10-Q 1 q093.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 September 30, 2009 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 has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes No X _ 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 November 6, 2009: 2,739,607. 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 20 Item 3. Quantitative and Qualitative Disclosures About Market Risk 28 Item 4. Controls and Procedures 29 Part II - Other Information Item 1. Legal Proceedings 29 Item 1A. Risk Factors 29 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 29 Item 6. Exhibits 30 Signatures 30 Exhibits 31.1 Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31 31.2 Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 33 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. 35 Item 1 - Financial Statements KENTUCKY BANCSHARES, INC. CONSOLIDATED BALANCE SHEETS (unaudited) (thousands) 9/30/2009 12/31/2008 Assets Cash and due from banks $ 11,484 $ 16,411 Federal funds sold 102 20,695 Cash and cash equivalents 11,586 37,106 Securities available for sale 169,558 172,834 Loans 427,921 424,276 Allowance for loan losses (6,338) (5,465) Net loans 421,583 418,811 Federal Home Loan Bank stock 6,731 6,731 Bank premises and equipment, net 17,612 17,875 Interest receivable 5,078 5,156 Goodwill 13,117 13,117 Other intangible assets 1,328 1,523 Mortgage servicing rights 751 465 Other assets 7,649 5,157 Total assets $ 654,993 $ 678,775 Liabilities and Stockholders' Equity Deposits Non-interest bearing $ 91,338 $ 90,480 Time deposits, $100,000 and over 102,192 108,465 Other interest bearing 303,053 321,863 Total deposits 496,583 520,808 Repurchase agreements and other borrowings 13,487 10,717 Federal Funds Purchased 4,687 - Federal Home Loan Bank advances 63,430 77,301 Subordinated debentures 7,217 7,217 Interest payable 2,588 2,874 Other liabilities 4,137 2,817 Total liabilities 592,129 621,734 Stockholders' equity Common stock 12,391 12,344 Retained earnings 46,350 44,683 Accumulated other comprehensive income (loss) 4,123 14 Total stockholders' equity 62,864 57,041 Total liabilities & stockholders' equity $ 654,993 $ 678,775 See Accompanying Notes KENTUCKY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (unaudited) (thousands, except per share amounts) Nine Months Ending 9/30/2009 9/30/2008 INTEREST INCOME: Loans, including fees $ 18,640 $ 20,976 Securities available for sale 5,361 5,414 Other 15 327 Total interest income 24,016 26,717 INTEREST EXPENSE: Deposits 7,100 8,776 Other 2,566 2,907 Total interest expense 9,666 11,683 Net interest income 14,350 15,034 Loan loss provision 1,350 1,500 Net interest income after provision 13,000 13,534 NON-INTEREST INCOME: Service charges 3,918 3,969 Loan service fee income 69 65 Trust department income 377 371 Securities available for sale gains (losses), net 351 21 Gain on sale of mortgage loans 1,026 342 Other 1,235 1,243 Total other income 6,976 6,011 NON-INTEREST EXPENSE: Salaries and employee benefits 8,618 7,806 Occupancy expenses 2,042 2,066 Amortization 195 199 Advertising and marketing 372 365 Taxes other than payroll, property and income 553 538 Other 4,494 3,379 Total other expenses 16,274 14,353 Income before taxes 3,702 5,192 Income taxes 277 1,157 Net income $ 3,425 $ 4,035 Other Comprehensive Income, net of tax: Change in Unrealized Gains on Securities 4,109 (1,590) Comprehensive Income $ 7,534 $ 2,445 Earnings per share Basic $ 1.25 $ 1.44 Diluted 1.25 1.44 See Accompanying Notes KENTUCKY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (unaudited) (thousands, except per share amounts) Three Months Ending 9/30/2009 9/30/2008 INTEREST INCOME: Loans, including fees $ 6,337 $ 6,893 Securities available for sale 1,574 1,825 Other 1 71 Total interest income 7,912 8,789 INTEREST EXPENSE: Deposits 2,204 2,574 Other 783 1,114 Total interest expense 2,987 3,688 Net interest income 4,925 5,101 Loan loss provision 450 600 Net interest income after provision 4,475 4,501 NON-INTEREST INCOME: Service charges 1,396 1,409 Loan service fee income 19 20 Trust department income 142 101 Securities available for sale gains (losses), net 148 6 Gain on sale of mortgage loans 215 64 Other 436 376 Total other income 2,356 1,976 NON-INTEREST EXPENSE: Salaries and employee benefits 2,632 2,576 Occupancy expenses 741 688 Amortization 64 66 Advertising and marketing 119 112 Taxes other than payroll, property and income 187 180 Other 1,627 1,115 Total other expenses 5,370 4,737 Income before taxes 1,461 1,740 Income taxes 108 384 Net income $ 1,353 $ 1,356 Other Comprehensive Income, net of tax: Change in Unrealized Gains on Securities 3,290 (740) Comprehensive Income $ 4,643 $ 616 Earnings per share Basic $ 0.49 $ 0.49 Diluted 0.49 0.49 See Accompanying Notes KENTUCKY BANCSHARES, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (unaudited) (thousands, except share information) Accumulated Other Total ----Common Stock---- Retained Comprehensive Stockholders' Shares Amount (1) Earnings Income Equity Balances, December 31, 2008 2,745,729 $ 12,344 $ 44,683 $ 14 $ 57,041 Common stock issued, including tax benefit, net (including stock grants of 3,660 shares) 3,678 - - - - Stock based compensation expense - 86 - - 86 Common stock purchased and retired (8,800) (39) (111) - (150) Net change in unrealized gain (loss) on securities available for sale, net of tax - - - 4,109 4,109 Net income - - 3,425 - 3,425 Dividends declared - $0.60 per share - - (1,647) - (1,647) Balances, September 30, 2009 2,740,607 $ 12,391 $ 46,350 $ 4,123 $ 62,864
(1) Common Stock has no par value; amount includes Additional Paid-in Capital See Accompanying Notes KENTUCKY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (thousands) Nine Months Ending 9/30/2009 9/30/2008 Cash Flows From Operating Activities Net Income $ 3,425 $ 4,035 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization 1,128 1,212 Securities amortization (accretion), net 1,156 (184) Noncash compensation expense 86 101 Provision for loan losses 1,350 1,500 Securities (gains) losses, net (351) (21) Originations of loans held for sale (45,213) (16,296) Proceeds from sale of loans 46,239 16,598 Federal Home Loan Bank stock dividends - (263) Losses (gains) on sale of bank premises and equipment - (5) Gain on sale of mortgage loans (1,026) (342) Changes in: Interest receivable 78 54 Other assets (2,947) (1,948) Interest payable (286) (2,651) Other liabilities (797) 3,963 Net cash from operating activities 2,842 5,753 Cash Flows From Investing Activities Purchases of securities available for sale (60,799) (63,690) Proceeds from sales of securities available for sale 20,646 9,427 Proceeds from principal payments, maturities and calls of securities available for sale 48,850 54,674 Net change in loans (4,122) (3,785) Purchases of bank premises and equipment (555) (2,038) Proceeds from the sale of bank premises and equipment - 5 Net cash from investing activities 4,020 (5,407) Cash Flows From Financing Activities: Net change in deposits (24,225) (14,426) Net change in securities sold under agreements to repurchase, federal funds purchased and other borrow 7,657 (92) Advances from Federal Home Loan Bank 10,000 51,000 Payments on Federal Home Loan Bank advances (23,817) (31,310) Proceeds from note payable - 5,500 Payment on note payable (200) (2,500) Proceeds from issuance of common stock - 15 Purchase of common stock (150) (3,119) Dividends paid (1,647) (2,353) Net cash from financing activities (32,382) 2,715 Net change in cash and cash equivalents (25,520) 3,061 Cash and cash equivalents at beginning of period 37,106 25,807 Cash and cash equivalents at end of period 11,586 28,868 Supplemental disclosures of cash flow information Cash paid during the year for: Interest expense $ 9,952 $ 14,334 Income taxes 400 1,200 Supplemental schedules of non-cash investing Activities Real estate acquired through foreclosure $ 4,109 $ 1,057 See Accompanying Notes KENTUCKY BANCSHARES, INC. NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The preparation of financial statements for Kentucky Bancshares, Inc., a bank holding company in Paris, Kentucky, (the "Company") 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 unaudited books and records. 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, 2008. Recently Issued But Not Yet Effective Accounting Standards ASC Topic 860, "Transfers and Servicing". Effective January 1, 2010, new accounting guidance under ASC Topic 860 will require more information about transfers of financial assets, including securitization transactions, and where entities have continuing exposure to the risks related to transferred financial assets. It eliminates the concept of a "qualifying special- purpose entity," changes the requirements for derecognizing financial assets, and requires additional disclosures about continuing involvements with transferred financial assets including information about gains and losses resulting from transfers during the period. The Company does not expect the guidance under this Topic to have a material impact on its consolidated results of operations or financial position upon adoption. ASC Topic 820, "Fair Value Measurements and Disclosures". In August 2009, the FASB issued ASU 2009-05, "Fair Value Measurements and Disclosures (Topic 820)-Measuring Liabilities at Fair Value". ASU 2009-05 includes amendments to Topic 820 for the fair value measurement of liabilities and provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using one or more of the techniques provided for in Topic 820. The guidance under ASU 2009-05 became effective October 1, 2009. The Company does not expect the guidance under this ASU to have a material impact on its consolidated results of operations or financial position upon adoption. ASC Topic 260, "Earnings Per Share". In September 2009, the FASB issued ASU 2009-08, "Earnings Per Share-Amendments to Section 260-10-S99". ASU 2009-08 includes technical corrections to Topic 260, based on EITF Topic D- 53, "Computation of Earnings Per Share for a Period that Includes a Redemption or an Induced Conversion of a Portion of a Class of Preferred Stock" and EITF Topic D-42, "The Effect of the Calculation of Earnings Per Share for the Redemption or Induced Conversion of Preferred Stock". The Company does not expect the guidance under this ASU to have a material impact on its consolidated results of operations or financial position upon adoption. Adoption of New Accounting Standards In June 2009 the Financial Accounting Standards Board ("FASB") issued an accounting pronouncement establishing FASB Accounting Standards CodificationTM ("ASC") as the source of authoritative U.S. generally accepted accounting principles ("GAAP") applicable to all nongovernmental entities effective July 1, 2009. ASC superseded then-existing FASB, American Institute of Certified Public Accountants, Emerging Issues Task Force ("EITF"), and related literature. Rules and interpretive releases of the Securities and Exchange Commission ("SEC") under the authority of federal securities laws are also sources of GAAP for SEC registrants. All other accounting literature is non-authoritative. The FASB will no longer issue new standards in the form of Statements of Financial Accounting Standards, FASB Staff Position's, or EITF Abstracts. Instead, the FASB will issue Accounting Standards Updates ("ASU"), which will serve only to: (a) update the ASC; (b) provide background information about the guidance; and (c) provide the bases for conclusions on changes in the ASC. The change to ASC changes how companies refer to GAAP in financial statements and accounting policies. Companies will now cite relevant accounting content by referring to the specific Topic, Subtopic, Section, or Paragraph structure of the ASC. The adoption of this accounting pronouncement did not have a material impact on the Company's consolidated financial position or results of operations. ASC Topic 820, "Fair Value Measurements and Disclosures". Effective for the second quarter of 2009, the Company adopted new accounting guidance under ASC Topic 820. New guidance under this Topic: ? Affirms that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction. ? Clarifies and includes additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active. ? Eliminates the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise. The new guidance instead requires an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence. ? Includes an example that provides additional explanation on estimating fair value when the market activity for an asset has declined significantly. ? Requires an entity to disclose a change in valuation technique (and the related inputs) resulting from the application of the FSP and to quantify its effects, if practicable. ? Applies to all fair value measurements when appropriate. The adoption of this accounting guidance did not have a material impact on the Company's consolidated financial position or results of operations. ASC Topic 320, "Investments-Debt and Equity Securities". Effective for the second quarter of 2009, the Company adopted new accounting guidance under ASC Topic 320. New guidance under this Topic: ? Changes existing guidance for determining whether impairment is other than temporary for debt securities; ? Replaces the existing requirement that the entity's management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert: (a) it does not have the intent to sell the security; and (b) it is more likely than not it will not have to sell the security before recovery of its cost basis; ? Incorporates examples of factors from existing literature that should be considered in determining whether a debt security is other-than- temporarily impaired; Under ASC Topic 320, declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of the impairment related to other factors is recognized in other comprehensive income. The adoption of this accounting guidance did not have a material impact on the Company's consolidated financial position or results of operations. Reference is made to Note 2 for additional disclosures required by this Topic. ASC Topic 825, "Financial Instruments". Effective for the second quarter of 2009, the Company adopted new accounting guidance under ASC Topic 825. New accounting guidance under this Topic requires an entity to provide disclosures about fair value of financial instruments in interim financial information. It also amends prior guidance to require those disclosures in summarized financial information at interim reporting periods. Under the new guidance, a publicly traded company shall include disclosures about the fair value of its financial instruments whenever it issues summarized financial information for interim reporting periods. In addition, an entity shall disclose in the body or in the accompanying notes of its summarized financial information for interim reporting periods and in its financial statements for annual reporting periods the fair value of all financial instruments for which it is practicable to estimate that value, whether recognized or not recognized in the statement of financial position. The adoption of this accounting guidance did not have a material impact on the Company's consolidated financial position or results of operations. Please refer to Note 8 for additional information related to the impact of adopting this guidance. ASC Topic 855, "Subsequent Events". Effective for the second quarter of 2009, the Company adopted new accounting guidance under ASC Topic 855. New accounting guidance under this Topic establishes general standards of accounting for and disclosures of events that occur after the balance sheet date, but before financial statements are issued or are available to be issued. This Topic defines 1) the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements; 2) the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements; and 3) the disclosures that an entity should make about events or transactions that occurred after the balance sheet date. The adoption of this accounting guidance did not have a material impact on the Company's consolidated financial position or results of operations. The Company evaluated subsequent events through November 13, 2009, the date its financial statements were issued, and believes that no events have occurred requiring further disclosure or adjustment to the consolidated financial statements. 2. INVESTMENT SECURITIES Period-end securities are as follows: (in thousands) Amortized Unrealized Unrealized Fair Cost Gains Losses Value Available for Sale September 30, 2009 U.S. government agencies $ 22,979 $ 83 $ (1) $ 23,061 States and political subdivisions 72,608 3,498 (7) 76,099 Mortgage-backed 67,455 2,689 (42) 70,102 Equity securities 270 26 - 296 Total 163,312 6,296 (50) 169,558 December 31, 2008 U.S. government agencies $ 19,138 $ 212 $ - $ 19,350 States and political subdivisions 65,091 1,061 (2,181) 63,971 Mortgage-backed 88,314 1,142 (233) 89,223 Equity securities 270 20 - 290 Total 172,813 2,435 (2,414) 172,834 Securities with unrealized losses at September 30, 2009 and December 31, 2008 not recognized in income are as follows:
September 30, 2009 (in thousands) 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 $ 3,014 $ (2) $ - $ - $ 3,014 $ (2) States and municipals - - 982 (6) 982 (6) Mortgage-backed 2,975 (3) 1,176 (39) 4,151 (42) Total temporarily impaired $ 5,989 $ (5) $ 2,158 $ (45) $ 8,147 $ (50) December 31, 2008 (in thousands) 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 $ - $ - $ - $ - $ - $ - States and municipals $13,055 $ (587) $23,023 $(1,594) $36,078 $(2,181) Mortgage-backed 30,903 (165) 1,565 (68) 32,468 (233) Total temporarily impaired $43,958 $ (752) $24,588 $(1,662) $68,546 $(2,414)
Other-than-temporary impairment ("OTTI") All unrealized losses are reviewed on at least a quarterly basis to determine whether the losses are other than temporary and are reviewed 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 our intent and ability to retain the 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, we 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. The term "other-than-temporary" is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value are not necessarily favorable, or that there is a general lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other- than-temporary, the value of the security is reduced and a corresponding charge to earnings is recognized for anticipated credit losses. The unrealized losses in the above charts are due primarily from the changes interest rates. 3. LOANS Loans at period-end are as follows: (in thousands) 9/30/2009 12/31/2008 Commercial $ 26,323 $ 21,505 Real estate construction 17,312 16,819 Real estate mortgage 283,316 286,846 Agricultural 82,333 80,779 Consumer 18,637 18,328 Total 427,921 424,277 Activity in the allowance for loan losses for the nine month period ended was as follows: 2009 2008 Beginning balance $ 5,464,864 $ 4,878,732 Charge-offs (956,397) (716,622) Recoveries 479,335 95,548 Provision for loan losses 1,350,000 1,500,000 Ending balance $ 6,337,802 $ 5,757,658 Impaired loans totaled $8,380,000 at September 30, 2009 and $6,562,000 at December 31, 2008. As of September 30, 2009, the Company approached the calculation for specific allocations differently than as of December 31, 2008. The change in the method of calculation did not have a significant effect on the allowance calculation. Nonperforming loans were as follows: 9/30/09 12/31/08 Loans past due over 90 days still on accrual $1,596,000 $ 779,000 Nonaccrual loans 7,278,000 6,562,000 Nonperforming loans include impaired loans and smaller balance homogeneous loans, such as residential mortgage and consumer loans, that are collectively evaluated for impairment. 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: Nine Months Ended September 30 2009 2008 (in thousands, except per share information) Basic Earnings Per Share Net Income $3,425 $4,035 Weighted average common shares outstanding 2,736 2,792 Basic earnings per share $ 1.25 $ 1.44 Diluted Earnings Per Share Net Income $3,425 $4,035 Weighted average common shares outstanding 2,736 2,792 Add dilutive effects of assumed exercise of stock options - 2 Weighted average common and dilutive potential common shares outstanding 2,736 2,794 Diluted earnings per share $ 1.25 $ 1.44 Three Months Ended September 30 2009 2008 (in thousands, except per share information) Basic Earnings Per Share Net Income $1,353 $1,356 Weighted average common shares outstanding 2,732 2,767 Basic earnings per share $ 0.49 $ 0.49 Diluted Earnings Per Share Net Income $1,353 $1,356 Weighted average common shares outstanding 2,732 2,767 Add dilutive effects of assumed exercise of stock options - 3 Weighted average common and dilutive potential common shares outstanding 2,732 2,770 Diluted earnings per share $ 0.49 $ 0.49 Stock options for 37,844 shares of common stock for the six and three months ended September 30, 2009, and for 39,761 shares of common stock for the three months ended September 30, 2008 were excluded from diluted earnings per share because their impact was antidilutive. 5. STOCK COMPENSATION The Company has two share based compensation plans, including a Stock Option Plan and a Stock Grant Plan, as described in more detail below. Stock Option Plan Under its 1999 Employee Stock Option Plan, the Company has granted 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 100,000 options. Under the expired 1993 Non-Employee Directors Stock Ownership Incentive Plan, the Company had also granted certain directors stock option awards which vest and become fully exercisable immediately and provided 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. No options have been granted in 2009. 2008 Weighted-average fair value of options granted during the year $2.38 Risk-free interest rate 2.96% Expected option life 8 years Expected stock price volatility 11.05% Expected dividend yield 3.61% Summary of activity in the stock option plan for the nine months ended September 30, 2009 follows: Weighted Weighted Average Average Remaining Aggregate Exercise Contractual Intrinsic Shares Price Term Value Outstanding, beginning of year 50,169 $28.57 Forfeited or expired (12,325) 25.86 Outstanding, end of period 37,844 29.45 51.6 months $ - Vested and expected to vest 37,844 29.45 51.6 months - Options exercisable at period end 35,374 29.38 50.8 months - 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 $86 thousand in stock compensation expense during the nine months ended September 30, 2009 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 Per Share Nonvested Shares Shares Fair Value Nonvested at December 31, 2008 10,006 $ 30.58 Granted 4,150 17.15 Vested (2,702) 29.65 Forfeited (280) 25.80 Nonvested at September 30, 2009 11,174 $ 25.94 6. DIVIDENDS Dividends per share paid for the quarter ended September 30, 2009 were $0.20 compared to $0.28 for September 30, 2008. 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 Nine months ended September 30 (in thousands) Pension Benefits 2009 2008 Service cost $ - $ 386 Interest cost - 350 Expected return on plan assets - (361) (Gain) loss amortization - 24 Net Periodic Benefit Cost $ - $ 399 Three months ended September 30 (in thousands) Pension Benefits 2009 2008 Service cost $ - $ 132 Interest cost - 119 Expected return on plan assets - (120) (Gain) loss amortization - 10 Net Periodic Benefit Cost $ - $ 141 Employer Contributions The defined benefit plan offered to employees by the Company was terminated effective December 31, 2008. Therefore, the Company had no contributions to the plan during the first quarter of this year and will also have no contributions going forward. As of December 31, 2008, the date of termination, the projected benefit obligation was $6,749,694 and the fair value of the plan assets was $5,206,908. The difference of $1,542,786 was recognized in other liabilities on the consolidated balance sheet. During the third quarter of 2009, distributions from the defined benefit plan was made to those employees in which the Company had an obligation to as of the December 31, 2008, the plan's termination date. All funds have been distributed and the Company no longer has any liabilities associated with the plan. During the second quarter of 2009, the Company recognized $860 thousand for the final expenses related to terminating the plan. 8. Fair Value Measurements Statement 157 establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value: Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date. Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data. Level 3: Significant unobservable inputs that reflect a reporting entity's own assumptions about the assumptions that market participants would use in pricing an asset or liability. The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities' relationship to other benchmark quoted securities (Level 2 inputs). The fair value of servicing rights is based on a valuation model that calculates the present value of estimated net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income. The Company is able to compare the valuation model inputs and results to widely available published industry data for reasonableness (Level 2 inputs). The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value. Assets and Liabilities Measured on a Recurring Basis For this disclosure, the Company only has available for sale investment securities that meet the requirement. Available for sale investment securities are the Company's only balance sheet item that meet the disclosure requirements for instruments measured at fair value on a recurring basis. Disclosures are as follows in the table below.
(In thousands) Fair Value Measurements at September 30, 2009 Using Quoted Prices In Active Markets for Significant Other Significant Identical Observable Unobservable Fair Value Assets Inputs Inputs Description 9/30/09 (Level 1) (Level 2) (Level 3) U.S. government agencies $ 23,061 $ - $ 23,061 $ - States and political subdivisions 76,099 - 76,099 - Mortgage-backed 70,102 - 70,102 - Equity securities 296 296 - - Total $169,558 $ 296 $ 169,262 $ -
(In thousands) Fair Value Measurements at December 31, 2008 Using Quoted Prices In Active Markets for Significant Other Significant Identical Observable Unobservable Fair Value Assets Inputs Inputs Description 12/31/08 (Level 1) (Level 2) (Level 3) U.S. government agencies $ 19,350 $ - $ 19,350 $ - States and political subdivisions 63,971 - 63,971 - Mortgage-backed 89,223 - 89,223 - Equity securities 290 290 - - Total $172,834 $ 290 $ 172,544 $ -
Assets and Liabilities Measured on a Non-Recurring Basis Servicing rights are carried at lower of cost or fair value. The current value of $751 thousand includes a valuation allowance of $213 thousand, which was recorded during the fourth quarter of 2008. Impaired loans totaled $8,380,000 at September 30, 2009 and $6,562,000 at December 31, 2008. The total allowance for loan losses related to these loans was $607,000 and $320,000 at September 30, 2009 and December 31, 2008. Impaired loans are measured at fair value based on the underlying collateral and are considered level 3 inputs. Fair Value of Financial Instruments In accordance with FSP SFAS 107-1, the carrying amounts and estimated fair values of financial instruments, at September 30, 2009 and December 31, 2008 are as follows: September 30, 2009 December 31, 2008 Carrying Carrying Amount Fair Value Amount Fair Value (In Thousands) Financial assets Cash and cash equivalents $ 11,586 $ 11,586 $ 37,106 $ 37,106 Securities 169,558 169,558 172,834 172,834 Loans, net 421,583 421,451 418,812 418,635 FHLB stock 6,731 6,731 6,731 6,731 Interest receivable 5,078 5,078 5,156 5,156 Financial liabilities Deposits $ 496,583 $ 503,848 $ 520,808 $ 528,949 Securities sold under agreements to repurchase and other borrowings 13,487 13,772 10,717 10,983 FHLB advances 63,430 65,566 77,301 79,665 Subordinated debentures 7,217 5,400 7,217 4,253 Interest payable 2,588 2,588 2,874 2,874 The methods and assumptions used to estimate fair value are described as follows: 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. 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 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. 9. 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 September 30, 2009 and December 31, 2008, 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) September 30, 2009 Consolidated Total Capital (to Risk-Weighted Assets) $ 57,012 12.5% $ 36,459 8% $ 45,573 N/A Tier I Capital (to Risk-Weighted Assets) 51,297 11.3 18,229 4 27,344 N/A Tier I Capital (to Average Assets) 51,297 8.0 25,554 4 31,943 N/A Bank Only Total Capital (to Risk-Weighted Assets) $ 59,565 13.1% $ 36,446 8% $ 45,557 10% Tier I Capital (to Risk-Weighted Assets) 53,850 11.8 18,223 4 27,334 6 Tier I Capital (to Average Assets) 53,850 8.4 25,549 4 31,936 5 December 31, 2008 Consolidated Total Capital (to Risk-Weighted Assets) $ 59,913 13.5% $ 35,618 8% $ 44,522 N/A Tier I Capital (to Risk-Weighted Assets) 54,364 12.2 17,809 4 26,713 N/A Tier I Capital (to Average Assets) 54,364 8.3 26,073 4 32,591 N/A Bank Only Total Capital (to Risk-Weighted Assets) $ 62,615 14.1% $ 35,593 8% $ 44,491 10% Tier I Capital (to Risk-Weighted Assets) 57,066 12.8 17,796 4 26,695 6 Tier I Capital (to Average Assets) 57,066 8.8 26,063 4 32,578 5
Item 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements This discussion contains forward-looking statements, with the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), under the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. In general, forward-looking statements related to a discussion of future financial results or projections, future economic performance, future operational plans and objectives, and statements regarding the underlying assumptions of such statements. 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; technological or operational difficulties; acts of war or terrorism; unexpected claims or litigation against the Company; changes in the level of non-performing assets and charge-offs; and other risks detailed in the Company's filings with the SEC, all of which are difficult to predict and many of which are beyond the control of the Company. The Company expressly disclaims any intent or 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 The Company recorded net income of $3.4 million, or $1.25 basic and diluted earnings per share for the first nine months ending September 30, 2009 compared to $4.0 million, or $1.44 basic and diluted earnings per share for the nine month period ending September 30, 2008. The first nine months earnings reflects a decrease of 15% compared to the same time period in 2008, due primarily to a decrease in net interest income of $684 thousand, an increase in salaries and benefits of $812 thousand and an increase in other expenses of $1.1 million. The increase in salaries and benefits was primarily due to final costs of $874 thousand related to terminating the pension plan. The increase in other expenses was mainly due to an increase of $873 thousand in FDIC insurance expense. These reductions to income were partially offset by an increase on the gain on securities of $330 thousand, the gain on sold loans of $394 thousand and a reduction in income tax expense of $942 thousand. The earnings were $1.4 million, or $0.49 basic and diluted earnings per share for the three month period ending September 30, 2009 compared to $1.4 million, or $0.49 basic and diluted earnings per share for the three month period ending September 30, 2008. This three month period earnings reflects no change in earnings compared to the same time period in 2008. Return on average assets was 0.68% for the nine months ended September 30, 2009 and 0.85% for the nine month period ended September 30, 2008. Return on average assets was 0.82% for the three months ended September 30, 2009 and 0.85% for the three month period ended September 30, 2008. Return on average equity was 7.8% for the nine month period ended September 30, 2009 compared to 9.3% for the nine month period ended September 30, 2008. Return on average equity was 9.1% for the three months ended September 30, 2009 and 9.4% for the same time period in 2008. Loans increased $3.6 million from $424.3 million on December 31, 2008 to $427.9 million on September 30, 2009. Decreases in real estate mortgage loans were offset by an increase in real estate construction, agricultural, commercial & consumer loans. Total deposits decreased from $520.8 million on December 31, 2008 to $496.6 million on September 30, 2009, a decrease of $24.2 million. This decrease is primarily the result of a decrease in interest bearing deposit accounts, excluding time deposits and time deposits with balances of $100 thousand and greater. Management attributes the decrease mainly due to large dollar public fund accounts that have rolled off during 2009 and increased competition for deposits. Net Interest Income Net interest income was $14.4 million for the nine months ended September 30, 2009 compared to $15.0 million for the nine months ended September 30, 2008, a decrease of 4.5%. The interest spread was 3.04% for the first nine months of 2009 comparable to 3.33% for the same period in 2008, a decrease of 29 basis points. Net interest income was $4.9 million for the three month period ending September 30, 2009 compared to $5.1 million for the three month period ending September 30, 2008, a decrease of 3.5%. The interest spread was 3.23% for the three month period ending September 30, 2009 compared to 3.35% for the three month period in 2008, a decrease of 12 basis points. For the first three months in 2009, the prime interest rate was 200 basis points less than the first 3 months in 2008. During the second and third quarters of 2009, the prime interest rate was 175 basis points less than the same period a year ago. These declines in rates have significantly impacted the Company's interest spread. In addition to lower rates and tightening interest margins, the net interest spread for 2009 is also lower than 2008 due to an increase in "lost" loan interest during 2009 that can be attributed to an increase in non- performing loans in the Company's loan portfolio. For the first nine months, the yield on assets decreased from 6.06% in 2008 to 5.17% in 2009. The cost of liabilities decreased from 2.72% in 2008 to 2.13% in 2009. Year to date average loans increased $4.6 million, or 1.1% from September 30, 2008 to September 30, 2009. Loan interest income has decreased $2.3 million for the first nine months of 2009 compared to the first nine months of 2008. Year to date average deposits increased from September 30, 2008 to September 30, 2009, up $40.0 million or 8.3%. The increase is primarily the result of an increase in interest bearing public funds. Deposit interest expense has decreased $1.7 million for the first nine months of 2009 compared to the same period in 2008. Non-Interest Income Non-interest income increased $965 thousand for the nine months ended September 30, 2009 compared to the same period in 2008 to $7.0 million, due primarily to an increase of $684 thousand on the gain of the sale of mortgage loans and an increase of $330 thousand on gains recognized from the sale of securities. These increases were partially offset by a decrease in service charges of $51 thousand. The decrease in service charges was primarily the result of a decrease in overdraft income of $106 thousand for the first nine months of 2009. Non-interest income increased $380 thousand for the three months ended September 30, 2009. The increase in non-interest income for the three months ended September 30, 2009 compared to same time period in 2008 is primarily due to an increase of $151 thousand on the gain of the sale of mortgage loans and an increase of $142 thousand on gains recognized from the sale of securities. Gain on sale of mortgage loans increased from $342 thousand in the first nine months of 2008 to $1.0 million during the first nine months of 2009. For the three months ended September 30, 2009 compared to the same time period in 2008, the gain on sale of mortgage loans increased $151 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 $1.9 million for the nine month period ended September 30, 2009 compared to the same period in 2008. For the three month period ended September 30, 2009, total non-interest expense increased $633 thousand. For the comparable nine month periods, salaries and benefits increased $812 thousand, an increase of 10%. The increase in salaries and benefits is primarily attributed to the Company terminating the defined benefit plan offered to employees of the Company as of December 31, 2008. During the second quarter of 2009, the Company recognized $860 thousand for the final expenses related to terminating the plan. In addition, the Company had offered a voluntary separation option to various employees effective as early as August 31, 2009 and as late as October 31, 2009. The first payouts for those electing this option occurred in September 2009 with the remaining payouts to be completed in the fourth quarter of 2009, with future salary and benefit savings from those electing this option to be realized in the latter part of this year and in future periods. Salaries and benefits increased $56 thousand for the three month period ending September 30, 2009 compared to the same time period in 2008 as a result of the voluntary separation offers. Occupancy expenses decreased $24 thousand to $2,042 thousand for the first nine months of 2009 compared to the same time period in 2008. Occupancy expenses increased $53 thousand for the three month period ended September 30, 2009 compared to the same time period in 2008. The decrease in year to date occupancy expense during 2009 is mainly due to a reduction in depreciation expense. For the first nine months ending September 30, 2009, depreciation expense decreased $59 thousand compared to the first nine months 2008. The decrease in depreciation expense is due to assets with a high cost basis becoming fully depreciated at the end of 2008. During the third quarter of 2009, the Company accrued an additional $60 thousand in depreciation expense for the estimated loss on the disposal of the fixed assets associated with the North Middletown building which was closed in July 2009. In April 2009, construction on the new Nicholasville location was completed and is expected to cause a slight increase in occupancy expenses going forward. In addition to the relocation of the Nicholasville branch, during the second quarter of 2009, the downtown Cynthiana location was consolidated with the Company's newer location in Cynthiana. On July 31, 2009, the North Middletown branch was closed, and accounts moved to the main office in Paris. Management believes that consolidating these locations will reduce costs and improve net income. Other expenses increased $1,115 thousand for the first nine months ended September 30, 2009 compared to the same time period in 2008. For the three month period ended September 30, 2009 other expenses increased $512 thousand compared to the three month period ended September 30, 2008. Increases in other expenses for both year to date and the three months ending September 30 are related to an increase in FDIC insurance expense. FDIC insurance expense increased $873 thousand for the first nine months in 2009 compared to the same period a year ago and increased $189 thousand for the three months ending September 30, 2009 compared to the three months ending September 30, 2008. The increase in FDIC insurance is primarily the result of two things. First, there has been an increase in FDIC insurance premiums (see below for more details). Second, a special assessment has been assessed by the FDIC on all FDIC insured banks. The special assessment was not made formal until May of this year and cost the Company $296 thousand which was expensed during the three months ending June 30, 2009. Deposit Insurance: In February 2009, the FDIC adopted a long-term deposit insurance fund ("DIF") restoration plan as well as an additional emergency assessment for 2009. The restoration plan increases base assessment rates for banks in all risk categories with the goal of raising the DIF reserve ratio from its current 0.40% to 1.15% within seven years. Banks in the best risk category, which include the Company's subsidiary bank, will pay initial base rates ranging from 12 to 16 basis points of assessable deposits beginning April 1, 2009, up from the initial base rate range of 12 to 14 basis points. Additionally, the FDIC approved an interim rule imposing a special emergency assessment to all financial institutions of five basis points as of June 30, 2009. The special assessment amounted to $296 thousand and was paid on September 30, 2009. The FDIC is also permitted to impose an emergency special assessment after June 30, 2009 of up to 10 basis points if necessary to maintain public confidence in federal deposit insurance. On November 12, 2009, the FDIC adopted a final rule requiring insured depository institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012, on December 30, 2009, along with each institution's risk-based deposit insurance assessment for the third quarter of 2009. The prepaid amount would be amortized over the prepayment period. The Company's estimated prepayment would be approximately $3.3 million. The increase in assessments by the FDIC could have a material adverse effect on the Company's earnings. Temporary Liquidity Guarantee Program ("TLGP"): The TLGP consists of two separate programs implemented by the FDIC in October 2008. This includes the Debt Guarantee Program ("DGP") and the Transaction Account Guarantee Program ("TAGP"). These programs were initially provided at no cost to participants during the first 30 days. Eligible institutions that do not "opt out" of either of these programs become participants by default and will incur the fees assessed for taking part. Under the DGP, the FDIC will guarantee senior unsecured debt issued on or after October 14, 2008 through June 30, 2009 up to certain limits by participating entities. The FDIC will provide guarantee coverage for debt issued between those dates until the earlier of the maturity date of the debt or June 30, 2012. The Company chose to opt out of the DGP. Under the TAGP, the FDIC guarantees 100% of certain noninterest bearing transaction accounts up to any amount to participating FDIC insured institutions. The unlimited coverage is applicable until December 31, 2009. The Company opted to participate in the TAGP; as such, it will incur an additional quarterly-assessed 10 basis point fee on balances in noninterest bearing transaction accounts exceeding the recently increased $250 thousand deposit limit that became effective on November 13, 2008. The previous deposit insurance limit amount was $100 thousand. Emergency Economic Stabilization Act of 2008 ("EESA"): EESA was signed into law by the President on October 3, 2008 as a measure to stabilize and provide liquidity to the U.S. financial markets. Under EESA, the Troubled Asset Relief Program ("TARP") was created. TARP granted the Treasury authority to, among other things, invest in financial institutions and purchase troubled assets in an aggregate amount up to $700 billion. In connection with TARP, the Capital Purchase Program ("CPP") was launched on October 14, 2008. Under the CPP, the Treasury announced a plan to use up to $250 billion of TARP funds to purchase equity stakes in certain eligible financial institutions, including the Company. The Company was preliminarily approved for $13 million of equity capital in December 2008, and subsequently withdrew its application. Income Taxes The effective tax rate for the nine months ended September 30, 2009 was 7.5% compared to 22.3% in 2008. The effective tax rate for the three months ended September 30, 2009 was 7.4% compared to 22.1% for the three month period ended September 30, 2008. These rates are less than the statutory rate as a result of the tax-free securities and loans held by the Company. In addition, beginning in June 2009, the Company began recognizing tax benefits the Company will receive from historic and low income housing credits. The rates for 2009 are lower due to the lower level of income for 2009. Nontaxable interest income increased $265 thousand for the first nine months of 2009 compared to the same time period in 2008. 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 September 30, 2009, 266,801 shares have been purchased under the program. The most recent share repurchase occurred on October 5, 2009. 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 $11.6 million as of September 30, 2009 compared to $37.1 million at December 31, 2008. 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 a decrease in borrowings from the Federal Home Loan Bank. In addition to cash and cash equivalents, the securities portfolio provides an important source of liquidity. Securities available for sale totaled $170.0 million at September 30, 2009. 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 a public fund account which brought $20 million in deposits to the Company. The full $20 million was expected to roll off by June 30, 2009. As of September 30, 2009, $4 million remains with the Company. In addition, in early January 2009, the Company received deposits in the amount of $18 million as a result of being the successful bidder on a public fund account. As of September 30, 2009, $14.9 million has rolled off with the remaining $2.6 million to roll off during the remainder of 2009 and another $2.5 million is expected to roll of during the first quarter of 2010. In July 2009, the Company successfully bid on another public fund account and was rewarded with additional public fund deposits totaling $16 million. As of September 30, 2009, the Company has sufficient collateral to borrow an additional $37 million from the FHLB. In addition, as of September 30, 2009, over $30 million is available in overnight borrowing through various correspondent banks. In light of this, management believes there is sufficient liquidity to meet all reasonable borrower, depositor and creditor needs in the present economic environment. Non-Performing Assets As of September 30, 2009, the Company's non-performing loans totaled $13.8 million or 2.07% of loans compared to $9.2 million or 1.73% of loans at December 31, 2008. (See table below) The Company experienced an increase of $716 thousand in non-accrual loans from December 31, 2008 to September 30, 2009. As of September 30, 2009, non-accrual loans include $2.3 million in loans secured by 1-4 family residential real estate, $2.1 million in real estate construction and $1.8 million in loans secured by non-farm non- residential properties. Real estate loans composed 94% of the non-performing loans as of September 30, 2009 and 96% as of December 31, 2008. Forgone interest income on the non-accrual loans was $394 thousand for the first nine months of 2009 compared to $455 thousand for the same time period in 2008. Nonperforming Assets 9/30/09 12/31/08 (in thousands) Non-accrual Loans $ 7,278 $ 6,562 Accruing Loans which are Contractually past due 90 days or more 1,596 779 Total Nonperforming and Restructured 8,874 7,341 Other Real Estate 4,870 1,840 Total Nonperforming and Restructured Loans and Other Real Estate $ 13,744 $ 9,181 Nonperforming and Restructured Loans as a Percentage of Loans 2.07% 1.73% Nonperforming and Restructured Loans and Other Real Estate as a Percentage of Total Assets 2.10% 1.35% Allowance as a Percentage of Period-end Loans 1.48% 1.29% Allowance as a Percentage of Non-performing and Restructured Loans 71% 60% Provision for Loan Losses The loan loss provision for the first nine months ending September 30, 2009 was $1.35 million for 2009 and $1.50 million for the same period in 2008 The loan loss provision for the three months ended September 30, 2009 was $450 thousand and $600 thousand for the same period in 2008. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Net charge-offs for the nine month period ended September 30, 2009 were $477 thousand compared to net charge-offs of $621 thousand for the same period in 2008. Net charge-offs for the three month period ended September 30, 2009 were $485 thousand compared to $236 thousand during the same time period in 2008. 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 Nine Months Ended September 30 (in thousands) 2009 2008 Balance at Beginning of Period $ 5,465 4,879 Amounts Charged-off: Commercial 289 57 Real Estate Construction 39 217 Real Estate Mortgage 221 171 Agricultural 6 12 Consumer 1,047 792 Total Charged-off Loans 1,602 1,249 Recoveries on Amounts Previously Charged-off: Commercial 2 6 Real Estate Construction 35 2 Real Estate Mortgage 393 13 Agricultural - 30 Consumer 695 577 Total Recoveries 1,125 628 Net Charge-offs 477 621 Provision for Loan Losses 1,350 1,500 Balance at End of Period 6,338 5,758 Loans Average 420,364 415,785 At September 30 427,921 420,552 As a Percentage of Average Loans: Net Charge-offs 0.11% 0.15% Provision for Loan Losses 0.32% 0.36% Allowance as a Multiple of Net Charge-offs 10.0 7.0 Loan Losses Quarter Ended September 30 (in thousands) 2009 2008 Balance at Beginning of Period $ 6,373 $ 5,394 Amounts Charged-off: Commercial 222 52 Real Estate Mortgage 139 116 Consumer 423 180 Total Charged-off Loans 784 348 Recoveries on Amounts Previously Charged-off: Commercial - 1 Real Estate Mortgage 6 1 Consumer 293 110 Total Recoveries 299 112 Net Charge-offs 485 236 Provision for Loan Losses 450 600 Balance at End of Period 6,338 5,758 Loans Average 424,342 422,257 At September 30 427,921 420,552 As a Percentage of Average Loans: Net Charge-offs 0.11% 0.06% Provision for Loan Losses 0.11% 0.14% Allowance as a Multiple of Net Charge-offs 3.3 6.1 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 its 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 September 30, 2009 the projected percentage changes are within the Board approved limits. This period's volatility is lower in each rate shock in a falling and rising rate environment when compared to the same period a year ago. The projected net interest income report summarizing the Company's interest rate sensitivity as of September 30, 2009 is as follows: PROJECTED NET INTEREST INCOME (dollars in thousands) Level Change in basis points: - 300 - 100 Rates + 100 + 300 Year One (10/09 - 9/10) Net interest income 20,843 21,447 21,938 22,122 22,280 Net interest income dollar change (1,095) (491) N/A 184 342 Net interest income percentage change -5.0% -2.2% N/A .8% 1.6% 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 September 30, 2008 is as follows: PROJECTED NET INTEREST INCOME (dollars in thousands) Level Change in basis points: - 300 - 100 Rates + 100 + 300 Year One (10/08 - 9/09) Net interest income 21,100 21,851 22,646 23,357 23,901 Net interest income dollar change (1,546) (795) N/A 711 1,255 Net interest income percentage change -6.8% -3.5% N/A 3.1% 5.5% Board approved limit >-10.0% >-4.0% N/A >-4.0% >-10.0% Projections from September 30, 2009, year one reflected a decline in net interest income of 2.2% with a 100 basis point decline compared to the 3.5% decline in 2008. The 100 basis point increase in rates reflected a .8% increase in net interest income in 2009 compared to a 3.1% increase in 2008. 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 September 30, 2009 balance sheet, a 300 basis point increase in rates results in a 13.8% decline in EVE. A 300 basis point decrease in rates results in a .2% 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, 2008 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 7/1/09 - 7/31/09 2,100 17.95 2,100 35,199 shares 8/1/09 - 8/31/09 - - - 35,199 shares 9/1/09 - 9/30/09 2,000 16.61 2,000 33,199 shares Total 4,100 4,100 33,199 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 September 30, 2009 266,801 shares have been purchased. Item 6. Exhibits 31.1 Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32 Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. KENTUCKY BANCSHARES, INC. Date _____11/16/09_______ __/s/Louis Prichard______________ Louis Prichard, President and C.E.O. Date _____11/16/09_______ __/s/Gregory J. Dawson___________ Gregory J. Dawson, Chief Financial Officer 2 3 7 Lexlibrary/197885.1