of mortgage home loans sold to FHLB under the Mortgage Purchase Program. Participating banks record the value of FHLB stock equal to its par value at $100 per share. At December 31, 2016 and December 31, 2015, the Company held $1.3 million in FHLB stock. The Company owns $1.0 million in common stock in PCBB, from which the Company receives a variety of corresponding banking services through its banking subsidiary Pacific Coast Bankers Bank. An investment by the Company in such an entity is permissible under 12 CFR 362.3(a)(2)(iv). When evaluating this investment for impairment, the value is determined based on the recovery of the par value through any redemption by PCBB or from the sale to another eligible purchaser, rather than by recognizing temporary declines in value. PCBB disclosed that it reported net income for the twelve month period ended December 31, 2016 and maintains capital ratios that exceed “well capitalized” standards for regulatory purposes. 13 20162015Gross realized gain on sale of securities$8$108Gross realized loss on sale of securities(2)(55)Net realized gain on sale of securities$6$53Twelve Months Ended December 31,(in thousands)Held to MaturityAvailable for SaleAmortizedAmortizedCostFair ValueCostFair ValueDue in one year or less$-$-$5,241$5,277Due after one year through five years10410425,86225,909Due after five years through ten years48548933,65033,793Due after ten years27027042,05941,122Declining Balance Securities--5,2445,195Total investment securities$859$863$112,056$111,296December 31, 2016(in thousands) NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES AND CREDIT QUALITY Loans held in the portfolio at December 31, 2016 and December 31, 2015, were as follows: Allowance for loan losses and credit quality The allowance for loan losses represents the Company’s estimate as to the probable credit losses inherent in its loan portfolio. The allowance for loan losses is increased through periodic charges to earnings through provision for loan losses and represents the aggregate amount, net of loans charged-off and recoveries on previously charged-off loans, that is needed to establish an appropriate reserve for credit losses. The allowance is estimated based on a variety of factors and using a methodology as described below:  The Company classifies loans into relatively homogeneous pools by loan type in accordance with regulatory guidelines for regulatory reporting purposes. The Company regularly reviews all loans within each loan category to establish risk ratings for them that include Pass, Watch, Special Mention, Substandard, Doubtful and Loss. Pursuant to ASC 310 “Accounting by Creditors for Impairment of a Loan”, the impaired portion of collateral dependent loans is charged-off. Other risk-related loans not considered impaired have loss factors applied to the various loan pool balances to establish loss potential for provisioning purposes.  Analyses are performed to establish the loss factors based on historical experience, as well as expected losses based on qualitative evaluations of such factors as the economic trends and conditions, industry conditions, levels and trends in delinquencies and impaired loans, levels and trends in charge-offs and recoveries, among others. The loss factors are applied to loan category pools segregated by risk classification to estimate the loss inherent in the Company’s loan portfolio pursuant to ASC 450 “Accounting for Contingencies.”  Additionally, impaired loans are evaluated for loss potential on an individual basis in accordance with ASC 310 “Accounting by Creditors for Impairment of a Loan” and specific reserves are established based on thorough analysis of collateral values where loss potential exists. When an impaired loan is collateral dependent and a deficiency exists in the fair value of collateral securing the loan in comparison to the associated loan balance, the deficiency is charged-off at that time or a specific reserve is established. Impaired loans are reviewed no less frequently than quarterly.  In the event that a current appraisal to support the fair value of the real estate collateral underlying an impaired loan has not yet been received, but the Company believes that the collateral value is insufficient to support the loan amount, an impairment reserve is recorded. In these instances, the receipt of a current appraisal triggers an updated review of the collateral support for the loan and any deficiency is charged-off or reserved at that time. In those instances where a current appraisal is not available in a timely manner in relation to a financial reporting cut-off date, the Company discounts the most recent third-party appraisal depending on a number of factors including, but not limited to, property location, local price volatility, local economic conditions, and recent comparable sales. In all cases, the costs to sell the subject property are deducted in arriving at the fair value of the collateral. 14 20162015Commercial and agricultural$134,318$131,734Real estate:Construction and development41,98333,170Residential 1-4 family91,68694,217Multi-family29,74726,828Commercial real estate -- owner occupied132,449134,366Commercial real estate -- non owner occupied138,078134,612Farmland25,58820,492Total real estate459,531443,685Consumer65,44251,352Gross loans659,291626,771 Deferred fees(1,488)(1,435)Loans, net$657,803$625,336(in thousands)December 31, Changes in the allowance for loan losses for the twelve months ended December 31, 2016 and December 31, 2015 were as follows: The allowance for loan losses disaggregated on the basis of the Company's impairment method as of December 31, 2016 and December 31, 2015 were as follows: 15 Balance at Beginning of YearCharge-offsRecoveriesProvision for Loan LossesBalance at End of YearCommercial and agricultural$1,095$(8)$7$1,174$2,268Real estate:Residential 1-4, Multi family, Const & Dev905(159)1343801,260Commercial real estate -- owner occupied2,038--(479)1,559Commercial real estate -- non owner occupied1,440--(318)1,122Farmland39--557596Total real estate4,422(159)1341404,537Consumer803(108)111,0661,772Unallocated1,997--(1,382)615Total $8,317$(275)$152$998$9,192Twelve Months Ended December 31, 2016(in thousands)Balance at Beginning of YearCharge-offsRecoveriesProvision for Loan LossesBalance at End of YearCommercial and agricultural$1,022$-$49$24$1,095Real estate:Residential 1-4, Multi family, Const & Dev701(86)94196905Commercial real estate -- owner occupied1,143-18942,038Commercial real estate -- non owner occupied2,249(806)254(257)1,440Farmland27--1239Total real estate4,120(892)3498454,422Consumer979(143)19(52)803Unallocated2,232--(235)1,997Total $8,353$(1,035)$417$582$8,317Twelve Months Ended December 31, 2015(in thousands)Loans Individually Evaluated for ImpairmentLoans Collectively Evaluated for ImpairmentTotal Allowance for Loan LossesCommercial and agricultural$-$2,268$2,268Real estate:Residential 1-4, Multi family, Const & Dev-1,2601,260Commercial real estate -- owner occupied-1,5591,559Commercial real estate -- non owner occupied-1,1221,122Farmland-596596Total real estate-4,5374,537Consumer121,7601,772Unallocated-615615Total $12$9,180$9,192(in thousands)Twelve Months Ended December 31, 2016 The recorded investment of loans disaggregated on the basis of the Company’s impairment method as of December 31, 2016 and December 31, 2016 were as follows: 16 Loans Individually Evaluated for ImpairmentLoans Collectively Evaluated for ImpairmentTotal Allowance for Loan LossesCommercial and agricultural$-$1,095$1,095Real estate:Residential 1-4, Multi family, Const & Dev-905905Commercial real estate -- owner occupied-2,0382,038Commercial real estate -- non owner occupied-1,4401,440Farmland-3939Total real estate-4,4224,422Consumer-803803Unallocated-1,9971,997Total $-$8,317$8,317Twelve Months Ended December 31, 2015(in thousands)Loans Individually Evaluated for ImpairmentLoans Collectively Evaluated for ImpairmentGross LoansCommercial and agricultural$287$134,031$134,318Real estate:Residential 1-4, Multi family, Const & Dev791162,625163,416Commercial real estate -- owner occupied-132,449132,449Commercial real estate -- non owner occupied-138,078138,078Farmland-25,58825,588Total real estate791458,740459,531Consumer53864,90465,442Total $1,616$657,675$659,291Twelve Months Ended December 31, 2016(in thousands)Loans Individually Evaluated for ImpairmentLoans Collectively Evaluated for ImpairmentGross LoansCommercial and agricultural$430$131,304$131,734Real estate:Residential 1-4, Multi family, Const & Dev1,221152,994154,215Commercial real estate -- owner occupied56134,310134,366Commercial real estate -- non owner occupied217134,395134,612Farmland-20,49220,492Total real estate1,494442,191443,685Consumer5751,29551,352Total $1,981$624,790$626,771(in thousands)Twelve Months Ended December 31, 2015 Credit Quality Indicators Federal regulations require that the Bank periodically evaluate the risks inherent in its loan portfolios. In addition, the Washington Division of Banks and the Federal Deposit Insurance Corporation (“FDIC”) have authority to identify problem loans and, if appropriate, require them to be reclassified. There are three classifications for problem loans: Substandard, Doubtful, and Loss. These terms are used as follows:  “Substandard” loans have one or more defined weaknesses and are characterized by the distinct possibility some loss will be sustained if the deficiencies are not corrected.  “Doubtful” loans have the weaknesses of loans classified as "Substandard," with additional characteristics that suggest the weaknesses make collection or recovery in full after liquidation of collateral questionable on the basis of currently existing facts, conditions, and values. There is a high possibility of loss in loans classified as "Doubtful."  “Loss” loans are considered uncollectible and of such little value that continued classification of the credit as a loan is not warranted. If a loan or a portion thereof is classified as "Loss," it must be charged-off; meaning the amount of the loss is charged against the allowance for loan losses, thereby reducing that reserve. The Bank also classifies some loans as “Pass” or Other Loans Especially Mentioned (“OLEM”). Within the “Pass” classification certain loans are “Watch” rated because they have elements of risk that require more monitoring than other performing loans. “Pass” grade loans include a range of loans from very high credit quality to acceptable credit quality. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt service capacity. Loans with higher grades within the “Pass” category may include borrowers who are experiencing unusual operating difficulties, but have acceptable payment performance to date. Overall, loans with a “Pass” grade show no immediate loss exposure. Loans classified as OLEM continue to perform but have shown deterioration in credit quality and require close monitoring. Credit quality indicators as of December 31, 2016 and December 31, 2015 were as follows: 17 Other Loans Especially PassMentionedSubstandardDoubtfulTotalCommercial and agricultural$121,841$3,734$8,743$-$134,318Real estate:Construction and development38,344-3,639-41,983Residential 1-4 family89,6722291,785-91,686Multi-family29,356-391-29,747Commercial real estate -- owner occupied128,9031,1202,426-132,449Commercial real estate -- non owner occupied136,4511,627--138,078Farmland24,574778236-25,588Total real estate447,3003,7548,477-459,531Consumer65,210-232-65,442Gross Loans634,3517,48817,452-659,291Deferred fees(1,488)---(1,488)Loans, net$632,863$7,488$17,452$-$657,803(in thousands)December 31, 2016 Impaired Loans Impaired loans by type as of December 31, 2016 and 2015, and interest income recognized for the twelve months ended December 31, 2016 and 2015, were as follows: Insider Loans Certain related parties of the Company, principally directors and their affiliates, were loan customers of the Bank in the ordinary course of business during 2016 and 2015. Total related party loans outstanding at December 31, 2016 and 2015 to executive officers 18 Other Loans Especially PassMentionedSubstandardDoubtfulTotalCommercial and agricultural$123,098$5,690$2,946$-$131,734Real estate:Construction and development32,375-796-33,171Residential 1-4 family91,3151,3321,569-94,216Multi-family26,828---26,828Commercial real estate -- owner occupied126,8945,5521,920-134,366Commercial real estate -- non owner occupied123,2362,7078,669-134,612Farmland20,251241--20,492Total real estate420,8999,83212,954-443,685Consumer51,16119172-51,352Gross Loans595,15815,54116,072-626,771Deferred fees(1,435)---(1,435)Loans, net$593,723$15,541$16,072$-$625,336(in thousands)December 31, 2015Recorded Investment With No Specific Valuation AllowanceRecorded Investment With Specific Valuation AllowanceTotal Recorded InvestmentUnpaid Contractual Principal BalanceRelated Specific Valuation AllowanceAverage Recorded Investment Interest Income RecognizedCommercial and agricultural$287$-$287$287$-$322$5Real Estate:Residential 1-4, Multi family, Const & Dev791-7911,308-94986Commercial real estate -- owner occupied-----56-Commercial real estate -- non owner occupied-----15-Total real estate791-7911,308-1,02086Consumer3551835385381243114Total$1,433$183$1,616$2,133$12$1,773$105December 31, 2016(in thousands)Recorded Investment With No Specific Valuation AllowanceRecorded Investment With Specific Valuation AllowanceTotal Recorded InvestmentUnpaid Contractual Principal BalanceRelated Specific Valuation AllowanceAverage Recorded Invesetment Interest Income RecognizedCommercial and agricultural$430$-$430$430$-$375$10Real Estate:Residential 1-4, Multi family, Const & Dev1,221-1,2211,809-1,59394Commercial real estate -- owner occupied56-5656-7792Commercial real estate -- non owner occupied217-217217-2,88370Farmland-----41-Total real estate1,494-1,4942,082-5,296166Consumer57-5757-353Total$1,981$-$1,981$2,569$-$5,706$179December 31, 2015(in thousands) and directors were $2.2 million and $2.1 million, respectively. During 2016 and 2015, new loans of $324,000 and $401,000, respectively, were made, and repayments totaled $251,000 and $679,000 respectively. 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, 2016. Aging Analysis The following tables summarize the Company’s loans past due, both accruing and nonaccruing, by type as of December 31, 2016 and December 31, 2015: Troubled Debt Restructured Loans A modification of a loan constitutes a troubled debt restructuring (“TDR”) when a borrower is experiencing financial difficulty and the modification constitutes a concession. There are various types of concessions when modifying a loan, however, forgiveness of principal is rarely granted by the Company. Commercial and industrial loans modified in a TDR may involve term extensions, below market interest rates and/or interest-only payments wherein the delay in the repayment of principal is determined to be significant when all elements of the loan and circumstances are considered. Additional collateral, a co-borrower, or a guarantor is often required. Commercial mortgage and construction loans modified in a TDR often involve reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor. Construction loans modified in a TDR may also involve extending the interest-only payment period. Residential mortgage loans modified in a TDR are primarily comprised of loans where monthly payments are lowered to accommodate the borrowers’ financial needs. Land loans are typically structured as interest-only monthly payments with a balloon payment due at maturity. Land loans modified in a TDR typically involve extending the balloon payment by one to three years, and 19 Greater30-59 Days60-89 DaysThanTotal PastNon-accrualTotalPast DuePast Due90 DaysDueLoansLoansCommercial and agricultural$176$-$-$176$38$134,104$134,318Real estate:Construction and development---65341,33041,983Residential 1-4 family441--44135590,89091,686Multi-family----29,74729,747Commercial real estate -- owner occupied----132,449132,449Commercial real estate -- non owner occupied----138,078138,078Farmland236----25,58825,588Total real estate677--4411,008458,082459,531Consumer205219-42418364,83565,442Deferred fees-----(1,488)(1,488)Total$1,058$219$-$1,041$1,229$655,533$657,803(in thousands)December 31, 2016Loans Not Past DueGreater30-59 Days60-89 DaysThanTotal PastNon-accrualTotalPast DuePast Due90 DaysDueLoansLoansCommercial and agricultural$76$-$-$76$164$131,494$131,734Real estate:Construction and development14--1479632,36033,170Residential 1-4 family100--10028493,83394,217Multi-family-----26,82826,828Commercial real estate -- owner occupied-857-857-133,509134,366Commercial real estate -- non owner occupied-66-66217134,329134,612Farmland-----20,49220,492Total real estate114923-1,0371,297441,351443,685Consumer114--1145751,18151,352Deferred fees-----(1,435)(1,435)Total$304$923$-$1,227$1,518$622,591$625,336December 31, 2015(in thousands)Loans Not Past Due providing an interest rate concession. Home equity modifications are made infrequently and are uniquely designed to meet the specific needs of each borrower. Loans modified in a TDR are considered impaired loans and typically already on non-accrual status. Partial charge-offs have in some cases already been taken against the outstanding loan balance. Loans modified in a TDR for the Company may have the financial effect of increasing the specific allowance associated with the loan. An allowance for impaired loans that have been modified in a TDR is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the estimated fair value of the collateral, less any selling costs, if the loan is collateral dependent. The Company’s practice is to re-appraise collateral dependent loans every six to nine months. During the twelve months ended December 31, 2016, there was no impact on the allowance from TDRs during the period, as the loans classified as TDRs during the period did not have a specific reserve and were already considered impaired loans at the time of modification and no further impairment was required upon modification. The Company had no commitments to lend additional funds for loans classified as TDRs at December 31, 2016. The Company closely monitors the performance of modified loans for delinquency, as delinquency is considered an early indicator of possible future default. The allowance may be increased, adjustments may be made in the allocation of the allowance, or partial charge-offs may be taken to further write-down the carrying value of the loan. The following table presents TDRs as of December 31, 2016 and 2015, all of which were modified due to financial stress of the borrower. There were not any subsequent defaulted TDRs as of December 31, 2016 and 2015. There were no loans modified or recorded as TDRs during the years ended December 31, 2016 and 2015. The following tables summarize the Company’s TDRs by type as of December 31, 2016 and December 31, 2015: 20 Number of Loans Pre-TDR Outstanding Recorded Investment Post-TDR Outstanding Recorded Investment Commercial and agriculture1$335$250Construction and development11,000654Residential 1-4 family1192137Total TDRs (1)3$1,527$1,041Number of Loans Pre-TDR Outstanding Recorded Investment Post-TDR Outstanding Recorded Investment Commercial and agriculture1$335$266Construction and development11,000796Residential 1-4 family1192141CRE -- owner occupied15956Total TDRs (1)4$1,586$1,259(1) The period end balances are inclusive of all partial pay-downs and charge-offs since the modification date. (dollars in thousands)(dollars in thousands)December 31, 2016December 31, 2015 The following tables present troubled debt restructurings by accrual or nonaccrual status as of December 31, 2016 and 2015: NOTE 5 – ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) The following table presents the changes in each component of accumulated other comprehensive income (loss), net of tax, for the twelve months ended December 31, 2016 and December 31, 2015: 21 Accrual StatusNon-Accrual StatusTotal TDRsCommercial and agriculture$250$-$250Construction and development-654654Residential 1-4 family137-137Total TDRs$387$654$1,041Accrual StatusNon-Accrual StatusTotal TDRsCommercial and agriculture$266$-$266Construction and development-796796Residential 1-4 family141-141CRE -- owner occupied56-56Total TDRs$463$796$1,259December 31, 2016(in thousands)December 31, 2015(in thousands)Net Unrealized Gain (Loss) on Investment SecuritiesDefined Benefit PlansTotalBalance, December 31, 2015$354$(254)$100Other comprehensive (loss) gain before reclassifications(852)65(787)Amounts reclassified from AOCI(4)-(4)Net current period other comprehensive income(856)65(791)Balance, December 31, 2016$(502)$(189)$(691)Net Unrealized Gain (Loss) on Investment SecuritiesDefined Benefit PlansTotalBalance, December 31, 2014$350$(485)$(135)Other comprehensive gain before reclassifications39231270Amounts reclassified from AOCI(35)-(35)Net current period other comprehensive income4231235Balance, December 31, 2015$354$(254)$100(in thousands)(in thousands) The following table presents the amounts reclassified out of each component of accumulated other comprehensive income (loss) for the twelve months ended December 31, 2016 and December 31, 2015: The following table presents the components of other comprehensive income for the twelve months ended December 31, 2016 and December 31, 2015: NOTE 6 – PREMISES AND EQUIPMENT The components of premises and equipment at December 31, 2016 and 2015 were as follows: 22 20162015Gain on sales of investments available for sale$(6)$(53)Income tax expense218Unrealized gain on investment securities, net of tax$(4)$(35)Twelve Months Ended December 31, (in thousands)Before TaxTax EffectNet of TaxNet unrealized gains on investment securities:Net unrealized gains arising during the period$(1,291)$(439)$(852)Less: reclassification adjustments for net gains realized in net income(6)(2)(4)Net unrealized gains on investment securities(1,297)(441)(856)Defined benefit plans:Amortization of unrecognized prior service costs and net actuarial gains983365Other Comprehensive Income$(1,199)$(408)$(791)Before TaxTax EffectNet of TaxNet unrealized gains on investment securities:Net unrealized gains arising during the period$59$20$39Less: reclassification adjustments for net gains realized in net income(53)(18)(35)Net unrealized gains on investment securities624Defined benefit plans:Amortization of unrecognized prior service costs and net actuarial losses350119231Other Comprehensive Income$356$121$235(in thousands)Twelve Months Ended December 31, 2016Twelve Months Ended December 31, 2015(in thousands)20162015Land and premises$18,766$19,600Equipment, furniture and fixtures8,5187,993Construction in progress2,17243129,45628,024Less accumulated deprecation and amortization(13,130)(12,275)Total premises and equipment$16,326$15,749December 31, (in thousands)20162015Depreciation expense$1,213$1,235Rental expense$675$567December 31, (in thousands) Minimum net rental commitments under non-cancelable operating leases having an original or remaining term of more than one year for future years ending December 31 were as follows (in thousands): Certain leases contain renewal options from five to ten years and escalation clauses based on increases in property taxes and other costs. NOTE 7 – OTHER REAL ESTATE OWNED The following table presents the activity related to OREO for the years ended December 31, 2016 and December 31, 2015: OREO property types were as follows for the years ended December 31, 2016 and December 31, 2015: NOTE 8 – DEPOSITS Time deposits that meet or exceed the FDIC Insurance limit of $250,000 at December 31, 2016 and 2015 were $66.9 million and $71.4 million, respectively. The composition of deposits at December 31, 2016 and December 31, 2015 was as follows: 23 2017$6102018579201951020204132021 - 2025314$2,42620162015Other real estate owned, beginning of period$3,610$999Transfers from outstanding loans2193,876Proceeds from sales(3,450)(1,289)Net gain on sales97128Impairment charges(71)(104)Total other real estate owned, end of period$405$3,610(in thousands)December 31,AmountNumber of PropertiesAmountNumber of PropertiesCommercial real estate -- owner occupied$4051 $1,7473 Commercial real estate -- non owner occupied-- 1,8631 Total OREO$4051 $3,6104 December 31,(dollars in thousands)2016201520162015Interest-bearing demand ("NOW")$179,209$165,544Money market deposits153,570133,799Savings deposits84,14690,380Time deposits ("CDs")129,175139,775 Total interest-bearing deposits546,100529,498Non-interest bearing demand233,631185,001 Total deposits$779,731$714,499December 31, (in thousands) Scheduled maturities of CDs were as follows for future years ending December 31 (in thousands): NOTE 9 – BORROWINGS Federal funds purchased and short-term advances from the Federal Home Loan Bank generally mature within one to four days from the transaction date. The following is a summary of these borrowings: Federal Home Loan Bank advances at December 31, 2016 and 2015 represent longer term advances from the Federal Home Loan Bank of Des Moines. Advances at December 31, 2016 bear interest from 2.23% to 2.54% with a weighted average rate of 2.41%. The advances mature in various years as follows (in thousands): NOTE 10 – JUNIOR SUBORDINATED DEBENTURES At December 31, 2016, two wholly-owned subsidiary grantor trusts established by the Company had outstanding $13.4 million of Trust Preferred Securities. Trust preferred securities accrue and pay distributions periodically at specified annual rates as provided in the indentures. The trusts used the net proceeds from the offering of trust preferred securities to purchase a like amount of Junior Subordinated Debentures (the “Debentures”) of the Company. The Debentures are the sole assets of the trusts. The Company’s obligations under the Debentures and the related documents, taken together, constitute a full and unconditional guarantee by the Company of the obligations of the trusts. The trust preferred securities are mandatorily redeemable upon the maturity of the Debentures, or upon earlier redemption as provided in the indentures. The Company has the right to redeem the Debentures in whole or in part, at a redemption price specified in the indentures plus any accrued but unpaid interest to the redemption date. The Debentures issued by the Company to the grantor trusts totaling $13.0 million are reflected in the consolidated balance sheet in the liabilities section under the caption “junior subordinated debentures.” The Company records interest expense on the corresponding junior subordinated debentures in the consolidated statements of income. The Company recorded $403,000 in the consolidated balance sheet at December 31, 2016 and December 31, 2015, respectively, for the common capital securities issued by the issuer trusts. As of December 31, 2016 and December 31, 2015, regular accrued interest on junior subordinated debentures totaled $54,000 and $42,000, respectively and is included in accrued interest payable on the balance sheet. 24 Maturities2017$59,380201824,540201928,02820208,92620218,301Thereafter-Total$129,17520162015Amount outstanding at end of period$-$-Average balance during the year$5,091$3,519Average interest rate during the year0.53%0.29%(dollars in thousands)December 31,2019$5,0002020$2,5002024$1,153 The terms of the junior subordinated debentures as of December 31, 2016 are: NOTE 11 – INCOME TAXES The Company recorded an income tax provision for the twelve months ended December 31, 2016 and 2015. The amount of the provision for each period was commensurate with the estimated tax liability associated with the net income earned during the period. As of December 31, 2016, the Company believes that it is more likely than not that it will be able to fully realize its deferred tax asset and therefore has not recorded a valuation allowance. The Company's provision for income taxes includes both federal and state income taxes and reflects the application of federal and state statutory rates to the Company's income before taxes. The principal difference between statutory tax rates and the Company's effective tax rate is the benefit derived from investing in tax-exempt securities and bank owned life insurance. Income taxes are accounted for using the asset and liability method. Under this method a deferred tax asset or liability is determined based on the enacted tax rates which will be in effect when the differences between the financial statement carrying amounts and tax basis of existing assets and liabilities are expected to be reported in the Company’s income tax returns. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established to reduce the net carrying amount of deferred tax assets if it is determined to be more likely than not, that all or some portion of the potential deferred tax asset will not be realized. The Company applies the provisions of FASB ASC 740, Income Taxes, relating to the accounting for uncertainty in income taxes. The Company periodically reviews its income tax positions based on tax laws and regulations, and financial reporting considerations, and records adjustments as appropriate. This review takes into consideration the status of current taxing authorities’ examinations of the Company’s tax returns, recent positions taken by the taxing authorities on similar transactions, if any, and the overall tax environment. The Company’s uncertain tax positions were nominal in amount as of December 31, 2016. Income taxes for the years ended December 31, 2016 and December 31, 2015 was as follows: 25 Issued Maturity Trust NameIssue DateAmountRateDatePacific Financial CorporationDecemberMarchStatutory Trust I20055,000$ LIBOR + 1.45% (1)2036Pacific Financial CorporationJuneJulyStatutory Trust II20068,000 LIBOR + 1.60% (2)203613,000$ (1) Pacific Financial Corporation Statutory Trust I securities incurred interest at the fixed rate of 6.39% until mid March2011, at which the rate changed to a variable rate of 3-month LIBOR (0.96% at December 13, 2016) plus 1.45%or 1.41%, adjusted quarterly, through the final maturity date in March 2036.(2) Pacific Financial Corporation Statutory Trust II securities incur interest at a variable rate of 3-month LIBOR (0.88%at October 13, 2016) plus 1.60% or 1.48%, adjusted quarterly, through the final maturity date in July 2036.(dollars in thousands)20162015Current$2,621$1,866Deferred (161)55Total income tax expense$2,460$1,921December 31,(in thousands) The tax effects of temporary differences that give rise to significant portions of deferred tax assets and liabilities and net deferred tax assets are recorded in other assets in the consolidated financial statements at December 31, 2016 and December 31, 2015 are: The following is a reconciliation between the statutory and effective federal income tax rate for the years ended December 31, 2016 and December 31, 2015: NOTE 12 – 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 $958,000 and $671,000 in 2016 and 2015, 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 $290,000 and $205,000 for 2016 and 2015, 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 no participants in the director or employee deferred compensation plan. There were no deferrals or ongoing expense to the Company for these plans in 2016 and 2015. 26 20162015Deferred Tax AssetsAllowance for loan losses$3,170$2,855Deferred compensation7792Supplemental executive retirement plan1,3521,286Unrealized loss on securities available for sale260-OREO write-downs257118Compensation expense239196Other245239Total deferred tax assets$5,600$4,786Deferred Tax LiabilitiesDepreciation$219$115Loan fees/costs1,4571,165Unrealized gain on securities available for sale-183Prepaid expenses137144FHLB Stock2020Other8970Total deferred tax liabilities1,9221,697Net deferred tax assets$3,678$3,089(in thousands)December 31, PercentPercentof Pre-taxof Pre-taxAmountIncomeAmountIncomeIncome tax at statutory rate$3,16735.0%$2,62435.0%Adjustments resulting from:Tax-exempt income(488)-5.4%(395)-5.3%Net earnings on life insurance policies(195)-2.2%(167)-2.2%Low income housing tax credit(18)0.2%(66)0.9%Other(6)0.1%(75)-1.0%Total income tax expense$2,46027.2%$1,92125.6%(dollars in thousands)December 31,20162015 The directors of a bank acquired by the Company in 1999 adopted two deferred compensation plans for directors. One plan provides retirement income benefits for all directors and the other, a deferred compensation plan, covers 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 $4.2 million and $4.1 million at December 31, 2016 and 2015, respectively. In 2016 and 2015, the net benefit recorded from these plans, including the cost of the related life insurance, was $324,000 and $378,000, 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 $224,000 and $268,000 at December 31, 2016 and 2015, respectively. Executive Long-Term Compensation Agreements – The Company has executive long-term compensation agreements to selected employees that provide incentive for those covered employees to remain employed with the Company for a defined period of time. The cost of these agreements was $147,000 and $136,000 in 2016 and 2015, respectively. Supplemental Executive Retirement Plan – Effective January 1, 2007, the Company adopted a non-qualified Supplemental Executive Retirement Plan (“SERP”) that provides retirement benefits to its executive officers. The SERP is unsecured and unfunded and there are no plan assets. The post-retirement benefit provided by the SERP is designed to supplement a participating officer’s retirement benefits from social security, in order to provide the officer with a certain percentage of final average income at retirement age. The benefit is generally based on average earnings, years of service and age at retirement. At the inception of the SERP, the Company recorded a prior service cost to accumulate other comprehensive income of $704,000. The Company has purchased bank owned life insurance covering all participants in the SERP. The cash surrender value of these policies totaled $6.2 million and $6.1 million at December 31, 2016 and 2015, respectively. The following table sets forth the net periodic pension cost and obligation assumptions used in the measurement of the benefit obligation for the years ended December 31, 2016 and 2015: The following table sets forth the change in benefit obligation at December 31, 2016 and December 31, 2015: 27 20162015Net periodic pension cost:Service cost$99$134Interest cost111103Amortization of prior service cost9190 Amortization of net loss2351Net periodic pension cost$324$378Weighted average assumptions:Discount rate3.91%3.57%Rate of compensation increasen/an/a(dollars in thousands)December 31, 20162015Change in benefit obligation:Benefit obligation at the beginning of year$3,045$2,944Service cost99134Interest cost111103Benefits paid(254)(45)Actuarial (gain) loss48(91)Benefit obligation at end of year$3,049$3,045December 31, (in thousands) Amounts recognized in accumulated other comprehensive income at December 31, 2016 and December 31, 2015 was as follows: The following table summarizes the projected and accumulated benefit obligations at December 31, 2016 and December 31, 2015: Estimated future benefit payments as of December 31, 2016 were as follows (in thousands): NOTE 13 – 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 its 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 off-balance sheet commitments at December 31, 2016 and December 31, 2015 is as follows: 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. Many of the commitments expire without being drawn upon; therefore total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management’s credit evaluation of the customer. 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. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Certain executive officers have entered into employment contracts with the Bank which provide for contingent payments subject to future events. In connection with certain loans held for sale, the Bank typically makes representations and warranties that the underlying loans conform to specified guidelines. If the underlying loans do not conform to the specifications, the Bank may have an obligation to repurchase the loans or indemnify the purchaser against loss. The Bank believes that the potential for loss under these arrangements is remote. Accordingly, no contingent liability is recorded in the consolidated financial statements. 28 20162015Loss$189$164Prior service cost-90Total recognized in AOCI$189$254December 31, (in thousands)20162015Projected benefit obligation$3,049$3,045Accumulated benefit obligation$3,049$3,045December 31, (in thousands)2017$1502018$2342019$2342020$2342021$2342022-2026$1,17220162015Commitments to extend credit$181,034$159,911Standby letters of credit$2,205$1,756December 31, (in thousands) At December 31, 2016, the Bank had $8.7 million in outstanding borrowings against its $170.3 million in established borrowing capacity with the FHLB, as compared to $11.3 million outstanding against a borrowing capacity of $158.7 million at December 31, 2015. The Bank’s borrowing facility with the FHLB is subject to collateral and stock ownership requirements. The Bank also had an available discount window primary credit line with the Federal Reserve Bank of San Francisco of approximately $58.8 million, subject to collateral requirements, and $16.0 million from correspondent banks with no balance outstanding on any of these facilities. The Company is currently not party to any material pending litigation. However, because of the nature of its activities, the Company may be subject to or threatened with legal actions 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 results of operations or financial condition of the Company. NOTE 14 – SIGNIFICANT CONCENTRATION OF CREDIT RISK Most of the Bank’s business activity is with customers and governmental entities located in the states of Washington and Oregon, including investments in state and municipal securities. Loans to any single borrower or group of borrowers are generally limited by state banking regulations to 20% of the Bank’s shareholder’s equity, excluding accumulated other comprehensive income (loss). 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 $8.5 million. NOTE 15 – STOCK BASED COMPENSATION The Company’s 2011 Equity Incentive Plan, as amended (the “2011 Plan”), provides for the issuance of up to 900,000 shares in connection with incentive and nonqualified stock options, restricted stock, restricted stock units and other equity-based awards. Prior to adoption of the 2011 Plan, the Company made equity-based awards under the Company’s 2000 Stock Incentive Plan, which expired January 1, 2011. Stock Options The 2011 Plan authorizes the issuance of incentive and non-qualified stock options, as defined under current tax laws, to key personnel. Options granted under the 2011 Plan either become exercisable ratably over five years or in a single installment five years from the date of grant. The Company uses the Black-Scholes option pricing model to calculate the fair value of stock option awards based on assumptions in the following table. Expected volatility is based on historical volatility of the Company’s common stock. The expected term of stock options granted is based on the simplified method, which is the simple average between contractual term and vesting period. The risk- free rate is based on the expected term of stock options and the applicable U.S. Treasury yield in effect at the time of grant. 29 Grant period endedExpected LifeRisk Free Interest RateExpected Stock Price VolatilityDividend YieldWeighted Average Fair value of Options GrantedDecember 31, 20166.5 years1.50%22.70%3.08%1.13$ December 31, 20156.5 years1.85%22.82%3.20%1.05$ The following tables summarize the stock option activity for the years ended December 31, 2016 and 2015: Information related to the stock option plan during each year follows: The Company accounts for stock based compensation in accordance with GAAP, which requires measurement of compensation cost for all stock-based awards based on grant date fair value and recognition of compensation cost over the service period of each award. The following information summarizes information about stock expense for the years ended December 31, 2016 and 2015: As of December 31, 2016, there was $25,000 of total unrecognized compensation cost related to nonvested stock options. The cost is expected to be recognized over a weighted-average period of 5.0 years. Restricted Stock Units The Company grants restricted stock units (“RSUs”) to employees qualifying for awards under the Company’s Annual Incentive Compensation Plan. Recipients of RSUs will be issued a specified number of shares of common stock under the 2011 Plan upon the lapse of applicable restrictions. Outstanding RSUs are subject to forfeiture if the recipient’s employment terminates prior to expiration. 30 SharesWeighted Average Exercise PriceWeighted Average Remaining Contractual Term (in Years)Outstanding at December 31, 2014565,120 $8.75 Granted12,500 6.64 Exercised(4,000) 5.00 Forfeited(23,575) 8.94 Expired(78,545) 14.71 Outstanding at December 31, 2015471,500 $7.72 Granted16,000 7.14 Exercised(1,000) 5.00 Forfeited(11,325) 7.07 Expired(39,875) 13.75 Outstanding at December 31, 2016435,300 $7.17 4.42 Vested and expected to vest at December 31, 2016435,300 $7.17 4.42 Exercisable at December 31, 2016329,800 $7.69 3.64 20162015Intrinsic value of options exercised$5$8Cash received from option exercises$5$20(in thousands)20162015Compensation Expense$24$31Tax Effect811Compensation Expense, net$16$20Twelve Months Ended December 31, (in thousands) The following table summarizes RSU activity during the twelve months ended December 31, 2016 and 2015: The following table summarizes RSU compensation expense during the twelve months ended December 31, 2016 and 2015: As of December 31, 2016, there was $261,000 of total unrecognized compensation cost related to nonvested RSUs. The cost is expected to be recognized over a weighted-average period of 2.0 years. NOTE 16 – 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 material adverse 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. Effective January 1, 2015 (with some changes transitioned into full effectiveness over two to four years), the Bank became subject to new capital adequacy requirements approved by the Federal Reserve and the FDIC that implement the revised standards of the Basel Committee on Banking Supervision, commonly called Basel III, and address relevant provisions of the Dodd-Frank Act. Pursuant to minimum capital requirements of the FDIC effective on January 1, 2015, all FDIC-insured financial institutions are required to maintain a minimum common equity Tier 1 risk-based capital to risk-weighted assets ratio of 4.5%, a minimum Tier 1 leverage ratio to average assets of 4.0% and minimum risk-based capital ratios of Tier 1 capital to risk-weighted assets and total capital to risk- weighted assets of 6.0% and 8.0%, respectively. Although new capital requirements were effective on January 1, 2015, certain provisions of the new rule will be phased-in from the effective date through 2019, including, among others, a new capital conservation buffer requirement, which requires financial institutions to maintain a common equity capital ratio more than 2.5% above the required minimum levels in order to avoid limitations on capital distributions, including dividend payments, and certain discretionary bonus payments based on percentages of eligible retained income that could be utilized for such actions. The new capital conservation buffer requirement began to be phased-in on January 1, 2016 at 0.625% of risk-weighted assets, and will continue to increase by 0.625% on each subsequent January 1, until it reaches 2.5% on January 1, 2019. At December 31, 2016, the capital conservation buffer was 5.1% and 4.8% for the Company and the Bank, respectively. As of December 31, 2016 and 2015, the Bank was 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 31 SharesWeighted Average Grant Date Fair ValueOutstanding at December 31, 201461,233 Granted44,966 $6.75 Vested(19,368) Forfeited(3,401) Outstanding at December 31, 201583,430 Granted55,825 $6.76 Vested(28,712) Forfeited(11,564) Outstanding at December 31, 201698,979 20162015Compensation Expense$301$213Tax Effect10272Compensation Expense, net$199$141Twelve Months Ended (in thousands) set forth in the table. There are no conditions or events since that notification that management believes have changed the institution’s category. Actual capital amounts and ratios for December 31, 2016 and 2015 are presented in the table below. NOTE 17 – FAIR VALUE MEASUREMENTS Fair Value Hierarchy The Company uses an established hierarchy for measuring fair value that is intended to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows: Level 1 – Valuations based on quoted prices in active exchange markets for identical assets or liabilities; also includes certain corporate debt securities actively traded in over-the-counter markets. Level 2 – Valuations of assets and liabilities traded in less active dealer or broker markets. Valuations include quoted prices for similar assets and liabilities traded in the same market; quoted prices for identical or similar instruments in markets that are not active; and model–derived valuations whose inputs are observable or whose significant value drivers are observable. Valuations may be obtained from, or corroborated by, third-party pricing services. This category generally includes certain U.S. Government, agency and non-agency securities, state and municipal securities, mortgage backed securities, corporate securities, and residential mortgage loans held for sale. Level 3 – Valuation based on unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, yield curves and similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities, but in all cases are corroborated by external data, which may include third-party pricing services. 32 AmountRatioAmountRatioAmountRatioAmountRatioAs of December 31, 2016CompanyCommon equity Tier 1 capital to risk-weighted assets$67,703 9.5%$32,070 4.5%$36,346 5.1%N/AN/ATier 1 leverage capital to average assets80,703 9.3%34,711 4.0%N/AN/AN/AN/ATier 1 capital to risk-weighted assets80,703 11.3%42,851 6.0%47,136 6.6%N/AN/ATotal capital to risk-weighted assets89,631 12.6%56,909 8.0%61,177 8.6%N/AN/ABankCommon equity Tier 1 capital to risk-weighted assets79,964 11.2%29,987 4.2%34,270 4.8%$46,408 6.5%Tier 1 leverage capital to average assets79,964 9.2%34,767 4.0%N/AN/A43,459 5.0%Tier 1 capital to risk-weighted assets79,964 11.2%42,838 6.0%47,122 6.6%57,117 8.0%Total capital to risk-weighted assets88,876 12.5%56,881 8.0%61,147 8.6%71,101 10.0%As of December 31, 2015CompanyCommon equity Tier 1 capital to risk-weighted assets$63,456 9.6%$29,838 4.5%N/AN/AN/AN/ATier 1 leverage capital to average assets76,456 9.4%32,397 4.0%N/AN/AN/AN/ATier 1 capital to risk-weighted assets76,456 11.5%39,786 6.0%N/AN/AN/AN/ATotal capital to risk-weighted assets84,742 12.8%53,047 8.0%N/AN/AN/AN/ABankCommon equity Tier 1 capital to risk-weighted assets75,725 11.4%27,801 4.2%N/AN/A$43,026 6.5%Tier 1 leverage capital to average assets75,725 9.4%32,396 4.0%N/AN/A40,495 5.0%Tier 1 capital to risk-weighted assets75,725 11.4%39,716 6.0%N/AN/A52,955 8.0%Total capital to risk-weighted assets84,001 12.7%52,956 8.0%N/AN/A66,195 10.0%Actual Minimum Capital AdequacyTo be Well Capitalized Under Prompt Correction Action Regulations(dollars in thousands)Minimum Capital Adequacy With Capital Buffer Investment Securities Available for Sale The Company uses an independent pricing service to assist management in determining fair values of investment securities available for sale. This service provides pricing information by utilizing evaluated pricing models supported with market based information. Standard inputs include benchmark yields, reported trades, broker/dealer quotes, credit ratings, bids and offers, relative credit information and reference data from market research publications. Investment securities that are deemed to have been trading in illiquid or inactive markets may require the use of significant unobservable inputs. The pricing service provides quoted market prices when available. Quoted prices are not always available due to bond market inactivity. For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows. Discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. Additionally, the pricing service may obtain a broker quote when sufficient information is not available to produce a valuation. Valuations and broker quotes are non-binding and do not represent quotes on which one may execute the disposition of the assets. The Company generally obtains one value from its primary external third-party pricing service. The Company’s third-party pricing service has established processes for us to submit inquiries regarding quoted prices. The Company’s third-party pricing service will review the inputs to the evaluation in light of any new market data presented by us. The Company’s third-party pricing service may then affirm the original quoted price or may update the evaluation on a going forward basis. On a quarterly basis, management reviews the pricing information received from the third party-pricing service through a combination of procedures that include an evaluation of methodologies used by the pricing service, analytical reviews and performance analyses of the prices against statistics and trends and maintenance of an investment watch list. Based on this review, management determines whether the current placement of the security in the fair value hierarchy is appropriate or whether transfers may be warranted. As necessary, the Company compares prices received from the pricing service to discounted cash flow models or through performing independent valuations of inputs and assumptions similar to those used by the pricing service in order to ensure prices represent a reasonable estimate of fair value. Although the Company does identify differences from time to time as a result of these validation procedures, the Company did not make any significant adjustments as of December 31, 2016 or December 31, 2015. The following table presents the balances of assets measured at fair value on a recurring basis at December 31, 2016 and December 31, 2015. 33 Description Fair ValueQuoted Prices in Active Markets for Identical Assets (Level 1)Other Observable Inputs (Level 2)Significant Unobservable Inputs (Level 3)Available-for-sale securities:Collateralized mortgage obligations: agency issued$35,515$-$35,515$-Collateralized mortgage obligations: non agency331-331-Mortgage-backed securities: agency issued15,199-15,199-U.S. Government agency securities7,635-7,635-State and municipal securities52,616-50,7411,875Total assets measured at fair value$111,296$-$109,421$1,875(in thousands)At December 31, 2016 As of December 31, 2016 and December 31, 2015, the Company had four available-for-sale securities classified as Level 3 investments which consist of non-rated municipal bonds for which the Company is the sole owner of the entire bond issue. The valuation of these securities is supported by analysis prepared by an independent third party. Their approach to determining fair value involves using recently executed transactions and market quotations for similar securities. As these securities are not rated by the rating agencies and there is no trading volume, management determined that these securities should be classified as Level 3 within the fair value hierarchy. The following table presents a reconciliation of assets that are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the twelve months ended December 31, 2016 and 2015, respectively. Transfers between level categorizations may occur due to changes in the availability of market observable inputs, which generally are caused by changes in market conditions such as liquidity, trading volume or bid-ask spreads. Transfers between level categorizations may also occur due to changes in the valuation source. For example, in situations where a fair value quote is not provided by the Company’s independent third-party valuation service provider and as a result the price is stale, the security is transferred into Level 3. There were no transfers in or out of Level 3 during the years ended December 31, 2016 and December 31, 2015. Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis Certain assets and liabilities are measured at fair value on a nonrecurring basis after initial recognition such as loans measured for impairment and other real estate owned. The following methods were used to estimate the fair value of each such class of financial instrument: Impaired loans – A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due (both interest and principal) according to the contractual terms of the loan agreement. Impaired loans are classified as Level 3 in the fair value hierarchy and are measured based on the present value of expected future cash flows or by the net realizable value of the collateral if the loan is collateral dependent. In determining the net realizable value of the underlying collateral, we consider third party appraisals by qualified licensed appraisers, less estimated costs to sell. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available and include consideration for variations in location, size, and income production capacity of the property. The income approach commonly utilizes a discount or cap rate to determine the present value of expected future cash flows. Additionally, the appraisals are periodically further adjusted by the Company in consideration of charges that may be incurred in the event of foreclosure and are based on management’s historical knowledge, changes in business factors and changes in market conditions. Such discounts are typically significant, and may range from 10% to 30%. 34 Description Fair ValueQuoted Prices in Active Markets for Identical Assets (Level 1)Other Observable Inputs (Level 2)Significant Unobservable Inputs (Level 3)Available-for-sale securities:Collateralized mortgage obligations: agency issued$39,045$-$39,045$-Collateralized mortgage obligations: non agency422-422-Mortgage-backed securities: agency issued12,178-12,178-U.S. Government agency securities8,646-8,646-State and municipal securities39,733-37,7072,026Total assets measured at fair value$100,024$-$97,998$2,026(in thousands)At December 31, 201520162015Balance beginning of period$2,026$2,150Transfers in to level 3--Change in FV (included in other comprehensive income)(151)(124)Balance end of period$1,875$2,026(in thousands)Twelve Months Ended December 31, Impaired loans are reviewed and evaluated quarterly for additional impairment and adjusted accordingly, based on the same factors identified above. Because of the high degree of judgment required in estimating the fair value of collateral underlying impaired loans and because of the relationship between fair value and general economic conditions, we consider the fair value of impaired loans to be highly sensitive to changes in market conditions. Other real estate owned – OREO is initially recorded at the fair value of the property less estimated costs to sell. This amount becomes the property’s new basis. Management considers third party appraisals in determining the fair value of particular properties. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available and include consideration for variations in location, size, and income production capacity of the property. Additionally, the appraisals are periodically further adjusted by the Company based on management’s historical knowledge, changes in business factors and changes in market conditions. Such adjustments are typically downward, and may range from 10% to 25%. Any write-downs based on the property fair value less estimated costs to sell at the date of acquisition are charged to the allowance for loan losses. Management periodically reviews OREO to ensure the property is carried at the lower of its new basis or fair value, net of estimated costs to sell. Any additional write-downs based on re-evaluation of the property fair value are charged to non-interest expense. Because of the high degree of judgment required in estimating the fair value of OREO and because of the relationship between fair value and general economic conditions, we consider the fair value of OREO to be highly sensitive to changes in market conditions. The following table presents the Company’s assets that were held at the end of December 31, 2016 that were measured at fair value on a nonrecurring basis: There were no assets held at the end of December 31, 2015 that were measured at fair value on a nonrecurring basis. The following table presents quantitative information about Level 3 inputs for financial instruments measured at fair value on a nonrecurring basis at December 31, 2016 (dollars in thousands): Fair Value of Financial Instruments The following methods and assumptions were used by the Company in estimating the fair values of financial instruments disclosed in these consolidated financial statements: Cash and due from banks, interest bearing deposits in banks, and certificates held for investment The carrying amounts of cash, interest bearing deposits at other financial institutions approximate their fair value. 35 Description Fair ValueQuoted Prices in Active Markets for Identical Assets (Level 1)Other Observable Inputs (Level 2)Significant Unobservable Inputs (Level 3)Other real estate owned$405$-$-$405Loans measured for impairment, net of specific reserves172--172Total assets measured on a nonrecurring basis$577$-$-$577At December 31, 2016(in thousands)Description Fair ValueValuation TechniqueSignificant Unobservable InputsRange (Weighted Average)Other real estate owned$405Market approach Adjustment for differences between comparable sales 21.8% (1)Loans measured for impairment, net of specifc reserves$172 Income approach Probability of default, discount rate 8.0%, 5.5% (1) Discount applied to appraisal value Investment securities available for sale and held to maturity The fair value of all investment securities are based upon the assumptions market participants would use in pricing the security. Such assumptions include observable and unobservable inputs such as quoted market prices, dealer quotes and analysis of discounted cash flows. Federal Home Loan Bank stock FHLB stock is not publically traded; thus, it is not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability. At December 31, 2016 and December 31, 2015 the stock was stock of the FHLB of Des Moines Pacific Coast Bankers’ Bank stock PCBB stock is carried at cost which approximates fair value and equals its par value based on a third-party valuation opinion as of December 31, 2016. Loans, net and loans held for sale The fair value of loans is estimated based on comparable market statistics for loans with similar credit ratings. An additional liquidity discount is also incorporated to more closely align the fair value with observed market prices. Fair values of loans held for sale are based on a discounted cash flow calculation using interest rates currently available on similar loans. The fair value was based on an aggregate loan basis. Deposits 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. Borrowings The fair values of the Company’s long-term borrowings is estimated using discounted cash flow analysis based on the Company’s incremental borrowing rates for similar types of borrowing arrangements. Junior Subordinated Debentures The fair value of the Junior Subordinated Debentures and trust preferred securities is estimated using discounted cash flow analysis based on interest rates currently available for Junior Subordinated Debentures. Off-balance sheet instruments The fair value of commitments to extend credit and standby letters of credit was estimated using the rates 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 material fair value. 36 The estimated fair value of the Company’s financial instruments at December 31, 2016 and December 31, 2015 was as follows: 37 Carrying ValueQuoted Prices in Active Markets for Identical Assets (Level 1)Other Observable Inputs (Level 2)Significant Unobservable Inputs (Level 3)Total Fair ValueFinancial assets:Cash and cash equivalents$59,298$59,298$-$-$59,298Interest-bearing certificates of deposit (original maturities greater than 90 days)2,2312,231--2,231Investment securities available-for-sale111,296-109,4211,875111,296Investment securities held-to-maturity859-465398863Federal Home Loan Bank stock1,335N/AN/AN/AN/APacific Coast Bankers Bank stock1,000-1,000-1,000Loans held-for-sale6,573-6,573-6,573Loans648,611--638,726638,726Financial liabilities:Deposits$779,731$-$778,705$-$778,705Long-term borrowings8,653-8,723-8,723Junior subordinated debentures13,403--8,5218,521As of December 31, 2016(in thousands)Carrying ValueQuoted Prices in Active Markets for Identical Assets (Level 1)Other Observable Inputs (Level 2)Significant Unobservable Inputs (Level 3)Total Fair ValueFinancial assets:Cash and cash equivalents$27,526$27,526$-$-$27,526Interest-bearing certificates of deposit (original maturities greater than 90 days)2,7272,727--2,727Investment securities available-for-sale100,024-97,9982,026100,024Investment securities held-to-maturity1,697-1,2854281,713Federal Home Loan Bank stock1,346N/AN/AN/AN/APacific Coast Bankers Bank stock1,000-1,000-1,000Loans held-for-sale12,333-12,333-12,333Loans617,019--584,432584,432Financial liabilities:Deposits$714,499$-$715,235$-$715,235Long-term borrowings11,303-11,379-11,379Junior subordinated debentures13,403--7,9907,990As of December 31, 2015(in thousands) NOTE 18 – EARNINGS PER SHARE The Company’s basic earnings per common share is computed by dividing net income available to common shareholders (net income less dividends declared by the weighted average number of common shares outstanding during the period). The Company’s diluted earnings per common share is computed similar to basic earnings per common share except that the numerator is equal to net income available to common shareholders and the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive potential common shares had been issued. Included in the denominator are the dilutive effects of stock options computed under the treasury stock method and outstanding warrants as if converted to common stock. The following table illustrates the computation of basic and diluted earnings per share: As of December 31, 2016 and 2015, the shares subject to outstanding options included some options that had exercise prices in excess of the current market value. Those specific shares are not included in the table above, as exercise of these options would not be dilutive to shareholders. 38 20162015Basic:Net income (numerator)$6,590$5,576Weighted average shares outstanding (denominator)10,416,16210,382,499Basic earnings per share$0.63$0.54Diluted:Net income (numerator)$6,590$5,576Weighted average shares outstanding10,416,16210,382,499Effect of dilutive stock options172,562141,804Weighted average shares outstanding assuming dilution (denominator)10,588,72410,524,303Diluted earnings per share$0.62$0.53For the Year EndedDecember 31, (dollars in thousands, except per share amounts)20162015Shares subject to outstanding options66,550260,350For the Year Ended December 31, NOTE 19 – CONDENSED FINANCIAL INFORMATION – PARENT COMPANY ONLY Pacific Financial Corporation – Parent Company Only Consolidated Statements of Financial Condition (in thousands) Pacific Financial Corporation – Parent Company Only Consolidated Statements of Income (in thousands) 39 December 31,December 31,20162015ASSETSCash and cash equivalents:$2,645$2,602Investment in bank92,26688,458Other assets1,037957Total assets$95,948$92,017LIABILITIES AND SHAREHOLDERS' EQUITYJunior subordinated debentures$13,403$13,403Dividends payable2,3982,287Other liabilities14242Total liabilities15,94315,732Total shareholders' equity80,00576,285Total liabilities and shareholders' equity$95,948$92,01720162015INTEREST EXPENSEJunior subordinated debentures$304$248Total interest expense304248NONINTEREST INCOMEDividends from subsidiary bank2,6002,786Equity in undistributed income from subsidiary bank4,1983,455Other income97Total noninterest income6,8076,248NONINTEREST EXPENSEOther expense291586Total noninterest income291586Income before income taxes6,2125,414Income tax benefit378162Net income$6,590$5,576Twelve Months Ended December 31, Pacific Financial Corporation – Parent Company Only Consolidated Statements of Comprehensive Income (Dollars in thousands) Pacific Financial Corporation – Parent Company Only Consolidated Statements of Cash Flows (Dollars in thousands) 40 20162015Net Income$6,590$5,576Change in fair value of securities available for sale(856)4Defined benefit plan65231Other comprehensive (loss) income, net of tax(791)235Comprehensive income$5,799$5,811Twelve Months Ended December 31,20162015Cash flows from operating activities:Net Income$6,590$5,576Adjustments to reconcile net income to net cash from operating activitiesEquity in undistributed income of subsidiary(4,198)(3,455)Net change in other assets(405)(162)Net change in other liabilities(12)2Stock compensation expense325213Net cash provided by operating activities2,3002,174Cash flows from financing activitiesCommon stock issued3021Cash dividends paid(2,287)(2,178)Net cash used in financing activities(2,257)(2,157)Net increase in cash and cash equivalents4317Cash and cash equivalents at beginning of year2,6022,585Cash and cash equivalents at end of year$2,645$2,602Twelve Months Ended December 31, NOTE 20 – SELECTED DATA Results of operations on a quarterly basis were as follows (unaudited): 41 First QuarterSecond QuarterThird QuarterFourth QuarterInterest and dividend income$8,529$8,394$8,518$8,694Interest expense607628616621Net interest income7,9227,7667,9028,073Loan loss provision262276276184Noninterest income2,5313,0263,1942,571Noninterest expense8,2707,9828,1788,507Income before provision for income taxes1,9212,5342,6421,953Provision for income taxes545773649493Net income$1,376$1,761$1,993$1,460Earnings per common shareBasic$0.13$0.17$0.19$0.14Diluted$0.12$0.17$0.19$0.14Year Ended December 31, 2016(dollars in thousands, except per share amounts)First QuarterSecond QuarterThird QuarterFourth QuarterInterest and dividend income$7,432$7,817$7,946$8,145Interest expense509528561603Net interest income6,9237,2897,3857,542Loan loss provision30187165200Noninterest income1,9732,8232,6862,317Noninterest expense7,4847,7327,7097,934Income before provision for income taxes1,3822,1932,1971,725Provision for income taxes286611596428Net income$1,096$1,582$1,601$1,297Earnings per common shareBasic$0.11 $0.15 $0.15 $0.12 Diluted$0.10 $0.15 $0.15 $0.12 Year Ended December 31, 2015(dollars in thousands, except per share amounts) GENERAL CORPORATE AND SHAREHOLDER INFORMATION Administrative Headquarters 1216 Skyview Drive Aberdeen, WA 98520 (360) 533-8870 Independent Accountants BDO USA LLP Spokane, Washington Transfer Agent and Registrar Computershare P.O. BOX 30170 College Station, TX 77842-3170. Telephone: 1-877-870-2422 Outside the U.S: 201-680-6578 Hearing Impaired: 800-952-9245 www.computershare.com/investor Shareholder Services Computershare, our transfer agent, maintains the records for our registered shareholders and can help you with a variety of shareholder related services at no charge including: Change of name or address Lost stock certificates Consolidation of accounts Transfer of stock to another person Duplicate mailings Additional administrative services As a Pacific Financial Corporation shareholder, you are invited to take advantage of our convenient shareholder services or request more information about Pacific Financial Corporation. Access your account directly through Investor Center at www.computershare.com/investor. Annual Meeting The annual meeting of shareholders will be held on April 26, 2017 at 4 p.m. at 1216 Skyview Drive, Aberdeen, WA 98520. Annual Report This annual report, including accompanying financial statements and schedules, is available without charge to shareholders or beneficial owners of our common stock upon written request to Sandra Clark, Corporate Secretary, Pacific Financial Corporation, P.O. Box 1826, Aberdeen, Washington 98520. It is also furnished upon request to customers of Bank of the Pacific pursuant to the requirements of the FDIC to provide an annual disclosure statement. This statement has not been reviewed or confirmed for accuracy or relevance by the FDIC. 42 BOARD OF DIRECTORS Randy W. Rognlin, Chairman Co-Owner Rognlins, Inc Douglas M. Schermer, Vice Chairman Owner and President Schermer Construction Inc. & Wishkah Rock Products Denise Portmann President & CEO Pacific Financial Corporation and Bank of the Pacific Randy J. Rust Private Investor Susan C. Freese Pharmacist Dwayne M. Carter President & General Manager Brooks Manufacturing Co. Edwin W. Ketel Owner Oceanside Animal Clinic Kristi Gundersen Partner & Chief Financial Officer Knutzen Farms, LP Dan J. Tupper Vice President & General Manager Crown Distributing Co. of Aberdeen, Inc. John Van Dijk Retired President & COO Bank of the Pacific OFFICERS SUBSIDIARIES Bank of the Pacific 1216 Skyview Drive Aberdeen, WA 98520 360-533-8870 www.bankofthepacific.com Denise J. Portmann President & CEO Pacific Financial Corporation and Bank of the Pacific Bruce MacNaughton Vice President Executive Vice President & CCO, Bank of the Pacific Douglas N. Biddle Treasurer Executive Vice President & CFO, Bank of the Pacific Sandra P. Clark Corporate Secretary 43 2016 Annual Report Cover-Proof1.ai 1 3/20/2017 2:32:11 PM C M Y CM MY CY CMY K 

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