UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-K

(Mark One)

☒  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2016

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

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Name on each exchange on which registered
Common Stock, no par value per share	OTC QX

Securities registered pursuant to Section 12(g) of the Act:  None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  ☐  No  ☒

Indicate by check mark if the registrant is not required to file reports to Section 13 or Section 15(d) of the Exchange Act.  Yes  ☐  No  ☒

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  ☒  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 (229.405 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  ☐

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  ☐	Accelerated filer  ☐
Non-accelerated filer   ☒	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  ☒

Aggregate market value of voting stock held by non-affiliates as of June 30, 2016 was approximately $68.0 million.  For purposes of this calculation, it is assumed that the Bank’s Trust Department, directors, executive officers and beneficial owners of more than 5% of the registrant’s outstanding voting stock are affiliates.

Number of shares of Common Stock outstanding as of March 15, 2017:  2,972,763.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement for its Annual Meeting of Stockholders to be held on May 17, 2017 are incorporated by reference into Items 10, 11, 12, 13 and 14 of Part III.

PART I

Item 1.  Business

General

Kentucky Bancshares, Inc. (“Company,” “Kentucky,” “we,” “our” and “us”) is a bank holding company headquartered in Paris, Kentucky.  The Company was organized in 1981 and is registered under the Bank Holding Company Act of 1956, as amended (“BHCA”).

The Company conducts its business in the Commonwealth of Kentucky through one banking subsidiary, Kentucky Bank, and one non-bank subsidiary KBI Insurance Company.

Kentucky Bank is a commercial bank and trust company organized under the laws of Kentucky.  Kentucky Bank has its main office in Paris (Bourbon County), with additional offices in Paris, Cynthiana (Harrison County), Georgetown (Scott County), Lexington (Fayette), Morehead (Rowan County), Nicholasville (Jessamine County), Richmond (Madison County), Sandy Hook (Elliott County), Versailles (Woodford County), Wilmore (Jessamine County) and Winchester (Clark County).  The deposits of Kentucky Bank are insured up to prescribed limits by the Deposit Insurance Fund (“DIF”) of the Federal Deposit Insurance Corporation (“FDIC”).  KBI Insurance Company is a captive insurance subsidiary and was incorporated in 2014.

The Company had total assets of $1.0 billion, total deposits of $803.0 million and stockholders’ equity of $93.0 million as of December 31, 2016.  The Company’s principal executive office is located at 339 Main Street, Paris, Kentucky  40361, and the telephone number at that address is (859) 987-1795.

Business Strategy

The Company’s current business strategy is to operate a well-capitalized, profitable and independent community bank with a significant presence in Central and Eastern Kentucky.  Management believes the optimum way to grow the Company is by attracting new loan and deposit customers within its existing markets through its product offerings and premier customer service.  Management continues to consider opportunities for branch expansion and will also consider acquisition opportunities that help advance its strategic objectives.

Lending

Kentucky Bank is engaged in general full-service commercial and consumer banking.  A significant part of Kentucky Bank’s operating activities include originating loans, approximately 81% of which are secured by real estate at December 31, 2016.  Kentucky Bank makes commercial, agricultural and real estate loans to its commercial customers, with emphasis on small-to-medium-sized industrial, service and agricultural businesses.  It also makes residential mortgage, installment and other loans to its individual and other non-commercial customers.

Loan Rates:  Kentucky Bank offers variable and fixed rate loans.  Loan rates on variable rate loans generally adjust upward or downward based on changes in the loan’s index.  Rate adjustments on variable rate loans are made from 1 day to 5 years.  Variable rate loans may contain provisions that cap the amount of interest rate increases or decreases over the life of the loan.  In addition to the lifetime caps and floors on rate adjustments, loans secured by residential real estate may contain provisions that limit annual increases at a maximum of 200 basis points.  There is usually no annual limit applied to loans secured by commercial real estate.

Credit Risk:  Commercial lending and real estate construction lending, generally include a higher degree of credit risk than other loans, such as residential mortgage loans.  Commercial loans, like other loans, are evaluated at the time of approval to determine the adequacy of repayment sources and collateral requirements. Collateral requirements vary to some degree among borrowers and depend on the borrower’s financial strength, the terms and amount of the loan, and collateral available to secure the loan.  Credit risk results from the decreased ability or willingness to pay by a borrower.  Credit risk also results when a liquidation of collateral occurs and there is a shortfall in collateral value as compared to a loan’s outstanding balance.  For construction loans, inaccurate initial estimates of a project’s costs and the property’s completed value could weaken the Company’s position and lead to the property having a value that is insufficient to satisfy full payment of the amount of funds advanced for the property.  Secured and unsecured consumer loans generally are made for automobiles, boats, and other motor vehicles.  In most cases, loans are restricted to Kentucky Bank’s general market area.

Other Products:  Kentucky Bank offers its customers a variety of other services, including checking, savings, money market accounts, certificates of deposits, safe deposit facilities, credit cards and other consumer-oriented financial services.  Kentucky Bank has Internet banking, including bill payment available to its customers at www.kybank.com.  Through its Wealth Management Department, Kentucky Bank provides brokerage services, annuities, life and long term care insurance, personal trust and agency services (including management agency services).

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Competition and Market Served

Competition: The banking business is highly competitive.  Competition arises from a number of sources, including other bank holding companies and commercial banks, consumer finance companies, thrift institutions, other financial institutions and financial intermediaries.  In addition to commercial banks, savings and loan associations, savings banks and credit unions actively compete to provide a wide variety of banking services.  Mortgage banking firms, finance companies, insurance companies, brokerage companies, financial affiliates of industrial companies and government agencies provide additional competition for loans and for many other financial services.  Kentucky Bank also currently competes for interest-bearing funds with a number of other financial intermediaries, including brokerage firms and mutual funds, which offer a diverse range of investment alternatives.  Some of the Company’s competitors are not subject to the same degree of regulatory review and restrictions that apply to the Company and its subsidiary bank.  In addition, the Company must compete with much larger financial institutions that have greater financial resources than the Company.

Market Served.  We primarily conduct our business in the Commonwealth of Kentucky.  Our primary market areas consist of Bourbon, Clark, Elliott, Fayette, Harrison, Jessamine, Madison, Rowan, Scott, Woodford and surrounding counties in Kentucky.  Per capita personal income for Kentucky increased from $38,989 in 2015 to $39,641 in 2016, according to the Bureau of Economic Analysis. The Bureau of Labor Statistics reports that the unemployment rate in Kentucky has declined. The unemployment rate in Kentucky is 4.8% for December of 2016, compared to 5.7% for December of 2015.

Supervision and Regulation

Governing Regulatory Institutions:  As a bank holding company, the Company is subject to the regulation and supervision of the Federal Reserve Board.  The Company’s subsidiary bank is subject to supervision and regulation by applicable state and federal banking agencies, including the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Kentucky Department of Financial Institutions.  Kentucky Bank is also subject to various requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon, and limitations on the types of investments that may be made and the types of services that may be offered.  In addition to the impact of regulation, Kentucky Bank is affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy.  The company also has a captive insurance subsidiary which is regulated by the State of Nevada Division of Insurance.

Laws Protecting Deposits:  There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy.  These obligations and restrictions are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insured funds in the event the depository institution becomes in danger of default or is in default.  For example, under a policy of the Federal Reserve Board with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and commit resources to support such institutions in circumstances where it might not do so absent such policy.  In addition, the “cross-guarantee” provisions of federal law require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default.

The federal banking agencies also have broad powers under current federal law to take prompt corrective action to resolve problems of insured depository institutions.  The extent of these powers depends upon whether the institutions in question are “well capitalized”, “adequately capitalized”, “undercapitalized”, “significantly undercapitalized” or “critically undercapitalized”, as such terms are defined under uniform regulation defining such capital levels issued by each of the federal banking agencies.

Capital and Liquidity:  On July 2, 2013, the Federal Reserve approved final rules known as the “Basel III Capital Rules” substantially revising the risk-based capital and leverage capital requirements applicable to bank holding companies and depository institutions.  The Basel III Capital Rules address the components of capital and other issues affecting the numerator in banking institutions’ regulatory capital ratios. Certain of the Basel III Capital Rules came into effect for the Company and Kentucky Bank on January 1, 2015; these rules are subject to a phase-in period which began on January 1, 2015.

Under the current rules, which were effective January 1, 2015, the Company is subject to additional capital requirements that include: (i) creation of a new required ratio for common equity Tier 1 (“CET1”) capital, (ii) an increase to the minimum Tier 1 Risk-based Capital ratio, (iii) changes to risk-weightings of certain assets for purposes of the risk-based capital ratios, (iv) creation of an additional capital conservation buffer in excess of the required minimum capital ratios, and (v) changes to what qualifies as capital for purposes of meeting these capital requirements.

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When fully phased-in on January 1, 2019, the Basel III Capital Rules will require banking organizations to maintain:

· a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased-in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7.0% upon full implementation);

· a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased-in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation);

· a minimum ratio of total capital (that is, Tier 1 plus Tier 2 capital) to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased-in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation); and

· a minimum leverage ratio of 4.0%, calculated as the ratio of Tier 1 capital to adjusted average consolidated assets.

The Basel III Capital Rules also provide for a “countercyclical capital buffer” that is applicable to only certain covered institutions and is not expected to have any current applicability to the Company or Kentucky Bank.

The aforementioned capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer will face limitations on the payment of dividends, common stock repurchases and discretionary cash payments to executive officers based on the amount of the shortfall.

The Basel III Capital Rules provides for a number of deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1.  Under the Basel III Capital Rules, the Company and Kentucky Bank were given a one-time election (“Opt-out Election”) to filter certain accumulated other comprehensive income (“AOCI”) components, comparable to the treatment under the current general risk-based capital rule. The Company and Kentucky Bank elected to choose the AOCI Opt-out Election.

Implementation of the deductions and other adjustments to CET1 began on January 1, 2015 and will be phased-in over a five-year period (20% per year). The implementation of the capital conservation buffer will begin on January 1, 2016 at the 0.625% level and be phased-in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019).  In addition, the Basel III Capital Rules revise the rules for calculating risk-weighted assets to enhance their risk sensitivity. They establish a new framework under which mortgage-backed securities and other securitization exposures will be subject to risk-weights ranging from 20% to 1,250%. The rules also establish adjusted risk-weights for credit exposures, including multi-family and commercial real estate exposures that are 90 days or more past due or on non-accrual, which will be subject to a 150% risk-weight, except in situations where qualifying collateral and/or guarantees are in place. The existing treatment of residential mortgage exposures will remain subject to either a 50% risk-weight (for prudently underwritten owner-occupied first liens that are current or less than 90 days past due) or a 100% risk-weight (for all other residential mortgage exposures including 90 days or more past due exposures).  As shown in Note 19, the Company and Kentucky Bank meet all capital adequacy requirements, and management does not anticipate any adverse impact from the implementation of the new capital ratio.

Deposit Insurance:  The Company is subject to several deposit insurance assessments, which are described below:

FDIC Assessments.  The Company’s subsidiary bank is a member of the FDIC, and its deposits are insured by the FDIC’s Deposit Insurance Fund (“DIF”) up to the amount permitted by law.  The Company’s subsidiary bank is thus subject to FDIC deposit insurance assessments.  The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank’s capital level and supervisory rating.

The assessment base must, with some possible exceptions, equal average consolidated total assets minus average tangible equity.  The FDIC has adopted a DIF restoration plan to ensure that the reserve ratio increases to 1.35% from 1.15% of insured deposits by 2020.

Financing Corporation (“FICO”) Assessments.  FICO assessment costs were $50 thousand in 2016, $47 thousand in 2015 and $44 thousand for 2014.  FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 possessing assessment powers in addition to the FDIC.  The FDIC acts as a collection agent for FICO, whose sole purpose is to function as a financing vehicle for the now defunct Federal Savings & Loan Insurance Corporation.  Outstanding FICO bonds, which are 30-year noncallable bonds, mature in 2017 through 2019.

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Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”):  Dodd-Frank was signed into law by the President on July 21, 2010, and represents a significant change in the American financial regulatory environment affecting all Federal financial regulatory agencies and affecting almost every aspect of the nation’s financial services industry.  Dodd-Frank includes, among others, the following:

· the creation of a Financial Stability Oversight Counsel to identify emerging systemic risks and improve interagency cooperation;

· the establishment of the same or strengthened capital and liquidity requirements for bank holding companies that apply to insured depository institutions;

· restrictions in proprietary trading and investing in or sponsoring of any hedge fund or private equity fund;

· the establishment of minimum credit risk retention requirements relating to securitizations;

· the establishment of detailed asset-level and data-level disclosure requirements relating to loan brokers and originators;

· codification and expansion of the “source of strength” doctrine as a statutory requirement.  The source of strength doctrine represents the long held policy view by the Federal Reserve that a bank holding company should serve as a source of financial strength for its subsidiary banks;

· a permanent increase of FDIC deposit insurance to $250,000;

· authorization for financial institutions to pay interest on business checking accounts;

· changes in the calculation of FDIC deposit insurance assessments;

· expanded restrictions on transactions with affiliates and insiders under Section 23A and 23B of the Federal Reserve Act and lending limits for derivative transactions, repurchase agreements and securities lending and borrowing transactions;

· provisions for new disclosure and other requirements regarding corporate governance and executive compensation;

· the creation of a Consumer Financial Protection Bureau, which is authorized to promulgate consumer protection regulations relating to bank and non-bank financial products and examine and enforce these regulations on institutions with more than $10 billion in assets.

Volcker Rule:  On December 10, 2013, in implementing section 619 of the Dodd-Frank Act, the final Volcker Rule was approved by the OCC, the Federal Reserve, the FDIC, the SEC, and the Commodities Futures Trading Commission (“CFTC”).  The Volcker Rule attempts to reduce risk and banking system instability by restricting U.S. banks from investing in or engaging in proprietary trading and speculation and imposing a strict framework to justify exemptions for underwriting, market making and hedging activities.  U.S. banks will be restricted from investing in funds with collateral comprised of less than 100% loans that are not registered with the SEC and from engaging in hedging activities that do not hedge a specific identified risk.  The Volcker Rule has not had a significant effect on operations of the Company.

Several of the requirements of Dodd-Frank still need to be implemented.  These requirements will be subject to regulations to be implemented, which will not become fully effective for several years.

Consumer Regulations:  In addition to the laws and regulations discussed above, Kentucky Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks.  While the list set forth herein is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Real Estate Settlement Procedures Act, the Fair Housing Act and the Fair and Accurate Transactions Act, among others.  These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with clients when taking deposits or making loans. These laws also limit Kentucky Bank’s ability to share information with affiliated and unaffiliated entities.  The bank must comply with the applicable provisions of these consumer protection laws and regulations as part of its ongoing business operations.

Dividend Restrictions:  There are various legal and regulatory limits on the extent to which the Company’s subsidiary bank may pay dividends or otherwise supply funds to the Company.  In addition, federal and state regulatory agencies also have the authority to prevent a bank or bank holding company from paying a dividend or engaging in any other activity that, in the opinion of the agency, would constitute an unsafe or unsound practice.  Dividends paid by the subsidiary bank have provided substantially all of the Company’s operating funds, and this may reasonably be expected to continue for the foreseeable future.

Employees

At December 31, 2016, the number of full time equivalent employees of the Company was 241.

Nature of Company’s Business

The business of the Company is not seasonal.  The Company’s business does not depend upon a single customer, or a few customers, the loss of any one or more of which would have material adverse effect on the Company.

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No material portion of the Company’s business is subject to renegotiation of profits or termination of contracts or subcontracts at the election of any governmental entity.

Available Information

The Company files annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports with the Securities and Exchange Commission (“SEC”) pursuant to section 13(a) or 15(d) of the Securities Exchange Act of 1934.

The public may read and copy any material the Company files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC  20549 and may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.  The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC on its website at www.sec.gov.  The Company’s website is located at www.kybank.com.

Item 1A.  Risk Factors

There are factors, many beyond our control, which may significantly affect the Company’s financial position and results of operations.  Some of these factors are described below in the sections titled financial risk, business risk and operational risk.  These risks are not totally independent of each other; some factors affect more than one type of risk.  These include regulatory, economic, and competitive environments.  As part of the annual internal audit plan, our risk management department meets with management to assess these risks throughout the Company.  Many risks are further addressed in other sections of this Form 10-K document.  Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Company’s business operations.  This report is qualified in its entirety by these risk factors.

Industry Risk

Industry risk includes risks that affect the entire banking service industry.

Significant decline in general economic conditions will negatively affect the financial results of our banking operations.  Kentucky Bank serves both individuals and business customers throughout Central and Eastern Kentucky. The substantial majority of our loan portfolio is to individuals and businesses in these markets. As a result, our financial condition, results of operations and cash flows are affected by local and regional economic conditions. A downturn in these economies could have a negative impact on us and the ability of Kentucky Bank’s customers to repay their loans. The value of the collateral securing loans to borrowers may also decline as the economy declines. As a result, deteriorating economic conditions in these markets could cause a decline in the overall quality of our loan portfolio requiring us to charge-off a higher percentage of loans and/or increase its allowance for loan losses. A decline in economic conditions in these markets may also force customers to utilize deposits held by Kentucky Bank in order to pay current expenses causing Kentucky Bank’s deposit base to shrink. As a result Kentucky Bank may have to borrow funds at higher rates in order to meet liquidity needs. These events may have a negative impact on our earnings and financial condition.

Significant declines in U.S. and global markets could have a negative impact on our earnings. The capital and credit markets could experience extreme disruption. These conditions result in less liquidity, greater volatility, widening of credit spreads and a lack of price transparency in certain asset types. In many cases, markets could exert downward pressure on stock prices, security prices and credit capacity for certain issuers without regard to those issuers’ underlying financial strength. Sustained weakness in business and economic conditions in any or all of the domestic or foreign financial markets could result in credit deterioration in investment securities held by us, rating agency downgrades for such securities or other market factors that (such as lack of liquidity for re-sales, absence of reliable pricing information or unanticipated changes in the competitive market) could result in us having to recognize other-than-temporary impairment in the value of such investment securities, with a corresponding charge against earnings.  If the markets deteriorate further, these conditions may be material to our ability to access capital and may adversely impact results of operations.

Further, Kentucky Bank’s trust and investment services income could be impacted by fluctuations in the securities market. A portion of this revenue is based on the value of the underlying investment portfolios. If the values of those investment portfolios decline, Kentucky Bank’s revenue could be negatively impacted.

The exercise of regulatory power may have negative impact on our results of operations and financial condition.  We are subject to extensive federal and state regulation, supervision and examination. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, rather than corporate shareholders. These regulations affect our lending practices, capital structure, investment practices, dividend policy, operations and growth, among other things. These regulations also impose obligations to maintain appropriate policies, procedure and controls. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect us in substantial and unpredictable ways.

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Such changes could subject us to additional costs, limit the types of financial services and products that could be offered, and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil penalties and/or reputation damage, which could have a material adverse effect on our business, financial condition and result of operations.

Regulation of the Company and our subsidiaries is expected to continue to expand in scope and complexity in the future. These laws are expected to have the effect of increasing our costs of doing business and reducing our revenues, and may limit our ability to pursue business opportunities or otherwise adversely affect our business and financial condition. The Dodd-Frank Act and other laws, as well as rules implementing or related to them, may adversely affect us. Specifically, any governmental or regulatory action having the effect of requiring us to obtain additional capital could reduce earnings and have a material dilutive effect on current shareholders, including the Dodd-Frank Act source of strength requirement that bank holding companies make capital infusions into a troubled subsidiary bank. Legislation and regulation of debit card fees, credit cards and other bank services, as well as changes in our practices relating to those and other bank services, may affect our revenue and other financial results. Additional information about increased regulation is provided in “Item 1. Business” under the heading “Supervision and Regulation.”

We are also subject to tax laws and regulations promulgated by the United States government and the states in which it operates. Changes to these laws and regulations or the interpretations of such laws and regulations by taxing authorities could impact future tax expense and the value of deferred tax assets.

A new accounting standard will result in a significant change in how we recognize credit losses and may have a material impact on our financial condition or results of operations.  In June 2016, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update, “Financial Instruments-Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments,” which replaces the current “incurred loss” model for recognizing credit losses with an “expected loss” model referred to as the Current Expected Credit Loss (“CECL”) model. Under the CECL model, we will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the “incurred loss” model required under current generally accepted accounting principles (“GAAP”), which delays recognition until it is probable a loss has been incurred. Accordingly, we expect that the adoption of the CECL model will materially affect how we determine our allowance for loan losses and could require us to significantly increase our allowance. Moreover, the CECL model may create more volatility in the level of our allowance for loan losses. If we are required to materially increase our level of allowance for loan losses for any reason, such increase could adversely affect our business, financial condition and results of operations.

The new CECL standard will become effective for us for fiscal years beginning after December 15, 2019 and for interim periods within those fiscal years. We are currently evaluating the impact the CECL model will have on our accounting, but we expect to recognize a one-time cumulative-effect adjustment to our allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective, consistent with regulatory expectations set forth in interagency guidance issued at the end of 2016. We cannot yet determine the magnitude of any such one-time cumulative adjustment or of the overall impact of the new standard on our financial condition or results of operations.

Deposit insurance premiums levied against the Company may increase if the number of bank failures increase or the cost of resolving failed banks increases.  The FDIC maintains a DIF to protect insured depositors in the event of bank failures. The DIF is funded by fees assessed on insured depository institutions including Kentucky Bank.  Future deposit premiums paid by Kentucky Bank depend on the level of the DIF and the magnitude and cost of future bank failures. Kentucky Bank may be required to pay significantly higher FDIC premiums if market developments change such that the DIF balance is reduced.

Increased competition from other providers may adversely affect our financial condition and results of operations.  We face vigorous competition from banks and other financial institutions.  This competition may reduce or limit our margins on banking services, reduce market share and adversely affect results of operations and financial condition.

Many other banks and financial institutions have substantially greater resources and lending limits, larger branch systems and a wider array of banking services.  Additionally, we encounter competition from both de novo and smaller community banks entering the markets we are currently in.  We also compete with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies and insurance companies.

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Changes in consumer use of banks and changes in consumer spending and saving habits could adversely affect our financial results.  Technology and other changes now allow many consumers to complete financial transactions without using banks. For example, consumers can pay bills and transfer funds directly without going through a bank and can access loans through lending groups and other non-regulated entities. This “disintermediation” could result in the loss of fee and interest income, as well as the loss of customer deposits and income generated from those deposits. In addition, changes in consumer spending and saving habits could adversely affect our operations, and we may be unable to timely develop competitive new products and services in response to these changes that are accepted by new and existing customers.

Financial Risk

Financial risk components include, but are not limited to, credit risk, interest rate risk, goodwill impairment, market risk and liquidity risk.  We have adopted various policies to minimize potential adverse effects of interest rate, market and liquidity risks.  However, even with these policies in place, a change in interest rates could negatively impact our results of operations or financial position.

Defaults in the repayment of loans may negatively impact our business.  Credit risk is most closely associated with lending activities at financial institutions.  Credit risk is the risk to earnings and capital when a customer fails to meet the terms of any contract or otherwise fails to perform as agreed.  Credit risk arises from all activities where the Company is dependent on issuer, borrower, or counterparty performance, not just traditional lending activities.  For example, the investment security portfolio has inherent credit risk as do counterparties in derivative contracts.  Credit risk encompasses a broad range of financial institution activities and includes items reflected both on and off the balance sheet.

Management makes various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of its borrowers and the value of real estate and other assets serving as collateral for repayment of many of the loans.  In determining the size of the allowance for loan losses, management considers, among other factors, the Company’s loan loss experience and an evaluation of economic conditions.  If these assumptions prove to be incorrect, the current allowance may not be sufficient to cover future loan losses and adjustments may be necessary to allow for different economic conditions or adverse developments in the loan portfolio.  Material additions to the Company’s allowance would materially decrease our net income.

Fluctuations in interest rates may negatively impact our banking business.  Interest rate risk focuses on the impact to earnings and capital arising from movements in interest rates.  Interest rate risk focuses on the value implications for accrual portfolios (e.g., available-for-sale portfolios) and includes the potential impact to the Company’s accrual earnings as well as the economic perspective of the market value of portfolio equity.  The interest rate risk is comprised of repricing risk, basis risk, yield curve risk and options risk.  Repricing risk represents the risk associated with the differences in timing of cash flows and rate changes with our products.  Basis risk represents the risk associated with changing rate relationships among varying yield curves.  Yield curve risk is associated with changing rate relationships over the maturity structure.  Options risk is associated with interest-related options, which are embedded in our products.

Changes in market multiples may negatively affect the value of Goodwill.  Goodwill resulting from business combinations prior to January 1, 2009 represents the excess of the purchase price over the fair value of the net assets of businesses acquired.  Goodwill resulting from business combinations after January 1, 2009, is generally determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date.  Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually.  The Company has selected December 31 as the date to perform the annual impairment test.  Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values.  Goodwill is the only intangible asset with an indefinite life on our balance sheet.  At a minimum, management is required to assess goodwill and other intangible assets annually for impairment.  This assessment involves estimating cash flows for future periods, preparing analyses of market multiples for similar operations, and estimating the fair value of the reporting unit to which the goodwill is allocated.  If these variables change negatively, the Company would be required to take a charge against earnings to write down the asset to the lower fair value.

Changes in market factors may negatively affect the value of our investment assets.  Market risk focuses on the impact to earnings and capital arising from changes in market factors (e.g., interest rates, market liquidity, volatilities, etc.) that affect the value of traded instruments.  Market risk includes items reflected both on and off the balance sheet.  Market risk focuses primarily on mark-to-market portfolios (e.g., accounts revalued for financial statement presentation).

Our inability to maintain appropriate levels of liquidity may have a negative impact on our results of operations and financial condition.  Liquidity risk focuses on the impact to earnings and capital resulting from our inability to meet our obligations as they become due in the normal course of business without incurring significant losses.  It also includes the management of unplanned decreases or changes in funding sources as well as managing changes in market conditions, which could affect the ability to liquidate assets in the normal course of business without incurring significant losses.  Liquidity risk includes items both on and off the balance sheet.

8

Our results of operations and financial condition may be negatively affected if we are unable to meet a debt covenant and, correspondingly, unable to obtain a waiver regarding the debt covenant from the lender.  From time to time we may obtain financing from other lenders.  The loan documents reflecting the financing often require us to meet various debt covenants.  If we are unable to meet one or more of our debt covenants, then we will typically attempt to obtain a waiver from the lender.  If the lender does not agree to a waiver, then we will be in default under our borrowing obligation.  This default could affect our ability to fund various strategies that we may have implemented resulting in a negative impact in our results of operations and financial condition.

Business Risk

Business risk is composed mainly of legal (compliance) risk, strategic risk and reputation risk.

Our results of operations and financial condition are susceptible to legal or compliance risks.  Legal or compliance risk is the risk to earnings or capital arising from the impact of unenforceable contracts, lawsuits, adverse judgments, violations or nonconformance with laws, rules, regulations, prescribed practices, or ethical standards.  The risk also arises in situations where laws or rules governing certain products or activities of our customers may be ambiguous or untested.  This risk is not limited to the traditional thinking that legal/compliance risk is only associated with consumer protection laws.  It includes the exposure to litigation from all aspects of both traditional and nontraditional financial institution activities.

Incorrect strategic decisions may have a negative impact on our results of operations and financial condition.

Adverse publicity may have a negative impact on our business. Reputation risk is the risk to earnings and capital arising from negative public opinion.  This affects the ability to establish new relationships or services or to continue servicing existing relationships.  Examiners will assess reputation risk by recognizing the potential effect the public’s opinion could have on our franchise value.

Operational Risk

Because the nature of the financial services business involves a high volume of transactions, we face significant operational risks.  Operational risk is the risk of loss resulting from our operations, including, but not limited to, the risk of fraud by employees or persons outside of the Company, the execution of unauthorized transactions by employees, errors relating to transaction processing and technology, breaches of the internal control system and compliance requirements and business continuation and disaster recovery.

This risk of loss also includes the potential legal actions that could arise as a result of an operational deficiency or as a result of noncompliance with applicable regulatory standards, adverse business decisions or their implementation, and customer attrition due to potential negative publicity.

In the event of a breakdown in the internal control system, improper operation of systems or improper employee actions, we could suffer financial loss, face regulatory action and suffer damage to its reputation.

Technology Risk

Systems failure, interruption or breach of security may have a negative impact on our business.  Communications and information systems are essential to the conduct of Kentucky Bank’s business, as such systems are used to manage customer relationships, deposits, loans, general ledger accounts, financial reporting and regulatory compliance.  While Kentucky Bank has established policies and procedures to prevent or limit the impact of systems failures, interruptions, and security breaches, there can be no assurance that such events will not occur or that they will be adequately addressed if they do.  In addition, any compromise of Kentucky Bank’s information security systems could deter customers from using Kentucky Bank’s web site and its internet banking service, both of which involve the transmission of confidential information.  

Although Kentucky Bank relies on commonly used security and processing systems to provide the security and authentication necessary to ensure the secure transmission and processing of data, these precautions may not protect our systems from all compromises or breaches of security.

The business continuity of third-party providers may have a negative impact on our technology operations.  Kentucky Bank outsources certain of its data processing to third-party providers.  If third-party providers encounter difficulties, or if the Bank has difficulty communicating with them, Kentucky Bank’s ability to adequately process and account for customer transactions could be affected, and its business operations could be adversely impacted.  Threats to information security also exist in the processing of customer information through various other vendors and their personnel.

We and our subsidiary bank have addressed technology risks through the use of logon and user access controls, transaction limits, firewalls, antivirus software, intrusion protection monitoring and third party vulnerability scans.  Systems failure or interruption has been addressed by adopting a disaster recovery and contingency plan.  In addition, for all third-party providers of data processing services, we obtain and review audit reports prepared by independent registered public accounting firms regarding their financial condition and the effectiveness of their internal controls.

9

Item 1B.  Unresolved Staff Comments

None.

Item 2.  Properties

The Company’s corporate headquarters is located at 339 Main Street, Paris, KY 40361, which it owns.  The main banking office of Kentucky Bank is located at 401 Main Street, Paris, Kentucky 40361.  In addition, Kentucky Bank serves customer needs at 16 other locations.  All locations offer a full range of banking services.  Kentucky Bank owns all of the properties at which it conducts its business with the exception of the Lexington and Richmond locations.  The Company owns approximately 100,000 square feet of office space and leases approximately 9,800 square feet of office space.

Note 6 to the Company’s audited and consolidated financial statements included in Item 8 (“2016 Consolidated Financial Statements and Notes”) contains additional information relating to amounts invested in premises and equipment.

Kentucky Bank Banking Offices

Owned

401 Main Street, Paris, KY 40361

2021 South Main Street, Paris, KY 40361

24 West Lexington Avenue, Winchester, KY 40391

1975 By Pass Road, Winchester, KY 40391

144 South KY 7, Sandy Hook, KY 41171

939 US Hwy 27 South, Cynthiana, KY 41031

920 North Main Street, Nicholasville, KY 40356

108 East Main Street, Wilmore, KY 40390

400 West First Street, Morehead, KY 40351

1500 Flemingsburg Road, Morehead, KY 40351

260 Blossom Park Drive, Georgetown, KY 40324

103 West Showalter Drive, Georgetown, KY 40324

520 Marsailles Road, Versailles, KY 40383

Leased

360 East Vine Street, Suite 100, Lexington, KY 40507

1001 Gibson Bay Drive, Suite 101, Richmond, KY 40475

680 Dwight Drive Richmond, KY 40475, Richmond, KY 40475

724 West Main Street, Richmond, KY 40475

Item 3.  Legal Proceedings

None to report.

PART II

Item 5.  Market for Common Equity and Related Stockholder Matters

Market Information

There is no established public trading market for the Company’s Common Stock.  The Company’s Common Stock is not listed on any national securities exchange.  However, it is traded on OTCQX under the symbol “KTYB”.  Trading in the Common Stock has been infrequent, with retail brokerage firms making the market.

10

The following table sets forth the high and low closing sales prices of the Common Stock from the OTC Bulletin Board and the dividends declared thereon, for the periods indicated as follows:

		High		Low		Dividend
2016	Quarter 4	$	32.65	$	30.01	$	0.27
	Quarter 3		31.00		27.00		0.27
	Quarter 2		28.00		26.41		0.27
	Quarter 1		29.65		26.01		0.27
2015	Quarter 4	$	30.19	$	29.54	$	0.26
	Quarter 3		33.00		30.05		0.26
	Quarter 2		32.35		27.75		0.26
	Quarter 1		28.15		27.00		0.26

Note 16 to the Company’s 2016 Consolidated Financial Statements and Notes included Item 8 contains additional information relating to amounts available to be paid as dividends.

Holders

As of December 31, 2016 the Company had 2,973,232 shares of Common Stock outstanding and approximately 563 holders of record of its Common Stock.

Dividends

During 2016 and 2015, the Corporation declared quarterly cash dividends aggregating $1.08 and $1.04 per share, respectively.

Purchases of Equity Securities by the Issuer and Affiliates Purchasers

The table below lists issuer purchases of equity securities.

	(a)		(c) Total Number	(d) Maximum Number
	Total	(b)	of Shares (or Units)	(or Approximate Dollar
	Number of	Average	Purchased as Part	Value) of Shares (or
	Shares (or	Price Paid	of Publicly	Units) that May Yet Be
	Units)	Per Share	Announced Plans	Purchased Under the
Period	Purchased	(or Unit)	Or Programs	Plans or Programs
10/1/16 - 10/31/16	3,000	$ 31.05	3,000	69,480 shares
11/1/16 - 11/30/16	—	—	—	119,480 shares
12/1/16 - 12/31/16	9,538	29.17	9,538	109,942 shares
Total	12,538	$ 29.62	12,538	109,942 shares

On October 25, 2000, the Company announced that its Board of Directors approved a stock repurchase program.  The Company was 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 the purchase of an additional 100,000 shares.  On May 17, 2011, the Board of Directors approved and authorized the Company’s repurchase of an additional 100,000 shares. On November 18, 2016, the Board of Directors approved and authorized the Company’s repurchase of an additional 50,000 shares.   Shares will be purchased from time to time in the open market depending on market prices and other considerations.

Through December 31, 2016, 340,058 shares have been purchased, with the most recent share repurchase under the Board-approved stock repurchase program having occurred on December 15, 2016.

11

Securities Authorized for Issuance under Equity Compensation Plans

The following table sets forth certain information regarding Company compensations plans under which equity securities of the company are authorized for issuance.

			No. of securities
			remaining available
	Number of securities		for future issuance
	to be issued	Weighted average	under equity
	upon exercise of	exercise price of	compensation plans
	outstanding options,	outstanding options	(excluding securities
Plan category	warrants and rights	warrants and rights	reflected in column 1)
Plans Approved By Stockholders:
1999 Nonemployee Directors Stock Ownership Incen- tive Plan	1,200	$ 31.00	—
2005 Stock Award Plan	—	—	1,069
2009 Stock Award Plan	—	—	140,378

12

Performance Graph

The information included under the caption “Performance Graph” in this Item 5 of this Form 10-K is not deemed to be “soliciting material” or to be “filed” with the SEC or subject to Regulation 14A or 14C under the Securities Exchange Act of 1934 or to the liabilities of Section 18 of the Securities Exchange Act of 1934, and will not be deemed to be incorporated by reference into any filings we make under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent we specifically incorporate it by reference into such a filing.

The graph below matches Kentucky Bancshares Inc's cumulative 5-Year total shareholder return on common stock with the cumulative total returns of the Russell MicroCap index and the NASDAQ Bank index. The graph tracks he performance of a $100 investment in our common stock and in each index (with the reinvestment of all dividends) from 12/31/2011 to 12/31/2016.

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Item 6.  Selected Financial Data (in thousands except per share data)

The following selected financial data should be read in conjunction with the Company’s Consolidated Financial Statements and the accompanying notes presented in Item 8.

	At or For the Year ended December 31,
	2016			2015			2014			2013			2012
CONDENSED STATEMENT OF INCOME:
Total Interest Income	$	36,554		$	33,185		$	29,731		$	28,168		$	28,233
Total Interest Expense		4,426			4,050			3,756			3,456			3,716
Net Interest Income		32,128			29,135			25,975			24,712			24,517
Provision for Losses		1,150			1,450			950			1,050			2,050
Net Interest Income After Provision for Losses		30,978			27,685			25,025			23,662			22,467
Noninterest Income		12,149			11,484			10,158			10,222			11,870
Noninterest Expense		33,785			31,807			27,215			27,203			25,686
Income Before Income Tax Expense		9,342			7,362			7,968			6,681			8,651
Income Tax Expense		773			530			897			859			1,643
Net Income		8,569			6,832			7,071			5,822			7,008
SHARE DATA:
Basic Earnings per Share (EPS)	$	2.87		$	2.40		$	2.60		$	2.15		$	2.59
Diluted EPS		2.87			2.40			2.60			2.15			2.59
Cash Dividends Declared		1.08			1.04			1.00			0.96			0.92
Book Value		31.27			29.62			28.65			24.90			27.21
Average Common Shares-Basic		2,991			2,823			2,721			2,705			2,705
Average Common Shares-Diluted		2,991			2,823			2,721			2,709			2,708
SELECTED BALANCE SHEET DATA:
Loans, net	$	648,466		$	617,600		$	532,293		$	463,214		$	423,928
Investment Securities		273,770			264,212			246,861			230,396			192,780
Trading Assets		5,592			5,531			5,370			—			—
Total Assets		1,028,447			974,684			855,209			770,579			701,010
Deposits		802,981			758,981			654,869			617,400			590,425
Securities sold under agreements to repurchase		20,873			18,514			12,457			12,867			4,315
Federal Home Loan Bank advances		92,500			87,833			93,785			57,847			17,449
Note Payable		4,090			4,794			—			—			—
Subordinated Debentures		7,217			7,217			7,217			7,217			7,217
Stockholders’ Equity		92,972			89,413			77,942			67,672			74,009
PERFORMANCE RATIOS:
(Average Balances)
Return on Assets		0.86	%		0.76	%		0.89	%		0.80	%		1.03	%
Return on Stockholders’ Equity		9.10	%		8.20	%		9.50	%		8.12	%		9.70	%
Net Interest Margin (1)		3.60	%		3.63	%		3.69	%		3.85	%		4.19	%
Equity to Assets (annual average)		9.41	%		9.25	%		9.34	%		9.84	%		10.60	%
SELECTED STATISTICAL DATA:
Dividend Payout Ratio		37.68	%		43.20	%		38.48	%		41.53	%		35.71	%
Number of Employees (at period end)		241			243			215			208			193
ALLOWANCE COVERAGE RATIOS:
Allowance to Total Loans		1.15	%		1.04	%		1.12	%		1.16	%		1.41	%
Net Charge-offs as a Percentage of Average Loans		0.02	%		0.16	%		0.08	%		0.37	%		0.44	%

(1) Tax equivalent

14

Item 7.  Management’s Discussion and Analysis

This section presents an analysis of the consolidated financial condition of the Company and its wholly-owned subsidiary, Kentucky Bank, at December 31, 2016, 2015 and 2014, and the consolidated results of operations for each of the years in the three year period ended December 31, 2016.  The following discussion and analysis of financial condition and results of operations should be read in conjunction with the 2016 Consolidated Financial Statements and Notes included in Item 8.  When necessary, reclassifications have been made to prior years’ data throughout the following discussion and analysis for purposes of comparability with 2016 data.

Critical Accounting Policies

Overview.  The accounting and reporting policies of the Company and its subsidiary are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry.  Significant accounting policies are listed in Note 1 of the Company’s 2016 Consolidated Financial Statements and Notes included in Item 8.  Critical accounting and reporting policies include accounting for loans and the allowance for loan losses, goodwill and fair value.  Different assumptions in the application of these policies could result in material changes in the consolidated financial position or consolidated results of operations.

Loan Values and Allowance for Loan Losses.  Loans are stated at the amount of unpaid principal, reduced by an allowance for loan losses.  Interest on loans is recognized on the accrual basis, except for those loans on the nonaccrual status.  Interest income received on such loans is accounted for on the cash basis or cost recovery method.  The allowance for loan losses is a valuation allowance for probable incurred credit losses.  Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors.  The accounting policies relating to the allowance for loan losses involve the use of estimates and require significant judgments to be made by management.  The loan portfolio also represents the largest asset group on the consolidated balance sheets.  Additional information related to the allowance for loan losses that describes the methodology and risk factors can be found under the captions “Asset Quality” and “Loan Losses” in this management’s discussion and analysis of financial condition and results of operation, as well as Notes 1 and 4 of the Company’s 2016 Consolidated Financial Statements and Notes.

Goodwill.   Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually.  The Company has selected December 31 as the date to perform the annual impairment test.  Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on our balance sheet.

Fair Values.  Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in the description of each asset and liability category in Note 17 of the Company’s 2016 Consolidated Financial Statements and Notes.  Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items.  Changes in assumptions or in market conditions could significantly affect the estimates.

Forward-Looking Statements

This discussion contains forward-looking statements under the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties.  Although the Company believes that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore, there can be no assurance that the forward-looking statements included herein will prove to be accurate.  Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to:  economic conditions (both generally and more specifically in the markets, including the tobacco market, the thoroughbred horse industry and the automobile industry relating to Toyota vehicles, in which the Company and its bank operate); competition for the Company’s customers from other providers of financial and mortgage services; government legislation, regulation and monetary policy (which changes from time to time and over which the Company has no control); changes in interest rates (both generally and more specifically mortgage interest rates); material unforeseen changes in the liquidity, results of operations, or financial condition of the Company’s customers; and other risks detailed in Part 1, Item 1A “Risk Factors” in this report and other risks detailed in the Company’s filings with the Securities and Exchange Commission, all of which are difficult to predict and many of which are beyond the control of the Company.  The Company undertakes no obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

Overview

We conduct our business through our one bank subsidiary, Kentucky Bank, and our one non-bank subsidiary KBI Insurance Company.  Kentucky Bank is engaged in general full-service commercial and consumer banking.  A significant part of Kentucky Bank’s operating activities include originating loans, approximately 81% of which are secured by real estate at December 31, 2016. 

15

Kentucky Bank makes commercial, agricultural and real estate loans to its commercial customers, with emphasis on small-to-medium-sized industrial, service and agricultural businesses.  It also makes residential mortgages, installment and other loans to its individual and other non-commercial customers.  Kentucky Bank’s primary market is Bourbon, Clark, Elliott, Fayette, Harrison, Jessamine, Madison, Rowan, Scott, Woodford and surrounding counties in Kentucky.  KBI Insurance Company is a captive insurance subsidiary and was incorporated in 2014.

Net income for the year ended December 31, 2016 was $8.6 million, or $2.87 per common share compared to $6.8 million, or $2.40 for 2015 and $7.1 million, or $2.60 for 2014.  Earnings per share assuming dilution were $2.87, $2.40 and $2.60 for 2016, 2015 and 2014, respectively.  For 2016, net income increased $1.7 million, or 25.4%.  Net interest income increased $3.0 million, provision for loan losses decreased $300 thousand, total other income increased $665 thousand, while total other expenses increased $2.0 million and income tax expense increased $243 thousand.

For 2015, net income decreased $239 thousand, or 3.4%.  Net interest income increased $3.2 million, the provision for loan losses increased $500 thousand, total other income increased $1.4 million, while total other expenses increased $4.6 million and income tax expense decreased $367 thousand.

Return on average equity was 9.1% in 2016 compared to 8.2% in 2015 and 9.5% in 2014.  Return on average assets was 0.86% in 2016 compared to 0.76% in 2015 and 0.89% in 2014.

Non-performing loans as a percentage of loans (including held for sale) were 1.15%, 1.54% and 2.36% as of December 31, 2016, 2015 and 2014, respectively.

RESULTS OF OPERATIONS

Net Interest Income

Net interest income, the Company’s largest source of revenue, on a tax equivalent basis increased from $27.6 million in 2014 to $30.7 million in 2015, and to $34.0 million in 2016.  The taxable equivalent adjustment (nontaxable interest income on state and municipal obligations net of the related non-deductible portion of interest expense) is based on our Federal income tax rate of 34%.

Average earning assets and interest bearing liabilities both increased from 2015 to 2016.  Average earning assets increased $97.9 million, or 11.6%.  Average investment securities increased $18.9 million and average loans increased $72.0 million, largely due to the acquisition of Madison Financial Corporation on July 24, 2015.  Average interest bearing liabilities increased $78.6 million, or 12.7% during this same period.  This change was mostly attributed to an increase of $65.9 million, or 13.2%, in interest bearing deposits, which ws partly attributed to the acquisition of Madison Financial Corporation on July 24, 2015.  Average borrowings from the Federal Home Loan Bank increased $3.3 million, or 3.6%.  The Company continues to actively pursue quality loans and fund these primarily with deposits and Federal Home Loan Bank advances.  Average Repurchase agreements and other borrowings increased $9.4 million or 35.7% from 2015 to 2016.

The bank prime rates remained unchanged from 2008 until December 2015 at which time they increased twenty-five basis points and increased another twenty-five basis points in December 2016.  The tax equivalent yield on earning assets decreased from 4.11% in 2015 to 4.07% in 2016.

The volume rate analysis for 2016 that follows indicates that $3.8 million of the increase in interest income is attributable to an increase in volume, while the change in rates contributed to a decrease of $461 thousand in interest income.  Further, an increase in interest bearing liability balances resulted in $375 thousand additional interest expense in 2016 compared to 2015.  The average rate of these liabilities decreased from 0.66% in 2015 to 0.64% in 2016.  In summary, the increase in the Company’s 2016 net interest income is attributed mostly to an increase in volume in the loan and security portfolios.

The volume rate analysis for 2015 that follows indicates that $4.1 million of the increase in interest income is attributable to an increase in volume, while the change in rates contributed to a decrease of $691 thousand in interest income. Further, decreases in rates caused a decrease in the cost of interest bearing liabilities. The average rate of these liabilities decreased from 0.68% in 2014 to 0.66% in 2015. Based on the volume rate analysis that follows, the lower level of interest rates contributed to a decrease of $235 thousand in interest expense and a change in volume contributed to a $530 thousand increase in interest expense. In summary, the increase in the Company’s 2015 net interest income is attributed mostly to an increase in volume in the loan and security portfolios and decreases in rates in time deposits and Federal Home Loan Bank advances.

The accompanying analysis of changes in net interest income in the following table shows the relationships of the volume and rate portions of these changes in 2016 vs. 2015 and 2015 vs. 2014.  Changes in interest income and expenses due to both rate and volume are allocated on a pro rata basis.

16

Changes in Interest Income and Expense

	(in thousands)
	2016 vs. 2015						2015 vs. 2014
	Increase		(Decrease)		Due to Change in		Increase		(Decrease)		Due to Change in
	Volume		Rate		Net Change		Volume		Rate		Net Change
INTEREST INCOME
Loans	$	3,349	$	(413)	$	2,936	$	3,742	$	(535)	$	3,207
Investment Securities		438		(70)		368		399		(182)		217
Trading Assets		6		(23)		(17)		8		(6)		2
Federal Funds Sold and Securities Purchased under Agreements to Resell		—		3		3		—		—		—
Deposits with Banks		36		43		79		(3)		32		29
Total Interest Income		3,829		(460)		3,369		4,146		(691)		3,455
INTEREST EXPENSE
Deposits
Demand		101		140		241		44		22		66
Savings		12		(6)		6		11		(16)		(5)
Negotiable Certificates of Deposit and Other Time Deposits		49		(109)		(60)		77		(152)		(75)
Securities sold under agreements to repurchase and other borrowings		156		(8)		148		103		19		122
Federal Home Loan Bank advances		57		(16)		41		295		(108)		187
Total Interest Expense		375		1		376		530		(235)		295
Net Interest Income	$	3,454	$	(461)	$	2,993	$	3,616	$	(456)	$	3,160

17

Average Consolidated Balance Sheets and Net Interest Income Analysis ($ in thousands)

	2016							2015							2014
	Average					Average		Average					Average		Average					Average
	Balance			Interest		Rate		Balance			Interest		Rate		Balance			Interest		Rate
ASSETS
Interest-Earning Assets
Securities Available for Sale (1)
U.S. Treasury and Federal Agency Securities	$	172,632		$	3,201	1.85	%	$	157,285		$	2,840	1.81	%	$	142,426		$	2,583	1.81	%
State and Municipal obligations		90,265			2,772	3.07	%		87,147			2,783	3.19	%		85,772			2,835	3.31	%
Other Securities		7,354			289	3.93	%		6,968			271	3.89	%		6,364			259	3.89	%
Total Investment Securities		270,251			6,262	2.32	%		251,400			5,894	2.34	%		234,562			5,677	2.42	%
Tax Equivalent Adjustment					1,878	0.69	%					1,586	0.63	%					1,620	0.69	%
Tax Equivalent Total					8,140	3.01	%					7,480	2.98	%					7,297	3.11	%
Trading Assets		5,625			153	2.72	%		5,431			170	3.13	%		5,199			168	3.23	%
Federal Funds Sold and Agreements to Repurchase		1,086			3	0.28	%		1,042			—	—			327			—	—
Interest-Bearing Deposits with Banks		20,403			136	0.67	%		13,609			57	0.52	%		13,359			28	0.23	%
Loans, Net of Deferred Loan Fees (2)
Commercial		77,284			2,970	3.84	%		60,269			2,577	4.28	%		48,307			2,268	4.69	%
Real Estate Mortgage		551,413			25,645	4.65	%		496,965			23,147	4.66	%		429,773			20,249	4.71	%
Consumer		17,470			1,385	7.93	%		16,907			1,340	7.93	%		16,886			1,340	7.94	%
Total Loans		646,167			30,000	4.64	%		574,141			27,064	4.71	%		494,966			23,857	4.82	%
Total Interest-Earning Assets		943,532			38,432	4.07	%		845,623			34,771	4.11	%		748,413			31,350	4.19	%
Allowance for Loan Losses		(7,244)							(6,068)							(5,673)
Cash and Due From Banks		12,230							16,607							12,274
Premises and Equipment		16,296							16,571							16,700
Other Assets		35,478							28,910							26,414
Total Assets	$	1,000,292						$	901,643						$	797,148
LIABILITIES
Interest-Bearing Deposits
Negotiable Order of Withdrawal (“NOW”) and Money Market Investment Accounts	$	272,286		$	675	0.25	%	$	225,604		$	434	0.19	%	$	202,185		$	368	0.18	%
Savings		90,907			84	0.09	%		78,217			78	0.10	%		68,023			83	0.12	%
Certificates of Deposit and Other Deposits		202,924			1,452	0.72	%		196,409			1,512	0.77	%		187,012			1,587	0.85	%
Total Interest-Bearing Deposits		566,117			2,211	0.39	%		500,230			2,024	0.40	%		457,220			2,038	0.45	%
Securities sold under agreements to repurchase and other borrowings		35,844			595	1.66	%		26,418			447	1.69	%		20,264			325	1.60	%
Federal Home Loan Bank advances		93,818			1,620	1.73	%		90,534			1,579	1.74	%		73,947			1,392	1.88	%
Total Interest-Bearing Liabilities		695,779			4,426	0.64	%		617,182			4,050	0.66	%		551,431			3,755	0.68	%
Noninterest-Bearing Earning Demand Deposits		201,395							194,538							164,712
Other Liabilities		8,957							6,197							6,587
Total Liabilities		906,131							817,917							722,730
STOCKHOLDERS’ EQUITY		94,161							83,726							74,418
Total Liabilities and Stockholders’ Equity	$	1,000,292						$	901,643						$	797,148
Average Equity to Average Total Assets		9.41	%						9.25	%						9.34	%
Net Interest Income					32,128							29,135							25,795
Net Interest Income (tax equivalent) (3)					34,006							30,721							27,595
Net Interest Spread (tax equivalent) (3)						3.43	%						3.45	%						3.51	%
Net Interest Margin (tax equivalent) (3)						3.60	%						3.63	%						3.69	%

(1) Averages computed at amortized cost.

(2) Includes loans on a nonaccrual status and loans held for sale.

(3) Tax equivalent difference represents the nontaxable interest income on state and municipal securities net of the related non-deductible portion of interest expense.

18

Noninterest Income and Expenses

Noninterest income was $12.1 million in 2016, $11.5 million in 2015 and $10.2 million in 2014.  In 2016, reductions in net loan servicing fee income, gains on available for securities and other income were offset by gains in service charges, gains on the sale of loans and debit card interchange income.  In 2015, reductions in gains on securities available for sale and gains on the trading account were offset by increases in gains on sold mortgage loans, debit card interchange income, service charges and loan servicing fee income.  In 2014, decreases in gains on sold mortgage loans, net loan servicing fees and overdraft income were offset by increases in fees generated within our wealth management department, gains on trading assets and debit card interchange income.

Securities gains were $287 thousand in 2016, $412 thousand in 2015 and $966 thousand in 2014.  These gains are primarily attributed to selling securities which had gains in market value due to declining interest rates and the related inverse relationship of interest rates and market values

Gains on loans sold were $2.1 million, $1.5 million and $951 thousand in 2016, 2015 and 2014, respectively.  Loans held for sale are generally sold after closing to the Federal Home Loan Mortgage Corporation or other government agencies.  During 2016, the loan servicing fee income, net of amortization expense for the mortgage servicing right asset, decreased $135 thousand, compared to an increase of $140 thousand in 2015.  In 2016, the mortgage servicing right asset had net write-downs of $105 thousand compared to a net recoveries of prior year write-downs of $59 thousand in the valuation allowance in 2015.  Proceeds from the sale of loans were $64 million, $51 million and $37 million in 2016, 2015 and 2014, respectively.  The volume of loan originations is inverse to rate changes with historic low rates spurring activity.  The volume of loan originations during 2016 was $62 million, $49 million in 2015, and $37 million in 2014.

Other noninterest income, excluding net security gains and gains on the sale of mortgage loans, was $9.8 million in 2016, $9.6 million in 2015 and $8.2 million in 2014.  Service charge income, and more particularly overdraft income, is the largest contributor to these numbers.  Overdraft income was $2.7 million in 2016, $2.6 million in 2015 and $2.6 million in 2014.  Debit card interchange income was the second largest contributor to noninterest income, excluding security gains and gains on the sale of mortgage loans.  Debit card interchange income was $2.7 million in 2016, $2.5 million in 2015 and $2.1 million in 2014.  Other income was $95 thousand in 2016, $849 thousand in 2015 and $81 thousand in 2014.  Other income increased $768 thousand in 2015 due to $747 received for restitution of a legal dispute.  Other income was also lower in 2016 due to the bank recording a loss of $335 thousand during the fourth quarter of 2016  for the write-off of bank premises and equipment associated with a branch building that is being demolished so a new branch building can be rebuilt.

Noninterest expense increased $2.0 million in 2016 to $33.8 million, and increased $4.6 million in 2015 to $31.8 million from $27.2 million in 2014.

The increase in salaries and benefits expense from $16.6 million in 2015 to $17.9 million in 2016 is mostly attributed to normal pay increases and having a full year of salary expense in 2016 for the acquisition of Madison Financial Corporation which occurred on July 24, 2015.  The number of full-time equivalent employees decreased from 243 at December 31, 2015 to 241 at December 31, 2016. 

Incentive compensation expense increased $153 thousand in 2016 compared to 2015 due to the Bank achieving many of the goals as stated in the incentive compensation plan and having more employees during the year in 2016 compared to 2015.

The largest component of occupancy expense, depreciation, decreased $92 thousand to $1.3 million in 2016, and increased $115 thousand to $1.4 million in 2015.  Computer maintenance increased $84 thousand during 2016 to $750 thousand and expense for equipment purchased and immediately expensed decreased $72 thousand.  Other noninterest expenses increased from $9.1 million in 2014 to $11.4 million in 2015 and increased to $12.1 million in 2016.  Expenses incurred during 2015 for the acquisition of Madison Financial Corporation totaled $858 thousand.   Losses on foreclosed properties decreased $122 thousand in 2016 compared to 2015 due to the Bank recognizing $128 thousand in net gains on sales of other real estate properties during 2016.  Amortization expense of core deposits was $244 thousand in 2016, compared to $205 thousand in 2015.  See Note 7 in the Company’s Consolidated Financial Statements and Notes included in Item 8 for more detail of the goodwill and intangible assets.

19

The following table is a summary of noninterest income and expense for the three-year period indicated.

	For the Year ended December 31,
	(in thousands)
	2016			2015			2014
NON-INTEREST INCOME
Service Charges	$	5,086		$	4,408		$	4,240
Loan Service Fee Income (Loss), net		71			206			66
Trust Department Income		1,086			1,056			979
Investment Securities Gains (Losses),net		287			412			966
Gains on trading assets		(92)			(9)			202
Gains on Sale of Mortgage Loans		2,098			1,488			951
Brokerage Income		778			597			554
Debit Card Interchange Income		2,740			2,477			2,119
Other		95			849			81
Total Non-interest Income	$	12,149		$	11,484		$	10,158
NON-INTEREST EXPENSE
Salaries and Employee Benefits	$	17,930		$	16,583		$	14,806
Occupancy Expense		3,772			3,781			3,308
Acquisition Expense		—			858			—
Other		12,083			10,585			9,101
Total Non-interest Expense	$	33,785		$	31,807		$	27,215
Net Non-interest Expense as a Percentage of Average Assets		2.16	%		2.25	%		2.14	%

Income Taxes

As part of normal business, Kentucky Bank typically makes tax free loans to select municipalities in our market and invests in selected tax free securities, primarily in the Commonwealth of Kentucky.  In making these investments, the Company considers the overall impact to managing our net interest margin, credit worthiness of the underlying issuer and the favorable impact on our tax position.  For the year ended December 31, 2016, the Company averaged $84.3 million in tax free securities, $5.6 million in tax free trading assets and $38.0 million in tax free loans.  For the year ended December 31, 2015, the Company averaged $83.3 million in tax free securities, $5.4 million in tax free trading assets and $31.5 million in tax free loans.  As of December 31, 2016, the weighted average remaining maturity for the tax free securities is 98 months, while the weighted average remaining maturity for the tax free loans is 145 months.

The Company had income tax expense of $773 thousand in 2016, $530 thousand in 2015 and $897 thousand in 2014.  This represents an effective income tax rate of 8.3% in 2016, 7.1% in 2015 and 11.3% in 2014.  The difference between the effective tax rate and the statutory federal rate of 34% is primarily due to tax exempt income on certain investment securities and loans.  In addition, the Company had additional tax credits which also contributed to the lower effective income tax rate for those years.  In 2016, the Company had tax credits totaling $882 thousand for investments made in low income housing projects which represented an increase of $271 thousand compared to similar tax credits in 2015.

Balance Sheet Review

Assets increased from $974 million at December 31, 2015 to $1 billion at December 31, 2016.  Securities available for sale increased $10 million during 2016, outstanding loan balances increased $32 million during 2016 and deposits increased $44 million during 2016.  Assets at year-end 2015 totaled $974 million compared to $855 million in 2014.  Securities available for sale increased $17 million, outstanding loan balances increased $86 million and deposits increased $104 million compared to 2014.  On July 24, 2015, the Company acquired Madison Financial Corporation, and its wholly owned subsidiary Madison Bank.  At the acquisition date, acquired securities available for sale totaled $28 million, acquired loan balances totaled $78 million and acquired deposit balances totaled $96 million.  Total acquired assets totaled $116 million at the acquisition date. 

20

Loans

Total loans (including loans held for sale) were $657 million at December 31, 2016 compared to $625 million at December 31, 2015 and $539 million at December 31, 2014.  The increase in the loan portfolio during 2016 is attributed to improved economic conditions and an increase in demand.  The increase in the loan portfolio during 2015 was mostly attributed to the acquisition of Madison Financial Corporation during the year.  As of December 31, 2016 and compared to the prior year-end, commercial loans increased $21.5 million, real estate construction loans decreased $151 thousand, 1-4 family residential property loans increased $13.9 million, multi-family residential property loans increased $8.9 million, non-farm & non-residential property loans decreased $7.7 million, agricultural loans decreased $4.3 million and consumer loans decreased $333 thousand.  As of December 31, 2015 and compared to the prior year-end, commercial loans increased $8.7 million, real estate construction loans increased $12.4 million, 1-4 family residential property loans increased $41.3 million, multi-family residential property loans increased $3.9 million, non-farm & non-residential property loans increased $21.9 million, agricultural loans decreased $4.6 million and installment loans increased $2.0 million. 

As of December 31, 2016, the real estate mortgage portfolio comprised 71% of total loans in 2016 and 73% in 2015.  Of this, 1-4 family residential property represented 37% both in  2016 and 2015.  Agricultural loans comprised 10% of the loan portfolio at December 31, 2016 and 11% at December 31, 2015. Approximately 87% of the agricultural loans are secured by real estate in both 2016 and 2015.  The remainder of the agricultural portfolio is used to purchase livestock, equipment and other capital improvements and for general operation of the farm.  Generally, a secured interest is obtained in the capital assets, equipment, livestock or crops.

Automobile loans account for 23%, in 2016 and 22% in 2015, of the consumer loan portfolio, while the purpose of the remainder of this portfolio is used by customers for purchasing retail goods, home improvement or other personal reasons.  The commercial loan portfolio is mainly for capital outlays and business operation.

Collateral is requested depending on the creditworthiness of the borrower.  Unsecured loans are made to individuals or companies mainly based on the creditworthiness of the customer.  Approximately 7% of the loan portfolio is unsecured.  Management is not aware of any significant concentrations that may cause future material risks, which may result in significant problems with future income and capital requirements.

The following table represents a summary of the Company’s loan portfolio by category for each of the last five years.  There is no concentration of loans (greater than 5% of the loan portfolio) in any industry.  The Company has no foreign loans or highly leveraged transactions in its loan portfolio.

	December 31,  (in thousands)
Loans Outstanding	2016		2015		2014		2013		2012
Commercial	$	77,436	$	55,929	$	47,185	$	34,654	$	33,137
Real Estate Construction		29,169		29,320		16,938		11,177		14,102
Real Estate Mortgage:
1-4 Family Residential		245,674		231,479		190,357		194,718		170,825
Multi-Family Residential		47,199		38,281		34,415		16,420		11,512
Non-Farm & Non-Residential		176,024		183,692		161,822		126,791		113,440
Agricultural		62,491		66,782		71,345		68,002		69,806
Consumer		18,867		18,880		16,863		17,065		17,442
Other		183		516		279		158		337
Total Loans		657,043		624,879		539,204		468,985		430,601
Less Deferred Loan Fees		312		134		123		107		140
Total Loans, Net of Deferred Loan Fees		656,731		624,745		539,081		468,878		430,461
Less loans held for sale		724		624		776		223		486
Less Allowance for Loan Losses		7,541		6,521		6,012		5,441		6,047
Net Loans	$	648,466	$	617,600	$	532,293	$	463,214	$	423,928

21

The following table sets forth the maturity distribution and interest sensitivity of selected loan categories at December 31, 2016.  Maturities are based upon contractual term.  The total loans in this report represent loans net of deferred loan fees, including loans held for sale but excluding the allowance for loan losses.  In addition, deferred loan fees on the above table are netted with real estate mortgage loans on the following table.

	December 31, 2016 (in thousands)
	One Year		One Through		Over		Total
Loan Maturities and Interest Sensitivity	or Less		Five Years		Five Years		Loans
Commercial	$	41,004	$	17,305	$	19,127	$	77,436
Real Estate Construction		12,299		11,493		5,377		29,169
Real Estate Mortgage:
1-4 Family Residential		86,884		104,951		52,803		244,638
Multi-Family Residential		6,172		33,735		7,292		47,199
Non-Farm & Non-Residential		26,505		80,840		68,679		176,024
Agricultural		23,509		36,224		2,758		62,491
Consumer		5,741		12,472		654		18,867
Other		183		—		—		183
Total Loans, Net of Deferred Loan Fees		202,297		297,020		156,690		656,007
Fixed Rate Loans		30,102		55,253		143,132		228,487
Floating Rate Loans		172,195		241,767		13,558		427,520
Total Loans, Net of Deferred Loan Fees	$	202,297	$	297,020	$	156,690	$	656,007

Mortgage Banking

The Company has been in mortgage banking since the early 1980’s.  The activity in origination and sale of these loans fluctuates, mainly due to changes in interest rates.  Mortgage loan originations increased from $37 million in 2014 to $49 million in 2015, and increased to $62 million in 2016.  Proceeds from the sale of loans were $37 million, $51 million and $64 million for the years 2014, 2015 and 2016, respectively.  Mortgage loans held for sale were $724 thousand at December 31, 2016 and $624 thousand at December 31, 2015.  Fixed rate residential mortgage loans are generally sold when they are made.  The volume of loan originations is inverse to rate changes.  During 2016, declining mortgage rates and an improvement in the housing market resulted in the Bank originating more mortgage loans when compared to 2015 and 2014.  The effect of these changes was also reflected on the income statement.  As a result, the gain on sale of loans was $2.1 million in 2016 compared to $1.5 million in 2015 and $951 thousand in 2014.

The Bank has sold various loans to the Federal Home Loan Mortgage Corporation (FHLMC) and the Federal Home Loan Bank (FHLB) while retaining the servicing rights.  Gains and losses on loan sales are recorded at the time of the cash sale, which represents the premium or discount paid by the FHLMC and FHLB.  The Bank receives a servicing fee from the FHLMC and FHLB on each loan sold.  Servicing rights are carried using the amortized cost method and are capitalized based on the relative fair value of the rights and the expected life of the loan and are expensed in proportion to, and over the period of, estimated net servicing revenues.

Mortgage servicing rights were $1.3 million at December 31, 2016, $1.3 million at December 31, 2015 and $1.2 million at December 31, 2014.

Amortization of mortgage servicing rights was $439 thousand (including $105 thousand in net valuation write-downs), $280 thousand (including $59 thousand in  net recoveries of prior year write-downs) and $405 thousand (including $20 thousand in net valuation write-downs) for the years ended December 31, 2016, 2015 and 2014, respectively.  See Note 4 in the Company’s 2016 Consolidated Financial Statements and Notes included in Item 8 for additional information.

Deposits

For 2016, total deposits increased $44 million to $803 million.  Noninterest bearing deposits increased $10 million, time deposits of $250 thousand and over increased $13 million, and other interest bearing deposits increased $21 million.  Public fund balances totaled $190 million at December 31, 2016, of which $190 million was interest bearing. 

For 2015, total deposits increased $104 million to $759 million.  Noninterest bearing deposits increased $33 million, time deposits of $250 thousand and over increased $8 million, and other interest bearing deposits increased $63 million.  Public fund balances totaled $168 million at December 31, 2015, of which $157 million was interest bearing.

22

The table below provides information on the maturities of time deposits of $100,000 or more at December 31, 2016:

	At December 31, 2016
Maturity of Time Deposits of $100,000 or More	(in thousands)
Maturing 3 Months or Less	$	33,509
Maturing over 3 Months through 6 Months		33,936
Maturing over 6 Months through 12 Months		23,464
Maturing over 12 Months		32,845
Total	$	123,754

Borrowings

The Company utilizes both long and short term borrowings.  Long term borrowing at the Bank is mainly from the Federal Home Loan Bank (FHLB).  This borrowing is mainly used to fund longer term, fixed rate mortgages, as part of a leverage strategy and to assist in asset/liability management.  Advances are either paid monthly or at maturity.  As of December 31, 2016, $92.5 million was borrowed from FHLB, an increase of $4.7 million from December 31, 2015. 

Throughout 2016, the Bank borrowed and repaid $138.5 million in short-term funds from the FHLB.  As of December 31, 2016, no short-term borrowings from the FHLB were outstanding.  Also, during 2016, the Bank borrowed $15.0 million in longer-term advances and repaid $10.3 million in long term advances.  These advances each have an original maturity of more than 1 year.

In 2015, the Bank borrowed $135 million in short-term advances from the FHLB and repaid $145 million in short-term advances.  The Bank borrowed $14.7 million in long-term advances during 2015 and repaid $10.7 million in long-term.  The long-term advances have an orginal maturity greater than 1 year.

The increase in long-term advances is attributed to funding the growth in the Banks’ loan portfolio and strategically locking in historically low interest rates.

On July 20, 2015, the Company borrowed $5.0 million which had an outstanding balance of $4.1 million at December 31, 2016.  The term loan has a fixed interest rate of 5.0%, requires quarterly principal and interest payments, matures July 20, 2025 and is collateralized by the Company’s stock.  Additional information pertaining to the note payable may be found in note 10 of the financial statements.

23

The following table depicts relevant information concerning our short term borrowings.

	As of and for the year ended
	December 31,  (in thousands)
Short Term Borrowings	2016			2015			2014
Federal Funds Purchased:
Balance at Year end	$	—		$	—		$	—
Average Balance During the Year		515			373			777
Maximum Month End Balance		10,517			4,300			7,952
Year end rate		—			—			—
Average annual rate		0.81	%		0.32	%		0.28	%
Repurchase Agreements:
Balance at Year end	$	20,873		$	18,514		$	12,457
Average Balance During the Year		23,755			16,596			12,270
Maximum Month End Balance		27,214			19,874			13,788
Year end rate		0.50	%		0.54	%		0.75	%
Average annual rate		0.45	%		0.59	%		0.76	%
Other Borrowed Funds:
Balance at Year end	$	—		$	—		$	10,000
Average Balance During the Year		—			—			—
Maximum Month End Balance		—			—			10,000
Year end rate		—			—	%		0.14	%
Average annual rate		—			—	%		0.14	%

Contractual Obligations

The Bank has required future payments for time deposits and long-term debt.  The other required payments under such commitments at December 31, 2016 are as follows:

	Payments due by period (in thousands)
			Less						More
			than 1		1-3		3-5		than 5
Contractual Obligations	Total		year		years		years		years
Federal Home Loan Bank advances	$	92,500	$	15,656	$	30,124	$	26,676	$	20,044
Note payable		4,090		383		826		912		1,969
Subordinated debentures		7,217		—		—		—		7,217
Time deposits		202,576		140,877		41,199		20,485		15
Lease payments on premises		2,290		308		616		547		819

Asset Quality

With respect to asset quality, management considers three categories of assets to merit close scrutiny.  These categories include:  loans that are currently nonperforming, other real estate, and loans that are currently performing but which management believes require special attention.

During periods of economic slowdown, the Company may experience an increase in nonperforming loans.

The Company discontinues the accrual of interest on loans that become 90 days past due as to principal or interest unless reasons for delinquency are documented such as the loan being well collateralized and in the process of collection.  A loan remains in a non-accrual status until factors indicating doubtful collection no longer exist.  A loan is classified as a restructured loan when the interest rate is materially reduced or the term is extended beyond the original maturity date because of the inability of the borrower to service the interest payments at market rates.  Other real estate is recorded at fair value less estimated costs to sell.  The acquisition of Madison Financial Corporation did not have a material impact on the asset quality of the Company.

24

A summary of the components of nonperforming assets, including several ratios using period-end data, is shown as follows.

	At December 31, 2016
Nonperforming Assets	2016			2015			2014			2013			2012
Non-accrual Loans	$	4,566		$	6,351		$	6,577		$	2,974		$	7,024
Accruing Loans which are Contractually past due 90 days or more		927			1,000			24			554			841
Restructured Loans		2,063			2,245			6,138			6,901			7,227
Total Nonperforming Loans		7,556			9,596			12,739			10,429			15,092
Other Real Estate		1,824			2,347			4,604			3,379			4,168
Total Nonperforming Assets	$	9,380		$	11,943		$	17,343		$	13,808		$	19,260
Total Nonperforming Loans as a Percentage of Loans (including loans held for sale) (1)		1.15	%		1.54	%		2.36	%		2.22	%		3.51	%
Total Nonperforming Assets as a Percentage of Total Assets		0.91	%		1.23	%		2.03	%		1.79	%		2.75	%
Allowance As a Percentage of nonperforming assets		80	%		55	%		35	%		39	%		31	%

(1) Net of deferred loan fees

Total nonperforming assets at December 31, 2016 were $9.4 million compared to $11.9 million at December 31, 2015 and $17.3 million at December 31, 2014.  The decrease from 2015 to 2016 is attributed to decreases in non-accrual loans, accruing loans 90 days or more past due, restructured loans and other real estate.  The decrease from 2014 to 2015 is credited to decreases in non-accrual loan balances, restructured loans and other real estate.  Total other real estate properties totaled $1.8 million at December 31, 2016, of which, none were income producing property.  Total nonperforming loans were $7.6 million, $9.6 million, and $12.7 million at December 31, 2016, 2015 and 2014, respectively.  The decrease in restructured loans during 2015 is attributed to one loan which had a balance of $3.8 million at December 31, 2014 and was placed on non-accrual in 2015.  The increase in non-accrual loan balances from December 31, 2013 to December 31, 2014 was mostly attributed to one customer who had total non-accrual balances of $4.0 million at December 31, 2014.  Total net loan charge offs in 2016 were $130 thousand.  The amount of lost interest on our non-accrual loans was $109 thousand for 2016 and $45 thousand for 2015.  At December 31, 2016, loans currently performing but which management believes requires special attention were $17.6 million, with 47% being non-farm and non-residential, 23% being 1-4 family residential, 15% being multi-family, 9% being agricultural and 6% being commercial.  The Company continues to follow its long-standing policy of not engaging in international lending and not concentrating lending activity in any one industry.

Impaired loans as of December 31, 2016 were $8.0 million compared to $9.5 million in 2015 and $13.8 million in 2014.  Purchased credit impaired loans totaled $1.9 million at December 31, 2016 and $4.2 million at December 31, 2015.  These amounts are generally included in the total nonperforming and restructured loans presented in the table above.  See Note 4 in the Company’s 2016 Consolidated Financial Statements and Notes included in Item 8 herein.

A loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.  All amounts due according to the contractual terms means that both the contractual interest payments and the contractual principal payments of a loan will be collected as scheduled in the loan agreement.

Nonaccrual loans are loans for which payments in full of principal or interest is not expected or which principal or interest has been in default for a period of 90 days or more unless the asset is both well secured and in the process of collection.  Impaired loans may be loans showing signs of weakness or interruptions in cash flow, but ultimately are current or less than 90 days past due with respect to principal and interest and for which we anticipate full payment of principal and interest through collateral liquidation.

Additional factors considered by management in determining impairment and non-accrual status include payment status, collateral value, availability of current financial information, and the probability of collecting all contractual principal and interest payments.  At December 31, 2016, impaired loans totaling $6.5 million had specific impairment allocations of $541 thousand.  The remaining $1.5 million in impaired loans did not have a specific impairment allocation.  The purchased credit impaired loans the Company had at December 31, 2016 had no allocated reserves. 

At December 31, 2015, impaired loans totaling $7.8 million had specific impairment allocations of $648 thousand.  The remaining $1.7 million in impaired loans did not have a specific impairment allocation.

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The allowance for loan losses on impaired loans is determined using one of two methods.  Either the present value of estimated future cash flows of the loan, discounted at the loan’s effective interest rate or the fair value of the underlying collateral.  The entire change in present value of expected cash flows is reported as a provision for loan losses in the same manner in which impairment initially was recognized or as a reduction in the amount of provision for loan losses that otherwise would be reported.  The total allowance for loan losses related to these loans was $541 thousand, $648 thousand and $998 thousand on December 31, 2016, 2015 and 2014, respectively.

Kentucky Bank has a “Problem Loan Committee” that meets at least monthly to review problem loans, including past due and non-performing loans, and other real estate.  When analyzing the problem loans and the loan quality as of December 31, 2016, the following factors have been considered:

· Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off and recovery practices not considered elsewhere in estimating credit losses.

· Change in international, national, regional and local economic and business conditions and developments that affect the collectability of the portfolio, including the condition of various market segments.

· Changes in the nature and volume of the portfolio and in the terms of loans.

· Changes in the experience, ability and depth of lending management and other relevant staff.

· Changes in the volume and severity of past due loans; the volume of non-accrual loans, and the volume and severity of adversely classified or graded loans.

· Changes in the quality of the Bank’s loan review system.

· Changes in the value of underlying collateral for collateral-dependent loans.

· The existence and effect of any concentrations of credit, and changes in the level of such concentrations.

· The effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the Bank’s existing portfolio.

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Loan Losses

The following table is a summary of the Company’s loan loss experience for each of the past five years.

	For the Year ended December 31,  (in thousands)
	2016			2015			2014			2013			2012
Balance at Beginning of Year	$	6,521		$	6,012		$	5,441		$	6,047		$	5,842
Amounts Charged-off:
Commercial		(5)			(30)			(258)			(12)			(21)
Real Estate Construction		—			—			—			(578)			(74)
Real Estate Mortgage:
1-4 Family Residential		(126)			(284)			(274)			(262)			(1,090)
Multi-Family Residential		—			(94)			(42)			(161)			(88)
Non-Farm & Non-Residential		—			—			—			(99)			(126)
Agricultural		(193)			(242)			(8)			(109)			(15)
Consumer and other		(1,206)			(1,300)			(758)			(1,083)			(921)
Total Charged-off Loans		(1,530)			(1,950)			(1,340)			(2,304)			(2,335)
Recoveries on Amounts Previously Charged-off:
Commercial		39			—			—			28			24
Real Estate Construction		15			11			14			23			19
Real Estate Mortgage
1-4 Family Residential		19			33			59			63			38
Multi-Family Residential		12			30			57			113			1
Non-Farm & Non-Residential		454			86			368			18			1
Agricultural		50			23			27			27			9
Consumer and other		811			826			436			379			398
Total Recoveries		1,400			1,009			961			651			490
Net Charge-offs		(130)			(941)			(379)			(1,653)			(1,845)
Provision for Loan Losses		1,150			1,450			950			1,050			2,050
Balance at End of Year		7,541			6,521			6,012			5,444			6,047
Total Loans (1)
Average		647,278			574,141			494,966			444,589			418,049
At December 31		656,731			624,745			539,081			468,878			429,975
As a Percentage of Average Loans (1):
Net Charge-offs		0.02	%		0.16	%		0.08	%		0.37	%		0.44	%
Provision for Loan Losses		0.18	%		0.25	%		0.19	%		0.24	%		0.49	%
Allowance as a Percentage of Year-end Loans (1)		1.15	%		1.04	%		1.12	%		1.16	%		1.41	%
Beginning Allowance as a Multiple of Net Charge-offs		50.2			6.4			14.4			3.7			3.2
Ending Allowance as a Multiple of Nonperforming Assets		0.80			0.55			0.35			0.39			0.31

(1) Net of deferred loan fees and includes loans held for sale

Loans are typically charged-off when the collection of principal is considered doubtful, and would be well documented and approved by the appropriate responsible party or committee.  The provision for loan losses for 2016 was $1.2 million compared to $1.5 million in 2015 and $950 thousand in 2014.  Net charge-offs were $130 thousand in 2016, $941 thousand in 2015 and $379 thousand in 2014.  Net charge-offs to average loans were 0.02%, 0.16% and 0.08% in 2016, 2015 and 2014, respectively.  The provision for loan losses decreased $300 thousand from 2015 to 2016 and increased $500 thousand from 2014 to 2015.  The allowance for loan losses increased $1.0 million from December 31, 2015 to December 31, 2016.

In evaluating the allowance for loan losses, management considers the composition of the loan portfolio, the historical loan loss experience, the overall quality of the loans and an assessment of current economic conditions.  At December 31, 2016, the allowance for loan losses was 1.15% of loans outstanding compared to 1.04% at year-end 2015 and 1.12% at year-end 2014.  Management believes the allowance for loan losses at the year-end 2016 is adequate to cover probable incurred credit losses within the portfolio.

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The following tables set forth an allocation for the allowance for loan losses and loans by category.  In making the allocation, management evaluates the risk in each category, current economic conditions and charge-off experience.  An allocation for the allowance for loan losses is an estimate of the portion of the allowance that represents probable incurred losses in each loan category, but it does not preclude any portion of the allowance allocated to one type of loan being used to absorb losses of another loan type.

Allowance for Loan Losses (in thousands)	2016		2015		2014		2013		2012
Commercial	$	862	$	536	$	410	$	280	$	250
Real Estate Construction		616		453		400		358		918
Real Estate Mortgage:
1-4 Family Residential		2,515		2,296		2,145		2,535		2,421
Multi-family Residential		635		505		562		327		414
Non-farm & Non-residential		1,315		1,338		800		664		628
Agricultural		935		748		1,125		678		845
Consumer and other		663		645		570		599		571
Total		7,541		6,521		6,012		5,441		6,047

	2016				2015				2014				2013				2012
Loans (in thousands)	Dollars		Percentage		Dollars		Percentage		Dollars		Percentage		Dollars		Percentage		Dollars		Percentage
Commercial	$	77,436	11.80	%	$	55,929	8.96	%	$	47,185	8.77	%	$	34,654	7.39	%	$	33,137	7.71	%
Real Estate Construction		29,169	4.45	%		29,320	4.70	%		16,938	3.15	%		11,177	2.38	%		14,102	3.28	%
Real Estate Mortgage:
1-4 Family Residential		244,638	37.29	%		230,721	36.97	%		189,458	35.2	%		194,388	41.50	%		170,199	39.58	%
Multi-family Residential		47,199	7.19	%		38,281	6.13	%		34,415	6.39	%		16,420	3.50	%		11,512	2.68	%
Non-farm & Non-residential		176,024	26.83	%		183,692	29.43	%		161,822	30.06	%		126,791	27.05	%		113,440	26.38	%
Agricultural		62,491	9.53	%		66,782	10.70	%		71,345	13.25	%		68,002	14.51	%		69,806	16.23	%
Consumer		18,867	2.88	%		18,880	3.03	%		16,863	3.13	%		17,065	3.64	%		17,442	4.06	%
Other		183	0.03	%		516	0.08	%		279	0.05	%		158	0.03	%		337	0.08	%
Total, Net (1)		656,007	100.00	%		624,121	100.00	%		538,305	100.00	%		468,655	100.00	%		429,975	100.00	%

(1) Net of deferred loan fees

Off-balance Sheet Arrangements

Some financial instruments, such as loan commitments, credit lines, letters of credit, and overdraft protection, are issued to meet customer financing needs.  These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met, and usually have expiration dates.  Commitments may expire without being used.  Off-balance sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated.  The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment.

Financial instruments with off-balance sheet risk were as follows at year-end (in thousands):

	2016		2015
Unused lines of credit	$	115,832	$	96,581
Commitments to make loans		37,906		9,854
Letters of credit		463		805

Unused lines of credit are substantially all at variable rates.  Commitments to make loans are generally made for a period of 60 days or less and are primarily fixed at current market rates ranging from 2.88% to 6.78% with maturities ranging up to 30 years.

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Capital

As displayed by the following table, the Company’s Tier I capital (as defined by the Federal Reserve Board under the Board’s risk-based guidelines) at December 31, 2016 increased $4.9 million to $86.7 million from December 31, 2015.  Stockholders’ equity, excluding accumulated other comprehensive income, was $93.9 million at December 31, 2016 compared to $89.1 million at December 31, 2015.  Included in Tier I capital is $7 million of trust preferred securities issued in August 2003.  The disallowed amount of stockholders’ equity is mainly attributable to the goodwill and/or core deposit intangibles, resulting from the Kentucky First acquisition in 2003, the Peoples Bank acquisition in 2006 and the Madison Financial Corporation acquisition in 2015.  The Company’s risk-based capital and leverage ratios, as shown in the following table, exceeded the levels required to be considered “well capitalized”.  The leverage ratio compares Tier I capital to total average assets less disallowed amounts of goodwill.

	At December 31, 2016 (in thousands)
	2016			2015			Change
Stockholders’ Equity (1)	$	93,928		$	89,054		$	4,874
Trust Preferred Securities		7,000			7,000			—
Less Disallowed Amount		14,210			14,205			5
Tier I Capital		86,718			81,849			4,869
Allowance for Loan Losses		7,616			6,596			1,020
Other		9			11			(2)
Tier II Capital		7,625			6,607			1,018
Total Capital		94,343			88,456			5,887
Total Risk Weighted Assets	$	678,506		$	662,816		$	15,690
Ratios:
Common Equity Tier I Capital to Risk-weighted Assets		11.8	%		11.3	%		0.5	%
Tier I Capital to Risk-weighted Assets		12.8	%		12.4	%		0.4	%
Total Capital to Risk-weighted Assets		13.9	%		13.4	%		0.5	%
Leverage		8.7	%		8.6	%		0.1	%

(1) Excluding accumulated other comprehensive income/loss.

The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) established five capital categories for insured depository institutions under its Prompt Corrective Action Provisions.  The bank regulatory agencies adopted regulations, which became effective in 1992, defining these five capital categories for banks they regulate.  The categories vary from “well capitalized” to “critically undercapitalized”.  A “well capitalized” bank is defined as one with a total risk-based capital ratio of 10% or more, a Tier I risk-based capital ratio of 8% or more, a leverage ratio of 5% or more, and one not subject to any order, written agreement, capital directive, or prompt corrective action directive to meet or maintain a specific capital level.  At December 31, 2016, the bank had ratios that exceeded the minimum requirements established for the “well capitalized” category.

In July 2013, the FDIC and the other federal bank regulatory agencies issued a final rule that will revise their leverage and risk-based capital requirements and the method of calculating risk-weighted assets to make them consistent with agreements that were reached by the Basel Committee on Banking Supervision and certain provisions of the Dodd-Frank Act. Among other things, the rule establishes a new common equity Tier 1 minimum capital requirement (4.5% of risk-weighted assets), increases the minimum Tier 1 capital to risk-based assets requirement (from 4% to 6% of risk-weighted assets) and assigns a higher risk weight (150%) to exposures that are more than 90 days past due or are on nonaccrual status and to certain commercial real estate facilities that finance the acquisition, development or construction of real property.

The final rule also requires unrealized gains and losses on certain “available-for-sale” securities holdings to be included for purposes of calculating regulatory capital requirement unless a one-time opt-in or opt-out is exercised. The rule limits a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital to risk-weighted assets in addition to the amount necessary to meet its minimum risk-based capital requirements. The final rule became effective for the Bank on January 1, 2015. The capital conservation buffer requirement was phased in beginning January 1, 2016 and will end January 1, 2019, when the full capital conservation buffer requirement will be effective.

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In management’s opinion, there are no other known trends, events or uncertainties that will have or that are reasonably likely to have a material effect on the Company’s liquidity, capital resources or operations.

Securities and Federal Funds Sold

Securities, classified as available for sale, increased from $264.2 million at December 31, 2015 to $273.8 million at December 31, 2016.   Federal funds sold totaled $1.2 million at December 31, 2016 and $1.5 million at December 31, 2015.

Per Company policy, fixed rate asset backed securities will not have an average life exceeding seven years, but final maturity may be longer.  Adjustable rate securities shall adjust within three years per Company policy.  As of December 31, 2016 and 2015, the Company held $6 million and $0 in adjustable rate mortgage backed securities.  Unrealized gains (losses) on investment securities are temporary and change inversely with movements in interest rates.  In addition, some prepayment risk exists on mortgage-backed securities and prepayments are likely to increase with decreases in interest rates.  The following tables present the investment securities for each of the past three years and the maturity and yield characteristics of securities as of December 31, 2016.

Securities Available for Sale and Trading Assets at Fair Value

	At December 31, 2016 (in thousands)
Investment Securities (at fair value)	2016		2015		2014
Available for Sale
U.S. government agencies	$	36,528	$	48,863	$	60,586
States and political subdivisions		91,132		91,962		89,281
Mortgage-backed
Fixed -
GNMA, FNMA, FHLMC Passthroughs		51,557		55,141		43,072
GNMA, FNMA, FHLMC CMO’s		94,213		67,902		53,626
Total mortgage backed		145,770		123,043		96,698
Equity Securities		340		344		296
Total	$	273,770	$	264,212	$	246,861
Trading Assets	$	5,592	$	5,531	$	5,370

Maturity Distribution of Securities Available for Sale

	December 31, 2016 (in thousands)
				Over One			Over Five						Asset
				Year			Years			Over			Backed
	One Year			Through			Through			Fifteen			& Equity
	or Less			Five Years			Fifteen Years			Years			Securities			Total
Available for Sale
U.S. government agencies	$	—		$	16,020		$	15,300		$	5,208		$	—		$	36,528
States and political subdivisions		301			9,464			75,278			6,089			—			91,132
Mortgage-backed		—			—			—			—			145,770			145,770
Equity Securities		—			—			—			—			340			340
Total		301			25,484			90,578			11,297			146,110			273,770
Percent of Total		0.1	%		9.3	%		33.1	%		4.1	%		53.4	%		100	%
Weighted Average Yield (1)		5.37	%		1.99	%		3.22	%		2.39	%		2.63	%		2.76	%

(1) Tax Equivalent yield

Trading assets totaling $5.6 million are generally held 60 days or less before being sold.

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Impact of Inflation and Changing Prices

The majority of the Company’s assets and liabilities are monetary in nature.  Therefore, the Company differs greatly from most commercial and industrial companies that have significant investments in nonmonetary assets and inventories.  However, inflation does have an important impact on the growth of assets in the banking industry and the resulting need to increase equity capital at higher than normal rates in order to maintain an appropriate equity to assets ratio.  Inflation also affects other expenses, which tend to rise during periods of inflation.

Item 7A.  Quantitative and Qualitative Disclosures about Market Risk

Market risk is the risk of loss arising from adverse changes in market prices and rates.  Management considers interest rate risk and liquidity risk to be significant market risks to the Company, but considers interest risk to be the most significant.

Kentucky Bank’s Asset/Liability Committee oversees the Company’s interest rate risk and liquidity risks.  The Bank has developed procedures designed to ensure safety and soundness, maintain liquidity and regulatory capital standards, and achieve acceptable net interest income.  The exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee.

Interest Rate Risk.  Interest rate risk is the potential of economic losses due to future interest rate changes.  These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values.  The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximize income.

Management realizes certain risks are inherent and that the goal is to identify and minimize the risks.  The primary tool used by management is an interest rate shock simulation model.

Certain assumptions, such as prepayment risks, are included in the model.  However, actual prepayments may differ from those assumptions.  In addition, immediate withdrawal of interest checking and other savings accounts may have an effect on the results of the model.  The Company has $5.6 million in market risk sensitive instruments which are held for trading purposes. These assets are held for a minimal period of time and are used to generate profits on short-term differences in price while earning interest while they are held.

The following table depicts the change in net interest income resulting from 100 and 300 basis point changes in rates.  The projections are based on balance sheet growth assumptions and repricing opportunities for new, maturing and adjustable rate amounts.  In addition, the projected percentage changes from level rates are outlined below along with the Board of Directors approved limits.  As of December 31, 2016 the projected net interest income percentages are within the Board of Directors limits.  Please note that in the current low interest rate environment, many rates cannot decline 100 basis points.  Therefore, the projected net interest income changes below as of December 31, 2016 for a declining rate environment are not as relevant.  The projected net interest income report summarizing the Company’s interest rate sensitivity as of December 31, 2016 and 2015 is as follows:

Projected Net Interest Income (December 31, 2016)

				Level
Rate Change:	—100			Rates		+100			+300
Year One (1/17 - 12/17)
Net interest income	$	30,735		$	31,274	$	31,216		$	31,119
Net interest income dollar change	$	(540)		$	—	$	(58)		$	(155)
Net interest income percentage change		(1.7)	%		N/A		(0.2)	%		(0.5)	%
Limitation on % Change		>-6.0	%		N/A		>-4.0	%		>-10.0	%

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Projected Net Interest Income (December 31, 2015)

				Level
Rate Change:	—100			Rates		+100			+300
Year One (1/16 - 12/16)
Net interest income	$	31,475		$	32,056	$	31,944		$	31,906
Net interest income dollar change	$	(581)		$	—	$	(31)		$	(150)
Net interest income percentage change		(1.8)	%		N/A		(0.1)	%		(0.5)	%
Limitation on % Change		>-6.0	%		N/A		>-4.0	%		>-10.0	%

The numbers in 2016 are comparable to 2015.  In 2016, year one reflected a decrease in projected net interest income of 0.2% compared to a 0.1% projected decrease in 2015 with a 100 basis point increase.  The 300 basis point increase in rates reflected a 0.5% decrease in net interest income in both 2016 and 2015.  The 100 point decrease in rates reflected a 1.7% decrease in net interest income in 2016 compared to a 1.8% decrease in 2015.

Management measures the Company’s interest rate risk by computing estimated changes in net interest income in the event of a range of assumed changes in market interest rates.  The Company’s exposure to interest rates is reviewed on a monthly basis by senior management and quarterly with the Board of Directors.

Exposure to interest rate risk is measured with the use of interest rate sensitivity analysis to determine the change in net interest income in the event of hypothetical changes in interest rates, while interest rate sensitivity gap analysis is used to determine the repricing characteristics of the Company’s assets and liabilities.  If estimated changes to net interest income are not within the limits established by the Board, the Board may direct management to adjust the Company’s asset and liability mix to bring interest rate risk within Board approved limits.

Liquidity Risk.  Liquidity risk is the possibility that the Company may not be able to meet its cash requirements.  Management of liquidity risk includes maintenance of adequate cash and sources of cash to fund operations and meet the needs of borrowers, depositors and creditors.  Excess liquidity generally has a negative impact on earnings resulting from the lower yields on short-term assets.

In addition to cash and cash equivalents, the securities portfolio provides an important source of liquidity.  Total securities maturing within one year along with cash and cash equivalents totaled $43.6 million at December 31, 2016.  Additionally, securities available-for-sale with maturities greater than one year totaled $273.5 million at December 31, 2016.  The available for sale securities are available to meet liquidity needs on a continuing basis.  In addition, trading assets totaled $5.6 million at December 31, 2016.

The Company maintains a relatively stable base of customer deposits and its steady growth is expected to be adequate to meet its funding demands.  In addition, management believes the majority of its $100,000 or more certificates of deposit are no more volatile than its core deposits.  At December 31, 2016 these balances totaled $123.8 million, approximately 15% of total deposits.

The Company also relies on Federal Home Loan Bank advances for both liquidity and asset/liability management purposes.  These advances are used primarily to fund long-term fixed rate residential mortgage loans.  We have sufficient collateral to borrow an additional $101 million from the Federal Home Loan Bank at December 31, 2016.  In addition, as of December 31, 2016, $61 million is available in overnight borrowing through various correspondent banks and the Company has access to an additional $303 million in brokered deposits.

Generally, the Company relies upon net cash inflows from financing activities, supplemented by net cash inflows from operating activities, to provide cash used in its investing activities.  As is typical of many financial institutions, significant financing activities include deposit gathering, and the use of short-term borrowings, such as federal funds purchased and securities sold under repurchase agreements along with long-term debt.  The Company’s primary investing activities include purchasing investment securities and loan originations.  Management believes there is sufficient cash flow from operations to meet investing and liquidity needs related to reasonable borrower, depositor and creditor needs in the present economic environment.

32

The cash flow statements for the periods presented provide an indication of the Company’s sources and uses of cash as well as an indication of the ability of the Company to maintain an adequate level of liquidity.

A number of other techniques are used to measure the liquidity position, including the ratios presented below.  These ratios are calculated based on annual averages for each year.

	December 31,
Liquidity Ratios	2016		2015		2014
Average Loans (including loans held for sale)/Average Deposits	84.2	%	82.6	%	79.6	%
Average Securities sold under agreements to repurchase and other borrowings/Average Assets	3.6	%	2.9	%	2.5	%

The above table shows that the loan to deposit ratio increased both in 2016 and 2015.  The increase in the ratio for both 2016 and 2015 is attributed to loan growth exceeding deposit growth.

Item 8.  Financial Statements

The management of the Company has the responsibility for preparing the accompanying consolidated financial statements and for their integrity and objectivity.  The statements were prepared in accordance with generally accepted accounting principles in the United States of America.  The consolidated financial statements include amounts that are based on management’s best estimates and judgments.  Management also prepared other information in the annual report and is responsible for its accuracy and consistency with the financial statements.

The Company’s 2016 consolidated financial statements have been audited by Crowe Horwath LLP, an independent registered public accounting firm. 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Audit Committee

Kentucky Bancshares, Inc.

Paris, Kentucky

We have audited the accompanying consolidated balance sheets of Kentucky Bancshares, Inc. as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016.  These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting.  Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles.

	/s/Crowe Horwath LLP
	Crowe Horwath LLP
Louisville, Kentucky
March 30, 2017

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KENTUCKY BANCSHARES, INC.

Paris, Kentucky

CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2016, 2015 and 2014

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CONSOLIDATED BALANCE SHEETS

December 31

	12/31/2016		12/31/2015
ASSETS
Cash and due from banks	$	42,052	$	26,546
Federal funds sold		1,198		1,502
Cash and cash equivalents		43,250		28,048
Interest bearing time deposits		5,029		4,874
Securities available for sale		273,770		264,212
Trading Assets		5,592		5,531
Loans held for sale		724		624
Loans		656,007		624,121
Allowance for loan losses		(7,541)		(6,521)
Net loans		648,466		617,600
Federal Home Loan Bank stock		7,034		7,034
Real estate owned, net		1,824		2,347
Assets held for sale		969		—
Bank premises and equipment, net		14,781		16,597
Interest receivable		3,715		3,681
Mortgage servicing rights		1,321		1,277
Goodwill		14,001		14,001
Other intangible assets		529		773
Other assets		7,442		8,085
Total assets	$	1,028,447	$	974,684
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits
Non-interest bearing	$	219,556	$	209,289
Time deposits, $250,000 and over		74,302		61,199
Other interest bearing		509,123		488,493
Total deposits		802,981		758,981
Repurchase agreements		20,873		18,514
Long-term Federal Home Loan Bank advances		92,500		87,833
Note payable		4,090		4,794
Subordinated debentures		7,217		7,217
Interest payable		692		659
Other liabilities		7,122		7,273
Total liabilities		935,475		885,271
Stockholders’ equity
Preferred stock, 300,000 shares authorized and unissued		—		—
Common stock, no par value; 10,000,000 shares authorized; 2,973,232 and 2,989,205 shares issued and outstanding at December 31, 2016 and December 31, 2015		20,767		20,730
Retained earnings		73,161		68,324
Accumulated other comprehensive income (loss)		(956)		359
Total stockholders’ equity		92,972		89,413
Total liabilities and stockholders’ equity	$	1,028,447	$	974,684

See accompanying notes.

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CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31

(in thousands, except per share data)	2016		2015		2014
Interest income
Loans, including fees	$	30,000	$	27,064	$	23,857
Securities
Taxable		3,362		2,951		2,612
Tax exempt		2,618		2,680		2,812
Trading Assets		153		170		168
Other		421		320		282
		36,554		33,185		29,731
Interest expense
Deposits		2,211		2,024		2,038
Repurchase agreements and other borrowings		108		100		96
Federal Home Loan Bank advances		1,620		1,579		1,392
Note payable		233		109		—
Subordinated debentures		254		238		230
		4,426		4,050		3,756
Net interest income		32,128		29,135		25,975
Provision for loan losses		1,150		1,450		950
Net interest income after provision for loan losses		30,978		27,685		25,025
Other income
Service charges		5,086		4,408		4,240
Loan service fee income, net		71		206		66
Trust department income		1,086		1,056		979
Securities gains, net		287		412		966
Gain (loss) on trading assets, net		(92)		(9)		202
Gain on sale of loans		2,098		1,488		951
Brokerage income		778		597		554
Debit card interchange income		2,740		2,477		2,119
Other		95		849		81
		12,149		11,484		10,158
Other expenses
Salaries and employee benefits		17,930		16,583		14,806
Occupancy expense		3,772		3,781		3,308
Repossession expense, net		401		416		371
FDIC insurance		526		576		535
Legal and professional fees		1,628		1,050		1,067
Data processing		1,627		1,427		1,351
Debit card expenses		1,311		1,287		1,005
Amortization		247		205		140
Advertising and marketing		925		1,003		827
Taxes other than payroll, property and income		1,134		904		851
Telephone		345		317		341
Postage		357		379		321
Loan fees		198		334		346
Acquisition expense		—		858		—
Other		3,384		2,687		1,946
		33,785		31,807		27,215
Income before income taxes		9,342		7,362		7,968
Provision for income taxes		773		530		897
Net income	$	8,569	$	6,832	$	7,071
Earnings per share:
Basic	$	2.87	$	2.40	$	2.60
Diluted		2.87		2.40		2.60

See accompanying notes.

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CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

Years Ended December 31

	2016		2015		2014
Net income	$	8,569	$	6,832	$	7,071
Other comprehensive income (loss)
Unrealized gains (losses) on securities arising during the period		(1,706)		(242)		9,931
Reclassification of realized amount		(287)		(412)		(966)
Net change in unrealized gain (loss) on securities		(1,993)		(654)		8,965
Less: Tax impact		(678)		(222)		3,048
Other comprehensive income (loss)		(1,315)		(432)		5,917
Comprehensive income	$	7,254	$	6,400	$	12,988

See accompanying notes.

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CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

Years Ended December 31, 2016, 2015 and 2014

									Accumulated
									Other		Total
	Common Stock			Preferred Stock			Retained		Comprehensive		Stockholders’
(Dollars in thousands)	Shares	Amount		Shares		Amount	Earnings		Income (Loss)		Equity
Balances, January 1, 2014	2,717,434	$	12,570	—	$	—	$	60,229	$	(5,126)	$	67,673
Common stock issued including tax benefit, net (including stock grants of 5,615 shares and employee gifts of 49 shares)	7,159		2	—		—		—		—		2
Stock compensation expense	—		111	—		—		—		—		111
Common stock purchased and retired	(4,495)		(21)	—		—		(90)		—		(111)
Other comprehensive income	—		—	—		—		—		5,917		5,917
Net income	—		—	—		—		7,071		—		7,071
Dividends declared - $0.96 per share	—		—	—		—		(2,721)		—		(2,721)
Balances, December 31, 2014	2,720,098	$	12,662	—	$	—	$	64,489	$	791	$	77,942
Assumption of Madison Financial Corporation preferred stock	—	$	—	12,047	$	4,390	$	—	$	—	$	4,390
Redemption of Madison Financial Corporation preferred stock	—		—	(12,047)		(4,390)		—		—		(4,390)
Common stock issued including tax benefit, net (including stock grants of 7,475 shares and employee gifts of 74 shares)	6,719		2	—		—		—		—		2
Shares issued to acquire Madison Financial Corporation, net of issuance costs	263,361		7,939	—		—						7,939
Stock compensation expense	—		133	—		—		—		—		133
Common stock purchased and retired	(973)		(6)	—		—		(25)		—		(31)
Other comprehensive loss	—		—	—		—		—		(432)		(432)
Net income	—		—	—		—		6,832		—		6,832
Dividends declared - $1.00 per share	—		—	—		—		(2,972)		—		(2,972)
Balances, December 31, 2015	2,989,205	$	20,730	—	$	—	$	68,324	$	359	$	89,413
Balances, January 1, 2016	2,989,205	$	20,730	—	$	—	$	68,324	$	359	$	89,413
Common stock issued (including employee stock grants of  6,170 shares and director stock awards of 1,352 shares), net of 1,181 shares forfeited	6,341		49	—		—		—		—		49
Stock compensation expense	—		153	—		—		—		—		153
Common stock purchased and retired	(22,314)		(165)	—		—		(503)		—		(668)
Other comprehensive loss	—		—	—		—		—		(1,315)		(1,315)
Net income	—		—	—		—		8,569		—		8,569
Dividends declared - $1.08 per share	—		—	—		—		(3,229)		—		(3,229)
Balances, December 31, 2016	2,973,232	$	20,767	—	$	—	$	73,161	$	(956)	$	92,972

See accompanying notes.

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CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31

(in thousands)	2016		2015		2014
Cash flows from operating activities
Net income	$	8,569	$	6,832	$	7,071
Adjustments to reconcile net income to net cash from operating activities:
Depreciation and amortization		1,115		1,326		1,830
Provision for loan losses		1,150		1,450		950
Securities amortization, net		1,133		975		638
Securities (gains) losses, net		(287)		(412)		(966)
Net change in trading assets		(61)		(161)		(5,370)
Originations of loans held for sale		(62,275)		(48,953)		(37,043)
Proceeds from sale of loans		64,273		50,593		37,441
Gain on sale of loans		(2,098)		(1,488)		(951)
Stock based compensation expense		153		133		111
Losses (gain) on disposal of fixed assets		(331)		(4)		(2)
Losses (gain) on other real estate		(128)		(5)		(146)
Deferred taxes		(309)		(17)		3,048
Changes in:
Interest receivable		(34)		(73)		319
Write-downs of other real estate, net		187		252		144
Other assets		1,624		(1,163)		1,506
Interest payable		33		(42)		(94)
Other liabilities		(151)		(1,186)		(4,637)
Net cash from operating activities	$	12,563	$	8,057	$	3,849
Cash flows from investing activities
Acquisition of Madison Financial Corp., net		—		3,514		—
Net change in interest bearing time deposits		(155)		(615)		(980)
Purchases of securities, available for sale		(145,232)		(84,479)		(127,326)
Proceeds from sales of securities, available for sale		23,888		21,627		73,985
Proceeds from principal payments and maturities of securities		108,949		71,988		46,170
Net change in loans		(35,357)		(12,211)		(73,304)
Proceeds from redemption of Federal Home Loan Bank Stock		—		—		749
Purchases of bank premises and equipment		(131)		(733)		(1,056)
Proceeds from sale of other real estate		4,199		5,848		2,053
Proceeds from sale of bank premises and equipment		4		7		2
Net cash from investing activities	$	(43,835)	$	4,946	$	(79,707)
Cash flows from financing activities
Net change in deposits		44,000		8,289		37,468
Net change in repurchase agreements and other borrowings		2,359		(188)		(410)
Net change in short-term advances from Federal Home Loan Bank		—		(10,000)		10,000
Long-term FHLB advances		15,000		14,709		38,666
Payments on long-term FHLB advances		(10,333)		(10,661)		(12,728)
Proceeds from note payable		—		5,000		—
Payments on note payable		(704)		(206)		—
Redemption of acquired preferred shares and unpaid dividends and interest		—		(6,066)		—
Proceeds from issuance of common stock, including options and grants, including tax benefits		49		2		2
Purchase of common stock		(668)		(31)		(111)
Dividends paid		(3,229)		(2,972)		(2,721)
Net cash from financing activities	$	46,474	$	(2,124)	$	70,166

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CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31

	2016		2015		2014
Net change in cash and cash equivalents	$	15,202	$	10,879	$	(5,692)
Cash and cash equivalents at beginning of year		28,048		17,169		22,861
Cash and cash equivalents at end of year	$	43,250	$	28,048	$	17,169
Supplemental disclosures of cash flow information Cash paid during the year for:
Interest expense	$	4,393	$	4,033	$	3,850
Income taxes		800		200		1,200
Supplemental schedules of non-cash investing activities
Real estate acquired through foreclosure	$	3,735	$	3,394	$	3,275
Issuance of common stock in exchange for net assets in acquisition, net of issuance costs		—		7,939		—
Transfer of premises and equipment to held for sale		969		—		—

See accompanying notes.

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NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation:  The consolidated financial statements include the accounts of Kentucky Bancshares, Inc. (the Company), its wholly-owned subsidiaries, Kentucky Bank (the Bank) and KBI Insurance Company, Inc., a captive insurance subsidiary, and the Bank’s wholly-owned subsidiary, KB Special Assets Unit, LLC.  Intercompany transactions and balances have been eliminated in consolidation.

Nature of Operations:  The Bank operates under a state bank charter and provides full banking services, including trust services, to customers located in Bourbon, Clark, Elliot, Fayette, Harrison, Jessamine, Madison, Rowan, Scott, Woodford and adjoining counties in Kentucky.  As a state bank, the Bank is subject to regulation by the Kentucky Department of Financial Institutions and the Federal Deposit Insurance Corporation (FDIC).  The Company, a bank holding company, is regulated by the Federal Reserve. KBI Insurance Company, Inc., a captive insurance subsidiary, is regulated by the State of Nevada Division of Insurance.

Estimates in the Financial Statements:  The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 

Cash Flows:  For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold, and certain short-term investments with maturities of less than three months.  Generally, federal funds are sold for one-day periods.  Net cash flows are reported for loan, deposit and short-term borrowing transactions.

Interest Bearing Time Deposits: Interest bearing time deposits in other financial institutions have original maturities between one and three years and are carried at cost.

Securities:  The Company is required to classify its securities portfolio into one of three categories:  trading securities, securities available for sale and securities held to maturity.  Fair value adjustments are made to the securities based on their classification with the exception of the held to maturity category.  The Company has no investments classified as held to maturity.  Securities available for sale and trading securities are carried at fair value. Unrealized holding gains and losses for securities which are classified as available for sale are reported in other comprehensive income, net of deferred tax.  Unrealized holding gains and losses for securities which are classified as trading securities are reported in other income.

Interest income includes amortization of purchase premium or discount.  Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments, except for mortgage backed securities where prepayments are anticipated.  Gains and losses on sales are recorded on the settlement date and determined using the specific identification method.

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation.  For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer.  Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis.  If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings.  For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) other-than-temporary impairment (OTTI) related to other factors, which is recognized in other comprehensive income.  The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis.  For equity securities, the entire amount of impairment is recognized through earnings.

Loans Held for Sale:  Loans held for sale are carried at the lower of cost or fair value as determined by outstanding commitments from investors or current secondary market prices, calculated on the aggregate loan basis.  The Company also provides for any losses on uncovered commitments to lend or sell.  Loans are generally sold with servicing rights retained but with some exceptions.

42

Loans: Loans that management has the intent and ability to hold for the foreseeable future or until maturity are stated at the amount of unpaid principal, net of deferred loan origination fees and costs and acquired purchase premiums and discounts, reduced by an allowance for loan losses.  Interest income on loans is recognized  on the accrual basis except for those loans on a nonaccrual status.  Interest income on real estate mortgage (1-4 family residential and multi-family residential) and consumer loans is discontinued at the time the loan is 90 days delinquent, and interest income on real estate construction, non-farm and non-residential mortgage, agricultural and commercial loans is discontinued at the time the loan is 120 days delinquent, unless the loan is well-secured and in process of collection.  Past due status is based on the contractual terms of the loan.  In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.  Nonaccrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.  Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment of the yield on the related loan.  Recorded investment is the outstanding loan balance, excluding accrued interest receivable.

When interest accrual is discontinued, interest income received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual.  Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.  Typically, the Company seeks to establish a payment history of at least six consecutive payments made on a timely basis before returning a loan to accrual status.  Consumer and credit card loans are typically charged off no later than 120 days past due.  Loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.

Concentration of Credit Risk:  Most of the Company’s business activity is with customers located within Bourbon, Clark, Elliott, Fayette, Harrison, Jessamine, Madison, Rowan, Scott, Woodford and surrounding counties located in Kentucky.  Therefore, the Company’s exposure to credit risk is significantly affected by changes in the economy in these counties.

Allowance for Loan Losses:  The allowance for loan losses is a valuation allowance for probable incurred credit losses.  Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed.  Subsequent recoveries, if any, are credited to the allowance.

Adjustments are made to the historical loss experience ratios based on the qualitative factors as outlined in the regulatory Interagency Policy Statement on the Allowance for Loan and Lease Losses.  These qualitative factors include the nature and volume of portfolio, economic and business conditions, classification, past due and non-accrual trends.  Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors.  Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.

The allowance for loan losses is evaluated at the portfolio segment level using the same methodology for each segment.  The recent historical actual net losses is the basis for the general reserve for each segment which is then adjusted for qualitative factors as outlined above (i.e., nature and volume of portfolio, economic and business conditions, classification, past due and non-accrual trends) specifically evaluated at individual segment levels.

The allowance consists of specific and general components.  The specific component relates to loans that are individually classified as impaired.  The general component covers non-classified loans and is based on historical loss experience adjusted for current factors for non-classified loans and a migration analysis for classified loans.

A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement.  Loans, for which the terms have been modified, and for which the borrower is experiencing financial difficulties and has been granted a concession, are considered troubled debt restructurings and classified as impaired.

Loans are charged off when available information confirms that loans, or portions thereof, are uncollectible.  While management considers the number of days a loan is past due in its evaluation process, we also consider a variety of other factors.

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Factors considered by management in evaluating the charge-off decision include collateral value, availability of current financial information for both borrower and guarantor, and the probability of collecting contractual principal and interest payments.  These considerations may result in loans being charged off before they are 90 days or more past due.  This evaluation framework for determining charge-offs is consistently applied to each segment. 

From time to time, the Company will charge-off a portion of impaired and non-performing loans.  Loans that meet the criteria under ASC 310 are evaluated individually for impairment.  Management considers payment status, collateral value, availability of current financial information for the borrower and guarantor, actual and expected cash flows, and probability of collecting amounts due.  If a loan’s collection status is deemed to be collateral dependent or foreclosure is imminent, the loan is charged down to the fair value of the collateral, less selling costs.  In circumstances where the loan is not deemed to be collateral dependent, but we believe, after completing our evaluation process, that probable loss has been incurred, we will provide a specific allocation on that loan.

The impact of recording partial charge-offs is a reduction of gross loans and a reduction of the loan loss reserve.  The net loan balance is unchanged in instances where the loan had a specific allocation as a component of the allowance for loan losses.  The allowance as a percentage of total loans may be lower as the allowance no longer needs to include a component for the loss, which has now been recorded, and net charge-off amounts are increased as partial charge-offs are recorded.

Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due.  Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.  Management determines the significance of payment delays and payment shortfalls on case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.

Commercial and real estate construction and real estate mortgage loans (multi-family residential, and non-farm and non-residential mortgage) over $200 thousand are individually evaluated for impairment.  If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.  Large groups of smaller balance homogeneous loans, such as consumer and 1-4 family residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures.  Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception.    If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.

The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors.  The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company over the most recent 5 years.  This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment.  These economic factors include consideration of the following:  levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations.

A “portfolio segment” is defined as the level at which an entity develops and documents a systematic methodology to determine its allowance for loan losses.  The Company has identified the following portfolio segments:  commercial, real estate construction, real estate mortgage, agricultural, consumer (credit cards and other consumer) and other (overdrafts).

Commercial:  These loans to businesses do not have real estate as the underlying collateral.  Instead of real estate, collateral could be business assets such as equipment or accounts receivable or the personal guarantee of one or more guarantors.  These loans generally present a higher level of risk than loans secured by commercial real estate because in the event of default by the borrower, the business assets must be liquidated and/or guarantors pursued for deficit funds.  Business assets are worth more while they are in use to produce income for the business and worth significantly less if the business is no longer in operation.

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Real estate construction:  Real estate construction consist of loans secured by real estate for additions or alterations to existing structures, as well as constructing new structures.  They include fixed and floating rate loans.  Real estate construction loans generally present a higher level of risk than loans secured by 1-4 family residential real estate primarily because of the length of the construction period and the potential change in prices of construction materials.

Real Estate Mortgage:

1-4 family residential:  Loans secured by 1-4 family residential real estate represent the lowest risk of loans for the Company.  They include fixed and floating rate loans as well as loans for commercial purposes or consumer purposes.  The Company generally does not hold subprime residential mortgages. Borrowers with loans in this category, whether for commercial or consumer purposes, tend to make their payments timely as they do not want to risk foreclosure and loss of property.

Multifamily residential:  Loans secured by multifamily residential real estate consist primarily of loans secured by apartment buildings and can be either fixed or floating rate loans.  Multi-family residential real estate loans generally present a higher level of risk than loans secured by 1-4 family residential real estate because the borrower’s repayment ability typically comes from rents from tenants.  Local economic and employment fluctuations impact rent rolls and potentially the borrower’s repayment ability.

Non-farm & non-residential:  Loans secured by non-farm non-residential real estate consist of loans secured by commercial real estate that is not owner occupied.  These loans generally consist of loans collateralized by property whereby rents received from commercial tenants of the borrower are the source of repayment.   These loans generally present a higher level of risk than loans secured by owner occupied commercial real estate because repayment risk is expanded to be dependent on the success of multiple businesses which are paying rent to the borrower.  If multiple businesses fail due to deteriorating economic conditions or poor business management skills, the borrower may not have enough rents to cover their monthly payment.  Repayment risk is also increased depending on the level of surplus available commercial lease space in the local market area.

Agricultural:  These loans to agricultural businesses do not have real estate as the underlying collateral.  Instead of real estate, collateral could be assets such as equipment or accounts receivable or the personal guarantee of one or more guarantors.  These loans generally present a higher level of risk than loans secured by real estate because in the event of default by the borrower, the assets must be liquidated and/or guarantors pursued for deficit funds.  Farm assets are worth more while they are in use to produce income and worth significantly less if the farm is no longer in operation.

Consumer:  Consumer loans are generally loans to borrowers for non-business purposes.  They can be either secured or unsecured.  Consumer loans are generally small in the individual amount of principal outstanding and are repaid from the borrower’s private funds earned from employment.  Consumer lending risk is very susceptible to local economic trends.  If there is a consumer loan default, any collateral that may be repossessed is generally not well maintained and has a diminished value.  For this reason, consumer loans tend to have higher overall interest rates to cover the higher cost of repossession and charge-offs.  However, due to their smaller average balance per borrower, consumer loans are collectively evaluated for impairment in determining the appropriate allowance for loan losses.

Other:  All other loan types are aggregated together for credit risk evaluation due to the varying nature but small number of the remaining types of loans in the Company’s loan portfolio.  Loans in this segment include but are not limited to overdrafts.  Due to their smaller balance, other loans are collectively evaluated for impairment in determining the appropriate allowance for loan losses.  Due to the overall high level of real estate mortgage loans within the loan portfolio as a whole, as compared to other portfolio segments, for risk assessment and allowance purposes this segment was segregated into more granular pools by collateral property type.  Real estate construction loans have the highest qualitative adjustments for economic and other credit risk factors, such as the incomplete status of the collateral and the effect of the recent economic downturn on these types of properties.

The non-farm non-residential and the multi-family real estate mortgage loan portfolio segments had the next highest level of qualitative adjustments due to the effects of local markets and economies on the underlying collateral property values, as well as for industry concentrations and risks related to the this type of property.  Within the commercial portfolio, risk analysis is performed primarily based on the individual loan type.

Mortgage Servicing Rights:  The Bank has sold certain residential mortgage loans to the Federal Home Loan Mortgage Corporation (FHLMC) while retaining the servicing rights.

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Servicing rights are recognized separately when they are acquired through sales of loans.  When mortgage loans are sold, servicing rights are initially recorded at fair value with the income statement effect recorded in gain on sale of mortgage loans.  Fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income.  The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses.  All classes of servicing assets are subsequently measured using the amortization method which requires servicing rights to be amortized into loan service fee income, net, included in non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans.

Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to carrying amount.  Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type.  Impairment is recognized through a valuation allowance for an individual grouping, to the extent that fair value is less than the carrying amount.  If the Company later determines that all or a portion of the impairment no longer exists for a particular grouping, a reduction of the allowance may be recorded as an increase to income.  The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses.

Servicing fee income, which is reported on the income statement as loan service income, net, is recorded for fees earned for servicing loans.  The fees are based on a contractual percentage of the outstanding principal or a fixed amount per loan and are recorded as income when earned.  The amortization of mortgage servicing rights and valuation allowance are netted against loan servicing fee income.  Servicing fees totaled $510 thousand, $486 thousand, and $471 thousand for the years ended December 31, 2016, 2015 and 2014 and are included in loan service fee income in the income statement.  Late fees and ancillary fees related to loan servicing are not material.

Federal Home Loan Bank (FHLB) Stock:  The Bank is a member of the FHLB system. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts.  FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value.  Both cash and stock dividends are reported as income.

Bank Premises and Equipment:  Land is carried at cost.  Bank premises and equipment are stated at cost less accumulated depreciation.  Buildings and related components are depreciated using the straight-line method with useful lives ranging from 5 to 40 years.  Furniture, fixtures and equipment are depreciated using the straight-line (or accelerated) method with useful lives ranging from 3 to 10 years.

Real Estate Owned:  Real estate acquired through foreclosure is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis.  These assets are subsequently accounted for at the lower of cost or fair value less estimated costs to sell.  The value of the underlying loan is written down to the fair value of the real estate to be acquired by a charge to the allowance for loan losses, if necessary.  Any subsequent write-downs are charged to operating expenses.  Operating expenses of such properties, net of related income, and gains and losses on their disposition are included in other expenses.

Investments in Limited Partnerships:  Investments in limited partnerships represent the Company’s investments in affordable housing projects for the primary purpose of available tax benefits.  The Company is a limited partner in these investments and as such, the Company is not involved in the management or operation of such investments.  These investments are accounted for using the equity method of accounting.  Under the equity method of accounting, the Company records its share of the partnership’s earnings or losses in its income statement and adjusts the carrying amount of the investments on the balance sheet.  These investments are evaluated for impairment when events indicate the carrying amount may not be recoverable.  The investment recorded at December 31, 2016 was $4.7 million and $4.0 million at December 31, 2015, respectively, and is included with other assets in the balance sheet.

Repurchase Agreements:  Substantially all repurchase agreement liabilities represent amounts advanced by various customers.  Securities are pledged to cover these liabilities, which are not covered by federal deposit insurance.

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Stock-Based Compensation:  Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant.  A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the date of grant is used for restricted stock awards.  Compensation cost is recognized over the required service period, generally defined as the vesting period.  For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.

Income Taxes:  Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities.  Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates.  A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.

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 Company recognizes interest related to income tax matters as interest expense and penalties related to income tax matters as other expense.

Retirement Plans:  Employee 401(k) and profit sharing plan expense is the amount of matching contributions.

Goodwill and Intangible Assets:  Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually.  The Company has selected December 31 as the date to perform the annual impairment test.  Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values.  Goodwill is the only intangible asset with an indefinite life on our balance sheet.

Intangible assets consist of core deposit intangible assets arising from whole bank and branch acquisitions.  They are initially measured at fair value and then are amortized on either an accelerated or straight-line basis, over ten or fifteen years.

Purchased Credit Impaired Loans:  As part of the Madison Financial Corporation acquisition, the Company purchased loans, some of which have shown evidence of credit deterioration since origination. These purchased credit impaired loans are recorded at the amount paid, such that there is no carryover of the seller’s allowance for loan losses. After acquisition, losses are recognized by an increase in the allowance for loan losses. Such purchased credit impaired loans are accounted for individually.  The Company estimated the amount and timing of expected cash flows for each loan and the expected cash flows in excess of amount paid is recorded as interest income over the remaining life of the loan. The excess of the loan's contractual principal and interest over expected cash flows is not recorded (non-accretable difference).

Over the life of the loan, expected cash flows continue to be estimated.  If the present value of expected cash flows is less than the carrying amount, a loss is recorded as a provision for loan losses.  If the present value of expected cash flows is greater than the carrying amount, it is recognized as part of future interest income.

Loan Commitments and Related Financial Instruments:  Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs.  The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay.  Such financial instruments are recorded when they are funded.

Earnings Per Common Share:  Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period.  Diluted earnings per common share include the dilutive effect of additional potential common shares issuable under stock options.  Earnings and dividends per share are restated for all stock splits and dividends through the date of issuance of the financial statements.

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Comprehensive Income (Loss):  Comprehensive income consists of net income and other comprehensive income.  Other comprehensive income (loss) includes unrealized gains and losses on securities available for sale, which are also recognized as a separate component of equity.

Fair Value of Financial Instruments:  Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note.  Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items.  Changes in assumptions or in market conditions could significantly affect the estimates.

Operating Segments:  While the Company’s chief decision makers monitor the revenue streams of the various Company products and services, operations are managed and financial performance is evaluated on a Company-wide basis.  Accordingly, all of the Company’s operations are considered by management to be aggregated into one reportable operating segment: banking.

Reclassifications:  Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior yet net income or stockholders’ equity. 

Adoption of New Accounting Standards

ASU 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments.” Issued in August 2016, ASU 2016-15 provides guidance to reduce the diversity in practice of how certain cash receipts and cash payments are presented and classified in the statement of cash flows.  The amendments of ASU 2016-15 provide guidance on eight specific cash flow: (i) debt prepayment or debt extinguishment costs; (ii) settlement of zero-coupon bonds; (iii) contingent consideration payments made after a business combination; (iv) proceeds from the settlement of insurance claims; (v) proceeds from the settlement of corporate-owned life insurance policies, including bank-owned life insurance policies; (vi) distributions received from equity method investees; (vii) beneficial interests in securitization transactions and (viii) separately identifiable cash flows and application of the predominance principle.  The amendments of ASU 2016-15 are effective for interim and annual periods beginning after December 15, 2017.  Management has evaluated the amendments of ASU 2016-15 and does not believe that adoption of this ASU will impact Kentucky Bancshares existing presentation of the applicable cash receipts and cash payments on its consolidated statements of cash flows.

ASU 2016-13, “Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.”  Issued in June 2016, ASU 2016-13 will add FASB ASC Topic 326, “Financial Instruments-Credit Losses” and finalizes amendments to FASB ASC Subtopic 825-15, “Financial Instruments-Credit Losses.”  The amendments of ASU 2016-13 are intended to provide financial statement users with more decision-useful information related to expected credit losses on financial instruments and other commitments to extend credit by replacing the current incurred loss impairment methodology with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to determine credit loss estimates.  The amendments of ASU 2016-13 eliminate the probable initial recognition threshold and, in turn, reflect an entity’s current estimate of all expected credit losses.  ASU 2016-13 does not specify the method for measuring expected credit losses, and an entity is allowed to apply methods that reasonably reflect its expectations of the credit loss estimate.  Additionally, the amendments of ASU 2016-13 require that credit losses on available for sale debt securities be presented as an allowance rather than as a write-down.  The amendments of ASU 2016-13 are effective for interim and annual periods beginning after December 15, 2019.  Earlier application is permitted for interim and annual periods beginning after December 15, 2018.  Kentucky Bancshares plans to adopt the amendments of ASU 2016-13 during the first quarter of 2020.  

Kentucky Bancshares has established a steering committee which includes the appropriate members of Management to evaluate the impact this ASU will have on the Company’s financial position, results of operations and financial statement disclosures and determine the most appropriate method of implementing the amendments in this ASU as well as any resources needed to implement the amendments.

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ASU 2016-09, “Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting.”  Issued in March 2016, ASU 2016-09 seeks to reduce complexity in accounting standards by simplifying several aspects of the accounting for share-based payment transactions.  The amendments of ASU 2016-09 include: (i) requiring all excess tax benefits and tax deficiencies to be recognized as income tax expense or benefit in the income statement; (ii) requiring excess tax benefits to be classified along with other income tax cash flows as an operating activity on the statement of cash flow; (iii) allowing an entity to make an entity-wide accounting policy election to either estimate the number of awards that expect to vest or account for forfeitures when they occur; (iv) change the threshold to qualify for equity classification to permit withholding up to the maximum statutory tax rates in the applicable jurisdictions; and (v) requiring that cash paid by an employer when directly withholding shares for tax-withholding purposes to be classified as a financing activity on the statement of cash flows.  The amendments of ASU 2016-09 became effective for Kentucky Bancshares on January 1, 2017 and did not have a material impact on Kentucky Bancshares consolidated financial statements.  The Company has made an entity-wide accounting policy election to account for forfeitures of stock awards as they occur.  Changes to Kentucky Bancshares consolidated statement of cash flows required by the amendments of ASU 2016-09 will be presented in the Quarterly Report on Form 10-Q for the three month period ending March 31, 2017.  

ASU 2016-02, “Leases (Topic 842).” Issued in February 2016, ASU 2016-02 was issued by the FASB to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and by disclosing key information about leasing arrangements.  ASU 2016-02 will, among other things, require lessees to recognize a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. ASU 2016-02 does not significantly change lease accounting requirements applicable to lessors; however, the ASU contains some targeted improvements that are intended to align, where necessary, lessor accounting with the lessee accounting model and with the updated revenue recognition guidance issued in 2014.  The amendments of ASU 2016-02 are effective for interim and annual periods beginning after December 15, 2018.  Kentucky Bancshares plans to adopt the amendments of ASU 2016-02 beginning in the first quarter of 2019.  At adoption, Kentucky Bancshares will recognize a lease asset and a corresponding lease liability on its consolidated balance sheet for its total lease obligation measured on a discounted basis.  As of December 31, 2016, all leases in which Kentucky Bancshares was the lessee were classified as operating leases.  Kentucky Bancshares does not anticipant any material impact to its consolidated statements of income as a result of the adoption of this ASU.  The Company has an immaterial amount of leases in which it is the lessor.  Based on Management’s evaluation to date, the Company does not expect the amendments of ASU 2016-02 to have any material impact to these leases or the related income.  Management will continue to evaluate the impact this ASU will have on the Company’s consolidated financial statements; however, the adoption of ASU 2016-02 is not expected to have a material impact on Kentucky Bancshares consolidated financial statements.

ASU 2016-01, “Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (An Amendment of the FASB Accounting Standards Codification).”  Issued in January 2016, ASU 2016-01 is intended to enhance the reporting model for financial instruments to provide users of financial statements with improved decision-making information.  The amendments of ASU 2016-01 include: (i) requiring equity investments, except those accounted for under the equity method of accounting or those that result in the consolidation of an investee, to be measured at fair value with changes in fair value recognized in net income; (ii) requiring a qualitative assessment to identify impairment of equity investments without readily determinable fair values; (iii) eliminating the requirement to disclose the method and significant assumptions used to estimate the fair value for financial instruments measured at amortized cost on the balance sheet; (iv) requiring the use of the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (v) requiring an entity that has elected the fair value option to measure the fair value of a liability to present separately in other comprehensive income the portion of the change in the fair value resulting from a change in the instrument-specific credit risk; (vi) requiring separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements and (vii) clarifying that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available for sale securities in combination with the entity’s other deferred tax assets.  The amendments of ASU 2016-01 are effective for interim and annual periods beginning after December 15, 2017.  Kentucky Bancshares plans to adopt the amendments of ASU 2016-01 during the first quarter of 2018.  Management has evaluated the impact this ASU will have on the Company’s consolidated financial statements.

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Through this evaluation, Management has determined that the principal areas impacted by the amendments of ASU 2016-01 will be Kentucky Bancshares investment in member bank stock, which are equity securities that do not have readily determinable fair values, and various fair value related disclosures.  See Note 1 – Significant Accounting Policies, “Federal Home Loan Bank (FHLB): for information regarding Kentucky Bancshares investment in member bank stock.  The adoption of ASU 2016-01 is not expected to have a material impact on the Company’s consolidated financial statements.

ASU 2014-09, “Revenue from Contracts with Customers (Topic 606).” Issued in May 2014, ASU 2014-09 will add FASB ASC Topic 606, “Revenue from Contracts with Customers,” and will supersede revenue recognition requirements in FASB ASC Topic 605, “Revenue Recognition,” as well as certain cost guidance in FASB ASC Topic 605-35, “Revenue Recognition – Construction-Type and Production-Type Contracts.”  ASU 2014-09 provides a framework for revenue recognition that replaces the existing industry and transaction specific requirements under the existing standards.  ASU 2014-09 requires an entity to apply a five-step model to determine when to recognize revenue and at what amount.  The model specifies that revenue should be recognized when (or as) an entity transfers control of goods or services to a customer at the amount in which the entity expects to be entitled.  Depending on whether certain criteria are met, revenue should be recognized either over time, in a manner that depicts the entity’s performance, or at a point in time, when control of the goods or services are transferred to the customer.  ASU 2014-09 provides that an entity should apply the following steps: (1) identify the contract(s) with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations in the contract; and (5) recognize revenue when, or as, the entity satisfies a performance obligation.  In addition, the existing requirements for the recognition of a gain or loss on the transfer of non-financial assets that are not in a contract with a customer are amended to be consistent with the guidance on recognition and measurement in ASU 2014-09.  The amendments of ASU 2014-09 may be applied either retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying ASU 2014-09 recognized at the date of initial application.  If the transition method of application is elected, the entity should also provide the additional disclosures in reporting periods that include the date of initial application of (1) the amount by which each financial statement line item is affected in the current reporting period, as compared to the guidance that was in effect before the change, and (2) an explanation of the reasons for significant changes.  ASU 2015-14, “Revenue from Contracts with Customers (Topic 606)-Deferral of the Effective Date,” issued in August 2015, defers the effective date of ASU 2014-09 by one year.  ASU 2015-14 provides that the amendments of ASU 2014-09 become effective for interim and annual periods beginning after December 15, 2017.  Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period.  All subsequently issued ASUs which provide additional guidance and clarifications to various aspects of FASB ASC Topic 606 will become effective when the amendments of ASU 2014-09 become effective.  Kentucky Bancshares plans to adopt these amendments during the first quarter of 2018.  Management is continuing to evaluate the impact ASU 2014-09 will have on Kentucky Bancshares consolidated financial statements as well as the most appropriate transition method of application.  Based on this evaluation to date, Management has determined that the majority of the revenues earned by Kentucky Bancshares are not within the scope of ASU 2014-09.  Management also believes that for most revenue streams within the scope of ASU 2014-09, the amendments will not change the timing of when the revenue is recognized.  Management will continue to evaluate the impact the adoption of ASU 2014-09 will have on Kentucky Bancshares consolidated financial statements, focusing on noninterest income sources within the scope of ASU 2014-09 as well as new disclosures required by these amendments; however, the adoption of ASU 2014-09 is not expected to have a material impact on Kentucky Bancshares consolidated financial statements.

NOTE 2 - RESTRICTIONS ON CASH AND DUE FROM BANKS

Included in cash and due from banks are certain interest bearing deposits that are held at the Federal Reserve or maintained in vault cash in accordance with average balance requirements specified by the Federal Reserve Board of Governors.  The reserve requirement was $2.3 million at December 31, 2016 and $0 at December 31, 2015.

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NOTE 3 - SECURITIES AVAILABLE FOR SALE

The following table summarizes the amortized cost and fair value of the securities at December 31, 2016 and 2015 and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) were as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
Available for Sale
December 31, 2016
U. S. government agencies	$	36,454	$	373	$	(299)	$	36,528
States and political subdivisions		90,117		1,731		(716)		91,132
Mortgage-backed - residential		148,327		120		(2,677)		145,770
Equity securities		320		20		—		340
Total	$	275,218	$	2,244	$	(3,692)	$	273,770
December 31, 2015
U. S. government agencies	$	49,012	$	51	$	(200)	$	48,863
States and political subdivisions		89,501		2,644		(183)		91,962
Mortgage-backed - residential		124,834		210		(2,001)		123,043
Equity securities		320		24		—		344
Total	$	263,667	$	2,929	$	(2,384)	$	264,212

The amortized cost and fair value of securities at December 31, 2016, by contractual maturity, are shown below.  Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.  Securities not due at a single maturity are shown separately.

	Amortized		Fair
	Cost		Value
Due in one year or less	$	3,300	$	3,299
Due after one year through five years		22,097		22,486
Due after five years through ten years		55,715		55,829
Due after ten years		45,459		46,046
		126,571		127,660
Mortgage-backed - residential		148,327		145,770
Equity		320		340
Total	$	275,218	$	273,770

Trading assets totaling $5.6 million are excluded from securities available for sale and consist primarily of municipal securities which are generally held for a minimal period of time.

Proceeds from sales of securities during 2016, 2015 and 2014 were $23.9 million, $21.7 million and $74.0 million. Gross gains of $317 thousand, $425 thousand, and $1.4 million and gross losses of $30 thousand, $13 thousand and $400 thousand, were realized on those sales, respectively.  The tax provision related to these realized gains and losses was $98 thousand, $140 thousand and $328 thousand, respectively.

Securities with an approximate carrying value of $252.4 million and $246.2 million at December 31, 2016 and 2015, were pledged to secure public deposits, trust funds, securities sold under agreements to repurchase and for other purposes as required or permitted by law.

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Securities with unrealized losses at year end 2016 and 2015 not recognized in income are as follows:

2016

	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 agencies	$	28,202	$	(299)	$	—	$	—	$	28,202	$	(299)
States and municipals		27,834		(716)		—		—		27,834		(716)
Mortgage-backed - residential		119,802		(1,938)		13,652		(739)		133,454		(2,677)
Total temporarily impaired	$	175,838	$	(2,953)	$	13,652	$	(739)	$	189,490	$	(3,692)

2015

	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 agencies	$	15,243	$	(56)	$	30,293	$	(144)	$	45,536	$	(200)
States and municipals		10,938		(102)		4,065		(81)		15,003		(183)
Mortgage-backed - residential		77,898		(1,231)		23,488		(770)		101,386		(2,001)
Total temporarily impaired	$	104,079	$	(1,389)	$	57,846	$	(995)	$	161,925	$	(2,384)

The Company evaluates securities for other than temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation.  In analyzing an issuer’s financial condition, the Company may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.

Unrealized losses on securities have not been recognized into income because the issues are of high credit quality, management does not intend to sell and it is more likely than not that management would be required to sell the securities prior to their anticipated recovery, and the decline in fair value is largely due to changes in interest rates.  The fair value is expected to recover as the securities approach maturity.

At December 31, 2016, eleven U.S. government agency securities have unrealized losses of 1.1% from their amortized cost, seventy mortgage-backed securities have unrealized losses of 1.6% from their amortized cost basis, and fifty two states and municipals have unrealized losses of 1.8% from their amortized cost basis.  Management believes the declines in fair value from these and other securities are largely due to changes in interest rates.  The Company believes there is no other than temporary impairment and does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery.

NOTE 4 - LOANS

Loans at year-end were as follows:

	12/31/2016		12/31/2015
Commercial	$	77,436	$	55,929
Real estate construction		29,169		29,320
Real estate mortgage:
1-4 family residential		244,638		230,721
Multi-family residential		47,199		38,281
Non-farm & non-residential		176,024		183,692
Agricultural		62,491		66,782
Consumer		18,867		18,880
Other		183		516
Total	$	656,007	$	624,121

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As discussed under Footnote 23 “Acquisition”, the above loan balances include loans purchased in the acquisition of Madison Financial Corporation.  All loan balances acquired in the Madison Financial Corporation acquisition have no allocated allowance for loan losses. The composition of loans acquired, as of December 31, 2016 and December 31, 2015, is as follows:

	12/31/2016		12/31/2015
Commercial	$	1,113	$	1,505
Real estate construction		398		1,616
Real estate mortgage:
1-4 family residential		11,462		16,376
Multi-family residential		5,043		5,652
Non-farm & non-residential		13,024		29,029
Agricultural		1,940		2,194
Consumer		107		379
Total	$	33,087	$	56,751

The following table presents the activity in the allowance for loan losses by portfolio segment for the years ending December 31, 2016, 2015 and 2014 (in thousands):

	Beginning								Ending
December 31, 2016	Balance		Charge-offs		Recoveries		Provision		Balance
Commercial	$	486	$	(5)	$	39	$	269	$	789
Real estate Construction		411		—		15		138		564
Real estate mortgage:
1-4 family residential		2,081		(126)		19		327		2,301
Multi-family residential		458		—		12		111		581
Non-farm & non-residential		1,213		—		454		(464)		1,203
Agricultural		678		(193)		50		321		856
Consumer		525		(298)		80		240		547
Other		60		(908)		731		177		60
Unallocated		609		—		—		31		640
	$	6,521	$	(1,530)	$	1,400	$	1,150	$	7,541

	Beginning								Ending
December 31, 2015	Balance		Charge-offs		Recoveries		Provision		Balance
Commercial	$	339	$	(30)	$	—	$	177	$	486
Real estate Construction		446		—		11		(46)		411
Real estate mortgage:
1-4 family residential		1,829		(284)		33		503		2,081
Multi-family residential		495		(94)		30		27		458
Non-farm & non-residential		813		—		86		314		1,213
Agricultural		998		(242)		23		(101)		678
Consumer		520		(283)		66		222		525
Other		32		(1,017)		760		285		60
Unallocated		540		—		—		69		609
	$	6,012	$	(1,950)	$	1,009	$	1,450	$	6,521

53

	Beginning								Ending
December 31, 2014	Balance		Charge-offs		Recoveries		Provision		Balance
Commercial	$	230	$	(258)	$	—	$	367	$	339
Real estate Construction		358		—		14		74		446
Real estate mortgage:
1-4 family residential		2,169		(274)		59		(125)		1,829
Multi-family residential		427		(42)		57		53		495
Non-farm & non-residential		564		—		368		(119)		813
Agricultural		578		(8)		27		401		998
Consumer		548		(239)		67		144		520
Other		51		(519)		369		131		32
Unallocated		516		—		—		24		540
	$	5,441	$	(1,340)	$	961	$	950	$	6,012

Purchased Credit Impaired Loans:

The Company has purchased loans, for which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected.  The carrying amount of those loans totaled $1.9 million at December 31, 2016 and $3.5  million at December 31, 2015.

There was no associated allowance for loan losses as of December 31, 2016 or December 31, 2015 for purchased credit impaired loans.  The contractually required payments of these loans were $2.6 million at December 31, 2016.

Accretable yield, or income expected to be collected, is as follows (in thousands):

	Year Ended		Year Ended
	12/31/2016		12/31/2015
Balance, beginning of period	$	408	$	—
New loans purchased		—		505
Accretion of income		168		97
Balance, end of period	$	240	$	408

54

The following tables present the balance in the allowance for loan losses and the recorded investment (excluding accrued interest receivable amounting to $2.4 million and $2.3 million) in loans by portfolio segment and based on impairment method as of December 31, 2016 and December 31, 2015 (in thousands):

	Individually		Collectively		Purchased
	Evaluated for		Evaluated for		Credit
As of December 31, 2016	Impairment		Impairment		Impaired		Total
Allowance for Loan Losses:
Commercial	$	—	$	789	$	—	$	789
Real estate construction		—		564		—		564
Real estate mortgage:
1-4 family residential		99		2,202		—		2,301
Multi-family residential		—		581		—		581
Non-farm & non-residential		15		1,188		—		1,203
Agricultural		427		429		—		856
Consumer		—		547		—		547
Other		—		60		—		60
Unallocated		—		640		—		640
	$	541	$	7,000	$	—	$	7,541
Loans:
Commercial	$	97	$	77,339	$	—	$	77,436
Real estate construction		153		29,016		—		29,169
Real estate mortgage:
1-4 family residential		2,704		240,906		1,028		244,638
Multi-family residential		—		46,637		562		47,199
Non-farm & non-residential		1,725		174,154		145		176,024
Agricultural		3,315		58,998		178		62,491
Consumer		—		18,867		—		18,867
Other		—		183		—		183
	$	7,994	$	646,100	$	1,913	$	656,007

	Individually		Collectively		Purchased
	Evaluated for		Evaluated for		Credit
As of December 31, 2015	Impairment		Impairment		Impaired		Total
Allowance for Loan Losses:
Commercial	$	—	$	486	$	—	$	486
Real estate construction		—		411		—		411
Real estate mortgage:
1-4 family residential		128		1,953		—		2,081
Multi-family residential		—		458		—		458
Non-farm & non-residential		181		1,032		—		1,213
Agricultural		339		339		—		678
Consumer		—		525		—		525
Other		—		60		—		60
Unallocated		—		609		—		609
	$	648	$	5,873	$	—	$	6,521
Loans:
Commercial	$	—	$	55,924	$	5		55,929
Real estate construction		835		28,474		11		29,320
Real estate mortgage:
1-4 family residential		1,454		226,523		2,744		230,721
Multi-family residential		—		38,281		—		38,281
Non-farm & non-residential		2,882		179,913		897		183,692
Agricultural		4,298		61,921		563		66,782
Consumer		—		18,880		—		18,880
Other		—		516		—		516
Total	$	9,469	$	610,432	$	4,220	$	624,121

55

The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2016

	Unpaid				Allowance for		Average		Interest		Cash Basis
	Principal		Recorded		Loan Losses		Recorded		Income		Interest
(in thousands):	Balance		Investment		Allocated		Investment		Recognized		Recognized
With no related allowance recorded:
Commercial	$	97	$	97	$	—	$	48	$	30	$	30
Real estate construction		153		153		—		494		9		9
Real estate mortgage:
1-4 family residential		606		606		—		488		—		—
Multi-family residential		—		—		—		—		—		—
Non-farm & non-residential		—		—		—		—		—		—
Agricultural		654		654		—		561		—		—
Consumer		—		—		—		—		—		—
Other		—		—		—		—		—		—
With an allowance recorded:
Commercial		—		—		—		—		—		—
Real estate construction		—		—		—		—		—		—
Real estate mortgage
1-4 family residential		2,098		2,098		99		1,590		56		56
Multi-family residential		—		—		—		—		—		—
Non-farm & non-residential		1,725		1,725		15		2,303		71		71
Agricultural		2,661		2,661		427		3,309		25		25
Consumer		—		—		—		—		—		—
Other		—		—		—		—		—		—
Total	$	7,994	$	7,994	$	541	$	8,795	$	191	$	191

The recorded investment in loans excludes accrued interest receivable and loan origination fees, net due to immateriality.

The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2015.

	Unpaid				Allowance for		Average		Interest		Cash Basis
	Principal		Recorded		Loan Losses		Recorded		Income		Interest
(in thousands):	Balance		Investment		Allocated		Investment		Recognized		Recognized
With no related allowance recorded:
Commercial	$	—	$	—	$	—	$	—	$	—	$	—
Real estate construction		835		835		—		820		29		29
Real estate mortgage:
1-4 family residential		370		370		—		1,493		15		15
Multi-family residential		—		—		—		—		—		—
Non-farm & non-residential		—		—		—		68		—		—
Agricultural		469		469		—		335		14		14
Consumer		—		—		—		—		—		—
Other		—		—		—		—		—		—
With an allowance recorded:
Commercial		—		—		—		—		—		—
Real estate construction		—		—		—		—		—		—
Real estate mortgage
1-4 family residential		1,083		1,083		128		1,916		6		6
Multi-family residential		—		—		—		24		—		—
Non-farm & non-residential		2,882		2,882		181		2,885		29		29
Agricultural		3,830		3,830		339		4,379		—		—
Consumer		—		—		—		—		—		—
Other		—		—		—		—		—		—
Total	$	9,469	$	9,469	$	648	$	11,920	$	93	$	93

56

The recorded investment in loans excludes accrued interest receivable and loan origination fees, net due to immateriality.

The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2014

	Unpaid				Allowance for		Average		Interest		Cash Basis
	Principal		Recorded		Loan Losses		Recorded		Income		Interest
(in thousands):	Balance		Investment		Allocated		Investment		Recognized		Recognized
With no related allowance recorded:
Commercial	$	—	$	—	$	—	$	—	$	—	$	—
Real estate construction		—		—		—		—		—		—
Real estate mortgage:
1-4 family residential		1,618		1,618		—		1,147		25		25
Multi-family residential		—		—		—		—		—		—
Non-farm & non-residential		—		—		—		552		—		—
Agricultural		442		442		—		2,696		29		29
Consumer		—		—		—		—		—		—
Other		—		—		—		—		—		—
With an allowance recorded:
Commercial		—		—		—		—		—		—
Real estate construction		—		—		—		—		—		—
Real estate mortgage
1-4 family residential		480		480		56		990		18		18
Multi-family residential		264		264		94		284		5		5
Non-farm & non-residential		2,958		2,958		136		3,173		115		115
Agricultural		8,037		8,037		712		5,341		116		116
Consumer		—		—		—		—		—		—
Other		—		—		—		—		—		—
Total	$	13,799	$	13,799	$	998	$	14,183	$	308	$	308

The recorded investment in loans excludes accrued interest receivable and loan origination fees, net due to immateriality.

Nonperforming loans include impaired loans and smaller balance homogeneous loans, such as residential mortgage and consumer loans, that are collectively evaluated for impairment.

Nonaccrual loans secured by real estate make up 96.9% of the total nonaccrual loans.

The following tables present the recorded investment in nonaccrual loans, loans past due over 90 days still on accrual, and troubled debt restructurings, excluding purchase credit impaired loans, by class of loans as of December 31, 2016 and 2015 (in thousands):

			Loans Past Due
			Over 90 Days
			Still		Troubled Debt
As of December 31, 2016	Nonaccrual		Accruing		Restructurings
Commercial	$	3	$	11	$	—
Real estate construction		—		153		—
Real estate mortgage:
1-4 family residential		2,725		31		338
Multi-family residential		25		—		—
Non-farm & non-residential		272		—		1,725
Agricultural		1,541		724		—
Consumer		—		8		—
Total	$	4,566	$	927	$	2,063
Loans included in totals above acquired from Madison Financial Corporation	$	578	$	22	$	—

57

			Loans Past Due
			Over 90 Days
			Still		Troubled Debt
As of December 31, 2015	Nonaccrual		Accruing		Restructurings
Commercial	$	6	$	—	$	—
Real estate construction		145		365		—
Real estate mortgage:
1-4 family residential		1,531		471		468
Multi-family residential		—		—		—
Non-farm & non-residential		481		137		1,777
Agricultural		4,171		—		—
Consumer		17		27		—
Other		—		—		—
Total	$	6,351	$	1,000	$	2,245
Loans included in totals above acquired from Madison Financial Corporation	$	1,107	$	446	$	—

The following tables present the aging of the recorded investment in past due and non-accrual loans as of December 31, 2016 and 2015 by class of loans (in thousands):

2016	30–59		60–89		Greater than				Total
	Days		Days		90 Days				Past Due &		Loans Not
(in thousands)	Past Due		Past Due		Past Due		Non-accrual		Non-accrual		Past Due
Commercial	$	54	$	45	$	11	$	3	$	113	$	77,323
Real estate construction		—		—		153		—		153		29,016
Real estate mortgage:
1-4 family residential		2,310		228		31		2,725		5,294		239,344
Multi-family residential		391		3		—		25		419		46,780
Non-farm & non-residential		159		61		—		272		492		175,532
Agricultural		647		61		724		1,541		2,973		59,518
Consumer		97		37		8		—		142		18,725
Other		—		—		—		—		—		183
Total	$	3,658	$	435	$	927	$	4,566	$	9,586	$	646,421
Loans included in totals above acquired from Madison Financial Corp.	$	155	$	—	$	22	$	578	$	755	$	32,332

58

2015	30–59		60–89		Greater than				Total
	Days		Days		90 Days				Past Due &		Loans Not
(in thousands)	Past Due		Past Due		Past Due		Non-accrual		Non-accrual		Past Due
Commercial	$	2,323	$	99	$	—	$	6	$	2,428	$	53,501
Real estate construction		—		—		365		145		510		28,810
Real estate mortgage:
1-4 family residential		1,508		264		471		1,531		3,774		226,947
Multi-family residential		—		—		—		—		—		38,281
Non-farm & non-residential		37		121		137		481		776		182,916
Agricultural		229		251		—		4,171		4,651		62,131
Consumer		50		45		27		17		139		18,741
Other		—		—		—		—		—		516
Total	$	4,147	$	780	$	1,000	$	6,351	$	12,278	$	611,843
Loans included in totals above acquired from Madison Financial Corp.	$	5	$	84	$	446	$	1,107	$	1,642	$	55,109

Troubled Debt Restructurings:

At December 31, 2016 and 2015, the Company had a recorded investment in troubled debt restructurings of $2.1 million and $2.2 million.  The Company has allocated $40 thousand and $101 thousand in reserves to customers whose loan terms have been modified in troubled debt restructurings as of December 31, 2016 and 2015.  The Company has not committed to lend additional amounts as of December 31, 2016 and 2015 to customers with outstanding loans that are classified as troubled debt restructurings.

During the years ending December 31, 2016 and 2015, no loans were modified that met the definition of troubled debt restructuring.

The allowance for loan losses for loans classified as troubled debt restructurings decreased $61 thousand for the year ending December 31, 2016 and increased $101 thousand for the year ending December 31, 2015.  Loans classified as troubled debt restructurings  resulted in no charge offs during the periods ending December 31, 2016 and 2015.  For the years ending December 31, 2016, 2015 and 2014, no loans modified as troubled debt restructurings had defaulted on payment.

Credit Quality Indicators:

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as:  current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors.  The Company analyzes loans individually by classifying the loans as to credit risk.  This analysis includes primarily non-homogeneous loans with an outstanding balance greater than $200 thousand such as commercial and commercial real estate loans.  This analysis is performed on a quarterly basis.  The Company uses the following definitions for risk ratings:

Special Mention.  Loans classified as special mention have a potential weakness that deserves management’s close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.

Substandard.  Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any.  Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.  They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Doubtful.  Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

59

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans.  The following tables present the risk category of loans by class of loans, based on the most recent analysis performed, as of December 31, 2016 and 2015 (in thousands):

			Special
(in thousands)	Pass		Mention		Substandard		Doubtful
Commercial	$	76,346	$	1,078	$	12	$	—
Real estate construction		28,577		—		592		—
Real estate mortgage:
1-4 family residential		232,969		4,031		7,627		11
Multi-family residential		43,681		2,617		901		—
Non-farm & non-residential		167,451		8,185		388		—
Agricultural		58,155		1,367		2,969		—
Total	$	607,179	$	17,278	$	12,489	$	11
Loans included in totals above acquired from Madison Financial Corporation	$	30,359	$	480	$	2,248	$	—

			Special
(in thousands)	Pass		Mention		Substandard		Doubtful
Commercial	$	54,392	$	1,323	$	215	$	—
Real estate construction		26,835		1,402		1,083		—
Real estate mortgage:
1-4 family residential		216,661		6,155		7,903		—
Multi-family residential		35,221		2,916		143		—
Non-farm & non-residential		178,289		4,448		955		—
Agricultural		60,177		1,198		5,407		—
Total	$	571,575	$	17,442	$	15,706	$	—
Loans included in totals above acquired from Madison Financial Corporation	$	44,367	$	2,533	$	3,189	$	—

For consumer loans, the Company evaluates the credit quality based on the aging of the recorded investment in loans, which was previously presented.  Non-performing consumer loans are loans which are greater than 90 days past due or on non-accrual status, and total $8 thousand at December 31, 2016 and $44 thousand at December 31, 2015.

Non-consumer loans with an outstanding balance less than $200 thousand are evaluated similarly to consumer loans. Loan performance is evaluated based on delinquency status. Both are reviewed at least quarterly and credit quality grades are updated as needed.

Certain directors and executive officers of the Company and companies in which they have beneficial ownership were loan customers of the Bank during 2016 and 2015.  An analysis of the activity with respect to all director and executive officer loans is as follows (in thousands):

	2016		2015
Balance, beginning of year	$	1,673	$	1,706
New loans		74		—
Effect of changes in composition of related parties		(590)		—
Repayments		(9)		(33)
Balance, end of year	$	1,148	$	1,673

60

Loan Servicing

Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets.  The unpaid principal balances of mortgage loans serviced for others were approximately $206.8 million and $196.2 million at December 31, 2016 and 2015.  Custodial escrow balances maintained in connection with the foregoing loan servicing, and included in demand deposits, were approximately $935 thousand and $890 thousand at December 31, 2016 and 2015.

Activity for mortgage servicing rights and the related valuation allowance follows (in thousands):

	2016		2015		2014
Servicing Rights, net:
Beginning balance	$	1,277	$	1,209	$	1,344
Additions		483		348		270
Amortization		(334)		(339)		(385)
Change in valuation allowance		(105)		59		(20)
Ending balance	$	1,321	$	1,277	$	1,209
Valuation Allowance:
Beginning balance	$	20	$	79	$	59
Additions expensed		109		—		34
Reductions credited to operations		4		59		14
Ending balance	$	125	$	20	$	79

The fair value of servicing rights was $1.8 million and $1.7 million at year-end 2016 and 2015.  Fair value at year-end 2016 was determined using a discount rate of 12.0%, prepayment speeds ranging from 8.5% to 45.0%, depending on the stratification of the specific right, and default rates ranging from 0.1% to 0.9%. Fair value at year-end 2015 was determined using a discount rate of 12.0%, prepayment speeds ranging from 8.1% to 21.0%, depending on the stratification of the specific right, and default rates ranging from 0.1% to 0.9%. 

The weighted average amortization period is 16.3 years.  Estimated amortization expense for each of the next five years is (in thousands):

2017	$	212
2018		162
2019		125
2020		101
2021		82

61

NOTE 5 - REAL ESTATE OWNED

Activity in real estate owned was as follows (in thousands):

	Year Ended
	December 31,
	2016		2015
Beginning of year, net	$	2,347	$	4,603
Additions		3,735		3,394
Acquired with Madison Financial Corporation		—		445
Sales		(4,071)		(7,062)
(Additions) subtractions to valuation allowance, net		(187)		967
End of period, net	$	1,824	$	2,347

Activity in the valuation allowance was as follows (in thousands):

	Year Ended
	December 31,
	2016		2015			2014
Beginning of year	$	616	$	1,583	$	1,524
Write-downs of other real estate, net		187		252		144
Reductions from sale		—		(1,219)		(85)
End of Period	$	803	$	616	$	1,583

Expenses related to foreclosed assets include (in thousands):

	Year Ended
	December 31,
	2016		2015			2014
Net (gain) loss on sales, included in other income on income statement	$	(128)	$	(5)	$	(146)
Additions to valuation allowance, net		187		252		144
Operating expenses, net of rental income		214		164		227
Repossession expense, net		401		416		371
Net expenses	$	273	$	411	$	225

62

NOTE 6 - PREMISES AND EQUIPMENT

Year-end premises and equipment were as follows (in thousands):

	2016		2015
Land and buildings	$	20,076	$	20,755
Furniture and equipment		17,785		17,773
Construction in process		438		—
		38,299		38,528
Less accumulated depreciation		(22,549)		(21,931)
		15,750		16,597
Less:  Held for sale		(969)		—
	$	14,781	$	16,597

Depreciation expense was $1.3 million, $1.4 million and $1.3 million in 2016, 2015, and 2014.

Certain premises, not included in premises and equipment above, are leased under operating leases.  Minimum rental payments are as follows (in thousands):

2017	$	308
2018		307
2019		309
2020		271
2021		276
Thereafter		819
	$	2,290

NOTE 7 - GOODWILL AND INTANGIBLE ASSETS

The change in balance for goodwill during the year is as follows (in thousands):

	2016		2015		2014
Beginning of year	$	14,001	$	13,117	$	13,117
Acquired goodwill		—		884		—
Impairment		—		—		—
End of year	$	14,001	$	14,001	$	13,117

Goodwill is not amortized but instead evaluated periodically for impairment.

Impairment exists when a reporting unit’s carrying value of goodwill exceeds its fair value, which is determined through a two-step impairment test.  Step 1 includes the determination of the carrying value of our single reporting unit, including the existing goodwill and intangible assets, and estimating the fair value of the reporting unit.  We determined the fair value of our reporting unit and compared it to its carrying amount.  If the carrying amount of a reporting unit exceeds its fair value, we are required to perform a second step to the impairment test.

Our annual impairment analysis as of December 31, 2016 and 2015 indicated that the Step 2 analysis was not necessary.  If needed, Step 2 of the goodwill impairment test is performed to measure the impairment loss.  Step 2 requires that the implied fair value of the reporting unit goodwill be compared to the carrying amount of that goodwill.  If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess.

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Acquired intangible assets were as follows at year-end (in thousands):

	2016				2015
	Gross				Gross
	Carrying		Accumulated		Carrying		Accumulated
	Amount		Amortization		Amount		Amortization
Amortized intangible assets:
Core deposit intangibles	$	800	$	271	$	3,330	$	2,557

Aggregate amortization expense was $244 thousand, $205 thousand and $140 thousand for 2016, 2015 and 2014.

Estimated amortization expense for each of the next five years (in thousands):

2017	$	160
2018		131
2019		102
2020		74
2021		45

NOTE 8 - DEPOSITS

Time deposits of $250 thousand or more were $74.3 million and $61.2 million at year-end 2016 and 2015, respectively.

At December 31, 2016, the scheduled maturities of time deposits for the next five years are as follows (in thousands):

2017	$	140,877
2018		30,081
2019		11,118
2020		10,679
2021		9,806

Certain directors and executive officers of the Company and companies in whom they have beneficial ownership are deposit customers of the Bank. The amount of these deposits was approximately $5.8 million and $7.3  million at December 31, 2016 and 2015.

NOTE 9 - REPURCHASE AGREEMENTS AND OTHER BORROWINGS

Securities sold under agreements to repurchase are secured by U.S. Government securities and mortgage-backed securities with a total carrying amount of $29.4 million and $18.5 million at year-end 2016 and 2015.

Repurchase agreements range in maturities from 1 day to 41 months.  The securities underlying the agreements are maintained in a third-party custodian’s account under a written custodial agreement.  Information concerning repurchase agreements for 2016, 2015 and 2014 is summarized as follows (in thousands):

	2016			2015			2014
Average daily balance during the year	$	23,755		$	16,596		$	12,270
Average interest rate during the year		0.45	%		0.59	%		0.76	%
Maximum month-end balance during the year	$	27,214		$	19,874		$	13,788
Weighted average interest rate at year end		0.50	%		0.54	%		0.75	%

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On July 20, 2015, the Company borrowed $5 million which had an outstanding balance of $4.1 million at December 31, 2016 and $4.8 million at December 31, 2015. The term loan has a fixed interest rate of 5.02%, requires quarterly principal and interest payments, matures July 20, 2025 and is collateralized by the Company’s stock. The maturity schedule for the term loan as of December 31, 2016 is as follows:

2017	$	383
2018		403
2019		423
2020		445
2021		467
Thereafter		1,969
	$	4,090

At December 31, 2015 the Company had a $5 million revolving promissory note with a maturity date of July 19, 2016.  Upon maturity, the Company renewed the revolving promissory note. The new note has similar terms as the original note and matures July 18, 2017. The Company had no outstanding balances related to this promissory note at December 31, 2016 or 2015.

NOTE 10 - FEDERAL HOME LOAN BANK ADVANCES

At year-end, advances from the Federal Home Loan Bank were as follows (in thousands):

	2016		2015
Long Term Advances
Maturities range from June 2017 through March 2030, fixed rates from 1.00% to 6.86%, averaging 1.75% in 2016 and 1.77% in 2015	$	92,500	$	87,833

Advances are paid either on a monthly basis or at maturity.  All advances require a prepayment penalty, and are secured by the Federal Home Loan Bank stock and substantially all first-mortgage residential, multi-family and farm real estate loans.

Scheduled principal payments due on advances during the years subsequent to December 31, 2016 are as follows

(in thousands):

2017	$	15,656
2018		17,691
2019		12,433
2020		19,275
2021		7,401
Thereafter		20,044
	$	92,500

NOTE 11 - SUBORDINATED DEBENTURES

In August 2003, the Company formed Kentucky Bancshares, Statutory Trust I (“Trust”).  The Trust issued $217 thousand of common securities to the Company and $7 million of trust preferred securities as part of a pooled offering of such securities.  The Company issued $7.2 million subordinated debentures to the Trust in exchange for the proceeds of the offering, which debentures represent the sole asset of the Trust.  The debentures paid interest quarterly at 7.06% for the first 5 years.  Starting September 2008, the rate converted to three-month LIBOR plus 3.00% adjusted quarterly, which was 4.00% at year-end 2016.  The Company is not considered the primary beneficiary of this Trust (variable interest entity), therefore the trust is not consolidated in the Company’s financial statements, but rather the subordinated debentures are shown as a liability.

65

The Company may redeem the subordinated debentures, in whole or in part, beginning September 2008 at a price of 100% of face value.  The subordinated debentures must be redeemed no later than 2033.  The Company has the option to defer interest payments on the subordinated debentures from time to time for a period not to exceed five consecutive years.

The subordinated debentures may be included in Tier I capital (with certain limitations applicable) under current regulatory guidelines and interpretations.

NOTE 12 - INCOME TAXES

Income tax expense was as follows (in thousands):

	2016		2015		2014
Current	$	1,082	$	629	$	853
Deferred		(309)		(99)		44
	$	773	$	530	$	897

Year-end deferred tax assets and liabilities were due to the following (in thousands).  No valuation allowance for the realization of deferred tax assets is considered necessary.

	2016		2015
Deferred tax assets
Allowance for loan losses	$	2,589	$	2,233
Other real estate owned		237		295
Nonaccrual loan interest		54		36
Accrued expenses		212		189
Acquisition market value adjustments		571		814
AMT tax credit		92		200
General business tax carryforward		—		244
Net operating loss carryforward		—		116
Unrealized loss on securities		492		—
Low income housing investments		150		—
Unearned income		362		—
Other		88		82
Deferred tax liabilities
Unrealized gain on securities		—		(185)
Bank premises and equipment		(1,041)		(1,109)
FHLB stock		(1,308)		(1,308)
Prepaid expenses		(260)		(263)
Mortgage servicing rights		(434)		(434)
Core deposit intangibles		(180)		(262)
Low income housing investments		—		(69)
Acquisition loan loss recapture		(236)		(193)
Other		(194)		(178)
Net deferred tax asset	$	1,194	$	208

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Effective tax rates differ from federal statutory rates applied to financial statement income due to the following:

	2016		2015		2014
U. S. federal income tax rate	34.0	%	34.0	%	34.0	%
Changes from the statutory rate
Tax-exempt interest income	(14.1)		(16.3)		(14.7)
Historic and low income tax credits	(9.4)		(8.2)		(7.0)
Insurance captive	(3.3)		(3.7)		(1.8)
Non-deductible interest expense related to carrying tax-exempt investments	0.4		0.4		0.4
Non-deductible merger expenses	—		0.9		—
Other	0.7		0.1		0.4
	8.3	%	7.2	%	11.3	%

Federal income tax laws provided the First Federal Savings Bank, acquired by the Company in 2003, with additional bad debt deductions through 1987, totaling $1.3 million.  Accounting standards do not require a deferred tax liability to be recorded on this amount, which otherwise would total a $441 thousand liability at December 31, 2016.  The Company’s acquisition of First Federal Savings Bank did not require the recapture of the bad debt reserve.  However, if Kentucky Bank was liquidated or otherwise ceased to be a bank, or if tax laws were to change, the $441 thousand would be recorded as expense.

Unrecognized Tax Benefits

The Company does not have any beginning and ending unrecognized tax benefits. The Company does not expect the total amount of unrecognized tax benefits to significantly increase or decrease in the next twelve months.

There were no interest and penalties recorded in the income statement or accrued for the years ended December 31, 2016 and 2015.

The Company and its subsidiaries file a consolidated U.S. Corporation income tax return and a corporate income tax return in the state of Kentucky.  The Company is no longer subject to examination by taxing authorities for years before 2013.

NOTE 13 - EARNINGS PER SHARE

The factors used in the earnings per share computation follow (in thousands):

	2016		2015		2014
Basic Earnings Per Share
Net income	$	8,569	$	6,832	$	7,071
Weighted average common shares outstanding		2,991		2,842		2,721
Basic earnings per share	$	2.87	$	2.40	$	2.60
Diluted Earnings Per Share
Net income	$	8,569	$	6,832	$	7,071
Weighted average common shares outstanding		2,991		2,842		2,721
Add effect of dilutive shares		—		—		—
Weighted average common shares outstanding including dilutive shares		2,991		2,842		2,721
Diluted earnings per share	$	2.87	$	2.40	$	2.60

Stock options of 1,200 shares common stock from 2016, 2,400 shares common stock from 2015 and 12,625 shares common stock from 2014 were excluded from diluted earnings per share because their impact was antidilutive.  No  restricted stock grants for 2016, 2015 and 2014 were excluded from diluted earnings per share because their impact was antidilutive.

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NOTE 14 - RETIREMENT PLAN

The Company has a qualified profit sharing plan which covers substantially all employees and includes a 401(k) provision.  Profit sharing contributions, excluding the 401(k) provision, are at the discretion of the Company’s Board of Directors.  Expense recognized in connection with the plan was $925 thousand, $815 thousand and $729 thousand in 2016, 2015 and 2014.

NOTE 15 - STOCK BASED COMPENSATION

The Company has four share based compensation plans as described below.  Total compensation cost that has been charged against income for those plans was $153 thousand, $133 thousand, and $111 thousand for 2016, 2015 and 2014. 

Two Stock Option Plans

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 issuance 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 various assumptions.  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.  No options were granted in 2016, 2015 or 2014.

Summary of activity in the two expired stock option plans for 2016 follows:

				Weighted
		Weighted		Average
		Average		Remaining	Aggregate
		Exercise		Contractual	Intrinsic
	Shares	Price		Term	Value
Outstanding, beginning of year	2,400	$	30.37
Granted	—		—
Forfeited or expired	(1,200)		29.75
Exercised	—		—
Outstanding, end of year	1,200	$	31.00	9.2 months	$	1,800
Vested and expected to vest	1,200	$	31.00	9.2 months	$	1,800
Exercisable, end of period	1,200	$	31.00	9.2 months	$	1,800

Options outstanding at year-end 2016 were as follows:

		Outstanding		Exercisable
		Weighted
		Average	Weighted		Weighted
		Remaining	Average		Average
		Contractual	Exercise		Exercise
Range of Exercise Prices	Options	Life (Months)	Price	Options	Price
From $31.00 to $31.00 per share	1,200	9.2	$ 31.00	1,200	$ 31.00

As of December 31, 2016, there was $0 of total unrecognized compensation cost related to nonvested stock options granted under the Plan.  Since both stock option plans have expired, as of December 31, 2016, neither plan allows for additional options to be issued.

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2005 Restricted Stock Grant Plan

Under its expired 2005 Restricted Stock Grant Plan, total shares issuable under the plan were 50,000.  There were no shares issued during 2016 and 5,385 shares issued during 2015.  There were 916 shares forfeited during 2016 and 88 shares forfeited during 2015.

A summary of changes in the Company’s nonvested shares for the year follows:

		Weighted-Average		Fair
		Grant-Date		Value
Nonvested Shares	Shares	Fair Value		Per Share
Nonvested at January 1, 2016	17,551	$	404,351	$	23.04
Granted	—		—		—
Vested	(5,999)		(128,453)		21.41
Forfeited	(916)		(22,380)		24.43
Nonvested at December 31, 2016	10,636	$	253,518	$	23.84

As of December 31, 2016, there was $160 thousand of total unrecognized compensation cost related to nonvested shares granted under the Plan.  The cost is expected to be recognized over a weighted-average period of 2.4 years.  The total grant-date fair value of shares vested during the years ended December 31, 2016, 2015 and 2014 was $128 thousand, $105 thousand and $88 thousand. The vesting-date fair value of shares vested during 2016, 2015 and 2014 is immaterially different when compared to the grant-date fair value. Since the plan has expired, as of December 31, 2016, no additional restricted stock share awards  will be issued.

2009 Stock Award Plan

On May 13, 2009, the Company’s stockholders approved a stock award plan that provides for the granting of both incentive and nonqualified stock options and other share based awards.  Total shares issuable under the plan are 150,000.  There were 6,170 shares issued during 2016 and 1,465 shares issued during 2015.  There were 265 shares forfeited during 2016 and none during 2015.

A summary of changes in the Company’s nonvested shares for the year follows:

		Weighted-Average		Fair
		Grant-Date		Value
Nonvested Shares	Shares	Fair Value		Per Share
Nonvested at January 1, 2016	1,945	$	54,024	$	27.78
Granted	6,170		182,941		29.65
Vested	(553)		(15,255)		27.59
Forfeited	(265)		(7,857)		29.65
Nonvested at December 31, 2016	7,297	$	213,853	$	29.31

As of December 31, 2016 there was $172 thousand of total unrecognized compensation cost related to nonvested shares granted under the Plan.  The cost is expected to be recognized over a weighted-average period of 3.9 years.  The total grant-date fair value of shares vested during the years ended December 31, 2016, 2015 and 2014 was $15 thousand, $6 thousand and $4. The vesting-date fair value of shares vested during 2016, 2015 and 2014 is immaterially different when compared to the grant-date fair value. As of December 31, 2016, the 2009 stock award plan allows for additional restricted stock share awards of up to 142 thousand shares.

NOTE 16 - LIMITATION ON BANK DIVIDENDS

The Company’s principal source of funds is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid by the Bank without prior approval of regulatory agencies.  Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net profits, as defined, combined with the retained net profits of the preceding two years.  During 2017 the Bank could, without prior approval, declare dividends on any 2017 net profits retained to the date of the dividend declaration plus $5.6 million.

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NOTE 17 - FAIR VALUE

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  There are three levels of inputs that may be used to measure fair values:

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 company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Company used the following methods and significant assumptions to estimate the fair value:

Securities Available for Sale and Trading Assets:  The fair values for investment securities and trading assets are determined by quoted market prices, if available (Level 1).  For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2).  For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3).

Impaired Loans:  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 usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification.  Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted in accordance with the allowance policy.  

Other Real Estate Owned:  Assets acquired through, or instead of, loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis.  These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals which are updated no less frequently than annually. 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 independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.  Real estate owned properties are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

Loan Servicing Rights:  Fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively based on a valuation model that calculates the present value of estimated future net servicing income, resulting in a Level 3 classification.

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Assets and Liabilities Measured on a Recurring Basis

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 tables below.

2016

			Quoted Prices
			In Active
			Markets for		Significant Other		Significant
			Identical		Observable		Unobservable
	Carrying		Assets		Inputs		Inputs
Description	Value		(Level 1)		(Level 2)		(Level 3)
U. S. government agencies	$	36,528	$	—	$	36,528	$	—
States and municipals		91,132		—		91,132		—
Mortgage-backed - residential		145,770		—		145,770		—
Equity securities		340		340		—		—
Trading Assets		5,592		1,608		3,984		—
Total	$	279,362	$	1,948	$	277,414	$	—

			Quoted Prices
			In Active
			Markets for		Significant Other		Significant
			Identical		Observable		Unobservable
	Carrying		Assets		Inputs		Inputs
Description	Value		(Level 1)		(Level 2)		(Level 3)
U. S. government agencies	$	48,863	$	—	$	48,863	$	—
States and municipals		91,962		—		91,962		—
Mortgage-backed - residential		123,043		—		123,043		—
Equity securities		344		344		—		—
Trading Assets		5,531		1,617		3,914		—
Total	$	269,743	$	1,961	$	267,782	$	—

There were no transfers between level 1 and level 2 during 2016 or 2015.

Assets measured at fair value on a non-recurring basis are summarized below:

	Fair Value Measurements at December 31, 2016 Using :
			Quoted Prices
			In Active
			Markets for		Significant Other		Significant
			Identical		Observable		Unobservable
	Carrying		Assets		Inputs		Inputs
(In thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Description
Impaired loans:
Real Estate Mortgage:
1-4 family Residential	$	1,685	$	—	$	—	$	1,685
Agricultural		2,234		—		—		2,234
Other real estate owned, net:
Residential		956		—		—		956
Commercial		272		—		—		272
Loan servicing rights		1,083		—		—		1,083

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	Fair Value Measurements at December 31, 2015 Using :
			Quoted Prices
			In Active
			Markets for		Significant Other		Significant
			Identical		Observable		Unobservable
	Carrying		Assets		Inputs		Inputs
(In thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Description
Impaired loans:
Real Estate Mortgage:
Multi-family residential	$	540	$	—	$	—	$	540
Non-farm & non-residential		285		—		—		285
Agricultural		—		—		—		—
Other real estate owned, net:
Residential		1,504		—		—		1,504
Loan servicing rights		87		—		—		87

Impaired loans measured for impairment using the fair value of the collateral had a net carrying amount of  $3.9 million, with a valuation allowance of $502 thousand at December 31, 2016.  During 2016, four new loans became impaired resulting in an additional provision for loan losses of $427 thousand.  The total allowance for specific impaired loans decreased $107 thousand for the year ending December 31, 2016.  At December 31, 2015, impaired loans measured for impairment using the fair value of the collateral had a net carrying amount of $825 thousand, with a valuation allowance of $170 thousand, resulting in an additional provision for loan losses of $170 thousand for the year ending December 31, 2015.

Other real estate owned measured at fair value less costs to sell, had a net carrying amount of $1.2 million, which is made up of the outstanding balance of $2.0 million, net of a valuation allowance of $803 thousand at December 31, 2016.  Write-downs of other real estate totaled $187 thousand for the year ending December 31, 2016.  At December 31, 2015, other real estate owned measured at fair value less costs to sell, had a net carrying amount of $1.5 million, which was made up of the outstanding balance of $2.1 million, net of a valuation allowance of $616 thousand at December 31, 2015. Write-downs of other real estate totaled $252 thousand for the year ending December 31, 2015.

Certain impaired loan servicing rights, which are carried at lower of cost or fair value, were carried at their fair value of $1.1 million, which is made up of the outstanding balance of $1.2 million, net of a valuation allowance of $125 thousand at December 31, 2016.  Net write-downs for the loan servicing rights totaled $105 thousand for the year ending December 31, 2016.  At December 31, 2015, impaired loan servicing rights were carried at their fair value of $87 thousand, which is made up of the outstanding balance of $106 thousand, net of a valuation allowance of $20 thousand at December 31, 2015. Net Recoveries for prior write-downs were recorded in the amount of $59 thousand for the year ending December 31, 2015.

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The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at December 31, 2016 and 2015:

					Range
December 31, 2016	Fair		Valuation	Unobservable	(Weighted
(In thousands)	Value		Technique(s)	Input(s)	Average)
Impaired loans
Real estate mortgage:
1-4 family residential	$	1,685	sales comparison	adjustment for differences between the comparable sales	0%-21%	(10)%
Agricultural		2,234	sales comparison	adjustment for differences between the comparable sales	2%-75%	(9)%
Other real estate owned:
Residential		956	sales comparison	adjustment for differences between the comparable sales	1%-16%	(9)%
Commercial		272	income approach	capitalization rate	10%-10%	(10)%
Loan Servicing Rights		1,083	discounted cash flow	constant prepayment rates	8%-45%	(13)%

					Range
December 31, 2015	Fair		Valuation	Unobservable	(Weighted
(In thousands)	Value		Technique(s)	Input(s)	Average)
Impaired loans
Real estate mortgage:
1-4 family residential	$	540	sales comparison	adjustment for differences between the comparable sales	1%-12%	(7)%
Non-farm & non-residential		285	sales comparison	adjustment for differences between the comparable sales	23%-31%	(27)%
Other real estate owned:
Residential		1,504	sales comparison	adjustment for differences between the comparable sales	10%-28%	(19)%
			income approach	capitalization rate	10%-10%	(10)%
Loan Servicing Rights		87	discounted cash flow	constant prepayment rates	8%-21%	(11)%

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Fair Value of Financial Instruments

The carrying amounts and estimated fair values of financial instruments, at December 31, 2016 and December 31, 2015 are as follows:

December 31, 2016:

	Carrying
(in thousands)	Value		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	43,250	$	43,250	$	—	$	—	$	43,250
Interest bearing deposits		5,029		5,029		—		—		5,029
Securities		273,770		340		273,430		—		273,770
Trading assets		5,592		1,608		3,984		—		5,592
Loans held for sale		724		—		750		—		750
Loans, net		648,466		—		—		648,234		648,234
FHLB Stock		7,034		—		—		—		N/A
Interest receivable		3,715		—		1,334		2,381		3,715
Financial liabilities
Deposits	$	802,981	$	607,617	$	195,528	$	—	$	803,145
Securities sold under agreements to repurchase		20,873		—		21,006		—		21,006
Long-term Federal Home Loan Bank advances		92,500		—		91,015		—		91,015
Note payable		4,090				4,564				4,564
Subordinated debentures		7,217		—		—		7,210		7,210
Interest payable		692		—		639		53		692

December 31, 2015:

	Carrying
(in thousands)	Value		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	28,048	$	28,048	$	—	$	—	$	28,048
Interest bearing deposits		4,874		4,874		—		—		4,874
Securities		264,212		344		263,868		—		264,212
Trading assets		5,531		1,617		3,914		—		5,531
Mortgage loans held for sale		624		—		633		—		633
Loans, net		617,600		—		—		616,206		616,206
FHLB Stock		7,034		—		—		—		N/A
Interest receivable		3,681		—		1,358		2,323		3,681
Financial liabilities
Deposits	$	758,981	$	557,146	$	203,192	$	—	$	760,338
Securities sold under agreements to repurchase		18,514		—		18,523		—		18,523
FHLB advances		87,833		—		82,349		—		82,349
Note payable		4,794		—		5,431		—		5,431
Subordinated debentures		7,217		—		—		7,206		7,206
Interest payable		659		—		649		10		659

The methods and assumptions, not previously presented, used to estimate fair value are described as follows:  Carrying amount is the estimated fair value for cash and cash equivalents, interest bearing deposits, accrued interest receivable and payable, demand deposits, short-term debt, and variable rate loans or deposits that reprice frequently and fully.  The methods for determining the fair values for securities were described previously. 

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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 (including consideration of widening credit spreads). The method used to determine the fair value of loans does not necessarily represent an exit price. Fair value of debt is based on current rates for similar financing.  It was not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability.  The fair value of off-balance sheet items is not considered material.

NOTE 18 - OFF-BALANCE SHEET ACTIVITIES AND COMMITMENTS

Some financial instruments, such as loan commitments, credit lines, letters of credit, and overdraft protection, are issued to meet customer financing needs. These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met, and usually have expiration dates.  Commitments may expire without being used.  Off-balance sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated.  The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment.

Financial instruments with off-balance sheet risk were as follows at year-end (in thousands):

		2016				2015
		Fixed Rate		Variable Rate		Fixed Rate		Variable Rate
Unused lines of credit	$	—	$	102,088	$	—	$	96,581
Commitments to make loans		12,526		17,040		9,854		11,894
Letters of credit		—		463		—		805

Unused lines of credit are substantially all at variable rates.  Commitments to make loans are generally made for a period of 60 days or less and are originated at current market rates ranging from 2.88% to 6.78% with maturities ranging up to 30 years.

NOTE 19 - 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 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.

The final rules implementing the Basel Committee on Banking Supervision’s capital guidelines for US banks (Basel III rules) became effective for the Company on January 1, 2015 with full compliance with all of the requirements being phased in over a multi-year schedule, and fully phased in by January 1, 2019.  Under the Basell III rules, the Company must hold a capital conservation buffer above the adequately capitalized risk-based capital ratios.  The capital conservation buffer is being phased in from 0.0% for 2015 to 2.50% by 2019.  The capital conservation buffer for 2016 is 0.625%.  The net unrealized gain or loss on available for sale securities is not included in computing regulatory capital.

Management believes as of December 31,2016, the Company and the Bank meet all capital adequacy requirements to which they are subject.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of Total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital to average assets (as defined).  Management believes, as of December 31, 2016 and 2015, that the Bank meets all capital adequacy requirements to which they are subject.

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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, exclusive of the capital conservation buffer, 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)
December 31, 2016
Consolidated
Total Capital (to Risk-Weighted Assets)	$	94,343	13.9	%	$	54,280	8.0	%		N/A	N/A
Tier I Capital (to Risk-Weighted Assets)		86,718	12.8			40,710	6.0			N/A	N/A
Common Equity Tier 1 Capital (to Risk-Weighted Assets)		79,718	11.8			30,533	4.5			N/A	N/A
Tier I Capital (to Average Assets)		86,718	8.7			39,795	4.0			N/A	N/A
Bank Only
Total Capital (to Risk-Weighted Assets)	$	95,118	14.0	%	$	54,246	8.0	%	$	67,808	10.0	%
Tier I Capital (to Risk-Weighted Assets)		87,493	12.9			40,685	6.0			54,246	8.0
Common Equity Tier 1 Capital (to Risk-Weighted Assets)		87,493	12.9			30,513	4.5			44,075	6.5
Tier I Capital (to Average Assets)		87,493	8.8			39,671	4.0			49,588	5.0
December 31, 2015
Consolidated
Total Capital (to Risk-Weighted Assets)	$	88,456	13.3	%	$	53,025	8.0	%		N/A	N/A
Tier I Capital (to Risk-Weighted Assets)		81,849	12.4			39,769	6.0			N/A	N/A
Common Equity Tier 1 Capital (to Risk-Weighted Assets)		74,849	11.3			29,827	4.5			N/A	N/A
Tier I Capital (to Average Assets)		81,849	8.6			38,232	4.0			N/A	N/A
Bank Only
Total Capital (to Risk-Weighted Assets)	$	90,855	13.7	%	$	52,981	8.0	%	$	66,227	10.0	%
Tier I Capital (to Risk-Weighted Assets)		84,248	12.7			39,736	6.0			52,981	8.0
Common Equity Tier 1 Capital (to Risk-Weighted Assets)		84,248	12.7			29,802	4.5			43,047	6.5
Tier I Capital (to Average Assets)		84,248	8.9			38,124	4.0			47,654	5.0

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NOTE 20 - PARENT COMPANY FINANCIAL STATEMENTS

Condensed Balance Sheets

December 31

	2016		2015
	(In Thousands)
ASSETS
Cash on deposit with subsidiaries	$	1,317	$	500
Investment in subsidiaries		102,658		100,495
Securities available for sale		70		70
Other assets		287		369
Total assets	$	104,332	$	101,434
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities
Note payable	$	4,090	$	4,794
Subordinated debentures		7,217		7,217
Other Liabilities		53		10
Stockholders’ equity
Preferred stock		—		—
Common stock		20,767		20,730
Retained earnings		73,161		68,324
Accumulated other comprehensive income (loss)		(956)		359
Total liabilities and stockholders’ equity	$	104,332	$	101,434

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Condensed Statements of Income and Comprehensive Income

Years Ended December 31

	2016		2015		2014
	(In Thousands)
Income
Dividends from subsidiaries	$	5,700	$	4,200	$	4,100
Interest income		—		—		—
Total income		5,700		4,200		4,100
Expenses
Interest expense		482		347		230
Other expenses		209		644		385
Total expenses		691		991		615
Income before income taxes and equity in undistributed income of subsidiaries		5,009		3,209		3,485
Applicable income tax benefits		235		269		209
Income before equity in undistributed income of subsidiaries		5,244		3,478		3,694
Equity in undistributed income of subsidiaries		3,325		3,354		3,377
Net income		8,569		6,832		7,071
Other comprehensive income (loss), net of tax:
Unrealized gains (losses) on securities arising during the period		(1,126)		(160)		6,555
Reclassification of realized amount		(189)		(272)		(638)
Other comprehensive income (loss)		(1,315)		(432)		5,917
Comprehensive income	$	7,254	$	6,400	$	12,988

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Condensed Statements of Cash Flows

Years Ended December 31

	2016		2015		2014
	(In Thousands)
Cash flows from operating activities
Net income	$	8,569	$	6,832	$	7,071
Adjustments to reconcile net income to net cash from operating activities
Equity in undistributed earnings of subsidiaries		(3,325)		(3,354)		(3,377)
Change in other assets		82		12		(109)
Change in other liabilities		43		(49)		50
Net cash from operating activities		5,369		3,441		3,635
Cash flows from investing activities
Acquisition of Madison Financial Corporation		—		(229)		—
Investment in captive insurance subsidiary		—		—		(250)
Net cash from investing activities		—		(229)		(250)
Cash flows from financing activities
Proceeds from issuance of long-term debt		—		5,000		—
Payments on note payable		(704)		(206)		—
Dividends paid		(3,229)		(2,972)		(2,721)
Payment to repurchase preferred stock		—		(6,066)		—
Proceeds from issuance of common stock		49		2		—
Purchase of common stock		(668)		(31)		(111)
Net cash from financing activities		(4,552)		(4,273)		(2,832)
Net change in cash		817		(1,061)		553
Cash at beginning of year		500		1,561		1,008
Cash at end of year	$	1,317	$	500	$	1,561

NOTE 21 - QUARTERLY FINANCIAL DATA (UNAUDITED)

(in thousands, except per share data)

	Interest		Net Interest		Net		Earnings Per Share
	Income		Income		Income		Basic		Fully Diluted
2016
First quarter	$	9,098	$	8,009	$	1,837	$	0.61	$	0.61
Second quarter		9,086		7,985		2,082		0.70		0.70
Third quarter		9,206		8,066		2,365		0.79		0.79
Fourth quarter		9,164		8,068		2,285		0.77		0.77
2015
First quarter	$	7,731	$	6,763	$	1,515	$	0.56	$	0.56
Second quarter		7,835		6,863		2,122		0.77		0.77
Third quarter		8,641		7,598		1,541		0.52		0.52
Fourth quarter		8,978		7,911		1,654		0.55		0.55

The Company recorded an additional $747 in other income during the second quarter of 2015 for the settlement of a legal matter.

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NOTE 22 - ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following is changes in Accumulated Other Comprehensive Income (Loss) by component, net of tax, for the years ending December 31, 2016 and 2015 (in thousands):

	Unrealized
	Gains and Losses on
	Available for Sale
	Securities
	For the Year Ended December 31,
	2016		2015
Beginning Balance	$	359	$	791
Unrealized holding gains (losses) for the period, net of tax		(1,126)		(160)
Less reclassification adjustment for:
Securities gains realized in income		287		412
Income taxes		(98)		(140)
		189		272
Net current period other comprehensive income (loss)		(1,315)		(432)
Ending balance	$	(956)	$	359

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NOTE 23 – ACQUISITION OF MADISON FINANCIAL CORPORATION

On July 24, 2015, the Company acquired Madison Financial Corporation and its wholly-owned subsidiary, Madison Bank, both of which were headquartered in Richmond, Kentucky.  As a result of the acquisition the Company expanded its presence into central Kentucky with minimal overlap of its existing market footprint and generate long-term value for the Company shareholders.  Madison Bank had $116.1 million in total assets and operated three financial centers. 

The total purchase price for Madison Financial Corporation was $7.9 million net of capital stock issuance costs, consisting of $3 thousand cash for fractional shares and the issuance of 263,361 shares of the Company’s common stock valued at $7.9 million net of capital stock issuance costs.  The acquisition was accounted for under the acquisition method of accounting.  Accordingly, the Company recognized amounts for identifiable assets acquired and liabilities assumed at their estimated acquisition date fair values, while approximately $858 thousand of transaction and integration costs associated with the acquisition were expensed as incurred.  Of the total purchase price, $884 thousand was allocated to goodwill which is not considered deductible for tax purposes.

Based on management’s valuation of the fair value of tangible and intangible assets acquired and liabilities assumed, the purchase price for the Madison Financial Corporation acquisition is allocated as follows (in thousands):

Cash and cash equivalents	$	3,517
Interest-bearing deposits in other financial institutions		2,979
Securities available for sale		27,704
Loans		77,729
Federal Home Loan Bank Stock		1,053
Accrued interest receivable		309
Premises and equipment		789
Other real estate		445
Deferred tax assets		624
Core deposit intangible asset		800
Other assets		116
Total assets acquired	$	116,065
Deposits	$	95,823
Other borrowings		6,245
Accrued interest payable		59
Other liabilities		817
Total liabilities assumed	$	102,944
Liquidation amount of preferred stock including unpaid dividends and interest		6,066
Total identifiable net assets	$	7,055
Goodwill		884
	$	7,939

The fair value of net assets acquired includes fair value adjustments to certain loan receivables that were not considered impaired as of the acquisition date.  The fair value adjustments were determined using discounted contractual cash flows.  However, the Company believes that all contractual cash flows related to these loans will be collected. 

As such, these loan receivables were not considered impaired at the acquisition date and were not subject to the guidance relating to purchase credit impaired loans, which have shown evidence of credit deterioration since origination.  Loan receivables acquired that were not subject to these requirements include non-impaired loans with a fair value and gross contractual amounts receivable of $73.6 million and $74.7 million as of the date of acquisition.

Item 9.     Changes In and Disagreements with Accountants on Accounting and Financial Disclosure

None

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Item 9A.  Controls and Procedures

Evaluation of Disclosure Controls.  Our Chief Executive Officer and Chief Financial Officer, with the participation of management, have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this annual report on Form 10-K.  Based on their evaluation, they have concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report to ensure that the Company is able to collect, process and disclose the information it is required to disclose in the reports it files with the SEC within the required time periods.

Management’s Report on Internal Control Over Financial Reporting.

General Overview of Internal Controls over Financial Reporting.  Management of the Company is responsible for establishing and maintaining effective internal control over financial reporting as defined in Rules 13a-15(f) under the Securities Exchange Act of 1934.

The Company’s internal control over financial reporting is designed to provide reasonable assurance to the Company’s management and Board of Directors regarding the reliability of financial reporting and the preparation and fair presentation of published financial statements.  All internal controls, however, have inherent limitations regardless of how well they have been designed.

General Description of Internal Control over Financial Reporting.  Internal control over financial reporting refers to a process designed by, or under the supervision of, the Company’s Chief Executive Officer and Chief Financial Officer and effected by the Company’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles and includes those policies and procedures that:

(1)  Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of Company assets;

(2)  Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that Company’s receipts and expenditures are being made only in accordance with the authorization of Company’s management and members of the Company’s Board of Directors; and

(3)  Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisitions, uses or dispositions of Company assets that could have a material effect on the Company’s financial statements.

Inherent Limitations in Internal Control over Financial Reporting.  Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations.  Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures.  Internal control over financial reporting also can be circumvented or overridden by collusion or other improper activities.  Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting.  However, these inherent limitations are known features of the financial reporting process, and it is possible to design into the process safeguards to reduce, though not eliminate, this risk.

Management’s Assessment of the Company’s Internal Control over Financial Reporting.  Management, with participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s internal control over financial reporting as of December 31, 2016.

Based on the evaluation, management concluded that the Company’s internal controls over financial reporting were effective to ensure that information required to be disclosed by the Company in reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.  In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in the 2013 Internal Control — Integrated Framework.

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No Changes in Internal Controls over Financial Reporting During Most Recent Quarter.  The Company’s Chief Executive Officer and Chief Financial Officer have also concluded that there were no changes in the Company’s internal control over financial reporting or in other factors that occurred during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting or any corrective actions with regard to significant deficiencies and material weaknesses in internal control over financial reporting.

Attestation Report of Registered Public Accounting Firm.  This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting.  Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.

Item 9B.Other Information

None

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PART III

Item 10.Directors and Executive Officers and Corporate Governance

Set forth below is information about our executive officers who do not serve as Directors, including their business experience for at least the past five years and their ages as of March 20, 2016.

Name	Age	Position with the Company
James B. Braden	38	Senior Vice President, Chief Administrative
		Officer since 2013. Director of Risk Management
		from 2010 to 2012. Previously a Senior Manager
		at a national public accounting firm serving
		financial institutions.
Brenda S. Bragonier	60	Senior Vice President, Director of Marketing
		since 1999.
Carol Caskey	59	Senior Vice President, Director of Human Resources
		since 2011. Previously an Associate Relations
		Consultant at a national health insurance
		carrier.
Gregory J. Dawson	56	Senior Vice President, Chief Financial Officer
		since 1989.
James L. Elliott	70	Senior Vice President, Director of Wealth
		Management since 2013.  Previously a Senior
		Vice President and Group Director of private
		financial services for a financial institution.
Norman J. Fryman	67	Executive Vice President, Chief Credit Officer
		since 2010. Director of Sales and Service
		from 2004 to 2009.
Christopher Gorley	46	Senior Vice President, Director of Operations
		since 2013. Previously a Vice President and
		Chief Operations Officer with a community bank.
Darren Henry	54	Vice President, Director of Commercial Lending since 2005.
William Hough	62	Senior Vice President, Director of Sales and
		Service since 2011. Previously a Market
		President from 2006 to 2010.

The remaining information required by Item 10 is hereby incorporated by reference under the headings “Corporate Governance”, “Section 16(a) Beneficial Ownership Reporting Compliance” and “Proposal No. 2 — Election of Directors” from the Company’s definitive proxy statement in connection with its annual meeting of stockholders scheduled for May 17, 2017, which will be filed with the Commission on or about April 13, 2017, pursuant to Regulation 14A (“2017 Proxy Statement”).

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Item 11.Executive Compensation

The information required by Item 11 is hereby incorporated by reference under the headings “Executive Compensation,” “Report of Compensation Committee” and “Compensation of Named Executive Officers” in the 2017 Proxy Statement.

Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information required by Item 12 is hereby incorporated by reference under the heading “Stock Ownership of Directors and Executive Officers” in the 2017 Proxy Statement.  See Part II, Item 5, for information about securities authorized for issuance under the Company’s equity compensation plans.

Item 13.Certain Relationships and Related Transactions, and Director Independence

The information required by Item 13 is hereby incorporated by reference under the headings “Corporate Governance” and “Transactions with Related Persons” in the 2017 Proxy Statement.

Item 14.Principal Accountant Fees and Services

The information required by Item 14 is hereby incorporated by reference under the heading “Fees of Independent Registered Public Accounting Firm” in the 2017 Proxy Statement.

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Part IV

Item 15.Exhibits, Financial Statement Schedules and Reports on Form 8-K

(a)(1)  Financial Statements

The following financial statements are included in Item 8 of this Form 10-K.

Report of Independent Registered Public Accounting Firm

Consolidated Balance Sheets

Consolidated Statements of Income

Consolidated Statements of Comprehensive Income

Consolidated Statements of Changes in Stockholders’ Equity

Consolidated Statements of Cash Flow

Notes to Consolidated Financial Statements

(a)(2)  Financial Statement Schedules.

All financial statement schedules have been omitted as the required information is inapplicable or the required information has been included in the Consolidated Financial statements or notes thereto.

(a)(3)  Exhibits

Reference is made to the Exhibit Index beginning on Page E-1 hereof.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Kentucky Bancshares, Inc.
By:	/s/Louis Prichard
Louis Prichard, President and Chief Executive Officer, Director
March 30, 2017

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

/s/Louis Prichard	March 30, 2017
Louis Prichard, President and Chief Executive Officer, Director
/s/Gregory J. Dawson	March 30, 2017
Gregory J. Dawson, Chief Financial and Accounting Officer
/s/Buckner Woodford, IV	March 30, 2017
Buckner Woodford, IV, Chairman of the Board, Director
/s/B. Proctor Caudill, Jr.	March 30, 2017
B. Proctor Caudill, Jr., Director
/s/Henry Hinkle	March 30, 2017
Henry Hinkle, Director
/s/Betty J. Long	March 30, 2017
Betty J. Long, Director
/s/Ted McClain	March 30, 2017
Ted McClain, Director
/s/Jack W. Omohundro	March 30, 2017
Jack W. Omonhundro, Director
/s/Edwin S. Saunier	March 30, 2017
Edwin S. Saunier, Director
/s/Robert G. Thompson	March 30, 2017
Robert G. Thompson, Director
/s/Woodford Van Meter	March 30, 2017
Woodford Van Meter, Director

87

Kentucky Bancshares, Inc.

Exhibit Index

2.1	Agreement and Plan of Merger with Peoples Bancorp of Sandy Hook is incorporated by reference to Exhibit 2.1 of the Registrant’s Current Report on Form 8-K dated February 24, 2006.
2.2	Agreement and Plan of Share Exchange with Madison Financial Corporation is incorporated by reference to Exhibit 2.1 of the Registrant’s Current Report on Form 8-K dated January 21, 2015.
3.1	Amended and Restated Articles of Incorporation of the Registrant are incorporated by reference to Exhibit 3.1 of the Registrant’s Quarterly Report on Form 10-Q for the quarterly period ending March 31, 2000.
3.2	Bylaws of the Registrant are incorporated by reference to Exhibit 3.1 of the Registrant’s Current Report on Form 8-K dated November 21, 2007.
3.3	Articles of Amendment to Amended and Restated Articles of Incorporation of the Registrant are incorporated by reference to Exhibit 3.3 of the Registrant’s Annual Report on Form 10-K for the period ending December 31, 2005.
10.1	Kentucky Bancshares, Inc. 1993 Non-Employee Directors Stock Ownership Incentive Plan is incorporated by reference to Exhibit 10.3 of the Registrant’s Registration Statement on Form S-4 (File No. 33-96358).
10.2	Kentucky Bancshares, Inc. 1999 Employee Stock Option Plan is incorporated by reference to Exhibit 99.1 of the Registrant’s Form 10-K for the fiscal year ended December 31, 1998.
10.3	Employment Agreement for Louis Prichard as incorporated by reference to the Registrant’s Current Report on Exhibit 10.1 of the Registrant’s Current Report on Form 8-K dated April 3, 2008.
10.4	2005 Restricted Stock Grant Plan, including form of Award Agreement, as incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K dated February 22, 2005.
10.5	2009 Stock Award Plan, as incorporated by reference to Exhibit 10.1 of the Registrant’s Quarterly Report on Form 10-Q for the quarterly period ending June 30, 2009.
11	Computation of earnings per share - See Note 13 in the notes to the consolidated financial statements included in Item 8.
21	Subsidiaries of Registrant
23	Consent of Crowe Horwath LLP
31.1	Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.
31.2	Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.
32.1	Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101	The following financial information from Kentucky Bancshares, Inc. Annual Report on Form 10-K for the period ended December 31, 2016, filed with the SEC on March 30, 2017, formatted in Extensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets at December 31, 2016 and 2015, (ii) Consolidated Statements of Income and Comprehensive Income (Loss) for the years ended December 31, 2016, 2015 and 2014, (iii) Consolidated Statement of Changes in Stockholders’ Equity for the years ended December 31, 2016, 2015 and 2014, (iv) Consolidated Statements of Cash Flows for the years ended December 31, 2016, 2015 and 2014 and (v) Notes to Consolidated Financial Statements.

88