10-K 1 k2007.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, 2007 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. [ ___ ] 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, 2007 was approximately $67.5 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 5, 2008: 2,850,590. PART I Item 1. Business General Kentucky Bancshares, Inc. ("Company" or "Kentucky") is a bank holding company headquartered in Paris, Kentucky. The Company was organized in 1981 and is 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 its business in the Commonwealth 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 Deposit Insurance Fund ("DIF") of the Federal Deposit Insurance Corporation ("FDIC"). On July 6, 2007, Kentucky Bank acquired Peoples Bancorp of Sandy Hook, Inc. and its subsidiary bank, Peoples Bank, with offices in Sandy Hook and Morehead, Kentucky. The Company had total assets of $631 million, total deposits of $486 million and stockholders' equity of $59 million as of December 31, 2007. The Company's principal executive office is located at 339 Main Street, Paris, Kentucky 40361, and the telephone number at that address is (859) 987-1795. Business Strategy The Company's current business strategy is to operate a well-capitalized, profitable and independent community bank with a significant presence in Central and Eastern Kentucky. Management believes the optimum way to grow the Company is by attracting new loan and deposit customers within its existing markets through it product offerings and customer service. Management continues to consider opportunities for branch expansion and will also consider acquisition opportunities that help advance its strategic objectives. Lending Kentucky Bank is engaged in general full-service commercial and consumer banking. A significant part of Kentucky Bank's operating activities include originating loans, approximately 71% of which are secured by real estate at December 31, 2007. 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. It also makes residential mortgage, installment and other loans to its individual and other non-commercial customers. Loan Rates: Kentucky Bank offers variable and fixed rate loans. Loan rates on variable rate loans generally adjust upward or downward based on changes in the loan's index. Rate adjustments on variable rate loans are made from 1 day to 5 years. Variable rate loans may contain provisions that cap the amount of interest rate increases or decreases over the life of the loan. In addition to the lifetime caps and floors on rate adjustments, loans secured by residential real estate may contain provisions that limit annual increases at a maximum of 200 basis points. There is usually no annual limit applied to loans secured by commercial real estate. Credit Risk: Commercial lending and real estate construction lending, generally includes a higher degree of credit risk than other loans, such as residential mortgage loans. Commercial loans, like other loans, are evaluated at the time of approval to determine the adequacy of repayment sources and collateral requirements. Collateral requirements vary to some degree among borrowers and depend on the borrower's financial strength, the terms and amount of the loan, and collateral available to secure the loan. Credit risk results from the decreased ability or willingness to pay by a borrower. Credit risk also results when a liquidation of collateral occurs and there is a shortfall in collateral value as compared to a loans outstanding balance. For construction loans, inaccurate initial estimates of a project's costs and the property's completed value could weaken the Company's position and lead to the property having a value that is insufficient to satisfy full payment of the amount of funds advanced for the property. Secured and unsecured consumer loans generally are made for automobiles, boats, and other motor vehicles. In most cases loans are restricted to the subsidiaries' general market area. Other Products: Kentucky Bank offers its customers a variety of other services, including checking, savings, money market accounts, certificates of deposits, safe deposit facilities, a credit card 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 and Market Served Competition: The banking business is highly competitive. Competition arises 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. Kentucky Bank 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. Market Served. The Company's primary market areas consist of Bourbon, Clark, Elliott, Harrison, Jessamine, Rowan, Scott, Woodford and surrounding counties in Kentucky. Supervision and Regulation Governing Regulatory Institutions: 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. Kentucky Bank 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, Kentucky Bank 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. Laws Protecting Deposits: 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. Consumer Regulations: 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. Dividend Restrictions: 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, 2007, the number of full time equivalent employees of the Company was 204. Nature of Company's Business The business of the Company is not seasonal. The Company's business does not depend upon a single customer, or a few customers, the loss of any one or more of which would have material adverse effect on the Company. No material portion of the Company's business is subject to renegotiation of profits or termination of contracts or subcontracts at the election of any governmental entity. Available Information The Company files annual reports on Form 10-K, quarterly reports on Form 10- Q, current reports on Form 8-K, and amendments to those reports with the Securities and Exchange Commission ("SEC") pursuant to section 13(a) or 15(d) of the Securities Exchange Act of 1934. The public may read and copy any material the Company files with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Washington, DC 20549 and may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800- SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC on its website at www.sec.gov. 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 our results of operations and financial condition. We are 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 our 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 our banking operations. Our 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. We face 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, we encounter competition from both de novo and smaller community banks entering the markets we are currently in. We also compete 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. We have 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 our 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 our 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 our 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 our inability to meet our 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 our 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 our 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 is located at 401 Main Street, Paris, Kentucky 40361. The principal office of Kentucky Bancshares, Inc. is located at 339 Main Street, Paris, KY 40631. In addition, Kentucky Bank serves customer needs at 14 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 2007 Quarter 4 $34.00 $31.75 $.27 Quarter 3 34.00 30.50 .27 Quarter 2 30.50 29.00 .27 Quarter 1 32.35 30.00 .27 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 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, 2007 the Company had 2,849,056 shares of Common Stock outstanding and approximately 555 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 10/1/07 - 10/31/07 100 $32.00 100 61,221 shares 11/1/07 - 11/30/07 8,500 32.00 8,500 52,721 shares 12/1/07 - 12/31/07 1,133 31.75 1,133 51,588 shares Total 9,733 9,733 51,588 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, 2007, 148,412 shares have been purchased, with the most recent share repurchase under the Board-approved stock repurchase program having occurred on December 31, 2007. 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.
CONDENSED STATEMENT OF INCOME: Total Interest Income $39,219 $35,593 $28,897 $25,846 $22,329 Total Interest Expense 19,034 16,718 11,766 9,067 7,875 Net Interest Income 20,185 18,875 17,131 16,779 14,454 Provision for Losses 1,000 475 508 840 1,300 Net Interest Income After Provision for Losses 19,185 18,400 16,623 15,939 13,154 Noninterest Income 7,936 7,236 6,495 6,547 6,707 Noninterest Expense 18,131 16,682 15,220 14,506 14,171 Income Before Income Tax Expense 8,990 8,954 7,898 7,980 5,690 Income Tax Expense 2,404 2,468 2,078 2,218 1,457 Net Income 6,586 6,486 5,820 5,762 4,233 SHARE DATA: Basic Earnings per Share (EPS) $2.31 $2.35 $2.17 $2.09 $1.52 Diluted EPS 2.30 2.34 2.16 2.07 1.50 Cash Dividends Declared 1.08 1.00 0.92 0.84 0.76 Book Value 20.65 19.59 17.45 16.77 16.90 Average Common Shares-Basic 2,852 2,762 2,677 2,757 2,781 Average Common Shares-Diluted 2,862 2,774 2,692 2,777 2,827 SELECTED BALANCE SHEET DATA: Loans, including loans held for sale $412,509 $439,159 $366,602 $354,294 $316,941 Investment Securities 147,750 127,891 160,652 126,767 128,790 Total Assets 630,939 629,542 572,750 528,544 500,852 Deposits 486,005 468,808 431,631 387,955 384,599 Securities sold under agreements to repurchase and other borrowings 6,735 11,327 16,838 25,593 7,285 Federal Home Loan Bank advances 63,993 80,030 66,749 59,750 53,232 Stockholders' Equity 58,844 55,281 46,546 45,027 46,057 PERFORMANCE RATIOS: (Average Balances) Return on Assets 1.04% 1.09% 1.08% 1.11% 1.00% Return on Stockholders' Equity 11.59% 12.82% 12.69% 12.57% 9.31% Net Interest Margin (1) 3.56% 3.48% 3.50% 3.60% 3.79% Equity to Assets (annual average) 8.97% 8.48% 8.50% 8.82% 10.73% SELECTED STATISTICAL DATA: Dividend Payout Ratio 46.89% 42.68% 42.30% 39.97% 50.00% Number of Employees (at period end) 204 203 172 167 182 ALLOWANCE COVERAGE RATIOS: Allowance to Total Loans 1.17% 1.12% 1.16% 1.16% 1.19% Net Charge-offs as a Percentage of Average Loans 0.26% 0.14% 0.10% 0.15% 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 2007 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, 2007 was $6.6 million, or $2.31 per common share compared to $6.5 million, or $2.35 for 2006 and $5.8 million, or $2.17 for 2005. Earnings per share assuming dilution were $2.30, $2.34 and $2.16 for 2007, 2006 and 2005, respectively. For 2007, net income increased $100 thousand, or 1.5%. Net interest income increased $1.3 million, the loan loss provision increased $525 thousand, other income increased $700 thousand, while total other expenses increased $1.4 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 2006, net income increased $666 thousand, or 11.4%. 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. Return on average equity was 11.6% in 2007 compared to 12.8% in 2006 and 12.7% in 2005. Return on average assets was 1.04% in 2007 compared to 1.09% in 2006 and 1.08% in 2005. Non-performing loans as a percentage of loans (including held for sale) were 1.57%, 0.59% and 0.26% as of December 31, 2007, 2006 and 2005, respectively. RESULTS OF OPERATIONS Net Interest Income Net interest income, the Company's largest source of revenue, on a tax equivalent basis increased from $17.7 million in 2005 to $19.5 million in 2006 and to $20.9 million in 2007. 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 2006 to 2007. Average earning assets increased $28 million, or 5%. Investment securities decreased $13 million primarily due to payoff borrowing used to fund the Peoples acquisition in July 2006. Loans increased $23 million as a result of the acquisition in July 2006, offset by a slower demand during 2007. Average interest bearing liabilities increased $21 million, or 5% 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. Starting in September 2007, rates have been decreasing. Bank prime rates decreased 100 basis points in 2007. As a result of this, the tax equivalent yield on earning assets increased from 6.47% in 2006 to 6.80% in 2007. The volume rate analysis that follows, during 2007, indicates that $2.0 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 $1.6 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 3.62% in 2006 to 3.94% in 2007. In addition, the change in volume contributed to an increase of $915 thousand in interest expense, while the higher level of rates was responsible for a $1.4 million increase in interest expense. As a result, the 2007 net interest income increase is primarily attributed to increases in volume. The volume rate analysis for 2006 that follows 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. The rate increase 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. Based on the volume rate analysis that follows, the change in volume contributed to an increase of $1.3 million to 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 attributed to increases in volume. In addition to the negative impact on net interest income that may result from the decreasing rate environment beginning in 2007 and continuing into 2008, competitive pressures on interest rates will continue and are likely to result in continued downward pressure on 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 2007 and 2006. Changes in interest income and expenses due to both rate and volume are allocated on a pro rata basis.
2007 vs. 2006 2006 vs. 2005 Increase (Decrease) Due to Change in Increase (Decrease) Due to Change in Volume Rate Net Change Volume Rate Net Change INTEREST INCOME Loans $ 1,656 $ 1,073 $ 2,729 $ 3,169 $ 2,527 $ 5,696 Investment Securities (604) 571 (33) 618 691 1,309 Federal Funds Sold and Securities Purchased under Agreements to Resell 919 9 928 (405) 90 (315) Deposits with Banks - 1 1 5 1 6 Total Interest Income 1,971 1,654 3,625 3,387 3,309 6,696 INTEREST EXPENSE Deposits Demand 99 (160) (61) 204 1,345 1,549 Savings (62) (75) (137) 68 214 282 Negotiable Certificates of Deposit and Other Time Deposits 1,739 1,466 3,205 351 1,754 2,105 Securities sold under agreements to repurchase and other borrowings (750) 94 (656) 298 261 559 Federal Home Loan Bank advances (111) 76 (35) 358 99 457 Total Interest Expense 915 1,401 2,316 1,279 3,673 4,952 Net Interest Income $ 1,056 $ 253 $ 1,309 $ 2,108 $ (364) $ 1,744
Average Consolidated Balance Sheets and Net Interest Analysis (dollars in thousands) 2007 2006 2005 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 74,648 3,727 4.99% 101,130 4,354 4.31% 92,524 3,366 3.64% State and Municipal obligations 52,674 2,134 4.05% 41,030 1,666 4.06% 34,888 1,444 4.14% Other Securities 8,046 510 6.34% 6,622 384 5.80% 6,085 285 4.68% Total Securities Available for Sale 135,368 6,371 4.71% 148,782 6,404 4.30% 133,497 5,095 3.82% Total Investment Securities 135,368 6,371 4.71% 148,782 6,404 4.30% 133,497 5,095 3.82% Tax Equivalent Adjustment 715 0.53% 624 0.42% 614 0.46% Tax Equivalent Total 7,086 5.23% 7,028 4.72% 5,709 4.28% Federal Funds Sold and Agreements to Repurchase 20,735 1,030 4.97% 2,212 102 4.61% 11,471 417 3.64% Interest-Bearing Deposits with Banks 432 19 4.40% 432 18 4.17% 321 12 3.74% Loans, Net of Deferred Loan Fees (2) Commercial 46,508 3,731 8.02% 46,194 3,520 7.62% 31,151 1,958 6.29% Real Estate Mortgage 370,699 26,802 7.23% 351,239 24,597 7.00% 321,619 20,660 6.42% Installment 13,677 1,265 9.25% 10,698 952 8.90% 8,962 755 8.42% Total Loans 430,884 31,798 7.38% 408,131 29,069 7.12% 361,732 23,373 6.46% Total Interest-Earning Assets 587,419 39,933 6.80% 559,557 36,217 6.47% 507,021 29,511 5.82% Allowance for Loan Losses (4,935) (4,766) (4,401) Cash and Due From Banks 13,642 11,844 10,927 Premises and Equipment 15,246 12,421 11,025 Other Assets 21,934 17,676 15,054 Total Assets 633,306 596,732 539,626 LIABILITIES Interest-Bearing Deposits Negotiable Order of Withdrawal ("NOW") and Money Market Investment Accounts 117,610 3,320 2.82% 114,195 3,381 2.96% 103,625 1,832 1.77% Savings 31,722 380 1.20% 36,425 517 1.42% 29,303 235 0.80% Certificates of Deposit and Other Deposits 244,408 11,424 4.67% 204,649 8,219 4.02% 193,986 6,114 3.15% Total Interest-Bearing Deposits 393,740 15,124 3.84% 355,269 12,117 3.41% 326,914 8,181 2.50% Securities sold under agreements to repurchase and other borrowings 18,935 1,001 5.29% 33,213 1,657 4.99% 26,689 1,098 4.11% Federal Home Loan Bank advances 70,132 2,909 4.15% 72,843 2,944 4.04% 63,918 2,487 3.89% Total Interest-Bearing Liabilities 482,807 19,034 3.94% 461,325 16,718 3.62% 417,521 11,766 2.82% Noninterest-Bearing Earning Demand Deposits 86,951 80,904 73,320 Other Liabilities 6,745 3,919 2,929 Total Liabilities 576,503 546,148 493,770 STOCKHOLDERS' EQUITY 56,803 50,584 45,856 Total Liabilities and Shareholders' Equity 633,306 596,732 539,626 Average Equity to Average Total Assets 8.97% 8.48% 8.50% Net Interest Income 20,184 18,875 17,131 Net Interest Income (tax equivalent) (3) 20,899 19,499 17,745 Net Interest Spread (tax equivalent) (3) 2.86% 2.85% 3.00% Net Interest Margin (tax equivalent) (3) 3.56% 3.48% 3.50%
Noninterest Income and Expenses Noninterest income was $7.9 million in 2007 compared to $7.2 million in 2006 and $6.5 million in 2005. In 2007, increasing service charges and increasing gain on sale of mortgage loans account for the majority of the increase. In 2006, service charges and trust department income increased. Securities gains were $37 thousand in 2007, $34 thousand in 2006 and $64 thousand in 2005. These are 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. Gains on loans sold were $432 thousand, $290 thousand and $334 thousand in 2007, 2006 and 2005, respectively. Loans held for sale are generally sold after closing to the Federal Home Loan Mortgage Corporation. During 2007, the loan service fee income increased $25 thousand, compared to an increase of $24 thousand in 2006. Proceeds from the sale of loans were $16 million, $17 million and $19 million in 2007, 2006 and 2005, respectively. The volume of loan originations is inverse to rate changes. The volume of loan originations during 2007 was $16 million, comparable to $17 million in 2006, and $18 million in 2005. Other noninterest income excluding security net gains and gain on sale of mortgage loans was $7.5 million in 2007, $6.9 million in 2006 and $6.1 million in 2005. Service charge income, and more particularly overdraft income, is the largest contributor to these numbers. Overdraft income was $4.6 million in 2007, $4.1 million in 2006 and $3.4 million in 2005. The increase in 2007 is primarily attributable to the Peoples acquisition in July 2006. Other income was $1.1 million in 2005, $1.1 million in 2006 and $1.4 million in 2007. The increase in 2007 is primarily attributable to a $200 thousand increase in interchange income and a $137 thousand increase in brokerage income. Noninterest expense increased $1.5 million in 2007 to $18.1 million, and increased $1.5 million in 2006 to $16.7 million from $15.2 million in 2005. The increases in salaries and benefits from $8.5 million in 2005 to $9.6 million in 2006 and to $10.6 million in 2007 are attributable to normal salary and benefit increases, and in 2006 and 2007 to the Peoples acquisition. Bonus compensation was $38 thousand higher in 2007 compared to 2006 and $160 thousand higher in 2006 compared to 2005. The 2007 increase is from higher compensation (the percentage payout of base salaries was lower in 2007 versus 2006), while the 2006 increase is mainly a result of higher compensation and improved net income. Occupancy expense increased $126 thousand in 2006 to $2.3 million and increased $240 thousand, or 10% in 2007 to $2.6 million. The largest expense, depreciation, increased $32 thousand to $956 thousand in 2006, and increased $85 thousand to $1.0 million in 2007. Other noninterest expense increased from $4.5 million in 2005 to $4.7 million in 2006 and increased to $5.0 million in 2007. Amortization of core deposits related to the Peoples acquisition was $175 thousand in 2007, compared to $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) 2007 2006 2005 NON-INTEREST INCOME Service Charges $ 5,495 $ 5,224 $ 4,511 Loan Service Fee Income 58 33 9 Trust Department Income 515 603 458 Investment Securities Gains (Losses),net 37 34 65 Gains on Sale of Mortgage Loans 432 290 334 Other 1,399 1,052 1,118 Total Non-interest Income 7,936 7,236 6,495 NON-INTEREST EXPENSE Salaries and Employee Benefits 10,594 9,613 8,548 Occupancy Expenses 2,560 2,320 2,194 Other 4,977 4,749 4,478 Total Non-interest Expense 18,131 16,682 15,220 Net Non-interest Expense as a Percentage of Average Assets 1.61% 1.58% 1.62% Income Taxes The Company had income tax expense of $2.4 million in 2007 and $2.5 million in 2006 and $2.1 million in 2005. This represents an effective income tax rate of 26.7% in 2007, 27.6% in 2006 and 26.3% in 2005. 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 slightly from $630 million at December 31, 2006 to $631 million at December 31, 2007. Loan decline was $27 million in 2007. Deposits grew $17 million and FHLB borrowings decreased $16 million. The gain in deposits of 4% is primarily from normal growth. Assets at year-end 2006 totaled $630 million compared to $573 million in 2005. In 2006, loan growth was $73 million (nearly $51 million was a result of the Peoples acquisition) and deposit growth was $37 million. The gain in deposits was primarily from $72 million obtained from the Peoples acquisition, offset by the loss of public money and a large certificate of deposit customer. See Note 15 in the notes to consolidated financial statements included as Exhibit 13 for additional information on the business combination. FHLB borrowings increased $13 million from 2005 to 2006. Loans Total loans (including loans held for sale) were $417 million at December 31, 2007 compared to $444 million at the end of 2006 and $371 million in 2005. Loans declined in 2007, following growth in 2006. The decline in 2007 is primarily attributable to the softening economy. The increase in 2006 is mainly attributable to improved loan demand and $51 million from the Peoples acquisition. As of the end of 2007 and compared to the prior year-end, commercial loans decreased $6.4 million, real estate construction loans decreased $2.9 million, real estate mortgage loans (including loans held for sale) decreased $19.6 million, agricultural loans increased $1.1 million and installment loans increased $.9 million. 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 December 31, 2007, the real estate mortgage portfolio comprised 65% of total loans compared to 65% in 2006. Of this, 1-4 family residential property represented 62% in 2007 and 61% in 2006. Agricultural loans comprised 19% in 2007 and 18% in 2006 of the loan portfolio. Approximately 72% of the agricultural loans are secured by real estate in 2007 compared to 72% in 2006. 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 36% in 2007 and 40% in 2006 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 6% 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 December 31 (in thousands) 2007 2006 2005 2004 2003 Commercial $ 22,924 $ 29,335 $ 27,302 $ 19,999 $ 14,278 Real Estate Construction 26,172 29,034 29,822 32,256 14,313 Real Estate Mortgage 270,749 290,324 245,326 238,661 222,342 Agricultural 80,774 79,627 59,328 57,497 56,615 Installment 15,421 15,684 8,954 9,062 12,978 Other 1,603 402 368 991 289 Total Loans 417,643 444,406 371,100 358,466 320,815 Less Deferred Loan Fees 255 256 188 10 54 Total Loans, Net of Deferred Loan Fees 417,388 444,150 370,912 358,456 320,761 Less loans held for sale - - - 175 7,759 Less Allowance For Loan Losses 4,879 4,991 4,310 4,163 3,820 Net Loans 412,509 439,159 366,602 354,118 309,182 The following table sets forth the maturity distribution and interest sensitivity of selected loan categories at December 31, 2007. 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 December 31, 2007 (in thousands) One Year One Through Over Total or Less Five Years Five Years Loans Commercial $ 12,702 $ 9,632 $ 590 $ 22,924 Real Estate Construction 25,950 222 - 26,172 Real Estate Mortgage 99,103 148,833 22,558 270,494 Agricultural 26,261 38,998 15,515 80,774 Installment 5,788 9,245 388 15,421 Other 1,603 - - 1,603 Total Loans, Net of Deferred Loan Fees 171,407 206,930 39,051 417,388 Fixed Rate Loans 51,437 166,220 38,917 256,574 Floating Rate Loans 119,970 40,710 134 160,814 Total Loans, Net of Deferred Loan Fees 171,407 206,930 39,051 417,388 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 $18 million in 2005 to $17 million in 2006, to $16 million in 2007. Proceeds from the sale of loans were $16 million, $17 million and $18 million for the years 2007, 2006 and 2005, respectively. Mortgage loans held for sale were zero at December 31, 2007 and December 31, 2006. Loans are generally sold when they are made. The volume of loan originations is inverse to rate changes. The rate environment rose in 2005 and 2006, resulting in decreased loan originations. Declining rates toward the end of 2007, resulted in higher loan orginations in the latter portion of 2007. The effect of these changes was also reflected on the income statement. As a result, the gain on sale of mortgage loans was $432 thousand in 2007 compared to $290 thousand in 2006 and $334 thousand in 2005. 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 $697 thousand at December 31, 2007, $746 thousand at December 31, 2006 and $802 thousand at December 31, 2005. Amortization of mortgage servicing rights was $214 thousand, $235 thousand and $254 thousand for the years ended December 31, 2007, 2006 and 2005, respectively. See Note 4 in the notes to consolidated financial statements included as Exhibit 13 for additional information. Deposits Total deposits increased to $486 million in 2007, up $17 million from 2006. Noninterest bearing deposits increased $1 million, time deposits of $100 thousand and over increased $11 million, and other interest bearing deposits increased $5 million. Public funds totaled $59 million at the end of 2007 ($58 million were interest bearing), a decrease of $1 million from the end of 2006. For 2006, total deposits increased $37 million to $469 million. Noninterest bearing deposits decreased $15 million, while 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). The table below provides information on the maturities of time deposits of $100,000 or more at December 31, 2007: Maturity of Time Deposits of $100,000 of More At December 31, 2007 (in thousands) Maturing 3 Months or Less $10,127 Maturing over 3 Months through 6 Months 21,207 Maturing over 6 Months through 12 Months 26,367 Maturing over 12 Months 20,360 Total $78,061 Borrowings The Company utilizes both long and short term borrowings. 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, 2007, $64 million was borrowed from FHLB, a decrease of $16 million from 2006. In 2007, $16 million of FHLB advances were paid and no additional advances were obtained. During 2006, $83 million of FHLB borrowing was paid, and advances were made for an additional $90 million. The remaining $7 million was obtained in the Peoples acquisition. The 2006 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) 2007 2006 2005 Federal Funds Purchased: Balance at Year end $ - $ - $ 1,470 Average Balance During the Year 117 8,616 3,001 Maximum Month End Balance - 27,723 15,919 Year end rate - - 4.25% Average annual rate 5.24% 5.37% 2.95% Repurchase Agreements: Balance at Year end $ 5,977 $ 9,628 $14,346 Average Balance During the Year 10,415 15,661 16,014 Maximum Month End Balance 16,073 18,372 18,072 Year end rate 4.72% 3.83% 3.18% Average annual rate 4.18% 3.79% 3.19% Other Borrowed Funds: Balance at Year end $ 758 $ 1,699 $ 1,021 Average Balance During the Year 1,186 1,719 457 Maximum Month End Balance 2,036 8,508 1,021 Year end rate 4.79% 5.90% 4.00% Average annual rate 5.58% 6.15% 3.10% 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, 2007 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 $ 63,993 $ 15,079 $33,005 $3,039 $12,870 Subordinated debentures 7,217 - - - 7,217 Time deposits 245,391 187,127 51,555 5,978 731 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) 2007 2006 2005 2004 2003 Non-accrual Loans $ 6,358 $ 2,379 $ 774 $ 1,781 $ 1,844 Accruing Loans which are Contractually past due 90 days or more 195 253 206 308 779 Restructured Loans - - - - - Total Nonperforming Loans 6,553 2,632 980 2,089 2,623 Other Real Estate 768 411 141 676 375 Total Nonperforming Assets 7,321 3,043 1,121 2,765 2,998 Total Nonperforming Loans as a Percentage of Loans (including loans held for sale) (1) 1.57% 0.59% 0.26% 0.58% 0.82% Total Nonperforming Assets as a Percentage of Total Assets 1.16% 0.48% 0.20% 0.52% 0.60% Allowance to nonperforming assets 0.67 1.64 3.84 1.51 1.27 (1) Net of deferred loan fees Total nonperforming assets at December 31, 2007 were $7.3 million compared to $3.0 million at December 31, 2006 and $1.1 million at December 31, 2005. The increase from 2006 to 2007 is attributable to the increase in various loans being put on non-accrual and additions to other real estate. Total nonperforming loans were $6.6 million, $2.6 million, and $1.0 million at December 31, 2007, 2006 and 2005, respectively. The non-accrual loan increase from 2006 to 2007 is mainly attributable to a $2.0 million loan, a $921 thousand loan and 13 other loans greater than $100,000, but less than $245,000. All these loans are secured by real estate. The amount of lost interest on our non- accrual loans is immaterial. At December 31, 2007, 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, 2007 were $6.4 million compared to $2.4 million in 2006 and $800 thousand in 2005. 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 $934 thousand, $553 thousand and $240 thousand on December 31, 2007, 2006 and 2005, 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) 2007 2006 2005 2004 2003 Balance at Beginning of Year $ 4,991 $ 4,310 $ 4,163 $ 3,820 $ 3,395 Balance of Allowance for Loan Losses of Acquired Bank at Acquisition Date - 775 - - 363 Amounts Charged-off: Commercial 131 15 146 197 569 Real Estate Construction 374 28 - - - Real Estate Mortgage 289 232 134 110 276 Agricultural 25 3 21 88 24 Consumer 449 365 225 293 529 Total Charged-off Loans 1,268 643 526 688 1,398 Recoveries on Amounts Previously Charged-off: Commercial 24 2 3 10 11 Real Estate Construction 19 - - - - Real Estate Mortgage 10 2 11 42 1 Agricultural 64 21 16 21 21 Consumer 39 49 135 118 127 Total Recoveries 156 74 165 191 160 Net Charge-offs 1,112 569 361 497 1,238 Provision for Loan Losses 1,000 475 508 840 1,300 Balance at End of Year 4,879 4,991 4,310 4,163 3,820 Total Loans (1) Average 430,884 408,131 361,732 338,465 290,502 At December 31 417,388 444,150 370,912 358,456 320,761 As a Percentage of Average Loans (1): Net Charge-offs 0.26% 0.14% 0.10% 0.15% 0.43% Provision for Loan Losses 0.23% 0.12% 0.14% 0.25% 0.45% Allowance as a Percentage of Year-end Loans (1) 1.17% 1.12% 1.16% 1.16% 1.19% Beginning Allowance as a Multiple of Net Charge-offs 4.5 7.6 11.5 7.7 2.7 Ending Allowance as a Multiple of Nonperforming Assets 0.67 1.64 3.84 1.51 1.27 (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 2007 was $1 million dollars compared to $475 thousand in 2006 and $508 thousand in 2005. Net charge-offs were $1.1 million in 2007, $569 thousand in 2006 and $361 thousand in 2005. Net charge-offs to average loans were 0.26%, 0.14% and 0.10% in 2007, 2006 and 2005, respectively. Based on the quality of the loan portfolio, the loan loss provision increased $525 thousand from 2006 to 2007 and decreased slightly from 2005 to 2006. 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 decline in the economy has resulted in more loan losses, higher loan loss provision and declining loan quality numbers over the past year. At December 31, 2007, the allowance for loan losses was 1.17% of loans outstanding compared to 1.12% at year-end 2006 and 1.16% at year- end 2005. Management believes the allowance for loan losses at the end of 2007 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
2007 2006 2005 2004 2003 Dollars Percentage Dollars Percentage Dollars Percentage Dollars Percentage Dollars Percentage Commercial $ 537 11.01% $ 594 11.90% $ 507 11.77% $ 350 8.41% $ 262 6.86% Real Estate Construction 633 12.97% 638 12.78% 566 13.14% 566 13.60% 266 6.96% Real Estate Mortgage 1,827 37.45% 1,806 36.19% 1,785 41.42% 1,801 43.26% 1,804 47.23% Agricultural 1,180 24.18% 1,241 24.86% 1,023 23.74% 1,028 24.69% 995 26.05% Consumer 702 14.39% 712 14.27% 428 9.93% 418 10.04% 493 12.91% Total 4,879 100.00% 4,991 100.00% 4,309 100.00% 4,163 100.00% 3,820 100.00%
Loans
2007 2006 2005 2004 2003 Dollars Percentage Dollars Percentage Dollars Percentage Dollars Percentage Dollars Percentage Commercial $ 22,924 5.49% $ 29,335 6.60% $ 27,302 7.36% $ 19,999 5.58% $ 14,278 4.45% Real Estate Construction 26,172 6.27% 29,034 6.54% 29,822 8.04% 32,256 9.00% 14,313 4.46% Real Estate Mortgage 270,494 64.81% 290,068 65.31% 245,138 66.09% 238,651 66.58% 222,288 69.30% Agricultural 80,774 19.35% 79,627 17.93% 59,328 16.00% 57,497 16.04% 56,615 17.65% Consumer 15,421 3.69% 15,684 3.53% 8,954 2.41% 9,062 2.53% 12,978 4.05% Other 1,603 0.39% 402 0.09% 368 0.10% 991 0.28% 289 0.09% Total, Net (1) 417,388 100.00% 444,150 100.00% 370,912 100.00% 358,456 100.00% 320,761 100.00% (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: 2007 2006 Unused lines of credit $ 65,298,282 $ 67,921,443 Commitments to make loans 1,871,000 658,000 Letters of credit 907,335 639,538 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 5.50% to 6.50% 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, 2007 increased $3.1 million to $51.5 million. During 2007, the Company purchased 30,202 shares of its stock for $933 thousand. These repurchases partially offset the $6.6 million in net income for 2007. Stockholders' equity, excluding accumulated other comprehensive income, was $59.4 million at December 31, 2007. 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) 2007 2006 Change Stockholders' Equity (1) $ 59,432 $ 56,595 2,837 Trust Preferred Securities 7,000 7,000 - Less Disallowed Amount 14,904 15,175 (271) Tier I Capital 51,528 48,420 3,108 Allowance for Loan Losses 4,954 5,067 (113) Other 9 5 4 Tier II Capital 4,963 5,072 (109) Total Capital 56,491 53,492 2,999 Total Risk Weighted Assets 414,171 426,900 (12,729) Ratios: Tier I Capital to Risk-weighted Assets 12.4% 11.3% 1.1% Total Capital to Risk-weighted Assets 13.6% 12.5% 1.1% Leverage 8.4% 7.8% 0.6% (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, 2007, 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, increased from $127.9 million at December 31, 2006 to $147.8 million at December 31, 2007. The increase is mainly attributable to a short term increase in deposits and a decline in loans. Federal funds sold totaled $10.4 million at December 31, 2007 and $4.1 million at December 31, 2006. 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, 2007 and 2006, the Company held no adjustable rate mortgage backed securities. 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, 2007. Investment Securities at market value At December 31 (in thousands) 2007 2006 2005 Available for Sale U.S. treasury $ - $ - $ 2,974 U.S. government agencies 36,021 31,492 67,033 States and political subdivisions 59,361 44,130 37,463 Mortgage-backed Fixed - GNMA, FNMA, FHLMC Passthroughs 40,261 38,262 33,566 GNMA, FNMA, FHLMC CMO's 11,817 13,720 17,390 Total 52,078 51,982 50,956 Variable - GNMA, FNMA, FHLMC Passthroughs - - 1,081 GNMA, FNMA, FHLMC CMO's - - 303 Total - - 1,384 Total mortgage-backed 52,078 51,982 52,340 Other 290 287 842 Total 147,750 127,891 160,652 Maturity Distribution of Securities
December 31, 2007 (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. treasury $ - $ - $ - $ - $ - $ - U.S. government agencies 23,190 9,992 2,839 - - 36,021 States and political subdivisions 1,180 7,513 16,335 34,333 - 59,361 Mortgage-backed - - - - 52,078 52,078 Equity Securities - - - - 290 290 Total 24,370 17,505 19,174 34,333 52,368 147,750 Percent of Total 16.5% 11.8% 13.0% 23.2% 35.4% 100.0% Weighted Average Yield (1) 4.25% 4.24% 5.67% 6.41% 5.27% 5.30% (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, 2007 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, 2007 and December 31, 2006 is as follows: Projected Net Interest Income (December 31, 2007)
Level Rate Change: -300 -100 Rates +100 +300 Year One (1/08 - 12/08) Net interest income 21,293 21,608 21,815 21,758 21,943 Net interest income dollar change (522) (207) - (57) 128 Net interest income percentage change -2.4% -0.9% N/A -0.3% 0.6% Limitation on % Change >-18.0% >-6.0% N/A >-4.0% >-10.0%
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%
The numbers in 2007 show less fluctuation when compared to 2006. In 2007, year one reflected a decrease in net interest income of 0.9% compared to 3.1% projected decrease from 2006 with a 100 basis point decline. The 300 basis point increase in rates reflected a 0.6% increase in net interest income in 2007 compared to a 7.3% increase in 2006. The risk is less in 2007 due to the current status of existing interest rates and their effect on rate sensitive assets and rate sensitive liabilities. Based on the model, a decrease in rates or a 100 basis point increase in rates would result in a decrease in net interest income, and a 300 basis point increase in rates would increase 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 $50.1 million at December 31, 2007. Additionally, securities available-for- sale with maturities greater than one year totaled $123.4 million at December 31, 2007. 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, 2007 these balances totaled $78.1 million, approximately 16% 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 $49 million from the FHLB at December 31, 2007. 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 2007 2006 2005 Average Loans (including loans held for sale)/Average Deposits 89.6% 93.6% 90.4% Average Securities sold under agreements to repurchase and other borrowings/Average Assets 3.0% 5.6% 4.9% This chart shows that the loan to deposit ratio decreased in 2007 and increased in 2006. The decrease in the ratio in 2007 compared to 2006 is mainly attributable to an increase in deposits and a decrease in loans. The increase in the ratio in 2006 compared to 2005 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 2007 Annual Report to Stockholders included as Exhibit 13, and are incorporated herein by reference. No other portion of the 2007 Annual Report to Stockholders is to be deemed "filed" as part of this filing. REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Audit Committee Kentucky Bancshares, Inc. Paris, Kentucky We have audited the accompanying balance sheets of Kentucky Bancshares, Inc. as of December 31, 2007 and 2006, and the related statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2007. 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. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. 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, 2007 and 2006, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. /s/Crowe Chizek and Company LLC Crowe Chizek and Company LLC Lexington, Kentucky March 3, 2008 KENTUCKY BANCSHARES, INC. Paris, Kentucky CONSOLIDATED FINANCIAL STATEMENTS December 31, 2007, 2006 and 2005 CONSOLIDATED BALANCE SHEETS December 31 2007 2006 ASSETS Cash and due from banks $ 15,445,596 $ 14,905,672 Federal funds sold 10,361,000 4,106,000 Cash and cash equivalents 25,806,596 19,011,672 Securities available for sale 147,749,546 127,890,612 Loans 417,388,048 444,150,390 Allowance for loan losses (4,878,732) (4,991,277) Net loans 412,509,316 439,159,113 Federal Home Loan Bank stock 6,468,200 6,468,200 Bank premises and equipment, net 16,323,314 14,327,050 Interest receivable 5,219,814 5,653,869 Mortgage servicing rights 696,826 745,834 Goodwill 13,116,710 13,116,710 Other intangible assets 1,787,413 2,058,149 Other assets 1,261,106 1,111,094 Total assets $ 630,938,841 $ 629,542,303 LIABILITIES AND STOCKHOLDERS' EQUITY Deposits Non-interest bearing $ 88,520,944 $ 87,503,263 Time deposits, $100,000 and over 78,060,572 67,255,274 Other interest bearing 319,423,702 314,049,382 Total deposits 486,005,218 468,807,919 Repurchase agreements and other borrowings 6,734,630 11,326,913 Federal Home Loan Bank advances 63,993,472 80,030,283 Subordinated debentures 7,217,000 7,217,000 Interest payable 4,983,549 3,682,785 Other liabilities 3,160,874 3,196,604 Total liabilities 572,094,743 574,261,504 Stockholders' equity Preferred stock, 300,000 shares authorized and unissued - - Common stock, no par value; 10,000,000 shares authorized; 2,849,056 and 2,864,586 shares issued and outstanding in 2007 and 2006 12,517,029 12,474,039 Additional paid-in capital 155,553 59,375 Retained earnings 46,759,262 44,061,889 Accumulated other comprehensive income (loss) (587,746) (1,314,504) Total stockholders' equity 58,844,098 55,280,799 Total liabilities and stockholders' equity $ 630,938,841 $ 629,542,303 See Accompanying notes. CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31 2007 2006 2005 Interest income Loans, including fees $ 31,798,307 $ 29,068,728 $ 23,373,434 Securities Taxable 3,810,348 4,395,404 3,388,793 Tax exempt 2,134,600 1,666,382 1,444,090 Other 1,475,831 462,333 690,660 39,219,086 35,592,847 28,896,977 Interest expense Deposits 15,124,114 12,117,444 8,180,571 Repurchase agreements and other borrowings 506,835 1,162,350 603,812 Federal Home Loan Bank advances 2,908,818 2,944,217 2,487,062 Subordinated debentures 494,338 494,197 494,227 19,034,105 16,718,208 11,765,672 Net interest income 20,184,981 18,874,639 17,131,305 Provision for loan losses 1,000,000 475,000 508,100 Net interest income after provision for loan losses 19,184,981 18,399,639 16,623,205 Other income Service charges 5,495,499 5,223,973 4,511,270 Loan service fee income, net 57,867 33,020 9,023 Trust department income 515,149 602,884 458,328 Securities gains (losses), net 36,556 34,259 64,395 Gain on sale of mortgage loans 432,314 290,035 333,742 Other 1,398,673 1,051,765 1,118,289 7,936,058 7,235,936 6,495,047 Other expenses Salaries and employee benefits 10,593,544 9,612,798 8,547,607 Occupancy expenses 2,560,353 2,320,418 2,194,431 Amortization 270,736 184,736 95,736 Advertising and marketing 545,648 519,685 473,848 Taxes other than payroll, property and income 683,443 537,485 547,509 Other 3,477,231 3,506,589 3,361,280 18,130,955 16,681,711 15,220,411 Income before income taxes 8,990,084 8,953,864 7,897,841 Provision for income taxes 2,404,132 2,467,810 2,077,741 Net income $ 6,585,952 $ 6,486,054 $ 5,820,100 Earnings per share: Basic $ 2.31 $ 2.35 $ 2.17 Diluted 2.30 2.34 2.16 See Accompanying notes. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Years Ended December 31 2007 2006 2005 Net income $ 6,585,952 $ 6,486,054 $ 5,820,100 Other comprehensive income (loss) Unrealized gains (losses) on securities arising during the period 892,171 735,236 (1,839,887) Reclassification of realized amount (36,556) (34,259) (64,395) Net change in unrealized gain (loss) on securities 855,615 700,977 (1,904,282) Less: Tax impact 290,909 238,332 (647,456) Changes related to SFAS No. 158: Net gain (loss) 210,941 - - Amortization of net gain (loss) 34,592 - - Total recognized in other comprehensive income 245,533 Less: Tax impact 83,481 - - Comprehensive income $ 7,312,710 $ 6,948,699 $ 4,563,274 See Accompanying notes.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY Years Ended December 31, 2007, 2006 and 2005 Accumulated Additional Other Total Common Stock Paid-in Retained Comprehensive Stockholders' Shares Amount Capital Earnings Income Equity Balances, January 1, 2005 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 - $0.92 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 - - - - (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 Common stock issued including tax benefit, net (including stock grants of 4,961 shares and employee gifts of 93 shares) 14,672 175,387 - - - 175,387 Stock compensation expense - - 96,178 - - 96,178 Common stock purchased (30,202) (132,397) - (800,680) - (933,077) Net change in unrealized gain (loss) on securities available for sale, net of tax - - - - 564,706 564,706 Net change related to SFAS No. 158, net of tax - - - - 162,052 162,052 Net income - - - 6,585,952 - 6,585,952 Dividends declared - $1.08 per share - - - (3,087,899) - (3,087,899) Balances, December 31, 2007 2,849,056 $12,517,029 $ 155,553 $ 46,759,262 $ (587,746) $ 58,844,098
See Accompanying notes.
CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31 2007 2006 2005 Cash flows from operating activities Net income $ 6,585,952 $ 6,486,054 $ 5,820,100 Adjustments to reconcile net income to net cash from operating activities Depreciation and amortization 1,499,855 1,313,476 1,174,954 Provision for loan losses 1,000,000 475,000 508,100 Securities amortization (accretion), net (178,289) (14,717) 331,355 Securities (gains) losses, net (36,556) (34,259) (64,395) Originations of loans held for sale (16,061,200) (17,156,711) (18,036,701) Proceeds from sale of loans 16,493,514 17,446,746 18,545,914 Gain on sale of mortgage loans (432,314) (290,035) (333,742) Stock based compensation expense 96,178 59,375 - Federal Home Loan Bank stock dividends - (342,200) (261,600) Losses (gain) on sale of fixed assets (2,672) (1,100) (71,045) Changes in: Interest receivable 434,055 (1,318,246) (492,656) Other assets (315,071) (1,906,617) 425,569 Interest payable 1,300,764 836,125 865,038 Other liabilities (164,587) 723,683 624,374 Net cash from operating activities 10,219,629 6,276,574 9,035,265 Cash flows from investing activities Purchases of securities (100,874,783) (30,905,332) (53,539,693) Proceeds from sales of securities 19,323,795 42,207,571 1,323,500 Proceeds from principal payments and maturities of securities 62,762,514 53,343,210 16,159,467 Cash paid for bank acquisition - (2,841,873) - Net change in loans 25,649,797 (22,106,318) (13,067,340) Purchases of bank premises and equipment (3,037,632) (1,540,977) (758,929) Proceeds from sale of bank premises and Equipment 2,672 1,100 581,881 Net cash from investing activities 3,826,363 38,157,381 (49,301,114) Cash flows from financing activities Net change in deposits 17,197,299 (35,102,694) 43,676,556 Net change in repurchase agreements and other borrowings (3,892,283) (9,380,282) (8,755,271) Advances from Federal Home Loan Bank - 90,000,000 15,000,000 Payments on Federal Home Loan Bank advances (16,010,495) (83,074,662) (7,902,073) Proceeds from note payable - 8,000,000 - Payments on note payable (700,000) (7,000,000) - Proceeds from issuance of common stock, including options and grants, including tax benefits 175,387 117,741 47,595 Purchase of common stock (933,077) (378,454) (629,399) Dividends paid (3,087,899) (2,768,428) (2,462,038) Net cash from financing activities (7,251,068) (39,586,779) 38,975,370 CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31 2007 2006 2005 Net change in cash and cash equivalents $ 6,794,924 $ 4,847,176 $ (1,290,479) Cash and cash equivalents at beginning of year 19,011,672 14,164,496 15,454,975 Cash and cash equivalents at end of year $ 25,806,596 $ 19,011,672 $ 14,164,496 Supplemental disclosures of cash flow information Cash paid during the year for: Interest expense $ 17,733,341 $ 15,749,929 $ 10,900,634 Income taxes 2,600,000 2,498,021 1,971,443 Supplemental schedules of non-cash investing activities Real estate acquired through foreclosure $ 914,000 $ 396,472 $ 391,743 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: the length of time and extent that fair value has been less than cost, the financial condition and near term prospects of the issuer, and 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. Servicing rights are recognized separately when they are acquired through sales of loans. For sales of mortgage loans prior to January 1, 2007, a portion of the cost of the loan was allocated to the servicing right based on relative fair values. The Company adopted SFAS No. 156 on January 1, 2007, and for sales of mortgage loans beginning in 2007, servicing rights are initially recorded at fair value with the income statement effect recorded in gain on sale of mortgage loans. Fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. The Company compares the valuation model inputs and results to published industry data in order to validate the model results and assumptions. All classes of servicing assets are subsequently measured using the amortization method which requires servicing rights to be amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual grouping, to the extent that fair value is less than the carrying amount. If the Company later determines that all or a portion of the impairment no longer exists for a particular grouping, a reduction of the allowance may be recorded as an increase to income. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses. Servicing fee income, which is reported on the income statement as loan service income, net, is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal; or a fixed amount per loan and are recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income. Servicing fees totaled $271,934, $268,194 and $262,629 for the years ended December 31, 2007, 2006 and 2005. Late fees and ancillary fees related to loan servicing are not material. 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 initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. 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. 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 year ending December 31, 2005, 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 year ending December 31, 2005. Net income As reported $ 5,820,100 Deduct: Stock-based compensation expense determined under fair value based method (56,241) Pro forma 5,763,859 2005 Basic earnings per share As reported $ 2.17 Pro forma 2.15 Diluted earnings per share As reported $ 2.16 Pro forma 2.14 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. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. The Company adopted FASB Interpretation 48, Accounting for Uncertainty in Income Taxes ("FIN 48"), as of January 1, 2007. A tax position is recognized as a benefit only if it is "more likely than not" that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the "more likely than not" test, no tax benefit is recorded. The adoption had no affect on the Company's financial statements. The Company recognizes interest related to income tax matters as interest expense and penalties related to income tax matters as other expense. 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. 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, 2007 and 2006. Adoption of New Accounting Standards: In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, which permits fair value remeasurement for hybrid financial instruments that contain an embedded derivative that otherwise would require bifurcation. Additionally, SFAS No. 155 clarifies the accounting guidance for beneficial interests in securitizations. Under SFAS No. 155, all beneficial interests in a securitization will require an assessment in accordance with SFAS No. 133 to determine if an embedded derivative exists within the instrument. In January 2007, the FASB issued Derivatives Implementation Group Issue B40, Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets (DIG Issue B40). DIG Issue B40 provides an exemption from the embedded derivative test of paragraph 13(b) of SFAS No. 133 for instruments that would otherwise require bifurcation if the test is met solely because of a prepayment feature included within the securitized interest and prepayment is not controlled by the security holder. SFAS No. 155 and DIG Issue B40 are effective for fiscal years beginning after September 15, 2006. The adoption of SFAS No. 155 and DIG Issue B40 did not have a material impact on the Company's consolidated financial position or results of operations. Effect of Newly Issued But Not Yet Effective Accounting Standards: In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. This Statement establishes a fair value hierarchy about the assumptions used to measure fair value and clarifies assumptions about risk and the effect of a restriction on the sale or use of an asset. The Statement is effective for fiscal years beginning after November 15, 2007. The impact of adoption on January 1, 2008 was not material. In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. The Statement provides companies with an option to report selected financial assets and liabilities at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. The new Statement is effective for the Company on January 1, 2008. The Company did not elect the fair value option for any financial assets or financial liabilities as of January 1, 2008. 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, 2007 and 2006 was $369,000 and $322,000. NOTE 3 - SECURITIES AVAILABLE FOR SALE Year-end securities are as follows: Fair Unrealized Unrealized Value Gains Losses 2007 U. S. government agencies $ 36,020,468 $ 495,539 $ (10,085) States and municipals 59,361,045 691,258 (661,819) Mortgage-backed 52,077,818 218,221 (610,211) Equity securities 290,215 20,215 - Total $ 147,749,546 $ 1,425,233 $(1,282,115) 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) The fair value of securities at December 31, 2007, 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 $ 24,370,258 Due after one year through five years 17,504,764 Due after five years through ten years 19,173,452 Due after ten years 34,333,039 95,381,513 Mortgage-backed 52,077,818 Equity 290,215 Total $ 147,749,546 Proceeds from sales of securities during 2007, 2006 and 2005 were $19,323,795, $42,207,571 and $1,323,500. Gross gains of $180,005, $452,218 and $89,943 and gross losses of $143,449, $417,959 and $25,548, were realized on those sales, respectively. The tax provision related to these realized gains and losses was $12,429, $11,648 and $21,894, respectively. Securities with an approximate carrying value of $112,499,000 and $108,120,000 at December 31, 2007 and 2006, 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 2007 and 2006 not recognized in income are as follows:
2007 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 $21,947,522 $ (10,085) $ - $ - $ 21,947,522 $ (10,085) States and municipals 21,940,792 (631,462) 7,054,136 (30,357) 28,994,928 (661,819) Mortgage-backed 2,595,724 (4,834) 30,212,510 (605,377) 32,808,234 (610,211) Total temporarily impaired $46,484,038 $ (646,381) $37,266,646 $ (635,734) $ 83,750,684 $(1,282,115) 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)
The Company evaluates securities for other than temporary impairment at least on a quarterly 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, 2007, thirteen mortgage-backed securities have unrealized losses with aggregate depreciation of 1.8% from their amortized cost basis, and seventy seven states and municipals have unrealized losses with aggregate depreciation of 2.2% from their amortized cost basis. Management believes the declines in fair value from these and other securities are 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: 2007 2006 Commercial $ 22,924,130 $ 29,335,344 Real estate construction 26,172,120 29,033,790 Real estate mortgage 270,494,250 290,068,211 Agricultural 80,774,195 79,627,134 Consumer 15,420,647 15,683,984 Other 1,602,706 401,927 $ 417,388,048 $ 444,150,390 Activity in the allowance for loan losses was as follows: 2007 2006 2005 Beginning balance $ 4,991,277 $ 4,309,403 $ 4,163,315 Allowance from acquisition - 775,913 - Charge-offs (1,268,568) (642,664) (526,735) Recoveries 156,023 73,625 164,723 Provision for loan losses 1,000,000 475,000 508,100 Ending balance $ 4,878,732 $ 4,991,277 $ 4,309,403 Impaired loans totaled $6,358,000 and $2,379,000 at December 31, 2007 and 2006. The average recorded investment in impaired loans during 2007, 2006 and 2005 was $4,253,000, $1,624,000 and $1,547,000. The total allowance for loan losses related to these loans was $934,000 and $553,000 at December 31, 2007 and 2006. Interest income on impaired loans of $121,000, $62,000 and $25,000 was recognized for cash payments received in 2007, 2006 and 2005. Nonperforming loans were as follows: 2007 2006 Loans past due over 90 days still on accrual $ 195,000 $ 253,000 Nonaccrual loans 6,358,000 2,379,000 Nonaccrual loans secured by real estate make up 99% of the total nonaccruals. Management does not see further material loss related to these loans. Nonperforming loans include impaired loans and smaller balance homogeneous loans, such as residential mortgage and consumer loans, that are collectively evaluated for impairment. Certain directors and executive officers of the Company and companies in which they have beneficial ownership were loan customers of the Bank during 2007 and 2006. An analysis of the activity with respect to all director and executive officer loans is as follows: 2007 Balance, beginning of year $ 4,893,000 New loans 504,000 Effect of changes in composition of related parties (92,000) Repayments (1,126,000) Balance, end of year $ 4,179,000 Loan Servicing 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 $110,175,000 and $107,766,000 at December 31, 2007 and 2006. Custodial escrow balances maintained in connection with the foregoing loan servicing, and included in demand deposits, were approximately $388,000 and $369,000 at December 31, 2007 and 2006. Changes in mortgage servicing rights were as follows: 2007 2006 2005 Beginning balance $ 745,834 $ 801,501 $ 875,633 Additions 165,059 179,507 179,474 Amortization (214,067) (235,174) (253,606) Ending balance $ 696,826 $ 745,834 $ 801,501 The valuation allowance as of December 31, 2007 was $0, and there have been no changes in the valuation allowance over the past three years. The fair value of servicing rights was $1,107,000 and $1,121,000 at year-end 2007 and 2006. Fair value at year-end 2007 was determined using a discount rate of 10.0%, prepayment speeds ranging from 8.0% to 15.0%, depending on the stratification of the specific right, and default rates ranging from 0.1% to 0.9%. Fair value at year-end 2006 was determined using a discount rate of 9.5%, prepayment speeds ranging from 8.0% to 13.5%, depending on the stratification of the specific right, and default rates ranging from 0.1% to 0.9%. The weighted average amortization period is 6.3 years. Estimated amortization expense for each of the next five years is: 2008 $ 180,000 2009 136,000 2010 105,000 2011 82,000 2012 64,000 NOTE 5 - PREMISES AND EQUIPMENT Year-end premises and equipment were as follows: 2007 2006 Land and buildings $ 17,243,311 $ 16,554,057 Furniture and equipment 11,958,611 11,756,195 Construction projects 1,163,406 217,591 30,365,328 28,527,843 Less accumulated depreciation (14,042,014) (14,200,793) $ 16,323,314 $ 14,327,050 Depreciation expense was $1,041,368, $956,221 and $924,564 in 2007, 2006, and 2005. NOTE 6 - GOODWILL AND INTANGIBLE ASSETS The change in balance for goodwill during the year is as follows: 2007 2006 2005 Beginning of year $ 13,116,710 $ 9,110,524 $ 9,110,524 Acquired goodwill - 4,006,186 - Impairment - - - End of year $ 13,116,710 $ 13,116,710 $ 9,110,524 Goodwill is not amortized but instead evaluated periodically for impairment. Acquired intangible assets were as follows at year-end: 2007 2006 Gross Gross Carrying Accumulated Carrying Accumulated Amount Amortization Amount Amortization Amortized intangible assets: Core deposit intangibles $5,133,403 $3,345,990 $5,133,403 $3,075,254 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 $270,736, $184,736 and $95,736 for 2007, 2006 and 2005. Estimated amortization expense for each of the next five years: 2008 $ 264,736 2009 259,736 2010 253,736 2011 243,736 2012 233,736 NOTE 7 - DEPOSITS At December 31, 2007, the scheduled maturities of time deposits are as follows: 2008 $ 187,127,228 2009 47,706,515 2010 3,848,656 2011 1,082,618 2012 4,895,933 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 $2,632,000 and $3,994,000 at December 31, 2007 and 2006. 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 $15,179,740 and $23,665,328 at year-end 2007 and 2006. Repurchase agreements generally mature within one year from the transaction date and range in maturities from 1 day to 5 years. The securities underlying the agreements are maintained in a third-party custodian's account under a written custodial agreement. Information concerning repurchase agreements for 2007, 2006 and 2005 is summarized as follows: 2007 2006 2005 Average daily balance during the year $ 10,415,241 $ 15,660,750 $ 16,014,304 Average interest rate during the year 4.18% 3.79% 3.19% Maximum month-end balance during the year $ 16,072,679 $ 18,372,446 $ 18,071,544 Weighted average interest rate at year end 4.72% 3.83% 3.18% Promissory note payable of $300,000 at December 31, 2007, 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: 2007 2006 Maturities July 2008 through March 2030, fixed rates from 1.00% to 3.08% $ 14,298,815 $ 17,226,422 Maturities January 2008 through February 2026, fixed rates from 3.58% to 4.43% 28,158,277 36,060,120 Maturities February 2008 through January 2026, fixed rates from 4.77% to 7.23% 21,536,380 26,743,741 Total $ 63,993,472 $ 80,030,283 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 residential loans. Scheduled principal payments due on advances during the years subsequent to December 31, 2007 are as follows: 2008 $ 15,078,887 2009 26,755,335 2010 6,250,000 2011 1,434,789 2012 1,604,055 Thereafter 12,870,406 $ 63,993,472 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: 2007 2006 2005 Current $ 2,457,421 $ 2,476,648 $ 1,969,865 Deferred (53,289) (8,838) 107,876 $ 2,404,132 $ 2,467,810 $ 2,077,741 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. 2007 2006 Deferred tax assets Allowance for loan losses $ 1,684,269 $ 1,645,241 Unrealized loss on securities - 242,249 Adjustment for SFAS No. 158 351,439 434,919 Other 280,111 327,074 Deferred tax liabilities Unrealized gain on securities (48,660) - Bank premises and equipment (724,892) (776,157) FHLB stock (1,254,026) (1,254,026) Mortgage servicing rights (236,921) (253,584) Core deposit intangibles (464,599) (491,132) Other (286,312) (253,075) Net deferred tax liability $ (699,591) $ (378,491) Effective tax rates differ from federal statutory rates applied to financial statement income due to the following: 2007 2006 2005 U. S. federal income tax rate 34.0% 34.0% 34.0% Changes from the statutory rate Tax-exempt investment income (9.2) (7.8) (7.3) Non-deductible interest expense related to carrying tax-exempt investments 1.3 1.1 0.8 Other 0.6 0.3 (1.2) 26.7% 27.6% 26.3% 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, 2007. 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. Unrecognized Tax Benefits The Company does not have any beginning and ending unrecognized tax benefits. The Company does not expect the total amount of unrecognized tax benefits to significantly increase or decrease in the next twelve months. There were no interest and penalties recorded in the income statement or accrued for the year ended December 31, 2007 related to unrecognized tax benefits. The Company and its subsidiary file a consolidated U.S. Corporation income tax return and a corporate income tax return in the state of Kentucky. The Company is no longer subject to examination by taxing authorities for years before 2004. NOTE 12 - EARNINGS PER SHARE The factors used in the earnings per share computation follow: 2007 2006 2005 Basic Earnings Per Share Net income $ 6,585,952 $ 6,486,054 $ 5,820,100 Weighted average common shares outstanding 2,852,094 2,761,826 2,676,890 Basic earnings per share $ 2.31 $ 2.35 $ 2.17 Diluted Earnings Per Share Net income $ 6,585,952 $ 6,486,054 $ 5,820,100 Weighted average common shares outstanding 2,852,094 2,761,826 2,676,890 Add dilutive effects of assumed exercise of stock options 10,292 11,736 14,965 Weighted average common and dilutive potential common shares outstanding 2,862,386 2,773,562 2,691,855 Diluted earnings per share $ 2.30 $ 2.34 $ 2.16 Stock options of 29,200 shares common stock from 2007, 11,736 shares common stock from 2006 and 31,100 shares common stock from 2005 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: 2007 2006 Change in benefit obligation: Beginning benefit obligation $ 7,084,741 $ 6,737,359 Service cost 483,518 472,140 Interest cost 405,547 364,248 Actuarial adjustment (197,530) (327,181) Benefits paid (204,130) (161,825) Ending benefit obligation 7,572,146 7,084,741 Change in plan assets, at fair value: Beginning plan assets 5,345,056 5,071,504 Actual return 393,712 378,550 Employer contribution 505,175 - Benefits paid (145,178) (104,998) Ending plan assets 6,098,765 5,345,056 Funded status $(1,473,381) $(1,739,685) Amounts recognized in accumulated other comprehensive income at December 31 consist of: 2007 2006 Net loss (gain) $ 1,034,012 $ 1,279,916 Transition obligation (asset) (371) (742) $ 1,033,641 $ 1,279,174 The accumulated benefit obligation for defined benefit pension plans was $5,821,550 and $5,312,906 at year-end 2007 and 2006. Components of net periodic pension cost and other amounts recognized in other comprehensive income: 2007 2006 2005 Service cost $ 483,518 $ 472,140 $ 432,429 Interest cost 405,547 364,248 346,223 Expected return on plan assets (439,253) (400,485) (376,195) Amortization 34,592 41,249 39,818 Net periodic cost $ 484,404 $ 477,152 $ 442,275 Net loss (gain) (210,941) - - Prior service cost (credit) - - - Amortization of net (gain) loss (34,592) - - Total recognized in other comprehensive income (245,533) - - Total recognized in net periodic benefit cost and other comprehensive income $ 238,871 $ 477,152 $ 442,275 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 $15,629 and $(371). Weighted-average assumptions used to determine pension benefit obligations at year-end 2007 2006 2005 Discount rate on benefit obligation 6.00% 5.75% 5.75% Rate of compensation increase 4.00% 4.00% 4.00% Weighted-average assumptions used to determine net periodic net cost 2007 2006 2005 Discount rate on benefit obligation 6.00% 5.75% 5.75% 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 discount rate assumption of 6.00% 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 rate of compensation increase assumption of 4.0% is based upon historical compensation increases at the Bank. The Company's pension plan asset allocation at year-end and expected long-term rate of return by asset category are as follows: Percentage Percentage Weighted of Plan of Plan Average Assets at Assets at Expected Year-End Year-End Long-Term Asset Category 2007 2006 Rate of Return Equity securities 63 63 10% Debt securities 33 35 6 Cash 4 2 4 Total 100 100 The asset allocation objective for 2007 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 $0 to $500,000 to its pension plan in 2008. The following benefit payments, which reflect expected future service, are expected: Pension Benefits 2008 $ 191,963 2009 207,923 2010 267,179 2011 302,885 2012 327,457 Years 2013-2017 2,361,981 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 $434,203, $369,847 and $320,670 in 2007, 2006 and 2005. 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 $96,178, $59,375, and $0 for 2007, 2006 and 2005. The total income tax benefit was $3,611, $911, 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. 2007 2006 2005 Fair value of options granted $4.22 $3.14 $4.82 Risk-free interest rate 4.51% 4.59% 3.98% Expected term 8 years 8 years 8 years Expected stock price volatility 12.69% 7.99% 15.11% Dividend yield 3.48% 3.39% 3.03% Summary of activity in the stock option plan for 2007 follows: Weighted Weighted Average Average Remaining Aggregate Exercise Contractual Intrinsic Shares Price Term Value Outstanding, beginning of year 69,914 $26.54 Granted 800 31.00 Forfeited or expired (2,140) 31.59 Exercised (9,800) 18.23 Outstanding, end of year 58,774 $27.80 60.8 months $253,793 Vested and expected to vest 58,774 $27.80 60.8 months $253,793 Exercisable, end of year 42,324 $26.73 53.9 months $226,356
Options outstanding at year-end 2007 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 $18.00 to $20.63 per share 9,990 12.1 20.51 9,990 20.51 From $23.50 to $28.00 per share 17,684 51.5 25.39 15,604 25.37 From $29.50 to $31.00 per share 20,950 86.3 30.37 10,240 30.33 From $33.90 to $34.00 per share 10,150 72.3 33.91 6,490 33.92 58,774 42,324
Information related to the stock option plan during each year follows: 2007 2006 2005 Intrinsic value of options exercised $141,258 $119,419 $53,586 Cash received from option exercises 178,692 124,756 43,650 Tax benefit realized from option exercises 3,611 911 - Weighted average fair value of options granted 3,376 4,082 89,306 As of December 31, 2007, there was $54,617 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 5,605 shares issued during 2007 and 3,875 shares issued during 2006, and 30 shares were forfeited during 2006. A summary of changes in the Company's nonvested shares for the year follows: Weighted-Average Grant-Date Nonvested Shares Shares Fair Value Nonvested at January 1, 2007 3,845 $ 112,466 Granted 5,605 173,755 Vested (769) (22,493) Forfeited (644) (19,365) Nonvested at December 31, 2007 8,037 $ 244,363 As of December 31, 2007, there was $208,648 of total unrecognized compensation cost related to nonvested shares granted under the Plan. The cost is expected to be recognized over a weighted-average period of 5 years. The total fair value of shares vested during the years ended December 31, 2007, 2006 and 2005 was $23,839, $0 and $0 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. The purchase price of $14 million was 40 percent stock and 60 percent cash. At the acquisition date, Peoples had $96,380,000 in total assets, $50,925,000 in loans and $72,279,000 in deposits. 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 2008 the Bank could, without prior approval, declare dividends on any 2008 net profits retained to the date of the dividend declaration less $363,000. NOTE 17 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The fair values of the Company's financial instruments at December 31, 2007 and 2006 are as follows: 2007 2006 Carrying Carrying Amount Fair Value Amount Fair Value (In Thousands) Financial assets Cash and cash equivalents $ 25,807 $ 25,807 $ 19,012 $ 19,012 Securities 147,750 147,750 127,891 127,891 Loans, net 412,509 409,134 439,159 433,610 FHLB stock 6,468 6,468 6,468 6,468 Interest receivable 5,220 5,220 5,654 5,654 Financial liabilities Deposits $ 486,005 $ 489,276 $ 468,808 $ 470,799 Securities sold under agreements to repurchase and other borrowings 6,735 6,843 11,327 11,249 FHLB advances 63,993 63,643 80,030 77,711 Subordinated debentures 7,217 7,098 7,217 7,232 Interest payable 4,984 4,984 3,683 3,683 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: 2007 2006 Unused lines of credit $ 65,298,282 $ 67,921,443 Commitments to make loans 1,871,000 658,000 Letters of credit 907,335 639,538 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 5.50% to 6.50% with maturities ranging from 15 to 30 years and are intended to be sold. NOTE 19 - CONTINGENT LIABILITIES The Bank is a defendant in legal actions arising from normal business activities. Management believes these actions are without merit or that the ultimate liability, if any, resulting from them will not materially affect the Company's consolidated financial position or results of operations. NOTE 20 - CAPITAL REQUIREMENTS 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, 2007 and 2006, 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 Thousands) 2007 Consolidated Total Capital (to Risk-Weighted Assets) $ 56,491 13.6% $ 33,134 8% $ 41,417 N/A Tier I Capital (to Risk-Weighted Assets) 51,528 12.4 16,567 4 24,850 N/A Tier I Capital (to Average Assets) 51,528 8.4 24,493 4 30,616 N/A Bank Only Total Capital (to Risk-Weighted Assets) $ 56,350 13.6% $ 33,130 8% $ 41,413 10% Tier I Capital (to Risk-Weighted Assets) 51,387 12.4 16,565 4 24,848 6 Tier I Capital (to Average Assets) 51,387 8.4 24,491 4 30,614 5 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
NOTE 21 - PARENT COMPANY FINANCIAL STATEMENTS Condensed Balance Sheets December 31 2007 2006 (In Thousands) ASSETS Cash on deposit with subsidiary $ 175 $ 940 Investment in subsidiary 65,703 62,160 Securities available for sale 20 20 Other assets 482 412 Total assets $ 66,380 $ 63,532 LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Subordinated debentures $ 7,217 $ 7,217 Notes payable 300 1,000 Other liabilities 19 34 Stockholders' equity Preferred stock - - Common stock 12,517 12,474 Additional paid-in capital 156 59 Retained earnings 46,759 44,062 Accumulated other comprehensive income (loss) (588) (1,314) Total liabilities and stockholders' equity $ 66,380 $ 63,532 Condensed Statements of Income and Comprehensive Income Years Ended December 31 2007 2006 2005 (In Thousands) Income Dividends from subsidiary $ 4,300 $ 9,800 $ 3,750 Securities gains (losses), net - 409 60 Interest income 1 16 13 Total income 4,301 10,225 3,823 Expenses Interest expense 531 577 494 Other expenses 128 250 134 Total expenses 659 827 628 Income before income taxes and equity in undistributed income of subsidiary 3,642 9,398 3,195 Applicable income tax (expense) benefits 224 166 178 Income before equity in undistributed income of subsidiary 3,866 9,564 3,373 Equity in undistributed income of subsidiary 2,720 (3,078) 2,447 Net income 6,586 6,486 5,820 Other comprehensive income (loss), net of tax: Unrealized gains (losses) on securities arising during the period 589 486 (1,215) Reclassification of realized amount (24) (23) (42) Net change in unrealized gain (loss) on securities 565 463 (1,257) Comprehensive income $ 7,151 $ 6,949 $ 4,563 Condensed Statements of Cash Flows Years Ended December 31 2007 2006 2005 (In Thousands) Cash flows from operating activities Net income $ 6,586 $ 6,486 $ 5,820 Adjustments to reconcile net income to net cash from operating activities Equity in undistributed earnings of subsidiary (2,720) 3,083 (2,447) Securities (gains) losses, net - (409) (60) Change in other assets (58) 43 32 Change in other liabilities (27) 18 (3) Net cash from operating activities 3,781 9,221 3,342 Cash flows from investing activities Proceeds from sales of securities available for sale - 664 143 Acquisition of Peoples Bancorp, Inc. - (8,080) - Net cash from investing activities - (7,416) 143 Cash flows from financing activities Proceeds from note payable - 8,000 - Payments on note payable (700) (7,000) - Dividends paid (3,088) (2,768) (2,462) Proceeds from issuance of common stock 175 118 48 Purchase of common stock (933) (378) (629) Net cash from financing activities (4,546) (2,028) (3,043) Net change in cash (765) (223) 442 Cash at beginning of year 940 1,163 721 Cash at end of year $ 175 $ 940 $ 1,163 NOTE 22 - QUARTERLY FINANCIAL DATA (UNAUDITED) Interest Net Interest Net Earnings Per Share Income Income Income Basic Fully Diluted 2007 First quarter $ 9,806 $ 4,972 $ 1,562 $ .55 $ .54 Second quarter 10,034 5,147 1,918 .67 .67 Third quarter 9,801 5,148 1,670 .58 .58 Fourth quarter 9,578 4,918 1,436 .51 .51 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 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, 2007. 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, 2007. There was no change in the Company's internal control over financial reporting during the fourth quarter of 2007 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 The information required by Item 10 is hereby incorporated by reference from the Company's definitive proxy statement in connection with its annual meeting of shareholders scheduled for May 14, 2008, which will be filed with the Commission on or about April 10, 2008, pursuant to Regulation 14A. Item 11. Executive Compensation The information required by Item 11 is hereby incorporated by reference from the Company's definitive proxy statement in connection with its annual meeting of shareholders scheduled for May 14, 2008, which will be filed with the Commission on or about April 10, 2008, pursuant to Regulation 14A. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by Item 12 is hereby incorporated by reference from the Company's definitive proxy statement in connection with its annual meeting of shareholders scheduled for May 14, 2008, which will be filed with the Commission on or about April 10, 2008, pursuant to Regulation 14A. Item 13. Certain Relationships and Related Transactions The information required by Items 13 is hereby incorporated by reference from the Company's definitive proxy statement in connection with its annual meeting of shareholders scheduled for May 14, 2008, which will be filed with the Commission on or about April 10, 2008, pursuant to Regulation 14A. Item 14. Principal Accountant Fees and Services The information required by Item 14 is hereby incorporated by reference from the Company's definitive proxy statement in connection with its annual meeting of shareholders scheduled for May 14, 2008, which will be filed with the Commission on or about April 10, 2008, pursuant to Regulation 14A. Part IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a)(1) Financial Statements The following financial statements are included in Item 8 of this Form 10-K. Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Changes in Shareholders' Equity Consolidated Statements of Cash Flow Notes to Consolidated Financial Statements (a)(2) Financial Statement Schedules. All financial statement schedules have been omitted as the required information is inapplicable or the required information has been included in the Consolidated Financial statements or notes thereto. (a)(3) Exhibits 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. 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. 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. 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. 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. 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. 11 Computation of earnings per share - See Note 12 in the notes to consolidated financial statements included as Exhibit 13. 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. (b) Exhibits See response to Item 15(a)(3). (c) Financial Statement Schedules See response to Item 15(a)(2). 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 28, 2008 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 28, 2008 Louis Prichard, President and Chief Executive Officer, Director /s/Gregory J. Dawson ______ March 28, 2008 Gregory J. Dawson, Chief Financial and Accounting Officer /s/Buckner Woodford ________ March 31, 2008 Buckner Woodford, Chairman of the Board, Director _/s/William Arvin____________ March 28, 2008 William Arvin, Director /s/B. Proctor Caudill ____ March 28, 2008 B. Proctor Caudill, Director /s/Henry Hinkle _ _ __ ____ March 28, 2008 Henry Hinkle, Director _/s/Theodore Kuster__________ March 28, 2008 Theodore Kuster, Director /s/Betty J. Long __________ March 28, 2008 Betty J. Long, Director /s/Ted McClain ___________ March 28, 2008 Ted McClain, Director _/s/Edwin S. Saunier_________ March 28, 2008 Edwin S. Saunier, Director /s/Robert G. Thompson _____ March 28, 2008 Robert G. Thompson, Director _____________________________ March __, 2008 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. 6 22 BOURBON BANCSHARES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2000, 1999 and 1998 44 58 63