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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549
 
 
 
FORM 10-Q
 
 


x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2018 or

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from __________ to __________
Commission File Number 000-29480 

 
HERITAGE FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter) 
 
 
 
Washington
 
91-1857900
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
201 Fifth Avenue SW, Olympia, WA
 
98501
(Address of principal executive offices)
 
(Zip Code)
(360) 943-1500
(Registrant’s telephone number, including area code) 

 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  ý
 
Accelerated filer  ¨
 
 
Non-accelerated filer  ¨ (Do not check if a smaller reporting company)
 
Smaller reporting company  ¨
 
 
 
 
Emerging growth company  ¨
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes  ¨    No  ý
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date:
As of July 31, 2018 there were 36,868,578 shares of the registrant's common stock, no par value per share, outstanding.


Table of Contents


HERITAGE FINANCIAL CORPORATION
FORM 10-Q
June 30, 2018
TABLE OF CONTENTS

 
 
 
 
Page
 
 
 
 
 
 
PART I.
ITEM 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
NOTE 1.
 
 
NOTE 2.
 
 
NOTE 3.
 
 
NOTE 4.
 
 
NOTE 5.
 
 
NOTE 6.
 
 
NOTE 7.
 
 
NOTE 8.
 
 
NOTE 9.
 
 
NOTE 10.
 
 
NOTE 11.
 
 
NOTE 12.
 
 
NOTE 13.
 
 
NOTE 14.
 
 
NOTE 15.
 
 
NOTE 16.
 
 
NOTE 17.
ITEM 2.
ITEM 3.
ITEM 4.
Part II.
ITEM 1.
ITEM 1A.
ITEM 2.
ITEM 3.
ITEM 4.
ITEM 5.
ITEM 6.
 

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FORWARD LOOKING STATEMENTS:
This Quarterly Report on Form 10-Q ("Form 10-Q") may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements often include the words “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future or conditional verbs such as “may,” “will,” “should,” “would” and “could.” These forward-looking statements are subject to known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from the results anticipated, including: our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel from our recent mergers with Puget Sound Bancorp, Inc., and Premier Commercial Bancorp, into our operations and our ability to realize related revenue synergies and cost savings within expected time frames or at all, and any goodwill charges related thereto and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, which might be greater than expected; the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and changes in our allowance for loan losses and provision for loan losses that may be effected by deterioration in the housing and commercial real estate markets, which may lead to increased losses and nonperforming assets in our loan portfolio, and may result in our allowance for loan losses no longer being adequate to cover actual losses, and require us to increase our allowance for loan losses; changes in general economic conditions, either nationally or in our market areas; changes in the levels of general interest rates, and the relative differences between short and long term interest rates, deposit interest rates, our net interest margin and funding sources; risks related to acquiring assets in or entering markets in which we have not previously operated and may not be familiar; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; results of examinations of us by the bank regulators, including the possibility that any such regulatory authority may, among other things, initiate an enforcement action against the Company or our bank subsidiary which could require us to increase our allowance for loan losses, write-down assets, change our regulatory capital position, affect our ability to borrow funds or maintain or increase deposits, or impose additional requirements on us, any of which could affect our ability to continue our growth through mergers, acquisitions or similar transactions and adversely affect our liquidity and earnings; legislative or regulatory changes that adversely affect our business including but not limited to, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and implementing regulations, changes in regulatory policies and principles, or the interpretation of regulatory capital or other rules as a result of Basel III; our ability to control operating costs and expenses; increases in premiums for deposit insurance; the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation; difficulties in reducing risk associated with the loans on our Condensed Consolidated Statements of Financial Condition; staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges; disruptions, security breaches, or other adverse events, failures or interruptions in, or attacks on, our information technology systems or on the third-party vendors who perform several of our critical processing functions; our ability to retain key members of our senior management team; costs and effects of litigation, including settlements and judgments; our ability to implement our growth strategies; increased competitive pressures among financial service companies; changes in consumer spending, borrowing and savings habits; the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; adverse changes in the securities markets; inability of key third-party providers to perform their obligations to us; changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board ("FASB"), including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods; and other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services and other risks detailed from time to time in our filings with the Securities and Exchange Commission including our Annual Report on Form 10-K for the year ended December 31, 2017.
The Company cautions readers not to place undue reliance on any forward-looking statements. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information then actually known to the Company. The Company does not undertake and specifically disclaims any obligation to revise any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. These risks could cause our actual results for future periods to differ materially from those expressed in any forward-looking statements by, or on behalf of, us, and could negatively affect the Company’s operating results and stock price performance.
As used throughout this report, the terms “we”, “our”, “us”, or the “Company” refer to Heritage Financial Corporation and its consolidated subsidiaries, unless the context otherwise requires.

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PART I.     FINANCIAL INFORMATION

ITEM 1.     FINANCIAL STATEMENTS

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Unaudited)
(In thousands, except shares)
 
 
June 30, 2018
 
December 31, 2017
ASSETS
 
 
 
 
Cash on hand and in banks
 
$
94,210


$
78,293

Interest earning deposits
 
35,733


24,722

Cash and cash equivalents
 
129,943


103,015

Investment securities available for sale, at fair value
 
873,670


810,530

Loans held for sale
 
3,598

 
2,288

Loans receivable, net
 
3,328,288

 
2,849,071

Allowance for loan losses
 
(33,972
)
 
(32,086
)
Total loans receivable, net
 
3,294,316

 
2,816,985

Other real estate owned
 
434


—

Premises and equipment, net
 
75,364


60,325

Federal Home Loan Bank stock, at cost
 
8,616


8,347

Bank owned life insurance
 
82,031

 
75,091

Accrued interest receivable
 
13,482


12,244

Prepaid expenses and other assets
 
104,718


99,328

Other intangible assets, net
 
15,767


6,088

Goodwill
 
187,549


119,029

Total assets
 
$
4,789,488


$
4,113,270

LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
Deposits
 
$
3,968,935

 
$
3,393,060

Federal Home Loan Bank advances
 
75,500

 
92,500

Junior subordinated debentures
 
20,156

 
20,009

Securities sold under agreement to repurchase
 
22,168

 
31,821

Accrued expenses and other liabilities
 
63,206

 
67,575

Total liabilities
 
4,149,965

 
3,604,965

Stockholders’ equity:
 
 
 
 
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at June 30, 2018 and December 31, 2017
 
—

 
—

Common stock, no par value, 50,000,000 shares authorized; 34,021,094 and 29,927,746 shares issued and outstanding at June 30, 2018 and December 31, 2017, respectively
 
491,026

 
360,590

Retained earnings
 
159,803

 
149,013

Accumulated other comprehensive loss, net
 
(11,306
)
 
(1,298
)
Total stockholders’ equity
 
639,523

 
508,305

Total liabilities and stockholders’ equity
 
$
4,789,488

 
$
4,113,270

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(In thousands, except per share amounts)
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
INTEREST INCOME
 
 
 
 
 
 
 
 
Interest and fees on loans
 
$
41,141

 
$
31,500

 
$
79,300

 
$
61,985

Taxable interest on investment securities
 
4,068

 
3,141

 
7,597

 
6,190

Nontaxable interest on investment securities
 
1,220

 
1,304

 
2,561

 
2,572

Interest on other interest earning assets
 
242

 
96

 
460

 
143

Total interest income
 
46,671

 
36,041

 
89,918

 
70,890

INTEREST EXPENSE
 
 
 
 
 
 
 
 
Deposits
 
2,195

 
1,407

 
4,155

 
2,673

Junior subordinated debentures
 
315

 
249

 
598

 
487

Other borrowings
 
418

 
251

 
585

 
464

Total interest expense
 
2,928

 
1,907

 
5,338

 
3,624

Net interest income
 
43,743

 
34,134

 
84,580

 
67,266

Provision for loan losses
 
1,750

 
1,131

 
2,902

 
1,998

Net interest income after provision for loan losses
 
41,993

 
33,003

 
81,678

 
65,268

NONINTEREST INCOME
 
 
 
 
 
 
 
 
Service charges and other fees
 
4,695

 
4,426

 
9,238

 
8,639

Gain on sale of investment securities, net
 
18

 
117

 
53

 
117

Gain on sale of loans, net
 
706

 
4,138

 
1,580

 
5,333

Interest rate swap fees
 
309

 
282

 
360

 
415

Other income
 
1,845

 
1,746

 
3,890

 
3,568

Total noninterest income
 
7,573

 
10,709

 
15,121

 
18,072

NONINTEREST EXPENSE
 
 
 
 
 
 
 
 
Compensation and employee benefits
 
19,321

 
16,272

 
40,688

 
32,296

Occupancy and equipment
 
4,810

 
3,818

 
9,437

 
7,628

Data processing
 
2,507

 
2,002

 
5,112

 
3,917

Marketing
 
823

 
805

 
1,631

 
1,612

Professional services
 
3,529

 
1,053

 
6,366

 
2,062

State and local taxes
 
716

 
639

 
1,404

 
1,188

Federal deposit insurance premium
 
375

 
357

 
730

 
657

Other real estate owned, net
 
—

 
21

 
—

 
52

Amortization of intangible assets
 
796

 
323

 
1,591

 
647

Other expense
 
2,829

 
2,519

 
5,494

 
4,973

Total noninterest expense
 
35,706

 
27,809

 
72,453

 
55,032

Income before income taxes
 
13,860

 
15,903

 
24,346

 
28,308

Income tax expense
 
2,003

 
4,075

 
3,402

 
7,164

Net income
 
$
11,857

 
$
11,828

 
$
20,944

 
$
21,144

Basic earnings per common share
 
$
0.35

 
$
0.40

 
$
0.62

 
$
0.71

Diluted earnings per common share
 
$
0.35

 
$
0.40

 
$
0.62

 
$
0.71

Dividends declared per common share
 
$
0.15

 
$
0.13

 
$
0.30

 
$
0.25

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(In thousands)

 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
Net income
 
$
11,857

 
$
11,828

 
$
20,944

 
$
21,144

Change in fair value of investment securities available for sale, net of tax of $(630), $1,491, $(2,638) and $2,285, respectively
 
(2,358
)
 
2,766

 
(9,874
)
 
4,239

Reclassification adjustment for net gain from sale of investment securities available for sale included in income, net of tax of $(4), $(41), $(12) and $(41), respectively
 
(14
)
 
(76
)
 
(41
)
 
(76
)
Other comprehensive (loss) income
 
(2,372
)
 
2,690

 
(9,915
)
 
4,163

Comprehensive income
 
$
9,485

 
$
14,518

 
$
11,029

 
$
25,307

See accompanying Notes to Condensed Consolidated Financial Statements.


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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited)
(In thousands, except per share amounts)
 
Number of
common
shares
 
Common
stock
 
Retained
earnings
 
Accumulated
other
comprehensive income (loss), net
 
Total
stock-
holders’
equity
Balance at December 31, 2016
29,955

 
$
359,060

 
$
125,309

 
$
(2,606
)
 
$
481,763

Restricted stock awards forfeited
(7
)
 
—

 
—

 
—

 
—

Exercise of stock options
8

 
109

 
—

 
—

 
109

Stock-based compensation expense
—

 
1,040

 
—

 
—

 
1,040

Common stock repurchased
(28
)
 
(674
)
 
—

 
—

 
(674
)
Net income
—

 
—

 
21,144

 
—

 
21,144

Other comprehensive income, net of tax
—

 
—

 
—

 
4,163

 
4,163

Cash dividends declared on common stock ($0.25 per share)
—

 
—

 
(7,497
)
 
—

 
(7,497
)
Balance at June 30, 2017
29,928

 
$
359,535

 
$
138,956

 
$
1,557

 
$
500,048

 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2017
29,928

 
$
360,590

 
$
149,013

 
$
(1,298
)
 
$
508,305

Restricted stock units vested, net of forfeitures of restricted stock awards
30

 
—

 
—

 
—

 
—

Exercise of stock options
3

 
47

 
—

 
—

 
47

Stock-based compensation expense
—

 
1,307

 
—

 
—

 
1,307

Common stock repurchased
(52
)
 
(1,688
)
 
—

 
—

 
(1,688
)
Net income
—

 
—

 
20,944

 
—

 
20,944

Other comprehensive loss, net of tax
—

 
—

 
—

 
(9,915
)
 
(9,915
)
Common stock issued in business combination
4,112

 
130,770

 
—

 
—

 
130,770

Cash dividends declared on common stock ($0.30 per share)
—

 
—

 
(10,247
)
 
—

 
(10,247
)
ASU 2016-01 implementation
—

 
—

 
93

 
(93
)
 
—

Balance at June 30, 2018
34,021

 
$
491,026

 
$
159,803

 
$
(11,306
)
 
$
639,523

See accompanying Notes to Condensed Consolidated Financial Statements.


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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(In thousands)
 
 
Six Months Ended June 30,
 
 
2018
 
2017
Cash flows from operating activities:
 
 
 
 
Net income
 
$
20,944

 
$
21,144

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation and amortization
 
5,140

 
5,459

Changes in net deferred loan costs, net of amortization
 
(254
)
 
(509
)
Provision for loan losses
 
2,902

 
1,998

Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities
 
419

 
3,482

Stock-based compensation expense
 
1,307

 
1,040

Amortization of intangible assets
 
1,591

 
647

Origination of loans held for sale
 
(40,048
)
 
(54,449
)
Proceeds from sale of loans
 
39,962

 
71,436

Earnings on bank owned life insurance
 
(666
)
 
(747
)
Gain on sale of loans, net
 
(1,580
)
 
(5,333
)
Gain on sale of investment securities, net
 
(53
)
 
(117
)
Gain on sale of assets held for sale
 
—

 
(53
)
Impairment of assets held for sale
 
75

 
—

Loss on sale or write-off of furniture, equipment and leasehold improvements
 
—

 
12

Net cash provided by operating activities
 
29,739

 
44,010

Cash flows from investing activities:
 
 
 
 
Loans originated, net of principal payments
 
(96,127
)
 
(135,709
)
Maturities, calls and payments of investment securities available for sale
 
41,436

 
52,461

Purchase of investment securities available for sale
 
(147,360
)
 
(57,972
)
Purchase of premises and equipment
 
(16,659
)
 
(1,382
)
Proceeds from sales of other loans
 
4,532

 
21,319

Proceeds from sales of investment securities available for sale
 
107,579

 
15,032

Proceeds from sale of assets held for sale
 
—

 
265

Proceeds from redemption of Federal Home Loan Bank stock
 
22,138

 
16,456

Purchases of Federal Home Loan Bank stock
 
(21,784
)
 
(17,975
)
Proceeds from sale of premises and equipment
 
21

 
—

Capital contribution to low-income housing tax credit partnership
 
(8,169
)
 
(7
)
Net cash received from acquisitions
 
80,133

 
—

Net cash used in investing activities
 
(34,260
)
 
(107,512
)
Cash flows from financing activities:
 
 
 
 
Net increase in deposits
 
69,990

 
61,602

Federal Home Loan Bank advances
 
536,450

 
442,700

Repayments of Federal Home Loan Bank advances
 
(553,450
)
 
(411,400
)
Common stock cash dividends paid
 
(10,247
)
 
(7,497
)
Net decrease in securities sold under agreement to repurchase
 
(9,653
)
 
(849
)
Proceeds from exercise of stock options
 
47

 
109

Repurchase of common stock
 
(1,688
)
 
(674
)
Net cash provided by financing activities
 
31,449

 
83,991


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Six Months Ended June 30,
 
 
2018
 
2017
Net increase in cash and cash equivalents
 
26,928

 
20,489

Cash and cash equivalents at beginning of period
 
103,015

 
103,745

Cash and cash equivalents at end of period
 
$
129,943

 
$
124,234

 
 
 
 
 
Supplemental disclosures of cash flow information:
 
 
 
 
Cash paid for interest
 
$
5,302

 
$
3,688

Cash paid for income taxes
 
2,724

 
1,007

 
 
 
 
 
Supplemental non-cash disclosures of cash flow information:
 
 
 
 
Transfers of loans receivable to other real estate owned
 
$
434

 
$
32

Transfers of loans receivable to loans held for sale
 
—

 
5,779

Transfers of properties held for sale recorded in premises and equipment, net to prepaid expenses and other assets
 
221

 
2,687

Purchases of investment securities available for sale not settled
 
—

 
2,268

     Business Combination:
 
 
 
 
Common stock issued for business combinations
 
130,770

 
—

Assets acquired (liabilities assumed) in acquisitions:
 
 
 
 
Investment securities available for sale
 
80,353

 
—

Loans receivable
 
388,462

 
—

Premises and equipment
 
732

 
—

Federal Home Loan Bank stock
 
623

 
—

Accrued interest receivable
 
1,448

 
—

Bank owned life insurance
 
6,264

 
—

Prepaid expenses and other assets
 
1,354

 
—

Other intangible assets
 
11,270

 
—

Deposits
 
(505,885
)
 
—

Accrued expenses and other liabilities
 
(2,504
)
 
—

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

(1)
Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements
(a) Description of Business
Heritage Financial Corporation ("Heritage" or the “Company”) is a bank holding company that was incorporated in the State of Washington in August 1997. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly-owned subsidiary, Heritage Bank (the “Bank”). The Bank is a Washington-chartered commercial bank and its deposits are insured by the Federal Deposit Insurance Corporation ("FDIC"). The Bank is headquartered in Olympia, Washington and conducts business from its 59 branch offices as of June 30, 2018 located throughout Washington State and the greater Portland, Oregon area. The Bank’s business consists primarily of commercial lending and deposit relationships with small businesses and their owners in its market areas and attracting deposits from the general public. The Bank also makes real estate construction and land development loans, consumer loans and originates first mortgage loans on residential properties primarily located in its market areas.
On January 16, 2018, the Company completed the acquisition of Puget Sound Bancorp, Inc. (“Puget Sound”), the holding company for Puget Sound Bank, both of Bellevue, Washington (“Puget Sound Merger”). See Note (2) Business Combination for additional information on the merger.
On March 8, 2018, the Company entered into a definitive agreement to acquire Premier Commercial Bancorp, ("Premier Commercial") and its wholly-owned bank subsidiary, Premier Community Bank, both of Hillsboro, Oregon (the "Premier Merger"). The Premier Merger was completed on July 2, 2018. See Note (17) Subsequent Event for additional information on the merger.

(b) Basis of Presentation
The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with the accounting principles generally accepted in the United States (“U.S. GAAP”) for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. It is recommended that these unaudited Condensed Consolidated Financial Statements and accompanying Notes be read with the audited Consolidated Financial Statements and the accompanying Notes included in the Company's Annual Report on Form 10-K for the year ended December 31, 2017 (“2017 Annual Form 10-K”). In management's opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018. In preparing the unaudited Condensed Consolidated Financial Statements, management is required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. Management believes that the judgments, estimates and assumptions used in the preparation of the financial statements are appropriate based on the facts and circumstances at the time. Actual results, however, could differ significantly from those estimates.

(c) Significant Accounting Policies
The significant accounting policies used in preparation of the Company's Condensed Consolidated Financial Statements are disclosed in the 2017 Annual Form 10-K. There have not been any material changes in the Company's significant accounting policies from those contained in the 2017 Annual Form 10-K, except for the accounting policy relating to revenue from contracts with customers adopted January 1, 2018, as discussed below.
Revenue from Contracts with Customers
Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, (“ASC 606”), as amended, was adopted by the Company on January 1, 2018. ASC 606 applies to all contracts with customers to provide goods or services in the ordinary course of business, except for contracts that are specifically excluded from its scope.  The Company's revenues are primarily composed of interest income on financial instruments, such as loans and investment securities, which are excluded from the scope of ASC 606.  Descriptions of our revenue-generating activities that are within the scope ASC 606, which are presented in Service Charges and Other Fees and Other Income on the Company’s Condensed Consolidated Statement of Income, are as follows:

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•
Service Charges on Deposit Accounts: The Company earns fees from its deposit customers from a variety of deposit products and services.  Non-transaction based fees such as account maintenance fees and monthly statement fees are considered to be provided to the customer under a day-to-day contract with ongoing renewals. Revenues for these non-transaction fees are earned over the course of a month, representing the period over which the Company satisfies the performance obligation.  Transaction-based fees such as non-sufficient fund charges, stop payment charges and wire fees are recognized at the time the transaction is executed as the contract duration does not extend beyond the service performed. 
•
Wealth Management and Trust Services: The Company earns fees from contracts with customers for fiduciary and brokerage activities. Revenues are generally recognized on a monthly basis and are generally based on a percentage of the customer’s assets under management or based on investment or insurance solutions that are implemented for the customer.
•
Merchant Processing Services and Debit and Credit Card Fees: The Company earns fees from cardholder transactions conducted through third party payment network providers which consist of (i) interchange fees earned from the payment network as a debit card issuer, (ii) referral fee income, and (iii) ongoing merchant fees earned for referring customers to the payment processing provider.  These fees are recognized when the transaction occurs, but may settle on a daily or monthly basis. 
    
(d) Recently Issued Accounting Pronouncements
FASB ASU 2014-09, Revenue from Contracts with Customers, (as amended by FASB ASU 2015-14; FASB ASU 2016-08; FASB ASU 2016-10 and FASB ASU 2016-12), was issued in May 2014. Under this Accounting Standard Update ("ASU" or "Update"), the Financial Accounting Standards Board ("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:
•
Remove inconsistencies and weaknesses in revenue requirements.
•
Provide a more robust framework for addressing revenue issues.
•
Improve comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets.
•
Provide more useful information to users of financial statements through improved disclosure requirements.
•
Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer.
The Company adopted the revenue recognition guidance, as amended, on January 1, 2018 using the modified retrospective approach. A significant amount of the Company’s revenues are derived from interest income on financial assets, which are excluded from the scope of the amended guidance. With respect to noninterest income and related disclosures, the Company has identified and evaluated the revenue streams and underlying revenue contracts within the scope of the guidance. The Company did not identify any significant changes in the timing of revenue recognition when considering the amended accounting guidance. The adoption of the Update did not have a material impact on the Company's Condensed Consolidated Financial Statements, but the adoption did change certain disclosure requirements as described in Significant Accounting Policies above.
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 Company adopted this Update effective January 1, 2018 using the cumulative catch-up transition method. This change resulted in a cumulative adjustment of $93,000 from accumulated other comprehensive loss, net to retained earnings for the unrealized gain related to the Company's equity security. The Company's processes and procedures utilized to estimate the fair value of loans receivable and certificate of deposit accounts for disclosure

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requirements were additionally changed due to adoption of this Update. Previously, the Company valued these items using an entry price notion. This ASU emphasized that these instruments be measured using the exit price notion; accordingly, the Company refined its calculation as part of adopting this Update. Prior period information has not been updated to conform with the new guidance. See the Condensed Consolidated Statements of Stockholders' Equity and Note (14) Fair Value Measurements.
FASB ASU 2016-02, Leases (Topic 842) was originally 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 anticipates adopting the Update on January 1, 2019. Upon adoption of the guidance, the Company expects to report increased assets and increased liabilities on its Condensed Consolidated Statements of Financial Condition as a result of recognizing right-of-use assets and lease liabilities related to certain banking offices and certain equipment under noncancelable operating lease agreements, which currently are not reflected in its Condensed Consolidated Statements of Financial Condition.  During 2017, management developed its methodology to estimate the right-of use assets and lease liabilities. The Company anticipates electing an exclusion accounting policy for lease assets and lease liabilities for leases with a term of twelve months or less. The Company was committed to $13.7 million of minimum lease payments under noncancelable operating lease agreements at June 30, 2018. The Company does not expect the adoption of this Update will have a significant impact to its Condensed 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 collectibility 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. The Update additionally addresses purchased assets and introduces the purchased financial asset with a more-than-insignificant amount of credit deterioration since origination ("PCD"). The accounting for these PCD assets is similar to the existing accounting guidance of FASB ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, for PCI assets, except the subsequent improvements in estimated cash flows will be immediately recognized into income, similar to the immediate recognition of subsequent deteriorations in cash flows. Current guidance only allows for the prospective recognition of these cash flow improvements. Because the terminology has been changed to a "more-than-insignificant" amount of credit deterioration, the presumption is that more assets might qualify for this accounting under the Update than those under current guidance. For public business entities, the Update is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years with early adoption permitted for fiscal years after December 15, 2018. An entity will apply the Update 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. An entity that has previously applied the guidance of FASB ASC 310-30 will prospectively apply the guidance in this Update for PCD assets. A prospective transition approach should be used for PCD assets where upon adoption, the amortized cost basis should be adjusted to reflect the addition of the allowance for credit losses. The Company is anticipating adopting the Update on January 1, 2020. Upon adoption, the Company expects a change in the processes, internal controls and procedures to calculate the allowance for loan losses, including changes in assumptions and estimates to consider expected credit losses over the life of the loan versus the current accounting practice that utilizes the incurred loss model. The new guidance may result in an increase in the allowance for loan losses which will also reflect the new requirement to include the nonaccretable principal differences on PCI loans; however, the Company is still in the process of determining the magnitude of the increase and its impact on the Condensed Consolidated Financial Statements. In addition, the current

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accounting policy and procedures for other-than-temporary impairment on investment securities available for sale will be replaced with an allowance approach. During 2017, the Company's management created a CECL steering committee which has begun developing and implementing processes and procedures to ensure it is fully compliant with the amendments at the adoption date. To date, the CECL steering committee has selected a vendor to assist the Company in the adoption and has completed the implementation discovery sessions. The CECL steering committee is in the process of selecting appropriate methodologies and refining key data points in an effort to complete a mock CECL model by fourth quarter 2018.
FASB ASU 2016-15, Statement of Cash Flows (Topic 230): 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 was effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years, and must be applied using a retrospective transitional method to each period presented. The Company adopted this Update on January 1, 2018. The adoption did not have a significant impact on its Condensed Consolidated Financial Statements as cash proceeds received from the settlement of bank-owned life insurance policies and cash payments for premiums on bank-owned life insurance policies were previously classified as cash inflows and outflows, respectively, from investing activities in the Condensed Consolidated Statements of Cash Flows.
FASB ASU 2017-04, Goodwill (Topic 350), was issued in January 2017 and eliminates Step 2 from the goodwill impairment test. Under the amendments, an entity should perform its 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. The loss recognized, however, 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.  The Update is effective for annual periods or any interim goodwill impairment tests beginning after December 15, 2019 using a prospective transition method and early adoption is permitted. The Company does not expect the Update will have a material impact on its Condensed Consolidated Financial Statements.
FASB ASU 2017-08, Receivables—Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities was issued in March 2017 and changes the accounting for certain purchased callable debt securities held at a premium to shorten the amortization period for the premium to the earliest call date rather than to the maturity date. Accounting for purchased callable debt securities held at a discount does not change. The discount would continue to amortize to the maturity date. The Update is effective for reporting periods beginning after December 15, 2018, with early adoption permitted. The Company adopted this Update in January 2018. The adoption did not have a material impact on its Condensed Consolidated Financial Statements as the Company had been accounting for premiums as prescribed under this guidance.
FASB ASU 2017-09, Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting was issued in May 2017 to provide clarity as to when to apply modification accounting when there is a change in the terms or conditions of a share-based payment award. According to this Update, an entity should account for the effects of a modification unless the fair value, vesting conditions and balance sheet classification of the award is the same after the modification as compared to the original award prior to the modification. The Update was effective for reporting periods beginning after December 15, 2017. The Company adopted the Update on January 1, 2018. The adoption did not have a material impact on its Condensed Consolidated Financial Statements because no share-based payment award was modified during the six months ended June 30, 2018. The Company will apply this Update prospectively for any subsequent modifications of share-based payment awards.
FASB ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income was issued to address the income tax accounting treatment of the stranded tax effects within other comprehensive income due to the prohibition of backward tracing due to an income tax rate change that was initially recorded in other comprehensive income. This issue came about from the enactment of the Tax Cuts and Jobs Act on December 22, 2017 ("Tax Cuts and Jobs Act") that changed the Company’s income tax rate from 35% to 21%. The Update changed current accounting whereby an entity may elect to reclassify the stranded tax effect from accumulated other comprehensive income to retained earnings. The Update is effective for periods beginning after December 15, 2018 although early adoption is permitted. The Company early adopted ASU 2018-02 effective December 31, 2017 and elected a portfolio policy to reclassify the stranded tax effects of the change in the federal corporate tax rate of the net unrealized gains on our available-for-sale investment securities from accumulated other comprehensive loss, net to retained earnings.
FASB ASU 2018-05, Income Taxes (Topic 740): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118 was issued to provide guidance on the income tax accounting implications of the Tax Cuts and Jobs Act, and allows for entities to report provisional amounts for specific income tax effects of the Tax Cuts and

13
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Jobs Act for which the accounting under ASC Topic 740 was not yet complete but a reasonable estimate could be determined. A measurement period of one-year is allowed to complete the accounting effects under ASC Topic 740 and revise any previous estimates reported. Any provisional amounts or subsequent adjustments included in an entity’s financial statements during the measurement period should be included in income from continuing operations as an adjustment to tax expense in the reporting period the amounts are determined. The Company adopted this Update with the provisional adjustments as reported in the Consolidated Financial Statements on Form 10-K as of December 31, 2017. As of June 30, 2018, the Company did not incur any adjustments to the provisional recognition.

(2)
Business Combination
On July 26, 2017, the Company, along with the Bank, and Puget Sound Bancorp, Inc. and its wholly owned subsidiary bank, Puget Sound Bank, jointly announced the signing of a definitive agreement. The Puget Sound Merger was effective on January 16, 2018. As of the acquisition date, Puget Sound merged into Heritage and Puget Sound Bank merged into Heritage Bank. The primary reason for the transaction was to create depth in the Company's geographic footprint consistent with its ongoing growth strategy, focused heavily on metro markets, and to achieve operational scale and realize efficiencies of a larger combined organization.
Pursuant to the terms of the definitive agreement, all outstanding Puget Sound restricted stock awards became immediately vested prior to the Puget Sound Merger and Puget Sound shareholders received 1.1688 shares of Heritage common stock per share of Puget Sound stock. Heritage issued an aggregate of 4,112,258 shares of its common stock based on the January 12, 2018 closing price of Heritage Common stock of $31.80 for total fair value of common shares issued of $130.8 million and paid cash of $3,000 for fractional shares in the transaction for total consideration paid of $130.8 million. Total consideration includes $851,000 representing 26,741 shares which were forfeited by the Puget Sound shareholders to pay applicable taxes.
The Puget Sound Merger resulted in $68.5 million of goodwill. This goodwill is not deductible for tax purposes.
The Puget Sound Merger constitutes a business acquisition as defined by FASB ASC 805, Business Combinations. FASB ASC 805 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. Heritage was considered the acquirer in this transaction. Accordingly, the preliminary estimates of fair values of the Puget Sound assets, including the identifiable intangible assets, and the assumed liabilities in the Puget Sound Merger were measured and recorded as of January 16, 2018. Fair values on the acquisition date are preliminary and represent management’s best estimates based on available information and facts and circumstances in existence on the acquisition date. Fair values are subject to refinement for up to one year after the closing date of the acquisition as additional information regarding the closing date fair values becomes available. The Company expects to finalize the purchase price allocation by the third quarter of 2018 when the valuation of tax-related matters is complete.

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The preliminary fair value estimates of the assets acquired and liabilities assumed in the Puget Sound Merger were as follows:
 
Puget Sound Merger
 
(In thousands)
Assets
 
Cash and cash equivalents
$
25,889

Interest earning deposits
54,247

Investment securities available for sale
80,353

Loans receivable
388,462

Premises and equipment, net
732

Federal Home Loan Bank stock, at cost
623

Bank owned life insurance
6,264

Accrued interest receivable
1,448

Prepaid expenses and other assets
1,354

Other intangible assets
11,270

Total assets acquired
$
570,642

Liabilities
 
Deposits
$
505,885

Accrued expenses and other liabilities
2,504

Total liabilities acquired
$
508,389

 
 
Fair value of net assets acquired
$
62,253


A summary of the net assets purchased and the preliminary estimated fair value adjustments and resulting goodwill recognized from the Puget Sound Merger are presented in the following tables. Goodwill represents the excess of the consideration transferred over the estimated fair value of the net assets acquired and liabilities assumed.
 
Puget Sound Merger
 
(In thousands)
Cost basis of net assets on merger date
$
54,405

Consideration transferred
(130,773
)
Fair value adjustments:
 
Investment securities
(348
)
Total loans receivable, net
1,400

Premises and equipment
(121
)
Other intangible assets
9,207

Prepaid expenses and other assets
(2,282
)
Deposits
(62
)
Accrued expenses and other liabilities
54

Goodwill recognized from the Puget Sound Merger
$
(68,520
)



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The operating results of the Company for the three and six months ended June 30, 2018 include the operating results produced by the net assets acquired in the Puget Sound Merger since the January 16, 2018 merger date. The Company has considered the requirement of FASB ASC 805 related to the contribution of the Puget Sound Merger to the Company’s results of operations. The table below presents only the significant results for the acquired business since the January 16, 2018 merger date:
 
Three Months Ended(1)
 
Six Months Ended(1)
 
June 30, 2018
 
(In thousands)
Interest income: Interest and fees on loans(2)
$
6,130

 
$
10,647

Interest income: Interest and fees on investments (3)
—

 
59

Interest income: Other interest earning assets
25

 
113

Interest expense
(180
)
 
(324
)
Provision for loan losses for loans
(350
)
 
(550
)
Noninterest income
109

 
257

Noninterest expense (4)
(2,092
)
 
(7,672
)
Net effect, pre-tax
$
3,642

 
$
2,530

(1) The Puget Sound Merger was completed on January 16, 2018.
(2) Includes the accretion of the discount on the purchased loans of $1.1 million and $1.5 million during the three and six months ended June 30, 2018, respectively.
(3) All securities were sold with trade date of January 16, 2018 and settlement dates on or before February 14, 2018.
(4) Excludes certain compensation and employee benefits for management as it is impracticable to determine due to the integration of the operations for this merger. Also includes certain merger-related costs incurred by the Company.
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 Puget Sound Merger is not material to the Company. The Company believes that the historical Puget Sound operating results are not considered of enough significance to be meaningful to the Company’s results of operations.
During the three and six months ended June 30, 2018, the Company incurred acquisition-related costs of approximately $551,000 and $5.0 million, respectively, related to the Puget Sound Merger.

(3)
Investment Securities

As a result of the adoption of ASU 2016-01 on January 1, 2018, equity investments (except for investments accounted for under the equity method of accounting) are now measured at fair value, with changes in fair value recognized in earnings. These investments were previously measured at fair value, with changes in fair value recognized in accumulated other comprehensive loss. Accordingly, these securities are no longer classified as investment securities available-for-sale and their presentation is not comparable to the presentation as of December 31, 2017. See Note (1) Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements, as well as Equity Securities section discussed below.


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Available for sale investment securities
(a) Securities by Type and Maturity
The amortized cost, gross unrealized gains, gross unrealized losses and fair values of investment securities available for sale at the dates indicated were as follows:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
 
(In thousands)
June 30, 2018
 
 
 
 
 
 
 
U.S. Treasury and U.S. Government-sponsored agencies
$
52,256

 
$
42

 
$
(234
)
 
$
52,064

Municipal securities
202,918

 
1,366

 
(1,262
)
 
203,022

Mortgage-backed securities and collateralized mortgage obligations(1):
 
 
 
 
 
 
 
Residential
319,492

 
352

 
(7,722
)
 
312,122

Commercial
257,858

 
141

 
(7,778
)
 
250,221

Collateralized loan obligations
2,253

 
3

 
—

 
2,256

Corporate obligations
25,617

 
153

 
(80
)
 
25,690

Other asset-backed securities
27,603

 
692

 
—

 
28,295

Total
$
887,997

 
$
2,749

 
$
(17,076
)
 
$
873,670

 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
U.S. Treasury and U.S. Government-sponsored agencies
$
13,460

 
$
6

 
$
(24
)
 
$
13,442

Municipal securities
247,358

 
3,720

 
(1,063
)
 
250,015

Mortgage-backed securities and collateralized mortgage obligations(1):
 
 
 
 
 
 
 
Residential
282,724

 
422

 
(2,935
)
 
280,211

Commercial
219,696

 
444

 
(3,061
)
 
217,079

Collateralized loan obligations
4,561

 
19

 
—

 
4,580

Corporate obligations
16,594

 
220

 
(44
)
 
16,770

Other securities (2)
27,781

 
652

 
—

 
28,433

Total
$
812,174

 
$
5,483

 
$
(7,127
)
 
$
810,530

(1) 
Issued and guaranteed by U.S. Government-sponsored agencies.
(2) 
Primarily asset-backed securities.
There were no securities classified as trading or held to maturity at June 30, 2018 or December 31, 2017.
The amortized cost and fair value of investment securities available for sale at June 30, 2018, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
 
Amortized Cost
 
Fair Value
 
(In thousands)
Due in one year or less
$
24,656

 
$
24,690

Due after one year through five years
149,590

 
148,197

Due after five years through ten years
254,873

 
248,759

Due after ten years
458,878

 
452,024

Total
$
887,997

 
$
873,670


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(b) Unrealized Losses and Other-Than-Temporary Impairments
The following table shows the gross unrealized losses and fair value of the Company's investment securities available for sale that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that the individual securities have been in continuous unrealized loss positions as of June 30, 2018 and December 31, 2017:
 
Less than 12 Months
 
12 Months or Longer
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
(In thousands)
June 30, 2018
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasury and U.S. Government-sponsored agencies
$
34,674

 
$
(223
)
 
$
536

 
$
(11
)
 
$
35,210

 
$
(234
)
Municipal securities
63,443

 
(552
)
 
22,903

 
(710
)
 
86,346

 
(1,262
)
Mortgage-backed securities and collateralized mortgage obligations(1):
 
 
 
 
 
 
 
 
 
 
 
Residential
178,865

 
(3,954
)
 
78,330

 
(3,768
)
 
257,195

 
(7,722
)
Commercial
128,298

 
(3,058
)
 
94,847

 
(4,720
)
 
223,145

 
(7,778
)
Corporate obligations
15,482

 
(80
)
 
—

 
—

 
15,482

 
(80
)
Total
$
420,762

 
$
(7,867
)
 
$
196,616

 
$
(9,209
)
 
$
617,378

 
$
(17,076
)
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasury and U.S. Government-sponsored agencies
$
11,436

 
$
(24
)
 
$
—

 
$
—

 
$
11,436

 
$
(24
)
Municipal securities
39,298

 
(384
)
 
26,509

 
(679
)
 
65,807

 
(1,063
)
Mortgage-backed securities and collateralized mortgage obligations(1):
 
 
 
 
 
 
 
 
 
 
 
Residential
175,847

 
(1,296
)
 
66,380

 
(1,639
)
 
242,227

 
(2,935
)
Commercial
75,121

 
(700
)
 
90,822

 
(2,361
)
 
165,943

 
(3,061
)
Corporate obligations
3,472

 
(44
)
 
—

 
—

 
3,472

 
(44
)
Total
$
305,174

 
$
(2,448
)
 
$
183,711

 
$
(4,679
)
 
$
488,885

 
$
(7,127
)
(1) Issued and guaranteed by U.S. Government-sponsored agencies.
The Company has evaluated these investment securities available for sale as of June 30, 2018 and December 31, 2017 and has determined that the decline in their value is not other-than-temporary. The unrealized losses are primarily due to increases in market interest rates. The fair value of these securities is expected to recover as the securities approach their maturity date. None of the underlying issuers of the municipal securities and corporate obligations had credit ratings that were below investment grade levels at June 30, 2018 or December 31, 2017. The Company has the ability and intent to hold the investments until recovery of the securities' amortized cost, which may be the maturity date of the securities.
For the three and six months ended June 30, 2018 and 2017, there were no other-than-temporary charges recorded to net income.

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(c) Realized Gains and Losses
The following table presents the gross realized gains and losses on the sale of securities available for sale for the three and six months ended June 30, 2018 and 2017.
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
 
(In thousands)
Gross realized gains
$
18

 
$
117

 
$
122

 
$
117

Gross realized losses
—

 
—

 
(69
)
 
—

   Net realized gains
$
18

 
$
117

 
$
53

 
$
117

    
(d) Pledged Securities
The following table summarizes the amortized cost and fair value of investment securities available for sale that are pledged as collateral for the following obligations at June 30, 2018 and December 31, 2017:
 
June 30, 2018
 
December 31, 2017
 
Amortized
Cost
 
Fair
Value
 
Amortized
Cost
 
Fair
Value
 
(In thousands)
Washington and Oregon state to secure public deposits
$
197,047

 
$
193,946

 
$
206,377

 
$
206,425

Repurchase agreements
45,463

 
44,207

 
48,750

 
48,237

Other securities pledged
20,048

 
19,742

 
12,484

 
12,498

Total
$
262,558

 
$
257,895

 
$
267,611

 
$
267,160


Equity Securities
The Company holds an equity security with a readily determinable fair value of $162,000 and $146,000 as of June 30, 2018 and December 31, 2017, respectively. As a result of the adoption of ASU 2016-01, this security is no longer classified as investment security available for sale and has been reclassified to prepaid expenses and other assets on the Company's Condensed Consolidated Statements of Financial Condition as of June 30, 2018. As such, its presentation is not comparable to the presentation as of December 31, 2017. The Company recorded the tax-effected unrealized gain on the equity security through an adjustment to accumulated other comprehensive loss, net and retained earnings in the Condensed Consolidated Statement of Stockholders' Equity during the six months ended June 30, 2018.

(4)
Loans Receivable
The Company originates loans in the ordinary course of business and has also acquired loans through FDIC-assisted and open bank transactions. Disclosures related to the Company's recorded investment in loans receivable generally exclude accrued interest receivable and net deferred fees or costs because they are insignificant.
Loans acquired in a business combination are further classified as “purchased” loans. Loans purchased with evidence of credit deterioration since origination for which it is probable that not all contractually required payments will be collected are accounted for under FASB ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. These loans are identified as "PCI" loans. Loans purchased that are not accounted for under FASB ASC 310-30 are accounted for under FASB ASC 310-20, Receivables—Nonrefundable Fees and Other Costs, and are referred to as "non-PCI" loans.

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(a) Loan Origination/Risk Management
The Company categorizes loans in one of the four segments of the total loan portfolio: commercial business, one-to-four family residential, real estate construction and land development and consumer. Within these segments are classes of loans for which management monitors and assesses credit risk in the loan portfolios. The Company has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and criticized loans. The Company also conducts internal loan reviews and validates the credit risk assessment on a periodic basis and presents the results of these reviews to management. The loan review process complements and reinforces the risk identification and assessment decisions made by loan officers and credit personnel, as well as the Company’s policies and procedures.
A discussion of the risk characteristics of each loan portfolio segment is as follows:
Commercial Business:
There are three significant classes of loans in the commercial business portfolio segment: commercial and industrial, owner-occupied commercial real estate and non-owner occupied commercial real estate. The owner and non-owner occupied commercial real estate classes are both considered commercial real estate loans. As the commercial and industrial loans carry different risk characteristics than the commercial real estate loans, they are discussed separately below.
Commercial and industrial. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may include a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. Commercial and industrial loans carry more risk than other loans because the borrowers’ cash flow is less predictable, and in the event of a default, the amount of loss is potentially greater and more difficult to quantify because the value of the collateral securing these loans may fluctuate, may be uncollectible, or may be obsolete or of limited use, among other things.
Commercial real estate. The Company originates commercial real estate loans primarily within its primary market areas. These loans are subject to underwriting standards and processes similar to commercial and industrial loans in that these loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate properties. Commercial real estate lending typically involves higher loan principal amounts and payments on loans, and repayment is dependent on successful operation and management of the properties. The value of the real estate securing these loans can be adversely affected by conditions in the real estate market or the economy. There is little difference in risk between owner-occupied commercial real estate loans and non-owner occupied commercial real estate loans.
One-to-Four Family Residential:
The majority of the Company’s one-to-four family residential loans are secured by single-family residences located in its primary market areas. The Company’s underwriting standards require that single-family portfolio loans generally are owner-occupied and do not exceed 80% of the lower of appraised value at origination or cost of the underlying collateral. Terms of maturity typically range from 15 to 30 years. The Company sells most of its single-family loans in the secondary market and retains a smaller portion in its loan portfolio.
Real Estate Construction and Land Development:
The Company originates construction loans for one-to-four family residential and for five or more family residential and commercial properties. The one-to-four family residential construction loans generally include construction of custom homes whereby the home buyer is the borrower. The Company also provides financing to builders for the construction of pre-sold homes and, in selected cases, to builders for the construction of speculative residential property. Substantially all construction loans are short-term in nature and priced with variable rates of interest. Construction lending can involve a higher level of risk than other types of lending because funds are advanced partially based upon the value of the project, which is uncertain prior to the project’s completion. Because of the uncertainties inherent in estimating construction costs as well as the market value of a completed project and the effects of governmental regulation of real property, the Company’s estimates with regard to the total funds required to complete a project and the related loan-to-value ratio may vary from actual results. As a result, construction loans often

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involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property or refinance the indebtedness. If the Company’s estimate of the value of a project at completion proves to be overstated, it may have inadequate security for repayment of the loan and may incur a loss if the borrower does not repay the loan. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being dependent upon successful completion of the construction project, interest rate changes, government regulation of real property, general economic conditions and the availability of long-term financing.
Consumer:
The Company originates consumer loans and lines of credit that are both secured and unsecured. The underwriting process for these loans ensures a qualifying primary and secondary source of repayment. Underwriting standards for home equity loans are significantly influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage of 80%, collection remedies, the number of such loans a borrower can have at one time and documentation requirements. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed. The majority of consumer loans are for relatively small amounts disbursed among many individual borrowers which reduces the credit risk for this type of loan. To further reduce the risk, trend reports are reviewed by management on a regular basis.
The Company also originates indirect consumer loans. These loans are for new and used automobile and recreational vehicles that are originated indirectly by selected dealers located in the Company's market areas. The Company has limited its purchase of indirect loans primarily to dealerships that are established and well-known in their market areas and to applicants that are not classified as sub-prime.
Loans receivable at June 30, 2018 and December 31, 2017 consisted of the following portfolio segments and classes:
 
June 30, 2018
 
December 31, 2017
 
(In thousands)
Commercial business:
 
 
 
Commercial and industrial
$
800,043

 
$
645,396

Owner-occupied commercial real estate
693,330

 
622,150

Non-owner occupied commercial real estate
1,187,548

 
986,594

Total commercial business
2,680,921

 
2,254,140

One-to-four family residential
92,518

 
86,997

Real estate construction and land development:
 
 
 
One-to-four family residential
71,934

 
51,985

Five or more family residential and commercial properties
93,315

 
97,499

Total real estate construction and land development
165,249

 
149,484

Consumer
385,987

 
355,091

Gross loans receivable
3,324,675

 
2,845,712

Net deferred loan costs
3,613

 
3,359

 Loans receivable, net
3,328,288

 
2,849,071

Allowance for loan losses
(33,972
)
 
(32,086
)
 Total loans receivable, net
$
3,294,316

 
$
2,816,985

(b) Concentrations of Credit
Most of the Company’s lending activity occurs within its primary market areas which are concentrated along the I-5 corridor from Whatcom County to Clark County in Washington State and Multnomah County in Oregon, as well as other contiguous markets. The majority of the Company’s loan portfolio consists of (in order of balances at June 30, 2018) non-owner occupied commercial real estate, commercial and industrial and owner-occupied commercial real estate. As of June 30, 2018 and December 31, 2017, there were no concentrations of loans related to any single industry in excess of 10% of the Company’s total loans.

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(c) Credit Quality Indicators
As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the risk grade of the loans, (ii) the level of classified loans, (iii) net charge-offs, (iv) nonperforming loans and (v) the general economic conditions of the United States of America, and specifically the states of Washington and Oregon. The Company utilizes a risk grading matrix to assign a risk grade to each of its loans. Loans are graded on a scale of 1 to 10. A description of the general characteristics of the risk grades is as follows:
•
Grades 1 to 5: These grades are considered “pass grade” and include loans with negligible to above average but acceptable risk. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt service capacity. Loans with the higher grades within the “pass” category may include borrowers who are experiencing unusual operating difficulties, but have acceptable payment performance to date. Increased monitoring of financial information and/or collateral may be appropriate. Loans with this grade show no immediate loss exposure.
•
Grade 6: This grade includes "Watch" loans and is considered a “pass grade”. The grade is intended to be utilized on a temporary basis for pass grade borrowers where a potentially significant risk-modifying action is anticipated in the near term.
•
Grade 7: This grade includes “Other Assets Especially Mentioned” (“OAEM”) loans in accordance with regulatory guidelines and is intended to highlight loans with elevated risks. Loans with this grade show signs of deteriorating profits and capital, and the borrower might not be strong enough to sustain a major setback. The borrower is typically higher than normally leveraged, and outside support might be modest and likely illiquid. The loan is at risk of further decline unless active measures are taken to correct the situation.
•
Grade 8: This grade includes “Substandard” loans in accordance with regulatory guidelines, which the Company has determined have a high credit risk. These loans also have well-defined weaknesses which make payment default or principal exposure likely, but not yet certain. The borrower may have shown serious negative trends in financial ratios and performance. Such loans may be dependent upon collateral liquidation, a secondary source of repayment or an event outside of the normal course of business. Loans with this grade can be placed on accrual or nonaccrual status based on the Company’s accrual policy.
•
Grade 9: This grade includes “Doubtful” loans in accordance with regulatory guidelines, and the Company has determined these loans to have excessive credit risk. Such loans are placed on nonaccrual status and may be dependent upon collateral having a value that is difficult to determine or upon some near-term event which lacks certainty. Additionally, these loans generally have a specific valuation allowance or have been partially charged-off for the amount considered uncollectible.
•
Grade 10: This grade includes “Loss” loans in accordance with regulatory guidelines, and the Company has determined these loans have the highest risk of loss. Such loans are charged-off or charged-down when payment is acknowledged to be uncertain or when the timing or value of payments cannot be determined. “Loss” is not intended to imply that the loan or some portion of it will never be paid, nor does it in any way imply that there has been a forgiveness of debt.
Numerical loan grades for loans are established at the origination of the loan. Loan grades are reviewed on a quarterly basis, or more frequently if necessary, by the credit department. The Bank follows the FDIC’s Uniform Retail Credit Classification and Account Management Policy for subsequent classification in the event of payment delinquencies or default. Typically, an individual loan grade will not be changed from the prior period unless there is a specific indication of credit deterioration or improvement. Credit deterioration is evidenced by delinquency, direct communications with the borrower, or other borrower information that becomes known to management. Credit improvements are evidenced by known facts regarding the borrower or the collateral property.
The loan grades relate to the likelihood of losses in that the higher the grade, the greater the loss potential. Loans with a pass grade may have some estimated inherent losses, but to a lesser extent than the other loan grades. The OAEM loan grade is transitory in that the Company is waiting on additional information to determine the likelihood and extent of the potential loss. The likelihood of loss for OAEM graded loans, however, is greater than Watch graded loans because there has been measurable credit deterioration. Loans with a Substandard grade are generally loans for which the Company has individually analyzed for potential impairment. For Doubtful and Loss graded loans, the Company is almost certain of the losses, and the outstanding principal balances are generally charged-off to the realizable value.

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The following tables present the balance of the loans receivable by credit quality indicator as of June 30, 2018 and December 31, 2017.
 
June 30, 2018
 
Pass
 
OAEM
 
Substandard
 
Doubtful/Loss
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
731,265

 
$
23,559

 
$
45,219

 
$
—

 
$
800,043

Owner-occupied commercial real estate
656,991

 
16,402

 
19,937

 
—

 
693,330

Non-owner occupied commercial real estate
1,161,596

 
10,972

 
14,980

 
—

 
1,187,548

Total commercial business
2,549,852

 
50,933

 
80,136

 
—

 
2,680,921

One-to-four family residential
91,264

 
—

 
1,254

 
—

 
92,518

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
70,499

 
267

 
1,168

 
—

 
71,934

Five or more family residential and commercial properties
93,258

 
57

 
—

 
—

 
93,315

Total real estate construction and land development
163,757

 
324

 
1,168

 
—

 
165,249

Consumer
381,341

 
—

 
4,121

 
525

 
385,987

Gross loans receivable
$
3,186,214

 
$
51,257

 
$
86,679

 
$
525

 
$
3,324,675


 
December 31, 2017
 
Pass
 
OAEM
 
Substandard
 
Doubtful/Loss
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
597,697

 
$
19,536

 
$
28,163

 
$
—

 
$
645,396

Owner-occupied commercial real estate
595,455

 
12,668

 
14,027

 
—

 
622,150

Non-owner occupied commercial real estate
955,450

 
10,494

 
20,650

 
—

 
986,594

Total commercial business
2,148,602

 
42,698

 
62,840

 
—

 
2,254,140

One-to-four family residential
85,762

 
—

 
1,235

 
—

 
86,997

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
49,925

 
537

 
1,523

 
—

 
51,985

Five or more family residential and commercial properties
96,404

 
707

 
388

 
—

 
97,499

Total real estate construction and land development
146,329

 
1,244

 
1,911

 
—

 
149,484

Consumer
349,590

 
—

 
4,976

 
525

 
355,091

Gross loans receivable
$
2,730,283

 
$
43,942

 
$
70,962

 
$
525

 
$
2,845,712


Potential problem loans are loans classified as OAEM or worse that are currently accruing interest and are not considered impaired, but which management is monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms. Potential problem loans may include PCI loans as these loans continue to accrete loan discounts established at acquisition based on the guidance of FASB ASC 310-30. Potential problem loans as of June 30, 2018 and December 31, 2017 were $101.5 million and $83.5 million, respectively.

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(d) Nonaccrual Loans
Nonaccrual loans, segregated by segments and classes of loans, were as follows as of June 30, 2018 and December 31, 2017:
 
June 30, 2018
 
December 31, 2017
 
(In thousands)
Commercial business:
 
 
 
Commercial and industrial
$
8,376

 
$
3,110

Owner-occupied commercial real estate
4,690

 
4,090

Non-owner occupied commercial real estate
2,169

 
1,898

Total commercial business
15,235

 
9,098

One-to-four family residential
77

 
81

Real estate construction and land development:
 
 
 
One-to-four family residential
1,084

 
1,247

Consumer
127

 
277

Nonaccrual loans
$
16,523

 
$
10,703

PCI loans are not included in the nonaccrual loan table above because these loans are accounted for under FASB ASC 310-30, which provides that accretable yield is calculated based on a loan's expected cash flow even if the loan is not performing under its contractual terms.
(e) Past due loans
The Company performs an aging analysis of past due loans using the categories of 30-89 days past due and 90 or more days past due. This policy is consistent with regulatory reporting requirements.
The balances of past due loans, segregated by segments and classes of loans, as of June 30, 2018 and December 31, 2017 were as follows:
 
June 30, 2018
 
30-89 Days
 
90 Days or
Greater
 
Total Past 
Due
 
Current
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
3,719

 
$
4,122

 
$
7,841

 
$
792,202

 
$
800,043

Owner-occupied commercial real estate
129

 
868

 
997

 
692,333

 
693,330

Non-owner occupied commercial real estate
1,501

 
3,238

 
4,739

 
1,182,809

 
1,187,548

Total commercial business
5,349

 
8,228

 
13,577

 
2,667,344

 
2,680,921

One-to-four family residential
—

 
—

 
—

 
92,518

 
92,518

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
—

 
309

 
309

 
71,625

 
71,934

Five or more family residential and commercial properties
—

 
—

 
—

 
93,315

 
93,315

Total real estate construction and land development
—

 
309

 
309

 
164,940

 
165,249

Consumer
1,634

 
53

 
1,687

 
384,300

 
385,987

Gross loans receivable
$
6,983

 
$
8,590

 
$
15,573

 
$
3,309,102

 
$
3,324,675



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December 31, 2017
 
30-89 Days
 
90 Days or
Greater
 
Total Past 
Due
 
Current
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
2,993

 
$
1,172

 
$
4,165

 
$
641,231

 
$
645,396

Owner-occupied commercial real estate
1,277

 
1,225

 
2,502

 
619,648

 
622,150

Non-owner occupied commercial real estate
870

 
3,314

 
4,184

 
982,410

 
986,594

Total commercial business
5,140

 
5,711

 
10,851

 
2,243,289

 
2,254,140

One-to-four family residential
513

 
—

 
513

 
86,484

 
86,997

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
84

 
1,331

 
1,415

 
50,570

 
51,985

Five or more family residential and commercial properties
40

 
—

 
40

 
97,459

 
97,499

Total real estate construction and land development
124

 
1,331

 
1,455

 
148,029

 
149,484

Consumer
1,939

 
687

 
2,626

 
352,465

 
355,091

Gross loans receivable
$
7,716

 
$
7,729

 
$
15,445

 
$
2,830,267

 
$
2,845,712


There were no loans 90 days or more past due that were still accruing interest as of June 30, 2018 or December 31, 2017, excluding PCI loans.

(f) Impaired loans
Impaired loans include nonaccrual loans and performing troubled debt restructured ("TDR") loans. The balances of impaired loans as of June 30, 2018 and December 31, 2017 are set forth in the following tables.
 
June 30, 2018
 
Recorded
Investment With
No Specific
Valuation
Allowance
 
Recorded
Investment With
Specific
Valuation
Allowance
 
Total
Recorded
Investment
 
Unpaid
Contractual
Principal
Balance
 
Related
Specific
Valuation
Allowance
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
5,716

 
$
12,238

 
$
17,954

 
$
18,825

 
$
1,706

Owner-occupied commercial real estate
930

 
11,254

 
12,184

 
12,493

 
1,724

Non-owner occupied commercial real estate
4,662

 
5,923

 
10,585

 
10,558

 
784

Total commercial business
11,308

 
29,415

 
40,723

 
41,876

 
4,214

One-to-four family residential
—

 
291

 
291

 
301

 
90

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
775

 
309

 
1,084

 
1,842

 
5

Total real estate construction and land development
775

 
309

 
1,084

 
1,842

 
5

Consumer
53

 
329

 
382

 
447

 
74

Total
$
12,136

 
$
30,344

 
$
42,480

 
$
44,466

 
$
4,383


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