Business Combinations

During the nine months ended September 30, 2013, the Company completed the acquisitions of Northwest Commercial Bank and Valley Community Bancshares, referred to jointly as the "NCB and Valley Acquisitions." There were no acquisitions completed during the year ended December 31, 2012.

Northwest Commercial Bank

On September 14, 2012, the Company and Heritage Bank entered into a definitive agreement to acquire NCB headquartered in Lakewood, Washington. NCB was a full service commercial bank that operated two branch locations in Lakewood and Auburn, Washington. Prior to the closing of the transaction, NCB redeemed its outstanding preferred stock of approximately $2.0 million issued to the U.S. Department of Treasury in connection with its participation in the Troubled Asset Relief Program Capital Purchase Plan. The NCB Acquisition was completed on January 9, 2013 with the merger of NCB with and into Heritage Bank. After the NCB Acquisition, the NCB Lakewood branch was consolidated into one of Heritage Bank’s full service banking offices in Lakewood, Washington.

In connection with the NCB Acquisition, the Company paid cash consideration of $3.0 million, or $5.50 per NCB share, to NCB shareholders on January 9, 2013. In addition, pursuant to the merger agreement, the NCB shareholders had the ability to potentially receive an additional cash payment based on an earn-out structure from the sale of a NCB asset included in “other real estate owned.” This contingent payment was factored into the NCB liabilities assumed by Heritage Bank as of the January 9, 2013 acquisition date. This asset was sold by Heritage Bank in June 2013, and the $491,000 of proceeds from the sale were paid to the NCB shareholders in July 2013. The payment of these proceeds did not impact the recorded bargain purchase gain on bank acquisition.

During the three and nine months ended September 30, 2013, the Company incurred NCB Acquisition-related costs (including conversion costs) of approximately $5,000 and $746,000, respectively.

Valley Community Bancshares

On March 11, 2013, the Company entered into a definitive agreement to acquire Valley Community Bancshares and its wholly-owned subsidiary, Valley Bank, both headquartered in Puyallup, Washington. The Valley Acquisition was completed on July 15, 2013. Valley operated eight branches prior to acquisition, of which only four are anticipated to be maintained by the Company. Of the four other branches, three leases will be terminated during the fourth quarter of 2013 and one owned branch building was considered held for sale at the time of acquisition.

Pursuant to the terms of the merger agreement, the shareholders of Valley common stock received $19.50 per share in cash and 1.3611 shares of Heritage common stock per Valley share. The merger consideration for Valley consisted of cash and stock, with $22.0 million paid in cash by the Company and 1,533,267 shares of the Company’s common stock being issued with fair value of $24.2 million. The Company also recognized $157,000 in capitalized acquisition costs related to the issuance of its securities.

The Valley Acquisition resulted in $16.4 million of goodwill. This goodwill is not deductible for tax purposes.

During the three and nine months ended September 30, 2013, the Company incurred Valley Acquisition-related costs (including conversion costs) of approximately $161,000 and $515,000, respectively.

Business Combination Accounting

The NCB and Valley Acquisitions constitute business acquisitions as defined by FASB Accounting Standards Codification (“ASC”) 805, Business Combinations. The Business Combinations topic establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired and the liabilities assumed. Accordingly, the estimated fair values of the acquired assets, including the identifiable intangible assets, and the assumed liabilities in the acquisition were measured and recorded as of the acquisition dates.

The fair value of the assets acquired and liabilities assumed in the NCB and Valley Acquisitions were as follows:



	Valley July 15, 2013			NCB January 9, 2013
	(In thousands)
Assets
Cash and cash equivalents	$	40,643		$	2,712
Other interest earning deposits	13,866			1,003
Investment securities available for sale	31,444			2,753
Investment securities held to maturity	22,908			—
Purchased non-covered loans receivable	117,071			51,509
Other real estate owned	—			2,279
Premises and equipment	6,558			214
FHLB stock	366			88
Accrued interest receivable	465			232
Core deposit intangible	916			156
Prepaid expenses and other assets	3,172			1,175
Deferred income taxes, net	(85		)	2,873
Total assets acquired	$	237,324		$	64,994
Liabilities
Deposits	$	207,013		$	60,442
Accrued expenses and other liabilities	342			1,186
Total liabilities assumed	207,355			61,628
Net assets acquired	$	29,969		$	3,366

Summaries of the net assets purchased and the estimated fair value adjustments and resulting bargain purchase gain or goodwill recognized from the NCB and Valley Acquisitions were as follows:



	Valley July 15, 2013			NCB January 9, 2013
	(In thousands)
Cost basis of net assets on acquisition date	$	29,720		$	6,113
Consideration transferred	(46,323		)	(2,967		)
Fair value adjustments:
Other interest earning deposits	162			7
Investment securities	—			(2		)
Purchased non-covered loans, net	(3,003		)	(3,299		)
Other real estate owned	—			(1,301		)
Premises and equipment	1,837			(69		)
Core deposit intangible	916			156
Prepaid expenses and other assets	323			(479		)
Deferred income tax, net	(125		)	2,873
Certificates of deposit	(9		)	(11		)
Accrued expenses and other liabilities	149			(622		)
(Goodwill) bargain purchase gain recognized from the acquisition	$	(16,353	)	$	399

Goodwill on bank acquisition represents the excess of the consideration transferred over the estimated fair value of the net assets acquired and liabilities assumed. A bargain purchase gain on bank acquisition represents the excess of the estimated fair value of the net assets acquired and liabilities assumed over the value of the consideration paid. The bargain purchase gain in the NCB Acquisition was influenced significantly by the net deferred tax asset acquired. NCB had significant net operating losses and as a result of its estimate of whether or not it was more likely than not that the net deferred tax asset would be realized, had recorded a full valuation allowance on the net deferred tax asset. The Company, however, has reviewed the net deferred tax asset and determined it is more likely than not that the net deferred tax asset would be realized by the Company.

The operating results of the Company for the three and nine months ended September 30, 2013 include the operating results produced by the net assets acquired from the NCB Acquisition since the January 9, 2013 acquisition date and from the Valley Acquisition since the July 15, 2013 acquisition date. The Company has considered the requirement of FASB ASC 805 related to the contribution of the NCB and Valley Acquisitions to the Company’s results of operations. The table below presents only the significant results for the acquired businesses from the acquisition dates.



	NCB						Valley			Total
	Three Months Ended September 30, 2013			Nine Months Ended September 30, 2013 (3)			Three and Nine Months Ended September 30, 2013 (3)			Three Months Ended September 30, 2013 (3)			Nine Months Ended September 30, 2013 (3)
	(In thousands)
Interest income: Interest and fees on loans (1)	$	608		$	1,768		$	1,290		$	1,898		$	3,058
Interest income: Interest and fees on loans (2)	250			1,712			399			649			2,111
Interest income: Securities and other interest earning assets	29			87			150			179			237
Interest expense: Deposits	(62		)	(219		)	(66		)	(128		)	(285		)
Provision for loan losses on purchased loans	(808		)	(1,058		)	—			(808		)	(1,058		)
Noninterest income	14			486			267			281			753
Noninterest expense	(117		)	(1,341		)	(829		)	(946		)	(2,170		)
Net effect, pre-tax	$	(86	)	$	1,435		$	1,211		$	1,125		$	2,646


(1)	Includes the contractual interest income on the purchased other loans.


(2)	Includes the accretion of the accretable yield on the purchased impaired loans and the accretion of the discount on the purchased other loans.


(3)	NCB was effective January 9, 2013 and Valley was effective July 15, 2013.

The Company also considered the pro forma requirements of FASB ASC 805 and deemed it not necessary to provide pro forma financial statements as required under the standard as the NCB and Valley Acquisitions were not material to the Company. The Company believes that the historical NCB and Valley operating results are not considered of enough significance to be meaningful to the Company’s results of operations.