10-Q 1 q082.txt FORM 10Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2008 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: 000-52598 KENTUCKY BANCSHARES, INC. (Exact name of registrant as specified in its charter) Kentucky 61-0993464 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) P.O. Box 157, Paris, Kentucky 40362-0157 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (859)987-1795 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No _____ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. Large accelerated filer ____ Accelerated filer ____ Non-accelerated filer X (Do not check if a smaller reporting company) Smaller reporting company ____ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No X _ Number of shares of Common Stock outstanding as of June 30, 2008: 2,757,965. KENTUCKY BANCSHARES, INC. Table of Contents Part I - Financial Information Item 1. Financial Statements Consolidated Balance Sheets 3 Consolidated Statements of Income and Comprehensive Income 4 Consolidated Statement of Changes in Stockholders' Equity 6 Consolidated Statements of Cash Flows 7 Notes to Consolidated Financial Statements 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 13 Item 3. Quantitative and Qualitative Disclosures About Market Risk 19 Item 4. Controls and Procedures 20 Part II - Other Information 21 Signatures 22 Exhibits 31.1 Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 23 31.2 Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 25 32 Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 27 Item 1 - Financial Statements KENTUCKY BANCSHARES, INC. CONSOLIDATED BALANCE SHEETS (unaudited) (thousands) 6/30/2008 12/31/2007 Assets Cash and due from banks $ 15,226 $ 15,446 Federal funds sold 98 10,361 Cash and cash equivalents 15,324 25,807 Securities available for sale 160,963 147,750 Mortgage loans held for sale 80 - Loans 418,820 417,388 Allowance for loan losses (5,394) (4,879) Net loans 413,426 412,509 Federal Home Loan Bank stock 6,641 6,468 Bank premises and equipment, net 17,146 16,323 Interest receivable 4,846 5,220 Goodwill 13,117 13,117 Other intangible assets 1,655 1,787 Mortgage servicing rights 730 697 Other assets 2,577 1,261 Total assets $ 636,505 $ 630,939 Liabilities and Stockholders' Equity Deposits Non-interest bearing $ 93,376 $ 88,521 Time deposits, $100,000 and over 72,365 78,060 Other interest bearing 289,458 319,424 Total deposits 455,199 486,005 Repurchase agreements and other borrowings 14,060 6,735 Federal Funds Purchased 10,853 - Federal Home Loan Bank advances 87,016 63,993 Subordinated debentures 7,217 7,217 Interest payable 3,165 4,984 Other liabilities 2,894 3,161 Total liabilities 580,404 572,095 Stockholders' equity Common stock 12,104 12,517 Additional paid-in capital 223 156 Retained earnings 45,440 46,759 Accumulated other comprehensive income (loss) (1,666) (588) Total stockholders' equity 56,101 58,844 Total liabilities & stockholders' equity $ 636,505 $ 630,939 See Accompanying Notes KENTUCKY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (unaudited) (thousands, except per share amounts) Six Months Ending 6/30/2008 6/30/2007 INTEREST INCOME: Loans, including fees $ 14,083 $ 16,094 Securities available for sale 3,589 3,184 Other 256 562 Total interest income 17,928 19,840 INTEREST EXPENSE: Deposits 6,202 7,710 Other 1,793 2,011 Total interest expense 7,995 9,721 Net interest income 9,933 10,119 Loan loss provision 900 320 Net interest income after provision 9,033 9,799 NON-INTEREST INCOME: Service charges 2,560 2,773 Loan service fee income 45 32 Trust department income 270 274 Securities available for sale gains (losses), net 15 3 Gain on sale of mortgage loans 278 210 Other 867 645 Total other income 4,035 3,937 NON-INTEREST EXPENSE: Salaries and employee benefits 5,230 5,382 Occupancy expenses 1,378 1,243 Amortization 133 136 Advertising and marketing 253 270 Taxes other than payroll, property and income 358 342 Other 2,264 1,575 Total other expenses 9,616 8,948 Income before taxes 3,452 4,788 Income taxes 773 1,308 Net income $ 2,679 $ 3,480 Other Comprehensive Income, net of tax: Change in Unrealized Gains on Securities (851) (1,381) Comprehensive Income $ 1,828 $ 2,099 Earnings per share Basic $ 0.95 $ 1.22 Diluted 0.95 1.21 See Accompanying Notes KENTUCKY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (unaudited) (thousands, except per share amounts) Three Months Ending 6/30/2008 6/30/2007 INTEREST INCOME: Loans, including fees $ 6,775 $ 8,137 Securities available for sale 1,855 1,612 Other 45 285 Total interest income 8,675 10,034 INTEREST EXPENSE: Deposits 2,696 3,916 Other 942 971 Total interest expense 3,638 4,887 Net interest income 5,037 5,147 Loan loss provision 500 170 Net interest income after provision 4,537 4,977 NON-INTEREST INCOME: Service charges 1,371 1,470 Loan service fee income 21 16 Trust department income 150 125 Securities available for sale gains (losses), net 8 4 Gain on sale of mortgage loans 117 144 Other 393 333 Total other income 2,060 2,092 NON-INTEREST EXPENSE: Salaries and employee benefits 2,581 2,606 Occupancy expenses 644 610 Amortization 66 68 Advertising and marketing 113 135 Taxes other than payroll, property and income 179 171 Other 1,071 811 Total other expenses 4,654 4,401 Income before taxes 1,943 2,668 Income taxes 457 750 Net income $ 1,486 $ 1,918 Other Comprehensive Income, net of tax: Change in Unrealized Gains on Securities (1,342) (1,339) Comprehensive Income $ 144 $ 579 Earnings per share Basic $ 0.53 $ 0.67 Diluted 0.53 0.67 See Accompanying Notes KENTUCKY BANCSHARES, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (unaudited) (thousands, except share information) Accumulated Additional Other Total ----Common Stock---- Paid-in Retained Comprehensive Stockholders' Shares Amount Capital Earnings Income Equity Balances, December 31, 2007 2,849,056 $ 12,517 $ 155 $ 46,759 $ (588) $ 58,843 Common stock issued, including tax benefit, net(including stock grants of 4,025 shares and employee gifts of 91 shares) 10,821 15 - - - 15 Stock based compensation expense - - 68 - - 68 Common stock purchased and retired (101,912) (428) - (2,414) - (2,842) Net change in unrealized gain (loss) on securities available for sale, net of tax - - - - (850) (850) Net change in SFAS No. 158, net of tax - - - - (228) (228) Net income - - - 2,679 - 2,679 Dividends declared - $0.56 per share - - - (1,584) - (1,584) Balances, June 30, 2008 2,757,965 $ 12,104 $ 223 $ 45,440 $ (1,666) $ 56,101
See Accompanying Notes KENTUCKY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (thousands) Six Months Ending 6/30/2008 6/30/2007 Cash Flows From Operating Activities Net Income $ 2,679 $ 3,480 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 797 736 Securities amortization (accretion), net (165) (78) Noncash compensation expense 68 50 Provision for loan losses 900 320 Securities (gains) losses, net (15) (3) Originations of loans held for sale (13,503) (5,936) Proceeds from sale of loans 13,701 6,017 Federal Home Loan Bank stock dividends (173) - Losses (gains) on sale of bank premises and equipment (5) - Gain on sale of mortgage loans (278) (210) Changes in: Interest receivable 374 535 Other assets (1,449) (320) Interest payable (1,819) 87 Other liabilities (57) 153 Net cash from operating activities 1,055 4,831 Cash Flows From Investing Activities Purchases of securities available for sale (63,690) (39,763) Proceeds from sales of securities available for sale - 19,324 Proceeds from principal payments, maturities and calls of securities available for sale 49,369 21,768 Net change in loans (1,817) 13,257 Purchases of bank premises and equipment (1,402) (1,456) Proceeds from the sale of bank premises and equipment 5 - Net cash from investing activities (17,535) 13,130 Cash Flows From Financing Activities: Net change in deposits (30,806) 23,196 Net change in securities sold under agreements to repurchase, federal funds purchased and other borrowings 15,478 749 Advances from Federal Home Loan Bank 35,000 - Payments on Federal Home Loan Bank advances (11,964) (10,372) Proceeds from note payable 5,000 - Payment on note payable (2,300) (500) Proceeds from issuance of common stock 15 32 Purchase of common stock (2,842) (378) Dividends paid (1,584) (1,548) Net cash from financing activities 5,997 11,179 Net change in cash and cash equivalents (10,483) 29,140 Cash and cash equivalents at beginning of period 25,807 19,011 Cash and cash equivalents at end of period 15,324 48,151 See Accompanying Notes KENTUCKY BANCSHARES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates used in the preparation of the financial statements are based on various factors including the current interest rate environment and the general strength of the local economy. Changes in the overall interest rate environment can significantly affect the Company's net interest income and the value of its recorded assets and liabilities. Actual results could differ from those estimates used in the preparation of the financial statements. The financial information presented as of any date other than December 31 has been prepared from the Company's books and records without audit. The accompanying consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Certain financial information that is normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America, but is not required for interim reporting purposes, has been condensed or omitted. In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of such financial statements, have been included. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2007. New accounting pronouncements - 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. 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 effect on the Company's financial statements, and the Company had no unrecognized tax benefits at December 31, 2007 or June 30, 2008. The Company and its subsidiaries are subject to U.S. federal income tax. The Company is no longer subject to examination by taxing authorities for years before 2002. The Company does not expect the total amount of unrecognized tax benefits to significantly increase in the next twelve months. The Company recognizes interest related to income tax matters as interest expense and penalties related to income tax matters as other expense. The Company did not have any amounts accrued for interest and penalties at December 31, 2007 or June 30, 2008. 2. INVESTMENT SECURITIES INVESTMENT SECURITIES Period-end securities are as follows: (in thousands) Amortized Unrealized Unrealized Fair Cost Gains Losses Value Available for Sale June 30, 2008 U.S. government agencies 18,758 400 (140) 19,018 States and political subdivisions 65,677 636 (1,284) 65,029 Mortgage-backed 77,404 239 (1,013) 76,630 Equity securities 270 16 - 286 Total 162,109 1,291 (2,437) 160,963 December 31, 2007 U.S. government agencies 35,535 496 (10) 36,021 States and political subdivisions 59,332 691 (662) 59,361 Mortgage-backed 52,470 218 (610) 52,078 Equity securities 270 20 - 290 Total 147,607 1,425 (1,282) 147,750 3. LOANS Loans at period-end are as follows: (in thousands) 6/30/2008 12/31/2007 Commercial $ 21,847 $ 22,924 Real estate construction 21,850 26,172 Real estate mortgage 274,074 270,494 Agricultural 82,976 80,774 Consumer 18,073 17,024 Total 418,820 417,388 4. EARNINGS PER 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 includes the dilutive effect of additional potential common shares issuable under stock options. The factors used in the earnings per share computation follow: Six Months Ended June 30 2008 2007 (in thousands, except per share information) Basic Earnings Per Share Net Income $2,679 $3,480 Weighted average common shares outstanding 2,819 2,860 Basic earnings per share $ 0.95 $ 1.22 Diluted Earnings Per Share Net Income $2,679 $3,480 Weighted average common shares outstanding 2,819 2,860 Add dilutive effects of assumed exercise of stock options 4 10 Weighted average common and dilutive potential common shares outstanding 2,823 2,870 Diluted earnings per share $ 0.95 $ 1.21 Three Months Ended June 30 2008 2007 (in thousands, except per share information) Basic Earnings Per Share Net Income $1,486 $1,918 Weighted average common shares outstanding 2,797 2,858 Basic earnings per share $ 0.53 $ 0.67 Diluted Earnings Per Share Net Income $1,486 $1,918 Weighted average common shares outstanding 2,797 2,858 Add dilutive effects of assumed exercise of stock options 3 10 Weighted average common and dilutive potential common shares outstanding 2,800 2,868 Diluted earnings per share $ 0.53 $ 0.67 Stock options for 31,900 shares of common stock for the six and three months ended June 30, 2008, and for 10,035 shares of common stock for the three months ended June 30, 2007 were excluded from diluted earnings per share because their impact was antidilutive. 5. STOCK COMPENSATION The Company has two share based compensation plans as described below. 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. 2008 2007 Weighted-average fair value of options granted during the year $2.38 $4.22 Risk-free interest rate 2.96% 4.51% Expected option life 8 years 8 years Expected stock price volatility 11.05% 12.69% Expected dividend yield 3.61% 3.48% Summary of activity in the stock option plan for the six months ended June 30, 2008 follows: Weighted Weighted Average Average Remaining Aggregate Exercise Contractual Intrinsic Shares Price Term Value Outstanding, beginning of year 58,774 $27.80 Granted 800 31.00 Forfeited or expired (2,020) 28.40 Exercised (6,705) 22.12 Outstanding, end of period 50,849 28.58 60.7 months $64,532 Vested and expected to vest 50,849 28.58 60.7 months 64,532 Options exercisable at period end 42,159 28.06 57.5 months 64,532 The intrinsic value for stock options is calculated based on the exercise price of the underlying awards and the market price of our common stock as of the reporting date. The Company recorded $68 thousand in stock compensation expense during the six months ended June 30, 2008 to salaries and employee benefits. 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. 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 December 31, 2007 8,037 $ 243,494 Granted 4,025 124,755 Vested (1,744) (52,691) Forfeited - - Nonvested at June 30, 2008 10,318 $ 315,558 6. DIVIDENDS Dividends per share paid for the quarter ended June 30, 2008 were $0.28 compared to $0.27 for June 30, 2007. This is the same rate of dividend paid for the first quarter of the respective years. 7. RETIREMENT PLAN Components of Net Periodic Benefit Cost Six months ended June 30 (in thousands) Pension Benefits 2008 2007 Service cost $ 254 $ 227 Interest cost 231 202 Expected return on plan assets (241) (217) (Gain) loss amortization 14 17 Net Periodic Benefit Cost $ 258 $ 229 Three months ended June 30 (in thousands) Pension Benefits 2008 2007 Service cost $ 132 $ 113 Interest cost 119 101 Expected return on plan assets (120) (108) (Gain) loss amortization 10 9 Net Periodic Benefit Cost $ 141 $ 115 Employer Contributions The estimates are based on assuming the Company's 2008 annual contribution to the Pension Plan is to be zero. No contributions to the Pension Plan were made for the quarter ended June 30, 2008, and the Company anticipates making its annual contribution, if any, in the third quarter of 2008. Item 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements This discussion contains forward-looking statements under the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. Words such as "believes," "anticipates," "expects," "intends," "plans," "targeted," and similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. Although the Company believes that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore, there can be no assurance that the forward-looking statements included herein will prove to be accurate. Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to: economic conditions (the Company and its bank operate in areas affected by various markets); competition for the Company's customers from other providers of financial and mortgage services; government legislation and regulation (which changes from time to time and over which the Company has no control); changes in interest rates (both generally and more specifically mortgage interest rates); material unforeseen changes in the liquidity, results of operations, or financial condition of the Company's customers; and other risks detailed in the Company's filings with the Securities and Exchange Commission, all of which are difficult to predict and many of which are beyond the control of the Company. The Company undertakes no obligation to update or revise forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Summary Kentucky Bancshares, Inc. recorded net income of $2.7 million, or $.95 basic earnings and diluted earnings per share for the first six months ending June 30, 2008 compared to $3.5 million, or $1.22 basic earnings per share and $1.21 diluted earnings per share for the six month period ending June 30, 2007. The first six months earnings reflects a decrease of 23.0% compared to the same time period in 2007, due primarily to an increase in the loan loss provision of $580 thousand and an increase in other expenses of $668 thousand. These increases in expenses were somewhat offset by a reduction in income tax expense of $535 thousand. The earnings for the three months ended June 30, 2008 were $1.5 million, or $.53 basic and diluted earnings per share for the three month period ending June 30, 2008 compared to $1.9 million, or $.67 basic and diluted earnings per share for the three month period ending June 30, 2007. This three months period earnings reflects a decrease of 22.5% compared to the same time period in 2007. Return on average assets was 0.85% for the six months ended June 30, 2008 and 1.08% for the six month period ended June 30, 2007. Return on average assets was .94% for the three months ended June 30, 2008 and 1.20% for the three month period ended June 30, 2007. Return on average equity was 9.1% for the six month period ended June 30, 2008 and 12.3% for the same period in 2007. Return on average equity was 10.1% for the three months ended June 30, 2008 and 13.6% for the same time period in 2007. Loans increased $1.4 million from $417.4 million on December 31, 2007 to $418.8 million on June 30, 2008. Decreases in commercial & real estate construction loans were offset by an increase in real estate mortgage, agricultural & consumer loans. Total deposits decreased from $486.0 million on December 31, 2007 to $455.2 million on June 30, 2008, a decrease of $30.8 million. This decrease is primarily the result of a decrease in interest bearing deposit accounts less than $100 thousand. Management attributes the decrease mainly to increased competition for deposits. As a result of this, management has utilized other lower costing funding sources, such as Federal Home Loan Bank advances. Net Interest Income Net interest income was $9.9 million for the six months ended June 30, 2008 compared to $10.1 million for the six months ended June 30, 2007, a decrease of 1.8%. The interest spread was 3.32% for the first six months of 2008 comparable to 3.31% for the same period in 2007, an increase of 1 basis point. Net interest income was $5.0 million for the three month period ending June 30, 2008 compared to $5.1 million for the three month period ending June 30, 2007, a decrease of 2.1%. The interest spread was 3.38% for the three month period ending June 30, 2008 compared to 3.36% for the three month period in 2007, an increase of 2 basis points. Net interest margins have thus far remained steady in 2008. The net interest spread during the second quarter of 2008 was lowered, primarily due to interest income that was placed into non- accrual status. For the first six months, the yield on assets decreased from 6.68% in 2007 to 6.15% in 2008. The cost of liabilities decreased from 3.37% in 2007 to 2.83% in 2008. Year to date average loans are down $27.0 million, or 6.1% from June 30, 2007 to June 30, 2008. Loan interest income has decreased $2.0 million for the first six months of 2008 compared to the first six months of 2007. Year to date average deposits decreased from June 30, 2007 to June 30, 2008, down $6.5 million or 1.3%. The slight decrease is primarily the result of a decline in interest bearing deposits less than $100 thousand during the second quarter. The decline in interest bearing deposit accounts was offset slightly with an increase in non-interest bearing deposits. Deposit interest expense has decreased $1.5 million for the first six months of 2008 compared to the same period in 2007. Non-Interest Income Non-interest income increased $98 thousand for the six months ended June 30, 2008 compared to the same period in 2007 to $4.0 million, due primarily to a decrease in service charges of $213 thousand offset by an increase in other non-interest income of $222 thousand. The decrease in service charges was primarily from a decrease in overdraft income of $251 thousand for the first six months of 2008. The other non-interest income increase was primarily due to an increase in brokerage income of $141 thousand and an increase of $75 thousand in debit card interchange income. The $32 thousand decrease in non- interest income for the three months ended June 30, 2008 compared to same time period in 2007 is primarily due to a decrease in service charges of $99 thousand. Gain on sale of mortgage loans increased from $210 thousand in the first six months of 2007 to $278 thousand during the first six months of 2008. For the three months ended June 30, 2008 compared to the same time period in 2007, the gain on sale of mortgage loans decreased $27 thousand. The volume of mortgage loan originations and sales is generally inverse to rate changes. A change in the mortgage loan rate environment can have a significant impact on the related gain on sale of mortgage loans. Non-Interest Expense Total non-interest expenses increased $668 thousand for the six month period ended June 30, 2008 compared to the same period in 2007. For the three month period ended June 30, 2008, total non-interest expense increased $253 thousand. For the comparable six month periods, salaries and benefits decreased $152 thousand, a decrease of 2.8%. Incentives decreased $309 thousand, due to the lower level of net income reported by the Company. Salaries & benefits decreased $25 thousand for the three month period ending June 30, 2008 compared to the same time period in 2007. Occupancy expenses increased $135 thousand to $1,378 thousand for the first six months of 2008 compared to the same time period in 2007. Occupancy expenses increased $34 thousand for the three month period ended June 30, 2008 compared to the same time period in 2007. The increase in year to date 2008 is mainly attributable to two additional facilities; the first being opened in the fourth quarter of 2007 and the second being opened during the first quarter of 2008. The relocation of the Nicholasville branch, scheduled to be complete in the fourth quarter of 2008, is expected to result in a slight increase in occupancy expense starting in the first quarter of 2009. Other expenses increased $689 thousand for the first six months ended June 30, 2008 compared to the same time period in 2007. For the three month period ended June 30, 2008 other expenses increased $260 thousand compared to the three month period ended June 30, 2007. The year to date increase is mainly a result of an increase of data processing fees of $351 thousand, an increase in ATM & debit card processing of $99 thousand, and an increase in legal and professional fees of $76 thousand. In August 2007, the Company started outsourcing its account processing to Fiserv, Inc. causing the data processing to be more in 2008 compared to 2007. The increase in ATM and debit card processing is a result of more customer usage. Higher legal and professional fees are mainly a result of outsourcing loan review, loan collection costs and other corporate matters. Income Taxes The effective tax rate for the six months ended June 30, 2008 was 22.4% compared to 27.3% in 2007. The effective tax rate for the three months ended June 30, 2008 was 23.5% compared to 28.1% for the three month period ended June 30, 2007. These rates are less than the statutory rate as a result of the tax-free securities and loans held by the Company. The rates for 2008 are lower due to the lower level of income for 2008. Nontaxable interest income increased $244 thousand for the first six months of 2008 compared to the same time period in 2007. Stock Repurchase Program On October 25, 2000, the Company announced that its Board of Directors approved a stock repurchase program 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. On May 20, 2008, the Board of Directors approved and authorized the Company to repurchase 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 June 30, 2008 245,921 shares have been purchased under the program. The most recent share repurchase occurred on July 29, 2008. The repurchase program has had a positive effect on earnings per share calculations. Liquidity and Funding Liquidity risk is the possibility that the Company may not be able to meet its cash requirements. Management of liquidity risk includes maintenance of adequate cash and sources of cash to fund operations and to meet the needs of borrowers, depositors and creditors. Excess liquidity has a negative impact on earnings as a result of the lower yields on short-term assets. Cash and cash equivalents were $15.3 million as of June 30, 2008 compared to $25.8 million at December 31, 2007. The decrease in cash and cash equivalents is mainly attributable to a decrease in federal funds sold resulting primarily from a decrease in deposits and also an increase in the Company's security portfolio. In addition to cash and cash equivalents, the securities portfolio provides an important source of liquidity. Securities available for sale totaled $161.0 million at June 30, 2008. The available for sale securities are available to meet liquidity needs on a continuing basis. The Company expects the customers' deposits to be adequate to meet its funding demands. Generally, the Company relies upon net cash inflows from financing activities, supplemented by net cash inflows from operating activities, to provide cash used in its investing activities. As is typical of many financial institutions, significant financing activities include deposit gathering and the use of short-term borrowings, such as federal funds purchased and securities sold under repurchase agreements along with long-term debt. The Company's primary investing activities include purchasing investment securities and loan originations. Management is aware of the challenge of funding sustained loan growth. Therefore, in addition to deposits, other sources of funds, such as Federal Home Loan Bank (FHLB) advances, may be used. The Company relies on FHLB advances for both liquidity and asset/liability management purposes. These advances are used primarily to fund long-term fixed rate residential mortgage loans. In early July 2008, the Company received deposits from being the successful bidder on $20 million in public deposits. These deposits will roll off over the next 12 months. As of June 30, 2008, we have sufficient collateral to borrow an additional $7 million from the FHLB. In addition, as of June 30, 2008, over $37 million is available in overnight borrowing through various correspondent banks. In light of this, management believes there is sufficient liquidity to meet all reasonable borrower, depositor and creditor needs in the present economic environment. Non-Performing Assets As of June 30, 2008, the Company's non-performing loans totaled $10.1 million or 2.40% of loans compared to $6.5 million or 1.57% of loans at December 31, 2007. (See table below) The Company experienced an increase of $2.5 million in non-accrual loans from December 31, 2007 to June 30, 2008, mainly due to some large dollar commercial loans being reclassified as non-accrual during the second quarter. As of June 30, 2008, non-accrual loans include $2.0 million in loans secured by 1-4 family residential real estate, $2.3 million in real estate construction and $4.0 million in loans secured by non-farm non- residential properties. Real estate loans composed 99% of the non-performing loans as of June 30, 2008 and 98% as of December 31, 2007. Forgone interest income on the non-accrual loans was $312 thousand for the first six months of 2008 compared to $156 thousand for the same time period in 2007. Nonperforming Assets 6/30/08 12/31/07 (in thousands) Non-accrual Loans $ 8,862 $ 6,358 Accruing Loans which are Contractually past due 90 days or more 1,190 195 Total Nonperforming and Restructured Loans 10,052 6,553 Other Real Estate 1,514 768 Total Nonperforming and Restructured Loans and Other Real Estate $ 11,566 $ 7,321 Nonperforming and Restructured Loans as a Percentage of Loans 2.40% 1.57% Nonperforming and Restructured Loans and Other Real Estate as a Percentage of Total Assets 1.82% 1.16% Allowance as a Percentage of Period-end Loans 1.29% 1.17% Allowance as a Percentage of Non-performing and Restructured Loans 54% 74% Provision for Loan Losses The loan loss provision for the first six months was $900 thousand for 2008 and $320 thousand for the same period in 2007. The loan loss provision for the three months ended June 30, 2008 was $500 thousand and $170 thousand for the same period in 2007. The current level of nonperforming loans has caused management to increase the 2008 provision in order to maintain an allowance for loan losses that is representative of the risk of loss based on the quality of loans currently in the portfolio. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Net charge-offs for the six month period ended June 30, 2008 were $385 thousand compared to $355 thousand for the same period in 2007. Net charge-offs for the three month period ended June 30, 2008 were $197 thousand compared to $257 thousand during the same time period in 2007. Future levels of charge-offs will be determined by the particular facts and circumstances surrounding individual loans. Management believes the current loan loss allowance is sufficient to meet probable incurred loan losses. Loan Losses Six Months Ended June 30, 2008 (in thousands) 2008 2007 Balance at Beginning of Period $ 4,879 $ 4,991 Amounts Charged-off: Commercial 5 127 Real Estate Construction 217 - Real Estate Mortgage 55 91 Agricultural 12 - Consumer 612 482 Total Charged-off Loans 901 700 Recoveries on Amounts Previously Charged-off: Commercial 5 1 Real Estate Construction 2 10 Real Estate Mortgage 12 2 Agricultural 30 29 Consumer 467 303 Total Recoveries 516 345 Net Charge-offs 385 355 Provision for Loan Losses 900 320 Balance at End of Period 5,394 4,956 Loans Average 412,549 439,559 At June 30 418,820 430,538 As a Percentage of Average Loans: Net Charge-offs 0.09% 0.08% Provision for Loan Losses 0.22% 0.07% Allowance as a Multiple of Net Charge-offs 7.0 7.0 Loan Losses Quarter Ended June 30 (in thousands) 2008 2007 Balance at Beginning of Period $ 5,091 $ 5,043 Amounts Charged-off: Commercial 5 127 Real Estate Construction 92 - Real Estate Mortgage 31 35 Consumer 254 261 Total Charged-off Loans 382 423 Recoveries on Amounts Previously Charged-off: Commercial 1 - Real Estate Construction - 5 Real Estate Mortgage 5 - Agricultural 1 14 Consumer 178 147 Total Recoveries 185 166 Net Charge-offs 197 257 Provision for Loan Losses 500 170 Balance at End of Period 5,394 4,956 Loans Average 413,840 436,937 At June 30 418,820 430,538 As a Percentage of Average Loans: Net Charge-offs 0.05% 0.06% Provision for Loan Losses 0.12% 0.04% Allowance as a Multiple of Net Charge-offs 6.6 4.8 Item 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Asset/Liability management control is designed to ensure safety and soundness, maintain liquidity and regulatory capital standards, and achieve acceptable net interest income. Management considers interest rate risk to be the most significant market risk. The Company's exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk, while at the same time, maximize income. Management realizes certain risks are inherent and that the goal is to identify and minimize the risks. The primary tools used by management are interest rate shock and economic value of equity (EVE) simulations. The Company has no market risk sensitive instruments held for trading purposes. Using interest rate shock simulations, the following table depicts the change in net interest income resulting from 100 and 300 basis point changes in rates on the Company's interest earning assets and interest bearing liabilities. The projections are based on balance sheet growth assumptions and repricing opportunities for new, maturing and adjustable rate amounts. As of June 30, 2008 the projected percentage changes are within the Board approved limits. This period's volatility is higher in each rate shock in a falling rate environment when compared to the same period a year ago. In a rising rate environment, there is little change in the projected net interest income volatility between the two periods. The projected net interest income report summarizing the Company's interest rate sensitivity as of June 30, 2008 is as follows: (dollars in thousands) PROJECTED NET INTEREST INCOME Level Rate Change: - 300 - 100 Rates + 100 + 300 Year One (7/08 - 6/09) Net interest income 23,304 24,135 25,061 25,481 25,816 Net interest income dollar change (1,757) (926) N/A 420 755 Net interest income percentage change -7.0% -3.7% N/A 1.7% 3.0% Board approved limit >-10.0% >-4.0% N/A >-4.0% >-10.0% The projected net interest income report summarizing the Company's interest rate sensitivity as June 30, 2007 is as follows: PROJECTED NET INTEREST INCOME (dollars in thousands) Level Change in basis points: - 300 - 100 Rates + 100 + 300 Year One (7/07 - 6/08) Net interest income 22,916 23,368 23,831 24,181 24,563 Net interest income dollar change (915) (463) N/A 350 732 Net interest income percentage change -3.8% -1.9% N/A 1.5% 3.1% Limitation on % Change >-10.0% >-4.0% N/A >-4.0% >-10.0% Projections from June 30, 2008, year one reflected a decline in net interest income of 3.7% with a 100 basis point decline compared to the 1.9% decline in 2007. The 100 basis point increase in rates reflected a 1.7% increase in net interest income in 2008 compared to 1.5% in 2007. EVE applies discounting techniques to future cash flows to determine the present value of assets, liabilities, and therefore equity. Based on applying these techniques to the June 30, 2008 balance sheet, a 300 basis point increase in rates results in a 21% decline in EVE. A 300 basis point decrease in rates results in a 19% increase in EVE. These are within the Board approved limits. Item 4 - CONTROLS AND PROCEDURES As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on the foregoing, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the reports the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required. The Company also conducted an evaluation of internal control over financial reporting to determine whether any changes occurred during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. Based on this evaluation, there has been no such change during the quarter covered by this report. Part II - Other Information Item 1. Legal Proceedings The Company is not a party to any material legal proceedings. Item 1A. Risk Factors There have been no material changes in risk factors, as previously disclosed in the December 31, 2007 Form 10-K. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds ISSUER PURCHASES OF EQUITY SECURITIES Period (a) Total (b) (c) Total Number (d) Maximum Number Number of Average of Shares (or Units) (or Approximate Dollar Shares (or Price Paid Purchased as Part Value) of Shares (or Units) Per Share of Publicly Units) that May Yet Be Purchased (or Unit) Announced Plans Purchased Under the Or Programs Plans of Programs 4/1/08 - 4/30/08 43,500 $30.76 43,500 839 shares 5/1/08 - 5/31/08 2,800 27.60 2,800 98,039 shares 6/1/08 - 6/30/08 43,960 27.33 43,960 54,079 shares Total 90,260 90,260 54,079 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. On May 20, 2008, the Board of Directors approved and authorized 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 June 30, 2008 245,921 shares have been purchased. Item 3. Defaults upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders The registrant's 2008 Annual Meeting of Shareholders was held May 14, 2008. Proxies were solicited by the registrant's Board of Directors. There was no solicitation in opposition to the Board's nominees as listed in the proxy statement, and all of the nominees were elected by vote of the shareholders. Voting results for each nominee were as follows: Votes For Votes Withheld Henry Hinkle 2,199,806 98,934 Theodore Kuster 2,218,434 80,306 Robert G. Thompson 2,229,434 69,306 The following directors have a term of office that will continue following the Annual Meeting: William Arvin, B. Proctor Caudill, Betty J. Long, Ted McClain, Louis Prichard, Edwin S. Saunier, Woodford Van Meter and Buck Woodford. The total number of Common Shares outstanding as of March 20, 2008, the record date for the Annual Meeting of Shareholders, was 2,852,367. Item 5. Other Information None Item 6. Exhibits 31.1 Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32 Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. KENTUCKY BANCSHARES, INC. Date _____7/14/08_______ __/s/Louis Prichard______________ Louis Prichard, President and C.E.O. Date _____7/14/08_______ __/s/Gregory J. Dawson___________ Gregory J. Dawson, Chief Financial Officer 2 3 22 Lexlibrary/197885.1