-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, OUY3J+yRfIZH1NIAsoytJ3Kdtdv5fVMuET6qHPX84CTQJFiKxm0PXbVrtAcXTfBM ESfUPx9A9EWUYE8knrcn9Q== 0001000232-07-000006.txt : 20070402 0001000232-07-000006.hdr.sgml : 20070402 20070402140018 ACCESSION NUMBER: 0001000232-07-000006 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 20061231 FILED AS OF DATE: 20070402 DATE AS OF CHANGE: 20070402 FILER: COMPANY DATA: COMPANY CONFORMED NAME: KENTUCKY BANCSHARES INC /KY/ CENTRAL INDEX KEY: 0001000232 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 610993464 STATE OF INCORPORATION: KY FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 033-96358 FILM NUMBER: 07737517 BUSINESS ADDRESS: STREET 1: 4TH & MAIN ST STREET 2: P O BOX 157 CITY: PARIS STATE: KY ZIP: 40362-0157 BUSINESS PHONE: 859-987-1795 MAIL ADDRESS: STREET 1: 4TH & MAIN ST STREET 2: PO BOX 157 CITY: PARIS STATE: KY ZIP: 40362-0157 FORMER COMPANY: FORMER CONFORMED NAME: BOURBON BANCSHARES INC /KY/ DATE OF NAME CHANGE: 19950907 10-K 1 k2006.txt FORM 10K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) [ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2006 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 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes No _X_ Indicate by check mark if the registrant is not required to file reports to Section 13 or Section 15(d) of the Exchange Act. Yes No _X_ 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ X ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. Large accelerated filer _ Accelerated filer _ Non-accelerated filer X Aggregate market value of voting stock held by non-affiliates as of June 30, 2006 was approximately $59.4 million. For purposes of this calculation, it is assumed that the Bank's Trust Department, directors, executive officers and beneficial owners of more than 5% of the registrant's outstanding voting stock are affiliates. Number of shares of Common Stock outstanding as of March 23, 2007: 2,871,090. PART I Item 1. Business General Kentucky Bancshares, Inc. ("Company" or "Kentucky") is a Kentucky corporation organized in 1981 and a bank holding company registered under the Bank Holding Company Act of 1956, as amended ("BHCA") and the Home Owners Loan Act of 1933, as amended ("HOLA"). The Company conducts business in the state of Kentucky through one banking subsidiary, Kentucky Bank. Kentucky Bank is a commercial bank and trust company organized under the laws of Kentucky. Kentucky Bank has its main office in Paris (Bourbon County), with additional offices in Paris, Cynthiana (Harrison County), Georgetown (Scott County), Morehead (Rowan County), Nicholasville (Jessamine County), North Middletown (Bourbon County), Sandy Hook (Elliott County), Versailles (Woodford County), Wilmore (Jessamine County) and Winchester (Clark County). The deposits of Kentucky Bank are insured up to prescribed limits by the Bank Insurance Fund ("BIF") and the Savings Association Insurance Fund ("SAIF"), both of the Federal Deposit Insurance Corporation ("FDIC"). Kentucky Bank is engaged in general full-service commercial and consumer banking. Kentucky Bank makes commercial, agricultural and real estate loans to its commercial customers, with emphasis on small-to-medium-sized industrial, service and agricultural businesses. Kentucky Bank makes residential mortgage, installment and other loans to its individual and other non-commercial customers. Kentucky Bank also offers its customers the opportunity to obtain a credit card. Kentucky Bank offers its customers a variety of other services, including checking, savings, money market accounts, certificates of deposits, safe deposit facilities and other consumer-oriented financial services. Kentucky Bank has Internet banking, including bill payment available to its customers at www.kybank.com. Through its Wealth Management Department, Kentucky Bank provides brokerage services, annuities, life and long term care insurance, personal trust and agency services (including management agency services). Competition The Company and its subsidiary face vigorous competition from a number of sources, including other bank holding companies and commercial banks, consumer finance companies, thrift institutions, other financial institutions and financial intermediaries. In addition to commercial banks, savings and loan associations, savings banks and credit unions actively compete to provide a wide variety of banking services. Mortgage banking firms, finance companies, insurance companies, brokerage companies, financial affiliates of industrial companies and government agencies provide additional competition for loans and for many other financial services. The subsidiary also currently competes for interest-bearing funds with a number of other financial intermediaries, including brokerage firms and mutual funds, which offer a diverse range of investment alternatives. Some of the Company's competitors are not subject to the same degree of regulatory review and restrictions that apply to the Company and its subsidiary bank. In addition, the Company must compete with much larger financial institutions that have greater financial resources than the Company. Supervision and Regulation As a bank holding company, the Company is subject to the regulation and supervision of the Federal Reserve Board. The Company's subsidiary is subject to supervision and regulation by applicable state and federal banking agencies, including the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Kentucky Office of Financial Institutions. The subsidiary is also subject to various requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon, and limitations on the types of investments that may be made and the types of services that may be offered. In addition to the impact of regulation, the subsidiary is affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy. There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insurance funds in the event the depository institution becomes in danger of default or is in default. For example, under a policy of the Federal Reserve Board with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and commit resources to support such institutions in circumstances where it might not do so absent such policy. In addition, the "cross-guarantee" provisions of federal law require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default. The federal banking agencies have broad powers under current federal law to take prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institutions in question are "well capitalized", "adequately capitalized", "undercapitalized", "significantly undercapitalized" or "critically undercapitalized", as such terms are defined under uniform regulation defining such capital levels issued by each of the federal banking agencies. In addition to the laws and regulations discussed above, Kentucky Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth herein is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Real Estate Settlement Procedures Act, the Fair Housing Act and the Fair and Accurate Transactions Act, among others. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with clients when taking deposits or making loans. These laws also limit Kentucky Bank's ability to share information with affiliated and unaffiliated entities. The bank must comply with the applicable provisions of these consumer protection laws and regulations as part of its ongoing business operations. There are various legal and regulatory limits on the extent to which the Company's subsidiary bank may pay dividends or otherwise supply funds to the Company. In addition, federal and state regulatory agencies also have the authority to prevent a bank or bank holding company from paying a dividend or engaging in any other activity that, in the opinion of the agency, would constitute an unsafe or unsound practice. Dividends paid by the subsidiary bank have provided substantially all of the Company's operating funds, and this may reasonably be expected to continue for the foreseeable future. Employees At December 31, 2006, the number of full time equivalent employees of the Company was 203. Item 1A. Risk Factors There are factors, many beyond our control, which may significantly change the results or expectations of the Company. Some of these factors are described below in the sections titled financial risk, business risk and operational risk. These risks are not totally independent of each other. Some factors affect more than one type of risk. These include regulatory, economic, and competitive environments. As part of the annual audit plan, our internal risk management department meets with management to assess these risks throughout the Company. Many risks are further addressed in other sections of this Form 10-K document. The exercise of regulatory power may have negative impact on the Company's results of operations and financial condition. The Company is subject to extensive regulation, supervision and examination by federal and state banking authorities. Any change in applicable regulations or federal or state legislation could have a substantial impact on our operations. Additional legislation and regulations may be enacted or adopted in the future that could significantly affect the Company's powers, authority and operations, which could have a material adverse effect on the financial condition and results of operations. Further, regulators have significant discretion and power to prevent or remedy unsafe or unsound practices or violations of laws by banks and bank holding companies in the performance of their supervisory and enforcement duties. Significant decline in general economic conditions, locally and nationally, will negatively affect the financial results of the Company's banking operations. The Company's success depends on general economic conditions both locally and nationally. Most of our customers are in the Central Kentucky area. Our customers are directly impacted by the local economy, as well as the national or global economies. Local economic conditions (such as the effect of the tobacco buyout on the agricultural industry) have an impact on the demand of customers for loans, the ability of some borrowers to repay these loans and the value of the collateral securing these loans. Factors influencing general national economic conditions include the change in interest rates (particularly mortgage lending rates), oil prices, inflation, recession and unemployment. As these factors impact the overall business climate, they can have a significant effect on loan demand. Loan growth is critical to our profitability. The Company faces vigorous competition from banks and other financial institutions. This competition may reduce or limit our margins on banking services, reduce market share and adversely affect results of operations and financial condition. A number of these banks and other financial institutions have substantially greater resources and lending limits, larger branch systems and a wider array of banking services. Additionally, the Company encounters competition from both de novo and smaller community banks entering the markets we are currently in. The Company also competes with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies and insurance companies. Financial Risk Financial risk components include, but are not limited to, credit risk, interest rate risk, market risk and liquidity risk. The Company has adopted various policies to minimize potential adverse effects of interest rate, market and liquidity risks. However, even with these policies in place, a change in interest rates could negatively impact the Company's results of operations or financial position. Defaults in the repayment of loans may negatively impact our business. Credit risk is most closely associated with lending activities at financial institutions. Credit risk is the risk to earnings and capital when a customer fails to meet the terms of any contract or otherwise fails to perform as agreed. Credit risk arises from all activities where the Company is dependent on issuer, borrower, or counterparty performance, not just traditional lending activities. For example, the investment security portfolio has inherent credit risk as do counterparties in derivative contracts. Credit risk encompasses a broad range of financial institution activities and includes items reflected both on and off the balance sheet. Management makes various assumptions and judgments about the collectibility of the Company's loan portfolio, including the creditworthiness of its borrowers and the value of real estate and other assets serving as collateral for repayment of many of the loans. In determining the size of the allowance for loan losses, management considers, among other factors, the Company's loan loss experience and an evaluation of economic conditions. If these assumptions prove to be incorrect, the current allowance may not be sufficient to cover future loan losses and adjustments may be necessary to allow for different economic conditions or adverse developments in the loan portfolio. Material additions to the Company's allowance would materially decrease our net income. Fluctuations in interest rates may negatively impact our banking business. Interest rate risk focuses on the impact to earnings and capital arising from movements in interest rates. Interest rate risk focuses on the value implications for accrual portfolios (e.g., held-to-maturity and available- for-sale portfolios) and includes the potential impact to the Company's accrual earnings as well as the economic perspective of the market value of portfolio equity. The interest rate risk is comprised of repricing risk, basis risk, yield curve risk and options risk. Repricing risk represents the risk associated with the differences in timing of cash flows and rate changes with the Company's products. Basis risk represents the risk associated with changing rate relationships among varying yield curves. Yield curve risk is associated with changing rate relationships over the maturity structure. Options risk is associated with interest-related options, which are embedded in our products. Changes in market factors may negatively affect the value of our investment assets. Market risk focuses on the impact to earnings and capital arising from changes in market factors (e.g., interest rates, market liquidity, volatilities, etc.) that affect the value of traded instruments. Market risk includes items reflected both on and off the balance sheet. Market risk focuses primarily on mark-to-market portfolios (e.g., accounts revalued for financial statement presentation), including trading accounts and certain derivatives. Our inability to maintain appropriate levels of liquidity may have a negative impact on our results of operations and financial condition. Liquidity risk focuses on the impact to earnings and capital resulting from the Company's inability to meet its obligations as they become due in the normal course of business without incurring significant losses. It also includes the management of unplanned decreases or changes in funding sources as well as managing changes in market conditions, which could affect the ability to liquidate assets in the normal course of business without incurring significant losses. Liquidity risk includes items both on and off the balance sheet. Business Risk Business risk is composed mainly of legal (compliance) risk, strategic risk and reputation risk. Our results of operations and financial condition are susceptible to legal or compliance risks. Legal or compliance risk is the risk to earnings or capital arising from the impact of unenforceable contracts, lawsuits, adverse judgments, violations or nonconformance with laws, rules, regulations, prescribed practices, or ethical standards. The risk also arises in situations where laws or rules governing certain products or activities of our customers may be ambiguous or untested. This risk is not limited to the traditional thinking that legal/compliance risk is only associated with consumer protection laws. It includes the exposure to litigation from all aspects of both traditional and nontraditional financial institution activities. Incorrect strategic decisions may have a negative impact on our results of operations and financial condition. Strategic risk is the risk to earnings and capital arising from adverse business decisions or improper implementation of those decisions. Strategic risk focuses on more than an analysis of the written strategic plan. Its focus is on how plans, systems and implementation affect franchise value. It also incorporates how management analyzes external factors that affect the Company's strategic direction. Adverse publicity may have a negative impact on our business. Reputation risk is the risk to earnings and capital arising from negative public opinion. This affects the ability to establish new relationships or services or to continue servicing existing relationships. Examiners will assess reputation risk by recognizing the potential effect the public's opinion could have on the Company's franchise value. Operational Risk An inability to process transactions may have a negative impact on our business. Operational risk is present on a daily basis through the Company's processing of transactions and is pervasive in all products and services provided to our customers. It can be defined as the impact to earnings and capital from problems encountered in processing transactions. Operational risk is a function of internal controls, operating processes, management information systems, and employee integrity. Item 1B. Unresolved Staff Comments None. Item 2. Properties The main banking office of Kentucky Bank, which also serves as the principal office of Kentucky Bancshares, Inc., is located at 339 Main Street, Paris, Kentucky 40361. In addition, Kentucky Bank serves customer needs at 13 other locations. All locations offer a full range of banking services. Kentucky Bank owns all of the properties at which it conducts its business. The Company owns approximately 83,000 square feet of office space. Note 5 to the Company's consolidated financial statements included in this report contains additional information relating to amounts invested in premises and equipment. Item 3. Legal Proceedings The Company and its subsidiary are from time to time involved in routine legal proceedings occurring in the ordinary course of business that, in the aggregate, management believes will not have a material impact on the Company's financial condition and results of operation. Item 4. Submission of Matters to a Vote of Security Holders Not Applicable. PART II Item 5. Market for Common Equity and Related Stockholder Matters There is no established public trading market for the Company's Common Stock. The Company's Common Stock is not listed on any national securities exchange nor is it quoted on the NASDAQ system. However, it is traded on the OTC Bulletin Board under the symbol "KTYB.OB". Trading in the Common Stock has been infrequent, with retail brokerage firms making the market. The following table sets forth the high and low closing sales prices of the Common Stock from the OTC Bulletin Board and the dividends declared thereon, for the periods indicated below: High Low Dividend 2006 Quarter 4 $32.00 $29.50 $.25 Quarter 3 30.00 26.65 .25 Quarter 2 29.75 27.00 .25 Quarter 1 30.00 29.00 .25 2005 Quarter 4 $30.50 $29.25 $.23 Quarter 3 30.50 29.50 .23 Quarter 2 30.50 28.05 .23 Quarter 1 31.00 29.25 .23 Note 16 to the Company's consolidated financial statements included in this report contains additional information relating to amounts available to be paid as dividends. As of December 31, 2006 the Company had 2,864,586 shares of Common Stock outstanding and approximately 501 holders of record of its Common Stock. The table below lists 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 or Programs 10/1/06 - 10/31/06 400 $29.50 400 82,140 shares 11/1/06 - 11/30/06 -0- N/A N/A 82,140 shares 12/1/06 - 12/31/06 350 31.00 350 81,790 shares Total 750 750 81,790 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. Shares will be purchased from time to time in the open market depending on market prices and other considerations. Through December 31, 2006, 118,210 shares have been purchased, with the most recent share repurchase under the Board-approved stock repurchase program having occurred on December 20, 2006. Item 6. Selected Financial Data The following selected financial data should be read in conjunction with the Company's Consolidated Financial Statements and the accompanying notes presented elsewhere herein.
At or For the Year Ended December 31 (dollars and shares in thousands, except per share amounts) 2006 2005 2004 2003 2002 CONDENSED STATEMENT OF INCOME: Total Interest Income $35,593 $28,897 $25,846 $22,329 $24,788 Total Interest Expense 16,718 11,766 9,067 7,875 9,367 Net Interest Income 18,875 17,131 16,779 14,454 15,421 Provision for Losses 475 508 840 1,300 1,204 Net Interest Income After Provision for Losses 18,400 16,623 15,939 13,154 14,217 Noninterest Income 7,236 6,495 6,547 6,707 6,590 Noninterest Expense 16,682 15,220 14,506 14,171 12,433 Income Before Income Tax Expense 8,954 7,898 7,980 5,690 8,374 Income Tax Expense 2,468 2,078 2,218 1,457 2,471 Net Income 6,486 5,820 5,762 4,233 5,903 SHARE DATA: Basic Earnings per Share (EPS) $2.35 $2.17 $2.09 $1.52 $2.13 Diluted EPS 2.34 2.16 2.07 1.50 2.10 Cash Dividends Declared 1.00 0.92 0.84 0.76 0.68 Book Value 19.59 17.45 16.77 16.90 15.90 Average Common Shares-Basic 2,762 2,677 2,757 2,781 2,770 Average Common Shares-Diluted 2,774 2,692 2,777 2,827 2,806 SELECTED BALANCE SHEET DATA: Loans, including loans held for sale $439,159 $366,602 $354,294 $316,941 $281,499 Investment Securities 127,891 160,652 126,767 128,790 89,509 Total Assets 629,542 572,750 528,544 500,852 419,771 Deposits 468,808 431,631 387,955 384,599 322,836 Securities sold under agreements to repurchase and other borrowings 11,327 16,838 25,593 7,285 5,277 Federal Home Loan Bank advances 80,030 66,749 59,750 53,232 43,937 Stockholders' Equity 55,281 46,546 45,027 46,057 44,092 PERFORMANCE RATIOS: (Average Balances) Return on Assets 1.09% 1.08% 1.11% 1.00% 1.48% Return on Stockholders' Equity 12.82% 12.69% 12.57% 9.31% 14.27% Net Interest Margin (1) 3.48% 3.50% 3.60% 3.79% 4.23% Equity to Assets (annual average) 8.48% 8.50% 8.82% 10.73% 10.36% SELECTED STATISTICAL DATA: Dividend Payout Ratio 42.68% 42.30% 39.97% 50.00% 31.94% Number of Employees (at period end) 203 172 167 182 173 ALLOWANCE COVERAGE RATIOS: Allowance to Total Loans 1.12% 1.16% 1.16% 1.19% 1.19% Net Charge-offs as a Percentage of Average Loans 0.14% 0.10% 0.15% 0.43% 0.43% (1) Tax equivalent
Item 7. Management's Discussion and Analysis The following discussion and analysis of financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements and accompanying notes included as Exhibit 13. When necessary, reclassifications have been made to prior years' data throughout the following discussion and analysis for purposes of comparability with 2006 data. Critical Accounting Policies The accounting and reporting policies of the Company and its subsidiary are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry. Significant accounting policies are listed in Note 1 in the "Notes to Consolidated Financial Statements". Critical accounting and reporting policies include accounting for loans and the allowance for loan losses. Different assumptions in the application of these policies could result in material changes in the consolidated financial position or consolidated results of operations. Loans are stated at the amount of unpaid principal, reduced by an allowance for loan losses. Interest on loans is recognized on the accrual basis, except for those loans on the nonaccrual status. Interest income received on such loans is accounted for on the cash basis or cost recovery method. The allowance for loan losses is a valuation allowance for probable incurred credit losses. 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. The accounting policies relating to the allowance for loan losses involve the use of estimates and require significant judgments to be made by management. Forward-Looking Statements This discussion contains forward-looking statements under the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. 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, regulation and monetary policy (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. Overview Net income for the year ended December 31, 2006 was $6.5 million, or $2.35 per common share compared to $5.8 million, or $2.17 for 2005 and $5.8 million, or $2.09 for 2004. Earnings per share assuming dilution were $2.34, $2.16 and $2.07 for 2006, 2005 and 2004, respectively. For 2006, net income increased $666 thousand, or 11%. Net interest income increased $1.7 million, the loan loss provision decreased $33 thousand, other income increased $741 thousand, while total other expenses increased $1.5 million. In July 2006, the Company purchased Peoples Bancorp of Sandy Hook, Inc. (Peoples Bancorp) and its subsidiary, Peoples Bank (Peoples) of Sandy Hook,to strengthen its business and grow its customer base. For 2005, net income increased $58 thousand, or 1%. Net interest income increased $352 thousand, the loan loss provision decreased $332 thousand, other income decreased $52 thousand, while total other expenses increased $715 thousand. Return on average equity was 12.8% in 2006 compared to 12.7% in 2005 and 12.6% in 2004. Return on average assets was 1.09% in 2006 compared to 1.08% in 2005 and 1.11% in 2004. Non-performing loans as a percentage of loans (including held for sale) were 0.59%, 0.26% and 0.58% as of December 31, 2006, 2005 and 2004, respectively. RESULTS OF OPERATIONS Net Interest Income Net interest income, the Company's largest source of revenue, on a tax equivalent basis increased from $17.4 million in 2004 to $17.7 million in 2005 and to $19.5 million in 2006. The taxable equivalent adjustment (nontaxable interest income on state and municipal obligations net of the related non-deductible portion of interest expense) is based on our Federal income tax rate of 34%. Average earning assets and interest bearing liabilities both increased from 2005 to 2006. Average earning assets increased $53 million, or 10%. Investment securities increased $15 million primarily due to the Peoples acquisition in July 2006. Loans increased $46 million as a result of the acquisition and improved loan demand. Average interest bearing liabilities increased $44 million, or 10% during this same period. This change was primarily from the acquisition less the loss of some public funds on deposit. The Company continues to actively pursue quality loans and fund these primarily with deposits and FHLB advances. During the second half of 2004 rates started increasing and this pattern continued into the middle of 2006. Bank prime rates increased 125 basis points during 2004, another 200 basis points in 2005 and another 100 basis points in 2006. As a result of this, the tax equivalent yield on earning assets increased from 5.82% in 2005 to 6.47% in 2006. The volume rate analysis that follows, during 2006, indicates that $3.4 million of the increase in interest income is attributable to the change in volume, while the higher level of rates contributed to an increase of $3.3 million in interest income. This higher level of rates also caused an increase in the cost of interest bearing liabilities. The average rate of these liabilities increased from 2.82% in 2005 to 3.62% in 2006. In addition, the change in volume contributed to an increase of $1.3 million in interest expense, while the higher level of rates was responsible for a $3.7 million increase in interest expense. As a result, the 2006 net interest income increase is primarily attributed to increases in volume. The volume rate analysis for 2005 that follows indicates that $1.4 million of the increase in interest income is attributable to the change in volume, while the increase in rates contributed to an increase of $1.7 million in interest income. The rate increase also caused an increase in the cost of interest bearing liabilities. The average rate of these liabilities increased from 2.25% in 2004 to 2.82% in 2005. Based on the volume rate analysis that follows, the change in volume contributed to an increase of $293 thousand to interest expense, while the increase in rates was responsible for a $2.4 million increase in interest expense. As a result, the 2005 net interest income increase is attributed to increases in volume reduced by the negative impact of increases in rates, more on the liability side than the asset side. In spite of the positive impact on net interest income that may result from the increasing rate environment beginning in 2004 and continued into the first half of 2006, competitive pressures on interest rates will continue and are likely to result in only modest changes in net interest margins. The accompanying analysis of changes in net interest income in the following table shows the relationships of the volume and rate portions of these changes in 2006 and 2005. Changes in interest income and expenses due to both rate and volume are allocated on a pro rata basis.
2006 vs. 2005 2005 vs. 2004 Increase (Decrease) Due to Change in Increase (Decrease) Due to Change in Volume Rate Net Change Volume Rate Net Change INTEREST INCOME Loans $ 3,169 $ 2,527 $ 5,696 $ 1,455 $ 1,448 $ 2,903 Investment Securities 618 691 1,309 (258) 54 (204) Federal Funds Sold and Securities Purchased under Agreements to Resell (405) 90 (315) 173 177 350 Deposits with Banks 5 1 6 (9) 11 2 Total Interest Income 3,387 3,309 6,696 1,361 1,690 3,051 INTEREST EXPENSE Deposits Demand 204 1,345 1,549 54 994 1,048 Savings 68 214 282 8 103 111 Negotiable Certificates of Deposit and Other Time Deposits 351 1,754 2,105 111 1,145 1,256 Securities sold under agreements to repurchase and other borrowings 298 261 559 (98) 291 193 Federal Home Loan Bank advances 358 99 457 218 (127) 91 Total Interest Expense 1,279 3,673 4,952 293 2,406 2,699 Net Interest Income $ 2,108 $ (364) $ 1,744 $ 1,068 $ (716) $ 352
Average Consolidated Balance Sheets and Net Interest Analysis (dollars in thousands) 2006 2005 2004 Average Average Average Average Average Average Balance Interest Rate Balance Interest Rate Balance Interest Rate ASSETS Interest-Earning Assets Securities Available for Sale (1) U.S. Treasury and Federal Agency Securities 101,130 4,354 4.31% 92,524 3,366 3.64% 97,486 3,510 3.60% State and Municipal obligations 41,030 1,666 4.06% 34,888 1,444 4.14% 35,762 1,518 4.24% Other Securities 6,622 384 5.80% 6,085 285 4.68% 7,035 271 3.85% Total Securities Available for Sale 148,782 6,404 4.30% 133,497 5,095 3.82% 140,283 5,299 3.78% Total Investment Securities 148,782 6,404 4.30% 133,497 5,095 3.82% 140,283 5,299 3.78% Tax Equivalent Adjustment 624 0.42% 614 0.46% 638 0.45% Tax Equivalent Total 7,028 4.72% 5,709 4.28% 5,937 4.23% Federal Funds Sold and Agreements to Repurchase 2,212 102 4.61% 11,471 417 3.64% 4,620 67 1.45% Interest-Bearing Deposits with Banks 432 18 4.17% 321 12 3.74% 827 10 1.21% Loans, Net of Deferred Loan Fees (2) Commercial 46,194 3,520 7.62% 31,151 1,958 6.29% 28,874 1,564 5.42% Real Estate Mortgage 351,239 24,597 7.00% 321,619 20,660 6.42% 299,062 17,989 6.02% Installment 10,698 952 8.90% 8,962 755 8.42% 10,529 917 8.71% Total Loans 408,131 29,069 7.12% 361,732 23,373 6.46% 338,465 20,470 6.05% Total Interest-Earning Assets 559,557 36,217 6.47% 507,021 29,511 5.82% 484,195 26,484 5.47% Allowance for Loan Losses (4,766) (4,401) (4,090) Cash and Due From Banks 11,844 10,927 10,642 Premises and Equipment 12,421 11,025 11,787 Other Assets 17,676 15,054 17,494 Total Assets 596,732 539,626 520,028 LIABILITIES Interest-Bearing Deposits Negotiable Order of Withdrawal ("NOW") and Money Market Investment Accounts 114,195 3,381 2.96% 103,625 1,832 1.77% 97,267 784 0.81% Savings 36,425 517 1.42% 29,303 235 0.80% 27,547 124 0.45% Certificates of Deposit and Other Deposits 204,649 8,219 4.02% 193,986 6,114 3.15% 189,739 4,858 2.56% Total Interest-Bearing Deposits 355,269 12,117 3.41% 326,914 8,181 2.50% 314,553 5,766 1.83% Securities sold under agreements to repurchase and other borrowings 33,213 1,657 4.99% 26,689 1,098 4.11% 29,664 905 3.05% Federal Home Loan Bank advances 72,843 2,944 4.04% 63,918 2,487 3.89% 58,421 2,396 4.10% Total Interest-Bearing Liabilities 461,325 16,718 3.62% 417,521 11,766 2.82% 402,638 9,067 2.25% Noninterest-Bearing Earning Demand Deposits 80,904 73,320 68,730 Other Liabilities 3,919 2,929 2,814 Total Liabilities 546,148 493,770 474,182 STOCKHOLDERS' EQUITY 50,584 45,856 45,846 Total Liabilities and Shareholders' Equity 596,732 539,626 520,028 Average Equity to Average Total Assets 8.48% 8.50% 8.82% Net Interest Income 18,875 17,131 16,779 Net Interest Income (tax equivalent) (3) 19,499 17,745 17,417 Net Interest Spread (tax equivalent) (3) 2.85% 3.00% 3.22% Net Interest Margin (tax equivalent) (3) 3.48% 3.50% 3.60% (1) Averages computed at amortized cost. (2) Includes loans on a nonaccrual status and loans held for sale. (3) Tax equivalent difference represents the nontaxable interest income on state and municipal securities net of the related non-deductible portion of interest expense.
Noninterest Income and Expenses Noninterest income was $7.2 million in 2006 compared to $6.5 million in 2005 and 2004. In 2006, increasing service charges and increasing trust fees account for the majority of the increase. Similarly, service charges and trust department income increased in 2005, but were offset by a reduction in securities gains in 2005. Securities gains were $34 thousand in 2006, $64 thousand in 2005 and $289 thousand in 2004. The lower gains in 2006 and 2005 are more normal and primarily attributable to rising interest rates and the related inverse relationship of interest rates and market values. Some equity gains were taken in 2006 and used to offset losses on sales of agency and municipal securities. The gains in 2004 were primarily a result of the Company taking advantage of the inverse relationship of interest rates and market values, and municipal securities being called at premiums before their maturities. In addition, U. S. Treasury securities were sold before maturity to restructure the portfolio and extend out the yield curve. Gains on loans sold were $290 thousand, $334 thousand and $376 thousand in 2006, 2005 and 2004, respectively. Loans held for sale are generally sold after closing to the Federal Home Loan Mortgage Corporation. During 2006, the loan service fee income increased $24 thousand, compared to an increase of $12 thousand in 2005. Proceeds from the sale of loans were $17 million, $18 million and $30 million in 2006, 2005 and 2004, respectively. The volume of loan originations is inverse to rate changes. The volume of loan originations during 2006 was $17 million, comparable to $18 million in 2005, but down from $22 million in 2004. Other noninterest income excluding security net gains and gain on sale of mortgage loans was $6.9 million in 2006, $6.1 million in 2005 and $5.9 million in 2004. Service charge income, and more particularly overdraft income, is the largest contributor to these numbers. Overdraft income was $4.1 million in 2006, $3.4 million in 2005 and $3.4 million in 2004. The increase in 2006 is primarily attributable to the Peoples acquisition in July 2006. Other income has remained steady with $1.2 million in 2004, $1.1 million in 2005 and $1.1 million in 2006. Noninterest expense increased $1.5 million in 2006 to $16.7 million, and increased $715 thousand in 2005 to $15.2 million from $14.5 million in 2004. The increases in salaries and benefits from $8.1 million in 2004 to $8.5 million in 2005 and to $9.6 million in 2006 are attributable to normal salary and benefit increases, and in 2006 to the Peoples acquisition. Bonus compensation was $160 thousand higher in 2006 compared to 2005 and $124 thousand higher in 2005 compared to 2004. The 2006 increase is from higher compensation and improved net income, while the 2005 increase is mainly a result of additional sales incentives. Occupancy expense decreased $61 thousand in 2005 to $2.2 million and increased $126 thousand, or 6% in 2006 to $2.3 million. The largest expense, depreciation, decreased $69 thousand to $924 thousand in 2005, but increased $32 thousand to $956 thousand in 2006. Other noninterest expense increased from $4.2 million in 2004 to $4.5 million in 2005 and increased to $4.7 million in 2006. Amortization of core deposits related to the Peoples acquisition was $89 thousand in 2006. See Note 6 in the notes to consolidated financial statements included as Exhibit 13 for more detail of the goodwill and intangible assets. The following table is a summary of noninterest income and expense for the three-year period indicated. For the Year Ended December 31 (in thousands) 2006 2005 2004 NON-INTEREST INCOME Service Charges $ 5,224 $ 4,511 $ 4,358 Loan Service Fee Income, net 33 9 (3) Trust Department Income 603 458 299 Investment Securities Gains (Losses),net 34 65 289 Gains on Sale of Mortgage Loans 290 334 376 Other 1,052 1,118 1,228 Total Non-interest Income 7,236 6,495 6,547 NON-INTEREST EXPENSE Salaries and Employee Benefits 9,613 8,548 8,053 Occupancy Expenses 2,320 2,194 2,255 Other 4,749 4,478 4,198 Total Non-interest Expense 16,682 15,220 14,506 Net Non-interest Expense as a Percentage of Average Assets 1.58% 1.62% 1.53% Income Taxes The Company had income tax expense of $2.5 million in 2006 and $2.1 million in 2005 and $2.2 million in 2004. This represents an effective income tax rate of 27.6% in 2006, 26.3% in 2005 and 27.8% in 2004. The difference between the effective tax rate and the statutory federal rate of 34% is primarily due to tax exempt income on certain investment securities and loans. Balance Sheet Review Assets grew from $573 million at December 31, 2005 to $630 million at December 31, 2006. Loan growth was $73 million in 2006. Nearly $51 million was a result of the Peoples acquisition. See Note 15 in the notes to consolidated financial statements included as Exhibit 13 for additional information on the business combination. Deposits grew $37 million and FHLB borrowings grew $13 million. The gain in deposits is primarily from $72 million obtained from the Peoples acquisition. The other decrease is primarily from the loss of public money and a large certificate of deposit customer. Assets at year-end 2005 totaled $573 million compared to $529 million in 2004. In 2005, loan growth was $13 million and deposit growth was $44 million. FHLB borrowings increased $7 million. Loans Total loans (including loans held for sale) were $444 million at December 31, 2006 compared to $371 million at the end of 2005 and $358 million in 2004. Loan growth continued to improve in 2006. The increase is mainly attributable to improved loan demand and $51 million from the Peoples acquisition. As of the end of 2006 and compared to the prior year-end, commercial loans increased $2.0 million, real estate construction loans decreased $.8 million, real estate mortgage loans (including loans held for sale) increased $45.0 million, agricultural loans increased $20.3 million and installment loans increased $6.7 million. As of the end of 2005 and compared to the prior year-end, commercial loans increased $7.3 million, real estate construction loans decreased $2.4 million, real estate mortgage loans (including loans held for sale) increased $6.7 million, agricultural loans increased $1.8 million and installment loans decreased $109 thousand. As of December 31, 2006, the real estate mortgage portfolio comprised 65% of total loans compared to 66% in 2005. Of this, 1-4 family residential property represented 61% in 2006 and 65% in 2005. Agricultural loans comprised 18% in 2006 and 16% in 2005 of the loan portfolio. Approximately 72% of the agricultural loans are secured by real estate in 2006 compared to 82% in 2005. The remainder of the agricultural portfolio is used to purchase livestock, equipment and other capital improvements and for general operation of the farm. Generally, a secured interest is obtained in the capital assets, equipment, livestock or crops. Automobile loans account for 40% in 2006 and 33% in 2005 of the consumer loan portfolio, while the purpose of the remainder of this portfolio is used by customers for purchasing retail goods, home improvement or other personal reasons. The commercial loan portfolio is mainly for capital outlays and business operation. Collateral is requested depending on the creditworthiness of the borrower. Unsecured loans are made to individuals or companies mainly based on the creditworthiness of the customer. Approximately 5% of the loan portfolio is unsecured. Management is not aware of any significant concentrations that may cause future material risks, which may result in significant problems with future income and capital requirements. The following table represents a summary of the Company's loan portfolio by category for each of the last five years. There is no concentration of loans (greater than 5% of the loan portfolio) in any industry. The Company has no foreign loans or highly leveraged transactions in its loan portfolio. Loans Outstanding At December 31 (in thousands) 2006 2005 2004 2003 2002 Commercial $ 29,335 $ 27,302 $ 19,999 $ 14,278 $ 16,803 Real Estate Construction 29,034 29,822 32,256 14,313 15,514 Real Estate Mortgage 290,324 245,326 238,661 222,342 182,958 Agricultural 79,627 59,328 57,497 56,615 52,188 Installment 15,684 8,954 9,062 12,978 17,134 Other 402 368 991 289 309 Total Loans 444,406 371,100 358,466 320,815 284,906 Less Deferred Loan Fees 256 188 10 54 12 Total Loans, Net of Deferred Loan Fees 444,150 370,912 358,456 320,761 284,894 Less loans held for sale 0 0 175 7,759 740 Less Allowance For Loan Losses 4,991 4,310 4,163 3,820 3,395 Net Loans 439,159 366,602 354,118 309,182 280,759 The following table sets forth the maturity distribution and interest sensitivity of selected loan categories at December 31, 2006. Maturities are based upon contractual term. The total loans in this report represent loans net of deferred loan fees, including loans held for sale but excluding the allowance for loan losses. In addition, deferred loan fees on the above schedule is netted with real estate mortgage loans on the following schedule. Loan Maturities and Interest Sensitivity At December 31, 2006 (in thousands) One Year One Through Over Total or Less Five Years Five Years Loans Commercial $ 15,917 $ 10,685 $ 2,733 $ 29,335 Real Estate Construction 23,662 5,290 82 29,034 Real Estate Mortgage 32,213 152,256 105,599 290,068 Agricultural 15,510 45,568 18,549 79,627 Installment 5,339 9,428 917 15,684 Other 402 0 0 402 Total Loans, Net of Deferred Loan Fees 93,043 223,227 127,880 444,150 Fixed Rate Loans 29,972 194,095 41,825 265,892 Floating Rate Loans 63,071 29,132 86,055 178,258 Total Loans, Net of Deferred Loan Fees 93,043 223,227 127,880 444,150 Mortgage Banking The Company has been in Mortgage Banking since the early 1980's. The activity in origination and sale of these loans fluctuates, mainly due to changes in interest rates. Mortgage loan originations decreased from $22 million in 2004 to $18 million in 2005, to $17 million in 2006. Proceeds from the sale of loans were $17 million, $18 million and $30 million for the years 2006, 2005 and 2004, respectively. Mortgage loans held for sale were zero at December 31, 2006 and December 31, 2005. Loans are generally sold when they are made. The volume of loan originations is inverse to rate changes. The rate environment has been rising, resulting in decreased loan originations in 2006 and 2005. The effect of these changes was also reflected on the income statement. As a result, the gain on sale of mortgage loans was $290 thousand in 2006 compared to $334 thousand in 2005 and $376 thousand in 2004. The Bank has sold various loans to the Federal Home Loan Mortgage Corporation (FHLMC) while retaining the servicing rights. Gains and losses on loan sales are recorded at the time of the cash sale, which represents the premium or discount paid by the FHLMC. The Bank receives a servicing fee from the FHLMC on each loan sold. Servicing rights are capitalized based on the relative fair value of the rights and the expected life of the loan and are included in intangible assets on the balance sheet and expensed in proportion to, and over the period of, estimated net servicing revenues. Mortgage servicing rights were $746 thousand at December 31, 2006, $802 thousand at December 31, 2005 and $876 thousand at December 31, 2004. Amortization of mortgage servicing rights was $235 thousand, $254 thousand and $249 thousand for the years ended December 31, 2006, 2005 and 2004, respectively. See Note 4 in the notes to consolidated financial statements included as Exhibit 13 for additional information. Deposits Total deposits increased to $469 million in 2006, up $37 million from 2005. Noninterest bearing deposits increased $15 million, time deposits of $100 thousand and over increased $6 million, and other interest bearing deposits increased $16 million. Public funds totaled $60 million at the end of 2006 ($59 million were interest bearing), a decrease of $25 million from the end of 2005. For 2005, total deposits increased $44 million to $432 million. Noninterest bearing deposits decreased $2 million, while time deposits of $100 thousand and over increased $2 million, and other interest bearing deposits decreased $44 million. Public funds totaled $85 million at the end of 2005 ($84 million were interest bearing). The table below provides information on the maturities of time deposits of $100,000 or more at December 31, 2006: Maturity of Time Deposits of $100,000 or More At December 31, 2006 (in thousands) Maturing 3 Months or Less $14,408 Maturing over 3 Months through 6 Months 16,958 Maturing over 6 Months through 12 Months 23,400 Maturing over 12 Months 12,489 Total $67,255 Borrowings The Company utilizes both long and short term borrowing. Long term borrowing at the Bank is mainly from the Federal Home Loan Bank (FHLB). This borrowing is mainly used to fund longer term, fixed rate mortgages, as part of a leverage strategy and to assist in asset/liability management. Advances are either paid monthly or at maturity. As of December 31, 2006, $80 million was borrowed from FHLB, an increase of $13 million from 2005. In 2006, $83 million of FHLB advances were paid, and advances were made for an additional $90 million. The remaining $7 million was obtained in the Peoples acquisition. FHLB advances were $67 million at December 31, 2005. During 2005, $8 million of FHLB borrowing was paid, and advances were made for an additional $15 million. The 2005 advances were obtained mainly to fund fixed rate loans, as detailed above. The following table depicts relevant information concerning our short term borrowings. Short Term Borrowings As of and for the year ended December 31 (in thousands) 2006 2005 2004 Federal Funds Purchased: Balance at Year end $ - $ 1,470 $ 6,383 Average Balance During the Year 8,616 3,001 3,706 Maximum Month End Balance 27,723 15,919 11,306 Year end rate 0.00% 4.25% 2.50% Average annual rate 5.37% 2.95% 1.52% Repurchase Agreements: Balance at Year end $ 9,628 $14,346 $18,314 Average Balance During the Year 15,661 16,014 18,398 Maximum Month End Balance 18,372 18,072 21,947 Year end rate 3.83% 3.18% 2.94% Average annual rate 3.79% 3.19% 1.90% Other Borrowed Funds: Balance at Year end $ 1,699 $ 1,021 $ 896 Average Balance During the Year 1,719 457 343 Maximum Month End Balance 8,508 1,021 1,011 Year end rate 5.90% 4.00% 1.87% Average annual rate 6.15% 3.10% 1.51% Contractual Obligations The Bank has required future payments for a defined benefit retirement plan, time deposits and long-term debt. See Note 13 in the notes to consolidated financial statements included as Exhibit 13 for further information on the defined benefit retirement plan. The other required payments under such commitments at December 31, 2006 are as follows: Payments due by period (in thousands) Less More than 1 1-3 3-5 than 5 Contractual Obligations Total year years years years FHLB advances $ 79,980 $ 15,909 $52,201 $ 7,181 $ 4,689 Subordinated debentures 7,217 - - - 7,217 Time deposits 229,277 193,592 33,931 1,754 - Asset Quality With respect to asset quality, management considers three categories of assets to merit close scrutiny. These categories include: loans that are currently nonperforming, other real estate, and loans that are currently performing but which management believes require special attention. During periods of economic slowdown, the Company may experience an increase in nonperforming loans. The Company discontinues the accrual of interest on loans that become 90 days past due as to principal or interest unless reasons for delinquency are documented such as the loan being well collateralized and in the process of collection. A loan remains in a non-accrual status until factors indicating doubtful collection no longer exist. A loan is classified as a restructured loan when the interest rate is materially reduced or the term is extended beyond the original maturity date because of the inability of the borrower to service the interest payments at market rates. Other real estate is recorded at fair market value less estimated costs to sell. A summary of the components of nonperforming assets, including several ratios using period-end data, is shown below. Nonperforming Assets At December 31 (dollars in thousands) 2006 2005 2004 2003 2002 Non-accrual Loans $2,379 $ 774 $1,781 $1,844 $1,573 Accruing Loans which are Contractually past due 90 days or more 253 206 308 779 789 Restructured Loans 0 0 0 0 0 Total Nonperforming Loans 2,632 980 2,089 2,623 2,362 Other Real Estate 411 141 676 375 172 Total Nonperforming Assets 3,043 1,121 2,765 2,998 2,534 Total Nonperforming Loans as a Percentage of Loans (including loans held for sale) (1) 0.59% 0.26% 0.58% 0.82% 0.83% Total Nonperforming Assets as a Percentage of Total Assets 0.48% 0.20% 0.52% 0.60% 0.60% Allowance to nonperforming assets 1.64 3.84 1.51 1.27 1.34 (1) Net of deferred loan fees Total nonperforming assets at December 31, 2006 were $3.0 million compared to $1.1 million at December 31, 2005 and $2.8 million at December 31, 2004. The increase from 2005 to 2006 is attributable to the increase in various loans being put on non-accrual and additions to other real estate. Total nonperforming loans were $2.6 million, $1.0 million, and $2.1 million at December 31, 2006, 2005 and 2004, respectively. The non-accrual loan increase from 2005 to 2006 is mainly attributable to 6 loans secured by real estate greater than $100,000, but less than $325,000. The amount of lost interest on our non-accrual loans is immaterial. At December 31, 2006, loans currently performing but which management believes require special attention were not significant. The Company continues to follow its long-standing policy of not engaging in international lending and not concentrating lending activity in any one industry. Impaired loans as of December 31, 2006 were $2.4 million compared to $800 thousand in 2005 and $1.8 million in 2004. These amounts are included in the total nonperforming and restructured loans presented in the table above. See Note 4 in the notes to consolidated financial statements included as Exhibit 13. A loan is considered impaired when it is probable that all principal and interest amounts will not be collected according to the loan contract. The allowance for loan losses on impaired loans is determined using the present value of estimated future cash flows of the loan, discounted at the loan's effective interest rate or the fair value of the underlying collateral. The entire change in present value of expected cash flows is reported as a provision for loan losses in the same manner in which impairment initially was recognized or as a reduction in the amount of provision for loan losses that otherwise would be reported. The total allowance for loan losses related to these loans was $553 thousand, $240 thousand and $416 thousand on December 31, 2006, 2005 and 2004, respectively. Loan Losses The following table is a summary of the Company's loan loss experience for each of the past five years. For the Year Ended December 31 (in thousands) 2006 2005 2004 2003 2002 Balance at Beginning of Year $ 4,310 $ 4,163 $ 3,820 $ 3,395 $ 3,386 Balance of Allowance for Loan Losses of Acquired Bank at Acquisition Date 775 0 0 363 0 Amounts Charged-off: Commercial 15 146 197 569 536 Real Estate Construction 28 0 0 0 18 Real Estate Mortgage 232 134 110 276 69 Agricultural 3 21 88 24 5 Consumer 365 225 293 529 701 Total Charged-off Loans 643 526 688 1,398 1,329 Recoveries on Amounts Previously Charged-off: Commercial 2 3 10 11 15 Real Estate Mortgage 2 11 42 1 19 Agricultural 21 16 21 21 10 Consumer 49 135 118 127 90 Total Recoveries 74 165 191 160 134 Net Charge-offs 569 361 497 1,238 1,195 Provision for Loan Losses 475 508 840 1,300 1,204 Balance at End of Year 4,991 4,310 4,163 3,820 3,395 Total Loans (1) Average 408,131 361,732 338,465 290,502 281,105 At December 31 444,150 370,912 358,456 320,761 284,894 As a Percentage of Average Loans (1): Net Charge-offs 0.14% 0.10% 0.15% 0.43% 0.43% Provision for Loan Losses 0.12% 0.14% 0.25% 0.45% 0.43% Allowance as a Percentage of Year-end Loans (1) 1.12% 1.16% 1.16% 1.19% 1.19% Beginning Allowance as a Multiple of Net Charge-offs 7.6 11.5 7.7 2.7 2.8 Ending Allowance as a Multiple of Nonperforming Assets 1.64 3.84 1.51 1.27 1.34 (1) Including loans held for sale, net of deferred loan fees Loans are typically charged-off after being 120 days delinquent. Limited exceptions for not charging-off a loan would be well documented and approved by the appropriate responsible party or committee. The provision for loan losses for 2006 was $475 thousand compared to $508 thousand in 2005 and $840 thousand in 2004. Net charge-offs were $569 thousand in 2006, $361 thousand in 2005 and $497 thousand in 2004. Net charge-offs to average loans were 0.14%, 0.10% and 0.15% in 2006, 2005 and 2004, respectively. Based on the quality of the loan portfolio, the loan loss provision decreased $33 thousand from 2005 to 2006 and decreased $332 thousand from 2004 to 2005. In evaluating the allowance for loan losses, management considers the composition of the loan portfolio, the historical loan loss experience, the overall quality of the loans and an assessment of current economic conditions. The recent improvement in the economy along with management's emphasis on improving the lending process resulted in fewer loan losses, lower loan loss provision and improved loan quality numbers over the past 3 years. At December 31, 2006, the allowance for loan losses was 1.12% of loans outstanding compared to 1.16% at year-end 2005 and 1.16% at year-end 2004. Management believes the allowance for loan losses at the end of 2006 is adequate to cover probable incurred credit losses within the portfolio. The following tables set forth an allocation for the allowance for loan losses and loans by category and a percentage distribution of the allowance allocation. In making the allocation, management evaluates the risk in each category, current economic conditions and charge-off experience. An allocation for the allowance for loan losses is an estimate of the portion of the allowance that will be used to cover future charge-offs in each loan category, but it does not preclude any portion of the allowance allocated to one type of loan being used to absorb losses of another loan type. Allowance for Loan Losses
At December 31 (in thousands) 2006 2005 2004 2003 2002 Dollars Percentage Dollars Percentage Dollars Percentage Dollars Percentage Dollars Percentage Commercial $ 594 11.90% $ 507 11.77% $ 350 8.41% $ 262 6.86% $ 820 24.15% Real Estate Construction 638 12.78% 566 13.14% 566 13.60% 266 6.96% 216 6.36% Real Estate Mortgage 1,806 36.19% 1,785 41.42% 1,801 43.26% 1,804 47.23% 1,166 34.34% Agricultural 1,241 24.86% 1,023 23.74% 1,028 24.69% 995 26.05% 698 20.56% Consumer 712 14.27% 428 9.93% 418 10.04% 493 12.91% 495 14.58% Total 4,991 100.00% 4,309 100.00% 4,163 100.00% 3,820 100.00% 3,395 100.00%
Loans
2006 2005 2004 2003 2002 Dollars Percentage Dollars Percentage Dollars Percentage Dollars Percentage Dollars Percentage Commercial $ 29,335 6.60% $ 27,302 7.36% $ 19,999 5.58% $ 14,278 4.45% $ 16,803 5.90% Real Estate Construction 29,034 6.54% 29,822 8.04% 32,256 9.00% 14,313 4.46% 15,514 5.45% Real Estate Mortgage 290,068 65.31% 245,138 66.09% 238,651 66.58% 222,288 69.30% 182,946 64.22% Agricultural 79,627 17.93% 59,328 16.00% 57,497 16.04% 56,615 17.65% 52,188 18.32% Consumer 15,684 3.53% 8,954 2.41% 9,062 2.53% 12,978 4.05% 17,134 6.01% Other 402 0.09% 368 0.10% 991 0.28% 289 0.09% 309 0.11% Total, Net (1) 444,150 100.00% 370,912 100.00% 358,456 100.00% 320,761 100.00% 284,894 100.00% (1) Including loans held for sale, net of deferred loan fees
Off-balance Sheet Arrangements 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: 2006 2005 Unused lines of credit $ 67,921,443 $ 56,354,000 Commitments to make loans 658,000 156,000 Letters of credit 639,538 183,000 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 5.625% to 6.125% with maturities ranging from 15 to 30 years and are intended to be sold. Capital As displayed by the following table, the Company's Tier I capital (as defined by the Federal Reserve Board under the Board's risk-based guidelines) at December 31, 2006 increased $3.8 million to $48.4 million. During 2006, the Company purchased 12,901 shares of its stock for $378 thousand. These repurchases partially offset the $6.5 million in net income for 2006. Stockholders' equity, excluding accumulated other comprehensive income, was $56.6 million at December 31, 2006. Included in Tier I capital is $7 million of trust preferred securities issued in August 2003. The disallowed amount of stockholders' equity is mainly attributable to the goodwill and core deposit intangible, resulting from the Peoples acquisition in 2006 and the Kentucky First acquisition in 2003(see Note 6 in the notes to consolidated financial statements included as Exhibit 13 for more information on the goodwill and core deposit intangible assets). The Company's risk-based capital and leverage ratios, as shown in the following table, exceeded the levels required to be considered "well capitalized". The leverage ratio compares Tier I capital to total average assets less disallowed amounts of goodwill. At December 31 (dollars in thousands) 2006 2005 Change Stockholders' Equity (1) $ 56,595 $ 47,479 9,116 Trust Preferred Securities 7,000 7,000 0 Less Disallowed Amount 15,175 9,877 5,298 Tier I Capital 48,420 44,602 3,818 Allowance for Loan Losses 5,067 4,385 682 Other 5 143 (138) Tier II Capital 5,072 4,528 544 Total Capital 53,492 49,130 4,362 Total Risk Weighted Assets 426,900 366,393 60,507 Ratios: Tier I Capital to Risk-weighted Assets 11.3% 12.2% -0.8% Total Capital to Risk-weighted Assets 12.5% 13.4% -0.9% Leverage 7.8% 8.0% -0.2% (1) Excluding accumulated other comprehensive income. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") established five capital categories for insured depository institutions under its Prompt Corrective Action Provisions. The bank regulatory agencies adopted regulations, which became effective in 1992, defining these five capital categories for banks they regulate. The categories vary from "well capitalized" to "critically undercapitalized". A "well capitalized" bank is defined as one with a total risk-based capital ratio of 10% or more, a Tier I risk-based capital ratio of 6% or more, a leverage ratio of 5% or more, and one not subject to any order, written agreement, capital directive, or prompt corrective action directive to meet or maintain a specific capital level. At December 31, 2006, the bank had ratios that exceeded the minimum requirements established for the "well capitalized" category. In management's opinion, there are no other known trends, events or uncertainties that will have or that are reasonably likely to have a material effect on the Company's liquidity, capital resources or operations. Securities and Federal Funds Sold Securities, classified as available for sale, decreased from $160.7 million at December 31, 2005 to $127.9 million at December 31, 2006. The decrease is mainly attributable to a short term decrease in deposits. Federal funds sold totaled $4.1 million at December 31, 2006 and $2.7 million at December 31, 2005. Per Company policy, fixed rate asset backed securities will not have an average life exceeding seven years, but final maturity may be longer. Adjustable rate securities shall adjust within three years per Company policy. As of December 31, 2006, the Company held no adjustable rate mortgage backed securities. Of the $1.4 million of adjustable asset backed securities held on December 31, 2005, $303 thousand were repriceable monthly and the remaining $1.1 million were repriceable annually. Unrealized gains (losses) on investment securities are temporary and change inversely with movements in interest rates. In addition, some prepayment risk exists on mortgage-backed securities and prepayments are likely to increase with decreases in interest rates. The following tables present the investment securities for each of the past three years and the maturity and yield characteristics of securities as of December 31, 2006. Investment Securities at market value At December 31 (in thousands) 2006 2005 2004 Available for Sale U.S. treasury $ 0 $ 2,974 $ 2,984 U.S. government agencies 31,492 67,033 39,031 States and political subdivisions 44,130 37,463 35,160 Mortgage-backed Fixed - GNMA, FNMA, FHLMC Passthroughs 38,262 33,566 35,013 GNMA, FNMA, FHLMC CMO's 13,720 17,390 11,335 Total 51,982 50,956 46,348 Variable - GNMA, FNMA, FHLMC Passthroughs 0 1,081 1,623 GNMA, FNMA, FHLMC CMO's 0 303 649 Total 0 1,384 2,272 Total mortgage-backed 51,982 52,340 48,620 Other 287 842 972 Total 127,891 160,652 126,767 Maturity Distribution of Securities
December 31, 2006 (in thousands) Over One Over Five Asset Year Years Backed One Year Through Through Over Ten & Equity or Less Five Years Ten Years Years Securities Total Available for Sale U.S. government agencies 12,890 15,614 2,988 0 0 31,492 States and political subdivisions 1,066 9,045 18,772 15,247 0 44,130 Mortgage-backed 0 0 0 0 51,982 51,982 Equity Securities 0 0 0 0 287 287 Total 13,956 24,659 21,760 15,247 52,269 127,891 Percent of Total 10.9% 19.3% 17.0% 11.9% 40.9% 100.0% Weighted Average Yield (1) 4.53% 5.90% 6.18% 6.52% 4.75% 5.40% (1) Tax Equivalent Yield
Impact of Inflation and Changing Prices The majority of the Company's assets and liabilities are monetary in nature. Therefore, the Company differs greatly from most commercial and industrial companies that have significant investments in nonmonetary assets and inventories. However, inflation does have an important impact on the growth of assets in the banking industry and the resulting need to increase equity capital at higher than normal rates in order to maintain an appropriate equity to assets ratio. Inflation also affects other expenses, which tend to rise during periods of inflation. Item 7A. Asset/Liability Management, Interest Rate Sensitivity, Market Risk and Liquidity Asset/Liability management control is designed to ensure safety and soundness, maintain liquidity and regulatory capital standards, and achieve acceptable net interest income. The Company's exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee. Management considers interest rate risk to be the most significant market risk. 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. Certain assumptions, such as prepayment risks, are included in the model. However, actual prepayments may differ from those assumptions. In addition, immediate withdrawal of interest checking and other savings accounts may have an effect on the results of the 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. The projections are based on balance sheet growth assumptions and repricing opportunities for new, maturing and adjustable rate amounts. In addition, the projected percentage changes from level rates are outlined below along with the Board of Directors approved limits. As of December 31, 2006 the projected net interest income percentages are within the Board of Directors limits. The projected net interest income report summarizing the Company's interest rate sensitivity as of December 31, 2006 and December 31, 2005 is as follows: Projected Net Interest Income (December 31, 2006)
Level -300 -100 Rates +100 +300 Year One (1/07 - 12/07) Net Interest Income $16,102 $17,505 $18,064 $18,557 $19,374 Net interest income dollar change (1,962) (559) 493 1,310 Net interest income percentage change -10.9% -3.1% N/A 2.7% 7.3% Limitation on % Change >-18.0% >-6.0% N/A >-4.0% >-10.0%
Projected Net Interest Income (December 31, 2005)
Level -300 -100 Rates +100 +300 Year One (1/06 - 12/06) Net interest income $21,476 $21,970 $22,473 $22,925 $23,361 Net interest income dollar change (997) (503) 452 888 Net interest income percentage change -4.4% -2.2% N/A 2.0% 4.0% Limitation on % Change >-18.0% >-6.0% N/A >-4.0% >-10.0%
The numbers in 2006 show more fluctuation when compared to 2005. In 2006, year one reflected a decrease in net interest income of 3.1% compared to 2.2% projected decrease from 2005 with a 100 basis point decline. The 300 basis point increase in rates reflected a 7.3% increase in net interest income in 2006 compared to a 4.0% increase in 2005. The risk is more in 2006 due to the current status of existing interest rates and their effect on rate sensitive assets and rate sensitive liabilities. Based on the model, an increase in rates should improve net interest income. Management measures the Company's interest rate risk by computing estimated changes in net interest income in the event of a range of assumed changes in market interest rates. The Company's exposure to interest rates is reviewed on a monthly basis by senior management and quarterly with the Board of Directors. Exposure to interest rate risk is measured with the use of interest rate sensitivity analysis to determine the change in net interest income in the event of hypothetical changes in interest rates, while interest rate sensitivity gap analysis is used to determine the repricing characteristics of the Company's assets and liabilities. If estimated changes to net interest income are not within the limits established by the Board, the Board may direct management to adjust the Company's asset and liability mix to bring interest rate risk within Board approved limits. 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 meet the needs of borrowers, depositors and creditors. Excess liquidity generally has a negative impact on earnings resulting from the lower yields on short-term assets. In addition to cash and cash equivalents, the securities portfolio provides an important source of liquidity. Total securities maturing within one year along with cash and cash equivalents totaled $33.0 million at December 31, 2006. Additionally, securities available-for- sale with maturities greater than one year totaled $113.9 million at December 31, 2006. The available for sale securities are available to meet liquidity needs on a continuing basis. The Company maintains a relatively stable base of customer deposits and its steady growth is expected to be adequate to meet its funding demands. In addition, management believes the majority of its $100,000 or more certificates of deposit are no more volatile than its core deposits. At December 31, 2006 these balances totaled $67.3 million, approximately 14% of total deposits. The Company also 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. We have sufficient collateral to borrow an additional $28 million from the FHLB at December 31, 2006. 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 believes there is sufficient cash flow from operations to meet investing and liquidity needs related to reasonable borrower, depositor and creditor needs in the present economic environment. The cash flow statements for the periods presented provide an indication of the Company's sources and uses of cash as well as an indication of the ability of the Company to maintain an adequate level of liquidity. A number of other techniques are used to measure the liquidity position, including the ratios presented below. These ratios are calculated based on annual averages for each year. Liquidity Ratios December 31 2006 2005 2004 Average Loans (including loans held for sale)/Average Deposits 93.6% 90.4% 88.3% Average Securities sold under agreements to repurchase and other borrowings/Average Assets 5.6% 4.9% 5.7% This chart shows that the loan to deposit ratio increased in 2006 and increased in 2005. The increase in the ratio in 2006 compared to 2005, and in 2005 compared to 2004 is mainly attributable to a larger increase in loans compared to deposits. Item 8. Financial Statements The consolidated financial statements of the Company together with the notes thereto and report of independent registered public accountants are contained in the Company's 2006 Annual Report to Stockholders included as Exhibit 13, and are incorporated herein by reference. No other portion of the 2006 Annual Report to Stockholders is to be deemed "filed" as part of this filing. Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure None Item 9A. Controls and Procedures The Company's management, with participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures as of December 31, 2006. Based on the evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective as of December 31, 2006. There was no change in the Company's internal control over financial reporting during the fourth quarter of 2006 that has materially affected, or is reasonably likely to materially affect, such internal control over financial reporting. Item 9B. Other Information None PART III Item 10. Directors and Executive Officers of the Registrant Under the Company's Articles of Incorporation, the Board of Directors consists of three different classes, each to serve, subject to the provisions of the Articles of Incorporation and Bylaws, for a three year term and until his successor is duly elected and qualified. The names of the directors and their terms are set forth below. Terms expiring in 2007: William Arvin, age 67, is an attorney. He has been a director of Kentucky Bank and the Company since 1995. B. Proctor Caudill, age 57, is Special Projects Manager of Kentucky Bank. He was President and Chief Executive Officer of the Peoples Bancorp from 1981 to 2006, and President from 1999 to 2006 and Chief Executive Officer from 1981 to 2006 of Peoples Bank. He has been a director of Kentucky Bank and the Company since 2006. Louis Prichard, age 53, is President and Chief Executive Officer of Kentucky Bank. He was President and Chief Operating Officer of Kentucky Bank from 2003 to 2004. He has been a director of Kentucky Bank and the Company since 2003. Since 1983, he was in banking in Danville and was the Chairman and Chief Executive Officer of Boyle Bancshares, Inc. and their banking subsidiary, Farmers Bank for 7 years before joining the Company in 2003. Woodford Van Meter, age 53, is an ophthalmologist. He has been a director of Kentucky Bank and the Company since 2004. Terms expiring in 2008: Henry Hinkle, age 55, is President of Hinkle Construction Company. He has been a director of Kentucky Bank and the Company since 1989. Theodore Kuster, age 63, is a farmer and thoroughbred horse breeder. He has been a director of Kentucky Bank since 1979 and the Company since 1985. Robert G. Thompson, age 57, is a farmer and thoroughbred horse breeder. He has been a director of Kentucky Bank and the Company since 1991. Terms expiring in 2009: Betty J. Long, age 59, is retired President and CEO of First Federal, Cynthiana. She has been a director of Kentucky Bank since 2006 and the Company since 2003. Ted McClain, age 55, is an insurance agent with Hopewell Insurance Company. He has been a director of Kentucky Bank since 2002 and the Company since 2003. Edwin S. Saunier, age 49, is President of Saunier North American, Inc. He has been a director of Kentucky Bank and the Company since 2007. Buckner Woodford, age 62, is Chairman of the Board of Kentucky Bancshares, Inc. and Kentucky Bank. He was President and Chief Executive Officer of the Company from 1991 to 2004, and President and Chief Executive Officer of the Kentucky Bank from 1984 to 2004. He has been a director of Kentucky Bank since 1971 and the Company since inception. The Company's other executive officers are Norman J. Fryman, age 57, Gregory J. Dawson, age 46 and Darren M. Henry, age 44. Mr. Fryman is the Vice President of Sales and Service of Kentucky Bank and has been with the Company since 1977. Mr. Dawson is the Chief Financial Officer and has been with the Company since 1985. Mr. Henry is Vice President, Director of Commercial Lending and has been with the Company since 2002. The Company has adopted a code of ethics for its Chief Executive Officer and its Chief Financial Officer. A copy of the code of ethics may be obtained, without charge, by contacting the CFO. The Company has named Betty J. Long of the audit committee as its financial expert and she is independent as that term is used in Item 7(d)(3)(iv) of Schedule 14A under the Securities Exchange Act of 1934. Item 11. Compensation Discussion and Analysis EXECUTIVE COMPENSATION Compensation Discussion and Analysis Overview of Compensation Program The Compensation Committee ("Committee") of the Board has responsibility for establishing, implementing and continually monitoring adherence with the Company's compensation philosophy. The Committee ensures that the total compensation paid is fair, reasonable and competitive. The individuals who served as the Company's Chief Executive Officer and Chief Financial Officer during fiscal 2006, as well as the other individuals included in the Summary Compensation Table, are referred to as the "named executive officers". Compensation Philosophy and Objectives The Committee believes that the most effective executive compensation program is one that is designed to reward the achievement of specific annual, long- term and strategic goals by the Company, and which aligns executives' interests with those of the stockholders by rewarding performance above established corporate and individual goals, with the ultimate objective of improving stockholder value. The Committee evaluates both performance and compensation to ensure that the Company maintains its ability to attract and retain superior employees in key positions and that compensation provided to key employees remains competitive relative to the compensation paid to similarly situated executives of our peer companies. To that end, the Committee believes executive compensation packages provided by the Company to its executives, including the named executive officers, should include both cash and stock-based compensation that reward performance as measured against established goals. The Committee, and the President and Chief Executive Officer ("CEO"), evaluate the information in the annual Kentucky Bankers Association Financial Institution Compensation Survey ("KBA Survey") and then use their subjective judgment to determine a percentage increase in the Company's total base pay. Each manager, based on this aggregate percentage increase, is allocated a pool of funds to allocate increases among the employees the manager supervises. Role of Executive Officers in Compensation Decisions The Committee makes all compensation decisions for the CEO and approves recommendations regarding equity awards to all officers of the Company. Decisions regarding the non-equity compensation of other executive officers are made by the CEO, in his discretion using the pool of funds allocated to the other executive officers based on the overall corporate percentage increase. Setting Executive Compensation Based on the foregoing objectives, the Committee has structured the Company's annual and long-term incentive-based cash and non-cash executive compensation to motivate executives to achieve the business goals set by the Company and reward the executives for achieving such goals. A significant percentage of total compensation is allocated to incentives. The Committee reviews relevant market data and alternatives when making compensation decisions for the CEO. Up to 40% of base compensation may be earned in performance-based incentive compensation as a result of the performance of the Company, compared to established goals. 2006 Executive Compensation Components For the fiscal year ended December 31, 2006, the principal components of compensation for named executive officers were base salary, performance-based incentive compensation, long-term equity incentive compensation, and retirement and other benefits. Base Salary The Company provides named executive officers and other employees with base salary to compensate them for services rendered during the fiscal year. Base salary ranges for named executive officers are determined for each executive based on his or her position and responsibility. Salary levels are typically considered annually as part of the Company's performance review process as well as upon a promotion or other change in job responsibility. The Committee and the CEO primarily use the annual KBA Survey in setting salary ranges on an annual basis. Every five years, the Committee recalibrates salary ranges based on the overall value of each job by comparing current market rates of bench mark jobs and assigning all jobs to salary grades, after considering their market value and internal value. During his review of base salaries for other executives, the CEO primarily focuses on the individual's performance. Performance-Based Incentive Compensation The Management Incentive Plan ("MIP") was created to promote high performance by officers of the Company by achievement of corporate goals and encouragement of growth of stockholder value. The Company currently has approximately 61 officers (including the named executive officers) who are eligible to receive cash awards under MIP. The MIP provides guidelines for the calculation of annual non-equity incentive based compensation, subject to Committee oversight and modification. Annually, the Committee considers whether any changes should be made with the MIP. The MIP includes various incentive levels based on the participant's accountability and impact on Company operations, with target award opportunities that are established as a percentage of base salary. These maximum targets range from 20% of base salary to 40% of base salary for the Company's named executive officers. For fiscal 2006, 50-100% of a named executive officer's MIP award was based upon achievement of corporate financial objectives relating to Company earnings on a quarterly basis, with goals set for threshold, target and maximum levels. The remaining percentage of an executive's MIP award was based upon individual performance goals (such as investment yield, net interest spread, loan volume, loan margin) also with threshold, target and maximum levels, determined by the CEO. Only the CEO's MIP award was based on 100% of the Company's earnings. The remaining executive's MIP awards were either 50% or 75% based on Company's earnings. Payment of awards under the MIP are based upon the achievement of such objectives for the current year. Named executive officers participating in the MIP receive: 50% of the maximum award if threshold levels are met, 75% of the maximum award if target levels are met and 100% of the maximum award if maximum levels are met. Generally, the Committee sets the target level for earnings at the Company's earnings objective for the current year. Threshold and maximum levels are set below and above the target level (generally five to seven percentage points, as applicable). In making the annual determination of the threshold, target and maximum levels, the Committee may consider the specific circumstances facing the Company during the coming year. In 2006, the established targets for each quarter were: Threshold Target Maximum Actual 1st quarter $ 1,391,000 $ 1,464,000 $ 1,566,000 $ 1,474,000 2nd quarter 1,587,000 1,671,000 1,788,000 1,780,000 3rd quarter 1,812,000 1,907,000 2,041,000 1,880,000 4th quarter 1,820,000 1,916,000 2,050,000 1,830,000 This plan has been in place for the last two years. The payout percentages for the Company's earnings over these two years have been between 43% and 63% of the participant's maximum. Generally, the Committee sets the threshold, target and maximum levels such that the relative difficulty of achieving the target level is consistent from year to year. Awards made to named executive officers under the MIP for performance in 2006 are reflected in column (g) of the Summary Compensation Table. Long-Term Incentive Compensation Stock Grant Plan The Stock Grant Plan encourages participants to focus on long-term Company performance and provides an opportunity for executives and other officers to increase their stake in the Company through grants of the Company's Common Stock. Starting in 2006, the Committee utilized the Stock Grant Plan to compensate executives and other officers for sustained increases in the Company's stock performance. Twenty percent of each grant vests annually on anniversary date of the grant. Upon a change of control while an employee is employed by the Company, any restriction period will expire immediately and the employee will hold the restricted stock free of any restrictions. Based on its subjective judgment, the Committee annually establishes the awards to the executive officers under the Stock Grant Plan based on the salary level of each employee. These awards are reflected in the Summary Compensation Table and the Grants of Plan Based Awards Table. Stock Option Plan The Employee Stock Option Plan assists the Company to enhance the link between the creation of stockholder value and long-term executive incentive compensation, provide an opportunity for increased equity ownership by executives and maintain competitive levels of total compensation. Since the establishment of the Stock Grant Plan in 2006, the Committee has not awarded any stock options. Currently, the committee anticipates that stock option awards for officers will be primarily used for newly hired or promoted executives. Options are awarded at the current closing price of the Company's Common Stock on the date of the grant. The options granted by the Committee vest at a rate of 20% per year over the first five years of the ten-year option term. Vesting and exercise rights expire 90 days after termination of employment, except in the case of death (subject to a one year limitation), disability or retirement. Prior to the exercise of an option, the holder has no rights as a stockholder with respect to the shares subject to such option, including voting rights and the right to receive dividends or dividend equivalents. In the event of a change of control of the Company, each outstanding option will become fully vested and immediately exercisable. Retirement and Other Benefits All employees of the Company are eligible to participate in the Pension Plan and the Profit Sharing (401k) Plan. Pension Plan Under the Retirement Plan, full or part-time employees working for the Company who have completed five continuous years of employment with the Company, including the named executive officers, earn the right to receive certain benefits upon retirement at the normal retirement age of 65 or upon early retirement on or after age 55. Retirement benefits are calculated as the product of 1% times the years of service multiplied by the final average eligible pay for the five highest consecutive years. If the employee retires between the ages of 55 and 64, the amount of benefits is reduced such that if the associate retires at age 55, he or she will be entitled to 50% of the accrued benefits. Of the named executive officers, Mr. Woodford and Mr. Fryman are eligible for early retirement benefits under the Retirement Plan. Profit Sharing (401k) Plan The Profit Sharing (401k) Plan is available to all employees, including the named executive officers. The Company will match 100% of the first 6% of pay that is contributed to the Savings. All employee contributions to the Savings Plan are fully-vested upon contribution, and matching contributions are vested after 3 years of service. The Company may, at its discretion, make a profit sharing contribution to the plan. This has not been done since the 401k feature was added to the plan. Stock Gift Program The Company provides stock gifts to full time Company employees, including the named executive officers, who have completed at least 15 years of service. Under the Stock Gift Program, participants may be awarded an increasing number of shares of the Company's Common Stock for each five year anniversary starting with 15 years for their continued dedicated service to the Company Tax and Accounting Implications Accounting for Stock-Based Compensation Beginning on January 1, 2006, the Company began accounting for stock- based payments including its Stock Option Program, Long-Term Stock Grant Program, Restricted Stock Program and Stock Award Program in accordance with the requirements of FASB Statement 123(R). The following table sets forth information with respect to the compensation of the Chairman of the Board (Buckner Woodford), President and Chief Executive Officer (Louis Prichard), Vice President of Sales and Service (Norman J. Fryman), Chief Financial Officer (Gregory J. Dawson) and Vice President Director of Commercial Lending (Darren M. Henry) of the Company (the "Named Executive Officers") for the fiscal year ended December 31, 2006. No other executive officer earned total compensation in excess of $100,000. Summary Compensation Table
(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) Change in Pension Value and Non-Equity Nonqualified Incentive Deferred Stock Option Plan Compensation All Other Name & Position Year Salary Bonus Awards Awards Compensation Earnings Compensation Total (1) (2) (3) (4) (5) Buckner Woodford 2006 $ 82,800 $ - $ 4,826 $ - $15,566 $48,273 $13,603 $116,795 Chairman Louis Prichard 2006 185,000 - 10,238 - 46,250 12,751 21,361 262,849 President, CEO Norman J. Fryman 2006 118,051 - 4,826 - 22,303 25,249 7,886 153,066 VP, Sales & Service Gregory J. Dawson 2006 90,155 2,700 4,826 - 22,719 11,190 6,369 126,769 CFO Darren M. Henry 2006 88,400 - 2,925 - 19,317 3,729 6,284 116,926 VP, Director of Commercial Lending
(1) Represents compensation for work done on special project (2) Represents the value from stock grants issued in 2006 (3) Represents cash incentives based on bank and/or individual performance (4) Represents change in value of pension benefits (5) Represents the Company's matching contribution to the qualified profit sharing plan that includes a 401(k) provision The following table contains information regarding the grant of stock options under the Company's stock option plan to the Named Executive Officers during the year ended December 31, 2006. Grants of Plan Based Awards
All Other Grant Date Stock Awards: Fair Value Estimated Future Payments Under Number of of Stock Grant Non-Equity Incentive Plan Awards (1) Shares of and Option Name Date Threshold Target Maximum Stock or Unit Awards (2) (3) ($) ($) ($) (#) ($) Buckner Woodford 1/3/2006 165 $ 4,826 N/A $12,731 $19,096 $25,461 Louis Prichard 1/3/2006 350 10,238 N/A 40,000 60,000 80,000 Norman J. Fryman 1/3/2006 165 4,826 N/A 18,327 27,491 36,655 Gregory J. Dawson 1/3/2006 165 4,826 N/A 16,755 25,133 33,511 Darren M. Henry 1/3/2006 100 2,925 N/A 9,172 13,757 18,343
(1) Represents incentive compensation from MIP plan (2) Represents the shares granted from stock grant plan (3) Represents the value of stock grant on grant date Outstanding Equity Awards at Fiscal Year-end
Option Awards (1) Stock Awards (2) Market Number of Number of Number of Value of Securities Securities Shares or Shares or Underlying Underlying Units of Units of Unexercised Unexercised Option Option Stock that Stock that Options Options Exercise Expiration Have not Have not Name Exercisable Unexercisable Price Date Vested Vested Buckner Woodford 3,600 $20.63 1/12/09 165 $ 5,115 500 24.00 1/3/10 500 23.50 1/2/11 400 100 26.00 1/2/12 600 400 25.50 1/2/13 400 600 33.90 1/2/14 200 800 30.50 1/3/15 Louis Prichard 1,800 1,200 25.50 1/2/13 350 10,850 400 600 33.90 1/2/14 800 3,200 30.50 1/3/15 Norman J. Fryman 400 15.50 1/7/08 165 5,115 300 24.00 1/3/10 300 23.50 1/2/11 240 60 26.00 1/2/12 300 200 25.50 1/2/13 200 300 33.90 1/2/14 100 400 30.50 1/3/15 Gregory J. Dawson 400 15.50 1/7/08 165 5,115 1,100 20.63 1/12/09 150 24.00 1/3/10 150 23.50 1/2/11 120 30 26.00 1/2/12 240 160 25.50 1/2/13 160 240 33.90 1/2/14 100 400 30.50 1/3/15 Darren M. Henry 300 200 25.50 1/2/13 100 3,100 120 180 33.90 1/2/14 160 640 30.50 1/3/15
(1) Represents stock options granted under the stock option plan (2) Represents grants of stock under the stock grant plan The following table sets forth certain information regarding options exercised by the Named Executive Officers during calendar year 2006. Option Awards Number of Shares Value Realized Name Acquired on Exercise on Exercise Gregory J. Dawson 600 $11,100 The table below shows the present value of accumulated benefits payable to each of the named executive officers, including the number of years of service credited to each such named executive officer, under the Pension Plan determined using interest rate and mortality rate assumptions consistent with those used in the Company's financial statements.
Payments Present Value During Number of Years of Accumulated Last Fiscal Name Plan Name Credited Service Benefit Year Buckner Woodford Kentucky Bancshares, Inc. 34 $ 589,272 $ - Retirement Plan & Trust Louis Prichard Kentucky Bancshares, Inc. 4 36,972 - Retirement Plan & Trust Norman J. Fryman Kentucky Bancshares, Inc. 21 169,523 - Retirement Plan & Trust Gregory J. Dawson Kentucky Bancshares, Inc. 20 65,180 - Retirement Plan & Trust Darren M. Henry Kentucky Bancshares, Inc. 4 11,200 - Retirement Plan & Trust
In general, a participant's remuneration covered by the Company's pension plan is his or her average annual cash compensation (W-2 earnings) for the highest 5 years. The years of service are 35 years for Mr. Woodford, 3 years for Mr. Prichard, 22 years for Mr. Fryman, 21 years for Mr. Dawson and 4 years for Mr. Henry. The normal benefit is a life annuity based on the 1984 Unisex Pension pre-retirement mortality table and a pre-retirement interest rate of 7%. The benefits are not subject to a deduction for Social Security or other offset amounts. Compensation of Directors Each director of the Company is a director of Kentucky Bank. Company Directors are paid $400 for each Company and Kentucky Bank board meeting attended ($400 for one paid absence per year) and non-employee Company directors are paid $100 for each Kentucky Bank committee meeting attended. Each Company Director is paid an annual retainer of $1,500 plus the audit committee chairman is paid an additional annual retainer of $2,000. Thos compensation is shown in the table below as fees earned or paid in cash. Non-employee Directors of Kentucky Bank are also granted a 10-year option (shown under options awards in the table below) to purchase 100 shares of the Company's common stock following each year in which Kentucky Bank has a return on assets of 1 percent or greater. The option's exercise price is the fair market value per share on the date of grant. Fees Earned or Paid Option Name in Cash Awards Total William Arvin $12,200 $ 497 $ 12,697 Henry Hinkle 8,300 497 8,797 Theodore Kuster 13,400 497 13,897 Betty J. Long 12,300 497 12,797 Ted McClain 12,100 497 12,597 Edward Saunier 2,500 497 2,997 Robert G. Thompson 14,200 497 14,697 Woodford Van Meter 10,300 497 10,797 COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The compensation committee of the Board is comprised of Messrs. Arvin, Hinkle and Kuster, each a non-employee director of the Company. None of our executive officers serve on the compensation committee or board of directors of any other company of which any members of our compensation committee or any of our directors is an executive officer. REPORT OF THE COMPENSATION COMMITTEE The Compensation Committee of the company has reviewed and discussed the Compensation Discussion and Analysis required by Item 402(b) of Regulation S-K with management and, based on such review and discussions, the Compensation Committee recommended to the Board that the Compensation Discussion and Analysis be included in this proxy statement. Members of the Compensation Committee: William Arvin Henry Hinkle Theodore Kuster Item 12. Security Ownership of Certain Beneficial Owners and Management Set forth below are the number of shares of the Company's common stock beneficially owned by each director and executive officer, and all current directors and executive officers as a group as of December 31, 2006. Name Shares Beneficially Owned(1) Number Percentage William Arvin (2) 30,271 1.0% B. Proctor Caudill (3) 177,010 6.0 Gregory J. Dawson (4) 8,762 * Norman J. Fryman (5) 3,935 * Darren M. Henry (6) 1,100 * Henry Hinkle (7) 38,135 1.3% Theodore Kuster (8) 18,105 * Betty J. Long (9) 1,700 * Ted McClain (10) 2,575 * Louis Prichard (11) 7,410 * Edwin S. Saunier (12) 700 * Robert G. Thompson (13) 6,250 * Woodford Van Meter (14) 32,500 1.1% Buckner Woodford (15) 250,429 8.5% All directors and officers (14 persons) as a group (consisting of those persons named above)(16) 578,882 19.7% * Less than 1% 1) Beneficial ownership as reported in the above table has been determined in accordance with Rule 13d-3 under the Exchange Act. Unless otherwise indicated, beneficial ownership includes both sole or shared voting and sole or shared investment power. 2) Includes 11,858 shares held in a retirement account, 11,968 shares held of record by Mr. Arvin's wife, as to which Mr. Arvin disclaims beneficial ownership, 5,465 shares held jointly with his wife and 750 shares that Mr. Arvin may acquire upon exercise of outstanding stock options. 3) Includes 19,725 shares held of record by Mr. Caudill's wife, as to which Mr. Caudill's disclaims beneficial ownership and 165 shares from future vesting of stock grants. 4) Includes 2,710 shares that Mr. Dawson may acquire upon exercise of outstanding stock options and 297 shares from future vesting of stock grants. 5) Includes 2,200 shares that Mr. Fryman may acquire upon exercise of outstanding stock options and 297 shares from future vesting of stock grants. 6) Includes 900 shares that Mr. Henry may acquire upon exercise of outstanding stock options and 180 shares from future vesting of stock grants. 7) Includes 1,000 shares held by his wife and 2,545 shares held by relatives, as to which Mr. Hinkle disclaims beneficial ownership. Includes 31,875 shares held of record by Hinkle Contracting Company, as to which Mr. Hinkle, as president, has shared voting power. Also includes 750 shares that Mr. Hinkle may acquire upon exercise of outstanding stock options. 8) Includes 6,250 shares held of record by Mr. Kuster's wife, as to which Mr. Kuster disclaims beneficial ownership. Also includes 5,500 shares held in a retirement account and 550 shares that Mr. Kuster may acquire upon exercise of outstanding stock options. 9) Includes 1,600 shares held in a retirement account and 100 shares that Ms. Long may acquire upon exercise of outstanding stock options. 10) Includes 1,000 shares held of record by Hopewell Company, as to which Mr. McClain, as a 1/3 owner, has voting power. Also includes 400 shares that Mr. McClain may acquire upon exercise of outstanding stock options. 11) Includes 2,110 shares held jointly with his wife and 4,600 shares that Mr. Prichard may acquire upon exercise of outstanding stock options and 630 shares from future vesting of stock grants. 12) Includes 200 shares that Mr. Saunier may acquire upon exercise of outstanding stock options. 13) Includes 200 shares held of record by Mr. Thompson's wife, as to which Mr. Thompson disclaims beneficial ownership. Includes 750 shares that Mr. Thompson may acquire upon exercise of outstanding stock options. 14) Includes 2,200 shares held of record by Mr. Van Meter's wife, as to which Mr. Van Meter disclaims beneficial ownership. Includes 200 shares that Mr. Van Meter may acquire upon exercise of outstanding stock options. 15) Includes 8,000 shares held by his wife, as to which Mr. Woodford disclaims beneficial ownership. Also 6,900 shares that Mr. Woodford may acquire upon exercise of outstanding stock options and 297 shares from future vesting of stock grants. 16) Includes 21,010 shares that may be acquired upon exercise of outstanding stock options and 1,866 shares from future vesting of stock grants. The following table sets forth as of December 31, 2006 the only persons known by the Company to own beneficially (as determined in accordance with the rules and regulations of the Commission) more than 5% of the outstanding common stock. See notes 3 and 15 in the preceding table for further information. Name and Address Shares Beneficially of Beneficial Owner Owned Percentage Buckner Woodford 250,429 8.5% 340 Stoner Avenue Paris, Kentucky 40361 B. Proctor Caudill 177,010 6.0 2075 Rice Road Morehead, KY 40351 The following table sets forth as of December 31, 2006 the Company's common stock authorized for issuance under equity compensation plans. The Company's shareholders have approved all of the Company's equity compensation plans.
Number of Securities Number of Securities remaining available for To be issued Weighted average future issuance under Upon exercise of exercise price of equity compensation plans Outstanding options, outstanding options, (excluding securities Plan category warrants and rights warrants and rights reflected in column (a) Equity compensation plans Approved by security holders: Employee Gift Program 0 $ n/a 572 1993 Employee Stock Ownership Incentive Plan 16,510 18.89 0 1993 Non-Employee Directors Stock Ownership Plan 7,100 27.10 8,000 1999 Employee Stock Option Plan 46,304 29.19 52,044 2005 Restricted Stock Grant Plan 0 n/a 46,155 Total 69,914 $26.54 106,771
Item 13. Certain Relationships and Related Transactions Directors and officers of the Company and their associates were customers of and had transactions with the Company's subsidiary bank in the ordinary course of business during the year ended December 31, 2006. Similar transactions may be expected to take place with the Company's subsidiary bank in the future. Outstanding loans and commitments made by such subsidiary bank in transactions with the Company's directors and officers and their associates were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and did not involve more than a normal risk of collectibility or present other unfavorable features. Certain directors and executive officers were loan customers of Kentucky Bank and outstanding loans were $4.7 million as of December 31, 2006 and as of December 31, 2005. See Note 4 in the notes to consolidated financial statements included as Exhibit 13. The Company purchased various types of insurance with aggregate premiums amounting to $256 thousand in 2006 from Hopewell Insurance Company. Director Ted McClain owns 33% of this company and is one of their insurance agents. Item 14. Principal Accountant Fees and Services The Audit Committee has pre-approved that management of the Company may consult with the primary independent auditor concerning certain additional services outside of the audit work that was specifically approved in the engagement letter for those services. Included were services such as: 1. Discussions related to accounting for mergers and acquisitions, 2. Tax return preparation 3. Discussions concerning loan review, 4. Discussions regarding regulatory requirements, 5. Data processing and retirement plan audits, and 6. Profit enhancement and other consulting. The fees for services provided by the primary independent auditor, Crowe Chizek and Company LLC for 2006 and for 2005 were as follows: Audit fees - Fees for the financial statement audit, and the review of the Company's Form 10-Q's were $115,000 for 2006 and $92,050 for 2005. Audit related fees - Aggregate fees for all assurance and related services were $14,450 for 2006 and $14,600 for 2005. These fees were incurred for audits of benefit plans. The 2006 and 2005 amounts were preapproved by the audit committee. Tax fees - Fees related to tax compliance, advice and planning were $16,000 for 2006 and $14,450 for 2005. The 2006 and 2005 amounts were preapproved by the audit committee. All other fees - Consulting fees related to acquisitions, profitability and risk management were $16,120 for 2006 and $14,400 for 2005. The 2006 and 2005 amounts were preapproved by the audit committee. All services provided by the Corporation's primary independent auditor in 2006 and 2005 were approved by the Audit Committee. Part IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) The following exhibits are incorporated by reference herein or made a part of this Form 10-K: 2.1 Agreement and Plan of Merger with Peoples Bancorp of Sandy Hook is incorporated by reference to Exhibit 2.1 of the Registrant's Current Report on Form 8-K dated February 24, 2006 (File No. 33-96358). 3.1 Articles of Incorporation of the Registrant are incorporated by reference to Exhibit 3.1 of the Registrant's Quarterly Report on Form 10-Q for the quarterly period ending March 31, 2000 (File No. 33-96358). 3.2 Bylaws of the Registrant are incorporated by reference to Exhibit 3.1 of the Registrant's Quarterly Report on Form 10-Q for the quarterly period ending June 30, 2000 (File No. 33-96358). 3.3 Articles of Amendment to Amended and Restated Articles of Incorporation of the Registrant are incorporated by reference to Exhibit 3.3 of the Registrant's Annual Report on Form 10-K for the period ending December 31, 2005 (File No. 33-96358). 10.1 Kentucky Bancshares, Inc. 1993 Employee Stock Ownership Incentive Plan is incorporated by reference to Exhibit 10.2 of the Registrant's Registration Statement on Form S-4 (File No. 33-96358).* 10.2 Kentucky Bancshares, Inc. 1993 Non-Employee Directors Stock Ownership Incentive Plan is incorporated by reference to Exhibit 10.3 of the Registrant's Registration Statement on Form S-4 (File No. 33-96358).* 10.3 Kentucky Bancshares, Inc. 1999 Employee Stock Option Plan is incorporated by reference to Exhibit 99.1 of the Registrant's Form 10-K for the fiscal year ended December 31, 1998.* 10.4 Schedule of 2006 Compensation Arrangements for Named Executive Officers is incorporated by reference to the Registrant's Current Report on Form 8-K dated December 20, 2005 (File No. 33-96358).* 10.5 2005 Restricted Stock Grant Plan, including form of Award Agreement, as incorporated by reference to Exhibit 10.1 of the Registrant's Current Report on Form 8-K dated February 15, 2005 (File No. 33-96358).* 11 Computation of earnings per share - See Note 12 in the notes to consolidated financial statements included as Exhibit 13. 13 Kentucky Bancshares, Inc. 2006 Annual Report and Proxy Statement, including Financial Statements: Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Comprehensive Income Consolidated Statements of Changes in Stockholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Report of Independent Auditors 21 Subsidiaries of Registrant 23 Consent of Crowe Chizek and Company LLC 31.1 Certification of Chief Executive Officer pursuant to Rule 13a- 14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended. 31.2 Certification of Chief Financial Officer pursuant to Rule 13a- 14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended. 32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * Denotes a management contract or compensatory plan or arrangement of the Registrant required to be filed as an exhibit pursuant to Item 601(10) (iii) of Regulation S-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. By: ___/s/Louis Prichard __ Louis Prichard, President and Chief Executive Officer, Director March 30, 2007 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. /s/Louis Prichard__ _______ March 30, 2007 Louis Prichard, President and Chief Executive Officer, Director /s/Gregory J. Dawson_________ March 30, 2007 Gregory J. Dawson, Chief Financial and Accounting Officer /s/Buckner Woodford__________ March 30, 2007 Buckner Woodford, Chairman of the Board, Director _____________________________ March __, 2007 William Arvin, Director /s/B. Proctor Caudill________ March 30, 2007 B. Proctor Caudill, Director /s/Henry Hinkle___ _ __ ____ March 30, 2007 Henry Hinkle, Director _____________________________ March __, 2007 Theodore Kuster, Director /s/Betty J. Long_____________ March 30, 2007 Betty J. Long, Director /s/Ted McClain______________ March 30, 2007 Ted McClain, Director _____________________________ March __, 2007 Edwin S. Saunier, Director /s/Robert G. Thompson________ March 30, 2007 Robert G. Thompson, Director _____________________________ March __, 2007 Woodford Van Meter, Director SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(d) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT. The Registrant refers to Exhibit 13 to the Form 10-K. INDEX TO EXHIBITS Exhibit Number Description of Document 2.1 Agreement and Plan of Merger with Peoples Bancorp of Sandy Hook is incorporated by reference to Exhibit 2.1 of the Registrant's Current Report on Form 8-K dated February 24, 2006 (File No. 33-96358). 3.1 Articles of Incorporation of the Registrant are incorporated by reference to Exhibit 3.1 of the Registrant's Quarterly Report on Form 10-Q for the quarterly period ending March 31, 2000 (File No. 33-96358). 3.2 Bylaws of the Registrant are incorporated by reference to Exhibit 3.1 of the Registrant's Quarterly Report on Form 10- Q for the quarterly period ending June 30, 2000 (File No. 33-96358). 3.3 Articles of Amendment to Amended and Restated Articles of Incorporation of the Registrant are incorporated by reference to Exhibit 3.3 of the Registrant's Annual Report on Form 10-K for the period ending December 31, 2005 (File No. 33-96358). 10.1 Kentucky Bancshares, Inc. 1993 Employee Stock Ownership Incentive Plan is incorporated by reference to Exhibit 10.2 of the Registrant's Registration Statement on Form S-4 (File No. 33-96358).* 10.2 Kentucky Bancshares, Inc. 1993 Non-Employee Directors Stock Ownership Incentive Plan is incorporated by reference to Exhibit 10.3 of the Registrant's Registration Statement on Form S-4 (File No. 33-96358).* 10.3 Kentucky Bancshares, Inc. 1999 Employee Stock Option Plan is incorporated by reference to Exhibit 99.1 of the Registrant's Form 10-K for the fiscal year ended December 31, 1998.* 10.4 Schedule of 2006 Compensation Arrangements for Named Executive Officers is incorporated by reference to the Registrant's Current Report on Form 8-K dated December 20, 2005 (File No. 33-96358).* 10.5 2005 Restricted Stock Grant Plan, including form of Award Agreement, as incorporated by reference to Exhibit 10.1 of the Registrant's Current Report on Form 8-K dated February 15, 2005 (File No. 33-96358).* 11 Computation of earnings per share - See Note 10 in the notes to consolidated financial statements included as Exhibit 13. 13 Kentucky Bancshares, Inc. 2006 Annual Report and Proxy Statement, including Financial Statements: Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Comprehensive Income Consolidated Statements of Changes in Stockholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Report of Independent Auditors 21 Subsidiaries of Registrant 23 Consent of Crowe Chizek and Company LLC 31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended. 31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended. 32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * Denotes a management contract or compensatory plan or arrangement of the Registrant required to be filed as an exhibit pursuant to Item 601(10) (iii) of Regulation S-K. 6 25 BOURBON BANCSHARES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2000, 1999 and 1998 44 39 EX-13 2 exhibit13annualrpt.txt ANNUAL REPORT Exhibit 13 KENTUCKY BANCSHARES, INC. ANNUAL REPORT 2006 Introduction Kentucky Bank sponsors and co-sponsors many types of community events throughout our regions. The events in 2006 included the Kentucky Bank High School Basketball Shootout, Big Brothers Big Sisters Duck Race, various community picnics, Chamber of Commerce events, grand openings, Wealth Managements Polo event, and sponsorships at school events in every community. We are proud to have fifteen banking centers in the eight Kentucky Counties we serve. Cynthiana, Georgetown, Morehead, N. Middletown, Nicholasville, Paris, Versailles, Sandy Hook, Wilmore and Winchester make up the communities Kentucky Bank calls home. Kentucky Bank increased its service markets by two communities in 2006. Our new East Kentucky Region includes banking offices in Morehead and Sandy Hook. To accommodate our growth in Rowan County, we will begin construction in 2007 on another office to serve our Morehead customers. During 2006 we purchased an additional building in downtown Paris. We will be remodeling that office and converting it to our downtown lobby to better serve our customers. This will provide our Bourbon County customers with more convenient drive-through and parking facilities. Technology has changed the manner and speed in which the world conducts its banking. The collection of funds, the movement of actual checks and electronic transmissions, as well as communication with customers, grows faster by the moment. We maintain our commitment to be at the forefront of new opportunities in technology. Online Banking continues to grow as a popular way for our customers to conduct their banking business. We strongly believe that whether the customer is served directly or indirectly, each of us has an obligation to deliver premier service. Our strategy is such that we want to distinguish ourselves from other financial institutions by providing excellent service. Throughout this annual report you will see photos of our employees and directors, certainly our greatest assets. At Kentucky Bank we are committed to an ongoing education program. As an organization, we can only reach our goals with a committed, intelligent, and service oriented staff. We have continuing education opportunities readily available to our employees. Whether they are interested in attending a graduate school of banking or simply an online education course, we encourage everyone to gain additional knowledge. By acquiring this knowledge, we feel that our customers can obtain the product that best meets their financial needs and we can provide the best in customer service. Dear Shareholders: For the year ended December 31, 2006, the assets of your company reached a year-end record high of $629.5 million, which represents a 9.9% increase over last year's total assets of $572.7 million. Loans increased 19.7% to reach $444.1 million; also a new year-end high. Deposits grew 8.6% over the prior year to reach a record high of $468.8 million. Much of that growth, along with growth in the loan area, can be attributable to not only our natural growth in our current markets, but also to our merger with Peoples Bank of Morehead and Sandy Hook which took place on July 7, 2006. Earnings per share, on a diluted basis, were $2.34, an 8.3% increase over the year ended December 31, 2005. Net income reached a record high of $6.5 million, which represented an 11.4% increase over the prior year- end. Again, these positive results can be traced to not only our natural growth in earnings, but also the addition of the earnings contributed by Peoples Bank. Our net interest margins continue to be compressed not only as a result of the flat, if not inverted, yield curve that exists in today's credit markets, but additionally as a result of the competitive markets in which we operate. As was mentioned above, one of our most noteworthy events in 2006 was the acquisition of Peoples Bancorp, Inc. of Sandy Hook and Morehead. The consideration of this transaction was $14 million with 40% in the form of Kentucky Bancshares, Inc. stock and 60% in the form of cash. We are very pleased that the accretion to earnings is occurring as anticipated. I want to take this time to thank both our employees in Rowan and Elliott Counties, as well as our operational people here in Paris, for working so hard to make this transition go as smoothly as possible. Other recent events of import that took place during 2006 consist of the purchasing of a lot in northern Jessamine County, on which we intend to build another full service facility to be operational by the latter part of 2008. Additionally, we purchased the former Fifth-Third Bank building in downtown Paris, and we are undertaking the necessary steps to make that facility fully functional for us in the next few months. We are also in the process of expanding our footprint in Rowan County with an additional location to be added in 2008. B. Proctor Caudill, Jr., former Chairman and CEO of Peoples Bank, has now become a member of the Kentucky Bank and Kentucky Bancshares, Inc. boards of directors. Also, he has become our Manager of Special Projects, and we look forward to his contribution not only as a board member, but also as an employee of the bank. We wanted to take this opportunity to also recognize two people who have recently retired from their service at Kentucky Bank. Dr. James Ferrell retired from our Board of Directors at the end of this year. Jim has served on our board since 1980, and his contributions have been significant, and have by no small measure contributed to the success of the bank and your company. Hugh Crombie, our Director of Operations, after 43 years of service has retired from Kentucky Bank. Hugh started out his work for the bank in 1963 as an assistant installment loan manager and has worked in various areas of the department, including our bookkeeping area. He worked his way up through the organization over the years, and ultimately brought our bank into the age of the computer. There are no words to express Hugh's contribution to the growth and well being of our bank. He will be greatly missed and we wish him nothing but the best in his retirement years. We are also pleased to announce that Martha W. Woodford, former Assistant Director of Operations, has assumed the responsibilities of Director of Operations. Martha started with the bank in 1984 in our Audit Department, and subsequent to that she has worked in our Loan Center, our Customer Service area, and became manager of our Corporate and Automated Products. In 2004 Martha became the Assistant Director of Operations in anticipation of Hugh's retirement. We are fortunate to have someone with her depth and breadth of experience, and we look forward to her future contributions to Kentucky Bank. Additionally, we are pleased to announce the directors for our newly created Rowan/Elliott Regional Advisory Board. Madonna Weathers is Vice President of Student Affairs at Morehead State University. G. R. (Sonny) Jones is CFO of St. Claire Regional Medical Center. Tod Barhorst is the owner of Abner Construction Company. Rocky Adkins is Majority Floor Leader of the Kentucky House of Representatives. We are confident that these community leaders will make significant contributions to our ongoing success in the Rowan/Elliott region. We also want to also announce the addition in January 2007 of Edwin S. Saunier, president of Saunier North American, Inc. to both our bank and holding company boards. Ed has been a long time Clark County regional board member, and has a successful moving and storage business located in Winchester. Ed has served on various committees within the bank and we very much look forward to his assuming the duties of bank and holding company director. After completing two acquisitions within the last five years, we believe that this is an opportune time to look at how our bank operates and delivers customer service. As we continue to grow, a paramount goal of Kentucky Bank is to ensure that we are able to continue to deliver outstanding customer service in the markets we serve. As our mission statement indicates, "Kentucky Bank will be the premier community financial institution in our markets." As a result of that desired goal, we have created a multitude of teams to examine our operating and administrative processes so that we will be able to continue to provide our customers the services and products they deserve, while at the same time providing an appropriate return to our shareholders. We are very encouraged by the progress of these teams and we look forward to the successful implementations of the recommendations they offer. In closing, we want to thank you for investing in Kentucky Bancshares, Inc. Your confidence in all of us is greatly appreciated, and we will do our best to enhance the value of your investment. Sincerely, /s/Louis Prichard Louis Prichard President and CEO Kentucky Bancshares, Inc. /s/Buck Woodford Buckner Woodford Chairman of the Board Kentucky Bancshares, Inc. Financial Highlights... Kentucky Bancshares, Inc. 2006 2005 2004 Assets ($ thousands) $ 629,542 $ 572,750 $ 528,544 Net Income ($ thousands) $ 6,486 $ 5,820 $ 5,762 Per Share Results... Earnings (assuming dilution) $ 2.34 $ 2.16 $ 2.07 Dividend $ 1.00 $ .92 $ .84 Annual Meeting The annual meeting of Kentucky Bancshares, Inc. will be held Friday, May 9, 2007 at 11:00 in the corporate headquarters. Investor Information Any individual requesting a copy of the Corporation's 2006 Form 10-K Report may obtain these by 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 Acquiring Stock Kentucky Banchshares common stock is available through your broker of Kentucky Bank's Wealth Management Department. We are listed on the over- the-counter board. Symbol KTYB.OB. CONSOLIDATED BALANCE SHEETS December 31 2006 2005 ASSETS Cash and due from banks $ 14,905,672 $ 11,456,496 Federal funds sold 4,106,000 2,708,000 Cash and cash equivalents 19,011,672 14,164,496 Securities available for sale 127,890,612 160,652,346 Loans 444,150,390 370,911,882 Allowance for loan losses (4,991,277) (4,309,403) Net loans 439,159,113 366,602,479 Federal Home Loan Bank stock 6,468,200 5,398,100 Bank premises and equipment, net 14,327,050 10,701,541 Interest receivable 5,653,869 3,719,135 Mortgage servicing rights 745,834 801,501 Goodwill 13,116,710 9,110,524 Other intangible assets 2,058,149 765,885 Other assets 1,111,094 834,288 Total assets $ 629,542,303 $ 572,750,295 LIABILITIES AND STOCKHOLDERS' EQUITY Deposits Non-interest bearing $ 87,503,263 $ 72,192,661 Time deposits, $100,000 and over 67,255,274 61,597,420 Other interest bearing 314,049,382 297,841,297 Total deposits 468,807,919 431,631,378 Repurchase agreements and other borrowings 11,326,913 16,837,573 Federal Home Loan Bank advances 80,030,283 66,748,641 Subordinated debentures 7,217,000 7,217,000 Interest payable 3,682,785 2,714,506 Other liabilities 3,196,604 1,054,954 Total liabilities 574,261,504 526,204,052 Stockholders' equity Preferred stock, 300,000 shares authorized and unissued - - Common stock, no par value; 10,000,000 shares authorized; 2,864,586 and 2,666,897 shares issued and outstanding in 2006 and 2005 12,474,039 6,812,805 Additional paid-in capital 59,375 - Retained earnings 44,061,889 40,666,332 Accumulated other comprehensive income (loss) (1,314,504) (932,894) Total stockholders' equity 55,280,799 46,546,243 Total liabilities and stockholders' equity $ 629,542,303 $ 572,750,295 See Accompanying notes. CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31 2006 2005 2004 Interest income Loans, including fees $ 29,068,728 $ 23,373,434 $ 20,470,306 Securities Taxable 4,395,404 3,388,793 3,574,235 Tax exempt 1,666,382 1,444,090 1,518,275 Other 462,333 690,660 283,196 35,592,847 28,896,977 25,846,012 Interest expense Deposits 12,117,444 8,180,571 5,765,690 Repurchase agreements and other borrowings 1,162,350 603,812 411,492 Federal Home Loan Bank advances 2,944,217 2,487,062 2,395,898 Subordinated debentures 494,197 494,227 494,052 16,718,208 11,765,672 9,067,132 Net interest income 18,874,639 17,131,305 16,778,880 Provision for loan losses 475,000 508,100 840,000 Net interest income after provision for loan losses 18,399,639 16,623,205 15,938,880 Other income Service charges 5,223,973 4,511,270 4,357,658 Loan service fee income, net 33,020 9,023 (2,993) Trust department income 602,884 458,328 299,448 Securities gains (losses), net 34,259 64,395 288,950 Gain on sale of mortgage loans 290,035 333,742 376,157 Other 1,051,765 1,118,289 1,227,614 7,235,936 6,495,047 6,546,834 Other expenses Salaries and employee benefits 9,612,798 8,547,607 8,053,306 Occupancy expenses 2,320,418 2,194,431 2,255,071 Amortization 184,736 95,736 275,490 Advertising and marketing 519,685 473,848 378,410 Taxes other than payroll, property and income 537,485 547,509 499,251 Other 3,506,589 3,361,280 3,044,294 16,681,711 15,220,411 14,505,822 Income before income taxes 8,953,864 7,897,841 7,979,892 Provision for income taxes 2,467,810 2,077,741 2,217,783 Net income $ 6,486,054 $ 5,820,100 $ 5,762,109 Earnings per share: Basic $ 2.35 $ 2.17 $ 2.09 Diluted 2.34 2.16 2.07 See Accompanying notes. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Years Ended December 31 2006 2005 2004 Net income $ 6,486,054 $ 5,820,100 $ 5,762,109 Other comprehensive income (loss) Unrealized gains (losses) on securities arising during the period 735,236 (1,839,887) (1,522,118) Reclassification of realized amount (34,259) (64,395) (288,950) Net change in unrealized gain (loss) on securities 700,977 (1,904,282) (1,811,068) Less: Tax impact 238,332 (647,456) (615,763) Comprehensive income $ 6,948,699 $ 4,563,274 $ 4,566,804 See Accompanying notes.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY Years Ended December 31, 2006, 2005 and 2004 Accumulated Additional Other Total Common Stock Paid-in Retained Comprehensive Stockholders' Shares Amount Capital Earnings Income Equity Balances, January 1, 2004 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 Common stock issued including tax benefit, net (including stock grants of 3,845 shares) 11,754 117,741 - - - 117,741 Stock compensation expense - - 59,375 - - 59,375 Common stock purchased (12,901) (56,385) - (322,069) - (378,454) Common stock issued in connection with Purchase of Peoples Bancorp, Inc. 198,836 5,599,878 - - - 5,599,878 Net change in unrealized gain (loss) on securities available for sale, net of tax - - - - 462,645 462,645 Adjustment to initially apply SFAS No. 158, net of tax (Note 1) - - - - (844,255) (844,255) Net income - - - 6,486,054 - 6,486,054 Dividends declared - $1.00 per share - - - (2,768,428) - (2,768,428) Balances, December 31, 2006 2,864,586 $12,474,039 $ 59,375 $ 44,061,889 $(1,314,504) $ 55,280,799
See Accompanying notes.
CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31 2006 2005 2004 Cash flows from operating activities Net income $ 6,486,054 $ 5,820,100 $ 5,762,109 Adjustments to reconcile net income to net cash from operating activities Depreciation and amortization 1,313,476 1,174,954 1,419,794 Provision for loan losses 475,000 508,100 840,000 Securities amortization (accretion), net (14,717) 331,355 635,725 Securities (gains) losses, net (34,259) (64,395) (288,950) Originations of loans held for sale (17,156,711) (18,036,701) (22,065,215) Proceeds from sale of loans 17,446,746 18,454,914 30,024,484 Gain on sale of mortgage loans (290,035) (333,742) (376,157) Stock based compensation expense 59,375 - - Federal Home Loan Bank stock dividends (342,200) (261,600) (206,400) Losses (gain) on sale of fixed assets (1,100) (71,045) (16,722) Changes in: Interest receivable (1,318,246) (492,656) 23,355 Other assets (1,906,617) 425,569 1,135,547 Interest payable 836,125 865,038 213,684 Other liabilities 723,683 624,374 942,501 Net cash from operating activities 6,276,574 9,035,265 18,043,755 Cash flows from investing activities Purchases of securities available for sale (30,905,332) (53,539,693) (70,689,970) Proceeds from sales of securities available for sale 42,207,571 1,323,500 37,973,553 Proceeds from principal payments and maturities of securities available for sale 53,343,210 16,159,467 32,581,271 Cash paid for bank acquisition (2,841,873) - - Net change in loans (22,106,318) (13,067,340) (45,775,823) Purchases of bank premises and equipment (1,540,977) (758,929) (948,546) Proceeds from sale of bank premises and Equipment 1,100 581,881 199,722 Net cash from investing activities 38,157,381 (49,301,114) (26,659,793) Cash flows from financing activities Net change in deposits (35,102,694) 43,676,556 3,356,226 Net change in repurchase agreements and other borrowings (9,380,282) (8,755,271) 18,307,586 Advances from Federal Home Loan Bank 90,000,000 15,000,000 25,000,000 Payments on Federal Home Loan Bank advances (83,074,662) (7,902,073) (18,383,678) Proceeds from note payable 8,000,000 - - Payments on note payable (7,000,000) - - Proceeds from issuance of common stock, including options and grants, including tax benefits 117,741 47,595 131,041 Purchase of common stock (378,454) (629,399) (3,424,456) Dividends paid (2,768,428) (2,462,038) (2,303,219) Net cash from financing activities (39,586,779) 38,975,370 22,683,500 See Accompanying notes. CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31 2006 2005 2004 Net change in cash and cash equivalents $ 4,847,176 $ (1,290,479) $ (5,932,538) Cash and cash equivalents at beginning of year 14,164,496 15,454,975 21,387,513 Cash and cash equivalents at end of year $ 19,011,672 $ 14,164,496 $ 15,454,975 Supplemental disclosures of cash flow information Cash paid during the year for: Interest expense $ 15,749,929 $ 10,900,634 $ 8,853,448 Income taxes 2,498,021 1,971,443 777,401 Supplemental schedules of non-cash investing activities Real estate acquired through foreclosure $ 396,472 $ 391,743 $ 1,325,942 Common stock issued in connection with purchase of Peoples Bancorp, Inc. 5,599,878 - -
See Accompanying notes. NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation: The consolidated financial statements include the accounts of Kentucky Bancshares, Inc. (the Company) and its wholly-owned subsidiary, Kentucky Bank (the Bank). Intercompany transactions and balances have been eliminated in consolidation. On July 7, 2006, the Company acquired 100% of the outstanding shares of Peoples Bancorp of Sandy Hook, Inc. (Peoples), parent of Peoples Bank of Sandy Hook and Morehead in Elliott and Rowan Counties, Kentucky, as discussed in Note 15. 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, Elliot, Harrison, Jessamine, Rowan, Scott, Woodford and adjoining counties in Kentucky. As a state bank, the Bank is subject to regulation by the Kentucky Office 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 homogeneous 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: Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 123(R), Share-based Payment, using the modified prospective transition method. Accordingly, the Company has recorded stock-based employee compensation cost using the fair value method starting in 2006. For 2006, adopting this standard resulted in a reduction of income before income taxes of $59,375, a reduction in net income of $39,188, a decrease in both basic and diluted earnings per share of $0.02. Prior to January 1, 2006, employee compensation expense under stock options was reported using the intrinsic value method; therefore, no stock-based compensation cost is reflected in net income for the years ending December 31, 2005 and 2004, 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, for the years ending December 31. 2005 2004 Net income As reported $ 5,820,100 $ 5,762,109 Deduct: Stock-based compensation expense determined under fair value based method (56,241) (42,178) Pro forma 5,763,859 5,719,931 2005 2004 Basic earnings per share As reported $ 2.17 $ 2.09 Pro forma 2.15 2.07 Diluted earnings per share As reported $ 2.16 $ 2.07 Pro forma 2.14 2.06 Weighted averages Fair value of options granted $ 4.82 $ 5.68 Risk free interest rate 3.98% 3.86% Expected life 8 years 8 years Expected volatility 15.11% 13.74% Expected dividend yield 3.03% 2.47% 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 cost, interest cost, return on plan assets and amortization of gains and losses not immediately recognized. See "Effect of Newly Issued But Not Yet Effective Accounting Standards" below for further discussion of the effect of adopting FASB Statement No. 158. 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 consist of core deposit intangible assets arising from whole bank and branch acquisitions. They are initially measured at fair value and then are amortized on either an accelerated or 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. These derivatives are carried at fair value. The Company did not have any mandatory forward sales contracts at December 31, 2006 and 2005. Adoption of New Accounting Standards: Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 123(R), Share-based Payment. See "Stock Compensation" above for further discussion of the effect of adopting this standard. FASB Statement No. 158: In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106 and 132(R). This Statement requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its balance sheet, beginning with year end 2006, and to recognize changes in the funded status in the year in which the changes occur through comprehensive income beginning in 2007. Additionally, defined benefit plan assets and obligations are to be measured as of the date of the employer's fiscal year-end, starting in 2008. Adoption had the following effect on individual line items in the 2006 balance sheet:
Before After Application of Application of SFAS No. 158 Adjustments SFAS No. 158 Liability for pension benefits $ 460,511 $ 1,279,174 $ 1,739,685 Deferred income taxes 813,410 (434,919) 378,491 Total liabilities 573,417,249 844,255 574,261,504 Accumulated other comprehensive income (470,249) (844,255) (1,314,504) Total stockholders' equity 56,125,054 (844,255) 55,280,799
SAB 108: In September 2006, the Securities and Exchange Commission (SEC) released Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108), which is effective for fiscal years ending on or after November 15, 2006. SAB 108 provides guidance on how the effects of prior-year uncorrected financial statement misstatements should be considered in quantifying a current year misstatement. SAB 108 requires public companies to quantify misstatements using both an income statement (rollover) and balance sheet (iron curtain) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. If prior year errors that had been previously considered immaterial now are considered material based on either approach, no restatement is required so long as management properly applied its previous approach and all relevant facts and circumstances were considered. Adjustments considered immaterial in prior years under the method previously used, but now considered material under the dual approach required by SAB 108, are to be recorded upon initial adoption of SAB 108. Adoption of this statement did not materially affect the Company's consolidated financial position or results of operations. Newly Issued Not Effective: New accounting standards have been issued that the Company does not expect will have a material effect on the financial statements when adopted in future years or for which the Company has not yet completed its evaluation of the potential effect upon adoption. In general, these standards revise the accounting for derivatives embedded in other financial instruments for 2007, revise the recognition and accounting for servicing of financial assets for 2007, establish a hierarchy about the assumptions used to measure fair value for 2008, change the recognition threshold and measurement guidance for tax positions that contain significant uncertainty in 2007, revise the accrual of post-retirement benefits associated with providing life insurance for 2008, and revise the accounting for cash surrender value for 2007. Additionally, a new accounting standard will require the company to record servicing assets at fair value instead of at allocated cost, and thereafter will allow the Company to carry new and existing classes of servicing assets at either fair value or amortized original basis, beginning in 2007. Adoption of this standard may increase servicing assets to the extent the Company elects to apply it to existing classes of servicing assets and to the extent fair value of servicing exceeds amortized cost. 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, 2006 and 2005 was $322,000 and $156,000. NOTE 3 - SECURITIES Year-end securities available for sale are as follows: Fair Unrealized Unrealized Value Gains Losses 2006 U. S. government agencies $ 31,492,403 $ 93,134 $ (124,991) States and municipals 44,129,640 703,114 (181,988) Mortgage-backed 51,981,681 - (1,218,655) Equity securities 286,888 16,888 - Total $ 127,890,612 $ 813,136 $(1,525,634) 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) The fair value of securities available for sale at December 31, 2006, 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 $ 13,955,375 Due after one year through five years 24,659,350 Due after five years through ten years 21,759,873 Due after ten years 15,247,445 75,622,043 Mortgage-backed 51,981,681 Equity 286,888 Total $ 127,890,612 Proceeds from sales of securities during 2006, 2005 and 2004 were $42,207,571, $1,323,500 and $37,973,553. Gross gains of $452,218, $89,943 and $483,888 and gross losses of $417,959, $25,548 and $194,938, were realized on those sales, respectively. The tax provision related to these realized gains and losses was $11,648, $21,894 and $98,243, respectively. Securities with an approximate carrying value of $108,120,000 and $122,961,000 at December 31, 2006 and 2005, 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 2006 and 2005 not recognized in income are as follows:
2006 Less than 12 Months 12 Months or More Total Fair Unrealized Fair Unrealized Fair Unrealized Description of Securities Value Loss Value Loss Value Loss U.S. Government securities $ 5,115,257 $ (9,164) $ 9,795,703 $ (115,827) $ 14,910,960 $ (124,991) States and municipals 4,918,106 (15,531) 10,263,653 (166,457) 15,181,759 (181,988) Mortgage-backed - 40,662,549 (1,218,655) 40,662,549 (1,218,655) Total temporarily impaired $10,033,363 $ (24,695) $60,721,905 $(1,500,939) $ 70,755,268 $(1,525,634) 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)
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, 2006, eleven 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: 2006 2005 Commercial $ 29,335,344 $ 27,301,633 Real estate construction 29,033,790 29,822,067 Real estate mortgage 290,068,211 245,138,321 Agricultural 79,627,134 59,327,772 Consumer 15,683,984 8,953,943 Other 401,927 368,146 $ 444,150,390 $ 370,911,882 Activity in the allowance for loan losses was as follows: 2006 2005 2004 Beginning balance $ 4,309,403 $ 4,163,315 $ 3,819,842 Allowance from acquisition 775,913 - - Charge-offs (642,664) (526,735) (687,798) Recoveries 73,625 164,723 191,271 Provision for loan losses 475,000 508,100 840,000 Ending balance $ 4,991,277 $ 4,309,403 $ 4,163,315 Impaired loans totaled $2,379,000 and $774,000 at December 31, 2006 and 2005. The average recorded investment in impaired loans during 2006, 2005 and 2004 was $1,624,000, $1,547,000 and $1,444,000. The total allowance for loan losses related to these loans was $553,000 and $240,000 at December 31, 2006 and 2005. Interest income on impaired loans of $62,000, $25,000 and $22,000 was recognized for cash payments received in 2006, 2005 and 2004. Nonperforming loans were as follows: 2006 2005 Loans past due over 90 days still on accrual $ 253,000 $ 206,000 Nonaccrual loans 2,379,000 774,000 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 were approximately $107,766,000 and $104,575,000 at December 31, 2006 and 2005. Custodial escrow balances maintained in connection with the foregoing loan servicing, and included in demand deposits, were approximately $369,000 and $509,000 at December 31, 2006 and 2005. Changes in mortgage servicing rights were as follows: 2006 2005 2004 Beginning balance $ 801,501 $ 875,633 $ 861,120 Additions 179,507 179,474 263,861 Amortization (235,174) (253,606) (249,348) Ending balance $ 745,834 $ 801,501 $ 875,633 Certain directors and executive officers of the Company and companies in which they have beneficial ownership were loan customers of the Bank during 2006 and 2005. An analysis of the activity with respect to all director and executive officer loans is as follows: 2006 Balance, beginning of year $ 4,707,000 New loans 1,076,000 Effect of changes in composition of related parties - Repayments (1,110,000) Balance, end of year $ 4,673,000 NOTE 5 - PREMISES AND EQUIPMENT Year-end premises and equipment were as follows: 2006 2005 Land and buildings $ 16,554,057 $ 12,560,227 Furniture and equipment 11,756,195 10,200,440 Construction projects 217,591 9,500 28,527,843 22,770,167 Less accumulated depreciation (14,200,793) (12,068,626) $ 14,327,050 $ 10,701,541 Depreciation expense was $956,221, $924,564 and $993,907 in 2006, 2005, and 2004. NOTE 6 - GOODWILL AND INTANGIBLE ASSETS The change in balance for goodwill during the year is as follows: 2006 2005 Beginning of year $ 9,110,524 $ 9,110,524 Acquired goodwill 4,006,186 - Impairment - - End of year $ 13,116,710 $ 9,110,524 Goodwill will not be amortized but instead evaluated periodically for impairment. Acquired intangible assets were as follows at year-end: 2006 2005 Gross Gross Carrying Accumulated Carrying Accumulated Amount Amortization Amount Amortization Amortized intangible assets: Core deposit intangibles $5,133,403 $3,075,254 $3,656,403 $2,890,518 Core deposit intangibles of $1,477,000 were acquired during 2006 in the Peoples acquisition, as further described in Note 15 - Business Combination. Aggregate amortization expense was $184,736, $95,736 and $275,490 for 2006, 2005 and 2004. 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: 2007 $ 270,736 2008 264,736 2009 259,736 2010 253,736 2011 243,736 NOTE 7 - DEPOSITS At December 31, 2006, the scheduled maturities of time deposits are as follows: 2007 $ 193,732,730 2008 27,425,545 2009 5,953,109 2010 1,271,792 2011 590,105 Certain directors and executive officers of the Company and companies in which they have beneficial ownership are deposit customers of the Bank. The amount of these deposits was approximately $3,994,000 and $1,700,000 at December 31, 2006 and 2005. NOTE 8 - REPURCHASE AGREEMENTS AND OTHER BORROWINGS Securities sold under agreements to repurchase are secured by U.S. Government securities with a carrying amount of $23,665,328 and $23,246,420 at year-end 2006 and 2005. Repurchase agreements generally mature within one year from the transaction date and range in maturities from 1 day to 1 year. The securities underlying the agreements are maintained in a third-party custodian's account under a written custodial agreement. Information concerning repurchase agreements for 2006 and 2005 is summarized as follows: 2006 2005 Average daily balance during the year $ 15,660,750 $ 16,014,304 Average interest rate during the year 3.79% 3.19% Maximum month-end balance during the year $ 18,372,446 $ 18,071,544 Weighted average interest rate at year end 3.83% 3.18% Promissory note payable of $1,000,000 at December 31, 2006, has principal due at July 7, 2009, interest payable quarterly at prime less 1.75%, and is secured by 100% of the common stock of the bank. NOTE 9 - FEDERAL HOME LOAN BANK ADVANCES At year-end, advances from the Federal Home Loan Bank were as follows: 2006 2005 Maturities February 2007 through March 2030, fixed rates from 1.00% to 3.08% $ 17,226,422 $ 19,802,691 Maturities February 2007 through February 2026, fixed rates from 3.55% to 4.43% 36,060,120 30,781,074 Maturities February 2007 through January 2026, fixed rates from 4.77% to 7.55% 26,743,741 16,164,876 Total $ 80,030,283 $ 66,748,641 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, 2006 are as follows: 2007 $ 14,556,348 2008 15,268,240 2009 26,759,315 2010 6,250,000 2011 1,480,136 Thereafter 15,716,244 $ 80,030,283 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: 2006 2005 2004 Current $ 2,476,648 $ 1,969,865 $ 2,063,949 Deferred (8,838) 107,876 153,834 $ 2,467,810 $ 2,077,741 $ 2,217,783 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. 2006 2005 Deferred tax assets Allowance for loan losses $ 1,645,241 $ 1,355,432 Unrealized loss on securities 242,249 480,581 Core deposit intangibles - 13,753 Adjustment to initially apply SFAS No. 158 434,919 - Other 327,074 121,049 Deferred tax liabilities Bank premises and equipment (776,157) (429,886) FHLB stock (1,254,026) (1,018,338) Mortgage servicing rights (253,584) (272,510) Core deposit intangibles (491,132) - Other (253,075) (188,099) Net deferred tax asset (liability) $ (378,491) $ 61,982 Effective tax rates differ from federal statutory rates applied to financial statement income due to the following: 2006 2005 2004 U. S. federal income tax rate 34.0% 34.0% 34.0% Changes from the statutory rate Tax-exempt investment income (7.8) (7.3) (7.0) Non-deductible interest expense related to carrying tax-exempt investments 1.1 0.8 0.6 Other 0.3 (1.2) 0.2 27.6% 26.3% 27.8% 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, 2006. 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: 2006 2005 2004 Basic Earnings Per Share Net income $ 6,486,054 $ 5,820,100 $ 5,762,109 Weighted average common shares outstanding 2,761,826 2,676,890 2,757,233 Basic earnings per share $ 2.35 $ 2.17 $ 2.09 Diluted Earnings Per Share Net income $ 6,486,054 $ 5,820,100 $ 4,233,377 Weighted average common shares outstanding 2,761,826 2,676,890 2,781,146 Add dilutive effects of assumed exercise of stock options 11,736 14,965 45,640 Weighted average common and dilutive potential common shares outstanding 2,773,562 2,691,855 2,826,786 Diluted earnings per share $ 2.34 $ 2.16 $ 2.07 Stock options of 11,736 shares common stock from 2006, 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. 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: 2006 2005 Change in benefit obligation: Beginning benefit obligation $ 6,737,359 $ 5,481,513 Service cost 472,140 432,429 Interest cost 364,248 346,223 Actuarial adjustment (327,181) 581,964 Benefits paid (161,825) (104,770) Ending benefit obligation 7,084,741 6,737,359 Change in plan assets, at fair value: Beginning plan assets 5,071,504 4,795,708 Actual return 378,550 166,535 Employer contribution - 211,031 Benefits paid (104,998) (104,770) Ending plan assets 5,345,056 5,071,504 Funded status (1,739,685) (1,665,855) Unrecognized net actuarial (gain) loss - 1,683,609 Unrecognized prior transition asset - (1,113) Net pension prepaid (accrued) benefit $(1,739,685) $ 16,641 Prior to adoption of FAS Statement 158, amounts recognized in the balance sheet at December 31, 2005 consist of: Prepaid benefit cost $ 16,641 Intangible assets - Accumulated other comprehensive income - Net amount recognized $ 16,641 Amounts recognized in accumulated other comprehensive income at December 31, 2006 consist of: Net loss (gain) $ 1,279,916 Transition obligation (asset) (742) $ 1,279,174 The accumulated benefit obligation for defined benefit pension plans was $5,312,906 and $4,973,145 at year-end 2006 and 2005. Net periodic pension cost include the following components: 2006 2005 2004 Service cost $ 472,140 $ 432,429 $ 369,481 Interest cost 364,248 346,223 286,326 Expected return on plan assets (400,485) (376,195) (319,050) Amortization 41,249 39,818 (372) Net periodic cost $ 477,152 $ 442,275 $ 336,385 The estimated net loss and transition obligation for the defined benefit pension plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year are $33,853 and $(371). Weighted-average assumptions used to determine pension benefit obligations at year-end 2006 2005 2004 Discount rate on benefit obligation 5.75% 5.75% 6.00% Rate of compensation increase 4.00% 4.00% 4.00% Weighted-average assumptions used to determine net periodic net cost 2006 2005 2004 Discount rate on benefit obligation 5.75% 5.75% 6.00% Long-term expected rate of return on plan assets 8.00% 8.00% 8.00% Rate of compensation increase 4.00% 4.00% 4.00% 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 2006 2005 2006 Equity securities 63 62 10% Debt securities 35 36 6 Cash 2 2 4 Total 100 100 The asset allocation objective for 2006 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 $172,604 to its pension plan in 2007. The following benefit payments, which reflect expected future service, are expected: Pension Benefits 2007 $ 167,027 2008 184,078 2009 195,666 2010 245,191 2011 272,934 Years 2012-2016 1,705,178 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 $369,847, $320,670 and $309,741 in 2006, 2005 and 2004. NOTE 14 - STOCK BASED COMPENSATION The Company has two share based compensation plans as described below. Total compensation cost that has been charged against income for those plans was $59,375, $0, and $0 for 2006, 2005 and 2004. The total income tax benefit was $911, $0, and $0. 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. The fair value of each option award is estimated on the date of grant using a closed form option valuation (Black-Scholes) model that uses the assumptions noted in the table below. Expected volatilities are based on historical volatilities of the Company's common stock. The Company uses historical data to estimate option exercise and post-vesting termination behavior. The expected term of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. The fair value of options granted was determined using the following weighted-average assumptions as of grant date. 2006 2005 2004 Fair value of options granted $3.14 $4.82 $5.68 Risk-free interest rate 4.59% 3.98% 3.86% Expected term 8 years 8 years 8 years Expected stock price volatility 7.99% 15.11% 13.74% Dividend yield 3.39% 3.03% 2.47% Summary of activity in the stock option plan for 2006 follows: Weighted Weighted Average Average Remaining Aggregate Exercise Contractual Intrinsic Options Price Term Value Outstanding, beginning of year 77,064 $25.32 Granted 1,300 29.50 Expired (300) 29.97 Exercised (8,150) 15.22 Outstanding, end of year 69,914 $26.54 65.8 months $344,090 Exercisable, end of year 44,072 $24.35 52.3 months $308,190
Options outstanding at year-end 2006 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 5,920 10.9 $15.26 5,920 $15.26 From $18.00 to $20.63 per share 11,990 24.0 20.51 11,990 20.51 From $23.50 to $28.00 per share 19,804 63.3 25.38 14,832 25.32 From $29.50 to $30.50 per share 21,050 97.4 30.34 6,210 30.19 From $33.90 to $34.00 per share 11,150 84.3 33.91 5,120 33.92 69,914 44,072
Information related to the stock option plan during each year follows: 2006 2005 2004 Intrinsic value of options exercised $119,419 $53,586 $121,625 Cash received from option exercises 124,756 43,650 105,223 Tax benefit realized from option exercises 911 - - Weighted average fair value of options granted 4,082 89,306 57,486 As of December 31, 2006, there was $89,575 of total unrecognized compensation cost related to nonvested stock options granted under the Plan. The cost is expected to be recognized over a weighted-average period of 5 years. 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 were 3,875 shares granted during 2006, and 30 shares were forfeited during 2006. NOTE 15 - BUSINESS COMBINATION On July 7, 2006, the Company acquired 100% of the outstanding shares of Peoples Bancorp of Sandy Hook, Inc., parent of Peoples Bank of Sandy Hook. Operating results of Peoples are included in the consolidated financial statements since the date of acquisition. As a result of this acquisition, the Company expects to further solidify its market share in Central Kentucky, 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. The purchase price of $14 million was 40 percent stock and 60 percent cash. The purchase price resulted in approximately $4,006,000 in goodwill, and $1,477,000 in core deposit intangible. The core deposit intangible asset will be amortized over 10 years, using an accelerated method. Goodwill will not be amortized but instead evaluated periodically for impairment. Management is still in the process of evaluating the purchase accounting entries, and additional adjustments may be made. The following table summarizes the estimated fair value of assets acquired and liabilities assumed at the date of acquisition. Securities available for sale $ 31,134,000 Loans 50,925,000 Goodwill 4,006,000 Core deposit intangibles 1,477,000 Market value adjustments 994,000 Other assets 7,844,000 Total assets acquired 96,380,000 Deposits (72,279,000) Other liabilities (10,101,000) Total liabilities assumed (82,380,000) Net assets acquired $ 14,000,000 The following table presents pro forma information as if the acquisition had occurred at the beginning of 2006 and 2005. The pro forma information includes adjustments for interest income on loans and securities acquired, amortization of intangibles arising from the transaction, depreciation expense on property acquired, interest expense on deposits acquired, and the related income tax effects. The pro forma financial information is not necessarily indicative of the results of operations as they would have been had the transactions been effected on the assumed dates. 2006 2005 Net interest income $ 20,808,000 $ 20,946,000 Net income 6,879,000 6,591,000 Basis earnings per share 2.32 2.29 Diluted earnings per share 2.31 2.28 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 2007 the Bank could, without prior approval, declare dividends on any 2007 net profits retained to the date of the dividend declaration less $635,000. NOTE 17 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The fair values of the Company's financial instruments at December 31, 2006 and 2005 are as follows: 2006 2005 Carrying Carrying Amount Fair Value Amount Fair Value (In Thousands) Financial assets Cash and cash equivalents $ 19,012 $ 19,012 $ 14,164 $ 14,164 Securities 127,891 127,891 160,652 160,652 Loans, net 439,159 433,610 366,602 362,686 FHLB stock 6,468 6,468 5,398 5,398 Interest receivable 5,654 5,654 3,719 3,719 Financial liabilities Deposits $ 468,808 $ 470,799 $ 431,631 $ 432,560 Securities sold under agreements to repurchase and other borrowings 11,327 11,249 16,838 16,612 FHLB advances 80,030 77,711 66,749 64,937 Subordinated debentures 7,217 7,232 7,217 7,328 Interest payable 3,683 3,683 2,715 2,715 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: 2006 2005 Unused lines of credit $ 67,921,443 $ 56,354,000 Commitments to make loans 658,000 156,000 Letters of credit 639,538 183,000 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 5.625% to 6.125% 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, 2006 and 2005, 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) 2006 Consolidated Total Capital (to Risk-Weighted Assets) $ 53,491 12.5% $ 34,181 8% $ 42,727 N/A Tier I Capital (to Risk-Weighted Assets) 48,420 11.3 17,091 4 25,636 N/A Tier I Capital (to Average Assets) 48,420 7.8 24,758 4 30,947 N/A Bank Only Total Capital (to Risk-Weighted Assets) $ 53,370 12.5% $ 34,159 8% $ 42,699 10% Tier I Capital (to Risk-Weighted Assets) 48,299 11.3 17,079 4 25,619 6 Tier I Capital (to Average Assets) 48,299 7.8 24,723 4 30,904 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 - PARENT COMPANY FINANCIAL STATEMENTS Condensed Balance Sheets December 31 2006 2005 (In Thousands) ASSETS Cash on deposit with subsidiary $ 940 $ 1,163 Investment in subsidiary 63,004 51,699 Securities available for sale 20 573 Other assets 412 345 Total assets $ 64,376 $ 53,780 LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Subordinated debentures $ 7,217 $ 7,217 Notes payable 1,000 - Other liabilities 34 17 Stockholders' equity Preferred stock - - Common stock 12,587 6,813 Retained earnings 44,008 40,666 Accumulated other comprehensive income (loss) (470) (933) Total liabilities and stockholders' equity $ 64,376 $ 53,780 Condensed Statements of Income and Comprehensive Income Years Ended December 31 2006 2005 2004 (In Thousands) Income Dividends from subsidiary $ 9,800 $ 3,750 $ 3,650 Securities gains (losses), net 409 60 82 Interest income 16 13 24 Total income 10,225 3,823 3,756 Expenses Interest expense 577 494 494 Other expenses 250 134 157 Total expenses 827 628 651 Income before income taxes and equity in undistributed income of subsidiary 9,398 3,195 3,105 Applicable income tax (expense) benefits 166 178 177 Income before equity in undistributed income of subsidiary 9,564 3,373 3,282 Equity in undistributed income of subsidiary (3,078) 2,447 2,480 Net income 6,486 5,820 5,762 Other comprehensive income (loss), net of tax: Unrealized gains (losses) on securities arising during the period 486 (1,215) (1,004) Reclassification of realized amount (23) (42) (191) Net change in unrealized gain (loss) on securities 463 (1,257) (1,195) Comprehensive income $ 6,949 $ 4,563 $ 4,567 Condensed Statements of Cash Flows Years Ended December 31 2006 2005 2004 (In Thousands) Cash flows from operating activities Net income $ 6,486 $ 5,820 $ 5,762 Adjustments to reconcile net income to net cash from operating activities Equity in undistributed earnings of subsidiary 3,083 (2,447) (2,480) Securities (gains) losses, net (409) (60) (82) Change in other assets 43 32 659 Change in other liabilities 18 (3) - Net cash from operating activities 9,221 3,342 3,859 Cash flows from investing activities Proceeds from sales of securities available for sale 664 143 675 Acquisition of Peoples Bancorp, Inc. (8,080) - - Net cash from investing activities (7,416) 143 675 Cash flows from financing activities Proceeds from note payable 8,000 - - Payments on note payable (7,000) - - Dividends paid (2,768) (2,462) (2,303) Proceeds from issuance of common stock 118 48 131 Purchase of common stock (378) (629) (3,424) Net cash from financing activities (2,028) (3,043) (5,596) Net change in cash (223) 442 (1,062) Cash at beginning of year 1,163 721 1,783 Cash at end of year $ 940 $ 1,163 $ 721 NOTE 22 - QUARTERLY FINANCIAL DATA (UNAUDITED) Interest Net Interest Net Earnings Per Share Income Income Income Basic Fully Diluted 2006 First quarter $ 8,051 $ 4,476 $ 1,293 $ .48 $ .48 Second quarter 8,245 4,511 1,716 .65 .64 Third quarter 9,493 4,850 1,714 .60 .60 Fourth quarter 9,804 5,038 1,763 .62 .62 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 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, 2006 and 2005, and the related statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2006. 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, 2006 and 2005, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. As discussed in Note 1 of the consolidated financial statements, Kentucky Bancshares, Inc. changed its method of accounting for defined benefit pension and other postretirement plans as of December 31, 2006, in accordance with Financial Accounting Standards Board Statement No. 158, Employers' Accounting for Defined Benefit and Other Postretirement Plans. /s/Crowe Chizek and Company LLC Crowe Chizek and Company LLC Lexington, Kentucky February 27, 2007 Senior Management Louis Prichard, President and CEO Brenda Bragonier, VP, Director of Marketing and 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 Martha Woodford, VP, Asst. Director of Operations Bourbon County Nancye Fightmaster, VP, Regional Manager Wallis Brooks, AVP, Branch Manager/CRA Rhonda Brown, Sr. Consumer Lender Lisa Highley, Consumer Lender Philip Hurst, Asst. Branch Manager Susan Lemons, AVP, Branch Manager/Consumer Lender Clark County Nick Carter, VP, Regional Manager Kathy Newkirk, Sr. Consumer Lender Teresa Shimfessel, AVP, Branch Manager/Consumer Lender Brandon Sumpter, Sr. Consumer Lender East Kentucky William Hough, VP, Regional Manager Benjamin Caudill, Asst. Branch Manager/Consumer Lender Cynthia Faulkner, AVP, Branch Manager/Consumer Lender Eulah Gray, Consumer Lender Sherry Mathis, AVP, Branch Manager/Consumer Lender Tammy Stegall, Consumer Lender Harrison County David Foster, VP, Regional Manager Dreama Harris, AVP, Sr. Consumer Lender Joyce Rainey, Consumer Lender Jessamine County Rick Walling, VP, Regional Manager Deborah Hamilton, Consumer Lender Scott County Pam Jessie, VP, Regional Manager Shane Foley, VP, Mortgage Lender Sharon Whitlock, Branch Manager/Consumer Lender Woodford County Duncan Gardiner, VP, Regional Manager 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 Officer Commercial Lending Darren Henry, VP, Director of Commercial Lending R. W. Collins, VP, Commercial Lender Ken Devasher, VP, Commercial Lender Brandon Eason, VP, Commercial Lender A. J. Gullett, VP, Commercial Lender James LeMaster, Business Development Officer Michael Lovell, VP, Commercial Lender George R. Wilder, VP, Commercial Lender Human Resources Brenda Bragonier, VP, Director of Marketing and Human Resources Christopher J. LeMaster, Director of Training Judith Taylor, VP, Human Resource Manager Operations Hugh Crombie, VP, Director of Operations Karen Anderson, Electronic Banking Officer Melinda Biddle, Government Reporting Officer Patricia Carpenter, AVP, Data Management Officer Cynthia Criswell, Data Processing Officer Catherine Hill, VP, Head of Collections Perry Ingram, AVP, Network Manager Jane Mogge, Document Management Officer Donald Roe, AVP, Sr. Data Processing Officer Arnita Willoughby, AVP, Secondary Market Professional Carolyn Wilkins, AVP, Overdraft Management Officer Martha Woodford, VP, Asst. Director of Operations Wealth Management Clark Nyberg, VP, Director of Wealth Management Rebecca Combs, Financial Consultant Dixie Fite, Personal Trust Officer Jan Worth, AVP, Personal Trust Officer James Gray, Financial Consultant Bourbon County Proctor Blair, Partner, Ludwig, Blair and Bush, PLLC Lonnie Conley, Businessman Allyson Eads, Co-owner, Eads Hardware Rodes Shackelford Parrish, President, Clay Ward Agency Clark County Mary Beth Hendricks, Director Clark County Child Support Services Donald Pace, Executive Director Central Kentucky Educational Co-op with UK John Roche, Optician Edwin S. Saunier, President, Saunier North American, Inc. East Kentucky Rocky Adkins, Majority Floor Leader, House of Representatives Ted Barhorst, President of Abner Construction G.R. "Sonny" Jones, CPA, VP, CFO, St. Claire Regional Medical Center Madonna Weathers, Vice President for Student Life at Morehead State University Harrison County 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 County 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 County Gus Bynum, Physician Mike Hockensmith, Owner and President, The Hockensmith Agency, Inc. R. C. Johnson, Jr., Owner, President, Johnson's Funeral Home George Lusby, County Judge Executive Everette Varney, Former Mayor Woodford County Loren Carl, Distric Coordinator for Congressman Ben Chandler James Kay, Businessman, Farmer Tricia Kittinger, Woodford County Circuit Clerk Robert Richardson, Farmer Board of 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 B. PROCTOR CAUDILL, JR. Special Projects Manager, Kentucky Bank HENRY HINKLE President, Hinkle Contacting Corporation THEODORE KUSTER Farmer and Thoroughbred Breeder, Westview-Hillside Farms BETTY LONG Retired President, First Federal Savings of Cynthiana TED McCLAIN Agent, Hopewell Insurance Company ROBERT G. THOMPSON Farmer and Thoroughbred Breeder, Snowhill Farm WOODFORD VAN METER Ophthalmologist 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 23, 2007 (the "Annual Meeting Record Date"), for use at the Annual Meeting of Shareholders of the Company (the "Annual Meeting") to be held on Wednesday, May 9, 2007, at 11:00 a.m. (Eastern Daylight Time) in the Board Room of Kentucky Bank, 339 Main Street, Paris, Kentucky, and at any adjournment or postponement thereof. This Proxy Statement is first being mailed to the Company's shareholders on or about April 9, 2007. The principal executive offices of the Company are located at 339 Main Street, 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 four Class II 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 II 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 2,871,090 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 four (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 four 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 four nominees as 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. The names of the nominees proposed for election as Class II directors 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. Class II Director Nominees William Arvin is an attorney. He has been a director of Kentucky Bank and the Company since 1995. B. Proctor Caudill is a Special Projects Manager. He was appointed as a director of the Company in August 2006 and as a director of Kentucky Bank in July 2006. In July 2006, the Company completed the merger of Peoples Bancorp of Sandy Hook, Inc. Before the merger, Mr. Caudill served as the president and chief executive officer of Peoples Bancorp of Sandy Hook, Inc. Louis Prichard is President and Chief Executive Officer of Kentucky Bank. He was President and Chief Operating Officer of Kentucky Bank from 2003 to 2004. He has been a director of Kentucky Bank and the Company since 2003. Woodford Van Meter is an ophthalmologist. He has been a director of Kentucky Bank and the Company since 2004. 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 II 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 April 9, 2007 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 23, 2007, at the 2007 Annual Meeting of Shareholders to be held on May 9, 2007 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 William Arvin, B. Proctor Caudill, Louis Prichard, and Woodford Van Meter (INSTRUCTION: To withhold authority to vote for any individual nominee, write the nominee's name on the line below) __________________________________________________________ 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___________, 2007 ________________________________ Signature ________________________________ Signature if held jointly 83 EX-21 3 exhibit21subsidiaries.txt SUBSIDIARIES Exhibit 21 Subsidiaries of Registrant Kentucky Bancshares, Inc.'s Subsidiary Kentucky Bank 97 EX-23 4 exhibit23.txt AUDIIOTRS' CONSENT EXHIBIT 23 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We consent to the incorporation by reference in Registration Statement No. 333-92725 on Form S-8 pertaining to the 1985 Incentive Stock Option Plan, the 1993 Employee Stock Ownership Incentive Plan, the 1993 Non-Employee Directors Stock Ownership Incentive Plan, the 1999 Employee Stock Option Plan and the Employee Gift Program, and No. 333-130791 on Form S-8 pertaining to the Kentucky Bancshares, Inc. 2005 Restricted Stock Grant Plan, of our report dated February 27, 2007 on the consolidated financial statements of Kentucky Bancshares, Inc., which report is included in Form 10-K for Kentucky Bancshares, Inc. for the year ended December 31, 2006 /s/Crowe Chizek and Company LLC Crowe Chizek and Company LLC Lexington, Kentucky March 30, 2007 98 EX-31 5 exhibit311.txt CEO EXCHANGE ACT CERTIFICATION Exhibit 31.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 302 OF SARBANES-OXLEY ACT I, Louis Prichard, certify that: 1. I have reviewed this annual report on Form 10-K of Kentucky Bancshares, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting. Date: March 30, 2007 BY /s/ Louis Prichard Louis Prichard President & Chief Executive Officer 92 99 EX-31 6 exhibit312.txt CFO EXCHANGE ACT CERTIFICATION Exhibit 31.2 CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 302 OF SARBANES-OXLEY ACT I, Gregory J. Dawson, certify that: 1. I have reviewed this annual report on Form 10-K of Kentucky Bancshares, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting. Date: March 30, 2007 BY /s/ Gregory J. Dawson Gregory J. Dawson Chief Financial Officer 100 EX-32 7 exhibit321.txt CEO SOX CERTIFICATION Exhibit 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Kentucky Bancshares, Inc. (the "Company") on Form 10-K for the period ended December 31, 2006 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Louis Prichard, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes- Oxley Act of 2002, that to my knowledge: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. ___/s/ Louis Prichard_______ Chief Executive Officer March 30, 2007 A signed original of this written statement required by Section 906 has been provided to Kentucky Bancshares, Inc. and will be retained by Kentucky Bancshares, Inc. and furnished to the Securities and Exchange Commission or its staff upon request. 101 EX-32 8 exhibit322.txt CFO SOX CERTIFICATION Exhibit 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Kentucky Bancshares, Inc. (the "Company") on Form 10-K for the period ended December 31, 2006 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Gregory J. Dawson, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to my knowledge: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. ___/s/ Gregory J. Dawson____ Chief Financial Officer March 30, 2007 A signed original of this written statement required by Section 906 has been provided to Kentucky Bancshares, Inc. and will be retained by Kentucky Bancshares, Inc. and furnished to the Securities and Exchange Commission or its staff upon request. 102 -----END PRIVACY-ENHANCED MESSAGE-----