10-Q 1 q053.txt 10Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2005 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____________________ to ___________________ Commission File Number: 33-96358 KENTUCKY BANCSHARES, INC. (Exact name of registrant as specified in its charter) Kentucky 61-0993464 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) P.O. Box 157, Paris, Kentucky 40362-0157 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (859)987-1795 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No _____ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes No X___ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No X___ Number of shares of Common Stock outstanding as of November 10, 2005: 2,665,022. KENTUCKY BANCSHARES, INC. Table of Contents Part I - Financial Information Item 1. Financial Statements Consolidated Balance Sheets 3 Consolidated Statements of Income and Comprehensive Income 4 Consolidated Statements of Changes in Stockholders' Equity 6 Consolidated Statements of Cash Flows 7 Notes to Consolidated Financial Statements 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk 18 Item 4. Controls and Procedures 20 Part II - Other Information 20 Signatures 21 Exhibits 31.1 Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 22 31.2 Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 24 32 Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 26 Item 1 - Financial Statements KENTUCKY BANCSHARES, INC. CONSOLIDATED BALANCE SHEETS (unaudited) (thousands) 9/30/2005 12/31/2004 Assets Cash and due from banks $ 13,194 $ 12,249 Federal funds sold 19,924 3,206 Cash and cash equivalents 33,118 15,455 Securities available for sale 133,869 126,767 Mortgage loans held for sale 214 175 Loans 359,524 358,282 Allowance for loan losses (4,510) (4,163) Net loans 355,014 354,119 Federal Home Loan Bank stock 5,321 5,137 Bank premises and equipment, net 10,803 11,378 Interest receivable 3,845 3,226 Goodwill 9,111 9,111 Other intangible assets 790 861 Mortgage servicing rights 834 876 Other assets 1,029 1,439 Total assets $ 553,948 $ 528,544 Liabilities and Stockholders' Equity Deposits Non-interest bearing $ 74,593 $ 74,048 Time deposits, $100,000 and over 59,478 59,469 Other interest bearing 280,741 254,438 Total deposits 414,812 387,955 Repurchase agreements and other borrowings 15,911 25,593 Federal Home Loan Bank advances 67,001 59,750 Subordinated debentures 7,217 7,217 Interest payable 1,897 1,849 Other liabilities 873 1,153 Total liabilities 507,711 483,517 Stockholders' equity Common stock 6,542 6,819 Retained earnings 40,174 37,884 Accumulated other comprehensive income (loss) (479) 324 Total stockholders' equity 46,237 45,027 Total liabilities & stockholders' equity $ 553,948 $ 528,544 See Accompanying Notes KENTUCKY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (unaudited) (thousands, except per share amounts) Nine Months Ending 9/30/2005 9/30/2004 INTEREST INCOME: Loans, including fees $ 17,265 $ 15,038 Securities available for sale 3,637 4,167 Other 172 30 Total interest income 21,074 19,235 INTEREST EXPENSE: Deposits 5,527 4,219 Other 2,695 2,426 Total interest expense 8,222 6,645 Net interest income 12,852 12,590 Loan loss provision 583 620 Net interest income after provision 12,269 11,970 NON-INTEREST INCOME: Service charges 3,377 3,424 Loan service fee income 197 182 Trust department income 332 220 Securities available for sale gains (losses), net 63 239 Gain on sale of mortgage loans 265 295 Other 873 788 Total other income 5,107 5,148 NON-INTEREST EXPENSE: Salaries and employee benefits 6,420 6,101 Occupancy expenses 1,686 1,704 Amortization 259 433 Advertising and marketing 330 294 Taxes other than payroll, property and income 407 373 Other 2,499 2,410 Total other expenses 11,601 11,315 Income before taxes 5,775 5,803 Income taxes 1,496 1,635 Net income $ 4,279 $ 4,168 Other Comprehensive Income, net of tax: Change in Unrealized Gains on Securities (803) (745) Comprehensive Income $ 3,476 $ 3,423 Earnings per share Basic $ 1.60 $ 1.50 Diluted 1.59 1.49 See Accompanying Notes KENTUCKY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (unaudited) (thousands, except per share amounts) Three Months Ending 9/30/2005 9/30/2004 INTEREST INCOME: Loans, including fees $ 5,937 $ 5,225 Securities available for sale 1,234 1,278 Other 150 2 Total interest income 7,321 6,505 INTEREST EXPENSE: Deposits 2,191 1,371 Other 884 882 Total interest expense 3,075 2,253 Net interest income 4,246 4,252 Loan loss provision 167 170 Net interest income after provision 4,079 4,082 NON-INTEREST INCOME: Service charges 1,182 1,207 Loan service fee income 66 63 Trust department income 117 73 Securities available for sale gains (losses), net 10 163 Gain on sale of mortgage loans 78 57 Other 266 247 Total other income 1,719 1,810 NON-INTEREST EXPENSE: Salaries and employee benefits 2,119 1,999 Occupancy expenses 566 575 Amortization 88 139 Advertising and marketing 110 98 Taxes other than payroll, property and income 135 125 Other 809 722 Total other expenses 3,827 3,658 Income before taxes 1,971 2,234 Income taxes 541 655 Net income $ 1,430 $ 1,579 Other Comprehensive Income, net of tax: Change in Unrealized Gains on Securities (604) 1,735 Comprehensive Income $ 826 $ 3,314 Earnings per share Basic $ 0.54 $ 0.58 Diluted 0.54 0.57 See Accompanying Notes KENTUCKY BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (unaudited) (thousands, except number of shares) Accumulated Other Total ----Common Stock---- Retained Comprehensive Stockholders' Shares Amount Earnings Income Equity Balances, December 31, 2004 2,684,498 $ 6,819 $ 37,884 $ 324 $ 45,027 Common stock issued 1,400 19 - - 19 Common stock purchased (14,576) (296) (140) - (436) Net change in unrealized gain (loss) on securities available for sale, net of tax - - - (803) (803) Net income - - 4,279 - 4,279 Dividends declared - $0.69 per share - - (1,849) - (1,849) Balances, September 30, 2005 2,671,322 $ 6,542 $ 40,174 $ (479) $ 46,237
See Accompanying Notes KENTUCKY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (thousands) Nine Months Ending 9/30/2005 9/30/2004 Cash Flows From Operating Activities Net Income $ 4,279 $ 4,168 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 707 759 Amortization of core deposits & mortgage servicing 259 433 Amortization of premium on debt (74) (49) Securities amortization (accretion), net 266 520 Provision for loan losses 583 620 Securities (gains) losses, net (64) (239) Originations of loans held for sale (14,612) (16,775) Proceeds from sale of loans 14,838 24,793 Federal Home Loan Bank stock dividends (184) (152) Losses (gains) on sale of fixed assets (71) - Gain on sale of mortgage loans (265) (295) Changes in: Interest receivable (619) (256) Other assets 264 (254) Interest payable 48 (139) Other liabilities 134 2,805 Net cash from operating activities 5,489 15,939 Cash Flows From Investing Activities Purchases of securities available for sale (23,520) (56,036) Proceeds from sales of securities available for sale 1,323 37,891 Proceeds from principal payments, maturities and calls of securities available for sale 13,676 27,430 Net change in loans (1,478) (38,755) Purchases of bank premises and equipment (643) (849) Proceeds from the sale of bank premises and equipment 582 - Net cash from investing activities (10,060) (30,319) Cash Flows From Financing Activities: Net change in deposits 26,857 (19,090) Net change in securities sold under agreements to repurchase and other borrowings (9,682) 16,829 Advances from Federal Home Loan Bank 15,000 10,000 Payments on Federal Home Loan Bank advances (7,675) (188) Proceeds from issuance of common stock 19 56 Purchase of common stock (436) (3,424) Dividends paid (1,849) (1,740) Net cash from financing activities 22,234 2,443 Net change in cash and cash equivalents 17,663 (11,937) Cash and cash equivalents at beginning of period 15,455 21,388 Cash and cash equivalents at end of period $ 33,118 $ 9,451 See Accompanying Notes KENTUCKY BANCSHARES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. 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 as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates used in the preparation of the financial statements are based on various factors including the current interest rate environment and the general strength of the local economy. Changes in the overall interest rate environment can significantly affect the Company's net interest income and the value of its recorded assets and liabilities. Actual results could differ from those estimates used in the preparation of the financial statements. The financial information presented as of any date other than December 31 has been prepared from the Company's books and records without audit. The accompanying consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Certain financial information that is normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America, but is not required for interim reporting purposes, has been condensed or omitted. In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of such financial statements, have been included. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2004. 2. INVESTMENT SECURITIES INVESTMENT SECURITIES Period-end securities are as follows: (in thousands) Amortized Unrealized Unrealized Fair Cost Gains Losses Value Available for Sale September 30, 2005 U.S. Treasury $ 3,008 $ - $ (39) $ 2,969 U.S. government agencies 45,855 - (735) 45,120 States and political subdivisions 36,188 945 (233) 36,900 Mortgage-backed 49,018 20 (974) 48,064 Equity securities 525 291 - 816 Total 134,594 1,256 (1,981) 133,869 December 31, 2004 U.S. Treasury $ 3,014 $ - $ (30) $ 2,984 U.S. government agencies 39,410 4 (384) 39,030 States and political subdivisions 34,026 1,297 (163) 35,160 Mortgage-backed 49,219 80 (678) 48,621 Equity securities 608 364 - 972 Total 126,277 1,745 (1,255) 126,767 3. LOANS Loans at period-end are as follows: (in thousands) 9/30/2005 12/31/2004 Commercial $ 21,358 $ 19,999 Real estate construction 29,208 32,256 Real estate mortgage 240,696 238,476 Agricultural 58,953 57,498 Consumer 9,309 10,053 Total 359,524 358,282 4. 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 includes the dilutive effect of additional potential common shares issuable under stock options. The factors used in the earnings per share computation follow: Nine Months Ended Septmber 30 2005 2004 (in thousands) Basic Earnings Per Share Net Income $4,279 $4,168 Weighted average common shares outstanding 2,680 2,782 Basic earnings per share $ 1.60 $ 1.50 Diluted Earnings Per Share Net Income $4,279 $4,168 Weighted average common shares outstanding 2,680 2,782 Add dilutive effects of assumed exercise of stock options 15 21 Weighted average common and dilutive potential common shares outstanding 2,695 2,803 Diluted earnings per share $ 1.59 $ 1.49 Three Months Ended September 30 2005 2004 (in thousands) Basic Earnings Per Share Net Income $1,430 $1,579 Weighted average common shares outstanding 2,682 2,745 Basic earnings per share $ 0.54 $ 0.58 Diluted Earnings Per Share Net Income $1,430 $1,579 Weighted average common shares outstanding 2,682 2,745 Add dilutive effects of assumed exercise of stock options 15 19 Weighted average common and dilutive potential common shares outstanding 2,697 2,764 Diluted earnings per share $ 0.54 $ 0.57 Stock options for 31,100 shares common stock for the nine months ended September 30, 2005 and for 27,600 shares common stock for the three months ended September 30, 2005, and for 11,550 shares of common stock for the nine and three months ended September 30, 2004 were excluded from diluted earnings per share because their impact was antidilutive. 5. Stock Compensation The Company grants certain officers and key employees stock option awards which vest and become fully exercisable at the end of five years. The Company also grants certain directors stock option awards which vest and become fully exercisable immediately. 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. Employee compensation expense under stock options is reported using the intrinsic value method. 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. Nine months ended September 30 (in thousands) 2005 2004 Net income As reported $ 4,279 $ 4,168 Deduct: Stock-based compensation expense determined under fair value based method (41) (16) Pro forma 4,238 4,152 Basic earnings per share As reported $ 1.60 $ 1.50 Pro forma 1.58 1.49 Diluted earnings per share As reported $ 1.59 $ 1.49 Pro forma 1.57 1.48 Three months ended September 30 (in thousands) 2005 2004 Net income As reported $ 1,430 $ 1,579 Deduct: Stock-based compensation expense determined under fair value based method (14) (6) Pro forma 1,416 1,573 Basic earnings per share As reported $ 0.54 $ 0.58 Pro forma 0.53 0.57 Diluted earnings per share As reported $ 0.54 $ 0.57 Pro forma 0.53 0.57 In December 2004, the Financial Accounting Standards Board issued a revised version of Statement of Financial Accounting Standards No. 123. It requires that the fair value of stock options and other share-based compensation be measured as of the date the grant is awarded and expensed over the period of employee service, typically the vesting period. It will be required for the Company starting January 1, 2006. Compensation cost will also be recorded for previously awarded options to the extent that they vest after the effective date. The effect on results of operations will depend on the level of future option grants and the calculation of the fair value of the options granted. The effect of existing options that will continue to vest after the adoption date is anticipated to be immaterial. 6. Dividends per share paid for the quarter ended September 30, 2005 were $0.23 compared to $0.21 for September 30, 2004. This is the same rate of dividend paid for the first two quarters of the respective years. 7. Components of Net Periodic Benefit Cost Nine months ended September 30 (in thousands) Pension Benefits 2005 2004 Service cost $ 324 $ 277 Interest cost 260 215 Expected return on plan assets (282) (240) (Gain) loss amortization 30 - Net Periodic Benefit Cost $ 332 $ 252 Three months ended September 30 (in thousands) Pension Benefits 2005 2004 Service cost $ 108 $ 92 Interest cost 87 72 Expected return on plan assets (94) (80) (Gain) loss amortization 10 - Net Periodic Benefit Cost $ 111 $ 84 Employer Contributions The Company previously disclosed in its financial statements for the year ended December 31, 2004 that it expected to contribute $255 thousand as its 2005 annual contribution to the Pension Plan. The Company's actual annual contribution was $211 thousand, and was made in the third quarter of 2005. Item 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements This discussion contains forward-looking statements under the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. Words such as "believes," "anticipates," "expects," "intends," "plans," "targeted," and similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. Although the Company believes that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore, there can be no assurance that the forward-looking statements included herein will prove to be accurate. Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to: economic conditions (both generally and more specifically in the markets, including the tobacco market, in which the Company and its bank operate); competition for the Company's customers from other providers of financial and mortgage services; government legislation and regulation (which changes from time to time and over which the Company has no control); changes in interest rates (both generally and more specifically mortgage interest rates); material unforeseen changes in the liquidity, results of operations, or financial condition of the Company's customers; and other risks detailed in the Company's filings with the Securities and Exchange Commission, all of which are difficult to predict and many of which are beyond the control of the Company. The Company undertakes no obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Summary Kentucky Bancshares, Inc. recorded net income of $4.3 million, or $1.60 basic and $1.59 diluted earnings per share for the first nine months ended September 30, 2005 compared to $4.2 million, or $1.50 basic earnings per share and $1.49 diluted earnings per share for the nine month period ending September 30, 2004. The first nine months earnings reflects an increase of 2.7% compared to the same time period in 2004. The earnings for the three months ended September 30, 2005 were $1.4 million compared to $1.6 million for the same time period in 2004. The basic and diluted earnings per share were both $0.54 for the three months ended September 30, 2005 and $0.58 basic and $0.57 diluted for the three months ended September 30, 2004. Return on average assets was 1.08% for the nine months ended September 30, 2005 and 1.08% for the nine month period ended September 30, 2004. Return on average equity was 12.5% for the nine month period ended September 30, 2005 and 12.0% for the same period in 2004. Return on average assets was 1.05% for the three months ended September 30, 2005 and 1.27% for the three month period ended September 30, 2004. Return on average equity was 12.3% for the three month period ended September 30, 2005 and 14.1% for the same period in 2004. Loans increased $1.2 million from $358.3 million on December 31, 2004 to $359.5 million on September 30, 2005. Increases in commercial, real estate mortgage and agricultural loans were offset by a decrease in real estate construction and consumer loans. Management attributes the growth in loans primarily to the improving economy, offset recently by the continuing rising interest rates and competitive pressure Total deposits increased from $388.0 million on December 31, 2004 to $414.8 million on September 30, 2005, an increase of $26.8 million, primarily the result of the addition of public fund deposits, reported in other interest bearing deposits. Net Interest Income Net interest income was $12.9 million for the nine months ended September 30, 2005 compared to $12.6 million for the nine months ended September 30, 2004, an increase of 2.1%. The interest spread was 3.38% for the first nine months of 2005 compared to 3.41% for the same period in 2004, a decrease of 3 basis points. For the three months ended September 30, 2005, the net interest income was $4.2 million compared to $4.2 million for the same time period in 2004. The interest spread was 3.20% for the three month period ended September 30, 2005 compared to 3.47% for the same period in 2004, a decrease of 27 basis points. Generally, the increasing interest rate environment, increased cost of public fund deposits and stronger competitive rates have contributed to declining net interest margins in the first nine months of 2005 compared to 2004, and more specifically to the recent quarter. For the first nine months, the yield on assets increased from 5.31% in 2004 to 5.67% in 2005. The cost of liabilities increased from 1.91% in 2004 to 2.28% in 2005. Year to date average loans are up $35.9 million, or 11.0% from September 30, 2004 to September 30, 2005. Loan interest income has increased $2.2 million for the first nine months of 2005 compared to the first nine months of 2004. Year to date average deposits increased from September 30, 2004 to September 30, 2005, up $6.8 million, or 1.8%. Deposit interest expense has increased $1.3 million for the first nine months of 2005 compared to the same period in 2004. During the first quarter of 2004, the Company determined that it was in its best interest to purchase additional investment securities. The Company implemented leverage strategies amounting to $30 million. Investments were purchased and funded by repurchase agreements and Federal Home Loan Bank advances. These strategies have added $134 thousand to net income before taxes for the first nine months of 2005, and $337 thousand for the first nine months of 2004. Following the 2004 enactment of federal legislation to end the federal tobacco program and to compensate quota owners and producers, the Company began to offer tobacco quota owners and producers upfront, lump-sum payment buyouts ranging from 75% to 80% of the future stream of federal buyout payments. The Company anticipates making approximately $10 million in lump-sum payments beginning in January 2006 under successor in interest contracts. This program will generate additional net interest income starting in January 2006. Non-Interest Income Non-interest income decreased $41 thousand for the nine months ended September 30, 2005 compared to the same period in 2004 to $5.1 million, due primarily to a decrease in securities net gains of $176 thousand. This is offset by the increase in trust department income from the collection of certain estate fees and the net gains on sale of premises of $71 thousand. A decrease of $47 thousand in service charges from the first nine months of 2004 to the comparable 2005 period is mainly attributable to a decrease in checking overdraft charges of $37 thousand. The $91 thousand decrease in non-interest income for the three months ended September 30, 2005 compared to the same period in 2004 is mainly attributable to the decrease in securities net gains of $153 thousand. Gain on sale of mortgage loans decreased $30 thousand during the first nine months of 2005 compared to the same period in 2004. For the three month period ended September 30, 2005, gain on sale of mortgage loans decreased $21 thousand compared to the same period in 2004. The volume of mortgage loan originations and sales is generally inverse to rate changes. The significant decrease in refinancing activity, along with the stable long term interest rates, have caused the originations of mortgage loans to be lower and the related gain on sale of mortgage loans to be lower in 2005 than in 2004. Non-Interest Expense Total non-interest expenses increased $286 thousand for the nine month period ended September 30, 2005 compared to the same period in 2004. For the three month period ended September 30, 2005, total non-interest expenses increased $169 thousand compared to the same three month period in 2004. For the comparable nine month periods, salaries and benefits increased $319 thousand, an increase of 5%. Salaries represented $143 thousand, incentives represented $71 thousand and employee benefits represented $105 thousand of the increase in salaries and employee benefits expense during these comparable periods. Salaries and employee benefits increased $120 thousand for the three month period ended September 30, 2005 compared to the same period in 2004. The reduction of part time hours and the salary reduction of the current Chairman, who was the previous President and CEO, helped limit the base salaries increase for the nine months ended September 30, 2005 to 3% when compared to 2004. Occupancy expenses decreased $18 thousand to $1.7 million for the first nine months of 2005 compared to the same period in 2004. The decrease in 2005 is mainly attributable to a decrease in depreciation of $52 thousand compared to 2004, offset by an increase of $57 thousand in repairs and maintenance on buildings and equipment, including computers. Occupancy expenses decreased $9 thousand for the three month period ended September 30, 2005 compared to the same period in 2004. Amortization decreased for the first nine months of 2005 compared to 2004 by $174 thousand, and decreased $51 thousand for the three month period ended September 30, 2005 compared to the same period in 2004, mainly from the deposit premium from a previous acquisition being fully amortized in 2004. Other expenses increased $89 thousand for the nine months ended September 30, 2005 compared to the same time period in 2004. The increase in losses on foreclosed property of $106 thousand is offset primarily from the decrease in repossession expenses of $47 thousand. Other expenses increased $87 thousand for the three months ended September 30, 2005 compared to the same time period in 2004. Income Taxes The tax equivalent rate for the nine months ended September 30, 2005 was 26% compared to 28% in 2004. The tax equivalent rate for the three months ended September 30, 2005 was 27% compared to 29% in 2004. These rates are less than the statutory rate as a result of the tax-free securities and loans held by the Company. Recognizing the remainder of the net operating loss carryforward from the 2003 Cynthiana acquisition also contributed to the lower rate in 2005. Stock Repurchase Program On October 25, 2000, the Company announced that its Board of Directors approved a stock repurchase program. The Company is authorized to purchase up to 100,000 shares of its outstanding common stock. On November 11, 2002, the Board of Directors approved and authorized the Company's repurchase of an additional 100,000 shares. In August 2004, the Board of Directors approved and the Company repurchased 122,302 shares from a third-party shareholder. These shares were outside of the previously mentioned stock repurchase programs. Shares will be purchased from time to time in the open market depending on market prices and other considerations. Through September 30, 2005, 98,909 shares have been purchased. An additional 6,400 shares were purchased in October, with the most recent share repurchase having occurred on October 31, 2005. The repurchase program has had a positive effect on earnings per share calculations. Liquidity and Funding Liquidity risk is the possibility that the Company may not be able to meet its cash requirements. Management of liquidity risk includes maintenance of adequate cash and sources of cash to fund operations and meeting the needs of borrowers, depositors and creditors. Excess liquidity has a negative impact on earnings as a result of the lower yields on short-term assets. Cash and cash equivalents were $33.1 million as of September 30, 2005 compared to $15.5 million at December 31, 2004. The increase in cash and cash equivalents is mainly attributable to an increase in federal funds sold resulting primarily from a short term increase in public deposits. In addition to cash and cash equivalents, the securities portfolio provides an important source of liquidity. Total securities available for sale totaled $133.9 million at September 30, 2005. The available for sale securities are available to meet liquidity needs on a continuing basis. The Company expects the customers' deposits to be adequate to meet its funding demands. Generally, the Company relies upon net cash inflows from financing activities, supplemented by net cash inflows from operating activities, to provide cash used in its investing activities. As is typical of many financial institutions, significant financing activities include deposit gathering, and the use of short-term borrowings, such as federal funds purchased and securities sold under repurchase agreements along with long-term debt. The Company's primary investing activities include purchasing investment securities and loan originations. Management is aware of the challenge of funding sustained loan growth. Therefore, in addition to deposits, other sources of funds, such as Federal Home Loan Bank (FHLB) advances, may be used. The Company relies on FHLB advances for both liquidity and asset/liability management purposes. These advances are used primarily to fund long-term fixed rate residential mortgage loans. As of September 30, 2005, we have sufficient collateral to borrow an additional $23 million from the FHLB. In addition, as of September 30, 2005, over $53 million is available in overnight borrowing through various correspondent banks. In light of this, management believes there is sufficient liquidity to meet all reasonable borrower, depositor and creditor needs in the present economic environment. Non-Performing Assets As of September 30, 2005, the Company's non-performing loans totaled $1.3 million or 0.37% of loans compared to $2.1 million or 0.58% of loans at December 31, 2004. (See table below) The decreases in non-accrual loans and in accruing loans past due 90 days or more are attributable to overall improvement in loan quality. Real estate loans composed 83% of the non- performing loans as of September 30, 2005 and 84% as of December 31, 2004. Forgone interest income on the non-accrual loans for both 2005 and 2004 is immaterial. Nonperforming Assets 9/30/05 12/31/04 (in thousands) Non-accrual Loans $ 1,202 $ 1,781 Accruing Loans which are Contractually past due 90 days or more 114 308 Total Nonperforming and Restructured 1,316 2,089 Other Real Estate 368 676 Total Nonperforming and Restructured Loans and Other Real Estate $ 1,684 $ 2,765 Nonperforming and Restructured Loans as a Percentage of Loans 0.37% 0.58% Nonperforming and Restructured Loans and Other Real Estate as a Percentage of Total Assets 0.30% 0.52% Provision for Loan Losses The loan loss provision for the first nine months was $583 thousand for 2005 and $620 thousand for 2004. The loan loss provision for the three months ended September 30, 2005 was $167 thousand and $170 thousand for the same time period in 2004. The decrease in nonperforming loans has caused management to decrease the 2005 provision in order to maintain an allowance for loan losses that is representative of the risk of loss based on the quality of loans currently in the portfolio. 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. Net charge-offs for the nine month period ended September 30, 2005 were $236 thousand compared to $179 thousand for the same period in 2004. Net charge-offs for the three month period ended September 30, 2005 were $88 thousand compared to $2 thousand for the same period in 2004. Future levels of charge-offs will be determined by the particular facts and circumstances surrounding individual loans. Management believes the current loan loss reserve is sufficient to meet probable incurred loan losses. Loan Losses Nine Months Ended September 30 (in thousands) 2005 2004 Balance at Beginning of Period $ 4,163 $ 3,820 Amounts Charged-off: Commercial 77 50 Real Estate Mortgage 96 26 Agricultural - 88 Consumer 180 179 Total Charged-off Loans 353 343 Recoveries on Amounts Previously Charged-off: Commercial 3 9 Real Estate Mortgage 7 38 Agricultural 1 21 Consumer 106 96 Total Recoveries 117 164 Net Charge-offs 236 179 Provision for Loan Losses 583 620 Balance at End of Period 4,510 4,261 Loans Average 362,029 326,162 At September 30 359,524 351,578 As a Percentage of Average Loans: Net Charge-offs 0.07% 0.05% Provision for Loan Losses 0.16% 0.19% Allowance as a Percentage of Period-end Loans 1.25% 1.21% Allowance as a Multiple of Net Charge-offs 14.3 17.9 Allowance as a Percentage of Non-performing and Restructured Loans 343% 179% Loan Losses Quarter Ended September 30 (in thousands) 2005 2004 Balance at Beginning of Period $ 4,431 $ 4,093 Amounts Charged-off: Commercial 15 5 Real Estate Mortgage 23 7 Agricultural - 5 Consumer 97 30 Total Charged-off Loans 135 47 Recoveries on Amounts Previously Charged-off: Commercial 1 3 Real Estate Mortgage 5 1 Agricultural 1 16 Consumer 40 25 Total Recoveries 47 45 Net Charge-offs 88 2 Provision for Loan Losses 167 170 Balance at End of Period 4,510 4,261 Loans Average 363,999 343,292 At September 30 359,524 351,578 As a Percentage of Average Loans: Net Charge-offs 0.02% 0.00% Provision for Loan Losses 0.05% 0.05% Allowance as a Multiple of Net Charge-offs 12.8 532.6 Item 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Asset/Liability management control is designed to ensure safety and soundness, maintain liquidity and regulatory capital standards, and achieve acceptable net interest income. Management considers interest rate risk to be the most significant market risk. The Company's exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximize income. Management realizes certain risks are inherent and that the goal is to identify and minimize the risks. The primary tool used by management is an interest rate shock simulation model. The Bank has no market risk sensitive instruments held for trading purposes. The following table depicts the change in net interest income resulting from 100 and 300 basis point changes in rates on the Company's interest earning assets and interest bearing liabilities. The projections are based on balance sheet growth assumptions and repricing opportunities for new, maturing and adjustable rate amounts. As of September 30, 2005 the projected percentage changes are within the Board approved limits, except for the "-100" and "- 300". In the "- 300" scenario, most of the rates used in the model cannot decline 300 basis points because of the current level of rates. The Company is also slightly outside the Board approved limit in the "-100" environment. In these scenarios, the net interest income changes are outside the Board approved limit for such net interest income changes, and are monitored by and reported to the Board on a monthly basis. This period's volatility is comparable to the same period a year ago. The projected net interest income report summarizing the Company's interest rate sensitivity as of September 30, 2005 is as follows: (dollars in thousands) PROJECTED NET INTEREST INCOME Level Change in basis points: - 300 - 100 Rates + 100 + 300 Year One (10/05 - 9/06) Interest Income $25,295 $29,367 $31,404 $33,378 $37,171 Interest Expense 10,116 12,103 13,260 14,416 16,730 Net Interest Income 15,179 17,264 18,144 18,962 20,441 PROJECTED DOLLAR INCREASE (DECREASE) FROM "LEVEL RATES" Year One (10/05 - 9/06) Interest Income $(6,109) $(2,037) N/A $ 1,974 $ 5,767 Interest Expense (3,144) (1,157) N/A 1,156 3,470 Net Interest Income (2,965) (880) N/A 818 2,297 PROJECTED PERCENTAGE INCREASE (DECREASE) FROM "LEVEL RATES" Year One (10/05 - 9/06) Interest Income -19.5% -6.5% N/A 6.3% 18.4% Interest Expense -23.7% -8.7% N/A 8.7% 26.2% Net Interest Income -16.3% -4.9% N/A 4.5% 12.7% Net Interest Income Board approved limit >-10.0% >-4.0% N/A >-4.0% >-10.0% The projected net interest income report summarizing the Company's interest rate sensitivity as of September 30, 2004 is as follows: (dollars in thousands) PROJECTED NET INTEREST INCOME Level Change in basis points: - 300 - 100 Rates + 100 + 300 Year One (10/04 - 9/05) Interest Income $ 21,112 $ 24,691 $ 26,519 $ 28,306 $ 31,731 Interest Expense 7,789 8,371 9,471 10,571 12,770 Net Interest Income 13,323 16,320 17,048 17,735 18,961 PROJECTED DOLLAR INCREASE (DECREASE) FROM "LEVEL RATES" Year One (10/04 - 9/05) Interest Income $ (5,407) $ (1,828) N/A $ 1,787 $ 5,212 Interest Expense (1,682) (1,100) N/A 1,100 3,299 Net Interest Income (3,725) (728) N/A 687 1,913 PROJECTED PERCENTAGE INCREASE (DECREASE) FROM "LEVEL RATES" Year One (10/04 - 9/05) Interest Income -20.4% -6.9% N/A 6.7% 19.7% Interest Expense -17.8% -11.6% N/A 11.6% 34.8% Net Interest Income -21.8% -4.3% N/A 4.0% 11.2% Net Interest Income Board approved limit >-10.0% >-4.0% N/A >-4.0% >-10.0% These projected changes in net interest income as of September 30, 2005 are slightly more when compared to the projected changes in net interest income as of September 30, 2004. Projections from September 30, 2005, year one reflected a decline in net interest income of 4.9% with a 100 basis point decline compared to the 4.3% decline in 2004. The 300 basis point increase in rates reflected a 12.7% increase in net interest income in 2005 compared to 11.2% in 2004. Item 4 - CONTROLS AND PROCEDURES As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on the foregoing, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the reports the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required. The Company also conducted an evaluation of internal control over financial reporting to determine whether any changes occurred during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. Based on this evaluation, there has been no such change during the quarter covered by this report. Part II - Other Information Item 1. Legal Proceedings The Company is not a party to any material legal proceedings. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds ISSUER PURCHASES OF EQUITY SECURITIES Period (a) Total (b) (c) Total Number (d) Maximum Number Number of Average of Shares (or Units) (or Approximate Dollar Shares (or Price Paid Purchased as Part Value) of Shares (or Units) Per Share of Publicly Units) that May Yet Be Purchased (or Unit) Announced Plans Purchased Under the Or Programs Plans of Programs 7/1/05 - 7/31/05 9,367 $30.06 9,367 101,091 shares 8/1/05 - 8/31/05 -0- N/A N/A 101,091 shares 9/1/05 - 9/30/05 -0- N/A N/A 101,091 shares Total 9,367 9,367 101,091 shares On October 25, 2000, the Company announced that its Board of Directors approved a stock repurchase program. The Company is authorized to purchase up to 100,000 shares of its outstanding common stock. On November 11, 2002, the Board of Directors approved and authorized the Company's repurchase of an additional 100,000 shares. In August 2004, the Board of Directors approved and the Company repurchased 122,302 shares from a third-party shareholder at a price of $28 per share. These shares were outside of the previously mentioned stock repurchase programs. Shares will be purchased from time to time in the open market depending on market prices and other considerations. Through September 30, 2005, 98,909 shares have been purchased. Item 3. Defaults upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits 31.1 Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32 Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. KENTUCKY BANCSHARES, INC. Date ____11/14/05________ __/s/Louis Prichard______________ Louis Prichard, President and C.E.O. Date ____11/14/05________ __/s/Gregory J. Dawson___________ Gregory J. Dawson, Chief Financial Officer 2 3 21 Lexlibrary/197885.1