EX-13 4 exhibit13annualrpt.txt ANNUAL REPORT Exhibit 13 KENTUCKY BANCSHARES, INC. ANNUAL REPORT 2005 Kentucky Bank's Vision Kentucky Bank will be the premier community financial institution in our markets. Kentucky Bank will create value for our shareholders by increasing our assets to $800 million while maintaining a focus on the growth of our earnings per share. We will focus on adding new customers through the sales efforts of our staff, a strong program to increase referrals from a variety of sources and expansion into additional high-valued markets. We will be opportunistic regarding acquisitions while maintaining our focus on earnings. Our customers will bank with us because we will provide consistent customer service at the highest level. We will maintain our practice of providing cutting-edge products and services for our customer. Because of our focus on customer service, we will experience high customer loyalty and above average retention. Our employees will be a part of a single Kentucky Bank team. We will hire and retain key talent in our marketplaces. We will recognize and reward success at all levels of the organization. We will win as one team. Communities Our slogan "Call it Home" reflects our dedication to the communities we serve. Collectively, the communities we call home have a population of over 175,000. Kentucky Bancshares' strategy has been to locate itself within the growth circle around Central Kentucky. This strategy has provided us with very steady increases in market share. Our vision is to "focus on adding new customers through the sales efforts of our staff, a strong program to increase referrals from a variety of sources and expansion into additional high-valued markets." One such opportunity, taking place in 2006, is a merger that will allow us to serve Rowan and Elliott counties with their combined populations totaling over 30,000. Products Kentucky Bank has always been progressive in developing and offering financial products to our clients. This tradition has been an integral part of our culture. Our vision directs us to "maintain our practice of providing cutting edge products and services for our customers." To help Kentucky Bank remain involved in the emergent face of Central Kentucky, we have developed a Commercial Lending group. They have been successful in providing the capital needed for many larger projects within the communities we serve. Our Wealth Management group continues to make strides in building their investment options and client base. We actively seek innovative solutions for our consumer clients, particularly for the low income housing market. Service This is the third year we have conducted "mystery shops" to measure branches on their level of customer service. This research is sent to managers with feedback identifying areas of improvement and successes. Our goal has been to raise the level of service to our vision of "providing consistent customer service at the highest level. Because of our focus on customer service, we will experience high levels of customer loyalty and above average retention." We are seeing success in realizing this vision. Technology Security is one of our highest priorities. Identity fraud, as well as many other types of intrusions into security, are an increasing consumer concern. Kentucky Bank's security measures are constantly tested and upgraded to face new challenges. Our dedication to technology and customer service allows us to offer the best of convenience and personal attention. Spirit We understand that in order for the bank to be strong, our communities need to be strong. Throughout the year we are involved in many organizations within our communities. We offer support through the involvement of Kentucky Bank employees and financial support for hundreds of charitable and community organizations including schools, YMCAs, Chambers of Commerce, local colleges, hospitals, local sports teams, and a little bit of everything in between. There are even times that we reach out beyond our border to help others. The spirit of our employees was especially evident this year when Kentucky Bank employees donated over $10,000 personally to the Katrina emergency efforts. We recognize that for our employees to help us succeed we need to help them succeed. We are all part of a single Kentucky Bank team. Our commitment and vision includes "hiring and retaining key talent in our marketplaces. We will recognize and reward success at all levels of the organization. We will win as one team." Dear Shareholder: For the year ended December 31, 2005, the assets of your company reached a record $572.7 million, which represents an 8.4% increase over last year's total assets of $528.5 million. Loans increased 3.5% to $370.9 million, also a new, year-end high. Deposits grew 11.3% for the year to a record high of $431.6 million. Much of that growth was fueled by a significant increase in depository relationships with many public entities throughout our markets. Earnings per share, on a diluted basis, were up 4.3% over the year ended December 31, 2004. Net income reached $5.8 million, which represented a 1.0% increase over the prior year-end. Net interest income was negatively impacted throughout the year by the competitive pressures on our short term deposit rates. With an anticipated slow down of the continued increase of short term rates, and our budgeted loan growth, we should see improvement in our 2006 net interest margins. A noteworthy event concluded in 2005, that should contribute to the financial success of your company, is the purchase of $14.9 million of tobacco settlement payments which we were able to acquire for $11.7 million. We were able to conclude these purchases in such a manner as to have a positive impact on our bottom line in the upcoming years. We do expect to continue the purchase of more of these payments, but not at the levels that we encountered in 2005. An extremely significant transaction that should be completed in 2006 is the merger and acquisition of Peoples Bancorp, Inc. of Sandy Hook and Morehead with Kentucky Bancshares, Inc. At year-end 2005, Peoples Bank had approximately $87 million in assets, with one office each in Elliott and Rowan Counties. The consideration of this transaction is $14 million, with 40% in the form of Kentucky Bancshares stock, and 60% in the form of cash. Our analysis indicates that this transaction should be accretive to earnings very quickly. This acquisition is somewhat different than prior mergers in that Morehead and Rowan County are one hour east of Paris. Our prior acquisitions and mergers have taken place in the counties that have surrounded Lexington and Fayette County. However, the community of Morehead has had very steady growth, the Peoples Bank itself has been growing significantly in its market share, and it has been a very profitable institution throughout its history. The management and board felt that this endeavor was an excellent opportunity for enhancing shareholder value. As we look strategically to the future, Kentucky Bank will continue to look for opportunities to enlarge our banking circle around Bourbon and Fayette Counties. B. Proctor Caudill, Jr. who is the Chairman and CEO of the Peoples Bank holding company, will become a significant shareholder in Kentucky Bancshares. Additionally, he will come to work for us with somewhat reduced responsibilities, and we anticipate his being on the bank and holding company boards of directors. We are very pleased about this affiliation as we anticipate that he will be able to make a significant contribution to the future success of your company. We are extremely excited about this impending acquisition, and our financial analysis of this transaction leads us to believe that, as a shareholder, you will be pleased as well. Sincerely, Sincerely, /s/Louis Prichard /s/Buck Woodford Louis Prichard Buck Woodford President and Chief Executive Officer Chairman of the Board Kentucky Bancshares, Inc. Kentucky Bancshares, Inc. Financial Highlights... Kentucky Bancshares, Inc. 2005 2004 2003 Assets ($ thousands) $ 572,750 $ 528,544 $ 500,852 Net Income ($ thousands) $ 5,820 $ 5,762 $ 4,233 Per Share Results... Earnings (assuming dilution) $ 2.16 $ 2.07 $ 1.50 Dividend $ .92 $ .84 $ .76 Annual Meeting The annual meeting of Kentucky Bancshares, Inc. will be held Friday, May 12, 2006 at 11:00 in the corporate headquarters. Investor Information Any individual requesting a copy of the Corporation's 2005 Form 10-K Report may obtain these by visiting our website at www.kybank.com or writing to Investor Relations at the Corporate Headquarters. 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 800-800-4693 Morgan Keegan & Company 489 E. Main Street Lexington, Kentucky 40507 800-937-0161 CONSOLIDATED BALANCE SHEETS December 31 2005 2004 ASSETS Cash and due from banks $ 11,456,496 $ 12,248,975 Federal funds sold 2,708,000 3,206,000 Cash and cash equivalents 14,164,496 15,454,975 Securities available for sale 160,652,346 126,766,861 Mortgage loans held for sale - 175,471 Loans 370,911,882 358,281,554 Allowance for loan losses (4,309,403) (4,163,315) Net loans 366,602,479 354,118,239 Federal Home Loan Bank stock 5,398,100 5,136,500 Bank premises and equipment, net 10,701,541 11,378,012 Interest receivable 3,719,135 3,226,479 Mortgage servicing rights 801,501 875,633 Goodwill 9,110,524 9,110,524 Other intangible assets 765,885 861,621 Other assets 834,288 1,439,331 Total assets $ 572,750,295 $ 528,543,646 LIABILITIES AND STOCKHOLDERS' EQUITY Deposits Non-interest bearing $ 72,192,661 $ 74,048,291 Time deposits, $100,000 and over 61,597,420 59,468,813 Other interest bearing 297,841,297 254,437,718 Total deposits 431,631,378 387,954,822 Repurchase agreements and other borrowings 16,837,573 25,592,844 Federal Home Loan Bank advances 66,748,641 59,749,666 Subordinated debentures 7,217,000 7,217,000 Interest payable 2,714,506 1,849,468 Other liabilities 1,054,954 1,153,035 Total liabilities 526,204,052 483,516,835 Stockholders' equity Preferred stock, 300,000 shares authorized and unissued - - Common stock, no par value; 10,000,000 shares authorized; 2,666,897 and 2,684,498 shares issued and outstanding in 2005 and 2004 6,812,805 6,818,664 Retained earnings 40,666,332 37,884,215 Accumulated other comprehensive income (loss) (932,894) 323,932 Total stockholders' equity 46,546,243 45,026,811 Total liabilities and stockholders' equity $ 572,750,295 $ 528,543,646 See Accompanying notes. CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31 2005 2004 2003 Interest income Loans, including fees $ 23,373,434 $ 20,470,306 $ 18,574,690 Securities Taxable 3,388,793 3,574,235 2,049,835 Tax exempt 1,444,090 1,518,275 1,430,589 Other 690,660 283,196 274,003 28,896,977 25,846,012 22,329,117 Interest expense Deposits 8,180,571 5,765,690 5,310,791 Repurchase agreements and other borrowings 603,812 411,492 27,460 Federal Home Loan Bank advances 2,487,062 2,395,898 2,293,297 Subordinated debentures 494,227 494,052 169,000 Other - - 75,000 11,765,672 9,067,132 7,875,548 Net interest income 17,131,305 16,778,880 14,453,569 Provision for loan losses 508,100 840,000 1,300,000 Net interest income after provision for loan losses 16,623,205 15,938,880 13,153,569 Other income Service charges 4,511,270 4,357,658 4,065,210 Loan service fee income 262,629 246,356 242,479 Trust department income 458,328 299,448 301,612 Securities gains (losses), net 64,395 288,950 139,438 Gain on sale of mortgage loans 333,742 376,157 853,340 Other 1,118,289 1,227,614 1,105,534 6,748,653 6,796,183 6,707,613 Other expenses Salaries and employee benefits 8,547,607 8,053,306 7,373,501 Occupancy expenses 2,194,431 2,255,071 2,044,515 Amortization 349,342 524,839 516,390 Advertising and marketing 473,848 378,410 399,483 Taxes other than payroll, property and income 547,509 499,251 439,084 Other 3,361,280 3,044,294 3,398,292 15,474,017 14,755,171 14,171,265 Income before income taxes 7,897,841 7,979,892 5,689,917 Provision for income taxes 2,077,741 2,217,783 1,456,540 Net income $ 5,820,100 $ 5,762,109 $ 4,233,377 Earnings per share: Basic $ 2.17 $ 2.09 $ 1.52 Diluted 2.16 2.07 1.50 See Accompanying notes. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Years Ended December 31 2005 2004 2003 Net income $ 5,820,100 $ 5,762,109 $ 4,233,377 Other comprehensive income (loss) Unrealized gains (losses) on securities arising during the period (1,839,887) (1,522,118) (360,141) Reclassification of realized amount (64,395) (288,950) (139,438) Net change in unrealized gain (loss) on securities (1,904,282) (1,811,068) (499,579) Less: Tax impact (647,456) (615,763) (169,857) Comprehensive income $ 4,563,274 $ 4,566,804 $ 3,903,655 See Accompanying notes. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY Years Ended December 31, 2005, 2004 and 2003
Accumulated Other Total Common Stock Retained Comprehensive Stockholders' Shares Amount Earnings Income Equity Balances, January 1, 2003 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 Common stock issued (including employee gifts of 75 shares) 3,375 47,595 - - 47,595 Common stock purchased (20,976) (53,454) (575,945) - (629,399) Net change in unrealized gain (loss) on securities available for sale, net of tax - - - (1,256,826) (1,256,826) Net income - - 5,820,100 - 5,820,100 Dividends declared - $.92 per share - - (2,462,038) - (2,462,038) Balances, December 31, 2005 2,666,897 $ 6,812,805 $ 40,666,332 $ (932,894) $ 46,546,243
See Accompanying notes. CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31
2005 2004 2003 Cash flows from operating activities Net income $ 5,820,100 $ 5,762,109 $ 4,233,377 Adjustments to reconcile net income to net cash from operating activities Depreciation and amortization 1,174,954 1,419,794 1,460,429 Provision for loan losses 508,100 840,000 1,300,000 Securities amortization (accretion), net 331,355 635,725 703,502 Securities (gains) losses, net (64,395) (288,950) (139,438) Originations of loans held for sale (18,036,701) (22,065,215) (42,872,837) Proceeds from sale of loans 18,545,914 30,024,484 36,707,617 Gain on sale of mortgage loans (333,742) (376,157) (853,340) Federal Home Loan Bank stock dividends (261,600) (206,400) (170,800) Losses (gain) on sale of fixed assets (71,045) (16,722) 161,849 Changes in: Interest receivable (492,656) 23,355 360,511 Other assets 425,569 1,135,547 451,918 Interest payable 865,038 213,684 (306,069) Other liabilities 624,374 942,501 (1,390,747) Net cash from operating activities 9,035,265 18,043,755 (354,028) Cash flows from investing activities Purchases of securities available for sale (53,539,693) (70,689,970) (65,248,350) Proceeds from sales of securities available for sale 1,323,500 37,973,553 8,434,570 Proceeds from principal payments and maturities of securities available for sale 16,159,467 32,581,271 39,625,276 Cash paid for bank acquisition - - (7,000,205) Net change in loans (13,067,340) (45,775,823) 1,481,580 Purchases of bank premises and equipment (758,929) (948,546) (1,632,487) Proceeds from sale of bank premises and Equipment 581,881 199,722 - Net cash from investing activities (49,301,114) (46,659,793) (24,339,616) Cash flows from financing activities Net change in deposits 43,676,556 3,356,226 8,662,228 Net change in repurchase agreements and other borrowings (8,755,271) 18,307,586 2,008,563 Proceeds from subordinated debentures - - 7,000,000 Advances from Federal Home Loan Bank 15,000,000 25,000,000 12,000,000 Payments on Federal Home Loan Bank advances (7,902,073) (18,383,678) (10,827,273) Proceeds from issuance of common stock 47,595 131,041 188,697 Purchase of common stock (629,399) (3,424,456) (10,800) Dividends paid (2,462,038) (2,303,219) (2,116,753) Net cash from financing activities 38,975,370 22,683,500 16,904,662 See Accompanying notes. CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31 2005 2004 2003 Net change in cash and cash equivalents $ (1,290,479) $ (5,932,538) $ (7,788,982) Cash and cash equivalents at beginning of year 15,454,975 21,387,513 29,176,495 Cash and cash equivalents at end of year $ 14,164,496 $ 15,454,975 $ 21,387,513 Supplemental disclosures of cash flow information Cash paid during the year for: Interest expense $ 10,900,634 $ 8,853,448 $ 8,084,469 Income taxes 1,971,443 777,401 1,637,706 Supplemental schedules of non-cash investing activities Real estate acquired through foreclosure $ 391,743 $ 1,325,942 $ 349,748
See Accompanying notes. 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. 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 one of 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. Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments, except for mortgage backed securities where prepayments are anticipated. 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 certain residential mortgage loans to the Federal Home Loan Mortgage Corporation (FHLMC) while retaining the servicing rights. Gains and losses on sales of mortgage loans are based on the difference between the selling price and the carrying value of the related loan sold. 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 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 (FHLB) Stock: The Bank is a member of the FHLB system. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income. Bank Premises and Equipment: Land is carried at cost. Bank premises and equipment are stated at cost less accumulated depreciation. Buildings and related components are depreciated using the straight-line method with useful lives ranging from 5 to 50 years. Furniture, fixtures and equipment are depreciated using the straight-line (or accelerated) method with useful lives ranging from 3 to 10. 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. 2005 2004 2003 Net income As reported $ 5,820,100 $ 5,762,109 $ 4,233,377 Deduct: Stock-based compensation expense determined under fair value based method (56,241) (42,178) (48,317) Pro forma 5,763,859 5,719,931 4,185,060 2005 2004 2003 Basic earnings per share As reported $ 2.17 $ 2.09 $ 1.52 Pro forma 2.15 2.07 1.50 Diluted earnings per share As reported $ 2.16 $ 2.07 $ 1.50 Pro forma 2.14 2.06 1.48 Weighted averages Fair value of options granted $ 4.82 $ 5.68 $ 4.14 Risk free interest rate 3.98% 3.86% 3.40% Expected life 8 years 8 years 8 years Expected volatility 15.11% 13.74% 16.90% Expected dividend yield 3.03% 2.47% 2.96% 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. Retirement Plans: Pension expense is the net of service and interest cost, return on plan assets and amortization of gains and losses not immediately recognized. Employee 401(k) and profit sharing plan expense is the amount of matching contributions. 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. 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, 2005 and 2004. Effect of Newly Issued But Not Yet Effective Accounting Standards: FAS 123, Revised, requires companies to record compensation cost for stock options provided to employees in return for employment service. The cost is measured at the fair value of the options when granted, and this cost is expensed over the employment service period, which is normally the vesting period of the options. This will apply to awards granted or modified in fiscal years beginning in 2006. Compensation cost will also be recorded for prior option grants that vest after the date of adoption. 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 at such future date, as well as the vesting periods provided, and so cannot currently be predicted. Existing options that will vest after adoption date are expected to result in additional compensation expense of approximately $48,000 in 2006 and $41,000 in 2007. Operating 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, 2005 and 2004 was $156,000 and $144,000. NOTE 3 - SECURITIES Year-end securities available for sale are as follows: Fair Unrealized Unrealized Value Gains Losses 2005 U. S. Treasury $ 2,974,354 $ - $ (32,397) U. S. government agencies 67,032,587 14,427 (825,849) States and municipals 37,462,770 756,298 (337,944) Mortgage-backed 52,340,502 4,150 (1,309,489) Equity securities 842,133 317,329 - Total $ 160,652,346 $ 1,092,204 $(2,505,679) 2004 U. S. Treasury $ 2,984,375 $ - $ (30,033) U. S. government agencies 39,029,910 4,220 (384,112) States and municipals 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) The fair value of securities available for sale at December 31, 2005, 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 $ 29,117,864 Due after one year through five years 41,549,332 Due after five years through ten years 19,861,663 Due after ten years 16,940,852 107,469,711 Mortgage-backed 52,340,502 Equity 842,133 Total $ 160,652,346 Proceeds from sales of securities during 2005, 2004 and 2003 were $1,323,500, $37,973,553 and $8,434,570. Gross gains of $89,943, $483,888 and $157,474 and gross losses of $25,548, $194,938 and $18,036, were realized on those sales, respectively. The tax provision related to these realized gains and losses was $21,894, $98,243 and $47,409, respectively. Securities with an approximate carrying value of $122,961,000 and $103,979,000 at December 31, 2005 and 2004, 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 2005 and 2004 not recognized in income are as follows:
2005 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 $ - $ - $ 2,974,354 $ (32,397) $ 2,974,354 $ (32,397) U.S. Government securities 38,032,999 (289,833) 23,442,038 (536,016) 61,475,037 (825,849) States and municipals 11,774,597 (186,615) 4,210,864 (151,329) 15,985,461 (337,944) Mortgage-backed 17,876,194 (187,827) 32,745,358 (1,121,662) 50,621,552 (1,309,489) Total temporarily impaired $67,683,790 $ (664,275) $63,372,614 $(1,841,404) $131,056,404 $(2,505,679) 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 municipals 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)
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. At December 31, 2005, eight mortgage-backed securities have unrealized losses with aggregate depreciation of 3% from their amortized cost basis. The decline in fair value from these and other securities is largely due to changes in interest rates. As management has the ability to hold debt securities until maturity, or for the foreseeable future, no declines are deemed to be other than temporary. NOTE 4 - LOANS Loans at year-end were as follows: 2005 2004 Commercial $ 27,301,633 $ 19,999,038 Real estate construction 29,822,067 32,256,168 Real estate mortgage 245,138,321 238,475,554 Agricultural 59,327,772 57,497,465 Consumer 8,953,943 9,062,518 Other 368,146 990,811 $ 370,911,882 $ 358,281,554 Activity in the allowance for loan losses was as follows: 2005 2004 2003 Beginning balance $ 4,163,315 $ 3,819,842 $ 3,395,075 Allowance from acquisition - - 362,900 Charge-offs (526,735) (687,798) (1,397,822) Recoveries 164,723 191,271 159,689 Provision for loan losses 508,100 840,000 1,300,000 Ending balance $ 4,309,403 $ 4,163,315 $ 3,819,842 Impaired loans totaled $774,000 and $1,781,000 at December 31, 2005 and 2004. The average recorded investment in impaired loans during 2005, 2004 and 2003 was $1,547,000, $1,444,000 and $1,051,000. The total allowance for loan losses related to these loans was $240,000 and $416,000 at December 31, 2005 and 2004. Interest income on impaired loans of $25,000, $22,000 and $14,000 was recognized for cash payments received in 2005, 2004 and 2003. Nonperforming loans were as follows: 2005 2004 Loans past due over 90 days still on accrual $ 206,000 $ 308,000 Nonaccrual loans 774,000 1,781,000 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 $104,575,000 and $102,024,000 at December 31, 2005 and 2004. Custodial escrow balances maintained in connection with the foregoing loan servicing, and included in demand deposits, were approximately $509,000 and $467,000 at December 31, 2005 and 2004. Changes in mortgage servicing rights were as follows: 2005 2004 2003 Beginning balance $ 875,633 $ 861,120 $ 704,034 Additions 179,474 263,861 381,205 Amortization (253,606) (249,348) (224,119) Ending balance $ 801,501 $ 875,633 $ 861,120 Certain directors and executive officers of the Company and companies in which they have beneficiary ownership were loan customers of the Bank during 2005 and 2004. 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: 2005 Balance, beginning of year $ 4,410,000 New Loans 1,051,000 Effect of changes in composition of Related parties (381,000) Repayments (373,000) Balance, end of year $ 4,707,000 NOTE 5 - PREMISES AND EQUIPMENT Year-end premises and equipment were as follows: 2005 2004 Land and buildings $ 12,560,227 $ 12,804,599 Furniture and equipment 10,200,440 9,732,639 Construction projects 9,500 - 22,770,167 22,537,238 Less accumulated depreciation (12,068,626) (11,159,226) $ 10,701,541 $ 11,378,012 Depreciation expense was $924,564, $993,907 and $960,512 in 2005, 2004, and 2003. NOTE 6 - GOODWILL AND INTANGIBLE ASSETS The change in balance for goodwill during the year is as follows: 2005 2004 Beginning of year $ 9,110,524 $ 10,199,830 Adjustment to goodwill - (1,089,306) End of year $ 9,110,524 $ 9,110,524 Goodwill was reduced in 2004 primarily for unanticipated tax benefits arising after the initial calculation of goodwill from the business combination in 2003. Goodwill will not be amortized but instead evaluated periodically for impairment. Acquired intangible assets were as follows at year-end: 2005 2004 Gross Gross Carrying Accumulated Carrying Accumulated Amount Amortization Amount Amortization Amortized intangible assets: Core deposit intangibles $3,656,403 $2,890,518 $3,656,403 $2,794,782 Aggregate amortization expense was $95,736, $275,490 and $292,271 for 2005, 2004 and 2003. The core deposit from the 1994 Clark County branch acquisition was completely amortized in 2004. Estimated amortization expense for each of the next five years: 2006 $ 95,736 2007 95,736 2008 95,736 2009 95,736 2010 95,736 NOTE 7 - DEPOSITS At December 31, 2005, the scheduled maturities of time deposits are as follows: 2006 $ 149,082,622 2007 38,020,991 2008 3,697,971 2009 1,188,208 2010 960,955 Certain directors and executive officers of the Company and companies in which they have beneficial ownership are deposit customers of the Bank. The amount of these deposits was approximately $1,700,000 and $3,421,000 at December 31, 2005 and 2004. NOTE 8 - REPURCHASE AGREEMENTS Securities sold under agreements to repurchase are secured by U.S. Government securities with a carrying amount of $23,246,420 and $27,275,000 at year-end 2005 and 2004. 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 2005 and 2004 is summarized as follows: 2005 2004 Average daily balance during the year $ 16,014,304 $ 18,398,243 Average interest rate during the year 3.19% 1.90% Maximum month-end balance during the year $ 18,071,544 $ 21,946,746 Weighted average interest rate at year end 3.18% 2.94% NOTE 9 - FEDERAL HOME LOAN BANK ADVANCES At year-end, advances from the Federal Home Loan Bank were as follows: 2005 2004 Maturities February 2005 through March 2030, fixed rates from 1.52% to 3.08% $ 19,802,691 $ 21,644,956 Maturities March 2005 through February 2026, fixed rates from 3.55% to 4.38% 30,781,074 16,846,606 Maturities June 2005 through November 2022, fixed rates from 4.82% to 7.23% 16,164,876 21,258,104 Total $ 66,748,641 $ 59,749,666 Advances are paid either on a monthly basis or at maturity. 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, 2005 are as follows: 2006 $ 13,182,609 2007 9,203,106 2008 11,231,617 2009 15,261,901 2010 7,293,215 Thereafter 10,576,193 $ 66,748,641 NOTE 10 - SUBORDINATED DEBENTURES In August 2003, the Company formed Kentucky Bancshares, Statutory Trust I ("Trust"). The Trust issued $217,000 of common securities to the Company and $7,000,000 of 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: 2005 2004 2003 Current $ 1,969,865 $ 2,063,949 $ 1,166,575 Deferred 107,876 153,834 289,965 $ 2,077,741 $ 2,217,783 $ 1,456,540 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. 2005 2004 Deferred tax assets Allowance for loan losses $ 1,355,432 $ 1,241,615 Unrealized loss on securities 480,581 - Core deposit intangibles 13,753 46,720 Other 121,049 358,420 Deferred tax liabilities Unrealized gain on securities - (166,874) Bank premises and equipment (429,886) (428,414) FHLB stock (1,018,338) (929,394) Mortgage servicing rights (272,510) (297,715) Other (188,099) (301,955) Net deferred tax asset (liability) $ 61,982 $ (477,597) Effective tax rates differ from federal statutory rates applied to financial statement income due to the following: 2005 2004 2003 U. S. federal income tax rate 34.0% 34.0% 34.0% Changes from the statutory rate Tax-exempt investment income (7.3) (7.0) (9.3) Non-deductible interest expense related to carrying tax-exempt investments .8 .6 .8 Other (1.2) .2 .1 26.3% 27.8% 25.6% Federal income tax laws provided the Federal Savings Bank, acquired by the Company in 2003, 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, 2005. 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: 2005 2004 2003 Basic Earnings Per Share Net income $ 5,820,100 $ 5,762,109 $ 4,233,377 Weighted average common shares outstanding 2,676,890 2,757,233 2,781,146 Basic earnings per share $ 2.17 $ 2.09 $ 1.52 Diluted Earnings Per Share Net income $ 5,820,100 $ 4,233,377 $ 5,902,525 Weighted average common shares outstanding 2,676,890 2,781,146 2,770,282 Add dilutive effects of assumed exercise of stock options 14,965 45,640 35,836 Weighted average common and dilutive potential common shares outstanding 2,691,855 2,826,786 2,806,118 Diluted earnings per share $ 2.16 $ 2.07 $ 1.50 Stock options of 31,100 shares common stock from 2005 and 11,350 shares of common stock from 2004 were excluded from 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: 2005 2004 Change in benefit obligation: Beginning benefit obligation $ 5,481,513 $ 4,290,391 Service cost 432,429 369,481 Interest cost 346,223 286,326 Actuarial adjustment 581,964 630,729 Benefits paid (104,770) (95,414) Ending benefit obligation 6,737,359 5,481,513 Change in plan assets, at fair value: Beginning plan assets 4,798,708 4,075,719 Actual return 166,535 541,419 Employer contribution 211,031 276,984 Benefits paid (104,770) (95,414) Ending plan assets 5,071,504 4,798,708 Funded status (1,665,855) (682,805) Unrecognized net actuarial (gain) loss 1,683,609 932,175 Unrecognized prior transition asset (1,113) (1,485) Net pension prepaid benefit $ 16,641 $ 247,885 Amounts recognized in the balance sheet consist of: Prepaid benefit cost $ 16,641 $ 247,885 Accrued benefit cost - - Net amount recognized $ 16,641 $ 247,885 The accumulated benefit obligation for defined benefit pension plans was $4,973,145 and $3,976,697 at year-end 2005 and 2004. Net periodic pension cost include the following components: 2005 2004 2003 Service cost $ 432,429 $ 369,481 $ 314,935 Interest cost 346,223 286,326 265,034 Expected return on plan assets (376,195) (319,050) (265,117) Amortization 39,818 (372) 16,758 Net periodic cost $ 442,275 $ 336,385 $ 331,610 Weighted-average assumptions used to determine net cost 2005 2004 2003 Discount rate on benefit obligation 5.75% 6.00% 7.00% Long-term expected rate of return on plan assets 8.00% 8.00% 8.00% Rate of compensation increase 4.00% 4.00% 5.00% The assumptions described above were determined using various factors. Based on the history of domestic investment experience, the expected long-term rate of return on assets for the income segment is assumed to be 6.0%. The expected long-term return on assets for the growth segment is assumed to be 10.0%. Thus, the assumed rate of return on the total portfolio is 8.0% per year. The rate of compensation increase assumption of 4.0% is based upon historical compensation increases at the Bank. The discount rate assumption of 5.75% is based on the expected movements of interest rates from economic forecasts, Federal Reserve monetary actions and commentary, the expected pace of economic activity, the issuance of new debt to finance significant fiscal policy deficits, and the benchmark Moody's AA rated long term corporate bond rate. The Company's pension plan asset allocation at year-end and expected long-term rate of return by asset category are as follows: Weighted Percentage Percentage Average of Plan of Plan Expected Assets at Assets at Long-Term Year-End Year-End Rate of Return Asset Category 2005 2004 2005 Equity securities 62.3 64.9 10% Debt securities 35.9 34.6 6 Cash 1.8 0.5 4 Total 100.0 100.0 The asset allocation objective for 2005 and thereafter 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. There is no target allocation for cash balances. The Company expects to contribute $204,000 to its pension plan in 2006. The following benefit payments, which reflect expected future service, are expected: Pension Benefits 2006 $ 121,559 2007 160,556 2008 176,305 2009 187,972 2010 241,301 Years 2011-2015 1,527,087 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 $320,670, $309,741 and $271,684 in 2005, 2004 and 2003. 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:
2005 2004 2003 Weighted Weighted Weighted Option Option Option Options Price Options Price Options Price Outstanding, beginning of year 60,564 $23.00 57,560 $20.23 83,114 $16.72 Granted 19,850 30.40 12,250 33.65 14,500 25.72 Expired (50) 26.00 (2,316) 27.03 (3,698) 25.00 Exercised (3,300) 13.23 (6,930) 17.55 (36,356) 13.89 Outstanding, end of year 77,064 $25.32 60,564 $23.00 57,560 $20.23 Exercisable, end of year 42,116 $21.38 38,676 $19.41 36,824 $17.80 Weighted remaining contractual Life 71.1 months 67.0 months 67.9 months
Options outstanding at year-end 2005 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 12,020 18.4 $14.24 12,020 $14.24 From $18.00 to $20.63 per share 13,640 36.1 20.52 13,640 20.52 From $23.50 to $28.00 per share 20,304 75.1 25.37 12,126 25.30 From $30.00 to $30.50 per share 19,850 108.6 30.40 1,200 30.25 From $33.90 to $34.00 per share 11,250 96.3 33.91 3,130 33.94 77,064 42,116
NOTE 15 - STOCK GRANT PLAN On February 15, 2005, the Company's Board of Directors adopted a restricted stock grant plan. Total shares issuable under the plan are 50,000. There was no activity in the plan during 2005. NOTE 16 - 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 2006 the Bank could, without prior approval, declare dividends of approximately $4,928,000 plus any 2006 net profits retained to the date of the dividend declaration. NOTE 17 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The fair values of the Company's financial instruments at December 31, 2005 and 2004 are as follows: 2005 2004 Carrying Carrying Amount Fair Value Amount Fair Value (In Thousands) Financial assets Cash and cash equivalents $ 14,164 $ 14,164 $ 15,455 $ 15,455 Securities 160,652 160,652 126,767 126,767 Mortgage loans held for sale - - 176 178 Loans, net 366,602 362,686 354,118 350,912 FHLB stock 5,398 5,398 5,136 5,136 Interest receivable 3,719 3,719 3,226 3,226 Financial liabilities Deposits $ 431,631 $ 432,560 $ 387,955 $ 390,296 Securities sold under agreements to repurchase and other borrowings 16,838 16,612 25,593 25,467 FHLB advances 66,749 64,937 59,750 59,281 Subordinated debentures 7,217 7,328 7,217 7,354 Interest payable 2,715 2,715 1,849 1,849 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 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: 2005 2004 Unused lines of credit $ 56,354,000 $ 54,785,000 Commitments to make loans 156,000 1,272,000 Letters of credit 183,000 145,000 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 6.125% to 6.25% 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 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, 2005 and 2004, 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 (Dollars in Thoursands) 2004 Consolidated Total Capital (to Risk-Weighted Assets) $ 45,987 13.2% $ 27,855 8% $ 34,819 N/A Tier I Capital (to Risk-Weighted Assets) 41,660 12.0 13,928 4 20,891 N/A Tier I Capital (to Average Assets) 41,660 8.2 20,410 4 25,512 N/A 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 2005 Consolidated Total Capital (to Risk-Weighted Assets) $ 49,130 13.4% $ 29,311 8% $ 36,639 N/A Tier I Capital (to Risk-Weighted Assets) 44,602 12.2 14,656 4 21,984 N/A Tier I Capital (to Average Assets) 44,602 8.0 22,342 4 27,928 N/A Bank Only Total Capital (to Risk-Weighted Assets) $ 47,346 13.0% $ 29,251 8% $ 36,564 10% Tier I Capital (to Risk-Weighted Assets) 42,952 11.8 14,626 4 21,938 6 Tier I Capital (to Average Assets) 42,952 7.7 22,309 4 27,887 5
NOTE 21 - SUBSEQUENT EVENT - BUSINESS COMBINATION On February 24, 2006, the Company announced the signing of a definitive merger agreement with Peoples Bancorp of Sandy Hook, Inc. (Peoples Bancorp). Under the terms of the merger agreement, Peoples Bancorp will merge into the Company and Peoples Bank, a subsidiary of Peoples Bancorp, will merge into the Bank. Peoples Bancorp is a privately held bank holding company with offices in Sandy Hook and Morehead, Kentucky. On December 31, 2005 it had assets, deposits and shareholders equity of $87 million, $68 million and $8.6 million, respectively. As a result of this merger, the Company expects to expand its customer base to enhance deposit fee income, provide an opportunity to market additional products and services to new customers, and reduce operating costs through economies of scale. Subject to regulatory approval, as well as approval of Peoples Bancorp stockholders, under the terms of the definitive agreement, each share of Peoples Bancorp common stock will be converted into consideration, sixty percent of which to be in the form of cash and forty percent of which to be in the form of shares of Kentucky Bancshares common stock. Based on the current market price of Kentucky Bancshares common stock, approximately 190,000 shares of Kentucky Bancshares common stock would be issued to Peoples Bancorp shareholders. The total purchase price will be approximately $14 million. NOTE 22 - PARENT COMPANY FINANCIAL STATEMENTS Condensed Balance Sheets December 31 2005 2004 (In Thousands) ASSETS Cash on deposit with subsidiary $ 1,163 $ 721 Investment in subsidiary 51,699 50,481 Securities available for sale 573 698 Other assets 345 363 Total assets $ 53,780 $ 52,263 LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Subordinated debentures $ 7,217 $ 7,217 Other liabilities 17 19 Stockholders' equity Preferred stock - - Common stock 6,813 6,819 Retained earnings 40,666 37,884 Accumulated other comprehensive income (933) 324 Total liabilities and stockholders' equity $ 53,780 $ 52,263 Condensed Statements of Income and Comprehensive Income Years Ended December 31 2005 2004 2003 (In Thousands) Income Dividends from subsidiary $ 3,750 $ 3,650 $ 13,025 Securities gains (losses), net 60 82 7 Interest income 13 24 20 Total income 3,823 3,756 13,052 Expenses Interest expense 494 494 169 Other expenses 134 157 360 Total expenses 628 651 529 Income before income taxes and equity in undistributed income of subsidiary 3,195 3,105 12,523 Applicable income tax (expense) benefits 178 177 175 Income before equity in undistributed income of subsidiary 3,373 3,282 12,698 Equity in undistributed income of subsidiary 2,447 2,480 (8,465) Net income 5,820 5,762 4,233 Other comprehensive income (loss), net of tax: Unrealized gains (losses) on securities arising during the period (1,215) (1,004) (237) Reclassification of realized amount (42) (191) (92) Net change in unrealized gain (loss) on securities (1,257) (1,195) (329) Comprehensive income $ 4,563 $ 4,567 $ 3,904 Condensed Statements of Cash Flows Years Ended December 31 2005 2004 2003 (In Thousands) Cash flows from operating activities Net income $ 5,820 $ 5,762 $ 4,233 Adjustments to reconcile net income to net cash from operating activities Equity in undistributed earnings of Subsidiary (2,447) (2,480) 8,465 Securities (gains) losses, net (60) (82) (7) Change in other assets 32 659 (553) Change in other liabilities (3) - (10) Net cash from operating activities 3,342 3,859 12,128 Cash flows from investing activities Purchase of securities available for sale - - (82) Proceeds from sales of securities available for sale 143 675 65 Acquisition of Kentucky First Bancorp, Inc. - - (20,998) Net cash from investing activities 143 675 (21,015) Cash flows from financing activities Proceeds from subordinated debentures - - 7,000 Dividends paid (2,462) (2,303) (2,117) Proceeds from issuance of common stock 48 131 189 Purchase of common stock (629) (3,424) (11) Net cash from financing activities (3,043) (5,596) 5,061 Net change in cash 442 (1,062) (3,826) Cash at beginning of year 721 1,783 5,609 Cash at end of year $ 1,163 $ 721 $ 1,783 NOTE 23 - QUARTERLY FINANCIAL DATA (UNAUDITED) Interest Net Interest Net Earnings Per Share Income Income Income Basic Fully Diluted 2005 First quarter $ 6,720 $ 4,221 $ 1,333 $ .50 $ .49 Second quarter 7,033 4,385 1,516 .56 .56 Third quarter 7,321 4,246 1,430 .54 .54 Fourth quarter 7,823 4,279 1,541 .57 .57 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 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, 2005 and 2004, and the related statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2005. 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 financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2005 and 2004, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. /s/Crowe Chizek and Company LLC Crowe Chizek and Company LLC Lexington, Kentucky January 27, 2006, except for Note 21 with respect to a pending acquisition, as to which the date is February 24, 2006 Senior Management Louis Prichard, President and Chief Executive Officer Brenda Bragonier, VP, Director of Marketing/Human Resources Hugh Crombie, VP, Director of Operations Gregory J. Dawson, VP, Chief Financial Officer Norman J. Fryman, Sr. VP, Director of Sales & Service Clark Nyberg, VP, Director of Wealth Management Bourbon Nancye Fightmaster, VP, Regional Manager Wallis Brooks, Branch Manager/Community Reinvestment Act Rhonda Brown, Sr. Consumer Lender Brandon Eason, Sr. Consumer Lender Philip Hurst, Branch Manager Susan Lemons, AVP, Branch Manager/Consumer Lender Clark Nick Carter, VP, Regional Manager Kathy Newkirk, Sr. Consumer Lender Teresa Shimfessel, AVP, Branch Manager/Consumer Lender Brandon Sumpter, Sr. Consumer Lender Harrison Ken Devasher, VP, Regional Manager Dreama Harris, AVP, Sr. Consumer Lender Joyce Rainey, Consumer Lender Jessamine Rick Walling, VP, Regional Manager Scott Pam Jessie, VP, Regional Manager Sharon Whitlock, Branch Manager/Consumer Lender Woodford Duncan Gardiner, VP, Regional Manager Shane Foley, VP, Mortgage Lender Accounting/Risk Management Gregory J. Dawson, VP, Chief Financial Officer Heather Barger, VP, Director of Risk Management Brenda Berry, AVP, Senior Accountant Robbie Cox, Senior Auditor Janice Hash, AVP, Sr. Accountant/Purchasing Lydia Sosby, VP, Compliance Collections Catherine Hill, VP, Head of Collections Mary Moreland, AVP, Collections Officer Commercial Lending Darren Henry, VP, Director of Commercial Lending R. W. Collins, VP, Agricultural Lender David Foster, VP, Agricultural Lender A. J. Gullett, VP, Commercial Lender James LeMaster, Business Development Michael Lovell, VP, Commercial Lender George R. Wilder, VP, Commercial Lender Human Resources Brenda Bragonier, VP, Director of Marketing/Human Resources James Gray, AVP, Director of Training Judith Taylor, VP, Human Resource Manager Operations Hugh Crombie, VP, Director of Operations Karen Anderson, Electronic Banking Melinda Biddle, Goverment Reporting Patricia Carpenter, Data Management Cynthia Criswell, Data Processing Perry Ingram, AVP, Network Manager Jane Mogge, Document Management Donald Roe, AVP, Sr. Data Processing Arnita Willoughby, Mortgage Operations Manager Carolyn Wilkins, Overdraft Management Martha Woodford, VP, Assistant Director of Operations Wealth Management Clark Nyberg, VP, Director of Wealth Management Lisa Highley, Personal Trust Janice Worth, AVP, Personal Trust Kentucky Bank Board of Directors William M. Arvin, Attorney Proctor Blair, Partner, Ludwig, Blair and Bush, PLLC James Ferrell, Physician Henry Hinkle, President, Hinkle Contracting Corporation Tricia Kittinger, Woodford County Circuit Clerk Theodore Kuster, Westview-Hillside Farms Betty Long, Retired President, First Federal Savings of Cynthiana George Lusby, County Judge Executive Ted McClain, Agent, Hopewell Insurance Company Eva McDaniel, Jessamine County Clerk Louis Prichard, President, CEO, Kentucky Bank John Roche, Optician Robert G. Thompson, Farmer, Thoroughbred Breeder, Snowhill Farm Woodford Van Meter, Ophthalmologist Buckner Woodford, Chairman, Kentucky Bank Bourbon Proctor Blair, Partner, Ludwig, Blair and Bush, PLLC Allyson Eads, Co-owner, Eads Hardware Rodes Shackelford Parrish, President, Clay Ward Agency 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 of Cynthiana Brad Marshall, Farmer, 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, Blue Grass 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, 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 Kentucky Bancshares, Inc. Directors LOUIS PRICHARD President and CEO, Kentucky Bank and Kentucky Bancshares, Inc. BUCKNER WOODFORD Chairman, Kentucky Bank and Kentucky Bancshares, Inc. WILLIAM M. ARVIN Attorney, Law Offices of William Arvin WOODFORD VAN METER Opthalmologist THEODORE KUSTER Farmer and Thoroughbred Breeder, Westview Hillside Farms HENRY HINKLE President, Hinkle Contacting Corporation ROBERT G. THOMPSON Farmer and Thoroughbred Breeder, Snowhill Farm BETTY LONG Retired President, First Federal Savings of Cynthiana TED McCLAIN Agent, Hopewell Insurance Company 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 17, 2006 (the "Annual Meeting Record Date"), for use at the Annual Meeting of Shareholders of the Company (the "Annual Meeting") to be held on Friday, May 12, 2006, 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 27, 2006. 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 I directors; and (2) 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 I directors. 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 2,671,672 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. 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 I 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). 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 member of a class to serve, subject to the provisions of the Amended and Restated Articles of Incorporation and Bylaws, for a three-year term and until the member's successor is duly elected and qualified. Except as listed below, each nominee for a Class I directorship has held the specified position for the last five years. The names of the nominees proposed for election as Class I 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. Betty J. Long is the retired President and CEO of First Federal, Cynthiana. She was appointed to the board of the Company in 2003. Ted McClain is an agent with Hopewell Insurance Company. He became a director of the Company in 2003. Buckner Woodford IV is Chairman of both Kentucky Bank and Kentucky Bancshares, Inc. He became a director of the Company in 1982. 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 I directors of the Company. Item 2 - 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 /s/Gregory J. Dawson Gregory J. Dawson, Secretary March 27, 2006 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 Shares which I held of record or am otherwise entitled to vote at the close of business on March 17, 2006, at the 2006 Annual Meeting of Shareholders to be held on May 12, 2006 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 Betty J. Long, Ted McClain, and Buckner Woodford IV (INSTRUCTION: To withhold authority to vote for any individual nominee, write the nominee's name on the line) _________________________________________________________ 2. 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 1. (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 on a duly executed proxy form, all shares will be voted "FOR" the nominees listed in Item 1. A vote FOR the election of nominees listed above includes discretionary authority to cumulate votes, selectively among the nominees as to whom authority to vote has not been withheld and to vote for a substitute nominee if any nominee becomes unavailable for election for any reason. 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___________, 2006 ________________________________ Signature ________________________________ Signature if held jointly 74