EX-13 3 exhibit13annualrpt.txt ANNUAL REPORT AND PROXY Exhibit 13 KENTUCKY BANCSHARES, INC. ANNUAL REPORT 2004 LETTER TO THE SHAREHOLDERS Financial results for Kentucky Bancshares, Inc. improved significantly with $2.07 earnings per share. I am pleased we have this positive momentum as my period of time as CEO ends. As previously announced, Louis Prichard assumed that position beginning in 2005. This change has my complete support. It has put into place excellent leadership for our future. I have stepped back and am now Chairman. For me it is not retirement as I still have an office and continue to work, but on a reduced schedule. My plans are to continue to help Louis build our franchise. I am deeply grateful to both current and past directors for the opportunity they gave me to lead this organization. The job of being a community bank CEO is both enjoyable and fulfilling. It enabled me to live in my hometown, raise a family, earn a living and help build a growing business enterprise. I had the opportunity to work with a wonderful group of fellow employees and build lasting friendships. Many of you are aware that I am the fourth generation of my family to be involved in this same bank. That has meant a lot to me also. It feels as if I am sharing an experience with them, contributing to a business enterprise they began before me. Those directors who gave me this opportunity enriched my life, and I can't thank them enough for that. Retiring from our board of directors at year-end were two men who made great contributions to our success over the years. William R. Stamler provided the company with thoughtful advice and guidance on many important issues throughout his service. He was instrumental in 1984 in the merger of Peoples Deposit Bank and Bourbon Agricultural Bank in Paris, creating a bank that has a market share in Bourbon County of over 65%. Dr. James L. Ferrell has been our Chairman since 1990. He has shown valuable leadership through the years. During that time our bank has expanded from one county to six counties surrounding Lexington. We are fortunate that Dr. Ferrell will remain on the board of our subsidiary, Kentucky Bank. I expect that I will find continued satisfaction in my new position as Chairman. It is with optimism about our future that I look forward to serving our company in that role. Sincerely, Buck Woodford Chairman of the Board Kentucky Bancshares, Inc. LETTER TO THE SHAREHOLDERS Dear Shareholders: The financial results of your company in 2004 were significantly improved over the performance of 2003. Assets increased 5.5% from $501.9 million to $528.5 million. Much of that increase was fueled by a 14.5% increase in the bank's loan portfolio. Our net interest income increased from $14.5 million to $16.8 million, a 16.1% increase. Along with this strong loan growth, we implemented a number of measures to control costs. Those were extremely beneficial in limiting the growth of non- interest expense to 4.1%. As a result, net income increased 36.1% from $4.2 million to $5.7 million. This bottom line increase allowed us to improve our return on average assets and our return on average equity to 1.11% and 12.6%, respectively. Our improved operating results, along with the repurchase of a large block of stock, ultimately led to a 38% increase in earnings per share to $2.07 on a diluted basis. As is the case in most well run businesses, success is the result of a team effort. This is true at Kentucky Bancshares as well. Your company is fortunate to have an experienced, well qualified group of people committed to the goal of enhancing the value of your company. People like James Ferrell and William R. Stamler, as directors, have been extremely dedicated to providing guidance to assist management in creating and implementing strong strategic initiatives. They have been invaluable to our success, and we would like to thank them for their past commitment to our institution. Mr. Stamler will be retiring from both the bank board as well as the holding company board, and Dr. Ferrell will be retiring from the holding company board, but will be continuing as a member of the Kentucky Bank board. We want to thank Mr. Stamler for his long-standing commitment to our institution and we want to thank Dr. Ferrell for his contributions as chairman of our holding company and we look forward to his future involvement as he continues as a bank board director. As shareholders, we should appreciate the outstanding leadership that Buck Woodford has provided over his past 31 years as Chief Executive Officer. We have expanded from a bank located in one county to a bank holding company with 13 locations in 6 counties throughout Central Kentucky. In those years, the shareholder equity of your bank has grown from $750 thousand to a market capitalization value of nearly $80 million. The value of your stock has increased from approximately $0.30 a share over that 31 year period to a value of almost $30 per share. I want to take this time to thank Buck on behalf of all of us, for his vision and the significant financial results that have been brought to all of us. I look forward to working with Buck in his new role as chairman of both Kentucky Bank and Kentucky Bancshares. His insight and knowledge will be of great value to me. In closing, I would say that our eye is on the future and that our goal will be to continue to build our franchise as has been done so successfully in the past. Sincerely, Louis Prichard President and Chief Executive Officer Financial Highlights... Kentucky Bancshares, Inc. 2004 2003 2002 Assets ($ thousands) $ 528,544 $ 500,852 $ 397,257 Net Income ($ thousands) $ 5,762 $ 4,233 $ 5,903 Per Share Results... Earnings (assuming dilution) $ 2.07 $ 1.50 $ 2.10 Dividend $ .84 $ .76 $ .68 Shareholder Information... Corporate Headquarters Kentucky Bancshares, Inc. 4th and Main Streets Paris, Kentucky 40361 859-987-1795 Transfer, Registrar and Dividend Agent Registrar and Transfer Company 10 Commerce Drive Cranford, New Jersey 07016 800-368-5948 rtco.com Kentucky Bancshares, Inc. - KTYB.OB Active Market Makers 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 312-655-2995 Morgan Keegan & Company 489 E. Main Street Lexington, Kentucky 40507 800-937-0161 Annual Meeting The annual meeting of Kentucky Bancshares, Inc. will be held Tuesday, May 10, 2005 at 11:00 in the corporate headquarters. Investor Information Any individual requesting a copy of the Corporation's 2004 Form 10-K Report may obtain these by writing to Investor Relations at the Corporate Headquarters. CONSOLIDATED BALANCE SHEETS December 31 2004 2003 ASSETS Cash and due from banks $ 12,248,975 $ 15,224,513 Federal funds sold 3,206,000 6,163,000 Cash and cash equivalents 15,454,975 21,387,513 Securities available for sale 126,766,861 128,789,830 Mortgage loans held for sale 175,471 7,758,583 Loans 358,281,554 313,002,258 Allowance for loan losses (4,163,315) (3,819,842) Net loans 354,118,239 309,182,416 Federal Home Loan Bank stock 5,136,500 4,930,100 Bank premises and equipment, net 11,378,012 11,606,373 Interest receivable 3,226,479 3,249,834 Goodwill 9,110,524 10,199,830 Other intangible assets 1,737,254 1,998,231 Other assets 1,439,331 1,749,434 Total assets $ 528,543,646 $ 500,852,144 LIABILITIES AND STOCKHOLDERS' EQUITY Deposits Non-interest bearing $ 74,048,291 $ 64,841,638 Time deposits, $100,000 and over 59,468,813 49,914,659 Other interest bearing 254,437,718 269,842,299 Total deposits 387,954,822 384,598,596 Repurchase agreements and other borrowings 25,592,844 7,285,258 Federal Home Loan Bank advances 59,749,666 53,232,296 Subordinated debentures 7,217,000 7,217,000 Interest payable 1,849,468 1,635,784 Other liabilities 1,153,035 826,569 Total liabilities 483,516,835 454,795,503 Stockholders' equity Preferred stock, 300,000 shares authorized and unissued - - Common stock, no par value; 10,000,000 shares authorized; 2,684,498 and 2,799,781 shares issued and outstanding in 2004 and 2003 6,818,664 6,984,784 Retained earnings 37,884,215 37,552,620 Accumulated other comprehensive income (loss) 323,932 1,519,237 Total stockholders' equity 45,026,811 46,056,641 Total liabilities and stockholders' equity $ 528,543,646 $ 500,852,144 CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31 2004 2003 2002 Interest income Loans, including fees $ 20,470,306 $ 18,574,690 $ 20,632,003 Securities Taxable 3,574,235 2,049,835 2,564,539 Tax exempt 1,518,275 1,430,589 1,254,065 Other 283,196 274,003 337,397 25,846,012 22,329,117 24,788,004 Interest expense Deposits 5,765,690 5,310,791 6,977,969 Repurchase agreements and other borrowings 411,492 27,460 42,148 Federal Home Loan Bank advances 2,395,898 2,293,297 2,257,413 Subordinated debentures 494,052 169,000 - Other - 75,000 90,000 9,067,132 7,875,548 9,367,530 Net interest income 16,778,880 14,453,569 15,420,474 Provision for loan losses 840,000 1,300,000 1,204,000 Net interest income after provision for loan losses 15,938,880 13,153,569 14,216,474 Other income Service charges 4,357,658 4,065,210 3,848,055 Loan service fee income 246,356 242,479 228,121 Trust department income 299,448 301,612 345,730 Securities gains (losses), net 288,950 139,438 218,604 Gain on sale of mortgage loans 376,157 853,340 948,369 Other 1,227,614 1,105,534 1,000,716 6,796,183 6,707,613 6,589,595 Other expenses Salaries and employee benefits 8,053,306 7,373,501 6,728,443 Occupancy expenses 2,255,071 2,044,515 1,908,479 Amortization 524,839 516,390 429,366 Advertising and marketing 378,410 399,483 330,069 Taxes other than payroll, property and income 499,251 439,084 406,077 Other 3,044,294 3,398,292 2,630,321 14,755,171 14,171,265 12,432,755 Income before income taxes 7,979,892 5,689,917 8,373,314 Provision for income taxes 2,217,783 1,456,540 2,470,789 Net income $ 5,762,109 $ 4,233,377 $ 5,902,525 Earnings per share: Basic $ 2.09 $ 1.52 $ 2.13 Diluted 2.07 1.50 2.10 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Years Ended December 31 2004 2003 2002 Net income $ 5,762,109 $ 4,233,377 $ 5,902,525 Other comprehensive income (loss), net of tax: Unrealized gains (losses) on securities arising during the period (1,004,597) (237,693) 1,245,448 Reclassification of realized amount (190,708) (92,029) (144,279) Net change in unrealized gain (loss) on securities (1,195,305) (329,722) 1,101,169 Comprehensive income $ 4,566,804 $ 3,903,655 $ 7,003,694 CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY Years Ended December 31, 2004, 2003 and 2002
Accumulated Other Total Common Stock Retained Comprehensive Stockholders' Shares Amount Earnings Income Equity Balances, January 1, 2002 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 Common stock issued (including employee gifts of 89 shares) 7,019 131,041 - - 131,041 Common stock purchased (122,302) (297,161) (3,127,295) - (3,424,456) Net change in unrealized gain (loss) on securities available for sale, net of tax - - - (1,195,305) (1,195,305) Net income - - 5,762,109 - 5,762,109 Dividends declared - $.84 per share - - (2,303,219) - (2,303,219) Balances, December 31, 2004 2,684,498 $ 6,818,664 $ 37,884,215 $ 323,932 $ 45,026,811
CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31
2004 2003 2002 Cash flows from operating activities Net income $ 5,762,109 $ 4,233,377 $ 5,902,525 Adjustments to reconcile net income to net cash from operating activities Depreciation and amortization 1,419,794 1,460,429 1,419,205 Provision for loan losses 840,000 1,300,000 1,204,000 Securities amortization (accretion), net 635,725 703,502 385,050 Securities (gains) losses, net (288,950) (139,438) (218,604) Originations of loans held for sale (22,065,215) (42,872,837) (38,541,844) Proceeds from sale of loans 30,024,484 36,707,617 40,702,420 Gain on sale of mortgage loans (376,157) (853,340) (948,369) Federal Home Loan Bank stock Dividends (206,400) (170,800) (180,800) Losses (gain) on sale of fixed assets (16,722) 161,849 - Changes in: Interest receivable 23,355 360,511 231,041 Other assets 1,135,547 451,918 32,115 Interest payable 213,684 (306,069) (969,876) Other liabilities 942,501 (1,390,747) (9,331) Net cash from operating activities 18,043,755 (354,028) 9,007,532 Cash flows from investing activities Purchases of securities available for sale (70,689,970) (65,248,350) (49,204,809) Proceeds from sales of securities available for sale 37,973,553 8,434,570 18,838,747 Proceeds from principal payments and maturities of securities available for sale 32,581,271 39,625,276 17,966,641 Cash paid for bank acquisition - (7,000,205) - Net change in loans (45,775,823) 1,481,580 (12,176,153) Purchases of bank premises and equipment, net (748,824) (1,632,487) (816,553) Net cash from investing activities (46,659,793) (24,339,616) (25,392,127) Cash flows from financing activities Net change in deposits 3,356,226 8,662,228 13,920,771 Net change in repurchase agreements and other borrowings 18,307,586 2,008,563 3,674,713 Proceeds from Subordinated debentures - 7,000,000 - Advances from Federal Home Loan Bank 25,000,000 12,000,000 6,980,000 Payments on Federal Home Loan Bank advances (18,383,678) (10,827,273) (6,640,623) Proceeds from issuance of common stock 131,041 188,697 187,889 Purchase of common stock (3,424,456) (10,800) (315,071) Dividends paid (2,303,219) (2,116,753) (1,885,051) Net cash from financing activities 22,683,500 16,904,662 15,922,628 CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31 2004 2003 2002 Net change in cash and cash equivalents $ (5,932,538) $(7,788,982) $ (461,967) Cash and cash equivalents at beginning of year 21,387,513 29,176,495 29,638,462 Cash and cash equivalents at end of year $ 15,454,975 $ 21,387,513 $ 29,176,495 Supplemental disclosures of cash flow information Cash paid during the year for: Interest expense $ 8,853,448 $ 8,084,469 $ 10,337,406 Income taxes 777,401 1,637,706 2,150,000 Supplemental schedules of non-cash investing Activities Real estate acquired through foreclosure $ 1,325,942 $ 349,748 $ -
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, or securities held to maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income. Other securities such as Federal Home Loan Bank stock are carried at cost. Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments. Gains and losses on sales are recorded on the settlement date and determined using the specific identification method. Declines in the fair value of securities below their cost that are other than temporary are reflected as realized losses. In estimating other-than-temporary losses, management considers: (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, and (3) the Company's ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value. 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. Interest income on mortgage and consumer loans is discontinued at the time the loan is 90 days delinquent, and interest income on commercial loans is discontinued at the time the loan is 120 days delinquent, unless the loan is well-secured and in process of collection. Past due status is based on the contractual terms of the loan. 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. Consumer and credit card loans are typically charged off no later than 120 days past due. Loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. 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 represent the allocated value of retained servicing rights on loans sold and the cost of purchased rights. Servicing assets are 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. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions. Any impairment of a grouping is reported as a valuation allowance, to the extent that fair value is less than the capitalized amount for a grouping. 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. 2004 2003 2002 Net income As reported $ 5,762,109 $ 4,233,377 $ 5,902,525 Deduct: Stock-based compensation expense determined under fair value based method (20,997) (31,972) (129,172) Pro forma 5,741,112 4,201,405 5,773,353 2004 2003 2002 Basic earnings per share As reported $ 2.09 $ 1.52 $ 2.13 Pro forma 2.08 1.51 2.08 Diluted earnings per share As reported $ 2.07 $ 1.50 $ 2.10 Pro forma 2.07 1.49 2.06 Weighted averages Fair value of options granted $ 3.01 $ 1.07 $ 2.43 Risk free interest rate 3.86% 3.40% 4.30% Expected life 8 years 8 years 8 years Expected volatility 13.74% 16.90% 22.28% Expected dividend yield 2.47% 2.96% 2.72% 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, 2004 and 2003. Adoption of New Accounting Standards: During 2004, 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, 2004 and 2003 was $144,000 and $51,000. NOTE 3 - SECURITIES Year-end securities available for sale are as follows: Fair Unrealized Unrealized Value Gains Losses 2004 U. S. Treasury $ 2,984,375 $ - $ (30,033) U. S. government agencies 39,029,910 4,220 (384,112) States and political subdivisions 35,160,329 1,297,405 (163,285) Mortgage-backed 48,620,711 79,835 (677,298) Equity securities 971,536 363,589 - Total $ 126,766,861 $ 1,745,049 $(1,254,728) 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) The fair value of securities available for sale at December 31, 2004, 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 $ 2,169,979 Due after one year through five years 34,877,005 Due after five years through ten years 23,322,989 Due after ten years 16,804,641 77,174,614 Mortgage-backed 48,620,711 Equity 971,536 Total $ 126,766,861 Proceeds from sales of securities during 2004, 2003 and 2002 were $37,973,553, $8,434,570 and $18,838,747. Gross gains of $483,888, $157,474 and $260,096 and gross losses of $194,938, $18,036 and $41,492, were realized on those sales, resprectively. The tax provision related to these realized gains and losses was $98,243, $47,409 and $74,325, respectively. Securities with an approximate carrying value of $103,979,000 and $83,220,000 at December 31, 2004 and 2003, 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 2004 and 2003 not recognized in income are as follows:
2004 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. Treasury $ 2,984,375 $ (30,033) $ - $ - $ 2,984,375 $ (30,033) U.S. Government securities 33,139,473 (384,112) - - 33,139,473 (384,112) States and political subdivisions 4,156,727 (91,011) 2,811,479 (72,274) 6,968,206 (163,285) Mortgage-backed 36,918,846 (571,246) 4,705,311 (106,052) 41,624,157 (677,298) Total temporarily impaired $77,199,421 $(1,076,402) $ 7,516,790 $ (178,326) $ 84,716,211 $(1,254,728)
2003 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) Other 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)
The Company evaluates securities for other-than-temporary impairment-at least on an annual basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer's financial condition, the Company may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer's financial condition. NOTE 4 - LOANS Loans at year-end were as follows: 2004 2003 Commercial $ 19,999,038 $ 14,277,927 Real estate construction 32,256,168 14,313,068 Real estate mortgage 238,475,554 214,529,347 Agricultural 57,497,465 56,615,266 Consumer 9,062,518 12,977,419 Other 990,811 289,231 $ 358,281,554 $ 313,002,258 Activity in the allowance for loan losses was as follows: 2004 2003 2002 Beginning balance $ 3,819,842 $ 3,395,075 $ 3,386,425 Allowance from acquisition - 362,900 - Charge-offs (687,798) (1,397,822) (1,329,218) Recoveries 191,271 159,689 133,868 Provision for loan losses 840,000 1,300,000 1,204,000 Ending balance $ 4,163,315 $ 3,819,842 $ 3,395,075 Impaired loans totaled $1,781,000 and $1,844,000 at December 31, 2004 and 2003. The average recorded investment in impaired loans during 2004, 2003 and 2002 was $1,781,000, $1,051,000 and $1,441,000. The total allowance for loan losses related to these loans was $416,000 and $345,000 at December 31, 2004 and 2003. Interest income on impaired loans of $22,000, $14,000 and $8,000 was recognized for cash payments received in 2004, 2003 and 2002. Nonperforming loans were as follows: 2004 2003 2002 Loans past due over 90 days still on accrual $ 308,000 $ 779,000 $ 789,000 Nonaccrual loans 1,781,000 1,844,000 1,573,000 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 $102,024,000 and $91,789,000 at December 31, 2004 and 2003. Custodial escrow balances maintained in connection with the foregoing loan servicing, and included in demand deposits, were approximately $467,000 and $658,000 at December 31, 2004 and 2003. Changes in mortgage servicing rights were as follows: 2004 2003 2002 Beginning balance $ 861,120 $ 704,034 $ 463,067 Additions 263,861 381,205 390,865 Amortization (249,348) (224,119) (149,898) Ending balance $ 875,633 $ 861,120 $ 704,034 Certain directors and executive officers of the Company and companies in which they have beneficiary ownership were loan customers of the Bank during 2004 and 2003. 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: 2004 2003 Balance, beginning of year $ 2,486,000 $ 1,626,000 Additions, including loans now meeting disclosure requirements 1,054,000 1,648,000 Amounts collected, including loans no longer meeting disclosure requirements (1,636,000) (788,000) Balance, end of year $ 1,904,000 $ 2,486,000 NOTE 5 - PREMISES AND EQUIPMENT Year-end premises and equipment were as follows: 2004 2003 Land and buildings $ 12,804,599 $ 12,242,809 Furniture and equipment 9,732,639 9,241,247 22,537,238 21,484,056 Less accumulated depreciation (11,159,226) (9,877,683) $ 11,378,012 $ 11,606,373 Depreciation expense was $993,907, $960,512 and $989,839 in 2004, 2003, and 2002. NOTE 6 - GOODWILL AND INTANGIBLE ASSETS The change in balance for goodwill during the year is as follows: 2004 2003 Beginning of year $ 10,199,830 $ - Acquired goodwill 10,199,830 Adjustment to goodwill (1,089,306) - End of year $ 9,110,524 $ 10,199,830 The adjustment to goodwill is a result of post merger Goodwill will not be amortized but instead evaluated periodically for impairment. Acquired intangible assets were as follows at year-end: 2004 2003 Gross Gross Carrying Accumulated Carrying Accumulated Amount Amortization Amount Amortization Amortized intangible assets: Core deposit intangibles $3,656,403 $2,794,782 $3,656,403 $2,519,292 Aggregate amortization expense was $275,490, $292,271 and $279,468 for 2004, 2003 and 2002. Estimated amortization expense for each of the next five years: 2005 $ 95,736 2006 95,736 2007 95,736 2008 95,736 2009 95,736 The change in balance for intangible assets during the year is as follows: 2004 2003 Beginning of year $ 1,137,111 $ 663,382 Amortization (275,490) (292,271) Acquired core deposit intangible - 766,000 End of year $ 861,621 $1,137,111 NOTE 7 - DEPOSITS At December 31, 2004, the scheduled maturities of time deposits are as follows: 2005 $ 147,472,621 2006 31,979,796 2007 14,097,399 2008 3,477,497 2009 1,264,782 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 $3,421,000 and $1,397,000 at December 31, 2004 and 2003. NOTE 8 - REPURCHASE AGREEMENTS Securities sold under agreements to repurchase are secured by U.S. Government securities with a carrying amount of $27,275,000 and $3,022,000 at year-end 2004 and 2003 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 2004 and 2003 is summarized as follows: 2004 2003 Average daily balance during the year $ 18,398,243 $ 1,691,154 Average interest rate during the year 1.90% 1.34% Maximum month-end balance during the year $ 21,946,746 $ 2,411,269 Weighted average interest rate at year end 2.94% 1.65% 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, 2004 and 2003, $59,749,666 and $53,232,296 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 two months to twenty-six years, with fixed interest rates ranging from 1.52% 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, 2004 are as follows: 2005 $ 8,256,036 2006 12,928,179 2007 7,953,684 2008 9,980,527 2009 14,010,028 Thereafter 6,621,212 $ 59,749,666 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: 2004 2003 2002 Current $ 2,179,238 $ 1,166,575 $ 2,189,931 Deferred 38,545 289,965 280,858 $ 2,217,783 $ 1,456,540 $ 2,470,789 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. 2004 2003 Deferred tax assets Allowance for loan losses $ 1,241,615 $ 942,354 Core deposit intangibles 46,720 18,569 Other 358,420 174,723 Deferred tax liabilities Unrealized gain on securities (166,874) (782,909) Bank premises and equipment (511,174) (460,980) FHLB stock (929,394) (859,218) Mortgage servicing rights (297,715) (292,781) Other (299,235) (401,183) Net deferred tax asset (liability) $ (557,637) $ (1,661,425) Effective tax rates differ from federal statutory rates applied to financial statement income due to the following: 2004 2003 2002 U. S. federal income tax rate 34.0% 34.0% 34.0% Changes from the statutory rate Tax-exempt investment income (7.0) (9.3) (5.7) Non-deductible interest expense related to carrying tax-exempt investments .6 .8 .6 Other .2 .1 .6 27.8% 25.6% 29.5% 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, 2004. 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: 2004 2003 2002 Basic Earnings Per Share Net income $ 5,762,109 $ 4,233,377 $ 5,902,525 Weighted average common shares outstanding 2,757,233 2,781,146 2,770,282 Basic earnings per share $ 2.09 $ 1.52 $ 2.13 Diluted Earnings Per Share Net income $ 5,762,109 $ 4,233,377 $ 5,902,525 Weighted average common shares outstanding 2,757,233 2,781,146 2,770,282 Add dilutive effects of assumed exercise of stock options 20,203 45,640 35,836 Weighted average common and dilutive potential common shares outstanding 2,777,436 2,826,786 2,806,118 Diluted earnings per share $ 2.07 $ 1.50 $ 2.10 Stock options for 3,050 shares common stock from 2002 and for 11,350 shares of common stock were excluded from 2004 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: 2004 2003 Change in benefit obligation: Beginning benefit obligation $ 4,290,391 $ 4,385,567 Service cost 369,481 314,935 Interest cost 286,326 265,034 Actuarial adjustment 630,729 (601,900) Benefits paid (95,414) (73,245) Ending benefit obligation 5,481,513 4,290,391 Change in plan assets, at fair value: Beginning plan assets 4,075,719 3,397,218 Actual return 541,419 358,868 Employer contribution 276,984 392,878 Benefits paid (95,414) (73,245) Ending plan assets 4,798,708 4,075,719 Funded status (682,805) (214,672) Unrecognized net actuarial (gain) loss 932,175 523,815 Unrecognized prior transition asset (1,485) (1,857) Net pension prepaid benefit $ 247,885 $ 307,286 Amounts recognized in the balance sheet consist of: Prepaid benefit cost $ 247,885 Accrued benefit cost - Net amount recognized $ 247,885 The accumulated benefit obligation for defined benefit pension plans was $3,976,697 at year-end 2004. The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for the pension plans were $5,481,513, $3,976,697, and $4,798,708 respectively, as of year end 2004. Net periodic pension cost include the following components: 2004 2003 2002 Service cost $ 369,481 $ 314,935 $ 299,744 Interest cost 286,326 265,034 245,253 Expected return on plan assets (319,050) (265,117) (255,964) Amortization (372) 16,758 5,221 Net periodic cost $ 336,385 $ 331,610 $ 294,254 Weighted-average assumptions used to determine net cost 2004 2003 2002 Discount rate on benefit obligation 6% 7% 7% Long-term expected rate of return on plan assets 8% 8% 8% Rate of compensation increase 4% 5% 5% The Company's pension plan asset allocation at year-end 2004, target allocation for 2005, and expected long-term rate of return by asset category are as follows: Weighted Percentage Percentage Average of Plan of Plan Expected Target Assets at Assets at Long-Term Allocation Year-End Year-End Rate of Return Asset Category 2005 2004 2003 2004 Equity securities 55-65 64.9 51.7 10% Debt securities 35-45 34.6 38.1 6 Cash 5-15 0.5 10.2 4 Total 100.0 100.0 The asset allocation objective for 2005 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 $255,000 to its pension plan in 2005. 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 $309,741, $271,684 and $270,048 in 2004, 2003 and 2002. 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:
2004 2003 2002 Weighted Weighted Weighted Option Option Option Options Price Options Price Options Price Outstanding, beginning of year 57,560 $20.23 83,114 $16.72 103,484 $15.52 Granted 12,250 33.65 14,500 25.72 6,520 25.85 Expired (2,316) 27.03 (3,698) 25.00 (6,096) 20.84 Exercised (6,930) 17.55 (36,356) 13.89 (20,794) 12.41 Outstanding, end of year 60,564 $23.00 57,560 $20.23 83,114 $16.72 Weighted remaining contractual Life 67.0 months 67.9 months 64.7 months
Options outstanding at year-end 2004 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 15,320 26.6 $14.02 15,320 $14.02 From $18.00 to $20.63 per share 13,640 48.1 20.52 13,640 20.52 From $23.50 to $28.00 per share 20,354 87.1 25.37 8,216 25.32 From $33.90 to $34.00 per share 11,250 108.3 33.91 1,100 34.00 60,564 38,276
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 2005 the Bank could, without prior approval, declare dividends of approximately $4,015,000 plus any 2005 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, 2004 and 2003 are as follows: 2004 2003 Carrying Carrying Amount Fair Value Amount Fair Value (In Thousands) Financial assets Cash and cash equivalents $ 15,455 $ 15,455 $ 21,388 $ 21,388 Securities 126,767 126,767 128,790 128,790 Mortgage loans held for sale 176 178 7,759 7,851 Loans, net 354,118 350,912 309,182 312,596 FHLB stock 5,136 5,136 4,930 4,930 Interest receivable 3,226 3,226 3,250 3,250 Financial liabilities Deposits $ 387,955 $ 390,296 $ 384,599 $ 387,083 Securities sold under agreements to repurchase and other borrowings 25,593 25,467 7,285 7,285 FHLB advances 59,750 59,281 53,232 53,747 Subordinated debentures 7,217 7,354 7,217 7,385 Interest payable 1,849 1,849 1,636 1,636 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 $9,111,000 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 9,111,000 Core deposit intangible 766,000 Other assets 19,557,000 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 2004 and 2003. 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 $ 16,368,000 Net income $ 4,838,000 $ 4,838,000 Basic earnings per share $ 1.74 $ 1.74 Diluted earnings per share $ 1.71 $ 1.71 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: 2004 2003 Unused lines of credit $ 54,930,000 $ 47,148,000 Commitments to make loans 1,272,000 1,379,000 Letters of credit 145,000 252,000 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 5.75% 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, 2004 and 2003, 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 2004 (Dollars in Thousands) Consolidated Total Capital (to Risk-Weighted Assets) $ 45,987 13.2% $ 27,855 8% $ 34,819 10% Tier I Capital (to Risk-Weighted Assets) 41,660 12.0 13,928 4 20,891 6 Tier I Capital (to Average Assets) 41,660 8.2 20,410 4 25,512 5 Bank Only Total Capital (to Risk-Weighted Assets) $ 44,512 12.8% $ 27,791 8% $ 34,739 10% Tier I Capital (to Risk-Weighted Assets) 40,338 11.6 13,895 4 20,843 6 Tier I Capital (to Average Assets) 40,338 7.9 20,368 4 25,460 5 2003 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 8.8 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
NOTE 21 - PARENT COMPANY FINANCIAL STATEMENTS Condensed Balance Sheets December 31 2004 2003 (In Thousands) ASSETS Cash on deposit with subsidiary $ 721 $ 1,783 Investment in subsidiary 50,481 49,593 Securities available for sale 698 1,247 Other assets 363 670 Total assets $ 52,263 $ 53,293 LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Subordinated debentures $ 7,217 $ 7,217 Other Liabilities 19 19 Stockholders' equity Preferred stock - - Common stock 6,819 6,985 Retained earnings 37,884 37,553 Accumulated other comprehensive income 324 1,519 Total liabilities and stockholders' equity $ 52,263 $ 53,293 Condensed Statements of Income and Comprehensive Income Years Ended December 31 2004 2003 2002 (In Thousands) Income Dividends from subsidiary $ 3,650 $ 13,025 $ 3,400 Securities gains (losses), net 82 7 145 Interest income 24 20 32 Total income 3,756 13,052 3,577 Expenses Interest expense 494 169 - Other expenses 157 360 55 Income before income taxes and equity in undistributed income of subsidiary 3,105 12,523 3,522 Applicable income tax (expense) benefits 177 175 (29) Income before equity in undistributed income of subsidiary 3,282 12,698 3,493 Equity in undistributed income of subsidiary 2,480 (8,465) 2,410 Net income 5,762 4,233 5,903 Other comprehensive income (loss), net of tax: Unrealized gains (losses) on securities arising during the period (1,004) (237) 1,245 Reclassification of realized amount (191) (92) (144) Net change in unrealized gain (loss) on securities (1,195) (329) 1,101 Comprehensive income $ 4,567 $ 3,904 $ 7,004 Condensed Statements of Cash Flows Years Ended December 31 2004 2003 2002 (In Thousands) Cash flows from operating activities Net income $ 5,762 $ 4,233 $ 5,903 Adjustments to reconcile net income to net cash from operating activities Equity in undistributed earnings of Subsidiary (2,480) 8,465 (2,410) Securities (gains) losses, net (82) (7) (145) Change in other assets 659 (553) (100) Change in other liabilities - (10) 103 Net cash from operating activities 3,859 12,128 3,351 Cash flows from investing activities Purchase of securities available for sale - (82) (109) Proceeds from sales of securities available for sale 675 65 869 Acquisition of Kentucky First Bancorp, Inc. - (20,998) - Net cash from investing activities 675 (21,015) 760 Cash flows from financing activities Proceeds from subordinated debentures - 7,000 - Dividends paid (2,303) (2,117) (1,885) Proceeds from issuance of common stock 131 189 188 Purchase of common stock (3,424) (11) (315) Net cash from financing activities (5,596) 5,061 (2,012) Net change in cash (1,062) (3,826) 2,099 Cash at beginning of year 1,783 5,609 3,510 Cash at end of year $ 721 $ 1,783 $ 5,609 NOTE 22 - QUARTERLY FINANCIAL DATA (UNAUDITED) Interest Net Interest Net Earnings Per Share Income Income Income Basic Fully Diluted 2004 First quarter $ 6,267 $ 4,071 $ 1,150 $ .41 $ .41 Second quarter 6,463 4,267 1,439 .51 .51 Third quarter 6,506 4,252 1,579 .58 .57 Fourth quarter 6,610 4,189 1,594 .59 .58 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 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 REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors Kentucky Bancshares, Inc. Paris, Kentucky We have audited the accompanying consolidated balance sheets of Kentucky Bancshares, Inc. as of December 31, 2004 and 2003, 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, 2004. 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 the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits 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, 2004 and 2003, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. Crowe Chizek and Company LLC Lexington, Kentucky March 1, 2005 Meet Our Officers... SENIOR MANAGEMENT Louis Prichard, President and Chief Executive Officer Norman J. Fryman, Sr. Vice President, Director of Sales and Service Greg Dawson, VP, Chief Financial Officer Brenda Bragonier, VP, Director of Marketing and Human Resources Hugh Crombie, VP, Director of Operations Clark Nyberg, VP, Director of Wealth Management OFFICERS BOURBON COUNTY Karen Anderson, Electronic Banking Officer Heather Barger, VP, Director of Risk Management Melinda Biddle, Government Reporting Officer Brenda Berry, AVP, Senior Accountant Rhonda Brown, Consumer Lender Wallis Brooks, Branch Manager, CRA Officer Patricia Carpenter, AVP, Data Management Officer R.W. Collins, VP, Agricultural Lender Robbie Cox, Senior Auditor Cynthia Criswell, Data Processing Officer Brandon Eason, Consumer Lender Nancye Fightmaster, VP, Bourbon County Regional Manager David Foster, VP, Agricultural Lender Janice Hash, AVP, Senior Accountant, Purchasing Lisa Highley, Personal Trust Officer Philip Hurst, Assistant Branch Manager Perry Ingram, AVP, Network Manager Susan Lemons, AVP, Branch Manager, Consumer Lender Jane Mogge, Document Management Officer Donnie Roe, AVP, Senior Data Processing Officer Lydia Sosby, AVP, Director of Training and Sales Judith Taylor, VP, Human Resource Manager George Wilder, VP, Commercial Lender Buckner Woodford, Chairman of the Board Martha Woodford, VP, Assistant Director of Operations Jan Worth, AVP, Personal Trust Officer CLARK COUNTY Nick Carter, VP, Clark County Regional Manager Darren Henry, VP, Director of Commercial Lending Kathy Newkirk, Branch Manager, Consumer Lender Rowena Ruff, Investment Advisor Teresa Shimfessel, AVP, Consumer Lender James Brandon Sumpter, Consumer Lender Carolyn Wilkins, Overdraft Management Officer HARRISON COUNTY Ken DeVasher, VP, Harrison County Regional Manager Dreama Harris, AVP, Consumer Lender Catherine Hill, VP, Collections Officer Mary Moreland, AVP, Collections Officer Iva Joyce Rainey, Consumer Lender Arnita Willoughby, Mortgage Operations Manager JESSAMINE COUNTY Mike Lovell, VP, Commercial Lender Rick Walling, VP, Jessamine County Regional Manager SCOTT COUNTY Shane Foley, VP, Mortgage Lender Pam Jessie, VP, Scott County Regional Manager Sharon Whitlock, Branch Manager, Consumer Lender WOODFORD COUNTY Duncan Gardiner, VP, Woodford County Regional Manager A. J. Gullett, VP, Commercial Lender Board of Directors - Kentucky Bank William M. Arvin, Attorney Dan Brewer, President and CEO Bluegrass Energy Gus Bynum, Physician Loren Carl, Field Representative, Congressman Ben Chandler James Ferrell, Physician Mary Beth Hendricks, Director of Clark County Child Support Services Henry Hinkle, President, Hinkle Contracting Corporation Theodore Kuster, Farmer and Thoroughbred Breeder, Westview-Hillside Farms Ted McClain, Agent, Hopewell Insurance Company Louis Prichard, President and CEO, Kentucky Bank William R. Stamler, Chairman, Signal Investments, Inc. Joel Techau, CEO, Techau Inc. Robert G. Thompson, Farmer and Thoroughbred Breeder, Snowhill Farm Woodford Van Meter, Ophthalmologist Buckner Woodford, Chairman, Kentucky Bank CLARK Mary Beth Hendricks, Director, Clark County Child Support Services Donald Pace, Executive Director, Central Kentucky Educational Co-op with UK John Roche, Optician Edwin Saunier, President, Saunier North American, Inc. HARRISON K. Bruce Florence, Director, Licking Valley College Betty Long, Retired President, First Federal Savings Bank of Cynthiana Brad Marshall, Farmer and Owner, Marshall's Tractor Supply Joel Techau, CEO, Techau Inc. Gerry Whalen, Broker, Whalen and Company JESSAMINE William M. Arvin, Attorney Dan Brewer, President and CEO, Bluegrass Energy Tom Buford, State Senator Jonah Mitchell, President, Jonah Mitchell Real Estate and Auction Company Eva McDaniel, Jessamine County Clerk SCOTT Gus Bynum, Physician Mike Hockensmith, Owner and President, The Hockensmith Agency, Inc. R. C. Johnson, Jr., Owner and President, Johnson's Funeral Home George Lusby, County Judge Executive Everette Varney, Mayor WOODFORD Loren Carl, Field Representative, Congressman Ben Chandler William Graul, Physician James Kay, Businessman, Farmer Tricia Kittinger, Woodford County Circuit Clerk 27 Kentucky Bancshares, Inc. LOUIS PRICHARD President and CEO, Kentucky Bank and Kentucky Bancshares, Inc. JAMES FERRELL Physician BUCKNER WOODFORD Chairman, Kentucky Bank and Kentucky Bancshares, Inc. WILLIAM STAMLER Chairman, Signal Investments, Inc. TED McCLAIN Agent, Hopewell Insurance Company BETTY LONG Retired President, First Federal Savings of Cynthiana ROBERT G. THOMPSON Farmer and Thoroughbred Breeder, Snowhill Farm HENRY HINKLE President, Hinkle Contacting Corporation THEODORE KUSTER Farmer and Thoroughbred Breeder, Westview-Hillside Farms WILLIAM M. ARVIN Attorney, William M. Arvin Associates WOODFORD VAN METER Opthalmologist KENTUCKY BANCSHARES, INC. PROXY STATEMENT Introduction This Proxy Statement is being furnished to shareholders of Kentucky Bancshares, Inc., a Kentucky corporation (the "Company"), in connection with the solicitation of proxies by the Board of Directors of the Company (the "Board") from holders of record of the Company's outstanding Common Shares (the "Common Shares") as of the close of business on March 18, 2005 (the "Annual Meeting Record Date"), for use at the Annual Meeting of Shareholders of the Company (the "Annual Meeting") to be held on Tuesday, May 10, 2005, at 11:00 a.m. (Eastern Daylight Time) in the Board Room of Kentucky Bank, Fourth and Main Streets, Paris, Kentucky, and at any adjournment or postponement thereof. This Proxy Statement is first being mailed to the Company's shareholders on or about March 28, 2005. The principal executive offices of the Company are located at Fourth and Main Streets, Paris, Kentucky 40361. Its telephone number is (859) 987-1795. Purposes of the Annual Meeting At the Annual Meeting, holders of Common Shares will be asked to consider and to vote upon the following matters: (1) To elect three Class III directors; (2) To approve the adoption of the 2005 Restricted Stock Grant Plan (the "Stock Grant Plan") and (3) To transact such other business as may properly come before the meeting. The Board recommends that shareholders vote FOR the election of the Board's nominees for Class III directors and FOR the adoption of the Stock Grant Plan. As of the date of this Proxy Statement, the Board knows of no other business to come before the Annual Meeting. Voting Rights and Proxy Information Only holders of record of Common Shares as of the close of business on the Annual Meeting Record Date will be entitled to notice of and to vote at the Annual Meeting or any adjournment or postponement thereof. As of the Annual Meeting Record Date, there were 2,684,698 Common Shares outstanding and entitled to vote at the Annual Meeting. The presence, either in person or by properly executed proxy, of the holders of a majority of the outstanding Common Shares as of the Annual Meeting Record Date is necessary to constitute a quorum at the Annual Meeting. Holders of Common Shares are entitled to one vote per share on any matter, other than the election of directors, that may properly come before the Annual Meeting. In the election of directors, holders of Common Shares have cumulative voting rights whereby each holder is entitled to vote the number of Common Shares owned multiplied by three (the number of directors to be elected at the Annual Meeting), and each holder may cast the whole number of votes for one candidate or distribute such votes among two or more candidates. The Board of Directors is soliciting discretionary authority for the individuals appointed in the proxies to cumulate votes represented by properly executed proxies and to vote for less than all the Company's nominees to the Board if deemed appropriate to ensure the election of as many of the Company's nominees to the Board as possible. Those persons receiving the three highest number of votes in the election of directors will be elected to the Board. The Stock Grant Plan will be approved if the holders of a majority of the Common Shares represented in person or by proxy at the Annual Meeting vote in favor of its adoption. All Common Shares that are represented at the Annual Meeting by properly executed proxies received before or at the Annual Meeting and not revoked will be voted at the Annual Meeting in accordance with the instructions indicated in such proxies. If no instructions are indicated, such proxies will be voted "FOR" the election of the Board's three nominees as Class III directors of the Company (or, if deemed appropriate by the individuals appointed in the proxies, cumulatively voted for less than all of the Board's nominees), and "FOR" the adoption of the Stock Grant Plan. Any proxy given pursuant to this solicitation may be revoked by the person giving it at any time before it is voted. Proxies may be revoked by (i) filing with the Company, to the attention of Gregory J. Dawson, Secretary, at or before the Annual Meeting, a written notice of revocation bearing a later date than the proxy, (ii) duly executing a subsequent proxy relating to the same Common Shares and delivering it to the Company at or before the Annual Meeting or (iii) attending the Annual Meeting and voting in person (although attendance at the Annual Meeting will not in and of itself constitute a revocation of a proxy). Any written notice revoking a proxy should be sent to Kentucky Bancshares, Inc., P. O. Box 157, Paris, Kentucky 40362-0157, Attention Gregory J. Dawson, Secretary. The Company will bear the cost of the solicitation of proxies by the Board in connection with the Annual Meeting. In addition to solicitation by mail, the Company will request banks, brokers and other custodian nominees and fiduciaries to supply proxy material to the beneficial owners of Common Shares, and will reimburse them for their expenses in so doing. Certain directors, officers and other employees of the Company, not specially employed for this purpose, may solicit proxies without additional remuneration therefore, by personal interview, mail, telephone, facsimile or other electronic means. Item 1 - Election of Directors Under the Company's Amended and Restated Articles of Incorporation, the Board of Directors consists of three different classes (Class I, Class II and Class III), each to serve, subject to the provisions of the Amended and Restated Articles of Incorporation and Bylaws, for a three year term and until his successor is duly elected and qualified. Except as listed below, each nominee for a Class III directorship has held the specified position for the last five years. The names of the nominees proposed for election as Class III directors, all of whom are presently directors of the Company, are set forth below. The Company is not aware of any other individual who may be nominated for election to the Board of Directors at the Annual Meeting. Henry L. Hinkle is president of Hinkle Contracting Corporation. He became a director of Kentucky Bank and the Company in 1989. Theodore Kuster is a farmer and thoroughbred breeder with West View Equine. He became a director of Kentucky Bank in 1979 and the Company in 1985. Robert G. Thompson is a farmer and thoroughbred breeder with Snowhill Farm. He became a director of Kentucky Bank and the Company in 1991. The Board of Directors does not contemplate that any of the nominees will be unable to accept election as a director for any reason. However, if one or more of such nominees is unable or unwilling to accept or is unavailable to serve, the persons named in the proxies or their substitutes shall have authority, according to their judgment, to vote or to refrain from voting for other individuals as directors. The Board recommends that shareholders vote "FOR" each of the above nominees for election as Class III directors of the Company. Item 2 - Adoption of Stock Grant Plan On February 15, 2005, the Company's Board of Directors adopted the 2005 Restricted Stock Grant Plan, subject to shareholder approval. A copy of the Stock Grant Plan is attached to the Proxy Statement as Annex A. The purpose of the Stock Grant Plan is to promote the growth and general prosperity of the Company and its subsidiaries by granting Company stock to employees who will largely be responsible for the long-term success and development of the Company and to better align their interests with those of Company shareholders. The Company further intends to use stock grants ("Restricted Stock Awards") to attract and retain new employees and stimulate their efforts on behalf of the Company. The Stock Grant Plan will be administered by a committee (the "Committee") appointed by the Board. Subject to the provisions of the Stock Grant Plan, the Committee will have full authority to administer the Stock Grant Plan, including without limitation, the authority to: (a) select participants to whom Restricted Stock Awards are granted; (b) determine the size and frequency of Restricted Stock Awards granted under the Stock Grant Plan; (c) determine the terms and conditions of Restricted Stock Awards, including any restrictions or conditions, which need not be identical; (d) waive any or all the restrictions and conditions applicable to, any Restricted Stock Award, for any reason; (e) construe and interpret the Stock Grant Plan and any agreement or instrument entered into under the Stock Grant Plan; (f) establish, amend and rescind rules and regulations for the Stock Grant Plan's administration; and (g) amend the terms and conditions of any outstanding Restricted Stock Award to the extent such terms and conditions are within the discretion of the Committee as provided in the Stock Grant Plan. The maximum number of shares which may be issued under to the Stock Grant Plan is 50,000 Common Shares. The Restricted Stock Awards and the maximum number of shares that may be issued under the Stock Grant Plan will be adjusted by the Board, but only in order to prevent dilution or enlargement of such awards in the event of a stock dividend, stock split-up or share combination, exchange of shares, recapitalizations, merger, consolidation, acquisition of property or shares, separation, reorganization, liquidation, or the like of or by Company. All employees of the Company and its subsidiaries are eligible to receive awards under the Stock Grant Plan. In selecting employees to receive awards under the Stock Grant Plan, as well as in determining the number of Common Shares subject to and the other terms and conditions applicable to each award, the Committee will take into consideration such factors as it deems relevant in promoting the purposes of the Stock Grant Plan, including the duties of the employees, their present and potential contribution to the success of Company and their anticipated number of years in active service remaining with Company or a subsidiary. The Stock Grant Plan will become effective on January 1, 2006, if the Stock Grant Plan has been approved by the Stockholders at the Annual Meeting. The Board recommends that shareholders vote "FOR" the adoption of the Stock Grant Plan. Item 3 - Other Matters As of the date of this Proxy Statement, the Company knows of no business that will be presented for consideration at the Annual Meeting other than that referred to above. At the Annual Meeting, only such business will be conducted, and only such proposals or director nominations will be acted upon, as have been properly brought before the meeting in accordance with the Company's Bylaws. Proxies in the enclosed form will be voted in respect of any other business that is properly brought before the Annual Meeting in accordance with the judgment of the person or persons voting the proxies. By Order of the Board of Directors Gregory J. Dawson, Secretary March 28, 2005 This Proxy Form is Solicited by the Board of Directors Kentucky Bancshares, Inc. Paris, Kentucky The undersigned hereby appoints Buckner Woodford IV and Gregory J. Dawson, or either one of them (with full power to act alone), my proxy, each with the power to appoint his substitute, to represent me to vote all of the Corporation's Common Stock which I held of record or am otherwise entitled to vote at the close of business on March 18, 2005, at the 2005 Annual Meeting of Shareholders to be held on May 10, 2005 and at any adjournments thereof, with all powers the undersigned would possess if personally present, as follows: 1. ELECTION OF DIRECTORS FOR all nominees listed below (except as otherwise indicated below) AGAINST all nominees listed below Henry L. Hinkle, Theodore Kuster, and Robert G. Thompson (INSTRUCTION: To withhold authority to vote for any individual nominee, write the nominee's name on the line) _________________________________________________________________ 2. ADOPTION OF STOCK GRANT PLAN FOR AGAINST ABSTAIN 3. OTHER BUSINESS. In their discretion, the Proxies are authorized to act upon such other matters as may properly be brought before the Annual Meeting or any adjournment thereof. THE BOARD OF DIRECTORS RECOMMENDS A VOTE "FOR" ALL OF THE NOMINEES LISTED IN ITEM I AND "FOR" THE ADOPTION OF THE STOCK GRANT PLAN IN ITEM 2. (PLEASE DATE, MARK, SIGN AND RETURN IMMEDIATELY) This proxy form relates to ALL shares owned by the undersigned. This proxy form is solicited by the Board of Directors and will be voted as specified and in accordance with the accompanying proxy statement. If no instruction is indicated, this proxy form will be voted "FOR" all of the nominees listed in Item 1 and "FOR" the adoption of the Stock Grant Plan in Item 2. Please sign exactly as name appears. When shares are held by joint tenants, both should sign. When signing as attorney, as executor, administrator, trustee, or guardian, please give full title as such. If a corporation, please sign full corporate name by President or other authorized officer. If a partnership, please sign partnership name by authorized person. DATE___________, 2005 ________________________________ Signature ________________________________ Signature if held jointly 89