EX-13 3 exhibit13annualrpt.txt ANNUAL REPORT Exhibit 13 KENTUCKY BANCSHARES, INC. ANNUAL REPORT 2003 Letter to the Shareholders Dear Shareholders, During 2003 we were able to complete a strategic acquisition that has strengthened our franchise. With the purchase of First Federal Savings Bank in Cynthiana, our customer base is substantially larger. We continue to actively seek good business opportunities throughout Central Kentucky. Regrettably, our year-end operating results were down when compared to the prior year. Net income for the year was $4,233,377, down from $5,902,525 for year-end 2002. Diluted earnings per share were $1.50, also lower than the $2.10 figure of a year earlier. The major factors that contributed to the drop in net income were the lack of loan growth and the continued tightening of net interest margins. Beyond that, there were some one-time expenses related to closing our original location in Scott County, and merger related expenses associated with the acquisition of First Federal Savings Bank of Cynthiana. On a positive note, the dividend to shareholders rose again. The company is quite proud of increasing the dividend every year since 1982. There are some encouraging signs that the economy may be improving. We would expect an increase in loan demand as well as an improvement in margins if the stronger economy continues throughout 2004. Because we are now over $500,000,000 in assets, management also feels that this is an opportune time to examine our current organizational structure to determine whether we are positioned to deliver services and products to our customers in the most efficient way. Also, we have already begun to put into place measures to continually improve revenues and control costs in a more disciplined manner. We expect that these actions will improve our bottom line. Our Wealth Management Department recently completed an evaluation of both its structure and the services it provides. The strength of this department has always been evident in the dedication to its clientele. Under the leadership of new department head Clark Nyberg, who has over twenty years of investment management experience, we offer an even stronger team of committed professionals. In the later part of the year we added two new directors to the board of your company: Betty Long, the former CEO of First Federal and Dr. Woodford Van Meter, a Lexington ophthalmologist with long time ties to our bank and Bourbon County. Finally, Senior Vice President James P. Shipp has announced his decision to retire in April. Since his banking career started in 1979, J. P. has made many important contributions to our growth and success. Most recently he has been our leader in branch administration and was named a Senior Vice President in 1997. He will be missed, but we all wish him well. Sincerely, Louis Prichard Buckner Woodford President and COO President and CEO Kentucky Bank Kentucky Bancshares, Inc. FINANCIAL HIGHLIGHTS Kentucky Bancshares, Inc. 2003 2002 2001 Assets ($ thousands) $500,852 $419,771 $397,257 Net Income ($ thousands) $ 4,233 $ 5,903 $ 5,524 Per Share Results Earnings(assuming dilution) $ 1.50 $ 2.10 $ 1.95 Dividends $ .76 $ .68 $ .60 Shareholder Information CORPORATE HEADQUARTERS Kentucky Bancshares, Inc. 4th and Main Street Paris, Kentucky 40361 859-987-1795 MARKET MAKERS Morgan Keegan & Company 489 East Main Street Lexington, Kentucky 40507 800-937-0161 Hilliard Lyons West Vine Street, Suite 400 Lexington, Kentucky 40507 800-944-2663 Howe Barnes Investments, Inc. 135 South LaSalle Street, Suite 150 Chicago, Illinois 60603-4398 800-800-4693 TRANSFER, REGISTRAR AND DIVIDEND AGENT Registrar and Transfer Company 10 Commerce Drive Cranford, New Jersey 07016-3572 800-368-5948 rtco.com Kentucky Bancshares, Inc. - KTYB.OB ANNUAL MEETING The annual meeting of Kentucky Bancshares, Inc. will be held Wednesday, May 5, 2004 at 11:00 in the corporate headquarters. INVESTOR INFORMATION Any individual requesting a copy of the Corporation's 2003 Form 10-K Report may obtain these by writing to Investor Relations at the Corporate Headquarters. CONSOLIDATED BALANCE SHEETS December 31 2003 2002 ASSETS Cash and due from banks $ 15,224,513 $ 10,493,495 Federal funds sold 6,163,000 18,683,000 Cash and cash equivalents 21,387,513 29,176,495 Securities available for sale 128,789,830 89,509,140 Mortgage loans held for sale 7,758,583 740,023 Loans 313,002,258 284,153,605 Allowance for loan losses (3,819,842) (3,395,075) Net loans 309,182,416 280,758,530 Federal Home Loan Bank stock 4,930,100 4,027,300 Bank premises and equipment, net 11,606,373 10,331,618 Interest receivable 3,249,834 3,276,432 Goodwill 10,199,830 - Other intangible assets 1,998,231 1,367,417 Other assets 1,749,434 584,441 Total assets $ 500,852,144 $ 419,771,396 LIABILITIES AND STOCKHOLDERS' EQUITY Deposits Non-interest bearing $ 64,841,638 $ 53,366,283 Time deposits, $100,000 and over 49,914,659 46,903,641 Other interest bearing 269,842,299 222,566,031 Total deposits 384,598,596 322,835,955 Repurchase agreements and other borrowings 7,285,258 5,276,695 Federal Home Loan Bank advances 53,232,296 43,937,306 Subordinated debentures 7,217,000 - Interest payable 1,635,784 1,844,705 Other liabilities 826,569 1,784,893 Total liabilities 454,795,503 375,679,554 Stockholders' equity Preferred stock, 300,000 shares authorized and unissued - - Common stock, no par value; 10,000,000 shares authorized; 2,799,781 and 2,772,754 shares issued and outstanding in 2003 and 2002 6,984,784 6,806,887 Retained earnings 37,552,620 35,435,996 Accumulated other comprehensive income (loss) 1,519,237 1,848,959 Total stockholders' equity 46,056,641 44,091,842 Total liabilities and stockholders' equity $ 500,852,144 $ 419,771,396 CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31 2003 2002 2001 Interest income Loans, including fees $ 18,574,690 $ 20,632,003 $ 23,658,873 Securities Taxable 2,049,835 2,564,539 2,591,330 Tax exempt 1,430,589 1,254,065 1,124,620 Other 274,003 337,397 671,231 22,329,117 24,788,004 28,046,054 Interest expense Deposits 5,310,791 6,977,969 11,306,963 Repurchase agreements and other borrowings 27,460 42,148 131,913 Federal Home Loan Bank advances 2,293,297 2,257,413 1,857,061 Subordinated debentures 169,000 - - Other 75,000 90,000 90,000 7,875,548 9,367,530 13,385,937 Net interest income 14,453,569 15,420,474 14,660,117 Provision for loan losses 1,300,000 1,204,000 1,068,000 Net interest income after provision for loan losses 13,153,569 14,216,474 13,592,117 Other income Service charges 4,065,210 3,848,055 3,663,990 Loan service fee income 242,479 228,121 257,823 Trust department income 301,612 345,730 346,554 Securities gains (losses), net 139,438 218,604 287,262 Gain on sale of mortgage loans 853,340 948,369 382,532 Other 1,105,534 1,000,716 734,043 6,707,613 6,589,595 5,672,204 Other expenses Salaries and employee benefits 7,373,501 6,728,443 6,019,279 Occupancy expenses 2,044,515 1,908,479 1,890,878 Amortization 516,390 429,366 419,486 Advertising and marketing 399,483 330,069 428,229 Taxes other than payroll, property and income 439,084 406,077 370,537 Other 3,398,292 2,630,321 2,627,444 14,171,265 12,432,755 11,755,853 Income before income taxes 5,689,917 8,373,314 7,508,468 Provision for income taxes 1,456,540 2,470,789 1,983,978 Net income $ 4,233,377 $ 5,902,525 $ 5,524,490 Earnings per share: Basic $ 1.52 $ 2.13 $ 1.98 Diluted 1.50 2.10 1.95 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Years Ended December 31 2003 2002 2001 Net income $ 4,233,377 $ 5,902,525 $ 5,524,490 Other comprehensive income (loss), net of tax: Unrealized gains (losses) on securities arising during the period (237,693) 1,245,448 945,748 Reclassification of realized amount (92,029) (144,279) (189,593) Net change in unrealized gain (loss) on securities (329,722) 1,101,169 756,155 Comprehensive income $ 3,903,655 $ 7,003,694 $ 6,280,645 CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY Years Ended December 31, 2003, 2002 and 2001
Accumulated Other Total Common Stock Retained Comprehensive Stockholders' Shares Amount Earnings Income Equity Balances, January 1, 2001 2,808,067 $ 6,627,255 $ 29,241,091 $ (8,365) $ 35,859,981 Common stock issued (including employee gifts of 77 shares) 29,149 319,530 - - 319,530 Common stock purchased (70,299) (297,767) (1,388,960) - (1,686,727) Net change in unrealized gain (loss) on securities available for sale, net of tax - - - 756,155 756,155 Net income - - 5,524,490 - 5,524,490 Dividends declared - $.60 per share - - (1,673,048) - (1,673,048) Balances, December 31, 2001 2,766,917 6,649,018 31,703,573 747,790 39,100,381 Common stock issued (including employee gifts of 85 shares) 20,879 260,183 - - 260,183 Common stock purchased (15,042) (102,314) (285,051) - (387,365) Net change in unrealized gain (loss) on securities available for sale, net of tax - - - 1,101,169 1,101,169 Net income - - 5,902,525 - 5,902,525 Dividends declared - $.68 per share - - (1,885,051) - (1,885,051) Balances, December 31, 2002 2,772,754 6,806,887 35,435,996 1,848,959 44,091,842 Common stock issued (including employee gifts of 54 shares) 36,410 507,071 - - 507,071 Common stock purchased (9,383) (329,174) - - (329,174) Net change in unrealized gain (loss) on securities available for sale, net of tax - - - (329,722) (329,722) Net income - - 4,233,377 - 4,233,377 Dividends declared - $.76 per share - - (2,116,753) - (2,116,753) Balances, December 31, 2003 2,799,781 $ 6,984,784 $ 37,552,620 $ 1,519,237 $ 46,056,641
CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31
2003 2002 2001 Cash flows from operating activities Net income $ 4,233,377 $ 5,902,525 $ 5,524,490 Adjustments to reconcile net income to net cash from operating activities Depreciation and amortization 1,460,429 1,419,205 1,380,148 Provision for loan losses 1,300,000 1,204,000 1,068,000 Securities amortization (accretion), net 703,502 385,050 155,678 Securities (gains) losses, net (139,438) (218,604) (287,262) Originations of loans held for sale (42,872,837) (38,541,844) (29,054,241) Proceeds from sale of loans 36,707,617 40,702,420 27,879,863 Gain on sale of mortgage loans (853,340) (948,369) (382,532) Federal Home Loan Bank stock Dividends (170,800) (180,800) (248,600) Losses (gain) on sale of fixed Assets 161,849 - - Changes in: Interest receivable 360,511 231,041 754,770 Other assets 451,918 32,115 (99,188) Interest payable (306,069) (969,876) (612,908) Other liabilities (1,390,747) (9,331) 573,565 Net cash from operating activities (354,028) 9,007,532 6,651,783 Cash flows from investing activities Purchases of securities available for sale (65,248,350) (49,204,809) (52,945,350) Proceeds from sales of securities available for sale 8,434,570 18,838,747 12,344,139 Proceeds from principal payments and maturities of securities available for sale 39,625,276 17,966,641 34,325,320 Cash paid for bank acquisition (7,000,205) - - Net change in loans 1,481,580 (12,176,153) (2,083,841) Purchases of bank premises and equipment, net (1,632,487) (816,553) (3,167,061) Net cash from investing activities (24,339,616) (25,392,127) (11,526,793) Cash flows from financing activities Net change in deposits 8,662,228 13,920,771 8,099,599 Net change in repurchase agreements and other borrowings 2,008,563 3,674,713 (7,844,411) Proceeds from Subordinated debentures 7,000,000 - - Advances from Federal Home Loan Bank 12,000,000 6,980,000 22,200,000 Payments on Federal Home Loan Bank advances (10,827,273) (6,640,623) (246,349) Proceeds from issuance of common stock 188,697 187,889 344,280 Purchase of common stock (10,800) (315,071) (1,711,477) Dividends paid (2,116,753) (1,885,051) (1,673,048) Net cash from financing activities 16,904,662 15,922,628 19,168,594 CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31 2003 2002 2001 Net change in cash and cash equivalents $ (7,788,982) $ (461,967) $ 14,293,584 Cash and cash equivalents at beginning of year 29,176,495 29,638,462 15,344,878 Cash and cash equivalents at end of year $ 21,387,513 $ 29,176,495 $ 29,638,462 Supplemental disclosures of cash flow information Cash paid during the year for: Interest expense $ 8,084,469 $ 10,337,406 $ 13,998,845 Income taxes 1,637,706 2,150,000 1,930,000 Supplemental schedules of non-cash investing Activities Real estate acquired through foreclosure $ 349,748 $ - $ 118,860 Transfer of held to maturity portfolio to available for sale - - 15,231,406
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation: The consolidated financial statements include the accounts of Kentucky Bancshares, Inc. (formerly Bourbon Bancshares, Inc.) (the Company) and its wholly-owned subsidiary, Kentucky Bank (the Bank). Intercompany transactions and balances have been eliminated in consolidation. On November 7, 2003, the Company acquired 100% of Kentucky First Bancorp, Inc., parent of First Federal Savings Bank, Cynthiana, Harrison County, Kentucky, as discussed in Note 17. Nature of Operations: The Bank operates under a state bank charter and provides full banking services, including trust services, to customers located in Bourbon, Clark, Harrison, Jessamine, Scott, Woodford and adjoining counties in Kentucky. As a state bank, the Bank is subject to regulation by the Kentucky Department of Financial Institutions and the Federal Deposit Insurance Corporation (FDIC). The Company, a bank holding company, is regulated by the Federal Reserve. Estimates in the Financial Statements: The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The allowance for loan losses, mortgage servicing rights and fair value of financial instruments are particularly subject to change. Cash Flows: For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold, and certain short-term investments with maturities of less than three months. Generally, federal funds are sold for one-day periods. Net cash flows are reported for loan, deposit and short-term borrowing transactions. Securities: The Company is required to classify its securities portfolio into three categories: trading securities, securities available for sale and securities held to maturity. Fair value adjustments are made to the securities based on their classification with the exception of the held to maturity category. The Company has no investments classified as trading. Securities available for sale are carried at fair value. The difference between amortized cost and fair value is recorded in stockholders' equity, net of related income tax, under accumulated other comprehensive income. Changes in this difference are recorded as a component of comprehensive income. Amortization of premiums and accretion of discounts are recorded as adjustments to interest income using the constant yield method. Securities for which the Company has the positive intent and ability to hold to maturity are stated at cost, adjusted for amortization of premiums and accretion of discounts which are recorded as adjustments to interest income using the constant yield method. Gains or losses on dispositions are based on the net proceeds and the adjusted carrying amount of the securities sold, using the specific identification method. Loans Held for Sale: Loans held for sale are valued at the lower of cost or market as determined by outstanding commitments from investors or current secondary market prices, calculated on the aggregate loan basis. The Company also provides for any losses on uncovered commitments to lend or sell. Loans: Loans are stated at the amount of unpaid principal, reduced by an allowance for loan losses. Interest income on loans is recognized on the accrual basis except for those loans on a nonaccrual status. The accrual of interest on impaired loans is discontinued when management believes, after consideration of economic and business conditions and collection efforts, that the borrowers' financial condition is such that collection of interest is doubtful. When interest accrual is discontinued, interest income received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment of the yield on the related loan. Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan losses and decreased by charge-offs less recoveries. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged-off. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. A loan is impaired when full payment under the loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage, consumer, and credit card loans, and on an individual loan basis for other loans. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan's existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogenous loans, such as consumer and residential real estate loans are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures. Mortgage Servicing Rights: The Bank has sold various loans to the Federal Home Loan Mortgage Corporation (FHLMC) while retaining the servicing rights. Gains and losses on loan sales are recorded at the time of the cash sale, which represents the premium or discount paid by the FHLMC. The Bank receives a servicing fee from the FHLMC on each loan sold. Servicing rights are capitalized based on the relative fair value of the rights and the loans' estimated lives and are included in intangible assets on the balance sheet and expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the assets, using interest rates, and geographic and prepayment characteristics. Federal Home Loan Bank Stock: Amount is carried at cost. Bank Premises and Equipment: Land is carried at cost. Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is recorded principally by the straight-line method over the estimated useful lives of the bank premises and equipment with useful lives ranging from 3 to 50 years. Real Estate Acquired Through Foreclosure: Real estate acquired through foreclosure is carried at the lower of the recorded investment in the property or its fair value. The value of the underlying loan is written down to the fair value of the real estate to be acquired by a charge to the allowance for loan losses, if necessary. Any subsequent write-downs are charged to operating expenses. Operating expenses of such properties, net of related income, and gains and losses on their disposition are included in other expenses. Repurchase Agreements: Substantially all repurchase agreement liabilities represent amounts advanced by various customers. Securities are pledged to cover these liabilities, which are not covered by federal deposit insurance. Stock Compensation: Employee compensation expense under stock options is reported using the intrinsic value method. No stock-based compensation cost is reflected in net income, as all options granted had an exercise price equal to or greater than the market price of the underlying common stock at date of grant. The following table illustrates the effect on net income and earnings per share if expense was measured using the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation. 2003 2002 2001 Net income As reported $ 4,233,377 $ 5,902,525 $ 5,524,490 Deduct: Stock-based compensation expense determined under fair value based method (31,972) (129,172) (76,748) Pro forma 4,201,405 5,773,353 5,447,742 2003 2002 2001 Basic earnings per share As reported $ 1.52 $ 2.13 $ 1.98 Pro forma 1.51 2.08 1.94 Diluted earnings per share As reported $ 1.50 $ 2.10 $ 1.95 Pro forma 1.49 2.06 1.91 Weighted averages Fair value of options granted $ 1.07 $ 2.43 $ 4.58 Risk free interest rate 3.40% 4.30% 4.93% Expected life 8 years 8 years 8 years Expected volatility 16.90% 22.28% 25.42% Expected dividend yield 2.96% 2.72% 2.54% Income Taxes: Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. The Company uses the liability method for computing deferred income taxes. Under the liability method, deferred income taxes are based on the change during the year in the deferred tax liability or asset established for the expected future tax consequences of differences in the financial reporting and tax bases of assets and liabilities. Goodwill: Goodwill results from prior business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment will be recognized in the period identified. Intangible Assets: Intangible assets include a premium on deposits paid in connection with the acquisition of a bank and branches which is being amortized on a straight-line basis over ten or fifteen years and capitalized mortgage servicing rights which are being amortized over the life of the related loans. Earnings Per Common Share: Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share include the dilutive effect of additional potential common shares issuable under stock options. Earnings and dividends per share are restated for all stock splits and dividends through the date of issuance of the financial statements. Comprehensive Income: Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale which are also recognized as a separate component of equity. Derivatives: The Company periodically enters into non-exchange traded mandatory forward sales contracts in conjunction with its mortgage banking operation. These contracts, considered derivatives, typically last 60 to 90 days and are used to offset the risk of interest rate changes between the time of the commitment to make a loan to a borrower at a stated rate and when the loan is sold. The Company did not have any mandatory forward sales contracts at December 31, 2003 and 2002. Adoption of New Accounting Standards: During 2003, the Company adopted FASB Statement 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, FASB Statement 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equities, FASB Statement 132 (revised 2003), Employers' Disclosures about Pensions and Other Postretirement Benefits, FASB Interpretation 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, and FASB Interpretation 46, Consolidation of Variable Interest Entities. Adoption of the new standards did not materially affect the Company's operating results or financial condition. Industry Segments: While the Company's chief decision makers monitor the revenue streams of the various Company products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company's operations are considered by management to be aggregated into one reportable operating segment. NOTE 2 - RESTRICTIONS ON CASH AND DUE FROM BANKS Included in cash and due from banks are certain non-interest bearing deposits that are held at the Federal Reserve or maintained in vault cash in accordance with average balance requirements specified by the Federal Reserve Board of Governors. The reserve requirement at December 31, 2003 and 2002 was $51 and $0. NOTE 3 - SECURITIES Year-end securities available for sale are as follows: Fair Unrealized Unrealized Value Gains Losses 2003 U. S. Treasury $ 3,033,125 $ 11,262 $ - U. S. government agencies 36,633,788 125,206 (132,778) States and political subdivisions 39,141,793 1,536,367 (49,808) Mortgage-backed 47,381,940 630,553 (192,657) Equity securities 1,534,666 326,787 (8,289) Other 1,064,518 55,503 - Total $ 128,789,830 $ 2,685,678 $(383,532) 2002 U. S. Treasury $ 5,059,063 $ 47,096 $ - U. S. government agencies 6,138,499 147,012 - States and political subdivisions 31,024,014 1,299,516 (6,143) Mortgage-backed 40,321,450 919,850 (57,387) Equity securities 3,747,550 285,695 (15,355) Other 3,218,564 197,169 (15,786) Total $ 89,509,140 $ 2,896,338 $ (94,671) The fair value of securities available for sale at December 31, 2003, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity are shown separately. Fair Value Due in one year or less $ 6,624,244 Due after one year through five years 33,500,677 Due after five years through ten years 20,940,540 Due after ten years 18,807,763 79,873,224 Mortgage-backed 47,381,940 Equity 1,534,666 Total $ 128,789,830 Proceeds from sales of securities during 2003, 2002 and 2001 were $8,434,570, $18,838,747 and $12,344,139. Gross gains of $157,474, $260,096 and $288,105 and gross losses of $18,036, $41,492 and $843, were realized on those sales. Securities with an approximate carrying value of $83,220,000 and $70,076,000 at December 31, 2003 and 2002, were pledged to secure public deposits, trust funds, securities sold under agreements to repurchase and for other purposes as required or permitted by law. Securities with unrealized losses at year end 2003 not recognized in income are as follows:
Less than 12 Months 12 Months or More Total Fair Unrealized Fair Unrealized Fair Unrealized Description of Securities Value Loss Value Loss Value Loss U.S. Government securities $ 1,023,844 $ (3,186) $ 15,971,530 $ (129,592) $ 16,995,374 $ (132,778) States and political subdivisions 681,517 (4,057) 4,129,333 (45,751) 4,810,850 (49,808) Mortgage-backed - - 16,190,489 (192,657) 16,190,489 (192,657) Equity securities 170,050 (8,289) - - 170,050 (8,289) Total temporarily impaired $ 1,875,411 $ (15,532) $ 36,291,352 $ (368,000) $ 38,166,763 $ (383,532)
Unrealized losses have not been recognized into income because management has the intent and ability to hold for the foreseeable future, and the decline in fair value is largely due to increases in market interest rates. The fair value is expected to recover as the bonds approach their maturity date and/or market rates decline. NOTE 4 - LOANS Loans at year-end were as follows: 2003 2002 Commercial $ 14,277,927 $ 16,802,888 Real estate construction 14,313,068 15,513,702 Real estate mortgage 214,529,347 182,206,697 Agricultural 56,615,266 52,187,812 Consumer 12,977,419 17,133,717 Other 289,231 308,789 $ 313,002,258 $ 284,153,605 Activity in the allowance for loan losses was as follows: 2003 2002 2001 Beginning balance $ 3,395,075 $ 3,386,425 $ 3,388,380 Allowance from acquisition 362,900 - - Charge-offs (1,397,822) (1,329,218) (1,145,942) Recoveries 159,689 133,868 75,987 Provision for loan losses 1,300,000 1,204,000 1,068,000 Ending balance $ 3,819,842 $ 3,395,075 $ 3,386,425 Impaired loans totaled $1,844,000 and $1,573,000 at December 31, 2003 and 2002. The average recorded investment in impaired loans during 2003, 2002 and 2001 was $1,051,000, $1,441,000 and $457,000. The total allowance for loan losses related to these loans was $345,000 and $675,000 at December 31, 2003 and 2002. Interest income on impaired loans of $14,000, $8,000 and $31,000 was recognized for cash payments received in 2003, 2002 and 2001. Nonperforming loans were as follows: 2003 2002 2001 Loans past due over 90 days still on accrual $ 779,000 $ 789,000 $ 1,278,000 Nonaccrual loans 1,844,000 1,573,000 935,000 Nonperforming loans include impaired loans and smaller balance homogeneous loans, such as residential mortgage and consumer loans, that are collectively evaluated for impairment. Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of mortgage loans serviced for others was approximately $91,789,000 and $93,530,000 at December 31, 2003 and 2002. Custodial escrow balances maintained in connection with the foregoing loan servicing, and included in demand deposits, were approximately $658,000 and $714,000 at December 31, 2003 and 2002. Changes in mortgage servicing rights were as follows: 2003 2002 2001 Beginning balance $ 704,034 $ 463,067 $ 521,467 Additions 381,205 390,865 81,619 Amortization (224,119) (149,898) (140,019) Ending balance $ 861,120 $ 704,034 $ 463,067 Certain directors and executive officers of the Company and companies in which they have beneficiary ownership were loan customers of the Bank during 2003 and 2002. Such loans were made in the ordinary course of business at the Bank's normal credit terms and interest rates. An analysis of the activity with respect to all director and executive officer loans is as follows: 2003 2002 Balance, beginning of year $ 1,626,000 $ 1,529,000 Additions, including loans now meeting disclosure requirements 1,648,000 1,346,000 Amounts collected, including loans no longer meeting disclosure requirements (788,000) (1,249,000) Balance, end of year $ 2,486,000 $ 1,626,000 NOTE 5 - PREMISES AND EQUIPMENT Year-end premises and equipment were as follows: 2003 2002 Land and buildings $ 12,242,809 $ 10,790,642 Furniture and equipment 9,241,247 8,001,811 Construction in process - 534,659 21,484,056 19,327,112 Less accumulated depreciation (9,877,683) (8,995,494) $ 11,606,373 $ 10,331,618 Depreciation expense was $960,512, $989,839 and $960,661 in 2003, 2002, and 2001. NOTE 6 - GOODWILL AND INTANGIBLE ASSETS The change in balance for goodwill during the year is as follows: 2003 Beginning of year $ - Acquired goodwill 10,199,830 End of year $ 10,199,830 Goodwill will not be amortized but instead evaluated periodically for impairment. Acquired intangible assets were as follows at year-end: 2003 Gross Carrying Accumulated Amount Amortization Amortized intangible assets: Core deposit intangibles $ 3,656,403 $ 2,519,292 Aggregate amortization expense was $292,271, $279,468 and $279,468 for 2003, 2002 and 2001. Estimated amortization expense for each of the next five years: 2004 $ 275,491 2005 95,736 2006 95,736 2007 95,736 2008 95,736 The change in balance for intangible assets during the year is as follows: 2003 2002 Beginning of year $ 663,382 $ 942,850 Amortization (292,271) (279,468) Acquired core deposit intangible 766,000 - End of year $ 1,137,111 $ 663,382 NOTE 7 - DEPOSITS At December 31, 2003, the scheduled maturities of time deposits are as follows: 2004 $ 130,497,174 2005 24,002,136 2006 23,312,636 2007 9,530,375 2008 3,015,207 Certain directors and executive officers of the Company and companies in which they have beneficial ownership are deposit customers of the Bank. The amount of these deposits was approximately $1,397,000 and $1,178,000 at December 31, 2003 and 2002. NOTE 8 - REPURCHASE AGREEMENTS Repurchase agreements generally mature within one year from the transaction date and range in maturities from 1 day to 3 years. The securities underlying the agreements are maintained in a third-party custodian's account under a written custodial agreement. Information concerning repurchase agreements for 2003 and 2002 is summarized as follows: 2003 2002 Average daily balance during the year $ 1,691,154 $ 2,097,456 Average interest rate during the year 1.34% 1.22% Maximum month-end balance during the year $ 2,411,269 $ 3,504,562 Weighted average interest rate at year end 1.65% 0.84% NOTE 9 - FEDERAL HOME LOAN BANK ADVANCES The Bank owns stock of the Federal Home Loan Bank (FHLB) of Cincinnati, Ohio. This stock allows the Bank to borrow advances from the FHLB. At December 31, 2003 and 2002, $53,232,296 and $43,937,306 represented the balance due on advances from the FHLB. All advances are paid either on a monthly basis or at maturity, over remaining terms of one month to twenty-seven years, with fixed interest rates ranging from 2.65% to 7.23%. All advances require a prepayment penalty and certain advances are callable by the FHLB at various call dates throughout the term of the advance. Advances are secured by the FHLB stock and substantially all first mortgage loans. Scheduled principal payments due on advances during the years subsequent to December 31, 2003 are as follows: 2004 $ 18,409,558 2005 6,933,551 2006 10,931,461 2007 954,273 2008 4,981,617 Thereafter 11,021,836 $ 53,232,296 NOTE 10 - SUBORDINATED DEBENTURES In August 2003, the Company formed Kentucky Bancshares, Statutory Trust I ("Trust"). The Trust issued $7,000,000 of fixed/variable rate trust preferred securities as part of a pooled offering of such securities. The Company issued $7,217,000 subordinated debentures to the Trust in exchange for the proceeds of the offering, which debentures represent the sole asset of the Trust. The debentures pay interest quarterly at 7.06% for the first 5 years. Starting September 2008, the rate converts to three-month LIBOR plus 3.00 adjusted quarterly. The Company may redeem the subordinated debentures, in whole or in part, beginning September 2008 at a price of 100% of face value. The subordinated debentures must be redeemed no later than 2033. In accordance with FASB Interpretation No. 46, the Trust is not consolidated with the Company. Accordingly, the Company does not report the securities issued by the Trust as liabilities, and instead reports as liabilities the subordinated debentures issued by the Company and held by the Trust, as these are no longer eliminated in consolidation. NOTE 11 - INCOME TAXES Income tax expense was as follows: 2003 2002 2001 Current $ 1,166,575 $ 2,189,931 $ 1,878,784 Deferred 289,965 280,858 105,194 $ 1,456,540 $ 2,470,789 $ 1,983,978 Year-end deferred tax assets and liabilities were due to the following. No valuation allowance for the realization of deferred tax assets is considered necessary. 2003 2002 Deferred tax assets Allowance for loan losses $ 942,354 $ 889,158 Core deposit intangibles 18,569 245,154 Other 174,723 181 Deferred tax liabilities Unrealized gain on securities (782,909) (952,708) Bank premises and equipment (460,980) (251,461) FHLB stock (859,218) (687,803) Mortgage servicing rights (292,781) (239,372) Other (401,183) (105,546) Net deferred tax asset (liability) $ (1,661,425) $ (1,102,397) Effective tax rates differ from federal statutory rates applied to financial statement income due to the following: 2003 2002 2001 U. S. federal income tax rate 34.0% 34.0% 34.0% Changes from the statutory rate Tax-exempt investment income (9.3) (5.7) (5.2) Non-deductible interest expense related to carrying tax-exempt investments .8 .6 .6 Rehabilitation tax credit - - (2.1) Other .1 .6 (.9) 25.6% 29.5% 26.4% Federal income tax laws provided First Federal Savings Bank with additional bad debt deductions through 1987, totaling $1.3 million. Accounting standards do not require a deferred tax liability to be recorded on this amount, which otherwise would total a $441,000 liability at December 31, 2003. The Company's acquisition of First Federal Savings Bank did not require the recapture of the bad debt reserve. However, if Kentucky Bank was liquidated or otherwise ceased to be a bank, or if tax laws were to change, the $441,000 would be recorded as expense. NOTE 12 - EARNINGS PER SHARE The factors used in the earnings per share computation follow: 2003 2002 2001 Basic Earnings Per Share Net income $ 4,233,377 $ 5,902,525 $ 5,524,490 Weighted average common shares outstanding 2,781,146 2,770,282 2,790,238 Basic earnings per share $ 1.52 $ 2.13 $ 1.98 Diluted Earnings Per Share Net income $ 4,233,377 $ 5,902,525 $ 5,524,490 Weighted average common shares outstanding 2,781,146 2,770,282 2,790,238 Add dilutive effects of assumed exercise of stock options 45,640 35,836 47,080 Weighted average common and dilutive potential common shares outstanding 2,826,786 2,806,118 2,837,318 Diluted earnings per share $ 1.50 $ 2.10 $ 1.95 Stock options for 3,050 shares common stock were excluded from 2002 diluted earnings per share because their impact was antidilutive. There were no shares that were antidilutive in 2003. NOTE 13 - RETIREMENT PLANS The Company has a defined benefit pension plan covering substantially all of its employees. The Company's funding policy is to contribute annually the maximum amount that can be deducted for federal income tax purposes. Benefits are based on one percent of employee average earnings for the previous five years times years of credited service. Information about the pension plan was as follows: 2003 2002 Change in benefit obligation: Beginning benefit obligation $ 4,385,567 $ 3,583,257 Service cost 314,935 299,744 Interest cost 265,034 245,253 Actuarial adjustment (601,900) 323,543 Benefits paid (73,245) (66,230) Ending benefit obligation 4,290,391 4,385,567 Change in plan assets, at fair value: Beginning plan assets 3,397,218 3,279,471 Actual return 358,868 (176,162) Employer contribution 392,878 360,139 Benefits paid (73,245) (66,230) Ending plan assets 4,075,719 3,397,218 Funded status (214,672) (988,349) Unrecognized net actuarial (gain) loss 523,815 1,236,596 Unrecognized prior transition asset (1,857) (2,229) Net pension prepaid benefit $ 307,286 $ 246,018 Amounts recognized in the balance sheet consist of: Prepaid benefit cost $ 307,286 Accrued benefit cost - Net amount recognized $ 307,286 The accumulated benefit obligation for defined benefit pension plans was $2,976,205 at year-end 2003. The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for the pension plans were $4,290,391, $2,976,205, and $4,075,719 respectively, as of year end 2003. Net periodic pension cost include the following components: 2003 2002 2001 Service cost $ 314,935 $ 299,744 $ 240,644 Interest cost 265,034 245,253 219,979 Expected return on plan assets (265,117) (255,964) (246,285) Amortization 16,758 5,221 (372) Net periodic cost $ 331,610 $ 294,254 $ 213,966 Weighted-average assumptions used to determine net cost 2003 2002 2001 Discount rate on benefit obligation 7% 7% 7% Long-term expected rate of return on plan assets 8% 8% 8% Rate of compensation increase 5% 5% 5% The Company's pension plan asset allocation at year-end 2003, target allocation for 2004, and expected long-term rate of return by asset category are as follows: Weighted Percentage Average of Plan Expected Target Assets at Long-Term Allocation Year-End Rate of Return Asset Category 2004 2003 2003 Equity securities 55-65 51.7 10% Debt securities 35-45 38.1 6 Cash 5-15 10.2 4 Total 100.0 The asset allocation objective for 2004 and following is to be 60% in equity securities and 40% in debt securities. These percentages may vary 5-10 basis points based on market conditions of equity and bond markets. The Company expects to contribute $375,000 to its pension plan in 2004. The Company also has a qualified profit sharing plan which covers substantially all employees and includes a 401(k) provision. Profit sharing contributions, excluding the 401(k) provision, are at the discretion of the Company's Board of Directors. Expense recognized in connection with the plan was $271,684, $270,048 and $237,661 in 2003, 2002 and 2001. NOTE 14 - STOCK OPTION PLAN The Company grants certain officers and key employees stock option awards which vest and become fully exercisable at the end of five years and provides for issue of up to 220,000 options. The Company also grants certain directors stock option awards which vest and become fully exercisable immediately and provides for issue of up to 20,000 options. The exercise price of each option, which has a ten year life, was equal to the market price of the Company's stock on the date of grant; therefore, no compensation expense was recognized. Summary of stock option transactions are as follows:
2003 2002 2001 Weighted Weighted Weighted Option Option Option Options Price Options Price Options Price Outstanding, beginning of year 83,114 $16.72 103,484 $15.52 131,730 $14.32 Granted 14,500 25.72 6,520 25.85 4,160 23.58 Expired (3,698) 25.00 (6,096) 20.84 (3,334) 18.34 Exercised (36,356) 13.89 (20,794) 12.41 (29,072) 10.92 Outstanding, end of year 57,560 $20.23 83,114 $16.72 103,484 $15.52 Weighted remaining contractual Life 67.9 months 64.7 months 62.3 months
Options outstanding at year-end 2003 were as follows:
Outstanding Exercisable Weighted Average Weighted Weighted Remaining Average Average Contractual Exercise Exercise Range of Exercise Prices Options Life Price Options Price From $12.50 to $15.50 per share 19,120 36.9 $13.91 19,120 $13.91 From $18.00 to $20.63 per share 15,706 60.1 20.52 12,308 20.49 From $23.50 to $28.00 per share 22,734 99.3 25.35 5,396 25.46 57,560 36,824
NOTE 15 - LIMITATION ON BANK DIVIDENDS The Company's principal source of funds is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid by the Bank without prior approval of regulatory agencies. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year's net profits, as defined, combined with the retained net profits of the preceding two years. During 2004 the Bank could, without prior approval, declare dividends of approximately $3,945,000 plus any 2004 net profits retained to the date of the dividend declaration. NOTE 16 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The fair values of the Company's financial instruments at December 31, 2003 and 2002 are as follows: 2003 2002 Carrying Carrying Amount Fair Value Amount Fair Value (In Thousands) Financial assets Cash and cash equivalents $ 21,388 $ 21,388 $ 29,176 $ 29,176 Securities 128,790 128,790 89,509 89,509 Mortgage loans held for sale 7,759 7,851 740 740 Loans, net 309,182 312,596 280,759 287,447 FHLB stock 4,930 4,930 4,027 4,027 Interest receivable 3,250 3,250 3,276 3,276 Financial liabilities Deposits $ 384,599 $ 387,083 $ 322,836 $ 325,454 Securities sold under agreements to repurchase and other borrowings 7,285 7,285 5,277 5,277 FHLB advances 53,232 53,747 43,937 45,343 Subordinated debentures 7,000 7,168 - - Interest payable 1,636 1,636 1,845 1,845 Carrying amount is the estimated fair value for cash and cash equivalents, short-term borrowings, Federal Home Loan Bank stock, accrued interest receivable and payable, demand deposits, short-term debt, and variable rate loans or deposits that reprice frequently and fully. Security fair values are based on market prices or dealer quotes, and if no such information is available, on the rate and term of the security and information about the issuer. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk. Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values. Fair value of debt is based on current rates for similar financing. The fair value of commitments to extend credit and standby letters of credit is not considered material. NOTE 17 - BUSINESS COMBINATION On November 7, 2003, the Company acquired 100% of the outstanding shares of Kentucky First Bancorp, Inc., parent of First Federal Savings Bank. Operating results of Kentucky First Bancorp, Inc. are included in the consolidated financial statements since the date of the acquisition. As a result of this acquisition, the Company expects to further solidify its market share in central Kentucky. The purchase price in cash was $23.25 per share or $22,271,000. The purchase price resulted in approximately $10,200,000 in goodwill, and $766,000 in core deposit intangible. The core deposit intangible asset will be amortized over 10 years, using the straight line method. Goodwill will not be amortized but instead evaluated periodically for impairment. The following table summarizes the estimated fair value of assets acquired and liabilities assumed at the date of acquisition. Securities available for sale $ 23,156,000 Loans 31,205,000 Goodwill 10,200,000 Core deposit intangible 766,000 Other assets 18,468,000 Total assets acquired $ 83,795,000 Deposits (52,939,000) Other liabilities (8,585,000) Total liabilities assumed $ (61,524,000) Net assets acquired $ 22,271,000 The following table presents pro forma information as if the acquisition had occurred at the beginning of 2003 and 2002. The pro forma information includes adjustments for interest income on loans and securities acquired, amortization of intangibles arising from the transaction, depreciation expense on property acquired, interest expense on deposits acquired, and the related income tax effects. The pro forma financial information is not necessarily indicative of the results of operations as they would have been had the transactions been effected on the assumed dates. 2003 2002 Net interest income $ 16,368,000 $ 18,187,000 Net income $ 4,838,000 $ 6,794,000 Basic earnings per share $ 1.74 $ 2.45 Diluted earnings per share $ 1.71 $ 2.42 NOTE 18 - OFF-BALANCE SHEET ACTIVITIES AND COMMITMENTS Some financial instruments, such as loan commitments, credit lines, letters of credit, and overdraft protection, are issued to meet customer financing needs. These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met, and usually have expiration dates. Commitments may expire without being used. Off-balance sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment. Financial instruments with off-balance sheet risk were as follows at year-end: 2003 2002 Unused lines of credit $ 47,148,000 $ 44,943,000 Commitments to make loans 1,379,000 - Letters of credit 252,000 345,000 Unused lines of credit are substantially all at variable rates. Commitments to make loans are generally made for a period of 60 days or less and are primarily fixed at current market rates ranging from 4.875% to 6.50% with maturities ranging from 15 to 30 years and are intended to be sold. NOTE 19 - CONTINGENT LIABILITIES The Bank is a defendant in legal actions arising from normal business activities. Management believes these actions are without merit or that the ultimate liability, if any, resulting from them will not materially affect the Company's consolidated financial position or results of operations. NOTE 20 - CAPITAL REQUIREMENTS 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 possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company's and the Bank's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company and Bank capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of Total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital to average assets (as defined). Management believes, as of December 31, 2003 and 2002, that the Company and the Bank meet all capital adequacy requirements to which they are subject. The most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum Total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the following table. There are no conditions or events since that notification that management believes have changed the institution's category. The Company's and the Bank's actual amounts and ratios are presented in the table below:
To Be Well Capitalized Under Prompt For Capital Corrective Actual Adequacy Purposes Action Provisions Amount Ratio Amount Ratio Amount Ratio 2003 (Dollars in Thousands) Consolidated Total Capital (to Risk-Weighted Assets) $ 44,078 13.9% $ 25.359 8% $ 31.698 10% Tier I Capital (to Risk-Weighted Assets) 40,115 12.7 12,679 4 19,019 6 Tier I Capital (to Average Assets) 40,115 8.2 18,154 4 22,692 5 Bank Only Total Capital (to Risk-Weighted Assets) $ 40,762 12.9% $ 25,264 8% $ 31,580 10% Tier I Capital (to Risk-Weighted Assets) 36,932 11.7 12,632 4 18,948 6 Tier I Capital (to Average Assets) 36,932 8.1 18,105 4 22,632 5 2002 Consolidated Total Capital (to Risk-Weighted Assets) $ 45,041 15.5% $ 23,247 8% $ 29,059 10% Tier I Capital (to Risk-Weighted Assets) 41,524 14.3 11,624 4 17,435 6 Tier I Capital (to Average Assets) 41,524 10.2 16,264 4 20,331 5 Bank Only Total Capital (to Risk-Weighted Assets) $ 38,481 13.3% $ 23,164 8% $ 28,955 10% Tier I Capital (to Risk-Weighted Assets) 35,073 12.1 11,582 4 17,373 6 Tier I Capital (to Average Assets) 35,073 8.6 16,292 4 20,306 5
NOTE 21 - PARENT COMPANY FINANCIAL STATEMENTS Condensed Balance Sheets December 31 2003 2002 (In Thousands) ASSETS Cash on deposit with subsidiary $ 1,783 $ 5,609 Investment in subsidiary 49,593 37,425 Securities available for sale 1,247 1,169 Other assets 670 - Total assets $ 53,293 $ 44,203 LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Subordinated debentures $ 7,217 $ - Other Liabilities 19 111 Stockholders' equity Preferred stock - - Common stock 6,985 6,807 Retained earnings 37,553 35,436 Accumulated other comprehensive income 1,519 1,849 Total liabilities and stockholders' equity $ 53,293 $ 44,203 Condensed Statements of Income and Comprehensive Income Years Ended December 31 2003 2002 2001 (In Thousands) Income Dividends from subsidiary $ 13,025 $ 3,400 $ 3,280 Securities gains (losses), net 7 145 72 Interest income 20 32 44 Total income 13,052 3,577 3,396 Expenses Interest expense 169 - - Other expenses 360 55 39 Income before income taxes and equity in undistributed income of subsidiary 12,523 3,522 3,357 Applicable income tax (expense) benefits 175 (29) (26) Income before equity in undistributed income of subsidiary 12,698 3,493 3,331 Equity in undistributed income of subsidiary (8,465) 2,410 2,193 Net income 4,233 5,903 5,524 Other comprehensive income (loss), net of tax: Unrealized gains (losses) on securities arising during the period (237) 1,245 946 Reclassification of realized amount (92) (144) (189) Net change in unrealized gain (loss) on securities (329) 1,101 757 Comprehensive income $ 3,904 $ 7,004 $ 6,281 Condensed Statements of Cash Flows Years Ended December 31 2003 2002 2001 (In Thousands) Cash flows from operating activities Net income $ 4,233 $ 5,903 $ 5,524 Adjustments to reconcile net income to net cash from operating activities Equity in undistributed earnings of Subsidiary 8,465 (2,410) (2,193) Securities (gains) losses, net (7) (145) (72) Change in other assets (553) (100) 72 Change in other liabilities (10) 103 - Net cash from operating activities 12,128 3,351 3,331 Cash flows from investing activities Purchase of securities available for sale (82) (109) (311) Proceeds from sales of securities available for sale 65 869 820 Acquisition of Kentucky First Bancorp, Inc. (20,998) - - Net cash from investing activities (21,015) 760 509 Cash flows from financing activities Proceeds from subordinated debentures 7,000 - - Dividends paid (2,117) (1,885) (1,673) Proceeds from issuance of common stock 189 188 344 Purchase of common stock (11) (315) (1,711) Net cash from financing activities 5,061 2,012) (3,040) Net change in cash (3,826) 2,099 800 Cash at beginning of year 5,609 3,510 2,710 Cash at end of year $ 1,783 $ 5,609 $ 3,510 NOTE 22 - QUARTERLY FINANCIAL DATA (UNAUDITED) Interest Net Interest Net Earnings Per Share Income Income Income Basic Fully Diluted 2003 First quarter $ 5,662 $ 3,620 $ 1,183 $ .43 $ .42 Second quarter 5,611 3,685 1,172 .42 .42 Third quarter 5,345 3,505 1,261 .45 .45 Fourth quarter 5,711 3,644 617 .22 .21 2002 First quarter $ 6,233 $ 3,626 $ 1,296 $ .47 $ .46 Second quarter 6,104 3,695 1,221 .44 .44 Third quarter 6,141 3,932 1,625 .59 .58 Fourth quarter 6,310 4,167 1,761 .63 .62 The fourth quarter 2003 decrease in net income is mainly attributable to an addition to the allowance for loan losses, business combination expenses and a loss on sale of fixed assets. REPORT OF INDEPENDENT AUDITORS Board of Directors Kentucky Bancshares, Inc. Paris, Kentucky We have audited the accompanying consolidated balance sheets of Kentucky Bancshares, Inc. as of December 31, 2003 and 2002, and the related consolidated statements of income, comprehensive income, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2003. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kentucky Bancshares, Inc. as of December 31, 2003 and 2002, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. Crowe Chizek and Company LLC Lexington, Kentucky January 16, 2004 MEET OUR OFFICERS BOURBON COUNTY. PARIS SENIOR MANAGEMENT BUCKNER WOODFORD, Chairman and CEO LOUIS PRICHARD, President and COO NORMAN J. FRYMAN, Sr. Vice President, Director of Lending JAMES P. SHIPP, JR., Sr. Vice President, Director of Branch Administration BRENDA BRAGONIER, Vice President, Director of Marketing and Human Resources HUGH CROMBIE, Vice President, Director of Operations GREG DAWSON, Vice President, Chief Financial Officer OFFICERS KAREN ANDERSON, Corporate and Automated Officer HEATHER BARGER, Vice President, Director of Risk Management BRENDA BERRY, Accountant WALLIS BROOKS, Branch Manager PATTY CARPENTER, Assistant Vice President, Loan Operations Officer R.W. COLLINS, JR., Vice President, Agricultural Lender ROBBIE COX, Senior Auditor CYNTHIA CRISWELL, Data Processing Officer NANCYE FIGHTMASTER, Vice President, Loan Officer DAVID FOSTER, Vice President, Agricultural Lender JANICE HASH, Accountant & Purchasing Agent LISA HIGHLEY, Jr. Personal Trust Officer CATHY HILL, Vice President, Head of Collections PERRY INGRAM, Assistant Vice President, Network Manager JANE MOGGE, Head of Deposit Operations MARY MORELAND, Assistant Vice President, Loan Officer DONALD ROE, Assistant Vice President, Sr. Data Processing Officer ROWENA RUFF, Investment Advisor LYDIA SOSBY, Assistant Vice President, Director of Training and Sales JUDY TAYLOR, Vice President, Human Resource Manager RICK WAGNER, Maintenance Supervisor GEORGE WILDER, Vice President, Loan Officer ARNITA WILLOUGHBY, Mortgage Operations Manager MARTHA WOODFORD, Assistant Vice President, Director of Corporate and Automated Products JAN WORTH, Assistant Vice President, Personal Trust Officer Lexington Road Branch Susan A. Lemons, Assistant Vice President, Branch Manager/Loan Officer Pleasant Street Branch Philip Hurst - Assistant Branch Manager CLARK COUNTY. WINCHESTER RITA BUGG, Vice President, Regional Manager MICHAEL SHANE FOLEY, Loan Officer DARREN HENRY, Vice President, Commercial Lender KATHY NEWKIRK, Branch Manager, Loan Officer TERESA SHIMFESSEL, Assistant Vice President, Loan Officer CAROLYN WILKINS, Overdraft Management Officer HARRISON COUNTY. CYNTHIANA RHONDA BROWN, Loan Officer KEN DEVASHER, Vice President, Regional Manager DREAMA HARRIS, Loan Officer IVA JOYCE RAINEY, Loan Officer KEVIN TOLLE, Loan Officer JESSAMINE COUNTY. NICHOLASVILLE MICHAEL LOVELL, Vice President, Regional Manager RICK WALLING, Assistant Vice President, Loan Officer SCOTT COUNTY. Georgetown PAMELA JESSIE, Vice President, Regional Manager BEN SARGENT, Vice President, Branch Manager, Loan Officer SHARON WHITLOCK, Branch Manager, Loan Officer WOODFORD COUNTY. VERSAILLES DUNCAN B. GARDINER, Vice President, Regional Manager A. J. GULLETT, Assistant Vice President, Loan Officer Board of Directors Kentucky Bank William M. Arvin, Attorney Tom Buford, State Senator James Ferrell, Physician William Graul, Physician Henry Hinkle, President, Hinkle Contracting Corporation R.C. Johnson, Jr., Owner, President, Johnson's Funeral Home Theodore Kuster, Farmer and Thoroughbred Breeder, Westview Equine Ted McClain, Agent, Hopewell Insurance Company Brad Marshall, Farmer, Owner Marshall's Tractor Supply Louis Prichard, President, COO, Kentucky Bank Edwin Saunier, President, Saunier North American, Inc. William R. Stamler, Chairman, Signal Investments, Inc. Robert G. Thompson, Farmer and Thoroughbred Breeder, Snowhill Farm Woodford Van Meter, Ophthalmologist Gerald Whalen, President, Whalen and Company Buckner Woodford, Chairman, CEO, Kentucky Bank REGIONAL BOARD OF DIRECTORS CLARK COUNTY Mary Beth Hendricks, Director of Clark County Child Support Services Donald Pace, Executive Director of Central Kentucky Educational Co-op with UK John Roche, Optician Edwin Saunier, President, Saunier North American, Inc. James Taulbee, Farmer REGIONAL BOARD OF DIRECTORS HARRISON COUNTY K. Bruce Florence, Director, Licking Valley College Betty Long, Retired President, First Federal Savings Bank of Cynthiana Brad Marshall Farmer, Owner Marshall's Tractor Supply Joel Techau, CEO, Techau Inc. Gerald Whalen, President, Whalen and Company REGIONAL BOARD OF DIRECTORS JESSAMINE COUNTY William M. Arvin, Attorney Dan Brewer, Bluegrass RECC Tom Buford, State Senator Jonah Mitchell, President, Jonah Mitchell Real Estate and Auction Company Eva McDaniel, Jessamine County Clerk REGIONAL BOARD OF DIRECTORS SCOTT COUNTY Gus Bynum, Physician Mike Hockensmith, Owner and President, The Hockensmith Agency, Inc. R.C. Johnson, Jr, Owner, President, Johnson's Funeral Home George Lusby, County Judge Executive Everette Varney, Major REGIONAL BOARD OF DIRECTORS WOODFORD COUNTY Loren Carl, Woodford County Chief of Police William Graul, Physician James Kay, Businessman, Farmer Tricia Kittinger, Woodford Circuit Clerk Kentucky Bancshares, Inc. Board of Directors James Ferrell Physician; Chairman, Kentucky Bancshares, Inc. Class of 2004 William M. Arvin Attorney, William M. Arvin Associates Class of 2004 Louis Prichard President & COO, Kentucky Bank Appointed 2003 Woodford Van Meter Ophthalmologist Appointed 2004 Henry Hinkle President, Hinkle Contracting Corporation Class of 2005 Theodore Kuster Farmer and Thoroughbred Breeder, West View Equine Class of 2005 Robert G. Thompson Farmer and Thoroughbred Breeder, Snowhill Farm Class of 2005 Buckner Woodford President & CEO, Kentucky Bancshares, Inc. Class of 2006 Ted McClain Agent, Hopewell Insurance Company Class of 2006 William Stamler Chairman, Signal Investments, Inc. Class of 2006 Betty Long Retired President, First Federal Savings Bank of Cynthiana Appointed 2003 81